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Abstract: During the 1970s and early 1980s, the Efficient Capital Market Hypothesis (ECMH) became one of the most widely-accepted and influential ideas in finance economics. More recently, however, the idea of market efficiency has fallen into disrepute as a result of market events and growing empirical evidence of inefficiencies. This Article argues that the weaknesses of efficient market theory are, and were, apparent from a careful inspection of its initial premises, including the presumptions of homogeneous investor expectations, effective arbitrage, and investor rationality. By the same token, a wide range of market phenomena inconsistent with the ECHM can be explained using market models that modify these three assumptions. In illustration, this Article explores three important strands of today's finance literature: (1) the expanding body of work on asset pricing when investors have heterogeneous expectations; (2) recent theoretical and empirical scholarship on how and why arbitrage may move certain types of publicly available information into price more slowly and incompletely than earlier writings suggested; and (3) the exploding literature in behavioral finance, which examines what happens to prices when market participants do not all share rational expectations. Taken together, these three bodies of work show signs of providing the essential framework on which can be built a new and more powerful working model of securities markets.
Efficient Capital Market Hypothesis (ECMH), market theory,
Abstract: Conventional legal and economic analysis assumes that opportunistic behavior is discouraged and cooperation encouraged within firms primarily through the use of legal and market incentives. This presumption is embodied in the modern view that the corporation is best described as a "nexus of contracts," a collection of explicit and implicit agreements voluntarily negotiated among the selfishly rational parties who join in the corporate enterprise. In this article we take a different approach. We start from the observation that, in many circumstances, legal and market sanctions provide at best imperfect means of regulating behavior within the firm. We consider an alternate hypothesis: that corporate participants often cooperate with each other not because of external constraints, but because of internal ones. In particular, we argue that the behavioral phenomena of internalized trust and trustworthiness play important roles in encouraging cooperation within firms. In support of this claim, we survey the extensive experimental evidence that has been produced over the past four decades on human behavior in "social dilemmas." This evidence demonstrates that internalized trust is a common phenomenon; that it is at least in part learned rather than innate; and that different individuals vary in their inclinations toward trust. Most important, the experimental evidence indicates that decisions whether or not to trust others are in large part determined by social context rather than external payoffs. By altering social context - subjects' perceptions of others' beliefs, expectations, likely actions, and relationships to themselves - experimenters can reliably produce everything from nearly universal trust, to an almost complete absence of trust, in subjects in social dilemmas. In other words, most people behave as if they have two personalities or preference functions. One is competitive and self-regarding. The other is cooperative and other-regarding. Social framing is key in triggering when the cooperative personality emerges. These behavioral findings carry important implications for corporate law. For example, in this article we demonstrate first that the phenomenon of trust offers insight into the substantive structure of corporate law and particularly the nature and purpose of that elusive legal concept, fiduciary duty. In the process, it adds weight to the claims of anticontractarian corporate scholars who argue against the notion that corporate officers and directors should be free to contract out of their fiduciary duty of loyalty. Second, the experimental evidence on trust sheds light on how corporate law works, by suggesting how judicial opinions in corporate cases direct corporate officers' and directors' behavior not only by altering their external incentives but also by changing their internalized preferences. This possibility helps explain the notoriously puzzling relationship between the duty of care and the business judgment rule. Third, trust highlights the limited power of law by explaining how cooperative patterns of behavior can sometimes develop within firms even when external incentives, such as legal sanctions, are unavailable or ineffective. In the process, it underscores the dangers of the contractarian approach by suggesting how an excessive emphasis on external sanctions - including formal contract and even the rhetoric of contract - may be not only ineffective but counterproductive, serving to undermine trust and trustworthiness within the firm.
Abstract: Taken together, the Efficient Capital Markets Hypothesis (ECMH) and the Capital Asset Pricing Model (CAPM) appear to predict that the market price of a security in an efficient market should reflect the best possible estimate of its fundamental value. Although this notion once exercised great influence among both finance theorists and legal scholars, closer inspection reveals it to be tautological: because the CAPM rests on an assumption that all investors make identical estimates of securities' future risks and returns, it naturally predicts that market prices reflect that consensus. More recent work in finance examines what happens to securities prices when investors hold disagreeing expectations for the future. This "heterogeneous expectations" literature offers to resolve a number of the mysteries that have plagued scholars who rely on the conventional ECMH/CAPM. In illustration, this paper presents a simple heterogeneous expectations pricing model premised on investor disagreement, risk aversion, and short sales restrictions. The model explains at least the following market puzzles: (1) why many investors don't diversify; (2) why target shareholders receive large premiums in corporate takeovers while bidding firms' share prices remain relatively unchanged; (3) why certain anomalous classes of securities, including neglected stocks, low P/E stocks, and low- beta stocks, offer superior risk-adjusted returns relative to the market; (4) why stock buyback programs and dividend payments support stock prices while stock issues depress market prices; and (5) how certain actively managed investment funds, Berkshire Hathaway chief among them, can consistently beat the market over long periods.
Abstract: Taken together, the Efficient Capital Markets Hypothesis (ECMH) and the Capital Asset Pricing Model (CAPM) appear to predict that the market price of a security in an efficient market should reflect the best possible estimate of its fundamental value. Although this notion once exercised great influence among both finance theorists and legal scholars, closer inspection reveals it to be tautological: because the CAPM rests on an assumption that all investors make identical estimates of securities' future risks and returns, it naturally predicts that market prices reflect that consensus. More recent work in finance examines what happens to securities prices when investors hold disagreeing expectations for the future. This "heterogeneous expectations" literature offers to resolve a number of the mysteries that have plagued scholars who rely on the conventional ECMH/CAPM. In illustration, this paper presents a simple heterogeneous expectations pricing model premised on investor disagreement, risk aversion, and short sales restrictions. The model explains at least the following market puzzles: (1) why many investors don't diversify; (2) why target shareholders receive large premiums in corporate takeovers while bidding firms' share prices remain relatively unchanged; (3) why certain anomalous classes of securities, including neglected stocks, low P/E stocks, and low-beta stocks, offer superior risk-adjusted returns relative to the market; (4) why stock buyback programs and dividend payments support stock prices while stock issues depress market prices; and (5) how certain actively managed investment funds, Berkshire Hathaway chief among them, can consistently beat the market over long periods.
