Columbia Law School The Center for Law and Economic studies 435 West 116St New York, NY 10027-7201 Working Paper No 231 Innovation in Corporate Law Katharina Pistor, Yoram Keinan, Jan Kleinheisterkamp mark d. west Forthcoming 2003 Journal of comparative economics This paper can be downloaded without charge from the Social Science research Network electronic library at http://ssrn.com/abstract=419861 An index to the working papers in the Columbia lay School Working Paper Series is located at http:/hwww.lanw.columbia.edwcenterprogramllanweconomics
1 Columbia Law School The Center for Law and Economic Studies 435 West 116th St. New York, NY 10027-7201 Working Paper No. 231 Innovation in Corporate Law Katharina Pistor, Yoram Keinan, Jan Kleinheisterkamp & Mark D. West Forthcoming 2003 Journal of Comparative Economics This paper can be downloaded without charge from the Social Science Research Network electronic library at: http://ssrn.com/abstract=419861 An index to the working papers in the Columbia Law School Working Paper Series is located at: http://www.law.columbia.edu/center_program/law_economics
Innovation in Corporate Law Associate Professor of law columbia law school 435 West 116 Street, New York, NY 10027 ng authorI Yoram Keinan JSD Candidate University of Michigan, Ann Arbor Jan Kleinheisterk Research associate Max Planck Institute for Foreign and Comparative Private Law Mark d. we Professor of li University of Michigan, Ann Arbor We would like to thank Konstantinos Kyriakakis for his help on the evolution of French corporate law Special thanks to Rick Messick, Peter Murell and Andrei Shleifer as well as other participants at the Conference on Appropriate Institutions held at the World Bank on 13 September 2002 for comments on an Associate Professor of law columbia law school Research Associate, Max Planck Institute for Foreign and Comparative Law, Hamburg Assistant Professor of Law, University of Michigan Law School
2 Innovation in Corporate Law1 Katharina Pistor+ Associate Professor of Law, Columbia Law School 435 West 116th Street, New York, NY 10027 [corresponding author] Yoram Keinan∗ JSD Candidate University of Michigan, Ann Arbor Jan Kleinheisterkamp# Research Associate Max Planck Institute for Foreign and Comparative Private Law Hamburg, Germany Mark D. West× Professor of Law University of Michigan, Ann Arbor 1 We would like to thank Konstantinos Kyriakakis for his help on the evolution of French corporate law. Special thanks to Rick Messick, Peter Murell and Andrei Shleifer as well as other participants at the Conference on Appropriate Institutions held at the World Bank on 13 September 2002 for comments on an earlier draft. + Associate Professor of Law, Columbia Law School. ∗ SJD Candidate, University of Michigan Law School. # Research Associate, Max Planck Institute for Foreign and Comparative Law, Hamburg. × Assistant Professor of Law, University of Michigan Law School
Abstract corporation with its key attributes of independent personality, limited liability and free o n most countries large business enterprises today are organized as corporations. Th tradeability of shares has played a key role in most developed market economies since the 9 century and has made major inroads in emerging markets. We suggest that the changing environment. We analyze a country's capacity to innovate using the rate or o resilience of the corporate form is a function of the adaptability of the legal framework statutory legal change, the flexibility of corporate law, and institutional change as indicators. Our findings suggest that origin countries are more innovative than transplant countries JEL Classification: G3 K2 N2 P5 Forthcoming in: Journal of Comparative Economics(2003)
3 Abstract: In most countries large business enterprises today are organized as corporations. The corporation with its key attributes of independent personality, limited liability and free tradeability of shares has played a key role in most developed market economies since the 19th century and has made major inroads in emerging markets. We suggest that the resilience of the corporate form is a function of the adaptability of the legal framework to a changing environment. We analyze a country’s capacity to innovate using the rate of statutory legal change, the flexibility of corporate law, and institutional change as indicators. Our findings suggest that origin countries are more innovative than transplant countries. JEL Classification: G3, K2, N2, P5 Forthcoming in: Journal of Comparative Economics (2003)
