September 02, 2010
Final Thank You to Participants in the Conglomerate Junior Scholars Workshop
Posted by Christine Hurt

Many thanks go out to the authors and commentators that made the 2010 Conglomerate Junior Scholars Workshop so enjoyable!  We think this is one of the best things we do around here at the Glom.  We enjoy getting to know the authors early in their careers so we can say "We know them when."  And of course, we couldn't have put on a workshop if it hadn't been for our outside commentators:  Katie Porter, Larry Garvin, Todd Zywicki, Todd Henderson, Dave Hoffman, Brett McDonnell, Bob Lawless, Larry Ribstein, Miriam Baer, Mike Guttentag, and Kim Krawiec!  You guys rock, but you knew that already.

I have been told over the years that many junior scholars find the JSW very intimidating -- this isn't like presenting in a room at Law & Society to 5 of your closest friends or even at AALS to a room full of like-minded people coming in and out.  Being in the JSW requires a great sense of self to be able to post a draft of a paper on the world-wide web and then receive very public comments on that paper.  And if that wasn't enough, anyone gets to jump in!  So, I tip my hat to our authors, who responded very well to expert criticism, some nuanced and some more pointed.  This is what being a scholar is about, and I applaud you.

If you're late to the party, you can find the discussions of the four papers that were spotlighted here:

Jim Hawkins, Regulating on the Fringe:  Reexamining the Link Between Fringe Banking and Financial Distress

Andrew Lund, Say on Pay's Bundling Problems

Mohsen Manesh, Delaware and the Market for LLC Law:  A Theory of Contractability and Legal Indeterminacy

Urska Velikonja, Leverage, Sanctions and Deterrence of Accounting Fraud

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September 01, 2010
Kim Krawiec on Velikonja’s Accounting Fraud
Posted by Kim Krawiec

In Leverage, Sanctions, and Deterrence of Accounting Fraud, Urska Velikonja proposes an alternative regime to deter accounting fraud, which she terms “leveraged sanctions” – a civil or regulatory sanction that is threatened against the firm or a group of insiders.  The firm (or group) can reduce or avoid these sanctions by divulging information to external enforcers, such as the SEC.  The hope is that the threat of sanction will provide the leverage needed to produce cooperation from the firm or group, inducing them to share information about individual wrongdoers with enforcers, who will then sanction the dishonest individuals.

I quite enjoyed the article – Velikonja has carefully researched this topic, and demonstrates an admirable breadth of knowledge and command of the literature.  Moreover, though some will no doubt disagree with her contention that increased personal liability will more effectively deter accounting fraud, her arguments on this front held some resonance for me, at least in theory. 

Ultimately, however, I was not convinced by Velikonja’s central claim that a shift to a leveraged sanctions regime would substantially reduce accounting fraud, for several reasons.  First, at least as it relates to firm-level leverage, I’m not as confident as Velikonja that her proposed regime is such a radical departure from current SEC informal practice.*  As Velikonja notes, there are no legal impediments to the use of leveraged sanctions by the SEC, and the SEC already has at its disposal a variety of monetary and non-monetary sanctions with which to threaten firms that withhold cooperation.  It would thus be rather surprising if the SEC, in contrast to other enforcers, failed to use the carrots and sticks within its repertoire to induce any desired cooperation.   

Second, to the extent that the SEC doesn’t currently use leveraged sanctions to the fullest extent possible, it is worth asking, “why?”  Most likely, the SEC -- given a constrained budget, complex political realities, and an informational disadvantage vis-à-vis the firm -- simply does not consider leveraged sanctions the most effective means of deterrence, and with good reason.

There is a tendency within most organizations (which would be exacerbated under Velikonja’s proposal) to push wrongdoing downward to lower-level employees.  An explicit direction or delegation from higher-level management is probably unnecessary to accomplish this aim.  Instead, it is more likely that firms (meaning senior management) create the incentives for misconduct, and then turn a blind eye to apparent violations. 

So long as the misconduct remains undetected by relevant outsiders and is in the firm’s (or management’s) immediate interest, this state of affairs can continue indefinitely.  If, however, the misconduct comes to light and the firm or an insider group is pressed to cooperate and turn over the wrongdoers, there are lower-level scapegoats (who, as noted, are not free from blame) at the ready, allowing the firm or group to reap the benefits of cooperation. 

Velikonja dismisses this possibility, arguing that external enforcers are able to control such strategic cooperation by independently comparing publicly available information with information provided by the firm.   It seems to me that this is highly unlikely, as evidenced by many misreporting and fraud cases.

Corporate misconduct cases, including accounting fraud, are often complex, with many causes and several levels of fault and blame.  Most of the time, corporate insiders will be able to “cooperate” by providing non-public information that is incomplete, but largely consistent with the even more incomplete public version of events.  After all, if enforcers had the means and desire to piece together the complete version of events from publicly available information, they would hardly need to leverage the firm or insider groups into cooperation.  And the more the SEC invests in investigation, the more it eviscerates any efficiency benefits associated with a leveraged sanction regime.

