Jim Hawkins thinks that fringe banking - payday loans, auto title loans, rent-to-own, and pawnbroking - needn't be regulated for the reason that people think it should be regulated. It is his smart observation about the way that fringe banking loan contracts are structured that is the heart of the paper. They are structured, he says, largely to avoid massive indebtedness. And since massive indebtedness is the main reason that people think fringe banking should be regulated, they need to come up with another reason to do it.
Hawkins is on to something here with his contract analysis, though I suppose there is an unanswered empirical question on how much actual indebtedness fringe banking creates that would bear on the argument. Hawkins observes that fringe bankers won't get repaid if their customers are too deep in the hole, so rent to own, title loans, and pawnbroking gives those customers the opportunity to just stop paying, and give up the collateral. Payday loans fall less comfortably in this paradigm, but such loans are on the order of hundreds, rather than thousands, of dollars. If you are worried about massive indebtedness leading to financial distress, Hawkins observes, you might look at credit cards, rather than at fringe banking, because fringe banking tends to give indebted consumers an easy and quick out.
So far, so good. But of course, massive indebtedness isn't the only reason people think a consumer credit regulator of fringe banking is needed. It might be that people misapprehend the true costs of rent-to-own, or that they get distressed when they pawn their valuables, even though they can always let the pawnbroker keep them, rather than making their payments. It could be that it is unproductive to have members of the workforce risking their transportation to their jobs on consumer credit.
I also wanted to know more about Hawkins' larger bottom line. Should consumer credit in fact be regulated? Hawkins limits his analysis to fringe banking. But the upshot appears to be either that there should be a bit more caveat emptor in consumer credit ... or that it might be fine to regulate credit cards, which is where the real problem lies. It is strange to finish an article and think that these two rather inconsistent approaches might be the way to go.
To that end, I'll note that the federal government has begun to regulate in this area anyway for counter-terrorism reasons. So it is not the case that we're choosing between free markets and command and control here. Also, there is another vision of consumer credit, which is that we ought to want Americans to participate in formal, not fringe banking, for civic reasons, making similar opportunities available to all, and that sort of thing.
I'm actually not sure where my own bottom line on consumer credit lies, so maybe I am like Hawkins in that regard. But I do think that his observations about the way that fringe banking actually works add nuance to the issue.
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Hawkins’ paper tackles conventional wisdom and points out untested assumptions, and I think he deserves credit for staking out a fresh view of fringe banking. We all benefit when a scholar pushes the existing literature, even if we ultimately are not persuaded.
The premise of Hawkins’ paper is that the relationships between fringe banking (such as payday loans, title lending, etc) and financial distress is “dubious.” He argues that prevention or reduction of financial distress is a principal rationale for intervening into fringe credit markets but that such regulation cannot be justified because the structure of fringe banking products actually prevents borrowers from financial distress.
As an initial matter, I think Hawkins makes an important contribution by pressing for a sharper elucidation of the concept of financial distress. He largely seems to settle on “unmanageable debt” as the definition of financial distress (but then sometimes waffles to say it is also the inability to pay one’s bills.) This latter condition can exist wholly without debt; people with very low incomes cannot pay even modest medical bills or utility bills. Yet they have not borrowed in the sense of accessing consumer credit markets. I think Hawkins largely abandons the struggles-with-bills idea in favor of equating financial distress with unmanageable debt. He then strands his readers, however, by failing to define unmanageable debt. He explores some definitions on pp. 10-12 but does not say where he comes out. Does unmanageable debt mean generally not paying debts when they come due, a traditional measure of insolvency used for example in the Uniform Fraudulent Transfer Act? Note that definition does not require an inability to pay, just the failure to do so. Or does unmanageable debt occur when a household exceeds a clear benchmark such as having debt payments that exceed 40% of its income? Or is it a subjective standard—unmanageable debt occurs when a debtor throws up her hands and declares that they can’t pay, say by defaulting on loans or filing bankruptcy? Hawkins perhaps can’t afford to delve too deeply into these important questions and still have ample time to describe the structure of fringe banking products, but I think his failure to define unmanageable debt qua financial distress troubles his overarching analysis.
Specifically, I think that the relationship between financial distress and fringe banking that animates policymakers and advocates is not the one that Hawkins’ uses. He says that fringe banking products do not cause unmanageable debt because the products themselves do not involve substantial amounts of borrowing and are often repaid without formal collection—for example, by repossession of a car offered up for a title loan. To use other examples from the paper, because payday loans are small in amount or because secured credit cards have an escape hatch (you just never get your deposit back and the creditor closes the account), then these products cannot be plausibly linked to unmanageable debt. I think that defense of fringe banking is undermined when we expand the scope of what we mean by unmanageable debt. We might think of unmanageable debt as an overarching state of affairs that shapes how a person interacts with the economy and society. In such a view, the act of taking out a title loan and losing one’s car could well deepen financial distress. A person might be stigmatized by using a fringe banking product; they might experience stress or anxiety about having the potential loss of their car as the consequence of non-payment; and despite Hawkins’ effort to minimize the value of the lost property (noting that debtors perhaps have only $700 in equity in their cars), that is a non-trivial amount of assets. We live, after all, in a world in which the median net worth of a non-homeowner in 2007 was $5,100. And surely those who take out auto-title loans are severely constrained in any effort to borrow to obtain new transportation. The effect is that loss of a vehicle—even for a short period while they obtain alternate transportation—a potentially devastating event in terms of their employment and well-being (even if it seems small in raw dollars).
Of course, my hypothesized consequences of title lending are empirical claims, backed by only intuition masquerading as evidence. Yet, the same critique can be made of Hawkins’ paper. He sets out to undermine an empirical claim (use of fringe banking causes financial distress) but does not put this to an empirical test or even suggest how such a test could be made. Instead he narrows the definition of “related to financial distress” to equate with “adding a significant number of dollars to one’s debt burdens.” He then relies on the small dollar amount of fringe banking product to debunk the relationship. In so doing, he fails to see financial distress as a rich phenomenon. It may well be that the loss of one’s car, or the fear of having losing even a single paycheck, is precisely what finally tips people into bankruptcy—even if these events might have an objective effect on one’s financial situation that seems negligible.