Corporate law and corporate governance are used in recent literature to explain differences in the performance of financial markets and firms. The objective of this research is to identify variables that account for diff in performance and to rectify deficiencies in corporate law and financial market development by changing these variables. Attempts to identify best legal practice and to develop legal standards that may be transplanted are endorsed by multinational institutions, such as the IMF and the World Bank(Pistor, 2002). This strategy receives empirical support in studies showing that the level of minority shareholder protection in laws on the books does indeed have a statistically significant impact on the development of financial markets as measured by standard indicators, such as market capitalization, liquidity, and the ownership concentration of firms(La Porta et al., 1997 and La Porta et al., 1998 ). These studies find hat countries belonging to the common law family have better minority shareholder protection on average than countries belonging to the German, French or even the Scandinavian civil law family. They also show that common law countries have better developed financial markets than do civil law countries Implicit in this analysis is a causal relation that runs from legal origin to the quality of law to financial outcome. However, a brief review of the history of corporate law in the mother country of the common law, England, shows that only a few of the indicators that account for the high level of minority shareholder protection in common law countries as measured in these studies were present at the time the first corporate statutes were enacted as table l indicates
4 1. Introduction Corporate law and corporate governance are used in recent literature to explain differences in the performance of financial markets and firms. The objective of this research is to identify variables that account for differences in performance and to rectify deficiencies in corporate law and financial market development by changing these variables. Attempts to identify best legal practice and to develop legal standards that may be transplanted are endorsed by multinational institutions, such as the IMF and the World Bank (Pistor, 2002). This strategy receives empirical support in studies showing that the level of minority shareholder protection in laws on the books does indeed have a statistically significant impact on the development of financial markets as measured by standard indicators, such as market capitalization, liquidity, and the ownership concentration of firms (La Porta et al., 1997 and La Porta et al., 1998). These studies find that countries belonging to the common law family have better minority shareholder protection on average than countries belonging to the German, French or even the Scandinavian civil law family. They also show that common law countries have better developed financial markets than do civil law countries. Implicit in this analysis is a causal relation that runs from legal origin to the quality of law to financial outcome. However, a brief review of the history of corporate law in the mother country of the common law, England, shows that only a few of the indicators that account for the high level of minority shareholder protection in common law countries as measured in these studies were present at the time the first corporate statutes were enacted as Table 1 indicates
Table 1: Minority Shareholder Protection in English l Prior to 1948, shareholders could vote by proxy only if this had been stipulated in the articles of incorporation no mention is made of proxy by mail No blocking of shares (-) Shareholder suit Direct suit implied in 1844; derivative action recognized nly in 1975 Preemptive rights Adopted in response to EU harmonization requirements. Shareholders re The 1862 law required 20 percent. more than 10 percent of total The threshold was lowered to 5 percent in 1948 stock can call extraordinary shareholder meeting Acts 1844 Note: () denotes that the relevant provision does not exist in the statutory corporate law This observation raises the issues of why some countries have developed these protective mechanisms while others have not and whether a set of static indicators can serve as a proxy for the quality of law. In this paper, we propose an alternative approach to assessing the quality of corporate law, namely, the capacity of a legal system to innovate. The more innovative and adaptable a legal system is, the more likely it is able to respond to a changing environment and thereby give firms the possibility to explore new opportunities while ensuring a minimum level of investor protection We use data on the evolution of corporate law in ten jurisdictions to explore this proposition. Each of the major legal families, namely, the common law family and civil law families of France and Germany, are represented For each family, we include origin countries, i.e. countries that developed their formal legal systems largely internally or with only limited borrowing, as well as transplant countries, i. e those that received their formal legal order from foreign sources. The four origin countries are France, Germany
