法学资料大全（英文）：综合的普通法

School of Law Law and Economics Research Paper No. 04 SYNTHETIC COMMON LAW Frank Partnoy This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://papers.ssrn.com/paper.taf?abstract_id=244558 10/9/00 DRAFT SYNTHETIC COMMON LAW FRANK PARTNOY* I. INTRODUCTION II. THE LIMITS TO COMMON LAW A. The Case for Common Law 1. Evolution and Efficiency 2. The Supply of Legal Rules B. The Case Against Common Law 1. Devolution and Inefficiency 2. The Shrinking Supply of Legal Rules III. ALTERNATIVES TO COMMON LAW A. The Viability of Statutory Law B. Private Law C. Opting Out through Private Adjudication IV. A PROPOSAL: SYNTHETIC COMMON LAW V. USING SYNTHETIC COMMON LAW IN DERIVATIVES DISPUTES A. Line-Drawing in the Derivatives Market B. A Critique of the Four Approaches 1. Piecemeal Regulation of Derivatives by Statute 2. Judicial Treatment of Derivatives Disputes 3. The Limited Applicability of Private Law 4. Some Attempts at Arbitration C. How Synthetic Common Law Could Govern Disputes D. Institutional Barriers to Synthetic Common Law VI. CONCLUSION I. INTRODUCTION In modern society, most everything is, or can be, synthetic: food, clothing, shelter, even thought.1 Yet law continues to be real.2 Real * Associate Professor, University of San Diego School of Law. J.D., Yale Law School, 1992. Larry Alexander, Kevin Cole, Mitu Gulati, Peter Huang, Shaun Martin, Dennis Patterson, Sai Prakash, Dan Rodriguez, Emily Sherwin, Tom Smith, Ed Ursin, and Mary Jo Wiggins provided helpful advice on an earlier draft. I am grateful to the University of San Diego School of Law for financial support. 1 As to thought, some scholars have attempted to use findings in the field of artificial intelligence to explain law and legal reasoning. See, e.g, Dan Hunter, Out of Their Minds: Legal Theory in Neural Networks, 7 ARTIFICIAL INTELLIGENCE & L. 129 (1999) (examining the use of neural networks in modeling legal reasoning). 2 Commentators previously have suggested some replacements for law in particular areas, but those suggestions have involved either (1) replacing current public statutes and cases with new public law, see MELVIN A. EISENBERG, THE NATURE OF THE COMMON LAW 78 (1988); or (2) replacing current public statutes and cases with new private law in the form of private statutes (i.e., contractual provisions), see Part III.B. infra. However, no commentator has suggested replacing public statutes and cases with new private law in the form of synthetic cases (i.e., synthetic common law). For an excellent review of Professor Eisenberg’s book, see Stephen M. Bainbridge, Social Propositions and Common Law Adjudication: The Nature of the Common Law by Melvin A. Eisenberg, 1990 U. ILL. L. REV. 231 (1990). 2 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# parties dispute real cases. Real judges apply real law. Is there a need for synthetic law? This article maintains that there is. I advocate a system of synthetic common law for use primarily in private dispute resolution. In this system, private synthetic law associations will publish menus of cases and commit to resolve disputes based on those cases. Private parties will select from among these competing associations a particular menu of cases to govern their contracts. The selected association will adjudicate any disputes based on those cases. Courts will have limited review of association judgments. This system will fill a sizeable gap in current law, both in theory and in practice. In terms of theory, synthetic common law is an attractive alternative to common law, statutory law, private law, and private adjudication. Because synthetic common law would be based on ex ante findings by the parties, it more likely would reflect societal practice and the parties’ expectations than does common law, which is based on ex post findings by a judge or jury. Because synthetic common law would be based on broadly ranging menus of cases, it would avoid the inflexibility of statute-based regimes.3 Because synthetic common law would rely on analogical reasoning by private judges based on cases specified ex ante, it would avoid certain intractable problems associated with private contract provisions, including the difficulty of specifying contingencies of rapidly evolving practices.4 Because synthetic common law would be administered privately it would generate the benefits of existing private dispute resolution regimes; moreover, because synthetic common law would provide to parties a list of cases to govern any dispute, it would avoid the uncertainty and secrecy associated with private arbitration. In terms of practice, synthetic common law would enable private parties to avoid the pitfalls of federal and state legislation, while also avoiding the ambiguity and uncertainty of modern alternative dispute resolution. In many instances, it would be cheaper, clearer, and fairer than current alternatives. The advantages would be especially great for private parties in areas of rapidly evolving technologies, where 3 To the extent common law regimes generate greater economic benefits than civil or statutory law regimes, as several recent studies have suggested, synthetic common law should achieve those benefits, too. For example, studies by Raphael LaPorta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny of the legal rules protecting shareholders and creditors in forty-nine countries conclude that common law governance rules tend to protect investors more than civil law rules. See Raphael La Porta, et al., Law and Finance, 106 J. POL. ECON. 1113, 1151 (1998); see also Andrei Shleifer & Robert Vishny, A Survey of Corporate Governance, 52 J. FIN. 737 (1997); Raphael La Porta, et al., Legal Determinants of External Finance, 52 J. FIN. 1131 (1997). For a criticism of the methodology of these studies, see Frank Partnoy, Why Markets Crash and What Law Can Do About It, 61 U. PITT. L. REV. # (forthcoming 2000). 4 Moreover, because private contractual provisions often are written in impenetrable boilerplate, it is far more likely that private parties will actually read and consider provisions articulated in narrative case format. Human beings often find it much more efficient to process information presented in narrative form. By presenting legal rules as narrative, a synthetic common law regime may level the playing field between parties facing information or sophistication asymmetry. Disadvantaged parties often do not read the relevant contractual provisions, but might read a provision articulated in narrative, case format. See, e.g, Melvin Eisenberg, Text Anxiety, 59 S. CAL. L. REV. 305 (1986) (discussing argument that it is reasonable for consumers to refuse to read dense form contracts). 2000] SYNTHETIC COMMON LAW 3 the choice between ever-expanding federal legislation or unpredictable private arbitration is increasingly unattractive. In one area in particular – disputes involving complex financial instruments – synthetic common law could solve a seemingly intractable problem for private parties. The $100 trillion market for financial derivatives5 is subject to piecemeal regulation by statute, or none at all, and the development of common law in this area has been slow and sporadic. Private contracting, while extensive, has failed to ameliorate these problems.6 Private parties to such transactions who end up in disputes face either costly and inefficient statutory law,7 highly uncertain common law,8 or even less certain arbitration.9 Thus, the derivatives markets are plagued by uncertainty. The costs to the market are substantial, and market participants are desperate for reform.10 A synthetic common law system would ameliorate this uncertainty by providing clarity regarding future disputes immediately while avoiding the high costs associated with heavy-handed regulation. More generally, synthetic common law is an alternative regime to consider for legal scholars writing in the area of institutional competence and public choice. A public choice analysis need not compare only a legislature captured by special interests to a sluggish and ill-equipped judiciary.11 In certain areas of practice, synthetic common law might be a reasonable middle road. To the extent a system of synthetic common law is successful in the derivatives markets, it could be adapted to other areas, especially those with rapidly evolving technologies. The model system proposed here for financial derivatives could apply equally well to private parties contracting in telecommunications, intellectual 5 Derivatives are financial instruments such as options and forward contracts whose value is derived from some underlying instrument or index. For a detailed description of the classes and uses of derivatives, see Frank Partnoy, Financial Derivatives and the Costs of Regulatory Arbitrage, 22 J. CORP. L. 211, 216-26 (1997). Derivatives may be traded on an exchange or over-the-counter (OTC) in private transactions. The Bank for International Settlements (BIS) has estimated that the size of the OTC derivatives market in notional amounts as of year-end 1999 was approximately $88.2 trillion. See BANK FOR INTERNATIONAL SETTLEMENTS, THE GLOBAL OTC DERIVATIVES MARKET AT END-DECEMBER 1999 3 (May 18, 2000) <http://www.bis.org>. Interestingly, the gross market values of these contracts has declined dramatically from 4.02 percent of the notional amounts at year-end 1998 to 3.19 percent of the notional amounts at year-end 1999, a decline of more than 20 percent. See id. This decline in market value may be a sign of very large losses in the industry during 1999, a fact which is very difficult to ascertain. Trading in OTC derivatives is highly concentrated, with the world’s ten largest banks accounting for almost 90 percent of OTC derivatives activity worldwide. See ALFRED STEINHERR, DERIVATIVES: THE WILD BEAST OF FINANCE 155 (2000). The BIS also has estimated that the OTC derivatives market comprises approximately 86% of the overall derivatives market. See id. at 152-53. Estimates of the size in notional amount of the exchange-traded derivatives market are in the $13 to 14 trillion range. See id. at 152. Hence, the total size in notional amount of the derivatives industry is greater than $100 trillion. 6 See infra Part V.B.3. 7 See infra Part V.B.1. 8 See infra Part V.B.2. 9 See infra Part V.B.4. 10 See infra Part V.A. 11 See, e.g., Ed Rubin, Law and Legislation in the Administrative State, 89 COLUM. L. REV. 369 (1989) (advancing a theory of legislation independent from judicial interpretation of legislative provisions). 4 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# property, computer law, the Internet, and perhaps commercial or corporate law.12 Part II critiques and updates the arguments for and against a common law system. Part III analyzes three alternatives to a common law system: statutory law, model acts and private law,13 and private adjudication. Part IV discusses the proposal for synthetic common law and compares it to the alternatives. Part V considers how common law and its alternatives have failed in the area of financial derivatives dispute resolution, and explains the potential advantages of a synthetic common law regime in resolving such disputes, and suggest how a synthetic common law regime might be implemented. II. THE LIMITS TO COMMON LAW Oliver Wendell Holmes, one of the great advocates for the common law,14 also recognized its limitations. Holmes told the story of a Vermont justice of the peace who, after considering a suit brought by one farmer against another for breaking a churn, ruled for the defendant because he had looked through the statutes and could not find anything about churns.15 The story illustrates some of the limits to common law adjudication.16 Common law depends on human, and therefore 12 There may also be applications to criminal law. In the sentencing guidelines context, Albert Alschuler has proposed using fake, paradigmatic cases, not unlike synthetic common law, to guide judges in sentencing criminal defendants. See Albert W. Alschuler, The Failure of Sentencing Guidelines: A Plea for Less Aggregation, 58 U. CHI. L. REV. 901 (1991) (noting as the advantages of such a system that “[n]o real-world case might fit any of the commission’s paradigms exactly, and unusual cases might be far removed from any situation that the commission had considered. But lawyers could use the commission’s paradigms at sentencing hearings in much the same way that they now use judicial precedents at other proceedings.”). However, Alschuler’s proposal – unlike synthetic common law – would require both the involvement of federal judges and close judicial appellate review. Moreover, because the entity creating the common law would be a regulatory monopoly, the U.S. Sentencing Commission, there would be no assurance that the “paradigmatic cases” would reflect societal practice. Of course, criminal sentencing might not be an appropriate area to introduce competing providers of law, whether synthetic or not. See infra notes 35-41 (assessing the regulatory competition debate). I am grateful to Kevin Cole for bringing Alschuler’s proposal to my attention. 13 Examples include the Uniform Commercial Code, the Model Penal Code, and the various Restatements of Laws. See Steven Walt, Novelty and the Risks of Uniform Sales Law, 39 VA. J. INT’L L. 671 (1999). 14 See generally OLIVER WENDELL HOLMES, THE COMMON LAW (1881). 15 See Oliver Wendell Holmes, The Path of the Law, 10 HARV. L. REV. 457, 474- 75 (1897). Holmes may have adapted this story from a passage in a letter to him from Sir Frederick Pollock. In that letter, the first of a series of correspondence between Holmes and Pollock from 1874 to 1932, Pollock described a “gem from Viner’s Abridgment somewhere in title Pleader, which may be useful to you [and] is not generally known. . . . A declaration in trover for bottles without naming how many bottles is ill: but a declaration for twelve pair of boots and spurs without naming how many spurs is well enough: for it shall be intended of the spurs that belong to the boots.” MARK DEWOLFE HOWE, ED., I HOLMES-POLLOCK LETTERS: THE CORRESPONDENCE OF MR. JUSTICE HOLMES AND SIR FREDERICK POLLOCK 1874-1932 5 (1942) (letter from Pollock to Holmes, dated July 3, 1874). 16 Melvin Eisenberg has made a similar point about the almost numberless rule permutations that are possible based on fact differences in common law cases. For example, he has noted that the “vehicle” of harm in a well-known British case in 2000] SYNTHETIC COMMON LAW 5 fallible, judges. A common law judge might adhere stubbornly to the view that if a statute (or perhaps a prior case) does not strictly cover the terms of a transaction, then an injured party to that transaction has no claim. Common law rules are fraught with contradictions and ambiguity, and, because they depend upon a limited number of specific cases, necessarily contain gaps.17 There has been vigorous academic debate about the merits and flaws of common law. This Part critiques and updates some of the most persuasive arguments for and against common law adjudication. In some sense, this Part seeks to understand whether we should laugh or cry in response to Holmes’s story. Is the story funny because of its implausibility, the assumption being that the common law is fair and efficient? Or is the story upsetting because it seems all too plausible, the implication being that the common law is neither fair nor efficient? A. The Case for Common Law In the modern regulatory state, dominated by federal statutes and administrative rules, it is easy enough to relegate the common law to the role of historical nicety. From the thirteenth century until recently common law was the primary source of law in the United States and England, and was revered by scholars and practitioners.18 In modern society, it assumes a lesser role. Notwithstanding the fact that much of law school still involves the study of common law topics, many legal commentators, scholars, and practitioners have abandoned the common law in favor of statutes, including model statutes, and private law, including model and uniform laws.19 In a few areas of rapidly evolving technology, common law is experiencing a renaissance, with some scholars advocating common law adjudication as a higher-speed alternative to the often-sluggish modern administrative state.20 Judge Learned Hand, drawing from Blackstone,21 described the common law as “a monument slowly raised, like a coral reef, from the which the plaintiff drank from a bottle containing a decomposed snail “could be characterized as a opaque bottle of ginger beer, an opaque bottle of beverage, a bottle of beverage, a container of chattels for human consumption, a chattel, or a thing.” EISENBERG, supra note 2, at 54 (citing M’Alister (or Donoghue) v. Stevenson, [1932] L.R. App. Cas. 562 (H.L. 1932)). 17 In his defense of common law regimes, Melvin Eisenberg has stated that an application and extension of common law is justified when it is both socially congruent and systemically consistent. See EISENBERG, supra note 2, at 68. These justifications, to the extent one believes they are important, place additional limitations on the power of common law. 18 Numerous commentators have described the history of common law adjudication, a topic that is well beyond the scope of this article. See, e.g., I WILLIAM HOLDSWORTH, A HISTORY OF ENGLISH LAW 194-350 (7th ed. 1956) (describing the early system of common law jurisdiction). 19 See infra Part II.B. Moreover, self-interested judges, lawyers, and commentators too often have supported the common law with assumptions and faith more than argument or analysis, making it even easier for opponents to reject arguments in favor of common law adjudication. Of course, the primary beneficiaries of a common law-dominated legal system are lawyers and judges, so it is no surprise that both groups historically supported the regime. 20 See infra notes 57-62 and accompanying text. 21 Blackstone stressed that the adherence to common law notions of stare decisis required that courts adhere to precedent and make changes slowly over time: “For it is an established rule to abide by former precedents, where the same points 6 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# minute accretions of past individuals, of whom each built upon the relics which his predecessors left, and in his turn left a foundation upon which his successors might work.”22 This romanticized notion of the common law as coral reef is (or was, until recently) deeply embedded in the psyche of lawyers and legal academics. The language is loaded: Learned Hand’s metaphor of the coral reef implicitly praises the role of judges in developing a “monument” (i.e., common law) through an incremental, gradual, and fair process. Why such lofty praise? As the argument goes, there are two chief advantages to the common law. First, it provides a mechanism for resolving disputes in a fair and efficient manner. Second, it generates a supply of incremental and consistent legal rules that reflect social practice. 1. Evolution and Efficiency First, the superiority of a common law approach is rooted in the notion that courts resolve disputes in a fair and efficient manner by reasoning from existing standards, either of society generally or of the legal system specifically.23 This function – dispute resolution – depends on current and past practice. Disputes typically derive from a claim of right by an individual or institution based on the application, meaning, or implications of a particular society’s existing standards.24 The process of common law dispute resolution is both decentralized and passive. A decentralized approach ensures that judges will hear disputes involving a large swath of experience in society; common law rules then should reflect differences in standards among various segments within society. Just as importantly, courts play a largely passive role, responding only when parties set in motion a particular legal dispute. Ideally, a society’s method of dispute resolution should be efficient and fair. Commentators have argued that the decentralized, passive common law is both. The efficiency argument has an evolutionary flair. In its most basic terms, the argument is that the common law is an efficient dispute resolution system simply because it is the system that has survived the test of time.25 The English come again in litigation: as well as to keep the scale of justice even and steady, and not liable to waiver with every new judge’s opinion; and also because the law in that case being solemnly declared and determined, what before was uncertain, and perhaps indifferent, is now become a permanent rule which is not in the breast of any subsequent judge to alter or vary from according to his private sentiments: he being not delegated to pronounce a new law, but to maintain and expound the old one.” I SIR WILLIAM BLACKSTONE, COMMENTARIES 68 (1775). The synthetic common law proposal offered embraces Blackstone’s appreciation of the utility of common law, but takes issue with his respect for its “permanent rule” status. 22 Learned Hand, Judge Cardozo’s The Nature of the Judicial Process, 35 HARV. L. REV. 479, 479 (1922). 23 See GORDON TULLOCK, THE CASE AGAINST THE COMMON LAW 2-3 (1997). 24 See id. at 1. 25 There may be a gap, of course, between the fact of evolution and the argument that evolution is efficient. In evolutionary biology, for example, there is strong evidence of evolutionary patterns that belie “survival of the fittest” arguments. The fact that a particular practice survives during a periodic of selection and variation does not necessarily mean it is the optimal current practice. For a discussion of evolution as applied to legal theory, see Jody S. Kraus, Legal Design and the 2000] SYNTHETIC COMMON LAW 7 common law system survived despite repeated threats, powerful criticism, and almost insurmountable obstacles, including – some argue – the emergence of Parliament as a power in the eighteenth century.26 As the argument goes, if common law adjudication had not been an efficient means of resolving disputes, given the state of English society at the time, it likely would not have persisted over time. Moreover, the fact that common law rules survived while legislatures were empowered to enact different rules is especially strong evidence that a well-functioning27 democratic society could do not better than those common law rules. Just as the common law was threatened in England,28 the expansive reach of Congress has threatened U.S. common law for many decades. Again, the argument goes, if the common law were not an efficient system, elected representatives would have substituted more efficient rules.29 In the 1970s, Judge Richard Posner and others attempted to buttress the intuitive appeal of the argument for common law with economic analysis. Their arguments also have an evolutionary perspective. In general, the economic argument, first advanced by Posner and William Landes, is that to the extent common law adjudication involves private parties acting in their own self-interest and judges deciding cases based on wealth-maximizing standards, only efficient rules will survive.30 Accordingly, the common law is wealth maximizing. Judges leave inefficient rules to the side, and over time preserve and follow only efficient rules. Other scholars then attempted to explain how the structure of common law adjudication reinforces this efficiency-seeking process. For example, George Priest argued that the process of litigation, and how parties choose whether and when to litigate, pushes common law Evolution of Commercial Norms, 26 J. LEGAL STUD. 377, 382 n.9 (1997) (citing several articles). 26 See TULLOCK, supra note 23, at 5-6; ARTHUR R. HOGUE, ORIGINS OF THE COMMON LAW 241 (1986). Tullock has argued that the common law was threatened several times during the Middle Ages, when the common law survived more in the memories of individual judges and practitioners as oral histories than in formal records. See, e.g., TULLOCK, supra note 23, at 8 (noting that the law was largely judge-made and unwritten, although some “common law court decisions were recorded, and occasionally the record would be consulted”). 27 This argument assumes the democracy is well-functioning one, an assumption that may or may not be true. 28 See TULLOCK, supra note 23, at 6 (quoting Justice William Blackstone as saying in 1783 that the competence of Parliament was so great that Blackstone knew “of no power in the ordinary forms of the constitution that is vested with authority to control it”). 29 This argument ignores the fact that high transaction costs, especially the collective action costs that dominate democratic voting, may prevent the legislature from effectively amending poor common law rules, although there is evidence that at least on occasion Congress can act to overturn or “amend” judicial decisions, notwithstanding these transaction costs. See, e.g. 18 U.S.C. § 1346 (amending definition of “property” in the mail fraud statute to include intangible rights, after the Supreme Court held that such rights were not included); see generally MANCUR OLSON, THE LOGIC OF COLLECTIVE ACTION: PUBLIC GOODS AND THE THEORY OF GROUPS (1965). 30 See William M. Landes & Richard A. Posner, Adjudication as a Private Good, 8 J. LEGAL STUD. 235 (1979). 8 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# rules in the direction of efficiency.31 Inefficient legal rules are litigated more frequently, so judges can dedicate their efforts to establishing efficient rules, which then lead parties to settle cases out of court. Along different lines, but still advocating for the common law, Guido Calabresi was one of the first scholars to use economic analysis to demonstrate some of the disadvantages of a primarily statutory regime in the U.S. as compared to a regime allowing common law judicial “amendment” of statutes through interpretation.32 These economic arguments added an element of science and logic to the claim that the common law provides the best method of dispute resolution. The economic arguments supporting the common law can be updated in the context of the ongoing debate about regulatory competition.33 This debate considers the question of whether a single monopolist regulator (e.g., the federal government) is superior or inferior to a group of competing regulators (e.g., the state governments). This argument, too, is evolutionary in tone: is the regulatory system that survives over time superior, or is the surviving system simply a result of a path-dependent movement from a set of somewhat arbitrary initial conditions?34 The contours of the debate vary, from corporate law35 to securities law36 to environmental regulation.37 31 See George L. Priest, The Common Law Process and the Selection of Efficient Rules, 6 J. LEGAL STUD. 65 (1977) (supporting efficiency conclusion with the argument that inefficient rules are more likely to be litigated, and then changed). But see Robert Cooter & Lewis Kornhauser, Can Litigation Improve the Law without the Help of Judges?, 9 J. LEGAL STUD. 139 (1980) (arguing efficiency conclusion requires very strong assumptions); Gillian K. Hadfield, Bias in the Evolution of Legal Rules, 80 GEO. L.J. 583 (1992) (arguing efficiency conclusion holds only on average and cases are not a random sample); Eric Talley, Precedential Cascades: An Appraisal, 73 S. CAL. L. REV. 87 (1999) (describing precedent in terms of rational herding). 32 See GUIDO CALABRESI, A COMMON LAW FOR THE AGE OF STATUTES (1982). Calabresi was prescient in arguing that such amendment was required, in part because of barriers to formal legislative amendment, including interest-group pressures; federal statutes in particular have multiplied many-fold in recent decades, without much, if any, improvement in the clarity of legal rules. See, e.g., Stephen D. Clymer, Unequal Justice: The Federalization of Criminal Law, 70 S. CAL. L. REV. 643 (1997) (describing recent expansion of federal criminal law). 33 See generally William W. Bratton & Joseph A. McCahery, Regulatory Competition, Regulatory Capture, and Corporate Self-Regulation, 73 N.C. L. Rev. 1861 (1995); James D. Cox, Regulatory Duopoly in U.S. Securities Markets, 99 COLUM. L. REV. 1200 (1999). 34 See, e.g., Bernard Black & Reinier Kraakman, A Self-Enforcing Model of Corporate Law, 109 HARV. L. REV. 1911, 1974-77 (1996) (suggesting path- dependent evolution of corporate law); Ehud Kamar, A Regulatory Competition Theory of Indeterminacy in Corporate Law, 98 COLUM. L. REV. 1908, 1927-28 (1998) (suggesting that corporate law has developed based on vague, open-ended standards); Lucian Arye Bebchuk & Mark Roe, A Theory of Path Dependence in Corporate Ownership and Governance, 52 STAN. L. REV. 127 (1999) (extending path dependence argument). 35 See, e.g., Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 YALE L.J. 2359, 2384 n.76 (1998) (offering race-to-the- top interpretation); Ralph K. Winter, Jr., State Law, Shareholder Protection, and the Theory of the Corporation, 6 J. LEGAL STUD. 251, 262-92 (1977) (same); James D. Cox, Choice of Law Rules for International Securities, 66 U. CIN. L. REV. 1179 (1998) (discussing problems associated with privatizing securities regulation); Lucian Arye Bebchuk, Federalism and the Corporation: The Desirable Limits on 2000] SYNTHETIC COMMON LAW 9 The common law is a good candidate for the regulatory competition debate because it originally depended on extensive competition among courts and judges.38 For example, just as many scholars argue that the competition among states for corporate charters is a race-to-the-top, driving the development of (Delaware) corporate law,39 one can argue that competition among courts and judges generally was a race-to-the-top,40 driving the development of English, and later American, common law. Over time, so the argument goes, the system that survived is superior.41 If it had not been superior, private parties would have opted to have their disputes governed by another regime; alternatively, rational and well-informed judges would have responded with different decisions. The viability of this argument depends on empirical research, which has not yet been done in the common law context. For some scholars, it is enough to establish that the common law is an efficient42 method of dispute resolution. Yet there remains the State Competition in Corporate Law, 105 HARV. L. REV. 1435, 1448-50 (1992) (offering race-to-the-bottom interpretation). 36 See, e.g, Roberta Romano, supra note 35 (arguing for regulatory competition among state securities law regimes within the U.S.); Stephen J. Choi & Andrew T. Guzman, Portable Reciprocity: Rethinking the International Reach of Securities Regulation, 71 S. CAL. L. REV. 903 (1998) (arguing for regulatory competition among national securities law regimes); Partnoy, Why Markets Crash, supra note 3, at # (criticizing and suggesting amendments to proposals for competition among international securities law regimes). 37 See, e.g., Richard L. Revesz, Rehabilitating Interstate Competition: Rethinking the "Race-to-the-Bottom" Rationale for Federal Environmental Regulation, 67 N.Y.U. L. Rev. 1210 (1992) (describing race-to-the-bottom versus race-to-the-top arguments in the context of environmental regulation). 38 Randy Barnett has written about the evolution of common law from the competitive law merchant: “Many of [common law’s] principles originated with the competitive law merchant that preceded the growth of the common law. Many more were determined in an era when common-law courts competed for legal business with other legal systems and therefore had a far greater incentive than today to be sensitive to the expectations of both parties. With this as its origin, I suggest that the correspondence between common sense and common law is no coincidence.” See Randy E. Barnett, The Sound of Silence: Default Rules and Contractual Consent, 78 VA. L. REV. 821, 910-11 (1992). 39 The argument in corporate law is that corporations choose to incorporate in Delaware to benefit from that state’s value-enhancing corporate law rules. See, e.g., Romano, supra note 35, at 2384 n.76 (substantiating this claim with event studies). 40 There is a question about whether common law competition was a race to the top or a race to the bottom. But it certainly was a race. See, e.g., Tom W. Bell, Public Choice and Public Law: The Common Law in Cyberspace, 97 MICH. L. REV. 1746, 1769-70 (1999) (describing efficiency arguments). The specialized courts of the law merchant often are cited as the predecessors to common law rules. See I. Trotter Hardy, The Proper Legal Regime for “Cyberspace,” 55 U. PITT. L. REV. 993, 1019-21 (1994); David R. Johnson & David Post, Law and Borders – The Rise of Law in Cyberspace, 48 STAN. L. REV. 1367, 1387-91 (1996); see also Lisa Bernstein, Merchant Law in a Merchant Court: Rethinking the Code’s Search for Immanent Business Norms, 144 U. PA. L. REV. 1765 (1996). The law merchant courts evolved during the eleventh and twelfth centuries, when clients paid fees to courts. See BRUCE L. BENSON, THE ENTERPRISE OF LAW 60-62 (1990). 41 An alternative view is that the competition in common law was a race-to-the- bottom, i.e., has led to an inefficient and unfair regime. See infra Part II.B.1. 42 In the debate about common law, it frequently is unclear whether scholars are arguing that common law is efficient in a Pareto sense (i.e., that no party can be made better off without making another party worse off) or in a Kaldor-Hicks sense (i.e., that no party can be made better off by an amount greater than the amount other parties are made worse off). In an environment of high transaction costs, the 10 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# additional question of fairness. To some extent, the above evolutionary arguments support the notion that the common law is fair. In a world with perfect information and zero transaction costs, rational, fully-informed judges would resolve disputes in a manner that both maximized not only the welfare of the parties to the dispute, but that of society as a whole. If they did not, the argument goes, parties in future disputes (or affected non-parties) would point out the ill effects of a particular decision, and a rational, fully-informed judge would alter the applicable common law legal rule. If some judges were irrational or ill informed, parties would find other, better judges.43 Notwithstanding these weaknesses, there are strong arguments that the common law is a fair method of dispute resolution because it protects parties’ expectations. The credibility of common law adjudication is based on the notion of replicability, i.e., that courts employ consistent methodologies across cases.44 Numerous scholars and commentators have focused on the preservation of expectations through replicable decision-making as justifying the fairness of common law. Melvin Eisenberg has noted that disputes in the U.S. during the nineteenth century often relied on usages, and therefore by definition depended on the behavior and expectations of private parties.45 Justice Cardozo believed in the general rule of following precedent to ensure that private parties’ rights and beliefs would be protected in an evenhanded, consistent, and fair manner.46 Jeremy Bentham – an opponent of common law generally – advocated a predictable judicial framework to protect parties’ expectations, saying that “[t]he business of the Judge is to keep the distribution of valuables and of rewards and punishments in the course of expectation.”47 Holmes, in his story about the judge in the churn redistribution scenarios underlying the normative force of Kaldor-Hicks efficiency may not occur. 43 The weaknesses of this argument are addressed in detail in Part II.B. For now, it is sufficient to note that judges might be irrational and typically do not have perfect information. See discussion infra at Part V.B. Moreover, private parties may face transaction costs or other insurmountable obstacles in finding better judges. 44 See TULLOCK, supra note 23, at 3. 45 See EISENBERG, supra note 2, at 38 (describing courts adopting miners’ usages as rules of law in mining claims, and whalers’ usages as rules of law in disputes of the property rights of harpooned whales). 46 See Mark D. Hinderks & Steve A. Leben, Restoring the Common in the Law: A Proposal for the Elimination of Rules Prohibiting the Citation of Unpublished Decisions in Kansas and the Tenth Circuit, 31 WASHBURN L.J. 155, 171 n.96 (1992). 47 “The deference is that due to the determination of former judgments is due not to their wisdom, but to their authority: not in compliment to dead men’s vanity, but in concern for the welfare of the living. That men may be enabled to predict the legal consequences of an act before they do it: that public expectation may know what course it has to take: that he who has property may trust to have it still: that he who meditates guilty may look for punishment, and in the self same guilty for the same punishment. . . . Why should decisions be uniform? Why should succeeding ones be such as to appear the natural and expected consequences of those preceding them? Not because it ought to have been established, but because it is established. . . . The business of the Judge is to keep the distribution of valuables and of rewards and punishments in the course of expectation: conformable to what the expectation of men concerning them is, or if apprised of the circumstances of each case, as he is, he supposes would be.” Jeremy Bentham, A Comment on the Commentaries, in A COMMENT ON THE COMMENTARIES AND A FRAGMENT ON GOVERNMENT 196-97 (J.H. Burns & H.L.A. Hart eds., 1977). 2000] SYNTHETIC COMMON LAW 11 case,48 hinted that the result is apocryphal: any judge would resolve a dispute about a damaged churn in a sensible way, in line with the parties’ expectations. Finally, recent empirical work in psychology supports a conclusion that there are non-economic reasons to believe common law adjudication is fair to the parties involved. Common law adjudication gives parties the thing they seem to desire most: their day in court. Recent studies in the psychology literature suggest that disputants believe having a chance to describe their version of the story to an impartial adjudicator is the most important factor determining whether they perceive a particular process of dispute resolution as “fair.” In fact, this “day in court” factor outweighs every other variable tested, including the actual outcome of the dispute.49 If these studies are correct, to the extent the common law is perceived as fair, it generates greater happiness among disputants than would a system that did not give parties the opportunity to air their views. 50 2. The Supply of Legal Rules A common law approach provides a second, equally valuable, function. Courts add to and enrich the supply of legal rules in a way that reflects the values of society.51 Thus, a key advantage to a common law approach is that judicial rules evolve slowly as a flexible response to the actions and preferences of individuals and institutions involved in disputes.52 As such rules evolve, those parties, as well as other non-parties who learn of the rules, can live and plan accordingly. Then, other individuals and institutions are involved in the next round of cases, which generates the next set of legal rules, and so forth, all reflecting the behavior and values of society. Several scholars have concluded that the common law upholds the rule of law more effectively than civil law because of its flexibility, coupled with the “stickiness” of precedent.53 Implicit in this argument is a distrust of the democratic process: the notion is that judges with life tenure are able to resolve disputes in an impartial manner, and therefore are better at generating legal rules than 48 See supra note 15 and accompanying text. 49 See, e.g., Tom R. Tyler, et al., The Two Psychologies of Conflict Resolution: Differing Antecedents of Pre-Experience Choices and Post-Experience Evaluations, 2(2) GROUP PROCESSES AND INTERGROUP RELATIONS 99 (1999) (describing these studies). 50 However, the fact that disputants believe common law adjudication is fair does not necessarily dispose of the fairness question: disputants might irrationally overweight the benefits of being heard in an apparently fair process; in reality, the process might be unfair. 51 See id. 52 Some scholars have argued that the behavior of parties in those relatively few cases that involve a published decision are not representative of the behavior of other parties. I consider these arguments infra at Part II.B.1. 53 See, e.g., F.A. HAYEK, LAW, LEGISLATION AND LIBERTY, LAW, LEGISLATION AND LIBERTY: A NEW STATEMENT OF THE LIBERAL PRINCIPLES OF JUSTICE AND POLITICAL ECONOMY (1983) (arguing that common law is preferable to civil law because legislative rules are both less flexible in form and more susceptible to sudden change); EISENBERG, supra note 2, at 6 (arguing that common law courts should play the role of developing the rule of law on a case-by-case basis). 12 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# legislators, who may be captured by particular individuals or institutions.54 Also implicit in this argument is the notion that common law legal rules evolve over time to reflect the values and practices of society in a more current and accurate manner than statutes can. Common law is passive and evolves in response to changes in the behavior of disputants. Common law rules are more adaptable than codified rules.55 As society changes judges can quickly56 alter the relevant legal rules. Statutes, in contrast, are fixed and difficult to change. The legislature would find it too costly and burdensome to make similar, quick changes to reflect changes in society. Legislation often cannot anticipate future controversies, especially in rapidly changing areas of practice. Legislation necessarily is active, and action requires time and is subject to the political process. On the other hand, because common law rules are “sticky,” judges may not change them simply based on a whim. Change must be incremental, requires careful analysis, and is subject to review. In contrast, the legislature, when it is moved to act, may act immediately and on its own, with only that analysis individual politicians facing reelection think necessary, even if the legislative action directly reverses prior law. Interestingly, several legal scholars recently have argued that in the area of rapidly evolving technologies – particularly involving telecommunications and the Internet – common law is uniquely able to generate timely rules to govern the actions of sophisticated parties.57 Melvin Eisenberg has argued that courts, not legislatures, have a unique capacity to generate the large body of legal rules a technologically advanced society needs to do its business.58 Bruce 54 See EISENBERG, supra note 2, at 4-5. 55 See M. Stuart Madden, The Vital Common Law: Its Role in a Statutory Age, 18 U. ARK. LITTLE ROCK L.J. 555 (1996) (arguing that an advantage of the common law is its adaptability). 56 Many court systems have implemented so-called “fast track” or “rocket docket” approaches, to speed the resolution of individual cases. See Chris A. Carr & Michael R. Jencks, The Privatization of Business and Commercial Dispute Resolution: A Misguided Policy Decision, 88 KY. L.J. 183, 197 n.34 (2000) (citing several articles describing such systems). Other courts, such as those in the Southern District of New York, resolve cases more slowly, and instead spend more time writing a smaller number of careful, often lengthy, opinions. 