Harvard Business Law Review (HBLR)

The Harvard Business Law Review (HBLR) aims to be the premier journal covering the laws of business organization and capital markets. HBLR will publish articles from professors, practitioners, and policymakers on corporate law and governance, securities and capital markets law, financial regulation and financial institutions, law and finance, financial distress and bankruptcy, and related subjects.

The Coconundrum

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The Coconundrum

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Frederick Ryan Castillo*

Digging deeper into their analytical toolbox, policymakers, academics, and regulators are increasingly exploring whether, and to what extent, a system of contingent capital can strengthen the resilience of the banking sector. The global financial crisis unearthed fragile and troubled banks, riddled with excessive leverage, poor quality capital buffers, and liquidity problems. Because these institutions were deemed “too big to fail,” governments were forced to intervene and prop them up by way of costly, taxpayer-funded bailouts. With the benefit of hindsight, regulators are now looking at contingent capital as a potentially speedy and less costly alternative for recapitalizing banks in periods of financial distress.[1]

But is contingent capital a desirable, feasible and sustainable proposition, or is it an overly-simplified theoretical concept fraught with practical difficulties and unrealistic expectations?

Contingent capital—also known as “contingent convertibles” or “CoCos,”[2] “regulatory hybrid securities,”[3] “contingent capital certificates,”[4] or “embedded contingent capital”[5]—refers to debt instruments which mandatorily convert into equity upon the happening of one or more pre-defined events or triggers.[6] Regulators have tinkered with the idea of requiring systemically important banks to issue these instruments as integral components of their capital structures. When a bank encounters a liquidity or capital crisis, the CoCos will be converted into equity, thus increasing the bank’s capital buffers and avoiding the need to seek governmental intervention.

Proponents of contingent capital, who include Mark Flannery[7], Robert McDonald[8], the Squam Lake Working Group[9], and John Coffee, Jr.[10], view it as a desirable and workable mechanism. Contingent capital, it is argued, will ease financial distress, reduce bank leverage, minimize incidents of bank insolvency, avoid costly public bailouts, set up a speedy bank resolution regime, internalize bank failure costs, and insulate the rest of the financial system from possible systemic spillover effects.[11] The Basel Committee on Banking Supervision (BCBS) also observes that the use of contingent capital would lessen moral hazard by increasing private sector involvement in the resolution of future banking crises.[12]

In contrast, critics such as Anat Admati, Peter DeMarzo, Martin Hellwig and Paul Pfleiderer point out that contingent capital and related “bail-in” mechanisms are too complicated to design, pose difficult implementation concerns, and are less effective than the straightforward approach of requiring banks to have more equity capital.[13]The Association of British Insurers has also voiced its concerns as to how the instruments would work in practice, noting that investors in CoCos would be made to absorb “haircuts” or losses when conversion takes place.[14]

However, it may be said that on the balance, the reservations critics have with respect to contingent capital focus largely on the practical difficulties likely to be encountered once these instruments are put into use, and not on the desirability of contingent capital as a potential tool for stabilizing banks. As Coffee points out, contingent capital is not an “abstract academic idea,” but “its optimal design remains open to legitimate and necessary debate.”[15]

Taking the debate a point further, it appears that the feasibility and sustainability of CoCos ultimately turns on a careful consideration and resolution of four key areas.

First, consensus with respect to the appropriate trigger (i.e. the point at which conversion of debt into equity takes place) needs to be reached. At present, there is a wide spectrum of proposals on this issue, with some advocating that the trigger be determined by a country’s regulatory authority, while others are arguing that a more objective measure, such as a reference to a market index or a specified capital ratio, be used.[16] For instance, in August, the BCBS issued a proposal that would allow capital instruments to be written off or converted to common shares at the discretion of the relevant authority if: (a) the bank was judged to be non-viable by the relevant authority or (b) the bank had received a public sector capital injection without which it would have become non-viable.[17] The Squam Lake Working Group suggests a double trigger: regulators must declare the existence of a systemic crisis, and the bank must fall below a given capital ratio.[18] In contrast, Flannery argues that the trigger should not depend on the state of the financial system, but rather on the contemporaneous market value of the firm’s outstanding common equity.[19]

Second, regulators must facilitate the market’s acceptance of CoCos by clarifying their essential investment features and, where appropriate, engaging in meaningful discourse with leading industry groups. For instance, a particular concern among investors is whether credit rating agencies are willing and able to adequately assess the risk features of CoCos.[20] In this regard, Fitch Ratings’ early November statement that it expects to be able to rate these new-generation bank hybrid securities may stimulate renewed interest in CoCos.[21] News last October that Swiss authorities are open to the use of CoCos to fund the capital requirements of UBS and Credit Suisse is also a welcome development.[22]

Third, the appropriate tax treatment of CoCos needs to be settled. The primary issue here is whether tax authorities would be willing to recognize contingent capital as debt (thereby allowing tax-deductible interest expenses) despite the instrument’s convertibility into equity.[23] If so, banks will enjoy the benefits of debt financing and will gravitate toward the use of CoCos in their capital structures.

Lastly, differences in the legal treatment of CoCos across relevant jurisdictions need to be sufficiently understood. Interestingly, the BCBS has already commenced this process by requesting feedback from market participants, including investors in bank capital instruments, on all aspects of its August proposal (on contingent capital and triggers), including “any legal or operational obstacles to their implementation.”[24] The BCBS has even encouraged industry practitioners to work with regulators in drafting terms and conditions for contingent capital instruments while “respecting relevant national constraints.”[25] Whether sufficient harmonization and acceptance of contingent capital across varying legal jurisdictions will be achieved, however, remains to be seen.

The discussion on contingent capital will likely continue and escalate in the coming weeks, but the ultimate verdict on its feasibility and sustainability will not be immediate. The conundrum of contingent capital presents broad challenges to the financial sector and to the economy as a whole, as stakeholders seek new and innovative ways of stabilizing the banking sector and preventing another financial crisis.

* LL.M. Candidate, 2011, Harvard Law School.

 

[1] See Damian Paletta, ‘Contingent Capital’ Idea Gaining More Steam Within Fed, Wall St. J. (Oct. 13, 2009), http://blogs.wsj.com/economics/2009/10/13/contingent-capital-idea-gaining-more-steam-within-fed; Steve Slater & Clara Ferreira-Marques, Contingent Capital: Cure or Cost for Banks?, Reuters (Oct. 27, 2009), http://uk.reuters.com/article/idUKLNE59Q01K20091027; Giuseppe De Martino, Masimo Libertucci, Mario Marangoni, & Mario Quagliariello, A Proposal for Countercyclical Contingent Capital Instruments, VOX (Oct. 30, 2010), http://www.voxeu.org/index.php?q=node/5728; BoE’s Tucker-CoCos Could Transform Bank Landscape, Reuters (Nov. 16, 2009), http://blogs.reuters.com/financial-regulatory-forum/2009/11/16/boes-tucker-cocos-could-transform-bank-landscape.  See also Press Release, Bank for International Settlements, Consultative Proposals to Strengthen the Resilience of the Banking Sector Announced by the Basel Committee (Dec. 17, 2009), http://www.bis.org/press/p091217.htm.

[2] See CoCo Nuts, The Economist (Nov. 5, 2009), http://www.economist.com/node/ 14816673?story_id=14816673.

[3] Squam Lake Working Group on Financial Regulation, An Expedited Resolution Mechanism for Distressed Financial Firms: Regulatory Hybrid Securities (Council on Foreign Relations, Center for Geoeconomic Studies, Working Paper 2009) at 2.

