Article: State and Local Government Funding of Health and Retirement Benefits for Employees: Current Problems and Possible Solutions with California Health Benefts as an Example

Government employee health and retirement benefits have come under a likely unprecedented critique, some may say attack, during the difficult economic times, particularly for state and local governments, during the beginning of the second decade of the twenty-first century.  Some suggested changes are more incremental than others.  The City of San Diego is putting a measure before voters to offer new city employees 401(k)’s rather than defined benefit pensions.[1]  The voters in the City of Carlsbad, a San Diego suburb, have already approved an initiative requiring future city employees’ benefits to be approved by voters.  Carlsbad had already implemented a two-tiered pension system in which new employees receive significantly lower retirement benefits.[2]  The University of California Board of Regents (“UC Regents”) has recently voted to increase employee and employer contributions to the retirement plan as well as to raise the retirement age for future university employees and to require those employees to pay more for their health care benefits.[3]  The UC Regents also has been resisting an effort to raise the limit on compensation upon which pensions are calculated.[4]  Other efforts have been to restrict the ability of employees to add to their pensions, for example, by buying additional years to add to the pension formula (normally, for example, years of services times final salary year or three year compensation times 1.2% to 3%).[5]

Some attempts at curtailing public employees’ retirement and health benefits are likely more radical.  The California Little Hoover Commission, an independent group including five governor-appointed citizens, four legislature-appointed citizens, two state senators, and two state representatives,[6] recently recommended “freez[ing] pension benefits for current state and local government workers” and moving to a “hybrid model” that would include a 401(k).[7]  The Commission also recommended a two-tiered system with lesser benefits for new employees, increasing contributions from government workers, preventing workers from increasing pay in final year of service, capping annual salary for calculating pension benefits, and increasing minimum retirement age, among other suggestions.[8]  The State of Wisconsin passed legislation to deny collective bargaining to government employees for benefits.[9]  Finally, the City of San Diego successfully litigated against the city police union to be able to renegotiate future health benefits of retirees.[10]

This article will first examine the various estimated costs for future retirement and health benefits of state and local government employees.  Secondly, the article will evaluate some of the suggested reductions in retiree health benefits and the limitations on such reductions, particularly in the context of the laws of California as an example.  Finally, the article will examine the health and retirement benefits of state and local government employees within the larger context of the societal stake in such benefits.

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John R. Dorocak, Honors A.B., Xavier University, J.D., Case Western Reserve University, LL.M. (Tax), University of  Florida, C.P.A., California and Ohio, is a Professor of Accounting at California State University, San Bernardino.  James Estes, B.A., M.B.A., California State University, Fullerton, Ph.D, California Coast University, CFP, CPCU, ChFC, CLU, is a Professor of Finance at California State University San Bernardino.  The Authors thank Lloyd E. Peake, B.A., University of Southern California, J.D., Southwestern University, Professor Emeritus in the Department of Management at California State University, San Bernardino, for his insightful comments.

[1]. Craig Gustafson, Public Safety Pensions Could Be On The Line Decision On Pensions May Go To Voters, San Diego Union-Trib., Feb. 26, 2011, at A1.

[2].See Aaron Burgin, Carlsbad Pension Reform Initiative Wins, SignOnSanDiego.Com (Nov. 2, 2010, 8:19 PM),

[3]. See Terence Chea, UC Regents Vote to Raise Pension Contributions, SignOnSanDiego.Com (Sep. 16, 2010, 11:44 AM),; Terence Chea, UC Raises Retirement Age for University Employees, SignOnSanDiego.Com (Dec. 13, 2010, 4:39 PM),

[4]. The Associated Press, Top Univ. of Calif. Execs. Seek Big Pension Boost, (Dec. 29, 2010, 12:22 PM),

[5]. See Anthony York & Jack Dolan, California State Employees Take Advantage of Pension Perk, L.A. Times, Feb. 16, 2011, available at

[6].Commissioners, Little Hoover Commission, (last visited Feb. 13, 2012).

[7]. Judy Lin, Commission: Freeze Pensions for Calif. Workers, (Feb. 24, 2011, 4:35 PM),; see also Marisa Lagos, Commission Urges Major Overhaul of State Pensions, The S.F. Chron., Feb. 25, 2011, at C8.

[8]. Lin, supra note 7.

[9]. Mark Trumbull, Did Wisconsin Senate Choose Nuclear Option in Collective-Bargaining Fight?, The Christian Sci. Monitor (Mar. 9, 2011),

[10]. San Diego Police Officers Ass’n v. San Diego City Emps. Ret. Sys., 568 F.3d 725, 740 (9th Cir. 2009).

