Law Commons^™

Split Derivatives: Inside The World's Most Misunderstood Contract, Dan Awrey

Cornell Law Faculty Publications

Derivatives are the "bad boys" of modern finance: exciting, dangerous, and fundamentally misunderstood. These misunderstandings stem from the failure of scholars and policymakers to fully appreciate the unique legal and economic structure of derivative contracts, along with the important differences between these contracts and conventional equity and debt securities. This Article seeks to correct these misunderstandings by splitting derivative contracts open, identifying their constituent elements, and observing how these elements interact with one another. These elements include some of the world's most sophisticated state-contingent contracting, the allocation of property and decision-making rights, and relational mechanisms such as reputation and the …

The Mechanisms Of Derivatives Market Efficiency, Dan Awrey

Cornell Law Faculty Publications

These are not your parents' financial markets. A generation ago, the image of Wall Street was one of floor traders and stockbrokers, of opening bells and ticker symbols, of titans of industry and barbarians at the gate. These images reflected the prevailing view in which stock markets stood at the center of the financial universe. The high point of this equity-centric view coincided with the development of a significant body of empirical literature examining the efficient market hypothesis (EMH): the prediction that prices within an efficient stock market will fully incorporate all available information. Over time, this equity-centric view became …

The Macroprudential Turn: From Institutional 'Safety And Soundness' To Systematic 'Financial Stability' In Financial Supervision, Robert C. Hockett

Cornell Law Faculty Publications

Since the global financial dramas of 2008-09, authorities on financial regulation have come increasingly to counsel the inclusion of macroprudential policy instruments in the standard ‘toolkit’ of finance-regulatory measures employed by financial supervisors. The hallmark of this perspective is its focus not simply on the safety and soundness of individual financial institutions, as is characteristic of the traditional ‘microprudential’ perspective, but also on certain structural features of financial systems that can imperil such systems as wholes. Systemic ‘financial stability’ thus comes to supplement, though not to supplant, institutional ‘safety and soundness’ as a regulatory desideratum.

The move from primarily micro- …

Lawyers And Fools: Lawyer-Directors In Public Corporations, Lubomir P. Litov, Simone M. Sepe, Charles K. Whitehead

Cornell Law Faculty Publications

The accepted wisdom—that a lawyer who becomes a corporate director has a fool for a client—is outdated. The benefits of lawyer-directors in today’s world significantly outweigh the costs. Beyond monitoring, they help manage litigation and regulation, as well as structure compensation to align CEO and shareholder interests. The results have been an average 9.5% increase in firm value and an almost doubling in the percentage of public companies with lawyer-directors.

This Article is the first to analyze the rise of lawyer-directors. It makes a variety of other empirical contributions, each of which is statistically significant and large in magnitude. First, …

Market Collaboration: Finance, Culture, And Ethnography After Neoliberalism, Annelise Riles

Cornell Law Faculty Publications

In the wake of the disasters of March 2011, financial regulators and financial-risk management experts in Japan expressed little hope that much could be done nor did they take great interest in defining possible policy interventions. This curious response to regulatory crisis coincided with a new fascination with culturalist explanations of financial markets, on the one hand, and a resort to what I term “data politics”—a politics of intensified data collection—on the other. In this article, I analyze these developments as being exemplary of a new regulatory moment characterized by a loss of faith in both free market regulation and …

The Shareholder Value Myth, Lynn A. Stout

Cornell Law Faculty Publications

No abstract provided.

Accidental Suicide Pacts And Creditor Collective Action Problems: The Mortgage Mess, The Deadweight Loss, And How To Get The Value Back, Robert C. Hockett

Cornell Law Faculty Publications

Sustained economic recovery will remain elusive in America, post-crash, until principal is reduced on some 10-13 million underwater home mortgage loans across the nation. Yet in the case of privately securitized loans, these write-downs are all but impossible to carry out on the requisite scale because bubble-era securitization contracts, which now effectively function as suicide pacts among bondholders, would require collective action by millions of geographically dispersed passive investors in order to authorize write-downs or sales out of securitization trusts. The solution, this article suggests, is for state and municipal governments to use their eminent domain powers to buy up …

A Federalist Blessing In Disguise: From National Inaction To Local Action On Underwater Mortgages, Robert C. Hockett, John Vlahoplus

Cornell Law Faculty Publications

While it is widely recognized that the mortgage debt overhang left by the housing price bubble and bust continues to operate as the principal drag upon U.S. macroeconomic recovery, few seem to appreciate just how locally concentrated the problem is. This paper takes the measure of the national mortgage debt overhang problem as a cluster of local problems warranting local action. It then elaborates on one form of such action that the localized nature of the ongoing mortgage crisis justifies - use of municipal eminent domain authority to purchase underwater loans, then modify them in a manner that benefits debtors, …

