24AnnRevBankingFinL375

Citation: 24 Ann. Rev. Banking & Fin. L. 375 2005

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DISPARATE REGULATORY SCHEMES FOR PARALLELACTIVITIES: SECURITIES REGULATION, DERIVATIVES

REGULATION, GAMBLING, AND INSURANCE

THOMAS LEE HAZEN*

Although bearing striking similarities to each other in many re-spects, securities investments, non-securities derivative investments,insurance and gambling are subject to different regulatory regimes andvastly different levels of government interference. Traditionally,stringent prohibitions characterize the insurance and gambling indus-tries, whereas regulation of investments in securities and derivativesoccurs primarily through disclosure requirements. 1 As between securi-ties and non-securities regulation, there is also striking contrast in thecurrent approaches being taken. If, however, these four activities areso similar in nature, does a rational basis exist for their widely differingregulatory schemes? If no rational basis can be found how do weidentify whether the current deregulation trend moving through thederivatives markets is a sensible change when regulation in thesecurities market is increasing? This article ultimately questions theabsence of a consistent approach in regulating securities, non-securitiesderivatives, insurance and gambling. Additionally, the article questionswhether deregulation of the derivatives market is a prudent maneuverin light of its similarities with more heavily regulated activities.

Part II provides an overview of the current regulatory scheme forsecurities and derivatives, including the deregulatory effects of theCommodities Futures Modernization Act of 2000. Part III looks at thepractice of gambling and the traditional moral concerns underlyingits stiffer regulatory regime. Part III also begins to explore behavioralmodels which might fairly apply to both investments and gambling,and which therefore cut in favor of increasingly homogeneous regula-tory treatment. Part IV examines regulation of the insurance industry,its underlying rationale, and its similarities to investment and gambling

* Cary C. Boshamer Distinguished Professor of Law, the University of North Caro-lina at Chapel Hill; B.A. 1969, J.D. 1972, Columbia University.

1 Although disclosure requirements can have an impact on the way activities areconduct, disclosure is a less invasive regulatory approach that imposing outrightprohibitions on targeted activities.

HeinOnline -- 24 Ann. Rev. Banking & Fin. L. 375 2005

376 ANNUAL REVIEW OF BANKING & FINANCIAL LAW [Vol. 24: 375

activities. After establishing the particularly strong similarities be-tween insurance and derivatives, Part IV further suggests how certainaspects of insurance regulation might play out in the context ofderivatives. Part V revisits the general trend of deregulation in thesecurities, derivatives, and (to a lesser degree) gambling industries inlight of the consistently demanding insurance regime and asks whetherderegulation is a wise course of action. Part VI concludes and offerssuggestions for further consideration of these issues.

I. BackgroundA. Illustrative AnalogiesB. Recent Scandals and Current Regulatory Climate

1I. Current Regulatory StructuresA. The Regulatory Structure of the Securities Markets - An

OverviewB. Regulation of the Derivatives MarketsC. Comparing Securities and Derivatives with Gambling

Ill. Regulatory Comparisons and SolutionsA. Theories of RegulationB. Explaining Investor Behavior in the Securities and Other Invest-

ment MarketsC. Rational Investing or Gambling?: Consequences of Regulating

Markets with a Gambling Perspective

D. Micro-regulatory IssuesIV. Insurance

A. Securities and Derivative Investments as InsuranceB. Managing Insurance RisksC. Substantive Control of Insurance - The Gate-keeping Function

of the Insurable Interest RequirementD. Regulating Solvency of Insurers and Investment Market Partici-

pants: Margin Requirements as an Alternative Means ofRegulation

V. Comparing Alternative Regulatory SchemesA. Insurance Regulation Compared

B. Hedging Versus Speculation: If It Walks Like a Duck . .

VI. Conclusion: Reconciling Divergent Regulatory Trends in the Securitiesand Non-securities Investment Markets


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcTIvrrIES 377

I. Background

Securities investing, derivatives transactions, insurance, and gam-bling are all activities designed in one way or another to reap economicbenefits. There are many similarities between gambling and the oftenperceived legitimate investment, hedging, and insurance transactions.One thing that investing, hedging, insurance, and gambling have incommon is that they all involve risk-taking, while only the first threeactiviites are generally seen as involving risk-shifting or other legiti-mate economic benefits. However, social norms create differentperceptions about these activities. Investing is generally consideredto be a productive activity because it allows businesses to raise capitalwhich in turn will increase productivity and benefit society. Investingalso offers the possibility of wealth building for those who invest.Derivatives transactions not only offer investment opportunities (oftenthought of as a speculation) but also, like insurance, provide anopportunity for risk-shifting. People and businesses who have exposureto risk can either hedge against that risk with a derivatives contractor seek insurance against losses that could occur if the contingenciescreated by the risk materialize.

In contrast to investing, hedging, and insurance, gambling is notgenerally viewed as a productive activity or one that provides anybenefit to society beyond its entertainment value. However, this"benefit" is generally seen as outweighed by the social costs ofgambling as well as moral objections to wagers and other gamblingactivities. Over time and in various respects, investing, hedging, andinsurance have been compared with gambling and, to varying degrees,social distaste for gambling has been used as a rationale for regulationof these other activities.

Regardless of any similarities, traditionally the law has been muchharsher on transactions that are characterized as gambling. Onepossible explanation for the difference in treatment results fromfocusing not so much on the substantive transactions, but on the partiesand their respective motives. Gambling laws have traditionally hadbarriers to entry; although those barriers are dwindling as legalizationincreases. Insurance law imposes some comparable barriers throughits insurable interest requirement. However, although some investmentopportunities may be limited to sophisticated investors, 2 there are no

2 For example, section 2(a)(15) of the Securities Act of 1933 contains a definitionof "accredited investor" so as to qualify for exemptions from some of the act'sdisclosure requirements. 15 U.S.C. §§ 77b(a)(15), 77d(6) (2000). Also, over-the-counter derivatives transactions are subject to less regulation than the exchanges.


ANNUAL REVIEW OF BANKING & FINANCIAL LAW [Vol. 24: 375

comparable barriers to the investment markets - thereby allowingaccess to "legalized gambling" for all. Furthermore, the sophisticationand wealth barriers to some investments do not protect againstspeculating and gambling; they simply foreclose opportunities to otherinvestors.

This article focuses in particular on both gambling and insuranceas two activities that are regulated and also are closely aligned to atleast certain segments of the investment markets. More generally, thisarticle explores the parallels among securities investments, derivativesand commodities investments, gambling, and insurance to probewhether there is too much focus on disclosure or whether disclosureas the primary means of securities market regulation should besupplemented by the approach taken with respect to those otheractivities.

A. Illustrative Analogies

The similarities of the activities discussed in this article may beexplained by way of examples. Consider two inveterate gamblers whomake a wager on whether it will rain the next day - a wager thatwould be illegal under the law in all states. Compare this "wager"with a farmer who is concerned about a predicted drought and seeksto protect her economic position. Realistically, in today's environmentthe farmer has several alternatives. She could hedge her crops in theground by entering into a crop futures contract. This arrangement isa legal futures contract and will be enforced. Alternatively, she hasthe opportunity to make the hedge specifically against damage dueto drought and enter into a derivatives contract based on the weather.This more closely resembles the illegal weather wager, but would bea legitimate (and hence enforceable) derivatives contract. That samefarmer might also seek crop insurance or more specifically droughtinsurance. In all of the above situations, including the wager, one partyis allocating to the other the risk of a drought. Yet the wager is illegal,whereas the derivatives contracts and insurance are legitimate com-mercial transactions.

Gambles and wagers are not the only examples of contracts thathave been outlawed because of their perceived moral repugnancy. In2003, there was a short-lived plan at the Pentagon to create a marketin futures contracts to with respect to future terror attacks. 3 Once the

3 See, e.g., Daniel Kadlec, Terrorism Futures: Good Concept, Bad P.R., TIME MAG-AZINE, Aug. 11, 2003, at 18. The idea behind the proposal was that, since markets


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL ACTIVITIES 379

controversial proposal came to light, it was quickly quashed. 4 Wasthe opposition to the proposed terrorism futures market a rationalresponse to a bad idea? Was it the result of moral outrage? Was itsimply the reaction to a politically incorrect idea? What was it aboutthe proposed terrorism futures that the public found so horrific? Someobservers suggested that a market for terrorism futures would allowpeople to profit from sharing information about future attacks that theyshould share simply as a matter of good citizenship.5 There also isthe visceral reaction that an investor should not be able to profit fromsomeone else's misery. However, we generally do not look at aninvestor's motives in determining whether a particular transaction islegal. When put in perspective, how different is a terrorism future fromtaking out insurance against acts of war? An investor who stands togain from a terror attack may simply be hedging against losses thatwould result from such an attack. Investors have always been ableto take investment positions in order to "bet" in favor of disaster.Defense industry stocks and gold traditionally have been among thehavens for investors desiring economic protection against the ill-effects of war or terrorism. Although the proposed terrorism futuresmarket may well have been ill-conceived, the proposal and the publicreaction provides illustrate how lawmakers will declare certain typesof contracts impermissible (or subject them to a significant regulation).In contrast, transactions trying to shift comparable risks are permissibleor subject to less stringent regulation. These comparisons can provideinsight on to how to evaluate existing regulatory schemes. How do

help filter information, a market in terrorism futures could provide the Pentagon withhelp in predicting and then thwarting attacks. See Jeff Brown, Was Terrorist FuturesMarket Really Such a Terrible Scheme?, THE PHILADELPHIA INQUIRER, July 31, 2003,at On Personal Finance Col. 1; Justin Wolfers & Eric Zitzewitz, The Furor Over'Terrorism Futures,' THE WASHINGTON POST, July 31, 2003, at A19.

4 For example, the originator of the controversial idea resigned his research postwith the Defense Department in the face of the huge public opposition to terrorismfutures even as a hypothetical model. See David Voss, from Sputnik to. . . Radar?Much-Maligned Defense Research Agency Has Long Been the Pentagon's FantasyShop, BOSTON GLOBE, Aug. 12, 2003, at DI.

5 See, e.g., D.J. Tice, 'Terror Market' Debate Exposed Roots of Many EconomicDisagreements, ST. PAUL PIONEER PRESS, Aug. 6, 2003, at 10A ("A terrorism marketwould inspire people to do out of a selfish desire for gain what they should havedone out of moral decency - to tell what they know. And of course that's just theproblem. The motives of terrorism 'investors' would be simply too barbarous to betolerated, and too repulsive to be used, even for the best of purposes. No result,however, beneficial, is worth the moral debasement in rewarding such motives -or at least that's what the politicians quickly decided.").



policymakers decide which markets to regulate and what level ofregulation is appropriate?

B. Recent Scandals and Current Regulatory Climate

For a number of years, questions have been raised as to the properapproach to regulation of the investment markets in the United States.This inquiry has addressed the extent of regulation, the basic premisesof regulation, and whether to regulate at all. A number of recent eventsspurred new regulation and also heated the debate between protection-ists calling for more regulation and free market advocates arguingagainst regulatory responses. There were a number of spectacularfrauds that came to light at the turn of the twenty-first century,including those involving Enron, Tyco and Worldcom. 6 These fraudswere perceived by many observers as the result of greed which wentunchecked by regulators and emboldened some corporate executivesto engage in conduct that violated existing laws. It has properly beensuggested that we can and should regulate greed when it gets out ofhand. Although capitalism is to a large extent premised on rewardingself interest, excess is not a necessary component of an efficientmarket. 7 Notwithstanding the fact that the existing securities laws weresufficient to pursue executives of Enron, Tyco, and Worldcom,Congress was of the view that additional regulation was necessary.

The well-documented frauds referred to above were only oneimpetus for increased securities regulation. When the stock marketbubble, fueled primarily by dot-com stocks, burst at the end of thetwentieth century, 8 a number of other bad practices came to light -

6 See, e.g., BRIAN CRUVER, ANATOMY OF GREED: THE UNSHREDDED TRUTH FROM

AN ENRON INSIDER (2002) (discussing Enron); Robert W. Hamilton, The Crisis inCorporate Governance, 40 Hous. L. REV. 1 (2003) (discussing among other thingsthe governance failures of Tyco, Global Crossing, and Qwest); Robert Prentice, Enron:A Brief Behavioral Autopsy, 40 AM. Bus. L.J. 417 (2003) (describing events at Enron).See also, e.g., William W. Bratton, Does Corporate Law Protect the Interests ofShareholders and Other Stakeholders?: Enron and the Dark Side of ShareholderValue, 76 TUL. L. REV. 1275 (2002) (same); Jeffrey N. Gordon, What Enron Meansfor the Management and Control of the Modem Business Corporation: Some InitialReflections, 69 U. CHI. L. REV. 1233 (2002) (discussing the implications of Enron).

7 Eric A. Posner, The Jurisprudence of Greed, 151 U. PA. L. REV. 1097, 1132 (2003)("Capitalism needs moderation, not excess; far-sightedness, not cunning; self-interest,not greed").

8 James D. Cox, Reforming the Culture of Financial Reporting: The PCAOB and

the Metrics for Accounting Measurements, 81 WASH. U. L.Q. 301 (2003) ("Thefinancial bubble that burst in 2000 began a meltdown of stock prices that ultimatelyremoved an estimated $8.5 trillion from the Nasdaq market alone.").



including improprieties involving public offerings. 9 Examples of theseunderhanded practices included improper allocation of hot offeringsand "laddering," or pre-selling the after market, whereby purchaserswere asked to commit to purchasing additional securities in theaftermarket in order to get in on a hot IPO. 1o Generating this additionaldemand for stock in the aftermarket helped push the post offering pricesignificantly above the price at which the securities were offered tothe public. Other scandals included conflicts of interests that compro-mised securities analysts' supposedly disinterested unbiased recom-mendations. 1' These are just some of the events that led to heightenedconcern over the adequacy of the then existing regulation of thesecurities markets and that prompted Congress to increase securitiesregulation. 12

Congress' response to the corporate governance scandals wasembodied in the Sarbanes-Oxley Act of 2002 ("Sarbanes-OxleyAct")13 which called for increased levels of corporate disclosure. The

9 In fact, the NASD adopted new rules to define improper IPO practices. See Self-Regulatory Organizations, Exchange Act Release No. 34-48701, 81 SEC Docket 1323(Oct. 24, 2003); News Release, NASD, NASD Board Approves Proposed ConductRules for IPO Activities (July 28, 2002), available at www.nasd.comlweb/idcplg?ldcService = SSGET_PAGE&ssDocName = NASDW_002921 &ssSourceNodeld = 555.

10 See Self-Regulatory Organizations, Exchange Act Release No. 34-50896, 69 Fed.Reg. 77804 (proposed Dec. 20, 2004); NASD Board Approves Proposed ConductRules for IPO Activities, supra note 9.

11 Among other measures, the SEC adopted a requirement that securities analystscertify their independence. Regulation Analyst Certification, Exchange Act ReleaseNo. 34-47384,68 Fed. Reg. 9482 (Feb. 27, 2003) (codified at 17 C.F.R. §§ 242.500-242.505). See Self-Regulatory Organizations, Release No. 34-45526, 67 Fed. Reg.11,526 (proposed Mar. 8, 2002); News Release, NASD, NASD Announces New RulesGoverning Recommendations Made by Research Analysts, (Feb. 7, 2002),www.nasdr.com/news/pr2002/release 02_009.html. See also, e.g., Self Regulatory Or-ganizations, Exchange Act Release No. 34-45526, 77 SEC Docket 196 (Mar. 8, 2002).

12 See, e.g., Larry E. Ribstein, Bubble Laws, 40 Hous. L. REV. 77 (2003) (question-ing whether the regulatory response is an overreaction to bubbles). See also, e.g.,Jeffrey N. Gordon, Governance Failures of the Enron Board and the New InformationOrder of Sarbanes-Oxley, 35 CONN. L. REV. 1125, 1126 (2003) (describing theincreased regulation following the bursting of the bubble as "relatively mild").

13 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified inscattered sections of 11, 15, 18, 28, and 29 U.S.C.); Brian Kim, Sarbanes-Oxley Act,40 HARV. J. ON LEGis. 235 (2003); Corporate Law - Congress Passes Corporateand Accounting Fraud Legislation. - Sarbanes-Oxley Act of 2002, 116 HARV. L.REV. 728 (2002). See also, e.g., Larry E. Ribstein, Market vs. Regulatory Responsesto Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002, 28 J. CORP. L.i (2002) (criticizing the Sarbanes-Oxley Act).



increased disclosure requirements and regulations imposed on publiccompanies highlight the continuing debate as to the efficacy ofdisclosure in securities regulation and, more generally, the approachto regulating investment markets. The increased regulation of thesecurities markets in the wake of the late 1990's corporate governancescandals, led by the Sarbanes-Oxley Act, stands in sharp contrast tothe massive deregulation of the commodities and non-securitiesderivatives1 4 markets that was ushered in by the Commodity FuturesModernization Act of 2000. 15 This divergence in recent regulatorydevelopments presents a propitious time to examine the whether thereis a rational basis for such disparate regulatory approaches to thesecurities and derivatives markets. A brief examination of the existingregulatory structure of the securities and derivatives markets and thegambling industry will lay the foundation for comparison.

II. Current Regulatory Structures

A. The Regulatory Structure of the Securities Markets -

An Overview

The first federal securities law was enacted in 1933, in the wakeof the stock market crash of 1929, when this country was well intothe Great Depression, and twenty-two years after the first comprehen-sive state legislation.' 6 The Securities Act of 1933 ("1933 Act"), hasbeen characterized as the first true consumer protection law1 7 and wasoften referred to as the "Truth in Securities" law. 's Congress debatedbut rejected a merit approach to regulation that would examine thesubstance of the investment product being offered and sold. 19 Instead,

14 Derivatives have been defined as any "financial arrangement whose returns arelinked to, or derived from, changes in the value of stocks, bonds, commodities,currencies, interest rates, stock indexes or other assets." Saul S. Cohen, Tile Challengeof Derivatives, 63 FORDHAM L. REV. 1993, 2000 (1995).

15 Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, 114 Stat.2763 (codified as amended at 7 U.S.C. §§ 1-27f).

16 Securities Act of 1933, ch. 38, 48 Stat. 74 (codified as amended at 15 U.S.C.

§§ 77a-77aa).17 See 1 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION

§ 1.2131 (5th ed. 2005). In fact, in signing the bill into law, President FranklinRoosevelt observed that the nation was moving from a period of caveat emptor intoone of caveat vendor.

18 See Milton H. Cohen, "Truth in Securities" Revisited, 79 HARV. L. REV. 1340

(1966).19 Merit regulation is a regulatory system under which a securities administrator


20051 DISPARATE REGULATORY SCHEMES FOR PARALLEL ACTIVITIES 383

the 1933 Act was premised solely on a system mandating full andfair disclosure to investors, under the guidance of a federal agency,as a mechanism for permitting informed investment decisions. Disclo-sure rather than a merit approach remains the regulatory philosophyof the federal securities laws today.

The focus of disclosure was based on the determination that"sunlight is the best disinfectant." 20 However, it is evident thatdisclosure has not been completely effective in eradicating securitiesfraud and the debate continues as to the wisdom of a disclosureapproach. Some argue that the current disclosure system overregu-lates, 2 ' while others have suggested that it does not go far enough.22For example, it has been suggested that disclosure does not giveadequate attention to investor education 23 to help rid investors of what

has the power to evaluate the merits of an investment before allowing it to be sold.See generally Report on State Merit Regulation of Securities Offerings, 41 Bus.Law.785 (1986). See also Roberta S. Karmel, Blue Sky Merit Regulation: Benefit toInvestors or Burden on Commerce?, 53 Brooklyn L.Rev. 105 (1987); Manning G.Warren III, Legitimacy in the Securities Industry: The Role of Merit Regulation, 53Brooklyn L.Rev. 129 (1987). The laws regulating insurance traditionally have takena merit approach, including requiring regulatory approval of the terms of insurancepolicies. Likewise, state laws regulating securities, most of which predated the federallegislation, imposed a merit approach to regulation. See 1 HAZEN supra note 17, at§§ 1.2, 8.1.

2 0 This is the oft-cited phrase of Louis D. Brandeis. Louis D. BRANDEIS, OTHER

PEOPLE'S MONEY ch. 5 (1914) ("Sunlight is said to be the best of disinfectants; electriclight the most efficient policeman."). Felix Frankfurter, one of the most influentialvoices in the drafting of the securities laws,is said to have been influenced by Brandeis.Cynthia A. Williams, The Securities and Exchange Commission and Corporate SocialTransparency, 112 HARV. L. REV. 1197, 1221-22 (1999); Felix Frankfurter, TheFederal Securities Act: I1, FORTUNE, Aug. 1933, at 53; see JOEL SELIGMAN, THE

TRANSFORMATION OF WALL STREET 71 (1982).21 E.g., Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the

Protection of Investors, 70 VA. L. REV. 669 (1984).22 For additional insight as to the role of the regulatory structure, see, for example,

Robert B. Ahdiehl, Making Markets: Network Effects and the Role of Law in TheCreation of Strong Securities Markets, 76 S. CAL. L. REV. 277 (2003).

23 See Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56STAN. L. REV. 1, 22 (2003) ("For behavioralists, the single-minded focus of the SECon disclosure presents a puzzle. We doubt that disclosure is the optimal regulatorystrategy if most investors suffer from cognitive biases. Disclosure may be ineffectivein educating investors who suffer from biases in decisionmaking."). See also, e.g.,Stephen J. Choi, Regulating Investors Not Issuers: A Market-Based Proposal, 88 CAL.

L. REV. 279 (2000); Donald C. Langevoort, Ego, Human Behavior, and Law, 81 VA.L. REV. 853, 880 (1995) ("[Wle can readily see why the law's prized warnings anddisclosure will so often have relatively little practical effect, especially if they are



many identify as irrational behavior. 24 It has also been suggested thatwe should consider information overload when evaluating the extentof the disclosure approach. 25

Investor education and merit regulation are not the only alternativesfor providing heightened regulation of the securities and other invest-ment markets. For example, one question to be considered is whetherincreased criminalization would help fill the regulatory void createdby the focus on disclosure. The criminal enforcement weapon isespecially applicable when we recognize that many market participantsare gamblers and many of the securities fraudsters seem to engagein behavior quite similar to those who profit from illegal gamblingactivities. The Sarbanes-Oxley Act included increased criminal penal-ties as an important part of its reforms. 26 In the first instance, theSarbanes-Oxley Act provides heightened criminal penalties for securi-ties law violations;2 7 it also imposes a requirement that CEOs andCFOs of publicly held companies personally certify their company'sfinancial statement with criminal consequences for false certifica-tions. 28 It remains to be seen whether this increased criminalizationwill be effective in promoting more accurate, timely public disclosures.

