The Prime Directive

Agency costs dominate academic thinking about corporate governance. The central challenge is to devise legal rules to align the interests of the managers (the agents) with those of the shareholders (the principals). This preoccupation is misplaced. Whether it is finding a baby-sitter or a dean, the challenge of hiring the right person dwarfs the challenge of aligning that person’s incentives. The central task for corporate governance—its Prime Directive—.0is to ensure that the right person is running the business. In this essay, we suggest that the challenge of aligning the managers\u27 incentives has been drastically overstated and the way in which legal rules affect hiring (and firing) decisions has been too often ignored. The current preoccupation with executive compensation runs the risk of inducing the board to worry more about the details of the employment contract rather than selecting the best person in the first instance. More important, the law can play an important role ensuring bad managers are fired. The market for corporate control does this, but debt contracts also play a crucial role, one that has been largely neglected. Covenants in debt contracts can insure that underperforming managers are called to task. Indeed, they may be as important as the market for corporate control

The End of Bankruptcy

The law of corporate reorganizations is conventionally justified as a way to preserve a firm’s going-concern value: Specialized assets in a particular firm are worth more together in that firm than anywhere else. This paper shows that this notion is mistaken. Its flaw is that it lacks a well-developed understanding of the nature of a firm. Initially, it is easy to confuse size with specialization and overstate the extent to which assets are dedicated to a particular enterprise. Even when such dedicated assets exist, they often do not need to stay in the same firm. As Coase taught us, as the costs of contracting go down, so too does the value of keeping assets in a particular firm. But even when specialized assets must be kept inside a firm, two other forces limit the need for a traditional law of corporate reorganizations. Capital structures are increasingly designed with financial distress in mind. For these firms, control rights shift from one set of investors to another as the firm encounters difficulty. Such firms either never file for bankruptcy, or, if they do, it is only to vindicate the predetermined allocation of control rights. Even where control rights are not sensibly allocated, a quick sale of the firm restores order. When firms can be sold as going concerns, the need for the traditional negotiated plan of reorganization disappears. The vast majority of firms in financial distress never enter bankruptcy. Today the Chapter 11 of a large firm is an auction of the assets, followed by litigation over the proceeds. To the extent we understand the law of corporate reorganizations as providing a collective forum in which creditors and their common debtor fashion a future for a firm that would otherwise be torn apart by financial distress, we may safely conclude that its era has come to an end

Fourt (or Five) Easy Lessons from Enron

Temptation. It lies at the heart of financial swindles. The promise of 50% returns in three months can lure thousands of investors-so too can a stock that soars 500% in three years. But those who are tempted are often skeptical. Before they invest, they want to know how one can enjoy such supracompetitive returns. The answer usually is a facially plausible story, though with a bit of mystery attached. The mystery is often touted as the reason that the investment opportunity is exclusive to the entrepreneur who discovered it. It is what ensures that the gains are not competed away. The classic case remains that of Charles Ponzi. While not a very adept con artist-he was caught several times-in a six-month period in 1920, Ponzi convinced ten thousand investors to part with an aggregate of $9.5 million. He promised amazing returns-50% in ninety days. As a testament to his financial wizardry, Ponzi often paid off his investors in half the time he had initially promised. How could he work such financial magic? Allegedly, Ponzi had discovered a lucrative arbitrage opportunity in postal reply coupons. Postal reply coupons allowed the sender of a letter to ensure that the recipient in another country would be able to obtain sufficient postage to respond. For example, a letter writer in America would purchase a reply coupon here and send it along with a letter to a relative in another country, say, Spain. The Spanish relative could then redeem the coupon for Spanish stamps sufficient to send a reply. Ponzi noticed a pricing discrepancy in the postal reply coupons. One could buy a coupon in one country for, say, one penny, and redeem it in another for six cents worth of stamps. This opportunity existed because exchange rates had been set in a postal convention in 1906, well before the outbreak of the Great War. The Great War changed the relative value of many currencies, but the rates for postal exchange coupons remained fixed. The failure to adjust the exchange rates on postal reply coupons meant that a trader could buy a postal reply coupon in a country where the relative value of the currency had declined, redeem it in a country where the relative value of the currency had increased, and turn a profit. There were, in theory, gains to be had by exploiting government inertia. But transaction costs limit any opportunity to profit from arbitrage. Consider the steps necessary to exploit this state of affairs. Money would be gathered in the United States. This money then had to be converted into a foreign currency and put in the hands of an agent in the appropriate foreign country. The agent would have to buy the postal reply coupons in large quantity, although there were limits on the number of coupons that could be bought at one time. The agent then had to send the coupons back to the United States. Another agent would have to redeem them. Given these elaborate requirements, it is hard to imagine how anyone could purchase a sufficient number of reply coupons to support the millions of dollars that Ponzi collected

