University of San Dies School of law Law and Economics Research Paper No 04 SYNTHETIC COMMON LAW Frank partno This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection per taf?
School of Law Law and Economics Research Paper No. 04 SYNTHETIC COMMON LAW Frank Partnoy This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://papers.ssrn.com/paper.taf?abstract_id=244558
10/9/00 DRAFT SYNTHETIC COMMON LAW FRANK PARTNOY L INTRODUCTION IL. THE LIMITS TO COMMON LAW A. The Case for Common Law 1. Evolution and Efficiency 2. The Supply of Legal Rules B. The Case Against Common Law 1. Devolution and inefficiency 2. The Shrinking Supply of Legal RI II. ALTERNATIVES TO COMMON LAW A. The viability of statutory Law B. Private law C. Opting Out through Private Adjudication IV. A PROPOSAL: SYNTHETIC COMMON LAW V. USING SYNTHETIC COMMON LAW IN DERIVATIVES DISPUTES A. Line-Drawing in the Derivatives Market B. A Critique of the Four Approaches 2. Judicial Treatment of Derivati 3. The Limited Applicability of Private Law C. How Synthetic Common Law Could Govern Disputes D. Institutional Barriers to Synthetic Common Law . INTRODUCTION In modern society, most everything is, or can be, synthetic: food clothing. shelter. even thought. Yet law continues to be real- Real Associate Professor, University of San Diego School of Law. J D, Yale Law School, 1992. Larry Alexander, Kevin Cole, Mitu Gulati, Peter Huang, Shaun Martin Dennis Patterson, Sai Prakash, Dan Rodriguez, Emily She and Mary Jo wiggins provided helpful advice on an earlier draft. I am grateful to the University of San Diego School of Law for financial suppor As to thought, some scholars have attempted to use findings in the field of to explain lay ng. See, e.g, Dan Hunter, Out of Their Minds: Legal Theory in Neural Nerworks, 7 ARTIFICIAL INTELLIGENCE L. 129 (999)(examining the use of neural networks in modeling legal reasoning) Commentators previously have suggested some replacements for law in stions ha nt ublic statutes and cases with new public law, see mElvin A EIsENBERG, THE NATURE OF THE COMMON LAW 78(1988); or(2)replacing current public statutes and cases with new private law in the form of private statutes (i.e, contractual provisions),see Part Ill. B infra. However, no commentator has suggested replacing public statutes and cases with new private law in the form of synthetic cases(.e, synthetic common aw). For an excellent review of Professor Eisenberg's book, see Stephen M Bainbridge, Social Propositions and Common Law Adjudication. The Nature of the Common Law by Melvin A. Eisenberg, 1990 U ILL L REV. 231(1990)
10/9/00 DRAFT SYNTHETIC COMMON LAW FRANK PARTNOY* I. INTRODUCTION II. THE LIMITS TO COMMON LAW A. The Case for Common Law 1. Evolution and Efficiency 2. The Supply of Legal Rules B. The Case Against Common Law 1. Devolution and Inefficiency 2. The Shrinking Supply of Legal Rules III. ALTERNATIVES TO COMMON LAW A. The Viability of Statutory Law B. Private Law C. Opting Out through Private Adjudication IV. A PROPOSAL: SYNTHETIC COMMON LAW V. USING SYNTHETIC COMMON LAW IN DERIVATIVES DISPUTES A. Line-Drawing in the Derivatives Market B. A Critique of the Four Approaches 1. Piecemeal Regulation of Derivatives by Statute 2. Judicial Treatment of Derivatives Disputes 3. The Limited Applicability of Private Law 4. Some Attempts at Arbitration C. How Synthetic Common Law Could Govern Disputes D. Institutional Barriers to Synthetic Common Law VI. CONCLUSION I. INTRODUCTION In modern society, most everything is, or can be, synthetic: food, clothing, shelter, even thought.1 Yet law continues to be real.2 Real * Associate Professor, University of San Diego School of Law. J.D., Yale Law School, 1992. Larry Alexander, Kevin Cole, Mitu Gulati, Peter Huang, Shaun Martin, Dennis Patterson, Sai Prakash, Dan Rodriguez, Emily Sherwin, Tom Smith, Ed Ursin, and Mary Jo Wiggins provided helpful advice on an earlier draft. I am grateful to the University of San Diego School of Law for financial support. 1 As to thought, some scholars have attempted to use findings in the field of artificial intelligence to explain law and legal reasoning. See, e.g, Dan Hunter, Out of Their Minds: Legal Theory in Neural Networks, 7 ARTIFICIAL INTELLIGENCE & L. 129 (1999) (examining the use of neural networks in modeling legal reasoning). 2 Commentators previously have suggested some replacements for law in particular areas, but those suggestions have involved either (1) replacing current public statutes and cases with new public law, see MELVIN A. EISENBERG, THE NATURE OF THE COMMON LAW 78 (1988); or (2) replacing current public statutes and cases with new private law in the form of private statutes (i.e., contractual provisions), see Part III.B. infra. However, no commentator has suggested replacing public statutes and cases with new private law in the form of synthetic cases (i.e., synthetic common law). For an excellent review of Professor Eisenberg’s book, see Stephen M. Bainbridge, Social Propositions and Common Law Adjudication: The Nature of the Common Law by Melvin A. Eisenberg, 1990 U. ILL. L. REV. 231 (1990)
