The Financial Turmoil and Judicial Responsibility (Part 2)

We are discussing the problem of a federal court system hostile towards regulation, something that Barack Obama will have to confront during his first term.  (According to one report, he will get enough appointments in his first term to "create a Democratic majority in eight circuits, leaving three with a Republican majority and the remaining two evenly split.").

The problem starts at the top.  The conservative Supreme Court has certainly issued some decisions that are antagonistic to shareholders and investors.  Stoneridge comes to mind.  There the Supreme Court basically announced that the controlling principle for future antifraud decisions would be "no expansion."  One of the reasons given by Justice Kennedy?  Bad for business.  "Overseas firms with no other exposure to our securities laws could be deterred from doing business here. . . This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from the domestic capital markets."

But the problem goes much deeper into the judiciary.  Much of his problem may come from the DC Circuit.  It is the DC Circuit that is considered perhaps the most important federal court other than the Supreme Court.  Moreover, in the realm of government regulation, it hears by far the largest number of cases that challenge administrative policy.  Nominees to the Supreme Court often come from the DC Circuit.  Scalia, Ginsburg and Roberts are the current examples.  Judges on the circuit, therefore, have an incentive to adhere to an ideological approach that is likely to bring them to the attention of the doyens in the Administration deciding on nominees to the Supreme Court.  The website for the Circuit lists 13 judges.  The membership consists largely of Republican appointees, with only four appointed by democrat presidents (Edwards, who is now senior, Rogers, Tatel, and Garland).  For the Obama Administration, it will be an unsympathetic court.

With that in mind, we turn to the court's responsibility for the current conflagration in the financial markets.  For that, we return to hedge funds.

Since mutual funds are likewise pooled investment vehicles, the critical component of the definition is private organization and unavailability to the public.  The non-public nature of the funds occurs because they need not register as investment companies with the SEC.  They avoid registration by keeping the number of investors to below 100 persons Investment Company Act of 1940, Section 3(c)(1)) or offering participation only to purchasers that own $5 million in assets (Section 2 (a)(51)(A)). Without registration, hedge funds operate with little or no regulatory oversight (the antifraud provisions an exception) and provide little or no public information about their activities.

Given the growing role of hedge funds in the financial markets, the absence of transparency is troubling. This is one of those issues where the staff at the SEC was out front. In 2003, the staff published a report on the funds. Implications of the Growth of Hedge Funds, Staff Report the United States Securities and Exchange Commission (September 2003). The report noted many of the problems that arise from the lack of transparency and recommended that the funds be required to register with the Commission. The Commission acted and subjected funds to registration and inspection. See 17 C.F.R. § 275.203. The Rule was opposed by the deregulatory faction on the Commission, Commissioners Atkins and Glassman.  See Investment Advisors Act Release No. 2333 (Dec. 10, 2004).

What the deregulators could not do at the Commission, the DC Circuit did at the appellate level.  In  Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), a panel consisting of a majority of Republican appointees struck down the modest rule.  The result was that as the financial crisis unfurled during the second half of 2008, regulators had almost no information about hedge funds and their activities.  While it is hard to pinpoint the role of hedge funds in the current crisis, it is beyond peradventure that the crisis started with the collapse of two funds run by Bear Stearns.  Moreover, their often highly levereged nature potentially imposes additional systemic risks to the financial system, although without disclosure, assessing the degree of risk is "virtually impossible."

While there may be a political consensus that favors a more activist government in the context of the current economic turmoil, the same consensus probably does not exist in the courts.  It is this interest group that may take the longest to shift.