June 2018 will mark the 60th anniversary of the publication of Franco Modigliani and Merton Miller’s classic article, The Cost of Capital, Corporation Finance, and the Theory of Investment. Widely hailed as the foundation of modern finance, their article, which purports to demonstrate that a firm’s value is independent of its capital structure, is little known by lawyers, including legal academics. That is unfortunate, because the Modigliani-Miller capital structure irrelevancy proposition (when inverted) provides a simple, but powerful framework that can be extremely useful to legal academics, practicing attorneys, and judges.
Sixty years ago, the field of finance lacked mathematical precision and conceptual rigor, relying heavily on anecdotes and rules of thumb. With their 1958 article, MM, as both the pair of authors and their joint articles are referred to by economists, directly challenged conventional thinking by arguing that under certain idealized assumptions capital structure had no impact on firm value.
Because MM’s proposition was so out-of-step with conventional thinking, it was initially met with deep skepticism. Ultimately, however, after debate, economists concluded that the argument was theoretically correct. Given the initial assumptions (efficient and frictionless markets, no taxes, and only cash flows matter) the result (a firm’s value was independent of its capital structure) held. Nonetheless, most practicing finance professionals ignored MM because their assumptions were so inaccurate as to render the conclusion irrelevant.
Academic economists, however, focused not on the MM result, but on their method of argumentation. MM introduced arbitrage, which is today the cornerstone of finance, into financial economics.
Economists, however, were not finished studying capital structure. And when they returned, they recognized that the MM theorem provided the key: If capital structure affects value, it must operate through the MM assumptions. This reverse MM theorem holds that capital structure can affect firm value only through information, market frictions, taxes, or the allocation of assets with consumption elements.
The reverse MM theorem provides a powerful framework to examine and evaluate capital structure decisions, which can be useful to lawyers as well as financial economists.
The first and most obvious group of lawyers who can use the reverse MM theorem are academics who study transactional structures. Because the reverse MM theorem provides a complete list of ways in which capital structure can affect value, it provides legal scholars with a roadmap, whether they seek to explain or criticize existing capital structures or recommend new structures.
Although not as immediately evident, the theorem is also useful to practicing lawyers. For nearly a century, transactional lawyers have been trained through the Cravath method, a form of apprenticeship whereby a junior associate would start by working on a small piece of a transaction under the supervision of a more senior associate. As the lawyer progressed, he would take responsibility for successively larger portions of the transaction. The rationale for the Cravath method was that transactional lawyering had to be learned through experience.
Roughly 30 years ago, Ronald Gilson challenged that view and suggested that important aspects of the professional education of transactional lawyers could be taught in the classroom. Gilson recognized that lawyers face the same types of fundamentally economic problems, such as dealing with incentives and imperfect information, over and over again. Although these economics-based problems arise in different situations and present themselves in different forms, ultimately there are only a small number of basic economic concepts that underlie the core of the work that transactional lawyers spend the vast majority of their time addressing. Gilson further believed that lawyers would benefit from studying these basic economic concepts. In Gilson’s view, such an economically trained lawyer would be better able to recognize one of these problems and would have a deeper understanding of the issue. Gilson then put that thought into practice by teaming with two Columbia University colleagues, Victor Goldberg and Daniel Raff, and offering the first Deals course at the Columbia law and business schools.
After Raff left Columbia for the University of Pennsylvania and recruited me to teach Deals with him, Raff and I began using the reverse MM theorem to organize the ideas presented in our Deals course. Because the MM assumptions span the ways transactional structures can affect the total value of a firm (and partition those ways into silos), the reverse MM theorem ensures that the full range of ways in which structure can affect value are at least introduced (and covered at a high level of generality), even though not all of the ways can be explored at length.
There are also benefits to lawyers from learning the reverse MM theorem. Lawyers (and other transaction professionals) structure and execute transactions. Each step of the way, they make choices. These choices involve tradeoffs, which operate within and across the MM assumptions. The reverse MM theorem makes those tradeoffs explicit. A lawyer who knows the reverse MM theorem and is familiar with the main ideas in each silo is better able to understand the issues driving a transaction. In addition, she can more quickly acquire knowledge, because she is building out a framework (using the reverse MM theorem as a skeleton), and she is better able to retain knowledge because she can store it systematically, not just as a series of one-off examples. Such a lawyer can also more readily recall and employ her knowledge. She can focus her search among solutions to structurally similar problems across various practice areas rather than gravitating towards what has been done before in the same practice area.
Finally, one area where, to the best of my knowledge, reverse MM theorem has yet to be explicitly applied is in the court room. The reverse MM theorem can assist courts in drafting common law rules and is, thus, another tool litigators can employ. There is a broad range of issues, including prejudgment interest and ex-ante versus ex-post damage awards, that involve choosing among multiple remedies that could in principle compensate a successful plaintiff. The reverse MM theorem provides an economic approach to resolving these issues efficiently.
If the reverse MM theorem is such a powerful tool for lawyers, why has it been overlooked for so long? One possible reason is suggested by Lee Anne Fennell and Richard H. McAdams’s recent working paper, Inverted Theories. Fennell and McAdams argue that some of the most well-known ideas in law, such as the Coase theorem, are commonly understood in their original form, in which they yield negative or impossible results. According to Fennell and McAdams, the many such theorems are better understood in their inverted form, which takes the focus off of the negative or impossible result and puts the focus on the assumptions.
Fennell and McAdams find that reverse or inverted theorems are very uncommon in the law. Moreover, the reverse MM theorem in its original forms says little about law – or at least little about law that is likely to appeal to lawyers – since it implies that transactional lawyers are wasting their time and their clients’ money. If the MM theorem in its original form is accurate, then lawyers are just transaction costs and add no value for their clients. That is not a theorem that lawyers (or legal academics) are likely to embrace.
Lawyers, however, need to embrace the MM theorem in its inverted form. It is a powerful tool that will help legal academics, practicing lawyers, and judges all perform their work better.
REFERENCES
Lee Anne Fennell & Richard H. McAdams, Inverted Theories, August 11, 2017 working paper, available at https://ssrn.com/abstract=3017437.
Ronald J. Gilson, Value Creation by Business Lawyers: Legal Skills and Asset Pricing, 94 Yale Law Journal 239 (1984).
Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporate Finance and the Theory of Investment, 48 The American Economic Review 261 (1958).
This post comes to us from Michael Knoll, Theodore Warner Professor at the University of Pennsylvania Law School, professor of real estate at The Wharton School, and co-director of the Center for Tax Law and Policy at the University of Pennsylvania. It is based on his recent article, “The Modigliani-Miller Theorem at 60: The Long-Overlooked Legal Applications of Finance’s Foundational Theorem,” available here.