Columbia law school The center for law and economic studies 435 West 116 St New York. NY 10027-7201 Working Paper No. 186 Updated Corporate laws Limits Prior Title- The Quality of Corporate law A ent and its Limits Mark roe Columbia University School of law January 16. 2002 This paper can be downloaded without charge from the Social Science research Network electronic library at http:/papers.ssrn.com/abstract=260582 An index to the working papers in the Columbia law School working Paper Series is located at http://www.law.columbia.edu/lawec/
Columbia Law School The Center for Law and Economic Studies 435 West 116th St. New York, NY 10027-7201 Working Paper No. 186 Updated Corporate Law’s Limits (Prior Title - The Quality of Corporate Law Argument and its Limits) Mark J. Roe Columbia University School of Law January 16, 2002 This paper can be downloaded without charge from the Social Science Research Network electronic library at: http://papers.ssrn.com/abstract=260582 An index to the working papers in the Columbia Law School Working Paper Series is located at: http://www.law.columbia.edu/lawec/
Corporate Laws Limits Mark j. roe A strong theory has emerged in recent years that the quality of corporate law primari determines whether securities markets arise, whether ownership separates from control, and whether the modern corporation can prosper. The theory has been used convincingly to explain why we se weak corporate structures in transition and developing nations, bur less convincingly to explain why concentrated ownership persists in continental Europe orwhny it became less important in the United States. The theory has its real-world correlates as international agencies focus on corporate overnance for transition and developing economies, while several alreadwwealthyy nations also focus on improving corporate lany. Surely, when an economicallyw-weak sociery lacks regularit-a anifested by weak or poorly enforced corporate lany-thar lack of regularity and that lack of economic strength precludes complex institutions like securities markets and diffitseh- owned public firms. But in several nations in the wealhy west legal structures are quite good and, by measurement, shareholders are well protected, but ownership has still not yet separated from camining the calculus of owners and imestors when they decide whether to difuse ownership. ownership cannot readily separate from control when managerial agency costs are especially high. And missing from curent discourse is the basic concept that even American corporate lant-usuially seen as high quality nowadays-does not burrow into the firm to root out those managerial agency costs that arise from mediocre business decisions. Judicial doctrine and legal inquiry attack self- dealing, not bad business judgment. The business judgment rule, under which judges do not second- guess managerial mistake, puts the fill panoply of agency costs-such as over-expansion, over- inestment, and reluctance to take on profitable but uncomfortable risks-beyond direct legal inquiry.(his limit from the business judgment rule is fect"in corporate lanr: aggressive judicial attack on managerialerrorwotdd replicate the costs of gonernment management of business. omething other than direct legal attack has to control basic managerial agency costs, because judicial action here is far too costy The consequence is that even if corporate law as usually conceied is"perfect, "it eliminates self-dealing, not managerial mistake. But managers can lose for shareholders as mmch, or more, than they can steal from them, and law directy controls only the second cost not the first. If the risk of managerial error naries widely from nmation-io-nation, ar from firm-to-firm, ownership struacture should vary equally widely, even jf coventional corporate lan with this analysis: by measurement several nations hane fine enough corporate lanr, distant stockholders are protected from controlling stockholder and managerial thievery, but uncontrolled agency costs though seem to be especially high in thase very nations
Corporate Law’s Limits Mark J. Roe A strong theory has emerged in recent years that the quality of corporate law primarily determines whether securities markets arise, whether ownership separates from control, and whether the modern corporation can prosper. The theory has been used convincingly to explain why we see weak corporate structures in transition and developing nations, but less convincingly to explain why concentrated ownership persists in continental Europe or why it became less important in the United States. The theory has its real-world correlates as international agencies focus on corporate governance for transition and developing economies, while several already-wealthy nations also focus on improving corporate law. Surely, when an economically-weak society lacks regularity¾a gap that may be manifested by weak or poorly enforced corporate law¾that lack of regularity and that lack of economic strength precludes complex institutions like securities markets and diffuselyowned public firms. But in several nations in the wealthy west legal structures are quite good and, by measurement, shareholders are well protected, but ownership has still not yet separated from control. Something