The Code of Capital: How the Law Creates Wealth and Inequality
Katharina Pistor
320 pages, Princeton University Press, 2019
Capital is not a thing; it is the capacity of an object, claim, or idea to produce wealth. Capital owes its wealth producing capacity to a handful of legal institutions that form part of private law. They are property and collateral law, corporate, trust, and bankruptcy as well as contract law. These are the modules of the code of capital, which have been used for centuries to graft wealth generating attributes, namely priority, durability, convertibility, and universality onto different assets: land, firms, financial assets, knowledge, even nature’s own genetic code and the data we produce in the digital age. The fact that capital is coded in domestic law poses a puzzle for our global system of financial capitalism: How is this system sustained in the absence of a global state and of global law? The answer is that in theory a single domestic legal system can sustain global capitalism as long as all other legal systems recognize and enforce the legal attributes that were coded in this system. In practice, we do not have one but two legal systems that support global capitalism: English law and the law of New York state. The bulk of financial assets that are traded globally are issued or managed by financial intermediaries that are located in these jurisdictions and most of the top 100 global law firms reside in London or New York. This is where capital is coded for the globe; other countries are rule-takers, not rule-makers; they only enforce legal choices made elsewhere. Viewed through the lens of the code of capital, globalization is not a law-free space detached from states and their legal systems. Rather, it is deeply rooted in select legal systems whose reach has been extended beyond their territories. — Katharina Pistor
Capital has become mobile and seems to know no borders; goods cross oceans and corporations roam the globe in search of new investment opportunities, or simply a more benign tax or regulatory environment; financial assets worth trillions of dollars are traded daily at the stroke of a key and settled in digital clouds with no land in sight. Yet, there is no single global legal system to support global capitalism; nor is there a global state to back it with its coercive powers. We thus confront a puzzle: If capital is coded in law, how can global capitalism exist in the absence of a global state and a global legal system?
The solution to this puzzle is surprisingly simple: global capitalism can be sustained, at least in theory, by a single domestic legal system, provided that other states recognize and enforce its legal code. Global capitalism as we know it comes remarkably close to this theoretical possibility: it is built around two domestic legal systems, the laws of England and those of New York State, complemented by a few international treaties, and an extensive network of bilateral trade and investment regimes, which themselves are centered around a handful of advanced economies.
Extending law in space to people and territories in faraway places is reminiscent of empire. For most people in most countries, the law that sustains global capitalism is also beyond reach, because these countries only recognize and enforce laws that were made by others. Exporting law has a long history. English settlers and colonizers applied the common law throughout the growing empire and sent judges to far-off places to implement it. Napoleon Bonaparte’s troops brought the French legal codes with them wherever they went, extending the reach of French law to Poland in the East, and to Spain, Portugal, and Egypt in the South. Imperialism was not only about military conquest, but also about spreading the legal system of the European states to the colonies they created in Africa, Asia, and the Americas.
Building the legal infrastructure for global commerce has taken, for the most part, one of two forms: the harmonization of laws in different states, and the recognition and enforcement of foreign law. The latter has been much more successful in protecting capital globally, but it did require that countries adapted their own conflict-of-law rules to ensure that private choice and autonomy would prevail over public concerns.
Extensive legal harmonization was tried at first—especially in the period following the Second World War, with the goal of reinvigorating global trade and investment. The European Union (EU) is the poster child for countries coming together to forge common rules for a common market. The alternative to the deliberate harmonization of laws through the political process is legal and regulatory competition among states combined with private autonomy for the law’s end-users, who get to pick and choose what is best for them. For this to work, countries do not need to engage in laborious legal harmonization projects regarding the contents of, say, contract or corporate law; they only need to put in place conflict-of-law rules that endorse the choices that private parties make. These rules have the additional advantage that they are so arcane, their passage ruffles few feathers in the day-to-day political process.
There are specific conflict-of-law rules for every area of the law, such as contracts, torts, property rights, corporate law, and so forth. For contract and corporate law, conflict-of-law rules have converged to a remarkable extent on the principle that the parties to a contract or the founding shareholders are free to choose the law by which they wish to be governed. When it comes to property rights, however, most states still insist on their legal sovereignty and impose domestic law on assets that are located within their territory. But territorial control is of little use for assets that lack physical form or location; for tradeable financial assets, other criteria had to be found to determine whose law should govern them—and ideally criteria that would point to one and the same legal system when invoked in different countries. To this end, legal practitioners and some academics gathered under the auspices of a prominent forum, the Hague Conference on Private International Law, and hammered out an international treaty that gives private parties a lot of choice: financial assets are governed by the laws of the issuing entity (which itself is up for grabs) or by a contract between account holder and account manager. Still, the extension of private choice did not resolve the question of the relation between private contracts and mandatory bankruptcy law. Given how politically sensitive bankruptcy is for sovereignty, it should not come as a surprise that this is one of the major the battle grounds over the global code of capital as the following case study illustrates.
Making State Law Compliant With Private Contracts
The rise of derivatives markets triggered a re-ordering of private contracts and mandatory state law. In general, private contracts have to comply with state law. For derivatives contracts, mandatory state law was made compliant with these contracts.
