A SELF-ENFORCING MODEL OF CORPORATE LAW 109 Harvard Law Review 1911-1982(1996) This paper can be downloaded without charge from the Social Science Research Network electronic library at http://papers.ssrn.com. tafabstract id=10037 Bernard Black Reinier Kraakman In this Article, Professors Black and Kraakman develop a"self-enforcing"approach to drafting corporate law for emerging capitalist economies, based on a case study. a model statute that they helped to draft for the Russian Federation, which formed the basis for the recently adopted Russian law on joint-stock companies. The article describes the contextual features of emerging economies -- including the prevalence of controlled companies and the weakness ofother institutional, market, cultural, and legal constraints-- that make it inappropriate to import company law from developed countries. Professors Black and Kraakman argue that in emerging economies, the best legal strategy for protecting outside investors in large companies while simultaneously preserving managers'discretion to invest is a self-enforcing model of corporate law The self-enforcing model structures corporate decisionmaking processes to allow large outside shareholders to protect themselves from insider opportunism with minimal resort to legal authority, including the courts. Among the model's provisions are a mandatory cumulative voting rule for election of directors, which ensures that mind blockholders have board representation, and a rule requiring both shareholder- and The authors are, respectively, Professor of Law, Columbia Law School, and Professor of Law, Harvard Law School. This Article builds on an earlier article that developed the concept of a"self-enforcing"corporate law in the context of Russia, prepared for the World Bank Conference on Corporate Governance in Eastern Europe and Russia held in December 1994, and which was subsequently published as Bernard Black, Reinier Kraakma Jonathan Hay, Corporate Law from Scratch, in 2 Corporate Governance in Central Europe and Russia nsiders and the State 245(Roman Frydman, Cheryl W. Gray Andrzej Rapaczynski eds, 1996) Acknowledgments should go first to Jonathan Hay, our coauthor on the precursor article, and to Anna Stanislavovna Tarassova, the principal Russian drafter of the Russian company law, the development of which provided the genesis and many of the ideas for this article. Other important participants in the effort to develop Russian company law include Alexander Abramov, lan Ayres, J. Robert Brown, Catherine Dixon, Louis Kaplow, Yevgeni Kulkov, Claudia Morgenstern, Melinda Rishkofski, Howard Sherman, Sergei Shishkin, Victoria Pavlovna Volkova, and John Wilcox. We thank the participants in the World Bank conference especially John Coffee, Ronald Gilson, Bruce Kogut, Mancur Olson, Ibrahim Shihata, and Douglas Webb, for helpful comments on earlier drafts. We also thank participants in the University of Toronto and Harvard Law School Law and Economics Workshops, Lucian Bebchuk, Jill Fisch, Jeffrey Gordon, Christine Jolls, Hideki Kanda, Mark Roe, and especially David Charny for his extensive comments. Finally, we wish to thank Joseph Blasi, Rolf Skog, Andrei Alexandrovich Volgin, and Daniel Wolfe for their comments on the draft law on which this article is based. Research support was provided by the World Bank(for both authors), the Open Society Institute( for Black), and the Harvard Program for Law and Economics, funded by the John M. Olin Foundation(for Kraakman)
* The authors are, respectively, Professor of Law, Columbia Law School, and Professor of Law, Harvard Law School. This Article builds on an earlier article that developed the concept of a "self-enforcing" corporate law in the context of Russia, prepared for the World Bank Conference on Corporate Governance in Eastern Europe and Russia held in December 1994, and which was subsequently published as Bernard Black, Reinier Kraakman & Jonathan Hay, Corporate Law from Scratch, in 2 Corporate Governance in Central Europe and Russia: Insiders and the State 245 (Roman Frydman, Cheryl W. Gray & Andrzej Rapaczynski eds., 1996). Acknowledgments should go first to Jonathan Hay, our coauthor on the precursor article, and to Anna Stanislavovna Tarassova, the principal Russian drafter of the Russian company law, the development of which provided the genesis and many of the ideas for this Article. Other important participants in the effort to develop Russian company law include Alexander Abramov, Ian Ayres, J. Robert Brown, Catherine Dixon, Louis Kaplow, Yevgeni Kulkov, Claudia Morgenstern, Melinda Rishkofski, Howard Sherman, Sergei Shishkin, Victoria Pavlovna Volkova, and John Wilcox. We thank the participants in the World Bank conference, especially John Coffee, Ronald Gilson, Bruce Kogut, Mancur Olson, Ibrahim Shihata, and Douglas Webb, for helpful comments on earlier drafts. We also thank participants in the University of Toronto and Harvard Law School Law and Economics Workshops, Lucian Bebchuk, Jill Fisch, Jeffrey Gordon, Christine Jolls, Hideki Kanda, Mark Roe, and especially David Charny for his extensive comments. Finally, we wish to thank Joseph Blasi, Rolf Skog, Andrei Alexandrovich Volgin, and Daniel Wolfe for their comments on the draft law on which this article is based. Research support was provided by the World Bank (for both authors), the Open Society Institute (for Black), and the Harvard Program for Law and Economics, funded by the John M. Olin Foundation (for Kraakman). A SELF-ENFORCING MODEL OF CORPORATE LAW 109 Harvard Law Review 1911-1982 (1996) This paper can be downloaded without charge from the Social Science Research Network electronic library at: http://papers.ssrn.com/paper.taf?abstract_id=10037 Bernard Black Reinier Kraakman* In this Article, Professors Black and Kraakman develop a "self-enforcing" approach to drafting corporate law for emerging capitalist economies, based on a case study: a model statute that they helped to draft for the Russian Federation, which formed the basis for the recently adopted Russian law on joint-stock companies. The Article describes the contextual features of emerging economies -- including the prevalence of controlled companies and the weakness of other institutional, market, cultural, and legal constraints -- that make it inappropriate to import company law from developed countries. Professors Black and Kraakman argue that in emerging economies, the best legal strategy for protecting outside investors in large companies while simultaneously preserving managers' discretion to invest is a self-enforcing model of corporate law. The self-enforcing model structures corporate decisionmaking processes to allow large outside shareholders to protect themselves from insider opportunism with minimal resort to legal authority, including the courts. Among the model's provisions are a mandatory cumulative voting rule for election of directors, which ensures that minority blockholders have board representation, and a rule requiring both shareholder- and