[4] Mark J. Flannery, Stabilizing Large Financial Institutions with Contingent Capital Certificates (2009), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1485689.

[5] Julie Dickson, Superintendant, Financial Institutions Canada, Remarks at Financial Services Invitational Forum (May 6, 2010) at 4, http://www.osfi-bsif.gc.ca/app/DocRepository/1/eng/speeches/jdlh20100506_e.pdf.

[6] Id.

[7] See Flannery, supra note 4.

[8] See Robert J. Mcdonald, Contingent Capital with a Dual Price Trigger (2010), available at http://papers. ssrn.com/sol3/papers.cfm?abstract_id=1553430.

[9] See Squam Lake Working Group, supra note 3.

[10] See John Coffee, Jr., Bail-Ins Versus Bail-Outs: Using Contingent Capital to Mitigate Systemic Risk (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1675015.

[11] See Flannery, supra note 4, at 3; Coffee, supra note 10, at 10, 33; McDonald, supra note 8, at 2, 21.

[12] See Basel Committee on Banking Supervision, Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability (2010), available at http://www.bis.org/publ/bcbs174.pdf.

[13] See R. Admati, Peter M. DeMarzo, Martin F. Helllwig, & Paul C. Pfleiderer, Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is not Expensive (2010), http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=1669704.

[14] Huw Jones, UK Insurers Say CoCo Capital Poorly Thought Out, Reuters (Nov. 9, 2010), http://www. reuters.com/article/idUSLDE6A812Z20101109.

[15] Coffee, supra note 10, at 9.

[16] See Coffee, supra note 10, at 34–35.

[17] Basel Committee on Banking Supervision, supra note 12; see also Martin Dozier, Basel Committee Commences Consultation Regarding Contingent Capital Requirement, Financial Markets Blog (Aug. 19, 2010), http://www.alston.com/financialmarketscrisisblog/blog.aspx?entry=3922; Press Release, Bank for International Settlements, Basel Committee Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability (Aug. 19, 2010).

[18] Squam Lake Working Group, supra note 3, at 4.

[19] Flannery, supra note 4, at 11.

[20] See Tracy Alloway, CoComplications, Financial Times Alphaville (Nov. 18, 2010), http://ftalphaville.ft. com/blog/2009/11/18/83946/cocomplications; see also Tracy Alloway, Will Rate CoCo Bonds for Food, Financial Times Alphaville (Nov 9, 2010), http://ftalphaville.ft.com/blog/2010/11/09/398811/will-rate-coco-bonds-for-food; Tracy Alloway, Cuckoo for CoCos, Financial Times (Nov 11, 2010), http://ftalphaville.ft.com/blog/2009/11/11/ 82756/cuckoo-for-cocos.

[21] “Mark Brown, Fitch Statement on Bank Hybrid Securities Seen as Constructive, Fox Business (Nov. 8, 2010), http://www.foxbusiness.com/markets/2010/11/08/fitch-statement-bank-hybrid-securities-seen-constructive/#ixzz16QleaUzf.

[22] Jane Merriman, Swiss Give Fresh Momentum to Contingent Bonds, Reuters (Oct. 4, 2010), http://blogs.reuters.com/financial-regulatory-forum/2010/10/04/snap-analysis-swiss-give-fresh-momentum-to-contingent-bonds.

[23] See Coffee, supra note 10, at 44; McDonald, supra note 8, at 16; Humphreys & Pinedo, supra note 2.

[24] Basel Committee on Banking Supervision, supra note 12, at 3.

[25] Id.

Preferred citation: Frederick Ryan Castillo, The Coconundrum, 1 Harv. Bus. L. Rev. Online 29 (2010), https://journals.law.harvard.edu/hblr//?p=832.

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Citizens United and the Nexus-Of-Contracts Presumption

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Stefan J. Padfield*

Citizens United v. Federal Election Commission[1] has been described as “one of the most important business decisions in a generation.”[2] In Citizens United, the Supreme Court of the United States invalidated section 441(b) of the Federal Election Campaign Act of 1971 as unconstitutional.[3] That section prohibited corporations (and unions) from financing “electioneering communications” (speech that expressly advocates the election or defeat of a candidate) within 30 days of a primary election. The five Justices in the majority rested their holding on the assertion that “Government may not suppress political speech on the basis of the speaker’s corporate identity.”[4] In reaching this conclusion, the majority relied on a view of the corporation fundamentally as an “association of citizens.”[5]

Meanwhile, the view of the corporation advanced by Justice Stevens in dissent differed markedly from that of the majority. Where the majority saw an association of citizens, the dissent saw state-created entities that: (1) “differ from natural persons in fundamental ways”;[6] (2) “have no consciences, no beliefs, no feelings, no thoughts, no desires”;[7]and (3) “must engage the political process in instrumental terms if they are to maximize shareholder value.”[8] Of particular note, the dissent asserted that “corporations have been ‘effectively delegated responsibility for ensuring society’s economic welfare.’”[9]

These competing visions of the corporation roughly align with two divergent theories of the corporation: nexus-of-contracts theory for the majority and concession theory for the dissent.[10] It is worth considering that adoption of these competing theories of the firm was in some meaningful way dispositive. By denying that there was anything more substantial to the corporation than an association of citizens, the majority could conclude that there was nothing about the corporation qua corporation that justified restricting corporate political speech solely on the basis of corporate identity.[11] Conversely, the dissent’s view of the corporation as “differ[ing] from natural persons in fundamental ways”[12] arguably made it much easier to conclude that the challenged limitations on speech survived strict scrutiny.

If the foregoing is correct, then it becomes quite puzzling that the majority remained silent as to the role of corporate theory and the dissent expressly disavowed any connection. Wrote Justice Stevens: “Nothing in this analysis turns on whether the corporation is conceptualized as a grantee of a state concession, a nexus of explicit and implicit contracts, a mediated hierarchy of stakeholders, or any other recognized model.”[13] What might explain such apparent incongruence?

One could argue that whatever differences the majority and dissent may have had regarding theories of the corporation, their differences were not dispositive because the only thing we need to know about the nature of the corporation in order to decide the case is that corporations are “persons” whose speech is protected under the First Amendment.[14] However, one also could argue that First Amendment analysis regarding a corporate person is incomplete without considering the theory of the corporation. According to this argument, speech by such a corporate person potentially fits within the “narrow class” of cases upholding identity-based speech restrictions,[15] but we cannot properly determine that issue without clarifying the “identity” of the corporation—which would need to be based on a theory of the corporation.

Overall, it might have been improper to focus on corporation theory because that theory is not in fact outcome determinative.[16] However, most modern commentators agree that the nexus-of-contracts theory generally is aligned with less regulation of corporations, while concession theory generally is aligned with more regulation.[17]

I suggest another explanation. It may well be that corporate theory was dispositive in Citizens United, but that acknowledging such a role for corporate theory would have raised serious questions about the propriety of the Supreme Court proclaiming what the “true” nature of the corporation might be. As recently as 1989, the Court described corporations as “entities whose very existence and attributes are a product of state law.”[18] Would the Court now turn around and tell states what they had created? Such a pronouncement would raise issues of federalism. Rather, one might view the majority’s effective adoption of the nexus-of-contracts theory as the adoption of a sort of presumption—not unlike the adoption of the fraud-on-the-market presumption in Basic Inc. v. Levinson.[19] The fraud-on-the-market theory then, like the nexus-of-contracts theory now, certainly had much academic support. Nonetheless, by merely adopting a presumption, the Court was able to employ the benefits of the widely accepted theory without having to confront difficult questions of having exceeded its expertise by determining whether the theory was in fact correct.[20]

Likewise, one might view the majority’s reliance on a view of the corporation as nothing more than an association of citizens as the adoption of a presumption in favor of the nexus-of-contracts theory—albeit an unexpressed adoption.[21] Interestingly, we may see the Court apply such a presumption again in the pending case of FCC v. AT&T.[22] In that case, the Court has been asked to decide whether corporations have personal privacy rights under the Freedom of Information Act (“FOIA”). While the case may well be decided on the basis of a purely textual analysis of the statute, there certainly appears to be room for an assertion that there is nothing unique about corporations—since they are merely associations of citizens (in accordance with the nexus-of-contracts presumption)—that should preclude them from claiming personal privacy rights under FOIA like other persons.