5 Table 1: Minority Shareholder Protection in English Law Date of Enactment Comment Proxy by mail 1948 Prior to 1948, shareholders could vote by proxy only if this had been stipulated in the articles of incorporation; no mention is made of proxy by mail. Cumulative voting ( - ) ( - ) No blocking of shares ( - ) ( - ) Shareholder suit 1844 Direct suit implied in 1844; derivative action recognized only in 1975. Preemptive rights 1980 Adopted in response to EU harmonization requirements. Shareholders representing not more than 10 percent of total stock can call extraordinary shareholder meeting 1909 The 1862 law required 20 percent. The threshold was lowered to 5 percent in 1948. Source: English Companies Acts 1844 to present. Note: (-) denotes that the relevant provision does not exist in the statutory corporate law. This observation raises the issues of why some countries have developed these protective mechanisms while others have not and whether a set of static indicators can serve as a proxy for the quality of law. In this paper, we propose an alternative approach to assessing the quality of corporate law, namely, the capacity of a legal system to innovate. The more innovative and adaptable a legal system is, the more likely it is able to respond to a changing environment and thereby give firms the possibility to explore new opportunities while ensuring a minimum level of investor protection. We use data on the evolution of corporate law in ten jurisdictions to explore this proposition. Each of the major legal families, namely, the common law family and civil law families of France and Germany, are represented. For each family, we include origin countries, i.e. countries that developed their formal legal systems largely internally or with only limited borrowing, as well as transplant countries, i.e., those that received their formal legal order from foreign sources. The four origin countries are France, Germany
England, and the United States. The six transplant countries are Spain, Chile and Colombia belonging to French civil law, Japan belonging to the German civil law, and Israel and Malaysia belonging to the common law families We find substantial differences in the capacity of legal systems to innovate along three dimensions, namely, the rate of statutory legal change, the flexibility of corporate law, i.e., enabling vS. mandatory, and the development of new enforcement mechanisms First, our findings suggest that the rate of statutory legal change is substantially higher in origin countries than in transplants. Although common law countries have had a somewhat higher rate of change than civil law countries among the four origin countries, the difference between origins and transplants within each legal family is greater than the differences across legal families. Second, countries with a highly mandatory statutory law exhibit less innovation than countries with a more enabling statutory law. Third, legal institutional innovation, in particular, the creation of new enforcement agents such as regulators, has been higher in countries with a more enabling corporate law than in those with a highly mandatory law Our evidence is drawn from statutory corporate law provisions on issues related to corporate finance. In parallel work, we investigate corporate law more broadly and include the governance structure of the firm as well as the rules governing entry and exist ( Pistor et al., 2002 ). However, it is in corporate finance law where we find both the greatest difference across jurisdictions and the greatest rate of innovation over time In section two. of this paper we explain the meaning of legal innovation and develop a set of propositions to assess the innovative capacity of different legal systems. In 2 Whether the U.S. is a transplant or origin country may be disputed. The U.S. received the common law system by way of transplantation from England. However, since the late 18 century, the legal evolution in 6
6 England, and the United States.2 The six transplant countries are Spain, Chile and Colombia belonging to French civil law, Japan belonging to the German civil law, and Israel and Malaysia belonging to the common law families. We find substantial differences in the capacity of legal systems to innovate along three dimensions, namely, the rate of statutory legal change, the flexibility of corporate law, i.e., enabling vs. mandatory, and the development of new enforcement mechanisms. First, our findings suggest that the rate of statutory legal change is substantially higher in origin countries than in transplants. Although common law countries have had a somewhat higher rate of change than civil law countries among the four origin countries, the difference between origins and transplants within each legal family is greater than the differences across legal families. Second, countries with a highly mandatory statutory law exhibit less innovation than countries with a more enabling statutory law. Third, legal institutional innovation, in particular, the creation of new enforcement agents such as regulators, has been higher in countries with a more enabling corporate law than in those with a highly mandatory law. Our evidence is drawn from statutory corporate law provisions on issues related to corporate finance. In parallel work, we investigate corporate law more broadly and include the governance structure of the firm as well as the rules governing entry and exist (Pistor et al., 2002). However, it is in corporate finance law where we find both the greatest difference across jurisdictions and the greatest rate of innovation over time. In section two. of this paper we explain the meaning of legal innovation and develop a set of propositions to assess the innovative capacity of different legal systems. In 2 Whether the U.S. is a transplant or origin country may be disputed. The U.S. received the common law system by way of transplantation from England. However, since the late 18th century, the legal evolution in
