311 Controlling Family Shareholders in Developing Countries: Anchoring Relational Exchange (Gilson, Ronald J.)
The Law and Finance account of the ubiquity of controlling shareholders in developing markets is based on conditions in the capital market: poor shareholder protection law prevents controlling shareholders from parting with control out of fear of exploitation by a new controlling shareholder who acquires a controlling position in the market. This explanation, however, does not address why we observe any minority shareholders in such markets, or why controlling shareholders in developing markets are most often family-based. This paper looks at the impact of bad law on shareholder distribution in a very different way. Developing countries typically provide not only poor minority protection, but poor commercial law generally. Specifically, the paper considers the impact on the distribution of shareholders of conditions in the product market, where the driving legal influence is the quality of commercial law that supports the corporation's actual business activities, and where the presence of a controlling family shareholder may help support reputation-based trading in a bad commercial law environment.
Keywords: controlling shareholders, family ownership, developing countries
312 No Derivative Shareholder in Europe - A Model of Percentage Limits, Collusion and Residual Owners (Grechenig, Kristoffel R. and Michael Sekyra)
We address one of the cardinal puzzles of European corporate law: the lack of derivate shareholder suits. In the vast majority of European jurisdictions, shareholders can bring a derivative action (for damages) against the management for breach of fiduciary duty. In spite of corporate fraud by managers there are no such lawsuits. We explain this apparent paradox on the basis of percentage limits which are extremely wide-spread in Europe and typically require shareholders to hold a minimum amount of 5% to 10% in order to bring an action against the management. Since small shareholders are not entitled to sue, there is an incentive for managers to collude with large shareholders. We show that, with the current percentage limits, managers will misappropriate corporate assets and split the proceeds with large shareholders. Contrary to current and past approaches to agency theory, we find that, in this equilibrium, (1) large shareholders do not monitor the management, (2) small shareholders do not free ride and (3) the residual ownership is not held by the shareholders on the whole but by the managers and the large shareholders. This interpretation of the current situation is consistent with empirical studies that find a more concentrated shareholder structure in Europe than in the United States. With lower percentage limits, the results are as predicted by past approaches to agency theory. It reflects the situation of a jurisdiction that has lowered the percentage limits beyond a certain threshold.
313 Law and Capitalism: What Corporate Crises Reveal About Legal Systems and Economic Development Around the World, (Milhaupt, Curtis and Katharina Pistor)
University of Chicago Press, 2008
This book explores the relationship between legal systems and economic development by examining, through a methodology we call the institutional autopsy, a series of high profile corporate governance crises around the world over the past six years. We begin by exposing hidden assumptions in the prevailing view on the relationship between law and markets, and provide a new analytical framework for understanding this question. Our framework moves away from the canonical distinction between common law and civil law regimes. It emphasizes the constant, iterative, rolling relationship between law and markets, and suggests that how a given country's legal system rolls with economic changes depends significantly on its organization rather than its formal characteristics or legal origin. We find that legal systems around the world differ significantly along two crucial organizational dimensions: their degree of centralization of the lawmaking and enforcement processes, and the primary function law serves in support of market activity, ranging from protective functions to coordinative functions.
We use this analytical framework to understand why countries as diverse as the United States, Germany, Japan, Korea, China, and Russia have all experienced corporate crises in recent years, and to analyze the different institutional responses to these crises. These case studies provide insights into the diversity of legal systems and institutional arrangements that support capitalist activity over time and across a range of societies. They also suggest that systemic legal change is rarely achieved by changes in formal law alone, but is the result of changes in the composition and identity of core constituencies within a given system who use (or avoid) law to advance their position in the market. Among other things, our study suggests the need for new thinking about how and why legal systems change, the limits of convergence even in a world where national laws increasingly look alike, and a new emphasis on the demand for law in the process of legal adaptation and change.
314 The "Prudent Retiree Rule": What To Do When Retirement Security Is Impossible? (Gordon, Jeffrey N.)
11 Lewis & Clark Law Review, 481, 2007
Policy debates about the appropriate risk levels for individual retirement plans and social retirement plans (like social security) often pay insufficient attention to the inescapable trade-off between “payment risk” (the risk of insufficient funding for anticipated benefits) and “short fall risk” (the risk of insufficient benefits for a satisfactory retirement).Thus a “prudent retiree rule” would permit a prudent level of “contingent funding” of retirement payouts.Contingent funding – basing benefit expectations on funding sources that may not materialize – increases payment risk, yet pension systems without some contingent funding will produce inferior benefits in most states of the world, increasing shortfall risk.Contingent funding can take different forms: underfunding (in an actuarial sense) of defined benefit promises, which means reliance on the firm’s continued profitability; a tilt toward equity investments in a defined contribution plan, including an appropriate level of employer own stock,and reliance on pay-as-you-go (PAYGO) funding of social security benefits in which each generation funds its predecessor’s benefits. The case for the prudent retiree rule is strengthened through a better appreciation of the underlying risks to retirement security:demographic risk (too many retirees relative to workers); economic risk (insufficient economic growth) and distributional risk (non-effort-based individual economic outcomes).Policies that address these risks can significantly reduce the risks associated with contingent funding.
315 Relational Tax Planning Under Risk-Based Rules (Raskolnikov, Alex)
August 2007 University of Pennsylvania Law Review, Vol. 156, 2008
Risk-based rules are the tax system's primary response to aggressive tax planning. They usually grant benefits only to those taxpayers who accept risk of changes in market prices (market risk) or business opportunities (business risk). Attempts to circumvent these rules by hedging, contractual safeguards, and diversification are well-understood. The same cannot be said about a very different type of tax planning. Instead of reducing risk directly, some taxpayers change the nature of risk. They enter into informal, legally unenforceable agreements with contractual counterparties that are designed to eliminate market or business risk entirely. The new uncertainty these tax planners inevitably accept, however, is the risk (counterparty risk) that the counterparties will violate the implicit agreements and betray taxpayers' trust. A deliberate substitution of counterparty risk for market or business risk is what this Article calls relational tax planning. The Article offers an economic analysis of different risks and considers two responses to the relational tax planning problem. The analysis suggests that business risk is superior to both market and counterparty risks. Counterparty risk is the most complex of the three. In addition to risk-bearing losses produced by all risks, it reduces transaction costs of future exchanges between relational tax planners, but only if they manage to overcome bargaining obstacles caused by opportunism and asymmetric information. These insights suggest two very different responses. A sweeping reform will allow - and even encourage - taxpayers to engage in relational tax planning, but will also ensure that counterparty risk they incur is sufficiently high. If only incremental improvements are pursued, courts should increase their scrutiny of relational tax planning involving extensive dyadic business relationships and interactions based on social norms.
