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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 affordedby 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 alldistortions 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.

A. The Distortion 8
B. Consequences of the Distortion 10
C.Towards a Framework for Balancing Consequences 13
D. Applying the Framework 21
A. Automatic Perfection 26
B. Priority Reversal for Minerals 31
C. Repo and Derivative Exemptions 33
D. Restatement of the Framework 36
A. Application to Government Lawmaking 39
B. Application to Judicial Decisionmaking 40
C.Application to Lawyering 42

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 apractice known as rehypothecation,[4] caused a type of intermediary risk[5] that was at the heart of the recent global financial crisis and that threatens to trigger future such crises.[6]

Using this distortion of nemo dat, the article constructs a framework for analyzing distortions of legal principles.[7] The central normative issue is when to allow or tolerate these types ofdistortions, given their potential costs. A proposed distortion might appear to be socially favorable on a simple balancing of costs and benefits, but there is also a chance it might end up seriously harming the public. This is especially likely when private interest groups favor the distortion, because they would almost certainly receive a disproportionate share of the benefits with the public potentiallysuffering a disproportionate share of any harm.

Because of the potential for significant public harm, the article argues that distortions of legal principles should be assessed not on a simple cost-benefit basis but by a higher standard. The article also examines which individuals and institutions should make the assessment and how they might do so.


A distortionof nemo dat resulted in a type of intermediary risk that was central to the recent financial crisis.[8] Intermediary risk, generally, is the risk that property held by an intermediary on behalf of third parties may be seized by creditors of the intermediary.[9] This risk has great practical importance where the property held by the intermediary is investment securities (hereinafter “securities”)and the intermediary is a broker-dealer, bank, or other financial services firm[10] holding the securities on behalf of third-party investors (hereinafter, “investors,” or “customers” of the intermediary).[11]

Although intermediary risk can arise in several ways,[12] the intermediary risk at issue in the financial crisis resulted from a distortion of nemo dat caused by a globally...