Stock Issuances and Managerial Agency Costs

Aug 4, 2011 D. Gordon Smith

D. Gordon Smith

Every state corporation statute authorizes the board of directors to issue stock. While one could imagine arguments for allocating this authority to the shareholders, the board of directors is better positioned to respond quickly to financing needs or to provide stock as a motivation for employees. Nevertheless, whenever the board of directors is given an important power, we must be attentive to the potential for abuse. In her new article, The Power to Issue Stock, Mira Ganor reveals various ways in which directors may pursue their own interests at the expense of a majority of the shareholders or thwart the veto power of minority shareholders through the issuance of stock.

Stock issuances are important in Ganor’s account of corporate governance because of the possibility of voting dilution, which occurs when an existing shareholder owns a smaller ownership interest after a new stock issuance. For example, assume that an investor owned one million shares of common stock in Company A, equal to a 25% ownership interest (i.e., the investor owned one million of four million shares outstanding). If Company A subsequently proposed to sell another one million shares to a new investor, the existing investor would see her ownership interest decline from 25% to 20% (she would own one million of five million shares outstanding).

Recognizing this risk of dilution, corporations (especially privately held corporations) sometimes place constraints on the power to issue stock to reassure prospective investors. For example, the number of authorized shares in the corporate charter may be limited or the existing investors may have veto rights or preemptive rights, which would allow them to maintain their ownership interest. In addition, public corporations may be subject to stock exchange listing requirements, which force managers to gain shareholder approval for all new stock issuances exceeding 20% of the outstanding shares.

Despite these potential constraints on the power to issue stock, most publicly held corporations grant the board of directors a great deal of discretion in this area, and boards frequently use that discretion for control purposes. The most familiar example of an issuance motivated by control is the poison pill, which is employed by managers to resist hostile takeovers. Another example is the top-up option, which has become an important mechanism used by managers to facilitate two-step mergers by a favorite bidder. A top-up option gives bidders who acquire a specified percentage of the target company–usually 50%–the option to purchase enough newly issued shares of the target company to reach 90% of the outstanding shares. At that level of ownership, the bidder is allowed to consummate a short-form merger, which does not require a shareholder meeting or a vote of the minority shareholders. Ganor describes the details of the purchase as follows:

Once the bidder exercises the top-up option, she needs to buy the new shares from the company and pay for these shares the same price that she paid in the tender offer. A lower price will not represent a fair market price and may be easily challenged since the tender offer price establishes a fair market price for the shares. [A] large number of shares is issued when the top-up option is exercised, hence the consideration that the bidder should pay the company for these shares is substantial. However, the consideration for the shares can be, and often is, paid with an unsecured note except for a small part, which represents the par value of the shares. Following the short form merger, the unsecured note issued in exchange for the shares is nulled, because after this merger the holder of the note is combined with the issuer of the note and they become one.

Dissenting shareholders may pursue an appraisal remedy after a short-form merger, but their ability to stop the merger seems rather limited. In a case involving a top-up option in the acquisition of Cogent, Inc. in 2010, In re Cogent, Inc. Shareholder Litigation, the Delaware Court of Chancery denied a request for an injunction, reasoning that the harm from the top-up option was too speculative. The plaintiffs in Cogent argued that the top-up option was a sham transaction because the note offered in consideration of the option shares was “illusory consideration,” but Vice-Chancellor Parsons was deferential to the board of directors, concluding that the Delaware code “leaves the judgment as to the sufficiency of consideration received for stock to the conclusive judgment of the directors, absent fraud.”

Top-up options provide an excellent illustration of the agency problems that may arise from the power to issue stock. The most original and important contribution of this article is Ganor’s attempt to capture the potential for abuse with the “excess-ratio,” which is the ratio of authorized non-outstanding shares to the issued and outstanding shares. Ganor observes:

[A]n excess-ratio of one signifies that there are enough authorized but not outstanding shares to double the number of shares already issued and outstanding. The stock exchanges‘ requirement of shareholder approval for an increase of more than 20% of the issued share is equivalent to a 0.2 excess-ratio; and the German limit of 50% can be expressed as a 0.5 excess-ratio.

Ganor concludes her paper with some limited empirical evidence on the excess-ratios of non-financial companies incorporated in Delaware that have completed an initial public offering in the United States. While the ratios seem high–with reported means in excess of 5 and reported medians typically between 3 and 4–Ganor found no meaningful correlations between the ratio and firm size or between the ratio and the likelihood of acquisition.

This paper focuses our attention on an aspect of director power that is rarely acknowledged in the vast literature on managerial agency costs. Ganor offers useful descriptions of the manner in which the power to issue stock can be problematic, and she takes the first step toward systematically analyzing that power.

Inviting both Amos Tversky and Solomon Asch: It’s not all Casino Capitalism

Apr 20, 2011 Robert Rosen

Robert Rosen

Donald Langevoort demonstrates, again, his ability not only to do behavioral economics but also to reframe it by placing actors in organizational contexts and relations.   Behavioral economics, sharing economics’ methodological individualism, analyzes biases and cognitive heuristics in regards to individual risk taking.  More broadly, social psychology investigates decision effects that result from affects, visceral and cultural factors, as well as pressures toward or against groups and authority. For example, Solomon Asch emphasized that people make decisions in public differently than they would in private, based on their impressions of others, and seeking legitimacy.¹ Langevoort presents research that builds on Asch, for example the finding that in the presence of an audience, facing rivals, with time pressure to make a mark, individual motivation may shift from goal attainment to an obsession with winning at all costs.² Such work not only uncovers other sources of bias, but also it reframes the subject as decision-making rather than only risk-taking.  In “the ‘competitive arousal’ model of decision making,”³ the actor doesn’t engage in risk analysis, rather other motivations and models engage the actor.  For some it is Tversky or Asch.  Langevoort learns and masters work in both traditions, and more.