316 Lawyers Asleep at the Wheel? The GM-Fisher Body Contract (Goldberg, Victor P.)
August 2007
In the analysis of vertical integration by contract versus ownership one event has dominated the discussion–General Motors’ merger with Fisher Body in 1926. The debates have all been premised on the assumption that the ten-year contract between the parties signed in 1919 was a legally enforceable agreement. However, it was not. Because Fisher’s promise was illusory the contract lacked consideration. This note suggests that GM’s counsel must have known this. It raises a significant question in transactional engineering: what is the function of an agreement that is not legally
A casebook favorite for exploring the liquidated damage-penalty clause distinction isLake River v. Carborundum in which Judge Posner found a minimum quantity clause to be an unenforceable penalty clause.In this paper I argue that the case was framed improperly.Had the litigators recognized that the contract afforded one party an option, the result should have been different. The contract was for the provision of a service—setting aside capacity—which was valuable to the buyer and costly to provide for the seller. The primary purpose of the minimum quantity clause was the pricing of that service.The case raised indirectly a significant damages issue: if there is an anticipatory repudiation of a contract that is take-or-pay or has a stipulated damage clause, should the promisee’s ability to mitigate be taken into account when reckoning damages?
318 Reputational Sanctions in China's Securities Market, (Liebman, Benjamin L. and Curtis J. Milhaupt)
June 8, 2007
Literature suggests two distinct paths to stock market development: an approach based on legal protections for investors, and an approach based on self-regulation of listed companies by stock exchanges. This paper traces China's attempts to pursue both approaches, while focusing on the role of the stock exchanges as regulators. Specifically, the paper examines a fascinating but unstudied aspect of Chinese securities regulation, namely, public criticism of listed companies by the Shanghai and Shenzhen exchanges. Based on both event study methodology and extensive interviews of market actors, we find that the criticisms have significant effects on listed companies and their executives. We evaluate the role of public criticisms in China's evolving scheme of securities regulation, contributing to several strands of research on the role of the media in corporate governance, the use of shaming sanctions in corporate governance, and the importance of informal mechanisms in supporting China's economic growth.
319 Collaboration, Innovation, and Contract Design (Jennejohn, Matthew C.)
May 30, 2007
The rise of the network as a form of economic organization renders problematic our standard understanding of how capitalism is governed. As the governance of production shifts from vertical integration to horizontal contract, a puzzle arises: how do contracts, presumed to be susceptible to hold-up problems due to incompleteness, control production arrangements that by their nature invite opportunism?Relying on publicly-available contracts taken from a number of industries, I argue that firms govern their collaborations through a number of new contract mechanisms, the summation of which is a novel governance system.Because traditional theories of contractual control struggle to fully explain this new behavior, I re-conceptualize contracting as an effort, inter alia, to establish a pragmatic learning process between collaborators.Such a learning process must be formally instituted among parties because of the unique, endogenous, and pervasive uncertainty that characterizes bilateral experimentation.Thus, to standard accounts of incomplete contracting, this article provides an alternative (but complementary) explanation of how contract governs inter-firm networks, not by downplaying the importance of hold-ups or by inflating the role of relational norms but by explicating a new positive theory of contract design.
320 Bargaining Around Bankruptcy: Small Business Workouts and State Law, (Morrison, Edward R.)
January 2008
In the United States, few failing businesses invoke the Bankruptcy Code to reorganize or liquidate. Most use non-bankruptcy procedures to accomplish the same purposes. These procedures include voluntary agreements between the debtor and its creditors (workouts) and formal devices such as friendly foreclosures, bulk sales, and assignments for the benefit of creditors. This paper documents the importance of non-bankruptcy procedures using firm-level data from Cook County, Illinois. I find that these procedures are used by eighty percent of distressed small businesses. The paper also identifies the conditions under which a business chooses federal bankruptcy law over non-bankruptcy procedures. I model this choice - theoretically and empirically - as the outcome of a bargaining game between the debtor's owner and its senior lenders. The parties are more likely to consent to non-bankruptcy procedures when bargaining costs are low and when the debtor has maintained a close relationship with senior lenders, who trust the information provided by the owner. When the number of senior lenders is relatively large (raising bargaining costs) or when the debtor has defaulted on senior debt (thereby harming its relationship with lenders), senior lenders are more likely to push for a federal bankruptcy filing. Owners may also prefer a federal filing when in-bankruptcy rules give greater priority to particular creditors whom the owner would like to favor. These findings suggest that federal bankruptcy reforms, such as the Bankruptcy Abuse and Protection Act of 2005, will have two effects on distressed small businesses: They will impact outcomes in federal courts (intensive margin) as well as the debtor's choice between bankruptcy and non-bankruptcy procedures (extensive margin). Variation along the extensive margin can neutralize reforms in federal law, as when a reform designed to protect unsecured creditors raises the cost of federal law and induces businesses to use cheaper non-bankruptcy procedures instead.
321 Creditor Control and Conflict in Chapter 11 (Ayotte, Kenneth and Edward R. Morrison
January 8, 2008
We analyze a sample of large privately and publicly held businesses that filed Chapter 11 bankruptcy petitions during 2001. We find that creditor control is pervasive. In contrast to the traditional view of Chapter 11, equityholders and managers exercise little or no leverage during the reorganization process. Eighty percent of CEOs are replaced before or soon after a bankruptcy filing, and very few reorganization plans (at most six percent) deviate from the absolute priority rule in order to distribute value to equityholders. In sharp contrast, creditors dictate the dynamics of the reorganization process. Senior lenders exercise significant control through stringent covenants contained in DIP loans, such as line-item budgets. Unsecured creditors gain leverage through objections and other court motions. We also find that bargaining between secured and unsecured creditors can distort the reorganization process. A Chapter 11 case is significantly more likely to result in a sal e if secured lenders are oversecured, consistent with a fire-sale bias. It is much less likely when these lenders are undersecured or when the firm has no secured debt at all. Our results suggest that the advent of creditor control has not eliminated the fundamental inefficiency of the bankruptcy process: resource allocation questions (whether to sell or reorganize a firm) are ultimately confounded with distributional questions (how much each creditor will receive), due to conflict among creditor classes.
