Working Papers 211-220
211. Did the Private Securities Litigation Reform Act Work? (Perino, Michael A.) October 2002
In 1995 Congress passed the Private Securities Litigation Reform Act to address abuses in securities fraud class actions. In the wake of Enron, WorldCom, Adelphia, and other high profile securities frauds, critics suggest that the law made it too easy to escape liability for securities fraud and thus created a climate in which frauds are more likely to occur. Others claim that the Act has largely failed because it did little to deter plaintiff's lawyers from filing non-meritorious cases. This article employs a database of the 1449 class actions filed from 1996 through 2001 to explore whether the Act achieved several of its primary goals—discouraging the filing of non-meritorious suits, reducing litigation risk for high technology issuers, and reducing the "race to the courthouse" whereby class actions were filed soon after significant stock price declines, apparently with very little pre-filing investigation.
The picture that emerges from studying these data is that the PSLRA did not work as intended. This article demonstrates that as many or more class actions are filed after the Act as before. High technology issuers remain at significantly greater risk than issuers in other industries. There is statistically significant evidence, however, that suggests that the Act improved overall case quality at least in the circuit that most strictly interprets one of the Act's key provisions, a heightened pleading standard. The data in the article also demonstrate that Congress did not achieve its goal of increasing the filing delay in class actions. Actions are filed as quickly now as they were before passage of the Act. Nonetheless, that too may provide indirect evidence that plaintiff's attorneys are selecting more apparent cases of fraud that require less pre-filing investigation. Perino Publications
212. Enron's Legislative Aftermath: Some Reflections on the Deterrence Aspects of the Sarbanes-Oxley Act of 2002 (Perino, Michael A.) October 30, 2002
Since Enron's implosion, an astounding string of accounting scandals have stunned the securities markets. Global Crossing, WorldCom, Adelphia, and a host of other companies have seen plummeting share prices and SEC and criminal investigations. Congress' reaction has been equally stunning and surprisingly swift. It passed with near unanimity the Sarbanes-Oxley Act of 2002, and President Bush quickly signed it into law. This paper analyzes the new criminal and civil liability provisions of the Act to evaluate whether the Act is likely to achieve its goal of deterring securities fraud. The article concludes that the new criminal liability provisions actually criminalize very little conduct that was not already criminal under existing statutes and do not substantially increase the likelihood of successful conviction. The enhanced criminal penalties are unlikely to create additional deterrence because the Act's predominant approach is to increase maximum potential sentences. Under the Federal Sentencing Guidelines, such increases have little impact on expected penalties. On the civil side, the article demonstrates that there was no empirical bais for increasing the statute of limitations for private securities fraud causes of action. Finally, the article concludes that the increase in resources and enforcement authority for the SEC may well provide more substantial deterrence than the more publicized criminal provisions of the Act to the extent that these provisions significantly increase the likelihood that securities fraud is detected. WP212.pdf
213. The Ossification of American Labor Law (Eslund, Cynthia L.) 102 Colum. L. Rev. 1527, 2002
In this article, Professor Estlund argues that the ineffectuality of American can labor law and the shrinking scope of collective representation and collective bargaining are partly traceable to the law's "ossification" - to its having been essentially sealed off both from democratic revision and renewal and from local experimentation and innovation to a remarkably complete extent and for a remarkably long time. The elements of this process of ossification are various and familiar; yet, once assembled, they make up an impressive set of barriers to innovation. The basic law has been cut off from revision at the national level by Congress; from "market"-driven competition by employers; from the entrepreneurial energies of individual plaintiffs and the plaintiff's bar, and the creativity they can sometimes coax from the courts; from variation at the state or local level by representative or judicial bodies; from the winds of changing constitutional doctrine; and from emerging transnational legal norms. Finally, the National Labor Relations Board - the designated institutional vehicle for adjusting the labor laws to modern conditions - is increasingly hemmed in by the age of the text and the large body of judicial interpretations that has grown up over the years. While the argument may seem to counsel only pessimism about the prospects for reform, it may also help to identify potential pathways of change that have not been fully appreciated. Indeed, some of those pathways are being paved by the process of ossification itself: By impelling private parties to find their own paths outside of the existing regime, the ossification of labor law may be setting in motion the very forces that may eventually lead toward legal change. Columbia Law Review
214. What Caused Enron?: A Capsule Social and Economic History of the 1990's (Coffee, John C. Jr.) January 20, 2003
Between January 1997 and June 2002, approximately 10% of all listed companies in the United States announced at least one financial statement restatement. The stock prices of restating companies declined 10% on average on the announcement of these restatements, with restating firms losing over $100 billion in market capitalization over a short three day trading window surrounding these restatements. Such generalized financial irregularity requires a more generic causal explanation than can be found in the facts of Enron, WorldCom or other specific case histories.
