Ronald J. Gilson & Alan Schwartz
For thirty-five years, courts and scholars have been divided over the effects of defensive tactics in the market for corporate control. Strong defensive tactics locate authority to accept a hostile bid in the target’s board. The board can bargain for a higher takeover price than uncoordinated shareholders could realize, but high takeover prices may reduce shareholder returns by reducing the likelihood of receiving a bid. The Delaware Courts themselves disagree. The Delaware Chancery Court would locate ultimate decision authority in the tar- get’s shareholders, while the Supreme Court, by permitting strong defensive tac- tics, allocates extensive power to the target’s board. Though the Supreme Court’s view settles the legal issue in Delaware for now, the normative debate among scholars and decision makers regarding whether the shareholders or the board should decide remains unresolved.
The Delaware courts ask whether defensive tactics maximize target shareholder welfare: the shareholders’ expected return from acquisitions. But the more important question concerns social welfare: do defensive tactics reduce efficiency in the market for corporate control? Empirical difficulties so far have prevented analysts from answering either the private or social welfare question rigorously. Regarding private welfare, the analyst cannot observe bids that a target’s defensive tactics level deterred. Regarding public welfare, the analyst cannot observe how an otherwise identical market would behave under either weak or strong defensive tactics levels.
We address the two empirical questions by creating a structural model that predicts how the market for corporate control performs under varying defensive tactics levels and then testing the model by simulating market performance. A simulation permits us to isolate the effect of different defensive tactics levels. It also permits us to solve for a target’s optimal tradeoff between the increased share of an acquisition’s gain that strong defensive tactics permits a target to capture and the reduced probability of receiving bids in consequence of the acquirer’s reduced gain.
The simulated corporate control market performs poorly, making 15% fewer acquisitions under strong defensive tactics than under weak defensive tactics. Target boards, however, apparently have been faithful fiduciaries for their shareholders, choosing defensive tactics levels that optimize the tradeoff be- tween bid frequency and bid returns. On the one hand, we show that the privately optimal target defensive tactics level greatly exceeds the socially efficient level. On the other, we suggest that some firms’ recent efforts further to strengthen defensive tactics, such as by combining a staggered board with a poison pill, reduce both efficiency and target shareholder welfare.
Our results do not support a call for an immediate regulatory response. Initially, we do not rigorously analyze other possible justifications for defensive tactics, such as that they encourage potential targets to take long-term projects that the market may undervalue. Also, simulations raise an external validity question: do the researcher’s assumed simulation parameters capture real world patterns? We argue that our parameters do well on this measure, but a simulated market cannot perfectly capture real world behavior. As well, the magnitude of our results and their consistency with theoretical predictions strongly support our central claim: today’s market for corporate control is so unlikely to maximize the number of value-increasing acquisitions that scholars, regulators, and courts should revisit the defensive tactics debate.
Event studies, a half-century-old approach to measuring the effect of events on stock prices, are now ubiquitous in securities fraud litigation. In determining whether the event study demonstrates a price effect, expert witnesses typically base their conclusion on whether the results are statistically significant at the 95% confidence level, a threshold that is drawn from the academic literature. As a positive matter, this represents a disconnect with legal standards of proof. As a normative matter, it may reduce enforcement of fraud claims because litigation event studies typically involve quite low statistical power even for large-scale frauds.
This Article, written for legal academics, judges, and policy makers, makes three contributions. First, it contributes to a nascent literature demonstrating that the standard event-study methodology can be problematic in securities litigation. In particular, the Article documents the tradeoff between power and confidence level and the ensuing impact on the likelihood that valid claims of fraud will erroneously be rejected. In so doing, the Article highlights that the choice of confidence level is a policy judgment about the appropriate balance between the costs of litigation and the costs of securities fraud. Second, the Article argues that the Securities and Exchange Commission (SEC) has both the legal power and the institutional competence to develop litigation standards that balance these costs.
Third, the Article provides a novel and feasible framework through which the SEC can implement such litigation standards. The framework relies on an assessment of the defendant firm’s market capitalization and abnormal returns distribution to determine the maximum confidence level (minimum significance level) that is consistent with the minimum required power of detecting a fraud of the benchmark magnitude. The SEC is uniquely positioned to make this determination based on the information it possesses about the level of fraud in the capital markets and the role of private litigation in deterring fraud.
Michael B. Dorff, James Hicks, & Steven Davidoff Solomon
The public benefit corporation (“PBC”) is one of the most hyped developments in corporate law, due to the PBC’s unique social purpose. Unlike the traditional corporation, directors of PBCs are required under their fiduciary duties to con- sider the impact of their decisions on a range of stakeholders and communities. This new form is hailed by many as a framework for a reformed capitalism. Critics, on the other hand, have assailed PBCs as unworkable, at best allowing corporations to “green wash,” or providing a thin disguise for ordinary corporate profit-seeking behavior.
What has been lacking in this debate is evidence about whether and how the new form is being adopted. We fill this gap with an empirical study of early-stage investment in PBCs. Early-stage investment, consisting of venture capital and similar funds, presents an interesting test case for PBC funding, because these investors have profit-maximizing incentives and fiduciary duties of their own. Using our novel dataset, we can discern whether for-profit investment is occur- ring in PBCs, and if so, whether it is different in kind from ordinary early stage investment.
