Disparate Regulatory Schemes for Parallel Activities - Hazen

This is a circulating draft of an article that is forthcoming in 24 Annual Review of Banking & Financial Law ----- (2005).

DISPARATE REGULATORY SCHEMES FOR PARALLEL ACTIVITIES:

SECURITIES REGULATION, DERIVATIVES REGULATION, GAMBLING, AND INSURANCE

Thomas Lee Hazena

Although bearing striking similarities to each other in many respects, securities

investments, non-securities derivative investments, insurance and gambling are subject

not only to different regulatory regimes but also to vastly different levels of government

interference. Traditionally, stringent prohibitions characterize the insurance and

gambling industries, whereas regulation of investments in securities and derivatives

occurs primarily through disclosure requirements.1 Also there is striking contrast in the

current approaches taken to securities and non-securities derivatives regulation. If,

however, these activities are so similar in nature, does a rational basis exist for widely

differing regulatory schemes? If no rational basis can be found how do we identify

whether the current deregulation trend moving through the derivatives markets is a

sensible change when regulation in the securities market is increasing? This article

ultimately questions the absence of a consistent approach in regulating securities, non-

securities derivatives, insurance and gambling. Among other things, the article questions

whether deregulation of the derivatives market is a prudent maneuver in light of its

similarities with more heavily regulated activities.

Part I provides an overview of the current regulatory scheme for securities and

derivatives, including the deregulatory effects of the Commodities Futures Modernization

Act of 2000. Part II looks at the practice of gambling and the traditional moral concerns

underlying its stiffer regulatory regime. Part II also begins to explore behavioral models

which might fairly apply to both investments and gambling, and which therefore cut in

a Cary C. Boshamer Distinguished Professor of Law, the University of North Carolina at Chapel

Hill, B.A. 1969, J.D. 1972 Columbia University. 1 Although disclosure requirements can have an impact on the way activities are conduct, disclosure is

a less imvasive regulatory approach that imposing outright prohibitions on targeted activities.

favor of more similar regulatory treatment among the industries. Part III then examines

regulation of the insurance industry, its underlying rationale, and its similarities with

investment and gambling activities. After establishing the particularly strong similarities

between insurance and derivatives, Part III further suggests how certain aspects of the

insurance regulation might play out in the context of derivatives. Finally, Part IV revisits

the general trend of deregulation in the securities, derivatives, and (to a lesser degree)

gambling industries in light of the consistently demanding insurance regime and asks

whether deregulation is a wise course of action. Part V concludes and offers suggestions

on further research in this area.

Introduction

Securities investing, derivatives transactions, insurance, and gambling are all

activities designed in one way or another to reap economic benefits. Investing is

generally considered to be a productive activity because it allows businesses to raise

capital which in turn will increase productivity and benefit society. Investing also offers

the possibility of wealth building for those who invest. Derivatives transactions not only

offer investment opportunities (often thought of as a speculation) but also, like insurance,

provide an opportunity for risk-shifting. People and businesses who have exposure to

risk can either hedge against that risk with a derivatives contract or seek insurance against

losses that could occur if the contingencies created by the risk materializes.

In contrast to investing, hedging, and insurance, gambling is not generally viewed

as a productive activity or one that provides any benefit to society beyond its

entertainment value. However, this “benefit” is generally seen as outweighed by the

social costs of gambling as well as moral objections to wagers and other gambling

activities. Over time and in various respects, investing, hedging, and insurance have been

compared with gambling and to varying degrees, distaste for gambling has been used as a

rationale for regulation of these other activities. .

There are many similarities between gambling and the often perceived legitimate

investment, hedging, and insurance transactions. One thing that investing, hedging,

insurance, and gambling have in common is that they all involve risk taking, while only

the first three that are generally seen as involving risk-shifting or other legitimate

economic benefits. Traditionally the law has been much harsher on transactions that are

characterized as gambling. One possible explanation for the difference in treatment is

focusing not so much on what the transactions are but who the parties are and their

respective motives. Gambling laws have traditionally had barriers to entry; although

there has been a dwindling of those barriers with increasing legalization. Insurance law

imposes some comparable barriers through its insurable interest requirement.2 However,

although some investment opportunities may be limited to sophisticated investors,3 there

are no comparable barriers to the investment markets generally thereby allowing access

for “legalized gambling” to all. Furthermore, the sophistication and wealth barriers to

some investments do not protect against speculating and gambling, they simply foreclose

opportunities to other investors.

This article focuses on both gambling and insurance in particular as two activities

that are regulated and also are closely aligned to at least certain segments of the investment

markets. More generally, this article explores the parallels among securities investments,

derivatives (and commodities) investments, gambling, and insurance to probe whether

there is too much focus on disclosure or whether disclosure as the primary means of

securities market regulation should be supplemented by the approach taken with respect

to those other activities.

a. Illustrative Analogies

The similarities of the activities discussed in this article may be explained by way

of examples. Consider two inveterate gamblers who make a wager on whether it will rain

the next day - a wager that would be illegal under the law in all states. Compare this

gamble with a farmer who is concerned about a predicted drought and decides to hedge

her crops in the ground by entering into a crop futures contract. This arrangement is a

legal futures contract and will be enforced. Alternatively, in today’s environment, the

2 See the discussion infra accompanying notes ##-##.

3 For example, section 2(a)(15) of the Securities Act of 1933 contains a definition of “accredited investor” so as to qualify for exemptions from some of the Act’s disclosure requirements. 15 U.S.C. § 77b(a)(15, 77d(6) (2003). Also, over-the-counter derivatives transactions are subject to less regulation than the exchanges. See the discussion infra accompanying notes ##..

farmer could make the hedge specifically against damage due to drought and enter into a

derivatives contract based on the weather. This more closely resembles the illegal

weather wager but would be a legitimate, and hence enforceable, derivatives contract.

That same farmer has the alternative of seeking crop insurance or more specifically

drought insurance. In all of the above situations one party is allocating to the other the

risk of a drought. Yet the wager is illegal, whereas the derivatives contracts and

insurance are legitimate commercial transactions. A similar comparison can be made

with respect to sports wagers,4 which are not permitted except to a limited extent through

some state sanctioned casinos. Even under those limited circumstances, participants in

the sport are not able to wager.5

Gambles and wagers are not the only examples of contracts that have been

outlawed because of their perceived moral repugnancy. In 2003, there was a short-lived

plan at the Pentagon to create a market in futures contracts to with respect to future terror

attacks.6 Once the controversial proposal came to light, it was quickly quashed. 7 What

was it about the proposed terrorism futures that the public found so horrific? Some

observers suggested that a market for terrorism futures would allow people to profit from

sharing information about future attacks that they should share simply as a matter of good

citizenship.8 There also is the visceral reaction that an investor should not be able to

4 See infra pp. 54-56 and note 320 and accompanying text. 5 Consider for example the current controversy as to whether Pete Rose’s wagers should disqualify him from the baseball Hall of Fame. 6 See, e.g., Daniel Kadlec, Terrorism Futures: Good Concept, Bad P.R., TIME MAGAZINE, Aug. 11, 2003, at 18, available at 2003 WL 58582307. The idea behind the proposal was that since markets help filter information, a market in terrorism futures could provide the Pentagon with help in predicting and then thwarting attacks. See Jeff Brown, Was Terrorist Futures Market Really Such a Terrible Scheme?, THE PHILADELPHIA INQUIRER, July 31, 2003, at On Personal Finance Col 1, available at 2003 WL 60559277; Justin Wolfers & Eric Zitzewitz, The Furor Over ‘Terrorism Futures,’THE WASHINGTON POST, July 31, 2003, at A19, available at 2003 WL 56509527.. 7 For example, the originator of the controversial idea resigned his research post with the Defense Department in the face of the huge public opposition to terrorism futures even as a hypothetical model. See David Voss, From Sputnik to . . . Radar? Much-Maligned Defense Research Agency Has Long Been the Pentagon's Fantasy Shop, BOSTON GLOBE, Aug. 12, 2003, at D.1, available at 2003 WL 3412852. 8 See, e.g., D.J. Tice, 'Terror Market' Debate Exposed Roots of Many Economic Disagreements, ST. PAUL PIONEER PRESS, Aug. 6, 2003, at 10A, available at 2003 WL 2619468 (“A terrorism market would inspire people to do out of a selfish desire for gain what they should have done out of moral decency – to tell what they know. And of course that’s just the problem. The motives of terrorism ‘investors’ would be simply too barbarous to be tolerated, and too repulsive to be used, even for the best of purposes. No result, however, beneficial, is worth the moral debasement in rewarding such motives – or at least that’s what the politicians quickly decided.”).

profit from someone else’s misery. However, we generally do not look at an investor’s

motives in determining whether a particular transaction is legal. When put in

perspective, how different is a terrorism future from taking out insurance against acts of

war? An investor who stands to gain from a terror attack may simply be hedging against

losses that would result from such an attack. Investors have always been able to take

investment positions in order to “bet” in favor of disaster. Defense industry stocks and

gold have traditionally been among the havens for investors desiring economic protection

against the ill-effects of war or terrorism. The proposed terrorism futures market may

well have been ill-conceived but the proposal and the public reaction provides an

example of how lawmakers will declare certain types of contracts impermissible (or

subject them to a significant regulation). In contrast, transactions trying to shift

comparable risks are permissible or subject to less stringent regulation.

Was the opposition to the proposed terrorism futures market a rational response to

a bad idea? Was it the result of moral outrage? Was it simply the reaction to a politically

incorrect idea? On a more general level, how do policy makers decide which markets to

regulate and what level of regulation is appropriate? Exploring these analogies can

provide insight on to how to evaluate existing regulatory schemes.

b. Recent Scandals and Current Regulatory Climate

For a number of years there have been questions raised as to the proper approach

to regulation of the investment markets in the United States.9 This inquiry has addressed

the extent of regulation, the basic premises of regulation, and whether to regulate at all.

A number of recent events spurred new regulation and also heated up the debate between

protectionists calling for more regulation and free market advocates arguing against

regulatory responses. There were a number of spectacular frauds that came to light at the

9 This article does not address questions relating to the appropriate regulatory approach to overseas and emerging markets. See, e.g., Robert B. Ahdiehl, Making Markets: Network Effects and the Role of Law in The Creation of Strong Securities Markets, 76 S. CAL. L. REV. 277 (2003) (discussing the role of the law in forming strong securities markets and the implications for regulation of emerging markets in central Europe and Russia).

turn of the twenty-first century such as those involving Enron, Tyco and Worldcom.10

These frauds were perceived by many observers as the result of greed which went

unchecked by regulators. This greed emboldened some corporate executives to engage in

conduct that violated existing laws. Notwithstanding the fact that the existing securities

laws were sufficient to pursue executives of Enron, Tyco, and Worldcom, Congress was

of the view that additional regulation was necessary. Congress thus viewed existing laws

insufficient to combat this magnitude of greed.

The seemingly unprecedented greed among a sector of our nation’s corporate

executives and decision-makers is seen by many as the cause of the above-mentioned

recent corporate scandals.11 The perpetrators of these frauds were not simply acting out

of their own self-interest but rather out of hideous greed which can lead to irrational and

malevolent results. It has properly been suggested that we can and should regulate greed.

Although capitalism is to a large extent premised on rewarding self interest, greed is not

necessarily a part of the self interest that is necessary to fuel capitalism and thus should

not go unregulated. 12

The well-documented frauds referred to above were only one impetus for

increased securities regulation. These frauds were uncovered shortly after the stock

market bubble,13 fueled primarily by dot-com stocks. When this bubble burst at the end

of the twentieth century, a number of other bad practices came to light – including

10 See, e.g., BRIAN CRUVER, ANATOMY OF GREED: THE UNSHREDDED TRUTH FROM AN ENRON INSIDER (2002) (discussing Enron); Robert W. Hamilton, The Crisis in Corporate Governance, 40 HOUS. L. REV. 1 (2003) (discussing among other things the governance failures of Tyco, Global Crossing, and Qwest); Robert Prentice, Enron: a Brief Behavioral Autopsy, 40 AM. BUS. L.J. 417 (2003) (describing events at Enron). See also, e.g., William W. Bratton, Does Corporate Law Protect the Interests of Shareholders and Other Stakeholders?: Enron and the Dark Side of Shareholder Value, 76 TUL. L. REV. 1275 (2002) (same); Jeffrey N. Gordon, What Enron Means for the Management and Control of the Modern Business Corporation: Some Initial Reflections, 69 U. CHI. L. REV. 1233 (2002) (discussing the implications of Enron). 11 See, e.g., CRUVER, supra note 12; Prentice, Behavioral Autopsy supra note 12.. 12 Eric A. Posner, The Jurisprudence of Greed, 151 U. PA. L. REV. 1097, 1132 (2003) (“Capitalism needs moderation, not excess; far-sightedness, not cunning; self-interest, not greed”). 13 James D. Cox, Reforming the Culture of Financial Reporting: The PCAOB and the Metrics for Accounting Measurements, 81 WASH. U. L.Q. 301 (2003) (“The financial bubble that burst in 2000 began a meltdown of stock prices that ultimately removed an estimated $8.5 trillion from the Nasdaq market alone.”).

improprieties involving public offerings.14 Examples of these underhanded practices

included improper allocation of hot offerings and “laddering,” or pre-selling the after

market, whereby purchasers were asked to commit to purchasing additional securities in

the aftermarket in order to get in on a hot IPO.15 Generating this additional demand for

stock in the aftermarket helped push the post offering price significantly above the price

at which the securities were offered to the public. Other scandals included securities

analysts’ conflicts of interests that compromised their supposedly disinterested unbiased

recommendations.16 These are just some of the events that led to heightened concern

over the adequacy of the then existing regulation of the securities markets and that

prompted Congress to increase securities regulation.17

14 In fact, the NASD adopted new rules to define improper IPO practices. See Self-Regulatory Organizations, Exchange Act Release No. 34-48701, 81 SEC Docket 1323 (Oct. 24, 2003); News Release, NASD, NASD Board Approves Proposed Conduct Rules for IPO Activities, (July 28, 2002), available at http://www.nasd.com/web/idcplg?IdcService=SS_GET_PAGE&ssDocName=NASDW_002921&ssSourceNodeId=555. The new rules explicitly prohibit a number of practices, most of which are improper under existing standards but are not subject to explicit rulemaking. The NASD rules as proposed outlaw allocation of IPO shares in exchange for excessive compensation to the broker making the allocations. The rule also prohibits “laddering” and other tie-in arrangements by expressly outlawing solicitation of aftermarket orders prior to the time that the registration statement has become effective and the offering has taken place. The rules cover “spinning” by prohibiting a broker-dealer firm from allocating IPO shares to an executive officer or director of a company on the condition that the officer or director send the company’s investment banking business to the brokerage firm. The rules also address penalty bids by prohibiting NASD members from penalizing registered representatives whose retail customers have "flipped" IPO shares when similar penalties have not been imposed with respect to institutional accounts. Finally, the rules require broker-dealers participating in IPOs to adopt procedures designed to ensure compliance with the foregoing restrictions on conduct during IPOs. 15 See See Notice of Filing of Proposed Rule Changes by the New York Stock Exchange, Inc. and the National Association of Securities Dealers, Inc. Relating to the Prohibition of Certain Abuses in the Allocation and Distribution of Shares in Initial Public Offerings ("IPOs"), Sec. Exch. Act Rel. No. 34-50896 69 Fed. Reg. 77804-01, 2004 WL 2981667 (SEC 2004); NASD Board Approves Proposed Conduct Rules for IPO Activities, supra note 16. [News Release, NASD, NASD Board Approves Proposed Conduct Rules for IPO Activities, (July 28, 2002), http://www.nasdr.com/news/pr2002/release_02_037.html] 16 Among other measures, the SEC adopted a requirement that securities analysts certify their independence. Regulation Analyst Certification, Sec. Act Rel. No. 33–8193, Sec. Exch. Act Rel. No. 34–47384, 68 Fed. Reg. 9482–01, 2003 WL 535908 (SEC Feb. 27, 2003), codified in 17 C.F.R. §§ 242.500–242.505.. See Self-Regulatory Organizations, 67 Fed. Reg. 11,526 (Mar. 14, 2002); News Release, NASD, NASD Announces New Rules Governing Recommendations Made by Research Analysts, (Feb. 7, 2002), http://www.nasdr.com/news/pr2002/release_02_009.html. See also, e.g., Self Regulatory Organizations, Exchange Act Release No. 45,526, 77 SEC Docket 196 (Mar. 8, 2002). 17 See, e.g.,Larry E. Ribstein, Bubble Laws, 40 HOUS. L. REV. 77 (2003) (questioning whether the regulatory response is an overreaction to bubbles). See also, e.g., Jeffrey N. Gordon, Governance Failures of the Enron Board and the New Information Order of Sarbanes-Oxley, 35 CONN. L. REV. 1125, 1126 (2003) (describing the increased regulation following the bursting of the bubble as “relatively mild”).

Congress’ response to the corporate governance scandals was embodied in the

Sarbanes-Oxley Act of 200218 which called for increased levels of corporate disclosure.

These increased disclosures and increased regulation of the operation of public

companies raises issues highlighted by the continuing debate as to the efficacy of

disclosure in securities regulation and, more generally, the approach to regulating

investment markets generally. This increased regulation of the securities markets in the

wake of the late 1990’s corporate governance scandals, led by Sarbanes-Oxley, stands in

sharp contrast to the massive deregulation of the commodities and non-securities

derivatives19 markets that was ushered in by the Commodity Futures Modernization Act

of 2000.20 This divergence in recent regulatory developments presents a propitious time

to examine the whether there is a rational basis for such divergent regulatory approaches

to the securities and derivatives markets. A brief examination of the existing regulatory

structure of the securities and derivatives, markets and the gambling industry will lay the

foundation for comparison.

I. Current Regulatory Structures

a. The Regulatory Structure of the Securities Markets – An Overview

In the wake of the stock market crash of 1929, when this country was well into

the Great Depression, and twenty-two years after the first comprehensive state legislation

the first federal securities law was enacted in 1933,21. Congress debated but rejected a

merit approach to regulation that would examine the substance of the investment product

18 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002); Brian Kim, Sarbanes-Oxley Act, 40 HARV. J. ON LEGIS. 235 (2003); Corporate Law -- Congress Passes Corporate and Accounting Fraud Legislation. -- Sarbanes- Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified in scattered sections of 11, 15, 18, 28, and 29 U.S.C.), 116 HARV. L. REV. 728 (2002). See also, e.g., Larry E. Ribstein, Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002, 28 J. CORP. L. 1 (2002) (criticizing the Sarbanes-Oxley Act). 19 Derivatives have been defined as any "financial arrangement whose returns are linked to, or derived from, changes in the value of stocks, bonds, commodities, currencies, interest rates, stock indexes or other assets." Saul S. Cohen, The Challenge of Derivatives, 63 FORDHAM L. REV. 1993, 2000 (1995). 20 Pub. L. No. 106-554, 114 Stat. 2763 (2000). 21 Securities Act of 1933, 48 Stat. 74 (1933) (codified as amended in 15 U.S.C. §77a (2003)).

being offered and sold. 22 The first federal securities law – the Securities Act of 1933, has

been characterized as the first true consumer protection law23 was often referred to as the

“Truth in Securities” law.24 Unlike many state blue sky laws,25 The Securities Act of 1933

did not establish a system of merit regulation. Instead, the Act was premised solely on a

system mandating full and fair disclosure to investors, under the guidance of a federal

agency, as a mechanism for permitting informed investment decisions. Disclosure rather

than a merit approach remains the regulatory philosophy of the federal securities laws.

The focus of disclosure was based on the determination that Louis Brandeis was

correct when he suggested that sunlight is the best disinfectant.26 However, it is evident

that disclosure has not been completely effective in eradicating securities fraud and the

debate continues as to the wisdom of a disclosure approach. Some argue that the current

disclosure system overregulates,27 while others have suggested that it does not go far

enough.28 For example, it has been suggested that disclosure does not give adequate

22 In contrast, the laws regulating insurance traditionally have taken a merit approach, including requiring regulatory approval of the terms of insurance policies See infra note XXX and accompanying text 23See 1 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 1.2[3] (5th ed. 2005). In fact, in signing the bill into law, President Franklin Roosevelt observed that the nation was moving from a period of caveat emptor into one of caveat vendor. [Need to cite source for FDR’s observation.] 24 Milton H. Cohen, "Truth in Securities" Revisited, 79 HARV. L. REV. 1340 (1966). 25 State laws regulating securities, most of which predated the federal legislation, imposed a merit approach to regulation. See 1 HAZEN supra note xx, at §§ 1.2, 8.1. THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 1.2[3] (5th ed. 2005). 26This is the oft-cited phrase of Louis D. Brandeis. LOUIS D. BRANDEIS, OTHER PEOPLE'S MONEY ch. 5 (1914) ("Sunlight is said to be the best of disinfectants; electric light the most efficient policeman."). Felix Frankfurter was one of the most influential voices in the drafting of the securities laws. As explained by one commentator, he was influenced by Brandeis:

Frankfurter, who was instrumental in shepherding the Securities Act through Congress, had been strongly influenced by Brandeis's ideas about the value of disclosure. Soon after the Securities Act was passed, Frankfurter wrote an article in Fortune magazine about the anticipated social and financial effects of the Act. Frankfurter was quite explicit that the purpose of disclosure was to affect the behavior of corporate managers, bankers, and accountants.

Cynthia A. Williams, The Securities and Exchange Commission and Corporate Social Transparency, 112 HARV. L. REV. 1197, 1221-22 (1999); Felix Frankfurter, The Federal Securities Act: II, FORTUNE, Aug. 1933, at 53. See JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET 71 (1982). 27 E.g., Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 VA. L. REV. 669 (1984). 28 For additional insight as to the role of the regulatory structure, see, e.g., Ahdiehl, supra note xx. Robert B. Ahdiehl, Making Markets: Network Effects and the Role of Law in The Creation of Strong Securities Markets, 76 S. CAL. L. REV. 277 (2003).

attention to investor education29 to help rid investors of what many identify as irrational

behavior.30 It has also been suggested that we should consider information overload when

evaluating the extent of the disclosure approach.31

Investor education and merit regulation32 are thus two alternatives for increasing

regulation. However, they are not the only alternatives for providing heightened regulation

of the securities and other investment markets. For example, one question to be considered

is whether increased criminalization will help fill the regulatory void created by the focus

on disclosure. The criminal enforcement weapon is especially applicable when we

recognize that many market participants are gamblers and many of the securities fraudsters

seem to engage in behavior quite similar to those who profit from illegal gambling

activities. The Sarbanes-Oxley Act included increased criminal penalties as an important

part of its reforms.33 In the first instance, Sarbanes-Oxley provides for heightened criminal

29 See Stephen Choi & Pritchard supra note XXX at 22 (2003) (“For behavioralists, the single-minded focus of the SEC on disclosure presents a puzzle. We doubt that disclosure is the optimal regulatory strategy if most investors suffer from cognitive biases. Disclosure may be ineffective in educating investors who suffer from biases in decisionmaking.”). See also, e.g., Stephen J. Choi, Regulating Investors Not Issuers: A Market-Based Proposal, 88 CAL. L. REV. 279 (2000);Donald C. Langevoort, Ego, Human Behavior, and Law, 81 VA. L. REV. 853, 880 (1995) ("[W]e can readily see why the law's prized warnings and disclosure will so often have relatively little practical effect, especially if they are formalized into boilerplate. Investors and consumers want to think the warnings are meant for someone else, not them.") 30 “Investors suffering from an overconfidence bias, for example, may ignore the warning signs from disclosure. Similarly, it is unclear how disclosure can overcome the cognitive dissonance of people who have made a poor investment choice in the past. Investors with intractable loss aversion will continue holding a losing position in hopes of reversing their losses without regard to disclosure. And what disclosure will help them avoid ratifying their poor investment choices as "good" decisions? Finally, investment decisions may be driven in substantial part by the conversations that investors have had most recently. Disclosure may do little to influence investment decisions based on "tips" or fads.”

Choi & Pritchard, supra note XXX at 22. [Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 71 (2003)], relying on Robert J. Shiller & John Pound, Survey Evidence on the Diffusion of Interest and Information Among Investors, 12 J. ECON. BEHAV. & ORG. 46 (1989) 31 Troy A. Paredes, Blinded by the Light: Information Overload and its Consequences for Securities Regulation, 81 WASH. U. L.Q. 417 (pages 419, 420, & 446.(Summer 2003).

32 Merit regulation is a regulatory system under which a securities administrator has the power to evaluate the merits of an investment before allowing it to be sold. See generally Report on State Merit Regulation of Securities Offerings, 41 Bus.Law. 785 (1986). See also Roberta S. Karmel, Blue Sky Merit Regulation: Benefit to Investors or Burden on Commerce?, 53 Brooklyn L.Rev. 105 (1987); Manning G. Warren III, Legitimacy in the Securities Industry: The Role of Merit Regulation, 53 Brooklyn L.Rev. 129 (1987).

33 Sarbanes-Oxley Act of 2002, PL 107-204 (July 30, 2002).

penalties for securities law violations.34 The Act also imposes a requirement that CEOs

and CFOs of publicly held companies personally certify their company’s financial

statement with criminal consequences for false certifications.35 It remains to be seen

whether this increased criminalization will be effective in promoting more accurate timely

public disclosures.

Securities regulation currently utilizes its disclosure approach to regulate various

segments of the securities markets.36 In addition to regulation of the securities markets, the

federal securities laws regulate the companies issuing securities (“issuers”37) as well as

purchasers and sellers of securities. Securities trading activities can be divided into two

basic subgroups. Most of the day-to-day trading on both the securities exchanges and

over-the-counter markets consists of "secondary" transactions between investors and

involve securities that have previously been issued by the corporation or other issuer.38 All

of the proceeds from these secondary sales, after applicable commissions to the securities

brokers handling the transaction, go to the investors who are parting with their securities.

None of these proceeds from secondary transactions in the securities markets flow back to

the companies issuing the securities. This aspect of the secondary securities markets is

frequently referred to as "trading" (as opposed to “distribution” of securities) and is

regulated primarily by the provisions of the Securities Exchange Act of 1934.39 The

regulation of the securities trading markets is often referred to as market regulation.

