Regulating Global Capital Markets: Somali Pirate Capital Markets, the South Sea Bubble and the Limits of Law

The 21st century has seen its share of efforts to extend the power of the state to regulate economic activity in new and increasingly comprehensive ways.  The economic scandals at the start of the 21st century and the economic collapse of 2007-2008 provided national governments, and international organizations more than enough excuse to push ambitious agendas for control.   Underlying these efforts are notions of fairness, investor protection, fairness, and the protection of the integrity of markets.    The conventional narrative of the organization of economic activity is founded on notions of legitimacy tied to law and the central role of legislator, administrator, judge and lawyer in the management of economic activity. See, Larry Catá Backer, From Narrative to Narrator: Remarks at "Business Law and Narrative Symposium" at MSU, Law at the End of the Day,  Sept. 16, 2009. 

In the absence of this public oversight, commercial activity is suspect, markets lose their integrity and  organized economic activity loses its welfare maximizing effects.  A recent story and an old scandal remind us that the narrative of state intervention in markets through regimes of positive law may be as much about the preservation of the power of the state as it is about the objects of regulation.  In the absence of state intervention is may be possible to run credible capital markets.  At the same time, markets in a highly regulated environment may produce the greatest corruption of systemic failure.

The recent story describes the development of capital markets to fund the increasingly lucrative business of piracy, currently centered in Somalia.    In a country without a credible state apparatus, and little by way of effective positive law, a credible market based economy may be elaborated without the intervention or management of the state.

In Somalia's main pirate lair of Haradheere, the sea gangs have set up a cooperative to fund their hijackings offshore, a sort of stock exchange meets criminal syndicate. Heavily armed pirates from the lawless Horn of Africa nation have terrorized shipping lanes in the Indian Ocean and strategic Gulf of Aden, which links Europe to Asia through the Red Sea.

The gangs have made tens of millions of dollars from ransoms and a deployment by foreign navies in the area has only appeared to drive the attackers to hunt further from shore. It is a lucrative business that has drawn financiers from the Somali diaspora and other nations -- and now the gangs in Haradheere have set up an exchange to manage their investments. One wealthy former pirate named Mohammed took Reuters around the small facility and said it had proved to be an important way for the pirates to win support from the local community for their operations, despite the dangers involved. "Four months ago, during the monsoon rains, we decided to set up this stock exchange. We started with 15 'maritime companies' and now we are hosting 72. Ten of them have so far been successful at hijacking," Mohammed said. "The shares are open to all and everybody can take part, whether personally at sea or on land by providing cash, weapons or useful materials ... we've made piracy a community activity."  Daniel Wallis, Somali sea gangs lure investors at pirate lair, Reuters, Dec. 1, 2009.

Like early stock exchanges in Northern Europe, the Somali exchange has become something of the center of economic and communal life in the city.  "Haradheere's "stock exchange" is open 24 hours a day and serves as a bustling focal point for the town. As well as investors, sobbing wives and mothers often turn up there seeking news of male relatives missing in action."   Id.  And it has brought a certain amount of wealth to this part of Somalia.  "Haradheere, 400 km (250 miles) northeast of Mogadishu, used to be a small fishing village. Now it is a bustling town where luxury 4x4 cars owned by the pirates and those who bankroll them create honking traffic jams along its pot-holed, dusty streets." Id.

"One wealthy former pirate told Reuters that the stock exchange had won local support by making piracy into a "community activity," which may underscore the root of the problem for nations seeking to battle piracy as a symptom."  Jeremy Hsu, Somali Pirate Exchange Lets Investors Bet on Hitting a Ransom Jackpot, Popsci, Dec. 2, 2009.  Of course, the result belies the conventional narrative of the critical need for state intervention to manage markets.  Ironically, it also brings home a reality that  should have become apparent in the now half century war against drugs--merely declaring an activity"illegal" will not suppress markets in activity with respect to which there is demand.  The standard narrative of law and economics suggests that behavior may be legislatively controlled--the effects of state power and the legitimacy producing effects of formal governance--is belied not only by the flourishing pirate trade but also by the development of markets to finance such activities.

