Working Papers 251-260
251. Chocie as Regulatory Reform: The Case of Japanese Corporate Governance (Gilson, Ronald J. and Curtis J. Milhaupt) April, 2004
In this paper, we examine a unique recent approach to corporate governance reform in Japan. The reform permits firms to switch from "Japanese" to "U.S." board structure, featuring independent committees of the board for audit, compensation, and nomination. We examine the first year of adoptions (the 2003 annual shareholders meeting season) in this natural experiment, frame hypotheses concerning why Japanese firms might make the switch, and conduct an event study to assess the hypotheses in light of the market's reaction to firm announcements of the decision to switch. We conclude with an intellectual roadmap for future reform of Japanese corporate governance, highlighting a potential shortcoming in the new board option. Detailed analysis of the adoptions reveals several surprising findings. First, cross-listing on a U.S. exchange is not highly predictive of the switch to a U.S. board committee structure. Second, firms which are part of a corporate group - including most prominently the Hitachi group - comprise about half the total adoptions. Adopting firms are also about evenly divided between globally active firms with a high percentage of foreign shareholders, and those with low international profiles. We suggest four hypotheses to explain why a Japanese firm might switch to a U.S. board structure: (1) the belief that U.S. corporate governance structures are superior to Japanese structures, so that the adoption serves a signaling and bonding function; (2) endogeneity, as firms for whom the committee structure is efficient (costly) adopt (resist) the new governance option; (3) strengthening of parent company control over group firms (made possible by the Japanese Commercial Code's very broad definition of outside director, which includes directors affiliated with parent firms and major shareholders); and (4) indeterminacy, as political economy tensions about the appropriateness of the reform apparent in the enactment process are replicated in the adoption/non-adoption process. Our event study results show no pattern of significant market price movement on announcement either for the entire sample or for sub-samples (though several firms individually experienced significant market price movements). Thus, the results are consistent with both the weakness of the signal sent by switching, and the limited impact of the amendments. We conclude with a cautionary note, suggesting that future development of Japanese corporate law may be compromised by use of the new committee structure in tandem with the Code's broad definition of outside director. The combination may create a powerful new technology for managerial entrenchment and what we call "stakeholder tunneling" - the diversion of firm assets and revenues away from shareholders and toward employees, banks and other constituencies. WP251.pdf
252. The Inevitability of Aggregate Settlement: An Institutional Account of American Tort Law (Issacharoff, Samuel and John F. Witt) Vanderbilt Law Review, Vol. 57, 2004
In the courts and in the academy, the ostensible commitment of American tort law to individualized justice has experienced a sustained revival in recent years. Neither the modern mass tort case-law nor the scholarly literature, however, has adequately grappled with long-standing practices of de facto aggregation that have sprung up in the shadow of American tort law since the very beginnings of tort as a field. Reviewing more than a century of private aggregation from employers' liability to automobile accident litigation to the modern asbestos cases, this article contends that American tort practice has been characterized almost from the start by decentralized and private institutions for the aggregate resolution of what may be described as "mature torts": personal injury cases that resolve themselves into regular and reiterated fact patterns. Private settlement institutions constitute a powerful counter-tradition to much better-known traditions of individualized justice in American tort law. The article begins with a historic account of the role of claims agents, sometimes lawyers but sometimes not, in providing claimants' side aggregation to offset the economies of scale and information that the coordinated defenders of local manufacturers or public transport companies held. The article then traces the same pattern of routinization and efficient claims settlement from the industrial setting to seemingly idiosyncratic, one-time events such as auto accidents. By focusing on the institutional actors who administratively expedite settlement of similar claims, the article adds a missing ingredient to the theoretical literature on settlement. It is not only shared assessments of the legal authorities governing claims that inform settlement, but the actual experience of repeat-play legal representatives in resolving factually similar cases in the past. The article concludes with an examination of the mass asbestos settlements rejected by the Supreme Court in Amchem and Ortiz. In contrast to the Court's characterization on these mass settlement cases as departures from a "day in court ideal," the article argues that the persistent aggregation of mature tort claims in private settlement markets situates the mass tort class action on a continuum of aggregating practices in American tort law. Moreover, the long-standing existence of private markets in aggregated settlement indicates that the truly distinctive challenges raised by class actions arise out of the monopolistic representation awarded to class counsel and the difficult agency relations that may ensue, not out of the mere fact of aggregation. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=539602
