The morals of the marketplace: a cautionary essay for our time.

AuthorMitchell, Lawrence E.

The law is well-established that neither shareholders nor creditors owe duties to the corporations or other productive entities they finance except in extraordinary circumstances. (3) The doctrine of limited liability provides the superstructure that contains this isolation. (4) I do not propose to challenge these rules nor suggest their modification. But recent events in American financial markets (5) raise questions as to whether, as an ethical or prudential matter, share holders and creditors should be held responsible for exercising some degree of consideration for the corporations and other productive enterprises in which they invest in order to ensure the integrity and stability of financial markets and the productive American economy that underlies them. (6) The matter is pressing because it appears to be the case that a distinct absence of investor responsibility at least catalyzed, and was probably a significant contributing cause of, much of the recent turmoil. If so, and given the well-known collective action problems existing in financial markets, (7) the question arises as to how an appropriate degree of investor responsibility might be coordinated. It is these questions that I propose to address in this Article. (8)

It is my argument that, in brief, securities of all types have become deracinated. (9) I mean by this that the relationship between securities and other financial instruments, and the activities which they purportedly finance, have become increasingly attenuated. The trading and investment incentives underlying securities and the capital market behavior that reflects them seem to have little to do with the fundamental economics of industrial production and the provision of goods and services. As I will discuss, the sphere of finance and the sphere of production, once closely connected (and still connected in some instances), (10) have increasingly become detached from one another such that holders of financial instruments have little knowledge of, or concern with, the productive economic activities that ultimately support the value of their securities. Rather, they trade in a market apart, a market that moves of its own logic based upon incentives and realities it creates for itself. The result is that finance finances finance.

While the separation of capital providers from productive activity often is sound as a matter of investment theory, and in fact frequently is applauded by finance theorists and traders alike, (11) it transforms the capital markets created to provide investor liquidity into a type of moral hazard for the real economy by altering investors' behavioral incentives. The result is an increasingly speculative, and thus volatile, financial realm that imposes on corporate managers significant incentives to make decisions that may well damage the long-term economic health of the enterprises they are managing.

The law that imposes no corporate obligation on shareholders or creditors (12) historically was based on the assumption that the financial incentives of investors would rationally direct them to act in their own self-interest, which would align with their perceptions of the entity's best interests, and the same may be said of financing productive activity more broadly. (13) The productive entity would be well-run, or at least for the purpose of achieving the success of its business, because it was in the interest of its financiers to ensure that it was. The more attenuated the security from the productive activity, the less is this true.

This is not to say that investors always agree. Indeed some of their disagreements might help to balance managerial behavior. For example, on the margins, investors' perceptions may differ with the type of investor in question. (14) Common stockholders generally are presumed to favor corporate risk taking; long-term unsecured creditors, in contrast, prefer no more risk than is necessary in order to allow the corporation to repay their principal and interest. But these differences are matters of degree. Common stockholders typically are not in favor of management "betting the farm," and long-term unsecured creditors understand that the corporation must take some degree of risk in order for it to survive and prosper. (15) In each case, the investor is concerned about the corporation because she must be concerned about the corporation if she is to realize the hoped-for return on her investment.

I argue that this state of affairs is no longer the case, at least in terms of investor perception. It is necessarily the case that the underlying entity in which an investor puts her money must indeed survive and prosper in order for her to realize the return on her investment. But, as I will explain, a dramatic shift in perception has occurred such that it is not any specific investment with which the investor is concerned, but rather with a portfolio of investments she holds in which some are expected to be winners and some to be losers. The combination of applied modern finance theory and the proliferation of new forms of securities encourage her to be more or less indifferent to the fate of any given corporation or other investment entity. Her interest shifts from a given productive activity to the capital markets. Investment activity thus becomes primarily a function of capital market behavior. (16)

The consequences for investors of this newer way of thinking often are salubrious. (17) Yet the market's behavior has profound, and often negative, effects on corporate management and other sectors of the real economy that have been securitized. I will focus, for reasons of economy and conciseness, on corporate stock and mortgage-backed securities. It is my argument that the analysis of these types of investment easily can be extrapolated to the universe of investments, and thus the behavior of the capital markets as a whole. (18)

In this Article, I will explore the ways in which modern finance theory and security proliferation have operated to legitimate the detachment of the security from the investment and, albeit unintentionally, to encourage their separation in practice. If financing productive activity is a major justification for the existence of capital markets, that justification is increasingly untenable. (19) Taming the capital markets to take responsibility, or at least to act as if they were responsible, for economic production in the real economy is the solution. (20)

  1. DISTILLING CORPORATE STOCK

    The problem is most clearly analyzed with respect to perhaps the least complicated form of investment, common stock. (21) I shall be especially concerned with the practice of portfolio investing and the development of portfolio theory as a catalyzing force in the separation of investment from production.

    Portfolio investing has been a recognized prudent practice at least since American industrial corporations first began to issue their stock to the public in significant numbers during the late nineteenth century. Benjamin Graham and David Dodd, in their 1934 classic, Security Analysis, turned it into an essential principal that justified an understanding of purchasing common stock as investing in contrast to speculation. Indeed, their book was in part an extended attempt to qualify common stocks as investments in the wake of their historical categorization as speculative and their actual treatment as such during the bubble market that began in 1927 and collapsed through 1933.

    Graham and Dodd attempted to find a place for common stocks as deserving of the category "investment." (22) They defined "[a]n investment operation [as] one which, upon thorough analysis, promises safety of principal and a satisfactory return," (23) in response to well-known analyst Lawrence Chamberlain's 1931 assertion that all stocks are speculative and that the only sound investment is a bond.

    In justifying the term "investment" as applied to common stock, Graham and Dodd described the inherent limitations in one's ability to value it. Noting that the popular valuation technique of looking to past earnings was highly unreliable with respect to any particular company, they developed a notion of common stock investment that had characteristics similar to insurance industry practices. Insurers, they noted, based their risk premiums on past experience, adjusting for moral hazard. Knowing that the losses in any given case could exceed the premiums paid, they assembled large portfolios of insureds. Similarly, wrote Graham and Dodd, while common stock investors attempt to maintain the security of principal and obtain the "full value" for each stock, the inability to forecast future earnings from past earnings serves as the equivalent of the insurer's moral hazard. Consequently, in order to conceive of common stock as an investment that fulfilled the demanding conditions of their definition, one must understand that "diversification [is] an integral part of all standard common-stock-investment operations. In our view, the purchase of a single common stock can no more constitute an investment than the issuance of a single policy on a life or a building can properly constitute an insurance underwriting." (24)

    With this established principle aligning profitable common stock purchases with the need to protect principal as best one could, common stock could escape its speculative status and be treated as an investment much in the way bonds were considered. But one had to know which stocks to pick. Their now-famous answer was fundamental valuation, careful attention to each company and each stock issue, in order to find stock that was correctly priced or, even better, a bargain.

    The important point for purposes of this Article is to note the manner in which portfolio investing was established as the bedrock upon which common stock investments were to be made. Graham and Dodd went on to teach a very careful and nuanced lesson to potential analysts in how to...

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