RETHINKING COMMERCIAL LAW’S UNCERTAIN BOUNDARIES
Steven L. Schwarcz
Although it is an essential part of business law, commercial law has uncertain boundaries. That uncertainty creates significant legal ambiguities and inconsist- encies, confusing lawyers and courts and causing misinterpretations that disrupt commerce and reduce efficiency. This Article hypothesizes and tests possible explanations for the uncertainty, including that commercial law’s development has been path dependent, ad hoc, and lacking well-defined normative purposes. The Article then analyzes what those boundaries should be, arguing that com- mercial law should cover all business-related transfers of property, subject to exceptions needed to reduce transaction costs and otherwise increase economic efficiency. The Article also compares its proposed boundaries to the scope of commercial law under the Uniform Commercial Code, both to test whether those boundaries are tethered to reality and to examine whether the scope of the UCC itself should be modified.
ZOMBIE STOCKS
Young Jae Choi, Joseph Engelberg, Frank Partnoy, Adam V. Reed & Matthew C. Ringgenberg
This Article examines a previously unstudied aspect of short selling: the risk that the shares a short seller has borrowed will be delisted and deregistered. We label such shares “zombie stocks” or “zombies,” because they appear to be “dead,” but nevertheless create financial horror for short sellers, exposing them to signifi- cant risks and costs even when the short seller has speculated correctly against a company’s shares. The central problem occurs when short sellers are unable to purchase shares to satisfy their borrowing obligations and instead become stuck paying equity loan fees and posting collateral, potentially indefinitely.
We argue that these risks and costs are a significant limit to arbitrage that impedes the ability and willingness of short sellers to correct stock mispricing. We explain for the first time in the literature how the existing legal framework gives rise to these costs because of the way shares are held, loaned, and traded in public markets.
We also collect and analyze a unique dataset of thousands of stocks that were delisted from 2002–2019, and we examine the risks and costs of stocks becoming zombies. We demonstrate that these risks and costs are substantial: for more than 250 firms in our sample, we show that short sellers could have been trapped in a position for at least a month, and possibly much longer. We quantify the cost of equity loan fees and collateral requirements, which can be substantial.
Finally, we propose and assess several policies to address the existence of “zombie stocks.” We contribute to the law and finance literature by providing the first evidence of zombie stocks as a barrier to short selling and by providing policy responses that could reduce the risks and costs associated with zombie stocks.
E O.G.: UNMASKING WHY GOVERNANCE IS THE MOST IMPORTANT COMPONENT OF ESG
Lisa M. Fairfax
Environmental, Social, and Governance (“ESG”) is now dominating the corporate landscape. ESG encompasses a broad array of “Environmental” issues such as climate change, “Social” issues ranging from workplace safety and child labor practices to diversity, equity, and inclusion (“DEI”) initiatives, and “Governance” matters related to shareholder voting rights and board composition.ESG has impacted the behavior of actors across the corporate ecosystem. Shareholders, asset managers, and financial institutions are increasingly demanding that corporations provide more ESG disclosure and make more concrete ESG commitments. Boards have become increasingly focused on ESG oversight, and have increasingly prioritized selecting new directors who have ESG expertise. Corporations have ramped up their ESG engagement, contributing to the steady rise in voluntary ESG disclosure and new ESG commitments, policies, and practices.
MANIPULATING CITADEL: PROFITING AT THE EXPENSE OF RETAIL STOCK TRADERS’ MARKET MAKERS
Merritt B. Fox, Lawrence R. Glosten & Sue S. Guan
This Article considers whether securities market strategies designed to profit at the expense of so-called “internalizers” should properly be considered illegal manipulation. An internalizer acquires from a brokerage firm the right to be the market maker for the broker’s full order flow from its retail customers, promising in return to execute each order at a price slightly better than the best price available on any exchange (“price improvement”) as well as to pay the broker a fee for each executed order (“payment for order flow”). Almost all retail trading—about 29% of the country’s total share volume—is executed in this fashion, amounting in 2021 to about $41 trillion in transactions, a figure almost twice the nation’s GDP that year.
