20 COLUMBIA LAW REVIEW [vol.91:10 one-quarter of the portfolio is unregulated.37)The SEC wanted that restriction to disable control.38 Some mutual funds might have com- peted as monitors owning large blocks of stock.That prospect was cut off for diversified investment companies by the 1940 Act,and for other nent co anies by the tax tion.Virtua e ements I discuss in the next se all mutual funds call themselves diversified;they can not control public firms. The 1940 Act also prohibits a"diversified"mutual fund from put- ting more than 5%of its regulated assets in the securities of any one r.40 As a div ersification sta ndard this prohibiti ion is crude but de 1 funds are d esig or unsophisticated investors who cannot assemble a diversified portfolio or evaluate the mutual fund's portfolio.41 By requiring some standard of fragmentation if the fund chooses to call itself diversified,the 1940 Act helps make sure that in- vestors get what they were promised. But the 10%restriction (no more than 10%of the porlfolio com- pany's stock)is unnecessary for true diversification.Obviously,a large investment company could have a small portion of its assets in a single firm,but if the portfolio firm were mid-sized the investment company could have an infuential block of stock e Code.-The tax enalties for not being are considerable. The mutual fund t t would control industry would be taxed unfavorably on its entire portfolio,since the tax code allows only diversified mutual funds to pass income through to shareholders,untaxed to the conduit mutual fund.And the tax notion of"diversification' arallels that found in the 1940 Act; it only fain tly re e diver sification c ncept taught in today's business schools.Under the tax code,mutual funds must have at least half of their investments in companies constituting no more than 5%of the portfolio and constituting no more than 10%of the portfolio com- bany's outstanding stock;for the other half,no more than 25%of the fund's total assets can go i to a s company's stock.42 80o5cCywS0 ee 1940 Act Hearir note 31.at 188.192 (statement of Davic at 348-5I;1 T.Frankel,The Regulation of Money Ma fund9.The SE more str restric P88150 na bar on any Code's or di control blocks)to nondiversified funds (which could)and wanted to prohibit mutual fund directors from serving as directors of any portfolio company.1940 Act Hearings, )(). 41 see pe ote30,at348-51c fund that uteintorad stoc). 42.I.R.C.$851(b)(4)(1988).Subchapter M is available only to companies that bonds and othe ne statute's face,there is a serious question w
COLUMBIA LAW REVIEW one-quarter of the portfolio is unregulated.37) The SEC wanted that restriction to disable control.38 Some mutual funds might have competed as monitors owning large blocks of stock. That prospect was cut off for diversified investment companies by the 1940 Act, and for other investment companies by the tax requirements I discuss in the next section.39 Virtually all mutual funds call themselves diversified; they cannot control public firms. The 1940 Act also prohibits a "diversified" mutual fund from putting more than 5%o of its regulated assets in the securities of any one issuer.40 As a diversification standard this prohibition is crude but defensible. Mutual funds are designed for unsophisticated investors who cannot assemble a diversified portfolio or evaluate the mutual fund's portfolio.41 By requiring some standard of fragmentation if the fund chooses to call itself diversified, the 1940 Act helps make sure that investors get what they were promised. But the 1Ore restriction (no more than 1017/ of the portfolio company's stock) is unnecessary for true diversification. Obviously, a large investment company could have a small portion of its assets in a single firm, but if the portfolio firm were mid-sized the investment company could have an influential block of stock. 2. Subchapter M of the Internal Revenue Code. - The tax penalties for not being "diversified" are considerable. The mutual fund that would control industry would be taxed unfavorably on its entire portfolio, since the tax code allows only diversified mutual funds to pass income through to shareholders, untaxed to the conduit mutual fund. And the tax code's notion of "diversification" parallels that found in the 1940 Act; it only faintly resembles the diversification concept taught in today's business schools. Under the tax code, mutual funds must have at least half of their investments in companies constituting no more than 5% of the portfolio and constituting no more than 10%o of the portfolio company's outstanding stock; for the other half, no more than 25%o of the fund's total assets can go into a single company's stock.42 37. Id. 38. See 1940 Act Hearings, supra note 31, at 188, 192 (statement of David Schenker, Chief Counsel, SEC Investment Trust Study); Pecora Report, supra note 30, at 348-51; 1 T. Frankel, The Regulation of Money Managers § 33.1, at 343 (1978). 