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Abstract:
This paper examines common arrangements for separating control from cash flow rights: stock pyramids, cross-ownership structures, and dual class equity structures. We describe the ways in which such arrangements enable a controlling shareholder or group to maintain a complete lock on the control of a company while holding less than a majority of the cash flow rights associated with its equity. Next, we analyze the consequences and agency costs of these arrangements. In particular, we show that they have the potential to create very large agency costs—costs that are an order of magnitude larger than those associated with controlling shareholders who hold a majority of the cash flow rights in their companies. The agency costs of these structures, we suggest, are also likely to exceed the agency costs of attending highly leveraged capital structures. Finally, we put forward an agenda for research concerning structures separating control from cash flow rights.

Pyramids, dual-class, cross-ownership, cash flow nights, votes, agency costs, corporate governance, law and finance

Abstract:
Recent scholarship has described a venture capital cycle which finances start-up technology companies. This cycle, however, bears striking similarities with its counterpart in the old economy under which banks financed young firms. Indeed, with one notable exception, venture capital has introduced little innovation in financial contract design between financial intermediaries and entrepreneurs. The same approaches to information problems are used by banks and venture capital partnerships alike. The significant exception is the frequent use in venture capital finance of convertible instruments in the place of secured debt financing by banks. This paper explains (i) the functional similarity between venture capital and bank contracts with entrepreneurs and (ii) the valuable role played by convertible debt or preferred stock in technology start-ups.

corporate governance, financial intermediation, bank lending, venture capital, convertible debt

Abstract:
Covenants not to compete (CNCs) are used in employment contracts to prevent employees from working for other employers. The legal enforcement of CNCs varies across jurisdictions in the U.S.: some states ban them (notably, California), while a majority of states enforce CNCs when they reasonably protect a legitimate interest of the employer. The discrepancy in the legal policy regarding CNCs is reflected in an academic debate over the economic efficiency of these covenants. One side argues that CNCs are bad because they restrict labor mobility; the other side argues that the restriction on the movement of workers is good because it prevents workers from appropriating their employers' human capital investments (and CNCs thereby encourage such investment). The paper addresses together the two objectives of ex post (labor mobility) and ex ante (human capital investment) efficiency. It compares CNCs with the the alternative contract breach remedies of specific performance and liquidated damages. A given CNC may be analyzed as a hybrid that adopts specific performance with respect to attempted movements to employers within its scope and liquidated damages equal to zero with respect to movements outside its scope. Among the results of the paper is the finding that, where a CNC can be renegotiated, first-best performance and first-best investment can be induced. The appropriate choice of the CNC scope can balance perfectly the overinvestment tendency of specific performance against the underinvestment effect caused by zero liquidated damages. Contracting parties, however, have the incentive to agree to excessively broad CNCs that enable them to extract rents from prospective new employers within the CNC scope. The law should be wary of this incentive in policing CNCs.

Covenant not to compete, employment, exclusive contracts

Abstract:
Economic contract theory postulates two obstacles to complete contracts: high transaction costs and high enforcement (or verification) costs. The literature has proposed how parties might solve these problems under a stylized litigation system, but it does not address the question of how parties design contracts under the existing adversarial system, that relies on the parties to establish relevant facts indirectly by the use of evidentiary proxies. We advance a theory of contract design in a world of costly litigation. We examine the efficiency of investment at the front-end and back-end of the contracting process, where we focus on litigation as the back-end stage. In deciding whether to express their obligations in specific or vague terms, contracting parties implicitly choose their allocation of costs between the front- and back-end. When the parties agree to vague terms (or standards), such as best efforts or commercial reasonableness, they delegate to the back-end the task of selecting proxies: e.g., the court selects market indicators that serve as benchmarks for performance. When the parties agree to specific terms(or rules), they invest more at the front-end to specify proxies in their contract and thereby leaving a smaller task for the enforcing court. In this Article, we explore the choice between rules and standards in terms of this tradeoff, and offer an explanation for why contracts in practice have a mix of vague and specific provisions. We then suggest that parties can achieve further contracting gains by varying procedural rules governing the prospective enforcement of their disputes. We illustrate by examining provisions in commercial contracts that allocate burdens and standards of proof. If the parties can improve the cost-effectiveness of litigation in this manner, they can reduce back-end costs. They thereby create opportunities to further lower contracting costs (or to improve the incentive gains from contracting) by shifting more investment to the back-end by increasing their use of vague terms. Vague terms have fallen into disfavor with contract theorists and this Article offers a justification for why they are nevertheless commonplace in commercial practice. Our analysis highlights the general and valuable lesson that the anticipated path of litigation is relevant to contract design.

