Elective shareholder liability.

AuthorConti-Brown, Peter

INTRODUCTION I. BACKGROUND; THE DODD-FRANK ACT, BAILOUT PREVENTION, AND INCREASED CAPITAL REQUIREMENTS A. The Dodd-Frank Approach B. Dodd-Frank's Bailout-Inducing Provisions C. The Impossibility of "Never Again" D. Fifteen to Twenty-Five Percent Capital Adequacy as a Supplement to Dodd-Frank II. ELECTIVE SHAREHOLDER LIABILITY A. Mechanics 1. The shareholder election 2. Governmental collection 3. Two-year blackout 4. Pro rata share 5. Ability to nullify evasion efforts through rulemaking 6. Treble damages, including litigation costs B. Benefits 1. Taxpayer reimbursement 2. Risk management 3. Partial elimination of TBTF subsidies 4. An active derivatives market for shareholder liability 5. Tailoring corporate form and leverage structure III. OBJECTIONS, COUNTERARGUMENTS, AND ALTERNATIVE PROPOSALS A. Alternative Risk-Bearers Purportedly Superior to Shareholders 1. Creditors a. Contingent capital 2. Corporation and government: government participation in SIFI equity 3. Industry and government: an insurance fund 4. Directors and officers 5. The taxpayers B. Where Are the Shareholders? 1. Poor shareholders 2. The sacred cow of limited liability 3. Banks and limited liability in history C. General Arguments Against Non-Limited Liability 1. Easy evasion and enforceability 2. Difficulty of determining who would be on the hook 3. Endogeneity problem 4. Exogeneity problem 5. Too much government discretion CONCLUSION INTRODUCTION

Taxpayer bailouts--that is, the deployment of public funds to prevent the rapid failure of a private institution--were the government's tool of choice during the fall of 2008. The resulting political and scholarly response has been nearly uniformly negative, with very few arguing in defense of bailouts, (1) and most advocating some version of the vision of "ending government bailouts as we know them." (2)

This reaction makes good sense at first blush. Bailouts are unjust, as private parties are able to pocket the benefits generated by their risky activities while forcing the costs onto the public. (3) They are massively unpopular and can dominate public discourse at the expense of other important policy issues. They are expensive, both directly through the cost of the bailout and indirectly through the general economic harm that the promise of bailouts can motivate. They represent extraordinary rule of law concerns, as governments bend and break laws that are aimed to prevent the utilization of taxpayer funds for private purposes. (4) And bailouts risk distorting the functioning of the entire free market financial system. As Larry Summers said, with ironic and unwitting prescience in 2000, "[I]t is certain that a healthy financial system cannot be built on the expectation of bailouts." (5)

But the problem with bailouts is not simply that they make for bad economics and bad politics. The problem, in addition to this parade of horribles, is that they are sometimes essential to the prevention of complete financial collapse, with its accompanying consequences of economic and human misery felt far beyond the financial markets themselves. Any policy reaction to bailouts must deal with this complexity--bailouts are almost always the wrong policy approach, except when they are not.

The Dodd-Frank Wall Street Reform and Consumer Protection Act fails to address this complexity. (6) Instead, Dodd-Frank seeks to end government bailouts--forever. (7) But this promise is implausible objectively, inaccurate subjectively, and, regardless, is undesirable as a matter of policy. The complex problem of bailouts after Dodd-Frank therefore remains unresolved.

This Article proposes to solve the problem of bailouts by means of a legal mechanism called "elective shareholder liability," which is both far less intrusive and far more effective than the regulatory apparatus that Dodd-Frank creates. (8)

Elective shareholder liability gives shareholders of the world's most important financial institutions--vailed systemically important financial institutions (SIFIs) in the clunky vernacular of banking regulation--the opportunity to choose how best to address their own too-big-to-fail (TBTF) problems themselves. (9) Elective shareholder liability gives SIFI shareholders the choice between two alternatives: either (1) dramatically limit the firm's leverage, consistent with a consensus proposal from leading economists--what we will call the "increased capital" option; (10) or (2) create a bailout exception to the SIFI's limited liability status, such that the government can recoup the losses associated with any taxpayer bailout from the SIFI shareholders directly.

