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Abstract:
In this Article, we begin what we believe will be a fruitful area of scholarly inquiry: an in-depth analysis of credit derivatives. We survey the benefits and risks of credit derivatives, particularly as the use of these instruments affect the role of banks and other creditors in corporate governance. We also hope to create a framework for a more general scholarly discussion of credit derivatives.

We define credit derivatives as financial instruments whose payoffs are linked in some way to a change in credit quality of an issuer or issuers. Our research suggests that there are two major categories of credit derivative. First, a credit default swap is a private contract in which private parties bet on a debt issuer's bankruptcy, default, or restructuring. For example, a bank that has loaned $10 million to a company might enter into a $10 million credit default swap with a third party for hedging purposes. If the company defaults on its debt, the bank will lose money on the loan, but make money on the swap; conversely, if the company does not default, the bank will make a payment to the third party, reducing its profits on the loan.

Second, a collateralized debt obligation (CDO) is a pool of debt contracts housed within a special purpose entity (SPE) whose capital structure is sliced and resold based on differences in credit quality. In a cash flow CDO, the SPE purchases a portfolio of outstanding debt issued by a range of companies, and finances its purchase by issuing its own financial instruments, including primarily debt but also equity. In a synthetic CDO, the SPE does not purchase actual bonds, but instead enters into several credit default swaps with a third party, to create synthetic exposure to the outstanding debt issued by a range of companies. The SPE finances its purchase by issuing financial instruments to investors, but these instruments are backed by credit default swaps rather than any actual bonds.

In the Article's first substantive part, we discuss the benefits associated with both types of credit derivatives, which include increased opportunities for hedging, increased liquidity, reduced transaction costs, and a deeper and potentially more efficient market for trading credit risk. We then discuss the risks associated with credit derivatives, such as moral hazard and other incentive problems, limited disclosure, potential systemic risk, high transaction costs, and the mispricing of credit. After considering the benefits and risks, we discuss some of the implications of our findings, and make some preliminary recommendations. In particular, we focus on the issues of disclosure, regulatory licenses associated with credit ratings, and the special treatment of derivatives in bankruptcy.

credit derivatives, credit quality, banks, credit default swap, collateralized debt obligation, risks, moral hazard, disclosure, credit ratings, bankruptcy

Abstract:
Using a large hand-collected dataset from 2001 to 2006, we find that activist hedge funds in the U.S. propose strategic, operational, and financial remedies and attain success or partial success in two thirds of the cases. Hedge funds seldom seek control and in most cases are nonconfrontational. The abnormal return around the announcement of activism is approximately 7%, with no reversal during the subsequent year. Target firms experience increases in payout, operating performance, and higher CEO turnover after activism. Our analysis provides important new evidence on the mechanisms and effects of informed shareholder monitoring.

Hedge Fund, Activism, Governance

Abstract:
This article revisits some issues I raised in a 1999 article on credit rating agencies, which increasingly are the focus of scholars and regulators. I discuss how and why credit rating agencies differ from other financial market gatekeepers, such as underwriters and accountants, and assess several recent policy proposals by considering the extent to which they take into account these differences.

The credit rating industry has changed radically since 1999. Credit rating agencies are now more profitable than other gatekeepers, face different and potentially more serious conflicts of interest, and are uniquely active in structured finance, particularly collateralized debt obligations, now a multi-trillion dollar market. I argue that these changes are related: Moody's Corp. has a $20 billion market capitalization in part because it earns high operating margins from conflicted transactions and credit derivatives. I describe a new approach to understanding the rationale for creating "synthetic" CDOs, whose assets consist of credit default swaps instead of bonds or loans. These transactions pose interesting theoretical challenges to some concepts of market efficiency and arbitrage based on mathematical modeling.

I also assess the agencies' argument that ratings are merely opinions protected by the First Amendment. In several recent cases, including the Enron litigation, judges have dismissed rating agency defendants on free speech grounds, and the agencies increasingly cite journalist privileges in opposing government subpoenas and proposed legislation that would subject them to securities law-type registration requirements. I critique the agencies' free speech claims, but find they are consistent with the agencies' past success in obtaining exemptions from securities law requirements such as Section 11 and Regulation FD.

