Corporate Law


The Infrastructure Ratchet Effect

Shlomit Azgad-Tromer

This article identifies a profound and previously overlooked incentive for excessive risk- taking by infrastructure providers. The magnitude and critical nature of infrastructure implies that negative externalities potentially far exceed the net assets of the infrastructure provider. The nonconsensual relationship of infrastructure providers with their stakeholders implies that excessive risks cannot be contracted for and incorporated into price. Shareholders of infrastructure providers thus develop asymmetric preferences towards excessive risk-taking: They could gain from risks if things go well but are shielded by limited liability rules if things do not. The article identifies this moral hazard and terms it “The Infrastructure Ratchet Effect.”

This Article shows that normal market forces and legal mechanisms fail to counter these distorted incentives in infrastructure providers: Regulation, reputation, litigation, and debt pricing all fail to deter excessive risk-taking in infrastructure. Project finance, leverage, executive compensation, and behavioral tendencies exacerbate the problem.

To illustrate the infrastructure ratchet effect, this Article presents the 2017 data breach at Equifax as a case study, arguing that Equifax is a data public utility and should be considered an infrastructure provider. It surveys the events leading to the massive Equifax data breach and shows that despite cataclysmic implications, Equifax eschewed adequate controls to ensure the security of its data. This Article proposes the infrastructure ratchet effect as a possible explanation for this series of events.

In addition to shedding new light on the infrastructure ratchet effect as a potential source of cataclysmic risks caused by infrastructure providers, this Article considers possible tools to tackle these distorted incentives. Insight is drawn from literature surrounding banking-risk regulation, where a similar moral hazard is well understood.

Agency Costs of Venture Capitalist Control in Startups

Jesse M. Fried, Mira Ganor

Venture capitalists investing in U.S. startups typically receive preferred stock and extensive control rights. Various explanations for each of these arrangements have been offered. However, scholars have failed to notice that these arrangements, when combined, often lead to a highly unusual corporate governance structure: one where preferred shareholders, rather than common shareholders, control the board and therefore the firm itself The purpose of this Article is threefold: (1) to highlight the unusual governance structure of these VC-backed startups; (2) to show that preferred shareholder control can give rise to potentially large agency costs; and (3) to suggest legal reforms that may help VCs and entrepreneurs reduce these agency costs and improve corporate governance in startups.

Deterring Fraud: Mandatory Disclosure and the FDA Drug Approval Process

Liora Sukhatme

The valuation of a pharmaceutical company often depends on its ability to bring a drug to market, making information about the likelihood of Food and Drug Administration (FDA) approval critical to investors and a highly sensitive issue for the company. Since the FDA drug approval process is not public, investors must rely on company disclosures to evaluate the likelihood of FDA approval. Currently, the FDA will not disclose the content of action letters sent to sponsor companies, giving company executives dangerous discretion over whether to disclose the information and how to present it. This discretion, coupled with a lack of oversight over the content of the disclosures, has resulted in several recent cases of fraud among pharmaceutical companies. As a way to curb such company discretion and prevent future fraud, this Note proposes mandatory public disclosure of action letters sent by the FDA to sponsor companies.

Finding a Reasonable Approach to the Extension of the Protective Sweep Doctrine in Non-Arrest Situations

Leslie A. O’Brien

Under the Supreme Court’s current protective sweep doctrine, it is constitutional for law enforcement officers to conduct a cursory sweep of a home incident to arrest where they have reasonable suspicion to believe the home may harbor a dangerous third party. The Supreme Court, however, has not clarified whether the protective sweep doctrine applies where there is no arrest. While at least one federal circuit court currently holds the view that protective sweeps are invalid absent an arrest, most circuits have indicated that protective sweeps may be valid even when they are not incident to an arrest. This Note argues that neither side of this circuit split has struck the right balance. By focusing too much attention on the “incident to arrest” language in Maryland v. Buie and not enough attention on the Court’s express concern for officer safety, the decisions refusing to extend the protective sweep doctrine to any non-arrest situations prohibit protective sweeps in cases where they would be reasonable and, thus, constitutional. In contrast, by failing to respect the Court’s repeated affirmations that exceptions to the warrant and probable cause requirements should be limited, and by brushing aside the importance of the arrest in Buie, the decisions extending the protective sweep doctrine to non-arrest situations either sanction unconstitutional searches or provide insufficient guidance to lower courts and the police, leaving Fourth Amendment privacy rights vulnerable. This Note argues that, to strike the right balance between protecting government interests and Fourth Amendment privacy rights, courts must incorporate a proper inquiry into the “need to search” into their reasonableness analysis. Specifically, they should require a compelling need for officers’ initial lawful entry into a home for protective sweeps to be valid. In applying this standard, courts should draw a bright line according to the type of entry involved, extending the protective sweep doctrine to situations where officers have entered a home pursuant to exigent circumstances or a court order, but not where officers have entered a home pursuant to consent. Such an approach will maintain the limited nature of this exception to the warrant and probable cause requirements while allowing officers to protect themselves when the public interest so requires. It will also provide lower courts and officers with clear guidelines on how to apply the law. As an ancillary benefit, this approach will also minimize the risk of pretextual searches.

