Distorting

2/22/10 Draft

Distorting Legal Principles [1]

Steven L. Schwarcz[2]

Abstract: Legal principles enable society to order itself by preserving broadly based expectations. Sometimes, however, parties transact in ways that are so inconsistent with generally accepted principles as to create uncertainty or confusion that undermines the basis for reasoning afforded by the principles. Such a distortion might occur, for example, if a normally mandatory legal rule were unexpectedly treated as a default rule. This article explores the problem of distorting legal principles, initially focusing on rehypothecation, a distortion whose uncertainty and confusion contributed to the downfall of Lehman Brothers and the resulting global financial crisis. But not all distortions are, on balance, harmful; sometimes they represent a positive evolution of law. To this end, the article also seeks to construct a normative framework for determining how government lawmakers, judges, and lawyers should address distortions of legal principles.

INTRODUCTION 3
I. REHYPOTHECATION AND INTERMEDIARY RISK 8
A. The Distortion 8
B. Consequences of the Distortion 10
C. Towards a Framework for Balancing Consequences 13
D. Applying the Framework 21
II. OTHER DISTORTIONS AND THEIR CONSEQUENCES 26
A. Automatic Perfection 26
B. Priority Reversal for Minerals 31
C. Repo and Derivative Exemptions 33
D. Restatement of the Framework 36
III. UTILITY OF THE FRAMEWORK 37
A. Application to Government Lawmaking 39
B. Application to Judicial Decisionmaking 40
C. Application to Lawyering 42
IV. CONCLUSIONS 44

This article explores the important but until now largely neglected problem of distorting legal principles, usually for business ends.[3] The exploration starts by examining a fundamental distortion of the legal principle of nemo dat quod non habet—one cannot give what one does not have (hereinafter, nemo dat). This distortion, resulting from a