Economic analysis of law.

Bebchuk, Lucian A.

My general interest is in using economics to analyze the effects of legal rules and institutions. In this article, I describe my current and recent work in the economics of four areas in which legal rules and institutions play a major role: corporate control and structure, bankruptcy, contracts, and litigation and settlement.

Corporate Control and Structure

While much of my earlier work in corporate control focused on takeover bids for companies with dispersed shareholders, my more recent research has focused on companies in which there is a controlling shareholder. In many public companies - both in the United States and (even more so) in other countries - a significant number of shares are concentrated in the hands of a controlling shareholder.(1)

One part of my research has focused on the decisions of controllers about selling their control blocks. In a recent article, I have shown that such decisions often might be distorted.(2) The efficiency costs produced by these distortions should be regarded as arising from having a controlling shareholder structure.

A central feature of the model of control transfers that I have developed is that controllers may differ from each other in two respects: their ability to manage and produce value; and their ability to capture private benefits of control. My analysis shows that, under the existing regime in the United States, inefficient transfers may take place; this will happen when the potential new controller has less managerial ability but a sufficiently greater ability to capture private benefits than the previous controller. Also under the existing regime, some efficient transfers may not take place; this will happen if the potential new controller, although better able to manage the company, has a sufficiently lower ability to capture private benefits.

My analysis also examined control transfers under the equal opportunity rule that prevails in many other countries. Under this rule, minority shareholders are entitled to participate in the transaction on the same terms as the control seller. My analysis shows that adopting the equal opportunity rule would prevent all inefficient transfers, but also would prevent a wider range of efficient transfers. Finally, the analysis has identified conditions under which adding the equal opportunity rule would and would not be efficient overall; for example, adopting the equal opportunity rule would produce an efficiency loss overall if existing and new controllers draw their characteristics from the same distributions.

In a related paper, Jesse Fried and I study the decisions of controllers on whether to effect a freezeout.(3) In a corporate freezeout, which is allowed under U.S. rules, a controller can take the shares of the minority shareholders and provide them instead with consideration exceeding the value of those shares as appraised by the court. Our model shows that decisions on whether to effect a freezeout may be distorted, thus producing another efficiency cost arising from having a controlling shareholder structure. The analysis identifies conditions under which efficient freezeouts might not take place or inefficient freezeouts might take place. We use this model to analyze how alternative legal rules perform with respect to the objectives of facilitating efficient freezeouts and discouraging inefficient ones.

These two projects take as given the existence of control blocks. Another part of my research examines the factors that determine the initial ownership structure. In joint work, Luigi Zingales and I(4) analyze the choice that initial owners make between retaining a complete ownership structure and creating a controlling shareholder structure by selling some shares to the public. We show that, in this choice, private and social optimality might diverge.

The source of this potential divergence is an externality. The initial choice of ownership structure will have important effects on both the initial shareholders and the potential future buyers of control. Since the IPO price will reflect the effects of the choice on the initial shareholders, the initial owner will internalize these effects fully. Since potential future buyers are not "at the table" at the time of the IPO, however, the initial owner will not take into account the effect of the ownership structure on them. Our analysis identifies three ways in which the initial choice of ownership structure can affect these future buyers.

Having identified a possible distortion, we turn to identifying conditions under which the distortion leads to excessive or suboptimal incidence of controlling shareholder structures. Our analysis has normative implications for the regulation of sale of control transactions and of public offerings of minority shares. Among its positive implications, our analysis suggests reasons for the substantial differences in the incidence of control blocks across different countries.

Bankruptcy

Much of my initial work on bankruptcy concerns the ex post distribution of value in corporate bankruptcy. In a joint article, Howard Chang and I develop a bargaining model that explains why, under the existing corporate reorganization regime, equityholders are able to obtain value even when the creditors are not paid in full.(5) This model can help to explain the empirical evidence about the commonality of such deviations from the absolute priority of debt over equity.

In another article, I put forward a proposal for dividing the reorganization pie in a way that would eliminate deviations from absolute priority.(6) Unlike the existing bargaining-based method for reorganizations, the method that I propose involves no bargaining, nor does it require that the value of the reorganized company be identified. Under this method, the participants in a reorganization would receive a set of options with respect to the securities of the reorganized company. These options can be designed so that, whatever the reorganization value, the participants ultimately will all receive the value to which they are entitled according to the absolute priority standard.

My proposed "options" method of corporate reorganization has received many and varied reactions. Some have endorsed it (Aghion, Hart, and Moore, for example, have used it as the basis for the distribution of the reorganization value in their proposal on corporate reorganizations(7)), while others have expressed various criticisms and concerns. To address the issues raised, I have been working on a follow-up project that will explore how the options approach can and should deal with the various problems that commentators have raised with respect to it.