As for the pirate stock exchange, it seems like just another natural step for Somali communities that increasingly depend on illegal activities for economic subsistence. Somali pirates put a percentage of their ransom money back into their communities to pay for hospitals and public schools. Reuters quotes a woman who contributed a rocket-propelled grenade to one group of pirates and eagerly anticipates the dividends.  This suggests that all the high-powered Navy weapons or non-lethal gadgets in the world won't solve that problem -- much as we love our anti-pirate gadgets.  Id.

But the converse is not true--that state regulation can prevent or manage market activity and protect the integrity of capital markets.   The story of the South Sea Bubble is worth recounting after the collapse of 2007-08.  It serves as a reminder that state may not be the answer.   This story is drawn from the masterful account in Malcolm Balen, A Very English Deceit:  The Secret History of the South Sea Bubble and the First Great Financial Scandal, (London:  Fourth Estate, 2002).

The similarities of the current economic situation in the United States and the economic collapses in England 1720 and France 1719 are striking. A careful read might find you checking and then re-checking the copyright on The Secret History of the South Sea Bubble, just to make sure Balen’s historical perspective or re-telling of events had not been skewed by the crash of 2007. Central themes of “rescue packages”, “saving banks” and “corruption” are all too familiar in this book. The copyrights were in fact in 2002 and 2003, an eerie reminder to the axiom of history oftentimes repeating itself. It is evident that Balen could foresee the United States’ economic “bubble” growing to an unsustainable size with the quotes of overconfidence from 1999-2001 he chose to preface each chapter.

The book begins with meticulous description about the atmosphere surrounding the building of St. Paul’s Cathedral in London, 1710. The people’s worship was said to be of money, not God. The architect, Christopher Wren, designed the top of the cathedral to resemble a sort of bubble which was so delicate that it needed a second inner bubble to support it. The economic scene included bank rivalries and stock jobbers in Exchange Alley. The bubble on the cathedral is symbolic of the era and fragility of the stock market investments when they grow to an unsustainable size.

John Law, the instigator in Frances’ economic collapse of 1719, was originally from Britain. Law fled the country early in his career after he was involved in a dual, which left the other participant dead. The dual was over a lady acquaintance and much of the details are left up to the imagination, sadly one of the most interesting background descriptions in the book. During his years abroad, Law made a fortune as a gambler and acquired a taste for finance. He observed the Bank of Amsterdam and their currency system. In a time where coins were frequently clipped and instantly devalued, Law had the radical idea of paper money whose value was backed by land.

Law attempted to persuade a few countries of his idea, and finally found a taker in France where the national debt was at an all time high of three billion livres. The country was desperate and decided to give Law a shot in 1716. France would join the club of only six other countries that used paper notes at the time. Law created a bank that would issue paper notes and also act as a trading corporation to buy and sell property. It would lend money at a fixed rate of interest and the gold and silver in the ducal treasury would act as its reserves. Law created the Mississippi Company who sold shares to investors hoping to capitalize on the rich mineral prosperity of Louisiana and Mississippi. He deported the sick, prisoners and low income citizens to cultivate the land after having no other volunteers. Needless to say his empty promises of returns on land development in America popped France’s economic prosperity like a bubble. Where people had once rushed to buy stock because the prices were rising so quickly; they could now practically use the paper currency for toilet paper as it lost almost all its value. The Plague followed soon after, which many French citizens viewed as punishment for their foolish admiration of investing in the get rich quick schemes.

