December 23, 2011
Bubbles, so the Coffee doesn't stain
Posted by Erik Gerding

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Corporate Governance, Corporate Law, Finance, Financial Crisis, Financial Institutions, Legal History, Legal Scholarship | Bookmark

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