The Race to the Bottom, the Royal Bank of Scotland, and the Law and Economics Movement

We will resume our discussion of Merck, the case pending before the Supreme Court on the standard for determining the onset of the statute of limitations under Rule 10b-5.

In the 20 or so years before the new millennium, the corporate law area was overrun by the law and economics movement.  Everything had to be tested based upon economic analysis.  There is nothing wrong with applying different disciplines to law.  It does, after all, provide useful insight and can point regulators in a more effective direction.  But the law and economics movement was really a guise for anti-regulation (it became strong during the Reagan Administration, when this was the preferred way to look at the regulatory universe) and for a pro-management approach to corporate law.  The adherents strongly supported the pro-management approach of the Delaware courts (and believers in the characterization of Delaware law as a race to the top). 

In the 1980s, adherents to this movement placed almost talismanic importance on the market for corporate control.  They believed that when management, with all of its discretion (gratis of the Delaware courts) abused the discretion, the inefficiencies would be exorcised by a takeover.  Another company would spot the inefficiencies, know they could do better, and take over the company. We don't hear much about this approach anymore because the Delaware courts, so praised by this movement, have given management the discretion (they get discretion on everything) to more or less stop hostile acquisitions.  That method of acquiring controls has largely been eliminated.

But even if we were to turn the clock back to the era of hostile takeovers, there were still many problems with the "solution" of redeployment to a higher use.  There are too many criticisms to discuss in a short post, but one comes to mind.  In proving that takeovers were beneficial, proponents pointed to studies that showed target shareholders on average received a significant premium for their shares.  Shareholders of the bidder, however, received nothing, on average.  The weight of the studies showed no movement on the part of the bidder.

This curious lack of movement (which actually masked the fact that some bidders saw a rise in value while others saw a decline) was nothing more than, at the time of a merger, the market's collective uncertainty about how to value a takeover.  It said nothing about what, in fact, happened after the takeover.  In other words, the stat said nothing about whether the company in fact mismanaged the assets of the target.  If this were the case, the costs of the takeover (less productive use of the target's assets) could easily outweigh the benefits (the premium paid to target shareholders).  Proponents of the law and economics movement professed indifference about this since the inefficient bidder would itself become a target because of its inefficient use of assets.

Put that aside for a moment (there were plenty of reasons to believe this was not true).  The professed indifference, in other words, ignored the costs associated with the inefficient use of the assets during the period before the bidder itself became a target.

Why bring up this ancient history?  For one thing, adherents to the law and economics movement still raise their head from time to time, although now using a different vocabulary (Commissioner Paredes use of the phrase "private ordering" in opposing access is a modern vestige of this movement and equally unsupported, see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom). 

But we mention all of this because of a recent article in the London Review of Books, Its Finished, by John Lanchester, in the May 28 issue (it takes a long time to find the time to read these things).  It's a piece about the financial crisis.  (You have to be a subscriber to get an online version).  Of great interest is the story of the Royal Bank of Scotland (as well as others).  It turns out that the RBS wanted to grow (at all costs, it seems) and went on an acquisition splurge.  Ultimately, however, these acquisitions brought down the bank.  Apparently by acquiring pieces of ABN-Amro, the RBS found itself excessively exposed to the subprime market.  The bank should have failed but was instead rescued by a government bailout (with accompanying government ownership).

First, the story of RBS is unusual only in the scale (although there are other similar large failures).  More importantly this is the type of thing that the law and economics movement tended to ignore.  Presumably RBS got very big but apparently became very inefficient.  Yet in part because of its size and in part because of the market's inability to see clearly what was going on (the article talks about how balance sheets put together legally and honestly nonetheless can mask the true financial status of a business), the inefficiencies continued until the crisis and the bank's failure.  During this period when RBS owned the assets of the acquired companies, it looks like RBS put them to a less efficient use.

Its an old story but one made poignant by the current crisis.  The truth is that it suggests fallacies in an argument that's not made anymore.  The law and economics folks don't rely on hostile takeovers anymore to ensure efficiency.  I'd like to think its because my arguments in earlier pieces convinced them but in fact that's not the case.  Instead, these acquisitions have been done away with by Delaware, as part of the "race to the top."