Initial public offerings (IPOs), frequently referred to as primary offerings or

distributions,40 are governed primarily by the Securities Act of 1933.41 This is the way in

34Id. 35 Sarbanes-Oxley, Sec. 302 – “Corporate Responsibiliy for Financial Reports” – codified at 15 U.S.C. § 7241. See 2 Hazen supra note XXX, at § 9.3[2] (5th ed. 2004 supp.) [1 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 1.2[3] (5th ed. 2005)] 36 Part of the discussion that follows is adapted from portions of 1 HAZEN supra note XXX §§ 1.1, 14.3. [1 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 1.2[3] (5th ed. 2005)]

37Section 2(a)(4) of the 1933 Act defines “issuer”. 15 U.S.C. § 77b(a)(4) (2003). 38 See1 HAZEN supra note XXX § 1.1[2].

3915 U.S.C. § 78a. (2003). 40 The first time a company goes public is known as an initial public offering or “IPO.” 41 15 U.S.C. § 77a (2003).

which corporate capital is raised in the public equity markets. The Securities Act of 1933

also includes within the concept of securities distributions so-called secondary

“distributions.”42 Secondary distributions occur, for example, when an extremely large

block of securities has been placed in the hands of a private investor, institution, or group

of investors and is subsequently offered by the selling shareholders to the members of the

general public. As is the case with secondary transactions generally, the proceeds from

secondary distributions inure to the benefit of the selling shareholder(s). In the case of both

primary and secondary distributions,43

In the case of both primary and secondary distributions, unless an appropriate

exemption is applicable, registration of the securities will be required under the Securities

Act of 1933.44 This, then, is the focus of the 1933 Act: initial, primary, and secondary

distributions of securities; although some selected provisions of the Act apply to more

private, non-open-market transactions.45

Whereas the distribution process triggers the registration provisions of the 1933

Act, the extent to which securities are widely held and actively traded provides the

jurisdictional trigger for most of the Securities Exchange Act of 1934’s regulation of public

companies and their securities.46 Registration and periodic reporting by issuers under the

1934 Exchange Act depend generally upon the degree to which the securities are widely

held.47

42In contrast to the secondary trading that takes place in the securities markets on a daily basis. 43 Primary and secondary distributions can occur as separate transactions or can be “piggy-backed” into one registered offering. It is not uncommon for an offering to be a combination of a primary and secondary distribution. Cf. Moffat v. Harcourt Brace & Co., 892 F.Supp. 1431 (M.D.Fla.1994) (issuer's delay in applying for registration did not violate agreement with holder of "piggy back" registration rights). 44See 1 HAZEN, supra note XXX chs. 2-3 infra. [1 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 1.2[3] (5th ed. 2005).]

45 For example, section 4(2) of the Act provides an exemption from registrations for transactions that do not involve a public offering. 15 U.S.C. § 77d(2) (XXXX)

46For example, sections 12 and 13 of the 1934 Act imposes registration and reporting requirements on issuers of securities that are publicly traded on a securities exchange or in the over-the-counter markets. 15 U.S.C. §§ 78j, 78k (XXXX). An important exception is found in the general antifraud Rule 10b-5, 17 C.F.R. § 240.10b-5 (2003), the reach of which extends to purchases or sales of any securities where the facilities of interstate commerce are implicated.

47 See 15 U.S.C. §§ 78j, 78k (XXXX).

1934 Act regulation extends far beyond public companies and their securities. The

Securities Exchange Act of 1934 also imposes a broad-based system of market

regulation.48 By way of summary, the SEC oversees securities exchanges and the National

Association of Securities Dealers (NASD), both of which are self regulatory organizations

that police their own markets. Market regulation is a complex series of rules and

prohibitions based on direct regulation by the SEC as well as self regulation through

exchange and NASD rules that have been approved by the SEC. Market regulation

provides rules designed to promote efficient transactions as well as to prohibit fraud and

manipulation. In addition to regulating the markets themselves, the SEC and the self

regulatory organizations regulate intermediaries, most notably, securities brokers and

dealers.49

Section 19(a)(1) of the Securities Exchange Act gives the Commission the authority

to register national exchanges.50 Section 19(h) gives the Commission the obligation to

discipline national exchanges for violating the securities Acts’ provisions.51 Each exchange

also has express authority to discipline persons associated with it, including power to

remove from office or censure its officers or directors from listed/member companies for

willful violations of the Act.52 The Commission has exercised its statutory authority53 to

48 See 4 HAZEN, supra note XXX ch. 14. [1 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 1.2[3] (5th ed. 2005).] 49 See 4 Hazen supra note XXXX ch. 14. The securities laws draw a distinction between brokers and dealers. Id. 5015 U.S.C. § 78s(a)(1) (2003). The SEC also has the responsibility for registering clearing agencies for exchanges. 15 U.S.C. § 78q-1 (2003). Cf. Board of Trade of City of Chicago v. SEC, 883 F.2d 525 (7th Cir.1989), appeal after remand 923 F.2d 1270 (1991) (reversing SEC order granting clearing agent registration for agent for electronic system for trading options on government securities). Commodities exchanges had complained that the registration as a clearing agent was improper since this in essence involved the SEC's recognition of an unregistered securities exchange. The Seventh Circuit agreed that the SEC first had to make a formal determination of whether the activity in question in fact constituted operating as a securities exchange. On remand, the Commission ruled that it did not and reissued the registration as a clearing agent. See 22 Sec.Reg. & L.Rep. (BNA) 56 (Jan. 12, 1990), judgment affirmed 923 F.2d 1270 (7th Cir.1991). 5115 U.S.C. § 78s(h) (2003). See, e.g., In the Matter of New York Stock Exchange, Inc., Administrative Proceeding File No. 3-9925, Sec. Exch. Act Rel. No. 34-41574, 70 S.E.C. Docket 106, 1999 WL 430863 (SEC June 29, 1999) (NYSE consented to improve surveillance regarding various improprieties including trading ahead of customer orders). 5215 U.S.C. § 78f(d) (2003). The authority to disciple;ine its members is found in the rules of the self regulatory organizations. See, e.g., NYSE Manual. Cf. Nicholaou v. SEC, 81 F.3d 161, 1996 WL 140339 (6th Cir.1996) (unpublished opinion) (holding that the limitations period for exchange disciplinary action is

expel a national exchange on only one occasion.54 But the Commission has exercised its

authority under subsection (h) to uphold expulsion of members from the exchange with a bit

more frequency.55 The power to discipline and sanction exchange members is given directly

to the exchange as a self regulatory body, with a right of appeal to the SEC which may in its

discretion review the record de novo.56 The SEC decision is then subject to review by a

federal court of appeals.57 The NASD has similar status and authority. The Commission

can suspend or revoke the securities association’s registration.58 The NASD has the power

to hold hearings and issue sanctions against including expulsion of its members from the

association for conduct in violation of the Act or the NASD’s rules.59

whether the delay was so unfair as to be a denial of due process; proceeding brought in 1992 for conduct during 1984–1988 was not untimely). 5315 U.S.C. § 78s(h)(1) (2003). 54San Francisco Mining Exchange v. SEC, 378 F.2d 162 (9th Cir.1967). Research has failed to reveal any other examples of this power being used. 55See, e.g., Archer v. SEC, 133 F.2d 795 (8th Cir.1943), cert. denied 319 U.S. 767 (1943). 5615 U.S.C. § 78f (2003); see 15 U.S.C. § 78s(h) (2003). 57See Lewis D. Lowenfels, A Lack of Fair Procedures in Administrative Process: Disciplinary Proceedings at the Stock Exchanges and the NASD, 64 CORNELL L.REV. 375 (1979); Norman S. Poser, A Reply to Lowenfels, 64 CORNELL L.REV. 402 (1979). 58 15 U.S.C. § 78o-1(h). See, e.g., Mister Disc. Stockbrokers v. SEC, 768 F.2d 875 (7th Cir. 1985) (upholding dismissal of firm from NASD membership and order barring individual from associating with an NASD member firm); Austin Mun. Sec. v. NASD, 757 F.2d 676 (5th Cir. 1985) (the NASD and its disciplinary officials enjoy absolute immunity in connection from civil liability for their disciplinary activities). See also, e.g., Barbara v. New York Stock Exch., Inc., 99 F.3d 49, 59 (2d Cir. 1996) (exchange enjoyed absolute immunity in connection with disciplinary proceedings). 59 15 U.S.C. § 78s(h)(2). See, e.g., Don D. Anderson & Co. v. SEC, 423 F.2d 813 (10th Cir. 1970) (suspension for violation of 1933 Act); L.H. Alton & Co. v. SEC, [1999-2000 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 91,021, available at 2000 WL 975183 (9th Cir. 2000) (affirming NASD sanctions). See also, e.g., Tager v. SEC, 344 F.2d 5 (2d Cir. 1965) (SEC action suspending registration); Fin. Counsellors, Inc. v. SEC, 339 F.2d 196 (2d Cir. 1964) (expulsion for violation of 1934 Act); Gilligan, Will & Co. v. SEC, 267 F.2d 461 (2d Cir. 1959) (suspension for violation of 1933 Act).

For additional cases, see, e.g., Prevatte v. NASD, 682 F. Supp. 913 (W.D.Mich. 1988) (administrative remedies must be exhausted prior to judicial challenge of NASD sanctions). Cf. Whiteside and Co., Inc. v. SEC, 883 F.2d 7 (5th Cir. 1989) (finding that SEC affirmance of NASD sanction was not an abuse of discretion); In re Application of Morgan Stanley & Co., SEC Admin. Proc. File No. 3–9289, 29 Sec. Reg. & L. Rep. (BNA) 7 (SEC 1997) (SEC lacked jurisdiction to review NASD refusal to grant exemption from MSRB's rule requiring two year ban from municipal securities business, since the automatic ban was not a sanction subject to SEC review under section 19(d) of the Exchange Act). See generally T. Grant Callery & Ann H. Wright, NASD Disciplinary Proceedings-Recent Developments, 48 Bus. Law. 791 (1993).

By virtue of section 15A of the Securities Exchange Act,60 the NASD operates as

the largest of the self regulatory organizations subject to SEC oversight. Although the

Commission has, pursuant to Section 15 of the Act,61 the direct authority to regulate

broker-dealers who are members of the NASD, as a practical matter the bulk of the

day-to-day regulation is generally delegated to the self regulatory organizations. The NASD

is a nationwide self regulatory organization with district offices around the United States.

The NASD has extensive rules governing its member brokerage firms and their employees

which relate both to organizational structure and standards of conduct.62

The preceding discussion provides an overview of public company and market

regulation. It is worth noting further that securities regulation does not stop with securities

issuers and the securities markets, it also extends to regulation of mutual funds and other

investment companies63 and investment advisers.64

b. Regulation of the Derivatives Markets65

The stock and other securities markets offer one set of opportunities to investors.

In addition to the securities markets, investors may look to the various commodities

markets and the trading of commodity futures. At one time the commodities markets were

limited to agricultural and other tangible commodities such as precious metals and fossil

fuels.66 Today more than seventy percent of all commodity futures transactions involve

60 15 U.S.C. § 78o-3. There was some movement toward establishing a self-regulatory organization for dealers in municipal securities. But no such group was ever formed. 61 15 U.S.C. § 78o. 62 The NASD constitution and rules are compiled in NASD Manual (CCH). As is the case with national exchanges, NASD rules are subject to SEC review. 15 U.S.C.A. § 78s. Cf.. McLaughlin, Piven, Vogel, Inc. v. NASD, 733 F. Supp. 694 (S.D.N.Y. 1990) (NASD member must exhaust his or her administrative remedies before seeking judicial relief from NASD's refusal to permit inspection of records pertaining to NASD investigation of member). See generally T. Grant Callery & Anne H. Wright, NASD Disciplinary Proceedings-Recent Developments, 48 BUS. LAW. 791 (1993). 63 This is accomplished through the Investment Company Act of 1940, 15 U.S.C. §§ 80a-1 to -52 (2003). See 5 HAZEN, supra note xxx, at ch. 20. 64 This is accomplished through the Investment Advisers Act of 1940, 15 U.S.C. §§ 80b-1 to -21. See 5 HAZEN, supra note xxx[56], at ch. 21. 65 This discussion is adapted from portions of 1 PHILIP MCBRIDE JOHNSON & THOMAS LEE HAZEN, Derivatives Regulation § 2.01. (2004)

66 See 1 JOHNSON & HAZEN, supra note xxx[??], § 2.01.

financial futures.67 There thus have developed a wide range of overlapping or hybrid

investments that have attributes of both commodities and securities.

Although there have been a number of jurisdictional disputes, the commodities

futures markets generally are regulated by the Commodity Futures Trading Commission

(“CFTC”) pursuant to the Commodity Exchange Act.68 Beginning in the 1970s and

carrying through the 1980s and 90s, the futures and commodity options markets regulated

by the CFTC and the options markets regulated by the SEC have become increasingly

competitive with the increased trading in derivative financial instruments, including

treasury bill, foreign currency and stock index futures (as compared, for example, with the

trading of stock index and foreign currency options).69 Options on securities are regulated

by the SEC but futures and commodity options (including options on futures) are not

subject to SEC regulation.70 Rather they are left to the Commodity Futures Trading

Commission.71

i. The Commodities Futures Modernization Act

The Commodity Futures Modernization Act of 200072 (the “Modernization Act”)

made significant changes in commodities and derivatives regulation by creating a three-

tiered system of regulation consisting of exchanges, less regulated organized markets,

and unregulated derivatives markets. Formerly, organized commodities markets

(“contract markets”) had their rules subject to CFTC oversight and approval. This is no

67 Id.

68 7 U.S.C. § 1-24 (2003). See generally JOHNSON & HAZEN, supra note xxx [??]. 69 Although the form of a futures contract may differ from a listed option, their operational effect and investment strategies are very similar, if not identical, when dealing with financial options and futures. 70In a controversial ruling, the SEC granted securities exchanges' applications to list index participation units which have some characteristics of futures but were found to be securities. Order Approving Proposed Rule Changes Relating to the Listing and Trading of Index Participations, Exchange Act Release No. 34-26709, 54 Fed. Reg. 15,280, 1989 WL 992762 (April 11, 1989). 71 See generally JOHNSON & HAZEN, supra note xxx [??]. 72 Commodity Futures Modernization Act, Pub. L. No. 106-554, 114 Stat. 2763 (Dec. 21, 2000).

longer the case under the current regulatory regime ushered in at the start of the twenty-

first century in the form of the Modernization Act.

The former contract market monopoly meant that all domestic “contracts of sale

of a commodity for future delivery” had to be executed on an organized commodities

market that has been “designated” as a “contract market” under the Commodity

Exchange Act.73 This meant that subject to limited exceptions,74 there were no over-the-

counter derivatives markets, and futures and commodity options contracts were traded

through the facilities of organized and regulated contract markets. The contract markets

and the Commodity Futures Trading Commission controlled the designation process so

that only contracts meeting certain criteria could be traded. The contract market

monopoly under the Commodity Exchange Act thus established a system parallel to

legalized gambling, in that legitimate transactions could only be effected through

regulated facilities – the contract markets. The regulatory constraints of legalized

gambling protect gamblers against organized crime and rigged gambling, whereas the

regulation of exchanges was designed not only to prohibit fraud and manipulation in the

commodities markets, but also to permit only those derivatives contracts that met certain

economic or public policy requirements.75

The regulatory landscape changed in 2001 with the adoption of the Modernization

Act.76 The Modernization Act sought to solidify changes that had been in the making for

years. In the latter part of the twentieth century, there was erosion of the contract market

73 See also 1 JOHNSON & HAZEN, supra note [??], § 1.02[2] (commodities and jurisdiction); id. § 1.02[8] (the deterioration of the contract market monopoly); id. § 4.05[8] (challenges to the Commission’s jurisdiction); id. § 4.05[9] (ongoing jurisdictional assaults); id. § 4.05[10] (reflections on CFTC/SEC jurisdiction). [This source depends on incorrect source in last footnote (if it refers to that statute), I think infra is used incorrectly] [JBE: I think sections refer to J&H] 74 During the 1990s, the number of over-the-counter (OTC) derivatives that were used by institutional investors grew at a staggering pace. Thus, for example, a report by the General Accounting Office in 1994 estimated that the notional amount of OTC derivatives outstanding at the end of fiscal year 1992 was at least $12.1 trillion, this was in addition to approximately $5.5 trillion of foreign currency exchange contracts used primarily by banks. See Jerry W. Markham, Banking Regulation: Its History and Future, 4 N.C. BANKING INST. 221, 274 n.333 (2000), citing U. S. G.A.O., FINANCIAL DERIVATIVES - ACTIONS NEEDED TO PROTECT THE FINANCIAL SYSTEM 34 (1994), available at 1994 WL 930437. See also, e.g., Jerry W. Markham, Protecting the Institutional Investor - Jungle Predator or Shorn Lamb? 12 YALE J. ON REG. 345, 353 (1995). 75 See 1 JOHNSON & HAZEN, supra note [??], § 2.02. 76 Commodity Futures Modernization Act, Pub. L. No. 106-554. See 1 JOHNSON & HAZEN, supra note XXX, § 2.02 [??]. [note 68? What source is this?]

monopoly, due to increased use of forward contracts and swap transactions that were

pigeon-holed into existing exemptions to the Commodity Exchange Act’s contract market

monopoly.77 Contemporaneously, monopoly was easing due to jurisdictional battles

between the CFTC and the SEC with respect to investments that could be characterized

either as futures contracts or as securities.78 The Modernization Act eliminated the

former monopoly by permitting over-the-counter, and essentially unregulated,

transactions between qualified market participants.79 The Modernization Act also

changed the designation process so that the CFTC no longer has responsibility for

reviewing the economics underlying publicly traded derivatives.80

Current derivatives and commodities regulation retains the concept of designated

contracts markets but substantially decreases the layers of regulation that they are subject

to. There are no longer categorical restrictions on the underlying commodities for futures

and options to be traded on contract markets. Additionally, there are no restrictions on

the types of market participants that may enter into transactions on a designated contract

market. Contract markets are no longer required to obtain separate designation for each

futures contract. Instead, contract markets are to be designated to trade all commodities,

though there are special requirements applicable to securities futures. In order for a new

entrant81 to qualify as a contract market under the amended regime, the exchange must, if

not previously registered, satisfy seven basic criteria for designation and seventeen “core

principles” set forth in the Act. The basic criteria include having mechanisms designed

to prevent market manipulations, to assure fair trading practices, to operate an effective

trading system, to ensure the financial integrity of transactions, to discipline offenders, to

make its rules and contract specifications available to the public, and to have access to all

relevant information.82 Moreover, in order to qualify for designation as a contract

77 See1 JOHNSON & HAZEN, supra note XXX[??], § 1.02[8]. [What source is this?] 78 See 2 id. § 4.05. [?] 79 See discussion supra in the text accompanying notes XXX-XXX. [?] 80 See 1 JOHNSON & HAZEN, supra note XXX, § 2.03. 81 Existing commodities futures contract markets were grandfathered and thus retained their designated status following the Modernization Act. [Cite source]

82 Section 5 of the Commodity Exchange Act, 7 U.S.C. § 7 (XXXX). .For an example of designation as a contract market under the new regulatory regime, see CFTC Designates Brokerage Futures Exchange as a

market, the trading facility applying for CFTC designation must demonstrate to the

CFTC in its application that seven specified standards are satisfied.83

The current regulatory regime for commodities markets and commodities

professionals is significantly streamlined. Whereas the former regulatory regime

imposed an affirmative day-to-day regulation , the Commodity Exchange Act, as

amended by the Modernization Act, charges the CFTC with a more general oversight role

with respect to contract markets. In comparison, with respect to the securities markets,

the SEC exercises a significantly more active supervisory role in the securities markets.

For example, rules of self-regulatory organizations (namely, the securities exchanges and

the National Association of Securities Dealers (NASD)) are subject to SEC approval.84

This is no longer the case with respect to the CFTC’s influence over self regulatory

organizations operating in the commodities markets.85

The Modernization Act allow the use of certain trading facilities with less of a

regulatory overseer than is the case with designated contract markets.86 Trading facilities

having a lower level of regulation than contract markets are defined by the Commodity

Exchange Act as derivatives transaction execution facilities (“DTEFs”).87 Unlike

designated contract markets, there are restrictions on both the categories of the futures

and options contracts that may be traded and the types of investors that may participate in

Contract Market and Brokered Clearing Corporation as a Resister Derivatives Organization, CTFC Rel. No. 4526-01 (June 19, 2001), [Tech checked?] 83 7 U.S.C. § 7 (XXXX).

84For discussion of the securities market regulation, see 4 HAZEN, supra note XXX, ch. 14. See also JERRY W. MARKHAM & THOMAS L. HAZEN, BROKER-DEALER OPERATIONS UNDER SECURITIES AND COMMODITIES LAW: REGISTRATION, FINANCIAL RESPONSIBILITIES, CREDIT REGULATION, AND CUSTOMER PROTECTION (2d ed. 2003). 85 The Commodity Exchange Act continues to impose self-regulatory requirements that are similar to those prior to the Modernization Act.

86 Section la(33) of the Act defines trading facility as “a person or group of persons that constitutes, maintains or provides a physical or electronic facility or system in which multiple participants have the ability to execute or trade agreements, contracts, or transactions by accepting bids and offers made by other participants that are open to multiple participants in the facility or system.” 7 U.S.C. § 1a(33)(A)(2003). See also 7 U.S.C. §§ 1a(33), 1a(10).

87 See 7 U.S.C. § 7.

transactions on DTEFs.88 DTEFs generally may trade futures contracts or options on

futures contracts based on commodities that are not susceptible to manipulation, have no

cash market, or are securities futures products. [89. Certain other commodities may be

traded on a DTEF, if trading is limited to eligible commercial entities trading for their

88 The Commodity Exchange Act currently permits two types of DTEFs: those serving the retail market and those serving the commercial market. A DTEF that operates as a retail market must limit its participants to those who trade through a futures commission merchant that (1) is a member of a futures self-regulatory organization (or if trading a security futures product, a national securities association); (2) is a clearing member of a derivatives clearing organization; and (3) has net capital of at least $20 million. Retail customers trading through derivatives transaction execution facilities are permitted to trade only in instruments based on commodities that meet certain requirements designed to make the contracts particularly unsusceptible to manipulation, and to security futures products if the DTEF is registered as a national securities exchange. The Act further authorizes the CFTC to approve on a case-by-case basis additional contracts that can be traded on a retail DTEF. 7 U.S.C. § 7a(b)(2) (2000).

Derivatives transaction execution facilities that operate as commercial markets are required to restrict its participants to those who qualify as “eligible commercial entities.” Commercial DTEFs are not limited to the same extent as retail DTEFs with respect to the contracts that may be traded. A commercial derivatives transaction execution facility may trade futures on any non�agricultural commodity if trade is limited to eligible commercial entities trading for their own account. [Need citation]

89 The Commodity Exchange Act as amended by the Commodity Futures Modernization Act sets forth eight core principles applicable to DTEF that must be followed in order for the DTEF to maintain its registration:

1. Compliance with rules. The DTEF establish rules and procedures to assure compliance with the rules of the facility;

2. Monitoring of trading. The DTEF must monitor trading in order to ensure orderly trading and to provide necessary trading information to the Commission;

3. Public disclosure. The DTEF must provide disclosure to the public and the Commission of the contract terms and conditions, the trading conventions and mechanisms, the financial integrity protections and other relevant information;

4. Daily publication of trading information. On a daily basis, the derivatives transaction execution facility must publish trading information if the Commission determines that the contracts perform a significant price discovery function;

5. Fitness standards. The DTEF must establish and enforce fitness standards for members of the trading facility, its directors, members of disciplinary committees, and affiliated persons;

6. Conflict of interest rules. The DTEF must adopt conflict of interest rules for its decision-making and adjudicatory personnel;

7. Recordkeeping requirements. The DTEF is required to establish recordkeeping requirements to maintain records for five years of all activities related to the DTEF’s business in a form and manner acceptable to the Commission;

8. Antitrust considerations. DTEFs must conduct themselves in such a way as to minimize unreasonable restraints of trade and anticompetitive burdens on trading.

7 U.S.C. § 7a(d)(2)-(9) (2000). The DTEF has discretion as to the manner in which it chooses to comply with the core principles. 7 U.S.C. § 7a(d)(1).

own accounts. A DTEF that is a national securities exchange, and thus subject to SEC

regulation, may trade security futures contracts.

In addition to contract markets and DTEFs, the Modernization Act recognized a

new category of marketplace known as an exempt board of trade, which can offer certain

types of futures contracts (except securities futures products without CFTC oversight. To

qualify as an exempt board of trade, the trading facility must limit trading to contracts

that are not susceptible to manipulation or have no cash market.90 Participation in an

exempt board of trade is limited to eligible contract participants, 91 and an exempt board

of trade may not trade securities futures products.92 CFTC rules permit eligible contract

participants to opt out of having the segregation requirements generally applicable to

funds held by a futures commission merchant with respect to trades on or through a

registered DTEF.93 The fraud and manipulation prohibitions of the Commodity

Exchange Act apply to exempt boards of trade but other provisions of the Act applicable

to DTEFs or designated contract markets do not apply.94

Thus, with the adoption of the Modernization Act, there is much broader

recognition of off-exchange or over-the-counter derivatives markets and much more

discretion accorded to participants. The streamlined regulatory structure and supervisory

role of the CFTC makes it easier for participants to establish the validity of exchange-

listed derivatives. As noted above, the Modernization Act replaced hands-on CFTC

oversight of the markets with general “core principles” that the contract markets and

registered derivatives transaction execution facilities must follow in their rulemaking and

90 7 U.S.C. § 7a-3(b). Moreover, Section 7a(f) of the Commodity Exchange Act permits a DTEF to authorize futures commission merchants to offer to eligible contract participants the right to not segregate customer funds in accordance with rules to be promulgated by the CFTC. 7 U.S.C. § 7a(f). 91 7 U.S.C. § 7a-3(b)(2) (2000). Every user must fall within one of 11 categories of “eligible contract participant”; and the item underlying the futures contract must have either: (i) a nearly inexhaustible deliverable supply; (ii) a supply large enough and sufficiently liquid to make a market manipulation “highly unlikely”; or (iii) no cash market at all.. 7 U.S.C. § 7a-3(b).