Langevoort’s subjects are the decisions that led to the Global Financial Crisis (GFC) and what gatekeepers need to learn from it.  A principal-agent approach to the GFC demands explaining excessive risk-taking by theoretically risk-averse employees (invested in and frightened of losing their jobs).  Although he has proffered other explanations, in this article, Langevoort focuses on the firm’s shaping of actor’s understandings and motivations.  A principal-agent approach normally addresses the design of appropriate contracts, incentives, compensation and monitoring systems.  In this article, Langevoort focuses on understanding the firm’s organizational culture.

Langevoort proposes the functionality to firms of employees being unrealistic and overconfident, able to deflect doubt and sometimes taking unjustified risks.  “He who hesitates is lost” is an adaptive mindset for a firm in a competitive environment.  In analyzing reports from the GFC, Langevoort draws out a wide range of aspects of firm culture, including routines, myths, scripts, rationalizations, fraternity-like excess, ideologies, and sense-making perceptions and inferences.  With such a developed understanding of corporate culture, Langevoort might have added that there are multiple cultures in any organization and the adaptive one on which Langevoort focuses may be joined to others, such as the one that might be carried by gatekeepers, inscribing “Look before you leap.”

Langevoort advises gatekeepers that they need to understand organizational culture.  Of course, one result is that gatekeepers will understand not to believe everything presented to them.  Understanding organizational culture importantly reveals that it is not normally the case that misreporting is the result of deception.  The misreporting is scripted in firm culture and makes sense to its participants.  Langevoort advises gatekeepers not to challenge the risk-taking culture (no “Fools rush in where angels dare to tread”), emphasizing that awareness of the culture will teach when objectivity must be sought.

Despite Langevoort’s analysis, at points he is unwilling to move beyond methodological individualism.  He says that the issue is what “might bias the assessment of financial, legal, and reputational risk.”(P. 30.)  He says he is only “project[ing] individual cognitive biases into the larger organizational culture.” (P. 12.)  Yet, at other points, he speaks of culture as “making it hard to perceive the need to rethink,” (P. 24), or providing “deeply held cultural ideologies” (P. 26.)

There are at least two reasons why it is difficult to move beyond risk-taking as the description of decision-making, neither of which I can do justice to here.  The first is that understanding decisions as risk analysis enables experiments and theory development, even as it eclipses the actor.  On the other hand, one of the joys of Langevoort’s work is that the actor peeks through.  In my understanding, to an organizational actor, the choice is not always (or normally) which of a well-defined set of options to choose.  The choice is “What shall I do.”  The organizational actor is immersed in actions and in culture.  Facing decisions, she solves problems.  Of course, she uses evidence and assesses probabilities.  But, as she conceives them, intelligence and imagination are her normal tools for decision-making, not risk-analysis.  Inscribing the actor within the broader understanding of decision-making may be noisy, but has its charms.

The second reason why it is difficult to move beyond risk-taking is an identification of risk-taking with corporate behavior.  One indication of this is that risk management has become the regulatory response to the GFC.  This article is relevant to corporate law because gatekeepers (including the board) are increasingly tasked with assessing financial, legal, and reputational risk.  This focus on risk management occludes that “risk” has multiple meaning (or that uncertainty differs from risk) and treats all business as if it were the casino capitalism that led to the GFC.

What does the failure to hedge against systemic risk in the CDO market tell us about, say, the decision to chance violating emission discharge laws by a manufacturer?  If by legal risk we mean the risk of getting caught and paying a fine greater than a certain sum, then everyone may be in a casino (and ignoring ALI Principles of Corporate Governance §2.01).  But, decisions are more complex than that and involve commitments, character and cultures.

Failing to recognize that risk-taking is one part of decision behavior and failing to recognize what appears as a risk may be a predicate to self-defining choices leaves us understanding all of business as casino capitalism.

By inviting both Tversky and Asch, Langevoort invites deeper understandings.

1. S.E. Asch, Effects of group pressure upon the modification and distortion of judgments.  In H. Gustzkow (ed.) Groups, Leadership, and Men 177-190. Pittsburgh, PA.: Carnegie Press (1951); Asch, S. E., Forming impressions of personality, 41 J. Abnormal and Social Psychology 258-90 (1946); Asch. S.E., The doctrine of suggestions, prestige and imitation in social psychology, 55 Psychological Review 250-276 (1948).
2. Langevoort, note 42.
3. Langevoort uses this phrase, drawn from G. Ku et. al., Towards a competitive arousal theory of decision making: A study of auction fever in live and internet auctions, 96 Org. Behav. & Human Dec. Processes 89 (2005), cited in Langevoort at n. 42.