John Blunt made his reputation through his idea of using lottery monies to help pay off the national debt in Britain. He and his partner, who was involved in the government, would sell tickets with a certain number of guaranteed winners. Although, the lottery was briefly successful, Blunt saw a potentially bigger return through buying the country’s debt and selling stocks. Blunt used the Sword Blade Bank to create the South Sea Company, which was initially supposed to be a trading company but never actually generated a profit. The South Sea Company was the front for the stocks in 1720 and filtered money through the bank, where citizens would buy at a days’ rate and as the company grew, the stocks would increase. Blunt was much more underhanded than Law, and bribed many government officials with free stock or highly discounted prices. The Company went through four different phases of selling stock, each time at a higher price, and many people made money hand over fist. Blunt issued generous credit and payment plans and kept little money in the reserves. When the word finally spread that The South Sea Company was collapsing and wasn’t actually based on trading or any sort of real income producing business, it was too late and the stock dropped well below what most people owed. Instead of an actual business plan or improved method of business, such as Law’s paper notes having value backed by land or gold, Blunt had made millions on his ability to corrupt government officials and inflate stock prices.

Most of Britain’s government officials and the King’s party had dirty hands, which made rectifying the economic collapse difficult. Robert Walpole, one of the only objectors to The South Sea Company buying the government’s debt, saw his opportunity to seek revenge on his political enemies and take control of the chaos. Walpole was able to save the monarchy and the masterminds behind The Company to create political leverage, while at the same time persecuting a minority of government officials who had received bribes to satiate the blood thirsty public. With this power he was able to put friends in recently vacated government positions and secure control over the country.  The parallels to the events of 2008-2009 are worth considering.

Plague provided the excuse.  Fear of contracting France’s plague caused England to quarantine its’ ports, leaving dozens of ships unable to unload their cargo. Churches were attempting to regain ground it had lost through the stock explosion by condemning those who had fallen weak to money and the Plague was their punishment. “Walpole had calculated that he needed the crisis to run out of control, and for the anger of investors to grow and be heard ever louder, in order to pitch the ruling duopoly…out of power…” Walpole sought political power and revenge against his colleagues. He aimed to sweep out the corruption, but not too far or else he himself could be entangled. Walpole began working out his new rescue deal with the Bank of England and then presented it to the King before the House of Commons. He aimed to show his support of his party and the King enough so that they would have favor with him before, for lack of better words, shit hit the fan. Walpole’s new plan included both the Bank of England and the East India Company acquiring a quarter each of the South Sea stock, and each would offer some of their own stock to annuitants in exchange for South Sea shares. Therefore, at least shareholders would own shares in reputable businesses.

When the plan was presented, Parliament was thirsty for blood and would not be satisfied until people were found to blame.  “Parliament began to flex its muscles, as the full scale of corruption began to emerge, Walpole would maneuver to undermine the actions of his parliamentary colleagues without leaving any evidence of his involvement in the cover-up he had orchestrated.” The Commons immediately formed an inquiry committee to investigate the South Sea Company. The Parliament wanted everything accounted for starting from December 1719, but it was too late the South Sea Companies cashier Robert Knight was already orchestrating a cover-up. Knight took steps to erase and fill in holes with fake names in the accounting ledgers where they had recorded the bribes and discounted share offerings.

When Parliament reconvened in January 1721 after the Christmas break, Walpole had promised to protect some, and was waiting for the opportune moment to guide the direction of the inquiries. The House of Commons then required that the South Sea Company’s Directors pay £25,000 in bail money and were presumed guilty until proven innocent. The worst sanction yet, would be the Commons’ refusal to appoint the Director’s lawyers. Trials were held in both the House of Lords and the Commons against the Directors of the Company. In the hustle and bustle of organizing the trials and deciding who and how those involved should be punished, Knight knew the stacks of evidence he had been keeping in his office would soon be discovered. “As the days went by in the run-up to [Knight’s] own appearance before the Commons’ inquiry, Knight desperately approached government ministers to try to blackmail them into protecting him.”  In Knights questioning he kept silent about the Company’s dealings, and planned his escape with the ledger in tow. Knight had transferred enough money to live on to foreign banks in his preparations, and when word spread of his departure it “stripped away the veneer of official respectability which had masked the Company’s disreputable dealings over the past year, so that the Commons saw for the first time the true nature of the South Sea enterprise.” The country was in an uproar and demanded that Knight be caught. The ministry continued to clean house by stripping all directors in the Company of their public offices, except of course the King, and continued to imprison and seek restitution from others. The most unexpected turn of events was when Blunt caved and told the inquiry committee everything, even names of government co-conspirators.