39. The SEC wanted more stringent control restrictions, including a bar on any fund exceeding $150 million in assets. The SEC also resisted recommending expanding the Internal Revenue Code's tax advantage for diversified funds (which could not own control blocks) to nondiversified funds (which could) and wanted to prohibit mutual fund directors from serving as directors of any portfolio company. 1940 Act Hearings, supra note 31, at 375, 400-01, 412. 40. 1940 Act, § 5(b)(1), 15 U.S.C. § 80a-5(b)(1) (1988). 41. See Pecora Report, supra note 30, at 348-51 (congressional criticism of mutual fund that put 19% of its assets into a railroad stock). 42. I.R.C. § 851(b)(4) (1988). Subchapter M is available only to companies that derive 90% of their income from investment in stocks, bonds and other securities. Id. § 851(b)(2) (1988). On the statute's face, there is a serious question whether a public [Vol. 91:10
19911 A POLITICAL THEORY OF THE CORPORATION 21 If the fund chose not to be"diversified"under the tax code or the 1940 Act,its income would be taxed at the ordinary corporate tax rate, destroying the fund by a triple taxation of its income.Income received by the noncomplying fund as dividends would be taxed twice,once at 34%when earned hy the portfolio company,and then again when re- ceived b the fund the noncomplying mutu al f d could clude 70% ceived,nett ng out to an effe ve tax rate of 10%on dividends.Capital gains would be taxed at 34% .And the income would be taxed a third time when realized by shareholders This triple taxation deters most ordinary corporations from actin as long-term undive rsi近e d deters most from losing their "diversified"status).A corporation might accept the unfavorable tax status in the short-run,as a prelude to a takeover and restructuring,but the corporation asserting control over the long-term would have to be confident it had unusually acute monitoring skills. After all,if the ed half of its inc ei th ould I pay approximately come in taxes.A great deal of effective monitoring would be needed to make up for that initial penalty;only unusually able monitors could overcome it.Nor could a public fund organize itself as a partnership to pass through without itself paying tax.Tog tatus,a also with subchapter M's portfolio restrictions. Thus,if a mutual fund wished to sell services as an intermediary/ monitor,dividing its portfolio into three or four stocks,it could not get sul And no subchapter M could any that th more than a quarter of its assets to obtain a majority of the portfolio company's stock and oust management.That threat,and the influence it would yield,is prohibitively expensive for a mutual fund.44 3.Other Restrictions on Control. For that quarter of the fund tha could be concentra other restrictions apply. If a mu tual fund owned 5%of a portfolio company's stock or sat on its board,the port folio firm would become a statutory affiliate of the mutual fund and of the mutual fund's principal underwriter.45 Many mutual funds are sponsored by investment banks.A sponsoring investment bank could Venture capital firms,which would provide monitoring for small firms,not the large a our subject,are partially exempt from the no-control provision.Id. 51988 riple taxation"rules and the partr ership rule are in id.$243,1201& 7704(G(1988) 44.Id.851(b)(4)(B)(1988).Nor can mutual funds readily issue senior securities to enhance abs ute size,and hence th size of its holding of any single company.1940 Act, 958407
1991] A POLITICAL THEORY OF THE CORPORATION 21 If the fund chose not to be "diversified" under the tax code or the 1940 Act, its income would be taxed at the ordinary corporate tax rate, destroying the fund by a triple taxation of its income. Income received by the noncomplying fund as dividends would be taxed twice, once at 34% when earned by the portfolio company, and then again when received by the fund. True, the noncomplying mutual fund could exclude 70% of the dividends received, netting out to an effective tax rate of 19% on dividends. Capital gains would be taxed at 34%. And the income would be taxed a third time when realized by shareholders. This triple taxation deters most ordinary corporations from acting as long-term, undiversified monitors (and deters most mutual funds from losing their "diversified" status). A corporation might accept the unfavorable tax status in the