Constraining Corporate Law Principles in Affiliate World

• Citation: Vol. 72 No. 4
• Publication year: 2023

Constraining Corporate Law Principles in Affiliate World

Anita K. Krug

Constraining Corporate Law Principles in Affiliate World

Cover Page Footnote

A defining characteristic of the financial industry is the overwhelming presence of affiliates—entities that are connected with one another through ownership, management, or a contractual relationship. Although the relationships among affiliated entities serve the business needs of financial enterprises, they give rise to conflicts of interest that create significant risks for investors, whether they be investment advisory clients, mutual fund shareholders, or brokerage customers. Reflecting this fact, the regulation of financial intermediaries under the securities laws focuses on mitigating these conflicts. However, when harm to investors occurs, the tools available to courts to provide remedies fail to do so because they are founded not on the special nature of the financial industry but, instead, on corporate law principles. Corporate law is incapable of helping harmed investors because it concerns itself only with relationships within an entity—primarily the relationship between a firm's shareholders and its board of directors. Accordingly, it cannot address concerns arising from extra-entity actors that are affiliated with one another. Although this incongruence has persisted for decades, no scholar has previously offered a workable solution to it. That is the project of this Article. It proposes that, to remedy investor harms, courts and policymakers ought to move past the entity-centrism of corporate law and its imperative to respect entity boundaries.

CONSTRAINING CORPORATE LAW PRINCIPLES IN AFFILIATE WORLD

Anita K. Krug^* ABSTRACT

A defining characteristic of the financial industry is the overwhelming presence of affiliates—entities that are connected with one another through ownership, management, or a contractual relationship. Although the relationships among affiliated entities serve the business needs of financial enterprises, they give rise to conflicts of interest that create significant risks for investors, whether they be investment advisory clients, mutual fund shareholders, or brokerage customers. Reflecting this fact, the regulation of financial intermediaries under the securities laws focuses on mitigating these conflicts. However, when harm to investors occurs, the tools available to courts to provide remedies fail to do so because they are founded not on the special nature of the financial industry but, instead, on corporate law principles. Corporate law is incapable of helping harmed investors because it concerns itself only with relationships within an entity—primarily the relationship between a firm's shareholders and its board of directors. Accordingly, it cannot address concerns arising from extra-entity actors that are affiliated with one another. Although this incongruence has persisted for decades, no scholar has previously offered a workable solution to it. That is the project of this Article. It proposes that, to remedy investor harms, courts and policymakers ought to move past the entity-centrism of corporate law and its imperative to respect entity boundaries.

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TABLE OF CONTENTS

INTRODUCTION..........................................................................................856

I. OMNIPRESENT AFFILIATES..............................................................861

A. Affiliate Proliferation.............................................................. 862

1. Investment Advisers .......................................................... 862
2. Public Funds..................................................................... 865
3. Broker-Dealers................................................................. 867

B. Risks to Investors in Affiliate World........................................ 869

1. Front-Running.................................................................. 870
2. Cross-Transactions........................................................... 873
3. Brokerage Arrangements .................................................. 875

II. FRONT-END REGULATION...............................................................876

A. Investment Advisers ................................................................ 877
B. Public Funds .......................................................................... 879
C. Broker-Dealers....................................................................... 882

I II. BACK-END REMEDIES ....................................................................885

A. Derivative Litigation............................................................... 886
B. Compensating Investor Losses ................................................ 891
C. Securities Fraud..................................................................... 896

IV. CONSTRAINING CORPORATE LAW PRINCIPLES................................902

CONCLUSION.............................................................................................907

INTRODUCTION

The world of financial services is a world of affiliates.¹ Almost by definition, key players in this realm—including those who manage investments and the intermediaries who bring together buyers and sellers of financial assets—have affiliates, often many of them. For example, an investment advisory firm that operates scores of mutual funds and other investment products, such as Fidelity² or Blackrock.³ necessarily has many affiliates. That is. the "firm" consists of numerous entities, with some entities owning others and some entities being under common control with each other. The same is true of mutual funds,

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exchange-traded funds ("ETFs"), and other publicly offered investment entities (collectively, "public funds"), which are affiliated with other entities not only by virtue of "control" relationships, but also as a result of contractual relationships. Then there are broker-dealers, which are also entities, most of which have multiple lines of business in numerous markets and, therefore, consist of numerous affiliates.

The ubiquity of affiliate relationships in the financial industry sets the industry apart from other regulatory subjects falling under the heading "business law." It also creates special risks for investors—a term that encompasses investment advisory clients, public fund shareholders, and brokerage customers—who necessarily rely on entities known as investment advisers, public funds, and broker-dealers to help them achieve their investment objectives.⁴ For example, if an investment adviser uses an affiliated broker-dealer to execute a client's securities transactions, there is a risk that the adviser will cause the client to pay inflated commissions to the broker for those trades, thereby harming the client and, if the client is a public fund, the fund's shareholders.

This circumstance has important implications for the regulation of entities that provide financial services, regardless of the particular roles they play. Indeed, it is largely due to the webs of affiliates in the financial industry that financial services regulation is so complex.⁵ Much of this regulation, which includes the regulation of investment advisers, public funds, and broker-dealers, focuses on the ways in which the existence of affiliates may create conflicts of interest that, if acted upon, counter the cause of investor protection, which is financial services regulation's signal objective.⁶ That affiliate relationships create conflicts that harm investors is especially problematic given the fiduciary obligations that many financial intermediaries owe to those they serve.⁷ Regulation exists as a prophylactic measure to prevent financial intermediaries

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from acting on these conflicts and furthering their own interests at the expense of investors' interests.⁸

Regulation is incomplete, however—a yin without a yang, a heads without a tails. As its name implies, financial services regulation governs financial intermediaries—and it has, for the most part, gotten it right. For example, regulation of public funds, which is set forth primarily in the Investment Company Act of 1940 ("Investment Company Act"),⁹ has as its overarching goal mitigating, if not eliminating, specific types of conflicts of interest.¹⁰ The statute recognizes that affiliates are a defining feature of the financial industry and, on that basis, requires investment advisers and other service providers to public funds to follow stringent procedures designed to ensure that those who serve public funds (and, indirectly, their shareholders) do not also take advantage of them.¹¹ Accordingly, law does what it needs to do on the front end—meaning in the day-to-day operations of the financial industry.

Unfortunately, however, law gets it wrong on the back end. The web of relationships that gives rise to laws and rules to prevent financial intermediaries from acting on conflicts of interest is all but ignored for purposes of compensating investors for injuries when something goes awry.¹² This is because financial services regulation itself often does not provide the remedy, which instead comes from a range of sources. These other sources are separate from, and independent of, financial services regulation and, as a result, do not embody the principles or share the goals of financial services regulation. Putting it simply, front-end law and back-end remedies do not match. The former is focused on the peculiar, affiliate-heavy universe that is the financial industry, while the latter are part of the doctrine of corporate law, which concerns itself with the relationship between corporate directors and shareholders.¹³ More specifically, corporate law is the body of laws and rules that govern such things as derivative shareholder litigation and fraud claims against corporate

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management and that are based on the principle that each corporate entity is a web of relationships...