Distorting legal principles.

• Author: Schwarcz, Steven L.

1. Introduction II. Background III. REHYPOTHECATION AND INTERMEDIARY RISK A. The Distortion B. Consequences of the Distortion C. Towards a Framework for Balancing Consequences 1. Balancing Consequences 2. Adjusting the Balancing for Potential Bias 3. Informing the Balancing Through Long-Standing Distortions D. Applying the Framework IV. Other Distortions and Their Consequences A. Automatic Perfection B. Priority Reversal for Minerals C. Repo and Derivative Exemptions D. Restatement of the Framework V. Utility of the Framework A. Application to Government Lawmaking B. Application to Judicial Decision-Making C. Application to Lawyering VI. Conclusions I. Introduction

   Legal principles enable society to order itself by preserving broadly based expectations. Sometimes, however, parties transact in ways that are so inconsistent with generally accepted principles as to create uncertainty or confusion that undermines the basis for reasoning afforded by the principles. Such a distortion might occur, for example, if a normally mandatory legal rule were unexpectedly treated as a default rule. This Article explores the problem of distorting legal principles, initially focusing on rehypothecation, a distortion whose uncertainty and confusion contributed to the downfall of Lehman Brothers and the resulting global financial crisis. But not all distortions are, on balance, harmful; sometimes they represent a positive evolution of law. To this end, this Article also seeks to construct a normative framework for determining how lawmakers, judges, and lawyers should address distortions of legal principles.

   This Article explores the important but until now largely neglected problem of distorting legal principles, usually for business ends. (1) The exploration starts by examining a fundamental distortion of the legal principle of nemo dat quod non habet ("nemo dat")--one cannot give what one does not have. This distortion, resulting from a practice known as rehypothecation, (2) caused a type of intermediary risk (3) that was at the heart of the recent global financial crisis and threatens to trigger future such crises. (4)

   Using this distortion of nemo dat, this Article constructs a framework for analyzing distortions of legal principles. (5) The central normative issue is when to allow or tolerate these types of distortions, given their potential costs. A proposed distortion might appear to be socially favorable on a simple balancing of costs and benefits, but there is also a chance it might end up seriously harming the public. This is especially likely when private interest groups favor the distortion, because they would almost certainly receive a disproportionate share of the benefits with the public potentially suffering a disproportionate share of any harm.

   Because of the potential for significant public harm, this Article argues that distortions of legal principles should be assessed not on a simple cost-benefit basis but by a higher standard. A heavily-outweigh balancing test, this Article contends, can help to rebalance distributive effects of the distortions. This Article also examines which individuals and institutions should make the assessment and how they might do so.

2. Background

   A distortion of nemo dat resulted in a type of intermediary risk that was central to the recent financial crisis. (6) Intermediary risk, generally, is the risk that property held by an intermediary on behalf of third parties may be seized by creditors of the intermediary. (7)

   This risk has great practical importance where the property held by the intermediary is investment securities (hereinafter "securities") and the intermediary is a broker-dealer, bank, or other financial services firm (8) holding the securities on behalf of third-party investors (hereinafter, "investors" or "customers" of the intermediary). (9)

   Intermediary risk can arise in several ways. (10) The intermediary risk at issue in the financial crisis resulted from a distortion of nemo dat caused by a globally widespread, albeit abstruse, (11) practice called "rehypothecation." Rehypothecation occurs when an intermediary holding securities on behalf of investors--often a broker-dealer acting as prime broker for its customers (12)--grants a security interest in (or otherwise encumbers) those securities in order to obtain financing for itself. (13)

   Rehypothecation has good business justification: enabling intermediaries to obtain low-cost financing. (14) However, its distortion of nemo dat creates uncertainty whether customer securities become subject to claims of an intermediary's creditors, to whom the securities have been rehypothecated. If customer securities were to become subject to those claims, customers could lose their securities if the intermediary fails. This intermediary risk can motivate the intermediary's customers to withdraw their investments if they hear rumors of, or otherwise fear, an intermediary's insolvency. (15)

