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.

Utility Regulation: The bad, the ugly and the good.

Summary: in an attempt to solve one problem, the regulation of public utilities unwittingly introduces another, potentially much worse one. But there is hope – we also discuss a potential improvement.

The Bad: Unregulated Natural Monopolies

Water, electric and natural gas utilities are often used as an example of natural monopolies – a service where the economies of scale are so great that it is efficient to only have one supplier in an area. This company would then be incentivized to charge inefficiently high prices, causing deadweight loss, as they prevent some customers from purchasing who otherwise would have at a competitive price. As such, people argue, they need to be regulated by the government, to ensure they don’t charge so high a price. As an added benefit, the regulation can ensure that they serve everyone in the service area, including those in hard-to-reach rural areas.

Which sounds very nice in theory. Unfortunately, in trying to fix this problem, regulation introduces another problem.

The Ugly: How Utilities are regulated in the United States

At present utilities are basically allowed to earn a profit on whatever services their regulator thinks they should provide. So the utility identifies certain projects that need to be done – putting in new transmission lines, or substations, or generation1, and present these projects to their regulator. The regulator approves the projects, and approves an ROE – (Return on Equity) – for the utility. The collection of approved and completed projects is called the utility’s Rate Base. The utility is then allowed to charge its customers enough to cover its costs and earn that ROE on its Rate Base.

So if a utility identifies a $100m project, and is awarded a 10% ROE, they make the investment, and then can charge customers enough to cover both their direct costs (labor, fuel, taxes etc.) and earn a $100m*10% = $10m profit on top.

This profit is very stable – it’s been granted to you by the government, who won’t allow anyone to compete with you2 – so investors are happy to fund the project. In fact, they’d be happy to fund the project even at lower ROEs – why ROEs have stayed high while interest rates have fallen is a mystery with basically no explanation other than regulatory capture. Suppose investors required a mere 6% return – then the extra 4%, or $4m in the above example, is pure monopoly profit – exactly what regulation was meant to avoid occurring!

But that’s not the main problem.

Utilities are not really businesses.

Normal businesses make money by selling stuff to customers for more than it cost them to make. If they can cut costs – use less of the earth’s precious resources – they can make more profits, either by earning more per unit or charging customers less and selling more units. As such, firms are incentivized to be as efficient as possible.

With utilities, however, you’ll notice this is not true. They’re allowed to charge customers enough to cover their costs and make a profit – if they cut costs, their regulator will make them return the savings to customers by lowering price. So utilities don’t really have any incentive to cut costs.

Worse, if they cut costs they might end up over-earning – earning a higher profit than their regulator has allowed – in which case they’ll be made to give money back to customers. To avoid this happening, utilities are deliberately wasteful in their operating expenses to ensure they can control exactly how high their costs are. They deliberately waste resources.3

But this is not even the worst part.

Remember how we discussed the $100m project earlier? It’s well known that the cost of construction projects is hard to estimate – government projects routinely go 100% over-budget. Well, what happens if instead of a $100m project, it was a $500m project? The utility would be allowed to earn a 10% on its Rate Base of $500m, or a $50m profit. So by building a more expensive and less efficient project, the utility makes 5x as much profit. And this is not idle speculation – utilities deliberately do this.

As a result, utilities are basically on a constant mission to find as many capital projects as possible, and to pay as much for them as possible. They spend twice as much to build a power plant as competitive firms spend to build one of the same type and capacity.

So regulation has taken one problem – utilities charging a high price and earning high profits – and replaced it with a far worse one – utilities charging a high price, earning reasonable profits but wasting most of the money on unnecessary spending. At least with unregulated monopolies someone benefits!

It’s possible that a similar thing might be happening with healthcare insurance companies now, as maximum Medical Loss Ratios mean that spending on drugs/treatments/etc. increases the amount they’re allowed to profit, but this is a relatively new issue for them – only becoming nationwide with obamacare. Utilities, on the other hand, have had this trouble for about 100 years.

The Good: How to save money by allowing unlimited profits

The problem is that utilities basically operate on a cost-plus basis. Here’s a simple alternative.

  • The utilities is allowed to charge a certain amount – either a total revenue sum or a per-kWh amount. This will rise by 1% a year.
    • Slightly below the current rate of increase. Alternatively you could tie this to inflation, say CPI -1%
  • The utility is legally obliged to connect all customers within its service territory.
  • The utility is fined for every blackout, with the fine set by a formula (e.g. $15/kWh not provided, which is roughly 100x what they would have charged for that kWh).

Now the utility is incentivized to be as efficient as possible. It can’t raise prices, but every dollar of savings will increase its profits. All of a sudden it goes from being a sleepy and inefficient company, whose only purpose is corrupting the regulator, to being a lean cost-cutting machine, dedicated to supplying electricity as efficiently and reliably as possible.

How should the initial revenue allowance be set? As we already have utilities, it would probably make sense to keep their current revenue allowance. It will take time for them to reform their infrastructure and become more efficient.

But if you were building the system anew, you might auction off regions. So you’d ask different companies to submit bids for the right to become the utility for an area, and accept the company who asked for the lowest revenue requirement. You don’t have to worry about their cutting corners, because electricity is homogeneous, and they’re massively penalized for any lack of reliability.