else has impeded separation. We can hypothesize what that something is by examining the calculus of owners and investors when they decide whether to diffuse ownership. Ownership cannot readily separate from control when managerial agency costs are especially high. And missing from current discourse is the basic concept that even American corporate law¾usually seen as high quality nowadays¾does not burrow into the firm to root out those managerial agency costs that arise from mediocre business decisions. Judicial doctrine and legal inquiry attack selfdealing, not bad business judgment. The business judgment rule, under which judges do not secondguess managerial mistake, puts the full panoply of agency costs¾such as over-expansion, overinvestment, and reluctance to take on profitable but uncomfortable risks¾beyond direct legal inquiry. (This limit from the business judgment rule is not a “defect” in corporate law: aggressive judicial attack on managerial error would replicate the costs of government management of business. Something other than direct legal attack has to control basic managerial agency costs, because judicial action here is far too costly.) The consequence is that even if corporate law as usually conceived is “perfect,” it eliminates self-dealing, not managerial mistake. But managers can lose for shareholders as much, or more, than they can steal from them, and law directly controls only the second cost not the first. If the risk of managerial error varies widely from nation-to-nation, or from firm-to-firm, ownership structure should vary equally widely, even if conventional corporate law tightly protected shareholders everywhere. There is also good reason, and some new data, consistent with this analysis: by measurement several nations have fine enough corporate law; distant stockholders are protected from controlling stockholder and managerial thievery, but uncontrolled agency costs though seem to be especially high in those very nations
TABLE OF CONTENTS Introduction The Argument: Corporate Law as Propelling Diffuse Ownership A. Protecting Minority Stockholders B. The Attractions of a Technical Corporate Law Theory Il. Its limits: Theory… A. Where Law Does not Reach: How Managerial Agency Costs apede Separation B. Improving Corporate Law without Increasing Separation 000 1. The mode 2. An example C. Corporate Law's Limited Capacity to Affect Agency Costs 1. The bu 2. Agency costs: shirking and steal 134467 D. Laws Indirect Effect on Agency Costs F. Precision in Defining Agency Costs and Private Benefits G. Ambiguity in the Legal Theory: Improving it Can Reduce Separatio 9900 1. The offsetting effects. 2. Illustrating the countervailing movement H. The Tight Limits to the Purely Legal Theory IIL. Its Limits: Data A. Measuring Quality 1. Corporate law. what counts 2. Corporate law: the bottom-line B. Data: Nations with Good Corporate Law but Without Separation 1. Market measures of the value of control 2. Dual class common stock 8800037 4. And not-so-rich nations? C. What Beyond Law is Needed for Separation in the Wealthy West 2. Political preconditions D. Data on Explanations Beyond Law Conclusion: The Quality of Corporate Law Argument and its Limits Bibliography
TABLE OF CONTENTS Introduction ................................................................................................................... 1 I. The Argument: Corporate Law as Propelling Diffuse Ownership .......................... 6 A. Protecting Minority Stockholders.................................................................. 7 B. The Attractions of a Technical Corporate Law Theory .................................. 9 II. Its Limits: Theory ................................................................................................ 10 A. Where Law Does not Reach: How Managerial Agency Costs Impede Separation....................................................................................... 10 B. Improving Corporate Law without Increasing Separation............................ 10 1. The model........................................................................................... 11 2. An example ......................................................................................... 13 C. Corporate Law’s Limited Capacity to Affect Agency Costs......................... 14 1. The business judgment rule................................................................ 14 2. Agency costs: shirking and stealing................................................... 16 D. Law’s Indirect Effect on Agency Costs........................................................ 17 E. Even if Law Critically Affects Both ............................................................. 19 F. Precision in Defining Agency Costs and Private Benefits............................ 19 G. Ambiguity in the Legal Theory: Improving it Can Reduce Separation......... 20 1. The offsetting effects........................................................................... 20 2. Illustrating the countervailing movement .......................................... 21 H. The Tight Limits to the Purely Legal Theory............................................... 