Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Monthly Archives: June 2017

Enterprise without entities

In recent months, a significant amount of money has been raised using smart contracts and initial coin offerings. In May 2016, The DAO raised about $150 million with an “objective to provide a new decentralized business model for organizing both commercial and non-profit enterprises”. It did not have a formal organizational structure or legal entity and consisted only of open source computer code. A bug in this code allowed a hacker to siphon off about $50 million of this money, but this was reversed by a hard fork of the Ethereum blockchain (see here for the details). A few days ago, Bancor raised even more money than the DAO amidst criticism that its business model is seriously flawed.

These smart contracts create business enterprises without creating any legal entity. You cannot sue a piece of code, nor send it to jail, but when this piece of code creates a self enforcing contract, it becomes an enterprise. This seems to create a challenge for the legal system.

It was in this context that I read “Enterprise without Entities” by Andrew Verstein (Michigan Law Review, 2017).

This Article challenges conventional wisdom by showing that vast enterprises – with millions of customers paying trillions of dollars – often operate without any meaningful use of an entity.

This Article introduces the reciprocal exchange, a type of insurance company that operates without any meaningful use of a legal entity. Instead of obtaining their insurance from a common nexus of contract, customers directly insure one another through a web of countless bilateral agreements. While often overlooked or conflated with mutual insurance companies, reciprocal exchanges include some of America’s largest and best known insurance enterprises.

This Article explores how it is possible to run an international conglomerate with essentially no recourse to organizational law as it is normally conceived.

The whole paper is worth reading for the wealth of detail and careful legal analysis. It tells us that enterprise without entities is not some radical new innovation made possible by smart contracts, but is something that has been successfully practised since the early twentieth century.

More importantly, it also tells us that the challenge in making smart contracts work is not going to be legal. The real challenge is the more mundane and much harder task of writing software without nasty bugs.

How to bury zombie companies quickly

Earlier this week I posted about the bankruptcy literature of the 1990s that sought to rely less on judges, administrators and experts and more on contracts and markets. As promised in that post, I now explore the implications of that framework for the widespread corporate distress in India today.

While much of the discussion on the Indian situation emphasizes the problem of bad loans in the banking system, the government’s Economic Survey rightly described it as a twin balance sheet problem encompassing problems in the balance sheets of the banking system and of the corporate sector. Of the two, I would argue that the problem in the banking system is the less serious one for many reasons.

  1. The overt problem is largely confined to the public sector banks and from past experience we know that these banks can run smoothly (without any run on the banks) regardless of how little capital they have. Indian Bank in the mid 1990s is a classic example of the depositors retaining their faith in the bank even after reporting a large loss that resulted in a negative net worth. These days, there is the issue of Basel norms, but strictly speaking, they apply only to internationally active banks. If the overseas operations of the unhealthy public sector banks are shut down or transferred to healthier ones, there is no technical bar on letting them operate with low levels of capital adequacy. By placing restrictions on their fresh lending, any moral hazard problems can be alleviated.

  2. Many observers believe that bad loans are not confined to the public sector banks, and that at least some private sector banks have a large but covert problem. But this issue can probably be addressed by imposing a large preemptive recapitalization on them.

  3. India needs to move away from a bank dominated financial system, and some degree of downsizing of the banking system is acceptable if it is accompanied by an offsetting growth of the bond markets and non bank finance.

In my view, the problem of zombie companies is far more serious than the problem of zombie banks. There is overwhelming anecdotal evidence that these zombie companies are a major drag on the economy. For those who are not swayed by anecdotal evidence, an IMF working paper published this month demonstrates that the decline in private investment in India is linked to over-leveraged companies being unable to start new projects or complete ongoing projects. For India to achieve high growth, it is necessary to sort out these zombie companies.

Bankruptcy is the most effective way of putting an end to the zombie companies, and recycling their assets for more efficient use. Bankruptcy breaks the vicious cycle through which past debt acts as a brake on future growth. As Heidt put it: “Bankruptcy separates the past from the future … it takes the debtor’s past assets to pay its past creditors.”

Traditional bankruptcy processes may not provide an adequate solution to this problem because the number of companies involved is quite high and because India does not yet have enough trained bankruptcy professionals and judges to do bankruptcy on a massive scale. This is where I am fascinated by the idea in the bankruptcy literature of the 1990s of using markets instead of courts. This is much more scaleable in the Indian context because some Indian financial markets are reasonably deep, and the supply of funds in these markets is quite elastic because they are open to foreign investors.

My preferred solution is basically the same as the AHM procedure that I mentioned in my last blog post. In this approach, the government forces the banks to converts all their loans into equity, and also forces the banks to sell the resulting equity in the stock market within a tight time frame. The new shareholders decide whether to sell the assets or to run the business. In any case, with the debt completely removed, the company is no longer a zombie company, and even a partial or total liquidation would be a voluntary liquidation by the shareholders that does not require significant court intervention. The difficulties with this method are easy to surmount:

  1. It assumes a well functioning equity market, but I think this is more reasonable assumption to make than that banks can suddenly figure out how to restructure all this debt, or that rating agencies can be trusted to provide useful guidance on this (Partnoy’s scathing piece last month should remove all doubts on the matter) or that an omniscient central bank can tell the banks how to restructure all the debt.

