Yale Law School
Yale Law School Legal Scholarship Repository
Faculty Scholarship Series
Yale Law School Faculty Scholarship
1-1-2010
The Demise of the Reputational Model in Capital
Markets: The Problem of the “Last Period Parasites”
Jonathan R. Macey
Yale Law School
Follow this and additional works at: http://digitalcommons.law.yale.edu/fss_papers
Part of the Law Commons
Recommended Citation
Macey, Jonathan R., "The Demise of the Reputational Model in Capital Markets: The Problem of the “Last Period Parasites”" (2010).
Faculty Scholarship Series. Paper 1388.
http://digitalcommons.law.yale.edu/fss_papers/1388
This Article is brought to you for free and open access by the Yale Law School Faculty Scholarship at Yale Law School Legal Scholarship Repository. It
has been accepted for inclusion in Faculty Scholarship Series by an authorized administrator of Yale Law School Legal Scholarship Repository. For
more information, please contact [email protected].
THE DEMISE OF THE REPUTATIONAL
REPUTATIONAL MODEL IN
CAPITAL MARKETS:
MARKETS:
PARASITES"
THE PROBLEM OF THE "LAST PERIOD PARASITES"
Maceyt
Jonathan Maceyt
INTRO DUCTION ......................................................
INTRODUCTION
427
THE REpUTATIONAL
REPUTATIONAL MODEL
M ODEL .............................................................
430
I. THE
430
II. THE DECLINE AND FALL OF THE REPUTATIONAL
REpUTATIONAL MODEL
MODEL ................. 432
432
A. Credit
433
Credit Rating Agencies ........................................................
Firms and
and Investment Banks Specializing
B. Law Firms
Specializing in
CorporateLaw and
and Securities
Securities Regulation
Corporate
Regulation for Public
Public
Company
Clients
................................................................
436
436
Company Clients
1. Improved Information
Information Technology ................................ 436
1.
436
2. The Relevance ofthe
of the Anti-Fraud
Provisionsofthe
of the
Anti-Fraud Provisions
436
Securities
Securities Laws
Laws .............................................................
3. Lawyers'
Specialization
Functions
................................
438
Lawyers' Specialization Functions
C. The Organized
C.
Organized Stock Exchanges
Exchanges .......................................... 439
439
D. A
ccounting Firms
F irms ................................................................
442
D.
Accounting
III. DATA ON REpUTATION
REPUTATION ...................................................................
445
C
ON
CLU
SION
........................................................
447
CONCLUSION
INTRODUCTION
INTRODUCTION
One of the most vexing questions facing economists
economists is why it is so
workable strategies for escaping the
hard for poor countries to develop workable
corruption and structural
pernicious and chronic cycles of poverty, corruption
unemployment with which they are plagued. Clearly, a large
unemployment
large part of the
answer
answer is that nations'
nations' prosperity is dependent on open and functional
tum,
markets for products, services, and capital. These markets,
markets, in turn,
depend on the ability of people to trade (contract) with one another with
a reasonable
contract
reasonable degree of confidence. The ability to trade and to contract
requires some sort of system that allows people both to: (a) establish
recognized
recognized and stable
stable property
property rights and (b) enter
enter into reliable
(predictably
(predictably enforceable)
enforceable) contractual
contractual commitments
commitments with their counteremployees and other
other
parties, including
including customers, suppliers, employees
constituents.
Corporate Law, Corporate Finance and
Professor of Corporate
and
tt Jonathan Macey, Sam Harris Professor
1982, Yale Law
Securities Regulation, Yale Law School, A.B. 1977, Harvard College; J.D. 1982,
School. The author wishes
wishes to thank workshop participants at Yale Law School for useful
comments
comments on an earlier draft of this Article.
HeinOnline -- 60 Syracuse L. Rev. 427 2009-2010
428
Syracuse Law Review
[Vol. 60:427
60:427
In tum,
turn, societies
societies in which promises tend to be kept, agreements
agreements
tend to be enforced and property rights tend to be respected, are those in
which we observe high levels of trust and cooperative
cooperative behavior. For
For
example, Frances
Frances Fukuyama argues
argues that the most important cultural
characteristic influencing
influencing a nation's prosperity
characteristic
prosperity is the presence of trust
Fukuyama
and cooperative behavior
behavior based upon shared norms. 11 Fukuyama
observes that the United States, Germany
and
Japan
(the
world's
top
Germany
Fukuyama was writing) have
economies, at least as of the time when Fukuyama
innovative organizations
innovative
organizations and institutions that reduce
reduce transaction
transaction costs
(i.e.
(i.e. lower the cost of doing business)
business) by enabling people
people to easily enter
enter
into contractual 2relationships and make business deals because they can
each other.
trust each
other. 2
Fukuyama
Fukuyama builds on Max Weber's powerful
powerful theory that the
Protestant religious admonition to treat all people (and not just members
of one's sib or family) in a morally acceptable
acceptable way is a great catalyst to
economic
economic growth.33 As Weber observed, these ethical and ascetic
religious precepts led to growth by dramatically
expanding the number
dramatically expanding
of people who could transact with one another by paving the way for
cooperative
cooperative economic activity to occur beyond
beyond one's immediate
immediate kinship
group.
groUp.44 Fukuyama further observes that in recent years, trust in the
United States, as well as in Japan and Germany, has been
been rapidly
rapidly
eroding. s5 For Fukuyama, the information
other
information economy and other
technological
scientific advances
advances have led to the rise of
of
technological and scientific
individualism,
individualism, the diminution
diminution of community and a general
general decrease in
the level of trust in society. 6 Robert Putnam, working in a similar
framework to Fukuyama, though focusing a bit more on "social
networks"
networks" as the catalysts
catalysts for trust, argued that such social networks
were on the decline as people
declined
people in places
places like the United
United States
States declined
7
7
to participate
participate in civic life.
Working within the general framework, I wish to make
make two
FUKUYAMA, TRUST: THE SOCIAL VIRTUES
1. FRANCIS
FRANCIS FUKUYAMA,
VIRTUES AND
AND THE CREATION
CREATION OF
PROSPERITY 9-11 (1995).
(1995).
PROSPERITY
ld. at
at26-31.
2. Id.
26-31.
Id. at 37.
3. Id.
AND TAOISM
CHINA: CONFUCIANISM
CONFUCIANISM AND
TAOISM 237 (Hans
(Hans H.
4. MAX WEBER, THE RELIGION OF CHINA:
Gerth ed. & trans., The Macmillan
Macmillan Company 1964) (1951)
(1951) ("The great achievement of
of
ethical religions, above all of the ethical and asceticist sects of Protestantism, was to shatter
the fetters of the sib.").
FUKUYAMA,
supra note 1, at 23-32
5. FUKUY
AMA, supra
6. JOHN G. BRUHN,
BRUN, THE SOCIOLOGY OF COMMUNITY
COMMUNITY CONNECTIONS
CONNECTIONS 18-20 (2005)
(2005)
(commenting on Fukuyama's views).
(commenting
7. See generally ROBERT
PUTNAM, MAKING
Civic TRADITIONS IN
IN
ROBERT PUTNAM,
MAKING DEMOCRACY WORK: CIVIC
ITALY (2004).
MODERN ITALY
HeinOnline -- 60 Syracuse L. Rev. 428 2009-2010
2010]
Markets
Capital Markets
429
contributions to our thinking about the relationship
contributions
relationship between
between trust and
explain the role that reputation
reputation plays in
growth. First, I want to explain
environment that is critical to the successful
successful
fostering the high trust environment
operation
of
capital
markets
and
corporate
markets
corporate financing transactions
operation
generally. Corporate finance and capital markets
markets rely heavily
heavily on the
ability of companies
companies and other firms to develop what is known as
reputational capital. This is true both in theory
theory as well as in practice.
For the industries on which I focus, credit
credit rating agencies, law firms,
investment banks, stock exchanges
exchanges and accounting
investment
accounting firms, reputational
capital historically has been the primary mechanism by which
In
businesses establish
establish trust in markets and in contracting relationships.
relationships. In
my view, reputation
reputation plays a far greater
greater role than that played either
either by
religion or social networks, which are the primary
primary institutions
institutions upon
upon
which Fukuyama
Fukuyama and Putnam, respectively, place
place their reliance.
Second, and more importantly, I argue that there has been a
collapse in the market
market demand
demand for reputation, at least in heavily
heavily
increasingly rely on
regulated countries
countries like the United States that increasingly
regulation rather than reputation
reputation to protect
protect market participants
participants from
fraud and other forms of abuse. It used to be the case that for a diverse
companies and industries involved in the capital markets,
array of companies
organizations' reputation was absolutely
nurturing and maintaining their organizations'
critical to their growth and continued success. I argue that this simply is
no longer the case, at least in the U.S.
To a large extent we have moved from a reputational paradigm to
of
what might best be described as a parasitic paradigm. Clients of
companies
companies involved in the financial markets
markets used to pay a premium to
be able to trade with high reputation
reputation companies, as well as with the
reputation companies. Additionally,
Additionally, when they would
clients of high reputation
deal with companies with weak or non-existent
non-existent reputations, they would
would
proceed, if at all, with great caution and skepticism. Now, company
reputation matters far less than it used to matter for two reasons.