57 See PETER HUBER, LAW AND DISORDER IN CYBERSPACE: ABOLISH THE FCC AND LET COMMON RULE THE TELECOSM 8, 206 (1997); Frank H. Easterbrook, Cyberspace and the Law of the Horse, 1996 U. CHI. LEGAL F. 207, 216 (1996); Lawrence Lessig, The Path of Cyberlaw, 104 YALE L.J. 1743, 1752 (1995). I explicitly consider arguments about the viability of common law as compared to statutory or civil law infra at Part III.A. 58 “Our society has an enormous demand for legal rules that actors can live, plan, and settle by. The legislature cannot adequately satisfy this demand. The capacity of a legislature to generate legal rules is limited, and much of that capacity must be allocated to the production of rules concerning governmental matters, such as spending, taxes, and administration, rules that are regarded as beyond the court’s competence, such as the definition of crimes; and rules that are best administered by a bureaucratic machinery, such as the principles for setting the rates charged by regulated industries. Furthermore, our legislatures are normally not staffed in a manner that would enable them to perform comprehensively the function of establishing law to govern action in the private sector. Finally, in many areas the flexible form of a judicial rule is preferable to the canonical form of a legislative rule. Accordingly, it is socially desirable that the courts should act to enrich that supply of legal rules that govern . . . [business] conduct – not by taking on 2000] SYNTHETIC COMMON LAW 13 Keller has pointed to the emergence of common law in intellectual property disputes, where a statutory regime, especially given a sluggish Congress, is much too slow.59 Peter Huber has advocated for common law rules in the telecommunications industry.60 Lawrence Lessig has discussed the benefits of common law related to the Internet.61 Judges and litigants recently have attempted to apply common law to disputes in the financial derivatives industry, where a statutory regime may be irrelevant at best.62 The arguments in favor of a common law system may be strongest in those areas involving rapid technological change, where the advantages of adaptability are more important, and where parties would benefit from a quick supply of relevant legal rules. One final advantage to the common law’s ability to supply legal rules is that by reporting decisions, courts generate a public record of what otherwise would be only unwritten law, customs, and oral legal traditions. Especially in the business context, certainty generated by a written record is essential; common law provides certainty by enabling parties to rely on reported judicial decisions.63 The reporting of decisions also ensures that changes in legal rules will be gradual and will need to be explained by reference to flaws in or departures from prior reported judicial reasoning.64 As publicly reported decisions increase in number and quality, the credibility of the common law system improves. A common law system with a sufficient number of well reasoned, publicly reported decisions can both provide parties with guidance in their daily lives and assure participants in the system that individual disputes will be resolved with appropriate attention and care.65 lawmaking as a free-standing function, but by attaching much greater emphasis to the establishment of legal rules than would be necessary if the courts’ sole function was the resolution of disputes.” EISENBERG, supra note 2, at 4-5. 59 “[T]he common law has emerged as a source of protection for intellectual property rights throughout this century whenever statutory protection for new forms of media were still evolving.” Bruce P. Keller, Condemned to Repeat the Past: The Reemergence of Misappropriation and Other Common Law Theories of Protection for Intellectual Property Rights, 11 HARV. J. L. & TECH. 401, 403 (1998). 60 See Huber, supra note 57. 61 See Lessig, supra note 57; see also LAWRENCE LESSIG, CODE: AND OTHER LAWS OF CYBERSPACE 218-23 (1999) (noting problems with legislators and need for judicial action in regulating the Internet). 62 See infra Part V.B.2. 63 Several scholars have noted that private parties interacting repeatedly in small groups may find ways of enforcing social practices without reported common law or published statutes. See, e.g., ROBERT C. ELLICKSON, ORDER WITHOUT LAW: HOW NEIGHBORS SETTLE DISPUTES (1991) (describing such private enforcement regimes); Catherine Mansell-Carstens, Popular Financial Culture in Mexico: The Case of the Tanda in CHANGING STRUCTURE OF MEXICO: POLITICAL, SOCIAL, AND ECONOMIC PROSPECTS 77 (Laura Randall ed., 1996) (describing the “tanda” or “rosco,” an informal mechanism used by members of many small Mexican villages to allocate credit). However, in many instances – and particularly for parties transacting in a global business environment, where the possibility of informal resolution may be difficult – parties will need a formalized, specified system of dispute resolution. Even in markets where parties risk suffering reputational costs from breaches of the parties’ expectations, those reputational costs alone – without the possibility of enforcement through a more formal dispute resolution system – may not be sufficient to deter such breaches. 64 See Hinderks & Leben, supra note 46, at 170. 65 To the extent the common law is thought to be incomplete or vague it is not unlike many other valuable social institutions, practices, and systems of ideas that 14 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# By publicly reporting decisions, courts also broadcast norms to society so that parties and lawyers can resolve the vast majority of disputes without burdening judicial resources.66 To the extent a society relies on the norms of self-regulating private communities transacting with each other in repeated interactions, public decisions can reinforce those norms, while making it clear that although most transactions will not lead to a dispute, clear rules will apply to those that do.67 B. The Case Against the Common Law Many legal scholars dispute the view of the common law as attractive, efficient coral reef.68 As to the efficiency of common law, there are arguments pointing to severe cracks in the reef’s foundation, which cannot support the weight of costly, complex dispute resolution. The core of these arguments is the economic notion that a common law system is a tragedy of the commons: overuse is rampant, court resources are rationed, and outcomes are inefficient. As to the common law’s ability to generate legal rules, there is a preliminary theoretical question as to whether there is any reef at all (i.e., whether common law can even be said to exist),69 and a more pragmatic question about the value of published common law decisions in modern society. For various reasons – fewer opinions written; more opinions depublished, selectively published, or vacated; more decisions subject to confidentiality orders or under seal; and increased use of private adjudication – the common law is disappearing from public view, and often is no longer useful to parties planning their lives and business affairs. 1. Devolution and Inefficiency First is the argument that any common law system that could survive in a democracy necessarily is inefficient. The argument goes like this: judicial resources, including published decisions, are a public are, at their core, more art than science. See Brian Simpson, The Common Law and Legal Theory, in LEGAL THEORY AND COMMON LAW 17 (William Twining ed., 1986) (“In the sense used here a theory or general view of the common law represents an attempt to provide an answer to the question whether the common law can be said to exist at all – and this has been seriously doubted – and, if so, in what sense.”); see also infra Part II.B.2. 66 See Marc Galanter, Real World Torts: An Antidote to Anecdote, 55 MD. L. REV. 1093, 1101-02 (1996) (noting that such norms “influence not only the disputes that are brought to the courts, but also matters that never reach the courts”); see also Howard Slavitt, Selling the Integrity of the System of Precedent: Selective Publication, Depublication, and Vacatur, 30 HARV. C.R.-C.L. L. REV. 109, 140 (1995) (noting that legal certainty enables parties to act in ways that avoid costly litigation). 67 See, e.g., Robert D. Cooter, Decentralized Law for a Complex Economy, 23 SW. U. L. REV. 443, 445-46 (1994) (labeling such norms as the “new law merchant”). For a detailed description of the law merchant, see I. Trotter Hardy, supra note 40, at 1019-21. 68 See, e.g., Richard A. Epstein, Law and Economics: Its Glorious Past and Cloudy Future, 64 U. CHI. L. REV. 1167, 1169-70 (1997) (criticizing early insistence “on the efficiency of the common law, even as the legal system was moving inexorably in the opposite direction”); TULLOCK, supra note 23 (similar criticism). 69 Simpson, supra note 65, at 9. 2000] SYNTHETIC COMMON LAW 15 good70 with no assigned ownership rights. Accordingly, if the government establishes courts but does not charge a user fee to cover costs, it encourages overuse of judicial resources, and therefore inefficiencies. The only way to prevent such inefficiencies is for the government to charge a high enough user fee to cover all of its costs. But in a society where disputes are costly to resolve, such a fee would be very high and necessarily would disadvantage a large segment of society, who would not approve it. Therefore, any possible common law system is inefficient. Consider the following thought experiment: residents of a newly established state have no system of dispute resolution. These residents decide to establish a “judicial park” staffed with judges at the center of the city. Any party with a dispute may enter the judicial park, where a judge will resolve the dispute and issue a well-reasoned written opinion. What problems does this state face? If entrance to the judicial park is free, any party with a dispute will enter the park to utilize judicial resources. Judicial resources will be overused and a tragedy of the commons will result.71 All parties will demand well-reasoned opinions, which are very expensive to provide. The externality benefits to such opinions are unlikely to outweigh these costs, because non-parties and judges cannot exercise discretion about which cases merit thorough review. The result will be a large number of potentially useless judicial opinions. The state may find itself unable to generate sufficient revenue, through taxes or otherwise, to support the judicial park. If the state is able to support the park, it will do so with resources that might be more highly valued in another use. Judicial resources will not be optimally used and judges will not be able to produce an efficient body of common law. The state could prevent this overuse by charging fees to enter the park. To the extent the fees are less than the total costs of dispute resolution, judicial resources still will be overused, albeit less so (i.e., a partial tragedy of the commons). If the fees charged are high, perhaps even high enough to cover the total costs of dispute resolution, judicial resources will be conserved, but the system will be regressive, favoring wealthy individuals and institutions. Residents of the state may find such a system politically unacceptable. As the costs of resolving disputes in the state increase,72 there are only a handful of possible results. One is that the efficiency of the common law system decreases because judicial resources are more overused. Another is that the system becomes more regressive as the state passes along the higher cost of using judicial resources by 70 A public good is a commodity or service which does not exhibit either “depletability” (i.e., if an additional user consumes a public good, the benefits of that good are not depleted) or “excludability” (i.e., it is difficult or impossible to exclude consumers from the benefits of a public good). See WILLIAM J. BAUMOL & ALAN S. BLINDER, ECONOMICS: PRINCIPLES AND POLICY 543 (1985). 71 See TULLOCK, supra note 23, at 16 (describing the inefficiencies of common law as a “tragedy of the commons”). 72 The costs of dispute resolution could increase for several reasons: the complexity of transactions increases, the number and/or severity of uncertain events (e.g., accidents or natural disasters) increases, or residents of the state demand fairer process. In the U.S., all of these costs have increased in recent years. 16 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# charging higher fees. Still another is that the state decides to keep fees constant, but to ration judicial resources, either by delaying the resolution of disputes, by dismissing a portion of suits based on specified standards, by punishing lawyers for filing frivolous suits, or by permitting judges to decide which disputes merit complete treatment in a written opinion. Public decisions about rationing are difficult, and high transaction costs may prevent private parties (including non-parties to disputes who seek externality benefits associated with published judicial opinions) from acting collectively to persuade legislators and judges to ration efficiently. This thought experiment casts doubt on the argument that the evolution of the common law has been efficient. In thirteenth century England, when the costs of resolving disputes were relatively low, it may have been possible to minimize the common law system’s inefficiencies without charging high fees or rationing judicial resources.73 However, in modern society, it is not possible. The cost of resolving even average disputes is very high, and there are political pressures preventing state and federal governments from charging high fees for access to judicial resources. Judicial resources are rationed through an implicit pricing system; this system favors wealthy institutions and individuals, who can afford the costs of delay.74 Empirical data also raise questions about the efficiency of common law. The inner workings of an effective system depend on rational, well-informed judges who move the common law along in the right direction. However, judges too often fall short of the ideal standard. The judiciary is politicized, with the results in many cases depending on which judge is drawn to hear a dispute.75 Judges are paid much less in real terms than they were fifty years ago,76 and they are confronting more complex cases brought by more parties and lawyers than ever before.77 Especially in areas of rapidly evolving technology, it is very difficult for judges to keep pace.78 For example, on average judges in the Ninth Circuit each write twenty thorough opinions per year, an amount Judges Alex Kozinski and Stephen Reinhardt have likened to “writing a law review article every 73 In fact, there is evidence that early British courts did both. In early common law systems, courts did charge fees, see BENSON, supra note 40, at 60-62, although it is difficult to assess how those fees compared to the courts’ costs. A reasonable assumption is that those courts that survived without other resources (e.g., tax revenue distributed by the crown) were charging fees high at least enough to cover their costs. 74 Delay benefits wealthy individuals and institutions involved in disputes with less wealthy individuals and institutions. See TULLOCK, supra note 23, at 17. Tullock notes that the tragedy of the commons aspects of U.S. courts could be eliminated by introducing market-clearing prices for access to courts, but that numerous interests – including lawyers – would oppose such an introduction. Id. at 17-18. 75 See Emerson H. Tiller & Frank B. Cross, A Modest Proposal for Improving American Justice, 99 COLUM. L. REV. 215 (1999); Patricia M. Wald, A Response to Tiller and Cross, 99 COLUM. L. REV. 235 (1999). 76 See RICHARD A. POSNER, THE FEDERAL COURTS: CRISIS AND REFORM 32 (1985). 77 The U.S. has 70 percent of the world’s supply of lawyers. See TULLOCK, supra note 23, at 25. 78 For example, judges have performed especially poorly in cases involving financial innovation. See infra Part V.B.2. 2000] SYNTHETIC COMMON LAW 17 two and a half weeks.”79 Moreover, the very presence of a common law system – especially a low fee system coupled with liberal procedural rules80 – creates incentives for parties to be litigious, thereby increasing the costs of dispute resolution, in a kind of litigation death spiral.81 This picture of the common law process is far different from the incremental growth and beauty imagined in Learned Hand’s coral reef. 2. The Shrinking Supply of Legal Rules Even if the common law is inefficient, it might nevertheless be of value if it adequately performed its second function: adding to and enriching the supply of legal rules in a way that reflects the values of society. There are two reasons to suspect that the U.S. common law system does not perform this function very well. First, the U.S. common law system arguably is incapable of generating legal rules at all, at least not the kind of credible, articulated legal rules parties need for use in daily life. Second, even if the common law system could generate appropriate legal rules in particular cases, reported judicial decisions in those cases are disappearing from public view, with the most important decisions disappearing first and most frequently. This disappearance of precedent is the result predicted by the judicial park thought experiment described in Part II.B.1. First, consider the argument that the common law system is incapable of generating legal rules at all. Jeremy Bentham expressed the opinion that the common law was “a fiction from beginning to end,”82 referring to the term variously as “mock law,” “sham law,” and “quasi law.”83 Many legal positivists adhere to this view.84 79 See Alex Kozinski & Stephen Reinhardt, Please Don’t Cite This!: Why We Don’t Allow Citations to Unpublished Dispositions, CAL. LAWYER, June 2000, at 43. I am grateful to Ed Ursin for pointing out this article, which is not available through electronic databases. During 1999, the Ninth Circuit decided 4,500 cases on the merits, 700 by opinion and 3,800 by memorandum disposition, known as “memdispo,” for an average of 20 opinions and 130 memdispos per judge, plus another 300 or so decisions for which the judge sits on a panel and comments on a decision, but does not author it. See id. at 44. Judges write thorough opinions in only 15 percent of cases overall (including cases not decided on the merits). See id. Memdispos cannot be cited as precedent; if they could, judges would need to spend much closer attention to drafting them. Id. (“Most [memdispos] are drafted by law clerks with relatively few edits from the judges.”). 80 An example is the class action, which although of great potential value and importance obviously leads to a greater quantity and cost of litigation. 81 At the same time, each state’s common law system competes for business, a competition that thus could be characterized as a race-to-the-bottom. This competition is especially heated among procedural rules, including choice of law and venue. For example, consider the popularity of certain states’ courts among plaintiffs’ lawyers. Such competition is in sharp contrast with the early competition among courts during the law merchant era. See supra note 38 (describing correlation between common law principles and expectations of both parties to a dispute). 82 IV JEREMY BENTHAM, COLLECTED WORKS 483 (1838-43). Bentham wrote of the phrase common law: “In these two words you have a name pretended to be the name of a really existent object: - look for any such existing object – look for it till doomsday, no such object will you find.” Id. See also JEREMY BENTHAM, A COMMENT ON THE COMMENTARIES 125 (1928) (“As a system of general rules, the common law is a thing merely imaginary.”). 83 Id. at 460. For an analysis of Bentham’s argument and the question of whether the common law is a “fiction,” see Simpson, supra note 65, at 16-18. 84 Brian Simpson has described this argument with a simple question, “How can it be said that the common law exists as a system of general rules, when it is 18 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# Legal positivism depends on two preconditions: (1) that all laws owe their status as law to the fact that they have been laid down, i.e., posited,85 and (2) that all laws exist as sets of rules, where the rule constitutes the law.86 For legal positivists, the epistemological argument is the end of the story: they reject common law, which satisfies neither of the two conditions. Even those who reject the strict legal positivism argument may nonetheless find there are other reasons to doubt the common law’s ability to generate valuable legal rules. Instead of conceiving of the common law as a system of legal rules, one can regard it as customary law, namely, the body of practices and ideas received over time by a specific group, predominantly lawyers, who have used these practices and ideas in disputes and in advising clients.87 In this sense, the common law does not exist as a freestanding entity; rather, it exists only in the minds of lawyers acting based upon it. Numerous legal philosophers have agreed that the value of common law propositions depends upon the degree to which they are accepted as accurate statements of received ideas or practice.88 Common law as customary law is valuable only if it preserves a considerable measure of continuity and cohesion. Such continuity and cohesion in turn require that the system reinforce strong pressures against innovation. New entrants to the system must be indoctrinated, to some extent, in the value of precedent and the importance of the system’s “sticky” adherence to prior decisions. Although these requirements may have been satisfied in the early English royal courts, it is difficult to argue that they are satisfied today. The barriers to entry in the legal profession are crumbling; non-lawyers can access and understand legal opinions and jargon; there are hundreds of law schools.89 Indoctrination into legal principles works very poorly in the U.S., even when directed at first year law students. impossible to say what they are?” Id.; see also id. (“As a system of legal thought the common law then is inherently incomplete, vague and fluid; it is a feature of the system that uniquely authentic statements of the rules which, so positivists tell us, comprise the common law cannot be made.”). 85 Hans Kelsen wrote, “Law is always positive law, and its positivity lies in the fact that it is created and annulled by acts of human beings, thus being independent of morality and other norm systems.” HANS KELSEN, GENERAL THEORY OF LAW AND THE STATE 114 (1961). The synthetic common law system proposed here is consistent with this notion: it envisions many versions of “law,” each of which is simply made up, or created. But note how radically different the operation of synthetic common law is from the traditional conception of common law. The status of synthetic common law as authoritative is driven, not by the fact that it has been created, but by the fact that private parties choose to have that “law” govern their lives. One obvious weakness in the first condition of the positivist view is that custom, which cannot plausibly said to have been laid down, also is said be a possible type of law; however, it is difficult to say that custom is “posited” in the same way statutes are, simply because custom is composed of some underlying human action. See Simpson, supra note 65, at 11. If that were the case, what notion of law would not encompass some positive aspect? 86 See id. at 11. 87 See id. at 20. 88 See id. at 21 (citing agreement with Hale and Blackstone). 89 Of course, the causation may work the other way, i.e., these changes may be the reason for the shift from common law to statutory law in the U.S. 2000] SYNTHETIC COMMON LAW 19 This breakdown in the system of customary law presents a serious paradox for proponents of the common law. If lawyers agree as to its meaning, it is not necessary, for common practice alone should be a sufficient guide for resolving disputes. If lawyers do not agree as to its meaning, rules alone are unlikely to provide the necessary authority for choosing one practice over another, however those rules are created. A final argument supporting a conclusion that common law cannot generate credible legal rules is that courts lack the respect and authority necessary for the generation of such rules. Courts derive authority, at least in part, from individuals’ perceptions that they are objective and impartial. Yet many scholars question the objectivity of judges.90 Because judges are arbitrary, the argument goes, decisions cannot be replicated.91 And if decisions cannot be replicated, the common law cannot generate credible legal rules. Gordon Tullock has contended that during the second half of the twentieth century92 courts have “severely eroded, if not entirely destroyed, the support- legitimacy of the common law.”93 There is a second, perhaps more important, reason that the modern version of common law in the U.S. does not add to or enrich the supply of legal rules: decisions in those cases are disappearing from public view. More than 60 percent of federal circuit court decisions are not published.94 Of those opinions, a large number either disappear or are pushed out of the relevant body of common law by a variety of processes, including depublication, confidentiality arrangements, vacatur, selective publication, and publication subject to no-citation rules. All of these processes are problematic, and they erode95 the value of traditional common law. How can private parties 90 Gordon Tullock has been a prominent proponent of this view. See, e.g., TULLOCK, supra note 23, at 2 (arguing that late twentieth century U.S. courts have failed to maintain objectivity on a consistent basis). 91 See TULLOCK, supra note 23, at 3 (finding that “the U.S. common law system has failed to preserve such replicability across major and growing areas of law”). 92 It may be that the common law would work in a less complex society, but is ill-suited to modern disputes in the twentieth-century U.S. One reason may be the expansion of tort law in the U.S. In the eighteenth century, the common law was composed largely of the law of contract, not of torts. Torts were thought to be of limited reach and achieved legal status only for relationships not covered by contract. See TULLOCK, supra note 23, at 11. Because synthetic common law involves ex ante agreement by private parties, it would not substantially affect problems generated by the recent expansion of tort law, although a synthetic common law regime might be applicable to certain areas of tort law, where private parties might be able to specify a probability distribution of accidents. 93 See TULLOCK, supra note 23, at 2-3. 94 See Hinderks & Leben, supra note 46, at 158. Much of the scholarship in this area has focused on the California state courts, where the problem is especially acute. Less than 15 percent of appellate decisions in California are certified for publication and the California Supreme Court depublishes 10 percent of those decisions. See Philip L. Dubois, The Negative Side of Judicial Decision Making: Depublication as a Tool of Judicial Power and Administration on State Courts of a Last Resort, 33 VILL. L. REV. 469, 488 (1988). 95 One commentator has described this erosion in terms of the building of a sculpture: “Our system of precedent has become subtractive as well as additive. Like a sculpture, it is shaped as much by what is removed as by what is added.” Slavitt, supra note 66, at 109. This erosion metaphor applies equally well to Learned Hand’s coral reef. 20 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# plan their affairs based on judicial determinations that are private or withdrawn or even do not exist? The problem is serious. As early as 1985, Judge Richard Posner noted that “[d]espite the vast number of published opinions . . . judges will confess that a surprising fraction of appeals are difficult to decide, not because there are too many precedents but because there are too few on point.”96 This problem has been magnified many-fold during the past fifteen years, as the number of disappearing precedents has increased and as the probability has declined of finding an on-point case, especially in areas subject to rapid technological change. In 1998, the federal appellate courts disposed of more than a thousand cases on the merits without any comment at all,97 and district courts frequently dispose of cases without a detailed opinion or even oral argument. Anthony Kronman has decried the shortcut opinion judges frequently issue in place of the type of “original composition” opinion that he believes “disciplines the imagination”98 Yet such short cut reasoning should not be surprising in a society where the costs of dispute resolution are very high; it is merely an attempt to ration precious judicial resources. Many courts now depublish or selectively publish decisions.99 Reduced publication means fewer case precedents and greater 96 See POSNER, supra note 76, at 123. 97 See William C. Smith, Big Objections to Brief Decisions, A.B.A. J., Aug. 1999, at 34, 36 (noting that "[l]ast year, the federal appeals courts disposed of 25,020 appeals on the merits. About six percent of the total were disposed of without comment, meaning the court did not expound the law as applied in the case, or did not explain the reasons for the ruling"); Carr & Jencks, supra note 56, at 219. 98 “[O]pinion-writing disciplines the imagination. It is one thing to reach a tentative conclusion in a case, but something very different to write an opinion defending it. The search for the right words to support a judgment one has provisionally formed often stirs up new objections and compels the reexamination of earlier beliefs. A judge may feel that he has decided a case and is finished with it. But when he attempts to justify his decision in writing, he will be forced to reenact the drama of the original conflict in his imagination, taking first one side and then the other in an effort to anticipate the strongest arguments that might be made against his own earlier position and the best responses to them. Writing judicial opinions imposes on the writer a duty of responsiveness that can be met only by giving each side to a dispute its due, by entertaining every claim in its most attractive light, and that in turn demands a special effort of imagination. The discipline of opinion-writing is thus a goad to the imagination, and the greater the distance of the writer from the original conflict in a case, the more valuable this discipline becomes as a guard against the relaxation of his imaginative powers: which is why it is especially needed at the appellate level. In many appellate courts, however, this discipline is weaker today than it has been in the past. In part this is due to procedural changes in court practice that permit more cases to be decided with no opinion or only an unpublished one-changes intended to increase the number of disputes that a court can decide in a given period of time. But a more important cause of the weakening of this discipline has been the growing tendency of appellate judges to work by editing draft opinions prepared for them by their clerks instead of writing opinions themselves . . . [E]diting does not in general make as strong a demand on the imagination as original composition.” ANTHONY T. KRONMAN, THE LOST LAWYER: FAILING IDEALS OF THE LEGAL PROFESSION 330-31 (1995). 99 For example, the California Supreme Court depublishes more appellate opinions each year than it publishes of its own. See Gerald F. Uelman, Losing Steam, CAL. LAW., June 1990, at 33, 43. Depublication and selective publication have been popular topics among legal commentators. See Slavitt, supra note 66; William L. Reynolds & William M. Richman, The Non-Precedential Precedent-Limited Publication and No-Citation Rules in the United States Court of Appeals, 78 COLUM. L. REV. 1167 (1978); Gerald F. Uelman, Publication and Depublication of 2000] SYNTHETIC COMMON LAW 21 uncertainty, especially in business disputes. The purported justification for selective publication and no-citations rules is to allocate scarce judicial resources away from the writing of less consequential opinions to the writing of a smaller number of well- crafted, more important opinions.100 Judges spend almost one-third of their time writing opinions,101 and simply do not have the time and resources necessary to write opinions that will be suitable additions to the body of common law.102 The effect of limiting publication is not merely a reduction in published decisions. Selective publication and no-citation rules also create moral hazard problems by giving judges a form of insurance against reversal. Armed with the knowledge that an opinion will not be published or cannot be cited, a judge is unlikely to devote sufficient care to crafting an opinion.103 As a result, both the quantity and quality of judicial decisions is reduced, perhaps so much that the limiting rules are unconstitutional. On August 22, 2000, Judge Arnold of the Eighth Circuit found unconstitutional a rule limiting the precedential effort of certain decisions within that Circuit, finding that the rule expanded the judicial power beyond the limits of Article III by allowing judges the discretion to determine which judicial decisions are binding and which are not.104 Another phenomenon chipping away at the common law occurs when parties to litigation reach a private settlement following a district court’s judgment with the condition that the appellate court vacate the lower court’s judgment. This process – known as “vacatur”105 – changes the shape of judicial precedent in a perverse California Court of Appeal Opinions: Is the Eraser Mightier than the Pencil?, 26 LOY. L.A. L. REV. 1007 (1993); Stephen R. Barnett, Making Decisions Disappear: Depublication and Stipulated Reversal in the California Supreme Court, 26 LOY. L.A. L. REV. 1033 (1993); Dubois, supra note 94, at 488; Joseph R. Grodin, The Depublication Practice of the California Supreme Court, 72 CAL. L. REV. 514 (1984). 100 See Carpenter, Jr., supra note 103, at 251 (arguing that the “real reason” for these rules is the overload on the appellate courts). 101 See Reynolds & Richman, supra note 99, at 1183 n.95. 102 See Slavitt, supra note 66, at 123. 103 “When a judge knows ahead of time that an opinion will not be published, she can save time. First, the judge does not need to recite carefully the facts of the case because the parties are already familiar with them. Second, it is unnecessary to rehearse all of the arguments; the judge is able to focus the opinion on the dispositive issues. Third, the judge need not spend as much time eliminating vague language that other litigants may attempt to expand in later cases. Because unpublished opinions serve no future purpose, judges need only provide a minimal indication of the reasoning that a fully explicated opinion would have followed.” Slavitt, supra note 66, at 123-24; see also Charles E. Carpenter, Jr., The No-Citation Rule for Unpublished Opinions: Do the Ends of Expediency for Overloaded Appellate Courts Justify the Means of Secrecy?, 50 S.C. L. REV. 235, 251 (1998). 104 See Anastasoff v. U.S., 2000 U.S. App. LEXIS 21179 (8th Cir. 2000). For a discussion of some of the policy implications raised by the Anastasoff case, as well as a detailed study of the Third Circuit’s practice of disposing of cases without comment, see Mitu Gulati & C.M.A. McCauliff, 61 LAW & CONTEMP. PROB. 157 (1998). 105 Vacatur also has been a popular topic among legal commentators. See Stephen R. Barnett, supra note 99; Judith Resnik, Whose Judgment? Vacating Judgments, Preferences for Settlement, and the Role of Adjudication at the Close of the Twentieth Century, 41 UCLA L. REV. 1471 (1994); Slavitt, supra note 66; Henry E. Klingeman, Settlement Pending Appeal: An Argument for Vacatur, 58 FORDHAM L. REV. 233 (1989). 22 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# way by eliminating a particular class of cases, typically those in which one party decides that the cost of the decision (including the cost of its precedential value in future cases106) is greater than the cost of settlement. For example, suppose Natasha sues her insurance company for its bad faith refusal to pay her claim. Natasha and her attorney refuse to settle the case for less than $100,000. The insurer is unwilling to pay that much and files a motion for summary judgment. The judge decides against the insurer in a decision that will cost the insurer millions of dollars in future cases. The insurer then offers to settle with Natasha for $100,000. Natasha and her attorney believe she will win if the insurer appeals, but that the appeals process will be costly. Therefore, Natasha is willing to settle. In this example, the insurer might even sweeten its offer to persuade Natasha to settle. The result would be a settlement for some amount between $100,000 and the insurer’s perceived cost (in present value terms) of future cases if it does not settle. Both of the individual parties to the litigation are better off. Who is worse off? If the judicial decision being vacated was correct in terms of assessing the overall costs and benefits, vacating that decision will transfer wealth from future claimants/insureds to the insurance company,107 enabling the insurance company to benefit from externalizing its future costs.108 Those future non-parties harmed by vacatur face very high transaction costs in acting collectively, and even if they were able to agree in time to pay for the benefits of the judicial decision, it is unclear how they would do so. Bribing the judge is illegal, and cases are vacated shortly after the judge issues the opinion. Moreover, the insurer and the non-parties might not agree about how much the decision would increase the insurer’s costs of resolving future cases, and there would be very little time to contract and bargain with the insurer. Not surprisingly, vacating large numbers of decisions erodes respect for courts, in part because vacated decisions likely attempted to assess the overall costs and benefits in a particular case, and likely favored future litigants more than they harmed the losing party. One judge, writing in dissent in a California state case, noted that “[p]ublic respect for the courts is eroded when this court decides that a party who has litigated and lost in the trial court can, by paying a sum of money sufficient to secure settlement conditioned on reversal, purchase the nullification of the adverse judgment.”109 Published judicial decisions also are disappearing because of the large number of decisions issued subject to confidentiality orders or under seal. Much litigation takes place under confidential stipulation, with documents and testimony sealed away from non-parties. Judges often conduct the pretrial phase of a case outside public view and without articulating their reasoning in writing or on the record. At pretrial conferences, after the judge calls a case, the parties’ counsel 106 In addition, a vacated judgment cannot be used for collateral estoppel purposes. See Carr & Jencks, supra note 56, at 216. 107 If the decision did not correctly assess overall costs and benefits, this settlement might be the optimal solution for both the private parties and for society. 108 See Resnik, Whose Judgment?, supra note 105, at 1500. 109 Neary v. Regents of Univ. of Cal., 834 P.2d 119, 127 (Cal. 1992) (Kennard, J. dissenting). 2000] SYNTHETIC COMMON LAW 23 often are led to the judge’s private chambers or a conference room to discuss the case with no court reporter present.110 These private aspects of the judicial process undercut judicial obligations and may even induce judges prematurely to favor one side of a dispute.111 Like vacatur, confidentiality benefits parties to the dispute at the expense of future non-parties who might have benefited from a public decision and opinion. Moreover, under current law, non-parties to the litigation have no basis for complaint. Courts generally have interpreted the public’s right of access to civil judicial proceedings to apply only to pleadings, motions, exhibits, and court transcripts.112 Other materials are off limits.113 Even those materials presumptively open to the public may be closed to the public by agreement of the court and the parties; even pleadings may be sealed.114 Confidentiality in disputes creates private benefits and imposes societal costs. It is unclear which weighs heavier. The private benefits include protecting the parties’ reputations and intellectual property. The societal costs include the loss of value associated with the information. Some of these benefits and costs are offsetting: for example, information about a case involving the manufacture of a product may harm the manufacturer (by making it subject to future litigation costs) in the same way it benefits consumers (by giving them the information necessary to litigate). On the other hand, private benefits are likely to be localized, in most cases involving only the parties to the litigation, whereas societal benefits are likely to be diffuse, depending on the nature of the underlying activity. Absent transaction costs, one would expect those harmed by the nondisclosure of information to bargain for the information; however, transaction costs in these instances are likely to be high, due both to collective action problems and the difficulty of valuing the external costs. The disappearance of common law may be a symptom of a more troubling problem: in the U.S. today, a “true” judicial common law may simply be too costly. Specifically, it may be too costly to have judges spell out their reasoning in complex business disputes. It is extraordinarily expensive for judges to hear every case publicly, decide all important issues in those cases on the record, and write detailed well-reasoned opinions supporting these decisions. These costs are especially high for business disputes in areas of rapidly evolving technology where judges lack expertise.115 Nearly half of federal district court judges come from a prosecutorial background, experience that is important for any judge who will be deciding 110 See Carr & Jencks, supra note 56, at 212 (describing the authors’ experience in California courts). 111 See generally Judith Resnik, Managerial Judges, 96 HARV. L. REV. 376 (1982). 112 See Resnik, Whose Judgment?, supra note 105, at 1493 n.84. 113 See Arthur R. Miller, Confidentiality, Protective Orders, and Public Access to the Courts, 105 HARV. L. REV. 427 (1991). 114 See Nault’s Auto Sales, Inc. v. American Honda Motor Co., 148 F.R.D. 25 (D.N.H. 1993). 115 See Carr & Jencks, supra note 56, at 205-07 (describing perceived lack of expertise in judges presiding over business disputes). 24 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# criminal cases,116 but many fewer have sophisticated business backgrounds.117 Moreover, in an environment of disappearing precedent, litigation becomes much more expensive, as parties are forced to litigate issues another court might have decided already but not have published an opinion describing the decision. Thereby, litigants find themselves forced to reinvent the wheel over and over again. At the same time the costs of judicial decisions are increasing, the benefits of decisions are decreasing. Who gains from a reported judicial decision? The parties gain something – a description of the basis for decision – although at least one party (the losing one) likely would prefer not to suffer public scrutiny based on the decision.118 Future litigants gain from the certainty associated with the precedential value of the opinion, but only if the opinion is clear, well reasoned, and relevant to future disputes. Often, decisions are too limited in scope to issues that are unlikely to arise in future litigation, or are too unclear, poorly reasoned, or irrelevant to be of value to future litigants. For all of these reasons, there are limits to the common law. Commentators and practitioners should understand how these arguments are relevant, especially in costly business disputes. In the U.S. today, a common law system may not be able to satisfy the efficiency and fairness goals of society, even if there are persuasive arguments that common law has done so historically. III. ALTERNATIVES TO COMMON LAW There are alternatives to common law, including statutory law, private law, and private adjudication. Alternatives can be classified119 116 Of recent appointees to federal district court, the percentages coming from a prosecutorial background were 40.7% under President Clinton, 39.2% under President Bush, 44.1% under President Reagan, and 38.1% under President Carter. See Sheldon Goldman & Elliot Slotnick, Clinton’s Second Term Judiciary: Picking Judges Under Fire, 82 JUDICATURE 264, 275 (May-June 1999). 