Richard Shamos is an Associate in the Investment Management practice at Schulte Roth & Zabel LLP in New York.
The relationship between free markets and government is perhaps one of the most prominent economic issues of modern political economy. In A Legal Theory of Finance, Katharina Pistor presents a powerful tool for analyzing this relationship by emphasizing the central role law plays in defining markets and market instruments. This article examines Pistor’s mode of analysis and then explores how it may be applied within the investment fund context to draw on real world examples of the relationship between law and finance.
As an inductive theory, Pistor’s legal theory of finance proposes an alternative mode of analysis from traditional theories on how markets work. Notably, neo-classical economic theories use deductive “top-down” reasoning to apply principles of supply and demand to our understanding of how markets function. These theories emphasize economic freedom as a precondition to the functioning of the market, and so tend to view government intervention as a manipulation of a Pareto efficient outcome. The supply and demand model, however, is static in time, and so assumes that a particular set of market conditions already exist. What Pistor’s legal theory of finance does, essentially, is to look under the hood of that static economic model and examine the structural components of the market in a dynamic fashion. By examining the role law plays in markets in this manner, LTF presents a fresh narrative on the relationship between governments and markets.
A central thesis to Pistor’s theory is the notion that financial assets are legally constructed, and so the financial systems they create “comprise a complex interdependent web of contractual obligations.” Whether through regulatory law, contractual law or judicial interpretation, law serves as a reference point and an interpretive backstop for all contracts constructed within its jurisdiction (and often in today’s market, outside of its jurisdiction as well). These laws may vary from one country to another because, as Cathy Kaplan notes, “the structure of laws in any country governing financial instruments and markets reflects the policies and politics being advanced within that country.” As a result, different legal regimes will spawn varying types of financial instruments and entities, and these different approaches often define the market in a given product.
The diversity in legal-financial structures is well demonstrated by the investment funds market, which presents an array of investment options for potential investors. Some of these options include a retail U.S. mutual fund, a private Delaware fund, a U.K. open-ended investment company, a Cayman Islands, British Virgin Islands or Bermuda fund, a Luxembourg or Ireland fund, or a UCITS-registered fund or variety of other entity types, each of which comes with its own unique “complex interdependent web of contractual obligations.” Each such contractual web draws on a distinct legal and regulatory regime that has often been finessed for a specific purpose through years of regulatory or judicial action. That is, the financial instrument in which an investor invests has been carefully and intentionally constructed by law. As a result, these various types of entities create an array of contractual options for an investor and give rise to a market in investment funds.
A Delaware fund, for example, may make an attractive investment for a taxable U.S. investor, because Delaware’s jurisdiction offers a robust body of entity law and a number of pass-through entity types that enable investors to take advantage of capital gains tax rates. On the other hand, a Cayman Islands company may make an attractive vehicle for a tax-exempt U.S. investor, since a Cayman limited company is generally treated as a corporation for tax purposes and thus enables the tax-exempt investor to avoid potential tax liabilities for “unrelated business taxable income.” A European investor may prefer to invest in a UCITS-registered fund, since this represents an EU standard that provides for greater liquidity, enhanced investor disclosures and financial safeguards, while a Japanese investor might make its investments through a Japanese investment trust or a specialized product such as a Cayman vehicle registered in Japan for retail distribution (a creature of Cayman law created specifically for this purpose). At the end of the day, any one of the above investors might be holding an interest we would all generally refer to as a “security,” yet each of these securities represents an interest in a distinct vehicle that has been molded through law to present a unique legal-financial construct.
It is no wonder then that law is elastic at its core, because the legal system and the market are often interdependent, and the collapse of a market or of an institution may likewise bring about the collapse of a government. Since 2008, this understanding seems to have been conventionally accepted, as demonstrated in the moniker “too big to fail.” Likewise, the creation of the Orderly Liquidation Authority under the Dodd-Frank Act has created a formal system for bringing together the government and markets to unwind systemically important financial institutions during a crisis. This is an explicit recognition by law of the need for elasticity and a blurring of the lines between government and markets when the core is threatened.
By examining this dynamic relationship between law and finance, Pistor’s legal theory of finance offers a mode for understanding not only how markets and governments interact during a crisis, but also how changes in the regulatory landscape can alter financial products and markets. Notably, the Dodd-Frank Act has introduced an array of new laws and regulations affecting financial markets, for example by introducing regulation of OTC derivatives and requiring registration of private investment advisers. In the investment funds context, this legislation and regulation has altered the market by changing the contractual web that an investor receives when it purchases interests in a private fund, and many would argue that such interests represent safer investments as a result. So while law may in some instances restrain markets, such restrictions may strengthen the final legal-financial “product” and open opportunities for greater market freedom. The dynamic process is revealed.