Blue Sky 2011-2012

• Doron Teichman, Sr. Lecturer, Faculty of Law, Hebrew University of Jerusalem

Discussion Topic: "Reference Points and Contract Interpretation: An Empirical Examination"

This Article focuses on the influence of framing on contractual interpretative decisions. A large body of both psychological and economic studies suggests that people treat payoffs framed as gains and payoffs framed as losses distinctly. Building on these studies we hypothesize that contract interpretation decisions will be affected by the way in which they are framed. More specifically, we expect that promisors will tend to adopt a more self-serving interpretation when they are making decisions in the domain of losses. To test this prediction, we design a series of three experiments that are all based on a between-subject design. The first two studies utilize experimental surveys that measure and compare participants’ attitudes toward a contract interpretation dilemma. The third study is an incentive-compatible lab experiment, in which participants’ actual interpretive decisions determine their payoff. All three experiments confirm our basic hypothesis, and show that framing contractual payoffs as losses rather than gains raises parties’ tendency to interpret their obligations selfishly. Based on these findings, the article revisits some of the basic questions of contract law, and sheds new light on an array of issues such as the law of liquidated damages and the optimal design of contracts.

• Merritt Fox, Michael E. Patterson Professor of Law, NASDAQ Professor for Law and Economics of Capital Markets, Columbia Law School
• Ronald J. Gilson, Marc and Eva Stern Professor of Law and Business, Columbia & Stanford Law Schools
• Darius Palia, Ph.D., Thomas A. Renyi Chair in Banking, Professor of Finance and Economics, Founding Director, Rutgers Financial Institutions Center, Rutgers Business School

Discussion Topic: "When it Hits the Fan: Identifying When Corporate Governance Matters"

The paper reports on an examination of the relationship in different economic times between various measures of corporate governance (the Gompers "G index" and the Bebchuk "E index") and Tobin's Q. The findings, using fixed effects linear regressions of Q on each of the two indices (including the usual control variables) for the period 1991-2008, are that the effect of a better governance score on Q is much more pronounced in periods of economic downturn than in normal or boom times. The results are statistically and economically very significant. The tentative hypothesis is that firms that score better in the G and E indices are firms, regardless of the direction of causation, with more capable management and that more capable management matters a great deal more in difficult economic times. The paper is still very preliminary, and the authors welcome alternative explanations of their results.

• Colin Mayer, Finance Economist, recently the Dean at Said Business School, Oxford University

Discussion Topic: "The Micro, Macro, and International Design of Financial Regulation" (Authored with Jeffrey N. Gordon)

Regulation that is designed to enhance the stability of individual financial institutions, micro-prudential regulation, can create and exacerbate systemic instability. This is particularly true of detailed prescriptive rules about corporate governance which are prone to incorrect specification and the imposition of unwarranted homogeneity on the conduct of firms. They can create externalities where none previously existed. Harmonization of micro-prudential regulation across countries elevates this problem to a global level of financial instability and can be a source of, rather than a cure for global financial crises.

Regulation required to protect the financial system as a whole, macro-prudential regulation, is fundamentally different in nature from micro-prudential regulation. It seeks to identify, immunize, isolate, and intervene in financial failures and, in contrast to micro-prudential regulation, it requires international harmonization across countries. The focus of harmonization to date has therefore been precisely the opposite of what is required to protect the financial system.

In a systemic context, capital is of fundamental significance, and the tax system should be employed to encourage banks to hold appropriate levels of capital. The capital provisions of individual institutions should be supplemented by reserves of central banks, the amounts being dependent on the systemically important banks under the central banks’ authority. Bail-ins of convertible debt should be triggered by systemic, not individual institutional failures. Costs of intervention and moral hazard should be minimized by writing down debt and equity in failing institutions, and equity but not debt in second round institutions threatened by first-round failures. Harmonization of macro-prudential regulation should be overseen by a global committee of central banks which ensures the correct designations of banks, adequate holdings of central bank reserves, and coordinated interventions organized around lead central banks.