* Associate Professor, University of Akron School of Law. The idea for this piece was presented at Citizens United v. FEC: A Panel Discussion, hosted by the West Virginia University College of Law on November 4, 2010. My thanks to all the participants for their helpful comments. Thanks also to Stephen Bainbridge, Kent Greenfield, and Larry Ribstein for their helpful comments.

 

[1] 130 S. Ct. 876 (2010).

[2] Larry E. Ribstein, The Court Unleashes the Corporation, Ideoblog (Jan. 22, 2010, 8:22 AM), http://busmovie.typepad.com/ideoblog/2010/01/the-court-unleashes-the-corporation.html.

[3] Bipartisan Campaign Reform Act of 2002, Pub. L. No. 107-155, 116 Stat. 81 (2002) (amending 2 U.S.C. § 441(b) (2006)).

[4] Citizens United, 130 S. Ct. at 885.

[5] See, e.g., id. at 906–07 (asserting that the Court’s prior ruling in Austin v. Michigan State Chamber of Commerce, 494 U.S. 652 (1990), “permits the Government to ban the political speech of millions of associations of citizens”); id. at 908 (asserting that, under 2 U.S.C.A. § 441(b), “certain disfavored associations of citizens—those that have taken on the corporate form—are penalized for engaging in . . . political speech”).

[6] Id. at 971 n.72 (Stevens, J., dissenting).

[7] Id. at 972.

[8] Id. at 965.

[9] Id. at 971 (quoting Milton Regan, Corporate Speech and Civic Virtue, in Debating Democracy’s Discontent 289, 302 (A. Allen & M. Regan eds.,1998)).

[10] See, e.g., Stephen M. Bainbridge, Citizens United v. FEC: Stevens’ Pernicious Version of the Concession Theory, ProfessorBrainbridge.com (Jan. 21, 2010, 4:05 PM), http://www.professorbainbridge.com/professorbainbridgecom /2010/01/citizens-united-v-fec-stevens-pernicious-version-of-the-concession-theory.html. But see Larry E. Ribstein, Citizens United v. FEC: A Roundtable Discussion, Federalist Society (Feb. 3, 2010), http://www.fed-soc.org/debates/dbtid.38/default.asp (“In general, Justice Kennedy’s majority opinion and Justice Stevens’ dissent represent diametrically opposed views of the corporation. . . . Neither the majority nor the dissent sees the corporation for what it is – a set of contracts among the participants.”); cf. Liam Seamus O’Melinn, Neither Contract nor Concession: The Public Personality of the Corporation, 74 Geo. Wash. L. Rev. 201, 201 (2006) (“This Article challenges the two preeminent theories of the corporation—contract and concession. . . .”); id. at n.3 (“Not all theorists use the language of contract and concession, with several preferring ‘property’ and ‘entity,’ but the contract and property theories are roughly the same, as are the concession and entity theories.”).

[11] See Citizens United, 130 S. Ct. at 899 (majority opinion) (concluding there was no reason to include BCRA in the “narrow class of speech restrictions that operate to the disadvantage of certain persons” because “[t]he corporate independent expenditures at issue in this case . . . would not interfere with governmental functions”).

[12] Id. at 971 n.72 (Stevens, J., dissenting).

[13] Id. (internal citations omitted).

[14] See First Nat’l Bank of Bos. v. Bellotti, 435 U.S. 765, 780 n.15 (1978) (“[C]orporations are persons within the meaning of the Fourteenth Amendment.”).

[15] See Daniel J.H. Greenwood, Fictional Shareholders: For Whom are Corporate Managers Trustees, Revisited, 69 S. Cal. L. Rev. 1021, 1093–94 (1996) (arguing that corporations lobby for laws that no human being would desire, and which may in fact be harmful to human beings).

[16] Cf. David Millon, Theories of the Corporation, 1990 Duke L.J. 201, 202 (1990) (“Historically, the political implications of the natural/artificial and entity/aggregate distinctions have been ambiguous, meaning different things at different times.”).

[17] Cf. William W. Bratton, Jr., The “Nexus of Contracts” Corporation: A Critical Appraisal, 74 Cornell L. Rev. 407, 433 (1989) (“Commentary grounded in the nexus of contracts concept declares ‘contract or concession’ to be the political issue regarding the theory of the firm. It asserts that advocates of government regulation subscribe to a concession theory of the corporation’s origin and then draws on the nexus of contracts to rebut concession theory.”).

[18] CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69, 89 (1989).

[19] 485 U.S. 224, 250 (1988) (holding that “[i]t is not inappropriate to apply a presumption of reliance supported by the fraud-on-the-market theory” in Rule 10b-5 actions).

[20] Id. at 242 (“Our task, of course, is not to assess the general validity of the theory, but to consider whether it was proper for the courts below to apply a rebuttable presumption of reliance, supported in part by the fraud-on-the-market theory.”).

[21] One possible reason that the Court did not expressly adopt the suggested presumption is that both the majority and the dissent considered their respective views of the corporation to be so obvious as to require little further comment. See Citizens United v. Fed. Election Comm’n, 130 S. Ct. 876, 971, n.72 (Stevens, J., dissenting) (“It is not necessary to agree on a precise theory of the corporation to agree that corporations differ from natural persons in fundamental ways, and that a legislature might therefore need to regulate them differently if it is human welfare that is the object of its concern.”). As far as the dissent is concerned, the motivation for avoiding further discussion of the theory of the corporation may also include a desire to avoid the objection that its concession theory ultimately seeks to impose an unconstitutional condition on the grant of corporate powers. See id. at 905 (“It is rudimentary that the State cannot exact as the price of those special advantages [of incorporation] the forfeiture of First Amendment rights.”) (quoting Austin v. Michigan State Chamber of Commerce, 494 U.S. 652, 680 (1990) (Scalia, J., dissenting)).

[22] 582 F.3d 490. See generally Stefan J. Padfield, Freedom of Information Act: FCC v. AT&T, 38 Preview of U.S. Sup. Ct. Cases 156, 158 (forthcoming Jan. 2011) (“One thing to watch for is the extent to which corporate theory plays a role in the decision.”).

Preferred citation: Stefan J. Padfield, Citizens United and the Nexus-Of-Contracts Presumption, 1 Harv. Bus. L. Rev. Online 25 (2010), https://journals.law.harvard.edu/hblr//?p=813.

