Quoth the Raven: The Maryland Law Faculty Blog

US News Rankings

Robert J. Rhee

Paul Caron's TaxProfBlog notes that a special committee of the ABA issued a report on the U.S. News & World Report law school ranking system. The report is only 4 pages, but there is a 61 appendix of supporting materials. The report cites three, well known adverse effects of the rankings: (1) the rankings increase the cost of legal education, (2) they decrease the incentive to award financial aid based on need, (3) they decrease the incentive to enhance diversity.  

The report concludes with a resignation and a warning: "We believe that, for better or worse, U.S. News rankings will continue for the foreseeable future to dominate public perceptions of how law schools compare, and that there is relatively little that leaders in legal education can do to change that in the short term. . . . [O]nce a single rankings system comes to dominate a particular field, it is very difficult to displace, difficult to change, and dangerous to underestimate the importance of its methodology to any school or firm that operates in that field."

Korean Legal Education

Robert J. Rhee

Korean legal education is undergoing a grand experiment. It is transitioning from an undergraduate school program to a US-style graduate school model. This change has been mandated by the Korean government. From what I have told here at Korea University, the government was concerned that there was a disparity in the level of sophistication and technical expertise between Korean and Western trained (mostly American) lawyers. I had also speculated that global competitiveness might have been a reason for the conversion, and it was nice to confirm that my speculation has some merit at least. Apparently, graduate school model is seen as a way to close this gap.

I think a graduate school model makes much sense, but not for the apparent primary reason motivating the Korean government. In a graduate school program, law students are older, have some more life experience, and have prior training in some other field of undergraduate study. These factors contribute greatly to the learning environment, capacity, and maturity. There is greater contextualization of the law and an appreciation of the practical aspects of "Law & ___". Moreover, a liberal arts based undergraduate education will develop critical and analytic skills, the raw stuff of good lawyering. My view is that the end product of a graduate school model is a better trained, better thinking lawyer.

Thoughts on Bilski (Part 2): Scalia's Turn

Robert J. Rhee

A word of caution: I am still not an IP scholar. In Bilski v. Kappos, the Supreme Court unanimously concluded that Bilski’s technique for hedging risk was not patentable because it was an abstract idea. The Court also unanimously opined that the “machine-or-transformation” test is not the exclusive test for what constitutes a patentable “process,” though there may be differences of opinion on how much deference the test should be given. The split in the opinions concerns whether business methods are patentable.

Kennedy’s majority opinion in section II.C.1 (joined by Roberts, Alito, Scalia, and Thomas) holds that the Patent Act “leave[s] open the possibility of some business method patents, [though] it does not suggest broad patentability of such claimed inventions.” Stevens’ concurring opinion (joined by Breyer, Ginsburg, and Sotomayor) suggests that the business methods cannot be patented at all. Scalia also joined section II of Breyer’s separate concurrence, which summarizes the points of agreement between the two opinions, but he notably did not join section I of Breyer’s concurrence, a two paragraph section written specifically to emphasize Breyer’s opinion that “[t]his Court has never before held that so-called ‘business methods’ are patentable, and, in my view, the text, history, and purposes of the Patent Act make clear that they are not.” Scalia believes that business methods are patentable, at least in the abstract (he may not have a firm idea what sort of a business method, if any, is patentable—nor it seems do Kennedy, Roberts, Alito and Thomas—but he is holding on to the abstract idea of some possibility). Notably, Scalia did not join Kennedy’s plurality ruminations in section II.C.2 on what the legal standard might be. Scalia seems willing to wait for the right case to come along. Thus, the next big case on the patentability of a business method may swing on the opinions of Scalia, though a Kagan confirmation may change the dynamic.

