Working Papers 451-475
451 Litigation Finance: What Do Judges Need to Know? (Bert I. Huang) July 1, 2013
The growth of “litigation finance” — the funding of lawsuits by outside investors who are neither parties nor counsel — is being closely watched by academics, the press, and the bar. The practice poses risks of conflicting interests and improper influence; and yet if carefully managed it may in fact enhance party autonomy. What questions, then, should judges be asking when dealing with a case with outside funding?
This symposium essay offers judges a starting point: a menu of questions to ask parties who receive such financing. These inquiries aim to pierce simplistic labels such as “loan” or “investment,” in order to help judges grasp the true nature of the funder’s stake, incentives, and control. For instance: Is the investor taking interest payments, a share of the recovery, or both? Does the investor’s return depend on whether the outcome is a judgment or a settlement? Or on whether the remedy is injunctive or monetary? Has the investor in effect chosen the party’s counsel? Can it exert de facto influence over litigation decisions by threatening to withdraw funding? Does the arrangement limit investments by other funders? How does it affect the amount or timing of the party’s or counsel’s compensation?
Further questions are raised here to prompt judges to consider new ways not only to uncover, but also to respond to — or even to harness — such third-party involvement. Special emphasis is given to the context of mass litigation. For instance: Should opposing counsel be allowed to pose questions about the financing? Should the court direct that financing details be included in motions for class certification and in notices to class members? How might the court take the funding structure into account in assigning attorneys’ fees, say, or in approving settlements?
452 Systemic Harms and Shareholder Value (John Armour and Jeffrey N. Gordon) August 5, 2013
The financial crisis has demonstrated serious flaws in the corporate governance of systemically important financial firms. In particular, the Shareholder Value norm, which has guided corporate governance reform for a generation, proves to be a faulty guide for managerial action in systemically important firms. This is not only because the failure of such firms will have spillovers that defy the cost-internalization of the tort system but also because these spillovers will harm their own majoritarian shareholders. The interests of diversified shareholders fundamentally diverge from the interests of managers and other controllers because the failure of a systemically important financial firm will produce losses throughout a diversified portfolio, not just own-firm losses. Among the consequences: the business judgment rule protection that makes sense for officers and directors of a non-financial firm leads to excessive risk-taking in a systemically important financial firm. To encourage appropriate modification of the Shareholder Value norm, we propose officer and director liability rules as a complement (and substitute) to the prescriptive rules that have emerged from the financial crisis.
453 Idiosyncratic Risk during Economic Downturns: Implications for the Use of Event Studies in Securities Litigation (Edward G. Fox, Merritt B. Fox and Ronald J. Gilson) August 27, 2013
We reported in a recent paper that during the 2008-09 financial crisis, for the average firm, idiosyncratic risk, as measured by variance, increased by five-fold. This finding is important for securities litigation because idiosyncratic risk plays a central role in event study methodology. Event studies are commonly used in securities litigation to determine materiality and loss causation.
Many bits of news affect an issuer’s share price at the time of a corporate disclosure that is the subject of litigation. Because of this, even if an issuer’s market–adjusted price changes at the time of the disclosure, one cannot determine with certainty whether the disclosure itself had any effect on price. An event study is used to make a probabilistic assessment of whether in fact it did. Use of event studies generates a certain rate of Type I errors (disclosures that had no actual effect on price being identified as having had an effect) and a certain rate of Type II errors (disclosures that had an actual effect not being identified as such).
This paper sets out a simple model of the tradeoff between these Type I and Type II errors. The model is used to establish three fundamental points. First, an economic crisis can radically worsen this tradeoff by making it much more difficult to catch a disclosure of a certain size without introducing more Type I errors. Second, during crisis periods a relaxation of this standard (and hence an increase in the acceptable rate of Type I errors) may actually decrease Type II errors by less than it would in normal times. We prove that whether the decrease is greater or smaller in crisis times depends on whether the disclosure’s actual impact on price is more or less negative than a definable crossover point. Third, whether relaxation of the standard in troubled times would increase or decrease social welfare is ambiguous. It depends on distribution of potentially actionable disclosures in terms of their actual impact on price and the social costs and social benefits of imposing liability for disclosures of each given level of actual negative impact on price.