Unfortunately this would be politically vulnerable. If a highly competent management team reduced costs by 50%, they could increase their profit margins from 20% to 60%, and raise their ROE from 10% to 30%. Customers would see their bills continue to rise (albeit below inflation) and blame the profit-gouging utility. Voters might then pressure the politicians to steal from the utility, which cannot threaten to leave the area. The only way the utility can respond is by lobbying and obfuscating their profits, which basically gets us back to where we are now – highly inefficient cost structures so that profits look small compared to costs. Still, it’s worth thinking about what an enlightened electorate, or benevolent dictator, could do. And actually this is a little like what FERC is doing with transmission in RTOs.

If you liked this post, you might also enjoy How not to reform the insurance industry and The Future of Socialism is Privatizing the Atmosphere.


  1. Outside of the North East and Texas, where generation is operates in a semi-competitive market 
  2. I hear you asking: “If it’s a natural monopoly, why does the government need to prevent competition?” 
  3. Source: conversations with CEOs, CFOs, regulators etc. of utility companies. 

The War on Drugs as Make-Work

An argument for ending the War on Drugs is that it would undermine the drug gangs. At the moment we have a baptists and bootleggers situation, where the drug ban benefits illegal providers, because it raises the price of drugs a lot. If drugs were legal, supply would increase a lot, lowering prices. Criminal gangs don’t actually have a comparative advantage at running efficient supply chains – if they did they would be running WalMart instead – so they will be out-competed by new, legal entrants to the market. This would dramatically reduce their revenues, making joining them less attractive, and leave them with less money to spend on sinful things.

And all of this is probably true. But…

Here’s another way of looking at it. At the moment some argue the US has a zero-marginal-product-worker problem; there are people who aren’t worth hiring at any price, because you can’t trust them not to steal from you, or break things, or insult customers, or get you into legal trouble. But, like the army before them, criminal gangs can make use of such people – perhaps because criminal gangs can make use of extra-legal motivational techniques. Normally, this would be bad, if criminal gangs were hiring such people to do immoral things like theft. But at present many of them are usefully employed in the socially productive activity of consumer product distribution.

And another group of thugs, who lack skills beyond the ability to yell loudly and order people around, get make-work as DEA agents.

So actually the War on Drugs is job security for semi-criminal ZMP workers, providing them with employment and protecting them from competition. Maybe pretty rubbish protection – it leaves many of them dead or imprisoned – but other forms of ‘protection’ for low-skilled workers also have some pretty negative consequences.

What if Regulation was a Finite Resource?

Alternative Title: Conservation of Regulation

Think of the fuels that have provided the energy for human civilization so far – coal, oil, gas. They existed for thousands of years, largely inert. A small part of them (mainly coal) was used by humans for forges and the like. But then we discovered them during the industrial revolution. We put them to good use, but there’s only a limited supply.

What if regulation was the same? There’s only a finite amount available. For most of history, this existed in a largely inert fashion, regulating the atmosphere, evolution, and so on. A small part of it was used by humans to regulate their habits and bowl movements.

But then during the industrial revolution regulation was discovered by socialists and paternalists. They started using it on a massive scale, trying to regulate all of society.

Unfortunately, there’s only a finite amount of regulation available. We’ve been using so much over the last few hundred years that there’s not enough to regulate the climate – hence climate change. It caused a breakdown in virtue when people’s ability to regulate their habits was reduced. It also caused the obesity crisis because we can no longer regulate our bowl movements properly.

Now, leading scientists are warning about an even greater threat: we might be using up so much regulation that the earth’s orbit will cease to be regular. This will have dramatic consequences, ranging from disruptions to the seasons and day-and-night cycle, to the earth crashing into the sun.

Leading scientists say we need to rapidly reduce our regulation consumption if this is to be avoided. They recommend bring our regulation uses back down to 1990s levels by 2020, and 1900 levels by 2050, and 1700 levels by 2100. Unfortunately, it may already be too late to avoid changing the day-and-night cycle by 1-2 hours, in an effect scientists have dubbed ‘daylight savings time’.

Economists are divided on the best way to respond to the crisis. Some favor a regulation tax, where anyone who implemented or enforced a regulation would have to pay a tax equal to the negative externality they caused. Others suggest a cap-and-trade system, whereby rich countries would be able to buy regulation credits from poor countries. Some politicians prefer a command-and-control approach, where they would pass regulations limiting the use of regulations in industry.

Some progress has been made – most countries have signed up to the Hong Kong Protocol, promising to reduce their regulation levels. The US risks becoming an international pariah by refusing to sign; the Obama administration defended its intransigence:

Hong Kong is, in many ways, unrealistic. Many states do not want to meet their Hong Kong targets. The targets themselves were arbitrary and not based upon political science. For America, complying with those mandates would have a positive economic impact, with increased hiring by small businesses and price decreases for consumers. And when you evaluate all these flaws, most reasonable people will understand that it’s not sound public policy.

But you too can make a difference! There are many easy steps you can take. Maybe turn off your thermostat – doesn’t the earth need that regulation more than your central heating? Write to politicians expressing your concern. Join a local libertarian group.

Remember, preventing the world crashing into the sun is more important than regulating your heartbeat, so ask yourself: do I really need a pace-maker?

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.