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Abstract: Until four days before Enron declared bankruptcy, its debt was still rated investment grade by the major credit rating agencies. Clearly, four days before Enron declared bankruptcy, its debt was highly speculative. The furor over Enron, WorldCom and other recent debacles has led to calls for regulatory change in a number of industries; the rating agency regulatory regime is being revisited as part of this effort. The regulatory regime requires or encourages many investors to buy debt securities highly-rated by a rating agency which has been designated by the SEC as a Nationally Recognized Statistical Rating Organization (NRSRO); at present, only 4 such agencies exist. There is even more market concentration in the rating agency industry than the existence of only 4 NRSROs suggests. Two of the agencies, Moody's and Standard & Poor's, dominate the market; it is the norm for most issuers to get ratings from both agencies. The regime does not impose substantive oversight over rating agencies. Some critics blame the market concentration and the rating agencies' poor performance in Enron (and, they say, more generally) on the regulatory regime. These critics argue that ratings agencies are selling favorable regulatory treatment rather than information. Such critics favor largely scrapping the regulatory regime. I argue that ratings do provide information, albeit probably of lesser quality than they might provide if the industry were more competitive. I argue, too, that while the present regulatory regime probably ought to be scrapped eventually, doing so immediately might have an opposite effect to the one intended, further entrenching Moody's and Standard & Poor's. No matter what regulatory changes are made, it won't be easy for a new rating agency to be established or gain a significant presence in the market. Market and institutional forces might have dictated market concentration even in the absence of the regulatory regime. A long-standing reputation is of considerable value as well, especially since the rating agency can't feasibly offer monetary guarantees of the caliber of its work. Moreover, agents who make the investment decisions, as well as the firms purchasing ratings, have every incentive to stick with the tried, true, and court- and market-vetted rating agencies. Recognizing that the market may still remain quite concentrated, regulatory reform should encourage rating agencies to be more responsive to the needs of market participants. One promising suggestion contemplates creation of a public forum in which market participants would comment on rating agencies' performance. Less promising are suggestions to begin substantive oversight of rating agency business operations, and to increase the ability of investors and others to sue rating agencies. Finally, conflicts of interest may become a significant problem, especially if the market becomes much less concentrated - an annual certification by rating agencies that they are operating in accordance with procedures to guard against conflicts may be desirable.
Abstract: This short article, written for a symposium on securitization in emerging markets, discusses whole business securitization. Whole business securitization is a transaction structure used in countries with creditor-friendly bankruptcy regimes more friendly than the United States's regime. Whole business securitization specifies the manner in which a firm's business will be structured if it becomes bankrupt; the structuring expenditure is worthwhile in a regime where secured creditors' rights are fully honored. The article considers the extent to which the transaction structure will be useful in emerging markets countries. After the first transaction, in Malaysia, the structure is sure to be used again. But, not surprisingly, the structure is no panacea for the difficulties emerging markets firms encounter in raising capital.
bankruptcy, securitization, whole business securitization, creditors' rights, transaction structures, emerging markets
Abstract: Securitization is a technique firms use to raise financing. In securitization transactions, a firm issues securities payable from collections on its receivables. Securitization, in its present form, was created in the early 1970s. Transaction volume has grown rapidly; by the end of 1994, more than $1.9 trillion in securitization securities were outstanding. I show how securitization can add value by identifying the real-world costs it reduces. I describe two different uses of securitization. One is for firms with many financing possibilities. Such firms often use securitization to exploit small, temporary price differences in different financial markets. The cost reduction is small, but real. The other is for firms with fewer financing possibilities. There, the cost reduction is larger. Indeed, securitization seems particularly effective in reducing information costs. Information about firms with fewer financing possibilities is often limited, unfavorable or particularly difficult to appraise. Investor fears about such firms are costly to dispel. Securitization reduces these costs by dividing the firm into slices which permit more specialized appraisal. The securitization 'slice' consists of non-firm-specific assets; securitization investors needn't appraise the particularly costly-to-appraise residual risks and prospects of such firms. Moreover, the securitization transaction structure inspired the development of more efficient appraisal techniques for the non-firm-specific assets at issue, receivables.
lemons, securitization, capital structures, Modigliani, Miller, financing
Abstract: Securitization is a technique firms use to raise financing. In securitization transactions, a firm issues securities payable from collections on its receivables. Securitization, in its present form, was created in the early 1970s. Transaction volume has grown rapidly; by the end of 1994, more than $1.9 trillion in securitization securities were outstanding. Financing transactions, such as securitization, are the principal means by which firms create their capital structures. Modigliani and Miller showed that in a world without transaction or other costs, a firm's capital structure cannot add value. I show how securitization can add value by identifying the real-world costs it reduces. I describe two different uses of securitization. One is for firms with many alternative financing possibilities. Such firms often use securitization to exploit small, temporary price differences in different financial markets. The cost reduction is small, but real. The other is for firms with fewer financing possibilities. There, the cost reduction is larger. This is because securitization seems particularly effective in reducing information costs. Information about firms with fewer financing possibilities is often limited, unfavorable or particularly difficult to appraise. Investor fears about such firms are costly to dispel. However, securitization reduces these costs by dividing the firm into slices which permit more specialized appraisal.