454 Protecting Reliance (Victor P. Goldberg) September 10, 2013
Reliance plays a central role in contract law and scholarship. One party relies on the other’s promised performance, or its statements, or its anticipated entry into a formal agreement. Saying that reliance is important, however, says nothing about what we should do about it. In this paper the focus is on the many ways that parties choose to protect reliance. The relation between what parties do and what contract doctrine cares about is tenuous at best. Contract performance takes place over time and the nature of the parties’ future obligations can be deferred to take account of changing circumstances. Reliance matters in this context since one or both of the parties might want to rely on the continuity of the arrangement; but they might also want the flexibility to adapt as new information becomes available. If one party has the discretion to react (terminating or adjusting quantity, for example) the other party can confront the decision maker with a price reflecting its reliance. That price need bear no relation to the formal remedies of contract law. The paper also considers other roles of reliance, including determination of compensation following excused performance, the irrevocability of an offer, and in a particular type of complex transaction—a corporate acquisition.
455 Beccaria's On Crimes and Punishments': A Mirror on the History of the Foundations of Modern Criminal Law (Bernard E. Harcourt) July 22, 2013
Beccaria’s treatise "On Crimes and Punishments" (1764) has become a placeholder for the classical school of thought in criminology, for deterrence-based public policy, for death penalty abolitionism, and for liberal ideals of legality and the rule of law. A source of inspiration for Bentham and Blackstone, an object of praise for Voltaire and the Philosophies, a target of pointed critiques by Kant and Hegel, the subject of a genealogy by Foucault, the object of derision by the Physiocrats, rehabilitated and appropriated by the Chicago School of law and economics — these ricochets and reflections on Beccaria’s treatise reveal multiple dimensions of Beccaria’s work and provide an outline of a history of the foundations of modern criminal law. In becoming a classic text that has been so widely and varyingly cited, though perhaps little read today, "On Crimes and Punishments" may be used as a mirror on the key projects over the past two centuries and a half in the domain of penal law and punishment theory — and this essay hopes to contribute, in a small way, to such an endeavor. In the end, we may learn as much about those who have appropriated and used Beccaria than we would about Beccaria himself — perhaps more.
456 Becker and Foucault on Crime and Punishment (Gary S. Becker, Francois Ewald and Bernard E. Harcourt) September 6, 2013
In his 1979 lectures at the Collège de France, The Birth of Biopolitics, Michel Foucault discussed and analyzed Gary Becker’s economic theory of crime and punishment, originally published in The Journal of Political Economy in 1968 under the title “Crime and Punishment: An Economic Approach.” In this historic, second encounter at the University of Chicago, Gary Becker responds to Foucault’s lectures and possible critical readings of his writings on crime and punishment, in conversation with Professors François Ewald (who was, at the time in 1979, Foucault’s assistant at the Collège and one of Foucault’s closest interlocutors) and Bernard Harcourt (a punishment theorist and an editor of Foucault’s lectures). The rich encounter explores potential overlaps, complementarities, and conflicts between Foucault’s theoretical work on punishment (both in Birth of Biopolitics and Discipline and Punish) and Becker’s economic theory of crime, builds on the previous confrontation over American neoliberalism, and provides a bridge between contemporary French philosophy and American economic theory.
457 Activating Actavis (Aaron S. Edlin, C. SWcott Hemphill, Herbert J. Hovenkamp and Carl Shapiro) August 26, 2013
In Federal Trade Commission v. Actavis, Inc., the Supreme Court provided fundamental guidance about how courts should handle antitrust challenges to reverse payment patent settlements. The Court came down strongly in favor of an antitrust solution to the problem, concluding that “an antitrust action is likely to prove more feasible administratively than the Eleventh Circuit believed.” At the same time, Justice Breyer’s majority opinion acknowledged that the Court did not answer every relevant question. The opinion closed by “leav[ing] to the lower courts the structuring of the present rule-of-reason antitrust litigation.”
This article is an effort to help courts and counsel fill in the gaps. We identify and operationalize the essential features of the Court’s analysis. We describe the elements of a plaintiff’s affirmative case, justifications that are ruled out by the Court's logic, and a test for viable justifications. For private cases, we outline an appropriate procedure for evaluating damages and suggest specific jury instructions.
