Certification drag: the opinion puzzle and other transactional curiosities.

• Author: Barnett, Jonathan M.

1. CERTIFICATION REVISITED A. Theory B. Evidence II. IDENTIFYING THE OPINION PUZZLE A. Content B. Costs C. Value 1. "Obvious" Limiting Factors 2. Legal Exposure 3. Reputational Exposure D. Evaluation: The Puzzle Emerges III. SOLVING THE OPINION PUZZLE A. Demand-Side Incentives B. Supply-Side Incentives IV. FIXING THE OPINION PUZZLE A. Law Firms B. Collective Organizations C. Insurance D. Obstacles to Self-Correction V. SOME MORE PUZZLES: APPLICATIONS AND EXTENSIONS A. Credit Ratings B. Fairness Opinions C. Contractual Boilerplate VI. CONCLUSION APPENDIX Financial markets are populated by a host of reputable intermediaries, including law firms, auditors, underwriters, investment banks, and credit rating agencies, which provide various stamps of approval attesting to costly-to-verify characteristics of the relevant asset. The law-and-economics literature has typically observed that these "certification intermediaries" have low rational incentives to endanger hard-won reputational capital by acting fraudulently or even negligently and therefore are generally viewed as enhancing market efficiency by mitigating informational asymmetries that may otherwise distort or even frustrate mutually beneficial transactions. (1) But it has largely gone unrecognized that this "happy" efficiency story has found at best mixed and often inconclusive empirical support in the case of certain commonly used certification instruments in the financial and other markets. (2) Nor, as has been increasingly recognized in the wake of Enron and other contemporary scandals (including by some of its original exponents), (3) does this unqualified "certification -thesis" (4) sit comfortably with the historical and recent recurrence of fraudulent and similar conduct even in sophisticated business environments monitored by a large population of prestigious (and expensive) intermediaries. (5)

   In this Article, I tell a "not-so-happy" story of certification intermediaries that anticipates in part these otherwise curious failures of the financial markets to satisfy the sanguine expectations of the standard certification thesis. Specifically, I identify a perverse "two-sided" incentive structure, which, through a combination of agency-cost and adverse-selection effects, sustains minimally informative but non-cost-justified certification practices even in sophisticated markets, thereby imposing a levy on business transactions--or, as referenced in this Article's title, a "certification drag"--without generating commensurate benefits in the form of improved transaction pricing or structuring. To oversimplify only slightly: these certification instruments cost something but often appear to say almost nothing (or more precisely, almost nothing new). Contrary to the standard account (and without assuming any of the "usual suspects" behind market failure, as identified below), non-cost-justified bonding practices that generally do little to facilitate efficient transactions may persist in a sophisticated market over a substantial period, with attendant social losses as a result. Hence it is not necessarily puzzling that routinely used certification practices fail to yield substantial informational value or that a gold-plated array of third party intermediaries fails to screen out recurrent patterns of fraudulent behavior.

   I develop this "degenerate" certification thesis through a detailed examination of the third party legal opinion (or in short, "closing opinion"), which is commonly issued by law firms at the consummation of certain significant business transactions such as acquisitions and financings. For the analytical purpose of identifying practical limits to the standard certification thesis, this narrow (but to practitioners, familiar) corner of business-law practice provides an unusually "clean" setting that substantially lacks several distorting characteristics that would otherwise be obvious sources of market failure: (1) both providers and recipients of the certification instrument are sophisticated, thereby probably barring any undersupply or oversupply inefficiencies characteristic of a "credence good" market; (6) (2) depending on market definition, there are at least tens and probably hundreds of actual and potential certification providers, thereby sharply reducing the reasonable likelihood of any collusion-related inefficiencies; and (3) there are few legal requirements or other regulatory interventions that would otherwise skew the market's "natural selection" of the most efficient certification practice. (7)

   Following the standard certification thesis, most of the limited academic literature (8) and some, but not all, of the voluminous practitioner literature (9) teaches that a closing opinion provides meaningful assurance from a trustworthy intermediary as to various fundamental matters that I group under the rubric of "contracting quality," which includes most notably the enforceability of the contractual obligations undertaken by the firm's client. (10) Contrary to this position, however, some legal practitioners (including the Business Law Section of the California Bar) (11) and other industry participants express concern that at least some closing opinions may be a costly distraction leading to no appreciable value-enhancing result. A close examination of closing opinion practice provides strong support for this alternative view, revealing multiple factors that substantially impede any meaningful assurance function, including most notably: the highly qualified language used in closing opinions, an opining firm's inherent conflict of interest and minimal legal and reputational liability exposure (as shown in part through a detailed survey of relevant case-law over the past 20 years), and the availability of more robust diligence alternatives. Taken together, these factors cast serious doubt on whether a closing opinion typically contributes significant incremental information to opinion recipients and therefore has any appreciable capacity to mitigate informational asymmetries that would otherwise generate pricing or structural distortions.

   Assuming, at least sometimes, that the incremental informational value typically conveyed by a closing opinion does not exceed the costs of preparing and negotiating it, why would this instrument persist as a routine transactional practice in sophisticated market settings? As a solution to this emergent "opinion puzzle" (and, by extension, other entrenched certification practices upon which market participants and observers routinely cast doubt), I propose a two-sided incentive structure that operates as follows: (1) demand is sustained by an agency-cost mechanism as a result of which a "requesting agent" requests a non-cost justified but entrenched certification instrument in order to mitigate the reputational penalty for perceived professional incompetence, and (2) supply is sustained by an adverse-selection mechanism as a result of which "requested parties" provide the requested certification in order to avoid being placed on the extreme low end of a contracting quality spectrum. So long as demand is sustained as a result of the misalignment of incentives between the requesting principal and its agent, supply usually follows; given that the requested certification is easily obtainable and customarily issued, failure to provide it triggers the negative implication that there exists a highly problematic fact that has not been previously disclosed, thereby resulting in a substantial quality discount up to and including termination of the proposed transaction.

   This incentive structure shows how a competitive market may rationally overinvest in minimally informative certification instruments that generate nontrivial transaction costs without at least commensurate benefits in the form of incremental informational value. While developed within the closing-opinion context, this structure is formulated generically and, as I show preliminarily with respect to credit ratings in the debt offering markets, fairness opinions in the corporate acquisitions market, and certain forms of contractual boilerplate in corporate law practice, offers a diagnostic tool for identifying and accounting for other certification practices that are both widely used in sophisticated settings and frequently questioned by the practitioner, policymaking, and scholarly communities. But this is not to say that "certification drag" is necessarily incurable. The relevant market may ultimately remedy this state of affairs through the pioneering actions of certain "lead" participants who are sufficiently confident in being able to accrue substantial reputational gains by deviating from inefficient industry convention. This self-curative outcome finds support in several modest contractions in the use of closing opinions and more radical contractions in the use of certain other legal opinions. However, any self-curative outcome may be substantially delayed where regulatory distortions, trade associations, entry barriers, or other market imperfections unduly increase the anticipated costs of deviating from entrenched industry protocol.

   This Article is organized as follows. In Part I, I describe the standard certification thesis and review relevant portions of the associated theoretical and empirical literature. In Part II, I examine the typical procedural and cost burdens in connection with issuing a closing opinion and describe multiple factors that may dilute its informational value, which together identify the emergent opinion puzzle. In Part III, I present the aforementioned incentive structure as a possible solution to the opinion puzzle. In Part IV, I assess the capacity of the legal market (and by implication, other certification markets) independently to correct a degenerate certification practice. In Part V, I explore applications of the proposed incentive structure to other widely used and widely questioned...