The disclosure approach is used to regulate various segments of thesecurities markets. 29 In addition to regulation of the markets

formalized into boilerplate. Investors and consumers want to think the warnings aremeant for someone else, not them.").

24 "Investors suffering from an overconfidence bias, for example, may ignore thewarning signs from disclosure. Similarly, it is unclear how disclosure can overcomethe cognitive dissonance of people who have made a poor investment choice in thepast. Investors with intractable loss aversion will continue holding a losing positionin hopes of reversing their losses without regard to disclosure. And what disclosurewill help them avoid ratifying their poor investment choices as 'good' decisions?Finally, investment decisions may be driven in substantial part by the conversationsthat investors have had most recently. Disclosure may do little to influence investmentdecisions based on 'tips' or fads." Choi & Pritchard, supra note 23, at 22 (relyingon Robert J. Shiller & John Pound, Survey Evidence on the Diffusion of Interest andInformation Among Investors, 12 J. ECON. BEHAV. & ORG. 46 (1989)).

2 5 Troy A. Paredes, Blinded by the Light: Information Overload and Its Conse-quences for Securities Regulation, 81 WASH. U. L.Q. 417, 419, 420, 446 (2003).

26 E.g,, Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204. § 906, 116 Stat. 743(codified at 18 U.S.C. § 1350(a)-(b)).

27 Id. §§ 302, 906.

28 Id. § 302; see 2 HAZEN, supra note 17, at § 9.3[2].

29 Part of the discussion that follows is adapted from portions of 1 HAZEN, supranote 17, at §§ 1.1, 1.2[3], 14.3.


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEl. ACTIVITIES 385

themselves, the federal securities laws regulate securities "players" -issuers, purchasers and sellers trading in securities. Securities tradingactivities can be divided into primary and secondary trading.

Initial public offerings (IPOs), frequently referred to as primaryofferings or distributions, are governed primarily by the 1933 Act. 30

This is the way in which corporate capital is raised in the public equitymarkets. The 1933 Act also includes within the concept of securitiesdistributions so-called secondary "distributions." Secondary distribu-tions occur, for example, when an extremely large block of securitieshas been placed in the hands of a private investor, institution, or groupof investors and is subsequently offered by the selling shareholdersto the members of the general public. As is the case with secondarytransactions generally, the proceeds from secondary distributions inureto the benefit of the selling shareholders. In the case of both primaryand secondary distributions, unless an appropriate exemption isapplicable, the 1933 Act requires registration of the issued securities.31

The 1933 Act thus focuses on initial, primary, and secondary distribu-tions of securities, although some selected provisions apply to moreprivate, non-open-market transactions. 32

Whereas the distribution process triggers the 1933 Act requirements,trading on the secondary securities markets is regulated primarily bythe Securities Exchange Act of 1934 ("1934 Act").33 The extent towhich securities are widely held and actively traded provides thejurisdictional trigger for most of the 1934 Act's regulation of publiccompanies and their securities. 34Likewise, registration and periodicreporting by issuers under the 1934 Act depend generally upon the

30 15 U.S.C. § 77a (2000).31 Primary and secondary distributions can occur as separate transactions or can

be "piggy-backed" into one registered offering. It is not uncommon for an offeringto be a combination of a primary and secondary distribution. Cf Moffat v. HarcourtBrace & Co., 892 F.Supp. 1431 (M.D. Fla. 1994) (issuer's delay in applying forregistration did not violate agreement with holder of "piggy back" registration rights).See I HAZEN, supra note 17, at chs. 2-3.

32 For example, section 4(2) of the 1933 Act provides an exemption from registra-tions for transactions that do not involve a public offering. 15 U.S.C. § 77d(2).

33 15 U.S.C. § 78a.34 For example, sections 12 and 13 of the 1934 Act impose registration and report-

ing requirements on issuers of securities that are publicly traded on a securitiesexchange or in the over-the-counter markets. 15 U.S.C. §§ 78j, 78k. An importantexception is found in the general antifraud rule, Rule 10b-5, 17 C.F.R. § 240.10b-5(2004), the reach of which extends to purchases or sales of any securities where thefacilities of interstate commerce are implicated.



degree to which the securities are widely held. 35 Most of the day-to-day trading on both the securities exchanges and over-the-countermarkets consists of "secondary" transactions between investors andinvolve securities that have previously been issued by the corporationor other issuer.3 6 All of the proceeds from these secondary sales, afterapplicable commissions to the securities brokers handling the transac-tion, go to the investors who are parting with their securities. Noneof the proceeds from secondary transactions in the securities marketsflow back to the issuers.

1934 Act regulation extends far beyond public companies and theirsecurities. It also imposes a broad-based system of market regulationdesigned to promote efficient transactions as well as to prohibit fraudand manipulation.37 Market regulation consists of complex series ofrules and prohibitions based on direct regulation by the SEC as wellas self regulation through exchange and NASD rules that have beenapproved by the SEC. By way of summary, the SEC oversees theseveral securities exchanges and the National Association of SecuritiesDealers ("NASD"), each of which is a self-regulatory organizationsthat polices its own market. In addition to regulating the markets, theSEC and the self-regulatory organizations regulate intermediaries,most notably, securities brokers and dealers.38

Section 19(a)(1) of the 1934 Act gives the SEC the authority toregister national exchanges. 3 9 Section 19(h) gives the SEC theobligation to discipline and even expel national exchanges for violatingprovisions of the 1933 and 1934 Acts. 40 Each exchange also hasexpress authority to discipline persons associated with it, includingpower to remove from office or censure the officers or directors of

35 See 15 U.S.C. §§ 78j, 78k.3 6 See I HAZEN, supra note 17, at § 1.l[2].37 See 4 HAZEN, supra note 17, at ch. 14.38 See id. The securities laws draw a distinction between brokers and dealers.

39 15 U.S.C. § 78s(a)(l). The SEC also is responsible for registering clearing agen-cies for exchanges. 15 U.S.C. § 78q-1. Cf. Board of Trade of City of Chicago v.SEC, 883 F.2d 525 (7th Cir. 1989), appeal after remand, 923 F.2d 1270 (1991)(reversing SEC order granting clearing agent registration for agent for electronicsystem for trading options on government securities).

40 15 U.S.C. § 78s(h). See, e.g., In the Matter of New York Stock Exchange, Inc.,

Exchange Act Release No. 34-41574, 70 SEC Docket 106 (June 29, 1999) (NYSEconsented to improve surveillance regarding various improprieties including tradingahead of customer orders).


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcrIivrrTES 387

listed/member companies for willful violations of the Act. 41 The SEChas exercised its statutory authority 42 to expel a national exchangeon only one occasion 43 but has exercised its authority under subsection(h) to uphold expulsion of members from the exchange with a bit morefrequency. 44The power to discipline and sanction exchange membersis given directly to the exchange as a self regulatory body. 45 Disci-plined firms or related members have a right of appeal to the SEC,which may in its discretion review the record de novo. 46 The SECdecision is then subject to review by a federal court of appeals. 47 TheNASD has similar status and authority. The SEC can suspend orrevoke the NASD's registration. 4 The NASD has the power to holdhearings and issue sanctions, including expulsion of its members fromthe association, for conduct in violation of the 1933 or 1934 Act orthe NASD's rules. 49

By virtue of section 15A of the 1934 Act, 50 the NASD operatesas the largest of the self-regulatory organizations subject to SEC

41 15 U.S.C. § 78f(d). The authority to discipline its members is found in the rulesof the self regulatory organizations. See, e.g., NYSE Listed Company Manual,available at www.nyse.com/Frameset.html?displayPage=/listed/1022221393251.html.

42 15 U.S.C. § 78s(h)(l).

43 San Francisco Mining Exchange v. SEC, 378 F.2d 162 (9th Cir.1967). Researchhas failed to reveal any other examples of this power being used.

" See, e.g., Archer v. SEC, 133 F.2d 795 (8th Cir. 1943), cert. denied, 319 U.S.767 (1943).

45 15 U.S.C. § 78f; see id. § 78s(h).46 Id. § 78f; see id. § 78s(h).

47 See Lewis D. Lowenfels, A Lack of Fair Procedures in Administrative Process:Disciplinary Proceedings at the Stock Exchanges and the NASD, 64 CORNELL L.REv.375 (1979); Norman S. Poser, A Reply to Lowenfels, 64 CORNELL L.REv. 402 (1979).

48 15 U.S.C. § 78o-1(h). See, e.g., Mister Disc. Stockbrokers v. SEC, 768 F.2d875 (7th Cir. 1985) (upholding dismissal of firm from NASD membership and orderbarring individual from associating with an NASD member firm).

49 15 U.S.C. § 78s(h)(2). See, e.g., Don D. Anderson & Co. v. SEC, 423 F.2d813 (10th Cir. 1970) (suspension for violation of 1933 Act); L.H. Alton & Co. v.SEC, [1999-2000 Transfer Binder] Fed. Sec. L. Rep. (CCH) 1 91,021, available at2000 U.S. App. LEXIS 17926 (9th Cir. 2000) (affirming NASD sanctions). See also,e.g., Tager v. SEC, 344 F.2d 5 (2d Cir. 1965) (SEC action suspending registration);Fin. Counselors, Inc. v. SEC, 339 F.2d 196 (2d Cir. 1964) (expulsion for violationof 1934 Act); Gilligan, Will & Co. v. SEC, 267 F.2d 461 (2d Cir. 1959) (suspensionfor violation of 1933 Act).

50 15 U.S.C. § 78o-3. There was some movement toward establishing a self-regulatory organization for dealers in municipal securities. But no such group wasever formed.



oversight. Although this section gives the Commission the directauthority to regulate broker-dealers who are members of the registeredsecurities associations such as the NASD, as a practical matter thebulk of the day-to-day regulation is generally delegated to the self-regulatory organizations themselves. The NASD has extensive rulesgoverning its member brokerage firms and their employees whichrelate both to organizational structure and standards of conduct.51

The preceding discussion provides an overview of public companyand market regulation. It is worth noting further that securitiesregulation does not stop with securities issuers and the securitiesmarkets, it also extends to regulation of mutual funds and otherinvestment companies 52 and investment advisers. 53

B. Regulation of the Derivatives Markets5 4

The stock and other securities markets offer one set of opportunitiesto investors. In addition to the securities markets, investors may lookto the various commodities markets and the trading of commodityfutures. At one time the commodities markets were limited to agricul-tural and other tangible commodities such as precious metals and fossilfuels. 5 5 Financial futures, including stock index contracts, havebecome increasingly important over the years. 56 Additionally, a widerange of overlapping or hybrid investments have developed that haveattributes of both commodities and securities.

Although there have been a number of jurisdictional disputes, thecommodities futures markets generally are regulated by the

51 The NASD constitution and rules are compiled in the NASD Manual (CCH).As is the case with national exchanges, NASD rules are subject to SEC review. 15U.S.C. § 78s; cf. McLaughlin, Piven, Vogel, Inc. v. NASD, 733 F. Supp. 694(S.D.N.Y. 1990) (NASD member must exhaust his or her administrative remediesbefore seeking judicial relief from NASD's refusal to permit inspection of recordspertaining to NASD investigation of member). See generally T. Grant Callery & AnneH. Wright, NASD Disciplinary Proceedings-Recent Developments, 48 Bus. LAW. 791(1993).

5 2 This is accomplished through the Investment Company Act of 1940, 15 U.S.C.§§ 80a-1 to -52 (2000). See 5 HAZEN, supra note 17, at ch. 20.

53 This is accomplished through the Investment Advisers Act of 1940, 15 U.S.C.§§ 80b-1 to -21. See 5 HAZEN, supra note 17, at ch. 21.

54This discussion is adapted from portions of 1 PHILIP McBRIDE JOHNSON &THOMAS LEE HAZEN, Derivatives Regulation § 2.02 (2004).

55 See id. § 1.02. Thus, for example, the Department of Agriculture was the regula-tor of the futures markets from 1922 until 1974. See id. § 2.02[2].

56 See id. § 2.02[4]-2.02[5].


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcTIVITIES 389

Commodity Futures Trading Commission ("CFTC") pursuant to theCommodity Exchange Act.5 Beginning in the 1970s and carryingthrough the 1980s and 90s, the futures and commodity options marketsregulated by the CFTC and the options markets regulated by the SEChave become increasingly competitive with the increased trading inderivative financial instruments, including treasury bill, foreign cur-rency and stock index futures (as compared, for example, with thetrading of stock index and foreign currency options). 58 Options onsecurities are regulated by the SEC, while futures and commodityoptions (including options on futures) are not subject to SEC regula-tion, 59 and instead are left to the CFTC.60

The Commodity Futures Modernization Act of 200061 (the "Mod-ernization Act") made significant changes in commodities and deriva-tives regulation by creating a three-tiered system of regulation consist-ing of exchanges, less regulated organized markets, and unregulatedderivatives markets. Formerly, the rules of organized commoditiesmarkets ("contract markets") were subject to CFTC oversight andapproval. This is no longer the case under the current regulatory regimeushered in at the start of the twenty-first century in the form of theModernization Act.

The former contract market monopoly meant that all domestic"contracts of sale of a commodity for future delivery" had to beexecuted on an organized commodities market that had been "designat-ed" as a "contract market" under the Commodity Exchange Act. 6 2

This meant that subject to limited exceptions, 63 there were no

57 7 U.S.C. § 1-24 (2000). See generally JOHNSON & HAZEN, supra note 54, at§ 2.01.

58 Although the form of a futures contract may differ from a listed option, theiroperational effect and investment strategies are very similar, if not identical, whendealing with financial options and futures.

59 In a controversial ruling, the SEC granted securities exchanges' applications tolist index participation units which have some characteristics of futures but were foundto be securities. Order Approving Proposed Rule Changes Relating to the Listing andTrading of Index Participations, Exchange Act Release No. 34-26709, 54 Fed. Reg.15,280 (April 11, 1989).

60 See generally JOHNSON & HAZEN, supra note 54, at § 2.01.61 Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, 114 Stat.

2763 (codified as amended at 7 U.S.C. §§ 1-270.62 See also I JOHNSON & HAZER, supra note 54, § 1.02[21 (commodities and juris-

diction); id. § 1.02[8] (the deterioration of the contract market monopoly); id.§ 4.05[81 (challenges to the Commission's jurisdiction); id. § 4.05[9] (ongoingjurisdictional assaults); id. § 4.05[101 (reflections on CFTC/SEC jurisdiction).

63 During the 1990s, the number of over-the-counter ("OTC") derivatives that were



over-the-counter derivatives markets, and futures and commodityoptions contracts were traded through the facilities of organized andregulated contract markets. The contract markets and the CommodityFutures Trading Commission controlled the designation process so thatonly contracts meeting certain criteria could be traded. The contractmarket monopoly under the Commodity Exchange Act thus estab-lished a system parallel to legalized gambling, in that legitimatetransactions could only be effected through the regulated contractmarkets. The regulatory constraints of legalized gambling protectgamblers against organized crime and rigged gambling, whereas theregulation of exchanges was designed not only to prohibit fraud andmanipulation in the commodities markets, but also to permit only thosederivatives contracts that met certain economic or public policyrequirements. 64

The regulatory landscape changed in 2001 following the adoptionof the Modernization Act. The Modernization Act sought to solidifychanges that had been in the making for years. In the latter part ofthe twentieth century, there was erosion of the contract marketmonopoly, due to increased use of forward contracts and swaptransactions that were pigeon-holed into existing exemptions to theCommodity Exchange Act's contract market monopoly.65 Contempo-raneously, monopoly was easing due to jurisdictional battles betweenthe CFTC and the SEC with respect to investments that could becharacterized either as futures contracts or as securities.6 6 TheModernization Act eliminated the former monopoly by permittingover-the-counter, and essentially unregulated, transactions betweenqualified market participants. The Modernization Act also changed thedesignation process so that the CFTC no longer has responsibility forreviewing the economics underlying publicly traded derivatives.6 7

used by institutional investors grew at a staggering pace. Thus, for example, a reportby the General Accounting Office in 1994 estimated that the notional amount of OTCderivatives outstanding at the end of fiscal year 1992 was at least $12.1 trillion, thiswas in addition to approximately $5.5 trillion of foreign currency exchange contractsused primarily by banks. See Jerry W. Markham, Banking Regulation: Its Historyand Future, 4 N.C. BANKING INST. 221, 274 n.333 (2000) (citing U.S. G.A.O.,FINANCIAL DERIVATIVES - ACTIONS NEEDED TO PROTECT THE FINANCIAL SYSTEM

34 (1994)). See also, e.g., Jerry W. Markham, Protecting the Institutional Investor-Jungle Predator or Shorn Lamb? 12 YALE J. ON REG. 345, 353 (1995).

6 4 See 1 JOHNSON & HAZEN, supra note 54, at § 2.02.6 5 See 1 id. § 1.02[8].66 See 2 id. § 4.05.6 7 See lid. § 2.03.


2005] DISPARATE REGULATORY SCHEMES FOR PARALILEI AcTivrTIES 391

Current derivatives and commodities regulation retains the conceptof designated contracts markets but substantially decreases the layersof regulation to which they are subject.6 8 There are no longercategorical restrictions on the underlying commodities for futures andoptions to be traded on contract markets. 6 9 Additionally, there are norestrictions on the types of market participants that may enter intotransactions on a designated contract market. 70 Contract markets areno longer required to obtain separate designation for each futurescontract. 71 Instead, contract markets are to be designated to trade allcommodities, though there are special requirements applicable tosecurities futures. In order for a new entrant 72 to qualify as a contractmarket under the amended regime, the exchange must, if not previ-ously registered, satisfy seven basic criteria for designation andseventeen "core principles" set forth in the Act. The basic criteriainclude having mechanisms designed to; prevent market manipula-tions, assure fair trading practices, operate an effective trading system,ensure the financial integrity of transactions, discipline offenders,make its rules and contract specifications available to the public, andhave access to all relevant information. 73 Moreover, in order to qualifyfor designation as a contract market, the trading facility applying forCFTC designation must demonstrate to the CFTC in its applicationthat seven specified standards are satisfied. 74

The current regulatory regime for commodities markets and com-modities professionals is significantly streamlined. Whereas the formerregulatory regime imposed an affirmative day-to-day regulation, theCommodity Exchange Act, as amended by the Modernization Act,charges the CFTC with a more general oversight role with respect tocontract markets. In comparison, the SEC exercises a significantlymore active supervisory role in the securities markets. For example,rules of self-regulatory organizations (namely, the securities exchanges

68 See id.69 See id.

70 See id.

71 See id.

72 See id. (existing commodities futures contract markets were grandfathered andthus retained their designated status following the Modernization Act).

73 7 U.S.C. § 7 (2000). For an example of designation as a contract market underthe new regulatory regime, see CFTC Designates Brokerage Futures Exchange as aContract Market and Brokered Clearing Corporation as a Resister DerivativesOrganization, CTFC Rel. No. 4526-01 (June 19, 2001).

74 7 U.S.C. § 7.



and the NASD are subject to SEC approval. 75 This is no longer thecase with respect to the CFTC's influence over self-regulatory organi-zations operating in the commodities markets. 76

The Modernization Act allows the use of certain trading facilitieswith less regulatory oversight than is the case with designated contractmarkets. 77 Trading facilities having a lower level of regulation thancontract markets are defined by the Commodity Exchange Act asderivatives transaction execution facilities ("DTEFs").78 Unlike desig-nated contract markets, there are restrictions on both the categoriesof the futures and options contracts that may be traded and the typesof investors that may participate in transactions on DTEFs. 79 DTEFsgenerally may trade futures contracts or options on futures contractsbased on commodities that are not susceptible to manipulation, have

75 For discussion of the securities market regulation, see 4 HAZEN, supra note 17,ch. 14. See also JERRY W. MARKHAM & THOMAS L. HAZEN, BROKER-DEALER

OPERATIONS UNDER SECURITIES AND COMMODITIES LAW: REGISTRATION, FINANCIAL

RESPONSIBILITIES, CREDIT REGULATION, AND CUSTOMER PROTEC'TION (2d ed. 2003).76 The Commodity Exchange Act continues to impose self-regulatory requirements

that are similar to those prior to the Modernization Act.77 Section la(33) of the Modernization Act defines trading facility as "a person or

group of persons that constitutes, maintains or provides a physical or electronic facilityor system in which multiple participants have the ability to execute or tradeagreements, contracts, or transactions by accepting bids and offers made by otherparticipants that are open to multiple participants in the facility or system." 7 U.S.C.§ la(33)(A). See also id. §§ la(33), la(10).

7 8 See id. § 7.79 The Commodity Exchange Act currently permits two types of DTEFs: those serving

the retail market and those serving the commercial market. A DTEF that operatesas a retail market must limit its participants to those who trade through a futurescommission merchant that (1) is a member of a futures self-regulatory organization(or if trading a security futures product, a national securities association); (2) is aclearing member of a derivatives clearing organization; and (3) has net capital of atleast $20 million. Retail customers trading through derivatives transaction executionfacilities are permitted to trade only in instruments based on commodities that meetcertain requirements designed to make the contracts particularly unsusceptible tomanipulation, and to security futures products if the DTEF is registered as a nationalsecurities exchange. The Act further authorizes the CFTC to approve on a case-by-casebasis additional contracts that can be traded on a retail DTEF. Id. § 7a(b)(2).Derivatives transaction execution facilities that operate as commercial markets arerequired to restrict its participants to those who qualify as "eligible commercialentities." Commercial DTEFs are not limited to the same extent as retail DTEFs withrespect to the contracts that may be traded. A commercial derivatives transactionexecution facility may trade futures on any non-agricultural commodity if trade islimited to eligible commercial entities trading for their own account. Id. § 7a(b).


