The SEC is a resource constrained agency that clearly misses much wrongdoing.  But by going after hedge funds with its insider trading powers, and now by investigating private equity, I think you can also tell a story of an agency that is increasingly unwilling to let some areas of the capital markets go as "buyer beware, big boys play here" alternatives to the heavily regulated public listings.  Dodd-Frank made the SEC more of a player in derivatives regulation, and with money market funds too.  

To be sure, there are still some dark pool markets out there.  But instead of picking its battles, it looks to me like the agency is trying to be comprehensive in its oversight.  As for the latest development, the SEC's investigation concerns the way that private equity firms value their hard-to-value assets, which may be being oversold to investors.  It sounds like a Rule 10b-5 matter:

One focus of the inquiry is how private equity firms value their investments and report performance. Unlike the valuing of publicly traded stocks, valuing private equity investments — largely in private companies that are not listed on an exchange — can be a thorny and subjective process.

The S.E.C.’s concern, say people familiar with the government inquiry, is that some private equity funds might overstate the value of their portfolios to attract investors for future funds.

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It is interesting to see the House sweat over whether they have to act on a bill that passed the Senate 96-3.  But part of the reason may be because the expert networks about which the SEC is so suspicious, at least if they are the political variants of the same, will have to register as lobbyists.  Can't imagine the hedge fund industry expected that.  Anyway, this Times piece is pretty interesting.

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Everyone, including Christine, thought that Carlyle's plan to require arbitration for "any disputes arising out of or relating in any way to our partnership agreement or the common units, including those under the federal securities laws of the United States" would encounter resistance. Today, Carlyle removed the provision after the SEC told the company that it would not approve the IPO.

I stand with Harvey Pitt on this one: "If somebody tells you that you’re going to have a very different set of remedies if you make this investment, and you still want to invest, it seems to me government has done its job."

And Hal Scott: "What’s at stake is the competitiveness of our capital markets. If the SEC is going to take this position, we are all entitled to know why they think securities class actions are helpful."

This is a nice example of how the right rules could encourage companies to become laboratories of corporate governance. If investors don't like arbitration provisions, let them punish the unit price, but if investors are willing to buy the units, why should the SEC stand in the way? The investors are not vulnerable consumers who need the SEC to evaluate the merits of the deal. Disclose the terms and let the market set the price.

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Bainbridge thinks maybe, and while I think that insider trading has distracted the government from financial crisis proseuctions (might not be a terrible thing, but something must be going on there), I approach the Galleon string of prosecutions with less trepidation.  Those guys were totally trading on inside information!  There's a bitter and a sweet here:

• The Bitter: if the government thinks expert networks shouldn't be permitted, it should regulate expert networks, rather than do it through criminal proseuctions of hedge funds.  
• The Sweet: Raj Rajnaratnam didn't exactly have a lot of sympathetic facts going his way (the link is to George Packer's great article on the case).  You want some investors to be seeking an edge, but paying members of boards to report to you with actions about to be taken by the corporation ... that sure seems like corruption to me.

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This post is a summary of a working paper the two of us finished recently, available here.

There are numerous discussions taking place about the future of housing finance, most focusing on the secondary market.  The central themes in theses discussions have been the government's future role in secondary markets and restarting private secondary markets.  But one area that is not receiving much attention is the potential liability of either the entities that arrange securitizations or the trusts (the assignees) that end up owning loans, for unlawful acts at loan origination. 

During the housing boom, everyone seemed to think that assignees were shielded from the consequences of lenders' illegal acts.  It appears that the market assumed that the holder in due course (HDC) rule(which protects note purchasers from most defenses to non-payment on notes) and originators' loan repurchase obligations through representations and warranties would take care of assignee liability risk.  These turned out to be pretty bad assumptions.  Originator repurchase obligations are only effective if the originator is still around to repurchase loans, which has been the case less and less frequently through the crisis.

In addition, assignees are not protected from liability by the HDC rule unless the notes are negotiable instruments, and the buyers and sellers of the notes observed the formalities necessary to obtain the rules protection. As we have seen with the shoddy foreclosure documentation, the industry ignored fundamental formalities and undermined the HDC shield.

