Embedded Options and the Case Against Compensation in Contract Law

Despite the fact that 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 (which is subject to the compensation principle) 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 options. We explain why compensation is of little relevance to the option price agreed to by the parties, which is a function of the value of the option to the buyer, its cost to the seller and the market in which they transact. We thus propose a novel justification for why penalty liquidated damages may be higher than 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, which is outside the realm of contract law. Moreover, in light of the heterogeneity among optimal option prices, we also make the case against having an expectation damages default rule to begin with. In thick markets, we argue for enforcing the parties ex ante risk allocation with market damages. In thin markets, we propose that parties be induced to agree explicitly with respect to all termination rights, including breach damages, by the threat of specific performance of their contemplated exchange or, in the case of consumers, by a default rule that provides them a termination option at no cost.

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

The Role of Debt in Interactive Corporate Governance

Most of the corporate governance literature rests on a premise that the interests of various stakeholder groups conflict and that managerial loyalty is more likely to be captured by shareholders than any other constituency. Yet, stakeholder interests do converge in the objective of controlling managerial slack and non-equity constituents have substantial influence over firm decisions. Although the study of governance has taken early steps to abandon its preoccupation with equity-centered solutions and identify interdependencies existing among a broader range of stakeholders, governance scholars have missed an important element of interactivity. A stakeholder reacts to the actions of others and thereby contributes to the collective interest in controlling slack. Each stakeholder has a window on the firm through which it can acquire some type of information at lower cost than other stakeholders. When a stakeholder detects an unsatisfactory state of affairs, it reacts by choosing to exit or exercise voice. The exercise of either the voice or exit option may pressure management to correct the unsatisfactory state of slack. More to the point, however, a stakeholder\u27s exit bears important information for other stakeholders, at least some of whom may be better placed to take action that corrects the slack. This Article describes an interactive system of corporate governance and provides a stylized theory of the role of lenders within this system. The divergence in the interests of these lenders and other stakeholders does not preclude interactive governance, but it does threaten to reduce the net benefits from the process. Therefore, the authors identify a number of legal and institutional mechanisms that help to channel the efforts of the lender toward the common goal of containing and correcting managerial slack. The interactive perspective thus permits new explanations for phenomena such as debt covenants, bankruptcy preference rules and lender liability laws. For example, the definition of debt covenants and events of default in lending agreements raise the likelihood that the lender exit is prompted by slack rather than lender opportunism and thereby enhances the informational value of the exit. Bankruptcy preference rules encourage early exit before the firm becomes insolvent, thereby enabling remaining stakeholders to take action before the firm\u27s condition becomes irreparable. Thus, debt covenants and preference rules provide a window that increases the value of lender exit in prompting the correction of managerial slack