Distorting Legal Principles

I. Introduction II. Background III. REHYPOTHECATION AND INTERMEDIARY RISK A. The Distortion B. Consequences of the Distortion C. Towards a Framework for Balancing Consequences 1. Balancing Consequences 2. Adjusting the Balancing for Potential Bias 3. Informing the Balancing Through Long-Standing Distortions D. Applying the Framework IV. Other Distortions and Their Consequences A. Automatic Perfection B. Priority Reversal for Minerals C. Repo and Derivative Exemptions D. Restatement of the Framework V. Utility of the Framework A. Application to Government Lawmaking B. Application to Judicial Decision-Making C. Application to Lawyering VI. Conclusions I. Introduction Legal principles enable society to order itself by preserving broadly based expectations. Sometimes, however, parties transact in ways that are so inconsistent with generally accepted principles as to create uncertainty or confusion that undermines the basis for reasoning afforded by the principles. Such a distortion might occur, for example, if a normally mandatory legal rule were unexpectedly treated as a default rule. This Article explores the problem of distorting legal principles, initially focusing on rehypothecation, a distortion whose uncertainty and confusion contributed to the downfall of Lehman Brothers and the resulting global financial crisis. But not all distortions are, on balance, harmful; sometimes they represent a positive evolution of law. To this end, this Article also seeks to construct a normative framework for determining how lawmakers, judges, and lawyers should address distortions of legal principles. This Article explores the important but until now largely neglected problem of distorting legal principles, usually for business ends. (1) The exploration starts by examining a fundamental distortion of the legal principle of nemo dat quod non habet ("nemo dat")--one cannot give what one does not have. This distortion, resulting from a practice known as rehypothecation, (2) caused a type of intermediary risk (3) that was at the heart of the recent global financial crisis and threatens to trigger future such crises. (4) Using this distortion of nemo dat, this Article constructs a framework for analyzing distortions of legal principles. (5) The central normative issue is when to allow or tolerate these types of distortions, given their potential costs. A proposed distortion might appear to be socially favorable on a simple balancing of costs and benefits, but there is also a chance it might end up seriously harming the public. This is especially likely when private interest groups favor the distortion, because they would almost certainly receive a disproportionate share of the benefits with the public potentially suffering a disproportionate share of any harm. Because of the potential for significant public harm, this Article argues that distortions of legal principles should be assessed not on a simple cost-benefit basis but by a higher standard. A heavily-outweigh balancing test, this Article contends, can help to rebalance distributive effects of the distortions. This Article also examines which individuals and institutions should make the assessment and how they might do so. II. Background A distortion of nemo dat resulted in a type of intermediary risk that was central to the recent financial crisis. (6) Intermediary risk, generally, is the risk that property held by an intermediary on behalf of third parties may be seized by creditors of the intermediary. (7) This risk has great practical importance where the property held by the intermediary is investment securities (hereinafter "securities") and the intermediary is a broker-dealer, bank, or other financial services firm (8) holding the securities on behalf of third-party investors (hereinafter, "investors" or "customers" of the intermediary). …