Contract design, litigation, verifiability, rules/standards, burdens of proof

Abstract:
Contract theory typically holds that verification costs are obstacles to complete contracting; yet, real world contracts often contain provisions that seem costly to verify. We show how a costly signal can play an important role in contracts. Verification (or litigation) costs operate as a screen on the promisee's incentive to sue and as an effective sanction against the breaching promisor. So long as the court's judgment is correlated with the promisor's behavior, therefore, the parties can design a set of prices (including damages) so as to provide additional incentive to the promisor through an off-the-equilibrium, credible litigation threat. We show that the parties may prefer to adopt a costly signal over a costless signal. Rather than focusing solely on either the problems of adjudication or those of contracting (without sufficient regard to how the disputes will be resolved in the future), we have attempted to take a more comprehensive approach by looking at the design of contracts in anticipation of the path of the adjudication process.

Incomplete Contracts, Costly Verification

Abstract:
Contract theory identifies verifiability as a critical determinant of the incompleteness of contracts. Although verifiability refers to the cost of proving relevant facts to a court, very little scholarship connects explicitly the evidentiary process to the drafting of substantive contract terms. This paper begins to explore this relationship to provide a more rigorous explanation of contract design. In particular, the paper concerns the very core of verifiability - truth-finding by a court - and examines the impact of the prospect of evidence fabrication on contracting. It thereby also explores the puzzling tolerance of the adjudicatory system for fabrication and the incentives to fabricate created by thresholds in burdens of proof. The paper suggests that, despite undermining truth-finding, evidence fabrication may be harnessed by contracting parties to improve the (evidentiary) cost-efficiency of performance incentives in their relationship.

Abstract:
Two types of theories of the firm have emerged in scholarship. Economic theories concern the allocation of control rights and residual claims: A firm is a group of assets under common ownership. Legal theories focus on the legal significance of firm boundaries: Each firm is a legal person. Thus, assets may be economically integrated under common control and yet be partitioned between distinct legal entities. This paper presents a theory of legal boundaries that focuses on the choice of capital structure, and traces the interplay between economic integration and legal partitioning. The law treats many capital structure decisions, including both financial and governance features, as in personam rather than in rem. Thus, these decisions must be made firm-wide: for example, the issuance of debt or of equity, the adoption of takeover defenses and the composition of the board of directors. Yet, the determinants of optimal capital structure are often asset-contingent: for example, the amount of leverage, the desirability of takeover defenses and the number of independent directors may vary with the industry. The resulting tension is significant in the choice of firm boundaries. If two groups of assets have divergent capital structure demands - in that the optimal design of financial and governance rights related to each group is different - then either the assets are put in separate firms that tailor capital structure to their respective asset groups or they are combined in a single firm with a blended capital structure. We suggest that "legal" integration in a single firm sacrifices efficiency in some cases, but not in others. Where the efficiency losses are large enough to offset countervailing advantages from legal integration, legal partitioning might occur. However, we also demonstrate that legal partitioning may undermine the benefits from economic integration, even if the discrete firms are kept under common control (as that concept is defined in law). Our theory thus suggests additional factors to be considered in explaining the structure of combinations (e.g. mergers or acquisitions) and divestitures (e.g., spin-offs, carve-outs or securitizations).

Abstract:
The unprecedented and unanticipated economic and financial shocks of the past couple of years have led parties to look for contractual escapes from deals. Some parties exercise options embedded in their contracts by paying liquidated damages or cancellation fees. Others invoke excuse provisions such as force majeure, material adverse change or market-out clauses, to terminate at no cost. Under either set of circumstances, disputes arise, are litigated and typically settled either by a termination of the deals or adjustments to their terms. The increased attention paid to these provisions has illuminated the vague language with which these options and excuses are framed, and their uncertain interpretation. One instance in which this has been noted is the common use of material adverse event or change (MAE/MAC) conditions in corporate acquisition contracts.