117 Much of this is for economic reasons. For attorneys, private practice pays more than judging, which discourages entry; for judges, private practice and private judging (e.g., serving as an arbitrator or mediator) pays more than judging, which encourages exit. See William C. Smith, Bailing From the Bench, A.B.A. J., May 1999, at 22 (noting that this drain from the bench especially is true for the best business judges). These comments are not in any way directed at the Honorable Michael B. Mukasey (for whom I clerked) of the Southern District of New York, who remains the best business judge I know. Unfortunately, Judge Mukasey has not yet had the opportunity to decide a major derivatives case. When and if he does, his opinion in that case may resolve some of the problems presented infra at Part V.B.2. 118 Especially in costly business disputes, one party may lose a great deal in reputational costs from an unfavorable decision, and therefore may be willing to settle prior to decision, even if the terms of the settlement are less favorable than the party believes is warranted in the particular case. 119 Thomas Barton has described the structure of decisional institutions in four parts: (1) the method of problem identification (active vs. reactive), (2) the degree of deliberation involving in reaching a decision (spontaneous vs. deliberative), (3) the level of participation and control by the disputants (disputants control vs. third- party control), and (4) the substantive justification for decisions (rigid vs. flexible). The classification here is similar to the first part of Barton’s structure, except that ex ante is substituted for active and ex post is substituted for reactive, and the public/private distinction is added. See Thomas D. Barton, Common Law and Its Substitutes: The Allocation of Social Problems to Alternative Decisional 2000] SYNTHETIC COMMON LAW 25 based on two variables. First, is the system’s source of legal rules public or private? Second, does the system specify legal rules to resolve disputes ex ante or does it adjudicate disputes based on an ex post specification? The following schematic diagram illustrates the different approaches: Institutions, 63 N.C.L. REV. 519 (1985). My classification obviously is stylized, and many regulatory approaches will not fit neatly within the confines of a particular quadrant in Figure 1 infra. 26 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# The left half of the diagram depicts methods of dispute resolution involving ex ante specification of applicable legal rules; the right half depicts methods involving ex post specification. The top half of the diagram depicts methods of dispute resolution where the source of the applicable legal rules is a public (i.e., governmental) entity; the bottom half of the diagram depicts methods where the source is a private entity. Part II analyzed the upper right quadrant, common law,120 the most important dispute resolution system for the purposes of this article. This Part briefly analyzes the alternatives in the remaining quadrants. Part III.A. considers the top left quadrant, statutory law, including codes in civil law regimes. Part III.B. considers the bottom left quadrant, private law, including model acts and model default terms for contracts. Part III.C. considers the bottom right quadrant, private adjudication. There are serious problems associated with each alternative. A. The Viability of Statutory Law A complete discussion of statutory law regimes is beyond the scope of this article. The purpose of this section is to sketch briefly some of the arguments for and against such regimes, to assess when statutory regimes are more (or less) likely to be efficient and fair, and to provide a benchmark for comparing synthetic common law. The dominant alternative to common law is statutory law. The vast majority of jurisdictions are civil law jurisdictions, in that their legal regimes consist largely of legal codes and statutes instead of common law. Moreover, the modern U.S. system is largely based on statutes and administrative law rules and regulations. The primary purported advantage of statutes is clarity. Ideally, a private party planning future action can read a statute and understand what class of conduct is prohibited, what class is permitted, and the 120 Common law adjudication frequently involves the specification of legal rules ex post, particularly in cases of first impression. To the extent common law legal rules are used in future cases, an argument can be made that common law adjudication also involves the specification of legal rules ex ante. In other words, not every common law specification of legal rules will fit neatly within the upper right quadrant of Figure 1. Private Public Ex PostEx Ante Statutory Law Common Law Private Adjudication Private Law Figure 1 2000] SYNTHETIC COMMON LAW 27 costs of undertaking prohibited conduct. Statutes can spell out details about how particular behavior will be governed. In doing so, statutes can attempt to regulate anticipated behavior. Accordingly, statutes are most highly valued when all contingencies can be specified clearly in advance. Moreover, in democratic regimes statutes are thought to reflect popular will. Unlike most common law judges, who are largely unaccountable to the public, legislators face reelection and must satisfy the concerns of their constituents – or lose their jobs. Another strength of statutes (and a weakness of common law) is that “the process of judicial development of law is of necessity gradual and may prove too slow to bring about the desirable rapid adaptation of the law to wholly new circumstances.”121 Thus, statutes are most likely to be effective when the democratic process is working to ensure protection of the reasonable expectations of parties. Unfortunately, statutes often are far from clear. Language may be ambiguous, and resort to legislative history may be unhelpful. Statutes require interpretation by human judges, who in turn require a theory of legislation.122 Interpretation is an elastic concept, composed of more than logic.123 Justice Cardozo believed judges were capable of enormous creativity when confronted with a wide range of statutes.124 Max Radin has emphasized the parity of statutes and common law in the hands of judges.125 In other words, although judges are not free to change the words of a statute (as they are with the common law) through the workings of judicial interpretation, judges have as much freedom in deciding difficult statutory cases as they have in deciding difficult common law cases. Judge Richard Posner has agreed with this point.126 Again, statutes are most valued when contingencies can be specified clearly. 121 HAYEK, supra note 53, at 88. Hayek has noted that it is undesirable for judicial decisions to reverse a development, because the judge “is not performing his function if he disappoints reasonable expectation created by earlier decisions.” Id. 122 See RONALD DWORKIN, LAW’S EMPIRE 17 (1986). 123 Judge Richard Posner is a proponent of this view: “The current bastion of legal formalism is not the common law; it is statutory and constitutional interpretation. It is here that we find the most influential modern attempts to derive legal outcomes by methods superficially akin to deduction. The attempts will fail. The interpretations of texts is not a logical exercise, and the bounds of ‘interpretation’ are so elastic (considering that among the verbal and other objects that are interpreted are dreams, texts in foreign languages, and … musical compositions) as to cast the utility of the concept into doubt.” RICHARD A. POSNER, OVERCOMING LAW 400 (1995). 124 Cardozo included the U.S. Constitution, noting that John Marshall “gave to the constitution of the United States the impress of his own mind; and the form of our constitutional law is what it is, because he moulded it while it was still plastic and malleable in the fire of his own intense convictions.” BENJAMIN N. CARDOZO, THE NATURE OF THE JUDICIAL PROCESS 169-170 (1921). 125 See generally Max Radin, Statutory Interpretation, 43 HARV. L. REV. 863, 881 (1930); Max Radin, A Short Way with Statutes, 56 HARV. L. REV. 388 (1942). James Landis argued, quite reasonably, that Radin’s approach should be limited to exclude “easy” cases, when the statute’s meaning is clear on its face or can be clarified by legislative history. See James M. Landis, A Note on “Statutory Interpretation”, 43 HARV. L. REV. 886 (1930). 126 POSNER, OVERCOMING LAW, supra note 123, at 392. 28 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# In addition, statutes are primary directed at regulating and limiting government; they perform less well in regulating and limiting private conduct.127 The legislative process is buffeted by greater interest- group pressures than the judicial process and therefore may be less likely to reflect sound policy judgments.128 As Hayek has argued, there is nothing magical about the legislative process that causes it to “uncover” efficient legal rules.129 Public choice and interest group theories have demonstrated that the legislative process often works to redistribute wealth to narrow coalitions, not in the public interest.130 Under pressure from these theories, it “becomes unclear where to locate statutory meaning, problematic to speak of judges discerning legislative intent, and uncertain why judges should seek to perfect through interpretation the decrees of the special-interest state.”131 At best, statutes reflect the popular will of a prior electorate, not the current one, and in areas where technologies are rapidly changing may not reflect the interests and expectations of the relevant parties. Therefore, in an imperfectly functioning democracy, statutes – even to the extent they accurately reflect constituent interests – may reflect only a portion of society’s interests. Next, consider how information becomes reflected in legal rules. In a common law system, the judge articulates the relevant legal rules after one or more private parties involved in a dispute have chosen to have the judge adjudicate that dispute. The judge decides the dispute with reference to statutory rules, prior cases, commentary, and societal practice. The information reflected in the judge’s decision includes the preferences of the parties to the transaction, as well as the body of existing law. This information is described in narrative form. In a statutory system, the legislature articulates the relevant legal rules after particular legislators (lobbied by supporters and constrained by voters) have chosen to have the legislature consider the rules. The legislature decides to adopt or reject the rules with reference to public debate, commentary, and societal practice. The information reflected in the legislature’s decision includes the preferences of society generally, or of the legislators’ supporters specifically. This information is described in non-narrative form. Thus, the information “forced” to be reflected in the relevant legal rules differs under common law and statutory law. The objective of fair and efficient legal rules is to reflect the interests of society. 127 See, e.g., HAYEK, supra note 53, at 127 (noting that for the past several centuries the overwhelming majority of statutes have been concerned with administrative law and direct measures of government); see also id. at 133. 128 POSNER, OVERCOMING LAW, supra note 123, at 393. 129 See, e.g., HAYEK, supra note 53, at 72 (noting that “[u]nlike law itself, which has never been ‘invented’ in the same sense, the invention of legislation came relatively late in the history of mankind”); see also id. at 73 (“Yet there can be no doubt that law existed for ages before it occurred to man that he could make or alter it.”). 130 As Judge Posner put it, “A further complication for the theory of statutory interpretation is that we no longer think of statutes as typically, let alone invariably, the product of well-meaning efforts to promote the public interest by legislators who are devoted to that interest and who are the faithful representatives of constituents who share the same devotion.” POSNER, OVERCOMING LAW, supra note 123, at 400. 131 Id. at 400. 2000] SYNTHETIC COMMON LAW 29 This information is the vehicle for doing so, and therefore the utility of one system over the other depends largely on the value of such information. Consequently, one should expect common law and statutory law to achieve different benefits in different areas of practice. One regime or the other is not inherently preferable. In some areas of practice, where the democratic process works effectively, statutory rules will best reflect overall societal preferences. In other areas, where a small number of private parties assisted by a judge can “outperform” the legislature, common law rules will best reflect such preferences. It is difficult to offer a general analysis of when a particular societal practice will be more susceptible to the information-forcing mechanisms of statutory versus common law. Common law is likely to deliver superior information when the legislative process is not working effectively or in a timely manner, and when the nature of the practice is best served by narrative, as opposed to statutory rules.132 Private parties interacting in the “traditional” areas of common law (e.g., contract, property, tort) may find legal rules expressed through narrative clearer and easier to understand than statutory specifications. In contrast, private parties interacting in the “traditional” areas of statutory law (e.g., utilities, transportation, commercial) may prefer clear articulation of general rules and abhor the ambiguity of legal narrative. Judge Posner has argued that reasoning by analogy is valuable in fixing the boundaries of a legal rule when language is vague and therefore is not a reliable guide to the rule’s actual scope; in such instances an adjudicator should determine that scope through reference to hypothetical cases (i.e., stories).133 In contrast, analogical reasoning is unnecessary when a legal rule is clear, even in translation (e.g., as in the instructions for assembling a table, or in the provision of the U.S. Constitution that the President must be at least 35 years old).134 The issue is complex, but there are reasons to believe individuals may benefit from common law over statutory rules simply because of the former’s narrative structure. People rarely read statutes or regulations, and when they do they rarely find them useful.135 Statutes often include narrative examples or cases to clarify any perceived ambiguities, or to draw the attention or interested parties. The various Restatements of the Laws are obvious examples. Finally, even if one rejects the above analysis of the benefits of analogical reasoning, it is more difficult to reject a series of recent studies by several economists attempting to determine whether statutory regimes or common law regimes generate superior economic results. These studies found common law systems to be superior in 132 See POSNER, OVERCOMING LAW, supra note 123, at 471-97. 133 See id. at 520. 134 See id. at 493. Numerous scholars have set forth the arguments for and against analogical reasoning. See, e.g, Emily Sherwin, A Defense of Analogical Reasoning in Law, 66 U. CHI. L. REV. 1179 (1999) (arguments for); Larry Alexander, Bad Beginnings, 145 U. PA. L. REV. 57 (1996) (arguments against). One need not accept either of the arguments to recognize that in certain areas of practice, analogical reasoning and narrative may have greater utility than statute-like rules. 135 See Eisenberg, Text Anxiety, supra note 4. 30 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# nearly every economic aspect.136 Economic performance speaks louder than philosophical argument. B. Private Law Legal scholars have been unsatisfied with the development of statutory law for many decades, and have made private efforts to improve these statutes. These efforts include model acts and uniform private laws, including the various Restatements of the Laws, the Model Penal Code, and the Uniform Commercial Code. For example, the UCC provides that every contract imposes an obligation of good faith in its performance or enforcement.137 Similarly, the Restatement (Second) of Contracts states as a general principle that every contract imposes upon each party a duty of good faith and fair dealing in its performance and enforcement.138 Commentators draft these model acts and uniform laws outside the context of the legislative process, in the hope that legislatures will adopt them and thereby rationalize or improve statutory law. In addition, lawyers and other parties also have created private default terms or standard form contracts, many of which are widely used. Much of agency, partnership, and corporate law consists of such default rules.139 Numerous services provide standard form contracts for parties to use in various areas of law.140 Private default terms and standard form contracts are analytically equivalent to model acts and uniform private laws, the primary difference being the intended audience. While the former is directed to private parties engaging in contracting, the latter is directed more generally to legislators. All such private law offers the benefits of the considered judgment of non-governmental actors. As with statutes, the primary purported advantage to private law is clarity. Model acts are drafted by commentators knowledgeable in the field, who attempt to delineate every possible anticipated result. Private parties using standard contract default terms are able to tailor such terms to reflect their best understanding of how future disputes should be resolved. The argument in favor of a private law system is that it is more likely to reflect societal practice than a system instituted by legislators or judges far removed from practice. Legal rules percolate up through private parties to practitioners to commentators and, finally, to legislators or judges. Legal rules need not be debated or litigated in a legislative or judicial setting; they can simply be written down. There is no general agreement as to the line of distinction between private and public law.141 The UCC, sections of the various Restatements, and many model acts all are now public law. Much private law consists simply of proposals aspiring to be public law. If 136 See supra note 3. 137 See U.C.C. § 1-203. 138 See Restatement (Second) of Contracts § 205. 139 Many of these default rules are embodied in state statutes; other simply become part of private contracts. 140 See, e.g., Standard Forms (2000) <http://findlaw.com>. Most large law firms have developed standard forms that attorneys can tailor to a individual party’s needs.. 141 See HAYEK, supra note 53, at 132. 2000] SYNTHETIC COMMON LAW 31 the legislative process is working properly, the legislature will adopt all private law proposals that make society better off; non-adopted proposals by definition are those that would not make society better off. However, if the legislative process is not working properly, advocates of private law that would make society better will face difficulties in persuading legislators to adopt their proposals. Note that these arguments relate to the workings of the democratic process, not to the comparative advantage or disadvantage of private law. To the extent private law consists of proposals to be made statutory law, all of the arguments in Part III.A. apply equally to private law, and need not be restated here. However, much of private law is not directed at legislators. To the extent private law consists of default terms and standard form agreements intended for use by private parties, it is not aspiring to be public law at all. In fact, the rationale for such terms and agreements is that private parties are best able to establish legal rules to govern their daily conduct, and that legislatures and courts should respect those decisions and not interfere. Unfortunately, there are limitations to the ability of private parties to establish such terms and agreements. Private law – like judicial opinions – has the characteristics of a public good, and therefore will tend to be underprovided unless subsidized. There are mechanisms for distributing private law to parties in a more efficient manner than a series of individual negotiations (i.e., reinventing the wheel), although these mechanisms are not tailored to, and often do not satisfy, the needs of particular parties, including confidentiality. Moreover, although private law may serve to guide practice absent a dispute, parties relying on private law provisions nevertheless will need to specify a means of resolving disputes. A major limitation to private law is that private ex ante alternatives do not provide a mechanism for resolving disputes. Consequently, even parties choosing private law must use either the courts or some means of private adjudication, both of which have drawbacks.142 Another problem with private law is that private parties attempting to specify all of the details associated with future dispute resolution will find it very costly to specify all contingencies. More importantly, they will not necessarily accrue any of the benefits of other parties’ similar efforts. As with statutes, the argument here is not a general indictment of private law; it simply indicates when private law is most likely to be useful: when parties can specify all or most contingencies.143 Finally, private law relies on a statute-like, non-narrative method of describing legal rules. For parties who understand and can assess narrative better than boilerplate, private law may not serve its intended purpose.144 For such parties, private law may create or leverage inequities. One party may use its advantageous position in information or sophistication to obtain agreement to lengthy or 142 See supra Part II.B. and infra Part III.C. 143 Contingencies can be thought of as options, and to the extent option rights are not allocated or specified ex ante, disputes based on private law agreements are very difficult to adjudicate. 144 See supra note 4. 32 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# complex terms the other party would not agreed to if such terms were understood. Private law may be of great utility, both to the extent it becomes public law and to the extent it specifies methods of dispute resolution. Ultimately, however, the utility of private law will turn on the efficiency and fairness of the means of dispute resolution, and on the ability of the parties to specify contingencies ex ante in non-narrative form. C. Opting Out through Private Adjudication As an alternative, parties may choose not to be subject to either common law or statute-based regimes. They may simply opt out of such regimes by choosing to have any dispute governed by a private dispute resolution mechanism.145 Subject to limited judicial review,146 parties to a private contract can decide in advance to adjudicate any disputes in a private regime, generally referred to as Alternative Dispute Resolution (ADR). Parties do so frequently.147 For example, private parties often choose to handle private arbitrations through the American Arbitration Association (“AAA”), which has been an especially popular venue for parties contracting in areas of rapidly evolving technologies, including computer, patent, trademark, and copyright law.148 The Federal Mediation and Conciliation Service (FMCS) and AAA each assist in the selection of arbitrators and provide some additional services, all for a nominal fee.149 As an alternative to ADR, parties often agree to mediation. Private adjudication is touted as offering certain advantages, especially lower cost, as compared to the other dispute resolution regimes. From an economic perspective, private adjudication is said to avoid the tragedy of the commons problem associated with common law, because all of the costs are internalized to the parties. Courts are publicly funded, but taxpayers do not subsidize alternative forums. Arbitration must create perceived economic efficiencies in some cases; otherwise, it could not compete against subsidized 145 For a general discussion of private dispute resolution and the dominating role played by Professor Lon Fuller, see Robert G. Bone, Lon Fuller’s Theory of Adjudication and the False Dichotomy Between Dispute Resolution and Public Law Models of Litigation, 75 B.U.L. REV. 1273 (1995). 146 The standards for judicial review of arbitration determinations are highly restrictive, based on standards such as “arbitrary and capricious,” “manifest disregard for the law,” and “completely irrational.” See Harold Brown, Alternative Dispute Resolution Realities and Remedies, 30 SUFFOLK U. L. REV. 743, 762 (1997); see also Carr & Jencks, supra note 56, at 208 n.67 (noting that in California “it has become virtually impossible to set aside an arbitrator’s award because the state legislature amended the state arbitration act to provide that an arbitrator’s award stands even where an error exists on the face of the award”). 147 The Center for Public Resources has established an Institute for Dispute Resolution, which has obtained more than 4,000 corporate and 1,500 law firm signatures. See Carr & Jencks, supra note 56, at 200, n.43; see also <http://www.cpradr.org/>. 148 See Carr & Jencks, supra note 56, at 200 n.43. 149 As of 2000, FMCS charged $30 per request; AAA charged $150 per case. See LAURA J. COOPER, DENNIS R. NOLAN & RICHARD A. BALES, ADR IN THE WORKPLACE 20 (2000). Of course, the arbitrator(s) selected will then charge their hourly or daily rate. 2000] SYNTHETIC COMMON LAW 33 judges.150 This phenomenon is not unusual. Profit and non-profit firms coexist within other industries, notwithstanding the tax advantages to non-profit firms.151 In addition to economic benefits, there may be psychological benefits to private adjudication. Recent empirical research in psychology shows that once people are persuaded to participate in private dispute resolution, they tend to prefer such regimes to court.152 Accordingly, many view private adjudication as both efficient and as a kinder, gentler way to resolve disputes.153 However, there are numerous problems associated with these alternatives. First, private adjudication actually may be very costly relative to its benefits. It is difficult to compare directly the costs and benefits of private adjudication and courts, because courts are publicly subsidized and judicial costs and benefits are difficult to specify. However, there are reasons to believe arbitration is quite costly compared to court, especially given that claims of the recent “litigation explosion” and increase in judicial costs in U.S. courts may be exaggerated, if not false.154 Moreover, private adjudication fails to generate the public benefits (e.g., maintaining credibility of a particular legal system, such as patent law) associated with judicial dispute resolution.155 Arbitration cannot provide the range of services a judge provides.156 Nor will arbitration always occur; for example, if the parties cannot agree on the selection of an arbitrator, they will resort to court. Also, judges must enforce arbitral awards. Even if the value of additional judicial services not available in arbitration cannot be measured precisely, it is clear that they are non-trivial. Accordingly, any cost reductions achieved through private adjudication may be at the 150 See, e.g, POSNER, OVERCOMING LAW, supra note 123, at 115 (“The incentive effect of conditioning the private judge’s compensation on satisfying a market demand may therefore enable the slack associated with the counterpart nonprofit service to be avoided at reasonable cost, so that in some areas of dispute resolution private judging can compete effectively with public judging even though the latter is subsidized.”); see also William M. Landes & Richard A. Posner, Adjudication as a Private Good, 8 J.LEG. STUDIES 235 (1979) (assessing the economics of arbitration and private judging generally); Robert D. Cooter, The Objectives of Private and Public Judges, 41 PUBLIC CHOICE 107 (1983); Jeffrey N. Gordon, Corporations, Markets, and Courts, 91 COL. L. REV. 1931, 1967-71 (1991). 151 See BURTON A. WEISBROD, THE NONPROFIT ECONOMY, Ch. 8 (1988). 152 Several studies have show that “it is difficult to induce conflicting parties to choose mediation, a procedure that lessens third party control and that makes the sure attainment of any given outcome problematic, but that also engenders feelings of social engagement and involvement. However, once experienced, mediation procedures tend to be evaluated quite positively by the disputing parties, and to produce decisions that the parties are likely to find satisfactory and voluntarily accept." Tyler, supra note 49 at 102. 153 See Tyler et al., supra note 49, at 102. 154 See Carr & Jencks, supra note 56, at 201. 155 See Brown, supra note 146, at 760-61. 156 Judge Posner has described these services as follows: “There is, it is true, a good deal of private judging. But an arbitrator or other private judge is hired by the parties to a dispute to resolve that dispute, not to produce the full range of judicial services. The full range includes rulemaking through the issuance of opinions that interpret statutes, common law principles, rules and regulations, and constitutional provisions; the provision of a stand-by dispute-resolution service for people who can’t agree on a neutral arbiter; the interposition of a neutral body between the state and the citizen – and the enforcement of arbitration awards, making the public judge a backstop to the private one.” POSNER, OVERCOMING LAW, supra note 123, at 114. 34 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# expense of one or more of the parties. For example, one of the greatest potential benefits of private adjudication is that it avoids the prospect of a jury trial, an event many business executives have little confidence in and seek to avoid. However, the absence of a jury trial may prejudice one or more parties, depending on the panel or arbitrator chosen to adjudicate the dispute.157 Although arbitration is not a common law system, both parties and arbitrators often attempt to behave as is they were in a common law system, citing precedents and decisions to support their positions.158 However, arbitrators owe little regard to the decisions of other arbitrators, and only a small number of such decisions are published. Those few published arbitration decisions are not representative of other decisions, and are difficult for parties to access.159 Common law reasoning in arbitration yields poor results because of the wide variation in arbitration agreements and factual contexts, variation that is not described in detail in individual arbitrations yet may account for different results.160 Of course, there is variation in fact patterns in common law cases, too, but to the extent judges describe this variation in published opinions, parties are able to distinguish among cases. The selection of an arbitrator is very much ad hoc.161 Typically, the parties do not select the arbitrator until after it is apparent they will not be able to resolve the dispute without recourse to 157 See id. at 204. Business people also seem to find judges inexperienced in commercial matters. Judge typically come to the bench as generalists. See Jack B. Weinstein, Limits on Judges Learning, Speaking and Acting – Part I – Tentative First Thoughts: How May Judges Learn?, 36 ARIZ. L. REV. 539, 540-41 (1994); see also supra notes 115-117 and accompanying text. Of judges with business experience, few have knowledge of a wide range of complex commercial practices. In one recent study, more than two-thirds of business executives and in-house counsel disagreed with the following statement: “the legal system generally considers the needs and practices of particular business communities.” John Lande, Failing Faith in Litigation? A Survey of Business Lawyers’ and Executives’ Opinions, 3 HARV. NEG. L. REV. 1, 34-35 (1998). This study quoted one utility company executive as saying, “Judges are trained in the law, not necessarily in the fundamentals of a particular industry or avenue of commerce. They’re coached on fairness and precedent and things like that. . . . For example, we have a number of disputes with people who we transact with in a transmission grid. Well, that’s a very complex engineering-econometric type of consideration where we use those mechanisms. It’s just not the type of thing you want to bring to the courts.” Id. at 32. Private adjudication can ameliorate these concerns by using industry specialists as adjudicators. 158 See COOPER ET AL., supra note 149, at 232 (“For good or ill, however, parties and arbitrators alike frequently refer to previous decisions. Parties usually do so in the hope that previous awards will persuade the arbitrator of the merits of their positions, not because they regard the awards as binding. Arbitrators usually do so to justify their decisions.”). 159 “Each arbitrator there owes no more than ‘due regard’ to the decisions of other arbitrators. Nor is there complete publication of awards. Those published form only a small, and not necessarily representative, portion of the whole. Many parties have no convenient access to the publishing services, and many parties forego the use of lawyers who could discover and argue the pertinent precedents.” Id. at 233. 160 “Contractual language, evidence of the drafters’ intentions, and the parties’ past practices differ widely. The same words may mean different things in different bargaining relationships. Factual contexts are usually unique.” Id. 161 The parties may select one arbitrator or select a tripartite panel with one or two arbitrators selected by each party. 2000] SYNTHETIC COMMON LAW 35 arbitration.162 Late selection of an arbitrator may be advantageous, because the parties can pick an arbitrator with current and particular expertise related to the dispute. However, late selection inevitably causes delay.163 The purported confidentiality benefits of private adjudication may be offset by reductions in fairness and efficiency. Parties involved in private adjudication generally relinquish the right of appeal. There generally is no public record of private proceedings; in fact, many commercial parties prefer private adjudication precisely because it is a way of protecting themselves from negative publicity.164 This protection may suit both parties, even the winner, who otherwise might have been forced to disclose trade secrets or negative information about its products or services during the proceedings.165 Moreover, businesses involved in repeated judicial determinations over time risk establishing negative precedents for future cases; because private proceedings are not reported, even an extremely negative result is unlikely to harm future litigation.166 When cases settle or are adjudicated through a private forum, there is no body of reported cases.167 To the extent there is public disclosure of private proceedings, such information is unlikely to be tracked, memorialized, and stored.168 Both the courts and Congress seem to have made a decision to divert business cases into arbitration to conserve judicial resources for 162 See id. at 18. 163 In a synthetic common law regime, the parties could both select and constrain an appropriate arbitrator without creating delay. 164 See Judith Resnik, Failing Faith: Adjudicatory Procedure in Decline, 53 U. CHI. L. REV. 494, 538 (1986). 165 In contrast, legal proceedings in courts are highly publicized, and even relatively low-level proceedings are reported in specialty journals. Important events during the proceedings are reflected quickly in the stock prices of publicly-traded participants. In fact, there now exist sophisticated financial instruments allowing private parties not involved in the litigation to bet on the outcome of particular cases. For example, after the Supreme Court held that savings and loan institutions could sue the U.S. government for breach of contract arising out of a governmental change in the accounting treatment of goodwill for regulatory capital purposes, see U.S. v. Winstar Corp., 518 U.S. 839 (1996), several plaintiffs, including Glendale Federal and California Federal issued securities, known as Litigation Tracking Warrants, whose return was based on the amount recovered in the suits against the government. See Frank Partnoy, Betting on Suing (1999) <http://www.lawnewsnetwork.com/opencourt/> (copy on file with the author). 166 The securities industry is an appropriate example. This industry created a system of specialist arbitration for both investors and employees, in which arbitrators are required to put their decisions in writing, but are not required to give any reasons. See Bird v. Shearson Lehman/Am. Express, Inc., 926 F.2d 116, 124 (2d Cir. 1991) (Kearse, J., dissenting). Securities arbitration is a hotly disputed topic. The securities industry asserts that the move to arbitration makes everyone better off because of reduced transaction costs. Numerous commentators counter that the securities industry, with its expertise in repeat litigation and vast resources, is taking advantage of individual employees and investors. See, e.g., Margaret A. Jacobs & Michael Siconolfi, Losing Battles: Investors Fare Poorly Fighting Wall Street – And May Do Worse, WALL ST. J., Feb. 8, 1995, at A1 (quoting one observer as saying, “Christians had a better chance against the lions than many investors and employees will have in the climate being created now.”). 167 See Owen M. Fiss, Against Settlement, 93 YALE L.J. 1073 (1984). 168 See Carr & Jencks, supra note 56, at 228 (citing Borzou Daragahi, Environmental ADR: Demand for Arbitration Raises Practical Concerns, N.Y. L.J., Sept. 8, 1994, at 5). 36 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# other types of cases, particularly criminal, family law, and civil rights cases.169 What is the consequence of having primarily only these non-business cases left in the judicial system? They could be quite serious. Many commentators are concerned that such a practice would split dispute resolution into private courts for the “haves” and public courts for the “have-nots,” in the same way many argue public and private schools have been split.170 Mediation171 purports to provide benefits not available in a confrontational proceeding, including both court and arbitration.172 On the other hand, the more mediation is used, the more it erodes whatever precedential value exists in dispute resolution by judges or arbitrators. If a large number of “normal” cases are resolved in mediation, then those cases resolved in judicial and arbitral fora may not reflect societal practice.173 Disputes resolved in mediation typically are resolved confidentially, and therefore other parties are denied all of the benefits associated with public resolution of decisions, including a body of decisions to guide future practice.174 In this way, mediation poses a more serious and specific version of the general problem posed by the settlement of large numbers of cases.175 169 See Carr & Jencks, supra note 56, at 213-15 (detailing judicial and legislative efforts to move business cases out of courts into ADR). For example, the Supreme Court has permitted arbitration of federal securities law claims based on contractual choice. See Rodriguez de Quijas v. Shearson/American Express, Inc., 490 U.S. 477 (1989); Shearson/American Express, Inc., v. McMahon, 482 U.S. 220 (1987). 170 See Carr & Jencks, supra note 56, at 231-33 (citing numerous commentators). It certainly is the case that the direct cost of judging in private ADR is greater than the cost of judging in a heavily-subsidized public judicial system; for example, JAMS rent-a-judges charge fees ranging from $350 to $500 per hour. See Richard C. Reuben, The Dark Side of ADR, CAL. LAW., Feb. 1994, at 55. Lisa Bernstein has argued that compulsory ADR reduces the frequency of settlements and increases costs to less wealthy parties. See Lisa Bernstein, Understanding the Limits of Court-Connected ADR: ADR: A Critique of Federal Court-Annexed Arbitration Programs, 141 U. PA. L. REV. 2169, 2216-30 (1993). 171 See J.B. Ruhl, Thinking of Mediation as a Complex Adaptive System, 1997 B.Y.U.L. REV. 777, 784 n.22 (1997) (discussion definition of mediation). 172 See, e.g., Jonathan R. Harkavy, Privatizing Workplace Justice: The Advent of Mediation in Resolving Sexual Harassment Disputes, 34 WAKE FOREST L. REV. 135, 156 (“Mediation provides a comfortable forum for all parties and thus is more likely to facilitate a workable resolution to a dispute than a more adversarial process involving rights adjudicated in a formal setting under a fixed set of rules.”). 173 Jonathan Harkavy has made this point in the context of sexual harassment dispute resolution: “Mediation may impair the orderly development of a coherent sexual harassment jurisprudence. To the extent that it is successful in resolving large numbers of disputes, the cases left for adjudication may involve such unique factual situations that the resultant body of case law will be shaped – and possibly warped – by mediation’s leftovers.” Harkavy, supra note 172, at 160. 174 For example, most mediated settlements of sexual harassment cases are confidential. This confidentiality deprives the public of valuable information need to answer important questions necessary to parties planning behavior, including: what is the law, who is violating the law, and what are the costs of illegal conduct? See Harkavy, supra note 172, at 163. Some scholars have argued that private interest should at least sometimes prevail over the public interests in clarifying legal rules through litigation. See Carrie Menkel-Meadow, Whose Dispute is it Anyway?: A Philosophical and Democratic Defense of Settlement (in Some Cases), 83 GEO. L.J. 2663 (1995) (arguing that private interests in settling a case should be respected, even when they are outweighed by the public interest in litigating the case). 175 The classic article posing these problems in the context of settlement is Fiss, Against Settlement, supra note 167. In that article, Owen Fiss stated that “[s]ettlement is for me the civil analogue of plea bargaining: Consent is often 2000] SYNTHETIC COMMON LAW 37 As an example of how the current system of private adjudication generates enormous uncertainty, consider the arbitration of securities employment contracts. Securities firms generally require employees to sign arbitration agreements, in order to opt into what the firms regard as a lower-cost option to judicial resolution of employment disputes. In fact, the arbitration of employment claims by securities employees has not always worked out as the employers planned. In several recent cases, New York Stock Exchange arbitration panels have awarded employees multi-million-dollar bonuses, even though the employees making the claims had been terminated for cause, and notwithstanding the fact that prior practice in the industry was that management awarded such bonuses at its discretion.176 These arbitrations were not adjudicated based on rules known to either party at the time of contracting; in fact, the rules by definition were contrary to the expectations of at least one of the parties. Because these arbitration decisions are unpublished and do not bind future arbitrators, there is great uncertainty surrounding the arbitration of securities employees’ bonus disputes. The result almost certainly will be an increase in the filing of bonus-related claims, some of which no doubt will succeed, many of which will be inconsistent, and all of which will require the additional expenses of lawyer and arbitration fees. This evidence in the securities firm employee bonus context is anecdotal, but there are general arguments indicating that similar problems will persist in other areas of arbitration. Consider the following hypothetical: First, suppose a judicial regime governs a particular dispute. Every year for ten years there is a contract dispute related to a particular type of contract. In each dispute, $1 million is at stake. Suppose it costs each side $50,000 in legal fees to adjudicate the dispute and it costs another $50,000 for the judge to hear the case. If the facts of each case, each year, are precisely the same, once the first case is decided, then all of the later cases will settle based on the terms of the first case. For example, the judicial decision in the coerced; the bargain may be struck by someone without authority; the absence of a trial and judgment renders subsequent judicial involvement troublesome; and although dockets are trimmed, justice may not be done.” Id. at 1075. Fiss argued that certain types of disputes are especially inappropriate for arbitration, including: (1) disputes where one party has disproportionate bargaining power or resources, (2) disputes where settlement is difficult, (3) disputes where parties must be supervised post-judgment, and (4) disputes where parties (and society) need an authoritative interpretation of the law. Fiss’s argument has some relevance to the discussion of derivatives disputes in Part V infra. Derivatives disputes arguably satisfy the first and fourth criteria – often one party has an information or sophistication advantage over the other party, and parties desperately need authoritative interpretation – but may not satisfy the other criteria. In particular, settlement seems to be relatively easy, at least compared to the prospects of costly and continued litigation, and parties typically do not need to be supervised post-judgment. Therefore, some derivatives disputes may be appropriate for arbitration, while others clearly would not be. 176 See Randall Smith, Traders, Bankers Who Lost Jobs Amid Charges of Wrongdoing Still Get Bonuses, WALL ST. J., July 19, 2000, at C1, C4 (describing awards of $2 million, $2 million, $1.5 million, and $1.44 million). The securities firms involved in these arbitrations were described as “taken aback” and one firm, UBS Securities, sought to vacate an award in New York state court, although New York Supreme Court Justice Carol E. Huff upheld the arbitrator’s award. See id. at C4. 