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E-MailYair Listokin is the Shibley Family Fund Professor of Law at Yale Law School, and Inho Andrew Mun is a graduate of Yale Law School. This post is based on their recent article, forthcoming in the Harvard Business Law Review.
After each financial crisis, policy and academic discussions debate what went wrong with the law of financial regulation and how the law can be improved to prevent future crises. For instance, the Panic of 1907 prompted the establishment of the Federal Reserve (the “Fed”) as the lender of last resort. In response to the banking panic that led to the Great Depression, the Banking Act of 1933 created the Federal Deposit Insurance Corporation. And the two main regulatory responses to the Financial Crisis of 2008, the Dodd-Frank Act and the Basel III accords, largely focus on reforming the law of financial regulation to prevent the next crisis.
But it is surprising to see how these policy debates overlook the role corporate law plays during crises and how corporate law can be improved to help mitigate future financial crises. In this article, we hope to fill in this gap. We emphasize that corporate law plays an important role in shaping the immediate response to these crises. Specifically, a critical regulatory tool used in many crises is called “regulation by deal,” where healthy firms acquire failing companies. During the Financial Crisis of 2008, for example, the Fed and the U.S. Treasury (the “Treasury”) regularly rescued failing financial firms by merging them with healthy firms or even directly taking over the failing firms. Examples include: JP Morgan’s subsidized takeover of Bear Stearns, the Fed’s takeover of AIG, Bank of America’s acquisition of Merrill Lynch, and Citigroup’s (ultimately failed) acquisition of Wachovia. Similarly, the responses to previous financial crises also involved corporate mergers. The motivation behind government-sponsored mergers during crises is that the failure of some firms would impose extraordinary harms—externalities—on the financial sector and the economy. In applying regulation by deal, regulators often spend a great deal of time and effort trying to bring their rescue efforts in conformity with corporate law.
We analyze important rescue merger deals during the Financial Crisis of 2008 using the externality framework. The goal is to evaluate if corporate law functioned effectively during the Financial Crisis and consider how corporate law should be reformed to better mitigate future financial crises.
Our central thesis is that, because the ordinary assumptions of corporate law become inapplicable during a financial crisis, corporate law should be different during a financial crisis than in ordinary times for systemically important, failing target firms. Shareholder rights in these firms should be curtailed during a crisis. Shareholder primacy in corporate law assumes that the shareholders are the residual claimants of the corporation. In ordinary times, it makes sense to direct directors’ fiduciary duty toward shareholder wealth maximization because shareholders bear the residual risks. However, in financial crises, the entire economy bears the residual risks of corporate actions, because the failure of systemically important corporations can impose large negative externalities. And unlike creditors or employees, the economy as a whole cannot negotiate for contractual protections. Corporate law built on the premise of shareholder primacy fails to make these shareholders internalize this external harm of the failure of their firm.
To put corporate law in tune with the economics of financial crises we propose that shareholder’s merger voting rights be suspended for systemically important target companies. For example, when JP Morgan attempted to acquire (and rescue) Bear Stearns, the deal ran into a big hurdle—Bear Stearns shareholders were not pleased with the merger offer price of $2 per share and were poised to vote to reject the deal. Bear shareholders knew that the failure of Bear Stearns would cause great harm to the economy, which enabled them to drive a harder bargain. The target shareholders’ voting rights (i) allowed the shareholders to hold the economy hostage to extract a higher deal price of $10, (ii) created uncertainty and high risks for the acquirer, and (iii) caused uncertainty to the rest of the financial system. The threat of holdup during a crisis is particularly serious because regulation by deal must happen very quickly for the troubled firm to not lose its value rapidly, whereas shareholder voting in a traditional setting can take at least thirty business days. This timing mismatch imposes uncertainty when uncertainty is very costly. In sum, the shareholder primacy norm manifested in the form of merger voting rights simply should not apply in this context when the whole economy is at risk.
Instead of relying on voting rights, we protect target shareholders’ interest with appraisal rights after a deal is completed in a manner similar to shareholder appraisal rights under § 262 of the Delaware General Corporate Law. Our proposed appraisal rights would value the company at its “long-term value” minus some haircut, assuming it would not get a bailout.
We also propose that fiduciary duties—duties of care and loyalty—owed by directors and officers to shareholders of systemically important, failing target firms should be altered in a crisis so that those directors and officers consider the interest of the broader economy. A parallel idea exists in some jurisdictions (not Delaware) where directors are directed to consider the interests of creditors as well as shareholders in the “zone of insolvency.”
For instance, before its failure, Lehman (according to many observers) engaged in various merger talks in which it played a game of chicken with the Fed and Treasury in order to obtain a higher price for its sale. Lehman CEO owed fiduciary duty to his shareholders to insist on a high price that had little to do with Lehman’s underlying value. Lehman knew that Bear Stearns had been bailed out in order to avoid a financial panic. The maximum price per share that Lehman could fetch was bounded not by the value of Lehman but by the value the government would pay to have Lehman rescued instead of going into bankruptcy. And this game of chicken led to the collapse of Lehman, with catastrophic effects on financial markets and the broader economy. The Lehman disaster might have been averted if fiduciary duties of Lehman directors and officers were directed to the broader economy rather than to Lehman shareholders.
In conclusion, regulation by deal is an indispensable tool during financial crises, and corporate law regulates these deals. Ordinary corporate law should not apply during financial crises because the role of shareholders of systemically important, failing target firms during financial crises differs from what ordinary corporate law assumes.
The complete article is available for download here.