Walpole now feeling things have utterly spiraled out of control, enters the scene from stage left, and begins to play the game. “While Walpole publicly protested that he wanted Knight to be extradited, and that he was doing everything he could to make it happen, behind the scenes he had resolved to keep him abroad at any price, rather than bring him back to give evidence.” Walpole knew that if Knight came back, the King would be incriminated; therefore it was in Walpole’s best interest to keep the Kings favor in his pocket. As it happened a British police officer in Brussels tracked down Knight, not knowing the true intentions of the King, and placed him inside the Citadel of Antwerp. The ledger was sent back to London, but was mysteriously lost en route. Walpole’s political dance continued and protested that Knight be returned to London, at the same time at the behest of the King a special envoy was sent to Vienna. Colonel Charles “Churchill had been ordered to persuade the Governor of the Austrian Netherlands…that Knight’s extradition posed insoluble difficulties for the British government. The delay of Knight’s return continued, and the measures taken to conceal Walpole and the King’s true intentions were extreme. Finally in September 1721, a letter was written on behalf of the King stating “…[the King] is pleased to express the wish that Your Excellency should order the Governor of the Antwerp Citadel to enlarge Knight from confinement, allowing him not only to have liberty to walk on the Citadel, but to escape…” Thus, the Emperor released Knight to live in exile abroad, where he would remain for many years.

Walpole then began strategically placing his friends and family in the government offices vacated by the South Sea scandal. February 1721 marked the beginning of the end for the committee’s inquiry, when they presented their initial findings to the Commons for a full 2 ½ hours. They revealed actual worth of stock and what it had been sold for, and “unraveled the process by which shares had been ‘sold’ for notional prices with no record of a date and without any money changing hands…” The committee reported that the Company had gone well beyond bribery and corruption, but that “there were no financial checks and balances placed upon it by Parliament, despite the fact that it had taken upon itself the role of guardian of the nation’s finances through its purchase of the national debt.” The Commons began to prosecute and sentence those revealed to be involved in accepting the bribes, and Walpole maneuvered once again to save those he felt important.

You may be asking yourself, what happened to Blunt and Law? By a vote, Blunt was allowed to keep just £1,000 (which was later raised to £5,000) and “retire to Bath to contemplate the ashes of his career.” By April 1722, Walpole had secured his anticipated control in government. He oversaw both “the Lords and the Commons and established Whig supremacy for a century.” Law was finally allowed to return home to London, by Walpole’s granting, and later died in Venice at age 58.

Both the story of governmental collusion in regulated markets in the crude for of the South Sea Bubble of the early 18th century and the modern story of the rise of unregulated capital markets in pirate activities remind us the simple binary relationship of private economic activity and public regulation may not provide either the legitimacy or integrity necessary to preserve a welfare maximizing framework.   Moncentric governance evidences both its thrust--to acquire power, and its limits.  It suggests that value of recent powerful efforts to try to fashion forms of polycentric governance.  See Larry Catá Backer, On Challenges to Operationalizing a Transnational Framework for Business and Human Rights--the View From Geneva, Law at the End of the Day, Oct. 13, 2009.  Just as the South Sea Bubble produced a crisis that proved irresistible to institutional actors seeking to use it as a pathway to strengthen their personal power and rearrange power allocations among stakeholders in the national economies of the time, so the economic crisis that started in 2007 has appeared to produce the same temptations--for management, and power shifting among political and economic actors.  Managing risk may be more about control than economics.  And indeed, as in the early 18th century, the principle object may be the management of political stability than economic productivity.  Yet this is undertaken in a context in which capital can hardly be managed by single states, and economic culture is not as easily dictated by a dominant global culture.  Governance has not managed to overcome the state yet it has undone national efforts to assert comprehensive political authority over economic actors. 