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Concerted Refusals to License Intellectual Property Rights

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Christina Bohannan and Herbert Hovenkamp*

The Federal Circuit recently issued a patent misuse decision that has implications for both innovation policy and antitrust law. Unilateral refusals to license intellectual property rights are virtually never antitrust violations, as is true of most unilateral refusals to deal.[1] The Patent Act provides that a unilateral refusal to license cannot constitute patent “misuse,”[2] which is a defense to an infringement suit based on the patentee’s anticompetitive acts, restraints on innovation, or improper sequestering of the public domain.[3] Concerted refusals to deal are treated much more harshly under the antitrust laws[4] because they can facilitate collusion[5] or, in the case of technology, keep superior products or processes off the market.[6]

In its en banc Princo decision a divided Federal Circuit debated whether Congress had protected concerted refusals to license from claims of patent misuse. The majority rejected the dissenter’s argument that Congress had no such intent and then went on to hold that an alleged concerted refusal to license was not misuse.[7] Princo involved a Sony/Philips joint venture to develop rewritable compact discs (CD-RWs). This process required working technology and also a “standard” that would ensure product compatibility for licensees building equipment.[8] One technical problem was placing location information on the disc so that the stylus could find the right spot. Philips’ solution was an analog method claimed by the Raaymakers patent, while Sony’s was a digital method claimed by the Lagadec patent.[9]

Philips and Sony agreed to use the analog method because the Lagadec technology was quirky and unstable.[10] However, one claim in the Lagadec patent arguably covered technology in the CD-RW standard[11], so the Lagadec patent was incorporated in the package license agreement as well.[12] Philips and Sony also allegedly agreed that they would not license the Lagadec patent for use by third parties.[13] The Lagadec digital patent was unused, except to the extent that it was included in the standard CD-RW package to prevent it from blocking other patents in that package.[14] If two patents block each other they must be licensed together or the licensee will not be able to use them.[15]

The Patent Misuse Reform Act provides that:

d) No patent owner otherwise entitled to relief for infringement or contributory infringement of a patent shall be denied relief or deemed guilty of misuse or illegal extension of the patent right by reason of his having … (4) refused to license or use any rights to the patent; or (5) conditioned the license of any rights to the patent or the sale of the patented product on the acquisition of a license to rights in another patent or purchase of a separate product, unless, in view of the circumstances, the patent owner has market power in the relevant market for the patent or patented product on which the license or sale is conditioned.[16]

The dissent believed that subsection (4) protected only unilateral refusals to deal. The majority disagreed and, without explicitly applying the statute, concluded that the alleged concerted refusal to license could not be misuse.

In its Illinois Tool Works (ITW) decision, the Supreme Court heavily relied on section 271(d)(5) to conclude that, just as the Patent Act requires proof of tying market power in a tying case, antitrust should assess the same requirement.[17] The Court noted that language similar to that found in the opening of this paragraph referred not merely to “misuse” but also to “illegal extension of the patent right,”[18] a phrase that the Court associated with antitrust liability.[19]

Blanket legality for concerted refusals to license patents, and unused patents in particular, would have serious implications for competition and innovation. A concerted refusal to license a plant or other input can facilitate collusion by denying resources to rivals unless they can find other sources.[20] A concerted refusal to license an unused patent can go much further. Not only does it deny rivals that particular technology but it also prevents them from developing any technology independently that would infringe one or more of that patent’s claims. Someone wishing to develop a digital alternative to the analog technology licensed in the Sony/Philips package would have to invent around the Lagadec patent claims even though the technology claimed in that patent is not in use.

Further, this licensing rule would not distinguish between internally developed patents and those acquired from the outside. A group of firms employing a particular technology could purchase exclusive rights in patents developed by a nascent rival and agree not to assign them to anyone else, thus protecting their own technology from competitive entry.

The Princo majority and dissent debated whether Congress intended section 271(d)(4) to cover concerted as well as unilateral refusals, but the legislative history is very thin, producing only a debate over whether noncompetition agreements in patent licenses amounted to concerted refusals.[21] They should have looked at the status of antitrust law on the issue, however, which made unilateral refusals to license virtually lawful per se while often condemning concerted refusals to license IP rights.[22]

Of course, not every concerted refusal to license should be unlawful per se. They are appropriately covered by the ancillary restraints doctrine. Naked agreements not to license are unlawful per se, while refusals reasonably necessary to further joint research or production would be unlawful only if market power and anticompetitive effects were proven.[23] By contrast, reading section 271(d) to authorize naked concerted refusals is likely to harm both competition and the incentive to innovate.

* Christina Bohannan is a Professor of Law at the University of Iowa. Herbert Hovenkamp is the Ben V. & Dorothy Willie Professor of Law at the University of Iowa.

 

[1] Cont’l Paper Bag Co. v. E. Paper Bag Co., 210 U.S. 405 (1908) (holding that patentee acting unilaterally has no duty to license acquired and unused patent). On unilateral refusals, see 3B Phillip E. Areeda & Herbert Hovenkamp, Antitrust Law ¶¶ 770–74 (3d ed. 2007); on unilateral refusals to license IP rights, see Herbert Hovenkamp et al., IP and Antitrust §13.2 (2d ed. 2010); cf. Am. Needle, Inc. v. Nat’l Football League, 130 S. Ct. 2201, 2208 (2010) (distinguishing unilateral from concerted refusal to license trademark rights; antitrust liability for unilateral action is narrower and reachable only when it monopolizes).

[2] 35 U.S.C. § 271(d)(4) (2006).

[3] On patent misuse, see Christina Bohannan, IP Misuse as Foreclosure, 96 Iowa L. Rev. (forthcoming 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1474407.6.

[4] See 13 Herbert Hovenkamp, Antitrust Law ¶¶ 2201–05 (2d ed. 2005); see also Areeda & Hovenkamp, supra note 1, ¶¶ 2220–23.

[5] E.g., Associated Press v. United States, 326 U.S. 1 (1945) (finding antitrust violation when an association of newspapers employed rules restricting sale of news to non-members and obstructing admission of rivals). While the Supreme Court did not separately analyze facilitation of collusion, it acknowledged the disciplining role of combination by affirming that it “provides extra-judicial tribunals for determination and punishment of violations.” Id. at 19.

[6] E.g., Allied Tube, Inc. v. Indian Head, Inc., 486 U.S. 492 (1988) (finding antitrust violation when producers of steel conduit agree to exclude rival’s innovative PVC conduit).

[7] Princo Corp. v. Int’l Trade Comm’n, 616 F.3d 1318, 1330 (Fed. Cir. 2010) (en banc).

[8] Id. at 1322.

[9] Id.

[10] Id. at 1322, 1337.

[11] Id. at 1324.

[12] Id.

[13] Id. at 1325, 1326, 1331.

[14] See id. at 1324.

[15] See id. at 1325; 10 Phillip E. Areeda & Herbert Hovenkamp, Antitrust Law ¶ 1782 (3d ed., forthcoming 2011).

[16] 35 U.S.C. § 261(d)(4), (5) (2006).

[17] Ill. Tool Works, Inc. v. Indep. Ink, Inc., 547 U.S. 28, 31 (2006) (“The question . . . is whether the presumption of market power in a patented product should survive as a matter of antitrust law despite its demise in patent law.”).

[18] Id. at 42.

[19] See id. at 34 (associating this language with the Sherman Act, the Clayton Act, and the FTC Act).

[20] See, e.g., Hartford Fire Ins. Co. v. California, 509 U.S. 764 (1993) (finding that dominant insurers forced reinsurers to deny coverage to rivals); E. States Retail Lumber Dealers’ Ass’n v. United States, 234 U.S. 600 (1914) (finding that lumber retailers boycotted wholesalers who were integrating vertically into retailing).

[21] Princo Corp. v. Int’l Trade Comm’n, 616 F.3d 1318, 1330 (Fed. Cir. 2010); id. at 1350–51 (Dyk, J, dissenting).

