Reform of American Business Law

This blog serves as support for a graduate course using the ongoing worldwide crisis as thread. The global nature of this crisis dispenses with the demonstration of the need for a course on the legal environment of business in the US, for students of other nationalities, who have registered for a Masters degree on International Business and Exports.

Last year the label of this course was "American Business Law". For many reasons, this label was debatable. The mildest one is that it sounded like a translation of "Droit des Affaires Américain" - in the US, one rather speaks of "Legal Environment of Business". The other is that nobody expects a 22 hour course to cover commercial contracts, corporate law, bankruptcy, banking law, securities law, monetary law, antitrust, intellectual property and taxation (and all of those are part of the "Legal Environment" in which businesses are created, grow, stagnate, decline and eventually die).

Last year we had used the then-ongoing financial crisis as thread for the course. This was a good choice, and we kept it for this year: "If you liked 1929, you will love 2009".

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As a reminder, this Masters Degree is on International Business and Exports.

This is highly intuitive, but the graduates in Entrepreneuship can confirm, exports can only be a fraction of production not consumed locally. They can also confirm how we write a production function: Q = f (K,L,T): the quantity produced is a function of factors known as capital, labor and technology.

"Technology" is used in a very broad sense, and does not refer only to certain technological rules one follows to produce an item. Looping back to what we said in the first session, it includes all the rules (including rules of Law) governing all the conditions under which the factors may be combined (not every combination is possible) to ultimately produce and sell an item (not every sales term is permitted).

Speaking of combination of factors, the rules of Monetary Law determine how much capital will be available, the rules of Employment Law dictate how much labor will cost, and the rules of Budgetary Law set forth the rate of taxation for income from capital and labor, the general rate of taxation for domestic sales and for exports, plus a galaxy of special duties and accises.

We also said that it is impossible, these days, to open a newspaper or turn the TV on without reading or hearing some outcry for the reform of these rules.

Which ones, what for, in what direction and with what specific content is left for us to figuer out, I guess. Obviously "in the direction of higher moral standards" and "with content that makes them better" are not guidance that helps immensely.

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What if, instead of asking complicated questions concerning liquidity and derivatives, one just came up with a simple answer? When asked what the origin of the crisis was, then-President George W. Bush came up with this kind of answer: "We built too many houses". Don't be dismissive: that I know of, he was, after all, the first American President to hold an MBA.

You all know that originally, "subprime" mortgage-backed loans were granted to people who would not qualify as "prime" risk, to put it mildly: NINJA debtors are but one example of this category of "subprime" debtors.

Before those of you familiar with risk management suggest that subprime risks should not be granted loans at prime rates, I would like to note that you be implying that the poor should pay more than the rich. Which might not be the best way of "moralizing capitalism", if that is what you intended at all.

Alternatively, and rule of Law permitting, one could still act generously and grant loans to the poor as if they weren't poor, and still comply with what you were taught in Risk Management, if one splits the risk.

Why not after all? You Banks grant loans to a sizable group of debtors, some of which are solvent, while others are not. Hopefully the more solvent will want better, more expensive houses, and demand higher loans; people with modest income will go for more modest houses and demand lower amounts of money.

Wel, OK, last time I looked the poor were more numerous than the rich, but adding many probable insignificant defaults and many good credits for a lot of money does not necessarily place you on the wrong side on risk management.

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Now let's measure cost and quality of the Bubble Act of 1720. It was passed in the midst of the South Sea Bubble, while the stock of the South Sea Company was still rising towards its peak at 700% of initial value, before collapsing to a few nickels above that initial value by the end of the year.

This historical fact leads to the discussion of success or failure of the Act. One needs to conclude to failure, if the purpose of the Act was to prevent the formation and burst of the bubble. On the other hand it was a resounding success if the purpose was the opposite.

Can we envision the possibility that the Act might have been passed to favor, not combat, a bubble; or is this too far fetched? The Statute's recitals referred to

persons who contrive or attempt dangerous and mischievous undertakings or projects, under false pretences of public good, do open books for public subscriptions, and draw in many unwary persons to subscribe therein towards raising great sums of money.

The Act prohibited this type of scheme and imposed penalties for those involved in the issue and trading of such shares. But was the South Sea Company itself a target or a beneficiary? All depends on whether it was or wasn't comprised in the language "persons who contrive or attempt dangerous and mischievous undertakings or projects, etc.".

The South Sea Company wanted to prevent other opportunities from diverting investment away from its own stock, that is fact. Also fact is that South Sea Stock was fashionable, and many influential people (from the King's mistress downwards) owned such stock and had everything to win from a prohibition of alternative investment products.

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In previous sessions we discussed the Law fencing permitted from prohibited in securities markets since the nineteen thirties, arguably closing the paddock when the stallions had already fled. Today we will see if the same was true of banking law.

In terms of purpose, we said Securities Law was there to protect investors and, as desirable side effects, enhancing market efficiency, and (more recently) correcting market failures. Why not suggest that Banking Law is there to protect depositors, enhance the banking system efficiency and suppress market failures?

Both Securities Law and Banking Law may pursue broader social objectives, such as containing systemic risk, fighting money laundering or facilitating the acquisition of houses.

May I suggest you handle "Systemic risk" with care, because there was a time when crises originated at the periphery of capitalism (Asian Flu, Tequila Crisis, etc.) and we used to blame them on bank-based financial systems (systems in which funding is mainly available from banks). Implicitly, we thought that only banks meant a systemic risk, because bank liabilities are non-contingent.

Now the current crisis (which by the way originated at the core, not the periphery of capitalism) taught us that there is "systemic risk" in the securities market, too; and also in supply chains; and ultimately there can be "systemic risk" in every "system", which should surprise nobody. So handle "systemic risk" with care, and don't think it is necessarily specific to some form of economic activity such as banking.

Back to purpose, or ratio legis as we Lawyers sometimes say of Securities Law and Banking Law, "protecting investors" and "protecting depositors" may sound very similar, except that the meaning and scope of "protection" is not the same.

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