Conversion Rights and the Design of Financial Contracts

Part II of this Article discusses the gains yielded by convertible debt financing. Convertible debt can act as a signal of favorable private information and can mitigate the incentives of shareholders to promote excessive risk taking by the firm. Part III describes puttable stock and the legal regulation that bears on it. The regulation of puttable stock ranges from prohibition to the requirement that the firm be solvent after the exercise of the put. Part IV compares convertible debt and puttable stock. Part V discusses the effect of the mildest form of legal restrictions on puttable stock, the solvency requirement, on these potential gains

Debt Financing and Motivation

An individual\u27s performance in a given activity is a function of her effort and her competence, as well as her surrounding conditions. Effort, in turn, can be divided into three characteristics: direction, intensity and duration. Intensity and duration of effort reflect the individual\u27s motivation with respect to the given activity. Motivation is the product of a cognitive process that anticipates the outcomes of effort and, particularly, the degree to which the individual will be satisfied or dissatisfied with her performance. While individuals might define satisfaction in terms of input (i.e., the amount of effort applied to the task), they more typically set standards for output (i.e., performance) that are derived from internal and external sources. Performance is commonly judged by a dichotomous success-failure standard as opposed to a graduated metric standard. This standard has both a prospective and retrospective impact on motivation. For example, an individual is motivated to raise her effort to avoid failure, and, if failure occurs, she may be motivated to redirect, intensify or prolong future effort to avoid the recurrence of failure

A Theory of the Regulation of Debtor-in-Possession Financing

The profile of Chapter 11 of the Bankruptcy Code in public consciousness has surged recently. Other than the automatic stay on the enforcement of claims, the most publicized feature of bankruptcy reorganizations is debtor-in-possession (DIP) financing. Indeed, along with the bankruptcy stay, DIP financing is the motivation for many Chapter 11 filings. Under Section 364 of the Code, a firm in bankruptcy (the debtor in possession) can finance its ongoing operations and investments by issuing new debt that enjoys any one of various levels of priority, all of which rank higher than the firm\u27s prepetition unsecured debt.\u27 The debtor\u27s financing arrangements under this section are subject to the oversight of the bankruptcy court; in fact, most arrangements require prior judicial authorization. Despite the frequency and significance of DIP financing, no coherent theory informs judicial determinations under Section 364. The conventional explanation for the provision is that it enables the debtor to offer inducements to lenders in the form of elevated priority without which the lenders would not be willing to invest. Yet, proponents of this rationale fail to explain the cause of this reticence, other than to imply that lenders associate a stigma with bankruptcy that causes them to shy away irrationally from financing profitable projects of firms in bankruptcy. However, DIP lending has expanded rapidly and a growing number of banks have departments that specialize in financing firms in bankruptcy, whether or not the bank has existing exposure to the debtor.\u27 The stigma of bankruptcy was probably an early casualty in the emergence of a competitive debt market in this area. The more serious problem with the conventional explanation is that it is incomplete. Even if priority debt is necessary to induce lending to firms in bankruptcy, this rationale for Section 364 provides no theoretical framework for the judicial oversight of financing arrangements that the section requires. It is not clear what factors the courts should refer to in determining whether a financing induced in this manner is desirable or not. To a large degree, the courts currently defer to the decisions of the debtor in possession and seek only to ensure that the parties negotiate DIP financing arrangements in competitive environments. History somewhat justifies their concern. In the past, DIP enders have reportedly enjoyed extraordinary rates of return as a result of the reduction in risk caused by the elevated priority and their ability to charge substantial up-front fees. More recently, however, the market has become much more competitive due to low barriers to entry into this sector and the growth in DIP lending opportunities

Embedded Options and the Case Against Compensation in Contract Law

Although compensation is the governing principle in contract law remedies, it has tenuous historical, economic, and empirical support. A promisor's right to breach and pay damages is only a subset of a larger family of termination rights that do not purport to compensate the promisee for losses suffered when the promisor walks away from the contemplated exchange. These termination rights can be characterized as embedded options that serve important risk management functions. We show that sellers often sell insurance to their buyers in the form of these embedded call options, and that termination fees, including damages, are in essence option prices. Furthermore, we explain why compensation is of little relevance to the option price agreed to by the parties, which is a function of the option's value to the buyer, its cost to the seller, and the market in which they transact. We propose, therefore, a novel justification for why penalty liquidated damages may be higher than the seller's costs: They are option prices that reflect the value of the options to the buyer. The regulation of liquidated damages is thus tantamount to price regulation -- a function outside the realm of contract law. Moreover, in light of the generosity among optimal option prices, this Article also makes the case against the expectation damages default rule. In thick markets, we argue for enforcing the parties' risk allocation with market damages. In thin markets, we propose the default rule should encourage parties to agree explicitly to termination rights, including break damages, by the threat of specific performance of their contemplation exchange or, in the case of consumers, by a default rule that provides them a termination option at no cost

What Do Lawyers Contribute to Law & Economics?

The law-and-economics movement has transformed the analysis of private law in the United States and, increasingly, around the world. As the field developed from 1970 to the early 2000s, scholars have developed countless insights about the operation and effects of law and legal institutions. Throughout this period, the discipline of law-and-economics has benefited from a partnership among trained economists and academic lawyers. Yet the tools that are used derive primarily from economics and not law. A logical question thus demands attention: what role do academic lawyers play in law-and-economics scholarship? In this Essay, we offer an interpretive theory of the practice of law-and-economics scholarship over the past 50 years that recognizes the distinct methodological tools of the academic lawyer. We claim that, in addition to the legal resources they provide to the economic analyst, academic lawyers have cognizable analytical skills, developed through their involvement in law as an applied discipline and their mastery of the common lawʼs analogical method of argument. We draw on the idea of analogical argument to explain some of the differences in the ways that economists and lawyers analyze some of the building blocks of our economy, including the relationship between formal and informal modes of enforcement and the reasons why inefficient boilerplate terms persist in certain standardized contracts. By enriching the standard economic model with insights from other disciplines and clarifying the connections among these disciplines, the lawyer provides skills that are critically important for advancing normative claims