« February 2011 | Main | April 2011 »
On Tuesday, after more than a year of silence, Judge Denny Chin rejected the proposed settlement in the Google book search case. The innovative settlement asked more than Rule 23 could deliver. In his words, the settlement “would simply go too far.” Others have offered a detailed run down on the opinion itself (see Kenneth Crews here and James Grimmelmann here) but I want to turn to the bigger picture and ask: Where does this result leave us?
Even though it’s the off-season, the New York Mets have been in the news quite a bit recently—and not, to the dismay of their fans, because of any free agent signings. Instead, the team’s owners—the Wilpon family—were named in a lawsuit filed on behalf of the victims of the Bernie Madoff Ponzi scheme. Though the Wilpons are not thought to have personally aided Madoff’s fraud, they are alleged to have ignored the red flags surrounding Madoff’s operation. The legal theories that form the basis for this suit—that, essentially, the Wilpons should have known better—are the subject of “Ponzi’s Legacy,” a paper delivered by Professor Douglas Baird at a recent WIP talk.
As Professor Baird points out, Ponzi schemes present a number of puzzles, and not only for the legal profession. To begin with, they don’t make a lot of economic sense. The premise of a Ponzi scheme is that old investors are paid off with the proceeds from new investors. This means that obligations increase geometrically over time, and the swindler has to spend ever more time finding new investors. No self-respecting con artist would adopt a scheme that requires that much work, especially since so much of the money coming in has to go right back out again to perpetuate the fraud.
It is this latter feature that, as Professor Baird puts its, “makes Ponzi schemes so interesting to bankruptcy professionals.” At the time a Ponzi scheme collapses—as they almost all inevitably do—the fraudster is typically in bankruptcy. Victims may seek to recover money from anyone who participated in or aided and abetted the fraud, but they are likely to be unsatisfied. That’s because the parties with the deepest pockets—financial institutions such as investment banks—rarely have actual knowledge of the fraud, an essential element of aiding and abetting liability. As Professor Baird notes, Wall Street firms “may be greedy, but they usually are not that stupid.”
Instead, the victims’ best bet is for the bankruptcy trustee to recover any assets that were transferred out of the scheme before it collapsed. That is, new investors will seek restitution from the old investors. To do so, the trustee will rely on two bankruptcy doctrines that can be traced back to the 16th century and Lord Coke—preference and fraudulent conveyance.
A preference is any payment outside the ordinary course of business made to a creditor in a 90-day window before a debtor enters bankruptcy. It could be argued that no payment made in furtherance of a Ponzi scheme is in the ordinary course of business since, after all, there was no business. But creditors subject to a preference claim have an available defense—that the fraudster was holding the investor’s money in a constructive trust, a legal theory by which someone can enjoy the possession of property, but not ownership of it. As Professor Baird illustrates, if a fraudster swindles you out of a $100 bill, and that same bill is in the fraudster’s pocket when the scheme collapses, other creditors cannot reach that bill because you still retain ownership of it. Among the difficulties with constructive trusts is accurately tracing the origin of commingled monies. If an investor can do so, her money is outside the reach of other victims; if not, then her preference is voided and she becomes “simply one creditor among many who was paid on the eve of bankruptcy.”
The “main event” of legal recourse for victims of Ponzi schemes, as Professor Baird puts it, is a fraudulent conveyance attack. For one thing, fraudulent conveyance applies even to money transferred outside of the 90-day preference window. Typically, fraudulent transfers are separated into two types: “constructive,” where the transfer was made for less than reasonably equivalent value while the debtor was insolvent; and “actual,” where there is an “intent to delay, hinder, or defraud.” As Professor Baird argues, this is something of a false distinction. To begin with, while the “actual intent” language is in the bankruptcy code, judges frequently overlook actual intent and instead require only that there are sufficient badges of fraud—that is, actual fraud can occur without “an outright lie or willful deception.” Typically, it is enough to qualify as actual fraud if there is a particular closeness between transferor and transferee, or if the debtor retains control after the conveyance, or if the transfer is concealed.
This is particularly relevant for Ponzi schemes, where nearly every payment is made in order to keep investors in the dark and perpetuate the fraud. As Professor Baird concludes, “[a]s long as Ponzi is making these transfers solely to sustain the illusion that profits exist when they do not, the transfers are voidable.” Often, as was the case with both Ponzi and Madoff, there is no underlying business, so any transaction—including paying rent or buying postage—is a fraudulent conveyance. This could spell trouble for Mets fans. As the Wilpons are reasonably sophisticated investors—and long-time family friends with the Madoffs—the bankruptcy trustee will argue that the money they withdrew from the scheme (reputedly more than $50 million) was a fraudulent transfer.
