Fee Effects

• Author: Kathryn Judge
• Position: Associate Professor of Law, Columbia University
• Pages: 1517-1574

1517

Fee Effects

Kathryn Judge

INTRODUCTION .................................................................................... 1518

I. THE FOUNDATION ............................................................................... 1524

A. THE UNDERSIDE OF TRANSACTION FEES ........................................... 1526

B. EFFECTS ......................................................................................... 1530

C. FRAMEWORK .................................................................................. 1534

1. Influence ............................................................................... 1534

2. Constraints ............................................................................ 1535

II. FINANCIAL INTERMEDIARIES ................................................................ 1538

A. THE INFLUENCE OF FINANCIAL INTERMEDIARIES .............................. 1538

B. COMPETITION ................................................................................ 1543

C. REPUTATION .................................................................................. 1547

III. CASE STUDIES ....................................................................................... 1558

A. HIGH-YIELD DEBT .......................................................................... 1559

B. MBSS AND CDOS ........................................................................... 1561

IV. RESPONSES ........................................................................................... 1565

A. PROHIBITION ................................................................................. 1566

B. OTHER RESPONSES ......................................................................... 1568

1. Follow the Fees ..................................................................... 1569

2. Improve Constraints to Better Align Incentives ................. 1571

a. Regulatory Restraint ......................................................... 1571

b. Improve External Constraints ............................................ 1572

c. Improve Internal Constraints ............................................ 1573

CONCLUSION ....................................................................................... 1574

 Associate Professor of Law, Columbia University. The author is grat eful to Peter Conti-

Brown, Jeffrey Gordon, Scott Hemphill, Robert Jackson, John Morley, Richard Posner, Alex

Raskolnikov, Robert Scott, and participants at the New York Junior Faculty Forum for helpful

comments on earlier drafts. Priya Merrill, Lena Qiu, and Jennifer Gaudette provided very

helpful research assistance. Special thanks to The William S. Friedman Faculty Research Fund.

1518 IOWA LAW REVIEW [Vol. 98:1517

INTRODUCTION

It is firmly established that transaction fees act as a friction.1

Transaction costs—the costs two parties incur finding one another,

overcoming information asymmetries, and negotiating the terms of a

transaction—reduce net welfare gains, making it less likely that an otherwise

value-creating transaction will occur. But, preventing transactions from

occurring is not the only impact of transaction fees. Because transaction fees

are revenue to the intermediaries to whom they are paid, intermediaries

prefer transactions that entail greater transaction fees. As a result, in

environments where intermediaries can influence decision-making, high

transaction fees can also increase the probability that a particular transaction

will go forward. This is the “underside” of transaction fees. While pulling in

opposite directions, the two effects of transaction fees are not inconsistent.

The tendency for transaction fees to act as a friction constrains the range of

possible transactions. Parties will not engage in a transaction unless they

believe that the transaction will create value in excess of the associated

costs.2 Oftentimes, however, the requirement of net value creation does not

reduce the range of possible transactions to just one. A company seeking to

raise capital for a new project, for example, may have the option of issuing

new debt in a public offering, issuing new equity in a public offering, or

issuing securities with features of both in a private offering.3 Each mode of

financing may enable the company to obtain the capital it needs at a cost

below the expected value of the project, taking all transaction fees into

account. In such circumstances, the underside of transaction fees comes into

play. Generally, a company seeking capital will work with intermediaries,

including an investment bank and outside counsel, in determining how to

proceed.4 Through the range of transactions they propose, the advice they

provide, and otherwise, the intermediaries can influence which transaction

1. OLIVER E. WILLIAMSON, ECONOMIC ORGANIZATION: FIRMS, MARKETS AND POLICY

CONTROL 176 (1986) (“Transaction costs are the economic equivalent of friction in physical

systems.”). This Article generally uses the term “transaction fees” to reflect that while the fees

are costs to the principals, they are revenue to intermediaries.

2. The requirement here is only that the parties believe the transaction creat es value; not

actual value creation. A variety of factors, including cognitive biases and inadequate or

incorrect information, can cause parties to proceed with transactions that are not welfare

enhancing. See, e.g., infra note 44 and accompanying text.

