William W. Bratton

Berle and Means Reconsidered at the Century's Turn

Follow this and additional works at: http://scholarship.law.upenn.edu/faculty_scholarship Part of the Business Law, Public Responsibility, and Ethics Commons, Corporate Finance Commons, Corporation and Enterprise Law Commons, Ethics and Political Philosophy Commons, Law and Economics Commons, Legal Commons, Legal Theory Commons, Securities Law Commons, and the Work, Economy and Organizations Commons

Bond Covenants and Creditor Protection: Economics and Law, Theory and Practice, Substance and Process

This article examines contractual protection of unsecured financial creditors in US credit markets. Borrowers and lenders in the United States contract against a minimal legal background that imposes the burden of protection on the lender. A working, constantly updated, set of contractual protections has emerged in response. But actual use of available contractual technology varies widely, depending on the level of risk and the institutional context. The credit markets sort borrowers according to the degree of the risk of financial distress, imposing substantial constraints only on the borrowers with the most dangerous incentives. At the same time, the contracting practice is sticky and lumpy, never quite managing to conform to the predictions of first generation agency theory. Levels of protection vary with institutional contexts. Exhaustive contracts providing something approaching complete protection against agency costs prove feasible only in relational contexts conducive to ongoing renegotiation over time due to small numbers of lenders operating under reputational constraints. The public bond markets do not hold out such a process context, and accordingly shut out the riskiest borrowers. The larger, less risky firms that do gain access to the bond markets borrow under contracts offering incomplete protection, with the level of protection roughly correlating to the borrower’s risk level. This leaves bondholders confronting a residuum of agency costs and relying on secondary protections like monitoring, exit, diversification, and hedging. This has worked reasonably well in practice, subject to an historical exception concerning the risk of high-leverage restructuring. The bond markets searched for two decades for a stable solution to this problem, finally settling on across-the-board contractual protection only in recent years.

Incomplete Contracts Theories of the Firm and Comparative Corporate Governance

This article draws on key models of monitoring and blockholding articulated in the incomplete contracts theory of the firm. Under incomplete contracts theory, different governance systems have incentive structures that entail different tradeoffs—tradeoffs between ownership concentration and liquidity, between monitoring and management initiative, and between private rent-seeking and activity benefiting shareholders as a group. The tradeoffs delimit opportunities for productive cross-reference. More specifically, blockholder systems, such as those in Europe, subsidize monitoring by permitting blockholders to reap private benefits of control through self-dealing and insider trading. Market systems, such as those in the United States and Britain, regulate such private rent-seeking toward the end of maintaining an institutional framework that supports diffuse share ownership and liquid trading markets. It follows that a legal framework conducive to blockholding may be ill-equipped to foster dispersed equity ownership and thick trading markets and that a legal framework conducive to liquid trading markets may have properties that discourage blockholding. This gives rise to questions for law reform agendas on both sides of the Atlantic. In the United States, proponents ask for deregulation of controls on institutional investors, looking to encourage blockholding and more effective monitoring. In Europe, proponents ask for stronger securities regulation, looking to encourage deeper trading markets. This article suggests that each reform program may lead to disappointing results because neither assures conforming adjustments to the pertinent actors’ incentives. Alternatively, strict reforms that materially change prevailing incentive patterns could perversely destabilize workable (if imperfect) arrangements without assuring the appearance of more effective alternatives.

Rules, Principles, and the Accounting Crisis in the United States

The Sarbanes-Oxley Act and the Securities Exchange Commission move too quickly when they prod the Financial Accounting Standards Board, the standard setter for US GAAP, to move immediately to a principles-based system. Priorities respecting reform of corporate reporting in the US need to be ordered more carefully. Incentive problems impairing audit performance should be solved first through institutional reform insulating the audit from the negative impact of rent-seeking and solving adverse selection problems otherwise affecting audit practice. So long as auditor independence and management incentives respecting accounting treatments remain suspect, the US reporting system holds out no actor plausibly positioned to take responsibility for the delicate law-to-fact applications that are the hallmarks of principles-based systems. Principles, taken alone, do little to constrain rent-seeking behaviour. In a world of captured regulators, they invite applications that suit the regulated actor’s interests. Rules, with all their flaws, better constrain managers and compromised auditors. Broadbrush reformulations of rules-based GAAP should follow only when institutional reforms have succeeded.

