I.
Theory of Financial Institution Failure

In recent years, it has become apparent that the failure of large, interconnected nonbank financial institutions, such as hedge funds and investment banks, can create substantial systemic risk and thereby impose external costs on the financial markets and economy.² Because no financial institution has the incentive to limit its own systemic risk,³ and because collective action by market participants to prevent systemic risk is unlikely,⁴ some regulation is needed to minimize the external costs produced by the failure of “too big to fail” (TBTF) institutions. Any remedial regulation should (1) prevent overly risky behavior by a TBTF institution that could cause it to fail and create contagion,⁵ and (2) prevent the panic among investors that can precipitate an institutional failure.

Regulation to avert systemic risk, however, can also create moral hazard and uncertainty. One way of reducing systemic risk is by “bailing out” TBTF institutions—guaranteeing their agreements with creditors and counterparties—which reduces the chances of their failure by preventing runs on the institutions. The problem with this approach, however, is that while loss-fearing counterparties and creditors normally exert market discipline to prevent institutions from taking on excessive risk, parties that come to expect future bailouts reduce their discipline accordingly. A policy of “constructive ambiguity”—only bailing out some creditors and counterparties so that none can count on a bailout ex ante—reduces this moral hazard. But constructive ambiguity also creates uncertainty in financial markets, leading panicked investors to withdraw their funds en masse from other financial institutions, which can increase systemic risk. The benefits of constructive ambiguity in reducing moral hazard will be produced most effectively through a discretionary and transparent process that retains uncertainty over the outcome of regulatory decision-making with regard to bailouts, but involves less ambiguity over the rules and process informing such decision-making. Creating clear procedures but preserving uncertainty over the outcome of a regulatory decision produces a better balance between uncertainty and moral hazard: Clear procedures will calm panicky investors, while uncertain outcomes will curb moral hazard.

II.
Evaluating Our Current Regulatory System

Our current regulatory system is suboptimal in both its ex ante and ex post regulation of systemic risk. Ex ante, the system fails to reduce the external costs caused by the overly risky behavior of nonbank financial institutions. Prudential regulations to curb such behavior are either insufficient, as with the Securities and Exchange Commission’s regulation of investment banks through the Consolidated Supervised Entities program, or nonexistent with respect to certain financial institutions, such as hedge funds. Ex post, the system does not sufficiently reduce the systemic risk caused by the failure of nonbank financial institutions and does an inadequate job of limiting the moral hazard and uncertainty that regulation creates. Under our current regulatory framework, when a large nonbank financial institution is on the verge of failure, regulators have two options: either undertake last minute, ad hoc actions to rescue the institution or permit the institution to file for bankruptcy. The problem is that this ad hoc approach can result in (1) bankruptcy filings by TBTF institutions that will likely cause contagion, as exemplified by the failure of Lehman Brothers, and (2) uncertainty in regulators’ decision-making processes that can create panic and worsen an ongoing financial crisis, also apparent during the aftermath of Lehman Brothers’ bankruptcy filing.

III.
The Obama Administration’s Framework for Regulatory Reform

The Obama administration’s proposed legislation would establish rules by which the Federal Reserve would designate certain financial institutions as TBTF—or Tier 1 financial holding companies (Tier 1 FHCs)—which would become subject to more stringent ex ante prudential regulations. The determination of whether an institution should be deemed a Tier 1 FHC would not depend upon the legal status of the institution, such as whether it is legally a bank, a hedge fund, or an investment bank, but rather on the extent to which a failure would be likely to impose external costs on financial markets and the economy. The Obama administration’s proposal retains the current bankruptcy process but adds a resolution regime that governs the failure of Tier 1 FHCs in some circumstances in order “to efficiently and equitably resolve the claims of creditors and other stakeholders”⁶ through a legal process similar to bankruptcy. Although the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) must approve a decision to invoke the resolution regime by a two-thirds vote, the Treasury would ultimately decide whether to invoke the regime upon consultation with the President.

The Obama administration’s proposal improves upon our current regulatory system, but it could do more to avert the systemic risk that could result from the failure of a Tier 1 FHC. Although the proposed framework instructs the regulatory agencies to consider “serious adverse effects” on the financial system and economy when deciding whether to invoke the resolution authority, the procedures for reaching such a determination are so stringent—requiring near consensus among numerous regulatory agencies—that it seems likely that at least some financial institutions whose failure will cause systemic risk will not be bailed out. The proposed legislation also leaves open the possibility that regulators, at the eleventh hour, might elevate moral hazard concerns above concerns about systemic risk. Furthermore, giving the Treasury—an agency firmly within the Executive branch—the ultimate authority to invoke the resolution regime overly politicizes what should be a technical decision based on an assessment of the expected systemic cost.

I also contend that the proposal fails to sufficiently reduce uncertainty in policymaking decisions, which could trigger panic and contribute to an environment where short-term creditors are likely to run a Tier 1 FHC. First, because the proposal leaves open the possibility of bankruptcy, creditors and counterparties of the institution now must worry about their ability to recover if the institution fails under both bankruptcy law and resolution rules. Second, the legislation does not require regulators to disclose the basis for the decision of whether an institution’s failure creates “serious adverse effects.” Without transparency in this crucial determination, ambiguity over the decision-making process remains, creating additional uncertainty for investors.

IV.
An Alternative Regulatory Reform Framework

While the Obama administration’s proposal has clear benefits, I suggest modifying the proposal’s ex post process for resolving the failure of TBTF financial institutions in order to prevent systemic risk more effectively and to reduce uncertainty. I propose that the Federal Reserve be given unilateral power to authorize the FDIC to seize a failing institution and place a value on the expected cost to the financial system and the economy of the institution’s failure. A cost-benefit provision in the new statute would then require the FDIC to provide the institution with financing only up to the cost of the systemic risk created by that institution’s failure.⁷ This will ensure that the expected cost of any bailout is less than the expected cost of systemic effects. Under my proposal, institutions deemed to be Tier 1 FHCs would not be subject to the bankruptcy process.

This alternative regulatory framework will improve upon the administration’s proposal in three ways. First, it will prevent systemic risk more reliably without worsening moral hazard. The cost-benefit provision of the resolution process ensures that systemic risk is properly considered and prioritized ex post in resolving a Tier 1 FHC failure. Under my proposal, regulators would not be permitted to elevate concern about creating moral hazard above the problem of systemic risk when deciding whether to allow a failed institution to liquidate. Furthermore, even though it is more likely under my proposal than under the administration’s proposal that Tier 1 FHCs will be rescued to some extent, any moral hazard will be limited because only short-term creditors with high-priority claims against an institution, not long-term subordinated creditors, are likely to recover fully in a resolution process.

Second, the Federal Reserve, as a regulatory agency with substantial prior experience regulating large, complex financial institutions and as the agency that would be responsible for monitoring and regulating Tier 1 FHCs ex ante, would have the most expertise and independence to make sound technical determinations about whether the systemic risk exception should be invoked.

Third, this framework reduces the additional harm and contagion caused by uncertainty in regulatory behavior without losing the benefit of reduced moral hazard. By removing the possibility of bankruptcy, the framework I propose eliminates a layer of legal uncertainty that could contribute to panic and trigger a run on financial institutions. Requiring transparency in the Federal Reserve’s methodology for making a systemic risk determination also reduces the ambiguity in decision-making procedures that can exacerbate a financial crisis.

Acknowledgments:

Copyright © 2010 New York University Law Review.

Alison M. Hashmall is a J.D. Candidate at New York University School of Law.

This Editorial introduces and is an abbreviated version of Alison M. Hashmall, Note, After the Fall: A New Framework To Regulate “Too Big to Fail” Nonbank Financial Institutions, 85 N.Y.U. L. Rev. (forthcoming June 2010).

Today, there are new fears that plaintiffs’ lawyers have co-opted securities class actions by paying-to-play. “Paying-to-play” describes the practice of lawyers giving campaign contributions to public pension funds’ political leadership in order to gain favorable consideration by the funds for appointment as class counsel. Many reforms have been proposed and enacted in response to paying-to-play fears. Aside from a few anecdotal reports, however, no examination of campaign contributions from plaintiffs’ lawyers to elected officials exists in the legal literature. This Editorial returns to the first stage of analyzing paying-to-play that many commentators have skipped: whether law firms are contributing to investment funds’ leadership at all. If law firms are not contributing, there can be no rational fear of paying-to-play. My study finds that law firms do indeed contribute to the investment funds that select them as lead counsel.

 
I.
The PSLRA and Paying-To-Play Fears

The PSLRA established a rebuttable presumption that the lead plaintiff is the plaintiff with the largest financial interest in the relief sought by the class. Congress’s theory was that the plaintiff with the largest financial stake would have the greatest incentive to manage the case competently and achieve the highest possible settlement. The PSLRA also guaranteed the lead plaintiff the power to select and control class counsel.

Congress explicitly targeted institutional investors to be the new lead plaintiffs in securities class actions because of their large financial interests and their experience as investors. While from 1997 to 2000, only between ten and twenty institutional investors were named as lead plaintiffs each year,¹ the number grew to thirty-one in 2001 and then to fifty-six institutions in 2002.² In the period covered in my study, 2002 to 2006, 41% of cases had an institutional investor as lead plaintiff.

The first fears over paying-to-play surfaced in media reports in 1998. The legal academy became concerned shortly thereafter, announcing the practice as a problem and then proposing solutions. However, my research revealed only two empirical studies of paying-to-play in the legal literature. Neither study examined lawyers’ campaign contributions; rather, they both used indirect means of investigating paying-to-play.

The lack of empirical evidence of paying-to-play, however, did not stop courts, the American Bar Association, pension funds, Congress, and state legislatures from discussing and implementing reform proposals. Reform may be necessary if paying-to-play indeed negatively affects securities class actions. However, reforms are not without cost; all efforts at reform make tradeoffs in an attempt to insulate pension fund officials from lawyers’ campaign contributions. Generally, there have been four proposals to combat the perceived paying-to-play problem. The first proposal calls for the lead plaintiff fund and the filing law firm to disclose to the court any payments made by the lawyers to the fund, enabling the court to decide whether the fund or firm are fit to serve. The second proposal is merely a bright-line version of the first: A lawyer is barred from representing a fund if the lawyer made a campaign contribution to the fund’s officials. The third proposal requires that elected officials be removed from pension funds’ governing boards and be replaced with unelected leadership. The final proposal is that courts, rather than the lead plaintiff, should select lead counsel through an auction.

The first two proposals would limit lawyers’ participation in the political process. Even if courts had discretion to allow lawyers to continue to serve, the threat of losing a client may be enough to silence lawyers’ political voices. Restructuring pension funds’ leadership—as required by the third proposal—also has costs. Public pension funds likely have elected officials in leadership positions to allow for state government control of the funds. This provides for democratic accountability with regard to the funds’ successes and failures, including their litigation decisions. Finally, as others have noted, a court-run auction to determine lead counsel “is inconsistent with the language of the PSLRA.”³ The PSLRA instructs the court to appoint the “most adequate plaintiff,” not the most adequate law firm, and then allows that plaintiff to choose the lead counsel. Replacing the lead plaintiff’s selection of counsel with that of the court undermines the PSLRA’s intent to empower the lead plaintiff to select and monitor class counsel.

 
II.
Data and Findings: Law Firms’ Contributions to Lead Plaintiff Funds

I examined the 1076 securities class actions filed in the United States from 2002 to 2006. I identified the 445 cases where an institutional investor was at least one of the plaintiffs filing to be lead plaintiff and then narrowed my dataset to the seventy-five cases where the lead plaintiff was an institutional investor with at least one state-level elected official, or person appointed by such an official, on its controlling board. I then identified the membership of the controlling boards of the institutional investors at the time the case was filed. Next, I identified the law firm or firms that each fund selected as counsel in each case. Finally, I used state-level campaign-finance filings to find campaign contributions from the plaintiffs’ law firm (or its lawyers) to any elected official affiliated with the pension fund that selected the firm as counsel. My campaign contribution dataset spanned both before and after the filing of the cases—from 1998 to 2008—in order to capture contributions that could come before law-firm selection as an enticement, or after as a reward. I included contributions made to the relevant candidates directly and also contributions to their political parties’ campaign committees under the theory that candidates may look favorably on contributions to their parties, and donors may seek to exploit such contributions.

I found that in a majority of cases where paying-to-play was possible, at least one law firm made a political contribution to an elected official affiliated with a lead plaintiff pension fund in the case. Of the seventy-four cases in my dataset, a law firm affiliated with a case made a political contribution to a pension fund in forty-eight cases, or 64% of the time.

Because there was sometimes more than one law firm or pension fund filing in each case, and my data grouped these firms and funds together, there were 184 total opportunities for pension funds and law firms to be matched through political contributions. Firms made contributions in seventy-eight of those 184 opportunities, or 42% of the time. Of all the total contributions from a particular firm to officials associated with a particular fund, the mean was $58,942 and the median was $9,300.

 
III.
Discussion and Future Areas of Research

My data confirms that plaintiffs’ law firms are contributing to the pension funds that hire them. These contributions form the baseline of the paying-to-play theory. My study thus provides the first set of paying-to-play data on which future scholarship can build. Some may argue that these contributions themselves create an appearance of impropriety that should be avoided. Others suggest that the focus should be on the actual performance of class counsel, no matter how selected.⁴ The resolution of this question is beyond the scope of this Editorial.

The debate over paying-to-play involves more than a concern over political contributions. The paying-to-play theory has three basic elements: (1) law firms are giving political contributions to officials affiliated with pension funds’ boards; (2) the firms are doing so with the intention of earning favors from the funds; and (3) pension funds are in fact giving those favors by selecting contributing firms as lead counsel in class action cases.

While this Editorial has provided some evidence of the presence of element one, we must examine elements two and three to understand fully the paying-to-play problem and to formulate an appropriate policy response. The factors listed below are not meant to be an exhaustive list of all important matters but rather a helpful guide for future researchers of what I consider to be the most interesting quantifiable factors surrounding the paying-to-play problem.

