Case Lounge
(Room 701)
Jerome Greene Hall

Limited Liability and the Organization
of Legal Services
(co-authored with John Romley)

Abstract:
During the 1990s, almost all states introduced business forms for law firms that limited owners' liability.  We develop a principle-agent model in which relatively large firms profit from decreased liability, as clients elicit attorney effort through increased compensation.  We predict that larger firms were much more likely to adopt the new business forms.  Our model also implies that marginal converters are likely to grow after recognizing in order to gain leverage over large clients; larger converters in contrast, are predicted to shrink marginally.  We then test some of the core predictions of our model using a new national panel data set of practicing attorneys at two points in time.  We find that the data is consistent with many (but not all) of our predictions.

Back to the top

Case Lounge
(Room 701)
Jerome Greene Hall

Completing Contracts in the Shadow
of Costly Verification
(co-authored with George Triantis,
Harvard Law School)

Abstract:
Contract theory typically holds that verification costs are obstacles to complete contracting; yet, real world contracts often contain provisions that seem costly to verify.  We show how a costly signal can play an important role in contracts. Verification costs might be avoided because litigation might not occur in equilibrium. Moreover, verification (or litigation) costs can function as an effective sanction against the breaching promisor. In equilibrium, the parties will design a set of prices so as to provide optimal incentive to the promisor while avoiding litigation. We show that a costly signal might not only improve a contract that relies only on a costless signal, but also, in certain circumstances, eliminate the need for the costless signal. This paper underscores the importance of incorporating the verification, particularly the adjudication, process into contract design and the various choices and incentives that parties have during the contracting stage. Rather than focusing solely on either the problems of adjudication or those of contracting (without sufficient regard to how the disputes will be resolved in the future), we have attempted to take a more comprehensive approach by looking at the design of contracts in anticipation of the path of the adjudication process.

Back to the top

Room 600
(6th Floor Conference Room)

William & June Warren Hall
(1125 Amsterdam Avenue)

Bargaining Around Bankruptcy: Small Business Distress and State Law

Abstract:
Discussions of small-business bankruptcy typically focus on the United States Bankruptcy Code. But few failing small businesses--around twenty percent--use federal law to reorganize or liquidate. Most use state insolvency laws for these purposes. State laws include foreclosures, bulk sales, and assignments for the benefit of creditors. Relative to federal law, these procedures are often faster, more private, and less costly to the debtor and its senior creditors. The procedures vary substantially by state in the protection offered to creditors. This paper documents the interplay between state and federal bankruptcy law and how this dynamic varies by state. Drawing on two data sets--state-level data from public records and firm-level data from Dun & Bradstreet records--I show that failing small business corporations and their senior creditors bargain around federal law. Because a debtor needs senior creditor consent to invoke most state procedures, a bankruptcy filing occurs only when the senior creditor distrusts the debtor and withholds consent. I show that a small business corporation is more likely to use bankruptcy law if it is encumbered by secured debt or tax liens and if it has defaulted or otherwise impaired its relationship with senior creditors. State procedures are more common in states with regulations that promote the transparency of the insolvency process and give senior lenders leverage to attack insider self-dealing. These findings suggest that any reform of federal bankruptcy law will have two effects--it will impact outcomes in federal courts (intensive margin) and the debtor's choice between state and federal procedures (extensive margin). Variation along the extensive margin can neutralize reforms in federal law, as when a reform designed to protect unsecured creditors induces businesses to use less-protective state procedures instead. The findings in this paper also raise questions about the appro-priate balance between state and federal law. The primary function of the Code is to serve as a backstop when bargaining fails, but state law could better serve the same function. The optimal balance between state and federal law, then, may be one that gives states greater authority to regulate small business bankruptcy.

Back to the top

Case Lounge
(Room 701)
Jerome Greene Hall

 

Optimal Strategic Complementarities in Litigation Design: With Application to the Allocation of Proof Burdens

Paper 1 (pdf): 
A Primary Activity Approach to Proof Burdens
Paper 2 (pdf): 
Harnessing Adversarial Process:  Optimal Strategic Complimentaries in Litigation

Two related papers on evidence production and adversarial process will be presented. The first paper concerns the question of which party should bear the burden of proof. The second paper considers the more general question of how strategic complementarities should be assigned in litigation.