As the current crisis works its way through our economic system, attention will be shifted from the collapsed deals to the design of future transactions. The vague language of past agreements has fueled disputes and threatened costly and uncertain litigation. Should future parties, in corporate acquisition deals and other commercial contracts, inject greater precision in their agreements? There are many proponents of this advice. However, we lack a theoretical framework for setting out the costs and benefits of vague and precise provisions. In this paper, we provide such a framework in order to improve awareness of the strategic use of vagueness in contracting.

The conventional rules-standards analysis suggests that vague terms are justified when the expected larger litigation costs in enforcing standards are outweighed by the lower costs of drafting. In acquisition agreements, this would suggest that vague MAC clauses yield benefits only by reducing front-end drafting costs. Yet, some proxies for material adverse change, such as quantitative thresholds in stock price, revenues or accounting earnings, are easy to draft and can be verified at low cost. They are usually noisy proxies, however, and therefore are not perfect.

We demonstrate that litigation costs, when properly harnessed, can in fact improve contracting by operating as a screen on the seller's decision to sue. We review three possible goals of MAC clauses: (a) to provide efficient incentives for investment and precautions against future contingencies by the seller between the time of the agreement and closing; (b) to allow the seller to better signal its private information to the acquirer at the time of contracting; and (c) to enable the seller to better signal private information at the time of closing, in order to promote ex post efficiency in terminating or executing the acquisition. We show that, in achieving these goals, vague provisions may work better than precise and even less noisy proxies.

contract design, mergers and acquisitions, options, litigation

Abstract:
Although extralegal enforcement is widely acknowledged, the conventional understanding of written contract provisions, such as the complex and detailed provisions in bond contracts, is that they are drafted to be enforced by law. This framing neglects the value of contracts in shaping extralegal forces, particularly where litigation is unlikely or not possible. Sovereign debt contracts provide an example in which lengthy and detailed contracts play a key role even though the debtor is largely litigation-proof. We examine how contract provisions in sovereign debt contracts improve the efficiency of creditor control outside the realm of legal enforcement.

Abstract:
In North LaSalle Street, the Supreme Court took an important step in insisting that new-value contributions in Chapter 11 bankruptcy reorganizations be tested by competitive market forces. This paper argues that, although the Court's statutory reading of the absolute priority rule is flawed, its policy decision to limit the debtor's exclusive right to propose a purchase of new equity by old shareholders is a step in the right direction. By analogy to the repricing of executive stock options, the paper shows that the conditions under which the continued equity participation by old owners is efficient - even in the case of owner-managed firms - are very narrow. Therefore, the decision to effectively reprice equity interests (by reducing the firm's debt and extending its maturity) should be left to negotiation among the parties rather than imposed by law as a default. The paper concludes with the hope that courts will seize on the implicit signal of the Supreme Court's decision and extend market-based checks to a broader range of judicial valuation determinations in Chapter 11 cases.

Abstract:
This paper examines common arrangements for separating control from cash flow rights: stock pyramids, cross-ownership structures, and dual class equity structures. We describe the ways in which such arrangements enable a controlling shareholder or group to maintain a complete lock on the control of a company while holding less than a majority of the cash flow rights associated with its equity. Next, we analyze the consequences and agency costs of these arrangements. In particular, we show that they have the potential to create very large agency costs - costs that are an order of magnitude larger than those associated with controlling shareholders who hold a majority of the cash flow rights in their companies. The agency costs of these structures, we suggest, are also likely to exceed the agency costs of attending highly leveraged capital structures. Finally, we put forward an agenda for research concerning structures separating control from cash flow rights.

