Daniel Gitner got a splashy profile in the Times today in celebration of his recent trial acquiting Rengen Rajnaratnam, and congratulations to him. My theory of white collar/defense lawyer eminence is that often, you don't have to win to be able to market yourself. You were "picked by Martha Stewart," or "represented General Motors during the financial crisis," or "handle pro bono representations for five detainees in Guantanamo." See? It sounds like you're important. You're so good you drew the assignment.
Still, you probably won't get a Times profile when you lose those cases. Gitner won, and drew a reporter who didn't appear to like him much. He forbade his staff to get haircuts during the trial for some uninteresting lucky rabbit foot related reasons, and generally came across as intense but yet very platitudinous.
That right there isn't bad marketing either, though. My lawyer is a pain but leaves no stone unturned; it's practically in the job description. And now Gitner gets to add that he's the only person to win an insider trading case in the Bharara era; he did two things right there. First, he persuaded the jury to absolve his client of the one marginal count the judge didn't dismiss, and second, he got the judge to dismiss the two serious counts. It could be his briefwriting, rather than his bedside manner, that did the trick here - that, at least is what Matt Levine thinks.
Usually thought of as unusually receptive, for a financial regulator, at least, to legislative pressure, the SEC, perhaps in a testament to its recent obsession with insider trading, has done the opposite and filed suit against Congress, subpeonaing a congressman and his aide to see whether the aide disclosed news to a lobby/law firm about health funding that caused a bunch of stock prices to spike ahead of the announcement of the new policy. DOJ is in on the game as well.
Congress is, it appears, displeased:
“What the SEC has done is embark on a remarkable fishing expedition for congressional records -- core legislative records,” [congressional lawyer] Kircher said in a court filing. “The SEC invites the federal judiciary to enforce those administrative subpoenas as against the Legislative Branch of the federal government. This court should decline that invitation.”
The so-called speech and debate clause in the Constitution protects members of Congress and staff from any outside inquiry into legislative business.
It is pretty juicy, and we'll outsource why to corp counsel. I'm just ballparking here, but a conversion between an aide and a lobbyist would seem to be deeply, deeply covered by the speech and debate clause, as unappetizing as it might seem. Here's a note on the clause, and here's the Heritage Foundation, which does these recaps pretty well.
And here's corp counsel:
the DOJ and SEC have sent subpoenas to Rep. David Camp, Chair of the House Ways & Means Committee, and Congressional Staffer Brian Sutter, regarding whether they tipped traders about a change in health care policy in the wake of a long-running investigation. And on Friday, as noted in this WSJ article, the SEC filed a lawsuit in the Southern District of New York seeking to compel the subpoenas. Possible grand jury to follow.
Here’s an excerpt from David Smyth’s blog about the case:
This is fascinating to me for so many reasons, among them: (1) the potential Constitutional cluster we’re about to witness; (2) the real test this poses for the recently passed STOCK Act’s effectiveness; and (3) another example of Mary Jo White’s severe distaste for those who defy Commission subpoenas.
And here’s an excerpt from the latest WSJ article:
“It’s not unheard of for an agency to serve a subpoena to Congress, but for an agency to sue is—if not unprecedented—at least very rare,” said Michael Stern, who was senior counsel to the U.S. House from 1996 to 2004. “It shows that there is a serious conflict; the SEC really wants the information and the House really wants it protected,” he said.
Call For Papers
AALS Section on Securities Regulation - 2015 AALS Annual Meeting
Saturday January 3, 2015, Washington, DC
The AALS Section on Securities Regulation invites papers for its program on "The Future of Rule 10b-5" for the AALS Annual Meeting in Washington, D.C. The AALS Section on Securities Regulation program will be held on Saturday January 3, 2015 from 3:30-5:15 PM.
TOPIC DESCRIPTION: This panel discussion will explore the current and future role of Rule 10b-5 in public and private offerings, public enforcement efforts, and private litigation. Participants also will discuss the manner in which Rule 10b-5 relates to expectations regarding public companies and their directors. Participants will explore these issues in light of recent court decisions (including, e.g., Halliburton), the Securities and Exchange Commission's enforcement priorities, and changing rules related to public disclosure obligations.
ELIGIBILITY: Full-time faculty members of AALS member law schools are eligible to submit papers. Pursuant to AALS rules, faculty at fee-paid law schools, foreign faculty, adjunct and visiting faculty (without a full-time position at an AALS member law school), graduate students, fellows, and non-law school faculty are not eligible to submit. Please note that all faculty members presenting at the program are responsible for paying their own annual meeting registration fee and travel expenses.
PAPER SUBMISSION PROCEDURE: Up to three papers will be selected from this call for papers. There is no formal requirement as to the form or length of proposals. Both shorter proposals and substantially complete papers will be considered.
Papers will be selected by the Section's Executive Committee in a double-blind review. Please submit only anonymous papers by redacting from the submission the author's name and any references to the identity of the author. The title of the email submission should read: "Submission - 2015 AALS Section on Securities Regulation."
Please email submissions to the Section Chair Lisa M. Fairfax at: email@example.com on or before August 21, 2014.
