Faculty Scholarship Digest
Paul Rose, Sovereigns as Shareholders, 87 N. CAR. L. REV. 83 (2008).
In this article, Rose conducts a comprehensive examination of equity investments by foreign governments, including the risks such investments present, the landscape of their regulation, and the dangers of heightened regulation. It is a fascinating picture of considerable importance. Sovereign wealth funds (“SWFs”) are investment funds owned and controlled by governments. China and the United Arab Emirates, for example, both have SWFs created from the huge sums flowing into those countries from trade; they use SWFs to invest their money in entities located in other countries, such as the United States. Worldwide, SWFs have become very significant. At the end of 2007, SWFs had more assets than all private equity and hedge funds combined, even though there were only about forty active SWFs. SWFs have raised substantial fears in the United States – fears of political risk (e.g., a SWF investing in a company and then pressuring it to move its plants to an ally of the SWF country outside of the U.S.), fears of regulatory risk (e.g., how will the SEC get cooperation from a foreign government if it fears that a country’s SWF is engaging in insider trading or similar misconduct) and fears of economic risk (e.g., what if a foreign country has to suddenly liquidate all its SWFs assets because of a domestic issue). This is just a taste of the potential problems raised by SWFs that Rose canvasses.
Notwithstanding these fears, Rose counsels caution regarding further regulation. He notes a number of factors — such as the likelihood of political backlash — that make some of these fears unlikely to be realized and supports that view by reference to the current practices of SWFs. Rose also describes the existing web of state and federal regulation that keeps SWFs in check. Just as important, Rose argues, regulation poses a significant risk of discouraging investment of needed capital in the United States (SWFs provided $37 billion to U.S. financial firms during a recent eight-month period) and creates opportunities for “political mischief,” in which the ability to block SWFs is exploited for private gain. Indeed, what Rose sees as the greater risk is that SWFs may invest in less well-regulated markets outside the U.S. or purchase or control commodity producers and with this activity outside the U.S. “have the ability to affect U.S. security interests more drastically than SWF activity in the United States.” For this reason, the article also analyzes SWF regulation by other countries, and the scope and prospects for international accords, voluntary and otherwise.
Rose’s article provides a thorough and accessible tour through this complicated arena of great and growing importance.
Paul Rose, Sovereign Wealth Funds: Active or Passive Investors?, 118 YALE L.J. POCKET PART 104 (2008).
In this short article Rose returns to the topic of Sovereign Wealth Funds (“SWFs”) that he covered comprehensively in his North Carolina Law Review article. In this piece, Rose pays special attention to the Treasury Department’s recently proposed regulations governing the process to be used by the Committee on Foreign Investment in the United States (“CFIUS”), a “multi-agency government committee that analyzes the national security implications of foreign acquisition of U.S. firms,” which was given a revamped role by a 2007 law. In Rose’s analysis, the new regulations will encourage great passivity in SWFs because the definition of “control” — which triggers CFIUS scrutiny — is both “slippery” and “cleverly structured,” so that scrutiny may come when an SWF “causes” such activities as hiring or firing of a senior manager, selling assets, issuing securities, or making a major investment. As a result, although Rose notes the scheme is limited by its reliance on CFIUS monitoring and self-reporting by SWFs, he concludes that they will effectively “diminish the threat of inappropriate SWF influence. Indeed . . . one may wonder what would constitute engagement between SWFs and [the companies they invest in]” that might not be construed as “control.”
Rose argues, however, that while this passivity may minimize political and security risks, it could also be a mixed blessing. New research indicates that SWF investment “might have a significant negative impact on returns.” One possible explanation that Rose offers is that other investors feel compelled to spend more resources monitoring the company in question out of fear that the SWF has a noneconomic interest, thereby lowering the share price as a result of the monitoring cost. If this is the explanation, the regulation-enforced passivity should help reassure other investors. A second explanation that Rose offers, however, is that SWF passivity decreases shareholder monitoring. In contrast to hedge funds or labor unions, for example, which often pursue governance influence, passive SWFs by definition may act like a large block of management votes, thereby increasing the likelihood that management will not maximize shareholder value. Moreover, as a separate matter, Rose notes that over time, SWFs may become dissatisfied with the passivity effectively demanded by the proposed regulations and “shift their investment capital to less restrictive markets.” For the time being, however, Rose concludes that the regulations are a “cautious, reasonable response by regulators to an overall lack of transparent and accountable fund governance by SWFs.”
Paul Rose, Regulating Risk by “Strengthening Corporate Governance,” 17 Conn. Ins. L.J. 1 (2011).