short-run, as a prelude to a takeover and restructuring, but the corporation asserting control over the long-term would have to be confident it had unusually acute monitoring skills. After all, if the corporation received half of its income in capital gains and half in dividends, then it would pay approximately 20% of its income in taxes. A great deal of effective monitoring would be needed to make up for that initial penalty; only unusually able monitors could overcome it. Nor could a public fund organize itself as a partnership to pass through its income to owners without itself paying tax. To get pass-through tax status, a publicly-traded partnership must also comply with subchapter M's portfolio restrictions. 43 Thus, if a mutual fund wished to sell services as an intermediary/ monitor, dividing its portfolio into three or four stocks, it could not get the advantage of subchapter M. And no subchapter M mutual fund could ever threaten a portfolio company that the fund would devote more than a quarter of its assets to obtain a majority of the portfolio company's stock and oust management. That threat, and the influence it would yield, is prohibitively expensive for a mutual fund.4 4 3. Other Restrictions on Control. - For that quarter of the fund that could be concentrated, other restrictions apply. If a mutual fund owned 5% of a portfolio company's stock or sat on its board, the portfolio firm would become a statutory affiliate of the mutual fund and of the mutual fund's principal underwriter.4 5 Many mutual funds are sponsored by investment banks. A sponsoring investment bank could company that intended to make most of its income from management, as opposed to passive investment, could obtain subchapter M pass-through at all. Venture capital firms, which would provide monitoring for small firms, not the large firms that are our subject, are partially exempt from the no-control provision. Id. § 851(e) (1988). 43. The "triple taxation" rules and the partnership rule are in id. §§ 243, 1201 & 7704(c) (1988). 44. Id. § 851(b)(4)(B) (1988). Nor can mutual funds readily issue senior securities to enhance absolute size, and hence the size of its holding of any single company. 1940 Act, § 18(a), 15 U.S.C. § 80a-18(a) (1988). 45. 1940 Act, § 2(a)(3), 15 U.S.C. § 80a-2(a)(3) (1988); 17 G.F.R. 270.17a-6 (1990)
22 COLUMBIA LAW REVIEW [Vol.91:l0 not sell securities to the affiliate industrial company without an SEC exemptive order.Moreover,if the mutual fund wanted to assert con- trol jointly with any affiliate of a portfolio company- would ne ral.46 The rule thereby discourages financial networks. C.Insurance Companies About twenty-five years ago,an historian of the insurance industry wrote [Insurance companies are]at the highest level of the nation's business structure.If size counts,and money talks,they should be among the most potent institutions of this society. Yet the large life insurance companies play a curiously limited role in American life.[After fifty years of prohibition on stock ownership,they finally]control increasing amounts of corpo rate stock,but they do not systematically and purposefully use their voting strength.In many ways,they are giants with- out power. In 1906.New York prohibited life insurance companiesfrom buy- n affected most ins uranc mpanies, more than half of insurance assets In I95I,a small wedge opened:3%of the company's assets could go into stock.50 Today 20%of a life insurer's assets,or one-half of its surplus, can go into stock 5 But even today insurers cannot take influential blocks;New York life insurers cannot put more than 2%of the insurance company's as- sets into the stock of any single issuer,52 and property and casualty in- ,80 -17(a)(1)-(2)(1988).There are some 10:AStudy in the Limits of erprise Corporate powe rix(1963) 48.Act of Apr.27,1906,ch.326,1906N.Y.Laws763,797. 49.At the turn of the century.common stock were an increasing part of large insurer's portfo supra note 47,at 12 Prudent person rules also re- 50.Mo rs third of s could go into common stock:investment in a particular company was limited to 2%of the rtfolio s.Act of Mar.31,1951,ch. 1070.In 1951,New Yor law gover 85%of the stry ices of Life In ega o6P4546 (1952). 51.N.Y.Ins.Law 1405(a)(6),(8)(McKinney 1985 Supp.1990). dia ,1705(a)(1)-(2).In the 1980s,New York expandedth of life ins 6d.891302a1,14140) s can ro into any subsidiary.and no more than5 of life insurer's assets can go into non-New York subsidiaries.(Another 5%can go into New York subsidiaries.Ownership of as little as 5%+of the portfolio company could
