Academic journal article Stanford Law & Policy Review

The Morals of the Marketplace: A Cautionary Essay for Our Time

Academic journal article Stanford Law & Policy Review

The Morals of the Marketplace: A Cautionary Essay for Our Time

Article excerpt

The law is well-established that neither shareholders nor creditors owe duties to the corporations or other productive entities they finance except in extraordinary circumstances. (3) The doctrine of limited liability provides the superstructure that contains this isolation. (4) I do not propose to challenge these rules nor suggest their modification. But recent events in American financial markets (5) raise questions as to whether, as an ethical or prudential matter, share holders and creditors should be held responsible for exercising some degree of consideration for the corporations and other productive enterprises in which they invest in order to ensure the integrity and stability of financial markets and the productive American economy that underlies them. (6) The matter is pressing because it appears to be the case that a distinct absence of investor responsibility at least catalyzed, and was probably a significant contributing cause of, much of the recent turmoil. If so, and given the well-known collective action problems existing in financial markets, (7) the question arises as to how an appropriate degree of investor responsibility might be coordinated. It is these questions that I propose to address in this Article. (8)

It is my argument that, in brief, securities of all types have become deracinated. (9) I mean by this that the relationship between securities and other financial instruments, and the activities which they purportedly finance, have become increasingly attenuated. The trading and investment incentives underlying securities and the capital market behavior that reflects them seem to have little to do with the fundamental economics of industrial production and the provision of goods and services. As I will discuss, the sphere of finance and the sphere of production, once closely connected (and still connected in some instances), (10) have increasingly become detached from one another such that holders of financial instruments have little knowledge of, or concern with, the productive economic activities that ultimately support the value of their securities. Rather, they trade in a market apart, a market that moves of its own logic based upon incentives and realities it creates for itself. The result is that finance finances finance.

While the separation of capital providers from productive activity often is sound as a matter of investment theory, and in fact frequently is applauded by finance theorists and traders alike, (11) it transforms the capital markets created to provide investor liquidity into a type of moral hazard for the real economy by altering investors' behavioral incentives. The result is an increasingly speculative, and thus volatile, financial realm that imposes on corporate managers significant incentives to make decisions that may well damage the long-term economic health of the enterprises they are managing.

The law that imposes no corporate obligation on shareholders or creditors (12) historically was based on the assumption that the financial incentives of investors would rationally direct them to act in their own self-interest, which would align with their perceptions of the entity's best interests, and the same may be said of financing productive activity more broadly. (13) The productive entity would be well-run, or at least for the purpose of achieving the success of its business, because it was in the interest of its financiers to ensure that it was. The more attenuated the security from the productive activity, the less is this true.

This is not to say that investors always agree. Indeed some of their disagreements might help to balance managerial behavior. For example, on the margins, investors' perceptions may differ with the type of investor in question. (14) Common stockholders generally are presumed to favor corporate risk taking; long-term unsecured creditors, in contrast, prefer no more risk than is necessary in order to allow the corporation to repay their principal and interest. …

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