Abstract: Contemporary corporate scholarship generally assumes that the central economic problem addressed by corporation law is getting managers and directors to act as loyal agents for shareholders. We take issue with this approach and argue that the unique legal rules governing publicly-held corporations are instead designed primarily to address a different problem - the "team production" problem - that arises when a number of individuals must invest firm-specific resources to produce a nonseparable output. In such situations team members may find it difficult or impossible to draft explicit contracts distributing the output of their joint efforts, and, as an alternative, might prefer to give up control over their enterprise to an independent third party charged with representing the team's interests and allocating rewards among team members. Thus we argue that the essential economic function of the public corporation is not to address principal-agent problems, but to provide a vehicle through which shareholders, creditors, executives, rank-and-file employees, and other potential corporate "stakeholders" who may invest firm-specific resources can, for their own benefit, jointly relinquish control over those resources to a board of directors. This alternative to the principal-agent approach offers to explain a variety of pivotal doctrines in corporate law that have proven difficult to explain using agency theory, including: the requirement that a public corporation be managed by a board of directors rather than by shareholders directly; the meaning and function of a corporation's "legal personality" and the rules of derivative suit procedure; the substantive structure of directors' fiduciary duties, including the application of the business judgment rule in the takeover context; and the highly-limited nature of shareholders' voting rights. The team production model also carries important normative implications for legal and popular debates over corporate governance, because it suggests that maximizing shareholder wealth should not be the principal goal of corporate law. Rather, directors of public corporations should seek to maximize the joint welfare of all the firm's stakeholders - including shareholders, managers, employees, and possibly other groups such as creditors or the local community - who contribute firm-specific resources to corporate production.
Abstract: Contemporary corporate scholarship generally assumes that the central economic problem addressed by corporation law is getting managers and directors to act as loyal agents for shareholders. We take issue with this approach and argue that the unique legal rules governing publicly-held corporations are instead designed primarily to address a different problem -- the "team production" problem -- that arises when a number of individuals must invest firm-specific resources to produce a nonseparable output. In such situations team members may find it difficult or impossible to draft explicit contracts distributing the output of their joint efforts, and, as an alternative, might prefer to give up control over their enterprise to an independent third party charged with representing the team's interests and allocating rewards among team members. Thus we argue that the essential economic function of the public corporation is not to address principal-agent problems, but to provide a vehicle through which shareholders, creditors, executives, rank-and-file employees, and other potential corporate "stakeholders" who may invest firm-specific resources can, for their own benefit, jointly relinquish control over those resources to a board of directors. This alternative to the principal-agent approach offers to explain a variety of pivotal doctrines in corporate law that have proven difficult to explain using agency theory, including: the requirement that a public corporation be managed by a board of directors rather than by shareholders directly; the meaning and function of a corporation's "legal personality" and the rules of derivative suit procedure; the substantive structure of directors' fiduciary duties, including the application of the business judgment rule in the takeover context; and the highly-limited nature of shareholders' voting rights. The team production model also carries important normative implications for legal and popular debates over corporate governance, because it suggests that maximizing shareholder wealth should not be the principal goal of corporate law. Rather, directors of public corporations should seek to maximize the joint welfare of all the firm's stakeholders -- including shareholders, managers, employees, and possibly other groups such as creditors or the local community -- who contribute firm-specific resources to corporate production.
Abstract: Since the public corporation first evolved as a business form, there has been a lively debate over whether its proper purpose always is to maximize shareholder wealth, or whether directors sometimes can consider the interests of creditors, employees, and other corporate stakeholders. This article reviews why two of the arguments traditionally used to justify strict shareholder primacy - that shareholders own the corporation, and that shareholders are the sole residual claimants of corporations - are bad arguments, in the sense that they are demonstrably incorrect from both an economic and a legal perspective. The article then explores a third and better argument for shareholder primacy: that requiring corporate directors to serve only shareholders is the best way to keep directors from imposing excessive agency costs on firms. This agency cost argument recognizes that in an ideal world, directors would take account of the interests of both shareholders and other stakeholders. Indeed, allowing this can provide ex ante benefits to shareholders by encouraging nonshareholder groups to make firm-specific commitments to corporate team production. Nevertheless (the argument goes), a rule of strict shareholder primacy remains preferable, because it permits corporations to monitor and reward director performance according to a single easily-observed metric: stock price. While plausible in theory, the agency cost argument for strict shareholder primacy suffers from a serious weakness. In practice, the business world displays a strong revealed preference for corporate governance rules that grant directors discretion to serve stakeholder groups, even at shareholders' ex post expense. What's more, this pattern is observed when firms are first incorporated and brought public, a time when corporate promoters have every incentive to cater to shareholder interests. Such observations suggest that business participants believe the ex ante benefits of allowing directors to consider stakeholder interests outweigh the ex post harms in terms of greater agency costs. They also raise serious questions about the empirical strength of the agency cost argument for ex post shareholder primacy.
shareholder primacy, agency costs
Abstract: Corporate law and scholarship generally assume that public corporations are controlled by professional managers, while shareholders play only a weak and passive role. As a result, corporate officers and directors are understood to be subject to extensive fiduciary duties, while shareholders traditionally have been thought to have far more limited obligations. Outside the contexts of controlling shareholders and closely-held firms, many experts argue shareholders have no duties at all. The most important trend in corporate governance today, however, is the move toward shareholder democracy. Changes in financial markets, in business practice, and in corporate law have given minority shareholders in public companies greater power than they have ever enjoyed before. Activist investors, especially rapidly-growing hedge funds, are using this new power to pressure managers into pursuing corporate transactions ranging from share repurchases, to special dividends, to the sale of assets or even the entire firm. In many cases these transactions uniquely benefit the activist while failing to benefit, or even harming, the firm and other shareholders. This article argues that greater shareholder power should be coupled with greater shareholder responsibility. In particular, it argues that the rules of fiduciary duty traditionally applied to officers and directors and, more rarely, to controlling shareholders, should be applied to activist minority investors as well. This proposal may seem a radical expansion of fiduciary doctrine. Nevertheless, the foundations of an expanded shareholder duty have been laid in existing case law. Moreover, there is no reason to believe that newly-empowered activist shareholders are immune to the forces of greed and self-interest widely understood to tempt corporate officers and directors. Corporate law can, and should, adapt to this reality.
