Claire A. Hill

A Cognitive Theory of Trust

Interpersonal trust is currently receiving widespread attention in the academy. Many legal scholars incorrectly assume that interpersonal trust is an unmitigated good (or bad) and that legal policy should therefore be crafted to maximize (or minimize) trust. A more nuanced understanding of trust indicates instead that it should be promoted or discouraged, depending on the context. Such an understanding needs to reflect the fact that trust and distrust can, and often do, coexist. In most relationships, the parties trust one another with regard to some matters and yet distrust one another with regard to other matters. More specifically, developing a relationship with somebody often involves acquiring an overall residual sense of how trustworthy the person is, as well as a specific sense of the persons trustworthiness in particular contexts. Our paper begins to develop a cognitive theory of trust. Our cognitive lens suggests specific types of relationships and contexts in which people are systematically inclined to trust one another nonoptimally. First, some accurate trust assessments may be socially nonoptimal. Consider a group whose members decide to forego costly assessments of strangers, confining their dealings to other group members. Or parties engaged in socially undesirable activities whose high trust for one another permits them to effectuate successful criminal conspiracies. In these cases, social gains can be realized by enacting regulatory measures that provide incentives for either trust-enhancing or trust-decreasing behaviors. Second, some relationships are plagued by mistaken initial trust assessments in contexts where accurate updating of these assessments is either precluded or impaired. In such contexts the law should intervene to either promote more accurate trust levels or to mitigate the costs of the mistaken assessments. We identify two relationships where, if left unregulated, one of the individuals will likely inaccurately assess the trustworthiness of the other. In the corporate management context, directors are inclined to overtrust officers, and we explore possible mechanisms for promoting specific types of distrust on the part of directors without excessively eroding the residual trust in the officer-director relationship. In doctor-patient relationships, patients similarly overtrust doctors albeit for different reasons. Because patients often benefit from overtrusting their doctors, however, promoting more accurate patient trust assessments likely would prove costly. Health care law should (and does) instead focus on promoting doctor trustworthiness and compensating patients who suffer harm from misplacing their trust.

Why Did Anyone Listen to the Rating Agencies After Enron

Enron was rated investment grade by Moody’s, Standard and Poor’s, and Fitch until four days before it declared bankruptcy - scarcely a ringing endorsement of the agencies’ acumen. Even before Enron, the rating agencies had come in for significant criticism. Yet many investors who lost considerable sums in the financial crisis are saying that they relied on the rating agencies. How can this reliance be reconciled with what preceded it? I argue that an adaptive trait - incorporating new data that potentially conflicts with one’s pre-existing worldview so as to preserve as much of that worldview as possible - proved to be maladaptive in this circumstance. There was a plausible story investors could tell themselves about why the rating agencies could ‘get it right’ about the complex securities at issue while having gotten it spectacularly wrong about Enron. It will be interesting to see how, and how much, the agencies’ recent failures affect investors’ beliefs and practices.

What cognitive psychologists should find interesting about tax

People have to pay taxes, and usually they do—even though they would rather not. What determines whether and how much they decide to pay depends on more than a cost—benefit calculation. Results from the literature at the intersection of economics and psychology suggest that many factors are relevant, including people’s perceptions of how the money is being spent, and who (else) is being asked to pay taxes. The results also suggest ways in which government may be able to use framing and various biases to influence payment of and attitudes toward tax. But much remains unknown, including, importantly, the extent to which tax incentives influence behavior.

The Promise and Limits of Financial Engineering in Emerging Markets

This paper considers why quality enhancement is sometimes, but not always, available for emerging markets financial instruments. It concludes that sometimes, but not always, economies of scope will permit quality enhancement to be provided at a cost lower than the associated benefit. These economies of scope are available when political risk is below a certain level; if political risk is, or is perceived to be, at or above that level, quality enhancement will not be available, except on terms likely not to be worthwhile for an emerging markets firm. More broadly, the increment of quality enhancement that can be exploited is limited. However, financial engineering has shown some promise in increasing the exploitable increment.

A personality theory of white collar criminals, near-criminals, and others involved in bad corporate actions (and what law should do about it)

Corporate actors have behaved badly in ways that have significantly harmed society. Some of the behavior is illegal - improving enforcement may help. But some of the behavior is not illegal and some is in a grey area. The law’s ability, using its traditional instrumental force, to address the problem is very limited. But penumbral and expressive law can play an important role. Law can encourage firms to take more seriously individual attributes of employees, including executives, in their hiring, firing or other punishment, compensation, and training, and how people with such attributes may interact and influence each other. This encouragement can come from judges’ decisions and regulators’ interactions with firms, and from an articulation of best practices under Caremark. The force of expressive and penumbral law, informed by a more nuanced understanding of people, can be more effective than it thus far has been to limit societal harm.

