Financial regulations often encourage or require market participants to hold particular types of financial assets. One unintended consequence of this form of regulation is that it can spur innovation to increase the effective supply of favored assets. This Article examines when and how changes in the law prompt the spread of “investor-driven financial innovations.” Weaving together theory, recent empirical findings, and illustrations, this Article provides an overview of why investors prefer certain types of financial assets to others, how markets respond, and how the spread of investor-driven innovations can transform the structure of the financial system. This examination suggests that investor-driven innovations can enhance efficiency and provide other benefits, but they can also increase complexity, interconnectedness, and rigidity in ways that render the financial system as a whole more fragile.
This Article thus draws attention to a core mechanism through which legal changes affect the structure and resilience of the financial system. This Article provides a framework for identifying the regulatory changes most likely to trigger investor-driven innovation, a critical first step toward improving rulemaking to reduce the likelihood of unintended consequences. The framework focuses attention on the need to develop an appropriate baseline when assessing the impact of an intervention and the need to cover the costs of innovation. This frame reveals that the regulations often blamed for contributing to bad forms of innovation are probably less transformative than commonly believed. Meanwhile, interventions outside the current debate could have important systemic effects.
The main policy implication is that, when the framework warrants, regulators should assess how a proposed rule change is likely to impact investor preferences, the types of innovations that might arise or spread in response, and how the intervention might otherwise affect the financial system structure. Focusing attention on a specific mechanism through which legal changes can inadvertently alter the structure of the financial system can help regulators develop the data, models, and mindset they need to assess the systemic ramifications of their actions.
Whether corporate arrangements should be mandated by public law or “privately ordered” by corporations themselves has been a foundational question in corporate law scholarship. State corporation laws are generally privately ordered. But a significant and growing number of arrangements are governed by “corporate regulations” created by the U.S. Securities and Exchange Commission (SEC). SEC corporate regulations are invariably mandatory. Whether they should be is the focus of this Article.
This Article contributes to the ongoing debate by showing that whether mandatory or privately-ordered rules are optimal depends on the nature of investors, and their incentives in choosing corporate arrangements. The rise of institutional investors means that investors can now be relied on to choose optimal arrangements, because institutional investors will make informed decisions about corporate arrangements and will internalize their effects on the capital markets.
This Article thus makes the case for a third alternative: “investor ordering.” For all but a few corporate regulations, investor ordering will result in the same or greater aggregate net benefit as mandatory regulations.
The optimality of investor ordering of SEC corporate regulations has important implications. First, the D.C. Circuit’s jurisprudence on cost-benefit analysis will require the SEC to consider investor ordering. In the many cases where investor ordering would be superior to mandatory regulation, were the SEC to nevertheless implement a mandatory regulation, it would be susceptible to invalidation by the D.C. Circuit under the Administrative Procedure Act. This alone should lead the SEC to implement investor ordering for many future corporate regulations.
Second, investor ordering substantially reduces the burden of the D.C. Circuit’s recent requirements for SEC cost-benefit analysis. This reduces the overall cost of SEC rule making, or permits the SEC to promulgate more regulations on its fixed budget. It also sidesteps the considerable academic debate about the value of cost-benefit analysis for corporate regulations.
Third, investor ordering reduces the need for retrospective analysis. To the extent retrospective analysis remains necessary, investor ordering makes it more straightforward and also permits lower-cost regulatory experimentation. Investor ordering therefore allows for a more dynamic regulatory system.
These benefits mean that the SEC should implement investor ordering as its default approach for new regulation and for deregulation. This Article considers a number of promising candidates for investor ordering among potential and proposed SEC regulations, and for deregulation of contentious existing SEC regulations. Investor ordering also has important implications for state corporation laws and for federal legislation.
Elizabeth de Fontenay
The field of corporate law is riven with competing visions of the corporation. This Article seeks to identify points of broad agreement by negative implication. It examines two developments in corporate law that have drawn widespread criticism from corporate law scholars: the Supreme Court’s recognition of corporate religious rights in Burwell v. Hobby Lobby and the Nevada legislature’s decision to eliminate mandatory fiduciary duties for corporate directors and officers. Despite their fundamental differences, both resulted in expanding individual rights or autonomy within the corporation—for shareholders and managers, respectively.
The visceral critiques aimed at these two developments suggest a broadly shared view that the corporation is a device that should be optimized for collective action of a particular type—namely large-scale economic activity. As such, once one has opted into the corporate form, little room remains for the exercise of individual rights and autonomy ex post. Corporate law permits shareholders and managers to act only in limited and highly formalized ways. In this view, the strong assertion of shareholder and managerial autonomy in Hobby Lobby and Nevada’s corporate law is problematic for three reasons. First, it conflicts with longstanding principles underlying the corporate form. Second, it is arguably inefficient, even where it comports with the parties’ private ordering. Third, despite its liberalizing aims, it is likely to foster even greater regulatory complexity or involvement in the long run.
While there are no easy answers to how one should weigh individual rights against economic efficiency, advancing personal autonomy by altering the corporate form may ultimately provide little autonomy bang for one’s buck. From both a rights and an efficiency perspective, there are better means to champion the individual over the group.
Yair J. Listokin and Inho Andrew Mun
Since the Financial Crisis of 2008, most reform measures and discussions have asked how the law of financial regulation could be improved to prevent or mitigate future crises. These discussions give short shrift to the role played by corporate law during the Financial Crisis of 2008 and other financial crises. One critical regulatory tool during the crisis was “regulation by deal,” in which healthy financial firms (“acquirers”) would hastily acquire failing firms (“targets”) to mitigate the crisis. The deals were governed by corporate law, so corporate law played an outsize role in the response to the crisis. But few observers have asked how corporate law—in addition to financial regulation—should govern dealmaking in financial crises. To fill in this gap, this Article focuses on the role played by corporate law during the Financial Crisis of 2008, and asks whether corporate law should be different during a financial crisis than in ordinary times. Using an externality framework—the failure of a systemically important firm can harm the entire economy, and not just the shareholders of the failed firm—this Article identifies a key problem with the current corporate law regime as applied in financial crises: the shareholder value maximization principle as applied to failing target companies. This principle, manifested in the form of shareholder voting rights on mergers and board fiduciary duties to shareholders, is inapplicable to systemically important target firms whose failure would have enormous negative externalities on the rest of the economy. This Article contends that corporate law as applied to systemically important, failing target firms during crises should change as follows: (1) replace shareholder merger voting rights with appraisal rights, and (2) alter fiduciary duties so that directors and officers of those failing target firms consider the interests of the broader economy.