First, improvements in information
information technology
technology have lowered
lowered the
discovering information
information about people. This, in turn, has made
costs of discovering
it worthwhile for individuals involved in the financial marketsmarketslawyers,
lawyers, investment
investment bankers,
bankers, accountants,
accountants, analysts, regulators-to
regulators-to focus
far more on the development of their own individual
individual reputation
reputation rather
rather
companies for which they work.
than on the reputation
reputation of the companies
Second, law and regulation
regulation serve as a substitute
substitute for reputational
capital, at least in the minds of regulators and market
market participants. In
modem times, particularly
particularly since the promulgation
promulgation of the modem
modem
securities
securities laws, market
market participants have come to rely far more on the
provided by
by
protections of the law, and far less on the comfort provided
HeinOnline -- 60 Syracuse L. Rev. 429 2009-2010
430
430
Syracuse Law
Law Review
Syracuse
[Vol. 60:427
60:427
reputation, when making investment decisions
decisions and in
in deciding
deciding whether
reputation,
to deal with aa particular counter-party.
counter-party. The
The current financial
or not to
demonstrates that, in
in reality, regulation is no
crisis, in my view, demonstrates
no
substitute for reputation in assuring contractual performance
performance and respect
for property rights.
This Article consists
consists of three parts, in
in addition
addition to the introduction
and conclusion. In
In Part I,I, I explain the role that reputation plays in
in
corporate governance and capital markets generally. In Part II, I discuss
four important contexts: (1)
(1)
the erosion of the reputational model in four
credit rating agencies; (2)
(2) law firms and investment banks specializing
specializing
in securities regulation and corporate law as applied to publicly held
(3) stock exchanges (particularly the New York Stock
Stock
companies; (3)
accounting firms. Part III
Exchange (NYSE)); and (4) the largest accounting
examines the empirical implications and support for the theory
presented here. One empirical implication is that we should expect
firms in the financial services industry to have weak reputations relative
to firms in other, less regulated industries. A second empirical
implication is that financial firms in countries like the United States,
implication
which have systematic
systematic and pervasive laws and regulations for the
financial services industry, locally domiciled will have weak incentives
incentives
developing and maintaining
maintaining their reputations. The evidence
evidence
to invest in developing
discussed in Part III of this Article is consistent
with
the hypothesis
consistent
hypothesis
developed in the Article.
developed
In each of these contexts, my story involves
involves important
important variations
on a single theme. The single theme is the rise and subsequent
subsequent fall of a
simple economic model in which
which companies
companies and firms in time period 0
find it rational (profitable)
(profitable) to make investments
investments in reputational
reputational capital,
do
and then, in time period
period 1 it turns out that it is no longer rational to do
this, so they stop. The investments
in
human
capital
investments
capital that occurred
occurred early
on required
required companies
companies and firms to make costly commitments
commitments to being
honest
successfully in their
compete successfully
honest and
and trustworthy
trustworthy in order
order to compete
businesses.
Concomitantly,
businesses.
Concomitantly, the
the later
later decline
decline in investment in
reputational
reputational capital
capital by such
such companies
companies and
and firms necessarily
necessarily resulted
resulted in
a dramatic
of honesty
honesty and trust in
in the business
business
dramatic decline
decline in the
the amount
amount of
sectors in which
which these companies
companies operate. Corporate
Corporate downfalls
downfalls from
from
Enron
can, in my view, best be explained
explained by the theory
theory of
of
Enron to Madoff can,
reputational
decline
that
is
the
core
of
this
Article.
reputational decline that is
core
I.1. THE
THE REPUTATIONAL
REpUTATIONAL MODEL
MODEL
The reputational
reputational model II employ
employ is very straightforward.
straightforward.
Companies
Companies and
and firms find it profitable,
profitable, and
and therefore
therefore rational,
rational, to invest
invest
money
immediately
in
developing
a
reputation
for
honesty,
money immediately in developing reputation for honesty, integrity
integrity
HeinOnline -- 60 Syracuse L. Rev. 430 2009-2010
2010]
Capital Markets
Markets
Capital
431
allows the company or firm to charge
and probity, because doing so allows
eam superior returns in later periods. The theory
higher prices, and thus earn
is that resources expended to develop a strong reputation enable the
firms that have developed such reputations to make credible
commitments to clients and counter-parties that they are honest and
commitments
desirable contracting
contracting partners.
reliable, and therefore are desirable
The reputational
model
posits
that companies and firms start their
reputational
corporate lives without any reputations. This lack of reputation is of far
corporate
more importance and relevance in some businesses than in others.
Where the quality of the product or service being offered by a business
can be evaluated accurately
accurately in a short period of time at zero cost, then
reputation matters little. People are willing to buy name-brand wrapped
wrapped
proprietor's
candy or newspapers at any newsstand
newsstand or kiosk because
because the proprietor's
rational purchaser.
reputation (or lack thereof) is largely irrelevant to a rational
A Baby Ruth candy bar or the Wall Street Journal
Journalis the same price and
the same quality at every newsstand.
In contrast, the industries in which I am interested (investment
banking, capital markets, accounting, law, etc.) require enormous
amounts of human
Indeed
human capital to deliver their products or services. Indeed
in these sectors of the economy, human capital is the only significant
participating businesses actually have. The physical
asset that participating
physical capital
necessary
to
conduct
such
businesses
is
trivial.
In
these sorts of
of
necessary
businesses
businesses, reputation plays a very important role. In such businesses,
businesses, it
substantial amount of time for a customer to observe the quality
takes a substantial
of the businesses'
businesses' human capital.
capital. As Morrison
Morrison and Wilhelm observe, in
these types of businesses, customers
can
only "observe
customers
"observe the quality of [a
... after their business relationship is well
business's] human capital ...
advanced. Hence they depend
depend upon their past experiences
experiences or the
8
to pay.",
willing to
are willing
fees they
to determine
determine the
the fees
they are
pay."g
partnership's reputation
reputation to
In my view, however, analysis
analysis of this sort, while historically
historically
case
accurate, has become
become dated. Specifically,
Specifically, while it used to be the case
that "[l]oss
[could] be quite costly and even
even fatal" to
to
"[l]oss of reputation [could]
accounting
firms
like
Arthur
Andersen,
law
firms
like
Vinson
and
accounting
Arthur
like
Elkins and
appear to
to
and credit rating agencies like Moody's
Moody's (all of which appear
have failed flamboyantly in protecting
protecting their reputations
reputations in the Enron
Enron
scandal),
longer true. 9 While
While these sorts
sorts of
of
scandal), I will argue
argue that this is no longer
firms once
depended
on
their
reputations
to
attract
and
retain
business,
once depended
their reputations
many such firms no longer need to do so. Instead, clients are
are required
8. Alan D. Morrison
Morrison &
& William
William J.
J. Wilhelm,
Wilhelm, Jr.,
Jr., Partnership
Partnership Firms,
Firms, Reputation,
Reputation, and
Human
AM. ECON.
ECON. REv.
REv. 1682,
1682, 1683
1683 (2004).
Human Capital,
Capital, 94 AM.
9. Id.
/d.
HeinOnline -- 60 Syracuse L. Rev. 431 2009-2010
[Vol. 60:427
Syracuse
Syracuse Law
Law Review
Review
432
particular firms, so reputation is no longer
longer
to use the services
services of particular
particularly important in customer and client
client decisions about which firm
to deal with. As such, reputation
reputation is no longer an asset in which it is
rational to invest heavily.
The concept of reputational risk is central to the theory and
international regulatory policy. For
practice of modem
modem domestic and international
example, the Board of Governors of the Federal Reserve System has
noted that bank regulators place great emphasis on the capacity of the
regulated financial institutions to manage "reputational
"reputational risk,"
risk," which it
defines as "the
"the potential that negative publicity regarding an
institution's business practices, whether true or not, will cause a decline
1
in the customer
customer base, costly litigation, or revenue reductions."
reductions."lo
This
statement by the Fed, however, fails to recognize
recognize that reputational
reputational risk
exists only for companies that have reputations to put at risk in the first
place. Where a company has no reputation for integrity and honesty in
the first place (or where it has such a reputation
reputation but does not rely on it
be
to attract and retain business), then the company
company cannot rationally be
trusted. In my view, this accurately
accurately describes
describes the state of the world for
corporate finance.
the key industries involved in capital markets
markets and corporate
reputation
These companies
companies once operated
operated in environments
environments in which reputation
was critical to survival. As discussed below, this is no longer the case.
II. THE DECLINE AND FALL OF THE REpUTATIONAL
REPUTATIONAL MODEL
The purpose of this section is to analyze the standard historical
assumption that investments
necessary for success in
investments in reputation
reputation are necessary
characterized by products and services involving
businesses that are characterized
what Morrison and Wilhelm
Wilhelm describe as "the
"the human capital-intensive
production of experience
experience goods.""
goodS.,,11 Where a business provides services
or produces
products
that
are capital-intensive
capital-intensive experience goods, then
produces products
firm reputation providing
providing such products or services is critical to the
success, indeed to the survival
survival of the firm. Moreover, in such cases, the
ability of customers
reputation of the companies
customers to rely on the reputation
companies with
which they are dealing lowers transaction
costs
dramatically,
transaction
dramatically, thereby
thereby
facilitating the development
development of markets and the creation of wealth.