COLUMBIA LAW REVIEW not sell securities to the affiliate industrial company without an SEC exemptive order. Moreover, if the mutual fund wanted to assert controljointly with any affiliate- defined as any company also owning 5% of a portfolio company-it would need prior SEC approval. 46 The rule thereby discourages financial networks. C. Insurance Companies About twenty-five years ago, an historian of the insurance industry wrote: [Insurance companies are] at the highest level of the nation's business structure. If size counts, and money talks, they should be among the most potent institutions of this society. Yet the large life insurance companies play a curiously limited role in American life. [After fifty years of prohibition on stock ownership, they finally] control increasing amounts of corporate stock, but they do not systematically and purposefully use their voting strength . In many ways, they are giants without power. 47 In 1906, New York prohibited life insurance companies from buying stock.48 The prohibition affected most insurance companies, since more than half of insurance assets were in New York insurers. 49 In 1951, a small wedge opened: 3% of the company's assets could go into stock. 50 Today 207 of a life insurer's assets, or one-half of its surplus, can go into stock.51 But even today insurers cannot take influential blocks; New York life insurers cannot put more than 2% of the insurance company's assets into the stock of any single issuer,5 2 and property and casualty in- 46. 1940 Act, § 17(a)(1)-(2), 15 U.S.C. § 80a-17(a)(1)-(2) (1988). There are some exceptions. See id., § 17(b), 15 U.S.C. § 80a-17(b) (1988). 47. M. Keller, The Life Insurance Enterprise, 1885-1910: A Study in the Limits of Corporate Power ix (1963). 48. Act of Apr. 27, 1906, ch. 326, 1906 N.Y. Laws 763, 797. 49. At the turn of the century, common stocks were an increasing part of large insurer's portfolios. M. Keller, supra note 47, at 129. Prudent person rules also restrained insurers from heavy investment in common stock. 50. More precisely, the lesser of 3% of assets or one-third of surplus could go into common stock; investment in a particular company was limited to 2% of the portfolio company's stock and one-tenth of 17o of the insurer's assets. Act of Mar. 31, 1951, ch. 400, § 5, 1951 N.Y. Laws 1065, 1070. In 1951, New York law governed 85%o of the insurance industry's assets. Bell & Fraine, Legal Framework, Trends, and Developments in Investment Practices of Life Insurance Companies, 17 Law & Contemp. Probs. 45, 46 (1952). 51. N.Y. Ins. Law § 1405(a)(6), (8) (McKinney 1985 & Supp. 1990). 52. Id. §§ 1405(a)(6)(i), 1705(a)(1)-(2). In the 1980s, New York expanded the permissible activities of life insurer subsidiaries. But portfolio rules still limit them: a subsidiary's goodwill is carved out from coverage tests (id. §§ 1302(a)(1), 1414()), no more than 2%o of a life insurer's assets can go into any subsidiary, and no more than 5% of a life insurer's assets can go into non-New York subsidiaries. (Another 5% can go into New York subsidiaries.) Ownership of as little as 5% + of the portfolio company could [Vol. 91:10
19911 A POLITICAL THEORY OF THE CORPORATION 23 surers cannot control a noninsurance company.53 Although the state of incorporation sets the major rules in corporate law,the state where the policy is sold sets insurance law.State insurance law has two implica- tions here.First,reincorporating an insurer in a small state with more favorable rules does little of the good,s e insurance. Second, insurers are e oft n governed by severa and insurance companies must comply with the most restrictive regula tion.54 New York law governs 58%of the life insurance industry's as- sets and 82%of the property and casualty industry's assets.55 And other states have similar rules.California,Illinois,and Texas prohibit life insurers from investing more than 10%of the insurer's ca pital and surplus in any singl mpany. orty states mit stock to between 2%and 25%of the insurer's assets. D.Pension Funds Pension funds are the newest,least regulated of the financial insti- tutions.Although they have fewer assets under their control than banks and insu ers,a ortion is in non stock Nevertheless Pension funds are themselves fragmented;each company typically sets up its own fund,often giving money to several managers,who re- trigger classification as a subsidiary out and the ove I07(a(40 emerge from their historical passivity. ven did not restrict life insurers' With t r payment oblgat ons actu 53.ia.s3107a4 403.1404a(13)B)0(a0mor than 5%of portfolio company's voting stock).1407(a)(),1600-12 (only insurance subsidiaries). nent investors,Laurence Tisch ISteinberg,and Warren Buffett, ance compan nd often take cor trol positio How,giver not investm h al i his organizational structure as he is in his investment success.His Nebraska-based in surance companies make large stock investments,but apparently do not do business in Sce N.Y.Ins a5A1p35 Stp。 I a 1990m New vark in t substantially con York also became the model state for insurance company invest- ment regulation. Keller,supra note 47,at 121-22 The Ne c came fom t York ork-gove e ra of Re h of the depaIn Code119 (Weat 1):Amn.Satch77) (Smith-Hurd Supp.1990);Tex.Ins.Code Ann.$3.39.C.3 (Vernon 1981). IMMarine,State Regulation of Life Insurance Companies,7A.Lif (1988)