Bankruptcy 2.0 versus Bailouts

Mar 10, 2011 Sarah WooAdd a Comment

Sarah Woo

As we try to learn the right lessons from the 2008 financial crisis, a debate has emerged as to the merits of bailouts versus bankruptcy. Although the chaotic days when Lehman and AIG were failing are starting to fade into financial history, ongoing news on European bailouts reminds us that this debate is still very much alive.  Bankruptcy or Bailouts by Kenneth Ayotte and David Skeel, provides an excellent Law and Finance discussion that unpacks the key issues of moral hazard underlying rescues of financial institutions and the systemic risk considerations. They identify cases where bankruptcy has been surprisingly effective, discuss how it avoids various distortions resulting from bailouts, and challenges the common view that Chapter 11 bankruptcy is an inappropriate vehicle for resolving distress in financial institutions.

This article confronts head-on the difficulties in this area – the difficult choices for policymakers, and the difficulty in establishing causality between past events (e.g., the Lehman filing and the AIG bailout) and the volatility and illiquidity in the market. As Ayotte and Skeel remarked, questions such as whether a Lehman rescue loan could have reduced the severity of the financial crisis that followed are “impossible to answer with certainty.” (P. 490.) They then proceed to present some data, which provides us reason to be skeptical about the conventional wisdom that Lehman’s Chapter 11 filing was the singular cause of the resulting credit crunch.

Given these difficulties, it is interesting to contrast this article with another recent paper, In Defence of Bailouts, by Adam Levitin, where systemic risk is described in terms of political accountability and legitimacy. It appears that Ayotte and Skeel differed from Levitin on whether moral hazard and systemic risk are minimized (or can be minimized) in a bailout versus in bankruptcy. In particular, Levitin argued that a bankruptcy court may not be capable of deciding upon (and enforcing) the politically acceptable distributional outcome, especially if there are systemic implications. This is consistent with what George Akerlof and Robert Shiller opined in Animal Spirits (2009) – that the creditors’ focus in bankruptcy proceedings is mainly on the institution in question and there needs to be a reconsideration of bankruptcy law to take special account of the fact that the public has an interest in such distress situations.

Nonetheless, the article by Ayotte and Skeel has complicated the usual assumption that nothing good can come from the bankruptcy of a large financial institution through an examination of the firm-specific costs, corporate governance distortions, and downsides of the prompt corrective action approach by regulators. They have made a convincing argument that the bankruptcy regime should play a role in resolving financial institution distress with a handful of changes, especially those pertaining to derivatives. There is, however, an open issue that we are reminded of by their article: the 900,000 derivative contracts to which Lehman was a counterparty. An issue, seldom discussed in this debate but one that can affect our assessment of the choice between bankruptcy and bailouts, is the extent of public disclosure in bankruptcy, as compared to bailouts. Just as a bank’s supervisory CAMELS ratings are kept confidential to prevent a bank’s customers and investors from losing confidence and potentially mounting a bank run, significant counterparty exposures to financial institutions disclosed in bankruptcy dockets could have spillover effects in terms of affecting market confidence in these counterparty institutions.

Flexibility and open-mindedness would seem to be the best course, and this is a recurring theme in this article. Ayotte and Skeel have adopted a realistic position in stating that “[i]f regulators conclude that systemic risk concerns are so great that intervention is necessary, [regulators] could use an intermediate strategy of allowing the firm to file for bankruptcy, while selectively guaranteeing certain ‘dangerous’ liabilities as an alternative to a rescue loan.” (P. 491.) At the end of the day, Ayotte and Skeel are essentially advocating Bankruptcy 2.0, where there may be pockets of government intervention alongside the bankruptcy regime, as opposed to the oft-cited view of bailouts without bankruptcy being an inevitable part of modern financial markets.

When Corporations Translate Treaties

Feb 7, 2011 Caroline BradleyAdd a Comment

Caroline Bradley

The transnational transmission of risk is increasingly visible as a subject of policy debate, from transnational terrorism to global warming, from food safety to the financial crisis.  These risk transmissions involve more fundamental security risks: for example, the global financial crisis has led to violent protests; low-lying states are threatened by rising water levels; populations facing issues of food security also have implications for security and stability more generally.  As these risks become increasingly recognized, international and transnational law, and also international standards, are increasingly relevant to US-based businesses. Private firms are affected when states enact and propose rules to address risks to global security, such as the SEC’s recent proposals for disclosures about the use of conflict minerals.

Our standard model of the impact of treaties (and agreements setting non-binding standards such as those developed by the Basel Committee) on non-state actors involves implementation through domestic legislation.  However, in this article Natasha Affolder argues that corporations engage with environmental treaty norms in ways that this standard model fails to reflect.  Instead, corporations interact with treaty norms directly and via the transnational standard-setting process.  Thus, she challenges the traditional model of treaty implementation and the usual separation between public international lawyers and scholars of private governance.  At the same time her article has implications for those of us who study the legal environment within which businesses operate, and illustrates a complex set of interactions between governmental and non-governmental bodies around environmental regulation and practices.

Affolder suggests corporations’ interactions with and translations of treaty norms may in fact produce changes in the underlying treaty obligations.  In some cases corporate action may undermine treaty commitments:

In translating treaty norms for corporate use, companies cherry-pick among treaty provisions, interpret treaty commitments in their least onerous forms, and obscure the ways in which corporate activities impede treaty implementation by selectively reporting on instances where corporate policies and actions advance treaty norms.