I think the harm of financial distress that motivates some push for regulation is not that the fringe banking debt is unmanageable itself but rather a belief that the “bucks” need to “stop” somewhere. The premise is that people in some situations just should not borrow on certain terms or at certain costs because doing so is inconsistent with social norms. We ban offering a kidney as collateral for precisely this reason, although it may well be that people with a fragile financial situation need their cars or their next paychecks more urgently than they need their kidneys. Another lurking, largely unarticulated idea in the fringe banking critiques is that many of the borrowers may themselves be receiving government or social support, and that we wish to curtail high-cost forms of borrowing as means of giving “our” money to fringe lenders as profit. This is precisely the argument that I make each year about Refund Anticipation Loans (a form of fringe banking that Hawkins does not discuss) because a very large fraction of those using Refund Anticipation Loans receive the Earned Income Tax Credit. I object to my tax dollars, intended for wealth-building for low-earners, being left behind in the tax office as profit for Jackson Hewitt and its affiliated lenders. This argument too is not new; we put limits on the kinds of food that people can buy with TANF for the same reason.
I also think Hawkins overstates the degree to which the arguments for regulating fringe banking are premised on financial distress, and in particular, the degree to which a Bureau of Consumer Financial Protection was predicated on preventing financial distress. I think the primary justification for regulating fringe banking is that much of that activity is the result of misunderstanding, distortions in markets, and sometimes outright fraud. Those concerns are precisely the core of the Bureau of Consumer Financial Protection, which can act to prevent “unfair, deceptive, or abusive practices,” a standard that is delineated to focus on informational failures. While Hawkins asserts that “researchers have spent little effort establishing the arguments for paternalistic interventions into fringe credit markets,” two recent papers have done exactly that. Marianne Bertrand & Adair Morse conducted an experiment at a national payday loan chain that showed that more salient disclosure can reduce people’s payday lending. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1532213). Sumit Agarwal, Paige Marta Skiba, and Jeremy Tobacman show that most people who borrow on payday loans have substantial liquidity available on their credit cards that would be a less expensive alternative. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1327125 . While Hawkins may characterize it as paternalistic to think that people should understand their financial transactions and seek to maximize their self-interest in those transactions, I see such behavior as central to a functional market.
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Welcome to the third week of the Conglomerate Junior Scholars Workshop! Today, we are spotlighting a new paper by Jim Hawkins, Associate Professor of Law at the University of Houston Law Center, entitled "Regulating on the Fringe: Reexamining the Link Between Fringe Banking and Financial Distress." Our panel of esteemed experts includes our own David Zaring and friends of the Glom Larry Garvin, Katie Porter and Todd Zywicki. We are looking forward to passionate debate on this controversial topic, starring our experts and you! Feel free to jump in with your thoughts either as comments to this post or as comments to the commentators' posts.
Here is the abstract:
Critics of fringe banking -- products like payday loans, pawn loans, and rent-to-own leases -- frequently argue that using these products causes borrowers to experience financial distress. This argument has enormous intuitive appeal: Fringe credit is very costly, and usually the borrowers who are forced to use it are already in a serious financial bind. Taking on additional debt and paying high costs for it, the reasoning goes, drives them over the brink.
Surprisingly, however, linking financial distress to fringe banking is extremely difficult to do. This Article represents the first attempt to uncover the relationship between fringe banking and financial distress by stystematically analyzing the structure of fringe credit markets and characteristics of specific fringe credit transactions. Contrary to the assumptions made by the bulk of the literature, I argue that the link between fringe banking and financial distress is dubious. . . . (Read more here.)
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Welcome to the third week of the Conglomerate Junior Scholars Workshop! This Wednesday (tomorrow), we will be spotlighting a new paper by Jim Hawkins, Associate Professor of Law at the University of Houston Law Center, entitled "Regulating on the Fringe: Reexamining the Link Between Fringe Banking and Financial Distress." Our panel of esteemed experts includes our own David Zaring and friends of the Glom Larry Garvin, Katie Porter and Todd Zywicki. We are looking forward to passionate debate on this controversial topic, starring our experts and you!
Here is the abstract:
Critics of fringe banking -- products like payday loans, pawn loans, and rent-to-own leases -- frequently argue that using these products causes borrowers to experience financial distress. This argument has enormous intuitive appeal: Fringe credit is very costly, and usually the borrowers who are forced to use it are already in a serious financial bind. Taking on additional debt and paying high costs for it, the reasoning goes, drives them over the brink.
Surprisingly, however, linking financial distress to fringe banking is extremely difficult to do. This Article represents the first attempt to uncover the relationship between fringe banking and financial distress by stystematically analyzing the structure of fringe credit markets and characteristics of specific fringe credit transactions. Contrary to the assumptions made by the bulk of the literature, I argue that the link between fringe banking and financial distress is dubious. . . . (Read more here.)
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Mohsen Manesh's new paper, Delaware and the Market for LLC Law, is a fascinating project, and I am grateful to him for allowing us to feature his paper in the Junior Scholars Workshop. Like Larry Ribstein and Bob Lawless, I admire Mohsen's scholarly ambition, but I feel like this paper has some distance to travel before it is complete.
Mohsen begins with the claim that Delaware lacks the sort of market power in the competition for LLC charters that it has in the competition for corporate charters. His evidence for this claim is the lack of price discrimination in LLC taxes. Like Larry and Bob, I am skeptical of this claim, but I am willing to play along for the sake of argument. I am more interested in his examination of contractability and indeterminacy under LLC law, and my interest in these arguments eventually leads me back to Mohsen's initial claim regarding Delaware's supposed lack of market power.
Indeterminacy in corporate law is often said to play a crucial role in enhancing Delaware's market power. On the nature of indeterminacy in corporate law, Mohsen observes: "Delaware corporate law, and in particular its judge-made law of fiduciary duties, tends to favor contextual, fact-intensive standards over bright-line rules." Note that the charge of indeterminacy is not necessarily an indictment of Delaware law. Indeterminacy is probably inherent and almost certainly desirable in fiduciary law. The somewhat counterintuitive claim that this indeterminacy enhances Delaware's market power is based on two observations: (1) indeterminate law is hard to copy, and (2) indeterminate law increases the importance of judges (and Delaware has the best judges).