322 Proxy Contests in an Era of Increasing Shareholder Power: Forget Issuer Proxy Access and Focus on E-Proxy (Gordon, Jeffrey N.)
The current debate over shareholder access to the issuer’s proxy for the purpose of making director nomination is both overstated in its importance and misses the serious issue in question.The Securities Exchange Commission’s new e-proxy rules, which permit reliance on proxy materials posted on a website, should substantially reduce the production and distribution cost differences between a meaningful contest waged via issuer proxy access and a freestanding proxy solicitation. The serious question relates to the appropriate disclosure required of a shareholder nominator no matter which avenue is used.Institutional investors and other shareholder activists should focus their energies on working through the mechanics of waging short-slate proxy contests using e-proxy solicitations.Activist institutions need to prepare the disclosure package required under the existing proxy rules.Such disclosure may be tested (and refined) through litigation, but a standardized package should emerge relatively quickly that the institution could use in proxy contests without a control motive.Institutional investors need to become facile with the e-proxy model (including coordinating a practice for opting-in to web-access) and should appreciate the extent to which proxy advisory services will do much of the actual solicitation work.If institutions are unwilling to make the relatively modest investment to master the mechanics of e-proxy contest, both in their initiation as well as voting in support of them, then their role in corporate governance will necessarily be limited.
323 The Rise of Independent Directors in the United States, 1950-2005: Of Shareholder Value and Stock Market Prices, (Gordon, Jeffrey N.)
59 Stanford Law Review 1465 (2007),
Between 1950 and 2005, the composition of large public company boards dramatically shifted towards independent directors, from approximately 20% independents to 75% independents. The standards for independence also became increasingly rigorous over the period. The available empirical provides no convincing explanation for this change. This Article explains the trend in terms of two interrelated developments in U.S. political economy: first, the shift to shareholder value as the primary corporate objective; second, the greater informativeness of stock market prices. The overriding effect is to commit the firm to a shareholder wealth maximizing strategy as best measured by stock price performance. In this environment, independent directors are more valuable than insiders. They are less committed to management and its vision. Instead, they look to outside performance signals and are less captured by the internal perspective, which, as stock prices become more informative, becomes less valuable. More controversially, independent directors may supply a useful friction in the operation of control markets. Independent directors can also be more readily mobilized by legal standards to help provide the public goods of more accurate disclosure (which improves stock price informativeness) and better compliance with law. In the United States, independent directors have become a complementary institution to an economy of firms directed to maximize shareholder value. Thus, the rise of independent directors and the associated corporate governance paradigm should be evaluated in terms of this overall conception of how to maximize social welfare.
324 Shareholder Initiative: A Social Choice and Game Theoretic Approach to Corporate Law, (Gordon, Jeffrey N.)
60 Univ. Cincinnati L. Rev. 347 (1991)
By longstanding practice, shareholders of large public corporations have delegated almost all decision rights over business matters to the board of directors.Given current calls for “shareholder empowerment,” it is worth revisiting the basis for the existing practice, as reflected in this 1991 paper.Among other things, we see that this “absolute delegation rule” minimizes potential pathologies in shareholder voting, including possibilities for opportunistic side-dealings and destructive voting cycles.These risks must be addressedlest shareholder empowerment merely replace one set of problems with another.
325 Adversary Proceedings in Bankruptcy: A Sideshow, (Biard, Douglas G. and Edward R. Morrison)
Amerian Bankruptcy Law Journal, Vol. 79, p. 951, 2005
Recent scholarship emphasizes the increasing rarity of trials (adversary proceedings) in bankruptcy cases. We assess the importance of this pattern using data from the Northern District of Illinois. Adversaries are indeed rare - they are absent from the vast majority of bankruptcy cases - but their rarity tells us little that is meaningful about the bankruptcy process. They tend to be clustered in a tiny number of cases (one percent of bankruptcy cases account for over fifty percent of adversaries). They also focus on a narrow range of issues (objections to discharge in consumer cases; recovery of preferential transfers in business cases). Little has changed since the early 1990s. Although we see a decline in the rate with which adversaries are filed (from six percent of bankruptcy cases in 1993 to about three percent in the late 1990s), the baseline rate was already very low. The decline only tells us that a rare event has become rarer. One temporal change, however, is noteworthy: the average duration of adversaries fell from ten months to 7.5 between 1993 and 2002. This is consistent with recent evidence on the speediness of today's Chapter 11 process. These patterns tell us two things about the bankruptcy process. First, in consumer cases, the persistent rarity of adversaries, even when consumer filings surged during the late 1990s, casts doubt on claims that bankruptcy abuse was prevalent during the late 1990s and early 2000s. If abuse were becoming more prevalent, we should have seen more frequent use of adversaries to contest a debtor's discharge. Second, in corporate cases, adversary proceedings generally address issues, such as preferential transfers, that are orthogonal to the primary concern of Chapter 11 - rehabilitation of the debtor's business. Moreover, when adversaries are brought to attack preferential transfers, the proceedings are often commenced after the court has confirmed a plan of reorganization.
326 Timbers of Inwood Forest, the Economics of Rent, and the Evolving Dynamics of Chapter 11, (Morrison, Edward R.)
Bankruptcy Law Stories, Robert K. Rasmussen, ed., Foundation Press, Forthcoming
The Supreme Court's decision in Timbers of Inwood Forest occupies an unhappy position in bankruptcy case law. It is often remembered as a troubled interpretation of the Code, denying undersecured creditors compensation for an important source of depreciation - depreciation in the real value of a creditor's claim during a lengthy reorganization process. But Timbers was not a simple case in which a bank was denied adequate protection for lost investment opportunities. It was instead a case in which the bank tried to opt out of the bankruptcy process itself. The debtor was an apartment complex. After it entered bankruptcy, it assigned the apartment rents to the bank. These rents, economic theory tells us, closely approximated compensation for physical depreciation as well as lost investment opportunities. Yet the bank wanted more: it requested a second helping of compensation for lost investment opportunities, citing the Code's provision for adequate protection. Surprisingly, the bankruptcy court agreed; so did the Court of Appeals. But by the time the case reached the Supreme Court, it had morphed into something altogether different. Instead of an illustration of bank over-reaching, the case had become a vehicle for testing an abstract question - whether the phrase adequate protection encompasses compensation for lost investment opportunities. The Court may have decided that question incorrectly, but the end result - preventing bank over-reaching - was probably the right one. Indeed, Timbers' long-run impact may not go far beyond the parties to the case itself. The past fifteen years have seen legislative reforms, speedier cases, relatively low interest rates, and creditor control over the bankruptcy process, all of which have effectively neutralized Timbers' impact on most secured creditors.