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcTIVInES 393

no cash market, or are securities futures productsSO Certain othercommodities may be traded on a DTEF if trading is limited to eligiblecommercial entities trading for their own accounts. A DTEF that isa national securities exchange, and thus subject to SEC regulation,may trade security futures contracts.81

In addition to contract markets and DTEFs, the Modernization Actrecognized a new category of marketplace known as an exempt boardof trade, which can offer certain types of futures contracts (exceptsecurities futures products) without CFTC oversight. To qualify as anexempt board of trade, the trading facility must limit trading tocontracts that are not susceptible to manipulation or have no cashmarket.8 2 Participation in an exempt board of trade is limited to

8 0 The Commodity Exchange Act as amended by the Commodity Futures Modern-ization Act sets forth eight core principles that must be followed in order for a faciltyto maintain its registration as a DTEF:

1. Compliance with rules. The DTEF must establish rules and procedures toassure compliance with the rules of the facility;

2. Monitoring of trading. The DTEF must monitor trading in order to ensureorderly trading and to provide necessary trading information to the Commis-sion;

3. Public disclosure. The DTEF must provide disclosure to the public andthe Commission of the contract terms and conditions, the trading conventionsand mechanisms, the financial integrity protections and other relevantinformation;

4. Daily publication of trading information. On a daily basis, the derivativestransaction execution facility must publish trading information if the Commis-sion determines that the contracts perform a significant price discoveryfunction;

5. Fitness standards. The DTEF must establish and enforce fitness standardsfor members of the trading facility, its directors, members of disciplinarycommittees, and affiliated persons;

6. Conflict of interest rules. The DTEF must adopt conflict of interest rulesfor its decision-making and adjudicatory personnel;

7. Recordkeeping requirements. The DTEF is required to establish recordkeep-ing requirements to maintain records for five years of all activities relatedto the DTEF's business in a form and manner acceptable to the Commission;

8. Antitrust considerations. DTEFs must conduct themselves in such a wayas to minimize unreasonable restraints of trade and anticompetitive burdenson trading.

Id. § 7a(d)(2)-(9) The DTEF has discretion as to the manner in which it choosesto comply with the core principles. Id. § 7a(d)(1).

81 Id. § 7a(b)(2)(D).82 Id. § 7a-3(b). Moreover, Section 7a(f) of the Commodity Exchange Act permits



eligible contract participants, 83 and an exempt board of trade may nottrade securities futures products.8 4 CFTC rules permit eligible contractparticipants to opt out of having the segregation requirements generallyapplicable to funds held by a futures commission merchant withrespect to trades on or through a registered DTEF.85 The fraud andmanipulation prohibitions of the Commodity Exchange Act apply toexempt boards of trade but provisions applicable to DTEFs ordesignated contract markets do not apply.8 6

Thus, with the adoption of the Modernization Act, there is muchbroader recognition of off-exchange or over-the-counter derivativesmarkets and much more discretion accorded to participants. Thestreamlined regulatory structure and supervisory role of the CFTCmakes it easier for participants to establish the validity of exchange-listed derivatives. As noted above, the Modernization Act replacedhands-on CFTC oversight of the markets with general "core princi-ples" that the contract markets and registered derivatives transactionexecution facilities must follow in their rulemaking and enforcementprograms. In sharp contrast to the SEC's active oversight of thesecurities exchanges and the NASD, the CFTC does not have directsupervisory authority with respect to the self-regulatory practices ofderivatives participants. Regulation of the non-securities derivativesmarkets is therefore significantly less rigorous than regulation of thesecurities markets.8 7

a DTEF to authorize futures commission merchants to offer to eligible contractparticipants the right to not segregate customer funds in accordance with rules to bepromulgated by the CFTC. Id. § 7a(f).

83 Id. § 7a-3(b)(2). Every user must fall within one of eleven categories of "eligiblecontract participants"; and the item underlying the futures contract must have either:(i) a nearly inexhaustible deliverable supply; (ii) a supply large enough and sufficientlyliquid to make a market manipulation "highly unlikely"; or (iii) no cash market atall. Id. § 7a-3(b).

84 Id.

85 17 C.F.R. § 1.68 (2004). See CFTC Adopts Rules for Opting Out of Segregation,as to Trading Conducted on a Registered Derivatives Transaction Execution Facility,CFTC Release No. 4510-01 (April 25, 2001).

86 7 U.S.C. § 7a-3(a).87 There is one exception to the divergence in the regulatory schemes applicable

to the non-securities derivative markets and the securities markets. Prior to 2000,futures contracts on single stocks were not permitted whereas options on individualsecurities had been publicly traded for years in the securities markets. Although over-the-counter futures contracts generally were not permissible under the former law,there arose a new variety of hybrid investments (used primarily by sophisticatedmarket participants). These hybrid investment instruments raised jurisdictional issues


2005] DISPARATE REGULATORY SCHEMES FOR PARAL.EL ACTIVITIES 395

Do the markedly different regulatory roles for the SEC and theCFTC in their respective markets accurately reflect differences in thebehaviors of investors and other market participants? If not, then it-is worth reconsidering the wisdom of such differing regulatoryschemes.

C. Comparing Securities and Derivatives with Gambling

The discussion so far has focused on regulation of the investmentmarkets. The investment markets provide opportunities for risk-shifting through the options, futures, and derivatives markets, but alsoexpose investors to risk. As developed more fully below, for a longtime some have referred to derivatives markets as a form of legalizedgambling - an accusation that has also been leveled against invest-ment markets generally. This article takes the position that there isstill some merit to the gambling/investment analogy. To the extentthat the gambling analogy is valid, then there should be some parallelsbetween the gambling laws and the securities and commodities laws.In other words, the legislature could reevaluate the regulation of theinvestment markets in light of the gambling laws.

Long ago, all forms of gambling were outlawed, primarily for moralreasons. However, over time state legislatures have eased gamblingregulation significantly as additional forms of legalized gambling arerecognized88 Therefore, while most bilateral wagering contractsremain illegal, many forms of organized gambling are now legal,including: state-operated lotteries, pani-mutual betting on horse and

and a turf war between the SEC and CFTC. The allocation of jurisdiction betweenthe SEC and CFTC with respect to index futures and options on indexes was a politicalcompromise arising out of a jurisdictional accord that had been reached in 1980. TheModernization Act eliminated the prohibition on single stock futures. As a result,security futures products, which include futures on individual securities as well asnarrow-based stock indexes, can be traded in the commodities markets. Unlike theother derivative contracts, security futures products are traded under a co-regulatorysystem such that the applicable CFTC and contract market regulation parallels thatwhich would be applicable to comparable security option products traded under SECregulation. This is a relatively small segment of the derivatives market and as suchthe overall regulatory schemes applicable to non-securities derivatives and securitiesremain strikingly different. See I JOHNSON & HAZEN, supra note 54, at § 1.02[9].

88 Historically, the federal government left gambling regulation to the states, theone exception being the federal law permitting gambling on Indian reservations. SeeTom Lundin Jr., Note, The Internet Gambling Prohibition Act of 1999: CongressStacks the Deck Against Online Wagering But Deals in Traditional Gaming IndustryHigh Rollers, 16 GA. ST. U. L. REV. 845, 853 (2000).


396 ANNUAL REVIEW OF BANKING & FINANCIAL LAW [Voi. 24: 375

dog racing, gambling casinos, and in Nevada, betting on sportingevents.8 9

Il. Regulatory Comparisons and Solutions

Market regulation presumably is based on legislators', regulators',and other policymakers' determination of what measures will be mosteffective in combating the evils that led to regulation in the first place.Overregulation imposes unnecessary transaction costs and undulyinterferes with efficient markets. Accordingly, the task for policy-makers is to strike a delicate balance between what is deemed to bethe minimum necessary or desirable regulation and encouraging freemarkets.

A. Theories of Regulation

To some extent, any form of market regulation is paternalism, 90

but paternalism that may be well justified. One of the longtime

89 See, e.g., Cory Aronovitz, The Regulation of Commercial Gaining, 5 CHAP. L.REV. 181 (2002) (discussing legalized gambling); Paul D. Delva, Comment, ThePromises and Perils of Legalized Gambling for Local Governments: Who DecidesHow to Stack the Deck?, 68 TEMP. L. REV. 847, 847-49 (1995) (discussing increasedlegalization); David B. McGinty, The Near-Regulation of Online Sports Wageringby United States v. Cohen, 7 GAMING L. REV. 205 (2003) (every state except Utahand Hawaii have some form of legalized gambling). See also, e.g., RICHARDMcGOWAN, STATE LOTTERIES AND LEGALIZED GAMBLING 21 (1994) (examininglegalization of gambling); R. Randall Bridwell & Frank L. Quinn, Mad Joy toMisfortune: The Merger of Law and Politics in the World of Gambling, 72 Miss.L.J. 565 (2002) (discussing the consequences of increased legalized gambling); WendyJ. Johnson, Tribal Gaming Expansion in Oregon, 37 WILLAMETTE L. REV. 399 (2001)(discussing gambling in Oregon); John Warren Kindt & John K. Palchak, LegalizedGambling Destabilization of U.S. Financial Institutions and the Banking Industry:Issues in Bankruptcy, Credit, and Social Norm Production, 19 BANKR. DEV. J. 21(2002) (discussing the societal costs of legalized gambling and bankruptcies); JohnW. Kindt, Increased Crime and Legalized Gambling Operations: The Impact on theSocio-Economics of Business and Government, 30 CRIM. L. BULL. 538 (1994)(discussing the impact of decriminalization); Kathryn R.L. Rand, There Are NoPequots on the Plains: Assessing the Success of Indian Gaming, 5 CHAP. L. REV.

47 (2002) (evaluating legalized casino gambling on Indian reservations); A. GregoryGibbs, Note, Anchorage: Gaming Capital of the Pacific Rim, 17 ALASKA L. REV.

343 (2000) (discussing gambling in Alaska).90 Cf Jeffrey J. Rachlinski, The Uncertain Psychological Case for Paternalism,

97 Nw. U. L. REV. 1165 (2003) (arguing against paternalism); Cass R. Sunstein,Behavioral Analysis of Law, 64 U. CHI. L. REV. 1175, 1178 (1997) ("objections topaternalism should be empirical and pragmatic, having to do with the possibility ofeducation and likely failures of government response, rather than a priori in nature").



premises of securities regulation is that investors need protection notonly against those who would take advantage of them, but also againstthemselves. 91 Regulation can, of course, be overly paternalistic.However, the fact that regulation is protectionist and therefore to someextent paternalistic is not a bad thing.92 For example, a recent articlesuggests that paternalistic regulation is appropriate where it results ina system of "asymmetric paternalism" where the regulation "createslarge benefits for those who make errors, while imposing little or noharm on those who are fully rational."93

The choice of the best regulatory structure for the markets isinfluenced by the ways in which we look at market structure and thebehavior of market participants. Since the inception of securitiesregulation in this country in 191 1,94 there has been debate concerningthe appropriate approach to regulating investment markets. 95 Morerecently, scholarly discussion has focused on revisiting the premisesof investment market regulation. As noted more fully below, there hasbeen much debate in the academic literature as to whether the rational-choice economic model or a more behaviorist approach best explainsinvestor behavior. For example, it has been suggested that we shouldlook at behavioral analysis in addition to the traditional economicanalysis that is the supposed foundation of securities regulation in theUnited States. 96 Other social science - most notably behavioral

91 See, e.g., Bateman, Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 310(1985) (rejecting in pad delicto defense based on plaintiffs alleged misconduct whereplaintiff acted merely as an investor).

92 See, e.g., Eyal Zamir, The Efficiency of Paternalism, 84 VA. L. REV. 229 (1998)(paternalism and efficiency are not necessarily incompatible).

93 Colin Camerer et al., Regulation for Conservatives: Behavioral Economics andthe Case for "Asymmetric Paternalism," 151 U. PA. L. REV. 1211, 1212 (2003).

94 In 1911, Kansas enacted the first comprehensive regulatory statute addressingsecurities marketing. KAN. LAWS ch. 133 (1911). Selective regulation predated theKansas enactment. Some more limited securities regulation existed before the Kansasstatute. For example, Massachusetts was regulating securities issued by commoncarriers in 1852. See HARRY G. HENN & JOHN R. ALEXANDER, LAWS OF CORPORA-TIONS 843 (3d ed. 1983).

95 For example, the states adopted a "merit" approach whereby an administratorwould pass on the merits of securities to be offered within the state. In contrast, federalsecurities regulation is premised on disclosure and has rejected the merit approachinitially adopted by the states. See THOMAS LEE HAZEN & DAVID L. RATNER,SECURITIES REGULATION CASES AND MATERIALS 1-11 (6th ed. 2003).

96 See Choi & Pritchard, supra note 23, at 71 (2003) ("Cognitive dissonance maythen affect investors, leading them to confirm the value of even poorly made decisions.Commentators have seized upon the evidence that investors act with limited cognitive



science - has been proffered as a better alternative for analyzingregulatory efforts. 97 As is the case with most social science analysis,valuable lessons can be learned from both the economic and behavior-ist perspective.

The choice of the applicable social science as a model of regulationis an important issue that has been discussed elsewhere and thus isnot the primary focus of this article. Instead, this article exploresinsurance and gambling analogies as a means of gaining insight intosecurities and derivatives regulation. The existing regulatory structurefocuses on disclosure as a way to keep the markets operating withboth efficiency and integrity. Disclosure should remain the core ofsecurities regulation. By drawing analogies to insurance and gambling,however, we can address conduct that is under-regulated within thecurrent disclosure framework and find potential ways to supplementthe existing regulatory structure.

B. Explaining Investor Behavior in the Securities and OtherInvestment Markets

Economic theory has long been asserted to be a helpful paradigmfor regulation of the securities markets. 98 The behavioral sciences also

capacity to justify regulatory intervention."); Lawrence A. Cunningham, BehavioralFinance and Investor Governance, 59 WASH. & LEE L. REV. 767 (2002) (arguingsecurities regulation reforms can benefit from behavioral finance); Donald C.Langevoort, Selling Hope, Selling Risk: Some Lessons for Law from BehavioralEconomics About Stockbrokers and Sophisticated Customers, 84 CAL. L. REV. 627,648-67 (1996) (a behavioral analysis of broker conduct); See also, e.g., Jon D. Hanson& Douglas A. Kysar, Taking Behavioralism Seriously: The Problem of MarketManipulation, 74 N.Y.U. L. REV. 630, 715 (1999) ("Behavioral research remains asomewhat haphazard collection of seemingly unrelated cognitive quirks. .. Drawinglegal conclusions for a topic like consumer risk perception then becomes primarilya game of 'who has the most anomalies wins.' "); Robert Prentice, Whither SecuritiesRegulation? Some Behavioral Observations Regarding Proposals for Its Future, 51DUKE L.J. 1397, 1400 (2001) ("American securities regulation is the optimal systemfor governing capital markets.").

97 See, e.g., Cunningham supra note 96.98 See, e.g., SIMON M. KEANE, STOCK MARKET EFFICIENCY: THEORY, EVIDENCE

AND IMPLICATIONS 9 (1983). See also, e.g., J. FRANCIS, INVESTMENT ANALYSIS AND

MANAGEMENT 643-86 (1979); JAMES H. LORIE ET AL., THE STOCK MARKET: THEORIES

AND EVIDENCE 56, 65 (2d ed. 1985); Eugene F. Fama, Efficient Capital Markets:A Review of Theory and Empirical Work, 25 J. FIN. 383, 383 (1970); Irwin Friend,The Economic Consequences of the Stock Market, 62 AM. ECON. REV. 212 (1972);Christopher P. Saari, Note, The Efficient Capital Market Hypothesis, Economic Theoryand the Regulation of the Securities Industry, 29 STAN. L. REV. 1031 (1977). For



provide useful insight. 99 Some observers have argued that there shouldbe a market for securities regulation, which would determine theoptimal regulatory structure. 10 0 A variation would be to leave securi-ties regulation to the exchanges on which securities are listed ratherthan to policy-making legislators or administrative agencies.1Ol Asnoted above, this is the approach taken by commodities regulation, 0 2

critical views of the efficient capital market hypothesis, see, for example, Jeffrey N.Gordon & Lewis A. Kornhauser, Efficient Markets, Costly Information, and SecuritiesResearch, 60 N.Y.U. L. REV. 761 (1985); William K. S. Wang, Some Arguments Thatthe Stock Market Is Not Efficient, 19 U.C. DAVIS L. REV. 341 (1986).

99 See Choi & Pritchard, supra note 23, at 71; Hanson & Kysar, supra note 96;Russell B. Korobkin & Thomas S. Ulen, Law and Behavioral Science: Removing theRationality Assumption from Law and Economics, 88 CAL. L. REV. 105 (2000);Donald C. Langevoort, Taming the Animal Spirits of the Stock Markets: A BehavioralApproach to Securities Regulation, 97 Nw. U. L. REV. 135 (2002); Paul G. Mahoney,Commentary: Is There a Cure for "Excessive" Trading?, 81 VA. L. REV. 713 (1995);Prentice, supra note 96; Lynn A. Stout, The Unimportance of Being Efficient: AnEconomic Analysis of Stock Market Pricing and Securities Regulation, 87 MICH. L.REV. 613 (1988). See also, e.g., Christine Jolls et al., A Behavioral Approach to Lawand Economics, 50 STAN. L. REV. 1471, 1518-19 (1998) (judgment biases haveimplications with respect to demand for environmental regulation); Lewis A.Kornhauser, The Domain of Preference, 151 U. PA. L. REV. 717 (2003) (discussinglaw and economics critiques of behavioral economics); Roger G. Noll & James E.Krier, Some Implications of Cognitive Psychology for Risk Regulation, 19 J LEGALSTUD. 747 (1990) (discussing cognitive psychology implications on regulation ofhealth and environmental risks).

For a critique of the behavioral approach, see, for example, Gregory Mitchell, WhyLaw and Economics' Perfect Rationality Should Not Be Traded for Behavioral Lawand Economics' Equal Incompetence, 91 GEO. L.J. 67, 72 (2002) ("Behavioral lawand economics bases its model of bounded rationality on a very limited set of empiricaldata and draws unsupportable conclusions about human nature from this partial dataset."); Richard A. Posner, Rational Choice, Behavioral Economics, and the Law, 50STAN. L. REV. 1551, 1560-61 (1998) (contending that that behavioral economics"have no theory, but merely a set of challenges to the theory-builders, who in therelevant instances are rational-choice economists and . . . evolutionary biologists").

100 See Roberta Romano, Search Term End Empowering Investors: A Market Ap-proach to Securities Regulation, 107 YALE L.J. 2359 (1998) ("The aim is to replicatefor the securities setting the benefits produced by state competition for corporatecharters - a responsive legal regime that has tended to maximize share value -and thereby eliminate the frustration experienced at efforts to reform the nationalregime. As a competitive legal market supplants a monopolist federal agency in thefashioning of regulation, it would produce rules more aligned with the preferencesof investors, whose decisions drive the capital market.").

101 See, e.g., Paul G. Mahoney, The Exchange as Regulator, 83 VA. L. REV. 1453(1997).

102 See, e.g., Stephen Craig Pirrong, The Self-Regulation of Commodity Exchanges:The Case of Market Manipulation, 38 J.L. & EcoN. 141 (1995).



especially in the wake of the deregulatory impact of the ModernizationAct.

Prior to the Modernization Act all publicly traded futures contractshad to take place on an organized exchange whose rules were subjectto oversight and approval by the CFTC.103 The self-regulatoryorganizations in the securities markets (the national securities ex-changes and the NASD) perform a similar function in regulating thesecurities exchanges and the over-the-counter (i.e., non-exchange)markets for securities. 104 As discussed in the preceding section, theCommodity Futures Modernization Act substituted a series of coreprinciples for organized public markets and leaves it to the contractmarkets and derivates transaction execution facilities to fashion rulesthat are consistent with those core principles.

A counterpart to the rational choice 105 law and economics explana-tion of human behavior is the behavioral economics concept ofprospect theory, 106 which posits, among other things, that we are morelikely to take risk to avoid losses than to amass gains.1 07 Thisasymmetry arises because we tend to weigh potential losses moreheavily than potential gains in assessing risks. '08 A variation of this

103 See generally 1 JOHNSON & HAZEN, supra note 54, at § 1.04.104 See 5 HAZEN, supra note 17, at ch. 14.105 See, e.g., Charles R. Plott, Rational Choice in Experimental Markets, 59 J. Bus.

S301 (1986); Thomas S. Ulen, Firmly Grounded: Economics in the Future of theLaw, 1997 Wis. L. REV. 433, 436 (1997).

106 See Daniel Kahneman & Amos Tversky, Prospect Theory: An Analysis of Deci-sion Under Risk, 47 ECONOMETRICA 263 (1979); Amos Tversky & Daniel Kahneman,Rational Choice and the Framing of Decisions, 59 J. Bus. L. S251, S257--60 (1986).See also, e.g., REID HASTIE & ROBYN M. DAWES: RATIONAL CHOICE IN ANUNCERTAIN WORLD: THE PSYCHOLOGY OF JUDGMENT AND DECISION MAKING

(2001).107 See Chris Guthrie, Prospect Theory, Risk Preference, and the Law, 97 Nw.

U. L. REV. 1115 (2003) ("In short, people are often willing to take risks to avoidlosses but are unwilling to take risks to accumulate gains"). But cf. Jason ScottJohnston, Paradoxes of the Safe Society: A Rational Actor Approach to the Reconcep-tualization of Risk and the Reformation of Risk Regulation, 151 U. PA. L. REV. 747(2003) (medical advancements have increased many individuals willingness to engagein high risk behavior).

10 8 See Richard Coughlan & Terry Connolly, Predicting Affective Responses to Unex-pected Outcomes, 85 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 211,217 (2001) ("losses loom larger than gains"); Janet Landman, Regret and ElationFollowing Action and Inaction: Affective Responses to Positive Versus NegativeOutcomes, 13 PERSONALITY & SoC. PSYCHOL. BULL. 524, 527 (1987) ("[W]henpeople are making real decisions in betting or life-dilemma situations, they weigh



phenomenon occurs in connection with regret - namely, emotion maymotivate rational actors to choose a more risk averse choice (even witha lower payoff) in order to avoid the regret that would follow fromselecting a riskier alternative that failed to realize the higher potentialgain. 109 The difficulty of distinguishing bona fide risk-shifting transac-tions from other transactions that the law has decided to regulatedifferently has been aptly described as the law's love-hate relationshipto risk. 110 The discussion that follows examines the parallels betweengambling and investor behavior and then explores how those parallelsmight affect regulatory structures.

