The 2011 symposium edition of the Berkeley Business Law Journal on Dodd-Frank is out.  I would like to thank the editors and the Berkeley Center for Law, Business and the Economy for inviting me to a great conference.  My contribution, Credit Derivatives, Leverage, and Financial Regulation’s Missing Macroeconomic Dimension is now up on ssrn.  Here is the abstract:

Of all OTC derivatives, credit derivatives pose particular concerns because of their ability to generate leverage that can increase liquidity - or the effective money supply - throughout the financial system. Credit derivatives and the leverage they create thus do much more than increase the fragility of financial institutions and increase counterparty risk. By increasing leverage and liquidity, credit derivatives can fuel rises in asset prices and even asset price bubbles. Rising asset prices can then mask mistakes in the pricing of credit derivatives and in assessments of overall leverage in the financial system. Furthermore, the use of credit derivatives by financial institutions can contribute to a cycle of leveraging and deleveraging in the economy.

This Article argues for viewing many of the policy responses to credit derivatives, such as requirements that these derivatives be exchange traded, centrally cleared, or otherwise subject to collateral or 'margin' requirements, in a second, macroeconomic dimension. These rules have the potential to change – or at least better measure – the amount of liquidity and the supply of credit in financial markets and in the 'real' economy. By examining credit derivatives, this Article illustrates the need to see a wide array of financial regulations in a macroeconomic context. 

Understanding credit derivatives’ macroeconomic effects has implications for macroprudential regulatory design. First, regulations that address financial institution leverage offer central bankers new tools to dampen inflation in asset markets and to fight potential asset price bubbles. Second, even if these regulations are not used primarily as monetary or macroeconomic levers, changes in these regulations, including changes in the effectiveness of these regulations due to regulatory arbitrage, can have profound macroeconomic effects. Third, the macroeconomic dimension of credit derivative regulation and other financial regulation argues for greater coordination between prudential regulation and macroeconomic policy.

Comments by e-mail are always welcome.

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Plagiarism is a hard word to spell, but that doesn't necessarily make it a disease or a medical condition.  However, one confessed plagiarist, Quentin Rowan, is comparing his habit of blatant copying to alcoholism and other addictions.  In light of the recent Rowan kerfuffle, in which he published a spy novel that lifted literally pages from famous spy novels, Salon has a debate concerning the definition of "plagiarism."

I was lured to read because I wanted to see what the experts thought the definition of plagiarism is.  Having had to witness too many students put through the wringer who claimed that no one ever told them what plagiarism was, I have to admit I think we are good at telling folks that plagiarism is wrong (or a violation of the honor code), but even better at assuming that everyone has already been told by someone else what plagiarism is.  I've also seen this with academics, too.  I've been told that in some areas of legal scholarship many articles contain almost stock explanations of traditional arguments, with the same cites in the same order.  I've been told by others that this is just wrong.  Most of the experts on Salon were also in the "everyone knows what plagiarism is" camp -- just repeating that it is the presentation of someone else's words or ideas without attribution.  The experts do agree that some plagiarism is unintentional and that one can misremember whether ideas were one's own or anothers.

But, the interesting event that spawned the debate answers some questions for me.  I have always wondered what could possibly be the mindset of someone who steals another's words and passes them off as her own, for a grade or for profit.  I've always thought that the plagiarist must rationalize this to themselves, possibly by assuming that everyone else does it or that this is just the way things are done.  Perhaps in a school setting, a student could convince herself that a teacher was so hard or so unfair that plagiarism was the only way to succeed under a rigged system.  Writing a novel, though, doesn't lend itself to those arguments.  Perhaps plagiarism is just another risky behavior that creates a sense of danger and excitement for the writer.  Hopefully, I'll never know firsthand.

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The Section on Financial Institutions and Consumer Financial Services will have a record four events at this weekend's Association of American Law Schools Annual Meeting in Washington, DC. The theme is rethinking and reviving the field of financial institutions on the ground and in the academy. We will take stock of reforms so far and consider the impact of the crises in the United States and Europe, but also will take a long-term view of the field from diverse theoretical, policy, and methodological perspectives.

The program begins on Saturday morning (10:30 am-12:15 pm, Marriott Wardman Park, Thurgood Marshall North - Mezzanine Level) with a big-think "revival" panel featuring Jill Fisch (Penn), Howell Jackson (Harvard), Kim Krawiec (Duke), Pat McCoy (Connecticut, recently at Consumer Financial Protection Bureau), Katharina Pistor (Columbia), and Annelise Riles (Cornell).

Next we have a lunch keynote speech by Governor Sarah Bloom Raskin, introduced by Arthur Wilmarth (George Washington) (12:15-1:30 pm)

Next comes an offsite event at American University starting at 4 pm (separate registration required).  This event will include a policy roundtable on moderated by Adam Feibelman (Tulane), with regulators and policy makers from different agencies, as well as a paper presentation.

The weekend will conclude on Sunday with a panel presentation of four scholarly papers (9 - 10:45 am - Maryland Suite A, Lobby Level).  Heidi Schooner will moderate the Call for Papers panel.

Full program details are here. 