Abstract: This paper considers why quality enhancement is sometimes, but not always, available for emerging markets financial instruments. It concludes that sometimes, but not always, economies of scope will permit quality enhancement to be provided at a cost lower than the associated benefit. These economies of scope are available when political risk is below a certain level; if political risk is, or is perceived to be, at or above that level, quality enhancement will not be available, except on terms likely not to be worthwhile for an emerging markets firm. More broadly, the increment of quality enhancement that can be exploited is limited. However, financial engineering has shown some promise in increasing the exploitable increment.
Abstract: In this essay, which was presented as the Galway Lecture at Queen's University, Kingston, Ontario, I argue that law and economics has largely neglected a critical facet of human cognition: the process by which people make sense of the world. People make sense of the world by categorizing - by labeling, sorting and organizing their experiences to form their worldviews. Categorization has been extensively studied in the cognitive psychology literature. Law and economics gives short shrift to the process of categorization because it typically assumes that there is often a correct sense to be made: a fact of the matter agreed to be such by society. A car is a lemon or it is not; the car dealer is lying or she is not; a corporate officer conceals bad news about her company while she sells many of her shares or offers new shares to the public; the renter of a car treats the car badly because she's returning it the next day. Behavioral law and economics thus far hasn't helped matters; it also assumes that there is a fact of the matter. The jury asked to assess liability for an accident determines that because the accident happened, it is more likely than it actually was. Similarly, a person making a car purchase decision concludes Volvos are less safe than they really are because he heard about 3 crashes last week in which Volvos were involved. I discuss examples, from others' work and from mine, in which there isn't a clear societal consensus as to the fact of the matter, and understanding the process by which people categorize to form their beliefs can therefore be a helpful component of our analysis. The examples come from such disparate fields as racial discrimination, disclosure policy, and corporate governance, as well as norms and expressive law. Among the features of categorization that are particularly relevant are the following. Categories are constructed around prototypes (the car is the prototypical vehicle, perhaps): the prototype is the typical case, but there are many penumbral cases (a motorcycle sidecar?). We categorize as much or more to help us organize our lives as to get it right. (We have categories such as things I look for in a job, things I need to take on a trip or things politician X (or business associate Y or friend Z) is capable of. Apocryphally, the Inuits have far more categories for snow than people living in warmer climates have.) Categorizations can be finer or coarser grained, depending on our needs. All else equal, the more members of a particular race we know and encounter regularly, the more fine-grained our categorizations concerning members of that race are apt to be. Who has only one prototype of their own race? By contrast, a person might very well have only one prototype of a race whose members she very rarely encounters. How might this affect employers and employees? What belongs in a category, and what categories we have, is also not given. How does a corporate director decide what (types of) possible misbehavior of corporate officers to look for? How might we appraise what will be most effective at changing norms as to what is status-conferring: will people respond to something's being made more costly, or will the added costliness only add to the thing's status-conferring ability? What disclosures might make investment options easier to compare? (More basically, how do people assemble the choice sets from which they choose their investments?) The approach I've described differs profoundly from the bulk of the behavioral literature to date. Most of the behavioral literature discusses people who are reaching sub-optimal outcomes. The approach I'm discussing contemplates that we may or may not know whether the result is a mistake, and often, our best guess is that it is not a mistake. And the focus of the explanation is on the behavior at issue as a neutral fact about the world, not on its status as a mistake; consistent with the more traditional law and economics paradigm, people are doing the best they can to advance their own interests, albeit confronting rather different obstacles to doing so than they do in traditional law and economics analyses.
Abstract: This comment, written for a symposium on securitization in emerging markets, discusses a short article by Ian Bell and Petrina Dawson on synthetic securitization, a transaction structure by which financial institutions insure on the capital markets credit risks from loans in their portfolios. Synthetic securitization is an exceedingly complex transaction structure; yet, Bell and Dawson manage the impressive feat of describing it accessibly. My comment considers how such a complex transaction structure will be affected by the 'flight to transparency' precipitated by Enron. In that regard, it notes that synthetic securitization is likely to inspire concerns of moral hazard; since its purpose can be achieved far more simply (namely, by selling the underlying loans to traditional loan-participation purchasers), investors may consider synthetic securitization?s complexity to be an end in itself, intended to confuse the inquiry into the caliber of the loans at issue. Synthetic securitization is surely a very important new transaction structure, but its trajectory may be bumpier and its volume of use may be more modest, at least in the moderate term, than Bell and Dawson argue.
