This is a circulating draft of an article that is forthcoming in 24 Annual Review of

Banking & Financial Law ----- (2005).

DISPARATE REGULATORY SCHEMES FOR PARALLEL ACTIVITIES:

SECURITIES REGULATION, DERIVATIVES REGULATION, GAMBLING,
AND INSURANCE

Thomas Lee Hazena

Although bearing striking similarities to each other in many respects, securities

investments, non-securities derivative investments, insurance and gambling are subject
not only to different regulatory regimes but also to vastly different levels of government
interference. Traditionally, stringent prohibitions characterize the insurance and
gambling industries, whereas regulation of investments in securities and derivatives
occurs primarily through disclosure requirements.1 Also there is striking contrast in the
current approaches taken to securities and non-securities derivatives regulation. If,
however, these activities are so similar in nature, does a rational basis exist for widely
differing regulatory schemes? If no rational basis can be found how do we identify
whether the current deregulation trend moving through the derivatives markets is a
sensible change when regulation in the securities market is increasing? This article
ultimately questions the absence of a consistent approach in regulating securities, non-
securities derivatives, insurance and gambling. Among other things, the article questions
whether deregulation of the derivatives market is a prudent maneuver in light of its
similarities with more heavily regulated activities.

Part I provides an overview of the current regulatory scheme for securities and
derivatives, including the deregulatory effects of the Commodities Futures Modernization
Act of 2000. Part II looks at the practice of gambling and the traditional moral concerns
underlying its stiffer regulatory regime. Part II also begins to explore behavioral models
which might fairly apply to both investments and gambling, and which therefore cut in

a
Cary C. Boshamer Distinguished Professor of Law, the University of North Carolina at Chapel
Hill, B.A. 1969, J.D. 1972 Columbia University.
1
Although disclosure requirements can have an impact on the way activities are conduct, disclosure is
a less imvasive regulatory approach that imposing outright prohibitions on targeted activities.
favor of more similar regulatory treatment among the industries. Part III then examines
regulation of the insurance industry, its underlying rationale, and its similarities with
investment and gambling activities. After establishing the particularly strong similarities
between insurance and derivatives, Part III further suggests how certain aspects of the
insurance regulation might play out in the context of derivatives. Finally, Part IV revisits
the general trend of deregulation in the securities, derivatives, and (to a lesser degree)
gambling industries in light of the consistently demanding insurance regime and asks
whether deregulation is a wise course of action. Part V concludes and offers suggestions
on further research in this area.

Introduction

Securities investing, derivatives transactions, insurance, and gambling are all

activities designed in one way or another to reap economic benefits. Investing is
generally considered to be a productive activity because it allows businesses to raise
capital which in turn will increase productivity and benefit society. Investing also offers
the possibility of wealth building for those who invest. Derivatives transactions not only
offer investment opportunities (often thought of as a speculation) but also, like insurance,
provide an opportunity for risk-shifting. People and businesses who have exposure to
risk can either hedge against that risk with a derivatives contract or seek insurance against
losses that could occur if the contingencies created by the risk materializes.

In contrast to investing, hedging, and insurance, gambling is not generally viewed

as a productive activity or one that provides any benefit to society beyond its
entertainment value. However, this “benefit” is generally seen as outweighed by the
social costs of gambling as well as moral objections to wagers and other gambling
activities. Over time and in various respects, investing, hedging, and insurance have been
compared with gambling and to varying degrees, distaste for gambling has been used as a
rationale for regulation of these other activities. .

There are many similarities between gambling and the often perceived legitimate
investment, hedging, and insurance transactions. One thing that investing, hedging,
insurance, and gambling have in common is that they all involve risk taking, while only
the first three that are generally seen as involving risk-shifting or other legitimate
economic benefits. Traditionally the law has been much harsher on transactions that are
characterized as gambling. One possible explanation for the difference in treatment is
focusing not so much on what the transactions are but who the parties are and their
respective motives. Gambling laws have traditionally had barriers to entry; although
there has been a dwindling of those barriers with increasing legalization. Insurance law
imposes some comparable barriers through its insurable interest requirement.2 However,
although some investment opportunities may be limited to sophisticated investors,3 there
are no comparable barriers to the investment markets generally thereby allowing access
for “legalized gambling” to all. Furthermore, the sophistication and wealth barriers to
some investments do not protect against speculating and gambling, they simply foreclose
opportunities to other investors.

This article focuses on both gambling and insurance in particular as two activities
that are regulated and also are closely aligned to at least certain segments of the investment
markets. More generally, this article explores the parallels among securities investments,
derivatives (and commodities) investments, gambling, and insurance to probe whether
there is too much focus on disclosure or whether disclosure as the primary means of
securities market regulation should be supplemented by the approach taken with respect
to those other activities.

a. Illustrative Analogies

The similarities of the activities discussed in this article may be explained by way
of examples. Consider two inveterate gamblers who make a wager on whether it will rain
the next day - a wager that would be illegal under the law in all states. Compare this
gamble with a farmer who is concerned about a predicted drought and decides to hedge
her crops in the ground by entering into a crop futures contract. This arrangement is a
legal futures contract and will be enforced. Alternatively, in today’s environment, the

2
See the discussion infra accompanying notes ##-##.
3
For example, section 2(a)(15) of the Securities Act of 1933 contains a definition of “accredited
investor” so as to qualify for exemptions from some of the Act’s disclosure requirements. 15 U.S.C. §
77b(a)(15, 77d(6) (2003). Also, over-the-counter derivatives transactions are subject to less regulation than the
exchanges. See the discussion infra accompanying notes ##..
farmer could make the hedge specifically against damage due to drought and enter into a
derivatives contract based on the weather. This more closely resembles the illegal
weather wager but would be a legitimate, and hence enforceable, derivatives contract.
That same farmer has the alternative of seeking crop insurance or more specifically
drought insurance. In all of the above situations one party is allocating to the other the
risk of a drought. Yet the wager is illegal, whereas the derivatives contracts and
insurance are legitimate commercial transactions. A similar comparison can be made
with respect to sports wagers,4 which are not permitted except to a limited extent through
some state sanctioned casinos. Even under those limited circumstances, participants in
the sport are not able to wager.5

Gambles and wagers are not the only examples of contracts that have been
outlawed because of their perceived moral repugnancy. In 2003, there was a short-lived
plan at the Pentagon to create a market in futures contracts to with respect to future terror
attacks.6 Once the controversial proposal came to light, it was quickly quashed. 7 What
was it about the proposed terrorism futures that the public found so horrific? Some
observers suggested that a market for terrorism futures would allow people to profit from
sharing information about future attacks that they should share simply as a matter of good
citizenship.8 There also is the visceral reaction that an investor should not be able to

4
See infra pp. 54-56 and note 320 and accompanying text.
5
Consider for example the current controversy as to whether Pete Rose’s wagers should disqualify him from
the baseball Hall of Fame.
6
See, e.g., Daniel Kadlec, Terrorism Futures: Good Concept, Bad P.R., TIME MAGAZINE, Aug. 11, 2003, at 18,
available at 2003 WL 58582307. The idea behind the proposal was that since markets help filter information, a
market in terrorism futures could provide the Pentagon with help in predicting and then thwarting attacks. See
Jeff Brown, Was Terrorist Futures Market Really Such a Terrible Scheme?, THE PHILADELPHIA INQUIRER, July
31, 2003, at On Personal Finance Col 1, available at 2003 WL 60559277; Justin Wolfers & Eric Zitzewitz, The Furor
Over ‘Terrorism Futures,’THE WASHINGTON POST, July 31, 2003, at A19, available at 2003 WL 56509527..
7
For example, the originator of the controversial idea resigned his research post with the Defense Department
in the face of the huge public opposition to terrorism futures even as a hypothetical model. See David Voss,
From Sputnik to . . . Radar? Much-Maligned Defense Research Agency Has Long Been the Pentagon's Fantasy Shop,
BOSTON GLOBE, Aug. 12, 2003, at D.1, available at 2003 WL 3412852.
8
See, e.g., D.J. Tice, 'Terror Market' Debate Exposed Roots of Many Economic Disagreements,
ST. PAUL PIONEER PRESS, Aug. 6, 2003, at 10A, available at 2003 WL 2619468 (“A terrorism market would
inspire people to do out of a selfish desire for gain what they should have done out of moral decency – to tell
what they know. And of course that’s just the problem. The motives of terrorism ‘investors’ would be simply
too barbarous to be tolerated, 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.”).
profit from someone else’s misery. However, we generally do not look at an investor’s
motives in determining whether a particular transaction is legal. When put in
perspective, how different is a terrorism future from taking out insurance against acts of
war? An investor who stands to gain from a terror attack may simply be hedging against
losses that would result from such an attack. Investors have always been able to take
investment positions in order to “bet” in favor of disaster. Defense industry stocks and
gold have traditionally been among the havens for investors desiring economic protection
against the ill-effects of war or terrorism. The proposed terrorism futures market may
well have been ill-conceived but the proposal and the public reaction provides an
example of how lawmakers will declare certain types of contracts impermissible (or
subject them to a significant regulation). In contrast, transactions trying to shift
comparable risks are permissible or subject to less stringent regulation.

Was the opposition to the proposed terrorism futures market a rational response to
a bad idea? Was it the result of moral outrage? Was it simply the reaction to a politically
incorrect idea? On a more general level, how do policy makers decide which markets to
regulate and what level of regulation is appropriate? Exploring these analogies can
provide insight on to how to evaluate existing regulatory schemes.

b. Recent Scandals and Current Regulatory Climate

For a number of years there have been questions raised as to the proper approach
to regulation of the investment markets in the United States.9 This inquiry has addressed
the extent of regulation, the basic premises of regulation, and whether to regulate at all.
A number of recent events spurred new regulation and also heated up the debate between
protectionists calling for more regulation and free market advocates arguing against
regulatory responses. There were a number of spectacular frauds that came to light at the

9
This article does not address questions relating to the appropriate regulatory approach to overseas and
emerging markets. See, e.g., Robert B. Ahdiehl, Making Markets: Network Effects and the Role of Law in
The Creation of Strong Securities Markets, 76 S. CAL. L. REV. 277 (2003) (discussing the role of the law in
forming strong securities markets and the implications for regulation of emerging markets in central Europe
and Russia).
turn of the twenty-first century such as those involving Enron, Tyco and Worldcom.10
These frauds were perceived by many observers as the result of greed which went
unchecked by regulators. This greed emboldened some corporate executives to engage in
conduct that violated existing laws. Notwithstanding the fact that the existing securities
laws were sufficient to pursue executives of Enron, Tyco, and Worldcom, Congress was
of the view that additional regulation was necessary. Congress thus viewed existing laws
insufficient to combat this magnitude of greed.

The seemingly unprecedented greed among a sector of our nation’s corporate

executives and decision-makers is seen by many as the cause of the above-mentioned
recent corporate scandals.11 The perpetrators of these frauds were not simply acting out
of their own self-interest but rather out of hideous greed which can lead to irrational and
malevolent results. It has properly been suggested that we can and should regulate greed.
Although capitalism is to a large extent premised on rewarding self interest, greed is not
necessarily a part of the self interest that is necessary to fuel capitalism and thus should
not go unregulated. 12

The well-documented frauds referred to above were only one impetus for
increased securities regulation. These frauds were uncovered shortly after the stock
market bubble,13 fueled primarily by dot-com stocks. When this bubble burst at the end
of the twentieth century, a number of other bad practices came to light – including

10
See, e.g., BRIAN CRUVER, ANATOMY OF GREED: THE UNSHREDDED TRUTH FROM AN ENRON INSIDER
(2002) (discussing Enron); Robert W. Hamilton, The Crisis in Corporate Governance, 40 HOUS. L. REV. 1
(2003) (discussing among other things the 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 of Shareholders and
Other Stakeholders?: Enron and the Dark Side of Shareholder Value, 76 TUL. L. REV. 1275 (2002) (same);
Jeffrey N. Gordon, What Enron Means for the Management and Control of the Modern Business
Corporation: Some Initial Reflections, 69 U. CHI. L. REV. 1233 (2002) (discussing the implications of
Enron).
11
See, e.g., CRUVER, supra note 12; Prentice, Behavioral Autopsy supra note 12..
12
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”).
13
James D. Cox, Reforming the Culture of Financial Reporting: The PCAOB and the Metrics for
Accounting Measurements, 81 WASH. U. L.Q. 301 (2003) (“The financial bubble that burst in 2000 began a
meltdown of stock prices that ultimately removed an estimated $8.5 trillion from the Nasdaq market
alone.”).
improprieties involving public offerings.14 Examples of these underhanded practices
included improper allocation of hot offerings and “laddering,” or pre-selling the after
market, whereby purchasers were asked to commit to purchasing additional securities in
the aftermarket in order to get in on a hot IPO.15 Generating this additional demand for
stock in the aftermarket helped push the post offering price significantly above the price
at which the securities were offered to the public. Other scandals included securities
analysts’ conflicts of interests that compromised their supposedly disinterested unbiased
recommendations.16 These are just some of the events that led to heightened concern
over the adequacy of the then existing regulation of the securities markets and that
prompted Congress to increase securities regulation.17

14
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 Conduct Rules for IPO Activities, (July 28, 2002), available at
http://www.nasd.com/web/idcplg?IdcService=SS_GET_PAGE&ssDocName=NASDW_002921&ssSource
NodeId=555. The new rules explicitly prohibit a number of practices, most of which are improper under
existing standards but are not subject to explicit rulemaking. The NASD rules as proposed outlaw
allocation of IPO shares in exchange for excessive compensation to the broker making the allocations. The
rule also prohibits “laddering” and other tie-in arrangements by expressly outlawing solicitation of
aftermarket orders prior to the time that the registration statement has become effective and the offering has
taken place. The rules cover “spinning” by prohibiting a broker-dealer firm from allocating IPO shares to
an executive officer or director of a company on the condition that the officer or director send the
company’s investment banking business to the brokerage firm. The rules also address penalty bids by
prohibiting NASD members from penalizing registered representatives whose retail customers have
"flipped" IPO shares when similar penalties have not been imposed with respect to institutional accounts.
Finally, the rules require broker-dealers participating in IPOs to adopt procedures designed to ensure
compliance with the foregoing restrictions on conduct during IPOs.
15
See See Notice of Filing of Proposed Rule Changes by the New York Stock Exchange, Inc. and the
National Association of Securities Dealers, Inc. Relating to the Prohibition of Certain Abuses in the Allocation
and Distribution of Shares in Initial Public Offerings ("IPOs"), Sec. Exch. Act Rel. No. 34-50896 69 Fed. Reg.
77804-01, 2004 WL 2981667 (SEC 2004); NASD Board Approves Proposed Conduct Rules for IPO
Activities, supra note 16. [News Release, NASD, NASD Board Approves Proposed Conduct Rules for IPO
Activities, (July 28, 2002), http://www.nasdr.com/news/pr2002/release_02_037.html]
16
Among other measures, the SEC adopted a requirement that securities analysts certify their
independence. Regulation Analyst Certification, Sec. Act Rel. No. 33–8193, Sec. Exch. Act Rel. No. 34–
47384, 68 Fed. Reg. 9482–01, 2003 WL 535908 (SEC Feb. 27, 2003), codified in 17 C.F.R. §§ 242.500–
242.505.. See Self-Regulatory Organizations, 67 Fed. Reg. 11,526 (Mar. 14, 2002); News Release, NASD,
NASD Announces New Rules Governing Recommendations Made by Research Analysts, (Feb. 7, 2002),
http://www.nasdr.com/news/pr2002/release_02_009.html. See also, e.g., Self Regulatory Organizations,
Exchange Act Release No. 45,526, 77 SEC Docket 196 (Mar. 8, 2002).
17
See, e.g.,Larry E. Ribstein, Bubble Laws, 40 HOUS. L. REV. 77 (2003) (questioning 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 Information Order of Sarbanes-Oxley, 35 CONN. L. REV. 1125, 1126
(2003) (describing the increased regulation following the bursting of the bubble as “relatively mild”).
 Congress’ response to the corporate governance scandals was embodied in the
Sarbanes-Oxley Act of 200218 which called for increased levels of corporate disclosure.
These increased disclosures and increased regulation of the operation of public
companies raises issues highlighted by the continuing debate as to the efficacy of
disclosure in securities regulation and, more generally, the approach to regulating
investment markets generally. This increased regulation of the securities markets in the
wake of the late 1990’s corporate governance scandals, led by Sarbanes-Oxley, stands in
sharp contrast to the massive deregulation of the commodities and non-securities
derivatives19 markets that was ushered in by the Commodity Futures Modernization Act
of 2000.20 This divergence in recent regulatory developments presents a propitious time
to examine the whether there is a rational basis for such divergent regulatory approaches
to the securities and derivatives markets. A brief examination of the existing regulatory
structure of the securities and derivatives, markets and the gambling industry will lay the
foundation for comparison.

I. Current Regulatory Structures

a. The Regulatory Structure of the Securities Markets – An Overview

In the wake of the stock market crash of 1929, when this country was well into
the Great Depression, and twenty-two years after the first comprehensive state legislation
the first federal securities law was enacted in 1933,21. Congress debated but rejected a
merit approach to regulation that would examine the substance of the investment product

18
Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002); Brian Kim, Sarbanes-Oxley
Act, 40 HARV. J. ON LEGIS. 235 (2003); Corporate Law -- Congress Passes Corporate and Accounting
Fraud Legislation. -- Sarbanes- Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified in
scattered sections of 11, 15, 18, 28, and 29 U.S.C.), 116 HARV. L. REV. 728 (2002). See also, e.g., Larry E.
Ribstein, Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of
2002, 28 J. CORP. L. 1 (2002) (criticizing the Sarbanes-Oxley Act).
19
Derivatives have been defined as any "financial arrangement whose returns are linked to, or derived from,
changes in the value of stocks, bonds, commodities, currencies, interest rates, stock indexes or other assets."
Saul S. Cohen, The Challenge of Derivatives, 63 FORDHAM L. REV. 1993, 2000 (1995).
20
Pub. L. No. 106-554, 114 Stat. 2763 (2000).
21
Securities Act of 1933, 48 Stat. 74 (1933) (codified as amended in 15 U.S.C. §77a (2003)).
being offered and sold. 22 The first federal securities law – the Securities Act of 1933, has
been characterized as the first true consumer protection law23 was often referred to as the
“Truth in Securities” law.24 Unlike many state blue sky laws,25 The Securities Act of 1933
did not establish a system of merit regulation. Instead, the Act was premised solely on a
system mandating full and fair disclosure to investors, under the guidance of a federal
agency, as a mechanism for permitting informed investment decisions. Disclosure rather
than a merit approach remains the regulatory philosophy of the federal securities laws.

The focus of disclosure was based on the determination that Louis Brandeis was
correct when he suggested that sunlight is the best disinfectant.26 However, it is evident
that disclosure has not been completely effective in eradicating securities fraud and the
debate continues as to the wisdom of a disclosure approach. Some argue that the current
disclosure system overregulates,27 while others have suggested that it does not go far
enough.28 For example, it has been suggested that disclosure does not give adequate

22
In contrast, the laws regulating insurance traditionally have taken a merit approach, including requiring
regulatory approval of the terms of insurance policies See infra note XXX and accompanying text
23
See 1 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 1.2[3] (5th ed. 2005).
In fact, in signing the bill into law, President Franklin Roosevelt observed that the nation was moving from
a period of caveat emptor into one of caveat vendor. [Need to cite source for FDR’s observation.]
24
Milton H. Cohen, "Truth in Securities" Revisited, 79 HARV. L. REV. 1340 (1966).
25
State laws regulating securities, most of which predated the federal legislation, imposed a merit approach
to regulation. See 1 HAZEN supra note xx, at §§ 1.2, 8.1. THOMAS LEE HAZEN, TREATISE ON THE LAW OF
SECURITIES REGULATION § 1.2[3] (5th ed. 2005).
26
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; electric light the most efficient policeman."). Felix
Frankfurter was one of the most influential voices in the drafting of the securities laws. As explained by
one commentator, he was influenced by Brandeis:
Frankfurter, who was instrumental in shepherding the Securities Act through Congress, had been strongly
influenced by Brandeis's ideas about the value of disclosure. Soon after the Securities Act was passed,
Frankfurter wrote an article in Fortune magazine about the anticipated social and financial effects of the
Act. Frankfurter was quite explicit that the purpose of disclosure was to affect the behavior of corporate
managers, bankers, and accountants.
Cynthia A. Williams, The Securities and Exchange Commission and Corporate Social Transparency, 112
HARV. L. REV. 1197, 1221-22 (1999); Felix Frankfurter, The Federal Securities Act: II, FORTUNE, Aug.
1933, at 53. See JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET 71 (1982).
27
E.g., Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors,
70 VA. L. REV. 669 (1984).
28
For additional insight as to the role of the regulatory structure, see, e.g., Ahdiehl, supra note xx. Robert
B. Ahdiehl, Making Markets: Network Effects and the Role of Law in The Creation of Strong Securities
Markets, 76 S. CAL. L. REV. 277 (2003).
attention to investor education29 to help rid investors of what many identify as irrational
behavior.30 It has also been suggested that we should consider information overload when
evaluating the extent of the disclosure approach.31

Investor education and merit regulation32 are thus two alternatives for increasing
regulation. However, they are not the only alternatives for providing heightened regulation
of the securities and other investment markets. For example, one question to be considered
is whether increased criminalization will help fill the regulatory void created by the focus
on disclosure. The criminal enforcement weapon is especially applicable when we
recognize that many market participants are gamblers and many of the securities fraudsters
seem to engage in behavior quite similar to those who profit from illegal gambling
activities. The Sarbanes-Oxley Act included increased criminal penalties as an important
part of its reforms.33 In the first instance, Sarbanes-Oxley provides for heightened criminal

29
See Stephen Choi & Pritchard supra note XXX at 22 (2003) (“For behavioralists, the single-minded
focus of the SEC on disclosure presents a puzzle. We doubt that disclosure is the optimal regulatory
strategy if most investors suffer from cognitive biases. Disclosure may be ineffective in 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) ("[W]e can readily see why the law's prized warnings
and disclosure will so often have relatively little practical effect, especially if they are formalized into
boilerplate. Investors and consumers want to think the warnings are meant for someone else, not them.")
30
“Investors suffering from an overconfidence bias, for example, may ignore the warning signs from
disclosure. Similarly, it is unclear how disclosure can overcome the cognitive dissonance of people who
have made a poor investment choice in the past. Investors with intractable loss aversion will continue
holding a losing position in hopes of reversing their losses without regard to disclosure. And what
disclosure will help them avoid ratifying their poor investment choices as "good" decisions? Finally,
investment decisions may be driven in substantial part by the conversations that investors have had most
recently. Disclosure may do little to influence investment decisions based on "tips" or fads.”
Choi & Pritchard, supra note XXX at 22. [Stephen J. Choi & A.C. Pritchard, Behavioral Economics and
the SEC, 56 STAN. L. REV. 1, 71 (2003)], relying on Robert J. Shiller & John Pound, Survey Evidence on
the Diffusion of Interest and Information Among Investors, 12 J. ECON. BEHAV. & ORG. 46 (1989)
31
Troy A. Paredes, Blinded by the Light: Information Overload and its Consequences for Securities
Regulation, 81 WASH. U. L.Q. 417 (pages 419, 420, & 446.(Summer 2003).
32
Merit regulation is a regulatory system under which a securities administrator 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 to Investors or Burden on Commerce?, 53 Brooklyn L.Rev. 105 (1987); Manning G.
Warren III, Legitimacy in the Securities Industry: The Role of Merit Regulation, 53 Brooklyn L.Rev. 129
(1987).
33
Sarbanes-Oxley Act of 2002, PL 107-204 (July 30, 2002).
penalties for securities law violations.34 The Act also imposes a requirement that CEOs
and CFOs of publicly held companies personally certify their company’s financial
statement with criminal consequences for false certifications.35 It remains to be seen
whether this increased criminalization will be effective in promoting more accurate timely
public disclosures.