board-level approval for self-interested transactions. The Article examines how to induce voluntary compliance with the company law, as well as the implications of the self-enforcing model for the ongoing debate over the efficiency of corporate law in developed economies
board-level approval for self-interested transactions. The Article examines how to induce voluntary compliance with the company law, as well as the implications of the self-enforcing model for the ongoing debate over the efficiency of corporate law in developed economies
Table of contents Introduction . The National Contexts That Shape Corporate Law A. Corporate Law in Developed Economies B. The Goals of Corporate Law in Emerging Economies 778 C. Legal and Market Controls in Emerging Economies 13 D. Cultural Norms for Manager and Large Shareholder Behavior 15 IL. A Self-Enforcement Approach to Corporate Law A. The Prohibitive model B. The Self-Enforcing Model 18 1. Structural Constraints 19 2. Simple, Bright-Line Rules and Strong Remedies C. The limits to the Self-Enforcement Approach D. Can Law Function Without Official Enforcement? Ill. Governance Structure and Voting rules A. Allocation of decisionmaking power B. Allocation of Voting Power: One Share, One Vote C. Voting for Directors: Cumulative voting D. Voting procedures Universal ballot E. Protecting Honesty and Quality in Voting V. Structural Constraints on Particular Corporate Actions A. Mergers and Other major transactions 1. Shareholder Approval 2. Appraisal Rights 3. Determining Market value B. Self-Interested Transactions C. Control Transactions 45 D. Issuance and Repurchase of Shares 1. Share Issuances 2. Repurchase of Shares E. Protecting Creditors and Preferred Shareholders F The state as part-Owner VI. The Path-Dependent Evolution of Developed Country Corporate Law Conclusion: Self-Enforcing Law in Emerging Economies
Table of Contents Introduction ......................................................... . 1 I. The National Contexts That Shape Corporate Law .......................... . 7 A. Corporate Law in Developed Economies ........................... . 7 B. The Goals of Corporate Law in Emerging Economies .................. . 8 C. Legal and Market Controls in Emerging Economies .................. . 13 D. Cultural Norms for Manager and Large Shareholder Behavior .......... . 15 II. A Self-Enforcement Approach to Corporate Law .......................... . 16 A. The Prohibitive Model ........................................ . 17 B. The Self-Enforcing Model ..................................... . 18 1. Structural Constraints .................................... . 19 2. Simple, Bright-Line Rules and Strong Remedies ................ . 21 C. The Limits to the Self-Enforcement Approach ...................... . 23 D. Can Law Function Without Official Enforcement? ................... . 26 III. Governance Structure and Voting Rules ................................ . 29 A. Allocation of Decisionmaking Power ............................. . 29 B. Allocation of Voting Power: One Share, One Vote ................... . 31 C. Voting for Directors: Cumulative Voting .......................... . 33 D. Voting Procedures: Universal Ballot .............................. . 35 E. Protecting Honesty and Quality in Voting .......................... . 36 IV. Structural Constraints on Particular Corporate Actions ..................... . 38 A. Mergers and Other Major Transactions ............................ . 38 1. Shareholder Approval .................................... . 39 2. Appraisal Rights ........................................ . 41 3. Determining Market Value ................................ . 42 B. Self-Interested Transactions .................................... . 43 C. Control Transactions ......................................... . 45 D. Issuance and Repurchase of Shares ............................... . 49 1. Share Issuances. ........................................ . 49 2. Repurchase of Shares .................................... . 51 E. Protecting Creditors and Preferred Shareholders ..................... . 52 F. The State as Part-Owner ....................................... . 55 V. Remedies ........................................................ . 55 VI. The Path-Dependent Evolution of Developed Country Corporate Law ......... . 58 Conclusion: Self-Enforcing Law in Emerging Economies ....................... . 61
APPENDIX: Survey of Company Law in Emerging Markets
APPENDIX: Survey of Company Law in Emerging Markets .................... . 64
ntroduction What kind of corporate law should govern publicly owned companies in emerging markets, including newly privatizing economies? This important question has no ready answer Corporate law, we believe, should have the same principal goal in developed and emerging economies-- succinctly stated, to provide governance rules that maximize the value of corporate enterprises to investors. However, emerging economies cannot simply copy the corporate laws of developed economies. These laws depend upon highlyevolved market, legal, and governmental institutions and cultural norms that often do not exist in emerging economies. Developed country corporate laws also reflect the idiosyncratic history of their country of origin. They are not necessarily efficient at home, let alone when transplanted to foreign soil. Moreover, in many emerging markets, corporate law must serve a second central goal that is less pressing in mature market economies: fostering public confidence in capitalism and in private ownership of large business enterprises Thus, corporate