27 III. Its Limits: Data.................................................................................................... 27 A. Measuring Quality....................................................................................... 28 1. Corporate law: what counts? ............................................................ 28 2. Corporate law: the bottom-line.......................................................... 30 B. Data: Nations with Good Corporate Law but Without Separation............... 30 1. Market measures of the value of control ............................................ 30 2. Dual class common stock ................................................................... 33 3. The control block premium................................................................. 37 4. And not-so-rich nations?.................................................................... 41 5. Enforcing contracts............................................................................ 41 C. What Beyond Law is Needed for Separation in the Wealthy West? ............. 42 1. Economic preconditions..................................................................... 42 2. Political preconditions....................................................................... 43 3. Social preconditions........................................................................... 44 D. Data on Explanations Beyond Law ............................................................. 44 Conclusion: The Quality of Corporate Law Argument and its Limits........................... 47 Bibliography ................................................................................................................ 50
Tables and Graphs Table 1: When agency costs high, private benefits to controller irrelevant Table 2: Indeterminate effect of better corporate law in rich nation Table 3: Voting premium and ownership separation Table 4: Control premium and ownership separation Table 5: Correlation matrix Table 6: F-test: Law politics Graph 1: Block premium vs ownership dispersion Graph 2: Block premium vs, ownership dispersion( without Italy and Austria)
Tables and Graphs Table 1: When agency costs high, private benefits to controller irrelevant................. ................................13 Table 2: Indeterminate effect of better corporate law in rich nation........................... ................................26 Table 3: Voting premium and ownership separation.................................................. ................................34 Table 4: Control premium and ownership separation................................................ ................................38 Table 5: Correlation matrix ....................................................................................... ................................46 Table 6: F-test: Law & politics.................................................................................. ................................47 Graph 1: Block premium vs. ownership dispersion .................................................... ................................39 Graph 2: Block premium vs. ownership dispersion (without Italy and Austria) ......... ................................40
Corporate Laws limits Mark j. roe Introduction The critical precondition to developing modern securities markets, and the economic and technological benefits that go with good stock marke most recent analyses posit, is a foundation of solid corporate and securities laws that protect stockholders from the rampages of the dominant majority stockholders or controlling managers. Without such corporate law protections securities markets, it is said, will not arise. And if corporate law is good enough in technologically advanced nations, ownership will infuse away from concentrated ownership into dispersed stock markets This perspective contributes to understanding the fragility of capital markets in transition and third-world economies. But there is too much that is critical to separation that corporate law does not reach in the worlds richest, most advanced nations. And if those conditions-which depend on institutions other than corporate law-aren't met, ownership will not diffuse. And in nations that do not meet those conditions, public policy makers would have little reason to invest much in developing good corporate law institutions, because they just would not be used The conceptual problem is basic: Current academic thinking lumps together costly opportunism due to a controller's self-dealing and costly managerial decision-making that inflicts losses on the owners. The first, self-dealing, corporate law seeks to control directly; the second, bad decision-making that damages shareholders, it does not Other institutions must control the latter and their strength varies from nation-to-nation. Owners tend to stay as blockholders if they expect managerial agency costs would be very high after full separation Corporate law does not even try to directly control the costs of 率 Berg Professor of L Law School. Thanks for comments go to Lucian Bebchuk, Victor Brune oates, Einer Elhauge, Howell Jackson, Ehud Kamar, Reinier Kraakman, Mi and participants in workshops at Harvard Business school. the national f Economic research. the italian Securities Commission(CONSOB), the Sorbonne, and the Columbia, Harvard, Stanford University of Southern California and Vanderbilt Law Schools