458 Freedom of Contracts (Hanoch Dagan and Michael A. Heller) September 12, 2013
“Freedom of contracts” has two components: (1) the familiar freedom to bargain for terms within a contract and (2) the long-neglected freedom to choose from among contract types. Theories built on the first freedom have reached an impasse; attention to the second points toward a long-elusive goal, a liberal and general theory of contract law. This theory is liberal because it develops an appealing conception of contractual autonomy grounded in the actual diversity of contract types. It is general because it explains how contract values – utility, community, and autonomy – properly relate to each other across contract types. Finally, it is a theory of contract law because it covers the field as a whole, including for example marriage, employment, and consumer contracts, not just arm’s length widget sales.
“Freedom of contracts” illuminates numerous puzzles in contract doctrines from liquidated damages to promissory estoppel and across the ABCs of contract types – agency, bailment, consumer transactions, etc. Our approach also generates a range of novel theoretical propositions. For example, it explains how sticky defaults and even mandatory terms within a contract type can actually increase freedom, so long as law offers sufficient choice among types. Finally, it offers law-and-economics contract scholars a way to situate efficiency analysis within a normatively appealing liberal framework. In sum, “freedom of contracts” suggests a refocus of how contract theory should be pursued – and how contract law should be designed and taught.
459 Extraterritorial Financial Regulation: Why E. T. Can't Come Home (John C. Coffee, Jr.) October 29, 2013
Systemic risk poses a classic "public goods" problem. All nations want systemic stability, but most would prefer that other nations pay for it, allowing them to "free ride." Moreover, because global financial institutions can park their higher risk operations almost anywhere, some nations can profit from regulatory arbitrage by keeping their regulatory controls laxer than in the more financially developed nations (which bear the principal share of the costs from financial contagion). As a result, the free riders do not need to internalize the full costs of systemic risk, but profit from imposing costs on others.
Under these conditions, all the preconditions for a "tragedy of the commons" are satisfied, because (i) the nations that profit from regulatory arbitrage cannot be excluded from offering under-regulated markets, and (ii) they do not need to internalize the costs they impose on others. While the "tragedy of the commons" literature has been much used in environmental law and related fields, it applies equally well to international financial markets. The solution to this problem lies in finding ways to tax the free riders or otherwise subject them to stronger controls. But here is exactly where current "soft law" approaches to international financial regulation fail. Because "soft law" is almost by definition non-binding and unenforceable, it cannot control a financial services industry that wishes to pursue highly profitable, higher risk strategies.
Aspirational theorists of international "soft law" thus misconceive the problem. To expect "soft law" to be kinder and gentler than formal law and to give every nation an equal voice is to prescribe the essential conditions for a "tragedy of the commons."
Instead, as this article argues, only the major financial nations have the right incentives to curb systemic risk, precisely because they are exposed to it. Thus, bilateral negotiations among them (particularly between the U.S. and the E.U.) and the assertion of extraterritorial jurisdiction by them is necessary to create a governance structure under which highly mobile financial institutions cannot flee to less regulated venues. Ultimately, this assertion of extraterritorial authority (which both the U.S. and the E.U. have now done) may be an interim stage in the longer term development of adequate international "soft law" standards. But, absent the assertion of such authority, the commons will predictably collapse again into tragedy.
This article examines recent negotiations over the international regulation of OTC derivatives markets and the uncertain status of the Volcker Rule as cases in point. With respect to the latter, it poses the question: how should a legal regime of "substituted compliance" deal with the Volcker Rule where no other nations has adopted or proposed a close financial equivalent? Finally, it asks: how "extraterritorial" does U.S. law need to be and proposes some limits.
460 Three Discount Windows (Kathryn Judge) November 18, 2013
It is widely assumed that the Federal Reserve is the lender of last resort in the United States and that the Fed’s discount window is the primary mechanism through which it fulfills this role. Yet, when banks faced liquidity constraints during the 2007-2009 financial crisis (the Crisis), the discount window played a relatively small role in providing banks much needed liquidity. This is not because banks forewent government-backed liquidity; rather, they sought it elsewhere. First, they increased their reliance on collateralized loans, known as advances, from the Federal Home Loan Bank system, a little-known government-sponsored enterprise that grew in size to over $1 trillion during the Crisis. Second, distressed banks offered exceptionally high interest rates on insured deposits, enabling them to retain and attract funds from depositors. As a result, Federal Home Loan Bank advances and insured deposits served as “alternative discount windows,” standing sources of government-backed liquidity that banks relied upon as market conditions deteriorated.