Credit ratings, agencies, regulation, first amendment, CDOs

Abstract:
This paper critiques the role of credit ratings and credit rating agencies in providing information about bonds. The dominant "reputational capital" view of credit rating agencies is that the agencies have survived and prospered since the early 1900s based on their ability to accumulate and retain reputational capital (i.e., good reputations) by providing valuable information about the bonds they rate. The paper argues that this view fails to explain, and is inconsistent with, certain types of market behavior including: the estimation of credit spreads, the number of credit ratings-driven transactions, and the explosion in use of credit derivatives.

In place of the reputational capital view, the paper offers a "regulatory license" view of rating agencies as generating value, not by providing valuable information, but by enabling issuers and investors to satisfy certain regulatory requirements. The paper concludes that regulators should eliminate regulatory dependence on credit ratings by substituting a regime based on market-determined bond credit spreads (i.e., the difference between the yield on a bond and the yield on a risk-free bond of comparable maturity). Such credit spreads reflect all available information, including credit ratings, and therefore are more accurate and reliable than credit ratings.

Abstract:
Credit ratings pose an interesting paradox. On one hand, rating agencies have great market influence and even greater market capitalization. On the other hand, numerous studies suggest credit ratings are of limited informational value. This paradox - continuing prosperity of credit rating agencies in the face of declining informational value of ratings - has generated extensive debate among commentators.

In this article, I expand on and update a claim I made in 1999 (some have dubbed it a "complaint") that regulatory dependence on credit ratings explains the paradox. Numerous legal rules and regulations depend substantively on credit ratings, and particularly on the credit ratings of a small number of Nationally Recognized Statistical Ratings Organizations (NRSROs). Moreover, the barriers to entering the NRSRO market are prohibitive. The result is that credit ratings issued by NRSROs are valuable to financial market participants even if their informational content is no greater than that of public information already reflected in the market.

In particular, I analyze how these arguments apply to The New Basle Capital Accord, issued for comment on May 31, 2001. I argue that this accord is flawed to the extent it incorporates risk weights that depend on credit ratings, and recommend risk weights based on credit spreads.

In addition, I respond to the argument some scholars have made that rating agencies should not and do not engage in reputation-depleting activity because of the risk of civil liability. In fact, the available evidence indicates that rating agencies' expected civil liability is very low; rating agencies have not paid substantial damage awards in such litigation and by federal statute are immune from certain types of liability.

Abstract:
This paper was written in response to a request by the United States Senate Committee on Governmental Affairs for testimony on Enron's involvement in financial derivatives. The paper argues
that Enron essentially was a derivatives trading firm, not an energy firm. It explains the transactions Enron used to generate false profits and to hide losses, and the failure of Enron's internal controls with respect to derivatives trading. It also addresses the question of why key gatekeepers - including
banks, accounting firms, law firms, and credit rating agencies - failed to uncover information about these transactions and control failures. The paper is based on interviews of current and former Enron employees, and on a review of key Enron documents.

Abstract:
It is difficult to predict the future regulation of derivatives markets, especially given that current parameters are largely unknown. For example, derivatives markets include: (1) both over-the-counter (OTC) and exchange-traded options, forwards, and combinations of each, which range greatly in complexity; (2) a vast array of underlying instruments and indices, including interest rates, foreign exchange, securities, and commodities; (3) both institutional and individual participants, who vary greatly in sophistication; (4) numerous regulators, both governmental and self-regulatory, often with overlapping jurisdiction; and (5) multiple purposes for transactions, including speculation, hedging, arbitrage, and regulatory arbitrage.1 Even the size of the market is seemingly incalculable, with conservative estimates topping $100 trillion.

Yet derivatives are not new, and their rich history presents several unifying themes, many of which are likely to map into the future. Regulation can evolve along four different paths, depending on the timing and source of applicable legal rules. Legal rules applicable to derivatives can be generated either ex ante or ex post, from entities that are either public or private, as depicted below.