Because it is no longer as rational
rational (profitable) as it once was for firms to
invest
reformulate our conception
of
invest in reputation, we must reformulate
conception of the role of
10. See BOARD OF
BANKING
OF GOVERNORS
GOVERNORS OF THE FEDERAL SYSTEM,
SYSTEM, DIVISION
DIVISION OF BANKING
SUPERVISION
REGULATION, SR
SUPERVISION AND
AND REGULATION,
SR 96-14, MEMORANDUM
MEMORANDUM TO THE OFFICER IN CHARGE
CHARGE OF
SUPERVISION
RISK-FOCUSED SAFETY
SUPERVISION AT EACH FEDERAL RESERVE
RESERVE BANK,
BANK, RISK-FOCUSED
SAFETY AND
AND SOUNDNESS
SOUNDNESS
EXAMINATIONS
EXAMINATIONS
AND
INSPECTIONS
(May
24,
AND
(May
www.federalreserve.gov/boarddocs/srletters/1996/sr9614.htm.
www.federalreserve.gov/boarddocs/srletters/1996/sr9614.htm.
11. Morrison &
& Wilhelm, supra
11.
supra note 8, at 1683.
1683.
1996),
HeinOnline -- 60 Syracuse L. Rev. 432 2009-2010
available
available
at
2010]
Capital Markets
433
reputation
governance and in the regulation of capital
reputation in corporate governance
markets. This section of the Article
Article develops, in a more granular way,
the point that reputation
reputation does not play the central
central role in the contracting
contracting
process in capital markets that it once did.
A. Credit
CreditRating
RatingAgencies
Credit ratings from credit rating agencies such as Moody's
Moody's and
Standard &
& Poor's provide predictive
predictive opinions
opinions on an isolated
characteristic of a company-the
company-the likelihood
characteristic
likelihood that the company will be
able to repay its rated debt in a timely manner. Credit rating agencies
agencies
corporate governance,
governance,
attempt to downplay the role that they play in corporate
claiming that, because their ratings are grounded on analysis of
of
information generated by the companies
companies themselves,
themselves, they are not in the
business
12 This claim is somewhat
business of searching
searching for and exposing fraud. 12
disingenuous. It is generally
generally accepted
accepted that the uninformed investors
who inhabit financial markets
markets clearly rely on the ratings generated
generated by
by
the major credit rating agencies. Why this is the case is something
something of a
mystery.
Moreover, as Frank Partnoy has observed, there is a great deal of
of
evidence indicating that the product generated
generated by the rating agencies,
agencies,
13
The truly abominable
abominable
information, is both stale and inaccurate.
inaccurate. 13
performance
ratings of a whole host
host
performance of the credit rating agencies in their ratings
Mercury Finance, Pacific Gas
of debt issues, including Orange County, Mercury
& Electric, Enron, WorldCom, and most recently
&
recently General Motors and
Ford, amply illustrates the point, as do a plethora of academic
academic studies
14
market.
the
lag
changes
ratings
credit
showing that
changes lag the market. 14
illustrative example
In particular, the Enron case provides
provides a rather illustrative
of the credit
ratings'
lag
behind
the
market.
credit ratings'
Neither Standard & Poor's nor Moody's downgraded
downgraded Enron's debt
below investment
investment grade status until November
November 28, 2001,
2001, four days
before the ftnn's
firm's bankruptcy, when the company's share price had
plunged to a paltry sixty-one
sixty-one cents.
12. Written
Written Statement of Raymond W. McDaniel, President, Moody's Investors
Securities and Exchange Commission (Nov. 21,
21, 2002),
Service, Before
Before the United
United States Securities
2002),
availableat
at http://www.sec.gov/news/extra/credrate/moodys.htm.
http://www.sec.gov/news/extra/credrate/moodys.htm.
available
Solutions for
Rating Agency Duopoly:
Hearing Before the
13. Legislative Solutions
for the Rating
Duopoly: Hearing
Subcomm. on Capital
Markets, Insurance,
Insurance,and Government
Government Sponsored
of the H.
Sponsored Enterprises
Enterprises ofthe
H.
Subcomm.
Capital Markets,
Services, I09th
109th Congo
Cong. 2 (2005) [hereinafter
[hereinafter Partnoy] (statement
of
Comm. on Financial
Financial Services,
(statement of
available at
Frank Partnoy, Professor of Law, University of San Diego School of Law), available
http://financialservices.house.gov/media/pdf/1 09-42.pdf.
http://financialservices.house.gov/media/pdf/l
14. Id.
Id. at 2 ("Numerous
("Numerous academic studies have shown that ratings
ratings changes lag the
"); see also Rating Agencies
Agencies and the Use of Credit Ratings Under the Securities
market ......");
12, 2003).
Laws, 68 Fed. Reg. 35,258 (concept release
release June 12,2003).
HeinOnline -- 60 Syracuse L. Rev. 433 2009-2010
434
434
Syracuse Law
Law Review
Review
Syracuse
[Vol.
[Vol. 60:427
60:427
For Enron, the corporation's
corporation's $250
$250 million
million in rated
rated senior
senior
. . . For
unsecured
debt had declined
declined in value from ninety cents to thirty-five
thirty-five
unsecured debt
downgrade. In other
cents on the dollar
dollar in the month preceding
preceding its downgrade.
other
words, the market
market rejected
rejected the investment
investment grade
grade rating on Enron's
Enron's
exercised their
debt before
credit
before the
credit rating agencies
agencies exercised
their power to
15
. 15
downgrade
downgrade it.
It.
Credit rating agencies
agencies have not lived
lived up to their
their promise
promise as
Credit
infrastructure. And,
important
corporate govemance
governance infrastructure.
important components
components of the corporate
economic theory
as with accounting
accounting firms, public choice
choice theory
theory and the economic
explanation for the failure
regulation provide
provide the best explanation
failure of credit rating
rating
of regulation
in American
American corporate
corporate governance.
governance.
Historically, companies
companies that
utilized the public
public markets
markets for debt and equity
equity utilized credit rating
agencies for the same reason they utilized
utilized the services of accounting
agencies
firms: they wanted their financial condition to be verified by a credible,
credible,
highly reputable source. Demand for
independent source; that is, by a highly
the services
companies
services of rating agencies derived from the fact that companies
the
services
of credit
when
they
subscribed
to
lowered their capital costs
costs
credit
rating agencies, and the savings from such lower capital
capital costs were
charged by the credit
subscription fees charged
greater than the costs of the subscription
rating agencies for assigning a rating to a company's
company's securities.
securities.
by
In the case of credit rating agencies, genuine demand fueled by
market forces was displaced by ersatz demand fueled by regulatory
cartelization of both of these
requirements. This, in turn,
tum, led to the cartelization
industries, as the number of accounting firms auditing large public
agencies
companies dropped to four, and the number of credit rating agencies
Recognized
SEC-sanctioned "Nationally Recognized
that enjoy the coveted status as SEC-sanctioned
three. 66 As
Organizations" (NRSROs) has dropped
Statistical Rating Organizations"
Statistical
dropped to three:
cartelization occurred, consumers
cartelization
consumers were given little, if any choice about
whether to do business with credit rating agencies, and over time we
observed a marked and undeniable diminution in the quality of the
l
markets.17
and markets.
investors and
?
services provided to investors
and Enron,
Enron,
Capital Markets,
CorporateDisclosure,
15. Jonathan R. Macey, Efficient
Efficient Capital
Markets, Corporate
Disclosure, and
CORNELL L. REv. 394,405-06
394, 405-06 (2004).
89 CORNELLL.
"nationally recognized statistical
16. In 1975, the SEC developed the concept of the "nationally
particular companies supplying credit ratings
organization" ("NRSRO") to identify particular
rating organization"
"NRSRO"
that could be relied on by the Commission for regulatory purposes. The term ''NRSRO''
for the purposes of Rule l5c3-1.
15c3-1.
was originally adopted by the Commission in 1975 solely for
See Adoption of Uniform Net Capital Rule and an Alternative Capital Requirement for
1975) (to be codified at
Brokers and Dealers, 40 Fed. Reg. 29795 (proposed July 16, 1975)
Certain Brokers
17 C.F.R pt. 240).
see generally
generally Claire A.
in the credit-rating industry,
industry, see
17. On the effects of
of cartelization in
17.
WASH. U. L.Q. 43 (2004). Hill calls particular
the Rating
Rating Agencies, 82
82 WASH.
Hill, Regulating
Regulating the
Hill,
HeinOnline -- 60 Syracuse L. Rev. 434 2009-2010
2010]
Capital Markets
435
designation, has
SEC regulation, in the form of the NRSRO designation,
created
created an artificial demand for ratings, despite their lack of usefulness
to investors.1188 These regulations require that investors
investors limit their
investments
investments in companies
companies to those whose debt is rated by one of the
three companies
companies designated by the SEC as NRSROs.
NRSROs. The SEC uses
NRSRO credit ratings to determine
determine how much capital broker-dealer
broker-dealer
firms must maintain when they hold debt securities
securities under Rule 15c3-1
of the Securities Exchange
Exchange Act of 1934 (the "Exchange
"Exchange Act"). The
ratings of NRSROs
NRSROs are also used to measure
measure the credit risk of shortterm instruments in the regulation
regulation of money market
market funds under Rule
2a-7 of the Investment Company Act of 1940 (the "1940
"1940 Act").