Abstract:
Property rights in productive assets are commonly held by legal entities rather than individuals. Only persons can own property, and the law defines persons to include organizations such as corporations, partnerships, and trusts. This chapter addresses the related issues of the justification for firm ownership of property and the efficient division of assets among distinct legal entities. In brief, firm ownership coordinates the productive activity of self-interested individuals. Earlier scholarship by economists suggested that the allocation of control over assets reduces the inefficiencies of incomplete contracts caused by imperfect information. Thus, economic integration brings assets into common ownership to avoid or simplify contracting. These theories, however, do not distinguish between assets owned directly by an individual and assets controlled indirectly through an entity. They also do not distinguish between assets held within a single entity and assets partitioned among multiple entities within common control. More recent literature fills this gap by explaining the legal significance of the boundaries of distinct entities, whether or not they fall under the control of a single owner. The starting point for understanding firm boundaries is the observation that the person who is best situated to control the use of an asset may not be in the best position to finance its use. Berle and Means (1932) famously noted that the corporation is a vehicle for achieving such separation and that the separation raises significant and costly conflicts between owners and managers. This chapter explains how the deliberate drawing of firm boundaries can reduce these agency costs and thereby lower the cost of financing productive activity. In particular, the discussion focuses on the advantages of tailoring financing (or capital structure) to asset type. The law presents significant challenges to the goals of tailoring. Although optimal financing terms are often asset-contingent, the law favors entity-based rather than asset-based financing. In particular, the law requires considerable uniformity in the manner in which assets are financed and governed within a single entity, and the law raises obstacles to collaborative efforts across legal entities (the trade of goods, services, or capital across firm boundaries) even if they are held under common control.

Abstract:
This essay traces the evolution of the scholarly understanding of contract remedies, beginning with the era in which the compensation principle and expectation damages dominated. Fuller and Perdue’s classic articles in 1936-7 and, later, the theory of efficient breach both offered important justifications for the principle. However, as economic analysis extended to incorporate a wider range of incentive and risk-bearing goals, the support for the compensation principle became increasingly frayed. Subsequently, the emergence of the incomplete contracts theory further weakened its normative significance. In practice, the cutting-edge uses of contract damages pursue several other objectives, unrelated to compensation. In particular, damages promote contracting goals by (a) providing the price for embedded options or (b) setting the stakes and thereby incentives for future litigation. Finally, the paper discusses the design of “tiered” damages within a single contract that are triggered by different contingencies. In this sense, damages and conditions act as complements as well as substitutes. In light of the complex role played by contract remedies, the essay suggests that this topic should be taught near the end rather than beginning of the first-year contracts course.

Abstract:
The design of legal obligations, whether by a public body such as a legislature or by private contract, should anticipate the enforcement process that induces compliance. Judicial enforcement is costly and imperfect, largely because of limits on the court's ability to detect facts accurately. In adversarial litigation, courts are often fooled by fabricated, suppressed, or otherwise manipulated evidence. Given that fabricated evidence is both more costly and less valuable than truthful evidence, one would think that contracting parties should design their agreement so as to deter future evidence fabrication. To the contrary, this article suggests that evidence fabrication may be harnessed by contracting parties to improve the (evidentiary) cost-efficiency of performance incentives in their relationship. This paper thereby addresses the concept of verifiability in contract theory, the puzzling tolerance of the adjudicatory system for fabrication, and the incentives to fabricate created by thresholds in burdens of proof.

Abstract:
Despite the fact that compensation is the governing principle in contract law remedies, it has tenuous historical, economic and empirical support. A promisor's right to breach and pay damages (which is subject to the compensation principle) is only a subset of a larger family of termination rights that do not purport to compensate the promisee for losses suffered when the promisor walks away from the contemplated exchange. These termination rights can be characterized as embedded options that serve important risk management functions. We show that sellers often sell insurance to their buyers in the form of these embedded options. We explain why compensation is of little relevance to the option price agreed to by the parties, which is a function of the value of the option to the buyer, its cost to the seller and the market in which they transact. We thus propose a novel justification for why penalty liquidated damages may be higher than seller's costs: they are option prices that reflect the value of the options to the buyer. The regulation of liquidated damages is thus tantamount to price regulation, which is outside the realm of contract law. Moreover, in light of the heterogeneity among optimal option prices, we also make the case against having an expectation damages default rule to begin with. In thick markets, we argue for enforcing the parties ex ante risk allocation with market damages. In thin markets, we propose that parties be induced to agree explicitly with respect to all termination rights, including breach damages, by the threat of specific performance of their contemplated exchange or, in the case of consumers, by a default rule that provides them a termination option at no cost.