So far, so good. Now the crucial move: Mohsen asserts that LLC law is less indeterminate than corporate law because LLCs are "creatures of contract." In Mohsen's words:
Virtually all of the default provisions specified in the Delaware LLC Act may be superseded or otherwise contractualized by the terms of a LLC’s governing agreement. As a result, many of the mandatory and indeterminate provisions that are imposed under Delaware corporate law—including the judge-made law of fiduciary duties—may be contractually waived, modified or clarified under Delaware LLC law.
According to Mohsen, one implication of this contractability is that LLCs can avoid the cost of uncertainty inherent in corporate law. I have several problems with Mohsen's argument.
First, Mohsen selects an unfortunate example to illustrate the mandatory indeterminacy of Delaware corporate law. He argues that DGCL Section 271, governing the sale of "all or substantially all" of a corporation's assets is a mandatory provision, meaning that it "cannot be modified, clarified or otherwise waived by the terms of a corporation's governing documents." While the statute does not expressly allow for contrary terms in the corporate charter, the process for selling assets is often subject to contractual specification. If powerful shareholders want a say in the sale of assets -- even when that sale constitutes less than "all or substantially all" of a corporation's assets -- they simply have to insert a negative covenant into their deal terms.
Second, while Mohsen illustrates how an LLC's governing documents could "contractualize" certain matters that, in a corporate context, might be evaluated under a mandatory, indeterminate, fiduciary standard, he does not provide evidence that LLCs routinely avail themselves of this opportunity. He rightly acknowledges that drafting highly specified contracts is expensive and difficult, and that should lead him to ask: would most Delaware LLCs invest in such contracts? The answer to this question depends on what these LLCs look like, and I agree with Bob Lawless that it would be nice to know more about this. Are most of these LLCs Mom-and-Pop businesses? Or are they non-operating companies? In any event, my guess is that the vast majority of Delaware LLCs are tightly controlled by one individual or parent company, thus eliminating the need for highly specified contracts.
Third, if one of the major advantages of LLCs is contractability, which reduces indeterminacy, why are so many LLCs formed in Delaware? Mohsen observes that many states have copied Delaware's LLC Act, which provides that its principal policy is "to give the maximum effect to the principle of freedom of contract." If contractability is the key feature of LLC law, why don't other states compete more effectively with Delaware? Under Mohsen's theory, contractability reduces indeterminacy, which implies that Delaware judges have no special advantages. Rather than puzzling over Delaware's lack of market power, I am left puzzling over Delaware's success in attracting LLC formations when its product has no discernible advantages.
By the way, Larry Ribstein disagrees with Mohsen on this point, arguing, "The contractual nature of LLCs increases the value of Delaware courts’ contract-enforcement technology." In other words, the important thing about Delaware is how the judges will interpret future contracts, and that feature of the Delaware system is not easily replicated by other states. This seems plausible to me, but it is in tension with the notion that contractability reduces indeterminacy and, thus, poses a significant challenge to Mohsen's paper.
Fourth, Mohsen dismisses the importance of the contractual duty of good faith and fair dealing too quickly, arguing, "the Delaware courts have made clear that the implied contractual covenant is doctrinally distinct and substantially narrower than the open-ended fiduciary duties imposed by corporate law." The Delaware courts have certainly made statements like this, but my sense is that the treatment of this doctrine is far more complex than Mohsen gives credit. Indeed, earlier this summer, I heard Chief Justice Steele address two distinct lines of cases involving the contractual duty of good faith and fair dealing and suggesting that these precedents were in serious conflict.
In the end, all of my points revolve around a single complaint, namely, that Mohsen exaggerates the extent to which the contractability of LLCs reduces indeterminacy when compared to corporations. Given that his argument rests on this claim, however, it is a point worth arguing.
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I am very happy to see somebody exploiting the theoretical and empirical potential of expanding the study of business organizations to fully include unincorporated business entities. And I applaud Professor Manesh’s selection of an intriguing question to study, something that I’ve been curious about but never pursued: Why do Delaware’s fees for forming LLCs look so much different than those for corporations?
To briefly summarize his thesis, Manesh argues that Delaware’s flat $250 fee for LLCs, compared to its much higher and graduated fees for corporations, indicates Delaware’s lack of market power in the market for LLCs. Kahan & Kamar (Price Discrimination in the Market for Corporate Law, 86 Cornell Law Review 1205 (2001)) theorized that Delaware’s scaling of corporate fees to firms’ capitalization showed price discrimination, something a producer can do with market power. Since Delaware doesn’t do that for LLCs it must not have market power in that area.
One problem with this analysis is that it assumes LLCs and corporations are comparable for purposes of pricing. But there is no reason to think this is the case. Corporations are standardized products. Delaware builds on this standardization to compute the corporate franchise tax in ways that apply fairly simply to all corporations in the state, as described in the article. LLCs’ main attraction, by contrast, is that they are not standardized, but rather creatures of contract, as Manesh discusses. LLCs’ capital structures depend on idiosyncratic contracts rather than statutory standard terms. If Delaware tried to apply something like the corporate franchise tax to LLCs they would simply engage in regulatory arbitrage to minimize the tax.
Why doesn’t Delaware force LLCs to be just as standardized as corporations so it can charge for them like it does for corporations? First, there just isn’t as much money in it because there’s much less variation in size of LLCs than corporations. Second, if Delaware forced LLCs to be as standardized as corporations, LLCs would lose a lot of their attraction, as Manesh himself argues. As a result, Delaware would get a lot fewer LLCs. By contrast, corporations, or at least large Delaware corporations, benefit from standardization apart from law compliance: they are traded in a public securities market, where variations cause information costs that would be reflected in securities prices. Corporations trying to arbitrage Delaware’s franchise tax would have to pay a penalty for being different.
(A broader problem with Manesh’s analysis is that the relationship between price discrimination and market power is less clear than Manesh assumes. See Kobayashi and Wright on Illinois Tool Works vs. Independent Ink on the non-inference of anti-competitive markets from price discrimination in the antitrust context. )
So, contrary to Manesh’s assumption, Delaware doesn’t necessarily lack market power in the LLC market just because it doesn’t price discriminate. But having made his assumption, Manesh then explains why the assumed fact about lack of market power is true: LLC law is based on the parties’ contracts and therefore is less indeterminate than its corporate law. Delaware therefore cannot attract LLC business to its courts through indeterminacy as it does for corporations.
