When should changes in markets for financial securities drive changes in law? In my forthcoming essay, available here, I argue that a normative framework for making that examination would increase transparency and legitimacy. It would also help counter the tendency of politics to distort legal responses to market changes. During economic prosperity, for example, the political push for deregulation can leave financial markets under-protected. But when the bubble of prosperity inevitably bursts, the political push for regulation can lead to over-protective laws.
The essay argues that the extent to which financial market changes should drive legal changes should depend on consequences: the consequences of market failures resulting from the market changes, and the consequences of changing the law to attempt to correct those failures. The first steps of this consequence-based inquiry, or “CBI,” are identifying financial market changes, determining whether any market failures result from those market changes, and assessing the consequences of those failures. If those consequences are harmful, the next steps are considering legal changes that could correct the market failures, examining the consequences of making those legal changes, and finally balancing consequences to reach a course of action.
In taking these steps, how should one assess and compare consequences? In the context of financial markets, consequences should be measured by economic costs and benefits. But that calls into question how CBI differs from cost-benefit analysis, which is widely used to assess the desirability of proposed regulation. The answer is that CBI includes but goes beyond the traditional and most common use of cost-benefit analysis (“CBA”)—addressing the “how” of regulation.
CBI addresses not only the “how” but also the “when” of regulation and, moreover, addresses the “how” more objectively than CBA. By starting with a regulatory proposal, CBA does not—at least in practice—engage the question of when regulation should be proposed to address a problem. In contrast, CBI begins by engaging that question. It does that by identifying market failures resulting from changes in financial markets—indeed, the essay also examines how financial markets could be proactively monitored to identify those failures—and assessing their consequences. If those consequences are significantly negative (for example, a market failure causes material harm), CBI gets to the next steps, constituting the “how”: considering legal changes that could correct the harmful failures, examining the consequences of making those changes, and finally balancing consequences to reach a course of action.
CBI also addresses the “how” more objectively than CBA. CBA assesses the desirability of proposed regulation, but the very existence of a proposal carries the possibility if not likelihood that the proposal will be biased or the analysis will be biased in favor of the proposal. The proposal may be biased because, as mentioned, politics can distort legal responses. The analysis may be biased in favor of the proposal because of confirmation bias—merely proposing a specific proposal can influence those assessing it to focus on evidence that confirms the proposal and to depreciate evidence in opposition.
The essay next tests and develops its CBI framework by applying it to an actual financial market change: the bond-market change from investors (a) holding their corporate bonds to maturity to (b) trading their corporate bonds by reselling them prior to maturity. When investors held their bonds to maturity, they expected to receive their value through the periodic payment of principal and interest. Today, however, most investors engage in bond trading (recent data indicate that the turnover rate of corporate bonds is approximately twice that of equity securities). As a result, investors now tend to view their bond investment decisions from a market-pricing standpoint (based on trading price), and are less likely to view those decisions from a periodic-payment standpoint.
This bond-market change causes at least two types of market failures, one of which is a significant agency failure—managers of firms do not act on behalf of bondholders, who should now be their constituents. Prior to the bond-market change, the law assumed that bondholders lacked a direct interest in their firm’s performance, and thus were unaffected by managerial decisions, so long as the firm remained solvent to repay principal and interest when due. The law also assumed that bondholders could rely on covenants to contractually protect against the firm’s insolvency.
The bond-market change undermines both of those assumptions. Because the resale price of bonds is tied to firm performance, solvency alone cannot protect bondholders. And bondholders cannot contractually assure that performance because, as the essay shows, covenants cannot control all of the operating and investment decisions necessary to run the firm efficiently. As a result, bondholders can now be directly affected by managerial decisions. If managers do not act on their behalf, would-be bondholders may be reluctant to invest, depriving firms of a critical source of funding. Managers may also be tempted to engage in morally hazardous behavior, acting with other people’s (i.e., bondholders’) money but not being responsible to them.
To help correct this agency failure, the essay examines and balances the consequences of changing corporate governance law to include bondholders. There are at least two ways that could occur: bondholders and shareholders could share governance, or managers could have a duty to both bondholders and shareholders. The sharing-governance approach would be simpler and involve less managerial discretion, and thus would be procedurally easier to implement. But if bondholder representatives could block management decisions, that could impair corporate profitability. The dual-duty approach would provide more flexibility for profit making. Although weighing that duty would require judgment, managers would be protected by the business judgment rule. The essay also balances the consequences of changing corporate governance law against the consequences of maintaining the status quo.
The essay does not claim that CBI is necessarily better than all conceptions of cost-benefit analysis. In its ideal form, CBA would look a lot like CBI (and indeed, the original goals of at least one federal executive order for assessing regulatory change even appeared to parallel CBI’s goals, although that order’s implementation has followed traditional limitations). The essay claims only that CBI should be better than traditional cost-benefit analysis.
This post comes to us from Steven L. Schwarcz, the Stanley A. Star Professor of Law & Business at Duke University School of Law and Senior Fellow at the Centre for International Governance Innovation. It is based on his essay, “Changing Law to Address Changing Markets: A Consequence-Based Inquiry,” which is available here.