Public Corporations, shareholder responsibilities, corporate governance, activist investors, corporate transactions
Abstract: One of the most pressing questions facing both corporate scholars and businesspeople today is the question of how corporate directors can be made accountable. Before addressing this issue, however, it seems important to consider two antecedent questions: To whom should directors be accountable? And for what? Contemporary corporate scholarship often starts from a "shareholder primacy" perspective that holds that directors of public corporations ought to be accountable only to the shareholders, and ought to be accountable only for maximizing the value of the shareholders' shares. This perspective rests on the conventional contractarian assumption that the shareholders are the sole residual claimants and risk bearers in a public firm. More recent work in economics suggests, however, that this assumption is false. In particular, options theory and the growing literature on the contracting difficulties associated with firm-specific investment both support the claim that a wide variety of groups are likely to bear significant residual risk and enjoy significant residual claims on firm earnings. These groups include not only shareholders, but also creditors, managers, and employees. Thus economic efficiency may be best served not by requiring corporate directors to focus solely on shareholders' interests, but by requiring them instead to maximize the sum of all the interests held by all the groups that bear residual risks and hold residual claims. In accord with this view, we argue that corporate directors ought to be viewed not as "agents" who serve only the shareholders, but as "mediating hierarchs" who enjoy ultimate control over the firm's assets and outputs and who are charged with the task of balancing the sometimes conflicting claims and interests of the many different groups that bear residual risk and have residual claims on the firm. This mediating model of the board's role offers to explain a variety of important doctrines in U.S. law that preserve director autonomy and insulate the board from the command and control of the shareholders or indeed any other group. At the same time, the mediating model raises the question of why directors who are largely insulated from outside pressures should be expected to do a good job of running the firm. We suggest that answers to this question are available, but only if we are willing to look beyond the homo economicus model of rationally selfish behavior commonly employed in economic analysis and to consider as well the extensive empirical evidence in the social sciences literature on the phenomenon of intrinsically trustworthy, other-regarding behavior. We briefly explore how this literature both supports the claim that directors may behave trustworthily even when they do not have explicit incentive to do so, and suggests some of the circumstances that are likely to promote accountable director behavior.
Abstract: Recent reports of massive accounting frauds at some of the nation's largest and most respected companies have provoked calls from policymakers and business leaders for market reforms to shore up investor confidence. Nevertheless, the phenomenon of investor confidence has received relatively little formal study. Current legal scholarship tends to assume, with little discussion, that investors have "confidence" when they have information that assures them that the incentives provided by the law and by the markets are adequate to constrain corporate insiders and securities professionals from shirking, stealing, and other forms of opportunistic behavior. This "rational expectations" approach also implies that, in the absence of such assurance, investors protect themselves from others' opportunism by refusing to invest in the market in the first place. This article argues that the phenomenon of investor confidence can be understood far better if we assume not that investors have rational expectations, but that they have what economists call "adaptive expectations". Individuals with rational expectations predict others' behavior by focusing on their external incentives and constraints. In contrast, individuals with adaptive expectations predict others' behavior (including possibly the behavior of such an abstract "other" as the stock market) by extrapolating from the past. Adaptive expectations consequently permit trust, meaning a belief that another will behave in a cooperative and trustworthy fashion simply because he or she has behaved trustworthily and cooperatively in the past. The article argues that there is substantial reason to believe that adaptive expectations-based trust is essential to a well-developed public securities market. It reviews experimental studies that shed light on how trust can be developed and how it can be destroyed. Finally, it considers some of the policy implications that flow from an adaptive expectations model of investor confidence. One of the most important is that trust may be subject to "history effects." If an individual or institution has behaved cooperatively in the past, trusting investors tend to assume that that institution or individual will behave cooperatively in the future - even if incentives change so that cooperation is no longer advantageous. Conversely, trust that has been abused tends to disappear, and it can be slow to return even when the problems that led to its abuse have been corrected. This second observation carries pessimistic implications for lawmakers' ability to restore investor confidence quickly through legal reforms after that confidence has been eroded.
Investor confidence, trust, securities
Abstract: During the 1970s and early 1980s, the Efficient Capital Market Hypothesis (ECMH) became one of the most widely-accepted and influential ideas in finance economics. More recently, however, the idea of market efficiency has fallen into disrepute as a result of market events and growing empirical evidence of inefficiencies. This essay argues that the weaknesses of the efficient market theory are, and were, apparent from a careful inspection of its initial premises, including the presumptions of homogeneous investor expectations, effective arbitrage, and investor rationality. By the same token, a wide range of market phenomena inconsistent with the ECHM can be explained using market models that modify these three assumptions. In illustration, this Article explores three important strands of today's finance literature: (1) the expanding body of work on asset pricing when investors have heterogeneous expectations; (2) recent theoretical and empirical scholarship on how and why arbitrage may move certain types of publicly available information into price more slowly and incompletely than earlier writings suggested; and (3) the exploding literature in behavioral finance, which examines what happens to prices when market participants do not all share rational expectations. Taken together, these three bodies of work show signs of providing the essential framework on which a new and more powerful working model of securities markets can be built.
market efficiency, behavioral finance
Abstract: One of the most important questions in corporate governance is how directors of public corporations can be motivated to serve the interests of the firm. Directors frequently hold only small stakes in the companies they manage. Moreover, a variety of legal rules and contractual arrangements insulate them from liability for business failures. Why then should we expect them to do a good job? Conventional corporate scholarship has great difficulty wrestling with this question, in large part because conventional scholarship usually adopts the economist's assumption that directors are rational actors motivated purely by self-interest. This homo economicus model of behavior may be fundamentally misleading when applied to corporate directors. The institution of the corporate board is premised on the expectation, and the experience, of director altruism, in the form of a sense of obligation to the firm and its shareholders. As a result, to properly understand the role and conduct of corporate directors, we must take into account the empirical phenomenon of altruism. One potential starting point for such a project can be found in the extensive evidence that has been developed over the past four decades on altruism among strangers in experimental games. This evidence demonstrates that altruistic behavior is in fact quite common. More important, it is predictable. A variety of factors can reliably increase, or decrease, the incidence of altruism observed in experimental games. These results may offer a foundation for building a model of human behavior that is both more accurate and more useful than the homo economicus model. They also carry important implications for how we select, educate, regulate, and compensate corporate directors.