I agree with Manesh’s observation about corporate vs. LLC indeterminacy – in fact I wrote and published that article a couple of years ago. I don’t necessarily buy K & K’s reasoning as to corporations. Rather, as discussed in my indeterminacy article, I think indeterminacy is inherent in the corporate form. But even assuming LLCs and corporations differ in this respect, I disagree with where Manesh goes from there.
Let’s begin with the evidence that Delaware does attract LLCs to its courts. Kobayashi and I find that Delaware is a massive winner in the national market for formations of large LLCs. Although this would be seem to suggest Delaware has power in the LLC market, Manesh doesn’t seem troubled by this finding, since he is relying on the absence of price discrimination. More interesting for present purposes is that Kobayashi and my regression analysis indicates that Delaware’s success is not because of any feature of Delaware’s law that we could find. Indeed, Manesh also notes that the feature that one might expect would attract LLCs to Delaware – the statutory provision allowing freedom of contract – has been replicated by other states. This suggests that large LLCs are attracted to Delaware because of Delaware’s legal infrastructure of courts and lawyers.
So why are LLCs drawn to Delaware’s courts if, as Manesh concludes, there’s relatively little those courts need to do for LLCs?The answer is that courts do have a lot to do for LLCs – that is, enforce their contracts. The contractual nature of LLCs increases the value of Delaware courts’ contract-enforcement technology. It is easy for a state to say in its statute that its courts will enforce contracts, but much more difficult to actually follow through on that promise, and to come up with intelligible and coherent contract-enforcement jurisprudence. As I have discussed in several writings, including my indeterminacy article above, my book (Rise of the Uncorporation and a number of blog posts (e. g. , Delaware courts have developed a very sophisticated approach to contract interpretation and enforcement in unincorporated firms. Other states can’t pick up formation business simply by linking to Delaware’s law because they also need to provide assurances as to how they’ll decide future cases.
In other words, LLCs are not flocking to Delaware just because it enforces contracts, but because of the way it enforces contracts. Although Manesh thinks that the “network” of Delaware’s cases is all about interpreting mandatory rules, in fact it is at least partly about applying any rules, whether or not contractual, to necessarily unpredictable fact situations. If Delaware were to follow Manesh’s suggestion and become more indeterminate to compete for LLCs, this would threaten, not solidify, its dominance in the market for LLCs.
(As an aside, I have a quibble about Manesh’s analysis of “network externalities” as a reason for the attractiveness of Delaware law. This confuses network effects in business association law and network externalities. My article with Kobayashi about choice of form, which Manesh cites a couple of times, shows some pretty good evidence that these aren’t network externalities. Contrary to Manesh’s brief discussion of this paper, this holds for both choice of form and choice of law, since the basic constraints are the same in both areas. )
Finally, Manesh discusses interest group pressures that might promote indeterminacy. He argues that lawyers would favor indeterminacy plus low LLC taxes to attract LLCs to Delaware and then produce more work for lawyers. I have also theorized that lawyers work on their states’ laws to attract clients to their states, and that lawyer licensing gives lawyers a kind of informal “property right” in their state’s law. However, it does not follow that lawyers would seek to attract business by promoting indeterminacy. If the market for business organizations is competitive (and, as shown above, Manesh hasn’t shown otherwise) lawyers can accomplish this goal by promoting laws that are not too indeterminate. Also, even if lawyers do seek more work from the clients Delaware attracts, this may mean different things to transactional lawyers (who want to encourage contracting by having contracts enforced) and to litigators (who want to undo contracts through litigation).
In conclusion, I applaud Professor Manesh’s choice of topics. This is a good start. I would encourage him to follow up this early draft with more extensive reading and analysis. Rather than putting all his eggs in the price discrimination basket, I would urge him to step back and keep an open mind about why competition in the corporate and LLC markets might differ, and alternative reasons why Delaware prices these products differently. I think the time spent on this reading and analysis will be rewarded by more robust conclusions.
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With one of his first articles, Professor Mohsen Manesh has boldly waded into a deep academic debate about the nature of regulatory competition for organization charters. There are a number of things I like about this paper, especially Manesh's instinct to look for empirical evidence. My advice for junior scholars is generally to think big, but write small. On balance, I found myself wishing this paper was smaller--not shorter, but smaller.
To understand Manesh's paper requires a background in the literature. In 2001, Marcel Kahan and Ehud Kamar published Price Discrimination in the Market for Corporate Law (Cornell L. Rev., vol. 86, p. 1257) and examined Delaware's fees and franchise taxes on corporations. I distinctly remember reading a working draft of the article over a stout while sitting in a pub during a business trip. Both the stout and the paper were excellent. Kahan and Kamar found that Delaware was able to charge a premium for the privilege of a Delaware incorporation. More controversially, they found that Delaware price discriminated by charging a higher price to publicly traded corporations, which were particularly likely to value Delaware corporate law. Together, these findings suggested Delaware enjoyed substantial market power in the market for incorporations. Although almost ten years has passed since Kahan and Kamar's article was published, there is no reason to think the situation has changed.
Manesh expands the methodology of Kahan and Kamar to the competition for LLC formation. He convincingly shows that Delaware neither charges a premium to form an LLC or price discriminates against small or large LLCs. Therefore, Manesh concludes (p. 26), "Delaware's relatively meager LLC tax suggests that, in the competition for LLC charters, Delaware lacks the kind of market power it has long enjoyed in the corporate context." But, Manesh's conclusion, does not necessarily follow from his evidence.
Kahan and Kamar observed evidence--Delaware's corporate fees and franchise tax have a particular structure indicative of market power. Manesh observes the absence of evidence--Delaware's LLC fees and taxes do have this structure. Observing the absence of evidence about a fact is not proof the fact does not exist. By looking at LLCs fees and taxes, we have looked under the street light, but are there darker places where there might be evidence of Delaware's market power in the competition for LLC charters?