Mergers and acquisitions: a cyclical and legal phenomenon

Mergers and acquisitions (M&A) have a rich history in the American economy. Over the course of the past century and a half, merger activity has proceeded in waves, each wave inevitably followed by a regulatory and legal response. Merger activity emerged during the late nineteenth century. The succeeding trust era, characterized by monopolies and frenetic acquisition activity, resulted in new regulations in the 1890s and early nineteenth century. Merger activity created vast conglomerates during the 1960s. During the 1970s and 1980s, the leveraged buyout boom led to the development of modern M&A legal doctrine. The late 1980s and 1990s saw the embracing of new participants such as private equity firms. Today, the Internet Age and globalization have led to the current M&A market, characterized by transactions that are global, very large (multibillion dollar), and sometimes both.

Short and Long Term Investors (and Other Stakeholders Too): Must (and Do) Their Interests Conflict?

In this chapter for an edited volume, we review and analyze theoretical and empirical questions raised by the ongoing debate over whether American public corporations face undue legal and market pressure to pursue short term profits. Orthodox theory holds that the highest ‘bucks’ should not necessarily be the ‘quickest’ – that is, that markets correctly value a company’s prospects, no matter how far in the future they are. Of course, given the time value of money, a long-term prospect has to be much better than a short-term one to be worthwhile. But the argument made with respect to shareholder activists, and to a lesser but still considerable degree corporate raiders, was that cost-cutting was being encouraged even if doing so saved less than the discounted value foregone.This argument is not consistent with orthodox theory. Here, we explain why this is so, consider reasons why that theory might be wrong, and make some suggestions for ways to proceed. In our view, there is plausible, and perhaps sufficient, evidence of a problem from shareholders’ perspective – corporations may indeed be shunning some potentially higher-yielding long-term strategies, emphasizing instead the short-term strategies that yield cash and savings in the short term. There may be a problem from the societal perspective as well, which is separate from but related to the question of short-term strategies. The market may be addressing the shareholder problem, although perhaps not sufficiently, and probably not sufficiently quickly. The societal problem, the underprovision of public goods, and the imposition of negative externalities, is far trickier to address. We offer some suggestions which might help on both fronts. That being said, in some cases, the conflict between a shareholder value maximization perspective and a societal perspective may be intractable.

Tax Avoidance and the Optimal Design of Tax Law

Although most individuals recognize the necessity of taxation, few like to pay taxes. Governments face costs to collect taxes; people expend resources to legally avoid taxation. Such expenditure represents social waste, as it is a form of rent-seeking. Since there is a market for tax planning methods, the magnitude of these costs depends on the market structure. We consider how a government might reduce tax planning by creating market inefficiencies or failures. We set forth a formal economic model to identify the optimal amount of tax planning the government should permit, and consider how governmentally-created market failures could be implemented.

Law and Economics of Mergers and Acquisitions

This book provides a broad survey of past and recent scholarship on mergers and acquisitions. Seminal work on the history, rationales and outcomes of mergers and acquisitions is followed by leading articles on what M&A lawyers do. Major articles by prominent authorities in the field explore how deals are done, defended and terminated. The collection concludes with several eminent selections on private equity deals and international issues.

Introduction: The Evolution of the Economic Analysis of Corporate Law: The evolution of the economic analysis of corporate law

This essay is the Introduction to the Research Handbook on the Economics of Corporate Law. After briefly surveying the origins of modern economic analysis of corporate law, it analyzes leading developments in recent decades. Major developments in the law and economics of corporate law have in some cases followed from developments in the law, including changes in fiduciary duty standards, the growth of shareholder activism, the increasing role of independent directors, changes in executive compensation, a new emphasis on various gatekeepers, federalization of corporate governance rules, and globalization. Other developments have followed from trends within economics, including some new ideas in the theory of the firm, greater emphasis on empirical research, a focus on market failures due to incomplete information, the growth of behavioral economics, and some increased emphasis on comparative institutional analysis. The essay speculates that future developments may include a new focus on systemic risk in light of the financial crisis and greater use of empirical research methodologies other than regression analysis. The essay concludes with an overview of the contributions to the volume, which is divided into five Parts: corporate constituencies, insider governance, gatekeepers, jurisdiction, and new theory.