Costly contracting in a long‐term relationship

We examine a model of contracting where parties interact repeatedly and can contract at any point in time, but writing formal contracts is costly. A contract can describe the external environment and the parties' behavior in a more or less detailed way, and the cost of writing a contract is proportional to the amount of detail. We consider both formal (externally enforced) and informal (self‐enforcing) contracts. The presence of writing costs has important implications both for the optimal structure of formal contracts, particularly the tradeoff between contingent and spot contracting, and for the interaction between formal and informal contracting. Our model sheds light on these implications and generates a rich set of predictions about the determinants of the optimal mode of contracting.     

The optimal extent of discovery

We characterize how the process of publicly gathering information via discovery affects strategic interactions between litigants. It allows privately informed defendants to signal through the timing of settlement offers, with weaker ones attempting to settle prediscovery. Discovery reduces the probability of trial. Properly designed limited discovery reduces expected litigation costs. Stronger defendants gain more (lose less) from a given amount of discovery. We find that the court should grant more discovery when defendants are believed to be stronger and should grant discovery on more efficient sources of information, leaving less efficient ones to trial.     

Contracting officer workload,incomplete contracting,and contractual terms

This article estimates the causal effect of retirement‐induced workload spikes on the selection of procurement terms. In a sample of 150,000 contracts from 85 procurement offices over 11 years, increases in workload decrease reliance on competitive acquisition procedures, decrease reliance on firm‐fixed‐price contracts, increase risk of renegotiation, and increase costs. These estimates are consistent with a model of endogenously incomplete contracting. The US federal government has experienced exceptional growth in acquisitions contracting over the past decade but limited growth in acquisitions manpower. This article provides some of the facts necessary to evaluate the consequences of these shifts.     

Fraud Allegations and Government Contracting

This paper examines whether fraud allegations affect firms’ contracting with the government. Using a data set of whistleblower allegations brought under the False Claims Act against firms accused of defrauding the government, we find that federal agencies do not reduce the total dollar volume of contracts with accused firms; however, they substitute approximately 14% of the harder‐to‐monitor cost‐plus contracts for fixed‐price contracts. This effect is concentrated in the procurement of services and explained by contract and service substitution. Finally, we find that after the conclusion of the investigation, the government reduces the contract dollar volume by approximately 15% for cases that resulted in a settlement. Our findings indicate that contract‐design changes are used to mitigate uncertainty in suppliers’ reputation.     

Earnouts: The real value of disagreement in mergers and acquisitions

Earnout agreements link part of the payment for an acquired company to its future performance. Despite their option-like features, they cannot be valued using vanilla option-pricing methods. Two peculiar sources of risk affect these contracts: Bidder default before the earnout expiration (default risk) and potential litigation associated with earnouts (litigation risk). We developed an option-pricing model that encompasses these sources of risk, showing that counterparty and litigation risk can have a remarkable impact on earnout values. Our model's relevance is further enhanced by recent accounting standards that require contingent payments to be valued at fair value.     

Catastrophe Bonds,Reinsurance, and the Optimal Collateralization of Risk Transfer

Catastrophe bonds feature full collateralization of the underlying risk transfer and thus abandon the reinsurance principle of economizing on collateral through diversification of risk transfer. Our analysis demonstrates that this feature places limits on catastrophe bond penetration, even if the structure possesses frictional cost advantages over reinsurance. However, we also show that catastrophe bonds have important uses when buyers and reinsurers cannot contract over the division of assets in the event of insolvency and, more generally, cannot write contracts with a full menu of state‐contingent payments. In this environment, segregation of collateral—in the form of multiple reinsurance companies, as well as catastrophe bond vehicles—can ameliorate inefficiencies due to reinsurance contracting constraints by improving welfare for those exposed to default risk. Numerical simulation illustrates how catastrophe bonds improve efficiency in market niches with correlated risks, or with uneven exposure of buyers to reinsurer default.     

Cost stickiness and bank loan contracting

This study examines whether and, if so, how borrowers' asymmetric cost behavior (i.e., cost stickiness) is factored into the price and non-price terms of bank loan contracts. We provide strong and reliable evidence that ex-ante, the loan spread increases with cost stickiness after controlling for other known determinants of loan contract terms. Moreover, we find that the effect is more pronounced for borrowers with higher default risk and higher information risk. This is consistent with borrowers' asymmetric cost behavior increasing lenders' uncertainty about the liquidation value of assets, and hence, lenders need to be compensated ex-ante. Additionally, we conjecture that higher cost stickiness may increase the need for ex-post monitoring. Consistent with this conjecture, we find some evidence that lenders impose tighter non-price terms on firms with stickier costs. This study integrates cost stickiness research with the banking literature by showing that banks incorporate borrowers' asymmetric cost behavior into loan contracting terms.     