C. Rational Investing or Gambling?: Consequences ofRegulating Markets with a Gambling Perspective

Many investors participate in the securities or derivatives marketsas a form of entertainment. Some suggest that market participants oftenview investing as a hobby"' or participate for the thrill of thegame. 112 To the extent that this is true, basing investment regulation

potential losses more heavily than potential gains."). It is also worth noting that causingsomeone to incur a risk is every bit as much a "harm" as actual economic loss. SeeClaire Finkelstein, Is Risk a Harm?, 151 U. PA. L. REV. 963, 992 (2003) (inflictionof risk can constitute a legally actionable harm, even if outcome harm is not actuallysuffered).

109 See, e.g., Robert A. Josephs et al., Protecting the Selffrom the Negative Conse-quences of Risky Decisions, 62 J. PERSONALITY & SOC. PSYCHOL. 26, 26-28 (1992);Graham Loomes & Robert Sugden, A Rationale for Preference Reversal, 73 AM.ECON. REV. 428, 428 (1983); Robert A. Prentice & Jonathan J. Koehler, A NormalityBias in Legal Decision Making, 88 CORNELL L. REV. 583, 606-609 (2003); MarcelZeelenberg & Jane Beattie, Consequences of Regret Aversion 2: Additional Evidencefor Effects of Feedback on Decision Making, 72 ORGANIZATIONAL BEHAV. & HUM.DECISION PROCESSES 63, 74-75 (1997).

110 Roy Kreitner, Speculations of Contract, or How Contract Law Stopped Worry-ing and Learned To Love Risk, 100 COLUM. L. REV. 1096, 1127-1137 (2000).

111 Ian Ayres & Stephen Choi, Internalizing Outsider Trading, 101 MICH. L. REV.313, 314 (2002) (describing investing as a hobby for many).

112 ROBERT J. SHILLER, MARKET VOLATILITY 59 (1989) ("Investing in speculative

assets clearly shares with gambling the element of play. . .. The satisfaction affordedby gambling is related to the individual's ego involvement in the activity; and thusindividual investors must themselves play to achieve satisfaction, and most do notrely on others for decisions."); Theresa A. Gabaldon, John Law, with a Tulip, in theSouth Seas: Gambling and the Regulation of Euphoric Market Transactions, 26 J.CORP. L. 225, 266 (2001); Charles R. P. Pouncy, The Rational Rogue: NeoclassicalEconomic Ideology in the Regulation of the Financial Professional, 26 VT. L. REV.263, 369 n.496 (2002); Lynn A. Stout, Are Stock Markets Costly Casinos? Disagree-ment, Market Failure, and Securities Regulation, 81 VA. L. REV. 611, 660 n.148



solely on efficient market or rational choice theories ignores asignificant segment of the market.

Several years ago, I explored the supposed rationality of derivativesmarkets and was struck then by the similarity between what many labelrational investment or bona fide market transactions and gambling,which traditionally has been illegal or alternatively subject to stringentregulation. 1'3 In that article, I questioned whether the regulatorystructure relied too heavily on the efficient capital market hypothesisand the supposed rationality of investors. 114 Subsequent literature hasexplored the ways in which investor behavior does not fit the rationalchoice model, suggesting instead that behavioral economics can betterexplain at least some aspects of investor activity.

The analogy between the investment markets and gambling has beenmade by others but not in a way which indicates that there shouldbe a greater parallel in applicable regulatory structures. For example,in a letter to President Washington, Thomas Jefferson wrote: "thewealth acquired by speculation and plunder is fugacious in its natureand fills society with the spirit of gambling."115 More than a century

(1995); Jonathan Clements, Are You Irrational or Thrill-Seeking When It Comes toRisky Investment?, WALL ST. J., June 4, 1996, at Cl. But cf de Kwiatkowski v. BearSteams & Co., Inc., 126 F.Supp.2d 672, 719 (S.D.N.Y. 2000), rev'd, 306 F.3d 1293(2nd Cir. 2002) ("At trial, and with these motions, Bear Steams sought to portrayKwiatkowski's motivations in assuming the massive risk he chose as those of a persondriven by ego gratification, exuberant greed or just reckless gambling thrills. Therecord in fact is clear that, throughout the times and circumstances relevant here,Kwiatkowski was a sophisticated investor and that he was fully aware of the largerisks associated with foreign currency trading and with his exceptionally large position.He admitted as much.") (footnote omitted).

113 See Thomas Lee Hazen, Rational Investment, Speculation, or Gambling? -

Derivative Securities and Financial Futures and Their Effects on the UnderlyingCapital Markets, 86 Nw. U. L. REV. 987, 987-1037 (1992); cf Wendy Collins Perdue,Manipulation of Futures Markets: Redefining the Offense, 56 FORDHAM L. REV. 345,401 (1987) (arguing that this manipulation should be defined in terms "as conductthat would be uneconomical or irrational, absent an effect on the market price"). Butsee, e.g., United States v. Dial, 757 F.2d 163, 165 (7th Cir.) (there is a differencebetween speculation and gambling), cert. denied, 474 U.S. 838 (1985); THOMAS A.HIERONYMUS, ECONOMICS OF FUTURES TRADING 138 (1971) ("Gambling involvesthe creation of risks that would not otherwise exist while speculation involves theassumption of necessary and unavoidable risks of commerce . . .. In every futurestransaction, the speculation incurs the duties and acquires the rights of a holding ofproperty and thus is an integral part of commerce"). See also, e.g., Gabaldon, supranote 112 (2001).

114 Hazen, Rational Investment, supra note 113, at 987-1037.

115 Letter from Thomas Jefferson to George Washington (Aug. 14, 1987), in 12



later, Theodore Roosevelt commented that: "[t]here is no moraldifference between gambling at cards or in lotteries or on the racetrack and gambling in the stock market. One method is just aspernicious to the body politic as the other in kind, and in degree theevil worked is far greater.116 The analogy has not been limited topolicymakers and politicians. 117 John Maynard Keynes observed: "Itis usually agreed that casinos should, in the public interest, beinaccessible and expensive. And perhaps the same is true of StockExchanges."s11

The illegality1 19 of, and law's disdain for, gambling has moralovertones which makes it difficult to draw the line between bona fide

THE PAPERS OF THOMAS JEFFERSON, 1787-88, at 38 (Julian P. Boyd ed., PrincetonU. Press 1955); see John S. Shockley & David A.Schultz, The Political Philosophyof Campaign Finance Reform as Articulated in the Dissents in Austin v. MichiganChamber of Commerce, 24 ST. MARY'S L.J. 165, 189 (1992).

116 42 CONG. REC. 1347, 1349 (1908); see Irwin Friend, Tire Economic Conse-quences of the Stock Market, 62 AM. ECON. REV. 212, 212 (1972) (describing publicsecurities market as a "legalized gambling casino."); Steve Thel, The OriginalConception of Section 10(b) of the Securities Exchange Act, 42 STAN. L. REV. 385,396 (1990); Robert J. Shiller, Financial Speculation: Economic Efficiency and PublicPolicy 9 (Jan. 15, 1991) (background paper prepared for the 20th Century Fund).

117 See, e.g., REUVEN BRENNER & GABRIELLE A. BRENNER, GAMBLING AND SPEC-

ULATION: A THEORY, A HISTORY AND A FUTURE OF SOME HUMAN DECISIONS 21-22(1990); CEDRICK B. COWING, POPULISTS, PLUNGERS & PROGRESSIVES: A SOCIAL

HISTORY OF STOCK & COMMODITY SPECULATION 1890-1936, at 3-24 (1965); ANNFABIAN, CARD SHARPS, DREAM BOOKS & BUCKET SHOPS: GAMBLING IN 19TH-CENTURY AMERICA 153-202 (1990); George Soule, The Stock Exchange in EconomicTheory, in FREDERICK W. JONES & ARTHUR D. LOWE, MANIPULATION, THE SECURITY

MARKETS: FINDINGS AND RECOMMENDATIONS OF A SPECIAL STAFF OF THE TWENTI-

ETH CENTURY FUND 3-18, 815-19 (A. Berheim & M. G. Schneider eds., 1935); H.S.Irwin, Legal Status of Trading in Futures, 32 ILL. L. REV. 155, 155 (1938) ("[tlhetime honored attitude has been that futures contracts are gambling contracts if, at themaking of the agreements, the parties do not intend to make and receive deliveryon the contracts"). See also, e.g., William W. Bratton, Jr., Corporate Debt Relation-ships: Legal Theory in a Time of Restructuring, 1989 DUKE L.J. 92, 109 (1989)("Obviously, in an uncertain world, investing entails risk. Undertaking this risk isgenerally desirable, as long as an investing manager brings care and deliberation tothe task. Speculation is a different, less prudent and more questionable endeavor. Itlacks a legitimating tie to the work ethic. The speculator seeks to get something fornothing, like a gambler.")

118 JOHN MAYNARD KEYNES, THE GENERAL THEORY OF EMPLOYMENT, INTEREST

AND MONEY 159 (1936). See generally COWING, supra note 117; Louis LOWENSTEIN,

WHAT'S WRONG WITH WALL STREET (1988).1 19 The legalization of gambling has far from eliminated concerns about its propri-

ety and utility. See, e.g., John Warren Kindt, Diminishing or Negating the Multiplier



market transactions and a wager.1 20 Even outside of derivativeinvestments, the law has had difficulty drawing the line betweenpermissible contracts and illegal gambling arrangements. The basicpremise is that wagers are illegal and therefore unenforceable as amatter of contract law. 121 Some courts have gone so far as to invalidatea loan on the grounds that the loan was designed to pay for illegalgambling debts. 12 2

The specifics of the similarity between gambling and derivativestransactions are exemplified by comparing illegal "difference con-tracts" with permissible futures and options transactions. 123 In additionto the examples at the beginning of this article, consider the case oftwo individuals who decide to wager on what the price of a certainsecurity will be one year from now. Under traditional analysis, thelaw has referred to this as a difference contract 124 and has declaredit to be illegal gambling. 125 In the earlier cases, courts had a difficulttime identifying which futures contracts were void as illegal gamblingand which were legal because of a valid delivery obligation. 126

Effect: The Transfer of Consumer Dollars to Legalized Gambling: Should a NegativeSocio-Economic "Crime Multiplier" Be Included in Gambling Cost/Benefit Analyses?,2003 MICH. ST. DCL L. REV. 281 (2003).

120 FABIAN, supra note 117, at 53-202; Kreitner, supra note 110, at 1098, 1138.121 For a history of the laws invalidating gambling contracts, see, for example, Joseph

Kelly, Caught in the Intersection Between Public Policy and Practicality: A Surveyof the Legal Treatment of Gambling-Related Obligations in the United States, 5 CHAP.L. REV. 87, 158 (2002).

122 See James L. Buchwalter, Annotation, Right To Recover Money Lent for Gam-bling Purposes, 74 A.L.R. 5th 369, at § 6 (1999) (collecting cases).

123 Questions have also been raised as to whether a gambling game could be classi-fied as a security. For example, in a highly questionable ruling a district court heldthat gambling even in the form of a fantasy stock exchange did not involve thepurchase or sale of a security and thus is not subject to the jurisdiction of the Securitiesand Exchange Commission. SEC v. SG Ltd., 142 F. Supp. 2d 126 (D. Mass. 2001),rev'd, 265 F.3d 42 (1st Cir. 2001).

124 See Hazen, Rational Investment, supra note 113, at 1015.125 Id.

126 Compare Uhlmann Grain Co. v. Dickson, 56 F.2d 525 (8th Cir. 1932) (futurescontract was not illegal where party intended to enter into offsetting contract ratherthan follow through with delivery obligation), and Gettys v. Newburger, 272 F. 209(8th Cir. 1921) (futures contract was enforceable unless both parties had perniciousintent to enter into nothing more than a wager), and ACLI Intern. Commodity Services,Inc. v. Lindwall, 347 N.W.2d 522 (Minn. Ct. App. 1984), vacated in part on othergrounds, 355 N.W.2d 704 (Minn. 1984) (since futures contract contains a deliverycontract it is not illegal gambling even though party entering into contract had no


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcrIVMES 405

Clothing what is essentially a difference contract as a derivativestransaction often will provide a cloak of legality. For example,institutional traders have engaged in synthetic stock transactions1 27

which consist of contracting with a counterparty to pay the differenceon the price of the underlying stock over time. 128 One of the professedreasons for a synthetic stock purchase (rather than a purchase of thesecurity itself) is to avoid leaving a footprint that would reveal theinstitutional investor was taking a buy position in the stock. 129 Theirony of this transaction is not only is it difficult to distinguish from

intent to deliver or take delivery of the underlying commodity), and Merrill Lynch,Pierce, Fenner & Smith, Inc. v. Schriver, 541 S.W.2d 799 (Tenn. Ct. App. 1976)(contract made on futures exchange was not illegal gambling), with Embrey v.Jemison, 131 U.S. 336 (1889) (illegality of difference contract was a valid defenseunder Virginia law to futures contract where there was no intent to deliver), and Jamesv. Clement, 223 F. 385 (5th Cir. 1915) (where both parties intended contract as agamble, futures contract would be void for illegality), and Carpenter v. Beal-McDonnell & Co., 222 F. 453 (E.D. Ark 1915) (faqade of futures contract did notshield illegal gambling transaction), and Waldron v. Johnston, 86 F. 757 (S.D. Ga.1898) (same).

127 Synthetic stock occurs when an investor sells a put option on a stock whilesimultaneously purchasing a call option with the same exercise price and expirationdate. For example, if ABC stock is trading in January at $35 per share, an investormay be able to sell ten June $35 puts (covering 1,000 shares of ABC stock) for $2,000and buy ten June $35 calls with the same $35 exercise price for $3,000. The investorthus has paid $1,000 for her position. Her investment will increase $1,000 for every$1 per share increase in ABC stock and will decrease $1,000 for every $1 per sharedecline. See Thomas Lee Hazen, The Short-TermlLong-Tenn Dichotomy and Invest-ment Theory: Implications for Securities Market Regulation and for Corporate Law,70 N.C. L. REV. 137, 167 n.139. Synthetic stock positions provide the opportunityfor leverage beyond that permitted by purchasing stock on margin. Sanford J.Grossman, An Analysis of the Implications for Stock and Futures Price Volatility ofProgram Trading and Dynamic Hedging Strategies, 61 J. BUS. 275, 276-78, 290-92(1988). Synthetic stock also allows the investor to receive the same profit or lossas she would had she paid $35,000 to purchase the 1,000 shares of ABC stock insteadof the ten call and ten put options covering 1,000 shares. See Joseph A. Grundfest,The Limited Future of Unlimited Liability: A Capital Markets Perspective, 102 YALE

L.J. 387, 404 (1992). In addition, it should be noted that synthetic stock is subjectto different tax consequences than a purchase and sale of the underlying stock. SeeDavid F. Levy, Towards Equal Tax Treatment of Economically Equivalent FinancialInstruments: Proposals for Taxing Prepaid Forward Contracts, Equity Swaps, andCertain Contingent Debt Instruments, 3 FLA. TAX REV. 471, 511-512 (1997). Seealso, e.g., Jeffrey M. Coin, Financial Products and Source Basis Taxation: U.S.International Tax Policy at the Crossroads, U. ILL. L. REV. 775 (1999).

128 See, e.g., Caiola v. Citibank, N.A., N.Y., 295 F.3d 312, 315-319 (2d Cir. 2002)(describing synthetic stock transactions).

129 See id. at 315-319.



what would otherwise be called an illegal difference contract, it isbeing used to deceive the market at large as to significant investmentactivity. 1 30 This transaction is just one example of how the law permitssophisticated market participants to engage in transactions that wouldbe illegal if carried out by other market participants.L3 1 In addition,some investors can also replicate difference contracts using publicly-traded options.

Since the law traditionally has characterized difference contracts asillegal, characterizing a contract as a gamble or a wager can providea basis for placing limits on freedom of contract. 132 Classical workson contract law have long pointed out the difficulties in trying todistinguish legitimate hedging activities from the more questionable(and often illegal) wager. 133 Trying to distinguish between legitimatehedging and impermissible gambling based on the intent-of the partiesdid not prove to be a satisfactory solution. 134 Although commercialenterprises frequently resemble gambling, many commentators whofavor a capitalist system have tended to object to gambling. 135 Further,the delivery obligation in futures and options contracts does not

130 In Caiola, for example, the investor complained of the counterparty's decisionto satisfy its side of the synthetic transaction by purchasing the stock in question andthereby leaving the footprint that the plaintiff wanted to avoid. Id. at 318.

131 Compare this type of transaction with the illegal practice of "parking," whichconsists of hiding the true identity of a security's owner. See, e.g., In re Barlage,63 SEC 1060, 1996 SEC LEXIS 3441, at *4 n.2 (1996) ("parking is the sale ofsecurities subject to an agreement or understanding that the securities will berepurchased by the seller at a later time and at a price which leaves the economicrisk on the seller."). See also, e.g., In re Hibbard & O'Connor Securities, Inc., 46SEC 328, 1976 SEC LEXIS 1889, at *4 (1976); 5 HAZEN, supra note 17, at § 14.23(5th ed. 2005). Parking can be used to evade reporting or accounting requirements.Id. The law apparently allows derivative transactions to have a similar effect. Seeid.

132 Kreitner, supra note 110, at 1096, 1098 ("around the turn of the last century,the question of wager was one of the key doctrinal areas that defined the scope offreedom of contract"); Mark Pettit, Jr., Freedom, Freedom of Contract, and the 'Riseand Fall,' 79 B.U. L. REV. 263, 319-324 (1999).

133 Edwin W. Patterson, Hedging and Wagering on Produce Exchanges, 40 YALE

L.J. 843, 878 (193 1) ("In endeavoring to distinguish hedging from wagering, the courtsare between the devil and the deep sea.").

13 4 Kreitner, supra note 110, at 1105-1110.135 As Ambrose Bearce reportedly said, "[tihe gambling known as business looks

with austere disfavor on the business known as gambling." See Paul H. Brietzke &Teresa L. Kline, The Law and Economics of Native American Casinos, 78 NEB3. L.REV. 263, 344 (1999).


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcTIVrIES 407

provide a satisfactory basis for the distinction between legal deriva-tives and illegal difference contracts. The delivery obligation is nota useful distinction because most futures and option contracts aresettled through offsetting contracts, thus obviating the need to deliverthe underlying commodity or security. Consider, for example, thesituation where two people enter into a contract to transfer the samestock a year from now at a stated price. This transaction is knownas a futures contract,1 36 and is legal in the United States.137 Mostfutures contracts, are functionally the same as a wager, since ratherthan delivering under the contract, the vast majority of futurescontracts are settled through a process known as offset, whereby ratherthan transfering the underlying commodity or security, the parties enterinto offsetting transactions. 138

In England, the prohibition on difference contracts dates back to1734 and reactions to the South Sea Bubble scandal in 1734.139 Inthe United States, the law of most states generally prohibits wagering.For example, by 1829, the speculative fever in New York's financialcenter had also led to legislation prohibiting stock jobbing, 140 another

136 The term futures contract is used to refer to a standardized contract for futuredelivery. In contrast, a forward contract is one, generally used by commercialparticipants with respect to the underlying commodity, calling for a present sale buta delivery date in the future. Functionally, futures and forward contracts are the same.The significance in the different terminology is primarily regulatory in nature. Futurescontracts are subject to the provisions of the Commodity Exchange Act whereasforward contracts are not. See I JOHNSON & HAZEN, supra note 54, at §§ 1.02[41,1.02[51.

137 Until 2000, futures contracts on individual securities were not permissible, butas a result of the Modernization Act, security futures products like this are permissible.Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, §§ 201-206,114 Stat. 2763 (codified as amended at 7 U.S.C. §§ 1-270.

138 In other words, the would-be seller goes into to the market and enters into anoffsetting futures contract to purchase the commodity or security at the same pricethat she is obligated to sell it for in the original obligation to sell the commodityor security. Similarly, the would-be buyer typically enters into an offsetting futurescontract to sell. The net result here is that the parties receive the difference betweentheir wagered price and the price of the commodity or security at the contract'sexpiration date.

139 See Barnard's Act, 7 Geo. 2, c. 8, § 5 (1734). ("IA]II and every such contractshall be specifically performed and executed on all sides, and the stock or securitythereby agreed to be assigned, transferred, or delivered, shall be actually so done,and the money, or other consideration thereby agreed to be given and paid for thesame, shall also be actually and really given."). See also, e.g., WALTER BAOEHOT,LOMBARD STREET 150-51 (Arno reprint ed. 1979) (1873) (comparing the South SeaBubble investor hysteria with gambling).

140 Stock Jobbing Act, 1 N.Y. Rev. Stat. 710, tit. 19, art. 2, § 6 (1829) ("All con-



term for difference contracts. Currently, the New York GeneralObligations Law provides: "All wagers, bets or stakes, made to dependupon any race, or upon any gaming by lot or chance, or upon anylot, chance, casualty, or unknown or contingent event whatever, shallbe unlawful." 141 The New York General Business Law (often referredto as a bucket shop prohibition)142 extends this to gambling on stockprices through the use of difference contracts. 143 Meanwhile, futures,options, and other derivatives contracts are treated as bona fideinvestment vehicles 144 rather than being regulated as differencescontracts or other types of gambling. This is in part because deriva-tives, unlike gambling, are viewed as providing a useful hedgingdevice for at least some market participants. 1 45 In one recent case,

tracts for the sale of stocks are void, unless the party so contracting to sell the sameshall, at the time of making such contracts, be in actual possession of the certificatesof such shares or be otherwise entitled thereto in his own right, or be duly authorizedby some person so entitled to sell the certificates of shares so contracted for). Theprohibition against difference contracts was designed to control "the more shadowyforms of financial speculation." See NATIONAL INSTITUTE OF LAW ENFORCEMENT AND

CRIMINAL JUSTICE, U.S. DEPARTMENT OF JUSTICE, THE DEVELOPMENT OF THE LAW

OF GAMBLING, 1776-1976 150 (1977) [hereinafter LAW OF GAMBLING]. See also, e.g.,THOMAS H. DEWEY, A TREATISE ON CONTRACTS FOR FUTURE DELIVERY AND

COMMERCIAL WAGERS INCLUDING "OTIONS," "FUTURES," AND SHORT SALES (1886)(demonstrating that the analogy between financial speculation and investmentspeculating is not a new one).

141 N.Y. GEN. OBLIG. LAW § 5-401 (McKinney 2003).

142 For discussion of bucket shop prohibitions, see 1 JOHNSON & HAZEN, supra

note 54, at § 2.02[2].14 3 See N.Y. GEN. BUS. LAW § 351 (McKinney 2003).