Issuers of certain debt securities
investment grade
securities that receive an investment
rating from an NRSRO are entitled to register under the Securities
Securities Act
of 1933 (the "Securities
"Securities Act") on the shorter
shorter Form S-3. Banking
Banking and
other regulators similarly rely upon NRSRO credit ratings to protect
the capital of financial institutions. Thus, many regulated
regulated financial
institutions
institutions can only purchase certain types of securities if they have
19
an NRSRO.
from an
rating from
grade rating
received an investment grade
NRSRO. 19
Thus, the best explanation for the puzzle, that credit rating
agencies
agencies simultaneously
simultaneously enjoy great success while providing
providing no
information
of
value
to
the
investing
public,
is
that
the SEC
information
inadvertently
created an artificial regulatory demand for the services
of
inadvertently created
services of
a small number of favored ratings agencies when it misguidedly
invented
invented the NRSRO
NRSRO designation. This designation
designation has, over time,
caused
an
artificial
demand
for
ratings,
despite
their lack of usefulness
caused
to investors.
attention
"encourag[ing] a less concentrated
concentrated market structure."
attention to reforming
reforming the industry by "encourag[ing]
Id. at 45.
45. For empirical evidence on the perceived poor quality of credit rating agencies,
agencies, see
Rating
Transparency and
and Competition:
Hearing Before
Rating the Rating
Rating Agencies: The State of Transparency
Competition: Hearing
the Subcomm.
Subcomm. on Capital
Capital Markets,
and Government Sponsored
of
Markets, Insurance,
Insurance, and
Sponsored Enterprises
Enterprises of
the H. Comm.
Comm. on Financial
Services, 108th Congo
Cong. 101-22
Financial Services,
101-22 (2003), available at
http://financialservices.house.gov/media/pdf1
08-18.pdf.
Reduced
http://financialservices.house.gov/media/pdfll 08-18.pdf.
Reduced competition in the
accounting
accounting firms to consolidate
consolidate in
accounting industry, largely as a result of pressures
pressures on accounting
response
independence rules, has "reduced
response to the SEC's auditor
auditor independence
"reduced the accounting
accounting firms'
incentives
differentiate their
incentives to differentiate
their products
products on the basis of quality."
quality." Jonathan
Jonathan Macey
Macey & Hillary
A. Sale, Observations
Commodification,Independence,
Governance in
Observations on the Role of Commodification,
Independence, and Governance
the Accounting Industry,
Industry, 48 VILL.
1177 (2003).
VILL. L. REv. 1167,
1167, 1177
18. Partnoy, supra
13, at 2.
18.
supra note 13,
19. Statement of Amy Lancellotta,
Lancellotta, Senior Counsel, Investment Company Institute
Institute for
for
the
Hearings on
to Credit
Credit Rating
21, 2002),
(Nov. 21,
the SEC
SEC Hearings
on Issues
Issues Relating
Relating to
Rating Agencies
Agencies (Nov.
2002), available
available
at http://www.sec.gov/news/extra/credrate/investcoinstit.htm.
http://www.sec.gov/news/extra/credrate/investcoinstit.htm.
HeinOnline -- 60 Syracuse L. Rev. 435 2009-2010
436
436
Syracuse
Review
Syracuse Law Review
[Vol. 60:427
B. Law Firms
Firms and Investment Banks Specializing
Specializing in Corporate
CorporateLaw
Company Clients
andSecurities
SecuritiesRegulation
and
Regulation for Public
Public Company
Clients
The existing general theory of law firm reputation
reputation is very simple.
Law firms serve as "gatekeepers."
"gatekeepers."
A gatekeeper, in turn,
tum, is a
"reputational intermediary"
role is "to assure investors
"reputational
intermediary" whose
whose role
investors as to the
20 As John Coffee,
'signal' sent by the corporate
issuer,,2o
quality of the 'signal'
corporate issuer
"repeat player" in the
and many others have observed, a gatekeeper
gatekeeper is a "repeat
capital
capital markets who enjoys both a reputation for integrity and privileged
privileged
access
access to their clients who are issuers (i.e. companies
companies trying to borrow
money (either directly or by selling securities
securities or by engaging
engaging in related
financing transactions)).
The basic idea, of course, is that, because of their reputations,
reputations,
investors and other counter-parties
counter-parties who have never heard of and do not
trust a particular
particular issuer, have heard of and are willing to trust that
issuer's highly reputed law firm. Therefore, high reputation law firms
(and accounting
accounting firms and investment banks) "rent"
"rent" their reputations to
issuers.
In my view, however, the reputational
reputational model as applied to law
firms is no longer particularly
particularly robust for three
three primary
primary reasons. These
reasons are as follows.
1. Improved
Improved Information
1.
Information Technology
First, because
because of improved
improved information technology, the value of
of
law firms'
advantage in relation to their issuer-clients
issuer-clients has
firms' reputational
reputational advantage
declined
declined dramatically. Whereas historically
historically (and particularly prior to
the passage of the securities
securities laws) investors would be reassured
reassured when
when
issuers (whose names and reputations were entirely
entirely unknown
unknown to them)
hired iconic corporate
corporate law firms (whose names and reputations
reputations were
well known
to
them).
With
improved
information
technology,
however,
known
clients have direct access to detailed information
about
issuers.
information
of the Anti-Fraud
the Securities
Securities
2. The Relevance ofthe
Anti-Fraud Provisions
Provisions of
ofthe
Laws
The second, and closely
of
closely related point, is that with the passage
passage of
20.
JOHN C.
C. COFFEE,
COFFEE, JR.,
JR., GATEKEEPERS:
PROFESSIONS AND
AND CORPORATE
CORPORATE
20.
JOHN
GATEKEEPERS: THE PROFESSIONS
GOVERNANCE 2 (2006); see also
also John C. Coffee, Jr.,
UnderstandingEnron:
"It's About the
GOVERNANCE
Jr., Understanding
Enron: "It's
Gatekeepers, Stupid," 57 Bus. LAW. 1403 (2002); Macey, supra
supra note 15,
15, at 405-10;
405-10; Macey
Macey
Gatekeepers,
& Sale, supra
supra note 17, at 1167;
POWERS, JR. ET AL.,
AL., REPORT OF INVESTIGATION
INVESTIGATION
&
1167; WILLIAM C. POWERS,
INVESTIGATIVE COMMITTEE
BY THE
THE SPECIAL INVESTIGATIVE
COMMITTEE OF
OF THE BOARD OF
OF DIRECTORS
DIRECTORS OF
OF ENRON CORP. 5,
5,
17,
24-26
(2002),
available
at
available
at
http://news.findlaw.com/hdocs/docs/enron/sicreport/sicreport020102.pdf.
http://news.findlaw.com/hdocs/docs/enron/sicreport/sicreport020102
.pdf.
HeinOnline -- 60 Syracuse L. Rev. 436 2009-2010
2010]
2010]
Markets
Capital Markets
437
securities laws,
laws, particularly
particularly the
the Securities
Securities Act of 1933
1933 and
and the
the
the securities
Securities and
and Exchange Act of
of 1934,
1934, not
not only could
could issuers and
more directly
directly (thereby
(thereby mitigating the
the historic
customers communicate more
of information problem that created the need for law firms
firms
asymmetry of
serve as informational
informational intermediaries), but also issuers
issuers could credibly
credibly
to serve
assert for the
the first
first time
time that the various
various claims they
they were making
making about
as well as
as the financial
financial information
information they were reporting,
reporting,
themselves, as
securities laws passed in the wake of the great stock
stock
were accurate. The securities
market crash of 1929 made issuers subject to civil and criminal
securities fraud liability if their claims were untrue, or if they knowingly
in clarifying information necessary
necessary to make any
failed to put in
information that was disclosed not misleading.
It is noteworthy that under the Securities Act
Act of 1933,
1933, which
governs the disclosures that companies make when they sell securities
to the public, disclosures outside of certain formats (i.e. outside of the
formal registration statement and its associated prospectus) are strongly
discouraged. In addition, disclosures in any format (oral, written,
communicated to third parties)
communicated
parties) that are false for any reason, whether as
negligence, result in strict
strict liability
liability
intentional fraud or mere negligence,
the result of intentional
21 This means
that
for the issuer, with the remedy being rescission. 21
anybody who purchases securities from an issuer in a public offering in
in
which there was a misstatement of a material fact can return them to the
issuer and receive the offering price for them.2222 Because issuers are
strictly liable for material
material misstatements or omissions in public
offerings, without
regard
to whether
without
whether these restatements
restatements or omissions
demand
were made intentionally
intentionally or even negligently, this reduced the demand
verification by law firms and other reputationa1
reputational
for independent
independent verification
intermediaries because the issuers
intermediaries
issuers assertions were
were more reliable.
reliable.
In addition,
addition, underwriters,
corporate managers and directors
underwriters, corporate
directors also
are liable for material
material misstatements
misstatements or omissions, although
although they are
23
diligence" defense.
"due diligence"
the "due
as the
defense. 23
entitled to the
the legal
legal defense
defense known
known as
The due diligence
diligence defense
defense provides
provides a method
method for escaping
escaping liability
liability for
false or
or misleading
misleading statements
statements or from omissions
omissions in
in disclosure
documents. 24 If a non-issuer
non-issuer (recall
(recall that
that the
the issuer
issuer is strictly
strictly liable
liable and
and
therefore
cannot
take
refuge
in
the
due
diligence
defense)
can
establish
therefore cannot take refuge
diligence defense)
establish
that
that it was appropriately
appropriately "diligent"
"diligent" in
in analyzing,
analyzing, verifying
verifying and
and
21.