Corporate Law’s Limits Mark J. Roe* Introduction The critical precondition to developing modern securities markets, and the economic and technological benefits that go with good stock markets, most recent analyses posit, is a foundation of solid corporate and securities laws that protect stockholders from the rampages of the dominant majority stockholders or controlling managers. Without such corporate law protections securities markets, it is said, will not arise. And if corporate law is good enough in technologically advanced nations, ownership will diffuse away from concentrated ownership into dispersed stock markets. This perspective contributes to understanding the fragility of capital markets in transition and third-world economies. But there is too much that is critical to separation that corporate law does not reach in the world’s richest, most advanced nations. And if those conditions—which depend on institutions other than corporate law—aren’t met, ownership will not diffuse. And in nations that do not meet those conditions, public policy makers would have little reason to invest much in developing good corporate law institutions, because they just would not be used. The conceptual problem is basic: Current academic thinking lumps together costly opportunism due to a controller’s self-dealing and costly managerial decision-making that inflicts losses on the owners. The first, self-dealing, corporate law seeks to control directly; the second, bad decision-making that damages shareholders, it does not. Other institutions must control the latter and their strength varies from nation-to-nation. Owners tend to stay as blockholders if they expect managerial agency costs would be very high after full separation. Corporate law does not even try to directly control the costs of * Berg Professor of Law, Harvard Law School. Thanks for comments go to Lucian Bebchuk, Victor Brudney, John Coates, Einer Elhauge, Howell Jackson, Ehud Kamar, Reinier Kraakman, Mitch Polinsky, and participants in workshops at Harvard Business School, the National Bureau of Economic Research, the Italian Securities Commission (CONSOB), the Sorbonne, and the Columbia, Harvard, Stanford, University of Southern California and Vanderbilt Law Schools
CORPORATE LAW'S LIMITS mismanagement. Other institutions do. For these other institutions (product market competition, incentive compensation, takeovers shareholder primacy norms, etc. ) corporate law is at most a supporting prop, not the central institution. And, even if one thinks law has an equa role to play in both--in motivating managers as well as in deterring insider machinations-the two depend on different laws and different institutions These would vary in strength, because of differing national histories, politics, and economic conditions; countries can, and do, better deal with one than the other, thereby affecting which organization-close or diffuse ownership-its institutions favor Among the world's richer nations, several by measurement have goo minority stockholder protection, which the quality-of-corporate law theory would predict should have long ago facilitated separating ownership from control. But despite protective results that keep the rampages of the majority stockholders in check, ownership has not yet neatly separated from control. Our task is to assess the theoretical implications of why paration did not happen, since these counter-examples tell us that deficient corporate law probably was not the basic impediment The fact that ownership did not separate from control in a nation does not tell us whether it didn't separate because blockholder rampages are uncontrolled or because managerial agency costs would be far too high if ownership separated. Each could have prevented separation. Or one alone could have, with the other not standing in the way. If underlying economic, social, or political conditions make managerial agency costs very high, and if those costs are best contained by a controlling shareholder, then concentrated ownership persists whatever the state of corporate law in checking blockholder mis-deeds I speculate on what underlying economic, political, and social conditions could make managerial agency costs persistently high. I also speculate on how a shrinking of these agency costs, one plausibly now going on in continental Europe, could raise the demand to build legal institutions that facilitate separation. Many business features could keep agency costs higher in one nation than another: a weak product market is one; especially opaque businesses is another; an inability to use incentive compensation effectively because it would, say, disrupt relationships within the firm, is a third; a high level of social mistrust that impedes professionalization of management is a fourth