Synthetic securitization, Ian Bell, Petrina Dawson, derivative transactions, Enron
Abstract: Interpersonal trust is currently receiving widespread attention in the academy. Many legal scholars incorrectly assume that interpersonal trust is an unmitigated good (or bad) and that legal policy should therefore be crafted to maximize (or minimize) trust. A more nuanced understanding of trust indicates instead that it should be promoted or discouraged, depending on the context. Such an understanding needs to reflect the fact that trust and distrust can, and often do, coexist. In most relationships, the parties trust one another with regard to some matters and yet distrust one another with regard to other matters. More specifically, developing a relationship with somebody often involves acquiring an overall residual sense of how trustworthy the person is, as well as a specific sense of the person's trustworthiness in particular contexts. Our paper begins to develop a cognitive theory of trust. Our cognitive lens suggests specific types of relationships and contexts in which people are systematically inclined to trust one another nonoptimally. First, some accurate trust assessments may be socially nonoptimal. Consider a group whose members decide to forego costly assessments of strangers, confining their dealings to other group members. Or parties engaged in socially undesirable activities whose high trust for one another permits them to effectuate successful criminal conspiracies. In these cases, social gains can be realized by enacting regulatory measures that provide incentives for either trust-enhancing or trust-decreasing behaviors. Second, some relationships are plagued by mistaken initial trust assessments in contexts where accurate updating of these assessments is either precluded or impaired. In such contexts the law should intervene to either promote more accurate trust levels or to mitigate the costs of the mistaken assessments. We identify two relationships where, if left unregulated, one of the individuals will likely inaccurately assess the trustworthiness of the other. In the corporate management context, directors are inclined to overtrust officers, and we explore possible mechanisms for promoting specific types of distrust on the part of directors without excessively eroding the residual trust in the officer-director relationship. In doctor-patient relationships, patients similarly overtrust doctors albeit for different reasons. Because patients often benefit from overtrusting their doctors, however, promoting more accurate patient trust assessments likely would prove costly. Health care law should (and does) instead focus on promoting doctor trustworthiness and compensating patients who suffer harm from misplacing their trust.
trust
Abstract: After the latest Disney decision, good faith seemed poised to take on a new and prominent role, either as an independent duty or as a component of one of the traditional fiduciary duties, loyalty or care. In the next case to arise, Stone v. Ritter, the Delaware Supreme Court quite specifically characterized the duty of good faith as part of the duty of loyalty. The Court also characterized Caremark, until then a paradigmatic duty of care case, as a duty of loyalty case. In our view, the court in Stone v. Ritter got it right, and indeed, should have gone further. It should have expanded more on the analytic underpinnings of the duty of good faith and better set the stage for a broader use of the doctrine in addressing the many cases involving problematic conduct by directors and officers that don't implicate the duty of loyalty as that duty has traditionally been conceived. In our essay, we propose a way of understanding how good faith fits within the broader context of Delaware fiduciary duty cases. We see potential cases as arrayed along a continuum. At one end are traditional care cases; in these cases, the only conflict between directors and the corporation arises from the natural human tendency to not work as hard or carefully as one might when one is not reaping all the fruits of one's labors. At the other end are the traditional loyalty cases, where a decision-maker has a material pecuniary interest that directly conflicts with that of the corporation - for instance, where a director or officer is selling land to the corporation. In between are cases where director or officer objectivity is impaired, but less so than in traditional loyalty cases. The emerging law of good faith helps courts deal with such cases. We suggest that this law is developing at two levels of abstraction. Particular clusters of cases develop detailed guidance for certain recurring problematic situations - the adoption of takeover defenses, board responses to shareholder derivative suits, the approval of executive compensation, and so on. At the same time, a more general doctrine of good faith is emerging that helps courts deal with more unique circumstances or with emerging problematic business practices; the more general doctrine provides an expressive handle on which to ground future holdings and encourage the development of appropriate norms.
corporate governance, good faith, fiduciary duty, duty of loyalty, duty of care
Abstract: This paper argues for an efficiency account of secured debt and against an externalization account. It describes the results of an investigation into firms' use of secured debt. I interviewed over twenty lawyers, bankers, and business people who are experts in this area and made use of my own knowledge as a former corporate lawyer. My investigation suggests the following pattern of secured debt and explanation therefor: At lower-quality levels, firms very often secure all their assets whereas at higher-quality levels, some firms secure some of their assets. At lower-quality levels, the divergence of interest between the firm and its lenders apparently dominates its financing choice. Granting the lender a security interest in all a firm's assets effectively prevents the firm from taking certain actions that would benefit the firm or the firm's owners but adversely affect the lenders. At higher-quality levels, there is still a divergence of interest between the lenders and the firm, but the divergence is not nearly as large. Other factors also influence a firm's financing choice. One such factor is the nature of the firm's assets: higher-quality firms tend only to secure assets that are easy to repossess and resell into a liquid secondary market. Other relevant factors include the availability of economies of scope, information cost savings, and regulatory and other arbitrage benefits. My investigation also suggests that most firms have limited ability to externalize liabilities using secured debt. Most voluntary creditors will adjust. And many firms will not have appreciable liabilities to involuntary creditors. My investigation thus casts doubt on some of the arguments for limiting the priority of secured creditors. The next step is empirical work to systematically appraise the results of my investigation.
