Securities Mosaic® Blogwatch
September 18, 2018
Was Glass-Steagall’s Demise Both Inevitable and Unimportant?
by Arthur E. Wilmarth, Jr.

The financial crisis of 2007-09 caused the Great Recession, the most severe global economic downturn since the Great Depression.  The financial crisis began with the collapse of the subprime mortgage market in the U.S. and spread to financial markets around the world.  Similarly, the disastrous financial events of the Great Depression began with the Great Crash on Wall Street in October 1929 and spread throughout the U.S. and Europe during the early 1930s.[1]

Congress responded to the Great Depression by passing the Glass-Steagall Banking Act of 1933.  Two of Glass-Steagall’s key provisions – Sections 20 and 32 – separated commercial banks from the capital markets.  As discussed below, Congress repealed Sections 20 and 32 in 1999, after a prolonged period of erosion during the 1980s and 1990s.  The recent financial crisis has revived popular interest in Glass-Steagall, given the similar boom-and-bust cycles that precipitated the Great Depression and the Great Recession.  The Democratic and Republican party platforms in 2016 called for a return to Glass-Steagall’s principles, and the issue has resurfaced again during the 2018 midterm election campaign.[2]

The Glass-Steagall Act transformed the U.S. financial industry after it collapsed during the Great Depression.  Section 8 established a new system of federal deposit insurance to prevent depositor runs on banks.  Sections 20 and 32 separated commercial banks from the capital markets.  Section 21 reinforced that separation by prohibiting nonbanks from accepting deposits.[3]

A central purpose of Glass-Steagall was to prevent banks from financing speculative securities booms like the one that occurred during the 1920s.  During the Roaring Twenties, large U.S. banks created securities affiliates and operated as “universal banks.”  Universal banks helped to finance an unsustainable credit bubble during the 1920s by packaging risky domestic and foreign loans into hazardous bonds that were sold to investors across the U.S. and around the world.  Universal banks also helped to promote an equally unsustainable bubble in the U.S. stock market by selling speculative stocks to unsophisticated purchasers.  Universal banks were at the center of major financial crises that erupted in the U.S. and Europe during the early 1930s.[4]

The Glass-Steagall Act (together with other New Deal legislation) established a decentralized financial system composed of separate and independent sectors.  Commercial banks accepted deposits, extended loans, and provided fiduciary services (including wealth management and investment advice) to consumers and businesses.  Securities firms attracted longer-term funding commitments from investors and arranged medium-term and longer-term financing for businesses.  Insurance companies collected premiums from consumers and businesses and provided medium-term and longer-term coverage for various types of risks.  The Bank Holding Company Act of 1956 (BHC Act) reinforced Glass-Steagall’s policy of structural separation by (1) preventing commercial or industrial firms from affiliating with banks, and (2) prohibiting nonbank subsidiaries of bank holding companies from engaging in activities that were not “closely related to banking.”[5]

The system of segmented financial sectors established by Glass-Steagall and the BHC Act prospered from the end of World War II through much of the 1970s.  During that period, no major financial crisis occurred.  An important reason for that era’s financial stability was that problems arising in one sector of the financial markets were much less likely to have a contagious impact on other sectors.  Regulators could address financial problems with targeted responses that did not require massive bailouts of the entire financial system.  Federal courts at first defended Glass-Steagall, as they struck down several attempts by large banks and federal regulators to open loopholes in the statute from the late 1960s through the early 1980s.[6]

The post-New Deal system of financial regulation experienced a series of economic shocks and legal challenges after 1970.  The economic shocks included the collapse of the Bretton Woods system of fixed exchange rates for international currencies as well as high inflation rates that rose steadily during the 1970s and peaked in 1980.  Those events put great pressure on Regulation Q, another component of Glass-Steagall’s reform program.  Regulation Q prohibited banks from paying interest on demand deposits and limited the interest rates that banks could pay on savings accounts and certificates of deposit.  Regulation Q was intended to restrain deposit-rate competition among banks and thereby discourage the excessive risk-taking that banks exhibited during the 1920s.[7]

Some scholars have argued that the collapse of Bretton Woods and the high inflation rates of the 1970s destroyed the economic foundations of Glass-Steagall.  Professor Paul Mahoney has provided a detailed account of that position in a recent article.  Professor Mahoney also contends that Glass-Steagall was undermined by the emergence of financial innovations like money market mutual funds (“MMMFs”), short-term commercial paper, short-term securities repurchase agreements (“repos”), securitization, and over-the-counter (“OTC”) derivatives.  MMMFs, short-term commercial paper, and short-term repos allowed securities firms to offer bank-like products to consumers and businesses.  Securitization and OTC derivatives permitted banks to offer financial services that competed directly with securities firms and insurance companies.  Professor Mahoney concludes that Glass-Steagall was effectively a dead letter by 1999, when Congress repealed its key provisions in the Gramm-Leach-Bliley Act (GLBA).[8]

I agree with Professor Mahoney that economic trends and financial innovations posed serious threats to the viability of Glass-Steagall.  However, I do not agree that Glass-Steagall’s demise was an inevitable outcome.  I contend that industry participants exploited market forces by mounting attacks on Glass-Steagall, and federal agencies and courts helped them to do so.

The Securities and Exchange Commission (“SEC”) allowed securities firms and asset managers to create MMMFs in the early 1970s.  MMMFs provided the functional equivalent of bank deposits by permitting customers to redeem their investments on demand at a fixed net asset value (“NAV”) of $1 per share.  The $1 fixed NAV represented a dramatic – and I believe unlawful – departure from basic principles governing mutual funds under the Investment Company Act of 1940.  For mutual funds that are not MMMFs, fund managers must redeem a customer’s investment based on the (variable) equity value of his or her investment on the date of redemption.  The SEC took another radical step by allowing MMMFs to offer check-writing features that turned MMMFs into functional substitutes for bank checking accounts.  The Federal Reserve Board (“Fed”) could have blocked that step by prohibiting banks from clearing checks for MMMFs.  However, the Fed never did so.

In 1979, the Bowery Savings Bank of New York filed a complaint with the Justice Department and the SEC, alleging that MMMFs with check-writing features violated Section 21 of the Glass-Steagall Act.  Based on a highly formalistic analysis, the Justice Department ruled that MMMFs were equity investments rather than “deposits,” and their check-writing features did not change their fundamental nature.  The Justice Department therefore advised the SEC that MMMFs did not violate Section 21’s prohibition on the acceptance of deposits by nonbanks.  The Justice Department (and the SEC) ignored the fact that MMMFs competed directly with bank deposit accounts and provided the functional equivalent of checking accounts.  After receiving this green light from regulators, the MMMF industry quickly grew from $3 billion in 1977 to $235 billion in 1982.[9]

The rapid expansion of MMMFs and the corresponding outflow of deposits from banks provided a convenient rationale for Congress to repeal Regulation Q – a result that federal regulators and many bankers welcomed.  MMMFs continued to grow because they enjoyed important cost advantages over banks.  MMMFs did not have to pay deposit insurance premiums or maintain capital buffers similar to those required for banks.  The total assets held by MMMFs increased to $740 billion in 1995, $1.8 trillion in 2000, and $3.8 trillion in 2007.

As MMMFs grew, so did the market for commercial paper, a short-term debt instrument (usually with maturities of 90 days or less) issued by nonfinancial corporations and financial firms.  MMMFs were the largest investors in commercial paper.  The volume of outstanding commercial paper grew from $50 billion in 1975 to $560 billion in 1990, $1.3 trillion in 2000, and $2 trillion in 2007.

MMMFs were also the most important cash lenders for repos.  Repos are short-term loans (frequently with terms of one to several days) secured by pledges of securities.  Like commercial paper, repos expanded in tandem with the growth of MMMFs.  The total volume of repos entered into by securities broker-dealers increased from $110 billion in 1981 to $800 billion in 1990, $2.5 trillion in 2002, and $3.5 trillion in 2007.  The short-term funding provided by MMMFs, commercial paper, and repos fueled the growth of the “shadow banking system.”   MMMFs, commercial paper, and repos served as “shadow bank deposits” and allowed securities firms and other nonbank financial companies to compete directly with banks in providing credit to consumers and businesses.[10]

Morgan Ricks has persuasively argued that the rapid growth of shadow bank deposits after the mid-1980s represented “an increasing privatization of the broad money supply in the pre-crisis years.”  MMMFs, commercial paper, and repos functioned as substitutes for bank deposits because they were debt instruments that were effectively payable at par on demand (or with very short notice).  In addition, federal regulators and Congress provided favorable treatment for those instruments, including safe harbors that exempted them from restrictions imposed on most creditors under the Bankruptcy Code.  The favored status of MMMFs, commercial paper, and repos caused many investors to consider them as being just as safe as bank deposits.[11]

The growing reliance of nonbanks and large, bank-centered financial conglomerates on shadow bank deposits exposed those institutions to severe liquidity problems in 2007 and 2008, when investors engaged in large-scale runs on MMMFs, commercial paper, and repos.  To prevent a collapse of the financial system, the Treasury Department, Fed, and Federal Deposit Insurance Corporation provided guarantees, asset purchase programs, and liquidity facilities that functioned as de facto deposit insurance for all three types of shadow bank deposits.[12]

The market forces that undermined Regulation Q did not compel policymakers to stand by while nonbanks offered deposit substitutes that violated Section 21 of Glass-Steagall.  Federal regulators and Congress could have removed or relaxed Regulation Q’s restrictions on deposit interest rates – thereby allowing more favorable returns to depositors – while prohibiting nonbanks from offering financial instruments that served as de facto deposits.  A realistic, functionally-grounded interpretation of Section 21 would have barred nonbanks from offering MMMFs, short-term commercial paper, and short-term repos.  Unfortunately, regulators never chose to prohibit those instruments and require securities firms and other nonbank financial companies to fund their operations in a more stable and transparent manner by issuing longer-term debt securities and entering into term loans with banks.[13]


The other two financial “innovations” that undermined Glass-Steagall – securitization and over-the-counter (OTC) derivatives – developed along similar story lines that included regulatory arbitrage and regulatory sponsorship.  Like MMMFs, securitization and OTC derivatives were not the result of unstoppable market forces.  Instead, they were actively encouraged and promoted by federal regulators who wanted to break down Glass-Steagall’s wall of separation between the banking industry and the capital markets.