92 Id.

93 17 C.F.R. § 1.68 (2004). See CFTC Adopts Rules for Opting Out of Segregation, as to Trading Conducted on a Registered Derivatives Transaction Execution Facility, CFTC Rel. No. 4510-01, 2001 WL 419959 (CFTC April 25, 2001). 94 7 U.S.C. § 7a-3(a) (2000).

enforcement programs.95 In sharp contrast to the SEC’s active oversight of the securities

exchanges and the NASD, the CFTC does not have direct supervisory authority with

respect to the self-regulatory practices of derivatives participants. Regulation of the non-

securities derivatives markets is therefore significantly less rigorous than regulation of

the securities markets.96

Do the markedly different regulatory roles for the SEC and the CFTC in their

respective markets accurately reflect differences in the behaviors of investors and other

market participants? If not, then it is worth reconsidering the wisdom of such differing

regulatory schemes.

c. Gambling

The discussion so far has focused on regulation of the investment markets. The

investment markets not only expose investors to risk, but also provide opportunities for

risk shifting through the options, futures, and derivatives markets. As developed more

fully in the section that follows, for a long time some have referred to derivatives markets

as a form of legalized gambling – an accusation that has also been leveled against

investment markets generally. This article takes the position that there is still some merit

to the gambling/investment analogy. To the extent that the gambling analogy is a valid

one, then there should be some parallels between the gambling laws and the securities

95 See infra note XXX and accompanying text.

96 There is one exception to the divergence in the regulatory schemes applicable to the non-securities derivative markets and the securities markets. Prior to 2000, futures contracts on single stocks were not permitted whereas options on individual securities had been publicly traded for years in the securities markets. Although over-the-counter futures contracts generally were not permissible under the former law, there arose a new variety of hybrid investments (used primarily by sophisticated market participants).96 These hybrid investment instruments raised jurisdictional issues and a turf war between the SEC and CFTC. The allocation of jurisdiction between the SEC and CFTC with respect to index futures and options on indexes was a political compromise arising out of a jurisdictional accord that had been reached in 1980. The Modernization Act eliminated the prohibition on single stock futures. As a result, security futures products, which include futures on individual securities as well as narrow-based stock indexes, can be traded in the commodities markets. Unlike the other derivative contracts, security futures products are traded under a co-regulatory system such that the applicable CFTC and contract market regulation parallels that which would be applicable to comparable security option products traded under SEC regulation. This is a relatively small segment of the derivatives market and as such the overall regulatory schemes applicable to non-securities derivatives and securities remain strikingly different. See 1 JOHNSON & HAZEN supra note XXX § 1.02[9].

and commodities laws. In other words, the legislature could reevaluate the regulation of

the investment markets in comparison with gambling laws.

Long ago, all forms of gambling were outlawed, primarily for moral reasons.97

Over time, the legislature has eased gambling regulation significantly as additional forms

of legalized gambling became apparent. While most bilateral wagering contracts remain

illegal, many forms of organized gambling are now legal. Legalized gambling includes a

wide range of activities. For example, there are state operated lotteries, legalized pari-

mutual betting on horse and dog racing, legalized gambling casinos, and in Nevada,

legalized betting on sporting events.98 Historically, the federal government left gambling

regulation to the states, the one exception being the federal law permitting gambling on

Indian reservations.99

II. Regulatory Comparisons and Solutions

Market regulation presumably is based on legislators’, regulators’, and other

policy makers’ determination of what measures will be most effective in combating the

evils that led to regulation in the first place. Overregulation imposes unnecessary

transaction costs and unduly interferes with efficient markets. Accordingly, the task for

97 See infra note XXX and accompanying text. 98 See, e.g., Cory Aronovitz, The Regulation of Commercial Gaming, 5 CHAP. L. REV. 181 (2002) (discussing legalized gambling); Paul D. Delva, Comment, The Promises and Perils of Legalized Gambling for Local Governments: Who Decides How to Stack the Deck?, 68 TEMP. L. REV. 847, 847-49 (1995) (discussing increased legalization); David B. McGinty, The Near-Regulation of Online Sports Wagering by United States v. Cohen, 7 GAMING L. REV. 205 (2003) (every state except Utah and Hawaii have some form of legalized gambling). See also, e.g., RICHARD MCGOWAN, STATE LOTTERIES AND LEGALIZED GAMBLING 21 (1994) (examining legalization of gambling); R. Randall Bridwell & Frank L. Quinn, Mad Joy to Misfortune: The Merger of Law and Politics in the World of Gambling, 72 MISS. L.J. 565 (2002) (discussing the consequences of increased legalized gambling); Wendy J. Johnson, Tribal Gaming Expansion in Oregon, 37 WILLAMETTE L. REV. 399 (2001) (discussing gambling in Oregon); John Warren Kindt & John K. Palchak, Legalized Gambling Destabilization of U.S. Financial Institutions and the Banking Industry: Issues in Bankruptcy, Credit, and Social Norm Production, 19 BANKR. DEV. J. 21 (2002) (discussing the societal costs of legalized gambling and bankruptcies); John W. Kindt, Increased Crime and Legalized Gambling Operations: The Impact on the Socio-Economics of Business and Government, 30 CRIM. L. BULL. 538 (1994) (discussing the impact of decriminalization); Kathryn R.L. Rand, There Are No Pequots on the Plains: Assessing the Success of Indian Gaming, 5 CHAP. L. REV. 47 (2002) (evaluating legalized casino gambling on Indian reservations); A. Gregory Gibbs, Note, Anchorage: Gaming Capital of the Pacific Rim, 17 ALASKA L. REV. 343 (2000) (discussing gambling in Alaska). 99 See Tom Lundin Jr., Note, The Internet Gambling Prohibition Act Of 1999: Congress Stacks the Deck Against Online Wagering But Deals in Traditional Gaming Industry High Rollers, 16 GA. ST. U. L. REV. 845, 853 (2000).

policy makers is to strike a delicate balance between what is deemed to be the minimum

necessary or desirable regulation and encouraging free markets.

a. Theories of Regulation

To some extent, any form of market regulation is paternalism,100 but paternalism

that may be well justified. One of the longtime premises of securities regulation is that

investors need protection not only against those who would take advantage of them, but

also against themselves.101 Regulation can, of course, be overly paternalistic. However,

the fact that regulation is protectionist and therefore to some extent paternalistic is not a

bad thing.102 For example, a recent article suggests that paternalistic regulation is

appropriate where it results in a system of “asymmetric paternalism” where the regulation

“creates large benefits for those who make errors, while imposing little or no harm on

those who are fully rational.”103

The choice of the best regulatory structure for the markets is influenced by the ways

in which we look at market structure and the behavior of market participants. Since the

inception of securities regulation in this country in 1911,104 there has been debate

concerning the appropriate approach to regulating investment markets.105 More recently,

scholarly discussion has focused on revisiting the premises of investment market 100 Cf. Jeffrey J. Rachlinski, The Uncertain Psychological Case for Paternalism, 97 NW. U. L. REV. 1165 (2003) (arguing against paternalism); Cass R. Sunstein, Behavioral Analysis of Law, 64 U. CHI. L. REV. 1175, 1178 (1997) (“objections to paternalism should be empirical and pragmatic, having to do with the possibility of education and likely failures of government response, rather than a priori in nature”). Paternalism is also a rationale for insurance regulation. See infra note XXX.. 101 See, e.g., Bateman, Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 310 (1985) (rejecting in pari delicto defense based on plaintiff’s alleged misconduct where plaintiff acted merely as an investor). 102 See, e.g., Eyal Zamir, The Efficiency of Paternalism, 84 VA. L. REV. 229 (1998) (paternalism and efficiency are not necessarily incompatible). 103 Colin Camerer, et al, Regulation for Conservatives: Behavioral Economics and the Case for "Asymmetric Paternalism", 151 U. PA. L. REV. 1211, 1212 (2003). 104 In 1911, Kansas enacted the first comprehensive regulatory statute addressing securities marketing. Kans. Laws 1911, c. 133. Selective regulation predated the Kansas enactment. Some more limited securities regulation existed before the Kansas statute. For example, Massachusetts was regulating securities issued by common carriers in 1852. See HARRY G. HENN & JOHN R. ALEXANDER, LAWS OF CORPORATIONS 843 (3d ed. 1983). 105 For example, the states adopted a “merit” approach whereby an administrator would pass on the merits of securities to be offered within the state. In contrast, federal securities regulation is premised on disclosure and has rejected the merit approach initially adopted by the states. See THOMAS LEE HAZEN & DAVID L. RATNER, SECURITIES REGULATION CASES AND MATERIALS 1-11 (6th ed. 2003).

regulation. As noted more fully below,106 there has been much debate in the academic

literature as to whether the rational-choice economic model or a more behaviorist approach

best explains investor behavior. For example, it has been suggested that we should look at

behavioral analysis in addition to the traditional economic analysis that is the supposed

foundation of securities regulation in the United States.107 Other social science – most

notably behavioral science – has been proffered as a better alternative for analyzing

regulatory efforts.108 As is the case with most social science analysis, valuable lessons can

be learned from both the economic and behaviorist perspective.

The choice of the applicable social science as a model of regulation is an

important issue that has been discussed elsewhere and thus is not the primary focus of

this article. Instead, this article explores insurance and gambling analogies as a means of

gaining insight into securities and derivatives regulation . The existing regulatory structure

focuses on disclosure as a way to keep the markets operating with both efficiency and

integrity. This should remain the core of securities regulation. By drawing analogies to

insurance and gambling, however, we can address conduct that is underregulated within

the current disclosure framework and find potential ways to supplement the existing

regulatory structure.

106 See infra note XXX and accompanying text. 107 See Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 71 (2003) (“Cognitive dissonance may then affect investors, leading them to confirm the value of even poorly made decisions. Commentators have seized upon the evidence that investors act with limited cognitive capacity to justify regulatory intervention.”); Lawrence A. Cunningham, Behavioral Finance and Investor Governance, 59 WASH. & LEE L. REV. 767 (2002) (arguing securities regulation reforms can benefit from behavioral finance); Donald C. Langevoort, Selling Hope, Selling Risk: Some Lessons for Law from Behavioral Economics About Stockbrokers and Sophisticated Customers, 84 CAL. L. REV. 627, 648-67 (1996) (a behavioral analysis of broker conduct); See also, e.g., Jon D. Hanson & Douglas A. Kysar, Taking Behavioralism Seriously: The Problem of Market Manipulation, 74 N.Y.U. L. REV. 630, 715 (1999) ("Behavioral research remains a somewhat haphazard collection of seemingly unrelated cognitive quirks.... Drawing legal conclusions for a topic like consumer risk perception then becomes primarily a game of 'who has the most anomalies wins.’”); Robert Prentice, Whither Securities Regulation? Some Behavioral Observations Regarding Proposals for its Future, 51 DUKE L.J. 1397, 1400 (2001) ("American securities regulation is the optimal system for governing capital markets.").

108 See, e.g., Cunningham supra note xxxx

b. Explaining Investor Behavior in the Securities and Other Investment Markets

Economic theory has long been asserted to be a helpful paradigm for regulation of

the securities markets.109 The behavioral sciences also provide useful insight.110 Some

observers have argued that there should be a market for securities regulation, allowing the

market to determine the optimal regulatory structure.111 A variation would be to leave

securities regulation to the exchanges on which securities are listed rather than to policy-

109 See, e.g., SIMON M. KEANE, STOCK MARKET EFFICIENCY: THEORY, EVIDENCE AND IMPLICATIONS 9 (1983); see also, e.g., J. FRANCIS, INVESTMENT ANALYSIS AND MANAGEMENT 643-86 (1979); JAMES H. LORIE ET AL., THE STOCK MARKET: THEORIES AND EVIDENCE 56, 65 (2d ed. 1985); Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, 25 J. Fin. 383, 383 (1970); Irwin Friend, The Economic Consequences of the Stock Market, 62 Am. Econ. Rev. 212 (1972); Christopher P. Saari, Note, The Efficient Capital Market Hypothesis, Economic Theory and the Regulation of the Securities Industry, 29 STAN. L. REV. 1031 (1977). For critical views of the efficient capital market hypothesis, see, e.g., Jeffrey N. Gordon & Lewis A. Kornhauser, Efficient Markets, Costly Information, and Securities Research, 60 N.Y.U. L. REV. 761 (1985); William K. S. Wang, Some Arguments that the Stock Market is not Efficient, 19 U.C. DAVIS L. REV. 341 (1986). 110 See Choi & Pritchard, supra note XXX; [Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 71 (2003); Hanson & Douglas, A. Kysar, Taking Behavioralism Seriously: the Problem of Market Manipulation, 74 N.Y.U. L. REV. 630 (1999); Russell B. Korobkin & Thomas S. Ulen, Law and Behavioral Science: Removing the Rationality Assumption From Law and Economics, 88 CAL. L. REV. 105 (2000); Donald C. Langevoort, Taming the Animal Spirits of the stock Markets: A Behavioral Approach to Securities Regulation, 97 NW. U. L. REV. 135 (2002); Paul G. Mahoney, Commentary Is There a Cure for "Excessive" Trading?, 81 VA. L. REV. 713 (1995); Robert Prentice, Whither Securities Regulation? Some Behavioral Observations Regarding Proposals for its Future, 51 DUKE L.J. 1397 (2002); Lynn A. Stout, The Unimportance of Being Efficient: an Economic Analysis of Stock Market Pricing and Securities Regulation, 87 MICH. L. REV. 613 (1988). See also, e.g., Christine Jolls, Cass R. Sunstein, & Richard Thaler, A Behavioral Approach to Law and Economics, 50 STAN L REV 1471, 1518-19 (1998) (judgment biases have implications with respect to demand for environmental regulation); Lewis A. Kornhauser, The Domain of Preference, 151 U. PA. L. REV. 717 (2003) (discussing law and economics critiques of behavioral economics); Roger G. Noll & James E. Krier, Some Implications of Cognitive Psychology for Risk Regulation, 19 J LEGAL STUD. 747 (1990) (discussing cognitive psychology implications on regulation of health and environmental risks).

For a critique of the behavioral approach, see, e.g., Gregory Mitchell, Why Law and Economics' Perfect Rationality Should Not Be Traded for Behavioral Law and Economics' Equal Incompetence, 91 GEO. L.J. 67, 72 (2002) ("Behavioral law and economics bases its model of bounded rationality on a very limited set of empirical data and draws unsupportable conclusions about human nature from this partial data set."); Richard A. Posner, Rational Choice, Behavioral Economics, and the Law, 50 STAN. L. REV. 1551, 1560-61 (1998) (contending that that behavioral economics "have no theory, but merely a set of challenges to the theory-builders, who in the relevant instances are rational-choice economists and, I am about to suggest, evolutionary biologists"). 111 See Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 YALE L.J. 2359 (1998) (“The aim is to replicate for the securities setting the benefits produced by state competition for corporate charters--a responsive legal regime that has tended to maximize share value--and thereby eliminate the frustration experienced at efforts to reform the national regime. As a competitive legal market supplants a monopolist federal agency in the fashioning of regulation, it would produce rules more aligned with the preferences of investors, whose decisions drive the capital market.”).

making legislators or administrative agencies.112 As noted above, this is the approach

taken by commodities regulation,113 especially in the wake of the deregulatory impact of

the Commodity Futures Modernization Act of 2000.114

Prior to the Modernization Act all publicly traded futures contracts had to take

place on organized exchange the rules of which were subject to oversight and approval by

the Commodity Futures Trading Commission.115 The self regulatory organizations in the

securities markets (the national securities exchanges and the National Association of

Securities Dealers) perform similar function in regulating the securities exchanges and

the over-the-counter (i.e., non-exchange) markets for securities.116 As discussed in the

preceding section, the Commodity Futures Modernization Act substituted a series of core

principles for organized public markets and leaves it to the contract markets and derivates

transaction execution facilities to fashion rules that are consistent with those core

principles.

A counterpart to the rational choice117 law and economics explanation of human

behavior is the behavioral economics concept of prospect theory,118 which posits, among

other things, that we are more likely to take risk to avoid losses than to amass gains.119

112 See, e.g., Paul G. Mahoney, The Exchange as Regulator, 83 VA. L. REV. 1453 (1997). 113 See, e.g., Stephen Craig Pirrong, The Self-Regulation of Commodity Exchanges: The Case of Market Manipulation, 38 J.L. & ECON. 141 (1995). 114 Pub. Law No. 106-554, 114 Stat. 2763 (Dec. 21, 2000). 115 See discussion in the text accompanying notes XXX-XXX infra. See generally 1 JOHNSON & HAZEN, supra note XXX § 1.04. 116 See 5 HAZEN, supra note XXX ch. 14 . [THOMAS LEE HAZEN, Treatise on the Law of Securities Regulation , § 1.2[3] (5th ed. 2005)] 117 See, e.g., Charles R. Plott, Rational Choice in Experimental Markets, 59 J. BUS. S301 (1986); Thomas S. Ulen, Firmly Grounded: Economics in the Future of the Law, 1997 WIS. L. REV. 433, 436 (1997). 118 See Daniel Kahneman & Amos Tversky, Prospect Theory: An Analysis of Decision Under Risk, 47 ECONOMETRICA 263 (1979); Amos Tversky & Daniel Kahneman, Rational Choice and the Framing of Decisions, 59 J. BUS. L. S251, S257-60 (1986). See also, e.g., REID HASTIE & ROBYN M. DAWES: RATIONAL CHOICE IN AN UNCERTAIN WORLD: THE PSYCHOLOGY OF JUDGMENT AND DECISION MAKING (2001). 119 See Chris Guthrie, Prospect Theory, Risk Preference, and the Law 97 NW. U. L. REV. 1115 (2003) (“In short, people are often willing to take risks to avoid losses but are unwilling to take risks to accumulate gains”). But cf. Jason Scott Johnston, Paradoxes of the Safe Society: A Rational Actor Approach to the Reconceptualization of Risk and the Reformation of Risk Regulation, 151 U. PA. L. REV. 747 (2003) (medical advancements have increased many individuals willingness to engage in high risk behavior).

This asymmetry arises because we tend to weigh potential losses more heavily than

potential gains in assessing risks.120 A variation of this phenomenon occurs in connection

with regret – namely, emotion may motivate rational actors to choose a more risk averse

choice (even with a lower payoff) in order to avoid the regret that would follow from

selecting a riskier alternative that failed to realize the higher potential gain.121 The

difficulty of distinguishing bona fide risk-shifting transactions from other transactions

that the law has decided to regulate differently has been aptly described as the law’s love-

hate relationship to risk.122 The discussion that follows examines the parallels between

gambling and investor behavior and then explores how those parallels might affect

regulatory structures.

c. Rational Investing or Gambling?

Many investors participate in the markets as a form of entertainment. Some

suggest that market participants often view investing as a hobby123 or participate for the

thrill of the game.124 To the extent that this is true, basing investment regulation solely

120 See Richard Coughlan & Terry Connolly, Predicting Affective Responses to Unexpected Outcomes, 85 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 211, 217 (2001) (“losses loom larger than gains”); Janet Landman, Regret and Elation Following Action and Inaction: Affective Responses to Positive Versus Negative Outcomes, 13 PERSONALITY & SOC. PSYCHOL. BULL. 524, 527 (1987) (“[W]hen people are making real decisions in betting or life-dilemma situations, they weigh potential losses more heavily than potential gains.”). It is also worth noting that causing someone to incur a risk is every bit as much a “harm” as actual economic loss. See Claire Finkelstein, Is Risk a Harm?, 151 U. PA. L. REV. 963, 992 (2003) (infliction of risk can constitute a legally actionable harm, even if outcome harm is not actually suffered). 121 See, e.g., Robert A. Josephs et al., Protecting the Self from the Negative Consequences of Risky Decisions, 62 J. PERSONALITY & SOC. PSYCHOL. 26, 26-28 (1992); Graham Loomes & Robert Sugden, A Rationale for Preference Reversal, 73 AM. ECON. REV. 428, 428 (1983); Robert A. Prentice & Jonathan J. Koehler, A Normality Bias in Legal Decision Making, 88 CORNELL L. REV. 583, 606-609 (2003); Marcel Zeelenberg & Jane Beattie, Consequences of Regret Aversion 2: Additional Evidence for Effects of Feedback on Decision Making, 72 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 63, 74-75 (1997). 122 Kreitner, supra note XXX at 1127-1137. [Roy Kreitner, Speculations of Contract, or How Contract Law Stopped Worrying and Learned to Love Risk, 100 COLUM. L. REV. 1096, 1127-1137 (2000)] 123 Ian Ayres & Stephen Choi, Internalizing Outsider Trading, 101 MICH. L. REV. 313, 314 (2002) (describing investing as a hobby for many). 124 ROBERT J. SHILLER, MARKET VOLATILITY 59 (1989) (“Investing in speculative assets clearly shares with gambling the element of play …. The satisfaction afforded by gambling is related to the individual's ego involvement in the activity; and thus individual investors must themselves play to achieve satisfaction, and most do not rely on others for decisions.”); Theresa A. Gabaldon, John Law, With A Tulip, In The South Seas: Gambling And The Regulation Of Euphoric Market Transactions, 26 J. CORP. L. 225, 266 (2001); Charles R. P. Pouncy, The Rational Rogue: Neoclassical Economic Ideology In The Regulation Of The

on efficient market on rational choice theories ignores a significant segment of the

market.

Several years ago, I explored the supposed rationality of derivatives125 markets

and was struck then by the similarity bet126ween what many label rational investment or

bona fide market transactions and gambling, which traditionally has been illegal or

alternatively subject to stringent regulation.127 In that article, I questioned whether the

regulatory structure relied too heavily on the efficient capital market hypothesis and the

supposed rationality of investors. Subsequent literature has explored the ways in which

investor behavior does not fit the rational choice model, suggesting instead that

behavioral economics can better explain at least some aspects of investor activity.128

Financial Professional, 26 VT. L. REV. 263, 369 n.496 (2002); Lynn A. Stout, Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation, 81 VA. L. REV. 611, 660 n.148 (1995); Jonathan Clements, Are You Irrational or Thrill-Seeking When It Comes To Risky Investment?, WALL ST. J., June 4, 1996, at C1. But cf. de Kwiatkowski v. Bear Stearns & Co., Inc., 126 F.Supp.2d 672, 719 (S.D.N.Y. 2000), rev’d 306 F.3d 1293 (2nd Cir. 2002) (“At trial, and with these motions, Bear Stearns sought to portray Kwiatkowski's motivations in assuming the massive risk he chose as those of a person driven by ego gratification, exuberant greed or just reckless gambling thrills. The record in fact is clear that, throughout the times and circumstances relevant here, Kwiatkowski was a sophisticated investor and that he was fully aware of the large risks associated with foreign currency trading and with his exceptionally large position. He admitted as much.”) (footnote omitted). 125 Derivative investments consist of options (“puts” and “calls”) and futures contracts. Options and futures contracts can be derivative of individual securities (or commodities) or can be derivative of groups (or baskets) of securities or commodities, such as those which comprise some of the more widely followed stock indexes. Complex derivative investments such as swap transactions can be based on a number of underlying formulas, based for example, on foreign currencies, interest rates, commodities prices, and the like.

126 Thomas Lee Hazen, Rational Investment, Speculation, or Gambling?--Derivative Securities and Financial Futures and Their Effects on the Underlying Capital Markets, 86 NW. U. L. REV. 987, 987-1037 (1992).

127 See T Hazen, Rational Investing, supra note XXX, at 987-1037; cf. Wendy Collins Perdue, Manipulation of Futures Markets: Redefining the Offense, 56 FORDHAM L. REV. 345, 401 (1987) (arguing that this manipulation should be defined in terms “as conduct that would be uneconomical or irrational, absent an effect on the market price”). But see, e.g., United States v. Dial, 757 F.2d 163, 165 (7th Cir.) (there is a difference between speculation and gambling), cert. denied, 474 U.S. 838 (1985); THOMAS A. HIERONYMUS, ECONOMICS OF FUTURES TRADING 138 (1971) (“1. Gambling involves the creation of risks that would not otherwise exist while speculation involves the assumption of necessary and unavoidable risks of commerce, and 2. In every futures transaction, the speculation incurs the duties and acquires the rights of a holding of property and thus is an integral part of commerce”). See also, e.g., Theresa A. Gabaldon, John Law, with a Tulip, in the South Seas: Gambling and the Regulation of Euphoric Market Transactions; 26 J. CORP. L. 225 (2001) 128See supra notes XXX XXX.