One distinct possibility is that Delaware's accounting, finance, and legal professionals are able to extract a premium for their services related to Delaware LLC formation. Through their special-interest groups, these professionals would shape Delaware LLC law so as to attract LLCs and create market power. Under this hypothesis, Delaware's market power for LLCs would not line the state coffers but instead would line the pockets of some of its residents.
Manesh recognizes the exact possibility (p. 79) that interest groups may reap benefits from Delaware's LLC law but in a different context. After asserting the fact that Delaware lacks market power for LLCs, the bulk of the paper discusses the "why" and then the "who cares" that stem from that basic fact. Part of the answer, Manesh asserts, to the "why" is that Delaware corporate law is indeterminate but that Delaware LLC law is determinate, with "determinancy" roughly meaning predictability about what courts will do. Manesh writes (p. 66) that determinate LLC law not only diminishes Delaware's advantage of having a large body of case law but "also marginalizes Delaware's judicial advantage by limiting the role and importance of Delaware's judges in the interpretation of the law." Part of the "who cares" is then that Delaware lawyers will push for Delaware LLC law to become indeterminate because "Delaware lawyers . . . stand to reap benefits from LLC charters in the state only if Delaware provides an indeterminate, litigation-intensive LLC law that would require the service of local lawyers." (p. 79)
For my money, this argument makes an often-repeated mistake in legal scholarship. The legal academy is so drawn to normative argumentation that papers often spend more effort on the normative implication of a fact than on ensuring the fact is true. Manesh recognizes the possibility of interest-group dynamics in the formation of Delaware LLC law but does not consider whether these interest groups may be reaping the benefits of the market power that Manesh says does not exist.
In any event, there is no reason to think that lawyers benefit only (p. 79) from "an indeterminate, litigation-intensive LLC law." Furthermore, there is no reason that the relevant interest groups have to be lawyers. At former station at UNLV, I casually knew one person who was in the registered agent business and was active in ensuring that Nevada corporate law helped attract clients for that business. Consider the following business model. For a flat fee, a Delaware service--it does not necessarily have to be a law firm--processes thousands of LLC formations using a routinized set of documents. For another fee, the service will serve as a registered agent and generally monitor compliance to ensure the LLC stays in good standing. If Delaware has market power in LLC formation, the premium the firm extracts would not even have to be monetary. It might be that the business model allows its principals more leisure time. It might also be a business model that works for professionals who lack the licensing or perhaps the native ability to benefit from a litigation-intensive LLC law. Indeed, one can imagine a set of specialists who benefit from a litigation-intensive corporate law (big law firm partners and associates) and another set of specialists who benefit from a determinate, routinized LLC system (owners and employees of business services firms).
Contrary to the paper's assertions, there are reasons to think that a determinate and contractible (that is, the ability of the parties to modify by contract) law is exactly what would be most attractive to LLCs and hence give a state market power. Manesh's prototypical LLC is a classic business firm, one with customers and employees and sales and a coffee pot. In these firms, legal issues between owners will predominate, and the legal dynamics that Manesh identifies may be salient in the decision where to organize. Many LLCs and especially LLCs forming in Delaware, however, are probably not operating business firms. Rather, they are financial shells set up for legitimate purposes in securitizations or other financial transactions. In these firms, legal issues with third parties will predominate. For example, a creditor or a bankruptcy trustee might make a claim against the LLC's assets. In anticipation of such a claim, the parties forming the LLC would most value a state LLC law that was determinate and most certain to respect the LLC's separateness.
Because of the nature of the records, it is difficult to know how many new LLCs fit my hypothesized description. The trend in LLC filings from Manesh (p. 16), however, suggests that nonoperating LLCs may constitute a significant portion of the total Delaware LLC filings. First, the annual growth in LLC filings from 2003-2007 is high (24%, 28%, 10%, 15%) and well beyond the level of growth that would result from increased economic activity as implied by GDP growth during those years. Instead, the growth in LLC filings is more consistent with the growth rate in securtizations during those years. (See, e.g., the Fed's G.19 releases.) Also, a huge annual decrease (27%) in LLC filings occurs after the 2007 financial meltdown and again is more consistent with the relative huge decline in securitizations rather than the substantial but relatively smaller decline in economic activity.
None of the facts that I have hypothesized are necessarily true, but that returns me to the point where I began. I wish this article was smaller. This article is not necessarily wrong, but it has not laid the groundwork to convince a reader that it is probably right. Tellingly, the paper almost seems to recognize this point by starting the last paragraph with the summary phrase, "If this analysis is right . . ." With the evidence at hand, I think the paper could sustain an argument something along the following, "If Delaware has market power for LLCs, it's not showing up in the state's fees and taxes for LLCs. The market power might show up in the way some professionals charge and deliver their services. It might also show up in the following creative ways that Lawless is too dumb to imagine: <insert your list here>. These are the next steps in a long-term project on regulatory competition and LLCs."
Manesh has done a great job in the first part of the paper where he convincingly peels back the Delaware structure for LLC fees and taxes. He shows that this structure is nothing special, and that portion of the article is a strong contribution to the literature. Let's not kid ourselves, however. There are huge pressures on junior scholars to produce big, path-breaking works right from the start. The legal academy needs to give its junior scholars support to write smaller. Manesh continues the article with a bold swing at a broad and established literature on an important topic. It's an ambitious project, and there a lot of details to pin down. I look forward to seeing where it goes from here.
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Wecome to the second week of the Conglomerate Junior Scholars Workshop. Today we are delighted to be discussing a recent paper byMohsen Manesh, a new assistant professor at the University of Oregon School of Law, entitled Delaware and the Market for LLC Law: A Theory of Contractability and Legal Indeterminacy." Leading our discussion will be our experts Bob Lawless,Larry Ribstein and Gordon Smith. We also hope that you will join in the fun either by commenting on this post or on one of the other posts, which should appear above this one. Remember, no anonymous comments.