144 See, e.g., Gen. Elec. Co. v. Metals Res. Group Ltd., 741 N.Y.S.2d 218, 219-220(N.Y. App. Div. 2002) (explaining that a swap contract did not constitute illegalgambling: "[c]ontrary to defendant's argument, the parties' contract was not an illegalcontract to gamble, but rather a legitimate commodity swap agreement exempt fromthe strictures of the Commodities Exchange Act"); Mitchell-Huntley Cotton Co. v.Waldrep, 377 F. Supp. 1215, 1222 (N.D. Ala. 1974) (explaining that a forward contractwas not illegal gambling).

145 See, e.g., Steven L. Schwarcz, The Universal Language of International Securit-

ization, 12 DUKE J. COMP. & INT'L L. 285, 300 n.68 (2002) ("Swaps are thereforeakin to gambles on future asset values. Indeed, there is ongoing controversy as towhether derivative products can be abused, particularly where investors borrow onleverage to purchase derivative products for speculation. In a non-leveraged context,however, the use of derivatives to hedge currency (or interest rate) risks in cross-bordertransactions is not only prudent but essential for minimizing the risk to investors.").



the judge characterized a derivatives contract as a gamble but neverthe-less found it to be a legal transaction. 146

Notwithstanding the similarity between difference contracts on theone hand and futures or options contracts on the other, 147 contractsfor the future sale of stock were generally upheld against a claim thatthey constituted gaming or wagering unless the facts revealed that thetransactions "were nothing more than mere speculation on fluctuationsin price with no genuine intent to accept or deliver the stock."' 48 Thus,the issue today is not whether to declare derivative and other specula-tions illegal. Rather, to the extent that the markets create a form oforganized gambling, then those investments which lend themselvesto the gambler should be regulated accordingly. This leads to thequestion of how regulating gambling should differ from regulatingmarkets and what market reforms should be introduced to reflect thegambling mentality of many investors.

Viewing the behavior of some investors as analogous to gamblingdoes not by itself negate entirely the rational choice model. Gamblingis not necessarily irrational behavior. 149 For example, gambling or

146 Korea Life Ins. Co. v. Morgan Guar. Trust Co. of N.Y., 269 F. Supp. 2d 424,442 (S.D.N.Y. 2003) ("Although I have characterized KLI's swap agreements as"bets" and "speculations" on currency fluctuations, the transactions were in the formof forward contracts, swaps and derivatives. Derivatives transactions, forwardcontracts and swap agreements in currencies and commodities are not consideredillegal gambles, and do not violate New York's gambling statute.").

147 See, e.g., Lynn A. Stout, Betting the Bank: How Derivatives Trading Under

Conditions of Uncertainty Can Increase Risks and Erode Returns in FinancialMarkets, 21 J. CORP. L. 53, 66 n.52 (1995) ("Indeed, derivatives trading is in manyrespects a more troubling activity than orthodox gambling. Gambling can be defendedas providing entertainment to individuals who usually bet relatively small amountsof their own funds. Even so, the gambling industry is tightly regulated and heavilytaxed. In contrast, the relatively-unregulated derivatives market is dominated by banks,corporations, pension funds, and municipalities. These institutions are run by managerswho have been entrusted with the savings of depositions, employees, and citizensseeking reasonable returns at reasonable risks, rather than recreation.").

148 LAW OF GAMBLING, supra note 140, at 151 (relying on Story v. Salomon, 71N.Y. 420 (1877)).

149 See, e.g., Choi & Pritchard, supra note 23, at 15 ("We do not share this specula-tive preference for our own investments, but we cannot dismiss it as irrational.")(footnotes omitted). See also, e.g., CHARLES T. CLOTFELTER & PHILIP J. COOK,SELLING HOPE: STATE LOTTERIES IN AMERICA 72-81 (1989); Lloyd R. Cohen, TheLure of the Lottery, 36 WAKE FOREST L. REV. 705 (2001); Donald C. Langevoort,Selling Hope, Selling Risk: Some Lessons for Law from Behavioral Economics AboutStockbrokers and Sophisticated Customers, 84 CAL. L. REV. 627 (1996); Edward J.McCaffery, Why People Play Lotteries and Why It Matters, 1994 Wis. L. REV. 71.



high risk investing can be seen as access to wealth that is not availablethrough other investment or productive activities. An individual nothaving sufficient capital to invest with hopes of modest incrementalgains and desiring larger returns makes a rational investment whenshe chooses high risk investments in much the same way as gamblingcan be rational. As noted earlier, most individuals have a high degreeof risk aversion that militates against risky-behaviors seeking a bigpayoff. Nevertheless, if an individual desires the high pay-off withsufficient intensity, then he or she will be acting rationally in toleratingrisk that many other rational actors will not.

The regulatory structure for our securities and derivatives marketsby and large is based on traditional economic market analysis. It ispresumed that since markets perform an economic function, marketparticipants are acting as rational actors. If this activity in fact hascharacteristics traditionally associated with gambling, then there isreason to reconsider market analysis as the sole basis for regulation.A gambling rationale if applicable would make regulators and policy-makers consider factors that traditionally have not been in play indesigning regulatory schemes. It may be possible to explain marketbubbles and what most observers would characterize as excessivetrading as at least in part rational (albeit risk-laden) decision-making;securities investment, like gambling, can be seen as a rational activitythat opens access to wealth that might not otherwise be available. Atthe same time, we cannot properly ignore economically irrationalactions such as investors engaging in herd behavior. 1 50

Even aside from purely economic motivations, investing in individ-ual securities or derivative products provides a form of entertainmentfor some investors in much the same way as rational actors are willingto gamble notwithstanding the odds and the cut to the house becauseof the enjoyment of the, game. These market investors who are makingrational choices based on factors other than traditional investmentreturn are creating what the efficient market hypothesis would charac-terize as noise. 151 Market regulation based on rational choice should

For some of the behavioral literature, see LEIGHTON VAUGHAN WILLIAMS (ED.),ECONOMICS OF GAMBLING (2003); G.S. Becker & K.M. Murphy, A Theory of RationalAddiction, 96 J. POL. ECON. 675 (1988); Athanasios Orphanides and David Zervos,RationalAddiction with Learning and Regret, 103 J. POL. ECON. 739 (1995); R. Sauer,The Economics of Wagering Markets, 36 J. OF ECON. LIT. 2021 (1998).

150 See Hazen, Rational Investing, supra note 113.

151 See, e.g., Anat R. Admani, A Noisy Rational Expectations Equilibrium for Mul-ti-Asset Securities Markets, 53 ECONOMETRICA 629, 632 (1985); Fisher Black, Noise,


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcTIVITIES 411

account for this phenomenon by focusing on adequate disclosure toassure that prospective "investment gamblers" are aware of therisks. 152

Professor Lynn Stout proposes a model to explain investor behaviorbased on rational choice; using rational choice analysis and informa-tion theory, her model of stock trading is "premised on the observationthat, in a world of costly and imperfect information, rational investorsare likely to form heterogeneous expectations - that is, to makedifferent forecasts of stocks' likely future performance." 15 3 In re-sponse, Professor Paul Mahoney contends that investor behavior maybe better explained as a result of noise154 that interferes with therational choice based on the supposed efficiency of the securitiesmarkets in pricing shares. 155 Professor Mahoney further suggests thatthe apparent excessive trading in the securities markets is due to thefact that the intermediaries (stockbrokers) are generally compensatedper transaction and thus have an economic incentive to encouragetrading. 156

To the extent that the excessive trading is caused by the incentiveto financial intermediaries, then stronger regulation addressing thoseconflicts of interest would seem appropriate. A recent example of thiswould be the regulatory crackdown on security analysts' conflict ofinterests. 157 Another approach is increased criminalization of willfulconduct that creates fraudulent fueled noisy markets. One irony hereis that while there has been increasing regulation of the securitiesmarkets to combat these practices, the non-securities derivativesmarkets have been subject to significant deregulation. It is difficult

41 J. FIN. 529 (1986); J. Bradford De Long et al., The Size and Incidence of the Lossesfrom Noise Trading, 44 J. FIN. 681 (1989); Larry J. Merville & Dan R. Pieptea, Stock-Price Volatility, Mean-Reverting Diffusion, and Noise, 24 J. FIN. ECON. 193 (1989).

152 After all, disclosure has been the basic premise of federal securities regulationsince 1933.

153 Stout, supra note 112, at 615-617, 641-642.

154 See id.155 Mahoney, supra note 99, at 715 (rejecting Stout's rational investor model and

raising an agency-based rationale for irrational investment decisions).1 56 Id. at 717.157 See 5 HAZEN, supra note 17, at § 14.16[6]. See also Stephen J. Choi & Jill

E. Fisch, How to Fix Wall Street: A Voucher Financing Proposal for SecuritiesIntermediaries, 113 YALE L.J. 269 (2003) (proposing a voucher system to compensatemarket intermediaries such as analysts to eliminate the conflict of interest resultingfrom securities issuers' subsidizing analysts activities).



to point to anything other than political pressure to account for thisdivergence in regulation.

In any particular case a recommendation with an undisclosed selfinterest of the person making the recommendation violates the securi-ties laws (and the common law as well). 158 However, to the extentthat this is a systemic problem individualized enforcement and privatecivil litigation will not cure the problem. 15 9 Instead, a macro approachthrough regulatory reform would seem the more appropriate coursethan micro regulation of each transaction. 160

D. Micro-regulatory Issues16'

Although there is sparse case law to date, there is some authorityto support holding gambling casinos accountable for losses incurredby intoxicated patrons 162 or for losses incurred by gambling addictswho should have been barred from the casino. 163 Although the courtshave so far been reluctant to expand the liability of gambling casi-nos,164 it could be argued that this could be used to support a parallelliability of broker-dealers who continue to allow their customers toenter into risky unsuitable transactions.

158 See 5 HAZEN, supra note 17, at § 14.16.159 Id.160 Id.

161 This discussion is adapted from id. § 14.16[7].162 See GNOC Corp. v. Aboud, 715 F. Supp. 644, 655 (D.N.J. 1989) (holding that

a casino has a duty to refrain from knowingly permitting an invitee to gamble wherethat patron is obviously and visibly intoxicated and/or under the influence of a narcoticsubstance). See also, e.g., Anthony Fernandez, Comment, Torts -Dram Shop Liability- Under New Jersey Law a Casino Patron Would Not Be Permitted To RecoverGambling Losses from a Casino That Served the Patron Free Alcohol and AllowedHim To Continue Gambling After He Became Visibly Intoxicated - Hakimoglu v.Trump Taj Mahal Assocs., 26 SETON HALL L. REV. 941, 948-950 (1996). CompareJessica L. Krentzman, Dram Shop Law - Gambling While Intoxicated: The WinnerTakes It All? The Third Circuit Examines a Casino's Liability for Allowing a PatronTo Gamble While Intoxicated, Hakinoglu v. Trump Taj Mahal Associates, 41 VILL.L. REV. 1255 (1996) (arguing in favor of liability), with Jeffrey C. Hallam, Comment,Rolling the Dice: Should Intoxicated Gamblers Recover Their Losses?, 85 Nw. U.L. REV. 240 (1990) (arguing that casinos should not have a duty to prevent lossesunder these circumstances). Contra Hakimoglu v. Trump Taj Mahal Assocs., 70 F.3d291, 292-94 (3d Cir. 1995) (refusing claim under dram shop law).

163 See, e.g., Joy Wolfe, Casinos and the Compulsive Gambler: Is There a DutyTo Monitor the Gambler's Wagers?, 64 Miss. L.J. 687, 695-702 (1995) (discussingthe basis for imposing this type of liability).

164 See, e.g., Merrill v. Trump of Ind., 320 F.3d 729, 733 (7th Cir. 2003) (dismiss-ing claim that casino could be held liable for failure to bar compulsive gambler).


2005] DISPARATE REGULATORY SCHEMES FOR PARALLIEL ACTIVITIES 413

Similarly, there are statutes, known as "dram shop" rules, imposingliability on tavern owners for serving too much alcohol to theircustomers. 165 The "dram shop" theory of liability is also now appliedin a relatively new variety of customer claim in broker-dealer arbitra-tion and customer initiated litigation. 166 Typically, in these so-calledcases "financial suicide" cases, 16 7 the claim is that the broker-dealerhad an obligation to protect customers from their own investmentdecisions resulting in unsolicited transactions - namely, not involvingsecurities recommended by the broker. 168 However, these claims havegenerally been unsuccessful since broker-dealer suitability obligationsare traditionally tied to securities recommended by the broker ascompared with the unsolicited transactions that form the basis of the"dram shop" or financial suicide claims. It seems clear that the mereexistence of a brokerage relationship does not put the broker underan obligation to prevent the customer from committing financialsuicide. 169 Nevertheless, fiduciary duties are created when a brokerundertakes the responsibility to monitor the account. 170

Under the suitability doctrine, securities brokers have an ongoingduty to monitor customer accounts even after the investment decisionhas been made to assure that the investments are still appropriate. 171

165 See Barbara Black & Jill I. Gross, Economic Suicide: The Collision of Ethicsand Risk in Securities Law, 64 U. Prrr. L. REV. 483, 506 (2003); Richard Smith,A Comparative Analysis of Dramshop Liability and a Proposal for UniformLegislation, 25 J. CORP. L. 553, 555-559 (2000).

166 See Jacob D. Smith, Rethinking a Broker's Legal Obligations to Its Customers- The Dramshop Cases, 30 SEC. REG. L.J. 51, 58-59 (2002); Michael Siconofoli,Brokerage Finns Pay Big Damages in "Dramshop" Cases, WALL ST. J., May 17,1995, at Cl; Michael Siconofoli, "Dramshop Awards" Increasingly Slapped onBrokerage Finns, WALL ST. J., Sept. 4, 1992, at A4B.

167 Thomas R. Grady, Trying the Financial Suicide Case, 950 PRAC. L. INST. 107,109 (1996). See also Lisa Bertrain, "Economic Suicide" Claims: An Emerging Trendin Securities Arbitration, 950 PRACr. L. INST. 185, 191 (1996).

168 See Smith, supra note 166, at 73-77. See also Siconofoli, supra note 166, atA4B, CI.

169 See Tatum v. Legg Mason Wood Walker, Inc., 83 F.3d 121, 123 (5th Cir. 1996)(applying Mississippi law); Puckett v. Rufenacht, Bromagen & Hertz Inc., 587 So.2d273, 279 (Miss. 1991); JERRY W. MARKHAM, COMMODITIES REGULATION: FRAUD,

MANIPULATION & OTHER CLAIMS § 10.08 (2000).170 Trans National Group Services, Inc. v. PaineWebber, Inc., NASD Case No.

91-00770, 1992 NASD Arb. LEXIS 593 (June 30, 1992) ($1 million arbitrationaward).

171 See 4 HAZEN, supra note 17, at § 14.16[8].



This duty draws a closer parallel to the accountability of gamblingcasinos to help prevent gambling addicts from feeding their addiction.This is a distinct issue from the traditional suitability cases where theobligation arises out of particular recommended transactions ratherthan the broker's ongoing duty to supervise the account. 172 Recogni-tion of such an ongoing obligation is a natural consequence of thesuitability doctrine with respect to investments that the broker recom-mended. 1

7 3

The foregoing discussion addresses some of the ways in which boththe securities and non-securities investment markets resemble gam-bling. There has been parallel deregulation of the non-securitiesinvestment markets and the world of gambling. This trend is in strikingcontrast to the heightened regulation of the securities markets. Thesuitability doctrine for recommendations by securities brokers marksanother significant divergence in the regulatory regime applicable tothe securities markets and the one applicable to non-securities deriva-tives under the commodities laws. While the suitability doctrine isfirmly entrenched in the 1934 Act 174 and in self-regulatory rules 175

172 Franklin Savings Bank of New York v. Levy, 551 F.2d 521, 527 (2d Cir. 1977)("where a broker-dealer makes a representation as to the quality of the security hesells, he impliedly represents that he has an adequate basis in fact for the opinionhe renders"); University Hill Foundation v. Goldman, Sachs & Co., 422 F. Supp. 879,898 (S.D.N.Y. 1976) ("broker-dealers are required to have a reasonable basis forrecommendation made to customers which in turn imposes an obligation to conducta reasonable investigation of the security's issuer").

173 See, e.g., Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969) (recommendationimplies reasonable basis in fact); In the Matter of Merrill Lynch, Pierce, Fenner &Smith, Inc., Release No. 34-14149 (Nov. 9, 1977) (recommendation implies thatbroker has made independent investigation beyond relying on company's manage-ment); In re Shearson Hammill & Co.,. Release No. 34-7743 (Nov. 12, 1965) (failureto investigate before making recommendation violated antifraud provisions); In reB. Fennekohl & Co., 41 SEC Docket 210, 215-17 (1962) (failure to investigatefinancial condition before making recommendation is a violation of 1933 and 1934Acts).

174 5 HAZEN supra note 17, at § 14.16. See also, e.g., Stephen B. Cohen, The Suitabil-ity Rule and Economic Theory, 80 YALE L.J. 1604 (1971); Janet E. Kerr, SuitabilityStandards: A New Look at Economic Theory and Current SEC Disclosure Policy,16 PAC. L.J. 805 (1985); Norman S. Poser, Civil Liability for Unsuitable Recommenda-tions, 19 REV. SEC. & COMMODrIIES REG. 67 (April 2, 1986); Tracy A. Miner, Note,Measuring Damages in Suitability and Churning Actions Under Rule lOb-5, 25 B.C.L. REV. 839 (1984). See generally Hilary H. Cohen, Suitability Doctrine: DefiningStockbrokers' Professional Responsibilities, 3 J. CORP. L. 533 (1978); D. Lowenfels& Alan R. Bromberg, Suitability in Securities Transactions, 54 Bus. LAW. 1557(1999); Robert H. Mundheim, Professional Responsibilities of Broker-Dealers: The



there is no comparable obligation of commodities brokers under theCommodity Exchange Act, CFTC regulations, or CFTC decisions. 176

Investors in non-securities derivatives thus receive significantly lessprotection than securities investors with respect to brokers' recommen-dations. So, the question raised earlier is worth repeating here: is therejustification for the divergent trends in securities regulation and non-securities investment regulation? If the answer to this question is "no,"then the next question becomes: which approach is more appropriate- regulation or deregulation?

The gambling analogy does not end here. The law's traditionaldistaste for gambling has also provided a basis for regulating insurancecontracts. As further developed in the following section, insurance,as is the case with derivatives contracts, provides a legitimate mecha-nism for contractual risk shifting by commercial participants in manymarkets - both commodity-based and non-commodity commercialenterprises. Hedging markets (i.e., derivatives markets) and insuranceproducts thus serve similar functions. However, insurance is subjectto yet another wholly different regulatory structure.

Suitability Doctrine, 1965 DUKE L.J. 445; Arvid E. Roach II, Suitability Obligationsof Brokers: Present Law and the Proposed Federal Securities Code, 29 HASTINGSL.J. 1067 (1978). See also, e.g., Franklin D. Ormsten, Norman B. Amoff & GreggR. Evangelist, Securities Broker Malpractice and Its Avoidance, 25 SETON HALL L.REV. 190 (1994).

175 See, e.g., In the Matter of Stout, Exchange Act Release. No. 34-43410, 73 SECDocket 1081 (2000) (imposing industry bar and $300,000 civil penalty); Departmentof Enforcement vs. Howard, Complaint No. Cl 1970032, 2000 NASD Discip. LEXIS16 (NASDR Nov. 16, 2000) (two year suspension and $17,500 fine for suitabilityviolations); In the Matter of McNabb, Complaint No. C01970021, 1999 NASD Discip.LEXIS 13 (NASDR March 31, 1999) ($50,000 fine, censure, NASD bar); In the Matterof Gliksman, Complaint No. C02960039, 1999 NASD Discip. LEXIS 12 (NASDRMarch 31, 1999) (failure to supervise registered representative who committedsuitability violations); In the Matter of Guevara, Complaint No. C9A970018, 1999NASD Discip. LEXIS I (NASDR Jan. 28, 1999) ($100,000 fine plus restitution,industry bar); In the Matter of Sisson, Complaint No. C01960020, 1998 NASD Discip.LEXIS 41 (NASDR Nov. 18, 1998) ($35,000 fine, suspension); In the Matter of Bruff,Complaint No. C01960005, 1997 NASD Discip. LEXIS 41 (NASDR Aug. 1, 1997)(censure and bar); In the Matter of Osborne, Complaint No. C8A930067, 1995 NASDDiscip. LEXIS 55 (NASDR Dec. 21, 1995) ($127,937.50 fine, industry bar); In theMatter of Klein, Complaint No. C01940014, 1995 NASD Discip. LEXIS 222 (NASDRJune 1995) ($150,000 fine, six month suspension); In the Matter of F.N. Wolf & Co.,Complaint No. C07930024, 1994 NASD Discip. LEXIS 61 (NASDR June 16, 1994)($500,000 fine, $2,176,986 disgorgement, two year suspension).

176 See 3 JOHNSON & HAZEN, supra note 54, at § 5.09[1 1].



IV. Insurance

So far, this article has compared three regulatory schemes -securities laws, commodities laws, and gambling laws. Now we turnto how the regulation of derivative investments can possibly relateto a fourth area - insurance regulation. There are many ways in whichinsurance and the insurance industry is regulated. For example, notall risks are insurable under state laws that regulate the terms ofinsurance policies and focus on consumer protection generally. Inaddition, insurance law limits the ways in which insurance companiesmay invest their assets as a means to protect solvency. 177 The heavilyregulated industry stands in contrast to the deregulation of thederivatives markets.

A. Securities and Derivative Investments as Insurance

Insurance contracts have many similarities with other forms ofinvestment contracts. 1

7 8 This assumption is recognized to some extentthrough the enactment of the Gramm-Leach-Bliley Act' 7 9 that nowpermits more efficient integration of securities, banking, and insuranceoperations of financial institutions. 180 Insurance is a risk shiftingtransaction where one party pays a premium in exchange for a rightto payment in the event that a designated risk or contingency oc-curs.' 8 ' Just as gambling may be used to characterize the activities

177 See, e.g., ROBERT H. JERRY II, UNDERSTANDING INSURANCE LAW 89-90 (2ded. 1996). This can be found in classic explanations of insurance regulation. SeeEDWIN W. PATTERSON, ESSENTIALS OF INSURANCE LAW 23-32 (1957) (discussingthe financial condition of insurers); WILLIAM R. VANCE, HANDBOOK ON THE LAWOF INSURANCE 43-44 (3d ed. 1951).

