In my last post—also a shameless plug for my recent article, “Boilerplate Shock”—I argued that boilerplate terms governing securities could serve as a trigger that transforms an isolated credit event into the risk of a broader systemic failure. I’ll now briefly explain why I see this danger—which I call “boilerplate shock”—as a general problem in securities regulation, not just some quirky feature of Eurozone sovereign debt (the focus of the paper and post). Any market where securities are governed by uniform boilerplate terms is vulnerable to boilerplate shock.
The nature of this phenomenon—systemic risk—is of course familiar, but its source in contract language is a little unintuitive. How could private contracts unravel an entire securities market or the world economy?
Coordination around uniform standards.
In the back of our mind most of us probably still conceive of contracting as an activity that occurs among two, or perhaps a few, individuals or firms. But when standard terms are used by virtually all actors within a given market, it’s worth considering the collective impact of those terms as a distinct phenomenon.
Coordination’s benefits are well known. Consider uniform traffic signals. But coordination can also compound the effects of bad individual decisions.
As Charles Whitehead has argued, widespread “destructive coordination” among banks during the precrisis days helped generate systemic risks. When the credit markets froze, for example, firms using the same risk management formulas reacted in the same way at the same time. This helped transform isolated events into systemic ones—e.g., Lehman, the canonical example of a failure that triggered a de facto coordinated panic.
A similar risk, I argue, is present where participants in a securities market rely on the same standardized contract terms. Whether they were intended to or not, these terms will often control what happens in the event of certain legal emergencies, like a country departing the euro or Lehman declaring bankruptcy.
For example, if an effort by Greece to pay its bonds in “new drachmas” is rejected because of Boilerplate Contract Terms A and B, the market will surely be concerned that Terms A and B also govern the bonds of similarly situated borrowers, like Spain, Italy, etc. You’ll see that the borrowing premium the “peripheral” euro countries (the uppermost five lines: Ireland, Italy, Greece (biggest spike), Portugal, Spain) paid versus richer euro countries (Germany, France, the Netherlands, the three lowest lines) zoomed higher as worry over a Greece exit gripped markets in late 2011/early 2012, and again (to a lesser extent) because of Cyprus exit talk in early 2013:
Bloomberg. Click to enlarge.
Moreover, this panic occurred against a backdrop of unduly rosy assumptions (namely, that a departing euro country could convert its bonds into a new currency and thereby avoid default, a likely contagion trigger). I argue that the uniformity of boilerplate across these bonds would intensify these problems significantly since it’s likely to result in a declaration of default.
To my mind, this demonstrates that boilerplate securities contracts, in the aggregate, can be systemically significant. “Boilerplate Shock” introduces this concept and offers a modest proposal to mitigate its dangers in the Eurozone.
Beyond the euro, what about the risks of boilerplate shock in general?
Boilerplate shock is probably an inherent and permanent risk in any securities market.
Securities contracts are quintessential candidates for boilerplate. They are used by sophisticated parties for repeat or similar transactions and are drafted quickly—sometimes in three and a half minutes. The (correct) assumption is that they are more efficient for the parties that use them.
I’d like to begin thinking about how contracts can be drafted with a view to systemic risk mitigation, or at least to avoid exacerbating existing risks. But I think this is a hard problem that lacks an off-the-shelf solution:
- The nature of the risk is that it is a byproduct, not the result of intentional choices about risk allocation. This is the reason for the information-forcing default rule I propose in the Eurozone.
- The risk is also an externality: it is severe because of its collective impact. The parties do not bear the primary risk that uniform contracts will result in a meltdown, and in the unlikely event a crash happens (1) no individual party will be to blame and (2) at least one party to the initial transaction (the initial purchaser of a bond, for example) will probably no longer hold the asset, because most systemically significant securities are actively traded on the secondary market.
But banning or discouraging boilerplate is not the answer:
- The risk that a bunch of assets governed by the same terms will plummet in value is not only an externality. Risk allocation among parties might improve if scrutiny of existing securities boilerplate improves. The terms can evolve.
- A requirement to craft unique, artisanal terms—disclosures, subordination provisions ("flip clauses"), choice of governing law—for each individual securities transaction would be criminally inefficient.
- A requirement to craft unique contract terms might even be unjustified on risk-management terms alone, because it would increase drafting errors.
It's tricky to mitigate the risks of securities boilerplate.
Some options for places to start:
- Validation by third parties: perhaps issuers could use risk-rated contract templates. For example, see credit ratings…but see credit ratings.
- Culture: inculcate systemic risk mitigation as a professional norm among private sector lawyers? In principle, this could work. The number of lawyers who draft these contracts is pretty small. In practice, one could envision many complications.
- Insurance: encourage the development of derivatives to account for the possibility of boilerplate shock? Like some of the other solutions, this one presumes some agreement on what terms create the risk of boilerplate shock. It could also encourage new forms of moral hazard.
- Mandatory regulation: some public entity could be tasked with the mission of proactively identifying and combating the risk of boilerplate shock in contract practices. Arguably a natural choice given that the risk is an externality. Nevertheless, I’m a little skeptical. First of all, who would do it? A domestic regulator, like the SEC or CFTC, that might be dodged on jurisdictional grounds? An international institution, which is arguably more subject to capture? More generally, regulation seems like a heavy-handed first choice.
In sum, when standardized and aggregated, choices that determine legal risks—e.g., contract terms designating governing law, payment priority—can create the same hazards as choices about business risks. This suggests that contract terms should be taken seriously as possible sources of systemic risk alongside more familiar sources, like leverage and credit quality.