3. See, e.g., K & L Gates Practice Guide Editors, Securities Practice Guide Excerpt: Conducting

a PIPE Offering, LEXISNEXIS (Aug. 28, 2009, 2:20 PM), http://law.lexisnexis.com/author-

center/K-&-L-Gates-Practice-Guide-Editors/Conducting-A-PIPE-Offering (examining “some of

the legal and strategic considerations that an issuer conducting a PIPE offering should take into

account during the various stages of the transaction as well as the mechanics of conducting a

PIPE offering”).

4. Bernard S. Black, The Leg al and Institutional Preconditions for Strong Securities Markets, 48

UCLA L. REV. 781, 787 (2001) (“Most American investors still expect financial statements to be

audited, shares to be underwritten by an investment banker, and the prospectus to be prepared

by securities counsel.”).

2013] FEE EFFECTS 1519

is ultimately consummated. And, as profit-maximizing entities, we can

expect that intermediaries will use their influence in a way that serves their

bottom line.5

The claim is not that intermediaries blindly promote the transaction

that yields the highest fees. Intermediary influence is subject to a number of

internal and external constraints. Factors like the value of a good reputation

and competition constrain how intermediaries use their influence. Other

factors, such as the nature of the intermediary’s role, can further reduce an

intermediary’s capacity to affect which transaction is consummated.

Nonetheless, whenever parties use an intermediary in connection with a

transaction, that intermediary can be expected to seek to maximize its profit

subject to these constraints. As a result, the use of a specialized intermediary

introduces a new market force into the process through which the

transaction is chosen and consummated. This Article explores the

significance of this under-examined market force.

The aim of this Article is twofold. First, the Article draws attention to

the underside of transaction fees as a pervasive phenomenon, present in

every transaction involving an intermediary. Scholars have long recognized

that intermediaries are self-interested actors whose interests do not align

perfectly with the interests of the parties they assist. They have also

developed a number of helpful conceptual frameworks, including agency

costs, gatekeepers, and two-sided markets, to explain many of the benefits

and costs of relying upon intermediaries.6 Yet, the overlap between the

underside of transaction fees and each of these alternative frames is

imperfect.7 No other work has yet broadened the lens beyond specific

settings while remaining focused on the way that intermediary influence

affects the probability that a particular transaction will be consummated. In

5. Recognizing that intermediaries seek to maximize profits, not revenue, this Article

uses the underside of transaction fees as a shorthand for the tendency of an intermediary to

favor the transaction that yields the greatest profit. See infra Part I.A.

6. See, e.g., JOHN C. COFFEE JR., GATEKEEPERS: THE PROFESSIONS AND CORPORATE

GOVERNANCE 15–47, 55–56 (2006); FINANCE, INTERMEDIARIES, AND ECONOMIC DEVELOPMENT

(Stanley L. Engerman et al. eds., 2003) (compiling essays that examine the way that the

movement of capital in a particular time and place sheds light on various aspects of financial

intermediation generally); George A. Akerlof, The Market for “Lemons”: Quality Unc ertainty and the

Market Mechanism, 84 Q.J. ECON. 488 (1970); Reinier H. Kraakman, Gatekeepers: The Anatomy of a

Third-Party Enforcement Strategy, 2 J.L. ECON. & ORG. 53 (1986); Hayne E. Leland & David H.

Pyle, Informational Asymmetries, Financial Structure, and Financial Intermediation, 32 J. FIN. 371

(1977); Frank Partnoy, How and Why Credit Rating Agencies Are Not Like Other Gatekeepers, in

FINANCIAL GATEKEEPERS: CAN THEY PROTECT INVESTORS? 59 (Yasuyuki Fuchita & Robert E.

Litan eds., 2006); Daniel F. Spulber, Market Microstructure and Intermediation, J. ECON. PERSP.,

Summer 1996, at 135; Merritt B. Fox, Gatekeeper Failures: Why Important, What to Do, 106 MICH. L.

REV. 1089 (2008) (reviewing COFFEE, supra); Thomas Philippon, Finance vs. Wal-Mart: Why Are

Financial Services So Expensive? (2012) (unpublished manuscript), available at http://www.

russellsage.org/sites/all/files/Rethinking-Finance/Philippon_v3.pdf.

7. See infra Part I.C.