As David notes, the Second Circuit reversal of Judge Rakoff in the SEC v. Citigroup litigation fails to surprise. But that doesn’t mean the Second Circuit was correct. Indeed, I believe the Second Circuit, in an attempt to be pragmatic, allowed the emperor to continue strolling naked. The fact that the walk has going on for a while doesn’t mean the clothes are there.
If asking for facts makes a judge a maverick …
For all the media talk of Judge Rakoff as a “hero” or “maverick,” he carefully crafted his original opinion. The essence of his ruling: a court cannot approve a settlement and agree to an injunction when the SEC and the defendant give the court no facts. According to Judge Rakoff’s reasoning, without “any proven or admitted facts” the court cannot “exercise even a modest degree of independent judgment.”
Note that Judge Rakoff did not ask for an admission of liability. The Second Circuit panel recognized this and disposed of this quickly in Part II of its opinion.
Without facts, Judge Rakoff asked, how can district courts judge whether a settlement that includes substantial injunctive relief is reasonable, fair, adequate, and in the public interest? (The Second Circuit ruled that courts should not inquire into the adequacy of settlements.) Judge Rakoff rightly found that the SEC’s complaint does not itself establish facts.
Second Circuit ignores absence of elephant in room
The Second Circuit, as did Judge Rakoff, underscores the deference that trial courts must afford to SEC settlements. But the Second Circuit opinion chose to focus on dicta in Judge Rakoff’s order rather than the simple problem: how can a judge determine whether a settlement meets the legal standard – that it is fair, reasonable, and in the public interest – absent any facts about the defendant’s conduct. The Second Circuit held:
“Absent a substantial basis in the record for concluding that the proposed consent decree does not meet these requirements, the district court is required to enter the order.”
But what if there isn’t any real factual record? In the absence of any facts, wouldn’t district courts automatically have to approve a settlement? The Second Circuit may have created a strong incentive for the SEC and defendants to avoid creating any factual record.
The Second Circuit said that in reviewing SEC consent decrees, courts should review at a minimum (1) the basic legality of the decree, (2) whether terms of the decree, including its enforcement mechanism are clear, (3) whether the consent decree reflects a resolution of the actual claims in the complaint, and (4) whether the decree is tainted by improper collusion or corruption.
That sets the bar incredibly low. Indeed, the Second Circuit limits Judge Rakoff to asking for “additional information sufficient to allay any concerns the district court may have regarding improper collusion between the parties.” Imagine the colloquial version of how this inquiry would proceed:
“Any colluders in there?”
“No – just us chickens.”
The potential absurdity of the Second Circuit’s position is underscored by its insistence that, of course, courts must develop a factual record.
“As part of its review, the district court will necessarily establish that a factual basis exists for the proposed decree. In many cases, setting out the colorable claims, supported by factual averments by the SEC, neither admitted nor denied by the wrongdoer, will suffice to allow the district court to conducts its review.”
Here is a fun exercise: find the facts in the preceding two sentences. “Factual averments by the SEC” are not facts (unless you want to get really cute: it is a fact that the SEC said A, B,and C were facts.)
Facts mean that judges can’t be mavericks
Perhaps this “just the facts” focus feels like wrestling with an epistemological dragnet. But Judge Rakoff’s insistence on a record of proven or admitted facts is crucial – not only to providing some check on the SEC, but, moreover, to restraining judicial powers.
Let’s focus on two pieces of the proposed consent decree between the SEC and Citi: the ongoing injunction not to violate federal securities laws and the injunction to enforce the internal compliance measures at Citigroup. A court cannot impose a broad and long-lasting injunction without having any factual basis to assess whether an injunction is appropriate and to guide the court in undertaking this responsibility.
In many ways, Judge Rakoff’s reasoning served to limit judicial power.
For the injunction on Citigroup’s internal behavior, the court needs some factual basis to grant this relief. The court needs admitted and proven facts for at least two related reasons. First, it needs to ascertain whether it can enforce this injunction. Second, it needs some factual basis to judge later requests by the agency to enforce the injunction. Injunctions are not computer codes, and courts require some factual basis to understand what it is that the parties are asking them to do.
For the injunction on violations of Section 17: an open-ended injunction invites courts to scrutinize all sorts of potential securities law behavior. A district court needs some factual basis in order to understand whether an injunction is an appropriate remedy, and if and how the court could prudently enforce the injunction. What types of conduct by the defendant should the court look to enjoin? The Second Circuit focuses on reviewing injunctions to make sure they are “legal” and “clear.” “I agree not to violate federal securities laws” is both legal and clear in one sense. But take a good read of Section 17 and see how less than specific this agreement is.
Open-ended injunctions sought by public agencies on the basis of no factual information run multiple risks. Among these risks, broad injunctions without a factual basis attempt to commandeer the judiciary in another branch’s responsibility to enforce the law. This creates real separation of powers problems.
Second, open-ended invite judges to take broad enforcement matters into their own hands. A factual basis helps to restrain judges from free-wheeling efforts to enforce injuctions.
Third, broad injunctions without facts run the risk of playing a running joke on the judiciary. If this injunction is a makeweight which the SEC will never seek to enforce (and there is quite a bit of evidence that the SEC does not follow-up on many injunctions), the agency should not be wasting the resources of the judicial branch. Nor should it be involving the judiciary in a charade in which it looks like the SEC is enforcing federal securities laws, but does little to follow through on injunctions it has already obtained.