 
A.     Geography

Pension funds might be likely to select local law firms with whom they are familiar and with whom they can meet frequently. This may be especially true if pension funds plan to, or have been, working with firms for a long period of time, such as funds hiring a firm to provide litigation monitoring services. Geography may also be important for researchers seeking to understand law firms’ political contributions. Contributions from lawyers to politicians in their own states may seem less suspicious than donations to those in distant states.

 
B.     Experience

Based on my data, from 2002 to 2006, pension funds selected the same few law firms repeatedly. Bernstein Litowitz Berger & Grossman was affiliated with an institutional plaintiff in thirty of the seventy-five cases in my dataset, or 40% of the cases. On the other hand, pension funds selected twenty-nine of the thirty-six total firms each three or fewer times. Future research could quantify indicators of a law firm’s experience, such as the number of previous securities fraud class action cases handled, in an effort to discover whether experience is an independently significant variable in funds’ selection decisions.

 
C.     Previous Relationships

Funds may also be more likely to select firms with which they have had a particular former relationship. This might mean a firm representing the fund in a previous class action, but it could also include a law firm providing other services for a fund. According to one securities class action expert, funds increasingly are relying on law firms to monitor their investments and to provide advice on possible suits to file or join.⁵ Funds typically do not pay the law firms for these litigation and investment monitoring services, but the firms instead hope to be rewarded by being selected as lead counsel if the fund decides to file suit and is named lead plaintiff. In a recent case, Judge Jed S. Rakoff raised concerns at a hearing that a proposed plaintiff law firm had a “blatant, shocking conflict of interest” stemming from free monitoring services provided for a union pension fund client.⁶ Additionally, pension funds have been reported to keep “short lists” of firms that have been prescreened to use when the fund decides to file suit. In these cases, the law firm that provides investment monitoring services competes with other firms on the fund’s list. Pension funds without exclusive lists rely on “requests for proposals” sent to law firms, inviting them to bid for the pension fund’s legal work. All of these arrangements may shed light on law firms’ decisions to contribute to funds, or may impact funds’ lead counsel selection decisions.

 
Conclusion

Past fears, and even reforms, of the paying-to-play practice have been based on anecdotal evidence in the media and scholarly literature. This Editorial provides empirical evidence for the first time showing that plaintiffs’ law firms do contribute to officials affiliated with the public pension funds that select them as lead counsel in securities fraud class actions. Given this prima facie evidence, it is still important to explore other factors that may explain why law firms contribute to funds and how funds choose which law firms to hire. Moreover, even if the worst paying-to-play fears are true and pension funds are selecting law firms based on political contributions, does paying-to-play actually have a negative effect on lawyer-client agency costs in securities fraud class actions? In other words, even if paying-to-play is happening, does it matter? This is a question Stephen J. Choi, Adam C. Pritchard, and I examine in an upcoming paper, The Price of Paying to Play in Securities Class Actions.⁷

Acknowledgments:

Copyright © 2010 New York University Law Review.

Drew T. Johnson-Skinner received his J.D. from New York University School of Law in 2009. He is currently a Law Clerk for Judge John G. Koeltl.

This Legal Workshop Editorial is based on the following Student Note: Drew T. Johnson-Skinner, Paying-To-Play in Securities Class Actions: A Look at Lawyers’ Campaign Contributions, 84 N.Y.U. L. REV. 1725 (2009).

Click here to access the raw data analyzed in this Editorial.

The actual enforceability of medical malpractice exculpatory agreements remains an unsettled and underexplored question.  Courts treat general exculpatory agreements—like those signed at amusement parks—as they do any other contract, enforcing the contracts as long as they are entered into voluntarily.  But medical malpractice exculpatory agreements have been repeatedly invalidated, often under the mysterious “void-for-public-policy” rationale.  This Editorial outlines the basic arguments put forward in my Note exploring the enforceability of medical malpractice exculpatory agreements.  In the process, I set out a blueprint that medical providers might use to craft an enforceable medical malpractice exculpatory agreement.  I argue that the agreement with the best chances of being enforced is one that is not just optional for the patient and clearly worded, but also confidential.

 
I.
Judicial Resistance to Medical Malpractice Exculpatory Agreements

Cases using the void-for-public-policy rationale to invalidate medical malpractice exculpatory agreements abound, while cases upholding the agreements are difficult to find.  However, it is unclear whether the resistance to these agreements is a result of something that renders them categorically void or, alternatively, of some quality of the specific subset of agreements that are actually brought to court.

New York follows the majority rule on medical malpractice exculpatory agreements, so an in-depth analysis of New York case law is illustrative.  When invalidating medical malpractice exculpatory agreements, New York courts seem to focus on the way medical malpractice agreements are presented and worded, rather than on the subject matter or parties to the agreement.  In case after case, the courts look beyond the mere fact that the agreement is between doctor and patient and relates to liability, instead scrutinizing the specific wording of the agreement, the presentation of the agreement, and the circumstances of the bargain before ruling on an agreement’s validity.

There is reason to believe a medical malpractice exculpatory agreement could be crafted such that a New York court (and presumably any court following the majority rule) would enforce it, in spite of the fact that most cases on record involving such agreements have found them to be void for public policy.  The cases suggest that it is neither the subject matter of nor the parties to medical malpractice exculpatory agreements that render them void for public policy, but rather some feature of their presentation and signing.  Unfortunately, the cases provide few clues as to what elements are problematic.

 
II.
A Possible Culprit: Signaling Pressure in Medical Malpractice Exculpatory Agreements

A behavioral economic perspective reveals that medical malpractice exculpatory agreements create a somewhat intuitive problem that may underlie courts’ skepticism.  At the core of this problem is the signaling involved in the decision to sign (or not sign) a medical malpractice exculpatory agreement:  By refusing to sign such an agreement in exchange for a lower fee, a patient unequivocally signals to her doctor that:

(1) she is the sort of patient who would sue her doctor if injured negligently,

and

(2) she thinks there is at least some chance her doctor will make a mistake.

By refusing to sign an exculpatory agreement, the patient essentially says to the doctor, “No thanks, while I like saving money, I think there is a chance I’ll end up suing you.”

This signaling is problematic because we patients want our doctors to think we trust them.  Call it fairness, fear of retaliation, or altruism—the fact remains that many of us are uncomfortable with letting our doctors know that we have anything but the utmost faith in their abilities, even when we do have serious doubts.  This is why we are so hesitant explicitly to ask for a second opinion, even though we do not think twice about double-checking our diagnosis through anonymous means such as logging into WebMD or calling a doctor friend.  The same is true when it comes to deciding whether or not to sign a medical malpractice exculpatory agreement.  We know that if we do not sign, we will signal a lack of trust to our doctors, and this signaling effect puts pressure on us to sign, even if we otherwise would rather retain the right to sue for malpractice.

 
III.
Blueprint for an Enforceable Medical Malpractice Exculpatory Agreement

In my full Note, I discuss the plausibility of the assumption that courts’ skepticism toward medical malpractice exculpatory agreements is related to the signaling pressure identified above.  Assuming that this encumbrance to patient decisionmaking does underlie judicial suspicion of these agreements, it is possible to set out a blueprint for an exculpatory agreement that avoids signaling pressure, thereby alleviating courts’ concerns.

First, courts have clearly stated that patients must actually understand what they are signing in order to be able to waive the right to sue for malpractice.  Furthermore, courts have stated that because medical care is a necessary service, doctors cannot present malpractice waivers on a take-it-or-leave-it basis.  Thus, as a preliminary matter, any agreement that hopes to be enforced must be nonadhesive (optional) and clearly worded.

Such an agreement would still be subject to the signaling encumbrance identified above.  To cure this defect and avoid claims that a patient’s decision was not really voluntary, a medical provider hoping to create an enforceable medical malpractice exculpatory agreement would need to find a way to insulate the patient’s decision from signaling.  This could be done by making the patient’s decision confidential.  By guaranteeing the patient a zone of privacy around her decision to sign—at least vis-à-vis her doctor—a medical provider presenting a patient with a medical malpractice exculpatory agreement could guarantee that the patient’s decision was not influenced by fear of how the doctor might respond.

Contracting over malpractice confidentially would not be difficult.  The simplest method would be to utilize direct contracting between patients and managed care providers.  The doctor would only know that some patients from the managed care provider withheld the malpractice right and some did not.  She would not find out whether a given patient had decided to withhold the right unless that patient chose to sue ex post.

Even without an intermediary, contract law leaves plenty of room for a doctor and patient to enter into a traditional contract confidentially.  The doctor could present and explain two fee arrangements—one including an exculpatory agreement, one not—as two separate offers.  She could then invite the patient’s confidential acceptance of either offer, so as to remain in the dark about the patient’s decision.  Such an arrangement would be perfectly legal:  The Restatement (Second) of Contracts makes clear that the offeror may invite acceptance by whatever reasonable means she designates in making the offer, be it performance or, in this case, acceptance delivered confidentially to a third party.

Of course, even if the contract were formed confidentially, the patient may want a guarantee that her decision would remain confidential.  Confidentiality and privacy clauses are common elements of contracts, and, in this case, both offered contracts need only include clauses that guarantee confidentiality, and perhaps provide some warranty in the event that confidentiality is breached.  In addition, they might designate an independent third party—such as the doctor’s malpractice insurance company—to maintain the confidentiality of the agreement.  Again, the doctor would never find out whether a patient had signed or not, unless that patient decided to sue.

 
Conclusion

This Editorial has focused on signaling effects and confidential contracting in the context of medical malpractice exculpatory agreements, but these ideas might be applicable to other situations.  Within health law, it might be that patient choice would be facilitated in many other highly sensitive areas by using the law to make patient decisions confidential, even vis-à-vis the family doctor.  Decisions like the choice to use birth control, get an STD test, or seek out a second opinion come to mind.  Beyond the medical arena, confidential contracts might be utilized anywhere a special relationship of trust between two parties is in conflict with the signaling caused by standard contracts. Such uses might include contracts in the employment context and contracts regarding legal representation.

Acknowledgments:

Copyright © 2010 New York University School of Law.

Matthew J.B. Lawrence received his J.D. in 2009 from New York University Law School. He is now clerking for Judge Douglas H. Ginsburg of the D.C. Court of Appeals.

This Legal Workshop Editorial is based on the following Student Note: Matthew J.B. Lawrence, In Search of an Enforceable Medical Malpractice Exculpatory Agreement: Introducing Confidential Contracts as a Solution to the Doctor-Patient Relationship Problem, 84 N.Y.U. L. REV. 850 (2009).

Now that we know that ongoing, day-to-day franchise tax competition is just not happening, we need to reframe the inquiry to examine the constraints that Delaware does face. If no state is immediately poised to take franchise revenues away from Delaware, does Delaware have unlimited discretion? If it does not, where do those limits come from?

Delaware does face constraints, and they do not seem small. First, Delaware’s chartering business interacts with the dynamism of the real economy in ways that make it hard for Delaware to rest on its franchise tax laurels. Even if no other state actively competes for chartering revenue, Delaware itself must vie to sell new charters because it needs to draw reincorporations from other states. Conceptually, this is clear. The question is its degree. When, decades ago, business turnover in the economy was slower than it is today, this competitive channel was not particularly important. Firms, or most of them, stayed organized from year-to-year about the way they had been. Once Delaware captured a firm’s franchise revenue in one year, that firm tended to be a reliable Delaware taxpayer in future years. But as corporate restructurings, spin-offs, mergers, and turnover have accelerated, keeping this channel flowing in to Delaware has become increasingly important for the state. Indeed, that acceleration has squeezed the half-life of its tax base down from a quarter century to a decade. That is, half of Delaware’s tax base in recent years comes from firms that got their Delaware charter in the prior decade; twenty years ago the tax base was more stable, with half of it coming from firms that got their Delaware charters in the prior quarter of a century. Delaware must run ever faster just to stay in place.

Second, another state, North Dakota, actively entered the market for corporate charters, drawing intense attention from Delaware and increasing attention from corporate dealmakers and corporate law academic analyses. Activist investors sought a corporate law attuned to their agenda and sought (unsuccessfully) first that Vermont and then (successfully) that North Dakota accept their agenda. Although that state has captured few reincorporations yet—and, hence, little in franchise fees—the North Dakota development potentially constrains Delaware, even if that constraint is only a loose one now. The North Dakota scenario highlights how severe state competition could break out:  not from an aggressive, innovative legislature (a mode usually thought to be unlikely and, hence, one of the reasons we’ve seen state competition as weak), but from disgruntled Delaware corporate players who instigate another state to enter the fray.

And, third, Washington, D.C. has always been a corporate governance player. In the scandals of the early part of this decade and the economic turmoil of the latter part, its role in potentially displacing and often enough affecting state lawmaking has become increasingly vivid. The early part of this decade saw Congress pass the Sarbanes-Oxley Act, a major corporate law statute. The end of the decade sees the Securities and Exchange Commission considering a major restructuring of corporate law that would give disgruntled shareholders access to their company’s proxy solicitation apparatus in a way that could shift corporate law authority in the firm.

Each of these three channels deserves further attention. For the first channel—the intensity of corporate turnover in the real economy, impelling Delaware to have to scramble to sell new charters just to stay even—data I obtained from the Delaware Secretary of State’s office show flow and turnover of Delaware’s tax base to be substantial in the past decade. Although ongoing state-to-state competition for chartering revenues is somnolent, as has been shown, competition in American business—in the real economy—is not. Preexisting Delaware-chartered firms merge, restructure, or close, thereby eliminating in each case one source of Delaware’s franchise fees. To keep up, Delaware must draw new firms into the state. The raw chartering numbers show that about 10% of the chartered firms at the beginning of each year are gone by the end of the year. And, typically, 10% of the firms at the end of the year are new firms that Delaware has drawn in. The dynamism of the real economy interacts with the structure of the chartering market to create a major arena where Delaware must continually vie for charters.

