Identifying and Managing Systemic Risk: An Assessment of Our Progress
Steven L. Schwarcz*
Although a chain of bank failures remains an important symbol of systemic risk, the ongoing trend towards disintermediation—or enabling companies to directly access the ultimate source of funds, the capital (i.e., financial) markets, without going through banks or other financial intermediaries—is making these failures less critical than in the past. While banks and other financial institutions remain important sources of capital, companies today are able to obtain most of their financing through financial markets without the use of intermediaries.[1] As a result, financial markets themselves are increasingly central to any examination of systemic risk.
THE FINANCIAL CRISIS
The relationship between financial markets and systemic risk has been dramatically illustrated by the recent financial crisis. Although the bankruptcy of Lehman Brothers filled the initial headlines, the trigger of the crisis was the collapse of the market for mortgage-backed securities. A significant number of these securities were backed by risky subprime home mortgages, which were expected to be refinanced through home appreciation. When home prices stopped appreciating, the borrowers could not refinance. In many cases, they defaulted. These defaults in turn caused substantial amounts of investment-grade rated securities backed by these mortgages to be downgraded and, in some cases, to default. Investors began losing confidence in these and other rated securities, and their market prices started falling.
Lehman Brothers, which held large amounts of mortgage-backed securities, was particularly exposed. Firms that had been doing business with Lehman—its ‘counterparties’—began demanding additional safeguards, which Lehman could not provide. As a result, absent a government bailout, Lehman could not continue doing business. The refusal of the Government to save Lehman Brothers, and Lehman’s resulting bankruptcy, added to this cascade. Securities markets became so panicked that even the short-term commercial paper market virtually shut down, and the market prices of mortgage-backed securities collapsed substantially below the intrinsic value of the mortgage assets underlying those securities.[2]
The collapse became a death spiral as banks and other financial institutions holding mortgage-backed securities had to write down their value under “mark-to-market” accounting rules. This caused these firms to appear more financially risky, in turn triggering widespread concern over counterparty risk. The high leverage of many of these firms effectively required fire-sales of assets, exacerbating the fall in prices.
Although the Dodd-Frank Act prescribes many steps to attempt to prevent another financial crisis, most of these steps focus on banks and other financial institutions, not on financial markets. Such a limited focus worked well when banks and financial institutions were the primary source of corporate financing. But the financial crisis reveals that this focus is insufficient now that companies obtain much of their financing directly through financial markets—such as through securitization financing.[3] Both financial institutions and financial markets can (if they fail) be triggers, and also transmitters, of systemic risk.
REGULATORY APPROACHES TO SYSTEMIC RISK
So how should we regulate systemic risk? The primary (if not sole) justification for regulating financial risk is the maximization of economic efficiency. Because systemic risk is a form of financial risk, efficiency should be a central goal in its regulation. But systemic risk creates an added regulatory dimension: without regulation, the externalities—harm to third parties—would not be prevented or internalized because systemic risk is a risk to the financial system itself. Market participants are motivated to protect themselves, but they are not as directly motivated to protect the system as a whole.
As a result, there is a type of “tragedy of the commons,” a collective action problem in which the benefits of exploiting finite capital resources accrue to individual market participants, each of whom is motivated to maximize use of the resources, whereas the costs of exploitation, which affect the real economy, are distributed among an even wider class of persons.[4] Any regulation of systemic risk thus should focus not only on traditional efficiency but also on the stability of the financial system.
In examining regulatory approaches to systemic risk, one should also take into account the costs of regulation. There are direct costs, such as hiring government employees to monitor and enforce the regulations. But more importantly there can be indirect costs, such as overregulation that stifles innovation and competitiveness. Subject to that caveat, a range of possible regulatory approaches, aimed at making the financial system more efficient and stable, should be considered when assessing Dodd-Frank.
Averting Panics. The ideal regulatory approach would focus on eliminating the risk of systemic collapse from the outset. This goal could be substantially achieved by preventing financial panics, since they are often the triggers that commence a chain of failures.[5] The recent financial crisis itself, for example, was initially triggered by financial market panic. But any regulation aimed at preventing panics that trigger systemic risk would almost certainly fail to anticipate all the causes of the panics. Furthermore, even when identified, panics cannot always be averted easily because investors are not always rational.[6]
Requiring Increased Disclosure. Another potential regulatory approach is to improve disclosure. Disclosing risks traditionally has been viewed, at least under U.S. securities law, as the primary market-regulatory mechanism.[7] Dodd-Frank puts great stock in the idea of improving disclosure.[8] Disclosure works by reducing, if not eliminating, asymmetric information among market players, making the risks transparent to all. In the context of systemic risk, however, individual market participants who fully understand that risk will be motivated to protect themselves but not necessarily the system as a whole. As a result of the aforesaid tragedy-of-the-commons, a market participant may well decide to engage in a profitable transaction even though doing so could increase systemic risk, since much of the harm from a possible systemic collapse would be externalized.
Furthermore, the efficacy of disclosure is limited by the increasing complexity of transactions and markets.[9] In the financial crisis, for example, there is little question that most, if not all, of the risks regarding the complex mortgage-backed securities were disclosed.[10] Yet many institutional investors bought these securities based primarily on their ratings, without fully understanding them. There are at least four reasons why disclosure failed:
(i) Investors overrelied on heuristics such as rating-agency ratings. Dodd-Frank attempts to fix this problem by focusing on ratings, not on investors.[11] However, the actions of S&P and Moody’s arguably met the Act’s requirements, had those requirements applied during the financial crisis. The real problem is not rating agency failure but investor complacency. Because human nature cannot be easily changed, it is unclear—and Dodd-Frank does not address—how investor complacency can be remedied.
(ii) Investors followed the herd in their investment choices. Again, this is an implacable problem of investor complacency.
(iii) Conflicts of interest were created by short-term management compensation schemes, especially for technically sophisticated secondary managers.[12] For example, as the VaR, or value-at-risk, model for measuring investment-portfolio risk became more accepted, financial firms began compensating secondary managers not only for generating profits but also for generating profits with low risks, as measured by VaR.[13] Thus, secondary managers turned to investment products with low VaR risk profile, like credit-defaults swaps that generate small gains but only rarely have losses. The managers knew, but did not always explain to their superiors, that any losses that might eventually occur would be huge. This is an intra-firm conflict, quite unlike the traditional focus of scholars and politicians on conflicts between senior executives and shareholders. Dodd-Frank attempts to fix the traditional type of conflict but completely ignores the problem of secondary-management conflicts.[14]
(iv) The retention by underwriters of residual risk portions may have fostered false confidence in buyers, in effect creating a mutual misunderstanding. Ironically, this could be exacerbated in the future by Dodd-Frank’s requirement that sellers of securitization products retain a minimum unhedged position in each class of products they sell.[15]
Imposing Financial-Exposure Limits. The failure of one or more large and interconnected institutions could create defaults large enough to de-stabilize other highly-leveraged investors, increasing the likelihood of a systemic market meltdown. This suggests another possible approach to regulation: placing limits on an institution’s financial exposure. The following financial-exposure limits may be considered:
(i) First, the limitation of an institution’s leverage could reduce the risk of failure of that institution in the first place. It could also reduce the likelihood of financial contagion between institutions. However, limiting leverage can create significant costs because some leverage is good, and there is no optimal across-the-board amount of leverage that is right for every institution. The Dodd-Frank Act, however, directs the Federal Reserve to set “prudential” capital standards for certain large financial institutions,[16] including a maximum debt-to-equity ratio of 15:1.[17]
(ii) Second, the limitation of an institution’s right to make risky investments could reduce that institution’s downside risk. It is, however, a highly paternalistic approach, substituting a blanket regulatory prescription for a firm’s own business judgment. One should be highly skeptical of any rule that attempts to protect a sophisticated financial institution from itself. Dodd-Frank’s implementation of the Volker Rule, however, attempts to do precisely that by limiting the ability of banks and certain other financial institutions to engage in “proprietary trading”—essentially investing in securities for their own account.[18]
(iii) Third, the limitation of amounts of inter-institution financial exposure would facilitate stability by diversifying risk, in effect by reducing the losses of any given contractual counterparty and thus the likelihood that such losses would cause the counterparty to fail. Limits might also reduce the urgency, and hence the panic, that contractual counterparties feel about closing out their positions. This approach already applies to banks through lending limits, which restrict the amount of bank exposure to any given customer’s risk. Its application beyond banks to other financial institutions is potentially appealing given the increasing blurring of lines between banks and non-bank financial institutions and the high volumes of financial assets circulating among non-bank financial entities.