Paying Paul And Robbing No One: An Eminent Domain Solution For Underwater Mortgage Debt, Robert C. Hockett

Cornell Law Faculty Publications

In the view of many analysts, the best way to assist “underwater” homeowners — those who owe more on their mortgages than their houses are worth — is to reduce the principal on their home loans. Yet in the case of privately securitized mortgages, such write-downs are almost impossible to carry out, since loan modifications on the scale necessitated by the housing market crash would require collective action by a multitude of geographically dispersed security holders. The solution, this study suggests, is for state and municipal governments to use their eminent domain powers to buy up and restructure underwater mortgages, …

On The Rise Of Shareholder Primacy, Signs Of Its Fall, And The Return Of Managerialism (In The Closet), Lynn A. Stout

Cornell Law Faculty Publications

No abstract provided.

Nullifying The Debt Ceiling Threat Once And For All: Why The President Should Embrace The Least Unconstitutional Option, Neil H. Buchanan, Michael C. Dorf

Cornell Law Faculty Publications

In August 2011, Congress and the President narrowly averted economic and political catastrophe, agreeing at the last possible moment to authorize a series of increases in the national debt ceiling. This respite, unfortunately, was merely temporary. The amounts of the increases in the debt ceiling that Congress authorized in 2011 were only sufficient to accommodate the additional borrowing that would be necessary through the end of 2012. In an economy that continued to show chronic weakness -- weakness that continues to this day -- the federal government would predictably continue to collect lower-than-normal tax revenues and to make higher-than-normal expenditures, …

Uncertainty, Dangerous Optimism, And Speculation: An Inquiry Into Some Limits Of Democratic Governance, Lynn A. Stout

Cornell Law Faculty Publications

People are often optimistic. Nearly fifty percent of marriages end in divorce, but one survey found that 100 percent of individuals planning to get married believed they would never get divorced. Most people think they drive better than the average driver, and at one university, ninety-four percent of professors placed themselves in the top fifty percent in terms of teaching skills. We often seem to think we are like the youth of Garrison Keillor’s fictional hometown Lake Wobegon, where “all the children are above average.”

This is not always a bad thing. Optimism can be advantageous. Without optimism, Columbus might …

Regulating Financial Innovation: A More Principles-Based Proposal?, Dan Awrey

Cornell Law Faculty Publications

Modem financial markets are characterized by complexity, seemingly perpetual innovation, chronic asymmetries of information and expertise, and pervasive agency costs. Perhaps nowhere are these characteristics-or their attendant regulatory challenges-more pronounced than within OTC derivatives markets. Mounting effective responses to these challenges must be considered amongst the most difficult and important tasks confronting financial regulators. Prescriptive, rules-based approaches toward financial regulation have thus far proven inadequate to this task. Through the utilization of outcome-oriented principles, enhanced dialogic relationships, intensive supervision, and targeted and proportional (yet vigorous) enforcement, "more principles-based" financial regulation (MPBR) manifests the potential to overcome these challenges and, in …

Derivatives And The Legal Origin Of The 2008 Credit Crisis, Lynn A. Stout

Cornell Law Faculty Publications

Experts still debate what caused the credit crisis of 2008. This Article argues that dubious honor belongs, first and foremost, to a little-known statute called the Commodities Futures Modernization Act of 2000 (CFMA). Put simply, the credit crisis was not primarily due to changes in the markets; it was due to changes in the law. In particular, the crisis was the direct and foreseeable (and in fact foreseen by the author and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.

Derivative contracts are probabilistic bets on future events. …

Risk, Speculation, And Otc Derivatives: An Inaugural Essay For Convivium, Lynn A. Stout

Cornell Law Faculty Publications

Speculative trading, including speculative trading in derivatives, is often claimed to provide social benefits by decreasing risk and improving the accuracy of market prices. This assumption overlooks the possibility that speculation can be driven not just by differences in traders' risk aversion and information investments, but also by differences in traders' subjective expectations. Disagreement-based speculation erodes traders' returns, increases traders' risks, and can distort market prices. There is reason to believe that by 2008, the market for OTC derivatives may have been dominated by disagreement-based speculation that contributed to the Fall 2008 credit crisis.