253. Revisiting the Noninsurable Costs of Accidents (Sharkey, Catherine M.) Maryland Law Review, 2004
This Article offers a fresh perspective on the longstanding debate over the insurability of punitive damages. Prepared for a symposium on Calabresi's The Costs of Accidents: A Generation of Impact on Law and Scholarship, the Article takes as its starting point Calabresi's insight that the line separating insurable costs from noninsurable penalties should be grounded upon the distinction between accidental and intentional misconduct. The Article asks: Should punitive damages be insurable in a Calabresian world? In order to answer this question, the Article chronicles the insurability debate itself, from its origins in the 1960s up to the present. Close study of the divergent legislative, judicial, and insurance industry approaches reveals two competing insurance coverage dividing lines: one separates compensatory and punitive damages, relying heavily upon public policy considerations as set forth by legislatures and courts; the second forges a line between accidental and intentional conduct, resting primarily upon moral hazard economic principles followed by insurance companies. The Article argues that the traditional contours of the public-policy driven debate, which focuses on the nature of the damages - i.e., compensatory or punitive - should give way to the market-driven intentionality line, which focuses on the nature of the underlying conduct. A switch to the Calabresian/insurance industry line respects the changing and expanding multifaceted roles of punitive damages. Since the insurability debate arose in the 1960s in the context of drunken driving cases, punitive damages have entered the more complex realms of products liability, mass torts, employment discrimination, and other civil rights violations - disputes that implicate common law and statutory punitive damages serving a range of not only penal, but also remedial or compensatory purposes. Finally, the Article acknowledges the difficulties posed by the accidental-intentional line drawing, as exemplified in drunken driving cases, and identifies statutory multiple damages as a future challenge for the insurability debate. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=548642
254. Venture Capital Limited Partnership Agreements: Understanding Compensation Arrangements (Litvak, Kate) June 1, 2004
This paper offers in-depth study of partnership agreements in the US venture capital industry. I analyze 37 partnership agreements from 17 venture firms, for funds raised mostly in the late 1990s and early 2000s. There are several new findings. First, contrary to a common academic belief, all elements of VC compensation vary significantly across funds, controlling for fund size and profitability. Second, VC compensation includes three central elements, rather than two (management fee and carry - the VC's share of profits). The third essential element of VC compensation is the value of an interest-free loan that VCs receive from investors. The amount and term of this loan are specified through distribution rules that determine when VCs receive their share of profits. A shift from the most pro-investor to most pro-VC distribution rule can affect VC compensation as much or more than common variations in management fee or carry percentage. The third main finding is that overall VC compensation, across all three elements, is strongly predicted by both fund size and fund number (proxies for VC prominence). A broader measure of VC compensation, which includes fund size, is strongly predicted by fund number. Forth, management fees are not inversely correlated with fund size when we control for fund's vintage year and other characteristics. Fifth, the hotness of the venture capital market, when separated from the time trend, does not predict any element of VC compensation. Finally, contrary to the only prior study, management fee and carry correlate positively, rather than inversely. Instead of raising one element of their compensation substantially above the industry norm, top VCs appear to raise all three elements, presumably by smaller amounts. http://ssrn.com/abstract=555626 WP254.pdf
255. Searching for Rational Investors In a Perfect Storm (Lowenstein, Louis) July 17, 2004
In October, 1991, there occurred off the coast of Massachusetts a "perfect storm," a tempest created by a rare coincidence of events. In the late ‘90s, there was another perfect storm, an also rare coincidence of forces which caused huge waves in our financial markets, as the NASDAQ index soared, collapsed, and bounced part way back.
What had happened to the so-called "rational" investors, the smart money, whom economists have for decades said would keep market prices in close touch with the underlying values? Despite the hundreds of papers on markets and their efficiency, no scholar, not one, has looked to see who are these rational, i.e., value investors, how they operate, and with what results.
I decided to see how a group of ten value funds, selected by a knowledgeable manager, performed in the disorderly boom-crash-rebound years of 1999-2003. Did they suffer the permanent loss of capital of so many who invested in the telecom, media and tech stocks? How did their overall performance for the five years compare with the returns on the S&P 500?
