Overdependence on Credit Ratings Was a Primary Cause of the Crisis

The first part of the paper describes how over time credit rating agencies ceased to play the role of information intermediaries. Rating agencies did not provide information about the risk associated with the securitized instruments, but they simply enabled structurers to create and maintain tranches of these instruments with unjustifiably high credit ratings. The second part of the paper suggests how future policy may minimize overdependence on credit ratings, by removing regulatory licences and by implementing shock-therapy mechanisms to wean investors simple rating mnemonics.Rating Agencies, Subprime Mortgages, Securitization

A List

Personal dedication to Prof. Fred Zacharias

Second-Order Benefits from Standards

This Article contributes to the new governance literature by analyzing how private parties profit from standards. Scholars previously have focused on what I call first-order profits from the right to extract rent directly from the ownership or application of standards. But some parties also make second-order indirect profits by engaging in some new enterprise not directly related to the value of the relevant standard. For example, an accounting firm can offer lucrative consulting services based on its reputation as a standard hearer. Second-order profits are most substantial for strong form standards, which arise when the government designates a private entity as standard setter and assigns it the task of enforcement and regulation. This Article suggests that the question of whether such privatization is beneficial depends not only on First-order rents, but also on second-order costs and benefits. It considers two examples from the financial markets: over-the-counter derivatives and credit rating agencies

The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies

Is a AAA rating of an institution’s bonds any different from a five-star Morningstar rating of a mutual fund, or a four-diamond American Automobile Association rating of a hotel, or a three-star Michelin rating of a restaurant, or a “two-thumbs-up” Siskel and Ebert rating of a film, or a single UL symbol on a blender? And if bond ratings differ from ratings of mutual funds, hotels, restaurants, films, and appliances, to what extent have legal rules caused those differences? To what extent should legal rules operate to minimize differences? This Article addresses these questions

Law and the Theory of Fields

The distinction between “material” and “existential” plays a prominent role in A Theory of Fields, and it played a prominent role in discussions at the Berle VII Symposium. In general, the authors advocated the importance of the ongoing use of social skills and the collaborative efforts to seek meaning, particularly in ways beyond the merely “material.” However, the extent to which rules might matter in these efforts was less clear. Overall, Fligstein and McAdam seek to use the concept of a strategic action field to develop a theory of social change and stability. Yet social change and stability are inextricably linked to law, legal regimes, and regulatory structures. During the Berle VII Symposium, I raised the point about the absence of law and regulation from the theory of strategic action fields. I attempted to demonstrate that law and regulation matter, substantially, in the application of Fligstein and McAdam’s theory. The two authors seemed open during our discussions to the notion that law might be added as a theoretical “friendly amendment” to their theory. With their openness as a motivation, I attempt in this brief Article to sketch how one might make such an addition to their theory

Multinational Regulatory Competition and Single-Stock Futures

Whereas these first two forms of regulatory competition are well documented and covered in the legal literature, the third form - which I call multinational regulatory competition - is newer and more difficult to characterize. Accordingly, any claims about future regulatory competition in this form necessarily are speculative. By multinational regulatory competition, I mean competition occurring when a group of regulators from more than one sovereign forms a partnership as a multinational regulator and then seeks to compete with other groups of regulators, also formed from more than one sovereign. There is some recent empirical evidence that regulatory trends in market for single-stock futures are in the direction of multinational regulatory competition. Multinational regulatory competition may be an attractive alternative to other forms of regulatory competition. As discussed in greater detail below, intrajurisdictional competition is subject to costly and inefficient turf battles over regulatory market power. Interjurisdictional competition is not subject to those same problems, but is likely to generate other costs and inefficiencies, as parties engage in territory-related regulatory arbitrage transactions, which are - at best - normatively indeterminate. Multinational competition - which involves competition between partners of regulators of different countries, and therefore captures both intranational and international competition - may be more likely to create race-to-the-top conditions. Part II describes this new framework for analyzing theories of regulatory competition (including the notion of multinational regulatory competition), and applies the framework to the regulation of single-stock futures.Part III discusses several policy issues related to the regulation of singlestock futures, and attempts to address whether or how multinational regulatory competition with respect single-stock futures might be a more efficient regulatory regime than other structures. In particular, Part III expands the discussion to focus on more general international regulatory issues relevant to single-stock futures. The three preliminary conclusions are: (1) single-stock futures will introduce opportunities for substantial leveraging of individual stock transactions in ways that previously were not available; (2) single-stock futures will shift the focus of securities fraud regulation in numerous areas, including insider trading and market manipulation, and (3) single-stock futures will allow investors to avoid costly restrictions on short sales, which should improve market efficiency. On balance, single-stock futures have the potential to make markets fairer and more efficient, and multinational regulatory competition is one likely method of encouraging such improvements