Securities contracts as a source of systemic risk—what do you think?
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© Disney, “Duck Tales”
I expressed concern in my last post that uniform contract terms could destabilize securities markets in unexpected ways. In a recent paper, I dub this risk “Boilerplate Shock.” The paper uses boilerplate terms in Eurozone sovereign bonds as a case study, but I argue that any market in which a lot of securities are governed by uniform contract terms is vulnerable to boilerplate shock. In this post, I will focus on the Eurozone and my proposed solution to the risk of boilerplate shock there.
One major problem is that no one really knows how to deal with sovereign debt obligations denominated in a currency that still exists but is no longer used by the debtor. A partial breakup of the European Monetary Union would trigger some question marks in commercial law and private international law (among other things).
In the Eurozone sovereign lending market, bond contracts typically contain standardized language specifying:
(a) choice of governing law (often foreign), and
(b) currency of payment (euros).
The combined effect of these clauses, I argue, is to render any country that departs the euro more likely to default on its debt. Whatever the impact of the departure itself, a forced default would make things much worse for Europe and the world economy.
Leading scholars have concluded or strongly suggested that a sovereign that changes currencies can redenominate (convert) its bonds to its new currency even where the contract is governed by foreign law (e.g., Philip Wood (p. 177), Michael Gruson (p. 456), Arthur Nussbaum (pp. 353-59), Robert Hockett (passim)). As a descriptive matter, I believe this to be a mistaken interpretation of New York (and probably English) private international law and commercial law (see “Boilerplate Shock” pp. 47-67). But normatively, I agree: a sovereign should be able to redenominate its bonds under certain circumstances. Among other things, the alternative would make currency union breakups far more dangerous than they already are.
- The prevailing consensus underestimates the risk that a departing Eurozone member’s attempt to redenominate its sovereign bonds into a new currency will be ruled a default.
- Since the bonds of other struggling euro countries are largely governed by the same boilerplate terms ((a) and (b) above), this misapprehension has the potential to be particularly damaging. In addition to surprising the market (which appears to incorporate this consensus), it is likely to spread beyond the immediate debtor to the bonds of similarly situated countries that have issued under the same terms.
- Same for CDSs (which are likewise often governed by foreign law, usually New York).
- Thus, given the widespread use of terms (a) and (b), a ruling that a departing country cannot pay its euro-denominated contracts in a new currency could cause the market to demand unsustainable premiums from other weak debtors.
- This could cause Eurozone countries to lose market access. Greece is not TBTF in any sense, but some of its neighbors are—and are also too big for the EU (including the ECB) and IMF to bail out. Italy (the world’s 9th largest economy) and Spain (13th) come to mind.
Thus, if my commercial law/private international law analysis is right, these boilerplate contracts could end up playing quite a big role in the event of any euro breakup.
To mitigate this risk of boilerplate shock, I suggest a new rule of contract interpretation. The proposal is detailed at pp. 67-71 of the article. I suggest commercially significant jurisdictions adopt it by statute. Here is a quick summary.
Any sovereign that:
- Belongs to an international monetary union, and
- Issues bonds in the currency of that monetary union subsequent to the adoption of this rule, and
- Leaves the monetary union and introduces its own currency,
shall retain the right to redenominate its bond obligations into its new currency, UNLESS the sovereign has affirmatively waived the right to redenominate its bonds.
You’ll notice this is a default rule—merely a presumption of the right to redenominate—not a mandatory rule. It is also prospective-only: it does not apply to existing issuances. It also does not protect sovereigns that issue in foreign currency (e.g., Argentina), only those that are monetary union members and issue in the common currency (e.g., France).
The reason for these limitations is to minimize unintended consequences and near-term disruption to the market, but also to embody the relatively modest objectives of the rule. It is an information-forcing default rule that is intended to facilitate better risk management by parties. It is not a “save the world” rule.
The challenge, as I’ll discuss in my next post on the paper, is not that redenomination would be ruled impermissible when it ought to be available (otherwise, that might suggest a mandatory “pro-redenomination” rule). It is that the likely effect of these boilerplate terms—to prohibit redenomination—was almost certainly not bargained for and is largely unknown to parties. This market failure has, in turn, created latent risks to the broader financial system and the existing legal tools are poorly suited to address them.
By now, the risk that a distressed European nation such as Greece might leave the Eurozone and thereby spark global economic calamity is well known. Regular readers of this blog may even privately relish the prominence of the issue. Not since the days of the gold standard has international monetary policy come so close to being a socially acceptable topic of dinner conversation.
As I noted in my first post, observers rightly perceive the Eurozone sovereign debt crisis to be driven by political and economic forces. But many consequences of a euro breakup would be determined by law, including sources of American (specifically New York) private law.
This is a complex issue. I try to address it more fully in a new article, "Boilerplate Shock," which I've just posted on SSRN.
In brief, and to continue picking on Greece, one key question in the event of a euro breakup would be: would a court recognize an attempt by Greece to convert its euro-denominated debt into its new currency, or would it instead insist that Greece pay in euros, the currency of contract? The answer is important because, as a practical matter, requiring payment in euro would be tantamount to forcing a default.
That's the familiar narrative, anyway. And I agree. But I believe that the ubiquity of boilerplate terms in these bonds—specifically, clauses selecting governing law (usually foreign) and currency of payment (euro)—is likely to make any dispute over redenomination even more damaging than this suggests.