But in some contexts, Affolder recognizes that corporate action may “lead to stronger and deeper implementation of treaty norms.”

The article focuses on environmental treaties, although Affolder suggests that the implications of “corporate channeling of treaty meanings” are broader.  She would extend the implications to human rights and labor, and I think that her work is also relevant to financial regulation.  The global financial crisis led to new efforts to reform financial regulation among domestic, regional and international policy-makers.  The Basel Committee has developed Basel III , the EU is reforming its structures for financial regulation, and the US enacted the Dodd-Frank Act.  But financial firms and the trade associations which represent their interests are also involved in developing the new rules, through efforts to lobby across borders, arguing that rules applied in one jurisdiction should not be more onerous than those in others, and through the development of private standards.  In October, staff of the IMF wrote that “private sector ownership of the financial reforms will be key to the successful implementation of the new rules”.

Affolder’s article is important, and nuanced.  Corporate action in translating and implementing treaty provisions is neither entirely positive, nor entirely negative.  Affolder does not offer a new theory — but this is the point: she pushes us to face the complex and multivalent facts about the interactions between business and law in a world of multi-level rules.

Taking Legal Origins Theory Seriously

Jan 7, 2011 D. Gordon SmithAdd a Comment

D. Gordon Smith

In the late 1990s, Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny (“LLSV”) launched a research project examining connections between legal rules governing investor protection and economic development. Working on the assumption that legal rules could be measured and quantified, LLSV purported to demonstrate that common law countries were more protective of outside investors – and, thus, more hospitable to economic development – than civil law countries. In the ensuing years, LLSV and other economists have expanded and refined their work, constructing the grandly named Legal Origins Theory, which holds that legal systems are important determinants of economic development. The influence of Legal Origins Theory is not confined to economics journals, but may be seen in policy reforms through the World Bank’s Doing Business reports.

While many legal scholars have dismissed this work because of its naïve assumptions about law and legal change, especially in early papers, a group of legal scholars at Cambridge University – led by Simon Deakin, John Armour, and Ajit Singh – took Legal Origins Theory seriously. Embracing the assumption that legal rules could be measured and quantified (“leximetrics”), the Cambridge Group produced legally sophisticated datasets on shareholder protection, creditor protection, and labor regulation. In Law and Financial Development: What We Are Learning from Time-series Evidence, published as part of a recent symposium on Legal Origins Theory in the BYU Law Review, four members of the Cambridge Group take stock of what we have learned from those datasets and chart some new directions for future research.

Critics of Legal Origins Theory will not be surprised to learn that the Cambridge Group finds little support for the theory in longitudinal data. While shareholder protections and corporate governance standards have been strengthened worldwide – reflecting the efforts of civil law countries to catch up with common law countries – these legal changes have not resulted in more dispersed share ownership and increased stock market activity, as predicted by Legal Origins Theory. According to Armour et al., these considerable legal reforms suggest that “lock-in through legal origin has not been much of an obstacle to the formal convergence of systems.” More importantly, legal reforms have not led to greater economic development. The authors offer alternative interpretations of their results:

One possible interpretation of our results is that a “one size fits all” approach to corporate governance reforms, stressing elements of British and American practice—the role of independent boards and the market for corporate control—may not be working as intended in civilian and developing systems. Another interpretation is that even in the common law world, shareholder protection can have counterproductive effects, by unnecessarily raising the costs associated with a stock exchange listing.

For those who remain interested in attempts to discern connections between law reform and economic development along the lines suggested by Legal Origins Theory, Armour et al. urge a reconceptualization of the role of legal systems: “legal systems are not the independent, ‘exogenous’ force  that legal origins theory takes them to be. Legal systems are, to some degree, ‘endogenous’ in the sense of being shaped by their economic and political environment.”

The work of the Cambridge Group is an important part of the most significant research advance on corporate governance since the advent of law and economics in the 1970s and 1980s. The analysis by the Cambridge Group has called into question many of the central tenets of Legal Origins Theory, but in my view, the more important long-term contributions of this work are twofold: (1) the work has gone a long ways toward legitimating “leximetrics” in studies of comparative corporate governance, and (2) the work has reignited interest in comparative corporate governance, a field that has traditionally suffered from a perceived lack of rigor.

This may seem a bit hyperbolic, but I believe that this work has paved the way for a re-examination of the whole of corporate law from an empirical, comparative perspective. Such work requires more resources than the traditional corporate law scholarship, but the Cambridge Group has demonstrated the power of leximetrics to provide new insights. One can imagine using these techniques to compare various states in the U.S. or various countries in Europe along any dimension of law that might possibly be related to economic development.

Embattled Delaware

Nov 5, 2010 Eric PanAdd a Comment

Eric Pan

Poor Delaware.  The small state (45^th in population and 49^th in geographic size) is the dominant corporate law jurisdiction in the United States, and for decades the academic community has been fascinated with the reasons why.  Initially, scholars portrayed Delaware as the savvy champion of a fierce competition for corporate charters.  The quality of its courts, the richness of its case law, and the responsiveness of its legislature made Delaware the most attractive place to incorporate for US public companies.  When Marcel Kahan and Ehud Kamar’s wrote The Myth of State Competition in Corporate Law, 55 Stan. L. Rev. 679 (2002), the academic community’s view of Delaware had changed:  Delaware was not facing direct competition from other states, but rather winning by default.