The data reveal another trend: just as we corporate law academics were coming to the conclusion that state chartering competition wasn’t happening, this pressure on Delaware to maintain flow has increased. Briefly put: only a couple of decades ago, the half-life of Delaware’s tax base was on the order of a quarter century. That posed a real consideration for Delaware, but was long enough not to be of immediate concern to the typical career state official, legislator, or local lawyer. This pressure has intensified, however—due to increasing pressures coming from the real economy interacting—to reduce the half-life of Delaware’s tax base down to a decade.

Delaware must continually provide enough value to new firms arising in other states (and to their controlling decisionmakers) to induce them to reincorporate into Delaware. The current focus on whether state lawmakers are sufficiently dynamic and competitive is surely warranted, but potentially overemphasized. Even if states are insufficiently dynamic and competitive, American business is dynamic. Firms arise, prosper, and merge. Others arise, fail, and disappear. For Delaware’s importance to persist over the decades, it must convince new firms to reincorporate away from their home states.

Second, Delaware faces other constraints. We can call those constraints competitive ones, if we expand our concept beyond ongoing competition for chartering revenue. Or we might just think of them as pressures and constraints preventing Delaware from being a fully free agent in its corporate decisionmaking, due to potential competition. Delaware must be wary of making a major mistake, one that would not just induce the inflow to dry up, but that could induce a new, previously inactive state to enter the market, conceivably in a way that could irreversibly erode Delaware’s existing base of charters if corporate America becomes unhappy with Delaware (or one that arrests the flow of firms that reincorporate into Delaware). Even states not actively seeking charters today can potentially compete in this limited sense with Delaware. Such a concept has a parallel in the industrial organization literature on contestable markets: a single producer can putatively dominate a market, but could lose its market share overnight. Hence, it acts like a competitor on some matters, or knows it must provide an overall package that is attractive to its primary customers. It has slack, but that slack is not unlimited, because its market, like Delaware’s, is contestable.

In this dimension, the focus on slow state bureaucracies and uninterested state legislatures is justified but easy to overemphasize. Thus, the second major constraint on Delaware is that the relevant actors who could undermine Delaware’s lead would be the interests already in Delaware. If they became unhappy with Delaware, it’s corporate players who would push another state to actively seek corporate charters. Corporate interests are not passive consumers, forced by the absence of another state purveying its own corporate law to accept whatever Delaware decides to offer. They can lobby another state’s lawmakers, ask for new law, offer that state the tax benefits of the law, and do the initial legal work; they are the ones who would motivate and press Delaware to change. And, as if to demonstrate this possibility, shareholder activists, unhappy with Delaware law, went shopping for a friendly state in the past couple of years and found one—North Dakota—to put competitive pressure on Delaware.

Delaware, despite not facing the intense Economics 101 competition of many other producers of corporate law, faces a contestable market, and that contestability limits the breadth of Delaware’s discretion. Its position is contestable horizontally, subject to several powerful interstate pressures. And it’s also contestable vertically, subject to pressures from Washington, the third major channel confining Delaware’s range of discretion. For example, Delaware legislation passed in March 2009 could seriously change core parts of corporate law dealing with election contests and access to the company’s proxy statement. That legislation is best understood as motivated by one or the other, or both, of these horizontal and vertical dimensions to competition.

That Delaware competes in some sense seems indisputable: its principal lawmakers are active, involved, and energetic. Indeed, as one inside commentator tells us, even if Delaware has won some race or another, “no one in Delaware is willing to play hare while some other state tortoise gains ground.” Delaware players worry. They don’t face day-to-day, head-to-head competition with other states for corporate chartering revenue, as we now know. But they are not free agents. Their actions are constrained.

Acknowledgments:

Copyright © 2010 Stanford Law Review.

Mark J. Roe is the David Berg Professor of Law at Harvard Law School.

This Legal Workshop Editorial is based on the following Article: Mark J. Roe, Delaware’s Shrinking Half-Life, 62 STAN. L. REV. 125 (2009).

Legal theory and, in particular, neoclassical law and economics will not be the same after the worst market collapse since the Great Depression, and the political engagement that resulted in the election of the nation’s first African-American President.  A quiet revolution is underway in the legal academy.  Indeed, one way of looking at a vast amount of seemingly unrelated scholarship over the past twenty years is to see that, in one way or another, it has sought to challenge the unrealistic assumptions of the neoclassical law and economics model.  We survey this scholarship under the mantle of a “new legal realism” and argue that much of it is a direct or indirect response to the “new formalism” of neoclassical law and economics.  New legal realists are not anti-economics (many of them are economists themselves), but they are challenging the new formalism’s assumptions about the individual, the state, and judging, as well as its approach to legal scholarship.

On the surface, neoclassical theory may appear to be the opposite of the old formalism, which advocated a “science” of doctrine based on common-law principles.  Neoclassical efficiency theory has touted instrumentalism rather than doctrinalism.  Oddly, however, the new formalism turns out, upon examination, to parallel the old in its form of deductive reasoning from axioms and the substantive policy prescriptions derived from it.  Neoclassical theory may talk about efficiency, but it ends up celebrating the common law.  It may claim to be a new science, but, like the old nineteenth century science of laissez-faire, it denigrates politics as the realm of special interests.

Perhaps it is not surprising then that, over the past eight years, new movements have arisen that characterize themselves as representative of a new legal realism.  Earlier articles have elaborated distinct versions of new legal realism in isolation.  We provide a taxonomy and overview of this literature in order to evaluate its commonalities and differences, facilitate mutual engagement among scholars, and build our own version of a “dynamic new legal realism.”

 
I.
Mapping New Legal Realism: Three Approaches

We categorize the new legal realism into three broad types.  First, there are behavioral approaches: studies that borrow from behavioral economics and political science to reach conclusions about law-as-behavior.  Second, there are contextual approaches: empirical work that includes studies using mixed methods involving bottom-up forms of empirical inquiry.  Third, there are institutional approaches: studies focusing on the power of institutions and institutional choices to determine our policies and shape our very ideas of self, society, and the state.

 
A.     The Behaviorists

There are two forms of what we call the “behavioral wing” of new legal realism.  One takes its inspiration from behavioral economics and the other, the attitudinal model in political science.  In 2001, Daniel Farber reviewed Cass Sunstein’s work on behavioral economics and proclaimed that studies challenging the rational-actor model were the new legal realism.² Farber argued that behavioral economists had successfully attacked the rational-choice models underlying neoclassical law-and-economics and public-choice theory by presenting a more realistic depiction of human behavior.

In a 1997 article, Frank Cross urged that a “new legal realism” take account of the “attitudinal model” of political scientists, which, in its more extreme variant, holds that legal reasons are irrelevant and that judicial decisions can be predicted based on ideological variables and political affiliations.³ This work, which forms part of the new empirical-legal-studies movement, has spurred a flurry of studies that find ideological bias across subject areas of judicial decision making.⁴ By 2008, Thomas Miles and Cass Sunstein dubbed such studies the cutting edge of new legal realism.⁵

 
B.     The Contextualists

Stewart Macaulay has deployed the term “law in action” to capture Wisconsin’s variety of new legal realism.⁶ Statistical studies are not enough for this version of new legal realism and are often complemented or replaced by sociological and anthropological approaches to law.  Macaulay’s canonical study of how businesspersons make bargains (largely in complete disregard of the law) is the starting but not the ending point of this model.  We call this work, for purposes of distinguishing it from other forms of empirical research, “action studies,” reflecting the subject of study—the law in action.

There are variations within the contextualist approach that reflect the variations in the law-and-society movement from which this version of new legal realism builds.⁷ Each of these variants uses different empirical tools to investigate behavior in social context.  Economists working in a contextualist vein, such as Ian Ayres, John Donohue, and Steven Levitt, deploy quantitative large-N studies and multivariate regressions.  Sociologists, such as Robert Nelson and Laura Beth Nielsen at the American Bar Foundation, use mixed qualitative and quantitative methods.  Legal historians, like Lawrence Friedman, Robert Gordon, and William Novak use qualitative and quantitative methods, as well as critical reflection.

 
C.     The Institutionalists

Building from different traditions in economics and sociology, a number of scholars have claimed that new legal realism should focus on institutional forces.  Neil Komesar has taken an important institutional turn for new legal realists, showing how social-goal choice alone is insufficient to inform law and policy decisions because the pursuit of all goals will be shaped and determined by institutional processes.⁸ Working in this vein, Ed Rubin advocates a microanalysis of institutions,⁹ an approach that is not limited to public institutions, but includes studies of private organizations, building on neo-institutional insights from sociology.¹⁰

“New governance” theory of law, coming out of Columbia Law School in particular, focuses on efforts to move beyond a court-centric and rights-focused basis of law and toward new forms of problem solving involving pragmatic institutional experimentation.¹¹ New-governance theory emphasizes the importance of innovation, learning, and flexible adaptation in light of experience.  Finally, other new legal realists have attacked the root image of the autonomous individual, not on the grounds of potential irrationality, but on the grounds of interdependence.  This approach has its roots in critical theory and feminism.  For scholars such as Martha Fineman, institutions must respond to universal human vulnerability, and thus institutional responsibility becomes central to policy analysis.¹²

 
II.
Responses to the New Formalism in Neoclassical Law and Economics

One can understand neoclassical law and economics as a new version of formalism if by formalism we mean a theory of law based on rationally organized first principles deductively applied.  It sets forth coherent principles (efficiency and wealth maximization) that it attempts to apply descriptively and prescriptively to all areas of law.  Judge Posner recognized this formalist argumentative structure when he wrote that “[e]conomic analysis of law is a formalist edifice erected on a realist [i.e., instrumentalist] base.”¹³

Some have claimed that law and economics is a “realist” enterprise since it rejects formal, self-contained doctrinalism.  New realists, however, argue that neoclassical theory turns realism on its head.  They contend that neoclassical theory seeks hypothetical end-states-of-affairs (wealth or welfare maximization) deduced from simplified assumptions rather than real-life facts and institutional processes.  New realists acknowledge that the new formalism differs from the old because of its instrumentalist base, but they contend that the new formalism arrives at conclusions remarkably like the old doctrinal formalism of the late nineteenth century—an idealization of common law and market processes, and a distrust of political institutions and state regulation.

In our article, we go into much greater detail regarding the new legal realist challenge to law and economics theories of judging, the individual, politics, and the state, as well as its general approach to scholarship.  For our purposes here, we note that each of the varieties of new legal realism directly or indirectly challenges aspects of neoclassical law and economics’ reasoning.  Behavioral economists challenge neoclassical law and economics’ rational-actor model.  Attitudinalists challenge the neoclassical law-and-economics notion of the efficiency of judging in the name of wealth-maximization.  Contextualists and institutionalists challenge an economics that does not compare institutional alternatives and their relative imperfections, and that fails to recognize that individuals’ situations vary so that some are in privileged or dominant positions in relation to others.  Like the old legal realists, new legal realists take aim at the “status quo bias” of formalist reasoning, a bias once entrenched in Herbert Spencer’s “laissez-faire” philosophy and its libertarian ideal and, subsequently, Chicago-school neoclassical law and economics’ recast exposition of that same ideal.

 
III.
Conclusion: A Dynamic New Legal Realism for a New World Order

As an alternative to existing forms of new realism, we begin the effort to outline a “dynamic new realism,” building from what we consider to be the best of the new realism.  Our form of dynamic realism focuses on “mediating” theory, which aims self-consciously to theorize the bridge between the world and legal institutions.  Unlike the old realism, such a dynamic new realism stresses that law is important within its sphere, in part because legal institutions exert power—the power both of violence and of reason.  Theories that simply ignore law leave the field open to those who would manipulate the law to achieve not only bad ends, but also literally terrifying ones (even torture).  In this sense, realisms that tend to explain law in terms of other disciplines are profoundly “unrealistic” to the extent that they leave law no place to exert its influence for ill or good.  Law cannot be reduced simply to economics, political science, sociology, or anthropology.  Neither the attitudinal model nor behavioral economics, neither large-N quantitative studies nor fieldwork, is enough.  Why?  Because legal institutions have power, and that power may transform knowledge and preferences in ways that may make them completely unrecognizable to its authors.

We suggest five conceptual moves that should be associated with a new realism and that offer scholars tools to bring particular analytics to bear on existing problems.  The first notion is recursivity.  Borrowing from Terence Halliday, we stress that legal-reform efforts are dynamic and involve the recursive interaction between law and society.¹⁴ The second notion is the simultaneity of law and politics.  One of the great (and unfortunate) habits of an age in which everyone is a “realist” has been to tend to reduce law to politics.  Yet law and politics involve different institutional processes that interact simultaneously in real life.  Dynamic new realism attempts to capture this dualism by telling “double stories” of law and politics or “triple stories” of law, markets, and politics, rather than stories that reduce one to the others.  The third notion is emergent analytics, which is the idea that a dynamic realism takes its concepts from evidence-based empirical engagement with the world and not from disembodied theory.

Fourth, functionalism is no longer enough.  We cannot simply posit values and expect them to be realized, just as legal scholarship cannot be reduced to other disciplines’ methods.  Unlike the old realists’ functionalism, dynamic new realism looks for concepts of “mediation” and “participation”—concepts that describe the ways in which law’s purposes are thwarted, amplified, condensed, or switched once translated into the world.  We should examine functions and ends in terms of how participatory structures of human interaction divert them.  Thus, the concepts of participation and accountability become central.  Fifth, and perhaps most importantly, borrowing from Dean Hanoch Dagan, we believe that law’s constitutive tensions between “power and reason, science and craft, tradition and progress” must be embraced not as a cause of a fundamental essentialist contradiction or defeat, but as productive and positive contradictions, reflecting a progressive struggle and dialogue about our deepest value commitments (as against value relativism, skepticism, and nihilism).¹⁵

New legal movements do not arise in the abstract.  They resonate if they fit a particular political moment in light of their confrontation with a dominant theory and practice.  Old legal realists played this role in the 1930s.  So, in our view, will the new-legal-realist movement today.  Dynamic new realism seeks an understanding of how law, like other institutions, reciprocally responds to and shapes individual preferences and political behavior.  If this dynamic new realism is taken seriously, we anticipate that new forms of analysis will emerge that will reconstruct law’s concepts to focus less on the individual preferences and more on how institutions shape and redirect those preferences, less on functional ideas and more on participatory institutional forms, less on idealized end-states of affairs or values and more on recursive interactions between ends and institutions, less on an imagined state in which we live, alone, on islands counting our preferences, and more on our shared human vulnerability.