Here are links to the selected papers, authors, and commentators (as well as my prior blog posts introducing the papers):

Saturday:

Anat R. Admati, Peter Conti-Brown, & Paul Pfleiderer, Liability Holding Companies (presented by Peter Conti-Brown (Stanford), comments by Saule Omarova (North Carolina)) (my introductory blog post)

Sunday:

Eric Chaffee (Dayton) & Geoffrey C. Rapp (Toledo), Regulating On-line Peer-to-Peer Lending in the Aftermath of Dodd-Frank (comments by Andrew Verstein (Yale)) (my introductory blog post)

Stavros Gadinis (U.C. Berkeley), From Independence to Politics in Banking Regulation (comments by Shruti Rana (Maryland))(my introductory blog post)

Anita K. Krug (Univ. of Washington), Institutionalization, Investment Adviser Regulation, and the Hedge Fund Problem (comments by Kristin N. Johnson (Seton Hall)) (my introductory blog post)

Wulf A. Kaal (St. Thomas)  & Christoph Henkel (Mississippi College School of Law), Sequential Contingent Capital Triggers in Europe and the United States (comments by Mehrsa Baradaran (BYU))(my introductory blog post)

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This is the fifth and final installment of a series of previews of the papers being presented at the AALS Financial Institutions & Consumer Financial Services Section events this weekend.  This final paper will be presented at a special off-site event starting at 4 pm on Saturday at American University.  (See here for details on the full weekend of Financial Institutions/Consumer Financial Services Section events).

Peter Conti-Brown (Academic Fellow, Stanford Law, Rock Center for Corporate Governance) will present, Liability Holding Companies, a paper he co-authored with Anat Admati and Paul Pfleiderer (both of Stanford’s Graduate School of Business).  To understand this paper, it helps to read an earlier, influential paper by Admati, Pfleiderer, and a number of co-authors on which it builds.  This earlier work, Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive, countered criticisms of higher capital requirements.  That earlier paper responded to charges that higher capital requirements would impose large social costs, including reducing bank lending.

Yet in Liability Holding Companies, Conti-Brown and his co-authors admit that bank debt may have some benefits; creditors may monitor and discipline bank management.  To balance this disciplinary benefit against reducing the social costs of excessive bank leverage (financial institution fragility, systemic risk, increased risk of bailouts), Admati, Conti-Brown, and Pfleiderer propose a regulatory innovation.  Here is their abstract:      

An international debate continues to unfold in banking law, corporate governance, and finance on whether the capital structure of the world’s largest financial institutions is too heavily dependent on debt, too little on equity. Two of us, with co-authors, have argued elsewhere that there is no socially beneficial purpose for this over-reliance on debt and, indeed, that such reliance increases the likelihood of taxpayer bailouts, with their associated economic, financial, and social costs. Some academics and bankers continue to insist, however, that increased equity is costly for banks and for society. The arguments proffered in defense of these propositions contradict the most basic insights from corporate finance, and often neglect to distinguish private costs from social costs in explaining their preference for debt-heavy capital structures.

While there are overwhelming costs that excessive bank debt can have on the broader economy, some contend that there may be some benefits from debt for a firm’s corporate governance. In particular, some academics have argued that debt is useful because it “disciplines” bank management. The idea suggests that creditors with hard claims against the firm will monitor the firm to prevent bank management from misusing the free cash flows that the banks’ economic activities generate. If these benefits exist and are substantial, we may face a vexing tradeoff: too much debt creates dramatic social costs, moral hazard, and systemic risk, while too little may have negative consequences for firm governance. The challenge is to find a way of optimizing that tradeoff.

This Article engages that challenge, and introduces a new kind of financial institution – called a Liability Holding Company (LHC) – that appropriately balances the social costs of excessive private leverage with the purported benefits for corporate governance that such leverage might create. Our proposal places an increased liability version of the bank’s equity in a conjoined but separately controlled entity, the LHC, that also owns other assets to which the banks’ liabilities have recourse in the event of failure. The equity shares of the LHC—a holding company subject to a unique regulatory regime supervised by the Federal Reserve, similar to Bank Holding Companies or Financial Holding Companies—are then traded in public markets. The LHC thus aims to eliminate or at least greatly reduce the role of the government as the effective guarantor of the systemically important financial institutions (SIFIs), thus reducing the distortions that current implicit governmental guarantees create. It additionally allows banks the benefits of two boards: an advising board, that the bank managers may appoint, and the monitoring board housed at the LHC, appointed by the LHC’s own public shareholders. This dual board structure resolves some important issues raised in the long-standing debate about the role corporate boards should play. We discuss in detail how this proposal would function within the present legal and regulatory environment—particularly within the contexts of bank regulation, corporate governance, and Dodd-Frank—and address counter-arguments and alternative proposals.

 Saule Omarova (North Carolina) will serve as discussant for the paper.

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This is the fourth installment of a series of previews of the papers being presented at the AALS Financial Institutions & Consumer Financial Services Section meeting this Sunday from 9 am to 10:45 am at the Marriott Wardman Park.

Stavros Gadinis (U.C. Berkeley) has authored the fourth paper that will be presented on Sunday. His work, From Independence to Politics in Banking Regulation (forthcoming in the Duke Law Journal) provides a very insightful empirical study of how lawmakers are responding to the financial crisis. Surprisingly, Gadinis finds across a number of countries, lawmakers are moving away from giving responsibility for bank regulations to independent agencies. Instead, lawmakers are increasingly assigning responsibility to officials subordinate to elected politicians or to politicians themselves.

Here is his abstract:

U.S. financial regulation traditionally relied on independent agencies, such as the Federal Reserve and the FDIC. In the last two decades, countries around the world followed the U.S. example by strengthening the independence of their financial regulators, encouraged by recommendations from international organizations such as the Basel Committee and the IMF. Yet, reforms introduced following the 2007-2008 financial crisis abandon the conventional paradigm of agency independence and allocate authority to officials under the direct control of elected politicians, such as the Secretary of the Treasury. This paper studies reforms in 10 key jurisdictions for international banking. It shows that politicians gained new powers with three distinct features. First, politicians have new authority not only to handle emergencies, but also to oversee banks’ financial condition during regular times of smooth business operation. Second, politicians exercise these powers directly, rather than by delegation to a regulatory bureaucracy. Third, while reforms did not dismantle independent regulators, they require them to work under the leadership of politicians in new systemic oversight arrangements. Whenever reformers established new regulatory bodies or mechanisms, they placed politicians at the helm.

