Chodorow: A Derivative Market For U.S. News Rankings

TaxProf Blog op-ed:  A Derivative Market for U.S. News Rankings, by Adam Chodorow (Arizona State):

Our law and economic brethren never tire of telling us that markets are the perfect solution for just about any problem. So, what is the biggest problem facing law schools? The slowdown in the legal employment market? The steep decline in applicants? Rising tuition? If you ask law professors and administrators, many would likely say the U.S. News & World rankings, which evaluate schools on an ever changing array of factors, often leading to head scratching results. Who doesn’t know of a school that is over or underrated?

I say we unleash the market on this problem. And by that I don’t mean create competing ranking systems that focus on more relevant factors. Instead, let’s treat schools like securities or commodities, with the rankings as their value, and allow people to buy and sell derivatives. Think a school is overrated? Short it. Think it is underrated? Go long. (Yes, Brian Leiter, I’m thinking of you and USD) If there is truly wisdom in crowds, the derivative market for schools could tell us (legal academics, prospective students, and employers) a lot more about schools than a much-maligned magazine. Think of this as akin to unskewed polls. Or perhaps not. That didn’t end so well, if memory serves.

Now I know this sounds crazy—and I’m not saying it’s not—but bear with me for a moment. Significant research is being done into predictive markets in a variety of different contexts. For instance, there is now a derivative market for presidential candidates (distinct from the actual market in which large donors participate), which some believe are more accurate than polls. Some companies are using this approach with their employees to get a handle on anticipated sales and other figures. They’re finding that markets beat estimates made the traditional way. The key is that people must have some skin in the game. It turns out that it’s not only a pending execution that focuses the mind.

Of course, turning to the market raises a host of issues that must be addressed. For instance, we need to be on guard for pump and dump schemes. The difficulty here is that it may be difficult to distinguish between the normal puffery and law porn we must wade through during “sweeps week” and truly actionable behavior. Who among us cannot readily think of a dean who issues a press release every time he burps? While I would love to see such pronouncements legally actionable, they may fall on the spin side of the line.

Perhaps what we need is to extend something like the Securities Act of 1933 and Securities Exchange Act of 1934, and the ensuing regulations and jurisprudence, to cover this new market. Adopting securities standards would reduce the burdens of proving fraud in the traditional context, perhaps giving fuel to the many lawsuits against law schools that have recently been filed and mostly dismissed.

Or perhaps we should look to the Commodity Futures Modernization Act of 2000 for the regulatory framework. Either way, it would be fun to watch the Security and Exchange Commission battle it out with the Commodity Futures Trading Commission in the political arena to see who would win this prize.

Another potential issue would be insider trading. Imagine the admissions director, who knows that her median LSAT is about to fall 2 points, shorting her school. Or, for more subtlety, the dean who knows that financial aid will significantly increase or decrease in the coming year. While some have argued that insider trading is a positive good because it sends market signals and aids efficiency, the law hasn’t quite caught up with them. Just imagining the lawsuits fills me with delight (from a purely legal perspective, of course).

We could explore again in this new context the question of who properly should be classified as an insider. How about large donors or legislators (in the case of public schools) when they know they are about to drop change-your-life money on a school? And what about tipper/tippee liability? The possibilities are truly endless.

For those who are over exposed or risk averse, we could add options to the mix to allow them to hedge their risks. We will have to decide what to do about short sellers. In one view, short sellers are vultures who take on more than just a rooting interest in the collapse of a given company or commodity. In another view, short sellers are important market players who expose fraud and overvaluation, correcting market failures. Law school transparency sort of fills this role under the current system.

If we regulate short selling too much, we’ll miss out on a lot of fun and games. Who hasn’t enjoyed watching the epic battle between hedge fund manager Bill Ackman and Herbalife, as Ackman has relentlessly (and apparently futilely) attempted to have Herbalife branded an illegal pyramid scheme? Just think what Paul Campos would do if there were real money at stake.

One of the benefits of this market is that it is impervious to bubbles. There will always be a number 1, so the market as a whole cannot fall. Only individual schools are capable of movement. The downside is that broad market index funds won’t work. However, index funds focused on market segments, such as public schools, religious schools, or schools whose name begins with the word “The” could work. So could managed funds, where fund managers do their research and handpick the schools they wish to hold or short.

Finally, in a fit of paternalism, we may want to think about margin rules to prevent over-eager market participants from going all in—and more—on a school or set of schools.

If the recent experience with mortgage backed securities and collateralized debt obligations is any indication, this could be huge! We could create a market involving billions and even trillions of dollars. And instead of listening to people gripe when the new U.S. News rankings come out, we can tell them to put their money where their mouth is. I will leave it to others to work out the details, such as how Dodd-Franks may affect all of this. I’m on to the next project, trying to convince Draft Kings to create a law professor fantasy league. All I ask for is credit, 10% of the take, and the opportunity to short our in-state rival to the South.  Go Devils!