Corporation and Securities Law, Financing Policy, Capital and Ownership Structure, Bankruptcy, Liquidation
Abstract: Investor reaction to political risk alternates: During or soon after a crisis, investors are quite reluctant to invest in politically risky securities, and will do so only at high 'lemons' discounts. After a period of calm, investors return, and bid down spreads to quite low levels-- levels that, after the next crisis, seem in retrospect too low. Investors are often depicted as overreacting to political risk: at times they are too scared,and at other times, they are not scared enough. My paper argues that while there may be some component of irrationality, the pattern of alternating skittishness and confidence may be the best even rational investors can do, as an investor's best guess about political risk may be that the future will be more like the recent past than the distant past. In other contexts, involving better-understood risks, heavily weighting recent events may be a cognitive mistake; in this context, where the 'correct' weighting is not known, it may sometimes be the best choice. Political risk is quite heterogenous, rising to the level of Knightian uncertainty. Payoffs and probabilities are difficult to estimate with precision. Our knowledge does not cumulate very effectively; indeed, events may, not infrequently, prompt us to redefine what political risk is, and what results it can have for investors. But standard finance methodology is predicated on homogeneity: saying that an event with a particular payoff will occur with 20% probability implicitly conjures up multiple trials where 20% of the time, an event akin to -- in the same 'class' as -- the event being considered occurs. While few classes in the real world are homogeneous -- even coin tosses are in some respects different from one another -- most risks investors face can be treated as belonging to classes more homogeneous than political risk. How, then, will investors react to political risk? At times of crisis, many investors may make a broad-brush determination to minimize their exposure to politically risky securities until they know more. After a period of calm, the spreads then being offered seem too high relative to the risks involved, more investors return, and the spread narrows. Eventually, there is another crisis and the cycle begins again.
Abstract: In a paper published in 2000, George Akerlof and Rachel Kranton introduce[d] identity - a person's sense of self - into economic analysis. Identity fits into the utility function: people seek identity benefits; they seek to avoid identity costs. Identity payoffs thus affect what people will do, interacting with other motivations for action. In this paper, I argue that law and economics' policy prescriptions can be enriched by taking identity into account. What counts as an identity? The category is potentially broad and amorphous: being African-American is an identity, as is being civic minded, as is being a jock or nerd. The common feature is the possibility of identity payoffs that strongly influence action. For instance, a person with a strong gourmand identity may incur significant identity payoffs if he receives a diagnosis of diabetes and has to restrict his diet accordingly. What generalizations can be made about identities so disparate? I consider at this juncture two stylized types of cases: one where the law is importantly involved in identity creation, and the other, where law is dealing more with identities that can be regarded as pre-existing. I discuss various examples in disparate contexts, including corporate law and criminal law. The paper also argues that taking identity into account doesn't just mean considering identity-as-payoff. As psychologists and sociologists have amply documented, identity is also a perceptual lens through which people perceive the world. Taking identity-as-perceptual-lens into account will be far more difficult than taking identity-as-payoff into account; it is necessary, though, to further the broader goal of making law and economics more realistic.
identity, behavioral law and economics
Abstract: German business contracts are much shorter than their American counterparts. They also avoid the worst excesses of legalese that American contracts are known for. But they seem to work as well as United States contracts. We seek to understand how German business contracts could do as much with fewer words. Our explanation is predicated on an account of what contracting does. Contracting aims to create a bigger transactional pie in a world where parties' incentives are misaligned and they need to coordinate the production of information, specify future rights, duties, and procedures, and allocate risks. The task of contracting thus has both adversarial and non-adversarial components. The German system permits considerable economics in the adversarial sphere; the economics extend to the non-adversarial sphere as well. The economies take the form of a reduction in transaction costs: transaction documents in Germany are far less custom-tailored to particular parties and their transactions than they are in the United States. Yet parties are not sacrificing much in the way of "getting the deal they want." This is because much custom-tailoring in the U.S. reflects (a) a costly attempt to constrain opportunism using contract language, and (b) a failure to create and accept "good enough" solutions to non-adversarial (and some adversarial) issues parties commonly face. We argue that German contracting does better on both these fronts. It does better at constraining opportunism more cheaply, by cutting short the "arms race" in which U.S. transacting parties and their lawyers too often engage in their negotiation and drafting of contracts. It also does better at creating and using "good enough" standardized solutions to common non-adversarial (and some adversarial) issues. But the German system has its costs. Parties may indeed compromise somewhat on getting, or at least specifying, "exactly the deal they want." And, more importantly, the German system may ultimately be unsustainable: The arms race in customizing contract provisions may be impossible to constrain in the more diffuse transactional community that European integration and globalization are bringing about; with enough customization, the benefits to using and developing standardized provisions diminish greatly.