38 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# first case might be to split the $1 million equally. Such a decision would mean it would cost a total of $150,000 (the costs of legal and judicial fees in the first case) to resolve ten years of annual contract disputes. However, if the facts or legal arguments in later cases differ from those in the first case, the cases may not settle. Assume that in each later case the facts differ in such a way that each party believes it is entitled to $600,000, or $100,000 more than was awarded in the first case. Then it is in each party’s economic interest to litigate. That means a judge will need to decide all 10 cases, at a total cost of $150,000 per case, or $1.5 million. The efficiency of judicial dispute resolution thus turns on the accuracy of the expectations of the parties. Now, suppose an arbitration regime governs the dispute. Note that arbitration actually increases society’s overall costs. If the first case is decided in arbitration, there is no guidance at all for future cases, which would need to be adjudicated, even if the later cases were factually similar. In other words, the total cost will be $1.5 million, regardless of the accuracy of the expectations of the parties, because the parties will not be able to rely on a published opinion. Accordingly, even if the cost of arbitration were substantially less than the cost of judicial review, arbitration might not be preferable. The use of arbitration may be even more problematic when two commercial parties contract ex ante for its use in a wide range of potential future disputes involving other non-parties. For example, Robert Kenagy has written about an agreement between Whirlpool Corporation and State Farm Fire and Casualty Company to remove subrogation177 disputes about damage to State Farm insureds caused by Whirlpool products from court to arbitration.178 The agreement committed any injured insureds to confidential arbitration with streamlined discovery.179 Of course, Whirlpool and State Farm benefit from the agreement. But at whose expense? Future claimants lose the ability to pursue a judicial subrogation remedy if one of Whirlpool’s products harms them (which, as the parties must have known, almost certainly would occur; otherwise, there was no reason for the agreement). These are parties who by definition cannot bargain because it is unknown in advance who, if anyone, will suffer the harms. Nor is the extent of the harms known. This is a classic externality example. 177 Subrogation has been defined as: “the equitable remedy by which, where the property of one person is used to discharge a duty of another or a lien upon the property of another, under such circumstances that the other will be unjustly enriched by the retention of the benefit thus conferred, the former is placed in the position of the obligee or lienholder.” RESTATEMENT OF SECURITY § 141, comment a, at 383 (1941). In the insurance claims context, subrogation disputes typically occur when an insured seeks recovery from a third party or third-party insurer after the insured’s (first-party) insurer already has paid some compensation to the insured; the first-party insurer then has a subrogation interest in the insured’s recover against the third party or third-party insurer in the amount paid. See, e.g, Texas Farmers Ins. Co. v. Seals, 948 S.W.2d 532 (2d Dist. Tex. 1997) (describing such a subrogation dispute). 178 See Robert T. Kenagy, Whirlpool’s Search for Efficient and Effective Dispute Resolutions, 59 ALB. L. REV. 895, 897-98 (1995). 179 Id. at 898. Importantly, the plaintiffs’ bar would be not privy to the arbitration proceedings. 2000] SYNTHETIC COMMON LAW 39 Absent transaction costs, State Farm insureds might bargain for an arbitration agreement, if that agreement would result in a lower cost of insurance. Or Whirlpool might be willing to pay insureds enough to compensate for any losses associated with committing to arbitration. In other words, arbitration might, in aggregate, be cheaper and fairer than judicial resolution. But is likely that such payments would occur (i.e., that agreement would have been reached) when transaction costs are very high? There is no evidence that the value of the Whirlpool-State Farm agreement was included in the price of the insurance contract offered to insureds.180 Private adjudication is used in business cases, but often for reasons unrelated to the fairness or efficiency of the alternative systems. It is increasingly costly and uncertain, and may not serve the public interest because of the external costs to non-parties. Often, it does not even satisfy the businesses opting in without recourse to appeal. Private adjudication is perhaps the worst of several evils. IV. A PROPOSAL: SYNTHETIC COMMON LAW The current systems of public and private adjudication of disputes are not the only alternatives. A synthetic common law system is a blend of the other systems, and resolves many of the problems in each. In Learned Hand’s terms, synthetic common law enables parties to build their own coral reefs. This Part describes the synthetic common law system in greater detail, and explains when and why it likely would obtain advantages over the other systems. Here, in greater detail, is how a synthetic common law regime would work. Private synthetic law associations would be established,181 consisting of experts in individual fields of law, perhaps including law professors.182 Those associations would publish menus of cases. The cases would involve simplified facts in particular areas of practice and would focus on the issues that, in the judgment of the association (and of parties who would choose that association), most likely would arise in future disputes. The cases could include published state and federal cases, or examples based on such cases, or even stylized versions of such cases with certain facts changed or omitted. Numerous associations would compete for a particular contract. Private parties might simply list, or check a box for, cases they selected to govern disputes under the contract. The association would then commit to resolve disputes based on those cases. The association might describe, or even commit to, its anticipated mode or process of reasoning in any future dispute.183 The reputation of the association over time would be based on the extent to which it was able to keep its commitments. The association could incorporate information gleaned from actual cases it adjudicated into new synthetic common law for future parties to choose. 180 See id. 181 These would be for-profit associations, established with a view to earning income both by providing synthetic common law cases ex ante and by adjudicating disputes ex post. 182 Writing synthetic cases would be similar to writing comments on proposed legislation or even final examination questions, areas in which law professors have expertise. 183 Parties might also specify ex ante the cost or rate structure for adjudication, and might list acceptable adjudicators. 40 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# Associations would compete for business over time. As with arbitration, courts would have limited review of association judgments.184 From the perspective of private parties, synthetic common law would be no more complex ex ante than arbitration. Parties would simply select an association to adjudicate their disputes, and then select from that association’s menu of cases a particular set of cases to govern their contract. The association would adjudicate any disputes based on the selected menu of cases, and the selected mode of legal reasoning, if applicable. A schematic diagram is illustrative: 184 See supra note 146. 2000] SYNTHETIC COMMON LAW 41 Note that synthetic common law is a hybrid of common law and the alternatives to common law.185 It contains some of the public aspects of common law and statutory law (e.g., limited judicial review, real common law cases forming the basis for synthetic cases included on a particular menu), as well as non-governmental aspects of private law and private adjudication (e.g., synthetic common law associations are private entities). Synthetic common law also involves both ex ante and ex post specification of legal rules: the governing legal rules (e.g., cases) are specified ex ante, as they are in statutory and private law, whereas the results in particular cases are decided ex post, as in common law or private adjudication. Synthetic common law draws advantages from each, as described below. Common Law In certain areas, a synthetic common regime might better accomplish both of the goals of common law. It could enable a private adjudicator to resolve parties’ disputes in a fair and efficient manner, while generating at lower cost a supply of legal rules that reflect social practice. First, unlike common law, synthetic common law cases need not evolve over time in order to reflect social practice. Advocates of common law laud the case or controversy requirement, and the purported efficiencies derived from having judges adjudicate only real cases involving real parties with real disputes. It is undeniably true that some filter works to limit those disputes percolating from real disagreements among private actors up to real judicial opinions. But a filter works to limit synthetic cases, too, and that filter does not depend on the potentially abnormal behavior of parties other than the contracting parties. Real cases and controversies are often based on disputes in which parties are behaving in an economically irrational manner. Numerous real cases are litigated because one or more parties misperceive either the probability of recovery, the likelihood of victory, or both. Most importantly, the case or 185 Figure 2 is simply Figure 1 plus synthetic common law. Private Public Ex PostEx Ante Statutory Law Common Law Private Adjudication Private Law Figure 2 Synthetic Common Law 42 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# controversy filter is incredibly costly. The synthetic common law filter costs very little.186 Synthetic common law likely would be fairer than common law, because it would avoid judicial temptation to create new law.187 The value of common law rules depends on their consistency (i.e., cases that are consistent with each other) and stability over time (i.e., the “stickiness” of precedent).188 Synthetic common law, because it is created all at once, is far more likely than common law to be consistent. Moreover, because synthetic common law cases will not change, absent agreement of the parties, during the life of the contract, they are guaranteed to be stable over time. Thus, synthetic common law could achieve one of the primary aims of the common law: “enabling private actors, within limits, to determine before they enter into a transaction the legal rules – including the ‘new’ legal rules – that will govern the transaction if a dispute should arise.”189 Private actors need a replicable process so they will not be insecure in planning future actions.190 To the extent common law is not replicable, as it often is not, it cannot achieve this aim. In contrast, synthetic common law by definition is replicable because the rules selected by the parties cannot change during the life of the contract, regardless of the views of particular judges. Synthetic common law eliminates the possibility that prospective overrulings191 or transformative192 rulings by judges will change the law relevant to any dispute between the parties. It avoids the difficulty of overruling or overturning a decision, which in a common law regime requires a judge to construct an elaborate justification.193 In contrast, under synthetic common law, private parties can avoid a bad case simply by not checking that particular box. Melvin Eisenberg, one of the leading scholars of common law, has summed up his view of the common law as follows: “What then does the common law consist of? It consists of the rules that would be generated at the present moment by application of the institutional principles of adjudication.”194 By this definition, synthetic common law arguably is superior to common law. Synthetic common law cases always are created “at the present moment” – the moment when the contract is executed, when the parties are determining what rights should govern any future disputes – whereas common law cases may not reflect the expectations of the parties at that crucial time. 186 In a competitive market for synthetic common law organizations, one organization is unlikely to have market power. The marginal cost of synthetic common law is likely to be low; it involves only a few people spending a relatively small amount of time writing cases. 187 See EISENBERG, supra note 2, at 35 (discussing problem of judges creating new legal rights after the event relevant to the dispute). 188 See id. at 44, 46. 189 Id at 11. 190 See id. at 48. 191 See id. at 127-32 (describing judicial decisions affecting transactions comparable to the one being adjudicated that occurred before the decision but remain open to legal challenge). 192 See id. at 132 (describing judicial process of transforming cases, including the example of Justice Cardozo’s radical reconstruction of precedents to reach a particular result). 193 See id. Ch. 7. 194 Id. at 154. 2000] SYNTHETIC COMMON LAW 43 Synthetic common law avoids the tragedy of the commons critique of common law, because the (very low) costs are internalized by the parties. To the extent there is a public goods problem in a synthetic common law regime, it is likely to be far less serious than the problem under common law. It would cost drafters creating synthetic cases only a fraction of the costs of litigating similar cases. Scholars who advocate regulatory competition should prefer synthetic common law, because it adds competing options to parties who currently can only choose which state (or federal) law to have govern their contract. The number of competing synthetic common law regimes is virtually unlimited. Competition among synthetic common law associations would eliminate problems associated with the common law mode of legal reasoning.195 Successful associations would develop reputations for deciding cases using a particular mode of reasoning; they might even advertise a particular type of legal reasoning methodology (e.g., reason like Holmes would have, err on the side of stability and consistency, decide our case like Dworkin believes judges decide cases). Alternatively, private parties could request particular modes of reasoning, and only associations agreeing in advance to provide such modes would obtain their business. Scholars who abhor regulatory competition nevertheless need to recognize the possibility of synthetic common law regimes, and explain why parties should not adopt them. Even if choice of law is a race-to-the-bottom, choice of synthetic law might not be, because to the extent there is information asymmetry or other market failure leading to unfair bargains in choice of law, synthetic common law levels the playing field by laying bare in narrative form the effects of particular contractual provisions. To the extent the justification for common law is its evolutionary process, synthetic common law better takes advantage of that process. Synthetic cases can evolve over time; the major difference is a certain amount of “genetic engineering” taking place while the first regime is created. Synthetic common law also could generate a superior body of legal rules. Although ardent legal positivists may not agree that synthetic common law is composed of actual legal rules, the argument that synthetic common law is based on such rules is much stronger than the corresponding argument for common law.196 Common law- style rules (including synthetic common law rules) enjoy their status as “law,” not because they are posited sets of rules, but because parties continue to accept them. Such acceptance is more likely in a synthetic common law regime, which necessarily requires that parties approve of applicable legal rules, than it is in a traditional common law regime, which limits choices to existing regimes and does not require that parties make an explicit choice about particular cases that will govern a dispute. Although the common law is said to “lack[] an authoritative authentic text”197 and “to develop and apply principles that have never been committed to any authentic form of words,”198 synthetic common law carries greater weight as text because the 195 See EDWARD LEVI, AN INTRODUCTION TO LEGAL REASONING (1948). 196 See supra Part II.B. 197 Simpson, supra note 65, at 16. 198 F. POLLOCK, A FIRST BOOK OF JURISPRUDENCE 249 (3d ed. 1911). 44 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# parties explicitly agree to the words contained in the cases specified in advance; under common law, the legal rules in the cases are specified ex post. To the extent common law is flexible, synthetic law is at least as flexible. The parties could choose whatever cases they would like to include in a particular contract, including existing common law cases. The parties could specify the process of adjudication, including “sticky” adherence to precedent, and could even indicate how they would like a judge to reason. Whereas common law in the U.S. now performs poorly in generating a public record of legal rules, for the various reasons analyzed in Part II.B.2., synthetic common law guarantees an adequate number of on-point cases. If the parties do not believe the cases cover a specific point, they can change or add a case. Many of the arguments offered in favor of common law adjudication depend on the assumption that a large number and wide variety of opinions will be published.199 Synthetic common law achieves this assumed objective better than common law does. Similarly, common law may be uncertain if parties are able to construct large numbers of plausible rules from a given precedent.200 Precedents often follow unstable, “jagged” paths, zigging and zagging until a judge or commentator is able to synthesize the results in existing cases. This synthesis typically requires explaining the cases while recognizing the prior legal rule.201 A synthetic common law regime would simply clarify the cases to eliminate such ambiguity. In difficult areas of commercial law, where some cases may seem irreconcilable even after years of legal commentary,202 parties using synthetic common law could reconcile such difficult cases simply by deleting problematic sections. Hard cases may be useful, even fun for law professors and students, but private parties likely will not find the intellectual challenge of such precedents, as originally written, to be worth their commercial while. In common law cases, a party often must show that the rule of a precedent is not in conflict with a particular decision.203 In a synthetic common law regime, there is no such need, and consequently synthetic common law regimes can avoid costs related to such showings. If a particular passage in a case seems troubling or confusing, the parties could simply delete it. The key point is that synthetic common law provides information that both (1) is not reflected in current precedent, and may contradict precedent; and (2) would not with certainty lead every judge to the principle articulated by the parties. Synthetic common law would not require parties to specify all contingencies, or to list the 199 Many pro-common law arguments depend upon the publication of opinions. See id. at 42. 200 See EISENBERG, supra note 2, at 63. 201 Examples of such synthesis have involved major figures in law. For example, the reliance principle in contract law was first explicitly formulated in Section 90 of the Restatement (First) of Contracts, authored principally by Samuel Williston; the modern principle of unconscionability was first formulated in Article 2 of the UCC, authored principally by Karl Llewellyn; and the principle of strict product liability was first explicitly formulated in Section 401A of the Restatement (Second) of Torts, authored principally by William Prosser. See id. at 78-79 (describing justifications for each example). 202 See id. at 61, 64, 97. 203 See id. at 62. 2000] SYNTHETIC COMMON LAW 45 many possible iterations of changes in a variable. Rather, synthetic common law would ask the parties to articulate the cases they would want a future adjudicator to use in a future dispute about some, but not all, facts that the parties anticipated.204 Of course, judges in common law judges today can reason based on hypothetical facts or cases, but synthetic common law is preferable to common law reasoning from hypotheticals, because the parties can specify the relevant hypotheticals ex ante, and need not attempt to anticipate a future judge’s reasoning.205 I am not saying that synthetic common law always will be superior to common law. In fact, it might be superior only in particular areas of law. In the vast majority of cases, both synthetic common law and common law are largely irrelevant, because most parties do not know the law and instead make plans implicitly, not explicitly (i.e., they do not consider specific legal consequences).206 Synthetic common law, to the extent it is more specific than common law, may alarm one of the parties and thereby “queer the deal.” Many aspects of contracting are uncertain ex ante and therefore cannot be specified in words, whether those words are contract terms or fake cases.207 Synthetic common law may not carry the authority of the “rule of law,”208 not only because it would be privately administered, but because it assumes there is not a fixed rule of law ex ante. Notwithstanding these flaws, my argument is that for some parties synthetic common law could be fairer and more efficient than common law. Statutory Law Second, a synthetic common law regime could be superior to a statutory regime. To the extent statutory law is inferior to common law, as a number of recent studies have indicated, synthetic common law should provide the same types of economic benefits as common law. Societies with a history of common law (e.g., the United States and England) would find it relatively easy to shift to synthetic common law in certain areas without a loss of economic benefits.209 In at least some cases, a synthetic common law system would achieve the primary purported advantage of statutes: clarity. If the applicable statute is clear, there would be no need for synthetic common law, and the parties would not choose to use it. However, the reality is that many statutes are unclear or limited, and require interpretation through hypotheticals or some other form of adjudication. If a statute is not clear, private parties could specify in fake cases how the judges of their imagination would resolve the ambiguities. Cases could include excerpts of the relevant statutes, existing or proposed, if such inclusion would make the cases clearer. 204 See id. at 86. 205 See id. at 99. 206 See id. at 157. 207 See id. at 158 (asserting, without justification, that “the greater part of the common law, although not certain, is nevertheless sufficiently determinate for planning purposes”). 208 See F.A. HAYEK, THE ROAD TO SERFDOM 72 (1944) (describing importance of government “being bound by rules fixed and announced beforehand”). 209 See supra note 3. 46 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# Consequently, synthetic cases could achieve, at minimum, that level of clarity already achieved by a statute. In addition, synthetic common law could achieve some of the benefits of democratically selected statutes. The information impounded in a set of synthetic common law cases is more likely to reflect the expectations of the parties than any statute. None of the noise associated with the legislative process pollutes the legal rules in synthetic common law. Because the cases more likely reflect the parties’ expectations, they are more likely to be fair and efficient. Synthetic common law also avoids the problem of statutes reflecting the popular will of a prior electorate, not the current one. In areas where technologies are rapidly changing, synthetic common law can change, too. Alternatively, parties can anticipate change and build it into cases. In at least some instances, private parties will be able to assess contingencies relevant to future disputes in individual cases better than legislators will. Although legislators are democratically elected, they may have been elected by parties with different interests and preferences than the contracting parties. Synthetic common law avoids the public choice and interest group pressures of legislation. Cases are influenced only by the choices of the parties and the availability of synthetic common law regimes. Synthetic common law may not be superior to statutes, in every area, or even in very many areas. In some areas of practice, the democratic process works effectively, and statutory rules will best reflect overall societal preferences. In relatively simple contracts, statutes may be reasonably clear, and developing synthetic common law may be too costly. Finally, to the extent narrative is important to assist parties in understanding the legal rules governing their contract, synthetic common law has obvious advantages. Statutes may enable parties with superior information to obtain an advantage in bargaining. The narrative aspects of synthetic common law might help to level the playing field for disadvantaged parties. For evenly-matched parties, explaining the legal rules governing their contract in narrative form may improve their ability to specify contingencies ex ante, a wealth- improving result. Private Law Third, a synthetic common law regime also may be superior to a regime of model acts and private law. Model acts suffer from the same weaknesses as statutes. The only true difference between a model act and a statute is that a model act front-loads most of the work onto commentators who consider various proposals carefully before the legislative process begins. Model acts take force only when adopted as statutes. Private law avoids some of these problems, because it derives its authority from the fact that the parties agree to include it in their contracts. Private law has expanded greatly in recent years, due in part to the recent arguments of law and economics scholars that 2000] SYNTHETIC COMMON LAW 47 private law is efficient. To some extent, existing private law regimes offer the same advantages of synthetic common law.210 There are, however, several differences between private law and synthetic common law, and these differences highlight the reasons why synthetic common law would be superior in particular cases. Private law is essentially private statutory law, and therefore suffers from a lack of clarity and completeness. It is very difficult to specify in advance the variety of factors relevant to any future dispute. Clarity is just as elusive in complex contracts as it is in complex statutes. Private law does not obtain any benefits of analogical reasoning. Why can’t lawyers and other parties create private default terms with sufficient specificity? As noted above, private default terms and standard form contracts are analytically equivalent to model acts and uniform private laws, the primary difference being the intended audience. While the former is directed to private parties engaging in contracting, the latter is directed more generally to legislators. All such private law offers the benefits of considered judgment of non- governmental actors. Moreover, although private law may serve to guide practice absent a dispute, the parties will need to specify the means of resolving a dispute. The choices are courts or private adjudication, each based on the language in the private law. Therefore, even if private parties can draft an ideal private contract, they are subject to the interpretation of a judge or arbitrator in a future case. More likely, the parties will not be able to, or even attempt to, specify all contingencies. Even the various Restatements of the Laws include short case examples explaining how particular statutory provisions would work in practice. For parties who prefer narrative to contract terms, private law may be inferior to synthetic common law. Synthetic common law is more likely to level the playing field between parties, especially for consumers and purchasers who do not read contracts because the costs of reading them exceed the benefits. Synthetic cases are less costly (i.e., painful) to read, and may generate additional benefits if parties are able to understand and intuit their implications more easily than they would be able to formulate hypotheticals based on contract language, even if a contract were clear. If contracts were written in terms of synthetic cases, the bargain over contract terms might be more party-to-party than lawyer-to-lawyer. As a result, lawyers may have a vested interest in supporting private law over synthetic common law. Contract lawyers have been trained in, and have acquired, a particular skill: drafting complex contracts that specify many often-related contingencies. This is difficult work. Many non-lawyers find such contracts difficult to read, and would find them impossible to draft. However, few contract lawyers have developed the skill of writing or interpreting synthetic cases. Even if synthetic common law were superior to private law, lawyers might oppose the synthetic regime for self-interested reasons. 210 One difference between the regimes is that private contract terms typically do not refer to an adjudication association, although there is no principled reason why they could not be enforced by private associations in the same way synthetic common law would be. 48 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# Private Adjudication Fourth, a synthetic common law regime could capture many of the benefits of private dispute resolution while avoiding many of its costs. First, a synthetic common law regime is essentially a form of private adjudication. The major differences are increased competition among regimes, and the addition of synthetic cases. Therefore, synthetic common law would achieve many of the benefits of existing forms of private adjudication. Synthetic common law could avoid some of the problems associated with the private nature of ADR and mediation. All of the synthetic cases would be known to the parties. To the extent parties valued additional decisions, they could pressure associations to include those real decisions in future menus of cases. Nevertheless, there would be some externality costs to non-parties, although those costs might not be as high to the extent non-parties learn of the contractual arrangement and read the synthetic cases. Most importantly, synthetic common law would avoid the arbitrary nature of private adjudication. There are few constraints on private adjudicators, and they are notoriously difficult to predict. In some areas, arbitration has not reflected the ex ante understandings of the contracting parties.211 Finally, to the extent parties prefer private adjudication to court because of the psychological benefits, as some studies have indicated,212 synthetic common law also could achieve those results. In fact, parties might even achieve some satisfaction ex ante from expressing in narrative form their expectations regarding future disputes. Moreover, private adjudication creates an adverse selection problem for judicial opinions, because as normal cases are resolved in arbitration or mediation, the body of disputes available to judges writing published opinions is not representative. Because parties involved in a synthetic common law regime have expressed their views about future cases ex ante, they may be less likely to perceive that a court would adjudicate their case differently, thereby avoiding the adverse selection problem. To the extent the problem continues, because parties contracting in a synthetic common law regime rely on synthetic cases, not judicial opinions, the problem will not be relevant. V. USING SYNTHETIC COMMON LAW IN DERIVATIVES DISPUTES This Part analyzes how synthetic common law would work in a particular context: the resolution of disputes involving financial derivatives.213 If Oliver Wendell Holmes were alive today, he surely 211 See supra note 176 and accompanying text (discussing securities arbitration bonus awards that conflicted with expectations). 212 See, e.g., Tyler, supra note 49, at 102. 213 Disputes in the derivatives market provide an excellent opportunity to compare the viability of common law and the various alternatives to common law. As shown in the previous subpart, ex ante attempts to cure the uncertainty in the derivatives market, through detailed statutes and extensive private law, have failed. This section considers the problems associated with common law attempts to resolve the disputes ex post and thereby create certainty. By and large, the common law, too, has failed. 2000] SYNTHETIC COMMON LAW 49 would want to decide – or at least to write about – disputes involving the multi-trillion market for over-the-counter (OTC) financial derivatives.214 Holmes was interested in the major conflicts of his day, in the influences of technology and scientific progress, and – as he often is quoted – in experience over logic.215 To a judge such as Holmes, the temptations of derivatives disputes would be overwhelming: hard-fought, novel claims involving leaders of industry and billions of dollars; breathtaking innovation and complexity underlying the relationships of the parties; and, above all, the kind of logic-defying real-world experience that Holmes believed defined the substance of the law.216 Most importantly, the jurisprudence of derivatives disputes is a tabula rasa, available for a bold, intelligent jurist to make his or her mark. Unfortunately, the judges thus far presented with OTC derivatives claims have, to put it charitably, not been of Holmes’s statute. Judges have shied from deciding any core issues in these cases, either because they fear the effects of an off-the-mark precedent or because they are overwhelmed by the detail and complexity of the cases. Although the OTC derivatives market is among the largest markets in the world and is chock full of disputes, judges only rarely have decided even narrow issues in derivatives disputes, and they almost never write detailed opinions.217 The vast majority of cases settle before trial in most areas of law, but the derivatives area is striking for the near total absence of judicial opinions and decided cases on important issues. Only one derivatives claim ever has been tried,218 and that trial was a decade ago, well before the recent waves of derivatives disputes. Only a handful of disputes have led to judicial opinions on dispositive motions. The trepidation of a judge facing a derivatives dispute is understandable. The financial instruments underlying the disputes are complex and the relationships among parties and transactions are In an earlier article, I suggested that society would be better served by ex post rules in the derivatives industry that ex ante rules, which parties would contract around through regulatory arbitrage transactions. See Partnoy, Regulatory Arbitrage, supra note 5, at #. This article extends that argument by supplying the means (synthetic common law) by which ex post evaluation of cases could generate efficient and fair legal rules. 214 Financial derivatives are financial instruments whose value is based on, or derived from, some other underlying instrument or index. See id. at 216-26 (describing classes and uses of derivatives). As of year-end 1999, the size of the derivatives market was estimated at more than $100 trillion. See supra note 5. Over- the-counter financial derivatives are those not traded on any exchange. 215 HOLMES, THE COMMON LAW, supra note 14, at 5. 216 Holmes’s attempt to present “a general view of the Common Law” recognized the importance of both history and current practice: “The substance of the law at any given time pretty nearly corresponds, so far as it goes, with what is then understood to be convenient; but its form and machinery, and the degree to which it is able to work out desired results, depend very much upon its past.” Id. 217 A rare exception is the opinion by Judge Feikens in Procter & Gamble Co. v. Banker Trust Co., 925 F. Supp. 1270 (S.D. Ohio 1996), which considered multiple claims in detail. Ironically, Judge Feikens, in Ohio, was interpreting New York state law, and the New York state courts subsequently have rejected a portion of his opinion with little analytical support or explanation. See infra at notes 353-356 and accompanying text. 218 To my knowledge, the only trial in a derivatives case was the one reviewed in BankAtlantic v. PaineWebber, Inc., 955 F.2d 1467 (11th Cir. 1992); see discussion infra at notes 444-445 and accompanying text. 50 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# difficult to understand.219 Some judges might find unraveling such a case to be impossible. Moreover, any decision likely would have vast repercussions, potentially affecting trillions of dollars of transactions. No judge wants to be accused of bringing down a market, especially in New York, where many derivatives disputes are filed. Eventually, one or more emboldened judges may write definitive opinions in the area; meanwhile, there is little or no judicial guidance. The situation is dire. Private parties continue to contract (or not) in a regime of enormous legal uncertainty. This Part argues that a synthetic common law system could eliminate much of that uncertainty. I begin by explaining briefly the challenges associated with deciding derivatives disputes: the complexity of the instruments themselves, the difficulties associated with regulatory arbitrage, and the problems associated with attempting to regulate only a subset of an economically equivalent class of financial instruments. Then, I assess how the four regulatory alternatives described in Parts II and III have fared in the derivatives area. The short answer: not well. Historically, statutes have played the most prominent role, so I begin there. Because participants in the OTC derivatives market have opted out of most of these statutory schemes, most securities and commodities statutes are of little relevance to OTC derivatives disputes. Next, I assess the relative small number of derivatives disputes that have been litigated in court. Interestingly, because statutory claims are not relevant to the OTC derivatives market, state common law claims are at the core of these disputes. Finally, I consider the bounds of private law and arbitration, which play a limited role in the area. In Part V.C., I explain how a synthetic common law regime could be a superior method of dispute resolution. I also suggest a specific menu of synthetic common law cases that could eliminate some of the uncertainty in these markets. In Part V.D., I analyze some institutional barriers to adopting synthetic common law. A. Line-Drawing in the Derivatives Market Derivatives are notoriously difficult to categorize. Part of the problem is the ambiguous meaning of the term “derivative.” The definition typically220 given by legal academics and commentators in the area is not particularly helpful: a derivative is a financial instrument whose value is based on (or “derived” from) some underlying instrument or index.221 According to this definition, nearly all financial instruments are derivatives.222 In more precise economic terms, derivatives include two basic classes of instruments: options and forwards. Both are financial 219 Because parties often use Special Purpose Vehicles, subsidiaries, off-shore partnerships and corporations, and other intermediaries, it often is difficult to discern the true counterparties to a particular transaction, a fact some derivatives sellers have attempted to use to distance themselves from purchasers. 220 The popular definition is not used by regulators, who define derivatives in increasingly obtuse and nonsensical ways. See infra Part V.B. 221 See, e.g., Partnoy, Regulatory Arbitrage, supra note 5, at 211, 216. 222 Even stocks and bonds can be thought of as derivatives. See Fisher Black & Myron S. Scholes, The Pricing of Options and Corporate Liabilities, 8 J. POL. ECON. (1973) (first describing equity as a call option). 2000] SYNTHETIC COMMON LAW 51 contracts, the primary difference being that options are “rights,” whereas forwards also include “obligations.”223 For example, a call option is the right to buy some underlying instrument at a specified time and price.224 An investor might purchase a call option on IBM stock with an exercise price of $100 and an exercise date of one year from today. Such an investor would have the right, but not the obligation, to buy IBM stock during the next year for $100. If the price of IBM increased, the value of the call option also would increase. If after one year, the price of IBM were below $100, the option would expire worthless. In contrast, a forward is the right and the obligation to buy or sell some underlying instrument at a specified time and price. A baker might buy a forward contract on a bushel of wheat with a forward price of $100 and a delivery date of one year from today. In this case, if the value of the wheat increased, the baker would make money on the forward contract, and these gains would offset the increase in the cost of the higher-priced wheat. Conversely, if the value of the wheat decreased, the baker would lose money on the forward contract, but these losses would be offset by gains associated with buying lower- priced wheat. There are additional complexities to derivatives.225 The purchaser of the call option in the previous example could purchase the option either through an exchange or from another private party.226 Similarly, the baker could purchase a forward contract either though an exchange (in which case it would be called a future) or from another private party. In addition, the simple examples of options and forwards can be combined in all sorts of complicated and fantastic ways.227 Many derivatives are off-balance sheet, and thus escape scrutiny.228 223 See Frank Partnoy, Adding Derivatives to the Corporate Law Mix, 34 GA. L. REV. # (2000). 224 Whereas a call option is the right to buy, a put option is the right to sell. For a detailed and colorful description of the various option payouts, including diagrams, see Peter H. Huang, Teaching Corporate Law from an Options Perspective, 34 GA. L. REV. 571 (2000). 