Acknowledgments:

Copyright © 2010 Cornell Law Review.

Victoria Nourse is the Burrus-Bascom Professor of Law at UW Madison Law School and is currently a Visiting Professor of Law at Georgetown University Law Center.
Gregory Shaffer is the Melvin C. Steen Professor of Law at the University of Minnesota Law School.

This Legal Workshop Editorial is based on the following Article: Victoria Nourse & Gregory Shaffer, Varieties of New Legal Realism: Can a New World Order Prompt a New Legal Theory?, 95 CORNELL L. REV. 61 (2010).

A more narrowly tailored way to protect property rights in the context of takings for private economic development focuses on the word “use” rather than the word “public” in the Fifth Amendment.³ Instead of requiring that takings be proposed for a purpose more “public” than private economic development, I would require that land taken for private economic development actually be used for the claimed public purpose.

My proposal would address two troubling aspects of current takings law.  First, current law allows for the taking of private land without assurance that a public benefit will ever be realized, such as with a taking justified by a development plan.  When the Court approves such a taking based on the public benefit promised by the plan, the owner has no remedy even if the proponent of the plan abandons the project and the public purpose is never realized.   This possibility has become reality in the aftermath of the takings at issue in Kelo.  Not only has no development occurred on the taken land, but Pfizer Inc. announced on November 9, 2009, that it will close the New London research facility that the development planned for the taken land was internded to complement.⁴ There is no prospect of public benefit being achieved on the taken land, and the former property owners have no claims.

Second, current law creates incentives that encourage inefficient takings, by which I mean takings where the political and legal costs are greater than the public benefit achieved.  These occur, at least in part, because the Court’s failure to require actual public use of taken land allows for takings based on exaggerated public benefits.  The following stylized analysis illustrates how the interaction between a government and a private developer seeking a taking leads to condemnations based on misinformation.

I.
The Problem of Inefficient Takings: A Simple Model

The process of taking land starts with a proponent, who I assume is a private developer.  After failing to convince a landowner to sell a parcel, the proponent proposes to a government that the land in question be taken via eminent domain.  The government responds by asking what public benefit will justify the use of this power.  The developer is unsure of the public benefit of the project, but she knows she needs the land to proceed and that current law will not force her to provide whatever public benefit she promises.  Additionally, the developer does not know how much benefit the government wants for the taking, and she wants to avoid underbidding.  The developer thus has every incentive to exaggerate her estimate of public benefit.

But why would the government accept these exaggerated claims of public benefit?  First, the government may actually believe the claims made by a private proponent, accepting them based on wishful thinking.  Officials, presumably feeling they have little to lose, may be willing to embrace exaggerated claims in hopes of fostering optimism and change.

Second, government officials may not be pursuing the public interest single-mindedly.  Instead, they may take their self-interest as well as the public interest into account when considering a proposed condemnation.  Government officials reviewing a request for a taking might be willing to embrace an implausible public benefit estimate for a number of self-interested reasons.  For example, officials concerned about their prospects for reelection might encourage development regardless of its likelihood of success so that voters will see them as taking action to address widely publicized problems such as urban blight.  After all, voters will not know the plausibility of the projects in the short term.  Another self-interested reason that government officials might accept inflated public benefit claims would be to garner political support from powerful interest groups, which could provide campaign financing and loyal constituents.

II.
The Solution: An Actual Use Requirement

My proposal solves this inefficient takings problem by focusing on changing the behavior of private actors while also making condemnees whole.  By forcing private developers to substantially deliver on their promises of public benefit or pay damages severe enough to deter, an actual use requirement would make real the imaginary currency of public benefit.  A developer would carefully consider all elements of a proposal that claims to yield a certain public benefit because she would be committed to substantially completing that proposal.  Completing an element of the plan that was supposed to provide a benefit—a hotel that would employ 100, for example—would be extremely expensive if the market could not support the element (for example, if demand for hotel rooms proved inadequate).  Thus, the developer would no longer have an incentive to exaggerate.

With an actual use requirement, the proponent would approach the government with an accurate estimate of the public benefit.  The public-minded government then could compare the condemnation cost with the public benefit using accurate information and make a good-faith takings decision.  The respective roles played by the legislative and judicial branches would not change, but each party would be better able to fulfill its current role because it would have more complete information.  A political branch remains empowered to make the political decision of how to expend public resources by taking land.  This is important not just because the Supreme Court demands it,⁵ but because the legislature, with its closer ties to the community in question and greater access to expert planners, is better positioned to evaluate a proposed development than the courts.

III.
The Remedy for Inefficient Takings

A fairly simple remedy would serve to deter inefficient takings.  When the public purpose that originally justified a taking is not substantially realized, the land must be returned to the condemnee, if practicable, in exchange for the compensation originally paid for the taking, and the condemnee must get damages to compensate her for the inconvenience of being forced from her property, as well as mental and emotional damages.

Unfortunately, the first part of this remedy—the return of condemned land in exchange for the original just compensation—will often be impracticable.  If the condemnee does not discover the development is falling short of its proclaimed purpose until the site of her former home has become a putting green, she cannot simply seek an injunction ordering the return of her home:  To issue an injunction would be disproportionate or wasteful.  Meanwhile, the condemnee may have moved to another city and no longer desire to return to her home years after being removed from it.  To account for this reality, condemnees would also have the option to keep the just compensation and only sue for the additional damages.

The damages component of this remedy is derived from remedies in tort where the cause of action arises under the Constitution.  Constitutional torts generally are awarded like common law torts, with damages designed to compensate for the injury resulting from the violation of a constitutional right.  Here, damages would total the amount necessary to compensate the condemnee for being forced from her property for a period of years, and they would in many cases include a significant emotional distress element.  Awards would vary case by case.  For example, a large emotional distress award might be appropriate in the case of someone like Wilhelmina Dery, the 91-year-old New London resident forced from the home of her birth by the Kelo taking.  However, a lesser award with no emotional damage component would be appropriate if a vacant lot had been taken.  This flexibility would partially compensate condemnees for subjective value, something not achieved by any current remedies.

IV.
The Trigger for the Actual Use Remedy

The development plan used to justify a taking would determine whether the actual use remedy is triggered.  The development plan already plays a key role in takings law:  When the Supreme Court approves an economic development taking, it does not rule that a certain public benefit justifies taking private land but rather that a development plan promising some benefit does.  To ensure the benefit promised by the plan is realized, an actual use requirement recognizes a condemnee’s continuing interest in her property until the public benefit laid out in the approved development plan is substantially achieved.  If the plan justifies the taking, then it should be the substantial achievement of the benefit promised by the plan within the time frame of the plan that extinguishes a condemnee’s right in the property.  Essentially, an actual use requirement treats a taking for economic development by a private party as contingent upon completion of the justifying development.

Requiring developers to follow through substantially on the justifying development plan is important for several reasons.  First, it provides an affirmative guarantee that a public benefit will be achieved from the taking.  Current statutory and contractual guarantees generally only prevent developers from straying from the plan justifying a taking; they do not require them to actually fulfill the plan.

Second, the plan sets the physical and temporal standards that must be met to prevent a taking from being unconstitutional.  Once the plan is fulfilled in good faith, the Fifth Amendment’s demands are met.  The plan’s success would be measured by the completion of its physical goals, such as building a 350-room hotel within a certain time frame.  The completion of the development plan, in most cases, should serve as an adequate proxy for the public benefits the plan will create.  A rational developer would be unlikely to expend the resources to build a facility with capacity it did not believe it could utilize.

Developers also would be free to sell the property they received by a taking.  However, the sale would be subject to the development plan that justified the taking; the constitutional right of condemnees would run with the land and plan, allowing condemnees to press their claim against the new developer.

Finally, the plan would control the timing of the constitutional right.  Development plans set out time frames for the achievement of the public benefit they promise.  The substantial achievement of this public purpose within the promised time frame would extinguish condemnees’ constitutional interest in the land, in effect ending the contingency of the transfer.  However, it bears emphasizing that actual use calls for substantial and not complete compliance with the development plan.  This is essential to provide courts and developers with the wiggle room to prevent wastefulness when complete compliance becomes impractical for unforeseen reasons despite the good faith efforts of the developer.  Whether a project is substantially complete would be a case-by-case inquiry.

V.
Responses to Possible Objections

The temporal element of my proposal could inspire objection.  A critic could argue that extending the possibility of suit until a public purpose is achieved would lead to uncertainty for governments and developers, waste for society, and headaches for the courts.  Developers and governments seeking only fair profit and the public good could end up having to pay damages if a well-intentioned project fails for reasons beyond their control.  Meanwhile, courts might have to confront the same parties multiple times as condemnees presented new challenges.

Regarding uncertainty, there is no question an actual use requirement would add to the risk faced by proponents and governments.  This risk is not unfair, however, because these parties would be aware of it before taking the land.  Among the many factors a developer would want to consider when proposing a taking would be whether the project would be worthwhile even when discounted by the remote possibility of a catastrophic event.  The proponent would only seek takings with benefits so large that they justify the risk.

In the event that a developer did seek and win approval for a taking, one could argue that forcing the developer to finish a project in the face of more socially advantageous alternatives would be wasteful.  However, an actual use requirement would permit solutions commonly used by businesses to deal with this situation, such as efficient breach.  A developer might very well opt out of her development plan if other opportunities were lucrative enough.  Of course, given the expense of the actual use remedy, breach would be efficient less often than under a standard contract.  But developers engaging in takings under an actual use regime would be well aware of the damages they face and thus would weigh this risk when considering whether to take on a project.

Moreover, an actual use requirement is not intended to provide a business environment on par with one that does not require the government’s coercive power to take land.  Rather, it is intended to protect constitutional property rights by giving developers the incentive to provide governments with accurate information on which to base their takings decisions.

Acknowledgments:

Copyright © 2009 New York University Law Review.

William A. Curran received his J.D. from New York University School of Law in 2009.

This Legal Workshop Editorial is based on Mr. Curran’s Student Note: William A. Curran, Preventing Real Takings for Imaginary Purposes: A Post-Kelo Public Use Proposal, 84 N.Y.U. L. REV. 1656 (2009).

The first two contests have already been carefully dissected in the academic literature.  This Editorial seeks to offer a partial solution to the third problem:  the civil war between majority and minority shareholders.  Several incongruous Delaware cases, the rise of private equity, and a flood of post-Sarbanes-Oxley freezeout mergers have underscored the need for lawmakers to confront the governance problems presented in this context.

The tension between majority and minority shareholders is especially interesting because lawmakers must walk a tightrope between two alternative hazards.  On the one hand, granting the majority shareholder untrammeled discretion can promote abuses of power that will depress the ex ante value of a firm.  Controlling shareholders enjoy many strategies for fleecing minority investors, but none are more potent than using a freezeout merger to take full ownership of the firm.  It is easy to see how an overly permissive freezeout policy might lower a firm’s market value:  Potential investors will fear that a controlling shareholder might price the merger at a ridiculously low level.  This fear will, in turn, depress the upfront price that minority investors would be willing to pay for the stock.

On the other hand, assigning too much power to minority shareholders can lead to a holdout problem, with recalcitrant dissenters demanding private payouts before blessing a beneficial merger.  Even if minority owners do not maintain an express veto over the transaction, generous remedial statutes or very strict standards of review present a risk of costly strike suits.  The legal challenge, of course, is how to balance the dual extremes of majority expropriation and minority holdout.

 
I.
Regulating Freezeout Mergers

Thus far, corporate law has dealt with the majority-minority governance problem, as it appears in the merger context, through a troika of regulatory policies.  First, under federal securities law, firms undergoing a freezeout merger must disclose detailed financial information to all shareholders.  Second, freezeout mergers are subject to judicial review (often in Delaware) to determine whether the firm’s directors or controlling shareholders have breached a fiduciary obligation to the minority owners.  And third, dissenting shareholders may have the right to file an appraisal claim, which theoretically ensures—again through a judicial proceeding—that minority owners receive fair value for their shares.  In a perfect world, these protections should act in concert to get the balance right.

Unfortunately, this three-part framework has not been very satisfying in practice.  Disclosure seems like a reasonable idea, but it often does not have much practical effect and is subject to loopholes.  Judicial review of fiduciary duties in freezeout mergers is messy, at least in Delaware, because inconsistent standards attach to similar economic transactions:  Courts will either adopt a strict “entire fairness” standard or award defendants the protection of the deferential “business judgment rule” depending on whether the deal is structured as a statutory merger or a tender offer.  And the appraisal remedy has long been criticized as a weak cure due to its stringent (and outdated) procedural requirements and its protracted use of costly adversarial litigation to value shares.

So if the current legal framework is not working, how should we deal with the freezeout problem?  Are there other sensible ways to divide the levers of power between majority and minority shareholders to help deter abusive deals and facilitate sensible ones?  Better yet, can we create rules that encourage firms to make reasonable tradeoffs themselves, using private contractual arrangements instead of costly judicial resources?