In the article, I argue that the sparse literature on the question of redenominating sovereign bonds overlooks some sources—especially cases interpreting New York contract law and private international law—that, if extended to Eurozone sovereign bonds, could surprise the market and cause serious global repercussions. I argue that the reason for this is not only that the dominant view overlooks what are likely controlling sources of law. It is that standardization of contract terms across the Eurozone sovereign lending market makes the stakes of surprise that much higher.
If Greece's attempt to redenominate its bonds is declared a default, then the fact that the operative terms in Italian, Spanish, Irish, etc. sovereign bonds are the same or similar makes markets likely to demand unsustainable premiums from those countries. Capital and investor flight could be very rapid. We have seen several previews of this movie over the past few years in the Eurozone, and each time official-sector bailout institutions have saved the day. But the European Union/European Central Bank and IMF probably do not have the resources to stop a broad-based bank run of this nature, to say nothing of the political support necessary to attempt it.
Maybe none of that will happen. Nevertheless, the potential for uniform contract terms to create risk not just to individual third parties but to securities markets seems likely to grow at least as fast as those markets. Using Eurozone sovereign bonds as a case study, I introduce the term "boilerplate shock" to describe the potential for standardized contract terms—when they come to govern the entire market for a given security—to transform an isolated default on a single contract into a threat to the market of which it is a part, and, possibly, to the economy in general. My larger objective here is to foster a discussion of the potential for securities law and private-sector securities lawyers to manage (or alternatively, to contribute to) systemic risk.
I've posted an abstract below and will be returning to the subject. I look forward your comments.
Boilerplate Shock abstract:
No nation was spared in the recent global downturn, but several Eurozone countries arguably took the hardest punch, and they are still down. Doubts about the solvency of Greece, Spain, and some of their neighbors are making it more likely that the euro will break up. Observers fear a single departure and sovereign debt default might set off a “bank run” on the common European currency, with devastating regional and global consequences.
What mechanisms are available to address—or ideally, to prevent—such a disaster?
One unlikely candidate is boilerplate language in the contracts that govern sovereign bonds. As suggested by the term “boilerplate,” these are provisions that have not been given a great deal of thought. And yet they have the potential to be a powerful tool in confronting the threat of a global economic conflagration—or in fanning the flames.
Scholars currently believe that a country departing the Eurozone could convert its debt obligations to a new currency, thereby rendering its debt burden manageable and staving off default. However, this Article argues that these boilerplate terms—specifically, clauses specifying the law that governs the bond and the currency in which it will be paid—would likely prevent such a result. Instead, the courts most likely to interpret these terms would probably declare a departing country’s effort to repay a sovereign bond in its new currency a default.
A default would inflict damage far beyond the immediate parties. Not only would it surprise the market, it would be taken to predict the future of other struggling European countries’ debt obligations, because they are largely governed by the same boilerplate terms. The possibility of such a result therefore increases the risk that a single nation’s departure from the euro will bring down the currency and trigger a global meltdown.
To mitigate this risk, this Article proposes a new rule of contract interpretation that would allow a sovereign bond to be paid in the borrower’s new currency under certain circumstances. It also introduces the phrase “boilerplate shock” to describe the potential for standardized contract terms drafted by lawyers—when they come to dominate the entire market for a given security—to transform an isolated default on a single contract into a threat to the broader economy. Beyond the immediate crisis in the Eurozone, the Article urges scholars, policymakers, and practitioners to address the potential for boilerplate shock in securities markets to damage the global economy.
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Before returning to the legal boundaries of monetary policy, I wanted to briefly highlight some interesting contract and regulatory issues lurking just beneath the surface of an unusual Kansas state court order declaring a sperm donor to be the legal father of a child, against the wishes of all persons involved.
In 2009, a Topeka man answered a Craigslist ad soliciting sperm donations. The ad was placed by a lesbian couple, Jennifer Schreiner and Angela Bauer. The man supplied a donation. Schreiner became pregnant and delivered a baby. Schreiner began receiving Kansas welfare benefits for the child. Seeking child support payments, the state sued the sperm donor to establish paternity. The state argued that the donor—who lacks any relationship with the child or the couple (now estranged) beyond supplying the donation—was the child’s legal father, and therefore must pay child support.
This is where the case gets interesting as a matter of private ordering and trade regulation.
Prior to the donation, all persons involved—the donor and both members of the couple—signed a non-paternity agreement in which the donor waived his parental rights and was released from his parental obligations.
Both mothers opposed the state’s campaign to declare the donor the child's legal father.
Nevertheless, the court granted the state’s paternity petition, which means it can now seek to compel the donor to provide child support. The paternity finding also appears to give the donor a good shot at asserting parental rights (though he seems unlikely to try).
Justifying its decision to ignore the wishes of both parents and the donor, the court intoned:
A parent may not terminate parental rights by contract, however, even when the parties have consented.
Well, maybe this case is a morality tale about those who would seek a father for their child on Craigslist. A warning from a heartland state to those who would selfishly try to contract around their sacred parental obligations. A sign that courts place the welfare of the child above all else. Right?
Haha, of course not!
Kansas law makes it easy to conclusively terminate the parental rights and obligations of sperm donors by contract. Care to guess what you need to do, besides sign a contract?
Pay a doctor.
The court explained:
Through K.S.A. 23-2208(f) [PDF], the Kansas legislature has afforded a woman a statutory vehicle for obtaining semen for [artificial insemination] in a manner that protects her and her child from a later claim of paternity by the donor. Similarly, the legislature has provided a man with a statutory vehicle for donating semen to a woman in a manner that precludes later liability for child support. The limitation on the application of these statutory vehicles, however, is that the semen must be “provided to a licensed physician." [FN1] (emphasis added)
The parties failed to do this.