It is questionable, though, whether the government should impose financial exposure limits on large financial institutions. These institutions have already tried to protect themselves through risk management and risk mitigation. The financial crisis has raised questions, however, whether conflicts of interest among managers and other failures can undermine institutional risk management. Dodd-Frank addresses this problem by requiring many large public financial firms to establish risk committees, including at least one risk-management expert, responsible for enterprise-wide risk management oversight.[19]
Limiting Financial Institution Size. This is related to financial exposure limits, but this approach also addresses potential moral-hazard from institutions who believe they are “too big to fail.” There is, however, no clear evidence of such risky behavior, and financial institutional losses in the recent financial crisis can be explained by other reasons.
Financial institution size should not be artificially limited. Size should be governed by the economies of scale and scope needed for institutions to successfully compete, domestically and abroad—so long as that size is manageable. We should watch out, however, for institutions that increase their size, especially by acquisition of other institutions, primarily to satisfy senior management egos. Dodd-Frank indirectly addresses this concern (at least weakly) by linking senior executive compensation to long-term results—for example, requiring stock exchanges to adopt standards whereby listed companies implement policies to recoup senior executive compensation in the event of an accounting restatement. [20]
Ensuring Liquidity. Ensuring liquidity could facilitate stability in two ways: by providing liquidity to financial institutions in order to prevent them from defaulting, and by providing liquidity to financial markets as necessary to keep them functioning.
The Federal Reserve Bank has had the role (under §13(3) of the Federal Reserve Act) of lender of last resort by providing liquidity to banks and other financial institutions in order to prevent them from defaulting. [21] However, acting as a lender of last resort to institutions can be costly. By providing a lifeline, a lender of last resort can at least theoretically foster moral hazard by encouraging financial institutions—especially those that believe they are “too big to fail”—to be fiscally reckless. It can also shift costs to taxpayers since loans made to institutions will not be repaid if the institutions eventually fail.
For these reasons, the Dodd-Frank Act sharply limits the power of the Federal Reserve to make emergency loans to individual or insolvent financial institutions. [22] That categorical limitation appears somewhat excessive, though; a lender of last resort can be an important safeguard if it acts judiciously.
One way that Dodd-Frank attempts to avoid the need to make emergency loans is by requiring banks and—to the extent designated as “systemically important”—other financial firms to be subject to a range of capital, leverage, and liquidity requirements[23] and periodic “stress testing.” [24] It also requires these entities to submit a resolution plan (a “living will”) that sets forth how, in the case of failure, the firm would wind down in a way that minimizes systemic impact. [25] The intention behind these provisions is to prevent failure and, if failure occurs, to mitigate the need for emergency loans by allowing the firm to fail in an orderly manner. The ultimate question, though, will be whether the ex ante plan matches the ex post reality.
Regardless of how one views a lender of last resort to financial institutions, the financial crisis has shown that, in an era of disintermediation, more attention needs to be focused on providing liquidity to financial markets as necessary to keep them functioning. This approach should also be less costly than lending to institutions. A market liquidity provider of last resort, especially if it acts at the outset of a market panic, can profitably invest in securities at a deep discount from the market price and still provide a “floor” to how low the market will drop.[26] Buying at a deep discount will mitigate moral hazard and also make it likely that the market liquidity provider will be repaid.
Reducing Complexity. An obvious way to address complexity would be to require investments and other financial products to be more standardized, so market participants do not need to engage in as much due diligence. One of the goals of Dodd-Frank is to standardize more derivatives transactions. To this end, the Act requires many derivatives to be cleared through clearinghouses,[27] which generally require a high degree of standardization[28] in the derivatives they clear.[29] The overall economic impact of standardization is unclear, though, because standardization can interfere with the ability of parties to achieve the efficiencies that arise when firms craft derivatives tailored to particular needs of investors.
RECOMMENDATIONS
Three regulatory initiatives that go beyond Dodd-Frank could address the aforementioned concerns: (1) requiring that managers, including secondary managers, of financial institutions be compensated based more on long-term firm performance; (2) establishing a market liquidity provider of last resort; (3) requiring financial institutions of systemic significance to contribute to a fund that would be used to mitigate systemic externalities.
A market liquidity provider of last resort would have the best chance of minimizing a systemic collapse under any number of circumstances. Chaos theory supports the concept of a market liquidity provider of last resort. In complex engineering systems, as in complex financial markets, failures are inevitable. Therefore modularity is needed to break the transmission of these failures and limit their systemic consequences. Such a mechanism usually exists (or should exist) for banks, in the form of a liquidity provider of last resort; we also need this type of mechanism for complex financial markets.[30]
Recent experience in the financial crisis supports establishment of a market liquidity provider of last resort. In response to the collapse of the commercial paper market, the Federal Reserve created the Commercial Paper Funding Facility (“CPFF”) to act as a lender of last resort for that market, with the goal of addressing “temporary liquidity distortions” by purchasing commercial paper from highly rated issuers that could not otherwise sell their paper.[31] The CPFF apparently helped to stabilize the commercial paper market.[32]
This same approach can be applied more generally to respond to panic in securities market. Say, for example, that the intrinsic value—effectively the present value of the expected value of the underlying cash flows—of a type of mortgage-backed security is estimated to be in the range of 80 cents on the dollar. If the market price of those securities had fallen significantly below that number, say, to 20 cents on the dollar, the market liquidity provider could purchase these securities at, say, 60 cents on the dollar, thereby stabilizing the market and still making a profit. To induce a holder of the mortgage-backed securities to sell at that price, the market liquidity provider could, for example, agree to pay a higher “deferred purchase price” if the securities turn out to be worth more than expected.[33] This is just one (simplified) example of the flexible pricing approaches used in structured financing transactions to buy financial assets of uncertain value which could be adapted to a market liquidity provider’s purchases.[34]
One might ask why, if a market liquidity provider of last resort can invest at a deep discount to stabilize markets and still make money, private investors would not also do so, thereby eliminating the need for some sort of governmental market liquidity provider. One answer is that individuals at investing firms will not want to jeopardize their reputations (and jobs) by causing their firms to invest at a time when other investors have abandoned the market. Another answer is that private investors usually want to buy and sell securities, without having to wait for their maturities; whereas a market liquidity provider of last resort should be able to wait until maturity, if necessary.
The third recommendation—to require financial institutions of systemic significance to contribute to a systemic risk fund—responds to the tragedy-of-the-commons problem by helping to mitigate systemic externalities. This type of approach was originally provided by the Dodd-Frank Act, but it was taken out before enactment because of opposition by politicians who believed (perhaps wrongly) that it would increase moral hazard by institutionalizing bailouts.[35]
A privately-funded systemic risk fund not only can mitigate systemic externalities but also can help minimize the potential for risky behavior caused by institutions that believe they are too big to fail. The too-big-to-fail problem is effectively an externality imposed on government (and ultimately taxpayers) by an institution engaging in such risky behavior. A privately-funded systemic risk fund would help to internalize that externality. Furthermore, the ability of government to require additional contributions to this type of fund should motivate contributors to the fund to monitor each other in order to reduce the potential for such risky behavior.
Recently, the European Commission has been toying with the idea of a systemic risk fund in connection with its proposal to tax the financial sector.[36] Although the ultimate use of the tax revenues is currently unresolved, news reports indicate that an originally contemplated use was a systemic risk fund.[37] The IMF also appears to be using the European Commission tax proposal as a platform to announce that “new taxes on banks [are] needed to provide an insurance fund for future financial meltdowns and to curb excessive risktaking.”[38]
The European Commission recognizes that in order to avoid making the EU financial sector uncompetitive, any tax on the financial sector should be applied in all financial centres. This illustrates a broader principle: because financial markets and institutions increasingly cross sovereign borders, any regulatory approaches must be designed to work in an international context. The Dodd-Frank Act does not, however, fully come to grips with how the U.S. financial regulatory framework should operate, or even fit, as part of a global financial regulatory framework.