Securities regulation currently utilizes its disclosure approach to regulate various

segments of the securities markets.36 In addition to regulation of the securities markets, the
federal securities laws regulate the companies issuing securities (“issuers”37) as well as
purchasers and sellers of securities. Securities trading activities can be divided into two
basic subgroups. Most of the day-to-day trading on both the securities exchanges and
over-the-counter markets consists of "secondary" transactions between investors and
involve securities that have previously been issued by the corporation or other issuer.38 All
of the proceeds from these secondary sales, after applicable commissions to the securities
brokers handling the transaction, go to the investors who are parting with their securities.
None of these proceeds from secondary transactions in the securities markets flow back to
the companies issuing the securities. This aspect of the secondary securities markets is
frequently referred to as "trading" (as opposed to “distribution” of securities) and is
regulated primarily by the provisions of the Securities Exchange Act of 1934.39 The
regulation of the securities trading markets is often referred to as market regulation.

Initial public offerings (IPOs), frequently referred to as primary offerings or

distributions,40 are governed primarily by the Securities Act of 1933.41 This is the way in

34
Id.
35
Sarbanes-Oxley, Sec. 302 – “Corporate Responsibiliy for Financial Reports” – codified at 15 U.S.C. §
7241. See 2 Hazen supra note XXX, at § 9.3[2] (5th ed. 2004 supp.) [1 THOMAS LEE HAZEN, TREATISE ON
th
THE LAW OF SECURITIES REGULATION § 1.2[3] (5 ed. 2005)]
36
Part of the discussion that follows is adapted from portions of 1 HAZEN supra note XXX §§ 1.1, 14.3. [1
THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 1.2[3] (5th ed. 2005)]
37
Section 2(a)(4) of the 1933 Act defines “issuer”. 15 U.S.C. § 77b(a)(4) (2003).
38
See1 HAZEN supra note XXX § 1.1[2].
39
15 U.S.C. § 78a. (2003).
40
The first time a company goes public is known as an initial public offering or “IPO.”
41
15 U.S.C. § 77a (2003).
which corporate capital is raised in the public equity markets. The Securities Act of 1933
also includes within the concept of securities distributions so-called secondary
“distributions.”42 Secondary distributions occur, for example, when an extremely large
block of securities has been placed in the hands of a private investor, institution, or group
of investors and is subsequently offered by the selling shareholders to the members of the
general public. As is the case with secondary transactions generally, the proceeds from
secondary distributions inure to the benefit of the selling shareholder(s). In the case of both
primary and secondary distributions,43

In the case of both primary and secondary distributions, unless an appropriate

exemption is applicable, registration of the securities will be required under the Securities
Act of 1933.44 This, then, is the focus of the 1933 Act: initial, primary, and secondary
distributions of securities; although some selected provisions of the Act apply to more
private, non-open-market transactions.45

Whereas the distribution process triggers the registration provisions of the 1933
Act, the extent to which securities are widely held and actively traded provides the
jurisdictional trigger for most of the Securities Exchange Act of 1934’s regulation of public
companies and their securities.46 Registration and periodic reporting by issuers under the
1934 Exchange Act depend generally upon the degree to which the securities are widely
held.47

42
In contrast to the secondary trading that takes place in the securities markets on a daily basis.
43
Primary and secondary distributions can occur as separate transactions or can be “piggy-backed” into
one registered offering. It is not uncommon for an offering to be a combination of a primary and secondary
distribution. Cf. Moffat v. Harcourt Brace & Co., 892 F.Supp. 1431 (M.D.Fla.1994) (issuer's delay in
applying for registration did not violate agreement with holder of "piggy back" registration rights).
44
See 1 HAZEN, supra note XXX chs. 2-3 infra. [1 THOMAS LEE HAZEN, TREATISE ON THE LAW OF
SECURITIES REGULATION § 1.2[3] (5th ed. 2005).]
45
For example, section 4(2) of the Act provides an exemption from registrations for transactions that
do not involve a public offering. 15 U.S.C. § 77d(2) (XXXX)
46
For example, sections 12 and 13 of the 1934 Act imposes registration and reporting requirements on
issuers of securities that are publicly traded on a securities exchange or in the over-the-counter markets. 15
U.S.C. §§ 78j, 78k (XXXX). An important exception is found in the general antifraud Rule 10b-5, 17
C.F.R. § 240.10b-5 (2003), the reach of which extends to purchases or sales of any securities where the
facilities of interstate commerce are implicated.
47
See 15 U.S.C. §§ 78j, 78k (XXXX).
 1934 Act regulation extends far beyond public companies and their securities. The
Securities Exchange Act of 1934 also imposes a broad-based system of market
regulation.48 By way of summary, the SEC oversees securities exchanges and the National
Association of Securities Dealers (NASD), both of which are self regulatory organizations
that police their own markets. Market regulation is a complex series of rules and
prohibitions based on direct regulation by the SEC as well as self regulation through
exchange and NASD rules that have been approved by the SEC. Market regulation
provides rules designed to promote efficient transactions as well as to prohibit fraud and
manipulation. In addition to regulating the markets themselves, the SEC and the self
regulatory organizations regulate intermediaries, most notably, securities brokers and
dealers.49

Section 19(a)(1) of the Securities Exchange Act gives the Commission the authority
to register national exchanges.50 Section 19(h) gives the Commission the obligation to
discipline national exchanges for violating the securities Acts’ provisions.51 Each exchange
also has express authority to discipline persons associated with it, including power to
remove from office or censure its officers or directors from listed/member companies for
willful violations of the Act.52 The Commission has exercised its statutory authority53 to

48
See 4 HAZEN, supra note XXX ch. 14. [1 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES
REGULATION § 1.2[3] (5th ed. 2005).]
49
See 4 Hazen supra note XXXX ch. 14. The securities laws draw a distinction between brokers and
dealers. Id.
50
15 U.S.C. § 78s(a)(1) (2003). The SEC also has the responsibility for registering clearing agencies for
exchanges. 15 U.S.C. § 78q-1 (2003). 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 electronic system for trading options on government securities). Commodities
exchanges had complained that the registration as a clearing agent was improper since this in essence
involved the SEC's recognition of an unregistered securities exchange. The Seventh Circuit agreed that the
SEC first had to make a formal determination of whether the activity in question in fact constituted
operating as a securities exchange. On remand, the Commission ruled that it did not and reissued the
registration as a clearing agent. See 22 Sec.Reg. & L.Rep. (BNA) 56 (Jan. 12, 1990), judgment affirmed
923 F.2d 1270 (7th Cir.1991).
51
15 U.S.C. § 78s(h) (2003). See, e.g., In the Matter of New York Stock Exchange, Inc., Administrative
Proceeding File No. 3-9925, Sec. Exch. Act Rel. No. 34-41574, 70 S.E.C. Docket 106, 1999 WL 430863
(SEC June 29, 1999) (NYSE consented to improve surveillance regarding various improprieties including
trading ahead of customer orders).
52
15 U.S.C. § 78f(d) (2003). The authority to disciple;ine its members is found in the rules of the self
regulatory organizations. See, e.g., NYSE Manual. Cf. Nicholaou v. SEC, 81 F.3d 161, 1996 WL 140339
(6th Cir.1996) (unpublished opinion) (holding that the limitations period for exchange disciplinary action is
expel a national exchange on only one occasion.54 But the Commission has exercised its
authority under subsection (h) to uphold expulsion of members from the exchange with a bit
more frequency.55 The power to discipline and sanction exchange members is given directly
to the exchange as a self regulatory body, with a right of appeal to the SEC which may in its
discretion review the record de novo.56 The SEC decision is then subject to review by a
federal court of appeals.57 The NASD has similar status and authority. The Commission
can suspend or revoke the securities association’s registration.58 The NASD has the power
to hold hearings and issue sanctions against including expulsion of its members from the
association for conduct in violation of the Act or the NASD’s rules.59

whether the delay was so unfair as to be a denial of due process; proceeding brought in 1992 for conduct
during 1984–1988 was not untimely).
53
15 U.S.C. § 78s(h)(1) (2003).
54
San Francisco Mining Exchange v. SEC, 378 F.2d 162 (9th Cir.1967). Research has failed to reveal
any other examples of this power being used.
55
See, e.g., Archer v. SEC, 133 F.2d 795 (8th Cir.1943), cert. denied 319 U.S. 767 (1943).
56
15 U.S.C. § 78f (2003); see 15 U.S.C. § 78s(h) (2003).
57
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).
58
15 U.S.C. § 78o-1(h). See, e.g., Mister Disc. Stockbrokers v. SEC, 768 F.2d 875 (7th Cir. 1985)
(upholding dismissal of firm from NASD membership and order barring individual from associating with
an NASD member firm); Austin Mun. Sec. v. NASD, 757 F.2d 676 (5th Cir. 1985) (the NASD and its
disciplinary officials enjoy absolute immunity in connection from civil liability for their disciplinary
activities). See also, e.g., Barbara v. New York Stock Exch., Inc., 99 F.3d 49, 59 (2d Cir. 1996) (exchange
enjoyed absolute immunity in connection with disciplinary proceedings).
59
15 U.S.C. § 78s(h)(2). See, e.g., Don D. Anderson & Co. v. SEC, 423 F.2d 813 (10th Cir. 1970)
(suspension for violation of 1933 Act); L.H. Alton & Co. v. SEC, [1999-2000 Transfer Binder] Fed. Sec.
L. Rep. (CCH) ¶ 91,021, available at 2000 WL 975183 (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. Counsellors,
Inc. v. SEC, 339 F.2d 196 (2d Cir. 1964) (expulsion for violation of 1934 Act); Gilligan, Will & Co. v.
SEC, 267 F.2d 461 (2d Cir. 1959) (suspension for violation of 1933 Act).
For additional cases, see, e.g., Prevatte v. NASD, 682 F. Supp. 913 (W.D.Mich. 1988) (administrative
remedies must be exhausted prior to judicial challenge of NASD sanctions). Cf. Whiteside and Co., Inc. v.
SEC, 883 F.2d 7 (5th Cir. 1989) (finding that SEC affirmance of NASD sanction was not an abuse of
discretion); In re Application of Morgan Stanley & Co., SEC Admin. Proc. File No. 3–9289, 29 Sec. Reg.
& L. Rep. (BNA) 7 (SEC 1997) (SEC lacked jurisdiction to review NASD refusal to grant exemption from
MSRB's rule requiring two year ban from municipal securities business, since the automatic ban was not a
sanction subject to SEC review under section 19(d) of the Exchange Act). See generally T. Grant Callery
& Ann H. Wright, NASD Disciplinary Proceedings-Recent Developments, 48 Bus. Law. 791 (1993).
 By virtue of section 15A of the Securities Exchange Act,60 the NASD operates as
the largest of the self regulatory organizations subject to SEC oversight. Although the
Commission has, pursuant to Section 15 of the Act,61 the direct authority to regulate
broker-dealers who are members of the NASD, as a practical matter the bulk of the
day-to-day regulation is generally delegated to the self regulatory organizations. The NASD
is a nationwide self regulatory organization with district offices around the United States.
The NASD has extensive rules governing its member brokerage firms and their employees
which relate both to organizational structure and standards of conduct.62

The preceding discussion provides an overview of public company and market

regulation. It is worth noting further that securities regulation does not stop with securities
issuers and the securities markets, it also extends to regulation of mutual funds and other
investment companies63 and investment advisers.64

b. Regulation of the Derivatives Markets65

The stock and other securities markets offer one set of opportunities to investors.
In addition to the securities markets, investors may look to the various commodities
markets and the trading of commodity futures. At one time the commodities markets were
limited to agricultural and other tangible commodities such as precious metals and fossil
fuels.66 Today more than seventy percent of all commodity futures transactions involve

60
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 was ever formed.
61
15 U.S.C. § 78o.
62
The NASD constitution and rules are compiled in NASD Manual (CCH). As is the case with national
exchanges, NASD rules are subject to SEC review. 15 U.S.C.A. § 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
remedies before seeking judicial relief from NASD's refusal to permit inspection of records pertaining to
NASD investigation of member). See generally T. Grant Callery & Anne H. Wright, NASD Disciplinary
Proceedings-Recent Developments, 48 BUS. LAW. 791 (1993).
63
This is accomplished through the Investment Company Act of 1940, 15 U.S.C. §§ 80a-1 to -52 (2003).
See 5 HAZEN, supra note xxx, at ch. 20.
64
This is accomplished through the Investment Advisers Act of 1940, 15 U.S.C. §§ 80b-1 to -21. See 5
HAZEN, supra note xxx[56], at ch. 21.
65
This discussion is adapted from portions of 1 PHILIP MCBRIDE JOHNSON & THOMAS LEE HAZEN,
Derivatives Regulation § 2.01. (2004)
66
See 1 JOHNSON & HAZEN, supra note xxx[??], § 2.01.
financial futures.67 There thus have developed a wide range of overlapping or hybrid
investments that have attributes of both commodities and securities.

Although there have been a number of jurisdictional disputes, the commodities

futures markets generally are regulated by the Commodity Futures Trading Commission
(“CFTC”) pursuant to the Commodity Exchange Act.68 Beginning in the 1970s and
carrying through the 1980s and 90s, the futures and commodity options markets regulated
by the CFTC and the options markets regulated by the SEC have become increasingly
competitive with the increased trading in derivative financial instruments, including
treasury bill, foreign currency and stock index futures (as compared, for example, with the
trading of stock index and foreign currency options).69 Options on securities are regulated
by the SEC but futures and commodity options (including options on futures) are not
subject to SEC regulation.70 Rather they are left to the Commodity Futures Trading
Commission.71

i. The Commodities Futures Modernization Act

The Commodity Futures Modernization Act of 200072 (the “Modernization Act”)

made significant changes in commodities and derivatives regulation by creating a three-
tiered system of regulation consisting of exchanges, less regulated organized markets,
and unregulated derivatives markets. Formerly, organized commodities markets
(“contract markets”) had their rules subject to CFTC oversight and approval. This is no

67
Id.

68
7 U.S.C. § 1-24 (2003). See generally JOHNSON & HAZEN, supra note xxx [??].
69
Although the form of a futures contract may differ from a listed option, their
operational effect and investment strategies are very similar, if not identical, when
dealing with financial options and futures.
In a controversial ruling, the SEC granted securities exchanges' applications to list index
70

participation units which have some characteristics of futures but were found to be
securities. Order Approving Proposed Rule Changes Relating to the Listing and Trading
of Index Participations, Exchange Act Release No. 34-26709, 54 Fed. Reg. 15,280, 1989
WL 992762 (April 11, 1989).
71
See generally JOHNSON & HAZEN, supra note xxx [??].
72
Commodity Futures Modernization Act, Pub. L. No. 106-554, 114 Stat. 2763 (Dec. 21, 2000).
longer the case under the current regulatory regime ushered in at the start of the twenty-
first century in the form of the Modernization Act.

The former contract market monopoly meant that all domestic “contracts of sale
of a commodity for future delivery” had to be executed on an organized commodities
market that has been “designated” as a “contract market” under the Commodity
Exchange Act.73 This meant that subject to limited exceptions,74 there were no over-the-
counter derivatives markets, and futures and commodity options contracts were traded
through the facilities of organized and regulated contract markets. The contract markets
and the Commodity Futures Trading Commission controlled the designation process so
that only contracts meeting certain criteria could be traded. The contract market
monopoly under the Commodity Exchange Act thus established a system parallel to
legalized gambling, in that legitimate transactions could only be effected through
regulated facilities – the contract markets. The regulatory constraints of legalized
gambling protect gamblers against organized crime and rigged gambling, whereas the
regulation of exchanges was designed not only to prohibit fraud and manipulation in the
commodities markets, but also to permit only those derivatives contracts that met certain
economic or public policy requirements.75

The regulatory landscape changed in 2001 with the adoption of the Modernization
Act.76 The Modernization Act sought to solidify changes that had been in the making for
years. In the latter part of the twentieth century, there was erosion of the contract market

73
See also 1 JOHNSON & HAZEN, supra note [??], § 1.02[2] (commodities and jurisdiction); id. § 1.02[8]
(the deterioration of the contract market monopoly); id. § 4.05[8] (challenges to the Commission’s
jurisdiction); id. § 4.05[9] (ongoing jurisdictional assaults); id. § 4.05[10] (reflections on CFTC/SEC
jurisdiction). [This source depends on incorrect source in last footnote (if it refers to that statute), I think
infra is used incorrectly] [JBE: I think sections refer to J&H]
74
During the 1990s, the number of over-the-counter (OTC) derivatives that were used by institutional investors
grew at a staggering pace. Thus, for example, a report by the General Accounting Office in 1994 estimated that
the notional amount of OTC derivatives outstanding at the end of fiscal year 1992 was at least $12.1 trillion,
this was in addition to approximately $5.5 trillion of foreign currency exchange contracts used primarily by
banks. See Jerry W. Markham, Banking Regulation: Its History and 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), available at 1994 WL 930437. See also, e.g., Jerry W. Markham, Protecting the
Institutional Investor - Jungle Predator or Shorn Lamb? 12 YALE J. ON REG. 345, 353 (1995).
75
See 1 JOHNSON & HAZEN, supra note [??], § 2.02.
76
Commodity Futures Modernization Act, Pub. L. No. 106-554. See 1 JOHNSON & HAZEN, supra note
XXX, § 2.02 [??]. [note 68? What source is this?]
monopoly, due to increased use of forward contracts and swap transactions that were
pigeon-holed into existing exemptions to the Commodity Exchange Act’s contract market
monopoly.77 Contemporaneously, monopoly was easing due to jurisdictional battles
between the CFTC and the SEC with respect to investments that could be characterized
either as futures contracts or as securities.78 The Modernization Act eliminated the
former monopoly by permitting over-the-counter, and essentially unregulated,
transactions between qualified market participants.79 The Modernization Act also
changed the designation process so that the CFTC no longer has responsibility for
reviewing the economics underlying publicly traded derivatives.80

Current derivatives and commodities regulation retains the concept of designated

contracts markets but substantially decreases the layers of regulation that they are subject
to. There are no longer categorical restrictions on the underlying commodities for futures
and options to be traded on contract markets. Additionally, there are no restrictions on
the types of market participants that may enter into transactions on a designated contract
market. Contract markets are no longer required to obtain separate designation for each
futures contract. Instead, contract markets are to be designated to trade all commodities,
though there are special requirements applicable to securities futures. In order for a new
entrant81 to qualify as a contract market under the amended regime, the exchange must, if
not previously registered, satisfy seven basic criteria for designation and seventeen “core
principles” set forth in the Act. The basic criteria include having mechanisms designed
to prevent market manipulations, to assure fair trading practices, to operate an effective
trading system, to ensure the financial integrity of transactions, to discipline offenders, to
make its rules and contract specifications available to the public, and to have access to all
relevant information.82 Moreover, in order to qualify for designation as a contract

77
See1 JOHNSON & HAZEN, supra note XXX[??], § 1.02[8]. [What source is this?]
78
See 2 id. § 4.05. [?]
79
See discussion supra in the text accompanying notes XXX-XXX. [?]
80
See 1 JOHNSON & HAZEN, supra note XXX, § 2.03.
81
Existing commodities futures contract markets were grandfathered and thus retained their designated status
following the Modernization Act. [Cite source]
82
Section 5 of the Commodity Exchange Act, 7 U.S.C. § 7 (XXXX). .For an example of designation as a
contract market under the new regulatory regime, see CFTC Designates Brokerage Futures Exchange as a
market, the trading facility applying for CFTC designation must demonstrate to the
CFTC in its application that seven specified standards are satisfied.83

The current regulatory regime for commodities markets and commodities

professionals is significantly streamlined. Whereas the former regulatory regime
imposed an affirmative day-to-day regulation , the Commodity Exchange Act, as
amended by the Modernization Act, charges the CFTC with a more general oversight role
with respect to contract markets. In comparison, with respect to the securities markets,
the SEC exercises a significantly more active supervisory role in the securities markets.
For example, rules of self-regulatory organizations (namely, the securities exchanges and
the National Association of Securities Dealers (NASD)) are subject to SEC approval.84
This is no longer the case with respect to the CFTC’s influence over self regulatory
organizations operating in the commodities markets.85

The Modernization Act allow the use of certain trading facilities with less of a
regulatory overseer than is the case with designated contract markets.86 Trading facilities
having a lower level of regulation than contract markets are defined by the Commodity
Exchange Act as derivatives transaction execution facilities (“DTEFs”).87 Unlike
designated contract markets, there are restrictions on both the categories of the futures
and options contracts that may be traded and the types of investors that may participate in

Contract Market and Brokered Clearing Corporation as a Resister Derivatives Organization, CTFC Rel.
No. 4526-01 (June 19, 2001), [Tech checked?]
83
7 U.S.C. § 7 (XXXX).
84
For discussion of the securities market regulation, see 4 HAZEN, supra note XXX, 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 PROTECTION (2d ed. 2003).
85
The Commodity Exchange Act continues to impose self-regulatory requirements that are similar to those
prior to the Modernization Act.
86
Section la(33) of the Act defines trading facility as “a person or group of persons that constitutes, maintains
or provides a physical or electronic facility or system in which multiple participants have the ability to execute
or trade agreements, contracts, or transactions by accepting bids and offers made by other participants that are
open to multiple participants in the facility or system.” 7 U.S.C. § 1a(33)(A)(2003). See also 7 U.S.C. §§
1a(33), 1a(10).
87
See 7 U.S.C. § 7.
transactions on DTEFs.88 DTEFs generally may trade futures contracts or options on
futures contracts based on commodities that are not susceptible to manipulation, have no
cash market, or are securities futures products. [89. Certain other commodities may be
traded on a DTEF, if trading is limited to eligible commercial entities trading for their

88
The Commodity Exchange Act currently permits two types of DTEFs: those serving the retail market and
those serving the commercial market. A DTEF that operates as a retail market must limit its participants to
those who trade through a futures commission 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 a clearing member
of a derivatives clearing organization; and (3) has net capital of at least $20 million. Retail customers trading
through derivatives transaction execution facilities are permitted to trade only in instruments based on
commodities that meet certain requirements designed to make the contracts particularly unsusceptible to
manipulation, and to security futures products if the DTEF is registered as a national securities exchange. The
Act further authorizes the CFTC to approve on a case-by-case basis additional contracts that can be traded on a
retail DTEF. 7 U.S.C. § 7a(b)(2) (2000).

Derivatives transaction execution facilities that operate as commercial markets are required to restrict its
participants to those who qualify as “eligible commercial entities.” Commercial DTEFs are not limited to the
same extent as retail DTEFs with respect to the contracts that may be traded. A commercial derivatives
transaction execution facility may trade futures on any non agricultural commodity if trade is limited to
eligible commercial entities trading for their own account. [Need citation]
89
The Commodity Exchange Act as amended by the Commodity Futures Modernization Act sets forth
eight core principles applicable to DTEF that must be followed in order for the DTEF to maintain its
registration:
1. Compliance with rules. The DTEF establish rules and procedures to assure
compliance with the rules of the facility;
2. Monitoring of trading. The DTEF must monitor trading in order to ensure orderly
trading and to provide necessary trading information to the Commission;
3. Public disclosure. The DTEF must provide disclosure to the public and the Commission of the
contract terms and conditions, the trading conventions and mechanisms, the financial integrity
protections and other relevant information;
4. Daily publication of trading information. On a daily basis, the derivatives transaction execution
facility must publish trading information if the Commission determines that the contracts perform
a significant price discovery function;
5. Fitness standards. The DTEF must establish and enforce fitness standards for members of the
trading facility, its directors, members of disciplinary committees, and affiliated persons;
6. Conflict of interest rules. The DTEF must adopt conflict of interest rules for its decision-
making and adjudicatory personnel;
7. Recordkeeping requirements. The DTEF is required to establish recordkeeping requirements to
maintain records for five years of all activities related to the DTEF’s business in a form and
manner acceptable to the Commission;
8. Antitrust considerations. DTEFs must conduct themselves in such a way as to minimize
unreasonable restraints of trade and anticompetitive burdens on trading.
7 U.S.C. § 7a(d)(2)-(9) (2000). The DTEF has discretion as to the manner in which it chooses to comply
with the core principles. 7 U.S.C. § 7a(d)(1).
own accounts. A DTEF that is a national securities exchange, and thus subject to SEC
regulation, may trade security futures contracts.