Gadinis’s paper promises to launch a fleet of subsequent scholarship. Beyond the normative/ policy question of whether this shift away from independence is a good development, are interesting questions that would drill down into the data. I would find it surprising that elected officials would assume all these new powers without building in mechanisms to hedge the risk of being blamed for the next crisis.

At the same time, Gadinis is writing at a particularly fertile juncture of financial regulation and administrative law. Some of the influential recent administrative law scholarship in this area has argued that traditional hallmarks to measure agency independence and traditional mechanisms to safeguard that independence need to be rethought, at least in the U.S. context. For example, Lisa Schulz Bressman & Robert Thompson have looked at the nuanced ways in which the President can exercise influence over agencies.   Rachel Barkow has laid out other ways in which agencies can be insulated from capture beyond the traditional mechanisms (which, include taking away the President’s power to fire an agency head and exempting agency regulations from Executive Office cost-benefit review). So we need to pay much more attention to texture and nuance in defining agency independence and serving its underlying goals. Of course, the coding in a comparative empirical study cannot take into account all the differences in institutional environments among numerous countries.

Gadinis’s paper is sure to spark a lively scholarly conversation. Shruti Rana (Maryland) will serve as discussant and be first to engage.

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This is the third installment of a series of previews of the papers being presented at the AALS Financial Institutions & Consumer Financial Services Section meeting this Sunday from 9 am to 10:45 am at the Marriott Wardman Park.

Anita Krug (Univ. of Washington) authored the third paper in our Sunday Panel, Institutionalization, Investment Adviser Regulation, and the Hedge Fund Problem (forthcoming in the Hastings Law Journal).  Professor Krug looks at the regulation of investment advisers, a corner of financial regulation that has mushroomed in importance in practice, but has not enjoyed enough focus in legal scholarship (for one exception, see Laby).

Her paper remedies that and points scholars to securities law beyond the ’33 and ’34 Act. As scholars focus on longstanding debates, high stakes turf wars have erupted in the world of regulatory practice over the boundaries of investment adviser regulation, the regulation of broker-dealers, and hedge fund regulation generally. At the same time Krug’s work fits into a body of work (e.g., Langevoort) that focus on another seismic shift by examining the regulatory consequences of the fact that capital markets investing is now dominated by institutions not retail investors.

Moreover, Krug’s paper fills a scholarly void at the nexus of securities regulation and financial institution regulation and shows the wide scope of the latter. Here is her abstract:

This Article contends that more effective regulation of investment advisers could be achieved by recognizing that the growth of hedge funds, private equity funds, and other private funds in recent decades is a manifestation of institutionalization in the investment advisory context. That is, investment advisers today commonly advise these “institutions,” which have supplanted other, smaller investors as advisory clients. However, the federal securities statute governing investment advisers, the Investment Advisers Act of 1940, does not address the role of private funds as institutions that now intermediate those smaller investors’ relationships to investment advisers. Consistent with that failure, investment adviser regulation regards a private fund, rather than the fund’s investors, as both the “client” of the fund’s adviser and the “thing” to which the adviser owes its obligations. The regulatory stance that the fund is the client, which recent financial regulatory reform did not change, renders the Advisers Act incoherent in its application to investment advisers managing private funds and, more importantly, thwarts the objective behind the Advisers Act: investor protection. This Article shows that policymakers’ focus should be trained primarily on the intermediated investors – those who place their capital in private funds – rather than on the funds themselves and proposes a new approach to investment adviser regulation. In particular, investment advisers to private funds should owe their regulatory obligations not only to the funds they manage but also to the investors in those funds.

We are fortunate to have Kristin Johnson (Seton Hall) act as discussant for this paper.

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This is the second installment of a series of previews of the papers being presented at the AALS Financial Institutions & Consumer Financial Services Section meeting this Sunday from 9 am to 10:45 am at the Marriott Wardman Park.

If the first paper I previewed looks at the challenges of disintermediation and allocating regulatory responsibility, the second paper that will be presented looks at another fundamental question facing financial institution regulation: how can regulation harness market discipline effectively?  Christoph Henkel (Mississippi College School of Law) and Wulf Kaal (Univ. of St. Thomas) take a deep, nuanced look at one approach, contingent capital requirements, in their paper Taking Contingent Capital Seriously – The Prospect of Sequential Triggers in Europe and the United States.  Contingent capital describes debt instruments that would automatically convert into equity upon the occurrence of a trigger event (which might be defined in a regulation).  The trigger would be set to signal the failing health of a financial institution.  Contingent capital provides an additional cushion for failing firms as well as a systemic risk buffer for financial markets.    

Here is Henkel and Kaal’s abstract:

Contingent capital has great potential to help make systemically important financial institutions safer and help avoid another financial crisis. United States policy makers may not have fully utilized the potential of contingent capital. A draft by the EU Commission already suggests the mandatory issuance of contingent capital securities in the resolution phase of systemically important banks in Europe. The Dodd Frank Act mandates a study on the feasibility of contingent capital. This article proposes the use of contingent capital with a sequential trigger as an early preventative tool and as a reorganization tool before liquidation and independent of protection under bankruptcy proceedings. The first preventative trigger would convert a fixed amount of debt to equity at a stage when the institution is still sound on a micro prudential basis, but shows early signs of substantial weakening. The second reorganization trigger would increase voting rights for holders of contingent capital after conversion to equity at the reorganization stage. Sequential triggers could incentivize corrective actions by bank management. The second trigger introduces a quasi preparation stage for bankruptcy, independent of management decisions or corrective action by regulators. The proposal would work seamlessly with the regulatory framework proposed by the EU Commission and could provide U.S. policy makers with a new perspective on the multiple uses of contingent capital in the context of bank restructuring.

