Center for Law and Economic Studies | Columbia Law School

Working Papers 191-200

191. The Acquiescent Gatekeeper: Reputational Intermediaries, Auditor Independence and the Governance of Accounting (Coffee, John C. Jr.)

The role of "gatekeepers" as reputational intermediaries who can be more easily deterred than the principals they serve has been developed in theory, but less often examined in practice. Initially, this article seeks to define the conditions under which gatekeeper liability is likely to work - - and, correspondingly, the conditions under which it is more likely to fail. Then, after reviewing the recent empirical literature on earnings management, it concludes that the independent auditor does not today satisfy the conditions under which gatekeeper liability should produce high law compliance. A variety of explanations - - poor observability, implicit collusion, and high agency costs within the gatekeeper - - provide overlapping explanations for gatekeeper failure. What remedy should work best to minimize such failures? As a more appropriate and supplementary remedy to reliance on class action litigation, this article recommends fundamental reform of the governance of the accounting profession. In particular, it contrasts the structure of self-regulation within the broker-dealer industry with the absence of similar self-discipline in the accounting profession. While such reform may be unlikely, its absence strongly implies that earnings management is likely to remain a pervasive phenomenon. Working Paper No.191.pdf

192. Competition Among Securities Markets: A Path Dependent Perspective (Coffee, John C. Jr.) April 1, 2002

Today, there are an estimated 150 securities exchanges trading stocks around the world. Tomorrow (or at least within the reasonably foreseeable future), this number is likely to shrink radically. The two great forces reshaping the contemporary world - globalization and technology - impact the world of securities markets in a similar and mutually reinforcing fashion:

1. they force local and regional markets into more direct competition with distant international markets;
2. they increase overall market capitalization and lower the cost of equity capital, as issuers are enabled to access multiple markets; and
3. they permit order flow and liquidity to migrate quickly from local markets to international "super-markets," sometimes with adverse consequences for smaller domestic markets.

In overview, these consequences follow because globalization has lowered the barriers to cross-border capital flows, including in particular traditional restrictions on foreign investments in domestic stocks, while technology has made instantaneous information flows feasible, thereby enabling electronic securities markets to link dealers and markets participants around the world in continuous world-wide trading. Working Paper No.192.pdf

193. Institutional Change and M & A in Japan: Diversity Through Deals (Milhaupt, Curtis J. & Mark D. West) November 5, 2001

This Article offers new perspectives on the market for corporate control, the convergence debate, and Japanese corporate governance. We begin by applying in the corporate governance setting two related insights from other fields: from economics, the theory that there is no universally efficient organizational model; from organizational behavior, evidence that diverse groups outperform homogeneous ones. We then consider the potential for convergence toward a particular governance technology—the market for corporate control—to increase the desirable trait of diversity within economic systems. Takeovers, we argue, are not exclusively a disciplinary device, but also an engine of managerial and legal innovation.

We apply these insights to Japan through a detailed examination of previously unexplored data on Japanese M&A. We first link the historically low level of Japanese M&A activity to a thick institutional environment much more complex than the conventional focus on cross-shareholding suggests. Among the more startling findings is the existence of negative control premiums in Japanese tender offers and the role of legal shareholder protections in dampening the market for corporate control. Next, we show how the dearth of takeovers is inextricably linked to the lack of diversity in Japanese corporate practices. We then explore how recent changes in "institutions for deals" in Japan correlate with increased takeover activity, which in turn is linked to the creation of a broader range of governance practices, managerial innovations, and structural shifts in corporate lawmaking processes. The Article concludes by analyzing the implications of our findings for two academic debates: the role of functional substitutes in comparative corporate governance theory, and the impact of legal investor protections on corporate governance patterns. Working Paper No.193.pdf

194. On the (Fleeting) Existence of the Main Bank System and Other Japanese Economic Institutions (Milhaupt, Curtis J.) November 9, 2001

In an accompanying essay to be published in the same journal, Professors Miwa and Ramseyer (M&R) argue that most of the comparative corporate governance academy interested in Japan has been chasing a myth. The myth, which M&R largely attribute to economist Masahiko Aoki's influential theories tying Japanese production to a system of delegated bank and governmental monitoring, is the existence of the "main bank system" and the related institutions of lifetime employment and keiretsu groups.