Private Equity's Three Lessons for Agency Theory

It is time to consider the lessons to be learned from the recent boom in private equity buyouts, not least in view of its abrupt termination in the wake of tightened credit. In the past, such inquiries have been undertaken in the context of agency theory and have focused on the buyout’s implications for solving the problem of separation of ownership and control. This article reverses the pattern of inquiry to consider the buyout’s implications for agency theory, pointing to three lessons. The first lesson addresses agency theory’s three-way association among control transfers, governance discipline and hostile takeovers, suggesting that this triptych needs to be unbundled and reconsidered. The buyout’s recent salience implies that we need no longer assume that hostility is the acquisition mode best suited to post-merger disciplinary governance. The second lesson concerns agency theory’s account of buyout motivations. The theory posits a world where agency cost reduction determines control outcomes at the transactional margin. On first inspection, private equity buyouts neatly fit this picture. But a deeper examination shows that buyouts are driven by the economics of leverage, with agency cost reduction taking only a secondary motivational role. The third lesson follows from financial returns. Even as buyouts ameliorate the agency costs of separated ownership and control, buyout structures implicate their own agency costs in the form of fees paid to buyout firms. Studies show that buyout firms take so much of the gain that the institutions investing in buyout funds would be better off investing in market indices. There result questions for the line of agency theory that looks to institutional investors as agency cost-reducing monitors. There also result questions respecting buyouts’ incentive compatibility, questions raising doubts as to whether buyout governance structures hold out a template for improving corporate governance generally, even as a matter of agency theory.

Welfare, Dialectic, and Mediation in Corporate Law

This essay comments on William Kleins Criteria for Good Laws of Business Association. Klein bids us to cull, modify, and restate a set of proposed criteria for good corporate law so as to state the laws goals more clearly. This essay takes up the invitation. It suggests that the criteria on which we can agree lie at a high level of generality: Corporate law makes us all welfare consequentialists who agree that good corporate law is about encouraging productivity. We differ over the means to that end in debates that have over time evolved away from the ideological and toward the functional. Within this framework, corporate law has two core and generally accepted objectives - freedom of action for management and the minimization of the cost of capital. The firms legal boundaries follow from these core objectives, and adherence to them triggers resistance to theoretical calls for social responsibility and constituent empowerment. In contrast, corporate laws core subject matter, the terms of the shareholder-manager agency relation, implicates tensions between the dual purposes of freedom of action for management and the minimization of the cost of capital. Corporate law mediates these tensions with open-ended terms and piecemeal resolutions. Although theorists have offered meta level means to resolve the tensions, the practice has never responded by endorsing the theories. Absent an ex ante set of empirically verifiable formulas for productive business organization, this debate will continue unresolved.