Here is the abstract:
Incorporating in Delaware can be expensive. Corporations pay up to $180,000 annually for this simple privilege – a figure that is substantially higher than incorporation in any other state. In their controversial article, Price Discrimination in the Market for Corporate Law, Professors Marcel Kahan and Ehud Kamar show that Delaware’s ability to charge a premium for incorporations, in the form of its annual franchise tax, is evidence of Delaware’s market power in the jurisdictional competition for corporate charters. Beyond simply charging a premium, however, Professors Kahan and Kamar show that Delaware further increases its profits by engaging in price discrimination – tailoring its premium according to the value each firm attributes to the privilege of incorporating in Delaware. The ability of Delaware to charge a premium and to further price discriminate leads Professors Kahan and Kamar to conclude that in the competition for corporate charters, “it is evident that Delaware possesses substantial market power.”
This Article projects Professors Kahan and Kamar’s analysis onto the world of limited liability companies (“LLCs”). To assess Delaware’s market power in the jurisdictional competition for LLC charters, this Article examines the LLC analog of the corporate franchise tax. Instead of a franchise tax, every Delaware LLC is charged a flat annual tax of $250. As this Article will show, unlike its corporate franchise tax, Delaware’s LLC tax does not represent a premium. Nor does it price discriminate. (Continue reading here. . .)
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Wecome to the second week of the Conglomerate Junior Scholars Workshop. On Wednesday, August 18, 2010 (two days from now), we will be spotlighting a discussion of a recent paper by Mohsen Manesh, a new assistant professor at the University of Oregon School of Law, entitled Delaware and the Market for LLC Law: A Theory of Contractability and Legal Indeterminacy." Leading our discussion will be our experts Bob Lawless,Larry Ribstein and Gordon Smith. And of course, you!
Here is the abstract:
Incorporating in Delaware can be expensive. Corporations pay up to $180,000 annually for this simple privilege – a figure that is substantially higher than incorporation in any other state. In their controversial article, Price Discrimination in the Market for Corporate Law, Professors Marcel Kahan and Ehud Kamar show that Delaware’s ability to charge a premium for incorporations, in the form of its annual franchise tax, is evidence of Delaware’s market power in the jurisdictional competition for corporate charters. Beyond simply charging a premium, however, Professors Kahan and Kamar show that Delaware further increases its profits by engaging in price discrimination – tailoring its premium according to the value each firm attributes to the privilege of incorporating in Delaware. The ability of Delaware to charge a premium and to further price discriminate leads Professors Kahan and Kamar to conclude that in the competition for corporate charters, “it is evident that Delaware possesses substantial market power.”
This Article projects Professors Kahan and Kamar’s analysis onto the world of limited liability companies (“LLCs”). To assess Delaware’s market power in the jurisdictional competition for LLC charters, this Article examines the LLC analog of the corporate franchise tax. Instead of a franchise tax, every Delaware LLC is charged a flat annual tax of $250. As this Article will show, unlike its corporate franchise tax, Delaware’s LLC tax does not represent a premium. Nor does it price discriminate. (Continue reading here. . .)
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In light of Dodd-Frank's requirement that all public corporations must offer their shareholder's a Say on Pay, Lund's article is both extremely timely and valuable since it examines how and to what extent Say on Pay will impact compensation practices in the US. Moreover, Lund's paper does not take on the debate about the propriety of enhancing shareholder power over compensation decisions more generally--presumably because in many ways that train has left the station. Instead, Lund's paper seeks to ascertain whether Say on Pay represents an ideal mechanism for shareholders to impact pay practices or otherwise enhance their power over corporate affairs. To that end, Lund argues that Say on Pay is a "relatively unattractive structure" for enhancing shareholder power in this area largely because its ex post nature generates significant bundling issues that distort shareholder decision-making and results in too little discipline of high-performing firms. As an alternative, Lund proposes an ex ante structure--a shareholder advisory vote on CEO compensation plans applicable to future CEO compensation arrangements. While I am not completely convinced of the propriety of his proposal, I did find it intriguing. Then too, as I mentioned at the outset, Lund's paper is certainly timely and a valuable contribution to this critical debate. Perhaps more importantly, his analysis was both engaging and thoughtful, offering novel insights regarding Say on Pay both in the US and the UK as well as the issue of shareholder power more generally.
As an initial matter, while it was not the focus of his paper, Lund does a very nice job of grappling with some of the criticisms of Say on Pay. He also does a very nice job of discussing the perceived benefits of Say on Pay in disciplining compensation decisions. Specifically, he notes that the threat of a no vote inherent in a Say on Pay regime potentially impacts corporate decision-making at two critical junctures. Thus, not only does it have an impact around the time of the vote for those seeking to avoid the largely reputational harm associated with a negative vote, but the threat of a no vote also may encourage increased consultation with shareholders prior to adoption of pay packages. And to this latter point, evidence from the UK (which has mandated Say on Pay since 2002) suggest a substantial increase in dialogue with shareholders around compensation matters as a result of Say on Pay.
Nevertheless, Lund concludes that Say on Pay falls short of its goal, and asserts that the reason for this failing stems largely from the ex post nature of the Say on Pay vote. Indeed, Lund notes that shareholders who are upset with a corporation's pay practices may nevertheless accede to such practices due to their fear of offending a seemingly valuable CEO. In other words, because the CEO may perceive a rejection of his or her pay package as a personal rejection, shareholders must weigh the cost of that rejection against any benefits to be gained. This bundling problem is most acute at high-performing firms where shareholders may perceive that the cost of offending a CEO who would be particularly high. Seeming to confirm this problem is evidence from the UK revealing that Say on Pay has only had an impact on pay practices at poorly performing firms, and has had no impact on the CEO pay at above-median performing firms even when such firms have had controversial pay practices. In Lund's view, this kind of result is inevitable in light of the bundling problems posed by an ex post Say on Pay vote. To mitigate this problem, Lund offers an ex ante solution.
On the one hand, this solution seems ideal. As he notes, we have had some experience with ex ante votes in the form of the shareholder vote on equity compensation plans. Then too, such a vote is likely to alleviate bundling concerns since it applies to future CEOs--though Lund notes that it does not completely alleviate such concerns in circumstances where the future CEO is known or predictable. Also, to the extent one of the primary purposes of the Say on Pay vote is to encourage more dialogue around compensation decisions, it is arguable that a vote on a Compensation Plan more directly achieves that result.