225 The existence of derivatives means that traditional financial market labels – such as “equity” and “debt” – are now meaningless. For example, suppose a particular legal rule applies only to the “equity” of a firm. Examples include the duties of care and loyalty, which the managers of a firm generally owe to the firm’s shareholders (e.g., equity), but not to the firm’s other stakeholders (e.g., debt). However, what constitutes “equity” may vary from firm to firm in ways that make the legal rules inconsistent. See Partnoy, Corporate Law Mix, supra note 223, at #. 226 The private transaction is classified as over-the-counter (OTC). 227 For examples of exotic derivatives, and the complexities of the valuation issues associated with them, see PAUL WILMOTT, FINANCIAL DERIVATIVES 34-41 (2000). Even complex combinations of options and forwards may not create “complete” markets. See Peter H. Huang, A Normative Analysis of New Financially Engineered Derivatives, 73 S. CAL. L. REV. 471, 498-500 (2000). More complex derivatives generally are more profitable for the derivatives dealers who sell them. See, e.g., STEINHERR, supra note 5, at 160 (“More complicated products are more profitable and therefore more attractive to dealers.”). Financier George Soros has expressed unease about the dangers in complex aspects of the derivatives market: “The explosive growth in derivative instruments holds other dangers. There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated of investors. Some of these instruments appear to be specifically designed to enable institutional investors to take gambles which they would 52 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# In the option example, the investor was using derivatives to speculate on the price of IBM stock. In the forward example, the baker was using derivatives to hedge the risk of an increase in the cost of wheat. Speculating and hedging are two of the primary uses of derivatives.229 A third use of derivatives – arbitrage, including regulatory arbitrage – presents additional difficulties. True arbitrage is the simultaneous, riskless purchase and sale of economically equivalent instruments for profit. True arbitrage rarely exists, but derivatives frequently are used to make arbitrage-like bets that economically similar instruments will converge in price. These bets are variously known as risk arbitrage, convergence trades, or relative value trades. A particular type of arbitrage, regulatory arbitrage, involves the use of derivatives to avoid costly regulation. Regulatory arbitrage involves purchases and sales of financial instruments designed to capture the difference in regulatory costs applicable to two economically equivalent assets.230 Private parties often use derivatives for regulatory arbitrage, a fact that makes the job of defining derivatives more difficult, especially for regulators, because to the extent a regulatory cost is imposed on a class of instruments, there is an incentive for market participants to create economically equivalent derivative assets that avoid the regulatory cost. Disputes in the financial market have involved all three uses of derivatives. The disputes have occurred in waves, typically after some major economic dislocation (e.g., an increase in interest rates or dramatic change in foreign exchange rates) causes market participants to sustain losses large enough to lead them to sue. Not all derivatives losses are relevant here. 231 An early round of derivatives losses, which led to the first major wave of derivatives cases, followed soon after when the Federal Reserve increased interest rates six times in early 1994.232 Another wave followed the Asia crisis of 1997, when several Asian currency collapsed.233 otherwise not be permitted to take. . . . And some other instruments offer exceptional returns because they carry the seeds of a total wipeout.” GEORGE SOROS, SOROS ON SOROS 313 (1995). 228 See STEINHERR, supra note 5, at 159 (describing off-balance sheet treatment and noting that for major commercial banks, including Chase Manhattan and Morgan Guaranty, the notional value of off-balance sheet derivatives represents 40 to 50 times the value of their balance sheet assets). 229 See, e.g., Kimberly D. Krawiec, Derivatives, Corporate Hedging, and Shareholder Wealth: Modigliani-Miller Forty Years Later, 1998 U. ILL. L. REV. 1039 (1998) (hedging); Lynn A. Stout, Betting the Bank: How Derivatives Trading Under Conditions of Uncertainty Can Increase Risks and Erode Returns in Financial Markets, 21 J. CORP. L. 53 (1995) (speculating). 230 See generally Partnoy, Regulatory Arbitrage, supra note 5. For example, a simple regulatory arbitrage transaction would be buying an untaxed asset and selling an economically equivalent taxed asset. 231 For example, although one publicized case, involving billion-dollar losses by Nicholas Leeson of Barings Bank, has raised numerous regulatory and policy issues about derivatives, but because the Barings losses did not involve a dispute between the purchaser and seller of the financial contracts, the Barings losses are not relevant here. It is worth noting, however, that in December 1995 a Singapore court sentenced Nick Leeson to six and a half years in prison, for fraud and for falsifying certain reports sent to SIMEX, the relevant exchange in Singapore. See Bennett & Marin, supra note 305, at 5. 232 These increases followed an extended period during which short-term U.S. interest rates had remained very low. During that period, many market participants 2000] SYNTHETIC COMMON LAW 53 Before 1994, numerous companies throughout the world had purchased derivatives contracts, including swap transactions, that essentially were bets that short-term rates would remain low. There were numerous ways to place this bet using derivatives. The most straightforward way would have been either to enter into a simple interest rate option or forward contract,234 betting that rates would not increase. Another would have been to enter into a simple U.S. dollar interest rate swap, pursuant to which the company would agree to pay a short-term floating interest rate and to receive a fixed interest rate, each as a percentage of some fixed, notional amount. For example, if in 1993 Procter & Gamble had believed interest rates would remain low (or if it had wanted to convert fixed rate liabilities into floating rate liabilities), it could have entered into an interest rate swap transaction with Bankers Trust, agreeing to pay every three months a short-term floating interest rate (e.g., LIBOR, the London Inter-Bank Offered Rate) times $100 million and to receive, say, 5 percent times $100 million, or $5 million. Then, if interest rates remained low, P&G would make money every quarter on its swap; if interest rates increased, it might lose money. Such swaps, known as “plain vanilla” interest rate swaps are very common, are relatively low risk, and are transacted in a competitive, transparent market. Unfortunately for the banks brokering such swaps, the large size and competitive nature of that market means that such swaps are a relatively unattractive low-margin business. The greatest growth in derivatives has been in swaps and other OTC derivatives, where “plain vanilla” trades have become less profitable in recent years.235 However, derivatives disputes, especially those involving large well-publicized losses, typically do not involve these simple financial contracts. Instead, they more often involve more complex swaps and structured transactions, which are neither liquid nor transparent, and which generate very large profits for dealers. In sum, although derivatives are difficult to categorize, derivatives disputes typically have involved transactions that were both more complex on average for the purchaser and more profitable on average to the seller. Frequently, these transactions were composed of several, simpler parts, which could have been sold separately in a small number of more straightforward transactions. “Plain vanilla” transactions are rarely disputed. B. A Critique of the Four Approaches Thus far, I have described only the economic complexities of financial derivatives, without mentioning the applicable regulatory made short-sighted bets that these rates would remain low, based on historical performance. 233 These collapses followed an extended period during which Asian foreign exchange rates were very stable. During that period, many market participants made short-sighted bets that these rates would remain stable, based on historical performance. 234 Interest rate option and forward contracts are traded on exchanges, whereas many of the transactions underlying the derivatives disputes during this period were based on similar, over-the-counter transactions. 235 See STEINHERR, supra note 5, at 161 (noting increase in use of OTC derivatives by non-financial institutions from $7.5 trillion in 1995 to $11 trillion in 1998). 54 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# regimes. Unfortunately, those regimes do not track the economic attributes of derivatives, and often seriously contradict them.236 The result is that the derivatives market is fraught with uncertainty.237 Frank Knight has distinguished between risk (which has an observable probability distribution) and uncertainty (which does not).238 Markets deal well with risk, but not with uncertainty. Some investors (in some instances including sophisticated derivatives market participants) face uncertainty in valuing complex derivatives.239 Others understand derivatives well enough to evaluate their market risks, but face uncertainty in assessing other aspects of the transactions, including potential liability in a future dispute. Much of the uncertainty in derivatives market stems from regulation and the OTC markets are the least certain.240 Most jurisdictions permit OTC derivatives transactions, although some limit or prohibit them when retail investors or unsophisticated counterparties are involved.241 Not surprisingly, a recent survey of derivatives regulators concluded “there is little uniformity in regulatory approach to OTC derivatives.”242 This section assesses how the four regulatory alternatives have addressed derivatives disputes (or have failed to do so). Statutory coverage is piecemeal and byzantine, and has led market participants to opt out of the statutory framework when dealing in the OTC markets. The common law, then, has been left to resolve these disputes, and it has performed abysmally. Private law has worked to insulate market participants from regulatory coverage and, potentially, from liability in disputes, but has failed to clarify transaction terms relevant to disputes. Arbitration has played only a limited role, and has provided even less certainty. 1. Piecemeal Regulation of Derivatives by Statute The greatest source of uncertainty in the derivatives market is the complex web of statutory regimes that govern (or do not govern) derivatives purchases and sales. Derivatives are regulated by multiple 236 This regulatory tension creates additional incentives for regulatory arbitrage transactions. 237 See, e.g., Michael Schroeder, Lugar in Senate Charges CFTC, SEC Impede Bill to Deregulate Derivatives, WALL ST. J., June 22, 2000, at C26 (describing current legal and regulatory uncertainty and legislation proposed to reduce it); Kathleen Day, The Derivatives Dilemma; Oversight Dispute Leaves Contracts in Perilous Limbo, WASH. POST, June 2, 2000, at E1 (describing the legal status of derivatives as “murky”); see generally Thomas A. Russo & Marlisa Vinciguerra, Financial Innovation and Uncertain Regulation: Selected Issues Regarding New Product Development, 69 TEX. L. REV. 1431 (1991). 238 See FRANK H. KNIGHT, RISK, UNCERTAINTY AND PROFIT (1921). 239 See STEINHERR, supra note 5, at 191-92 (“There are significant difficulties in understanding, pricing and managing inherently complex derivative instruments, particularly longer-date instruments, for example currency options. The statistical and mathematical techniques that underlie pricing and trading strategies are based on the assumption that historical distributions of price changes are good guides to future volatility. Uncertainty about the value of derivative positions may lead to liquidation sales in declining markets.”). 240 In response to a recent survey, regulators in sixteen countries240 listed “the types of OTC derivatives transactions permitted” as the primary area of concern. See id. 241 See id 242 Id. 2000] SYNTHETIC COMMON LAW 55 laws under multiple regulatory jurisdictions.243 Many classes of derivatives are not regulated at all. Many pockets of the derivatives market exist precisely because of the range of nonsensical and costly statutory applications. This section is an attempt to explain some of the differential aspects of those statutory regimes. There are two primary244 sets of federal statutes and agencies regulating derivatives.245 First, the Securities and Exchange Commission (SEC) regulates “securities”246 (which include stocks, 243 See, e.g., HAMILTON, ET AL., A GUIDE TO FEDERAL DERIVATIVES REGULATION 9 (1998). 244 Not all derivatives disputes with federal statutory claims involve either of these two statutes (the securities and commodities statutes). Plaintiffs in recent derivatives disputes have alleged other novel theories, even including violations of the Racketeer Influenced and Corrupt Organizations Act (RICO), allegations that were made together with allegations of common law fraud. See Sumitomo Copper Swaps Complaint Seeks $1.5B from Chase Manhattan, DERIVATIVES LITIG. REPTR., Jan. 24, 2000, at 6 (noting the including of a RICO claim). One leading derivatives cases was decided under the Employee Retirement Income Security Act (ERISA). In that case, Laborers Nat’l Pension Fund v. American Nat’l Bank & Trust Co. of Chicago, 173 F.3d 313 (5th Cir.), cert. denied, 120 S. Ct. 406 (1999), the Fifth Circuit ruled that a pension fund’s investment in Interest Only (IO) strips did not violate the prudent investment standards contained in ERISA. See also Trying to Recoup Losses, Fund Fails to Win Sup. Ct. Review, SECURITIES LITIG. & REG. REPTR., Jan. 12, 2000, at 6. In that case, Laborers National Pension Fund (LNPF) lost $4.2 million on IOs it bought from American National Bank. LNPF sued in the Northern District of Texas, and the district court found the investments violated ERISA and awarded damages of $7.1 million. However, the Fifth Circuit reversed, holding that although IOs are volatile, they were only 6.5 percent of the fund’s portfolio and served to hedge other portions of the fund. See id. 245 Other federal agencies, including the Federal Reserve Board, also play a role in the regulation of derivatives. Most prominently, the Fed plays an active role in system-wide concerns about risk, as it did in the recent near-collapse of Long-Term Capital Management. See Peter H. Huang, Kimberly D. Krawiec & Frank Partnoy , Derivatives on TV: A Tale of Two Derivatives Debacles in Prime-Time, <http://www.greenbag.org> (2000) (copy on file with the author). The U.S. Department of Treasury also plays an important, although often informal, role. The “Treasury Amendment” – though not explicitly directed at the U.S. Treasury – expressly excludes certain financial instruments from the scope of federal commodities regulation. The Treasury Amendment provides that “[n]othing in this Act shall be deemed to govern or in any way be applicable to transactions in foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase options, government securities, or mortgages and mortgage purchase commitments, unless such transactions involve the sale thereof for future delivery conducted on a board of trade.” 7 U.S.C. § 2; see also 50 Fed. Reg. 42963 (Oct. 23, 1985) (CFTC interpretation of Treasury Amendment). The Treasury Amendment arguably exempts from regulation certain types of derivatives, including swaps. 246 There is substantial uncertainty surrounding the definition of “security.” The question of whether a particular financial contact is a “security” (and therefore falls within the ambit of federal securities law) typically turns on judicial interpretation of the relevant federal statutes. In the 1933 Securities Act, Congress defined the term “security” as any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or a certificate of 56 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# bonds, and options), pursuant to the 1993 Securities Act247 and 1934 Securities Exchange Act.248 Second, the Commodity Futures Trading Commission (CFTC) regulates “futures”249 (which include exchange- traded futures on various commodities, instruments, and indices),250 pursuant to the Commodity Exchange Act.251 Many of the conflicts in derivatives regulation stem from the turf battle between the SEC and CFTC created by these two statutory regimes.252 Such a bifurcated regime is in general problematic. It is increasingly difficult to determine whether, under the applicable tests, a particular instrument is a “security” or “future” or neither.253 Regulated derivatives may be economically equivalent, but fit under different statutory regimes.254 Competition between these two interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. 15 U.S.C. § 77b(1). The definition in the 1934 Securities Exchange Act is virtually identical to the definition in the 1933 Act and courts have held that the 1933 and 1934 Acts cover the same instruments. See 15 U.S.C. § 78c(a)(10); see also Reves v. Ernst & Young, 494 U.S. 56 (1989). 247 15 U.S.C. § 77. 248 15 U.S.C. § 78c. 249 An additional wrinkle is added by the fact that the CFTC also has exclusive jurisdiction over option transactions involving commodities. See 7 U.S.C. § 2(a)(1)(A) (granting the CFTC exclusive jurisdiction over “accounts, agreements (including any transaction which is of the character of . . . an ‘option’ . . .), and transactions involving contracts of sale of a commodity for future delivery traded or executed on a contract market . . . or any other board of trade, exchange, or market . . . .”). 250 Congress passed the Commodity Exchange Act, and amended it to establish the CFTC in 1974, in response to widespread abuses in commodity futures trading and to protect investors amid “the volatile and esoteric futures trading complex.” CFTC v. Schor, 478 U.S. 833, 836 (1986) (quoting H.R. Rep. No. 93-975, p. 1 (1974)). 251 7 U.S.C. §§ 2 et seq. 252 The lines between regulatory areas in the U.S. often are less than clear. For example, a “futures contract” may only be traded on a designated exchange, but a “forward contract” – even if it is economically equivalent – may be traded off- exchange, or over-the-counter (OTC). See Willa E. Gibson, Are Swap Transactions Securities or Futures?: The Inadequacies of Applying Traditional Regulatory Approach to OTC Derivatives Transactions, 24 J. CORP. L. 379 (1999). 253 Consider, for example, an unusual type of derivative instrument called a “viatical settlement.” The purchaser of a viatical settlement pays cash upfront for an interest in the life insurance policy of a terminally ill person, typically a victim of AIDS. The price of the viatical settlement is discounted depending on the life expectancy of the insured. When the insured dies, the investor receives a share of the insurance proceeds. The courts have struggled with the question of whether viatical settlements are “securities,” ultimately relying on the Howey test, which holds that an investment contract is a security if investors purchase with an expectation of profits arising from a common enterprise that depends upon the efforts of others. See SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946). In 1996, the D.C. Circuit held, over a vigorous dissent by Judge Wald, that viatical settlements were not securities, because although they are purchased with an expectation of profits arising from a common enterprise, those profits did not depend upon the “efforts of others,” because the intermediaries selling the contracts performed only ministerial services and, instead, it is the length of the insured’s life that is of overwhelming importance to the value of the viatical settlements. See SEC v. Life Partners, 87 F.3d 536, 542-48 (D.C. Cir. 1996). 254 Even relatively straightforward regulatory regimes present complex and intractable questions. For example, the task of matching purchase and sale transactions for the purpose of calculating liability under Section 16(b) of the Securities Exchange Act, 15 U.S.C. § 78p(b), becomes enormously complicated once 2000] SYNTHETIC COMMON LAW 57 regimes has not led to the efficiencies predicted by scholars who advocate expanded regulatory competition.255 To the contrary, competition has led to a nasty and inefficient turf battle, and costly uncertainty. Consider, for example, the regulation of forward contracts on individual stocks or bonds. The SEC and CFTC have disagreed about this issue for decades. The SEC claimed it should have jurisdiction because such contracts behave like the underlying individual stocks and bonds; the CFTC claimed it should have jurisdiction because such contracts behave like futures.256 For such contracts, it was unclear which regulatory regime applied, if any, and competition between the two relevant jurisdictions had only increased uncertainty and paralyzed the markets for those instruments.257 In fact, the only resolution to the dispute was a Congressional ban on futures contracts on individual stocks and bonds; now, such contracts are illegal and unenforceable.258 In other words, options on single securities are allowed; futures on single securities are not.259 Recent efforts to remove the ban have provoked heated debate.260 In this area, regulatory competition did not lead to efficient results; it forced a stalemate. Over time, exceptions have been carved out of this ban against futures trading of individual stocks and bonds. There are exceptions for futures on government securities, including U.S. Treasury bonds, and for futures on broad-based equity indices, including the Standard & Poor’s 500 Index.261 Other “illegal” futures still can be, and are, traded in the OTC market.262 In other words, regulation banning the trading of these instruments has created a gray market in economically equivalent OTC derivatives transactions. This gray market is not trivial. By 2000, the market for equity swaps was several trillion dollars.263 derivatives are added to the mix. See Magma Power Co. v. Dow Chemical Co., 136 F.3d 316 (2d Cir. 1998) (finding that Dow Chemical’s delivery of Magma Power stock was not eligible for 16(b) purposes where the stock was delivered pursuant to the exercise of subordinated exchangeable notes Dow Chemical previously had issued; the notes gave the noteholder the option to exchange the notes at any time prior to maturity for a fixed number of Magma Power Co. shares). 255 See supra notes 35-36. 256 See, e.g., Day, supra note 237, at E1 (describing turf battle between the SEC and CFTC since 1982). 257 See Day, supra note 237, at E1 258 Section 4(a) of the Commodity Exchange Act provides that it is unlawful to enter into a commodity futures contract that is not made “on or subject to the rules of a board of trade which has been designated by the Commission as a ‘contract market’ for such commodity.” 7 U.S.C. § 6(a). 259 See Board of Trade of the City of Chicago v. SEC, 187 F.3d 713, 716 (7th Cir. 1999) (noting that “[t]his allocation appears to be a political compromise; no one has suggested an economic rationale for the distinction.”). 260 See SEC’s Levitt Sees “Gaping Loophole” in Senate Bill 2697, 6 DERIVATIVES LITIG. REPTR., July 3, 2000, at 9. 261 See Day, supra note 237, at E1. 262 The creation of such instruments is another example of regulatory arbitrage. See Partnoy, Regulatory Arbitrage, supra note 5. 263 In an equity swap, one counterparty agrees to receive (and the other agrees to pay) the increase in value of a particular stock or stocks and, in exchange, that counterparty agrees to pay (and the other agrees to receive) a specific periodic payment, typically based on some fixed or floating interest rate. 58 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# In the same way, market participants created large classes of OTC derivatives to fill gaps in other CFTC regulation. The CFTC requires that any CFTC-regulated financial contracts be traded on a CFTC- regulated exchange,264 and Congress allows the CFTC to create a list of forward contracts that could be excluded entirely from CFTC regulation (and that therefore were not required to be traded on a CFTC-regulated exchange). Today, such forward contracts are traded in the OTC market, and include some of the largest markets in the world, including the market for interest rate and currency swaps. Derivatives traded in these OTC markets remain legal so long as the CFTC keeps those trades on its list of exempt contracts. However, there is the possibility, albeit unlikely, that the CFTC would remove one or more contracts from its list. If it did so, such contracts would become illegal and unenforceable, because they would not be traded on a CFTC-regulated exchange.265 This remote possibility has contributed to the uncertainty among derivatives market participants. The statutory uncertainty of OTC derivatives regulation has a complex history. During the 1980s, as derivatives were developing,266 regulators struggled with possible responses to the differential jurisdictional treatment of derivatives.267 In 1984, the CFTC and the SEC issued a Joint Policy Statement spelling out the types of financial derivatives the agencies believed were suitable for trading.268 Following that statement, the CFTC issued several releases addressing the issue, and responded on a case-by-case basis to inquiries about regulation of particular instruments through its no-action letter process.269 The primary focus of the releases and responses was on the market for swaps,270 which had been growing dramatically in the 264 See 7 U.S.C. § 6(a), 6c(b), 6c(c). 265 In the example of equity swaps, which were created to sidestep the ban of forward contracts on individual stocks and bonds, the legal uncertainty is especially great. See, e.g., Day, supra note 237, at E1 (“If equity swaps were deemed by a court to be futures contracts, they would become instantly illegal, on or off a regulated exchange, because of the ban on futures contracts based on individual corporate securities.”). 266 Even by 1989, there was a mere $7.1 trillion worth of outstanding notional amount of derivative financial instruments. JAMES HAMILTON, ET AL., supra note 243, at 9. By June 1999, the estimated global notional amount was $81.5 trillion. See Bank for International Settlements Releases Global Derivatives Statistics, DERIVATIVES LITIG. REPTR., Dec. 20, 1999, at 6. 267 Courts struggled, too. For example, in 1984, the Seventh Circuit held that a forward contract to purchase a Government National Mortgage Associate security was properly regulated by the antifraud provisions of the securities laws, even though the forward contract itself is not a security as defined by the securities laws. See Abrams v. Oppenheimer Gov’t Securities, Inc., 737 F.2d 582 (7th Cir. 1984). 268 See Joint Policy Statement, 49 Fed. Reg. 2884 (Jan. 24, 1984). Although this statement was simply a statement, not a regulation, and therefore lacked legal force, market participants observed its limits for many years when proposing new contracts. See Board of Trade, supra note 259, at 716. 269 See CFTC Policy Statement Concerning Swap Transactions, 54 Fed. Reg. 30694, at 2 n.2 (July 21, 1989) (describing relevant proposed rules, requests for comments, and notices of proposed rulemaking from 1985 through 1989); see also id. at 2 n.3 (describing several no-action letters addressing proposed offerings of derivative transactions by the CFTC Task Force on Off-Exchange Instruments). 270 A swap is simply a contract pursuant to which two counterparties agree to exchange cash flows. In an interest rate swap, the counterparties exchange cash flows based on changes in some interest rate or interest rate index; in a currency swap, they exchange cash flows based on changes in some foreign exchange rate or index. 2000] SYNTHETIC COMMON LAW 59 late 1980s. In response to a perceived need for clarification, the CFTC issued a detailed policy statement on swaps on July 21, 1989.271 The 1989 CFTC policy statement took the position that most swap transactions were not appropriately regulated by the CFTC and recognized a “non-exclusive safe harbor for transactions satisfying the requirements set forth herein.”272 The CFTC relied on multiple rationales for exempting swaps from regulation,273 but recognized the argument that swaps are economically equivalent to futures.274 The CFTC policy statement listed five specific criteria relevant to determining whether the safe harbor applied. The CFTC’s stated objective in issuing the policy statement was to generate “a greater degree of clarity”275 for swap market participants. These criteria – (1) (1) individually tailored terms, (2) absence of exchange-style offset, (3) absence of clearing organization or margin system, (4) the transaction is undertaken in conjunction with a line of business, and (5) prohibition against marketing to the public276 – are examined in detail below. From 1989 until early 1993, the derivatives industry lobbied the CFTC to adopt regulations embodying the principles and objectives in the 1989 policy statement.277 At the eleventh hour, one-week before the end of her term, CFTC Chair Wendy Gramm – wife of Senator Phil Gramm – finally persuaded the CFTC to adopt the exemption (in what was described as Gramm’s “farewell gift” to the swaps industry278) in 17 C.F.R. § 35, known as Part 35. Part 35 is a framework for exempting particular OTC swaps from the CEA’s exchange trading requirements. Part 35 exempts swaps that meet particular categories279 and authorizes the CFTC to grant additional exemptions on a case-by-case basis.280 271 See id. at 1. 272 See CFTC Policy Statement, supra note 269, at 4. 273 “Commentators have described the swap market as one in which the customary large transaction size effectively limits the market to institutional participants rather than the retail public. Market participants also have noted that swaps typically involve long-term contracts, with maturities ranging up to twelve years. In addition to these characteristics, many comparisons between swaps and futures contracts have stressed the tailored, non-standardized nature of swap terms; the necessity for particularized credit determinations in connection with each swap transaction (or series of transactions between the same counterparties); the lack of public participation in the swap markets; and the predominantly institutional and commercial nature of swap participants.” Id. at 5 (citations omitted). 274 “Other commentators have stressed that despite these distinctions in the manner of trading of swaps and exchange products, the economic reality of swaps nevertheless resembles that of futures contracts.” Id. at 5. Economically, swaps can be described as a series of forward contracts. 275 See CFTC Policy Statement, supra note 269, at 7. 276 Id. at 7-10. 277 See Matt Rees, Swap Market: Farewell Gift from CFTC’s Gramm for Swap Traders, BLOOMBERG BUSINESS NEWS, Jan. 14, 1993, at 1 (copy on file with the author). 278 See id. 279 These categories include minimum financial thresholds for various institutions. See 17 C.F.R. § 35.1(b)(2). 280 See 17 C.F.R. § 35.2(d). 60 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# Part 35 does not provide nearly the certainty it could.281 Part 35.1(b)(1) explicitly exempts certain swap agreements, including any agreement which is “a rate swap agreement, basis swap, forward rate agreement, commodity swap, interest rate option, forward foreign exchange agreement, rate cap agreement, rate floor agreement, rate collar agreement, currency swap agreement, cross-currency rate swap agreement, currency option, any other similar agreement (including any option to enter into any of the foregoing) . . . [or] Any combination of the foregoing .”282 However, these particular terms are not defined, and it is unclear what tests should be applied to determine if a particular instruments fits within the list. Part 35.1(b)(2) limits eligible swap participants to (1) financial institutions, including banks, trust companies, savings associations, credit unions, insurance companies, investment companies, commodity pools, broker-dealers, and futures commission merchants (including floor brokers or floor traders);283 (2) large corporations, including business entities with total assets of $10 million, or a net worth of $1 million if it is entering into the swap in connection with its business or if the swap obligations are secured;284 (3) employee benefit plans, including both certain employee benefit plans subject to the Employee Retirement Income Security Act of 1974 and certain foreign persons performing similar functions;285 and (4) governmental entities, including the United States, states, foreign governments, multinational entities, and their political subdivisions.286 These provisions are clear, but static, and are neither indexed to inflation nor flexible enough to allow additions or subtractions from the list based on changes over time. In the seven years since Part 35 was enacted, it has not changed at all; during the same time, the derivatives industry has experienced revolutionary change. Although derivatives industry participants have relied on the safe harbor of the CFTC policy statement since 1989, and Part 35 since 1993, they do not appear to have considered in detail the application of the factors in either case. Indeed, because Part 35 is ambiguous in several respects,287 it is useful to consider the factors in the 1989 CFTC policy statement in greater detail. For many swaps at least one of the criteria – often several – are not satisfied. Moreover, the 1989 CFTC policy statement is a very useful statement of the intended coverage of any swaps exemption; to the extent the regulatory exemption as implemented has exceeded the scope of this coverage (and perhaps of its own language), this expansion may need to be reconsidered. The 1989 criteria are now among the most important, yet least discussed, aspects of U.S. derivatives regulation. Legal 281 See Rees, supra note 277, at 2 (quoting a prominent derivatives attorney as saying “it’s not a completely clean exemption”). 282 17 C.F.R. Part 35.1(b)(1)(i), (ii). 283 See 17 C.F.R. Part 35.1(b)(2)(i)- (v), (ix), (x). 284 See 17 C.F.R. Part 35.1(b)(2)(vi). 285 See 17 C.F.R. Part 35.1(b)(2)(vii). 286 See 17 C.F.R. Part 35.1(b)(2)(viii). 287 For example, Part 35 does not include as exempt any swaps that are part of a “fungible class of agreements that are standardized as to their material economic terms.” 17 C.F.R. § 35.2(b) (1993). This language, while ambiguous, draws heavily from all five criteria in the 1989 CFTC policy statement. See CFTC Policy Statement, supra note 269, at 1-10. 2000] SYNTHETIC COMMON LAW 61 commentators have largely ignored them. Therefore, it is worth considering these criteria in greater detail. The first criterion is individually tailored terms, which relatively few swaps have. The CFTC stated, “[s]uch tailoring and counterparty credit assessment distinguish swap transactions from exchange transactions, where the contract terms are standardized and the counterparty is unknown.”288 The assumption that swaps were individually tailored may have been true in 1989; it certainly no longer holds today. Most swap agreements are fully standardized. The International Swap Dealers Association (ISDA) has established a detailed standardized contract that is used for the vast majority of swap contracts. Interest rate swaps and currency swaps in particular are highly standardized. In the 1989 policy statement, the CFTC recognized that swap counterparties entering into several swap transactions might find it beneficial to enter into a “master agreement” covering all of the transactions, although it warned that it nevertheless required that “material terms of the master agreement and transaction specifications are individually tailored by the parties.”289 The market has moved away from the CFTC’s expressed understanding in 1989. According to the CFTC, “[t]o qualify for safe harbor treatment, swaps must be negotiated by the parties as to their material terms, based upon individualized credit determinations, and documented by the parties in an agreement or series of agreements that is not fully standardized.”290 By this standard, many swaps – including many disputed swaps – would not qualify. Second, in order to qualify for a safe harbor, the CFTC required that a swap not have an “exchange-style offset.” This term refers to the ability of a party to liquidate a futures position by acquiring an opposite, or off-setting, position.291 For exchange traded futures, because the counterparty to any trade is the exchange and there is a single clearing organization for any trade, there is no need to obtain the consent of the clearing organization in order to offset futures transactions. The CFTC seemed to believe in 1989 that there was a substantive difference between futures and swap transactions because the counterparty to a swap is another party whose consent was required in order to offset the swap.292 The purpose of this requirement, as articulated by the CFTC, was to exempt only transactions that “are not readily used as trading vehicles, that are entered into with the expectation of performance and that are terminated as well as entered into based upon private negotiation.”293 This is a distinction without a difference. Parties enter into offsetting swaps quite commonly. Counterparties routinely net swaps, and it may be possible – though frequently it is very costly – to find several counterparties (other than the original counterparty to a swap) to enter into a mirror to the original swap. Legal rules, including tax and net capital requirements, explicitly recognize netting, and private parties net swaps in assessing credit exposure to various counterparties. Moreover, some swaps are quite liquid and 288 Id. at 7. 289 Id. at 7. 290 Id. at 7. 291 Id. at 8. 292 Id. at 8. 293 Id. at 9. 62 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# fungible and are traded using broker screens in a way that is virtually indistinguishable from exchange trades. There have been proposals to trade swaps on exchanges, and one commentator believes exchange trading is a natural solution to some of the problems posed by OTC derivatives.294 At least one website has proposed acting as an intermediary for swap transactions.295 Thus, since 1989, the swaps market has changed in ways that conflict with the CFTC’s understanding of this second criterion. The third safe harbor criterion is that swaps should not have a clearing organization or margin system. The CFTC clearly did not intend to exempt swaps for which there was a clearing organization or some similar system used to minimize credit risk. According to the CFTC, “this safe harbor is applicable only to swap transactions that are not supported by the credit of a clearing organization and that are not primarily or routinely supported by a mark-to-market margin and variation settlement system designed to eliminate individualized credit risk.”296 As noted above, private parties act in ways (e.g., netting) that make the swaps market very similar in economic substance to the futures market. Banks use daily mark-to-market, and often monitor positions more frequently. There are a few banks with large numbers of counterparties that are at least as sophisticated as the futures exchanges in reducing credit risk. There are various risk management systems available, including well known approaches such as CreditMetrics and Value-at-Risk. There even have been efforts to securitize or insure derivatives exposure, to offload credit risk.297 In short, the swaps market has developed private risk management systems that resemble the credit, clearing, and margin systems of exchange markets. Fourth, to qualify for the safe harbor, swap transactions should be undertaken in conjunction with a line of business. It is unclear how far the CFTC originally envisioned the “line of business” test would extend, but it noted that “[s]wap transactions entered into with respect to exchange rate, interest rate, or other price exposure arising from a participant’s line of business or the financing of its business would be consistent with this standard.”298 This statement appears to draw a distinction between dealer transactions and transactions by non-dealer or non-financial parties. Transactions between banks in the OTC market – the vast majority of OTC derivatives – may be related to “line of business” exposure, although frequently they will involve speculation or arbitrage instead. But more importantly, transactions involving non-bank parties, 294 See STEINHERR, supra note 5, at xiv. 295 See http://www.MyCFO.com. 296 See CFTC Policy Statement, supra note 269, at 9. 297 For example, the London Clearing House, the clearing house for London’s main derivatives exchanges, bought from a subsidiary of American International Group ￡150 million in credit insurance. See Sophie Belcher, London Clearing House Buys GBP100 Million in Credit Protection, DERIVATIVES WK., Feb. 10, 1997, at 1, 11. This insurance protects the clearing house from credit losses of more than this amount during a three-year period. Other exchanges have purchased similar forms of default insurance. 298 See CFTC Policy Statement, supra note 269, at 9. 2000] SYNTHETIC COMMON LAW 63 which are more frequently disputed than bank-to-bank transactions, often will not relate to a line of business at all.299 Fifth, swap transactions may not be marketed to the public.300 This criteria merits only a short paragraph in the CFTC policy statement, although that paragraph makes it clear that the CFTC assumed swaps would not be part of a banks’ core sales function. This assumption also proved incorrect. Swaps dealers aggressively market their transactions to clients outside the financial sector, and the greatest profits from swaps involve sales to public investors (individuals and institutions) who may lack the sophistication and information necessary to evaluate the transactions. This movement away from the CFTC’s original understanding of swaps generates great uncertainty about the regulation of OTC derivatives. Obviously, swap dealers understand the implications of this uncertainty, and therefore are lobbying for clearer exemptions.301 Regulators have resisted this lobbying, in part because they understand OTC dealers lobbied previously for the 1993 exemptions in Part 35, and then expanded it to support a multi-trillion dollar unregulated industry. For all these reasons, the legal rights of the parties to any dispute stemming from losses on OTC derivatives are mired in uncertainty. As of August 2000,302 both industry executives and federal regulators were publicly expressing concern that a counterparty might walk away from its obligations under an OTC derivatives contract, and successfully argue that the contract was illegal and therefore unenforceable.303 In late 1998, such uncertainty had generated fear among regulators that the collapse of Long-Term Capital Management, which had relied heavily on OTC derivatives contracts, would cause securities markets to unravel.304 More recently, this uncertainty has stifled innovation and contracting in the derivatives markets. In a recent article, Michael Bennett and Michael Marlin argue that the regulators use legal uncertainty and ambiguity to enhance and maintain their control over derivatives market participants.305 Regulators in Asia often overlook or ignore questionable market 299 Consider, for example, the payments Gibson Greetings was to owe on a swap transaction it entered into with Bankers Trust in October 1992: Gibson’s payments would equal 5.5 percent minus LIBOR-squared divided by 6 percent. This swap, known as a “ratio swap,” could not possibly be related to any Gibson line of business. Arguably, a swap with a squared term cannot be related to any entity’s line of business, at least on this planet. The CFTC policy statement should not cover transactions like ratio swaps, which are unrelated to a line of business. 300 See CFTC Policy Statement, supra note 269, at 10. 301 See sources cited supra at note 237. 