327 Subsidizing Charitable Contributions: Incentives, Information and the Private Pursuit of Public Goals, (Schizer, David M.)
February 22, 2008
The charitable deduction has enjoyed relatively little support in the legal academy.Many commentators have asked what it adds to the tax system and, as critics have observed, the deduction obviously does not itself collect tax revenue.Defenders respond that the deduction helps measure income and keeps taxpayers from inefficiently substituting leisure for work, but these points are, of course, contested.Instead of revisiting debates about what the deduction adds to the tax system, this Article focuses on the broader question of what it adds to the pursuit of public goals. The deduction – and any other government subsidy that matches charitable contributions through the tax system (here called “subsidized charity”) – enlists private individuals to pursue public goals in a somewhat unique manner.While in other settings the government delegates implementation but still specifies the goal to be pursued, charitable donors are allowed to select the goal as well.Is it desirable to pursue public goals in this way?
This Article analyzes three reasons to subsidize charitable contributions, each responding to a different information or incentive problem that is inherent in the pursuit of public goals.First, the subsidy can counter free-riding by encouraging donors to be more generous. A second objective is to measure and respond to popular preferences about public goals.Subsidized charity can encourage experimentation and competition and can empower minority perspectives that are underrepresented in the political process.Yet subsidized charity also disproportionately represents the views of wealthy donors.The third goal, which is new to the academic literature, is to recruit private donors to monitor the quality of nonprofits, so that the government can piggyback on these quality-control efforts.
Since there are three competing rationales for the subsidy, its institutional design can vary depending upon which has priority – an insight that is new to the literature.To encourage generosity, the subsidy should focus on wealthy donors, giving them broad discretion about which causes to support and targeting marginal contributions.Recruiting these wealthy donors as monitors is largely compatible with this program.Yet by focusing on wealthy donors, the subsidy may fail to reflect broad popular preferences.In response, one option is to compensate with other policy instruments, such as government programs, to address the preferences of low-income nondonors.While I find this approach appealing, others could reasonably want subsidized charity itself to be more representative.Toward that end, we can go to extra lengths to persuade low income taxpayers to contribute more (e.g., through extra-generous matches) or, for that matter, to induce wealthy donors to contribute less (e.g., through caps on giving) or to support causes that reflect broad popular consensus (e.g., through limits on which causes are subsidized).Yet the cost of making the subsidy more representative in this way is that it will be less effective at advancing our other goals of encouraging generosity and recruiting monitors.
328 Sovereign Wealth Funds and Corporate Governance: A Minimalist Response to the New Merchantilism, (Gilson, Ronald J. and Curtis J. Milhaupt)
February 18, 2008
Sovereign wealth funds (SWFs) have increased dramatically in size as a result of increased commodity prices and the increase in the foreign currency reserves of Asian trading countries. SWF assets now roughly equal those in hedge and private equity funds combined. This growth, and the shift of SWF investment strategy toward equities and increasingly high profile investments like capital infusions into U.S. financial institutions following the subprime mortgage problem, have generated calls for domestic and international regulation. The U.S. and other western economies already regulate the foreign acquisition of control of domestic corporations. However, acquisitions of significant but non-controlling positions are not regulated. The danger is that new regulation will compromise the beneficial recycling of trade surpluses accomplished by SWF investments.
In this paper, we situate the controversy over SWF investments in the increasing global trend toward direct governmental involvement in corporate activity, a phenomenon we label the New Merchantilism. We explain why increased transparency of SWF investment portfolios and strategy, the most commonly advanced policy recommendation, does not respond to the chief concern that SWF investments have engendered. We offer a regulatory minimalist response to fears that SWFs will make portfolio investments for strategic rather than economic reasons. Under our proposal, voting rights of SWF equity investments in U.S. corporations would be suspended but reinstated on sale. Thus, SWFs would buy and sell fully voting rights, thereby assuring that the incentives to make non-strategic investments would be unaffected, while the capacity to exercise influence for strategic motives would be constrained. The paper concludes by assessing the extent to which even a regulatory minimalist response remains both over and under inclusive; however, the limited imprecision does not undermine the effectiveness of the response.
329 Accountability and Competition in Securities Class Actions: Why "Exit" Works Better than "Voice", (Coffee, Jr., John C.)
March 27, 2008
The consensus view has long been that the class action plaintiff’s attorney possesses excessive discretion to prefer his own interests over those of the class. Critics have thus favored remedies such as the "lead plaintiff" provision of the Private Securities Litigation Reform Act ("PSLRA"), which in theory give class members a stronger voice. Empirically, however, such "voice-based" reforms appear to have had no more than a modest impact. But an alternative remedy appears to be more promising: "exit-based" reforms that seek to provoke greater competition between class counsel and attorneys soliciting class members to opt out of the class and file individual actions with them in state court. Unnoticed by academics, a major trend towards institutional investors opting out of securities class actions has developed over the past five years. More importantly, these opt outs appear to be recovering per share amounts that are a multiple of the class per share recovery. This development poses a variety of issues that this paper examines: (1) Do the opt outs gains come at the expense of those who remain in the class?; (2) Can defendants feasibly restrict opt outs and how should courts respond to such attempts?; (3) Are institutional investors under a fiduciary or ERISA-based duty to opt out?; and (4) Will greater competition produce greater accountability?
330 Civil Liability and Mandatory Disclosure, (Fox, Merritt B.)
Published Vol. 109, No. 2 Colum. L. Rev. , March 2009
This paper explores the appropriate system of civil liability for mandatory securities disclosure violations by established, publicly traded issuers. The U.S. system's design has become outmoded as the underlying mandatory disclosure regime that has moved from an emphasis on disclosure at the time that an issuer makes a public offering, to an emphasis on the issuer's ongoing periodic disclosures. An efficiency analysis shows that, unlike U.S. law today, the relevant actors should have equally great civil liability incentives to comply with the disclosure rules whether or not the issuer is offering securities at the time.
