September 2005

Long-term contracts are designed to manage risk.  After a brief discussion of why it is unhelpful to invoke risk aversion for analyzing serious commercial transactions between sophisticated entities, this paper focuses on adaptation to changed circumstances.  In particular, it considers the options to abandon and the discretion to change quantity.  It then analyzes a poorly designed contract between Alcoa and Essex showing how the parties misframed their problem and designed a long-term contract that was doomed to fail.  (JEL: K3)

The collapse of the UAL employee stock ownership experiment in UAL's bankruptcy does not demonstrate the inevitable failure of the institutional form any more than the collapse of Enron shows the impossibility of the large publicly held corporation.  Rather, UAL suffered from particular design flaws in its stock ownership plan and, more seriously, the absence of complementary institutions focused on the distinctive problems of employee-owned firms.

Avoidance and evasion continue to frustrate the government's efforts to collect much needed tax revenues. This article articulates one of the reasons for this lack of success and proposes a new type of penalty that would strengthen tax enforcement while improving efficiency. The economic analysis of deterrence suggests that rational taxpayers choose among various avoidance or evasion strategies that are subject to identical statutory sanctions those that are more difficult for the government to find. I argue that many taxpayers do just that. Because probability of detection varies dramatically among different items on a tax return while nominal penalties do not take likelihood of detection into account, expected penalties for inconspicuous noncompliance are particularly low. Adjusting existing penalties will not solve the problem because what is (and is not) inconspicuous depends on a given tax return and, therefore, is not susceptible to the type of generalization on which the current penalties rely. I propose to complement the existing sanctions with a new penalty equal to a fraction of the legitimate subtraction item (such as a deduction, credit, or loss) reported on the same line of a return that contains the illegitimate one. With this penalty in place, the harder it is for the government to find a given avoidance transaction, the higher is the statutory sanction if the transaction is detected. The proposed penalty adjusts itself. As a result, the differences in expected penalties for many forms of avoidance and, to a lesser extent, evasion are reduced, the inefficient incentive to hide noncompliance is diminished, and the overall deterrence is improved.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=823468

The paper explores how law affects lending behavior in twelve transition economies of Central and Eastern Europe. In contrast to previous studies, we use bank level data rather than aggregate data, which allow us to control for country level heterogeneity and to analyze the effect of legal change on different types of lenders. Using differences-in-differences methodology to analyze the within country variation of changes in creditor rights protection, we find that lending volume increases subsequent to legal change. Further, we find that Collateral law matters more for development of financial markets as compared to Bankruptcy law. We also find that new entrants respond more strongly to legal change than do incumbents. In particular, foreign owned banks extend their lending volume substantially morethan do domestic banks, be they private or state owned. The same holds when we use foreign green field banks as proxies for new entrants. These results are robust after controlling for a wide variety of possibilities.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=846665

My empirical study first replicates and then extends a prior preliminary empirical study of sexual harassment damages awards by Cass Sunstein and Judy Shih. It covers a comprehensive set of 232 cases in which plaintiffs won some positive amount of compensatory damages from state and federal, trial and appellate court decisions from 1982-2004 (published either in official Reporters or solely on Westlaw). Contrary to Sunstein and Shih's finding, my analysis of these data reveals a consistent, and statistically significant, positive relationship between punitive and compensatory damages (at least in cases where punitive damages are awarded).

My new empirical study then employs dependent variables that, in my view, are more theoretically and statistically sound than those employed by Sunstein and Shih and others who have focused exclusively on the relationship between punitive and compensatory damages: total combined damages (i.e., all compensatory and punitive damages), and what I term "outrage" damages, or combined noneconomic compensatory and punitive damages. My empirical results, using these new dependent variables, essentially confirm Sunstein and Shih's conclusions regarding the irrelevance of variables pertaining to the nature and severity of harassment. What my study reveals as crucial predictive factors, by contrast, are factors pertaining to damages limitations. My study highlights that these factors - including the effect of the 1991 Civil Rights Act, and whether plaintiffs append state civil rights and tort claims to their Title VII claims - are critical to a fuller understanding of damages determinations in sexual harassment cases.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=852264