Contingent capital has emerged as one of the most innovative potential responses to the financial crisis.  A few years back, Rob Beard blogged at the Conglomerate on CoCo bonds, one version of contingent capital. 

Contingent capital has a long intellectual lineage, including proposals to replace or supplement capital requirements with subordinated debt.  However, the track record in Europe of bank subordinated debt serving as a buffer and early warning system during the crisis was less than stellar. 

One response to this: subordinated debt instruments were poorly designed.  But how should sub debt, contingent capital, or other market discipline instruments be designed?  We need to move beyond the “concept car – looks sexy at the auto fair” phase to doing the safety and road testing to make sure the car doesn’t explode in a turnpike pileup.  Attention to the engineering details is the real strength of the Henkel and Kaal paper. 

Designing these instruments properly is a high stakes job.  The challenge facing market discipline proposals is that we most need them to work when markets go haywire.  This is a challenge, indeed, for all financial institution regulation.

I look forward to hearing Henkel present the paper and to the comments by discussant Mehrsa Baradan (BYU).

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On Sunday, January 8th, the AALS Section on Financial Institutions and Consumer Financial Services will be holding a panel discussing featuring an impressive list of papers selected from an annual Call for Papers. The panel will take place from 9 am to 10:45 am in the Marriott Wardman Park in Maryland Suite B.  It is part of a full weekend of programs by the section, including a Saturday lunch speech by Federal Reserve Governor Sarah Bloom Raskin.

In advance of that panel, let me showcase the papers one by one. (The Conglomerate is all about emphasizing the scholarly aspects of the AALS Annual Meeting.) Each of the four papers deals with a different set of foundational challenges to the regulation of financial institutions. The first paper I will preview looks at three interrelated problems:

• Distintermediation;
• Which regulator should be responsible for consumer/investor protection; and  
• How to allocate regulatory responsibility generally, when innovative financial services do not fit neatly within traditional regulatory silos.

In many ways, the first challenge – disintermediation -- is an echo (an extremely loud one) of an old problem. Starting over 30 years ago the cozy world of depository banking was rocked first by the rise of rival intermediaries – money market mutual funds, deeper bond markets and more sophisticated structured finance, as well as other elements of shadow banking.

Now scholars are looking at another competitive wave coming from radical disintermediation, in which the web facilitates direct connections between lenders and borrowers. This is the subject of the first paper, Regulating On-line Peer-to-Peer Lending in the Aftermath of Dodd-Frank,  by Eric Chaffee (Univ. of Dayton School of Law) and Geoffrey C. Rapp (Univ. of Toledo College of Law). Eric will be presenting the paper, which is forthcoming in the Washington & Lee Law Review. Andrew Verstein (Yale Law School) will serve as discussant. Andrew has also written a fantastic paper on the same topic, The Misregulation of Person-to-Person Lending, which is forthcoming in the U.C. Davis Law Review.  

Chaffee and Rapp outline the business model and current regulatory treatment of peer-to-peer lending, which includes platforms like Prosper Marketplace and Lending Club. They examine how securities laws govern the investment by lenders and banking law regulates the borrower end. The Dodd-Frank Act required the GAO to look at the regulation of p2p lending, and the GAO responded by formulating two alternatives. The first was continued regulation of investors on p2p sites by the SEC and regulation of borrowers by agencies responsible for consumer financial regulation (i.e. the CFPB). The second is assigning regulation to a unified consumer regulator.

In the end, Chaffee and Rapp argue that regulatory heterogeneity is not bad, but actually the way to go. They argue for an “organic” approach to regulating P2P lending, allowing different regulators to govern different aspects of the business. Here is their abstract:

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act called for a government study of the regulatory options for on-line Peer-to-Peer lending. On-line P2P sites, most notably for-profit sites Prosper.com and LendingClub.com, offer individual “investors” the chance to lend funds to individual “borrowers.” The sites promise lower interest rates for borrowers and high rates of return for investors. In addition to the media attention such sites have generated, they also raise significant regulatory concerns on both the state and federal level. The Government Accountability Office report produced in response to the Dodd-Frank Act failed to make a strong recommendation between two primary regulatory options – a multi-faceted regulatory approach in which different federal and state agencies would exercise authority over different aspects of on-line P2P lending, or a single-regulator approach, in which a single agency (most likely the new Consumer Financial Protection Bureau) would be given total regulatory control over on-line P2P lending. After discussing the origins of on-line P2P lending, its particular risks, and its place in the broader context of non-commercial lending, this paper argues in favor of a multi-agency regulatory approach for on-line P2P that mirrors the approach used to regulate traditional lending.

Verstein comes out the other way and argues against SEC regulation of P2P lending and for unified regulation of p2p lending by the CFPB. Here is his abstract:

Amid a financial crisis and credit crunch, retail investors are lending a billion dollars over the Internet, on an unsecured basis, to total strangers. Technological and financial innovation allows person-to-person (“P2P”) lending to connect lenders and borrowers in ways never before imagined. However, all is not well with P2P lending. The SEC threatens the entire industry by asserting jurisdiction with a fundamental misunderstanding of P2P lending. This Article illustrates how the SEC has transformed this industry, making P2P lending less safe and more costly than ever, threatening its very existence. The SEC’s misregulation of P2P lending provides an opportunity to theorize about regulation in a rapidly disintermediating world. The Article then proposes a preferable regulatory scheme designed to preserve and discipline P2P lending’s innovative mix of social finance, microlending, and disintermediation. This proposal consists of regulation by the new Consumer Financial Protection Bureau.