Several different explanations are plausible, each focusing on a different actor (but none giving primary attention to the board of directors):
- The Gatekeeper Story looks to the professional "reputational intermediaries"on whom investors rely for verification and certification - - i.e., auditors, analysts, debt rating agencies and attorneys - - and views the surge in financial restatements as the product of both (a) reduced legal exposure for gatekeepers (as the result of legislation and judicial decisions in the 1990's sheltering them from liability) and (b) the increased potential for consulting income or other benefits from their clients (resulting in gatekeeper acquiescence in accounting or financial irregularities). This is essentially the story to which the Sarbanes-Oxley Act responds.
- The Misaligned Incentives Story instead focuses on managers and a dramatic change in executive compensation during the 1990's, as firms shifted from cash to equity-based compensation. Stock options (and legal changes that enabled management to exercise the option and sell the security without any delay) arguably gave management a strong incentive to inflate reported earnings and create short-term price spikes that were unsustainable, but which they alone could exploit. Sarbanes-Oxley does not address this potential cause of irregularities.
- The Herding Story focuses on the incentives of investment fund managers and argues that they are uniquely focused on their quarterly performance vis-a-viz their rivals. As a result, they have an incentive to "ride the bubble," even when they sense danger, because they fear more the mistake of being prematurely prophetic. Again, Sarbanes-Oxley does not address this cause of bubbles and price spikes.
This comment compares and contrasts these explanations, finding them highly complementary WP214.pdf
215. Law, Rules, and Presidential Selection (Issacharoff, Samuel) February, 2003
Robert Dahl, in "How Democratic is the American Constitution?" criticizes the institution of the Electoral College as "morally, politically, and constitutionally wrong." This Article addresses the third of those claims. Dahl's critique, like many directed against the Electoral College, presumes a constitutional commitment to majoritarianism. This Article examines the rather commonplace departures from strict majoritarian rule in the Constitution, and concludes that the distortions from majoritarian preferences created by the Electoral College are actually much smaller in scope than those created by the U.S. Senate, the Article V amendment process and, to some extent, the House of Representatives. Moreover, subsequent constitutional developments—namely the "Reapportionment Revolution" of Baker v. Carr and later cases—have not enshrined a constitutional principle of simple majoritarianism that might undermine the constitutional foundation of the Electoral College. The Article then explores the controversies surrounding the presidential elections of 1800 and 1876 to argue that there are nonetheless important constitutional principles at stake in the operation of the Electoral College, namely in the manner in which Congress dictates rules for the settlement of disputes arising from presidential elections. The Article concludes by discussing one aspect of the Electoral College that could be susceptible to constitutional challenge: the "winner-take-all" system employed by nearly all states to allocate electoral votes. This practice, which is not mandated by the Constitution, could be challenged, not on the grounds that it is inconsistent with majoritarianism, but rather on the grounds that it gives the majority too much power—an argument that finds much stronger support in our constitutional jurisprudence. WP215.pdf
216. Governance Failures of the Enron Board and the New Information Order of Sarbanes-Oxley (Gordon, Jeffrey N.) March, 2003 (Prepared for the University of Connecticut Law Review Symposium Crisis in Confidence: Corporate Governance and Professional Ethics Post-Enron)
This paper argues that the principal governance failure of the Enron board was to approve a disclosure policy that made the firm's financial results substantially opaque to public capital markets, despite also approving a compensation strategy that made managerial payoffs highly sensitive to stock price changes and despite its unwillingness to engage in intense monitoring of business results and financial controls. In comparable circumstances of constrained monitoring by public markets, LBO firms and venture capitalists undertake a vigorous monitoring role. Important provisions of the Sarbanes Oxley Act can be seen as correcting for a public board's probable inability to adequately monitor a complex corporate finance strategy, "corrective disclosure." But the Act also seems to contemplate immediate disclosure of material business developments even in circumstances where premature disclosure may well sacrifice shareholder value for very little gain in capital market efficiency. The paper criticizes such "price- perfecting disclosure." A further consequence of the Act's disclosure regime may be to shift governance authority away from management and the board toward shareholders, including in the case of hostile takeovers. Keywords: corporate governance, Enron, Sarbanes-Oxley, takeover law WP216.pdf
217. Market Bubbles and Wasteful Avoidance: Tax and Regulatory Constraints on Short Sales (Powers, Michael R., David M. Schizer & Martin Shubik) March 24, 2003