Sovereign Debt Restructuring and the Best Interest of Creditors

In April 2002 the International Monetary Fund introduced a sovereign bankruptcy proposal only to be rebuffed by the United States Treasury. Where the IMF wanted a mandatory bankruptcy regime, the Treasury wanted to solve distress problems with contractual devices. Sovereign bondholders and sovereign issuers themselves flatly rejected both proposals, even though they were nominally the beneficiaries of both proponents. This Article addresses and explains this bondholder reaction. In so doing, it takes a highly skeptical view of the IMFs proposal even as it shows that the incentive structure surrounding sovereign lending renders untenable the Treasurys contractarian proposal. The Articles analysis follows from a review and restatement of the economic learning on sovereign debt relationships. The IMF and the Treasury share the objective facilitating restructuring by substituting a regime of collective action for the prevailing practice of requiring unanimous bondholder consent to significant amendments of bond contracts. In so doing they follow a conventional wisdom respecting bond contracts under which standard unanimity provisions are inefficient and irrational. The Article shows that this dismissal of the unanimity requirement comes too quickly. Under our analysis of the problem the debtor distress, bondholders rationally may prefer to make compositions harder to conclude. There is no first best equilibrium bond contract; instead bondholders select from a menu of second best forms, making trade offs between unanimous action and collective action provisions in an imperfect world. One factor leading lenders to favor unanimous action is the need to self protect. In a world without a good faith backstop, creditors motivated by side deals can take advantage of majority rule to impose suboptimal compositions. Holding out is the only weapon available to the minority creditor. The Article argues that, given such side deals, a stable majoritarian regime cannot be achieved as a matter of free contract. Mandate will be necessary. It follows that the Treasurys contractarian approach is implausible absent a backstop regime of intercreditor good faith duties. The Article draws on the history of corporate reorganization prior to the enactment of the section 77B of the Bankruptcy Act of 1934 to show that courts have grappled with these questions before, intervening aggressively on equitable principles.

Fiscal Federalism, Jurisdictional Competition and Tax Coordination: Translating Theory to Policy in the European Union

This paper applies the economic theories of fiscal federalism and jurisdictional competition to the question whether the juridical presumption favoring decentralization of authority manifested in the European Unions subsidiarity principle has been rebutted in the case the Code of Conduct on Business Taxation. The Code is a pending EU tax coordination initiative that identifies and prohibits a zone of distortionary member state competition respecting taxation of capital. Evaluation of the Code under subsidiarity gives rise to three questions: (1) Whether subsidiaritys decentralization presumption implies a further presumption favoring tax competition; (2) whether subsidiaritys decentralization presumption can be overcome by a purely theoretical showing of distortionary effects of tax competition; and (3) whether, if empirical evidence of distortionary effects is required, the coordination legislation in question must address the empirically-established distortion with adjudicative particularity. The paper reaches a firm answer as to question (1): Subsidiarity does not favor tax competition, remaining neutral on the subject. It brings fiscal federalism theory to bear in reaching this conclusion: Under fiscal federalism the list of legitimate central government functions lengthens as a minimal federation like the EU successfully brings about economic integration by opening national borders to free movement. As member state economies become less heterogeneous and economic interconnections between them increase in number and depth, member state economic policies, particularly taxing and spending policies, cause more fiscal externalities. Fiscal federalism theory also describes allocative inefficiencies in competitive tax systems, particularly with respect to corporate income and commodity taxes, and highlights negative distributional consequences of tax competition. Coordinative initiatives directed to the elimination of resulting inefficiencies in resource allocations therefore hold a legitimate place on the EUs integration agenda. The papers answers for questions (2) and (3) are more qualified. The strength of both subsidiaritys decentralization presumption and of any rebuttal case depend on political risks and economic factors specific to the situation. In the tax coordination case addressed, the risks turn out to be low, permitting the presumption to be rebutted by a strong theoretical case articulated on a spotty empirical record.

An anatomy of corporate legal theory

This chapter collects and categorizes the principal theoretical debates respecting corporate law in the United States. What emerges is not a synthetic whole but a dialectic framework. Corporate laws theoretical debates do not resolve; their arguments and conclusions are determined by metapolitical preferences and unverified notions about aligning productivity incentives. But despite the debates, the acknowledged premise that corporations exist to create wealth by producing goods and services at a profit directs all theories of corporate law to two objectives. First, corporate law encourages long-term investment and risk-taking by facilitating a delegation of decision-making authority from the providers of capital to the expert managers who deploy it. Second, corporate law facilitates investment in producing assets at the lowest possible cost of capital, securing the presence of liquid trading markets in corporate securities.