2 CORPORATE LAW’S LIMITS mismanagement. Other institutions do. For these other institutions (product market competition, incentive compensation, takeovers, shareholder primacy norms, etc.), corporate law is at most a supporting prop, not the central institution. And, even if one thinks law has an equal role to play in both—in motivating managers as well as in deterring insider machinations—the two depend on different laws and different institutions. These would vary in strength, because of differing national histories, politics, and economic conditions; countries can, and do, better deal with one than the other, thereby affecting which organization—close or diffuse ownership—its institutions favor. Among the world’s richer nations, several by measurement have good minority stockholder protection, which the quality-of-corporate law theory would predict should have long ago facilitated separating ownership from control. But despite protective results that keep the rampages of the majority stockholders in check, ownership has not yet neatly separated from control. Our task is to assess the theoretical implications of why separation did not happen, since these counter-examples tell us that deficient corporate law probably was not the basic impediment. The fact that ownership did not separate from control in a nation does not tell us whether it didn’t separate because blockholder rampages are uncontrolled or because managerial agency costs would be far too high if ownership separated. Each could have prevented separation. Or one alone could have, with the other not standing in the way. If underlying economic, social, or political conditions make managerial agency costs very high, and if those costs are best contained by a controlling shareholder, then concentrated ownership persists whatever the state of corporate law in checking blockholder mis-deeds. I speculate on what underlying economic, political, and social conditions could make managerial agency costs persistently high. I also speculate on how a shrinking of these agency costs, one plausibly now going on in continental Europe, could raise the demand to build legal institutions that facilitate separation. Many business features could keep agency costs higher in one nation than another: a weak product market is one; especially opaque businesses is another; an inability to use incentive compensation effectively because it would, say, disrupt relationships within the firm, is a third; a high level of social mistrust that impedes professionalization of management is a fourth
CORPORATE LAW'SLIMITS 3 Corporate law, when it's effective, impedes insider machinations: it stops, or reduces, controlling shareholders from diverting value to themselves, and bars managers from putting the firm into their own pockets. When, for example, controllers obtain very high private benefits from control, because they divert firm value into their own pockets, then holders mistrust the insiders and ar Ownership concentration should, all else equal, persist. Good corporate law(or substitutes like stock exchange rules, contract, media glare, or reputational intermediaries)can, by reducing this potential for thievery, facilitate separating ownership from control But there is more to running a firm than controlling insider machinations. Managerial agency costs to distant shareholders come in two basic flavors: thievery and mismanagement. Law can reduce the first, but does very little directly to minimize the second. Not yet fully recognized in the current literature is that american law avoids dealing with the second. The business judgment rule has courts refusing to intervene when shareholders attack managerial mistake. Indeed, one might argue in only a modest over-statement that in modern American business history, there has been only one significant successful judicial attack on managers for mistake, that in Smith v. Van gorkom, an attack the legislature promptly reversed It's business conditions, incentives, professionalism, capital structure product and managerial labor market competition, and financial alignment ith shareholders that directly impede managerial mistakes, not corporate law. Conventional, technical corporate law has little to say here.( True law can create or destroy anything, so law isn't irrelevant, but it is a second-order phenomenon: other institutions primarily control managerial mistake, law's role here, if any, is either to support or drag on those primary institutional controls. Even if one believes law to be central to competition, compensation, and so on-the institutions that reduce managerial agency costs--one must recognize that these laws differ from orporate law that controls insider machinations, and their efficaciot could differ: one nation's laws might control machinations well but managerial error poorly Today's corporate theory cannot explain why several wealthy ons protect minority shareholders well, bu have concentrated ownership. The most plausible theory is that ownership hasnt separated not because of weak corporate law, but because a