Corporate directors
Abstract: One of the most important questions in corporate governance is how directors of public corporations can be motivated to serve the interests of the firm. Directors frequently hold only small stakes in the companies they manage. Moreover, a variety of legal rules and contractual arrangements insulate them from liability for business failures. Why then should we expect them to do a good job? Conventional corporate scholarship has great difficulty wrestling with this question, in large part because conventional scholarship usually adopts the economist's assumption that directors are rational actors motivated purely by self-interest. This homo economicus model of behavior may be fundamentally misleading when applied to corporate directors. The institution of the corporate board is premised on the expectation, and the experience, of director altruism, in the form of a sense of obligation to the firm and its shareholders. As a result, to properly understand the role and conduct of corporate directors, we must take account of the empirical phenomenon of other-regarding behavior. One potential starting point for such a project can be found in the extensive evidence that has been developed over the past four decades on other-regarding behavior among strangers in experimental games. This evidence demonstrates that cooperative, altruistic behavior is in fact quite common. More important, it is predictable. A variety of factors can reliably increase, or decrease, the incidence of cooperation observed in experimental games. These results may offer a foundation for building a model of human behavior that is both more accurate and more useful than the homo economicus model. They also carry important implications for how we select, educate, regulate, and compensate corporate directors.
corporate governance, corporate directors, public firms
Abstract: Legal experts traditionally distinguish corporations from unincorporated business forms by focusing on such corporate characteristics as limited shareholder liability, centralized management, perpetual life, and freely transferred shares. While this approach has value, this essay argues that the nature of the corporation can be better understood by focusing on a fifth, often-overlooked, characteristic of corporations: their capacity to lock in equity investors' initial capital contributions by making it far more difficult for those investors to subsequently withdraw assets from the firm. Like a tar pit, a corporation is much easier for equity investors to get into, than to get out of. An emerging school of theorists has begun to explore the implications of this idea for corporate law and practice. The idea is still novel enough to lack a uniformly-accepted label - in addition to the phrase capital lock-in, scholars have described this aspect of incorporation as affirmative asset partitioning, the absence of a repurchase condition, and asset separation from shareholders. Whatever label one chooses, the idea shows great promise for illuminating a variety of thorny problems that have long troubled corporate scholars and practitioners. In illustration, this essay considers how the idea of capital lock-in sheds light on three corporate mysteries: the sui generis nature of corporate directors' fiduciary duties; the rise of the large modern service partnership; and lawmakers' enthusiasm for meddling with corporate governance rules.
corporations, capital lock-in, corporate directors
Abstract: By the early 1980s, the Efficient Capital Market Hypothesis (ECMH) had become one of the most widely-accepted and influential ideas in finance. More recently the idea of market efficiency has fallen into disrepute as a result of market events and growing empirical evidence of inefficiencies. This article, which is extracted from a longer essay, argues that the weaknesses of efficient market theory are and were apparent from inspection of its initial premises, including the presumptions of homogeneous investor expectations, effective arbitrage, and investor rationality. By the same token, a wide range of phenomena inconsistent with the ECMH can be explained using market models that modify these three assumptions. To illustrate, this article explores three important strands of today's finance literature: (1) work on asset pricing when investors have heterogeneous expectations; (2) scholarship on how and why arbitrage may move public information into prices more slowly and incompletely than earlier writings suggested; and (3) the exploding literature in "behavioral finance." Taken together, these literatures provide the framework for building a new and more powerful working model of securities markets.
Efficient Capital Market Hypothesis (ECMH)
Abstract: For the past two decades, legal and economic scholarship has tended to assume that the central economic problem addressed by corporation law is getting managers and directors to act as faithful agents for shareholders. There are other important economic problems faced by business firms, however. This article introduces a Symposium that explores one of those alternate economic problems: the problem of "team production". Team production problems can arise whenever three conditions are met: (1) economic production requires the combined inputs of two or more individuals; (2) at least some of these inputs are "team-specific," meaning they have a significantly higher value when used in the team than in their next best use; and (3) the gains resulting from team production are nonseparable, making it difficult to attribute any particular portion to any single team member's contribution. In such situations, it can be difficult or impossible for team members to draft explicit contracts that protect their team-specific investments from other team members' opportunism. Thus the nine articles in the Symposium explore the implications of team production analysis for a wide variety of business organizations, including public corporations, private companies, multinational firms, and venture capital firms.
Abstract: For the past two decades, legal and economic scholarship has tended to assume that the central economic problem addressed by corporation law is getting managers and directors to act as faithful agents for shareholders. There are other important economic problems faced by business firms, however. This article introduces a Symposium that explores one of those alternate economic problems: the problem of "team production". Team production problems can arise whenever three conditions are met: (1) economic production requires the combined inputs of two or more individuals; (2) at least some of these inputs are "team-specific," meaning they have a significantly higher value when used in the team than in their next best use; and (3) the gains resulting from team production are nonseparable, making it difficult to attribute any particular portion to any single team member?s contribution. In such situations, it can be difficult or impossible for team members to draft explicit contracts that protect their team-specific investments from other team members? opportunism. Thus the nine articles in the Symposium explore the implications of team production analysis for a wide variety of business organizations, including public corporations, private companies, multinational firms, and venture capital firms.
Abstract: In 'The Myth of the Shareholder Franchise', Professor Lucian Bebchuk argues that the notion that shareholders in public corporations can remove directors is a myth. The same argument was made by Berle and Means in 1932. Not only is shareholder power to remove directors largely a myth in U.S. public companies, it has been widely recognized as a myth for three-quarters of a century. What should we conclude from this? Professor Bebchuk concludes the time has come to make shareholder power a reality. But there are many myths - vampires, alligators in the sewers - we would not want to make real. Part I of this Response to Professor Bebchuk's article argues that we should not want to make shareholder power to oust directors more real because, while board control worsens agency costs, it offers important economic benefits to shareholders as well. In particular, board control promotes efficient and informed decisionmaking; discourages intershareholder opportunism; and encourages valuable specific investment in corporate team production. Because board control has costs and benefits, theory cannot tell us whether we should make it easier for shareholders to oust directors. We must look to the evidence. Part II concludes the evidence does not support Bebchuk's proposal. To the contrary, it suggests shareholders in public firms reap net benefits from board control. Why then do so many observers believe shareholders need more power over boards? Part III argues that calls for shareholder democracy appeal to the media and many observers not because they are based on evidence, but because of emotion. The emotional appeal of shareholder power can be traced to three sources; the common but misleading metaphor that shareholders own corporations; the opportunistic calls of activists seeking leverage over boards for self-interested reasons; and a strong but unfocused sense that something (anything!) should be done in the wake of recent corporate scandals. The result has been widespread propagation of a second myth - the myth that shareholder control of public companies benefits shareholders. The Response concludes by reminding readers of the dangers of policymaking based on myth rather than evidence, using the cautionary case of stock options.