It is in this sense that one can appreciate the understated insights recently elaborated by Peer Zumbansen, in his excellent work, The Next 'Great Transformation' of Markets and States in the Transnational Space: Global Assemblages of Corporate Governance & Financial Market Regulation (June 6, 2009). CLPE Research Paper No. 9/2009 ("The corporation at the end of the 20th century was no longer primarily seen as an organizational entity, but had become a financial vehicle, operating in a regulatory framework largely out of control of domestic company law legislation. This emerging regulatory environment consists of supra-national legislation directed at increased efficiency of regional and global financial markets on the one hand and increasingly incentive-oriented, indirect regulation of corporate governance rules, placed to a large degree within the discretion of market actors. The financialization of corporate governance and the emergence of a transnational legal pluralist regime of applicable rules and standards" Abstract).  The Somali markets for pirate enterprises provide a nice example of Zumbansen's insight that

The corporation had become a nodal point for an ephemeral crossing, interlinking and overlapping of financial vectors, channelled through the glass structure of the legal person, with almost to no relation to the original ‘business’ of the corporation. A dream fulfilled, with money flowing in and out of the firm, the corporation had become a virtual realm for strategic investment.  Id., at 9.

The resulting financialization of the corporation has produced a change in both the behavior of stakeholders and the character of regulatory approaches.  Corporate autonomy has not freed it from regulation and the state so much as made both as much an object of consumption and part of the calculus of production, in the way that labor  and distribution channels are for the production and distribution of goods. Larry Catá Backer, Economic Globalization Ascendant: Four Perspectives on the Emerging Ideology of the State in the New Global Order. University of California, Berkeley La Raza Law Journal, Vol. 17, No. 1, 2006.   The nature of that challenge, and the changing face of finance were nicely illustrated by the new form of in-kind micro investment made possible in regulation free environments, like that of the capitalization of piracy. Consider the following:

Piracy investor Sahra Ibrahim, a 22-year-old divorcee, was lined up with others waiting for her cut of a ransom pay-out after one of the gangs freed a Spanish tuna fishing vessel. "I am waiting for my share after I contributed a rocket-propelled grenade for the operation," she said, adding that she got the weapon from her ex-husband in alimony. "I am really happy and lucky. I have made $75,000 in only 38 days since I joined the 'company'."

Daniel Wallis, Somali sea gangs lure investors at pirate lair, Reuters, Dec. 1, 2009. The consequences for development, the extent of political management of economic activity, the role of the state, and the form of effective governance cannot be underestimated.  It is to Somalia, perhaps, rather than to the overwrought markets in New York, London and Shanghai that the future of global capital markets, and the financialized corporation, will be shaped for large segments of global economic actors operating below the level of elite actors.   And this is a reality that has begun to shape some of the outreach of those well developed markets as they seek to protect their culture, behavior rules and the unity of their markets.  June McLaughlin recently described efforts by the exchanges of developed states to help acculturate new financial exchanges in Uganda. June McLaughlin, SITI in East Africa, Muzungu on Africa, Dec. 28, 2009 ("A securities training institute has been launched in East Africa. The Securities Industry Training Institute (Siti East Africa) is based at the Uganda Securities Exchange (USE) in Kampala, Uganda.").  The initiative is financed by the IFC in its role in promoting development through "capacity building."  I will leave her with the last word of this essay--a  last word tinged with tremendous irony and insight:

Africa has many progressive initiatives. This education is run by the IFC but I don’t care about that. I no longer care where people come from. I only care about people as humans. What difference does it make anyway? Enough crazy politicians want to seem effective and make us sit for the last hour of a transatlantic flight. Well ok. June McLaughlin, SITI in East Africa, Muzungu on Africa, Dec. 28, 2009.

The future belongs, in a perverse way and to a certain extent, to "Somalia".