The Modigliani-Miller Theorem at 60: The Long-Overlooked Legal Applications of Finance’s Foundational Theorem

Sixty years ago, Professors Franco Modigliani and Merton Miller unveiled their capital structure irrelevancy theorem and revolutionized financial economics with their ‘bombshell assertion’ that under certain idealized assumptions (efficient and frictionless markets, no taxes, and only cash flows matter) the total value of a firm was independent of its capital structure.  Although the MM theorem (economists refer to the authors, their articles, and their results all simply as MM) has made little inroad into legal scholarship, many ideas that have developed out of MM’s fundamental insight – that capital structure can affect firm value only through the MM theorem’s assumptions – are today part of the canon of foundational legal ideas, such as informational asymmetries and agency costs.   In a recent working paper, The Modigliani-Miller Theorem at 60: The Long-Overlooked Legal Applications of Finance’s Foundational Theorem, I argue that the legal profession’s failure to recognize the many legal settings where the MM theorem can be applied and the numerous issues it can illuminate has deprived legions of lawyers of a powerful analytical framework.  Explicitly incorporating the MM theorem into legal analysis and giving it a prominent place in the legal canon will help legal academics, practicing lawyers, and judges all perform their work better.

The power of the MM theorem is found not in its original form, where it states that given certain idealized assumptions, capital structure does not impact firm value.  Instead, it comes from its reverse or inverse form, where it states that capital structure can impact value only through the assumptions.  The reverse MM theorem holds that capital structure can impact firm value only through information, market frictions, taxes, or through the allocation of consumables.

The reverse MM theorem, thus, provides a powerful, yet compact analytical framework.  Because it covers the full range of ways in which capital structure can impact value and divides those ways into four categories or silos, the reverse MM theorem provides a roadmap for anyone interested in understanding how capital structure broadly defined can impact value.

Such a framework would, most obviously, be useful to academics studying businesses and their capital structures. Thus, the reverse MM theorem can be used positively by scholars to understand how capital structures have evolved and developed over time.  It can also be used normatively to criticize existing structures as inefficient or prescriptively to develop new and improved structures.

Less intuitively, the reverse MM theorem would be useful to practicing transactional lawyers.  The reverse MM theorem makes explicit the tradeoffs lawyers make structuring and executing transactions, such as choosing an acquisition method or negotiating representations and warranties, because it lays bare what is at stake.  The reverse MM theorem is also a powerful pedagogical tool for young lawyers trying to learn the trade.  Because it provides a short and succinct summary of the economics that drive many of the issues that transactional lawyers regularly confront, the reverse MM theorem can be used to accumulate knowledge systematically, rather than as a series of one-off experiences.  Such a framework, once internalized, makes it easier to accumulate, store, and recall knowledge, which is critical to the practice of law.

Third, and still less intuitively, the reverse MM theorem is a tool that would be useful to judges and litigators.  There are a wide range of damages issues, including prejudgment interest, choice of currency, and whether to use an ex-ante or ex-post measure of damages, where there are alternative methods of calculating an award that would be fair to both parties.  Different rules, however, will likely have different efficiency consequences.  The reverse MM theorem provides the framework to make those efficiency arguments.

Nonetheless, lawyers and legal academics, however, have been reluctant to embrace reverse theories, and the original MM theorem says nothing to appeal to lawyers as it implies that they are merely a transaction cost.  However, in its inverted form, the MM theorem describes how lawyers can create value for their clients.  The reverse MM theorem, though, is not merely a descriptive device.  It is also a powerful tool that can help legal academics, practicing lawyers, and judges all perform their work better.

Michael S. Knoll is Theodore Warner Professor at the University of Pennsylvania Law School, Professor of Real Estate at the Wharton School, and Co-director at Center for Tax Law and Policy, University of Pennsylvania.