This article, which was part of a symposium on regulating risk, takes a close and critical look at the corporate governance provisions of the Dodd-Frank law enacted in 2010 in response to the financial crisis. Most post-mortems of the financial crisis identify inadequate risk management among financial firms as a significant part of the problem. One of the legislative responses was to make changes in federal law regarding corporate governance that were designed to enhance shareholder power. Paul notes that, as a solution to inadequate risk management, this approach assumes (i) that risk-management failures are corporate governance failures, and (ii) that shareholder empowerment, (iii) of the kind included in Dodd-Frank, will improve corporate governance. While agreeing on the first point, Paul vigorously contests the other two, suggesting that the corporate governance provisions in Dodd-Frank will be, at best, neutral, and likely harmful.
As an overarching matter, the article suggests that, other things being equal, national “one size-fits-all” mandates about corporate structure are likely to be inefficient from the start and to stifle innovation in corporate structure going forward. In supporting this argument, Paul makes reference to the empirical literature suggesting that perceived “good governance” standards as seen by ratings agencies have little or no correlation with firm performance (as in the example of Enron’s high rating for its governance structure). More specifically, Paul argues that shareholders tend to be risk-preferring, in part because of their limited downside risk, certainly so relative to taxpayers, so that the result of Dodd-Frank shareholder empowerment runs counter to the better (i.e., less risk-taking) risk-management deemed necessary in light of the crisis. Moreover, the principal method the new law uses to enhance shareholder influence, proxy access, has been shown to tend to diminish shareholder value, at a minimum because of the direct costs it imposes on firms.
Paul Rose & Christopher J. Walker, Dodd-Frank Regulators, Cost-Benefit Analysis, and Agency Capture, 66 Stan. L. Rev. Online 9 (2013), http://www.stanfordlawreview.org/sites/default/files/online/articles/DoddFrankFinal.pdf.
Building on their U.S. Chamber of Commerce Report, Paul Rose and Christopher Walker present good governance rationales for the use of cost-benefit analysis by financial regulators in this essay. So far, there has been an absence of serious discussion of the importance of cost-benefit analysis in promoting good governance and democratic accountability. The current silence is all the more troubling post-Dodd-Frank, given both the exponential increase in regulations and the regulators’ status as independent agencies, making them less accountable to presidential oversight. Rose and Walker contend that “robust cost-benefit analysis embedded in notice-and-comment rulemaking” is necessary. Without rigorous cost-benefit analysis via notice-and-comment rulemaking, “democratic accountability suffers, and agency capture becomes a greater threat. The authors predict that as the regulators fail to grapple with these accountability issues themselves, Congress, the President, or the courts will likely intervene to require more transparent economic analysis.
Paul Rose, Sovereign Wealth Fund Investment in the Shadow of Regulation and Politics, 40 G’TOWN J. INT’L L. 1207 (2009).
In this article, part of a symposium arising from a conference regarding sovereign wealth funds, Paul continues his exploration of this emerging subject. Sovereign wealth funds (“SWF’s”) are investment funds owned by a government which invest in foreign assets to achieve financial objectives. While SWF’s have existed since the 1950's, “[i]ntense national security and political discussions have surrounded . . . [SWF] transaction in the past two years.”
After setting out the background of the SWF controversy and the substantial regulatory framework governing SWF transactions in the United States, Paul compares the U.S. government’s (the “recipient country’s”) interest and concerns (as expressed through that regulatory process) with the interests of the SWF “target firms” — the U.S. entities in which the SWF’s seek to invest. Paul carefully identifies where these interest converge, (e.g., hoping for economics-driven investment rather than politically driven investment from the SWF) and where they do not (e.g., target firms are likely much more interested than the recipient country in reducing the firm’s cost of capital).
The article examines how SWF regulation can interact with these preferences, for example, by forcing an SWF to be a passive investor. Paul concludes that “[t]arget firms are sensitive to the transactions costs [imposed by regulation and public sentiment] associated with SWF investment, and will structure transactions in a way that matches up with recipient country ideals in order to avoid higher transaction costs.” They will also pursue a policy of disclosure to reduce transaction costs by reducing public concern and preparing the market for future transactions.
After reviewing some specific SWF transactions, Paul finds “there is no evidence to suggest that SWF’s face higher transaction costs than other foreign investors as a result of [the special SWF regulation.]” Although there has been a recent marked decline in SWF investment in the U.S., the article concludes that “the current economic difficulties and internal sponsor country politics may have more to do with this shift than U.S. politics and regulation.”
