Postedon SSRN by Jennifer Taub:
Abstract: This paper explores certain legal acts and omissions that facilitated the over-leveraging and near collapse of the global financial system. These “Legal Enablers” fostered the boom that enriched a class of financial intermediaries who followed a storied tradition of gambling away “other people’s money.” These mechanisms also made the pain of the bust disproportionately felt by the middle class and poor while shielding the middlemen who created the problems. These Legal Enablers permitted the growth of a shadow banking system, without investment limits, transparency or government oversight. In the shadows grew a variety of highly leveraged private investment pools, undercapitalized conduits of securitized loans and speculation in complex credit derivatives. The rationale for allowing this unregulated, parallel system was that it helped to create innovation and provide liquidity. The conventional wisdom was that any risks associated with a hands-off approach could be managed by the “invisible hand” of the market. In other words, instead of public police, it relied upon private gatekeepers. A legal framework including legislation, rules and court decisions supported this system. This legal structure depended upon corporate managers, counterparties, “sophisticated investors” and the market generally to prevent irrational conduct.
The hands-off approach was premised upon a series of beliefs or expectations. The first was that corporate managers would not sacrifice long-term shareholder value for short-term gains. The second was that trading counterparties would monitor each other closely and discourage excessive risk. The third was that “sophisticated investors” had the ability to select and monitor “private” unregulated investment options and that such decisions affected the direct owners, not underlying investors and market integrity. And, the catch-all fourth belief was that even if there were blips and bubbles, the market would quickly “heal itself” before causing any major disruption or harm to society.
Only after the global financial crisis (“GFC”) struck and the government committed nearly $13 trillion and spent almost $4 trillion, to rescue the financial system and the economy, did many ministers of “private ordering” admit that these premises were faulty. They were shocked to find that, contrary to their expectations, corporate managers were willing to pursue unsustainable short-term strategies. When executives threatened shareholder value, they greatly enriched themselves personally. This was revealed not just in elevated pay that was decoupled from performance, but also in the behavior of executives in times of crisis, some literally off playing bridge while their firm went under. And sophisticated investors were out-matched by the complexity of new instruments. Unable to monitor, many were deceived and sometimes outright swindled. When President Bush declared “I’ve abandoned free-market principles to save the free-market system,” it was evident that the market could not heal itself.
These private gatekeepers failed for a few reasons. First, there was an explosion of increasingly varied and complex financial instruments. Even the most intelligent, experienced individuals using complex mathematical models could not accurately price them or understand their risk because there was not enough performance history, transparency as to the amounts outstanding and they were incredibly interdependent. Indeed some estimated that it would take many days for a powerful computer to calculate the price of some collateralized debt obligations. This was aggravated by the fact that whom the law deemed to be “sophisticated” enough to purchase these instruments and invest in unregulated pools were not defined by particular skills or knowledge, but wealth alone. Second, compensation structures at all levels encouraged short term gain over long-term value. Third, tremendous personal rewards came to those individuals who participated in these schemes and the players understood that it was a career stopper to be contrarian during this bubble.
It should not have taken the GFC to call the hands-off approach into question. There was plenty of historical evidence that demonstrated the dangers of excessive leverage and speculation. And, there was a largely effective legal framework available that had worked to rein in this behavior by mutual funds. This paper attempts to identify the causes of this collective amnesia. It also offers a challenge to those who resist regulation by building arguments upon these shaky premises.
Borrowing from the social sciences, this paper deems these acts and omissions “Enablers.” An enabler helps further another person’s self-destructive, addictive behavior, protects the abuser from suffering consequences and denies both the abuse and the harm caused to others. The enabler takes these actions due to his or her own dependency upon the abuser. By analogy, we created laws that further an unhealthy dependency on excessive borrowing or leverage and speculation. Legal Enablers protected those who engaged in these risky practices from suffering economic and legal consequences. In addition, Legal Enablers denied redress for the harm caused to the most vulnerable victims of this credit addiction. These Enablers depend upon the faulty premises identified above - the irrational belief in the police power of corporate managers, counterparties, sophisticated investors and the market to heal itself.