This should be a lively discussion and of interest to our securities law junkies. Disintermediation is of course a topic a challenge for securities regulation generally, as other platforms are linking equity investors and companies seeking capital. Usha has been blogging about Sharespost and friend of the Glom Joan Heminway is working away on disintermediation too, looking at “crowdfunding” from the securities regulation angle (See her working paper here,  see also, among others, Pope )

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Update 12/24:  I wrote this post before I learned that Larry Ribstein had fallen ill two days ago.   Sadly, Larry passed away early this morning,  The University of Illinois press release is here.  

I will always be touched by how generous Larry was as a scholar and a person. He reached out to me at a conference several years ago.  I was dumbfounded that someone of his stature cared about the scholarship of someone just starting out and someone who didn't share his (occasionally strong) views.  I will miss him and know my colleagues here will as well.  

When the shock dulls a little, I will share more memories of Larry.

Just in time for the Holidays, the corporate law blogosphere has all lit up. The less-than-festive occasion: a draft paper by John Coffee (not on ssrrn, but I have a copy), in which Coffee, among other things, criticizes Roberta Romano, Stephen Bainbridge, and Larry Ribstein for being members of academic “Tea Party" that has opposed Sarbanes Oxley and other recent federal corporate law reforms. (Posts by Ribstein, Bainbridge, Bodie, Leiter).

Coffee usually doesn’t stain permanently, I don’t like doing laundry, and I know little about civility.  So I will make a few questions and observation to switch the discussion to a more productive track.  Hopefully, this might focus on some important differences in ideas among a group of scholars who I admire.

The immediate debate about Professor Coffee’s civility is obscuring a big difference between two very different scholarly approaches to the political economy of law and “bubbles.” This is a topic near and dear to me. I’ve written about it before, and am feverishly working to finish a book on the topic before Winter Break ends.

First, two introductory points: One, as I’ve written before, the greatest cost of Sarbanes Oxley and its debate was that it distracted attention from the growing storm of the financial crisis. While scholars and policymakers were debating whether or not that statute was too little, too much, or just right, financial institutions were making decisions that would do far greater and more lasting damage to the competitiveness of U.S. capital markets than anything SOX did.  

Two, I have yet to be convinced that corporate governance was a first order cause of the crisis or that fixing corporate governance should be a first-order response. The crisis was about financial institutions, not corporations generally. Instead of focusing on executive pay at the Caterpillars of the corporate world or the board composition at Google, we should be worried about the leverage of the Bank of Americas and risk concentrations at the BONYs.  Even if corporate governance played a role,it's financial institutions, smarty.

Now onto the main course… I do think there is an important difference in focus between Coffee on the one hand, and Romano, Bainbridge, and Ribstein on the other. The latter group has labeled SOX as an example of mis-regulation after financial crises and asset price bubbles. For example, Ribstein, in an article I enjoyed quite a bit, includes SOX in a history of “bubble laws.”

Even if you disagree with Ribstein, Romano and Bainbridge with respect to SOX, there is a long history of misguided legal responses to financial crises and bubbles. Some of this legal history is downright ugly. For example, the collapse of one of the first stock market bubbles, that of England in the 1690s, led to restriction on the number of Jewish stock brokers in the City of London. (See my article, p. 406, n. 74.) (As a footnote, the infamous “Bubble Act,” by which Parliament imposed legal restrictions on the formation of new joint stock companies, was not technically a response to a collapsed bubble. In fact, it was passed at the urging of insiders of the notorious “South Seas Company” before the collapse of the eponymous bubble. The law was an attempt to prevent competitors from entering English capital markets (see that same paper, p. 408)).

However, the focus on legal reactions in the wake of bubbles is only half the historical and political economy story. The criticism of bubble laws misses the ways in which legal change contributed to the formation of bubbles and financial crises. By legal change, I mean more than just deregulation, but also under-enforcement of laws and, in many cases, government subsidization of booming asset markets.

One way governments provide these subsidies is by granting legal monopolies to certain investment ventures. These monopolies are intended stimulate financial investment, foreign trade or the development of certain industries. In my book, I am tracing this practice from the royal charters in the South Seas and French Mississippi bubbles all the way to Freddie and Fannie in the present day. Corporate governance can and has been a part of the bubbles, just not in the way the SOX debate suggests. Indeed, it can be helpful in looking at history to see corporate law as an important tool (albeit a crude one, often used to dangerous effect) in the greater set of financial market regulations. Corporate law and corporate monopolies have been used to stimulate markets. The problem is that it is hard to pull away the punch when the party gets rockin’.

The focus on bubble laws misses the contribution of laws to bubble formation. By contrast, Coffee, in the disputed paper, provides an analysis of the political economy of financial regulation pre-crisis. However, his analysis is too spare. It focuses on Mancur Olson’s writings and leaves out the broader spectrum of theories – public choice and otherwise – that attempt to explain regulation and deregulation of financial markets and otherwise. It also misses the fact that law and regulation can stimulate markets beyond just deregulation and rollback. I argue that governments also subsidize have a history and incentive to provide excessive subsidies to particular financial markets, through corporate law and otherwise.

Coffee seems to miss the government subsidy story and the potential for misregulation.  By contrast, Romano and Ribstein focus on the risk of legal overreaction to bubbles, but do not focus on the perverse political incentives to deregulate or stimulate financial markets during boom times.  

I’ll save my analysis of this political economy of law and bubbles for another day. The story or regulation and bubbles I am writing doesn’t fit into neat political boxes in which de-regulation or re-regulation alone is to blame. Like cloying good cheer at this wintry time of year, there is plenty of blame to go around and provoke (if not inflame).