• John Morley, Assoc. Professor of Law, University of Virginia School of Law

Discussion Topic: "The Separation of Investments and Management"

Investment funds—including hedge funds, private equity funds, venture capital funds, mutual funds, exchange-traded funds and closed-end funds—have unusual corporate structures: They separate investments and management. In a typical setup, all of the investment assets belong to one entity (a “fund”) with one set of owners, and all of the managers, workers. and other operational assets belong to a different entity (a “management company” or “adviser”) with a different set of owners. These funds also limit investors’ control in radical ways. For example, many funds cannot even fire and replace their management companies or their employees—not even by unanimous vote of the funds’ boards and equity holders. Regulators, courts, and popular commentators have long been suspicious of these ownership and control arrangements, and have tended to view them as odd and isolated phenomena. This paper shows for the first time, however, that the separation of investments and management is actually a defining feature of all investment funds. This paper also explains for the first time why this pattern occurs. Paradoxically, it occurs because—for several reasons unique to investment funds—investors actually value the ways that the separation of investments and management limits their control over managers and their exposure to managers’ earnings and liabilities. This understanding suggests the need for a fundamental shift in the way we define investment funds, and the reasons we offer for regulating them.

• Edward B. Rock, Saul A. Fox Professor of Business Law, University of Pennsylvania Law School

Discussion Topic: "Shareholder Eugenics in the Public Corporation"

In a world of active, empowered shareholders, the match between shareholders and public corporations potentially affects firm value. This article examines the extent to which publicly held corporations can shape their shareholder base. Two sorts of approaches are available: direct/recruitment strategies; and shaping or socialization strategies. Direct/recruitment strategies through which “good” shareholders are attracted to the firm include: going public; targeted placement of shares; traditional investor relations; the exploitation of clientele effects; and de-recruitment. “Shaping” or “socialization” strategies in which shareholders of a “bad” or unknown type are transformed into shareholders of the “good” type include: choice of domicile; choice of stock exchange; the new “strategic” investor relations; and capital structure. For each type of strategy, I consider the extent to which corporate and securities law facilitates or interferes with the strategy, as well as the ways in which it controls abuse. In paying close attention to the relationship between shareholder base and firms, this article attempts to merge investor relations, very broadly construed, with corporate governance.

• Ryan Bubb, Assistant Professor of Law, New York University School of Law

Discussion Topic: “Securitization and Moral Hazard: Evidence for Credit Score Cutoff Rules” Authored with Alex Kaufman

Mortgage originators use credit score cutoff rules to determine how carefully to screen loan applicants. Recent research has hypothesized that these cutoff rules result from a securitization rule of thumb. Under this theory, an observed jump in defaults at the cutoff would imply that securitization led to lax screening. We argue instead that originators adopted credit score cutoff rules in response to underwriting guidelines from Fannie Mae and Freddie Mac and offer a simple model that rationalizes such an origination rule of thumb. Under this alternative theory, jumps in default are not evidence that securitization caused lax screening. We examine loan-level data and find that the evidence is inconsistent with the securitization rule-of-thumb theory but consistent with the origination rule-of-thumb theory. There are jumps in the number of loans and in their default rate at credit score cutoffs in the absence of corresponding jumps in the securitization rate. We conclude that credit score cutoff rules provide evidence that large securitizers were to some extent able to regulate originators' screening behavior.

• Sharon Hannes, Visiting Professor and Vice-Dean of the Buchmann Faculty of Law at Tel Aviv University

Discussion Topic: "The Silver Lining of Managerial Opportunism;" "Managerial Incentive Pay: The Tradeoff between Risk-Taking and Manipulation"

There are two separate branches of the literature on executive pay: 1. Arguing that managers pay creates perverse incentives for misrepresentation. 2. Arguing that managers pay creates perverse incentives for excessive risk-taking. Sharon Hannes' model connects these two arguments and shows that incentive pay actually creates a tradeoff between risk-taking an misrepresentation – i.e. the possibility to cook the books represses excessive incentives to take risks. On the normative side this means that improvements in the disclosure environment may enhance motivations for risk-taking (and this is perhaps what happened in the period between SOX and the last financial crisis).