As amicus briefs to the Second Circuit pointed out, the SEC was able to get admissions of facts in other consent decrees before the Citigroup case. And the SEC has other administrative remedies available to it: suing and then asking for a consent decree in the S.D.N.Y. was not the only game in town.
But the SEC chose to sue Citigroup in federal court and to ask a federal judge to approve a consent decree with a broad injunction. Judge Rakoff’s message to the SEC might have been paraphrased succinctly: “Don’t attempt to invoke the machinery of the judicial system, unless you are serious and you are willing to give a court the information necessary to perform its judicial role.”
The Second Circuit turns this on its head. Its message to trial judges seems to be: “unless the SEC hands you facts that this consent decree is illegal, unrelated to the complaint, or collusive/corrupt, you must approve.”
The only real hook for judges who are frustrated by settlement agreements without facts is the Second Circuit’s insistence that judges can review whether terms of a decree are “clear.”
How lasting a legacy?
Judge Rakoff’s opinion did leave an incredibly thorny question unanswered: what kinds of facts does a judge need to approve a settlement? His opinion simply said no facts cannot suffice. The Second Circuit answered the question in a very cramped way. The appellate court warns judges to take very limited role, which might be as little as comparing a consent decree to the SEC’s complaint.
Some commentators point out that Judge Rakoff’s now overturned opinion still prompted the SEC to change its enforcement policies with respect to “neither admit nor deny.” I agree. But there is nothing to say that the SEC’s policy cannot change. Certainly not this Second Circuit opinion.
After the SEC settled with Citigroup over misreprsentations made about a toxic security it sold during the financial crisis for a centimillion dollar fine among other things, Judge Rakoff rejected the settlement for failing to contain "cold, hard, solid facts established either by admissions or trials." I've been pretty critical of the decision, which was always headed for reversal. Not that Judge Rakoff cares: his familiarity with the agency (he once was in it), his generally respected status as a judge, and rumblings of discontent by other courts asked to approve other settlements once he fired his shot across the SEC's bow has led to a change in approach by the agency; I talked about the new policy here.
The problem with the decision was twofold, according to the Court of Appeals, at least as I interpret it.
Problem 1: Doctrinally, a settlement decision is an exercise of enforcement discretion, and enforcement discretion is basically unreviewable because the alternative - making it reviewable - would thrust the courts into the heart of what the executive branch does. Because the SEC wanted continuing court supervision of Citigroup as a consequence of the settlement, Rakoff did, indeed, have something to do. But if the SEC had simply dismissed its suit in exchange for the payment of a fine, which is less onerous than a fine plus continuing supervision by a court, Rakoff would have had, literally, no role to play in the resolution of the case. So requiring cold, hard facts to be established as a condition of signing off on a deal was a radical increase in the oversight of the SEC by a court.
No surprise, then, that the Second Circuit said that "there is no basis in the law for the district court to require an adminision of liability as a condition for approving a settlement between the parties. The decision to require an admission of liability before entering into a consent decree rests squarely with the SEC."
Problem 2: Settlements are not about right and wrong, while admissions of guilt are. Settlements are about moving on. We don't expect private parties to establish whether management caused the bankruptcy or someone else did, whether that product really was dangerous, or was misused by consumers, or whatever. And these can be matters of great public import. So it was never clear why the government, even though, yes, it is a state actor, should be treated very differently.
No shock, then, that the Second Circuit has said that "consent decrees are primarily about pragmatism" and "normally compromises in which the parties give up something they might have won in litigation and waive their rights to litigation."
According to the appellate court, the right way to review consent decrees is for procedural clarity and, as far as the public interest is concerned, with Chevron deference to reasonable decisions by the agency. It's not totally clear what that deference means - the court faulted Rakoff for figuring out whether the public interest in the truth was served by the deal when he should have been deciding "whether the public interest would be disserved by entry of the consent decree." But there you go.
Anyway, I think this stuff is interesting, because it's a tool in the regulatory arsenal, and indeed, my first baby law professor article was on just that.
While the very long and detailed SEC crowdfunding proposed rules continue to not be final, individual states have passed their own legislation exempting purely local crowdfunding efforts from state securities laws. Because purely intrastate offerings are exempt from federal legislation already under Section 3(a)(11) of the Securities Act. Of course, the trick is not to offer crowdfunded securities to residents of more than one state, even if only in-state residents purchase the securities. This is very tricky when you are using a website to attract investment.
So far, Michigan, Kansas, Georgia, Wisconsin, Washington, Indiana, and Alabama have passed crowdfunding exemptions from state securities laws. North Carolina's crowdfunding law has passed the House but not the Senate (yet). Other legislation is pending in Florida, Texas and California. These exemptions are not identical; crowdfunding portals hoping to serve more than one state will have to be aware of these differences in maximum amounts, disclosure, number of purchasers, and purchaser qualifications.
