For many years, the traditional law and economics literature advocated strongly against legal transition relief. Led most prominently by Louis Kaplow, scholars argued that we should treat legal transitions no differently from other types of transitions faced by societal actors, for which the government does not provide relief. Recent commentary, however, questions the scope of Kaplow’s claim. Scholars have pointed out that considerations of efficiency, incentives for socially desirable investments, governmental legitimacy, and fairness might justify legal transition relief.

Assuming then that transition relief is appropriate under at least some circumstances, we identify two centrally important questions for which scholars have yet to find satisfactory answers. First, while societal actors often hedge against transitions in technology and the economy by obtaining insurance in the private market, such a market does not exist with respect to legal transitions. We attempt to explain its puzzling absence. Second, commentators who advocate transition relief in limited circumstances do not confront the critical question of what institutional structure is best designed to ensure that transition relief is meted out only where justified and in an appropriately limited form. We suggest a framework for allocating authority over transition relief within the government.

First, there exists no meaningful market for regulatory insurance in the United States—not even a market for insurance against government takings (which would appear to be a much simpler endeavor). In attempting to explain this gap in the market, scholars have pinned the blame on a variety of the usual economic culprits: moral hazard, adverse selection, and the difficulty of finding uncorrelated risks. But we do not believe that these effects, or any combination of them, can explain the lack of a private market.

Moral hazard problems exist when an insured party engages in behavior—particularly as a consequence of purchasing insurance—that the insurer has not priced into the contract. So long as coverage is based upon a firm’s current business rather than hypothetical developments and new product lines, the insurer should be able to accurately price the firm’s behavior. A fixed-payment insurance contract that provided a lump-sum payout in the event of regulation, rather than one that protected a firm against its full losses, would protect the insurer against threats of moral hazard. Similarly, insurers would need to protect themselves against lobbying that increased the likelihood of regulation. Insurers should again be able to cure these moral hazard problems through contract. The parties simply could write regulatory insurance contracts to ban any lobbying activities by insured firms (and to force them to take no public position on relevant regulatory action). And it should not be difficult for insurers to monitor this type of activity. Thus, it seems unlikely that private insurance markets have failed to arise due to unavoidable moral hazard problems.

Several scholars have suggested that adverse selection problems are likely to plague systems designed to insure against takings or regulation. For instance, homeowners who know that they are more likely to be subject to takings will opt into insurance plans at higher rates. Like threats of moral hazard, however, adverse selection problems depend at their core on information asymmetries. If all relevant information is public, insurers can price contracts accurately, and higher-risk private parties who wish to opt in will be able to do so only at elevated rates. Information asymmetries may be present in the context of takings of real property, but they are unlikely to plague more general regulatory insurance. The key to the adverse selection problem for takings insurance is that both the vast majority of the relevant governmental action and the potential insured parties are local, while the principal insurers are not. It is this geographic and political divide that gives rise to the necessary informational asymmetries. The types of economic regulation that concern us here, by contrast, are rarely local; they are almost always created by state and federal governmental entities. There is negligible private information about these types of regulation (except the information held by the government actors themselves), and so regulated firms possess essentially no informational advantage over their putative insurers. Without such an asymmetry, there can be no problem of adverse selection.

Finally, state and national regulation can have potent and widespread effects, particularly if it comes from a populous, highly industrialized state such as California or New York. The difficulty in assembling a portfolio of truly uncorrelated risk positions in the face of such widespread single-event threats might be preventing a robust market for regulatory insurance from forming. We do not, however, believe that this is the case. Well-conceived regulatory insurance would cover only one (or a finite number) of the potential business risks to a firm. A potential insurer could select which of these many available risks it is willing to assume, knowing that any individual regulation would lead only to a partial decrease in firm value—not the complete destruction of the firm. In a competitive marketplace of multiple insurers, any given firm should be able to find one or more insurers willing to take on some slice of risk. Thus, a fear of correlated risks cannot account for the complete absence of a market for regulatory insurance.

Rather, we believe that the major impediment to a private market for legal transition insurance is the chore of pricing. In comparison to typical accidents, significant regulatory acts occur extremely infrequently, usually numbering just below one thousand per year nationally. Even this description overstates their quantity in the same way that a reporting of all fires, floods, automobile accidents, and illnesses would overstate the effective number of insurance claims (and thus the number of useful data points) in a given year. Each federal agency issues no more than a handful of regulations each year, and thus any given regulatory field is altered only rarely. Without a broader pool of data to draw upon, an insurance firm cannot reliably estimate the hazards presented by any given regulation. In addition, unlike traffic accidents or house fires, regulatory acts are effectively one-off, nonstochastic events. An individual fitting a given demographic profile in 2005 is, for the most part, equally likely to have an automobile accident as a similarly situated individual in 2006; what variation exists is captured by the easily obtainable demographic information that insurers collect. Accordingly, data from 2005 are useful in predicting 2006 outcomes, data from 2004 are useful in predicting both 2005 and 2006, and so on. The likelihood of a particular regulation, on the other hand, depends upon a wide variety of factors, the impact of which is often unobservable or unpredictable. A shift in agency leadership or political priorities, a transfer of governmental power, a change in membership or chairmanship on a key committee, or even new developments in science or technology (or even culture) can affect the probability of any given regulation in any particular field in unforeseeable ways.

Worse still, regulation in one period is not necessarily a good proxy for regulation in another period. The fact that the EPA has acted once to regulate the level of arsenic in drinking water has ambiguous effects on the likelihood that the agency will act again, either to raise or lower allowable levels. It may indicate that a similarly situated EPA will tighten the arsenic standard; it may lead the EPA to learn that the current level of protection is needlessly high and prompt a relaxation of those limits; or it may simply indicate that the EPA already has selected a near-optimal level of regulation and that the status quo is likely to persist. Based on available quantitative data alone, an outside observer has almost no capacity to select among these possibilities. Even the meaning of potential explanatory variables can change over time, and often rapidly. Democrats in Georgia in 1972 were very different than Democrats in Georgia in 1992, who were in turn very different than Democrats in Georgia in 2006.

These pricing difficulties imply that government efforts to foster a private market in insurance will be ultimately unsuccessful; the informational difficulties are too great, and the government lacks a means of surmounting them. In addition, even more exotic options such as information markets and regulatory derivatives will not serve as workable substitutes. The same pricing problems that inhibit private insurance will prevent firms from investing in regulatory derivatives in quantities necessary to make them a useful hedge.

In the absence of a private market for transition relief, government-provided relief remains a viable option. The key to our solution is the disaggregation of transition relief into various steps and the allocation of individual duties based on institutional competency. We proceed in three stages. First, we unbundle the various steps that compose transition relief, and we explain how the decisions or decisionmaking involved in some of those steps differ from those involved in other steps (and from decisions and decisionmaking in the ordinary regulatory context). Some decisions regarding transition relief are more akin to plenary lawmaking. These decisions affect numerous societal actors and draw their resolution from broad societal values. Here, one might think of the broad decision of whether transition relief is warranted in the first instance. Other decisions are more in the nature of applications of an existing legal structure to particular private actors. Numerous issues that arise in transition relief settings are highly technocratic (as opposed to value-laden) in this sense: for instance, whether a modification of an existing building should subject the structure to regulation as if it were new construction; whether a transaction was consummated before or after the advent of a new legal regime; and how to allocate limited funds or grandfathering rights.

Second, consider the role of expertise in making these narrow, technocratic decisions. To be sure, expertise in the particular area of law at issue is of some value. But that kind of expertise is often exceeded in value by more general expertise in meting out transition relief. Questions that arise in these decisions transcend particular areas of law. The question of whether a modification should be treated as a new construction arises in environmental law, land use law, and disabilities law, to name just a few areas. The question of whether a transaction should be deemed consummated before or after a legal change takes effect arises in tax law and bankruptcy law. And the question of how to distribute limited funds or grandfathering rights arises in environmental law and natural resources law. This strongly suggests that a single government agency could accumulate considerable relevant expertise were it charged with handling such transition relief decisions across various legal specialties.

Finally, we observe that private actors will naturally be willing to invest money and time to obtain transition relief, and government actors will face an incentive to mete it out in return for private benefits. A government actor that is charged with distributing transition relief—even in accordance with some set legal scheme—likely will enjoy some discretion in making those decisions. The less that a government body is subject to lobbying by outside influences, the less it will fall prey to private rent-seeking in the allocation of transition relief. Accordingly, we conclude that an independent agency might be best situated to make some decisions related to the provision and application of transition relief.

Acknowledgments:

Copyright © 2010 NYU Law Review.

Jonathan Masur is a professor at the University of Chicago Law School.

Jonathan Nash is a professor at Emory University Law School.

Much of the literature related to large settlements seeks to improve how judges and private actors serve the large groups of people impacted by a massive settlement.¹  Settlement funds have reformed, in turn, by giving people more choices, such as more filing opportunities, different settlement outcomes, and extended deadlines. More opportunities to opt out of a large settlement theoretically assure that the fund’s administrators represent the interests of those who do not opt out. More choices of settlement awards means that more claimants can elect awards that fit their individual needs and circumstances. And more time to decide helps claimants to arrive at decisions that reflect their divergent interests. Few commentators have considered, however, how claimants to a large settlement fund make those choices.² Modern reform efforts, rather, assume that claimants make rational decisions about their options based on their own stable values and preferences.³

But is that correct? Studies have long shown that because of cognitive bias, people may buy things they do not want, save too little for retirement, or make risky choices about their health—based on their point of reference, the timing of the decision, and the presence of seemingly irrelevant choices.⁴ Behavioral economists have examined these ostensibly irrational decisions in many other legal contexts, but few commentators have explored these effects in the context of a large group settlement. Because claimants to large settlements are generally unassisted laypersons, large settlement funds may be particularly compelling settings to examine the adverse impact of cognitive bias.

To that end, I make three claims in this Essay. First, people may make irrational decisions about their settlement options in a large settlement fund because of cognitive bias. Second, cognitive bias may undermine some of the stated purposes of public and private settlement funds—to provide claimants with more access, efficiency, and fairness than in traditional litigation. Third, “fund designers”—judges, lawmakers, and agencies—should identify and, in some cases, capitalize on claimants’ cognitive bias by altering the context, timing, and sequence of settlement options. Fund designers, however, should avoid reforms that unduly eliminate settlement options or impose excessive administrative costs. Rather, the benefits of any reform—preventing avoidable harm to irrational claimants—must outweigh the potential costs, including the value of client autonomy, the chance of error, and the burden on the courts and public administrators.

I examine these three claims by describing how three cognitive biases are likely to affect claimants in large settlement funds. These biases are: (1) status quo bias, (2) contrast bias, and (3) time-inconsistency bias.

I.

Status Quo Bias

Status quo bias refers to a person’s tendency to stick to the status quo even when other options would increase well-being. In principle, a completely rational person will choose between alternatives based on his or her preferences and the potential costs of making an informed decision. In practice, however, simply characterizing an option as the status quo significantly increases the chances that a person will choose that option. Some speculate that this preference for the status quo derives from a general aversion to risks caused by one’s own actions, even when there are greater risks associated with inaction.⁵

For example, alternative investment and saving options are significantly more popular among college professors when designated as the status quo or the default choice.⁶ Because of the status quo effect, some commentators like Cass Sunstein and Richard Thaler have advocated “libertarian paternalistic” ways to encourage saving.⁷ They advocate changing the default rules to promote particular outcomes—like an employee’s decision to enroll in a 401(k) retirement plan—without limiting the employee’s opportunity to opt out of the plan at a later time.

Of course, switching costs also might explain adherence to default rules. A decisionmaker may rationally determine that it is not worth the time, money, or potential opportunity cost to deviate from the status quo. Moreover, people may be rationally indifferent to certain choices. Such explanations, however, do not fully account for how people make decisions. Although the subject of some criticism, many studies show that people irrationally overvalue either the default option or the costs associated with departing from the default option.⁸

In class action settlements and public settlement funds, status quo bias may be unavoidable. After all, there must be a default rule that asks people either to affirmatively join or affirmatively withdraw from a large settlement fund. But status quo effects complicate the long-held belief that opt-out rights (1) ensure fairer settlements and (2) provide an adequate opportunity to claim or reject awards through the fund. When few people affirmatively opt out or object to a settlement, courts and administrators have assumed that the fund successfully represents what claimants rationally want and therefore ensures a “fair, reasonable, and adequate” settlement.⁹ Status quo bias, however, provides a reason to be skeptical of these assumptions and the policies based on them, even when very large payouts are involved. Many people will join a large fund not because the overall settlement reflects their values and interests but simply because the default rule requires parties to affirmatively opt out of the fund.

