The Madoff Scandal, Market Regulatory Failure and the Business Education of Lawyers

I. INTRODUCTION II. THE REALITY OF COMPLEXITY III. MADOFF'S FRAUD AND THE SEC'S FAILURE IV. BUSINESS LITERACY AS THE OBJECT LESSON V. A PRAGMATIC PROPOSAL (MAYBE) VI. CONCLUSION I. INTRODUCTION The financial crisis of 2008 ushered in a "new" new era of financial folly. This historic chapter in American business and economic history has exposed failures of many institutions of society, from Main Street to Wall Street to K Street. For years to come, many commentators, like investigators of a plane crash, will comb through every minute detail of this catastrophe. This Article contributes in a small way to that process. It suggests that a deficiency in legal education is a contributing cause of the regulatory failure. The most scandalous malfeasance of this new era, the Madoff Ponzi scheme, provides a well-documented, important case study on how a deficit in competence and training of lawyer regulators contributed to market regulatory failure. This Article answers a question underlying these considerations: What can legal education do to better train business lawyers and regulators for a market that is becoming more complex? The answer, it suggests, is a simple one: teach a little more business and a little less law. II. THE REALITY OF COMPLEXITY It is obvious that our world is becoming more complex. The financial crisis conveys innumerable lessons for lawyers, bankers, regulators, and society at large. Perhaps the biggest lesson is a realization of just how complex our financial system and economic organization are. (1) In the past several decades, the financial markets have seen geometric growth in complexity. The junk bond market matured in the 1980s, the derivatives market saw explosive growth in the 1990s, and the new century witnessed the evolution of ever more exotic derivatives and financial instruments that directly connected Main Street to Wall Street. We no longer live in the simple days of stocks and bonds, nor Graham and Dodd's fundamental analysis of them. (2) Only recently did Alan Greenspan, the former chairman of the Federal Reserve, applaud the complexity injected by derivatives markets and hedge funds as a stabilizing force in the financial system. (3) Since then, his assessment has proven to be quite wrong, but there is no denying that the growth of technology and knowledge increases the level of complexity in an ordered system. The intellectual germ of this complexity originated not from the clubrooms of Lower Manhattan, but from the classrooms of university economics departments and business schools and the corridors of government. Intellectual breakthroughs provided the architecture of the modern financial market. (4) Some of the most prominent innovations have been applied on Wall Street. These include portfolio theory, which taught us to distinguish between unique and market risks and the benefits of diversification. (5) Asset pricing theory taught us how to value risky streams of cashflow and to quantify the cost of capital. (6) Option pricing theory taught us how to value legally simple yet financially complex contractual bets on the direction of future price movements. (7) The government facilitated the invention of securitization as a way to expand the credit market in residential mortgages. (8) The connection between Wall Street and academia has always been close. The capital market is supported by an intellectual superstructure. Also, it is obvious that the financial crisis has elevated the connection between Wall Street and government to a level at which the two are joint adventurers in an ongoing financial enterprise, and perhaps will be for years to come. (9) If the crisis was a failure of regulation, and if regulators are lawyers, then it follows that lawyers in a complex world must have an awareness and basic knowledge of the nature of this complexity. Explicitly, it is difficult to see how a lawyer regulator, from the most senior to the most junior rank and file, can purport to regulate complex financial instruments and markets without having a detailed understanding of these matters beyond legal definitions, qualitative intuitions, and half-guesses. …