2 10/9/00 DRAFT-DO NOT CITE WITHOUT PERMISSION VOL #: parties dispute real cases. Real judges apply real law. Is there a need for synthetic law? This article maintains that there is. I advocate a system of synthetic common law for use primarily in private dispute resolution In this system, private synthetic law associations will publish menus of cases and commit to resolve disputes based on those cases. Private parties will select from among these competing associations a particular menu of cases to govern their contracts. The selected association will adjudicate any disputes based on those cases. Court will have limited review of association judgments This system will fill a sizeable gap in current law, both in theory and in practice. In terms of theory, synthetic common law is an attractive alternative to common law, statutory law, private law, and private adjudication. Because synthetic common law would be based on ex ante findings by the parties, it more likely would reflect societal practice and the parties' expectations than does common law, which is based on ex post findings by a judge or jury. Because synthetic common law would be based on broadly ranging menus of cases, it would avoid the inflexibility of statute-based regimes. Because synthetic common law would rely on analogical reasoning by private judges based on cases specified ex ante, it would avoid certain intractable problems associated with private contract provisions including the difficulty of specifying contingencies of rapidly evolving practices. Because synthetic common law would be administered privately it would generate the benefits of existing private dispute resolution regimes; moreover, because synthetic common law would provide to parties a list of cases to govern any dispute, it would avoid he uncertainty and secrecy associated with private arbitration In terms of practice, synthetic common law would enable private parties to avoid the pitfalls of federal and state legislation, while also avoiding the ambiguity and uncertainty of modern alternative dispute resolution. In many instances, it would be cheaper, clearer, and fairer than current alternatives. The advantages would be especially great for private parties in areas of rapidly evolving technologies, where s To the extent common law regimes generate greater economic benefits than civil or statutory law regimes, as several recent studies have suggested, syntheti common law should achieve those benefits, too. For example, studies by raphael LaPorta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny of the lega rules protecting shareholders and creditors in forty-nine countries conclude that common law governance rules tend to protect investors more than civil law rules See Raphael La Porta, et al., Law and Finance, 106 J. POL ECoN. 1113, 1151(1998 see also Andrei Shleifer Robert Vishny, A Survey of Corporate Governance, 52J IN. 737(1997); Raphael La Porta, et al., Legal Determinants of External Finance, 52 J FIN. 1131(1997). For a criticism of the methodology of these studies, see Frank artno, Why Markets Crash and What Law Can Do About It, 61 U. PITT. L REV.# Moreover, because private contractual provisions often are written in mpenetrable boilerplate, it is far more likely that private parties will actually read and consider provisions articulated in narrative case format. Human beings often find it much more efficient to process information presented in narrative form. By resenting legal rules as narrative, a synthetic common law regime may level th laying field between parties facing information or sophistication asymmetry might read a provision articulated in narrative, case format. See, e.g. Melvin reasonable for consumers to refuse to read dense form contracy s argument that it is 59S.CAL.L.REV.305(1986)
