The legal origins of financial value

I came across the work of Katharina Pistor recently through a friend. This post draws from an article published here.

She makes the important point that the value of any asset derives from its legal enforceability - capital is coded in law. For example, apart from the traditional land and labour, they now include anything from a pile of debt (securitisation) to an idea (patent) to a business organisation (share) etc. 

All tangible assets have some physical form that can lay claim to their value. However, in the case of intangible assets like financial assets or patents, there is no physical form and the value derives directly and completely from the underlying law. 

Capital is coded in law and cannot thrive without the ability to invoke the coercive powers of a state if and when needed. For no assets is this more relevant than for the assets that owe their very existence to law itself; namely, for intangibles, such as financial assets.Financial assets are claims to future cash flows, which are not worth much unless they are backed by a credible threat of enforcement.

In recent decades there has been a dramatic expansion in the application of such laws to underpin newer assets.

The spread of shadow banking domestically and globally would not have been possible without their implicit backing by the state’s coercive powers. A promise to future cash flows is an empty promise unless it or the assets that back it, can be enforced. Anonymous markets in which trillions of dollars are traded by the stroke of a key don’t rely on personal trust; they depend on the possibility of coercion. This implies that is not accurate to suggest that state power has not been scaled back in the age of globalization; rather, it has been repurposed to serve the interests of capital. States have offered their laws, the modules of the code of capital to asset holders; and they have empowered private parties to pick and choose from among different legal systems the modules that best suit their needs, while resting assured that their choices will be enforced.

In addition, they have consented to the privatization of dispute settlement and encouraged arbitration in domains that used to be off limits, thereby eliminating courts as the only space for public contestation that the private coding of capital affords to contest capital’s preferred coding strategies. The ability of private parties to pick and choose from among the different legal systems the law that best suits their transactional needs or gives them the most accommodating tax or regulatory regime stands in tension with the use of law as a means of democratic self-governance. The ease with which some can opt out of one legal system and into another weakens the effectiveness of law as a collective self-governance device.

As Pistor writes, financial instruments benefit from private law that has its basis in one country (typically the US) or a few jurisdictions (typically US and Europe) being extended transnationally, its scope being extended from the private realm to even the public realm, and its formulation and even implementation being delegated to private entities. It's actually worse still since the private law itself emerged from rules framed by private interest groups and has its basis in the private law of one reference country. Good examples of such legal encroachment are international standards-setting organisations like International Accounting Standards Board or the International Swaps and Derivatives Association. 

Unlike elsewhere, in the US, private law is mostly in the realm of states and not federal law. Further, being a common law country, these private laws are built on legal precedents which in turn have local origins in US states among clubby private interest groups. In other words, given the institutional dominance of the US in global financial markets, many of the rules that underpin them have their origins in the US and from private laws decreed (and not legislated) into being through lower court orders. 

Supreme Court justices in the USA, especially the originalists among them, have been more inclined to protect the integrity of the common law and to shield it from interference. As an added complication, in the USA private law is largely a matter of state, not federal law. This sets the country apart from other federalist systems like Germany or India, for example, where most private law falls within the jurisdiction of the federation. The extension of constitutional principles into matters of private law in areas that concern racial or sexual equality, for example, is criticized not only on jurisdictional (or federalist) grounds, but because this threatens to upends the norms of a private legal order that preceded the Constitution... In the common law, which was transposed from England to the USA, private attorneys have much leeway to mold the law and graft legal protections onto new assets, subject only to the occasional vindication by a court of law. Moreover, unlike in civil law systems, where judges are career bureaucrats, in common law systems judges are recruited from the practicing bar. Not surprisingly, they have always been inclined to validate the legal innovations that their former colleagues have brought before them.

She points to the egregious flaw in the legal protections offered to entities like Trusts and corporate shells which exist only to obfuscate origins and ownership, and shield assets from credits and tax authorities. She also discusses how property rights have gradually evolved from being a "use value" to an "exchange value" to now even an "expected value" (securitisation). 

She also gives two examples of the differential treatments meted out by this legal system, 

Of course, not all claims to future cash flows are equally protected. Future cash flows that the state promises in the form of social security or explicit subsidies are typically not deemed to be property rights but entitlements that states can give or take at their discretion, except in the rare cases when they have created reliance expectations. This disparity in the treatment of expectations has long been criticized. Decades ago, Charles Reich called for the protection of “government largess,” that is, cash flows that emanated directly from the state, as the “new property”...