The more interesting point is that many securitization arrangers may find themselves exposed to liability for the illegal actions of originators based on theories such as joint venture.  Such claims have survived summary judgment motions when the arrangers prospectively agreed to purchase all or some of the loans originators made, and the arrangers had some knowledge of the originators' illegal acts.  Arrangers could often glean information on lenders and their loan practices through due diligence, media reports, and informal information sharing in vertically-integrated firms (the last being very difficult to prove).  Arrangers have also exposed themselves to liability by actually supplying deceptive disclosures and payment schedules to originators, who then provided the documents to borrowers.

So far, consumer claims against securitization arrangers have been rare and most have been settled, but this trend may reverse.  Now that litigators and judges better understand the organization of the private label securities markets, these claims may have sturdier footing and judges and juries may be more sympathetic to consumers.

Uncertainty is clearly the theme when it comes to both assignee and arranger liability.  This uncertainty impedes accurate pricing of MBS, especially given the potential for claims by attorneys general, large class actions, and widespread borrower rescission of loans.  Policy-makers that want to stimulate the secondary market need to address the legal complexity that causes uncertainty (among other things).  Going forward, the simplest solution is to create incentives for the market to police itself, by allowing assignee and arranger liability for originator wrongdoing.  The next step should be to set parameters for arranger and assignee liability to allow it to be quantified and priced into credit.  Together these actions will sanction future bad actors, protect consumers, and help the MBS market by making it possible to price litigation risk.

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[Last year I blogged about some research my student, Brad Flynt, had done on SharesPost.  As promised, here is the second of two posts from him.]

The company research reports available on SharesPost were fascinating.  The amount of information in them was incredible. For example, there is a 68-page research report on Facebook dated May 30, 2011 that includes a specific per share valuation of $22.24-22.57 and a market capitalization of an estimated $52.3-53.1 billion.  These specific estimates are despite disclaimers that the source of the information was only “believed to be reliable”!  This lack of concrete information is amazing to me.

Taking a step back, I do not think these research reports are necessarily bad.  Assuming they are reasonably accurate, facilitating the transfer of capital is a good thing.  The issue to me is who is creating the reports and what is their incentive.  Professor Davidoff’s article addresses that SharesPost is now paying for the research reports.  The question then becomes, why are they paying for the reports and what is their incentive? 

The principals in SharesPost have created their own broker-dealer in the form of SP Investments Management, LLC, a “wholly owned subsidiary of SharesPost, Inc.”  It is not exactly clear what SP Investments Managements’ role in the transaction is and where they are making money.  If SP Investments Management’s revenue is in any way tied to procuring shares of Facebook at the lowest price possible, there seems to be a clear conflict of interest.  The issue is that this relationship is not disclosed.  

Additionally, there is another potential conflict of interest between SharesPost, GSV Capital Corp (NASDAQ: GSVC), and Candlestick Advisors.  GSVC is a fund created for the sole purpose of purchasing pre-IPO shares through platforms such as SharesPost.  In fact, Michael Moe, the creator of the GSVC fund, is on the SharesPost board.  Candlestick Advisors is a supposedly independent, third-party creator of research reports for SharesPost.  But the GSVC logo is on the Candlestick research reports, thus leading me to question what sort of influence GSVC might have on them.  What is not specifically addressed is whether GSVC or an affiliate pays Candlestick for producing the reports.  That is the key.  Is GSVC paying Candlestick to produce reports pricing shares below market value so GSVC can purchase at a lower price?  If so, anyone selling shares of Facebook on SharesPost has been misled. 

The bottom line is that there might not be anything more than lousy disclosure in this case.  In fact, I believe that is the most likely scenario and all of these players are all operating legitimately.  And to be clear, my research paper does not accuse anyone of actual wrongdoing.  It simply addresses the possibility of market manipulation and suggests the need for more transparent disclosure. 

The takeaway here is that the potential for fraud is so great because there is the possibility of making large sums of money.  This is not some Mom-n-Pop operation.  This is Facebook.  Hundreds of thousands of shares are exchanging hands at over $30/share, meaning hundreds of millions of dollars are at stake.  It’s scary to think how in the dark everyone really is. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Jesse Eisenger of the Times write again (the Times bangs this drum pretty regularly) with amazement that more people aren't going to jail in the wake of the financial crisis.  This time, he's blaming the SEC, and thinks the agency should be forced to sue Citigroup.

