Colorado Law Scholarly Commons Remutualization

University of Colorado Law School Colorado Law Scholarly Commons Articles Colorado Law Faculty Scholarship 2020 Remutualization Erik F. Gerding University of Colorado Law School Follow this and additional works at: https://scholar.law.colorado.edu/articles Part of the Administrative Law Commons, Banking and Finance Law Commons, Business Organizations Law Commons, Consumer Protection Law Commons, Insurance Law Commons, Law and Economics Commons, Securities Law Commons, and the Tax Law Commons Citation Information Erik F. Gerding, Remutualization, 105 CORNELL L. REV. 797 (2020), available at https://scholar.law.colorado.edu/articles/1323. Copyright Statement Copyright protected. Use of materials from this collection beyond the exceptions provided for in the Fair Use and Educational Use clauses of the U.S. Copyright Law may violate federal law. Permission to publish or reproduce is required. This Article is brought to you for free and open access by the Colorado Law Faculty Scholarship at Colorado Law Scholarly Commons. It has been accepted for inclusion in Articles by an authorized administrator of Colorado Law Scholarly Commons. For more information, please contact [email protected]. \\jciprod01\productn\C\CRN\105-3\CRN305.txt unknown Seq: 1 28-JUL-20 17:16 REMUTUALIZATION Erik F. Gerding† INTRODUCTION ........................................... 798 R I. DEMUTUALIZATION AND REMUTUALIZATION ACROSS FINANCIAL SECTORS ................................ 809 R A. Investment Banks ............................ 812 R 1. The Demise of Investment Banks as Partnerships .............................. 812 R 2. Consequences............................. 816 R 3. Policy Solutions ........................... 818 R B. Banks and Lenders ........................... 818 R 1. Demutualization........................... 821 R 2. Consequences of the Shift Away from Mutuals .................................. 823 R C. Insurance Companies ........................ 823 R 1. The Emergence and Dominance of Mutuals in Life Insurance .......................... 826 R 2. Life-Insurance Policyholder Protection: The Importance of the Residual Claimant ....... 826 R 3. Regulation as a Substitute for the Mutual Form ..................................... 829 R 4. Why the Mutual Form Works in Life Insurance: Costs to the Mutual Form ....... 829 R 5. Demutualization Wave Among Life Insurers at the Turn of the Twenty-First Century .... 830 R 6. Size and Systemic Risk Concerns .......... 831 R 7. Mutuals in Property and Liability Insurance .......................................... 833 R D. Common Threads Among Industries .......... 834 R 1. Reasons for Demutualization; Industry Dynamics ................................. 834 R 2. Compensation and Incentives; Shareholders as Residual Claimants .................... 835 R II. MUTUALIZING RISK ACROSS THE FINANCIAL INDUSTRY: COMMUNITIES OF FATE AND CLEARINGHOUSES ......... 836 R A. Communities of Fate ......................... 837 R † Professor of Law and Wolf-Nichol Fellow, University of Colorado Law School. I would like to thank the participants in the Cornell Law School Memorial Symposium for Lynn Stout, as well as Claire Hill, Roberta Karmel, Saule Omarova, Dan Schwarcz, and Arthur Wilmarth for comments on this Article. 797 \\jciprod01\productn\C\CRN\105-3\CRN305.txt unknown Seq: 2 28-JUL-20 17:16 798 CORNELL LAW REVIEW [Vol. 105:797 B. Clearinghouses and the Clearing of Securities and Derivatives............................... 840 R C. Mutual Insurance for a Financial Sector ...... 842 R III. POLICY INSTRUMENTS ............................... 843 R A. The Limits of Private Ordering ................ 843 R B. Tax Subsidies ................................ 846 R C. Regulatory Preferences ....................... 847 R D. Deferred Prosecution Agreements and Civil Settlements by Regulators .................... 848 R E. Promoting Clearinghouses .................... 850 R F. Less than Full Remutualization: Hybrid Forms ................................ 851 R IV. CRITIQUES AND COMPARATIVE ADVANTAGES OF REMUTUALIZATION ................................. 852 R A. The Costs of Ownership for Partnerships, Mutuals, and Cooperatives (and the Comparative Benefits of Investor-Owned Corporations) ................................ 853 R 1. Agency Costs/Managerial Opportunism .... 853 R 2. Diversification ............................. 854 R 3. Costs of Raising Capital/Capital Needs .... 855 R B. Complexity and Information .................. 857 R C. Regulating Size ............................... 858 R D. The Comparative Advantage of Organizational Form as Regulatory Tool ...................... 858 R E. The Importance of Culture .................... 860 R F. Clubs, Competition, and Exclusion ........... 