21. James
James Spindler,
Spindler, Is
Is ItIt Time
Time to
to Wind
Wind Up
Up the
the Securities
Securities Act
Act of
of1933?,
1933?, 29
29 REGULATION
REGULATION
48,
50 (Winter
48,50
(Winter 2006)
2006) (emphasis
(emphasis in original).
original).
22.
22. Id.
Id.
23.
23. Id.
Id.
24.
24. Id.
Id.
HeinOnline -- 60 Syracuse L. Rev. 437 2009-2010
438
Syracuse Law
Law Review
Review
Syracuse
60:427
[Vol. 60:427
25
by the issuer, itit can
can avoid
avoid liability.
liability. 25
investigating the statements
statements made by
investigating
In my
my view,
view, the potential
potential liability
liability of underwriters,
underwriters, corporate
corporate managers
managers
of
directors has
has reduced
reduced the demand for the verification
verification function of
and directors
lawyers, who charge
charge high prices for providing
providing this service, by imposing
lawyers,
organizations provide
provide the
legal requirement
requirement that a host of other organizations
the legal
to pay for
laws
the
securities
by
service.
Since
customers
are
securities
laws
forced
customers
service.
reason that many of them will be
verification services,
services, it stands
stands to reason
these verification
unwilling to pay law firms again to perform
perform such services.
unwilling
of
Moreover, these provisions,
provisions, along with the anti-fraud
anti-fraud provisions of
1Ob-5, which
particularly SEC Rule
Rule 10b-5,
which makes it illegal
the securities laws, particularly
statement "in
misleading statement
"in connection
connection with the
to make a false or misleading
security," reduce
reduce the incentives
incentives for law firms to
purchase or sale
sale of any security,"
purchase
of
invest in reputational capital
capital and improve
improve the competitive
competitive positions of
26
This is because
investments.
firms that have not made such investments.
because the
low-reputation firms (firms that have
securities laws make it easier for low-reputation
securities
claim
made little or no reputation in developing
developing reputation
reputation capital) to claim
the
vetting
job
of
credibly that they will do a thorough and reliable
anti-fraud provisions of the
statements made by potential issuers. The anti-fraud
statements
compete with high
securities laws enable low-reputation
low-reputation firms to compete
securities
securities laws
reputation firms because the legal liability created by the securities
that
historically
capital
is a substitute for the reputational
reputational
historically was enjoyed
by the venerable law finns
firms of old. After the passage of the securities
laws, new firms (like the Venture Law Group, Wilson Sonsini and
others) could enter the market for the first time by claiming, even
without having invested in developing reputational capital, that they
could be trusted to refrain from associating themselves
themselves with
unscrupulous clients, not because of concerns about reductions in the
value of their reputational capital, but because of concerns about civil
and criminal liability under the securities laws.
Functions
3. Lawyers' Specialization
Specialization Functions
incentives to invest in
Another factor in the decline of law firms' incentives
reputation is the dramatic increase in the sophistication of client's inlawyers'
specialization of lawyers'
concomitant increased specialization
house counsels and the concomitant
functions. It used to be the case, in decades past, that law firms would
handle all or virtually all of the legal work for their corporate clients.
The big firms would advise on banking law, corporate law, securities
intellectual property, antitrust, commercial
law, intellectual
commercial law, international
Id.
25. Id
240.10b-5 (2009).
17 C.F.R.
C.F.R. §§ 240.lOb-5
26. 17
HeinOnline -- 60 Syracuse L. Rev. 438 2009-2010
2010]
2010]
Capital Markets
439
business
transactions, franchising law, employment
employment and labor relations,
business transactions,
contracts, and torts. These firms also would litigate as well as do the
corporate work on behalf
behalf of their big clients. Nowadays, in-house
lawyers are much more sophisticated
sophisticated in their selection of outside
counsel.
In-house lawyers develop detailed, highly textured
individual lawyers rather than firms nowadays. This
information about individual
means that corporate clients no longer choose law firms so much as they
represent them in particular matters. This,
choose individual lawyers to represent
in turn, means two things.
investments in law firm reputations
First, it means that investments
reputations are not as
valuable as they used to be because it is the reputation of individual
individual
lawyers within firms (or perhaps departments
departments of lawyers within firms)
and not the law firms themselves that attract
attract clients. Second, it means
means
of
extent that there is still a payoff to law firms in the form of
that, to the extent
increased client demand from investing in reputation, this payoff has
increased
been reduced
reduced because the client demand is likely to be only for the
particular lawyer
lawyer or legal group within the firm that has developed the
reputation.
individual lawyers has replaced
replaced the
Now that the reputation
reputation of individual
incentive for lawyers to invest
invest in their own
reputation of law firms, the incentive
reputations is on the rise, and the incentive of lawyers to invest in their
their
reputations
firms'
firms' reputations is on the wane. Individual lawyers
lawyers change firms far
Lawyers' incentives to monitor their
more often than they used to. Lawyers'
colleagues
colleagues has diminished, not only because
because lawyers no longer have the
expertise to monitor other lawyers in the firm with different
specializations,
incentive
specializations, but also because lawyers no longer have the incentive
even
further
by
reduced
to do this. Of course, this incentive
has
been
incentive
by
the replacement
replacement of the general partnership,
partnership, which
which provided strong
lawyers' accountants
accountants and other professionals
monitor
incentives
incentives for lawyers'
professionals to monitor
their colleagues,
corporation and the limited
colleagues, with the professional
professional corporation
limited
which
eliminates
those
incentives
by
removing
liability partnership,
partnership,
eliminates
removing the
risk that lawyers who fail to monitor their colleagues will face liability.
Exchanges
C.
OrganizedStock Exchanges
C. The Organized
Organized stock exchanges,
exchanges, particularly
particularly the NYSE, used to play an
important role in U.S. corporate
corporate governance. To some extent, the
of
exchanges
exchanges provided
provided secondary market liquidity for the equity of
companies
companies with publicly traded securities.
But as technology
technology
over-the-counter trading, particularly
developed,
developed, over-the-counter
particularly electronic trading,
became
became a superior, low-cost substitute for costly exchange listing. But
exchanges,
particularly the NYSE, continued
reputational
exchanges, particularly
continued to thrive as reputational
intermediaries, at least until fairly recently.
HeinOnline -- 60 Syracuse L. Rev. 439 2009-2010
Syracuse Law
Law Review
Review
Syracuse
440
[Vol. 60:427
exchanges is easy to describe: in days goneThe role of the stock exchanges
by when a public corporation listed on a stock exchange,
exchange, that
of
corporation
corporation was making
making a credible commitment
commitment to abide by a set of
shareholder wealth.
corporate
corporate governance
governance rules designed to maximize shareholder
The commitment
which
commitment was made credible
credible by the threat of delisting, which
draconian effects on companies
of
historically had draconian
companies because of the lack of
alternative
alternative trading venues for shares in public companies. Over time,
development of markets
however, advances
markets have
advances in technology and the development
of
exchanges. A whole host of
weakened the primacy
primacy of the traditional exchanges.
weakened
competitors
competitors for the traditional
traditional stock exchanges has emerged.
Two decades ago, it would have been unimaginable for companies
companies
on
the
NYSE
to
choose
a
competing
that were eligible
for
listing
eligible
competing venue,
but it is common for companies
companies to do so today. For example,
example, prominent
Automatic Data Processing
Processing (ADP), Amazon.com,
Amazon.com,
companies such as Automatic
Amgen, Apple, Dell, Fifth Third Bancorp, Intel, Microsoft, News
News
meet
Corporation, Oracle,
Oracle, and Sun Microsystems, all of which easily meet
the NYSE's
NYSE' s listing requirements,
requirements, opt out of listing on the NYSE in
favor of being traded on the NASDAQ stock market. There does not
associated with this choice.
appear to be any reputational cost associated
Traditionally
Traditionally firms moved from one trading venue to another
another (i.e.
viewed
from the NASDAQ to the NYSE) because
because they had grown and viewed
over-the-counter markets which
the move as a promotion
promotion from the over-the-counter
which
of
catered to start-up companies, to the NYSE, which was the venue of
Decisions
choice for mature, successful companies.
Decisions by highly
highly
successful
companies, such as Google and Microsoft, to remain in the
successful companies,
over-the-counter
over-the-counter markets, along with the ability of firms such as
simultaneously listed on both the NYSE and
Hewlett-Packard
Hewlett-Packard to be simultaneously
NASDAQ, illustrate the change in the traditional ordering and the
decline
decline of the reputational model.
competition from aa
modem stock exchange is subject to vigorous competition
The modern
exchanges and alternative
variety of sources, including both rival exchanges
trading venues, such as Electronic Communications
Communications Networks (ECNs)
Alternative Trading Systems (ATSs). This competition has
and Alternative
undermined
capacity for self-regulation
exchanges' capacity
strained the exchanges'
self-regulation and undermined
respect to issues
issues
to regulate in
in the
the public
public interest
interest with27respect
their incentives
incentives to
their members.
the corporate
to the
corporate governance
governance of
of their
members. 27
related to
organized
Moreover, the available evidence indicates that organized
exchanges do not even act as stand-alone
stand-alone regulators anymore. There is
advantage associated with an exchange listing.
no longer a reputational
reputational advantage
27.