...the reason for putting Citigroup in the dock goes beyond the bank itself. The S.E.C. is not getting big enough settlements out of the largest banks. It’s not bringing enough financial cases. It isn’t going after the big banks’ top executives. It’s being way too cautious in its interpretation of its role as defender of the fairness and sanctity of the markets. The frustration, shared by Judge Rakoff and the rest of humanity, is all the greater because the agency rarely, if ever, gets anyone to admit guilt when they settle.

I have a sociological and a normative view about this stuff and they aren't that consistent.  Here's the sociological one.  In the wake of financial crises, usually people go to jail.  It happened with Enron, it happened with the S&Ls, it happened when the junk bond market went south.  I would go so far as to say it happens every time ... except this one.  After a financial crisis, you get reform legislation and some white collar convictions.  I almost thought it was a rule.  The SEC, Justice, the NY AG, and everyone else is, in effect, declining to give people politically popular prosecutions, and that is strange - and infuriating to the "we bailed them out and they're still rich" crowd like Eisenger.

My normative view, shared by a bunch of law professors, is that it is easy to overcriminalize business conduct and overpolice "fraud" that is really simply a market decline, and that it makes little sense to do so.  There are good arguments out there that Michael Milken and even Ken Lay were not criminals, and were not engaged in even the sort of fraud that the SEC polices.

Where does this leave us with the SEC and Citigroup?  I don't understand why agencies shouldn't settle cases, as Eisenger and Judge Rakoff appear to suggest - that's what they do.  Occasionally you try the most heinous actor - see Rajnaratnam - but you do a deal with everyone else.  And usually, civil settlements don't include admissions of guilt.  I'm not sure what the affection for truth commission style "what really happened" stipulations is rooted in, and why it should be the answer now.  I also wouldn't want to try the case against Citigroup, given that the bank has a completely plausible and easy to understand defense ("we sold to big boys products that by their nature had a short side, as those buyers knew; we have done that for years, as has every other Wall Street bank, and the SEC never complained").  Citi probably has to settle - Goldman did.  But I suspect that if the case was presented to a jury, Citi would win, just like Tanin and Cioffi did.

It is still worth relfecting on how strange and seemingly ineffective it has been for the SEC of late.  Its big, market-reforming rules are faring badly in the D.C. Circuit, albeit unfairly.  So regulation isn't getting anywhere.  And enforcement appears to be obsessed with hedge funds, instead of with the financial crisis.  When it has done financial crisis work, it has been random forays against Goldman Sachs and Citi, and little else.  Strange times for an agency that might not be guilty of overpolicing, but that appears to be ignoring the "laws" of nature.

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Don't get too excited, people, but in today's WSJ Franceso Guerrerra raised the prospect of a nontraditional Facebook IPO:

By virtue of its size, business model and popularity, Facebook is the rare company that doesn't need Wall Street to go public. It should press home the advantage and blaze a trail for others to follow.

Mr. Zuckerberg's has two options: a traditional IPO, in which banks distribute shares to investors in exchange for a percentage of total proceeds; and the little-used "Dutch auction" that cuts out the Wall Street middlemen by making the allocation of shares dependent on prices bid by each investor.

The biggest difference between the two systems, apart from the lower fees paid by companies in auctions, is that when IPOs go Dutch, banks don't choose who gets shares, giving all investors a fair shake and avoiding potential conflicts of interests.

Many Glom readers will remember that Google went public via Dutch auction in 2004, dubbed a failure by some, but an exercise in branding by Glom emeritus Vic Fleischer. 

I teach both the traditional IPO process and the Google IPO in my Lifecycle of the Corporation class, and students invariably love it.  So yes, please, bring on a Dutch auction!

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[Last month I blogged about some research my student, Brad Flynt, had done on SharesPost.  I asked Brad to share with us some more thoughts on his research, and this is the first of two posts from him.]

