Academic journal article Vanderbilt Law Review

Information Technology and Non-Legal Sanctions in Financing Transactions

Academic journal article Vanderbilt Law Review

Information Technology and Non-Legal Sanctions in Financing Transactions

Article excerpt

This Essay investigates the effect of advances in information technology on the private institutions that businesses use to resolve information asymmetries in financing transactions. The first part of the Essay discusses how information technology can permit direct verification of the information, obviating the problem entirely; the Essay discusses the example of the substitution of the debit card for the check, which provides an immediate payment that obviates the need for the merchant to consider whether payment will be forthcoming when the check is presented to the bank on which it is drawn.

The second part of the Essay discusses how advances in information technology can solve information problems indirectly: leaving the problem in place to some degree but mitigating its severity. The Essay uses three examples. First, it discusses how advances in information technology improve the functioning of reputational verification systems, with a special emphasis on the dis-intermediation of securities issuance. Second, the Essay discusses the rise of intermediation by pooling in the area of securitization. The Essay closes by discussing how information technology has facilitated the rise of the information merchant, which can sell information directly to those who need it for their transactions.

The problem of information asymmetry is at the core of all financing transactions. It is almost inevitable that the party seeking funds will possess information not already known to the parties that might provide funds. Because the information asymmetry increases the costs of the transaction-the lender should charge more to accommodate the risks associated with the borrower's informational advantage-any arrangement that mitigates the information asymmetry has the potential to lower the costs of the transaction.

Parties faced with that problem can respond in any number of ways. The simplest response would be to leave the problem unresolved, accepting the premium that the lender would charge as a cost of the transaction. Alternatively, the lender might expend funds to ascertain the relevant information directly (through a tedious process of "due diligence").

Often, however, businesses can use mechanisms to verify the truth of the borrower's assertions, mechanisms that generally might be called verification institutions.' From the perspective of the legal system as a whole, those institutions range along a spectrum from mechanisms provided by the law-a suit for misrepresentation or fraud, for example2-to mechanisms that operate almost completely outside the law, such as reputational sanctions.3 In between those two mechanisms fall such institutions as secured credit, for which legal recourse is formally part of the arrangement, but not demonstrably crucial to the effectiveness of the institution.4

If we believe that commercial enterprises in the longer run generally design their transactions so as to minimize the costs of such information problems, then the parties to those transactions generally should select the mechanism that best resolves the information problem at the lowest cost.5 Thus, two features of the current environment suggest that the current set of institutions is unstable. The first of those is a general rise in the costs of legal sanctions, reflected both in the increasing pecuniary costs of litigation and slowing rates of resolution of civil disputes presented to the courts.6 The second is a general decrease in the cost of acquiring, processing, and analyzing information. Taken together, those two effects would presage a significant shift in the balance of institutions away from formal legal sanctions-which apparently are beIMAGE FORMULA7coming more expensive and less effective-to non-legal sanctionswhich should become more effective as information-related costs continue to fall.

This Essay does not attempt to prove that point by examination of the non-legal sanctions that appear in a random sample of financing transactions or by case studies drawn to represent all major types of financing transactions. …

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