CONCLUSION
We have made some, but not nearly enough, progress in identifying and managing systemic risk. Being a political response, Dodd-Frank consists largely of politically targeted responses to the recent financial crisis, at times looking for villains (whether or not they exist) who caused the crisis. To be most effective, however, financial regulation must be situated within an analytical framework that realistically explains how systemic risk is transmitted and why free-market factors do not limit that transmission.[39] The tragedy of the commons, for example, is certainly part of that explanation.[40]
The Dodd-Frank Act nonetheless has the potential to ultimately reach beyond politically targeted responses. The Act delegates much of the regulatory details to administrative rulemaking, in many cases after the relevant government agencies engage in further study. Perhaps even more significantly, the Act creates a Financial Stability Oversight Council, part of whose mission is to monitor and identify potential systemic threats in order to find regulatory gaps. [41] The Council will be aided in this task by a newly-created and, hopefully, nonpartisan Office of Financial Research. [42] In these ways, regulators have the ability to look beyond the Act’s confines. This article has attempted to provide ideas they might pursue.
* Stanley A. Star Professor of Law & Business, Duke University School of Law; Founding/Co-Academic Director, Duke Global Capital Markets Center. E-mail: schwarcz@law.duke.edu. I thank Kenneth Anderson and participants in the George Mason University AGEP Advanced Policy Institute for valuable comments. This article was referenced in Professor Schwarcz’s testimony before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affair on May 18, 2011. The article is itself based on his keynote address at the March 2011 George Mason University AGEP Advanced Policy Institute on Financial Services Regulation.
[2] For example, in July 2008 I was an expert in the Orion Finance SIV case in the English High Court of Justice. Orion’s mortgage-backed securities had a market value of around 22 cents on the dollar, whereas the present value of its reasonably-expected cash flows was around 88 cents on the dollar because most of the mortgages were prime.
[3] Securitization generally involves the issuance by special-purpose entities of securities backed by a wide range of financial assets, such as mortgage loans, and the process of creating and issuing those securities. Steven L. Schwarcz, Regulating Complexity in Financial Markets, 87 Wash. U. L. Rev. 211, 221 (2009).
[6] For an analysis of how regulation can help to mitigate the impact of panic in financial securities markets see infra notes 30-34 and accompanying text.
[7] See, e.g., Cynthia A. Williams, The Securities and Exchange Commission and Corporate Social Transparency, 112 Harv. L. Rev. 1197 (1999) (discussing the general purpose of disclosure in the Exchange Act and the Securities Act).
[8] E.g. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 1103, 124 Stat. 1376, 2118 (2010) (requiring additional disclosure from the Federal Reserve).
[9] This increasing complexitiy may very well be the greatest challenge for the twenty-first century financial system.
[10] See Steven L. Schwarcz, Disclosure’s Failure in the Subprime Mortgage Crisis, 2008 Utah L. Rev. 1109, 1110 (2008).
[12] See Steven L. Schwarcz, Conflicts and Financial Collapse: The Problem of Secondary-Management Agency Costs, 26 Yale J. on Reg. 457 (2009).
[13] See, e.g., Philippe Jorion, Value at Risk: The New Benchmark for Managing Financial Risk 568 (3d ed. 2006).
[14] Dodd-Frank’s attempt to fix the traditional conflict might actually backfire; recent research suggests that shareholders, even more than senior executives, want the company to take risks. See Iman Anabtawi, Who’s the Boss? Re-writing the Rules of Corporate Governance, Chapman Law Review 2011 Symposium Panel (Jan. 28, 2011), available at http://ibc.chapman.edu/Mediasite/Viewer/?peid=1976265402884963a7346be7bc42763b.
[15] See Dodd-Frank Act sec. 941, § 15G (directing the SEC to require sponsors of asset-backed securities to retain at least five percent of the credit risk of the underlying assets).
[26] This is very different from quantitative easing, in which a central bank purchases securities as a form of monetary policy. For example, the U.S. Federal Reserve recently concluded a $600 billion quantitative easing program of purchasing U.S. Treasury securities in order to hold down long-term interest rates. See, e.g., Burton Frierson, Richard Leong, & Chris Reese, Federal Reserve Announces It Will Conclude Quantitative Easing, Huffington Post, June 10, 2011, available at http://www.huffingtonpost.com/2011/06/10/federal-reserve-plans-to-_n_875044.html. In contrast, the task of a market liquidity provider of last resort (as contemplated by this article) would be much more targeted: to prevent market collapses due to panic. See infra notes 32-36 and accompanying text (explaining how a market liquidity provider of last resort would act).
[28] See Martin N. Baily et al., Credit Default Swaps, Clearinghouses, and Exchanges 4 (Squam Lake Working Group on Financial Regulation, Working Paper, July 2009), available at http://www.cfr.org/content/publications/attachments/Squam_Lake_Working_Paper5.pdf.
[29] This can become a little circular, though, because Dodd-Frank includes an exception for derivatives that a clearinghouse will not accept for clearing. Dodd-Frank Act sec. 723(a), § 2(h)(3). Further, the clearinghouse requirement might inadvertently concentrate systemic risk in the clearinghouses themselves.
[31] See Tobias Adrian, Karin Kimbrough, & Dina Marchioni, The Federal Reserve’s Commercial Paper Funding Facility, Fed. Reserve Bank of N.Y. Staff Report No. 423 (April 1, 2010).
[32] Id. at 11 (concluding that “[t]he CPFF indeed had a stabilizing effect on the commercial paper market”).
[33] See Steven L. Schwarcz, Too Big To Fail?: Recasting the Financial Safety Net, in The Panic of 2008 (Lawrence E. Mitchell & Arthur E. Wilmarth, Jr. eds., Edward Elgar 2010), available at http://ssrn.com/abstract=1352563 (where this example was taken from).
[34] Alternatively, the market liquidity provider of last resort could attempt to stabilize the market by entering into derivatives contracts to strip out risks that the market has the greatest difficulty hedging—in effect, the market’s irrationality element—thereby stimulating private investment. By hedging—and not actually purchasing securities directly—the market liquidity provider would appear to be taking less investment risk, and thus its function may be seen as more politically acceptable. Id.
[35] S. Amdt. 3827, 111th Cong. (2010) (eliminating the proposed $50 billion dollar fund, financed by a tax on banks, that would help wind down failed financial companies).
[36] European Commission, Taxation of the Financial Sector, a Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions: (Brussels COM (2010) 549/5; SEC (2010) 1166).
[37] Commission Proposes a Bank Tax to Cover the Costs of Winding Down Banks that Go Bust (May 26, 2010), available at http://ec.europa.eu/news/economy/100526_en.htm (last visited Mar. 1, 2011).
[38] Larry Elliott & Jill Treanor, IMF: Supervise and Tax Banks or Risk Crisis, The Guardian, Oct. 8, 2010, at 25 (London-final ed.) (paraphrasing an announcement by the IMF’s then-Managing Director Dominique Strauss-Kahn).
[39] See, e.g., Iman Anabtawi & Steven L. Schwarcz, Regulating Systemic Risk: Towards an Analytical Framework, 86 Notre Dame L. Rev., issue no. 4 (forthcoming Spring 2011).
[40] See Steven L. Schwarcz, Understanding the Subprime Financial Crisis, 60 S.C. L. Rev. 549 (2009) (arguing that the failures giving rise to the recent financial crisis can be attributed conceptually to at least four market imperfections: conflicts of interest, complacency of investors and other market participants, complexity of financial markets and of the securities traded therein, and the tragedy of the commons).
Inaugural Issue Now Available (Spring 2011)
The Harvard Business Law Review is pleased to announce the publication of its inaugural issue. By focusing on specific aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act, each of the following scholars helps to illuminate the merits and missteps of this century’s most sweeping financial reform. It features articles from leading authorities such as Lynn Stout, Charles K. Whitehead, P. Morgan Ricks, Annette L. Nazarath, Margaret E. Tahyar, Richard W. Painter, and John C. Coffee, Jr. Issue 1 also has a foreword by Professor Lucian Bebchuk, along with special introductions by Congressmen Ed Towns and Bobby Rush. Check out Volume 1-Issue 1 today!