178 See, e.g., Steven J. Williams, Note, Distinguishing "Insurance" from Invest-ment Products Under the McCarran-Ferguson Act: Crafting a Rule of Decision, 98COLUM. L. REV. 1996 (1998).

179 Gramm-Leach-Bliley Act, Pub. L. No. 106-102, 113 Stat. 1338, 1436-50 (1999)(codified as amended in scattered sections of 15 U.S.C.).

180 See generally James M. Cain & John J. Fahey, Banks And Insurance Companies- Together in the New Millennium, 55 Bus. LAW. 1409 (2000); James M. Cain,Financial Institution Insurance Activities - A New 2001 Odyssey Begins 57 Bus.LAW. 1357 (2002); Scott A. Sinder, The Gramm-Leach-Bliley Act and State Regulationof the Business of Insurance - Past, Present and. . . Future?, 5 N.C. BANKINGINST. 49 (2001); Arthur E. Wilmarth, Jr., The Transformation of the U.S. FinancialServices hIdustry, 1975-2000: Competition, Consolidation, and Increased Risks, 2002U. ILL. L. REV. 215 (2002).

181 1 LEE R. Russ & THOMAS F. SEGALLA, COUCH ON INSURANCE § 1:6 n.20(3d ed. 2003) [hereinafter COUCH] (" 'Insurance' may be defined as a contract to paya sum of money upon the happening of a particular event") (citing CNA Ins. Co.v. Selective Ins. Co., 354 N.J. Super. 369 (N.J. Super. Ct. App. Div. 2002)).



of many participants in the derivatives markets, some participants maybe seen as using derivatives as insurance. 182 Although it has not beengiven much attention in the literature, the idea that derivativescontracts can serve as an alternative to insurance is not totally new.Many observers of the investment markets have rejected the deriva-tives to gambling analogy in favor of an insurance analogy.183

Additionally, scholars in the field of insurance law have identified thesimilarity between insurance and commodities contracts. 184

Long ago, insurance was characterized as a form of gambling. 185

Insurance law doctrines have tried to distinguish insurance contractsfrom gambling with requirements such as a valid insurable interestas the basis for life insurance policies, 186 indemnity, 187 and the

182 See, e.g., Philip McBride Johnson, Stepping It Up, FOW DERIVATIVES INTELLI-

GENCE FOR THE RISK PROFESSIONAL, Issue 366 (Nov. 2001) ("Derivatives have alwaysbeen a type of insurance. They differ from the classical model only in that, insteadof assembling a 'risk pool' funded by a large number of at-risk holders, the risk ispassed on to people who would not otherwise face it. The world's most legendaryspeculators are the 'Names' of Lloyd's of London.").

183 Peter H. Huang, A Normative Analysis of New Financially Engineered Deriva-tives, 73 S. CAL. L. REV. 471, 479-80 (2000); Peter H. Huang et al., Derivativeson TV a Tale of Two Derivatives Debacles in Prime-Time, 4 GREEN BAG 2D 257,262 (2001) (rejecting the gambling analogy and finding it "misleading because buyingcertain derivatives is like buying insurance against an accident, while not buying thosederivatives is essentially betting on the accident not happening."); Philip McBrideJohnson, In Defense of "Terrorist" Derivatives, 23 FUTURES & DERIVATIVES LAWREP. 26 (2003); Joseph L. Motes Il, Comment, A Primer on the Trade and Regulationof Derivative Instruments, 49 SMU L. REV. 579, 580 (1996) ("Derivatives have mostoften been employed as a sort of 'insurance,' protecting investors' positions throughallocation of risk, but the instruments have also been used to generate profits throughspeculation on market positions.").

184 ROGER C. HENDERSON & ROBERT H. JERRY, II, INSURANCE LAW CASES AND

MATERIALS 135 (2d ed. 1996) ("In an insurance contract, risk is the item which isexchanged - the equivalent of a commodity in a contract for sale. In other words,the insured bears a risk of some kind of loss; the insured pays money (the premium)to the insurer in exchange for the insurer's promise to assume the risk.").

1 8 5 See JOHN ASHTON, THE HISTORY OF GAMBLING IN ENGLAND 275 (PattersonSmith 1969) ("paradoxical as it may appear, there is a class of gambling which isnot only considered harmless, but beneficial, and even necessary - I mean Insurance.Theoretically, it is gambling proper. You bet 2s. 6d. to £ 100 with your Fire Insurance;you equally bet on a Marine Insurance for the safe arrival of your ships or merchandise;and it is also gambling when you insure your life.").

186 Kreitner, supra note 110, at 1116-28. See also, e.g., Franklin L. Best, Jr., Defin-ing Insurable Interests in Lives, 22 TORT & INS. L.J. 104, 105 (1986).

187 Lynn A. Stout, Why the Law Hates Speculators: Regulation and Private Order-ing in the Market for OTC Derivatives, 48 DUKE L.J. 701, 728 (1999).



assignability of polices. 188 In a further effort to differentiate itself fromgambling, insurance has been promoted as a pooling of risks to achievea type of communal efficiency in risk shifting.18 9 In many ways,however, these attempts to distinguish insurance from gambling arereally not that convincing.

For example, derivatives can be used to hedge against catastrophicoccurrence, as suggested in the controversial proposal to use deriva-tives to hedge the risk of a terrorist attack. 190 While some observersmight characterize a terrorism futures contract as a horrific bet, it moreclosely resembles insurance1 91 if used by a party to hedge againstlosses that could be incurred by terrorist attacks. 192 This again pointsto the question raised at the outset of this article: we do not considerinsurance against loss due to terrorist attacks to be against publicpolicy, 193 so why should derivatives be so characterized?

B. Managing Insurance Risks

The typical insurance company in the United States manages therisks created by the policies it underwrites by pooling the premiumsreceived and managing the investment pool. 194 State insurance

188 Kreitner, supra note 110, at 1116-28. See also, e.g., Rylander v. Allen, 53 S.E.1032 (Ga. 1906).

189 Kreitner, supra note 110, at 1128. VIVIANA A. ROTMAN ZELIZER, MORALS AND

MARKETS: THE DEVELOPMENT OF LIFE INSURANCE IN THE UNITED STATES 89 (1979)("[L]ife insurance emerged as the most efficient secular risk-bearing institution tohandle the economic hazards of death through cooperative self-help.").

190 See, e.g., Johnson, supra note 183.191 Id. ("[Dlerivatives that cover losses occasioned by a terrorist activity are no

more a 'bet' on recurrence than a key employee life insurance policy is a company'swish for a key official's death. Both instruments exist 'just in case,' and both areproper.").

192 Rod D. Margo, War Risk hIsurance in the Aftermath of September 11, 18 AIR

& SPACE LAW. 1 (2003).193 See, e.g., Jeffrey Manns, Note, hsuring Against Terror?, 112 YALE L.J. 2509

(2003) (discussing government subsidies for insurance companies). See also, e.g.,Steven Plitt, The Changing Face of Global Terrorism and a New Look of War: AnAnalysis of the War-Risk Exclusion in the Wake of the Anniversary of September 11,and Beyond, 39 WILLAME-TrE L. REV. 31 (2003); Mark Boran, Note, To Insure orNot To Insure, That is the Question: Congress' Attempt To Bolster the InsuranceIndustry After the Attacks on September 11, 2001, 17 ST. JOHN'S J. LEGAL COMMENT

523 (2003).194 The company can be organized as a stock corporation or as a mutual insurance

company. See PATTERSON, supra note 177, at 50-51.



regulators place limits on the types of investments insurance compa-nies may use. 195 These limitations are designed to protect policyhold-ers. In addition, insurance companies may use derivatives to helpmanage their risk. In contrast, in the derivatives markets, risks areallocated through a network of bilateral contracts. The basic mecha-nisms of insurance and derivatives differ in that insurance basicallyconsists of a pooling of premiums to manage the risk.

However, where modem insurance began - in England -Lloyd'sof London ("Lloyd's") uses an exchange-type market to find investorsto help share risks and profits. 196 Lloyd's operates more like anexchange or derivative based system than an insurance company thatpools its premiums and invests them to manage the insurance risk.' 97

Consider the following brief description of how Lloyd's insurancemarket or exchange operates:

Lloyd's syndicates literally date to the underwriters who gathered atLloyd's Coffee House in London in the 1600s. Currently Lloyd's hasabout 26,000 underwriting members; most of these are nonprofes-sional investors known as "Names," and a few are full-time insuranceunderwriters. The Names have joined to form syndicates, each ofwhich has as few as two or three but perhaps as many as a fewthousand members. The syndicates (currently there are about 200 ofthem) subscribe on behalf of their members to cover risks or percent-ages of risks.198

There have been some unsuccessful attempts to use a Lloyd's-typeexchange system in the United States. 199 Notwithstanding these failedattempts, the system's potential reveals that the differences betweeninsurance and derivatives are not as clear as we may initially think,even when looking at the ways in which the insurer manages its risk.Lloyd's syndicated, reciprocal insurance organization resembles theseries of bilateral contracts that constitute the derivatives markets -

195 See, e.g, CAL. INS. CODE § 1192.8 (West 2003) (investments in specified inter-est-bearing notes, bonds, or obligations); N.Y. INS. LAW §§ 1402, 1404 (McKinney2004) (minimum capital or minimum surplus to policyholder investments).

196 PATTERSON, supra note 177, at 49 (describing Lloyd's as a "reciprocal insurer,or interinsurance exchange").

197 See, e.g., Shell v. R.W. Sturge, Ltd., 55 F.3d 1227, 1228 (6th Cir. 1995) ("TheSociety of Lloyd's, or Lloyd's of London ('Lloyd's'), is not an insurance company,but rather is an insurance marketplace in which individual Underwriting Members,or Names, join together in syndicates to underwrite a particular type of business.").

198 See JERRY, supra note 177, at 41-42 (footnotes omitted).199 See id. at 43.



both having characteristics of an exchange. "Names" are solicited inmuch the same manner as investors who participate in other investmentmarkets. 200 The Lloyd's market for Names, having been characterizedas an exchange, thus resembles the other investment markets beingdiscussed herein. This similarity is yet another reason to question suchwidely disparate regulatory structures for markets and enterprises suchas insurance and derivatives, which have many similar features.

The discussion below explores another parallel - the extent towhich the law (or regulators) impose substantive control over the typesof risk that can be managed using insurance or derivatives.

C. Substantive Control of Insurance - The Gate-keepingFunction of the Insurable Interest Requirement

Insurance law has long imposed a requirement that an insured havean insurable interest 201 in the contingency insured against in orderto uphold the insurance contract. 202 The origins of the insurableinterest doctrine date back to an eighteenth century English statutedesigned to protect citizens against the evils of gambling and the moralhazard 203 of eliminating the incentive to minimize risk. 204 The

200 Cf. Richards v. Lloyd's of London, 135 F.3d 1289 (9th Cir. 1998) (suit claimingsolicitation of Names in the U.S. constituted an offering of a security were dismisseddue to contractual choice of law provision opting for English law); Shell, 55 F.3dat 1228 (same); Roby v. Corporation of Lloyd's, 996 F.2d 1353 (2d Cir. 1993) (same).

201 The law in this area is quite muddled. See, e.g., GRAYDON S. STARING, LAWOF REINSURANCE § 6:1 (1993) ("In limited space we can talk around insurable interestbut never talk it through. A standard text confesses that '[i]t is very difficult to giveany definition of an insurable interest,' and then discusses it for about 70 pages").

202 See Michael J. Henke, Corporate-Owned Life Insurance Meets the Texas Insur-able Interest Requirement: A Train Wreck in Progress, 55 BAYLOR L. REV. 51, 54-60(2003).

203 See, e.g., Teague-Strebeck Motors, Inc. v. Chrysler Ins. Co., 127 N.M. 603,613, 985 P.2d 1183, 1193 (N.M. App. 1999). ("The second rationale - avoidinginducements to destruction of insured property - recognizes the problem of 'moralhazard.' If one's financial well-being would be enhanced by the loss of property ratherthan its preservation, there would be a temptation to destroy the property or, at least,to fail to take reasonable precautions to protect the property. This moral hazard ariseswhenever one can obtain insurance coverage on property for more than the propertyis worth to the insured. Given current societal attitudes toward gambling, the moralhazard concern appears to be the stronger peg on which to hang the insurable-interestdoctrine today."). See also, e.g., 8 COUCH, supra note 181, at § 37A:292, at 331(describing moral hazard).

204 Act of 1746, St. Geo. 2, ch. 37; Act of 1774, St. 14 Geo. 3, ch. 48. See Henke,supra note 255, at 54 relying on Kreitner, supra note 110, at 1116 ("A version of


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcTivrnIEs 421

preamble to the original English statutes address "pernicious practices"and "a mischievous kind of gambling" as the basis for requiring aninsurable interest. 205 The insurable interest doctrine first appeared asa matter of case law. 206 The requirement is frequently reaffirmed bythe courts, and now also appears in some statutes. 20 7 It has beenextended beyond life insurance and applied to other insurance con-tracts 208 covering economic loss.209 New York's statute is typical ofthe modern statement of the insurable interest requirement:

No contract or policy of insurance on property made or issued in thisstate, or made or issued upon any property in this state, shall beenforceable except for the benefit of some person having an insurableinterest in the property insured. In this article, "insurable interest" shallinclude any lawful and substantial economic interest in the safety orpreservation of property from loss, destruction or pecuniary dam-age. 210

Currently, the law in essence sets up a presumption that an insurancecontract is a wager on the occurrence or nonoccurrence of a particularcontingency but allows the presumption to be rebutted by demonstrat-ing an insurable interest - "proof of circumstances that negative theexistence of a wagering intent." 21' The insurable interest requirementof a lawful and substantial economic interest describes the type of

the insurable interest doctrine first arose in England in a 1774 statute responding toperceived excesses by early insurers combined with widespread religious aversionto the concept of gambling on the lives of others."). See, e.g., JERRY, supra note 177,at 14-15 (with respect to moral hazard).

2 0 5 Act of 1746, St. Geo. 2, c. 37; 1774, St. 14 Geo. 3, c. 48. See HENDERSON

& JERRY, supra note 184, at 31.206See PATERSON, supra note 177, at 130.207 Id., at 131 (referring to the "hoary dictum repeated by countless courts and

text writers and even embodied in some statutes").208 See, e.g., Delk v. Markel American Ins. Co., 2003 OK 88, 81 P.3d 629, 635

n.18 (Okla. 2003).209 See, e.g., In re Balfour MacLaine Int'l Ltd., 85 F.3d 68 (2d Cir. 1996) (insured

had insurable interest in coffee); Rogers v. Mech. Ins. Co., 1 Story 603, 20 F. Cas.1118 (C.C.D. Mass. 1841) (whalers had an insurable interest in blubber that was castoverboard during a hurricane); Kreitner, supra note 110, at 1099-1000 (quotingVIVIANA A. Ro mAN ZELIZER, MORALS AND MARKETS: THE DEVELOPMENT OF LIFE

INSURANCE IN THE UNITED STATES 45-46 (1979)).210 N.Y. INS. LAW. § 3401 (McKinney 2004). See also, e.g., CAL. INS. CODE Art.

4, §§ 280-284 (West 2004).211 HENDERSON & JERRY, supra note 177, at 25.


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interest that is present when commercial enterprises decide to enterinto hedging contracts.

A major difficulty with the gambling rationale for limiting insurancecontracts is the same problem identified earlier with respect toderivative investments of distinguishing a gamble from a legitimatespeculation. Professors Speidel and Ayres, among others, attempt todistinguish between insurance and gambling on the basis that insurancedeals with an existing risk while a wager creates a risk. 212 This doesnot appear to be a satisfactory distinction. 213 The wager simply addseconomic consequences for the parties to the wager, much as aderivatives contract on the price of a commodity provides a paralleleconomic consequence for the speculator.

Illegal gambling is not the only rationale for the insurable interestrequirement. 214 A second reason advanced for the insurable interestrequirement is to deter people from seeking insurance and then takingaction to cause the insured-against contingency to occur.215 This moral

212 RICHARD E. SPEIDEL & IAN AYRES, STUDIES IN CONTRACT LAW 612 (6th ed.

2003) (claiming that those insured seek insurance "to compensate them for the possibleoccurrence of an existing risk" while "[g]amblers by their contract create the riskat issue."). This same point was made in HIERONYMUS, supra note 113, at 138.

213 For example, synthetic stock (see discussion supra note 127) has been said to

create a risk rather than merely allocate it. Cf. Ted S. Helwig & Christian T. Kemnitz,Synthetic Security Transactions Under the Security Laws, Old and New, 21 Fur. &DERIV. L. REP. 6 (Sept. 2001) ("A synthetic stock trade is not a swap . . .. [tihesynthetic stock transactions did not allocate risk, but instead created risk and thereforewere more sales than swaps . . . there was no 'exchange' of payments based solelyon the price of [the underlying stock].").

214 See ALAN I. WIDISS, INSURANCE 124 (1989) ("It now seems evident that the

principle of indemnity and the insurable interest doctrine rest - and undoubtedlyhave, in reality, always been at least partially predicated - on public interests otherthan opposition to gambling.").

215 Belton v. Cincinnati Ins. Co., 577 S.E.2d 487,492 (S.C. Ct. App. 2003) (Hearn,

C.J., dissenting) ("Two fundamental purposes of the doctrine of insurable interest areto prevent insurance contracts from becoming gambling devices and to discouragethe intentional destruction of property"). See also, e.g., Nationwide Mut. Ins. Co. v.Goerlitz, 2001 Del. Super. LEXIS 268, at *14-15 (Del. Super. Ct. 2001) ("Thedoctrine of insurable interest is tied to the principle of indemnity and serves a numberof purposes, among them the prevention of using insurance contracts as gamblingor wagering contracts. Additionally, the doctrine is designed to protect against societalwaste and to avoid the danger in allowing persons without an insurable interest topurchase insurance, because those persons might then intentionally destroy lives orproperty); Kyle D. Logue, The Current Life Insurance Crisis: How the Law ShouldRespond, 32 CuMB. L. REV. 1, 22 (2001-2002).


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL ACTIVITES 423

hazard or deterrence rationale, however, also seems to be a question-able basis for an insurable interest requirement. 216 One can have aninsurable interest and still have the same improper incentive such asa property owner who tries to cash in on fire insurance using arson. 217

Some courts have recognized the weakness of the destruction ofproperty rationale as a basis for the insurable interest requirement.218

This is in part because of another insurance law doctrine that addressesthe problem.

The requirement of fortuitousness holds "that insurance covers onlyrisks, not certainties, so that a loss must be caused by a fortuitousevent in order to be covered." 219 Damages that are intentionally causedby the insured are not fortuitous and thus are not properly coveredby insurance. 220 The fortuitousness doctrine is one way of determiningwhich aleatory contracts22 1 are enforceable (such as insurance con-tracts and legitimate derivatives transactions), 222 and which are not

216 See, e.g., Tom Baker, On the Genealogy of Moral Hazard, 75 TEX. L. REV.

237, 239 (1996) ("conventional economic accounts of moral hazard exaggerate theincentive effects of real-world insurance and, at the same time, underestimate the socialbenefits of insurance.").

217 Cf. Luchansky v. Farmers Fire Ins. Co., 515 A.2d 598, 601 (Pa. Super. Ct.1986) ("When appellants purchased insurance protection they were not gambling onthe destruction of somebody else's property by fire. They were insuring against theloss of their own interest, an insurable interest, in the home whose legal title theyhad conveyed to their son.").

218 See, e.g,, Teague-Strebeck Motors, Inc. v. Chrysler Ins. Co., 985 P.2d 1183,

1193 (N.M. Ct. App. 1999).219 See Compagnie des Bauxites de Guinee v. Insurance Co. of North America,

724 F.2d 369, 371 (3d Cir. 1983).220 See, e.g., Hedtcke v. Sentry Ins. Co., 326 N.W.2d 727 (1982); Crossmark, Inc.

v. DeGeorge, 655 N.W.2d 547, 2002 Wisc. App. LEXIS 1268, at *7 (Wis. App. 2002).221 An aleatory contract is one under which the "duty to perform is conditional

on the occurrence of a fortuitous event." RESTATEMENT (SECOND) OF CONTRACTS§ 76 cmt. c (1981). The common law generally finds aleatory contracts to beenforceable unless they fall with the "subset of aleatory promises [that] are notenforceable" such as illegal wagers. Id. § 178 illus. 1 (1981).

222 When section la(13) of the Commodity Exchange Act was amended in 2000

Congress recognized explicitly what the CFTC had permitted as implicit - that"commodity" may include events, contingencies or incidents that take place whichare beyond the control of the contracting parties. 7 U.S.C. § la (2000). Section la(13)of the act states that "excluded commodity" embraces "any occurrence, extent of anoccurrence or contingency. . . that is beyond the control of the parties to the relevantcontract . . . and . . . associated with a financial or economic consequence." Thislegislative acknowledgement took note of the fact that futures contracts were alreadyallowed on weather phenomenon and other uncontrollable occurrences that can have



enforceable because they are illegal wagers. 223

The moral hazard concern of insurance - namely, that an insuredwill be overly insured and therefore be able to profit from an event 224

- is not a limitation imposed on those who opt to "insure" againstcertain risks by utilizing derivatives contracts or other hedgingmechanisms. There is no law or stated public policy that militatesagainst someone "doubling up" by seeking more hedging protectionthan is needed to offset feared losses. Another way of examining thisdistinction is the fact that insurance is often viewed as protectingagainst loss, whereas a hedge or other derivatives transaction may bemade to generate profit. 225 The insurable interest doctrine is used toexplain the rule frequently stated that over-insurance beyond antici-pated losses will result in illegal wagers. 226 Overvaluation resultingfrom a good faith attempt will not render the insurance policy void, 227

whereas an attempt to reap a profit would invalidate the policy.

severe economic consequences. The 2000 amendment also recognized a vast newworld of "event-based" futures and options that may evolve to address lossesoccasioned by uncontrollable phenomena. Id.

223 Professor Leff recognized the aleatory nature of derivatives contracts and the

contrast with illegal gambling; he also suggested that all contracts are aleatory in thesense that profitability may depend on chance. See his definition of aleatory contractin Arthur Allen Leff, The Leff Dictionary of Law: A Fragment, 94 YALE L.J. 1855,1990 (1985) ("any contract the performance of which by other party is dependentupon a fortuitous or uncertain event").