CORPORATE LAW’S LIMITS 3 Corporate law, when it’s effective, impedes insider machinations: it stops, or reduces, controlling shareholders from diverting value to themselves, and bars managers from putting the firm into their own pockets. When, for example, controllers obtain very high private benefits from control, because they divert firm value into their own pockets, then distant shareholders mistrust the insiders, and are unwilling to buy. Ownership concentration should, all else equal, persist. Good corporate law (or substitutes like stock exchange rules, contract, media glare, or reputational intermediaries) can, by reducing this potential for thievery, facilitate separating ownership from control. But there is more to running a firm than controlling insider machinations. Managerial agency costs to distant shareholders come in two basic flavors: thievery and mismanagement. Law can reduce the first, but does very little directly to minimize the second. Not yet fully recognized in the current literature is that American law avoids dealing with the second. The business judgment rule has courts refusing to intervene when shareholders attack managerial mistake. Indeed, one might argue in only a modest over-statement that in modern American business history, there has been only one significant successful judicial attack on managers for mistake, that in Smith v. Van Gorkom, an attack the legislature promptly reversed. It’s business conditions, incentives, professionalism, capital structure, product and managerial labor market competition, and financial alignment with shareholders that directly impede managerial mistakes, not corporate law. Conventional, technical corporate law has little to say here. (True, law can create or destroy anything, so law isn’t irrelevant, but it is a second-order phenomenon: other institutions primarily control managerial mistake, law’s role here, if any, is either to support or drag on those primary institutional controls.) Even if one believes law to be central to competition, compensation, and so on—the institutions that reduce managerial agency costs—one must recognize that these laws differ from corporate law that controls insider machinations, and their efficaciousness could differ: one nation’s laws might control machinations well but managerial error poorly. Today’s corporate theory cannot explain why several wealthy European nations protect minority shareholders well, but nevertheless still have concentrated ownership. The most plausible theory is that ownership hasn’t separated not because of weak corporate law, but because a)
CORPORATE LAW'S LIMITS managerial agency costs from dissipating shareholder value would be very costs to shareholders enough. I suggest why these costs to shareholders ary from nation-to-nation and firm-to-firm Moreover, by shifting our focus from legally malleable private benefits to managerial agency costs, we can see why sub-standard corporate law persists in a few richer, well-developed nations. Low quality law might in some nations be a symptom of weak separation, not its base-line cause If these kinds of managerial agency costs from dissipating shareholder value would be too high anyway for there to be much separation even if corporate law were perfect, then there's little reason for the players(public policy-makers, investors, founding and family owners)to build good corporate law, because it wouldnt be much used anyway A second theoretical limit afflicts the quality-of-corporate-law argument. High quality corporate law could propel diffusion. But it can just as easily propel concentration. Its effect is indeterminate. High qualit porate lay blockholders, because good law channels blockholders away from stealing from distant stockholders and into productive activity(such as overcoming shareholder free rider and informational problems or monitoring managers for example). Channeling blockholders away from anti-stockholder action should mean in theory that improving the quality of corporate law could all else equal, increase blockholding as easily as it could decrease it. Minority stockholders have less reason to fear the big blockholders when corporate law protects them. If the blockholders increase value, then we could see more of them develop, not fewer of them, as corporate law quality improved Good corporate law that stymies a grasping controller, or good substitutes like effective stock exchanges, effective reputational intermediaries and the like, is good for a nation to have. It reduces the costs of running a large enterprise. But it is insufficient to induce ownership separation. It's thus at least possible that some reformers may be pinning their hopes too heavily on good corporate law institutions to propel development in third world and transition countries
4 CORPORATE LAW’S LIMITS managerial agency costs from dissipating shareholder value would be very high after full separation, and b) concentrated ownership reduces those costs to shareholders enough. I suggest why these costs to shareholders vary from nation-to-nation and firm-to-firm. Moreover, by shifting our focus from legally malleable private benefits to managerial agency costs, we can see why sub-standard corporate law persists in a few richer, well-developed nations. Low quality law might in some nations be a symptom of weak separation, not its base-line cause. If these kinds of managerial agency costs from dissipating shareholder value would be too high anyway for there to be much separation even if corporate law were perfect, then there’s little reason for the players (public policy-makers, investors, founding and family owners) to build good corporate law, because it wouldn’t be much used anyway. * * * A second theoretical limit afflicts the quality-of-corporate-law argument. High quality corporate law could propel diffusion. But it can just