In addition to contract markets and DTEFs, the Modernization Act recognized a

new category of marketplace known as an exempt board of trade, which can offer certain
types of futures contracts (except securities futures products without CFTC oversight. To
qualify as an exempt board of trade, the trading facility must limit trading to contracts
that are not susceptible to manipulation or have no cash market.90 Participation in an
exempt board of trade is limited to eligible contract participants, 91 and an exempt board
of trade may not trade securities futures products.92 CFTC rules permit eligible contract
participants to opt out of having the segregation requirements generally applicable to
funds held by a futures commission merchant with respect to trades on or through a
registered DTEF.93 The fraud and manipulation prohibitions of the Commodity
Exchange Act apply to exempt boards of trade but other provisions of the Act applicable
to DTEFs or designated contract markets do not apply.94

Thus, with the adoption of the Modernization Act, there is much broader
recognition of off-exchange or over-the-counter derivatives markets and much more
discretion accorded to participants. The streamlined regulatory structure and supervisory
role of the CFTC makes it easier for participants to establish the validity of exchange-
listed derivatives. As noted above, the Modernization Act replaced hands-on CFTC
oversight of the markets with general “core principles” that the contract markets and
registered derivatives transaction execution facilities must follow in their rulemaking and

90
7 U.S.C. § 7a-3(b). Moreover, Section 7a(f) of the Commodity Exchange Act permits a DTEF to
authorize futures commission merchants to offer to eligible contract participants the right to not segregate
customer funds in accordance with rules to be promulgated by the CFTC. 7 U.S.C. § 7a(f).
91
7 U.S.C. § 7a-3(b)(2) (2000). Every user must fall within one of 11 categories of “eligible contract
participant”; and the item underlying the futures contract must have either: (i) a nearly inexhaustible
deliverable supply; (ii) a supply large enough and sufficiently liquid to make a market manipulation “highly
unlikely”; or (iii) no cash market at all.. 7 U.S.C. § 7a-3(b).
92
Id.
93
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 Rel. No. 4510-01, 2001 WL
419959 (CFTC April 25, 2001).
94
7 U.S.C. § 7a-3(a) (2000).
enforcement programs.95 In sharp contrast to the SEC’s active oversight of the securities
exchanges and the NASD, the CFTC does not have direct supervisory authority with
respect to the self-regulatory practices of derivatives participants. Regulation of the non-
securities derivatives markets is therefore significantly less rigorous than regulation of
the securities markets.96

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

c. Gambling

The discussion so far has focused on regulation of the investment markets. The
investment markets not only expose investors to risk, but also provide opportunities for
risk shifting through the options, futures, and derivatives markets. As developed more
fully in the section that follows, for a long time some have referred to derivatives markets
as a form of legalized gambling – an accusation that has also been leveled against
investment markets generally. This article takes the position that there is still some merit
to the gambling/investment analogy. To the extent that the gambling analogy is a valid
one, then there should be some parallels between the gambling laws and the securities

95
See infra note XXX and accompanying text.
96
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 individual securities 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 sophisticated market participants).96 These hybrid investment
instruments raised jurisdictional issues and a turf war between the SEC and CFTC. The allocation of
jurisdiction between the SEC and CFTC with respect to index futures and options on indexes was a political
compromise arising out of a jurisdictional accord that had been reached in 1980. The Modernization Act
eliminated the prohibition on single stock futures. As a result, security futures products, which include futures
on individual securities as well as narrow-based stock indexes, can be traded in the commodities markets.
Unlike the other derivative contracts, security futures products are traded under a co-regulatory system such
that the applicable CFTC and contract market regulation parallels that which would be applicable to
comparable security option products traded under SEC regulation. This is a relatively small segment of the
derivatives market and as such the overall regulatory schemes applicable to non-securities derivatives and
securities remain strikingly different. See 1 JOHNSON & HAZEN supra note XXX § 1.02[9].
and commodities laws. In other words, the legislature could reevaluate the regulation of
the investment markets in comparison with gambling laws.

Long ago, all forms of gambling were outlawed, primarily for moral reasons.97
Over time, the legislature has eased gambling regulation significantly as additional forms
of legalized gambling became apparent. While most bilateral wagering contracts remain
illegal, many forms of organized gambling are now legal. Legalized gambling includes a
wide range of activities. For example, there are state operated lotteries, legalized pari-
mutual betting on horse and dog racing, legalized gambling casinos, and in Nevada,
legalized betting on sporting events.98 Historically, the federal government left gambling
regulation to the states, the one exception being the federal law permitting gambling on
Indian reservations.99

II. Regulatory Comparisons and Solutions

Market regulation presumably is based on legislators’, regulators’, and other

policy makers’ determination of what measures will be most effective in combating the
evils that led to regulation in the first place. Overregulation imposes unnecessary
transaction costs and unduly interferes with efficient markets. Accordingly, the task for

97
See infra note XXX and accompanying text.
98
See, e.g., Cory Aronovitz, The Regulation of Commercial Gaming, 5 CHAP. L. REV. 181 (2002)
(discussing legalized gambling); Paul D. Delva, Comment, The Promises and Perils of Legalized Gambling
for Local Governments: Who Decides How to Stack the Deck?, 68 TEMP. L. REV. 847, 847-49 (1995)
(discussing increased legalization); David B. McGinty, The Near-Regulation of Online Sports Wagering by
United States v. Cohen, 7 GAMING L. REV. 205 (2003) (every state except Utah and Hawaii have some
form of legalized gambling). See also, e.g., RICHARD MCGOWAN, STATE LOTTERIES AND LEGALIZED
GAMBLING 21 (1994) (examining legalization of gambling); R. Randall Bridwell & Frank L. Quinn, Mad
Joy to Misfortune: The Merger of Law and Politics in the World of Gambling, 72 MISS. L.J. 565 (2002)
(discussing the consequences of increased legalized gambling); Wendy J. Johnson, Tribal Gaming
Expansion in Oregon, 37 WILLAMETTE L. REV. 399 (2001) (discussing gambling in Oregon); John Warren
Kindt & John K. Palchak, Legalized Gambling 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); John W. Kindt, Increased Crime
and Legalized Gambling Operations: The Impact on the Socio-Economics of Business and Government, 30
CRIM. L. BULL. 538 (1994) (discussing the impact of decriminalization); Kathryn R.L. Rand, There Are No
Pequots on the Plains: Assessing the Success of Indian Gaming, 5 CHAP. L. REV. 47 (2002) (evaluating
legalized casino gambling on Indian reservations); A. Gregory Gibbs, Note, Anchorage: Gaming Capital of
the Pacific Rim, 17 ALASKA L. REV. 343 (2000) (discussing gambling in Alaska).
99
See Tom Lundin Jr., Note, The Internet Gambling Prohibition Act Of 1999: Congress Stacks the Deck
Against Online Wagering But Deals in Traditional Gaming Industry High Rollers, 16 GA. ST. U. L. REV. 845,
853 (2000).
policy makers is to strike a delicate balance between what is deemed to be the minimum
necessary or desirable regulation and encouraging free markets.

a. Theories of Regulation

To some extent, any form of market regulation is paternalism,100 but paternalism

that may be well justified. One of the longtime premises of securities regulation is that
investors need protection not only against those who would take advantage of them, but
also against themselves.101 Regulation can, of course, be overly paternalistic. However,
the fact that regulation is protectionist and therefore to some extent paternalistic is not a
bad thing.102 For example, a recent article suggests that paternalistic regulation is
appropriate where it results in a system of “asymmetric paternalism” where the regulation
“creates large benefits for those who make errors, while imposing little or no harm on
those who are fully rational.”103

The choice of the best regulatory structure for the markets is influenced by the ways
in which we look at market structure and the behavior of market participants. Since the
inception of securities regulation in this country in 1911,104 there has been debate
concerning the appropriate approach to regulating investment markets.105 More recently,
scholarly discussion has focused on revisiting the premises of investment market

100
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 to paternalism should be empirical and pragmatic, having to do with the
possibility of education and likely failures of government response, rather than a priori in nature”).
Paternalism is also a rationale for insurance regulation. See infra note XXX..
101
See, e.g., Bateman, Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 310 (1985) (rejecting in pari delicto
defense based on plaintiff’s alleged misconduct where plaintiff acted merely as an investor).
102
See, e.g., Eyal Zamir, The Efficiency of Paternalism, 84 VA. L. REV. 229 (1998) (paternalism and efficiency
are not necessarily incompatible).
103
Colin Camerer, et al, Regulation for Conservatives: Behavioral Economics and the Case for
"Asymmetric Paternalism", 151 U. PA. L. REV. 1211, 1212 (2003).
104
In 1911, Kansas enacted the first comprehensive regulatory statute addressing securities marketing.
Kans. Laws 1911, c. 133. Selective regulation predated the Kansas enactment. Some more limited
securities regulation existed before the Kansas statute. For example, Massachusetts was regulating
securities issued by common carriers in 1852. See HARRY G. HENN & JOHN R. ALEXANDER, LAWS OF
CORPORATIONS 843 (3d ed. 1983).
105
For example, the states adopted a “merit” approach whereby an administrator would pass on the merits
of securities to be offered within the state. In contrast, federal securities regulation is premised on
disclosure and has rejected the merit approach initially adopted by the states. See THOMAS LEE HAZEN &
DAVID L. RATNER, SECURITIES REGULATION CASES AND MATERIALS 1-11 (6th ed. 2003).
regulation. As noted more fully below,106 there has been much debate in the academic
literature as to whether the rational-choice economic model or a more behaviorist approach
best explains investor behavior. For example, it has been suggested that we should look at
behavioral analysis in addition to the traditional economic analysis that is the supposed
foundation of securities regulation in the United States.107 Other social science – most
notably behavioral science – has been proffered as a better alternative for analyzing
regulatory efforts.108 As is the case with most social science analysis, valuable lessons can
be learned from both the economic and behaviorist perspective.

The choice of the applicable social science as a model of regulation is an

important issue that has been discussed elsewhere and thus is not the primary focus of
this article. Instead, this article explores insurance and gambling analogies as a means of
gaining insight into securities and derivatives regulation . The existing regulatory structure
focuses on disclosure as a way to keep the markets operating with both efficiency and
integrity. This should remain the core of securities regulation. By drawing analogies to
insurance and gambling, however, we can address conduct that is underregulated within
the current disclosure framework and find potential ways to supplement the existing
regulatory structure.

106
See infra note XXX and accompanying text.
107
See Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 71
(2003) (“Cognitive dissonance may then 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
capacity to justify regulatory intervention.”); Lawrence A. Cunningham, Behavioral Finance and Investor
Governance, 59 WASH. & LEE L. REV. 767 (2002) (arguing securities regulation reforms can benefit from
behavioral finance); Donald C. Langevoort, Selling Hope, Selling Risk: Some Lessons for Law from
Behavioral Economics 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 Market Manipulation, 74 N.Y.U. L. REV. 630, 715 (1999)
("Behavioral research remains a somewhat haphazard collection of seemingly unrelated cognitive quirks....
Drawing legal conclusions for a topic like consumer risk perception then becomes primarily a game of 'who
has the most anomalies wins.’”); Robert Prentice, Whither Securities Regulation? Some Behavioral
Observations Regarding Proposals for its Future, 51 DUKE L.J. 1397, 1400 (2001) ("American securities
regulation is the optimal system for governing capital markets.").
108
See, e.g., Cunningham supra note xxxx
 b. Explaining Investor Behavior in the Securities and Other Investment Markets

Economic theory has long been asserted to be a helpful paradigm for regulation of
the securities markets.109 The behavioral sciences also provide useful insight.110 Some
observers have argued that there should be a market for securities regulation, allowing the
market to determine the optimal regulatory structure.111 A variation would be to leave
securities regulation to the exchanges on which securities are listed rather than to policy-

109
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 Theory and the Regulation of the
Securities Industry, 29 STAN. L. REV. 1031 (1977). For critical views of the efficient capital market
hypothesis, see, e.g., Jeffrey N. Gordon & Lewis A. Kornhauser, Efficient Markets, Costly Information, and
Securities Research, 60 N.Y.U. L. REV. 761 (1985); William K. S. Wang, Some Arguments that the Stock
Market is not Efficient, 19 U.C. DAVIS L. REV. 341 (1986).
110
See Choi & Pritchard, supra note XXX; [Stephen J. Choi & A.C. Pritchard, Behavioral Economics and
the SEC, 56 STAN. L. REV. 1, 71 (2003); Hanson & Douglas, A. Kysar, Taking Behavioralism Seriously:
the Problem of Market Manipulation, 74 N.Y.U. L. REV. 630 (1999); Russell B. Korobkin & Thomas S.
Ulen, Law and Behavioral Science: Removing the Rationality Assumption From Law and Economics, 88
CAL. L. REV. 105 (2000); Donald C. Langevoort, Taming the Animal Spirits of the stock Markets: A
Behavioral Approach 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); Robert Prentice,
Whither Securities Regulation? Some Behavioral Observations Regarding Proposals for its Future, 51
DUKE L.J. 1397 (2002); Lynn A. Stout, The Unimportance of Being Efficient: an Economic Analysis of
Stock Market Pricing and Securities Regulation, 87 MICH. L. REV. 613 (1988). See also, e.g., Christine
Jolls, Cass R. Sunstein, & Richard Thaler, A Behavioral Approach to Law and Economics, 50 STAN L REV
1471, 1518-19 (1998) (judgment biases have implications with respect to demand for environmental
regulation); Lewis A. Kornhauser, The Domain of Preference, 151 U. PA. L. REV. 717 (2003) (discussing
law and economics critiques of behavioral economics); Roger G. Noll & James E. Krier, Some Implications
of Cognitive Psychology for Risk Regulation, 19 J LEGAL STUD. 747 (1990) (discussing cognitive
psychology implications on regulation of health and environmental risks).
For a critique of the behavioral approach, see, e.g., Gregory Mitchell, Why Law and Economics' Perfect
Rationality Should Not Be Traded for Behavioral Law and Economics' Equal Incompetence, 91 GEO. L.J.
67, 72 (2002) ("Behavioral law and economics bases its model of bounded rationality on a very limited set
of empirical data and draws unsupportable conclusions about human nature from this partial data set.");
Richard A. Posner, Rational Choice, Behavioral Economics, and the Law, 50 STAN. 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 the relevant instances are rational-choice economists and, I am about to suggest,
evolutionary biologists").
111
See Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 YALE
L.J. 2359 (1998) (“The aim is to replicate for the securities setting the benefits produced by state
competition for corporate charters--a responsive legal regime that has tended to maximize share value--and
thereby eliminate the frustration experienced at efforts to reform the national regime. As a competitive
legal market supplants a monopolist federal agency in the fashioning of regulation, it would produce rules
more aligned with the preferences of investors, whose decisions drive the capital market.”).
making legislators or administrative agencies.112 As noted above, this is the approach
taken by commodities regulation,113 especially in the wake of the deregulatory impact of
the Commodity Futures Modernization Act of 2000.114

Prior to the Modernization Act all publicly traded futures contracts had to take
place on organized exchange the rules of which were subject to oversight and approval by
the Commodity Futures Trading Commission.115 The self regulatory organizations in the
securities markets (the national securities exchanges and the National Association of
Securities Dealers) perform similar function in regulating the securities exchanges and
the over-the-counter (i.e., non-exchange) markets for securities.116 As discussed in the
preceding section, the Commodity Futures Modernization Act substituted a series of core
principles for organized public markets and leaves it to the contract markets and derivates
transaction execution facilities to fashion rules that are consistent with those core
principles.

A counterpart to the rational choice117 law and economics explanation of human

behavior is the behavioral economics concept of prospect theory,118 which posits, among
other things, that we are more likely to take risk to avoid losses than to amass gains.119

112
See, e.g., Paul G. Mahoney, The Exchange as Regulator, 83 VA. L. REV. 1453 (1997).
113
See, e.g., Stephen Craig Pirrong, The Self-Regulation of Commodity Exchanges: The Case of Market
Manipulation, 38 J.L. & ECON. 141 (1995).
114
Pub. Law No. 106-554, 114 Stat. 2763 (Dec. 21, 2000).
115
See discussion in the text accompanying notes XXX-XXX infra. See generally 1 JOHNSON & HAZEN,
supra note XXX § 1.04.
116
See 5 HAZEN, supra note XXX ch. 14 . [THOMAS LEE HAZEN, Treatise on the Law of Securities
Regulation , § 1.2[3] (5th ed. 2005)]
117
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 the Law, 1997 WIS. L. REV. 433, 436 (1997).
118
See Daniel Kahneman & Amos Tversky, Prospect Theory: An Analysis of Decision 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 AN UNCERTAIN WORLD: THE PSYCHOLOGY OF JUDGMENT AND DECISION MAKING
(2001).
119
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 avoid losses but are unwilling to take risks to accumulate
gains”). But cf. Jason Scott Johnston, Paradoxes of the Safe Society: A Rational Actor Approach to the
Reconceptualization of Risk and the Reformation of Risk Regulation, 151 U. PA. L. REV. 747 (2003)
(medical advancements have increased many individuals willingness to engage in high risk behavior).
This asymmetry arises because we tend to weigh potential losses more heavily than
potential gains in assessing risks.120 A variation of this phenomenon occurs in connection
with regret – namely, emotion may motivate rational actors to choose a more risk averse
choice (even with a lower payoff) in order to avoid the regret that would follow from
selecting a riskier alternative that failed to realize the higher potential gain.121 The
difficulty of distinguishing bona fide risk-shifting transactions from other transactions
that the law has decided to regulate differently has been aptly described as the law’s love-
hate relationship to risk.122 The discussion that follows examines the parallels between
gambling and investor behavior and then explores how those parallels might affect
regulatory structures.

c. Rational Investing or Gambling?

Many investors participate in the markets as a form of entertainment. Some

suggest that market participants often view investing as a hobby123 or participate for the
thrill of the game.124 To the extent that this is true, basing investment regulation solely

120
See Richard Coughlan & Terry Connolly, Predicting Affective Responses to Unexpected Outcomes, 85
ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 211, 217 (2001) (“losses loom larger than
gains”); Janet Landman, Regret and Elation Following Action and Inaction: Affective Responses to Positive
Versus Negative Outcomes, 13 PERSONALITY & SOC. PSYCHOL. BULL. 524, 527 (1987) (“[W]hen people
are making real decisions in betting or life-dilemma situations, they weigh potential losses more heavily
than potential gains.”). It is also worth noting that causing someone to incur a risk is every bit as much a
“harm” as actual economic loss. See Claire Finkelstein, Is Risk a Harm?, 151 U. PA. L. REV. 963, 992
(2003) (infliction of risk can constitute a legally actionable harm, even if outcome harm is not actually
suffered).
121
See, e.g., Robert A. Josephs et al., Protecting the Self from the Negative Consequences 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 Normality Bias in Legal Decision Making, 88 CORNELL L. REV. 583, 606-609 (2003); Marcel
Zeelenberg & Jane Beattie, Consequences of Regret Aversion 2: Additional Evidence for Effects of
Feedback on Decision Making, 72 ORGANIZATIONAL BEHAV. & HUM. DECISION PROCESSES 63, 74-75
(1997).
122
Kreitner, supra note XXX at 1127-1137. [Roy Kreitner, Speculations of Contract, or How Contract Law
Stopped Worrying and Learned to Love Risk, 100 COLUM. L. REV. 1096, 1127-1137 (2000)]
123
Ian Ayres & Stephen Choi, Internalizing Outsider Trading, 101 MICH. L. REV. 313, 314 (2002)
(describing investing as a hobby for many).
124
ROBERT J. SHILLER, MARKET VOLATILITY 59 (1989) (“Investing in speculative assets clearly shares with
gambling the element of play …. The satisfaction afforded by gambling is related to the individual's ego
involvement in the activity; and thus individual investors must themselves play to achieve satisfaction, and
most do not rely on others for decisions.”); Theresa A. Gabaldon, John Law, With A Tulip, In The South
Seas: Gambling And The Regulation Of Euphoric Market Transactions, 26 J. CORP. L. 225, 266 (2001);
Charles R. P. Pouncy, The Rational Rogue: Neoclassical Economic Ideology In The Regulation Of The
on efficient market on rational choice theories ignores a significant segment of the
market.

Several years ago, I explored the supposed rationality of derivatives125 markets

and was struck then by the similarity bet126ween what many label rational investment or
bona fide market transactions and gambling, which traditionally has been illegal or
alternatively subject to stringent regulation.127 In that article, I questioned whether the
regulatory structure relied too heavily on the efficient capital market hypothesis and the
supposed rationality of investors. Subsequent literature has explored the ways in which
investor behavior does not fit the rational choice model, suggesting instead that
behavioral economics can better explain at least some aspects of investor activity.128

Financial Professional, 26 VT. L. REV. 263, 369 n.496 (2002); Lynn A. Stout, Are Stock Markets Costly
Casinos? Disagreement, Market Failure, and Securities Regulation, 81 VA. L. REV. 611, 660 n.148 (1995);
Jonathan Clements, Are You Irrational or Thrill-Seeking When It Comes To Risky Investment?, WALL ST.
J., June 4, 1996, at C1. But cf. de Kwiatkowski v. Bear Stearns & 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 Stearns
sought to portray Kwiatkowski's motivations in assuming the massive risk he chose as those of a person
driven by ego gratification, exuberant greed or just reckless gambling thrills. The record 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 large risks associated with foreign currency trading and with his exceptionally
large position. He admitted as much.”) (footnote omitted).
125
Derivative investments consist of options (“puts” and “calls”) and futures contracts. Options and futures
contracts can be derivative of individual securities (or commodities) or can be derivative of groups (or
baskets) of securities or commodities, such as those which comprise some of the more widely followed
stock indexes. Complex derivative investments such as swap transactions can be based on a number of
underlying formulas, based for example, on foreign currencies, interest rates, commodities prices, and the
like.
126
Thomas Lee Hazen, Rational Investment, Speculation, or Gambling?--Derivative Securities and
Financial Futures and Their Effects on the Underlying Capital Markets, 86 NW. U. L. REV. 987, 987-1037
(1992).
127
See T Hazen, Rational Investing, supra note XXX, at 987-1037; 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 conduct that would be uneconomical or irrational,
absent an effect on the market price”). But see, e.g., United States v. Dial, 757 F.2d 163, 165 (7th Cir.)
(there is a difference between speculation and gambling), cert. denied, 474 U.S. 838 (1985); THOMAS A.
HIERONYMUS, ECONOMICS OF FUTURES TRADING 138 (1971) (“1. Gambling involves the creation of risks
that would not otherwise exist while speculation involves the assumption of necessary and unavoidable
risks of commerce, and 2. In every futures transaction, the speculation incurs the duties and acquires the
rights of a holding of property and thus is an integral part of commerce”). See also, e.g., Theresa A.
Gabaldon, John Law, with a Tulip, in the South Seas: Gambling and the Regulation of Euphoric Market
Transactions; 26 J. CORP. L. 225 (2001)
128
See supra notes XXX XXX.
 The analogy between the investment markets and gambling has been made by
others but not in a way as to indicate that there should be a greater parallel in applicable
regulatory structures. For example, in a letter to President Washington, Thomas
Jefferson wrote: “the wealth acquired by speculation and plunder is fugacious in its
nature and fills society with the spirit of gambling.”129 More than a century later
Theodore Roosevelt commented that: “[t]here is no moral difference between gambling
at cards or in lotteries or on the race track and gambling in the stock market. One method
is just as pernicious to the body politic as the other in kind, and in degree the evil worked
is far greater.”130 The analogy has not been limited to policy makers and politicians.131
John Maynard Keynes observed: "It is usually agreed that casinos should, in the public
interest, be inaccessible and expensive. And perhaps the same is true of Stock
Exchanges."132 Even the federal tax laws draw a distinction between gambling and other
types of potentially gainful activities. While gambling gains are taxable, gambling losses
are deductible only to the extent of being able to offset gambling income and thus cannot