More so than any other corporate law scholar, Mark Roe has tried to explain why Delaware still has much to fear.  Roe is well known for his argument, articulated in Delaware’s Politics, 118 Harv. L. Rev. 2491 (2005), that Delaware faces a competitive threat from the possibility of corporate governance regulation by the federal government.  Roe’s analysis, originally written in the wake of the Sarbanes-Oxley Act of 2002, has proven prescient with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act last July, which introduced a host of significant corporate governance reforms for US public companies, including say-on-pay and proxy access.

Like the Stephen King of corporate law, Roe is now back with a new set of reasons why Delaware should be afraid . . . very afraid.  First, armed with data on Delaware’s franchise tax receipts and incorporations by companies into Delaware, Roe presents some striking statistics:

• Every year, Delaware experiences a 10 percent turnover in its list of active firms;
• About 70 percent of Delaware’s active firms incorporated in the state only in the last ten years;
• 54 percent of Delaware’s 2008 franchise tax revenues came from firms that incorporated in Delaware in the past ten years; and
• The amount of time it would take for Delaware to lose half of its franchise tax base (assuming no replacements through new incorporations) has shrunk from 25 years in 1983 to only about ten years in 2008.

Thus, Delaware’s position is precarious.  Due to corporate mergers, reorganizations and failures, Delaware’s base of firms decreases at a steady rate.  In order to maintain franchise tax receipts at current levels, Delaware must constantly convince new and existing firms to incorporate or reincorporate in Delaware.  This need to attract new business, even in the absence of active competition from other states for these incorporations, is a competitive pressure on Delaware to invest in improvements to its corporate law regime.

Second, Roe notes that the threat of a new entrant into the market for incorporations is enough to keep Delaware on its toes.  While no state has the same combination of attractive attributes as Delaware, Roe does note that other states do have “toeholds” that could quickly make them viable challengers to Delaware if an opportunity arose.  Roe is fascinated by recent efforts by shareholder activists, like Carl Icahn, to push companies to reincorporate in North Dakota where a lawyer for Icahn and other shareholder activist groups drafted a new corporate law for the state.  But even beyond North Dakota, other toeholds include those states that are developing quite sophisticated jurisprudence regarding the governance of non-corporate business entities and New York with its commercial court system.

Finally, Roe returns to his old theme of the threat posed by federal agencies expanding their efforts to make corporate law.

Roe’s portrayal of North Dakota and other states quietly waiting for Delaware to stumble before making their move would normally generate skepticism.  As Lucian Bebchuk, Assaf Hamdani and others have noted before, the barriers to entry for states to enter into a market for corporate charters are quite high.  But what makes the threat more serious is Roe’s data on reincorporations and the half-life of Delaware franchise tax base.  I do not believe that anyone, other than perhaps those who work for the Delaware Secretary of State, realized how much Delaware relies on a constant flow of new incorporations.  As franchise taxes fund a remarkable 17 percent of the its budget, Delaware cannot afford to let this revenue stream end.

The implication is that Delaware is on the defensive.  Its priorities lie in preventing other jurisdictions from developing advantages that could draw away new incorporations, and there is no incentive for Delaware to go out on a limb with new reforms that could alienate either the corporate managers who make the reincorporation decisions or the institutional investors who may escalate efforts to avoid Delaware.  For those of us who have been critical of various aspects of Delaware corporate law (see, e.g., my paper on problems with the Delaware duty to monitor, available at SSRN), the lesson appears to be to effect change from the outside.  Having federal agencies or other state courts and legislatures consider certain corporate governance reforms may be the best way to get the attention of the Delaware legislature and courts.

August Thoughts on Central Banking

Sep 7, 2010 Anna GelpernAdd a Comment

Anna Gelpern

I signed up for the August review slot before considering the August mindset.  Several things about August make it ill-suited to reviewing:  summer is gone, May ideas have hit the wall, and Congress picked July to pass a law that is too-hard-to-teach but too-big-to-skip.  I yearn for holiday fun, theoretical breakthrough, and instructional clarity, combined.  And I happen on last winter’s symposium in Theoretical Inquiries in Law, Money Matters:  The Law, Economics, and Politics of Currency, and historian Jeffrey Sklansky’s article on Nicholas Biddle, President of the Second Bank of the United States.

The volume is part of a wave of crisis-inspired scholarship that is helping fill the wide and widely-acknowledged gap in legal treatments of macroeconomics and finance.  This lot stands out for its thorough interdisciplinarity, its thematic coherence, and the gratifying match between what it promises and what it delivers.  Contributions from law, economics, history, sociology, and political science are all at impressive levels, but more importantly, they work well together while exploiting the particular advantage of each discipline.  Although none offers a grand legal theory of money or a spell to stop crises, together, the articles begin to tease out a picture of the law’s role in constructing money at the intersection of public and private credit, domestic and international regulation—exposing the political, contingent, and instrumental character of money law, even as they highlight the power of legal ideas and techniques.

For an article to shine in this group, it helps to have a colorful protagonist.  Biddle served as President of the Second Bank for sixteen years beginning in 1823 (four years after McCulloch v Maryland), and led its losing battle with Andrew Jackson.  He was also a litigator specializing in “international debt-collection,” a legislator, a bureaucrat, a poet and an editor.  He edited, among other things, a digest of commercial laws of the United States’ major trading partners, Lewis and Clark’s journals, and a literary weekly.  And he graduated from Princeton at 15.