 
II.
Reframing Freezeouts as a Cathedral Problem

Except for the ubiquitous Coase Theorem,¹ there may be no more famous law and economics framework than Guido Calabresi and Douglas Melamed’s “view of the cathedral.”² This line of scholarship—dealing with the design, allocation, and transfer of legal entitlements—shows how rights can be protected either through property rules or liability rules.  Property rules vest the legal entitlement in one party, who may then sell that entitlement to another party if she wishes, but who cannot be required to sell it.  Liability rules, by contrast, allow the second party to force the first party to sell the entitlement at a judicially determined price.  Under either rule, the entitlement should end up with the party who values it most.

The freezeout problem can be perfectly mapped onto the cathedral framework by conceptualizing the right of minority shareholders to block a freezeout—or, alternatively, the right of a majority controller to conduct one—as a legal entitlement.  A property rule would unconditionally award minority owners the right to block a freezeout merger, which is effectively what the unanimous merger voting requirements of the early 1900s accomplished.  A liability rule, by contrast, gives the entitlement to conduct a freezeout merger to the majority shareholder, subject to the dissenting minority shareholders receiving a judicially determined price under appraisal.  The switch from unanimous shareholder voting to majority rule with appraisal rights can thus be understood as a move from a property regime to a liability regime for freezeouts.

This model is helpful in the freezeout context because recent work in this area has started to show how it is possible to parse legal entitlements even more finely.³ Instead of adopting a strict property or liability rule for freezeouts, we should consider intermediate strategies where embedded options are used as a form of mechanism design to award partial rights to each side.  If successful, this compromise might help to balance the dual concerns of holdout and expropriation by smoking out the concealed subjective valuations that form the heart of the freezeout problem.

The main idea is to replace a naked entitlement with a conditional one where the party receiving the entitlement has an obligation to write the other parties their own option as an additional part of the exercise price for the entitlement.  For example, a factory could be given a liability entitlement to pollute on neighboring land, but only if it writes the neighbor an option to purchase this entitlement at a strike price reflecting the factory’s subjective valuation of this right.  In other words, a privileged party is not just an option taker but also an option maker.  This means that those not receiving the entitlement would be allowed (and may be willing) to “buy back” the right under certain conditions.  The ultimate goal is to move away from judicial determination of an entitlement’s value by encouraging the parties to set private mechanisms (embedded options) that elicit their relative subjective values.  That is, laws are used not to allocate or price an entitlement, but rather to persuade private parties to expose their subjective valuations.

 
III.
Pressing an Internal Poison Pill

Along these lines, I believe that a new type of economic instrument can better balance the tension between majority and minority shareholders in the freezeout context.  I call it an “internal poison pill”—in obvious reference to the antitakeover device that famously sets the balance of power between target firms and third-party acquirers in the hostile takeover context.  An internal poison pill is similar to its cousin in that it seeks to craft economic disincentives to the trampling of the rights of impacted shareholders (minority owners in this context) as a way of restoring balance to merger deliberations.  Indeed, a traditional “external” poison pill (with only slight modifications) might be used to address this problem, although this is not the approach that I ultimately recommend.

Instead, I argue that a more flexible, though weaker, “internal” pill can offer a better compromise than the conventional medicine.  The focus of my proposed modification is on the power of redemption.  The main trick is to use embedded options to qualify the pill’s de facto veto power.  For example, as a requirement for exercising the pill’s discounted call option, minority shareholders would be required to write the triggering controlling shareholder an embedded option setting a price under which the minority shareholders’ poison pill rights could be redeemed.  Economic incentives (what I call a “catch”) should also be adopted to discourage the minority shareholders from demanding outrageous terms—such as requiring a redemption payment of $1,000,000 per share.  The procedures and economic incentives of this “internal” pill are more complex than those of a conventional pill; the easiest way to understand how it would work is to set out the basic design in the form of an extended example.

Start with the most elementary of freezeout scenarios.  A firm is divided among thirty-one owners:  a majority controller holding seventy shares and thirty minority owners, each holding one share.  The controller wants to conduct a freezeout and offers $55 per share ($5 above the prevailing market price of $50), conditioned on the tender of at least twenty shares, which would give the controlling shareholder 90% of the shares and unlock the use of a short-form merger to buy the other shares.  Some subset of the minority owners resist this transaction, arguing that the shares are worth more.  One of two things is happening here:  (1) $55 is a fair price and the dissenters are jockeying for more than they deserve; or (2) the shares really are worth more (perhaps because the market price is depressed by threat of expropriation), and the controller is attempting to pay less than she should.

Historically, the 70% owner enjoyed a unilateral option to execute the merger—subject only to the dissenting shareholders’ willingness to file a fiduciary duty lawsuit or seek appraisal rights.  Suppose, however, that the firm has an “internal” poison pill.  This pill contains three main features:  the primary call, the embedded redemption option, and the catch.

 
1.     The Primary Call

Under an internal poison pill, each shareholder receives the right—typically through the issuance of convertible preferred stock—to obtain additional common shares for a discounted price (which I will assume here to be zero for simplicity) if the pill is triggered through a control acquisition (i.e., the contemplated freezeout).  The pill discriminates against the triggering acquirer, however, and she is precluded from exercising her primary call.  So far, then, the pill operates exactly like the “flip-in” feature of a conventional poison pill by making it painfully expensive for the acquirer to trigger these rights.  If five shareholders sell their shares to the controlling shareholder, for instance, the collective stake of the other twenty-five owners doubles to fifty shares, hamstringing the controlling shareholder’s position.

 
2.     The Embedded Redemption Option

Importantly, however, the internal pill also includes an embedded redemption option.  Before suffering any dilution, the controlling shareholder enjoys an opportunity to disarm the pill by redeeming the preferred stock rights.  Any minority shareholder seeking to exercise the primary call must pay a price (in addition to the discounted strike price):  He must write a return option to the triggering controlling shareholder allowing her to redeem the pill by purchasing his common stock at a price set by that minority holder.  For example, “pushover” shareholder A may set a price of $56, “average” shareholder B may set a price of $60, and “hardball” shareholder C may set a price of $100.  If the controlling shareholder is willing to buy any (or all) of these shares at those stated prices, then the attached poison pill flip-in right expires.  Of course, the controller is not obligated to redeem; she simply possesses that option.

The goal of this second feature is to elicit an honest statement from the minority shareholder of her valuation that can be compared to the controlling shareholder’s valuation of the freezeout.  If the shares in this example are really worth $60 (and shareholder B knows this), then B can set his reservation price at $60 through the pill redemption option.  The majority shareholder can then work her way up from the lowest to the highest redemption price and decide whether to buy a 90% stake, which would trigger short-form merger rights.  (There is another important ramification of exceeding this 90% threshold, which I will discuss momentarily.)

 
3.     The Catch

There is one final problem that has perhaps already crossed your mind.  What prevents all minority shareholders from acting like shareholder C, selfishly demanding a very high redemption price in order to keep their pill armed, thereby blocking the merger?  Indeed, greedy shareholder D could set a redemption price of $1,000,000 to virtually assure himself that the controlling shareholder will not redeem his pill.  The third feature of our internal pill, then, needs to address this problem by placing a “catch,” or ceiling, on a minority shareholder’s temptation to exaggerate his subjective value.

This potential solution comes from an insight of mechanism design:  In order to elicit honest valuations, the minority holder must be placed under a veil of ignorance—unaware of whether he will have to buy or sell at his stated price.  Specifically, to mitigate the greedy shareholder problem, the internal pill should contain one last feature:  If the majority shareholder reaches or exceeds the 90% ownership threshold (or, conceivably, some other preset target), then all remaining preferred stock dissolves, and the controlling shareholder gains the right (but not the obligation) to sell shares to each remaining minority shareholder at exactly the price that each minority shareholder just demanded in the redemption option.  This is really just a conditional put option with the price set at the dissenter’s stated valuation.

Giving the controlling shareholder the protection of this catch should discourage minority dissenters from naming outrageous redemption terms.  The controlling shareholder will begin to buy shares (and simultaneously redeem pills) from minority shareholders—starting at the lowest named price and working her way up to a 90% (or more) stake.  She can then force a sale of extra shares on greedy overreachers.  In our earlier example, the controlling shareholder might buy ninety-one shares and sell that one extra share to shareholder D for $1,000,000.  Or, more likely, the threat of releasing the catch would preclude shareholder D from setting an outrageous redemption price in the first place.  After any catch sales are executed, the controlling shareholder can complete the short-form merger to take unified control.

If designed correctly, these (admittedly more complex) securities might be used to elicit and compare the subjective values that each party places on a transaction.  If the freezeout is a rip-off (because the majority shareholder has set an artificially low price), then the internal pill would have bite, and the minority shareholders could receive additional discounted shares—or, more likely, the majority shareholder would not attempt the abusive freezeout in the first place.  If, on the other hand, a minority shareholder is simply stonewalling a sensible deal, he will be unwilling to put his money where his mouth is for fear of springing the catch, and the majority shareholder can economically redeem the internal pill.  This three-part internal pill may seem overly complicated at first, but my longer Article explains the detailed mechanics of the pill and works through a few short scenarios that quickly elucidate the inner gears and springs of the idea.⁴

 
IV.
Concluding Thoughts

Even if the internal pill works as designed, it is fair to ask why a firm would ever wish to implement one.  Indeed, we might expect majority shareholders to resist vehemently any effort to water down their current freezeout prerogative with a more restrictive governance regime.  Yet there are at least three possible reasons to adopt the pill:  (1) It may be in the majority shareholder’s economic interest to do so as a form of precommitment that would increase the value of the company’s stock; (2) private gadfly shareholders or advisory organizations may lobby for the pill; or (3) the law could evolve to encourage or require firms to adopt internal pills.

One of the more exciting developments in economic theory posits that incentive-molding rules can corral parties toward optimal social ends strictly by appealing to their rational self-interest.  If these ideas can be put into practice, it may become possible for policymakers to craft intermediate legal entitlements—somewhere in between the property and liability rules of Calabresi and Melamed—that promote welfare-enhancing substantive outcomes without large administrative costs or expensive litigation.

The device is not flawless, however, and inside information or colluding dissenters may undermine the effects of an internal pill.  Moreover, powerful controlling shareholders could resist adoption efforts.  But there are strong theoretical justifications for promoting internal pills as an improved form of corporate governance.  Lawmakers should consider donning the white coat of pharmacists in order to improve the incentives that influence the ongoing balance between public and private corporate status.

Acknowledgments:

Copyright © 2009 New York University School of Law.

George S. Geis is the John V. Ray Research Professor of Law at the University of Virginia School of Law.

This Legal Workshop Editorial is based on the following Article: George S. Geis, Internal Poison Pills, 84 N.Y.U. L. REV. 1169 (2009).

To reject the axiom of fixed procedural laws, we must make only a small, but crucial conceptual leap.  If we can envision a hybrid process—a public adjudication capable of some degree of private ordering—then perhaps a party should be allowed to opt in or out of certain important procedural laws.  The idea of optional laws seems counterintuitive, if not oxymoronic.  But it is informed by Ronald Coase’s work.  The Coase Theorem proposes that absent transaction cost, parties can efficiently rearrange rights irrespective of their initial assignment.  Like substantive entitlements, procedural laws set forth an initial assignment of rights and obligations that have significant consequences on the value of the suit and the cost to the litigation system.  My thesis is simple:  The immutability of certain procedural rules in public adjudication imposes significant cost and risk on parties, and private rearrangement of procedural rights and duties can yield more efficient dispute resolution.

I.
Proposal

Procedural optionality can mitigate persistent inefficiencies in the litigation system.  Two well-known subsets of the larger problem are studied here, both stemming from the American rule of attorney fees (i.e., absent statute or contract, each party is responsible for his own attorney fees) (hereinafter American Rule).  In the first subset, low value cases, characterized by high probability of liability with low damage amount, are not prosecuted because litigation cost can impose an insurmountable cost barrier.  This problem has an inverse.  In the second subset, plaintiffs pursue low probability frivolous cases to extract an extortionate settlement.  These inverse problems share the same fundamental dynamic:  In each case, the merits may not sufficiently influence the ultimate disposition because the standard of proof and the rule of attorney fees are fixed as legal constants.  Compare this situation to the potential prospects of optional laws.  If the defendant in a frivolous action were able unilaterally to opt for a scheme in which the loser indemnifies the winner’s cost, he could avoid settling with the frivolous plaintiff.  Likewise, if an aggrieved plaintiff in a clearly meritorious but low value action could unilaterally opt for fee shifting, she could economically pursue her claim in court.

The goal is to implement an incentive structure that optimizes enforcement and cost.  To show the efficacy of procedural optionality, I propose a scheme in which each party has the unilateral power to shift fees to the other side (hereinafter English Rule) as long as she bonds her good faith belief by voluntarily assuming a higher standard of proof.  The baseline assumption is that the action is governed by the American Rule and that the civil standard of proof is the preponderance of the evidence standard (hereinafter Default Standard).  The Default Standard can be elevated to a higher standard:  the clear and convincing evidence standard (hereinafter Heightened Standard).  The rules of election are simple.  In a two-party suit, there are two standards of proof and two rules of attorney fees, leaving four possible combination scenarios.

Scenario 1 – No Party Elects: The status quo remains, i.e., the Default Standard and the American Rule apply.

Scenario 2 – Both Parties Elect:  Both the Default and Heightened Standards apply.  Where either party proves his case under the Default Standard, the American Rule applies.  The election of the Heightened Standard becomes a nullity because both parties failed to meet it.  Fee shifting occurs only when one party prevails under the Heightened Standard, in which case fees are shifted to the loser in a manner consistent with the English Rule.

Scenario 3 – Plaintiff Elects:  The plaintiff unilaterally imposes a one-way fee shifting rule on the defendant but can only win by proving her case under the Heightened Standard, upon which fees are shifted to the defendant.  This means that if the plaintiff proves her case only under the Default Standard, the defendant still prevails, though he is not entitled to fee shifting.