I took a look at two websites purport to engage in intrastate crowdfunding, Localstake and Groundfloor. These two sites take two different approaches to ensuring that no offers are made to out-of-state residents. On Localstake, a potential investor cannot see actual projects until the investor registers, which is a lengthy process that includes giving your driver license number and social security number. I did not finish the registration process, which also included linking my bank account. The portal would then know the investor's residence and then show only those intrastate projects suitable to that investor. (I think Localstake has projects in Michigan and Indiana only). Groundfloor allows you to see projects, but with the disclaimer "Information on this page is not an offer or a solicitation to sell or purchase securities." Registration was very quick, but I received an email immediately telling me I could "follow" projects for informational purposes, but I could not invest: "As soon as we're set up in your state, you'll be among the very first to know." The Localstake method seems to have a higher likelihood of success fitting the definition of "offer," but I hope that the Groundfloor method would satisfy federal securities laws as well. However, there could be an argument that letting nonresidents see the projects and "follow" them conditions the market, in securities law jargon.
For more on crowdfunding, see my latest paper, forthcoming in the Illinois Law Review.
Earlier in May, the Delaware Supreme Court decided a certified question from the District of Delaware as to whether a Delaware corporation could adopt a bylaw whereby any member in a nonstock corporation would pay legal fees of the corporation if it instituted litigation against it and was not wholly successful. As you might have guessed, the answer was yes, and this also applies to any Delaware corporation. Here are Kevin LaCroix at D&O Diary and the HLS Forum with the gory factual details. A few humble thoughts to add to the mix:
What sorts of companies will adopt these loser-pays bylaws? Presumably, shareholders could balk, particularly if the director-amended bylaws can be amended by shareholder consent. Companies might believe that this additional deterrent is unnecessary given 102(b)(7) carveouts and simply abstain. Or, companies might believe it to be a costless measure that adds an incremental deterrent factor, particularly in merger litigation. Considering the flood of 102(b)(7) charter amendment provisions, a tidal wave of fee-shifting bylaws might not be surprising.
Are these bylaws always permissible? the opinion said that the bylaws were facially valid, but might be impermissible given the circumstances. Which circumstances? I can imagine a Blasius-like circumstance in which a shareholder group is in the middle of a tender offer or a proxy fight and threatening to seek an injunction and the board adopts a fee-shifting amendment. Can the bylaw apply to litigation concerning subject matter that happened prior to the bylaw adoption? It also seems a bit unseemly that such a provision could be used to deter litigation over self-dealing or conflicts of interest.
What about multi-jurisdictional litigaton? Say a shareholder (ok, a plaintiff's lawyer) files a shareholder suit in jurisdiction 1 and attempts to stay identical litigation in jurisdiction 2. The case proceeds in jurisdiction 2, but is dismissed in jurisdiction 1. Does the shareholder have to pay costs of the defendant to dismiss in jurisdiction 1? That would be interesting and definitely change incentives.
It has been some time since we've done a download list, and it does seem that SSRN has gone off the boil a bit as a source of both downloads, and a source of good information about interesting new articles. Still, these below do look like they could deserve a look!
|1||316||The Equity Risk Premium in 2014
John R. Graham and Campbell R. Harvey
Duke University and Duke University - Fuqua School of Business
Date posted to database: 8 Apr 2014
Last Revised: 8 Apr 2014
|2||199||The Futility of Cost Benefit Analysis in Financial Disclosure Regulation
Omri Ben-Shahar and Carl E. Schneider
University of Chicago Law School and University of Michigan Law School
Date posted to database: 23 Mar 2014
Last Revised: 25 Mar 2014
|3||173||Do Hedge Funds Trade on Private Information? Evidence from Upcoming Changes in Analysts’ Stock Recommendations
April Klein, Anthony Saunders and Yu Ting Forester Wong
New York University (NYU) - Department of Accounting, Taxation & Business Law, New York University - Leonard N. Stern School of Business and Columbia Business School - Accounting, Business Law & Taxation
Date posted to database: 8 Apr 2014
Last Revised: 8 Apr 2014
|4||171||Do the Securities Laws Matter? The Rise of the Leveraged Loan Market
Elisabeth de Fontenay
Duke University - School of Law
Date posted to database: 4 Apr 2014
Last Revised: 10 Apr 2014
|5||147||Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law
Leo E. Strine
Government of the State of Delaware - Supreme Court of Delaware
Date posted to database: 8 Apr 2014
Last Revised: 8 Apr 2014
|6||137||CEOs and Presidents
Tom C. W. Lin
Temple University - James E. Beasley School of Law
Date posted to database: 25 Apr 2014
Last Revised: 7 May 2014
|7||121||Contractual Innovation in Venture Capital
John F. Coyle and Joseph M. Green
University of North Carolina School of Law and Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP
Date posted to database: 30 Mar 2014
Last Revised: 1 May 2014
|8||98||Evasive Shareholder Meetings
Yuanzhi Li and David Yermack
Temple University - Department of Finance and New York University (NYU) - Stern School of Business
Date posted to database: 17 Mar 2014
Last Revised: 21 Apr 2014
|9||97||Culpability and Modern Crime
Samuel W. Buell
Duke University School of Law
Date posted to database: 12 Apr 2014
Last Revised: 12 Apr 2014
|10||91||Proposed Crowdfunding Regulations Under the Jobs Act: Please, SEC, Revise Your Proposed Regulations in Order to Promote Small Business Capital Formation
Rutheford B. Campbell
University of Kentucky - College of Law
Date posted to database: 9 Mar 2014
Last Revised: 9 Mar 2014
Over at the DC Bar, SEC staffer James Lopez took a look at how the first IPO prospectus in the United States measured up to the requirements imposed by the commision today. That would have been in 1791, for the Society for Establishing Useful Manufactures (SUM), which was going to build a manufacturing district. A taste:
today’s IPO prospectus includes a discussion of the most significant factors that make the offering speculative or risky, pursuant to Item 503 of Reg. S–K. The SUM prospectus’ third paragraph consists of the following sentence: “The dearness of labour and the want of Capital are the two great objections to the success of manufactures in the United States.” Well, then, that’s clear and concise. In a few additional paragraphs the SUM prospectus focuses on each of these challenges in detail. For example, as for needing labor it states that “emigrants may be engaged on reasonable terms in countries where labour is cheap, and brought over to the United States,” and that “women and even children in the populous parts of the Country may be rendered auxiliary to undertakings of this nature.”