Thoughts on Bilski (Part 1): Financial Instruments

Robert J. Rhee

A word of caution before reading further: I am not an IP scholar (nor do I play one on TV or in academic conferences). I am interested in Bilski v. Kappos because it concerns the patentability of a financial technique to hedge risk in the volatile energy market. The Supreme Court unanimously ruled that Bilski’s method was not a patentable “process” under Section 101 of the Patent Act because it was an abstract idea. Indeed, twenty out of twenty-one judges on the Supreme Court and the Federal Circuit agreed that the hedging technique at issue was not patentable. The courts clearly answered the legal question, but there remains a financial question: Is Bilski even relevant in sophisticated trading and the capital markets?

Given the nature of the claim for patent, it is interesting that this case has not garnered much interest from Wall Street. A cursory review of the many amicus briefs filed in the case shows only one brief clearly identified with Wall Street (a brief filed by Bank of America, Barclays Capital, Morgan Stanley, and the Financial Services Roundtable, among others). This brief argued against Bilski and the proposition that financial instruments and processes were patentable. The Supreme Court was right to reject the patentability of the hedging technique in question. Can we imagine the halt to innovation if someone had patented the ideas of “stock” or “bond” or “derivative”? Or, any specific financial instrument or process derived from these ideas?

Bad idea or not, if there is money to be made, investment banks will be interested. There is money in a monopoly. Or is there? In a liquid, efficient capital market where investment banks operate, the profit opportunity from a monopoly would be largely illusory because for all practical purpose there is infinite substitutability of financial instruments and means for the purpose of eliminating firm specific risk through diversification. That is, the demand curve of a particular financial instrument is effectively horizontal. Since the idea of achieving a particular end of a particular transaction, say hedging weather risk, obviously cannot be patented, a business method to achieve that specific end, a particular combination of cash flow and risk profile, can be synthetically replicated through other means with substitutes. This substitutability precludes pure arbitrage if the difference in transaction cost of execution are not substantial, which would probably be the case in a liquid capital market. Add to this, then, the transaction cost of patenting, litigation cost, and rent-seeking behavior, and the incorporation of new legal risk into all non-patented financial instrument, which must significantly diminish the aggregate value of these instruments. The cost-benefit for the financial industry and the stifling of innovation do not work in favor of patentability of financial instruments and processes.

AIG Bailout and Counterparty Risk

Robert J. Rhee

One of the most disturbing aspects of the financial industry bailout was the AIG bailout. Controversy ensued when news broke that counterparties to AIG in derivative transactions were receiving a large portion of the historic bailout through full payment on their contracts. A bailout may have been the least worst choice at the time, but many people, including me, asked why these counterparties (Wall Street firms) were not taking a discount on their contracts, i.e., share the pain with everyone else. (My March 2009 opinion editorial in the National Law Journal is available at http://www.law.com/jsp/nlj/PubArticleNLJ.jsp?id=1202429172527). The point was obvious to the public: "One needn't have the acumen of a Goldman Sachs chief executive officer or a Treasury secretary to know that the capital provider of a distressed firm has enormous bargaining leverage. Contracts can be torn up and obligations restructured. . . . Did the government coerce valuational concessions from AIG's creditors and executives before committing to the bailout?" The New York Times reports today that the government's failure to coerce concessions from AIG's creditors was not due to negligence, but was an intentional policy decision. See http://www.nytimes.com/2010/06/30/business/30aig.html?hp=&pagewanted=all. The NYT reports: "The documents also indicate that regulators ignored recommendations from their own advisers to force the banks to accept losses on their A.I.G. deals and instead paid the banks in full for the contracts. That decision, say critics of the A.I.G. bailout, has cost taxpayers billions of extra dollars in payments to the banks." Additionally, the government coerced AIG to waive potential legal rights against the counterparties. Since the US government is the largest investor in AIG, this forced concession from AIG further benefited the counterparties at the expense of taypayers.

One way to understand the AIG bailout is a bailout of AIG. As I have suggested before, a better view is this: "The AIG bailout is a wealth transfer scheme in the guise of a public investment in a supposedly going concern." Because AIG was so deeply interconnected through its derivatives transaction, it served as a conduit to pump public funds directly into Wall Street firms without taking further equity stakes in these firms through TARP, politically convenient perhaps. Of course, this explanation still does not answer the question why the government did not require these firms to share the pain.

