Volume 4, Issue 1 (2014)

ARTICLES

Regulating Capital

Prasad Krishnamurthy

Most observers agree that the excessive debt or leverage of systemically important financial institutions (SIFIs) was a central reason why the housing crash of 2007–2009 led to a recession. The Dodd-Frank Act authorizes the Financial Stability Oversight Council and the Federal Reserve to adopt new prudential standards for regulating these institutions. A fundamental challenge for these standards is how to restrain the leverage of SIFIs by prescribing a minimum amount of capital or equity they must hold relative to their assets.

This Article develops a framework for the regulation of capital in SIFIs that departs from current regulatory practice. Starting from the assumption of perfect capital markets, it first shows that a limit on leverage is an optimal regulatory policy when capital markets are perfect, but bank failures entail an external social cost. It then argues that capital regulation can be effectively adapted to the imperfections that exist in real financial markets such as taxes, transaction costs, and incomplete information. Many of these imperfections strengthen the argument for capital regulation. In cases where capital regulation may inefficiently reduce lending, suitable regulatory design can mitigate this effect. This Article proposes a security design—automatic convertibles—to mitigate the cost of issuing capital; considers the strategic responses of SIFIs to regulation; and critiques current regulations as well as other market-based proposals in this literature.

Do Outside Directors Face Labor Market Consequences? A Natural Experiment from the Financial Crisis

Steven M. Davidoff, Andrew C.W. Lund, and Robert Schonlau

The shock of the financial crisis focused shareholder and regulator attention on financial firm performance. We use the crisis as a lens through which to study labor market consequences for outside directors at banks and other financial firms. Examining 4,856 outside director-years at such institutions over the period from 2006 to 2010, we find that the increased chance of being replaced for poor performance is between 1.22% and 5.79% for a one standard deviation change in performance, an arguably trivial amount. We also find no labor market reaction to poor firm performance in the form of lost directorship opportunities at other firms. We draw on these empirical findings to assess the limitations of board-centered responses to the financial crisis.

The Case for an Unbiased Takeover Law (with an Application to the European Union)

Luca Enriques, Ronald J. Gilson, and Alessio M. Pacces

Takeover regulation should neither hamper nor promote takeovers, but instead allow individual companies to decide the contestability of their control. Based on this premise, we advocate a takeover law exclusively made of default and menu rules supporting an effective choice of the takeover regime at the company level. For political economy reasons, we argue that different default rules should apply to newly public companies and companies that are already public when the new regime is introduced. Newly public companies should be governed by default rules that favor the interests of (minority) shareholders over those of management and controlling shareholders, because these are more efficient on average and easier to opt out of when they are or become inefficient for the particular company. Companies that are already public when the new regime is introduced should instead be governed by default rules matching the status quo, even if this favors the incumbents. This regulatory dualism strategy is intended to overcome the resistance of vested interests towards efficient regulatory change. Appropriate menu rules should be available to both groups of companies in order to ease opt-out of unfit defaults. Finally, we argue that European takeover law should be reshaped along these lines. Particularly, the board neutrality rule and the mandatory bid rule should become defaults that only individual companies, rather than member states, can opt out of. The overhauled Takeover Directive should also include menu rules, for instance a poison pill defense and a time-based breakthrough rule. Existing companies would continue to be governed by the status quo until incumbents decide to opt into the new regime.

Statutes of Limitations for Equitable and Remedial Relief in SEC Enforcement Actions

Steven R. Glaser

The sanctions that can be imposed by the Securities and Exchange Commission (SEC) in civil enforcement actions can be severe. Where the SEC prevails, the agency can impose significant civil monetary penalties on an individual. The SEC may also seek the disgorgement of ill-gotten gains or enjoin an individual from future violations of securities laws. Perhaps most significantly, the SEC can bar someone from associating with a registered investment adviser or broker- dealer, or from serving as an officer or director of a public company, which could be tantamount to a complete prohibition from working in the securities industry. Given the severity of the available sanctions and the SEC’s increasingly aggressive enforcement posture, the SEC’s enforcement actions frequently resemble criminal prosecutions brought by the Department of Justice. Yet given the civil nature of these claims, defendants in SEC actions frequently lack certain procedural and other protections afforded to criminal defendants.