corporate governance, shareholder control, board of directors, public corporations
Abstract: The business judgment rule is one of the most puzzling and widely-criticized doctrines in corporate law. As described in Smith v. Van Gorkom, the rule prohibits courts from second-guessing the wisdom of disinterested corporate directors' substantive decisions. Instead, courts may consider only the quality of the boards' decisionmaking process and particularly whether the board "informed" itself before taking action. This focus on procedure seems dysfunctional from a rational choice perspective. If directors are rational and self-interested actors, imposing liability on them for following shoddy procedures does not in itself give them incentive to exercise due care. It only gives them incentive to adopt more elaborate, and more expensive, procedures. In this essay I argue that the business judgment rule can be understood if we are willing to modify the "homo economicus" model of human behavior that underlies rational choice analysis to take account of the reality of socially contingent altruism. Extensive empirical evidence demonstrates that altruistic behavior is both a common and a predictable phenomenon. In particular, numerous studies of behavior in experimental social dilemma games demonstrate that altruism is easily triggered by social context (e.g., subjects' beliefs regarding others' needs, expectations, or behavior). These studies also demonstrate, however, that altruistic behavior tends to diminish as the personal sacrifice involved increases. This last finding suggests that the business judgment rule can be best understood as a mechanism for encouraging director altruism, in the form of a sense of obligation to the firm and its shareholders, by reducing the marginal personal costs associated with altruistic director behavior. In particular, I argue that the rule (1) reduces directors' marginal "cost of comprehending" what is going on at the firm and what the likely consequences of alternative courses of action might be, and (2) reduces directors' marginal "cost of confronting" the firm's managers to demand more information or to challenge a management-recommended course of action. The result is that the business judgment rule's procedural focus may provide an elegant, second-best solution to the problem of encouraging director care in situations where courts cannot assess the substantive wisdom of directors' decisions.
Abstract: Academics have generated a large empirical literature examining whether antitakeover defenses like poison pills or staggered board provisions decrease the wealth of shareholders in target corporations. Many studies, however, rely primarily on ex post analysis - they consider only how antitakeover defenses (ATDs) influence shareholder wealth after the corporation has been formed and, in some cases, long after the ATD was adopted. This article argues that it may be impossible to fully understand the purpose or effects of ATDs without also considering their ex ante effects. In particular, ATDs may increase net target shareholder wealth ex ante if they encourage nonshareholder groups to make extracontractual investments in corporate team production. The article reviews recent empirical evidence suggesting that shareholders do in fact perceive ATDs as beneficial ex ante. It also explores some implications for contemporary corporate scholarship and the attempt to measure the effects of antitakeover rules.
Abstract: This essay explores the feasibility of exporting U.S.-style corporate fiduciary duty rules to other nations. It suggests that fiduciary duty rules are best understood as open-ended standards of behavior that exhort corporate officers, directors, and controlling shareholders to focus on the firm's interests rather than their own, in circumstances where a failure to do this often would be difficult to punish. Put differently, fiduciary rules ask corporate insiders to show altruistic concern for the firm and its shareholders. Extensive empirical evidence demonstrates that altruistic behavior is in fact common, predictable, and reliable among U.S. subjects. However, a recent study also reports significant cross-cultural differences in altruistic behavior. The essay explores some possible sources of such cross-cultural differences, and what each implies about the challenges to be faced in transplanting fiduciary duty rules to other societies. In the process, it offers insight into the phenomenon often described as "culture".
Abstract: Legal scholars have become keenly interested in behavioral approaches to law that recognize that real people do not always behave in a rationally selfish fashion. For example, numerous recent papers examine how human choice can be distorted by endowment effects, anchoring effects, availability biases, and other cognitive deficiencies. There is a curious imbalance to this "behavioral law and economics" literature, however. Contemporary critiques of the rational selfishness model of human behavior tend to focus far more on the first modifier - the assumption of rationality - than on second - the assumption of self interest. This essay reverses that emphasis. It argues that the human tendency to act in an other-regarding fashion (to sacrifice in order to help or harm others) is far more pervasive, powerful, and important than generally recognized. In support of this claim, it reviews the extensive empirical evidence that has been accumulated over the past four decades on human behavior in social dilemma games, ultimatum games, and dictator games. This evidence establishes that in the right circumstances, experimental subjects routinely behave as if they care about costs and benefits to others. (In the parlance of economics, their behavior "reveals" other-regarding preferences.) Moreover, subjects' decisions to act in an other-regarding fashion seem driven primarily not by their own payoffs but by social context - their perceptions of what others believe, what others expect, and how others are likely to behave. These findings are important not only to our understanding of individual behavior, but also to our understanding of a wide variety of social institutions. To illustrate, this essay considers how the reality of socially-contingent, other-regarding behavior may offer insight into the nature and workings of social norms. In particular, it considers how the phenomenon of other-regarding preferences sheds light on a variety of questions that have been debated in the norms literature. These include the questions of what sorts of behaviors are most likely to solidify into norms; why people follow norms; and how policymakers and other "norm entrepreneurs" can best use norms to change behavior.
Abstract: Among non-experts, conventional wisdom holds that corporate law requires boards of directors to maximize shareholder wealth. This common but mistaken belief is almost invariably supported by reference to the Michigan Supreme Court's 1919 opinion in Dodge v. Ford Motor Co. This Essay argues that Dodge v. Ford is bad law, at least when cited for the proposition that maximizing shareholder wealth is the proper corporate purpose. As a positive matter, U.S. corporate law does not and never has imposed a legal obligation on directors to maximize shareholder wealth. From a normative perspective, options theory, team production theory, the problem of external costs, and differences in shareholder interests all suggest why a rule of shareholder wealth maximization would be bad policy and lead to inefficient results. Courts accordingly treat Dodge v. Ford as a dead letter. (In the past three decades the Delaware courts have cited the case only once, and then on controlling shareholders' duties to minority shareholders). Nevertheless, legal scholars continue to teach and cite it. This Essay suggests that Dodge v. Ford has achieved a privileged position in the legal canon not because it accurately captures the law - it does not - or because it provides good normative guidance - it does not - but because it serves professors' need for a simple answer to the question, What do corporations do? Simplicity is not a virtue when it leads to misunderstanding, however. Law professors should mend their collective ways, and stop teaching Dodge v. Ford as anything more than an example of how courts can go astray.
Dodge vs Ford, nature of corporations, shareholder weath
Abstract: A rise in the price of a company's stock is commonly believed to signal an equivalent rise in both the value of the company and in aggregate social wealth. This belief can be traced to three influential ideas in modern finance: the Efficient Capital Market Hypothesis (ECMH), the Capital Asset Pricing Model (CAPM), and what might be called the principal-agent or shareholder primacy model of the firm. In the decades since these ideas were first developed, scholars have produced an extensive body of theoretical and empirical work that revises, extends, and in some cases challenges them. This article reviews some of that work and concludes that the relationship between stock prices and social wealth is far more indirect and complex than generally understood, even if investors are assumed to be rational. It offers examples of a variety of situations in which stock prices predictably will fail to capture corporate value and suggests a research agenda for developing more accurate means of measuring the corporate sector's capacity to generate social wealth.
