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Bright Lines and Cheating

photo: littlevanities via Flickr

When I was Securities Commissioner in Tennessee in the early 1980s, I had the discretion to judge whether specific securities met fairness guidelines adopted by regulations. That concept must startle people today. A poorly-paid and doubtless ignorant state bureaucrat has the power to deny the masters of the universe their heaven-sent right to sell whatever garbage they dreamed up to my fellow Tennesseans? That’s probably incomprehensible to a generation raised not to notice that the theory that markets regulate themselves is crazy.

In the early 1980s, state securities regulators were coming under attack from the SEC over our intrusive regulation and our sour attitude towards the securities industry. Lobbyists were all over us at our meetings, telling us that we were interfering with the brilliance of their business, and otherwise insulting our intelligence. One of their principal demands was that we provide bright line tests for fairness and for any regulation, so that they would know exactly what they could and couldn’t do.

I never understood the point of that. If a regulator is bound by fixed rules there is no way to prevent people from trying to game the system. Consider the case SEC v. Howey Co., 328 US 293 (1946). Howey owned citrus groves in Florida. It offered people the opportunity to buy into the orange grove business, one acre at a time. The acre was one row of 48 trees, right next to another row of 48 trees. You could also buy a contract to take care of the oranges and market them. Obviously folks from Ohio and Vermont weren’t going to cultivate their grove, so they hired Howey or another company to do it for them. . . .

The SEC filed suit asking for an injunction barring Howey from offering to sell the combination of real estate and orange grove management services, on the grounds that it was a security. They argued that the combination was an investment contract, a term used in the statutory definition of security. The District Court and Court of Appeals ruled against the SEC. The lower courts treated the two contracts separately, and held that they were merely a transfer of real estate and a contract to manage the real estate. The Supreme Court unanimously disagreed.

The Court observed that there is no statutory definition of the term investment contract, nor was there any relevant legislative history. The Court pointed out that the term was widely used in state Blue Sky laws, the kind I enforced, where it was interpreted broadly to provide protection for investors. “Form was disregarded for substance, and emphasis was placed on economic reality.” The correct interpretation of the term investment contract was purchase of a share in“… a common enterprise with the expectation that they would earn a profit solely through the efforts of the promoter or of some one other than themselves.” Id. at 298.

Now consider this case: a guy sells earthworms to people and promises to buy back their total production at the same or higher price. If we were under a bright line test, he would argue that the people did all the work, he just bought the worms back. Because the Supreme Court didn’t establish bright lines, the Court in Murfreesboro could hold that he provided the essential services necessary to make the venture profitable, and off to jail with him.

Now, of course, we live in bright line times. If Howey Co. came up today, the school of statutory construction led by noted Lewis Carroll scholar Antonin Scalia would rule that Congress must have meant the words it used, because business needs bright lines so it can operate efficiently. There was a contract, they would say, in fact two contracts. On the other hand, where was the investment? Buyers acquired something of value in itself, and they made the decision to hire some help to realize that value. They would have agreed with the lower courts in Howey.

The recent case of insurance companies announcing that they had found a loophole in the health insurance reform laws which permitted it to deny coverage to children with pre-existing conditions is a present-day example. In the same way, women with breast cancer will be exposed to loss of coverage under fraud exceptions, no matter how the language is drafted. When Angela Merkel announced that Germany would ban certain naked short sales, the business press said it was irrelevant because naked shorts are permitted in London, so everyone will just go there.

That is exactly what the Scalia school of interpretation wanted: laws regulating corporations can’t be enforced because they cannot be written carefully enough to cover every contingency. Corporations only need to stay within the bright lines as they interpret them. And a law that cannot be enforced might as well not exist.

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