May 24, 2011
Elective Shareholder Liability
Posted by Peter Conti-Brown

During this guest stint, I hope to blog about some of my recent writing, which has focused at the intersection of banking, bankruptcy, corporate, and administrative law. That’s not historically been a very large intersection, I’ll grant you, but the crisis and subsequent 2,300 page Dodd-Frank Act has been a boost in that regard (if that's not too macabre). Most recently, this intersection has produced two broad projects. The first focuses on how to increase shareholder participation in resolving the problems associated with implicit governmental guarantees of systemically important financial institutions (SIFIs), and second, the institutional design of banking, administrative, and corporate law. I’ll blog about the first area today, and hopefully get to institutional design questions later in the week.

Although I know there is a great deal of “crisis fatigue” brewing from the onslaught of memoirs, explanatory books, and law review articles on this topic, one of the central problems that the financial crisis revealed remains unsolved. That problem is the problem of bailouts. Taxpayer bailouts, the governmental tool of choice in 2008-2009, undermine the core principles of capitalism. They are also expensive, unjust, unpopular, and usually represent dramatic deviations from the rule of law. Here’s the catch: they are, in some cases, also essential. The “problem of bailouts,” then, is that they are almost always inimical to the interests of society, except when they are not. Dodd-Frank ignores this complexity, improbably guaranteeing an end of taxpayer bailouts forever. And ironically, as many have argued, much of the Act makes bailouts more likely, not less, making the wrong kind of bailouts available far too often.

My article, Solving the Problem of Bailouts: A Theory of Elective Shareholder Liability, available here, proposes to solve the problem of bailouts by giving the government the ability to make the right kinds of bailouts—that is, those not deemed inevitable by by market participants—possible by forcing the bailed out firms to internalize the costs of such bailouts when they do occur. The proposal—called elective shareholder liability—allows bank shareholders, according to their own internal risk analyses, the option of either changing their capital structure to include dramatically less debt, consistent with a consensus recommendation of leading economists led by Anat Admati, Peter De Marzo, Martin Hellwig, and Paul Pfleiderer; or, alternatively, adding a bailout exception to the banks’ limited shareholder liability status to require shareholders—not taxpayers—to cover the ultimate costs of their firm’s failure.

If firms opt for shareholder liability, they would face a governmental collection, similar to a tax assessment, for the recoupment of all bailout costs, on a pro-rata basis. The regime would also include an up-front stay on collections to ensure that there are, in fact, taxpayer losses to be recouped, and to mitigate government incentives for over-bailout, political manipulation, and crisis exacerbation. The proposed structure would also give the government the authority to declare the shareholders’ use of the corporate form to evade liability null and void, and require that shareholders who litigate against collection and subsequently lose to pay the government’s litigation expenses.

There are a lot of counter-arguments, and I try to address the most obvious (though would love to hear thoughts on others that I have missed, or fail to engage adequately). But among the many benefits of elective shareholder liability, the proposal anticipates the development of a derivatives market that would insure shareholders against liability, the price of which will contain more relevant market information than any other asset price presently available. Consider that CDS spreads have been frequently suggested as useful in gleaning information about the likelihood of failure. The problem, of course, is that the market presumes that systemically important financial institutions are going to be bailed out. The price of a CDS incorporates that market expectation. The price of what I call Shareholder Liability Swaps (or SLS, with thanks and apologies to Stanford Law School) wouldn’t reflect that uncertainty. Instead, it would be the market’s sense that trouble is afoot, precipitating a taxpayer bailout, not creditor losses which may not materialize. Volatility in the SLS  market would provide key insights into how the SIFIs were managing themselves, and include an earlier warning system than the Dodd-Frank liquidation authority provides.

This article relies heavily on the debate, sparked by Henry Hansmann and Reinier Kraakman’s article Toward Unlimited Shareholder Liability for Corporate Torts, on whether limited shareholder liability makes sense for involuntary tort creditors, and on the recent literature on bailouts, moral hazard, and Too Big To Fail (Adam Levitin, David Skeel, and Art Wilmarth’s respective work is the essential reading here). But it’s more than simply stapling together the literatures on moral hazard and limited liability. The idea here is that SIFIs should be willing to change their leverage structure to include significantly less debt, the precursor for any bailout, unless there are efficiencies to be gained by high leverage not simply gained, privately, through picking the pockets of taxpayers. If there are efficiencies to be gained without imposing bailout costs on taxpayers, then bank shareholders should have no problem with what would end up being a hypothetical relaxation of their limited liability status.

I still have a couple of months before I can no longer meddle with it, so if you have comments or critiques, I’d love to hear them, whether here in the comments or by email. And if adjusting the limited liability of firms with publicly traded securities isn’t your idea of a sound policy proposal, stay tuned for the companion article, co-authored with Anat Admati and Paul Pfleiderer. That piece, called Liability Holding Companies, proposes a different approach to solve the same problem by introducing another elective structure whereby banks effectively endow themselves by creating a wholly independent, and indeed dominant, institution—the Liability Holding Company—that retains the firm’s unlimited liability equity, as well as other assets to guarantee the SIFI’s debt in case of failure. We argue that there are significant governance benefits from such a structure, as well as other benefits distinct from elective shareholder liability. We hope to post that paper by the end of June.

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