129
Letter from Thomas Jefferson to George Washington (Aug. 14, 1987), in 12 THE PAPERS OF THOMAS
JEFFERSON, 1787-88, at 38 (Julian P. Boyd ed., Princeton U. Press 1955); see John S. Shockley & David
A.Schultz, The Political Philosophy of Campaign Finance Reform as Articulated in the Dissents in Austin
v. Michigan Chamber of Commerce, 24 ST. MARY'S L.J. 165, 189 (1992).
130
42 CONG. REC. 1347, 1349 (1908); see Irwin Friend, The Economic Consequences of the Stock Market,
62 AM. ECON. REV. 212, 212 (1972) (describing public securities market as a “legalized gambling
casino.”); Steve Thel, The Original Conception of Section 10(b) of the Securities Exchange Act, 42 STAN.
L. REV. 385, 396 (1990), Robert J. Shiller, Financial Speculation: Economic Efficiency and Public Policy 9
(Jan. 15, 1991) (background paper prepared for the 20th Century Fund)
131
See, e.g., REUVEN BRENNER & GABRIELLE A. BRENNER, GAMBLING AND SPECULATION: 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); ANN FABIAN, CARD SHARPS, DREAM BOOKS & BUCKET SHOPS: GAMBLING IN 19TH-CENTURY
AMERICA 153-202 (1990); George Soule, The Stock Exchange in Economic Theory, in Frederick W. Jones
& Arthur D. Lowe, Manipulation, THE SECURITY MARKETS: FINDINGS AND RECOMMENDATIONS OF A
SPECIAL STAFF OF THE TWENTIETH 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) (“[t]he time honored
attitude has been that futures contracts are gambling contracts if, at the making of the agreements, the
parties do not intend to make and receive delivery on the contracts”). See also, e.g.,
William W. Bratton, Jr., Corporate Debt Relationships: 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
is generally desirable, as long as an investing manager brings care and deliberation to the task. Speculation
is a different, less prudent and more questionable endeavor. It lacks a legitimating tie to the work ethic. The
speculator seeks to get something for nothing, like a gambler.”)
132
JOHN MAYNARD KEYNES, THE GENERAL THEORY OF EMPLOYMENT, INTEREST AND MONEY 159 (1936).
See generally COWING, supra note XXX [CEDRICK .B. COWING, POPULISTS, PLUNGERS & PROGRESSIVES:
A SOCIAL HISTORY OF STOCK & COMMODITY SPECULATION 1890-1936, at 3-24 (1965)]; LOUIS
LOWENSTEIN, WHAT'S WRONG WITH WALL STREET (1988).]
be used to defray other income.133 In contrast investing losses may be used, albeit
possibly on a deferred basis,134 to offset other income.135

The illegality136 of and law’s disdain for gambling has its moral overtones which
makes it difficult to draw the line between bona fide market transactions and a wager.137
Even outside of derivative investments, the law has had difficulty drawing the line
between permissible contracts and illegal gambling arrangements. The basic premise is
that wagers are illegal and unenforceable as a matter of contract law and the
unenforceability of illegal contracts generally.138 Some courts have gone so far as to

133
IRC § 165(d) (2003). There is, however, an exception for professional gamblers who are able to deduct
losses in excess of their offsetting gains. Cf., e.g., Commissioner v. Groetzinger,, 480 U.S. 23 (1987) (full-time
gambler making wagers solely for his own account was engaged in a “trade or business,” and thus gambling
losses were not an item of tax preference subjecting him to a minimum tax). But see IRC § 183 (2003)
(limitation on hobby losses).
134
For example, capital losses that are not offset by capital gains may be used to offset other income only up to
$3000 per year. IRC § 1212(b) (2003).
135
There is an exception for so-called hobby losses – activities that could arguably be characterized as
businesses that are engaged in for enjoyment but generate losses rather than income. See IRC § 183 (2003).
136
The legalization of gambling has far from eliminated concerns about its propriety and utility. See, e.g.,
John Warren Kindt, Diminishing or Negating the Multiplier Effect: The Transfer of Consumer Dollars to
Legalized Gambling: Should A Negative Socio-Economic "Crime Multiplier" be Included In Gambling
Cost/Benefit Analyses?, 2003 MICH. ST. DCL L. REV. 281 (2003).
137
FABIAN supra note XXX at 5 [ANN FABIAN, CARD SHARPS, DREAM BOOKS & BUCKET SHOPS:
GAMBLING IN 19TH-CENTURY AMERICA 153-202 (1990)]; Kreitner supra note XXX, at 1138 [Roy Kreitner,
Speculations of Contract, or How Contract Law Stopped Worrying and Learned to Love Risk, 100 COLUM.
L. REV. 1096, 1098 (2000):
[J]udicial discourse surrounding the problem of gambling in contract law around the turn of the
century was involved in such an ideological function. By spinning out an economy of
appropriation and distance with regard to risk, chance and hazard in the economic processes of
contracting, contract discourse helped its audiences come to terms with the deep fears and
uncertainties that accompanied the transition into modernity. By retaining its condemnatory
critique of gambling, or banishing its gambling doubles, it played the protector of souls. And by
recognizing that efficient economies required speculative activity, and that an element, albeit a
controlled element, of gambling existed in all economic activity, contract discourse made way for
the emergence of an individual who could claim mastery even while acknowledging uncertainty.
Throwing itself between the devil and the deep sea, contract helped Americans stop worrying and
learn to love risk. (footnotes omitted).
138
For a history of the laws invalidating gambling contracts, see, for example, Joseph Kelly, Caught in the
Intersection Between Public Policy and Practicality: A Survey of the Legal Treatment Of Gambling-Related
Obligations In The United States, 5 CHAP. L. REV. 87, 158 (2002).
invalidate a loan on the grounds that the loan was designed to pay for illegal gambling
debts.139

The specifics of the similarity between gambling and derivatives transactions are
exemplified by comparing illegal “difference contracts” with permissible futures140 and
options141 transactions.142 In addition to the examples at the beginning of this article,
consider the case of two individuals who decide to wager on the price of a certain
security and what it will be a year from now. Under traditional analysis, the law has
referred to this as a difference contract143 and has declared it to be illegal gambling.144 In
the earlier cases, courts had a difficult time identifying which futures contracts were void
as illegal gambling and which were valid because of a valid delivery obligation.145

139
See James L. Buchwalter, Annotation, Right to Recover Money Lent for Gambling Purposes, 74 A.L.R. 5th
369, at § 6 (1999) (collecting cases).
140
A futures contract is a contract for future delivery--it creates a bilateral obligation of the buyer (to
purchase) and the seller (to sell) the underlying commodity at a specified price, on a specified date, with
delivery to take place at a specified delivery point. Notwithstanding the delivery obligation, however, most
futures contracts are settled through a process known as offset whereby rather than make or take delivery,
the parties typically enter into an offsetting futures contract thereby canceling their existing delivery
obligation.
141
As compared with futures contracts, option contracts do not create delivery obligations unless and until
the option-holder exercises the option. An option contract will not result in an obligation to deliver the
underlying commodity or security since out-of-the-money options will expire without being exercised. On
the other hand, if an option is in the money, that is, if exercise of the option will result in a profit to the
option holder, the option will be exercised and the underlying commodity or security will change hands,
unless the obligation is extinguished as a result of an offsetting options transaction.
142
Questions have also been raised as to whether a gambling game could be classified as a security. For
example, in a highly questionable ruling a district court held that gambling even in the form of a fantasy
stock exchange did not involve the purchase or sale of a security and thus is not subject to the jurisdiction
of the Securities and Exchange Commission. SEC v. SG Ltd., 142 F. Supp. 2d 126 (D. Mass. 2001),
reversed, 265 F.3d 42 (1st Cir. 2001). Fortunately, the district court's ruling was overturned, with the First
Circuit reasoning that the “virtual” stock in question was a security. Id. [SEC v. SG Ltd., 142 F. Supp. 2d
126 (D. Mass. 2001), reversed, 265 F.3d 42 (1st Cir. 2001)].
143
See Hazen, Rational Investing, supra note XXX, at 1015.
144
See id. [See Hazen, Rational Investing, supra note XXX, at 1015.]
145
Compare Uhlmann Grain Co. v. Dickson, 56 F.2d 525 (8th Cir. 1932) (futures contract was not illegal
where party intended to enter into offsetting contract rather than follow through with delivery obligation),
and Gettys v. Newburger, 272 F. 209 (8th Cir. 1921) (futures contract was enforceable unless both parties
had pernicious intent 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 other grounds, 355 N.W.2d 704
(Minn. 1984) (since futures contract contains a delivery contract it is not illegal gambling even though
party entering into contract had no 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 defense under Virginia law to futures contract where there was
Clothing what is essentially a difference contract as a derivatives transaction often will
provide a cloak of legality. For example, institutional traders have engaged in synthetic
stock transactions146 which consist of contracting with a counterparty to pay the
difference on the price of the underlying stock over time.147 One of the professed reasons
for a synthetic stock purchase (rather than a purchase of the security itself) is to avoid
leaving a footprint that would reveal the institutional investor was taking a buy position
in the stock.148 The irony with respect to this transaction is not only is it difficult to
distinguish from what would otherwise be called an illegal difference contract,149 it is
being used to deceive the market150at large as to significant investment activity.151 This

no intent to deliver), and James v. Clement, 223 F. 385 (5th Cir. 1915) (where both parties intended
contract as a gamble, futures contract would be void for illegality), and Carpenter v. Beal-McDonnell &
Co., 222 F. 453 (E.D. Ark 1915) (façade of futures contract did not shield illegal gambling transaction),
and Waldron v. Johnston, 86 F. 757 (S.D. Ga. 1898) (same).
146
Synthetic stock occurs when an investor sells a put option on a stock while simultaneously purchasing a call
option with the same exercise price and expiration date. For example, if ABC stock is trading in January at $35
per share, an investor may be able to sell ten June $35 puts (covering 1,000 shares of ABC stock) for $2,000
and buy ten June $35 calls with the same $35 exercise price for $3,000. The investor thus 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 share decline. See Thomas Lee Hazen, The Short-Term/Long-Term
Dichotomy And Investment Theory: Implications For Securities Market Regulation And For Corporate Law, 70
N.C. L. REV. 137, 167 n.139. Synthetic stock positions provide the opportunity for leverage beyond that
permitted by purchasing stock on margin. Sanford J. Grossman, An Analysis of the Implications for Stock and
Futures Price Volatility of Program 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 loss as she would had she paid
$35,000 to purchase the 1,000 shares of ABC stock instead of 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 subject to different tax
consequences than a purchase and sale of the underlying stock. See David F. Levy, Towards Equal Tax
Treatment Of Economically Equivalent Financial Instruments: Proposals For Taxing Prepaid Forward
Contracts, Equity Swaps, And Certain Contingent Debt Instruments, 3 FLA. TAX REV. 471, 511-512 (1997).
See also, e.g., Jeffrey M. Colón, Financial Products and Source Basis Taxation: U.S. International Tax Policy
at the Crossroads, U. ILL. L. REV. 775 (1999). (Without pinpoint cite there is no way I can find it.)
147
See, e.g., Caiola v. Citibank, N.A., N.Y., 295 F.3d 312, 315-319 (2d Cir. 2002) (describing synthetic stock
transactions).
148
See id. [Caiola, 295 F.3d 312 at 315-319.]
149
It has been suggested that synthetic stock creates the risk rather than merely allocating it. This is a
distinction that others have used to distinguish gambling from legitimate business transactions. See infra note
XXX.
150
In Caiola, the investor complained of the counterparty’s decision to satisfy its side of the synthetic
transaction by purchasing the stock in question and thereby leaving the footprint that the plaintiff wanted to
avoid. Caiola, 295 F.3d at 318.
151
Compare this type of transaction with the illegal practice of “parking,” which consists of hiding the true
identity of a security’s owner. See, e.g., In re Barlage, 63 S.E.C. 1060 (1996), 1996 WL 733756, at *1 n.2 .
(“parking is the sale of securities subject to an agreement or understanding that the securities will be
transaction is just one example of how the law permits sophisticated market participants
to engage in transactions that would be illegal if carried out by other market
participants.152 In addition, some investors can also replicate difference contracts using
publicly traded options.153

Since the fact that the law traditionally has characterized difference contracts as
illegal places other restrictions on gambling contracts, characterizing a contract as a
gamble or a wager can provide a basis for placing limits on freedom of contract.154
Classical works on contract law have long pointed out the difficulties in trying to

repurchased by the seller at a later time and at a price which leaves the economic risk on the seller.”). See also,
e.g., In re Hibbard & O’Connor Securities, Inc., 46 S.E.C. 328 (1976), 1976 SEC LEXIS 1889, at *4); 5
THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 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.See id.
152
The essence of a parking violation is the intent to deceive. As I have stated elsewhere:
Not every sale followed by a repurchase between accounts will constitute parking. Bona fide
transactions that carry a true shift in investment risk following the initial sale are not improper
parking transactions. In order to establish a parking violation it must be established that the
transactions were in fact a sham designed to hide the true ownership of the securities.
5 HAZEN supra note XXX § 14.23 (footnotes omitted).[SEE COMMENT ON MISSING HAZEN
SOURCE] There was clearly a deceptive intent in the Caiola case[add cite]. It may have been to a lesser
degree, however, since the synthetic stock transaction in Caioloa, unlike parking, involved a shift of
investment risk, albeit in a way designed to deceive the market by disguising the transaction[add cite].
153
Synthetic stock can be used by other investors through options that are traded on the securities options
markets. See HAZEN, supra note XXX § 1.7. [SEE COMMENT] Particularly for ordinary investors, however,
transaction costs can make complex derivatives policies prohibitively expensive, as exemplified by the
following description of the alligator spread:
Alligator Spreads are any of a class of complicated option transactions so constructed that the
investor is likely to be eaten alive by the commissions. As with real alligators, rumors of their
extinction have been greatly exaggerated, for they live on. I once witnessed a supposedly serious
presentation of a 'triple boxcar spread' with more commission-generating moving parts than a
Swiss watch. When the dust settled, only the broker would be left standing. Since I witnessed this
sideshow at an ostensibly 'institutional' options conference, I can only speculate (bad choice of
words) on what may thrive in the retail reaches of this nation.
One symptom of Alligator Spreads, apart from the pile of digested scraps of capital lying
nearly[sic], called commissions, is an incredibly complex pattern of open and adjusted option
positions in pursuit of a profit, eventually. Then again, depending on who controlled the account,
profit may not necessarily have been the motive.
Robert E. Conner, Option-Related Securities Disputes: Analytical Considerations, 650 PLI/CORP 899
(1989), WL 650 PLI/Corp 899 (July 13, 1989), at *919.
154
Roy Kreitner, Speculations of Contract, or How Contract Law Stopped Worrying and Learned to Love
Risk, 100 COLUM. L. REV. 1096, 1098 (2000) (“around the turn of the last century, the question of wager
was one of the key doctrinal areas that defined the scope of freedom of contract”); Mark Pettit, Jr.,
Freedom, Freedom of Contract, and the 'Rise and Fall,' 79 B.U. L. REV. 263, 319-324 (1999).
distinguish legitimate hedging activities from the more questionable (and often illegal)
wager.155 Trying to distinguish between legitimate hedging and impermissible gambling
based on the intent of the parties did not prove to be a satisfactory solution.156 Although
commercial enterprises frequently resemble gambling, many commentators who favor a
capitalist system have tended to object to gambling.157 The delivery obligation in futures
and options contracts does not provide a satisfactory basis for the distinction between
legal derivatives and illegal difference contracts. The delivery obligation is not a useful
distinction because most futures and option contracts are settled through offsetting
contracts, thus obviating the need to deliver the underlying commodity or security.

Consider, for example, the situation where two people enter into a contract to
transfer the same stock a year from now at a stated price. This transaction is known as a
futures contract,158 and is legal in the United States.159 Most futures contracts, are
functionally the same as a wager, since rather than delivering under the contract, the vast
majority of futures contracts are settled through a process known as offset, whereby
rather than transfering the underlying commodity or security, the parties enter into
offsetting transactions.160 In England, the prohibition on difference contracts dates back

155
Edwin W. Patterson, Hedging and Wagering on Produce Exchanges, 40 YALE L.J. 843, 878 (1931) ("In
endeavoring to distinguish hedging from wagering, the courts are between the devil and the deep sea.").
156
Kreitner, supra note XXX, at 1105-1110 .
157
As reportedly said by Ambrose Bearce, "[t]he 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 NEB. L. REV. 263, 344 (1999).
158
The term futures contract is used to refer to a standardized contract for future delivery. In contrast, a
forward contract is one, generally used by commercial participants with respect to the underlying commodity,
calling for a present sale but a delivery date in the future. Functionally, futures and forward contracts are the
same. The significance in the different terminology is primarily regulatory in nature. Futures contracts are
subject to the provisions of the Commodity Exchange Act whereas forward contracts are not. See 1 PHILLIP
MCBRIDE JOHNSON & THOMAS LEE HAZEN, DERIVATIVES REGULATION §§ 1.02[4], 1.02[5] (2004).
159
Until 2000, futures contracts on individual securities were not permissible, but as a result of the
Commodity Futures Modernization Act, § [provide section, per comment], security futures products like
this are permissible. Commodity Futures Modernization Act, Pub. L. No. 106-554, 114 Stat. 2763 (2000),
160
In other words, the would-be seller goes into to the market and enters into an offsetting futures contract
to purchase the commodity or security at the same price that she is obligated to sell it for in the original
obligation to sell the commodity or security. Similarly, the would-be buyer typically enters into an
offsetting futures contract to sell. The net result here is that the parties receive the difference between their
wagered price and the price of the commodity or security at the contract’s expiration date.
to 1734 and reactions to the South Sea Bubble scandal in 1734.161 In the United States,
by 1829, the speculative fever in New York’s financial center had also led to legislation
prohibiting stock jobbing, 162 another term for difference contracts.

Notwithstanding the similarity between difference contracts on the one hand and
futures or options contracts on the other,163 contracts for the future sale of stock were
generally upheld against a claim that they constituted gaming or wagering unless the facts
revealed that the transactions "were nothing more than mere speculation on fluctuations
in price with no genuine intent to accept or deliver the stock."164

The law of most states generally prohibits wagering. For example, the New York
General Obligations Law provides: “All wagers, bets or stakes, made to depend upon any
race, or upon any gaming by lot or chance, or upon any lot, chance, casualty, or unknown

161
See Barnard's Act, 1734, 7 Geo. 2, c.. 8, § 5. ("[A]ll and every such contract shall be specifically
performed and executed on all sides, and the stock or security thereby 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 the same, shall also be actually and really given."). See also, e.g., WALTER BAGEHOT, LOMBARD
STREET 150-51 (Arno reprint ed. 1979) (1873) (comparing the South Sea Bubble investor hysteria with
gambling).
162
Stock Jobbing Act, 1 N.Y. Rev. Stat. 710, tit. 19, art. 2, § 6 (1829). Section 6 of that Act provided:
All contracts for the sale of stocks are void, unless the party so contracting to sell the same shall, at the time
of making such contracts, be in actual possession of the certificates of such shares or be otherwise entitled
thereto in his own right, or be duly authorized by some person so entitled to sell the certificates of shares so
contracted for.
The prohibition against difference contracts was designed to control "the more shadowy forms of financial
speculation." See THE DEVELOPMENT OF THE LAW OF GAMBLING 1776-1976 150 (National Institute for
Law Enforcement and Criminal Justice Grant No. 74-NI-99-0030, Nov. 1977) [hereinafter LAW OF
GAMBLING]. See also, e.g., THOMAS H. DEWEY, A TREATISE ON CONTRACTS FOR FUTURE DELIVERY AND
COMMERCIAL WAGERS INCLUDING "OPTIONS," "FUTURES," AND SHORT SALES (PUBLISHER AND DATE
WHEN WE GET BOOK ON INTERLIB LOAN) (1886) (demonstrating that the analogy between financial
speculation and investment speculating is not a new one).
163
See, e.g., Lynn A. Stout, Betting the Bank: How Derivatives Trading Under Conditions of Uncertainty
Can Increase Risks and Erode Returns in Financial Markets, 21 J. CORP. L. 53, 66 n.52 (1995):
Indeed, derivatives trading is in many respects a more troubling activity than orthodox gambling. Gambling
can be defended as providing entertainment to individuals who usually bet relatively small amounts of their
own funds. Even so, the gambling industry is tightly regulated and heavily taxed. In contrast, the relatively-
unregulated derivatives market is dominated by banks, corporations, pension funds, and municipalities.
These institutions are run by managers who have been entrusted with the savings of depositions,
employees, and citizens seeking reasonable returns at reasonable risks, rather than recreation.
164
LAW OF GAMBLING, supra note XXX, at 151 (relying on Story v. Salomon, 71 N.Y. 420 (1877)).
[NAT’L INST. FOR LAW ENFORCEMENT AND CRIMINAL JUSTICE, GRANT NO. 74-NI-99-0030, THE
DEVELOPMENT OF THE LAW OF GAMBLING 1776-1976 150 (1977) [hereinafter LAW OF GAMBLING]].
or contingent event whatever, shall be unlawful.”165 The New York General Business
Law (often referred to as a bucket shop prohibition166) extends this to gambling on stock
prices through the use of difference contracts.167 Futures, options, and other derivatives
contracts are treated as bona fide investment vehicles168 rather than being regulated as
differences contracts or other types of gambling. This is in part because derivatives,

165
N.Y. GEN. OBLIG. LAW § 5-401 (McKinney 2003).
166
For discussion of bucket shop prohibitions, see (1 PHILIP MCBRIDE JOHNSON & THOMAS LEE HAZEN,
DERIVATIVES REGULATION § 2.02[2] (2004).
167
N.Y. GEN. BUS. LAW § 351 (McKinney 2003):
Any person, copartnership, firm, association or corporation, whether acting in his, their or its own right or
as the officer, agent, servant, correspondent or representative of another, who shall:
1. Make or offer to make, or assist in making or offering to make any contract respecting the purchase or
sale, either upon credit or margin, of any securities or commodities, including all evidences of debt or
property and options for the purchase thereof, shares in any corporation or association, bonds, coupons,
scrip, rights, choses in action and other evidences of debt or property and options for the purchase thereof
or anything movable that is bought and sold, intending that such contract shall be terminated, closed or
settled according to, or upon the basis of the public market quotations of or prices made on any board of
trade or exchange or market upon which such commodities or securities are dealt in, and without intending
a bona fide purchase or sale of the same; or,
2. Makes or offers to make or assists in making or offering to make any contract respecting the purchase or
sale, either upon credit or margin, of any such securities or commodities intending that such contract shall
be deemed terminated, closed and settled when such market quotations of or such prices for such securities
or commodities named in such contract shall reach a certain figure, without intending a bona fide purchase
or sale of the same; or,
3. Makes or offers to make, or assists in making or offering to make any contract respecting the purchase or
sale, either upon credit or margin of any such securities or commodities, not intending the actual bona fide
receipt or delivery of any such securities or commodities, but intending a settlement of such contract based
upon the difference in such public market quotations of or such prices at which said securities or
commodities are, or are asserted to be, bought or sold; or,
4. Shall, as owner, keeper, proprietor or person in charge of, or as officer, director, stockholder, agent,
servant, correspondent or representative of such owner, keeper, proprietor or person in charge of, or as
officer, director, stockholder, agent, servant, correspondent, or representative of such owner, keeper,
proprietor or person in charge, or of any other person, keep, conduct or operate any bucket shop, as
hereinafter defined; or knowingly permit or allow or induce any person, copartnership, firm, association or
corporation whether acting in his, their or its own right, or as the officer, agent, servant, correspondent or
representative of another to make or offer to make therein, or to assist in making therein, or in offering to
make therein, any of the contracts specified in any of the three preceding subdivisions of this section.
Shall be guilty of a felony. The prosecution, conviction and punishment of a corporation hereunder shall
not be deemed to be a prosecution, conviction or punishment of any of its officers, directors or
stockholders.
168
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 illegal gambling: “[c]ontrary to defendant's argument,
the parties' contract was not an illegal contract to gamble, but rather a legitimate commodity swap
agreement exempt from the 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 contract was not
illegal gambling).
unlike gambling, are viewed as providing a useful hedging device for at least some
market participants.169 In one recent case, the judge characterized a derivatives contract
as a gamble but nevertheless found it to be a legal transaction.170 The issue today is not
whether to declare derivative and other speculations illegal. Rather, to the extent that the
markets create a form of organized gambling, then those investments which lend
themselves to the gambler should be regulated accordingly. This leads to the question of
how regulating gambling should differ from regulating markets and what market reforms
should be introduced to reflect the gambling mentality of many investors.