860 R G. Reinforcing Reputational Markets from the Inside Out ................................... 861 R CONCLUSION ............................................ 862 R A. “Corporate” Social Responsibility.............. 862 R B. Conversion Not Required: Shifting Capital and a Diversified Ecosystem ...................... 863 R C. Access ....................................... 864 R D. A Ripe Moment for Remutualization?.......... 865 R INTRODUCTION Lynn Stout heartily embraced heterodox economic theories for describing capital markets and a progressive zeal for re- forming them. Yet when she came to formulate her policy pre- scriptions for financial markets, one of the most prominent progressive corporate and financial law scholars of the twenti- eth century could sometimes take these twin intellectual en- gines into surprisingly “conservative” waters. Lynn’s landmark \\jciprod01\productn\C\CRN\105-3\CRN305.txt unknown Seq: 3 28-JUL-20 17:16 2020] REMUTUALIZATION 799 1999 article in the Duke Law Journal, “Why the Law Hates Speculators” provides an example of her coming to the unex- pected policy conclusions of returning to ancient solutions to the problems of modern financial markets.1 She advocated for identifying and reducing excessive financial speculation in derivatives markets by reviving the common law doctrine of in- surable interest.2 This Article explores how a similar intellectual move—returning to common law or traditional approaches to financial institution governance—can inform and improve a range of financial reforms. In particular, this Article seeks to revive the use of organizational form as a tool of financial regulation. Very old varietals, including partnerships and mutual companies, decanted in new bottles can promote financial stability, lower incentives for excessive risk-taking by financial intermediaries, provide mechanisms to police their market con- duct, and better align their incentives with the interests of their customers and consumers. In arguing for the use of organizational form as a regulatory tool, this Article examines a common but somewhat hid- den thread running through a range of innovative, contemporary scholarship on financial regulation. In a num- ber of works, both the contemporaries and intellectual heirs of Professor Stout have explored ways to “remutualize” ownership of financial intermediaries. For instance, Professors Claire Hill and Richard Painter argue that reintroducing elements of the old partnership structure of investment banks would curb excessive risk-taking by, and change the culture of, those impor- tant financial intermediaries.3 Professor Saule Omarova moves from the level of the firm to the level of industry and argues for a self-regulatory legal regime in which large financial institu- tions would collectively bear the costs of systemically risky ac- 1 Lynn A. Stout, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48 DUKE L.J. 701, 777–78 (1999). 2 Id. at 777–82. Under this doctrine, insurance and, in turn, derivative contracts are only legally enforceable if at least one of the parties uses the contract to transfer or hedge a preexisting risk. Id. at 725. If the contract involves the transfer of risks to which neither counterparty was subject before the bargain was struck, then courts would not enforce the agreement. Id. at 724–27. The opera- tion of this rule can be seen in a simple example: the common law would not enforce a contract in which one person purchases fire insurance for a neighbor’s house. 3 See CLAIRE A. HILL & RICHARD W. PAINTER, BETTER BANKERS, BETTER BANKS: PROMOTING GOOD BUSINESS THROUGH CONTRACTUAL COMMITMENT 146–48 (2015). \\jciprod01\productn\C\CRN\105-3\CRN305.txt unknown Seq: 4 28-JUL-20 17:16 800 CORNELL LAW REVIEW [Vol. 105:797 tivities and thus police each other’s behavior.4 Her ideas harken back to historical structures in which exchanges were mutually owned and regulated by the brokers who traded on them.5 It also recalls how the organizational form used to oper- ate on an industry-wide level: in the nineteenth century, large banks formed clearinghouses that provided a form of deposit insurance to one another and helped a large swath of the financial sector withstand banking panics.6 Professor Paolo Saguato examines a different, modern version of clearinghouses: entities that facilitate the clearing and settlements of trillions of dollars of securities and derivatives trades each day.7 Modern clearinghouses, or clearing companies, reduce risk to parties to these transactions and to the entire financial system by serving as central counterparties to trades.8 Profes- sor Saguato argues that the demutualization of clearinghouses results in their shareholders having incentives to

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