And yet this solution does raise some questions. First, one has to wonder if Say on Pay votes in the US will have the same impact as such votes have had in the UK. According to Lund, in the 8 years since the UK has adopted Say on Pay, there have only been 8 adverse votes. By comparison, thus far this year there have already been three negative say on pay votes in the US at Motorola, Occidental Petroleum, and KeyCorp. Moreover, at least with respect to Occidental, it is arguable that the vote reflects outrage over the pay package itself, as opposed to outrage about the link between the package and company performance. This albeit anecdotal evidence not only suggest that US shareholders may be more willing to exercise their authority under a Say on Pay regime, but also suggest that such shareholders may not experience the same sort of bundling problems as UK shareholders, making the Say on Pay threat more credible and hence its potential to impact pay practices at all firms more likely.
Second, it is not clear that shareholders would actually view an ex ante Say on Compensation Plan regime as preferable to an ex post Say on Pay regime. Hence, although Lund's Say on Compensation Plan regime would encompass more than just an advisory vote on equity compensation plans, it may nevertheless be telling that shareholders have insisted on Say on Pay notwithstanding the fact that they already have a vote on equity compensation plans. Indeed, it may be that an ex ante vote will not provide shareholders with sufficient information to judge the adequacy of a company's compensation practices. This may be because the flaws in a plan may not be clear unless and until an equity or compensation plan is applied to a particular executive in a particular setting--which may explain why shareholders express outrage about compensation that in some cases stems from equity plans they already have approved.
Third, one has to wonder if the apparent fact that the UK version of Say on Pay has only managed to discipline poorly performing firms just reflects shareholders' discipline preferences. That is, do shareholders only really care about paying for failure? To be sure, Lund anticipates and grapples with this issue, but ultimately concludes that the more plausible explanation for the inability of Say on Pay to impact high-performing firms lies with the timing of the vote. However, it seems possible that both of these explanations play a factor. Indeed, while it may be true that participants in the Say on Pay debate appear to be concerned about so-called excessive pay across firms, shareholders may be less concerned with high performing companies not only because it may be too difficult and costly to assess whether such pay should be viewed as excessive when a corporation performs at a high level, but also because it appears to be less of a zero sum game at high performing companies. The notion that shareholders are more concerned about pay for failure seems to be supported at least anecdotally in the kind of outrage that pay for failure sparks. For example, the firestorm about AIG seemed to stem from the fact that AIG paid bonuses despite being "bailed out" by taxpayer dollars. Similarly, people appeared to be outraged by Nardelli's exit pay package at Home Depot because the company was not doing well. And, in the midst of the Home Depot saga, when Barney Frank began thinking about holding hearings about excessive pay, his concern appeared to revolve around what he termed payment for "bad performance." From this perspective, it could be that Say on Pay only disciplines poor firms because shareholders care most about the pay practices at those firms. And while Lund certainly anticipates and addresses this point,one is still left wondering if this point is not one of the primary explanations for the empircal evidence. Of course, it does not have to be the only explanation, nor does it mean that shareholders do not also care about excessive pay practices more generally. Hence, it does not negate the benefit of a rule, like that proposed by Lund, that would enable shareholders to better address pay practices at all firms.
In the end, Lund's article represents a thought-provoking analysis of a truly critical topic that pushes us to think beyond the debate about Say on Pay, and towards examining the more fundamental question about how shareholders can exercise increased power in a responsible and efficient manner.
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American public corporations are going to have to institute Say on Pay
advisory votes as a result of a provision in the Dodd-Frank Act. Say on Pay
has been required in the UK since 2002. The UK experience suggests that
insofar as Say on Pay has had any sort of limited effect, it has only been
for poorly-performing companies. Most debate over Say on Pay so far has
been a battle within the general war over shareholder rights, with
pro-shareholder types supporting it and pro-management types opposing it.
In "Say on Pay's Bundling Problems," Andrew Lund tries to change the focus.
He is dissatisfied with the limited impact of the British (and now the
American) version of Say on Pay, and he is looking for a way to increase
that impact. He argues that the current version has a bundling problem: if
shareholders unhappy with a company's compensation scheme vote "no," the
CEO is likely to take that as a personal insult. The result may be lowered
performance or the CEO's departure. Shareholders are willing to pay that
cost only at poorly-performing companies, even though they may prefer
different pay packages at well-run companies too. Lund suggests an "ex
ante" version of Say on Pay to address this problem. Shareholders would
vote on the outlines of compensation schemes to be offered to the next CEO,
before she is chosen. Thus, there is no personal insult, and shareholders
can vote purely on the basis of their preference on pay systems.
This is a clever idea, well worth considering. I would assume that
opponents of shareholder power will oppose this version of Say on Pay as
well. Indeed, perhaps they will oppose it more strongly--as Lund
recognizes, insofar as his scheme allows shareholders to flex their muscles
more easily, it is for that reason objectionable to those who want to keep
them bound. I do wander whether the CEO offense problem within the current
scheme is really as severe as Lund posits. Are CEOs really that
thin-skinned, so that a non-binding vote against their pay package will
send them off in a huff? Would one really want to retain such a
thin-skinned narcissist? But if indeed enough shareholders do believe their
CEOs are that thin-skinned and yet do want to keep them happy, then the
problem he identifies is real (for those who want Say on Pay to be an
effective shareholder tool).
Also, it seems to me that the pattern observed in the UK of shareholders
voting no only at poorly-performing companies is not really all that bad.
Doesn't that fact make the system in effect more performance-based? Lund
marshals evidence that this is not what institutional investors and proxy
advisors say they way to do, but even if it is an unintended effect, it
seems to me to have some redeeming features.
One concern about Lund's scheme. What compensation scheme is best may
depend rather heavily on the particular CEO. Is she an insider or outsider?
Experienced and nearing retirement or at an earlier career stage? Is she a
well-known star, or an obscure person in whom the company sees promise?
What kind of pay does she receive at her previous job? And so on. Voting on
the compensation scheme in advance of knowing the answer to these questions
may be difficult and misleading.