Instead, the protection of “old” property, expectations based on private bets not public commitments, has been further expanded. Of course, private bets don’t always work out, and in most instances, the betters will have to absorb the losses. However, if the losses reach a magnitude that might affect the price of private assets across the board, governments often step in ex post and socialize the losses. In these cases the only difference between old and new property is that explicit government pledges to future cash flows will have been approved in a democratic process, whereas ex-post rescue operations are often crisis-driven and conducted by independent agencies, such as a central bank, or backed by ad hoc legislation that leave little room for deliberation. The central bank rescue deals in the midst of the 2008 crisis followed by bailout legislation in the USA, the UK, Germany and elsewhere, are prominent examples. They are often justified by noting that the governments recovered most of their losses when they sold these assets back to the market. But this misses the negative effect of the crisis on firms and households on the periphery of the system that did not receive similar support and were driven into default.

The power of private law over public law, and common law over even constitutional law, is amplified at the global level due to the dominance and co-ordination powers of American financial market actors, network effects from cross-border financial flows, and the fear among other countries of being excluded  from the markets. 

One of the least discussed aspects of international law concerns arbitration law, specifically its almost blanket adoption in the now common bilateral investment treaties between countries. As Pistor brilliantly articulates, such treaties are draconian in so far as they confer protections on investments and even contracts that equate with property rights, allow foreign firms to invoke its provisions even if there’s only a tenuous contractual connection with the host government, provide omnibus protections against actions including by the host country courts, impose liabilities on national governments for actions of even local governments, bind sovereign countries from changing their laws even for right reasons. 

Since the early 1990s most treaties incorporate so-called investor state dispute settlement (ISDS) mechanisms. The sovereign states that are the parties to a BIT thereby empower private parties, specifically investors from their own country, to take the host state of their investments to arbitration for alleged infringements of their “investment.” Several aspects of this arrangement are worth noting. First, the investor needs only a formal attachment to a state to invoke the rights created in the BITs that the state has entered into with other states. Incorporating a subsidiary for the purpose of taking advantage of particularly generous investment treaty is sufficient. Technically, a foreign subsidiary of a parent company that is located in the “host state” is sufficient... 

Second, investment is an even more open-ended term than property rights. Whereas the meaning of property rights has been contested in most legal systems for centuries, the same cannot be said for investments, the term found in most BITs. Most BITs claim that they protect “every kind of investment,” followed by a list of examples that includes movable and immovable property; and direct investments as well as portfolio investments (i.e., shares), including minority shares or indirect shareholders according to some arbitral tribunals; intellectual property rights and “claims to money and claims having a financial value.” This latter wording indicates that not just property rights but even contracts can trigger remedies on par with compensation for expropriating property rights. Any government actions, by the executive, the legislature, or even the courts, might trigger claims, the defense against which alone can run into the millions of dollars. 

They effectively override the sovereignty of the host country. Consider the case of a state or local government corporation in a developing country in which a foreign investor (from a country with which the host country has a BIT) takes a minority right. Now it comes to light that the domestic promoter has indulged in corruption to obtain a license to start the business. The new government in the host country investigates and follows due process and cancels the license, a decision which is also upheld by the local courts. This ends up sharply eroding the valuation of the business and the foreign investor's stake. The domestic investor does not contest the matter any longer. But the foreign investor invokes the ISDS provision in the BIT and goes for arbitration in London. The arbitration court rules in favour of the foreign investor and directs the federal government of the host country to pay compensatory damages and reimburse the equity  valuation differential for repatriation to the foreign country.  

This is not uncommon. Rulings like this in favour of a minority foreign investor, on an issue litigated and closed by the courts in the host country create several perverse incentives. It encourages foreign investors to get around the sovereign power of a state to cancel a license given in violation of extant law and with rents. Apart from legalising rent-purchased assets and condoning corruption, it also encourages foreign investors to strike deals (especially in natural resource mining and public contracts) through corrupt practices. It also provides a superior right to foreign investors in their investment protection over that enjoyed by domestic investors.

Such mechanisms create perverse incentives, open opportunities for abuse, and are certain to invite backlash against foreign investments in general. It's therefore important to revise bilateral investment treaties and provide a fairer and more equitable sharing of risks and responsibilities among governments and private investors.