For most managers, mimicking the index, it was difficult not to own Enron, Oracle and the like, but the ten value funds had stayed far away. Instead, they owned highly selective portfolios, mostly 34 stocks or less, vs. the 160 in the average equity fund. They turned their portfolios at one-sixth the rate of the average fund. Bottom line: every one of the ten outperformed the index over the five year period, and as a group they did so by an average of 11% per year, the financial equivalent of back-to-back no-hitters.
The article closes with a discussion of the clearly large implications for investors, market watchers and public policy. As for those economic models, let the chips fall where they will. WP255.pdf
256. A Perfect Storm: Changing a Culture ( Lowenstein, Louis) Swedish Corporate Governance Forum, Stockholm, December 11, 2003
In October, 1991, there occurred off the coast of Massachusetts a "perfect storm," a tempest created by a rare coincidence of events. In the late ?90s, there was another perfect storm, an also rare coincidence of forces which caused huge waves in our financial markets, as the NASDAQ index, for one, soared from 1200 in 1997 to 5000 in 2000 and back to 1100 in 2002. These were the days of the New Economy - low inflation and unemployment, government surpluses, and the Internet that would change how we work and play. Suddenly, all of us were watching crawlers on CNBC to see how rich we were. But the bubble triggered a period of unmatched and pervasive corporate fraud. Using academic blessings of stock options as the link of pay for performance, executives took huge helpings and then manipulated reported earnings to achieve the stock gains that would bring their compensation to stunning heights. In the five years ended 2003, over 1300 companies, many major, restated their earnings, and those were only the more egregious cases. It was a broad-based, cultural failure, one that enlisted the active support, nay connivance, of the various gatekeepers, notably of course auditors, but also analysts, audit committees, bankers, and, yes, the lawyers who crafted the hollow transactions that would enable debt to disappear from balance sheets and create revenues from thin air. But then, we all wanted so much to believe. The author brought to the article his background as a member of the Panel on Audit Effectiveness, appointed in 1998 at the instance of Chairman Levitt of the SEC, and also his longstanding skepticism about efficient market theory. WP256.pdf
257. The Forgotten Third: Liability Insurance and the Medical Malpractice Crisis (Sage, William M.) Published in Health Affairs, Vol. 23, No. 4, pp. 10-21, August 2004
Although the most visible manifestations of medical malpractice involve patient safety and the legal process, the availability and affordability of liability insurance largely determine the direction of medical malpractice policy. Scientific and industrial developments since the first modern malpractice crisis in the 1970s reveal major problems with the structure and regulation of liability insurance. Comprehensive reforms that approach medical malpractice insurance as a health policy problem are needed, and the Medicare program may have a major role to play.
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258. Derivatives and the Bankruptcy Code: Why the Special Treatment? (Edwards, Franklinh R. and Edward R. Morrison) August 16, 2004
The collapse of Long Term Capital Management (LTCM) in Fall 1998 and the Federal Reserve Bank's subsequent efforts to orchestrate a bailout raise important questions about the structure of the Bankruptcy Code. The Code contains numerous provisions affording special treatment to financial derivatives contracts, the most important of which exempts these contracts from the "automatic stay" and permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral. No other counterparty or creditor of the debtor has such freedom; to the contrary, the automatic stay prohibits them from undertaking any act that threatens the debtor's assets. It is commonly believed that the exemption for derivatives contracts helps reduce "systemic risk" in financial markets, that is, the risk that multiple major financial market participants will fail at the same time and, as a result, drastically reduce market liquidity. Indeed, Congress is now contemplating reforms that would extend the exemption to include a broader array of financial contracts, all in the name of reducing systemic risk. This is a mistake. The Bankruptcy Code can do little to reduce systemic risk and may in fact exacerbate it, as the experience of LTCM suggests. Risk of a systemic meltdown arose there and prompted intervention by the Fed precisely because derivatives contracts were exempt from the automatic stay. Derivatives contracts may merit special treatment, but fear of systemic risk is a red herring. A better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economic theory underlying the automatic stay. The stay protects assets to the extent they are needed to preserve a firm's going-concern surplus (its value above and beyond the sale value of its assets). Assets are needed to preserve going-concern surplus only if they are firm-specific, that is, only if they are worth more inside the firm than outside it. This is often true for plant and equipment. It is never true for derivatives contracts. This observation helps rationalize the Code's treatment of derivatives contracts and other features of the automatic stay. There are, however, downsides to treating derivatives contracts differently (creditors, for example, would like to disguise loans as derivatives contracts). These downsides are probably not significant, but they highlight the fragility of the Code's treatment of derivatives contracts, which should worry members of Congress as they consider arguments to expand the Code's exemptions for derivatives contracts. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=589261#PaperDownload