Don Langevoort’s work on the incentives and political realities of enforcers, such as the SEC, is particularly instructive here.   Though the times they are a-changin’, the political, economic, and institutional reality has so far been one in which the SEC doesn’t have the luxury for the sort of deep scrutiny and second-guessing of the “official story” contemplated by Valikonja or similar proposals on any grand scale. 

Without some hard evidence ex ante, expending resources to investigate deeper in the face of a ready-made story of wrongdoing offered up by the firm or insider group is an unappealing prospect from the standpoint of the SEC.  Costly, and with a high risk of turning up little or nothing beyond what was given freely in cooperation, such a move risks embarrassment, and accusations of waste or overzealousness on the part of investigators. 

Velikonja’s article is a good one and well worth reading.  I trust that this and her other work (of which there is an astonishing amount already) will receive the attention it deserves in the academic community.  But I hope that the proposal gains no traction with the SEC or Congress.  My prediction for a world of leveraged sanctions is not more deterrence, but less liability for both firms and high-level insiders, with a corresponding increase in blame leveled at lower-level employees.

* Velikonja’s proposal also contemplates the possibility of leveraged sanctions against insider groups, including the audit committee, the entire board, and the top management team.  These options are currently not within the SEC’s regulatory arsenal and would require enacting legislation that, as Velikonja recognizes, is not likely to be forthcoming.  My analysis regarding scapegoating and SEC incentives is largely the same with respect to these variations on the leveraged sanction proposal.  

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Erik Gerding on Velikonja’s Leverage, Sanctions and Deterrence of Accounting Fraud
Posted by Erik Gerding

Among the hallmarks of a really good law review article for me are, first, when an article inspires me to have a storm of fresh thoughts about a given topic and, second, just as I think of an objection I then find that the author deals with the question on the very next page. Urska Velikonja’s piece meets both criteria. This paper is ambitious and engages a difficult subject of securities fraud deterrence. With all the moving parts in the legal system for deterring fraud, it is difficult to write a focused, cogent piece of scholarship and balance the need to be comprehensive without getting pulled in too many directions. Velikonja should be commended for it; she engages a number of the big fish in this particular pond yet manages to add many fresh ideas.

My main wish would be that Velikonja spend more time on the crux of her diagnosis of the problem and her proposal. One key element of Velikonja’s thesis is that individual culprits are under-deterred because management can protect itself by refusing to share information with enforcers (whether the SEC or private plaintiffs) about who was really responsible for an act of accounting fraud. We could spend a lot of time analyzing whether under-deterrence is a problem, but to keep my comments focused, I will assume it is real.

A more focused question is: what causes it? I’d like to read a little more about the scope of this particular problem of information sharing. Is information not being shared with enforcers via the discovery process? My brief and limited experience in practice with SEC enforcement actions suggested that the information requested and provided can be quite comprehensive. What information is being withheld on a systemic basis? The paper briefly touches on the ability of firms to stonewall with broad assertions of attorney-client privilege and work-product (p. 30, citing Sam Buell’s work). This could be fleshed out more, since ultimately information-forcing is a central rationale behind the paper’s proposal of leveraged sanctions.

One means of answering this question of what information is missing would be to speak with prosecutors and practitioners off-the-record to get a nuanced understanding of the games being played and the scope of information that might be missing. It may not be citable empirical research, but might let us know where to look for additional proof.  (It might add some valuable practical insights to a fascinating theoretical piece, and help the author’s ideas gain policy traction.)

This same question of “what is the missing information” reappears in the details of the regime Velikonja proposes. Under the proposal, firms could reduce their liability, by cooperating with enforcers (p. 41). I would like to hear more about what would qualify as “cooperation.” To what extent are “internal accounting documents, memoranda, e-mails or other messages, and minutes of meetings” already being provided in discovery? If privilege is the central problem, is waiver of privilege the central part of the solution? There are a host of potential concerns with creating incentives for/coercing a waiver of privilege that recall the debates about the SEC attorney conduct rules several years ago. (For example, would pressure to waive privilege undermine close, trusting lawyer/client relationships and discourage clients from seeking counsel that would otherwise further compliance with the law?)

Velikonja’s proposal also brings to mind the debate seven years ago in the wake of the much-debated Thompson Memo, in which a Deputy Attorney General set forth guidelines for federal prosecutors to weigh cooperation from a corporation in making decisions to prosecute. The literature in the wake of that memo, although dominated by practitioners, has direct bearing on this paper. (As an aside, it would be interesting to re-examine (a) whether the Thompson Memo had any effect on prosecutor behavior, and (b) whether corporate cooperation changed).

Should cooperation be enough to release a firm completely from liability? Velikonja addresses the problem of whether innocent individuals may scapegoated, but I wonder even if the firm provided more information, might we still have under-deterrence of individuals. The probability of a prosecutor bringing a successful case against individuals even with full disclosure from a firm may be quite low for any number of other reasons. Just a few examples: the enforcer might be able to prove all of the elements of a case, just not for any one person. It may also prove harder to get a jury verdict against a person with pictures of kids in her/his wallet than against a corporation with no soul to damn or body to kick. If under-deterrence of individuals is the problem, is lack of cooperation from firms the main cause?