law must be designed substantially from scratch to work within the infrastructure available in an emerging market. Fortunately, this can be politically feasible Precisely because existing institutions( to which the law must adapt )are often weak or missing, one can rethink from first principles what corporate law ought to look like and what related institutions it ought to rely on and promote Beyond producing a new model for emerging markets, the effort to develop corporate law from scratch can expose weaknesses and idiosyncracies in the corporate laws of developed countries. The model can highlight the ways in which these laws did not simply evolve toward efficiency, but instead evolved from historically contingent starting places to ending places shaped by preexisting institutions, by the inertial power of the status quo, and by the preferences of key participants in the corporate enterprise. For example, German corporate law adapted to strong banks and labor unions, while american law adapted to strong capital markets, weak financial institutions, and strong corporate managers In this Article, we sketch the basic elements of a"self-enforcing"model of corporate law, designed for an emerging economy. The model is grounded in a case study: the effort, in which we participated, to develop a new corporate law for Russia. We begin with three We use the term"institution"in a broad sense to include private organizational structures such as stock ading systems and securities registrars; public organizational structures such as securities regulators, courts with experience in commercial matters, an honest police force, and a reliable mail system; and mixed public private structures such as self-regulatory organizations, an accounting profession, and sophisticated financial accounting rules 2 A modified version of our proposed law was adopted in December 1995 as the company law of the Russian Federation. See Federal Law of the Russian Federation on Joint-Stock Companies, No. 208-FZ(1995) published in Rossiiskaya Gazeta, Dec. 29, 1995, at 1, translation available in Westlaw, Rusline Database 1995 WL 798968. An annotated English translation of the law(by Bernard Black and Anna Tarassova) available from Professor black
1 We use the term "institution" in a broad sense to include private organizational structures such as stock trading systems and securities registrars; public organizational structures such as securities regulators, courts with experience in commercial matters, an honest police force, and a reliable mail system; and mixed publicprivate structures such as self-regulatory organizations, an accounting profession, and sophisticated financial accounting rules. 2 A modified version of our proposed law was adopted in December 1995 as the company law of the Russian Federation. See Federal Law of the Russian Federation on Joint-Stock Companies, No. 208-FZ (1995), published in Rossiiskaya Gazeta, Dec. 29, 1995, at 1, translation available in Westlaw, Rusline Database, 1995 WL 798968. An annotated English translation of the law (by Bernard Black and Anna Tarassova) is available from Professor Black. 1 Introduction What kind of corporate law should govern publicly owned companies in emerging markets, including newly privatizing economies? This important question has no ready answer. Corporate law, we believe, should have the same principal goal in developed and emerging economies -- succinctly stated, to provide governance rules that maximize the value of corporate enterprises to investors. However, emerging economies cannot simply copy the corporate laws of developed economies. These laws depend upon highly evolved market, legal, and governmental institutions and cultural norms that often do not exist in emerging economies.1 Developed country corporate laws also reflect the idiosyncratic history of their country of origin. They are not necessarily efficient at home, let alone when transplanted to foreign soil. Moreover, in many emerging markets, corporate law must serve a second central goal that is less pressing in mature market economies: fostering public confidence in capitalism and in private ownership of large business enterprises. Thus, corporate law must be designed substantially from scratch to work within the infrastructure available in an emerging market. Fortunately, this can be politically feasible. Precisely because existing institutions (to which the law must adapt) are often weak or missing, one can rethink from first principles what corporate law ought to look like and what related institutions it ought to rely on and promote. Beyond producing a new model for emerging markets, the effort to develop corporate law from scratch can expose weaknesses and idiosyncracies in the corporate laws of developed countries. The model can highlight the ways in which these laws did not simply evolve toward efficiency, but instead evolved from historically contingent starting places to ending places shaped by preexisting institutions, by the inertial power of the status quo, and by the preferences of key participants in the corporate enterprise. For example, German corporate law adapted to strong banks and labor unions, while American law adapted to strong capital markets, weak financial institutions, and strong corporate managers. In this Article, we sketch the basic elements of a "self-enforcing" model of corporate law, designed for an emerging economy. The model is grounded in a case study: the effort, in which we participated, to develop a new corporate law for Russia.2 We begin with three