302 Congress was required to reauthorize the CFTC by end of September 2000. 303 See, e.g., Day, supra note 237, at E1 (“The legal status of OTC derivatives is murky. The enforceability of these contracts has never been tested in court. Regulators and industry executives hope it stays that way until Congress clears up the laws governing these complex, increasingly essential financial products.”). 304 See Day, supra note 237, at E1. 305 See Michael S. Bennett & Michael J. Marin, The Casablanca Paradigm: Regulatory Risk in the Asian Financial Derivatives Markets, 5 STAN. J.L. BUS. & FIN. 1, 9 (1999) (describing the regulatory model for such legal uncertainty as the “Casablanca Paradigm,” named for the 1942 Warner Bros. movie). 64 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# practices until political pressures force them to act.306 This approach creates uncertainty for market participants, “because it limits the importance of regulatory precedent.”307 In Asia, regulators provide guidance to market participants on an informal basis, through the administrative approach known as gyousei shidou, creating burdens for firms that do not comply with the regulators, and awarding benefits to firms that do.308 This informal process has benefits. However, market participants do not have advance warning of a change in position. If the market participants have a close relationship with the regulators, it may lead to greater flexibility and perhaps greater certainty in the short term. It is difficult to obtain reliable information about derivatives losses, so it is difficult to say how such losses result in disputes.309 The regulators’ positions with respect to statutory coverage of derivatives are in constant flux. In derivatives markets outside the U.S., there is even greater uncertainty, because market participants believe regulators might change their approach to derivatives at any time.310 But even in the U.S., there is no consistent regulatory position. For example, on November 9, 1999, the President’s Working Group on Financial Markets311 issued a report recommending additional deregulation and exemptions for OTC derivatives.312 At approximately the same time, two members of Congress cosponsored a bill making equity swaps – a commonly-used type of OTC derivative – subject to regulation.313 A recent proposal to allow trading of futures or swaps on individual securities faces intense opposition.314 As of September 2000, bills were pending in both the Senate and House of Representatives to reauthorize and 306 See CHARLES ADAMS ET AL., INTERNATIONAL MONETARY FUND, INTERNATIONAL CAPITAL MARKETS (1998); Antony Currie, Asian Derivatives: Waiting for the Big One, EUROMONEY, Feb. 1997. 307 Bennett & Marin, supra note 305, at 10. 308 See Curtis J. Milhaupt, Managing the Market: The Ministry of Finance and Securities Regulation in Japan, 30 STAN. J. INT’L L. 423 (1994); see also Bennett & Marin, supra note 305, at 11 n.43 (citing numerous sources). 309 See Robert W. McSherry, Experts Worry Over the Potential for Derivatives Defaults by Asian Companies, DERIVATIVES LITIG. REPTR., Feb. 5, 1998, at 3 (“Insider reports, however, are hard to verify because of a culture of reticence that permeates the derivatives business.”). 310 “The fact that regulators have tolerated a practice in the past does not necessarily mean that the practice will continue to be tolerated in the future or that market participants will be given any warning before the regulators change their position.” Bennett & Marin, supra note 305, at 11. 311 The President’s Working Group on Financial Markets consists of the Secretary of the Treasury, and the chairpersons of the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Federal Reserve Board. See Conrad G. Bahlke, A Brief Review of the President’s Working Group Issues Report on OTC Derivatives, SECURITIES LITIG. & REG. REPTR., Dec. 22, 1999, at 10. 312 The President’s Working Group Report warned that the uncertain status of some derivatives could, if not addressed, discourage innovation and growth in derivatives markets, and recommended, among other things, an exclusion from the Commodity Exchange Act for sophisticated counterparties to OTC transactions. See id. 313 In early November 1999, Rep. Edward J. Markey and Senator Byron L. Dorgan cosponsored the Derivatives Market Reform Act, which would have made equity swaps subject to regulation under the Securities Exchange Act. See Bahlke, supra note 311, at 10. 314 See Senate Bill 2697, supra note 260, at 9. 2000] SYNTHETIC COMMON LAW 65 amend the Commodity Exchange Act; included in the bills are provisions exempting numerous additional derivatives transactions and entities from federal regulation.315 Finally, the statutory uncertainty about derivatives is not limited to federal laws. Certain state laws, too, have generated uncertainty. In particular, there is uncertainty surrounding state laws prohibiting certain forms of gambling. There are such statutes in most U.S. states316 and foreign jurisdictions,317 and although there are few, if any, recent cases decided under those statutes, their language is broad enough to encompass literally billions of dollars of derivatives transactions.318 Not surprisingly, derivatives purchasers have seized on this broad language, claiming that the applicable transactions were illegal under the anti-gambling laws of various jurisdictions.319 To the extent particular OTC derivatives are not covered by the swaps exemption, this argument is a serious one. Several legal scholars have argued that many financial derivatives can be considered as gambling, and that the line between legitimate transactions and gambling is less than clear.320 New rules promulgated 315 See 106 S. 2697 (2000); 106 H.R. 4541 (2000). 316 For example, under New York law a transaction is illegal gambling if it is a “wager, bet or stake made to depend upon . . . any . . . chance, casualty or unknown or contingent event or whatever.” N.Y. Gen. Obl. Law § 5-401 (McKinney 1989). Similarly, New York’s criminal states that “[a] person engages in gambling when he stakes or risks something of value upon . . . a future contingent event not under his control or influence, upon an agreement or understanding that he will receive something of value in the even of a certain outcome.” N.Y. Penal Law § 225.00 (McKinney 1989). 317 For example, most Asian countries have anti-gambling statutes. In Asia, a cash settled transaction (as opposed to a physically settled transaction) is more likely to be deemed an illegal gambling contract. For example, courts in Taiwan have found cash settled derivatives transactions constitute gambling. See Bennett & Marin, supra note 305, at 41 (basing such a conclusion on advice received from the Taipei law firm of Lee and Li), and under the Philippine Civil Code cash-settled over- the-counter equity option and forward contracts are likely to be held null and void as illegal gaming contracts. See id. (basing such a conclusion on advice received from the Manila law firm of SyCip, Salazar, Hernandez & Gatmaitan). In a cash settled transaction, the underlying asset never changes hands; the parties simply exchange cash at the end of the contract. For example, if a party contracts to buy gold on a forward basis, at the expiration of a physically settled contract, she would pay cash and receive the gold; at the expiration of a cash settled contract, she would pay or receive the difference between the value of the gold and the value of the cash. See ZVI BODIE & ROBERT C. MERTON, FINANCE 366-68 (2000). Cash settled transactions are less costly and more convenient, especially for parties who do not actually require delivery of physical assets. 318 Many such statutes are both vague and broad, especially outside the U.S. For example, the Indonesian Civil Code provides simply that all claims arising from games or betting are unenforceable; Hong Kong’s Gambling Ordinance prohibits gaming, betting, and bookmaking, and defines gaming as the playing of any game for winnings in money or other property. See Bennett & Marin, supra note 305, at 39-40; see also Gilliam Tett, Traders Gamble on an Anomaly, FIN. TIMES, July 17, 1988, at 6 (discussing applicability of Japanese anti-gambling laws to financial derivatives). 319 See Korea Life Files 2nd Amended Complaint Against Morgan Guaranty, 6 DERIVATIVES LITIG. REPTR. 3 (noting claims raised under New York gambling statute). 320 See Thomas Lee Hazen, Public Policy: Rational Investments, Speculation or Gambling? – Derivative Securities and Financial Futures and Their Effect on Underlying Capital Markets, 86 NW. U. L. REV. 987 (1992); Lynn Stout, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48 DUKE L.J. 701 (1999). Legislators also have made this point. See 66 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# by the Financial Accounting Standards Board attempt to draw the line between hedging and speculation in the derivatives context, with results that are both complex and often counterintuitive.321 Many recently issued securities easily could be categorized as illegal gambling contracts including, for example, a bond linked to the number of victories by the Utah Jazz, a professional basketball team;322 a derivative security based on an interest rate index multiplied by itself three times;323 or so-called Asian options, whose payoff can depend on a continuously-sampled geometric average.324 Several states also have so-called “bucket shop” laws,325 which present a similar problem to those posed by the anti-gambling statutes. “Bucket shop” laws prohibit wagering on changes in the market prices of securities by means of “fictitious transactions in such securities.”326 One court has held that an interest rate swap was not subject to California’s bucket shop law.327 However, it is questionable whether the analysis in that case would prevent most derivatives from falling under the law.328 In sum, statutes regulating derivatives are all over the financial map. They provide little clarity or certainty to market participants, who have attempted to opt out of these statutes by structuring transactions outside their reach. For parties involved in derivatives disputes, it is unclear if the statutes apply at all. 2. Judicial Treatment of Derivatives Disputes I began Part IV.B. with a discussion of the statutory coverage of derivatives in order to demonstrate upfront how difficult it is to determine whether a particular derivative is a regulated security, a STEINHERR, supra note 5, at 151 (citing Rep. Henry Gonzalez as saying, “You can call it [the use of derivatives] whatever you want, but in my book it’s gambling.”). 321 See FINANCIAL ACCOUNTING STANDARDS BOARD STATEMENT OF FINANCIAL CONCEPTS NO. 113; see also Michael S. Lesak, FASB’s Folly: A Look at the Misguided New Rules on Derivatives Valuation and Disclosure, 29 LOY. U. CHI. L.J. 649 (1998). 322 See JOHN EATABLE & LANCE TAYLOR, GLOBAL FINANCE AT RISK: THE CASE FOR INTERNATIONAL REGULATION 101 (2000). I am grateful to Peter Huang for pointing out this example. 323 See FRANK PARTNOY, FIASCO: THE INSIDE STORY OF A WALL STREET TRADER 139-40 (1999). 324 See WILMOTT, supra note 227, at 215-26. 325 See, e.g., Cal. Corp. Code §§ 29000-29201 (West 1997). 326 See In re Thrifty Oil Co., 212 B.R. 147, 153 (Bankr. S.D. Cal. 1997) (citing California statutes). 327 See id. 328 First, that court noted that the interest rate swap did not involve a security or commodity, as California’s law requires. See Cal. Corp. Code § 29004 (West 1997) (defining security as “all shares in any corporation or association . . . and other evidences of debt or property and options for the purchase or sale thereof or any right entitling the holder thereof to participate in profits or a division of assets”); Cal. Corp. Code § 29005 (West 1997) (defining commodity as “anything movable that is bought and sold”). Even if it were the case that the payments on a fixed-for- floating interest rate swap did not involve a security or commodity according to the statutory definition, many other derivatives would involve a security or commodity. Second, the court noted that the bucket shop statute only covers agreements where neither party intends to deliver the security or commodity. See Cal. Corp. Code § 29004 (West 1997). The court apparently misunderstood the meaning of this section of the statute as requiring that one or both of the parties not intend to fulfill its part of the contract: “[The parties] fully intended to perform their payment obligations under the swaps – there was no fictitious transaction.” In re Thrifty Oil Co., supra note 326, at 154. 2000] SYNTHETIC COMMON LAW 67 regulated commodity, or is unregulated.329 This determination is crucial in a dispute about losses stemming from an investment in derivatives: if a judge determines that the derivatives subject to dispute were securities or commodities, then a federal regulatory regime would apply to the resolution of the dispute;330 if not, the judge would dismiss the federal claims and any state law claims would remain. In some cases, judges and regulators have strained to argue that particular OTC derivatives were governed by securities or commodities laws.331 However, in most of the relevant cases, the derivatives are governed by neither, as the parties intended, and the judges are left to resolve state law claims, predominantly under common law.332 The problem presented here thus relates to the resolution of disputes when there is no applicable federal statutory law. In these cases, the parties are seeking to resolve disputes based on common law and analogical reasoning. Derivatives complaints in such cases have alleged breach of fiduciary duty, common law fraud and negligent misrepresentation, lack of authority, and various contract-based claims.333 This subpart analyzes how courts in some representative cases have treated these various state common law claims. The drawbacks of common law in this area are enormous. It is extraordinarily expensive to resolve these disputes, and there are few published 329 For example, a court would resolve a dispute concerning an investment in a “security,” see supra note 246 (defining “security” in the 1933 and 1934 Acts), under the applicable federal securities laws (most likely under Rule 10b-5),329 regardless of whether the economic qualities of the instrument make it a “derivative.” Similarly, a court would resolve a dispute concerning a commodity under the relevant federal law. Such disputes involving “regulated” derivatives do not present the same serious difficulties posed in disputes involving OTC derivatives. 330 In disputes about derivative securities or commodities, a court will rule that a particular statute applies and then the parties will go about litigating under the terms of that statute. The parties may be uncertain whether the statutory regime applies to their contract, but that is the problem addressed in Part IV.B.1., and is not of any additional concern for purposes of this section. 331 See, e.g., In the Matter of BT Securities Corp., Exchange Act Release No. 35,136, [1994-95 Transfer Binder] Fed. Sec. L. Rep. (CCH) P 85,477, at 86114 (Dec. 22, 1994) (assuming that Bankers Trust violated the securities and commodities laws without finding explicitly that the interest rate swaps Bankers Trust sold were securities or commodities). 332 These claims also may include state statute-based claims. See supra notes 316-324 and accompanying text (describing New York anti-gambling statutes and relevant derivatives). For a description of some of the common law arguments by practitioners in derivatives cases through 1997, see Aaron Rubinstein, Derivatives and Risk Management: Common Law Theories of Liability in Derivatives Litigation, 66 FORDHAM L. REV. 737 (1997). 333 See, e.g., Joanne Medero, et al., Investing in Derivatives: Current Litigation Issues, 8 INSIGHTS 4 (Nov. 1994) (noting that complaints include “claims for common law fraud, negligence, negligent misrepresentation, and breach of fiduciary duty” as well as claims under section 10(b) of the Securities Exchange Act, Sections 11 and 12(2) of the Securities Act, and various sections of the Investment Company Act). Another potential ground for recovery is commercial frustration or impracticability, based on unanticipated changes in one or more of the instrument or indices underlying a particular derivatives contract. See, e.g., Aluminum Co. of America v. Essex Group, Inc., 499 F. Supp. 53 (W.D. Pa. 1980) (purpose of contract based on wholesale price index was commercially frustrated by unexpected increases in the price of oil). 68 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# decisions to guide future parties. Facts are difficult to ascertain. Complaints often do not describe the underlying transactions accurately.334 Neither do the paltry number of judicial opinions. Jurisdictional battles are fierce, and costly.335 Documents are not available, or are under seal. Much important evidence is destroyed or is otherwise unavailable by the time discovery begins.336 The result is an expensive, inefficient, unfair, and uncertain process. 334 The parties and their lawyers may not completely understand the transactions. See, e.g., STEINHERR, supra note 5, at 78 (“OTC products can be complex enough to raise questions about how well understood they are even by experienced corporate treasurers. There is an associated uncertainty about the value of complex products for which there is no market.”). 335 For example, Judge Feikens held in Procter & Gamble v. Bankers Trust that because the parties agreed to be bound by New York statutes and case law, there was no claim under Ohio statutes, and therefore dismissed such claims. See Procter & Gamble, supra note 217, at 1289. This ruling was not particularly controversial, although it shows that federal judges are willing to defer to private choice of law provisions, even when one party may have violated the law of that court’s jurisdiction. (Note that this deference would be critical to the survival of a synthetic common law regime. Although federal courts would retain limited judicial review of synthetic common law dispute resolution, courts would need to show deference to private parties’ choice of regime, even if one party acted contrary to federal or state law.) Several derivatives cases have presented difficult jurisdictional issues. When Societe Nationale D’Expoitation Industrielle Des Tabacs (SEITA), the French national tobacco company, filed suit against Salomon Brothers International Limited, the London arm of a U.S. investment bank, in the Southern District of New York, Judge Sweet dismissed the claim for lack of subject matter jurisdiction, because the alleged fraudulent representations were made in London and “[a]s a French corporation headquartered in Paris, SEITA relied on the alleged misrepresentations, executed the Swaps, and realized its losses in Paris.” Societe Nationale D’Exploitation Industrielle Des Tabacs et Allumettes v. Salomon Brothers International Limited, No. 95-Civ-9484 (S.D.N.Y. 1996). SEITA subsequently sued in New York Supreme Court. I served as a consultant to SEITA during a portion of the litigation. In a more recent case, Merrill Lynch International moved to dismiss a complaint by Slovnaft A.S., the former Slovak national oil company, on grounds of forum non conveniens, claiming the parties had no New York interests and had agreed to resolve any disputes in English courts. See Merrill Lynch Seeks Dismissal, supra note 446, at 10. When PT Dharmala Sakti Sejahtera, an Indonesian financial services company, sued Bankers Trust, arguing it was not obligated to pay for losses on a complex derivative because it had not fully understood the transaction, see Bankers Trust Int’l PLC v. PT Dharmala Sakti Sejahtera, Queen’s Bench Division (Commercial Court) (Dec. 1, 1995), an Indonesian court ruled in favor of Dharmala, but the case was transferred to a British court, which ruled that Dharmala was capable of understanding the risks involved in the transaction. See id. The parties later settled the dispute. Chase Manhattan Bank recently moved to dismiss on the basis of forum non conveniens two complaints filed in the Southern District of New York by two Liberian companies acting on behalf of Greek individuals, arguing that New York was an inconvenient forum because witnesses and documents are in Europe, and that the parties chose English law to govern their investments. See Briefs Submitted on Motion to Dismiss Suit Against Chase Manhattan, 6 ANDREW’S DERIVATIVES LITIG. REPTR., July 3, 2000, at 5, 7. The suit and motion obviously were motivated by the availability in the U.S. of punitive damages and liberal discovery. This motion was pending as of August 2000. 336 For example, tape recordings of incriminating conversations were of critical importance in the litigation against Bankers Trust. See BT Securities, supra note 331, at 86114; see also Donald C. Langevoort, Selling Hope, Selling Risk: Some Lessons for Law from Behavioral Economics About Stockbrokers and Sophisticated Customers, 84 CALIF. L. REV. 627, 627-28 n.1 (1996) (discussing and quoting conversations among BT Securities employees). However, banks have learned from Bankers Trust’s mistakes, and now either do not record conversations or set up systems to erase or destroy the tapes within a relatively short period of time as a 2000] SYNTHETIC COMMON LAW 69 Breach of Fiduciary Duty One of the core common law claims in financial disputes has been breach of fiduciary duty.337 However, the derivatives cases on fiduciary duty have been so conflicted, muddled, and restrictive that many plaintiffs are now choosing not to include fiduciary duty claims in their complaints, in large part to avoid the cost associated with resolving complex motions to dismiss, and for strategic reasons to avoid early partial dismissal, which now seems likely given recent cases. Fiduciaries and fiduciary concepts have a long history in the law, beginning in the Roman law.338 Yet there is no clear definition of a fiduciary or a fiduciary relationship. As Justice Frankfurter famously put it, “to say that a man is a fiduciary only begins analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary?”339 These inquiries rarely lead to clear answers. In recent years, fiduciary notions have become hopelessly muddled in many areas of law. The term fiduciary is infused with the concept of trust; a fiduciary holds something in trust for another. But the term also includes notions of power and duty; a fiduciary relationship is created when one person is given power, and the duty to use that power to help another person.340 The term fiduciary is an objective notion; a person either is a fiduciary or is not and fiduciary duties may be triggered or halted341 based on certain objective standards of conduct or behavior.342 routine business practice. In one recent case, the plaintiffs requested additional depositions because the defendant bank allegedly had erased tape recordings related to the relevant swap transactions. See Seita Claims SBIL Destroyed Tapes; ‘Nonsense,’ Salomon Says, DERIVATIVES LITIG. REPTR., May 7, 1998, at 9. 337 In contrast to the stock markets, where most breach of fiduciary duty claims arise in the context of shareholder suits against managers and directors, most of the breach of fiduciary claims in the derivatives context have been by one party to a derivatives contract alleging a breach of fiduciary duty by the other, not by shareholders alleging breach of fiduciary duties by managers. There are some such shareholder-against-management cases, however. For example, in the litigation related to Orange County’s losses on derivatives, shareholders of Merrill Lynch & Co. sued the company’s directors in New York state court for breach of fiduciary duty to Merrill and its shareholders. However, the suit was dismissed because shareholders failed to support their assertion that a pre-suit demand on the board would have been futile. See Wilson et al. v. Tully et al. and Merrill Lynch & Co., No. 619-2-61903 (N.Y. Sup. Ct., App. Div. June 18, 1998); Shareholder Suit Against Merrill Lynch Dismissed for Failure to Make Pre-Suit Demand, PROFESSIONAL LIABILITY LITIG. REPTR., Aug. 1999, at 10. For a discussion of such suits based on hedging decisions by managers, see Kimberly D. Krawiec, Derivatives, Corporate Hedging, and Shareholder Wealth: Modigliani-Miller Forty Years Later, 1998 U. ILL. L. REV. 1039, 1102-04 (1998); see also George Crawford, A Fiduciary Duty to Use Derivatives?, 1 STAN. J.L. BUS. & FIN. 307, 329-30 (1995). 338 The term fiduciary is derived from the Roman law. In general, a fiduciary was a person holding the character of a trustee. For example, a fiduciary heir (fiduciaries h?res) was the person who was instituted heir and who was charged to deliver the succession to a person designated by the testament. A fiducia was an early form of mortgage under Roman law. See BLACK’S LAW DICTIONARY 563-64 (5th ed. 1979). 339 SEC v. Chenery Corp., 318 U.S. 80, 85-86 (1943). 340 J. SHEPHERD, LAW OF FIDUCIARIES 97 (1981). 341 There is no fixed scale for measuring fiduciary duty, although the courts have balanced allowing fiduciaries to act or transact with protecting shareholders. See ARTHUR R. PINTO & DOUGLAS M. BRANSON, UNDERSTANDING CORPORATE LAW 182 70 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# For example, much of corporate law is fiduciary duty law. Corporate law says that directors and officers of corporations – and sometimes shareholders – are in a fiduciary relationship with their corporation and its shareholders. Many corporate law scholars view fiduciary duty simply as a gap filler. As two leading corporate law scholars have noted, “[c]orporate law – and in particular the fiduciary principle enforced by courts – fills in the blanks and oversights with the terms that people would have bargained for had they anticipated the problems and been able to transact costlessly in advance.”343 With this uncertainty about fiduciary duty as a backdrop, parties began adding breach of fiduciary duty claims to their derivatives complaints. The results of combining fiduciary duty claims with the facts of complex derivatives have been abysmal, as one might expect, given the complexity surrounding each notion independently. The first judge to consider in detail a breach of fiduciary duty claim by a derivatives purchaser against a seller was Judge John Feikens of the Southern District of Ohio in the suit brought by Procter & Gamble against Bankers Trust in 1994.344 Although most scholars have focused on the federal securities and commodities claims in P&G’s complaint, the complaint also included a variety of state common law claims – fraud, misrepresentation, breach of fiduciary duty, negligence, and negligent misrepresentation – in addition to numerous federal statutory claims.345 These claims are of great interest and relevance here.346 (1999); see also Guth v. Loft, 5. A.2d 503 (Del. 1961) (indicating that fiduciary duties are subject to “no fixed scale.”). 342 Interestingly, the term fiduciary also refers to the system of marking in the reticule of an optical instrument used as a reference point or a measuring scale. See WEBSTER’S II NEW RIVERSIDE DICTIONARY 475 (1984). 343 Frank H. Easterbrook & Daniel R. Fischel, Contractual Freedom in Corporate Law: Articles and Comments; The Corporate Contract, 89 COLUM. L. REV. 1416, 1444-45 (1989). The hypothetical bargain approach of corporate law assumes that managers and shareholders have symmetric information. Fiduciary duty default rules thus are intended to ameliorate asymmetric information that actually persists. It is necessary to impose duties on management, because it is the rule shareholders and managers would have agreed to absent transaction costs, i.e., it is the rule necessary to resolve the information asymmetry between shareholders and management. If management has superior information, the argument goes, fiduciary duty rules are necessary to prevent management from using such information to exploit shareholders. 344 See Procter & Gamble, supra note 217. Judge Feikens’s opinion remains one of the most thorough and well-reasoned judicial considerations of any derivatives claim to date, although many regard as dicta the discussion in that case of state common law claims. 345 The federal statutory claims included alleged violations of Section 17 of the Securities Act of 1933, Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, and Sections 4b and 4o of the Commodity Exchange Act, and Section 32.9 of the Rules of the Commodity Futures Trading Commission. See Procter & Gamble, supra note 217, at 1274. P&G also included claims based on Ohio state law, including violation of Ohio Blue Sky Laws and the Ohio Deceptive Trade Practices Act. See id. Gibson Greetings, Inc., a manufacturer of greeting cards, filed a suit alleging similar state common law claims against Bankers Trust on September 12, 1994. See Gibson Greetings, Inc. v. Bankers Trust Co., 925 F. Supp. 1270 (S.D. Ohio 1994). 346 At the time, there already existed a body of statutory law and common law cases for use in resolving the federal claims. However, the state common law claims were novel in the derivatives context, and to some extent still are. 2000] SYNTHETIC COMMON LAW 71 P&G alleged that BT had not adequately explained the risks inherent in swap transactions P&G entered into with the bank. In each case, the swap payments were based on complex formulas, and consisted in economic terms of a portfolio of forward and option contracts. Because of leverage, the bets embedded in the swap contracts were very large, approaching the size of the entire issue of a U.S. government bond of comparable maturity. Moreover, the swap contracts were designed in a way that masked the size of the exposure on the contract, although the terms of the contract clearly specified its payouts and a sophisticated party would have been able to analyze the swap’s exposure. In addition, there were recordings of BT salespeople discussing misrepresentations related to such swap valuations. The suit was settled well before trial, with P&G agreeing to pay $35 million of roughly $200 million it owed.347 P&G contended that a fiduciary relationship existed between it and BT. Judge Feikens granted BT’s motion for summary judgment as to P&G’s claim of breach of fiduciary duty, but noted that “[t]his does not mean, however, that there are no duties and obligations in their swaps transactions.”348 It is difficult to interpret this sweeping statement. How are market participants to know if the seller bank owes a fiduciary duty of any kind or scope? Did P&G’s size or sophistication matter to this determination? Was the nature of the relationship between P&G and BT a factor? Was the swap’s structure relevant? Was the fact that a swap was individually tailored to a particular counterparty evidence that the purchaser was receiving some special treatment? Although this Ohio decision did not bind other courts outside of Ohio deciding breach of fiduciary duty claims under New York law, it did create uncertainty for future cases. In a more recent, similar, case involving a more complex product sold to a less sophisticated purchaser, a New York state court also rejected a breach of fiduciary duty claim. In 1994 and 1995, Societe Nationale D’Expoitation Industrielle Des Tabacs (SEITA), the French national tobacco company, lost $29 million on two swap transactions it entered into with Salomon Brothers International Limited (SBIL).349 According to the allegations, a SBIL salesman in London, Gilles Albou, acted fraudulently and concealed certain risks in order to convince former SEITA treasurer, Marc Tardieu, that he could make millions of dollars for his company by investing in two swaps.350 Thus, the facts resembled those of the earlier P&G case. SBIL, like BT, ran a sophisticated derivatives trading operation, while SEITA, like P&G, obviously was less sophisticated. SEITA had far less experience with derivatives than P&G, which had been trading billions of dollars of derivative instruments for several years.351 The derivative SEITA purchased was a complex swap that SBIL had designed in a way that masked both its size and risk, and that a 347 Gibson agreed to pay $6.18 million of roughly $20 million it owed to BT. See Bennett & Marin, supra note 305, at 5 (describing resolution of Procter & Gamble and Gibson Greetings cases). 348 Id. at 1289. 349 See SD NY Denies French Firm Federal Jurisdiction for Suit over U.S. Swaps, ANDREW’S DERIVATIVES LITIG. REPTR., July 8, 1996, at 3. 350 One swap was tied to the German mark; the other was tied to the Japanese yen. See id. 351 See Partnoy, FIASCO, supra note 323, at 94. 72 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# sophisticated buyer might have understood fully, but that SEITA likely did not. The instrument SEITA purchased involved a portfolio of digital (or binary) options,352 and therefore was more difficult to evaluate than P&G’s swap with BT. New York law applied in both cases, although SEITA’s suit was in state court in New York, not in Ohio.353 In deciding SBIL’s motion for summary judgment, Judge Charles Edward Ramos found that SEITA was a sophisticated counterparty to the swap and granted summary judgment to SBIL on the fiduciary duty claim.354 Unfortunately, Judge Ramos did not clarify the coverage of the P&G case, except to note in passing that a large French tobacco company is a sophisticated party and was aware of the risks involved; BT had made similar arguments in the prior case.355 At best, Judge Ramos’s five-paragraph discussion of fiduciary duty in his opinion is of little or no value to other participants in the derivatives industry. It fails to articulate any general principles of law, to analyze existing precedents in other areas, to explain what facts were important to the decision, or even to set forth the nature of the transaction in any comprehensible detail. It provides roughly the same guidance that the judge in Holmes’s story provided by explaining he could not find applicable law dealing with churns. At worst, Judge Ramos’s cursory dismissal of the claim is very costly. Judge Ramos’s opinion has generated great uncertainty among participants in the derivatives industry, who cannot understand from the opinion when, if ever, a counterparty to a derivative contract would be able to survive a summary judgment motion. The New York Appellate Division, First Department, did not help matters, affirming the decision with little additional guidance.356 The decisions’ naked rejection of fiduciary duty claims seem to have scared plaintiffs from including such claims in their complaints, a result that even contractarian legal scholars should find difficult to justify based on the historical treatment of fiduciary duty claims as gap-fillers in at least some circumstances. Recent federal cases also provide little guidance.357 The law in the Second Circuit, the leading court for business disputes, regarding 352 Digital options either pay a fixed or sum or zero (i.e., have a discontinuous payoff), depending on some contingency. See WILMOTT, supra note 227, at 34-35. 353 SEITA had sued first in federal court in New York, but that suit was dismissed on jurisdictional grounds. See supra note 349. SEITA’s state court suit also included other common law claims, including fraud. Societe Nationale D’Exploitation Industrielle Des Tabacs et Allumettes v. Salomon Brothers Int’l Ltd., Index No. 113154/96 (N.Y. Sup. Ct. Feb. 9, 1998). 354 See id. Ultimately, the judge dismissed SEITA’s other claims, too. 355 See id. at *6. 356 See Societe Nationale D’Exploitation Industrielle Des Tabacs et Allumettes v. Salomon Brothers Int’l Ltd., 2000 N.Y. App. Div. LEXIS 5004 (N.Y. App. Div. 1st Dep’t April 27, 2000) (denying without opinion leave to appeal to the New York Court of Appeals). The First Department of the New York Appellate Division previously noted that it did not subscribe to the articulation of New York law in the P&G case, although it left open the possibility of finding something more than a “business relationship” in future cases, thereby creating additional uncertainty. See Societe Nationale D’Exploitation Industrielle Des Tabacs et Allumettes v. Salomon Brothers Int’l Ltd., 674 N.Y.S.2d 648, 649 ((N.Y. App. Div. 1st Dep’t June 16, 1998). 357 A few cases have attempted to resolve these issues under federal statutory law. See, e.g., Banca Cremi, S.A. v. Alex. Brown & Sons, Inc., 132 F.3d 1017 (4th Cir. 2000] SYNTHETIC COMMON LAW 73 fiduciary duties owed by brokers to clients is hopelessly muddled.358 For example, in Independent Order of Foresters v. Donaldson, Lufkin & Jenrette, Inc.,359 the Second Circuit upheld the dismissal of a complaint, noting that that where there were insufficient allegations to support a finding of any broader duties, a broker owes a client only limited duties with respect to a non-discretionary account.360 However, in interpreting Independent Order of Foresters and a similar, later Second Circuit case,361 Judge Koeltl, in Kwiatkowski v. Bear Stearns (Kwiatkowski II),362 held it remains clear that the “relationship between a broker and its client is fiduciary in nature and that duties broader than those related to the execution of a transaction may arise as a result of the particular relationship between the broker and the client and the scope of the matters with which the broker is entrusted.”363 The catch phrase noting the existence of a fiduciary duty, but limiting its scope to “matters relevant to affairs entrusted to the broker” appears in numerous recent cases in the Second Circuit.364 The results in the cases are difficult to reconcile. Consider, for example, the differences between the allegations in Press v. Chemical Investment Services Corp.365 and Independent Order of Foresters on one hand, and Kwiatkowski II on the other. In Press, the broker failed to disclose a substantial markup on the sale of a Treasury Bill. In Independent Order of Foresters, the broker failed to explain the risks 1997) (evaluating claim related to investment in mortgage derivatives under federal law). 358 To complicate the analysis further, there also are other, sometime contradictory, lines of cases on fiduciary duty in New York. One line holds that absent a showing of “special circumstances” that could have transformed a business relationship into a fiduciary relationship, a court will dismiss a claim for fiduciary duty; such “special circumstances” can include control by one party of the other, or creation of an agency relationship. See, e.g., L. Magarian & Co. v. Timberland Co., 665 N.Y.S.2d 413, 414 (1997) (citing cases for both sets of “special circumstances” and, finding neither, dismissing the complaint). Another holds that generally the legal relationship between customer and bank is arm’s length, but that a fiduciary relationship may arise when the bank “assumes control and responsibility” over the customer’s assets, or when the customer “places special trust and confidence in the bank and thereby becomes dependent on it.” ADT Operations, Inc. v. Chase Manhattan Bank, 662 N.Y.S.2d 190, 192-93 (1997). There are separate, related cases, involving insurance companies. See, e.g., Goshen v. Mutual Life Ins. Co. of New York, 1997 N.Y. Misc. LEXIS 486, at *34 (Sup. Ct. N.Y. Oct. 24, 1997) (citing both “special trust and confidence” and “dependence” prongs of the banking fiduciary duty test). 359 See Independent Order of Foresters v. Donaldson, Lufkin & Jenrette, Inc., 157 F.3d 933 (2d Cir. 1998). This case involved the appeal of the dismissal of breach of fiduciary duty claims by a fraternal society that issued insurance policies and annuities to its members and had invested in certain derivatives. Id. 360 These duties include, for example, a duty to notify a customer before making trades where authorization is required, and a duty to execute requested trades. See id. at 940. 361 See Press v. Chemical Investment Services Corp., 166 F.3d 529, 536-37 (2d Cir. 1999) (attempting to reconcile the notion that the broker owes no fiduciary duty to the client with the notion that a broker’s fiduciary duty to a client is limited to “matters relevant to affairs entrusted with the broker”). 362 Kwiatkowski v. Bear, Stearns & Co., 1999 U.S. Dist. LEXIS 19966, (S.D.N.Y. Dec. 29, 1999) (“Kwiakowski II”). 363 See id. at *29 364 See Press, supra note 361, at 537; Rush v. Oppenheimer & Co., 681 F. Supp. 1045, 1055 (S.D.N.Y. 1988); Kwiatkowski II, supra note 362, at *31. 365 See Press, supra note 361. 74 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# associated with several complex transactions to a “fraternal society.” In Kwiatkowski II, the broker liquidated the client’s positions in a downward-moving market in order to avoid unsecured losses. In the first two cases, the fiduciary duty claim was dismissed; in the third, it was upheld. Is it possible to say that secretly adding a substantial mark-up to a virtually risk-free transaction or failing to advise a less sophisticated party about a complex instrument is not a “matter relevant to affairs entrusted to the broker,” but that liquidating a client’s positions in a volatile market is? The rationale for fiduciary duty traditionally has been based on the information or sophistication gap between parties. It is difficult to understand how this gap varied in the three cases, and the courts do not attempt to address the difficulty. There certainly is no explanation, for example, of how the plaintiff in Kwiatkowski II, but not in the other cases, could or would have bargained for fiduciary protection absent transaction costs. It is worth setting forth in greater detail some of the facts and analysis in Kwiatkowski II, to demonstrate how difficult it is for a judge to resolve a fiduciary duty claim in a complex financial dispute.366 Before 1990, when he opened a foreign currency trading account at Bear, Stearns, Henryk de Kwiatkowski, a wealthy individual investor,367 had engaged in hundreds of millions of dollars of foreign currency transactions through his bank in the Bahamas, Bank Leu.368 Bear, Stearns made standard form disclosures in which Kwiatkowski acknowledged the risk of trading in foreign currency futures, and Kwiatkowski then began trading billions of dollars worth of currency futures on the Chicago Mercantile Exchange (CME).369 As Kwiatkowski’s positions increased during late 1994, they became too large for the CME,370 and on December 6 and 7, 1994, Bear, Stearns transferred one half of his positions to the OTC derivatives market.371 Although Kwiatkowski was making money in late 1994, on December 28, 1994, the dollar weakened dramatically and he lost $112 million in a few hours. Kwiatkowski posted margin for these losses and other losses during the following several weeks.372 More than a month later, Kwiatkowski acknowledged in writing that he was an “eligible swap participant” with total assets exceeding $10 million and that he was familiar with foreign currency 366 Moreover, Kwiatkowski II is one of the few cases from which parties can glean the relevant facts. In other cases, facts are missing, either because the judge decided to omit them (or could not understand and articulate them), or because the facts were under seal or subject to a confidentiality order. See, e.g., SEITA, supra note (limited recitation of facts does not even include a description of the transaction). 367 In 1991, Kwiatkowski had a net worth of $100 million. See Kwiatkowski II, supra note 362, at *7. 368 See id. at *6. 369 See id. at *6-11. 370 At one point, Kwiatkowski’s positions constituted substantial percentages of the December 1994 contracts available for trading on the CME. See id. at *11. The court recognized that “the OTC market is a much larger market than the CME, with more participants trading more currency” and that “[t]he OTC market is also more liquid than the CME and it allows a large investor to liquidate a large position with less impact on the market than would be the case on the CME.” Id. at *11-12. 371 See id. at *11. 372 See id. at *13-14. 