In 1987, the Fed took the first major step by allowing bank holding companies to establish “Section 20 subsidiaries.”  The Fed permitted those subsidiaries to engage (to a limited extent) in underwriting mortgage-backed securities, asset-backed securities, municipal revenue bonds, and commercial paper.  The Fed ruled that Section 20 subsidiaries did not violate Section 20 of the Glass-Steagall Act because they were subject to numerous Fed-imposed restrictions.  In view of those restrictions, the Fed declared that Section 20 subsidiaries were not “engaged principally” in underwriting or dealing in bank-ineligible securities and, therefore, did not violate Section 20 of Glass-Steagall.

The Securities Industry Association challenged the Fed’s Section 20 order.  The Second Circuit Court of Appeals recognized that the Fed’s order would help to “dismantle the wall of separation” established by Glass-Steagall.  However, the court concluded that it was required to defer to the Fed’s interpretation of an “ambiguous” statute under the Supreme Court’s 1984 decision in Chevron.  The Second Circuit stated, “Whether [George] Santayana’s notion that those who will not learn from the past are condemned to repeat it fairly characterizes the consequences of the [Fed’s] action is not for us to say.”  The Second Circuit’s allusion to Santayana’s oft-quoted warning was tragically prescient, but it unfortunately did not alter the court’s highly deferential approach.  Under Chairman Alan Greenspan’s leadership, the Fed steadily removed the restrictions on Section 20 subsidiaries and expanded the scope of its Section 20 loophole between 1987 and 1996.[14]

The Office of the Comptroller of the Currency (“OCC”) followed the Fed’s example by allowing national banks to securitize residential mortgages and other loans directly (instead of being required to use holding company affiliates).  The OCC’s efforts were part of that agency’s intense competition with Alan Greenspan’s Fed to be viewed as deregulator-in-chief for the banking industry.

In 1987, the OCC issued an order confirming the authority of national banks to securitize residential mortgages.  The Securities Industry Association promptly challenged that order.  As it had done with the Fed, the Second Circuit deferred to the OCC’s view that national banks could securitize loans without violating Glass-Steagall.  The Second Circuit concluded that investors in mortgage-backed securities would be adequately protected by the securities laws.  The court agreed with the OCC that purchasers of mortgage-backed securities would be “informed investors” with “full disclosure” of all “material facts” concerning the “underlying loans.”  The court also concurred with the OCC’s opinion that national banks would be “unlikely” to securitize “unsound loans.”  The assumptions of the OCC and the Second Circuit proved to be completely wrong.  The financial crisis revealed that bank underwriters of mortgage-backed securities did have financial incentives to securitize hazardous loans and did not provide investors with full disclosure about the quality and risks of the underlying mortgages.[15]

By 1999, when Congress repealed Sections 20 and 32 of Glass-Steagall, banks had already underwritten $900 billion of mortgage-backed securities and other asset-backed securities.  Following Glass-Steagall’s repeal, the volume of outstanding mortgage-backed securities and other asset-backed securities underwritten by banks increased to $5 trillion by 2007.  Securitization of nonprime mortgages and other high-risk loans played a decisive role in fueling the toxic credit boom that led to the financial crisis of 2007-09.  Securitization by banks could not have occurred prior to 1999 without a prolonged campaign of successful litigation that was financed by major banks and facilitated by friendly regulators.[16]

OTC derivatives were the third major “innovation” that broke down Glass-Steagall’s barriers.  OTC derivatives enabled banks to offer synthetic securities and synthetic insurance products to their customers, in much the same way that shadow bank deposits allowed securities firms and other nonbanks to offer bank-like products to their clients.  As Saule Omarova has documented, the OCC followed a prolonged, step-by-step process that allowed national banks to offer a wide range of OTC derivatives.

National banks first offered interest rate swaps and currency rate swaps, which grew out of their traditional activities of discounting debt obligations and exchanging foreign currencies.  The OCC drew analogies from those swaps and developed a steadily expanding concept of “the business of banking,” which rationalized orders permitting national banks to provide equity swaps and commodity swaps.  The OCC subsequently authorized national banks to offer credit default swaps (“CDS”), which provided the equivalent of insurance against defaults on loans and debt securities.

The OCC and the Fed ruled that banks could reduce their capital requirements by obtaining CDS protection for their loans from AIG and other insurance companies.  CDS from insurance companies also enabled banks to create collateralized debt obligations (“CDOs”).  CDOs were second-level securitizations based on pools of unsold mortgage-backed securities.  CDS from insurance companies supported the decisions by credit ratings agencies to issue AAA ratings for CDOs.  The nonprime mortgage boom could not have reached its massive size without the crucial roles provided by CDOs and CDS.  Without CDOs, many lower-rated mortgage-backed securities would have remained unsold, and funding for nonprime mortgages would have dried up.  Without CDS, banks could not have obtained the AAA credit ratings they used to sell CDOs to investors.

By 2007, there were $58 trillion of outstanding CDS, and some estimates indicate that a third of those CDS represented bets on the performance of nonprime mortgages, mortgage-backed securities, and CDOs.  AIG and the other insurance companies that issued CDS were not required to hold any reserves for those CDS because state insurance commissioners had no authority to regulate CDS.  The vast pyramid of bets created by CDS and CDOs magnified the losses that occurred when borrowers defaulted on their nonprime mortgages.[17]


I agree with Professor Mahoney that Glass-Steagall’s wall of separation eroded significantly prior to its repeal in 1999.  As shown above, federal agencies and federal courts opened a number of loopholes in the legal barriers that separated banks from the securities and insurance sectors during the 1980s and 1990s.  However, those loopholes were subject to many restrictions and did not allow banks to establish full-scale affiliations with securities firms and insurance companies.  Leaders of the largest banks needed two major pieces of legislation to achieve their goal of creating true universal banks.

First, the big-bank lobby needed to repeal Sections 20 and 32 of the Glass-Steagall Act and modify Section 4 of the BHC Act.  Those three provisions prevented banks from creating unrestricted affiliations with securities firms and insurance companies.  Large banks and their trade associations pursued a 20-year campaign to accomplish that objective.  Their campaign gained significant momentum in 1997 and 1998, when securities broker-dealers and insurance underwriters finally joined big banks in pushing Congress to authorize financial holding companies that could own all three types of financial institutions.  However, community banks and insurance agents continued to defend Glass-Steagall.

To overcome the remaining pockets of resistance, Alan Greenspan’s Fed issued a 1998 order allowing Travelers, a big securities and insurance conglomerate, to acquire Citicorp, the largest U.S. bank.  President Bill Clinton and Treasury Secretary Robert Rubin publicly endorsed the creation of Citigroup – the first U.S. universal bank since 1933.  The Fed approved the acquisition by relying on a temporary exemption in the BHC Act, which allowed newly-formed bank holding companies to divest nonconforming activities within 2-5 years.  As one banking lawyer noted, that temporary exemption was “intended to provide an orderly mechanism for disposing of impermissible activities, not warehousing them in hopes that the law would change so you could keep them.”[18]

The creation of Citigroup confronted Congress with a Hobson’s choice – either repeal the anti-affiliation provisions of Glass-Steagall and the BHC Act or force Citigroup (a $1 trillion financial conglomerate) to break up within five years.  Thus, the Citigroup deal put a gun to the head of Congress, and it did so with the blessing of the president and the two most important financial agency leaders.  As Jeff Madrick observed, Citigroup’s creation was “a stark example of the ease with which the powerful on Wall Street got the ear of key policymakers, and how easily the Fed, through its rulings, could bypass the intentions of Congress.”[19]

Citigroup spearheaded the final assault on Glass-Steagall, a campaign fueled by $300 million of political contributions and lobbying expenditures.  Advocates for repeal called on Congress to clear away the “costly” and “unstable” loopholes created by federal agency and court rulings, and to provide a definitive legal framework for unrestricted affiliations among banks, securities firms, and insurance companies.  In November 1999, Congress passed GLBA, which repealed Sections 20 and 32 of Glass-Steagall and modified Section 4 of the BHC Act.  Senator Phil Gramm declared, “We are here to repeal Glass-Steagall because we have learned that government is not the answer.”  President Clinton signed GLBA into law with enthusiasm, stating, “[W]e have done right by the American people.”[20]

The financial lobby’s second major legislative goal was to insulate OTC derivatives from substantive regulation by the SEC and the Commodity Futures Trading Commission (“CFTC”).  During the 1990s, the ability of banks and securities firms to offer OTC derivatives depended on a tenuous exemption approved by the CFTC in 1993.  CFTC chairman Brooksley Born proposed a reconsideration of that exemption in 1998, but she was blocked by the derivatives lobby and the vigorous opposition of Fed Chairman Greenspan, Treasury Secretary Rubin, and SEC Chairman Arthur Levitt.[21]

The Treasury, Fed, and SEC continued to push for a broad deregulation of OTC derivatives despite the near-collapse of Long-Term Capital Management (“LTCM”) in 1998.  LTCM was a big hedge fund with massive derivatives exposures that suffered devastating losses after Russia’s debt default in August 1998.  The Fed prevented a potentially serious disruption of the financial markets by persuading a group of large banks and securities firms to rescue LTCM.  The LTCM debacle vividly illustrated the dangers of unrestrained speculation in derivatives.[22]

Unfortunately, the LTCM crisis proved to be the canary in the coal mine, or the tree falling in the forest, that advocates of “financial modernization” were determined neither to see nor hear.  In November 1999, the President’s Working Group on Financial Markets (the “Working Group”) – including Rubin, Greenspan, and Levitt – recommended legislation that would broadly exempt OTC derivatives from federal and state regulation.  The Working Group argued that comprehensive deregulation was needed to remove “legal uncertainty” and “provide a permanent clarification of the legal status” of OTC derivatives.[23]

Armed with the Working Group’s recommendation, the derivatives lobby and its political supporters persuaded Congress to enact the Commodity Futures Modernization Act (“CFMA”) in December 2000.  The only major question was how far-reaching the deregulation of OTC derivatives would be.  Senator Gramm led the successful effort to exempt OTC derivatives from all types of substantive regulation under federal and state laws as long as the counterparties to those instruments were financial institutions, corporations, institutional investors, or wealthy individuals.  Gramm declared that CFMA “completes the work of [GLBA]” and “protects financial institutions from over-regulation.”  He left the Senate in 2002 and became vice chairman and a registered lobbyist for UBS, a giant Swiss universal bank.  UBS suffered more than $50 billion of losses during the financial crisis and was forced to accept a large bailout from the Swiss government in the fall of 2008.[24]


As the foregoing summary indicates, GLBA and CFMA were highly consequential laws.  They enabled banking organizations to become much larger and more complex and engage in a far broader range of activities.  They transformed the U.S. financial system from a decentralized system of independent financial sectors into a highly consolidated industry dominated by a small group of giant financial conglomerates.  The big-bank lobby secured passage of GLBA and CFMA after prolonged and carefully planned campaigns that cost hundreds of millions of dollars.