Paul Rose, Common Agency and the Public Corporation, 63 VAND. L. REV. 1355 (2010).
In this important article, Paul offers a reconceptualization of the agency role of corporate managers that offers significant descriptive and prescriptive payoffs. The relationship of corporate managers to shareholders is traditionally seen as one of agent to principal. Traditional problems of such agency relationships (the agent may shirk her duties or may use her delegated power to benefit herself at the expense of her principal) are recognized in the corporate setting, and recent decades have brought the traditional response to such agency problems: empowering the principle (in this case the shareholders).
The crux of Paul’s insight in this article is that this traditional model misses the diversity of interests of the principles (shareholders) who are sharing a “common agent,” the corporate management. Shareholders frequently differ in their goals for the corporation and, perhaps more significantly, in their preferences regarding corporate governance—hedge funds, mutual funds, pension funds, and insurance companies, for example, have different preferences in this area. In this common-agency context, generic shareholder empowerment, while addressing the shirking and management expropriation problems described above, can simultaneously create potentially worse problems of certain empowered shareholders “maximizing their own utility...at the expense of other shareholders or corporate stakeholders.” As the article describes, such influential shareholders may, and in fact do, “extract private benefits from the corporation, incur and impose lobbying costs, and pressure corporations to adopt inapt corporate governance structures.”
After describing how this common agency model (defined as shareholders with heterogeneous interests some of whom can influence management to advance their particular preferences) often accurately describes the landscape of public corporations and detailing numerous ways (from receipt of private benefits to cross-shareholder monitoring) that increased shareholder power can unfortunately increase the costs of “common agency,” even as it reduces traditional agency costs, the article turns to realistic regulatory approaches that, by accounting for the threat of common agency costs, ought to be more efficient. The article considers this a serious matter. Given where things stand, Paul argues, “[w]ithout limitations on the exercise of shareholder power, enhancing shareholder power is more likely to exacerbate agency costs than resolve them.” Recognizing that “an attempt to reduce shareholder power is likely to meet strong resistance,” Paul suggests employing regulatory tools with shareholders that are already used with management to control agency costs—fiduciary duties and disclosure requirements. The article considers the “considerable complexities” in the “complicated challenge” of such an effort to regulate shareholders to reduce the costs of common agency.
Paul Rose, On the Role and Regulation of Proxy Advisors, 109 Mich. L. Rev. First Impressions 62 (2010)
Corporate governance structures have undergone substantial change over the past decade, driven in significant part by the views of the proxy advisor firms that provide “corporate governance ratings” to institutional investors. Even though neither these firms recommendations nor their ratings have been shown to improve either governance or performance, there is no doubt that this tail does wag the corporate dog: “firms feel compelled to make the [recommended] change in order to improve its corporate governance rating.” In this commentary Paul discusses why institutional investors pay for these ratings agencies, adding an original suggestion to the literature: that institutional investors support the ratings industry because the rise of the latter tends to shift power from directors and managers to shareholders, even if their ratings qua ratings have no value. The problem Paul sees is that “powerful shareholders may use their [newfound] influence to extract gains at the expense of less powerful, less activist shareholders.” After canvassing possible ways of improving agency rating performance, the commentary suggests stricter SEC scrutiny and enforcement of institutional investors’ fiduciary duties in regard to proxy voting that does not let them simply rely on ratings agencies when the latter are riddled with conflicts of interest or lack independent evidence of reliability.
Paul Rose & Christopher Walker, The Importance of Cost-Benefit Analysis In Financial Regulation (U.S. Chamber of Commerce Report, Mar. 2013).
Paul Rose and Christopher Walker authored this special report for the Chamber of Commerce. Just as the title implies, the report surveys the history, policy, and law surrounding the use of cost-benefit analysis by financial regulators. Rose and Walker argue for even more rigorous economic analysis by financial regulators now that Dodd-Frank has exponentially increased the amount of financial rulemaking. The authors contend that the use of cost-benefit analysis in financial services regulation will allow regulators to determine if their proposals will actually solve the problem they are trying to address. While the SEC has issued a March 2012 guidance memorandum on the use of cost-benefit analysis in its rulemaking, Rose and Walker remain somewhat skeptical and do not “attempt to predict whether the SEC will actually put these words into practice.” Nonetheless, the authors believe that other financial regulators should follow the SEC’s stated intention and ground their rulemaking in “rigorous cost-benefit analysis to arrive at more rational decision-making.”