There were a considerable number of Legal Enablers of the recent global financial crisis (“GFC”), however this paper focuses upon those that contributed to the excessive leverage and speculation in the financial system and/or have the potential to ignite a future boom and bust cycle. First, investor protections were diminished and systemic risk elevated when the exceptions from the securities laws for hedge funds and other “private” investment pools were expanded. These unregulated pools were supposed to be limited to “sophisticated investors” in private offerings. However, with additional loopholes created in the 1996-7, these pools were able to flourish by attracting more investors through “retailization.” Unlike mutual funds, hedge funds were not restricted in areas such as use of excessive leverage. Individuals were exposed to risky investments from which they would have been protected as direct, retail investors. Yet, because their assets were gathered and then invested into these “private” pools by “sophisticated investors” such as U.S. mutual funds, corporate pension funds, public pension funds and union pension funds, they were exposed. The exceptions to government oversight through the securities laws were premised upon the ability of private gatekeepers to oversee increasingly complex instruments. However, our expectations of the ability of sophisticated investors to select and monitor investments proved unreasonably high. Second, the Commodity Futures Modernization Act of 2000 fostered the credit default swap (“CDS”) pandemic. These credit derivatives insured and ensured the origination and global distribution of risky securitized loans. Third, interpretations of and the wrong amendments to the U.S. Bankruptcy Code helped to support unwise financing trends and helped push overloaded borrowers into more debt. Fourth, court decisions in the area of corporate governance and securities fraud have created incentives for financial intermediaries to seek short-term, unsustainable, if not illusory profits and also shielded those same middlemen from liability. The convergence of undercapitalized mortgage pools, credit default swaps and leveraged hedge funds created the perfect storm.
After the bust, these Legal Enablers helped the middlemen to not just walk away unscathed, but wealthier than ever, and to leave the rest of society bereft. Uncertainty about the bankruptcy treatment of complex instruments and transnational structures made commercial bankruptcy through Chapter 11 less viable, thus the “middlemen” financial firms received massive taxpayer-funded bailouts. Meanwhile, Chapter 13 after the 1993 Court decision, prevented consumers from down-sizing underwater mortgages. Finally, the ability for ultimate investors to seek redress has been eroded through securities laws changes and legal doctrines shielding fiduciaries from liability.
This paper contends that if we wish to restore investor confidence and sustain a stable financial system, we must stop enabling the excessive leverage and speculation that create cycles of irrational exuberance followed by financial panics. Specifically, it recommends that we eliminate the loopholes that allow unregistered investment pools broad discretion to operate in the shadows, without transparency or supervision, to engage in self-dealing or related-party transactions, to inaccurately value and inadequately protect assets and to take on excessive leverage and illiquid portfolio holdings. This surpasses the Obama Administration’s proposal to bring hedge fund advisers under the Investment Advisers Act. In addition to the disclosure and enforcement that would affect hedge funds and advisers under that bill, this paper recommends revisiting the substantive protections of the Investment Company Act that apply to mutual funds. While the federal securities laws generally used mandated disclosure and enforcement as tools to regulate conduct, the country learned in 1929 and again in 2008 that regarding investment pools, disclosure is not enough. Substantive restrictions are more effective tools to protect pools of other people’s money. As part of this recommendation, the myth of the sophisticated investor and the private offering are confronted.
Second, this paper suggests that we avoid allowing devices, like credit default swaps, initially designed to minimize and distribute risk to be used for speculation or gambling. Third, it advises that we change our Bankruptcy Code to allow lien-stripping under Chapter 7 and 13, thus discouraging poor underwriting and inflated home valuations and protect the most vulnerable from the impact of the financial system abuses. Fourth, we should remove the obstacles that shield corporate officers, directors and others from liability for enabling destructive behavior.
This paper will also address the arguments that might be offered that would resist these reforms. These include, among others: (1) that we should not regulate hedge funds because they did not cause the GFC; (2) sophisticated investors can take care of themselves; (3) human nature (i.e. greed) cannot be successful constrained; (4) government regulation is ineffective and undermines business growth; (5) lien-stripping is too expensive and creates moral hazard; and (6) one should not second guess the behavior of corporate directors and managers trying to operate in the midst of a market-wide correction or collapse.
The paper can be downloaded here.