224 See, e.g., DeCespedes v. Prudence Mut. Cas. Co. of Chi., 193 So. 2d 224, 226(Fla. Dist. Ct. App. 1966) ("the insured must not be encouraged to use the coveragefor profit as this intends to increase moral hazard and could ultimately underminethe whole concept of insurance"); Liberty Mut. Ins. Co. v. State Farm Auto. Ins. Co.,277 A.2d 603, 608 (Md. 1971) (describing insurance clauses as designed to protectinsurers from moral hazard resulting from over-insurance).

225 Cf SPEIDEL & AYRES, supra note 212, at 612-613 ("insureds tend to bargain

for payments conditional upon something untoward happening: while gamblers tendto bargain for payments conditional upon something fortuitous happening").

226 3 COUCH, supra note 181, at § 41.2, ("When the interest of the insured is grosslydisproportionate to the amount of the insurance, the policy is regarded as a wageringcontract. Thus, if a creditor insures his or her debtor's life for a sum grossly in excessof any loss that he or she can possibly suffer by the debtor's death, the policy isa wager and invalid."); Cooper v. Shaeffer, 11 A. 548 (Pa. 1887); Guardian Mut.Life Ins. Co. v. Hogan, 80 I11. 35 (1875); Mitchell v. Union Life Ins. Co., 45 Me.104 (1858).

227 3 COUCH, supra note 181, at § 41.2 ("a valued policy is not rendered a wagering

contract merely because the value placed on the property is greater than the actualvalue, although recovery will be limited to the extent of the actual interest"), (relyingon Fidelity Union Fire Ins. Co. v. Mitchell, 249 S.W. 536 (Tex. Civ. App. 1923)).



Consistent with the general trend to deregulate gambling and tofavor freedom of contract, courts generally havd taken a broad viewof insurable interest. 228 For example, the insurable interest doctrinearose in the context of the relatively recent controversy surroundingviatical contracts that are designed to provide prepayment of insurancebenefits to terminally ill patients so that they can use the money topay medical expenses.2 29 Often, viatical contracts are marketed toinvestors in order to raise the cash to provide the prepayment of theinsurance benefits. Although there have been a number of challengesmade, until recently most federal decisions held that the marketingof viatical contracts does not implicate the securities laws 23 0 even

228 See, e.g., Butterworth v. Miss. Valley Trust Co., 240 S.W.2d 676 (Mo. 1951)(even though it was doubtful that an insurable interest existed, the court upheld theassignment of a purported insurance contract "since the assignment had been madein the utmost good faith and was not a mere cloak to cover a gambling transaction");Hammers v. Prudential Life Ins. Co. of Am., 216 S.W.2d 703 (Tenn. 1948) (upholdingvalidity of contract). See generally PATTERSON, supra note 177, at 131 (concludingthat "an examination of the reports shows very few decisions that turned upon theabsence of an insurable interest when the contract was entered into.").

229 See, e.g., Malcolm E. Osborn, Rapidly Developing Law on Viatical Settlements,31 WAKE FOREST L. REV. 471 (1996); Joy D. Kosiewicz, Comment, Death for Sale:A Call To Regulate the Viatical Settlement Industry, 48 CASE W. RES. L. REV. 701(1998); Denise M. Schultz, Comment Angels of Mercy or Greedy Capitalists? BuyingLife Insurance Policies from the Terminally Ill, 24 PEPP. L. REV. 99 (1996).

230 E.g., SEC v. Life Partners, Inc., 87 F.3d 536 (D.C. Cir. 1996), rehearing denied102 F.3d 587 (D.C. Cir. 1996) (viatical settlements, whereby investor receives deathbenefits of life insurance policy taken out on AIDS victim, were not securities sinceefforts of others was ministerial rather than substantive). Contra, SEC v. MutualBenefits Corp., 408 F.3d 737 (1I1th Cir. 2005) (viatical settlements were securitiesunder federal law); Wuliger v. Owens, 365 F. Supp. 2d 838 (S.D. Ohio 2005) (same).See, e.g., Timothy P. Davis, Should Viatical Settlements be Considered "Securities"Under the 1933 Securities Act?, 6 KAN. J.L. & PUB. Poi.'v 75 (1997) (concludingthat "public policy is best supported by a finding that viatical settlements are not"securities" under the Securities Act of 1933); Albert R. Miriam, The Future of DeathFutures: Why Viatical Settlements Must Be Classified as Securities, 19 PACE L. REV.

345 (1999); Elizabeth L. Deeley, Note, Viatical Settlements Are Not Securities: IsIt Law or Sympathy?, 66 GEO. WASH. L. REV. 382 (1998) (concluding that the D.C.Circuit erred in holding that viatical settlements were not "securities"); Comment,An Extended Interpretation of the Howey Test Finds That Viatical Settlements AreInvestment Contracts, 22 DEL. J. CORP. L. 253 (1997). But see SEC v. Brandau, 32Sec. Reg. & L. Rep. (BNA) 642 (S.D. Fla. 2000) (SEC brought charges against viaticalinvestment scheme); cf. Carrington v. Ariz. Corp. Comm'n, 2000 Ariz. App. LEXIS194 (Ariz. Ct. App. 2000) (Life Partners and lower state court decision holding viaticalagreements were not securities did not preclude state securities commission frominvestigating whether viatical settlements were securities); US Allianz Sec. Inc. v.S. Mich. Bancorp, Inc., 290 F. Supp. 2d 827 (W.D. Mich. 2003) (claims involving



though courts have deemed them securities under state law. 2 3 '

The insurable interest doctrine attempts to provide a basis fordrawing the line with respect to insurance contracts that the law willtolerate. It is an imperfect measure at best. A significant problem iswhether the insurance limitation is really meaningful without acomparable control of derivatives contracts? The derivatives marketsmay now offer a way around the insurable interest requirement, unlesscourts treat the contract in question as insurance rather than as aderivative investment. If the insurable interest requirement remainsjustifiable for insurance contracts, then there may be good reason toclose the gap with respect to parallel derivatives transactions createdby the Modernization Act. It would appear appropriate to either rethinkthe insurable interest doctrine or attempt to import something compara-ble into derivatives regulation.

D. Regulating Solvency of Insurers and Investment MarketParticipants: Margin Requirements as an AlternativeMeans of Regulation

Generally, there has been a division in the regulation of financialservices, particularly with respect to insurance and securities mar-kets. 232 Some observers argue that private ordering is a more effectiveregulatory structure,233 as was the practice before massive regulationof securities and commodities markets. 234 In addition, it has beensuggested that the law should focus on market structure rather thanthe more traditional disclosure approach to securities regulation.2 35

sales of viatical contracts were subject to NASD rules compelling arbitration); MONYSec. Corp. v. Bornstein, 250 F. Supp. 2d 1352 (M.D. Fla. 2003) (transactions in viaticalsettlements executed by associated person formed the basis of an arbitrable claimagainst the securities brokerage firm).

231 Siporin v. Carrington, 23 P.3d 92, 104 (Ariz. Ct. App. 2001); Joseph v. ViaticalManagement, 55 P.3d 264, 267 (Colo. Ct. App. 2002) (holding that trust unitsconsisting of viatical settlements were investment contracts, and therefore securitiesunder Colorado law).

232 See generally Jerry W. Markham, Super Regulator: A Comparative Analysis

of Securities and Derivatives Regulation in the United States, the United Kingdom,and Japan, 28 BROOK. J. INT'L L. 319 (2003).

233 Compare Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosureand the Protection of Investors, 70 VA. L. REV. 669 (1984), and Mahoney, supranote 104, with Stout, supra note 187, at 783.

234 Mark D. West, Private Ordering at the World's First Futures Exchange, 98Mich. L. Rev. 2574 (2000).

235 See JERRY, supra note 177, at 89-90; PATrERSON, supra note 177, at 23-32;

VANCE, supra note 177, at 43-44.


2005] DISPARATE REGULATORY SCHEMES FOR PARALI.EI. ACTIvITIES 427

Insurance regulation to a large extent focuses on maintaining, to theextent possible, the solvency of insurance companies. This is doneby guarding the capital of insurance companies and the ways in whichinsurers can invest their funds and provide an adequate reserve forthe risks they insure against. 236 In England, the exchange-type systemthat Lloyd's uses to manage risk imposes substantial net worthrequirements on the investors who share the insurer's risk. 237 Shouldwe take a similar approach to derivatives? And, if so, to what extent?

The insurance parallel would seem to call for a system of requiringminimum capitalization of speculators in the derivatives markets. Thiswould involve much more restrictive regulation than currently existswith the margin requirements. Participants in publicly-traded andexchange-traded futures contracts are currently subject to marginrequirements, although the concept of a margin transaction has adiffering meaning in the commodities and securities markets. 238 In

236 See, e.g., CAL. INS. CODE § 1192.8 (West 2003) (investments in specified inter-est-bearing notes, bonds, or obligations); N.Y. INS. LAW §§ 1402, 1404 (McKinney2003) (minimum capital or minimum surplus to policyholder investments, types ofreserve investments permitted for non-life insurers). See generally JERRY, supra note177, at 89-90; PATTERSON, supra note 177, at 23-32.

237 See description in JERRY, supra note 177 at 42.238 1 JOHNSON & HAZEN, supra note 54, at § 1.02[13]:

The term margin first came into usage in the financial world as shorthandfor the minimum amount that a securities purchaser must deliver to his brokerbefore title to the securities would pass to him. The remaining balance wasborrowed (from the broker in most instances), and the buyer-now-owner ofthe securities would often deposit the certificates with the broker as a pledgeagainst the unpaid balance. The securities margin, therefore, had twosignificant features: (1) The buyer was conveyed title to the securitiesimmediately despite an unpaid balance; and (2) the broker (or other lender)extended credit to the new owner for the remainder of the purchase price.In the wake of the 1929 stock market crash, Congress lamented what itconsidered to have been excessive extensions of this type of credit to stockpurchasers in earlier years and authorized the Board of Governors of the then-new Federal Reserve System to set regulations limiting the amount of moneythat could be loaned by a broker or dealer to a securities purchaser.

Through a process that can only be described as unfortunate, the commodityindustry has chosen to utilize the same term - margin - to signify adrastically different economic event. Futures trading occurs in executorycontracts as yet uncompleted, representing an exchange of mutual promisesto conclude a sale later on specific terms. Acquisition of a futures contract,therefore, leaves title and ownership of the underlying commodity exactlywhere it was before the contract was entered. Title will not pass unless anduntil the futures contract is fully performed by both parties: the seller by



the commodities markets, the margin requirements operate to requirea deposit or down payment for any futures or commodities optioncontract that provides a safety net, enabling the investor to purchasean offsetting contract. In the event that market forces increase the costof an offsetting transaction, the broker will issue a margin call thatwill require the investor to liquidate his or her position or to providean additional margin amount. In the securities markets, the marginrules address the amount of collateral necessary for the extension ofcredit. When an investor invests in securities options by taking a shortposition, 239 even without borrowing funds to do so, a portion of theinvestor's marginable securities or cash in the account is restrictedso as to operate in much the same way as a commodity margin -namely to require an additional security deposit should the value ofa short option decline below a certain level.

delivering what he has promised; the buyer by tendering the full purchaseprice.

At the same time, however, entry into a futures contract creates the riskthat, when required, one of the parties may default on his obligation. Theseller might fail to deliver the commodity as promised, or the buyer may failto pay. For the protection of both, each party (seller as well as buyer) isrequired by exchange rules to deposit with his broker a certain sum of money(or a qualified property equivalent) in the nature of a performance bond orearnest money. This sum, inappropriately called a margin, is not recordedas a down payment or partial payment of the purchase price of the commodity.The seller, as well as the buyer, must make the deposit, and the deposits aretreated by law, specifically section 4d(2) of the Commodity Exchange Act,as remaining the property of the depositor during the life of the futurescontract.

239 In this context, a short position would be the writing of a put option, whereby

the option writer (or seller) gives the counterparty to the option to ability to forcea sale of the underlying security at the option exercise price. If the price of theunderlying security drops below the option exercise price, the option holder willeventually exercise the option requiring the option writer to sell the underlying securityto the counterparty at the option exercise price which has fallen below its marketvalue of the underlying security. Thus, when the option is exercised, the option sellerwill either have to sell stock out of his or her investment portfolio at a price belowits current market value or will have to cover his or her short position by purchasingthe underlying security in order to satisfy the sale obligation created by the option'sexercise.

With respect to a call option, a short position occurs when an investor writes acall option that entitles the counterparty to the option contract to buy the underlyingsecurity at the option exercise price. If the price of the underlying security rises abovethe option exercise price then the option writer will be required to sell the securityat a price below the current market price of the underlying security.



On the other hand, the over-the-counter derivatives markets do notimpose margin requirements. Participation in over-the-counter deriva-tives markets is limited to qualified investors; certain institutionalinvestors and individuals who comply with specified minimum networth requirements. 2 40 These qualification requirements provide somecapital protection. However, unlike margin requirements, the investorqualification requirements do not vary with the amount of the inves-tor's investment exposure. Thus, qualified contract participants whoover-commit to a derivatives transaction or enter into an economicallydisastrous derivatives transaction run the risk of insolvency. Whereascontract participants in an exchange transaction would be subject tomargin calls or a forced liquidation of the position, there is nocomparable protection for the counterparty to over-the-counter deriva-tives contracts.

Over-the-counter market derivative contract participants can allevi-ate these concerns by hedging the credit risk of the counterparties totheir bilateral derivates transaction by entering into a second deriva-tives contract to shift these credit risks to a less risk adverse counter-party. 241 Derivative contract investors may neutralize multiple risksthrough the use of multiple derivatives transactions. As is the casewith any derivatives transactions, the markets utilize speculators tohelp provide liquidity to these risk-shifting markets. Even the earlycases recognized that one party's speculative intent did not void afutures contract where the other party had a bona fide intent. 242

2 40 The 2000 amendments to the Commodity Exchange Act introduced a new cate-gory of eligible contract participants ("ECPs") consisting of institutional and highlyaccredited customers. ECPs include financial institutions, insurance companies,registered investment companies; corporations, partnerships, trusts, and other entitieshaving total assets exceeding $10,000,000, employee benefit plans subject to ERISAthat have total assets exceeding $5,000,000, and governmental entities, as well as someother categories of investors. Commodity Futures Modernization Act of 2000, Pub.L. No. 106-554, § 101, 114 Stat. 2763 (codified as amended at 7 U.S.C § la(12)).

241 This can be demonstrated by the following example. If Hedger wants to shiftsome risks involving currency rates, Hedger can enter into a currency swap transactionwith Counterpartyl that provides the desired risk protection. At this point Hedgermay be concerned with the solvency of or credit risks involved in dealing withCounterpartyl, so hedger may enter into a second contract with Counterparty2 underwhich Counterparty2 assumes the risk of default by Counterpartyl.

242 See, e.g., Irwin v. Williar, 110 U.S. 499 (1884) (if one party to a grain futurescontract intended delivery then the contract is not void for illegality even if the otherparty had had no intent with respect to delivery; however, if both parties had theimproper intent the contract could void for illegality).



Speculators in the derivatives markets help offset risks that hedgerswant to minimize or eliminate.

V. Comparing Alternative Regulatory Schemes

In contrast to the deregulatory trend in gambling activities and thenon-securities derivatives markets, insurance remains a highly-regulated industry. However, the justifications for substantive regula-tion of insurance contracts may be equally applicable to securitiesregulation. If so, more stringent securities regulation than is currentlyin place would be justified. The discussion below demonstrates thatthe underlying concerns of insurance regulation are especially relevantin the context of commodities investment.

A. Insurance Regulation Compared

There are several justifications for regulating insurance. 243 Thejustification "to compensate for inadequate information"2 44 is mostanalogous to the traditional justification for regulation of investmentmarkets, and, by extension, the traditional disclosure rationale ofsecurities regulation. Paternalism - a desire to protect what policy-makers deem as "the common good." 245

- also drives stronginsurance laws and more substantive regulation. This rationale, how-ever, is controversial since it sacrifices freedom of contract.

One explanation for the regulatory discrepancy between the insur-ance and investment markets is the widespread nature of insuranceand the fact that in many areas insurance is a necessity. 246 Home

243 Although the larger objectives of insurance regulation are to prevent destructivecompetition, compensate for inadequate information, relieve unequal bargainingpower, and assist consumers incapable of rationally acting in their best interests, thearticulated objectives of state legislative regulation are essentially four-fold: (1)ensuring that consumers are charged fair and reasonable prices for insurance products;(2) protecting the solvency of insurers; (3) preventing unfair practices and overreach-ing by insurers; and (4) guaranteeing the availability of coverage to the public. JERRY,supra note 177, at 85 (the first three objectives apply equally to securities and otherinvestment regulation). See also Spencer L. Kimball, The Purpose of InsuranceRegulation: A Preliminary Inquiry in the Theory of Insurance Law, 45 Minn. L. Rev.471, 501 (1961).

244 JERRY, supra note 177, at 52.245 Id. at 53.246 For example, it has been suggested that because of the pivotal role insurance

plays in our capitalistic system, the importance of insurance warrants public regulation.See Roger C. Henderson, The Tort of Bad Faith in First-Party Insurance Transactions:Refining the Standard of Culpability and Reformulating the Remedies by Statute, 26


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL. ACTIVITIES 431

owners insurance and health insurance are two examples that areconsidered necessities. Other types of insurance, such as life insurance,also span a large sector of the consumer population. Thus, theconsumer protectionist or paternalistic approach may be more justifi-able than with respect to investment markets, gambling, and othermore voluntary activities. Nevertheless, there are valid reasons forconsidering increased regulation with respect to these transactions. Thecollateral damage resulting from gambling losses and investmentlosses is tremendous. On one level, policymakers often consider theincreased incentive of addicts - whether it be drugs or gambling -to commit crimes to feed their habits. The domino effect of excessiverisk-taking also raises concerns. Consider, for example, the Enronemployees who lost their jobs and the Arthur Anderson employeesand retirees who lost their pensions. These are costs of speculativeactivity that if checked by regulation might have been prevented.

The paternalistic approach to interpreting insurance contracts, andspecifically, the interpretation of insurance contracts to protect in-sureds, is particularly pertinent in drawing analogies to investmentregulation. As a general matter, insurance companies have such asuperior bargaining position that there is no true opportunity tonegotiate insurance contracts. 247 Accordingly, when in doubt, courtstend to construe policies in favor of the insured. 248 There thus is asubstantial consumer protection element of the law governing

U. MICH. J.L. REFORM 1, 8-11 (1992). This has been described as a "public interest"basis for regulation. James M. Fischer, Should Advice of Counsel Constitute a Defensefor Insurer Bad Faith?, 72 TEx. L. REV. 1447, 1457 n.37 (1994).

247 See JERRY, supra note 177, at 52. Insurance policies are often characterizedas contracts of adhesion. As explained by one court, "in the typical situation, the policyrepresents a contract of adhesion entered into between two parties of unequalbargaining strength, expressed in the language of a standardized contract, written bythe more powerful bargainer to meet its own needs, and offered to the weaker partyon a 'take it or leave it basis.' " Garcia v. Truck Ins. Exchange, 682 P.2d 1100, 1106(Cal. 1984), citing Gray v. Zurich Insurance Co., 419 P.2d 168 (Cal. 1966). This claimhas been a long-standing one. See, e.g., Isaacs, The Standardizing of Contracts, 27Yale L.J. 34 (1917). See also, e.g., C & J Fertilizer, Inc. v. Allied Mut. Ins. Co.,227 N.W.2d 169, 174 (Iowa 1975).

248 See, e.g., James M. Fischer, Why Are Insurance Contracts Subject to SpecialRules of Interpretation?: Text Versus Context, 24 ARIZ. ST. L.J. 995 (1992). Forcontrary views, see, for example, Michael B. Rappaport, The Ambiguity Rule andIlsurance Law: Why Insurance Contracts Should Not Be Construed Against theDrafter, 30 GA. L. REV. 171 (1995); David S. Miller, Note, Insurance as Contract:The Argument for Abandoning the Ambiguity Doctrine, 88 COLUM. L. REV. 1849(1988).



insurance. 249 In addition to the contract rules on unconscionabilityand interpreting policies favorably towards insureds, the consumer-protection impetus is underscored by state insurance regulation. Forexample, under the doctrine of reasonable expectations, courts readilyinterpret insurance policies to reflect the reasonable expectations ofthe insured even in the face of contradictory language in the insurancepolicy itself.250 In addition, most insurance policies (at least thosemarketed to consumers) must be approved by state regulators whoconsider fairness, among other things. 251 Insurance law in this respectalso resembles the merit approach to securities regulation that wasrejected by Congress.

Moreover, as noted earlier, this pre-approval of the terms ofinsurance contracts parallels the CFTC's former role in approvingfutures contracts before they could be publicly traded. Formerly, thecommodities laws imposed a gate-keeping requirement on types ofpermissible derivatives contracts, which functioned similarly to theinsurable interest requirement for insurance policies. Until the adoptionof the amendments to the Commodity Exchange Act, brought in bythe Modernization Act, the CFTC and the various commodity contractmarkets approved each contract that was traded. One purpose of thiscontract approval process was to assure the economic integrity of each

249 See SPENCER KIMBALL & WERNER PFENNIGSTORF, THE REGULATION OF IN-

SURANCE COMPANIES IN THE UNITED STATES AND THE EUROPEAN COMMUNITIES 12(1981).

250 See, e.g., Robert A. Hillman & Jeffrey J. Rachlinski, Standard-Form Contract-ing in the Electronic Age, 77 N.Y.U. L. REV. 429, 459 (2002) ("The reasonable-expectations doctrine, also prominent in insurance form-contract cases, holds that'[t]he objectively reasonable expectations of applicants and intended beneficiariesregarding the terms of insurance contracts will be honored even though painstakingstudy of the policy provisions would have negated those expectations.' As worded,the doctrine allows courts to overturn express contract language if the term contradictsthe consumer's reasonable expectations."). See also, e.g., Roger C. Henderson, TheFormulation of the Doctrine of Reasonable Expectations and the Influence of ForcesOutside Insurance Law, 5 CONN. INS. L.J. 69 (1998); Roger C. Henderson, TheDoctrine of Reasonable Expectations in Insurance Law After Two Decades, 51 OHIOST. L.J. 823 (1990); Robert E. Keeton, Insurance Law Rights at Variance with PolicyProvisions, 83 HARV. L. REV. 961, 967 (1970); Peter Nash Swisher, A RealisticConsensus Approach to the Insurance Law Doctrine of Reasonable Expectations, 35TORT & INS. L.J. 729 (2000).