First are private ex ante legal rules developed primarily by the International Swaps and Derivatives Association, Inc. (ISDA) for OTC derivatives (and by various exchanges and self-regulatory organizations for exchange-traded derivatives). The recent trend has been toward increased privatization of derivatives regulation, with trading volumes shifting from exchanges to OTC transactions, and this trend is likely to continue. Privately-negotiated contracts based on ISDA form agreements should continue to dominate ex ante legal rules in the derivatives market. For example, the nascent credit derivatives markets are governed primarily by these types of contracts.

Second are private ex post legal rules applied by arbitrators in disputes, particularly those of the National Association of Securities Dealers (NASD). Although securities firms generally favor arbitration of disputes with customers and employees, derivatives dealers seem not to favor arbitration, even in complex derivatives disputes. Arbitration has numerous drawbacks, especially uncertainty, and likely will not predominate in future adjudication of derivatives disputes, especially if judges continue along the current path of ex post legal rules in the public adjudication of derivatives disputes. To the extent arbitration continues, the most important issue is likely to concern the treatment of suitability claims by institutions.

Third are public ex ante legal rules, including securities, commodities, and banking laws and regulation, but also including derivatives-specific rules. Historically, public regulation in these areas has not achieved its goals; instead public legal rules too often have generated perverse incentives related to regulatory arbitrage, regulatory licenses, and regulatory competition. Of particular significance now is the Commodity Futures Modernization Act of 2000 (CFMA), which - among other things - legalized the trading of security futures (i.e., futures contracts on individual equity securities). The proposed rules for margin requirements under the CFMA need reworking, as described in detail below. Fourth are public ex post legal rules, including rulings by courts adjudicating derivatives disputes. Thus far, judges have shied from deciding important issues in derivatives disputes, and end-users of derivatives increasingly avoid litigation - even when losses are large - because of the high costs of discovery and motion practice. Nevertheless, there are several important cases outstanding, and it is likely that a federal district court judge - probably one in the Southern District of New York (SDNY), where many such cases are heard - could write an opinion deciding dispositive motions in one of those cases, thereby reconfiguring the regulatory map.

This article addresses each of these four regulatory paths in turn: ISDA, NASD, CFMA, and SDNY. Although these paths are likely to diverge, they present some common themes. Future derivatives regulation likely will be dominated by private legal rules. To the extent public legal rules impose substantial costs on market participants, those rules will create incentives for regulatory arbitrage transactions. The same is true of public legal rules that depend greatly on private gatekeepers. The most contentious issues likely will surround whether legal rules should depend on the relative sophistication of the parties, whether derivatives regulation should be narrow and precise or broad and open, and whether regulators are able to generate legal rules that apply consistently throughout the derivatives markets. Public and private legal rules will remain interdependent.

The remainder of this article attempts to support the assertions made in this Introduction with analysis and data. Section II covers private legal rules generally, where ISDA forms have become the dominant private law in derivatives markets. Section II.A. analyzes private rules within the ISDA framework; Section II.B. covers arbitration. Section III looks more closely at public legal rules. Section III.A. analyzes public ex ante rules with a focus on the proposed margin requirements for security futures pursuant to the CFMA. Section III.B. examines recent data concerning litigation of derivatives disputes.

Abstract:
Hedge fund activism is a new form of arbitrage. Using a large hand-collected data set from 2001 to 2006 we find that activist hedge funds in the U.S. propose strategic, operational, and financial remedies and attain success or partial success in two-thirds of the cases. The abnormal stock return upon announcement of activism is approximately seven percent, with no reversal during the subsequent year. Target firms experience increases in payout, operating performance, and higher CEO turnover after activism. We also find large positive abnormal return to the self-reported hedge fund activists during our sample period. The abnormal return significantly exceeds the returns to all hedge funds, the returns to equity-oriented hedge funds and is robust to alternative risk adjustments and selection biases.

Hedge Fund, Activism, Governance

Abstract:
This essay discusses two recent episodes in the financial derivatives industry and the television coverage of those episodes. Our discussion focuses on (1) the 1994 bankruptcy of Orange County and the 60 Minutes television program describing that county's derivatives losses and (2) the 1998 near-collapse of Long-Term Capital Management (LTCM) and the PBS NOVA program describing that hedge funds' losses.