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=770844

In Wood v. Lucy, Lady Duff Gordon, Cardozo found consideration in an apparently illusory contract by implying a reasonable effort obligation. Unbeknownst to Cardozo, Wood had agreed to represent Rose O'Neill, the inventory of the kewpie doll in an earlier exclusive contract. Wood sued O'Neill two months prior to entering into the Lucy arrangement. That contract included an explicit best efforts clause. The failure to include such a clause in this contract was, quite likely, deliberate, suggesting that Wood was trying to avoid making a binding commitment to Lucy. The paper examines both the kewpie doll and Lucy contract in some detail. It then goes on to argue that the decision's role in finding consideration is probably minimal-it would be easy enough for the parties to provide an alternative source of consideration if they desired. The mischief of the opinion is its impact on contract interpretation. The UCC and some common law courts have taken to imposing a vague effort standard on promisors, even if there exists an explicit source of consideration.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=870474

Two primary arguments are advanced for the functional importance of federalist constraints on centralized political power. The first is captured in Justice Brandeis's famous invocation of the states as the laboratories of democracy in which "a single courageous State" may blaze new paths by trying "novel social and economic experiments." The second ties the smaller, decentralized scale of subnational units to a more robust democratic accountability, by which "government is brought closer to the people, and democratic ideals are more fully realized." This Article is largely about circumstances in which these two arguments for federalism fail. The question that concerns us is what happens when one state's experimentation poses "risks to the rest of the country," in the form of spillover effects that adversely affect citizens of other states. In such circumstances, not only may the benefits of heterogeneity fail, but the citizens of other states are deprived the political means of compelling democratic accountability on economic actors shielded by other states' claims of sovereignty.

In this Article, we will address the emergence of partial federalization of areas historically governed by state law. Our approach is to think of the battles over federalism as running across two dimensions. The more familiar is the question of which law controls, state or federal. But a second dimension is the battle over which forum should control, state or federal, and which is to be the catalyst for new legal norms. Focusing on the rise of federal preemption of state law, on the expansion of the federal forum through federal question subject matter jurisdiction or the newly minted Class Action Fairness Act, and on the constitutional override of matters formally assigned to state law, such as punitive damages, we hope to highlight and explain a quiet federalization of vital areas of law - one far less noticed than the heavily (and perhaps overly) publicized limitations on federal regulation of internal matters of state governance. Our main argument is that the push toward federal standards and the federal forum flows from the need to coordinate the fact of an increasingly national (let alone international) market for goods and services with the inherited presumption of state level legal oversight. We hope to give a broader rendition of the legal response to market pressures toward predictability and uniformity than would emerge from a narrow focus on formal constitutional doctrine. We also aim to underscore aspects of "horizontal federalism" - namely, policing relations between the States - that have tended to be obscured by the looming shadow of "vertical federalism" - namely, the balance of power, and division of labor, between federal and state sources of authority.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=875843

The mutual fund is a superb concept, a vehicle for investors to pool their savings in a diversified portfolio and thus acquire experienced management, as well as economies of scale in fees and expenses. Mutual funds offer, too, remarkable flexibility, the ability to invest and withdraw at will even modest sums, at the underlying asset value. Being a favored child of the law, investors receive detailed disclosures, a safe harbor from double taxation, and SEC oversight. Markets fluctuate, but a mutual fund's diversity and presumably skilled management allow the investor to take a longer view, freeing him from the concern that Stock A or B will report lower earnings next week. Clearly, those thrifty Scots had a brilliant idea, and equity mutual funds alone now have $4 trillion in assets, up from a mere $250 billion as recently as 1990.

What follows is a speech I gave in December 2005 before the NY Society of Security Analysts. It was billed as a celebration of Graham-and-Dodd style value investing, and indeed the invitation had been a consequence of an article I wrote earlier that year, in which I explored a dramatically successful group of patient investors. I used the occasion to look at some quite different funds, ones which play the performance game, turning over their portfolios at stunning rates and at disheartening cost. An update of my earlier data provided a useful benchmark.