   The most dramatic and consequential example of this occurred in the autumn of 2008. Thousands of customers, including many hedge funds, rushed to withdraw their investments from the accounts of Lehman Brothers, which had been acting as their prime-brokerage intermediary. (16) Much like a "run on the banks" (17), this rush to withdraw inadvertently triggered--or, at least significantly contributed to--Lehman's collapse. (18) And Lehman's collapse was one of the central triggers of the worldwide financial crisis. (19)

   This Article's analysis proceeds as follows. Part III uses rehypothecation, its distortion of nemo dat, and the resulting intermediary risk to construct a policy framework for assessing distortions of legal principles. Part IV tests and expands that framework by applying it to other distortions. Part V examines contexts in which individuals and institutions could apply the framework.

   A threshold question is: what does this Article mean by "distortion of a legal principle"? The distinction between mandatory and default rules helps to inform the answer. By "legal principle," this Article means a normally mandatory rule or doctrine, such as the nemo dat rule, that is so generally accepted within a legal system that it forms a basis for reasoning. (20) Distortion of a legal principle would occur when something distorts the principle in an unexpected way, creating uncertainty or confusion that undermines the basis for reasoning afforded by the principle. A distortion might occur, for example, if a normally mandatory legal rule were unexpectedly treated as a default rule.

   The concept of distorting a legal principle also has temporal elements. For example, a long-standing distortion of a legal principle may become so generally accepted that it no longer distorts the principle in an unexpected way. (21) Such a long-standing distortion would have trivial consequences, ultimately devolving into a mere exception to the principle. (22) Furthermore, the concept of distorting a legal principle refers to a legal principle at the time of the distortion. Legal principles can change, and indeed the centralized filing principle discussed in Part IV.A below exemplifies relatively recent change. (23)

   There may be doubt at the margins as to what falls within these categories. Nonetheless, I believe that most would agree that the examples used in this Article are relatively clear in a business context. In that context, economic efficiency demands that parties be able to anticipate what is expected and assess the consequences. (24)

3. Rehypothecation and Intermediary Risk A. The Distortion

   Rehypothecation can distort the legal principle of nemo dat. An intermediary's granting of a security interest in securities that it owns would be conceptually clear and consistent with nemo dat: one may always grant a security interest in property (which, after all, is a "bundle of rights") (25) to the extent of one's rights therein. (26) The rehypothecation that occurred in Lehman's case, however, was different. (27)

   Lehman, like many other prime-brokerage intermediaries, insisted that customers contractually consent to allow the intermediary to directly rehypothecate the customers' securities as collateral for financing obtained by the intermediary. (28) Although this practice has been widespread and longstanding, (29) it is conceptually flawed in that the intermediary does not own those securities but merely holds those securities on behalf of its customers, who at most give the intermediary a security interest in those securities. Lacking ownership of the customers' securities, the intermediary should not be able, under the principle of nemo dat, to grant a security interest that enables its creditors to obtain ownership of those securities through foreclosure. Conceptually, therefore, Lehman and other prime-brokerage intermediaries ignored nemo dat when engaging in this form of rehypothecation. (30)

   2. Consequences of the Distortion

      Rehypothecation has both positive and negative consequences. As discussed, it enables securities intermediaries to obtain low-cost financing. (31) But its negative consequences (intermediary risk) have been devastating, including the failure of Lehman Brothers and the resulting worldwide financial crisis. (32)

      At least in the United States, these consequences should have been mitigated--if not eliminated--by protections provided in commercial law, (33) by a limitation on rehypothecation provided in securities law, (34) and by government insurance of securities accounts (through the Securities Investor Protection Corporation, or "SIPC"). (35) The commercial-law protections failed, however, because intermediaries had lobbied in the UCC revision process to exempt rehypothecated securities from those protections. (36) The securities-law limitation failed because it was insufficient in amount to prevent customer "runs" from destroying intermediaries. (37) The government insurance failed because its coverage was insufficient to...