2000] SYNTHETIC COMMON LAW 75 transactions.373 Bear, Stearns would have sought this acknowledgment to satisfy the Part 35 swaps exemption,374 although the hints at some uncertainty about the exemption. In early March 1995 the dollar declined in value again, and Bear, Stearns – facing a potentially unsecured loss – liquidated all of Kwiatkowski’s positions.375 Kwiatkowski alleged that he lost more than $300 million because of this hurried liquidation.376 Consider the array of questions raised in Kwiatkowski II. What facts are relevant in deciding whether or not a purchaser of derivatives is sophisticated? Does it matter that the purchaser is an individual, as opposed to an institution? Does it matter that the purchaser is not from the U.S.? Is the amount of the seller’s profit from the sale of the derivatives relevant?377 How and why? What is the relevance of standard form disclosures or disclaimers? Do they insulate a seller from liability? What is the effect of the (delayed) Part 35 acknowledgment? Does it matter if the disputed transaction was economically equivalent to a transaction that would not have generated losses?378 Finally, how should a judge distinguish among federal statutory claims and state common law claims when there is extensive overlap and some common elements.379 (Kwiatkowski’s claims included fraud, negligent misrepresentation, breach of 373 See id. at *12. 374 See discussion supra at notes 279-287 and accompanying text. 375 Interestingly, Bear, Stearns seems to have liquidated Kwiatkowski’s positions on Sunday, March 5, 1995, a day the CME was not open. See id. at *14-15. The court did not discuss this fact. 376 See id. at *15. An expert for Kwiatkowski testified that even if Kwiatkowski had begun liquidating his positions by March 1, 1995 – a Wednesday, just four days earlier, when the markets were more active – he would have reduced his losses by $139 million. See id. at *20. Kwiatkowski claimed he had asked Bear, Stearns to segregate his trading account from a larger account he was holding for his children; instead, Bear, Stearns used the children’s account to provide leverage for the OTC derivatives transactions. See Businessman’s $300M Fiduciary Claims Survive Bear Stearns’ Summary Judgment Motion, DERIVATIVES LITIG. REPTR., Jan. 24, 2000, at 3. 377 The seller’s profits may be relevant in several ways. First, if the profits were very large and undisclosed, the buyer may have a claim to damages for a portion of those profits. Second, a very large profit margin may be a sign that the buyer did not understand the transaction; the argument is that if the buyer had been able to value the transaction properly, it would not have paid such a large mark-up to the seller (alternatively, if the buyer understood the terms of the transaction, a very large profit margin is evidence that the transaction was risky or illiquid for the seller in ways the buyer might not have known and that the seller might not have disclosed). Third, the seller’s profits – and particularly the individual salesperson’s compensation and incentive structure – are relevant to discerning the seller’s motivation to complete the transaction: was this a standard transaction the seller entered into repeatedly with other, similar counterparties, or was it a kind of “this will make my year” transaction the seller only rarely was able to sell? 378 For example, an OTC derivative might be economically equivalent to an exchange-traded derivative, but might nevertheless generate additional losses due to illiquidity, large mark-ups, or other factors unique to the OTC markets. 379 In most derivatives complaints, as in most commercial complaints generally, a long recitation of facts is followed by and incorporated into much shorter, often boilerplate, recitations of the formal claims being made in the case. In many ways, the quandary faced by a drafter of such a complaint is not so different from that faced by lawyers centuries ago; the major difference is that the choices (e.g., breach of fiduciary duty or negligent misrepresentation, as contrasted with early common law forms of complaint, e.g., trespass) have changed. 76 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# contract,380 and claims under the Commodity Exchange Act,381 all of which the court dismissed,382 as well as claims for breach of fiduciary duty and negligence, which the court allowed to proceed.383). These questions, though posed in every derivatives dispute including Kwiatkowski II, remain unresolved. Such questions are so difficult to answer in part because it is so impossible to know how much a judge will understand about the particular OTC derivatives market and transactions at issue. An understanding of the market is important in answering questions about a dispute. Justice Cardozo argued that fiduciary duty was closely linked to custom and practice. He wrote, “Some relations in life impose a duty to act in accordance with the customary morality and nothing more. In those the customary morality must be the standard for the judge.”384 Unfortunately, the “customary morality” in derivatives markets is often complex, counterintuitive, and largely unknown to judges. In many situations, the customary morality is that derivatives counterparties owe each no duties at all. Certainly the trillions of dollars of swap transactions between large banks do not involve expectations of any such fiduciary duty. Yet in other instances the customary morality is that such duties not only are owed, but also are a precondition to the transaction. Derivatives sellers treat less sophisticated customers differently than they treat each other, for good reason. Less sophisticated derivatives purchasers rely on sellers to help them understand and access complex transactions. Such reliance is efficient; it would be too costly for every derivatives purchaser to understand every nuance to every transaction. As a result, sellers rationally should believe they owe some such duties, and their customers should not be willing to buy from them if they do not believe they were entitled to such duties. The information and sophistication gap between purchasers and sellers warrants a rule that the seller owes the buyer at least some limited duty in some circumstances. Yet the courts have not understood either the implications of the “customary morality” of the derivatives industry or the traditional analysis of fiduciary duty claims. Courts have recognized two poles of fiduciary duty analysis: one where no duties are owed, another where they are. The problem is that in derivatives cases, courts have not clarified where the line is drawn. That failure to draw the line has generated great uncertainty. My point here is not necessarily that the line should be drawn in a particular location as to fiduciary duty claims; I would hope that a sophisticated, fully-informed judge with adequate time and resources who engaged in a careful hypothetical bargain analysis could do a fine 380 The breach of contract claim alleged an oral agreement that was inconsistent with the terms of a written Foreign Exchange Memorandum. See id. at *48. 381 Kwiatkowski’s CEA claims included a claim that Bear, Stearns had solicited and dealt in illegal futures transactions. This claim, which was dismissed, would have raised the complex web of issues discussed supra in Part III.A. 382 See Kwiatkowski v. Bear, Stearns Co., 1997 U.S. Dist. LEXIS 13078 (S.D.N.Y. Aug. 29, 1997) (dismissing claims pursuant to Fed. R. Civ. P. 12(b)(6)) (“Kwiatkowski I”). 383 See Kwiatkowski II, supra note 367, at *2-3. 384 Benjamin Cardozo, The Nature of the Judicial Process 152, in SELECTED WRITINGS OF BENJAMIN NATHAN CARDOZO (Margaret E. Hall, ed. 1947). 2000] SYNTHETIC COMMON LAW 77 job. Instead, my point is that the common law has failed to draw such a line at all. It may be that it is simply too difficult and costly for the judges selected to hear the relatively small number of real adjudicated derivatives disputes to draw these lines in the manner suggested here. If so, the common of law of fiduciary duty as applied to derivatives- related disputes may be doomed to uncertainty. Fraud (and Negligent Misrepresentation) Derivatives complaints also have include fraud and fraud-related claims. Like fiduciary duty analysis, the treatment of fraud has deep historical roots. The common law of fraud is relatively easy to describe, even if results in individual cases are no easier to predict. Fraud involves reliance by one party to its detriment on a material misstatement made by the other party. Fraud in the derivatives context can be relatively easy to assess. Consider, for example, the 1994 civil cases brought by the government against Bankers Trust.385 In related cases, the SEC and CFTC found Bankers Trust had committed fraud in its dealings with Gibson Greetings and fined the bank $10 million, in part because the derivatives were too complicated for Gibson Greetings employees to understand, and in part because Banker Trust employees misrepresented the value of the derivatives at various points.386 Similarly, the fraud claims involved in cases filed by several Korean institutions against Morgan Guaranty involved complex facts, but required relatively simple analysis.387 However, the fact that fraud claims in derivatives cases might not be complex analytically does not necessarily mean they will be simple to resolve. The question remains what facts support a claim of fraud, and because the facts in derivatives cases can be difficult, so can the resolution of a fraud claim. For example, Martin A. Armstrong, president of Princeton Economics International Ltd., was a defendant in several cases related to hundreds of millions of dollars of losses on structured notes388 Princeton sold. Japan-based Amada Co. and its subsidiaries bought $123 million of these notes from Princeton.389 Amada alleged that Princeton falsely represented that the notes’ value was based on Princeton’s holdings of AAA-rated U.S. government securities. Amada sued in the Southern District of New York, claiming violations of federal securities laws, common law fraud, breach of fiduciary duty, and unjust enrichment. The resolution of Amada’s fraud claim depends not on any difficulties related to the law of fraud, but to complex fact questions related to Princeton’s representations. The key facts involve the 385 See BT Securities Corp., Exch. Act. Rel. No. 35, 136 [1994-95 Tr. Binder] Fed. Sec. L. Rep. (CCH) (Dec. 22, 1994); BT Securities Corp., CFTC Docket No. 95-a, app. A, at 2 (Dec. 22, 1994). In those cases, tape recordings indicated that BT employees had lied about material elements of the transactions, including how they should be evaluated over time. Given such evidence, a fraud case can be simple, even in the derivatives context. 386 See id. 387 See discussion infra at notes 392-406 and accompanying text. 388 Structured notes are a type of derivative instrument in which the payments of the note are linked to one or more variables using mathematical formulas. See Partnoy, Regulatory Arbitrage, supra note 5., at 220-21. 389 See Japanese Company Sues NY Bank for $123M Alleging Investment Fraud, BANK & LENDER LIAB. REPTR., Jan. 19, 2000, at 5. 78 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# nature of the AAA-rated U.S. government securities that formed the basis of the deals. Before the development of structured notes, the moniker “AAA-rated U.S. government security” indicated a safe, low risk investment. That indication is no longer true. Instead, such a label now says virtually nothing about the market risk of an instrument: AAA relates only to credit risk and can mask all sorts of non-credit-related risks.390 Highly-rated issuers, including the U.S. government and its agencies, issue securities with a wide variety of market risk and leverage.391 Among the most prominent recent fraud cases in the derivatives area involve are a series of suits filed in the Southern District of New York arising out of losses sustained by several Korean entities on purchases from Morgan Guaranty392 of derivative instruments linked to the currency of Thailand, known as the baht. A brief recitation of some publicly available facts from the cases will show how complex even a relatively simple fraud case can become in the derivatives context.393 In 1997, Morgan Guaranty arranged a series of complex derivatives transactions for SK Securities and several other Korean counterparties. The transactions involved the establishment of Malaysian special purpose investment funds394 that borrowed money to purchase units of a Korean trust, which then used the proceeds to purchase Korean stocks, bonds, or complex derivatives. The loans were to be repaid through a series of one-year-maturity total return swap transactions.395 At the termination of these swaps, Morgan Guaranty was to sell the trust units and pay the Malaysian funds the value of those units plus (or minus) an amount to be determined by reference to a formula based on a comparison of the prices of the Thai baht and Japanese yen currencies to the U.S. dollar at the dates of inception and termination of the underlying agreement,396 as well as the value of the underlying stocks, bonds, or other derivatives. Needless to say, the derivatives transactions were far from “plain vanilla” interest rate swaps. 390 See Frank Partnoy, The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies, 77 Wash. U. L. Q. # (1999). 391 See id. at #. 392 Morgan Guaranty is a U.S.-based lending institution and a subsidiary of J.P. Morgan, a large U.S. commercial bank and one of the leading participants in the derivatives market. I served as a consultant to certain Korean entities during portions of this litigation. 393 Some of the details of these transactions are described in complaints available through Andrew’s Derivatives Litigation Reporter. See, e.g, Second Amended Complaint, Korea Life Ins. Co. v. Morgan Guaranty Trust Co., 99 Civ. 12175 (May 17, 2000), available at 6 DERIVATIVES LITIG. REPTR., July 3, 2000, at A1- A11. 394 In the derivatives market, it is very common for transactions to involve so- called “special purpose” entities, which are established solely for the purpose of a given transaction or group of transactions. See Partnoy, Regulatory Arbitrage, supra note 5, at 221-22. Such special purpose entities typically are needed so the transaction is in compliance with, or takes advantage of, a particular regulation. See id. 395 In a total return swap, one party pays or receives the total return on some asset in exchange for paying or receive a pre-specified periodic amount. 396 Robert W. McSherry, Candlelight, Midnight Sessions, and Dealings in the Dark: SD NY Transcript Outlines the Road to a “Complex” Settlement, SEC. LITIG. & REG. REPTR., Nov. 10, 1999, at 13. 2000] SYNTHETIC COMMON LAW 79 After the Thai baht collapsed on July 2, 1997,397 the valuation of the total return swaps moved dramatically against the Korean parties, and in favor of Morgan. Because the Malaysian companies involved had been created only for purposes of this transaction, and therefore had no other assets, Morgan looked to the Korean companies and to four Korean guarantors to pay on the swaps.398 The Korean entities refused to pay, and litigation ensued. On February 10, 1998, two of the losing parties sued Morgan Guaranty in the Southern District of New York, alleging violations of federal securities laws; a few days later, Morgan Guaranty sued in the same court, alleging breach of contract.399 The Korean entities alleged that Morgan concealed information about the transactions, including its insider knowledge that the Thai central bank was preparing to allow the baht to devalue. Thus, the claims sounded in fraud. Although numerous issues in the case were complex, one appeared to be quite simple. One of the Korean guarantor banks, Housing & Commercial Bank (HCB), alleged that Morgan had inserted new pages into an already-initialed document, thereby changing HCB’s limited 397 There have been several substantial disputes over derivatives losses in Asia, including numerous losses related to the Thai baht collapse and ensuing crisis in Asia. This collapse in foreign exchange rates triggered a second wave of derivatives disputes, in the same way the increase in short-term interest rates in early 1994 triggered the first wave. The companies losing large amounts of money on derivatives included Japanese companies such as Yakult Honsha, a maker of fermented beverages, Alps Electric, a maker of electronics parts, and Aoyama Trading, a fashion retailer, and Showa Shell Sekiyu K.K, an oil refiner; several large Indonesian corporate groups, including the Indah Kiat, Sinar Mas., and Tanoto groups, and several companies and corporate groups in Korea, Thailand, and Malaysia. See Bennett & Marin, supra note 305, at 6-7 (describing details of losses). Japanese companies in particular incurred large losses from derivative contracts, although many of these losses were not caused by any market movements, but were actually the losses associated with gains previously recognized on mirror derivative contracts. In the mid-1990s, Japanese companies were notorious for engaging in sham transactions that generated immediate false accounting profits, pushing the corresponding losses to a future date. The losses recognized by many of these companies were simply the inevitable losses associated with the previous false accounting gains. For a detailed description of such transactions, see Partnoy, F.I.A.S.C.O., supra note 323, Ch. 10. Japanese regulatory authorities encouraged these sham transactions during the 1990s, perhaps because they believed accurate disclosure of the companies’ poor financial condition would have hurt the economy, perhaps because they believed the economy might improve, thereby reducing future losses. In any event the regulators abruptly changed position in 1998, even suspending one non-Japanese bank’s license for selling such transactions: “Beginning in 1998, however, the financial authorities changed their regulatory posture on window dressing transactions. Responding to both international and domestic pressure to address the problems in the country’s banking system, the regulators determined that window dressing was an inappropriate practice. Because of the ambiguity of the legal and accounting framework for financial derivatives in Japan, this policy shift was possible without any change or amendment to any regulation and without providing market participants with any advance notice. The most dramatic result of this policy was the severe penalties imposed on Credit Suisse.” Bennett & Marin, supra note 305, at 29 (footnotes omitted). Such an abrupt change in position adds to the regulatory uncertainty concerning financial derivatives. 398 The four Korean guarantors were SK Securities, Hannam Investment Securities, Housing & Commercial Bank, and Boram Bank. See id. 399 See id; see also J.P. Morgan Sues S. Korean Banks, Securities Firm Over Derivatives Deals, SEC. REG. & L. REP., Feb. 20, 1998, at 282. 80 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# guarantee of $50 million to an unlimited guarantee.400 (The losses greatly exceeded $50 million.) Such straightforward allegations, if true, established a relatively simple case of fraud. The allegations involving the other banks were more complex, but also included fraud. However, the Korean entities and Morgan had ongoing business relationships,401 and were able to agree to settle several of the cases.402 Obviously, HCB was assisted in its settlement negotiations by the fact that it was able to allege a relatively simple fraud case.403 However, note how little value the litigation and settlement of these complex claims generated for participants in the derivatives market. Parties to the case, and more importantly their attorneys, may have intuited a sense of how the judge in the cases, Alvin K. Hellerstein, might rule in future cases. Although confidentiality orders governed the dispute, sufficient facts became public to give non-parties some sense of the factual basis for the fraud claims. But because the parties settled the case subject to a confidentiality agreement, Judge Hellerstein’s role was simply to grant the stipulated dismissal404 without a detailed opinion. Neither he nor any other judge in New York would be bound by his actions in this series of cases. Nor would any future party benefit from any wisdom or judgment Judge Hellerstein accumulated during the litigation. Notwithstanding millions of dollars of legal fees spent to resolve one of the largest derivatives disputes in history, the result was absolutely no common law – not a single legal rule – of use to future parties. Not every Korean entity settled its claims, and there are ongoing disputes involving Morgan, so there is some chance a common law precedent still will be established. In a related case also before Judge Hellerstein, Korea Life Insurance Co. (KLI) sued Morgan Guaranty for fraud, unjust enrichment, frustration of commercial purpose, negligent misrepresentation, lack of authority, breach of the duty of good faith and fair dealing, and violation of the New York gaming laws.405 In this suit, KLI seeks approximately $100 million in damages it allegedly incurred on derivatives linked to the Thai baht and Japanese yen.406 Part of the fraud claim in KLI’s complaint relates to the structure of the transaction; part relates to Morgan using information it procured to the disadvantage of KLI without disclosing that information in advance.407 This latter argument has empirical support: there is evidence of dealers acting to take advantage of information in the foreign exchange markets to the detriment of their counterparties.408 400 See Korean Bank: Morgan Fudged, BOND BUYER, Apr. 27, 1998, at 1. 401 The transcript of the settlement conference describes the parties as “business partners.” See McSherry, supra note 396, at 13. 402 J.P. Morgan & Co., parent of Morgan Guaranty, agreed to purchase a substantial stake in SK Securities and to forgo payment of the $300 million it was owed. The value of the settlement was estimated at $250 million. See id. 403 See Morgan Fudged, supra note 400, at 1. 404 See id. 405 See Korean Insurer’s NY Swaps Suit Seeks $350M from Morgan Guaranty Trust Co., DERIVATIVES LITIG. REPTR., Jan. 24, 2000, at 7. 406 See id. (describing negative effect of devaluation of Thai baht on the investment). 407 See Second Amended Complaint, supra note 393, at 6-14. 408 For example, in early 1995, when the Japanese yen appreciated towards the “knock-out” levels relevant to a series of structured derivatives transactions, dealers 2000] SYNTHETIC COMMON LAW 81 Judge Hellerstein has a unique opportunity in this suit to contribute an important common law decision to the global derivatives market, an opportunity Holmes would have relished. The case was pending as of August 2000. In addition to “straight” fraud claims, fraud-related complaints often include claims filed under the heading “negligent misrepresentation.” The law of negligent misrepresentation is more complex than that of fraud, and generates some additional difficulties in derivatives disputes. Nevertheless, the analysis of negligent misrepresentation claims, and the duties required for such claims, parallels that of fiduciary duty claims.409 In general, a defendant is liable for negligent misrepresentation only from the breach of a duty running to the plaintiff who is injured.410 Specifically, in the commercial context, this rule means that to be liable a defendant must “possess unique or specialized expertise, or . . . [be] in a special position of confidence and trust with the injured party such that reliance on the negligent misrepresentation is justified.”411 The facts that justify a finding of such special position include whether the person making the representations knew how the information would be used and whether this person appeared to hold a position of trust and confidence.412 New York courts have distinguished between (1) commercial actors such as insurance agents, who are not in a better position than their client insureds to know the insured’s personal assets and ability to protect themselves, and (2) other providers of services, such as doctors, attorneys, or architects, who are in a better position than their clients to know and understand such information.413 The cases do not specifically mention derivatives dealers: the question remains whether (and when) a buyer of derivatives is “at a substantial disadvantage to question the actions of the provider of services.”414 When might a derivatives purchaser be at a substantial disadvantage to question the actions of the seller? The cases seem to indicate that when a sophisticated party is “ripped off” by another had an incentive to push the value of the yen up through these levels, and thus eliminate their obligations on the transactions. See STEINHERR, supra note 5, at 109. There is evidence that dealers did precisely this. See A.M. Malz, Currency Options Markets and Exchange Rates: A Case Study of the U.S. Dollar in March 1995, 1 CURRENT ISSUES IN ECON. & FIN. 4 (1995) (describing substantial increase in such transactions during the relevant period of time). 409 See, e.g., Pinky Originals, Inc. v. Bank of India, 1996 U.S. Dist. LEXIS 15575, at *78 (S.D.N.Y. Oct. 21, 1996) (grouping together negligent misrepresentation and fiduciary claims and noting that “plaintiffs’ claims premised on negligence, failure to disclose, and breach of fiduciary duty are dependent on a showing that the Bank owed some fiduciary duty to the plaintiffs”). 410 See, e.g., Kimmell v. Schaefer, 89 N.Y.2d 257, 263 (Ct. App. 1996) (“Liability for negligence may result only from the breach of a duty running between a tortfeasor and the injured party.”). 411 Id. 412 Id. Professionals, including lawyers and accountants, are subject to higher duties. Id. at 263-64. 413 See, e.g., Murphy v. Kuhn, 90 N.Y.2d 266 (Ct. App. 1997) (affirming grant of defendant’s motion to dismiss plaintiff insured’s claims for tortious misrepresentation and breach of implied contract). 414 Id. at 273. 82 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# sophisticated party, there is no cause of action.415 However, cases are less clear about facts that do not rise to the level of fraud or breach of fiduciary duty, yet involve one party that is more sophisticated than the other and therefore might support a negligent misrepresentation claim. For example, in Kwiatkowski II, there was evidence of a “substantial advisory relationship”416 between the purchaser and seller. Does providing financial advice trigger a duty that would support a negligent misrepresentation claim? It is difficult to know how to draw such a line. Courts have not done it, and lawyers pressing such claims have had difficulty articulating any such line. In both Press and Independent Order of Foresters, the courts criticized the formulation and drafting of the complaint as inadequate.417 In contrast, in Kwiatkowski II, the district court made great use of the detailed allegations in the complaint, and cited favorably the testimony of several experts that the plaintiff was exposed to an excessive risk of loss, that based on existing industry standards the defendants should have advised him of this risk, that the defendants did not provide sufficient supervision or monitoring of the plaintiff’s positions, and that the defendants failed to develop an appropriate “exit strategy” for liquidating the contracts.418 Thus, the difference in the cases may be due more to the quality of the lawyering than to any distinguishing feature of fact or law. The differences in these cases present some bitter ironies. Perhaps the existence of a duty depends more on the quality of the lawyering than on the facts in a particular case. Perhaps it is easier for a judge to jettison a case on a motion to dismiss, before the parties have had a chance to gather evidence, than on a motion for summary judgment, even though the law states that allegations made in a complaint are assumed to be true for purposes of deciding a motion to dismiss. In any event, judges and lawyers faced with fraud-related claims in derivatives cases have had a difficult time, and the result is pitiful: increased uncertainty for participants in the derivatives market and virtually no common law guidance. Lack of Authority The once-important topics of agency and authority receive short shrift in law school today.419 Yet in recent derivatives disputes, authority issues have been important, even dispositive. 415 See Compania Sud-Americana de Vapores, S.A. v. IBJ Shroder Bank & Trust Co., 1992 U.S. Dist. LEXIS 1948, at *46 (calling the suit by a plaintiff who was charged very high mark-ups in foreign currency transactions “merely an effort to avoid the repercussions of its lack of diligence in monitoring the rates at which conversions were made for over six years”). 416 See Kwiatkowski II, supra note 367, at *33. 417 See Independent Order of Foresters, supra note 359, at *8-10 (pointing out absence and limitation of allegations); Press, supra note 361, at 386-87 (characterizing complaint as “naked allegation”). 418 See Kwiatkowski II, supra note 367, at *39. 419 Many schools do not offer courses in agency, although the topic receives brief treatment at the beginning of many corporate law casebooks. See, e.g., WILLIAM A. KLEIN, J. MARK RAMSEYER & STEPHEN M. BAINBRIDGE, BUSINESS ASSOCIATIONS: CASES AND MATERIALS ON AGENCY, PARTNERSHIPS, AND CORPORATIONS 33-45 (4th ed. 1999) (discussing agency and apparent authority); see also MELVIN A. EISENBERG, AN INTRODUCTION TO AGENCY AND PARTNERSHIP 1-27 (3d ed. 1995). 2000] SYNTHETIC COMMON LAW 83 The authority argument in the context of derivatives is relatively simple. A financial derivative transaction is simply a contract, typically between two parties. If one party did not have legal authority to enter into that contract, it is not binding on that party. Alternatively, even if the party did not have actual legal authority, the party might be bound if there was apparent authority. Apparent authority is a common law concept holding that a principal may be bound by the actions of an agent who does not have actual authority when the principal acts in a way that reasonably could lead a third party to conclude that the principal consented to the agent’s exercise of authority.420 Plaintiffs have claimed in derivatives disputes that the underlying transactions were illegal or unauthorized.421 For example, in Sumitomo Corp. v. J.P. Morgan & Co.,422 Sumitomo argued both (1) that derivatives financing transactions entered into by an individual trader were unauthorized because only Sumitomo’s treasury department – not any individual trader – could authorize financing on behalf of Sumitomo, and (2) that the transactions were prohibited by Japanese law.423 These two claims – lack of authority and illegality – are often put together. Lack of authority stems from the fact that a grant of authority was illegal; illegality, in turn, implies that an individual lacked authority. Courts have held that contracts made in violation of a country’s law (or with a view of being in violation of that country’s law) are unenforceable.424 In Sumitomo Corp. v. J.P. Morgan & Co., for example, a Sumitomo copper trader, Yasuo Hamanaka, obtained financing from J.P. Morgan without the approval of Sumitomo’s treasury department or board of directors. Sumitomo’s argument was that if approval was required and not given, the transactions were null and void. Alternatively, Article 260 of the Japanese Commercial Code prohibited such financing transactions without approval of the 420 See, e.g., JAMES D. COX, THOMAS LEE HAZEN & F. HODGE O’NEAL, CORPORATIONS 129-130 (1997) (describing apparent authority). 421 The first prominent derivatives case in the area was a British case holding that derivatives transactions entered into by the London boroughs of Fulham and Hammersmith were contrary to law. See Hazell v. Hammersmith and Fulham London Borough Council, 2 W.L.R. 372 (1991). The state of West Virginia raised similar claims in West Virginia v. Morgan Stanley. See State v. Morgan Stanley & Co., 459 S.E.2d 906 (W. Va. 1995) Authority issues also arose in the Orange County litigation. Orange County sued the brokers who sold it certain derivatives and alleged that the transactions were ultra vires, or beyond the limits of the law. The specific allegation was that the investment strategy was so risky it violated California law, and that the brokers had a duty to halt their business dealings with Orange County and report the activities. See Orange County, Brokers File Cross- Motions for Summary Judgment, DERIVATIVES LITIG. REPTR., Oct. 15, 1998, at 5. Orange County also claimed that certain reverse repurchase transactions it entered into with the brokers violated state law and would have required voter approval. Id. 422 See Sumitomo Corp. v. J.P. Morgan & Co., No. 99-CV-8780 (S.D.N.Y. 2000). 423 See Memorandum of Plaintiff Sumitomo Corporation in Opposition to Defendants’ Motion to Dismiss Certain Claims in the Complaint, at 32, Sumitomo Corp. v. J.P. Morgan & Co., No. 99-CV-8780 (S.D.N.Y. May 25, 2000) (copy on file with the author). 424 See, e.g., Dornberger v. Metropolitan Life Ins. Co., 961 F. Supp. 506, 532-38 (S.D.N.Y. 1997) (contract made in violation of European law subject to rescission); Rutkin v. Reinfeld, 229 F.2d 248, 255 (2d Cir. 1956) (contract entered into “with a view of violating the laws of another country is unenforceable”). 84 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# board of directors.425 According to this argument, if Japanese law required board approval, and approval was not given, the transactions were illegal, and therefore were void. This case was pending as of August 2000. Authority issues can arise based on the scope of an investment agreement between two parties, where one is investing in derivatives on behalf of the other. For example, AT&T Corp.’s pension plan and the Massachusetts Pension Reserves Investment Trust lost a combined $162 million based on unauthorized trading by the chief investment officer of Rhumbline Advisers, an investment adviser the two pension funds were using.426 Authority issues also have arisen in recent derivatives disputes in Asia. For example, Indonesian corporations often have a two-tiered board structure and articles of association requiring that major financial transactions be approved by both boards: the board of directors, which has general executive authority, and the board of commissioners, which oversees and advises the directors.427 Unfortunately, Indonesian law and most articles of association are unclear about when the board of commissioners must approve a transaction. Although in theory, a party could eliminate authority- related risk by requiring the board of commissioner’s approval, most Indonesian companies balk at obtaining such approval.428 Plaintiffs in derivatives disputes often include along with lack of authority claims an argument that the derivatives were not suitable investments.429 The underlying rationale for suitability claims is similar to that for breach of fiduciary duty: the seller has an information, knowledge, or sophistication advantage over the purchaser and therefore owes the purchaser a duty not to mislead it about the risks of the instrument and, in any event, not to sell instruments that are too complicated for a particular purchaser to understand.430 Unfortunately, no jurisdiction has clarified what circumstances or facts would generate such a duty owed by derivatives seller to buyer. In addition, derivatives purchasers have brought an array of common law claims based on the notion that the instruments were 425 Article 260 provides that “[t]he Board [of Directors] cannot delegate the following decisions to a manager, but must itself make them: . . . (2) Borrowing a substantial sum of money.” 12 Commercial Laws of the World 40 (1993). The amount borrowed in this case was approximately $283 million (in Japanese yen), see Brief, at 33, arguably a “substantial sum.” 426 See DERIVATIVES LITIG. REPTR, supra, note 421, at 5. 427 See Bennett & Marin, supra note 305, at 30, n.121 (citing advice received by the authors from the Jakarta law firm of Ali Budiardjo, Nugroho, Beksodiputro). 428 See id. at 31 n.123. 429 See Bennett & Marin, supra note 305, at 35. For a recent general discussion of suitability claims in the securities context, see Lewis D. Lowenfels & Alan R. Bromberg, Suitability in Securities Transactions, 54 BUS. LAWYER 153 (1999). There are numerous articles about derivatives and suitability. See Lyle Roberts, Suitability Claims Under Rule 10b-5: Are Public Entities Sophisticated Enough to Use Derivatives?, 63 U. CHI. L. REV. (1996); Geoffrey B. Goldman, Crafting a Suitability Requirement for the Sale of Over-the-Counter Derivatives: Should Regulators Punish the Wall Street Hounds of Greed, 95 COLUM. L. REV. 1112 (1995). 430 This rationale is not based on some notion of fairness to particular purchasers. Rather, it is an economic-based rationale designed to benefit the derivatives industry as a whole. Without some such perceived protection, purchasers might not transact. 2000] SYNTHETIC COMMON LAW 85 not suitable. For example, in UBS Int’l Trustees Ltd. v. Morgan Stanley Dean Witter & Co.,431 the plaintiff alleged, as trustee on behalf of the purchaser who lost money on the instruments that the purchaser was not sophisticated in the use of leverage and derivatives.432 These suitability allegations supported common law claims of fraud, misrepresentation, and breach of fiduciary duty. In Springwell Navigation Corp. v. The Chase Manhattan Bank,433 the plaintiff alleged breach of contract, breach of fiduciary duty, fraudulent misrepresentation, negligent misrepresentation, professional negligence, and negligent supervision, all based on the defendant’s failure to inform the plaintiff that investments in certain emerging markets bond derivatives434 were very risky and unsuitable for the plaintiff’s goals.435 Unfortunately, the legal basis for suitability claims is wrought with ambiguity and confusion. Under U.S. law, suitability claims typically arise out of “securities” transactions only. The National Association of Securities Dealers has adopted suitability rules, including rules extending suitability obligations to broker-dealers selling securities to institutional customers.436 Outside of the U.S., the law is even less clear, and there are no guidelines or standards describing the suitability obligations of a derivatives seller.437 As in other areas of derivatives litigation, disputes over suitability typically are settled before judicial decision or trial.438 It is unclear whether suitability claims fit under breach of fiduciary duty439 or lack of authority,440 or whether they are even relevant in OTC derivatives disputes. Courts facing lack of authority claims have not clarified the issue. 431 UBS Int’l Trustees Ltd. v. Morgan Stanley Dean Witter & Co., No. 99 Civ. 8957 (S.D.N.Y. amended complaint filed Dec. 20, 1999). 432 See, e.g., U.K. Investment Co.’s Amended Complaint Names Morgan Stanley Director, SEC. & COMMODITIES LITIG. REPTR., Jan. 26, 2000, at 7 (describing sophistication difference between derivatives purchaser and Morgan Stanley). 433 Springwell Navigation Corp. v. The Chase Manhattan Bank,, No. 99 Civ. 11855 (S.D.N.Y. complaint filed Dec. 7, 1999). 434 A large portion of the plaintiff’s money was used to buy Russian derivatives consisting of CMSCI Notes, which were tied to Russian government short-term zero coupon ruble-denominated bonds known as Gosudarstvenniye Kratkosrochniye Obligatsii, or GKOs. See Greek Company Sues Chase Manhattan over $200M Bond Derivatives Loss, DERIVATIVES LITIG. REPTR., Jan. 10, 2000, at 4. Interestingly, the complaint’s description of the derivative instrument was incomplete, presumably because either the plaintiff or the lawyers or both were unable to understand and describe it. See id. (“The value of the Note was linked in as yet an unexplained way to the value of the underlying GKOs.”). 435 See id. 436 See NASD Release No. 34-37 588, 61 Fed. Reg. 44, 100 (1996). 437 See, e.g., Bennett & Marin, supra note 305, at 36 (noting that in Asia “[t]he local legal systems contain neither guidelines on what constitutes a suitable derivative nor express obligations on the part of a lesser of a derivative instrument to ensure that the instrument is suitable for the buyer in light of its particular circumstances”). 438 See id. at 36 n. 150, 38 n.160 (citing examples of suitability claims by TPI Polene PLC, a Thai plastic and cement maker, against UBS and claims by SK Securities, a Korean firm, against J.P. Morgan & Co., both of which settled for undisclosed amounts). 439 The question in this case would be whether unsuitable trades were made in violation of a duty owed by seller to buyer. 440 The question in this case would be whether unsuitable trades were beyond the authority of a purchaser. 86 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# Contract-Based Claims Finally, derivatives disputes often involve claims for breach of contract. A breach of contract claim can be relative straightforward, even in the derivatives context. For example, in a 1997 state court case in Maryland, a judge awarded $1.7 million to two businessmen who lost money on several currency swaps with FX Concepts Inc.441 FX Concepts claimed to have a sophisticated computer model that identified winning foreign currency bets.442 An official of FX Concepts had instructed the employee dealing with the two businessmen to tell them about certain risks in European currencies, and that employee failed to do so. The court found that failure to deliver this instruction was a breach of contract.443 I have found only one case involving OTC derivatives that went to trial, and that case essentially presented a breach of contract claim. Although numerous other claims were involved in the case, the verdict is based primarily on a breach of contract rationale. Unfortunately, this case provides no certainty at all to a prospective derivatives investor, and in fact contains confusing and contradictory statements about the applicable derivatives transactions. This case, BankAtlantic v. PaineWebber, Inc.,444 involved two interest rate swaps between two financial institutions: BankAtlantic and Homestead Savings, with PaineWebber serving as a broker to BankAtlantic. BankAtlantic lost more than $30 million on the swaps, and sued PaineWebber for breach of contract, breach of fiduciary duty, fraud, fraudulent concealment, negligence, and negligent misrepresentation. After a five-week jury trial in 1989, the jury returned a verdict in favor of PaineWebber. BankAtlantic appealed on various grounds, and the Eleventh Circuit affirmed. The opinion is notable, not for its analysis of any particular legal issues, but for how little guidance it provides to any derivatives market participant. The relevant portion of the Eleventh Circuit opinion – in its entirety – is as follows: “Based on PaineWebber’s recommendation, BankAtlantic entered into the two interest rate swaps with Homestead Savings (“Homestead”) in an effort to hedge its adjustable rate deposit payables against an increase in interest rates. Alleging non- performance under the agreement, BankAtlantic terminated the services of PaineWebber as financial advisor and employed another firm to assist with the interest rate swaps. During this time, interest rates were falling drastically, allegedly causing BankAtlantic to suffer losses in excess of $30 million. In August 1987, BankAtlantic brought suit against PaineWebber alleging these losses were caused by PaineWebber’s failure to disclose the risks involved in interest rate swaps, e.g., that if interest rates fell, the high yielding fixed rate mortgages would be prepaid as borrowers refinanced. BankAtlantic also alleged that PaineWebber failed to disclose its extensive relationship with Homestead, that Homestead 441 Investors Win $1.7 Million Award on Md. Claim Against Management Firm, SEC. REG. & L. REP., Oct. 17, 1997, at 1455. 442 Id. 443 Id. 444 See BankAtlantic v. Paine Webber, Inc., 955 F.2d 1467 (11th Cir. 1992). 