HT: Corp Counsel.
The DC Circuit rather shockingly threw out the SEC's conflict minerals rule ONLY because it compelled publicly traded companies to speak about the issue in their securities filings, which it concluded violated the First Amendment. EDIT: This means that the parts of the rule that require reporting but not a statement that goods are "not DRC conflict free," might still be okay. Bainbridge has takes here and here, Jonathan Adler here, Matt Levine here.
But, you are thinking, the SEC compels companies to do a million things in their securities filings! Does the very existence of a disclosure regime violate the First Amendment? The court's novel theory was that it is okay to mandate disclosures that aim to prevent consumer deception (so the books of publicly traded companies could be opened to investors), but any other goal must have more than a rational basis to be sustainable.
It is a crazy theory. Warning labels, origin labels, nutrition labels, mandatory agricultural marketing schemes, they don't involve consumer deception, and they're okay. And maybe this reveals a lack of adoration for the First Amendment, but if Congress could prohibit companies from using conflict minerals, which it surely can, then requiring them instead to disclose the use is both less burdensome and possibly more efficient. Why would we want a legal system that does not permit disclosure regimes, thereby requiring command and control?
Some other observations:
- One judge wanted the court to wait for a ruling in a related case going en banc before the now democratically controlled circuit, and the two majority judges declined to do so because now the SEC and the petitioners could participate in the en banc. Unless the new Obama judges on the court cannot hear the en banc, this seems like a request for a quick reversal.
- Also interesting, the court didn't bullet proof the opinion. The SEC survived the adlaw challenges, and the very controversial cost-benefit analysis requirement the DC Circuit has started imposing, though that is likely to change very soon, on the agency. There is only one ground for reversal here: disclosure is unconstitutional.
- There is a difference between speech and conduct in the First Amendment, but the other big thing the SEC does in foreign policy is corrupt practices prosecutions (bribes paid to foreign government officials, that is). Could that be affected by the holding of this opinion, were it to stand? It sure isn't consumer protection.
- One of my many pet theories about why people care about constitutional law, though they often overdo it, is the sense that stare decisis is only sort of a good way to think about the subject. Conservative judges clearly love commercial speech, and have been using it to reverse some settled doctrines that have been in place for decades. I doubt a single securities lawyer thought that this was a plausible holding by the Court. Some smarter on the subject than I were clearly surprised. Let's see if it lasts.
Over at DealBook, I've got a look at the low-key rejection of Rajat Gupta's criminal appeal:
Judge Jed Rakoff, who presided over Mr. Gupta’s trial, demanded in another case that the government proffer “cold, hard, solid facts, established either by admissions or by trials” in enforcement proceedings against financial firms. He has called for more prosecutions over the crisis, and expressed a desire to see wrongdoing exposed in court. Other trial judges have also expressed some sympathy for public sanctions expressed through judicial orders.
But powerful and influential appellate judges have indicated less interest in sending this sort of a message. The Court of Appeals for the Second Circuit indicated in another case that it thought that Judge Rakoff had been too insistent on admissions of wrongdoing. And, as the opinion in Mr. Gupta’s appeal suggests, the court seems disinclined to make strong statements about appropriate business conduct when it could do so.
For more, head that way!
In my last post—also a shameless plug for my recent article, “Boilerplate Shock”—I argued that boilerplate terms governing securities could serve as a trigger that transforms an isolated credit event into the risk of a broader systemic failure. I’ll now briefly explain why I see this danger—which I call “boilerplate shock”—as a general problem in securities regulation, not just some quirky feature of Eurozone sovereign debt (the focus of the paper and post). Any market where securities are governed by uniform boilerplate terms is vulnerable to boilerplate shock.
The nature of this phenomenon—systemic risk—is of course familiar, but its source in contract language is a little unintuitive. How could private contracts unravel an entire securities market or the world economy?
Coordination around uniform standards.
In the back of our mind most of us probably still conceive of contracting as an activity that occurs among two, or perhaps a few, individuals or firms. But when standard terms are used by virtually all actors within a given market, it’s worth considering the collective impact of those terms as a distinct phenomenon.
