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Financial Product Complexity, Moral Hazard, and the Private Law

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Financial Product Complexity, Moral Hazard, and the Private Law American University Washington College of Law Digital Commons @ American University Washington College of Law Articles in Law Reviews & Other Academic Journals Scholarship & Research Spring 2015 Financial Product Complexity, Moral Hazard, and the Private Law Heather Hughes Follow this and additional works at: https://digitalcommons.wcl.american.edu/facsch_lawrev Part of the Banking and Finance Law Commons Financial Product Complexity, Moral Hazard, and the Private Law Heather Hughes* Extensive debate surrounds the question of how regulators should respond to the ex- ternalizationof risk associated with moral hazard in financial markets. The capacity of market actors to externalize risk is related to transactional complexity. Complexity, for example, augments reliance on valuation methods that can obscure risk, aggravatingmoral hazard. Re- cently, scholars and policymakers have articulated strategies for regulating transactional complexity that, this Article finds, reflect a shift from a contract law to a property law rubric for understandingfinancial products. This Article articulates this shift and assesses its regu- latory implications. Some call for standardizationof financial products. Others call for treat- ing financial products like goods, to be regulated for public safety. But what justifies curtail- ing freedom of contract? While there are numerous theories of regulation, and of the relationship between law and markets, this Article contends that markets are legally con- structed and that the private law doctrines that govern financial transactionspresent under- explored regulatory possibilities. It considers the extent to which financial products have property - distinguishable from contract - attributes, such that their regulation could fall within the justificatory ambit of property law doctrines that concern liquidity and soundness of markets. The normative implications of a property-orientedview offinancial products are under-developedfor want of the type of analysis that this Article begins. The problem of moral hazard could become less menacing if lawmakers were to effectively balance complexity and third-party concerns. This Article lays groundforfurther inquiry into how they might do so. * Professor of law, American University, Washington College of Law. I thank David Snyder, Anna Gelpern, Ken Anderson, Eric Claeys, Fernanda Nicola, Ezra Rosser, Pierre Schlag, Daniel Bradlow, Jorge Contreras, Mary Clark, and Barlow Burke for helpful comments; and Jess Robinson for excellent research assistance. 179 180 Stanford Journal of Law, Business & Finance Vol 20:2 Introduction ...................................................... 181 I. The Private Law Infrastructure of Financial Products ..................... 189 A. Private Law Responses to Complexity ..................... 189 B. Theory: Financial Engineering and Property. ..................... 194 C. Doctrine: Financial Engineering and Property........... .............. 205 II. Complexity and Moral Hazard . ...................................... 207 A. Transferring Risk, Externalizing Risk...........................208 B. Valuation and Complex Financial Products ........... .......... 209 III. Private Law Strategies ..................................... ....... 210 A. Numerus Clausus ................................................. 211 B. Shifting from a Contract-based to a Property-based Conception of Financial Products ....................................................217 C. Normative Implications ................................ ...... 219 Conclusion ....................................................... 220 Spring 2015 Financial Product Complexity 181 Introduction Extensive debate surrounds the question of how regulators should respond to the externalization of risk-and socialization of loss-associated with moral haz- ard in financial markets. This Article turns attention to the relationship between moral hazard' and the private law infrastructure of financial markets. 2 Contract and property doctrines3 determine the enforceability of the transactional arrangements with which market actors externalize risk.4 The capacity of market actors to externalize risk is related to transactional complexity.5 While we do not fully understand the problems of complexity, or how 1Moral hazard has featured prominently in discussions of originate-to-distribute ap- proaches to lending and of contexts in which financial institutions act with expectations that the state will ultimately prevent their failure. 