Note: Death and Taxes: (Over?)Reaction to Section 1706 of the Tax Reform Act

“If you’re reading this, you’re no doubt asking yourself, ‘[w]hy did this have to happen?’”[1]  Indeed, many people across the country asked this very question after the events that took place on February 18, 2010.  At approximately 9:40 that morning, after setting fire to his home in North Austin, Texas, a man climbed into his Piper Cherokee PA-28 aircraft at Georgetown Municipal Airport.[2]  Just sixteen minutes later, that same plane crashed into an office building at 9430 Research Boulevard—seven miles from the state capitol.[3]  As the building burned and smoke plumed, details began to emerge.  One person missing.[4]  Twelve injured.[5]  The smoldering building housed the local office of the Internal Revenue Service (IRS).[6]  There also surfaced a name: Andrew Joseph Stack III.

In the hours following the crash, those investigating the situation discovered an online posting signed by “Joe Stack.”[7]  It quickly became clear that the events of that day were no accident.  Part suicide note and part manifesto, Stack’s online post railed against God and government, placing primary blame on the latter for devouring his savings and ruining his life.[8]  In particular, Stack cited a specific provision of federal tax law (Section 1706 of the Tax Reform Act of 1986), insisting that it had stripped him of his livelihood.[9]  Stack’s solution?  The closing lines of his online posting not only answered that question, but also offered a disturbing explanation for the events of that day: “[w]ell, Mr. Big Brother IRS man, let’s try something different; take my pound of flesh and sleep well.”[10]  In his final act, Stack had boarded his single-engine plane and targeted the group that he perceived as his greatest maligners: the IRS.

In the days, weeks, and months following February 18, 2010, Stack’s actions produced a wide range of reaction.  While his tactics drew everything from condemnation to commendation in the political realm, one of the more heated debates swirled around Stack’s harsh commentary on Section 1706.[11]  Stack viewed that provision as the origin of his financial woes.[12]  According to his colorful interpretation, Section 1706 declared him “a criminal and non-citizen slave,” stripping him of the freedom to decide how he would make a living.[13]  While most serious commentators provided a more muted framing of the situation than Stack himself, a surprising number of them agreed with Stack’s underlying premise that Section 1706 placed an unfair burden on people in his situation.  Evoking images of a destroyed American dream and stifled technological creativity, critics of the section denounced Stack’s suicidal actions, but agreed with the proposition that “something had to give.”  According to these commentators, the burden Section 1706 placed on a particular group far outweighed any perceived benefits.  In their view, the “discrimination” against individuals in Stack’s position had to end.

Proponents of Section 1706 did not remain silent.  Responding to those criticizing the law as unfair, several commentators defended the necessity of Section 1706; without it, tax avoidance by those similar to Stack would produce huge shortfalls in IRS collections as a result of exploitation.  These advocates of Section 1706 viewed Stack’s opposition to the provision as a concomitant of pure self-interest.  He objected to the law because it prevented him from cheating the tax system.  In this way, supporters perceived Section 1706 as accomplishing its intended goal of foreclosing the attempts of people like Stack to circumvent paying their fair share of taxes.  In short, the section served to prevent unfairness, not engender it.

In this note I will analyze the arguments for and against Section 1706.  First, I will explain the fundamental differences between an independent contractor and an employee, as well as the confusion between the two that required Congress to act.  Next, I will detail the enactment of Section 530 of the Revenue Act of 1978 and its effect on the problem of worker classification, explaining both the immediate aftermath and the long-term implications for workers.  Then, I will discuss the origin of Section 1706, detailing its impact on federal taxation and the technological community.  Finally, I will turn to the heated debate that began in the aftermath of Stack’s violent actions and determine whether, despite his methods, that angry taxpayer had a valid point.  Given the combustible nature of the present national dialogue, it is important to know if people like Andrew Joseph Stack have some method underlying their madness.

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Steven Cunningham: J.D. Candidate, Syracuse University College of Law, 2012; B.A. & M.A., Classical Studies, magna cum laude, Boston University, 2009.

[1]. Suicide note of Andrew Joseph Stack III, N.Y. Times (Feb. 18, 2010),

[2]. Michael Brick, Man With Grudge Against Tax System Crashes Plane Into Texas I.R.S. Office, N.Y. Times, Feb. 19, 2010, at A14, available at

[3]. Id.

