Too Small to Fail: State Bailouts and Capture by Market Underdogs

• Author: Sharon Yadin
• Position: Assistant Professor of Law and Business, Peres Academic Center, Israel. Email: sharon@yadin.com. This Article was written as part of my Lady Davis postdoctoral fellowship at The Hebrew University of Jerusalem and with the generous support of The Peres Academic Center. I would like to thank Judge David Mintz and Prof. Ruth Plato-Shinar for...
• Pages: 889-932

TOO SMALL TO FAIL: STATE BAILOUTS AND CAPTURE

BY MARKET UNDERDOGS

SHARON YADIN *

ABSTRACT

Bailouts have become a pervasive phenomenon, particularly around

the 2008 global financial crisis, as states came to the rescue of financial

institutions considered Too Big to Fail (TBTF) faced with imminent

bankruptcy. While TBTF bailouts are officially designed to prevent

catastrophic domino effects in markets, critics view these bailouts as a

result of industry manipulations of regulators and state officials, leading to

regulatory capture. Scholars describe regulatory capture as a situation

where regulators favor the private interests of regulated firms over public

interests, in exchange for legally-dubious gains such as political capital,

monetary support, or lucrative future employment opportunities. While the

phenomenon of regulatory capture by large and resourceful firms is well

researched by economists, jurists, and political scientists, a new

unexplained phenomenon, yet to be addressed in academic literature, is

emerging in modern economies: the bailout of small firms. Due to the

relatively insignificant size and influence of those firms, they cannot be

considered economically too big to fail and are usually unable to provide

regulators with sufficient incentives to secure bailouts through classic

capture. Aiming to explain this phenomenon, this paper develops a Too

Small to Fail (TSTF) approach, asserting that small firms adopt an

underdog rhetoric designed to facilitate regulatory capture. TSTF firms

capture regulatory decision-making for lucrative bailouts by blaming

regulation, regulators, global and local catastrophes, or by pleading for

special consideration due to social importance. The case studies examined

in this paper include U.S.-owned firms in both health and media sectors

operating in Israel under Israeli regulation. This is an extremely useful

Copyright © 2015, Sharon Yadin.

* Assistant Professor of Law and Business, Peres Academic Center, Israel.

Email: sharon@yadin.com. This Article was written as part of my Lad y Davis

postdoctoral fellowship at The Hebre w University of Jerusalem and with the

generous support of The Peres Academic Center. I would like to thank Judge

David Mintz and Prof. Ruth Plato-Shinar for illuminating i nsights, professors

Barak Medina, Ro y Kreitner and Tal Zars ky for helpful advice a nd guidance, a nd

Jessica Paulik, Brian Finch and the ed itorial team at Capital University Law

Review for their diligence.

890 CAPITAL UNIVERSITY LAW REVIEW [43:889

arena for examining the underdog rhetoric of small firms because of its

unique geopolitical characteristics and disposition to capture, stemming

from an absence of comprehensive regulation policies. The paper

concludes with normative suggestions for overcoming TSTF capture by

imposing new legal duties on the regulatory decision-making process of

administrative agencies.

I. INTRODUCTION

Bailouts have become a pervasive phenomenon, particularly around

the 2008 global financial crisis and states’ rescue of major financial

institutions considered Too Big to Fail (TBTF).

1

The TBTF approach

intends to prevent catastrophic market domino effects due to the collapse

of interconnected firms, through state subsidies. Critics who object to state

bailouts of financially troubled firms point at manipulations that regulated

institutions perform on regulators and state officials, who become captured

by industries interested in state aid via the exchange of legally-dubious

favors.

2

While the phenomenon of regulatory capture by large and resourceful

firms is well researched by economists, jurists, and political scientists,

3

a

new unexplained phenomenon, yet to be addressed in academic literature,

is emerging in modern economies: the bailout of small firms. Due to the

relatively insignificant size and resources of those firms, the economic

logic of TBTF and regulatory capture does not account for their bailout.

Attempting to explain this phenomenon, this Article proposes a Too Small

to Fail (TSTF) bailout theory in which small firms capture regulatory

decision-making to obtain lucrative bailouts by employing an underdog

rhetoric: blaming regulation, regulators, global and local catastrophes, or

by pleading for special consideration due to social importance.

4

The case

studies examined in this Article include U.S.-owned firms in both health

1

For a general explanation of the idea of Too Big to Fail see infra part III.A. For the

emergence and development of the term and policy in U.S. financial history, see Jonathan

R. Macey & James P. Holdcroft, Jr., Failur e is an Option: An Ersa tz-Antitrust Approach to

Financia l Regulation, 120 YALE L.J. 1368, 1376–78 (2011).

2

For the general idea of capture see, e.g., DANIEL CARPENTER & DAVID A. MOSS,

Introduction, in PREVENTING REGULATORY CAPTURE: SPECIAL INTER EST INFLUENCE AND

HOW TO LIM IT IT 1, 13 (Daniel Carpenter & David A. Moss eds., 2013) [hereinafter

PREVENTING CAPTURE]; George Stigler, The Theory of Economic Regulation, 2 BELL J.

ECON. & MGMT. SCI. 3, 4 (1971).

3

See infra Part III.A.

4

See infra Part III.B.

2015] TOO SMALL TO FAIL 891

and media sectors operating in Israel under Israeli regulation.

5

This is an

extremely useful arena for examining the underdog rhetoric of small firms

because of its unique geopolitical characteristics and disposition to

capture,

6

stemming from an absence of comprehensive regulation policies.

While Israeli government administration relies heavily on regulating

private sectors, it has only recently started developing general regulation

guidelines and procedures, following Israel’s acceptance to the

Organization for Economic Cooperation and Development (OECD) in

2010. Israeli market regulatory and administrative procedure flaws are

especially evident, making it a good backdrop for legal analysis of

regulatory capture.

In 2008, one of history’s biggest financial crises erupted in the United

States and then spread worldwide. Similar to other countries, the U.S.

financial crisis was eventually resolved through government subsidies—

state bailouts of major commercial and investment banks that were

considered too big to fail, such as JPMorgan Chase, Citigroup, Bank of

America, Bear Stearns, and large insurance companies like AIG.

However, this bailout practice, seemingly serving the public’s interest in

financial stability, was not immune to regulatory capture, as critics have

since pointed out.

Regulatory capture refers to regulatory agencies that prioritize the

interests of private regulated firms at the expense of the public interest they

are supposed to uphold.

7

Private regulated firms steer regulators away

from their public duties, encouraging regulators to act in those firms’ favor

when promoting legislation or taking regulatory action. These TBTF firms

use their vast resources to secure future posts for retired regulators,

influence political outcomes to favor regulators who seek reelection, or

refrain from media campaigns against regulators that might harm

regulatory reputation.

8

For example, a bank regulator may be considered

captured when he refrains from imposing strict regulation on the bank he

expects to chair after his retirement or extends regulatory favors when the

regulated bank has the power to publicly shame him or help his political

campaign.

5

See infra Part II.

6

See, e.g., Manuel Puppis, Media Regulation in Small States, 71 INTERNATIONAL

COMMUNICATION GAZETTE 7, 9 (2009).

7

See supra notes 148–51 and accompanying text.

8

PREVENTING CAPTURE, supra note 2.