[22] E.g., United States v. Krasnov, 143 F. Supp. 184 (E.D. Pa. 1956), aff’d per curiam, 355 U.S. 5 (1957) (finding that cartel of upholstery manufacturers cross-licensed and refused to license to others; per se unlawful); United States v. Nat’l Lead Co., 63 F. Supp. 513 (S.D.N.Y. 1945), aff’d, 332 U.S. 319 (1947).

[23] On the rule of reason for ancillary concerted refusals to deal, see Hovenkamp, supra note 4, at ¶¶ 2210–14.

Preferred citation: Christina Bohannan & Herbert Hovenkamp, Concerted Refusals to License Intellectual Property Rights, 1 Harv. Bus. L. Rev. Online 21 (2010), https://journals.law.harvard.edu/hblr//?p=788.

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Understanding the Commercial Real Estate Debt Crisis

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Tanya D. Marsh*

The popular, if simplistic, understanding of the most recent economic crisis is that it was triggered by the bursting of an unprecedented residential real estate bubble. In this narrative, the bubble was caused by interrelated factors—the irrational beliefs of homeowners that property values would continue to rise and the aggressive lending practices, which focused on maximizing the size and volume of loan originations at the expense of prudent underwriting. Although we see signs of a slow recovery,[1] the bubble’s collapse continues to have a destabilizing effect on every corner of our economy and society, from financial institutions struggling with “toxic assets” on their balance sheets, to community disruption caused by residential foreclosures.

Although the total amount of outstanding commercial real estate debt is less than a third of the amount of outstanding residential debt,[2] there is increasing concern that a commercial real estate debt crisis is on the horizon. The Congressional Oversight Panel, chaired by Elizabeth Warren, issued a report in February 2010 that warned that a commercial real estate debt crisis could cause a “second wave of property-based stress on the financial system.”[3] Given the potential threat to our fragile recovery, we should act quickly to understand the scope and causes of the looming collapse of commercial real estate so that we can craft appropriate policies to mitigate losses and prevent future problems. As we analyze the issues, however, we need to be careful not to summarily adopt the prevailing narrative of the residential crisis—that irresponsible borrowers and aggressive lenders are to blame.

Increasing Delinquency Rates. In comparison to residential foreclosure statistics,[4] the commercial real estate debt problems currently appear to be mild.[5] Over 50% of outstanding commercial real estate debt is held by banks, which reported that as of September 30, 2010, only 4.41% of such mortgages were more than 90 days delinquent.[6] However, as the table below shows, the delinquency rates for commercial real estate mortgages have shown steady and marked increases since the beginning of 2007.[7] If these trends do not reverse themselves soon, commercial real estate defaults will become a significant issue, particularly for our nation’s banks.

 

 

 

 

 

 

 

 

 

Comparing Residential and Commercial Real Estate Debt. There are important differences between residential and commercial real estate debt that make it difficult to analogize causation factors. The most common residential default is failure to make monthly loan payments because the borrower has suffered an economic setback, such as unemployment, or because the loan was structured so that payments dramatically increased at some point during the term. In some cases, particularly if a property has suffered increased vacancy, commercial borrowers also default due to a failure to make monthly payments. But the increasingly common commercial defaults are “maturity defaults” in which the borrower is unable to borrow a large enough sum to pay off an expiring loan.[8] The difference between the balloon payment owed on the maturing loan and the amount that can be borrowed today is the “equity gap.” The equity gap is caused by two factors: falling valuations of commercial real estate and lack of liquidity.

All lenders use written and informal guidelines to analyze potential loans to residential and commercial borrowers.[9] These “underwriting standards” are a product of market conditions, guidance from federal banking supervisors, and internal decisions about risk tolerance. Underwriting standards include pricing decisions (fees and interest rates), loan-to-value ratios, creditworthiness of the borrower or guarantor, and loan covenants. The extent to which a lender conducts due diligence on property, borrower, and guarantor is also determined by underwriting standards.

A residential real estate loan is underwritten by evaluating both the market value of the property and the creditworthiness of the borrower. The value of residential real estate is primarily determined by analyzing the sales prices of comparable properties, and therefore values can fluctuate widely over time.  Regardless of the value of a home, the borrower’s financial stability and ability to repay the loan are critical components of residential underwriting. Relaxed underwriting standards clearly contributed to problems in residential real estate because: (1) Many homes were over-valued during the 2000s; and (2) many borrowers qualified for loans that they were unlikely to repay even in the most  optimistic circumstances.[10]

In commercial lending, the collateral and the borrower are both evaluated, but the emphasis is on the ability of income-producing real estate to continue to generate income in an amount sufficient to cover operating expenses and debt service.[11] Most commercial real estate is owned in a single-asset limited liability company or limited partnership, which serves to segregate exposure to contract and tort liability. This ownership structure is significant in the debt context because most permanent commercial real estate loans are non-recourse or limited-recourse to the parent company or individuals behind the single-asset entity. Therefore, the creditworthiness of that parent is not a significant factor in underwriting because it is unlikely that they will be called upon to satisfy a deficiency. The experience and ability of the owner to operate the collateral to obtain maximum return, however, is highly relevant.

It has been estimated that commercial real estate has dropped in value 35-45% since the height of the market in 2007.[12] That decline is the result of two factors: (1) Downward pressure on rent and increasing vacancy rates; and (2) increasing capitalization rates. The value of commercial real estate is generally estimated by dividing the net operating income of a property by a capitalization rate. The capitalization rate is essentially the market’s attempt to quantify the risk in collecting a particular income stream in the future. Capitalization rates are impacted by macroeconomic phenomena like liquidity and tax policy, and microeconomic factors like local unemployment rates and supply and demand of the type of asset. A lower capitalization rate results in a higher property value and a higher capitalization rate results in a lower property value. Capitalization rates are problematic where a market is stalled, as ours is, by limited liquidity and decreased demand.[13] Capitalization rates have increased significantly since 2007, which has in turn devastated appraisal values of commercial real estate. As a result, many borrowers who have no problem making monthly mortgage payments find themselves in technical default because of low appraisals that fail to satisfy required loan-to-value ratios.

The more significant problem is that borrowers of performing assets are finding themselves in maturity defaults, unable to refinance expiring debt. Unlike residential loans, which normally fully amortize over a 30-year term, permanent commercial loans normally partially amortize over a 10-year term. As a result, every ten years the borrower must refinance a balloon payment. Over $1.4 trillion in commercial debt will mature before 2013.[14] Combining the dramatic increase in capitalization rates with the sluggish capital markets, borrowers and lenders are faced with an equity gap that some analysts have estimated will exceed $800 billion.[15]

Understanding What Went Wrong. A few governmental agencies have begun to review the issues surrounding commercial real estate debt, particularly in the contexts of small business lending and the stability of banks and thrifts.[16] The February 2010 report by the Congressional Oversight Panel (COP) is the most thorough attempt by policymakers to describe the challenges posed by commercial real estate debt. But one weakness of the COP report is that it adopted the narrative borrowed from the residential crisis—that aggressive underwriting by lenders is largely to blame.[17] The COP primarily relies upon surveys of senior loan officers[18] to summarily conclude that “faulty”[19] and “dramatically weakened”[20] underwriting standards resulted in “riskier” commercial real estate loans during the mid-2000s.[21] The COP assumes too much when it relies on broad survey information that underwriting standards were “relaxed.”[22] For example, lowering the interest rate on a commercial real estate loan, or providing a ten-year rather than five-year term would constitute weakened underwriting standards but would not make the loan inherently riskier. Empirical work should be done to evaluate changes over time in debt service coverage ratios, reserves, and loan covenants before we can conclude that the reported “easing” of underwriting standards during the 2000s resulted in riskier loans.[23]

In the absence of empirical evidence, it is important to challenge the COP’s connection between weakened underwriting standards and increased risk because of the strong moral dimension in political responses to the broader financial crisis. It is human nature to balk at helping those that we believe created their own problems. Understanding the root causes of the commercial real estate debt crisis, and determining whether “blame” can be appropriately assigned to “reckless” borrowers or to “aggressive” lenders may have a significant impact on our policy responses.