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In the wake of the recent financial crisis, I’ve been pondering the role of courts in the formation and execution of corporate financial law and policy. My focus quickly shifts to a predicate question: How do courts currently handle controversies relating to complex corporate financial arrangements? And what can we learn from judicial action and inaction in this realm?

My Article, Confronting the Certainty Imperative in Corporate Finance Jurisprudence (forthcoming in the Utah Law Review), explores the (seemingly nonexistent) role of the judiciary in shaping corporate financial law. Analyzing finance and lending jurisprudence, including cases in the related areas of consumer finance and public finance, I discover a judicial narrative of restraint, deference and abstention.

In particular, the dominant judicial decision-making paradigm in lending and finance asserts that stable financial markets require an environment of “legal certainty,” which is achieved when courts exercise considerable restraint. In disputes that stem from private financial agreements, courts show restraint by narrowly tailoring opinions to strict construction and passive enforcement of underlying contracts, and by declining to extend common law doctrines.

I call this paradigm the “Certainty Imperative.” I trace the Imperative to decisions rendered in the wake of the economic instability of the late 1970s and early 1980s, and I find that the paradigm continues to dominate finance and lending jurisprudence to this day. In fact, it has been bolstered by state and federal statutes that further constrain judicial decision-making in the corporate financing realm.

Ostensibly a creature of neoclassical economic theory, the Imperative infuses the specific goal of stability in financial markets into the broader and more deeply entrenched normative theme of legal certainty. The Imperative is rooted in the belief that financial markets are vital to the national interest, and that judges ought to decide cases in this realm in a manner that advances broad economic efficiency goals. What is more, the Imperative reflects the neoclassical conviction that markets are inherently stable in the absence of governmental intervention (including via judicial decision).

Imperative-abiding courts invoke forceful language, expressing fear that a decision might “throw credit markets into confusion and destabilize this area of law,” Smith v. Anderson, 801 F.2d 661, 665 (4th Cir. 1986), or “disrupt orderly credit markets.” Algemene Bank Nederland v. Hallwood Indus., 133 B.R. 176, 180-81 (W.D. Pa. 1991). The Fourth Circuit went so far as to suggest a slippery slope, whereby a ruling adverse to the expectations of lenders might send tremors through the industry, causing “untold and unknown consequences that cannot now be fully foreseen,” “undefinable instability” and even “widespread confusion.” Cetto v. LaSalle Bank Nat’l Ass’n, 518 F.3d 263, 277 (4th Cir. 2008). Other times, courts express this Imperative in vague terms, as if to imply some universal understanding that markets are profoundly sensitive to judicial decisions that modify existing law. For instance, courts have referred to undefined “ripple effects,” Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 189 (1994), and the simply-stated policy concern: “credit markets may be affected.” In re Fracasso, 210 B.R. 221, 228 (Bankr. D. Mass. 1997).

Generally focused on the needs of financial institutions rather than borrowers, the Imperative promotes bright-line rules that provide “all prospective lenders the certainty that is so important to the effective operation of markets,” In re Bulson, 327 B.R. 830, 845 (Bankr. W.D. Mich. 2005), or that deliver “guiding principle[s] for those whose daily activities must be limited and instructed” by laws governing commercial transactions. Dirks v. S.E.C., 463 U.S. 646, 664 (1983). The theme is often invoked as a rationale for maintaining the legal status quo, as courts lament a seemingly inequitable outcome under current law, but decline to engage in legal reform out of concern that any deviation from the expectations of lenders might disrupt financial markets.

When we consider this judicial narrative in its historical context, the Imperative seems not to be a reasoned legal philosophy, but rather a consequence of a shaken economy and a loose synthesis of emerging academic theories that seemed to offer new direction for maintaining financial market stability.

In my opinion, if courts are to assume a meaningful role in financial law reform, the Imperative must be confronted and overcome. The dominant paradigm heavily privileges the legal status quo, and its methodological constraints are a paralyzing force on the judiciary. The Article provides an in-depth critique of the Imperative’s strict interpretive norms, and suggests several possibilities for expanding the scope of judicial inquiries in the corporate financing realm.

I welcome your comments, questions and reactions!

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Please see the following announcement of a panel from Michael Malloy of McGeorge School of Law.  The timing is scheduled around the AALS Annual Meeting in January in Washington, D.C.:

On Wednesday, 4 January 2012, the Society of Socio-Economists will hold its Annual Meeting in Washington, DC (room assignments TBA). The preliminary program, Socio-Economics in the Academy and the Economy, includes a Roundtable discussion from 1:30 to 3:00 p.m. entitled Permeable Economies, Not Globalized Economy: The Situation and Performance of Financial Services Markets. As moderator of the Roundtable, I am inviting you to participate, either as a presenter, commentator, or general participant. We hope that all interested views will contribute to the flow of discussion and the proceedings that will result. The discussion will launch from the following resolution:

Resolved, that the ongoing financial crisis results from the asymmetrical interactions of separate but permeable economies, rather than from the workings of a “globalized” economy.

Background Statement: Reflecting upon the initial series of collapses in capital and financial services markets in 2008, and the recent failure of MF Global, many commentators begin with the assumption that these phenomena are the natural result of a globalized economy. However, this view would appear to ignore the fact that financial services markets, in their regulatory structure and in much of their retail operation, remain intensely national or even local in character. Should it make a difference to our understanding of – and to the appropriate responses to – the ongoing crisis if it is the result of the interaction of permeable national economies?