I disagree with Professor Mahoney and other scholars who contend that GLBA and CFMA did not play important roles in promoting the toxic credit boom that led to the financial crisis of 2007-09.  Those scholars argue that GLBA and CFMA merely ratified what federal regulators and courts had already done, prior to 1999, by permitting nonbank financial institutions to offer shadow bank deposits, by allowing banking organizations to engage in securitization, and by enabling both types of institutions to offer OTC derivatives.

I agree that regulators and courts opened loopholes that seriously weakened the structural barriers established by the Glass-Steagall and BHC Acts.  However, those loopholes rested on highly contestable legal interpretations and could have been reversed by either regulators or the courts.  Supporters of GLBA and CFMA argued that both statutes were urgently needed to remove burdensome restrictions and provide “legal certainty” for a deregulated regime of universal banking.  It is very unlikely that the largest financial institutions and their trade associations would have pursued a 20-year campaign to enact GLBA and CFMA unless they viewed both statutes as having great significance.

One very tangible way to confirm the importance of GLBA and CFMA is to see how quickly the U.S. financial industry changed after they were enacted.  GLBA’s first major dividend was to validate Citigroup’s universal banking structure – a result that allowed Citigroup to remain intact.  During 2000, Credit Suisse and UBS capitalized on GLBA by acquiring two large U.S. securities firms (Donaldson, Lufkin & Jenrette and Paine Webber).  Another short-term benefit was that GLBA permitted large bank holding companies to convert their limited Section 20 subsidiaries into full-service securities broker-dealers.  As one federal regulator noted in 2000, “Loopholes cost money. . . . A top bank told me [GLBA] was a major boost to their bottom line.”[25]  GLBA helped banking organizations to triple their share of the U.S. corporate debt underwriting market from 25 percent in 1998 to 75 percent in 2002 and 2003.[26]

A second indication of GLBA’s and CFMA’s significance was the explosive growth that occurred in the shadow banking, securitization, and derivatives markets between 2000 and the outbreak of the financial crisis in 2007.  The volume of outstanding MMMFs increased from $1.8 to $3.8 trillion, while commercial paper grew from $1.3 trillion to $2 trillion, and repos at broker-dealers rose from $2.5 trillion to $3.5 trillion.  Mortgage-backed securities and other asset-backed securities (including CDOs) expanded from $1.6 trillion to $5 trillion, while OTC derivatives mushroomed from $95 trillion to $673 trillion.  It is very unlikely that such dramatic growth would have occurred in all of those markets without the comprehensive deregulation authorized by GLBA and CFMA.

To answer the question posed by this essay’s title, Glass-Steagall’s demise was not inevitable, and its disappearance had highly important and devastating consequences.  Economic disruptions and changes in financial markets created serious challenges for Glass-Steagall beginning in the 1970s.  However, regulators, the courts, and Congress could have chosen to preserve the basic principles of Glass-Steagall while making appropriate changes in response to those developments.  Instead of defending Glass-Steagall, regulators and the courts supported the financial industry’s determined efforts to open numerous loopholes in Glass-Steagall’s structural barriers.  Congress ultimately decided to repeal Glass-Steagall rather than preserve it.

The same financial “innovations” that helped to erode Glass-Steagall – shadow banking deposits, securitization, and OTC derivatives – ultimately fueled the toxic credit boom and created the unstable financial conditions that led to the crisis of 2007-09.  Had Glass-Steagall remained intact, I believe the financial crisis might not have happened, and it certainly would have had a much smaller impact if it did occur.  I agree with Professor Kathryn Judge’s suggestion that we should consider both “market forces” and “legal changes” in evaluating whether it was a wise policy decision to repeal Glass-Steagall (or to allow it to be undermined by federal agency rulings and court decisions).[27]


[1] The analysis in this essay is drawn from my forthcoming book on the Glass-Steagall Act.  Portions of that analysis appear in two of my articles: “Prelude to Glass-Steagall: Abusive Securities Practices by National City Bank and Chase National Bank During the ‘Roaring Twenties’,” 90 Tulane Law Review 1285 (2016) [hereinafter “Prelude to Glass-Steagall”], available at, and “The Road to Repeal of the Glass-Steagall Act,” 17 Wake Forest Journal of Business & Intellectual Property Law 441 (2017) [hereinafter “Road to Repeal”], available at

[2] Victoria Finkle, “Is Glass-Steagall posed for a political comeback?”, American Banker (Sept. 10, 2018), available at

[3] Wilmarth, “Road to Repeal,” supra note 1, at 449-50.

[4] See generally Wilmarth, “Prelude to Glass-Steagall,” supra note 1.

[5] Wilmarth, “Road to Repeal,” supra note 1, at 450-52; see also Prasad Krishnamurthy, “George Stigler on His Head: The Consequences of Restrictions on Competition in (Bank) Regulation,” 35 Yale Journal on Regulation 823, 825, 841-43 (2018).

[6] Wilmarth, “Road to Repeal,” supra note 1, at 452-53; see also Krishnamurthy, supra note 5, at 825.  For examples of court decisions upholding Glass-Steagall, see, e.g., Sec. Indus. Ass’n v. Bd. of Governors of Fed. Reserve Sys., 468 U.S. 137 (1984); Investment Co. Instit. v. Camp, 401 U.S. 617 (1971); Port of N.Y. Auth. v. Baker, Watts & Co., 392 F.2d 497 (D.C. Cir. 1968).

[7] Wilmarth, “Road to Repeal,” supra note 1, at 450-51, 456-58; see also Krishnamurthy, supra note 5, at 836-43, 846-47.

[8] Paul G. Mahoney, “Deregulation and the Subprime Crisis,” 104 Virginia Law Review 235 (2018).  For other scholars who have presented similar arguments, see Wilmarth, “Road to Repeal, supra note 1, at 444 n.7 (citing works by Jerry W. Markham, Peter J. Wallison, and Lawrence J. White).

[9] Wilmarth, “Road to Repeal,” supra note 1, at 458-60.

[10] Id. at 460-62.

[11] See generally Morgan Ricks, The Money Problem: Rethinking Financial Regulation (2016) (quote at 36); Anna Gelpern & Erik F. Gerding, “Inside Safe Assets,” 33 Yale Journal on Regulation 363 (2016).

[12] Wilmarth, “Road to Repeal,” supra note 1, at 462-64; see also Zoltan Pozsar et al., Shadow Banking (Fed. Res. Bank of N.Y. Working Paper, July 2010), available at

[13] Wilmarth, “Road to Repeal,” supra note 1, at 462; see also Krishnamurthy, supra note 5, at 846.

[14] Wilmarth, “Road to Repeal,” supra note 1, at 468-73 (discussing Chevron U.S.A., Inc. v. NRDC, 467 U.S. 837 (1984), and Sec. Indus. Ass’n v. Bd. of Governors of Fed. Reserve Sys., 839 F.2d 47, 49 (2d Cir.), cert. denied, 486 U.S. 1059)).

[15] Id. at 472-76 (discussing Sec. Indus. Ass’ n v. Clarke, 885 F.2d 1034 (2d Cir. 1989)).

[16] Id. at 476-77.

[17] For discussions of CDS and other OTC derivatives, see id. at 477-91; Saule T. Omarova, “The Quiet Metamorphosis: How Derivatives Changed the ‘Business of Banking’,” 63 University of Miami Law Review 1041 (2009).

[18] Wilmarth, “Road to Repeal,” supra note 1, at 512-14 (quoting Barbara A. Rehm, “Megamerger Plan Hinges on Congress,” American Banker (April 7, 1998), at 1 (quoting an unnamed banking lawyer)).

[19] Id. at 514-15 (quoting Jeff Madrick, The Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present 313 (2011)).

[20] Id. at 515-18 (quoting statements by congressional supporters of GLBA, as well as Sen. Gramm and President Clinton)

[21] Id. at 524-29, 534.

[22] Id. at 530-33.

[23] Id. at 533-39 (quoting the Working Group’s report issued in November 1999).

[24] Id. at 539-41 (quoting Sen. Gramm); Eric Lipton & Stephen Labaton, “A Deregulator Looks Back, Unswayed,” New York Times (Nov. 17, 2008), A1.

[25] Id. at 543 (quoting Barbara Rehm, “No Merger Wave, But Money Saved,” American Banker (Nov. 7, 2000) (quoting an unnamed federal regulator)).

[26] Randall S. Kroszner & Philip E. Strahan, “Regulation and Deregulation of the US Banking Industry,” in Nancy L. Rose, ed. Economic Regulation and Its Reform: What Have We Learned? 485, 499-500 (2014) (also noting that the number of banking organizations ranked among the top-five corporate debt underwriters rose from zero in 1996 to four in 2003).

[27] Kathryn Judge, “Regulation and Deregulation: The Baseline Challenge,” 104 Virginia Law Review Online 101 (2018).

This post comes to us from Arthur E. Wilmarth, Jr., at The George Washington University Law School.

September 18, 2018
The Deregulation Debate: The Challenge of Using Static Rules to Govern a Dynamic System
by Kathryn Judge

In their lively disagreement about the role of deregulation in contributing to the 2007-2009 financial crisis, professors Arthur Wilmarth and Paul Mahoney inadvertently illuminate why the processes through which finance is regulated are so ill-suited to that purpose.  Finance is dynamic.  Today’s financial system bears only a coarse resemblance to the financial system of the 1950s.  Tomorrow, the system will evolve yet further and in ways we may not be able to imagine today.   In contrast, the legal regime is designed to stagnate. Frictions make statutes and regulations difficult to change, even when market changes have already altered the substantive effects of the current regime.  And because regulatory arbitrage contributes to the evolving structure of finance, rules that stay the same tend to be deregulatory in effect.