Conclusion. Determining how that equity gap will be satisfied, and by whom, will be a major challenge over the next few years. If borrowers cannot raise the funds, then lending institutions, particularly local and regional banks and thrifts, will be confronted with severe losses.[24] Government action will then likely be needed to prevent commercial real estate debt from derailing our fragile economic recovery. Given the potential political and economic impact, it is important that empirical work be done to fully investigate the factors that have contributed to a commercial real estate debt crisis.

* Assistant Professor, Wake Forest Law School. J.D., 2000, Harvard Law School.

[1] See Sudeep Reedy, Jobs Setback Clouds Recovery, Wall St. J., Dec. 4, 2010.

[2] Total outstanding commercial real estate debt is currently $3.2 trillion compared to $10.6 trillion in outstanding residential real estate debt. Flow of Funds Accounts of the United States: Flows and Outstandings Third Quarter 2010, Fed. Res. Stat. Release (Bd. Of Governors of the Fed. Reserve Sys., Wash., D.C.), Dec. 9, 2010, available at http://www.federalreserve.gov/RELEASES/z1/Current.

[3] See, e.g., Cong. Oversight Panel, February Oversight Report: Commercial Real Estate Losses and the Risk to Financial Stability 6 (2010), available at http://cop.senate.gov/reports/library/report-021110-cop.cfm [hereinafter COP Report]; CRE Complications Infecting Small Banks, May Cause Double Dip, Says Hill Roundtable, 3 Real Estate L. & Indus. Rep. 840 (BNA) (Nov.18, 2010) (quoting Rep. Walter Minnick as stating that “the losses are coming, and if the CRE credit markets are not stabilized, the losses could . . . trigger both an avalanche of bank failures and the much talked-about second dip of the recession”).

[4] In the third quarter of 2010, nearly 14% of residential mortgage loans were in foreclosure or at least one payment past due. Although the overall delinquency rate is improving, the percentage of loans that are 90 days or more past due remains almost four times the average percentage over the past twenty years. See Press Release, Mortg. Bankers Ass’n, Delinquencies and Loans in Foreclosure Decrease, but Foreclosure Starts Rise in Latest MBA National Delinquency Survey (Nov. 18, 2010), http://www.mortgagebankers.org/NewsandMedia/PressCenter/74733.htm.

[5] In the third quarter of 2010, 8.58% of mortgages held in commercial mortgage backed securities, which represent 25% of outstanding commercial real estate debt, were at least one payment past due or in foreclosure. Commercial/Multifamily Mortgage Delinquency Rates for Major Investor Groups, Third Quarter 2010, Surv. (Mortg. Bankers Ass’n), Dec. 2010, available at www.mortgagebankers.org/files/Research/CommercialNDR/3Q10CommercialNDR.pdf.

[6] Id.

[7] Id.

[8] The Impact Of Economic Recovery Efforts On Corporate and Commercial Real Estate Lending: Hearing Before the S. Cong. Oversight Panel, 111th Cong. 33 (May 28, 2009) (Statement of Richard Parkus, Head of CMBS and ABS Synthetics Research, Deutsche Bank Securities, Inc.) [hereinafter COP Transcript].

[9] Real Estate Lending Standards, 57 Fed. Reg. 62,900 (Dec. 31, 1992) (codified at 12 C.F.R. pt. 365.2).

[10] COP Transcript, supra note 8, at 34.

[11] Fed. Fin. Insts. Examination Council, Policy Statement on Prudent Commercial Real Estate Loan Workouts (2009), available at http://www.occ.gov/news-issuances/news-releases/2009/nr-ia-2009-128a.pdf [hereinafter FFIEC Report].

[12] COP Transcript, supra note 8, at 34.

[13] FFIEC Report, supra note 3, at 31–32.

[14] Deutsche Bank, CMBS Research: The Future Refinancing Crisis in Commercial Real Estate 7 (2009), available at http://cop.senate.gov/documents/report-042309-parkus.pdf.

[15] COP Transcript, supra note 8, at 34.

[16] See, e.g., Managing Commercial Real Estate Concentrations in a Challenging Environment, Fin. Inst. Letters (Fed. Deposit Ins. Corp., Arlington, Va.), March 17, 2008, available at www.fdic.gov/news/ news/financial/2008/fil08022.html; The Condition of Small Business and Commercial Real Estate Lending in Local Markets before the H. Fin. Services Comm. on Small Bus., 111th Cong. 4–8 (February 26, 2010) (Testimony of Stephen G. Andrews on behalf of the Independent Community Bankers of America) [hereinafter HFS Hearing].

[17] The Executive Summary to the COP Report states that “[t]he loans most likely to fail were made at the height of the real estate bubble when commercial real estate values had been driven above sustainable levels and loans; many were made carelessly in a rush for profit.” COP Report, supra note 3, at 2.

[18] See Release, Bd. of Governors of the Fed. Reserve Sys., The October 2009 Senior Loan Officer Opinion Survey on Bank Lending Practices 33 (Nov. 9, 2009), available at http://www.federalreserve.gov/boarddocs/SnloanSurvey/200911/; see also Office of the Comptroller of the Currency, Survey of Credit Underwriting Practices 2006, at 25–27 (2006), available at http://www.occ.treas.gov/publications/publications-by-type/survey-credit-underwriting/pub-survey-cred-under-2006.pdf.

[19] COP Report, supra note 3, at 28.

[20] Id. at 27.

[21] Id. at 20.

[22] The surveys may also be challenged by other data as not all senior loan officers agree that underwriting standards were relaxed during the 2000s. Wells Fargo Chairman Richard Kovacevich has stated that at his institution, commercial real estate underwriting was actually “more disciplined” during that decade compared to previous periods. See Ari Levy & Daniel Taub, Defaulting Commercial Properties Hit Banks on Vacancy-Rate Rise, Bloomberg, Mar. 22, 2009.

[23] In another example, the COP stated that “lax underwriting” is apparent in CMBS loans made from 2005–07, relying on data which shows that the number of interest-only and partial-interest-only loans contained in CMBS portfolios during those years increased significantly. Again, however, the COP summarily concluded that the partial- or non-amortization of a commercial real estate loan necessarily leads to the conclusion that such loan was “risky.” COP Report, supra note 3, at 22.

[24] HFS Hearing, supra note 16, at 5.

Preferred citation: Tanya D. Marsh, Understanding the Commercial Real Estate Debt Crisis, 1 Harv. Bus. L. Rev. Online 33 (2011), https://journals.law.harvard.edu/hblr//?p=900.

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A Brief History of Hedge Fund Adviser Registration and Its Consequences for Private Equity and Venture Capital Advisers

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William K. Sjostrom, Jr.