Why the Federal Reserve is Dodd-Frank’s Big Winner
Evan Schnidman*
At the height of the financial crisis, pundits and politicians were telling us all to expect an overhaul of financial regulation that would result in a brand new financial system.[1] Those of us who study such matters knew the term “overhaul” was a bit hyperbolic, but genuine reform was certainly anticipated, and some might argue that Dodd-Frank was that genuine reform. Despite all the ink spilled about the impacts of Dodd-Frank, the post-crisis financial structure fails to look dramatically different than before. If anything, the major change in the post-crisis financial regulatory system is an increasingly powerful Federal Reserve.[2]
Recent disclosures[3] have indicated that, at the height of the financial crisis the Fed’s balance sheet tripled from about $800 billion to roughly $2.5 trillion[4] as it took on an increasingly prominent role as a national lender of last resort; perhaps more striking is the fact that much of these expenditures were loans to foreign banks.[5] This foreign lending illustrates that, in addition to serving as a domestic lender of last resort, the Fed is taking an increasingly prominent role as an international or systemic lender of last resort.[6]
Beyond the Fed’s increased lender of last resort capacity,[7] and partially as a result of Dodd-Frank, the Fed is newly empowered to take on more regulatory enforcement issues.[8] The significance of the Fed as a regulator is not a result of statutory authority—since many other regulators have similar legal authority to regulate[9]—but the fact that the Federal Reserve is self-funded.[10] No other financial regulator is self-funded.[11] This is of particular significance when it comes to enforcing financial regulations in the wake of a recession.
As the parable goes, “in the land of the blind, the man with one eye is king;” likewise, in the land of underfunded regulatory agencies, the independently funded agency is powerful. As a result of this independent funding the Fed has taken on an increasingly prominent role in the domestic regulatory environment.[12] But this increased power is not all the Fed’s doing; much of it is tied to the compromise reached over Dodd-Frank.
In their effort to reach common ground on a central piece of the legislation, moderate Republicans compromised with the Democratic leadership of the 111th Congress, agreeing to a weaker Consumer Financial Protection Bureau (CFPB) housed in the Federal Reserve rather than as a stand-alone agency. The Republican opposition did not account for the fact that a CFPB housed in the Fed would be completely self-funded and thus relatively autonomous from Congress.[13] In the effort to create a weaker agency, Congress largely gave up its power of the purse over the new regulatory body.
The irony of Congress losing control of the CFPB to the Fed does not stop there; with respect to broader regulatory policy, it is the action (or inaction) of Congress that has continued to empower the Fed.[14] In recent months, the CFTC and the SEC have sought increased funding from Congress to comply with the creation of new regulations mandated by Dodd-Frank.[15] While criticizing the agencies for being ineffectual,[16] the Republican majority in the House responded by offering plans to cut funding to the agencies.[17] Since these agencies are beholden to Congress for funding,[18] they simply do not have the resources to enforce regulations.[19] Therefore, the agencies have fallen behind schedule in their rulemaking and enforcement and have sought other avenues to implement Dodd-Frank.[20]
One such avenue is for each respective agency to pair with the Fed in creating a set of regulations. As the funding problem grows, this is becoming increasingly common and increasingly public.[21] The SEC Chairwoman, Mary Schapiro, testified before the Senate Banking Committee in April 2011 that she was working jointly with the Fed and CFTC to implement derivatives regulation.[22] While some might applaud such coordination, it was clear from her testimony that the Fed is playing a large role here because it is crucial in financially supporting new regulatory efforts. This begs the question, why is the Fed volunteering its resources for these actions? The answer is simple, turf. With Congress unwilling to fund other financial regulators, it has left an opening for the Fed to expand its regulatory turf.[23]
Fed officials claim that being a regulator increases the information base upon which they make monetary policy,[24] so it is possible that an increasingly powerful regulatory Fed will actually end up producing better monetary policy.[25] Still, policymakers will continue to debate the wisdom of having our monetary policymaking institution not only focused on inflation (as is common amongst central banks around the world) but also on employment (a much less common practice for central banks) and regulation (a rarity amongst central banks).[26] Some scholarship suggests that central banks with a supervisory role are more able to accurately forecast key variables involved in monetary policy.[27] However, at this juncture, it is not clear whether the Fed will use its new powers to become a more effective and efficient monetary and regulatory player or if the Fed is taking on more than it can handle.
Emerging evidence suggests the Fed may be taking on a bit too much responsibility; rulemaking deadlines are continuously being missed, and Dodd-Frank is being implemented far more slowly than Congress intended.[28] This leads to the conclusion that either the Fed is not making a full effort to gain turf[29] or it is incapable of fulfilling the funding role largely abdicated by Congress. Even as this domestic regulatory story remains unclear, recent statements by the President of the New York Federal Reserve Bank, William Dudley, suggest that the Fed is striving to play an increased role as a global financial regulator.[30] Dudley has made it very clear that the Fed ought to and will fill the regulatory void in international financial markets,[31] so it stands to reason that the Fed will continue to become an increasingly powerful regulator of U.S. financial markets.[32]
As it has become clear that the Fed is gaining more power relative to other domestic financial regulatory bodies, the Republican Congressional majority have begun to realize their error in compromising on Dodd-Frank. Since Congress has little authority to sanction the Fed, it has sought other ways to curtail Fed power. Chief among these methods has been a series of Congressional oversight hearings. In recent weeks, these hearings have grown extremely acrimonious, ultimately culminating in Sub-Committee Chairman Patrick McHenry’s (R-NC) accusation that CFPB adviser Elizabeth Warren lied about a simple scheduling issue.[33] Such an instance highlights how frustrated the new House Majority have become with the law passed in the previous Congress and how dedicated they are to continuing to prevent its implementation.
Although decorum has largely prevailed on the Senate side, the minority party has pursued a strategy of obstructing efforts to appoint a director of the new CFPB. On May 5, 2011, forty-four of the Senate’s forty-seven Republican Senators signed a letter indicating they will not confirm anyone to head the new CFPB until the bureau’s rules are changed to give Congress control over its funding.[34] These Senators essentially made a public declaration that they were mistaken in passing the legislation as written in the previous Congress and will not comply with it.
While obstructionist tactics might work to mitigate Fed power on the margins, the continued attempts by the 112th Congress to use the power of the purse to tie the hands of financial regulators risks further empowering the Federal Reserve.[35] The Fed[36] has gladly accepted this increased power[37] and is unlikely to cede it back to another agency anytime soon.[38] When compounded with the Fed’s increased global monetary powers that came as a result of the recent crisis, one can only hope that Chairman Bernanke and others were correct in their assertions that central banks gather crucial information from regulatory actions that improve monetary forecasting.[39] If this is indeed the case, then we should see a prolonged period of stable economic growth led by a Federal Reserve that has superior information to that of virtually any other central bank in the world. If this is not the case, then by not funding the implementation of Dodd-Frank, the 112th Congress has inadvertently given a great deal of turf to an already powerful independent agency. That agency, the Fed, has yet to demonstrate its ability to effectively harness its new powers to produce superior economic outcomes. At this stage, we can only hope that the economists supporting increased Fed regulatory powers were being sincere and not simply acting as turf warrior. If these hopes prove unfounded, we could be in for a prolonged period of regulatory and central banking mediocrity.
[1] See Greg Hitt & Damien Paletta, Senate Passes Finance Bill, http://online.wsj.com/article/SB10001424052748703559004575256352143175906.html (last visited June 12, 2011).
[2] For an explanation of the explicit regulatory powers sought by the Fed, see Edmund Andrews & Eric Dash, U.S. Seeks Expanded Power in Seizing Firms, http://www.nytimes.com/2009/03/25/business/economy/25web-bailout.html (last visited June 12, 2011). As discussed in this essay, there has been other, less obvious growth in the Fed’s power as well.
[3] See Fed To Release More Crisis Lending Data After High Court Order, http://online.wsj.com/article/BT-CO-20110321-710221.html (last visited June 12, 2011).