Abstract: This essay has two goals: to praise Professor Robert Clark as a remarkable corporate scholar, and to explore how his work has helped to advance our understanding of corporations and corporate law. Clark wrote his classic treatise at a time when corporate scholarship was dominated by a principal-agent paradigm that viewed shareholders as the principals or sole residual claimants in public corporations and treated directors as shareholders' agents. This view naturally led contemporary scholars to assume the chief economic problem of interest in corporate law was the "agency cost" problem of getting corporate directors to do what shareholders wanted them to do (presumably, to maximize share value). Clark's treatise in some ways adopted this perspective. It also, however, carefully noted important but anomalous aspects of corporate law that the principal-agent model could not explain, including directors' extensive and sui generis legal powers; the fact that directors control dividends; the device of legal personality; and the open-ended rules of corporate purpose. Today, economic and legal scholars have begun to move beyond agency costs and to focus attention on a second economic problem that arises in public corporations: protecting specific investment. When corporate production requires more than one individual or group to make specific investments, problems of intrafirm opportunism arise as shareholders try to exploit each other and try as well to exploit creditors, employees, customers, and other groups that make specific investments. Board authority, while worsening agency costs, may provide a second-best solution to such intrafirm rent-seeking. This perspective can explain the important corporate law anomalies Clark described. Because Clark wrote his treatise at a time when the principal-agent paradigm was ascendant, he could not himself easily explain the anomalies he carefully noted. His treatise nevertheless showed both remarkable insight and remarkable honesty in discussing them. As result Clark played an important role in drawing scholars' attention to the limitations of the principal-agent model and in spurring them to explore alternatives. His treatise remains one of the best available starting points for the reader who wants an accurate portrait of the structure of corporate law.
corporate law, principal-agent, agency costs, boards of directors, legal personality, specific investment, law and economics, scientific revolutions, nexus of contracts, shareholder wealth maximization, residual claimants, theory of the firm, capital lock-in, shareholder primacy, team production
Abstract: Academics, reformers, and business leaders all yearn for a single, objective, easy-to-read measure of corporate performance that can be used to judge the quality of public corporation law and practice. This collective desire is so powerful that it has led many commentators to grab onto the first marginally plausible candidate: share price. Contemporary economic and corporate theory (as well as recent business history) nevertheless warn us against unthinking acceptance of share price as a measure of corporate performance. This Essay offers a brief reminder of some of the many reasons why stock prices often fail to reflect true corporate performance, including the problem of private information; obstacles to effective arbitrage; investors' cognitive defects and biases; options theory and the problem of multiple residual claimants; and the problem of corporate spillover effects that erode diversified shareholders' returns. These considerations argue against assuming there is a tight connection between stock prices and underlying corporate wealth generation. A corporation or a corporate law system designed around the philosophy that anything that raises share price is good is likely to produce a firm that cooks its books; that avoids long-term projects that won't appeal to unsophisticated investors; that chases after investment fads and fancies; that tries to opportunistically exploit creditors, employees, and customers; and that pursues business strategies that harm its diversified shareholders' other investment interests. The Essay concludes that, if we allow our desire for a universal performance measure to blind us to the fallibility of share price, we court costly error. The Essay examines three recent examples of just such erroneous triumphs of hope over experience: the rise and fall of the Revlon doctrine; the 1990s infatuation with options-based executive compensation; and academics' current preoccupation with event studies, regressions on Tobin's Q, and other forms of empirical scholarship that attempt to judge the quality of corporate law and practice according to changes in share price.
corporate performance
Abstract: Why do investors in public corporations cede control over corporate assets and outputs to a board of directors, rather than retaining control for themselves? This Article reviews two possible explanations for why shareholders tolerate board control: the monitoring hypothesis, which posits that shareholders rely on boards primarily to control the "agency costs" associated with turning day-to-day control over the firm to self-interested corporate executives; and the mediating hypothesis, which posits that shareholders also seek to "tie their own hands" by ceding control to directors as a means of attracting the extracontractual, firm-specific investments of stakeholder groups such as creditors, executives, and employees. Part I of the Article reviews each hypothesis and concludes that each is theoretically plausible and internally consistent. As a result, the validity of each only can be established, or rejected, on the basis of empirical evidence. Part II of the Article reviews the available empirical evidence. Many aspects of contemporary corporate law and governance seem, on first inspection, consistent with either the monitoring or the mediating model. In the context of corporate control transactions, however, it is possible to distinguish between legal rules and governance structures consistent with a purely monitoring board, and rules and structures consistent with a mediating board. Part II concludes that, as a positive matter, corporate takeover law is consistent with the view that directors are not just monitors, but also perform a mediating function. Recognizing this, commentators who subscribe only to the monitoring model often argue that the legal rules that govern changes of control are flawed and should be reformed. Part II demonstrates, however, that this normative claim is undermined by other empirical evidence, especially new evidence on the charter provisions of firms involved in initial public offerings. Part III of the Article discusses some future directions for empirical research and identifies some pitfalls to be avoided. It concludes that, while the issue has not been resolved with certainty, at this point the empirical evidence favors the claim that directors do more than simply restrain executive opportunism; they also restrain shareholder opportunism, and so mediate between the firm's shareholders and other important constituencies that make extracontractual specific investments in the firm. What's more, shareholders favor this arrangement. Accordingly, the burden of proof should shift to those who would defend a purely monitoring model of the board.