Contracts, options, risk management, expectation damages, liquidated damages

Abstract:
This paper explains a function of the legal boundaries of various organizations (such as corporations, security interests and trusts): they define internal capital markets within which capital may be redeployed over time by fiat and over which it may be moved only at greater cost and with greater difficulty. The option to switch capital allocations among available projects is valuable and its value can be enhanced when management of the option is delegated to an informed and loyal agent. However, if the switching option has low value, agents have little private information or agency costs are severe, the principal should constrain the ability of her agent to reallocate capital. She may accomplish this by shrinking the legal boundaries of the relevant internal capital markets: that is, by segregating projects into separate legal organizations. For example, a number of corporate, securities, tax and debtor-creditor law rules make switching between affiliate corporations significantly more costly than within a firm. Security interests and trusts also constrain capital budgeting flexibility. Indeed, the law provides a menu of instruments that, to varying degrees, remove from agents the discretion to adjust capital allocations among projects over time. The paper also examines the charitable sector: the prevailing information conditions and tax rules differ in important respects from those in the commercial sector and they raise interesting internal capital market issues. Capital budgeting flexibility in charities is constrained by charitable trust law principles. In both commercial and charitable sectors, intermediaries offer an attractive alternative solution to the agency tradeoff.

legal organizations, corporations, security interests, trusts, charities, corporate finance, corporate governance

Abstract:
This paper explains a function of the legal boundaries of various organizations (such as corporations, security interests and trusts): they define internal capital markets within which capital may be redeployed over time by fiat and over which it may be moved only at greater cost and with greater difficulty. The option to switch capital allocations among available projects is valuable and its value can be enhanced when management of the option is delegated to an informed and loyal agent. However, if the switching option has low value, agents have little private information or agency costs are severe, the principal should constrain the ability of her agent to reallocate capital. She may accomplish this by shrinking the legal boundaries of the relevant internal capital markets: that is, by segregating projects into separate legal organizations. For example, a number of corporate, securities, tax and debtor-creditor law rules make switching between affiliate corporations significantly more costly than within a firm. Security interests and trusts also constrain capital budgeting flexibility. Indeed, the law provides a menu of instruments that, to varying degrees, remove from agents the discretion to adjust capital allocations among projects over time. The paper also examines the charitable sector: the prevailing information conditions and tax rules differ in important respects from those in the commercial sector and they raise interesting internal capital market issues. Capital budgeting flexibility in charities is constrained by charitable trust law principles. In both commercial and charitable sectors, intermediaries offer an attractive alternative solution to the agency tradeoff.

Legal organizations, corporations, security interests, trusts, charities, corporate finance, corporate governance

Abstract:
The apparent willingness of commercial parties to agree to vague terms (e.g., reasonableness, good faith) is puzzling: contract economics scholarship predicts that parties will avoid the costly verification determinations and litigation uncertainty that vague terms invite. However, the literature treats verifiability as an exogenous, binary variable: a given state of the world or action is either verifiable or not. This paper analyzes verifiability as the product of the parties' investment decisions in evidence production and manipulation at two points in time: when a dispute arises and in anticipation of a dispute. In this analysis, parties may contract in order to optimize ex ante and ex post incentives along two parallel tracks: contract performance and evidence management during the course of the contract. This paper shows that, contrary to current theory, commercial parties may efficiently condition performance on vague terms whose interpretation is uncertain and which encompass factors that are costly to verify.

Abstract:
A manager's discretion depends on the firm's internal funds and its capacity to issue low-risk debt (together "financial slack"). The optimal amount of financial slack is a challenging problem in corporate finance. Too much slack encourages managerial misbehavior and exacerbates corporate agency problems. Too little slack prevents the firm from exploiting profitable investment opportunities. The various features of financial leverage -- including the amount of debt, maturity, covenants and default rights, and collateral -- may be used to regulate the degree of slack in a firm. This paper demonstrates how (1) the priority rules and (2) the property rights in collateral and proceeds associated with security interests under each of U.C.C. Article 9 and the Bankruptcy Code contribute to optimal slack policy.

