Matthew Jennejohn (BYU)
The game theoretic models of contract economics assume that agreements are fully customized, while, on the other hand, recent legal research highlights the role standardized terms play in contract design. Those lines of research overlook an important class of contracts that transcends those extremes. Many contracts, such as the merger agreements studied here, are complex combinations of customized and standardized terms, and thereby achieve economies of both scale and scope. Such contracts are “mass customized,” to borrow a term from engineering research.
This Article introduces a theoretical framework and methodological toolkit for studying such complex agreements. With respect to theory, it adds to recent scholarship that applies modularity theory to the design of complex agreements by introducing an alternative approach to harnessing contractual complexity—flexible specialization. Whereas modularity attempts to manage systemic complexity by isolating discrete subsystems from one another and ensuring their interoperability through a set of static interface rules, flexible specialization allows for tightly coupled connections between subsystems, and interoperability is achieved through a suite of explicit and tacit organizational routines that reduce the design team’s communication and learning costs, allowing them to quickly process adjustments across the interlocking sub-systems. If modularity “hides” information within subsystems and relies on accurate ex ante planning of the system’s structure to reduce the costs of change, then flexible specialization makes information radically transparent and uses robust feedback mechanisms to provide flexibility over time.
Using hand-collected data from samples of public company merger agreements and of the teams of deal lawyers that designed them, this Article presents the results of a preliminary empirical study testing whether the architecture of mass customized contracts reflects either modularity theory or the logic of flexible specialization. Methods developed in systems engineering, organizational theory, and network analysis are used to map the structural topology of the sampled agreements and deal teams. Results of the merger agreement analysis suggest that the contracts are more integrated, rather than modular systems. Similarly, analysis of the internal organization of the corporate law firms designing those agreements suggests thickly interwoven organizational structures, consistent with flexible specialization’s rich information-sharing routines. Thus, the picture of contract design that emerges is of agreements built upon a flexible architecture provided by a dynamic cluster of experts, more similar to the industrial districts of Emilia-Romagna in Italy than Ford Motor Company’s famous Highland Park assembly line.
Preliminary evidence that transaction designers mass customize agreements through flexible specialization raises important implications for doctrine, policy, and research. In regard to doctrine, this Article adds a missing dimension to recent attempts to articulate a non-unitary theory of American contract law. With respect to policy, evidence that flexible specialization underpins the infrastructure of the M&A market challenges deterministic accounts of the legal industry’s transformation, and illuminates the overlooked trade-offs presented by recent arguments to further standardize complex contracting. Finally, in regard to research, this Article provides a basis for much needed theoretical and empirical work on the interaction effects between governance mechanisms within an agreement.
Oren Bar-Gill (Harvard Law) with Omri Ben-Shahar (U Chicago)
The design of default provisions in consumer contracts involves an aspect that does not normally arise in other contexts. Unlike commercial parties, consumers have only limited information about the content of the default rule and how it fits with their preference. Inefficient default rules may not lead to opt outs when they deal with technical aspects consumers rarely experience and over which consumers’ preferences are defined only crudely. This paper develops a model in which consumers are uninformed about their preferences, but can acquire costly information and then choose a contract term that best matches their preferences. The paper explores the optimal design of default rules in such environments, and how it differs from the existing conceptions of efficient default rule design.
Adam Badawi (Washington University in St. Louis)
The law and finance literature characterizes debt covenants as a means to manage agency conflicts between creditors and shareholders. While both banks and bond holders make use of these covenants, they do so in quite different ways. Banks typically monitor their debtors closely and rely on financial maintenance covenants to protect their interests. When these covenants get triggered, banks can use the leverage of accelerating the loan to achieve their governance goals. This ability to monitor and renegotiate suggests that tailoring precise ex ante contract restrictions is not of paramount importance because a bank and a debtor can negotiate around those restrictions based on ex post contract conditions. Bond holders, in contrast, generally do not monitor and renegotiate with their debtors because these bond holders tend to be large groups of passive investors who face substantial collective action problems. As a consequence, ex ante restrictive terms in the contract are likely to be the primary means through which bondholders can address potential conflicts with shareholders. These differences in contracting technologies suggest that the restrictions in bond contracts are more likely to be responsive to changes in background legal rules. This paper tests this theory by treating two Delaware decisions that limited the default duties that the directors of Delaware corporations owe to their creditors as a shock to the contracting conditions for Delaware firms. Difference-in-difference and triple difference tests suggest that restrictive terms in bond contracts for Delaware firms increased in reaction to this change, while there was not a detectable shift in the strictness of loan agreements.