Coordination’s benefits are well known. Consider uniform traffic signals. But coordination can also compound the effects of bad individual decisions.
As Charles Whitehead has argued, widespread “destructive coordination” among banks during the precrisis days helped generate systemic risks. When the credit markets froze, for example, firms using the same risk management formulas reacted in the same way at the same time. This helped transform isolated events into systemic ones—e.g., Lehman, the canonical example of a failure that triggered a de facto coordinated panic.
A similar risk, I argue, is present where participants in a securities market rely on the same standardized contract terms. Whether they were intended to or not, these terms will often control what happens in the event of certain legal emergencies, like a country departing the euro or Lehman declaring bankruptcy.
For example, if an effort by Greece to pay its bonds in “new drachmas” is rejected because of Boilerplate Contract Terms A and B, the market will surely be concerned that Terms A and B also govern the bonds of similarly situated borrowers, like Spain, Italy, etc. You’ll see that the borrowing premium the “peripheral” euro countries (the uppermost five lines: Ireland, Italy, Greece (biggest spike), Portugal, Spain) paid versus richer euro countries (Germany, France, the Netherlands, the three lowest lines) zoomed higher as worry over a Greece exit gripped markets in late 2011/early 2012, and again (to a lesser extent) because of Cyprus exit talk in early 2013:
Bloomberg. Click to enlarge.
Moreover, this panic occurred against a backdrop of unduly rosy assumptions (namely, that a departing euro country could convert its bonds into a new currency and thereby avoid default, a likely contagion trigger). I argue that the uniformity of boilerplate across these bonds would intensify these problems significantly since it’s likely to result in a declaration of default.
To my mind, this demonstrates that boilerplate securities contracts, in the aggregate, can be systemically significant. “Boilerplate Shock” introduces this concept and offers a modest proposal to mitigate its dangers in the Eurozone.
Beyond the euro, what about the risks of boilerplate shock in general?
Boilerplate shock is probably an inherent and permanent risk in any securities market.
Securities contracts are quintessential candidates for boilerplate. They are used by sophisticated parties for repeat or similar transactions and are drafted quickly—sometimes in three and a half minutes. The (correct) assumption is that they are more efficient for the parties that use them.
I’d like to begin thinking about how contracts can be drafted with a view to systemic risk mitigation, or at least to avoid exacerbating existing risks. But I think this is a hard problem that lacks an off-the-shelf solution:
- The nature of the risk is that it is a byproduct, not the result of intentional choices about risk allocation. This is the reason for the information-forcing default rule I propose in the Eurozone.
- The risk is also an externality: it is severe because of its collective impact. The parties do not bear the primary risk that uniform contracts will result in a meltdown, and in the unlikely event a crash happens (1) no individual party will be to blame and (2) at least one party to the initial transaction (the initial purchaser of a bond, for example) will probably no longer hold the asset, because most systemically significant securities are actively traded on the secondary market.
But banning or discouraging boilerplate is not the answer:
- The risk that a bunch of assets governed by the same terms will plummet in value is not only an externality. Risk allocation among parties might improve if scrutiny of existing securities boilerplate improves. The terms can evolve.
- A requirement to craft unique, artisanal terms—disclosures, subordination provisions ("flip clauses"), choice of governing law—for each individual securities transaction would be criminally inefficient.
- A requirement to craft unique contract terms might even be unjustified on risk-management terms alone, because it would increase drafting errors.
It's tricky to mitigate the risks of securities boilerplate.
Some options for places to start:
- Validation by third parties: perhaps issuers could use risk-rated contract templates. For example, see credit ratings…but see credit ratings.
- Culture: inculcate systemic risk mitigation as a professional norm among private sector lawyers? In principle, this could work. The number of lawyers who draft these contracts is pretty small. In practice, one could envision many complications.
- Insurance: encourage the development of derivatives to account for the possibility of boilerplate shock? Like some of the other solutions, this one presumes some agreement on what terms create the risk of boilerplate shock. It could also encourage new forms of moral hazard.
- Mandatory regulation: some public entity could be tasked with the mission of proactively identifying and combating the risk of boilerplate shock in contract practices. Arguably a natural choice given that the risk is an externality. Nevertheless, I’m a little skeptical. First of all, who would do it? A domestic regulator, like the SEC or CFTC, that might be dodged on jurisdictional grounds? An international institution, which is arguably more subject to capture? More generally, regulation seems like a heavy-handed first choice.
In sum, when standardized and aggregated, choices that determine legal risks—e.g., contract terms designating governing law, payment priority—can create the same hazards as choices about business risks. This suggests that contract terms should be taken seriously as possible sources of systemic risk alongside more familiar sources, like leverage and credit quality.
Securities contracts as a source of systemic risk—what do you think?
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I expressed concern in my last post that uniform contract terms could destabilize securities markets in unexpected ways. In a recent paper, I dub this risk “Boilerplate Shock.” The paper uses boilerplate terms in Eurozone sovereign bonds as a case study, but I argue that any market in which a lot of securities are governed by uniform contract terms is vulnerable to boilerplate shock. In this post, I will focus on the Eurozone and my proposed solution to the risk of boilerplate shock there.