BROKEN
GOVERNANCE: PROMISES KEPT, PROMISES
JONATHAN
MACEY, CORPORATE
JONATHAN R. MACEY,
CORPORATE GoVERNANCE:
112 (2008).
HeinOnline -- 60 Syracuse L. Rev. 440 2009-2010
20101
2010]
Markets
Capital Markets
441
Modem technology, the securities fraud rules and the SEC's
SEC's
Modern
unwillingness to allow exchanges any leeway in the way that different
different
firms all have combined
combined to eviscerate the
exchanges regulate listing finns
ability of competing trading venues, particularly that of the NYSE to
intermediary for listing finns.
firms.
compete by serving as a reputational intennediary
Instead, today all trading venues are properly understood as mere
coordinates the corporate governance
governance
conduits for the SEC, which coordinates
promulgated under the exchanges'
exchanges'
regulations that ostensibly are promulgated
28 As the Special
authority as self-regulatory organizations. 28
Special Study on
Market Structure,
Structure, Listing
Listing Standards
Standards and
and Corporate
Corporate Governance,
Governance,
Market
exchanges
pointed out, "the SEC had adopted a practice of encouraging exchanges
'voluntarily' to adopt given corporate governance
standards and
'voluntarily'
to adopt given corporate governance listing standards
in the process has urged the exchanges,
exchanges, listed companies and
29 The
shareholders to reach consensus
shareholders
consensus on those standards."
standards.,,29
SEC now
coordinates the regulatory
regulatory price
price fixing among the exchanges'
exchanges' selfexchanges'
regulatory organizations with respect to every facet of the exchanges'
relationships with listed companies. Thus, the SEC has undermined
undennined the
traditional way that exchanges competed with one another by serving as
a reputational intermediary
intennediary and by providing and enforcing efficient
governance rules and to enhance
corporate governance
enhance the reputations of listing
firms.
finns.
As I have pointed out before, a powerful
powerful example
example of the
reputational
Exchange's inability to enforce
enforce
reputational demise
demise of the NYSE is the Exchange's
its most powerful rule concerning corporate
governance.
This
was
the
corporate
rule requiring
requiring listed firms
finns to limit themselves
themselves to having only one class
of common stock outstanding, and to providing
providing that class of stock with
no less and no more than one vote per share of stock.
corporate managers
At the height of the takeover wave, when corporate
wanted
wanted to insulate themselves
themselves from takeover, they violated this rule by
by
28.
28. The available
available evidence
evidence here consists
consists largely
largely of series of episodes
episodes in which the
exchanges
followed by a coordinated
coordinated regulation
regulation led by the SEC.
exchanges failed
failed to self-regulate,
self-regulate, often fol1owed
Self-regulation by the exchanges
Self-regulation
exchanges is in general
general dysfunctional
dysfunctional in significant
significant part because
because
securities are often traded
traded simultaneously
simultaneously in multiple
multiple venues,
venues, thus inhibiting
inhibiting the ability of
of
exchanges
exchanges to unilaterally
unilateral1y enforce
enforce regulations.
regulations. See Jonathan
Jonathan R. Macey
Macey & Maureen
Maureen O'Hara,
From Markets
Regulation in an Evolving World, 58
Markets to Venues: Securities
Securities Regulation
58 STAN.
STAN. L. REV.
REv.
563, 575,
563,
575, 577-79
577-79 (2005) ("As
("As aa purely descriptive
descriptive matter, the available
available evidence
evidence is
inconsistent
inconsistent with the assertion
assertion that rival
rival trading venues
venues compete
compete to produce corporate
corporate law
law
rules.
the accurate
depiction of the competitive
rules. Rather,
Rather, the
accurate depiction
competitive situation
situation is that
that the SEC coordinates
coordinates
the regulatory standards
standards of the exchanges
exchanges and the Nasdaq
Nasdaq in order
order to prevent competition
competition
among
among these trading
trading venues from occurring
occurring at
at all.").
all.").
29.
29. Robert
Robert Todd
Todd Lang
Lang et al.,
aI., Special Study on Market
Market Structure,
Structure, Listing Standards
Standards and
Corporate
57 Bus.
Bus. LAW.
LAW. 1487,
1487, 1503
1503 (2002).
(2002).
Corporate Governance,
Governance, 57
HeinOnline -- 60 Syracuse L. Rev. 441 2009-2010
442
442
Syracuse Law
Law Review
Review
Syracuse
[Vol.
60:427
[Vol. 60:427
0
The NYSE
so-called "dual
"dual class"
class" capital
capital structure. 330
NYSE found
found
adopting so-called
threatened to delist
delist major companies
companies who
who violated this rule
that when it threatened
General Motors
Motors and Dow Jones,
companies, like General
exchange, the companies,
from the exchange,
would have
that
a
result
Inc., responded
responded by agreeing
agreeing to delist,
have imposed
imposed
Inc.,
significantly higher
higher costs on the NYSE
NYSE than
than on the
the listed companies,
companies,
significantly
NYSE would
would lose listing
listing fees and trading revenue,
revenue, while
while
because the NYSE
companies would
would simply move their listings
listings to a rival venue
the listed companies
NASDAQ Stock Market.
like the NASDAQ
accounting rules, the NYSE
Unable to enforce
enforce its own accounting
NYSE lobbied the
prevent these companies
companies from delisting
delisting or, barring that, to
SEC to prevent
one-share-one-vote capital structure
require the NASDAQ
NASDAQ to adopt a one-share-one-vote
structure in
require
incentive to delist
delist for companies
companies desiring
desiring a dual
order to eliminate the incentive
class voting structure. In other words, as the Exchange
Exchange began
began to face
its own
to
enforce
the
ability
to
lose
it
began
listings,
for
competition
competition
own
companies
turn, meant that companies
governance. This, in tum,
rules of corporate governance.
Exchange could no longer claim that such listing provided
provided
listing on the Exchange
governance
NYSE' s corporate governance
a credible commitment
commitment to abide by the NYSE's
rules in the future.
D.
D. Accounting Firms
Firms
Likewise, the role of accounting
accounting firms in corporate
corporate governance
governance has
declined
independent accounting
declined over time. Historically, the services
services of independent
demanded by companies to perform
firms was demanded
perform audits in order to signal
alike) that the firm was not
and
creditors
(debtors
of
capital
suppliers
to
financial fraud. 331' Investors
Investors who did not feel that they could
engaged in fmancial
engaged
Update-The Effects of Dual-Class
30. See SEC Office
Office of Chief Economist, Update-The
Dual-Class
1987, Table 11
and 1987,
from 1986 and
IncludingEvidence
Wealth: Including
ShareholderWealth:
Recapitalizations
Recapitalizations on Shareholder
Evidencefrom
Class Common Stock and
Bond: Dual
Ties that
that Bond:
also Jeffrey
1987); see also
(July 16, 1987);
Jeffrey N. Gordon, Ties
Dual Class
1, 4 (1988).
(1988). Gordon counts over
REV. 1,
Problem of Shareholder
the Problem
Shareholder Choice,
Choice, 76 CAL. L. REv.
eighty public firms that have "adopted, or proposed
proposed to adopt, capital structures with two
"[o]ne recent estimate is that
Id. In footnote 2, Gordon adds, "[o]ne
of common stock." Id.
classes of
306."
since 1985 the number of companies with dual classes of stock has risen from 119 to 306."
Powerful
Spur Powerful
Categories Spur
Dual Stock Categories
Class Struggle:
Sandler, Class
also Linda Sandler,
see also
Id.
Id. at n.2; see
Struggle: Dual
Raiders and
and
CorporateRaiders
Multiple Votes
Votes Annoy Corporate
With Multiple
Gain-SharesWith
Stability vs. Gain-Shares
over Stability
Debate over
Debate
1988, at 1.
1.
17, 1988,
Sell, WALL ST. J., May 17,
Investors Too-If You Don't
Many Investors
Don't Like It,
It, Sell,
auditors do not perform
31. Interestingly, outside auditors
31.
perform any services for a company that the
itself. The role of the auditor is not to prepare
company does not already perform for itself.
Rather, the auditor's role is
financial reports for clients (that is the role of the accountant). Rather,
generally Rick
to provide a reliable verification of the company's financial reports. See generally
J. Benston, The Value of
(1984); George 1.
REs. 11 (1984);
Independence, 22 J.J. ACCT. REs.
Antle, Auditor
Auditor Independence,
of
R.
(1969); Ronald R.
REV. 515 (1969);
Requirements, 44 ACCT. REv.
Disclosure Requirements,
SEC's Accounting Disclosure
the SEC's
Investigation, 71
Experimental Investigation,
Reporting: An Experimental
Reliable Reporting:
Formationfor Reliable
Reputation Formation
King, Reputation
King,
and
Simulacrum and
as Simulacrum
al., Accounting as
Macintosh et aI.,
B. Macintosh
375 (1996);
(1996); Norman B.
REV. 375
ACCT. REv.
(2000).
SOC'Y 13
13 (2000).
Capital, 25 ACCT., ORGS. && SOC'y
and Capital,
Income and
Perspectives on Income
Hyperreality: Perspectives
Hyperreality:
REs. 599
599 (2001); Brian W.
39 J.
J. ACCT.
ACCT. REs.