Giuseppe Dari-Mattiacci (University of Amsterdam)
I develop a theory of corporate personhood starting from a fundamental question: Who should own firm assets, the collection of investors or a distinct legal entity, which is in turn owned by the investors? In a partnership, individual investors own firm assets as they have the right to unilaterally withdraw their capital at will. If, instead, firm assets are owned by a distinct legal entity (the corporation), investors implicitly waive this right, locking capital in the firm. Capital lock in facilitates long-term investments and enhances the liquidity of the secondary market for shares. Hence, liquidity-strapped investors can sell their shares and the firm survives individual liquidity shocks. Dispersed ownership, however, comes at the cost of a more entrenched management and inefficient continuation decisions. While partnerships are at times inefficiently liquidated due to their vulnerability to liquidity shocks, corporation live inefficiently long. The amount of own capital needed to start a business is lower and share value at issuance is higher in a corporation if the number of investors is large, while the partnership might be preferred with few investors. The analysis sheds light on the choice between different business organizations, practices and rules that foster dispersed ownership, insider trading, and the separation between ownership and control in large corporations.
Kenneth Ayotte (Berkeley)
In the post-financial crisis period, many corporate bankruptcies involve complicated, fragmented capital structures characterized by many layers of debt and complex legal entity structures with many subsidiaries. Why do capital structures evolve this way, given that they make distress more costly to resolve? I suggest an answer based on the notion that investors may disagree about the value of assets that back loans. When such disagreement exists, firms have the incentive to exploit it by issuing claims that are targeted to subsets of the assets that investors are more optimistic about. This can create zero-sum disputes about entitlements to the firmi's value when distress occurs. These disagreements minimize the borrower's cost of funds ex-ante by maximizing perceived recoveries, but they can be inefficient ex-post, because resolving disputes is socially costly. I show that disagreement about collateral values can cause inefficient liquidations. I also find that allocating securities in bankruptcy rather than selling firms for cash allows parties to continue "agreeing to disagree" about entitlements, which can avoid costly litigation over valuation.
George Triantis (Stanford)
The Design of Staged Contracting (with Albert Choi)
In negotiating complex business transactions, parties decide whether, when and how to invite legal enforcement of the rules that govern their relationships, particularly in their use of intermediate agreements that reflect some agreement on a number of provisions but contemplate further negotiation (variously labelled memorandum of understanding, agreement in principle, letter of intent, term sheet). Under the common law of most U.S. jurisdictions, the parties have an intermediate option between enforcement and no-enforcement of such intermediate agreements: a duty to bargain or negotiate in good faith or with best efforts. Law firms warn their clients about the risk of inadvertently bringing on this type of enforcement but with care, this risk is small. Rather, the parties are often unclear about the freedom they prefer for themselves or their counterparties to deviate from the terms of their intermediate agreements. They expect these terms to be sticky to some degree, but do not think through how much and by what means to achieve this. Judges and commentators identify the protection of specific investments as the principal goal of the commitment to bargain or negotiate. We suggest, however, that the benefit of the flexible standard of good faith or best efforts comes more broadly from mid-stream regulation of the negotiation process. The parties need flexibility in optimizing their deal, while also efficiently constraining value-claiming behavior and allocating exogenous risks during their negotiations. Building on our earlier work on strategic ambiguity, we also show that concerns about the uncertainty of such flexible standards can be addressed.
Lin Peng (Baruch)
CEO Incentives: Measurement, Determinants, and Impact on Performance (with Ailsa Röell)
This paper examines different measures of CEO incentives: pay-performance elasticity (PPE), pay-performance semi-elasticity (PPSE), and the traditional pay-performance sensitivity (PPS).
We clarify the theoretical settings under which each measure best captures incentives and provide insight into the determinants of the optimal level of incentives. Consistent with model predictions, our empirical analysis finds that larger, more R&D intensive, and low idiosyncratic risk firms have higher PPE and PPSE. The results on size and risk are intuitively plausible and help resolve puzzling prior empirical findings that were obtained using PPS. Concerning the impact of incentives, we find that performance, as measured by ROA and Tobin’s Q, is first increasing and eventually decreasing in PPE and PPSE, while results using PPS are mixed. Furthermore, a shortfall in PPE or PPSE relative to the predicted level appears detrimental to firm performance, suggesting that the average CEO compensation contract is at or below the optimal level of incentives. Overall, the results obtained with the PPE and PPSE measures accord better with economic intuition than those obtained using PPS.