Legal theory of finance redux

Six years ago, I blogged about Katharina Pistor’s Legal Theory of Finance, and observed that there seemed to be nothing novel about her claim that powerful institutions at the centre of the financial system tend to be bailed out while the small fry are allowed to die. But if one takes the politics out of the theory, the idea of the elasticity of law is an interesting insight. Pistor wrote:

Contracts are designed to create credible commitments that are enforceable as written. Yet, closer inspection of contractual relations, laws and regulations in finance suggests that law is … is elastic. The elasticity of law can be defined as the probability that ex ante legal commitments will be relaxed or suspended in the future

I was reminded of this when I read Emily Strauss’ paper Crisis Construction in Contract Boilerplate which describes how during the Global Financial Crisis, judges in the US interpreted a boilerplate contractual clause to reach a result clearly at odds with its plain language. She writes:

In the aftermath of the financial crisis, trustees holding residential mortgage backed securities sued securities sponsors en masse on contracts warranting the quality of the mortgages sold to the trusts. These contracts almost universally contained provisions requiring sponsors to repurchase individual noncompliant loans on an individual basis. Nevertheless, court after court permitted trustees to prove their cases by sampling rather than forcing them to proceed on a loan by loan basis.

While the reasoning of these decisions is frequently dubious, they gave trustees the leverage to salvage millions – even billions – of dollars in settlements from the sponsors who had sold the shoddy loans, reassuring investors that sponsors would be forced to stand behind their contracts. However, as the crisis ebbed, courts retrenched, and more recent decisions adhere to the plain language requiring loan-by-loan repurchase. I argue that the rise and fall of decisions permitting sampling reflect a largely unexpressed judgment that in times of severe economic crisis, courts may produce decisions to help stabilize the economy.

This phenomenon is in many ways quite the opposite of Pistor’s theory. The dubious decisions referred to above went against some of the largest banks in the world while benefiting a large and disparate group of investors. While Strauss describes this as an attempt to stabilize the economy, it appears to me to be more of fairness and pragmatism trumping the express terms of the contract. But, at a deeper level, Pistor is right: the law can be very elastic in a crisis.

Posted at 7:05 pm IST on Sun, 15 Sep 2019         permanent link

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