"Are these counterparties being bailed out because, in Fitzgeraldian terms, they are different from you and me?" Just this month, the Congressional Oversight Panel released the report, The AIG Rescue, Its Impact on Markets, and the Government's Exit Strategy, report available at http://cop.senate.gov/documents/cop-061010-report.pdf. This report provides the government's account: "Secretary Geithner later testified that he believed that payment in full to all AIG counterparties was necessary to stop a panic. In short, the government chose not to exercise its substantial negotiating leverage to protect taxpayers or to maintain basic market discipline." But the congressional report goes on to conclude: "But if the effort had succeeded, the impact on market confidence would have been extraordinary, and the savings to taxpayers would have been immense. Asking for shared sacrifice among AIG‟s counterparties might also have provoked substantial opposition from Wall Street. Nonetheless, more aggressive efforts to protect taxpayers and to maintain market discipline, even if such efforts had failed, might have increased the government‟s credibility and persuaded the public that the extraordinary actions that followed were undertaken to protect them."

Lastly, in light of the obvious giveaway, many people, including me, asked at the controversey whether anyone seriously thought the government will recoup its full investment, let alone a decent return on taxpayer funds. We now have some answers. The June 2010 Congressional Oversight Panel's report concludes: "Even at this late stage, it remains unclear whether taxpayers will ever be repaid in full." The current Congressionl Budget Office estimate of the government's loss on the AIG bailout is $36 billion. It is now clear that much of this loss was avoidable.

Teaching BP

Robert J. Rhee

There are many teaching aspects to the BP disaster. The most obvious are lessons in environmental and tort laws. There are lessons in corporate law as well. As corporate entities, BP and its subsidiaries have limited liability. In addition to this standard subsidy for the shareholders of corporations in general, the oil industry has additional limited liability through a statutory cap on liability for an oil spill, though this cap does not apply if there has been gross negligence, willful misconduct, or violations of regulations. The economics of risk externalization would make for a nice class discussion in the torts or environmental law class. Another perspective is that the political process can contract the standard rule of limited liability, which was made clear by BP’s announcement of a $20 billion compensation fund. Thus, the default standard of limited liability is not only affected by the judicial doctrine of veil piercing, but also by the variable outcome of a political dialogue on the liability of an industry or a specific company.  This leads to a broader point.

BP, Fishermen, and Pure Economic Loss

Robert J. Rhee

Those who suffered personal injuries or incurred property damage have viable tort claims against BP. These private claims alone will be substantial, perhaps into the billions of dollars outside of cleanup costs for public lands and waters. But these private claims for physical loss represent only a portion of the economic harm. The true economic cost will surely be multiples of the legal claims ultimately paid. For example, hotels, restaurants, bars, and recreational companies will lose substantial tourism profit even though they may suffer no physical loss. Their claims for pure economic loss are not recognized in torts. This rule of preclusion has a long pedigree in Anglo-American common law. A defendant has no duty to protect against pure economic loss, and this rule was firmly established in America by Holmes in Robins Dry Dock & Repair Co. v. Flint, 275 U.S. 303 (1927). See also Cattle v. Stockton Waterworks Co., 10 Q.B. 453 (1875).

But a curious exception to the general rule exists for those who subsist from the bounty of the sea. Fishermen do not own the marine fauna in the commons until the catch is hauled into the ship, but they have economic interests in the future catch. Courts across many jurisdictions routinely recognize this interest in lost profit. See, e.g., Union Oil Co. v. Oppen, 501 F.2d 558 (9th Cir. 1974). The claims of fishermen are not small amounts either. In the Exxon Valdez case, the jury awarded them $287 million, much of this attributable to the prospective catch of fishermen. For further thoughts on the pure economic loss doctrine and its underlying theory, see Robert J. Rhee, A Production Theory of Pure Economic Loss, 104 Nw. U. L. Rev. (forthcoming 2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1344503. So much for shameless self-promotion . . . Let’s continue.