Challenging assumptions in corporate law and financial regulation

Mainstream debates on corporate law and financial regulation are resting on flawed assumptions, argues Claire A. Hill, drawing insights from a seminal new book.

Guest article by Claire A. Hill
Professor and James L. Krusemark Chair in Law, University of Minnesota Law School

It’s hard to have a productive dialogue as to what interests, besides profit-maximisation, corporations should serve. It’s hard to have a productive dialogue as to what corporate and financial institution conduct should be regulated and how. Why is this so? A big reason is that the different sides’ views are grounded in different assumptions that yield different answers.

Our edited volume, Hidden Fallacies in Corporate Law and Financial Regulation: Reframing the Mainstream Narratives (Andhov, Hill & Omarova, eds.), identifies some of those assumptions that might actually be fallacies.

One fallacy is that innovation is necessarily good, from which criticism of regulation as “hobbling innovation” often follows. Indeed, the word “innovation” connotes progress, improvement, an advance; an antonym is stagnation. As one chapter discusses, what is characterised as an innovation, notably in finance, may not improve social welfare, and indeed, may even detract from it.

In a 2009 discussion with the Wall Street Journal on the topic of financial innovation, Paul Volcker, Chairman of the Federal Reserve Bank, famously expressed scepticism about the value of many innovations, stating that the most important financial innovation he had seen in the past 20 years was really a technical innovation, not a financial one—the automatic teller machine.

“I do not want to stop you all from innovating,” said Volcker, “but do it within a structure that will not put the entire world economy at risk.” While hobbling innovation is a risk, its prominence is strongly exaggerated by the fallacy that innovation is necessarily good.

Another related fallacy, is that the public and private domains are separable, and separate. But all “private” entities exist in and against a backdrop of regulation, including property and contract rules. That these entities could be “left alone” is thus a fallacious framing. Again, there is no shortcut to a nuanced assessment of costs and benefits- of both corporate conduct and of law.

Indeed, and relatedly, another fallacy is that if something is good (bad), more (or less) of it is better: More securities and financial disclosure is necessarily better; or to those who think law is cumbersome, corrupt, or both, less law is better. There are important qualitative dimensions that this fallacy diminishes. For instance, as the volume discusses, artificial intelligence (AI) is significantly changing who writes, and “reads,” financial disclosures.

As we consider what sorts of disclosures are appropriate, we will need to be mindful of the rapidly changing landscape that is AI. Moreover, the emphasis on “more disclosure” has always neglected the extent to which investment is herd-like, with many investors, even sophisticated ones, looking more to what the “hot new issue” is than the specifics of expansive disclosure.

Tinkering with disclosure requirements is far easier than addressing these more complex social dynamics, as our history too often reminds us. The securities disclosure investors got as they were considering purchasing “toxic subprime securities” was frightening indeed, warning of all sorts of dire outcomes. Somehow, though, the rush to purchase the securities was a stampede.

Moving to socially conscious financial practices, attempts to bring “responsibility” and “inclusion” to such practices reflect fallacies that complicate if not negate those attempts. Once such concepts become salient and favoured, they can easily become unanchored from what they originally sought to do.

Market actors start having a stake in particular constructions of the term from which they benefit. Regular examination of whether a type of investment that has been called “responsible” or “inclusive” lives up to its name is costly and inconvenient at best, and against many influential actors’ interests.

In the corporate realm, a fallacy is the prominence accorded to managerial agency costs – that is, corporate managers taking advantage of their positions in a corporation to benefit themselves at the expense of the corporation and its shareholders. Yes, corporate managers may take advantage. But stressing their ability and incentive to take advantage detracts attention from potentially more important corporate pathologies that warrant constraining, notably those that yield negative externalities on the broader society.

Aligning incentives as between corporate managers and shareholders is a critical tool for minimising managerial agency costs. But it may be useless, or worse, when externalities are at issue. Shareholders have the incentive, and are given some ability, to address managerial agency costs. But both the managers and shareholders may benefit when the corporation is able to maximise its profits while foisting the costs onto others; other constraint mechanisms are thus required.

The volume discusses these and other fallacies—an approach that we have not previously seen in the literature.

It’s too easy for those making arguments to talk past one another, without realising that their arguments follow from what may be flawed premises.

Corporate law and financial regulation have never been more important: We face significant challenges from new (financial and other) technologies, increasing wealth and income disparities, climate change, and so much else. Our hope is that more productive dialogue, and perhaps even some measure of consensus, can be more readily achieved if we identify, and even revisit, some of our starting points.

Photo (at the top of this page) shows Professor Alexandra Andhov, Professor Saule T. Omarova, Professor Claire A. Hill and Professor Jennifer Hill in discussion with Professor Susan Watson at the New Zealand launch of their book, “Hidden Fallacies in Corporate Law and Financial Regulation”.
This launch was co-hosted at the University of Auckland Business School by:
The Aotearoa Centre for Leadership and Governance
ALTeR: Center for Advancing Law and Technology Responsibly
Juncture: Dialogues on Inclusive Capitalism.

Photo credit: Media Productions, University of Auckland

The opinions expressed in this article reflect the views of the author and are not necessarily the views of Waipapa Taumata Rau, the University of Auckland.