In this essay, I critique M&R's revisionist thesis. After a brief survey of formative events in the creation of the "conventional wisdom" about Japanese corporate governance, I present data and analysis that call into question the significance of the evidence relied upon by M&R to substantiate their claims. Next, I sketch a legal and norm-based analysis of postwar corporate governance that complements Aoki's economic perspective. I conclude that while M&R provocatively challenge several stylized facts, they do not ultimately cast great doubt on the power of Aoki's theoretical construct or the (past) existence of Japan's institutional setting for corporate governance. Interested observers can rest at ease: these economic institutions did exist. Attention can now turn to a more pressing issue: how best to replace them. Working Paper No.194.pdf

195. Economic Development, Legality, and the Transplant Effect (Berkowitz, Daniel, Katharina Pistor & Jean-Francois Richard) September 2001 European Economic Review

We analyze the determinants of effective legal institutions (legality) using data from forty-nine countries. We show that the way the law was initially transplanted and received is a more important determinant than the supply of law from a particular legal family. Countries that have developed legal orders internally, adapted the transplanted law, and/or had a population that was already familiar with basic principles of the transplanted law have more effective legality than countries that received foreign law without any similar pre-dispositions. The transplanting process has a strong indirect effect on economic development via its impact on legality, while the impact of particular legal families is weaker and not robust to alternative legality measures. Working Paper No.195.pdf

196. The Content of Our Casebooks: Why Do Cases Get Litigated (Issacharoff, Samuel) January 2002 Forthcoming in Florida State Law Review, Vol. 29, No. 4

This is the 2000 Mason Ladd Lecture delivered at Florida State. It is intended primarily for law students as a guide to the different approaches to the question of why cases actually litigate. The article begins with the premise that in any dispute the only mechanism for reducing the joint welfare of the parties is to engage agents to litigate the distribution of the contested assets. Beginning with that premise, the Article traces the various explanations given for why cases do actually proceed to litigation. The first part of the article is a rendition of the classic account from the economic analysis of law. The second, and longer, part of the Article then turns to various behavioral insights that call into question some of the simpler assumptions of the standard law and economics account of litigation. The paper includes data drawn from posing classic framing questions to the first-year body at FSU to highlight some of the behavioral considerations in litigation. Working Paper No.196.pdf

197. Lipton and Rowe's Apologia for Delaware: A Short Reply (Gilson, Ronald J.) December 2001

In Unocal Fifteen Years Later I offered a respectful but negative assessment of the Delaware Supreme Court's post- Unocal efforts to walk a line between managerialists who believe directors should be able to block a hostile takeover, and those who believe the ultimate decision whether to accept a takeover bid belongs to the shareholders. I suggested that Delaware law could be repositioned without requiring the Delaware Supreme Court to confess error by allowing shareholder adopted bylaws that repeal or amend poison pills. Martin Lipton and Paul Rowe responded to my essay by arguing that recent economic challenges to efficient market theory, together with studies showing that the poison pill leads to increased takeover premia, undermines the premise on which a shareholder choice regime is based. In this reply, I correct Lipton and Rowe's misunderstanding of the role of market efficiency (and recent critical studies) in assessing shareholders' role in the governance of takeovers, as well as their assessment of why a poison pill may increase takeover premia. Working Paper No.197.pdf

198. Free Riding on Hot Wheels (Goldberg, Victor P.) October 2002 Forthcoming, Winter 2002 issue of Antitrust Bulletin

When warehouse clubs started making inroads into its market, Toys R Us responded with a policy designed to limit the clubs' access to certain toys. The FTC successfully challenged the policy, arguing that TRU had coordinated a horizontal agreement amongst the toy manufacturers to eliminate competition from this new class of competitors.