Board of directors, corporate assets, governance structures, shareholders
Abstract: In 1979 Martin Lipton published an essay arguing that corporate law gives directors and not shareholders the authority to decide whether a company should sell itself at a premium, and that this is a good arrangement for both shareholders and society. After years of vocal disagreement many academics are starting to suspect that Martin Lipton was right. Much of the academic hostility that initially greeted Lipton's claim was based on two important ideas in finance economics: efficient market theory and the "principal-agent" model of the public corporation. Scholars recently have begun to examine each of these ideas more closely. Neither is holding up especially well. New theories are being developed to explain important aspects of securities markets and corporate law that cannot be explained by efficient market theory and the principal-agent model. These new theories suggest the practitioner may have been correct: maximizing share price is not always in the best interest of society, the firm, or the shareholders themselves.
efficient market theory, principal-agent model of the public corporation, Martin Lipton, share price, shareholders, board of directors
Abstract: At the close of the twentieth century, U.S. corporate scholarship was dominated by a principal-agent paradigm that assumed that shareholders were the principals or sole residual claimants in public corporations, and also assumed that corporate directors were the shareholders' agents. This approach led many corporate scholars to assume that the proper purpose of the corporation was to maximize shareholder wealth and that the chief economic problem of interest in corporate law was the agency cost problem of getting corporate directors to focus on this goal. There are basic aspects of U.S. corporate law, however, that the principal-agent model cannot explain. These include directors' extensive and sui generis legal powers; the fact that directors control dividends; the device of legal personality; and the open-ended rules of corporate purpose. These corporate law anomalies have prompted contemporary economic and legal scholars to begin to move beyond a focus on agency costs and to pay attention to a second economic problem that arises in public corporations: the problem of protecting specific investment. When corporate production requires more than one individual or group to make specific investments, problems of intrafirm opportunism arise if shareholders try to exploit each other's specific investments or try to exploit the specific investments of creditors, employees, customers, and other groups. Board governance, while worsening agency costs, may provide a second-best solution to such intrafirm rent-seeking. This perspective explains many important corporate law anomalies that cannot be explained by the principal agent model. It also suggests a pressing need to revisit conventional notions of corporate purpose. Focusing on the problem of specific investment suggests that the proper purpose of the public corporation is not maximizing shareholder wealth, but promoting long-term, value-creating economic production under conditions of complexity and uncertainty, in a fashion that provides surplus benefits not only to shareholders but to other groups that make specific investments in corporations as well. This corporate objective is difficult to measure, much less maximize. Nevertheless, it may provide a better gauge of good corporate governance than the simplistic rubric of shareholder wealth.
Abstract: Rational choice analysis generally assumes that most people are both rational and selfish. Although self-interest is sometimes defined in a broad and tautological fashion to include a taste for altruism or ethics, most rational choice analyses implicitly equate self-interest with maximizing personal payoffs. This homo economicus approach is widely employed in part because it is so tractable: selfish behavior is easy to predict and model mathematically. There is a second important reason, however, why the homo economicus account is so widely accepted. In brief, people tend not to notice unselfish behavior. As a result they mistakenly view the homo economicus account as a good description of how most people behave most of the time. The tendency to overlook unselfish behavior can be illustrated using a simple example. Imagine that you see a dozen pedestrians walk by a sleeping homeless man who is lying next to a sign that reads, "Please Help" and a cup that contains a few dollar bills. Many people might conclude they are observing selfish behavior when no one puts any money in the cup. Few would recognize that they are witnessing multiple acts of unselfishness as person after person walks by without stealing from the helpless homeless man. This essay, prepared as a chapter for a book on free enterprise and values, argues that we should take conscience far more seriously. It explores how numerous influences work together to blind us to unselfish, conscience-driven behavior, even though it occurs repeatedly under our noses every day. These influences include certain ambiguities in the English language; cognitive biases that cause us to fixate our attention on selfish behavior while overlooking unselfishness; the common correlation between external legal, market and reputation sanctions and the internal sanctions of conscience; the belief that altruism cannot survive Darwinian pressures; and the possibility that studying certain fields, including law, economics, and business, can distort perceptions of the incidence of selfishness. Taken together, these factors conspire to make the homo economicus account appear more accurate and reliable than it actually is. They also blind us to the power and pervasiveness of conscience.
Abstract: When credit markets froze up in the fall of 2008, many economists pronounced the crisis both inexplicable and unforeseeable. That’s because they were economists, not lawyers. Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, understood what went wrong. (Some even predicted it.) That’s because the roots of the catastrophe lay not in changes in the markets, but changes in the law. Perhaps the most important of those changes was the U.S. Congress’s decision to deregulate financial derivatives with the Commodity Futures Modernization Act (CFMA) of 2000. Prior to 2000, off-exchange derivatives contracts were subject to a common-law rule called the “rule against difference contracts” that treated derivative contracts that could not be proven to hedge against a real position in the underlying asset as legally unenforceable wagering contracts. Speculative wagers on prices could only be safely made on regulated exchanges. Congress overturned this centuries-old rule in 2000, making it legal for hedge funds, banks and insurance companies to use derivatives for speculative gambling, not just for true hedging. This led to the collapse of AIG and the 2008 credit crisis.
financial regulation, credit markets, Commodity Futures Modernization Act (CFMA) of 2000, derivatives regulation
Abstract: Many formal discussions of judicial behavior employ a rational choice framework that presumes that judges are rational actors concerned only with improving their own welfare. This essay, prepared as the 2001 George P. Wythe Lecture at the William & Mary School of Law, suggests it may be both inappropriate and misleading to focus exclusively on self-interest as a judicial motivation. The social institution of the judiciary is premised on the expectation of a certain amount of judicial "altruism," in the form of a willingness to devote significant effort to deciding cases impartially and according to law even when external punishments and rewards are largely absent. This expectation rests on a solid empirical foundation: social scientists have compiled extensive evidence demonstrating that other-regarding behavior, including altruistic behavior, is both a common and a predictable phenomenon. As a result there may be much to be gained from formally incorporating the reality of other-regarding behavior into our accounts of the judiciary. As a first step in that direction, the essay reviews some of the voluminous evidence that has been compiled on when and why people display altruistic behavior in experimental games. It explores some implications for how we might better encourage judges largely insulated from external pressures to nevertheless decide cases carefully, impartially, and well.
Abstract: Contemporary legal scholars have become keenly interested in behavioral approaches to law that recognize that real people do not always behave in a rationally selfish fashion. For example, numerous recent papers examine how human choice can be distorted by endowment effects, anchoring effects, availability biases, and other cognitive deficiencies. There is a curious imbalance to the modern "behavioral law and economics" literature, however. In brief, critiques of the rational selfishness model tend to focus far more on the first modifier - the assumption of rationality - than on second - the assumption of self interest. This book chapter reverses the emphasis. It argues that the human tendency to act in an other-regarding fashion (that is, to sacrifice to help or harm others) is far more pervasive, powerful, and important than is generally recognized. In support of this claim, the chapter reviews the extensive empirical evidence that has been accumulated over the past four decades on human behavior in social dilemma games, ultimatum games and dictator games. In the right circumstances, experimental subjects routinely behave as if they care about costs and benefits to others. In the parlance of economics, subjects "reveal" other-regarding preferences. Moreover, the decision to act in an other-regarding fashion seems mostly driven not by personal payoffs but by social context - perceptions of what others believe, what others expect, and how others are likely to behave. These empirical findings are important not only to our understanding of individual behavior but also to our understanding of a wide variety of social institutions. To illustrate, the chapter considers how the phenomenon of other-regarding preferences may offer insight into the nature and workings of social norms. In particular, it considers how other-regarding preferences may shed light on a variety of questions that have long troubled the norms literature, including the questions of what sorts of behaviors are most likely to solidify into norms, why people follow norms, and how policymakers and "norm entrepreneurs" can best use norms to change behavior.
behavioral approaches to law, rational selfishness, social norms, other-regarding preferences
Abstract: Several commentators, most notably Harvard law professor Lucian Bebchuk, have called for greater shareholder control over public firms. Yet an extensive academic literature suggests that shareholders enjoy net benefits from board governance. Why, then, do so many observers believe shareholders should be given greater influence over boards?
