Yale law school Center for Law, Economics and Public policy Research Paper No 300 What is Corporate law? Henry hansmann Reinier Kraakman This paper can be downloaded without charge from Social Science Research Network Electronic Paper Collection at http://ssrn.com/abstract=568623
Social Science Research Network Electronic Paper Collection at: http://ssrn.com/abstract=568623 Center for Law, Economics and Public Policy This paper can be downloaded without charge from: Yale Law School Henry Hansmann Research Paper No. 300 What is Corporate Law? Reinier Kraakman
Kraakman/The Anatoeny of Corporate Law Final Proof 25.2.2004 8: 38am page 1 What is Corporate law? HENRY HANSMANN and REINIER KRAAKman 1.1 INTRODUCTION What is the common structure of the law of business corporations- or, as it rould be put in the UK, company law-across different national jurisdictions? Although this question is rarely asked by corporate law scholars, it is critically important for the comparative investigation of corporate law. Recent scholar- hip emphasizes the divergence among European, American, and Japanese cor- porations in corporate governance, share ownership, capital markets, and business culture. But, notwithstanding the very real differences across jurisdic tions along these dimensions, the underlying uniformity of the corporate form is at least as impressive. Business corporations have a fundamentally similar set of legal characteristics-and face a fundamentally similar set of legal probler all jurisdictions Consider, in this regard, the basic legal characteristics of the business corpor ation. To anticipate our discussion below, there are five of these characteristics, most of which will be easily recognizable to anyone familiar with business affairs. They are: legal personality, limited liability, transferable shares, dele gated management under a board structure, and investor ownership. These haracteristics are--for reasons we will explore-induced by the economic exigencies of the large modern business enterprise. Thus, corporate law every- where must, of necessity, provide for them. To be sure, there are other forms of business enterprise that lack one or more of these characteristics. But the remarkable fact-and the fact that we wish to stress--is that in market econ- omies, almost all large-scale business firms adopt a legal form that possesses all five of the basic characteristics of the business corporation. Indeed, most smal jointly-owned firms adopt this corporate form as well, although sometimes with deviations from one or more of the five basic characteristics to fit the special needs of closely held firms. ( Throughout this book, we will follow the usual See, e.g., Ronald J. Gilson and Mark J. Roe, Understanding the Japanese Keiretsu: Overlaps Between Corporation Governance and Industrial Organization, 102 YALE LAW JOURNAL 871(1993) Mark ]. Roe, Some Differences in Corporation Structure in Germany, Japan, and the United States, 02 YALE LAW JOURNAL 1927(1993); Bernard S. Black and John C. Coffee, Hail Britannia?Insti- futional Investor Behavior Under Limited Regulation, 92 MICHIGAN LAW REVIEW 1997(1994); Klaus ]. Hopt and Eddy Wymeersch (eds ) COMPARATIVE CORPORATE GoVERNANCE: ESSAYS AND MATERIALS(1997); and Mark J. Roe, PoLITICAL DETERMINANTS OF CORPORATE GovERNANCE
1 What is Corporate Law? HENRY HANSMANN and REINIER KRAAKMAN 1.1 Introduction What is the common structure of the law of business corporations—or, as it would be put in the UK, company law—across different national jurisdictions? Although this question is rarely asked by corporate law scholars, it is critically important for the comparative investigation of corporate law. Recent scholarship emphasizes the divergence among European, American, and Japanese corporations in corporate governance, share ownership, capital markets, and business culture.1 But, notwithstanding the very real differences across jurisdictions along these dimensions, the underlying uniformity of the corporate form is at least as impressive. Business corporations have a fundamentally similar set of legal characteristics—and face a fundamentally similar set of legal problems—in all jurisdictions. Consider, in this regard, the basic legal characteristics of the business corporation. To anticipate our discussion below, there are five of these characteristics, most of which will be easily recognizable to anyone familiar with business affairs. They are: legal personality, limited liability, transferable shares, delegated management under a board structure, and investor ownership. These characteristics are—for reasons we will explore—induced by the economic exigencies of the large modern business enterprise. Thus, corporate law everywhere must, of necessity, provide for them. To be sure, there are other forms of business enterprise that lack one or more of these characteristics. But the remarkable fact—and the fact that we wish to stress—is that, in market economies, almost all large-scale business firms adopt a legal form that possesses all five of the basic characteristics of the business corporation. Indeed, most small jointly-owned firms adopt this corporate form as well, although sometimes with deviations