Live, From Tsinghua University, It’s Saturday Night!
posted by Jonathan Lipson
Okay, just about everything in the title is false, except that I have been at Tsinghua University, in Beijing, to present a talk entitled “Enron Rerun: The Credit Crisis in Three “Easy” Pieces.” [ Download file]
Every year, Tsinghua, which partners with Temple’s China LLM program, puts on an international conference on corporate or commercial law. This year’s theme: Corporate Restructuring. Speakers from around the world (but mostly Asia) gathered to talk about everything from bringing the ineffable elegance of the reverse triangular merger to China to the scourge of needless transactional complexity.
Organized by Tsinghua Professors Wang Baoshu and Zhu Ciyuan, speakers included Helmut Kohl (University of Frankfurt); Professor Chih-Cheng (Spencer) Wang (National Chung Cheng University (Taiwan)); Professor Len-Yu Liu (Chengchi University, Taiwan; Professor Alain Couret (Sorbonne); Jennifer Hill (Sydney University); Daniel Ohl (Orleans); Nicholas Howson (Michigan) and Daniel Kleinberger (William Mitchell).
Kleinberger’s paper was especially interesting to me, as it was on the problems inherent in what he considers needless transactional complexity. His examples of this complexity involved things like dual entity citizenship and the phenomenon in LLC law of permiting “series” to subsist as distinct legal entities (at least for certain purposes) within a larger LLC. He could, of course, just as easily have talked about the role that arguably needless complexity played in the current credit crisis.
Fortunately for me, he didn’t, so I had something to talk about.
My talk was pretty much what it sounded like. Today’s crisis can be seen as Enron writ large, as both have been dominated by (1) needlessly complex trsactions, (2) regulatory and investor complacency; and (3) unchecked conflicts of interest. The affirmative claim—and this is the hard part—is that complexity played a material role in facilitating the complacency and complexity that produced both debacles. The talk as presented doesn’t get into this question in detail (I had only 10 minutes). But the basic point is that we’ve used complex contracts and entity structures to facilitate (or mask) all sorts of bad behavior, for a variety of reasons.
If I get a real paper out of this, it will have to address some of the following problems:
(1) What do I mean by “complexity”? Contracts with lots of words? Deals with lots of contracts? Lots of choices (options) embedded in the deals? Lots of entities?
(2) Assume for the moment it is possible to define complexity: What’s so bad about it? Don’t parties willingly choose it? And doesn’t complexity really just represent the advance of legal technology? Concerns about complexity might be equivalent to concerns about the development of the microcircuit.
(3) Even if I am correct that complexity was a screen to mask self-dealing, what exactly would we do about it? Even if you could distinguish a (bad) complex transaction from a (good) simple transaction, what would you do to alter it? What is the regulatory response to complexity?
(4) If it is a problem, won’t excess complexity cure itself? We know that this is not the first time in history that transactions and structures were comparatively complex. The trusts that grew up around the railroads and the rapid development and aggregation of assets and rights throughout the late 19th and early 20th century reflected tremendous complexity. The ultimate response was, in part, a drastic reduction in deal activity generally (the Depression). This produced much simpler transactions. Won’t the market for legal technology correct itself here, as it (arguably) did in the past?
(5) If complexity is a problem, what besides disclosure is the solution? If disclosure is the cure, isn’t it really just more of the disease? After all, there is no claim (at least not yet) that MBS/CDO issuers were concealing the real risks of loss. From what we know, the securities disclosures were likely to have been adequate. The deals may have been too complex to fully understand (or investors over-relied on ratings, etc). But would more information have made them less complex? Arguably not.
In any case, I’d welcome comments on this.
October 26, 2008 at 11:03 pm
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Responses (2)
Timon - October 27, 2008 at 7:17 am
Lately I’ve been thinking about a metaphor for a certain kind of complexity: a vicious clique of 13-year-old girls. A complete graph of every undermining comment, and instance of or reaction to jealousy, sycophancy, revenge — it could overwhelm the computing power of Palo Alto, CA. It is possible for complexity to be meaningless in itself (say the tax code), but to concisely and elegantly convey something if viewed impressionistically (congress is cosmically corrupt.)
I think a good little heuristic for telling when complexity is more a symptom of misunderstanding than a cause of it, is whether experts in the field dwell on how complex what they do is — in my experience electrical engineers like to explain themselves and offer clear analogies and examples, while people who worked at hedge funds go on about how impossibly complex their system of guaranteed returns is. (If I had a nickel for every time I’ve heard about the complexity of this or that political or historical atrocity, I would be Neel Kashkari.)
A.J. Sutter - October 28, 2008 at 10:04 am
A. Before I comment on your questions, I’d like to ask: what was the general reaction to the talks (yours and others) from the Chinese attendees, especially students? Were there any questions or reactions that surprised you? Did people express any loss of confidence in US-style economics or business practices? In my experience as an occasional guest lecturer to Chinese grad students in finance, the unexpected nature of some reactions is what makes the trip worthwhile. (And BTW, was that ex-Bundeskanzler Helmut Kohl, or a homonym?)
B. (1) All of the factors you describe sound pretty plausible. Since “complexity” is such a buzzword these days, it might be wise to avoid it if possible, and just talk about deals being “overly complicated”. I don’t think you want to give in to fashion and gravitate toward a “complexity theory” notion of complexity; in any case, there are several flavors of that, not just the Santa Fe Institute version of it espoused by Murray Gell-Mann & al. and favored by US-based social scientists with physics/computer science envy.
(2) “What’s so bad about it? Don’t parties willingly choose it?” Parties may willingly chose it, but not its consequences — because the complexity makes consequences difficult to see. The real issue may be more transparency and predictability than “complexity” per se. And what’s bad about it is that the consequences of that choice may affect many more people than just the parties.
(3) What to do depends on what role you’re playing. If I were advising a client considering such a deal, I might suggest that the complexity of the deal doesn’t pass the smell test, and that he should look for a different kind of deal to do. If he insisted on doing it, and if I felt that the complexity really did mask something dishonest or at least questionable, I would either cover my rear with numerous cautionary memos to him, or even end the engagement (been there, done that, though not with subprime stuff). This goes to a larger point, which I address at the end of this comment.
(4) “If it is a problem, won’t excess complexity cure itself?” Do you really think the Depression is an acceptable model for fixing issues like this? Wouldn’t it be better to avoid such a drastic type of correction? Also is there really only one “market” for “legal technology”? Or could the repeat of this problem in another country lead to another global mess in the future?
(5) These are good questions, to which I don’t have any good suggestion at the moment other than my very Reagan-era “Just Say No,” supra.
Larger point: Although you pointed out many conflicts of interest in your talk, you implicitly assume that regulation is the way to deal with them. You omit mention of individual ethics. If I may wax anecdotal: I know from friends who worked at a California bank branch (retail) several years ago that there was internal debate about whether to push subprime loans on customers, e.g., introduce them to brokers. Several people wanted to do it because they’d earn fees for originating the loans; one even mentioned she was about to retire in a year or so, and if there were any problem with the re-sets she’d never hear about it. Fortunately, the branch manager was against it on ethical grounds (and more fortunately, she had the ear of the bank’s CEO, so that the entire bank, a subsidiary of MUFJ, stayed clear of them). The point is, this catastrophe began with — and maybe could have been avoided thanks to — a lot of those individual ethical decisions. That would have been a very important message for the Chinese university audience to hear, IMHO.
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