Intermediaries revisited: is efficient certification consistent with profit maximization?

• Author: Barnett, Jonathan M.

1. INTRODUCTION II. CRACKS IN THE REPUTATIONAL INFRASTRUCTURE A. The Simple Intermediary Thesis: Theory and Evidence B. Towards a Complex Intermediary Thesis III. ECONOMICS OF CERTIFICATION MARKETS A. Certification Goods B. Supply-Side Entry Barriers C. Demand-Side Entry Barriers D. Preliminary Evidence IV. THE CERTIFICATION PARADOX V. A REGULATORY CONUNDRUM A. Regulatory Risk I: Too Much Information B. Regulatory Risk II: Too Much Competition C. Summary VI. ORGANIZATIONAL FORM: REGULATION BY PROXY A. Constrained Organizational Forms: A Partial Remedy for Certifier Opportunism B. Constrained Entities in Financial Certification Markets C. Constrained Entities in Social Certification Markets D. Implications: Organizational Degradation or Evolution? 1. Efficiency Effects 2. Substitution Effects 3. Learning Effects VII. CONCLUSION I. INTRODUCTION

   Intermediaries are the linchpin in any market economy characterized by enormous volumes of transactions conducted among anonymous participants that have limited capacities to directly evaluate each other's products and services. Without gatekeepers (1) to supply reliable evaluation and monitoring services, efficient trade would often be distorted, curtailed, or blocked. The magnitude and longevity of the most prominent private certification entities are impressive. (2) Consider some notable examples: Underwriters' Laboratories (founded in 1894), the country's leading product safety certification firm, has developed more than 1300 safety standards and, in 2009, tested almost 90,000 products and authorized use of its "UL" mark on 20 billion items from over 66,000 manufacturers; (3) Standard & Poor's and Moody's (founded, respectively, in 1860 and 1909), (4) the world's leading bond rating agencies, rate hundreds of thousands of securities each year and exert influence over Fortune 500 corporations and even entire countries; and Dun & Bradstreet, the country's leading provider of business credit information (founded in 1841), (5) maintains trade payment information on 190 million companies and influences millions of transactions every day throughout the world. Without exaggeration, few consumers or enterprises do business without relying directly or indirectly on the information the intermediaries collect and evaluate.

   Outside the case of the credit rating agencies, legal scholars have devoted little attention to the actual operation of certification markets (6) and, in theoretical discussions in the law-and-economics literature, usually assert that reputational pressures drive repeat-player certifiers to provide a nearly infallible solution to informational asymmetries in certified markets. (7) But even casual scrutiny of real-world certification markets finds substantial departures from this optimistic view. Even the most established certifiers (or a close relative, accreditors) have been alleged to engage in self-dealing, laxity, collusion, and other deviations from perfect rectitude. (8) This discrepancy between theory and practice is most pronounced in the financial markets--ironically, a market that legal and economic scholars have widely touted as a paragon of informational efficiency due in part to the scrutiny of third-party intermediaries. (9) in the recent financial crisis, credit rating agencies failed to properly assess the financial condition of certain bond issuers and structured finance instruments; (10) in the (2001) Enron scandal, credit rating agencies lagged behind the market in reflecting Enron's insolvent condition while a leading accounting firm, Arthur Andersen, and a respected law firm, Vinson & Elkins, failed to stop Enron's fraudulent use of off-balance-sheet vehicles; (11) in 2002, prestigious accountants, lawyers, and other intermediaries failed to stop fraudulent disclosure in connection with bond issuances by WorldCom, a telecommunications firm that had inflated its earnings by $11 billion (12) (and promptly thereafter made the then-largest bankruptcy filing in U.S. history); (13) in 1991, PriceWaterhouseCoopers and Ernst & Young were implicated in the multi-billion dollar fraud perpetrated by the Bank of Credit and Commerce International, at one time the seventh-largest bank in the world by assets; (14) and, in the early 1990s, several leading national law firms and accounting firms settled suits alleging that they aided the multi-billion dollar frauds perpetrated in the "Savings and Loans Crisis." (15) The list goes on much further. (16)