An issuer not making a public offering of securities should have no liability because the compensatory justification is weak. Deterrence will be achieved instead by imposing liability on other actors. An issuer's annual filings should be signed by an external certifier - an investment bank or other well capitalized entity with financial expertise. If the filing contains a material misstatement and the certifier fails to do due diligence, the certifier would face measured liability. Officers and directors would be subject to similar liability. Damages would be payable to the issuer. When an issuer is making a public offering, it would be liable to investors for its disclosure violations as an antidote to what otherwise would be an extra incentive not to comply.
This design would address two major complaints concerning the existing U.S. civil liability system: underwriter Section 11 liability for a lack of due diligence concerning disclosures that in modern offerings underwriters have no realistic ability to police, and litigation-expensive issuer class action fraud-on-market liability. The system suggested here would eliminate both sorts of liability. But unlike elimination reforms proposed by underwriters and issuers, it would retain deterrence by substituting in place of these liabilities more effective and efficient civil liability incentives for disclosure compliance.
331 Network Neutrality and the False Promise of Zero-Price Regulation, (Hemphill, C. Scott)
April 13, 2008
This Article examines zero-price regulation, the major distinguishing feature of modern network neutrality proposals compared to traditional regulation of infrastructure industries. A zero-price rule prohibits a broadband Internet access provider from charging a content provider to send information to consumers. The Article differentiates two access provider strategies thought to justify a zero-price rule. Exclusion is anticompetitive behavior that harms a content provider to favor its rival. Extraction is a toll imposed upon content providers to raise revenue. Neither strategy raises policy concerns that justify implementation of a broad zero-price rule. First, there is no economic exclusion argument that justifies the zero-price rule as a general matter, given existing legal protections against exclusion. A stronger but narrow argument for regulation exists where socially produced content--content (such as Wikipedia) produced by collaboration without anticipation of financial reward--competes with ordinary market production. Second, prohibiting direct extraction is undesirable and counterproductive, in part because it induces costly and unregulated indirect extraction. I conclude, therefore, that recent calls for broad-based zero-price regulation are mistaken.
332 Market Damages, Efficient Contracting and The Economic Waste Fallacy (Schwartz, Alan and Robert E. Scott)
May, 2008, Forthcoming 108 Colum. L. Rev. (Nov. 2008)
Market damages - the difference between the market price for goods or services at the time of breach and the contract price - are the best default rule whenever parties trade in thick markets: they induce parties to contract efficiently and to trade if and only if trade is efficient, and they do not create ex ante inefficiencies. Courts commonly overlook these virtues, however, when promisors offer a set of services some of which are not separately priced. For example, a promisor may agree to pay royalties on a mining lease and later to restore the promisee's property. In these cases, courts compare the cost to the promisor of providing the service that was not supplied to the increase in the market value of the promisee/buyer's property had the promisor/seller performed. When the cost of completion is large relative to the "market delta"- the increase in market value - courts concerned to avoid "economic waste" limit the buyer to the market value increase. This concern is misguided. Since the buyer commonly prepays for the service at the ex ante market price, a cost of completion award actually has a restitution element - the prepaid price - and an expectation interest element - the market damages. The failure to recognize the joint nature of cost of completion damages causes courts to deny these damages more frequently than they should. In this paper, we argue that the unappreciated virtues of market based damages justify removing the courts' discretion to deny them no matter how high they appear to be. The rule that denies buyers market damages induces excessive entry into these service markets. Moreover, buyers are under-compensated when they prepay and cannot recover the price paid for the breached services but instead are restricted to the market delta. As a result, too few buyers contract ex ante for the relevant service and surplus maximizing contracts are forgone. Finally, sellers often can take actions in the interim between making the contract and the time for performance of the service that would reduce the service cost to manageable proportions. Sellers are less likely to take these precautions if they are required to pay buyers only the market delta rather than the full performance cost that their actions could have avoided.
Tolerated use is a term that refers to the contemporary spread of technically infringing, but nonetheless tolerated use of copyrighted works. Such patterns of mass infringement have occured before in copyright history, though perhaps not on the same scale, and have usually been settled with the use of special laws called compulsory licensing regimes, more familiar to non-copyright scholars as liability rules. This paper suggests that, in present times, a different and slightly unusual solution to the issue of widespread illegal use is emerging - an opt-in system for copyright holders, that is in property terms a rare species of ex post notice right. In addition, this paper proposes a several ways to deal with tolerated use problems, including a complement-driven theory of derivative works, and the copyright no action policy.
334 Is the U.S. Ready for FDI from China? Lessons from Japan in the 1980s, (Milhaupt, Curtis J.)
May 2008
The U.S. environment for inbound FDI from China today exhibits striking parallels with the environment for Japanese FDI in the 1980s. The motivations for Chinese FDI, such as building on extensive export activity by reaping advantages from location and ownership in the U.S., and internalizing processes that are currently external to Chinese firms targeting U.S. markets, are also likely to parallel those of Japanese firms during the boom in FDI from Japan in the 1980s. While the Japanese experience in the U.S. was initially rocky, many Japanese firms learned to adapt and thrive, particularly at the local level. Much can be learned from these parallels, particularly the sources of friction that Chinese firms are likely to encounter in Washington, and the means of dealing with these frictions both nationally and regionally.
Foremost among these lessons is the need to distinguish between the FDI environment at the federal and state levels. While the federal political and regulatory climate may be problematic for Chinese firms, state and local governments and communities are likely to be much more receptive to Chinese investment, particularly of the greenfield variety. Chinese firms will need to integrate fully into the community by forming dense networks of interaction with local suppliers, businesspeople and politicians, and by being good citizens in the realms of employment practices, philanthropy and community involvement. At the national level, Chinese firms probably can anticipate substantial wariness toward Chinese FDI by Congress and federal agencies. There is no magic formula for escaping political skepticism and even hostility at the national level. The Japanese case suggests that avoiding high profile acquisitions and overt lobbying efforts by individual Chinese firms (as opposed to working with organizations representing foreign investors generally) is a sound strategy for mitigating friction.