[4]. Michael Brick, For Texas Pilot, Rage Simmered With Few Hints, N.Y. Times, Feb. 20, 2010, at A1, available at

[5]. Id.

[6]. Brick, supra note 2.

[7]. Stack, supra note 1.

[8]. See id.

[9]. See id.

[10]. Id.

[11]. One of the more indelicate instances of the political commendation appeared on Facebook.  On that site, Syracuse conservative talk show host Jon Alvarez created a group praising Stack’s “sacrifice.”  Facebook removed the tribute within hours, citing its ban on hateful and threatening posts.  See Christina Boyle, Facebook Pulls Plug on Tax-icide Tribute to Joseph Stack, Pilot Who Crashed Plane into Austin Office, N.Y. Daily News (Feb. 20, 2010),; see also Dave Tobin, Facebook Shuts Down Radio Host’s Homage to Suicide Pilot, The Post-Standard, Feb. 20, 2010, at A3, available at

[12]. See Stack, supra note 1.

[13]. Id.

Note: Nights on the Museum: Should Free Housing Provided to Museum Directors Also be Tax-Free

The Metropolitan Museum of Art is, arguably, one of the great cultural institutions of our time.  Visitors come from all over the world to indulge in its timeless collection spanning five thousand years of art and history.  It carries with its name not only the sound of resonating prestige, but also a mission to “stimulate appreciation for and advance knowledge of works of art that collectively represent the broadest spectrum of human achievement at the highest level of quality, all in the service of the public and in accordance with the highest professional standards.”[1]  To accomplish this mission, it requires that its director reside in a $4 million co-op, across the street from the museum, for free.[2]

Mr. Thomas Campbell, the newest director of the museum, is not the only curator receiving this generous fringe benefit.  This surprising advantage to the promotion of art and culture is also welcomed by the directors of other prestigious New York City museums,[3] including the president of the American Museum of Natural History, and director of the Museum of Modern Art.[4]  These three museums serve not only as homes to priceless works of art, but they also serve to provide their directors with about $15 million worth of “home.”[5]  A combined fair rental value of about $400,000 per year is provided free of charge, and free of tax, by the museums.[6]  This means that each director, in signing his or her employment agreement, accepts the luxurious housing, in addition to a handsome salary, as compensation.  Compensation, as most Americans know, is taxed.  However, for these museum directors, though their cash salary is included on their yearly income tax return, the value of the housing is not.  It apparently does not count as compensation.

In some situations this tax-free arrangement is not surprising.  It may be essential that an employee, such as a hospital worker, be available for twenty-four hour emergency calls.[7]  Parks may also provide housing for their rangers if they are required to be around at all hours of the day and night.[8]  Alternatively, certain jobs require individuals to move to isolated locations, such as a construction worker employed at a project at a remote job site,[9] or a military official called to relocate to a camp.[10]  Each of these situations seems fair, since if the employees were not provided with housing, it would be unlikely that they would be able to properly perform their work.  Does this call for necessity resonate in a museum director’s profession?  Of course, one important function of a museum director is to solicit and charm donors to contribute works of art to the museum.  However, does a museum director’s need for extravagant housing in a metropolitan area parallel a construction worker’s requirements for housing after he relocates to a secluded job site in Alaska?

Perhaps the answer to this question is buried deep within the purposes and policies of our tax code.  Though the government must collect revenues, maybe relief should be given to certain individuals to lighten their load.  This Note will argue that a museum director, or other executive of a cultural institution, does not qualify as one of these burdened taxpayers, and should not be able to exclude from his gross income the value of housing provided for him by his museum employer.  Part I will provide a history of Section 119, the provision of the Internal Revenue Code (the “Code”) that these directors look to for excluding the value of housing from gross income.  This part will include a brief discussion of Section 119’s legislative history and the reasons behind its enactment in 1954.  Next, Part II will illustrate the three “elements” of Section 119, which must all be satisfied to qualify for the exclusion.  This part will include several examples of how regulations, rulings, and judicial decisions have interpreted each element, and the standards that have been applied.  Part III applies these interpretations to a museum director’s treatment of housing, and argues that based on current case law, the value of housing should be included income.  Finally, Part IV concludes that though Section 119 is a necessary provision designed to alleviate the burden on those in unique professions, it does not serve the purposes of the Section to exclude the value of housing from a museum director’s income.

Jane Zhao: Syracuse University College of Law, J.D. 2012.