New Demands, Better Boards: Rethinking Director Compensation in an Era of Heightened Corporate Governance

Katherine M. Brown

Sarbanes-Oxley and the accompanying era of heightened corporate governance dramatically changed the composition, role, and responsibilities of corporate boards. As a result of these changes, many of the justifications for traditional director compensation plans no longer apply. As directors struggle with their new responsibilities as independent corporate monitors, the manner in which they are compensated must reflect these changes. A director compensation plan in which directors receive compensation primarily in the form of cash, coupled with finely tailored equityholding requirements, strikes the right balance of director independence and director accountability. It also facilitates the creation of corporate boards drawn from a more diverse pool of talent.

Layovers and Cargo Ships: The Prohibition of Internet Gambling and a Proposed System of Regulation

Ryan S. Landes

Since its emergence in the 1990s, Internet gambling has grown into a $12-billion-per-year industry. In October 2006 Congress passed the Security and Accountability for Every Port Act, which includes a provision that prohibits domestic financial institutions from moving funds to and from online casinos, all of which are located overseas. While the new law has certainly caused a major stir in the Internet gambling community, users and overseas companies are continuing to find new ways to circumvent it. In this Note, the author first gives an overview of the gambling industry and the problems it poses to gamblers and communities. The author then reviews the tactics Congress attempted to use over the last decade in fighting Internet gambling—criminalizing the operation of a gambling website, criminalizing individual gambling, and criminalizing funds transfers to and from casinos—and explains why each method fails to address, and often exacerbates, the very problems the legislation seeks to resolve. The author then proposes a new method of regulation and explores how that system could significantly reduce the problems of Internet gambling.

Internal Poison Pills

George S. Geis

Corporate law largely addresses three basic relationships: shareholder versus manager, shareholder versus non-equity investor, and majority shareholder versus minority shareholder. Ever since the pioneering work of Adolf Berle and Gardiner Means, a great deal of scholarly attention has been directed toward the first relationship. The second relationship earned its share of the limelight with the leveraged buyout trend of the 1980s. It is only in this decade, however, that the third relationship has taken center stage—in the wake of several incongruous Delaware cases and a flood of post-Sarbanes-Oxley freezeout mergers.

This scrutiny is certainly warranted, as the tension between majority and minority shareholders presents thorny concerns and has the potential to erode considerable social welfare. In essence, lawmakers must walk a tightrope between two alternative hazards. On the one hand, assigning too much power to minority shareholders can lead to a holdout problem where recalcitrant dissenters demand private tribute before blessing a decision (such as a merger). On the other hand, granting the majority untrammeled discretion to freeze out minority owners can promote tunneling or other abuses of power that will depress the ex ante value of a firm. Thus far, the law has addressed these concerns with disclosure obligations, special committees, judicial review of fiduciary duties, and appraisal rights. But the results are far from satisfying.

This Article offers a novel idea for governing the tension between majority and minority shareholders: an “internal poison pill.” Borrowing conceptually from the famous shareholder rights plans created in the 1980s to address bullying external bidders, I show how an analogous (though economically distinct) financial instrument might be used by shareholders to navigate the twin internal governance tensions of holdout and expropriation. Two key features of this proposal distinguish it from alternative reforms: (1) It focuses on a privately enacted solution with room for contextual customization; and (2) it uses embedded option theory to construct an intermediate legal entitlement (as opposed to an extreme property or liability rule) for both majority and minority shareholders. If successfully scoped and swallowed, these internal poison pills could facilitate efficient freezeouts, chill coercive ones, supplant the awkward remedy of appraisal, and, ultimately, increase the ex ante value of firms by mitigating agency problems between majority and minority shareholders.

