Spring 2010 Workshops
January 25, 2010
George Triantis (Harvard)
Strategic Vagueness in Contract Design: The Case of Corporate Acquisitions
(with Albert Choi)
The unprecedented and unanticipated economic and financial shocks of the past couple of years have led parties to look for contractual escapes from deals. Some parties exercise options embedded in their contracts by paying liquidated damages or cancellation fees. Others invoke excuse provisions such as force majeure, material adverse change or market-out clauses, to terminate at no cost. Under either set of circumstances, disputes arise, are litigated and typically settled either by a termination of the deals or adjustments to their terms. The increased attention paid to these provisions has illuminated the vague language with which these options and excuses are framed, and their uncertain interpretation. One instance in which this has been noted is the common use of material adverse event or change (MAE/MAC) conditions in corporate acquisition contracts.
As the current crisis works its way through our economic system, attention will be shifted from the collapsed deals to the design of future transactions. The vague language of past agreements has fueled disputes and threatened costly and uncertain litigation. Should future parties, in corporate acquisition deals and other commercial contracts, inject greater precision in their agreements? There are many proponents of this advice. However, we lack a theoretical framework for setting out the costs and benefits of vague and precise provisions. In this Article, we provide such a framework in order to improve awareness of the strategic use of vagueness in contracting.
The conventional rules-standards analysis suggests that vague terms are justified when the expected larger litigation costs in enforcing standards are outweighed by the lower costs of drafting. In acquisition agreements, this would suggest that vague MAC clauses yield benefits only by reducing front-end drafting costs. Yet, some proxies for material adverse change, such as quantitative thresholds in stock price, revenues or accounting earnings, are easy to draft and can be verified at low cost. They are usually noisy proxies, however, and therefore are not perfect.
We demonstrate that litigation costs, when properly harnessed, can in fact improve contracting by operating as a screen on the seller's decision to sue. We review three possible goals of MAC clauses: (a) to provide efficient incentives for investment and precautions against future contingencies by the seller between the time of the agreement and closing; (b) to allow the seller to better signal its private information to the acquirer at the time of contracting; and (c) to enable the seller to better signal private information at the time of closing, in order to promote ex post efficiency in terminating or executing the acquisition. We show that, in achieving these goals, vague provisions may work better than precise and even less noisy proxies.
February 8, 2010
Alan Schwartz (Yale)
Contract Interpretation and Contextual Asymmetry
(with Joel Watson)
A problem in economic contract theory is to know when parties can create efficient investment incentives with contracts. A problem in legal contract theory is to develop rules to guide courts in interpreting contracts. These problems are related because the law’s interpretive rules affect how parties describe what they want to trade in their contracts, and when parties will offer evidence at trial of their ex ante intentions. The more illuminating contacts and evidence production are, the better contracting works. Hence, some interpretive rules are more efficient than others. We study these rules and show, among other things, that (a) an optimal interpretive rule trades off accuracy in recovering the parties’ ex ante intentions against the costs of contract writing and evidence production; (b) an optimal rule sometimes prevents parties from introducing relevant evidence and deters some parties from writing contracts (in these cases, communicating the parties’ intentions to an adjudicator would not be worth its costs); (c) different enforcement institutions--courts and arbitrators--exist in equilibrium; (d) contract writing and evidence production are substitutes, while enforcer expertise (appropriately defined) and contract writing are complements; (e) under an optimal enforcement scheme, parties need not give interpretive instructions to enforcers because the enforcers and the parties share the same goal (to create efficient incentives to invest); and (f) current courts are more interested in accuracy than in incentives, so parties may want to send interpretive instructions to them.
February 22, 2010
Michal Barzuza (Virginia)
Lemon Signaling in Cross-Listing
This paper develops a signaling model of agency costs. The model shows that when private benefits are heterogeneous and unobservable, and when cross-listing creates bonding, a separating equilibrium could emerge in which insiders that cross-list and bond signal that they extract little private benefits, and insiders that do not cross-list signal that they extract high private benefits.
The model shows that under these assumptions managers and controlling shareholders have different incentives - while managers may want to cross-list and signal that they extract little private benefits, controlling shareholders may want to convey the opposite signal to increase their control premium in a future sale.