335 Standard Breach Remedies, Quality Thresholds, and Cooperative Investments, (Stremitzer, Alexander)
March 27, 2009
When investments are non-verifiable, inducing cooperative investments with simple contracts may not be as difficult as previously thought. Indeed, modeling "expectation damages" close to legal practice, we show that the commonly applied remedy of US contract law induces the first best. Yet, in order to lower informational requirements of courts, parties may opt for a "specific performance" regime which grants the breached-against buyer an option to choose "restitution" if the tender's value falls below some (arbitrarily chosen) quality threshold. In order to implement this regime, no more information needs to be verifiable than is implicitly assumed in Che and Hausch (1999).
336 "Say on Pay": Cautionary Notes on the UK Experience and the Case for Muddling Through," (Gordon, Jeffrey N.)
September 1, 2008
Shareholder and public dissatisfaction with executive compensation has led to calls for an annual shareholder advisory vote on a firm’s compensation practices and policies, so-called “say on pay.”Governance activists have recently begun to use the proxy machinery to target specific firms for such a shareholder vote.Some governance activists have also backed federal legislative proposals that would implement “say on pay” generally for US public companies.This paper assesses the case for such a mandatory federal rule in light of the experience with a similar regime adopted in 2002.The best argument for a mandatory rule is that it would destabilize pay practices that have produced excessive compensation and that would not yield to firm-by-firm pressure.This has not been the experience; pay continues to increase.The most serious concern is the likely evolution of a “best compensation practices” regime which would embed normatively-opinionated practices that would ill-suit many firms. There is some evidence of a evolution in that direction.This problem might be more pronounced in the US because US shareholders are even more likely than their UK counterparts to delegate judgments over compensation practices to a small number of proxy advisors who themselves will be economizing on analysis.The paper argues that the jury-rigged system now operating to push for compensation reform in US firms in light of the SEC’s robust new compensation disclosure regime should be permitted to operate for a few more years before mandatory say-on-pay is seriously considered.In any event, if compensation levels are unacceptable as social matter rather than as a pay-for-performance matter, then general tax law changes would be more productive than tinkering with corporate governance.
337 Beyond Deterrence: Targeting Tax Enforcement with a Penalty Default, (Raskolnikov, Alex)
Forthcoming, Columbia Law Review
People pay their taxes for many different reasons. Some try to game the system, paying only when the cost of noncompliance outweighs its benefits. Others comply out of habit, a sense of duty or reciprocity, a desire to avoid feelings of guilt or shame, and so on. Our tax enforcement system has ignored this variety of taxpayer motivations for decades. It continues to rely primarily on audits and penalties, at least where information reporting and withholding are impossible. These policy instruments work well for those rationally playing the tax compliance game, but are wasteful or even counterproductive when applied to others. The shortcomings of the current one-size-fits-all approach to tax enforcement are well understood. They also appear to be insurmountable. This Article argues that it is possible to design a more tailored regime. The idea is to separate all taxpayers based on their taxpaying motivations by creating two different enforcement environments and inducing taxpayers to choose one when they file their returns. Once the separation is accomplished, the government can target enforcement by matching enforcement policies to taxpayer types. Those who try to game the system will be deterred by higher penalties in one regime. All others will be induced to comply by cooperative enforcement measures in the other environment. If successful, separation and targeted enforcement can improve tax compliance without raising its social cost, or keep the level of compliance unchanged while making tax administration more efficient.
338 Trapped in a Metaphor: The Limited Implications of Federalism for Corporate Goverance, (Ahdieh, Robert B.)
Trapped in a metaphor created at the founding of modern corporate law, the study of corporate governance has - for some thirty years - been asking the wrong questions. Rather than a singular race among states, whether to the bottom or the top, the synthesis of Cary and Winter's famous exchange is properly conceived as two competitions, each serving distinct normative ends. Managerial competition promotes the project that has motivated corporate law since Berle and Means - efficient regulation of the separation of ownership and control. State competition, by contrast, advances neither a race to the top nor to the bottom in shareholder-managerial relations.
Instead of the vertical allocation of wealth between shareholders and managers, state competition speaks to its horizontal allocation between state and firm. Even as state competition encourages a shift of surplus from state to firm, it is entirely agnostic as to the distribution of that surplus within the firm. Understood as such, the metrics of "efficiency" in corporate governance - and hence the core inquiries of the corporate law literature - must necessarily shift. Prevailing approaches to questions from the potential utility of federal corporate law to the long persistence of state anti-takeover statutes must likewise be reconsidered.
339 Global Network Finance: Organizational Hedging in Times of Uncertainty, (Pistor, Katharina)
October 2008
The financial market crisis that began to unfold in the summer of 2007 and has deepened in September 2008 has revealed some fundamental problems of global financial system: A massive market failure; a high level of global financial interdependence; regulatory failures at level of nation states; and a looming governance vacuum at the global level. The crisis has forced market participants, policy makers and regulators to enter unchartered waters in their attempt to stabilize financial markets and to begin the process of building a more sustainable governance regime for global financial markets. This paper suggests that elements of such a regime have already emerged over the course of the past eighteen months as major financial intermediaries, incluing banks and Sovereign Wealth Funds from different parts of the world began to engage in "organizational hedging" strategies (Stark). By partnering with institutions from different governance regimes, different expertise and institutional practices, they have created the foundation for transposing elements from one regime to another and recombining them to ultimately form a new governance regime. Whether or not this was their intention at the outset, the pattern of investments among these various organizations has taken the form of relational ties, which collectively can be described as an emergent global financial network. This paper argues that Global Network Finance (GNF) has the potential of performing critical governance functions for the global financial market place.
340 Contracting for Innovation: Vertical Disintegration and Interfirm Collaboration (Gilson, Ronald J., Charles F. Sabel and Robert E. Scott)
Published Vol. 109, No 3, Colum. L. Rev. (April 2009)
Rapidly innovating industries are just not behaving the way theory expected. Conventional industrial organization theory predicts that when parties in the supply chain have to make transaction-specific investments, the risk of opportunism will drive them away from contracts and toward vertical integration.Despite the conventional theory, contemporary practice is moving in the other direction.Instead of vertical integration, we observe vertical disintegration in a significant number of industries, as producers recognize that they cannot themselves maintain cutting-edge technology in every field required for the success of their product.In doing this, the parties are developing forms of contracting beyond the reach of contract theory models.In this Article, we connect the emerging contract practice to theory, learning from what has happened in the real world to frame a theoretical explanation of this cross-organizational innovation and to reconceptualize the boundaries of the firm accordingly.We argue that the vertical disintegration of the supply chain in many industries is mediated neither by fully specified technical interfaces that allow suppliers to produce a modular piece of the ultimate product, nor by entirely implicit relational contracts supported only by norms of reciprocity and the expectation of future dealings.Rather, we suggest that the change in the boundary of the firm has given rise to a new form of contracting between firms – what we call contracting for innovation. This pattern braids explicit and implicit contracting to support iterative collaborative innovation by raising switching costs.These costs, represented by the parties’ parallel investment in transaction specific investment in knowledge about their collaborators’ capacities, deter opportunism under circumstances when explicit contracting, renegotiation and the anticipation of future dealings cannot.