In addition to drawing attention to the important and largely overlooked role that the alternative discount windows played in the Crisis, the Article considers the normative implications of banks’ capacity to obtain government-backed liquidity without going to the Federal Reserve. The analysis reveals both benefits and costs. As a result of the changing nature of banking and financial intermediation, the Fed’s discount window alone cannot meet liquidity needs of a modern financial system in distress. By facilitating the transfer of additional liquidity to the market during crisis periods, the alternative discount windows may reduce the adverse systemic consequences that arise from liquidity shortages. Yet, there are also significant costs. In contrast to the Federal Reserve, the Federal Home Loan Banks and insured depositors lack the incentives and competence needed to understand the systemic consequences of their actions. As a result, the provision of liquidity through the alternative discount windows tends to facilitate inefficient risk taking, increase moral hazard, reduce regulatory accountability, and compromise information generation, in addition to adversely affecting healthy banks. The Article accordingly concludes by proposing ways to reform the underlying programs to reduce the costs of having alternative discount windows.
461 Agency Capitalism: Further Implications of Equity Intermediation (Ronald J. Gilson and Jeffrey N. Gordon) November 2013
This chapter continues our examination of the corporate law and governance implications of the fundamental shift in ownership structure of U.S. public corporations from the Berle-Means pattern of widely distributed shareholders to one of Agency Capitalism – the reconcentration of ownership in intermediary institutional investors as record holders for their beneficial owners. A Berle-Means ownership distribution provided the foundation for the agency cost orientation of modern corporate law and governance – the goal was to bridge the gap between the interests of managers and shareholders that dispersed shareholders could not do for themselves. The equity intermediation of the last 30 years gives us Agency Capitalism, characterized by sophisticated but reticent institutional shareholders who require market actors to invoke their sophistication. We examine here three implications of this shift in ownership distribution. The first addresses a proposal to turn back the clock in the regulation of ownership disclosure under the Williams Act to a time when shareholders were small and dispersed rather than large and concentrated as they are today. The next two share a common theme: that the allocation of responsibility between directors, shareholders and courts can no longer be premised on a paternalism grounded in an anachronistic belief concerning the distribution and sophistication of shareholders. We show that the Chancery Court has recognized that Agency Capitalism counsels different rules concerning the roles of shareholders and the court in policing freezeouts. And we argue that the Supreme Court will come to realize what the Chancery Court has recognized for some time – that the doctrine of substantive coercion as a basis for takeover defense must give way as Delaware corporate law adapts to the very different shareholder distribution the capital market has now given us.
462 Due Diligence With Residential Mortgage Backed Securities (Merritt B. Fox) November 25, 2013
In seeking to explain how securitized funds became available for the large volume of mortgages that were inappropriately extended in the runup to the financial crisis, a number of commentators have argued that credit rating agencies and the market itself were unaware of the low quality of the assets backing many residential mortgage back securities (RMBS) offerings and that this lack of awareness was the result of inadequate due diligence. These concerns prompted a number of due diligence related provisions in the Dodd-Frank Act that are now the subject of SEC rule-making.
These developments raise two central questions: what is the socially appropriate level of due diligence that should be undertaken by persons preparing RMBS offering documents and credit ratings, and what is the proper role of regulation, if any, in assuring this level of due diligence. The paper reviews the general theory of asymmetric information in economics and applies this theory to the particular institutional features of securitized mortgage finance. The desirability of two possible policy options are discussed. One is direct regulation of the conduct of due diligence by certain securitization process participants. The other is imposition of liability on such participants for investor losses if these participants do not engage in due diligence that meets a governmentally determined standard.
The paper then engages in a review and assessment of the due-diligence-related provisions of Dodd-Frank and of the rules that have been adopted or are currently proposed by the SEC pursuant to these Dodd-Frank provisions or otherwise in reaction to the perceived role of RMBS offerings in the financial crisis. The paper concludes with a set of recommendations.
