A Flawed Solution: The Difficulties of Mandating a Leverage Ratio in the United States – Note by John Holman

From Volume 84, Number 3 (March 2011)
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While the causes of the recent financial crisis have been debated extensively, the conclusion that excessive leverage by financial institutions contributed to the crisis has garnered widespread support. Concerns over the role of leverage have spurred a renewed focus on banks’ ability to exploit the presence of moral hazard due to limited liability and the government’s tendency to rescue banks in distress. The crisis painfully underscored how banks use leverage to increase their expected returns while simultaneously shifting risk to creditors and the public at large.


 

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Rewriting Frankenstein Contracts: Workout Prohibitions in Residential Mortgage-Backed Securities – Article by Anna Gelpern & Adam J. Levitin

From Volume 82, Number 6 (September 2009)
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Modification-proof contracts boost commitment and can help overcome information problems. But when such rigid contracts are ubiquitous, they can function as social suicide pacts, compelling enforcement despite significant externalities. At the heart of the current financial crisis is a contract designed to be hyperrigid: the pooling and servicing agreement (“PSA”), which governs residential mortgage securitization. The PSA combines formal, structural, and functional barriers to its own modification with restrictions on the modification of underlying mortgage loans. Such layered rigidities fuel foreclosures, with spillover effects for homeowners, communities, financial institutions, financial markets, and the macroeconomy.

This Article situates PSAs in the context of theoretical and policy debates about contract rigidity, bond contract modification, and contractual bankruptcy. We propose a typology of contract rigidities, ranging from formal prohibition on amendment (formal rigidity) to extreme collective action problems (functional rigidity). We then draw on New Deal jurisprudence for strategies to overcome each type of rigidity. These strategies include narrowly tailored legislation that renders the problematic terms unenforceable on public policy grounds, administrative restructuring mandates, and special bankruptcy regimes.


 

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Equity Compensation and Informant Bounties: How Tying the Latter to the Former May Finally Alleviate the Securities Fraud Predicament in America – Note by Justin Tyler Hughes

From Volume 82, Number 5 (July 2009)
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Recent Supreme Court decisions, including Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. and Tellabs, Inc. v. Makor Issues & Rights, Ltd., have brought complex securities fraud issues back into the national limelight. Moreover, growing frustration with the Sarbanes-Oxley Act of 2002 and the current financial catastrophe have further intensified securities concerns. Regardless of which side one supports in the ongoing debate regarding appropriate regulation, one thing is certain: securities fraud continues to purge the American markets of billions of dollars per year. With today’s political disposition favoring increased government oversight of corporate America, and with a new presidential regime, the time for reevaluating America’s procedure for detecting and deterring large-scale securities fraud is swiftly approaching.


 

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Protecting Privacy Expectations and Personal Documents in SEC Investigations – Note by Abraham Tabaie

From Volume 81, Number 4 (May 2008)
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Consider the following hypothetical: the Securities and Exchange Commission (“SEC”) is investigating a corporation for stock option backdating by the corporation’s officers and directors, and possible criminal charges are looming. The implicated company fires an executive, and seals her office. All of the executive’s documents inside the office, including her personal documents, are subpoenaed by the SEC. In a modern world, both work related documents and purely personal documents are often left at the office. These documents could include, but are not limited to, personal bank statements, other personal financial documents, letters, a diary, and even medical information. While personal files could have nothing to do with the corporation, the corporation must turn over these documents to the SEC pursuant to a valid subpoena. The SEC later can provide these documents to the U.S. Attorney’s office in a parallel criminal investigation of securities fraud. In a traditional criminal case, the government would need a search warrant and probable cause to enter someone’s home or office and take personal documents from the individual. Through the SEC subpoena, however, the documents may be subpoenaed for mere “official curiosity” and then handed over to the U.S. Attorney’s office, as long as the parallel proceedings were not carried out in bad faith.


