The Law School held its annual Coase Lecture on February 10, drawing students, faculty, and other guests into a packed auditorium for a tradition that began in 1992. This year’s lecture, titled, “What’s Optimal(ity) in Financial Contracting?”, was delivered by Professor Vincent Buccola, ’08, a scholar in corporate law and finance.
Organized by the Coase-Sandor Institute for Law and Economics, the Coase Lecture honors the late Nobel Laureate Ronald Coase, whose groundbreaking scholarship helped shape the field of law and economics in the late twentieth century. Coase joined the Law School faculty in 1964 and remained a member for the rest of his life.
Adam Chilton, the dean and Howard G. Krane Professor of Law, kicked off the program with opening remarks, emphasizing with pride the great scholars and thinkers—chief among them Coase—who sparked the law and economics movement at UChicago. “Each year we have a member of our faculty provide a lecture on important themes in law and economics to share ideas and insights about how economics can shape the way we use the law,” he said.
Before diving into his topic, Buccola, a graduate of the Law School and former Bigelow Fellow, noted that he began attending Coase lectures two decade ago as a 1L. “I think I’ve watched every one of them since then,” he said, “so it is an honor to be doing this.”
The Problem with Financial Contracts
Buccola’s lecture explored the extent to which financial contracts—deals in which one party, an investor, agrees to give capital to another party, a manager, for use in growing a business—are written to maximize the rewards for both parties.
There are two basic problems at the heart of all financial contracts, he said.
The first is adverse selection, which occurs when managers know more about the business than the investors do, leading to anxiety on the part of the investor. The second is moral hazard, which arises when the interests of the manager diverge from the interests of the investor after the funding moves from investor to manager.
“How exactly their interests will diverge will depend on variables beyond our scope today, but in general, the direction of travel is going to be ambiguous,” said Buccola, adding that because the future is “non-contractable,” this problem generates agency costs.
Buccola then arrived at the aim of his talk: to challenge the conventional wisdom that financial contracts solve the two problems he laid out.
“[I’m going to] suggest that the picture is wrong,” Buccola said, “that [we] have misconceived financial contracts. First, though, we need to understand why one would ever suppose that contract terms are even roughly value-maximizing.”
The Mechanisms (and Limitations) of Producing Contracts
To develop his argument that financial contracts are not as maximizing as theory might suggest, Buccola discussed the two mechanisms used to produce contracts: design and selection.
Drawing on the Coase theorem—which states that absent bargaining frictions, resources are allocated to their highest value use—Buccola explained that, in theory, parties attempt to create surplus-maximizing contract terms. In practice, however, there are limits to design that prevent this maximization from occurring.
These limits, which he said “warp the outputs” of contract design, include:
- Principal-agent misalignment, including conflicts of interest that exist at the investor level
- Complexity in language, as contracts are written in language that is difficult to interpret and predict
- Pricing difficulties, because investors do not in fact know how to price marginal variations in contract terms because they are too complex to value
Turning to selection—the market forces that weed out inefficient contracts over time—Buccola argued that there are relatively few contractual variants among available alternatives in the selection environment. He referenced the evolutionary concept of “neutral variation,” which describes non-essential traits like the appendix that don’t influence an organism’s chance for survival. “Most contract terms as like appendices,” he said. “So, you need a lot of generations, so to speak, for inefficient approaches to that problem to be weeded out.”
Buccola also noted that economic conditions change too rapidly, which undermines the selection process. “In evolutionary theory, fitness is always relative to an organism’s environment. If the environment changes frequently, then traits selected for in one generation might be selected against in the next. You don’t get convergence on an optimum measure at any particular time. That’s the situation in financial contracting.”
Practical Takeaways
Buccola concluded that while financial contracts work reasonably well in practice, the theoretical mechanisms of design and selection ultimately do not deliver optimal contract terms. For lawyers and judges, whose job it is “to use words to try and ring the last 0.4% of a perspective value of a deal,” Buccola emphasized the need “to put more weight on first principles thinking relative to the wisdom of the actual.”
He also urged innovation, inviting legal practitioners to embrace the complexities of financial contracting and not just blindly follow precedent. “The lesson is that if you can find ways to erase or avoid a source of friction, you can develop a product and offering that may generate more value than standard loan economic models