The analogy between the investment markets and gambling has been made by

others but not in a way as to indicate that there should be a greater parallel in applicable

regulatory structures. For example, in a letter to President Washington, Thomas

Jefferson wrote: “the wealth acquired by speculation and plunder is fugacious in its

nature and fills society with the spirit of gambling.”129 More than a century later

Theodore Roosevelt commented that: “[t]here is no moral difference between gambling

at cards or in lotteries or on the race track and gambling in the stock market. One method

is just as pernicious to the body politic as the other in kind, and in degree the evil worked

is far greater.”130 The analogy has not been limited to policy makers and politicians.131

John Maynard Keynes observed: "It is usually agreed that casinos should, in the public

interest, be inaccessible and expensive. And perhaps the same is true of Stock

Exchanges."132 Even the federal tax laws draw a distinction between gambling and other

types of potentially gainful activities. While gambling gains are taxable, gambling losses

are deductible only to the extent of being able to offset gambling income and thus cannot 129 Letter from Thomas Jefferson to George Washington (Aug. 14, 1987), in 12 THE PAPERS OF THOMAS JEFFERSON, 1787-88, at 38 (Julian P. Boyd ed., Princeton U. Press 1955); see John S. Shockley & David A.Schultz, The Political Philosophy of Campaign Finance Reform as Articulated in the Dissents in Austin v. Michigan Chamber of Commerce, 24 ST. MARY'S L.J. 165, 189 (1992). 13042 CONG. REC. 1347, 1349 (1908); see Irwin Friend, The Economic Consequences of the Stock Market, 62 AM. ECON. REV. 212, 212 (1972) (describing public securities market as a “legalized gambling casino.”); Steve Thel, The Original Conception of Section 10(b) of the Securities Exchange Act, 42 STAN. L. REV. 385, 396 (1990), Robert J. Shiller, Financial Speculation: Economic Efficiency and Public Policy 9 (Jan. 15, 1991) (background paper prepared for the 20th Century Fund) 131See, e.g., REUVEN BRENNER & GABRIELLE A. BRENNER, GAMBLING AND SPECULATION: A THEORY, A HISTORY AND A FUTURE OF SOME HUMAN DECISIONS 21-22 (1990); CEDRICK .B. COWING, POPULISTS, PLUNGERS & PROGRESSIVES: A SOCIAL HISTORY OF STOCK & COMMODITY SPECULATION 1890-1936, at 3-24 (1965); ANN FABIAN, CARD SHARPS, DREAM BOOKS & BUCKET SHOPS: GAMBLING IN 19TH-CENTURY AMERICA 153-202 (1990); George Soule, The Stock Exchange in Economic Theory, in Frederick W. Jones & Arthur D. Lowe, Manipulation, THE SECURITY MARKETS: FINDINGS AND RECOMMENDATIONS OF A SPECIAL STAFF OF THE TWENTIETH CENTURY FUND 3-18, 815-19 (A. Berheim & M. G. Schneider eds., 1935); H.S. Irwin, Legal Status of Trading in Futures, 32 ILL. L. REV. 155, 155 (1938) (“[t]he time honored attitude has been that futures contracts are gambling contracts if, at the making of the agreements, the parties do not intend to make and receive delivery on the contracts”). See also, e.g., William W. Bratton, Jr., Corporate Debt Relationships: Legal Theory In A Time Of Restructuring, 1989 DUKE L.J. 92, 109 (1989): (“Obviously, in an uncertain world, investing entails risk. Undertaking this risk is generally desirable, as long as an investing manager brings care and deliberation to the task. Speculation is a different, less prudent and more questionable endeavor. It lacks a legitimating tie to the work ethic. The speculator seeks to get something for nothing, like a gambler.”) 132JOHN MAYNARD KEYNES, THE GENERAL THEORY OF EMPLOYMENT, INTEREST AND MONEY 159 (1936). See generally COWING, supra note XXX [CEDRICK .B. COWING, POPULISTS, PLUNGERS & PROGRESSIVES: A SOCIAL HISTORY OF STOCK & COMMODITY SPECULATION 1890-1936, at 3-24 (1965)]; LOUIS LOWENSTEIN, WHAT'S WRONG WITH WALL STREET (1988).]

be used to defray other income.133 In contrast investing losses may be used, albeit

possibly on a deferred basis,134 to offset other income.135

The illegality136 of and law’s disdain for gambling has its moral overtones which

makes it difficult to draw the line between bona fide market transactions and a wager.137

Even outside of derivative investments, the law has had difficulty drawing the line

between permissible contracts and illegal gambling arrangements. The basic premise is

that wagers are illegal and unenforceable as a matter of contract law and the

unenforceability of illegal contracts generally.138 Some courts have gone so far as to

133 IRC § 165(d) (2003). There is, however, an exception for professional gamblers who are able to deduct losses in excess of their offsetting gains. Cf., e.g., Commissioner v. Groetzinger,, 480 U.S. 23 (1987) (full-time gambler making wagers solely for his own account was engaged in a “trade or business,” and thus gambling losses were not an item of tax preference subjecting him to a minimum tax). But see IRC § 183 (2003) (limitation on hobby losses). 134For example, capital losses that are not offset by capital gains may be used to offset other income only up to $3000 per year. IRC § 1212(b) (2003). 135There is an exception for so-called hobby losses – activities that could arguably be characterized as businesses that are engaged in for enjoyment but generate losses rather than income. See IRC § 183 (2003). 136The legalization of gambling has far from eliminated concerns about its propriety and utility. See, e.g., John Warren Kindt, Diminishing or Negating the Multiplier Effect: The Transfer of Consumer Dollars to Legalized Gambling: Should A Negative Socio-Economic "Crime Multiplier" be Included In Gambling Cost/Benefit Analyses?, 2003 MICH. ST. DCL L. REV. 281 (2003). 137FABIAN supra note XXX at 5 [ANN FABIAN, CARD SHARPS, DREAM BOOKS & BUCKET SHOPS: GAMBLING IN 19TH-CENTURY AMERICA 153-202 (1990)]; Kreitner supra note XXX, at 1138 [Roy Kreitner, Speculations of Contract, or How Contract Law Stopped Worrying and Learned to Love Risk, 100 COLUM. L. REV. 1096, 1098 (2000):

[J]udicial discourse surrounding the problem of gambling in contract law around the turn of the century was involved in such an ideological function. By spinning out an economy of appropriation and distance with regard to risk, chance and hazard in the economic processes of contracting, contract discourse helped its audiences come to terms with the deep fears and uncertainties that accompanied the transition into modernity. By retaining its condemnatory critique of gambling, or banishing its gambling doubles, it played the protector of souls. And by recognizing that efficient economies required speculative activity, and that an element, albeit a controlled element, of gambling existed in all economic activity, contract discourse made way for the emergence of an individual who could claim mastery even while acknowledging uncertainty. Throwing itself between the devil and the deep sea, contract helped Americans stop worrying and learn to love risk. (footnotes omitted).

138For a history of the laws invalidating gambling contracts, see, for example, Joseph Kelly, Caught in the Intersection Between Public Policy and Practicality: A Survey of the Legal Treatment Of Gambling-Related Obligations In The United States, 5 CHAP. L. REV. 87, 158 (2002).

invalidate a loan on the grounds that the loan was designed to pay for illegal gambling

debts.139

The specifics of the similarity between gambling and derivatives transactions are

exemplified by comparing illegal “difference contracts” with permissible futures140 and

options141 transactions.142 In addition to the examples at the beginning of this article,

consider the case of two individuals who decide to wager on the price of a certain

security and what it will be a year from now. Under traditional analysis, the law has

referred to this as a difference contract143 and has declared it to be illegal gambling.144 In

the earlier cases, courts had a difficult time identifying which futures contracts were void

as illegal gambling and which were valid because of a valid delivery obligation.145

139 See James L. Buchwalter, Annotation, Right to Recover Money Lent for Gambling Purposes, 74 A.L.R. 5th 369, at § 6 (1999) (collecting cases). 140 A futures contract is a contract for future delivery--it creates a bilateral obligation of the buyer (to purchase) and the seller (to sell) the underlying commodity at a specified price, on a specified date, with delivery to take place at a specified delivery point. Notwithstanding the delivery obligation, however, most futures contracts are settled through a process known as offset whereby rather than make or take delivery, the parties typically enter into an offsetting futures contract thereby canceling their existing delivery obligation. 141 As compared with futures contracts, option contracts do not create delivery obligations unless and until the option-holder exercises the option. An option contract will not result in an obligation to deliver the underlying commodity or security since out-of-the-money options will expire without being exercised. On the other hand, if an option is in the money, that is, if exercise of the option will result in a profit to the option holder, the option will be exercised and the underlying commodity or security will change hands, unless the obligation is extinguished as a result of an offsetting options transaction. 142 Questions have also been raised as to whether a gambling game could be classified as a security. For example, in a highly questionable ruling a district court held that gambling even in the form of a fantasy stock exchange did not involve the purchase or sale of a security and thus is not subject to the jurisdiction of the Securities and Exchange Commission. SEC v. SG Ltd., 142 F. Supp. 2d 126 (D. Mass. 2001), reversed, 265 F.3d 42 (1st Cir. 2001). Fortunately, the district court's ruling was overturned, with the First Circuit reasoning that the “virtual” stock in question was a security. Id. [SEC v. SG Ltd., 142 F. Supp. 2d 126 (D. Mass. 2001), reversed, 265 F.3d 42 (1st Cir. 2001)]. 143 See Hazen, Rational Investing, supra note XXX, at 1015. 144 See id. [See Hazen, Rational Investing, supra note XXX, at 1015.] 145 Compare Uhlmann Grain Co. v. Dickson, 56 F.2d 525 (8th Cir. 1932) (futures contract was not illegal where party intended to enter into offsetting contract rather than follow through with delivery obligation), and Gettys v. Newburger, 272 F. 209 (8th Cir. 1921) (futures contract was enforceable unless both parties had pernicious intent to enter into nothing more than a wager), and ACLI Intern. Commodity Services, Inc. v. Lindwall, 347 N.W.2d 522 (Minn. Ct. App. 1984), vacated in part on other grounds, 355 N.W.2d 704 (Minn. 1984) (since futures contract contains a delivery contract it is not illegal gambling even though party entering into contract had no intent to deliver or take delivery of the underlying commodity), and Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Schriver, 541 S.W.2d 799 (Tenn. Ct. App. 1976) (contract made on futures exchange was not illegal gambling), with Embrey v. Jemison, 131 U.S. 336 (1889) (illegality of difference contract was a valid defense under Virginia law to futures contract where there was

Clothing what is essentially a difference contract as a derivatives transaction often will

provide a cloak of legality. For example, institutional traders have engaged in synthetic

stock transactions146 which consist of contracting with a counterparty to pay the

difference on the price of the underlying stock over time.147 One of the professed reasons

for a synthetic stock purchase (rather than a purchase of the security itself) is to avoid

leaving a footprint that would reveal the institutional investor was taking a buy position

in the stock.148 The irony with respect to this transaction is not only is it difficult to

distinguish from what would otherwise be called an illegal difference contract,149 it is

being used to deceive the market150at large as to significant investment activity.151 This

no intent to deliver), and James v. Clement, 223 F. 385 (5th Cir. 1915) (where both parties intended contract as a gamble, futures contract would be void for illegality), and Carpenter v. Beal-McDonnell & Co., 222 F. 453 (E.D. Ark 1915) (façade of futures contract did not shield illegal gambling transaction), and Waldron v. Johnston, 86 F. 757 (S.D. Ga. 1898) (same). 146 Synthetic stock occurs when an investor sells a put option on a stock while simultaneously purchasing a call option with the same exercise price and expiration date. For example, if ABC stock is trading in January at $35 per share, an investor may be able to sell ten June $35 puts (covering 1,000 shares of ABC stock) for $2,000 and buy ten June $35 calls with the same $35 exercise price for $3,000. The investor thus has paid $1,000 for her position. Her investment will increase $1,000 for every $1 per share increase in ABC stock and will decrease $1,000 for every $1 per share decline. See Thomas Lee Hazen, The Short-Term/Long-Term Dichotomy And Investment Theory: Implications For Securities Market Regulation And For Corporate Law, 70 N.C. L. REV. 137, 167 n.139. Synthetic stock positions provide the opportunity for leverage beyond that permitted by purchasing stock on margin. Sanford J. Grossman, An Analysis of the Implications for Stock and Futures Price Volatility of Program Trading and Dynamic Hedging Strategies, 61 J. BUS. 275, 276-78, 290-92 (1988). Synthetic stock also allows the investor to receive the same profit or loss as she would had she paid $35,000 to purchase the 1,000 shares of ABC stock instead of the ten call and ten put options covering 1,000 shares. See Joseph A. Grundfest, The Limited Future of Unlimited Liability: A Capital Markets Perspective, 102 YALE L.J. 387, 404 (1992). In addition, it should be noted that synthetic stock is subject to different tax consequences than a purchase and sale of the underlying stock. See David F. Levy, Towards Equal Tax Treatment Of Economically Equivalent Financial Instruments: Proposals For Taxing Prepaid Forward Contracts, Equity Swaps, And Certain Contingent Debt Instruments, 3 FLA. TAX REV. 471, 511-512 (1997). See also, e.g., Jeffrey M. Colón, Financial Products and Source Basis Taxation: U.S. International Tax Policy at the Crossroads, U. ILL. L. REV. 775 (1999). (Without pinpoint cite there is no way I can find it.) 147 See, e.g., Caiola v. Citibank, N.A., N.Y., 295 F.3d 312, 315-319 (2d Cir. 2002) (describing synthetic stock transactions). 148 See id. [Caiola, 295 F.3d 312 at 315-319.] 149 It has been suggested that synthetic stock creates the risk rather than merely allocating it. This is a distinction that others have used to distinguish gambling from legitimate business transactions. See infra note XXX. 150 In Caiola, the investor complained of the counterparty’s decision to satisfy its side of the synthetic transaction by purchasing the stock in question and thereby leaving the footprint that the plaintiff wanted to avoid. Caiola, 295 F.3d at 318. 151 Compare this type of transaction with the illegal practice of “parking,” which consists of hiding the true identity of a security’s owner. See, e.g., In re Barlage, 63 S.E.C. 1060 (1996), 1996 WL 733756, at *1 n.2 . (“parking is the sale of securities subject to an agreement or understanding that the securities will be

transaction is just one example of how the law permits sophisticated market participants

to engage in transactions that would be illegal if carried out by other market

participants.152 In addition, some investors can also replicate difference contracts using

publicly traded options.153

Since the fact that the law traditionally has characterized difference contracts as

illegal places other restrictions on gambling contracts, characterizing a contract as a

gamble or a wager can provide a basis for placing limits on freedom of contract.154

Classical works on contract law have long pointed out the difficulties in trying to

repurchased by the seller at a later time and at a price which leaves the economic risk on the seller.”). See also, e.g., In re Hibbard & O’Connor Securities, Inc., 46 S.E.C. 328 (1976), 1976 SEC LEXIS 1889, at *4); 5 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 14.23 (5th ed. 2005). Parking can be used to evade reporting or accounting requirements. Id. The law apparently allows derivative transactions to have a similar effect.See id. 152 The essence of a parking violation is the intent to deceive. As I have stated elsewhere:

Not every sale followed by a repurchase between accounts will constitute parking. Bona fide transactions that carry a true shift in investment risk following the initial sale are not improper parking transactions. In order to establish a parking violation it must be established that the transactions were in fact a sham designed to hide the true ownership of the securities.

5 HAZEN supra note XXX § 14.23 (footnotes omitted).[SEE COMMENT ON MISSING HAZEN SOURCE] There was clearly a deceptive intent in the Caiola case[add cite]. It may have been to a lesser degree, however, since the synthetic stock transaction in Caioloa, unlike parking, involved a shift of investment risk, albeit in a way designed to deceive the market by disguising the transaction[add cite]. 153 Synthetic stock can be used by other investors through options that are traded on the securities options markets. See HAZEN, supra note XXX § 1.7. [SEE COMMENT] Particularly for ordinary investors, however, transaction costs can make complex derivatives policies prohibitively expensive, as exemplified by the following description of the alligator spread:

Alligator Spreads are any of a class of complicated option transactions so constructed that the investor is likely to be eaten alive by the commissions. As with real alligators, rumors of their extinction have been greatly exaggerated, for they live on. I once witnessed a supposedly serious presentation of a 'triple boxcar spread' with more commission-generating moving parts than a Swiss watch. When the dust settled, only the broker would be left standing. Since I witnessed this sideshow at an ostensibly 'institutional' options conference, I can only speculate (bad choice of words) on what may thrive in the retail reaches of this nation.

One symptom of Alligator Spreads, apart from the pile of digested scraps of capital lying nearly[sic], called commissions, is an incredibly complex pattern of open and adjusted option positions in pursuit of a profit, eventually. Then again, depending on who controlled the account, profit may not necessarily have been the motive.

Robert E. Conner, Option-Related Securities Disputes: Analytical Considerations, 650 PLI/CORP 899 (1989), WL 650 PLI/Corp 899 (July 13, 1989), at *919. 154 Roy Kreitner, Speculations of Contract, or How Contract Law Stopped Worrying and Learned to Love Risk, 100 COLUM. L. REV. 1096, 1098 (2000) (“around the turn of the last century, the question of wager was one of the key doctrinal areas that defined the scope of freedom of contract”); Mark Pettit, Jr., Freedom, Freedom of Contract, and the 'Rise and Fall,' 79 B.U. L. REV. 263, 319-324 (1999).

distinguish legitimate hedging activities from the more questionable (and often illegal)

wager.155 Trying to distinguish between legitimate hedging and impermissible gambling

based on the intent of the parties did not prove to be a satisfactory solution.156 Although

commercial enterprises frequently resemble gambling, many commentators who favor a

capitalist system have tended to object to gambling.157 The delivery obligation in futures

and options contracts does not provide a satisfactory basis for the distinction between

legal derivatives and illegal difference contracts. The delivery obligation is not a useful

distinction because most futures and option contracts are settled through offsetting

contracts, thus obviating the need to deliver the underlying commodity or security.

Consider, for example, the situation where two people enter into a contract to

transfer the same stock a year from now at a stated price. This transaction is known as a

futures contract,158 and is legal in the United States.159 Most futures contracts, are

functionally the same as a wager, since rather than delivering under the contract, the vast

majority of futures contracts are settled through a process known as offset, whereby

rather than transfering the underlying commodity or security, the parties enter into

offsetting transactions.160 In England, the prohibition on difference contracts dates back

155 Edwin W. Patterson, Hedging and Wagering on Produce Exchanges, 40 YALE L.J. 843, 878 (1931) ("In endeavoring to distinguish hedging from wagering, the courts are between the devil and the deep sea."). 156 Kreitner, supra note XXX, at 1105-1110 . 157 As reportedly said by Ambrose Bearce, "[t]he gambling known as business looks with austere disfavor on the business known as gambling." See Paul H. Brietzke & Teresa L. Kline, The Law and Economics of Native American Casinos, 78 NEB. L. REV. 263, 344 (1999). 158 The term futures contract is used to refer to a standardized contract for future delivery. In contrast, a forward contract is one, generally used by commercial participants with respect to the underlying commodity, calling for a present sale but a delivery date in the future. Functionally, futures and forward contracts are the same. The significance in the different terminology is primarily regulatory in nature. Futures contracts are subject to the provisions of the Commodity Exchange Act whereas forward contracts are not. See 1 PHILLIP MCBRIDE JOHNSON & THOMAS LEE HAZEN, DERIVATIVES REGULATION §§ 1.02[4], 1.02[5] (2004). 159 Until 2000, futures contracts on individual securities were not permissible, but as a result of the Commodity Futures Modernization Act, § [provide section, per comment], security futures products like this are permissible. Commodity Futures Modernization Act, Pub. L. No. 106-554, 114 Stat. 2763 (2000), 160 In other words, the would-be seller goes into to the market and enters into an offsetting futures contract to purchase the commodity or security at the same price that she is obligated to sell it for in the original obligation to sell the commodity or security. Similarly, the would-be buyer typically enters into an offsetting futures contract to sell. The net result here is that the parties receive the difference between their wagered price and the price of the commodity or security at the contract’s expiration date.

to 1734 and reactions to the South Sea Bubble scandal in 1734.161 In the United States,

by 1829, the speculative fever in New York’s financial center had also led to legislation

prohibiting stock jobbing, 162 another term for difference contracts.

Notwithstanding the similarity between difference contracts on the one hand and

futures or options contracts on the other,163 contracts for the future sale of stock were

generally upheld against a claim that they constituted gaming or wagering unless the facts

revealed that the transactions "were nothing more than mere speculation on fluctuations

in price with no genuine intent to accept or deliver the stock."164

The law of most states generally prohibits wagering. For example, the New York

General Obligations Law provides: “All wagers, bets or stakes, made to depend upon any

race, or upon any gaming by lot or chance, or upon any lot, chance, casualty, or unknown

161 See Barnard's Act, 1734, 7 Geo. 2, c.. 8, § 5. ("[A]ll and every such contract shall be specifically performed and executed on all sides, and the stock or security thereby agreed to be assigned, transferred, or delivered, shall be actually so done, and the money, or other consideration thereby agreed to be given and paid for the same, shall also be actually and really given."). See also, e.g., WALTER BAGEHOT, LOMBARD STREET 150-51 (Arno reprint ed. 1979) (1873) (comparing the South Sea Bubble investor hysteria with gambling). 162 Stock Jobbing Act, 1 N.Y. Rev. Stat. 710, tit. 19, art. 2, § 6 (1829). Section 6 of that Act provided:

All contracts for the sale of stocks are void, unless the party so contracting to sell the same shall, at the time of making such contracts, be in actual possession of the certificates of such shares or be otherwise entitled thereto in his own right, or be duly authorized by some person so entitled to sell the certificates of shares so contracted for.

The prohibition against difference contracts was designed to control "the more shadowy forms of financial speculation." See THE DEVELOPMENT OF THE LAW OF GAMBLING 1776-1976 150 (National Institute for Law Enforcement and Criminal Justice Grant No. 74-NI-99-0030, Nov. 1977) [hereinafter LAW OF GAMBLING]. See also, e.g., THOMAS H. DEWEY, A TREATISE ON CONTRACTS FOR FUTURE DELIVERY AND COMMERCIAL WAGERS INCLUDING "OPTIONS," "FUTURES," AND SHORT SALES (PUBLISHER AND DATE WHEN WE GET BOOK ON INTERLIB LOAN) (1886) (demonstrating that the analogy between financial speculation and investment speculating is not a new one). 163 See, e.g., Lynn A. Stout, Betting the Bank: How Derivatives Trading Under Conditions of Uncertainty Can Increase Risks and Erode Returns in Financial Markets, 21 J. CORP. L. 53, 66 n.52 (1995):

Indeed, derivatives trading is in many respects a more troubling activity than orthodox gambling. Gambling can be defended as providing entertainment to individuals who usually bet relatively small amounts of their own funds. Even so, the gambling industry is tightly regulated and heavily taxed. In contrast, the relatively-unregulated derivatives market is dominated by banks, corporations, pension funds, and municipalities. These institutions are run by managers who have been entrusted with the savings of depositions, employees, and citizens seeking reasonable returns at reasonable risks, rather than recreation. 164 LAW OF GAMBLING, supra note XXX, at 151 (relying on Story v. Salomon, 71 N.Y. 420 (1877)). [NAT’L INST. FOR LAW ENFORCEMENT AND CRIMINAL JUSTICE, GRANT NO. 74-NI-99-0030, THE DEVELOPMENT OF THE LAW OF GAMBLING 1776-1976 150 (1977) [hereinafter LAW OF GAMBLING]].

or contingent event whatever, shall be unlawful.”165 The New York General Business

Law (often referred to as a bucket shop prohibition166) extends this to gambling on stock

prices through the use of difference contracts.167 Futures, options, and other derivatives

contracts are treated as bona fide investment vehicles168 rather than being regulated as

differences contracts or other types of gambling. This is in part because derivatives,

165 N.Y. GEN. OBLIG. LAW § 5-401 (McKinney 2003). 166 For discussion of bucket shop prohibitions, see (1 PHILIP MCBRIDE JOHNSON & THOMAS LEE HAZEN, DERIVATIVES REGULATION § 2.02[2] (2004). 167 N.Y. GEN. BUS. LAW § 351 (McKinney 2003):

Any person, copartnership, firm, association or corporation, whether acting in his, their or its own right or as the officer, agent, servant, correspondent or representative of another, who shall:

1. Make or offer to make, or assist in making or offering to make any contract respecting the purchase or sale, either upon credit or margin, of any securities or commodities, including all evidences of debt or property and options for the purchase thereof, shares in any corporation or association, bonds, coupons, scrip, rights, choses in action and other evidences of debt or property and options for the purchase thereof or anything movable that is bought and sold, intending that such contract shall be terminated, closed or settled according to, or upon the basis of the public market quotations of or prices made on any board of trade or exchange or market upon which such commodities or securities are dealt in, and without intending a bona fide purchase or sale of the same; or,

2. Makes or offers to make or assists in making or offering to make any contract respecting the purchase or sale, either upon credit or margin, of any such securities or commodities intending that such contract shall be deemed terminated, closed and settled when such market quotations of or such prices for such securities or commodities named in such contract shall reach a certain figure, without intending a bona fide purchase or sale of the same; or,

3. Makes or offers to make, or assists in making or offering to make any contract respecting the purchase or sale, either upon credit or margin of any such securities or commodities, not intending the actual bona fide receipt or delivery of any such securities or commodities, but intending a settlement of such contract based upon the difference in such public market quotations of or such prices at which said securities or commodities are, or are asserted to be, bought or sold; or,

4. Shall, as owner, keeper, proprietor or person in charge of, or as officer, director, stockholder, agent, servant, correspondent or representative of such owner, keeper, proprietor or person in charge of, or as officer, director, stockholder, agent, servant, correspondent, or representative of such owner, keeper, proprietor or person in charge, or of any other person, keep, conduct or operate any bucket shop, as hereinafter defined; or knowingly permit or allow or induce any person, copartnership, firm, association or corporation whether acting in his, their or its own right, or as the officer, agent, servant, correspondent or representative of another to make or offer to make therein, or to assist in making therein, or in offering to make therein, any of the contracts specified in any of the three preceding subdivisions of this section.

Shall be guilty of a felony. The prosecution, conviction and punishment of a corporation hereunder shall not be deemed to be a prosecution, conviction or punishment of any of its officers, directors or stockholders. 168 See, e.g., Gen. Elec. Co. v. Metals Res. Group Ltd., 741 N.Y.S.2d 218, 219-220 (N.Y. App. Div. 2002) (explaining that a swap contract did not constitute illegal gambling: “[c]ontrary to defendant's argument, the parties' contract was not an illegal contract to gamble, but rather a legitimate commodity swap agreement exempt from the strictures of the Commodities Exchange Act ….”); Mitchell-Huntley Cotton Co. v. Waldrep, 377 F. Supp. 1215, 1222 (N.D. Ala. 1974) (explaining that a forward contract was not illegal gambling).

unlike gambling, are viewed as providing a useful hedging device for at least some

market participants.169 In one recent case, the judge characterized a derivatives contract

as a gamble but nevertheless found it to be a legal transaction.170 The issue today is not

whether to declare derivative and other speculations illegal. Rather, to the extent that the

markets create a form of organized gambling, then those investments which lend

themselves to the gambler should be regulated accordingly. This leads to the question of

how regulating gambling should differ from regulating markets and what market reforms

should be introduced to reflect the gambling mentality of many investors.

As demonstrated by the foregoing discussion, policy-makers have long struggled

with the question of whether derivatives contracts are illegal gambling contracts is not a

new one. If they could be characterized as futures contracts and fell within the ambit of

CFTC regulation, these contracts are permissible. Until 2001, most derivatives

transactions had to take place on an organized exchange, subject to some limited

exemptions. With the adoption of the Commodity Futures Modernization Act of 2000,171

there is much broader recognition of off-exchange or over-the-counter derivatives

markets. The validity of exchange-listed derivatives is easier to establish because of the

regulatory structure under the supervision of the Commodity Futures Trading

Commission. In contrast, over-the-counter derivatives are essentially unregulated. As a

result, it is appropriate to consider whether the gambling analogy warrants some fine-

tuning of the regulatory structure.