The status quo bias also contributes to the phenomenon of underclaiming, in which parties refuse to opt out of a settlement but never claim an award. Many public and private settlements require parties to complete a new form to claim an award, to choose among substantive settlement options, or to select a settlement process. Commentators studying claim rates in class action settlements have found that the fraction of funds actually disbursed was very modest in these so-called claims-made settlements.¹⁰ This includes cases in which claimants were otherwise entitled to substantial awards.

Accordingly, settlement funds could automatically process claims, not unlike automatic 401(k) plan enrollment. Under such a system, a settlement fund would automatically distribute presumed awards to claimants who join the fund. Such a policy, however, would come at a cost. Among other things, funds would bear the administrative cost of precisely identifying eligible claimants in advance of payment.

In light of potential costs, automatic processing would be more justified in certain funds. In large-value cases, for example, automatically processing claims would not be worth the administrative cost, the burden on the courts, and the potential for error or fraud. Thus, automatic processing may be warranted in welfare benefit settlements or shareholder class action funds, in which fund designers typically have a great deal of information about claimants, the awards are modest, and claimants generally do not choose among multiple settlement options.¹¹ Such policies would be more problematic in large mass tort settlements, in which settlement trusts or public settlement funds have less information about potential claimants, the awards are large, and claimants may be offered various procedural and substantive options in the settlement.

II.

Contrast Bias

Contrast bias is the irrational tendency to weigh an option more or less favorably depending on the presence of other options. Theoretically, a rational decisionmaker should not rank options differently simply because the options are described in a particular way. Moreover, the introduction of an additional choice should not alter a decisionmaker’s relative valuation of the original options. But this is not always the case.

Take, for example, the uncanny effects of decoy options—options that no one ever chooses but that make another alternative more appealing—on physical attraction. In a survey of six hundred students, a behavioral economist asked subjects to rate the looks of two men.¹² When asked to choose between the photographs of two equally attractive candidates—call one “George Clooney” and the other “Brad Pitt”—subjects were equally divided. When another group of subjects was asked to choose between the two initial candidates and a third candidate, a photoshopped and deformed version of George Clooney, however, 75 percent chose the unspoiled version of George Clooney and 25 percent chose Brad Pitt. Although no one selected the third option, the seemingly irrelevant introduction of an ugly version of George Clooney led 50 percent more students to believe that the original George Clooney was better looking than Brad Pitt.

Psychologists and behavioral economists have found that contrast effects directly impact a wide array of decisions, including consumer purchases, employment decisions, elective medical procedures, and even presidential elections.¹³ There are many explanations for contrast bias. Some suggest that it is simply easier to compare similar options among a set of choices than to give an absolute or innate value to any particular option. ¹⁴

The presence of contrast bias may be relevant to laws designed to improve the oversight of large settlements. Many settlement funds ask claimants to choose from an array of options after joining a settlement, in part to maximize the benefit to claimants with different interests in settlement. But the interrelationship of various settlement options may unwittingly impact a choice between cash and nonpecuniary awards, like coupons and warranties. In my own classes, I distribute an altered Apple iPod Settlement Notice as an illustration. After litigation over reported battery problems in old Apple iPods models, Apple settled and offered customers a choice of a $50 store credit or $25 in cash. Half of my students receive the original version of the iPod settlement notice. The other half receives a modified notice that contains the same two options—a $50 store credit and $25 in cash—and a decoy option, a $35 store credit. The results show the addition of a seemingly irrelevant coupon dramatically affects the students’ willingness to take the coupon settlement. The original group chooses cash more than 61 percent of the time; the decoy group chooses the cash only 40 percent of the time.

Contrast bias has implications for laws like the Class Action Fairness Act (“CAFA”), which expressly requires courts to conduct “fairness hearings” in coupon-only settlements and to postpone decisions about the amount of attorneys’ fees until after the coupons have been redeemed.¹⁵ CAFA’s purpose is to ensure that the attorneys’ fees are closely connected to the actual value of the settlement to the class. But CAFA does not impose a similar requirement for settlements involving both coupons and other options. Rather, courts may award attorneys’ fees upfront, based on an estimate of the cash value of the settlement apart from the portion of the settlement involving coupons. Due to contrast bias, courts may also have reason to wait for claimants to redeem these kinds of settlement awards: the coupon may encourage claimants to accept another settlement option that, by comparison, seems to offer a better value or greater liquidity. Such delay imposes costs. Class action litigation is risky business, and delaying even a portion of attorneys’ fees may dampen some attorneys’ willingness to file in the first place. But delay may be justified if it ensures that the attorneys’ fees better reflect the actual value that class members derive from the settlement.

III.

Time-Inconsistency Bias

Rational models of choice assume that people have time-consistent preferences. That is, a person’s relative preference for gratification will be the same no matter when he or she is asked. Substantial evidence, however, demonstrates that people have time-inconsistent or present-biased preferences. Ask whether a person prefers to rent Schindler’s List or So I Married an Axe Murderer, and the answer should not depend upon whether the decisionmaker plans to watch the movie today or later next week. But the proportion of people who elect to watch Schlindler’s List in the near future may be thirteen times higher than those willing to watch it on the same day they are asked.¹⁶ Present-biased preferences explain the systematic tendency to seek out more immediately gratifying benefits today than the long term benefits called for by earlier plans.¹⁷ More often than not, people choose a bird in the hand—be it dessert, a little extra cash, or a silly movie¹⁸—over three or four in the bush.

Time-inconsistency is compounded by nonintegrated decisionmaking. Nonintegrated decisions are rational decisions about costs and benefits in irrationally short periods of time. If a person had to choose whether to spend the next five minutes writing a paper or watching a YouTube video, she would rationally choose YouTube, the more pleasurable activity. After five minutes, she would rationally make the same decision again. But when the decision is viewed under a more integrated time horizon—four hours of paper writing versus four hours watching YouTube—she would rationally choose to write her paper. Because people are susceptible to nonintegrated decisionmaking, even small tastes for immediate gratification, or small costs associated with a task, may cause a naïve person to continuously postpone making decisions.

The converse of nonintegrated decisionmaking is that procrastinators will be highly sensitive to very small short-term incentives or penalties. Policies that make the cost of a short delay loom larger thus make procrastination less likely.¹⁹

Time-inconsistency bias may prove costly to claimants filing with a fund and to the administrative operation of the fund. Although some settlement funds fix relatively short deadlines, requiring filing within three to six months of settlement, other more complicated mass tort funds may allow one to two years to file. In many cases, there is no overt penalty for failing to file at an earlier time. There is a very powerful hidden penalty, however, to claimants—the time value of money and potential lost interest. For example, as illustrated in the graph below, more than half of the families affected by the September 11 attacks waited two years to file with the September 11 Victim Compensation Fund; as a result, each gave up, on average, over $100,000 in lost interest per year.

September 11 Victim Compensation Fund Claims Filed²⁰

Note the large spike in claims that appears just before the filing deadline on December 22, 2003. Rational considerations certainly explain some of the late filings. Claimants may choose to gather more information before filing with a large settlement fund. Or, particularly in large funds involving personal injuries, parties may need additional psychological distance from the event that gave rise to the claim. These explanations, however, are insufficient to account for the concentration of claims that appear just at the filing deadline of many large settlement funds. It is more likely that many claim filings represent present-biased preferences.

One solution is that large settlements could adopt rolling deadlines to encourage earlier filings. Parties could be required to file in the first week of each month until the final deadline. Human resource departments often use such rolling window systems to encourage employees to enroll in benefit programs, but these systems have never been applied in large public or private settlement funds. Cognitive science, however, suggests that such short-term incentives will encourage claimants to file more often over the duration of the fund, saving both opportunity costs to claimants and administrative costs to the fund.

Any such solution must take costs into account. Undoubtedly, rolling deadlines impose a cost on individual actors, who would suffer the inconvenience of filing at the beginning of the month, as well as on the fund, which would have to expend additional resources making such a filing system easy and transparent. But it would impose comparably small costs to claimants’ autonomy. A party unable to file at the beginning of the first month would always retain the ability to file the following month. A party that wants to wait for other strategic, information-driven, or psychological reasons would still retain that right.

Because of such costs, rolling deadlines may be more justified in funds that award high-value claims, like mass torts and some antitrust settlements, but not necessarily low-value claims, like consumer class actions. For high-value claims, the additional savings to the individual and the fund justify taking measures to encourage parties who might otherwise suboptimally delay filing.²¹

***

By “funding irrationality,” I do not challenge efforts to increase choices and opportunities for claimants to large funds. I only question whether such efforts, by themselves, are enough to accomplish their objectives of greater fairness, efficiency, and equity. Although such measures help rational participants to monitor, object, and exclude themselves from such funds, few measures exist to protect claimants who will make decisions based upon cognitive error. As this Essay demonstrates, there will be cases in which, on balance, many subjects will make poor decisions—both for themselves and for the fund as a whole—when available settlement options are not adjusted to account for cognitive biases. This is, in part, because in many large funds parties lack individual access to third-party expertise, like lawyers. Given the tremendous economic, social, and institutional resources devoted to operating large funds, it is worth asking: Are there better ways to design large funds? Can their design accommodate both rational and irrational decisionmaking?

I answer both questions with a qualified “yes” by recommending policies that benefit those prone to make cognitive errors but impose minimal costs on those who otherwise choose rationally. In so doing, I recommend accounting for and sometimes exploiting the timing, structure, and combination of options in large settlements to increase the welfare of all potential participants.

But such solutions raise fundamental questions of fairness and efficiency themselves: Will fund designers suffer from their own biases? Will procedures that fund irrationality unfairly limit claimants’ rights to control their own litigation? Will funding irrationality risk replacing one set of claimant biases with new biases that lead to even less desirable outcomes? These are all valid concerns. The compensatory goals of large funds require, however, that fund designers understand how claimants make choices and, when possible, adjust rules so that funds better serve them.

Acknowledgments:

Copyright © 2010 Duke Law Journal.

Adam S. Zimmerman is an Acting Assistant Professor at the New York University School of Law.

This Legal Workshop Editorial is based on the following article: Adam S. Zimmerman, Funding Irrationality, 59 DUKE L.J. 1105 (2010)

These changes in law have generated a significant shift in trust investment practices.  Equities represent a larger share of trust portfolios—just as modern portfolio theory would suggest they should.  Widespread belief in the investment community that equities always outperform fixed-income investments undoubtedly exacerbated the shift to equities.  This shift has not generated tangible benefits for trust beneficiaries.  The 2008–09 stock market decline has been dramatic.  But, even over a longer time horizon—ten years rather than one—equity investments have performed poorly; both the Dow Jones Industrial Average and the Standard & Poor’s 500 Index stand at lower levels in June 2009 than they did ten years earlier.  In other words, trust law’s implementation of modern portfolio theory has apparently left many trust beneficiaries worse off than if the law had retained more traditional principles of trust investing. That fact suggests that it is time for a re-assessment of the recent “revolution” in trust law doctrine.

The Trust Reform Movement

Trust law traditionally mandated conservative investment strategies for trustees, prohibiting all investment in “speculative” enterprises and focusing on “safe” investments in real estate mortgages, government securities, and high-grade corporate bonds.  A trustee who invested in equities generated no personal gain if the equities increased in value, but the trustee risked liability for imprudence if the trust portfolio declined in value.  Dissatisfaction with the traditional approach became intense during the 1960s and 1970s, when it became painfully apparent to many trust beneficiaries that conservative, “safe” investments bore a significant risk of their own—the risk that high inflation rates would erode the real value of trust principal.

At roughly the same time that inflation risk was eroding the real value of traditional trust investments, academic theory began to challenge the notion that prudent investing required avoidance of all risky investing.  Modern portfolio theory emphasized that diversifying among firms and industries could minimize firm-specific and industry-specific risk.  Moreover, the strongest form of the efficient capital markets hypothesis leads to the conclusion that no investment is a bad investment, because the risk associated with the investment has already been factored into the investment’s price.