[4] See Board of Governors of the Federal Reserve System: Credit and Liquidity Programs and the Balance Sheet, http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm (last visited June 13, 2011)
[5] See Bradley Keoun & Craig Torres, Foreign Banks Tapped Fed’s Secret Lifeline Most at Crisis Peak, http://www.bloomberg.com/news/2011-04-01/foreign-banks-tapped-fed-s-lifeline-most-as-bernanke-kept-borrowers-secret.html (last visited June 12, 2011).
[6] The international role filled by the Fed at the height of the crisis is one that, in theory, the International Monetary Fund holds. Although the IMF is capable of acting as a lender of last resort to smaller, developing economies in crisis, it does not have the funds to buoy a major developed economy, let alone several of them simultaneously. This is where a central bank capable of monetizing must step in, as the Federal Reserve did. These foreign lending actions have caused several members of Congress to publicly berate Fed personnel at Congressional hearings for over-utilizing foreign bank swaps and not knowing what private sector borrowers benefited from the dollars flowing into foreign central banks.
[7] See Henry Wallich, Central Banks as Regulators and Lenders of Last Resort in an International Context: A View from the United States, Federal Reserve Bank of Boston (1977), available at http://www.bos.frb.org/economic/conf/conf18/conf18d.pdf.
[8] In some cases the Fed is simply using its existing enforcement powers, but on issues like consumer financial protection, the Fed has gained additional statutory power.
[9] The Fed is not the only entity to gain increased responsibilities from Dodd-Frank. The Securities and Exchange Commission (SEC), Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of Currency (OCC), and the Commodity Futures Trading Commission (CFTC) all gained substantial new powers.
[10] See Board of Governors of the Federal Reserve System, What does it mean that the Federal Reserve is “independent within the government”?, http://www.federalreserve.gov/faqs/about_12799.htm (last visited June 12, 2011).
[11] Although several other agencies in the U.S. government are “fee-funded,” the Fed is the only true self-funded agency. This means it operates off profits from market operations, not just fees collected from regulatory infractions.
[12] This increased role is particularly obvious with the Fed’s explicit new role as a consumer financial protector. See Federal Reserve Consumer Help, Ready to File a Complaint?, http://www.federalreserveconsumerhelp.gov/about/consumer-complaint.cfm (last visited June 12, 2011).
[13] The head of the CFPB needs to be confirmed by the Senate, so the agency is not completely autonomous from Congress.
[14] Many of the same members of Congress who are seeking to underfund regulators are those who heavily criticize the Fed. Chief among these individuals is libertarian Republican Congressman Ron Paul. See Ron Paul, End the Fed (2010).
[15] See SEC, CFTC ask Congress for Budget Increases, http://online.wsj.com/article/BT-CO-20110504-714062.html (last visited June 12, 2011).
[16] See John J. Curran & Jesse Hamilton, Schapiro SEC Seen Ineffectual Amid Dodd-Frank Funding Curbs, http://www.bloomberg.com/news/2011-03-31/schapiro-sec-seen-ineffectual-amid-dodd-frank-funding-curbs.html (last visited June 12, 2011).
[17] See Silla Brush, CFTC Budget Scrutinized by House Republicans Seeking 15% Cut, http://www.bloomberg.com/news/2011-05-23/cftc-budget-scrutinized-by-house-republicans-seeking-15-cut.html (last visited June 12, 2011).
[18] This is despite calls by many prominent regulators, politicians and lawyers that the SEC should be self-funded. See e.g., Top Securities Lawyers Call for Self-Funded S.E.C., http://dealbook.nytimes.com/2010/06/11/top-securities-lawyers-call-for-self-funded-s-e-c (last visited June 12, 2011).
[19] SEC Union NTEU Chapter 293, Kelley Emphasizes Need for SEC Resources as Fiscal 2012 Funding Process Advances, http://www.secunion.org/KelleySECBudget3182011 (last visited June 12, 2011).
[20] Ronald Orol, The Dawdle-Frank Act: Regulators’ missed deadlines, http://www.marketwatch.com/story/the-dawdle-frank-act-regulators-missed-deadlines-2011-05-05?reflink=MW_news_stmp (last visited June 12, 2011).
[21] Bruce Carton, How Can Congress Kill Dodd-Frank? By Underfunding It, http://www.securitiesdocket.com/2011/01/20/how-can-congress-kill-dodd-frank-by-underfunding-it (last visited June 12, 2011).
[22] Mary Schapiro, Testimony on “Building the New Derivatives Regulatory Framework: Oversight of Title VII of the Dodd-Frank Act”, http://www.sec.gov/news/testimony/2011/ts041211mls.htm (last visited June 12, 2011).
[23] There is a large political science literature on turf wars in the U.S. government, but key examples include food and drug regulation being moved from the USDA to the FDA and intelligence agencies attempting to undercut each other’s reach. In the case of financial regulation, several news articles have discussed the role of the Fed in turf wars. See Matthew Jaffe, Turf War: Bernanke Fights for Fed’ Powers, http://blogs.abcnews.com/politicalpunch/2010/03/turf-war-bernanke-fights-for-feds-powers-1.html (last visited June 12, 2011).
[24] Craig Torres, Bernanke Sees ‘Strong Case’ for Fed Supervisory Role, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a3YEbR7LEkv0 (last visited June 12, 2011).
[25] When Britain decided to decouple regulation from monetary policy many academics and monetary policymakers engaged in the debate about whether the costs of regulation outweigh the benefits of the information drawn from being a market regulator; most academics and nearly all practicing American monetary policymakers deemed regulation a net benefit to central banks, specifically the Federal Reserve.
[26] Most central banks around the world follow a single mandate to provide price stability (control inflation); very few have a mandated responsibility to deal with unemployment. Since inflation and unemployment are largely at odds with each other (according to a simple Phillip’s Curve interpretation) it can be argued that these other banks inherently also deal with employment even though it not part of their mandates, but since it is not part of their mandates, it certainly changes the pressures on the bank in certain economic and political circumstances.
[27] See Joe Peek, Eric S. Rosengren, & Geoffrey M. B. Tootell, Is Bank Supervision Central to Central Banking? 114 Q.J. of Econ. 629, 629–53 (1999).
[28] As the David-Polk scores identify, the agencies are all behind schedule in their rule making. See Davis Polk, Dodd-Frank Rulemaking Progress Report, May 1, 2011, available at http://www.davispolk.com/files/uploads/sites/18/FIG/050211_ProgressReport.pdf.
[30] See Caroline Salas & Aki Ito, U.S. Fed’s Dudley Calls for More Cooperation Among Global Regulators, http://www.bloomberg.com/news/2011-04-11/fed-s-dudley-calls-for-more-cooperation-among-global-regulators.html (last visited June 12, 2011).
[31] This is of particular interest in the context of Basel 3 and the fact that the US has never really taken a strong stance on Basel before. Dudley’s comments were significant because he basically says he will support Basel 3 and the U.S. might even want tighter regulations on global banks and their capital requirements.
[32] Even with Dudley’s statements, Europe has recently criticized the U.S. for being slow in implementing financial regulatory reform. This demonstrates that, without Congressional funding for other agencies, the Fed has certain limitations. See Peter Spiegel, EU Warns US to Speed Up Bank Reform, http://www.ft.com/intl/cms/s/0/cc0e7382-8bcb-11e0-854c-00144feab49a.html?ftcamp=rss#axzz1NzgVWu1V (last visited June 12, 2011).
[33] See Edward Wyatt, Hearing Over a Consumer Bureau Descends Into Sharp Accusations, N.Y. Times, May 25, 2011, at B1.
[34] See Edward Wyatt & Ben Protess, Foes Revise Plan to Curb New Agency, N.Y. Times, May 6, 2011, at B1.
[35] See Sharon K. Blei, If Fed Becomes Super Regulator, Politicians Would Be Its Kryptonite, http://stlouisfed.org/publications/re/articles/?id=1323 (last visited June 12, 2011).
[36] At least most officials from the Federal Reserve Board, but possibly not some regional bank personnel.
[37] Consistent with a long history of turf war theories in bureaucratic politics it would be anomalous for a bureaucratic agency to halt its own turf expansion when turf brings them increased power, prestige, and possibly even increased autonomy.
