Working Papers 241-250
241. The Economics of Form and Substance in Contract Interpretation (Katz, Avery W.) November 2003
For the past 100 years or so the historical trend in the law of contracts has been to water down formal interpretive doctrines in favor of a more all-things considered analysis of what the parties may have meant or what justice might require in the individual case. This trend away from formal and toward substantive interpretation of contracts has been alternately celebrated and criticized for over a century; and in recent years, a number of economically influenced scholars, in translating some of the classic arguments into economic language, have helped to clarify some of the traditional commentators' concerns. While this new economic analysis of formalism has been relatively successful in relating the traditional debates over formalism to specific transactional and institutional problems such as imperfect information and rent-seeking, however, it has fallen short along the dimension of advancing toward practical legal or policy recommendations. This essay, accordingly, proposes a different approach: one that focuses on private rather than public legal decisionmakers as a primary audience. In general, private lawmakers are likelier to be in a better position to make practical use of the economic analysis of contracts, in part because the detailed information that is necessary to implement such analysis intelligently is much likelier to be available at the individual level. Furthermore, there are many opportunities for contracting parties to choose between relatively formal and relatively substantive interpretive regimes. What is needed is a basic taxonomy of economic considerations that can serve as an organizing framework for parties choosing between form and substance when designing contracts; and the later part of the essay attempts to establish such a taxonomy.
Keywords: Contract law, contract interpretation Columbia Law Review, Vol. 104, March 2004 WP241.pdf
242. Scrubbing the Wash Sale Rules (Schizer, David M.) Draft of January 21, 2004
Loss limitations are an ugly but inevitable feature of any realization-based income tax. In essence, because the system mismeasures gains, it also has to mismeasure losses. Otherwise, the "timing option" inherent in the realization rule would allow taxpayers to defer gains (thereby reducing the tax's present value) while accelerating losses (thereby preserving the deduction's present value).
The wash sale regime of Section 1091 is one of our system's most important brakes on the timing option. Yet it is only a slight exaggeration to say that compliance with the regime is voluntary for very wealthy taxpayers - or, at least, for those who are willing to take aggressive positions. In response, this Article flags seven glitches in the regime that, at least arguably, permit "perfect end runs." As used here, this phrase refers to strategies in which taxpayers can deduct losses while effecting virtually no change in their economic position. The essential point is that, if we are going to have a wash sale regime, these end runs should not be allowed.
This Article also takes a more controversial position: Losses should still be deferred - even when taxpayers make meaningful changes in their economic position - as long as they keep material elements of their old return. The policy goal here is to ensure that, on average, taxpayers expect losses to be deferred as long as gains. This Article proposes concrete modifications in the regime to implement this goal, while also offering a caveat: The case for a strong wash sale regime is less strong if the regime can never be tough enough to stop loss harvesting. If so, other constraints on the timing option may be preferable, including accelerated timing for gains or a broader capital loss regime. WP242.pdf
243. The Relative Costs of Incorporating Trade Usage into Domestic versus International Sales Contracts (Katz, Avery Wiener) Chicago Journal of International Law, Vol. 5, No. 1, Spring 2004
This Comment expands upon Clayton Gillette's defense of Article 8(2) of the Convention on the International Sale of Goods (CISG), which directs tribunals to incorporate international trade usage into private contracts governed by the Convention, unless the parties agree otherwise. The Comment attempts to offer a more robust and systematic account of when substantive interpretative doctrines such as trade usage might be desirable, as well as why such doctrines appear to be especially useful in the transnational setting of the CISG. It argues that Gillette's account is incomplete because he does not provide an explanation of why international tribunals have been more restrained than US domestic courts in their use of trade usage, and because he focuses primarily on the costs of interpretative uncertainty to the exclusion of a fuller list of costs and benefits relevant to the choice of interpretative regime. Taking this fuller list of considerations into account renders the widespread use of trade usage and similar contextual standards in the transnational setting more comprehensible, and reinforces Gillette's conclusions regarding trade usage's commercial functionality. http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID510462_code213269.pdf?abstractid=510462
244. The Poison Pill In Japan: The Missing Infrastructure ( Gilson, Ronals J.) January 2004
The fact of a small number of hostile takeover bids in Japan the recent past, together with technical amendments of the Civil Code that would allow a poison pill-like security, raises the question of how a poison pill would operate in Japan should it be widely deployed. This paper reviews the U.S. experience with the pill to the end of identifying what institutions operated to prevent the poison pill from fully enabling the target board to block a hostile takeover. It then considers whether similar ameliorating institutions are available in Japan, and concludes that with the exception of the court system, Japan lacks the range institutions that proved to be effective in the United States. As a result, the Japanese courts will have a heavy responsibility in framing limits on the use of poison pills. http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID509522_code17982.pdf?abstractid=509522