Viewing the behavior of some investors as analogous to gambling does not by

itself negate entirely the rational choice model. Gambling is not necessarily irrational

169 See, e.g., Steven L. Schwarcz, The Universal Language of International Securitization, 12 DUKE J. COMP. & INT'L L. 285, 300 n.68 (2002) (“Swaps are therefore akin to gambles on future asset values. Indeed, there is ongoing controversy as to whether derivative products can be abused, particularly where investors borrow on leverage to purchase derivative products for speculation. In a non-leveraged context, however, the use of derivatives to hedge currency (or interest rate) risks in cross-border transactions is not only prudent but essential for minimizing the risk to investors.”). 170 Korea Life Ins. Co. v. Morgan Guar. Trust Co. of N.Y., 269 F. Supp. 2d 424, 442 (S.D.N.Y. 2003) (“Although I have characterized KLI's swap agreements as "bets" and "speculations" on currency fluctuations, the transactions were in the form of forward contracts, swaps and derivatives. Derivatives transactions, forward contracts and swap agreements in currencies and commodities are not considered illegal gambles, and do not violate New York's gambling statute.”). 171 Pub. L. No. 106-554, 114 Stat. 2763 (2000).

behavior.172 For example, gambling or high risk investing can be seen as access to wealth

that is not available through other investment or productive activities. An individual not

having sufficient capital to invest with hopes of modest incremental gains and desiring

larger returns makes a rational investment when she chooses high risk investments in

much the same way as gambling can be rational. As noted earlier, most individuals have

a high degree of risk aversion that militates against risky-behaviors seeking a big payoff.

Nevertheless, if an individual desires the high pay-off with sufficient intensity, then he or

she will be acting rationally in tolerating risk that many other rational actors will not.

Even aside from purely economic motivations, investing in individual securities

or derivative products provides a form of entertainment for some investors in much the

same way as rational actors are willing to gamble notwithstanding the odds and the cut to

the house because of the enjoyment of the game. These market investors who are making

rational choices based on factors other than traditional investment return are creating

what the efficient market hypothesis would characterize as noise. 173 Market regulation

based on rational choice should account for this phenomenon. In the first instance, the

regulation should focus on adequate disclosure to assure that those who are interested in

investment gambling have adequate disclosure with respect to the risks.174

172 See, e.g., Choi & Pritchard, supra note XXX at 15 (“We do not share this speculative preference for our own investments, but we cannot dismiss it as irrational.”) (footnotes omitted) [Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 71 (2003).]; see also, e.g., CHARLES T. CLOTFELTER & PHILIP J. COOK, SELLING HOPE: STATE LOTTERIES IN AMERICA 72-81 (1989); Lloyd R. Cohen, The Lure of the Lottery, 36 WAKE FOREST L. REV. 705 (2001); Donald C. Langevoort, Selling Hope, Selling Risk: Some Lessons for Law From Behavioral Economics About Stockbrokers and Sophisticated Customers, 84 CAL. L. REV. 627 (1996); Edward J. McCaffery, Why People Play Lotteries and Why it Matters, 1994 WIS. L. REV. 71. For some of the behavioral literature, see LEIGHTON VAUGHAN WILLIAMS (ED.), ECONOMICS OF GAMBLING (2003); G.S. BECKER & K.M. MURPHY, A Theory of Rational Addiction, 96 J. OF POL. ECON. 675 (1988); Athanasios Orphanides and David Zervos, Rational Addiction with Learning and Regret, 103 J. OF POL. ECON. 739 (1995); R. Sauer, The Economics of Wagering Markets, 36 J. OF ECON. LIT. 2021 (1998). 173 See, e.g., Anat R. Admani, A Noisy Rational Expectations Equilibrium for Multi-Asset Securities Markets, 53 ECONOMETRICA 629, 632 (1985); Fisher Black, Noise, 41 J. FIN. 529 (1986); J. Bradford De Long et al., The Size and Incidence of the Losses from Noise Trading, 44 J. FIN. 681 (1989); Larry J. Merville & Dan R. Pieptea, Stock-Price Volatility, Mean-Reverting Diffusion, and Noise, 24 J. FIN. ECON. 193 (1989). 174 After all, disclosure has been the basic premise of federal securities regulation since 1933. See discussion in the text accompanying notes XXX-XXX supra.

The regulatory structure for our securities and derivatives markets by and large is

based on traditional economic market analysis. It is presumed that since markets perform

an economic function, market participants are acting as rational actors. If this activity in

fact has characteristics traditionally associated with gambling, then there is reason to

reconsider market analysis as the sole basis for regulation. A gambling rationale if

applicable would make regulators and policy-makers consider factors that traditionally

have not been in play in designing regulatory schemes. As noted above, there are

accounts of gambling as rational activity: specifically that it opens access to wealth that

might not be available through other investment opportunities.175 It thus may be possible

to explain market bubbles and what most observers would characterize as excessive

trading as at least in part based on rational (albeit risk laden) decision making. At the

same time, we cannot properly ignore economically irrational actions such as investors

engaging in herd behavior.176 These issues have been examined in th legal literature.

For example, Professor Lynn Stout proposes a model to explain investor behavior

based on rational choice.177 In response, Professor Paul Mahoney contends that investor

behavior may be better explained as a result of noise178 that interferes with the rational

choice based on the supposed efficiency of the securities markets in pricing shares.179

175 See supra note XX 176 See Hazen, Rational Investing, supra note XX. [Thomas Lee Hazen, Rational Investment, Speculation, or Gambling? -- Derivative Securities and Financial Futures and Their Effects on the Underlying Capital Markets, 86 Nw. U. L. Rev. 987 (1992). 177 Lynn A. Stout, Are Stock Markets Costly Casinos? Disagreement, Market Failure and Securities Regulation, 81 VA. L. REV. 611, 615-617 (1995):

Using rational choice analysis and information theory, it presents a model of stock trading premised on the observation that, in a world of costly and imperfect information, rational investors are likely to form heterogeneous expectations -- that is, to make different forecasts of stocks' likely future performance. The heterogeneous expectations ("HE") model predicts that investors' asymmetrical expectations will inspire them to seek short-term profits by speculating on stocks they perceive as misruled. Thus, John buys General Motors expecting that GM's share price will soon rise, whereas Mary sells expecting GM to decline.

(footnotes omitted). See also id. 641-642. 178 See supra note XX. 179 Paul G. Mahoney, Commentary: Is There a Cure for "Excessive" Trading, 81 VA. L. REV. 713, 715 (1995) (rejecting Stout's rational investor model and raising an agency-based rationale for irrational investment decisions) (“I will attempt to show that Stout's model is actually one of irrational, rather than rational, investor behavior, and accordingly has more in common with the noise trader approach than she claims.”).

Professor Mahoney then goes on to suggest that the apparent excessive trading in the

securities markets is due to the fact that the intermediaries (stock brokers) are generally

compensated per transaction and thus have an economic incentive to encourage

trading.180 In any particular case a recommendation with an undisclosed self interest of

the person making the recommendation violates the securities laws (and the common law

as well).181 However, to the extent that this is a systemic problem, individualized

enforcement and private civil litigation will not cure the problem, macro approach

through regulatory reform would seem the more appropriate course than micro regulation

of each transaction.

To the extent that the excessive trading is caused by the incentive to financial

intermediaries, then stronger regulation addressing those conflicts of interest would seem

appropriate. A recent example of this would be the regulatory crackdown on security

analysts’ conflict of interests.182 Another approach is increased criminalization of willful

conduct that creates fraudulent fueled noisy markets. One irony here is that while there

has been increasing regulation of the securities markets to combat these practices, the

non-securities derivatives markets have been subject to significant deregulation. It is

difficult to point to anything other than political pressure to account for this divergence in

investment market regulation when comparing securities and non-securities derivatives

investments.

d. Consequences of Regulating Markets with a Gambling Perspective

As noted earlier, the regulation of gambling has been moving from an absolute

prohibition to legalized gambling under controlled circumstances. Extending this

analogy into the securities and derivatives markets could yield some insight.

The gambling analogy provides an interesting parallel to the history of the

regulation of the derivatives markets that in this country have traditionally been under the

180 Id. at 717. 181 See 5 TOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 14.16 (5th ed. 2005). 182 See Id. § 14.16[6] (2004 pocket part). See also Stephen J. Choi & Jill E. Fisch, How to Fix Wall Street: A Voucher Financing Proposal for Securities Intermediaries, 113 YALE L.J. 269 (2003) (proposing a voucher system to compensate market intermediaries such as analysts to eliminate the conflict of interest resulting from securities issuers’ subsidizing analysts activities.)

regulatory regime applicable to commodities. Formerly, the typical approach to

gambling was to ban it.183 This evolved into a system where organized gambling is now

permitted in several states through centralized and regulated gambling casinos, race

tracks, and off-track betting facilities.184 Many states now also operate lotteries.185 As

one observer has explained, "[t]his once officially criminal activity is now being chosen

by business and community leaders as a lynchpin for economic development."186

One of the exceptions in the trends involving gambling has been the continued

criminalization of Internet gambling.187

Before the Commodity Futures Modernization Act, regulation of the derivatives

markets in many ways closely resembled gambling regulation. Until 2001, the

commodities markets in this country were based on a system premised on a contract

market monopoly.188 This monopoly resulted in a heightened regulatory environment.

The elimination of the contract market monopoly along with the significant decrease in

the CFTC’s oversight responsibility for the organized exchanges was a significant part of

the deregulatory reform of the Commodity Futures Modernization Act. Concurrently, the

Modernization Act opened up unregulated over the counter markets for non-securities

derivatives. This market is open, however, only to qualified investors. Finally, the

CFTC has been removed from its former role of pre-approving futures and options

contracts before they could be traded. The deregulation of the non-securities derivatives

markets thus somewhat parallels deregulatory trends in gambling laws.

e. Mirco-regulatory Issues

183 THE LAW OF GAMBLING supra note XX. [THE DEVELOPMENT OF THE LAW OF GAMBLING 1776-1976 150 (National Institute for Law Enforcement and Criminal Justice Grant No. 74-NI-99-0030, Nov. 1977). [hereinafter LAW OF GAMBLING]]. 184 See the authorities cited in supra note XX. 185 See, e.g., CLOTFELTER & COOK, supra note XX. [CHARLES T. CLOTFELTER & PHILIP J. COOK, SELLING HOPE: STATE LOTTERIES IN AMERICA 72-81 (1989)]. 186 See ROBERT GOODMAN, LEGALIZED GAMBLING AS A STRATEGY FOR ECONOMIC DEVELOPMENT 6 (1994). 187 See generally Lawrence G. Walters, The Law of Online Gambling in the United States--A Safe Bet, or Risky Business?, 7 GAMING L. REV. 445 (2003) (discussing the current legal risks associated with operating online gambling websites). 188 See 1 PHILIP MCBRIDE JOHNSON & THOMAS LEE HAZEN, DERIVATIVES REGULATION § 1.02[7] (2004).

The foregoing discussion addressed overall regulatory parallels between gambling

and the derivatives markets. There also are some more particularized regulatory issues.

Consider, for example, the so-called financial suicide cases.189 Although there is sparse

case law to date, there is some authority to support holding gambling casinos accountable

for losses incurred by intoxicated patrons190 or for losses incurred by gambling addicts

who should have been barred from the casino.191 Although the courts have so far been

reluctant to expand the liability of gambling casinos,192 some have argued that this could

be used to support a parallel liability of broker-dealers who continue to allow their

customers to enter into risky unsuitable transactions.

Further, there are statutes, known as “dram shop” rules, imposing liability on

tavern owners for serving too much alcohol to their customers.193 The "dram shop"

theory of liability is also now applied in a relatively new variety of customer claim in

broker-dealer arbitration and customer initiated litigation.194 Typically, in these cases,

the claim is that the broker-dealer had an obligation to protect customers from their own

investment decisions resulting in unsolicited transactions—namely, not involving 189 This discussion is adapted from 5 Hazen, supra note XXX, at § 14.16[7]. 190 See GNOC Corp. v. Aboud, 715 F.Supp. 644, 655 (D.N.J. 1989) (holding that a casino has a duty to refrain from knowingly permitting an invitee to gamble where that patron is obviously and visibly intoxicated and/or under the influence of a narcotic substance.). See also, e.g., Anthony Fernandez, Comment, Torts - Dram Shop Liability - Under New Jersey Law a Casino Patron Would Not be Permitted to Recover Gambling Losses From A Casino That Served the Patron Free Alcohol and Allowed Him to Continue Gambling After he Became Visibly Intoxicated – Hakimoglu v. Trump Taj Mahal Assocs., 26 SETON HALL L. REV. 941, 948-950 (1996). Compare, Jessica L. Krentzman, Dram Shop Law – Gambling While Intoxicated: The Winner Takes it All? The Third Circuit Examines a Casino's Liability for Allowing a Patron to Gamble While Intoxicated, Hakimoglu v. Trump Taj Mahal Associates, 41 VILL. L. REV. 1255 (1996) (arguing in favor of liability), with Jeffrey C. Hallam, Comment, Rolling the Dice: Should Intoxicated Gamblers Recover Their Losses?, 85 NW. U. L. REV. 240 (1990) (arguing that casinos should not have a duty to prevent losses under these circumstances). Contra Hakimoglu v. Trump Taj Mahal Assocs., 70 F.3d 291, 292-94 (3d Cir. 1995) (refusing claim under dram shop law). 191 See, e.g., Joy Wolfe, Casinos and the Compulsive Gambler: Is There a Duty to Monitor the Gambler's Wagers?, 64 MISS. L.J. 687, 695-702 (1995) (discussing the basis for imposing this type of liability). 192 See, e.g., Merrill v. Trump of Ind., 320 F.3d 729, 733 (7th Cir. 2003) (dismissing claim that casino could be held liable for failure to bar compulsive gambler). 193 See Barbara Black & Jill I. Gross, Economic Suicide: The Collision Of Ethics and Risk in Securities Law, 64 U. PITT. L. REV. 483, 506 (2003); Richard Smith, A Comparative Analysis of Dramshop Liability and a Proposal for Uniform Legislation, 25 J. CORP. L. 553, 555-559 (2000). 194 See Jacob D. Smith, Rethinking a Broker's Legal Obligations to its Customers – The Dramshop Cases, 30 Sec. Reg. L.J. 51, 58-59 (2002); Michael Siconofoli, Brokerage Firms Pay Big Damages in "Dramshop" Cases, Wall St. J. May 17, 1995 at C1; Michael Siconofoli, "Dramshop Awards" Increasingly Slapped on Brokerage Firms, Wall St. J. Sept. 4, 1992, at A4B.

securities recommended by the broker.195 These claims also have alternatively been

described as "financial suicide" cases.196

However, these claims have generally been unsuccessful since broker-dealer

suitability obligations are traditionally tied to securities recommended by the broker as

compared with the unsolicited transactions that form the basis of the “dram shop” or

financial suicide claims. It seems clear that the mere existence of a brokerage

relationship does not put the broker under an obligation to prevent the customer from

committing financial suicide.197 However, fiduciary duties are created when a broker

undertakes the responsibility to monitor the account.198

The suitability doctrine for recommendations by securities brokers marks another

significant divergence in the regulatory regime applicable to the securities markets and

the one applicable to non-securities derivatives under the commodities laws. While the

suitability doctrine is firmly entrenched in the Securities Exchange Act199 and in self-

regulatory rules200 there is no comparable obligation of commodities brokers under the

195 See Smith, supra note XXX, at 73–77; See also Siconofoli, supra note XXX, at C1; Siconofoli, supra note XXX, at A4B. 196 Thomas R. Grady, Trying the Financial Suicide Case, 950 PRAC. L. INST. 107, 109 (1996); see also, Lisa Bertrain, "Economic Suicide" Claims: An Emerging Trend in Securities Arbitration, 950 PRACT. L. INST. 185, 191 (1996). 197 See Tatum v. Legg Mason Wood Walker, Inc., 83 F.3d 121, 123 (5th Cir. 1996) (applying Mississippi law); Puckett v. Rufenacht, Bromagen & Hertz Inc., 587 So.2d 273, 279 (Miss. 1991); JERRY W. MARKHAM, COMMODITIES REGULATION: FRAUD, MANIPULATION & OTHER CLAIMS § 10.08 (2000). 198 Trans National Group Services, Inc. v. PaineWebber, Inc., NASD Case No. 91–00770, 1992 WL 472902 (N.A.S.D. June 30, 1992) ($1 million arbitration award). 199 5 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 14.16 (5th ed. 2005). See also, e.g., Stephen B. Cohen, The Suitability Rule and Economic Theory, 80 Yale L.J. 1604 (1971); Janet E. Kerr, Suitability Standards: A New Look at Economic Theory and Current SEC Disclosure Policy, 16 PAC. L.J. 805 (1985); Norman S. Poser, Civil Liability for Unsuitable Recommendations, 19 Rev. Sec. & Commodities Reg. 67 (April 2, 1986); Note, Measuring Damages in Suitability and Churning Actions Under Rule 10b-5, 25 B.C. L. Rev. 839 (1984). See generally Hilary H. Cohen, Suitability Doctrine: Defining Stockbrokers' Professional Responsibilities, 3 J. CORP. L. 533 (1978); short cite needed D. Lowenfels & Alan R. Bromberg, Suitability in Securities Transactions, 54 BUS. LAW. 1557 (1999); Robert H. Mundheim, Professional Responsibilities of Broker-Dealers: The Suitability Doctrine, 1965 DUKE L.J. 445; Arvid E. Roach II, Suitability Obligations of Brokers: Present Law and the Proposed Federal Securities Code, 29 HASTINGS L.J. 1067 (1978). See also, e.g., Franklin D. Ormsten, Norman B. Arnoff & Gregg R. Evangelist, Securities Broker Malpractice and Its Avoidance, 25 SETON HALL L. REV. 190 (1994). This should be in footnote 198 ??? 200 See, e.g., In the Matter of Stout, 2000 WL 1469576, Exchange Act Release. No. 34-43410, 73 S.E.C. Docket 1081, 73 SEC Docket 1094 (SEC 2000) (imposing industry bar and $300,000 civil penalty); Department of Enforcement vs. Howard, Complaint No. C11970032, 2000 WL 1736882 (NASDR Nov. 16, 2000) (2 year suspension and $17,500 fine for suitability violations); In the Matter of McNabb, Complaint No.

Commodity Exchange Act, CFTC regulations, or CFTC decisions.201 Accordingly,

investors in non-securities derivatives receive significantly less protection than securities

investors with respect to brokers’ recommendations.

One extension of the suitability obligation is that securities brokers owe a duty to

monitor customer accounts even after the investment decision has been made to assure

that the investments are still appropriate.202 This type of claim draws a closer parallel to

the accountability of gambling casinos to help prevent gambling addicts from feeding

their addiction. Again, this is a distinct issue from the traditional suitability cases where

the obligation arises out of particular recommended transactions rather than the broker's

ongoing duty to supervise the account. 203 Recognition of such an ongoing obligation is a

natural consequence of the suitability doctrine with respect to investments that the broker

recommended. 204 However, it is a different matter to impose an ongoing duty with regard

C01970021, 1999 WL 515761 (NASDR March 31, 1999) ($50,000 fine, censure, NASD bar); In the Matter of Gliksman, Complaint No. C02960039, 1999 WL 515762 (NASDR March 31, 1999) (failure to supervise registered representative who committed suitability violations); In the Matter of Guevara, Complaint No. C9A970018, 1999 WL 515766 (NASDR Jan. 28, 1999) ($100,000 fine plus restitution, industry bar); In the Matter of Sisson, Complaint No. C01960020, 1998 WL 1084546 (NASDR Nov. 18, 1998) ($35,000 fine, suspension); In the Matter of Bruff, Complaint No. C01960005 1997 WL 1121302 (NASDR Aug. 1, 1997) (censure and bar); In the Matter of Osborne, Complaint No. C8A930067 1995 WL 1093401 (NASDRDec. 21, 1995) ($127,937.50 fine, industry bar); In the Matter of Klein, Complaint No. C01940014, 1995 WL 1093353 (NASDR June 1995) ($150,000 fine, 6 month suspension); In the Matter of F.N. Wolf & Co., Complaint No. C07930024, 1994 WL 1067226 (NASDR June 16, 1994) ($500,000 fine, $2,176,986 disgorgement, 2 year suspension). 201 See 3 JOHNSON & HAZEN, supra note XXX, § 5.09[11].

202 See 4 HAZEN, supra note XXX § 14.16[8].

203 Franklin Savings Bank of New York v. Levy, 551 F.2d 521, 527 (2d Cir. 1977) (“where a broker-dealer makes a representation as to the quality of the security he sells, he impliedly represents that he has an adequate basis in fact for the opinion he renders”); University Hill Foundation v. Goldman, Sachs & Co., 422 F. Supp. 879, 898 (S.D.N.Y. 1976) ("broker-dealers are required to have a reasonable basis for recommendation made to customers which in turn imposes an obligation to conduct a reasonable investigation of the security’s issuer").

204 See, e.g., Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969) (recommendation implies reasonable basis in fact); In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Exchange Act Release. No. 34-14149 (Nov. 9, 1977) (recommendation implies that broker has made independent investigation beyond relying on company’s management); In re Shearson Hammill & Co.,. Exchange. Act Release. No. 34-7743 (Nov. 12, 1965) (failure to investigate before making recommendation violated antifraud provisions); In re B. Fennekohl & Co., 41 S.E.C. 210, 215-17 (1962) (failure to investigate financial condition before making recommendation is a violation of 1933 and 1934 Acts).

to investments that were initiated by the customer without the broker's

recommendation.205

The foregoing discussion addresses some of the ways in which investment

markets resemble gambling. There has been parallel deregulation of the non-securities

investment markets and the world of gambling. This is in striking contrast to the

heightened regulation of the securities markets. So, the question raised earlier is worth

repeating here: is there justification for the divergent trends in securities regulation and

non-securities investment regulation? If the answer to this question is “no,” then the next

question becomes: which approach is more appropriate – regulation or deregulation?

The gambling analogy does not end here, however. The law’s traditional distaste

for gambling has also provided a basis for regulating insurance contracts. As further

developed below, insurance, as is the case with derivatives contracts, provides a

legitimate mechanism for contractual risk shifting by commercial participants in many

markets – both commodity-based and non-commodity commercial enterprises. Hedging

markets (i.e., derivatives markets) and insurance products thus serve similar functions.

However, insurance is subject to yet another wholly different regulatory structure.

205 Scioscia v. Fidelity Brokerage Services, Inc. Docket Number 95–01147 1996 WL 403335 (NASD May 20, 1996) (no liability for preventing client from committing financial suicide); Gean v. Charles Schwab & Co., Docket Number 94–00344, 1995 WL 102889 (N.A.S.D. Jan. 27, 1995) (no liability for changing cash account to margin account where customer controlled the account and the trades were unsolicited transaction); Scheer v. Citizens & Southern Securities Corp., Docket Number 92–00305, 1994 WL 1248601 (NASD March 9, 1994) (no liability where customer directed the trading in the account); Weinstein v. Brokers Exchange, Inc., Case No. 93–04713, 1994 WL 733962 (NASD Dec. 7, 1994) (no liability to customer who presented herself as sophisticated investor and who directed her own trading); Salinas v. A.G. Edwards & Sons, Inc., Docket Number 92–00710, 1992 WL 448307 (NASD Dec. 11, 1992) (no liability to sophisticated investor where many of the challenged trades were unsolicited). But see Aaron v. Paine Webber, Inc., Am. Arb. Ass'n Case No. 72–136–1146–87, at 1, (June 28, 1989) (Wilson, Arb.) (on file with The Business Lawyer, University of Maryland School of Law), as described in Lewis D. Lowenfels & Alan R. Bromberg, Suitability in Securities Transactions, 54 BUS. LAW. 1557, 1595 (1999).

A middle ground is when the broker recommends a specific trading strategy but the customer initiates the trades. For example, in one arbitration a broker was held accountable for breach of ongoing duties with respect to the account after having recommended options trading to the customer, even though the customer initiated the trades in question. Peterzell v. Charles Schwab & Co., 1991 WL 202358 (N.A.S.D. June 17, 1991).