One major problem is that no one really knows how to deal with sovereign debt obligations denominated in a currency that still exists but is no longer used by the debtor. A partial breakup of the European Monetary Union would trigger some question marks in commercial law and private international law (among other things).
In the Eurozone sovereign lending market, bond contracts typically contain standardized language specifying:
(a) choice of governing law (often foreign), and
(b) currency of payment (euros).
The combined effect of these clauses, I argue, is to render any country that departs the euro more likely to default on its debt. Whatever the impact of the departure itself, a forced default would make things much worse for Europe and the world economy.
Leading scholars have concluded or strongly suggested that a sovereign that changes currencies can redenominate (convert) its bonds to its new currency even where the contract is governed by foreign law (e.g., Philip Wood (p. 177), Michael Gruson (p. 456), Arthur Nussbaum (pp. 353-59), Robert Hockett (passim)). As a descriptive matter, I believe this to be a mistaken interpretation of New York (and probably English) private international law and commercial law (see “Boilerplate Shock” pp. 47-67). But normatively, I agree: a sovereign should be able to redenominate its bonds under certain circumstances. Among other things, the alternative would make currency union breakups far more dangerous than they already are.
- The prevailing consensus underestimates the risk that a departing Eurozone member’s attempt to redenominate its sovereign bonds into a new currency will be ruled a default.
- Since the bonds of other struggling euro countries are largely governed by the same boilerplate terms ((a) and (b) above), this misapprehension has the potential to be particularly damaging. In addition to surprising the market (which appears to incorporate this consensus), it is likely to spread beyond the immediate debtor to the bonds of similarly situated countries that have issued under the same terms.
- Same for CDSs (which are likewise often governed by foreign law, usually New York).
- Thus, given the widespread use of terms (a) and (b), a ruling that a departing country cannot pay its euro-denominated contracts in a new currency could cause the market to demand unsustainable premiums from other weak debtors.
- This could cause Eurozone countries to lose market access. Greece is not TBTF in any sense, but some of its neighbors are—and are also too big for the EU (including the ECB) and IMF to bail out. Italy (the world’s 9th largest economy) and Spain (13th) come to mind.
Thus, if my commercial law/private international law analysis is right, these boilerplate contracts could end up playing quite a big role in the event of any euro breakup.
To mitigate this risk of boilerplate shock, I suggest a new rule of contract interpretation. The proposal is detailed at pp. 67-71 of the article. I suggest commercially significant jurisdictions adopt it by statute. Here is a quick summary.
Any sovereign that:
- Belongs to an international monetary union, and
- Issues bonds in the currency of that monetary union subsequent to the adoption of this rule, and
- Leaves the monetary union and introduces its own currency,
shall retain the right to redenominate its bond obligations into its new currency, UNLESS the sovereign has affirmatively waived the right to redenominate its bonds.
You’ll notice this is a default rule—merely a presumption of the right to redenominate—not a mandatory rule. It is also prospective-only: it does not apply to existing issuances. It also does not protect sovereigns that issue in foreign currency (e.g., Argentina), only those that are monetary union members and issue in the common currency (e.g., France).
The reason for these limitations is to minimize unintended consequences and near-term disruption to the market, but also to embody the relatively modest objectives of the rule. It is an information-forcing default rule that is intended to facilitate better risk management by parties. It is not a “save the world” rule.
The challenge, as I’ll discuss in my next post on the paper, is not that redenomination would be ruled impermissible when it ought to be available (otherwise, that might suggest a mandatory “pro-redenomination” rule). It is that the likely effect of these boilerplate terms—to prohibit redenomination—was almost certainly not bargained for and is largely unknown to parties. This market failure has, in turn, created latent risks to the broader financial system and the existing legal tools are poorly suited to address them.
The following post comes to us from Jill Fisch, the Perry Golkin Professor of Law at the University of Pennsylvania:
Just a few more thoughts about the event studies and question II in Halliburton. As I noted in my prior post, the level of discussion on the feasibility and mechanics of event studies was disappointing. I have explained the limitations with using event studies to address the question of price impact or price distortion for purposes of Basic. See Jill E. Fisch, The Trouble with Basic: Price Distortion after Halliburton, 90 Wash. U. L. Rev. 895, 919-21 (2013). In particular, a statement or series of statements that falsely confirm existing market expectations will not move stock price at the time it is made. An event study is incapable of measuring the effect that a counterfactual accurate disclosure would have had on the market, had it been made. A substantial number of securities fraud lawsuits present exactly this factual context. Basic itself was such a case. Basic denied the existence of merger negotiations for over a year during which time it was, in fact, involved in such negotiations. Basic’s lies had little or no effect on the stock price (indeed, the price rose after two of the three denials). When the merger was subsequently announced, the stock price rose dramatically. The argument in Basic was that, had the merger negotiations been accurately disclosed at an earlier time, the stock price would have been higher. What the stock price would have been, in October 1977, if Basic had not lied, is a question that event study methodology cannot answer. This, however, is the test that Professors Henderson and Pritchard seek to have the Court impose through a requirement that plaintiffs prove price impact at class certification.