We find that PBCs are receiving investment at significant rates, and that funding is coming from typical sources of venture capital—including traditional, profit- seeking VC firms. We also find that VC firms are investing more in consumer- facing industries, as well as investing smaller amounts than in traditional companies at the same stage, which raises concerns about greenwashing. While the ultimate arc of the PBC remains uncertain, our results show that it is gaining acceptance as an investment that can earn an acceptable rate of return— though, as we argue, the PBC status itself may be a secondary factor in VCs’ decisions.
We use these results to develop a theory of future PBC development, which asserts that in the medium term, investment in PBCs is likely to remain siloed in smaller, newly formed firms. We conclude that widespread adoption of the form will take time, as network effects build and experience with the form becomes embedded within the entrepreneurial and legal ecosystem. The PBC is not a failure. But it is in its infancy, and any full embrace will take a significant period of time.
Steven L. Schwarcz
To improve financial regulation, scholars have engaged in extensive research over the past decade to try to understand why systemically important financial firms engage in excessive risk-taking. None of that research fully explains, how- ever, the unusually excessive risk-taking by financial guarantors such as bond insurers, protection sellers under credit-default-swap (CDS) derivatives, credit enhancers in securitization transactions, and even issuers of standby letters of credit. With tens of trillions of dollars of financial guarantees outstanding, the potential for failure is massive. This Article argues that financial guarantor risk- taking is influenced by a previously unrecognized cognitive bias, which it calls “abstraction bias.” Unlike banks and other financial firms that pay out capital—for example, by making a loan—at the outset of a project, financial guarantors do not actually transfer their property at the time they make a guarantee. As a result, they may view their risk-taking more abstractly, causing them to underestimate the risk (even after discounting for the fact that payment on a guarantee is a contingent obligation). The Article provides empirical evidence showing that abstraction bias is real and can influence even sophisticated financial guarantors. The Article also examines how understanding abstraction bias can improve the regulation of financial guarantor risk-taking.
† Full Professor of Business Law; Director of the PhD in Legal Studies, Bocconi University, Milan.
ESTIMATING THE NEED FOR ADDITIONAL BANKRUPTCY JUDGES IN LIGHT OF THE COVID-19 PANDEMIC
Benjamin Iverson, Jared A. Ellias, and Mark Roe†
In this Article, we present the first effort to use an empirical approach to bolster the capacity of the bankruptcy system during a national crisis—here, the COVID-19 crisis. We provide two analyses, one using data from May 2020, very early on in the crisis, and another using data from September 2020, closer to the publication of this Article. Our analysis is based on an empirical observation: Historically, an increase in the unemployment rate has been a leading indicator of a rise in bankruptcy filings. If this historical trend continues to hold, the May 2020 unemployment rate of 13.3% would have predicted a substantial increase in bankruptcy filings and the lower September 2020 level would still predict noticeably increased filings. Clearly, governmental assistance, the unique features of the COVID-19 pandemic, the possibility of a quick economic recovery, and judicial triage are likely to reduce the volume of bankruptcies and increase the courts’ capacity to handle those that occur. It is also plausible that the recent unemployment spike will be short-lived—indeed, by September 2020, the rate had declined to 7.9%. Further, medical solutions to the underlying pandemic—such as the recent initial distribution of an effective vaccine—would further reduce the pressure on the bankruptcy system. Yet, even assuming that the worst-case scenarios are averted, our analysis suggests that a substantial investment in the bankruptcy system resources should be considered, even if only on a standby basis.
Our model assumes that Congress would like to have enough bankruptcy judges so that the average judge would not work more than the last bankruptcy peak in 2010, when the bankruptcy system was pressured and judges worked 50 hour weeks on cases on average. Because the bankruptcy system before the pandemic was not stretched as severely as it was prior to the 2010 financial crisis, it has some extra capacity to handle extra cases.
To keep judicial workload at 2010 levels, the bankruptcy system would need at least 50 additional temporary judges based on the number of unemployed in May 2020 who did not see themselves as temporarily unemployed. In the worst-case scenario, in which none of the May 2020 unemployed returned to work quickly, the bankruptcy system would have needed as many as 243 temporary judges—which would have represented a considerable expansion, even if only temporary, of the bankruptcy judiciary. The lower September 2020 unemployment rate points to a need for 20 temporary judges. Because of this model’s sensitivity to unemployment data, it reports a wide range of estimations for additional bankruptcy judgeships.
We discovered a considerable administrative lag of about a year or more for appointing additional bankruptcy judges. Therefore, given that economic crises can unfurl much faster, embedding extra capacity in the bankruptcy judicial system in normal economic times is a prudent precaution to prepare for unexpected stress of additional bankruptcy petitions.
† BYU Marriott School of Business; University of California, Hastings College of the Law; and Harvard Law School. The authors thank Jacob Barrera, Denise Han, Jessica Ljustina, Spencer Kau, Victor Mungary, Julia Staudinger, and Sara Zokaei for research assistance. We earlier, at the very beginning of the COVID-19 crisis, wrote a report on the potential pressure on bankruptcy judicial capacity due to the Covid-19 crisis, on which this document is based. That report was endorsed by a group of bankruptcy academics and then forwarded to Congress. For recent Congressional action related to our report, see infra note 8.