251 See COUCH, supra note 181 (describing these regulatory statutes). See also, e.g.,Susan Randall, Insurance Regulation in the United States: Regulatory Federalism andthe National Association of Insurance Commissioners, 26 FLA. ST. U. L. REV. 625(1999) (discussing the role of state law in insurance regulation).


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcIVrITIES 433

contract.25 2 This process functioned in much the same way as theinsurance regulation that requires state insurance regulators to approveinsurance policies that are marketed to consumers.253

From 1922 until 2000, the Commodity Exchange Act requiredfederal approval of a futures contract involving a demonstration thatthe instrument could and would be used substantially to hedge againstprice risks or to assist in the price formation (price "discovery")process. Known early as an "economic purpose" test, and later as a"public interest" test, this standard was deleted from the CommodityExchange Act by the Modernization Act. The Commission and thecourts will decide whether this standard resides invisibly within thecurrent statute, but arguably, it does not. 254 Moreover, the principalmeans of administering this standard was lost under the CFMA'selimination of the Commission's right to prevent or even block thelisting of new contracts. Yet the Commodity Exchange Act stillprotects listed futures contracts from being attacked under state gamingand bucket shop laws. 25 5

Indeed, many of the reasons for heavy regulation of insurance mayalso apply (albeit in a secondary or derivative manner) when consider-ing regulation of derivative investments - at least in reevaluating thedisparity in the current regulatory environment. The comparisonbetween insurance and derivatives regulation is even more strikingthan the disparity between securities and derivatives regulation. Justas we assume that insured do not read their insurance contracts, it isequally likely that consumers do not read derivatives contractscarefully. 256 Yet, we impose stringent regulation on one industry and

252 See 1 JOHNSON & HAzES, supra note 54, at § 2.03.

253 See, e.g., CoucH, supra note 181.

254 Although not rising to the level of an agency or judicial adjudication, therewas considerable controversy when terrorism futures were first proposed following9/11 and the nation's subsequent concerns over terrorist attacks. The issue resurfacedin late 2003.

2 55 See generally Julie M. Allen, Kicking the Bucket Shop: The Model State Com-modity Code as the Latest Weapon in the State Administrator's Anti-fraud Arsenal,42 WASH. & LEE L. REV. 889 (1985) (discussing the application of state anti-bucketshop laws).

256 See, e.g., Paul D. Carrington, Self-Deregulation, The "National Policy" of theSupreme Court, 3 NEV. L.J. 259, 278 (2002/2003) ("It is the premise of insuranceregulation that citizens cannot be expected to read and understand the intricate termsof the policies they buy."). Courts readily recognize that consumers do not read thedetails of insurance policies: "It is generally recognized the insured will not read thedetailed, cross-referenced, standardized, mass-produced insurance form, nor under-


434 ANNUAi REVIEW OF BANKING & FINANCIAL LAW [Vol. 24: 375

relegate protection of the other to mere disclosure. Unless we arewilling to consider eliminating the role of state insurance administra-tors in protecting policyholders, it seems appropriate to considerreinstating the former futures approval process at least with respectto publicly traded derivatives. In deciding the future of derivativesregulation, we must ask whether this regulatory disparity can beexplained other than as an accident of the different history and publicchoice input - whether insurance is so different from the gambling,securities investments, and derivatives investments as to warrant suchdifferent regulatory treatment.

B. Hedging Versus Speculation: If It Walks Like a Duck...

Stepping back a moment from the issue of derivatives, let usexamine how much of the distinction between bona fide hedging (orinsurance) and gambling is in the eye of the beholder. Consider, forexample, merchants in a city hosting major league baseball who haverecently enjoyed great success in the fall as a result of the home teammaking it through divisional playoffs and into the World Series. Themerchants clearly have a legitimate interest in hedging against lostsales due to the absence of a post season event. Further, consider thefact that a seven-game world series will bring more income than afour-game series. Should a merchant be able to enter into a hedgecontract to protect itself against the home team not making it into thepost season or having a truncated post season due to losing games?If so, how does this differ from betting on the outcome of the specificgames that would determine the length of the post season? Note thatto the extent that attendance will increase even during the regular

stand it if he does." C & J Fertilizer, Inc. v. Allied Mut. Ins. Co., 227 N.W.2d 169,174 (Iowa 1975), relying on 7 WILLISTON ON CONTRACTS § 906B, p. 300 ("But wherethe document thus delivered to him is a contract of insurance the majority rule isthat the insured is not bound to know its contents"); 3 CORBIN ON CONTRAcrs § 559,pp. 265-66 ("One who applies for an insurance policy ... may not even read thepolicy, the number of its terms and the fineness of its print being such as to discouragehim"); Note, Unconscionable Contracts: The Uniform Commercial Code, 45 IOWAL.REV. 843, 844 (1960) ("It is probably a safe assertion that most involvedstandardized form contracts are never read by the party who 'adheres' to them. Insuch situations, the proponent of the form is free to dictate terms most advantageousto himself"). See also, e.g., Hully v. Aluminum Company of America, 143 F.Supp.508, 513 (S.D.Iowa 1956), aff'd sub nom. Columbia Casualty Company v. EichleayCorp., 245 F.2d 1 (8th Cir. 1957); Collegiate Mfg. Co. v. McDowell's Agency, Inc.,200 N.W.2d 854, 859 (Iowa 1972); Quinn v. Mutual Benefit Health & Acc. Ass'nof Omaha, 55 N.W.2d 546, 550 (Iowa 1952); Lankhorst v. Union Fire Ins. Co., 20N.W.2d 14, 17 (Iowa 1945).


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcrvITIES 435

season according to the team's success, there could be an interest inhedging against losses on a daily basis. Would the law allow a poolingof these risks among major league baseball teams as a type ofinsurance? If so, how does this differ from allowing organizedgambling throughout the country?

Continuing with the same sports analogy, an owner of a professionalsports team invests significant funds in the franchise, players' con-tracts, and the stadium with the hopes of reaping a return on theseinvestments through attendance and media contracts. The payout ofa sports team is clearly connected to the team's success. It would seemrational for a team owner to hedge against the team's lack of successthrough a futures contract against a down turn in attendance or byhedging against the team's failure to make it into post-season play.It would thus make sense, for example, to bet against ones own teamas a hedge against revenue loss. How is this any different than thewheat farmer who hedges against a crop loss by entering into a wheatfutures or forward contract?

One point that might be raised is that a team owner who bets againsthis own team will have an incentive to try to promote a loss in orderto cash in on the wager or hedging contract. One way to deal withthis problem would be to make an analogy to the insurable interestdoctrine and to allow a hedge so long as it would be sufficient tocompensate for the economic loss but would not provide the moralhazard associated with over insurance. Furthermore, the moral hazardproblem does not occur with respect to the merchant who is tryingto hedge against revenue loss and is not in a position to affect theoutcome of the game. The law does not distinguish between these typesof wagers that could serve as hedges or insurance and those, such asa craps game, that are pure gambles.

Presumably, these hedging contracts against a loss in revenuesoccasioned by losing a game would constitute illegal gambling. Toput it another way, it would seem unlikely that there would be apermissible insurable interest here. Would these hedging contracts bepermissible derivatives contracts? On the one hand, the hedgingfunction to the team owner is self evident. On the other hand, if thelaw permits these hedging contracts, the opportunity for speculatorscreates an opportunity for a form of legalized gambling that is notpermitted under the laws dedicated to gambling regulation.

Although there is a moral hazard concern, that concern should notbe the sole factor in determining the legitimacy of any particular



contract. It is not sufficient to say that since the team owner has theopportunity to affect the outcome, the hedge or insurance contractshould not be allowed. The farmer has an equal opportunity to affecthis or her crops and thereby alter the outcome as does the propertyowner who seeks fire insurance. The law deals with these potentialevils by outlawing arson, or in the case of sports by tampering in muchthe same way as securities and commodities law prohibits manipula-tion.257 The rules against investment market manipulation are deemedsufficient to allow companies to invest in their own securities. Parallelrules protect against hedgers altering the outcome of the event hedged- including the outcome of a sports event. As pointed out above,if this type of sports hedging is legitimate, then the parallel to thesecurities and derivatives markets would call for allowing speculators(i.e., gamblers) to engage in the same activity as a way to make thehedging market more efficient.

It is conceivable in the derivatives markets that both parties to abilateral derivatives contract will be hedgers who are able to allocatereciprocal risks to one another. However, it is also common inderivatives transactions for risk averse parties to look to speculatorsto unload their risk. For example, a commercial participant in a marketmay not be able to locate a counterparty to a desired hedging contractif that counterparty must itself be a commercial hedger. Speculatorshave thus been characterized "people who accept the risk hedgers donot want." 2 58 As such, they perform a very important function forcommercial participants looking to hedge business risks. In fact, oneanswer to the charge that derivatives are nothing more than legalizedgambling is that they provide legitimate hedging opportunities forinvestors and, more importantly, for commercial participants in theunderlying commodities markets. It also is often pointed out thatspeculators help make markets more efficient by providing additionalliquidity, which in turn performs a price discovery function.2 59

Commercial participants in the public commodities and derivativesmarkets (designated contract markets) may thus be relying on specula-tors to provide them with efficient markets for their hedging activities.

257 See 3 JOHNSON & HAZEN, supra note 54, at ch. 5.

258 Scott Marc Kolbrenner, Derivatives Design and Taxation, 15 VA. TAX REV.

211, 217 (1995) (quoting ROBERT A. STRONG, SPECULATIVE MARKETS 5 (2d ed.1994)).

259 While certain commodities markets may be relatively illiquid, allowing for amore actively traded futures market means that the pricing of futures contracts willreflect pricing in the cash or spot market for the underlying commodity.


2005] DISPARATE REGULATORY SCHEMES FOR PARALLEL AcrIVITIES 437

Indeed, hedging operates much like a variety of insurance 260 as itallows a risk averse party to pass the risk on to someone else 26' whois willing to do so for a premium. 262 That premium can take the formof insurance premium or the cost of an options, futures, or swapcontract. With respect to insurance, the risk is absorbed by theinsurance company, which pools its premiums and manages that poolas an investment to cover the claims as they are made by thepolicyholders. 263 With respect to hedging, a credit event derivativescontract 264 is a type of insurance against an undesired credit eventsuch as a default on a loan. 26 5 Similarly, interest-rate derivativetransactions such as caps, 2 66 floors, 26 7 and collars 268 are used by

260 As explained by one court: "Hedging affords such protection; it is in the natureof price insurance. The real difference between hedging and gambling is that thehedger has a legitimate interest to protect apart from the hedging transactions, whilethe gambler has no interest except in the transactions depending on the rise and fallof the market. An insurance contract becomes a wager when the insured has nolegitimate interest to be protected against the happening of the event insured against."Boilin-Harrison Co. v. Lewis & Co., 187 S.W.2d 17, 24 (1945), relying on EdwinW. Patterson, Hedging and Wagering on Produce Exchanges, 40 YALE L. J. 843-884(1931). See also, Note, Legislation Affecting Commodity and Stock Exchanges, 45HARv. L. REV. 912 (1931-1932).

261 "Like someone seeking catastrophic health insurance, for example, a hedgeris thought of as a risk-averse party seeking to pass on an amount of risk to a risk-neutral(or less risk-averse) party, such as an insurance company, better able to bear it."Kolbrenner, supra note 258, at 217.

262 "[Like a writer of insurance, the option-writer receives a small benefit, thepayment of a premium, for entailing comparatively large risk, the unlimited liabilityto purchase or sell the underlying [commodity, security, index or other referencepoint]." Id. at 222.

263 Although this is the traditional structure of insurance companies in the UnitedStates, Lloyd's of London finances its risk management in a manner much moreanalogous to the commodities and derivatives markets.

264 See, e.g., Andrd Scheerer, Credit Derivatives: An Overview of Regulatory Initia-tives in the U.S. and Europe, 5 FORDHAM J. CORP. & FIN. L. 149 (2000).

265 John D. Finnerty & Mark S. Brown, An Overview of Derivatives Litigation,1994 to 2000, 7 FORDHAM J. CORP. & FIN. L. 131, 136 n.12 (2001).

266 In a cap, one party shifts the risk of an increase in interest rates by enteringinto a derivatives transaction that shifts the risk of an interest rate increase to thecounterparty to the contract.

267 In a floor, a party (for example, a lender in a variable rate loan) can shift therisk of an increase in interest rates to the counterparty to the derivates contract.

268 A collar transaction consists of a party contracting for interest rate protectionon both the upside and the downside by locking in both maximum and minimuminterest rates for which the party will bear the risk; these risks are thus shifted tothe counterparty.



banks and other lenders (as well as by some borrowers) to transferor hedge against undesired credit risks. As a general proposition whenderivatives transactions are used as hedging devices, they are mostdefinitely a type of risk shifting, 269 as is insurance.270 The risk-shifting function of derivatives contracts thus operates as a type ofinsurance.

The practical similarities between the hedging, insurance, andgambling are gaining recognition. Both the legal community 271 andthe popular press have recognized the ways in which derivativesoperate as insurance. 272 There are derivatives based on environmentalcompliance such as clean air futures, 273 which are another way ofshifting the risks allocated by environmental insurance. 274 Businesseshave begun to use derivatives strategies to help deal with insurancerisks. 275 Participants in the investment markets have developedstrategies that operate as insurance. 276 Now, it is up to regulators to

269 See Joseph J. Bianco, The Mechanics of Futures Trading: Speculation and Ma-nipulation, 6 HOFSTRA L. REV. 27, 32 (1977); Alan N. Rechtschaffen, InternationalSymposium on Derivatives and Risk Management, 69 FORDHAM L. REV. 13, 15 (2000).

270 Benjamin E. Kozinn, Note, The Great Copper Caper: Is Market ManipulationReally a Problem in the Wake of the Sumitomo Debacle?, 9 FORDHAM L. REV. 243,253 (2000) ("In other words, the futures markets provide an insurance function forthe hedger.").

271 See George Crawford, A Fiduciary Duty To Use Derivatives?, 1 STAN. J.L.Bus & FIN. 307, 321 (1995); Jonathan R. Macey et al., Symposium on the Regulationof Secondary Trading Markets: Program Trading, Volatility, Portfolio Insurance, andthe Role of Specialists and Market Makers, 74 CORNELL L.REv. 799, 811-812 (1989);John Andrew Lindholm, Note, Financial Innovation and Derivatives Regulation -Minimizing Swap Credit Risk Under Title V of the Futures Trading Practices Actof 1992, 1994 COLUM. Bus. L. REV. 73, 100 (1994) (referring to "swap insurance").

272 See, e.g., Gregory J. Millman, Derivatives as Dump Trucks; They Are Risky,but They Haul away the Refuse of Bad Government Policy, WASH. POST, Dec. 18,1994, at C2 ("Financial engineers, many of them holding PhDs in mathematics,physics or other sciences, designed new derivatives contracts to function like a formof financial insurance.").

273 Henry E. Mazurek, Jr., The Future of Clean Air: The Application of FuturesMarkets to Title IV of the 1990 Amendments to the Clean Air Act, 13 TEMP. ENVTL.L. & TECH. J. 1, 16 (1994); Adam J. Rosenberg, Note, Emissions Credit FuturesContracts on the Chicago Board of Trade: Regional and Rational Challenges to theRight To Pollute, 13 VA. ENVTL. L.J. 501, 518-519 (1994).

274 See, e.g., Christopher R. Hermann, Joan P. Snyder & Paul S. Logan, The Unan-swered Question of Environmental Isurance Allocation in Oregon Law, 39 WiLLAm-ETrE L. REV. 1131 (2003).

275 See, e.g., Tamar Frankel & Joseph W. LaPlume, Securitizing Insurance Risks,19 ANN. REV. BANKING L. 203 (2000).

276 For example, program trading and other options strategy in the securities mar-


2005] DISPARATE REGULATORY SCHEMES FOR PARALiLEL AcrIVITIES 439

acknowledge the similarities between these parallel industries and tosynthesize their various regulatory approaches into a comprehensivemodern scheme.

VI. Conclusion: Reconciling Divergent RegulatoryTrends in the Securities and Non-securitiesInvestment Markets

This article has examined four areas of economic activity -

securities, non-securities derivatives investments, gambling, and insur-ance. There are two divergent regulatory trends exemplified byincreased regulation of the securities markets and the deregulation ofthe markets for non-securities derivative instruments. The deregulatoryenvironment for derivatives parallels the general trend towards de-regulation of gambling. It is worth noting that the increased securitiesregulation brought in by the Sarbanes-Oxley Act of 2002 began justfive years after the second of two deregulatory efforts. The PrivateSecurities Litigation Reform Act of 1995277 and the SecuritiesLitigation Uniform Standards Act of 1998278 were efforts to deregu-late the securities markets through the imposition of barriers on privatelitigation to redress alleged securities law violations. 279

There was a parallel deregulatory tone sounded by the SEC undera new Republican majority on the Commission and the leadership of

kets have been described as portfolio insurance. See, e.g., MARKHAM & HAZEN, supranote 75, at § 2:22 (portfolio insurance "is simply hedging by institutional traders toprotect their portfolios in the event of adverse market movements"); Hazen, supranote 127, at 167; Stout, supra note 99, at 627 (1988). Notwithstanding the foregoingsimilarities, there clearly is some division between insurance and derivatives riskshifting. For example, it was held that a commodities broker acted negligently andin violation of state insurance law for an insurance company to enter into hedgetransactions on a commodities exchange. Investors Equity Life Ins. Co. of Haw. v.ADM Investor Serv., Inc., 1997 U.S. Dist. LEXIS 23881, at *26-27 (D. Haw. 1997)(the investments violated the rules of the Chicago Board of Trade).

277 Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat.737 (codified as amended in scattered sections of 15 and 18 U.S.C.).

278 Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112Stat. 3227, 3230 (codified as amended in scattered sections of 15 and 18 U.S.C.).

279 The Private Securities Litigation Reform Act provided heightened pleading stan-dards and tightened procedural requirements that were designed to inhibit strike suits.Private Securities Litigation Reform Act §§ 101-203. The Securities LitigationUniform Standards Act preempted plaintiffs trying to go to state court to avoid thelimitations of the Private Securities Litigation Reform Act. Securities LitigationUniform Standards Act § 2.



new Chairman Harvey Pitt who took over in 2001.280 The burstingof the market bubble that existed in dot.com and other surging high-tech securities combined with the series of massive corporate fraudsthat came to light nudged Congress out if its deregulatory bias andback into a re-regulatory mode. Although the impetus for their positiondiffers from the investment markets, some commentators have sug-gested that even outside of the securities and derivatives markets,policymakers should consider re-criminalizing gambling. 281

Deregulation clearly has been the trend with respect to derivativesand gambling and even with respect to securities laws prior to theSarbanes-Oxley Act. Coherence in these parallel regulatory environ-ments could call for continued deregulation of derivatives and gam-bling, as well as renewed deregulation of the securities markets.

Some of the securities law re-regulation may well be an overreactionto events in the news. On the other hand, it seems more likely thatthis was a necessary wake-up call and that a similar reaction iswarranted with respect to the non-securities derivatives markets (andto the gambling laws as well). Lest we forget, one of the majorcorporate failures was Enron, which resulted not only from aggressiveaccounting practices that were addressed by the Sarbanes-Oxley Act,but also Enron's heavy involvement in derivatives transactions.

The deregulation of the non-securities derivatives markets leavesgaps that may provide openings for additional failures. It would bewise to reconsider the deregulation of the non-securities derivativesmarkets before having to reactivate re-regulation in the wake of thenew major scandals. There would be obvious opposition to re-regulation of the derivatives markets from those observers andcommentators who generally favor free unregulated markets. Opposi-tion to increased regulation has come from other directions as well.For example, another interesting spin is that overregulation may createa moral hazard by encouraging investors to take on risk. 28 2 This

280 See SEC, Historical Summary, www.sec.gov/about/concise.shtml.28L See John Warren Kindt, Would Re-Criminalizing U.S. Gambling Pump-Prime

the Economy and Could U.S. Gambling Facilities Be Transformed into Educationaland High-Tech Facilities?: Will the Legal Discovery of Gambling Companies' SecretsConfirm Research Issues? 8 STAN. J.L. Bus. & FIN. 169 (2003). See also John WarrenKindt, The Failure To Regulate the Gambling Industry Effectively: Incentives forPerpetual Non-Compliance, 27 S. ILL. U. L.J. 221 (2003).

282 See, e.g., Mark Klock,, Two Possible Answers to the Enron Experience: WillIt Be Regulation of Fortune Tellers or Rebirth of Secondary Liability?, 28 J. CORP.

L. 69, 79 (2002) ("Investors take risks in the hopes of rewards. When they obtain


20051 DISPARATE REGULATORY SCHEMES FOR PARALLEL ACTIVITIES 441

concern seems misplaced, given the litigations costs and the huge legalfees to plaintiffs' lawyers; the increased incentive to investors to takeon risk to be compensated for in subsequent litigation seems marginalat best.

This article has discussed the generalities of these regulatoryregimes. The similarity of transactions and disparity of regulation canprovide fertile fields for exploration of specific regulatory rules inaddition to the more generalized policies discussed herein. This articlehas raised the question of the general parameters of industry or marketregulation. I have suggested that a more coherent regulatory approachis needed. Once policymakers accept the need for bringing theseparallel regulatory schemes more in line with one another, then theycan turn to formulating specific proposals that have not been addressedin this article. For example, the divergent re-regulatory approach ofthe securities laws and deregulation under the commodities laws needto be reconciled. As another example, policymakers should considerfashioning disclosure rules applicable to insurance sales to moreclosely approximate those applicable to securities and non-securitiesderivative transactions. This author hopes that this article serves asa springboard for these types of deliberations.

an unfavorable outcome, they seek restitution. This is the 'heads I win, tails you lose'game. It can also be modeled as giving investors a free option or as creating a moralhazard problem in which investors are encouraged to seek out excessive risk. Afteran investor incurs a loss on a risky investment, she has the incentive to assert thatthe ex post outcome proves the ex ante risk to be too large. Since such assertionsinherently lack credibility, they should only be considered if there is evidence of fraud.This rule is designed to prevent gamblers from placing a bet knowing the risks andthen after losing the bet, demanding the return of the stakes on the theory that thebet was unfair) (footnotes omitted).


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