As demonstrated by the foregoing discussion, policy-makers have long struggled

with the question of whether derivatives contracts are illegal gambling contracts is not a
new one. If they could be characterized as futures contracts and fell within the ambit of
CFTC regulation, these contracts are permissible. Until 2001, most derivatives
transactions had to take place on an organized exchange, subject to some limited
exemptions. With the adoption of the Commodity Futures Modernization Act of 2000,171
there is much broader recognition of off-exchange or over-the-counter derivatives
markets. The validity of exchange-listed derivatives is easier to establish because of the
regulatory structure under the supervision of the Commodity Futures Trading
Commission. In contrast, over-the-counter derivatives are essentially unregulated. As a
result, it is appropriate to consider whether the gambling analogy warrants some fine-
tuning of the regulatory structure.

Viewing the behavior of some investors as analogous to gambling does not by

itself negate entirely the rational choice model. Gambling is not necessarily irrational

169
See, e.g., Steven L. Schwarcz, The Universal Language of International Securitization, 12 DUKE J.
COMP. & INT'L L. 285, 300 n.68 (2002) (“Swaps are therefore akin to gambles on future asset values.
Indeed, there is ongoing controversy as to whether derivative products can be abused, particularly where
investors borrow on leverage 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-border transactions is not
only prudent but essential for minimizing the risk to investors.”).
170
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 form of forward contracts, swaps and derivatives. Derivatives
transactions, forward contracts and swap agreements in currencies and commodities are not considered
illegal gambles, and do not violate New York's gambling statute.”).
171
Pub. L. No. 106-554, 114 Stat. 2763 (2000).
behavior.172 For example, gambling or high risk investing can be seen as access to wealth
that is not available through other investment or productive activities. An individual not
having sufficient capital to invest with hopes of modest incremental gains and desiring
larger returns makes a rational investment when she chooses high risk investments in
much the same way as gambling can be rational. As noted earlier, most individuals have
a high degree of risk aversion that militates against risky-behaviors seeking a big payoff.
Nevertheless, if an individual desires the high pay-off with sufficient intensity, then he or
she will be acting rationally in tolerating risk that many other rational actors will not.

Even aside from purely economic motivations, investing in individual securities

or derivative products provides a form of entertainment for some investors in much the
same way as rational actors are willing to gamble notwithstanding the odds and the cut to
the house because of the enjoyment of the game. These market investors who are making
rational choices based on factors other than traditional investment return are creating
what the efficient market hypothesis would characterize as noise. 173 Market regulation
based on rational choice should account for this phenomenon. In the first instance, the
regulation should focus on adequate disclosure to assure that those who are interested in
investment gambling have adequate disclosure with respect to the risks.174

172
See, e.g., Choi & Pritchard, supra note XXX at 15 (“We do not share this speculative preference for our
own investments, but we cannot dismiss it as irrational.”) (footnotes omitted) [Stephen J. Choi & A.C.
Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 71 (2003).]; see also, e.g., CHARLES T.
CLOTFELTER & PHILIP J. COOK, SELLING HOPE: STATE LOTTERIES IN AMERICA 72-81 (1989); Lloyd R.
Cohen, The Lure of the Lottery, 36 WAKE FOREST L. REV. 705 (2001); Donald C. Langevoort, Selling
Hope, Selling Risk: Some Lessons for Law From Behavioral Economics About Stockbrokers 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. For some of the behavioral literature, see LEIGHTON VAUGHAN
WILLIAMS (ED.), ECONOMICS OF GAMBLING (2003); G.S. BECKER & K.M. MURPHY, A Theory of Rational
Addiction, 96 J. OF POL. ECON. 675 (1988); Athanasios Orphanides and David Zervos, Rational Addiction
with Learning and Regret, 103 J. OF POL. ECON. 739 (1995); R. Sauer, The Economics of Wagering
Markets, 36 J. OF ECON. LIT. 2021 (1998).
173
See, e.g., Anat R. Admani, A Noisy Rational Expectations Equilibrium for Multi-Asset Securities
Markets, 53 ECONOMETRICA 629, 632 (1985); Fisher Black, Noise, 41 J. FIN. 529 (1986); J. Bradford De
Long et al., The Size and Incidence of the Losses from 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).
174
After all, disclosure has been the basic premise of federal securities regulation since 1933. See
discussion in the text accompanying notes XXX-XXX supra.
 The regulatory structure for our securities and derivatives markets by and large is
based on traditional economic market analysis. It is presumed that since markets perform
an economic function, market participants are acting as rational actors. If this activity in
fact has characteristics traditionally associated with gambling, then there is reason 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 in designing regulatory schemes. As noted above, there are
accounts of gambling as rational activity: specifically that it opens access to wealth that
might not be available through other investment opportunities.175 It thus may be possible
to explain market bubbles and what most observers would characterize as excessive
trading as at least in part based on rational (albeit risk laden) decision making. At the
same time, we cannot properly ignore economically irrational actions such as investors
engaging in herd behavior.176 These issues have been examined in th legal literature.

For example, Professor Lynn Stout proposes a model to explain investor behavior
based on rational choice.177 In response, Professor Paul Mahoney contends that investor
behavior may be better explained as a result of noise178 that interferes with the rational
choice based on the supposed efficiency of the securities markets in pricing shares.179

175
See supra note XX
176
See Hazen, Rational Investing, supra note XX. [Thomas Lee Hazen, Rational Investment, Speculation,
or Gambling? -- Derivative Securities and Financial Futures and Their Effects on the Underlying Capital
Markets, 86 Nw. U. L. Rev. 987 (1992).
177
Lynn A. Stout, Are Stock Markets Costly Casinos? Disagreement, Market Failure and Securities
Regulation, 81 VA. L. REV. 611, 615-617 (1995):
Using rational choice analysis and information theory, it presents a model of stock trading premised on the
observation that, in a world of costly and imperfect information, rational investors are likely to form
heterogeneous expectations -- that is, to make different forecasts of stocks' likely future performance. The
heterogeneous expectations ("HE") model predicts that investors' asymmetrical expectations will inspire
them to seek short-term profits by speculating on stocks they perceive as misruled. Thus, John buys
General Motors expecting that GM's share price will soon rise, whereas Mary sells expecting GM to
decline.
(footnotes omitted). See also id. 641-642.
178
See supra note XX.
179
Paul G. Mahoney, Commentary: Is There a Cure for "Excessive" Trading, 81 VA. L. REV. 713, 715
(1995) (rejecting Stout's rational investor model and raising an agency-based rationale for irrational
investment decisions) (“I will attempt to show that Stout's model is actually one of irrational, rather than
rational, investor behavior, and accordingly has more in common with the noise trader approach than she
claims.”).
Professor Mahoney then goes on to suggest that the apparent excessive trading in the
securities markets is due to the fact that the intermediaries (stock brokers) are generally
compensated per transaction and thus have an economic incentive to encourage
trading.180 In any particular case a recommendation with an undisclosed self interest of
the person making the recommendation violates the securities laws (and the common law
as well).181 However, to the extent that this is a systemic problem, individualized
enforcement and private civil litigation will not cure the problem, macro approach
through regulatory reform would seem the more appropriate course than micro regulation
of each transaction.

To the extent that the excessive trading is caused by the incentive to financial
intermediaries, then stronger regulation addressing those conflicts of interest would seem
appropriate. A recent example of this would be the regulatory crackdown on security
analysts’ conflict of interests.182 Another approach is increased criminalization of willful
conduct that creates fraudulent fueled noisy markets. One irony here is that while there
has been increasing regulation of the securities markets to combat these practices, the
non-securities derivatives markets have been subject to significant deregulation. It is
difficult to point to anything other than political pressure to account for this divergence in
investment market regulation when comparing securities and non-securities derivatives
investments.

d. Consequences of Regulating Markets with a Gambling Perspective

As noted earlier, the regulation of gambling has been moving from an absolute
prohibition to legalized gambling under controlled circumstances. Extending this
analogy into the securities and derivatives markets could yield some insight.

The gambling analogy provides an interesting parallel to the history of the

regulation of the derivatives markets that in this country have traditionally been under the

180
Id. at 717.
181
See 5 TOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 14.16 (5th ed. 2005).
182
See Id. § 14.16[6] (2004 pocket part). See also Stephen J. Choi & Jill E. Fisch, How to Fix Wall Street:
A Voucher Financing Proposal for Securities Intermediaries, 113 YALE L.J. 269 (2003) (proposing a
voucher system to compensate market intermediaries such as analysts to eliminate the conflict of interest
resulting from securities issuers’ subsidizing analysts activities.)
regulatory regime applicable to commodities. Formerly, the typical approach to
gambling was to ban it.183 This evolved into a system where organized gambling is now
permitted in several states through centralized and regulated gambling casinos, race
tracks, and off-track betting facilities.184 Many states now also operate lotteries.185 As
one observer has explained, "[t]his once officially criminal activity is now being chosen
by business and community leaders as a lynchpin for economic development."186

One of the exceptions in the trends involving gambling has been the continued
criminalization of Internet gambling.187

Before the Commodity Futures Modernization Act, regulation of the derivatives

markets in many ways closely resembled gambling regulation. Until 2001, the
commodities markets in this country were based on a system premised on a contract
market monopoly.188 This monopoly resulted in a heightened regulatory environment.
The elimination of the contract market monopoly along with the significant decrease in
the CFTC’s oversight responsibility for the organized exchanges was a significant part of
the deregulatory reform of the Commodity Futures Modernization Act. Concurrently, the
Modernization Act opened up unregulated over the counter markets for non-securities
derivatives. This market is open, however, only to qualified investors. Finally, the
CFTC has been removed from its former role of pre-approving futures and options
contracts before they could be traded. The deregulation of the non-securities derivatives
markets thus somewhat parallels deregulatory trends in gambling laws.

e. Mirco-regulatory Issues

183
THE LAW OF GAMBLING supra note XX. [THE DEVELOPMENT OF THE LAW OF GAMBLING 1776-1976
150 (National Institute for Law Enforcement and Criminal Justice Grant No. 74-NI-99-0030, Nov. 1977).
[hereinafter LAW OF GAMBLING]].
184
See the authorities cited in supra note XX.
185
See, e.g., CLOTFELTER & COOK, supra note XX. [CHARLES T. CLOTFELTER & PHILIP J. COOK, SELLING
HOPE: STATE LOTTERIES IN AMERICA 72-81 (1989)].
186
See ROBERT GOODMAN, LEGALIZED GAMBLING AS A STRATEGY FOR ECONOMIC DEVELOPMENT 6 (1994).
187
See generally Lawrence G. Walters, The Law of Online Gambling in the United States--A Safe Bet, or Risky
Business?, 7 GAMING L. REV. 445 (2003) (discussing the current legal risks associated with operating online
gambling websites).
188
See 1 PHILIP MCBRIDE JOHNSON & THOMAS LEE HAZEN, DERIVATIVES REGULATION § 1.02[7] (2004).
 The foregoing discussion addressed overall regulatory parallels between gambling
and the derivatives markets. There also are some more particularized regulatory issues.
Consider, for example, the so-called financial suicide cases.189 Although there is sparse
case law to date, there is some authority to support holding gambling casinos accountable
for losses incurred by intoxicated patrons190 or for losses incurred by gambling addicts
who should have been barred from the casino.191 Although the courts have so far been
reluctant to expand the liability of gambling casinos,192 some have argued that this could
be used to support a parallel liability of broker-dealers who continue to allow their
customers to enter into risky unsuitable transactions.

Further, there are statutes, known as “dram shop” rules, imposing liability on
tavern owners for serving too much alcohol to their customers.193 The "dram shop"
theory of liability is also now applied in a relatively new variety of customer claim in
broker-dealer arbitration and customer initiated litigation.194 Typically, in these cases,
the claim is that the broker-dealer had an obligation to protect customers from their own
investment decisions resulting in unsolicited transactions—namely, not involving
189
This discussion is adapted from 5 Hazen, supra note XXX, at § 14.16[7].
190
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 where that patron is obviously and visibly intoxicated and/or
under the influence of a narcotic substance.). See also, e.g., Anthony Fernandez, Comment, Torts - Dram Shop
Liability - Under New Jersey Law a Casino Patron Would Not be Permitted to Recover Gambling Losses From
A Casino That Served the Patron Free Alcohol and Allowed Him to Continue Gambling After he Became
Visibly Intoxicated – Hakimoglu v. Trump Taj Mahal Assocs., 26 SETON HALL L. REV. 941, 948-950 (1996).
Compare, Jessica L. Krentzman, Dram Shop Law – Gambling While Intoxicated: The Winner Takes it All? The
Third Circuit Examines a Casino's Liability for Allowing a Patron to Gamble While Intoxicated, Hakimoglu 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 losses under these circumstances). Contra
Hakimoglu v. Trump Taj Mahal Assocs., 70 F.3d 291, 292-94 (3d Cir. 1995) (refusing claim under dram shop
law).
191
See, e.g., Joy Wolfe, Casinos and the Compulsive Gambler: Is There a Duty to Monitor the Gambler's
Wagers?, 64 MISS. L.J. 687, 695-702 (1995) (discussing the basis for imposing this type of liability).
192
See, e.g., Merrill v. Trump of Ind., 320 F.3d 729, 733 (7th Cir. 2003) (dismissing claim that casino could be
held liable for failure to bar compulsive gambler).
193
See Barbara Black & Jill I. Gross, Economic Suicide: The Collision Of Ethics and Risk in Securities
Law, 64 U. PITT. L. REV. 483, 506 (2003); Richard Smith, A Comparative Analysis of Dramshop Liability
and a Proposal for Uniform Legislation, 25 J. CORP. L. 553, 555-559 (2000).
194
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 Firms Pay Big Damages in "Dramshop"
Cases, Wall St. J. May 17, 1995 at C1; Michael Siconofoli, "Dramshop Awards" Increasingly Slapped on
Brokerage Firms, Wall St. J. Sept. 4, 1992, at A4B.
securities recommended by the broker.195 These claims also have alternatively been
described as "financial suicide" cases.196

However, these claims have generally been unsuccessful since broker-dealer

suitability obligations are traditionally tied to securities recommended by the broker as
compared with the unsolicited transactions that form the basis of the “dram shop” or
financial suicide claims. It seems clear that the mere existence of a brokerage
relationship does not put the broker under an obligation to prevent the customer from
committing financial suicide.197 However, fiduciary duties are created when a broker
undertakes the responsibility to monitor the account.198

The suitability doctrine for recommendations by securities brokers marks another

significant divergence in the regulatory regime applicable to the securities markets and
the one applicable to non-securities derivatives under the commodities laws. While the
suitability doctrine is firmly entrenched in the Securities Exchange Act199 and in self-
regulatory rules200 there is no comparable obligation of commodities brokers under the

195
See Smith, supra note XXX, at 73–77; See also Siconofoli, supra note XXX, at C1; Siconofoli, supra
note XXX, at A4B.
196
Thomas R. Grady, Trying the Financial Suicide Case, 950 PRAC. L. INST. 107, 109 (1996); see also,
Lisa Bertrain, "Economic Suicide" Claims: An Emerging Trend in Securities Arbitration, 950 PRACT. L.
INST. 185, 191 (1996).
197
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.2d 273, 279 (Miss. 1991); JERRY W.
MARKHAM, COMMODITIES REGULATION: FRAUD, MANIPULATION & OTHER CLAIMS § 10.08 (2000).
198
Trans National Group Services, Inc. v. PaineWebber, Inc., NASD Case No. 91–00770, 1992 WL
472902 (N.A.S.D. June 30, 1992) ($1 million arbitration award).
199
5 THOMAS LEE HAZEN, TREATISE ON THE LAW OF SECURITIES REGULATION § 14.16 (5th ed. 2005). See
also, e.g., Stephen B. Cohen, The Suitability Rule and Economic Theory, 80 Yale L.J. 1604 (1971); Janet E.
Kerr, Suitability Standards: A New Look at Economic Theory and Current SEC Disclosure Policy, 16 PAC.
L.J. 805 (1985); Norman S. Poser, Civil Liability for Unsuitable Recommendations, 19 Rev. Sec. &
Commodities Reg. 67 (April 2, 1986); Note, Measuring Damages in Suitability and Churning Actions Under
Rule 10b-5, 25 B.C. L. Rev. 839 (1984). See generally Hilary H. Cohen, Suitability Doctrine: Defining
Stockbrokers' Professional Responsibilities, 3 J. CORP. L. 533 (1978); short cite needed D. Lowenfels & Alan
R. Bromberg, Suitability in Securities Transactions, 54 BUS. LAW. 1557 (1999); Robert H. Mundheim,
Professional Responsibilities of Broker-Dealers: The Suitability Doctrine, 1965 DUKE L.J. 445; Arvid E. Roach
II, Suitability Obligations of Brokers: Present Law and the Proposed Federal Securities Code, 29 HASTINGS L.J.
1067 (1978). See also, e.g., Franklin D. Ormsten, Norman B. Arnoff & Gregg R. Evangelist, Securities Broker
Malpractice and Its Avoidance, 25 SETON HALL L. REV. 190 (1994). This should be in footnote 198 ???
200
See, e.g., In the Matter of Stout, 2000 WL 1469576, Exchange Act Release. No. 34-43410, 73 S.E.C.
Docket 1081, 73 SEC Docket 1094 (SEC 2000) (imposing industry bar and $300,000 civil penalty);
Department of Enforcement vs. Howard, Complaint No. C11970032, 2000 WL 1736882 (NASDR Nov. 16,
2000) (2 year suspension and $17,500 fine for suitability violations); In the Matter of McNabb, Complaint No.
Commodity Exchange Act, CFTC regulations, or CFTC decisions.201 Accordingly,
investors in non-securities derivatives receive significantly less protection than securities
investors with respect to brokers’ recommendations.

One extension of the suitability obligation is that securities brokers owe a duty to
monitor customer accounts even after the investment decision has been made to assure
that the investments are still appropriate.202 This type of claim draws a closer parallel to
the accountability of gambling casinos to help prevent gambling addicts from feeding
their addiction. Again, this is a distinct issue from the traditional suitability cases where
the obligation arises out of particular recommended transactions rather than the broker's
ongoing duty to supervise the account. 203 Recognition of such an ongoing obligation is a
natural consequence of the suitability doctrine with respect to investments that the broker
recommended. 204 However, it is a different matter to impose an ongoing duty with regard

C01970021, 1999 WL 515761 (NASDR March 31, 1999) ($50,000 fine, censure, NASD bar); In the Matter of
Gliksman, Complaint No. C02960039, 1999 WL 515762 (NASDR March 31, 1999) (failure to supervise
registered representative who committed suitability violations); In the Matter of Guevara, Complaint No.
C9A970018, 1999 WL 515766 (NASDR Jan. 28, 1999) ($100,000 fine plus restitution, industry bar); In the
Matter of Sisson, Complaint No. C01960020, 1998 WL 1084546 (NASDR Nov. 18, 1998) ($35,000 fine,
suspension); In the Matter of Bruff, Complaint No. C01960005 1997 WL 1121302 (NASDR Aug. 1, 1997)
(censure and bar); In the Matter of Osborne, Complaint No. C8A930067 1995 WL 1093401 (NASDRDec. 21,
1995) ($127,937.50 fine, industry bar); In the Matter of Klein, Complaint No. C01940014, 1995 WL 1093353
(NASDR June 1995) ($150,000 fine, 6 month suspension); In the Matter of F.N. Wolf & Co., Complaint No.
C07930024, 1994 WL 1067226 (NASDR June 16, 1994) ($500,000 fine, $2,176,986 disgorgement, 2 year
suspension).
201
See 3 JOHNSON & HAZEN, supra note XXX, § 5.09[11].
202
See 4 HAZEN, supra note XXX § 14.16[8].
203
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 he sells, he impliedly represents that he has an adequate
basis in fact for the opinion he 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 for recommendation made to
customers which in turn imposes an obligation to conduct a reasonable investigation of the security’s issuer").
204
See, e.g., Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969) (recommendation implies reasonable basis in
fact); In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Exchange Act Release. No. 34-14149 (Nov.
9, 1977) (recommendation implies that broker has made independent investigation beyond relying on
company’s management); In re Shearson Hammill & Co.,. Exchange. Act Release. No. 34-7743 (Nov. 12,
1965) (failure to investigate before making recommendation violated antifraud provisions); In re B. Fennekohl
& Co., 41 S.E.C. 210, 215-17 (1962) (failure to investigate financial condition before making recommendation
is a violation of 1933 and 1934 Acts).
to investments that were initiated by the customer without the broker's
recommendation.205

The foregoing discussion addresses some of the ways in which investment

markets resemble gambling. There has been parallel deregulation of the non-securities
investment markets and the world of gambling. This is in striking contrast to the
heightened regulation of the securities markets. So, the question raised earlier is worth
repeating here: is there justification 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, however. The law’s traditional distaste
for gambling has also provided a basis for regulating insurance contracts. As further
developed below, insurance, as is the case with derivatives contracts, provides a
legitimate mechanism for contractual risk shifting by commercial participants in many
markets – both commodity-based and non-commodity commercial enterprises. Hedging
markets (i.e., derivatives markets) and insurance products thus serve similar functions.
However, insurance is subject to yet another wholly different regulatory structure.