The Reach of State Corporate Law Beyond State Borders: Reflections Upon Federalism

The Honorable Jack B. Jacobs

Brennan Lecture

In this speech, delivered for the annual Justice William J. Brennan, Jr., Lecture on State Courts and Social Justice, the Honorable Jack B. Jacobs demonstrates that state corporate law sometimes acquires an extraterritorial reach. The federalist model of corporation law assumes that each state’s law only reaches to that state’s border, but reality has diverged from that model through state anti-takeover statutes, the internal affairs doctrine, and state “corporate outreach” statutes that impose internal governance requirements on companies incorporated in other states. Anti-takeover statutes are essentially grounded upon the internal affairs doctrine, which holds that such affairs are governed by a company’s state of incorporation. But the corporate outreach statutes attempt to supersede the law of the state of incorporation, exposing companies to conflicting internal governance requirements. The Supreme Court could resolve this conflict by deeming the internal affairs doctrine either a choice-of-law rule or a rule of constitutional law. The former choice could lead to economic disruption, while the latter would increase interstate competition for incorporation business and sustain the current diversity of legal choices available to corporations.

The Politics of Shareholder Voting

Lee Harris

Economic theory that suggests underperforming boards of directors should be
fearful of an ouster vote by shareholders underappreciates the complexity of shareholder
voting decisions. Skill at enhancing firm value has less to do with whether
directors win votes and stay at the helm of public companies than previous commentators
have presumed. Instead, like incumbent politicians, managers of some of
the largest U.S. firms tend to stay in charge of firms because they understand—and
take advantage of—the political dynamics of corporate voting. This Article presents
a competing theory of shareholder voting decisions, one that suggests that shareholder
voting in corporate elections is not dissimilar from citizen voting in political
elections. Next, the Article presents the evidence. Using a hand-collected dataset
from recent board elections, the Article compares the explanatory power of a standard
economic variable (long-term stock price returns) and a political variable
(money budgeted for campaigning) on election outcomes. Based on the data, directors’
ability to enhance firm value (as measured by stock price returns) is not significantly
related to whether they win reelection. Rather, the likelihood of being
returned to office appears to be a function of typical election politics—how much
was spent by challengers to persuade shareholder voters. These findings have at
least two implications. First, the theory that shareholder voting may be politicized
helps point the way to how the SEC ought to craft reforms—and, just as important,
how not to craft them. Recent SEC reform efforts have the laudable goals of creating
new conduits for shareholders to participate in firm affairs, increasing
shareholder-nominated candidate success, and disciplining incumbent managers.
The results of this study suggest that these reforms will not achieve the stated goals.
Even with these reforms, the board continues to have an important political advantage,
which likely translates into real votes. As the research here shows, the outcome
of elections depends on persuasion and, not simply, as the SEC contends, on shareholders’
director nominees being presented alongside those of management.
Second, the evidence and theory about shareholder voting presented here has significant
implications for understanding mergers and acquisitions, particularly hostile
acquisitions. The theory is that acquirers have steep incentives to target firms
with poor performance. In most cases, however, such acquisitions depend on winning
a vote from shareholders. Thus, if there is any disciplinary effect created by the
prospect of takeovers, it depends crucially on understanding what motivates shareholder
voting behavior. If voting shareholders respond to political motivations, not
economic ones, then the performance of target board members might not be as
relevant as takeover theorists had previously surmised.

A Modified Caremark Standard to Protect Shareholders of Financial Firm from Poor Risk Management

Alec Orenstein

The recent collapse of the world financial system exposed excessive risk taking at
many of the largest financial services firms. However, when shareholders of
Citigroup sued the board of directors alleging that the board failed to adequately
monitor the firm’s risk exposure, the Delaware Chancery Court dismissed the suit
under the famous Caremark case. Caremark held that a board’s failure to monitor
will not result in liability unless there was a failure to implement a monitoring
system or a “sustained or systematic” failure to use that monitoring system. This
deferential standard is premised on an assumption that managers are risk averse
and the law should encourage risk taking. However, certain characteristics of financial
firms make such firms more prone to risk taking and more susceptible to catastrophic
losses resulting from that risk taking than other firms. In this Note, I argue
that Caremark should be reworked in cases involving managers of financial firms
in order to deter the excessive risk taking that caused such massive losses to shareholders
of these firms recently. This standard should take the form of a gross negligence
standard that allows the court to take a close look at whether management
took the necessary steps to prevent their firm from being exposed to excessive risk.