Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives

A wide variety of statutory and common law doctrines in American law evidence hostility towards speculation. Conventional economic theory, however, generally views speculation as an efficient form of trading that shifts risk to those who can bear it most easily and improves the accuracy of market prices. This Article reconciles the apparent conflict between legal tradition and economic theory by explaining why some forms of speculative trading may be inefficient. It presents a heterogeneous expectations model of speculative trading that offers important insights into antispeculation laws in general, and the ongoing debate concerning over-the-counter (OTC) derivatives in particular. Although trading in OTC derivatives is presently largely unregulated, the Commodity Futures Trading Commission recently announced its intention to consider substantively regulating OTC derivatives under the Commodity Exchange Act (CEA). Because the CEA is at heart an antispeculation law, the heterogeneous expectations model of speculation offers policy support for the CFTC\u27s claim of regulatory jurisdiction. This model also, however, suggests an alternative to the apparently binary choice now available to lawmakers (i. e., either regulate OTC derivatives under the CEA, or exempt them). That alternative would be to regulate OTC derivatives in the same manner that the common law traditionally regulated speculative contracts: as permitted, but legally unenforceable, agreements. By requiring derivatives traders to rely on private ordering to ensure the performance of their agreements, this strategy may offer significant advantages in discouraging welfare-reducing speculation based on heterogeneous expectations while protecting more beneficial forms of derivatives trading

Share Price as a Poor Criterion for Good Corporate Law

Academics, reformers, and business leaders all yearn for a single, objective, easy-to-read measure of corporate performance that can be used to judge the quality of public corporation law and practice. This collective desire is so powerful that it has led many commentators to grab onto the first marginally plausible candidate: share price. Contemporary economic and corporate theory, as well as recent business history, nevertheless warn us against unthinking acceptance of share price as a measure of corporate performance. This Essay offers a brief reminder of some of the many reasons why stock prices often fail to reflect true corporate performance, including the problem of private information; obstacles to effective arbitrage; investors\u27 cognitive defects and biases; options theory and the problem of multiple residual claimants; and the problem of corporate spillover effects that erode diversified shareholders\u27 returns. These considerations argue against assuming there is a tight connection between stock prices and underlying corporate wealth generation. A corporation or a corporate law system designed around the philosophy that anything that raises share price is good is likely to produce a firm that cooks its books; that avoids long-term projects that won\u27t appeal to unsophisticated investors; that chases after investment fads and fancies; that tries to opportunistically exploit creditors, employees, and customers; and that pursues business strategies that harm its diversified shareholders\u27 other investment interests. The Essay concludes that, if we allow our desire for a universal performance measure to blind us to the fallibility of share price, we court costly error. The Essay examines three recent examples of just such erroneous triumphs of hope over experience: the rise and fall of the Revlon doctrine; the 1990s infatuation with options-based executive compensation; and academics\u27 current preoccupation with event studies, regressions on Tobin\u27s Q, and other forms of empirical scholarship that attempt to judge the quality of corporate law and practice according to changes in share price

Risk, Speculation, and OTC Derivatives: An Inaugural Essay for Convivium

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\u27 risk aversion and information investments, but also by differences in traders\u27 subjective expectations. Disagreement-based speculation erodes traders\u27 returns, increases traders\u27 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 Corporation as a Time Machine: Intergenerational Equity, Intergenerational Efficiency, and the Corporate Form

This Symposium Article argues that the board-controlled corporation can be understood as a legal innovation that historically has functioned as a means of transferring wealth forward and sometimes backward through time, for the benefit of present and future generations. In this fashion the board-controlled corporation promotes both intergenerational equity and intergenerational efficiency. Logic and evidence each suggest, however, that the modern embrace of shareholder value as the only corporate objective and shareholder democracy as the ideal of corporate governance is damaging the corporate form\u27s ability to serve this economically and ethically important function

Uncertainty, Dangerous Optimism, and Speculation: An Inquiry Into Some Limits of Democratic Governance