The internalizer can run a viable business while promising both price im- provement and payment for order flow because retail traders rarely possess information not already reflected in price. This makes the buy and sell orders internalizers receive less dangerous to fill than the more varied order flow going to exchanges. The internalizer’s business model, though, has a vulnerability: a trader can influence what is the best price available on the exchanges and then profit by sending an order to an internalizer that, as a result, executes at a price more favorable to her.
Using a framework that derives its key results from microstructure and fi- nancial economics, this Article seeks answers to four questions: (1) Exactly what actions in the market can traders take that would allow them to profit in this fashion? (2) What are the consequences to the various players in the market from traders undertaking such actions? (3) Would it be socially desirable to use legal prohibitions to try to prevent traders from profiting in this fashion? (4) How are such practices treated under existing law, and what reforms, if any, are desirable?
The usual rhetoric concerning the evils of manipulation stresses its unfairness and its distortion of prices. This Article, however, concludes that strategies aimed at profiting off internalizers raise no serious fairness issues. Equally surprisingly, it concludes that if these strategies were freely occurring, they would probably in- directly marginally improve price accuracy. It is unlikely, however, that this effect would be more socially valuable than the practices’ socially negative impact on liquidity. This negative social welfare assessment becomes that much bigger when one adds in the resources consumed by traders engaging in these strategies and by internalizers to protect against them, resources that otherwise would have been available to produce valuable goods and services for society.
The status of these strategies under current case law is uncertain. If they are ultimately adjudicated to be legal, their use would expand greatly. The lan- guage of Sections 9(a)(2) and 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 leave room, however, for the development of a coherent doctrine that definitively extends the Act’s prohibitions against manipulation to cover these strategies. The analysis in this Article gives the courts good reasons to do so.
HIGH-END SECURITIES REGULATION: REFLECTIONS ON THE SEC’S 2022-23 PRIVATE FUNDS RULEMAKING
William W. Clayton
For most of its history, the SEC has taken a hands-off approach to private markets. Instead of direct regulation, the SEC has relied primarily on investor access restrictions to create high-end contracting environments where investors (in theory) have the resources needed to fend for themselves. But in early 2022, this hands-off philosophy was turned on its head. In response to booming growth and concerns about harms to public pension plans and other institutional inves- tors, the SEC proposed a sweeping set of regulatory interventions in the private fund industry, a vast and important part of the private market ecosystem with over $25 trillion in assets under management. At the conclusion of a long and con- tentious comment period, the agency released a set of final rules requiring fund managers to provide detailed, standardized quarterly disclosures to investors and regulating preferential treatment, among other things.
In this Article, I argue that efforts to intervene in private securities markets for investor protection purposes should pay special attention to a basic question: What are the causes of bargaining inefficiency? What, in other words, is stopping well-resourced industry participants from structuring their affairs effectively? To help enhance the policy dialogue on private funds, this Article presents the first study asking institutional investors to identify the issues that they think cause pri- vate ordering in private equity funds to fall short of optimality, discusses the many uncertainties that remain, and considers the implications.
This Article offers two recommendations for regulatory policy in this new territory for private securities markets. First, it sets forth a basic framework en- couraging policymakers to take into account what is (and is not) known about the causes of bargaining inefficiency when deciding how to intervene in private funds, and it shows how the optimal selection of interventions likely depends on these underlying causes. Second, it calls on the SEC, industry participants, and scholars to work together more deliberately to study when private ordering does (and does not) fall short of efficiency in private funds and why. As private markets continue to grow and evolve, the policy dialogue over securities regulation in private markets is likely just getting started, and these principles provide building blocks to help guide the future of securities law policy in private funds and across the spectrum of private markets.