I think the secondary market for private transactions is an incredibly interesting and valuable platform for the exchange of capital.  This research project began when I explored the topic in Professor Rodrigues’ ‘Lifecycle of the Corporation’ class.  At that time, my research was focused on who could purchase Facebook shares, but it slowly developed into a closer look at the actual platform used to exchange shares and research reports on the companies trading on the site. 

When I began my general research on SharesPost, it became clear that there was not much information on the company except that it was selling thousands upon thousands of shares of Facebook, among other companies.  SharesPost says it operates as a ‘passive bulletin board.’   I had a difficult time determining exactly what a passive bulletin board is, since the only mention of it is from a series of SEC no-action letters.   

The key characteristics present in a passive bulletin board seem to be the extent of the issuer involvement, the complexity of the transaction, the compensation structure for the creator of the board, and the presence of Section 12 financial information.  In the case of SharesPost, each of these factors cut against it being a passive bulletin board.

Legal definitions aside, when you visit www.sharespost.com (and sign-up for the free account), it just does not feel passive.  Among other things, the presence of research reports with precise valuations seems to go beyond the passivity accompanying a simple post to buy or sell.  Open a research report.  Take a look.  They read like a hybrid prospectus/analyst report and are filled with information that should make any buyer or seller more comfortable with the transaction. [UR note: here's an earlier blogpost describing Brad's project last year, with a link to one of these reports]

The next step was determining SharesPost was more correctly defined as a broker-dealer, based upon the GlobalTec factors.  Among others, the relevant factors include whether the company charges fees, holds funds, or recommends/provides investment advice.  SharesPost charges a 3% fee to both buyer and seller, potentially holds funds, and provides research reports to investors.  It thus appears as though SharesPost may be operating as an unregistered broker-dealer. 

This is my first real investigation into a Silicon Valley startup, and it surprised me that a company would go through such significant expense when it was not even sure it was properly operating within the bounds of the current securities framework.  However, the notion that a Silicon Valley company believes it is easier to ask for forgiveness rather than permission is apparently as old as the Valley itself. 

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David Smyth at the Cady Bar The Door blog has a pretty plausible take as to what prompted DOJ to indict Rajat Gupta well after the SEC's civil case against him had collapsed.  Here's some of the relevant analysis:

I think the delay in the criminal case against Gupta is explainable if one assumes two things are true:  First, that a criminal prosecutor would much rather go to trial in a case like this with incriminating taped conversations than without.  It makes sense; proving a case beyond a reasonable doubt is no easy trick.  Insider trading cases can be very hard to prove, and one can imagine that the prosecutors in the Southern District of New York would want to have the best evidence possible before walking onto that big stage.

The second key assumption is that prosecutors made a final run at trying to get Rajaratnam to flip on Gupta just before Rajaratnam was sentenced.  It’s hard to know if this is true, but Rajaratnam did recently submit to a wide-ranging interview with Newsweek magazine in which he revealed that prosecutors had asked again for his cooperation against Gupta....

To me, one of the interesting questions in this involves the lobbying of the prosecuting agency, DOJ, by the investigating agency, the SEC, to commit to a criminal case.  Once the SEC had lost on the administrative proceedings (which it may have begun because DOJ was unwilling to indict), it may have presented DOJ with something of an ultimatum.  We'll never know.  

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Go give it a look over here; essentially, he's saying that the "ban" doesn't exactly do what it is purported to do:

Read literally, the bill prohibits insider trading by members of Congress only if the member not only personally trades on the basis of such information but also tips the information to "another person" with intent to aid that other person to use the information to trade for personal profit.

Which wouldn't be legislation worth passing at all, unless the point is to have worthless legislation.

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Last week a Subcommittee of the House Financial Services Committee passed H.R. 2308, the "SEC Regulatory Accountability Act," which aims to "improve the consideration by the Securities and Exchange Commission of the costs and benefits of its regulations and orders."  Among other things, when deciding how and whether to regulate, the Act requires the SEC to assess the costs and benefits of available regulatory alternatives, and the Act contains eleven factors that the SEC may consider in making such assessment.  The Act is a clear response to the DC Circuit's proxy access decision in which the court found the SEC's cost-benefit analysis lacking.  Thus, there are those who applaud congressional response on this issue and the corresponding push to strengthen the SEC's economic examination of the rules it enacts.  However, there are those who have questioned the wisdom of this Act, including, interestingly enough, a spokesman for the U.S. Chamber of Commerce (one of the groups that challenged the SEC's proxy access law).