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 not have discovered the New World and Steve Jobs might not have started Apple Computer in his parents’ garage. Indeed, without optimism, many of us might not be able to rouse ourselves from our beds each morning to face the day. But optimism poses dangers as well. This Article examines one of the more costly and intractable problems that can arise from optimism: the problem of regulating optimism-driven speculation in financial markets. Part I shows how optimism-driven speculative trading can be a kind of market failure that predictably generates economic losses to society. It begins by defining the difference between risk and uncertainty, and demonstrating how uncertainty (unlike risk) permits subjective disagreement over future values. It then offers a simple model of markets in which relative optimism generates disagreement-based trading in financial instruments and derivative contracts by speculators who hope to profit from predicting future events more accurately than others do. It notes how this sort of disagreement-based trading has received relatively little attention in the modern economic literature, which instead tends to implicitly (and somewhat misleadingly) assume that “speculative” trading is driven not by subjective disagreement in the face of uncertainty, but by differences in traders’ risk aversion and liquidity needs, or differences in their access to certain, but costly, information. Nevertheless, disagreement-based speculative trading represents a form of market failure that deserves attention. Part I demonstrates how transactions driven by uncertainty and disagreement can generate net economic losses by increasing traders’ risks, eroding their returns, and distorting consumption decisions in a fashion that leads to boom-and-bust cycles. Part II then turns to a second, and still more daunting, challenge raised by the phenomenon of dangerous optimism: the challenge that societies that rely on democratic governance face in attempting to use law to limit the social costs of disagreement-based speculation. Part II shows how, just as optimism in the face of uncertainty leads to adverse selection among participants in speculative trading markets, it also leads to adverse selection among participants in democratic political systems. In particular, optimism systematically stunts the development of constituencies that favor reining in costly speculation, both before and after social losses have been incurred. This suggests that democratic institutions may be fundamentally unsuited for dealing with the economic problems that can arise from optimism-fueled financial speculation. Part II develops this argument by examining the history of the regulation of derivatives, perhaps the quintessential speculative financial market. History supports the view that only relatively undemocratic institutions—in particular, courts, independent agencies, and private self-regulatory bodies—have proven successful at stemming social losses from speculative trading. It also offers cautionary lessons into the likely success of the newly enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) as a regulatory response intended to ward off future speculative crises like those we have just experienced

Killing Conscience: The Unintended Behavioral Consequences of Pay for Performance

Contemporary lawmakers and reformers often argue that ex ante incentive contracts providing for large material rewards are the best and possibly only way to motivate corporate executives and other employees to serve their firms\u27 interests. This Article offers a critique of the pay for performance approach. In particular, it explores why, for a variety of mutually reinforcing reasons, workplaces that rely on ex ante incentive contracts suppress unselfish prosocial behavior (conscience) and promote selfishness and opportunism. The end result may not be more efficient, but more uncooperative, unethical, and illegal employee behavior

The Unimportance of Being Efficient: An Economic Analysis of Stock Market Pricing and Securities Regulation

Part I of this article describes how perceptions that market efficiency is an important regulatory objective have influenced the development of securities law. For illustration, Part I examines the role of market efficiency goals in recent debates on the scope of insider trading liability, on trading in stock index futures, and on mandatory disclosure of merger negotiations. Part II then evaluates the notion that more efficient stock markets necessarily produce more optimal resource allocation. A closer look at the economic consequences of stock prices suggests that the principal function of stock prices is not resource allocation but rather the redistribution of wealth among investors. Consequently, more efficient public stock markets may contribute little to allocative efficiency., Part III presents reasons why legal rules designed to improve market efficiency may, on the whole, produce social losses. It concludes that enhancing market efficiency should not be a goal of securities regulation and describes significant policy changes that would follow from the abandonment of efficiency as a goal

Why We Should Stop Teaching Dodge v. Ford

What is the purpose of a corporation? To many people, the answer to this question seems obvious: corporations exist to make money for their shareholders. Maximizing shareholder wealth is the corporation\u27s only true concern, its raison d\u27être. Devoted corporate officers and directors should direct all their efforts toward this goal. Some find this picture of the corporation as an engine for increasing shareholder wealth to be quite attractive. Nobel Prize-winning economist Milton Friedman famously praised this view of corporate purpose in his 1970 New York Times essay, The Social Responsibility of Business Is to Increase Its Profits. To others, the idea of the corporation as a relentless profit-seeking machine seems less appealing. In 2004, Joel Bakan published The Corporation: The Pathological Pursuit of Profit and Power, a book accompanied by an award-winning documentary film of the same name. Bakan\u27s thesis is that corporations are indeed dedicated to maximizing shareholder wealth, without regard to law, ethics, or the interests of society. Thus, as Bakan argues, corporations are dangerously psychopathic entities. Whether viewed as cause for celebration or for concern, the idea that corporations exist only to make money for shareholders is rarely subject to challenge. Although there is a tradition of scholarly debate among legal academics on this point, it has attracted little attention outside the pages of specialized journals. Much of the credit, or perhaps more accurately the blame, for this state of affairs can be laid at the door of a single judicial opinion: the 1919 Michigan Supreme Court decision in Dodge v. Ford Motor Company