Private Debt and the Missing Lever of Corporate Governance

Traditional approaches to corporate governance focus exclusively on shareholders and neglect the large and growing role of creditors. Today’s creditors craft elaborate covenants that give them a large role in the affairs of the corporation. While they do not exercise their rights in sunny times when things are going well, these are not the times that matter most. When a business stumbles, creditors typically enjoy powers that public shareholders never have, such as the ability to replace the managers and install those more to their liking. Creditors exercise these powers even when the business is far from being insolvent and continues to pay its debts. Bankruptcy provides no sanctuary as senior lenders ensure that their powers either go unchecked or are enhanced. The powers that modern lenders wield rival in importance the hostile takeover in disciplining poor or underperforming managers. This essay explores these powers and begins the task of integrating this lever of corporate governance into the modern account of corporate law

Chapter 11 at Twilight

In The End of Bankruptcy we set out the forces that have rendered obsolete traditional conceptions of corporate reorganization. Lynn LoPucki wrote a critique that asserted that our paper lacked empirical foundation. In this response, we draw on LoPucki’s data set of the reorganization of large, publicly held entities to show the robustness of our claims, both empirical and theoretical. Looking in detail at the firms whose Chapter 11 cases ended in 2002, most of which concluded after we completed our original piece, we find that in over 80% of the cases the assets of the firm were either sold or the bankruptcy proceeding put in place a restructuring plan agreed to before bankruptcy was filed. The remaining firms evince little in the way of going-concern value. Moreover, equityholders are nearly always wiped out, and the board of directors is usually replaced. Today\u27s bankruptcy practice reveals creditors, particularly the senior lenders, in control. They use their powers to remove managers in whom they have lost confidence, replace the board of directors, put the corporation on the auction block and terminate the interest of equityholders. This paper provides further evidence that issues of control rather than priority dominate modern reorganization practice

The Role of the IMF in Future Sovereign Debt Restructurings: Report of the Annenberg House Expert Group

A meeting of international finance and insolvency experts was held on November 2, 2013 at the Annenberg House in Santa Monica, California. The meeting was co-hosted by the USC Law School and the Annenberg Retreat at Sunnylands. The goal was to solicit the views of experts on the implications of the IMF’s April 26, 2013 paper captioned “Sovereign Debt Restructuring -- Recent Developments and Implications for the Fund’s Legal and Policy Framework”. The April 26 paper may signal a shift in IMF policies in the area of sovereign debt workouts. Although the Expert Group discussed a number of the ideas contained in the April 26 paper, attention focused on paragraph 32 of that paper. That paragraph states in relevant part: “There may be a case for exploring additional ways to limit the risk that Fund resources will simply be used to bail out private creditors. For example, a presumption could be established that some form of a creditor bail-in measure would be implemented as a condition for Fund lending in cases where, although no clear-cut determination has been made that the debt is unsustainable, the member has lost market access and prospects for regaining market access are uncertain.” This Report summarizes the consensus views of the Expert Group on the practical implications of the suggestions contained in paragraph 32 of the April 26 paper