Scenario 4 – Defendant Elects: The defendant unilaterally imposes a one-way fee shifting rule on the plaintiff, but can only win by proving his case under the Heightened Standard, upon which his fees are shifted to the plaintiff.  This means that if the defendant fails to meet the voluntarily assumed Heightened Standard, the plaintiff will win even if she fails to prove her case under the Default Standard, though she will not be entitled to fee shifting.

These simple rules of election and bonding allow the parties to reorder the value, cost, and risk of a case.  The following table summarizes these election rules and their consequences.

II.
The Bond

A scheme of optional laws would quickly unravel into an anarchist’s impasse absent bonding of the parties’ good faith.  The bond must be priced correctly.  There must be proportionality between incentive and deterrence such that the effects of self-interested and strategic behavior serve a normative social goal, or at least minimally conflict with it.  The bonding proposed here facilitates better conveyance of information.  The act of election signals that the electing party has significant information, is confident of the completeness of that information such that variance is not a large concern, and believes in good faith he is likely to succeed.  This information is valuable.  It is reliable because a party voluntarily imposes a substantial cost on himself to communicate it, namely the assumption of a higher standard of proof.

An election materially changes the prospects of a case, and as such the decision to elect is no small matter.  It requires a complex calculus involving several factors.  An election necessarily reduces the expected success of a case, and there is a net benefit only if the benefit of fee indemnity outweighs this risk-related cost.  An election also reconfigures the risk profile of a case.  Parties will elect only when they are highly confident in their assessments of the case, which corresponds to a high level of probability and information.  Moreover, attorneys have significant say in the management of a case, and they will generally not be inclined to opt for a reduction in the probability of success.  Where probability of success is not a significant issue or fee shifting would create a new business opportunity (i.e., open up a class of cases that are otherwise economically infeasible), an attorney’s incentive is more closely aligned with the client’s interest.  This set of unique conditions is met in two types of cases—low value but highly meritorious actions and patently frivolous actions.

III.
Result

Since most cases do not fit this profile, the most likely choice in the vast majority of cases is no election at all, resulting in the status quo of the American Rule and the Default Standard.  In a small but significant class of cases, one party will believe it has a strong chance of winning and will elect, resulting in potential one-way fee shifting.  Lastly, since belief that there is a high probability of success is a natural condition of election, the English Rule (with its corresponding Heightened Standard) will be seldom invoked through bilateral choice.

Any procedural innovation should be feasible and practical.  There are several aspects to administering this proposal.  First, simultaneous disclosure of election is required to ensure procedural symmetry.  Serial disclosure leads to information asymmetry, unfairness, gamesmanship, and possibly costly judicial intervention.  Second, an election must be irreversible.  A bond is worthless if it is redeemable by the obligor, whether at will or upon the occurrence of some contingency.  Third, the application of two standards of proof requires particular findings of facts as to different claims and defenses.  In a two-party, multi-claim litigation, each claim and defense must be individually subject to election (likewise in multi-party single-claim litigation).  As a result of this, complex multi-party litigation may be infeasible.  The complexity of multi-party, multi-claim litigation increases nonlinearly with additional claims and parties, and the administrative cost will quickly outweigh the benefits of private ordering.  Lastly, the timing of the election is crucial.  There are two competing policies at work:  Parties should make their election with the most complete information possible but should expend the least amount of transaction cost.  The balance of these competing policies suggests that an election should be made at some time during discovery and that discovery could, perhaps, be bifurcated to facilitate the process by allowing the parties to elect at the end of the first stage of information gathering.

IV.
Policy Implications

Procedural optionality raises several policy implications.  It solves two recurring problems of litigation:  prosecution of frivolous lawsuits and nonprosecution of low value cases.  These cases form the bookends of the spectrum of litigation.

Frivolous actions are most problematic in the early phases of litigation.  They are characterized by the occurrence of needless cost in the beginning followed by an extortionate settlement or dismissal later.  Parties, not courts, should determine the issue of frivolity.  The only justification for a judicial determination is that they are neutral arbiters, a rather uninspiring reason given the cost associated with achieving a degree of information parity between the parties.  Adjudication of frivolity is a blunt instrument that undermines the policy of cost mitigation.  In truth, the parties are in the best position to recognize a frivolous suit.  My proposal solves this problem by forcing the parties to reveal whether they believe the case is frivolous.  If the case is frivolous, the defendant will elect for fee shifting and the plaintiff will not.  The defendant’s election is a trustworthy signal because it comes at the cost of the voluntary assumption of a higher standard of proof, which will be the most efficient price of bonding if the action is indeed meritless.

Procedural optionality also facilitates better adjudication of the low value cases, essentially the inverse of the marginally frivolous suits.  The problem is that low value cases, while meritorious, are not economically feasible.  This means that the culpable defendant can systematically escape liability if the harm is sufficiently low.  If a plaintiff with the low value claim does not want to risk significant cost, she must find a means to spread the risk and cost.  The class action was designed for this type of situation.  But it is not a readily available option in many disputes, such as those in which plaintiffs are not similarly situated.  Procedural optionality provides an alternative to the traditional class action and the forced waiver of a legitimate action due to economic infeasibility.  It enables an entire class of valid suits by removing the economic barrier.  Moreover, procedural optionality as an alternative to class actions, at the margins of litigation, may help to reduce the agency cost problem of class attorney fee and settlement practices.

Conclusion

If the parties are allowed to privately order the procedural rules to better reflect the value, risk, and cost profile of a case, the system of public adjudication can help the parties reach a more efficient settlement.  A conceptual barrier between private resolution and public adjudication is needlessly formalistic.  The problem with the application of inalienable rules of law, such as the American and English Rules, is that each rule works well in some circumstances, but not in others.  Fixed rules of law can impart costs on the litigation system.  Once public adjudication is selected, many decisions affecting the allocation of value, cost, and risk should be subject to private ordering as long as strategic behavior is minimized through a bonding requirement.  It is a mistake to equate private ordering of disputes with settlement.  The former is a process, the latter an outcome.  Private ordering of a dispute is achieved when the parties are allowed to unilaterally rearrange the procedural rules governing public adjudication so as to reach an efficient result at the lowest private and social cost.

The theoretical potential of procedural optionality is seen when it is applied to the regime of attorney fee rules.  There is no reason why the criterion for the assignment of these rules should be limited to the class of the case or underlying substantive entitlement.  In the ideal world, an important consideration in the assignment of the fee rule would be case merit.  We have assumed thus far that rulemaking tailored to the unique circumstances of a case cannot be done in public adjudication.  The habit of thought has been to propose solutions requiring sovereign intervention through general rulemaking and uniform application.  This Editorial provides a different approach:  Instead of intervening directly, the sovereign can permit the parties to choose the procedural scheme in public adjudication.  When parties are allowed to reorder procedural rules after their initial assignment, dispute resolution can be more efficiently achieved, both at the settlement table and in the courtroom.

Acknowledgments:

Copyright © 2009 New York University Law Review.

Robert J. Rhee is Associate Professor of Law at University of Maryland School of Law.

This Legal Workshop Editorial is based on the following Article:   Robert J. Rhee, Toward Procedural Optionality: Private Ordering of Public Adjudication, 84 N.Y.U. L. REV. 514 (2009).

The identification of intense preferences is clearly crucial when a market for the relevant entitlement does not exist or when there is a significant risk of market failure.  In such cases, we cannot rest assured that voluntary transactions would eventually transfer goods to those who desire them most.  Identification is important, however, also in circumstances where functioning markets exist.  Rules directly addressing the needs of individuals with strong preferences can economize on transaction costs and increase the resultant efficiency gains, while simultaneously avoiding the market’s inherent bias against those unable to pay.

The detection of intense preferences is a difficult task.  For example, people asked to verbally state the strength of their preferences may lie in order to improve their position.  The Law-and-Economics literature has largely focused on a narrow, though important, aspect of this identification issue.  Much attention has been devoted to the case of owners’ subjectively high valuation of land, primarily in the context of compensation for takings.  It was proposed, for instance, that compensation be determined according to owners’ self-valuations (declared either in advance, before any conflict has arisen, or after the government considers expropriation of the property).  Such devices as basing property taxes on self-assessments and requiring future sale prices to at least equal self-declared values would achieve truthfulness.  Alternatively, owners selling their property below their former evaluation would have to pay the difference to the government or to their favored charity.  This literature can be characterized by three features: It requires case-by-case inquires, involves monetary payments, and employs sanctions to ensure people’s truthfulness.

This Article argues that the land-valuation problem is but a specific manifestation of a much broader concern.  The need to identify intense preferences may arise in all fields of law and with respect to all types of entitlement.  More importantly, additional and fundamentally different methods can be used to discover strong preferences.  For example, identifiers can be generalized rather than case-specific, thus dispensing with the need for ad-hoc examination of individual cases.  That is to say, we can generalize about circumstances in which intense preferences are likely to exist and incorporate the relevant proxies—such as use value, possession, or declining marginal utility—into the legal rules themselves.  Furthermore, identifiers may entail burdens in-kind rather than monetary costs, thereby reducing a bias in favor of the rich.  Thus, instead of detecting strong preferences via individuals’ willingness to pay, we may reveal them through their readiness to sacrifice time, effort, or honor.  Finally, identifiers may adopt non-penalizing—instead of penalizing—approaches.  Detection of intense preferences can sometimes be achieved without taxing the subjective, unique utility that people obtain from entitlements.  Individuals need not hand over some (or all) of this special value as proof that strong preferences indeed exist.

The goal of the Article is twofold.  First, it demonstrates how legal rules can, and do, employ generalized and non-penalizing (“GNP”) devices to identify intense preferences.  Second, it argues for the superiority of GNP identifiers over other identification methods.

The major feature of GNP identifiers is that they do not tax, neither in money nor in kind, the exceptional utility that some individuals derive from entitlements.  GNP devices are based on observations, experience, or studies of human nature and behavior.  They represent judgments about what most people would feel or prefer in certain scenarios.  This type of identifier has not received systematic theoretical treatment and has not been sufficiently utilized in practice.  Prime examples of non-penalizing proxies for strong preferences are the following:

• Use value vs. exchange value: Preferences regarding property are likely to be more intense when an individual holds the property for her own (and continuous) use than when she holds it for exchange or when she subsequently chooses to part with it, for instance, by sale. It is possible to locate circumstances in which use value exists and to protect owners against involuntary injury to this value.
• Possession: Possession is often a good proxy for intense preferences. Therefore, by limiting the exercise of certain rights to possessors, one assures that only people with strong preferences are entitled to use them.
• Declining marginal utility: According to this well-known economic rule, the amount of extra utility enjoyed from every additional unit of a good usually declines as a person consumes more of the good. Thus, when allocating goods between individuals, we may sometimes reasonably assume that the incremental utility from having the good would be larger for persons with fewer units of the good.
• Redemption: Rights of redemption detect strong preferences because they are rights that only, or mostly, people with intense preferences would use. The actual redemption of an asset both identifies the strong preference and fulfills it.
• Reasons: Requiring individuals to provide reasons for their preferences may help assess both the intensity and authenticity of the preferences.

The above identifiers of intense preferences can be found in diverse legal fields and contexts.  They constitute a hidden common denominator of such dissimilar rules as those governing rights of first refusal, takings compensation, damages in contract law, self-help remedies, adoption, bankruptcy exemptions, secured transactions, and conscientious objection.  Current law has not exhausted the potential for crafting GNP identifiers, and additional rules of this kind can be adopted.  The full-length article in the Cornell Law Review offers various examples of such desirable new rules.

This Article further argues that GNP identifiers have various advantages that other techniques for detecting strong preferences lack, either wholly or in part.  The Article compares GNP devices with four alternative methods, all of which are used in practice:

• “Mouth“: Preference-intensity is revealed through people’s verbal statements alone, as in public opinion polls, contingent valuation questionnaires, and quality-adjusted life year surveys.
• “Mouth & Purse“: Strong preferences are identified through verbal statements backed up by monetary sanctions, as employed in self-assessment mechanisms for land valuation.
• “Generalized and Penalizing“: Generalizations regarding cases of strong preferences that utilize people’s readiness to bear in-kind sanctions. For instance, a strong preference for receiving welfare benefits can be conditioned on willingness to go through a grueling and humiliating bureaucratic process.
• “Case-Specific and Penalizing“: Case-by-case detection of intense preferences through individuals’ willingness to incur non-monetary burdens. A prime example is logrolling or vote trading, which identifies strong preferences on a certain issue by readiness to bear the cost of not realizing a weaker preference on another issue.

The Article demonstrates that the GNP technique is, overall, the superior identification method since it is the only one that scores highly on all six parameters of evaluation.  GNP identifiers treat people with dignity and respect and are in no way insulting or humiliating.  They afford equal treatment to individuals’ preferences by not imposing heavier burdens on people with intense preferences (vertical equity) and by treating all individuals with strong preferences equally (horizontal equity).  Furthermore, GNP identifiers are not biased in favor of more affluent people and also reduce the risk of lies.  Finally, the GNP method entails relatively low administrative costs and is capable of dealing with objectionable preference-intensities (such as excessively high intensities of preferences).  The other four methods fail on more than one of these grounds.

For all these reasons, the role played by GNP identifiers should be expanded by the law and rules utilizing them should be adopted whenever possible.  Generalized and Non-Penalizing identifiers are feasible, for example, whenever one can generalize that a certain proxy-such as use value, possession, declining marginal utility or redemption—succeeds in capturing cases in which systematically high preference—intensities are likely to exit.  GNP devices are especially suitable when all one needs is an affirmation that an intense preference exists, or a relatively “rough” comparison between stronger and weaker preferences, rather than an exact quantification of the preferences’ strength.  This may explain why “Mouth & Purse” techniques have been suggested in the literature with respect to compensation for takings of land.  In compensation scenarios, we ideally seek the “magic number,” which represents the individual’s true valuation of an asset or the precise extent of her losses.  Nevertheless, GNP identifiers—which compensate landowners with high subjective valuation by granting them some fixed percentage (e.g., 50%) above market price—may be superior even in this context.  The relative crudeness of such a compensation formula is offset by the many advantages of GNP devices.  Moreover, the significant shortcomings of penalizing identifiers have been ignored or downplayed, while the impressive advantages of GNP identifiers have been overlooked in the theoretical literature.  We should therefore create additional rules that utilize GNP techniques.  In closing, the Article demonstrates that the GNP method’s value is not limited to the detection of high intensity preferences, but can also apply to low intensity preferences.  Proxies for exceptionally low valuation of entitlements can also be incorporated into legal rules.  A good example is the proxy of “non-use,” which is a reliable identifier of weak preferences with respect to trademarks, rent-controlled housing, and servitudes.