Trust law reformers implemented these insights into trust law doctrine.  Although the Second Restatement⁴, which the American Law Institute promulgated in 1959, had recognized a duty to diversify, that duty plays a far more critical role in the Third Restatement and the Uniform Prudent Investor Act (UPIA).  Under prior law, the duty to diversify was superimposed on a “prudent person rule” that also required a trustee to evaluate the prudence of each individual investment in a diversified portfolio.  By contrast, the Third Restatement and the UPIA permitted trustees to avoid liability for even the riskiest investments—investments that would previously have been deemed imprudent—so long as the trustee adequately diversified those investments.  Moreover, because modern portfolio theory required more sophisticated investment decisions, the likelihood that an individual trustee, or even a corporate trustee, would be able to assemble an ideal portfolio without relying on persons with investment expertise diminished.  As a result, reformers freed trustees from the shackles of the common law rule that prohibited delegation of trustee obligations.

Taken together, these doctrinal changes were designed to afford trust beneficiaries the benefits associated with modern portfolio theory.  But, the changes operated primarily by relieving trustees from liability for actions inconsistent with modern portfolio theory.  They did not impose liability on trustees for failure to take affirmative steps to implement modern portfolio theory.  Of the three major “reforms,” only one imposed liability on trustees, and that one—the duty to diversify—had largely been established before promulgation of the UPIA and the Restatement (Third).  Significantly, neither the Restatement nor the UPIA developed liability rules that would constrain trustees from assuming too much market risk, despite modern portfolio theory’s clear recognition that diversification alone would do nothing to protect investors against market risk.

Re-Examining Modern Portfolio Theory as a Basis for Trust Investing

Market reverses over the past decade have left intact some of the basic premises of modern portfolio theory.  First, the premise that diversification of investments can reduce risk without compromising expected return has emerged largely unscathed.  The jury may still be out on whether a select number of savvy investors can reduce risk and increase return more effectively by careful study of the “fundamentals” associated with a small number of investments.  The empirical evidence, however, suggests that it will be a rare investor who can consistently “beat the market,” and it certainly appears unlikely that trust beneficiaries as a whole would be better off if trust law doctrine relieved trustees of the duty to diversify.

Second, market reverses have not undermined modern portfolio theory’s conclusion that an investment portfolio, including a trust portfolio, can optimally deal with non-diversifiable market risk by adjusting the portfolio’s percentage of high-risk, high-return investments.  Recent market reverses cast doubt on the proposition that, over the long term, equities will always outperform bonds and treasury bills.  But,  ignoring the historical returns of equities would be imprudent, just as it would be imprudent to ignore more recent events.  What recent events have emphasized is the standard caveat that past performance is no guarantee of future results.  In the face of uncertainty, hedging one’s bets remains a sensible strategy.

Other premises of portfolio theory seem less inevitable than they once did.  Consider first the premise that to compensate for the risk an investor takes the expected return on common stocks and other more volatile investments must be higher than the expected return on more stable investments .  That premise assumes that investors are risk averse rather than risk neutral or even risk preferring—a premise that appears not to be universally true.  Moreover, even if investors were risk averse, the investments that would command a risk premium would be those that present the greatest perceived risk to investors.  Over the last several decades, however, modern portfolio theory has conditioned many investors to believe that the risk associated with equity investments is low (because stocks always outperform fixed-income investments in the long run), and that fixed-income investments generate significant inflation risk.  If the investing public internalizes these messages, there is little reason to expect that equity investments must pay a “risk premium” to entice investors; instead, in periods of steady rise in stock prices, investors are more likely to underestimate the risks associated with market decline.

Second, insights from behavioral economics challenge the premise that every investment is, in appropriate proportion, a suitable trust investment.  That premise derives from the strong form of the efficient capital markets hypothesis, which holds that because the market price reflects all available information about a security’s risk and return, every investment is a suitable investment at its current price.  Behavioral economics suggests, however, that the pricing of individual securities reflects investor psychology as much as it reflects economic fundamentals.  A “herd” mentality causes many investors to bid up the price of securities (or to sell them off) without any economic foundation for the investment decisions.  The problem is especially serious with new issues, where the investor has no significant basis for determining expected return or covariance.  But, if an investor has no sound basis for determining expected return, the investor has no basis for assuming that adding the stock to a portfolio will preserve expected return or reduce risk—the objectives of diversification.

Putting Theory Into Practice:  Re-examining Doctrinal Implementation of New Learning About Investment Practice

Even if one were to accept all of the modern portfolio theory principles endorsed in the UPIA and the Restatement, the doctrinal structure those enactments established provides an inadequate framework for assuring that trustees apply those insights.  And, to the extent that modern portfolio theory underestimates particular investment risks, the doctrinal structure magnifies the risk to trust beneficiaries.

Unlike individual investors, trustees do not reap the benefits or suffer the losses that result from their investment decisions.  As a result, the trust relationship generates agency costs, raising questions about the role legal doctrine can and should play in addressing any mismatch between the interests of the beneficiaries and those of the agent (the trustee).

So long as preservation of trust principal is treated as the trust’s primary objective, aligning the trustee’s interests with those of the trust beneficiaries is not difficult.  Imposing liability on a trustee who makes investments that place trust principal at risk creates the right incentives; because the trustee receives no personal benefit from the higher returns the trust will generate from investments that do place trust principal at risk, but does bear the downside loss associated with such investments, the trustee who is at all sensitive to financial incentives will avoid risking trust principal—the hypothesized goal of the trust settlor.

Rejection of traditional theory complicated the agency-cost problem.  The “prudent” trustee could no longer look to any single talisman in making investment decisions; an investment strategy that balanced risk and return would best serve beneficiaries.  How, then, should the legal system encourage trustees to take the appropriate risks?  Traditional doctrine discouraged all investment in equities, particularly equities in companies not regarded as “blue chips.”  As a result, the drafters of the Third Restatement and the UPIA focused their efforts on eliminating any inference that a trustee could be held liable for imprudence merely because the trustee had invested part of a trust portfolio in high-risk, high-expected-return securities.

Once the drafters of the Restatement and the UPIA rejected categorical restrictions on types of investment, they were largely content to make marginal changes to the traditional standard-based prudent-person rule.  The standard-based approach provides little protection to beneficiaries against a trustee’s assumption of excess market risk.  The drafters, however, provided no black-letter substitute for the old regime’s protection against market risk.  Instead, they exhorted trustees to consider the risk tolerance of the trust in assessing how much market risk to take.  But neither the Restatement nor the UPIA indicates what standard of review to apply to the decisions trustees make in response to that exhortation.

The Restatement and the UPIA admit two possible interpretations.  First, courts might construe the Restatement and UPIA to confer broad discretion on trustees, with limited judicial review of a trustee’s investment judgment, so long as the trustee adequately diversifies firm-specific risk.  That interpretation imposes little discipline on trustees.  Second, courts might construe the Restatement and UPIA as imposing on courts a responsibility to provide more substantive oversight of the prudence of a trustee’s decisions.  That interpretation imposes on the trustee a liability risk that the trustee cannot reasonably avoid, which is likely to raise trustee fees and price some settlors out of the trust market.  Neither alternative is attractive.

How can trust law induce trustees to be more responsive to the investment objectives of the trust settlor and to the financial needs of the trust beneficiaries?  One answer is to develop a set of rule-like safe harbors that provide trustees with significantly more guidance than current law while simultaneously providing incentives for the settlor and the trustee to discuss and agree upon trust investment strategy at the time the settlor creates the trust.

Suppose, however, that the UPIA and the Restatement were amended to include, either in black letter or in a comment, something like the following language: “No trustee shall be liable for exposing the trust or its beneficiaries to excessive market risk if the trustee limits the trust’s investment in equities to 60% of the aggregate trust portfolio.” The addition of this language would not expose trustees to additional liability, but would instead create a “safe harbor” for them.

The safe harbor would provide a blueprint for trustees seeking to avoid liability.  A trustee who takes advantage of the safe harbor avoids both the expense of legal advice and the threat of liability of a de novo review regime, under which a court would substantively examine the prudence of the trustee’s investment decisions.  Because these costs would otherwise be passed on to the trust settlor and/or beneficiaries, the safe harbor approach would make trusts more affordable than would a regime that imposed more risk on the trustee.

At the same time, superimposing a safe-harbor provision on a regime that otherwise carefully scrutinizes investment decisions mitigates agency costs far better than a regime in which courts defer to trustee decisions.  If the primary concern in a regime regulated only by the market is that trustees will be inclined to pursue high expected return even when the risk associated with that return is not in the interest of trust beneficiaries, a safe-harbor regime addresses that concern by providing an incentive to limit equity investments to the amounts encompassed by the safe harbor.

Consider now the principal objections to such a safe-harbor regime (or one like it).   One potential objection is that rulemakers—legislators, with the aid of experts and lobbyists—do not have enough information about optimal investment strategy to craft sensible rules.  Were it not for the inadequacy of market discipline, the absence of reliable information about investment strategy might be a plausible argument for deference to the decisions of trustees.  This, however, is not an argument that a standard-based regime would be preferable to the safe-harbor approach.  In a standard-based regime, legal decision-makers will ultimately have to evaluate the prudence of particular investment strategies, but they will do so ex post, generating the potential for hindsight bias—a problem mitigated by a legal regime that provides trustees with ex ante safe harbors.

A second objection focuses on the inadequacy of one-size-fits-all safe harbors to account for the disparate needs and risk tolerances of trusts established for a multitude of different purposes.  A trustee, however, can protect itself against liability for departing from the safe harbor regime by ensuring that language in the trust instrument authorizes trust investment practices that differ from those that qualify for safe harbors. Alternatively, the trustee can protect itself by obtaining consent from the trust beneficiaries.

None of this is to suggest that a rule-based safe-harbor approach would have avoided all losses to beneficiaries during recent bear markets or to suggest that it will prevent future losses.  A safe harbor approach, however, does have greater potential for reducing agency costs than does the current version of the prudent-investor rule.

Acknowledgments:

Stewart E. Sterk is the Mack Professor of Law at Benjamin N. Cardozo Law School.

This Legal Workshop Editorial is based on Mr. Sterk’s Article: Stewart E. Sterk, Rethinking Trust Law Reform: How Prudent is Modern Prudent Investor Doctrine?, 95 CORNELL L. REV. 851 (2010), available at http://www.lawschool.cornell.edu/research/cornell-law-review/upload/Sterk-final.pdf

How do such commons work?  Where do they come from, what contributes to their durability and effectiveness, and what undermines them?  These questions are at the heart of an institutionalist research paradigm that has been extremely successful in understanding the successes and failures of natural resource commons arrangements.  The Nobel Committee recently recognized the importance of institutionalism by awarding  the 2009 Nobel Prize in Economics to political scientist Elinor Ostrom and institutional economist Oliver E. Williamson.

Constructing Commons in the Cultural Environment, our full-length article in the Cornell Law Review, confronts the challenge of understanding the governance of what we refer to as constructed commons in the cultural environment, in which the resources to be produced, conserved, and consumed are not crustaceans but information: copyrighted works of authorship, patented inventions, and other forms of information and knowledge that need not be aligned with formal systems of intellectual property law.  The phrase “constructed cultural commons,” as we use it, refers to socially constructed institutions for developing and sharing cultural and scientific knowledge in a formally or informally managed way, much as a natural resource commons refers to the type of managed sharing environment for natural resources exemplified by the Maine lobster fishery.

A commons is neither a place nor a thing.  Rather, a commons is a resource management or governance regime.  Cultural commons are regimes for managing the sharing of information or cultural resources.  Commons are “constructed” in the sense that their creation, existence, operation, and persistence are not matters of pure accident or random chance, but of emergent social process and institutional design.  Examples of constructed cultural commons include: intellectual property pools, in which owners of patents in a technological domain license their patents to a common “pool” from which producers of complex products can obtain all of the permissions needed to make and sell goods that use the patents; open source computer software projects, which offer users of open source programs the ability to create and share modifications to the programs; Wikipedia, which offers users of this Internet encyclopedia the power to add to and edit its contents; the wire service for journalism operated by the Associated Press, which allows individual member media outlets the opportunity to publish work produced by other members; and “jamband” fan communities, which record, share and comment on musical performances of their favorite groups—with the permission of the artists themselves.  The best-known jamband is the community that grew up around and that is still associated with the Grateful Dead.