1. TRU defended itself, invoking the free-rider rationale. This the Commission rejected as pretext. TRU's argument was better than the Commission gave it credit for, but it failed to press its best argument. That failure stems in part from the shortcomings of the standard free rider formulation, and in part from the defendant's need to tailor its arguments to ill-fitting doctrinal constraints. TRU attempted to convince the Commission that its actions were unilateral, within the Colgate exception.
2. Perhaps they were, although the Commission found to the contrary. Regardless, the net result was suppression of an efficiency rationale that emphasized the benefits of cooperation by the toy manufacturers.

In this paper, I will argue that TRU emphasized the wrong free rider problem. Properly framed, the behavior of TRU and the toy companies can be seen as consistent with the efficiency goals of antitrust policy. That a plausible efficiency argument can be constructed does not mean that the outcome itself was wrong. My narrow focus here is on showing that the standard formulation led to asking the wrong question.

Part I provides a brief overview of the market and TRU's behavior. Part II summarizes the defense's rationale and the Commission's rejection of it. Part III provides an alternative explanation. Part IV concludes. Working Paper No.198.pdf

199. Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock (Gilson, Ronald J. & David M. Schizer) February 2002

The capital structures of venture capital-backed U.S. companies share a remarkable commonality: overwhelmingly, venture capitalists make their investments through convertible preferred stock. Not surprisingly, a large part of the academic literature on venture capital has sought to explain this peculiar pattern. Financial economists have developed models showing, for example, that convertible securities allocate control depending on the portfolio company's success, operate as a signal to overcome various kinds of information asymmetry, and align the incentives of entrepreneurs and venture capital investors. In this Article we extend this literature by examining the influence of a more mundane factor, tax law, on venture capital structure. A firm that issues convertible preferred stock to venture capitalists is able to offer more favorable tax treatment for incentive compensation paid to the entrepreneur and other portfolio company employees: Instead of being taxed currently at ordinary income rates, the entrepreneur and employees can defer tax until the incentive compensation is sold (or even longer), at which point a preferential tax rate is available.

No tax rule explicitly connects the employee's tax treatment with the issuance of convertible preferred stock to venture capitalists. Rather, this link is part of tax "practice" - the plumbing of tax law, familiar to practitioners but, predictably, opaque to those, including financial economists, outside the day-to-day tax practice. Despite its obscurity, this tax factor is likely to be of first order importance. Intense incentive compensation for portfolio company founders and employees is a fundamental feature of venture capital contracting. Favorable tax treatment for this compensation is a by-product and, we believe, a core purpose of the use of convertible preferred stock.

We also highlight an important but low visibility tax subsidy for the venture capital market, and the early stage, usually high technology, firms that are financed there. Although this subsidy arose inadvertently, it has an interesting structure. Funds are not provided directly to companies selected by the government (a familiar technique outside the United States), or to all companies. Instead, venture capital investors are enlisted as the subsidy's gatekeeper. As a practical matter, only companies that can attract venture capital investment receive this subsidy. Our analysis thus adds a different twist on the familiar debate about providing subsidies through the tax system, instead of through direct expenditures or favorable regulatory treatment. Working Paper No.199.pdf

200. Enron's Dirty Little Secret: Waiting for the Other Shoe to Drop (Fleischer, Victor) Tax Notes, Vol. 94, No. 8, February 2002

How is it that Enron, allegedly the seventh-largest company in the U.S., didn't pay any income tax for four out of the last five years? In this short commentary piece, I argue that the tax Code got it right and the accountants got it wrong. Using the MIPS transaction (a debt/equity hybrid) and an off-balance sheet partnership as examples, I argue that in Enron's case, the tax Code did a better job of measuring income than the accountants. The reason Enron didn't pay any income tax is because it didn't have any real income. On a more cautionary note, however, the article suggests that the tax bar must move quickly towards effective self-regulation if it wants to avoid the current problems facing the accounting industry. Tax Notes gives permission for academic downloading. Working Paper No.200.pdf