On the other hand, firms may rightly worry about a loose definition of “cooperation” leading to ratcheting by the government.  If we are unsure if lack of cooperation is the dominant cause of under-deterrence or if we are concerned with how to define cooperation, the proposal might instead condition a liability release for the firm on a verdict or settlement against individuals. (I assume that the proposal would also have to constrict indemnification for individual settlements if not insurance). The problem with this alternative is that it might create too strong an incentive to scapegoat (a problem, my fellow commentator, Professor Krawiec, has written about). Calibrating the trigger for release of leveraged sanctions seems extremely tricky.

Then there is the question of calibrating the size and nature (civil, criminal) of the leveraged sanction. Would the sanction on the firm be larger than the liability an individual would face? Trying to work out the size of the sanction in more detail may be too much to add to this paper, and Velikonja makes the wise decision to frame the question in terms of comparing alternative solutions rather than talking about optimal deterrence. However, I am not yet convinced that these calibration problems with leveraged sanctions are easier to solve than the calibration problem Velikonja identifies with an alternative solution – namely better design of executive compensation.

Velikonja considers over-deterrence (p. 47), but I’d like to read just a little bit more on this too. Management and employees will still need to exercise judgment in divining the line between “aggressive accounting” and fraud. How careful should they be? Velikonja writes “…there is no social value in aggressive accounting.” (p. 48) To play devil’s advocate, where is the dividing line between aggressive accounting and a valid exercise of discretion among different options to reflect the financial results of the firm more accurately? Courts answer this problem all the time, but the challenge still remains for firms and employees in day-to-day decisions on accounting. Again, better designed compensation, orienting it towards long term firm performance, may be easier to resolve than this question of over-deterrence.

These comments shouldn’t be construed to mean the paper should have focused on executive compensation or some other solution to the problem of accounting fraud. Quite the contrary: this author, her ideas and her proposal are so engaging and stand out so much in a crowded field, that I would like to hear more of her.

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Mike Guttentag on Velikonja's Accounting Fraud
Posted by Christine Hurt

In “Leverage, Sanctions, and Deterrence of Accounting Fraud” Professor Velikonja proposes an interesting and novel way to structure the civil liability penalties for firms accused of committing accounting fraud.  While reading this thoroughly researched article, I wondered most about the reliability of assumptions about the causes and consequences of accounting fraud upon which Velikonja builds her argument.  I am not convinced that we know as much about accounting fraud as Velikonja’s analysis presumes.  To be fair to Velikonja, many of my concerns would also apply to recommendations made by other scholars who offer prescriptions as to the optimal liability regime to deter accounting fraud.  A more detailed consideration of two of the assumptions made by Velikonja might help to assuage my concerns. 

The first assumption I would recommend exploring further is Velikonja’s claim that “managers control the information revealing who was involved in accounting fraud and thus can impede external investigations and sanctions.”  Velikonja supports this assertion with citations to Kaytal (2003), Brown (2004), and Buell (2007).  In general, relying on a law review article to support an important empirical claim invites skepticism, unless the cited article is specifically aimed at gathering evidence in support of the claim.  I would argue that Velikonja’s use of these citations as evidence for an important element of her argument is no exception.  My own suspicion is that accounting fraud is “traceable” in ways that other frauds may not be.  And, indeed, Arlen and Carney hypothesize that “because Fraud on the Market involves false statements made in a public way by company officials to a market populated by large, well-informed investors, ultimate detection of individual wrongdoers should be relatively certain” (1992, at 701).  Perhaps a more precise discussion by Velikonja regarding what kinds of hidden information would be helpful in detecting the ultimate wrongdoers in an accounting fraud would strengthen her claim. 

The second assumption Velikonja makes which I believe merits further discussion (perhaps even in a separate paper) is the assumption that the decision to commit accounting fraud is a calculated one. This is an assumption made by many of the legal scholars writing about the optimal liability regime to deter accounting fraud.  However, there are a growing number of reasons to be suspicious about the claim that accounting fraud is strongly influenced by economic considerations.  Increasingly, the evidence suggests managers “stumble into” committing accounting fraud rather than committing these frauds with premeditation. 

One reason to suspect that economic considerations are not paramount in the decision to commit accounting fraud are findings such as those reported in Erickson et al. (2006).  Erickson et al. find no connection between the amount of contingent compensation managers receive and how likely managers are to commit fraud.  If accounting fraud were a product of planning and forethought, then we would expect to find a relationship between the amount of a manager’s contingent compensation and the propensity to commit accounting fraud.  More generally, the evidence connecting economic incentives to the propensity to act unethically is mixed, at best (see Dan Ariely’s research, for example).    

Furthermore, it appears to be unlikely that it is ever reasonable for a manager to commit accounting fraud.  Dechow et al. (2008) (cited by Velikonja) finds that firms accused by the SEC of manipulating their financial performance have had strong performance prior to the manipulations, and surmises that most manipulations are motivated by managers’ desire to hide a downturn in financial performance.  Yet it is hard to imagine when the perceived benefits from issuing a fraudulent disclosure in order to delay the disclosure of such a downturn would approach the substantial costs that might be incurred if the fraud is uncovered.  Arlen has concluded upon reviewing the consequences to a firm of having the fraud discovered that committing accounting fraud is rarely in the shareholders best interest (Jennifer Arlen, Public versus Private Enforcement of Securities Fraud, at 27).  I would argue a similar conclusion holds for a manager considering the costs and benefits of committing accounting fraud.  Among the potential costs to a manager of committing accounting fraud are: the almost certain loss of employment, a substantial reduction in the value of the untoward manager’s human capital, and the possibility of ending up in jail (Karpoff et al. (2008)). 