[38] The Fed is unlikely to cede power since Congress cannot force it financially, but rather can only do so through legislation.
[39] See Ben Bernanke, The Federal Reserve’s Role in Bank Supervision, Testimony before the U.S. House of Rep. Comm. on Fin. Serv., March 17, 2010, available at http://www.federalreserve.gov/newsevents/testimony/bernanke20100317a.htm.
Preferred citation: Evan Schnidman, Why the Federal Reserve is Dodd-Frank’s Big Winner, 1 Harv. Bus. L. Rev. Online 88 (2011), https://journals.law.harvard.edu/hblr//?p=1203.
LLCs and Corporations: A Fork in the Road in Delaware?
Joshua P. Fershee*
The limited liability company (LLC) has evolved from a little used entity option to become the leading business entity of choice.[1] The primary impetus for this change was an Internal Revenue Service (IRS) determination in 1988 that permitted pass-through tax status for a Wyoming LLC.[2] Then, in 1997, the IRS passed its check-the-box regulations permitting LLCs (and other non-corporate entities) to simply opt-in to the benefits of partnership tax treatment.[3] These two rulings have been viewed as having “had a profound, unprecedented, and perhaps unpredictable impact on the future development of unincorporated business organizations.”[4] Since that time, some scholars argued that the LLC should be treated as a third, and separate, entity unto itself with its own developing body of law.[5] Nonetheless, many courts have applied corporate law to LLCs with seemingly little appreciation of the differences between LLCs and corporations.[6] That may be about to change.
Some legal scholars and practicing attorneys were highly skeptical of LLCs because, unlike partnerships and corporations, LLCs lacked a significant body of well-developed, LLC-specific law.[7] This has changed over time, and there seem to be some indications that a body of LLC law is developing.[8] Still, LLCs are often viewed as “hybrid” entities,[9] and as such, LLCs will be treated like a partnership in some settings and like a corporation in others.[10] Of course, the other option is to treat LLCs as truly an entity unto themselves, but courts have a tendency to choose to fill in empty segments of LLC law with either partnership law or the law of corporations, rather than crafting an LLC-specific set of rules.[11]
Among some legal scholars, one of the more controversial areas in LLC law has been courts’ treatment of plaintiffs’ requests to “pierce the veil” of LLCs.[12] Veil piercing occurs when a court disregards the veil of limited liability granted to equity holders of an entity, which is traditionally a corporation.[13] Plaintiffs seek this option when the limited liability entity lacks resources to pay a debt, but the equity holder or holders have the resources to cover some or all of the debt.[14] Thus, the plaintiff would be unable to collect on the debt because the shareholder is not liable for the debts of the corporation unless the veil is pierced.[15]
The veil-piercing concept has long been a part of corporate law,[16] and many states added the concept to their state’s LLC law. Minnesota and North Dakota, for example, specifically incorporate the state’s corporate veil piercing laws.[17] Wyoming, the state that originated the LLC in the United States in 1977, did not put veil-piercing language in the original statute, but the state’s court nonetheless incorporated veil-piercing principles.[18]
Some scholars have taken an adamant view that courts should not read the veil-piercing concept into LLC law where the underlying statute does not address the issue and have argued against including veil piercing as an option for LLCs.[19] Despite this opposition, most (if not all) courts faced with the question of whether to allow piercing of an LLC veil where the statute is silent have done so.[20]
Similarly, some courts have applied other corporate law rules to LLCs, such as granting standing for creditors of an insolvent LLC to sue the LLC derivatively, as if the LLC were a corporation.[21] Thus, the law of LLCs seemed to be developing as a true hybrid law of partnership and corporate law, without a clearly stated rationale for how or why that should be the case.[22] There is some evidence, however, that trend may be coming to an end.
The Delaware Court of Chancery in 2010 determined that, unlike similarly situated creditors of Delaware corporations, LLC creditors of an insolvent LLC do not have standing to pursue a derivative claim against the LLC under Section 18-1002 of the Delaware Limited Liability Company Act.[23] The plaintiff in that case, CML V, loaned money to JetDirect Aviation Holdings, LLC, and JetDirect’s operating companies went into bankruptcy.[24] In an effort to recover the loan, CML V instituted three derivative claims alleging bad faith and breaches of fiduciary duties against the board and senior management.[25] If those claims were successful, the liable individuals would pay JetDirect directly.[26] CML V would then be able to recover the funds through a direct claim alleging that JetDirect breached the loan agreement with CML V.[27]
In the opinion, Vice Chancellor Laster noted that “[d]espite the ostensibly obvious implications of the statute, virtually no one has construed the derivative standing provisions as barring creditors of an insolvent LLC from filing suit.”[28] In fact, the opinion notes, there was significant commentary assuming that creditors could sue an insolvent LLC derivatively.[29] In contrast, there was almost nothing to indicate that plaintiffs, practicing attorneys, or other commentators thought a derivative suit was excluded by Section 18-1002.[30]
Nonetheless, after careful analysis, Vice Chancellor Laster determined that it did “not create an absurd or unreasonable result to deny derivative standing to creditors of an insolvent LLC.”[31] Instead, he noted that the Delaware LLC Act, unlike the comparable provision in the Delaware General Corporation Law, created a derivative claim exclusively for “a member or an assignee.”[32] As such, the plain language of the LLC Act meant that creditors lacked standing to pursue a derivative claim.[33] Furthermore, this “outcome does not frustrate any legislative purpose of the LLC Act; it rather fulfills the statute’s contractarian spirit.”[34]
The CML V decision portrays a heightened appreciation for the distinct nature of LLCs not often found in reviewing courts’ decisions.[35] For his part, Vice Chancellor Laster explains, “As a threshold matter, there is nothing absurd about different legal principles applying to corporations and LLCs.”[36] This view of LLCs is hardly the default.
More typically, courts provide LLC claimants the same rights in LLC cases that would be available in corporate cases. For example, the New York courts determined that LLC derivative suits were available under New York law, even though the statute “omit all reference to such suits.”[37] The court based its decision in significant part “on the long-recognized importance of the derivative suit in corporate law.”[38] Similarly, in another key LLC case, the Wyoming Supreme Court stated that, to decide if piercing the LLC veil was permissible, “we must first examine the development of the doctrine within Wyoming’s corporate context.”[39] In the view of these courts, the state corporations laws provide the context in which the LLC laws operate.
Many courts thus seem to view LLCs as close cousins to corporations, and many even appear to view LLCs as subset or specialized types of corporations.[40] A May 2011 search of Westlaw’s “ALLCASES” database provides 2,773 documents with the phrase “limited liability corporation,” yet most (if not all) such cases were actually referring to LLCs—limited liability companies.[41] As such, it is not surprising that courts have often failed to treat LLCs as alternative entities unto themselves. It may be that some courts didn’t even appreciate that fact.
The point here is that not that LLCs must have different rules than corporations, although is the likely preference of some commentators.[42] Vice Chancellor Laster’s decision in CML V was not the only proper or conceivable outcome where the autonomy of the LLC as an entity would be respected. However, the “threshold matter” from CML V should be the default rule in analyzing all LLC questions: “[T]here is nothing absurd about different legal principles applying to corporations and LLCs.”[43]
Where legislatures have decided that distinctly corporate concepts should apply to LLCs—such as allowing piercing the veil or derivative lawsuits—those wishes (obviously) should be honored by the courts.[44] And where state LLC laws are silent, the court should carefully consider the legislative context and history, as well as the policy implications of the possible answers to the questions presented. Courts should put forth cogent reasons for their decisions, rather than blindly applying corporate law principles in what are seemingly analogous situations between LLCs and corporations.[45]
The members of an LLC chose the LLC as their entity, and they should enjoy both the benefits and burdens of that choice.[46] Where courts refuse to acknowledge the distinct nature of LLCs, the promoters’ choice of entity is, at least in part, ignored. In CML V, Vice Chancellor Laster respected the LLC as a form, as well as the legislature’s choice of language in the Delaware LLC Act. Hopefully future courts, and thus the law of LLCs, will follow suit.
* Associate Professor, University of North Dakota School of Law.