Participants design these environments with limitations tailored to the character of the resources and communities involved. They do not operate solely via market transactions grounded in traditional proprietary rights, nor are they structured exclusively by government regulation.  Research on intellectual property and related cultural resources has generally failed to focus sufficiently on managed sharing or on the governance of cultural resources via collective mechanisms.  The theoretical discussion of intellectual property policy has been focused on extremes of exclusion and open access, ignoring a wide range of constructed commons that persist between the extremes.  Such discussion is often divorced from empirical studies of creative and inventive communities.  In Constructing Commons, we argue that it is high time to devote more attention to the middle ground of constructed cultural commons.

Research on the Maine lobster fishery and other natural resource commons is grounded in the empirical case study approach pioneered by political scientist Elinor Ostrom and her colleagues.  That approach employs an “Institutional Analysis and Development” (IAD) framework of structured inquiries to study a variety of commons arrangements before moving on to create theories and models to explain them.¹  Commons researchers divide their inquiries into nested groups.  A set of inquiries into “exogenous variables” is further divided into questions about the biophysical characteristics of the shared resources, the attributes of the community, and the “rules-in-use” or governance mechanisms.²  A second set of inquiries focuses on the “action arena” in which social interactions and exchange take place.³  Finally, each study inquires about the outcomes of the commons management system.

A simple illustration of the framework might be a soccer league.  The formal rules of soccer are fixed, but the rules-in-use clearly vary somewhat between a professional league and a recreational league, between children’s leagues and adult leagues, and so forth.  A specific soccer league is also characterized by the relationships among the players (neighbors, professional competitors, friends, etc.), by the attributes of the fields on which games are played, and even by the climate of the places where the games take place.  The action arena (soccer games) depends on complex and specific interactions among all of these characteristics.  Nonetheless, the outcomes over time in a particular league are the patterns of interaction that are clearly identifiable as “professional soccer,” “friendly weekend game,” “children’s soccer league” and so forth.  Moreover, some leagues may be successful, lasting for years even as players come and go, while others will fail.  The goal of applying the Ostrom framework of analysis in this context would be to use studies and analyses of many different soccer leagues to come to an understanding of success and failure as a function of specific context.

This method of structured inquiry has the advantages of a systematic approach without prematurely imposing any one theoretical paradigm on the study of commons.  It allows the complexity of real-world commons arrangements to inform the search for theoretical understanding rather than papering over such complexity in an attempt to shoehorn existing commons arrangements into a pre-existing model.  After engaging in a large number of such studies, Ostrom’s approach permits generalization (for example, with regard to design principles for successful commons) along with more specific theorizing, modeling, and even experimental studies of particular aspects observed in the case studies.

Borrowing from and building on Ostrom’s work, Constructing Commons develops and argues for the use of a similar framework to systematize case-study-based research exploring the construction of cultural commons.  The time is ripe for such an approach, as a number of scholars have begun to do case studies of constructed cultural commons.  To the extent that researchers have undertaken case studies so far, however, they tend to have studied isolated areas (such as open source software or academic publishing) and to have considered a limited number of descriptive variables.  This makes integration and learning from a body of case studies quite difficult, which in turn discourages people from pursuing further case studies.

Constructing Commons in the Cultural Environment adapts, extends and distinguishes Ostrom’s IAD framework to account for important differences between constructed cultural commons and natural resource commons.  Understanding the origins and operation of constructed cultural commons requires detailed assessments that recognize that they operate simultaneously at several levels, each nested in a level above, and that each level entails a variety of possible attributes.  We suggest a set of buckets or clusters of issues that should guide further inquiry, including the ways in which information resources and resource commons are structured by default rules of exclusion, and the ways in which members of these pools manage participation in the collective production and extraction of information resources.  Case studies across disciplines and reviews of existing literature that addresses cultural commons will help specify relevant attributes within each cluster.

Because space does not permit a detailed exposition of the framework here, we will briefly discuss only a few of the most important issues that distinguish the inquiries necessary for studying cultural commons from those appropriate to natural resource commons.  Most importantly, unlike commons in the natural resource environment, cultural commons arrangements usually must create a governance structure within which participants not only share existing resources but also engage in producing those resources.  This characteristic of cultural commons creates a more intertwined set of exogenous variables, since separating the managed resources from the attributes and rules-in-use of the community that produces them is impossible.   Moreover, in cultural commons, distinguishing outcomes from resources and community attributes is not strictly possible, since the interactions of the participants in such a commons are inextricably linked with the form and content of the knowledge output, which in turn is itself a resource for future production.  These differences call for a set of inquiries tailored to cultural commons.

Because the resources shared within a cultural commons are themselves culturally constructed and non-rivalrous, defining the boundaries of the commonly managed resource is also more complex than in the natural resource commons context.  A reference “natural environment” must be consciously chosen: either the public domain or a proprietary intellectual property environment may be most appropriate depending upon the particular commons (e.g., university research community or patent pool) under investigation.  Nuanced questions about openness are in order.  In natural resource commons, in many cases, the commons is open to members and closed to everyone else, and that is the end of the story.  This is sensible because natural resources are rivalrous—preventing over-consumption is usually the goal of the commons arrangement.  Intellectual resources, by contrast, are not subject to the same natural constraints and are naturally shareable without a risk of congestion or overconsumption.  Thus, a constructed cultural commons arrangement reflects many choices about the degree and type of participation that is available to various persons and entities.  Open source software projects, for example, often allow anyone to comment, make suggestions, or submit code for potential adoption, but are managed by a small group of core programmers who determine what code to incorporate into official releases.  Additionally, individuals having nothing to do with the writing of the code can use it, subject to constraints on commercialization incorporated into the copyright license, which vary from project to project.  Constructing Commons discusses in some detail how to adapt the Ostrom framework to account for these and other differences between natural resource commons and constructed cultural commons.  We expect the framework to evolve further as researchers apply it to specific case studies.

The Constructing Commons framework suggests a means to investigate the social role and significance of constructed commons institutions.  This investigation is relevant to property law in particular and social ordering more generally.  The conventional view of property scholars, particularly those with interests in intellectual property law, is that resource production and consumption are, and ought to be, governed primarily by entitlements to individual resource units, held individually and allocated via market mechanisms.  To the extent that those market mechanisms are inadequate to optimize the welfare of society, in the event of market failure, government intervention is the suggested remedy.  Intellectual property rights themselves are generally justified as remedies for market failure.  Creative works and new inventions are characterized as public goods, whose intangibility prevents their originators from excluding potential users and thus recouping their investments via pricing.  Copyright and patent laws create artificial but legally sanctioned forms of exclusion, restoring a measure of market control to creators and innovators.  The conventional view regards communal and collectivist institutions, particularly those that blend informal normative structures with formal government rules, as exceptional and dependent upon pre-existing property entitlements.

Systematically performing and analyzing case studies of constructed cultural commons across a wide range of domains according to the proposed framework offers a critical method for assessing the validity of this property-focused narrative.  We suspect that, over time, the constructed cultural commons framework that we describe will yield a far larger and richer set of commons cases in the cultural context than one might discover by focusing only on patent law or scientific research or software development.  We anticipate that social ordering both depends on and generates a wide variety of formal and informal institutional arrangements, and that the logical and normative priority assigned to proprietary rights and government intervention may turn out to be misplaced.  Importantly, understanding commons in the cultural environment is likely to shed light on the ways in which managed sharing or openness with respect to cultural resources generates the “spillovers,” or third-party benefits, that are critical to the welfare effects of those resources.⁴  The social value of information lies not only in its effect on the producer and the consumer of that information, but also in the ways in which the consumer shares that information with others.

Beyond our proposal of a framework for studying them, our consideration of constructed cultural commons also highlights a number of points that are important in the study of intellectual property going forward.  Considering constructed commons helps to elevate collective, intermediate solutions to their possible place of significance in accounts of property regimes and should diminish the skepticism of many scholars that collective solutions can work beyond narrowly defined situations.  Case studies will also call our attention to the constructed, designed character of both the cultural and the legal environment in regard to knowledge and information policy problems.  Finally, as they have they have done in the study of natural resource management, systematic analyses of constructed commons across a wide range of collected case studies should lead us to doubt panacea prescriptions drawn from overly simplistic models.

Acknowledgments:

Copyright © 2010 Cornell Law Review.

Michael J. Madison is Professor of Law and Associate Dean for Research, University of Pittsburgh School of Law.  Brett Frischmann is Associate Professor of Law, Loyola University Chicago School of Law.  Katherine Strandburg is Professor of Law, New York University School of Law.  Parts of this work were completed while Professor Strandburg was visiting at New York University School of Law (2007-08) and Fordham University Law School (Fall 2008).

This Legal Workshop Editorial is based on: Michael J. Madison, Brett Frischmann & Katherine J. Strandburg, Constructing Commons in the Cultural Environment, 95 CORNELL L. REV. ___ (2010).

I.
Theory of Financial Institution Failure

In recent years, it has become apparent that the failure of large, interconnected nonbank financial institutions, such as hedge funds and investment banks, can create substantial systemic risk and thereby impose external costs on the financial markets and economy.² Because no financial institution has the incentive to limit its own systemic risk,³ and because collective action by market participants to prevent systemic risk is unlikely,⁴ some regulation is needed to minimize the external costs produced by the failure of “too big to fail” (TBTF) institutions. Any remedial regulation should (1) prevent overly risky behavior by a TBTF institution that could cause it to fail and create contagion,⁵ and (2) prevent the panic among investors that can precipitate an institutional failure.

Regulation to avert systemic risk, however, can also create moral hazard and uncertainty. One way of reducing systemic risk is by “bailing out” TBTF institutions—guaranteeing their agreements with creditors and counterparties—which reduces the chances of their failure by preventing runs on the institutions. The problem with this approach, however, is that while loss-fearing counterparties and creditors normally exert market discipline to prevent institutions from taking on excessive risk, parties that come to expect future bailouts reduce their discipline accordingly. A policy of “constructive ambiguity”—only bailing out some creditors and counterparties so that none can count on a bailout ex ante—reduces this moral hazard. But constructive ambiguity also creates uncertainty in financial markets, leading panicked investors to withdraw their funds en masse from other financial institutions, which can increase systemic risk. The benefits of constructive ambiguity in reducing moral hazard will be produced most effectively through a discretionary and transparent process that retains uncertainty over the outcome of regulatory decision-making with regard to bailouts, but involves less ambiguity over the rules and process informing such decision-making. Creating clear procedures but preserving uncertainty over the outcome of a regulatory decision produces a better balance between uncertainty and moral hazard: Clear procedures will calm panicky investors, while uncertain outcomes will curb moral hazard.

II.
Evaluating Our Current Regulatory System

Our current regulatory system is suboptimal in both its ex ante and ex post regulation of systemic risk. Ex ante, the system fails to reduce the external costs caused by the overly risky behavior of nonbank financial institutions. Prudential regulations to curb such behavior are either insufficient, as with the Securities and Exchange Commission’s regulation of investment banks through the Consolidated Supervised Entities program, or nonexistent with respect to certain financial institutions, such as hedge funds. Ex post, the system does not sufficiently reduce the systemic risk caused by the failure of nonbank financial institutions and does an inadequate job of limiting the moral hazard and uncertainty that regulation creates. Under our current regulatory framework, when a large nonbank financial institution is on the verge of failure, regulators have two options: either undertake last minute, ad hoc actions to rescue the institution or permit the institution to file for bankruptcy. The problem is that this ad hoc approach can result in (1) bankruptcy filings by TBTF institutions that will likely cause contagion, as exemplified by the failure of Lehman Brothers, and (2) uncertainty in regulators’ decision-making processes that can create panic and worsen an ongoing financial crisis, also apparent during the aftermath of Lehman Brothers’ bankruptcy filing.

III.
The Obama Administration’s Framework for Regulatory Reform

The Obama administration’s proposed legislation would establish rules by which the Federal Reserve would designate certain financial institutions as TBTF—or Tier 1 financial holding companies (Tier 1 FHCs)—which would become subject to more stringent ex ante prudential regulations. The determination of whether an institution should be deemed a Tier 1 FHC would not depend upon the legal status of the institution, such as whether it is legally a bank, a hedge fund, or an investment bank, but rather on the extent to which a failure would be likely to impose external costs on financial markets and the economy. The Obama administration’s proposal retains the current bankruptcy process but adds a resolution regime that governs the failure of Tier 1 FHCs in some circumstances in order “to efficiently and equitably resolve the claims of creditors and other stakeholders”⁶ through a legal process similar to bankruptcy. Although the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) must approve a decision to invoke the resolution regime by a two-thirds vote, the Treasury would ultimately decide whether to invoke the regime upon consultation with the President.