463 Updating the Competitive Tax Plan: A New Epilogue for 100 Million Unnecessary Returns (Michael J. Graetz) November 21, 2013
This is the first step of a new epilogue for my book 100 Million Unnecessary Returns: A Simple, Fair, and Competitive Tax Plan for the United States. In January 2012, the Tax Policy Center (TPC), pursuant to a grant from Pew Charitable Trust, published an article analyzing and estimating the parameters of the tax plan set forth in this book. TPC has now updated its estimates to take into account the January 2013 “fiscal cliff” legislation and other economic changes. Certain details of the plan have also been revised somewhat.
The competitive tax reform plan has five pieces: First, enact a VAT, a broad-based tax on sales of goods and services, now used by more than 160 countries worldwide. Many English-speaking countries call this a goods and services tax (GST). Second, use the revenue produced by this consumption tax to finance an income tax exemption of $100,000 of family income — freeing more than 120 million American families from income taxation — and lower the income tax rates on income above that amount. Third, lower the corporate income tax rate to 15 percent. Fourth, protect low-and-moderate-income workers from a tax increase through payroll tax cuts. Fifth, protect low-and-moderate income families from a tax increase by substantially expanded refundable tax credits for children, delivered through debit cards to be used at the cash register.
This paper was presented at the annual meeting of the National Tax Association on November 21, 2013. It will be revised for publication in the National Tax Journal.
464 The Empty Call for Benefit-Cost Analysis in Financial Regulation (Jeffrey N. Gordon), December 24, 2013
“Benefit-cost analysis” as applied to financial regulation is a serious category mistake that has the potential to stymie regulation aimed at the reduction of systemic risk in favor of privileging a status quo that we know is unstable. Benefit-cost analysis, which gained prominence from its applications in health safety, and environmental regulation, contemplates an omniscient social planner who can calculate costs and benefits generated by a system that is essentially stable, because it rests on natural constraints, in particular the laws of chemistry, biology, and physics. By contrast, finance is a constructed system, created by financial regulation itself and subsequent adaptations. Any non-trivial new rule would change the system of finance in ways that are hard to foresee and thus would undercut the value of a prior calculation of benefits and costs. Instead, optimal financial regulation policy should be understood as based on a series of trade-offs of values that are normatively derived, for example: the desire to achieve the economic benefits from the free flow of capital and the ready availability of credit as balanced against the risks of systemic distress and the associated economic disruption. These value trade-offs will produce subsidiary principles of pragmatic design, for example: minimize the extent to which financial institution can free-ride on systemic stability costs paid by others; provide regulators with sufficient information to observe the build-up of imbalance in the financial system and the power to make regulatory modifications accordingly. Rather than insist on a meaningless, if not misleading, benefit cost analysis that seems not required by any substantive regulatory statute, a reviewing court should apply rationality review to a regulatory agency’s application of pragmatic judgment.
465 Banking Union Resolution Without Deposit Guarantee: A Transatlantic Perspective on What it Would Take," (Jeffrey N. Gordon and Wolf-Georg Ringe), November 29, 2013
The project of creating a Banking Union is designed to overcome the fatal link between sovereigns and their banks in the Eurozone. As part of this project, political agreement for a common supervision framework has been reached with difficulty, and it looks possible that resolution may follow soon. However, Member States’ disagreements appear to rule out a federalized deposit insurance scheme, commonly regarded as the necessary third pillar of a successful Banking Union. This paper argues for an organizational and capital structure substitute that can minimize the systemic distress costs of the failure of a large financial institution. We borrow from the approach the FDIC has devised in the implementation of the "Orderly Liquidation Authority" under the Dodd Frank Act. The FDIC’s experience teaches us three important lessons: first, systemically important institutions need to have in their liability structure sufficient subordinated term debt so that in the event of bank failure, the conversion of debt into equity will be sufficient to absorb asset losses without impairing deposits and other short term credit; second, the organizational structure of the financial institution needs to permit such a debt conversion without putting core financial constituents through a bankruptcy, and third, a federal funding mechanism deployable at the discretion of the resolution authority must be available to supply liquidity to a reorganizing bank. On these conditions, deposit insurance plays a subsidiary role in resolution and could remain at the national (not EU) level.