So, the upshot is that you are free to find a father for your child on Craigslist—and you can even count on the State of Kansas to keep him out of your child’s life in the future—so long as you hire a doctor to do the procedure. Similarly, you can spend your free time fathering children on Craigslist without losing sleep over child support suits—as long as you kick some of the action upstairs to an M.D.
It’s not just Kansas; California, Illinois, and as many as 10 other states [FN2] follow the same law, the Uniform Parentage Act of 1973.
I’m not a family law expert, but it seems to me that a complete list of legitimate and unique public policy concerns that are implicated when a couple and a third-party sperm donor settle their parental obligations by contract looks something like this:
- Ensuring that the state can identify who can be held legally responsible for supporting the child.
Nevertheless, let’s assume there are also truly compelling public health reasons to involve a physician in artificial insemination. After speaking with a few doctors, I’m skeptical that this is the case, but even if it were here are ten points that I think are worth considering:
- Should a mother who became pregnant by artificial insemination be forced to share parental rights with a stranger who donated sperm simply because she decided not to hire a doctor for the procedure?
- Conversely, should the scope of a sperm donor’s rights and responsibilities as a father turn on the decision whether to enlist a doctor to oversee the procedure?
- Should the adequacy of a child support scheme turn on whether couples using sperm donors choose to hire a doctor?
- There are sound public policy reasons to be concerned about voluntariness in agreements that waive paternity. But if this case is really about ensuring voluntariness, why is enlisting doctors the solution? Establishing consent during contract formation is not some novel problem. Hiring a doctor is a novel solution, but as an evidentiary device it is not very probative.
- Hiring doctors for artificial insemination is not cheap. A single attempt through a physician’s office costs about $3,000, and sometimes multiple attempts are necessary. Unsurprisingly, the American Fertility Association (a trade group for the fertility industry) applauded the court’s decision.
- This rule looks even more like an attempt to extract rents when you consider that for many people, the price of artificial insemination without physician assistance may be zero.
- If the state interest in the use of doctor-assisted artificial insemination is so compelling, maybe the law should simply require it on penalty of criminal sanction. I have never even heard this idea floated, probably because it would be perceived (rightly) as an excessive intrusion on various important freedoms…
- …yet while they do not provide criminal sanctions, about 13 states are willing to provide unbelievably harsh "family-law sanctions." If a woman declines to hire a doctor, she is placing herself and her child in eternal jeopardy; at any time, the donor or the state can move to declare the donor to be the legal father, which would put the donor in a position to seek full parental rights—even if he is a stranger. (The same is true in reverse re: child support.) It is unsurprising that both mothers opposed the state’s petition.
- Although facially neutral, this rule is almost certainly discriminatory in practice. It means that lesbian couples must either hire a doctor or adopt—there is no other way they can safely preclude the donor from being granted parental rights. And of course this is just one of many unofficial taxes gays and lesbians must pay, especially in states like Kansas that do not allow them to marry. It seems to me that there’s a good argument the law should fail rational basis or equal protection review, but I will leave that brief to the con law scholars.
- Finally, beyond any constitutional infirmity, this law should serve as a reminder that protectionist regulations—which often take the form of onerous occupational licensing restrictions and NIMBY zoning rules—frequently have regressive distributional consequences, because they tend to favor powerful incumbents. And although probably not the case here, such laws can harm the broader economy as well by stifling innovation.
I welcome your comments. And I hope my doctor friends still talk to me.
* * * *
[FN1] It should be noted that under the letter of the statute as well as a 2007 Kansas Supreme Court decision (PDF) on this issue, the court did not have an obvious alternative to finding for the state. The problem, such as there is one, is with the statute.
[FN2] An accurate count is not possible without doing a full 50-state survey. As I have written about previously, the Uniform Law Commission’s Enactment Status Maps are often unreliable or imprecise (see FNs 163 & 188).
The Chancery Daily flagged a pending case in the Delaware Court of Chancery, NAMA Holdings, LLC v. Related WMC, LLC, et al., involving a claim for "tortious interference with the implied covenant of good faith and fair dealing." A Westlaw search reveals that this is not an entirely novel claim. The earliest instance of such a claim appears to be Haynal v. Target Stores, 1996 WL 806706 (S.D.Cal.,1996), and the federal court drop-kicked the claim: "Plaintiff's attempt to convert a contract action into a tort action is not supported by law." Two other courts note the claim, but neither addresses its merits. No law review articles discuss the claim, and even Google shows no results ... well, until this post gets included in the search results.
Of course, lots of cases involve claims of "tortious interference with contract" and "breach of the implied covenant of good faith and fair dealing." The arguments against recognizing tortious interference with contract would seem to apply to a claim of "tortious interference with the implied covenant of good faith and fair dealing," but if you are willing to recognize the one, is there a reason not to recognize the other?
Just before Christmas the Washington Law Review published a symposium issue honoring Larry Cunningham's new book, Contracts in the Real World. The issue is a good read for Contracts teachers. You can read my contribution, "Contracts as Pattern Language" here. The abstract for this essay is below:
Christopher Alexander’s architectural theory of a "pattern language" influenced the development of object-oriented computer programming. This pattern language framework also explains the design of legal contracts. Moreover, the pattern language rubric explains how legal agreements interlock to create complex transactions and how transactions interconnect to create markets. This pattern language framework helps account for evidence, including from the global financial crisis, of failures in modern contract design.
