As in a bad horror movie (or a great Rolling Stones song), observers of the current crisis may have been disquieted that one of the central characters in this disaster also played a central role in the Enron era. Is it coincidence that special purpose entities (SPEs) were at the core of both the Enron transactions and many of the structured finance deals that fell part in the Panic of 2007-2008?
Bill Bratton (Penn) and Adam Levitin (Georgetown) think not. Bratton and Levin have a really fine new paper out, A Transactional Genealogy of Scandal, that not only draws deep connections between these two episodes, but also traces back the lineage of collateralized debt obligations (CDOs) back to Michael Millken. The paper provides a masterful guided tour of the history of CDOs from the S&L/junk bond era to the innovations of J.P. Morgan through to the Goldman ABACUS deals and the freeze of the asset-backed commercial paper market .
Their account argues that the development of the SPE is the apotheosis of the firm as “nexus of contracts.” These shell companies, after all, are nothing but contracts. This feature, according to Bratton & Levin, allows SPEs to become ideal tools either for deceiving investors or arbitraging financial regulations.
Here is their abstract:
Three scandals have fundamentally reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together — a deal structure known as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit.
The SPE remains mysterious and poorly understood, despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through pre-set instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality.
When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and the SPE’s economic reality. The standard legal model looks to equity ownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firm connections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equity ownership.
The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory is emerging, not from corporate law or financial economics but from accounting principles. Accounting has responded to these scandals by abandoning the equity touchstone in favor of an analysis in which contractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, and approach that redraws the boundaries of the firm. Transaction engineers need to come to terms with this new functional model as it could herald unexpected liability, as Goldman Sachs learned with its Abacus CDO.
The paper should be on the reading list of scholars in securities and financial institution regulation. The historical account also provides a rich source of material for corporate law scholars engaged in the Theory of the Firm literature.
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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.
Last week I posted the first of a three-part series on my new article with Mike Stegemoller on SPACs. In this post I'll discuss our second finding, which relates to underwriter discounts, or the gross spread. In a normal IPO, the nominal way an underwriting bank makes money is by buying stock from the company at a discount, and then turning around and selling it to the public at full price. The difference, or "spread" between the purchase price and the sale price, is the investment bank's official compensation for bringing the fledgling firm to market. Some scholars would point to underpricing--and the banks' corresponding ability to curry favor with client--as the true compensation for underwriting, but we covered underpricing last week.
What do underwriters do to earn their discount? Well, they expend a lot of effort trying to value the firm correctly (I'm looking at you, Morgan Stanley), because in a firm-commitment offering they take on the "risk" that they won't be able to unload the shares they buy from the company and offer to the public. "Risk" is in quotation marks because the underwriters build a "book" of pre-sale offers of interest, and generally won't agree to take the firm public without being sure all of its shares will sell. The underwriter does face a real risk of liability for false statements in the offering documents, however, and the spread may also compensate the bankers for this risk.
A curious fact about traditional U.S. IPOs is that the gross spread is sticky--underwriters almost always buy company shares at a 7% discount, as documented in this fabulously named Chen Ritter paper, shouting out to Sherlock Holmes, no less. As Chen & Ritter, describe, the clustering of spreads around 7% is 1) a relatively recent phenomenon, 2) specific to the U.S., and 3) roughly twice as high as in other countries.1
Suspicious. After all, shouldn't some firms be riskier to underwrite than others, and thus command a higher spread? And others by the same token be surer bets, with a correspondingly smaller spread? Chen and Ritter conclude that most spreads for firms over $30 million are above competitive levels and discuss explanations ranging from implicit or explicit collusion to reducing underpricing.
SPACs, essentially piles of cash, should be easier to value than the typical company. The information asymmetries that characterize the average company just aren't there. Moreover, bookbuilding should be an easier process because there isn't much of a "story" needed to persuade potential customers to buy. By the same token, SPACs should be less risky to underwrite, since the trust fund creates a floor price below which the stock should not drop. As a shell company, disclosures are boilerplate and close to risk-free for the underwriter. So we hypothesize that the spread should be lower than 7%.