245. Understanding MACs: Moral Hazard in Acquisitions (Gilson, Ronald J. and Alan Schwartz) February 2004
The standard contract that governs friendly mergers contains a material adverse change clause (a MAC) and a material adverse effect clause (a MAE); these clauses permit a buyer costlessly to cancel the deal if such a change or effect occurs. In recent years, the application of the traditional standard-like MAC and MAE term has been restricted by a detailed set of exceptions that curtails the buyer's ability to exit. The term today engenders substantial litigation and occupies center stage in the negotiation of merger agreements. This paper asks what functions the MAC and MAE term serve, what function the exceptions serve and why the exceptions have arisen only recently. It answers that the term encourages the target to make otherwise noncontractable synergy investments that would reduce the likelihood of low value realizations, because the term permits the buyer to exit in the event the proposed corporate combination comes to have a low value. The exceptions to the MAC and MAE term impose exogenous risk on the buyer; the parties cannot affect this risk and the buyer is a relatively superior risk bearer. The exceptions have arisen recently because the changing nature of modern deals make the materialization of exogenous risk a more serious danger than it had been. The modern MAC and MAE term thus responds to the threat of moral hazard by both parties in the sometimes lengthy interim between executing a merger agreement and closing it. The paper's empirical part examines actual merger contracts and reports preliminary results that are consistent with the analysis. http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID515105_code17982.pdf?abstractid=515105
246. Self-Enforcing International Agreements and the Limits of Coercion (Scott, Robert E. and Paul B. Stephan, III) March 2004
International law provides an ideal context for studying the effects of freedom from coercion on cooperative behavior. Framers of international agreements, no less than the authors of private contracts, can choose between self enforcement and coercive third-party mechanisms to induce compliance with the commitments they make. Studies of individual contracting provide some evidence that coercive sanctions may crowd out self enforcement, implying that too great a propensity by external actors to intervene in the contractual relationship may produce welfare losses. We explore the possibility that too much coercive third-party enforcement similarly can reduce the value of international agreements. We argue that, in spite of the obvious differences between state and individual decisionmaking, enough similarities exist to make the inquiry worthwhile. Using analytic moves worked out in the context of private contracts, we make two general claims about international agreements, one conventional and one controversial. First, we maintain that one usefully can evaluate efforts to frame and implement international agreements in terms of optimal enforcement structure. Choosing from a broad range of normative criteria, one still can distinguish between better and worse enforcement strategies. Second, we argue that the optimal enforcement structure for any particular international agreement will depend on both the goals of the agreement and the context in which it designed and implemented. Because these goals and contexts are diverse, the set of optimal enforcement structures is heterogenous. Some optimal enforcement structures will depend largely on self enforcement, while others will not. Central to our claim is an appreciation of the interaction of self enforcement and third-party coercion including binding arbitration, use of international courts, and enforcement by domestic actors. We maintain that in a far from trivial number of instances subject to international agreement, self enforcement and coercive enforcement may be rivalrous and the optimal enforcement structure would preclude or limit coercive enforcement. In particular, we argue that good theoretical arguments buttress the general tendency of domestic courts not to extend their coercive powers to implement an international agreement without a clear signal from the framers of the agreement that this coercion is desired. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=511362
247. Balance in the Taxation of Derivative Securities: An Agenda for Reform (Schizer, David M.) March 4, 2004
By now, it is well understood that aggressive tax planning among high-income individuals and corporations represents a grave threat to the U.S. tax system, and that derivatives are staples of this planning. In response, the usual recommendation is consistency, which means that the same tax treatment should apply to economically comparable bets, regardless of what form is used. Yet because consistency is unattainable, this Article develops an alternative theory: Policymakers should strive instead for balance. This means that for each risky position, the treatment of gains should match the treatment of losses. For example, if the government bears 15% of losses, it has to share in 15% of gains. On a different derivative, if the government bears 35% of losses, it should share in 35% of gains. As long as this matching is achieved across the board for all risky bets, the admittedly counterintuitive reality is that taxpayers need not prefer, or engage in planning to attain, a low effective rate. A low rate obviously is appealing for gains, but it is correspondingly unappealing for losses (i.e., since deducting the loss is less valuable). Moreover, even if a low rate is desired, taxpayers can get the same aftertax return by increasing the size of their bet. The main advantage of this reform agenda is flexibility. To prove this point, this Article outlines three ways to match gains and losses on derivatives: mark-to-market accounting; a novel reform called the stated-term approach, in which gains and losses are deferred until the scheduled maturity date of the derivative, even if the contract is terminated earlier; and a zero tax rate. The provocative conclusion is that these thoroughly inconsistent approaches can coexist for economically comparable derivatives, without prompting planning. Yet this flexibility is not free, so the limitations of this reform agenda are considered as well, along with implications for cutting edge problems in the taxation of derivatives, including the timing and character rules for swaps, Section 1032, and the wash sale rules. WP247.pdf