The following post comes to us from Jill Fisch, the Perry Golkin Professor of Law at the University of Pennsylvania:
I was at the Supreme Court this morning to hear the oral argument in the Halliburton case. The debate was lively and the Justices were engaged. Two big surprises. First, the Justices devoted very little attention to the question of whether Basic should be overruled. This was a disappointment to some of the conservative lawyers who were watching the argument with me. Although Aaron Streett led off aggressively in his argument, as in Petitioner’s Brief, with the statement that Basic was wrong when it was decided and more wrong now, the Justices did not seem to have much appetite for discussing this issue. Of course that doesn’t mean they won’t vote to overrule – it is impossible to read the Court from the questions asked at oral argument – but there was very little discussion on economic theory, fraud on the market, congressional intent, etc. Justice Kagan stopped Streett early on when he tried to argue that the Court said 10(b) was just like section 18, and asked wasn’t section 9 a closer analogy, but that was about it.
There was some discussion about congressional acquiescence. Streett argued that Congress hadn’t decided for or against Basic in the PSLRA. Roberts seemed mildly interested in this, but David Boies had a pretty good answer in terms of not just citing the PSLRA but also SLUSA and noting that the legislation would make little sense if class actions were eliminated. The biggest issue here was Justice Alito raising section 203 of the PSLRA in which Congress says nothing in the statute is intended to affect whether there is a private right of action. Justice Scalia critically noted that the parties did not even address section 203 in their briefs.
When Streett tried to talk about the economic arguments, saying that the economic premises for Basic have changed, CJ Roberts asked “How do I review the economic literature?” He then asked, somewhat skeptically whether Streett was suggesting that the Court “jettison” Basic because economists believe the efficient capital markets hypothesis is no longer true. Streett had trouble answering that. Several other Justices noted that the economic debate over the degree of market efficiency was beside the point, stating that prices generally respond to information. Streett did not disagree. Streett also argued that Basic was no longer right because today’s traders don’t rely on the integrity of market price, citing hedge funds, index funds and program traders. David Boies made use of this point when his turn came around, arguing that these new types of traders make market prices respond even more quickly to information and noting that the only information that program traders have is market price.
The second major surprise was the degree of attention that the Justices devoted to question II in the petition for cert. The Justices seemed quite taken by the position advocated by Professors Pritchard and Henderson (which they termed the “law professors’ position) (too bad for the rest of us law professors) that plaintiffs be required to prove price impact, at the class certification stage, through an event study. Several Justices characterized modifying Basic to require that plaintiffs prove price impact as a “middle ground.” They repeatedly asked detailed questions about event studies and why requiring event studies at class certification would be a big deal, especially since they are already used to establish market efficiency in some courts, as well as to prove loss causation. Justice Sotomayor for example, asked why proving price impact would be so difficult
Malcolm Stewart, arguing for the SEC, focused exclusively on retaining Basic, but was happy to sell the plaintiff’s down the river on requiring proof of price impact. Perhaps the most damaging point came when he was asked by Justice Kennedy whether the plaintiffs would be hurt by a requirement that they prove price impact at class certification. Stewart said that the plaintiffs would not be hurt and might even be helped because they would be focusing on the effect of the fraud on a particular stock and not on the market generally.
Two points from the oral argument were particularly troubling. First, as Stewart’s answer demonstrated, the argument was permeated with a limited understanding of how event studies work and the complexities involved in using an event study to measure price impact, particularly in the case of misrepresentations that falsely confirm continued good news. Several of the Justices seemed to think that an event study is an easy and reliable way to ascertain price impact; so if it is available, why not require it? CJ Roberts even asked Malcolm Stewart if event studies were around at the time of Basic. David Boies failed to explain the fact that, in many FOTM cases, there is no price effect at the time of the false statement and that an event study is faced with the complex or possibly scientifically impossible task of ascertaining how price would have reacted in the counterfactual situation in which the truth had been disclosed earlier. The big picture discussion of event studies also overlooked logistical issues that could turn out to be quite significant in the lower courts such as burden of proof – what happens if the economists cannot say whether or not the price was distorted to a sufficient degree of statistical significance? Boies did try to explain that the loss causation event study looks at a different event – the corrective disclosure – which is often a cleaner event for purposes of the event study methodology in that it is less likely to be affected by confounding information.
Second, Streett suggested and appeared to persuade the Justices that class certification was the end of the game – that if a class is certified, it is almost a sure win or an inevitable settlement because of the in terrorem effect of class actions. He repeatedly argued that, because the NYSE is an efficient market and therefore market efficiency is easy to prove for all NYSE-listed companies, relying on efficiency alone without also requiring price impact is not enough. Sotomayor appeared quite troubled by the fact that less than 1% of securities fraud cases go to trial and then asked David Boies what percentage of cases involve a court rejecting class certification, seeming to suggest that it is problematic if cases were not weeded out by the class certification stage. No one raised the fact that the PSLRA pleading requirement coupled with the motion to dismiss together effectively weed out a substantial number of cases at an early stage, prior to discovery and its effect on the incentives to settle. Similarly none of the lawyers focused on why price impact must be litigated at class certification or at trial – why not, alternatively, in the context of a motion for summary judgment – although Justice Ginsburg asked what difference it made at what stage price impact is litigated.