A pattern represents an encapsulated conceptual solution to a recurring design problem. Patterns save architects and designers from having to reinvent the wheel; they can use solutions that evolved over time to address similar problems. Contract patterns represent encapsulated solutions within a legal agreement (or set of agreements) to a specific legal problem. This problem might consist of a need to match the particular objectives of counterparties in a discrete part of a bargain or to address certain legal rules. A contract pattern interlocks, nests, and works together with other contract patterns to solve more complex problems and create more elaborate bargains. Interlocking patterns enable scalability. Just as Alexander’s architectural patterns for rooms create patterns for buildings, which create patterns for neighborhoods and cities, patterns of individual contract provisions form legal agreement patterns, which interlock to create patterns for transactions, which, mesh to create patterns for markets. For example, contract patterns help lawyers draft real estate contracts. These contracts interlock in sophisticated real estate transactions, which mesh with other contract patterns to form securitization transactions. Securitization patterns create markets for asset-backed securities, which, form part of the larger shadow banking system.
This scalability differentiates contract patterns from boilerplate. However, legal scholarship on boilerplate – including Henry Smith’s work on the modularity of contract boilerplate – patterns allow certain debt contracts to become what Gary Gorton calls "informationally insensitive" and to enjoy many of the economic features of money.
The pattern language framework explains not only how sophisticated contracts function, but also how they fail. The pattern language framework provides a lens for examining recent contracts law scholarship on the failures of sophisticated contract design, including "sticky" contract provisions in sovereign bond agreements, "Frankenstein" contracts in mortgage-backed securitizations, and the "flash crash." If modularity and contract design patterns foster the development of new financial instruments and markets, then their features can also contribute to the unraveling of these markets. For example, by restricting the information content of contracts, patterns and modularity not only midwifed the creation of liquid markets for those contracts, they also played a role in "shadow bank runs" and the catastrophic freezing of these markets. The failure of contracts can have systemic effects for entire markets when a particular contract enjoys widespread use or when it is so connected to other critical contracts that cascading failures occur.
This essay was a contribution to a symposium for Larry Cunningham’s book, Contracts in the Real World.
One of my colleagues said that my latest article (written with one of my excellent students, Jordan Lee) sounds like an R-rated movie. The title is Discretion, and here is the abstract:
Discretion is an important feature of all contractual relationships. In this Article, we rely on incomplete contract theory to motivate our study of discretion, with particular attention to fiduciary relationships. We make two contributions to the substantial literature on fiduciary law. First, we describe the role of fiduciary law as “boundary enforcement,” and we urge courts to honor the appropriate exercise of discretion by fiduciaries, even when the beneficiary or the judge might perceive a preferable action after the fact. Second, we answer the question, how should a court define the boundaries of fiduciary discretion? We observe that courts often define these boundaries by reference to industry customs and social norms. We also defend this as the most sensible and coherent approach to boundary enforcement.
I wrote an article about a decade ago called "The Critical Resource Theory of Fiduciary Duty" that still gets downloaded and cited a fair amount, at least for a fiduciary duty article. It is about the structure of fiduciary relationships, and I wanted to do a follow on article about how courts know when someone has breached a fiduciary duty. I actually had a fairly long draft of an article that was just horrible, and I never published it, but I kept thinking about and teaching about this problem. Earlier this year, I had a brainstorm about the subject, and the result is this new article.
By the way, interest in fiduciary law seems to have exploded in the past decade. Some of that interest stems from Tamar Frankel's book and the accompanying conference at Boston University. Some of the interest stems from the fact that fiduciary law is interesting in many countries outside the United States, where much of the best writing on this subject is found (see Paul Miller, for example). I look forward to a new surge in interest this summer, as Andrew Gold and Paul Miller have organized an excellent conference on The Philosophical Foundations of Fiduciary Law, to be held in Chicago. I am writing a paper entitled "True Loyalty" for that conference and very much looking forward to reading the other contributions.
The Washington Law Review is devoting a symposium issue this fall to Larry Cunningham's new book Contracts in the Real World: Stories of Popular Contracts and Why They Matter. (I'll be contributing an essay/case study). This follows an online discussion group on the book that took place last semester over at Concurring Opinions.
In connection with the symposium issues, the Washington Law Review is asking all Contracts professors to participate in a brief online survey (see this web page to access the survey).
I thought I would highlight a few sessions I will be attending at the AALS Annual Meeting in New Orleans. First up, Contracts ...
The Law of Contract or Laws of Contracts?
Moderator: Thomas W. Joo, University of California, Davis, School of Law
Rachel Arnow-Richman, University of Denver Sturm College of Law,
David A. Hoffman, Temple University, James E. Beasley School of Law
Robert C. Illig, University of Oregon School of Law,
Karen E. Sandrik, Willamette University College of Law,
“There is a story of a Vermont justice of the peace before whom a suit was brought by one farmer against another for breaking a churn. The justice took time to consider, and then said that he had looked through the statutes and could find nothing about churns, and gave judgment for the defendant.” - O.W. Holmes, The Path of the Law.
This story was meant to ridicule the Vermont justice, but he may have been ahead of his time. This year’s Section program will revisit the perennial and fundamental questions about “contract law” as a legal rubric. Is it preferable to analyze “contracts” as a category, or to disperse contracts into “churn” – like categories, such as sales, consumer protection, employment, family relations, intellectual property, securities, and so on? To what extent does the experience of one type of contract justify generalizations about “contract law”? Conversely, what kinds of contracts implicate context-specific practices, markets, or policy concerns justifying specialized analysis and/or doctrine?