section threewe present the evidence we find in the ten countries included in the analysis Section four concludes 2. Legal Innovation and Propositions Our major proposition is that the capacity of legal systems to innovate is more important than the level of protection a legal system may afford to particular stakeholders at any point in time. Minimum protections may be taken as a first indicator to assess the quality of legal systems. However, such protections may soon be out of date, as changes in the environment or the capacity of economic agents to circumvent established rules and to develop new forms of arbitrage will render previously effective protective mechanisms ineffective. This is true especially in areas such as corporate law and financial market regulation because socioeconomic and technological change is rapid and challenges the legal system persistently. The recent wave of financial accounting frauds in the U.S., a legal system that has been hailed as the most advanced system with regard to financial market regulation, Coffee(2002b)and rock(2002), illustrate that innovative capacity is a continuous challenge Innovative capacity does not specify the type of legal protections different legal systems should adopt or the institutions they should establish. In fact, innovative capacity refers to a given system' s ability to respond to the challenges it faces, which may well differ from those faced by a neighboring system. Therefore, we are not interested in a set of best practice indicators but, in legal change that responds to country or system specific problems. Moreover, we do not limit legal change to changes in the law on the books the U.S. has been sufficiently idiosyncratic( Horwitz, 1977)to justify its classification as an origin country
7 section threewe present the evidence we find in the ten countries included in the analysis. Section four concludes. 2. Legal Innovation and Propositions. Our major proposition is that the capacity of legal systems to innovate is more important than the level of protection a legal system may afford to particular stakeholders at any point in time. Minimum protections may be taken as a first indicator to assess the quality of legal systems. However, such protections may soon be out of date, as changes in the environment or the capacity of economic agents to circumvent established rules and to develop new forms of arbitrage will render previously effective protective mechanisms ineffective. This is true especially in areas such as corporate law and financial market regulation because socioeconomic and technological change is rapid and challenges the legal system persistently. The recent wave of financial accounting frauds in the U.S., a legal system that has been hailed as the most advanced system with regard to financial market regulation, Coffee (2002b) and Rock (2002), illustrate that innovative capacity is a continuous challenge. Innovative capacity does not specify the type of legal protections different legal systems should adopt or the institutions they should establish. In fact, innovative capacity refers to a given system’s ability to respond to the challenges it faces, which may well differ from those faced by a neighboring system. Therefore, we are not interested in a set of best practice indicators but, in legal change that responds to country or system specific problems. Moreover, we do not limit legal change to changes in the law on the books, the U.S. has been sufficiently idiosyncratic (Horwitz, 1977)to justify its classification as an origin country
although data availability implies that this is the least difficult case to establish; rather, we include indicators for the flexibility of corporate law and institutional change Hayek(1973)emphasizes the importance of legal evolution and change and points It that judge made law is evolutionary by nature. Statutory law enacted by legislatures may be swifter at times and may serve to correct judge-made law, but statutory law may also be used to restrict innovation and to infringe on individual liberties Several authors argue that the common law is efficient, because the process of lawmaking by judges on a case by case basis lends itself to efficient rule selection(Priest, 1977 and Rubin, 1977) However, a potential selection bias affects litigation as Bailey and Rubin(1994)argue Finally, a comparative legal analysis emphasizes the differences between code and case law in bringing about legal change(Merryman, 1985, Merryman, 1996 and Zweigert and Kotz, 1998 ). Building on this literature, Beck et al. (2002)use case law, defined as a dummy variable that indicates whether judicial decisions are a source of law, in addition to requirements that statutory law rather than principles of equity are a basis for court ulings as proxies for the adaptability of legal systems. Our approach differs in several respects. The focus of our analysis is on the law governing the corporate enterprise Corporate law has been codified in all major jurisdictions, including the common law families, since the early 19 century. Therefore, we treat statutory law as an important source of information for the innovative capacity of legal systems. In particular, we use the rate of statutory legal change since the first enactment of a formal corporate law as a proxy for legal innovation 8