central claims. First, effective corporate law is context-specific, even if the problems it must address are universal. The law that works for a developed economy, when transplanted to an emerging economy, will not achieve a sensible balance among company managers need for flexibility to meet rapidly changing business conditions, companies' need for low-transaction cost access to capital markets, large investors' need to monitor what managers do with the investors'money, and small investors' need for protection against self-dealing by managers and large investors. The defects in the law will increase the cost of capital and reduce its availability In developed countries, corporate law combines with other legal, market, and cultural constraints on the actions of corporate managers and controlling shareholders to achieve a sensible balance among these sometimes competing needs. Corporate law plays a relatively small, even"trivial"role. In emerging economies, these other constraints are weak or absent, so corporate law is a much more central tool for motivating managers and large shareholders to create social value rather than simply transfer wealth to themselves from others. The market"cannot fill the regulatory gaps that an American-style"enabling"corporate law leaves behind Further, corporate law in developed countries evolved in tandem with supporting leg: institutions. For example, the United States relies on expert judges to assess the reasonableness of takeover defenses and the fairness of transactions in which managers have a conflict of interest. When necessary, these judges make decisions literally overnight to ensure that judicial delay does not kill a challenged transaction. A company law that depends on fast and reliable judicial decisions is simply out of the question in many emerging markets. In Russia, for example, courts function slowly if at all, some judges are corrupt, and many are Soviet-era holdovers who neither understand business nor care to learn. Better judges and courts will emerge only over several decades, as the old judges die or retire. In the meantime, Russian corporate law must rely on courts as little as possible More generally, every emerging economy has some legal and market institutions, some norms of behavior, some distribution of share ownership, and some financial institutions Corporate law must reflect these background facts. For example, if(as in Russia) employees often own large stakes in their companies, but are vulnerable to having their votes controlled by corporate managers, company law needs special rules that safeguard the rights ofemployee- shareholders. Company law must also limit the influence of dysfunctional background features such as widespread corruption See Bernard s. Black, Is Corporate Law Trivial?: A Political and Economic Analysis, 84 Nw. U. L. Rev 542(1990)[hereinafter Black, Is Corporate Law Trivial? see also Ronald J. Gilson, A Structural Approach to Corporations: The Case Against Defensive Tactics in Tender Offers, 33 Stan. L. Rev. 819, 839-44(1981) describing market mechanisms that complement legal controls on corporate managers); Mark J. Roe, Some Differences in Corporate Structure in Germany, Japan, and the United States, 102 Yale L.J. 1927, 1932(1993 [hereinafter Roe, Some Differences)(same)
3 See Bernard S. Black, Is Corporate Law Trivial?: A Political and Economic Analysis, 84 Nw. U. L. Rev. 542 (1990) [hereinafter Black, Is Corporate Law Trivial?]; see also Ronald J. Gilson, A Structural Approach to Corporations: The Case Against Defensive Tactics in Tender Offers, 33 Stan. L. Rev. 819, 839- 44 (1981) (describing market mechanisms that complement legal controls on corporate managers); Mark J. Roe, Some Differences in Corporate Structure in Germany, Japan, and the United States, 102 Yale L.J. 1927, 1932 (1993) [hereinafter Roe, Some Differences] (same). 2 central claims. First, effective corporate law is context-specific, even if the problems it must address are universal. The law that works for a developed economy, when transplanted to an emerging economy, will not achieve a sensible balance among company managers' need for flexibility to meet rapidly changing business conditions, companies' need for low-transactioncost access to capital markets, large investors' need to monitor what managers do with the investors' money, and small investors' need for protection against self-dealing by managers and large investors. The defects in the law will increase the cost of capital and reduce its availability. In developed countries, corporate law combines with other legal, market, and cultural constraints on the actions of corporate managers and controlling shareholders to achieve a sensible balance among these sometimes competing needs. Corporate law plays a relatively small, even "trivial" role.3 In emerging economies, these other constraints are weak or absent, so corporate law is a much more central tool for motivating managers and large shareholders to create social value rather than simply transfer wealth to themselves from others. The "market" cannot fill the regulatory gaps that an American-style "enabling" corporate law leaves behind. Further, corporate law in developed countries evolved in tandem with supporting legal institutions. For example, the United States relies on expert judges to assess the reasonableness of takeover defenses and the fairness of transactions in which managers have a conflict of interest. When necessary, these judges make decisions literally overnight to ensure that judicial delay does not kill a challenged transaction. A company law that depends on fast and reliable judicial decisions is simply out of the question in many emerging markets. In Russia, for example, courts function slowly if at all, some judges are corrupt, and many are Soviet-era holdovers who neither understand business nor care to learn. Better judges and courts will emerge only over several decades, as the old judges die or retire. In the meantime, Russian corporate law must rely on courts as little as possible. More generally, every emerging economy has some legal and market institutions, some norms of behavior, some distribution of share ownership, and some financial institutions. Corporate law must reflect these background facts. For example, if (as in Russia) employees often own large stakes in their companies, but are vulnerable to having their votes controlled by corporate managers, company law needs special rules that safeguard the rights of employeeshareholders. Company law must also limit the influence of dysfunctional background features, such as widespread corruption