Contracts, relational contracts, default provisions, comparative law
Abstract: Securitization, a complex financing technique, has been used by Latin American firms since the late 1980s. After the debt crisis of the mid-1980s, Latin American firms needed to develop new ways of appealing to foreign investors fearful of political risk; securitization, a transaction structure which had become popular in the United States, was well-suited for this purpose. The typical Latin American transaction structure differs from that commonly used in the United States. Yet, the chief value-adding mechanism is the same. The transaction structure extracts a high-quality, readily appraisable asset (a firm's receivables) from a lower quality and/or less readily appraisable, mass of assets and liabilities (the remainder of the firm). Since the late 1980s, emerging markets countries and firms, especially those in Latin America, have increasingly entered the global financial community. Better quality Latin American firms are increasingly able to obtain financing from foreign investors on quite-favorable terms, using securitization and other, simpler structures. Domestic banks, Latin American firms' traditional sources of capital, facing more competition, are apparently reducing their "tax," and otherwise becoming more efficient: competition from foreign markets makes domestic disparities and inefficiencies harder and more costly to sustain. And domestic capital markets are maturing. Indeed, competition among financing sources also may be fueling a race to the top, as countries vie to adopt investor-friendly and business-friendly regimes to attract the most foreign capital. The story of Latin American securitization is thus an arbitrage story, following theory's script: a too-wide spread has been exploited, and eventually, narrowed. But securitization's role in helping narrow the spread is more than a triumph of theory. The narrowed spread reflects amelioration of the conditions giving rise to the spread: the inefficiency of domestic banks, and immaturity of domestic capital markets. Foreign investor fears of political risk had declined as well, until the recent "Asian flu." However, Latin America appears to have caught only a mild case of the flu, and, as of this writing, investor fears of political risk in Latin America appear to be receding once again. Latin American securitization does not deserve full credit for these changes. Investors' constant search for new opportunities, and their fading memories, would certainly have led them to Latin American firms. But securitization made the journey shorter, and perhaps, less perilous. For foreign capital markets investors, Latin American securitization provided a relatively safe entree into unsafe territory; it isolated risks those investors were willing to take from those they were not. Securitization thus contributed to, and arguably, accelerated, changes narrowing the spread it sought to exploit: an arbitrage dynamic writ large. The crisis in Asia may present securitization with another opportunity to accelerate the return of skittish foreign investors, and help resume the region's integration into the global financial community.
Abstract: This article assesses the recent Disney decisions, and argues that on the facts presented, the decision was probably correct. However, the court squandered an opportunity: to develop and articulate an appropriate doctrinal approach for the issues the case presented. The case was an excellent opportunity for courts to provide some means to constrain executive compensation, and more generally to address problems caused by "structural bias," the cozy relationship directors may have with officers (and, less often, controlling shareholders). In such cases, there is no breach of the duty of loyalty as that duty has been articulated. However, the duty of care rubric doesn't seem properly applicable either. What the directors have done isn't to simply be careless; rather, they seem to have gone through some motions of decision making when their decision was, given their ties to the officers, a foregone conclusion. The court created space for a separate doctrine of good faith, but it provided little guidance as to how that doctrine might work, even in cases like Disney itself. We suggest an extension of the duty of good faith that could provide a bit more bite. Plaintiffs should be allowed to demonstrate bad faith with a two-part showing: (1) the decision occurred within an environment of structural bias, and (2) influenced by that structural bias, the directors were grossly negligent in making the decision. Even if a court were to follow our suggestion, most cases would turn out as they historically have, with defendant victories. But we think that articulation by the courts of a doctrine contemplating more scrutiny for decisions made in an environment of structural bias may help fuel a Caremark-like shift in norms and practices, directed by a combination of legal and extra-legal forces.
good faith, structural bias, fiduciary duty, executive compensation
Abstract: Business contracts have been reviled since before the Marx Brothers' infamous 'there ain't no Sanity Clause' sketch as being replete with duplicative, cumbersome, inartful, and sometimes imprecise language. My article seeks to understand why practice apparently hasn't made perfect - why business contracts are not as clear, and only as long, as would seem to be optimal. I argue that the contract production process combines rational, and what some would consider irrational, elements to create a serviceable, but arguably second-best, product. I discuss dynamics of law firms and their clients that contribute to the continuing viability of an 'imperfect product.'