Please RSVP by email to malloympm@aol.com and indicate whether you would like to be:  

•  
  •  
    • a presenter (with a five- to ten-minute statement of position),
    • a commentator (pre-assigned to a particular presentation), or
    • a general participant (speaking quod lib. during the general discussion).

Organization of the Roundtable in terms of selected presenters and commentators will be announced no later than 30 November 2011. Further details will be provided in advance of the Roundtable. We are looking forward to a vigorous discussion!

With best regards,

Michael P. Malloy

Distinguished Professor and Scholar

McGeorge School of Law University of the Pacific

malloympm@aol.com

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Note that the earlybird deadline for registering for the AALS Annual Meeting is coming up next week.

The AALS Section on Financial Institutions & Consumer Financial Services has put together a great program this year:

 Sat. Jan. 7, 10:30 am-12:15 pm: Reviving Financial Institutions [Program # 6220]

Panelists:

• Jill E. Fisch, University of Pennsylvania Law School
• Howell E. Jackson, Harvard Law School
• Kimberly D. Krawiec, Duke University School of Law
• Patricia A. McCoy, University of Connecticut School of Law (currently on leave at the Consumer Financial Protection Bureau)
• Katharina Pistor, Columbia Law School
• Annelise Riles, Cornell University Law School
• Peter Conti-Brown, Stanford Law School

Moderator: Anna Gelpern, American University Washington College of Law

This panel is part of a project to engage the legal academy in sustained theoretical and policy contributions to the regulation of financial institutions. We will step back from the daily news of reform to analyze the functions of today's financial institutions, revisiting the rationale for their regulation: what they do for their immediate constituents (debtors, creditors, shareholders) and for the economy as a whole (savings intermediation, liquidity, monetary policy transmission), as well as the risks they present. As we put the evolving U.S. regime in historical and comparative perspective, we will consider whether the focus on institutions detracts from regulating instruments, markets, economic functions and risks--and how to reconcile the proliferating regulatory objectives.

Sat. Jan. 7, 12:15-1:30 pm: Section Lunch [Program # 1425]

[The section has a fantastic lunch time speaker.  I will announce the name in the blog as soon as I am allowed.] 

Sun. Jan 8, 9:00-10:45 am: Rubber Hits Road: Implementing Dodd-Frank amid Reform Fatigue (Call for Papers) [Program # 7060]

Authors will explore the state of financial reform implementation in a still-weak national and global economy, against reform fatigue, polarization, and the risks of regulatory capture. Among other topics, the papers address the challenges inherent in moving from the legislative to the administrative realm, meshing domestic, regional, and international initiatives, and institutional design for markets and regulation. The session is an opportunity to look at specific rulemakings in detail, as well as to address larger questions about the course of reform after laws are made.

• Eric Chaffee (Univ. of Dayton School of Law) & Geoffrey C. Rapp (Univ. of Toledo College of Law), Regulating On-line Peer-to-Peer Lending in the Aftermath of Dodd-Frank                           
  • Discussant: Andrew Verstein (Yale Law School)
• Stavros Gadinis (U.C. Berkeley School of Law), From Independence to Politics in Banking Regulation
  • Discussant: Shruti Rana (Univ. of Maryland School of Law)
• Wulf A. Kaal (Univ. of St. Thomas School of Law) & Christoph Henkel (Mississippi College School of Law), Sequential Contingent Capital Triggers in Europe and the United States                                    
  • Discussant: Mehrsa Baradaran (BYU Law School)
• Anita K. Krug (Univ. of Washington School or Law), Institutionalization, Investment Adviser Regulation, and the Hedge Fund Problem                                                                                           
  • Discussant: Kristin N. Johnson (Seton Hall Univ. School of Law)

Moderator: Heidi Mandanis Schooner (Columbus School of Law, Catholic Univ. of America).

 i will be blogging more about these papers later.

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The semester is waning.  I've been traveling. It's a busy time.  Still, I've read Peter's posts with interest and, time and again, been tempted to put fingers to keyboard to write on the general topic that he's explored so fruitfully in law reviews and blog posts: happiness research.

I've had 2 children in the past 4.5 years, so take this with some salinity: I think happiness research has been the academic development that's had the most impact on me personally in the recent past.  I mean, I love the corporate law and securities, don't get me wrong.  But hedonics: what makes me happy as a person?  A short commute over long commute makes people markedly more happy.  People with children say that kids make them happy, but day-to-day kids make you unhappier than being without.  Are single people happier than married people?  Does the memory of vacation give you more pleasure than the vacation itself?  I find it all fascinating and it shapes my daily choices and reaffirms (or causes me to question) my life choices.  Happiness research goes to the core of myself as a person.

Still  I wonder: what does this have to do with law?  Which is the challenge Peter seems to issue, backhandedly, in his post.  I don't know that I'm afraid of law and emotions: I just don't see the academic implications of an admittedly fascinating field of research.  Cue Abrams and Keren, who say 

[Mainstream legal academics ] have not predictably viewed it as a resource for addressing questions within their substantive fields; it is often treated as a novel academic pastime rather than an instrument for addressing practical problems. This reception contrasts sharply with that accorded to two fields that have also challenged dominant notions of (legal) rationality: behavioral law and economics, and the emerging field of law and neuroscience....

Notwithstanding the breadth of its epistemological challenges, law and emotions scholarship can contribute to the familiar normative work of the law—revising and strengthening existing doctrine, improving decisionmaking, and informing new legal policies. Moreover, it can facilitate the less familiar but nevertheless valuable task of using law to improve people’s affective lives. 

I don't know.  The studies Peter cites about emotion governing financial markets sounds fascinating and worth reading.  What's the legal payoff, though?  I get that, over time, $6000 spent on a trip to Europe will give me more pleasure than spending $6,000 on a more expensive car.  That's useful information to me (although admittedly it just reinforces my prior inclinations).  But legal implications?  