Like its talented subject, Sklansky’s piece moves easily among history, law, economics, architecture, politics and literature.  Morsels of Biddle’s poetry, his part in fueling the Greek revival, and the contemporary political uses of Mary Shelley’s Frankenstein are enjoyable and rewarding, more for the way the author combines them to frame Biddle’s civic vision in context:

[I]n the solid geometry of pillars and planes, Biddle found an analog for his notion of banking as the poetry of capital, distilling the Platonic  ideals concealed within the hustle and bustle of market relations.

Then there is the theoretical insight.  In mapping its lawyer-subject’s worldview, the article hits on what I think is still the core legal challenge of central banking:  steering aggregate economic activity through the medium of individually regulated financial institutions, while maintaining both technocratic autonomy and political legitimacy.  Decades before federal paper money took hold, Biddle headed a hybrid institution that was quite unlike today’s Federal Reserve.  Yet he too grappled with a fast-growing gaggle of money-printing private banks, which he sought to control and whose actions reflected back on him with real estate bubbles, financial crises, and urgent demands for public accountability.

Biddle’s conceptions of monetary policy and regulation projected nationalist ambition rooted in international trade and debt experience; they were global to begin with, and from the start, appeared to struggle with the relationship between finance and the real economy.  Biddle’s answer to the accountability challenge, in Sklansky’s telling, constructed the central banker as a public servant autonomous from the markets and politics alike, protecting both from themselves and each other, and legitimate thereby.  (Curiously, this was similar to his vision of the lawyer.)  Whether it is compelling or delusional is beside the point; we are still arguing about central bank independence and regulatory capture with lawyers under-represented in the debate.

Biddle is a famous guy and I am not a Biddle buff, so have limited capacity to assess Sklansky’s contribution to the Biddle canon.  However, in my August moment, this historian gave me food for thought on framing legal approaches to central banking.  Seeing as I have been looking for a while, and as the Fed did rather well in the recent financial overhaul, I am very grateful.

***

Separately and in brief, do not miss Marcus Miller and Joseph Stiglitz on macro-bankruptcy, or “Super Chapter 11.”  They started this project after the Asian financial crises in the 1990s, and have recently published the latest iteration.  Then and now it is hardly pragmatic, but important for forcing us to face the logical implications of deploying bankruptcy in a financial crisis.

Banking on Bailouts

May 14, 2010 Bill BrattonAdd a Comment

Bill Bratton

The Goldman Sachs circus currently playing Washington certainly is energizing.  And it’s a relief to see some life in the legislative process looking to financial reform.  But the policy posturing is starting to get to me.  Are you, like me, tired of all the claptrap?  For a restorative, take out Jeffrey N. Gordon and Christopher Muller, Avoiding Eight-Alarm Fires in the Political Economy of Systemic Risk Management.

Gordon and Muller offer a learned, yet quite readable review of the financial crisis.  I particularly recommend their treatment of the role played by credit default swaps and their recounting of the steps that ended in the TARP and the role played by Federal Reserve Act section 13(3) in the sequence of events.  The authors know their economics, but in this paper the legal perspective dominates to the reader’s great benefit.  There is also a clear-eyed and reasonable analysis of the policy choices.  Here Gordon and Muller clear up much of the murkiness that surrounds discussions of “resolution authority.” That accomplished, they suggest that we get used to the prospect of future bailouts.  Where a $50 billion fund raises hackles on the Hill, they think $1 trillion is more like it.

If, after reading and assimilating Gordon and Muller, you are ready for something a little more over-the-top, pick up my Georgetown colleague Adam Levitin’s In Defense of Bailouts.  Levitin is on the same page as Gordon and Muller and sees bailouts in the cards of whatever future hand we deal ourselves.  He makes a stand up case for them on distributive grounds, also showing us where we can expect regulation to succeed and where its likely to come up short.  The best stuff is at the end of the paper, where Levitin suggests how to structure bailouts better.  Their incidental beneficiaries (read Goldman) should be made to give back once the crisis passes, either through recoupment taxes or returns to the government on force-placed investments.

I’m still worried about the Senate bill.  But papers like these somehow make me feel better about it all.

Size Matters: Wealth Accumulation as a New Mission in Higher Education

Apr 5, 2010 Ezra MitchellAdd a Comment

Ezra Mitchell

The question of why universities seem to hoard their endowments had become a Senate-level issue prior to the Panic of 2008, and now that normalcy slowly is returning the issue promises to become a live one again.   Simply put, in the years preceding the panic, tax-exempt institutions of higher education appeared to be growing enormous endowments while spending only a tiny proportion of them on their current needs.  The issue became more sharply illustrated as, in the face of significant endowment losses during the crisis,  elite universities with the highest endowments chose to cut budgets, lay-off employees, freeze hiring and salaries, close libraries, and cancel capital projects, among other measures, rather than maintain their then-current levels of spending, at the same time remaining in possession of endowments that still counted in the billions.  Conti-Brown asks why, and gives a deeply thoughtful and creative explanation for the endowment puzzle.  His answer:  endowment building — the accumulation of wealth for its own sake — has taken its place as one of the missions of the institutions, alongside their pedagogical and scholarly pursuits.