Although short sales make an important contribution to financial markets, this transaction faces legal constraints that do not govern long positions. In evaluating these constraints, other commentators, who are virtually all economists, have not focused rigorously enough on the precise contours of current law. Some short sale constraints are mischaracterized, while others are omitted entirely. Likewise, the existing literature neglects many strategies in which well advised investors circumvent these constraints; this avoidance may reduce the impact of short sale constraints on market prices, but may contribute to social waste in other ways. To fill these gaps in the literature, this paper offers a careful look at current law and draws three conclusions. First, short sales play a valuable role in the financial markets; while there may be plausible reasons to regulate short sales- most notably, concerns about market manipulation and panics - current law is very poorly tailored to these goals. Second, investor self-help can ease some of the harm from this poor tailoring, but at a cost. Third, relatively straightforward reforms can eliminate the need for self-help while accommodating legitimate regulatory goals. In making these points, we focus primarily on a burden that other commentators have neglected: profits from short sales generally are ineligible for the reduced tax rate on long-term capital gains, even if the short sale is in place for more than one year. WP217.pdf
218. Nonprofit Organizations as Investor Protection: Economic Theory, and Evidence from East Asia (Milhaupt, Curtis J.) March 10, 2003
Enforcement problems plague shareholder activism and investor protection in many parts of the world. The importance of solving this problem has led scholars to consider a range of partial alternatives to weak domestic corporate law enforcement regimes, ranging from writing "self enforcing" corporate laws to using cross listings on foreign stock exchanges as a means of bonding firms to higher quality enforcement.
The recent experience of the three largest capitalist market economies of East Asia suggests that there is another partial solution to the problem of weak investor protection and corporate law enforcement, one that has received no theoretical or empirical attention—the nonprofit organization. This partial solution emerges from a puzzle at the center of contemporary East Asian corporate governance. With the possible exception of the government itself, nonprofit organizations (NPOs) have emerged as the most important corporate law enforcement agents in Korea, Japan and Taiwan. In each system, an NPO holding a portfolio of shares is engaged directly in the exercise of shareholders' rights to combat corporate fraud and mismanagement, and to improve the investor protection climate. In numerous instances, these organizations have won significant court victories or settlements against management. This development is puzzling because the defining characteristic of an NPO is the nondistribution constraint. That is, while nonprofits are not prohibited from making profits, they are prohibited from distributing them to their owners. Why are three organizations operating within the nondistribution constraint—rather than institutional investors or individual shareholders represented by plaintiffs' attorneys—the principal shareholder activists cum corporate law enforcement agents in this region?
This paper analyzes the role of NPOs in East Asian corporate governance, and applies economic theory on the existence of nonprofits as suppliers of public goods (along with several complementary theories) to explain the rise of NPOs as suppliers of investor protection in the region. The paper also examines the academic and policy implications of the East Asian experience. Academically, the NPO as a corporate law enforcement mechanism is a highly distinctive illustration of functional convergence in corporate governance: several societies have spontaneously generated substitutes for the attorney-oriented incentive mechanisms relied upon in the United States to enhance investor protection. Yet each NPO displays its own unique structure and strategy, differences that can be tied directly to the distinct domestic legal and political structures in which they operate. At the level of law reform, for transition economies the NPO has several advantages as a corporate law enforcement device, particularly in societies reluctant or unable to transplant the U.S. "attorney as bounty hunter" model of law enforcement. First, the nondistribution constraint inherent in the NPO form provides a built-in check on frivolous litigation. Second, shareholder activist NPOs seek to use and improve local law enforcement institutions, while most of the alternatives discussed in the literature involve abandoning weak local enforcement regimes. WP218.pdf
219. Re-examining Legal Transplants: The Director's Fiduciary Duty in Japanese Corporate Law (Kanda, Hideki & Curtis J. Milhaupt) March 24, 2003 The transplantation of legal rules from one country to another is commonly observed around the world. Legal transplants can range from the wholesale adoption of entire systems of law to the copying of a single rule. Despite the importance of transplants to legal development around the world, scholarly understanding of this ubiquitous form of legal development is still fairly rudimentary. For example, there is little agreement among scholars on transplant feasibility and the conditions for successful transplants, or even how to define "success." Moreover, there is little analysis of how the success or failure of legal transplants relates to the achievement of larger goals, such as economic development.