466 Trial by Perview, (Bert I. Huang), 6/1/2013
It has been an obsession of modern civil procedure to design ways to reveal more before trial about what will happen during trial. Litigants today, as a matter of course, are made to preview the evidence they will use. This practice is celebrated because standard theory says it should induce the parties to settle; why incur the expenses of trial, if everyone knows what will happen? Rarely noted, however, is one complication: The impact of previewing the evidence is intertwined with how well the parties know their future audience — that is, the judge or the jury who will be the finder of fact at trial. Both theory and policy have focused narrowly on previewing the evidence, while barely noticing the complementary effect of previewing the audience. How this interplay might affect leading theories of settlement has yet to be articulated. This Essay begins to fill the gap.
This Essay also presents preliminary empirical findings from a policy experiment in the federal courts, arising from recent reforms in civil procedure. These data suggest that the current use of evidentiary previews may be driving a wedge between trials by jury and trials by judge. Trials are “vanishing” indeed — but not all trials vanish alike. Preview policies may be accelerating a decline in bench trials more than in jury trials. New policy concerns emerge from both the data and the theoretical analysis, and this Essay explores how an awareness of asymmetric preview effects might inform current debates about procedural values and policy design.
467 Shallow Signls, (Bert I. Huang), June 1, 2013
Whether in dodging taxes, violating copyrights, misstating corporate earnings, or just jaywalking, we often follow the lead of others in our choices to obey or to flout the law. Seeing others act illegally, we gather that a rule is weakly enforced or that its penalty is not serious. But we may be imitating by mistake: what others are doing might not be illegal — for them.
Whenever the law quietly permits some actors to act in a way that is usually forbidden, copycat misconduct may be erroneously inspired by the false appearance that “others are doing it too.” The use of loopholes or exemptions can cause such illusions of misconduct. So can unseen licenses, cures, or private releases from liability. Selective enforcement, nonharmonization of laws, and legal transitions can also create similar misimpressions. The imitator sees others’ actions but not the crucial fact — of legal permission or tolerance — that distinguishes them. These behavior signals are “shallow,” missing a key dimension. The spread of misconduct can thus be accelerated by a peculiar, avoidable form of information failure.
For a regulator confronting this class of errors, it does little good to express the law in the conventional sense. What needs to be made more salient is not the law’s prohibition, but the fact of permission. This Essay offers an exploratory look at potential solutions, which vary by context and by whether actors are sophisticated or naive. Simple disclosures can sometimes do the job, but they can also be self-defeating due to what we might call an “ignorance externality.” Designing policies to work around such perverse effects may be possible, however, by drawing on heuristics introduced here.
468 Economic Crisis and Share Price Unpredictability: Reasons and Implications, (Edward G. Fox, Merritt B. Fox and Ronald J. GIlson), February 19, 2014
During the recent financial crisis, there was a dramatic spike, across all industries, in the volatility of individual firm share prices after adjustment for movements in the market as a whole. In this Article, we demonstrate that a similar spike has occurred with each major downturn in the economy since the 1920s. The existence of this long history of crisis-induced spikes has not been previously recognized.
The Article evaluates a number of potential explanations for these recurrent spikes in firm-specific price volatility, a pattern that poses a puzzle in terms of existing financial theory. The most convincing explanations relate to reasons why information specifically concerning individual firms would become more important in difficult economic times.
This discovery of a long history of crisis-induced spikes in firm-specific price volatility has important implications for several areas of corporate and securities law. With regard to securities law, the Article concludes, for example, that because of these spikes, private damages actions are much less effective deterrents to corporate misstatements and insider trading in crisis times than in normal times. Consequently, substantial additional resources should be devoted to SEC enforcement actions during crisis times. The Article considers as well the most contentious corporate law issue of the last 30 years: the extent to which a target board of directors will be allowed to prevent shareholders from accepting a hostile takeover bid at a premium over the pre-bid share price. The Delaware Supreme Court’s approach to this question has been largely based on the difficult-to-define concept of “substantive coercion.” The Article concludes that these spikes could be a way of giving real meaning to the “substantive coercion” justification for board approval of defenses against hostile takeover attempts, but that the instances where this justification is appropriate will be rare.