Derivates are assets that are derived from another, underlying, asset. Options, swaps and futures have been around for long; credit derivatives were added to the mix more recently; they are credit derivatives are credit claims built on credit claims, packaged in law to bundle risks and rewards to attract willing buyers.
The rise of credit derivatives prompted the establishment of a private association of international derivatives traders and their lawyers, the International Swaps and Derivatives Association (ISDA). ISDA was formed in 1985 at a time when the issuers of these innovative instruments each fashioned their own derivatives contracts that were tailored to the specific needs of their clients. The success of ISDA has been beyond anyone’s imagination. Today, the association has more than 850 primary members in sixty-seven countries—the who’s who in global finance and, as associate members, the who’s who in global law. ISDA’s key contribution to the emergence of a global derivatives market was a contractual platform for swaps and other derivatives—the “Master Agreement,” or MA for short. It is a framework contract, fondly referred to by ISDA insiders as a piece of private legislation, which specifies the rights and obligations of counterparties wishing to engage in derivatives transactions with one another.
The MA is not intended as a substitute for domestic law but uses it as a gap filler. It prompts the parties of the MA to choose a default law and to elect the courts from that legal system for resolving any disputes. Notably, the MA advises the parties to limit their choice to one of two legal systems, English law or the law of New York State. The parties may choose otherwise, but they are advised that they risk increasing legal uncertainty if they do so.
Well-crafted contracts offer guidance not only for good but also for bad times and ISDA’s MA is highly attentive to questions of default and termination, which loom large in finance. According to ISDA’s MA, bankruptcy is a triggering event that allows the non-defaulting party to clear out all outstanding claims against the party that finds itself in bankruptcy proceedings, and to pay what it owes, or take out what the debtor owes to it. There is no waiting, no concern for the other creditors, and no consideration for reorganizing the defaulting debtor. With these contractual provisions, the MA sought to create a special default regime for derivatives traders that allows them to reposition their bets even as one of their counterparties finds itself in bankruptcy. In fact, the close-out netting provisions of the MA were in direct tension to most countries’ bankruptcy laws. These laws typically prohibit the use of bankruptcy as an event that triggers contractual default; they also impose a wait period, or automatic stay, on any enforcement actions by any creditor; and they give the receiver in bankruptcy the right to cherry pick contracts that the other party must fulfill, even though it may not recover its own obligation in full from the insolvent debtor.
Bankruptcy is mandatory law, therefore private actors cannot just contract around it. The only option for ISDA was to get legislatures to change their bankruptcy laws so that they would accommodate the provisions of ISDA’s MA, that is, to make state law consistent with private contracts. ISDA did just that; in total, the association successfully lobbied more than fifty legislatures to change their bankruptcy laws.
These legal changes hardly ever raised objections or caught the attention of the broader public. Exemptions from the ordinary operation of bankruptcy law were sold to legislatures as technical fixes that were necessary to ensure that their country would be able to integrate with the global marketplace. The fact that bankruptcy safe harbors altered the priority rights of creditors and subordinated trade creditors, as well as claims of employees and other ordinary creditors to the counterparties of derivatives transactions, was swept under the carpet. So was the fact that the privileging of these assets prompted others to organize their loan contracts as derivatives as well. Who would not want a priority right that is enforceable against the rest of the world, if all it takes is tweaking a contract? Lawmakers tilted the playing field in favor of the top tier of financial intermediaries, who were deeply vested in derivatives markets without giving it much thought. They realized only after the crisis that in doing so, they had also put their own governments on the hook.
The great financial crisis served as a wake-up call that the concessions lawmakers had made to finance not only did not produce the desired effects but were even counterproductive. Contrary to the advocates of these new financial instruments, they were not safe, and neither did bankruptcy safe harbors protect the market for derivatives, much less anybody else. Many legislatures now had second thoughts about bankruptcy safe harbors and decided to roll them back.
One would think that what a legislature has given it can also take back. But this proved more difficult, not the least because of the size of global derivatives markets. Millions of MAs governed by English or New York law were in use that contained close-out netting rules. Even if one state decided to change its domestic bankruptcy law and to roll the clock back to the state of the world prior to ISDA’s global lobbying campaign, that state would not necessarily be able to prevent a foreign private party from making use of its contractual close-out netting rights in time to preserve the debtor’s assets.
In the end, the FSB negotiated a deal with ISDA to create a new protocol to the MA that would include the new waiting periods. After a long battle, governments scored a goal, even though a 48-hour waiting period may not seem all that remarkable. The fact that sovereign states had to co-opt a private business association, namely ISDA, to achieve their regulatory goals, indicates the extent to which states have lost control over the governance of global finance.
Looking back, there was no grand strategy that set out how private parties would conquer the state’s coercive powers without submitting to its rules. Instead, private lawyers have pieced together different portions of legal rules that were adopted in different eras, and their combined effect became apparent only after all the pieces had been put into place. States offered a helping hand by dismantling legal barriers of entry, and even more importantly, facilitated private party choice of foreign law and foreign or international arbitral tribunals, while maintaining the promise to enforce these laws and wards with their coercive powers.