[1] See, e.g., Larry E. Ribstein & Jeffrey M. Lipshaw, Unincorporated Business Entities (2009); Carter G. Bishop, Through the Looking Glass: Status Liability and the Single Member and Series LLC Perspective, 42 Suffolk L. Rev. 459, 460 (2009) (“Until [1997], the corporation was unquestionably the dominant entity of choice for an operating business.”).
[2] Rev. Rul. 88-76, 1988-2 C.B. 360, obsoleted by Rev. Rul. 98-37, 1998-2 C.B. 133.
[3] T.D. 8697, 1997-1 C.B. 215.
[4] Bishop, supra note 1, at 460.
[5] See, e.g., Larry E. Ribstein, Litigating in LLCs, 64 Bus. Lawyer 739, 741 (2009) (“[T]his Article demonstrates the dangers of failing to analyze carefully the special functions of the LLC form and forcing structures from other business associations on the LLC business entity.”).
[6] See id. at 739 (“Not surprisingly, legislators and courts frequently apply rules from existing business entities. Unfortunately, they sometimes apply the wrong analogies.”).
[7] Dominick T. Gattuso, Series LLCs, Bus. Law Today, July-Aug. 2008, at 33, 38 (“Some . . . practitioners and commentators went so far as to advise others to eschew LLCs in favor of limited liability partnerships, because limited liability partnerships had a well-developed body of law to which courts could turn.”).
[8] Peter J. Walsh, Jr. & Dominick T. Gattuso, Delaware LLCs: The Wave of the Future and Advising Your Clients About What to Expect, Bus. Law Today, Sept.-Oct. 2009, at 11 (stating that some recent Delaware judicial opinions “reflect a concerted effort by Delaware’s courts, legislators, and practitioners to develop a body of law for LLCs with the depth, breadth, and stability that are hallmarks of the state’s corporate law.”).
[9] Anderson v. Wilder, No. E2003-00460-COA-R3-CV, 2003 WL 22768666, at *4 (Tenn. Ct. App. Nov. 21, 2003) (stating that the LLC is a “relatively new form of business entity, a hybrid” that has some of the benefits of partnerships and some of the benefits of a corporation”); Larry E. Ribstein, Are Partners Fiduciaries, 2005 U. Ill. L. Rev. 209, 248 (2005) (citing the same).
[10] See Ribstein, supra note 5, at 739.
[11] See id.
[12] Compare Stephen M. Bainbridge, Abolishing LLC Veil Piercing, 2005 U. Ill. L. Rev. 77, 77–78 (2005) with Geoffrey Christopher Rapp, Preserving LLC Veil Piercing: A Response to Bainbridge, 31 Iowa J. Corp. L. 1063, 1064–65 (2006). Professor Rapp explains: “Veil piercing has been one of the most hotly debated concepts in business law. Unlike many concepts in American corporate law, there are strong, even moralistic arguments on both sides of the veil piercing debate, and thus it has become a lightning rod for academic dispute.” Rapp, supra at 1065 (footnote omitted).
[13] See Walkovszky v. Carlton, 223 N.E.2d 6, 7 (N.Y. 1966).
[14] See id. at 9.
[15] See id. (explaining that, nonetheless, courts cannot piece the veil “merely because the assets of the corporation, together with the mandatory insurance coverage of the vehicle which struck the plaintiff, are insufficient to assure [the plaintiff] the recovery sought”).
[16] See, e.g., I. Maurice Wormser, Piercing the Veil of Corporate Entity, 12 Colum. L. Rev. 496, 496 (1912) (discussing the difficulty of knowing “when to apply fearlessly the theory of the existence of a corporation as entity distinct and separate from its shareholders and when, on the other hand, to just as fearlessly disregard it”).
[17] Minn. Stat. § 322B.303(2) (2003) (“The case law that states the conditions and circumstances under which the corporate veil of a corporation may be pierced under Minnesota law also applies to limited liability companies.”); N.D. Cent. Code § 10-32-29(3) (“The case law that states the conditions and circumstances under which the corporate veil of a corporation may be pierced under North Dakota law also applies to limited liability companies.”).
[18] See Kaycee Land & Livestock v. Flahive, 46 P.3d 323, 326–27 (Wyo. 2002).
[19] See, e.g., Bainbridge, supra note 12, at 79 (“[O]ther than in those jurisdictions whose statute commands courts to do so, courts have erred by importing the corporate veil piercing doctrine into LLC law.”).
[20] See Rapp, supra note 12, at 1065.
[21] See Ribstein, supra note 5, at 739.
[22] Cf. id. at 755 (“A generation after the LLC’s birth, it is time to start analyzing the LLC as a distinct business entity and to stop dressing it in hand-me-down clothes.”).
[23] CML V, LLC v. Bax, 6 A.3d 238 (Del. Ch. Nov. 3, 2010).
[24] Id.
[25] Id.
[26] Id. at 240.
[27] Id.
[28] Id. at 242.
[29] See id.
[30] Id. at 242–43.
[31] Id. at 254.
[32] Id. at 241.
[33] Id. at 241–42.
[34] Id. at 254.
[35] See id. at 238.
[36] Id. at 249. “Because the conceptual underpinnings of the corporation law and Delaware’s [alternative entity] law are different, courts should be wary of uncritically importing requirements from the DGCL into the [alternative entity] context.” Id. at 250 (alterations in original) (quoting Twin Bridges Ltd. P’ship v. Draper, 2007 WL 2744609, at *19 (Del. Ch. Sept. 14, 2007)).
[37] Tzolis v. Wolff, 884 N.E.2d 1005, 1006 (N.Y. 2008).
[38] Id.
[39] Kaycee Land & Livestock v. Flahive, 46 P.3d 323, 325 (Wyo. 2002).
[40] Ribstein, supra note 5, at 755 (stating that “a basic problem with LLC jurisprudence [is that LLCs have] been viewed as a hybrid of older types of business associations”).
[41] See, e.g., Deuley v. DynCorp Intern., Inc., 8 A.3d 1156, 1156, 1158 (Del. Supr. 2010) (listing DynCorp International LLC “as a Delaware Limited Liability Corporation” in the caption, but stating that the entity “is a limited liability Delaware company” in the text of the case).
[42] See, e.g., Ribstein, supra note 5, at 755 (“[T]he derivative remedy is inappropriate in the sort of closely held firms for which LLC statutes are designed.”).
[43] CML V, LLC v. Bax, 6 A.3d 238, 249 (Del. Ch. Nov. 3, 2010).
[44] Bainbridge, supra note 12, at 79 (stating that unless a state LLC statute “commands” applying the veil piercing concept to LLCs, the concept should not apply).
[45] See id. (stating that courts are often applying the veil piercing doctrine to LLCs “in a way that can only be described as unthinking”); Ribstein, supra note 5, at 747–55 (explaining that courts are often wrong to assume that corporate law remedies are often not the best or appropriate alternative for LLCs).
[46] Cf. eBay Domestic Holdings, Inc. v. Newmark, No. 3705, 2010 WL 3516473, at *23 (Del. Ch. Sept. 9, 2010) (“Having chosen a for-profit corporate form, the craigslist directors are bound by the fiduciary duties and standards that accompany that form.”).
Preferred citation: Joshua P. Ferhsee, LLCs and Corporations: A Fork in the Road in Delaware?, 1 Harv. Bus. L. Rev. Online 82 (2011), https://journals.law.harvard.edu/hblr//?p=1181.
Contingent Convertible Bonds and Banker Compensation: Potential Conflicts of Interest?
Gaurav Toshniwal*
Two issues related to financial regulation have received significant academic and regulatory attention since the financial crisis: Contingent Convertible Bonds (“CoCos”) and banker compensation. The discussion, however, has largely been silent on the interaction between the two. This brief note explores the potential conflicts that may exist in the design and implementation of CoCos because of the incentive structure created by managerial compensation. Regulators, academics and market participants will need to address these concerns in designing the regulatory framework for CoCo instruments and managerial compensation.