Acknowledgments:

Copyright © 2009 Cornel Law Review.

Daphna Lewinsohn-Zamir is Louis Marshall Professor of Environmental Law at Hebrew University of Jerusalem.

Special thanks to Greg Alexander, Hanoch Dagan, Lee Fennell, Robert Ellickson, Amnon Lehavi, Barak Medina, Gideon Parchomovsky, Ariel Porat, Stephanie Stern, Joseph Singer, Doron Teichman, Eyal Zamir and participants in the Property Works in Progress Conference, University of Colorado Law School, and Faculty Workshops at Cornell Law School, Interdisciplinary Center (IDC) Herzliya, and Tel-Aviv University, for very helpful comments and suggestions. Thanks to Yehoyada Mande’el for excellent research assistance.

This Legal Workshop Editorial is based on the following full-length Article:   Daphna Lewinsohn-Zamir, Identifying Intense Preferences, 94 CORNELL L. REV. ___ (2009).

In this Article, I suggest that trade secrets can be justified as a form, not of traditional property, but of intellectual property (IP). The incentive justification for encouraging new inventions is straightforward. Granting legal protection for those new inventions not only encourages their creation, but enables an inventor to sell her idea. And while we have other laws that encourage inventions, notably patent law, trade secrecy offers some significant advantages for inventors over patent protection. It is cheaper and quicker to obtain, since it doesn’t require government approval, and it extends to protection of types of business and process information that likely would not be patentable.

It seems odd, though, for the law to encourage secrets, or to encourage only those inventions that are kept secret. I argue that, paradoxically, trade secret law actually encourages disclosure, not secrecy. Without legal protection, companies in certain industries would invest too much in keeping secrets. Trade secret law develops as a substitute for the physical and contractual restrictions those companies would otherwise impose in an effort to prevent competitors from acquiring their information.

The puzzle then becomes why the law would require secrecy as an element of the cause of action if its goal is to reduce secrecy. I argue that the secrecy requirement serves a channeling function. Only the developers of some kinds of inventions have the option to overinvest in physical secrecy in the absence of legal protection. For products that are inherently self-disclosing (the wheel, say, or the paper clip), trying to keep the idea secret is a lost cause. We don’t need trade secret law to encourage disclosure of inherently self-disclosing products—inventors of such products will get patent protection or nothing. But if trade secret law prevented the use of ideas whether or not they were secret, the result would be less, not more, diffusion of valuable information. The secrecy requirement therefore serves a gatekeeper function, ensuring that the law encourages disclosure of information that would otherwise be kept secret, while channeling inventors of self-disclosing products to the patent system.

My argument has a number of implications for trade secret policy. First, the theory works only if we treat trade secrets as IP rights, requiring proof of secrecy as an element of protection. If we give the protection to things that are public, we defeat the purpose and give windfalls to people who may not be inventors (what we might call “trade secret trolls”). Courts that think of trade secret law as a common law tort rather than an IP right are apt to overlook the secrecy requirement in their zeal to reach “bad actors.” But it is the courts that emphasize secrecy, not appropriation, as the key element of the cause of action that have it right. Second, an IP theory of trade secrets also encourages preemption of “unjust enrichment” theories and other common law ways courts are tempted to give private parties legal control over information in the public domain. Thus, an IP theory of trade secrets is in part a “negative” one: the value of trade secret law lies in part in defining the boundaries of the cause of action and preempting others that might reach too far. Analyzing trade secret claims as IP claims rather than common law contract or tort claims requires courts to focus on what the law is protecting, how, and why—something the common law did not do. As a result, the unified trade secret approach does not expand, but rather cabins, the overbroad reach of the common law.

I.
Constructing an IP Theory of Trade Secrets

Trade secrets are best understood not as applications or extensions of existing common law principles (warranted or unwarranted), but as IP rights. In this Part, I explain the two critical features trade secrets share with other IP rights—they promote inventive activity and they promote disclosure of those inventions. I then seek to explain the most significant anomaly—the requirement of secrecy.

A.     Incentives to Invent

Trade secret law confers an exclusive right on the possessor of valuable information not generally known to or readily ascertainable by competitors. Exclusivity is the hallmark of an IP right. Both patents and copyrights confer similar rights to prevent use by others on the developers of new and valuable information. In so doing, patents and copyrights are generally acknowledged to serve a utilitarian purpose—the grant of that legal control encourages the development of new and valuable information by offering the prospect of supracompetitive returns, returns possible only if the developer does not face competition by others who use the same idea. In this way, patents and copyrights avoid the risk of underinvestment inherent with public goods, which are more costly to invent than to imitate once invented.

Trade secrecy has the same effect. It gives the developer of new and valuable information the right to restrict others from using it, and therefore the prospect of deriving supracompetitive profits from the information. This may be true of business as well as technical secrets, since some protection for business ideas helps ensure a first-mover advantage for those who take risks on untested business models. True, the right of exclusion in trade secret law is not absolute. The trade secret owner cannot sue someone who develops the idea independently, or who reverse engineers a product on the open market to learn the secret. But the same is true of copyright law. A right to exclude does not have to be absolute to be effective in rewarding and therefore encouraging innovation. It need merely provide sufficient advantage in terms of lead time or relative costs to minimize or eliminate the public goods problem.

The additional incentive provided by trade secret law is important for innovation. Trade secret law reaches into a number of corners patent law cannot. The definition of trade secret (valuable information) is broader than the definition of patentable subject matter, for example, protecting business plans, customer lists, and so-called “negative know-how” against use by others. Patent law cannot protect valuable information of that sort. Further, inventors must apply for patents, publish their applications after eighteen months, and then wait perhaps four years for the Patent and Trademark Office to decide whether to grant protection. That significant delay renders patents unavailable as a practical matter in fast-moving industries. Trade secrets, by contrast, are automatically protected upon creation provided the requirements of the statute are met. Finally, patent litigation is as much as three times as expensive as trade secret litigation, with a price tag—a median of $5 million per side in legal fees for large cases—that puts it out of reach of many small firms. Small wonder, then, that economic literature suggests that some firms, particularly start-ups, rely heavily on the incentive to invent provided by trade secret law. In many cases patents are simply not an adequate substitute.

Trade secret law also reaches where contract alone cannot. Trade secret law precludes acquisition of information by strangers using improper means—computer hacking and other forms of corporate espionage. Further, it extends the reach of the law beyond privity of contract to anyone who comes into contact with a secret knowing that they have acquired it by accident, mistake, or by another’s malfeasance.

B.     Incentives to Disclose

Patent and copyright law do not exist solely to encourage invention, however. A second purpose—some argue the main one—is to ensure that the public receives the benefit of those inventions. There is decent evidence to support the idea that at least one function of an IP right is not just to encourage new invention, but to encourage the dissemination of those new ideas.

At first blush, trade secret law seems to push in the opposite direction. After all, protection under trade secret laws is conditioned on secrecy, and so it seems to encourage secrecy, or at least the development of inventions that can be kept secret. Paradoxically, however, trade secret law actually encourages broader disclosure and use of information, not secrecy. It does so in two ways. First, the legal protection trade secret law provides serves as a substitute for investments in physical secrecy that companies might otherwise make. The facts of E. I. du Pont de Nemours & Co. v. Christopher² provide an example. There, the plaintiff was constructing a chemical plant, and during construction it was apparently possible to see the layout of the plant from the air and so to discern the secret process du Pont was using. The court noted that du Pont could have built a temporary roof over the plant during construction, but only at “enormous expense.” It didn’t need to build that roof because the law protected its interest in avoiding (aerial) prying eyes. Had the law not done so, however, it is reasonable to suppose that du Pont might have built the roof rather than risk loss of its trade secrets. That investment in secrecy would have been inefficient; it is cheaper (both for du Pont and for society) for the law to provide that protection. And even if the investment in secrecy were efficient for du Pont in the absence of the law, it would still impose a social cost by restricting the flow of information—a cost du Pont would have no reason to take into account.

There is empirical evidence that overinvestment in secrecy is a real problem in the absence of trade secret protection. Examples can be found as far back as the guild system that pervaded Western economies in the Middle Ages. Guilds were places that could and did develop technical knowledge, but in the absence of legal means to protect that knowledge they went to great lengths to prevent others from learning of it, imposing draconian limits on the mobility of employees and the development of competing firms. The same problem remains today in countries that do not provide legal protection for secrets. Robert Sherwood studied business practices in Mexico and Brazil, two countries that do not have strong legal protection for trade secrets and in which resort to the courts may not be viable for a variety of reasons.³ He found that companies in those countries make business decisions that inefficiently limit the disclosure of information because they fear that they cannot rely on the courts to prevent the use of information they do disclose. For example, they may be less willing to contract production out to third parties if it means giving out information about secret processes, even where the third party could use the process more efficiently. They may take elaborate security measures, building walls and fences and hiring armed guards. And they may hire employees whom they expect to be loyal—such as family members—rather than strangers who would do a better job.

The problem also remains for products or industries that do not qualify for IP protection. Michael Pollan explains that the developers of new breakfast cereals, for example, engage in enormous efforts to protect the secrecy of their new ideas in order to gain a few months’ first-mover advantage. For the same reason, they operate their own machine shops to design the cereals, rather than outsourcing that work to those presumably more specialized in it.⁴

None of this evidence is perfect. One of the problems with social science is that it is hard to run clean tests in the real world. Nonetheless, there are both logical and evidentiary reasons to believe that, without legal protection, companies in certain industries would invest too much in keeping secrets. These investments are inefficient, in several senses. In many cases, the problem they address could be avoided by the courts at lower cost than the building of walls and fences. Second, physical investments must be made for each secret, while legal investments need be made only if there is misappropriation. That means that even if a physical investment in secrecy is individually cheap, in the aggregate the cost of having to make that investment for every secret may outweigh the cost of resort to law, which will be necessary only in those few cases in which the secret is actually misappropriated. Finally, and most importantly, restrictions on the flow of information between business partners or to new employees slow the process of commercialization and improvement of the secret inventions, and therefore interfere with both the invention and disclosure functions of IP law. Trade secret law developed as a substitute for the physical and contractual restrictions those companies would otherwise impose in an effort to prevent a competitor from acquiring their information. In so doing, it encourages disclosure of information that companies might otherwise be reluctant to share for fear of losing the competitive advantage it provides.

To be sure, trade secret law still encourages some secrecy. So if the alternative were a world in which companies freely disclosed their inventions, that world might be preferable. But the empirical evidence suggests that is unlikely to be the alternative. Rather, a world without trade secret protection is likely to have more, not less, secrecy.

Trade secret laws can encourage disclosure in a second way as well: they serve as a partial solution to Arrow’s Information Paradox. The paradox is this: In the absence of any legal protection, the developer of a potentially valuable but secret idea will have a difficult time selling that idea to someone who could make more efficient use of it. In order to sell the idea he will have to disclose it to allow the buyer to evaluate it, but disclosing it destroys the value inherent in its secrecy. To see this, imagine that I tell you I have a great idea, and I’ll share it with you for $1 million. Should you take the deal? You can’t know the answer to that question unless I tell you what the idea is. But in the absence of legal protection, if I tell you what my idea is, you no longer need to pay me $1 million.

Now add trade secret law (or any IP right) to the picture. The existence of a legal right to prevent others from using or disclosing my idea in breach of a confidential relationship allows me to disclose the idea in precontractual negotiations, secure in the knowledge that the other side is not free to take the idea without compensating me. The law, by giving certain rights to the holder of the secret, allows him to disclose information he would otherwise have been unwilling to share, and therefore permits business negotiations that can lead to commercialization of the invention or sale of the idea, serving both the disclosure and incentive functions of IP law. True, the parties could have entered into a contract limiting what could be done with the information, but the putative buyer may be reluctant to sign such a contract without knowing what they might be limiting themselves from using. Both venture capitalists and Hollywood executives, for example, are notoriously unwilling to sign nondisclosure agreements before reading business plans or movie scripts. Trade secret law reaches beyond contract law by allowing courts to infer the existence of a confidential relationship from circumstances in which transactions might be difficult or impossible without that assumption.

C.     Channeling Protection Between Patents and Trade Secrets

So far, so good. But at this point the reader might object that, if the goal of trade secret law is to give legal rights over an invention while encouraging its disclosure, we don’t really need the secrecy requirement at all. In this vein, a number of scholars have suggested that any investment in protecting trade secrecy is wasted, since the law is requiring companies to spend money in ways that reduce, not increase, the dissemination of ideas. If the goal of trade secret law is to encourage dissemination by giving the security of a legal right, this argument runs, why not just grant that right to any information, regardless of whether it is secret?

The problem with this argument is that without some basis for defining the legal right, it will sweep too broadly. If I can get ownership rights in any information, no matter how public, the result will be to deter, not promote, the dissemination of that information. Broad legal rights may restrict employee mobility, with negative consequences for the economy. If any idea, no matter how public, is subject to a claim of legal rights, individuals and companies will reasonably worry about using any information they do not themselves develop. If I could sue you for repeating my explanation of trade secret law, the result is not likely to be wide discussion of that explanation, even if I have no intention of actually suing you for discussing my idea.⁵ And while we could theoretically substitute a defendant’s conduct for proof of secrecy as the basis for entitlement to a legal right, such conduct-based definitions are circular—competition is unfair if it is likely to be defined by courts as unfair—and ultimately empty.