Historically, hedge fund advisers have not had to register under the Investment Advisers Act of 1940 (the Advisers Act)[1] because of the private adviser exemption. This exemption applied to an investment adviser who (1) had fewer than fifteen clients during the previous twelve months, (2) did not publicly hold itself out as an investment adviser, and (3) did not advise registered investment companies.[2] Even though a hedge fund routinely has fifteen or more investors, hedge fund advisers were able to meet the fewer than fifteen client requirement because they only had to count as clients the funds they advised (which they were careful to keep at fourteen or fewer) and not individual investors in the funds.[3]

As a result, hedge fund advisers were able to avoid the various provisions of the Advisers Act triggered by registration. These provisions include the requirement to disclose specified information to clients,[4] maintain certain business records,[5] permit the Securities and Exchange Commission (SEC) to examine those books and records,[6] make periodic filings with the SEC,[7] and have a corresponding compliance program in place.[8] While hedge funds were exempt from registration, they were subject to the Advisers Act’s prohibition on engaging in fraudulent or deceptive practices, as this provision applies to both registered and unregistered investment advisers.[9]

In light of the growth of hedge funds, hedge fund risk, and malfeasance by hedge fund advisers, the SEC in 2004 determined that hedge fund advisers should have to register under the Advisers Act.[10] Hence, it adopted a rule requiring investment advisers of hedge funds to look-through the fund and count as clients the fund’s investors for purposes of the fifteen client threshold.[11] As a result, most hedge fund advisers could no longer rely on the private adviser exemption and thus had to register.

This look-through rule went into effect on February 1, 2006 but was short-lived. In June 2006, a federal appeals court held, in Goldstein v. SEC,[12] that the rule exceeded the SEC’s authority and was thus invalid. Shortly thereafter and in response, Congressman Barney Frank introduced a bill giving the SEC express authority to adopt a look-through rule, but the bill stalled out in committee, [13] as did a similar bill introduced the following year by Senator Grassley.[14]

Congressional desire to require hedge funds to register under the Advisers Act did not, however, die. Hence, the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in the wake of the global financial crisis and signed by President Obama in July 2010, included a hedge fund adviser registration provision.[15] This provision reflected a different approach. Instead of adopting or authorizing the SEC to adopt a look-through rule, it simply deleted the private adviser exemption from the Advisers Act.[16]

Given this development, ironically, the private fund industry (hedge funds, private equity funds, and venture capital funds) may have been better off had the SEC prevailed in Goldstein. If the SEC had won, perhaps Congress would not have revisited the hedge fund adviser registration issue in the Dodd-Frank Act, leaving the SEC’s look-through approach in place. The look-through approach was favorable to advisers to private equity funds and venture capital funds, both of which also relied on the private adviser exemption, because the SEC tailored the look-through rule so it did not to apply to them. Specifically, the rule applied only to an adviser of a “private fund,” a term limited to, among other things, a fund that permitted investors to cash out within two years of investing. An investor lockup of less than two years is a standard feature of hedge funds but not of private equity funds or venture capital funds.[17] Because the Dodd-Frank Act deleted the private adviser exemption and does not include a carve out for private equity funds, they are now required to register under the Advisers Act too. Additionally, under the SEC approach, a hedge fund adviser still had the option of avoiding registration by imposing a two-year lockup on its funds. No such option exists under the Dodd-Frank Act approach.

The Dodd-Frank Act did amend the Advisers Act to create a new registration exemption for advisers to venture capital funds and it directs the SEC to define venture capital fund for purposes of the exemption.[18] The SEC released its proposed definition in November 2010.[19] The proposed definition, however, is much more elaborate and stringent than the minimum investor lockup concept reflected in the SEC’s look-through rule. To fall under the definition, a fund, among other things, (1) must invest only in equity securities of private operating companies who use the investment proceeds primarily for operating or business expansion capital, hold the proceeds in cash, or invest them in short-term U.S. Treasury securities; (2) cannot be leveraged and its portfolio companies cannot borrow in connection with the fund’s investment; (3) must either control its portfolio companies or offer to provide them significant managerial assistance; (4) must not provide its investors with redemption rights except in extraordinary circumstances; and (5) must represent itself to investors as being a venture capital fund.[20] Thus, assuming the SEC adopts this definition as proposed, a venture capital fund adviser will have to constrain the fund’s activities to avoid having to register under the Advisers Act. For example, the fund will not be able to make debt investments in private companies or private investments in public companies—both of which some venture capital funds have done in the past—as these types of investments would, at a minimum, violate criteria (1) above.[21]

Additionally, as part of the venture capital fund adviser exemption, the Dodd-Frank Act directed the SEC to require exempt venture capital fund advisers to maintain records and provide reports as dictated by the SEC.[22] Further, as the SEC noted in its release proposing the definition of venture capital fund, exempt venture capital fund advisers will now be subject to SEC examination.[23] Although the Dodd-Frank Act did not specifically provide for this, it is so because the language that exempts exempt advisers from the examination requirement does not apply to advisers exempt from registration under the venture capital exemption.[24] Hence, even though the Dodd-Frank Act included an exemption for venture capital fund advisers, its effect is quite a bit narrower than the deleted private fund adviser exemption.

In conclusion, I do not want to give the impression that having to register under the Advisers Act is dire for an adviser to a hedge fund, private equity fund, or venture capital fund. The requirements triggered by registration are not particularly onerous, and presumably registration provides some benefits to fund investors and maybe even helps the government reduce systemic risk. The real question is whether the costs of this regulation outweigh the benefits. Private fund advisers have always been able to voluntarily register, and some hedge fund advisers have done so. The fact that most have not is perhaps evidence that private fund investors believe that the costs—most of which would likely be passed on to them—do exceed the benefits.

[1] Investment Advisers Act of 1940, 15 U.S.C. § 80b-1 to -21 (2006).

[2] Advisers Act, § 203(b)(3), 15 U.S.C. § 80b-3(b)(3).

[3] See 17 C.F.R. § 275.203(b)(3)-1 (2006).

[4] Advisers Act § 206, 15 U.S.C. § 80b-6.

[5] § 204, 15 U.S.C. § 80b-4.

[6] Id.

[7] Id.

[8] § 204A, 15 U.S.C. § 80b-4a.

[9] See § 206, 15 U.S.C. 80b-6.

[10] See Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2333, at 72,059, 17 C.F.R. pt. 275, 279 (effective Feb. 10, 2005) [hereinafter Look-through Rule Release].

[11] See id. at 72,070.

[12] Goldstein v. S.E.C., 451 F.3d 873 (D.C. Cir. 2006).

[13] See H.R. 5712, 109th Cong. (2d Sess. 2006).

[14] See S. 1402, 110th Cong. (1st Sess. 2007).

[15] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (to be codified at 15 U.S.C. § 780-7).

[16] See § 403.

[17] See Look-through Rule Release, supra note 10, at 72,074.

[18] See Dodd-Frank Act § 407.

[19] See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Advisers Act Release No. 3111, 17 C.F.R. pt. 275 (proposed Nov. 19, 2010) [hereinafter Venture Capital Fund Adviser Exemption Release].

[20] See id. at 13.

[21] Note that the proposed definition of “venture capital fund” incorporates a grandfathering provision to include within the definition “any private fund that: (i) represented to investors and potential investors at the time the fund offered its securities that it is a venture capital fund; (ii) has sold securities to one or more investors prior to December 31, 2010; and (iii) does not sell any securities to, including accepting any additional capital commitments from, any person after July 21, 2011.” Id. at 56.

[22] See Dodd-Frank Act § 407; see also Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3110, 17 C.F.R. pt. 275, 279, at 35–46 (proposed Nov. 19, 2010), for the SEC’s proposed requirements under this provision.

[23] See Venture Capital Fund Adviser Exemption Release, supra note 19, at 8.