Abstract: Companies openly and notoriously use accounting techniques (financial "cosmetics") to improve their financial appearance. They have been doing so for a very long time. Common examples include the use of "pooling" accounting in mergers, and the use of long-term leases that are functionally debt. The former increases earnings; the latter reduces debt. Both higher earnings and lower debt make for a more pleasing financial appearance. Companies' open and notorious use of financial cosmetics presents a puzzle. Financial vanity should be punished; expenditures on cosmetics applications divert from more worthwhile (that is, more profitable) pursuits. Yet the practice persists. I propose an explanation. Companies fear that markets, attracted by beautified companies' luster, might shun plainer ones. This fear is rational: Proclamations that financial appearances matter are loud and constant. So long as the cosmetics are tastefully applied (that is, the techniques do not adversely affect cash flows), markets seem indifferent; in short, there's nothing to drown out the proclamations. Why not? I argue that markets, trying to minimize aggregate information costs of unmasking beautification, concentrate their resources on discouraging and detecting makeup that masks a company's true appearance. They are indifferent to, and may even prefer, open and notorious makeup applications. The more openly a company applies its makeup, the more markets know about how the company really looks underneath. And a company applying its makeup in public may be signalling that it has little to hide.
accounting, dirty pooling , financial appearance, financial cosmetics
Abstract: In this paper we consider the role of governments in designing their policy for tax planning strategies. We consider two distinct types of social costs: the cost associated with lost tax revenue, and the cost that arises from taxpayers' search for new methods to reduce their tax burden. Inevitably, reducing one of these costs comes at the expense of increasing the other; the government faces a tradeoff. By recognizing these costs and the tradeoff the government faces, we can better understand current tax policy. Moreover, a wider recognition of the tradeoff described above, and a systematic consideration of how to disrupt markets in tax planning activities, should lead to better tax policy.
tax planning, tax enforcement policy, dissipation
Abstract: Complex contracts, such as those governing loans and acquisitions, create a state of the world - parties entering into a contract thereby become bound. The contract expressly summons up legal consequences for every promise it contains. But the relationship between the promises and the law's force is attenuated. Very often, contract provisions set the stage rather than provide the script: accommodation seems more the rule than the exception. Indeed, for most contracting parties, the law's specter is one of many reasons to do what they promised to do, and often, not the most important reason. Parties also feel constrained by reputational and other extralegal forces within the complex contracting community. Moreover, the process of contracting itself can serve to elicit information and compliance. The combination of legal and extralegal forces permits parties to craft a constrained, yet flexible, relationship - probably the best the parties can do given the limits of language, knowledge and imagination.
contracts, acquisitions, legal consequences, contracting parties, contracting, business contracting, complex contracts, contractual provisions, loan agreements
Abstract: This essay considers, and rejects, arguments for libertarian paternalism based on behavioral law and economics' findings that people sometimes make mistakes and lack self-control. It doesn't follow from the fact that people don't always do 'what they really want' that we can know what they really want and with confidence put in place laws and policies to nudge them in that direction. Still, in part because we don't necessarily do 'what we really want,' there may be sensible reasons to adopt paternalistic policies.
paternalism, behavioral law and economics
Abstract: Complex business contracts are notoriously difficult to write and read. Certainly, when litigation arises, courts scarcely have an easy time interpreting them. Indeed, contracts don't look at all as though they are written to tell a court what the parties want. Why can't smart, well-motivated lawyers do a better job? My article argues that they rationally don't try. I argue for a view of contracting in which parties aren't principally trying to set forth an agreement for a court to enforce. Rather, by leaving inartful language and ambiguity in the agreement, parties are bonding themselves not to seek precipitous recourse to litigation. The agreement entered into provides each party with grounds to bring a lawsuit if it so desires. Thus, if one party sues, the other party will virtually always have grounds to countersue. The complex transacting community has a norm against litigation in any event; bonding encourages and bolsters this norm, as well as norms of appropriate conduct throughout the contracting relationship. The contracting process, and the contract that results, thus serves importantly to create the parties' relationship and to set the stage for dispute-resolution consistent with preserving the relationship, as well as to keep available the backstop of enforcement if needed.
incomplete contracts, norms, Delaware, Journal, Corporate, Law, complex, business, contract, contracts
Abstract: Economists typically assume that preferences are fixed - that people know what they like and how much they like it relative to all other things, and that this rank-ordering is stable over time. But this assumption has never been accepted by any other discipline. Economists are increasingly having difficulty arguing that the assumption is true enough to generate useful predictions and explanations. Indeed, law and economics scholars increasingly acknowledge that preferences are constructed, and that the law itself can help construct preferences. Still, fixed preferences are often treated as a normative ideal: Even if people don't have fixed preferences, they should. Behavioral law and economics scholars offer approaches to deal with this normative shortcoming. My article argues that preference construction, properly understood, is not normatively undesirable. Having fixed preferences means having a complete and stable rank ordering of what we want that dictates our choices. But we often do not have such an ordering, and rationally so. My article argues instead for an alternative process-based, account of preference construction. Rather than having a complete rank ordering, we have ways of making choices. We construct narratives, using evaluative criteria against a backdrop of wants, desires and inclinations, some of which we rank order and some of which we do not. The evaluative criteria embed a consideration of transaction costs: critically, where a decision is not very consequential, a formulaic decision rule that permits a ready choice among roughly comparable alternatives may serve our purposes better than a more considered alternative-by-alternative assessment. Our wants, desires and inclinations are for both traditional objects of choice and higher order values and desires; they are both previously constructed and constructed and elicited in the choice-making process. My article makes the case for such an account's potential explanatory power, as well as its tractability.