[1]. IRS Form 990, Schedule O for the Metropolitan Museum of Art for 2008,, (last visited Nov. 9, 2011).  “The Internal Revenue Service (IRS) Form 990 is titled “Return of Organization Exempt From Income Tax.”  Form 990 returns are required to be filed annually by most tax-exempt organizations, except for church and government-affiliated organizations.  Form 990 is “the primary tool for gathering information about tax-exempt organizations, for educating organizations about tax law requirements and ensuring their compliance.  Organizations use it to inform the public about their programs.”  Form 990 Resources and Tools,,,,id=214479,00.html (last visited Nov. 21, 2011).

[2]. Kevin Flynn & Stephanie Strom, Plum Benefit to Cultural Post: Tax-Free Housing, N.Y. Times, Aug. 9, 2010, at A1, available at

[3]. Though this Note will mainly focus on examples of New York City museums, it should be mentioned that museums throughout the nation are inconsistent in whether the housing provided to their director is tax-free.  For example, in 2008, the Art Institute of Chicago, recognized the value of housing provided to its director as gross income.  See IRS Form 990, Schedule J for the Art Institute of Chicago for 2008,, (last visited Nov. 9, 2011).  The Smithsonian, in Washington, D.C., did not provide housing to any employees.  See IRS Form 990, Schedule J for the Smithsonian Institution for 2008,, (last visited Nov. 9, 2011).  The Museum of Fine Arts in Boston and the San Francisco Museum of Modern Art did provide housing to their directors but did not disclose whether such housing was treated as gross income on the directors’ tax returns.  See IRS Form 990, Schedule J for the Museum of Fine Arts for 2008,, (last visited Nov. 9, 2011); IRS Form 990, Schedule J for the San Francisco Museum of Modern Art for 2008,, (last visited Nov. 9, 2011).

[4]. Flynn, supra note 2.

[5]. Id.

[6]. Id.

[7]. See 4 C.B. 85, 1921 WL 50340 (1921).

[8]. See Coyner v. Bingler, 344 F.2d 736 (3d Cir. 1965).

[9]. See Treas. Reg. § 1.119-1(f), Example (7) (2010).

[10]. See infra note 28.

Article: Ebbing the Tide of Local Bank Concentration: Granting Sole Authority to the Department of Justice to Review the Competitive Effects of Bank Mergers

Take a trip back: the year is 1991, and First Hawaiian, Inc., Honolulu, Hawaii (“Applicant”) has applied for Federal Reserve Board (“Fed”) approval to acquire First Interstate of Hawaii, Inc., Honolulu, Hawaii, (“FIH”) which owns a bank as one of its subsidiaries.[1]  The Fed, instructed by statute to determine whether a particular transaction is likely to lessen competition, notes first that the Applicant is the second largest commercial banking organization in Hawaii, and that FIH is the fourth largest commercial banking organization in Hawaii.[2]  Further, after consummation of the transaction, the Applicant would control 37.3% of the total deposits in commercial banking organizations in Hawaii.[3]  Upon first blush, one would assume that the Fed would be hesitant to approve the transaction, given that the Applicant would occupy an even more dominant position in the Hawaiian commercial banking market.  But the Fed, much to the chagrin of the United States Department of Justice’s Antitrust Division (“DOJ”), approves the transaction, concluding that the proposed acquisition would not have “a substantially anticompetitive effect in any relevant market.”[4]

Now flash forward to the present day.  The United States has suffered through an economic collapse that required multiple bank bailouts, including $700 billion under the Troubled Assets Relief Program (TARP).[5]  All told, the Fed lent $2 trillion to shore up banks,[6] with much of the money going towards bailing out America’s largest banks, such as Bank of America[7] and Citigroup.[8]  Although the causes of the crisis are numerous,[9] there is no denying that regulators “pumped tens of billions of dollars into the nation’s leading financial institutions because the banks were so big that officials feared their failure would ruin the entire financial system.”[10]  After the financial collapse, the public and policymakers alike heaped much scorn upon banks that had become “too big to fail.”  But another pressing concern rose from the ashes of the fallout of the financial crisis: increasing levels of bank concentration in small, local markets and the dangers such concentration presents.

Banks in localized, small markets have sought out consolidation with equal vigor as the titans of the industry, and for good reason.  Empirical analysis demonstrates that as concentration among local markets increases, the banks operating in those markets have increased profit rates, can pay lower interest rates on deposits, and can charge higher interest rates on loans.[11]  This has a particularly potent effect on small businesses that rely primarily on local banks for their credit needs.[12] Yet under the current banking regulators’ antitrust analysis, lending to small- and medium-sized businesses as a distinct submarket is ignored, which presents opportunities for local banks, such as those involved in First Hawaiian, to exploit their increased market power, or, at the very minimum, to continue to seek consolidation in hopes of obtaining a monopoly over local markets.