III Insurance

So far, this article has compared three regulatory schemes – the securities laws,

the commodities laws, and gambling laws. Now we turn to how the regulation of

derivative investments can possibly relate to a fourth area – insurance regulation. The

deregulation of the derivatives markets stands in contrast to insurance, which remains a

heavily regulated industry. There are many ways in which insurance and the insurance

industry is regulated. For example, not all risks are insurable.206 Also, the states regulate

the terms of insurance policies and focus on consumer protection generally. In addition,

insurance law limits the ways in which insurance companies may invest their assets as a

means designed to protect solvency.207

a. Derivatives as Insurance

Insurance contracts have many similarities with other forms of investment

contracts.208 This assumption is recognized to some extent through the enactment of the

Gramm-Leach-Bliley Act209 that now permits for more efficient integration of securities,

banking, and insurance operations of financial institutions.210 Derivatives specifically can

function as a form of insurance. Although it has not been given much attention in the

literature, the idea that derivatives contracts can serve as an alternative to insurance is not

206 See supra notes XXX discussing the insurable interest requirement. 207 See, e.g. JERRY, supra note XXX, at 89-90. This can be found in classic explanations of insurance regulation. See, ,EDWIN W. PATTERSON, ESSENTIALS OF INSURANCE LAW 23-32 (1957) (discussing the financial condition of insurers); WILLIAM R. VANCE, HANDBOOK ON THE LAW OF INSURANCE 43-44 (3d ed. 1951). 208 See, e.g., Steven J. Williams, Note, Distinguishing "Insurance" From Investment Products Under the McCarran-Ferguson Act: Crafting a Rule of Decision, 98 COLUM. L. REV. 1996 (1998). 209 Title of 1999, Pub. L. No. 106-102113 Stat. 1338, 1436-50 (codified at scattered sections of 15 U.S.C.).??? 210 See generally James M. Cain & John J. Fahey, Banks And Insurance Companies--Together In The New Millennium 55 BUS. LAW. 1409 (2000); James M. Cain, Financial Institution Insurance Activities--A New 2001 Odyssey Begins 57 BUS. LAW. 1357 (2002); Scott A. Sinder, The Gramm-Leach-Bliley Act and State Regulation of the Business of Insurance - Past, Present and . . . Future?, 5 N.C. BANKING INST. 49 (2001); Arthur E. Wilmarth, Jr., The Transformation of the U.S. Financial Services Industry, 1975-2000: Competition, Consolidation, and increased Risks, 2002 U. ILL. L. REV. 215 (2002).

totally new.211 Many observers of the investment markets have rejected the gambling

analogy in favor of an insurance analogy.212 Additionally, scholars in the field of

insurance law have identified the similarity between insurance and commodities

contracts.213

Just as gambling may be used to characterize the activities of many participants in

the derivatives markets, some participants may be seen as using derivatives as

insurance.214 Insurance is a risk shifting transaction where one party pays a premium in

exchange for a right to payment in the event that a designated risk or contingency

occurs.215 In certain situations, the distinction between insurance and gambling is no

clearer than the distinction between hedging and gambling, because in both instances the

law is trying to draw a distinction on public policy grounds between legitimate

commercial transactions and “illegitimate: wagers.216

211 See supra note XXX [???] 212 Peter H. Huang, A Normative Analysis of New Financially Engineered Derivatives, 73 S. CAL. L. REV. 471, 479-80 (2000); Peter H. Huang, Kimberly D. Krawiec & Frank Partnoy , Derivatives on TV a Tale of Two Derivatives Debacles in Prime-Time, 4 GREEN BAG 2D 257, 262 (2001) (rejecting the gambling analogy and finding it “misleading because buying certain derivatives is like buying insurance against an accident, while not buying those derivatives is essentially betting on the accident not happening.”); Philip McBride Johnson, In Defense of “Terrorist” Derivatives, 23 FUTURES & DERIVATIVES LAW REP. 26 (2003); Joseph L. Motes III, Comment, A Primer on the Trade and Regulation of Derivative Instruments, 49 SMU L. REV. 579, 580 (1996) (“Derivatives have most often been employed as a sort of ‘insurance,’ protecting investors’ positions through allocation of risk, but the instruments have also been used to generate profits through speculation on market positions.”). 213 ROGER C. HENDERSON & ROBERT H. JERRY, II, INSURANCE LAW CASES AND MATERIALS 135 (2d ed. 1996) (“In an insurance contract, risk is the item which is exchanged – the equivalent of a commodity in a contract for sale. In other words, the insured bears a risk of some kind of loss; the insured pays money (the premium) to the insurer in exchange for the insurer’s promise to assume the risk.”). 214 See, e.g., Philip McBride Johnson, Stepping it Up, FOW DERIVATIVES INTELLIGENCE FOR THE RISK PROFESSIONAL, (Issue 366 Nov. 2001) at PAGE (“Derivatives have always been a type of insurance. They differ from the classical model only in that, instead of assembling a ‘risk pool’ funded by a large number of at-risk holders, the risk is passed on to people who would not otherwise face it. The world’s most legendary speculators are the ‘Names’ of Lloyd’s of London.”). NOT IN FILES??? 215 1 LEE R. RUSS & THOMAS F. SEGALLA, COUCH ON INSURANCE § 1:6 n.20 (3d ed. 2003) (“‘Insurance’ may be defined as a contract to pay a sum of money upon the happening of a particular event.”) (citing CNA Ins. Co. v. Selective Ins. Co., 354 N.J. Super. 369 (N.J. Super. Ct. App. Div. 2002)). 216 See, e.g., RICHARD E. SPEIDEL & IAN AYRES, STUDIES IN CONTRACT LAW 612 (6th ed. 2003) (“It is . . . not always easy to distinguish illegal wagering contracts from other ‘aleatory’ contracts that have a legitimate commercial or other purpose and are not considered contrary to public policy. Likewise insurance contracts can often be characterized as wagers (and vice versa). . . .”). NOT IN FILES

Long ago, insurance was characterized as a form of gambling.217 Insurance law

doctrines have tried to distinguish insurance contracts from gambling with requirements

such as a valid insurable interest as the basis for life insurance policies,218 indemnity,219

and the assignability of polices.220 In a further effort to differentiate itself from gambling,

insurance has been promoted as a pooling of risks to achieve a type of communal

efficiency in risk shifting.221 In many ways however, these attempts to demonstrate a

way in which insurance differs from gambling, are really not that convincing.

For example, derivatives can be used to hedge against catastrophic occurrence, as

done in the controversial proposal to use derivatives to hedge the risk of a terrorist

attack.222 While some observers might characterize a terrorism futures contract as a

horrific bet, it more closely resembles insurance223 if used by a party to hedge against

losses that could be incurred by terrorist attacks.224 This again points to the question

raised at the outset of this article: we do not consider insurance against loss due to

217 See JOHN ASHTON, THE HISTORY OF GAMBLING IN ENGLAND 275 (Patterson Smith 1969) (1898) (author? Editor?) (“paradoxical as it may appear, there is a class of gambling which is not only considered harmless, but beneficial, and even necessary--I mean Insurance. Theoretically, it is gambling proper. You bet 2s. 6d. to £ 100 with your Fire Insurance; you equally bet on a Marine Insurance for the safe arrival of your ships or merchandise; and it is also gambling when you insure your life.”). 218 Kreitner, supra note XXX, at 1116-28. See also, e.g., Franklin L. Best, Jr., Defining Insurable Interests in Lives, 22 TORT & INS. L.J. 104, 105 (1986). 219 Lynn A. Stout, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48 DUKE L.J. 701, 728 (1999). 220 Kreitner, supra note XXX, at 1116-28. See also, e.g., Rylander v. Allen, 53 S.E. 1032 (Ga. 1906). 221 Kreitner, supra note XXX, at 1128. VIVIANA A. ROTMAN ZELIZER, MORALS AND MARKETS: THE DEVELOPMENT OF LIFE INSURANCE IN THE UNITED STATES 89 (1979) ("[L]ife insurance emerged as the most efficient secular risk-bearing institution to handle the economic hazards of death through cooperative self-help."). 222 See, e.g., Philip McBride Johnson, In Defense of “Terrorist” Derivatives, 23 FUTURES & DERIVATIVES LAW REP. 26 (2003). 223 Id. (“[D]erivatives that cover losses occasioned by a terrorist activity are no more a ‘bet’ on recurrence than a key employee life insurance policy is a company’s wish for a key official’s death. Both instruments exist ‘just in case,’ and both are proper.”).

Additionally, consider, for example, tontine policies, where participants contribute to a pool to be awarded entirely to the surviving participant. ??? were a form of insurance betting. See Kreitner, supra note XXX, at 1100 n.13 (2000), (relying on Brenner & Brenner, supra note XXX, at 104 and MORTON KELLER, THE LIFE INSURANCE ENTERPRISE 1885-1910, at 56-58 (1963)). 224 Rod D. Margo, War Risk Insurance in the Aftermath of September 11, 18 AIR & SPACE LAW. 1 (2003).

terrorist attacks to be against public policy,225 so why should derivatives be so

characterized?

b. Managing Insurance Risks

The typical insurance company in the United States manages the risks created by

the policies it underwrites by pooling the premiums received and managing the

investment pool.226 State insurance regulators place limits on the types of investments

insurance companies may use.227 These limitations are designed to protect policy

holders. In addition, insurance companies may use derivatives to help manage their risk

and hedgers may use insurance to deal with theirs. In contrast, in the derivatives markets,

risks are allocated through a nexus of bilateral contracts. Thus, the basic mechanisms of

insurance and derivatives differ in that insurance is basically conceived of a pooling of

premiums to manage the risk.

However, if we look to where modern insurance began -- in England -- and the

structure of Lloyd’s of London, we see that Lloyd’s uses an exchange-type market to find

investors (“Names”) to help share the insurance risk (and the profits as well). 228 Lloyd’s

then operates more like an exchange or derivative based system than an insurance

company that pools its premiums and invests them to manage the insurance risk.229

225 See, e.g., Jeffrey Manns, Note, Insuring Against Terror?, 112 YALE L.J. 2509 (2003) (discussing government subsidies for insurance companies). See also, e.g., Steven Plitt, The Changing Face of Global Terrorism and a New Look of War: An Analysis of the War-Risk Exclusion in the Wake of the Anniversary of September 11, and Beyond, 39 WILLAMETTE L. REV. 31 (2003); Mark Boran, Note, To Insure or Not to Insure, That is the Question: Congress' Attempt to Bolster the Insurance Industry After the Attacks on September 11, 2001, 17 ST. JOHN'S J. LEGAL COMMENT 523 (2003). 226 The company can be organized as a stock corporation or as a mutual insurance company. See PATTERSON, supra note XXX, at 50-51. 227 See, e.g, CAL. INS. CODE § 1192.8 (West 2003) (investments in specified interest-bearing notes, bonds, or obligations); N.Y. INS. §§ 1402, 1404 (McKinney 2003) (minimum capital or minimum surplus to policyholder investments). 228 PATTERSON, supra note XXX, at 49 (describing Lloyd’s as a “reciprocal insurer, or interinsurance exchange”). 229 See, e.g., Shell v. R.W. Sturge, Ltd., 55 F.3d 1227, 1228 (6th Cir. 1995) (“The Society of Lloyd's, or Lloyd's of London (‘Lloyd's’), is not an insurance company, but rather is an insurance marketplace in which individual Underwriting Members, or Names, join together in syndicates to underwrite a particular type of business.”). For additional descriptions of Lloyd’s of London, see, e.g., ANTHONY BROWN, HAZARD UNLIMITED: THE STORY OF LLOYD'S OF LONDON (1973); HUGH ANTHONY LEWIS COCKERELL, LLOYD'S OF LONDON: A PORTRAIT (1984); CATHY GUNN, NIGHTMARE ON LIME STREET: WHATEVER HAPPENED TO LLOYD'S OF LONDON? (1992); RAYMOND FLOWER, LLOYD'S OF LONDON (1974); D. E. W. GIBB, LLOYD'S OF LONDON, A

Consider the following brief description of how Lloyd’s insurance market or exchange

operates:

Lloyd’s syndicates literally date to the underwriters who gathered at Lloyd’s

Coffee House in London in the 1600s. Currently Lloyd’s has about 26,000

underwriting members; most of these are nonprofessional investors known as

“Names,” and a few are full-time insurance underwriters. The Names have joined

to form syndicates, each of which has as few as two or three but perhaps as many

as a few thousand members. The syndicates (currently there are about 200 of

them) subscribe on behalf of their members to cover risks or percentages of

risks.230

Thus, the Names are generally private investors who provide capital to the insurance

underwriters.231 Names are solicited in much the same manner as investors who

participate in other investment markets.232

STUDY OF INDIVIDUALISM (1957); GODFREY HODGSON, LLOYD'S OF LONDON: A REPUTATION AT RISK (1986); ELIZABETH LUESSENHOP, RISKY BUSINESS: AN INSIDER'S ACCOUNT OF THE DISASTER AT LLOYD'S OF LONDON (1995); JONATHAN MANTLE, FOR WHOM THE BELL TOLLS: THE LESSON OF LLOYD'S OF LONDON (1992). 230 See JERRY, supra note XXX, at 41-42 (footnotes omitted):

The liability of a Name depends on his or her percentage share of the syndicate, but each Name is personally liable without limit for a syndicate’s losses. Thus, to become a Name, an individual (corporations cannot become Names) must have substantial means; currently a British Name must have net worth exceeding ₤250,000 (roughly $450,000) and an American Name must have a net worth exceeding $1 million; also, each Name must restate his or her net worth annually. A syndicate or group of syndicates is managed by an underwriting agency, which employs a management staff, maintains a “box” on the floor of the Lloyd’s exchange, and staffs the box with a representative of the agency. See also, e.g., DEBORAH A. THOMPKINSON, CHALLENGE AT LLOYD’S (1994). 231 See, e.g., Lipcon v. Underwriters at Lloyd's, London, 148 F.3d 1285, 1288 (11th Cir. 1998) (“A Name becomes a Member of the Society of Lloyd's through a series of agreements, proof of financial means, and the deposit of an irrevocable letter of credit in favor of Lloyd's. By becoming a Member, a Name obtains the right to participate in the Lloyd's Underwriting Agencies. The Names, however, do not deal directly with Lloyd's or with the Managing Agents. Instead, the Names are represented by Members' Agents, who, pursuant to agreement, act as fiduciaries for the Names. Upon becoming a Name, an individual selects the underwriting agencies in which he wishes to participate. The Names generally join more than one underwriting agency in order to spread their risks across different types of insurance. In large part because of the experience of the Members' Agents, Names generally rely on the advice of their Members' Agents in deciding in which syndicates to invest. Selecting well is of the utmost financial importance because a Name is responsible for his share of an agency's losses.”).

A syndicate with respect to a policy underwritten by Lloyd’s can be quite large. See, e.g., Underwriters at Lloyd's London v. The Narrows, 846 P.2d 118, 119 (Alaska 1993) (lead syndicate of 1500 Names that lead 32 syndicate consisting of “thousands of individual Lloyd’s members”).

The similarity between this type of insurance and the derivatives market is

exemplified by the description of the Lloyd’s system as one of “reciprocal insurers.”233

The similarity is that the reciprocal insurance organization resembles the series of

bilateral contracts that constitute the derivatives markets – both having characteristics of

an exchange. The Lloyd’s market for names, having been characterized as an exchange,

thus resembles the other investment markets being discussed herein. This similarity is

yet another reason to question such widely disparate regulatory structures for markets and

enterprises such as insurance and derivatives, which have many similar features.

There have been some unsuccessful attempts to use the exchange system in the

United States.234 Notwithstanding the inability to import this exchange type system to the

United States, its potential reveals that the differences between insurance and derivatives

are not as clear as we may initially think, even when looking at the ways in which the

insurer seeks capital manages its risk. The discussion below explores another parallel –

the extent to which the law (or regulators) impose substantive control over the types of

risk that can be managed using insurance or derivatives.

c. Substantive Control of Insurance – The Gate-keeping Function of the

Insurable Interest Requirement

Insurance law has long imposed a requirement that an insured have an insurable

interest235 in the contingency insured against in order to uphold the insurance contract.236

232 Cf. Richards v. Lloyd's of London, 135 F.3d 1289 (9th Cir. 1998) (suit claiming solicitation of Names in the U.S. constituted an offering of a security were dismissed due to contractual choice of law provision opting for English law); Shell v. R.W. Sturge, Ltd., 55 F.3d 1227, 1228 (6th Cir. 1995) (same); Roby v. Corporation of Lloyd's, 996 F.2d 1353 (2d Cir.1993) (same). 233 See PATTERSON, supra note XXX at 49-50. 234 See JERRY, supra note XXX, at 43. 235 As a line-drawing rule as to which contracts are enforceable, a bright line test is not applicable. The law in this area is quite muddled. See, e.g., GRAYDON S. STARING, LAW OF REINSURANCE § 6:1 (1993), pointing to SIR M. MUSTILL & J. GILMAN, ARNOULD ON THE LAW OF MARINE INSURANCE AND AVERAGE §§ 331-410 (16th ed. 1981) (“In limited space we can talk around insurable interest but never talk it through. A standard text confesses that ‘[i]t is very difficult to give any definition of an insurable interest,’ and then discusses it for about 70 pages.). . Only an overview is presented here. 236 See Michael J. Henke, Corporate-Owned Life Insurance Meets the Texas Insurable Interest Requirement: A Train Wreck in Progress, 55 BAYLOR L. REV. 51, 54-60 (2003).

This doctrine originated with respect to life insurance.237 One extreme example of this

manifested itself in the practice of taking out insurance on famous people and then

speculating on their demise much in the same way as any gamble.238 This practice of

wagering on celebrity lives raised a public policy issue often expressed in terms of the

policy against gambling.239 The law in essence sets up a presumption that an insurance

contract is a wager on the occurrence or nonoccurrence of a particular contingency and

that presumption can be rebutted by demonstrating an insurable interest -- “proof of

circumstances that negative the existence of a wagering intent.”240

The origins of the insurable interest doctrine date back to an eighteenth century

English statute designed to protect citizens against the evils of gambling and the moral

hazard241 of eliminating the incentive to minimize risk.242 The preamble to the original

237 Roy Kreitner, Speculations of Contract, or How Contract Law Stopped Worrying and Learned to Love Risk, 100 COLUM. L. REV. 1096, 109900-1101 (2000) (“Early insurance schemes were relatively straightforward forms of gambling, with people insuring against the death of public figures with whom they had no personal relationship." ). See also, e.g., American Casualty Co. v. Rose, 340 F.2d 469 (10th Cir. 1964) (upholding employer’s insurable interest in life of employee); 3 COUCH, supra note XXX § 24:117 [3 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 41:17, at 197-198 (2d ed. 1984)]; John M. Limbaugh, Note, Life Insurance as Security for a Debt and the Applicability of the Rule Against Wager Contracts Estate of Bean v. Hazel, 64 MO. L. REV. 693 (1999). 238 See Lorraine J. Daston, The Domestication of Risk: Mathematical Probability and Insurance 1650-1830, in 1 THE PROBABILISTIC REVOLUTION 237, 244 (Lorenz Krüger et al. eds., 1987) ("London underwriters issued policies on the lives of celebrities like Sir Robert Walpole, the success of battles, the succession of Louis XV's mistresses, the outcome of sensational trials, the fate of 800 German immigrants who arrived in 1765 without food and shelter, and in short served as bookmakers for all and sundry bets."). 239 See, e.g., Lissa L. Broome & Jerry W. Markham, Banking and Insurance: Before and After the Gramm-Leach-Bliley Act, 25 J. CORP. L. 723, 726 (2000); Lynne A. Stout, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48 Duke L.J. 701, 724-728 (1999); George Steven Swan, The Law and Economics of Company-Owned Life Insurance (COLI): Winn- Dixie Stores, Inc. V. Commissioner of Internal Revenue, 27 S. ILL. U. L.J. 357, 375 (2003):

Economic insights are studied to ascertain the economic function of the insurable interest doctrine. Public policy contrary to gambling, and the public interest in the minimization of moral hazard, each has been proposed as justification of that doctrine. However, each in turn will be seen to lack sufficient economic weight to justify the doctrine. The economic phenomenon of externality seems to be the true rationale for the application of the insurable interest doctrine to [company owned life insurance].

See also, e.g., 3 COUCH, supra note XXX § 24:114 [3 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 24:117, at 197-98 (2d ed. 1984)]; Dale A. Whitman, Mortgage Prepayment Clauses: an Economic and Legal Analysis, 40 UCLA L. REV. 851, 882 (1993). 240 ROGER C. HENDERSON & ROBERT H. JERRY, II, INSURANCE LAW CASES AND MATERIALS 25 (2d ed. 1996). 241 See, e.g., Teague-Strebeck Motors, Inc. v. Chrysler Ins. Co., 127 N.M. 603, 613, 985 P.2d 1183, 1193 (N.M.App.1999):

The second rationale--avoiding inducements to destruction of insured property--recognizes the problem of “moral hazard” If one's financial well- being would be enhanced by the loss of property rather than its

English statutes address “pernicious practices” and “a mischievous kind of gambling” as

the basis for requiring an insurable interest.243 The insurable interest first appeared as a

matter of case law.244 The requirement is frequently reaffirmed by the courts, and now

also appears in some statutes.245 It has been extended beyond life insurance and applied

to other insurance contracts246 covering economic loss.247 New York’s statute is typical

of the modern statement of the insurable interest requirement:

preservation, there would be a temptation to destroy the property or, at least, to fail to take reasonable precautions to protect the property. This moral hazard arises whenever one can obtain insurance coverage on property for more than the property is worth to the insured. Given current societal attitudes toward gambling, the moral-hazard concern appears to be the stronger peg on which to hang the insurable-interest doctrine today.

See also, e.g., 8 COUCH, supra note XXX § 37A:292 (describing moral hazard). [ 8 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 37A:292, at 331 (2d ed. 1984).] 242 Act of 1746, St. Geo. 2, c. 37; 1774, St. 14 Geo. 3, c. 48. See Henke, supra note XXX, at 54 (“A version of the insurable interest doctrine first arose in England in a 1774 statute responding to perceived excesses by early insurers combined with widespread religious aversion to the concept of gambling on the lives of others.”), relying on Kreitner, supra note XXX, at 1116. See, e.g., JERRY, supra note XXX at 14-15 (with respect to moral hazard). 243 Act of 1746, St. Geo. 2, c. 37; 1774, St. 14 Geo. 3, c. 48. See HENDERSON & JERRY, supra note 228 at 31 (an ILL request). 244 See PATTERSON, supra note XXX, at 130. [EDWIN W. PATTERSON, ESSENTIALS OF INSURANCE LAW 130 (1957)] 245 PATTERSON, supra note XXX, at 131 (referring to the “hoary dictum repeated by countless courts and text writers and even embodied in some statutes”). [[EDWIN W. PATTERSON, ESSENTIALS OF INSURANCE LAW 131 (1957)] 246See, e.g., Delk v. Markel American Ins. Co., 2003 WL 22390053 *2 n.18 (Okla., Oct 21, 2003):

Gambling was the "pet vice" of seventeenth and eighteenth century England and the courts' attitude toward the practice "reflected popular feeling." Fegan, supra note 16, at 7-8. Hence, before Parliament intervened, most forms of wagering were valid at common law and wagering agreements were generally enforceable in English courts. MacGillivray, supra note 16, at 104. The courts' practice of enforcing wagers per se was applied in the eighteenth century to the enforcement of wagers in the form of marine and life insurance policies, but the early English decisions with respect to fire insurance took the opposite view. See Sadlers Co. v. Badcock, 2 Atk. 554, 26 Eng. Rep. 733 (1743). Lord Hardwicke explained that fire insurance did not have the same history or attributes as marine insurance and that for fire insurance to be enforceable the insured must have an interest in the property insured. Id. at 556, 26 Eng. Rptr. at 734. See also Lynch v. Dalzell, 4 Bro. P.C. 431, 2 Eng. Rep. 292 (1729).

See also, e.g., Kreitner, supra note XXX, at 1099-1100 (“London underwriters [who] issued policies on the lives of celebrities like Sir Robert Walpole, the success of battles, the succession of Louis XV's mistresses, the outcomes of sensational trials, the fate of 800 German immigrants who arrived in 1765 without food and shelter, and in short served as bookmakers for all and sundry bets."). [Roy Kreitner, Speculations of Contract, or How Contract Law Stopped Worrying and Learned to Love Risk, 100 COLUM. L. REV. 1096, 1099-1100 (2000)] 247 See, e.g., In re Balfour MacLaine Int’l Ltd., 85 F.3d 68 (2d Cir. 1996) (insured had insurable interest in coffee); Rogers v. Mech. Ins. Co, 1 Story 603, 20 F. Cas. 1118 (C.C.D. Mass. 1841) (whalers had an insurable interest in blubber that was cast overboard during a hurricane); Kreitner, supra note 148, at 1099-

No contract or policy of insurance on property made or issued in this state, or

made or issued upon any property in this state, shall be enforceable except for the

benefit of some person having an insurable interest in the property insured. In this

article, "insurable interest" shall include any lawful and substantial economic

interest in the safety or preservation of property from loss, destruction or

pecuniary damage.248

The insurable interest requirement of a lawful and substantial economic interest describes

the type of interest that is present when commercial enterprises decide to enter into

hedging contracts.

A major difficulty with the gambling rationale for limiting insurance contracts is

the same problem identified earlier with respect to derivative investments of

distinguishing a gamble from a legitimate speculation.249 Professors Speidel and Ayres,

among others, attempt to distinguish between insurance and gambling on the basis that

insurance deals with an existing risk while a wager creates a risk.250 This does not appear

to be a satisfactory distinction.251 The wager simply adds economic consequences for the

parties to the wager, much as a derivatives contract on the price of a commodity provides

a parallel economic consequence for the speculator.

The insurable interest doctrine attempts to provide a basis for drawing the line

with respect to insurance contracts that the law will tolerate. It is an imperfect measure at

best. A significant problem here is that without a comparable control of derivatives

contracts, is the insurance limitation really meaningful? It would thus appear appropriate

1000 (quoting VIVIANA A. ROTMAN ZELIZER, MORALS AND MARKETS: THE DEVELOPMENT OF LIFE INSURANCE IN THE UNITED STATES 45-46 (1979)). 248 N.Y. Ins. L. § 3401 (McKinney 2004). See also, e.g., Cal. Ins. Code Art. 4, §§ 280-284 (West 2004). 249 See the discussion accompanying notes XXX supra. 250 SPEIDEL & AYRES, supra note 214, at 612 (claiming that those insured seek insurance “to compensate them for the possible occurrence of an existing risk” while “[g]amblers by their contract create the risk at issue.”). (ILL request) This same point was made in HIERONYMUS, supra note 121 at 138. (ILL request) 251 For example, synthetic stock (See supra note ## XXX) has been said to create a risk rather than merely allocate it. Cf. Ted S. Helwig & Christian T. Kemnitz, Synthetic Security Transactions Under the Security Laws, Old and New, 21 FUT. & DERIV. L. REP. 6 (Sept. 2001) ("A synthetic stock trade is not a swap . . . . [t]he synthetic stock transactions did not allocate risk, but instead created risk and therefore were more sales than swaps . . . there was no "exchange" of payments based solely on the price of [the underlying stock]").

to either rethink the insurable interest doctrine or attempt to import something

comparable into derivatives regulation.

