Judges and Systematic Risk in the Financial Markets

INTRODUCTIONThis paper will keep company with others that consider the regulation of over-the-counter ("OTC") derivatives, and the particular role and potential effectiveness of proposals in the new regulatory regimes that have emerged since the recent financial crisis (or crises, depending on how you count) for central clearing as a means of mitigating systemic risk.1However, in what follows, I want the reader to think outside the current regulatory debate for a moment. Instead, I would ask the reader to pause while contemplating the subject of systemic risk in the global financial markets and consider how courts and judges fit in.I. THE COURTS AS HOSPITALSOur newspapers are full of articles about financial market regulation. Parliamentarians and congressmen do not shy away from weighing in on this subject too. Financial regulation can be seen as a kind of 'preventive medicine,' and we attach great importance to getting it right.That is as it should be. Preventive medicine in matters of both personal and financial health is important. In the recent crisis, the malaise afflicting the financial markets had arguably reached epidemic proportions. Financial market participants were, and some still are, seriously, if not terminally, ill. Moreover, we can expect more accidents to occur and more victims to surface in the future. However, as the courts are our 'hospitals,' perhaps we should worry more about the condition of the courts and whether we have enough qualified staff for them.It is indeed a little surprising that with all the debate about the future of financial regulation and the statements on the subject that politicians, regulators, economists and academics make - and even statements by the legal profession itself - so little attention has been paid to the role of our judges in mitigating risk. After all, judges around the world interpret regulations, fill in the legislative and regulatory gaps, and resolve ambiguities. In addition, they can be expected to settle any number of financial market disputes - some of them highly complex and technical - that are likely to follow from the considerable losses, and in some cases the demise, of major financial institutions and their counterparties.This paper aims to address an apparent gap in the debate. What role should we wish to see our courts play in dealing with complex financial instruments, disputes arising from the financial crisis, and, in due course, matters requiring interpretation of the new regulatory regime? Are the courts, as currently constituted, equipped to play that role? Is there more that the markets, the regulatory community, and the legal profession can do to ready them?II. WHY COURTS ARE IMPORTANTWhy are courts relevant to discussions about financial market systemic risk? Well, for a start, courts are potential allies of regulators in the battle to safeguard our financial markets from systemic risk. Courts in the United States and elsewhere have 'fleshed out' securities regulation in the past, thereby promoting legal certainty and, as a result, contributed to market stability. That is why, as law students and young lawyers, although we were taught black letter law and we read regulations, we spent a lot more time reading and studying cases. When addressing questions such as, "How much due diligence should I do in connection with this IPO?", we looked to the cases: in one such case we read what one lawyer did (poor young Stanton) - and it wasn't enough; while another told the story of a lawyer who did do enough. The cases showed the way to the 'safe harbors' into which to sail, gave examples of 'shipwrecks' as a warning along the way, and, most importantly, related the principles of law and regulation to real world facts. The facts will change, and the facts are always important.Intelligently interpreting financial market regulations in light of new facts will continue to be important. Judges who understand finance can do this. …