1991] A POLITICAL THEORY OF THE CORPORATION 23 surers cannot control a noninsurance company. 53 Although the state of incorporation sets the major rules in corporate law, the state where the policy is sold sets insurance law. State insurance law has two implications here. First, reincorporating an insurer in a small state with more favorable rules does little good, since the small state has few buyers of the insurance. Second, insurers are often governed by several states and insurance companies must comply with the most restrictive regulation. 54 New York law governs 58%o of the life insurance industry's assets and 82%o of the property and casualty industry's assets.55 And other states have similar rules. California, Illinois, and Texas prohibit life insurers from investing more than 10% of the insurer's capital and surplus in any single company. 56 Approximately forty states limit stock to between 2% and 25% of the insurer's assets. 57 D. Pension Funds Pension funds are the newest, least regulated of the financial institutions. Although they have fewer assets under their control than banks and insurers, a large portion is in common stock. Nevertheless, the structure of pension funds inhibits them from acting as monitors. Pension funds are themselves fragmented; each company typically sets up its own fund, often giving money to several managers, who retrigger classification as a subsidiary, thereby triggering the goodwill carve-out and the overall 5% limit on deployment of the life insurer's assets. Id. § 107(a)(40). And finally, networking with banks is limited, since insurance companies cannot own banks. Id. § 1701(a). But since it is at leastpossible to take control now, insurance companies might emerge from their historical 'passivity. Even if law did not restrict life insurers' investments, they would prefer debt to equity. With their payment obligations actuarially fixed, insurers would presumably prefer debt so that their investment returns track their obligations. 53. Id. §§ 107(a)(40), 1403(c), 1404(a)(13)(B)(i) (no more than 5% of portfolio company's voting stock), 1407(a)(4), 1600-12 (only insurance subsidiaries). Three prominent investors, Laurence Tisch, Saul Steinberg, and Warren Buffett, are associated with insurance companies and often take control positions. How, given New York's restrictions? Tisch and Steinberg do not funnel control investments through their insurance company, but use a holding company. Buffett is as unusual in his organizational structure as he is in his investment success. His Nebraska-based insurance companies make large stock investments, but apparently do not do business in New York; they obtained a change in Nebraska's portfolio rules to allow concentrated investments. Neb. Rev. Stat. § 44-311.04 (1988). 54. See N.Y. Ins. Law § 1413 (McKinney 1985 & Supp. 1990) (non-New York insurers must substantially comply with New York law if the insurer wishes to sell policies to New Yorkers). New York also became the model state for insurance company investment regulation. M. Keller, supra note 47, at 121-22. 55. The New York-governed statistic came from the Bureau of Research of the New York Insurance Department. Aggregate assets came from A.M. Best's information department. 56. Cal. Ins. Code §§ 1198, 1199 (West 1972); Ill. Ann. Stat., ch. 73, § 737.12(a)(c) (Smith-Hurd Supp. 1990); Tex. Ins. Code Ann. § 3.39.C.3 (Vernon 1981). 57. McCown & Martinie, State Regulation of Life Insurance Companies, 27 A. Life Ins. Couns. Proc. 8 (1988)