Building, 39
Reputation Building,
Auditor Reputation
Brian W. Mahew, Auditor
HeinOnline -- 60 Syracuse L. Rev. 442 2009-2010
2010]
2010]
Markets
Capital Markets
443
trust an issuing company felt
felt that they could better trust the information
information
such a company if
if itit committed to procuring audited
audited
generated by such
financial statements.3322 Auditor reputation is not only central to
accounting firms began conducting audits from an
understanding why accounting
historical perspective. In addition:
[A]uditors' reputations are central to the standard economic theory of
of
[A]uditors'
auditing. Only auditors with reputations for honesty and integrity are
valuable to audit-clients. The idea is that, absent a reputation for
honesty and integrity, the auditor's verification
verification function loses its
value. In theory, then, auditors invest heavily in creating and
maintaining their reputations for performing honest, high-quality
audits. High-quality audits by independent auditors who have good
reputations are assured. The quality assurance is derived from the fact
that performing poor-quality audits
diminishes the value of the audit
audit
33
reputation. 33
investment in
firm's investment
in reputation.
"pre-Enron" analysis was used to explain
This historical, "pre-Enron"
explain why
incentives to conduct honest audits, even in
in
accounting firms had strong incentives
situations in which their clients preferred
preferred dishonest audits.
There was a time that the audit function was carried out in a market
environment that induced high quality
quality financial reporting. In that era,
accounting firms were willing to put their seal of approval on the
financial records of a client company
company only if the company agreed to
conform to the high standards imposed by the accounting
accounting profession.
Investors
trusted
accountants
because
investors
Investors
accountants because investors knew that any
accounting firm that was sloppy or corrupt could not stay in business
for long. Auditors had significant
significant incentives to do 'superior
'superior audit
work'
because
'auditors
with
strong
reputations
could
command
work' because 'auditors
reputations
command34a fee
fee'
auditing
the
in
'signaled' quality
fees 'signaled'
high fees
premium, and high
quality in the auditing market.
market,34
Inother words, audit firms had incentives
incentives to provide
In
provide high quality
audit services because
protect their reputation for
because they wanted to protect
independence
independence and integrity.
In a world in which auditors
auditors have both
both invested
invested in developing
developing high
quality
quality reputations
reputations and in which no single
single client represents
represents more
more than
a tiny fraction of
of total billings,
billings, high audit quality seems assured.
Mayhew
Reputation on Auditor
Mayhew et
et al.,
aI., The Effect
Effect of Accounting Uncertainty
Uncertainty and Auditor Reputation
Auditor
Objectivity,
2001, at
& Jerold
Objectivity, AUDITING
AUDITING J. PRAC.
PRAC. &
& THEORY,
THEORY, Sept. 1,
1,2001,
at 49; Ross
Ross L. Watts &
Jerold L.
Zimmerman,
the Firm:
Firm: Some Evidence, 26 J.
Zimmennan, Agency
Agency Problems,
Problems, Auditing,
Auditing, and the Theory of
ofthe
1.
L. &ECON.
& ECON. 613 (1983).
(1983).
32.
Eisenberg & Jonathan
Jonathan R. Macey, Was Arthur Anderson Different?
Different? An
An
32. Theodore
Theodore Eisenberg
Empirical
Large Clients,
Empirical Examination
Examination of
of Major
Major Accounting
Accounting Firm
Firm Audits
Audits of
ofLarge
Clients, 1 J. EMPIRICAL
EMPIRICAL
LEGAL
266 (2004).
LEGAL STUD.
STUD. 263,
263,266
33.
33. Id.
ld.
34.
34. Macey
Macey &
& Sale,
Sale, supra
supra note 17,
17, at 1168.
1168.
HeinOnline -- 60 Syracuse L. Rev. 443 2009-2010
444
Syracuse Law Review
Review
[Vol. 60:427
Under these conditions,
conditions, any potential gain to an auditor from
client's
performing
performing a shoddy audit, much less from participating in aa client's
fraud, would be vastly
vastpr outweighed
outweighed by the diminution in value to the
auditor's reputation.
reputation. 3
Thus,
clients'
[p]ublic accountants
accountants knew they had a lot to lose if their clients'
information turned out to be false or misleading. Auditors who did a
clients' issuing
superior job would reduce the chance of their clients'
unreliable information and so reduce their own risk of being sued by
aggrieved investors.
Such suits are costly to36 auditors; even
even
reputations. 6
valuable reputations.3
unsuccessful suits damage their
their valuable
economics of the accounting industry critically
critically
This view of the economics
depends on the existence
existence of competition
among
accounting
competition
accounting firms.
When
Accounting firms who compete do so along the vector of quality. When
competitive environment,
environment, their
these firms cease to operate in a competitive
evaporates.37
37 In fact, there is
incentive to produce high quality results evaporates.
no evidence that accounting
accounting firms compete
on
the
basis
of quality any
compete
longer. In this environment, when clients are selecting their accounting
accounting
firms, price,
price, and, perhaps
perhaps other, more subjective factors such as
personal relationships,
relationships, or even malleability, will substitute for quality,
to the extent that there is any competition at all. The demonstrable
demonstrable lack
lack
accounting
of quality differentials among
among accounting firms means that accounting
firms no longer serve as effective
effective gate-keepers
gate-keepers for issuing companies.
organized stock exchanges, are, therefore,
Audit firms, like the organized
therefore,
ineffective
corporate
governance
devices
in
the
modem
world.
Simply
ineffective corporate governance devices
modem
Simply
put, one cannot distinguish between
between large public companies on the basis
of the quality
quality of the auditors they have selected
selected Audits have become
become
more expensive,
expensive, not because
because the quality of audits has improved but
because competition has decreased
companies are required to
decreased and companies
ever-increasing quantities of audit services in order to comply
purchase ever-increasing
with regulatory requirements.3388
In other words, not only has regulation imposed unnecessary
restricted
observable costs on industry (in the form of higher prices and restricted
& Macey, supra
supra note 32, at 267.
35. Eisenberg &
Quality: Implications
of Accounting Research:
Research: Submission to
36. Financial
Financial Reporting
Reporting Quality:
Implications ofAccounting
the (Canadian)
(Canadian)S.
Standing Comm. on Banking,
Commerce (2002) (statement of
S. Standing
Banking, Trade
Trade and Commerce
of
Daniel
Daniel B.
B. Thornton) (on file with author).
37. According to a 2002 Gallup poll, "70%
investors stated that business
"70% of U.S. investors
'a lot.
lot."'
accounting issues were hurting the investment climate 'a
", Paul Atkins, Comm'r, SEC,
Twentieth Annual
14, 2002), available
available
Remarks at the Federalist Society
Society Twentieth
Annual Convention (Nov. 14,2002),
at http://www.sec.gov/news/speech/spchII1402psa.htm.
http://www.sec.gov/news/speech/spch 111402psa.htm.
Id.
38. Id.
HeinOnline -- 60 Syracuse L. Rev. 444 2009-2010
2010]
2010]
Capital Markets
Markets
Capital
445
445
output), regulation has also
also led
led to
to unfortunate
unfortunate unobservable
unobservable costs,
costs, which
which
output),
come in
in the
the form
form of
of the reduced ability
ability of
of companies to
to distinguish
distinguish
come
themselves from
from their
their creditors'
creditors' on
on the basis of
of the
the reputations
reputations of their
themselves
auditors.
auditors.
III. DATA ON REpUTATION
REPUTATION
The theory developed in this Article is that the value to financial
institutions of investing in reputation declines to the extent that a
institutions
regulatory system that people believe is effective is put into place. This
is because reputation and regulation, both of which serve the role of
of
providing contracting parties with some reassurance that they won't be
providing
cheated or taken advantage of in the course of financial dealings, are
cheated
substitutes for one another.
This theory
theory has at least two empirical
empirical implications. First, as a
general matter, to the extent that a particular industry, such as the
financial services industry, is highly regulated, then the individual firms
financial
in that industry will have fewer incentives to invest in reputational
capital. Thus, we would expect that, in general, firms in the financial
services industry
have weaker reputations than firms in less
services
industry will have
regulated industries.
Second, in a country such as the United States, which has a vast
and
system of financial regulation
and complete
complete system
regulation and securities
securities law as well
as a highly vigorous enforcement
enforcement regime for such laws, locally
domiciled
financial firms will be relatively less willing to invest
domiciled financial
invest in
developing
developing their reputations.
The
consulting firms
firms conducted
conducted over 70,000 online
The reputation
reputation consulting
interviews
with
the
general
public
in
thirty-two
interviews with
general
thirty-two countries
countries on six
continents
during
the months of January
January and February
continents
February 2009. 39 More
than
190,000 ratings
than 190,000
ratings were
were used to create
create what
what appear
appear to be reliable
reliable
measures
measures of
of the
the corporate
corporate reputation
reputation of the 1,300 largest companies
companies in
40
the
These
the world.
world. 4o
These companies
companies represent
represent twenty-five
twenty-five distinct
distinct
39.
39. REPUTATION
REpUTATION INST.,
INST., 2009
2009 GLOBAL
GLOBAL REPUTATION
REPUTATION PULSE:
PULSE: THE
THE WORLD'S
WORLD'S MOST
REPUTABLE
REpUTABLE COMPANIES:
COMPANIES: GLOBAL
GLOBAL SECTION
SECTION 2 (2009),
(2009),
http://www.corporatereputation.it/idee/docs/Global-Pulse-2009-Free-GlobalReport.pdf
http://www.corporatereputation.it/idee/docs/Global_Pulse_2009_Free_Global_Report.pdf
[hereinafter
GLOBAL REPUTATION
REPUTATION PULSE].