A final example that the propensity to commit accounting fraud may depend on factors other than a manager’s personal cost-benefit analysis comes from an experiment several colleagues and I published titled “Brandeis’ Policeman.”  We structured our experiment to replicate many of the salient features of accounting fraud.  We then manipulated several different variables to see if they would reduce the propensity to commit our experimental proxy for accounting fraud.  We found that a disclosure treatment greatly reduced the extent to which participants in our study were willing to act in an unethical manner.  Yet this disclosure treatment was specifically designed not to affect the cost-benefit analysis of study participants.  Our finding is consistent with other experimental evidence that willingness to commit unlawful or unethical behavior in a context similar to committing accounting fraud is rarely a function of economic considerations.

Despite my concerns about Velikonja’s foundational assumptions, her article is well-written, thoroughly-researched and well-argued.  Moreover, I think Velikonja's idea of reducing civil sanctions on firms accused of committing accounting fraud in exchange for their cooperation with investigators may be useful.  I would encourage Velikonja, and other scholars as well, to focus more of their efforts on exploring the interaction between the law and “the nuanced social calculus of theft” (Stephen Dubner & Steven Levitt, NY Times, June 6, 2004, M:64), rather than designing liability regimes based on more simplistic behavioral and operational assumptions.

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Miriam Baer on Velikonja's Accounting Fraud
Posted by Christine Hurt

I would like to offer a big thank you to the Conglomerate and to Christine for inviting me to comment on Urska Velikonja’s interesting and provocative paper, Leveraged Sanctions.  Urska revisits the issue of entity liability for accounting fraud and argues that a system of “leveraged sanctions” will correct what she believes is an under-deterrence of accounting fraud among corporate officers.  Urska’s scheme is one in which the firm and/or “knowledgeable insiders” suffer less liability provided they report wrongdoing and “cooperate” by aiding in the investigation and sanctioning of culpable corporate officers.

The paper comes at an interesting time.  Although financial institutions have been roundly attacked for causing the financial crisis and economic downturn, it is not at all clear (as indicated by Brian Cheffin’s paper up on SSRN here) that accounting fraud and related corporate governance issues remain the problem that they were in the early 2000’s.  To the extent the Enron-type scandals were caused by poor gatekeeping and auditor conflicts-of-interest, the Sarbanes-Oxley Act arguably has reduced some of these issues.  (Either that, or the capital markets have found ways to correct for fraud, depending on where you fall on the ideological spectrum).  So it’s a question – at least for me – whether deterrence of accounting fraud is the order of the day when in fact other issues (properly judging risk, allocating power between shareholders and management, shaping the future of financial regulation) have become so important in contemporary scholarship.

According to the paper, accounting fraud remains important because corporate officers are under-deterred from accounting fraud.  Urska bases this opinion on both theory and empirical evidence.  First, she theorizes that officers who otherwise might lose their jobs for failure to meet performance goals, and who have the most knowledge about the firm’s financial status, have little incentive to disclose their own malfeasance to either the market or to public enforcers.  It seems largely unassailable that: (a) fraud can be a substitute for performance; (b) corporate managers have incentives to commit fraud; and (c) managers who intentionally commit fraud have every reason to cover it up when gatekeepers, shareholders and public enforcers investigate the firm’s financial performance.  However, Urska also relies on the two relatively recent empirical studies reported by Jonathan Karpoff et. al in both the Journal of Financial Economics and the Journal of Financial and Quantitative Analysis to come to the conclusion that officers routinely escape detection and liability.  I do not think these articles can be said to support this conclusion.

First, Karpoff et al’s papers did not conclude that officers walk away from accounting fraud without penalty.  To the contrary, they found that, of those corporations whose frauds were detected, 93% of the top officers either were forced to leave or explicitly fired.  A significant number (above 20%) were prosecuted criminally, and even those who escaped prosecution still had to deal with potential SEC fines and penalties, as well as difficulties in securing new jobs.  Moreover, as Karpoff et al show, the market reacts to fraud allegations quite badly.  Now, there may be an argument that there are many frauds left undetected, but I don’t think these studies establish pervasive underdeterrence.  Moreover, the studies cannot and do not capture the intangible costs of securities fraud investigations and prosecutions – the endless meeting with corporate counsel, the resulting distrust both within the firm and between the firm’s management and its Board, the difficult relationships with regulators and the SEC, etc. 