The Fsa, Integrated Regulation, And The Curious Case Of Otc Derivatives, Dan Awrey

Cornell Law Faculty Publications

With a view to better understanding the optimal structure of financial regulation, this paper tests prevailing theoretical hypotheses respecting the efficiency and overall desirability of integrated financial regulation relative to competing institutional models. This test is conducted through the lens of a comparative case study examining the approaches adopted by (fragmented) U.S financial regulators and the (integrated) UK Financial Services Authority (FSA) toward the myriad of regulatory challenges posed by the emergence, growth, and systemic importance of over-the-counter (OTC) derivatives markets. More specifically, this paper examines why, despite the numerous theoretical advantages of integrated regulation, the FSA adopted a non-interventionist …

Punitive Damages In Securities Arbitration: An Empirical Study, Stephen Choi, Theodore Eisenberg

Cornell Law Faculty Publications

This article provides the first empirical analysis of punitive damages in securities arbitrations. Using a data set of over 6,800 securities arbitration awards, we find that claimants prevailed in 48.9 percent of arbitrations and that 9.1 percent of those claimant victories included a punitive damages award. The existence of a punitive damages award was associated with claims that suggested egregious misbehavior and with claims that provided higher compensatory awards. The pattern of punitive awards is more consistent with a traditional view of punitive damages that incorporates a retributive component than with a law and economics emphasis on efficient deterrence. We …

Reframing Financial Regulation, Charles K. Whitehead

Cornell Law Faculty Publications

Financial regulation today is largely framed by traditional business categories. The financial markets, however, have begun to bypass those categories, principally over the last thirty years. Chief among the changes has been convergence in the products and services offered by traditional intermediaries and new market entrants, as well as a shift in capital-raising and risk-bearing from traditional intermediation to the capital markets. The result has been the reintroduction of old problems addressed by (but now beyond the reach of) current regulation, and the rise of new problems that reflect change in how capital and financial risk can now be managed …

Regulate Otc Derivatives By Deregulating Them, Lynn A. Stout

Cornell Law Faculty Publications

When credit markets froze up in the fall of 2008, many economists pronounced the crisis inexplicable and unforeseeable. Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, knew better.That's because the roots of the catastrophe lay not in changes in the markets, but changes in the law. In particular, the credit crisis can be traced to Congress's 2000 passage of the Commodity Futures Modernization Act, which radically altered the traditional legal approach to financial derivatives.

This shift in the legal treatment of financial derivatives has brought the banking system to its knees. The …

The Quiet Metamorphosis: How Derivatives Changed The "Business Of Banking", Saule T. Omarova

Cornell Law Faculty Publications

In the wake of an unprecedented global financial crisis, one of the fundamental questions preoccupying policymakers and students of financial regulation worldwide is "How did we get here?" This Article uncovers and analyzes an important part of our recent regulatory history, which provides a key to understanding some of the deeper, hidden causes of the crisis but whose significance legal scholars have so far failed to appreciate.

The Article examines interpretive letters issued by the Office of the Comptroller of the Currency (OCC), the primary regulator of federally chartered U.S. banks, interpreting the National Bank Act of 1863 to allow …

Changing The Paradigm Of Stock Ownership From Concentrated Towards Dispersed Ownership? Evidence From Brazil And Consequences For Emerging Countries, Érica Gorga

Cornell Law Faculty Publications

This paper analyzes micro-level dynamics of changes in ownership structures. It investigates a unique event: changes in ownership patterns currently taking place in Brazil. It builds upon empirical evidence to advance the theoretical understanding of how and why concentrated ownership structures can change towards dispersed ownership.

Commentators argue that the Brazilian capital markets are finally taking off.

The number of listed companies and Initial Public Offerings (IPOs) in the São Paulo Stock Exchange (Bovespa) has greatly increased. Firms are migrating to Bovespa's special listing segments, which require higher standards of corporate governance. Companies have sold control in the market, and …

How Deregulating Derivatives Led To Disaster, And Why Re-Regulating Them Can Prevent Another, Lynn A. Stout

Cornell Law Faculty Publications

When credit markets froze up in the fall of 2008, many economists pronounced the crisis both inexplicable and unforeseeable. That’s because they were economists, not lawyers.

Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, understood what went wrong. (Some even predicted it.) That’s because the roots of the catastrophe lay not in changes in the markets, but changes in the law. Perhaps the most important of those changes was the U.S. Congress’s decision to deregulate financial derivatives with the Commodity Futures Modernization Act (CFMA) of 2000.

