1. Assignment for Next Class
Agenda for 16th Class
Admin
Slide Handout
Cleaner Skies
Information
Assignment for Next Class
King v Burwell (Obama Care case), #129 (pp )
Questions to think about
pp Qs 1 (WG1), 2 (WG2), 4 (WG3), 5 (WG4), 7 (WG1), 11 (WG2)

2. Structure of Class Interpretation
Statutory Interpretation. Chapter 1 (## 3-12)
Common Law Interpretation. ## 127, #37
Normative Reasoning
Economic Analysis. Chapter 4
Rights. Chapter 5A,C-E
Legal Theory
Dworkin/Scalia. Chapter 6 (already covered)
Positivism & Realism. Chapter 2 ##20-23
Rules & Standards. #126,128

3. Exam Info Probably In class ~12 multiple choice questions
Could finish in 40 minutes, but will have 1-2 hours
Take home
1 essay
Could finish in 2 hours, but will have several more hours
Open book -- Can use any materials, including dictionary and calculator
Multiple choice and Essay will test your ability to apply methods of interpretation and normative reasoning to new factual/legal situations
Will not test details of cases or other materials have read
Will be like exercises we have done for class
Warden Grim, Union Pacific, Cleaner Skies
Cleaner Skies is best indication integrates interpretive and normative materials
Will give 2-3 more examples of old exams which integrate normative and interpretive parts of class
Model answer for Cleaner Skies is exam memo and 3 model answers
Will post other old exams & answers later

4. How to Study Prepare carefully for each class
Do as many writing assignments as you can
Especially assignments which are old exams
Review after each class
Make sure you understand all the concepts
Review model answers posted to Portal
Especially model answers to old exams
Outlining
Do your own
Other outlines can be model
Other outline can help you check and improve
In late November / early December
Do additional old exams that I will post
Write out full answer individually
Discuss and compare answers in group
Discuss and compare to model answers in group
Review class in early December

5. Cleaner Skies

6. Moral Hazard Insurance context Contracts generally
Insured has suboptimal incentive to take precautions
If insured against fire, may not install sprinklers or be as careful with fireplace
If have health insurance, may not be as careful to eat right or exercise
If have health insurance, may request treatments that unlikely to be effective
Tort law is form of insurance
Product liability may make consumers less careful
Duty to rescue may make parents (and others) less careful
Government programs are a form of insurance
Welfare may dull incentive to work
Income tax may dull incentives to work
Contracts generally
After contract entered into, party may have incentive to act in way that is detrimental to other party
Employee may not work hard
Lawyer paid by hour may spend too much time on project
Renter may not take good care of apartment

7. Responses to Moral Hazard
Gather information
Moral hazard is result of fact that insurer does not know how insured is behaving
If insurer knew, then could condition insurance on insured behaving properly
Insurer’s “monitor” insured
Fire insurer may inspect home for smoke detectors, brush clearance, roof materials, etc
Government monitors welfare recipients, requires job search, etc.
Deny insurance if precautions not taken
Comparative/contributory negligence in tort
Insurance exclusion for arson
Fire employees if shirk
Build incentive into contract
Insurance seldom covers full cost of hazard
So insured has some incentive to take precaution
Employer can make pay proportional to output
Government regulation seldom helpful
Government doesn’t usually have superior information
But sometimes can help
By using information gathering of criminal law
By threatening larger penalties (e.g. imprisonment)
E.g. imprisonment for securities fraud

8. Moral Hazard, Coase Theorem, & Externalities
Cost of obtaining relevant information is transactions cost
If info could be obtained costlessly, moral hazard wouldn’t exist
Since info is expensive, inefficiency may result
Moral Hazard is kind of externality
Insured imposes costs on insurer
Employee imposes costs (or less benefit) on employer
Sometimes not considered an externality, because
Insured and insurer are in contractual relationship
Employer and employee in contractual relationship

9. Principal-Agent Problem
Many situations where one person (agent) works for another (principal)
Lawyer works for client
Employee works for employer
Promisor works for promisee
Problem
How get agent to act in interest of principal
Problem is often moral hazard
Agent can take actions which adversely affect prinicipal (not work sufficiently hard (shirking), damage equipment, etc.)

10. Responses to Principal-Agent Problem
Monitoring
Terminate contract if agent shirks
Performance-based contract
Pay agent in accordance with some measure of performance
Contingent fee for lawyer
Plaintiff’s lawyer gets 1/3rd of damages, if prevails
Piece work
Pay CEO in stock or option
Bonuses for good performance evaluations
Input-based contacts
Hourly fee or wage
Cost-plus construction contracts
Fixed fee contracts
Salary
Best contract depends on circumstances
Incentive contract -- if performance easy to measure
Fixed fee – if repeated interactions or agent is very concerned about reputation
Input based – if cost unpredictable, agent is risk averse, and efficiency can be monitored

11. Adverse Selection I
Markets may fail where one side lacks information and thus sets prices based on average
Thus inducing those who are above average to leave the market (b/c price not attractive to them)
Classic example: Insurance
If insurer has imperfect information
Insurance priced at average risk
But person who knows low risk may then decide not to insurer
But that raises average risk of those still buying insurance
Thus raising prices
Causing more people to drop out of insurance market
Examples
Health insurance
Product liability/warranty, if voluntary
Those who are careful may opt not to purchase warranty
Thus raising average risk and cost…