Orange County and LTCM appear at opposite ends of the spectrum of recent derivatives losses. Orange County's Treasury was a one-man show, and its now-infamous treasurer, Robert L. Citron, was a seventy-year-old college dropout. In contrast, LTCM was a slick, sophisticated hedge fund, led by John Meriwether, whose principals included two Nobel laureates and several "rocket scientists" recruited from the investment bank Salomon Brothers. Notwithstanding these differences, Orange County and LTCM had two things in common: each lost more than a billion dollars on derivatives and each shrouded the details of its operations in secrecy.

Coverage of LTCM was more accurate than coverage of Orange County. We discuss possible reasons for the difference and make some recommendations about how television programs could depict the derivatives markets more accurately, an important issue given the substantial number of policymakers who learn about derivatives through television. We conclude that television, when done properly, is more than capable of keeping pace with derivatives markets.

Abstract:
In this paper, we examine changes in financial instruments and institutions by contrasting the successes and failures of institutional shareholder activism during the 1990s with more recent developments in hedge fund activism and the use of financial innovation. We find that although institutional investor activism was the watch word of the 1990's, overall traditional institutional activism has been of marginal importance at targeted firms. In contrast, there is evidence of real monitoring in the more aggressive recent activism of hedge fund managers, in part because financial innovation has generated a host of new opportunities that did not exist a decade ago.

To illustrate these points, we compare institutional activism and hedge fund activism with respect to voting, litigation, and change of control contests. We also categorize the costs and benefits of four major types of strategies activist hedge funds recently have pursued: information asymmetry and convergence trades; capital structure motivated trades; merger and risk arbitrage; and, most controversially, governance and strategy. We conclude with a discussion of the policy implications of our work, pointing out some of the regulatory challenges created by this new wave of investor activism.

hedge funds, activism, corporate governance, risks, derivatives, institutional investors

Abstract:
This article addresses the question of why financial markets crash and proposes new rules to prevent or ameliorate the effects of crashes. I define a market "crash" as a sudden and widespread downward movement in asset prices. I describe the importance of market crashes to real economic growth and their relationship to efficient market theory. I explain the market failure rationales for crashes, including theories of investor cognitive error, moral hazard, and information asymmetry. I then analyze the role of law in encouraging an environment of trust in financial markets. I am critical of recent finance studies explaining the correlation between strict corporate governance rules and real economic performance. I attempt to explain how efficient legal rules can create incentives for widespread, public ownership by non-controlling minority shareholders, and conversely how inefficient legal rules may lead to a predominance of family-controlled firms. I also am critical of recent proposals for regulating markets to prevent crashes, including self-regulation, creation of a new so-called "global architecture," various kinds of capital controls, and mechanisms for establishing a lender of the last resort. In place of the existing approach to financial market regulation, I propose a new framework for analyzing law as a product that can be traded, and suggest how countries may opt into competing regulatory jurisdictions to prevent market crashes. I argue that regulatory competition already has resulted in issuers opting out of inefficient regulatory jurisdictions based on comparative advantage, and suggest mechanisms, including a "public poison pill," to encourage broad distribution of shares in countries in which most large firms are family-controlled. I also propose a system of short-term market insurance to protect investors from sudden and widespread downward movements in markets. In such a system, the government would act as a "stock buyer of last resort," instead of as a lender of last resort (the current U.S. policy), to support prices at some specified level in the event of investor panic.

I conclude with an application of these arguments to the recent crisis in Asia. I explain how the Asia crisis fits the model described above, and describe the failures of the U.S.-led response. In particular, World Bank and International Monetary Fund policies solved few problems and created many more, particularly by increasing the moral hazard associated with implicit guarantees to those investing in emerging markets. Perhaps most important, policymakers ignored the importance of family-dominated firms in the crisis.

Abstract:
This article analyzes how financial innovation, particularly the development of the derivatives market, has changed basic corporate law concepts, in two primary ways. First, derivatives have altered fundamental notions of fiduciary duty. Corporations are able to slice and dice cash flows in so many novel ways that it no longer makes sense to speak of a fiduciary duty owed by managers and directors to shareholders. Options theory contributes principally to this analysis. Second, derivatives lurk beneath the surface in a variety of corporate law cases, in ways that illuminate and challenge the legal rules established in those cases. For example, in the well-known case of Smith v. Van Gorkom, an option to purchase shares can be analyzed using finance theory in ways that contribute to an understanding of the court's duty of care discussion and provide additional insight into the behavior of the parties. In similar ways, derivatives are "uncovered" in other cases.