as easily propel concentration. Its effect is indeterminate. High quality corporate law makes distant stockholders comfortable with blockholders, because good law channels blockholders away from stealing from distant stockholders and into productive activity (such as overcoming shareholder free rider and informational problems or monitoring managers, for example). Channeling blockholders away from anti-stockholder action should mean in theory that improving the quality of corporate law could, all else equal, increase blockholding as easily as it could decrease it. Minority stockholders have less reason to fear the big blockholders when corporate law protects them. If the blockholders increase value, then we could see more of them develop, not fewer of them, as corporate law quality improved. * * * Good corporate law that stymies a grasping controller, or good substitutes like effective stock exchanges, effective reputational intermediaries and the like, is good for a nation to have. It reduces the costs of running a large enterprise. But it is insufficient to induce ownership separation. It’s thus at least possible that some reformers may be pinning their hopes too heavily on good corporate law institutions to propel development in third world and transition countries
CORPORATE LAW'SLIMITS My logic here is that the current wisdom and theory tell us that when the core of corporate law is atrocious, and substitutes unavailable, complex firms cannot be stabilized. This is true, and the empirical contributions here are considerable. But the converse of the current wisdom is believed as well, although it is false: Bad law impedes separation, but when there's no separation, law could be good with something else impeding that separation, not corporate law. Since several nations have protective corporate law but nevertheless have very little separation, we need some new theory to explain why A roadmap for this Article: I outline in Part I the quality of corporate law argument and why it is important. In Part Il I show why when potential dissipator managerial agency costs are perniciously high in a society, but containable by dominant stockholders, corporate law quality is irrelevant or tertiary: even if it's good, ownership will not separate from control.(I distinguish two types of agency costs: those that shift value away from stockholders to controllers and those that dissipate shareholder value. )Conventional corporate law can contain managerial agency costs due to thievery, but does not directly contain managerial agency costs due to mismanagement. Concentrated ownership will persist in firms in high- agency-cost nations even if comventional corporate law quality is high as ong as the owner can contain enough of these costs. In Part Ill I show why the data indicates that the quality of corporate law argument, although it explains transition economies nicely, is over-stated for several of the worlds richest nations: in too many of them basic shareholder protections seem adequate, stock can be and is sold, but ownership neverthel doesnt separate from control. Something else has made concentrated control persist. I speculate what that might have been Lastly, I conclude, High quality, protective corporate law is a good institution for a society to have. It lowers the costs of building strong, large business enterprises. It can prevent, or minimize, controlling stockholder diversions, a necessary condition for separation. But among he world's wealthier nations, it doesnt primarily determine whether its worthwhile to build those enterprises It's a tool, not the foundation
CORPORATE LAW’S LIMITS 5 My logic here is that the current wisdom and theory tell us that when the core of corporate law is atrocious, and substitutes unavailable, complex firms cannot be stabilized. This is true, and the empirical contributions here are considerable. But the converse of the current wisdom is believed as well, although it is false: Bad law impedes separation, but when there’s no separation, law could be good with something else impeding that separation, not corporate law. Since several nations have protective corporate law but nevertheless have very little separation, we need some new theory to explain why. * * * A roadmap for this Article: I outline in Part I the quality of corporate law argument and why it is important. In Part II I show why when potential dissipatory managerial agency costs are perniciously high in a society, but containable by dominant stockholders, corporate law quality is irrelevant or tertiary: even if it’s good, ownership will not separate from control. (I distinguish two types of agency costs: those that shift value away from stockholders to controllers and those that dissipate shareholder value.) Conventional corporate law can contain managerial agency costs due to thievery, but does not directly contain managerial agency costs due to mismanagement. Concentrated ownership will persist in firms in highagency-cost nations even if conventional corporate law quality is high as long as the owner can contain enough of these costs. In Part III I show why the data indicates that the quality of corporate law argument, although it explains transition economies nicely, is over-stated for several of the world’s richest nations: in too many of them basic shareholder protections seem adequate, stock can be and is sold, but ownership nevertheless doesn’t separate from control. Something else has made concentrated control persist. I speculate what that might have been. Lastly, I conclude. High quality, protective corporate law is a good institution for a society to have. It lowers the costs of building strong, large business enterprises. It can prevent, or minimize, controlling stockholder diversions, a necessary condition for separation. But among the world’s wealthier nations, it doesn’t primarily determine whether it’s worthwhile to build those enterprises. It’s a tool, not the foundation