Illegal gambling is not the only rationale for the insurable interest requirement.252

Beyond the avoidance of illegal gambling, a second reason advanced for the insurable

interest requirement is to deter people from seeking insurance and then taking action to

cause the insured-against contingency to occur.253 This moral hazard or deterrence

rationale seems to be a questionable basis for an insurable interest requirement.254 One

can have an insurable interest and still have the same improper incentive such as a

property owner who tries to cash in on fire insurance using arson.255 Some courts have

recognized the weakness of the destruction of property rationale as a basis for the

insurable interest requirement.256 This is in part because of another insurance law

doctrine that addresses the problem. The requirement of fortuitousness holds “that 252 See ALAN I. WIDISS, INSURANCE 124 (1989) ("It now seems evident that the principle of indemnity and the insurable interest doctrine rest--and undoubtedly have, in reality, always been at least partially predicated--on public interests other than opposition to gambling."). (ILL request) 253 Belton v. Cincinnati Ins. Co., 353 S.C. 363, 371, 577 S.E.2d 487, 492 (S.C. Ct. App. 2003) Hearn, C.J., dissenting) (“Two fundamental purposes of the doctrine of insurable interest are to prevent insurance contracts from becoming gambling devices and to discourage the intentional destruction of property”), relying on ROBERT E. KEETON & ALAN I. WIDISS, INSURANCE LAW, A GUIDE TO FUNDAMENTAL PRINCIPLES, LEGAL DOCTRINES, AND COMMERCIAL PRACTICES, Practitioner's Edition § 3.1(c), at 136-138 (1988). See also, e.g., Nationwide Mut. Ins. Co. v. Goerlitz, 2001 WL 845703 *4 (Del. Super. Ct. Jun 29, 2001) (“The doctrine of insurable interest is tied to the principle of indemnity and serves a number of purposes, among them the prevention of using insurance contracts as gambling or wagering contracts. Additionally, the doctrine is designed to protect against societal waste and to avoid the danger in allowing persons without an insurable interest to purchase insurance, because those persons might then intentionally destroy lives or property), relying on Gossett v. Farmer’s Ins. Co. of Washington, 948 P.2d 1264, 1271-72 (Wash. Supr. 1997); Kyle D. Logue, The Current Life Insurance Crisis: How The Law Should Respond, 32 CUMB. L. REV. 1, 22 (2001-2002). 254 See, e.g., Tom Baker, On the Genealogy of Moral Hazard, 75 TEX. L. REV. 237, 239 (1996) (“conventional economic accounts of moral hazard exaggerate the incentive effects of real-world insurance and, at the same time, underestimate the social benefits of insurance.”). 255 Cf. Luchansky v. Farmers Fire Ins. Co., 357 Pa. Super. 136, 142, 515 A.2d 598, 601 (Pa. Super. Ct. 1986) (“When appellants purchased insurance protection they were not gambling on the destruction of somebody else's property by fire. They were insuring against the loss of their own interest, an insurable interest, in the home whose legal title they had conveyed to their son.”). 256 Teague-Strebeck Motors, Inc. v. Chrysler Ins. Co., 127 N.M. 603, 613, 985 P.2d 1183, 1193 (N.M. Ct. App. 1999) (“The second rationale--avoiding inducements to destruction of insured property--recognizes the problem of "moral hazard." If one's financial well- being would be enhanced by the loss of property rather than its preservation, there would be a temptation to destroy the property or, at least, to fail to take reasonable precautions to protect the property. This moral hazard arises whenever one can obtain insurance coverage on property for more than the property is worth to the insured. Given current societal attitudes toward gambling, the moral-hazard concern appears to be the stronger peg on which to hang the insurable-interest doctrine today.”).

insurance covers only risks, not certainties, so that a loss must be caused by a fortuitous

event in order to be covered.”257

Damages that are intentionally caused by the insured are not fortuitous and thus

are not properly covered by insurance.258 The fortuitousness doctrine is one way of

determining which aleatory contracts259 are enforceable (such as insurance contracts and

legitimate derivatives transactions260), as opposed to aleatory contracts which are

unenforceable because they are void illegal wagers.261 The policy against wagers and

gambles is the primary reason for invoking the insurable interest requirement.

257 See Compagnie des Bauxites de Guinee v. Insurance Co. of North America, 724 F.2d 369, 371 (3d Cir. 1983). 258 See, e.g., Hedtcke v. Sentry Ins. Co., 109 Wis. 2d 461, 483, 326 N.W.2d 727 (1982), Crossmark, Inc. v. DeGeorge, 259 Wis. 2d 482, 655 N.W.2d 547, 2002 WL 31641091,*2 (Wis. App. 2002). 259 An aleatory contract is one under which the “duty to perform is conditional on the occurrence of a fortuitous event.” RESTATEMENT (SECOND) OF CONTRACTS § 76 cmt. c (1981). The common law generally finds aleatory contracts to be enforceable unless they fall with the “subset of aleatory promises [that] are not enforceable” such as illegal wagers. RESTATEMENT (SECOND) OF CONTRACTS § 178 illus. 1 (1981).

Aleatory “derives from the Latin word ‘alea’ for ‘die’ (as in Caesar’s comment on crossing the Rubicon: “Alia iacta est!’ ‘the die is cast’).” SPEIDEL & AYRES, supra note XXX at 612. [RICHARD E. SPEIDEL & IAN AYRES, STUDIES IN CONTRACT LAW 612-613 (6th ed. 2003).] More simply, aleatory has been described as derived “from the Latin word for dice-rollers.” Charles Tiefer, Forfeiture by Cancellation or Termination, 54 MERCER L. REV. 1031, 1064 (2003). Lord Mansfield described an aleatory contract (such as an insurance contract) as a "contract on speculation." Carter v. Boehm, 96 Eng. Rep. 342, 343 (K.B. 1776). 260 When section 1a(13) of the Commodity Exchange Act was amended in 2000 Congress recognized explicitly what the CFTC had permitted as implicit -- that “commodity” may include events, contingencies or incidents that take place which are beyond the control of the contracting parties. 7 U.S.C. § 1a (2004). Section 1a(13) of the Act states that “excluded commodity” embraces “any occurrence, extent of an occurrence or contingency . . . that is beyond the control of the parties to the relevant contract . . . and . . . associated with a financial or economic consequence.” Id. This legislative acknowledgement took note of the fact that futures contracts were already allowed on weather phenomenon and other uncontrollable occurrences that can have severe economic consequences. The 2000 amendment also gave recognition to a vast new world of “event-based” futures and options that may evolve to address losses occasioned by uncontrollable phenomena.

261 Professor Leff recognized the aleatory nature of derivatives contracts and the contrast with illegal gambling; he also suggested that all contracts are aleatory in the sense that profitability may depend on chance. See his definition of aleatory contract in Arthur Allen Leff, The Leff Dictionary of Law: A Fragment, 94 YALE L.J. 1855, 1990 (1985):

aleatory contract ( ). Broadly, any contract the performance of which by other party is dependent upon a fortuitous or uncertain event. (Note that this is to be distinguished from the "aleatory" feature of almost all contracts, that profitability may depend on chance.) The concrete example most frequently given is the insurance contract: The insured party must pay premiums, but the insurer need not do anything at all unless the insured even say a fire, or a death, takes place during the relevant time period. But there are non-insurance aleatory contracts too, e.g., a contract by which one agrees to buy 5000 tons of wheat (or 5000 shares of stock) if but only if the market price goes above or below a particular level.

The moral hazard concern of insurance – namely, that an insured will be overly

insured and therefore be able to profit from the event262 – is not a limitation imposed on

those who opt to “insure” against certain risks by utilizing derivatives contracts or other

hedging mechanisms. There is no law or stated public policy that militates against

someone “doubling up” by seeking more hedging protection than is needed to offset

feared losses. Another way of examining this distinction is the fact that insurance is often

viewed as protecting against loss, whereas a hedge or other derivatives transaction may

be made to generate profit.263 The insurable interest doctrine is used to explain the rule

frequently stated that over-insurance beyond anticipated losses will result in illegal

wagers.264 Overvaluation resulting from a good faith attempt to set a valuation in an

insurance policy will not render the policy invalid.265 However, an attempt to reap a

profit would.

The insurable interest requirement is said to come into play most often today in

the context of a business’ insurance on its employees. While key employee insurance is

upheld as based on a valid insurable interest, an employer has no insurable interest in the

Though some "aleatory contracts" are obviously perfectly lawful and enforceable, in many jurisdictions, some are not, e.g., a contract to pay $10,000 if the other party is dealt three aces when one is dealt only three kings. For those kinds of aleatory contracts, and the grave difficulties is coming up with a clear conceptual distinction between them and the lawful enforceable kind, see gambling contract. 262 See, e.g., DeCespedes v. Prudence Mut. Cas. Co. of Chi., 193 So. 2d 224, 226,( Fla. Dist. Ct. App. 1966) (“the insured must not be encouraged to use the coverage for profit as this intends to increase moral hazard and could ultimately undermine the whole concept of insurance.”); Liberty Mut. Ins. Co. v. State Farm Auto. Ins. Co., 262 Md. 305, 313; 277 A.2d 603, 608 (Md. 1971) (describing insurance clauses as designed to protect insurers from moral hazard resulting from overinsurance). 263 Cf. SPEIDEL & AYRES supra note XXX 612-613 (“insureds tend to bargain for payments conditional upon something untoward happening: while gamblers tend to bargain for payments conditional upon something fortuitous happening”). [RICHARD E. SPEIDEL & IAN AYRES, STUDIES IN CONTRACT LAW 612-613 (editor? 6th ed. 2003).] 264 3 COUCH, supra note XXX § 41.2, (“When the interest of the insured is grossly disproportionate to the amount of the insurance, the policy is regarded as a wagering contract. Thus, if a creditor insures his or her debtor's life for a sum grossly in excess of any loss that he or she can possibly suffer by the debtor's death, the policy is a wager and invalid.”), relying on dicta in Cammack v. Lewis, 82 U.S. 643 (1873); Guardian Mut. Life Ins. Co. v. Hogan, 80 Ill. 35 (1875); Mitchell v. Union Life Ins. Co., 45 Me. 104 (1858); Cooper v. Shaeffer, 7 Sadler 405, 11 A. 548 (Pa. 1887). [3 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 41.2 (2d ed. 1984).] 265 3 COUCH, supra note XXX § 41.2 (“a valued policy is not rendered a wagering contract merely because the value placed on the property is greater than the actual value, although recovery will be limited to the extent of the actual interest”), relying on Fidelity Union Fire Ins. Co. v. Mitchell, 249 S.W. 536 (Tex. Civ. App. 1923). [3 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 41.2 (2d ed. 1984).]

lives of less skilled, lower ranking employees who are presumed to be easily replaced

through the labor market.266 The derivatives markets may now offer a way around the

insurable interest requirement, unless courts treat the contract in question as insurance

rather than as a derivative investment. If the insurable interest requirement remains

justifiable for insurance contracts, then there may be good reason to close the gap with

respect to parallel derivatives transactions. As discussed in the next section, this gap was

created by the Commodity Futures Modernization Act of 2000.

Consistent with the general trend to deregulate gambling267 and to favor freedom

of contract, courts generally have taken a broad view of insurable interest.268 For

example, the insurable interest doctrine arose in the context of the relatively recent

controversy surrounding viatical contracts that are designed to provide prepayment of

insurance benefits to terminally ill patients so that they can use the money to pay medical

expenses.269 Often, viatical contracts are marketed to investors in order to raise the cash

to provide the prepayment of the insurance benefits. Although there have been a number

of challenges made, most federal decisions hold that the marketing of viatical contracts

does not implicate the securities laws270 even though courts have deemed them securities

under state law.271 The marketing of viatical contracts has been challenged by some

266 See, e.g., Bauer v. Bates Lumber Co., 84 N.M. 391, 503 P.2d 1169 (N.M. Ct. App. 1972), cert. denied, 84 N.M. 390, 503 P.2d 1168 (1972). 267 See the discussion accompanying notes XXX supra. 268 See, e.g., Butterworth v. Miss. Valley Trust Co., 362 Mo. 133, 240 S.W.2d 676 (Mo. 1951) (even though it was doubtful that an insurable interest existed, the court upheld the assignment of a purported insurance contract “since the assignment had been made in the utmost good faith and was not a mere cloak to cover a gambling transaction”); Hammers v. Prudential Life Ins. Co. of Am., 188 Tenn. 6, 216 S.W.2d 703 (Tenn. 1948) (upholding validity of contract). See generally PATTERSON, supra note XXX at 131 (concluding that “an examination of the reports shows very few decisions that turned upon the absence of an insurable interest when the contract was entered into.”). [EDWIN W. PATTERSON, ESSENTIALS OF INSURANCE LAW 131 (1957).] 269 See, e.g., Malcolm E. Osborn, Rapidly Developing Law on Viatical Settlements, 31 Wake FOREST L. REV. 471 (1996); Joy D. Kosiewicz, Comment Death For Sale: A Call to Regulate the Viatical Settlement Industry, 48 CASE W. RES. L. REV. 701 (1998); Denise M. Schultz, Comment Angels of Mercy or Greedy Capitalists? Buying Life Insurance Policies From the Terminally Ill, 24 PEPP. L. REV. 99 (1996). 270 E.g., SEC v. Life Partners, Inc., 87 F.3d 536 (D.C. Cir. 1996), rehearing denied 102 F.3d 587 (D.C. Cir. 1996), rehearing denied 102 F.3d 587 (D.C. Cir. 1996) (viatical settlements, whereby investor receives death benefits of life insurance policy taken out on AIDS victim, were not securities since efforts of others was ministerial rather than substantive). See, e.g., Timothy P. Davis, Should Viatical Settlements be Considered "Securities" Under the 1933 Securities Act?, 6 KAN. J.L. & PUB. POL'Y 75 (1997)(concluding that “public policy is best supported by a finding that viatical settlements are not “securities” under the

d. Regulating Solvency of Insurers and Investment Market Participants

Generally, there has been a division in the regulation of financial services,

particularly with respect to insurance and securities markets.272 Some observers argue

that private ordering is a more effective regulatory structure,273as was the practice before

massive regulation of securities and commodities markets.274 In addition, it has been

suggested that the law should focus on market structure rather than the more traditional

disclosure approach to securities regulation.275 Insurance regulation to a large extent

focuses on maintaining, to the extent possible, the solvency of insurance companies.276

This is done by guarding the capital of insurance companies and the ways in which

insurers can invest their funds and provide an adequate reserve for the risks they insure

against.277 In England, the exchange-type system Lloyd’s uses to manage risk imposes

Securities Act of 1933); Albert R. Miriam, The Future of Death Futures: Why Viatical Settlements Must be Classified as Securities, 19 PACE L. REV. 345 (1999); Note, Viatical Settlements are not Securities: Is it Law or Sympathy?, 66 GEO. WASH. L. REV. 382 (1998) (concluding that the D.C. Circuit erred in holding that viatical settlements were not “securities”); Comment, An Extended Interpretation of the Howey Test Finds that Viatical Settlements are Investment Contracts, 22 DEL. J. CORP. L. 253 (1997). But see SEC v. Brandau, 32 Sec. Reg. & L. Rep. (BNA) 642 (S.D. Fla. 2000) (SEC brought charges against viatical investment scheme). But cf. Carrington v. Ariz. Corp. Comm’n, 2000 Ariz. App. LEXIS 194 (Ariz. Ct. App. 2000) (Life Partners and lower state court decision holding viatical agreements were not securities did not preclude state securities commission from investigating whether viatical settlements were securities). But cf. US Allianz Sec. Inc. v. S. Mich. Bancorp, Inc., 2003 WL 22671010 (W.D. Mich., Oct 20, 2003) (claims involving sales of viatical contracts were subject to NASD rules compelling arbitration); MONY Sec. Corp. v. Bornstein, 250 F. Supp. 2d 1352 (M.D. Fla. 2003) (transactions in viatical settlements executed by associated person formed the basis of an arbitrable claim against the securities brokerage firm). 271 Siporin v. Carrington, 23 P.3d 92, 104 (Ariz. Ct. App. 2001) ; Joseph v. Viatical Management, 55 P.3d 264, 267 (Colo. Ct. App. 2002) (holding that trust units consisting of viatical settlements were investment contracts, and therefore securities under Colorado law). 272 See generally Jerry W. Markham, Super Regulator: A Comparative Analysis of Securities and Derivatives Regulation in the United States, the United Kingdom, and Japan, 28 BROOK. J. INT'L L. 319 (2003). 273 Compare Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 VA. L. REV. 669 (1984), and Mahoney, supra note XXX, [Paul G. Mahoney, Is There a Cure for "Excessive" Trading, 81 VA. L. REV. 713, 715 (1995)] with Lynn A. Stout, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48 DUKE L.J. 701, 783 (1999). 274 Mark D. West, Private Ordering at the World's First Futures Exchange, 98 Mich. L. Rev. 2574 (2000).

, 335-36276 See JERRY, supra note XXX at 89-90 PATTERSON, supra note XXX at 23-32; VANCE, supra note XXX at 43-44 (3d ed. 1951) 277 See, e.g., West's Ann. Cal. Ins. Code § 1192.8 (2003) (Investments in specified interest-bearing notes, bonds, or obligations); N.Y. Ins. Law §§ 1402, 1404 (McKinneys 2003) (Minimum capital or minimum surplus to policyholder investments, Types of reserve investments permitted for non-life insurers). See generally JERRY, supra note XXX at 89-90; PATTERSON supra note XXX at 23-32.

substantial net worth requirements on the investors who share the insurer’s risk.278

Should we take a similar approach to derivatives? And, if so, to what extent?

Participants in publicly-traded and exchange traded futures contracts are subject

to margin requirements. The concept of a margin transaction has a differing meaning in

the commodities and securities markets.279 In the commodities markets, the margin

requirements operate to require a deposit or down payment for any futures or

commodities option contract that provides a safety net, enabling the investor to purchase

an offsetting contract. In the event that market forces increase the cost of an offsetting

transaction, the broker will issue a margin call that will require the investor to liquidate

his or her position or to provide an additional margin amount. In the securities markets,

the margin rules address the amount of collateral necessary for the extension of credit.

When an investor invests in securities options by taking a short position,280 even without

278 See the description in JERRY, supra note XXX at 42 that is reproduced in note XXX supra . 279 1 JOHNSON & HAZEN supra note XXX § 1.02[13]:

The term margin first came into usage in the financial world as shorthand for the minimum amount that a securities purchaser must deliver to his broker before title to the securities would pass to him. The remaining balance was borrowed (from the broker in most instances), and the buyer-now owner-of the securities would often deposit the certificates with the broker as a pledge against the unpaid balance. The securities margin, therefore, had two significant features: (1) The buyer was conveyed title to the securities immediately despite an unpaid balance; and (2) the broker (or other lender) extended credit to the new owner for the remainder of the purchase price. In the wake of the 1929 stock market crash, Congress lamented what it considered to have been excessive extensions of this type of credit to stock purchasers in earlier years and authorized the Board of Governors of the then-new Federal Reserve System to set regulations limiting the amount of money that could be loaned by a broker or dealer to a securities purchaser.

Through a process that can only be described as unfortunate, the commodity industry has chosen to utilize the same term--margin--to signify a drastically different economic event. Futures trading occurs in executory contracts as yet uncompleted, representing an exchange of mutual promises to conclude a sale later on specific terms. Acquisition of a futures contract, therefore, leaves title and ownership of the underlying commodity exactly where it was before the contract was entered. Title will not pass unless and until the futures contract is fully performed by both parties: the seller by delivering what he has promised; the buyer by tendering the full purchase price.

At the same time, however, entry into a futures contract creates the risk that, when required, one of the parties may default on his obligation. The seller might fail to deliver the commodity as promised, or the buyer may fail to pay. For the protection of both, each party (seller as well as buyer) is required by exchange rules to deposit with his broker a certain sum of money (or a qualified property equivalent) in the nature of a performance bond or earnest money. This sum, inappropriately called a margin, is not recorded as a down payment or partial payment of the purchase price of the commodity. The seller, as well as the buyer, must make the deposit, and the deposits are treated by law, specifically section 4d(2) of the Commodity Exchange Act, as remaining the property of the depositor during the life of the futures contract. 280 In this context, a short position would be the writing of a put option, whereby the option writer (or seller) gives the counterparty to the option to ability to force a sale of the underlying security at the option

borrowing funds to do so, a portion of the investor’s marginable securities or cash in the

account is restricted so as to operate in much the same way as a commodity margin –

namely to require an additional security deposit should the value of a short option decline

below a certain level.

On the other hand, the over-the-counter derivatives markets do not impose margin

requirements. Participation in over-the-counter derivatives markets is limited to qualified

investors; certain institutional investors and individuals who comply with specified

minimum net worth requirements.281 These qualification requirements provide some

capital protection. However, unlike margin requirements, the investor qualification

requirements do not vary with the amount of the investor’s investment exposure. Thus,

qualified contract participants who over-commit to a derivatives transaction or enter into

an economically disastrous derivatives transaction run the risk of insolvency. Whereas

contract participants in an exchange transaction would be subject to margin calls or a

forced liquidation of the position, there is no comparable protection for the counterparty

to over-the-counter derivatives contracts.

Over-the-counter market derivative contract participants can alleviate these

concerns by hedging the credit risk of the counterparties to their bilateral derivates

transaction by entering into a second derivatives contract to shift these credit risks to a

exercise price. If the price of the underlying security drops below the option exercise price, the option holder will eventually exercise the option requiring the option writer to sell the underlying security to the counterparty at the option exercise price which has fallen below its market value of the underlying security. Thus, when the option is exercised, the option seller will either have to sell stock out of his or her investment portfolio at a price below its current market value or will have to cover his or her short position by purchasing the underlying security in order to satisfy the sale obligation created by the option’s exercise.

With respect to a call option, a short position occurs when an investor writes a call option that entitles the counterparty to the option contract to buy the underlying security at the option exercise price. If the price of the underlying security rises above the option exercise price then the option writer will be required to sell the security at a price below the current market price of the underlying security.. 281 The 2000 amendments to the Commodity Exchange Act introduced a new category of eligible contract participants (“ECPs”) consisting of institutional and highly accredited customers. ECPs include financial institutions, insurance companies, registered investment companies; corporations, partnerships, trusts, and other entities having total assets exceeding $10,000,000, employee benefit plans subject to ERISA that have total assets exceeding $5,000,000; and governmental entities, as well as some other categories of investors. Section 1a(12) of the Commodity Exchange Act , 7 U.S.C. § 1a(12) (2003) that was enacted by the Commodity Futures Modernization Act of 20000 § 101, Pub. Law No. 106-554, 114 Stat. 2763 (Dec. 21, 2000).

less risk adverse counterparty.282 Derivative contract investors may neutralize multiple

risks through the use of multiple derivatives transactions. As is the case with any

derivatives transactions, the markets utilize speculators to help provide liquidity to these

risk-shifting markets. Even the early cases recognized that one party’s speculative intent

did not void a futures contract where the other party had a bona fide intent.283

Speculators in the derivatives markets help offset risks that hedgers want to minimize or

eliminate. The insurance parallel would seem to call for a system of requiring minimum

capitalization of speculators in the derivatives markets. This would involve much more

restrictive regulation than currently exists with the margin requirements.

IV. Comparing Alternative Regulatory Schemes

In contrast to the deregulatory trend in gambling activities and the non-securities

derivatives markets, insurance remains a highly regulated industry. However, the

justifications for substantive regulation of insurance contracts may be equally applicable

to securities regulation. If so, more stringent securities regulation than is currently in

place would be justified. The discussion below demonstrates that the underlying

concerns of insurance regulation are especially relevant in the context of commodities

investment.

a. Insurnace Regulation Compared

282 This can be demonstrated by the following example. If Hedger wants to shift some risks involving currency rates, Hedger can enter into a currency swap transaction with Counterparty1 that provides the desired risk protection. At this point Hedger may be concerned with the solvency of or credit risks involved in dealing with Counterparty1, so hedger may enter into a second contract with Counterparty2 under which Counterparty2 assumes the risk of default by counterparty1. 283 See, e.g., Irwin v. Williar,110 U.S. 499 (1884) (if one party to a grain futures contract intended delivery then the contract is not void for illegality even if the other party had had no intent with respect to delivery; however, if both parties had the improper intent the contract could void for illegality).

There are several justifications for regulating insurance.284 The justification “to

compensate for inadequate information” 285 is most analogous to the traditional

justification for regulation of investment markets, and, by extension, the traditional

disclosure rationale of securities regulation. Paternalism – a desire to protect what policy

makers deem as “the common good.”286 – also drives strong insurance laws and more

substantive regulation. This rationale, however, is controversial since it sacrifices

freedom of contract .

One explanation for the regulatory discrepancy between the insurance and

investment markets is the widespread nature of insurance and the fact that in many areas

insurance is a necessity.287 Home owners insurance and health insurance are two

examples that are considered necessities. Other types of insurance, such as life insurance,

also span a large sector of the consumer population. Thus, the consumer protectionist or

paternalistic approach may be more justifiable than with respect to investment markets,

gambling, and other more voluntary activities. Nevertheless, there are valid reasons for

considering increased regulation with respect to these transactions. The collateral

damage resulting from gambling losses and investment losses is tremendous. On one

level, policymakers often consider the increased incentive of addicts – whether it be

drugs or gambling – to commit crimes to feed their habits. The domino effect of

284 Although the larger objectives of insurance regulation are to prevent destructive competition, compensate for inadequate information, relieve unequal bargaining power, and assist consumers incapable of rationally acting in their best interests, the articulated objectives of state legislative regulation are essentially fourfold: (1) ensuring that consumers are charged fair and reasonable prices for insurance products; (2) protecting the solvency of insurers; (3) preventing unfair practices and overreaching by insurers; and (4) guaranteeing the availability of coverage to the public.

ROBERT H. JERRY II, UNDERSTANDING INSURANCE LAW 85 (2d ed. 1996) (The first three objectives apply equally to securities and other investment regulation). See also Spencer L. Kimball, The Purpose of Insurance Regulation: A Preliminary Inquiry in the Theory of Insurance Law, 45 MINN. L. REV. 471, 501 (1961). 285 JERRY, supra note XXX at 52. [ROBERT H. JERRY II, UNDERSTANDING INSURANCE LAW 51-54 (2d ed. 1996)] 286 JERRY, supra note XXX at 53. 287 For example, it has been suggested that because of the pivotal role insurance plays in our capitalistic system, the importance of insurance warrants public regulation. See Roger C. Henderson, The Tort of Bad Faith in First-Party Insurance Transactions: Refining the Standard of Culpability and Reformulating the Remedies by Statute, 26 U. MICH. J.L. REFORM 1, 8-11 (1992). This (what? Not sure what author referring to) has been described as a “public interest” basis for regulation. James M. Fischer, Should Advice of Counsel Constitute a Defense for Insurer Bad Faith?, 72 TEX. L. REV. 1447, 1457 n.37 (1994).

excessive risk-taking also raises concerns. Consider, for example, the Enron employees

who lost their jobs and the Arthur Anderson employees and retirees who lost their

pensions. These are costs of speculative activity that if checked by regulation might have

been prevented.