As I explain in a new piece, “Regulation and Deregulation: The Baseline Challenge,” responding to Professor Mahoney, the mismatch between finance and the mechanisms through which laws are promulgated comes through in the deregulation debate as a disagreement about baseline. Professor Arthur Wilmarth and other advocates of the deregulation hypothesis see the trend toward less stringent bank rules in the years leading up to the crisis and regulators’ failure to stop shadow banking as core causes of the crisis. Professor Paul Mahoney challenges this claim by focusing on the way macroeconomic trends undermined the viability and substantive impact of the earlier regime, making the legal changes second order and reactive to these broader trends.  Critical to understanding these very different assessments of whether deregulation was a major factor behind the crisis is a profound disagreement about the balance struck by the original legal regime and hence the range of actions that undermined its efficacy.

To oversimplify, Wilmarth sees the original bargain as a commitment to keep banking boring.  Hence mainstays of the pre-crisis system of finance, such as money market funds and large, complex banking organizations ran directly contrary to the original deal. Had we instead kept banks small and boring, the whole fiasco might have been averted. Mahoney, again to simplify, is focused on the content of the rules themselves, and the challenge of mapping the changing substance of those rules onto the extension of risky mortgages and other developments at the core of the crisis.  Regardless of where one comes down on this issue, this disagreement matters.

Moreover, this issue is not just about making sense of the last crisis, nor is it just about stability.  Consider the opportunities and challenges that fintech currently poses for the future of financial intermediation.  Should regulators try to keep innovative new modes of extending credit within banks or outside of banks?  Or should they try to shut down those innovations altogether, even if they might expand the pool of borrowers who have access to credit on favorable terms?  These are not the questions that Wilmarth or Mahoney purport to be asking, but they are precisely the types of questions that are at stake in their disagreement.

The financial system is structured to change.  No matter what rules are adopted at Time A, their substantive effect will often be quite different at Time B.  The processes for financial regulation are not well suited to address this dynamic.  Laws are difficult to change.  And those processes require engagement only when the rules are changed, not when their substantive effect is undermined, changing the option available when lawmakers make it to the table.  There is no easy answer to this challenge, but taking it seriously is a critical threshold for both policymakers and academics to understand what went wrong in the past and how best to improve financial regulation in the years ahead.

This post comes to us from Professor Kathryn Judge at Columbia Law School.

September 18, 2018
Did Deregulation End the “Quiet Period” of Low-Risk Banking?
by Paul G. Mahoney

From the New Deal until the 1970s, banks were on a tight leash. Regulators controlled the rate of interest they could pay on deposits. Banks could not underwrite or deal in corporate securities. With some exceptions, they could not expand geographically.

These restrictions were gradually eliminated beginning in the 1970s. Simultaneously, banking grew riskier. From the end of World War II to 1970, bank failures were virtually nonexistent. From that time on, the U.S. experienced waves of bank distress culminating in the financial crisis of 2007-09.

It is tempting to conclude that the deregulation caused the instability. I believe, however, that this confuses correlation with causation. The evidence supports a different causal story:  Macroeconomic instability unrelated to banking regulation made banks riskier. Regulators responded by loosening regulatory restrictions that were viable in an era of stable inflation and interest rates but had become untenable during the Great Inflation of the 1970s. This post will provide a brief summary of the argument that regulatory change did not cause the end of the “quiet period” of low-risk banking and, in particular, did not cause the financial crisis of 2007-09.[1]

The 1944 Bretton Woods agreement established a system of pegged exchange rates in which many developed countries agreed to maintain a nearly fixed exchange rate between their currencies and the U.S. dollar, and the U.S. agreed to allow foreign governments and central banks to convert dollars to gold at a fixed rate. The system imposed a degree of discipline on the signatories’ fiscal and monetary policies. Should a country spend excessively or hold domestic interest rates too low, it would find it difficult to maintain its currency’s tie to the dollar or, in the case of the United States, to gold.

For a 20-year period beginning in the late 1940s, the United States experienced extraordinary macroeconomic stability while operating within the constraints of the Bretton Woods system. The federal budget and current account were roughly in balance. Inflation averaged less than 2 percent per year. Interest rates were low and stable. The yield curve sloped persistently upward, allowing banks to borrow short, lend long, and make a consistent and predictable profit.

In 1971, however, facing growing inflation, a current-account deficit, and outflows of gold, President Nixon decided to sever the dollar’s link to gold. For the next 10 years, the annual increase in the Consumer Price Index would average 8.7 percent.

The United States was not the only country to experience a quiet period followed by tumult. This chart, reprinted from my above-cited article, shows median inflation rates, in percent (dashed line) and the percentage of countries experiencing banking crises (solid line) for more than a century in 66 countries accounting for over 90 percent of world GDP, courtesy of Carmen Reinhart’s web page:

Source: Reinhart and Rogoff, This Time is Different

I hope this simple chart is enough to persuade the reader that the quiet period was not primarily a function of U.S. banking regulation. It was a global phenomenon among countries with widely divergent regulatory systems.

It is also somewhat misleading to call what happened in the 1970s and 1980s “deregulation.” The number of regulatory restrictions to which banks were subject grew steadily during both decades. The principal change was in the method of regulation. In banking, as in transportation, communications, and other fields, the United States abandoned the attempt to segment markets and restrict competition within each balkanized sector. Instead, banks would be subject to safety-and-soundness regulation through capital and other prudential requirements.

In a series of thoughtful and carefully researched articles summarized in a companion blog post, Professor Arthur Wilmarth argues that the regulatory changes that began in the 1970s were not inevitable. On the specifics, he is clearly correct: Congress and regulators made choices and might have made different ones. The regulatory system we had just prior to the 2007-09 financial crisis was not the inevitable result of economic forces.

But I remain convinced that I’m right on the big picture: It’s a Wonderful Life-style banking (taking demand deposits paying 0 percent and savings deposits paying 2.5 percent, making mortgage loans paying 5.5 percent, pocketing the difference and going home at 3:00) existed because it was a wonderful economy. It was inevitable that banking would become different, and riskier, once that environment changed. The details might have come out differently, but change and additional risk were unavoidable.

Why did banks suddenly and more or less simultaneously become interested in mortgage securitization and securities and derivatives activities? They wanted to reduce the risks of the maturity transformation banking model, primarily by substituting fee-generating activities for interest rate spread-generating activities. Securitization allows banks to earn fees for originating and servicing mortgages while shifting interest rate and prepayment risk to investors. Securities brokerage and underwriting generate fee income, which banks thought would be less volatile than interest rate spreads. Swaps allow banks to hedge interest rate and exchange rate risks and to earn a bid-ask spread by making markets.

From the late 1980s through the early 2000s, macroeconomic volatility again declined, producing the so-called Great Moderation. In principle, regulators could have responded to the reduction in risk by dialing back the new powers banks had obtained. As Professor Wilmarth correctly notes, however, Congress instead enshrined them into statutory law.

Banks responded to the more benign interest rate environment by shifting activity back to borrowing short and lending long. Instead of whole mortgages, however, they held (theoretically) less risky AAA-rated tranches of mortgage-backed securities and CDOs. Shadow banks got into the game as well.  Instead of retail deposits, they financed their mortgage-related holdings through repo and commercial paper.

Banks, regulators, and economists all concluded that this new form of maturity transformation was safer than the old form because banks now had the tools to manage interest rate and prepayment risk. Moreover, thanks to geographic diversification, subordination, and other credit protections, the senior securities were default-proof unless housing prices declined nationwide by double-digit percentages, something that had never happened before.

Unfortunately, it did happen beginning in 2006. Short-term creditors of financial institutions came to doubt the value of even AAA-rated collateral. In the event, securitized mortgages performed as designed. A recent analysis finds cumulative realized losses of about 2.3 percent on AAA-rated RMBS through 2013. But even this was too much for short-term lenders: If you have the right to exit immediately at 100 cents on the dollar, it is entirely rational to do so rather than roll over your short-term loan and risk losing even a couple of cents. As a result, the trading prices of these securities fell dramatically as financial institutions rushed to liquidate them to pay back short-term creditors.

Could Congress have prevented the financial crisis by refusing to enact the Gramm-Leach-Bliley Act of 1999 (GLBA), which permitted universal banking? I am unconvinced that universal banking was a major cause of the crisis. The first systemically important institutions to come to grief, Bear Stearns, Lehman Brothers, and Merrill Lynch, were stand-alone investment banks.

Indeed, here’s the irony: Had Glass-Steagall never existed, stand-alone investment banks might not have existed either. We would more likely have had a system of universal banks engaged in lending, deposit taking, and securities and derivatives activities. If so, Lehman, et al. would have had access to insured deposits and the Fed’s discount window and been subject to prudential regulation by banking regulators (the SEC is an investor protection agency, not a prudential regulator; its brief foray into the latter did not go well.) Would this have prevented these entities from getting into so much trouble? Maybe not, but at a minimum, the Fed and FDIC would have had much clearer authority to intervene when they did get in trouble.

How much is securitization to blame for the crisis? In the mid-2000s, lenders extended mortgage credit based on housing values rather than borrower ability to repay.  Investors readily purchased the resulting securities, believing that residential real estate prices could not decline as sharply and widely as in fact occurred.

One common explanation for this phenomenon is misaligned incentives: Banks didn’t care about the quality of the mortgages they originated because they planned to sell them off. The weakness in this explanation is that the same banks that originated subprime loans and the same investment banks that underwrote subprime RMBS and CDOs also invested heavily in these securities. Had subprime lending been driven primarily by misaligned incentives, originators and underwriters would have shunned the asset class in their own investment accounts.

Why did mortgage originators make so many subprime loans during the mid-2000s? The reach for yield at a time of low interest rates was a factor. So was government pressure on banks and the GSEs to facilitate home ownership among low-income households. Another simple factor, which also helps explain the global dimension of the crisis, was that the global demand for AAA-rated, dollar-denominated assets exceeded the supply. Trade and investment imbalances led investors in China and other countries to search for dollar-denominated “safe” assets. For centuries, financial institutions have used real estate as collateral for obligations that are thought to be “safe as houses,” and they did so in the run-up to the crisis.

All of these factors have some explanatory power. I do not, however, believe that GLBA or a decades-long deregulatory wave were important contributors to the crisis.


[1] The arguments are adapted from my article Deregulation and the Subprime Crisis, 104 Va. L. Rev. 235 (2018); the SSRN version can be downloaded here.

This post comes to us from Paul G. Mahoney at the University of Virginia School of Law.