8 although data availability implies that this is the least difficult case to establish; rather, we include indicators for the flexibility of corporate law and institutional change respectively. Hayek (1973) emphasizes the importance of legal evolution and change and points out that judge made law is evolutionary by nature. Statutory law enacted by legislatures may be swifter at times and may serve to correct judge-made law, but statutory law may also be used to restrict innovation and to infringe on individual liberties. Several authors argue that the common law is efficient, because the process of lawmaking by judges on a case by case basis lends itself to efficient rule selection (Priest, 1977 and Rubin, 1977). However, a potential selection bias affects litigation as Bailey and Rubin (1994) argue. Finally, a comparative legal analysis emphasizes the differences between code and case law in bringing about legal change (Merryman, 1985, Merryman, 1996 and Zweigert and Kötz, 1998). Building on this literature, Beck et al. (2002) use case law, defined as a dummy variable that indicates whether judicial decisions are a source of law, in addition to requirements that statutory law rather than principles of equity are a basis for court rulings as proxies for the adaptability of legal systems. Our approach differs in several respects. The focus of our analysis is on the law governing the corporate enterprise. Corporate law has been codified in all major jurisdictions, including the common law families, since the early 19th century. Therefore, we treat statutory law as an important source of information for the innovative capacity of legal systems. In particular, we use the rate of statutory legal change since the first enactment of a formal corporate law as a proxy for legal innovation
Given the importance of statutory corporate law in all jurisdictions, the simple distinction between case law and statutory law is unlikely to capture major differences across legal families. Therefore, we classify corporate laws on the continuum from mandatory to enabling corporate law following Coffee(1989)and Gordon(1989) Mandatory law means that private agents may not opt out of the allocation of control rights prescribed in the statutory law. By contrast, an enabling law makes most of the statutory provisions optional and allows parties to reallocate control rights. The classification of a corporate law as enabling or mandatory has important implications for the relevance of judge-made law. When law is mandatory, judges may be called upon to enforce these rules but they have comparatively little lawmaking functions because the mandatory nature of the law implies that these functions are reserved for the legislature When law is enabling or optional, judges play an important role in determining the boundaries of the permissible reallocation of control rights and in settling disputes among private actors with different claims to control rights This classification allows us to distinguish between legal systems that belong to the same legal family. In particular, we show that there are important differences within the common law family in the mandatory vs. enabling dimension. The law in Delaware, which is the leading jurisdiction for corporate law within the U.S., represents a highly enabling corporate law. However, England, as well as Malaysia and Israel are located somewhere in the middle of a continuum from mandatory to enabling law. The classification also leads us to reject the proposition by Beck et al. (2002)that Germany falls within the case law category. In many areas of the law e.g., contracts and torts judges in germany carry out important lawmaking functions, but this is not the case for
9 Given the importance of statutory corporate law in all jurisdictions, the simple distinction between case law and statutory law is unlikely to capture major differences across legal families. Therefore, we classify corporate laws on the continuum from mandatory to enabling corporate law following Coffee (1989) and Gordon (1989). Mandatory law means that private agents may not opt out of the allocation of control rights prescribed in the statutory law. By contrast, an enabling law makes most of the statutory provisions optional and allows parties to reallocate control rights. The classification of a corporate law as enabling or mandatory has important implications for the relevance of judge-made law. When law is mandatory, judges may be called upon to enforce these rules but they have comparatively little lawmaking functions because the mandatory nature of the law implies that these functions are reserved for the legislature. When law is enabling or optional, judges play an important role in determining the