The Mythical Benefit of Shareholder Control, Lucian Bebchuk, shareholder control, public firms, board governance, advantages, decision making, accountability, inter-shareholder opportunism, team production, shareholder ownership, shareholder democracy, ENRON, ENRON effect
Abstract: Computer network technology promises to revolutionize the secondary securities market and particularly to reduce dramatically the marginal costs associated with trading corporate equities. Lowering transactions costs usually is presumed to increase trader welfare. Certain unique characteristics of the secondary securities market suggest, however, that reducing the marginal costs associated with trading stocks may have the perverse and counterintuitive effect of decreasing investor welfare. Policymakers should consider this possibility as they respond to the market's rapid evolution.
Abstract: Computer network technology promises to revolutionize the secondary securities market and particularly to reduce dramatically the marginal costs associated with trading corporate equities. Lowering the transactions costs usually is presumed to increase trader welfare. Certain unique characteristics of the secondary securities market suggest, however, that reducing the marginal costs associated with trading stocks may have the perverse ad counterintuitive effect of decreasing investor welfare. Policymakers should consider this possibility as they respond to the market's rapid evolution.
Abstract: Evidence is accumulating that in making investment decisions, many investors do not employ a 'rational expectations' approach in which they anticipate others’ future behavior by analyzing their incentives and constraints. Rather, many investors rely on trust. Indeed, trust may be essential to a well-developed securities market. A growing empirical literature investigates why and when people trust, and this literature offers several useful lessons. In particular, most people seem surprisingly willing to trust other people, and even institutions like 'the market,' in novel situations. Trust behavior, however, is subject to history effects. When trust is not met by trustworthiness but instead is abused, trust tends to disappear. These lessons carry significant implications for our understanding of modern securities markets.
market investing, securities markets, investing behavior, market expectations
Abstract: As a result of the current financial crisis, there have been many calls for strict new regulation of over-the-counter financial derivatives. This paper proposes, instead, that we return to the now-voided common law on derivatives and consider them non-legally enforceable gambling contracts except when one of the parties can prove a bona fide hedging purpose. Doing this would not outlaw derivatives, but would instead require the rise of private institutions to enforce and control them, and would discourage their use for wild speculation. The paper includes appended comments from Jean Helwege (Penn State University), Peter Wallison (American Enterprise Institute), and Craig Pirrong (University of Houston), as well as a response from the author.
OTC derivatives, derivatives, Irwin v. Williar, CDS, speculation, Commodities Futures Modernization Act
Abstract: Each man takes care that his neighbor shall not cheat him. But a day comes when he begins to care that he does not cheat his neighbor. Then all goes well -- he has changed his market-cart into a chariot of the sun. -Ralph Waldo Emerson The rule of law is essential to peace and economic growth. Unselfish behavior, in turn, may be essential to maintaining rule of law. Indeed, there is substantial empirical evidence to suggest that cultural habits of unselfish, prosocial behavior are correlated with economic prosperity at the national level. If this correlation reflects a causal link, the dominance of the homo economicus model in contemporary academic and policymaking circles may have serious and negative consequences for American society. Earlier Chapters developed a "three-factor" model that treats unselfish prosociality as socially-contingent behavior that responds to (1) instructions from authority; (2) perceptions that others are, or would, behave prosocially; and (3) the magnitude of the perceived benefits to others from one’s own unselfish prosocial actions. This approach suggests that widespread acceptance of the homo economicus assumption of rational self-interest can prove a "self-fulfilling prophecy" that induces people to behave more selfishly than they otherwise would - to our collective loss.
Abstract: In May of 1998, the Commodities Futures Trading Commission (CFTC) announced its intention to review whether it should regulate financial derivatives under the Commodities Exchange Act (CEA). Applying the CEA to derivatives would render much, if not most, derivatives trading illegal absent CFTC approval. The CFTC's announcement accordingly has unsettled the multi-trillion dollar derivatives industry. In response, Congress is now considering legislation that would block the CFTC from taking action by explicitly exempting financial derivatives from the CEA. This article offer insights into the impending battle over derivatives by addressing the fundamental link between derivatives and speculation. The CEA is at heart an antispeculation law, part of a network of legal doctrines dating back to the earliest days of the common law that systematically discourages speculative trading and confines it primarily to the stock market and the regulated futures exchanges. This longstanding pattern of legal hostility towards speculators appears to enjoy little support from economic theory. According to the prevailing risk hedging and information arbitrage models of speculative trading, speculation promotes economic efficiency by reducing risk and increasing the accuracy of market prices. The article argues that the apparent conflict between economic theory and legal tradition can be resolved by considering an alternative model of speculation that focuses on traders' heterogeneous expectations as a cause of trading. This heterogeneous expectations approach provides theoretical support for antispeculation laws by explaining how some forms of speculation can inefficiently increase risk, erode returns, and trigger speculative price bubbles. It also suggests an alternative to the apparently binary choice now available to lawmakers (i.e., either apply the CEA to derivatives, or exempt them). That alternative would be to permit traders to deal in OTC derivatives without the CFTC's approval under the CEA, but return to the common law rule that viewed such contracts as legally unenforceable. A heterogeneous expectations analysis suggests that this time-honored strategy, which requires traders to rely on private ordering and especially reputation to enforce their deals, may discourage welfare-reducing speculation while protecting more beneficial forms of derivatives trading. It also suggests that any proposed legislative"reform" that declares derivatives exempt under the CEA may, by resolving existing legal uncertainty about OTC derivatives' enforceability, have the undesirable and unintended consequence of increasing the incidence of welfare reducing derivatives speculation.
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