2Regulation in response to the 2008 crisis has centered on federal, legislative initia- tives focused on regulated institutions and federal, administrative bodies with regulatory power. See Lawrence A. Cunningham & David Zaring, The Three or Four Approaches to Financial Regulation: Cautionary Analysis Against Exuberance in Crisis Response, 78 GEo. WASH. L. REv. 39 (2009); Lynn A. Stout, Derivatives and the Legal Origin of the 2008 Credit Crisis, 1 HARV. Bus. L. REv. 1 (2011) (discussing the role of speculative trading of over-the-counter derivatives in the financial crisis). Much of the recent regulation targets due diligence incentives, fraud incen- tives, capital adequacy, and conflicts of interest. Dodd-Frank Wall Street Reform and Consum- er Protection Act, 12 U.S.C. § 5301 (2011). 3 Meaning, the laws contained, in the United States, in the common law and the Uni- form Commercial Code of each jurisdiction, along with related statutes, such as corporation and other limited liability entity statutes. 4 This Article contends that markets are legally constructed, and that we should take a closer look at the nature of the private law obligations from which markets derive. We can un- derstand the legal infrastructure of markets not just as a "web of legally permissible IOUs," but also as a system that creates and transfers in rem rights. This understanding can potentially expand regulatory possibilities. Cf Katharina Pistor, A Legal Theory of Finance, 41 J. COMP. ECON. 315 (2013) (stating a legal theory of finance (LTF) in which markets are legally con- structed and occupy a hybrid public-private space). Pistor describes the legal constitution of markets in contract-oriented terms, contending that a "web of legally permissible IOUs - cred- its, bonds, derivatives, but also common stock, convertible shares, etc. - that link parties to one another constitutes financial markets and determines their scope." Id. at 318. The law-finance paradox puts markets in tension with law when enforcement of contractual obligations threat- ens the financial system. As such, legal elasticity at the apex of financial/ legal systems demar- cates power: we can relate the political economy of markets to the intersection between hierar- chies in finance and elasticity in law. Id.at 316, 328. Pistor finds that law tends to be binding at the periphery of the financial system and elastic at its apex. Id. at 317. She suggests that more elasticity at the periphery could provide important safety valves to prevent financial crises. Id. at 329. This Article, in contrast, turns attention to the efficacy of contracts/property distinc- tions among the private law rules that constitute markets in order to lay groundwork for ex- ploring the possibility that property doctrine could reduce instability by reigning in complexi- ty and moral hazard in financial transactions. 5 While there is much discussion of whether and how to regulate market complexity, relatively few legal scholars directly take up the challenge of defining market complexity and 182 Stanford Journal of Law, Business & Finance Vol 20:2 best to regulate it,6 complexity can aggravate complacency of investors and regula- tors, conflicts of interest, and the efficacy of valuation methods, all of which aggra- vate moral hazard.7 Since the 2008 financial crisis, scholars and policymakers have articulated strategies for regulating complexity that-this Article contends -reflect a shift from a contract law to a property law rubric for understanding financial products. Scholars invoke the property concept of numerus clausus, contending that the law should not permit financial products that are so novel or "excessively" complex8 as to be unrec- ognizable to market actors.9 In addition, the recently created U.S. Consumer Finan- cial Protection Bureau regulates financial products for public safety and fitness for consumers: as analogous to goods.10 What, from a regulatory standpoint, justifies curtailing freedom of contract? Contract rights are enforceable only against parties to a contract, and as such can be unlimited in their potential complexity. Property conveyances, on the other hand, are enforceable against third parties; property law considers the interests of third parties. It does so in a variety of ways, such as with rules that reflect the concept of numerus clausus, through selective enforcement (with ostensible ownership and bona fide pur- chaser doctrines, for example), and with registries that establish notice conventions." its regulatory implications. See infra notes 133-36 and accompanying text. For a discussion of the nature of market complexity, see Dan Awrey, Complexity, Innovation and the Regulation of Modern FinancialMarkets, 2 HARv. Bus. L. REV. 235 (2012) (assessing the elements of complexity in financial markets, the relationship between complexity and innovation, and their regulatory implications) and Manuel A. Utset, Financial System Engineering, 32 REV. BANKING & FIN. L. 377 (2013) (applying concepts from the field of engineering
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