The model predicts that managers have a higher inclination to cross-list than controlling shareholders; that control premia and the frequency of sales should increase for non-cross-listed firms, upon cross-listing by peers; and that the cross-listing premia may decline over time.
The paper suggests that the attraction of U.S. capital markets is not necessarily decreasing. Rather, the firms that haven't cross-listed yet have insiders with higher appetite for private benefits.
March 8, 2010
Andrew Ellul (Indiana University, Kelley School of Business)
Regulatory Pressure and Fire Sales in the Corporate Bond Market
(with Chotibhak Jotikasthira & Christian T. Lundblad)
This paper investigates fire sales of downgraded corporate bonds induced by regulatory constraints imposed on insurance companies. Regulations either prohibit or impose large capital requirements on the holdings of speculative-grade bonds. As insurance companies hold over one third of all outstanding investment-grade corporate bonds, the collective need to divest downgraded issues may be limited by a scarcity of counterparties and associated bargaining power. Using insurance company transaction data from 2001-2005, we find insurance companies that are relatively more constrained by regulation are, on average, more likely to sell downgraded bonds. This forced selling generates elevated selling pressure around the downgrade which causes price pressures and subsequent price reversals, indicative of significant periods during which transaction prices deviate from fundamental values. Conditionally, the selling pressure, as well as the resulted price reversals, appears larger during periods in which insurance companies as a group are more constrained and other potential buyers' capital is scarce. In the cross section, bonds widely held by constrained insurance companies experience significantly larger selling pressure and larger price reversals. Investors providing liquidity to this market appear to earn abnormal returns.
March 29, 2010
Tracy Lewis (Duke, Fuqua School of Business)
Long Term Efficient Contracting with Private Information
(with Alan Schwartz)
This paper explores the possibility for efficient long term contracts for traders with changing and privately known incentives for exchange. We suggest a negociation process enabling the parties to adapt the default rules of exchange to changes in their preferences for trade. The selection of control rights and default options is delegated to the traders themselves who are collectively best informed as to what investment and exchanges are efficient. The paper demonstrates how contracts with flexible and endogenous default options are tailored to maximize the gains from exchange. Applications of our findings for contract theory and the design of commercial contracts are discussed.
April 12, 2010
Per Strömberg (Stockholm School of Economics)
Equity: Debtholder Conflicts and Capital Structure
(with Bo Becker)
We use an important legal event as a natural experiment to examine equity--debt conflicts in the vicinity of financial distress. A 1991 Delaware bankruptcy ruling changed the nature of corporate directors’ fiduciary duties in that state. This change limited incentives to take actions favoring equity over debt. We show that, as predicted, this increased the likelihood of equity issues, increased investment, and reduced risk taking. The changes are isolated to indebted firms (where the legal change applied). These reductions in agency costs were followed by an increase in average leverage and a reduction in interest costs. Finally, we can estimate the welfare implications of agency costs, because firm values increased when the rules were introduced. We conclude that equity--bond holder conflicts are economically important, determine capital structure choices, and affect welfare.
April 26, 2010
Louis Kaplow (Harvard)
Direct Versus Communications-Based Prohibitions on Price Fixing
This article compares two policies toward coordinated oligopolistic price elevation. Most courts and commentators endorse the view that the law should (and does) prohibit only those price elevations produced by certain sorts of interfirm communications, such as secret price negotiations. By contrast, little attention has been devoted to a more direct approach that encompasses all price elevations that can be detected and sanctioned effectively. It is demonstrated that the conventional formulation rests on numerous misconceptions, involves complex and costly detection if its logical implications are taken seriously, and tends to target cases with relatively low deterrence benefits yet high chilling costs compared to those found liable under the direct alternative. Accordingly, a wholesale reassessment is warranted.
Note to Readers: This manuscript is part of a larger project. The first is entitled "On the Meaning of Horizontal Agreements in Antitrust" and is primarily addressed to interpretations of the agreement requirement. This half consists of policy analysis. Given the length, the presentation will focus on Part III. Reviewing the introduction and/or conclusion will give a sense of the whole.