2 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# parties dispute real cases. Real judges apply real law. Is there a need for synthetic law? This article maintains that there is. I advocate a system of synthetic common law for use primarily in private dispute resolution. In this system, private synthetic law associations will publish menus of cases and commit to resolve disputes based on those cases. Private parties will select from among these competing associations a particular menu of cases to govern their contracts. The selected association will adjudicate any disputes based on those cases. Courts will have limited review of association judgments. This system will fill a sizeable gap in current law, both in theory and in practice. In terms of theory, synthetic common law is an attractive alternative to common law, statutory law, private law, and private adjudication. Because synthetic common law would be based on ex ante findings by the parties, it more likely would reflect societal practice and the parties’ expectations than does common law, which is based on ex post findings by a judge or jury. Because synthetic common law would be based on broadly ranging menus of cases, it would avoid the inflexibility of statute-based regimes.3 Because synthetic common law would rely on analogical reasoning by private judges based on cases specified ex ante, it would avoid certain intractable problems associated with private contract provisions, including the difficulty of specifying contingencies of rapidly evolving practices.4 Because synthetic common law would be administered privately it would generate the benefits of existing private dispute resolution regimes; moreover, because synthetic common law would provide to parties a list of cases to govern any dispute, it would avoid the uncertainty and secrecy associated with private arbitration. In terms of practice, synthetic common law would enable private parties to avoid the pitfalls of federal and state legislation, while also avoiding the ambiguity and uncertainty of modern alternative dispute resolution. In many instances, it would be cheaper, clearer, and fairer than current alternatives. The advantages would be especially great for private parties in areas of rapidly evolving technologies, where 3 To the extent common law regimes generate greater economic benefits than civil or statutory law regimes, as several recent studies have suggested, synthetic common law should achieve those benefits, too. For example, studies by Raphael LaPorta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny of the legal rules protecting shareholders and creditors in forty-nine countries conclude that common law governance rules tend to protect investors more than civil law rules. See Raphael La Porta, et al., Law and Finance, 106 J. POL. ECON. 1113, 1151 (1998); see also Andrei Shleifer & Robert Vishny, A Survey of Corporate Governance, 52 J. FIN. 737 (1997); Raphael La Porta, et al., Legal Determinants of External Finance, 52 J. FIN. 1131 (1997). For a criticism of the methodology of these studies, see Frank Partnoy, Why Markets Crash and What Law Can Do About It, 61 U. PITT. L. REV. # (forthcoming 2000). 4 Moreover, because private contractual provisions often are written in impenetrable boilerplate, it is far more likely that private parties will actually read and consider provisions articulated in narrative case format. Human beings often find it much more efficient to process information presented in narrative form. By presenting legal rules as narrative, a synthetic common law regime may level the playing field between parties facing information or sophistication asymmetry. Disadvantaged parties often do not read the relevant contractual provisions, but might read a provision articulated in narrative, case format. See, e.g, Melvin Eisenberg, Text Anxiety, 59 S. CAL. L. REV. 305 (1986) (discussing argument that it is reasonable for consumers to refuse to read dense form contracts)
20001 SYNTHETIC COMMON LAW the choice between ever-expanding federal legislation or unpredictable private arbitration is increasingly unattractive In one area in particular -disputes involving complex financial Instrument synthetic common law could solve a seemingly intractable problem for private parties. The $100 trillion market for financial derivatives is subject to piecemeal regulation by statute, or none at all, and the development of common law in this area has been slow and sporadic. Private contracting, while extensive, has failed to ameliorate these problems. Private parties to such transactions who end up in disputes face either costly and inefficient statutory law highly uncertain common law, or even less certain arbitration Thus, the derivatives markets are plagued by uncertainty. The costs to the market are substantial, and market participants are desperate for reform. A synthetic common law system would ameliorate this uncertainty by providing clarity regarding future disputes immediately while avoiding the high costs associated with heavy-handed regulatio More generally, synthetic common law is an alternative regime to consider for legal scholars writing