September 18, 2018
SEC No-Action Letters on Investment Adviser Responsibilities in Voting Client Proxies and Use of Proxy Voting Firms
by Andrew Freedman, Ron Berenblat, Steve Wolosky, Olshan Frome Wolosky

As reported in our prior Client Alert, the Securities and Exchange Commission (“SEC”) issued a statement in July announcing that it will host a roundtable regarding the U.S. proxy process. The roundtable, expected to be held in November, will give the SEC an opportunity to discuss with market participants various topics, including the hotly debated role of proxy voting firms. On September 13, 2018, the Division of Investment Management of the SEC (the “Staff”) issued an Information Update stating that in developing the roundtable agenda, the Staff has been considering whether prior SEC guidance on the responsibilities of investment advisers with regard to voting client proxies and retaining proxy voting firms should be “modified, rescinded or supplemented.” As part of this process, the Staff announced that it has revisited no-action letters it issued in 2004 to Egan-Jones Proxy Services (“Egan-Jones”) and Institutional Shareholder Services (“ISS”) that provided guidance regarding the reliance of investment advisers on the recommendations of proxy voting firms and determined to withdraw these letters effective immediately.



Under Rule 206(4)-6 of the Investment Advisers Act of 1940 (“Rule 206(4)-6”), it is fraudulent and deceptive for investment advisers to exercise voting authority with respect to client securities unless, among other things, they adopt and implement written policies and procedures designed to ensure they vote the securities in the best interests of the clients, which procedures must include how the advisers address conflicts between them and their clients. In the adopting release for Rule 206(4)-6, the SEC stated that investment advisers have a fiduciary duty of care and loyalty to their clients with respect to proxy voting and emphasized that their policies and procedures must address how they resolve material conflicts of interest with clients before voting their proxies. The release goes on to state that an investment adviser could demonstrate that a vote of client securities was not a product of a conflict of interest if it voted, in accordance with a pre-determined policy, based upon the recommendations of an “independent” third party.

Egan-Jones and ISS

In Egan-Jones, the Staff provided guidance on the circumstances under which a third party, such as a proxy voting firm, may be considered “independent” under Rule 206(4)-6 and the steps an investment adviser should take to verify that the third party is in fact independent in order to cleanse the vote of any conflict. The Staff specifically addressed whether a proxy voting firm would be considered independent if it receives compensation from a company for providing advice on corporate governance issues. The Staff stated that “the mere fact that the proxy voting firm provides advice on corporate governance issues and receives compensation from the Issuer for these services generally would not affect the firm’s independence from an investment adviser.” However, the investment adviser must first ascertain whether the proxy voting firm has the “capacity and competency” to analyze proxy issues and can make recommendations in an impartial manner and in the best interests of the clients. In addition, the investment adviser should have procedures requiring the proxy voting firm to disclose “any relevant facts concerning the firm’s relationship with an Issuer, such as the amount of the compensation that the firm has received or will receive from an Issuer.”

In ISS, the Staff was specifically asked by Institutional Shareholder Services to agree with its view that an investment adviser may determine that a proxy voting firm can dispense voting recommendations in an impartial manner and in the best interests of the adviser’s clients based on the procedures implemented by the firm to insulate the firm’s voting recommendations from its relationships with companies rather than a review of the firm’s relationship with individual companies on a case-by-case basis. The Staff agreed that

“a case-by-case evaluation of a proxy voting firm’s potential conflicts of interest is not the exclusive means by which an investment adviser may fulfill its fiduciary duty of care to its clients in connection with voting client proxies according to the firm’s recommendations.”

Without taking a position regarding Institutional Shareholder Services’ specific conflicts policies and procedures, the Staff stated that the steps taken by an adviser to fulfill this fiduciary duty to clients may include a “thorough review of the proxy voting firm’s conflict procedures and the effectiveness of their implementation” and provided guidance on how investment advisers should examine and assess a proxy voting firm’s conflict procedures.

Over the years, investment advisers have embraced a view that their reliance on the voting recommendations of proxy voting firms, in accordance with the guidance provided by the Staff in Egan-Jones and ISS and subsequently issued guidance, will insulate their client voting decisions from any conflicts of interest while allowing them to discharge their fiduciary duty of care and loyalty to their clients with respect to proxy voting.

Reactions and Implications

The withdrawal of the no-action letters has been reported by the media as a “win” for Republicans in Congress, the U.S. Chamber of Commerce and corporate lobbyists who believe proxy voting firms such as Institutional Shareholder Services and Glass Lewis have too much influence over corporate voting decisions, are not adequately held accountable for their recommendations and should be more heavily regulated.

However, it may be premature for critics of proxy voting firms to claim victory. SEC guidance issued in 2014 (Staff Legal Bulletin No. 20) regarding investment advisers’ responsibilities in voting client proxies and retaining proxy voting firms is still in effect. In response to the announcement, Steven Friedman, General Counsel of Institutional Shareholder Services, stated that “Corporate lobbyists have created a mythology surrounding these letters” and that their withdrawal “does not change the law, does not change the manner in which institutional investors are able to use proxy advisory firms, nor does it change the approach that institutions need to take in performing diligence on their proxy advisory firms.”

SEC Commissioner Robert Jackson was similarly critical of the announcement, stating that the questions suddenly raised by the Staff are “long-resolved” and that the laws governing the use of proxy voting firms have not changed. He also expressed concern that the SEC’s efforts to address “proxy plumbing” issues “will be stymied by misguided and controversial efforts to regulate proxy advisors.” According to Commissioner Jackson, “Regulating proxy advisors has long been a top priority for corporate lobbyists, who complain that advisors have too much power. There is, of course, little proof of that proposition, and the empirical work that’s been done in the area makes clear that that claim is vastly overstated.”

The impact the withdrawal of the no-action letters will have on shareholder activism is unclear. While large institutional investors are becoming less dependent on proxy voting firms, the influence wielded by the voting recommendations of these firms on the outcomes of contested elections is not insignificant. Investment advisers may now face uncertainty as to whether their continued reliance on these voting recommendations is contrary to their fiduciary duty of care and loyalty to their clients. A statement released by SEC Chairman Jay Clayton concurrently with the announcement that SEC staff guidance is non-binding and does not create enforceable legal rights or obligations may add to this uncertainty.

We will continue to monitor developments relating to the role of proxy voting firms and other “proxy plumbing” topics that will be reviewed during the SEC roundtable in November.

September 18, 2018
SEC Ratification for Defective Administrative Proceedings
by Daniel Ward, David Nasse, R. Daniel O'Connor, Ropes & Gray

The Securities and Exchange Commission (“SEC” or “Commission”) has issued an order clearing the way for cases to proceed before its own administrative law judges (“ALJs”), notwithstanding a Supreme Court decision issued earlier this year that declared the SEC’s prior appointment of ALJs to be unconstitutional. Respondents in nearly 200 SEC proceedings with pending cases will now be granted the opportunity to have their case reheard by a different ALJ. Through the ratification order, the Commission has also attempted to comply with the Appointments Clause of the Constitution. Whether this post hac ratification passes constitutional muster, however, remains to be tested in the courts.


On August 22, 2018, the SEC issued an order (the “Order”) lifting its stay on all pending administrative proceedings and reaffirming its November 30, 2017 order ratifying the constitutional appointment of certain ALJs (the “Ratification Order”). The SEC imposed the stay in June 2018 following the Supreme Court’s decision in Lucia v. SEC, 138 S. Ct. 2044 (2018), in which the Court held that the SEC’s ALJs are “officers” pursuant to the Constitution’s Appointments Clause and thus must be appointed by the President, “Courts of Law,” or “Heads of Department.” In issuing the Order, the SEC purports to address several questions left unanswered by Lucia regarding the impact of the decision on current administrative proceedings.

First, the Court in Lucia declined to address the validity of the SEC’s Ratification Order, and one of the open questions post-Lucia included the extent to which the SEC would pursue the Ratification Order as an avenue for rendering its appointment of ALJs constitutional. The August 22, 2018 Order “reiterates” the Commission’s “approval of [the ALJs’] appointments as [its] own under the Constitution.” In other words, the Order attempts to confirm that the SEC has appointed those ALJs as per the Appointments Clause of the Constitution, and that the ALJs may adjudicate cases.

Second, the Order addresses the Lucia majority’s only definitive command regarding a remedial scheme—that Lucia be afforded the opportunity for a new hearing in front of a different ALJ than the one who had previously decided his case. In fact, the Order grants all respondents in the newly un-stayed proceedings the “opportunity for a new hearing before an ALJ who did not previously participate in the matter,” and remands all cases pending before the Commission to the Office of the ALJs “for this purpose.” Moreover, the Order vacates “any prior opinion” the Commission has issued in nearly 130 matters pending before the Commission, listed in Exhibit A to the Order. Chief ALJ Brenda P. Murray confirmed via notice on August 23, 2018 (the “Notice”) that another nearly 70 cases pending before ALJs prior to the Order would be reheard pursuant to the Order. As a result of this Order, respondents (and possibly the SEC) who received a negative initial decision from an ALJ prior to the SEC’s Ratification Order but have not yet exhausted their appeal, will now get a fresh “bite at the apple” and a completely new hearing before a different ALJ.

Finally, the Order outlines a set of procedures and deadlines for all cases that will be assigned to a new ALJ pursuant to the Order, thereby vacating any pending deadlines in those cases. The new ALJs are instructed not to “give weight or otherwise presume the correctness” of any prior ruling from the previous ALJ. The new ALJs must also issue an order within 21 days of assignment directing the parties to “submit proposals” for further proceedings, at which point the new ALJ will conduct a new hearing. Parties who do not submit proposals for further proceedings may be subject to a default ruling or sanctions. Parties can opt out of being assigned to a new ALJ or propose an alternate procedure by submitting an express written agreement to the Chief ALJ by September 7, 2018. Indeed, Chief ALJ Murray stated in her Notice that parties can “agree[] that the proceeding remain with the previously designated administrative law judge.”

In ordering that all respondents in proceedings before ALJs and the Commission be given the opportunity to have a new hearing before a different ALJ, the SEC has undertaken a hefty administrative burden in rehearing pending cases for a second time. However, the constitutionality of these developments remains to be seen.

September 18, 2018
SEC Sanctions Citi Dark Pool
by Tom Gorman

High-frequency trading and its impact on other traders has been a hotly debated question in recent years. Some argue that the practice should be banned while others claim that it has a beneficial impact, adding liquidity to the markets. Regardless of which position one adopts, there is no doubt that many seek to avoid such traders by using alternative trading venues. That point is at the center of a recent Commission enforcement action involving a dark pool that claimed those who engage in high frequency trading were not admitted to the pool. In the Matter of Citigroup Global Markets, Inc., Adm. Proc. File No. 3-18766 (Sept. 14, 2018).