In a September hearing before the House Financial Services Committee Chairman Mary Schapiro expressed several concerns with the Act.  She noted that the Act appeared to be redundant in light of statutory rules that already require the SEC to consider the economic effects of its rules.  From this perspective, while one may quarrel with the SEC's application of its cost-benefit analysis, it is not clear if a new rule directing the SEC to do what it is already supposed to do adds anything to the mix.

Schapiro also noted that some of the factors that the SEC is directed to consider under the new Act appear to be in conflict with one another or the SEC's mission.  For example, the Act indicates that the SEC should "assess the best ways of protecting market participants and the public."  But Schapiro noted that at times the SEC's mission to protect investors demands that it protects them from certain market participants.  If such a conflict arises, one wonders how the Act expects the SEC to address it in a way that it is not merely about checking the box that a concern has been duly raised and noted.

Others have raised equity concerns given that the cost-benefit analysis (and the costs of such analysis) would not apply to similar federal financial regulators.  To be sure, such a critique does not appear to be a bid for an extension of such regulation.

In his remarks before the House Committee on Financial Services, Jonathan Katz, representing the US Chamber of Commerce, noted that while he supported the use of a cost-benefit analysis, such analysis has limitations that are "often overlooked."  In his view, "Cost-benefit analyses are and will always be fundamentally limited.  They require estimates of the impact of events that have not yet happened.  Simply put, it is difficult if not impossible for any regulator to know what will happen when a regulation is adopted."  Katz went on to say, "If a regulator can't predict the response [to a new rule], it is difficult to accurately quantify the cost of compliance or quantify the value of benefits before one knows how the industry will achieve compliance."

Like others who have raised concerns about the DC Circuit decision, Katz's remarks underscore the problem with measuring the adequacy of a regulation primarily, if not solely, on the purported strength of its related cost-benefits analysis.  Namely, such analyses can always be subject to critique because both the costs and benefits are uncertain and unpredictable.  Capturing this sentiment, Schapiro concluded her remarks by noting that the Act could produce a rulemaking process that is incapable of implementation and "consistently subject to challenge."  From this perspective, one wonders if the Subcommittee should be directed to do a better job of assessing the costs and benefits of its rules prior to implementation.

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I am grateful for Usha’s latest post about her ambivalence to law and emotions scholarship because it provides an opportunity to engage in extended public discussion about what are some of the legal payoffs to (business) law professors of learning and teaching about emotions in general and happiness in particular.

I concur with Usha that it’s a busy time of the academic year as the semester is coming to a close and many of us will soon be traveling for the holidays (and some of us have traveled to participate in conferences). Of course, most of us feel that we are if not always, then at least constantly busy. In their article titled Idleness Aversion and the Need for Justifiable Busyness, Christopher K. Hsee, Adelle X. Yang, and Liangyan Wang present experimental evdience that busier people self-report being happier. The following is a video short about how the days are long, but the years are short.

I am quite sympathetic to Usha’s opinion that while happiness research is “all fascinating and it shapes my daily choices and reaffirms (or causes me to question) my life choices. Happiness research goes to the core of myself as a person.  Still  I wonder: what does this have to do with law?” This is partly because her view is one that many people including myself from a couple of years ago share. As Usha pointed out, I’ve already written a number of law review articles and some peer-referred articles about law and emotions including but not limited to happiness. Rather than repeating any of those article’s themes (those interested can find all of them available here), I’ll share five concrete responses to the specific challenge that Usha issued about what are the legal implications of and payoff to emotions and happiness research.