Moreover, when corporate managers are prosecuted criminally, we know quite well that in the corporate context, their resulting sentences are likely to be very long.  Why? Because in the federal system, the United States Sentencing Guidelines measures criminal culpability in fraud cases  in terms of the attempted loss, which for a public corporation can very quickly range in the tens or hundreds of millions of dollars, even when the CEO’s participation in the fraud is relatively slight.  As a result, despite the fact that the Guidelines are now advisory, federal judges are now quite accustomed to handing out 15 and 20 year sentences to white collar corporate offenders.  Given the media’s reporting on such sentences, it is difficult to conclude that corporate officers who commit fraud are sitting in their offices, laughing at the possibility of going to jail.  If the sanction is extremely high, and 20% of the corporate managers investigated for fraud are going to jail, then perhaps something other than rational cost-benefit analysis is propelling them towards fraud.  Perhaps, indeed, the problem is that they are boundedly rational and either convince themselves that they aren’t really committing fraud or they irrationally believe they won’t get caught.  In sum, psychology tells us that in ambiguous circumstances, we are very talented at rationalizing our actions.  Leveraged sanctions will not necessarily cure this problem. 

I also had some trouble with the real-world implications of Urska’s proposed liability scheme.  Urska contends that her proposal is broader than the one made by Jennifer Arlen and Renier Kraakman in their 1997 NYU article (see SSRN link here), in which they explained that the corporate liability regime that would most optimally control misconduct was a “composite liability” scheme.  The composite scheme holds all firms strictly liable for their employees’ conduct, but then imposes an additional penalty on firms that have failed to monitor and report misconduct. 

Urska’s “leveraged sanction” scheme is similar, except that she applies it beyond the criminal context (where arguably, the DOJ’s approach on prosecuting business organizations imperfectly tracks the Arlen/Kraakman composite liability scheme) to the civil context, and also applies it beyond firms to “knowledgeable insiders.”

I enjoy reading theoretical papers, but it is not at all clear to me that this proposal “fixes” the under-deterrence problem without imposing other, unintended costs.  Chief among them is figuring out which person or persons are “knowledgeable insiders.”  Surely, the shareholders of the firm are not likely to be in this group.  They have little knowledge of, or rights to participate in, the corporation’s daily affairs.  Nor is it clear (and I credit Urska for conceding this in her article) that the Board or Audit Committee would have this knowledge.  Independent directors receive information from the corporation’s officers.  They might pick out discrepancies and provide a safe space for whistleblower employees to talk, but they also are likely to be in the dark when managers set out intentionally to defraud them.  Indeed, the groups that most likely might fall within the “knowledgeable insider” label are attorneys and compliance officers.  I can’t imagine too many lawyers or compliance personnel who would willingly work at a firm whose insiders were collectively subject to “leveraged sanctions.”  Moreover, I cannot imagine too many corporate managers or employees would want to talk to those persons who were identified as “knowledgeable insiders.”  Finally, it is not all that clear to me that there exists some category of “enforcer” who would accurately and intelligently impose an optimal schedule of sanctions.  One need not be a total cynic to conclude that enforcers, be they public or private, impose a number of agency costs on the people they are charged with protecting.  Although Urska’s paper touches on this problem, I think she can and should do much more here.

In sum, Urska’s paper is interesting and returns us to the perennial topic of how best to reduce wrongdoing within the corporate world – in this case, accounting fraud.  Where she could greatly improve her proposal, however, is by providing a far more fine-grained analysis of the institutions she assumes will be implementing such a scheme, and the likely effects her proposal would have on the real-world human beings who populate such firms. 

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Conglomerate Junior Scholars Workshop: Urska Velikonja's Leverage, Sanctions and Deterrence of Accounting Fraud
Posted by Christine Hurt

Welcome to the fourth and final week of the Conglomerate Junior Scholars Workshop!  Today we will be spotlighting a paper by Urska Velikonja entitled Leverage, Sanctions and Deterrence of Accounting Fraud.  Urska just finished a position as an O'Connor Fellow at Arizona State University Sandra Day O'Connor College of Law and is now beginning a clerkship with Judge Stephen F. Williams of the D.C. Circuit Court of Appeals.  For this paper, we will turn to expert commentary by our own Erik Gerding and friends of the Glom Miriam BaerKim Krawiec andMike Guttentag.  And, of course, we welcome discussion and debate from you!  Feel free to enter the conversation by commenting on this post or on the post of one of the expert commentators.

Here is the abstract of the paper:

The article argues that firm-level liability for fraud is justified by the need to secure the cooperation of the firm in pursuing individual wrongdoers ex post rather than in controlling top-level officer ex ante. Firm-level liability for fraud has often been criticized. The empirical evidence suggests that firms overpay for fraud liability and overspend on internal compliance mechanisms (which are generally ineffective at preventing fraud). Yet, insiders who commit fraud are rarely sanctioned for their wrongdoing, leading to moral hazard and underdeterrence of individuals. This article argues that two factors explain the failure to sanction managers who commit fraud. . . .(read more here).

