Fee Effects

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

To continue reading

FREE SIGN UP