First, much of law concerns and is about human behavior: how to discourage anti-social human behavior and encourage pro-social human behavior. In attempting to change human behavior, law is and must be predicated upon a theory of human behavior. The theory can be Oliver Wendell Holmes’ bad man or neoclassical economics’ much caricatured rational actor. Whatever that underlying theory of human behavior is that law is based upon, that theory must address human JDM (Judgment and Decision Making) because in order for the law to change human behavior the law must change the judgments and/or decisions that humans make. It just so happens there has been a recent flood of research about how emotions in general and happiness in particular influence human JDM. This research is diverse and scattered across many disciplines, including anthropology, economics, finance, neuroscience, marketing, philosophy, political science, psychology, and sociology. Of course, this plethora of non-legal interest and research does not have to mean there are legal implications of new understandings about how emotions and happiness shape human JDM. But at least some law professors can and should read this rapidly growing literature to digest it and see if any of it has legal implications or payoffs. Professor Emeritus and former Dean of Stanford Law School and current President of the William and Flora HEwlett Foundation, Paul Brest teaches a graduate course on JDM at Stanford University. He has co-authored with Professor of Law and Director of the Ulu Lehua Scholars Program at the William S. Richardson School of Law in Honolulu, Hawai'i and Senior Research Fellow at the Center for the Study of Law and Society at the University of California, Berkeley, Linda Hamilton Krieger a book titled Problem Solving, Decision Making, and Professional Judgment: A Guide for Lawyers amd Policymakers. Chapter 13 of their book analyzes complexities about decision-making including predicting future well-being and Chapter 16 is titled The Role ofAffect In Risky Decisions.

Second, much of business law is premised upon the neoclassical economics model of utility maximization or the behavioral economics challenge to that model. In either case, business law can benefit from recent work on happiness economics because happiness economics raises a more fundamental challenge to and radical critique of neoclassical economics than does behavioral economics. Some view happiness economics as being a proper subset of behavioral economics, while others view happiness economics as being an extension of behavioral economics. In any event, behavioral economics points out that people have bounded rationality, willpower, and self-interest. The theoretical core of behavioral economics is an article titled Prospect Theory: An Analysis of Decision under Risk by Daniel Kahneman and Amos Tversky. This is an article which is likely to have been cited more times than it has been read by law professors and certainly more times than it has been understood by law professors as evidenced by overly broad attempted legal applications.

Happiness economics points out how people often systematically make decisions that fail to maximize their experienced happiness ex post as opposed to their anticipated or predicted happiness ex ante. This robust empirical and experimental finding means that at least in principle there is room for some other party, public or private, to help improve (or take advantage of) people’s JDM. In a recent working paper that is a forthcoming article in the American Economic Review, titled What Do You Think Would Make You Happier? What Do You Think You Would Choose?, Daniel Benjamin, Ori Heffetz, Miles S. Kimball, and Alex Rees-Jones present survey evidence that although what people choose hypothetically and what they predict would maximize their SWB (Subjective Well-Being) typically coincide, there are systematic reversals. They identify such factors as autonomy, family happiness, predicted sense of purpose, and social status to help account for hypothetical choices while controlling for predicted SWB. Their methodology has a number of possible legal and policy applications, including the development of aggregate measures of happiness. Another example is the application of their approach to reconcile the tension between an empirical finding in the article The Paradox of Declining Female Happiness by economists Betsey Stevenson and Justin Wolfers of declining average SWB of American women since the 1970s, both in absolute terms and in relative terms compared to men, with a common intuition that expanded political and economic freedoms for American women have made American women better off.  Survey respondents who were asked to rank living in a world with or without such increased political and economic freedoms for women. Significantly more respondents choose to live in a world having expanded political and economic freedoms for women despite believing that a world without such expanded political and economic freedoms would make them happier than the opposite.  Their National Bureau of Economic Research working paper 16489 titled Do People Seek to Maximize Happiness? Evidence from New Surveys contains additional examples and more details.