The paternalistic approach to interpreting insurance contracts, and specifically,

the interpretation of insurance contracts to protect insureds, is particularly pertinent in

drawing analogies to investment regulation. As a general matter, insurance companies

have such superior bargaining position that there is no true opportunity to negotiate

insurance contracts.288 Accordingly, when in doubt, courts tend to construe policies in

favor of the insured.289 There thus is a substantial consumer protection element of the

law governing insurance.290 In addition to the contract rules on unconscionability and

interpreting policies favorably towards insureds, the consumer-protection impetus is

underscored by state insurance regulation. For example, under the doctrine of reasonable

expectations, courts readily interpret insurance policies to reflect the reasonable

expectations of the insured even in the face of contradictory language in the insurance

policy itself.291 In addition, most insurance policies (at least those marketed to

288 See JERRY, supra note XXX at 52. Insurance policies are often characterized as contracts of adhesion. As explained by one court, “in the typical situation, the policy represents a contract of adhesion ‘entered into between two parties of unequal bargaining strength, expressed in the language of a standardized contract, written by the more powerful bargainer to meet its own needs, and offered to the weaker party on a 'take it or leave it basis. . . .’” Garcia v. Truck Ins. Exchange, 682 P.2d 1100, 1106 (Cal. 1984) (citing Gray v. Zurich Insurance Co., 419 P.2d 168 (Cal. 1966)). This claim has been a long-standing one. See, e.g., Isaacs, The Standardizing of Contracts, 27 Yale L.J. 34 '(1917). See also, e.g., C & J Fertilizer, Inc. v. Allied Mut. Ins. Co., 227 N.W.2d 169, 174 (Iowa 1975). 289 See, e.g., James M. Fischer, Why Are Insurance Contracts Subject to Special Rules of Interpretation?: Text Versus Context, 24 ARIZ. ST. L.J. 995 (1992). For contrary views, see, for example, Michael B. Rappaport, The Ambiguity Rule And Insurance Law: Why Insurance Contracts Should Not be Construed Against the Drafter, 30 GA. L. REV. 171 (1995); David S. Miller, Note, Insurance as Contract: The Argument for Abandoning the Ambiguity Doctrine, 88 COLUM. L. REV. 1849 (1988). 290 See SPENCER KIMBALL & WERNER PFENNIGSTORF, THE REGULATION OF INSURANCE COMPANIES IN THE UNITED STATES AND THE EUROPEAN COMMUNITIES 12 (1981). 291 See, e.g., Robert A. Hillman & Jeffrey J. Rachlinski, Standard-Form Contracting In The Electronic Age, 77 N.Y.U. L. REV. 429, 459 (2002) (“The reasonable-expectations doctrine, also prominent in insurance form- contract cases, holds that ‘[t]he objectively reasonable expectations of applicants and intended beneficiaries regarding the terms of insurance contracts will be honored even though painstaking study of the policy provisions would have negated those expectations.’ As worded, the doctrine allows courts to overturn express contract language if the term contradicts the consumer's reasonable expectations.”). See also, e.g., Roger C. Henderson, The Formulation of the Doctrine Of Reasonable Expectations and the Influence of Forces Outside Insurance Law, 5 CONN. INS. L.J. 69 (1998); Roger C. Henderson, The Doctrine of Reasonable Expectations in Insurance Law After Two Decades, 51 OHIO ST. L.J. 823 (1990); Robert E. Keeton, Insurance Law Rights at

consumers) must be approved by state regulators who consider fairness, among other

things.292 Insurance law in this respect also resembles the merit approach to securities

regulation that was rejected by Congress.293

Moreover, as noted earlier,294 this preapproval of the terms of insurance contracts

parallels the CFTC’s former role in approving futures contracts before they could be

publicly traded. Formerly, the commodities laws imposed a gate-keeping requirement

on types of permissible derivatives contracts, which functioned similarly to the insurable

interest requirement for insurance policies. Until the adoption of the amendments to the

Commodity Exchange Act, brought in by the Modernization Act,295 the CFTC and the

various commodity contract markets approved each contract that was traded. One

purpose of this contract approval process was to assure the economic integrity of each

contract,296 because this process functioned in much the same way as the insurance

regulation that requires state insurance regulators to approve insurance policies that are

marketed to consumers.297

From 1922 until 2000, the Commodity Exchange Act required federal approval of

a futures contract involving a demonstration that the instrument could and would be used

substantially to hedge against price risks or to assist in the price formation (price

“discovery”) process. Known early as an “economic purpose” test, and later as a “public

interest” test, this standard was deleted from the Act by the Commodity Futures

Modernization Act. The Commission and the courts will decide whether this standard

Variance with Policy Provisions, 83 HARV. L. REV. 961, 967 (1970); Peter Nash Swisher, A Realistic Consensus Approach to the Insurance Law Doctrine of Reasonable Expectations, 35 TORT & INS. L.J. 729 (2000). 292 See LEE R. RUSS & THOMAS F. SEGALLA, COUCH INSURANCE (3D) (1997) (describing these regulatory statutes). See also, e.g., Susan Randall, Insurance Regulation in the United States: Regulatory Federalism and the National Association of Insurance Commissioners, 26 FLA. ST. U. L. REV. 625 (1999) (discussing the role of state law in insurance regulation). 293 See supra note XXX and accompanying text. 294 See supra note XXX and accompanying text.

295 Commodity Futures Modernization Act of 2000, Pub. Law No. 106-554, 114 Stat. 2763 (2000). 296 See 1 PHILLIP MCBRIDE JOHNSON & THOMAS LEE HAZEN, DERIVATIVES REGULATION § 2.03. (2004). 297 See, e.g., COUCH supra note XXX. [3 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 24:117, at 197-198 (2d ed. 1984).]

resides invisibly within the current statute, but arguably, it does not.298 Moreover, the

principal means of administering this standard was lost under the CFMA’s elimination of

the Commission’s right to prevent or even block the listing of new contracts. Yet the Act

still protects listed futures contracts from being attacked under state gaming and bucket

shop laws.299

Indeed, many of the reasons for heavy regulation of insurance may also apply

(albeit in a secondary or derivative manner) when considering regulation of derivative

investments – at least in reevaluating the disparity in the current regulatory environment.

As discussed in the next section, the comparison between insurance and derivatives

regulation is even more striking than the disparity between securities and derivatives

regulation. Just as we assume that insured do not read their insurance contracts, it is

equally likely that consumers do not read derivatives contracts carefully.300 Yet, we

impose stringent regulation on one industry and relegate protection of the other to mere

disclosure. Unless we are willing to consider eliminating the role of state insurance

administrators in protecting policy holders, it seems appropriate to consider reinstating

the former futures approval process at least with respect to publicly traded derivatives.

In deciding the future of derivatives regulation, we must ask whether this regulatory 298Although not rising to the level of an agency or judicial adjudication, there was considerable controversy when terrorism futures were first proposed following 9/11 and the nation’s subsequent concerns over terrorist attacks. The issue resurfaced in late 2003. 299 See generally Julie M. Allen, Kicking the Bucket Shop: the Model State Commodity Code as the Latest Weapon in the State Administrator's Anti- fraud Arsenal, 42 WASH. & LEE L. REV. 889 (1985) (discussing the application of state anti-bucket shop laws). 300 See, e.g., Paul D. Carrington, Self-Deregulation, The “National Policy” of the Supreme Court, 3 NEV. L.J. 259, 278 (2002/2003) (“It is the premise of insurance regulation that citizens cannot be expected to read and understand the intricate terms of the policies they buy.”). Courts readily recognize that consumers to not read the details of insurance policies: “It is generally recognized the insured will not read the detailed, cross- referenced, standardized, mass-produced insurance form, nor understand it if he does.” C & J Fertilizer, Inc. v. Allied Mut. Ins. Co., 227 N.W.2d 169, 174 (Iowa 1975), relying on 7 WILLISTON ON CONTRACTS § 906B, p. 300 (“But where the document thus delivered to him is a contract of insurance the majority rule is that the insured is not bound to know its contents”); 3 CORBIN ON CONTRACTS § 559, pp. 265--66 (“One who applies for an insurance policy … may not even read the policy, the number of its terms and the fineness of its print being such as to discourage him”); Note, Unconscionable Contracts: The Uniform Commercial Code, 45 IOWA L.REV. 843, 844 (1960) (“It is probably a safe assertion that most involved standardized form contracts are never read by the party who ‘adheres’ to them. In such situations, the proponent of the form is free to dictate terms most advantageous to himself”). See also, e.g., Hully v. Aluminum Company of America, 143 F.Supp. 508, 513 (S.D.Iowa 1956), aff'd sub nom. Columbia Casualty Company v. Eichleay Corporation, 245 F.2d 1 (8th Cir. 1957); Collegiate Mfg. Co. v. McDowell's Agency, Inc., 200 N.W.2d 854, 859 (Iowa 1972); Quinn v. Mutual Benefit Health & Acc. Ass'n of Omaha, 55 N.W.2d 546, 550 (Iowa 1952); Lankhorst v. Union Fire Ins. Co., 20 N.W.2d 14, 17 (Iowa 1945).

disparity can be explained other than as an accident of the different history and public

choice input – whether insurance is so different from the gambling, securities

investments, and derivatives investments as to warrant such different regulatory

treatment.

b. Hedging Versus Speculation

Stepping back a moment from the issue of derivatives, let us first examine how

much of the distinction between bona fide hedging (or insurance) and gambling is in the

eye of the beholder. Consider, for example, merchants in a city hosting major league

baseball who have recently enjoyed great success in the fall as a result of the home team

making it through divisional play-offs and into the world series. The merchants clearly

have a legitimate interest in hedging against lost sales due to the absence of a post season

event. Further, consider the fact that a seven-game world series will bring more income

than a four-game series. Should a merchant be able to enter into a hedge contract to

protect itself against the home team not making it into the post season or having a

truncated post season due to losing games? If so, how does this differ from betting on the

outcome of the specific games that would determine the length of the post season? Note

that to the extent that attendance will increase even during the regular season according to

the team’s success, there could be an interest in hedging against losses on a daily basis.

Would the law allow a pooling of these risks among major league baseball teams as a

type of insurance? If so, how does this differ from allowing organized gambling

throughout the country?301

Continuing with the same sports analogy, an owner of a professional sports team

invests significant funds in the franchise, players’ contracts, and the stadium with the

hopes of reaping a return on these investments through attendance and media contracts.

The payout of sports teams is clearly connected to the team’s success. It would seem

rational for a team owner to hedge against the team’s lack of success through a futures

contract against a down turn in attendance or by hedging against the team’s failure to

301 One difference could be the ability to keep the organized pool clean of organized crime.

make it into post-season play. It would thus make sense, for example, to bet against ones

own team as a hedge against revenue loss. How is this any different than the wheat

farmer who hedges against a crop loss by entering into a wheat futures or forward

contract?

One point that might be raised is that a team owner who bets against his own team

will have an incentive to try to promote a loss in order to cash in on the wager or hedging

contract. One way to deal with this problem would be to make an analogy to the

insurable interest doctrine and to allow a hedge so long as it would be sufficient to

compensate for the economic loss but would not provide the moral hazard associated

with over insurance.302 Furthermore, the moral hazard problem does not occur with

respect to the merchant who is trying to hedge against revenue loss and is not in a

position to affect the outcome of the game. The law does not distinguish between these

types of wagers that could serve as hedges or insurance and those, such as a craps game,

that are pure gambles.

Presumably, these hedging contracts against a loss in revenues occasioned by

losing a game would constitute illegal gambling. To put it another way, it would seem

unlikely that there would be a permissible insurable interest here.303 Would these

hedging contracts be permissible derivatives contracts? On the one hand, the hedging

function to the team owner is self evident. On the other hand, if the law permits these

hedging contracts, the opportunity for speculators creates an opportunity for a form of

legalized gambling that is not permitted under the laws dedicated to gambling regulation.

Although there is a moral hazard concern, that concern should not be the sole

factor in determining the legitimacy of any particular contract. It is not sufficient to say

that since the team owner has the opportunity to affect the outcome, the hedge or

insurance contract should not be allowed. The farmer has an equal opportunity to affect

his or her crops and thereby alter the outcome as is even more vividly the case with

respect to the property owner who seeks fire insurance. The law deals with these

potential evils by outlawing arson, or in the case of sports by tampering in much the same

302 See the discussion accompanying notes XXX infra. 303 See infra note XXX and accompanying text.

way as securities and commodities law prohibits manipulation.304 The rules against

investment market manipulation are deemed sufficient to allow companies to invest in

their own securities. Parallel rules protect against hedgers altering the outcome of the

event hedged – including the outcome of a sports event. As pointed out above, if this

type of sports hedging is legitimate, then the parallel to the securities and derivatives

markets would call for allowing speculators (i.e., gamblers) to engage in the same activity

as a way to make the hedging market more efficient.

It is conceivable in the derivatives markets that both parties to a bilateral

derivatives contract will be two hedgers who are able to allocate reciprocal risks to one

another. However, it is also common in derivatives transactions for risk averse parties

may look to speculators to lay off their risk. For example, a commercial participant in a

market may not be able to locate a counterparty to a desired hedging contract if that

counterparty must itself be a commercial hedger. Speculators have thus been

characterized “people who accept the risk hedgers do not want.” 305 As such, they

perform a very important function for commercial participants looking to hedge business

risks.

In fact, one answer to the charge that derivatives are nothing more than legalized

gambling is that they provide legitimate hedging opportunities for investors and, more

importantly, for commercial participants in the underlying commodities markets. It also

is often pointed out that speculators help make markets more efficient by providing

additional liquidity, which in turn performs a price discovery function.306 Commercial

participants in the public commodities and derivatives markets (designated contract

markets) may thus be relying on speculators to provide them with efficient markets for

their hedging activities.

304 See 3 PHILLIP MCBRIDE JOHNSON & THOMAS LEE HAZEN CH. 5 (2004).

305 ROBERT A. STRONG, SPECULATIVE MARKETS 5 (2nd ed. 1994), as quoted in Kolbrenner, supra note XXX at 217.

306 While certain commodities markets may be relatively illiquid, allowing for a more actively traded futures market means that the pricing of futures contracts will reflect pricing in the cash or spot market for the underlying commodity.

Indeed, hedging operates much like a variety of insurance307 as it allows a risk

averse party to pass the risk on to someone else308 who is willing to do so for a

premium.309 That premium can take the form of insurance premium or the cost of an

options, futures, or swap contract. With respect to insurance, the risk is absorbed by the

insurance company, which pools its premiums and manages that pool as an investment to

cover the claims as they are made by the policyholders.310 With respect to hedging, a

credit event derivatives contract311 is a type of insurance against an undesired credit event

such as a default on a loan.312 Similarly, interest-rate derivative transactions such as

caps,313 floors,314 and collars315 are used by banks and other lenders (as well as by some

borrowers) to transfer or hedge against undesired credit risks. As a general proposition

when derivatives transactions are used as hedging devices, they are most definitely a type

307 As explained by one court: “Hedging affords such protection; it is in the nature of price insurance. The real difference between hedging and gambling is that the hedger has a legitimate interest to protect apart from the hedging transactions, while the gambler has no interest except in the transactions depending on the rise and fall of the market. An insurance contract becomes a wager when the insured has no legitimate interest to be protected against the happening of the event insured against.” Boillin-Harrison Co. v. Lewis & Co., 187 S.W.2d 17, 24 (1945), relying on Edwin W. Patterson, Hedging and Wagering on Produce Exchanges, 40 YALE L. J. 843-884 (1931). See also, Note, Legislation Affecting Commodity and Stock Exchanges, 45 HARV. L. REV. 912 (1931-1932). 308 “Like someone seeking catastrophic health insurance, for example, a hedger is thought of as a risk-averse party seeking to pass on an amount of risk to a risk-neutral (or less risk-averse) party, such as an insurance company, better able to bear it.” Scott Marc Kolbrenner, Derivatives Design and Taxation, 15 VA. TAX REV. 211, 217 (1995). 309 “[L]ike a writer of insurance, the option-writer receives a small benefit, the payment of a premium, for entailing comparatively large risk, the unlimited liability to purchase or sell the underlying [commodity, security, index or other reference point].” Id. at 222 310 Although this is the traditional structure of insurance companies in the United States, Lloyd’s of London finances its risk management in a manner much more analogous to the commodities and derivatives markets. See infra note XXX and accompanying text. 311 See, e.g., André Scheerer, Credit Derivatives: An Overview of Regulatory Initiatives in the U.S. and Europe, 5 FORDHAM J. CORP. & FIN. L. 149 (2000). 312 John D. Finnerty & Mark S. Brown, An Overview of Derivatives Litigation, 1994 TO 2000, 7 FORDHAM J. CORP. & FIN. L. 131, 136 n.12 (2001). 313 In a cap, one party shifts the risk of an increase in interest rates by entering into a derivatives transaction that shifts the risk of an interest rate increase to the counterparty to the contract. 314 In a floor, a party (for example, a lender in a variable rate loan) can shift the risk of an increase in interest rates to the counterparty to the derivates contract. 315 A collar transaction consists of a party contracting for interest rate protection on both the upside and the downside by locking in both maximum and minimum interest rates for which the party will bear the risk; these risks are thus shifted to the counterparty.

of risk shifting,316 as is insurance.317 The risk-shifting function of derivatives contracts

thus operates as a type of insurance.

c. If It Walks Like a Duck…

The foregoing discussion demonstrates that it is not always easy to distinguish

between hedging, insurance, and gambling. The practical similarities between these

industries are gaining recognition. Both the legal community318 and the popular press

have recognized the ways in which derivatives operate as insurance.319 There are

derivatives based on environmental compliance such as clean air futures,320 which are

another way of shifting the risks allocated by environmental insurance.321 Businesses

have begun to use derivatives strategies to help deal with insurance risks.322 Participants

in the investment markets have developed strategies that operate as insurance. For

example, program trading and other options strategy in the securities markets have been

described as portfolio insurance.323

316 See Joseph J. Bianco, The Mechanics of Futures Trading: Speculation and Manipulation, 6 HOFSTRA L. REV. 27, 32 (1977); Alan N. Rechtschaffen, International Symposium on Derivatives and Risk Management, 69 FORDHAM L. REV. 13, 15 (2000). 317 Benjamin E. Kozinn, Note, The Great Copper Caper: Is Market Manipulation Really a Problem in the Wake of the Sumitomo Debacle?, 9 FORDHAM L. REV. 243, 253 (2000) (“In other words, the futures markets provide an insurance function for the hedger."). 318 See George Crawford, A Fiduciary Duty to Use Derivatives?, 1 STAN. J.L. BUS & FIN. 307, 321 (1995); Jonathan R. Macey Mark Mitchell & Jeffry Netter, Symposium on the Regulation of Secondary Trading Markets: Program Trading, Volatility, Portfolio Insurance, and the Role of Specialists and Market Makers, 74 CORNELL L.REV. 799, 811-812 (1989); John Andrew Lindholm, Note, Financial Innovation and Derivatives Regulation -- Minimizing Swap Credit Risk Under Title V of the Futures Trading Practices Act of 1992, 1994 COLUM. BUS. L. REV. 73, 100 (1994) (referring to “swap insurance”). 319 See, e.g., Gregory J. Millman, Derivatives as Dump Trucks; They Are Risky, But They Haul Away the Refuse of Bad Government Policy, WASH. POST, Dec. 18, 1994, at C2 (“Financial engineers, many of them holding PhDs in mathematics, physics or other sciences, designed new derivatives contracts to function like a form of financial insurance.”). 320 Henry E. Mazurek, Jr., The Future Of Clean Air: The Application of Futures Markets to Title IV of the 1990 Amendments to the Clean Air Act, 13 TEMP. ENVTL. L. & TECH. J. 1, 16 (1994); Adam J. Rosenberg, Note, Emissions Credit Futures Contracts on the Chicago Board of Trade: Regional and Rational Challenges to the Right to Pollute, 13 VA. ENVTL. L.J. 501, 518-519 (1994). 321 See, e.g., Christopher R. Hermann, Joan P. Snyder & Paul S. Logan, The Unanswered Question of Environmental Insurance Allocation in Oregon Law, 39 WILLAMETTE L. REV. 1131 (2003). 322 See, e.g., Tamar Frankel & Joseph W. LaPlume, Securitizing Insurance Risks, 19 ANN. REV. BANKING L. 203 (2000). 323 See, e.g., JERRY W. MARKHAM & THOMAS L. HAZEN, BROKER-DEALER OPERATIONS UNDER SECURITIES AND COMMODITIES LAW: REGISTRATION, FINANCIAL RESPONSIBILITIES, CREDIT REGULATION, AND

V. Reconciling Divergent Regulatory Trends in the Securities and Nonsecurities

Investment Markets

This article has examined four areas of economic activity – securities, non-

securities derivatives investments, gambling, and insurance. There are two divergent

regulatory trends exemplified by increased regulation of the securities markets and the

deregulation of the markets for non-securities derivative instruments. The deregulatory

environment for derivatives parallels the general trend towards deregulation of gambling.

It is worth noting that the increased securities regulation brought in by the Sarbanes-

Oxley Act of 2002 began just five years after the second of two deregulatory efforts. The

Private Securities Litigation Reform Act of 1995324 and the Securities Litigation Uniform

Standards Act of 1998325 were efforts to deregulate the securities markets through the

imposition of barriers on private litigation to redress alleged securities law violations.326

There was a parallel deregulatory tone sounded by the SEC under a new

Republican majority on the Commission and the leadership of new Chairman Harvey Pitt

who took over in 2001.327 The bursting of the market bubble that existed in dot.com and

CUSTOMER PROTECTION § 2:22 (2d ed., 2003) (portfolio insurance “is simply hedging by institutional traders to protect their portfolios in the event of adverse market movements”)[; Thomas Lee Hazen, The Short-Term/Long-Term Dichotomy and Investment Theory: Implications for Securities Market Regulation and for Corporate Law, 70 N.C. L. REV. 137, 167 (1991); Lynn A. Stout, The Unimportance of Being Efficient: An Economic Analysis of Stock Market Pricing and Securities Regulation, 87 MICH. L. REV. 613, 627 (1988). Notwithstanding the foregoing similarities, there clearly is some division between insurance and derivatives risk shifting. For example, it was held that a commodities broker acted negligently and in violation of state insurance law for an insurance company to enter into hedge transactions on a commodities exchange. Investors Equity Life Ins. Co. of Haw. v. ADM Investor Serv., Inc., 1997 WL 33100645, at *9 (D. Haw. 1997) (the investments violated the rules of the Chicago Board of Trade). 324 Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 and 18 of the U.S.C.). 325 Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227, 3230 (codified as amended in scattered sections of 15 and 18 of the U.S.C.). 326 The Private Securities Litigation Reform Act provided heightened pleading standards and tightened procedural requirements that were designed to inhibit strike suits. Private Securities Litigation Reform Act §§ 101-203. The Securities Litigation Uniform Standards Act preempted plaintiffs trying to go to state court to avoid the limitations of the Private Securities Litigation Reform Act. Securities Litigation Uniform Standards Act § 2. 327 See SEC, Historical Summary, http://www.sec.gov/about/concise.shtml (not sure why he cites this. I went there (b/c the sourced coordinated one is wrong) and it just shows a list of past commissioners.)

other surging high-tech securities combined with the series of massive corporate frauds

that came to light nudged Congress out if its deregulatory bias and back into a re-

regulatory mode. Although the impetus for their position differs from the investment

markets, some commentators have suggested that even outside of the securities and

derivatives markets, policy makers should consider re-criminalizing gambling.328

Deregulation clearly has been the trend with respect to derivatives and gambling

and even with respect to securities laws prior to Sarbanes-Oxley. Coherence in these

parallel regulatory environments could call for continued deregulation of derivatives and

gambling, as well as renewed deregulation of the securities markets.

Some of the securities law re-regulation may well be an overreaction to events in

the news.329 On the other hand, it seems more likely that this was a necessary wake-up

call and that a similar reaction is warranted with respect to the non-securities derivatives

markets (and to the gambling laws as well). Lest we forget, one of the major corporate

failures was Enron, which resulted not only from aggressive accounting practices that

were addressed by the Sarbanes-Oxley Act, but also Enron’s heavy involvement in

derivatives transactions.

The deregulation of the non-securities derivatives markets leaves gaps that may

provide openings for additional failures. It would be wise to reconsider the deregulation

of the non-securities derivatives markets before having to reactivate re-regulation in the

wake of the new major scandals. There would be obvious opposition to re-regulation of

the derivatives markets from those observers and commentators who generally favor free

unregulated markets. Opposition to increased regulation has come from other directions

as well. For example, another interesting spin is that overregulation may create a moral

hazard by encouraging investors to take on risk.330 This concern seems misplaced, given

328 See John Warren Kindt, Would Re-Criminalizing U.S. Gambling Pump-Prime the Economy and Could U.S. Gambling Facilities be Transformed into Educational and High-Tech Facilities?: Will the Legal Discovery of Gambling Companies' Secrets Confirm Research Issues? 8 STAN. J.L. BUS. & FIN. 169 (2003); see also John Warren Kindt, The Failure to Regulate the Gambling Industry Effectively: Incentives for Perpetual Non-Compliance, 27 S. ILL. U. L.J. 221 (2003). 329 See, e.g., Ribstein supra note XXX, at 97. 330 See, e.g., Mark Klock,, Two Possible Answers to the Enron Experience: Will it be Regulation of Fortune Tellers or Rebirth Of Secondary Liability?, 28 J. CORP. L. 69, 79 (2002):

the litigations costs and the huge legal fees to plaintiffs’ lawyers; the increased incentive

to investors to take on risk to be compensated for in subsequent litigation seems marginal

at best.

This article has discussed the generalities of these regulatory regimes. The

similarity of transactions and disparity of regulation can provide fertile fields for

exploration of specific regulatory rules in addition to the more generalized policies

discussed herein. This article has raised the question of the general parameters of

industry or market regulation. I have suggested that a more coherent regulatory approach

is needed. Once policy makers accept the need for bringing these parallel regulatory

schemes more in line with one another, then they can turn to formulating specific

proposals that have not been addressed in this article. For example, the divergent re-

regulatory approach of the securities laws and deregulation under the commodities laws

need to be reconciled. As another example, policy makers should consider the fashioning

disclosure rules applicable to insurance sales to more closely approximate those

applicable to could readily be compared with those applicable to securities and non-

securities derivative transaction. The author hopes that this article serves as a

springboard for these types of deliberations.

Investors take risks in the hopes of rewards. When they obtain an unfavorable outcome, they seek restitution. This is the "heads I win, tails you lose" game. It can also be modeled as giving investors a free option or as creating a moral hazard problem in which investors are encouraged to seek out excessive risk. After an investor incurs a loss on a risky investment, she has the incentive to assert that the ex post outcome proves the ex ante risk to be too large. Since such assertions inherently lack credibility, they should only be considered if there is evidence of fraud. This rule is designed to prevent gamblers from placing a bet knowing the risks and then after losing the bet, demanding the return of the stakes on the theory that the bet was unfair.

(footnotes omitted). (I’m no sure if this “footnotes omitted” was done correctly.)