This Article argues that the DOJ, rather than the banking regulators, such as the Fed, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC), should be given the sole power to review the competitive effects of bank mergers to minimize the dangers of continued local bank concentration.  Although we will never know the extent to which bank consolidation could have been prevented, it is clear that mergers such as First Hawaiian Inc., Honolulu, Hawaii would have come out differently under DOJ review.  Section I of this Article explores America’s long storied fear—shared by the public and policymakers alike—of concentration among industries, particularly that of the banking industry.  Section II describes the laws governing bank mergers that grew out of this fear of concentration, and details the reemergence of concentration in the banking industry.  Section III begins with a look at how the bank merger process works and then proceeds to explain why the DOJ should be the agency responsible for reviewing the competitive effects of bank mergers.  Finally, Section IV contemplates and responds to potential counterarguments.

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Aaron Stine: J.D., The George Washington University Law School.  B.A., International Relations, Mandarin Chinese, Michigan State University.

Eric Gorman: J.D., The John Marshall Law School.  B.S., Mechanical Engineering, Michigan State University.

[1]. See First Hawaiian, Inc., Honolulu, Hawaii, 77 Fed. Res. Bull. 52, 52 (1991).

[2]. Id. at 54.

[3]. Id.

[4]. Id. at 57.

[5]. See Alex Johnson, Bush Signs $700 Billion Financial Bailout Bill, (Oct. 3, 2008),

[6]. See Alan Feuer, Battle Over the Bailout, N.Y. Times,  Feb. 14, 2010, at MB1.

[7]. Bank of America received a $20 billion bailout and a government guarantee for almost $100 billion of potential losses on toxic assets through an individual rescue plan, in addition to the $25 billion it received under TARP.  See Patrick Rucker & Jonathan Stempel, Bank of America Gets Big Government Bailouts, (Jan. 16, 2009),

[8]. Citigroup received guarantees on losses of its pool of approximately $306 billion in troubled assets, along with $45 billion in capital.  See David Enrich et al., U.S. Agrees to Rescue Struggling Citigroup, Wall Street J., Nov. 24, 2008, at A1.

[9]. For an overview of the causes of the financial crisis, see generally Kenneth E. Scott, The Financial Crisis: Causes and Lessons, 22 J. Applied Corp. Fin. 8 (Dec. 10, 2009), available at; see also Sheila C. Bair, Chairman, FDIC, Causes and Current State of the Financial Crisis Before the Financial Crisis Inquiry Commission (Jan. 14, 2010), available at

[10]. See David Cho, Banks ‘Too Big to Fail’ Have Grown Even Bigger, Wash. Post, Aug. 28, 2009, at A01.

[11]. See generally R. Alton Gilbert & Adam M. Zaretsky, The Federal Reserve Bank of St. Louis, Banking Antitrust: Are the Assumptions Still Valid? (2003), available at

[12]. See generally Robert DeYoung et al., Youth, Adolescence, and Maturity of Banks: Credit Availability to Small Business in an Era of Banking Consolidation, 23 J. Banking & Fin. 463 (1999), available at http://

Article: Sacrificing Functionality for Transparency? The Regulation of Swap Agreements in the Wake of the Financial Crisis

Once the sole province of chief executive officers and hedge fund managers, swap agreements (or “swaps”), most notably credit default swaps,[1] came to the forefront of politicians’ and regulators’ minds with the near-collapse of the U.S. financial system in 2008.  Having operated largely in the shadows of the lightly regulated over-the-counter (OTC) derivatives market, companies went unimpeded when they sold credit default swaps to cover trillions of dollars in securities and bonds.[2] Credit default swaps written by American International Group, Inc. (AIG), for instance, covered more than $440 billion in bonds.[3] Unable to cover the contracts’ costs when they became due at the onset of the financial crisis, the U.S. government, arguably to save the larger financial system,[4] bailed out AIG and some of the largest financial institutions in the world.[5]

In response, and in an effort to gain control over the opaque OTC derivatives market, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in 2010, which, in part, provided authorization to both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to regulate swap agreements.[6]  Acting on its congressional mandate, the SEC in early 2011 released for public comment Regulation SB SEF,[7] which purports to remove many swap agreements from the OTC market and put them on exchanges or swap execution facilities, and thereby inject greater transparency into the OTC derivatives market.