CORPORATE LAW'S LIMITS I. The Argument: Corporate Law as Propelling Diffuse Today's most powerful and most widely-accepted academic explanation for why continental Europe lacks deep and rich securities markets is the purportedly weak role of corporate and securities law in protecting minority stockholders, a weakness that is said to contrast with America's strong protections of minority stockholders. A major European- wide research network, leading financial economists, and leading legal commentators have stated so. One can imagine the nobel prize winning Franco Modigliani shaking his head in disappointment when writing that nations with deficient legal regimes cannot get good stock markets and hence,the provision of funding shifts from dispersed risk capital [via the stock market].. to debt, and from stock and bond] markets to institutions, i.e., towards intermediated credit. In a powerful set of important articles insightful economists showed that deep securities markets correlate with an index of basic shareholder legal protections These protections are important: " IP]rotection of shareholders .. by the legal system is central to understanding the patterns of corporate finance difference countries. Investor protection [is] crucial because, in many ountries,expropriation of minority shareholders.. by the controlling shareholders is extensive. Leading legal commentators have signed on to the law-driven theory At the same time. international agencies such as the Imf and the World Bank have admirably promoted corporate law reform, especially that which would protect minority stockholders. The OECD has had major initiatives to improve corporate governance, both in the developing 1. La Porta, Lopez-de-silanes Shleifer(1999); La Porta et al. (1998), at 1136- 37 and(1997), at 1138; Bebchuk(1999); Becht Roell, (1999), Carlin Mayer(Oct 998,at3;, Coffee(1999) 2. Modigliani Perotti(1998), at 5; see also Modigliani Perotti(1997) 4. La Porta, Lopez-de-Silanes, Shleifer vishny (2000), at 4 5. See Coffee(1999) 6. The IMF's joumal, Finance Development, tells us that"improved governance [institutions] are essential parts of economic reform programs in many countries. " Iskander, Meyerman, Gray Hagan(1999)
6 CORPORATE LAW’S LIMITS I. The Argument: Corporate Law as Propelling Diffuse Ownership Today’s most powerful and most widely-accepted academic explanation for why continental Europe lacks deep and rich securities markets is the purportedly weak role of corporate and securities law in protecting minority stockholders, a weakness that is said to contrast with America’s strong protections of minority stockholders. A major Europeanwide research network, leading financial economists, and leading legal commentators have stated so.1 One can imagine the Nobel Prize winning Franco Modigliani shaking his head in disappointment when writing that nations with deficient legal regimes cannot get good stock markets and, hence, “the provision of funding shifts from dispersed risk capital [via the stock market] ¼ to debt, and from [stock and bond] markets to institutions, i.e., towards intermediated credit.”2 In a powerful set of important articles insightful economists showed that deep securities markets correlate with an index of basic shareholder legal protections.3 These protections are important: “[P]rotection of shareholders … by the legal system is central to understanding the patterns of corporate finance in difference countries. Investor protection [is] crucial because, in many countries, expropriation of minority shareholders ¼ by the controlling shareholders is extensive.”4 Leading legal commentators have signed on to the law-driven theory.5 At the same time, international agencies such as the IMF and the World Bank have admirably promoted corporate law reform, especially that which would protect minority stockholders.6 The OECD has had major initiatives to improve corporate governance, both in the developing 1. La Porta, Lopez-de-Silanes & Shleifer (1999); La Porta et al. (1998), at 1136- 37 and (1997), at 1138; Bebchuk (1999); Becht & Röell, (1999); Carlin & Mayer (Oct. 1998), at 33; Coffee (1999). 2. Modigliani & Perotti (1998), at 5; see also Modigliani & Perotti (1997). 3. See La Porta et al. articles, cited supra note 2. 4. La Porta, Lopez-de-Silanes, Shleifer & Vishny (2000), at 4.. 5. See Coffee (1999). 6. The IMF’s journal, Finance & Development, tells us that “improved corporate governance [institutions] are essential parts of economic reform programs under way in many countries.” Iskander, Meyerman, Gray & Hagan (1999)