Let me start out with a criticism of Larry’s book: it is too much fun. I had a hard time breaking off just a chunk of Contracts in the Real World to write about and found myself spending several hours reading one interesting vignette after another on famous and infamous contracts.
The book will make a wonderful companion text to a traditional contracts casebook. Its value is not just in its engaging account of contract stories or in giving context to chestnut cases, but in providing a very intuitive framework for understanding contract law. The traditional contracts course, perhaps by virtue of having the doctrine of consideration at its heart, can be one of the most confusing in the One-L year. Students are often left to divine the inner structure (or lack thereof) of contract law on their own, likely while cramming for finals. Sometimes the epiphany comes. For many students it does not.
Larry has a real genius for laying out the doctrinal building blocks in a very thoughtful and accessible structure. He groups cases around a rough life cycle of contracts, with chapters devoted to “Getting In: Contract Formation,” to “Facing Limits: Unenforceable Bargains,” to “Paying Up: Remedies.” The layout of the book combined with its lucid writing demystifies contracts.
The layout may at first appear to make this book an ill fit as a companion text to many case books, because many of the cases appear in Contracts in the Real World under a different doctrinal heading than in a particular case book. For example, in the case book I currently use Batsakis v. Demotsis appears in the chapter on “consideration.” Larry places this classic next to cases on unconscionability. I also teach Lucy, Lady Duff Gordon in consideration, while Larry situates it in “Performing: Duties, Modification, Good Faith.”
These differences actually demonstrate a strength of the book. Some disconnect between the organization of a primary case book and a companion text forces students to move beyond a facile understanding of contract law in terms of rigid doctrines. Seeing cases in different contexts and fitting into different doctrinal boxes can help students see that lawyering involves more than memorizing black letter rules and putting issues into the right doctrinal box. Indeed, sometimes different doctrinal boxes can apply to the same problem and lead to the same result (witness rules on past consideration and duress). At other times, the choice of the doctrinal box makes a huge difference (see those same two doctrines). Accomplished students can move from memorizing blackletter law to seeing the possibility of creative lawyering. Larry’s organization – both intuitive and surprising – will help students at both stages.
One final strength of the book is Larry’s choice to include not only court cases but many contemporary contract disputes that never reached the courtroom (such as the dispute between NBC and Conan O’Brien). This brings into the classroom a wider panorama of how lawyers encounter and shape contractual problems in practice. After all, few contracts and few lawyers find their way into a courtroom. Most disputes are resolved in the shadow of law.
I also have a wish list for Larry’s next project (from personal experience, I can tell you how invigorating it is for an author who has just finished a book to be asked “what’s next?’). One of the limitations of the traditional contracts curriculum is how rarely students read and interpret – let alone negotiate or draft – actual contracts. It would be incredibly helpful as a professor to have some of the source contracts behind these stories. Although some of these contracts are already contained in a judicial opinion (Carbolic Smoke Ball) and many will not be public (Conan’s deal with NBC), others might be available with some digging. Having real and full contracts would allow professors to meet many of the items on Professor Collins’ wish list, such as transactional perspectives and drafting exercises. Although some lawyers litigate over failed contractual relationships, many more help parties plan prospectively – including by drafting and negotiating deals. For most attorneys, contracts are not an autopsy subject, to be dissected in a court opinion, but a living thing.
Professor Cunningham’s book provides a joyful reminder of the life in contracts.
I am getting ready to teach MGM v. Scheider next week in Contracts. The case (347 N.Y.S.2d. 755) involves whether a series of communications between a Hollywood studio and actor Roy Scheider (who would later star in JAWS) constituted a contract that bound the star to act in an ABC tv series. [Note: should any of my contract students read this post, the foregoing is not an example of a good case brief.]
When going over the aftermath of this case in class, the inevitable question comes up: “Why didn’t the lawyers insist on a more formal, written, and executed contract?” The same answers surface: sloppiness, lack of sophistication, time pressure. It makes for an easy moral for law students (“be tougher and more careful”), but one that I find increasingly less satisfying and nutritious. Sloppiness just seems too pat an answer to explain this or many of the other lawyer “mistakes” that populate a Contracts case book.
Fortunately, Jonathan Barnett (USC Law) has a new working paper that provides a much more nuanced answer. Barnett’s “Hollywood Deals: Soft Contracts for Hard Markets” explores why many contracts between Hollywood studios and star level talent (both sides usually represented by experienced lawyers) fall into this netherworld of “soft contracts” – that is agreements of questionable status as enforceable contracts. Barnett’s explanation involves both parties navigating two different risks – project risk (the risk a film won’t happen or will flop) and hold-up risk (the risk that a necessary party to a film will back out, possibly to hold the project hostage). The studio system used to provide a way to balance these two risks. The decline of this sytem, according to Barnett, gave rise to a growing use of “soft contracts.” Here is the abstract:
Hollywood film studios, talent and other deal participants regularly commit to, and undertake production of, high-stakes film projects on the basis of unsigned “deal memos,” informal communications or draft agreements whose legal enforceability is uncertain. These “soft contracts” constitute a hybrid instrument that addresses a challenging transactional environment where neither formal contract nor reputation effects adequately protect parties against the holdup risk and project risk inherent to a film project. Parties negotiate the degree of contractual formality, which correlates with legal enforceability, as a proxy for allocating these risks at a transaction-cost savings relative to a fully formalized and specified instrument. Uncertainly enforceable contracts embed an implicit termination option that provides some protection against project risk while maintaining a threat of legal liability that provides some protection against holdup risk. Historical evidence suggests that soft contracts substitute for the vertically integrated structures that allocated these risks in the “studio system” era.
