Submitting Merger Lawyers to the Market Test

Matt Levine shall supply the problem:

The way merger lawsuits work is that after a deal is signed, a bunch of plaintiffs’ lawyers race to sue, claiming that the merger was underpriced, the board breached its fiduciary duties, and the whole thing was corrupt. This might sometimes be true, but it can’t be true in every merger, and the lawyers sue in virtually every merger. But then they sign a settlement with the company in which the company agrees to make a few extra disclosures about the deal and pay the lawyers a six-figure fee. The advantage for the company and the board is that the settlement binds all shareholders, so they get a release from future litigation if someone figures out that the deal was actually corrupt. The advantage for the lawyers is that they get the fee. There is no advantage for shareholders.

We shall provide the solution:

Do not pay the lawyers a cash fee.

At a random time, while the market is open, announce the disclosures that will be provided.

Then, pay the lawyers a fee proportionate to the stock’s movement (relative to the overall market) over the next hour (or second, or day, or week).

If the disclosure they heroically provided to shareholders is valuable, they will be rewarded.

But, if the disclosure they provided was a disappointment to the market, they have to pay the company. (And the court).

This system is both fair and efficient. Fair, because the lawyers will be paid if they added value to the company, and punished if they subtracted value. Efficient, because this will encourage them to only pursue lawsuits they think will add value.

Now, the lawyers (and perhaps my readers) will object that news of these disclosures would be but one small thing effecting the price of the stock that day. There would be a lot of noise – how then can it be fair to use such an unreliable method to reward the noble public servants who forced the disclosures?

And other lawyers (and perhaps other readers) will object that this could be manipulated. The lawyers could short the stock in to the announcement, and then cover their shorts when the news broke, and buy a lot of stock instead, to try to temporarily support the stock.

Fortunately, both issues can be solved together. Because this is not a single game, it is a repeated game. Any one time the lawyers might get unlucky and have the stock move “the wrong way”. But if done often enough (and this is their profession) they will come out ahead… if the disclosures they achieve are valuable. And maybe they could manipulate the stock once. But if they try to do it systematically, hedge funds will learn off it and take the opportunity to buy the stock when it is inefficiently cheap before the announcement… and then short it when the lawyers temporarily drive it up. The lawyers would need to burn a huge amount of money to manipulate the stock in the face of hedgies after an easy trade… at which point the whole thing would no longer be net profitable for them.

Does this sound plausible to you? It should, if they are adding value. If they’re on the side of angels, they should leap at the chance to have their worth measured.

Of course, this is rather a stretch. I suspect that if this were implemented, lawyers would cease these lawsuits.

And that would be good.

How not to reform the insurance industry

Browsing the comments on Scott’s blog recently, I came across an interesting suggestion for reforming the insurance industry.

If I were declared supreme fascist dictator of the world (which would be GOOD for the world), I’d decree that insurance companies had some specific fixed amount of time to investigate a client and return the premiums not consumed by that investigation. After that, unless they could prove deliberate fraud they were on the hook for their contract.

– William O. B’Livion

However, this is probably a pretty bad idea.

At the moment insurance companies only need to investigate clients who make a claim. If enacted, this would require insurance companies to investigate at length everyone who took out a policy.  As such, investigation costs would be much higher, requiring higher premiums for everyone.

Additionally, at the moment there is an implicit punishment for attempting to cheat an insurance company: you pay the premiums, but then don’t get the payout, so the premiums paid act like a fine for your attempted fraud. If insurance companies had to investigate at the very beginning instead, people would have more incentive to try to defraud insurance companies, as there would be less cost. As such, both fraud and anti-fraud costs would rise, both of which require an increase in premiums for everyone.

Finally, at the moment these foregone premiums go to the insurance company. As the insurance market is pretty competitive, this money ultimately results in lower premiums for honest customers. Requiring insurance companies to investigate immediately would take away this cross-subsidy and again raise premiums for everyone.

So it turns out that, like most such suggestions involving restricting people’s ability to freely sign contracts without any clear market failure identified, the proposal is a bad idea. Perhaps this might be a popular policy, if people somehow ignore the costs, or assume they’re being paid by evil corporations. Indeed, this might even be popular with incumbent insurance companies, if the high upfront costs of investigation it would require act as a barrier to entry and protect them from competition. As usual, ultimately the consumer pays. But it’s interesting how, in exploring why it’s a bad idea, we come to appreciate more the virtues of the current system.

Laying down the Law

Recently Bill Barlow wrote an excellent piece in the Harvard Law Record, recommending law students go into corporate law so they could donate money to charity. Sima Atri wrote a response, to which Jeff Kaufman wrote a convincing rebuttal. I’m going to address one very small part of Atri’s article, which to be fair she probably didn’t put much thought into.

Because if you choose to go into Big Law and care about the poor and otherwise marginalized, giving your money to charity is the least you can do. I say this because you are not choosing to go into neutral, apolitical, work. None of us working in the legal profession are. Your firm, Bill, has represented JPMorgan Chase, a bank that backed thousands of predatory and racist loans and helped create the foreclosure crisis.

I think this attack on Bill’s firm is almost impressive in how mistaken it is. Specifically, I think
1) The banks were not at fault for what it did
2) What it did was not predatory
3) What it did was not racist
4) Even if 1,2,3) are all wrong, it’s still good to represent banks.
This is a lot to show, so lets begin.

1) The banks were not at fault.

Yes, banks lent to many poor people: subprime lending. But in part this was because the government forced them to make these loans, in an attempt to promote home-ownership. If anyone if to blame, it is the government, not the banks. Left to themselves, the banks would have preferred not to lend to such people, as they present higher risks. So it’s strange to blame the banks for this, who had little choice in the matter. The high default rates among minorities during the crisis was the result of government intervention, not the fault of the banks.

2) The banks were not predatory

Given 1), the worst we can really accuse the banks of is “only following orders” or being involuntarily predatory. But even this isn’t the case. Banks didn’t force anyone to borrow money. Having the opportunity to take out a loan is a benefit – it’s the reason we try to maintain good credit scores! As Arnold Kling noted, borrowers get a free option on rising house prices. Being given the option to borrow money is a good thing – you’re not taking advantage of people by giving them choices. (And stories about people not understanding that their repayments rates would rise don’t work, as the defaults frequently happened among people still paying the introductory rate.

Indeed, one part of the crisis was the so called ‘NINJA’ loans, where borrowers frequently defrauded the banks. It is hard to see how the banks can be taking advantage of people by being defrauded.

3) The banks were not racist

Indeed, JPMorgan Chase made many loans to minorities. As we noted in 1), left to their own devises, banks apparently made too few loans to minorities – they were accused of being racist for refusing to lend money. This was why the Community Reinvestment Act was passed. So it seems very strange to accuse them of being racist for making too many loans to minorities as well. Maybe it’s just impossible to win.

4) Even if 1,2,3) are all wrong, it’s still good to represent the banks.

Ok, so suppose 1),2) and 3) are all false; the banks are truly evil companies. Is it therefore bad to defend them in court? Well, the adversarial court system depends on their being lawyers available to defend the guilty. The ACLU often defends extremely unpopular causes, because it is in these cases that harmful precedents are most likely to be created. In the same way that anti-terrorist laws, originally aimed only at extremely dangerous and unpopular people are now being abused in much more mundane situations, so too will the extraordinary legal steps being used against the big banks one day be used against other targets.

I realize that this was just a small part of Atri’s article. But it’s worth commenting on anyway.