Respondent Citigroup Global Markets is an indirect, wholly owned subsidiary of Citigroup, Inc., and is a registered broker-dealer. Citi Order Routing and Execution, LLC, also named as a Respondent and known as CORE, is an indirect subsidiary of Citigroup and a registered broker-dealer.

CORE was acquired by a Citigroup subsidiary in 2007. At the time the firm was engaged in the equity market making business. It then launched a new trading product called I-Match which catered to institutional users. The product allowed users to place resting orders to trade against retail order flow purchased by the CORE market maker before the market maker had an opportunity to trade against the orders. Later in 2007 CORE rebranded the new product as Citi Match. Marketing for Citi Match stated that it was a dark pool for institutional investors that was separate from CORE’s market maker operations. Citi Match was also depicted as a “premium” and “exclusive” dark pool. The quality of the order flow in Citi Match was emphasized. Premium fees were charged.

During the period Citi Match was marketed as not permitting high-frequency trading firms or HFT to enter orders in the dark pool. Nevertheless, from at least July 2011 through September 2012 at least two HFT firms traded in the venue. During that period about 17% of all executions based on dollar volume were with one of those firms. Those executions represented about $8.4 billion in notional value.

During the same period traders were not adequately informed that in fact Citi Match routed orders to more than twenty different external venues. Those included ATSs, national securities exchanges and electronic market makers. Generally, the commissions charged for executions at those venues were less that the premium charges of Citi Match. In 2013, for example, 37% of Citi Match executions took place in external venues. In 2014 about 54% of the executions were in external venues. Indeed, a significant portion of those orders went through an affiliated ATS that charged lower commissions. In addition, the electronic messages furnished to some users contained inaccurate information about the execution venue for those orders.

Finally, CORE acted as an unregistered exchange in its provision of Citi Match. Section 5 of the Exchange Act prohibits any broker-dealer or exchange to effect transactions in a security unless the exchange is registered as a national securities exchange under section 6 of the Exchange Act or is otherwise exempt. Here Citi Match acted as a marketplace for NMS stocks. Nevertheless, CORE failed to register or qualify for an exemption. The aforementioned conduct constituted violations of Securities Act section 17(a)(2) and Exchange Act section 5.

To resolve the proceedings Citi Group Markets consented to the entry of a cease and desist order based on the Securities Act section cited in the order and to a censure. The firm will also pay disgorgement of $4,718,784.59, prejudgment interest of $718,690.47 and a penalty of $6.5 million. CORE consented to the entry of a cease and desist order based on the Exchange Act section cited in the Order and to a censure. The firm will also pay a civil penalty of $1 million.

The post SEC Sanctions Citi Dark Pool appeared first on SEC ACTIONS.

September 18, 2018
Course Materials Now Available: Many Sets of Talking Points!
by Broc Romanek

For the many of you that have registered for our Conferences coming up next Tuesday, September 25th, we have posted the “Course Materials” (attendees received a special ID/PW yesterday via email that will enable you to access them; note that copies will be available in San Diego). The Course Materials are better than ever before – with numerous sets of talking points. We don’t serve typical conference fare (ie. regurgitated memos and rule releases); our conference materials consist of originally crafted practical bullets & examples. Our expert speakers certainly have gone the extra mile this year!

Here is some other info:

How to Attend by Video Webcast: If you are registered to attend online, just go to the home page of or to watch it live or by archive (note that it will take a few hours to post the video archives after the panels are shown live). A prominent link called “Enter the Conference Here” – which will be visible on the home pages of those sites – will take you directly to the Conference (and on the top of that Conference page, you will select a link matching the video player on your computer: HTML5, Windows Media or Flash Player).

Remember to use the ID and password that you received for the Conferences (which may not be your normal ID/password for or If you are experiencing technical problems, follow these webcast troubleshooting tips. Here are the conference agendas; times are Pacific.

How to Earn CLE Online: Please read these “FAQs about Earning CLE” carefully to see if it’s possible for you to earn CLE for watching online – and if so, how to accomplish that. Remember you will first need to input your bar number(s) and that you will need to click on the periodic “prompts” all throughout each Conference to earn credit. Both Conferences will be available for CLE credit in all states except for a few – but hours for each state vary; see our “CLE Credit By State” list.

Register Now to Watch Online: There is still time to register for our upcoming pair of executive pay conferences – which starts on Tuesday, September 25th – to hear Keith Higgins, Meredith Cross, etc. If you can’t make it to San Diego to catch the program in person, you can still watch it by video webcast, either live or by archive. Register now to watch it online.

Register to Watch In-Person in San Diego: Starting this Saturday, you will no longer be able to register online to attend in San Diego – but you can still register to attend when you arrive in San Diego! You just need to bring payment with you to the conference and register in-person. Through the end of this Friday, you can still register online to attend in-person in San Diego. And you can always register online to watch the conference online…

E&S Proxy Disclosure: Good Examples

In our “Q&A Forum” (#9598), we were recently asked which companies did a good job providing proxy disclosure about their E&S situation. There are many to choose from – but we mentioned these:

– State Street
– Citigroup
– Prudential
– Jet Blue
– Entergy

Lead Audit Engagement Partners? Not Many Women

Here’s the lowlights from this new report from the CFA Institute based on the new “lead audit engagement partners” disclosure made by companies in their proxies this year (the report covers much more ground than gender of the lead partners):

– Only 15% of lead engagement partners of the S&P 500 were female
– Only 11% of lead engagement partners of the S&P 100 were female
– Percentages of female lead engagement partners by S&P 500 firms were Deloitte (20.8%), PwC (16.3%), EY (12.9%), and KPMG (10.6%)
– 30% of the S&P 500 were audited by PwC, 31% by EY, 20% by Deloitte, and 19% by KPMG
– We found no female partners among the 36 longest tenured engagements (those over 75 years) in the S&P 500
– We found only 6 female partners in the 107 companies with auditor relationships exceeding 40 years

Broc Romanek

September 18, 2018
Corporate Governance Oversight and Proxy Advisory Firms
by Ike Brannon, Jared Whitley, Capital Policy Analytics

The Securities and Exchange Commission requires that investment management funds submit proxy votes for all companies in which they own shares. Because of the vast number of stocks held by the typical institutional investor, hedge fund, or mutual fund, most of these investors draw on the research of a proxy advisory firm, which provides them some guidance in their task and allows them to focus on managing their portfolio.

But while their clients want to maximize returns, the objectives of proxy advisory firms may not be completely aligned with theirs. The opacity with which these firms operate makes it difficult for investment management companies—and individual shareholders—to discern that alignment.


Proxies have become increasingly contentious in recent years as political activists have taken to leveraging shareholder proposals to pursue fashionable political goals in a variety of ways. Proxy advisors have themselves become more political in their support of some of these goals. Accordingly, these activities have been receiving closer scrutiny—especially from Congress, which is currently debating legislation to increase transparency at these proxy advisory firms. The SEC has also declared its concern with political activism in proxy voting and may pursue further action in this area.

These days, some investors perceive that the growing importance of proxy advisors to investment managers may be problematic, as the number of proxy votes multiplies. The worry many have is that political or social agendas that may be peripheral—or harmful—to long-run returns may be capturing undue priority, with potentially harmful ramifications for the interests of retail investors and other shareholders focused on value maximization. On such a basis, significant reform of the industry may be necessary.

Conflicts of Interest in Proxy Voting

Few individual investors are aware of the role that proxy advisors play in guiding the activities of institutional investors—or that they even exist, for that matter. But as the use of proposals for political advocacy accelerates, their role is growing in importance.

Ordinary-course management proxy items typically include the retention of existing board members, approval of new members, or the ratification of the CEO’s pay package. However, companies are increasingly seeing proposals from shareholders that call on the company to take action on broader public policy proposals, both major and minor.

Proxy advisors are important because institutional investors—pensions, college endowments, and investment management companies—dominate shareholder voting. A recent analysis estimated that institutional investors control as much as 80% of the stock market. The SEC requires that institutional investors vote on corporate proxy matters, but permits them to use recommendations from third-party proxy advisory firms. These frequently call on the company to take additional actions on environmental and social causes. The Economist magazine reported that there were 459 shareholder proposals submitted by early April of this year, a high proportion of which concerned climate change, racial and gender diversity, pay, and political spending. Given the increasing frequency of shareholder proposals that are tangential to the core activities of the company, the recommendations of proxy advisors are becoming more important every year.

There is nothing inherently wrong with companies seeking guidance from a third-party source. The sheer number of proxy items makes it difficult for institutional investors to perform this activity themselves. However, three potential problems bedevil the proxy advisory industry.

The first is a lack of transparency on proxy firms’ methods and accountability for their recommendations. Proxy advisory firms have become, in some respects, akin to a self-appointed regulatory body, capable of making demands on public companies but without any actual statutory authority.

The second problem is that many in the investment community view proxy advisory firms as neutral arbiters, akin to referees in a sporting event. But in fact, these firms are for-profit enterprises with the potential for conflicts of interest no different than any other professional service or consultant. Without robust oversight or copious disclosure, regular investors may not understand the costs they impose on their investments.

A third problem is a practice called “robo-voting.” It is common for investment managers to simply and automatically heed the advice of a proxy advisory firm without giving the recommendations even a cursory review.

The Importance of Proxy Advisor Recommendations

No one could have predicted how powerful proxy advisor firms have become. For instance, earlier this year financial journalist Michelle Celarier wrote in Institutional Investor about the proxy advisor Institutional Shareholder Services (ISS):

That ISS has become the kingmaker in proxy contests between billionaire hedge fund activists and their multi-billion-dollar corporate prey is even more astonishing given that ISS itself is worth less than $1 billion and started out as a back-office support system, helping shareholders cast their ballots on what are typically mundane matters of corporate governance. Says one former ISS executive who now works at a hedge fund: “ISS sort of stumbled into this powerful role.”

ISS’s role now is so powerful the company and industry have drawn the attention of Congress. In May 2018, representatives from ISS and another advisory firm, Glass Lewis, sent letters to the Senate Banking Committee, which is considering legislation to address these longstanding concerns about their industry. [1] Both companies downplayed their influence and the weight their recommendations hold, arguing that it is incorrect to paint them as anything but neutral arbiters or “data aggregators”—rather than for-profit influencers with numerous potential conflicts of interest.