Our second central claim is that despite the context-specificity of effective corporate law, there is a large class of emerging capitalist economies (including formerly Communist countries)that are sufficiently similar to permit generalization about the type of corporate law that will be useful for them. Russia is perhaps an extreme case, but it is hardly alone in having insider-controlled companies, malfunctioning courts, weak and sometimes corrupt regulators, and poorly developed capital markets. For example, an acute problem in Russia is protecting minority investors against exploitation by managers or controlling shareholders. Protection of minority investors has also emerged as a central political issue in the most successful post- Communist economy the Czech Republic. 4 and is at the core of recent reforms in Israeli corporate law 5 Our third claim is that our task is not impossible. Despite weak markets and institutions, one can design a company law that prevents a significant fraction of the corporate governance failures that would otherwise occur. Even developed country corporate governance systems fail with uncomfortable frequency. We can expect still more failures in emerging markets. Nonetheless, it is possible to design a law that works tolerably well -that vests substantial decisionmaking power in large outside shareholders, who have incentives to make good decisions; that reduces, though it cannot eliminate fraud and self-dealing by corporate insiders; that minimizes, though it cannot altogether avoid, the need for official enforcement through courts; that gives managers and controlling shareholders incentives to obey the rules even when they could often get away with ignoring them; that reinforces desirable cultural attitudes about proper managerial behavior; and that still leaves managers with the flexibility they need to take risks and make quick decisions. Such a law can add far more value than corporate law adds in developed economies, precisely because other institutions that could shape corporate behavior are weak in developing economies The central features of our"self-enforcing"model of corporate law are See Vincent Boland Kevin Done, Prague to Update Market Regulations, Fin. Times, Oct. 24, 1995 S See Uriel Procaccia, Crafting a Corporate Code from Scratch, Public Lecture at Cardozo Law School 12-14 (Oct. 18, 1995)(on file with the Harvard Law School Library) 6 See generally Jonathan P. Charkham, Keeping Good Company: A Study of Corporate Governance in Five Countries(1994)(detailing failures in the United States, Britain, Germany, Japan, and France); Mark J. Roe, Strong Managers, Weak Owners: The Political Roots of American Corporate Finance 149-230 (1994)(United States, Japan, Germany); Bernard S. Black John C Coffee, Jr, Hail Britannia?: Institutional Investor Behavior Under Limited Regulation, 92 Mich. L. Rev. 1997, 2007-77(1994)(Britain); Ronald J Gilson Reinier Kraakman, Imvestment Companies as Guardian Shareholders: The Place of the MSIC in the Corporate Governance Debate, 45 Stan. L Rev. 985, 992-97(1993)(Sweden ); Ronald J. Gilson Mark J Roe, Understanding the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organi=ation, 102 Yale LJ.871,874-82(1993)(Japan)
4 See Vincent Boland & Kevin Done, Prague to Update Market Regulations, Fin. Times, Oct. 24, 1995, at 30. 5 See Uriel Procaccia, Crafting a Corporate Code from Scratch, Public Lecture at Cardozo Law School 12-14 (Oct. 18, 1995) (on file with the Harvard Law School Library). 6 See generally Jonathan P. Charkham, Keeping Good Company: A Study of Corporate Governance in Five Countries (1994) (detailing failures in the United States, Britain, Germany, Japan, and France); Mark J. Roe, Strong Managers, Weak Owners: The Political Roots of American Corporate Finance 149-230 (1994) (United States, Japan, Germany); Bernard S. Black & John C. Coffee, Jr., Hail Britannia?: Institutional Investor Behavior Under Limited Regulation, 92 Mich. L. Rev. 1997, 2007-77 (1994) (Britain); Ronald J. Gilson & Reinier Kraakman, Investment Companies as Guardian Shareholders: The Place of the MSIC in the Corporate Governance Debate, 45 Stan. L. Rev. 985, 992-97 (1993) (Sweden); Ronald J. Gilson & Mark J. Roe, Understanding the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organization, 102 Yale L.J. 871, 874-82 (1993) (Japan). 3 Our second central claim is that despite the context-specificity of effective corporate law, there is a large class of emerging capitalist economies (including formerly Communist countries) that are sufficiently similar to permit generalization about the type of corporate law that will be useful for them. Russia is perhaps an extreme case, but it is hardly alone in having insider-controlled companies, malfunctioning courts, weak and sometimes corrupt regulators, and poorly developed capital markets. For example, an acute problem in Russia is protecting minority investors against exploitation by managers or controlling shareholders. Protection of minority investors has also emerged as a central political issue in the most successful postCommunist economy, the Czech Republic,4 and is at the core of recent reforms in Israeli corporate law.5 Our third claim is that our task is not impossible. Despite weak markets and institutions, one can design a company law that prevents a significant fraction of the corporate governance failures that would otherwise occur. Even developed country corporate governance systems fail with uncomfortable frequency.6 We can expect still more failures in emerging markets. Nonetheless, it is possible to design a law that works tolerably well -- that vests substantial decisionmaking power in large outside shareholders, who have incentives to make good decisions; that reduces, though it cannot eliminate, fraud and self-dealing by corporate insiders; that minimizes, though it cannot altogether avoid, the need for official enforcement through courts; that gives managers and controlling shareholders incentives to obey the rules even when they could often get away with ignoring them; that reinforces desirable cultural attitudes about proper managerial behavior; and that still leaves managers with the flexibility they need to take risks and make quick decisions. Such a law can add far more value than corporate law adds in developed economies, precisely because other institutions that could shape corporate behavior are weak in developing economies. The central features of our "self-enforcing" model of corporate law are:
Enforcement, as much as possible, through actions by direct participants in the corporate enterprise(shareholders, directors, and managers), rather than indirect participants (judges, regulators, legal and accounting professionals, and the financial press) (i) Greater protection of outside shareholders than is common in developed economies, to respond to a high incidence of insider-controlled companies, the weakness of other constraints on self-dealing by managers and controlling shareholders and the need to control self-dealing to strengthen the political credibility of a market economy (iii) Reliance on procedural protections --such as transaction approval by independent directors, independent shareholders, or both - rather than on flat prohibitions of suspect categories of transactions. The use of procedural devices balances the need for shareholder protection against the need for business flexibility (iv)Whenever possible, use of bright-linerules, rather than standards, to define proper and improper behavior. Bright-line rules can be understood by those who must comply with them and have a better chance of being enforced. Standards, in contrast require judicial interpretation, which is often unavailable in emerging markets, and presume a shared cultural understanding of the regulatory policy that underlies the standards, which may also be absent. 7 (v)Strong legal remedies on paper, to compensate for the low probability that the sanctions will be applied in fact Enforcement takes place primarily through a combination of voting transactional rights. The central voting elements include: shareholder approval (including in some cases supermajority approval or approval by a majority of outside shareholders) for broad classes of major transactions and self-interested transactions; approval of self-interested transactions by a majority of outside directors; mandatory cumulative voting for directors, which empowers large minority shareholders to select directors(this power is protected by requirements of one common share, one vote, minimum board size; and no staggering of board terms); and a unitary ballot on which both managers and large shareholders can nominate directors. The honesty of the vote is protected through confidential voting and independent vote tabulation, while the quality of voting decisions is buttressed by mandatory disclosure We use here the conventional distinction between a precise"rule"(don't drive faster than 55 miles per hour)and a vague"standard"(don 't drive faster than appropriate for the road and weather conditions). See Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42 Duke L.J. 557(1992)
7 We use here the conventional distinction between a precise "rule" (don't drive faster than 55 miles per hour) and a vague "standard" (don't drive faster than appropriate for the road and weather conditions). See Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42 Duke L.J. 557 (1992). 4 (i) Enforcement, as much as possible, through actions by direct participants in the corporate enterprise (shareholders, directors, and managers), rather than indirect participants (judges, regulators, legal and accounting professionals, and the financial press). (ii) Greater protection of outside shareholders than is common in developed economies, to respond to a high incidence of insider-controlled companies, the weakness of other constraints on self-dealing by managers and controlling shareholders, and the need to control self-dealing to strengthen the political credibility of a market economy. (iii) Reliance on procedural protections -- such as transaction approval by independent directors, independent shareholders, or both -- rather than on flat prohibitions of suspect categories of transactions. The use of procedural devices balances the need for shareholder protection against the need for business flexibility. (iv) Whenever possible, use of bright-line rules, rather than standards, to define proper and improper behavior. Bright-line rules can be understood by those who must comply with them and have a better chance of being enforced. Standards, in contrast, require judicial interpretation, which is often unavailable in emerging markets, and presume a shared cultural understanding of the regulatory policy that underlies the standards, which may also be absent.7 (v) Strong legal remedies on paper, to compensate for the low probability that the sanctions will be applied in fact. Enforcement takes place primarily through a combination of voting rules and transactional rights. The central voting elements include: shareholder approval (including in some cases supermajority approval or approval by a majority of outside shareholders) for broad classes of major transactions and self-interested transactions; approval of self-interested transactions by a majority of outside directors; mandatory cumulative voting for directors, which empowers large minority shareholders to select directors (this power is protected by requirements of one common share, one vote; minimum board size; and no staggering of board terms); and a unitary ballot on which both managers and large shareholders can nominate directors. The honesty of the vote is protected through confidential voting and independent vote tabulation, while the quality of voting decisions is buttressed by mandatory disclosure rules
Shareholders also receive transactional rights(put and call options) triggered by specified corporate actions. These include preemptive rights when a company issues new shares; appraisal rights for shareholders who do not approve major transactions; and takeout rights when a controlling stake in the firm is acquired( that is, minority shareholder rights to sell their shares to the new controlling shareholder) The self-enforcing model seeks to build legal norms that managers and large shareholders will see as reasonable and comply with voluntarily. The need to induce voluntary compliance reinforces our preference for procedural rather than substantive protections. For example, managers may evade a flat ban on self-interested transactions, yet comply with a procedural requirement for shareholder approval because they think that they can obtain approval. Once they decide to obtain shareholder approval, the managers may make the transaction more favorable to shareholders, to ensure approval and avoid embarrassment. The model often relies not only on bright-line rules, but also on relatively simple rules. Managers can't comply with, and judges can,'t enforce, rules