As one might imagine, universities are highly secretive about their endowments, and Conti-Brown has done a good job of obtaining such information as he could, focusing on the universities with the five highest endowments: Harvard, Yale, Princeton, Stanford, and MIT.   Important among this is that despite the average 30% drop in endowments at these schools (an assumption Conti-Brown makes based on the data he has), endowments remained at the same levels they had attained in 2005 and 2006.  Thus the budget cuts seem all the more puzzling and the plot thickens.

The main portion of the article consists of Conti-Brown thoughtfully and systematically debunking the principal theories which have been put forth to justify the accumulation of large endowments (he more modestly puts it  that these explanations are incomplete).  These include the argument that universities spent unsustainable amounts of money during prosperity and thus had to make significant adjustments when the values of their endowments fell, that legal restrictions on endowment spending prohibited these universities from making up the shortfall out of endowments, and that new styles of endowment investment resulted in the substantial illiquidity of endowment funds, making their use prohibitively expensive or impossible when the crisis hit.  The more plausible explanation, as he shows, is that size matters to universities or, as he delicately puts it, “universities’ endowments are like a cowboy’s belt buckle: the bigger the buckle, the more impressive the cowboy.”  Elite universities, in this age of rankings, use the size of their endowments as a signal of their superiority to other universities.  Seen as such, maintaining the size of an endowment becomes a critical part of the university’s mission.

Conti-Brown’s analysis is careful, and his understanding of the cultural imperative that has driven economic decisionmaking is both persuasive and original.  The writing is lively and engaging, and provides an important challenge to universities’ self-justifications for their actions at the same time that it  questions the justification of the substantial tax breaks that allow those endowments to grow.  If further proof were needed that the issue is alive and important, consider the following:

On February 1 of this year, The New York Times reported that the interim president of Williams College (full disclosure, this commentator’s alma mater) announced that Williams was eliminating its recently enacted program of providing loan-free financial aid to needy students due to a $500 million drop in endowment (which still remained at a rather healthy level of $1.4 billion for a college of approximately 2,000 students).  The president was quoted as saying: “Williams is in a strong financial situation by virtually any comparison — except with the Williams of three years ago.”  The decision to end a financial aid program that has widely been lauded in order to save $2 million over four years instead of spending more from the endowment, together with the president’s explicit comparison of (recent) past and present endowment size rather than attention to the current size of the endowment in relationship to Williams’ financial needs, may be all the proof the Conti-Brown needs to be assured that he is on the right track.

This is a piece well worth reading, and is rich and deep in a way that raises even more questions about the issue that I hope will be addressed by future scholars who will be indebted to Conti-Brown for his excellent work.

Unknown Unknowns: Uncertainty, Contracts, and Crisis

Jan 14, 2010 Robert Ahdieh2 comments

Robert Ahdieh

It may be characteristic of the human condition generally, as much as complex transactions particularly, that we don’t sweat the details.

It should come as little surprise, then, that even parties to significant commercial contracts, drafted by able counsel, are often caught on the shoals of boilerplate terms that received something less than their full attention at the time of drafting.  In an area of interest to me, for example, sovereign debt contracts drafted over the last century routinely included so-called pari passu clauses–that is, until Peru’s otherwise unremarkable debt restructuring in 1997 was stymied by a New York-based vulture fund that sought full payment on its bonds, based on that theretofore mysterious provision.

Amidst the recent financial crisis, firms have been forced to face similar questions about boilerplate force majeure provisions – “material adverse change” and/or ”material adverse event” clauses–buried in their contracts.  Scholarly interest has followed, including a particularly notable recent contribution by Eric Talley.

In On Uncertainty, Ambiguity, and Contractual Conditions, Talley uses MAC/MAE clauses–as well as the recent analysis of them by the Delaware Court of Chancery, in Hexion v. Huntsman–to reflect broadly on the distinction between risk and uncertainty, and on importance of attending more closely to the latter in contract design and interpretation, whether in corporate settings or elsewhere.  Building on this foundation, in turn, Talley offers an empirical analysis of MAC/MAE provisions in recent merger agreements, finding a correlation between changes in the level of ambient uncertainty, and the scope of MAC/MAE provisions incorporated into relevant contracts.

The distinction between risk and uncertainty, as Talley notes, is most commonly traced to the work of Frank Knight, almost a century ago.  In Risk, Uncertainty and Profit, Knight first highlighted the distinction between risk and uncertainty, suggesting that where the probability of a random occurrence is unknown, relevant actors are faced not simply with risk, but with uncertainty as well.

More tangibly, one can see the distinction between risk and uncertainty at work in the famous thought experiment devised by Daniel Ellsberg–yes, that Daniel Ellsberg–in his 1961 article, Risk, Ambiguity, and the Savage Axioms.  Ellsberg thus suggested offering a given subject the choice of picking a ball from one of two (opaque) urns, in the first of which there are fifty blue balls and fifty red balls, while in the second, there is some random distribution of a hundred balls.  The subject is promised a reward, further, if she should select a blue ball.  Faced with this choice, Ellsberg suggested, individuals can be expected to prefer the first urn over the second one.  Yet more suggestive of the distinct impact of uncertainty, Ellsberg posited that even were the rules altered mid-stream, to offer the very same subject a reward for selection of a red ball, she would continue to prefer the urn containing the known distribution of blue and red balls.  (Subsequent experimental evidence, it bears noting, has largely confirmed Ellsberg’s conjecture.)