Abstract:
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.

strict liability, gatekeepers, insurance

Abstract:
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.

Abstract:
This article considers efforts to regulate (and to prevent the regulation of) the $100 trillion-plus global market for financial derivatives. It divides the universe of derivatives regulation into four categories of rule making - statutory, judicial, private, and arbitral - and proposes changes within each category.

Abstract:
This article makes two points about the academic and regulatory reaction to Enron's collapse. First, it argues that what seems to be emerging as the conventional story of Enron, involving alleged fraud related to Special Purpose Entities, is incorrect. Instead, this article claims that Enron is largely a story about derivatives - financial instruments such as options, futures, and other contracts whose value is linked to some underlying financial instrument or index. A close analysis of the facts shows that the most prominent SPE transactions were largely irrelevant to Enron's collapse, and that most of Enron's deals with SPEs were arguably legal, even though disclosure of those deals did not comport with economic reality. This first point about derivatives is important to the literature studying the relationship between finance and law: legal rules create incentives for parties to engage in economically equivalent unregulated transactions and financial innovation creates incentives for parties to increase risks (to increase expected return) outside the scope of legal rules requiring disclosure. Second, this article argues that the regulatory response to Enron was misguided, in part because it focused too much on the conventional story. Congress - in a little noticed provision of the Sarbanes-Oxley Act of 2002, Section 401(a) - directed the Securities and Exchange Commission to adopt new regulations requiring that periodic filings disclose off-balance sheet transactions that may have a material effect on a company's financial condition. The SEC originally proposed disclosure regulations based on this heightened may standard, but in its final release reverted to a lower reasonably likely standard. Surprisingly, the SEC promulgated these reasonably likely regulations even though Congress, in debating Sarbanes-Oxley, already had considered - and rejected - this approach. This second point about regulatory response is important to the literatures studying both mandatory disclosure and the relationship between Congress and administrative agencies: not only did interested private actors quickly capture the agency rule-making process, but they were able to persuade the agency to revive an interpretation the legislature already had considered and rejected.

Abstract:
On Dec. 15, 2000, Congress approved the use of single-stock futures. This essay analyzes some of the policy issues related to that approval. In particular, I discuss (1) the benefits and costs of margin rules applicable to single-stock futures, (2) the amendments to the securities laws to cover single-stock futures in areas such as insider trading and market manipulation, and (3) some potential benefits associated with the use of single-stock futures to avoid restrictions on shorting stock (e.g., the elimination of so-called "parent-subsidiary" anomalies, as when 3Com was worth less than Palm even though 3Com owned 95 percent of Palm's stock).

Abstract:
This article attempts to fill a few of the gaps in current scholarship about gatekeepers, and sets forth a proposal for a modified strict liability regime that would avoid many of the problems and costs associated with the current due diligence-based approaches. Under the proposed regime, gatekeepers (investment banking, accounting, and law firms) would be strictly liable for any securities fraud damages paid by the issuer pursuant to a settlement or judgment. Gatekeepers would not have any due diligence-based defenses for securities fraud. Instead, gatekeepers would be permitted to limit their liability by agreeing to and disclosing a percentage limitation on the scope of their liability for the issuer's damages.

For example, a gatekeeper for an issue might agree ex ante to be strictly liable for 10 percent of the issuer's liability related to the issuance, measured by the present value of any payment by the issuer pursuant to a settlement or judgment. A particular gatekeeper's liability would be limited to the issuer's liability related to that gatekeeper's role (e.g., counsel for the issuer or the underwriters generally would not be liable for material misstatements or omissions in audited financial statements). The percentage for each gatekeeper could range based on competitive bargaining and market forces, with a minimum limit (e.g., the amount of the gatekeeper's fee, or perhaps a fixed amount of 1 to 5 percent) set by law.