In developing the options method, my premise has been, as that of much of the literature on bankruptcy reform, that it is desirable to distribute the bankruptcy value in accordance with the absolute priority principle. The problem that I sought to solve was just how to produce such a distribution, given that the bankruptcy value is not verifiable by courts. But an important question that might be raised is what the desirable distribution is. Of course, in choosing the bankruptcy distribution, it is important to consider the ex ante effects of alternative distributions. Some of my recent work seeks to contribute to the understanding of these ex ante effects.

In a recent article, Jesse Fried and I(8) analyze the ex ante effects of providing secured claims with full bankruptcy priority over unsecured claims. We show that, contrary to the conventional wisdom, providing such full priority has certain undesirable ex ante effects. In particular, full priority of secured claims leads to excessive use of security interests, distorts the choice between security interests and covenants, and produces suboptimal precautions against tort liability, use of covenants, and monitoring by secured creditors. Accordingly, we have put forward alternative rules for partial priority of secured claims, and we have analyzed the efficiency costs and benefits involved in the adoption of a partial priority regime.

In two other working papers, I analyze some of the ex ante effects of providing debtholders with absolute priority over equityholders. In one, I show that deviations from such absolute priority of debt over equity might have an adverse effect on the moral hazard problem between debt and equity.(9) In particular, such deviations might increase the excessive incentive that equityholders have to prefer risky projects over safe ones, to make dividend distributions, and to engage in claim dilution by issuing extra debt.

In the second paper, Randy Picker and I analyze certain positive ex ante effects of deviations from the absolute priority of debt over equity.(10) Such deviations might have a positive effect on those decisions by managers-owners that determine the extent to which a firm's managers have an advantage over others in operating the firm's assets. Without any such deviations, managers will entrench themselves by over-investment in assets that require their unique skills, and they also will under-invest in firm-specific human capital. Allowing ex post deviations from absolute priority decreases the severity of these two problems.

Contracts

In contract law, my interest is in understanding how the rules can affect the various aspects of the contracting parties' behavior. In an article published several years ago, Steven Shavell and I showed that contractual rules might have an effect on informational transfer between the contracting parties.(11) In analyzing the optimal default rule in a contractual setting, models generally had taken the information held by the contracting parties to be given. However, as our model suggested (and as was suggested by Ayres and Gertner in an article published at the same time(12)), the choice of an appropriate default rule might lead to transfers of information between the contracting parties and thus might reduce informational asymmetries between them. Our model also has analyzed when inducing such informational transfers would and would not be socially optimal.

In a recent paper Omri Ben-Shahar and I(13) examine the effects of legal rules on pre-contractual reliance. During contractual negotiations, but before entering a contract, parties might make reliance expenditures - expenditures that would increase the surplus should a contract be made but would be wasted otherwise. In the absence of any pre-contractual liability, parties' reliance will be socially suboptimal. The focus of our model is on analyzing whether and how rules could be designed to induce optimal reliance decisions. We also study the effects of the rules governing pre-contractual liability on parties' decisions whether to enter into contractual negotiations.

In another recent working paper Ivan P'ng and I(14) analyze the effect of remedies for breach in those cases in which breach is not deliberate (a situation that has already received comprehensive treatment) but rather inadvertent. We analyze the effects of alternative remedies on parties' decisions with respect to taking precautions against inadvertent breach and with respect to investment in reliance on contractual performance.

Litigation and Settlement

About a decade ago, I participated in initiating game-theoretic analysis of litigation and settlement decisions. A large literature has grown since then, and my 1984 model of pre-trial bargaining under imperfect information has been used by many of the subsequent papers.(15) I have remained very interested in this area and am currently working on two subjects within it.

One subject is the credibility of threats to sue. In negative-expected-value (NEV) suits, the expected litigation costs exceed the expected judgment. While it is widely believed that plaintiffs with NEV suits are often able to get something from the defendant, the question is what enables such potential plaintiffs to have a credible threat and to succeed in extracting value.

One possible explanation for the success of such suits, which I advanced in an early article on the subject, is rooted in the existence of imperfect information on the defendant's side.(16) My more recent work, however, has examined the numerous situations in which the plaintiff is known to have an NEV suit.(17) In an article published last year and in a subsequent paper, I developed a model that can explain why plaintiffs might have a credible threat in such situations.

My model is based on the recognition that litigation costs are generally not incurred all at once but rather over time, with bargaining possibly taking place at various points throughout the litigation process. This divisibility of the litigation process plays a critical strategic role. Indeed, I demonstrate that greater divisibility of litigation costs can never hurt - and may help - the plaintiff's strategic position. Because of this effect of divisibility, plaintiffs have credible threats in a much wider set of cases - including numerous small-stake cases - than has been suggested by the prior economic analysis of the subject.

My analysis also attempts to identify the conditions under which a plaintiff with an NEV suit will succeed in extracting a settlement. In particular, my work shows how the credibility of such threats is shaped both by the relative sizes of the parties' litigation costs and by the ways in which the parties' litigation costs are expected to be distributed over time.

