Richard Squire

Principal Costs: A New Theory for Corporate Law and Governance

The dominant paradigm in corporate law is agency-cost theory, which asserts that the law’s proper role is to reduce managerial agency costs by forcing firms to allocate more control to shareholders. That theory cannot explain why shareholders voluntarily invest in firms that circumscribe their powers to hold managers accountable. This Article introduces principal-cost theory, which states that each firm’s optimal governance structure minimizes the sum of principal costs, produced when investors exercise control, and agent costs, produced when managers exercise control. Because the optimal division of control is firm-specific, firms rationally select from a range of governance structures that empower shareholders to varying degrees. Principal-cost theory generates more accurate empirical predictions than agency-cost theory. It also suggests different policy prescriptions: rather than banning some governance features and mandating others, lawmakers should permit each firm to tailor its structure based on its firm-specific substitution rate between principal costs and agent costs.

Clearinghouses as Liquidity Partitioning

To reduce the risk of another financial crisis, the Dodd-Frank Act requires that trading in certain derivatives be backed by clearinghouses. Critics mount two main objections: a clearinghouse shifts risk instead of reducing it; and a clearinghouse could fail, requiring a bailout. This Article’s observation that clearinghouses engage in liquidity partitioning answers both. Liquidity partitioning means that when one of its member firms becomes bankrupt, a clearinghouse keeps a portion of the firm’s most liquid assets, and a matching portion of its short-term debt, out of the bankruptcy estate. The clearinghouse then applies the first toward immediate repayment of the second. Economic value is created because creditors within the clearinghouse are paid much more quickly, and other creditors are paid no less quickly, than they would be otherwise. The rapid cash payouts for clearinghouse members reduce illiquidity and uncertainty in the financial sector, the main causes of contagion in a crisis. And because the clearinghouse holds only liquid assets, it avoids the maturity mismatch between short-term liabilities and long-term assets that characterizes the balance sheets of many financial institutions. A clearinghouse therefore is much less likely than its members to fail during a crisis. To ensure that clearinghouses remain stable and systemically valuable, rulemakers should require clearing of a wide variety of derivatives contracts, but should limit clearinghouse membership to dealer firms.

How Does Legal Enforceability Affect Consumer Lending? Evidence from a Natural Experiment

We use a natural experiment—an unexpected judicial decision—to study how the enforceability of debt contracts affects consumer lending. In May 2015, a federal court unexpectedly held that the usury statutes of three states—Connecticut, New York, and Vermont—applied to certain loans that market participants had assumed were exempt from those statutes. The case introduced substantial uncertainty about whether borrowers affected by the decision were under any legal obligation to repay principal or interest on their loans. Using proprietary data from three marketplace-lending platforms, we use a difference-in-differences design to study the decision’s effects. We find no evidence that borrowers defaulted strategically as a result of the decision. However, the decision reduced credit availability for higher-risk borrowers in affected states. Secondary-market data indicate that the price of notes backed by above-usury loans issued to borrowers in affected states declined, particularly when those borrowers were late on their payments.

The Effects of Usury Laws on Higher-Risk Borrowers

We use a natural experiment — an unexpected judicial decision — to study how the legal enforceability of debt contracts affects consumer lending. In May 2015, a federal court unexpectedly held that the usury laws of three states — New York, Connecticut, and Vermont — applied to certain loans that market participants had assumed were exempt from those statutes. The case introduced substantial uncertainty about whether borrowers affected by the decision were under any legal obligation to repay principal or interest on their loans. Using proprietary data from three marketplace lending platforms, we use a difference-in-differences design to study the decision’s effects. We find no evidence that borrowers defaulted strategically as a result of the decision. However, the decision reduced credit availability for higher-risk borrowers in affected states. And secondary-market data indicate that the price of notes backed by above-usury loans issued to borrowers in affected states declined, particularly when those borrowers were late on their payments.

The Artificial Collective-Action Problem in Lawsuits Against Insured Defendants

In lawsuits against defendants covered by liability insurance, the parties negotiate toward a single settlement amount that collectively binds the plaintiff and all defense-side parties (the defendant and its liability insurer). This settlement method produces a collective-action problem whenever the trial outcome is uncertain and the potential damages exceed the limit of the defendant’s liability policy. When such a suit settles, the insurer often pays more, and the defendant/policyholder pays less, than each expected to pay if the case had gone to trial. The insurer is thus biased against, and the policyholder toward, pre-trial settlement. This conflict could produce an unnecessary trial or a settlement that overcompensates the plaintiff, depending on which bias prevails. To prevent such results, courts (and some insurance policies) place settlement duties on liability insurers. But enforcing these duties entails additional litigation, compliance costs, and the risk of legal error. An alternative solution would be to replace collective settlements with “segmented” settlements. Each defense-side party would bargain separately with the plaintiff for a release of the plaintiff’s right to collect any damages which, if awarded at trial, would be that defense-side party’s contractual responsibility. The collective-action problem would then disappear, as would the need for settlement duties. The benefits would be greatest in lawsuits against corporate defendants, which often have multiple excess insurers in addition to a primary insurer. Why parties continue to follow a settlement method that produces an avoidable collective-action problem is an open question in the study of insurance law.