   These "surprising" intermediary failures occur with such regularity that each incident is really not much of a surprise. To the contrary: the true puzzle is why intermediary failure (17) is a regular feature of certification markets and why certification markets thrive and expand even in the face of such failure. in this Article, I advance a theory of intermediary behavior that anticipates that controlled forms of intermediary failure will occur with regularity even in the most successful certification markets. This holds true even--and, remarkably, especially--in the case of the most well-established intermediaries. The inherent fallibility of any dominant certifier rests on a defining characteristic of certification markets. Any successful intermediary is protected by an entry barrier that induces it both to act diligently in order to protect its stream of reputational rents against competitive threats and to exercise its market power by relaxing investments in certification quality. That entry barrier derives from two sources: (i) on the supply side, the time lag required for any entrant to accumulate reputational capital in order to pose a competitive threat; and (ii) on the demand side, the switching costs that users (18) would incur to migrate to a competing intermediary. Entry costs on the supply side and switching costs on the demand side have a crucial implication: users of any established certification instrument do not have a credible threat of immediate termination in every case of intermediary failure. A dominant intermediary will therefore "shade" on quality just up to the point where users still prefer its degraded instrument relative to "taking a chance" on any competing provider, evaluating quality directly, or exiting the market. This is not to say that certifiers are free to make zero effort; unconstrained slack would exceed users' tolerance and invite competitive entry, direct evaluation, or market exit. However, so long as switching costs are positive, reputation effects will fail to deter intermediary opportunism to some substantial extent. At best, the certification market can provide a partial solution to informational asymmetries in the certified market.

   This qualified understanding of intermediary markets yields qualified policy implications that move beyond the traditional dichotomy between simple opposition to and support for aggressive state intervention in informationally opaque markets. The standard positive theory of intermediary behavior yields the normative proposition that regulatory interventions in intermediated markets are superfluous at best and distortionary at worst in light of existing incentives to act diligently. (19) That intuition has driven widespread academic skepticism of mandatory disclosure laws and other regulatory interventions designed to alleviate informational asymmetries in the capital markets and other settings. (20) Recent turmoil in the capital markets has put those views under substantial stress (with a surprisingly meager response from law and economics scholars). (21) The apparent discrepancy between theory and practice, however, does not support a simple reaffirmation of standard regulatory tools or, in the extreme but not atypical case, state provision of certification functions in order to improve gate-keeping quality. Given certifiers' reputation-driven incentive structure and regulators' severe informational constraints, none of these options is a sure recipe for improving certifier performance and can easily make things worse. As anticipated by theory and demonstrated by experience, expanding certifier liability or relaxing entry barriers into certification markets can reduce--sometimes dramatically--certifiers' incentives to invest in informational accuracy. (22) A reasonably well-functioning certification market is a fragile mechanism; regulating it aggressively to achieve marginal gains in certification accuracy can easily kill it.

   Any intervention into a certification market must balance the risk of future regulatory failure against current market failures. Consistent with this principle, I examine an alternative institutional strategy that exploits organizational structures to reduce certifier shirking at a low to zero risk of regulatory error. This approach is not hypothetical; certifiers have historically sought to commit against opportunistic action by adopting nonprofit, mutual, and partnership forms of organization that limit the opportunities and incentives for managers and other controlling parties to extract value from locked-in users. These organizational forms--which I group under the rubric of "constrained" forms--are used by most leading certification entities in consumer and industrial goods markets, historically by law and accounting intermediaries in professional services markets, and recently by intermediaries in certifying the "ethical" production of food and other consumer goods. (23) The years preceding the recent financial crisis were characterized by a striking organizational transformation: virtually all leading certifiers in the financial markets abandoned these constrained forms for corporate and other forms of organization that place few limitations on the distribution of profits to investors or compensation to managers. (24) This single observation does not support mandating that certifiers operate under nonprofit and other constrained forms of organization; however, those forms appear to be...