Second, I am working on an analysis of the terms of settlement. Much of the literature on settlement has focused on the factors determining its likelihood. The likelihood of settlement is of interest to economists, of course, since it determines the extent to which the deadweight costs of litigation will be incurred. In analyzing the effect of the law on behavior, however, the terms of settlement are also of great importance. And some of my current research concerns how these terms are effected by various procedural, institutional, and contractual arrangements.

In a recent paper, I analyze the effect of fee-shifting rules on the terms of settlement.(18) For each of the main fee-shifting rules, the analysis examines whether the rule will make settlement terms more favorable to the plaintiff or the defendant - and also whether the rule will move these terms closer to, or further away from, the expected judgment.

In another recent paper, Howard Chang and I model the effects of offer-of-settlement rules on the terms of settlement.(19) Under such rules, if a party to a lawsuit makes a formal offer to settle and the offer is rejected, then this offer will become part of the record in the case and the allocation of litigation costs will depend on how the judgment in the case compares with this offer. Our model makes it possible to derive the expected settlement amount under any given offer-of-settlement rule. Our analysis also shows how such a rule can be designed, if this is deemed desirable, to eliminate the bargaining disadvantage that a party with higher litigation costs would have otherwise.

Finally, in a recent article Andrew Guzman and I(20) analyze the strategic role that fee arrangements between lawyers and clients can play in settlement negotiations. Compared with an hourly fee arrangement, contingent fee arrangements strengthen the bargaining position of the side employing them, and thus make the terms of settlement more favorable to this party.

1 See M. Barclay and C. Holderness, "Private Benefits from Control of Public Corporations," Journal of Financial Economics 25, (1989), pp. 371-95.

2 See L. Bebchuk, "Efficient and Inefficient Sales of Corporate ControL" NBER Reprint No. 2012, October 1995, and Quarterly Journal of Economics 109, (1994), pp. 957-93.

3 See L. Bebchuk and J. Fried, "Efficient and Inefficient Freezeouts of Minority Shareholders," mimeo, Harvard Law School (1997).

4 See L. Bebchuk and L. Zingales, "Corporate Ownership Structures: Private versus Social Optimality," NBER Working Paper No. 5584, May 1996.

5 See L. Bebchuk and H. Chang, "Bargaining and the Division of Value in Corporate Reorganization," Journal of Law, Economics, and Organization 8, (1992), pp. 253- 79.

6 See L. Bebchuk, "A New Approach to Corporate Reorganization," Harvard Law Review 101, (1988), pp. 775-804.

7 See P. Aghion, O. Hart, and J. Moore, "The Economics of Bankruptcy Reform," Journal of Law, Economics, and Organization 8, (1992), pp. 523-546.

8 See L. Bebchuk and J. Fried, "The Uneasy Case for the Priority of Secured Claims in Bankruptcy," The Yale Law Journal 105, (1996), pp. 857-934.

9 See L. Bebchuk, "On the Effects of Deviations from Absolute Priority on Ex Ante Corporate Decisions," mimeo, Harvard Law School (1996).

10 See L. Bebchuk and R. Picker, "Bankruptcy Rules, Managerial Entrenchment, and Firm-Specific Human Capital," forthcoming in the Journal of Law and Economics.

11 See L. Bebchuk and S. Shavell, "Information and the Scope of Liability for Breach of Contract: The Rule of Hadley v. Baxendale,"Journal of Law, Economics, and Organization 7, (1991), pp. 284-12.

12 See I. Ayres and R. Gertner, "Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules,"Yale Law Journal 99, (1989), pp. 87-130.

13 See L. Bebchuk and O. Ben-Shahar, "Pre-Contractual Reliance," mimeo, Harvard Law School (1996).

14 See L. Bebchuk and L P'ng, "Damage Measures for Inadvertent Breach of Contract," mimeo, Harvard Law School (1996).

15 See L. Bebchuk, "Litigation and Settlement under Imperfect Information," Rand Journal of Economics 15, (1984), pp. 404-15.

16 See L. Bebchuk, "Suing Solely to Extract a Settlement Offer," Journal of Legal Studies 17, (1988), pp. 437-50.

17 See L. Bebchuk, "A New Theory Concerning the Credibility and Success of Threats to Sue," Journal of Legal Studies 25, (1996), pp. 1-26; L. Bebchuk, "On Divisibility and Credibility: the Effects of the Distribution of Litigation Costs over Time on the Credibility of Threats to Sue," mimeo, Harvard Law School (1996).

18 See L. Bebchuk, "The Effect of Fee-Shifting Rules on Settlement Terms," Harvard Law School, Discussion Paper No. 202 (1996).

19 See L. Bebchuk and H. Chang, "The Effect-of-Settlement Rules on the Terms of Settlements," mimeo, Harvard Law School (1997).

20 See L. Bebchuk and A. Guzman, "How Would You Like to Pay for That?", Harvard Negotiation Law Review 1, (1996), pp. 53-63.

Lucian A. Bebchuk is a research associate in the NBER's Program in Law and Economics and a professor at Harvard Law School. His profile appears later in this issue.