259. The Essential Role of Securities Regulation (Goshen, Zohar and Gideon Parchomovsky) October 5, 2004
This Article posits that the essential role of securities regulations is to create a competitive market for information traders ("analysts"). The Article advances two related theses—one descriptive and the other normative. Descriptively, it demonstrates that securities regulation is specifically designed to facilitate and protect the work of analysts. Normatively, the Article shows that analysts are the only group that can best underwrite efficient and liquid capital markets and, hence, it is the group securities regulation should strive to protect. By protecting analysts, securities regulations enhance efficiency and liquidity in financial markets. This protection, in turn, benefits other types of investors by reducing transaction costs. Furthermore, by protecting analysts, securities regulation represents the highest form of market integrity by ensuring accurate pricing to all investors, and improves the allocation of resources in the economy.
Securities regulation may be divided into three broad categories—disclosure duties; restrictions on fraud and manipulation; and restrictions on insider trading—each of which contributes to the creation of a vibrant market for analysts. Disclosure duties reduce analysts' costs of gathering information, and diminish the ability of analysts to produce biased analyses in exchange for pay. Restrictions on fraud and manipulation lower analysts' cost of verifying the credibility of information, and enhance analysts' ability to make accurate predictions. Finally, restrictions on insider trading protect analysts from competition from insiders that would undercut the ability of analysts to recoup their investment in information, and thereby drive analysts out of the market. Thus, the effect of securities regulation is to develop and secure a competitive market for analysts.
Moreover, a competitive market for analysts reduces management agency costs. While courts can discern fraud or illegal transfers, they are ill-equipped to evaluate the quality of business decisions. Judicial oversight can curtail breaches of the duty of loyalty but not breaches of the duty of care; the tasks of curbing breaches of the duty of care and restraining inefficient investments are performed by analysts. Furthermore, a competitive analysts' market generates positive externalities for the rest of the economy by improving the information market and facilitating the operations of the investment banking industry.
Our account has important implications for several policy debates. First, our account supports the system of mandatory disclosure. We show that while market forces may provide management with an adequate incentive to disclose at the initial public offering (IPO) stage, they cannot be relied on to effect optimal disclosure thereafter. Second, our analysis categorically rejects the calls to limit disclosure duties to hard information and self-dealing by management. Third, our analysis supports the use of the fraud-on-the-market presumption in all fraud cases regardless of how efficient financial markets are. Fourth, our analysis suggests that in cases involving corporate misstatements, the appropriate standard of care should, in principle, be negligence, not fraud. WP259.pdf
260. The Value of the Freezeout Option (Goshen, Zohar, and Zvi Wiener) September 2003
The value of the freezeout option is important in many legal policy issues concerning corporate law. In this article, we present, for the first time, a method for determining the value of the minority stock and the freezeout option. We price the freezeout option with two different sets of assumptions regarding the controlling shareholder informational advantage, using both an exogenous and endogenous stock prices in our pricing. The result of our model indicates that when using an exogenous market price to determine fair value, the freezeout option has a low value and the minority stock is only slightly discounted. This result implies that the use of publicly known information, excluding market prices, in determining a fair value for minority stocks will not cause expropriation of minority shareholders and will not lead to inefficiency in corporate and controlling owners' decisions. Additionally, our model shows that a complete reliance on market prices will lead to inability to positively price and trade minority shares. Any consistent and predictable use of market prices by the courts in the valuation process will cause a discount relative to the weight given to market prices in that process. Combining both results it can be said that, indeed, in an efficient market, prices do reflect fair value, but this is so because courts do not heavily and consistently base their valuations on market prices. Empirical studies support our results. WP260.pdf