Certification Drag: The Opinion Puzzle and Other Transactional Curiosities

Abstract:     
The law-and-economics literature typically depicts certification intermediaries, such as law firms, auditors, underwriters, investment banks and rating agencies, as socially valuable market participants who ameliorate informational asymmetries that would otherwise distort pricing or transaction structures. This standard view is incomplete. Using the example of the "closing opinion", a third-party legal opinion commonly delivered at the consummation of a variety of business transactions, I argue that intermediaries, even when operating under substantially competitive conditions and in sophisticated market settings, may supply widely consumed certification products that fail to mitigate informational asymmetries while increasing transaction costs. Based on the highly qualified language used in closing opinions, an opining firm's inherent conflict of interest and limited legal and reputational liability exposure (shown in part through a detailed survey of relevant case-law over the past 20 years), and the common availability of more robust diligence mechanisms, there is substantial doubt as to whether closing opinions typically convey significant incremental informational value. Nonetheless the widespread use of closing opinions persists. To account for this potential anomaly (and, by extension, other potentially anomalous certification mechanisms in sophisticated business settings), I propose a two-sided incentive structure whereby: (i) demand is sustained by an agency-cost effect as a result of which "requesting agents" request a minimally informative but entrenched certification instrument in order to avoid any reputational penalty for perceived incompetence, and (ii) supply is sustained by an adverse-selection effect as a result of which "requested parties" provide a minimally informative but entrenched certification instrument in order to avoid triggering a substantial transaction discount. Using this same incentive structure, I then describe (and illustrate historically) how the market may ultimately cure a non-cost-justified certification practice through "lead" participants who anticipate unusual reputational gains by unilaterally deviating from an inefficient industry convention. Finally, I show how this incentive structure can be applied with minimal customization to account preliminarily for the curious persistence of other commonly questioned and commonly used certification practices in the financial markets.

Number of Pages in PDF File: 78

Accepted Paper Series