Monday, March 30, 2009
My Iconoclastic Approach to Contract Theory (or Its Ultimate Failure) - The Financial Crisis Edition
Posted by Jeff Lipshaw
I was reading Bill Saporito's article in the March 19 Time on how AIG got "too big to fail," and one comment jumped out at this contract theorist, particularly after having just recently looked at another take on the relationship between contract and promise. Last year, Seana Shiffrin (UCLA) published an article in the Harvard Law Review called The Divergence of Contract and Promise, and its thrust was that, to the extent contract law let promise-makers off the hook as, for example, by the doctrine of efficient breach, it was inconsistent with the flourishing of moral agency. I responded to that piece with my own essay in the Canadian Journal of Law & Jurisprudence.
No, thank God, there was nothing on contract theory as such in Time. It's difficult, however, to avoid the subject of contracts (or their limits) when the issue is financial systemic risk. One way of looking at financial systemic risk is the limit of contract. What AIG provided was an insurance contract against default on a security known as a collateralized debt obligation (CDO). "Credit default swap" or CDS is a fancy name for the insurance contract. The security issuer paid a premium to AIG (which AIG got to book as revenue), and AIG promised to pay the value of the security if there was an underlying default. Of course, the trick in insurance is setting reserves for potential claims, and as long as the risk is diversified it usually works (assuming you reserve enough, which is a good question here). Any middling competent deal lawyer knows that you can have the fanciest indemnification provisions in the world but they are worth diddly-squat if there's no (or not enough) money backing them up. And that's the problem here. The whole system (game?) of contract law breaks down, or becomes irrelevant when this extra-systemic aspect comes into play. Oops, counterparties aren't supposed to go broke.
The article does a pretty good job of spelling this out. What really got my attention, however, was a comment from Maurice Greenberg, the exiled former CEO of AIG, reported thusly:
In a rare interview, former CEO Greenberg, who is suing AIG and being sued by the company over financial-management issues, tells TIME that once the company lost its top credit rating, AIG FP should have stopped writing swaps and hedged, or reinsured, its existing ones. But Cassano's unit doubled down after the spring of 2005, writing more and more subprime-linked swaps as the ratings plunged, which made the possible need for collateral enormous in the event its debt was downgraded. The downgrades occurred in 2008. "Of course they were going to run out of money," says Greenberg. He adds that as the liquidity crunch hit in 2008, AIG FP should have renegotiated terms with the banks to ease their demands on collateral. "You can renegotiate almost anything, anytime." (Emphasis added.)
Wait a minute! For classical contract formalists, what about the "sanctity of contract"? For Professor Shiffrin, what about the morality of promise-keeping? For my friend Rob Kar, late of Loyola-LA and soon of Illinois, what about second-person morality? And for all the economists out there, what about opportunism?
A blog post is no place to do anything other than suggest a direction, and so that's all I will do. My suggestion is that the "theory of everything" explanation of contract law is futile because of the paradox of the search for foundational principles. The morality theory founders because it doesn't take us long to dispose of the idea that promise-keeping (as the moral basis of contract) isn't as foundational as it's cracked to be. The economic theory founders because if the contract obligor is relieved from his opportunistic impulse by the fact the contract obligee gets more utils out of the new deal, then the utilitarian justification for contract law either explains everything or nothing, but is wholly unpredictive.
For more on this, see Freedom, Compulsion, Compliance, and Mystery: Reflections on the Duty Not to Enforce a Contract, 3 Law, Culture, and the Humanities 82 (2007), whose opening hypothetical might well describe the moral-legal dilemma of an AIG employee who had a right to a bonus, but for some reason other than "law" decided to give it up. Also see some of Jody Kraus's later work on this. In the meantime, ponder whether Greenberg's comment is pragmatic or unprincipled, moral or immoral, legal or illegal, reconcilable with law or not?