This modified strict liability proposal is intended to solve two important and parallel problems in securities regulation. The first problem is the rapidly increasing and substantial costs related to the role of gatekeepers in securities fraud, including both the costs of behavior designed to capture the benefit of due diligence-based defenses and - more importantly - the costs of resolving disputes about gatekeeper behavior. The second problem is that the value of gatekeeper certification is declining at the same time costs are increasing. The article gathers evidence to demonstrate these two problems, and shows how a strict liability regime might ameliorate them. Throughout this discussion, the article challenges the assumption that gatekeepers act as reputational intermediaries.

Abstract:
The fundamental assumptions in the law and economics literature about shareholder voting and the one-share/one-vote rule are flawed. The classic view is that share ownership is necessary and sufficient to create voting rights and that such rights should be directly proportional to share ownership. We demonstrate that this assumption is unfounded, both for shares that are economically encumbered (held by shareholders who are not pure residual claimants; e.g., a shareholder who owns one share and is also short one or more shares) as well as shares that are legally encumbered (held or associated with more than one shareholder; e.g., shares that are loaned to a short, who sells that share to another buyer).

The one-share/one-vote rule is not only economically suboptimal, but results in substantial deleterious consequences. Quorum and regulatory requirements are distorted; mergers and acquisitions are too easily approved; securities class actions are undervalued and simultaneously under- and over-compensate; bankruptcy distributions are over- and under-inclusive; and fixed-ratio stock offers are preferred over economically superior alternatives. These results all derive from an unfounded reliance upon the one-share/one-vote principle and the belief that even economically or legally encumbered shares are entitled to vote.

shareholder, shareholder voting, law and economics, encumbered shares, one-share one-vote principle

Abstract:
A primary cause of the recent credit market turmoil was overdependence on credit ratings and credit rating agencies. Without such overdependence, the complex financial instruments, particularly Collateralized Debt Obligations (CDOs) and Structured Investment Vehicles (SIVs), which were at the center of the crisis could not, and would not, have been created or sold. Long-term sustainable policy measures should take into account both regulatory and behavioral overdependence on ratings.

credit ratings, credit rating agencies, derivatives, stuctured finance, regulation, accounting, credit derivatives

Abstract:
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

Abstract:
This article was my contribution to the Symposium Professor Hillary Sale at Iowa organized to celebrate Robert C. Clark's treatise, Corporate Law. This abstract is taken from the review essay of the Symposium by Professors Ronald Gilson and Reinier Kraakman, 31 Iowa J. Corp. L. at 606, and is an advertisement for the entire Symposium issue. In any event, Gilson and Kraakman summarize the article better than I could.

Frank Partnoy's contribution to this Symposium adopts a different tact to questioning the dominant ideology of shareholder primacy in corporate law. Rather than proposing someone other the shareholders to whom, in the eyes of the law, the board owes allegiance, Partnoy questions the internal coherence of the claim that corporate law should follow shareholder interests. The essential point of Partnoy's paper is that the capital structure of a typical modern corporation is likely to contain several ticket-holders with equity-like claims on the firm's cash flows. In any given conflict-of-interest scenario, forcing the board to favor the nominal shareholders over another class of the firm's residual claimants may have perverse consequences. Instead, lining up with Jill Fisch, Partnoy concludes that the board should maximize the economic value of the firm, regardless of how cash flows are ultimately distributed to the firm's security holders.

CDOs, credit derivatives, credit quality, banks, credit default swap, collateralized debt obligation, risks, moral hazard, disclosure, credit ratings, bankruptcy

Abstract:
In this paper, I demonstrate the inefficiency of the current and historical patent terms, conduct simulations of an economic model of optimal patent length, and recommend some changes in patent policy based on these findings. First, I sketch the evolution of the current twenty-year patent term and its lack of responsiveness to changes in various financial variables. Unlike patent breadth, patent length has been fixed by legislatures for extended periods of time, even during recent years, when the 1998 State Street decision and it progeny have dramatically expanded patent breadth. Second, I conduct a series of simulations based on a dynamic model of the optimal patent term in order to analyze explicitly the effects of changes in certain financial variables (e.g., interest rates and the structure of patent-related cashflows). I find that the optimal patent term is highly sensitive to changes in the term structure of interest rates and to changes in the timing of cash outflows and inflows related to patents. For example, I find that under certain assumptions a one percent shift in interest rates results in an approximately one-year shift in the optimal patent term. Finally, I propose several alternative regimes under which the patent term could be made to vary in length based on interest rates or other financial variables.