Japanese law, particularly the legal rules governing economic organization, is a prime example of the transplant phenomenon, both in its systemic and single-rule variations. Japan imported its original Commercial Code (including legal rules on business corporations) from Germany in 1898 as part of a fundamental reform of its legal system, and made large-scale amendments to the corporate law in the immediate post-war period by importing many specific legal rules from the United States. This article attempts to shed light on the role of legal transplants in corporate law by examining Japan's transplantation of a single corporate rule: the director's duty of loyalty, which was added to the Commercial Code in 1950 as a direct import from the United States. For almost forty years after it was transplanted, however, the duty of loyalty was never separately applied by the Japanese courts, and played little role in Japanese corporate law and governance. It finally began to be used in the late1980s, long after Japan had achieved high economic growth. Using a simple theory of legal transplants, we explain the initial non-use and subsequent use of the duty of loyalty transplant in Japanese corporate law.
Part I of the paper provides a simple analytical framework for determining the success or failure of a legal transplant. Part II takes up the specific case study of the transplantation of the duty of loyalty into Japanese corporate law. It begins with a brief examination of the central role of duty of loyalty doctrine in U.S. corporate law. We then contrast the situation under Japanese corporate law, tracing the duty of loyalty from its transplantation to its eventual application by the Japanese courts. Part III evaluates the transplantation of the duty of loyalty in Japan in light of our theoretical discussion. WP219.pdf
220. A Political Theory of Corporate Crime Legislation (Khanna, Vikramaditya S.) April 2003
Corporate crime has once again become an important issue on the US legislative agenda. Following the recent economic downturn and the spectacular revelations of corporate wrongdoing, Congress and the various regulatory bodies have begun to tighten the law and enhance honesty and completeness in disclosure. The enactment of the Sarbanes-Oxley Act of 2002 is one example and adds to the already sprawling area of corporate criminal liability. However, the continued and rather explosive growth of corporate crime legislation leaves one with a rather strange puzzle: how can such a state of the world arise? After all, corporations and business interests are considered some of the most powerful and effective lobbyists, if not the most effective and powerful, in the country. Yet, we witness the continued expansion of legislation that criminalizes some of their behavior (one estimate suggests over 300,000 federal regulatory offenses that can be prosecuted criminally). How could this have happened given that business interests should be able to lobby to protect themselves? This paper sets out to answer this puzzle.
An answer is important not only for purposes of understanding the political dynamics of current regulation, but also because it provides insights into the effectiveness of our current approach for regulating corporate wrongdoing. Overall, my analysis suggests that corporate criminal liability - the imposition of criminal sanctions on the corporate entity - serves little deterrent or expressive function above that offered by corporate civil liability. This suggests, on first glance, weak support for the growth of corporate criminal liability. However, this is only on first glance. Indeed, on closer inspection, it appears that corporate criminal liability imposes relatively low costs on corporate interests, may help to avoid legislative and judicial responses that are more harmful to their interests, and may at times help to deflect criminal liability away from managers and executives and on to corporations. These effects may often benefit corporate interests and weakens their opposition to corporate crime legislation. In light of this, the growth of corporate crime legislation becomes more understandable. This not only provides some explanations for the impressive growth of corporate criminal liability, but also leads to some interesting normative conclusions. In particular, it leads to the counter-intuitive result that if one starts with the view that there is under-deterrence of corporate wrongdoing then one would probably prefer to reduce corporate criminal liability and focus more on corporate civil liability and managerial liability. WP220.pdf