boundaries of the permissible reallocation of control rights and in settling disputes among private actors with different claims to control rights. This classification allows us to distinguish between legal systems that belong to the same legal family. In particular, we show that there are important differences within the common law family in the mandatory vs. enabling dimension. The law in Delaware, which is the leading jurisdiction for corporate law within the U.S., represents a highly enabling corporate law. However, England, as well as Malaysia and Israel are located somewhere in the middle of a continuum from mandatory to enabling law. The classification also leads us to reject the proposition by Beck et al. (2002) that Germany falls within the case law category. In many areas of the law e.g., contracts and torts, judges in Germany carry out important lawmaking functions, but this is not the case for
the law governing the publicly traded corporation(Aktienrecht). German corporate law is highly mandatory so that case law is virtually absent. Indeed, corporate law textbooks suggest that, because of the scarcity of case law in this area, it is sufficient to read the provisions of the statute(Kubler, 1994) Our third indicator of innovative capacity is legal institutional change. The development of stock markets has been accompanied by the emergence of new lawmaking and law enforcement institutions in the form of regulators, i.e., stock exchanges and state regulators such as the Securities and Exchange Commission(SEC)in the U.s. and the Financial Services Authority(fsa)in the UK (Coffee, 2002a). Recent work attributes the emergence of financial market regulators to the failure of courts to enforce the law effectively enough to deter stock and corporate fraud Glaeser and Shleifer(2003 )argue that this failure in the U. S in the early 20 century is due to the fact that the judiciary was captured by powerful industry groups, which necessitated the creation of a new independent state agent. Pistor and Xu (2003)suggest that, even if courts are impartial, the design of courts as neutral arbiters implies that courts can enforce the law only reactively, i. e, after the victim or a state agent have brought action This limits their capacity to prevent harmful actions from taking place. By contrast, regulators are designed to initiate law enforcement independently, which places them in a better position to prevent harmful actions from occurring. Tentative support for the latter proposition is found in La Porta, Lopez-de-Silanes, and Shleifer(2002), who suggest that According to para. 23 V Aktiengesetz (Law on Joint Stock Companies)all provisions of the law are mandatory, unless explicitly stated otherwise in the law The situation is quite different for closely held corporations( GmbH), for which courts play a very active ole. The reason for the lack of case law governing the Aktiengesellschaft(ag)is widely attributed to the lack of procedural rules that would allow shareholders to take judicial re 10
10 the law governing the publicly traded corporation (Aktienrecht). German corporate law is highly mandatory3 so that case law is virtually absent. Indeed, corporate law textbooks suggest that, because of the scarcity of case law in this area, it is sufficient to read the provisions of the statute (Kübler, 1994).4 Our third indicator of innovative capacity is legal institutional change. The development of stock markets has been accompanied by the emergence of new lawmaking and law enforcement institutions in the form of regulators, i.e., stock exchanges and state regulators such as the Securities and Exchange Commission (SEC) in the U.S. and the Financial Services Authority (FSA) in the UK (Coffee, 2002a). Recent work attributes the emergence of financial market regulators to the failure of courts to enforce the law effectively enough to deter stock and corporate fraud. Glaeser and Shleifer (2003) argue that this failure in the U.S. in the early 20th century is due to the fact that the judiciary was captured by powerful industry groups, which necessitated the creation of a new independent state agent. Pistor and Xu (2003) suggest that, even if courts are impartial, the design of courts as neutral arbiters implies that courts can enforce the law only reactively, i.e., after the victim or a state agent have brought action. This limits their capacity to prevent harmful actions from taking place. By contrast, regulators are designed to initiate law enforcement independently, which places them in a better position to prevent harmful actions from occurring. Tentative support for the latter proposition is found in La Porta, Lopez-de-Silanes, and Shleifer (2002), who suggest that 3 According to para. 23 V Aktiengesetz (Law on Joint Stock Companies) all provisions of the law are mandatory, unless explicitly stated otherwise in the law. 4 The situation is quite different for closely held corporations (GmbH), for which courts play a very active role. The reason for the lack of case law governing the Aktiengesellschaft (AG) is widely attributed to the lack of procedural rules that would allow shareholders to take judicial recourse