The very accessible paper is worth a read – not only for Contracts scholars and teachers, but also for those interested in the theory of the firm. For a different, stimulating approach to supplementing the teaching of contracts (Hollywood and otherwise), Larry Cunningham’s new book, Contracts in the Real World: Stories of Popular Contracts and Why They Matter is out from Cambridge University Press. Larry gave a preview of the book and his approaching to teaching the subject in our Conglomerate forum on teaching contracts last summer. The book is chock full of very useful stories on chestnut casebook opinions, as well as contracts straight out of Variety involving stars from Eminem to Jane Fonda.
Others have blogged about the Van Halen brown M&M clause (no brown M&Ms backstage), attributed to rock star over-indulgence and egocentrism. There's another, more rational explanation available here.
Jeremy Telman doesn't buy David Lee Roth's explanation. But it's so much fun!
Update: I thought the Glom had posted on this story back in the day, but I couldn't find it in our archives. Here's Gordon back in 2009.
Law schools are under attack. Depending upon the source, between 20-50% of corporate counsel won’t pay for junior associate work at big firms. Practicing lawyers, academics, law students and members of the general public have weighed in publicly and vehemently about the perceived failure of America’s law schools to prepare students for the real world.
Admittedly, before I joined academia a few months ago, I held some of the same views about lack of preparedness. Having worked with law students and new graduates as outside and in house counsel, I was often unimpressed with the level of skills of these well-meaning, very bright new graduates. I didn’t expect them to know the details of every law, but I did want them to know how to research effectively, write clearly, and be able to influence the clients and me. The first two requirements aren’t too much to expect, and schools have greatly improved here. But many young attorneys still leave school without the ability to balance different points of view, articulate a position in plain English, and influence others.
To be fair, unlike MBAs, most law students don’t have a lot of work experience, and generally, very little experience in a legal environment before they graduate. Assuming they know the substantive area of the law, they don’t have any context as to what may be relevant to their clients.
How can law schools help?
First, regardless of the area in which a student believes s/he wants to specialize, schools should require them to take business associations, tax, and a basic finance or accounting course. No lawyer can be effective without understanding business, whether s/he wants to focus on mom and pop clients, estate planning, family law, nonprofit, government or corporate law. More important, students have no idea where they will end up after graduation or ten years later. Trying to learn finance when they already have a job wastes the graduate’s and the employer’s time.
Of course, many law schools already require tax and business organizations courses, but how many of those schools also show students an actual proxy statement or simulate a shareholder’s meeting to provide some real world flavor? Do students really understand what it means to be a fiducuiary?
Second and on a related point, in the core courses, students may not need to draft interrogatories in a basic civil procedure course, but they should at least read a complaint and a motion for summary judgment, and perhaps spend some time making the arguments to their brethren in the classroom on a current case on a docket. No one can learn effectively by simply reading appellate cases. Why not have students redraft contract clauses? When I co-taught professional responsibility this semester, students simulated client conversations, examined do-it-yourself legal service websites for violations of state law, and wrote client letters so that the work came alive.
When possible, schools should also re-evaluate their core requirements to see if they can add more clinicals (which are admittedly expensive) or labs for negotiation, client consultation or transactional drafting (like my employer UMKC offers). I’m not convinced that law school needs to last for three years, but I am convinced that more of the time needs to be spent marrying the doctrinal and theoretical work to practical skills into the current curriculum.
Third, schools can look to their communities. In addition to using adjuncts to bring practical experience to the classroom, schools, the public and private sector should develop partnerships where students can intern more frequently and easily for school credit in the area of their choice, including nonprofit work, local government, criminal law, in house work and of course, firm work of all sizes. Current Department of Labor rules unnecessarily complicate internship processes and those rules should change.
This broader range of opportunities will provide students with practical experience, a more realistic idea of the market, and will also help address access to justice issues affecting underserved communities, for example by allowing supervised students to draft by-laws for a 501(c)(3). I’ll leave the discussion of high student loans, misleading career statistics from law schools and the oversupply of lawyers to others who have spoken on these hot topics issues recently.
Fourth, law schools should integrate the cataclysmic changes that the legal profession is undergoing into as many classes as they can. Law professors actually need to learn this as well. How are we preparing students for the commoditization of legal services through the rise of technology, the calls for de-regulation, outsourcing, and the emerging competition from global firms who can integrate legal and other professional services in ways that the US won’t currently allow?
Finally and most important, what are we teaching students about managing and appreciating risk? While this may not be relevant in every class, it can certainly be part of the discussions in many. Perhaps students will learn more from using a combination of reading law school cases and using the business school case method.
If students don’t understand how to recognize, measure, monitor and mitigate risk, how will they advise their clients? If they plan to work in house, as I did, they serve an additional gatekeeper role and increasingly face SEC investigations and jail terms. As more general counsels start hiring people directly from law schools, junior lawyers will face these complexities even earlier in their careers. Even if they counsel external clients, understanding risk appetite is essential in an increasingly complex, litigious and regulated world.
When I teach my course on corporate governance, compliance and social responsibility next spring, my students will look at SEC comment letters, critically scrutinize corporate social responsibility reports, read blogs, draft board minutes, dissect legislation, compare international developments and role play as regulators, legislators, board members, labor organizations, NGOs and executives to understand all perspectives and practice influencing each other. Learning what Sarbanes-Oxley or Dodd-Frank says without understanding what it means in practice is useless.