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August 30, 2010
Conglomerate Junior Scholars Workshop: Wednesday, September 1, 2010
Posted by Christine Hurt

Welcome to the fourth and final week of the Conglomerate Junior Scholars Workshop!  This Wednesday (two days from now) we will be spotlighting a paper by Urska Velikonja entitled Leverage, Sanctions and Deterrence of Accounting Fraud.  Urska just finished a position as an O'Connor Fellow at Arizona State University Sandra Day O'Connor College of Law and is now beginning a clerkship with Judge Stephen F. Williams of the D.C. Circuit Court of Appeals.  For this paper, we will turn to expert commentary by our own Erik Gerding and friends of the Glom Miriam Baer, Kim Krawiec and Mike Guttentag

Here is the abstract of the paper:

The article argues that firm-level liability for fraud is justified by the need to secure the cooperation of the firm in pursuing individual wrongdoers ex post rather than in controlling top-level officer ex ante. Firm-level liability for fraud has often been criticized. The empirical evidence suggests that firms overpay for fraud liability and overspend on internal compliance mechanisms (which are generally ineffective at preventing fraud). Yet, insiders who commit fraud are rarely sanctioned for their wrongdoing, leading to moral hazard and underdeterrence of individuals. This article argues that two factors explain the failure to sanction managers who commit fraud. . . .(read more here).

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August 25, 2010
Larry Garvin on Hawkins' Regulating on the Fringe
Posted by Christine Hurt

In Regulating on the Fringe: Reexamining the Link Between Fringe Banking and Financial Distress, Jim Hawkins takes on the conventional wisdom about payday loans, pawn loans, and rent-to-own leases. These commonly are thought to help push financially shaky clients into genuine financial distress. Professor Hawkins first looks at the fairly strong evidence that the promiscuous granting and use of credit cards can lead to distress. He identifies three aspects of credit card use that can bring this about. First, credit cards are painless to use, at least when compared with cash. The relative obscurity of mounting debt increases the user’s propensity to spend. Second, credit cards allow consumer to amass large amounts of debt, essentially mortgaging future income for present desires. Because credit cards are issued and limits sent largely on the basis of credit scores, drops in income will not generally affect credit limits. As a result, consumers lack most external constraints. In addition, because credit card issuers will grant credit lines for up to a fifth of annual income on a single card, it is easy to be awash in debt very quickly. Third, high credit limits provide a faulty heuristic about the amount of debt one can prudently incur. Consumers look at the credit limit as a gauge of the potential to repay in due course, even though the two are only loosely related.

Professor Hawkins then argues that the standard vehicles of fringe banking do not display these characteristics, certainly not to the degree shown by credit cards. Rent-to-own transactions (the subject of an excellent article by Professor Hawkins published in 2007) don’t pile up debt, because the lessee can walk away from the transaction at any time without penalty, and in any event they don’t provide the customer with a freely usable line of credit. Pawnbroking and auto title lending don’t pile up debt freely, because they are limited to a percentage of the value of the collateral. Secured credit cards (those where the customer deposits with the issuing bank a sum equal to the size of the credit line) similarly are limited to the amount of collateral provided, and in some respects aren’t really credit at all. (It occurs to me that secured credit cards resemble greatly evergreen retainers, perhaps with some of the same questions about trust and reliability.) Payday loans are a closer question, because there is no escape hatch if the borrower wishes to walk away from the transaction and because they are genuine credit transactions. But in many jurisdictions these are capped, and the average payday loan is only about $300. Moreover, payday lending is imperfectly linked to bankruptcy, given the fairly modest amount of added interest a typical borrower would pay.

This is not to say that these fringe banking areas need no further regulation, but rather that basing regulation on the assumption that fringe banking causes financial distress may yield bad regulation. There may be paternalistic reasons to regulate these financial products, and mandatory disclosure rules or cooling-off rules may thus be supported. Bans or impracticably low price caps may not. Finally, the tentative evidence for secondary effects of fringe banking, such as the financial consequences of pawning the tools of one’s trade, might justify appropriately tailored regulation.

Professor Hawkins writes clearly and makes a fairly persuasive case that the financial consequences of many fringe banking products are overstated. His analysis of secured lending is, with one caveat to come, particularly strong. But I remain uneasy, particularly about his analysis of payday lending, for several reasons. First, I think he too readily dismisses the effects of apparently modest added interest payments. For example: "It is highly unlikely that a $45 payment every other week [interest payments on a rolled-over payday loan for $300] will substantially exacerbate significant financial distress, although, admittedly, it will cost the borrower money." (p. 39) But what is the baseline? One recent study of payday loans found that payday customers who also had credit cards – presumably a relatively creditworthy subset of the payday customer population – had mean annual incomes of about $20,000 per year, or approximately $400 per week. $22.50 is not a trivial part of $400, particularly given the relatively low purchasing power commonly held by the poor. Second, and related, is the problem of studying the fringe banking products in isolation. The empirical studies I have seen suggest that payday borrowers usually have credit cards and frequently use other fringe products. It also seems empirically true, as work by Tobacman and colleagues has shown, that those using payday loans often are not using their credit cards because they are at or near the credit limit and are not current on payments, and that taking out a payday loan signals a marked increase in the likelihood of default on a credit card. To the extent that regulating just one product will simply mean that another product is used more heavily, the relation of these products might suggest a need to regulate across the board.

