This Article argues for a "public governance duty" to help manage excessive risk-taking by systemically important firms. Although governments worldwide, including the United States, have issued an array of regulations to attempt to curb that risk-taking by aligning managerial and investor interests, those regulations implicitly assume that investors would oppose excessively risky business ventures. That leaves a critical misalignment: because much of the harm from a systemically important firm's failure would be externalized onto the public, including ordinary citizens impacted by an economic collapse, such a firm can engage in risk-taking ventures with positive expected value to its investors but negative expected value to the public. The Article analyzes why corporate governance law should, and shows how it feasibly could, take the public interest into account.
INTRODUCTION I. THE REGULATORY MISALIGNMENT A. Compensation B. Contingent Capital C. Too Big to Fail D. Volcker Rule E. Firm-Specific Financial Requirements II. Redesigning Regulation A. Additional Regulation Is Needed B. Regulating Substance C. Regulating Governance III. Towards Regulatory Alignment: A Public Governance Duty A. Analyzing a Public Governance Duty Under Corporate Governance Legal Theory 1. The Stakeholder Model of Governance 2. The Contractarian Model of Governance 3. The Shareholder-Primacy Model B. Implementing a Public Governance Duty 1. Legally Imposing the Duty 2. Assessing Costs and Benefits 3. Balancing Costs and Benefits 4. Enforcing a Public Governance Duty 5. Business Judgment Rule as a Defense 6. Protecting Managers Under D&O Liability Insurance CONCLUSION APPENDIX: MODEL REGULATORY LANGUAGE FOR A PUBLIC GOVERNANCE DUTY Public Governance Duty Act SECTION 1. TITLE SECTION 2. DEFINITIONS SECTION 3. PUBLIC GOVERNANCE DUTY SECTION 4. LIABILITY AND ENFORCEMENT SECTION 5. DEFENSES AND INSURANCE SECTION 6. WHISTLEBLOWING RIGHTS AND OBLIGATIONS INTRODUCTION
Should corporate governance law take into account risk-taking that could systemically harm the public? Corporate risk-taking is certainly economically necessary and often desirable. (1) Successful risk-taking increases profitability, thereby enhancing welfare by generating jobs and purchasing power. (2) But corporate risk-taking can sometimes cause harm. There is widespread agreement that excessive corporate risk-taking was one of the primary causes of the systemic economic collapse that became the 2008-2009 global financial crisis (the "financial crisis"). (3) There is also a consensus that existing regulatory measures to curb that risk-taking and prevent another crisis are inadequate. (4)
Many of the regulatory responses to the financial crisis, both in the United States and abroad, seek to mitigate excessive risk-taking by systemically important financial firms. (5) Various of those responses are designed to control that risk-taking by aligning managerial and investor interests to reduce agency costs and make managers less likely to engage their firms in risky business ventures that could jeopardize investors. These responses implicitly assume that the investors themselves would oppose excessively risky business ventures.
That assumption, however, is flawed, and therefore financial regulation based on the assumption's validity is unreliable. The assumption is flawed because what constitutes "excessive" risk-taking depends on the observer. Risk-taking is excessive from a given observer's standpoint if it has a negative expected value to that observer (i.e., the expected costs to that observer exceed the expected benefits). Thus, it is reasonable to assume that investors would oppose risky business ventures that have a negative expected value to them. The problem, however, is that systemically important firms--the primary focus of post-financial crisis regulation, and also the focus of this Article--can engage in risk-taking ventures that have a positive expected value to their investors but a negative expected value to the public. That is because much of the systemic harm from such a firm's failure would be externalized (6) onto other market participants as well as onto the public, including ordinary citizens impacted by an economic collapse. (7)
This misalignment occurs because corporate governance law requires managers of a firm--by which this Article means the most senior managers who have ultimate responsibility to manage the firm, such as a corporation's directors--to view the consequences of their firm's actions, and thus to view the expected value of corporate risk-taking, only from the standpoint of the firm and its investors. (8) That perspective ignores externalities (9) caused by the actions. In general, that makes sense because myriad externalities result from corporate risk-taking; (10) it would not be feasible to take all those externalities into account. Even the Federal Reserve's regulations requiring systemically important financial firms to establish risk committees direct those committees to consider risks to the firm, not to the public. (11) But risk-taking that causes the failure of a systemically important firm could trigger a domino-like collapse of other firms or markets, causing systemic externalities that damage the economy and harm the public. (12) This Article argues that corporate governance law should, and feasibly could, take into account risk-taking that causes systemic externalities.