preferences, behavioral law and economics
Abstract: Enron was rated investment grade by Moody’s, Standard and Poor’s, and Fitch until four days before it declared bankruptcy - scarcely a ringing endorsement of the agencies’ acumen. Even before Enron, the rating agencies had come in for significant criticism. Yet many investors who lost considerable sums in the financial crisis are saying that they relied on the rating agencies. How can this reliance be reconciled with what preceded it? I argue that an adaptive trait - incorporating new data that potentially conflicts with one’s pre-existing worldview so as to preserve as much of that worldview as possible - proved to be maladaptive in this circumstance. There was a plausible story investors could tell themselves about why the rating agencies could ‘get it right’ about the complex securities at issue while having gotten it spectacularly wrong about Enron. It will be interesting to see how, and how much, the agencies’ recent failures affect investors’ beliefs and practices.
rating agencies, belief perseverance
Abstract: Although most individuals recognize the necessity of taxation, few like to pay taxes. Governments face costs to collect taxes; people expend resources to legally avoid taxation. Such expenditure represents social waste, as it is a form of rent-seeking. This gives rise to a modified Samuelson Rule which considers this additional cost of taxation. Since there is a market for tax planning methods, the magnitude of these costs depends on the market structure. We consider how a government might reduce tax planning by creating market inefficiencies or failures. We set forth a formal economic model to identify the optimal amount of tax planning the government should permit, and consider how governmentally-created market failures could be implemented.
optimal taxation, tax avoidance, public goods, patents, market failure
Abstract: Corporate law has done a very bad job on executive pay: executives have been rewarded for stellar performance that turned out to be anything but stellar, and shareholders have had no meaningful recourse. Indeed, there are many other such cases, where there is no breach of the fiduciary duties of care and loyalty, but the board's behavior nevertheless smacks of a classic agency problem known as structural bias. We argue that law on the books and as enforced is not well situated to deal with structural bias. What shows some promise is the marshaling of extra legal forces that effectively extend Delaware corporate law, constituting a penumbra. Corporate directors' behavior is very much influenced by what is in the penumbra. The penumbra is importantly influenced by the Delaware corporate judiciary's participation in the corporate law debate in fora other than the courtroom. Law firm memos to clients play an important role too, conveying both the court holdings and the dicta as advice to clients. The penumbra also includes the many voices participating in the corporate governance debate through shareholder proposals, court cases brought about shareholder proposals, the views of corporate governance activists involved in the debate. While the penumbra is not an unambiguous good - certainly, actors with problematic self-interests may be among those helping shape it - it provides an important counterweight to the directors' ability to prefer their own interests over those of their principals, the corporation and its shareholders.
executive compensation, social norms, structural bias
Abstract: People of diverse backgrounds - most notably, diverse ethnic, racial and religious backgrounds - increasingly live in close proximity to one another. The trajectory is inexorable, and has many benefits. However, it also has had significant costs, including violent conflict between people with different identities, especially ethnic and religious identities. One important way to deal with this conflict starts with the recognition that people have multiple dimensions to their identities - in Amartya Sen's words, people's identities are "inescapably plural." A person's identities may change over time: various contexts, and stages of life, make different dimensions of identity more salient. Society can aim to strengthen alternative identity dimensions that would substitute for and weaken ethnic, religious, and other identity dimensions that may lead to conflict and violence, instead of complementing and strengthening them. We argue that the nonprofit sector is well situated to help in this endeavor. Nonprofit organizations may provide suitable circumstances for the encouragement of single alternative dimensions, such as musical and sports identities, or for the development of a set of complementary dimensions of identity that do not involve ethnicity and religion. Such organizations would engage in the provision of relational goods, thus playing on the nonprofit sector's relative advantage. The paper makes a concrete proposal for a community center model that could contribute to the reduction of negative effects of identity.