Yet the mean and median underwriting discount for our sample is 7%. We argue this offers further evidence that spreads are above competitive levels. Moreover, as the SPAC form evolved, investment banks began to accept a portion of the spread as deferred compensation. Meaning that the nominal discount remained 7%, but some of that cash was tied up in escrow, and only released to the bank if and when a subsequent acquisition occurred. The fact that the SPAC underwriting discount initially clustered around 7%, but all of the banks quickly proved willing to sacrifice nearly half of their compensation, without demanding any increase in overall spread as compensation for the delay in payment, is further evidence that a 7% spread is not the product of a competitive market. In other words, if competition is fierce enough, underwriters can apparently operate at spread levels much lower than 7%.
That sticky 7% is looking curiouser and curiouser...
1 The Chen Ritter study is from 2000, but Abrahamson, Jenkinson, and Jones (2011) confirm their findings.
And now for a little law professor inside baseball. For personal reasons I have found myself enveloped in the August submission cycle, which is a little more mysterious than the spring. Be that as it may, I have been quite pleased with the offers that have come in, and should reach a final decision soon.
There's been blogosphere buzz about a new entrant to the submissions business, long dominated by ExpressO. Being old enough to remember the pain of submitting articles via snail mail (mail merge, anyone?), I have found ExpressO a pure delight, offering easy quick electronic service at negligible cost. The new kid on the block is Scholastica, and it scored a coup by nabbing the California Law Review and the Chicago Law Review as early adopters. See blog posts from Dan Filler at the Faculty Lounge,Gerard Magliocca at ConOp, and Jesse Hill at Prawfs. In a comment to the last post, a founder of Scholastica writes:
Scholastica provides powerful software that goes beyond ExpressO's submission/distribution service, all at no additional charge to the journal – so journals of all sizes/rankings can easily have software to make the start-to-finish journal management process easier.
Journals using Scholastica get more than just article submission; they get an entire platform for efficiently running their journal, from submissions to reviews to decisions to copyediting to publishing – again, at no charge to the journal. We also give law reviews flexibility to be part of the standard law review submission pool or they can operate as a standalone single/double blind peer reviewed journal. They can also publish open-access content online with just a few clicks.
Hmm, appealing to the law reviews as a kind of one-stop shop? It will be interesting to see how this market shake-up plays out. I offer but one small insight from a new customer.
Professors who play the game know that myriad rejections are one price of admission. Even articles that wind up at the likes of Harvard Law Review garner, through the natural course of things, dozens of rejection emails. The wording of these emails varies, but they share a few points in common:
1. Thank you for your submission.
2. Each year we receive thousands of articles and can only select a few for publication.
3. After careful consideration, we have decided we cannot accept your article.
4. We hope you will consider us for submissions in the future.
Here was the email I received from the Chicago Law Review via Scholastica:
Think of the roller coaster of emotions. First, the email's subject line creates a sense of anticipation: oooo, a decision has been reached! What will it be? And then, upon opening the email in question, harsh reality, in 2 terse, bolded words. Decision: Reject.
What do you think? Admirably to-the-point? Unduly harsh for the tender of ego, particularly the young assistant prof or prof-wannabe?
The more I look at the email the funnier it gets.
Call for Papers
AALS Joint Program of the Securities Regulation Section and
Financial Institutions & Consumer Financial Services Section
The Regulation of Financial Market Intermediaries:
The Making and Un-Making of Markets
AALS Annual Meeting, January 4, 2013
The AALS Section on Securities Regulation and the Section of Financial Institutions & Consumer Financial Services are pleased to announce that they are sponsoring a Call for Papers for their joint program on Friday, January 4th at the AALS 2013 Annual Meeting in New Orleans, Louisiana.
The topic of the program and call for papers is “The Regulation of Financial Market Intermediaries: The Making and Un-Making of Markets.” The financial crisis witnessed numerous market failures involving an array of financial market intermediaries, including banks, broker dealers, and various kinds of investment funds (from money market mutual funds to hedge funds). The crisis came at the end of a decades-long transformation of the U.S. financial services sector that blurred the boundaries between banking and securities businesses. During this period a range of new intermediaries emerged and connected individuals and firms seeking financing to investors in capital markets. At the same time, capital markets became increasingly dominated by financial institutions and other institutional investors. Intermediaries devised and “made markets” for new and often highly illiquid and opaque financial instruments. Many of these new markets froze or crashed in the financial crisis. In response, Dodd-Frank and other financial reforms have imposed a grab bag of new rules on financial intermediaries.