PULSE].
[hereinafter 2009
2009 GLOBAL
40.
40. Id.
Id. The
The data
data in
in this
this section
section of
of the
the Article
Article is
is taken
taken from
from surveys
surveys performed
perfonned and
and
analyzed
analyzed by
by the
the Reputation
Reputation Institute.
Institute. The
The list
list of
of the
the world's
world's most reputable
reputable industries
industries and
and
countries
Reputation
countries is
is available
available at
at the
the Reputation
Reputation Institute's
Institute's website.
website.
Reputation Institute,
Institute,
http://www.reputationinstitute.com
2010). Reputation
http://www.reputationinstitute.com (last
(last visited
visited Mar.
Mar. 18,
18,2010).
Reputation Institute
Institute (RI)
(RI) is
aa private
private advisory
advisory and
and research
research firm
finn headquartered
headquartered in New
New York
York with
with representation
representation in more
more
than
than twenty
twenty countries
countries around
around the
the world.
world. Founded
Founded in
in 1997,
1997, RI
RI is
is aa pioneer
pioneer and
and global
global leader
leader
in
in the
the field
field of
of corporate
corporate reputation
reputation management,
management, with
with aa mission
mission to
to help
help companies
companies create
create
value
GLOBAL REPUTATION
REPUTATION PULSE,
PULSE, supra
supra note
note 39,
39, at
at 24.
24. RI
RI connects
connects
value from
from reputation.
reputation. 2009
2009 GLOBAL
HeinOnline -- 60 Syracuse L. Rev. 445 2009-2010
446
Syracuse Law Review
Syracuse
[Vol. 60:427
60:427
industries.441'
Interestingly,
Interestingly, counter-intuitively,
counter-intuitively, and consistent
consistent with the theory
propounded
propounded in this Article, as a general matter, companies in emerging
emerging
so-called BRIC countries (Brazil,
countries, particularly those in the so-called
Russia, India and China) rank extremely high in terms of their
their
example, Corporate India has the best reputed
reputations.4422 For example,
companies. 4433 Of the twenty-seven Indian companies ranked among the
companies.
six hundred
hundred largest
largest in the world, almost ninety percent
percent received scores
scores
50."" Only
above the global mean, with five ranking among the "Top 50.'.44
the United States had more in the "Top
"Top 50"
50" (seventeen companies),
companies), but
of course, the United
United States has five times the number of companies on
45
companies than India.45
the list of large companies
Further, "corporate
"corporate trust [is] higher in Emerging Markets, [and]
46
Lower in Industrialized
Industrialized [(i.e. relatively
relatively highly regulated)]
regulated)] Markets.
Markets.',46
More specifically:
[p]roportionally,
[p
]roportionally, the largest companies
companies in Brazil,
Brazil, Russia, India and
and
China enjoy a stronger emotional connection
connection with consumers than the
[Moreover], [o]f the
largest companies
companies in the industrialized
industrialized world...
world... [Moreover],
289 companies from the US, Japan, the UK, France and Germany,
45%
45% have reputations below the global average,
average, while only 34%
34% of the
142 companies
companies from Brazil, Russia, India and China have belowaverage reputations, with Chinese companies
companies dragging down the
BRIC average substantially. These
These results highlight that large
companies in emerging countries have greater success in building
of
relevance with the general public. It also points to the challenge of
redefining stakeholder
stakeholder interactions
interactions that many companies
companies face in more
developed markets. For example, despite significant presence on the
a global network of practitioners
practitioners and academics working towards this common mission
through
Id In 2009, Reputation Institute's Global
through research,
research, analysis, and consulting. Id.
Reputation Pulse project surveyed more than
than sixty thousand people in thirty-two
thirty-two countries,
Latin
to measure
measure consumer perceptions
perceptions of one thousand companies in North America, Latin
America, Europe, Asia, Australia, and Africa. Id.
corporate leaders
Id. at 2. RI works with corporate
who trust RI to use its cutting-edge
international network, and experienced
cutting-edge knowledge,
knowledge, international
experienced
advisors to help develop resilient reputing strategies. Id.
Id. at 24.
41. These
& Aerospace,
41.
These industries are: Airlines &
Aerospace, Automotive,
Automotive, Beverage, Chemicals,
Conglomerate, Construction/Engineering,
&
Computer, Conglomerate,
Construction/Engineering, Consumer Products,
Products, Electrical
Electrical &
Electronics, Energy, Financial-Bank,
Financial-Bank, Financial-Diversified
Financial-Diversified Services, Financial-Insurance,
Financial-Insurance,
Food &
& Tobacco,
Tobacco, Health
Health Care,
Care, Industrial
Industrial Products,
Products, Information &
& Media, Pharmaceuticals,
Pharmaceuticals,
Food
Retail-General Services, Telecommunications,
Telecommunications, Transport &
&
Raw Materials,
Materials, Retail-Food, Retail-General
Logistics, and Utilities.
supra note 39,
REPUTATION PULSE,
5.
PULSE, supra
39, at 5.
42. 2009 GLOBAL REpUTATION
43. Id.
Id. at 6.
Id.
44. Id.
45. Id.
Id.
5.
46. Id.
Id. at 5.
HeinOnline -- 60 Syracuse L. Rev. 446 2009-2010
2010]
Capital Markets
447
companies), no German company
list (31
01 companies),
company was among the global Top
47
50.
services industry is at
With the exception
exception of tobacco, the financial services
48
in
terms
of
reputation.
the bottom of the list of companies
companies tenns
48 Here below
is a list of industries, ranked in order of their reputation, from highest to
lowest. Not only is the financial services industry at the bottom of the
industries when industries are ranked by reputation, but U.S.
list of industries
firms in the
financial services firms
finns are at the bottom of the list of finns
49
49
financial services industry when ranked by reputation.
fmancial
To summarize the data, there are no financial institutions among
the top twenty companies in the world when ranked by reputation. The
of
highest ranked financial institution in the world on the basis of
reputation is China Merchants
Merchants Bank, which is ranked twenty-fourth.
The next financial institution on the list is the Russian bank Sberbank,
which is ranked twenty-seventh,
twenty-seventh, followed by the State Bank of India at
twenty-nine. The highest ranked U.S. financial institution on the list is
firm, Berkshire
Warren Buffett's finn,
Berkshire Hathaway, which is ranked sixty-sixth.
The list of major U.S. financial institutions that did not even make the
companies ranked by reputation is rather remarkable.550°
list of global companies
Absent from the list are: Bank of America, Citigroup, Goldman Sachs,
JP Morgan Chase, Morgan Stanley.551'
CONCLUSION
From the perspective
perspective of economic
economic theory, companies care if they
marketplace because companies whose customers,
are trusted in the marketplace
counter-parties and suppliers trust them will-all else being equal-be
counter-parties
more profitable than companies whose constituents don't trust them.
not. free. It's not even particularly
But developing
developing trust is not·
particularly cheap.
Rather, developing trust requires a costly investment in reputational
firms will invest
capital. In environments
environments in which reputation matters, finns
in their reputations
reputations because
because such investments cause
cause rational
counter-parties, and suppliers
constituents,
constituents, particularly
particularly customers, counter-parties,
suppliers to
because, after having made the costly investment
trust them. This is because,
47. 2009 GLOBAL REpUTATION
REPUTATION PULSE,
PULSE, supra
supra note 39, at 5-6.
48. Id. at 10.
49. Id.
Id.
AIG, Allstate, Bank of America, Bank
50. Id.
Id. at 19-23. Aetna, Aflac,
Aflac, AlG,
Bank of NY Mellon,
Capital
Capital One Financial, Chubb, Cigna, Citigroup, Goldman Sachs, The Hartford
Hartford Financial
Services Group, JP Morgan Chase, Liberty
Liberty Mutual Insurance,
Insurance, MetLife,
MetLife, Morgan Stanley,
Progressive
Progressive Insurance, Prudential
Prudential Insurance, State
State Farm Insurance, Travelers,
Travelers, and Wells
Fargo.
51. Id.
Id. at 6.
51.
HeinOnline -- 60 Syracuse L. Rev. 447 2009-2010
448
Syracuse Law Review
[Vol. 60:427
required to develop a good reputation, a company's
constituents know
company's constituents
that it will be irrational for the company
company making such a reputation to
cheat or to otherwise
otherwise be dishonorable,
dishonorable, since doing so will be irrational.
Cheating
Cheating is irrational for firms with good reputations that have been
been
costly and time-consuming
lower
time-consuming to develop, because it results in a lower
demand for the products and services of such companies, while
producing only limited, short-term
short-term benefits.
exogenous
In this Article I have argued that a variety of exogenous
developments,
developments, particularly
particularly the promulgation of the securities laws, but
also the rise of more efficient
efficient capital markets and improved technology,
are making
it
less
rational
for certain companies,
credit
making
companies, particularly credit
rating agencies, law firms, investment
investment banks, stock exchanges
exchanges and
accounting
accounting firms to invest in (or to maintain their investments
investments in)
developing
developing strong reputations for integrity and honesty. Rather, such
organizations
organizations are likely to monetize the value of their reputations by
by
participating
participating in one-shot frauds and declining to invest in the external
and internal
internal controls necessary
necessary to maintain their reputations.
HeinOnline -- 60 Syracuse L. Rev. 448 2009-2010