Abstract:
This article proposes a regime in which contracting parties would select menus of synthetic (hypothetical) cases published by private associations who then would commit to adjudicate future disputes between the parties based on those cases. The first half of the article analyzes common law and its regulatory alternatives and explains the advantages of synthetic common law relative to each alternative. The second half of the article analyzes how a synthetic common law regime could reduce uncertainty and unfairness in the market for financial derivatives.

A synthetic common law regime could eliminate many of the problems associated with the current regulatory alternatives of common law, statutory law, private law, and private arbitration. Because synthetic common law would be based on ex ante findings by the parties, it more likely would reflect societal practice and parties' expectations than does common law, which is based on ex post findings by a judge or jury. Because parties could incorporate synthetic common law cases at very low cost, the regime would not suffer from the depletion of relevant precedents, as real common law has. Because synthetic common law would be based on broadly ranging menus of cases, it would avoid the inflexibility of statute-based regimes. Because synthetic common law would rely on analogical reasoning by private judges based on cases specified ex ante, it would avoid certain intractable problems associated with private contract provisions, including the difficulty of specifying contingencies of rapidly evolving practices. Because synthetic common law would be administered privately it would generate the benefits of existing private dispute resolution regimes, but because synthetic common law would provide to parties a list of cases to govern any dispute, it would avoid the uncertainty and secrecy associated with private arbitration.

Synthetic common law is an alternative regime to consider for legal scholars writing in the area of institutional competence and public choice. A public choice analysis need not compare only a legislature captured by special interests to a sluggish and ill-equipped judiciary. In certain areas of practice ? especially those with rapidly evolving technologies (e.g., finance, telecommunications, intellectual property, computer law, the Internet, and perhaps commercial or corporate law) ? synthetic common law may be a reasonable middle road.

Abstract:
This white paper was commissioned by the Council of Institutional Investors for the purpose of educating its members, policymakers, and the general public about important credit rating agency regulation proposals and their potential impact on investors. It offers an institutional investor perspective of the pros and cons of several proposals for redesigning credit rating agency regulation. It focuses on two areas of primary importance - oversight and accountability - and offers specific recommendations in both areas.

First, Congress should create a new Credit Rating Agency Oversight Board (CRAOB) with the power to regulate rating agency practices, including disclosure, conflicts of interest, and rating methodologies, as well as the ability to coordinate the reduction of reliance on ratings. Alternatively, Congress could enhance the authority of the Securities and Exchange Commission (SEC) to grant it similar power to oversee the rating business. Second, Congress should eliminate the effective exemption of rating agencies from liability and make rating agencies more accountable by treating them the same as banks, accountants, and lawyers.

As financial gatekeepers with little incentive to “get it right,” credit rating agencies pose a systemic risk. Creating a rating agency oversight board and strengthening the accountability of rating agencies is thus consistent with the broader push by U.S. policymakers for greater systemic risk oversight. Over the long term, other measures for assessing credit risk may become more acceptable and accessible to regulators and investors. Meanwhile, a more powerful overseer and broader accountability would help reposition credit rating agencies as true information intermediaries.

credit ratings, credit rating agencies, derivatives, structured finance, regulation, accounting, credit derivative

Abstract:
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 consulting services based on its reputation as a standard bearer. 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.

CDOs, credit derivatives, credit quality, banks, credit default swap, collateralized debt obligation, risks, moral hazard, disclosure, credit ratings, bankruptcy

Abstract:
Hedge fund activism is a new form of investment strategy. Using a large hand-collected dataset from 2001 to 2006, we find that activist hedge funds in the United States propose strategic, operational, and financial remedies and attain success or partial success in two-thirds of the cases. The abnormal stock return upon announcement of activism is approximately 7 percent, with no reversal during the subsequent year. Target firms experience increases in payout and operating performance and higher CEO turnover after activism. We find large positive abnormal return to hedge fund activists, which is higher than the return to other equity-oriented hedge funds.

Alternative Investments - Hedge Fund Strategies, Portfolio Management - Hedge Fund Strategies, Corporate Governance