24 COLUMBIA LAW REVIEW Vol.91:10 ceive money from several companies.Since ERISA(the Employee Re- tirement Income Security Act of 1974)generally requires each fund to be diversified,58 there is little room for an influential position in an op- erating company.ERISA allows deviation from diversification only if "rprudent not [to minimize]the risk of large losses. Prudence is not what a business school graduate might first ex- pect-maximization of net present value,with due regard to risk.Com- mentators suggest that.the rule looks to prevailing investment practices,to the average,but with a substantial conservative drag:pres- n in the face of reduced return novatio iability s tell us that just toud magpcom rquire invement hundreds of issuers Onto this baselin of average opinion,tilting toward safety,ERISA enhances the stan a of care r plan operators to that of an expert they must act "with the care,skill,prudence,and diligence.that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."62 As such,a plan op rator could not t get very y far in front of the pension ma ager crowd. sio managers v seats on the board of portfolio companies would run the risk that their actions would be judged in a lawsuit by beneficiaries not by the low-level scru- tiny of the business judgment rule,but by ERISA's higher standard of care,63 Of greater significance is the conrol that aplan sponsor nage ment has over the investment managers of the pension fund.Senior managers hire the people who run the company's pension.Pension managers who took an active role in overseeing the operating managers of another company could expect to incur the ire of their own com- pany's senior 64 Th senio manager. ntrol of th com 58.ERISA 40 29 U.S.C. 59.ERISA 81041 )d(1988 60.B.L0 ent Mana 29,39-40(1986 Lorie,P.Dodd M.Kimpton,The Stock Market:Theories and Evidence 104(1)(B)C(()(1 63.See B.Kriko nda nd Trust Fund mana agement 290-91(1989). 64.See Senate Subcomm.on Oversight of Government Management of the Comm airs,Th Depar58 (19 Dor s E forcement of the ER 20 1.F 6) ISA 237.242.441988.That the E come directly or through politics.A business-labor task force.chaired bya leadin ng h
COLUMBIA LAW REVIEW ceive money from several companies. Since ERISA (the Employee Retirement Income Security Act of 1974) generally requires each fund to be diversified, 58 there is little room for an influential position in an operating corhpany. ERISA allows deviation from diversification only if "clearly prudent not [to minimize] the risk of large losses." 5 9 Prudence is not what a business school graduate might first expect-maximization of net present value, with due regard to risk. Commentators suggest that. the rule looks to prevailing investment practices, to the average, but with a substantial conservative drag: preservation of principal, even in the face of reduced return, is critical. Innovation risks liability.60 While financial economists tell us that just about all of the possible diversification comes with the first sixteen stocks, 6 1 fund managers expect diversification to require investment in hundreds of issuers. Onto this baseline of average opinion, tilting toward safety, ERISA enhances the standard of care for plan operators to that of an expert: they must act "with the care, skill, prudence, and diligence., that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.' '6 2 As such, a plan operator could not get very far in front of the pension manager crowd. Pension managers who took seats on the boards of portfolio companies would run the risk that their actions would be judged in a lawsuit by beneficiaries not by the low-level scrutiny of the business judgment rule, but by ERISA's higher standard of care.63 Of greater significance is the control that a plan sponsor's management has over the investment managers of the pension fund. Senior managers hire the people who run the company's pension. Pension managers who took an active role in overseeing the operating managers of another company could expect to incur the ire of their own company's senior managers. 64 The senior managers' control of their com- 58. ERISA § 404, 29 U.S.C. § 1404 (1988). 59. ERISA § 104(1)(C), 29 U.S.C. § 1104(1)(c) (1988) (emphasis added). 60. B. Longstreth, Modem Investment Management and the Prudent Man Rule 21, 29, 39-40 (1986). 61. SeeJ. Lorie, P. Dodd & M. Kimpton, The Stock Market: Theories and Evidence 85 (2d ed. 1985). 62. ERISA § 104(1)(B), 29 U.S.C. § 1104(1)(B) (1988). 63. See B. Krikorian, Fiduciary Standards in Pension and Trust Fund Management 290-91 (1989). 64. See Senate Subcomm. on Oversight of Government Management of the Comm. on Governmental Affairs, The Department of Labor's Enforcement of the ERISA, S. Rep. No. 144, 99th Cong., 1st Sess. 53-58 (1986); Pound, Proxy Contests and the Efficiency of Shareholder Oversight, 20 J. Fin. Econ. 237, 242-44 (1988). That ire might come directly or through politics. A business-labor task force, chaired by a leading member of the New York bar, recently proposed prohibiting New York public pension systems from financing hostile takeovers. White, Panel Seeks to Curb New York State Funds, Wall St. J., June 22, 1989, at C1, col. 3. [Vol. 91:10