Contingent Capital Instruments
The financial crisis exposed the inadequacy of equity capital at the major financial institutions. In response, academics, regulators and banking executives have focused on bolstering banking capital requirements, partly through innovative capital instruments.[1] One such instrument is the Contingent Convertible Bond.[2] This bond converts into equity capital based on a pre-set trigger, thereby augmenting a bank’s capital during a financial crisis.[3]
The trigger could be based on three different types of metrics: 1) capital-based triggers that rely on accounting measures of capital adequacy, 2) regulatory discretion-based triggers that allow regulators to mandate conversion of CoCos into common equity during a banking crisis, and 3) market-based triggers that are triggered by declines in stock prices or increases in the premiums of credit default swaps. [4] The potential problems with these different mechanisms have been discussed at length: accounting-based measures may respond too slowly in a financial crisis, market-based measures may be susceptible to banking runs and market manipulation and regulatory discretion-based triggers may lead to ad hoc decisions.[5] In response, some commentators have suggested a dual trigger mechanism—for instance, one that relies on accounting measures coupled with regulatory discretion.[6]
Regulators and banking executives are divided on the benefits of CoCos and their optimal design. The Basel III committee has recommended further study on whether contingent capital instruments should be counted towards equity capital for banking institutions.[7] Regulators in America and Britain have also been ambivalent about approving CoCo transactions.[8] Nevertheless, some regulators have embraced CoCos wholeheartedly. The Swiss National Bank has been particularly aggressive on capital rations; it has mandated capital adequacy ratios of nineteen percent for the major Swiss banks, of which nine percent can be fulfilled with CoCo instruments.[9]
Banking executives are similarly divided on CoCos. Some are concerned about the efficacy of Cocos or about the level of investor demand for such instruments.[10] Others, however, have embraced the instruments. For instance, Credit Suisse has announced that it will issue billions of dollars worth of CoCos; its initial plan to raise CoCo capital was highly successful and the bank successfully raised two billion dollars.[11]
Although there is continuing disagreement over the design of CoCos and their role in fulfilling capital adequacy requirements, these instruments are likely to play a significant role in providing capital support for banking institutions in future financial crises.
Bankers Pay
Banker compensation levels and pay structures have come in for significant criticism since the crisis.[12] Previous compensation policies are said to have exacerbated risk taking and richly compensated bankers despite poor long term performance.[13] Some have viewed the problem of banker pay as a corporate governance problem.[14]
Bebchuk and Spamann have suggested that corporate governance reforms alone may not be sufficient to address these problems because shareholders are incentivized to take risks beyond the socially optimal level.[15] Furthermore, bondholders and other creditors are also not incentivized to monitor financial risks because of the implicit government guarantee of bank debt during a financial crisis.[16] Accordingly, the authors propose that banking executive should be compensated through a broader basket of securities including common shares, preferred shares and debt instruments issued by the bank.[17]
Exploring the Link between CoCos and Banker Pay
The academic literature has largely been silent on the interaction between CoCos and banker compensation. The socially optimal design and implementation of CoCos will be impacted by managerial incentives created by compensation structures. This problem is particularly acute when managerial compensation is partially or exclusively in the form of CoCo instruments. Several banks have announced that they are considering paying senior executives and bankers with such instruments.[18] Barclays, most prominently, has sought approval from the UK regulators for paying its bankers with CoCo instruments.[19] Before approving such plans, regulators need to understand what the proper incentive structure for bankers should be. In particular, they will need to address the following two problems.
First, are bankers incentivized to select the socially optimal design for CoCo instruments? Managers may have considerable influence in the design of CoCo instruments, including selecting the type of trigger (e.g. capital-based) and the trigger level at which the CoCo mandatorily converts into common equity (e.g. if capital adequacy ratio falls below seven percent). Managerial compensation structures will influence their preferences on these design choices. If bankers are primarily compensated with equity stock, they are likely to design CoCo instruments with weak triggers because they would not want their equity holdings diluted by the conversion of these instruments into common equity. If bankers, by contrast, are primarily compensated with CoCos instruments, they may design inefficiently strong triggers because they could potentially acquire cheap stock during a crisis. Thus, the pay structure of bankers will determine their ex-ante preference for different design features of CoCo instruments.
Second, are banking executives incentivized to optimally trigger conversion during a financial crisis? Although the trigger may be “mandatory” in design, managers are likely to have significant discretion regarding the trigger point because of their ability to disclose (or withhold) material information, their use of other market signaling devices, and their discretion over when to approach financial regulators. During a financial crisis, will managers have the appropriate incentives to aid an optimal conversion of these instruments? How will this be impacted by whether managers are partially or solely compensated with equity or CoCo instruments? For instance, if managers are compensated primarily with equity instruments and a mandatory CoCo conversion dilutes equity holders, then managers may be incentivized to delay disclosure of material information to prevent such a conversion from taking place. By contrast, if they are compensated primarily through CoCo instruments, managers might view a financial crisis as a mechanism for acquiring cheap equity in their bank and therefore take overly conservative positions in the bank’s financial disclosures. Thus, different managerial compensation packages may determine the ex-post behavior of bankers when it comes to triggering the conversion of CoCo instruments into equity capital.
In designing and implementing a regulatory framework for CoCos, regulators need to be aware of the potential conflicts of interest that could be created by banker compensation structures. Potential solutions could include regulating both the level of discretion afforded to managers in designing and implementing CoCo instruments and the magnitude of executive compensation that is linked to or denominated in CoCo instruments.
[1] See Hal S. Scott, Reducing Systemic Risk Through the Reform of Capital Regulation, 13 J. Int. Econ. L. 763, 763 (2010).
[4] See Louise Pitt et. al, Contingent Capital: Possibilities, Problems and Opportunities 6, Goldman Sachs Global Markets Institute (March 2011).
[6] See Robert L. McDonald, Contingent Capital with a Dual Price Trigger (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1553430.
[7] See Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems 3, Basel Committee on Banking Supervision (2010), available at http://www.bis.org/publ/bcbs189.pdf.
[8] See Anousha Sakoui & Patrick Jenkins, Stability Concerns over Coco Bonds, Financial Times, Nov. 6, 2009, http://www.ft.com/cms/s/0/7982578c-ca75-11de-a3a3-00144feabdc0.html#axzz1IxBwhf2L; Nicole Bullock & Francesco Guerrera, Wall Street and Fed in Discussions Over CoCos, Financial Times, Nov. 12, 2009, http://www.ft.com/cms/s/0/f312d108-cf2a-11de-8a4b-00144feabdc0.html#axzz1IxBwhf2L.
[9] See Switzerland Gets Extra Tough With Its Banks. Others Will Follow, The Economist, Oct. 7, 2010, http://www.economist.com/node/17202233?story_id=17202233.
[10] See Sara S. Muñoz, A Hard Road for New ‘Coco’ Securities, Wall St. J., Oct. 15, 2010, http://online.wsj.com/article/SB10001424052748703631704575552231208013398.html.
[11] See Jennifer Hughes, Credit Suisse Cocos Issue Deluged, Financial Times, Feb. 17, 2011, http://www.ft.com/cms/s/0/31da02a0-3ac6-11e0-9c1a-00144feabdc0.html#axzz1IxBwhf2L.
[12] See, e.g., Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States 61-66, Financial Crisis Inquiry Commission (2011), available at http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.
[15] See Lucian A. Bebchuk and Holger Spamann, Regulating Bankers’ Pay, 98 Geo. L.J. 247, 274–75 (2010).
[18] See Francesco Guerrera et al, Banks Keep Close Eye on Barclay’s Cocos Plan, Financial Times, Jan. 30, 2011, http://www.ft.com/cms/s/0/e939a8a6-2ca2-11e0-83bd-00144feab49a,s01=1.html#axzz1IxBwhf2L.
[19] See Jennifer Hughes & Patrick Jenkins, Barclays Forced to Adapt Cocos Bonus Plan, Financial Times, Feb. 14, 2011, http://www.ft.com/cms/s/0/7e1cac78-387b-11e0-959c-00144feabdc0.html#axzz1IxBwhf2L (noting that Barclay’s initial plan had to be modified because the UK regulators were undecided on the efficacy of such compensation arrangements).
Preferred citation: Gaurav Toshniwal, Contingent Convertible Bonds and Banker Compensation: Potential Conflicts of Interest?, 1 Harv. Bus. L. Rev. Online 77 (2011), https://journals.law.harvard.edu/hblr//?p=1162.