They emphasized that their task is to identify the priorities of their clients—with the client’s assistance—in order to help them vote as they would if they had the time and resources to study the issue themselves. The crux of their argument is that if there’s any deviation from investment companies maximizing shareholder returns, it’s the fault of their clients. An industry trade group, the Council of Institutional Investors, explained it in a 2016 letter to the House Committee of Financial Services:

ISS and Glass Lewis tend to follow investors on governance policy, not lead them…. Their franchises are built on credibility with investors. As a result, advisors’ views reflect those of many funds. Indeed, if there were a sharp divergence, we would expect to see advisors punished in the marketplace.

ISS claims that it plays only a marginal role in affecting the outcome of proxy votes, and that its recommendations only shift the vote by 6–10%. However, academic research suggests that the figure is more significant and may be as high as 25%. ISS also has its own corporate consulting arm, ICS Corporate Solutions, which is (somewhat opaquely) described on its website.

ISS leans heavily on its Registered Investment Advisor status to deflect criticism of its conflicts of interest, notes the Center on Executive Compensation. ISS argues that proxy advisory work constitutes “investment advice” under the Advisors Act, which would make the company a fiduciary and subsequently a “a disinterested fiduciary.” This description diverges from Glass Lewis’s view of itself in its letter to the Senate Banking Committee, which declares that it neither dispenses “investment advice” nor serves as a fiduciary.

The fact that ISS is registered as a fiduciary but Glass Lewis is not suggests a fundamentally different interpretation of their obligations and breeds confusion and uncertainty as to what the industry is and is not required to do. Given the SEC’s ongoing efforts to ensure transparency in the markets and to protect the interests of retail investors through Regulation Best Interest and other requirements, it is possible that this difference of opinion may prove problematic.

Glass Lewis tries to distance itself from ISS, in part because (unlike ISS) it does not have a consulting arm. But Glass Lewis also fails to offer any substantive, transparent insight into its guidelines and methodologies.

While proxy advisory firms provide advice on standard proxies for well-managed companies, they have in the past regularly failed to identify major problems on the horizon for the firms they analyze. For instance, immediately prior to the recent Wells Fargo scandal involving the creation of fake customer accounts, which revealed a startling lack of management oversight, ISS recommended against removing any of the sitting board members even though most had been in place well beyond a time period normally considered prudent. Similarly, the company recommended a vote against a shareholder proposal to split the president and chairman of the board. ISS did subsequently recommend jettisoning incumbent board members, but not until well after the scandal came to light.

Efforts to push environmental, socially responsible, and good governance priorities via proxy battles are getting more traction these days. While the total number of votes pertinent to such issues have fallen slightly this year from 2017, the percentage scoring 50% approval doubled this year to 6%, and the percentage scoring 40% approval went from 12% last year to 19%.

Robo-Voting and its Implications

Institutional investors and large financial management companies have come to rely on the services of proxy advisors to help them decide how to vote on various shareholder resolutions. However, there is a moral hazard endemic in that decision-making process.

Certain investors—generally the largest ones—have sufficient personnel and resources to review the analysis and recommendations of their proxy advisors. But for most investment companies it is easier to simply concur without further review if both major proxy advisors make the same recommendation, a process referred to as “robo-voting.” The result is an overreliance on the recommendations of potentially understaffed and underqualified proxy advisor analysts.

Robo-voting is most common among smaller investors that lack the capacity or appetite to review individual reports and recommendations. Some of these investors have an arrangement with Glass Lewis and ISS that effectively dictates that they will automatically follow the recommendations provided, and that any deviation requires that a case be made to the internal investment committee. The extent to which these firms are effectively signing over their proxy recommendations has led some to question whether this might constitute a breach of fiduciary duty.

Given the number of clients they have (ISS claims over 1,900 institutional clients and Glass Lewis approximately 1,300) and the fact that many appear to have such arrangements in place, the two firms have significant influence on final voting outcomes. For example, institutions vote as directed by ISS and Glass Lewis more than 80% of the time, according to a study by the American Council for Capital Formation.

The Transparency Solution

The moral hazard that exists in the relationship between proxy advisors and investment management firms is the result of a government regulation mandating that they vote their proxies. That effectively coerces them into an over-reliance on firms whose influence exceeds their size, resources, and statutory authority.

Rep. Sean Duffy (R-WI) and Rep. Gregory Meeks (D-NY) introduced bipartisan legislation that would address many of these issues. The intent of HR 4015 is to enhance transparency in shareholder proxy systems, requiring proxy advisory firms to register with the SEC. Firms would also have to disclose potential conflicts of interest, codes of ethics, and methodologies for formulating recommendations and analyses. The House passed the bill in December 2017, but the Senate Banking Committee has not yet considered it, although it held a hearing on the issue in June.

In testimony at that hearing, Thomas Quaadman, executive vice president for the Chamber of Commerce Center for Capital Markets Competitiveness, described ISS and Glass Lewis as “the de facto standard setters for corporate governance in the United States.” Given that position, he suggests that both operate with conflicts of interest and a lack of transparency. He further alleges that each has made significant errors when developing vote recommendations. He also suggests that because Glass Lewis is owned by two somewhat politically active institutions—the Ontario Teachers’ Pension Plan and the Alberta Investment Management Corporation—it creates an inherent conflict of interest. Quaadman pointed out that the company may be able to exploit its influence to advance a broader agenda at the expense of investors.

At the same hearing, Darla Stuckey, president and CEO of the Society for Corporate Governance, also refuted the notion that ISS and Glass Lewis have no influence on how clients vote. She described how these firms “own and control the software platforms that send investor votes to the tabulator for a shareholder meeting.”

The issue is entirely created by the requirement that financial managers vote their proxies. Given that in the past most have been manifestly uninterested in doing so and have found the most expedient answer to this requirement to be outsourcing it as much as possible, it is worth asking whether the requirement makes sense in this day and age. Removing the requirement would likely give individual investors more weight in any proxy vote, which we suggest would be superior to the status quo. Allowing investment managers to vote proxies when and where they choose might make them more engaged in these issues than they currently are.

The Costs of Activism Is Borne by Investors

There is recent precedent for government intervention when a perception develops that investors are being given short shrift. In 2015, the Obama Administration called for more stringent rules overseeing investment managers. The administration pointed out that even a small reduction in the long-run return on an investor’s portfolio resulting from higher management fees can result in a large reduction in the value of a portfolio over a sustained period of time. This reality, according to the administration, necessitated closer government scrutiny of the actions of these advisors.

This is particularly relevant given the conflicts of interest apparent in the situation. Regarding proxy firms’ professed neutrality; for instance, the Manhattan Institute’s James Copland noted:

ISS receives a substantial amount of income from labor-union pension funds and socially responsible investing funds, which gives the company an incentive to favor proposals that are backed by these clients. As a result, the behaviors of proxy advisors deviate from concern over share value, [suggesting] that this process may be oriented toward influencing corporate behavior in a manner that generates private returns to a subset of investors while harming the average diversified investor.

The actions of proxy advisors may be imposing a similar cost on investors, we submit. Given their conflicts of interest, shoddy guidance, and lack of certainty, they deserve the same scrutiny as fiduciaries, if not more.

Financial Regulation: Getting It Right

The federal government has painfully learned over the last two decades that effectively regulating corporate governance in financial markets is easier said than done. The pattern of legislative and regulatory action in this realm is best described as a punctuated equilibrium, with most activity taking place in direct response to a perceived change in the market environment.

The 2001 financial collapse of Enron brought the problem of shoddy corporate governance to the attention of Congress. By using accounting loopholes, special purpose entities, and myriad other tricks obscured by deficient financial reporting, the company’s executives hid billions in debt and failed deals. It became the largest corporate bankruptcy in U.S. history. Reacting to this debacle, Congress passed the Sarbanes-Oxley Act in an attempt to prevent similar calamities in the future. While the legislation compelled companies to provide substantially more information to investors, it also increased compliance costs, which in turn reduced the number of Initial Public Offerings on American stock exchanges. That reduction still exists today.

In the aftermath of the 2008–2009 financial market crisis, Congress passed Dodd-Frank, a measure intended to prevent a similar disaster from occurring again. Dodd-Frank certainly has some merits: the increase in capital requirements and stricter regulatory oversight likely diminishes the odds of another major financial crash or at least blunts the damage such a crash could inflict. But the legislation has major downsides as well: by increasing compliance costs for banks, Dodd-Frank has contributed to a marked reduction in banks across the country, with over 1,000 having been acquired or otherwise disappeared since the act’s passage. (See “Banking,” p. XX.) That outcome, many believe, effectively made access to capital more difficult for smaller firms operating in smaller cities and rural communities where community banks tend to dominate the financial market landscape. Because of this, the law may have contributed to the growing economic gap between rural America and the prosperous cities along the coasts.

Again, retail investors were the victims of legislation intended to help them.

Addressing deficiencies in domestic financial markets in a way that mitigates the long-term economic effect on retail investors requires a measured, focused approach. Too little regulation can leave people out in the cold, while too much could exacerbate inequality, reduce economic growth, and make U.S. capital markets less competitive. The lessons that Congress and regulators have taken from 21st century financial incidents—act sooner rather than later, and do so judiciously but decisively—may apply to the current status of proxy advisors as well.

The potential conflicts of interest, factually inaccurate guidance, and lack of transparency that can arise from a reliance on proxy advisory firms tend to dilute the focus on stock price performance and maximizing returns in favor of other special interests. This ultimately hurts investors. Ending the requirement that investment funds vote their proxies would reduce the potential cost of this moral hazard problem.

The complete article is available for download here.


“Bank Consolidation and Merger Acquisition Following the Crisis,” by Michal Kowalik, Charles S. Morris, and Kristen Regehr. Economic Review (Federal Reserve Bank of Kansas City) 2015(Q1): 31–49 (Summer 2015).

“Politicized Proxy Advisers vs. Individual Investors,” by James Copland. Wall Street Journal, Oct. 7, 2012.

“Regulation and Bonding: The Sarbanes-Oxley Act and the Flow of International Listings,” by Joseph Piotroski and Suraj Srinivasan. Journal of Accounting Research 46(2): 383–425 (May 2008).

“The Conflicted Role of Proxy Advisors,” by Timothy Doyle. American Council for Capital Formation, May 2018.