341 In (Partial) Defense of Strict Liability in Contract (Scott, Robert E.)
November 2008, Forthcoming 107 Mich. L. Rev. (2009)
Many scholars believe that notions of fault should and do pervade contract doctrine.Notwithstanding the normative and positive arguments in favor of a fault-based analysis of particular contract doctrines, I argue that contract liability is strict liability at its core.This core regime is based on two key prongs: (1) the promisor is liable to the promisee for breach, and that liability is unaffected by the promisor’s exercise of due care or failure to take efficient precautions; and (2) the promisor’s liability is unaffected by the fact that the promisee, prior to the breach, has failed to take cost-effective precautions to reduce the consequences of non-performance. I offer two complementary normative justifications for contract law’s stubborn resistance to consider fault in either of these instances. First, I argue that there are unappreciated ways in which courts’ adherence to strict liability doctrine at the core of contract reduces contracting costs.In addition, I argue that a strict liability core best supports parties’ efforts to access informal or relational modes of contracting, especially where key information is unverifiable.
342 Redesigning the SEC: Does the Treasury Have a Better Idea? (Coffee, John C. and Hillary A. Sale)
November 2008
The 2008 financial crisis has necessarily raised the question of regulatory redesign. Were regulatory failures responsible to any significant degree for the insolvency of the major investment banks? Even prior to the crisis's cresting, the Treasury Department issued a Blueprint in early 2008 concluding that the regulation of financial institutions in the U.S. was overly fragmented. This paper analyses both the Treasury Department's proposals and the role of the SEC in the rapid increase of leverage at major investment banks in the 2005 to 2008 era that led to their insolvency. Finding the SEC to be more competent at consumer protection and antifraud enforcement than at prudential financial regulation, this paper supports a twin peaks model for financial regulation in preference to either a universal regulator or the U.S.'s current system of functional regulation. It disagrees, however, with the Treasury's recommendation of greater reliance on self-regulation and principles over rules, finding that deference to self-regulation was at the heart of the SEC's recent failure in the Consolidated Supervised Entity Program and provides a paradigm of when self-regulation will fail. An alternative (and more modest) proposal is also made to Treasury's proposed preemption of state securities regulation. This article will appear in the 75th Anniversary SEC Symposium in the Virginia Law Review.
343 "Say on Pay": Cautionary Notes on the UK Experience and the Case for Shareholder Opt-In, (Gordon, Jeffrey N.)
January 17, 2009
Shareholder and public dissatisfaction with executive compensation has led to calls for an annual shareholder advisory vote on a firm's compensation pratices and policies, so-called "say on pay." Proposed federal legislation would mandate "say on pay" generally for US public companies. This paper assesses the case for such a mandatory federal rule in light of the UK experience with a similar regime adopted in 2002. The best argument for a mandatory rule is that it would destabilize pay practices that have produced excessive compensation and that would not yield to firm-by-firm pressure. This has not been the UK experience; pay continues to increase. The most serious concern is the likely evolution of a "best compensation practices" regime which would embed normatively-opinionated practices that would ill-suit many firms. There is some evidence of a UK evolution in that direction. This problem might be more pronounced in the US because US shareholders are even more likely than their UK counterparts to delegate judgements over compensation practices to a small number of proxy advisors who themselves will be economizing on analysis. The paper argues instead for a federally provided shareholder opt-in right to a "say on pay" regime, which would change the present reliance on precatory proposals in the issuer proxy which are in turn subject to the power delegated to shareholders under state law. Secondarily, the paper argues that any mandatory regime should be limited to the 500 the largest public companies by public market float and not cover the other 13,500 firms that make public disclosure. Compensation practices at key financial firms present a distinct set of safety and soundness issues because of potential systemic risk from a failure of such firms. These risks should be separately addressed.
344 The Law, Culture, and Economics of Fashion (Hemphill, C. Scott and Jeannie Suk)
Stanford Law Review 2009
Fashion is one of the world's most important creative industries. As the most immediate visible marker of self-presentation, fashion creates vocabularies for self-expression that relate individuals to society. Despite being the core of fashion and legally protected in Europe, fashion design lacks protection against copying under U.S. intellectual property law. This Article frames the debate over whether to provide protection to fashion design within a reflection on the cultural dynamics of innovation as a social practice. The desire to be in fashion - most visibly manifested in the practice of dress - captures a significant aspect of social life, characterized by both the pull of continuity with others and the push of innovation toward the new. We explain what is at stake economically and culturally in providing legal protection for original designs, and why a protection against close copies only is the proper way to proceed. We offer a model of fashion consumption and production that emphasizes the complementary roles of individual differentiation and shared participation in trends. Our analysis reveals that the current legal regime, which protects trademarks but not fashion designs from copying, distorts innovation in fashion away from this expressive aspect and toward status and luxury aspects. The dynamics of fashion lend insight into dynamics of innovation more broadly, in areas where consumption is also expressive. We emphasize that the line between close copying and remixing represents an often underappreciated but promising direction for intellectual property today.
345 The Empagran Exception: Between Illinois Brick and a Hard Place (Goldberg, Victor P.)
February 2009
In F. Hoffmann-La Roche Ltd. v. Empagran S.A., the Supreme Court interpreted the Foreign Trade Antitrust Improvements Act (“FTAIA”) to bar an antitrust suit by foreign plaintiffs against foreign defendants despite the fact that the foreign and domestic markets were interconnected.I identify one narrow class of cases that would satisfy the statutory exception. Rather than focusing on the interrelatedness of the foreign and domestic prices, the inquiry centers on the resale of goods to the domestic market.The argument is a variant on Illinois Brick.