in the area of institutional competence and public choice. A public choice analysis need not compare only a legislature captured by special interests to a sluggish and ill-equipped judiciary. In certain areas of practice, synthetic common law might be a reasonable middle road. To the extent a system of synthetic common law is successful in the derivatives markets, it could be adapted to other areas, especially those with rapidly evolving technologies. The model system proposed here for financial derivatives could apply equally well to private parties contracting in telecommunications, intellectual S Derivatives are financial instruments such as options and forwar whose value is derived from some underlying instrument or index. For description of the classes and uses of derivatives, see Frank Partnoy, Fi Derivatives and the Costs of Regulatory Arbitrage, 22 J CORP. L 211, 216-26 (1997). Derivatives may be traded on an exchange or over-the-counter (OTC)in the size of the otc derivatives market in notional amounts as of year-end 1999 was approximately $88.2 trillion. See BANK FOR INTERNATIONAL SETTLEMENTS, THE GLOBAL OTC DERIVATIVES MARKET AT END-DECEMBER 1999 3(May 18, 2000) http://www.bis.org>.Interestinglythegrossmarketvaluesofthesecontractshas declined dramatically from 4.02 percent of the notional amounts at year-end 1998 to 3. 19 percent of the notional amounts at year-end 1999, a decline of more than 20 percent. See id. This decline in market value may be a sign of very large losses in he industry during 1999, a fact which is very difficult to ascertain. Trading in OTC derivatives is highly concentrated, with the worlds ten largest banks accounting for almost 90 percent of oTC derivatives activity worldwide. See ALFRED STEINHERR DERIVATIVES: THE WILD BEAST OF FINANCE 155(2000). The Bis also has estimated hat the otc derivatives market comprises approximately 86% of the overall derivatives market. See id. at 152-53. Estimates of the size in notional amount of he exchange-traded derivatives market are in the $13 to 14 trillion range. See id. at 152. Hence, the total size in notional amount of the derivatives industry is greater han $100 trill See infra Part V B 3 nra See infra Part V B VB.4. See infra Part VA I See, e.g. Ed Rubin, Law and Legislation in the Administrative State, 89 COLUM. L REv. 369(1989)(advancing a theory of legislation independent from judicial interpretation of legislative provisions)
2000] SYNTHETIC COMMON LAW 3 the choice between ever-expanding federal legislation or unpredictable private arbitration is increasingly unattractive. In one area in particular – disputes involving complex financial instruments – synthetic common law could solve a seemingly intractable problem for private parties. The $100 trillion market for financial derivatives5 is subject to piecemeal regulation by statute, or none at all, and the development of common law in this area has been slow and sporadic. Private contracting, while extensive, has failed to ameliorate these problems.6 Private parties to such transactions who end up in disputes face either costly and inefficient statutory law,7 highly uncertain common law,8 or even less certain arbitration.9 Thus, the derivatives markets are plagued by uncertainty. The costs to the market are substantial, and market participants are desperate for reform.10 A synthetic common law system would ameliorate this uncertainty by providing clarity regarding future disputes immediately while avoiding the high costs associated with heavy-handed regulation. More generally, synthetic common law is an alternative regime to consider for legal scholars writing in the area of institutional competence and public choice. A public choice analysis need not compare only a legislature captured by special interests to a sluggish and ill-equipped judiciary.11 In certain areas of practice, synthetic common law might be a reasonable middle road. To the extent a system of synthetic common law is successful in the derivatives markets, it could be adapted to other areas, especially those with rapidly evolving technologies. The model system proposed here for financial derivatives could apply equally well to private parties contracting in telecommunications, intellectual 5 Derivatives are financial instruments such as options and forward contracts whose value is derived from some underlying instrument or index. For a detailed description of the classes and uses of derivatives, see Frank Partnoy, Financial Derivatives and the Costs of Regulatory Arbitrage, 22 J. CORP. L. 211, 216-26 (1997). Derivatives may be traded on an exchange or over-the-counter (OTC) in private transactions. The Bank for International