The Article proceeds as follows. Part I examines the "macroprudential" regulatory responses to the financial crisis--that is, regulatory responses intended to protect against "systemic" risk to the integrity of the financial system (13)--that purport to mitigate excessive corporate risk-taking by systemically important firms. (14) To the extent these responses attempt to mitigate that risk-taking by aligning interests, they seek to align managerial and investor interests (collectively, the "firm's interests"). That leaves a critical misalignment: even if those interests could be perfectly aligned, that would be insufficient to control excessive risk-taking that causes systemic externalities. Part I also shows that the regulatory responses to the financial crisis that profess to mitigate excessive corporate risk-taking in other ways (i.e., without aligning managerial and investor interests) are also inadequate to prevent systemic externalities.
Part II examines and compares possible regulatory redesign options to help align the firm's interests with the public's interests, in order to control excessive risk-taking that causes systemic externalities. Although financial regulation traditionally focuses on regulating substance, such as imposing capital-adequacy standards, this Part argues that these redesign options should additionally focus on reforming a firm's governance.
Part III analyzes how a firm's governance should be reformed to reduce systemic externalities. To that end, it first shows how imposing a public governance duty to help align the firm's interests with the public's interests would fit within corporate governance legal theory. Thereafter, it shows how such a duty could be feasibly and efficiently implemented. Finally, the Appendix to the Article proposes possible model language, in the form of a Public Governance Duty Act, for regulation imposing the duty.
THE REGULATORY MISALIGNMENT
Various types of macroprudential regulatory responses to the financial crisis purport to mitigate excessive corporate risk-taking by systemically important firms. (15) Certain of these responses attempt to mitigate that risk-taking by aligning managerial and investor interests. Thus, requiring a systemically important firm to tie management compensation to the firm's long-term performance is intended to better align managerial and investor interests by penalizing managers who engage such firms in risky ventures that, notwithstanding short-term appeal, ultimately jeopardize investors. (16) Requiring a systemically important firm to maintain so-called contingent capital, in which debt securities convert into equity securities upon specified conditions, is designed to motivate holders of those convertible debt securities to better monitor and impose covenants against excessive risk-taking, since they more clearly bear the risk of the firm failing. (17) As shown below, however, these types of responses are insufficient: even if managerial and investor interests to engage in risk-taking could be perfectly aligned, that would be insufficient to control risk-taking that causes systemic externalities.
Other types of regulatory responses that are currently used to control excessive corporate risk-taking by systemically important firms do not profess to align managerial and investor interests. Because there is no formal categorization of macroprudential regulatory responses, (18) there is no formal categorization of this subset of responses. For discussion purposes, this Article categorizes these responses along functional lines: regulation attempting to limit the so-called too-big-to-fail (TBTF) problem, (19) regulation implementing the so-called Volcker Rule, (20) and regulation imposing capital and other types of firm-specific financial requirements. (21) Some of these categories overlap. (22) However one categorizes these responses, however, the analysis below shows--and policymakers agree (23)--that they too are inadequate to control risk-taking that causes systemic externalities.
One approach to control excessive corporate risk-taking is to better align managerial compensation with investor interests. To this end, commentators, legislators, and regulators have proposed aligning the long-term compensation of senior and secondary managers of systemically important firms with the interests of those firms' investors. (24) The U.S. Securities and Exchange Commission (SEC), for example, is authorized to enforce the recovery of bonuses paid...