Jan 14, 2010 Robert Ahdieh
Eric L. Talley,
On Uncertainty, Ambiguity, and Contractual Conditions,
34 Del. J. Corp. L. 755 (2009),
available at SSRN.
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.
Cite as: Robert Ahdieh,
Unknown Unknowns: Uncertainty, Contracts, and Crisis, JOTWELL
(January 14, 2010) (reviewing Eric L. Talley,
On Uncertainty, Ambiguity, and Contractual Conditions,
34 Del. J. Corp. L. 755 (2009),
available at SSRN),
https://corp.jotwell.com/unknown-unknowns-uncertainty-contracts/.
Nov 23, 2009 Caroline Bradley
Kenneth A. Bamberger, Technologies of Compliance: Risk and Regulation in a Digital Age, 88 Tex. L. Rev. (forthcoming 2010), available at SSRN. The global financial crisis raises profound questions about how financial markets and the participants in those markets should be regulated. The scale of the crisis has meant that issues which are normally discussed only by technical experts now are the subject of public debate. However, much of this public debate (and even some academic debate) about the future of financial regulation seems to assume that introducing a few new national and transnational institutions and changing a few rules can make a significant difference. For this reason, Kenneth Bamberger’s article, Technologies of Compliance: Risk and Regulation in a Digital Age, forthcoming in the Texas Law Review, is essential reading. The article shows that it is necessary to think about the ways in which private and obscure technologies of compliance risk distorting financial regulation.
Over the last few years, and somewhat ironically given the crisis, financial regulation has evolved to emphasize risk management by financial firms. Regulators have identified many varieties of interconnected risks which financial firms should manage. But although the crisis illustrates weaknesses in how financial firms have in fact managed the risks involved in their businesses, risk management as a focus of regulation is clearly here to stay. The G20, most recently in the Leaders’ Statement from the Pittsburgh Summit, and the Basel Committee (for example in its revisions to the Basel II market risk framework) continue to emphasize the idea of risk management as a core component of financial regulation. Policy makers are advocating the development of more sophisticated domestic and transnational institutions for the management of systemic risk.
The complexities of large financial corporations and financial regulation are such that modern risk management is necessarily a zone of automation. Transnational systemic risk management is also likely to involve automated systems. But although some of the critiques of the financial regulatory system in which the crisis was born, such as the UK’s Turner Review, note that regulators had acquiesced in the market’s over-reliance on complex mathematical models for risk management (in particular in the context of capital adequacy), the larger debate around financial regulation tends to be innocent of the complexities of compliance. By unpacking some of the layers of financial regulation, Bamberger provokes his readers to think carefully about the implications of the use of automated compliance systems for risk management.
Programmers who develop automated compliance systems, Bamberger argues, effectively make choices about how to interpret the law, and how to translate it into code. The law as applied may be different in important ways from the law that legislators and regulators promulgated — not least because the regulators’ choices to emphasize principles rather than rules are subverted by an implementation which turns principles into rules. Not only is law modified through the actions of managers of financial firms in applying it, but it is modified, perhaps in ways not fully understood by managers, by the programs which are used to apply it. Bamberger describes the processes which generate compliance systems as involving interactions between separate expert systems which communicate with each other imperfectly. The resulting risk management systems are ultimately a source of risk.
In contrast to public processes for the development of laws and regulations, the processes which generate compliance systems are private and opaque. Bamberger argues that choices about the interpretation of law should not be made by “private third-parties invisible to regulators.” He asks: “how does the technological instantiation of law-elaboration through implementation fare in light of the public law norms of accountability, effectiveness and legitimacy that traditionally govern the exercise of delegated discretion?”
Bamberger thus shows us that automated compliance systems are problematic from the perspective of genuine risk management and also from the perspective of good governance. The solutions he proposes for both sets of problem involve increasing transparency and improving the technical expertise of regulators, facilitating a dynamic collaboration of regulators and firms to develop effective risk management systems, including recognizing the importance of human judgment. Bamberger is not the only scholar whose work suggests that corporate lawyers should become more familiar with the implications of new governance scholarship, but his elegant unpacking of the subtle issues involved in automated compliance and the implications of this unpacking for thinking about risk management make this article required reading.
Oct 27, 2009 Bill Bratton
Anna Gelpern,
Financial Crisis Containment, 41
Conn. L. Rev. 1051 (2009). Available at
SSRN.