The Obama administration’s proposal improves upon our current regulatory system, but it could do more to avert the systemic risk that could result from the failure of a Tier 1 FHC. Although the proposed framework instructs the regulatory agencies to consider “serious adverse effects” on the financial system and economy when deciding whether to invoke the resolution authority, the procedures for reaching such a determination are so stringent—requiring near consensus among numerous regulatory agencies—that it seems likely that at least some financial institutions whose failure will cause systemic risk will not be bailed out. The proposed legislation also leaves open the possibility that regulators, at the eleventh hour, might elevate moral hazard concerns above concerns about systemic risk. Furthermore, giving the Treasury—an agency firmly within the Executive branch—the ultimate authority to invoke the resolution regime overly politicizes what should be a technical decision based on an assessment of the expected systemic cost.

I also contend that the proposal fails to sufficiently reduce uncertainty in policymaking decisions, which could trigger panic and contribute to an environment where short-term creditors are likely to run a Tier 1 FHC. First, because the proposal leaves open the possibility of bankruptcy, creditors and counterparties of the institution now must worry about their ability to recover if the institution fails under both bankruptcy law and resolution rules. Second, the legislation does not require regulators to disclose the basis for the decision of whether an institution’s failure creates “serious adverse effects.” Without transparency in this crucial determination, ambiguity over the decision-making process remains, creating additional uncertainty for investors.

IV.
An Alternative Regulatory Reform Framework

While the Obama administration’s proposal has clear benefits, I suggest modifying the proposal’s ex post process for resolving the failure of TBTF financial institutions in order to prevent systemic risk more effectively and to reduce uncertainty. I propose that the Federal Reserve be given unilateral power to authorize the FDIC to seize a failing institution and place a value on the expected cost to the financial system and the economy of the institution’s failure. A cost-benefit provision in the new statute would then require the FDIC to provide the institution with financing only up to the cost of the systemic risk created by that institution’s failure.⁷ This will ensure that the expected cost of any bailout is less than the expected cost of systemic effects. Under my proposal, institutions deemed to be Tier 1 FHCs would not be subject to the bankruptcy process.

This alternative regulatory framework will improve upon the administration’s proposal in three ways. First, it will prevent systemic risk more reliably without worsening moral hazard. The cost-benefit provision of the resolution process ensures that systemic risk is properly considered and prioritized ex post in resolving a Tier 1 FHC failure. Under my proposal, regulators would not be permitted to elevate concern about creating moral hazard above the problem of systemic risk when deciding whether to allow a failed institution to liquidate. Furthermore, even though it is more likely under my proposal than under the administration’s proposal that Tier 1 FHCs will be rescued to some extent, any moral hazard will be limited because only short-term creditors with high-priority claims against an institution, not long-term subordinated creditors, are likely to recover fully in a resolution process.

Second, the Federal Reserve, as a regulatory agency with substantial prior experience regulating large, complex financial institutions and as the agency that would be responsible for monitoring and regulating Tier 1 FHCs ex ante, would have the most expertise and independence to make sound technical determinations about whether the systemic risk exception should be invoked.

Third, this framework reduces the additional harm and contagion caused by uncertainty in regulatory behavior without losing the benefit of reduced moral hazard. By removing the possibility of bankruptcy, the framework I propose eliminates a layer of legal uncertainty that could contribute to panic and trigger a run on financial institutions. Requiring transparency in the Federal Reserve’s methodology for making a systemic risk determination also reduces the ambiguity in decision-making procedures that can exacerbate a financial crisis.

Acknowledgments:

Copyright © 2010 New York University Law Review.

Alison M. Hashmall is a J.D. Candidate at New York University School of Law.

This Editorial introduces and is an abbreviated version of Alison M. Hashmall, Note, After the Fall: A New Framework To Regulate “Too Big to Fail” Nonbank Financial Institutions, 85 N.Y.U. L. Rev. (forthcoming June 2010).

Today, there are new fears that plaintiffs’ lawyers have co-opted securities class actions by paying-to-play. “Paying-to-play” describes the practice of lawyers giving campaign contributions to public pension funds’ political leadership in order to gain favorable consideration by the funds for appointment as class counsel. Many reforms have been proposed and enacted in response to paying-to-play fears. Aside from a few anecdotal reports, however, no examination of campaign contributions from plaintiffs’ lawyers to elected officials exists in the legal literature. This Editorial returns to the first stage of analyzing paying-to-play that many commentators have skipped: whether law firms are contributing to investment funds’ leadership at all. If law firms are not contributing, there can be no rational fear of paying-to-play. My study finds that law firms do indeed contribute to the investment funds that select them as lead counsel.

 
I.
The PSLRA and Paying-To-Play Fears

The PSLRA established a rebuttable presumption that the lead plaintiff is the plaintiff with the largest financial interest in the relief sought by the class. Congress’s theory was that the plaintiff with the largest financial stake would have the greatest incentive to manage the case competently and achieve the highest possible settlement. The PSLRA also guaranteed the lead plaintiff the power to select and control class counsel.

Congress explicitly targeted institutional investors to be the new lead plaintiffs in securities class actions because of their large financial interests and their experience as investors. While from 1997 to 2000, only between ten and twenty institutional investors were named as lead plaintiffs each year,¹ the number grew to thirty-one in 2001 and then to fifty-six institutions in 2002.² In the period covered in my study, 2002 to 2006, 41% of cases had an institutional investor as lead plaintiff.

The first fears over paying-to-play surfaced in media reports in 1998. The legal academy became concerned shortly thereafter, announcing the practice as a problem and then proposing solutions. However, my research revealed only two empirical studies of paying-to-play in the legal literature. Neither study examined lawyers’ campaign contributions; rather, they both used indirect means of investigating paying-to-play.

The lack of empirical evidence of paying-to-play, however, did not stop courts, the American Bar Association, pension funds, Congress, and state legislatures from discussing and implementing reform proposals. Reform may be necessary if paying-to-play indeed negatively affects securities class actions. However, reforms are not without cost; all efforts at reform make tradeoffs in an attempt to insulate pension fund officials from lawyers’ campaign contributions. Generally, there have been four proposals to combat the perceived paying-to-play problem. The first proposal calls for the lead plaintiff fund and the filing law firm to disclose to the court any payments made by the lawyers to the fund, enabling the court to decide whether the fund or firm are fit to serve. The second proposal is merely a bright-line version of the first: A lawyer is barred from representing a fund if the lawyer made a campaign contribution to the fund’s officials. The third proposal requires that elected officials be removed from pension funds’ governing boards and be replaced with unelected leadership. The final proposal is that courts, rather than the lead plaintiff, should select lead counsel through an auction.

The first two proposals would limit lawyers’ participation in the political process. Even if courts had discretion to allow lawyers to continue to serve, the threat of losing a client may be enough to silence lawyers’ political voices. Restructuring pension funds’ leadership—as required by the third proposal—also has costs. Public pension funds likely have elected officials in leadership positions to allow for state government control of the funds. This provides for democratic accountability with regard to the funds’ successes and failures, including their litigation decisions. Finally, as others have noted, a court-run auction to determine lead counsel “is inconsistent with the language of the PSLRA.”³ The PSLRA instructs the court to appoint the “most adequate plaintiff,” not the most adequate law firm, and then allows that plaintiff to choose the lead counsel. Replacing the lead plaintiff’s selection of counsel with that of the court undermines the PSLRA’s intent to empower the lead plaintiff to select and monitor class counsel.

 
II.
Data and Findings: Law Firms’ Contributions to Lead Plaintiff Funds

I examined the 1076 securities class actions filed in the United States from 2002 to 2006. I identified the 445 cases where an institutional investor was at least one of the plaintiffs filing to be lead plaintiff and then narrowed my dataset to the seventy-five cases where the lead plaintiff was an institutional investor with at least one state-level elected official, or person appointed by such an official, on its controlling board. I then identified the membership of the controlling boards of the institutional investors at the time the case was filed. Next, I identified the law firm or firms that each fund selected as counsel in each case. Finally, I used state-level campaign-finance filings to find campaign contributions from the plaintiffs’ law firm (or its lawyers) to any elected official affiliated with the pension fund that selected the firm as counsel. My campaign contribution dataset spanned both before and after the filing of the cases—from 1998 to 2008—in order to capture contributions that could come before law-firm selection as an enticement, or after as a reward. I included contributions made to the relevant candidates directly and also contributions to their political parties’ campaign committees under the theory that candidates may look favorably on contributions to their parties, and donors may seek to exploit such contributions.

I found that in a majority of cases where paying-to-play was possible, at least one law firm made a political contribution to an elected official affiliated with a lead plaintiff pension fund in the case. Of the seventy-four cases in my dataset, a law firm affiliated with a case made a political contribution to a pension fund in forty-eight cases, or 64% of the time.

Because there was sometimes more than one law firm or pension fund filing in each case, and my data grouped these firms and funds together, there were 184 total opportunities for pension funds and law firms to be matched through political contributions. Firms made contributions in seventy-eight of those 184 opportunities, or 42% of the time. Of all the total contributions from a particular firm to officials associated with a particular fund, the mean was $58,942 and the median was $9,300.

 
III.
Discussion and Future Areas of Research

My data confirms that plaintiffs’ law firms are contributing to the pension funds that hire them. These contributions form the baseline of the paying-to-play theory. My study thus provides the first set of paying-to-play data on which future scholarship can build. Some may argue that these contributions themselves create an appearance of impropriety that should be avoided. Others suggest that the focus should be on the actual performance of class counsel, no matter how selected.⁴ The resolution of this question is beyond the scope of this Editorial.

The debate over paying-to-play involves more than a concern over political contributions. The paying-to-play theory has three basic elements: (1) law firms are giving political contributions to officials affiliated with pension funds’ boards; (2) the firms are doing so with the intention of earning favors from the funds; and (3) pension funds are in fact giving those favors by selecting contributing firms as lead counsel in class action cases.

While this Editorial has provided some evidence of the presence of element one, we must examine elements two and three to understand fully the paying-to-play problem and to formulate an appropriate policy response. The factors listed below are not meant to be an exhaustive list of all important matters but rather a helpful guide for future researchers of what I consider to be the most interesting quantifiable factors surrounding the paying-to-play problem.

 
A.     Geography

Pension funds might be likely to select local law firms with whom they are familiar and with whom they can meet frequently. This may be especially true if pension funds plan to, or have been, working with firms for a long period of time, such as funds hiring a firm to provide litigation monitoring services. Geography may also be important for researchers seeking to understand law firms’ political contributions. Contributions from lawyers to politicians in their own states may seem less suspicious than donations to those in distant states.

 
B.     Experience

Based on my data, from 2002 to 2006, pension funds selected the same few law firms repeatedly. Bernstein Litowitz Berger & Grossman was affiliated with an institutional plaintiff in thirty of the seventy-five cases in my dataset, or 40% of the cases. On the other hand, pension funds selected twenty-nine of the thirty-six total firms each three or fewer times. Future research could quantify indicators of a law firm’s experience, such as the number of previous securities fraud class action cases handled, in an effort to discover whether experience is an independently significant variable in funds’ selection decisions.

 
C.     Previous Relationships

Funds may also be more likely to select firms with which they have had a particular former relationship. This might mean a firm representing the fund in a previous class action, but it could also include a law firm providing other services for a fund. According to one securities class action expert, funds increasingly are relying on law firms to monitor their investments and to provide advice on possible suits to file or join.⁵ Funds typically do not pay the law firms for these litigation and investment monitoring services, but the firms instead hope to be rewarded by being selected as lead counsel if the fund decides to file suit and is named lead plaintiff. In a recent case, Judge Jed S. Rakoff raised concerns at a hearing that a proposed plaintiff law firm had a “blatant, shocking conflict of interest” stemming from free monitoring services provided for a union pension fund client.⁶ Additionally, pension funds have been reported to keep “short lists” of firms that have been prescreened to use when the fund decides to file suit. In these cases, the law firm that provides investment monitoring services competes with other firms on the fund’s list. Pension funds without exclusive lists rely on “requests for proposals” sent to law firms, inviting them to bid for the pension fund’s legal work. All of these arrangements may shed light on law firms’ decisions to contribute to funds, or may impact funds’ lead counsel selection decisions.