205
Scioscia v. Fidelity Brokerage Services, Inc. Docket Number 95–01147 1996 WL 403335 (NASD May
20, 1996) (no liability for preventing client from committing financial suicide); Gean v. Charles Schwab &
Co., Docket Number 94–00344, 1995 WL 102889 (N.A.S.D. Jan. 27, 1995) (no liability for changing cash
account to margin account where customer controlled the account and the trades were unsolicited
transaction); Scheer v. Citizens & Southern Securities Corp., Docket Number 92–00305, 1994 WL
1248601 (NASD March 9, 1994) (no liability where customer directed the trading in the account);
Weinstein v. Brokers Exchange, Inc., Case No. 93–04713, 1994 WL 733962 (NASD Dec. 7, 1994) (no
liability to customer who presented herself as sophisticated investor and who directed her own trading);
Salinas v. A.G. Edwards & Sons, Inc., Docket Number 92–00710, 1992 WL 448307 (NASD Dec. 11,
1992) (no liability to sophisticated investor where many of the challenged trades were unsolicited). But see
Aaron v. Paine Webber, Inc., Am. Arb. Ass'n Case No. 72–136–1146–87, at 1, (June 28, 1989) (Wilson,
Arb.) (on file with The Business Lawyer, University of Maryland School of Law), as described in Lewis D.
Lowenfels & Alan R. Bromberg, Suitability in Securities Transactions, 54 BUS. LAW. 1557, 1595 (1999).
A middle ground is when the broker recommends a specific trading strategy but the customer initiates the
trades. For example, in one arbitration a broker was held accountable for breach of ongoing duties with
respect to the account after having recommended options trading to the customer, even though the customer
initiated the trades in question. Peterzell v. Charles Schwab & Co., 1991 WL 202358 (N.A.S.D. June 17,
1991).
III Insurance

So far, this article has compared three regulatory schemes – the securities laws,
the commodities laws, and gambling laws. Now we turn to how the regulation of
derivative investments can possibly relate to a fourth area – insurance regulation. The
deregulation of the derivatives markets stands in contrast to insurance, which remains a
heavily regulated industry. There are many ways in which insurance and the insurance
industry is regulated. For example, not all risks are insurable.206 Also, the states regulate
the terms of insurance policies and focus on consumer protection generally. In addition,
insurance law limits the ways in which insurance companies may invest their assets as a
means designed to protect solvency.207

a. Derivatives as Insurance

Insurance contracts have many similarities with other forms of investment

contracts.208 This assumption is recognized to some extent through the enactment of the
Gramm-Leach-Bliley Act209 that now permits for more efficient integration of securities,
banking, and insurance operations of financial institutions.210 Derivatives specifically can
function as a form of insurance. Although it has not been given much attention in the
literature, the idea that derivatives contracts can serve as an alternative to insurance is not

206
See supra notes XXX discussing the insurable interest requirement.
207
See, e.g. JERRY, supra note XXX, at 89-90. This can be found in classic explanations of insurance
regulation. See, ,EDWIN W. PATTERSON, ESSENTIALS OF INSURANCE LAW 23-32 (1957) (discussing the
financial condition of insurers); WILLIAM R. VANCE, HANDBOOK ON THE LAW OF INSURANCE 43-44 (3d ed.
1951).
208
See, e.g., Steven J. Williams, Note, Distinguishing "Insurance" From Investment Products Under the
McCarran-Ferguson Act: Crafting a Rule of Decision, 98 COLUM. L. REV. 1996 (1998).
209
Title of 1999, Pub. L. No. 106-102113 Stat. 1338, 1436-50 (codified at scattered sections of 15 U.S.C.).???
210
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
Regulation of the Business of Insurance - Past, Present and . . . Future?, 5 N.C. BANKING INST. 49 (2001);
Arthur E. Wilmarth, Jr., The Transformation of the U.S. Financial Services Industry, 1975-2000: Competition,
Consolidation, and increased Risks, 2002 U. ILL. L. REV. 215 (2002).
totally new.211 Many observers of the investment markets have rejected the gambling
analogy in favor of an insurance analogy.212 Additionally, scholars in the field of
insurance law have identified the similarity between insurance and commodities
contracts.213

Just as gambling may be used to characterize the activities of many participants in

the derivatives markets, some participants may be seen as using derivatives as
insurance.214 Insurance is a risk shifting transaction where one party pays a premium in
exchange for a right to payment in the event that a designated risk or contingency
occurs.215 In certain situations, the distinction between insurance and gambling is no
clearer than the distinction between hedging and gambling, because in both instances the
law is trying to draw a distinction on public policy grounds between legitimate
commercial transactions and “illegitimate: wagers.216

211
See supra note XXX [???]
212
Peter H. Huang, A Normative Analysis of New Financially Engineered Derivatives, 73 S. CAL. L. REV.
471, 479-80 (2000); Peter H. Huang, Kimberly D. Krawiec & Frank Partnoy , Derivatives on 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 buying certain derivatives is like buying insurance against an
accident, while not buying those derivatives is essentially betting on the accident not happening.”); Philip
McBride Johnson, In Defense of “Terrorist” Derivatives, 23 FUTURES & DERIVATIVES LAW REP. 26
(2003); Joseph L. Motes III, Comment, A Primer on the Trade and Regulation of Derivative Instruments,
49 SMU L. REV. 579, 580 (1996) (“Derivatives have most often been employed as a sort of ‘insurance,’
protecting investors’ positions through allocation of risk, but the instruments have also been used to
generate profits through speculation on market positions.”).
213
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 is exchanged – 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.”).
214
See, e.g., Philip McBride Johnson, Stepping it Up, FOW DERIVATIVES INTELLIGENCE FOR THE RISK
PROFESSIONAL, (Issue 366 Nov. 2001) at PAGE (“Derivatives have always been a type of insurance. They
differ from the classical model only in that, instead of assembling a ‘risk pool’ funded by a large number of
at-risk holders, the risk is passed on to people who would not otherwise face it. The world’s most
legendary speculators are the ‘Names’ of Lloyd’s of London.”). NOT IN FILES???
215
1 LEE R. RUSS & THOMAS F. SEGALLA, COUCH ON INSURANCE § 1:6 n.20 (3d ed. 2003) (“‘Insurance’
may be defined as a contract to pay a 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)).
216
See, e.g., RICHARD E. SPEIDEL & IAN AYRES, STUDIES IN CONTRACT LAW 612 (6th ed. 2003) (“It is . . .
not always easy to distinguish illegal wagering contracts from other ‘aleatory’ contracts that have a
legitimate commercial or other purpose and are not considered contrary to public policy. Likewise
insurance contracts can often be characterized as wagers (and vice versa). . . .”). NOT IN FILES
 Long ago, insurance was characterized as a form of gambling.217 Insurance law
doctrines have tried to distinguish insurance contracts from gambling with requirements
such as a valid insurable interest as the basis for life insurance policies,218 indemnity,219
and the assignability of polices.220 In a further effort to differentiate itself from gambling,
insurance has been promoted as a pooling of risks to achieve a type of communal
efficiency in risk shifting.221 In many ways however, these attempts to demonstrate a
way in which insurance differs from gambling, are really not that convincing.

For example, derivatives can be used to hedge against catastrophic occurrence, as

done in the controversial proposal to use derivatives to hedge the risk of a terrorist
attack.222 While some observers might characterize a terrorism futures contract as a
horrific bet, it more closely resembles insurance223 if used by a party to hedge against
losses that could be incurred by terrorist attacks.224 This again points to the question
raised at the outset of this article: we do not consider insurance against loss due to

217
See JOHN ASHTON, THE HISTORY OF GAMBLING IN ENGLAND 275 (Patterson Smith 1969) (1898)
(author? Editor?) (“paradoxical as it may appear, there is a class of gambling which is not 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.”).
218
Kreitner, supra note XXX, at 1116-28. See also, e.g., Franklin L. Best, Jr., Defining Insurable Interests
in Lives, 22 TORT & INS. L.J. 104, 105 (1986).
219
Lynn A. Stout, Why the Law Hates Speculators: Regulation and Private Ordering in the Market for
OTC Derivatives, 48 DUKE L.J. 701, 728 (1999).
220
Kreitner, supra note XXX, at 1116-28. See also, e.g., Rylander v. Allen, 53 S.E. 1032 (Ga. 1906).
221
Kreitner, supra note XXX, 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 to handle the economic hazards of death through cooperative
self-help.").
222
See, e.g., Philip McBride Johnson, In Defense of “Terrorist” Derivatives, 23 FUTURES & DERIVATIVES
LAW REP. 26 (2003).
223
Id. (“[D]erivatives 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’s wish for a key official’s death. Both instruments
exist ‘just in case,’ and both are proper.”).
Additionally, consider, for example, tontine policies, where participants contribute to a pool to be awarded
entirely to the surviving participant. ??? were a form of insurance betting. See Kreitner, supra note XXX,
at 1100 n.13 (2000), (relying on Brenner & Brenner, supra note XXX, at 104 and MORTON KELLER, THE
LIFE INSURANCE ENTERPRISE 1885-1910, at 56-58 (1963)).
224
Rod D. Margo, War Risk Insurance in the Aftermath of September 11, 18 AIR & SPACE LAW. 1 (2003).
terrorist attacks to be against public policy,225 so why should derivatives be so
characterized?

b. Managing Insurance Risks

The typical insurance company in the United States manages the risks created by
the policies it underwrites by pooling the premiums received and managing the
investment pool.226 State insurance regulators place limits on the types of investments
insurance companies may use.227 These limitations are designed to protect policy
holders. In addition, insurance companies may use derivatives to help manage their risk
and hedgers may use insurance to deal with theirs. In contrast, in the derivatives markets,
risks are allocated through a nexus of bilateral contracts. Thus, the basic mechanisms of
insurance and derivatives differ in that insurance is basically conceived of a pooling of
premiums to manage the risk.

However, if we look to where modern insurance began -- in England -- and the

structure of Lloyd’s of London, we see that Lloyd’s uses an exchange-type market to find
investors (“Names”) to help share the insurance risk (and the profits as well). 228 Lloyd’s
then operates more like an exchange or derivative based system than an insurance
company that pools its premiums and invests them to manage the insurance risk.229

225
See, e.g., Jeffrey Manns, Note, Insuring 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: An Analysis of the War-Risk Exclusion in the Wake of the Anniversary of
September 11, and Beyond, 39 WILLAMETTE L. REV. 31 (2003); Mark Boran, Note, To Insure or Not to Insure,
That is the Question: Congress' Attempt to Bolster the Insurance Industry After the Attacks on September 11,
2001, 17 ST. JOHN'S J. LEGAL COMMENT 523 (2003).
226
The company can be organized as a stock corporation or as a mutual insurance company. See PATTERSON,
supra note XXX, at 50-51.
227
See, e.g, CAL. INS. CODE § 1192.8 (West 2003) (investments in specified interest-bearing notes, bonds, or
obligations); N.Y. INS. §§ 1402, 1404 (McKinney 2003) (minimum capital or minimum surplus to policyholder
investments).
228
PATTERSON, supra note XXX, at 49 (describing Lloyd’s as a “reciprocal insurer, or interinsurance
exchange”).
229
See, e.g., Shell v. R.W. Sturge, Ltd., 55 F.3d 1227, 1228 (6th Cir. 1995) (“The Society 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.”).
For additional descriptions of Lloyd’s of London, see, e.g., ANTHONY BROWN, HAZARD UNLIMITED: THE
STORY OF LLOYD'S OF LONDON (1973); HUGH ANTHONY LEWIS COCKERELL, LLOYD'S OF LONDON: A
PORTRAIT (1984); CATHY GUNN, NIGHTMARE ON LIME STREET: WHATEVER HAPPENED TO LLOYD'S OF
LONDON? (1992); RAYMOND FLOWER, LLOYD'S OF LONDON (1974); D. E. W. GIBB, LLOYD'S OF LONDON, A
Consider the following brief description of how Lloyd’s insurance market or exchange
operates:

Lloyd’s syndicates literally date to the underwriters who gathered at Lloyd’s

Coffee House in London in the 1600s. Currently Lloyd’s has about 26,000
underwriting members; most of these are nonprofessional investors known as
“Names,” and a few are full-time insurance underwriters. The Names have joined
to form syndicates, each of which has as few as two or three but perhaps as many
as a few thousand members. The syndicates (currently there are about 200 of
them) subscribe on behalf of their members to cover risks or percentages of
risks.230

Thus, the Names are generally private investors who provide capital to the insurance
underwriters.231 Names are solicited in much the same manner as investors who
participate in other investment markets.232

STUDY OF INDIVIDUALISM (1957); GODFREY HODGSON, LLOYD'S OF LONDON: A REPUTATION AT RISK (1986);
ELIZABETH LUESSENHOP, RISKY BUSINESS: AN INSIDER'S ACCOUNT OF THE DISASTER AT LLOYD'S OF LONDON
(1995); JONATHAN MANTLE, FOR WHOM THE BELL TOLLS: THE LESSON OF LLOYD'S OF LONDON (1992).
230
See JERRY, supra note XXX, at 41-42 (footnotes omitted):
The liability of a Name depends on his or her percentage share of the syndicate, but each Name is
personally liable without limit for a syndicate’s losses. Thus, to become a Name, an individual
(corporations cannot become Names) must have substantial means; currently a British Name must have net
worth exceeding ₤250,000 (roughly $450,000) and an American Name must have a net worth exceeding $1
million; also, each Name must restate his or her net worth annually. A syndicate or group of syndicates is
managed by an underwriting agency, which employs a management staff, maintains a “box” on the floor of
the Lloyd’s exchange, and staffs the box with a representative of the agency. See also, e.g., DEBORAH A.
THOMPKINSON, CHALLENGE AT LLOYD’S (1994).
231
See, e.g., Lipcon v. Underwriters at Lloyd's, London, 148 F.3d 1285, 1288 (11th Cir. 1998) (“A Name
becomes a Member of the Society of Lloyd's through a series of agreements, proof of financial means, and the
deposit of an irrevocable letter of credit in favor of Lloyd's. By becoming a Member, a Name obtains the right
to participate in the Lloyd's Underwriting Agencies. The Names, however, do not deal directly with Lloyd's or
with the Managing Agents. Instead, the Names are represented by Members' Agents, who, pursuant to
agreement, act as fiduciaries for the Names. Upon becoming a Name, an individual selects the underwriting
agencies in which he wishes to participate. The Names generally join more than one underwriting agency in
order to spread their risks across different types of insurance. In large part because of the experience of the
Members' Agents, Names generally rely on the advice of their Members' Agents in deciding in which
syndicates to invest. Selecting well is of the utmost financial importance because a Name is responsible for his
share of an agency's losses.”).
A syndicate with respect to a policy underwritten by Lloyd’s can be quite large. See, e.g., Underwriters at
Lloyd's London v. The Narrows, 846 P.2d 118, 119 (Alaska 1993) (lead syndicate of 1500 Names that lead
32 syndicate consisting of “thousands of individual Lloyd’s members”).
 The similarity between this type of insurance and the derivatives market is
exemplified by the description of the Lloyd’s system as one of “reciprocal insurers.”233
The similarity is that the reciprocal insurance organization resembles the series of
bilateral contracts that constitute the derivatives markets – both having characteristics of
an exchange. The Lloyd’s market for names, having been characterized as an exchange,
thus resembles the other investment markets being discussed herein. This similarity is
yet another reason to question such widely disparate regulatory structures for markets and
enterprises such as insurance and derivatives, which have many similar features.

There have been some unsuccessful attempts to use the exchange system in the
United States.234 Notwithstanding the inability to import this exchange type system to the
United States, its potential reveals that the differences between insurance and derivatives
are not as clear as we may initially think, even when looking at the ways in which the
insurer seeks capital manages its risk. The discussion below explores another parallel –
the extent to which the law (or regulators) impose substantive control over the types of
risk that can be managed using insurance or derivatives.

c. Substantive Control of Insurance – The Gate-keeping Function of the

Insurable Interest Requirement

Insurance law has long imposed a requirement that an insured have an insurable
interest235 in the contingency insured against in order to uphold the insurance contract.236

232
Cf. Richards v. Lloyd's of London, 135 F.3d 1289 (9th Cir. 1998) (suit claiming solicitation of Names in the
U.S. constituted an offering of a security were dismissed due to contractual choice of law provision opting for
English law); Shell v. R.W. Sturge, Ltd., 55 F.3d 1227, 1228 (6th Cir. 1995) (same); Roby v. Corporation of
Lloyd's, 996 F.2d 1353 (2d Cir.1993) (same).
233
See PATTERSON, supra note XXX at 49-50.
234
See JERRY, supra note XXX, at 43.
235
As a line-drawing rule as to which contracts are enforceable, a bright line test is not applicable. The law in
this area is quite muddled. See, e.g., GRAYDON S. STARING, LAW OF REINSURANCE § 6:1 (1993), pointing to
SIR M. MUSTILL & J. GILMAN, ARNOULD ON THE LAW OF MARINE INSURANCE AND AVERAGE §§ 331-410 (16th
ed. 1981) (“In limited space we can talk around insurable interest but never talk it through. A standard text
confesses that ‘[i]t is very difficult to give any definition of an insurable interest,’ and then discusses it for about
70 pages.). . Only an overview is presented here.
236
See Michael J. Henke, Corporate-Owned Life Insurance Meets the Texas Insurable Interest
Requirement: A Train Wreck in Progress, 55 BAYLOR L. REV. 51, 54-60 (2003).
This doctrine originated with respect to life insurance.237 One extreme example of this
manifested itself in the practice of taking out insurance on famous people and then
speculating on their demise much in the same way as any gamble.238 This practice of
wagering on celebrity lives raised a public policy issue often expressed in terms of the
policy against gambling.239 The law in essence sets up a presumption that an insurance
contract is a wager on the occurrence or nonoccurrence of a particular contingency and
that presumption can be rebutted by demonstrating an insurable interest -- “proof of
circumstances that negative the existence of a wagering intent.”240

The origins of the insurable interest doctrine date back to an eighteenth century
English statute designed to protect citizens against the evils of gambling and the moral
hazard241 of eliminating the incentive to minimize risk.242 The preamble to the original

237
Roy Kreitner, Speculations of Contract, or How Contract Law Stopped Worrying and Learned to Love
Risk, 100 COLUM. L. REV. 1096, 109900-1101 (2000) (“Early insurance schemes were relatively
straightforward forms of gambling, with people insuring against the death of public figures with whom they
had no personal relationship." ). See also, e.g., American Casualty Co. v. Rose, 340 F.2d 469 (10th Cir.
1964) (upholding employer’s insurable interest in life of employee); 3 COUCH, supra note XXX § 24:117 [3
GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 41:17, at 197-198 (2d ed. 1984)]; John M.
Limbaugh, Note, Life Insurance as Security for a Debt and the Applicability of the Rule Against Wager
Contracts Estate of Bean v. Hazel, 64 MO. L. REV. 693 (1999).
238
See Lorraine J. Daston, The Domestication of Risk: Mathematical Probability and Insurance 1650-1830, in
1 THE PROBABILISTIC REVOLUTION 237, 244 (Lorenz Krüger et al. eds., 1987) ("London underwriters issued
policies on the lives of celebrities like Sir Robert Walpole, the success of battles, the succession of Louis XV's
mistresses, the outcome of sensational trials, the fate of 800 German immigrants who arrived in 1765 without
food and shelter, and in short served as bookmakers for all and sundry bets.").
239
See, e.g., Lissa L. Broome & Jerry W. Markham, Banking and Insurance: Before and After the Gramm-
Leach-Bliley Act, 25 J. CORP. L. 723, 726 (2000); Lynne A. Stout, Why the Law Hates Speculators:
Regulation and Private Ordering in the Market for OTC Derivatives, 48 Duke L.J. 701, 724-728 (1999);
George Steven Swan, The Law and Economics of Company-Owned Life Insurance (COLI): Winn- Dixie
Stores, Inc. V. Commissioner of Internal Revenue, 27 S. ILL. U. L.J. 357, 375 (2003):
Economic insights are studied to ascertain the economic function of the insurable interest doctrine. Public
policy contrary to gambling, and the public interest in the minimization of moral hazard, each has been
proposed as justification of that doctrine. However, each in turn will be seen to lack sufficient economic
weight to justify the doctrine. The economic phenomenon of externality seems to be the true rationale for
the application of the insurable interest doctrine to [company owned life insurance].
See also, e.g., 3 COUCH, supra note XXX § 24:114 [3 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW
§ 24:117, at 197-98 (2d ed. 1984)]; Dale A. Whitman, Mortgage Prepayment Clauses: an Economic and
Legal Analysis, 40 UCLA L. REV. 851, 882 (1993).
240
ROGER C. HENDERSON & ROBERT H. JERRY, II, INSURANCE LAW CASES AND MATERIALS 25 (2d ed. 1996).
241
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--avoiding inducements to destruction of insured property--recognizes the problem of
“moral hazard” If one's financial well- being would be enhanced by the loss of property rather than its
English statutes address “pernicious practices” and “a mischievous kind of gambling” as
the basis for requiring an insurable interest.243 The insurable interest first appeared as a
matter of case law.244 The requirement is frequently reaffirmed by the courts, and now
also appears in some statutes.245 It has been extended beyond life insurance and applied
to other insurance contracts246 covering economic loss.247 New York’s statute is typical
of the modern statement of the insurable interest requirement:

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 arises whenever one can obtain insurance coverage
on property for more than the property is worth to the insured. Given current societal attitudes toward
gambling, the moral-hazard concern appears to be the stronger peg on which to hang the insurable-interest
doctrine today.
See also, e.g., 8 COUCH, supra note XXX § 37A:292 (describing moral hazard). [ 8 GEORGE J. COUCH,
CYCLOPEDIA OF INSURANCE LAW § 37A:292, at 331 (2d ed. 1984).]
242
Act of 1746, St. Geo. 2, c. 37; 1774, St. 14 Geo. 3, c. 48. See Henke, supra note XXX, at 54 (“A
version of the insurable interest doctrine first arose in England in a 1774 statute responding to perceived
excesses by early insurers combined with widespread religious aversion to the concept of gambling on the
lives of others.”), relying on Kreitner, supra note XXX, at 1116. See, e.g., JERRY, supra note XXX at 14-
15 (with respect to moral hazard).
243
Act of 1746, St. Geo. 2, c. 37; 1774, St. 14 Geo. 3, c. 48. See HENDERSON & JERRY, supra note 228 at 31
(an ILL request).
244
See PATTERSON, supra note XXX, at 130. [EDWIN W. PATTERSON, ESSENTIALS OF INSURANCE LAW 130
(1957)]
245
PATTERSON, supra note XXX, at 131 (referring to the “hoary dictum repeated by countless courts and text
writers and even embodied in some statutes”). [[EDWIN W. PATTERSON, ESSENTIALS OF INSURANCE LAW 131
(1957)]
246
See, e.g., Delk v. Markel American Ins. Co., 2003 WL 22390053 *2 n.18 (Okla., Oct 21, 2003):
Gambling was the "pet vice" of seventeenth and eighteenth century England and the courts' attitude toward
the practice "reflected popular feeling." Fegan, supra note 16, at 7-8. Hence, before Parliament intervened,
most forms of wagering were valid at common law and wagering agreements were generally enforceable in
English courts. MacGillivray, supra note 16, at 104. The courts' practice of enforcing wagers per se was
applied in the eighteenth century to the enforcement of wagers in the form of marine and life insurance
policies, but the early English decisions with respect to fire insurance took the opposite view. See Sadlers
Co. v. Badcock, 2 Atk. 554, 26 Eng. Rep. 733 (1743). Lord Hardwicke explained that fire insurance did
not have the same history or attributes as marine insurance and that for fire insurance to be enforceable the
insured must have an interest in the property insured. Id. at 556, 26 Eng. Rptr. at 734. See also Lynch v.
Dalzell, 4 Bro. P.C. 431, 2 Eng. Rep. 292 (1729).
See also, e.g., Kreitner, supra note XXX, at 1099-1100 (“London underwriters [who] issued policies on the
lives of celebrities like Sir Robert Walpole, the success of battles, the succession of Louis XV's mistresses,
the outcomes of sensational trials, the fate of 800 German immigrants who arrived in 1765 without food
and shelter, and in short served as bookmakers for all and sundry bets."). [Roy Kreitner, Speculations of
Contract, or How Contract Law Stopped Worrying and Learned to Love Risk, 100 COLUM. L. REV. 1096,
1099-1100 (2000)]
247
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 cast overboard during a hurricane); Kreitner, supra note 148, at 1099-
 No contract or policy of insurance on property made or issued in this state, or
made or issued upon any property in this state, shall be enforceable except for the
benefit of some person having an insurable interest in the property insured. In this
article, "insurable interest" shall include any lawful and substantial economic
interest in the safety or preservation of property from loss, destruction or
pecuniary damage.248

The insurable interest requirement of a lawful and substantial economic interest describes
the type of interest that is present when commercial enterprises decide to enter into
hedging contracts.

A major difficulty with the gambling rationale for limiting insurance contracts is
the same problem identified earlier with respect to derivative investments of
distinguishing a gamble from a legitimate speculation.249 Professors Speidel and Ayres,
among others, attempt to distinguish between insurance and gambling on the basis that
insurance deals with an existing risk while a wager creates a risk.250 This does not appear
to be a satisfactory distinction.251 The wager simply adds economic consequences for the
parties to the wager, much as a derivatives contract on the price of a commodity provides
a parallel economic consequence for the speculator.

The insurable interest doctrine attempts to provide a basis for drawing the line
with respect to insurance contracts that the law will tolerate. It is an imperfect measure at
best. A significant problem here is that without a comparable control of derivatives
contracts, is the insurance limitation really meaningful? It would thus appear appropriate

1000 (quoting VIVIANA A. ROTMAN ZELIZER, MORALS AND MARKETS: THE DEVELOPMENT OF LIFE
INSURANCE IN THE UNITED STATES 45-46 (1979)).
248
N.Y. Ins. L. § 3401 (McKinney 2004). See also, e.g., Cal. Ins. Code Art. 4, §§ 280-284 (West 2004).
249
See the discussion accompanying notes XXX supra.
250
SPEIDEL & AYRES, supra note 214, at 612 (claiming that those insured seek insurance “to compensate them
for the possible occurrence of an existing risk” while “[g]amblers by their contract create the risk at issue.”).
(ILL request) This same point was made in HIERONYMUS, supra note 121 at 138. (ILL request)
251
For example, synthetic stock (See supra note ## XXX) 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 FUT. & DERIV. L. REP. 6 (Sept. 2001) ("A synthetic stock trade is not a swap . . . . [t]he
synthetic stock transactions did not allocate risk, but instead created risk and therefore were more sales than
swaps . . . there was no "exchange" of payments based solely on the price of [the underlying stock]").
to either rethink the insurable interest doctrine or attempt to import something
comparable into derivatives regulation.