Third, research into two specific emotions, namely fear and greed finds that participants in financial markets are sometimes emotional and sometimes unemotional because they engage in both emotional and unemotional types of mental processing in responding to ever-changing market circumstances. In a series of articles titled,

(1) The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective 

(2) Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis

(3) The Three P’s of Total Risk Management

finance professor Andrew W. Lo posits that many tenets of rational expectations and the so-called efficient markets hypothesis fail to hold always, despite serving as useful benchmarks of what might eventually happen under certain idealized conditions. He speculates that an evolutionary theory of punctuated equilibria involving rare but big environmental shocks resulting in mass extinctions and eruption of new species could apply to financial markets. As Lo points out, law and policy that is based upon assuming rationality or more precisely lack of emotionality is going to be inapt during financial crises. Similarly, law and policy that is based upon assuming emotionality is going to be inapt during financially calm times. His Adaptive Markets Hypothesis implies that effective law and policy should adapt in light of changing financial markets and their participants. Examples of such adaptive business law and policy include:

(1) Countercyclical capital requirements.

(2) Collection, communication, dissemination, publication, and transparency of information about accurate systemic risk measures.

(3) Creation of a Capital Markets Safety Board (CMSB), analogous to the National Transportation Safety Board which conducts an independent investigation of all transportation accidents, in order to perform definitive forensic analysis of past financial crises. The CMSB would be made up of “teams of experienced professionals— forensic accountants, financial engineers from industry and academia, and securities and tax attorneys—that work together on a regular basis to investigate the collapse of every major financial institution.”

As Professor Lo cogently observes,

“The fact that the 2,319-page Dodd-Frank financial reform bill was signed into law on July 21, 2010—six months before the Financial Crisis Inquiry Commission submitted its January 27, 2011 report, and well before economists have developed any consensus on the crisis—underscores the relatively minor scientific role that economics has played in responding to the crisis. Imagine the FDA approving a drug before its clinical trials are concluded, or the FAA adopting new regulations in response to an airplane crash before the NTSB has completed its accident investigation.”

Fourth, central to effective JDM is the development and practice of skills related to emotions and emotional intelligence. A number of business trade books and business school courses focus on how managers can improve their emotional intelligence and in so doing become more effective organizational leaders. Law school clinical and negotiation casebooks and courses often discuss the importance of recognizing and responding appropriately to emotions in attorneys, clients, judges, juries, and other legal actors. For example, in their chapter, If I’d Wanted to Teach About Feelings, I Wouldn’t Have Become a Law Professor, Melissa L. Nelken, Andrea Kupfer Schneider, & Jamil Mahuad present concrete tools for teaching law students about the importance of emotions in negotiation. Yet much of current American legal non-clinical education teaches students explicitly and implicitly that lawyering is just about logical analysis and not about feelings. For example, in another article titled The Discourse Beneath: Emotional Epistemology in Legal Deliberation and Negotiation, Erin Ryan writes that "[b]y acknowledging the salience of wise emotionality in individual and collective deliberation, lawyers will not only improve their own personal repertoires, but propel the practice of law, negotiation, and policymaking toward new horizons of efficacy." Similarly, a recent book titled How Leading Lawyers Think: Expert Insights into Judgment and Advocacy by Randall Kiser discusses (at pages 75-85) how important emotional intelligence is to legal practice.

Fifth and finally, law professors can and should incorporate more information about emotions into law school. Many law professors and law students share a common discomfort with and disdain for emotions in part because of what many law students and faculty believe it means to think like a lawyer. For example, see page 422 of the article titled Negotiation and Psychoanalysis: If I’d Wanted to Learn about Feelings, I Wouldn’t Have Gone to Law School by Melissa L. Nelken. In her anthropological study of first–year contracts classes at eight law schools, law professor and senior fellow of the American Bar Foundation Elizabeth Mertz found that being taught to think like a lawyer caused students to lose their sense of self as they develop analytical and emotional detachment, resulting from the discounting of personal moral reasoning and values, as they learn to substitute purely analytical and strategic types of reasoning in place of personal feelings of compassion and empathy.

In fact, empathy is an important skill that lawyers can and should learn. In his article, Thinking Like Nonlawyers: Why Empathy Is a Core Lawyering Skill and Why Legal Education Should Change to Reflect Its Importance, Ian Gallacher analyzes pedagogical implications of lawyers communicating a lot with people who are not lawyers, such as clients, jurors, and witnesses.

In conclusion, a better and more nuanced understanding of what roles emotions generally and happiness particularly can play in human JDM, economic behavior, financial markets, legal practice, and legal education can and should inform how law professors conduct academic research and teach law students. 

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