 

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Markets as Regulators: A Survey – Article by Stavros Gadinis & Howell E. Jackson

From Volume 80, Number 6 (September 2007)
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Stock exchanges around the world have recently discarded their traditional mutual membership structure in favor of a for-profit corporate format. This development increased fears of conflicts of interest, as for-profit exchanges are more sensitive to pressures from their constituents and more likely to abuse their regulatory powers. In this Article, we explore the allocation of regulatory responsibilities to market infrastructure institutions, administrative agencies, and central government entities in the eight most influential jurisdictions for securities regulation in the world. Examining how different jurisdictions answer this question is particularly pressing given the December 2006 transatlantic stock exchange merger activity. After discussing the role of self-regulatory organizations in the oversight of modern stock exchanges, we report the results of a survey of the allocation of regulatory powers in a sample of eight key jurisdictions. In that survey, we examine the allocation of such powers at three levels: rulemaking, monitoring of compliance with these rules, and enforcement of rules violations. Based on our findings, we categorize these jurisdictions in three distinct models of allocation of regulatory powers: a Government-led Model that preserves significant authority for central government control over securities markets regulation, albeit with a relatively limited enforcement apparatus (France, Germany, and Japan); a Flexibility Model that grants significant leeway to market participants in performing their regulatory obligations, but relies on government agencies to set general policies and maintain some enforcement capacity (United Kingdom, Hong Kong, and Australia); and a Cooperation Model that assigns a broad range of power to market participants in almost all aspects of securities regulation, but also maintains strong and overlapping oversight of market activity through well-endowed governmental agencies with more robust enforcement traditions (United States and Canada).


 

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Pleading Around the Private Securities Litigation Reform Act: Reevaluating the Pleading Requirements for Market Manipulation Claims – Note by Damian Moos

From Volume 78, Number 3 (March 2005)
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In 1995, Congress enacted the Private Securities Litigation Reform Act of 1995 (“PSLRA”) to address the serious flaws in the private securities litigation system. Courts, Congress, and many commentators agreed that the chief evil plaguing the system was strike suits, suits “based on no valid claim, brought either for nuisance value or as leverage to obtain a favorable or inflated settlement.” Strike suits prevailed in private securities claims because, irrespective of the merits of the claim, it was usually less costly for defendants to settle than fight the allegations. Plaintiffs’ attorneys realized that defendants would settle and took advantage of the situation, sometimes filing claims based on bad news rather than evidence of wrongdoing. Congress stepped in to put an end to these abusive strike suits by enacting the PSLRA, which, among other things, raised the pleading standards for private securities claims, stopped plaintiffs from abusing the discovery process to force settlements, and made the threat of sanctions under Federal Rule of Civil Procedure 11 (“Rule 11”) more imposing.

In an attempt to avoid the PSLRA, plaintiffs began filing their securities claims in state courts. The shift to state courts undermined the PSLRA’s goal of deterring strike suits, because the safeguards of the PSLRA only applied to federal claims. In response, Congress passed the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) to stop the movement to state courts. The SLUSA preempted state law causes of action for securities fraud and market manipulation and made securities class actions brought in state courts removable to federal courts. Thus, Congress slammed shut the state court back door.


 

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Law’s Signal: A Cueing Theory of Law in Market Transition – Article by Robert B. Ahdieh

From Volume 77, Number 2 (January 2004)
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Securities markets are commonly assumed to spring forth at the intersection of an adequate supply of, and a healthy demand for, investment capital. In recent years, however, seemingly failed market transitions—the failure of new markets to emerge and of existing markets to evolve—have called this assumption into question. From the developed economies of Germany and Japan to the developing countries of central and eastern Europe, securities markets have exhibited some inability to take root. The failure of U.S. securities markets, and particularly the New York Stock Exchange, to make greater use of computerized trading, communications, and processing technologies, meanwhile, seems to suggest some market resistance to technological modernization. In light of this pattern, one must wonder: How are strong markets created and maintained, and what might be law’s role in this process?

