Shining a Light on Shadow Banks

Patrick M. Corrigan

To date, descriptive accounts and reform proposals have framed the problems arising from “shadow banking” as about the risks of lending and maturity transformation by nonbanks operating outside the guardrails of banking law. But shadow banks engage in the business of investing, not lending, and their ownership interests are often held by traditional banking entities. By ignoring the ownership structure and investment activities of shadow banks, the academic literature has overstated the risks that nonbanks pose to financial stability and underestimated the ability of existing regulatory frameworks to address the information and incentive problems posed by shadow banks.

This Article first shows that the innovative design of many securitization vehicles is to give banking entities residual and subordinated economic exposure to securitization vehicles without triggering a legal conclusion that the vehicles are bank “affiliates” or “investment companies.” Thus, these securitization vehicles are not regulated under the banking laws orinvestment company laws. Nevertheless, this Article presents data showing that the traditional banking sector owned, controlled, and backstopped many of the securitization vehicles at the heart of the 2007–2009 financial crisis. Thus, most of these so-called shadow banks were instruments of the traditional banking sector, not bank competitors. This Article identifies the shadow banks of most concern to ongoing financial stability as entities that would be regulated as investment companies but for an asset-based exemption from regulation under the Investment Company Act—especially when the shadow bank is backstopped by a banking entity.

This Article advances a reform proposal that would update the boundary lines between banking entities, regulated investment companies, and unregulated investment companies. The banking laws should add an economic exposure test to the definition of “affiliate” to bring unregulated entities backstopped by banks, and indirectly backstopped by the federal safety net, into the regulatory perimeter. Moreover, the exemptions from the Investment Company Act of 1940 for investment companies that hold only certain types of assets should be narrowed or eliminated altogether. This bottom-up, transactional approach would better regulate risks to investors and the public than the top-down approach in the Dodd-Frank Act that relies on regulators identifying and regulating “systemically important” nonbanks.

Aggregated Risks in Mutual Fund Disclosures

Susan Navarro Smelcer, Anne Tucker & Yusen Xia

Scholars have roundly criticized compulsory consumer disclosure over the past decade for good reason. Disclosures, whether describing the terms of a loan or the risks of investing, purport to inform consumers. But who actually reads disclosures? We argue that mutual fund disclosures are different. Unlike other consumer-facing disclosures, mutual fund disclosures are dynamic and, therefore, informative. The Securities and Exchange Commission (SEC) requires funds to report changing market conditions that affect a fund’s investments. As a result, aggregated risk statements provide information about new and evolving risks over and above insights from any single risk disclosure. But disclosures’ utility comes not from their superior ability to inform the ordinary investor. Rather, we propose that fund disclosures’ true value lies in what they can tell regulators about funds’ perception of market risks in the aggregate. We evaluate our thesis through an analysis of all U.S. mutual funds’ narrative risk disclosures from 2011 through 2022. We leverage social science theories of risk and uncertainty to conceptualize and operationalize the choices funds make in depicting changing market conditions. We locate these risks and uncertainties along a distribution from common and manageable to uncommon and catastrophic. We then assess funds’ disclosure of changing market conditions using a “most likely” case design by examining funds’ disclosure of increasing inflation, public health crises, and severe weather events resulting from climate change. Each case study presents either a risk—meaning that the universe of bad outcomes is known and can be accounted for—or uncertainty—meaning that the universe of outcomes is unknown and cannot be meaningfully estimated. We find that, in the aggregate, funds reconceptualize and adjust their disclosures in response to external events. Disclosure topics and language move in predictable and statistically significant ways. Changes in disclosure language are, in fact, meaningful. Such a response, when taken as a whole, provides insight into funds’ perception of risk. Our findings suggest that quantitative text analysis can help the SEC assess overall fund compliance with disclosure mandates. But it can also help regulators, market participants, and researchers better understand changing risk environments.

Tech Supremacy: The New Arms Race Between China and the United States

Xuan-Thao Nguyen

In the brewing tech war between the United States and China, the quest for tech supremacy is in full force. Through enacting a series of laws and policies, China aims to reach its goal of tech supremacy. If China succeeds, U.S. corporations will face a daunting task in competing against Chinese products and services in core industries and in sectors where artificial intelligence and technological breakthroughs reign. This Article is the first to identify and analyze China’s 2022 Law on Science and Technology Progress, Personal Information Protection Law, Made in China 2025, National Intellectual Property Strategies, and digital currency e-CNY; explore their potential impact on U.S. business; and urge immediate attention to the tech war.

Out with Fiduciary Out?

Guy Firer & Adi Libson

In one of the most renowned and highly controversial decisions in Delaware in the last 20 years, Omnicare, Inc. v. NCS Healthcare, Inc., the Delaware Supreme Court ruled that the board of a publicly traded target company cannot completely lock up a merger. According to the court’s ruling, the merger must include a fiduciary out clause that enables the board and the company to terminate the agreement if a better offer is proffered before the deal is approved by the company’s shareholders. The Omnicare decision has been widely criticized by practitioners and scholars who argue that it prevents the execution of time-sensitive deals that cannot take place without a complete lock-up of the agreement. The requirement also introduces a high degree of uncertainty into M&A transactions. No persuasive justification has been provided to explain this anomaly, which led the Delaware courts to narrow the scope of the requirement as much as possible. Vice Chancellor Lamb went as far as noting that “Omnicare is of questionable continued vitality.”

In this Article, we offer a novel justification for the Omnicare ruling: shareholders are unable to effectively monitor the functioning of the board when deals are insulated from market forces. Shareholders lack the requisite information to assess whether the price the board approved is the best price the company could receive. The only meaningful check on the board in making this crucial decision is the market. The emergence of a better offer prompts shareholders to question the desirability of the transaction that the board has approved. A complete lock-up of a deal prevents the emergence of competing offers and leaves the board without effective oversight in this crucial decision. In this Article, we discuss the implications of the oversight rationale for fine-tuning the Omnicare ruling. We argue that transactions in which directors and managers commit to having no role in the company after the merger or acquisition should be exempt from the Omnicare ruling. Further, by contrast to the narrow interpretation of Omnicare adopted by courts in subsequent cases, which treated mergers lacking an intervening bidder more leniently, we argue that even in such cases, the merger should be enjoined if it did not include a fiduciary out. Finally, we expand the Omnicare ruling to apply to mergers approved by immediate shareholder written consent.