[24] Section 204(a) of the Advisers Act requires an investment adviser to maintain records and provide reports as dictated by the SEC unless the adviser is exempt from registration by § 203(b) of the Advisers Act. See Advisers Act § 204(a), 15 U.S.C. §80b-4(a). While the private advisers exemption was a § 203(b) exemption, the venture capital fund adviser exemption is not; the Dodd-Frank Act added it to the Advisers Act as § 203(l). See Dodd-Frank Act §407.

Preferred citation: William K. Sjostrom, Jr., A Brief History of Hedge Fund Adviser Registration and Its Consequences for Private Equity and Venture Capital Advisers, 1 Harv. Bus. L. Rev. Online 39 (2011), https://journals.law.harvard.edu/hblr//?p=908.

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Injury or Deterrence: The End of Class-Action Litigation and Its Benefit to Consumers

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Jason Sherman*

On November 8, The Wall Street Journal asked, “Is D-Day Approaching For Class-Actions Lawsuits?”  The next day, the Supreme Court heard oral arguments for AT&T Mobility v. Concepcion. The lower courts held AT&T Mobility’s (“ATTM”) adhesion contract’s arbitration clause unconscionable because it prevented class actions through either litigation or arbitration. However, the Federal Arbitration Act, as argued by ATTM, may preempt the finding by the lower courts, ultimately allowing corporations to use “no class action” clauses to shield themselves from class action litigation or arbitration. The media has mostly predicted that the case will be resolved in favor of ATTM, and as Professor Brian Fitzpatrick said, “it could end class-action litigation in American as we know it.” Many believe this lack of access to class action will “have harmful public policy consequences”[1] that “would cut off the only meaningful method to redress widespread discrimination, fraud, or other violations of the law.”[2]

But Justice Alito asks the hinging question, “Why are these people better off with class rights than not?” Class-action rights are an important tool for deterring corporate exploitation, but a ruling for ATTM effectively destroys arbitration—an important tool for consumers to efficiently recover for their injuries without costly litigation expenses.

ATTM argued that without the class action waiver in contracts, companies would likely stop using arbitration altogether. The Chamber of Commerce similarly argues that businesses will stop opting for arbitration without the class action waiver because class arbitration doesn’t share the advantages of individual arbitration. Instead, a single class arbitrator deals with sometimes thousands of disputes leading to time-consuming, procedurally complex, and expensive suits—even more so than the traditional class litigation due to the lack of access to appellate review and complex class arbitration rules.

Despite the focus on the advantages of class actions, consumers individually benefit more from the one-on-one non-aggregated arbitration. While a simplification of the class arbitration rules by Congress is ultimately advantageous, that is arguably a slow process. In the meantime, preserving the bilateral arbitration as alternative means of dispute resolution provides consumers access to a neater, cleaner, cheaper, and faster way of solving disputes.[3] Studies have also shown that consumers prevail against businesses more often in arbitration[4] and the average duration of the claim is only 8.6 months compared to 2.5 years in litigation.[5] Arbitration allows consumers to bring claims for significantly smaller damage amounts into court because of the decreased costs of resolution. Additionally, 82% of people would choose arbitration over litigation to sue a corporation,[6] and many individual-to-individual contracts including property and second-hand car sales almost always require arbitration. Thus, consumers not only benefit from arbitration, but prefer it to resolve their legal disputes.

Admittedly, truly small claims are still expensive to resolve through basic arbitration, but a private competitive marketplace forces most corporations to make adjustments to contracts that make arbitration more attractive to consumers with smaller monetary claims. ATTM’s contract, for instance, includes many consumer friendly features to encourage consumer arbitration of even small amounts including a $7,500 minimum recovery if the arbitral award is greater than ATTM’s last settlement offer and double attorney fees and expenses which ATTM states it similarly will not seek for itself.[7] These provisions allow consumers, such as the Concepcion’s, to use arbitration for almost any monetary claim. The district court (which held against ATTM) even agreed that these provisions “sufficiently incentivize consumers” to pursue “small dollar” claims and “prompts” ATTM to make favorable offers “even for claims of questionable merit.” Also, Professor Robert Mnookin of Harvard Law School states, “The question to ask is why an individual AT&T customer would not be better, should she have a dispute . . . with the waiver and the provision with the $7,500 kicker.”[8] In a competitive market, such as mobile phone coverage, companies will respond to the consumer pressure to litigate small claims through the inclusion of consumer friendly contractual provisions.

In summation, if the primary goal of dispute resolution is injury recovery for consumers and not private deterrence, arbitration clauses with provisional incentives for small monetary claims benefit the individual even with the class-action waiver. Without discussing the merits of class-action lawsuits, legal theorists mostly agree that the monetary receivers of class action litigation are normally the plaintiffs’ attorneys and rarely do consumers receive any of the injury compensation. While this private deterrence mechanism may be seen as important, the individual seeking recovery for injuries inflicted on them will benefit from a ruling for ATTM by the Supreme Court in the spring.

* J.D. Candidate, 2013, Harvard Law School.

[1] Brief of Civil Procedure and Complex Litigation Processors as Amici Curiae in Support of Respondents at 3, AT&T Mobility LLC v. Vincent and Liza Concepcion, 584 F.3d 849 (2010) (No. 09-893).

[2] Public Citizen’s Consumer Justice Project, AT&T Mobility LLC v. Vincent and Liza Concepcion Enforceability of Class-Action Bans in Arbitration Agreements, Consumer L. & Pol’y Blog (Feb. 11, 2011, 1:49 PM), http://pubcit.typepad.com/clpblog/concepcion/.

[3] U.S. Chamber Institute for Legal Reform, Arbitration: Simpler, Cheaper, and Faster Than Litigation (survey conducted by Harris Interactive, Inc. Apr. 2005), http://www.adrforum.com/rcontrol/documents/ResearchStudiesAndStatistics/2005HarrisPoll.pdf.

[4] Ernst & Young LLP, Outcomes of Arbitration (2004), http://www.adrforum.com/rcontrol/documents/ResearchStudiesAndStatistics/2005ErnstAndYoung.pdf; see also Arbitration Better than Court for Consumer Debtors, Study Shows. U.S. Chamber Institute for Legal Reform (Feb. 11, 2011, 4:02 PM), http://www.instituteforlegalreform.com/component/ilr_media/30/pressrelease/2008/422.html.

[5] Mark Fellows, The Same Result As in Court, More Efficiently: Comparing Arbitration and Court Litigation Outcomes, Metro. Corp. Counsel, July 2006, at 32, available at http://www.adrforum.com/rcontrol/documents/ArticlesByFORUMStaff/200607FellowsMCC.pdf.

[6] U.S. Institute for Legal Reform, Key Findings From a National Survey of Likely Voters (Apr. 2008), http://www.instituteforlegalreform.com/issues/docload.cfm?docId=1092.

[7] Philip J. Loree Jr., AT&T Mobility LLC v. Concepcion: What is the Scope of Federal Preemption in Class Waiver Cases?, Loree Reinsurance & Arb. L.F. (Feb. 11, 2011, 4:15 PM), http://loreelawfirm.com/blog/att-mobility-llc-v-concepcion-what-is-the-scope-of-federal-preemption-in-class-waiver-cases.

[8] Email from Robert H. Mnookin, Samuel Williston Professor of Law, Harvard Law School, to Jason Sherman, J.D. Candidate, 2013, Harvard Law School (Nov. 22, 2011, 19:10 EST) (on file with author)

Preferred citation: Jason Sherman, Injury or Deterrence: The End of Class-Action Litigation and Its Benefit to Consumers, 1 Harv. Bus. L. Rev. Online 50 (2011), https://journals.law.harvard.edu/hblr//?p=978.