“The Role of Proxy Advisor Firms: Evidence from a Regression-Discontinuity Design,” by Nadya Malengo and Yao Shen. Review of Financial Studies 29(12): 3394–3427
(December 2016).



HR 4015, which has already passed the House of Representatives.(go back)
September 18, 2018
Corporate Law Should Embrace Putting Workers On Boards: The Evidence Is Behind Them
by Ewan McGaughey

When the Dean of Harvard Law, Robert Clark, wrote his classic text on Corporate Law in 1986, he said that if you only wanted to grasp the basics, “you must, at the very least, also gain a working knowledge of labor law.” That neglected truth might become much more significant soon, because a growing number of lawmakers are proposing federal rights for employee representation on corporate boards. The Accountable Capitalism Act, which is getting a lot of attention, would require 40% of boards in $1bn companies are employee-elected, and those companies would also get a federal charter. The Reward Work Act, which caught less attention, would require one third employee-elected boards in all listed companies.

On this forum, four posts have been sceptical about the merits of ending the shareholder monopoly on corporate governance. Summarizing a forthcoming article of mine called “Democracy in America at work: the history of labor’s vote in corporate governance“, this post sets out a positive case: (1) the evidence shows worker voice is embedded in American tradition and would expand economic prosperity, (2) worker voice now represents best corporate governance practice in the majority of OECD countries, and (3) there is no credible defense for “shareholder primacy”, because asset managers are voting on “other people’s money”: those people are usually employees saving for retirement.


(1) Worker voice is embedded in American tradition, and economically efficient

The United States has among the richest traditions of employee voice in corporate governance in the world, and it would be far more widespread if labor rights had not been continually suppressed. The opposite theory was put forward by business scholars Michael Jensen and Bill Meckling in 1979. Notoriously, they argued putting more workers on boards in Germany would make the country’s economy like Marshall Tito’s Yugoslavia. Codetermination is “less efficient than the alternatives which grow up and survive in a competitive environment”, they argued, because it was imposed by legal “fiat”. In fact, as I have written elsewhere, German codetermination was collectively bargained by unions both after WW1, and (after the Nazis abolished worker voice) again after WW2. It would have happened faster if the British occupying government had not opposed it. Codetermination came from collective bargaining, free and voluntary, when labor’s bargaining power was less unequal. Laws codified the social practice.

In the USA, the first examples of worker representation on boards emerged in the early 20th century: for instance, the Filene retail store in Boston, and 20 companies by 1919 which had adopted a House – Senate – Cabinet model of governance, known as the Leitch plan. This led Governor Calvin Coolidge to sign what is probably the world’s oldest codetermination law (outside universities) still on the statute books today. Under the Massachusetts Laws, manufacturing companies can voluntarily enable employees to elect board members. But during the Lochner era, virtually all experiment in labor voice was suppressed. So the “attainment of rule by the people” which as Louis Brandeis advocated, “involves industrial democracy as well as political democracy” was never given “a fighting chance”.

In the 1970s, as evidence was growing about the efficiency of worker participation, and more examples were spreading around the world, American labor unions began to bargain for board seats—and they used the money in pension funds to make shareholder proposals. In 1971-2, employees put forward proxy proposals at GM, Ford, the Illinois retailer Jewel, United Air Lines, and AT&T where they said (accurately) that employee representation would “provide a continuing flow of information to management” and “avoid periodic labor disruptions which place financial hardships on employees and impose losses on the company and shareowners.” All proposals faced massive opposition, although one union at the Providence and Worcester Railroad was successful in 1973 in getting an agreement for board representation. The Wall Street Journal called it a “precedent-shattering labor agreement“.

Seeing labor’s enthusiasm, the Nixon administration decided to suppress the experiments. In 1974, the SEC ruled that management could exclude shareholder proposals for employee directors, ostensibly because it would conflict with state law rights of shareholders to elect directors. But unions kept pressing: the Teamsters tried to get board seats at the brewing company Anheuser-Busch, the engineers union kept pushing at AT&T, and finally, the United Auto Workers succeeded at Chrysler. In 1979, Douglas Fraser got a collective agreement, which lasted till 1991 (showing state law was actually no barrier) for union representatives on the board. This was even more important as Chrysler restructured, because “it isn’t enough for a union to argue about plant closings or layoffs after the decision has been made.” The Reagan administration felt this needed to be halted—the Department of Justice denied clearance for the UAW to have a representative on the American Motors Corporation board in 1981. It argued this could violate the antitrust rule against interlocking directorates, without any evidence of anti-competitive effects, or that seeing any problem could be easily resolved by having local union appointees, or direct employee elections. The Federal Trade Commission thought there was no legal problem.

But despite all the obstacles, employees were also on boards in airlines and steel—a remarkable achievement that has not often been matched abroad. It is even more impressive because American labor rights are among the worst in the developed world. This has harmed the American economy, not made it stronger. It’s obvious that as labor has been suppressed, inequality has soared:

But also, the cutting edge empirical evidence suggests voice at work is good for employment and prosperity, and this includes the right to vote for boards. Labor rights do not harm labor, they empower us all. The most comprehensive dataset at Cambridge University’s Centre for Business Research is putting this to the test right now. Results are still in preliminary stages, but it’s becoming ever more clear that if you’re “Doing Business”, you should want an educated, empowered workforce.

In other words, the Reward Work Act and the Accountable Capitalism Act provisions on worker voice will definitely improve American economic performance, and probably restrain escalating inequality. The evidence-free assertions that employees take a “narrower and shorter-term view” of prosperity, or they are somehow “corporate insiders accountable to nobody” are not the best contributions to this debate.

(2) Worker voice now represents best corporate governance practice in the OECD

America is not alone in taking another look at labor’s vote in corporate law. The United Kingdom’s Conservative government has just passed a comply-or-explain rule requiring listed companies to put a worker on board, or adopt other employee involvement plans. The UK Labour Party, following the Manifesto for Labour Law (which I am involved with) would go further: a minimum of two worker representatives on boards, plus one-third of votes for workers in the general meeting of every company startup. Companies would be able to opt-out of this, until they have over 250 staff. It also proposes ensuring every pension vehicle has half-employee representation, and asset managers will only be allowed to vote shares pursuant to instructions or a policy made by representative trustees. We take the view that worker voice promotes long-term vision and sustainability. Good examples include that old corporation, the University of Oxford, which has required staff representation in governance since 1854.

Today, both a majority of European Union countries, and (with Norway) a majority of countries in the Organization for Economic Cooperation and Development have laws for staff on boards. Slowly but steadily, this practice has been growing:

The continuing success of codetermination probably has a lot to do with what was once named the “force of logic“, example and competition. Accountable corporations perform better. But also, there is a conviction that in a democratic society, people in power should be accountable to those over whom power is exercised. That principle goes for every social institution, including the corporation.

(3) Shareholder primacy has no legitimacy, because asset managers vote on “other people’s money”

Shareholders today have no legitimacy in controlling the voting rights in the economy, because they are mostly asset managers and banks investing “other people’s money“. The money mostly comes from pensions, life insurance and mutual funds. Unlike public pensions, or labor union funds, that have democratic representation (around one third of public pension trustees are elected), the big mutual funds that control most shareholder votes have no legitimacy. Vanguard, State Street, BlackRock, and the rest, are damaging competition, raising prices for consumers, because combined they are the largest shareholder in 438 of America’s 500 biggest companies.

Even worse, the mutual firm business model relies on using shareholder votes to make companies buy their own pension products. Since the 1970s, they have developed an awesome self-dealing industry, using their power for “smashing and scattering” people’s pensions, shifting everyone from secure defined benefit schemes, to individual 401(k) plans. This whole structure of shareholding was set on a different course in the 1980s, as collective pensions were forcibly replaced by individual accounts, dominated by mutual firms:

Mutual firms want to smash and scatter pensions because they can charge more fees on individual accounts than on collective pension funds which have bargaining power. Accountable investors—where employees or unions elect pension boards—have been pushing back, and driving all the best practices in corporate governance (including social rights, environmental protection) against tremendous odds.

These basic facts are not reflected in theories that still hold unjustified sway in corporate scholarship. To give just two examples, in 1983 Easterbrook and Fischel argued that shareholders monopolize votes because “[v]oting flows with the residual interest in the firm” and if laws do anything else “there will be a needless agency cost of management”. But this is just not true: asset managers do not have the residual interest in any firm, because they are voting on and controlling shares bought with other people’s money. In 1984, Oliver Williamson suggested that shareholders make the only “asset-specific” investments in corporations that cannot be protected without monopolizing votes for the board of directors. While workers’ interests could apparently be protected through job security, the whole capital investment is at “hazard”. But shareholders—mainly asset managers—are not making any firm-specific investments at all: they hold other people’s money. Theories of shareholder primacy are evidence-free, and even missed elementary facts on how institutional investment works when they were first written.

Most money in the stock markets comes from employees saving for retirement. Americans—like people everywhere—want to have fair pay and social security, so that they can realize their dreams. The best guarantee for those universal rights are a voice and a vote. But people do not just want to have a voice as investors as capital—though they certainly should. People also want to have voice as employees, who invest their labor. One recent survey of 3,330 likely voters, found that 53% supported having the right to vote for employee representatives on the boards of large companies, while just 22% were opposed, and 25% did not know. With the current President and Congress there will be no federal law reform. But two-thirds of companies are incorporated in Delaware, California and New York, where the political balance is favorable to meaningful progress. States can start the shift, revive as laboratories of democracy and enterprise, recreate a living law, by democratizing the corporation.

The complete article is available for download here.

View today's posts

9/18/2018 posts

CLS Blue Sky Blog: Was Glass-Steagall’s Demise Both Inevitable and Unimportant?
CLS Blue Sky Blog: The Deregulation Debate: The Challenge of Using Static Rules to Govern a Dynamic System
CLS Blue Sky Blog: Did Deregulation End the “Quiet Period” of Low-Risk Banking?
The Harvard Law School Forum on Corporate Governance and Financial Regulation: SEC No-Action Letters on Investment Adviser Responsibilities in Voting Client Proxies and Use of Proxy Voting Firms
The Harvard Law School Forum on Corporate Governance and Financial Regulation: SEC Ratification for Defective Administrative Proceedings
SEC Actions Blog: SEC Sanctions Citi Dark Pool Blog: Course Materials Now Available: Many Sets of Talking Points!
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Corporate Governance Oversight and Proxy Advisory Firms
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Corporate Law Should Embrace Putting Workers On Boards: The Evidence Is Behind Them

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.