Yet the effects of these financial reforms remain unclear. Moreover, policymakers and scholars often disagree about the precise problems that these reforms are meant to address. For example, the SEC’s headline-grabbing suit against Goldman Sachs over the ABACUS transactions focused on conflicts of interest for large financial conglomerates with different stakes in a transaction. Meanwhile, other financial reforms have focused on the opacity of pricing in financial markets or on the solvency or liquidity risk faced by intermediaries.
The tangle of potential market failures has led to a range of policy responses. Often banking and securities scholars seem to look at the same set of market practices through radically different lenses. Banking scholars focus on solvency crises and banking runs and debate the application of prudential rules on the risk-taking, leverage, and liquidity of intermediaries. At the same time, securities scholars emphasize the problems of conflicts of interest and asymmetric information. They then look to the traditional policy tools in their field such as disclosure, fiduciary duties, and corporate governance.
The dearth of dialogue between these two fields creates the risk of confusion in identifying both problems and solutions for financial intermediaries and the markets in which they operate. To move the discussion forward, scholars in both fields may have to move outside their comfort zones. The study of financial institutions cannot be limited to deposit-taking banks. Similarly, securities regulation involves more than securities offerings and litigation, but the regulation of broker-dealers, investment advisers and funds, and the regulation of trading and markets.
Form and length of submission
The submissions committee looks forward to reviewing any papers that address the foregoing topics. Abstracts should be comprehensive enough to allow the review committee to meaningfully evaluate the aims and likely content of papers they propose. Eligible law faculty are invited to submit manuscripts or abstracts dealing with any aspect of the foregoing topics. Untenured faculty members are particularly encouraged to submit manuscripts or abstracts.
The initial review of the papers will be blind. Accordingly the author should submit a cover letter with the paper. However, the paper itself, including the title page and footnotes must not contain any references identifying the author or the author’s school. The submitting author is responsible for taking any steps necessary to redact self-identifying text or footnotes.
Papers may be accepted for publication but must not be published prior to the Annual Meeting.
Deadline and submission method
To be considered, papers must be submitted electronically to Erik Gerding at email@example.com. The deadline for submission is August 10, 2012.
Papers will be selected after review by members of a Committee appointed by the Chairs of the two sections. The authors of the selected papers will be notified by September 30, 2012.
The Call for Paper participants will be responsible for paying their annual meeting registration fee and travel expenses.
Full-time faculty members of AALS member law schools are eligible to submit papers. The following are ineligible to submit: foreign, visiting (without a full-time position at an AALS member law school) and adjunct faculty members, graduate students, fellows, non-law school faculty, and faculty at fee-paid non-member schools.
Please forward this Call for Papers to any eligible faculty who might be interested.
In addition to blogging about social enterprise, I plan to blog a bit about being a new law professor. To start, I decided to interview (via e-mail) my friend Sabrina Ursaner about something important to law professors – the law review submission process. The focus will be on the article selection process of corporate law specialty journals, though much of Sabrina's advice can be applied more broadly.
Currently, Sabrina is an M&A associate at Davis Polk & Wardwell. She also clerked for former-Chancellor William B. Chandler III of the Delaware Court of Chancery. I met Sabrina when I was clerking for former-Vice Chancellor Stephen P. Lamb and she was an intern for the court.
Sabrina was the Editor-in-Chief of the NYU Journal of Law & Business from 2009-2010 and was actively involved in the article selection process. My interview mimics, in some respects, the helpful series of posts/interviews on PrawfsBlawg by Professor Shima Baradaran. Despite the wealth of information on PrawfsBlawg, I thought that Sabrina’s advice might be of interest to Glom readers because corporate law specialty journals do some things differently than generalist journals.
The interview is below the fold.
1. Please provide the readers with a brief description of the NYU Journal of Law & Business (“JLB”).
The JLB is a specialty journal at NYU focusing on law and business, as its title suggests. The journal has two main functions: (1) it publishes 2 issues a year – generally one fall issue around November/December and one spring or summer issue depending on the publication schedule that year, and (2) it holds an annual symposium in January and publishes edited transcripts of the symposium proceedings in the spring/summer issue.