To defeat fraudulent transfer, a transferee has to show both that “she gave value and that she acted in good faith.” Good faith was once judged by the “pure heart and empty head test”—or, as Professor Baird reformulates it, “[y]ou could be as stupid as you wanted,” so long as you subjectively did not know a fraud was going on. Modern courts tend to focus more on objective indices of good faith, such as whether an investor ought to have realized that a deal was too good to be true. This is a troubling test, however, since, as Professor Baird notes, even perfectly legitimate investment schemes are growing increasingly incomprehensible to even sophisticated investors. Furthermore, even honest investment managers are often reluctant to divulge their strategy for fear that rivals will mimic it, which makes distinguishing them from those who can’t divulge their strategy because they don’t have one near impossible. Last, Ponzi schemes, for a time at least, appear to work—early investors are paid off. Many legitimate funds beat the market year to year (and, in fact, Madoff’s mythical 10% was not the highest rate of return during the period of his fraud, though it was suspiciously stable). Given this context, is it reasonable to expect an average investor to ferret out a scam?
When an early investor gives a fraudster $100 and receives a payment of $150, it is often said that she did not provide “reasonably equivalent value” for the $50 since the debtor was insolvent throughout the entire scheme. But, as Professor Baird notes, this is at tension with our normal understanding of the time-value of money—a loan today for $100 in exchange for a promise of a future $150 is acceptable. So why should it matter if the borrower is a swindler? Perhaps the terms of the transaction are so unbelievable as to raise suspicion—but Professor Baird points out that this is a question of good faith, not reasonably equivalent value. Similarly, when the transfer is for an equity stake in an enterprise, the transferee gets to keep the value of the initial investment, and very often gets to keep whatever interest has accrued. These principles suggest that fraudulent conveyance would only provide limited relief to fraud victims from the early investors.
Thanks to technological advances, con artists today can more easily find new marks and can concoct increasingly inscrutable scams. Complicated schemes can now reach into the tens of billions of dollars, with devastating repercussions for hundreds upon hundreds of investors. The aftereffects of a Ponzi scheme can impact retirement funds, charitable institutions, and National League pennant races. Unfortunately, the questions Professor Baird grapples with in “Ponzi’s Legacy” are only likely to take on ever-greater importance. Thankfully, the clarity and concision with which Professor Baird tackles these age-old doctrines should give us some measure of confidence in addressing this looming risk.
Spring break is for grading exams but also for skiing and movie-going. My bad judgment was to believe some of the good reviews garnered by The Adjustment Bureau. It's an inept movie that begins with a clever idea but cannot figure out where to go. The conceit, based on a Philip K. Dick story, is that there is a plan for each human, and that when any of us drifts from our plan, a small adjustment is administered by overworked angels (who circulate among us in 1960s’ fedoras and suits) in order to nudge us back on our intended paths. At the start, an angel falls asleep and misses the assigned moment to nudge Matt Damon away from a distracting Emily Blunt, and then our hero proves too headstrong to be nudged back to his path, which involves a rising political career. He discovers the existence and ways of the Adjustment Bureau and rebels against it, so that he and his not-so-intended might live happily ever after. At one point he asks a middle-management angel about the loss of free will and is told that "we" tried that with you guys for several long periods, but each time you botched it (most recently with world wars, depressions, and a holocausts), and so here we are.
The film is not without its charms. The angels cannot function without their hats. I took this to be a cute joke about head coverings in some religions and bare heads in others. Indeed, an important angel wears a hat and a scarf - a fun tallit, or an even better, maniple joke. As the film wandered toward its predictable conclusion, I found myself wishing that Damon had asked a better question. Every observed adjustment was a mishap. The adjuster, or angel, tries to cause a coffee spill in order to get a character to head home. A dancer falls and sprains an ankle. Phone lines go dead. Damon is prevented from escaping by an administered trip in a parking garage, and he falls flat on his face. A car crash is summoned to prevent him from finding his love interest. We learn that his father and brother were killed in a car crash in order to adjust Damon's political career. Why, he might have asked, do you guys always use sticks instead of carrots? Why spilled coffees and car crashes instead of lucky coincidences, lottery winnings, and other goodies?
The larger, intellectual question about organized religions is why some encourage humans to fear higher power while others focus on rewards (and others a mix). The question is an important one for legal systems, and a rich academic literature puzzles over the use of subsidies and taxes, rewards and fines, and more. If the message of the movie had been that a system of behavior control that relies only on penalties is inferior to one that cleverly mixes penalties and rewards, after taking moral hazards and baseline considerations into account, then it might have been a worthy film.