The question of which party should bear the burden of proof on a given factual issue remains one of the most important and problematic in evidence and procedure. The first paper approaches this question from a relatively unstudied perspective, viewing litigation as a device for influencing primary activity behavior rather than as a standalone search for truth. Its main finding is as follows: when a given evidentiary contest concerns the primary activity behavior of one of the parties, placing the burden of proof on the other party maximizes the incentive impact of that contest. Though counterintuitive, the finding accords with a striking regularity in existing law. The adversary of the incentive target typically does bear the burden of proof with regard to the target's primary activity behavior. Thus, in tort the plaintiff bears the burden on the defendant's negligence, but the defendant typically bears the burden on the defense that plaintiff was contributorily negligent. And in contract the plaintiff bears the burden on the defendant's non-performance, while the defendant bears the burden of proof on his defense that the plaintiff failed to perform.

A second, more technical paper studies the evidence production game in a more general setting. The payoff structure of the evidence production game is such that one party strategically complements (i.e. mimics her opponent's advances and retreats) while the other strategically substitutes (i.e., does the opposite of her opponent). Which party plays which role depends on how litigation is structured. The question thus arises: should litigation be designed to induce the plaintiff to complement and the defendant to substitute, or vice versa? The paper argues that the answer depends on whether and whose primary activity incentives are being set by the particular evidentiary contest in question. Within each subsidiary evidentiary contest, the "incentive target" should be induced to complement and her adversary to substitute. In some cases the defendant will be the incentive target, as when the issue is the defendant's negligence or contractual breach. In other cases, the plaintiff will be the target, as when the defendant defends by claiming that the plaintiff has been "contributorily negligent" or has herself failed to meet a prior contractual obligation.

Back to the top

Case Lounge
(Room 701)
Jerome Greene Hall

Resource Allocation and Firm Scope
(joint with Guido Friebel, Toulouse)

Abstract:
We develop a theory of firm scope based on the benefits and costs of allocating a firm's resources by managerial authority. To allocate resources efficiently, top management must rely on infor-mation that is communicated by self-interested division managers. Competition for scarce resources improves the managers' incentives to spend effort on creating profitable projects, but it also creates an incentive for them to overstate the quality of their projects. The firm can counter this by paying the managers partly based on firm performance, but doing so weakens their effort incentives. We show that the second effect dominates; i.e., achieving an efficient allocation of resources in an integrated firm necessarily goes along with higher costs of inducing managerial effort, relative to stand-alone firms. The benefit and cost of integration thus arise from the same problem--the aggregation and use of dispersed information. We also compare different structures that an integrated firm can use to allocate resources. In terms of dealing with incentive problems, a hierarchical structure with centralized resource allocation always dominates alternative structures. If resources are highly complementary, however, a decentralized structure in which divisions voluntarily share resources can do equally well. Our results lead to several testable predictions concerning integration decisions, wages, and organizational structure.

Back to the top

Case Lounge
(Room 701)
Jerome Greene Hall

Market versus Non-Market
Assignment of Initial Ownership
(with Ian Gale, Georgetown)

Abstract:
We study the assignment of initial ownership of a good when agents differ in their ability to pay. Selling the good at the market-clearing price favors the wealthy in the sense that they may acquire the good instead of poor buyers who value it more highly. Non-market assignment schemes, even simple random rationing, may yield a more efficient allocation than the competitive market would--if recipients of the good are allowed to resell. Schemes that favor the poor are even more desirable in that context. The ability to resell the good is critical to the results, but allowing resale also invites speculation, which undermines its effectiveness. If the level of speculation is sufficiently high, restricting resale may be beneficial.

Back to the top

Case Lounge
(Room 701)
Jerome Greene Hall

Optimal Takeover Mechanisms and Innovation
(with Haresh Sapra, Chicago GSB)

Full text of paper

Abstract:
There has been significant controversy over the desirability of anti-takeover protection devices, such as poison pills and golden parachutes. These devices are usually viewed negatively because they are associated with entrenchment and insider rent extraction. This position, however, is subject to debate. Insider protection, for instance, has the advantage of transferring control to better-informed insiders. In fact, in this paper we show that insider protection can arise endogenously as an optimal contracting device. Our main result is that the optimality of insider protection depends crucially on the degree of innovation of the firm's activities, with insider protection being desirable only under significant innovation. For highly innovative projects, in particular, a take-over bid can be optimally rejected even when it offers a significant premium over the market price of the firm.

Back to the top