Third, Professor Hawkins downplays the significance of default in auto title lending. Doing so based on the frequency of default is plausible, but the data are incomplete. He notes that the default rate is eight to ten percent. But how frequently are these loans turned over? Professor Hawkins tells us that the usual length of a title loan is thirty days. In theory, then, the loan could be turned over as many as twelve times a year if allowed to go to maturity. If a typical title loan customer borrows even, say, three times in a year, that suggests an annual default rate per customer, rather than per loan, materially higher than eight to ten percent. Without data on the per-customer default rate, I don’t think one can minimize the consequences of title lending. Nor can it be done simply by looking at the typical loss when those loans go into default – according to the studies cited to by Professor Hawkins, around $700 in lost equity for the typical repossession. The absolute amount is small, but what about the amount as a percentage of annual income or of net assets? The article doesn’t state the mean income or asset portfolio of title loan borrowers. If they resemble payday customers, though, $700 is just under two weeks of income – one paycheck in the normal biweekly cycle. If you live paycheck to paycheck, losing the equivalent of almost one full check would seem disastrous, and very likely would lead to increased use of other fringe loans.

Fourth, Professor Hawkins might wish to incorporate some findings from the debiasing literature. A leading defense of heightened disclosure, a regulation Professor Hawkins mentions briefly in his conclusion, is that it produces its salutary effects with minimal cost and no real harm. But is this true? Professor Lauren Willis, for instance, has written about disclosure in real property transactions, pointing to the substantial literature that finds disclosure at best ineffective. Indeed, too much disclosure runs the risk of swamping important facts in a mass of irrelevant or minimally relevant information – the dark side of the availability heuristic, perhaps, or an instance of cognitive overload. But if there are ways to present the most salient facts vividly, debiasing may indeed work. There have been some very recent studies posted on SSRN that look at exactly this in the context of payday loans. (While I’m discussing the behavioral literature, I wonder whether rolling over loans of the types mentioned here is easy enough that it feeds into the biases Professor Hawkins invoked in his discussion of credit cards.)

Fifth, and blessedly last, I think Professor Hawkins might want to incorporate some of the recent empirical work on the effects of stringent payday regulation on such things as bankruptcy rates, use of other expensive forms of credit, defaults on credit, calls upon public assistance, and so forth. The modest portion I’ve read suggests at least on the surface that axing payday loans decreases the solvency of their erstwhile customers, though the studies do not all go in one direction and do not always examine representative populations or control for confounding effects. It does not necessarily follow that if payday lending costs a lot, then its abolition will yield a net benefit; the alternatives may be worse, and more to the point there may be none. The secondary effects of no access to needed credit have to be taken into account if one is looking at the secondary effects of access to needed, but costly credit. On a somewhat related point, do payday lenders have unusually high profit margins, or do their high interest rates merely reflect high default rates and high operating costs?

I suppose in the end I am persuaded that fringe banking products contribute materially less than credit cards to the financial distress of their users. This is an important point, and Professor Hawkins should be applauded for taking on the conventional wisdom so lucidly and fairly. I remain unpersuaded, however, that a materially smaller contribution is not worth serious attention. The marginal effects of high interest costs, as with all costs, mean more to those with low incomes and modest assets. Moreover, the close linkage of these fringe banking products makes it difficult for me to agree that high costs for any one of them will not have a material adverse effect on financial stability, whether directly or indirectly. But even here Professor Hawkins has raised important questions about the too-casual assumptions underlying much recent policymaking in this field. How sound empirical work will answer these questions, however, remains very much to be seen. In the meantime, Professor Hawkins’s call for greater attention to the secondary effects of fringe banking products seems appropriate and indeed urgent.

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Todd Zywicki on Hawkins' Regulating on the Fringe
Posted by Christine Hurt

Overall, this is one of the most enlightening and insightful articles by a law professor on consumer credit that I have read in some time.  I especially like Jim’s methodology: rather than starting with the all-too-common assumption that fringe lending products are “bad” and then essentially launching an investigation to document all the ways in which it is bad, Jim actually disaggregates the claims about the various defects in fringe lending to consider their truth.  Certainly fringe lending products are expensive.  It also seems clear that borrowers who use fringe lending do so because they believe that they lack more attractive alternatives and that the alternatives are more expensive (such as bounced checks and overdraft fees).  (See my papers on auto title lending and payday lending for a summary of the theory and evidence).

Jim’s analysis focuses on a particular discrete question: even if those who use fringe lending believe themselves to be made better off, is fringe lending structured in such a manner so that it tends to produce economic distress?  The hypothesis is potentially plausible: fringe lending often has high costs (measured at least by APR measures) and consumers appear to often exhibit use patterns that seem baffling to upper middle-class law professors and bureaucrats who observe their behavior. 

A researcher could address this question in two ways.  First, one could examine the experience of fringe lending customers to see what they think of the products and how they use them.  As noted, fringe lending customers themselves overwhelmingly believe that access to fringe lending products improves their welfare and makes it easier for them to manage their finances.

But Hawkins’s paper takes a novel, and extremely useful approach: he asks not about the borrowers but examines the loan products themselves.  And he argues—compellingly in my view—that the structure of fringe lending products are unlikely to be a substantial source of financial distress even for low-income borrowers.