And then there is the question of why we go to bad movies, and what might be done about that. Films are reviewed, by professionals and by acquaintances, but of course not everyone has the same taste as the reviewer. Netflix famously tackles this with its algorithm, recently improved in response to a substantial prize. It assumes, more or less, that each of us has different but fixed preferences. A quibble about that algorithm is that it is account-specific, rather than person-specific. A family rents movies and then rates the movies in order to help determine Netflix's recommendations for further rentals. Netflix uses the aggregated information to recommend movies to all its subscribers. The first point is that the system might be improved if different members of the household had different rating accounts. The second point is to puzzle over the difficulty of developing such algorithms and recommendations for movies while they are still in theaters. Netflix takes on the easier task of predicting tastes based on a very large number of observations – including the target movie itself. If many viewers submitted their ratings during the first weekend of a movie's run, it is possible that those who waited just a week (or one evening?) would learn a good deal about whether they would like the movie in question. Unfortunately, it is difficult to charge for such a service, and no studio or chain of theaters has much of an incentive to sponsor this pooling and application of information. But given the progress we are making with information markets, and smartphones as networking devices, we will get there one day.
In the 1973 movie The Paper Chase, there is a well-known scene in which the protagonist law student Hart goes with trepidation to the office of the stern Professor Kingsfield. Hart’s entrance disturbs Professor Kingsfield from his work – reading and writing about the latest developments in contracts law.
When viewed in 2011, so much of the movie seems dated. Legal education – and our image of it – have in many ways changed a great deal since then. Instructors and students no longer accept routine humiliation as an effective pedagogic technique. In an age of laptops, i-pads, and electronic casebooks, the very notion of a paper chase seems anachronistic.
While our image of legal teaching has kept up with the times, our image of legal scholarship has remained relatively fixed. Most of us imagine that today’s law professor still works like Professor Kingsfield. Alone in the office, the law professor reads cases and statutes, thinks about them, and then writes about them. We imagine that legal scholarship remains an inherently solitary and essentially literary endeavor.
In a recent co-authored paper, we found that this image of legal scholarship has for some law professors become just as anachronistic as the paper chase. Some law professors now work in teams to produce scholarship; more and more scholars utilize statistical methods and other social science techniques rather than purely conceptual analysis in their scholarship.
We examined patterns of collaboration and methodology in top law reviews and two faculty-edited law journals. We found that the fraction of articles in the top fifteen law reviews that were co-authored trended upwards between 2000 and 2010. What explains this increase in collaborations? An increase in empirical articles accounted for a substantial share of the growth in co-authored articles, and the correlation between co-authorship and empiricism persisted after controlling for numerous other influences.
These patterns are consistent with standard economic predictions about human capital and teamwork: academic collaboration rises with scholarly specialization. As the complexity of a field grows, more and more diverse types of human capital are needed to make a contribution. Prior research has found a similar growth in co-authorship in some social science fields, such as economics, but the trend in law toward more collaboration has received relatively little attention.
As a further test of whether empiricism spurred more co-authorship in law, we examined the articles published since 1989 in two prominent, faculty-edited journals specializing in law & economics. Co-authored articles were far more common in these journals than in the general-interest, student-edited law reviews – a pattern which itself is consistent with the specialization hypothesis. The share of articles without empirical analysis or formal models in these journals plummeted over this period, while co-authorship rose sharply. These results support the view that specialization, and specifically the growth of empirical scholarship, has contributed to the trend of co-authorship in legal academia.
Some have given the recent growth in empirical scholarship the moniker Empirical Legal Studies (ELS), and others, including our own colleague Brian Leiter, have criticized it as an incoherent category and removed from the central normative and conceptual questions of law [see also Professor Wright's critique here]. We do not defend or oppose ELS as a category or a distinct legal subfield. But our evidence suggests that empirical studies of law and legal institutions increasingly occupy an important place in legal scholarship. Indeed, our results indicate that the expansion of empirical scholarship is one of the major developments in the legal academy during the last generation, and prima facie, we assume that at least some of it is responsive to the central concerns in law. The growth in co-authored empirical work in particular likely reflects real gains from specialization rather than simply a trend or fad.
It is no secret that today’s law professors do not conduct their classrooms in the same manner that Professor Kingsfield ran his. It is also becoming apparent that the scholarship that some of today’s law professors produce and the manner in which they produce it also bear little resemblance to Professor Kingsfield’s approach.
--Tom Ginsburg and Tom Miles
I’ve been tracking the budget debates regarding incarceration and I’ve just started a thread over at Goodreads to interactively discuss the puzzling relationship between punishment and economic logics. The major question on the table is how come laissez faire has gone hand-in-hand with mass incarceration? How can these paradoxical notions of liberty co-exist?
Another way to ask this is: What makes the prison budget seemingly impervious to deficit constraints? Although most of the cost of mass incarceration today is borne by states, the case of the federal budget is a perfect illustration. Think about it. We have a Democratic presidential administration that explicitly calls for reducing mass incarceration and has plans to release well-behaved convicts. We have continuing drops in violent crime at the national level. We are about to slash education programs because of our exponential federal deficit. And yet the Obama administration just proposed an 11 percent increase in spending on the federal prison system. What makes that particular budget line impervious?
Join me over at Goodreads if you would like to join in on the conversation...
The University of Chicago Law School | 1111 East 60th Street, Chicago, Illinois 60637 | 773.702.9494
Recent Comments