This article aims to address one procedural protection that may not be available to defendants in civil enforcement actions: defenses based on statutes of limitations. I review the relevant case law and find that, although courts consider some remedies sought by the SEC to be “punitive,” and therefore subject to a five-year statute of limitations prescribed by 28 U.S.C. § 2462, other remedies sought by the SEC are considered either “equitable” or “remedial,” and are therefore not subject to any statute of limitations. These equitable remedies include the SEC’s ability to bar individuals from working in the securities industry. This article discusses a developing body of law, which holds that where sanctions imposed by the SEC are sufficiently severe, and where they fail to either (a) involve ill-gotten gains by a defendant or (b) address a plausible threat to public safety, they cannot be considered remedial in nature. Accordingly, some limitations period must apply to such offenses. This limitation is especially important when a defendant may be barred from the securities industry, effectively ending his or her career. I argue further that, as the SEC’s civil enforcement of securities laws becomes increasingly aggressive and prosecutorial in nature, courts should ensure that the SEC does not impose these quasi-criminal penalties while enjoying a lower burden of proof to establish liability, and should afford defendants certain procedural protections to which they are entitled.

Missing the Forest for the Trees: a New Approach to Shareholder Activism

Yaron Nili

Shareholder activism has dominated corporate governance literature for the last decade. However, despite the abundance of research focusing on specific manifestations of activism, there is a dearth of literature tackling shareholder activism as a whole. This article puts forward a novel theory situating shareholder activism within a more complete framework, treating activism as a collection of diverse models that differ by motives, tools, and structures. This paper provides a more complete perspective on activism—an analytical understanding of activism as a model rather than an investigation of specific occurrences thereof—and a demonstration that different models of activism are present both in the U.S. and around the globe. In this way, the paper responds to calls from academia, practitioners, and the U.S. legislature for potential regulatory changes aimed at shareholder activism.

By surveying eleven different countries and the models of activism prevalent therein, and by widening the framework to account for the myriad forms of shareholder activism, this paper fills an important gap in current corporate governance literature. In particular, the paper’s main argument is that calls for regulatory changes are currently framed both too specifically and too generally. By targeting specific actors like hedge funds without accounting for how such reform may affect other players, these regulatory proposals operate too narrowly. Still, others increasingly call for the adoption of specific arrangements from foreign jurisdictions without considering a full model of activism. This paper tackles these issues by providing a comparative examination of different models and proposing a procedural framework for any discussion of shareholder activism.

NOTE

A Two-Part Disclosure Mandate as a Compromise Solution to the Debate on Section 13(d)’s Disclosure Window

David Daniels

For several decades, Section 13(d) of the Securities Exchange Act of 1934 has required that investors acquiring more than 5% of the outstanding equity securities in a publicly traded company disclose to the Securities and Exchange Commission (SEC) their stake in that company within ten days of exceeding the 5% threshold—thus acting as a de facto deterrence mechanism against potential surreptitious takeovers of such companies. With the passage of the Dodd-Frank Act in 2010, the SEC was able to shorten this disclosure window, which sparked an intense debate over the proper scope and strictness of Section 13(d). The protransparency faction urges the SEC to reduce the disclosure window to one day, while its opponents urge that the status quo remain and raise concerns about the deterrent effect a shortened window would have on beneficial activist investor scrutiny on corporate management. The decline of shareholder rights plans and the simultaneous rise of activist investing in the U.S. increases the urgency of finding the ideal resolution to this seemingly intractable issue.

A compromise solution could help bridge the gap between these two factions. Under the proposed solution, investors would be required to notify the board of a public company within one day of acquiring more than 5% of the company’s shares, while still having ten days to publicly notify the Commission. On its face, the compromise solution creates the potential to satisfy both sides of the debate. On one hand, a board could disclose to their shareholders any significant investor acquisitions in their company within a day of the Section 13(d) threshold being reached, and, on the other, the investor could negotiate with the board to keep the information confidential for a longer period of time so that the investor could acquire more shares while simultaneously advancing ideas for enhancing the value of the company without the glare of the public spotlight. Although legal and strategic challenges exist in implementing this solution, neither poses a risk of undermining its utility.