Settlements (BIS) has estimated that the size of the OTC derivatives market in notional amounts as of year-end 1999 was approximately $88.2 trillion. See BANK FOR INTERNATIONAL SETTLEMENTS, THE GLOBAL OTC DERIVATIVES MARKET AT END-DECEMBER 1999 3 (May 18, 2000) <http://www.bis.org>. Interestingly, the gross market values of these contracts has declined dramatically from 4.02 percent of the notional amounts at year-end 1998 to 3.19 percent of the notional amounts at year-end 1999, a decline of more than 20 percent. See id. This decline in market value may be a sign of very large losses in the industry during 1999, a fact which is very difficult to ascertain. Trading in OTC derivatives is highly concentrated, with the world’s ten largest banks accounting for almost 90 percent of OTC derivatives activity worldwide. See ALFRED STEINHERR, DERIVATIVES: THE WILD BEAST OF FINANCE 155 (2000). The BIS also has estimated that the OTC derivatives market comprises approximately 86% of the overall derivatives market. See id. at 152-53. Estimates of the size in notional amount of the exchange-traded derivatives market are in the $13 to 14 trillion range. See id. at 152. Hence, the total size in notional amount of the derivatives industry is greater than $100 trillion. 6 See infra Part V.B.3. 7 See infra Part V.B.1. 8 See infra Part V.B.2. 9 See infra Part V.B.4. 10 See infra Part V.A. 11 See, e.g., Ed Rubin, Law and Legislation in the Administrative State, 89 COLUM. L. REV. 369 (1989) (advancing a theory of legislation independent from judicial interpretation of legislative provisions)
4 10/9/00 DRAFT-DO NOT CITE WITHOUT PERMISSION VOL #: property, computer law, the Internet, and perhaps commercial or corporate law Part II critiques and updates the arguments for and against common law system. Part Ill analyzes three alternatives to common law system: statutory law, model acts and private law, and private adjudication. Part IV discusses the proposal for synthetic common law and compares it to the alternatives. Part V considers how common law and its alternatives have failed in the area of financial derivatives dispute resolution, and explains the potential advantages of a synthetic common law regime in resolving such disputes, and suggest how a synthetic common law regime might be implemented II. THE LIMITS TO COMMON LAW Oliver Wendell Holmes, one of the great advocates for the common law,also recognized its limitations. Holmes told the story of a Vermont justice of the peace who, after considering a suit brought by one farmer against another for breaking a churn, ruled for the defendant because he had looked through the statutes and could not find anything about churns The story illustrates some of the limits to common law adjudication. Common law depends on human, and therefore 1 There may also be applications to criminal law. In the sentencing guidelines ontext, Albert Alschuler has proposed using fake, paradigmatic cases, not unlike synthetic common law, to guide judges in sentencing criminal defendants. Se Ibert w. Alschuler, The Failure of sentencing Guidelines: A Plea for Less Aggregation, 58 U CHI. L REv. 901(1991)(noting as the advantages of such a tem that"In]o real-world case might fit any of the co exactly, and unusual cases might be far removed from any situation that the ommission had considered. But lawyers could use the commission's paradigms at sentencing hearings in much the same way that they now use judicial precedents at other proceedings. ). However, Alschuler's proposal -unlike synthetic common law would require both the involvement of federal judges and close judicial appellate review. Moreover, because the entity creating the common law would be a regulator monopoly, the U.S. Sentencing Commission, there would be no assurance that theo paradigmatic cases" would reflect societal practice. Of course, criminal sentencing ight not be an appropriate area to introduce competing providers of law, whether synthetic or not. See infra notes 35-41(assessing the regulatory competition debate ). I am grateful to Kevin Cole for bringing Alschuler's proposal to my Examples include the Uniform Commercial Code, the Model Penal Code, and the various Restatements of Laws. See Steven Walt, Novelty and the Risks of Uniform Sales la, 39 VA.J. INT'L L 671(1999) See generally OLIvER WENDELL HOLMEs, THE COMMON LAW(1881 i See Oliver Wendell Holmes, The Path of the Law, 10 HARV.LREV.457,474 75(1897). Holmes may have adapted this story from a passage in a letter to him from Sir Frederick Pollock. In that letter, the first of a series of correspondence between Holmes and pollock from 1874 to 1932, Pollock described a"gem from Viner's Abridgment