His reasoning is straightforward: although each of these loans are often expensive, the overall risk exposure that they present for borrowers is inherently constrained.  All of these loan products are capped either by their small size (as with payday loans) or by the value of any collateral posted for the loan (as with auto title lending or pawnshops).  Certainly, a borrower can confront hardship from losing personal property from an unredeemed pawn or a repeatedly-revolved payday loan.  But it is highly unlikely that in all but the rarest cases the total amounts of these loans can be ruinous.

Supporting Hawkins’s hypothesis, Elliehausen found that 40 percent of bankruptcy filers who list payday loans on their bankruptcy schedules have only one payday loan and the average amount of those payday loans was $350, which was 1.3 percent of the bankrupt’s unsecured debt and the cost of servicing the debt was only about 2.4 percent of the bankrupt’s average net monthly income. Moreover, as Hawkins notes, those who find a connection between financial distress and fringe lending often mistake causation for correlation: it may be that many of those who turn to fringe lending do so as a last resort, thus these loans may be a manifestation of financial distress, not a cause.  Thus, for example, absent access to fringe loans it is plausible that studies of bankrupts would reveal an unusually high level of bounced checks or utility shut-offs in the period preceding bankruptcy.

But this is only the tip of the iceberg.  As I note in my papers referenced above, in evaluating the costs and benefits of fringe lending and its contribution to financial distress, it is also necessary to consider financial distress that could be caused by the absence of payday lending.  For example, Morgan and Strain find that when Georgia banned payday lending, chapter 7 bankruptcy filings increased.  Donald R. Morgan and Michael R. Strain, Payday Holiday: How Households Fare after Payday Credit Bans (Fed. Res. Bank of NY Staff Report no. 309) (Feb. 2008).  By depriving consumers of access to short-term loans that can bridge liquidity problems, banning short-term loans can convert a short-term liquidity problem into a solvency problem.  Similarly, auto title loans can enable a borrower to liquify wealth contained in household durables—again, making it impossible to access that wealth can convert a short-term liquidity problem into a solvency and bankruptcy problem.

Finally, banning fringe lending products can induce borrowers to use credit cards and cash advances on credit cards that can be more likely to precipitate financial breakdown.  For most consumers credit cards are a preferred source of personal credit relative to payday and title loans.  Those who use payday or title loans, however, do so because credit cards are either unavailable or would turn out to be more expensive than fringe products.  Thus, for example, when those who would otherwise prefer to use payday loans are forced instead to use credit cards, the result is a tendency to have higher levels of delinquency and to trigger behavior-based fees more frequently, resulting in an effective cost that is higher than fringe lending.  Thus again, eliminating access to fringe products is more likely to accelerate rather than prevent financial breakdown.

And, of course, that doesn’t even account for illegal lending, which tends to be more prominent in places that restrict access to fringe lending.

On the central point of the paper, therefore, I think that Hawkins has made a compelling case on his central thesis.

In the interests of completeness I note a few other passing observations:


The paper contains a very interesting discussion of how to measure the concept of financial distress—noting in particular that bankruptcy is not necessarily the ideal manner.  Hawkins appears to accept the claim that the “best measure of a typical middle class family’s financial distress is its debt-to-income ratio.”  But that contention is simply untenable.  As I have noted previously, far from being the “best measure” of financial distress, debt-to-income ratio is almost certainly one of the worst measures.  Debt-to-income measure measures a stock variable—debt—against a flow variable—income.  It is thus no more sensible than the alternative would be—the current debt to assets ratio.  For a household, the best measure of financial distress is probably the debt-service ratio (or alternatively the financial obligations ratio), which is analogous to the concept of “equity insolvency” in corporate law.  Alternatively, balance-sheet insolvency (net wealth) is also plausible, but probably less useful for reasons I have discussed elsewhere.

The reason, of course, is that debt-to-income ratio takes no account of either the interest rate on debt or the maturity period of debt.  Thus, the broad secular drop in interest rates—which is largely responsible for the growth in the stock of debt for American households over the past 25 years—is lost in the debt-to-income ratio.

One could raise other issues about other elements of Hawkins’s article (such as his acceptance of the thesis that credit cards are generally a unique cause of financial distress), but many of those issues are sidelights to his central thesis about the purported connection between fringe lending and financial distress.  On that central point his argument is persuasive and his cautions about regulation are well-advised.

This is an important paper for those results alone.  But this is an important paper for a larger reason—Hawkins’s approach here is an excellent model for future scholars investigating the welfare effects of fringe lending and its regulation.  One hopes that it will spur similarly enlightening research in the future.

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David Zaring On Hawkins' Regulating The Fringe
Posted by David Zaring

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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Katie Porter on Hawkins' Regulating on the Fringe
Posted by Christine Hurt

    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. ( 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. . 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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Conglomerate Junior Scholars Workshop: Jim Hawkins on Regulating on the Fringe
Posted by Christine Hurt

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 GarvinKatie 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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August 24, 2010
Conglomerate Junior Scholars Workshop: Wednesday, August 25, 2010
Posted by Christine Hurt

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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August 18, 2010
Gordon Smith on Manesh on "Delaware and the Market for LLC Law"
Posted by Gordon Smith

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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Larry Ribstein on Manesh on "Delaware and the Market for LLC Law"
Posted by Account Deleted

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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