The good news is that more schools are starting to look at those kinds of issues. The Carnegie Model of legal education “supports courses and curricula that integrate three sets of values or ‘apprenticeships’: knowledge, practice and professionalism.” Educating Tomorrow’s Lawyers is a growing consortium of law schools which recommends “an integrated, three-part curriculum: (1) the teaching of legal doctrine and analysis, which provides the basis for professional growth; (2) introduction to the several facets of practice included under the rubric of lawyering, leading to acting with responsibility for clients; and (3) exploration and assumption of the identity, values and dispositions consonant with the fundamental purposes of the legal profession.” The University of Miami’s innovative LawWithoutWalls program brings students, academics, entrepreneurs and practitioners from around the world together to examine the fundamental shifts in legal practice and education and develop viable solutions.
The problems facing the legal profession are huge, but not insurmountable. The question is whether more law schools and professors are able to leave their comfort zones, law students are able to think more globally and long term, and the popular press and public are willing to credit those who are already moving in the right direction. I’m no expert, but as a former consumer of these legal services, I’m ready to do my part.
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Time Magazine’s “person of the year” is the “protestor.” Occupy Wall Street’s participants have generated discussion unprecedented in recent years about the role of corporations and their executives in society. The movement has influenced workers and unemployed alike around the world and has clearly shaped the political debate.
But how does a corporation really act? Doesn’t it act through its people? And do those people behave like the members of the homo economicus species acting rationally, selfishly for their greatest material advantage and without consideration about morality, ethics or other people? If so, can a corporation really have a conscience?
In her book Cultivating Conscience: How Good Laws Make Good People, Lynn Stout, a corporate and securities professor at UCLA School of Law argues that the homo economicus model does a poor job of predicting behavior within corporations. Stout takes aim at Oliver Wendell Holmes’ theory of the “bad man” (which forms the basis of homo economicus), Hobbes’ approach in Leviathan, John Stuart Mill’s theory of political economy, and those judges, law professors, regulators and policymakers who focus solely on the law and economics theory that material incentives are the only things that matter.
Citing hundreds of sociological studies that have been replicated around the world over the past fifty years, evolutionary biology, and experimental gaming theory, she concludes that people do not generally behave like the “rational maximizers” that ecomonic theory would predict. In fact other than the 1-3% of the population who are psychopaths, people are “prosocial, ” meaning that they sacrifice to follow ethical rules, or to help or avoid harming others (although interestingly in student studies, economics majors tended to be less prosocial than others).
She recommends a three-factor model for judges, regulators and legislators who want to shape human behavior:
“Unselfish prosocial behavior toward strangers, including unselfish compliance with legal and ethical rules, is triggered by social context, including especially:
(1) instructions from authority
(2) beliefs about others’ prosocial behavior; and
(3) the magnitude of the benefits to others.
Prosocial behavior declines, however, as the personal cost of acting prosocially increases.”
While she focuses on tort, contract and criminal law, her model and criticisms of the homo economicus model may be particularly helpful in the context of understanding corporate behavior. Corporations clearly influence how their people act. Professor Pamela Bucy, for example, argues that government should only be able to convict a corporation if it proves that the corporate ethos encouraged agents of the corporation to commit the criminal act. That corporate ethos results from individuals working together toward corporate goals.
Stout observes that an entire generation of business and political leaders has been taught that people only respond to material incentives, which leads to poor planning that can have devastating results by steering naturally prosocial people to toward unethical or illegal behavior. She warns against “rais[ing] the cost of conscience,” stating that “if we want people to be good, we must not tempt them to be bad.”
In her forthcoming article “Killing Conscience: The Unintended Behavioral Consequences of ‘Pay for Performance,’” she applies behavioral science to incentive based-pay. She points to the savings and loans crisis of the 80's, the recent teacher cheating scandals on standardized tests, Enron, Worldcom, the 2008 credit crisis, which stemmed in part from performance-based bonuses that tempted brokers to approve risky loans, and Bear Sterns and AIG executives who bet on risky derivatives. She disagrees with those who say that that those incentive plans were poorly designed, arguing instead that excessive reliance on even well designed ex-ante incentive plans can “snuff out” or suppress conscience and create “psycopathogenic” environments, and has done so as evidenced by “a disturbing outbreak of executive-driven corporate frauds, scandals and failures.” She further notes that the pay for performance movement has produced less than stellar improvement in the performance and profitability of most US companies.
She advocates instead for trust-based” compensation arrangements, which take into account the parties’ capacity for prosocial behavior rather than leading employees to believe that the employer rewards selfish behavior. This is especially true if that reward tempts employees to engage in fraudulent or opportunistic behavior if that is the only way to realistically achieve the performance metric.
Applying her three factor model looks like this: Does the company’s messaging tell employees that it doesn’t care about ethics? Is it rewarding other people to act in the same way? And is it signaling that there is nothing wrong with unethical behavior or that there are no victims? This theory fits in nicely with the Bucy corporate ethos paradigm described above.
Stout proposes modest, nonmaterial rewards such as greater job responsibilities, public recognition, and more reasonable cash awards based upon subjective, ex post evaluations on the employee’s performance, and cites studies indicating that most employees thrive and are more creative in environments that don’t focus on ex ante monetary incentives. She yearns for the pre 162(m) days when the tax code didn’t require corporations to tie executive pay over one million dollars to performance metrics.
Stout’s application of these behavioral science theories provide guidance that lawmakers and others may want to consider as they look at legislation to prevent or at least mitigate the next corporate scandal. She also provides food for thought for those in corporate America who want to change the dynamics and trust factors within their organizations, and by extension their employee base, shareholders and the general population.
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