Granted that we need some definition of the entitlement, why secrecy? The answer, I believe, is that the secrecy requirement serves to channel inventors into the appropriate form of IP protection. Consider three different types of inventions: one that is impossible to conceal once it is in widespread use (think of the wheel or the paper clip), one that is impossible to discern by evaluating the product (think of the formula for Coca-Cola), and one that can be discerned by evaluating the product, but only with difficulty (think of software source code, which is not evident from the object code sold to customers but which might be reverse engineered). In a world with patent law but no trade secret law, companies with inventions in the first category—those who have developed inherently self-disclosing inventions—will turn to patent law if they can. If not, they will be out of luck. If the paper clip were not patentable, companies wouldn’t be able to keep it secret and still make much profit from it. Their best option would likely be to sell the paper clip and hope to make some profit from brand recognition or first-mover advantages.

Companies with inventions in the second category, by contrast—those who develop inventions that are not transparent to the world, such as chemical processes and some formulas—might well decide to keep an invention secret in the absence of legal protection. They may reason that secrecy may give them a greater advantage than patent law, since patents may be held invalid, may be easy to design around, and in any event will expire within twenty years. Indeed, there is some empirical evidence that they do so—that where secrecy is possible, inventors choose it over patent protection. Without trade secret law, the efforts those companies take to protect their secrets may be excessive. That overinvestment may be specific—protection of a particular idea—or general—imposing too many restrictions on employees and business partners. Either way, the result is both inefficiency from overinvestment in secrecy and the loss of the benefits of public disclosure of information.

A secrecy requirement provides protection to companies in the second category, not in the first. Thus, it ensures that trade secret law provides legal protection in circumstances in which inventors might otherwise choose excessive secrecy, but denies protection to inventions that companies would not keep secret in the absence of patent protection. By drawing this line, even the secrecy requirement of trade secret law has the surprising effect of reducing, not increasing, the secrecy of inventions.

What, then, of inventions in the intermediate category? Companies with inventions in this third category might or might not rely on secrecy rather than patent law. Both approaches have risks. As noted above, patents might be invalid, or easy to evade, and in any event will expire in a set period of time. On the other hand, reliance on secrecy provides only tenuous protection, since the secret could be discerned by reverse engineering or independent development or disclosed by an employee or business partner in the absence of trade secret law. In this case, the effects of introducing trade secret law are ambiguous. If companies in this third category would have opted for secrecy, then the introduction of trade secret law reduces the negative effects of that secrecy for the same reasons it did in the second category. But if they would have opted for patent protection rather than secrecy without law, adding trade secret law might encourage them to keep secret information they would otherwise have patented (and therefore disclosed).

To avoid inadvertently encouraging secrecy rather than disclosure, trade secret law incorporates limits on the scope of the right, notably the defenses of independent development and reverse engineering. As the Supreme Court suggested in Kewanee Oil Co. v. Bicron Corp.,⁶ and as commentators have suggested, these defenses weaken the trade secret right sufficiently that it does not entice inventors to choose secrecy over patent protection. That isn’t always true, of course; the inventors of Coca-Cola could have chosen to patent it but didn’t. But importantly, weakening trade secrets means that those in the intermediate category are unlikely to choose secrecy over patenting. Taken together, the secrecy requirement and the relative weakness of the trade secret law help ensure that the law protects those who would otherwise rely on secrecy without law, and encourages disclosure in those cases, while not displacing patent law as the means of protection for self-disclosing inventions. Put another way, the secrecy requirement channels particular inventors to the form of IP protection that best achieves the goals of society.

II.
Implications for Trade Secret Law

The IP theory of trade secret rights has several implications for the development of trade secret doctrine.

A.     The Centrality of Secrecy

One implication of the theory I articulated in Part I is that the requirement of secrecy is not an accident or a mistake. It is a central part of what makes trade secret law work. A significant benefit of thinking of trade secrets as IP rights rather than as unfair competition torts is that it puts the focus of the legal inquiry first and foremost on whether the plaintiff has an IP right at all. The UTSA, for example, defines the legal rights of trade secret owners by requiring the existence of a secret and defining what constitutes a secret. Doing so prevents plaintiffs from ignoring or glossing over proof of the existence of a trade secret in their effort to prevent what they see as improper use of their information.

This point may seem obvious—of course winning a trade secret case requires the plaintiff to prove the existence of a trade secret. But in fact a number of cases and commentators that have applied the tort theory of trade secrecy have minimized or even ignored that requirement. The Supreme Court itself led courts astray in E.I. du Pont de Nemours Powder Co. v. Masland, where it said that “[w]hether the plaintiffs have any valuable secret or not, the defendant knows the facts, whatever they are, through a special confidence that he accepted. The property may be denied, but the confidence cannot be.”⁷ A number of courts applying the Restatement of Torts have followed the lead of the Masland dictum, holding that defendants misappropriated trade secrets by acquiring or using a secret by improper means or in breach of a confidential relationship without determining that the information was itself a secret at all. An example is Smith v. Dravo Corp., in which the defendant had clearly made use of information obtained from the plaintiff during acquisition negotiations in later entering the market in competition with the plaintiff.⁸ The court found liability on the basis of the defendant’s admittedly troubling business behavior. But in doing so, the court elided the distinction between the use of information that was truly secret, such as the plaintiff’s confidential patent applications, and information that was readily accessible to the public, such as the dimensions of plaintiff’s shipping containers that were already on the market.

There are a number of other examples. In United States Sporting Products, Inc. v. Johnny Stewart Game Calls, Inc.,⁹ for example, the court held that publicly sold, uncopyrightable recordings of bird calls were protectable. The court focused on the labor the plaintiff had put into collecting them, but ignored the fact that they were not secret. In Rohm & Haas Co. v. Adco Chemical Co.,¹⁰ the court ignored the fact that the defendant’s alleged secret process was in fact disclosed in a number of industry publications because it found that the defendant did not in fact learn the information from those publications, but instead from the plaintiff. And in Franke v. Wiltschek, the Second Circuit elevated this idea to a general rule based on Masland:

It matters not that defendants could have gained their knowledge from a study of the expired patent and plaintiffs’ publicly marketed product. The fact is that they did not. Instead they gained it from plaintiffs via their confidential relationship, and in so doing incurred a duty not to use it to plaintiffs’ detriment. This duty they have breached.¹¹

These courts have departed from the principle of trade secrets as IP rights. Perhaps they are blinded by the defendant’s suspicious conduct, or perhaps they view employee mobility itself as suspect. Whatever the reason, they ignore the critical limit on the scope of that IP right. Doing so risks turning trade secrets from a well-defined legal right that serves the broader purposes of IP law into a standardless, free-roaming right to sue competitors for business conduct that courts or juries might be persuaded to deem objectionable. Secrecy is critical to ensuring that trade secret law does not interfere with robust competition or with the dissemination of new ideas. Courts that ignore that requirement undermine the purpose of trade secret law. The dictum of Masland should not only be disregarded but reversed: “The starting point in every case of this sort is not whether there was a confidential relationship, but whether, in fact, there was a trade secret to be misappropriated.” Understanding trade secrets as IP rights, and therefore as premised first and foremost on the existence of such a legal right, will help restore the centrality of the secrecy inquiry. And as a corollary, it may help ensure that the plaintiff clearly defines what it claims to own, rather than (as happens all too often in practice) falling back on vague hand waving.

B.     The Relationship Between Trade Secret Law and Other Torts

The importance of secrecy in channeling inventors between patent and non-patent IP protection has a second implication as well. Requiring trade secret plaintiffs to prove that they own real secrets will do little good if those same plaintiffs can turn to other legal doctrines to provide equivalent protection without the requirement of secrecy. Unfortunately, there are a number of state common law doctrines that offer just that prospect. The common law doctrine of breach of confidence, for example, required only proof that something was offered to the defendant in confidence, and that the defendant disclosed that information. Other common law doctrines, including misappropriation, unfair competition, and unjust enrichment (at least in those states in which it is an independent cause of action), similarly have no elements other than a loose definition of improper conduct. And still other torts, such as interference with contract or “idea submission,” may well overlap almost completely with trade secret claims in particular cases.

Trade secret law should preempt these torts when they are applied to protect information that would, if secret, have been protected by trade secret law. That is, a plaintiff who complains of the defendant’s use of its information, but who cannot prove that the information is secret, should not be able to rely on one of these torts (or any other common law variants) to bypass the requirement that it prove secrecy. If trade secret law does not preempt these torts, the point of the secrecy requirement will be lost, and with it the benefits of dissemination of new inventions. Companies will be unable to rely on the presence of ideas in the public domain; any information might potentially be subject to one of these torts. As a result, companies will be less willing to compete vigorously on the merits. Departing employees will be less willing to rely on information in the public domain to start new companies, and as a result more reluctant at the margins to start those companies. As Jim Pooley notes, “there is arguably little social utility” in allowing state claims based on misappropriation of trade secrets to go forward if the plaintiff cannot prove the elements of a trade secret claim.

Trade secret law should not, however, preempt state laws that have as an object something other than the protection of information. A defendant who breaks into an office to steal information has committed a tort (and indeed a crime) regardless of whether the information in question was secret. Trade secret law should preempt laws within the same general scope as trade secrecy, but not laws that serve fundamentally different purposes.

Once again, conceiving of trade secrets as IP rights helps achieve the goal of preemption of conflicting common law torts. If trade secret law is one tort among many common law torts, there is no reason to privilege it over other torts when the two conflict. But we have a well-established set of principles by which IP rights preempt state common law rules that interfere with those rights. We have those preemption principles because we recognize IP rights as utilitarian rules created by government to address public-goods problems, and the policy decisions implicit in those rules will at a minimum be complicated and may even be overridden by layering on additional causes of action not designed with public goods problems in mind. Treating trade secret law as an IP right dependent on proof of secrecy highlights the policy stakes, and will encourage courts to preempt common law claims that threaten to undermine the balance trade secret law strikes. In so doing, it may further advance the trade secret policy of disclosure by removing state laws that block the flow of non-trade secret information.

C.     Reasonable Efforts to Protect Secrecy

While proof that the plaintiff’s information is secret serves a critical role in channeling towards trade secret protection only those inventions that are best served by trade secret law, the same is not necessarily true of the parallel requirement that trade secret owners take reasonable efforts to protect their secrets. That requirement seems to stem from traditional tort notions of contributory negligence, under which plaintiffs were barred from relief if they themselves contributed to the tort. The explanation I have offered for trade secret law (and for the secrecy requirement) is not one that values secrecy as an end in itself; far from it. The benefit of trade secret law is that it reduces investment in secrecy compared to what would happen absent that law. So there is no reason we should want to establish a minimum investment level as an end in itself. And it may have negative consequences in particular circumstances.

The question then becomes whether reasonable efforts serve some other end. For example, some courts suggest that efforts to protect information as a secret are a sufficiently strong proxy for the secrecy of the invention that we should rely on them as evidence in support of the existence of a secret. But they are surely not perfect evidence; any litigator will tell you that companies regularly label as secret lots of things that clearly are not secret. Even assuming that reasonable efforts at secrecy do offer such evidence, that doesn’t justify the imposition of reasonable efforts as a separate requirement, just the consideration of that evidence in the overall secrecy inquiry. Alternatively, it may be that efforts to protect secrecy serve to put potential defendants on notice of the claim of secrecy, and therefore prevent inadvertent misappropriation. This may be true of some, but not all, efforts at secrecy, so again, it seems to justify reasonable efforts only as evidence, not as a separate requirement. More to the point, it will be true only as to some defendants; others may be aware of the secrecy of the information they take whether or not those secrets were reasonably protected. It seems more logical to cabin the risk of liability for inadvertent misappropriation by imposing some kind of scienter requirement than through this kind of constructive notice through enforcement efforts.

Reasonable efforts to protect secrecy, then, may make sense as evidence of secrecy or even as evidence of scienter, but they probably don’t make sense as a separate requirement.

Conclusion

Trade secrets are IP rights. They serve the same purposes as patent and copyright law—they encourage innovation and the disclosure and dissemination of that innovation, though they sometimes serve those purposes in surprising ways. Trade secret law reduces investments in secrecy and encourages the dissemination of the secret to more people who can make productive use of it. Indeed, trade secret rights may serve the purposes of IP law better than more traditional IP rights, at least for certain classes of inventions. The public disclosure function of the patent system doesn’t work very well in most industries, and doesn’t work at all if inventors opt out of the patent system.

Understanding trade secrets as IP rights allows them to take their proper place in the pantheon of social policy designed to encourage innovation. It also gives us a way to think about how those rights are designed, a way that has significant implications for how trade secret law looks and how it interacts with other laws. Most surprisingly, those implications are ones that offer greater, not lesser, latitude for competitors and departing employees than the unfair competition rationale most commonly articulated as an alternative.

Acknowledgments:

Copyright © 2009 Stanford Law Review.

Thanks to Chuck Adams, John Barton, Bob Bone, Dick Craswell, Zohar Efroni, Paul Goldstein, Wendy Gordon, Tait Graves, Joe Grundfest, Rose Hagan, Eran Kahana, Larry Lessig, David Levine, Jacqueline Lipton, Rob Merges, Mike Meurer, Roger Milgrim, Michael Risch, Sharon Sandeen, Peter Swire, Rebecca Tushnet, and participants in workshops at Stanford Law School and the IP Scholars’ Conference for discussions of these issues or comments on a prior draft.

Mark Lemley is William H. Neukom Professor at Stanford Law School and Of Counsel at Durie Tangri Lemley Roberts & Kent LLP.

This Legal Workshop Editorial is based on the following Article:   Mark A. Lemley, The Surprising Virtues of Treating Trade Secrets as IP Rights, 61 STAN. L. REV. 311 (2008).