Each issue contains academic articles (written by law professors), practitioner pieces (written by practicing lawyers, whether in private practice, government, etc.), and student notes (written by JLB students who participate in the journal’s note-writing program). The juxtaposition of academic pieces with practitioner pieces helps keep the JLB at the cutting edge of law and business, and focused on issues that are not only interesting areas of the law, but hot topics that are evolving today.
Also, while the JLB is student-run, I would be remiss if I didn’t mention our fantastic faculty advisors, including former-Chancellor William Allen and Professor Marcel Kahan, whose advice and support have helped make the journal what it is today. In addition, Dean Revesz and the NYU Law administration are extremely supportive of all of the Law School's journals, providing funding, space for events, publicity, encouragement, and more.
2. Please briefly explain the JLB’s law review article submission process.
The JLB takes a somewhat more pragmatic and flexible approach to the review process than what I’ve heard about some law review selection processes. The JLB board has four executive editors: academic articles, practitioner notes, submissions and selection, and student notes. All four of them, plus the EIC, receive Expresso emails and submissions that go to the firstname.lastname@example.org address. Often practitioner pieces don’t come through the usual channels, but somehow they need to get into the hands of those five (the EIC and the four executive editors). Generally each executive editor is responsible for managing the review process for his “type” of article, and the “submissions and selection” editor keeps track of submissions and offers and generally helps out with the review process. The EIC plus the four executive editors essentially make up the entire review committee. If any of the five likes an article, that person forwards it to the others to review. If an additional person likes it but the group is on the fence, the article is assigned to a committee to read. A committee read may not be necessary if the EIC and executive editors are all in agreement and feel strongly that they want to make an offer. The process can range from a few days or less to several weeks depending on the article.
3. I see your submission deadlines are 9/15 and 1/15 for your two issues, when is the ideal time of the year to submit to JLB?
Those aren’t hard deadlines. The dates are actually pretty flexible (particularly the 1/15 deadline for the spring issue), but it is certainly true that most of the fall articles are selected before 9/15. The typical March submission flood is generally where we fill our fall issue (the academic articles at least). Because the JLB focuses on timely pieces that often relate to recent cases or regulatory events (i.e. the Volcker rule, recent Delaware rulings by the Court of Chancery that may be on appeal), it often makes sense for us to wait until a bit later in the summer to fill the fall issue, but we try to get at least a few articles nailed down from the March submissions. I think the best time to submit is late March or April, but I’d say really anytime through June or even early July is still worth a shot. For the spring/summer issue, articles are accepted all fall, but there are often last minute opportunities so unlike typical law reviews that have a set number of articles, it’s worth contacting the editors to see if the issues are full.
4. Approximately how many submissions does your journal receive each year? Approximately how many offers are given?
In the last 4 years, we have received approximately 400-500 submissions each year, and we’ve made offers to approximately 2-5% of those. Those are generally unsolicited submissions from ExpressO and sent to the submissions email address.
We also directly solicit some of the articles we publish (particularly the practitioner pieces – i.e., if we see a recent client memo or blog post that seems interesting, we may contact the author and ask if they are interested in turning it into a short article or piece for the JLB). For example, Bradley Sabel and Gregg Rozansky published an article based in part on client memoranda about the Volcker Rule, and Francis Pileggi and Kevin Brady published an article based on a few of their “Key Delaware Corporate and Commercial Decisions” blog posts.
5. How important is the cover letter/CV and how can a candidate help his or her chances through the cover letter/CV?
Extremely important – the cover letter is literally the most important part of the submission, because with a weak or poorly written cover letter, your article probably will not be seen. Interestingly, I saw an interview with a past EIC of Stanford Law Review who mentioned that their committee’s review process is blind. The JLB’s process is quite the opposite – it is clear from ExpressO and email submissions who the author is, and the CV and cover letter were always the first thing we opened. They gave a glimpse into the article and often were what caught our attention to focus on a particular article. In addition, if we didn’t know the author submitting the paper, the CV gave us quick insight into their career and past publications.