Abstract: This paper, published in a symposium on the work of Adolf Berle, approaches the Berle-Dodd debate from the perspective that corporate managers have responsibilities beyond pursuing the interests of shareholders. Stock based executive compensation, designed to align managers’ interests with those of shareholders, has, in the investment banking industry in particular, failed to avert, and may have caused, managers to take excessive risks that in the 2008 financial crisis inflicted great damage on creditors and on society as a whole. We describe here the broad outlines of a proposal that we will discuss in future publications in more detail to impose some measure of personal liability for a bank’s debts on the most highly paid bankers. The proposal would revive two mechanisms that imposed such personal liability in an earlier era: general partnership, which was common for investment banks prior to the 1980s, and assessable stock, which was relatively common in corporations including some commercial banks through the 1930s. One proposal is that bankers earning over $3 million per year be required to enter into a partnership/joint venture agreement with the employing bank that would make them personally liable for some of the bank’s debts. The other proposal is that compensation in excess of $1 million per year be paid to bankers only in stock that is assessable in the event of the bank’s insolvency in an amount equal to the book value of the stock on the date of issue. In either case, the bankers’ liability would not be unlimited: they would be allowed to shield $1 million from creditors. Imposing genuine downside risk through these or other vehicles for personal liability may be the best way to make bankers approach risk in a manner that reflects the potential for externalities of the sort the crisis has so dramatically demonstrated.
Adolph Berle, executive compensation, financial crisis
Abstract: The financial crisis poses a challenge to orthodox theorists of markets and market participants. My talk will consider alternative views of how investors and markets behave. I consider the psychological dynamics implicated in the following questions: How do markets decide which financial products to develop and market? How do we understand the mindset of “rocket scientists” who create financial products? How do investors decide what financial products to buy and what price to pay? Whose assessments do they find it reasonable to rely on, and why? How would they articulate their strategy, and do they articulate it correctly? To what extent do investment bankers and lawyers feel the need to justify what they are doing in structuring and selling a financial instrument, or even to fully understand it? There are many interesting psychological dynamics involved. Many of these dynamics implicate our complex responses to uncertainty. Some may have evolutionary roots. We need to understand them far better to minimize the chance and severity of future crises.
Abstract: People of diverse backgrounds most notably, diverse ethnic, racial and religious backgrounds increasingly live in close proximity to one another. The trajectory is inexorable, and has many benefits. However, it also has had significant costs, including violent conflict between people with different identities, especially ethnic and religious identities. One important way to deal with this conflict starts with the recognition that people have multiple dimensions to their identities in Amartya Sen's words, people's identities are inescapably plural. A person's identities may change over time: various contexts, and stages of life, make different dimensions of identity more salient. Society can aim to strengthen alternative identity dimensions that would substitute for and weaken ethnic, religious, and other identity dimensions that may lead to conflict and violence, instead of complementing and strengthening them. We argue that the nonprofit sector is well situated to help in this endeavor. Nonprofit organizations may provide suitable circumstances for the encouragement of single alternative identity dimensions, such as musical and sports identities, or for the development of a set of complementary dimensions of identity that do not involve ethnicity and religion. Such organizations would engage in the provision of relational goods, thus playing on the nonprofit sector's relative advantage. The paper makes a concrete proposal for a community center model that could contribute to the reduction of negative effects of identity.
Abstract: My review essay makes the case for law and economics in the personal sphere by reviewing and appraising the following four books: Richard Posner, Sex and Reason; Eric Posner, Law and Social Norms; Robert Frank, Luxury Fever, and Margaret Brinig, From Contract to Covenant. My focus is on answering objections from those who may be skeptical of law and economics methodology generally, but are particularly skeptical of its applicability in the personal sphere. Law and economics does not (certainly now, and perhaps even before the advent of behavioral law and economics) require viewing people as conducting their lives wholly with conscious calculation, constantly cutting the best deal they can for themselves. Such people are as much caricatures as are people conducting their lives completely without calculation, conscious or otherwise, always giving freely of themselves with no thought of getting something in return. My essay considers why some people might want to reject the applicability of law and economics to the personal sphere. Law and economics seems determined (indeed, even eager) to make people see themselves warts and all. A person might want to think of himself as caring deeply about the environment, persons with disabilities, world poverty, and other social ills. Law and economics often tells people they don't care as much about such things as they like to think, insofar as they want good results without being willing to pay for them. Similarly, a person might want to think of himself as a romantic, being carried away by sentiment in his choice of romantic mate. Law and economics would point out the extent to which mate-choice is influenced by market-like considerations. Some people therefore may look to dismiss the message; they haven't had to look far, because certain of law and economics' pathologies, principally the claim to more of a scientific mantle than is sometimes warranted, have invited cheap shots - ways to dismiss the messenger without listening to his whole message. And this is a shame. Law and economics could be a bit more agnostic about its claims in the personal sphere. It could spend more time explaining why market shouldn't be an expletive, stressing the pervasiveness of metaphor, and metaphor's instrumental character. Using a concept in a new context - carrying the suitcase - doesn't commit us to wearing all the clothes in the suitcase. As the books I'm reviewing show, we can get the benefits of the explanatory power law and economics has to offer while limiting or even eliminating the use of the clothes we would like to have left behind.
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