Team Production and Securities Laws

• Publication year: 2014

SEATTLE UNIVERSITY LAW REVIEW Volume 38, No. 2, WINTER 2015

Team Production and Securities Laws

Urska Velikonja(fn*)

I. INTRODUCTION

In the seminal paper that this symposium celebrates, A Team Production Theory of Corporate Law, Margaret Blair and Lynn Stout made two related points.(fn1) The first one is a straightforward and fairly modest claim: Delaware law does not require shareholder primacy in public cor-porations.(fn2) Rather, the broad deference afforded to the decisions of predominantly independent corporate boards of directors is consistent with a contrary theory, that of team production, or, as they call it, "the mediating hierarch" theory.(fn3) The fundamental role of the board of directors is to mediate between the interests of various stakeholders that contribute to the corporation's output. As a result, Delaware courts have repeatedly authorized board decisions that further the interests of stakeholders at the expense of shareholders' short-term interests, so long as directors are pursuing the long-term interests of the corporation.

Blair and Stout's second claim is normative: that such an arrangement is more efficient than narrow shareholder primacy.(fn4) Board decisions are protected by the business judgment rule, which allows and enables the board, without risk of liability, to further the interests of stakeholders because that increases overall social welfare. In their subsequent writing, Blair and Stout have focused on the normative question and stressed that whether their mediating hierarch model is more efficient than shareholder primacy can only be answered empirically.(fn5) They have since assembled a solid amount of empirical evidence in support of their theory.

Blair and Stout's positive and normative assessments that team production is a better fit with Delaware corporate law, and likely more efficient, are convincing. In my brief contribution, I will draw on a closely related area of law-securities regulation-to make two related points. First, unlike corporate law, and as a positive matter, securities regulation can be described as requiring shareholder primacy, or at least investor primacy. This is important because securities compliance takes up more of directors' and officers' time than compliance with corporate law, and thus likely influences and informs their day-to-day decisionmaking to a greater degree than does corporate law. If so, perhaps the persistent dominance of shareholder primacy in corporate governance should not be surprising. Second, as a normative matter, investor primacy in securities regulation and enforcement may produce efficient results for most securities activities, but produces suboptimal compliance and enforcement for the most heavily litigated and debated category of securities misconduct: accounting fraud. Empirical evidence on the economic consequences of fraudulent financial reporting suggests that the exclusive focus on shareholders is misplaced. I discuss these observations in turn in Parts II and III of this Essay, and suggest some implications.

II. INVESTOR PRIMACY IN SECURITIES LAWS: A POSITIVE ACCOUNT

Despite Blair and Stout's, and others', efforts to dethrone shareholder primacy from dominating academic and policy debates about corporate governance and regulation, it continues to reign supreme. Professor Stout has advanced three reasons for the persistent dominance of shareholder primacy: misleading metaphors describing shareholders as "owners," activist shareholder opportunism, and accounting scandals.(fn6) I would like to add a fourth reason: the rising importance of securities reg-ulation-a closely related area of law and economic activity-where the law does appear to require investor primacy.

The twin goals of securities regulation are to protect investors and further the public interest, which have been understood relatively narrowly as relating to capital market efficiency and competition.(fn7) When the Securities and Exchange Commission (SEC) regulates, section 106 of the National Securities Markets Improvement Act of 1996 requires the SEC to consider investor protection and the impact of proposed regulations on efficiency, competition, and capital formation.(fn8) Although its governing statutes afford the SEC some flexibility to consider both overall social welfare and the impact of proposed rules on overall efficiency, the SEC has limited its cost-benefit assessments by comparing the out-of-pocket cost of compliance for firms with benefits accruing to investors.(fn9) Indeed, the D.C. Circuit, reviewing the SEC's proxy-access rule, has suggested that the SEC should limit its analysis to "maximizing shareholder value" and ignore the economic consequences on employees, retirees, and local governments, even in their capacity as investors.(fn10)

Moreover, when the SEC and the Department of Justice (DOJ) enforce securities laws, they do so with investor protection in mind.(fn11) Investors, (which, to be fair, includes bondholders) are the only group entitled to remedies under the securities laws.(fn12) Only purchasers and sellers of securities have standing to bring a lawsuit for damages caused by securities violations, and only they are entitled to compensation from the SEC's and DOJ's compensation funds.(fn13)

To a large extent, the exclusive focus on investors in securities laws makes perfect economic sense. Although section 2 of the Securities Exchange Act lists, as one of four reasons justifying the need for securities regulation, the impact of capital market dislocations on "general wel-fare"-specifically on employment, trade, transportation, and indus-try(fn14)-many securities violations affect investors primarily, if not exclu-sively.(fn15) When investment banks fix interest rates paid to municipalities for reinvesting their bond proceeds, municipalities are hurt in their capacity as investors, not as local governments.(fn16) When brokers embezzle funds from their customers' accounts, (fn17) charge undisclosed commis-sions,(fn18) or cherry-pick by allocating cheaply bought securities to the firm's own account and more expensive ones to customers' accounts,(fn19) their investor-customers bear the cost of the misconduct. Meanwhile, individual brokers and their firms benefit. Competition among broker-dealers may be distorted as a result of such misconduct, but the economic costs of such distortions-beyond the losses to brokers' customers-are generally relatively small.(fn20)

More to the point, most investment vehicles fit the underlying assumptions of shareholder primacy-that the firm is a nexus of contracts and that shareholders are the residual claimants-more closely than public corporations. Blair and Stout start their article with a statement of the shareholder primacy view: "[P]ublic corporations are little more than bundles of assets collectively owned by shareholders (principals) who hire directors and officers (agents) to manage those assets on their be-half."(fn21) While the shareholder primacy model does not describe public corporations, it is a fairly accurate abstraction for another type of entity: an investment fund.

An investment fund is little more than a contract between two parties: fund investors and a management company (often called an investment adviser) that agrees to manage assets of fund investors in exchange for a fee.(fn22) The fund is a legal entity distinct from the management company. The fund has no employees, no office space, no leases, and no operational assets. Under the terms of the contract, the management company agrees to supply all of the...