Illegal gambling is not the only rationale for the insurable interest requirement.252
Beyond the avoidance of illegal gambling, a second reason advanced for the insurable
interest requirement is to deter people from seeking insurance and then taking action to
cause the insured-against contingency to occur.253 This moral hazard or deterrence
rationale seems to be a questionable basis for an insurable interest requirement.254 One
can have an insurable interest and still have the same improper incentive such as a
property owner who tries to cash in on fire insurance using arson.255 Some courts have
recognized the weakness of the destruction of property rationale as a basis for the
insurable interest requirement.256 This is in part because of another insurance law
doctrine that addresses the problem. The requirement of fortuitousness holds “that
252
See ALAN I. WIDISS, INSURANCE 124 (1989) ("It now seems evident that the principle of indemnity and the
insurable interest doctrine rest--and undoubtedly have, in reality, always been at least partially predicated--on
public interests other than opposition to gambling."). (ILL request)
253
Belton v. Cincinnati Ins. Co., 353 S.C. 363, 371, 577 S.E.2d 487, 492 (S.C. Ct. App. 2003) Hearn, C.J.,
dissenting) (“Two fundamental purposes of the doctrine of insurable interest are to prevent insurance
contracts from becoming gambling devices and to discourage the intentional destruction of property”),
relying on ROBERT E. KEETON & ALAN I. WIDISS, INSURANCE LAW, A GUIDE TO FUNDAMENTAL
PRINCIPLES, LEGAL DOCTRINES, AND COMMERCIAL PRACTICES, Practitioner's Edition § 3.1(c), at 136-138
(1988). See also, e.g., Nationwide Mut. Ins. Co. v. Goerlitz, 2001 WL 845703 *4 (Del. Super. Ct. Jun 29,
2001) (“The doctrine of insurable interest is tied to the principle of indemnity and serves a number of
purposes, among them the prevention of using insurance contracts as gambling or wagering contracts.
Additionally, the doctrine is designed to protect against societal waste and to avoid the danger in allowing
persons without an insurable interest to purchase insurance, because those persons might then intentionally
destroy lives or property), relying on Gossett v. Farmer’s Ins. Co. of Washington, 948 P.2d 1264, 1271-72
(Wash. Supr. 1997); Kyle D. Logue, The Current Life Insurance Crisis: How The Law Should Respond, 32
CUMB. L. REV. 1, 22 (2001-2002).
254
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 the incentive effects of real-world insurance and, at the same
time, underestimate the social benefits of insurance.”).
255
Cf. Luchansky v. Farmers Fire Ins. Co., 357 Pa. Super. 136, 142, 515 A.2d 598, 601 (Pa. Super.
Ct. 1986) (“When appellants purchased insurance protection they were not gambling on the destruction of
somebody else's property by fire. They were insuring against the loss of their own interest, an insurable
interest, in the home whose legal title they had conveyed to their son.”).
256
Teague-Strebeck Motors, Inc. v. Chrysler Ins. Co., 127 N.M. 603, 613, 985 P.2d 1183, 1193 (N.M. Ct.
App. 1999) (“The second rationale--avoiding inducements to destruction of insured property--recognizes
the problem of "moral hazard." If one's financial well- being would be enhanced by the loss of property
rather than 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 arises whenever one can obtain insurance
coverage on property for more than the property is worth to the insured. Given current societal attitudes
toward gambling, the moral-hazard concern appears to be the stronger peg on which to hang the insurable-
interest doctrine today.”).
insurance covers only risks, not certainties, so that a loss must be caused by a fortuitous
event in order to be covered.”257

Damages that are intentionally caused by the insured are not fortuitous and thus
are not properly covered by insurance.258 The fortuitousness doctrine is one way of
determining which aleatory contracts259 are enforceable (such as insurance contracts and
legitimate derivatives transactions260), as opposed to aleatory contracts which are
unenforceable because they are void illegal wagers.261 The policy against wagers and
gambles is the primary reason for invoking the insurable interest requirement.

257
See Compagnie des Bauxites de Guinee v. Insurance Co. of North America,
724 F.2d 369, 371 (3d Cir. 1983).
258
See, e.g., Hedtcke v. Sentry Ins. Co., 109 Wis. 2d 461, 483, 326 N.W.2d 727 (1982), Crossmark, Inc. v.
DeGeorge, 259 Wis. 2d 482, 655 N.W.2d 547, 2002 WL 31641091,*2 (Wis. App. 2002).
259
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 be enforceable unless they fall with the “subset of aleatory promises [that] are not enforceable”
such as illegal wagers. RESTATEMENT (SECOND) OF CONTRACTS § 178 illus. 1 (1981).
Aleatory “derives from the Latin word ‘alea’ for ‘die’ (as in Caesar’s comment on crossing the Rubicon: “Alia
iacta est!’ ‘the die is cast’).” SPEIDEL & AYRES, supra note XXX at 612. [RICHARD E. SPEIDEL & IAN AYRES,
STUDIES IN CONTRACT LAW 612-613 (6th ed. 2003).] More simply, aleatory has been described as derived
“from the Latin word for dice-rollers.” Charles Tiefer, Forfeiture by Cancellation or Termination, 54 MERCER
L. REV. 1031, 1064 (2003). Lord Mansfield described an aleatory contract (such as an insurance contract) as a
"contract on speculation." Carter v. Boehm, 96 Eng. Rep. 342, 343 (K.B. 1776).
260
When section 1a(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 which are beyond the control of the contracting parties. 7 U.S.C. § 1a (2004).
Section 1a(13) of the Act states that “excluded commodity” embraces “any occurrence, extent of an
occurrence or contingency . . . that is beyond the control of the parties to the relevant contract . . . and . . .
associated with a financial or economic consequence.” Id. This legislative acknowledgement took note of
the fact that futures contracts were already allowed on weather phenomenon and other uncontrollable
occurrences that can have severe economic consequences. The 2000 amendment also gave recognition to a
vast new world of “event-based” futures and options that may evolve to address losses occasioned by
uncontrollable phenomena.
261
Professor Leff recognized the aleatory nature of derivatives contracts and the contrast with illegal gambling;
he also suggested that all contracts are aleatory in the sense that profitability may depend on chance. See his
definition of aleatory contract in Arthur Allen Leff, The Leff Dictionary of Law: A Fragment, 94 YALE L.J.
1855, 1990 (1985):
aleatory contract ( ). Broadly, any contract the performance of which by other party is dependent upon a
fortuitous or uncertain event. (Note that this is to be distinguished from the "aleatory" feature of almost all
contracts, that profitability may depend on chance.) The concrete example most frequently given is the
insurance contract: The insured party must pay premiums, but the insurer need not do anything at all unless
the insured even say a fire, or a death, takes place during the relevant time period. But there are non-
insurance aleatory contracts too, e.g., a contract by which one agrees to buy 5000 tons of wheat (or 5000
shares of stock) if but only if the market price goes above or below a particular level.
 The moral hazard concern of insurance – namely, that an insured will be overly
insured and therefore be able to profit from the event262 – is not a limitation imposed on
those who opt to “insure” against certain risks by utilizing derivatives contracts or other
hedging mechanisms. There is no law or stated public policy that militates against
someone “doubling up” by seeking more hedging protection than is needed to offset
feared losses. Another way of examining this distinction is the fact that insurance is often
viewed as protecting against loss, whereas a hedge or other derivatives transaction may
be made to generate profit.263 The insurable interest doctrine is used to explain the rule
frequently stated that over-insurance beyond anticipated losses will result in illegal
wagers.264 Overvaluation resulting from a good faith attempt to set a valuation in an
insurance policy will not render the policy invalid.265 However, an attempt to reap a
profit would.

The insurable interest requirement is said to come into play most often today in
the context of a business’ insurance on its employees. While key employee insurance is
upheld as based on a valid insurable interest, an employer has no insurable interest in the

Though some "aleatory contracts" are obviously perfectly lawful and enforceable, in many jurisdictions,
some are not, e.g., a contract to pay $10,000 if the other party is dealt three aces when one is dealt only
three kings. For those kinds of aleatory contracts, and the grave difficulties is coming up with a clear
conceptual distinction between them and the lawful enforceable kind, see gambling contract.
262
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 coverage for profit as this intends to increase moral hazard and
could ultimately undermine the whole concept of insurance.”); Liberty Mut. Ins. Co. v. State Farm Auto. Ins.
Co., 262 Md. 305, 313; 277 A.2d 603, 608 (Md. 1971) (describing insurance clauses as designed to protect
insurers from moral hazard resulting from overinsurance).
263
Cf. SPEIDEL & AYRES supra note XXX 612-613 (“insureds tend to bargain for payments conditional upon
something untoward happening: while gamblers tend to bargain for payments conditional upon something
fortuitous happening”). [RICHARD E. SPEIDEL & IAN AYRES, STUDIES IN CONTRACT LAW 612-613 (editor? 6th
ed. 2003).]
264
3 COUCH, supra note XXX § 41.2, (“When the interest of the insured is grossly disproportionate to the
amount of the insurance, the policy is regarded as a wagering contract. Thus, if a creditor insures his or her
debtor's life for a sum grossly in excess of any loss that he or she can possibly suffer by the debtor's death, the
policy is a wager and invalid.”), relying on dicta in Cammack v. Lewis, 82 U.S. 643 (1873); Guardian Mut.
Life Ins. Co. v. Hogan, 80 Ill. 35 (1875); Mitchell v. Union Life Ins. Co., 45 Me. 104 (1858); Cooper v.
Shaeffer, 7 Sadler 405, 11 A. 548 (Pa. 1887). [3 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 41.2
(2d ed. 1984).]
265
3 COUCH, supra note XXX § 41.2 (“a valued policy is not rendered a wagering contract merely because the
value placed on the property is greater than the actual value, although recovery will be limited to the extent of
the actual interest”), relying on Fidelity Union Fire Ins. Co. v. Mitchell, 249 S.W. 536 (Tex. Civ. App. 1923).
[3 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 41.2 (2d ed. 1984).]
lives of less skilled, lower ranking employees who are presumed to be easily replaced
through the labor market.266 The derivatives markets may now offer a way around the
insurable interest requirement, unless courts treat the contract in question as insurance
rather than as a derivative investment. If the insurable interest requirement remains
justifiable for insurance contracts, then there may be good reason to close the gap with
respect to parallel derivatives transactions. As discussed in the next section, this gap was
created by the Commodity Futures Modernization Act of 2000.

Consistent with the general trend to deregulate gambling267 and to favor freedom
of contract, courts generally have taken a broad view of insurable interest.268 For
example, the insurable interest doctrine arose in the context of the relatively recent
controversy surrounding viatical contracts that are designed to provide prepayment of
insurance benefits to terminally ill patients so that they can use the money to pay medical
expenses.269 Often, viatical contracts are marketed to investors in order to raise the cash
to provide the prepayment of the insurance benefits. Although there have been a number
of challenges made, most federal decisions hold that the marketing of viatical contracts
does not implicate the securities laws270 even though courts have deemed them securities
under state law.271 The marketing of viatical contracts has been challenged by some

266
See, e.g., Bauer v. Bates Lumber Co., 84 N.M. 391, 503 P.2d 1169 (N.M. Ct. App. 1972), cert. denied, 84
N.M. 390, 503 P.2d 1168 (1972).
267
See the discussion accompanying notes XXX supra.
268
See, e.g., Butterworth v. Miss. Valley Trust Co., 362 Mo. 133, 240 S.W.2d 676 (Mo. 1951) (even
though it was doubtful that an insurable interest existed, the court upheld the assignment of a purported
insurance contract “since the assignment had been made in the utmost good faith and was not a mere cloak
to cover a gambling transaction”); Hammers v. Prudential Life Ins. Co. of Am., 188 Tenn. 6, 216 S.W.2d
703 (Tenn. 1948) (upholding validity of contract). See generally PATTERSON, supra note XXX at 131
(concluding that “an examination of the reports shows very few decisions that turned upon the absence of
an insurable interest when the contract was entered into.”). [EDWIN W. PATTERSON, ESSENTIALS OF
INSURANCE LAW 131 (1957).]
269
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? Buying Life Insurance Policies From the Terminally Ill, 24 PEPP. L. REV. 99 (1996).
270
E.g., SEC v. Life Partners, Inc., 87 F.3d 536 (D.C. Cir. 1996), rehearing denied 102 F.3d 587 (D.C. Cir.
1996), rehearing denied 102 F.3d 587 (D.C. Cir. 1996) (viatical settlements, whereby investor receives
death benefits of life insurance policy taken out on AIDS victim, were not securities since efforts of others
was ministerial rather than substantive). See, e.g., Timothy P. Davis, Should Viatical Settlements be
Considered "Securities" Under the 1933 Securities Act?, 6 KAN. J.L. & PUB. POL'Y 75 (1997)(concluding
that “public policy is best supported by a finding that viatical settlements are not “securities” under the
 d. Regulating Solvency of Insurers and Investment Market Participants

Generally, there has been a division in the regulation of financial services,

particularly with respect to insurance and securities markets.272 Some observers argue
that private ordering is a more effective regulatory structure,273as was the practice before
massive regulation of securities and commodities markets.274 In addition, it has been
suggested that the law should focus on market structure rather than the more traditional
disclosure approach to securities regulation.275 Insurance regulation to a large extent
focuses on maintaining, to the extent possible, the solvency of insurance companies.276
This is done by guarding the capital of insurance companies and the ways in which
insurers can invest their funds and provide an adequate reserve for the risks they insure
against.277 In England, the exchange-type system Lloyd’s uses to manage risk imposes

Securities Act of 1933); Albert R. Miriam, The Future of Death Futures: Why Viatical Settlements Must be
Classified as Securities, 19 PACE L. REV. 345 (1999); Note, Viatical Settlements are not Securities: Is it
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 are Investment Contracts, 22 DEL. J. CORP. L. 253 (1997). But see SEC v.
Brandau, 32 Sec. Reg. & L. Rep. (BNA) 642 (S.D. Fla. 2000) (SEC brought charges against viatical
investment scheme). But cf. Carrington v. Ariz. Corp. Comm’n, 2000 Ariz. App. LEXIS 194 (Ariz. Ct.
App. 2000) (Life Partners and lower state court decision holding viatical agreements were not securities
did not preclude state securities commission from investigating whether viatical settlements were
securities). But cf. US Allianz Sec. Inc. v. S. Mich. Bancorp, Inc., 2003 WL 22671010 (W.D. Mich., Oct
20, 2003) (claims involving sales of viatical contracts were subject to NASD rules compelling arbitration);
MONY Sec. Corp. v. Bornstein, 250 F. Supp. 2d 1352 (M.D. Fla. 2003) (transactions in viatical settlements
executed by associated person formed the basis of an arbitrable claim against the securities brokerage firm).
271
Siporin v. Carrington, 23 P.3d 92, 104 (Ariz. Ct. App. 2001) ; Joseph v. Viatical Management, 55 P.3d
264, 267 (Colo. Ct. App. 2002) (holding that trust units consisting of viatical settlements were investment
contracts, and therefore securities under Colorado law).
272
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).
273
Compare Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the Protection of
Investors, 70 VA. L. REV. 669 (1984), and Mahoney, supra note XXX, [Paul G. Mahoney, Is There a Cure
for "Excessive" Trading, 81 VA. L. REV. 713, 715 (1995)] with Lynn A. Stout, Why the Law Hates
Speculators: Regulation and Private Ordering in the Market for OTC Derivatives, 48 DUKE L.J. 701, 783
(1999).
274
Mark D. West, Private Ordering at the World's First Futures Exchange, 98 Mich. L. Rev. 2574 (2000).
, 335-36276 See JERRY, supra note XXX at 89-90 PATTERSON, supra note XXX at 23-32; VANCE, supra
note XXX at 43-44 (3d ed. 1951)
277
See, e.g., West's Ann. Cal. Ins. Code § 1192.8 (2003) (Investments in specified interest-bearing notes,
bonds, or obligations); N.Y. Ins. Law §§ 1402, 1404 (McKinneys 2003) (Minimum capital or minimum
surplus to policyholder investments, Types of reserve investments permitted for non-life insurers). See
generally JERRY, supra note XXX at 89-90; PATTERSON supra note XXX at 23-32.
substantial net worth requirements on the investors who share the insurer’s risk.278
Should we take a similar approach to derivatives? And, if so, to what extent?

Participants in publicly-traded and exchange traded futures contracts are subject

to margin requirements. The concept of a margin transaction has a differing meaning in
the commodities and securities markets.279 In the commodities markets, the margin
requirements operate to require a deposit or down payment for any futures or
commodities option contract that provides a safety net, enabling the investor to purchase
an offsetting contract. In the event that market forces increase the cost of an offsetting
transaction, the broker will issue a margin call that will require the investor to liquidate
his or her position or to provide an additional margin amount. In the securities markets,
the margin rules address the amount of collateral necessary for the extension of credit.
When an investor invests in securities options by taking a short position,280 even without

278
See the description in JERRY, supra note XXX at 42 that is reproduced in note XXX supra .
279
1 JOHNSON & HAZEN supra note XXX § 1.02[13]:
The term margin first came into usage in the financial world as shorthand for the minimum amount that a
securities purchaser must deliver to his broker before title to the securities would pass to him. The
remaining balance was borrowed (from the broker in most instances), and the buyer-now owner-of the
securities would often deposit the certificates with the broker as a pledge against the unpaid balance. The
securities margin, therefore, had two significant features: (1) The buyer was conveyed title to the securities
immediately 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 it considered to have been excessive extensions of this type of credit to stock purchasers in
earlier years and authorized the Board of Governors of the then-new Federal Reserve System to set
regulations limiting the amount of money that could be loaned by a broker or dealer to a securities
purchaser.
Through a process that can only be described as unfortunate, the commodity industry has chosen to utilize
the same term--margin--to signify a drastically different economic event. Futures trading occurs in
executory contracts as yet uncompleted, representing an exchange of mutual promises to conclude a sale
later on specific terms. Acquisition of a futures contract, therefore, leaves title and ownership of the
underlying commodity exactly where it was before the contract was entered. Title will not pass unless and
until the futures contract is fully performed by both parties: the seller by delivering what he has promised;
the buyer by tendering the full purchase price.
At the same time, however, entry into a futures contract creates the risk that, when required, one of the
parties may default on his obligation. The seller might fail to deliver the commodity as promised, or the
buyer may fail to pay. For the protection of both, each party (seller as well as buyer) is required 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 or earnest money. This sum, inappropriately called a margin, is not recorded
as 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 are treated by law, specifically section 4d(2) of the
Commodity Exchange Act, as remaining the property of the depositor during the life of the futures contract.
280
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 force a sale of the underlying security at the option
borrowing funds to do so, a portion of the investor’s marginable securities or cash in the
account is restricted so as to operate in much the same way as a commodity margin –
namely to require an additional security deposit should the value of a short option decline
below a certain level.

On the other hand, the over-the-counter derivatives markets do not impose margin
requirements. Participation in over-the-counter derivatives markets is limited to qualified
investors; certain institutional investors and individuals who comply with specified
minimum net worth requirements.281 These qualification requirements provide some
capital protection. However, unlike margin requirements, the investor qualification
requirements do not vary with the amount of the investor’s investment exposure. Thus,
qualified contract participants who over-commit to a derivatives transaction or enter into
an economically disastrous derivatives transaction run the risk of insolvency. Whereas
contract participants in an exchange transaction would be subject to margin calls or a
forced liquidation of the position, there is no comparable protection for the counterparty
to over-the-counter derivatives contracts.

Over-the-counter market derivative contract participants can alleviate these

concerns by hedging the credit risk of the counterparties to their bilateral derivates
transaction by entering into a second derivatives contract to shift these credit risks to a

exercise price. If the price of the underlying security drops below the option exercise price, the option
holder will eventually exercise the option requiring the option writer to sell the underlying security to the
counterparty at the option exercise price which has fallen below its market value of the underlying security.
Thus, when the option is exercised, the option seller will either have to sell stock out of his or her
investment portfolio at a price below its current market value or will have to cover his or her short position
by purchasing the underlying security in order to satisfy the sale obligation created by the option’s exercise.
With respect to a call option, a short position occurs when an investor writes a call option that entitles the
counterparty to the option contract to buy the underlying security at the option exercise price. If the price
of the underlying security rises above the option exercise price then the option writer will be required to
sell the security at a price below the current market price of the underlying security..
281
The 2000 amendments to the Commodity Exchange Act introduced a new category of eligible contract
participants (“ECPs”) consisting of institutional and highly accredited customers. ECPs include financial
institutions, insurance companies, registered investment companies; corporations, partnerships, trusts, and
other entities having total assets exceeding $10,000,000, employee benefit plans subject to ERISA that
have total assets exceeding $5,000,000; and governmental entities, as well as some other categories of
investors. Section 1a(12) of the Commodity Exchange Act , 7 U.S.C. § 1a(12) (2003) that was enacted by
the Commodity Futures Modernization Act of 20000 § 101, Pub. Law No. 106-554, 114 Stat. 2763 (Dec.
21, 2000).
less risk adverse counterparty.282 Derivative contract investors may neutralize multiple
risks through the use of multiple derivatives transactions. As is the case with any
derivatives transactions, the markets utilize speculators to help provide liquidity to these
risk-shifting markets. Even the early cases recognized that one party’s speculative intent
did not void a futures contract where the other party had a bona fide intent.283
Speculators in the derivatives markets help offset risks that hedgers want to minimize or
eliminate. The insurance parallel would seem to call for a system of requiring minimum
capitalization of speculators in the derivatives markets. This would involve much more
restrictive regulation than currently exists with the margin requirements.

IV. Comparing Alternative Regulatory Schemes

In contrast to the deregulatory trend in gambling activities and the non-securities

derivatives markets, insurance remains a highly regulated industry. However, the
justifications for substantive regulation of insurance contracts may be equally applicable
to securities regulation. If so, more stringent securities regulation than is currently in
place would be justified. The discussion below demonstrates that the underlying
concerns of insurance regulation are especially relevant in the context of commodities
investment.

a. Insurnace Regulation Compared

282
This can be demonstrated by the following example. If Hedger wants to shift some risks involving
currency rates, Hedger can enter into a currency swap transaction with Counterparty1 that provides the
desired risk protection. At this point Hedger may be concerned with the solvency of or credit risks
involved in dealing with Counterparty1, so hedger may enter into a second contract with Counterparty2
under which Counterparty2 assumes the risk of default by counterparty1.
283
See, e.g., Irwin v. Williar,110 U.S. 499 (1884) (if one party to a grain futures contract intended delivery
then the contract is not void for illegality even if the other party had had no intent with respect to delivery;
however, if both parties had the improper intent the contract could void for illegality).
 There are several justifications for regulating insurance.284 The justification “to
compensate for inadequate information” 285 is most analogous to the traditional
justification for regulation of investment markets, and, by extension, the traditional
disclosure rationale of securities regulation. Paternalism – a desire to protect what policy
makers deem as “the common good.”286 – also drives strong insurance laws and more
substantive regulation. This rationale, however, is controversial since it sacrifices
freedom of contract .

One explanation for the regulatory discrepancy between the insurance and
investment markets is the widespread nature of insurance and the fact that in many areas
insurance is a necessity.287 Home owners insurance and health insurance are two
examples that are considered necessities. Other types of insurance, such as life insurance,
also span a large sector of the consumer population. Thus, the consumer protectionist or
paternalistic approach may be more justifiable than with respect to investment markets,
gambling, and other more voluntary activities. Nevertheless, there are valid reasons for
considering increased regulation with respect to these transactions. The collateral
damage resulting from gambling losses and investment losses is tremendous. On one
level, policymakers often consider the increased incentive of addicts – whether it be
drugs or gambling – to commit crimes to feed their habits. The domino effect of

284
Although the larger objectives of insurance regulation are to prevent destructive competition,
compensate for inadequate information, relieve unequal bargaining power, and assist consumers incapable of
rationally acting in their best interests, the articulated objectives of state legislative regulation are essentially
fourfold: (1) ensuring that consumers are charged fair and reasonable prices for insurance products; (2)
protecting the solvency of insurers; (3) preventing unfair practices and overreaching by insurers; and (4)
guaranteeing the availability of coverage to the public.
ROBERT H. JERRY II, UNDERSTANDING INSURANCE LAW 85 (2d ed. 1996) (The first three objectives apply
equally to securities and other investment regulation). See also Spencer L. Kimball, The Purpose of
Insurance Regulation: A Preliminary Inquiry in the Theory of Insurance Law, 45 MINN. L. REV. 471, 501
(1961).
285
JERRY, supra note XXX at 52. [ROBERT H. JERRY II, UNDERSTANDING INSURANCE LAW 51-54 (2d ed.
1996)]
286
JERRY, supra note XXX at 53.
287
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 U. MICH. J.L. REFORM 1, 8-11 (1992). This (what? Not sure what author referring to) has been
described as a “public interest” basis for regulation. James M. Fischer, Should Advice of Counsel Constitute a
Defense for Insurer Bad Faith?, 72 TEX. L. REV. 1447, 1457 n.37 (1994).
excessive risk-taking also raises concerns. Consider, for example, the Enron employees
who lost their jobs and the Arthur Anderson employees and retirees who lost their
pensions. These are costs of speculative activity that if checked by regulation might have
been prevented.