that they don,'t understand. Nor will managers respect an unduly complex statute The british City Code on Takeovers and mergers offers a good set of self-enforcing ules to govern change-of-control transactions, which we largely adopt. We propose a delay period before a change of control occurs to provide a market check on the fairness of the price (30% ownership is our proxy for control); a takeout offer requirement, under which a new controlling shareholder must offer to purchase minority shares(unless the minority shareholders waive this requirement by majority vote); and a ban on defensive actions that could frustrate a takeover bid (unless the actions are approved in advance by the target's shareholders) Shareholders are protected against dilutive share issuances through a combination of preemptive rights; a requirement that shares be issued only at market value(determined by the board of directors); shareholder approval for issuances to insiders(under the self-interested transaction rules) and shareholder approval for large issuances(our threshold is 20% of the previously outstanding shares SIn the economic literature, "self-enforcement"is sometimes given only this narrower meaning-a contract is said to be self-enforcing if it induces voluntary compliance. See, e.g., Lester G. Telser, A Theory of Self- Enforcing Agreements, 53 J. Bus. 27, 27-28(1980). Inducing voluntary compliance is an important element of our approach to company law, but it is only part of what we mean by a"self-enforcing"law 9 Panel on Takeovers and Mergers, The City Code on Takeovers and Mergers and the Rules Governing Substantial Acquisitions of Shares(1993)[hereinafter City Code on Takeovers and mergers] The Panel on Takeovers and Mergers, which administers the City Code, is a self-regulatory organization, with a chair chosen by the Bank of England and members representing institutional investors, public companies, and the London Stock Exchange. Panel rulings can be enforced by a number of sanctions, including delisting from the London Stock Exchange. See Black Coffee, supra note 6, at 2027 C. City Code on Takeovers and Mergers, supra note 9, General Principles 4, 7, 10, at Bl-B2, Rule 9.1 at F1, Rule 21, at 113 (stating similar rules)
8 In the economic literature, "self-enforcement" is sometimes given only this narrower meaning -- a contract is said to be self-enforcing if it induces voluntary compliance. See, e.g., Lester G. Telser, A Theory of SelfEnforcing Agreements, 53 J. Bus. 27, 27-28 (1980). Inducing voluntary compliance is an important element of our approach to company law, but it is only part of what we mean by a "self-enforcing" law. 9 Panel on Takeovers and Mergers, The City Code on Takeovers and Mergers and the Rules Governing Substantial Acquisitions of Shares (1993) [hereinafter City Code on Takeovers and Mergers]. The Panel on Takeovers and Mergers, which administers the City Code, is a self-regulatory organization, with a chair chosen by the Bank of England and members representing institutional investors, public companies, and the London Stock Exchange. Panel rulings can be enforced by a number of sanctions, including delisting from the London Stock Exchange. See Black & Coffee, supra note 6, at 2027. 10 Cf. City Code on Takeovers and Mergers, supra note 9, General Principles 4, 7, 10, at B1-B2, Rule 9.1, at F1, Rule 21, at I13 (stating similar rules). 5 Shareholders also receive transactional rights (put and call options) triggered by specified corporate actions. These include preemptive rights when a company issues new shares; appraisal rights for shareholders who do not approve major transactions; and takeout rights when a controlling stake in the firm is acquired (that is, minority shareholder rights to sell their shares to the new controlling shareholder). The self-enforcing model seeks to build legal norms that managers and large shareholders will see as reasonable and comply with voluntarily. The need to induce voluntary compliance reinforces our preference for procedural rather than substantive protections. For example, managers may evade a flat ban on self-interested transactions, yet comply with a procedural requirement for shareholder approval because they think that they can obtain approval. Once they decide to obtain shareholder approval, the managers may make the transaction more favorable to shareholders, to ensure approval and avoid embarrassment.8 The model often relies not only on bright-line rules, but also on relatively simple rules. Managers can't comply with, and judges can't enforce, rules that they don't understand. Nor will managers respect an unduly complex statute. The British City Code on Takeovers and Mergers offers a good set of self-enforcing rules to govern change-of-control transactions, which we largely adopt.9 We propose a delay period before a change of control occurs to provide a market check on the fairness of the price (30% ownership is our proxy for control); a takeout offer requirement, under which a new controlling shareholder must offer to purchase minority shares (unless the minority shareholders waive this requirement by majority vote); and a ban on defensive actions that could frustrate a takeover bid (unless the actions are approved in advance by the target's shareholders).10 Shareholders are protected against dilutive share issuances through a combination of: preemptive rights; a requirement that shares be issued only at market value (determined by the board of directors); shareholder approval for issuances to insiders (under the self-interested transaction rules); and shareholder approval for large issuances (our threshold is 20% of the previously outstanding shares)