346 The Devil Made Me Do It: The Corporate Purchase of Insurance (Goldberg, Victor P.)
February 2009
Despite the fact that public corporations ought to be risk neutral, they often carry insurance. This note first considers why insurance (or, more precisely, the package of services provided by insurance companies) might create value, regardless of the risk preferences of managers, shareholders, or other corporate stakeholders.One motive is that their contractual counterparties—buyers, lessors, and lenders—require that they carry insurance.Two explanations for why the requirement might be value enhancing are proposed.
347 An Aggregate Approach to Antitrust: Using New Data and Rulemaking to Preserve Drug Competition, (Hemphill, C. Scott)
Columbia Law Review, May, 2009
This Article examines the "aggregation deficit" in antitrust: the pervasive lack of information, essential to choosing an optimal antitrust rule, about the frequency and costliness of anticompetitive activity. By synthesizing available information, the present analysis helps close the information gap for an important, unresolved issue in U.S. antitrust policy: patent settlements between brand-name drug makers and their generic rivals. The analysis draws upon a new dataset of 143 such settlements.
Due to the factual complexity of individual brand-generic settlements, important trends and arrangements become apparent only when multiple cases are examined collectively. This aggregate approach provides valuable information that can be used to set enforcement priorities, select a substantive liability standard, and identify the proper decisionmaker. The analysis uncovers an evolution in the means - including a variety of complex side deals - by which a brand-name firm can pay a generic firm to delay entry. The Article proposes two solutions for such anticompetitive behavior, one doctrinal and one institutional: a presumption of (illegal) payment where a side deal is reached contemporaneously with delayed entry, and an expanded role for agencies, to gather and synthesize nonpublic information regarding settlements, and potentially to promulgate substantive rules of their own. The aggregate approach also reveals the shortcomings of antitrust enforcement where, as here, firms can exploit regulatory complexity to disguise collusive activity.
349 A Proposed Petroleum Fuel Price Stabilization Plan (Merrill, Thomas and David M. Schizer)
May 5, 2009, Forthcoming, Yale Journal of Regulation
The high level of petroleum consumption in the United States contributes to environmental harms, burdens national security, and increases urban sprawl and traffic congestion. In response, the Obama administration has proposed targeted subsidies and regulatory mandates. We do not believe this will be an effective strategy because Congress has no comparative advantage in picking technological winners and losers. Among serious policy analysts, there is consensus that the best approach is to increase prices through a gas tax. The problem, however, is intense and widespread public opposition to this approach.
We propose an alternative that offers many important benefits of a gas tax but is more politically palatable, and also will not reduce aggregate consumer demand: a revenue-neutral petroleum fuel price stabilization plan (the “PFPS”). The essential idea is to set a floor under the price of gasoline. If the market price falls below this threshold, then consumers would pay an additional levy on petroleum fuels to make up the difference. For example, suppose the PFSP sets a floor of $3.50 per gallon. If the price would otherwise fall to $3.00, the PFPS contribution would raise the price by 50 cents. But if the market price rises to $3.75, the levy would be zero. Our goal is not to collect revenue, but to influence behavior. Accordingly, we propose that any revenues collected be fully refunded to consumers pro rata. While consumers as a group would experience no net decline in purchasing power, individuals would, of course, be affected: those who consume less than the average amount of gasoline would enjoy a net benefit, while those who consume more would incur a net cost. Thus, the PFPS would create a systematic long-term incentive to reduce petroleum fuel consumption with a neutral fiscal impact.
Our proposal would signal to consumers, auto manufacturers, and investors in alternative energy technology that petroleum fuel prices will not decline below the floor price in the future. Armed with this information, consumers, manufacturers and energy investors would commit to making fundamental changes in their behavior and their investments in new technology – without need of targeted government subsidies – because they would know that their investments would not be undermined by a future collapse in petroleum prices. Such assurances are crucial, as recent events have shown. Without a stabilization program, the wild fluctuation in oil prices in 2008 will leave investors and consumers all the more wary of investing in energy efficiency. Our proposal also has significant political advantages. The fact that it is refundable means that those who consume the average amount of petroleum or less will make net profit from the program, and thus will become a constituency for it. Moreover, if the floor on gas prices is set below the level of gas prices when the program is enacted – something that is easy to do when prices are high – then voters could take comfort in the fact that they would never have to make any payments under the program as long as oil prices do not decline. Of course, if the price floor is set at a low level, the program would have less impact. This is apt to be the case if the plan is adopted at a time when gas prices are low, and the price floor is kept at a level below the market price. In response, a range of adjustments to our proposal are possible.
350 Contract Design and the Structure of Contractual Intent, (Kraus, Jody S. and Robert E. Scott)
March 2009, Forthcoming 84 N.Y.U. L. Rev. (Oct. 2009)
Modern contract law is governed by a two-stage adjudicative regime—an inheritance of the centuries-old conflict between law and equity. Under this regime, formal contract terms are treated as prima facie provisions that courts can override by invoking equitable doctrines so as to substantially “correct” the parties’ contract by realigning it with their contractual intent. This ex post judicial determination of the contractual obligation serves as a fallback mechanism for vindicating the parties’ contractual intent whenever the formal contract terms fall short of achieving the parties’ purposes. Honoring the contractual intent of the parties is thus the central objective of contract law. Yet little scholarly attention has been given to the structure of contractual intent. Courts naturally identify contractual intent with the parties’ contractual objectives, which we call the “contractual ends” of their collaboration. But reaching agreement on a shared objective is only the first step to designing an enforceable contract. Thereafter, the parties must create the particular rights and duties that will serve as their “contractual means” for achieving their shared ends. The thesis of this Article is that the current regime of contract adjudication conflates the parties’ contractual means with their contractual ends. In so doing, it reduces the range of contractual arrangements to which contract law gives effect, thereby potentially depriving commercially sophisticated parties of essential tools for contract design. Sophisticated actors engage in ex ante determinations of their means of enforcement, choosing whether enforcement is to be either legal or relational and whether legal enforcement should rely on either rules or standards. Both theory and available evidence suggest, therefore, that such parties would prefer a default rule that strictly enforces formal contract doctrine unless they have expressly indicated their intent to delegate hindsight authority to a court. By eliminating the risk that courts will erroneously infer the parties’ preference for ex post judicial intervention, such a regime increases the reliability of formal contract terms and enhances the parties’ control over the content of their contract.