6. What did you look for in an article and author?
Personally, the very first thing I looked for was a good title – usually because it was in the subject of the email. A good title could make a submission jump to the top of my reading list in an otherwise full email inbox.
Cover letter is next. I read every single cover letter that was submitted. That is your one page chance to quickly summarize the article in a sentence or two, explain why would it be a good fit for the JLB, and tell us why we should publish it. Some cover letters went out of their way to explain why they thought a specialty journal was a good fit, and even personalized it to the JLB – that’s a great move. Some had obvious typos and seemed to have been thrown together hastily – even if your article is amazing, that’s a surefire way not to get it seen.
Substantively, what do we look for in articles? Interesting, relevant topics. Recent developments in Delaware case law. Hot issues in corporate governance. Deal trends in the M&A world. Cross-border issues. Federal securities law. SEC and financial crisis-related rulemaking. The list goes on.
As far as the writing, once you make it past that initial screening (topic, cover letter, etc.), we basically looked for articles that we could comfortably work with. Here’s an example of what I mean by that – the footnotes don’t have to be perfect (that’s what the cite-checking process is for), there is no drop-dead length that is too short or too long, and we expect to see at least a few substantive issues that we would want to work through with the author. But on the whole, we are fairly deferential on substance and author writing preferences/style, so while we do give substantive and big picture edits in addition to line edits, the writing has to be such that it would not require a significant reworking of the article before we would be happy publishing it.
7. What are some of the shortcuts used to identify good articles?
One quick shortcut for me was when we received a request for expedited review because the article had received an offer from another journal. Bare requests for expedition generally didn’t help (i.e., just saying that you have another offer). If, however, the expedition request specified that the article had received an offer from one of our peer or competitive journals (i.e., a different business journal), we generally would immediately skim it and decide whether it was worth sending to committee read or whether we wanted to make an offer. I always carefully reviewed articles that had received offers from the Delaware Journal of Corporate Law, the U. Penn. Journal of Business Law, Columbia Business Law Review, and a number of other corporate and business journals (U.C. Davis, Northwestern, several others that I’m sure I’m forgetting here…).
8. How did law professor blogging factor into your decision making process, if at all?
I would say that law prof blogging does factor into the decision-making process, and that a blogging presence definitely helps. For example, you asked about shortcuts we use to identify good articles – one easy shortcut is if we already know the author and are familiar with his/her writing and topics of interest.
Actually, I have a funny story about this that relates to one of the Conglomerate bloggers! The year I was EIC, we received a submission from Afra Afsharipour. I believe she was guest blogging on the Glom at the time, and right around the time we received the submission, I had just read a few of her posts and was already interested in the paper. We made an offer in a matter of days, and she may not remember this, but I recall emailing with Afra about her blogging presence because I had really enjoyed one of her posts! In the end, she received an offer to workshop the paper, and I’m not sure where it was ultimately published, but it was one of the articles we really tried hard to get.
In short, I think blogging is a great way for professors – especially junior professors – to get their names and ideas out there.
9. Any final thoughts for us?
Two points I would urge professors to think about when considering whether to publish in a generalist journal versus a specialty journal (in this case, business and corporate journals, but I think these factors would apply to other specialty journals as well for professors in those areas of law):
One, readers of journals like the JLB tend to be regular readers because of their business focus, and thus they make an excellent audience for academics who want to use scholarly journals as a way to affect the professional discourse.
Two, the students on these journals (often) have a specific interest in the subject matter that you are writing on. While law reviews and other generalist journals may take one or two corporate articles per issue or per year, business journals are only looking for those types of articles, on a wide range of corporate topics. When I was EIC, we tried to assign editing responsibilities based in part on the interests of the student editors, and in my experience, that helped keep students personally engaged in the editing process.
Obviously, there are numerous reasons to publish in a generalist journal as well – these are just two considerations to keep in mind, particularly for one-off articles that may be too narrowly-focused for a law review but may be well-suited for a specialty business journal.
10. Thank you for sharing with us, Sabrina. I found it very helpful and I am sure the readers did as well.
Thanks for having me! I’m a big fan of the Glom, so this has been fun.
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.
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.
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 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):
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)
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)
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)
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.
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.
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.
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).
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:
- 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 )
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).