Perhaps most familiarly–for its recency, if not otherwise–Talley cites Donald Rumsfeld’s famous contrast between “known unknowns” and “unknown unknowns” as suggestive of the distinction between risk and uncertainty.  At least as I understand Rumsfeld’s point, however, I am less sure of the analogy.  Rumsfeld’s concern would thus seem to be grounded in the question of what we do and do not know, rather than in the nature of what we don’t know.  Putting it more precisely, the uncertainty of interest to Talley is that which might influence our expected utility curve.  An unknown unknown, on the other hand, would seem by definition to be excluded from the latter–unless, that is, we are to understand our mere awareness of the existence of unknown unknowns to function as an independent determinant of our utility.

In any case, Talley’s reference to Rumsfeld’s now famous remark helps to highlight the importance of attending to the distinct phenomenon of uncertainty, and more carefully evaluating its nature and implications, in various realms of decision-making.  In the financial and insurance markets, in mergers and acquisitions, in the fostering of innovation, and elsewhere, it seems likely to be important for us to better understand the nature of uncertainty–just as we already understand risk.

We might, for example, do well to think about the distinct dynamics of uncertainty, across different substantive settings.  On financial markets (and similarly thick markets), for example, one might imagine that the assumption of market efficiency (even if only of the mildest form) would generate particular, and perhaps relatively more targeted, patterns of uncertainty.  By contrast, in a single-shot setting, perhaps with an unknown counterparty–the purchase of an existing home or used car, for example–we might expect the nature of relevant uncertainty to be relatively more diffuse.

Notably, Talley offers some insight into this question, in conjunction with his empirical assessment of Ron Gilson and Alan Schwartz’s distinct, moral hazard/synergy account of MAC/MAE clauses in merger agreements.  In high technology deals, Talley suggests, the degree–and perhaps the nature, I would add–of uncertainty may be different, given the greater proportion of firm value likely to lie in intangible assets.

One might also think about the nature of uncertainty, with reference to the counterpoise of diversifiable and undiversifiable risk.  Plausibly, one might think about the latter as taking on some–though perhaps not all–of the characteristics of uncertainty.  Diversifiable risk might thus be thought to implicate risks of which the probability is “known,” at least across the entire universe of firms within a given sector.  Market risk, by contrast–as perhaps suggested by the recent financial crisis–can be understood as relatively more “unknown” in terms of its probability.

An interest in multiple equilibrium dynamics, finally, leads me to wonder whether certain occasions for uncertainty, perhaps including the mergers context explored by Talley, might be characterized by punctuated equilibria of a sort.  As in multiple equilibria settings such as the bank runs modeled by Diamond and Dybvig, we might sometimes expect uncertainty not to be evenly distributed over a relevant range, but instead to exist as between two or more particular equilibrium points.  Uncertainty might thus be seen as clustered around a handful of possibilities–whether because the relevant probabilities are, in fact, distributed in that fashion, or alternatively because of a cognitive bias toward thinking in those terms, rather than in the manner predicted by Savage’s subjective expected utility framework (as outlined by Talley), in which consistent probabilities are assigned to each and every potential outcome.

Beyond such questions about the nature of uncertainty, Talley’s empirical analysis of MAC/MAE clauses also sparked my interest for the questions it raises about the nature of contract boilerplate in sophisticated contracts, an issue I have previously explored.

Perhaps most importantly, I wondered about Talley’s decision to calculate the strength of MAC/MAE provisions in relevant contracts by simply counting the number of said provisions in each contract.  As Claire Hill and others have suggested, the drafting of complex commercial contracts may, as often as not, be characterized by a kind of one-way ratchet.  In this account, risk-averse lawyers (often junior associates in large law firms) incorporate a succession of new terms from one contract to the next–whether in the face of new issues, or simply because they hear that others are doing so.  By contrast, they never delete old ones, for fear of potential unintended consequences, for which they–having removed the relevant provision–will end up being blamed.

In the presence of such a dynamic, a mere count of MAC/MAE provisions has the potential to prove misleading, as one would expect greater friction in the downward versus the upward movement of the number of relevant terms.  Further, one would not expect the quantity of relevant terms to be evenly distributed over the relevant range.  Rather, one might expect to see patterns of exponential rather than arithmetic growth in the number of terms, as the presence of any given number of provisions fosters the addition of more.

This possibility, in turn, raises the related question of who exactly determines to incorporate MAC/MAE provisions of one scope or another, in the first place.  In the latter account of contract drafting, of course, it is the attorneys who do.  Likewise, in the development of sovereign debt contracts:  Thus has the empirical analysis of Stephen Choi and Mitu Gulati identified repeat-player attorneys for issuers as the primary determinants of innovation in sovereign debt contract instruments.

Coming back to where we started, though, one might plausibly surmise that no one at all is paying much attention to MAC/MAE and other boilerplate provisions in complex contracts, in the absence of some pressing impetus for them to do so.  Useful data to this effect might well be generated over the ensuing months; it would be helpful, thus, to see how the scope of MAC/MAE provisions does (or does not) change over the year ahead, as the level of uncertainty necessarily declines.  For the moment, however, it remains at least plausible that contract provisions on uncertainty truly are unknown unknowns–as terms that simply do not get the attention they deserve, until crisis is already upon us.