The first of these options comes from a proposal entertained during the debates that produced Dodd-Frank, and still hotly debated as this Article goes to press. (11) Anat Admati, Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer-among the world's leading financial economists--have proposed dramatically increasing the capital adequacy requirements to more than twice the level ultimately accepted under the Basel III Accords. (12)

Admati et al.'s proposal is simple, extremely effective at reducing TBTF problems, and has been, until now, fought vociferously by the banks it would affect. (13) The banks have argued, and their political supporters have embraced, the notion that, effective though increased capital requirements may be at avoiding future bailouts, the costs that such requirements inflict on banks and society are simply too great. (14) The banks assert that higher capital requirements mean less lending and, consequently, put a brake on economic recovery when recovery should be the government's exclusive focus. (15) Admati et al. make very little of these assertions in every respect. (16) Other economists agree. (17)

Elective shareholder liability resolves the impasse by allowing SIFIs to make those costs concrete: should their own internal assessments of increased capital requirements show that there are efficient benefits from leverage that outweigh the taxpayer costs of bailouts--both direct and indirect--then SIFIs can appropriately dismiss increased capital without forcing the costs of their private failure on to taxpayers. If that internal cost-benefit analysis comes out differently, and banks conclude that the only benefits of increased capital are those taken inefficiently from the pockets of taxpayers in the form of TBTF subsidies, they can opt into the alternative regimes and maintain their limited shareholder liability.

This is not a Hobson's choice--there may well be real economic value in preferring shareholder liability to increased capital requirements. For instance, elective shareholder liability is effectively a bet on a bank's ability to avoid a taxpayer bailout, and thus the shareholder liability that would result. The upside would be that banks could continue to use the subsidies of leverage--subsidies that exist through the tax code and implicit government guarantees.

Taken on its own merits, elective shareholder liability provides important cost internalization at critical junctures both ex ante and ex post. Ex ante, elective shareholder liability requires directors and officers to increase self-monitoring when, as is often the case, these officers and directors are themselves significant shareholders. Furthermore, when shareholders and management do not significantly overlap, shareholders have heightened incentives either to demand more ownership for their shareholder dollars to reflect bailout reimbursement, or, alternatively, to monitor management's own risk measurement practices such that bailouts become less likely because of internal controls. Ex post, elective shareholder liability creates a fund--until now unavailable--that can serve to reimburse taxpayers at least partially for the costs of bailouts. Elective shareholder liability is thus the only proposal that provides mechanisms of monitoring and reimbursement using the same legal apparatus.

To introduce and assess elective shareholder liability, the Article proceeds as follows. Part I provides the context of the Dodd-Frank legislation, explaining what the Act attempts to do to prevent taxpayer bailouts and why it will fail to deliver on that promise. Part I also explains increased capital requirements as an alternative to the Dodd-Frank structure. This Part is synthetic; readers familiar with these arguments should feel free to skim or skip this Part as needed.

Part II.A presents the six elements of elective shareholder liability. They are: (1) SIFI shareholder election of either a bailout exception to limited liability and a fifteen to twenty-five percent capital requirement; (2) if shareholder liability is elected and a bailout occurs, the government shall issue an obligatory assessment against shareholders, with a lookback period of one year; (3) collections are subject to a blackout period--similar to the automatic stay in bankruptcy--of two years, under which the collection cannot be assessed; (4) shareholders are liable pro rata; (5) the government shall have authority to declare efforts to evade liability through corporate ownership--using limited liability entities to own shares in non-limited liability SIFIs--null and void; and (6) shareholders who challenge these collections and lose will pay treble damages and the government's litigation costs.

Part II.B presents several benefits of elective shareholder liability, including better incentives for shareholders and officers for internal risk management; the partial elimination of the economically deleterious consequences of limited liability, namely shareholder risk shifting, debt overhang, and, more specifically, what one scholar has called "correlation seeking"; (18) creation of an active market of derivatives, the prices of which would contain more information regarding the potential for taxpayer bailouts--and their potential costs--than is presently available in the markets; and freedom for SIFI...

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