 
Conclusion

Past fears, and even reforms, of the paying-to-play practice have been based on anecdotal evidence in the media and scholarly literature. This Editorial provides empirical evidence for the first time showing that plaintiffs’ law firms do contribute to officials affiliated with the public pension funds that select them as lead counsel in securities fraud class actions. Given this prima facie evidence, it is still important to explore other factors that may explain why law firms contribute to funds and how funds choose which law firms to hire. Moreover, even if the worst paying-to-play fears are true and pension funds are selecting law firms based on political contributions, does paying-to-play actually have a negative effect on lawyer-client agency costs in securities fraud class actions? In other words, even if paying-to-play is happening, does it matter? This is a question Stephen J. Choi, Adam C. Pritchard, and I examine in an upcoming paper, The Price of Paying to Play in Securities Class Actions.⁷

Acknowledgments:

Copyright © 2010 New York University Law Review.

Drew T. Johnson-Skinner received his J.D. from New York University School of Law in 2009. He is currently a Law Clerk for Judge John G. Koeltl.

This Legal Workshop Editorial is based on the following Student Note: Drew T. Johnson-Skinner, Paying-To-Play in Securities Class Actions: A Look at Lawyers’ Campaign Contributions, 84 N.Y.U. L. REV. 1725 (2009).

Click here to access the raw data analyzed in this Editorial.

The actual enforceability of medical malpractice exculpatory agreements remains an unsettled and underexplored question.  Courts treat general exculpatory agreements—like those signed at amusement parks—as they do any other contract, enforcing the contracts as long as they are entered into voluntarily.  But medical malpractice exculpatory agreements have been repeatedly invalidated, often under the mysterious “void-for-public-policy” rationale.  This Editorial outlines the basic arguments put forward in my Note exploring the enforceability of medical malpractice exculpatory agreements.  In the process, I set out a blueprint that medical providers might use to craft an enforceable medical malpractice exculpatory agreement.  I argue that the agreement with the best chances of being enforced is one that is not just optional for the patient and clearly worded, but also confidential.

 
I.
Judicial Resistance to Medical Malpractice Exculpatory Agreements

Cases using the void-for-public-policy rationale to invalidate medical malpractice exculpatory agreements abound, while cases upholding the agreements are difficult to find.  However, it is unclear whether the resistance to these agreements is a result of something that renders them categorically void or, alternatively, of some quality of the specific subset of agreements that are actually brought to court.

New York follows the majority rule on medical malpractice exculpatory agreements, so an in-depth analysis of New York case law is illustrative.  When invalidating medical malpractice exculpatory agreements, New York courts seem to focus on the way medical malpractice agreements are presented and worded, rather than on the subject matter or parties to the agreement.  In case after case, the courts look beyond the mere fact that the agreement is between doctor and patient and relates to liability, instead scrutinizing the specific wording of the agreement, the presentation of the agreement, and the circumstances of the bargain before ruling on an agreement’s validity.

There is reason to believe a medical malpractice exculpatory agreement could be crafted such that a New York court (and presumably any court following the majority rule) would enforce it, in spite of the fact that most cases on record involving such agreements have found them to be void for public policy.  The cases suggest that it is neither the subject matter of nor the parties to medical malpractice exculpatory agreements that render them void for public policy, but rather some feature of their presentation and signing.  Unfortunately, the cases provide few clues as to what elements are problematic.

 
II.
A Possible Culprit: Signaling Pressure in Medical Malpractice Exculpatory Agreements

A behavioral economic perspective reveals that medical malpractice exculpatory agreements create a somewhat intuitive problem that may underlie courts’ skepticism.  At the core of this problem is the signaling involved in the decision to sign (or not sign) a medical malpractice exculpatory agreement:  By refusing to sign such an agreement in exchange for a lower fee, a patient unequivocally signals to her doctor that:

(1) she is the sort of patient who would sue her doctor if injured negligently,

and

(2) she thinks there is at least some chance her doctor will make a mistake.

By refusing to sign an exculpatory agreement, the patient essentially says to the doctor, “No thanks, while I like saving money, I think there is a chance I’ll end up suing you.”

This signaling is problematic because we patients want our doctors to think we trust them.  Call it fairness, fear of retaliation, or altruism—the fact remains that many of us are uncomfortable with letting our doctors know that we have anything but the utmost faith in their abilities, even when we do have serious doubts.  This is why we are so hesitant explicitly to ask for a second opinion, even though we do not think twice about double-checking our diagnosis through anonymous means such as logging into WebMD or calling a doctor friend.  The same is true when it comes to deciding whether or not to sign a medical malpractice exculpatory agreement.  We know that if we do not sign, we will signal a lack of trust to our doctors, and this signaling effect puts pressure on us to sign, even if we otherwise would rather retain the right to sue for malpractice.

 
III.
Blueprint for an Enforceable Medical Malpractice Exculpatory Agreement

In my full Note, I discuss the plausibility of the assumption that courts’ skepticism toward medical malpractice exculpatory agreements is related to the signaling pressure identified above.  Assuming that this encumbrance to patient decisionmaking does underlie judicial suspicion of these agreements, it is possible to set out a blueprint for an exculpatory agreement that avoids signaling pressure, thereby alleviating courts’ concerns.

First, courts have clearly stated that patients must actually understand what they are signing in order to be able to waive the right to sue for malpractice.  Furthermore, courts have stated that because medical care is a necessary service, doctors cannot present malpractice waivers on a take-it-or-leave-it basis.  Thus, as a preliminary matter, any agreement that hopes to be enforced must be nonadhesive (optional) and clearly worded.

Such an agreement would still be subject to the signaling encumbrance identified above.  To cure this defect and avoid claims that a patient’s decision was not really voluntary, a medical provider hoping to create an enforceable medical malpractice exculpatory agreement would need to find a way to insulate the patient’s decision from signaling.  This could be done by making the patient’s decision confidential.  By guaranteeing the patient a zone of privacy around her decision to sign—at least vis-à-vis her doctor—a medical provider presenting a patient with a medical malpractice exculpatory agreement could guarantee that the patient’s decision was not influenced by fear of how the doctor might respond.

Contracting over malpractice confidentially would not be difficult.  The simplest method would be to utilize direct contracting between patients and managed care providers.  The doctor would only know that some patients from the managed care provider withheld the malpractice right and some did not.  She would not find out whether a given patient had decided to withhold the right unless that patient chose to sue ex post.

Even without an intermediary, contract law leaves plenty of room for a doctor and patient to enter into a traditional contract confidentially.  The doctor could present and explain two fee arrangements—one including an exculpatory agreement, one not—as two separate offers.  She could then invite the patient’s confidential acceptance of either offer, so as to remain in the dark about the patient’s decision.  Such an arrangement would be perfectly legal:  The Restatement (Second) of Contracts makes clear that the offeror may invite acceptance by whatever reasonable means she designates in making the offer, be it performance or, in this case, acceptance delivered confidentially to a third party.

Of course, even if the contract were formed confidentially, the patient may want a guarantee that her decision would remain confidential.  Confidentiality and privacy clauses are common elements of contracts, and, in this case, both offered contracts need only include clauses that guarantee confidentiality, and perhaps provide some warranty in the event that confidentiality is breached.  In addition, they might designate an independent third party—such as the doctor’s malpractice insurance company—to maintain the confidentiality of the agreement.  Again, the doctor would never find out whether a patient had signed or not, unless that patient decided to sue.

 
Conclusion

This Editorial has focused on signaling effects and confidential contracting in the context of medical malpractice exculpatory agreements, but these ideas might be applicable to other situations.  Within health law, it might be that patient choice would be facilitated in many other highly sensitive areas by using the law to make patient decisions confidential, even vis-à-vis the family doctor.  Decisions like the choice to use birth control, get an STD test, or seek out a second opinion come to mind.  Beyond the medical arena, confidential contracts might be utilized anywhere a special relationship of trust between two parties is in conflict with the signaling caused by standard contracts. Such uses might include contracts in the employment context and contracts regarding legal representation.

Acknowledgments:

Copyright © 2010 New York University School of Law.

Matthew J.B. Lawrence received his J.D. in 2009 from New York University Law School. He is now clerking for Judge Douglas H. Ginsburg of the D.C. Court of Appeals.

This Legal Workshop Editorial is based on the following Student Note: Matthew J.B. Lawrence, In Search of an Enforceable Medical Malpractice Exculpatory Agreement: Introducing Confidential Contracts as a Solution to the Doctor-Patient Relationship Problem, 84 N.Y.U. L. REV. 850 (2009).

Now that we know that ongoing, day-to-day franchise tax competition is just not happening, we need to reframe the inquiry to examine the constraints that Delaware does face. If no state is immediately poised to take franchise revenues away from Delaware, does Delaware have unlimited discretion? If it does not, where do those limits come from?

Delaware does face constraints, and they do not seem small. First, Delaware’s chartering business interacts with the dynamism of the real economy in ways that make it hard for Delaware to rest on its franchise tax laurels. Even if no other state actively competes for chartering revenue, Delaware itself must vie to sell new charters because it needs to draw reincorporations from other states. Conceptually, this is clear. The question is its degree. When, decades ago, business turnover in the economy was slower than it is today, this competitive channel was not particularly important. Firms, or most of them, stayed organized from year-to-year about the way they had been. Once Delaware captured a firm’s franchise revenue in one year, that firm tended to be a reliable Delaware taxpayer in future years. But as corporate restructurings, spin-offs, mergers, and turnover have accelerated, keeping this channel flowing in to Delaware has become increasingly important for the state. Indeed, that acceleration has squeezed the half-life of its tax base down from a quarter century to a decade. That is, half of Delaware’s tax base in recent years comes from firms that got their Delaware charter in the prior decade; twenty years ago the tax base was more stable, with half of it coming from firms that got their Delaware charters in the prior quarter of a century. Delaware must run ever faster just to stay in place.

Second, another state, North Dakota, actively entered the market for corporate charters, drawing intense attention from Delaware and increasing attention from corporate dealmakers and corporate law academic analyses. Activist investors sought a corporate law attuned to their agenda and sought (unsuccessfully) first that Vermont and then (successfully) that North Dakota accept their agenda. Although that state has captured few reincorporations yet—and, hence, little in franchise fees—the North Dakota development potentially constrains Delaware, even if that constraint is only a loose one now. The North Dakota scenario highlights how severe state competition could break out:  not from an aggressive, innovative legislature (a mode usually thought to be unlikely and, hence, one of the reasons we’ve seen state competition as weak), but from disgruntled Delaware corporate players who instigate another state to enter the fray.

And, third, Washington, D.C. has always been a corporate governance player. In the scandals of the early part of this decade and the economic turmoil of the latter part, its role in potentially displacing and often enough affecting state lawmaking has become increasingly vivid. The early part of this decade saw Congress pass the Sarbanes-Oxley Act, a major corporate law statute. The end of the decade sees the Securities and Exchange Commission considering a major restructuring of corporate law that would give disgruntled shareholders access to their company’s proxy solicitation apparatus in a way that could shift corporate law authority in the firm.

Each of these three channels deserves further attention. For the first channel—the intensity of corporate turnover in the real economy, impelling Delaware to have to scramble to sell new charters just to stay even—data I obtained from the Delaware Secretary of State’s office show flow and turnover of Delaware’s tax base to be substantial in the past decade. Although ongoing state-to-state competition for chartering revenues is somnolent, as has been shown, competition in American business—in the real economy—is not. Preexisting Delaware-chartered firms merge, restructure, or close, thereby eliminating in each case one source of Delaware’s franchise fees. To keep up, Delaware must draw new firms into the state. The raw chartering numbers show that about 10% of the chartered firms at the beginning of each year are gone by the end of the year. And, typically, 10% of the firms at the end of the year are new firms that Delaware has drawn in. The dynamism of the real economy interacts with the structure of the chartering market to create a major arena where Delaware must continually vie for charters.