The paternalistic approach to interpreting insurance contracts, and specifically,

the interpretation of insurance contracts to protect insureds, is particularly pertinent in
drawing analogies to investment regulation. As a general matter, insurance companies
have such superior bargaining position that there is no true opportunity to negotiate
insurance contracts.288 Accordingly, when in doubt, courts tend to construe policies in
favor of the insured.289 There thus is a substantial consumer protection element of the
law governing insurance.290 In addition to the contract rules on unconscionability and
interpreting policies favorably towards insureds, the consumer-protection impetus is
underscored by state insurance regulation. For example, under the doctrine of reasonable
expectations, courts readily interpret insurance policies to reflect the reasonable
expectations of the insured even in the face of contradictory language in the insurance
policy itself.291 In addition, most insurance policies (at least those marketed to

288
See JERRY, supra note XXX at 52. Insurance policies are often characterized as contracts of adhesion. As
explained by one court, “in the typical situation, the policy represents a contract of adhesion ‘entered into
between two parties of unequal bargaining strength, expressed in the language of a standardized contract,
written by the more powerful bargainer to meet its own needs, and offered to the weaker party on 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 claim has been a long-standing one. See, e.g., Isaacs, The
Standardizing of Contracts, 27 Yale 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).
289
See, e.g., James M. Fischer, Why Are Insurance Contracts Subject to Special Rules of Interpretation?: Text
Versus Context, 24 ARIZ. ST. L.J. 995 (1992). For contrary views, see, for example, Michael B. Rappaport, The
Ambiguity Rule And Insurance Law: Why Insurance Contracts Should Not be Construed Against the Drafter,
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).
290
See SPENCER KIMBALL & WERNER PFENNIGSTORF, THE REGULATION OF INSURANCE COMPANIES IN THE
UNITED STATES AND THE EUROPEAN COMMUNITIES 12 (1981).
291
See, e.g., Robert A. Hillman & Jeffrey J. Rachlinski, Standard-Form Contracting 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 beneficiaries
regarding the terms of insurance contracts will be honored even though painstaking study of the policy
provisions would have negated those expectations.’ As worded, the doctrine allows courts to overturn express
contract language if the term contradicts the consumer's reasonable expectations.”). See also, e.g., Roger C.
Henderson, The Formulation of the Doctrine Of Reasonable Expectations and the Influence of Forces Outside
Insurance Law, 5 CONN. INS. L.J. 69 (1998); Roger C. Henderson, The Doctrine of Reasonable Expectations in
Insurance Law After Two Decades, 51 OHIO ST. L.J. 823 (1990); Robert E. Keeton, Insurance Law Rights at
consumers) must be approved by state regulators who consider fairness, among other
things.292 Insurance law in this respect also resembles the merit approach to securities
regulation that was rejected by Congress.293

Moreover, as noted earlier,294 this preapproval of the terms of insurance contracts

parallels the CFTC’s former role in approving futures contracts before they could be
publicly traded. Formerly, the commodities laws imposed a gate-keeping requirement
on types of permissible derivatives contracts, which functioned similarly to the insurable
interest requirement for insurance policies. Until the adoption of the amendments to the
Commodity Exchange Act, brought in by the Modernization Act,295 the CFTC and the
various commodity contract markets approved each contract that was traded. One
purpose of this contract approval process was to assure the economic integrity of each
contract,296 because this process functioned in much the same way as the insurance
regulation that requires state insurance regulators to approve insurance policies that are
marketed to consumers.297

From 1922 until 2000, the Commodity Exchange Act required federal approval of
a futures contract involving a demonstration that the instrument could and would be used
substantially to hedge against price 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 Act by the Commodity Futures
Modernization Act. The Commission and the courts will decide whether this standard

Variance with Policy Provisions, 83 HARV. L. REV. 961, 967 (1970); Peter Nash Swisher, A Realistic
Consensus Approach to the Insurance Law Doctrine of Reasonable Expectations, 35 TORT & INS. L.J. 729
(2000).
292
See LEE R. RUSS & THOMAS F. SEGALLA, COUCH INSURANCE (3D) (1997) (describing these regulatory
statutes). See also, e.g., Susan Randall, Insurance Regulation in the United States: Regulatory Federalism and
the National Association of Insurance Commissioners, 26 FLA. ST. U. L. REV. 625 (1999) (discussing the role of
state law in insurance regulation).
293
See supra note XXX and accompanying text.
294
See supra note XXX and accompanying text.
295
Commodity Futures Modernization Act of 2000, Pub. Law No. 106-554, 114 Stat. 2763 (2000).
296
See 1 PHILLIP MCBRIDE JOHNSON & THOMAS LEE HAZEN, DERIVATIVES REGULATION § 2.03. (2004).
297
See, e.g., COUCH supra note XXX. [3 GEORGE J. COUCH, CYCLOPEDIA OF INSURANCE LAW § 24:117, at
197-198 (2d ed. 1984).]
resides invisibly within the current statute, but arguably, it does not.298 Moreover, the
principal means of administering this standard was lost under the CFMA’s elimination of
the Commission’s right to prevent or even block the listing of new contracts. Yet the Act
still protects listed futures contracts from being attacked under state gaming and bucket
shop laws.299

Indeed, many of the reasons for heavy regulation of insurance may also apply
(albeit in a secondary or derivative manner) when considering regulation of derivative
investments – at least in reevaluating the disparity in the current regulatory environment.
As discussed in the next section, the comparison between insurance and derivatives
regulation is even more striking than the disparity between securities and derivatives
regulation. Just as we assume that insured do not read their insurance contracts, it is
equally likely that consumers do not read derivatives contracts carefully.300 Yet, we
impose stringent regulation on one industry and relegate protection of the other to mere
disclosure. Unless we are willing to consider eliminating the role of state insurance
administrators in protecting policy holders, it seems appropriate to consider reinstating
the former futures approval process at least with respect to publicly traded derivatives.
In deciding the future of derivatives regulation, we must ask whether this regulatory
298
Although not rising to the level of an agency or judicial adjudication, there was considerable controversy
when terrorism futures were first proposed following 9/11 and the nation’s subsequent concerns over
terrorist attacks. The issue resurfaced in late 2003.
299
See generally Julie M. Allen, Kicking the Bucket Shop: the Model State Commodity 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-bucket shop laws).
300
See, e.g., Paul D. Carrington, Self-Deregulation, The “National Policy” of the Supreme Court, 3 NEV.
L.J. 259, 278 (2002/2003) (“It is the premise of insurance regulation that citizens cannot be expected to
read and understand the intricate terms of the policies they buy.”). Courts readily recognize that consumers
to not read the details of insurance policies: “It is generally recognized the insured will not read the
detailed, cross- referenced, standardized, mass-produced insurance form, nor understand 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 where the document thus delivered to him is a contract of insurance the
majority rule is that the insured is not bound to know its contents”); 3 CORBIN ON CONTRACTS § 559, pp.
265--66 (“One who applies for an insurance policy … may not even read the policy, the number of its
terms and the fineness of its print being such as to discourage him”); Note, Unconscionable Contracts: The
Uniform Commercial Code, 45 IOWA L.REV. 843, 844 (1960) (“It is probably a safe assertion that most
involved standardized form contracts are never read by the party who ‘adheres’ to them. In such situations,
the proponent of the form is free to dictate terms most advantageous to 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. Eichleay Corporation, 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'n of Omaha,
55 N.W.2d 546, 550 (Iowa 1952); Lankhorst v. Union Fire Ins. Co., 20 N.W.2d 14, 17 (Iowa 1945).
disparity can be explained other than as an accident of the different history and public
choice input – whether insurance is so different from the gambling, securities
investments, and derivatives investments as to warrant such different regulatory
treatment.

b. Hedging Versus Speculation

Stepping back a moment from the issue of derivatives, let us first examine how
much of the distinction between bona fide hedging (or insurance) and gambling is in the
eye of the beholder. Consider, for example, merchants in a city hosting major league
baseball who have recently enjoyed great success in the fall as a result of the home team
making it through divisional play-offs and into the world series. The merchants clearly
have a legitimate interest in hedging against lost sales due to the absence of a post season
event. Further, consider the fact that a seven-game world series will bring more income
than a four-game series. Should a merchant be able to enter into a hedge contract to
protect itself against the home team not making it into the post season or having a
truncated post season due to losing games? If so, how does this differ from betting on the
outcome of the specific games that would determine the length of the post season? Note
that to the extent that attendance will increase even during the regular season according to
the team’s success, there could be an interest in hedging against losses on a daily basis.
Would the law allow a pooling of these risks among major league baseball teams as a
type of insurance? If so, how does this differ from allowing organized gambling
throughout the country?301

Continuing with the same sports analogy, an owner of a professional sports team
invests significant funds in the franchise, players’ contracts, and the stadium with the
hopes of reaping a return on these investments through attendance and media contracts.
The payout of sports teams is clearly connected to the team’s success. It would seem
rational for a team owner to hedge against the team’s lack of success through a futures
contract against a down turn in attendance or by hedging against the team’s failure to

301
One difference could be the ability to keep the organized pool clean of organized crime.
make it into post-season play. It would thus make sense, for example, to bet against ones
own team as a hedge against revenue loss. How is this any different than the wheat
farmer who hedges against a crop loss by entering into a wheat futures or forward
contract?

One point that might be raised is that a team owner who bets against his own team
will have an incentive to try to promote a loss in order to cash in on the wager or hedging
contract. One way to deal with this problem would be to make an analogy to the
insurable interest doctrine and to allow a hedge so long as it would be sufficient to
compensate for the economic loss but would not provide the moral hazard associated
with over insurance.302 Furthermore, the moral hazard problem does not occur with
respect to the merchant who is trying to hedge against revenue loss and is not in a
position to affect the outcome of the game. The law does not distinguish between these
types of wagers that could serve as hedges or insurance and those, such as a craps game,
that are pure gambles.

Presumably, these hedging contracts against a loss in revenues occasioned by

losing a game would constitute illegal gambling. To put it another way, it would seem
unlikely that there would be a permissible insurable interest here.303 Would these
hedging contracts be permissible derivatives contracts? On the one hand, the hedging
function to the team owner is self evident. On the other hand, if the law permits these
hedging contracts, the opportunity for speculators creates an opportunity for a form of
legalized gambling that is not permitted under the laws dedicated to gambling regulation.

Although there is a moral hazard concern, that concern should not be the sole
factor in determining the legitimacy of any particular contract. It is not sufficient to say
that since the team owner has the opportunity to affect the outcome, the hedge or
insurance contract should not be allowed. The farmer has an equal opportunity to affect
his or her crops and thereby alter the outcome as is even more vividly the case with
respect to the property owner who seeks fire insurance. The law deals with these
potential evils by outlawing arson, or in the case of sports by tampering in much the same

302
See the discussion accompanying notes XXX infra.
303
See infra note XXX and accompanying text.
way as securities and commodities law prohibits manipulation.304 The rules against
investment market manipulation are deemed sufficient to allow companies to invest in
their own securities. Parallel rules 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 the securities and derivatives
markets would call for allowing speculators (i.e., gamblers) to engage in the same activity
as a way to make the hedging market more efficient.

It is conceivable in the derivatives markets that both parties to a bilateral

derivatives contract will be two hedgers who are able to allocate reciprocal risks to one
another. However, it is also common in derivatives transactions for risk averse parties
may look to speculators to lay off their risk. For example, a commercial participant in a
market may not be able to locate a counterparty to a desired hedging contract if that
counterparty must itself be a commercial hedger. Speculators have thus been
characterized “people who accept the risk hedgers do not want.” 305 As such, they
perform a very important function for commercial participants looking to hedge business
risks.

In fact, one answer to the charge that derivatives are nothing more than legalized
gambling is that they provide legitimate hedging opportunities for investors and, more
importantly, for commercial participants in the underlying commodities markets. It also
is often pointed out that speculators help make markets more efficient by providing
additional liquidity, which in turn performs a price discovery function.306 Commercial
participants in the public commodities and derivatives markets (designated contract
markets) may thus be relying on speculators to provide them with efficient markets for
their hedging activities.

304
See 3 PHILLIP MCBRIDE JOHNSON & THOMAS LEE HAZEN CH. 5 (2004).
305
ROBERT A. STRONG, SPECULATIVE MARKETS 5 (2nd ed. 1994), as quoted in Kolbrenner, supra note
XXX at 217.
306
While certain commodities markets may be relatively illiquid, allowing for a more actively traded
futures market means that the pricing of futures contracts will reflect pricing in the cash or spot market for the
underlying commodity.
 Indeed, hedging operates much like a variety of insurance307 as it allows a risk
averse party to pass the risk on to someone else308 who is willing to do so for a
premium.309 That premium can take the form of insurance premium or the cost of an
options, futures, or swap contract. With respect to insurance, the risk is absorbed by the
insurance company, which pools its premiums and manages that pool as an investment to
cover the claims as they are made by the policyholders.310 With respect to hedging, a
credit event derivatives contract311 is a type of insurance against an undesired credit event
such as a default on a loan.312 Similarly, interest-rate derivative transactions such as
caps,313 floors,314 and collars315 are used by banks and other lenders (as well as by some
borrowers) to transfer or hedge against undesired credit risks. As a general proposition
when derivatives transactions are used as hedging devices, they are most definitely a type

307
As explained by one court: “Hedging affords such protection; it is in the nature of price insurance. The
real difference between hedging and gambling is that the hedger has a legitimate interest to protect apart
from the hedging transactions, while the gambler has no interest except in the transactions depending on the
rise and fall of the market. An insurance contract becomes a wager when the insured has no legitimate
interest to be protected against the happening of the event insured against.” Boillin-Harrison Co. v. Lewis
& Co., 187 S.W.2d 17, 24 (1945), relying on Edwin W. Patterson, Hedging and Wagering on Produce
Exchanges, 40 YALE L. J. 843-884 (1931). See also, Note, Legislation Affecting Commodity and Stock
Exchanges, 45 HARV. L. REV. 912 (1931-1932).
308
“Like someone seeking catastrophic health insurance, for example, a hedger is 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.” Scott Marc Kolbrenner, Derivatives Design and Taxation, 15
VA. TAX REV. 211, 217 (1995).
309
“[L]ike a writer of insurance, the option-writer receives a small benefit, the payment of a premium, for
entailing comparatively large risk, the unlimited liability to purchase or sell the underlying [commodity,
security, index or other reference point].” Id. at 222
310
Although this is the traditional structure of insurance companies in the United States, Lloyd’s of London
finances its risk management in a manner much more analogous to the commodities and derivatives markets.
See infra note XXX and accompanying text.
311
See, e.g., André Scheerer, Credit Derivatives: An Overview of Regulatory Initiatives in the U.S. and
Europe, 5 FORDHAM J. CORP. & FIN. L. 149 (2000).
312
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).
313
In a cap, one party shifts the risk of an increase in interest rates by entering into a derivatives transaction
that shifts the risk of an interest rate increase to the counterparty to the contract.
314
In a floor, a party (for example, a lender in a variable rate loan) can shift the risk of an increase in
interest rates to the counterparty to the derivates contract.
315
A collar transaction consists of a party contracting for interest rate protection on both the upside and the
downside by locking in both maximum and minimum interest rates for which the party will bear the risk;
these risks are thus shifted to the counterparty.
of risk shifting,316 as is insurance.317 The risk-shifting function of derivatives contracts
thus operates as a type of insurance.

c. If It Walks Like a Duck…

The foregoing discussion demonstrates that it is not always easy to distinguish

between hedging, insurance, and gambling. The practical similarities between these
industries are gaining recognition. Both the legal community318 and the popular press
have recognized the ways in which derivatives operate as insurance.319 There are
derivatives based on environmental compliance such as clean air futures,320 which are
another way of shifting the risks allocated by environmental insurance.321 Businesses
have begun to use derivatives strategies to help deal with insurance risks.322 Participants
in the investment markets have developed strategies that operate as insurance. For
example, program trading and other options strategy in the securities markets have been
described as portfolio insurance.323

316
See Joseph J. Bianco, The Mechanics of Futures Trading: Speculation and Manipulation, 6 HOFSTRA L.
REV. 27, 32 (1977); Alan N. Rechtschaffen, International Symposium on Derivatives and Risk
Management, 69 FORDHAM L. REV. 13, 15 (2000).
317
Benjamin E. Kozinn, Note, The Great Copper Caper: Is Market Manipulation Really 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 for the hedger.").
318
See George Crawford, A Fiduciary Duty to Use Derivatives?, 1 STAN. J.L. BUS & FIN. 307, 321 (1995);
Jonathan R. Macey Mark Mitchell & Jeffry Netter, Symposium on the Regulation of Secondary Trading
Markets: Program Trading, Volatility, Portfolio Insurance, and the 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 Act of 1992,
1994 COLUM. BUS. L. REV. 73, 100 (1994) (referring to “swap insurance”).
319
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 form of financial insurance.”).
320
Henry E. Mazurek, Jr., The Future Of Clean Air: The Application of Futures Markets 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 Futures Contracts on the Chicago Board of Trade: Regional and Rational
Challenges to the Right to Pollute, 13 VA. ENVTL. L.J. 501, 518-519 (1994).
321
See, e.g., Christopher R. Hermann, Joan P. Snyder & Paul S. Logan, The Unanswered Question of
Environmental Insurance Allocation in Oregon Law, 39 WILLAMETTE L. REV. 1131 (2003).
322
See, e.g., Tamar Frankel & Joseph W. LaPlume, Securitizing Insurance Risks, 19 ANN. REV. BANKING L.
203 (2000).
323
See, e.g., JERRY W. MARKHAM & THOMAS L. HAZEN, BROKER-DEALER OPERATIONS UNDER SECURITIES
AND COMMODITIES LAW: REGISTRATION, FINANCIAL RESPONSIBILITIES, CREDIT REGULATION, AND
V. Reconciling Divergent Regulatory Trends in the Securities and Nonsecurities
Investment Markets

This article has examined four areas of economic activity – securities, non-
securities derivatives investments, gambling, and insurance. There are two divergent
regulatory trends exemplified by increased regulation of the securities markets and the
deregulation of the markets for non-securities derivative instruments. The deregulatory
environment for derivatives parallels the general trend towards deregulation of gambling.
It is worth noting that the increased securities regulation brought in by the Sarbanes-
Oxley Act of 2002 began just five years after the second of two deregulatory efforts. The
Private Securities Litigation Reform Act of 1995324 and the Securities Litigation Uniform
Standards Act of 1998325 were efforts to deregulate the securities markets through the
imposition of barriers on private litigation to redress alleged securities law violations.326

There was a parallel deregulatory tone sounded by the SEC under a new
Republican majority on the Commission and the leadership of new Chairman Harvey Pitt
who took over in 2001.327 The bursting of the market bubble that existed in dot.com and

CUSTOMER PROTECTION § 2:22 (2d ed., 2003) (portfolio insurance “is simply hedging by institutional
traders to protect their portfolios in the event of adverse market movements”)[; Thomas Lee Hazen, The
Short-Term/Long-Term Dichotomy and Investment Theory: Implications for Securities Market Regulation
and for Corporate Law, 70 N.C. L. REV. 137, 167 (1991); Lynn A. Stout, The Unimportance of Being
Efficient: An Economic Analysis of Stock Market Pricing and Securities Regulation, 87 MICH. L. REV. 613,
627 (1988). Notwithstanding the foregoing similarities, there clearly is some division between insurance
and derivatives risk shifting. For example, it was held that a commodities broker acted negligently and in
violation of state insurance law for an insurance company to enter into hedge transactions on a
commodities exchange. Investors Equity Life Ins. Co. of Haw. v. ADM Investor Serv., Inc., 1997 WL
33100645, at *9 (D. Haw. 1997) (the investments violated the rules of the Chicago Board of Trade).
324
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 of the U.S.C.).
325
Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227, 3230 (codified as
amended in scattered sections of 15 and 18 of the U.S.C.).
326
The Private Securities Litigation Reform Act provided heightened pleading standards and tightened
procedural requirements that were designed to inhibit strike suits. Private Securities Litigation Reform Act §§
101-203. The Securities Litigation Uniform Standards Act preempted plaintiffs trying to go to state court to
avoid the limitations of the Private Securities Litigation Reform Act. Securities Litigation Uniform Standards
Act § 2.
327
See SEC, Historical Summary, http://www.sec.gov/about/concise.shtml (not sure why he cites this. I went
there (b/c the sourced coordinated one is wrong) and it just shows a list of past commissioners.)
other surging high-tech securities combined with the series of massive corporate frauds
that came to light nudged Congress out if its deregulatory bias and back into a re-
regulatory mode. Although the impetus for their position differs from the investment
markets, some commentators have suggested that even outside of the securities and
derivatives markets, policy makers should consider re-criminalizing gambling.328

Deregulation clearly has been the trend with respect to derivatives and gambling
and even with respect to securities laws prior to Sarbanes-Oxley. Coherence in these
parallel regulatory environments could call for continued deregulation of derivatives and
gambling, as well as renewed deregulation of the securities markets.

Some of the securities law re-regulation may well be an overreaction to events in

the news.329 On the other hand, it seems more likely that this was a necessary wake-up
call and that a similar reaction is warranted with respect to the non-securities derivatives
markets (and to the gambling laws as well). Lest we forget, one of the major corporate
failures was Enron, which resulted not only from aggressive accounting 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 leaves gaps that may
provide openings for additional failures. It would be wise to reconsider the deregulation
of the non-securities derivatives markets before having to reactivate re-regulation in the
wake of the new major scandals. There would be obvious opposition to re-regulation of
the derivatives markets from those observers and commentators who generally favor free
unregulated markets. Opposition to increased regulation has come from other directions
as well. For example, another interesting spin is that overregulation may create a moral
hazard by encouraging investors to take on risk.330 This concern seems misplaced, given

328
See John Warren Kindt, Would Re-Criminalizing U.S. Gambling Pump-Prime the Economy and Could U.S.
Gambling Facilities be Transformed into Educational and High-Tech Facilities?: Will the Legal Discovery of
Gambling Companies' Secrets Confirm Research Issues? 8 STAN. J.L. BUS. & FIN. 169 (2003); see also John
Warren Kindt, The Failure to Regulate the Gambling Industry Effectively: Incentives for Perpetual Non-
Compliance, 27 S. ILL. U. L.J. 221 (2003).
329
See, e.g., Ribstein supra note XXX, at 97.
330
See, e.g., Mark Klock,, Two Possible Answers to the Enron Experience: Will it be Regulation of Fortune
Tellers or Rebirth Of Secondary Liability?, 28 J. CORP. L. 69, 79 (2002):
the litigations costs and the huge legal fees to plaintiffs’ lawyers; the increased incentive
to investors to take on risk to be compensated for in subsequent litigation seems marginal
at best.

This article has discussed the generalities of these regulatory regimes. The
similarity of transactions and disparity of regulation can provide fertile fields for
exploration of specific regulatory rules in addition to the more generalized policies
discussed herein. This article has raised the question of the general parameters of
industry or market regulation. I have suggested that a more coherent regulatory approach
is needed. Once policy makers accept the need for bringing these parallel regulatory
schemes more in line with one another, then they can turn to formulating specific
proposals that have not been addressed in this article. For example, the divergent re-
regulatory approach of the securities laws and deregulation under the commodities laws
need to be reconciled. As another example, policy makers should consider the fashioning
disclosure rules applicable to insurance sales to more closely approximate those
applicable to could readily be compared with those applicable to securities and non-
securities derivative transaction. The author hopes that this article serves as a
springboard for these types of deliberations.

Investors take risks in the hopes of rewards. When they obtain 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 moral hazard problem in which investors are encouraged to seek out excessive risk.
After an investor incurs a loss on a risky investment, she has the incentive to assert that the ex post outcome
proves the ex ante risk to be too large. Since such assertions inherently 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 and then after losing the bet, demanding the return of the stakes on the theory that the bet
was unfair.
(footnotes omitted). (I’m no sure if this “footnotes omitted” was done correctly.)