on the decision to regulate hedge funds - University of Illinois Law ...

PAREDES.DOC
9/8/2006 9:12:27 AM
1008 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2006
and jarring frauds are salient events that are readily recalled when crafting
regulation, particularly in light of the drumbeat of the media and
politicians who play up the losses and abuses, magnifying their salience.
125 As such, these events will likely more prominently feature in the
decision making of regulators than the events’ actual magnitude warrant.
This disproportionate impact of especially salient events on decision
making is often associated with the so-called “availability heuristic,”
whereby salient risks are more available to one’s mind and thus receive
more attention, as well as the “representativeness heuristic” and “probability
neglect,” according to which people tend to overstate the probability
of some bad recent event occurring again in the future. 126 In addition,
regulators, by virtue of their positions, may be inclined to respond
aggressively to a perceived risk because, after all, regulators are there to
regulate. 127 The costs of greater securities regulation—such as the risk of
less flexible, less efficient, and less liquid financial markets—are not
nearly as stirring or tangible as the perceived costs of not regulating.
Perhaps such biases would be countered, and the regulatory calculus dif-
125. See, e.g., Sunstein, Precautions Against What?, supra note 120, at 21–27 (discussing “cascade”
effects).
More generally, it has been shown that market crashes are often met with a strong regulatory response.
See STUART BANNER, ANGLO-AMERICAN SECURITIES REGULATION: CULTURAL AND
POLITICAL ROOTS, 1690–1860 (1998); Stuart Banner, What Causes New Securities Regulation? 300
Years of Evidence, 75 WASH. U. L.Q. 849 (1997); see also Paul G. Mahoney, The Pernicious Art of Securities
Regulation, 66 U. CHI. L. REV. 1373 (1999); Larry E. Ribstein, Bubble Laws, 40 HOUS. L. REV.
77 (2003); cf. Joseph A. Grundfest, Punctuated Equilibria in the Evolution of United States Securities
Regulation, 8 STAN. J.L. BUS. & FIN. 1 (2002).
126. See, e.g., DANIEL KAHNEMAN & SHANE FREDERICK, Representativeness Revisited: Attribute
Substitution in Intuitive Judgment, in HEURISTICS AND BIASES: THE PSYCHOLOGY OF INTUITIVE
JUDGMENT 49, 60–73 (Thomas Gilovich et al. eds., 2002); AMOS TVERSKY & DANIEL KAHNEMAN,
Availability: A Heuristic for Judging Frequency and Probability, in HEURISTICS & BIASES 163, 175–78
(Daniel Kahneman et al. eds., 1982); see also Dana, supra note 120, at 1321–36; Sunstein, Beyond the
Precautionary Principle, supra note 120, at 1035–54; Sunstein, Precautions Against What?, supra note
120, at 13–21; cf. Gregory Mitchell, Case Studies, Counterfactuals, and Causal Explanations, 152 U. PA.
L. REV 1517, 1538–39 (2004) (describing how single events, particularly vivid events such as Enron’s
collapse, affect policy debates as a person “transforms her specific explanation for the isolated event
into a general explanation for a class of potential events, and it becomes a prediction for future problems”).
For a more critical analysis that questions such biases, see Charles Yablon, The Meaning of
Probability Judgments: An Essay on the Use and Misuse of Behavioral Economics, 2004 U. ILL. L. REV.
899.
For important work explaining the role of psychology in SEC decision making, see Choi &
Pritchard, supra note 91 (cataloging behavioral biases at the SEC, including bounded search; bounded
rationality; availability, hindsight, and fundamental attribution biases; framing effects; overconfidence;
confirmation bias; and groupthink); see also Pritchard, supra note 115, at 1078–87.
Emotion may also play a role in regulatory decision making. One could imagine regulators, as well
as the public, being “disgusted” with and “angry” at senior executives, attorneys, investment bankers,
money managers, auditors, and the like after Enron and the other scandals. For a useful overview of
law and emotion, see Eric A. Posner, Law and the Emotions, 89 GEO. L.J. 1977 (2001).
127. Langevoort has characterized this in terms of the psychology of commitment—that is, regulators
are committed to regulating. Donald C. Langevoort, Managing the “Expectations Gap” in Investor
Protection: The SEC and the Post-Enron Reform Agenda, 48 VILL. L. REV. 1139, 1144 n.16 (2003).
Milton Friedman has made a similar point, but contended that regulators regulate to serve their selfinterest.
Milton Friedman, Why Government is the Problem, in ESSAYS ON PUBLIC POLICY 1, 7–9
(1993).