Prior to 2000, off-exchange derivatives contracts …

A New Look At Judicial Impact: Attorneys' Fees In Securities Class Actions After Goldberger V. Integrated Resources, Inc., Theodore Eisenberg, Geoffrey P. Miller, Michael A. Perino

Cornell Law Faculty Publications

Judicial impact studies have generally found widespread compliance by lower courts. Often, however, these studies employ relatively insensitive measures of compliance, limit their focus to compliance with Supreme Court precedent, and only occasionally examine the impact of judicial decisions on the ultimate consumers of those rulings - the members of society who are subject to them. Significant questions thus remain, such as whether and to what extent lower courts in fact comply with precedent and what if any role fear of reversal plays in compliance. To address these gaps, we use regression analysis to examine how the district courts in …

Principles, Prescriptions, And Polemics: Regulating Conflicts Of Interest In The Canadian Investment Fund Industry, Dan Awrey

Cornell Law Faculty Publications

Conflicts of interest permeate the Canadian investment fund industry. In response, securities regulators have promulgated National Instrument 81-107 Independent Review Committee for Investment Funds. In the view of securities regulators, NI 81-107 reflects a "principles-based" approach toward the regulation of conflicts of interest. This Article articulates a theoretical conception of principles-based securities regulation, one which transcends the formalism of the traditional "rules" versus "principles" debate to reveal a new regulatory paradigm. Thereafter, the author explores whether and to what extent NI 81-107 truly reflects this principles-based paradigm, manifesting the potential to tap into its inherent wisdom while at the same …

Deconstructing Equity: Public Ownership, Agency Costs, And Complete Capital Markets, Charles K. Whitehead, Ronald J. Gilson

Cornell Law Faculty Publications

The traditional law and finance focus on agency costs presumes that the premise that diversified public shareholders are the cheapest risk bearers is immutable. In this Essay, we raise the possibility that changes in the capital markets have called this premise into question, drawn into sharp relief by the recent private equity wave in which the size and range of public companies being taken private expanded significantly. In brief, we argue that private owners, in increasingly complete markets, can transfer risk in discrete slices to counterparties who, in turn, can manage or otherwise diversify away those risks they choose to …

Ex Ante Choices Of Law And Forum: An Empirical Analysis Of Corporate Merger Agreements, Theodore Eisenberg, Geoffrey P. Miller

Cornell Law Faculty Publications

Legal scholars have focused much attention on the incorporation puzzle—why business corporations so heavily favor Delaware as the site of incorporation. This paper suggests that the focus on the incorporation decision overlooks a broader but intimately related set of questions. The choice of Delaware as a situs of incorporation is, effectively, a choice of law decision. A company electing to charter in Delaware selects Delaware law (and authorizes Delaware courts to adjudicate legal disputes) regarding the allocation of governance authority within the firm. In this sense, the incorporation decision is fundamentally similar to any setting in which a company selects …

In Praise Of Investor Irrationality, Gregory La Blanc, Jeffrey J. Rachlinski

Cornell Law Faculty Publications

How should a market filled with investors who chronically make bad investments, but is nevertheless efficient, be regulated? A growing body of evidence suggests that this is the state of most securities markets; investors rely on cognitive processes that produce systematically bad choices, and yet the market remains largely efficient. In fact, cognitive errors might be essential to their efficient operation. Even investors who make systematic errors also often possess real and unique information that can contribute to accurate pricing of securities. If such investors became mindful of their limited ability to distinguish between real information and erroneous information, they …

Fraud By Hindsight, G. Mitu Gulati, Jeffrey J. Rachlinski, Donald C. Langevoort

Cornell Law Faculty Publications

In securities-fraud cases, courts routinely admonish plaintiffs that they are not permitted to rely on allegations of "fraud by hindsight." In effect, courts disfavor plaintiffs' use of evidence of bad outcomes to support claims of securities fraud. Disfavoring hindsight evidence appears to tap into a well known, well-understood, and intuitively accessible problem of human judgment of "20/20 hindsight." Events come to seem predictable after unfolding, and hence, bad outcomes must have been predicted by people in a position to make forecasts. Psychologists call this phenomenon the hindsight bias. The popularity of this doctrine among judges deciding securities cases suggests that …

Was Arthur Andersen Different? An Empirical Examination Of Major Accounting Firm Audits Of Large Clients, Theodore Eisenberg, Jonathan R. Macey

Cornell Law Faculty Publications

Enron and other corporate financial scandals focused attention on the accounting industry in general and on Arthur Andersen in particular. Part of the policy response to Enron, the criminal prosecution of Andersen eliminated one of the few major audit firms capable of auditing many large public corporations. This article explores whether Andersen’s performance, as measured by frequency of financial restatements, measurably differed from that of other large auditors. Financial restatements trigger significant negative market reactions and their frequency can be viewed as a measure of accounting performance. We analyze the financial restatement activity of approximately 1,000 large public firms from …

Legal And Ethical Duties Of Lawyers After Sarbanes-Oxley, Roger C. Cramton, George M. Cohen, Susan P. Koniak

Cornell Law Faculty Publications

No abstract provided.