This Article argues that Regulation SB SEF does not adequately consider the fundamental differences between securities and swap agreements that render swap agreements less amenable to securities-like exchanges.  Part I of this Article defines what a swap agreement is and describes the SEC’s attempt to regulate them.  Part II dissects the case for regulating swap agreements and analyzes their fundamentals in order to better understand how to regulate them.  Part III suggests an alternative regulatory structure that will better allow the swaps market to function.

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Reed Schuster: Associate, Faegre Baker Daniels LLP; J.D. 2011, University of Minnesota Law School.

[1]. For a more in-depth discussion of credit-default swaps, see infra Part I.A.1.b.

[2]. See Marco Avellaneda & Rama Cont, Int’l Swaps & Derivatives Ass’n, Transparency in Credit Default Swap Markets 8 (July 2010), available at (“In 1997, the notional open interest in [credit default swaps] was on the order of 200 billion dollars; by 2007 it had grown to approximately USD 60 trillion.”).

[3]. Adam Davidson, How AIG Fell Apart, Reuters (Sept. 18, 2008),

[4]. Cf. Henry M. Paulson Jr., On the Brink: Inside the Race to Stop the Collapse of the Global Financial System 99 (2010) (“A Bear Stearns failure wouldn’t just hurt the owners of its shares and its bonds.  Bear had hundreds, maybe thousands, of counterparties—firms that lent it money or with which it traded stocks, bonds, mortgages, and other securities.  These firms . . . all in turn had myriad counterparties of their own.  If Bear fell, all these counterparties would be scrambling to collect their loans and collateral. . . .  That was how bank runs started these days.”).

[5]. See, e.g., Steven M. Davidoff, Uncomfortable Embrace: Federal Corporate Ownership in the Midst of the Financial Crisis, 95 Minn. L. Rev. 1733, 1737-44, 1754-55 (2011) (discussing the U.S. government’s assistance to AIG, Citigroup, and Bank of America); Matthew Karnitschnig et al., U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up, Wall Street J. Online (Sept. 16, 2008), (reporting on the U.S. government’s bailout of AIG).

[6]. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 762, 124 Stat. 1376, 1759 (2010).  Interestingly, save for section 10(b) of the Securities Exchange Act of 1934, see Commodity Futures Modernization Act, Pub. L. 106-554, § 303(d), 114 Stat. 2763, 2763A-454 (2000) (providing for the regulation of swap agreements under section 10(b)); see also Caiola v. Citibank, 295 F.3d 312, 327 (2d Cir. 2002) (“Sections 302 and 303 of the [Commodity Futures Modernization Act] define ‘swap agreements’ and then expressly exclude them from the definition of ‘securities,’ but amend section 10(b) to reach swap agreements.”).  Swap agreements were expressly exempted from regulation in the Securities Exchange Act of 1934.  15 U.S.C. § 78c-1(a)-(b) (2006).

[7].Registration and Regulation of Security-Based Swap Execution Facilities, 76 Fed. Reg. 10,948 (proposed Feb. 28, 2011) (to be codified at 17 C.F.R. pts. 240, 242, 249).

Article: Financing Innovation: Branding, Monitoring, and Uncertainty

A recent breakthrough in contract theory identified the practice of braiding, in which parties weave informal and formal elements of contract together to overcome uncertainty.  These contracts are especially prevalent in the context of collaboration for technological innovation, but they also appear in other contexts with significant uncertainty, such as preliminary agreements in mergers and acquisitions.  Thus far, the literature has focused solely on the core contractual relationship—the crystallized instance of the initial agreement between two companies, such as a research collaboration between a large pharmaceutical company and a small biotechnology company.

This article builds on braiding theory in several ways.  It provides new empirical information by analyzing actual contracts, modifications, and financing arrangements.  It expands braiding theory’s initial inquiry and seeks to understand how modifications to such original agreements affect braiding and how secured lenders finance such uncertain collaborations and monitor debtors.

Modifications reveal how parties gradually resolve uncertainty and how they respond to newly arising uncertainty.  First, modifications have shifted power within the “contract referee mechanism,” suggesting that braiding also works well as a mechanism to deal with ex ante uncertainty of bargaining power, revelation of information throughout the relationship, and ex post reallocation of that power.[1]  Second, modifications have formalized certain switching costs in termination provisions, and have adjusted those costs over time.[2]  This formalization suggests that crowding out of informal elements (here, switching costs) is not a necessary result even when there is a high-powered formal element.  Third, modifications reveal innovative nested option structures[3] that are developed in stages as nested uncertainty is revealed.[4]  Low-powered formal mechanisms[5] appear to be essential in developing an option-based response to these unforeseen uncertainties.