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Outrage over Bank of America's proposal to charge a monthly fee for debit cards has not abated, even though the bank has backed down on making the change.  A social media protest to encourage customers to move funds from Bank of America (and other national banks) to credit unions has gained steam.  Organizers have named tomorrow, November 5th, "Dump Your Bank Day" (evidently, the "V is for Vendetta" film has staying power and revived popular American interest in Guy Fawkes).

This raises two empirical questions.  First, do credit unions treat their customers any better?  A great recent paper by Ryan Bubb (NYU Law) and Alex Kaufman both suggests that they do and explains why.  The paper provides both a model and empirical evidence that explain how the ownership structure of credit unions reduces the incentive for these lenders to extract hidden fees from their customers compared to for-profit, shareholder-owned banks.  (Note that this paper was written long before the "Dump Your Bank" protest started and does not endorse this movement).  Here is the abstract:

In this paper we show how ownership of the firm by its customers, as well as nonprofit status, can prevent the firm from exploiting consumer biases. By eliminating an outside residual claimant with control over the firm, these alternatives to investor ownership reduce the incentive of the firm to offer contractual terms that exploit the mistakes consumers make. However, customers who are unaware of their problems making good decisions, and consequent vulnerability to exploitation, may fail to recognize this advantage of non-investor-owned firms and instead continue to patronize investor-owned firms. We present evidence from the consumer financial services market that supports our theory. Comparing contract terms, we find that mutually owned firms offer lower penalties, such as default interest rates, and higher up-front prices, such as introductory interest rates, than do investor-owned firms. However, consumers most vulnerable to these penalties are no more likely to use mutually owned firms.

Ryan presented the paper at a workshop here in Colorado over the summer.  One of the questions I had then was why credit unions can't win customers by sending a credible signal that, to put it colloquially, "we'll screw you less."  This Bank of America episode provides an interesting answer that perhaps customers are starting to recognize hidden fees and market choices.

A second question is whether this protest will hurt Bank of America and other national banks?  There are historical antecedents for this movement.  In the 1960s, protestors tried to start bank runs with calls for depositors to withdraw all funds from banks and then re-deposit them.  I'm not aware that any banks suffered as a result. 

There is a possibility that this current protest may actually help banks somewhat.  There have been plenty of news stories of banks complaining about excess deposits.  Some banks have mulled charging fees for large corporate customers and large deposits.  Still, I would be surprised if BofA welcomed this protest, just as I would be surprised if the protest inflicted more than p.r. damage on BofA.

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Many thanks to Eric and fellow Glom bloggers for this real option to contribute some guest posts. I’ll focus in these posts on how these three areas relate to business, law, economics, and society:

1)   Recent empirical and experimental research by economists, psychologists, and others about happiness, also known as SWB (Subjective Well-Being).

2)   Popular culture portrayals of the great recession, e.g. the movie Margin Call,

(Note: in the interests of full disclosure this film does not involve any margin calls).

3)   Ethics and professionalism in business and law.

First, today’s post is an enthusiastic and whole-hearted endorsement of a new book from 2002 economics Nobel Laureate, Danny Kahneman: Thinking, Fast and Slow, just published last Tuesday.

Kahneman's book is a fascinating intellectual memoir by the co-creator (with his frequent co-author Amos Tversky) of prospect theory, pioneer of much of behavioral economics and behavioral finance, and most recently a leader in SWB research. His book provides a delicious buffet of food for thought about thinking from a Jedi master in how to think appropriately. As with all great books, this one is not only informative, but also transformative.

Kahneman is of course familiar or should be so to law professors because many scholars in behavioral law and economics have widely applied and cited Kahneman’s fundamental research on cognitive biases and heuristics in order to intellectually justify increased regulatory intervention. It is on the basis of this research that such well-known legal scholars as Chris Guthrie, Samuel Issacharoff, Christine Jolls, Jeff Rachlinksi, and Cass Sunstein among others advocate various types of paternalism (including asymmetric, libertarian, and weak).

The objective that Kahneman states and succeeds at in his book is to provide a more accurate, richer language (of diagnostic labels much like those from the scenes of differential diagnosis in the television series House)

to help all of us better identify, understand, and improve poor choice and judgment by others and ourselves. Recall the scene from the film, Indiana Jones and the Last Crusade, in which after a Nazi ages to death in mere seconds, the holy grail knight observes: “He chose … poorly.” 

After a delightful personal history of science introduction, Kahneman divides his book into these five parts. Part 1 offers insights on two systems of thinking, processing information, judging, and choosing. System one type of reasoning is affective, associative, automatic, fast, habitual, heuristic-based, holistic, intuitive, and unconscious. System two kind of reasoning is analytical, cognitive, conscious, controlled, deliberative, effortful, logical, rule-based, and slow. Part 2 explains why people are able to think analogically, associatively, causally, and metaphorically, but have difficulties in thinking statistically. Part 3 analyzes overconfidence in understanding events and underestimation of chance’s role in explaining things. Part 4 is an engagement of and essential challenge to rationality assumptions classical economics a la the University of Chicago school privileges. Part 5 introduces a riddle of two selves with divergent goals: an experiencing self and a remembering self. There is a final chapter that investigates the consequences of the three dichotomies that the book detailed: system 1 versus system 2, behavioral versus classical economic views of agent rationality, and our experiences versus memories. Finally, two seminal articles by Kahneman and Tversky are reproduced in appendices.

Analyzing the many implications of this book for business and law could easily take several fun lifetimes. In a later post, I’ll focus on when law and policy should care more about our experiences than our memories of them.

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