2000] SYNTHETIC COMMON LAW 87 was not creditworthy and therefore that BankAtlantic should have obtained collateral from Homestead.” That is the relevant discussion, in its entirety. The remainder of the opinion is no more illuminating; neither is the district court’s three-page opinion and order denying the plaintiff’s assertions of error, motion for judgment notwithstanding the verdict, and motion for a new trial.445 Consider the questions someone considering a derivatives transactions would have about this case: What were the basic terms of the interest rate swap? Did BankAtlantic agree to pay a fixed rate and receive a floating rate, or vice versa? If BankAtlantic lost money when interest rates dropped, how were the swaps designed to hedge against an increase in interest rates? If these were truly interest rate swaps, what did the prepayment risk associated with fixed rate mortgages have to do with the transaction? How was Homestead’s credit and collateral related to BankAtlantic’s losses? Did BankAtlantic money lose money because the swaps moved in its favor and Homestead defaulted , or because the swaps moved against BankAtlantic? What was the relationship of the parties, and was it relevant? Were there alleged misrepresentations? A party looking for guidance from this case will not find answers. Other contract-based claims have been for excessive fees changed in derivatives deals. Between 1994 and 1997, Slovnaft A.S., the former Slovak national oil company, purchased four structured loans from Merrill Lynch International, Inc., and lost $175 million.446 Slovnaft sued Merrill in 1999 in New York state court alleging that crude oil-linked derivatives embedded in the loans had cost Slovnaft $75 million in “exorbitant” interest payments.447 Contractual duties can arise out of obligations described in standard form agreements signed by both parties. These agreements can serve as the basis for claims based on implied contractual duties. Judge Feikens found support for such a claim in the P&G case. In that case, Section 4 of the standard form ISDA agreement between the parties provided that each party must furnish specified information and that such information must also relate to any documents specified in the confirmation.448 In other words, the specification of such information in the standard form created a duty to furnish the specified information. New York case law establishes such an implied contractual duty to disclose in business negotiations. As Judge Feikens read this duty, it may arise where (1) a party has superior knowledge of certain information, (2) that information is not readily available to the other party, and (3) the first party knows that the second party is acting on 445 See BankAtlantic v. Paine Webber, Inc., 130 F.R.D. 153 (S.D. Fla. 1990) (three-page opinion, less than one page of which considers the plaintiff’s motions). 446 See Merrill Lynch Seeks Dismissal of $75 Million Slovnaft Derivatives, BANK & LENDER LIABILITY LITIGATION REPORTER, Jan. 19, 2000, at 10. 447 See Slovnaft A.S. v. Merrill Lynch Int’l Inc., (N.Y. Sup. Ct. 1999). 448 Judge Feikens wrote in the P&G case, “Documents that are referred to in the Confirmation (here I allude specifically to the documents that will enable a party to determine the correlation between the price and yields of the five-year Treasury notes and thirty-year Treasury bonds, the sensitivity tables, the spreadsheets regarding volatility, and documents related to the yield curve) should be provided.” Id. at 1290. 88 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# the basis of the mistaken knowledge.449 Such a duty to disclose may arise even in the absence of a fiduciary duty between the parties.450 Judge Feikens concluded “that defendants had a duty to disclose material information to plaintiff both before the parties entered into the swap transactions and in their performance, and also a duty to deal fairly and in good faith during the performance of the swap transactions.”451 As a result, even if the duty-based claims for breach of fiduciary duty, negligent misrepresentation, and suitability fail, an implied breach of contract claim may survive based on obligations created by swap documentation. Analytically, this result makes little sense. These claims all are based on essentially the same rationale:452 that sophistication or information asymmetry will support a duty to disclose material facts. This rationale is wrapped in different packages, each with a different jurisprudence, each with a small set of indeterminate cases. Not surprisingly, it is very difficult for parties to derivatives transactions – even if they agree on the facts – to know how or why a judge will resolve their dispute. The remaining two alternatives merit only brief consideration. They have presented only a handful of issues relevant to derivatives disputes. 3. The Limited Applicability of Private Law The implied breach of contract claim in the P&G case is a rare instance of a claim arising out of a private derivatives contract. These contracts are form agreements created by derivatives dealers and their lawyers, and – not surprisingly – are structured to ensure that derivatives contracts are not subject to federal regulation and to prevent most non-dealer derivatives parties’ claims in a dispute with a dealer from surviving.453 Private law has evolved in the derivatives area along two paths. The first path, designed for transactions between derivatives dealers, has ended in a very complete, self-regulatory mechanism of little relevance in the derivatives disputes discussed here. For private law enthusiasts, these packages of default rules are things of beauty. The standard form contract, created by the International Swap Dealers Association (ISDA), is a complete, well-constructed private law governing most contingencies that might arise between dealers.454 It is flexible yet comprehensive, and is a standard within the industry. 449 See Procter & Gamble, supra note 217, at 1290 (citing Banque Arabe et Internationale D’Investissement v. Maryland National Bank, 57 F.3d 146 (2d Cir. 1995)). 450 See id. (citing numerous New York cases). 451 See id. at 1291. 452 An additional rationale not yet addressed in any derivatives dispute is commercial frustration or impracticability. See supra note 333. 453 For a general description of such contract-based efforts in the securities context, see Margaret V. Sachs, Freedom of Contract: The Trojan Horse of Rule 10b- 5, 51 WASH. & LEE L. REV. 879 (1994). 454 The basic form contract is the 1992 ISDA Master Agreement (Local Currency – Single Jurisdiction). There also are more complex standard forms, forms in translation, as well as recent annexes with updated definitions. The basic form is available to non-members through the ISDA website for $25; the complete set of forms is $1,600. See <http://www.isda.org> (2000). 2000] SYNTHETIC COMMON LAW 89 But because few derivatives disputes are between dealers, it is largely irrelevant here. The second path, designed for transactions between dealers and non-dealers, is much shorter, ending in a relatively small number of non-reliance provisions included in the standard ISDA documentation, as well as in other documentation related to derivatives transactions between dealers and non-dealers, including term sheets, economic reports and forecasts, and analysis of particular trades, including “scenario analysis.”455 These non-reliance provisions, or “disclaimers,” which are virtually the same in every derivatives transaction, purport to absolve the dealer of liability associated with the transaction.456 A typical disclaimer says something like “the purchaser fully understands the above terms and conditions, including the risks and benefits of the transactions.” Derivatives sellers argue that if they obtain a signed disclaimer of a duty and/or provide adequate scenario analysis, a purchaser should not be able to sustain the common law claims articulated in Part V.B.2. For example, derivatives sellers argue that if a purchaser represents that the seller owes no duty to it, the buyer cannot later sue to recover on a duty-based theory; similarly, a buyer cannot later complain about oral misrepresentations if they are inconsistent with a later-signed written statement setting forth in an accurate way the substance of the allegedly misrepresented facts. There is an initial question about whether disclaimers actually are negotiated provisions that should be enforced against buyers. If some derivatives contracts were sold with disclaimers and others were not, there would be an argument that the disclaimers were both negotiated and priced by the parties. It is more difficult to make this argument when there is unanimous use of essentially similar disclaimers. It seems incredible to argue that each such disclaimer was priced and negotiated in a multi-trillion dollar argument. Neither is it credible to argue that it is sufficient if a small number of disclaimers are priced and negotiated because then all contracts will reflect those prices and negotiations; such an argument makes little sense in a market consisting of privately negotiated, often-confidential transactions. However, even if one assumes that the disclaimers were negotiated and are not adhesion contracts, there are other strong reasons to believe neither a signed disclaimer nor a detailed scenario analysis should preclude a duty-related claim. First, disclaimers or scenario analyses may be misleading, inadequate, or fail to disclose important information the seller possesses that the buyers does not.457 For example, prior to the Asia crisis, numerous investment and commercial banks had information about specific countries’ central 455 Analysis of particular trades includes “scenario analysis,” which describes the gains and losses on a particular derivative transaction based on changes in one or more variables. For example, scenario analysis for a swap based on a particular index might show the financial position of the purchaser given a increase or decrease of one, two, and five percent in the index. 456 Courts have upheld such nonreliance clauses in the securities context. See, e.g., Rissman v. Rissman, 213 F.3d 381 (7th Cir. 2000) (holding that written non- reliance clause prohibited recover based on prior oral statements). 457 See, e.g., Bennett & Marin, supra note 305, at 39 (“A scenario analysis that is based on historical volatility, for example, may prove to be inadequate if markets move in an unexpected manner.”). 90 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# bank practices and currency reserves and were in fact taking large speculative positions based on this information. Any bank selling derivatives based on foreign exchange rates in those countries would have an obvious information and knowledge advantage. If the bank did not disclose this information, and made other disclosures (including scenario analysis) that would be made misleading by this information, any purchaser of derivatives from the bank would have a strong argument that the bank owed that purchaser a duty (because of the superior information and knowledge) and breached that duty (because of the omissions and misrepresentations). In addition, a disclaimer must be sufficiently specific to disclaim the misrepresentations and omissions that form the basis of a purchaser’s claim. For example, the Second Circuit has held that the contract language must “match the alleged fraud.”458 The New York appellate courts have held that a disclaimer of reliance on representations must be specifically related to the contents of the fraud claim.459 For example, disclaimers related to the “physical nature of the premises” and “environmental matter” were not sufficiently specific to preclude a fraud claim based on the “presence of underground tanks containing possible toxic chemicals.”460 The policy behind these cases is, consistent with hypothetical bargain analysis, that purchasers would not willingly accept a broad disclaimer absent some reduction in price or increase in quality. At the extreme, purchasers cannot (and would not ex ante) disclaim fraud. Accordingly, such disclaimers should be read narrowly, especially when the parties were in a situation involving information or sophistication asymmetry. To the extent disclaimers arise as issues in derivatives disputes, they should be read narrowly and certainly should not be read to preclude purchaser claims based on inaccurate or misleading statements. Even ISDA, the dealers’ own organization has recognized this principle.461 No court has yet published an opinion on this issue in a derivatives dispute. The first judge to do so should carefully consider the implications of informational asymmetry in a hypothetical bargain analysis, and should not simply accept a dealer’s attempts to skirt a principle in a dispute that it previously had endorsed through ISDA as good policy. 4. Some Attempts at Arbitration Given the problems associated with the alternative means of resolving disputes, one might expect derivatives counterparties to sign arbitration clauses. Yet arbitration of such disputes is rare. One reason may be that both counterparties fear the uncertainty associated with an arbitrator even more than they fear the courtroom. The recent evidence of New York Stock Exchange arbitration panels 458 See Manufacturers Hanover Trust Co. v. Yanakas, 7 F.3d 310, 317 (2d Cir. 1993). 459 See Hi Tor Industrial Park v. Chemical Bank, 494 N.Y.S.2d 751 (2d Dep’t 1985). 460 See id. at 752. 461 See Raj Bhala, Applying Equilibrium Theory and the FICAS Model: A Case Study of Capital Adequacy and Currency Trading, 41 ST. LOUIS L.J. 125, 209 n.369 (1996) (citing ISDA’s strong recommendation that U.S. members follow the ISDA Principles and Practices for Wholesale Financial Market Transactions). 2000] SYNTHETIC COMMON LAW 91 ruling against Wall Street investment banks in ways the banks did not expect would support this reason.462 Another reason may be that more sophisticated counterparties may prefer the less fair forum of court precisely because it is more expensive. In court, a derivatives dealer can force a plaintiff to engage in expensive litigation, which the dealer easily can afford, but which the purchaser may find more difficult to sustain, especially given the expense of discovery. Delay typically works to the dealer’s advantage. If the case seems to be moving in the plaintiff’s favor, the dealer can, and will, simply settle to avoid an adverse ruling. There is little evidence of derivatives disputes moving from court to arbitration. On the other hand, it seems clear that parties to a derivatives contract may effectively incorporate external law into an arbitration agreement, or may authorize an arbitrator to decide such questions of external law.463 Parties also may, by agreement, establish discovery rules, including rules resembling those applicable to disputes in federal court.464 These benefits might make arbitration more attractive to derivatives market participants. The evidence of arbitration agreements in the derivatives market is scant and very recent. In late 1999, Panama-based Dorigol S.A. agreed to arbitrate a derivatives dispute with J.P. Morgan & Co. before a National Association of Securities Dealers panel.465 Dorigol had filed sued in the Southern District of New York, alleging J.P. Morgan committed fraud when it sold Dorigol OTC call and put option on Brady bonds without disclosing facts it knew about risks in that market.466 Specifically, Dorigol alleged J.P. Morgan knew it was going to issue a margin call against Long-Term Capital Management in late 1998, and that such a margin call would cause the market for emerging market bonds to collapse.467 In fact, this market did collapse, and Dorigol ultimately lost $7 million on the trades.468 Although attorneys for J.P. Morgan were advocating the move from court to arbitration, attorneys for Dorigol also suggested they might be better off with an arbitration panel.469 Resisting arbitration would have been expensive, and not necessarily in Dorigol’s best interest. Morgan did not disclose its motives in moving to arbitration. 462 See Smith, supra note 176, at C1, C4 (citing several awards to employees in bonus disputes with their employer bank). 463 See COOPER ET AL., supra note 149, at 153 (“No one doubts that the parties may authorize the arbitrator to decide external law questions, either by incorporating the law in the … agreement or by posing the external law issue in the submission agreement.”). Where private parties have not indicated that particular external law should govern, arbitrators are not constrained by external law or cases. See id. at 247 (noting that “arbitrators usually do not treat as conclusive the determinations of administrative agencies or courts”). 464 See id. at 225 (describing contract assuring parties access to “all nonconfidential information as is relevant and appropriate to the negotiation, maintenance and enforcement of this agreement”). 465 See Panamanian Firm, J.P. Morgan Agree to Arbitrate $7M Derivatives Case, SECURITIES LITIG. & REG. REPTR., Jan. 12, 2000, at 8. 466 Id. 467 Id. 468 Id. 469 Id. (quoting one attorney for Dorigol as saying “educating an already ‘highly educated’ panel about financial derivatives will be much easier than educating a lay jury”). 92 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# In a similar case, in early 2000, Lehman Brothers Inc. filed a motion asking the Southern District of New York to stay a suit against Lehman and compel arbitration.470 The plaintiff, Banco Disa S.A., a Panamanian bank, had filed suit alleging common law breach of fiduciary duty, fraud, and negligent misrepresentation, as well as fraud and misrepresentation under Section 10(b) of the Securities Exchange Act, for losses it incurred on several investments in U.S. Treasury-based derivatives.471 Again, the parties’ motivations were unclear. The defendant banks may have been motivated by very large, recent settlements other banks had agreed to pay in other cases.472 To the extent the motivations were to avoid large settlements encouraged by the unpredictability of a jury verdict, the role of arbitration in derivatives disputes might become more substantial over time, as it has in other areas.473 C. How Synthetic Common Law Could Govern Disputes Parties to derivatives transactions could eliminate much of the uncertainty surrounding such transactions by agreeing ex ante to have a synthetic common law regime govern any future disputes. This section explains the arguments in favor of synthetic common law and suggests a few synthetic cases for parties to use.474 Most obviously, parties could select or modify already-decided cases to include as part of a contract. For example, parties might include Procter & Gamble v. Bankers Trust,475 but eliminate Judge Feikens’s sweeping statement about duties and obligations in swap transactions. Alternatively, parties might adopt the facts of the case, but have the judge in the case refuse to grant summary judgment in 470 See Lehman Brothers Files Motion to Compel Arbitration in $6.6M Dispute, BANK & LENDER LIAB. LITIG. REPTR., Jan. 19, 2000, at 3. 471 Banco Disa S.A. v. Lehman Brothers Inc., No. 99 Civ. 9487 (S.D.N.Y. 1999). The suit contended that Lehman knew the portfolio was risky and unsuitable, but pressed the risky strategy in order to make commissions and fees. See $6.6M Dispute, supra note 470, at 3. 472 In 1998, several investment banks paid very large settlements to settle suits related to Orange County’s 1994 bankruptcy. Merrill Lynch paid $400 million, the fifth-largest settlement in Wall Street history; Morgan Stanley paid $69.6 million; CS First paid $52.5 million. See Credit Suisse First Boston Settles Orange County Suit for $52.5 Million, SEC. REG. L. REP., May 15, 1998, at 748; FIASCO, supra note 323, at 268. In agreeing to settle these claims, CS First Boston’s CEO, Allen Wheat, noted that “given the magnitude of the County’s losses and the fact that litigation is unpredictable and distracting for any firm, this settlement is the right course of action.” Id. Similarly, Bear Stearns & Co. paid $39 million to settle a suit brought by three bankrupt hedge funds alleging fraud in the sale of collateralized mortgage obligations known as “toxic waste.” See Bear Stearns Settles Granite Partners “Toxic Waste” CMO Suit for $39M, DERIVATIVES LITIG. REPTR., Jan. 24, 2000, at 4. The losses, totaling $225 million, were incurred following the Federal Reserve Board’s increase in interest rates in 1994. 473 See supra Part III.C. 474 I am including the synthetic cases for illustrative purposes only, and I would defer to the choices of current derivatives market participants (and their lawyers) to determine whether particular cases satisfy the expectations of the parties to a particular contract. In fact, it is precisely such deference to the market – based on the assumption that private parties will choose the cases that most efficiently and fairly would govern any dispute – that is critical to the success of a synthetic common law regime. 475 See Procter & Gamble, supra note 217. 2000] SYNTHETIC COMMON LAW 93 favor of Bankers Trust, perhaps noting that a fiduciary relationship existed. Similarly, parties might adopt the facts of the SEITA case,476 but reverse the outcome, or incorporate Press, Independent Foresters, and Kwiatkowski II into a single, sensible decision.477 In addition, parties could create new cases to govern future disputes. The following cases are meant to be illustrative, not comprehensive, and indicate the types of issues that parties might decide to address in individual cases. In addition, parties could specify how important certain facts were to the decision in the case, or what type of reasoning they would like an adjudicator to use if the facts do not match the facts of the case. First, the regime could reduce uncertainty associated with differential statutory coverage of derivatives.478 The parties would make it clear that federal securities and commodities statutes did not govern their disputes. For example, the menu of cases could include the following illustrative case: Case No. 1: Party A and Party B enter into the derivative transaction described in the attached term sheet.479 Party B loses money and sues in federal court, claiming the federal securities laws should govern the dispute because derivative is a “security.”480 Held: the derivative instrument is not a security. Note that the above case depends on the acquiescence of the federal courts. When Party B filed suit, the judge drawing the case would need to recognize the party’s prior agreement to resolve all disputes through the synthetic common law regime, and dismiss the claim. Notwithstanding the Supreme Court’s statement that such dismissal is warranted based on the parties’ prior agreement,481 there is some risk that a judge would refuse to dismiss the claim. In such an event, the parties would bear the litigation costs associated with an appeal, and the litigation risk of a change in Supreme Court position. However, this same problem is present for arbitration generally and does not appear to be serious. In any event, the costs would be lower than the costs of litigating a federal claim, which neither party believed ex ante would govern any future dispute. Second, synthetic cases could reduce the uncertainty associated with ambiguous common law decisions. For example, consider the case law dealing with lack of authority claims.482 To the extent parties are concerned, as they seem to be, that one party could avoid its obligations on a derivatives contract simply by refusing to pay any losses, the parties could include a case holding that refusal to pay would be a breach of the derivatives contract, entitling the non- breaching party to damages under the regime. 476 See Societe Nationale, supra note 353. 477 See discussion at notes 361 to 383 and accompanying text. 478 This uncertainty is described in detail supra at Part V.B.1. 479 The parties would simply attach or incorporate by reference a copy of the term sheet for their transaction, once the terms are finalized. 480 The parties could include a similar case to make it clear the commodities laws did not apply, either. 481 See cases cited supra note 169. 482 See supra notes 421-437 and accompanying text. 94 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# Case No. 2: Party A and Party B enter into the derivative transaction described in the attached term sheet. Party B provides evidence that the transaction is both legal and authorized.483 Party B loses money and is in “default”484 on the transaction. Party B claims the contract is illegal and unenforceable. Held: unless another case in this menu establishes otherwise,485 Party A is entitled to payment from Party B of the amount owed. Including such a case in a derivatives contract might resolve the problem of authority in a way statutes or cases could not. Recall the problem associated with the Indonesian statute requiring board approval, notwithstanding the fact that it often is impracticable to obtain such approval. An Indonesian statute could specify when a contract will be binding on an Indonesian company even without board of commissioner’s approval. Alternatively, Indonesian courts could hear and resolve cases, preferably by reported opinion, in a way that provided guidance to future parties. However, neither resolution by statute nor common law seems likely, given the dearth of finance- related legislation and cases. Nor does it seem probable that a treaty or executive agreement between Indonesian and another country would allow parties to choose another, clearer legal regime, with the knowledge that they would be able to collect and enforce a judgment. A synthetic common law regime could specify what types of contracts would require board of commissioner’s approval, and give plenty of examples, based on easy-to-discern variables, such as notional amount, value-at-risk, and scenario analysis, as functions of revenue, net income, or some other accounting variables. The parties to the contract could choose among these regimes the one most closely corresponding to their expectation of which transactions would be authorized. Unauthorized transactions would be unenforceable, although such transactions still might occur with adequate collateral. As an alternative, or perhaps additional, synthetic case, consider the following. Case No. 3: Party A and Party B enter into derivative transactions with a notional value in aggregate of [$100 million] or less. Party B is an Indonesian company and therefore normally must obtain the approval of its board of commissioners for any derivative transactions. Party B loses money on the derivative transaction described in the attached term sheet and fails to pay Party A. Party B’s board of commissioners did not approve the transaction. Held: the transaction was deemed approved because Party A and Party B had entered into derivative transactions with 483 Such evidence might include the signed authorization of the board of directors or particular managers, applicable powers of attorney, or even a video or audiotape of a conversation in which the purchaser authorized approval of the transaction. 484 Events of default are specified in great detail in the standard form ISDA agreement already used by derivatives counterparties. Accordingly, the parties could simply make reference to that agreement and incorporate the definitions there by reference. 485 For example, another case might hold that if Party A defrauded Party B, then Party B would not be liable. 2000] SYNTHETIC COMMON LAW 95 notional value of [$100 million] or less, and Party A therefore is entitled to payment from Party B of the amount owed. Similar problems arise when the purchaser of derivatives attempts to renege by claiming one its employees (a “rogue trader”) engaged in unauthorized trading in those instruments. This issue has arisen in numerous cases, including disputes between three Chinese companies and Lehman Brothers Inc.,486 between Sumitomo Corp. and several large banks,487 and between a Malaysian company and Credit Suisse.488 Many of these suits were filed under non-U.S. legal regimes that do not recognize the common law doctrine of apparent authority. As a result, derivatives sellers need to assure themselves before a transaction occurs that the agent for the purchaser has actual authority. A synthetic common law regime would enable the parties to specify in advance what facts would constitute apparent authority. For example, the synthetic cases might find that there was authority when an employee with the title “managing director” (or some similar title) signs a derivatives contract, representing that she has authority to act on behalf of the purchaser. Or the case might say that it is not enough to rely on only one signature; two or three are required. Or the case might require board approval for each transaction. In any event, the parties in advance could choose the law that fits their situation best. Significantly, the fact that parties engaged in deliberations about the choice of synthetic law would be strong evidence that they considered the authority issue in advance and that the transaction would be either authorized or not, if the facts fit one of the hypothetical synthetic cases. As to other common law claims, the parties could include cases related to duty-based claims (i.e., breach of fiduciary duty or negligent misrepresentation), describing several relationships and then concluding for each whether a particular duty existed. Then, if the parties’ relationship changed over time, a duty might or might not be 486 The suits occurred after United Petroleum & Chemicals Co., China National Chemicals Import & Export Corp., and Minmetals International Non-Ferrous Metals Trading Co. refused to pay amounts owed to Lehman on various foreign exchange and interest rate derivatives transactions. Each Chinese firm claimed the trades were unauthorized because the employees who signed the contracts did not have the necessary corporate authority. The argument was simple: if the trades were unauthorized, they were unenforceable. In each case, Lehman filed suit in the Southern District of New York for breach of contract. See Victor Hou, Derivatives and Dialectics: The Evolution of the Chinese Futures Market, 72 N.Y.U. L. REV. 175, 187 (1997). 487 Sumitomo sued Union Bank of Switzerland (in Tokyo District Court) and Chase Manhattan Bank (in the Southern District of New York) claiming that the banks had made unauthorized loans to Sumitomo’s head copper trader who had engaged in unauthorized copper trading, sustaining losses of $2.6 billion. Sumitomo alleged not only that the banks knew that the trader was not authorized to take out loans, but that the banks had disguised the loans as derivative swap transactions to help hide the unauthorized losses. See Bennett & Marin, supra note 305, at 33. 488 Malaysian conglomerate Berjaya Group lost $14 million on a derivatives transaction between Credit Suisse and Berjaya’s Cayman Islands’ subsidiary, and sued in Malaysia High Court, claiming the transaction was unauthorized because the Berjaya director who entered into the transaction had not obtained the required approvals. See Stephen Duthie, Berjaya Group Files Suit Over Interest Rate Swap, ASIAN WALL ST. J., Mar. 7, 1995, at 3. 96 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# triggered. The parties could do the same for fraud-related claims. Cases might specify what type of misrepresentation would be actionable. Consider the following case: Case No. 4: Party A and Party B enter into the derivative transaction described in the attached term sheet. Party A sends to Party B the attached scenario analysis.489 Party B loses materially490 more money on the derivative than the scenario analysis had indicated Party B would lose. Held: Party A is not entitled to payment from Party B of any amount owed, and Party B is entitled to payment from Party A of any amount owed. A series of similar cases could define the parameters of the actionable misstatements, and thereby define precisely the parameters of any disclaimer statements included in the contracts.491 The cases would provide a guidepost indicating what sort of behavior would constitute reasonable reliance by the purchaser. Descriptions of cases in an ISDA Master Agreement might even cover which contracts would fall under anti-gambling statutes.492 For example, synthetic cases involving direct bets on a single economic variable (i.e., interest rates, foreign exchange, stock prices) would be enforceable, whereas cases involving complex bets on multiple economic variables that could have been made more simply, or that involve non-economic variables (e.g., bets on a sporting event) would be unenforceable. Finally, a synthetic common law regime could incorporate whatever aspects of private law and private adjudication the parties 489 A scenario analysis indicates how a particular instrument is expected to perform, given changes in one or more variables. Typically, scenario analysis is provided by the more sophisticated derivative seller (e.g., Party A) to the less sophisticated derivative buyer (e.g., Party B). For example, consider a derivative contract that paid Party B $10 million x (JPY/USD – 100)/100 minus $10 million, where JPY/USD is the Japanese Yen to U.S. Dollar exchange rate at the maturity of the contract. A scenario analysis might resemble the following: JPY/USD Payment Owed To (From) Party B 120 $2 million 110 $1 million 100 $0 million 90 ($1 million) 80 ($2 million) If the numbers in the “Gain (Loss) to Party B” column were materially inaccurate, Party A would not be entitled to payment from Party B of any amount owed. For example, if materially was defined to be a deviation of more than one percent, and the scenario analysis indicated that if JPY/USD = 80, the Payment Owed To (From) Party B would be ($1 million), when the actual expected amount owed was double that amount, then Party A would not be entitled to payment of the $2 million owed to Party A by Party B. 490 Materially could be defined to be more than a certain percentage above the amount of losses indicated in the scenario analysis. If the payoff from the derivative security was linear, the exact amount of loss implied by the scenario analysis could be calculated simply using linear interpolation. If the payoff from the derivative security was non-linear, the exact amount of loss implied by the scenario analysis could be calculated by Party A, with review by the adjudicator and/or appointed experts. 491 See supra notes 454-461 and accompanying text. 492 See supra notes 316-324 and accompanying text. 2000] SYNTHETIC COMMON LAW 97 found of value. Nothing in the regime would prohibit parties from signing a detailed ISDA agreement, or from specifying additional provisions in the form of private law contractual language. Neither would the regime prohibit the use of already-established arbitration or mediation regimes, to the extent they were to accept the methodology of reasoning by analogy to synthetic cases. Synthetic common law simply adds another arrow or two to the quiver. D. Institutional Barriers to Synthetic Common Law What are the barriers to parties implementing a synthetic common law regime today? There are several. First, there is no evidence private parties have actively considered the idea; it may be the case that no private party has thought to consider such a regime, or that a few parties have considered it but either did not implement the regime or did not publicize their implementation. Second, arbitrators and arbitration systems might benefit from uncertainty about future decisions. Arbitration regimes appear to have a degree of market power493 and might benefit if its legal rules and conclusions remain both secret and indeterminate.494 Synthetic common law would turn arbitration into a much more commodity-like product than it currently is. Third, the prohibition of judicial advisory opinions495 prevents courts from using synthetic common law, and might lead some courts to balk at enforcing awards if the decision used advisory opinions. The synthetic cases could be considered advisory opinions, although it is arguable they are simply an expression of the intent of the parties, in case form. Of course, if a federal district court were to implement directly a synthetic common law regime, it almost certainly would be reversed. But there is little reason to believe a court’s reliance on such a system, especially given the limited standards of review of arbitration judgments, would trigger much appellate court scrutiny. Fourth, it is possible that there is market failure in the market for competitive adjudication firms. There is some evidence that the market for arbitration does not work particularly well, and there are structural reasons competition among adjudicators might not be effective. Judge Richard Posner has considered and rejected the notion that a competitive industry might evolve in which adjudicators competed for business, although he seems to have assumed such competition could occur only on an ex post basis.496 Posner appears 493 There are reasons to believe arbitration may be the sort of business that leads to oligopoly: there are economies of scale associated with arbitration, arbitration may be a natural monopoly, and there may be a path dependence story in which particular regimes are chosen first and then persist. In any event, there are only a few arbitration regimes, the market is highly concentrated, and there has been very little entry into or change in structure of the arbitration industry. 494 See Kamar, supra note 34 (making the same indeterminacy argument for Delaware corporate law). 495 See HART & WECHSLER'S THE FEDERAL COURT AND THE FEDERAL SYSTEM 65-67 (Paul M. Bator et al., eds., 3d ed. 1988). Some state courts do not have a constitutional prohibition against advisory opinions. See Barry Latzer, Whose Federalism?, or Why “Conservative” States Should Develop Their State Constitutional Law, 61 ALB. L. REV. 1399, 1413 (1998) (noting that “some state courts, unlike the Supreme Court, have no prohibition against advisory opinions”). 496 “Hiring competitive judicial firms is not the answer either, quite apart from the difficulty of maintaining consistency of legal decisions. Competition doesn’t 98 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# not to have considered the possibility of dispute resolution firms competing on an ex ante basis, as private synthetic common law services would. In such a competitive environment, private parties easily could assess the quality of firms, as well as the menu of already- decided cases. Private parties considering competing firms could examine the cases offered, read any additional decisions by the firms, examine other representations as to process or mode of reasoning, and then – after any dispute – compare the result with prior cases and representations. Firms whose decisions did not match the agreed- upon cases would not exist for long, because they would acquire a reputation for such decisions, and private parties would not choose them. By writing clear opinions in the cases it adjudicated, a firm could obtain a competitive advantage over firms not offering such opinions. For example, parties clearly are able to obtain sufficient information to enable them to choose which judge in a particular district they would like to govern their dispute; in fact, the selection of a particular judge typically drives the parties’ litigation strategies.497 Fifth, private law typically has been generated by sophisticated parties, who benefit from the use of uniform contract terms when contracting with less sophisticated parties. A few investment banks, and primarily a single law firm, developed the standard form ISDA contracts used in the derivatives area, and an unsophisticated party is at a great disadvantage when negotiating over such documents with an investment bank’s lawyers. As a result, many of the ambiguities and omissions in these contracts may be intentional on the part of the investment bank, but unanticipated or unknown on the part of the less sophisticated counterparty. Synthetic common law might not generate as serious an information asymmetry problem as private law ISDA provisions, because a description of the results in particular cases would be more obvious, even to an unsophisticated counterparty. Suppose a sophisticated party selects synthetic cases that are unfavorable to the unsophisticated party; at least in this instance, the unsophisticated party would be able to (and likely would want to) read the cases and might even recognize an unfavorable result. In contrast, an unsophisticated party presented with a long, standard-form contract written in broad, general terms is less likely to read the contract and even less likely to understand it. If synthetic common law would impose costs on the more sophisticated party to an established contractual arrangement, that party naturally would oppose the regime. These arguments indicate some reasons why synthetic common law is not the way of the world today, and some obstacles that would need to be overcome in order to implement a synthetic common law regime. They do not indicate that a synthetic common law regime would be inefficient or unfair. There is support for private law regime generally, and the Supreme Court has endorsed the notion of two contracting parties in different jurisdictions specifying ex ante the law work well when customers cannot determine even roughly the quality of the output offered by the competing firms and when warranties or equivalent guarantees are infeasible.” POSNER, OVERCOMING LAW, supra note 123, at 115. 497 A recent example of this was the selection of Judge Thomas Penfield Jackson to adjudicate the antitrust suit by the U.S. Department of Justice against Microsoft. 2000] SYNTHETIC COMMON LAW 99 to be applied to their contractual relationship.498 These barriers could be overcome, and, at the very least, the arguments supporting the regime merit a try. VI. CONCLUSION Certainty is important. When the common law or its alternatives cannot provide certainty, private parties may benefit from a system of synthetic common law. In areas of rapidly evolving technology, it is increasingly difficult for either public or private entities to specify useful legal rules ex ante. In addition, as the cost of resolving disputes increases, it is more difficult for judges or arbitrators to resolve disputes in a fair and efficient manner ex post. A synthetic common law regime captures the ex ante advantages associated with statutes, while preserving the flexibility associated with ex post adjudication. In this article, I have analyzed how parties transacting in derivatives markets might use synthetic common law to resolve their disputes. The proposal would provide much needed certainty to derivatives market participants.499 I also have attempted to set forth enough general principles and arguments to guide scholars in other areas of rapidly evolving technologies500 to make use of the synthetic common law idea. As our society shifts to more synthesized experiences and virtual realities, it is tempting to stick by what is authentic and real. Real common law will always have a place in modern society, just as some people always will prefer organic food, natural fur clothing, antediluvian housing, and interacting with human beings rather than computers. But in some segments of society, the cost of holding fast to reality based on subjective or uncertain belief is too great. In those areas, it is time to consider abandoning the reality of law. 498 See Scherk v. Alberto-Culver Co., 417 U.S. 506, 516 (1974) (stating that where the governing law is unclear “[a] contractual provision specifying in advance the forum in which disputes shall be litigated and the law to be applied is, therefore, an almost indispensable precondition to achievement of the orderliness and predictability essential to any international business dispute . . . .”). 499 It is difficult to overstate the importance of certainty to the derivatives markets. Following the uncertainty associated with unwinding transactions involving Long-Term Capital Management in August and September 1998, the volume of derivatives trading dropped markedly. The Bank for International Settlements said the “most striking development” in the derivatives market during the first half of 1999 was the sharp decline in foreign exchange contracts, a decline that began during the second half of 1998. See Global Derivatives Statistics, supra note 269, at 6. 500 Likely candidates for a synthetic common law regime include telecommunications, intellectual property, computer law, the Internet, and perhaps commercial or corporate law.