Do Banks Price Litigation Risk in Debt Contracting? Evidence from Class Action Lawsuits

Class action lawsuits can be detrimental to debtholders because they deteriorate defendant firms’ financial position and lower these firms’ value. This study examines whether banks price their borrowers’ litigation risk in debt contracting. We find that banks charge 19% higher interest spreads on loans to lawsuit firms after litigation. In addition, banks monitor lawsuit firms more closely by using tighter non‐price terms. The results are robust after correcting for possible endogeneity issues using the propensity score matching approach. We further find that the effects of lawsuit filing are more pronounced for firms with weaker corporate governance. Following a lawsuit in the industry, banks also perceive an increased likelihood of litigation for industry peer firms and adjust price and non‐price terms accordingly. Finally, we find that the magnitude of the lawsuit filing effect is greater for firms with lower ex‐ante litigation risk. Taken as a whole, our findings suggest that banks, as informed stakeholders, perceive litigation risk to be detrimental and price this risk in debt contracting.     

The Changing Nature of Contracting and Trust in Public‐Private Partnerships: The Case of Victorian PPP Prisons

This paper examines shifting constructions of contracting and trust that are manifest between pre‐2000 and post‐2000 public‐private partnerships (PPPs) providing prison facilities and/or services in the Australian State of Victoria. As such, this paper is significant because it outlines longitudinal insights into the nature of changing practices sustaining these PPPs. The post‐2000 period examined reflects a change of government and the policy context. Our examination is based on a range of primary and secondary documents. The primary documents comprise three pre‐2000 Prison Services Agreements and two post‐2000 Facilities Services Agreements. A number of government and other reports constitute the secondary documents consulted. While there are many substantive similarities between the contracts, we find five main areas of changed contracting practices over the period examined. These relate to: first, the objectives of the PPP prisons; second, risk management practices; third, the approach to performance measurement and reporting; fourth, the structuring of incentive and payment mechanisms; and fifth, the emphasis on collaboration. Overall, we find that the post‐2000 contracts promote a more overt development of goodwill trust and relational contracting, building on presumptions of contractual and competence forms of trust. However, quite different outcomes have been achieved from particular contractual contexts. Our study suggests that in complex PPP contracts, the influences of both the transacting parties and the transaction environment have been insufficiently recognized in the literature on PPPs.     

Trend inflation, wage and price rigidities, and productivity growth

What are the steady-state implications of inflation in a general-equilibrium model with real per capita output growth and staggered nominal price and wage contracts? Surprisingly, a benchmark calibration implies an optimal inflation rate of -1.9 percent. The analysis also shows that trend inflation has important effects on the economy when combined with nominal contracts and real output growth. Steady-state output and welfare losses are quantitatively important even for low values of trend inflation. Further, nominal wage contracting is found to be quantitatively more important than nominal price contracting in generating the results. This conclusion does not arise from price dispersion per se, but from an effect of nominal output growth on the optimal markup of monopolistically competitive labour suppliers. Finally, accounting for productivity growth is found to be important for calculating the welfare costs of inflation. Indeed, the presence of 2 percent productivity growth increases the welfare costs of inflation in the benchmark specification by a factor of four relative to the no-growth case.     

Subcontracting and competitive bidding on incomplete procurement contracts

This article examines the impact of incomplete contracts on subcontracting and the design of procurement auctions. I estimate the effect of ex post contract revisions on unit costs for both subcontracted and in‐house performed work items on bridge projects procured by the California Department of Transportation. I model a scoring auction showing how ex post revisions skew bidding decisions and estimate unit costs from bid data using the method of sieve estimation. The results highlight the cost implications of incomplete contracting frictions, subcontracting decisions, and bidding distortions. In conclusion, I propose alternative auction mechanisms that could improve outcomes.     

NOT REPORTING A PROFIT: CONSTRUCTING A NON‐PROFIT ORGANISATION

Public sector reformers advocate contracting‐out as a means of improving cost‐effectiveness. In the health sector, market‐based contracts with for‐profit organisations can reduce equity of access and divert public funds to private gain. Such issues have prompted policy makers to seek alternative contracting strategies. This paper examines a primary health care policy whereby government contracts with private non‐profit organisations to increase efficiency and meet World Health Organisation ideals. The study found that the policy's implementation has not achieved these aims when for‐profit providers masquerade as non‐profit organisations. The implication is that governments may find it more effective to manage for structural diversity than mandate homogenisation.     

Federal Judge Ideology: A New Measure of Ex Ante Litigation Risk

Drawing on the political theory of judicial decision making, our paper proposes a new and parsimonious ex ante litigation risk measure: federal judge ideology. We find that judge ideology complements existing measures of litigation risk based on industry membership and firm characteristics. Firms in liberal circuits (the third quartile in ideology) are 33.5% more likely to be sued in securities class action lawsuits than those in conservative circuits (the first quartile in ideology). This result is stronger after the U.S. Supreme Court's ruling in the Tellabs case. We next show that the effect of judge ideology on litigation risk is greater for firms with more sophisticated shareholders and with higher expected litigation costs. Furthermore, judicial appointments affect litigation risk and the value of firms in the circuit, highlighting the economic consequences of political appointments of judges. Finally, using our new measure, we document that litigation risk deters managers from providing long‐term earnings guidance, a result that existing measures of litigation risk cannot show.     