The secured lender’s behavior in these contracts is initially puzzling: neither the braiding solution nor the traditional secured credit solution is present to resolve uncertainty or even manage the risk of routine opportunism.[6]  The secured credit theory predicts that the lender will take one of two measures to police opportunism: monitor the debtor’s behavior or accept a bonding gesture by the debtor.[7]  Here, neither of those occur in any significant way.  The lender cedes control over the primary assets of the small collaborator, the intellectual property (IP), and allows the big collaborator an exclusive license.  The lender also does minimal monitoring: it might receive financial statements, but it does not actively monitor debtor behavior, the collaborative process, or the collateral.  Instead, the lender’s primary strategy is to take a security interest in the small company’s payment rights from any IP that emerges from the collaboration.

This article solves the puzzle with two steps that refine foundational assumptions in secured credit theory and the theory of transacting around uncertainty.  First, it is not the secured lender who monitors the debtor, but the big collaborator.  The big collaborator’s monitoring acts as a substitute for the secured lender’s expected monitoring.  Secured credit theory typically describes the secured lender as a “cop on the beat,” which allows other unsecured creditors to provide credit without worrying about monitoring.  Here, the big collaborator is the “cop on the beat,” and it is the secured lender who is benefitting from that diligence.  This particular monitoring arrangement is also normatively optimal as the secured creditor does not have the usual combination of countervailing effects—focused monitoring and security’s disincentivizing insulated recovery.[8]

Second, Knightian uncertainty is relative.[9]  The underlying uncertainty problem that braiding contracts attempt to solve is not an absolute attribute of a particular event or series of events as economics literature has typically suggested.  Instead, one’s economic position with regard to specific uncertainties can transform an uncertain event into a risky event.  This result can be seen in the secured lender’s strategy.  The big and small collaborators effectively solve the uncertainty problem in their technological innovation contract, but the uncertainty is not automatically solved for other parties.  Unlike the elimination of risk by monitoring, the uncertainty is still present and will not dissipate until the necessary information is revealed (or created).  The secured lender, however, cares nothing of this uncertainty and instead makes a bet on the exogenous probability of the success of the venture.  The uncertainty endogenous to the collaborative relationship determines that outcome, but need not be a part of the secured lender’s risk calculus.[10]  For example, any collaboration may have a ten percent chance of success, but the direction of each individual collaboration may be radically uncertain.  By having a position outside of that relationship, the secured lender has a different relative position and can avoid the uncertainty problem inherent in braiding contracts.  Portfolio theory provides a more rigorous explanation of this phenomenon by describing how specific uncertainty may be diversified away, a fact previously undeveloped in economic and legal academic literature.

Part II describes the theoretical background for this discussion.  It describes the phenomenon of braiding contracts and how they solve problems of technological and partnership uncertainty.[11]  It also considers alternative theories that seek to explain how the uncertainty problem has been solved, such as modularity theory and relational contracting theory.  It also examines prior empirical literature on collaborative alliances and questions its underlying assumptions about contracts underlying this literature.

Part III examines a new example of a prototypical braiding relationship and its contractual modifications as that relationship developed over time.  Specifically, it examines how modifications affect the contract referee mechanism, switching costs, and the nested options structure.  The modifications of these features reveal that braiding also deals with uncertainty of bargaining power[12] and unforeseen uncertainties which only emerge once the relationship has developed.  The formalization of switching costs through high-powered mechanisms also further undermines the explanatory power of the crowding-out phenomenon in the economics literature, but perhaps only where the formal and informal elements of the contract are tied to different information streams.

Part IV examines the third-party loan agreement with the small collaborator in that relationship.  The actual structure of this loan agreement undermines the standard predictions one would make under current theories of secured credit and policing debtor opportunism.  This analysis discerns a new pattern of monitoring, helps to refine existing secured credit theories and adds a new tool for solving puzzles in explaining the pattern of secured credit.

Part V considers the loan agreement’s approach to the collaboration’s uncertainty, finding that the only plausible explanation is that Knightian uncertainty is positionally relative.[13]  The secured lender is actually operating under a risk-based scenario despite the uncertainty inherent in the collaboration that it is lending into.  After describing intuitive analogies for this argument, this Part adds a first cut at using portfolio theory to establish a rigorous basis for the relativity of uncertainty.  The Part concludes by considering what the relativity of uncertainty means for the role of business lawyers in such transactions.