Strict Liability for Gatekeepers: A Reply to Professor Coffee

This article responds to a proposal by Professor John C. Coffee, Jr. for a modified form of strict liability for gatekeepers. Professor Coffee’s proposal would convert gatekeepers into insurers, but cap their insurance obligations based on a multiple of the highest annual revenues the gatekeepers recently had received from their wrongdoing clients. My proposal, advanced in 2001, would allow gatekeepers to contract for a percentage of issuer damages, after settlement or judgment, subject to a legislatively-imposed floor. This article compares the proposals and concludes that a contractual system based on a percentage of the issuer’s liability would be preferable to a regulatory system with caps based on a multiple of gatekeeper revenues. Both proposals mark a shift in the scholarship addressing the problem of gatekeeper liability. Until recently, scholarship on gatekeepers had focused on reputation – not regulation or civil liability – as the key limitation on gatekeeper behavior. Indeed, many scholars have argued that liability should not be imposed on gatekeepers in various contexts, and that reputation-related incentives alone would lead gatekeepers to screen against fraudulent transactions and improper disclosure in an optimal way, even in the absence of liability. From a theoretical perspective, this article is an attempt to move the literature away from a focus on reputation to an assessment of a potential reinsurance market for securities risks, where gatekeepers would behave more like insurers than reputational intermediaries

What’s (Still) Wrong with Credit Ratings?

Scholars and regulators generally agree that credit rating agency failures were at the center of the recent financial crisis. Congress responded to these failures with reforms in the 2010 Dodd-Frank Act. This Article demonstrates that those reforms have failed. Instead, regulators have thwarted Congress’s intent at every turn. As a result, the major credit rating agencies continue to be hugely profitable, yet generate little or no informational value. The fundamental problems that led to the financial crisis—overreliance on credit ratings, a lack of oversight and accountability, and primitive methodologies—remain as significant as they were before the financial crisis. This Article addresses each of these problems and proposes several solutions. First, although Congress attempted to remove credit rating agency “regulatory licenses,” the references to ratings in various statutes and rules, regulatory reliance on ratings remains pervasive. This Article shows that regulated institutions continue to rely mechanistically on ratings and demonstrates that regulations continue to reference ratings, notwithstanding the Congressional mandate to remove references. This Article suggests several paths to reduce reliance. Second, although Congress authorized new oversight measures, including an Office of Credit Ratings (OCR), that oversight has been ineffective. Annual investigations have uncovered numerous failures, many in the same mortgage-related areas that precipitated the financial crisis, but regulators have imposed minimal discipline on violators. Moreover, because regulators refuse to identify particular rating agencies in OCR reports, wrongdoers do not suffer reputational costs. This Article proposes reforms to the OCR that would enhance its independence and sharpen the impact of its investigations. Third, although Congress authorized new accountability measures, particularly removing rating agencies’ exemptions from liability under section 11 of the Securities Act of 1933 and Regulation FD, the Securities and Exchange Commission has gutted both of those provisions. The SEC performed an end-run around Dodd-Frank’s explicit requirements, reversing the express will of Congress. Litigation has not been effective as an accountability measure, either, in part because rating agencies continue to assert the dubious argument that ratings are protected speech. This Article argues that the SEC should reverse course and implement Congress’s intent, including encouraging private litigation