Abstract:
A manager's discretion depends on the firm's internal funds and its capacity to issue low-risk debt (together "financial slack"). The optimal amount of financial slack is a challenging problem in corporate finance. Too much slack encourages managerial misbehavior and exacerbates corporate agency problems. Too little slack prevents the firm from exploiting profitable investment opportunities. The various features of financial leverage -- including the amount of debt, maturity, covenants and default rights, and collateral -- may be used to regulate the degree of slack in a firm. This paper demonstrates how (1) the priority rules and (2) the property rights in collateral and proceeds associated with security interests under each of U.C.C. Article 9 and the Bankruptcy Code contribute to optimal slack policy.

Abstract:
The debate in law and economics on secured financing has focused on the very basic features of secured transaction law: (a) the first-in time priority rule, (b) the foreclosure right of the secured party, and (c) the continuation of the security interest when the collateral is transferred to a third party. Agency theory has provided the most plausible efficiency explanations for the use of secured debt: given these three basic features, security interests constrain self-interested actions by managers that compromise firm value. In particular, secured debt restricts management's discretion to fund negative NPV projects by spending liquid assets, liquidating existing non-liquid assets or borrowing new funds. On the other hand, the absence of secured debt in a firm's capital structure (and the corresponding capacity to borrow on a secured basis) enables the firm to exploit profitable growth opportunities in the future. Where markets do not know the extent of future profitable opportunities available to the firm (or, conversely, the temptation for overinvestment), the texture of secured transaction laws yields a balance in managerial discretion that goes some distance toward enabling profitable while deterring unprofitable investment. This paper demonstrates how the details of the rules in Article 9 and the Bankruptcy Code control, without constricting, managerial access to internal and external finance.

Abstract:
Several commentators in law and in economics have argued that debt financing encourages managers to exert greater effort. For example, Michael Jensen has called debt "an agent for change" and Frank Easterbrook has suggested that leveraging is good because it forces managers to "skate on thin ice". This paper draws on several strands of behavioral theory to demonstrate the complexity of the motivational outcomes of compelling actors to skate on thin ice. Goal setting theory posits that performance is enhanced by the setting of specific goals (as opposed to do-your-best goals) that are proximal and challenging. One might think of debt financing as imposing periodic and specific goals for cash flow production, in contrast to equity financing that is more likely to set do-your-best goals. However, goals that are too challenging can diminish effort or produce an erratic scramble: a person standing on thin ice may well freeze or panic. Perhaps more significant are the ex post motivational consequences of setting specific goals. By clearly demarcating success and failure, specific goals can contribute to a failure that triggers a downward motivational spiral, which in turn spills over into personal, family and other facets of an actor's life (sometimes known as "learned helplessness"). Therefore, to the extent that debt financing produces ex ante motivational benefits that are enjoyed by the firm, it does so at the risk of ex post motivational costs which are at least partly externalized. This suggests one reason why firms may have incentives to be more leveraged than is socially optimal.

Abstract:
Under a regime of expectation damages, each party has the option to breach and pay damages, rather than incur the cost of performance. This paper concerns the timing of breach or repudiation. The benefit to the repudiating party from early repudiation is the decrease in damages liability due to the prospective mitigation activity of the nonrepudiating party. The loss is the sum of the expected value of the contracted exchange and the value of the option to breach in the future. Where efficient breach is meaningful (i.e. the cost of performance to the promisor is not correlated with the value of performance to the promissee), repudiation is the contract analog to the decision of a single firm to abandon a project. We show that, because the abandonment decision is split between two parties when the project is exploited by contract rather than in an integrated firm, each party may have the incentive to repudiate too early, which causes the premature abandonment of their project. This results from the fact that expectation damages compensate the nonrepudiating party only for the loss of the completed exchange and not the value of its lost breach option. This problem is particularly acute in long term, fixed price contracts in which the cost of performance to the promisor and the value to the promisee are volatile and uncorrelated. We explore various responses to this problem including vertical integration, changes in contract remedies (including specific performance), flexible price provisions and the capital structure of each party.