Part VI concludes.

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Nicholas J. Houpt: Associate, Akin Gump Strauss Hauer & Feld LLP.  J.D., Columbia Law School; B.A. University of Notre Dame.

[1]. Ronald J. Gilson et. al., Braiding: The Interaction of Formal and Informal Contracting in Theory, Practice, and Doctrine, 110 Colum. L. Rev. 1377, 1403 (2010) [hereinafter Gilson, Braiding].  A “contract referee mechanism” is a dispute resolution mechanism used in braiding contracts.  Id.  The mechanism typically requires (near) unanimous consent for certain key decisions in the collaborative relationship.  Id.  Lower-level employees are typically the ones deciding at first, with any unresolved disputes going to higher-level employees.  Id.

[2].Id.  Switching costs are the costs of finding another partner with whom to collaborate.  Gilson, Braiding, supra note 1, at 1403.  These costs include the learning curve that the new partner would have to undergo to catch up to the current partner, and would include a discount for reliability and trust that has not yet been established.

[3]. See id. at 1407-09.  Nested options are a mechanism used to solve potential hold-up problems that may arise once uncertainty is dissipated.  For example, once a technological innovation is developed, the next stage is commercialization.  One can predict these stages beforehand and use an option structure at each stage to prevent opportunism.  One collaborator may have an option of first refusal on the commercialization of any product that is developed, and if that collaborator cannot reach a commercialization agreement with the other, the other has an option to purchase the product and commercialize it through other means.  Without these options, the parties might try to hide their successes from each other and act opportunistically.

[4]. In this article, I challenge the effectiveness of nested options by pointing to evidence of nested uncertainty.  As one type of uncertainty is resolved and a predictable stage is entered, another type of uncertainty may develop that presents its own opportunism problems.  This unpredictable uncertainty can only be dealt with once it arises.

[5]. Low-powered formal mechanisms are soft commitments, like an obligation to negotiate in good faith.  High-powered formal mechanisms are much harder commitments, such as the obligation to perform a certain task at a certain time.  In the context of braiding contracts, low-powered formal mechanisms are used because hard terms, like price, quantity, and typical covenants, do not fit well with uncertain processes.  The options that are typically used are options to negotiate about a particular term or to terminate the agreement.

[6]. I explain other standard theories of secured credit not discussed in the Introduction, such as relational contracting and contextualist theory in Part IV.

[7]. See Saul Levmore, Monitors and Freeriders in Commercial and Corporate Settings, 92 Yale L.J. 49, 50-59 (1982) (describing monitoring and bonding as the two methods secured lenders use to manage agency costs).  See infra Part III.A for a more thorough discussion of the many different theories of secured credit.

[8]. See infra Part IV.C (discussing Richard Squire’s theory of symmetry in creditor’s rights).

[9]. Knightian uncertainty and risk are categories of risk proposed by the economist Frank Knight.  See generally Frank H. Knight, Risk, Uncertainty and Profit 197-232 (1921).  Risk is quantifiable and can be probabilistically allocated, whereas uncertainty is so radically unquantifiable that any allocation of risk would be arbitrary.


[10]. A familiar analogy might be the way that venture capitalists fund start-up firms.  The venture capitalist does not care that the entrepreneur wanted to invent a war-time anesthetic for soldiers and ended up with Novocain, a product that was successful in a different market; the venture capitalist looks for an innovative product with a chance of success.  Once found, the venture capitalist typically provides funds in exchange for equity, and the venture capitalist sells off a large portion of that equity once the product has succeeded.

[11]. Partnership uncertainty is the uncertainty involved in finding a collaborator whom one can trust, who will fit well with one’s working style, and who has the skills and know-how to make a successful collaboration.  Each of these things is difficult to signal before the collaboration begins, leaving these qualities uncertain ex ante.  As the collaboration proceeds, one can establish informational mechanisms to observe these qualities in the partner.


[12]. Uncertainty of bargaining power refers to the parties’ inability ex ante to determine which party is least likely to defect when given an ex post decision right.  In other words, it is not clear which party has the most to gain or most to lose in any future state of the world.

[13]. Positionally relative might mean several things and this article is only a first cut at clarifying the concept.  Uncertainty can be relative to one’s economic position, which would differentiate between the lender and the big collaborator, who each have very different economic transactions with the small collaborator and hence each have different concerns about uncertainty.  The other possibility is that uncertainty is relative to legal position.  The legal structure of the loan can be asset-based or cash-flow based and this structure might change how much uncertainty matters to the lender.