The data reveal another trend: just as we corporate law academics were coming to the conclusion that state chartering competition wasn’t happening, this pressure on Delaware to maintain flow has increased. Briefly put: only a couple of decades ago, the half-life of Delaware’s tax base was on the order of a quarter century. That posed a real consideration for Delaware, but was long enough not to be of immediate concern to the typical career state official, legislator, or local lawyer. This pressure has intensified, however—due to increasing pressures coming from the real economy interacting—to reduce the half-life of Delaware’s tax base down to a decade.

Delaware must continually provide enough value to new firms arising in other states (and to their controlling decisionmakers) to induce them to reincorporate into Delaware. The current focus on whether state lawmakers are sufficiently dynamic and competitive is surely warranted, but potentially overemphasized. Even if states are insufficiently dynamic and competitive, American business is dynamic. Firms arise, prosper, and merge. Others arise, fail, and disappear. For Delaware’s importance to persist over the decades, it must convince new firms to reincorporate away from their home states.

Second, Delaware faces other constraints. We can call those constraints competitive ones, if we expand our concept beyond ongoing competition for chartering revenue. Or we might just think of them as pressures and constraints preventing Delaware from being a fully free agent in its corporate decisionmaking, due to potential competition. Delaware must be wary of making a major mistake, one that would not just induce the inflow to dry up, but that could induce a new, previously inactive state to enter the market, conceivably in a way that could irreversibly erode Delaware’s existing base of charters if corporate America becomes unhappy with Delaware (or one that arrests the flow of firms that reincorporate into Delaware). Even states not actively seeking charters today can potentially compete in this limited sense with Delaware. Such a concept has a parallel in the industrial organization literature on contestable markets: a single producer can putatively dominate a market, but could lose its market share overnight. Hence, it acts like a competitor on some matters, or knows it must provide an overall package that is attractive to its primary customers. It has slack, but that slack is not unlimited, because its market, like Delaware’s, is contestable.

In this dimension, the focus on slow state bureaucracies and uninterested state legislatures is justified but easy to overemphasize. Thus, the second major constraint on Delaware is that the relevant actors who could undermine Delaware’s lead would be the interests already in Delaware. If they became unhappy with Delaware, it’s corporate players who would push another state to actively seek corporate charters. Corporate interests are not passive consumers, forced by the absence of another state purveying its own corporate law to accept whatever Delaware decides to offer. They can lobby another state’s lawmakers, ask for new law, offer that state the tax benefits of the law, and do the initial legal work; they are the ones who would motivate and press Delaware to change. And, as if to demonstrate this possibility, shareholder activists, unhappy with Delaware law, went shopping for a friendly state in the past couple of years and found one—North Dakota—to put competitive pressure on Delaware.

Delaware, despite not facing the intense Economics 101 competition of many other producers of corporate law, faces a contestable market, and that contestability limits the breadth of Delaware’s discretion. Its position is contestable horizontally, subject to several powerful interstate pressures. And it’s also contestable vertically, subject to pressures from Washington, the third major channel confining Delaware’s range of discretion. For example, Delaware legislation passed in March 2009 could seriously change core parts of corporate law dealing with election contests and access to the company’s proxy statement. That legislation is best understood as motivated by one or the other, or both, of these horizontal and vertical dimensions to competition.

That Delaware competes in some sense seems indisputable: its principal lawmakers are active, involved, and energetic. Indeed, as one inside commentator tells us, even if Delaware has won some race or another, “no one in Delaware is willing to play hare while some other state tortoise gains ground.” Delaware players worry. They don’t face day-to-day, head-to-head competition with other states for corporate chartering revenue, as we now know. But they are not free agents. Their actions are constrained.

Acknowledgments:

Copyright © 2010 Stanford Law Review.

Mark J. Roe is the David Berg Professor of Law at Harvard Law School.

This Legal Workshop Editorial is based on the following Article: Mark J. Roe, Delaware’s Shrinking Half-Life, 62 STAN. L. REV. 125 (2009).

Legal theory and, in particular, neoclassical law and economics will not be the same after the worst market collapse since the Great Depression, and the political engagement that resulted in the election of the nation’s first African-American President.  A quiet revolution is underway in the legal academy.  Indeed, one way of looking at a vast amount of seemingly unrelated scholarship over the past twenty years is to see that, in one way or another, it has sought to challenge the unrealistic assumptions of the neoclassical law and economics model.  We survey this scholarship under the mantle of a “new legal realism” and argue that much of it is a direct or indirect response to the “new formalism” of neoclassical law and economics.  New legal realists are not anti-economics (many of them are economists themselves), but they are challenging the new formalism’s assumptions about the individual, the state, and judging, as well as its approach to legal scholarship.

On the surface, neoclassical theory may appear to be the opposite of the old formalism, which advocated a “science” of doctrine based on common-law principles.  Neoclassical efficiency theory has touted instrumentalism rather than doctrinalism.  Oddly, however, the new formalism turns out, upon examination, to parallel the old in its form of deductive reasoning from axioms and the substantive policy prescriptions derived from it.  Neoclassical theory may talk about efficiency, but it ends up celebrating the common law.  It may claim to be a new science, but, like the old nineteenth century science of laissez-faire, it denigrates politics as the realm of special interests.

Perhaps it is not surprising then that, over the past eight years, new movements have arisen that characterize themselves as representative of a new legal realism.  Earlier articles have elaborated distinct versions of new legal realism in isolation.  We provide a taxonomy and overview of this literature in order to evaluate its commonalities and differences, facilitate mutual engagement among scholars, and build our own version of a “dynamic new legal realism.”

 
I.
Mapping New Legal Realism: Three Approaches

We categorize the new legal realism into three broad types.  First, there are behavioral approaches: studies that borrow from behavioral economics and political science to reach conclusions about law-as-behavior.  Second, there are contextual approaches: empirical work that includes studies using mixed methods involving bottom-up forms of empirical inquiry.  Third, there are institutional approaches: studies focusing on the power of institutions and institutional choices to determine our policies and shape our very ideas of self, society, and the state.

 
A.     The Behaviorists

There are two forms of what we call the “behavioral wing” of new legal realism.  One takes its inspiration from behavioral economics and the other, the attitudinal model in political science.  In 2001, Daniel Farber reviewed Cass Sunstein’s work on behavioral economics and proclaimed that studies challenging the rational-actor model were the new legal realism.² Farber argued that behavioral economists had successfully attacked the rational-choice models underlying neoclassical law-and-economics and public-choice theory by presenting a more realistic depiction of human behavior.

In a 1997 article, Frank Cross urged that a “new legal realism” take account of the “attitudinal model” of political scientists, which, in its more extreme variant, holds that legal reasons are irrelevant and that judicial decisions can be predicted based on ideological variables and political affiliations.³ This work, which forms part of the new empirical-legal-studies movement, has spurred a flurry of studies that find ideological bias across subject areas of judicial decision making.⁴ By 2008, Thomas Miles and Cass Sunstein dubbed such studies the cutting edge of new legal realism.⁵

 
B.     The Contextualists

Stewart Macaulay has deployed the term “law in action” to capture Wisconsin’s variety of new legal realism.⁶ Statistical studies are not enough for this version of new legal realism and are often complemented or replaced by sociological and anthropological approaches to law.  Macaulay’s canonical study of how businesspersons make bargains (largely in complete disregard of the law) is the starting but not the ending point of this model.  We call this work, for purposes of distinguishing it from other forms of empirical research, “action studies,” reflecting the subject of study—the law in action.

There are variations within the contextualist approach that reflect the variations in the law-and-society movement from which this version of new legal realism builds.⁷ Each of these variants uses different empirical tools to investigate behavior in social context.  Economists working in a contextualist vein, such as Ian Ayres, John Donohue, and Steven Levitt, deploy quantitative large-N studies and multivariate regressions.  Sociologists, such as Robert Nelson and Laura Beth Nielsen at the American Bar Foundation, use mixed qualitative and quantitative methods.  Legal historians, like Lawrence Friedman, Robert Gordon, and William Novak use qualitative and quantitative methods, as well as critical reflection.

 
C.     The Institutionalists

Building from different traditions in economics and sociology, a number of scholars have claimed that new legal realism should focus on institutional forces.  Neil Komesar has taken an important institutional turn for new legal realists, showing how social-goal choice alone is insufficient to inform law and policy decisions because the pursuit of all goals will be shaped and determined by institutional processes.⁸ Working in this vein, Ed Rubin advocates a microanalysis of institutions,⁹ an approach that is not limited to public institutions, but includes studies of private organizations, building on neo-institutional insights from sociology.¹⁰

“New governance” theory of law, coming out of Columbia Law School in particular, focuses on efforts to move beyond a court-centric and rights-focused basis of law and toward new forms of problem solving involving pragmatic institutional experimentation.¹¹ New-governance theory emphasizes the importance of innovation, learning, and flexible adaptation in light of experience.  Finally, other new legal realists have attacked the root image of the autonomous individual, not on the grounds of potential irrationality, but on the grounds of interdependence.  This approach has its roots in critical theory and feminism.  For scholars such as Martha Fineman, institutions must respond to universal human vulnerability, and thus institutional responsibility becomes central to policy analysis.¹²

 
II.
Responses to the New Formalism in Neoclassical Law and Economics

One can understand neoclassical law and economics as a new version of formalism if by formalism we mean a theory of law based on rationally organized first principles deductively applied.  It sets forth coherent principles (efficiency and wealth maximization) that it attempts to apply descriptively and prescriptively to all areas of law.  Judge Posner recognized this formalist argumentative structure when he wrote that “[e]conomic analysis of law is a formalist edifice erected on a realist [i.e., instrumentalist] base.”¹³

Some have claimed that law and economics is a “realist” enterprise since it rejects formal, self-contained doctrinalism.  New realists, however, argue that neoclassical theory turns realism on its head.  They contend that neoclassical theory seeks hypothetical end-states-of-affairs (wealth or welfare maximization) deduced from simplified assumptions rather than real-life facts and institutional processes.  New realists acknowledge that the new formalism differs from the old because of its instrumentalist base, but they contend that the new formalism arrives at conclusions remarkably like the old doctrinal formalism of the late nineteenth century—an idealization of common law and market processes, and a distrust of political institutions and state regulation.

In our article, we go into much greater detail regarding the new legal realist challenge to law and economics theories of judging, the individual, politics, and the state, as well as its general approach to scholarship.  For our purposes here, we note that each of the varieties of new legal realism directly or indirectly challenges aspects of neoclassical law and economics’ reasoning.  Behavioral economists challenge neoclassical law and economics’ rational-actor model.  Attitudinalists challenge the neoclassical law-and-economics notion of the efficiency of judging in the name of wealth-maximization.  Contextualists and institutionalists challenge an economics that does not compare institutional alternatives and their relative imperfections, and that fails to recognize that individuals’ situations vary so that some are in privileged or dominant positions in relation to others.  Like the old legal realists, new legal realists take aim at the “status quo bias” of formalist reasoning, a bias once entrenched in Herbert Spencer’s “laissez-faire” philosophy and its libertarian ideal and, subsequently, Chicago-school neoclassical law and economics’ recast exposition of that same ideal.

 
III.
Conclusion: A Dynamic New Legal Realism for a New World Order

As an alternative to existing forms of new realism, we begin the effort to outline a “dynamic new realism,” building from what we consider to be the best of the new realism.  Our form of dynamic realism focuses on “mediating” theory, which aims self-consciously to theorize the bridge between the world and legal institutions.  Unlike the old realism, such a dynamic new realism stresses that law is important within its sphere, in part because legal institutions exert power—the power both of violence and of reason.  Theories that simply ignore law leave the field open to those who would manipulate the law to achieve not only bad ends, but also literally terrifying ones (even torture).  In this sense, realisms that tend to explain law in terms of other disciplines are profoundly “unrealistic” to the extent that they leave law no place to exert its influence for ill or good.  Law cannot be reduced simply to economics, political science, sociology, or anthropology.  Neither the attitudinal model nor behavioral economics, neither large-N quantitative studies nor fieldwork, is enough.  Why?  Because legal institutions have power, and that power may transform knowledge and preferences in ways that may make them completely unrecognizable to its authors.