Lund hints at a multiple equilibrium possibility. The insulting the CEO
effect would diminish or disappear if shareholder votes against bad pay
schemes were more common outside of poorly-performing firms. But given the
current pattern, a no vote does have that message, and hence shareholders
will vote no only where they are unhappy with the CEO. If this is right, is
there any way to encourage the widespread no vote equilibrium as we start
the Say on Pay system here? If in the first year activists and proxy
companies focused on no campaigns in a group of prominent companies with
good CEOs and strong performance but dubious pay schemes, might that keep
us from going down the road that Lund fears?
I would like to see Lund expand upon and defend some important details.
Should all public corporations be required to offer his version of Say on
Pay, or should shareholders be able to opt out? Or might an opt in version
be better? Why should the shareholder vote be advisory rather than binding?
Should a company use Lund's scheme along with more traditional Say on Pay?
Lund suggests the latter possibility in note 202, but does not elaborate.
The question is important, since for now the traditional Say on Pay is the
law for the U.S., and given its newness, I doubt that will change in the
immediate future.
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There are many terrific things to say about Lund's paper. Ignoring some good advice about how to give comments, I will focus this response on a few criticisms, none fatal.
First, Lund argues that neither "theory or evidence" explains shareholders' discipline of losing firms and complacency regarding winning firms. He denies that there are cognizable constraints on high pay -- "shareholders should be neutral to bullish regarding total compensation even at otherwise extraordinarily high levels." Though he at first attributes shareholders' bundling to "inchoate intrafirm populism," "hedging," or error, Lund ultimately settles on a more concrete and novel explanation: shareholders do not wish to offend executives with negative votes after positive performance.
I suppose this is plausible, but it felt to me like a bit of a just-so story. As Lund points out, executives are "more narcissistic as a class than others," winners of a tournament in which each level made them feel even more convinced that they were destined to succeed all along. It is not clear to me how a CEO would take a negative "say of pay". Perhaps they would be "humiliated." But perhaps they would simply shrug it off -- a constraint that great men face which must be managed. Such uncertain application of main-effect experimental findings are an important limit on what Donald Langevoort has called "clinical" behavioral psychology. And there is little evidence support Lund's position -- even anecdata on UK CEO tantrums is missing from the paper. Far more significantly, I don't know why would attribute to shareholders such a sophisticated and psychologically nuanced theory of the CEO mind. Indeed, I bet shareholders don't think all that much about the actual executive's reaction to their decision, which, after all, must be aggregated with others to have any social meaning. In politics, voters don't often think about how their preference for candidate A will make candidate B feel; they vote their hopes, dreams, fears and pocketbooks. This doesn't conflict at all with Lund's point that CEOs are becoming more identified with their firms, and that CEO behavior matters for the firm's value. The point is that most people are relatively bad at knowing how others will react to their decisions. We mispredict in casual interactions, with our significant others, with our friends, our students, our mentors. Why would be any better when thinking about how a CEO of a firm that did well would respond to our vote on pay? Maybe we'd think it would spurr the CEO to greater efforts. Or signal that she was great, but not the greatest. Lund could strengthen the paper by adding discussion regarding how social norms and ordinary psychology motivate our views about how to pay executives. Check out Harwell Well's terrific history piece, "'No Man Can Be Worth $1,000,000 a Year': The Fight Over Executive Compensation in 1930s America" for a sense of how such anti-reward norms used to be expressed. Additionally, prospect theory classically teaches that we find losses more aversive than gains, therefore it would make sense that we both pay more attention to them and punish failure executives more than we reward ones that succeed. That's true although, as Lund points out, "there is little evidence that institutional shareholders or proxy service firms feel pay-for-performance is conceptually limited to the avoidance of pay-for-failure." Such firms are aggregating the preferences & biases of their employees, and loss aversion is particularly difficult to debias, even in an institutional framework. Quite obviously, my preferred explanations do not detract from Lund's bundling argument -- they strengthen it. I do think that shareholders are likely to monitor more carefully when firms underperform, and the result is that high-performing firms will be less constrained (than they ought to be) by say on pay mechanisms. To the extent you think those mechanisms worthwhile, this is a problem in need of a solution. Perhaps Lund's ex ante proposal is right one. Because this response has gone on a bit long already, I'll leave that analysis to others, and look forward to the discussion!Permalink | Junior Scholars | Comments (0) | TrackBack (0) | Bookmark
Welcome to the first
week of the Conglomerate Junior Scholars Workshop. On Wednesday, August
11, 2010 (two days from now), we will be spotlighting a discussion of Say on Pay's
Bundling Problem by Andrew Lund, an associate professor at Pace University Law
School. Leading our
discussion will be our experts: Lisa Fairfax, Todd
Henderson, Dave Hoffman and Brett McDonnell, with hopefully some follow-up from you!
Here is the abstract:
The newly enacted federal Say on Pay rule will require public firms to periodically provide shareholders with an opportunity to cast an advisory vote regarding its most recent year's executive compensation. Like other efforts to increase shareholder power, Say on Pay has attracted criticism from those who fear that empowering shareholders will harm firms. This Article instead offers a critique of Say on Pay internal to the shareholder empowerment movement. The problem with Say on Pay is that its ex post nature neuters its ability to influence executive pay at high-performing firms. This hypothesis has been borne out by the experience with Say on Pay in the U.S. where a mandatory version has been in effect for seven years. . . . (read more here).
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The roster for the Conglomerate Junior Scholars Workshop has been set. All four papers this year will be spotlighted on an upcoming Wednesday. As in previous years, I will post the link to the paper and the abstract prior to that Wednesday, and then on Wednesday morning, I will post comments to that paper from illustrious friends of the Glom. Then, everyone else jumps in. As always, we treat this as an academic conference, so if you raise your hand to make a comment or a question, your nametag has to show, and it can't read "Anonymous." We are looking forward to four Wonderful Wednesdays. Here's the 2010 Dream Team:
August 11: Andrew Lund, Associate Professor, Pace, Say on Pay's Bundling Problems
August 18: Mohsen Manesh, Assistant Professor, Oregon, Delaware and the Market for LLC Law: A Theory of Contractability and Legal Indeterminacy.
August 25: Jim Hawkins, Associate Professor, Houston, Regulating on the Fringe: Reexamining the Link Between Fringe Banking and Financial Distress.
September 1: Urska Velikonja, O'Connor Fellow, Arizona State, Leverage, Sanctions, and Deterrence of Accounting Fraud.
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