The financial crisis caught many unawares, and not just in their pocketbooks. Those of us who do corporate law had been operating for ever so long under a paradigm favoring market control of corporate actors. In so doing we familiarized ourselves with the financial economics of market success. Market failure did not escape our view, however. Between the standard objections to law and economics, the tech bubble of the late 1990s, and emerging literatures on behavioral influences on stock prices and pricing under heterogeneous expectations, we spent plenty of time writing about it and debating it. But matters like total or near-total economic collapse and prudential regulation occupied the desks of only a handful of people – specialists on structured finance like Steve Schwarcz and banking experts like Pat McCoy, Dan Tarullo, and Arthur Wilmarth. Lehman and TARP meant that the rest of us had some catching up to do, especially those of us who purport to know about finance.
Since last fall I have read a stack of papers and books about financial crisis, theoretical and historical. Some of this has been old material, old here meaning publication before the fall of 2008, and some of it has been new. But for the aforementioned colleagues, it has been the work of economists.
I would like to take the occasion to note that a new member has joined the small club of legal academic writers who have something to teach us about financial crisis. The writer is Anna Gelpern of American University, and the paper of admission is Financial Crisis Containment, 41 Conn. L. Rev. 1051 (2009), available at http://ssrn.com/abstract=1401062. The thesis is that crisis containment proceeds in a distinct regulatory space. Those who occupy it do not and cannot play by the usual rules. When regulators stand at the precipice and try to get things stabilized, standard concerns like ex ante incentive compatibility, security of contract, moral hazard, and even the liquidity-solvency distinction take the back seat. Gelpern reorients our perspective, coaxing common patterns of response from five past crises – this country in 1933, Mexico in 1982, Japan in the mid 1990s, Indonesia in 1997-1998, and Argentina in 2001-2002. As she does so, she emphasizes political choices and their distributive consequences. The account is refreshing and instructive.
Now, do not pick up this paper looking for the roadmap forward. This is description and typology. But the limits do not matter. It is compelling reading. Some of it is as gut wrenching as financial discourse can get. I found it especially valuable because I read it in tandem with a stack of material that approached the same phenomena within tight methodological boxes or with built in policy agendas. Some papers teach you volumes of what you need to know to formulate sound policy without purporting to dictate policy to you.
Oct 26, 2009 Michael Froomkin
Section Editors
The Section Editors choose the Contributing Editors and exercise editorial control over their section. In addition, each Section Editor will write at least one contribution (”jot”) per year. Questions about contributing to a section ought usually to be addressed to the section editors.
Professor Caroline M. Bradley
University of Miami School of Law
Professor William Wilson Bratton
Peter P. Weidenbruch Jr. Professor of Business Law at Georgetown University Law Center
Contributing Editors
Contributing Editors agree to write at least one jot for Jotwell each year.
Professor Robert B. Ahdieh
Director of the Center on Federalism and Intersystemic Governance at Emory University School of Law
Professor Steven M. Davidoff
University of Connecticut School of Law
Professor Anna Gelpern
American University – Washington College of Law
Professor Joe McCahery
University of Amsterdam, Amsterdam Center for Law & Economics
Professor Lawrence E. Mitchell
Theodore Rinehart Professor of Business Law at The George Washington University Law School
Professor Eric J. Pan
Director of the Samuel and Ronnie Heyman Center on Corporate Governance at
Benjamin N. Cardozo School of Law / Yeshiva University
Professor David Arthur Skeel
S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School
Professor D. Gordon Smith
Associate Dean and Glen L. Farr Professor of Law
Oct 25, 2009 Michael Froomkin
Jotwell: The Journal of Things We Like (Lots) seeks short reviews of (very) recent scholarship related to the law that the reviewer likes and thinks deserves a wide audience. The ideal Jotwell review will not merely celebrate scholarly achievement, but situate it in the context of other scholarship in a manner that explains to both specialists and non-specialists why the work is important.
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Oct 19, 2009 Michael Froomkin
The Journal of Things We Like (Lots)–JOTWELL–invites you to join us in filling a telling gap in legal scholarship by creating a space where legal academics will go to identify, celebrate, and discuss the best new legal scholarship. Currently there are about 350 law reviews in North America, not to mention relevant journals in related disciplines, foreign publications, and new online pre-print services such as SSRN and BePress. Never in legal publishing have so many written so much, and never has it been harder to figure out what to read, both inside and especially outside one’s own specialization. Perhaps if legal academics were more given to writing (and valuing) review essays, this problem would be less serious. But that is not, in the main, our style.
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