We suggest five conceptual moves that should be associated with a new realism and that offer scholars tools to bring particular analytics to bear on existing problems.  The first notion is recursivity.  Borrowing from Terence Halliday, we stress that legal-reform efforts are dynamic and involve the recursive interaction between law and society.¹⁴ The second notion is the simultaneity of law and politics.  One of the great (and unfortunate) habits of an age in which everyone is a “realist” has been to tend to reduce law to politics.  Yet law and politics involve different institutional processes that interact simultaneously in real life.  Dynamic new realism attempts to capture this dualism by telling “double stories” of law and politics or “triple stories” of law, markets, and politics, rather than stories that reduce one to the others.  The third notion is emergent analytics, which is the idea that a dynamic realism takes its concepts from evidence-based empirical engagement with the world and not from disembodied theory.

Fourth, functionalism is no longer enough.  We cannot simply posit values and expect them to be realized, just as legal scholarship cannot be reduced to other disciplines’ methods.  Unlike the old realists’ functionalism, dynamic new realism looks for concepts of “mediation” and “participation”—concepts that describe the ways in which law’s purposes are thwarted, amplified, condensed, or switched once translated into the world.  We should examine functions and ends in terms of how participatory structures of human interaction divert them.  Thus, the concepts of participation and accountability become central.  Fifth, and perhaps most importantly, borrowing from Dean Hanoch Dagan, we believe that law’s constitutive tensions between “power and reason, science and craft, tradition and progress” must be embraced not as a cause of a fundamental essentialist contradiction or defeat, but as productive and positive contradictions, reflecting a progressive struggle and dialogue about our deepest value commitments (as against value relativism, skepticism, and nihilism).¹⁵

New legal movements do not arise in the abstract.  They resonate if they fit a particular political moment in light of their confrontation with a dominant theory and practice.  Old legal realists played this role in the 1930s.  So, in our view, will the new-legal-realist movement today.  Dynamic new realism seeks an understanding of how law, like other institutions, reciprocally responds to and shapes individual preferences and political behavior.  If this dynamic new realism is taken seriously, we anticipate that new forms of analysis will emerge that will reconstruct law’s concepts to focus less on the individual preferences and more on how institutions shape and redirect those preferences, less on functional ideas and more on participatory institutional forms, less on idealized end-states of affairs or values and more on recursive interactions between ends and institutions, less on an imagined state in which we live, alone, on islands counting our preferences, and more on our shared human vulnerability.

Acknowledgments:

Copyright © 2010 Cornell Law Review.

Victoria Nourse is the Burrus-Bascom Professor of Law at UW Madison Law School and is currently a Visiting Professor of Law at Georgetown University Law Center.
Gregory Shaffer is the Melvin C. Steen Professor of Law at the University of Minnesota Law School.

This Legal Workshop Editorial is based on the following Article: Victoria Nourse & Gregory Shaffer, Varieties of New Legal Realism: Can a New World Order Prompt a New Legal Theory?, 95 CORNELL L. REV. 61 (2010).

A more narrowly tailored way to protect property rights in the context of takings for private economic development focuses on the word “use” rather than the word “public” in the Fifth Amendment.³ Instead of requiring that takings be proposed for a purpose more “public” than private economic development, I would require that land taken for private economic development actually be used for the claimed public purpose.

My proposal would address two troubling aspects of current takings law.  First, current law allows for the taking of private land without assurance that a public benefit will ever be realized, such as with a taking justified by a development plan.  When the Court approves such a taking based on the public benefit promised by the plan, the owner has no remedy even if the proponent of the plan abandons the project and the public purpose is never realized.   This possibility has become reality in the aftermath of the takings at issue in Kelo.  Not only has no development occurred on the taken land, but Pfizer Inc. announced on November 9, 2009, that it will close the New London research facility that the development planned for the taken land was internded to complement.⁴ There is no prospect of public benefit being achieved on the taken land, and the former property owners have no claims.

Second, current law creates incentives that encourage inefficient takings, by which I mean takings where the political and legal costs are greater than the public benefit achieved.  These occur, at least in part, because the Court’s failure to require actual public use of taken land allows for takings based on exaggerated public benefits.  The following stylized analysis illustrates how the interaction between a government and a private developer seeking a taking leads to condemnations based on misinformation.

I.
The Problem of Inefficient Takings: A Simple Model

The process of taking land starts with a proponent, who I assume is a private developer.  After failing to convince a landowner to sell a parcel, the proponent proposes to a government that the land in question be taken via eminent domain.  The government responds by asking what public benefit will justify the use of this power.  The developer is unsure of the public benefit of the project, but she knows she needs the land to proceed and that current law will not force her to provide whatever public benefit she promises.  Additionally, the developer does not know how much benefit the government wants for the taking, and she wants to avoid underbidding.  The developer thus has every incentive to exaggerate her estimate of public benefit.

But why would the government accept these exaggerated claims of public benefit?  First, the government may actually believe the claims made by a private proponent, accepting them based on wishful thinking.  Officials, presumably feeling they have little to lose, may be willing to embrace exaggerated claims in hopes of fostering optimism and change.

Second, government officials may not be pursuing the public interest single-mindedly.  Instead, they may take their self-interest as well as the public interest into account when considering a proposed condemnation.  Government officials reviewing a request for a taking might be willing to embrace an implausible public benefit estimate for a number of self-interested reasons.  For example, officials concerned about their prospects for reelection might encourage development regardless of its likelihood of success so that voters will see them as taking action to address widely publicized problems such as urban blight.  After all, voters will not know the plausibility of the projects in the short term.  Another self-interested reason that government officials might accept inflated public benefit claims would be to garner political support from powerful interest groups, which could provide campaign financing and loyal constituents.

II.
The Solution: An Actual Use Requirement

My proposal solves this inefficient takings problem by focusing on changing the behavior of private actors while also making condemnees whole.  By forcing private developers to substantially deliver on their promises of public benefit or pay damages severe enough to deter, an actual use requirement would make real the imaginary currency of public benefit.  A developer would carefully consider all elements of a proposal that claims to yield a certain public benefit because she would be committed to substantially completing that proposal.  Completing an element of the plan that was supposed to provide a benefit—a hotel that would employ 100, for example—would be extremely expensive if the market could not support the element (for example, if demand for hotel rooms proved inadequate).  Thus, the developer would no longer have an incentive to exaggerate.

With an actual use requirement, the proponent would approach the government with an accurate estimate of the public benefit.  The public-minded government then could compare the condemnation cost with the public benefit using accurate information and make a good-faith takings decision.  The respective roles played by the legislative and judicial branches would not change, but each party would be better able to fulfill its current role because it would have more complete information.  A political branch remains empowered to make the political decision of how to expend public resources by taking land.  This is important not just because the Supreme Court demands it,⁵ but because the legislature, with its closer ties to the community in question and greater access to expert planners, is better positioned to evaluate a proposed development than the courts.

III.
The Remedy for Inefficient Takings

A fairly simple remedy would serve to deter inefficient takings.  When the public purpose that originally justified a taking is not substantially realized, the land must be returned to the condemnee, if practicable, in exchange for the compensation originally paid for the taking, and the condemnee must get damages to compensate her for the inconvenience of being forced from her property, as well as mental and emotional damages.

Unfortunately, the first part of this remedy—the return of condemned land in exchange for the original just compensation—will often be impracticable.  If the condemnee does not discover the development is falling short of its proclaimed purpose until the site of her former home has become a putting green, she cannot simply seek an injunction ordering the return of her home:  To issue an injunction would be disproportionate or wasteful.  Meanwhile, the condemnee may have moved to another city and no longer desire to return to her home years after being removed from it.  To account for this reality, condemnees would also have the option to keep the just compensation and only sue for the additional damages.

The damages component of this remedy is derived from remedies in tort where the cause of action arises under the Constitution.  Constitutional torts generally are awarded like common law torts, with damages designed to compensate for the injury resulting from the violation of a constitutional right.  Here, damages would total the amount necessary to compensate the condemnee for being forced from her property for a period of years, and they would in many cases include a significant emotional distress element.  Awards would vary case by case.  For example, a large emotional distress award might be appropriate in the case of someone like Wilhelmina Dery, the 91-year-old New London resident forced from the home of her birth by the Kelo taking.  However, a lesser award with no emotional damage component would be appropriate if a vacant lot had been taken.  This flexibility would partially compensate condemnees for subjective value, something not achieved by any current remedies.

IV.
The Trigger for the Actual Use Remedy

The development plan used to justify a taking would determine whether the actual use remedy is triggered.  The development plan already plays a key role in takings law:  When the Supreme Court approves an economic development taking, it does not rule that a certain public benefit justifies taking private land but rather that a development plan promising some benefit does.  To ensure the benefit promised by the plan is realized, an actual use requirement recognizes a condemnee’s continuing interest in her property until the public benefit laid out in the approved development plan is substantially achieved.  If the plan justifies the taking, then it should be the substantial achievement of the benefit promised by the plan within the time frame of the plan that extinguishes a condemnee’s right in the property.  Essentially, an actual use requirement treats a taking for economic development by a private party as contingent upon completion of the justifying development.

Requiring developers to follow through substantially on the justifying development plan is important for several reasons.  First, it provides an affirmative guarantee that a public benefit will be achieved from the taking.  Current statutory and contractual guarantees generally only prevent developers from straying from the plan justifying a taking; they do not require them to actually fulfill the plan.

Second, the plan sets the physical and temporal standards that must be met to prevent a taking from being unconstitutional.  Once the plan is fulfilled in good faith, the Fifth Amendment’s demands are met.  The plan’s success would be measured by the completion of its physical goals, such as building a 350-room hotel within a certain time frame.  The completion of the development plan, in most cases, should serve as an adequate proxy for the public benefits the plan will create.  A rational developer would be unlikely to expend the resources to build a facility with capacity it did not believe it could utilize.

Developers also would be free to sell the property they received by a taking.  However, the sale would be subject to the development plan that justified the taking; the constitutional right of condemnees would run with the land and plan, allowing condemnees to press their claim against the new developer.

Finally, the plan would control the timing of the constitutional right.  Development plans set out time frames for the achievement of the public benefit they promise.  The substantial achievement of this public purpose within the promised time frame would extinguish condemnees’ constitutional interest in the land, in effect ending the contingency of the transfer.  However, it bears emphasizing that actual use calls for substantial and not complete compliance with the development plan.  This is essential to provide courts and developers with the wiggle room to prevent wastefulness when complete compliance becomes impractical for unforeseen reasons despite the good faith efforts of the developer.  Whether a project is substantially complete would be a case-by-case inquiry.

V.
Responses to Possible Objections

The temporal element of my proposal could inspire objection.  A critic could argue that extending the possibility of suit until a public purpose is achieved would lead to uncertainty for governments and developers, waste for society, and headaches for the courts.  Developers and governments seeking only fair profit and the public good could end up having to pay damages if a well-intentioned project fails for reasons beyond their control.  Meanwhile, courts might have to confront the same parties multiple times as condemnees presented new challenges.

Regarding uncertainty, there is no question an actual use requirement would add to the risk faced by proponents and governments.  This risk is not unfair, however, because these parties would be aware of it before taking the land.  Among the many factors a developer would want to consider when proposing a taking would be whether the project would be worthwhile even when discounted by the remote possibility of a catastrophic event.  The proponent would only seek takings with benefits so large that they justify the risk.

In the event that a developer did seek and win approval for a taking, one could argue that forcing the developer to finish a project in the face of more socially advantageous alternatives would be wasteful.  However, an actual use requirement would permit solutions commonly used by businesses to deal with this situation, such as efficient breach.  A developer might very well opt out of her development plan if other opportunities were lucrative enough.  Of course, given the expense of the actual use remedy, breach would be efficient less often than under a standard contract.  But developers engaging in takings under an actual use regime would be well aware of the damages they face and thus would weigh this risk when considering whether to take on a project.

Moreover, an actual use requirement is not intended to provide a business environment on par with one that does not require the government’s coercive power to take land.  Rather, it is intended to protect constitutional property rights by giving developers the incentive to provide governments with accurate information on which to base their takings decisions.

Acknowledgments:

Copyright © 2009 New York University Law Review.

William A. Curran received his J.D. from New York University School of Law in 2009.

This Legal Workshop Editorial is based on Mr. Curran’s Student Note: William A. Curran, Preventing Real Takings for Imaginary Purposes: A Post-Kelo Public Use Proposal, 84 N.Y.U. L. REV. 1656 (2009).