Information Asymmetry and Dual Distribution in Franchise Networks

We examine whether a dual distribution system that uses both franchisor‐operated and franchisee‐operated outlets reduces a franchisor's information disadvantage when contracting with franchisee retailers. Using detailed qualitative and quantitative managerial data, we find persuasive evidence of the strategic use of performance information obtained from franchisor‐operated outlets to reduce information asymmetry and enhance contracting efficiency for franchisee‐operated outlets. We test whether the proximity of franchisor‐operated retail outlets to franchisee‐operated retail outlets reduces underpricing of quasi‐franchise contracts. Our results accord with the proposition that information asymmetry reduces contracting efficiency and are consistent with our prediction that a manufacturer can reduce intrinsic information asymmetry by maintaining franchisor‐operated outlets that are geographically proximate to the franchisee‐operated outlets, and that this improves the franchisor's pricing of franchising contracts. We conclude that dual distribution reduces the franchisor's information asymmetry and increases their contract pricing efficiency.     

The Effect of Alternative Judicial Systems and Settlement on Auditing

The accounting profession claims that the substantial litigation costs incurred to defend against negligence claims are used by plaintiffs to coerce settlement. We examine a model of auditing and settlement under the U.S. and British systems of allocating litigation costs between a plaintiff and defendant and compare the level of equilibrium auditing and audit pricing across the two regimes.If the unit cost of auditing is sufficiently high, then the system in the U.K. induces more auditing than does the U.S. system. Second, for some parameters, the system in the U.K. achieves this result while inducing lower audit prices.     

Optimal risk sharing through renegotiation of simple contracts

We frequently observe that contracts do not include all of the contingencies that would seem to be necessary for optimal risk sharing between the parties to the contract. One reason may be that the possibility of renegotiation makes the contract more contingent than it appears. A simple contracting problem is used to show how even a simple contract may achieve optimal risk sharing if new information arrives slowly relatively to the speed of renegotiation.     

VOLUNTARY DISCLOSURE BY FINANCIAL INTERMEDIARIES: EVIDENCE FROM AUSTRALIAN LIFE INSURERS PROMOTING INVESTMENT-RELATED CONTRACTS

Voluntary financial disclosure by Australian life insurers promoting investment-related contracts is predicted to be related to fees, funds under management, investment risk and return, liability risk and marketing costs factors. The decision to voluntarily disclose various forms of financial data in documents promoting investment-related contracts was studied during 1989-90. Life insurance managers providing financial disclosures tend to: (a) charge lower fees, (b) hold larger funds under management, (c) are exposed to higher investment risk, (d) are exposed to lower liability risk and (e) bear lower marketing costs. This evidence supports Mayers and Smiths' [1981] positive theory of insurance-related contracting.     

Managerial Opportunism during Corporate Litigation

Using a large sample of litigation events involving publicly listed defendants, we document a surprising fact. The resolution of litigation through a court's decision dominates settlement of litigation from the shareholders' point of view, even when the firm loses. We develop a model using agency costs within the firm to explain why the market views settlement as a negative outcome on average and find empirical evidence supporting the implications of the model. Specifically, firms with weak corporate governance settle litigation more quickly, and the market reacts more negatively to settlements involving firms with higher agency costs.     

The impact of litigation risk on the strategic timing of management earnings forecasts

This paper examines whether managers strategically time their earnings forecasts (MEFs) as litigation risk increases. We find as litigation risk increases, the propensity to release a delayed forecast until after the market is closed (AMC) or a Friday decreases but not proportionally more for bad news than for good news. How costly this behaviour is to investors is questionable as share price returns do not reveal any under‐reaction to strategically timed bad news MEF released AMC. We also find evidence consistent with managers timing their MEFs during a natural no‐trading period to better disseminate information.     

Contingent Commissions and the Management of the Independent Agency

Insurance agencies continue to exist as an important distribution mechanism because they give their contracting insurers advantages in risk selection and enable insurance applicants to transfer complex risks. While independent agencies are compensated by upfront commissions, a key component of their profitability is tied to contingent commissions. A contingency arrangement represents ex post compensation normally tied to underwriting profitability, volume, and annual growth. We report two actual contingency contracts in the context of a decision process for choosing among contingency offerings by insurers. We incorporate both uncertainty and correlation among key variables to arrive at values for competing contracts, then use a downside risk approach that helps agency owners select the better contract. The approach offered in this article is scalable to a selection problem for any number of contingency arrangements.