The recent unanimous decision of the United States Supreme Court (“Supreme Court” or “Court”) in GE Energy Power Conversion France SAS, Corp. v. Outokumpu Stainless USA, LLC (“Outokumpu”) resolves a relatively straightforward question: whether a non-signatory to an international commercial arbitration agreement can enforce it on the basis of the equitable estoppel doctrine. The United States Courts of Appeals for the Eleventh and Ninth Circuits had categorically ruled out the availability of equitable estoppel in this context. In contrast, the First and Fourth Circuits had applied the doctrine to enforce international commercial arbitration agreements by or against non-signatories. Answering the question in the affirmative and reversing the Eleventh Circuit, the Supreme Court has now resolved this split among the circuit courts. Its decision also brings much-needed clarity and predictability to the enforcement of international commercial arbitration agreements in the United States. However, in its narrow judgment the Supreme Court left unresolved two related and equally contentious questions: first, whether international commercial arbitration agreements must be signed to be valid and enforceable in the United States, and second, how the equitable estoppel doctrine is to be formulated in this context and whether state or federal law governs its application.
A brief introduction to international commercial arbitration in the United States will set the stage for further discussion of Outokumpu and these lingering questions. Congress enacted the Federal Arbitration Act (“FAA” or “Act”) to govern the enforcement of arbitration agreements falling within its jurisdiction. Chapter 1 of the Act governs domestic arbitration agreements, while Chapter 2 incorporates the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (“New York Convention” or “Convention”), which governs the enforcement of international commercial arbitration agreements and awards. Chapter 1 of the FAA also applies to actions and proceedings brought under Chapter 2 to the extent that Chapter 1 is not “in conflict” with Chapter 2 or the New York Convention.
The Supreme Court has consistently interpreted the FAA as embodying a “liberal federal policy favoring arbitration agreements,” and as creating “a body of federal substantive law” that requires arbitration agreements to be placed “upon the same footing as other contracts.” Moreover, “[t]he goal of the [New York] Convention, and the principal purpose underlying American adoption and implementation of it, was to encourage the recognition and enforcement of commercial arbitration agreements in international contracts and to unify the standards by which agreements to arbitrate are observed and . . . enforced in the signatory countries.” In line with this pro-arbitration approach, the Supreme Court in Outokumpu held that non-signatories can rely on the equitable estoppel doctrine to enforce international commercial arbitration agreements under the Convention. However, two related questions that have long been the subject of contradictory circuit court decisions remain unresolved in the Court’s opinion.
The first question is antecedent to the equitable estoppel issue and relates to the “in writing” requirement of Article II(1) of the New York Convention. Article II(1) provides that the “[c]ontracting State shall recognize an [arbitration] agreement in writing.” The term “in writing” is in turn defined in Article II(2) as including “an arbitral clause in a contract or an arbitration agreement, signed by the parties or contained in an exchange of letters or telegrams.” Circuit courts have not consistently interpreted the Convention’s “in writing” requirement. The Second, Third, Ninth, and Eleventh Circuits have found that the Convention requires an actual signature for an international commercial arbitration agreement to be valid. The First, Fourth, and Fifth Circuits, in contrast, have not insisted on a strict signature requirement and have enforced international commercial arbitration agreements on the basis of various contract and agency principles. The Supreme Court’s decision in Outokumpu may be interpreted as effectively siding with the latter circuit courts on this question. After all, how can courts continue to impose a strict signature requirement when the Supreme Court has allowed non-signatories to rely on equitable estoppel under the Convention? Nonetheless, the Court explicitly declined to decide “whether Article II(2) requires a signed agreement.”
The second question, which the Supreme Court left to the Eleventh Circuit to determine on remand, arises from the Court’s holding that non-signatories can enforce international commercial arbitration agreements on the basis of equitable estoppel. This question relates to the specific formulation of the equitable estoppel doctrine in this context and to “which body of law” governs its application––federal or state law. In her concurring opinion, Justice Sotomayor noted the varied formulations of the doctrine across jurisdictions, but she would leave lower courts to determine the matter “on a case-by-case basis.” The general understanding has been that courts are to apply “ordinary state law principles that govern the formation of contracts” to the enforcement of domestic arbitration agreements under Chapter 1 of the FAA. However, circuit courts have divided as to whether federal common law or state law governs the application of equitable estoppel in the international context. The First, Second, and Fourth Circuits have applied federal law to address this question, while the Fifth and Eight Circuits have held that state law governs the enforcement of international arbitration agreements on the basis of doctrines such as equitable estoppel. The Supreme Court’s opinion in Outokumpu is ambiguous on this question
This Note will next summarize the facts of the Outokumpu case and the lower courts’ judgments. It will then turn to the opinion of the Supreme Court and discuss both the questions the Court decided and the questions that it left unanswered or ambiguous.
† Assistant Professor, University of Alberta Faculty of Law