12. Adverse Selection Example I
Suppose 2 people want life insurance
A is smoker, 10% probability that will die next year
$10,000 expected cost to insurer for $100,000 policy
A is willing to pay $11,000 for insurance
B is non-smoking marathon-runner
1% probability that will die next year
$1,000 expected cost to insurer for $100,000 policy
B is willing to pay $2000 for insurance
If insurer can’t get credible information on smoking and exercise habits
Price for insurance, if both A and B are both buying insurance must be at least, $5500 (average of $10,000 and $1,000)
But then insurance is not worthwhile to B

13. Adverse Selection II Lemons problem
Used car purchaser has imperfect information
Willing to pay price that reflects average used car quality
But person who has above average quality used car doesn’t want to sell at average price, so doesn’t sell
But that lowers average quality and thus price, leading more used car owners not to sell
Other examples
Loans for new businesses

14. Responses to Adverse Selection
Ex ante information gathering
So can price product in accordance with individual characteristics, rather than market average
Life insurance – blood pressure and cholestoral screenings, different rates for smokers, etc.
Health insurance – exclusion of preexisting conditions
Inspection and certification of used cars
Warranties
Reputation
Mandatory insurance
So no one can drop out of market
Health insurance “mandates” / universal coverage

15. Questions on pp. 254ff
4. Consider an employment decision. A law firm is considering whether to offer an associate position to a 2L, and the 2L is deciding whether to accept the offer.
a) What are the information asymmetries in this potential transaction? What relevant information does the 2L know which the firm does not? What relevant information does the firm know which the 2L does not?
b) What can the firm do to (partially) overcome the information asymmetry?
c) What can the 2L do to (partially) overcome the information asymmetry?
d) Note that many law firms and lawyers have no written contracts. In such cases, the law provides default rules. One of those default rules is “employment at will,” which means that the employee can quit at any time, and the employer can fire the employee at any time. How does employment at will help overcome informational asymmetries or at least reduce their adverse affects?
e) Are there any legal rules which help overcome the informational symmetries?

16. Questions on pp. 254ff
5. Consider the way home mortgages are often sold. A bank contracts with a mortgage broker. A mortgage broker is an independent businessperson, not an employee of the bank. The mortgage broker solicits customers and, when a customer wants a loan, helps the customer fill out the relevant paperwork and sends the paperwork to the bank for approval of the loan.
a) The contract with the mortgage broker might specify that the mortgage broker gets a fixed salary – perhaps $3000 per month. What problems might occur under such a contract? Would the bank be wise to offer such a contract?
b) The contract with the mortgage broker might specify that the mortgage broker gets a percentage of the value of all loans approved. For example, the mortgage broker might get 0.5% of the value of each loan, which would be $2500 on a $500,000 loan. What problems might occur under such a contract? Would the bank be wise to offer such a contract?
c) What macro-economic problems might occur if most loans were negotiated through contacts such as those described in (b)?
d) Can you think of a better contract between the bank and the mortgage broker?
e) The relationship between a bank and a mortgage broker presents all three types of asymmetric information problems discussed in readings ##50-51, supra – adverse selection, moral hazard, and principal-agent. Identify which aspects of the relationship present which kinds of problems.

17. Gilson, Role of Lawyers Functions of Lawyer
Litigate
Advise
Draft & negotiate contracts (transactional lawyer)
Role of Transactional Lawyer
Transaction Cost Engineer
Reduce transactions costs for benefit of both parties
Solve informational problems
Lawyers often cynically viewed just transactions costs
But Gilson suggests that function of (good) lawyer is to reduce transactions costs
Value Creation
Function of (good) lawyer is to “create value”
i.e. increase the pie
Not just bargaining to get greater share of surplus for client
Other roles
Regulatory compliance
Getting most for client

18. Gilson, Corporate Acquisition Agreement
Lawyer as transactions cost engineer
Lawyer create value (increases pie) by reducing transaction costs, especially informational problems
Representations and Warranties
Detailed statements of facts concerning the relevant business
Including accuracy of financial statements, absence of particular liabilities, ownership and condition of key assets, pending litigation.
Seller liable if turn out to be false
Purpose. Provide credible information that is key to transaction and its pricing
Earn out provisions
Part of price depends on performance of business
Part of payment delayed and contingent on how well business does
Helps parties to agree on deal, even if disagree on profitability of business
Also gives former owners an incentive to help

19. Gilson, Corporate Acquisition Agreement II
Covenants and Conditions
Covenants. Agreement on how owner will conduct business in period between signing of contract and transfer of ownership
Conditions, if not satisfied, relieve buyer of obligation to purchase

20. Question on pp. 273ff
1. Would you characterize the informational problem in a typical corporate acquisition agreement as primarily an adverse selection, moral hazard, or principal-agent problem?
3. Gilson focuses on private, contractual solutions to the informational problems posed by corporate acquisitions. Is there a role for courts, legal rules, and/or legislation?