Charles K. Whitehead

Deconstructing Equity: Public Ownership, Agency Costs, and Complete Capital Markets

The traditional law and finance focus on agency costs presumes, without acknowledgement, that the premise that diversified public shareholders are the cheapest risk-bearers is immutable. In this Essay, we raise the possibility that changes in the capital markets have called this premise into question, drawn into sharp relief by the recent private equity buying wave in which the size and range of public companies being taken private expanded significantly. In brief, we argue that private owners, in increasingly complete markets, can transfer risk in discrete slices to counterparties who, in turn, can manage or otherwise diversify away those risks they choose to forego, arguably becoming a lower cost substitute for traditional risk capital. If diversified shareholders are no longer the cheapest risk-bearers, then the associated agency costs may now be voluntary; and, if risk management can substitute for risk capital, without requiring a transfer of ownership, then why go public at all? Do more complete capital markets herald (once again) the eclipse of the public corporation? We offer some preliminary responses, suggesting that the line between public and private firms may begin to blur as the traditional balance between agency costs and the benefits of public ownership shifts towards a new equilibrium. For some, the benefits of public ownership may continue to outweigh the associated agency costs. For others, changes in risk transfer may implicate how a firm is (or should be) governed. The Essay then ends with a final question: If the opportunity to invest in common stock recedes, by what means will former investors in public equity be able to invest capital?

Lawyers and Fools : Lawyer-Directors in Public Corporations

The accepted wisdom — that a lawyer who becomes a corporate director has a fool for a client — is outdated. The benefits of lawyer-directors in today’s world significantly outweigh the costs. Beyond monitoring, they help manage litigation and regulation, as well as structure compensation to align CEO and shareholder interests. The results have been an average 9.5 percent increase in firm value and an almost doubling in the percentage of public companies with lawyer-directors. This Article is the first to analyze the rise of lawyer-directors. It makes a variety of other empirical contributions, each of which is statistically significant and large in magnitude. First, it explains why the number of lawyer-directors has increased. Among other reasons, businesses subject to greater litigation and regulation, and firms with significant intangible assets (such as patents) value a lawyer-director’s expertise. Second, this Article describes the impact of lawyer-directors on corporate monitoring. Among other results, it shows that lawyer-directors are more likely to favor a board structure and takeover defenses that reduce shareholder value — balanced, however, by the benefits of lawyer-directors, such as the valuable advice they can provide. Finally, this Article analyzes the significant reduction in risk-taking and the increase in firm value that results from having a lawyer on the board. Our findings fly in the face of requirements that focus on director independence. Our results show that board composition — and the training, skills, and experience that directors bring to managing a business — can be as or more valuable to the firm and its shareholders.

Creditors and Debt Governance

This chapter, from the forthcoming Research Handbook on the Economics of Corporate Law (Claire Hill & Brett McDonnell, eds.), provides an introduction to the law and economic theory relating to creditors and debt governance. The chapter begins with a look at the traditional role of debt, focusing on the impact of debt on corporate governance and, in particular, the effect of an illiquid credit market on creditors’ reliance on covenants and monitoring. It then turns to changes in the private credit market and their effect on lending structure. Greater liquidity raises its own set of agency costs. In response, loans and lending relationships have adjusted to mitigate those costs, providing new means by which debt can influence corporate governance. Going forward, a firm’s decision to borrow must increasingly take account of the costs and benefits of a liquid credit market. How firms are governed is closely related to how they raise capital. Managers who maximize firm value can finance their business at lower cost than managers who pursue personal goals. Thus, actions that affect a firm’s credit quality are likely to be reflected in changes in the secondary price at which its loans and other credit instruments trade. Those changes, in turn, may affect a borrower’s cost of capital, providing managers with a real incentive to minimize risky behavior. The intuition, described at the end of the chapter, is that a liquid private credit market may begin to provide a discipline that complements the traditional protections of contract.

The Nonprime Mortgage Crisis and Positive Feedback Lending

The “great recession” of 2007-2009 was sparked by a bubble in U.S. housing prices, driven in turn by a bubble in nonprime mortgage lending. We collect evidence that the risk of a bubble (not the certainty, but a meaningful risk) should have been obvious to the main participants in the markets for nonprime lending and related mortgage-backed securities (nonprime MBS), including originators, securitizers, rating agencies, money managers, and institutional investors. Those who did not see the risk were willfully blind. We also discuss the strong positive feedback nature of typical nonprime mortgages. This positive feedback made it highly likely that, if nonprime housing prices flattened, let alone fell, they would soon crash and take many nonprime MBS with them. We discuss regulatory responses that might limit positive feedback lending, make the next bubble smaller and less likely, and the post-bubble aftermath less painful.

Equivalence: Form and Substance in Business Acquisitions

This is a chapter in a forthcoming Research Handbook on Mergers and Acquisitions. It asks to what extent should law and regulation treat business transactions — that differ in form, but are economically equivalent — in the same way? And what justifies the imposition of different costs across different transactional forms? The chapter considers equivalence by assessing the effect of different business acquisition forms on corporate stakeholders. It sets out factors that may be used to determine equivalence, as well as considering the extent to which different forms merit the same or different legal and regulatory treatment. There very well may be reasons to impose different requirements on different transactional forms — for example, based on differences in statutes, stakeholders, and judicial scrutiny, as well as the practical realities that make legal or regulatory equivalence difficult to achieve — but by starting with equivalence, we can begin to assess the relative merits of those differences. The chapter also begins to explore the limits of equivalence, suggesting that the computational skills needed to fully assess equivalence around business acquisitions have not yet caught up with the business lawyers’ ability to use different forms to achieve the same substantive results.