This Article attempts to articulate a model for understanding the needs of efficient market transition and the resulting role of law in that process. Specifically, it suggests a “cueing” function for law in market transition. Grounded in largely ignored lessons of game theory and in the microeconomic analysis of so-called network effects, cueing theory identifies the coordination of market participants’ expectations as law’s central role in market transition. Building on recent legal literature on private regulation, social norms, and the expressive function of law, this theory suggests that in securities market transition—whether it be market creation in central and eastern Europe or market restructuring in the United States—law primarily serves to convene, encourage, inform, and facilitate.

A cueing role for law constitutes an important extension of traditional conceptions of what law does, particularly in securities regulation, but in other areas as well. Regulatory cues are neither coercive nor outcome determinative and involve a close intertwining of public and private regulation. The exceptional character of law in this context, and the recent growth in areas where regulatory cues might have fruitful application, may explain why such a role has not previously been analyzed. Yet in securities markets and other industries exhibiting network economies—from electricity transmission and interstate transportation to telecommunications and the Internet—a cueing function for law may be central to efficient transition. It may explain much of why “law matters” in the modern economy.


 

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Gatekeeper Liability – Article by Assaf Hamdani

From Volume 77, Number 1 (November 2003)
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The recent crisis in the wake of the Enron debacle has demonstrated the importance of enlisting gatekeepers – such as accountants, underwriters, and lawyers – to prevent corporate fraud. But while a consensus may exist over the basic need to expand liability to gatekeepers, little is known about the appropriate scope of such liability. Going beyond the capital-market context, this Article develops a framework to determine the scope of gatekeeper liability for client misconduct. Specifically, the Article analyzes the fundamental tradeoff between the potentially adverse impact of gatekeeper liability on relevant markets and the incentives such liability provides for gatekeepers to foil wrongdoing. Expanding the scope of their liability will make gatekeepers increase the price of their services to reflect their liability exposure. Although initially appealing as a means to screen out wrongdoers, this price increase may turn out to have adverse consequences when clients vary with respect to their wrongful intentions: Rather than screen out wrongdoers, gatekeeper liability may drive out only law-abiding clients. Enhanced liability, however, will also induce gatekeepers to monitor clients and prevent them from committing misconduct. The Article explores the policy implications of this analysis for determining which third parties should face gatekeeper liability, identifying the adequate scope of gatekeeper liability, and recognizing the shortcomings of gatekeeper liability as an instrument of social policy. The Article concludes by putting forward a tentative outline of the proper regime of gatekeeper liability for securities fraud.


 

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Making Markets: Network Effects and the Role of Law in the Creation of Strong Securities Markets – Article by Robert B. Ahdieh

From Volume 76, Number 2 (January 2003)
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As Russia and other formerly socialist states construct market economies, the appearance of strong securities markets remains an unfulfilled expectation. Notwithstanding broad privatization of state-owned enterprises and the elimination of industrial subsidies – essential precursors to demand for capital-raising securities markets – stock markets in Central and Eastern Europe remain illiquid, inefficient, and unreliable.

Strong securities markets do not, it seems, neatly follow from the welfare-maximizing behavior of individuals and institutions. Nor can the appearance of securities markets be effectively dictated by government decree. Post-communist securities market transition therefore presents a puzzle: Do markets emerge, or must they be created?

Joining the debate over whether “law matters” in the creation of securities markets, this Article draws on recent finance and microeconomic analysis of network effects to propose an alternative theory of why law might matter in the creation of securities markets, and to challenge traditionally limited views of how it matters. After articulating the proposed network model of securities markets, this Article outlines the model’s implications for securities market transition. Specifically, it highlights two categories of network inefficiencies that may help explain the persistent weaknesses of securities markets in Russia and other transitional states. The model suggests such inefficiencies may also arise in the modernization of established securities markets, however, implying lessons for the United States and other developed economies as well.

Where network effects undermine the spontaneous emergence of strong markets, this Article proposes a limited coordination of market expectations – as distinct from law’s demarcation of property rights and enforcement of contracts, as conventionally acknowledged, and its protection of minority investors, as recently emphasized by “law matters” corporate and securities law scholars – as a central role for law in the very creation and design of strong securities markets.


 

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