248. The Efficient Design of Option Contracts: Principles and Applications (Katz, Avery W.) March 2004
The law of contracts has often treated options quite differently from other contractual transactions; for example, the characterization of a transaction as an option contract calls forth specially required formalities, but on the other hand often has the effect of releasing parties from doctrinal limitations on their contractual freedom, such as the duty to mitigate damages or the rule that holds excessively high liquidated damages void as penalties. Such differential treatment is challenging to explain from a functional viewpoint, in part because all contracts resemble options to the extent they are enforceable in terms of monetary damages, and in part because contracts that are nominally structured as explicit options can be close economic substitutes for contracts that are nominally structured as unconditional. This essay sets out a theoretical account of the efficient design of option contracts - one that explains how contracting parties should strike the balance among option premium, option life, and exercise price, in order to maximize the expected surplus from their transaction. It shows that the tradeoffs between these various aspects of option contracts can affect the parties incentives to acquire and disclose information, to invest in relation-specific investments, and to take efficient precautions against the event of breach. It then goes on to develop an organizing framework for private parties choosing whether and how to structure their contractual arrangements as options, and for policymakers choosing whether or how to regulate such private choices. In short, the appropriate balance between option premium, option life, and exercise price will depend on the relative importance that the one attaches to these various dimensions of incentives. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=512146
249. Monopsony as an Agency and Regulatory Problem in Health Care (Hammer, Peter J. and William M. Sage) Antitrust Law Journal, Vol. 71, No. 3, pp. 949-988, 2004
Antitrust courts have shortchanged the economic analysis of buyer-side market power in health care. This failure derives to a surprising degree from a single judicial decision, then-Judge Stephen Breyer's 1984 opinion for the First Circuit Court of Appeals in Kartell v. Blue Shield of Massachusetts. Breyer's opinion, while sound when read in context, has been understood by subsequent courts broadly to excuse health insurers' imposition of price and non-price terms on contracting providers on the grounds that the insurers were merely acting as aggressive purchasing agents, implying that their actions were welfare-enhancing for consumers. This view of health insurers as proxies for end users collapses a three-level model of industrial production -- comprised of provider-suppliers, insurer-producers, and patient-consumers -- into a single buyer-seller dyad, and thereby sidesteps an inquiry into the competitive conditions of resale that is central to the traditional antitrust analysis of producer monopsony. It simultaneously avoids questions regarding insurers as agents that are specific to health care, such as the relationship between risk-aggregation and individual treatment preferences, and the arguably competing role of physicians as patients' clinical agents. The Kartell court's failure to delve into agency issues is directly attributable to the regulatory climate in which the challenged conduct occurred, which constrained Blue Shield's ability to exploit supplier discounts for its own advantage and walled off its conduct from the important public policy considerations of access to insurance and quality of health care. Because regulatory conditions and industry practices have changed dramatically since the Kartell decision was rendered, it is incumbent on antitrust courts to pay closer attention to agency issues when evaluating buyer-side conduct in health care. More generally, the Kartell experience teaches that regulation has significant implications for antitrust analysis even, perhaps especially, when it falls short of constituting "state action." http://papers.ssrn.com/sol3/papers.cfm?abstract_id=557067
250. Managed Care's Crimea: Medical Necessity, Therapeutic Benefit, and the Goals of Administrative Process in Health Insurance (Sage, William M.) Published in Duke Law Journal, Vol. 53, pp. 593-666, 2003
This essay explores the concept of medical necessity as it has evolved in the judicial and administrative oversight of managed care. The goals of the essay are to illustrate the range of plausible rationales for establishing administrative procedures to govern medical necessity disputes, and to demonstrate the difficulty of incorporating into those procedures the most important professional and social responsibilities of managed care in today's health care system. Part I of the essay explains the ideological and practical significance of medical necessity as managed care has evolved. Part II examines medical necessity as a legal problem, and questions whether current independent review programs match social needs. Part III offers an alternative perspective on oversight of decisionmaking in managed care that emphasizes therapeutic effect rather than contractual enforcement. Part IV describes improvements in both independent review and overall medical necessity policy that would better serve therapeutic objectives. Among other things, the essay suggests that independent review procedures should be different for insured individuals who are severely or chronically ill than for those who are only occasional users of health care services and those who are severely or chronically ill. WP250.pdf