These and other features of the self-enforcing approach produce a company law that is novel in the aggregate, even though many individual provisions(such as one share, one vote and cumulative voting)are familiar in developed markets. To be sure, there are limits to what a self-enforcing corporate law can accomplish. For example, cumulative voting can strengthen the monitoring power of large outside shareholders but is of little direct help to shareholders who own five shares each. Nor are these shareholders likely to exercise appraisal rights if they oppose a merger. Nevertheless, the self-enforcing model can partially protect smal shareholders. All shareholders benefit if large outside shareholders can monitor management performance and control self-dealing. All shareholders also benefit ifthe law induces managers to comply voluntarily. Small investors remain vulnerable to insider self-dealing that includes hidden payoff to large outside shareholders. But concealment won't al ways be possible and when possible, won't al ways be attractive because each participant is thereafter vulnerable to exposure by the others A caveat: we call our model"self-enforcing. This phrase is a shorthand attempt to capture the main lines of our model, including our effort to minimize reliance on official enforcement. But our model is not purely self-enforcing, any more than Delaware's"enabling corporate law is purely enabling, or the"prohibitive"model that characterized American corporate law a century ago was purely prohibitive in character. We can only reduce, not wholly avoid, the need for official enforcement ' e develop the basic elements of a corporate law for emerging economies as follows Part I describes the goals of corporate law in an emerging economy and the elements of national context that affect the laws shape. Part Il outlines the alternative drafting strategies open to emerging economies and explains why our preferred strategy -a structural"or"self- enforcing"corporate law --is likely to be superior to the available alternatives. Parts Ill, IV, and v describe the primary components of a self-enforcing corporate law in the particular context of Russia. Finally, Part VI considers the lessons that can be drawn from the self- enforcement approach for the supposed efficiency of corporate law in developed countri The Appendix compares selected features of the Russian self-enforcing law with the corporate statutes of seventeen relatively advanced emerging markets. The self-enforci model contains more procedural protections and fewer substantive protections than any of the other statutes. We do not, however, advocate wholesale change in existing laws. a company law that is already meeting a particular countrys needs should enjoy deference because its success probably reflects adaptation to local institutions. The self-enforcing model can be a base for a new law if the current law is seriously deficient, and a source of ideas for improving laws that already work tolerably well We focus here only on corporate law as conventionally understood: the law that articulates company structure and regulates relationships among shareholders and between shareholders and corporate managers. American corporate law, thus defined, includes state corporation statutes; the common law of fiduciary duty, the provisions of the securities laws that regulate insider liability, shareholder voting, and control contests;, and stock exchange
6 These and other features of the self-enforcing approach produce a company law that is novel in the aggregate, even though many individual provisions (such as one share, one vote and cumulative voting) are familiar in developed markets. To be sure, there are limits to what a self-enforcing corporate law can accomplish. For example, cumulative voting can strengthen the monitoring power of large outside shareholders but is of little direct help to shareholders who own five shares each. Nor are these shareholders likely to exercise appraisal rights if they oppose a merger. Nevertheless, the self-enforcing model can partially protect small shareholders. All shareholders benefit if large outside shareholders can monitor management performance and control self-dealing. All shareholders also benefit if the law induces managers to comply voluntarily. Small investors remain vulnerable to insider self-dealing that includes a hidden payoff to large outside shareholders. But concealment won't always be possible and, when possible, won't always be attractive because each participant is thereafter vulnerable to exposure by the others. A caveat: we call our model "self-enforcing." This phrase is a shorthand attempt to capture the main lines of our model, including our effort to minimize reliance on official enforcement. But our model is not purely self-enforcing, any more than Delaware's "enabling" corporate law is purely enabling, or the "prohibitive" model that characterized American corporate law a century ago was purely prohibitive in character. We can only reduce, not wholly avoid, the need for official enforcement. We develop the basic elements of a corporate law for emerging economies as follows. Part I describes the goals of corporate law in an emerging economy and the elements of national context that affect the law's shape. Part II outlines the alternative drafting strategies open to emerging economies and explains why our preferred strategy -- a "structural" or "selfenforcing" corporate law -- is likely to be superior to the available alternatives. Parts III, IV, and V describe the primary components of a self-enforcing corporate law in the particular context of Russia. Finally, Part VI considers the lessons that can be drawn from the selfenforcement approach for the supposed efficiency of corporate law in developed countries. The Appendix compares selected features of the Russian self-enforcing law with the corporate statutes of seventeen relatively advanced emerging markets. The self-enforcing model contains more procedural protections and fewer substantive protections than any of the other statutes. We do not, however, advocate wholesale change in existing laws. A company law that is already meeting a particular country's needs should enjoy deference because its success probably reflects adaptation to local institutions. The self-enforcing model can be a base for a new law if the current law is seriously deficient, and a source of ideas for improving laws that already work tolerably well. We focus here only on corporate law as conventionally understood: the law that articulates company structure and regulates relationships among shareholders and between shareholders and corporate managers. American corporate law, thus defined, includes state corporation statutes; the common law of fiduciary duty; the provisions of the securities laws that regulate insider liability, shareholder voting, and control contests; and stock exchange