  2. One “discretionary” question still appears to remain: how much of the old equity should be wiped before the conversion of the loans. In the original AMH procedure, this problem is solved using Bebchuk options: old shareholders are given the option to buy out the creditors pro rata. In most of the zombie companies, the Bebchuk options are unlikely to be exercised, and the old shareholders would be completely wiped out. Allowing the old shareholders to retain 5-10% of the expanded equity might be another possibility to make it politically more palatable.

  3. The banks would take large losses in this process that could leave them poorly capitalized. I have already discussed this above. For public sector banks, the capital does not really matter, and for the private sector banks, the problem can be solved by imposing a preemptive recapitalization. The important thing is to downsize the banking system so that we do not get into this mess again.

Bankruptcy ideas from the 1990s

During the last few weeks, I had the opportunity to read (and in some cases re-read) the large stream of literature about bankruptcy that emerged in the United States in the early 1990s. (That is one of the benefits of taking a serious vacation). There are a lot of original ideas in this literature because a serious application of the law and economics paradigm to this field probably began around this time. As Aghion, Hart and Moore wrote, prior to the 1990s, “economic analysis – which has been applied with such great success to other aspects of law in the last thirty years – has, with a few notable exceptions, not been used to shed light on optimal bankruptcy procedure”. The radical thinking in the 1990s literature can probably be attributed to the backlash against corporate abuses during the late 1980s and early 1990s. The savings and loan crisis of the 1980s in the United States somehow managed to provoke a greater outrage against financial fraud than the much bigger global financial crisis of the last decade.

Probably the best compilation of the 1990s bankruptcy literature is the proceedings of the Interdisciplinary Conference on Bankruptcy and Insolvency Theory of 1994 published in the Washington University Law Review. This features provocative articles like Adler’s “A World Without Debt” and Heidt’s article that begins with the line “The Bankruptcy Code is fifteen years old and fourteen years out of date”. Above all, there is the famous paper by Aghion-Hart-Moore describing one of the most radical bankruptcy procedures ever proposed – the AHM procedure.

In keeping with the law and economics paradigm, most proposals of that era are based on a greater reliance on contracts and markets rather than on judges, administrators and experts. The complication is that the problem of bankruptcy arises only under imperfect capital markets and there are obvious difficulties in relying too strongly on imperfect capital markets. Yet this 1990s idea underlies a number of the post crisis innovations in reorganization of distressed financial enterprises – contingent equity, contingent convertible bonds (CoCos), and hair cutting of claims against clearing corporations.

My motivation for studying this literature stems from the problem of corporate distress in India today. It is hard to see how India’s zombie companies can be efficiently and speedily resolved without relying much more on markets than on so called experts. That is the subject of a future blog post.

Are markets efficient if you are a particle physicist?

Among the thousands of pages that I read during my two month long vacation were two papers that show that many of the large number of published asset pricing anomalies (Cochrane’s “zoo”) have withered away over time. The papers are
Hou, Xue and Zhang (2017), Replicating Anomalies, NBER Working Paper 23394 and
Mclean and Pontiff (2016) Does Academic Research Destroy Stock Return Predictability?, Journal of Finance.

Hou, Xue and Zhang show that out of the 447 anomalies that they study as many as 286 (64%) are insignificant at the conventional 5% level. Increasing the cutoff t-value to 3.0 raises the
number of insignificance to 380 (85%). Clearly, there are a lot of Type M errors in the anomalies literature and a few Type S errors as well.

I started wondering what would happen if we imposed an even higher standard of statistical significance. This is where particle physics comes in. While the social sciences are quite happy with significance levels of 5% and 1% (implying cutoffs of around 2 or 3 standard deviations), the significance level required for the discovery of a new particle in physics is 0.0001% or one in a million (implying a cutoff of around 5 standard deviations). For example, when the Higgs particle was discovered in July 2012, the official press release from CERN stated: “Today, both the ATLAS and CMS experiments are beyond the level of around one per million that’s required to claim a discovery.” For more discussion on the 5 sigma standard, see here, here and here.

Asset prices exhibit significantly fatter tails than the Gaussian distribution and that would require raising the cutoff even higher. The statistical quality control world uses a shift of 1.5 standard deviations so that 6 standard deviations (six sigma) are required to achieve quality standards that would otherwise require only 4.5 standard deviations.

I pored over Table 4 of Hou, Xue and Zhang that lists the t-values for all the anomalies that are significant at the 5% level. Not one of these is above 6.0 and only two (Abr1 and dRoe1) are above 5.0. Adjusted for fat tails, there is no anomaly that meets a one in a million standard of significance. By this standard, therefore, markets can be assumed to be efficient. More prosaically, finance is still at the Tycho_Brahe stage of assembling enough high quality data to discriminate between competing theories.