Certification Drag: The Opinion Puzzle and Other Transactional Curiosities

I. CERTIFICATION REVISITED A. Theory B. Evidence II. IDENTIFYING THE OPINION PUZZLE A. Content B. Costs C. Value 1. "Obvious" Limiting Factors 2. Legal Exposure 3. Reputational Exposure D. Evaluation: The Puzzle Emerges III. SOLVING THE OPINION PUZZLE A. Demand-Side Incentives B. Supply-Side Incentives IV. FIXING THE OPINION PUZZLE A. Law Firms B. Collective Organizations C. Insurance D. Obstacles to Self-Correction V. SOME MORE PUZZLES: APPLICATIONS AND EXTENSIONS A. Credit Ratings B. Fairness Opinions C. Contractual Boilerplate VI. CONCLUSION APPENDIX Financial markets are populated by a host of reputable intermediaries, including law firms, auditors, underwriters, investment banks, and credit rating agencies, which provide various stamps of approval attesting to costly-to-verify characteristics of the relevant asset. The law-and-economics literature has typically observed that these "certification intermediaries" have low rational incentives to endanger hard-won reputational capital by acting fraudulently or even negligently and therefore are generally viewed as enhancing market efficiency by mitigating informational asymmetries that may otherwise distort or even frustrate mutually beneficial transactions. (1) But it has largely gone unrecognized that this "happy" efficiency story has found at best mixed and often inconclusive empirical support in the case of certain commonly used certification instruments in the financial and other markets. (2) Nor, as has been increasingly recognized in the wake of Enron and other contemporary scandals (including by some of its original exponents), (3) does this unqualified "certification -thesis" (4) sit comfortably with the historical and recent recurrence of fraudulent and similar conduct even in sophisticated business environments monitored by a large population of prestigious (and expensive) intermediaries. (5) In this Article, I tell a "not-so-happy" story of certification intermediaries that anticipates in part these otherwise curious failures of the financial markets to satisfy the sanguine expectations of the standard certification thesis. Specifically, I identify a perverse "two-sided" incentive structure, which, through a combination of agency-cost and adverse-selection effects, sustains minimally informative but non-cost-justified certification practices even in sophisticated markets, thereby imposing a levy on business transactions--or, as referenced in this Article's title, a "certification drag"--without generating commensurate benefits in the form of improved transaction pricing or structuring. To oversimplify only slightly: these certification instruments cost something but often appear to say almost nothing (or more precisely, almost nothing new). Contrary to the standard account (and without assuming any of the "usual suspects" behind market failure, as identified below), non-cost-justified bonding practices that generally do little to facilitate efficient transactions may persist in a sophisticated market over a substantial period, with attendant social losses as a result. Hence it is not necessarily puzzling that routinely used certification practices fail to yield substantial informational value or that a gold-plated array of third party intermediaries fails to screen out recurrent patterns of fraudulent behavior. I develop this "degenerate" certification thesis through a detailed examination of the third party legal opinion (or in short, "closing opinion"), which is commonly issued by law firms at the consummation of certain significant business transactions such as acquisitions and financings. For the analytical purpose of identifying practical limits to the standard certification thesis, this narrow (but to practitioners, familiar) corner of business-law practice provides an unusually "clean" setting that substantially lacks several distorting characteristics that would otherwise be obvious sources of market failure: (1) both providers and recipients of the certification instrument are sophisticated, thereby probably barring any undersupply or oversupply inefficiencies characteristic of a "credence good" market; (6) (2) depending on market definition, there are at least tens and probably hundreds of actual and potential certification providers, thereby sharply reducing the reasonable likelihood of any collusion-related inefficiencies; and (3) there are few legal requirements or other regulatory interventions that would otherwise skew the market's "natural selection" of the most efficient certification practice. …