somewhere in title Pleader, which may be useful to you [and]is not generally known,. A declaration in trover for bottles without naming how many bottles is ill: but a declaration for twelve pair of boots and spurs without naming how many spurs is well enough: for it shall be intended of the spurs that belong to the boots MARK DEWOLFE HOWE. ED.. I HOLMES-POLLOCK LETTERS: THE CORRESPONDENCE OF MR JUSTICE HOLMES AND SIR FREDERICK POLLOCK 1874-1932 5 (1942)(letter from Pollock to Holmes, dated July 3, 1874) Melvin Eisenberg has made a similar point about the almost numberless rule permutations that are possible based on fact differences in common law cases. For example, he has noted that the "vehicle" of harm in a well-known British case in
4 10/9/00 DRAFT – DO NOT CITE WITHOUT PERMISSION [VOL. #:# property, computer law, the Internet, and perhaps commercial or corporate law.12 Part II critiques and updates the arguments for and against a common law system. Part III analyzes three alternatives to a common law system: statutory law, model acts and private law,13 and private adjudication. Part IV discusses the proposal for synthetic common law and compares it to the alternatives. Part V considers how common law and its alternatives have failed in the area of financial derivatives dispute resolution, and explains the potential advantages of a synthetic common law regime in resolving such disputes, and suggest how a synthetic common law regime might be implemented. II. THE LIMITS TO COMMON LAW Oliver Wendell Holmes, one of the great advocates for the common law,14 also recognized its limitations. Holmes told the story of a Vermont justice of the peace who, after considering a suit brought by one farmer against another for breaking a churn, ruled for the defendant because he had looked through the statutes and could not find anything about churns.15 The story illustrates some of the limits to common law adjudication.16 Common law depends on human, and therefore 12 There may also be applications to criminal law. In the sentencing guidelines context, Albert Alschuler has proposed using fake, paradigmatic cases, not unlike synthetic common law, to guide judges in sentencing criminal defendants. See Albert W. Alschuler, The Failure of Sentencing Guidelines: A Plea for Less Aggregation, 58 U. CHI. L. REV. 901 (1991) (noting as the advantages of such a system that “[n]o real-world case might fit any of the commission’s paradigms exactly, and unusual cases might be far removed from any situation that the commission had considered. But lawyers could use the commission’s paradigms at sentencing hearings in much the same way that they now use judicial precedents at other proceedings.”). However, Alschuler’s proposal – unlike synthetic common law – would require both the involvement of federal judges and close judicial appellate review. Moreover, because the entity creating the common law would be a regulatory monopoly, the U.S. Sentencing Commission, there would be no assurance that the “paradigmatic cases” would reflect societal practice. Of course, criminal sentencing might not be an appropriate area to introduce competing providers of law, whether synthetic or not. See infra notes 35-41 (assessing the regulatory competition debate). I am grateful to Kevin Cole for bringing Alschuler’s proposal to my attention. 13 Examples include the Uniform Commercial Code, the Model Penal Code, and the various Restatements of Laws. See Steven Walt, Novelty and the Risks of Uniform Sales Law, 39 VA. J. INT’L L. 671 (1999). 14 See generally OLIVER WENDELL HOLMES, THE COMMON LAW (1881). 15 See Oliver Wendell Holmes, The Path of the Law, 10 HARV. L. REV. 457, 474- 75 (1897). Holmes may have adapted this story from a passage in a letter to him from Sir Frederick Pollock. In that letter, the first of a series of correspondence between Holmes and Pollock from 1874 to 1932, Pollock described a “gem from Viner’s Abridgment somewhere in title Pleader, which may be useful to you [and] is not generally known. . . . A declaration in trover for bottles without naming how many bottles is ill: but a declaration for twelve pair of boots and spurs without naming how many spurs is well enough: for it shall be intended of the spurs that belong to the boots.” MARK DEWOLFE HOWE, ED., I HOLMES-POLLOCK LETTERS: THE CORRESPONDENCE OF MR. JUSTICE HOLMES AND SIR FREDERICK POLLOCK 1874-1932 5 (1942) (letter from Pollock to Holmes, dated July 3, 1874). 16 Melvin Eisenberg has made a similar point about the almost numberless rule permutations that are possible based on fact differences in common law cases. For example, he has noted that the “vehicle” of harm in a well-known British case in