from one or more of the five basic characteristics to fit the special needs of closely held firms. (Throughout this book, we will follow the usual 1 See, e.g., Ronald J. Gilson and Mark J. Roe, Understanding the Japanese Keiretsu: Overlaps Between Corporation Governance and Industrial Organization, 102 Yale Law Journal 871 (1993); Mark J. Roe, Some Differences in Corporation Structure in Germany, Japan, and the United States, 102 Yale Law Journal 1927 (1993); Bernard S. Black and John C. Coffee, Hail Britannia? Institutional Investor Behavior Under Limited Regulation, 92 Michigan Law Review 1997 (1994); Klaus J. Hopt and Eddy Wymeersch (eds.), Comparative Corporate Governance: Essays and Materials (1997); and Mark J. Roe, Political Determinants of Corporate Governance (2003). Kraakman / The Anatomy of Corporate Law Final Proof 25.2.2004 8:38am page 1
Kraakman/The Anatoeny of Corporate Law Final Proof 25.2.2004 8: 38am page 2 Introductio unlikeof using the term closely heldto refer to corporations whose shares- practi se of"publicly held'corporations--do not trade freely in impersonal markets, either because the shares are held by a small number of persons or because they are subject to restrictions that limit their transferability. Self-evidently, a principal function of corporate law is to provide business enterprises with a legal form that possesses these five core attributes. By making his form widely available and user-friendly-i. e, by altering background prop- rty rights and providing off-the-shelf housekeeping rules--corporate law en- ables entrepreneurs to transact easily through the medium of the corporate entity, and thus lowers the costs of business contracting. Of course, the number of provisions that the typical corporation statute devotes to defining the corpor- ate form is likely to be only a small part of the statute as a whole. Nevertheless these are the provisions that comprise the legal core of corporate law that hared by every jurisdiction. In this Chapter, we briefly explore the contracting efficiencies(some familiar and some not) that accompany these five features of rm, and that, we believe, have helped el the worldwide diffusion of the corporate form. Like corporate law itself, however, our principal focus in this book is not on establishing the corporate form per se, but rather on a second, equally important function of corporate law: that is, constraining value-reducing forms of oppor tunism among the constituencies of the corporate enterprise. In particular, we address three principal conflicts within the corporation: those between managers and shareholders, those among shareholders, and those between shareholders and the corporations other constituencies, including creditors and employees All three of these generic conflicts give rise to problems that are usefully charac terized as what economists call " agency problems. 'Consequently, Chapter 2 examines these three agency problems, both in general and as they arise in the corporate context, and surveys the range of legal strategies that can be employed to deal with those problems. The reader might object that these agency conflicts-which, in our view, occupy most of corporate law-are not uniquely corporate. 'After all, any form of jointly-owned enterprise must expect conflicts among its owners, man- agers, and third-party contractors. We agree; insofar as the corporation is only one of several legal forms for the jointly-owned firm, it faces the same generic agency problems that confront all jointly-owned firms. Nevertheless, the char- acteristics of this particular form matter a great deal, since it is the form that is hosen by most large-scale enterprises-and, as a practical matter, the only form hat widely held firms can choose in many jurisdictions. 3 Moreover, the unique 2 See Henry Hansmann and Reinier Kraakman, The Essential Role of Organizational Law, 110 YALE LAW AL387(2000) Only the corporate form is available in many jurisdictions to the extent that large-scale enter prises are forced to look to the public equity markets for financing. Some jurisdictions permit the equity of non-corporate entities to trade in the public markets as well: for example, in the U.S, the equity securities of so-called'master'limited partnerships and limited liability companies may be registered for public trading
practice of using the term ‘closely held’ to refer to corporations whose shares— unlike those of ‘publicly held’ corporations—do not trade freely in impersonal markets, either because the shares are held by a small number of persons or because they are subject to restrictions that limit their transferability.) Self-evidently, a principal function of corporate law is to provide business enterprises with a legal form that possesses these five core attributes. By making this form widely available and user-friendly—i.e., by altering background property rights2 and providing off-the-shelf housekeeping rules—corporate law enables entrepreneurs to transact easily through the medium of the corporate entity, and thus lowers the costs of business contracting. Of course, the number of provisions that the typical corporation statute devotes to defining the corporate form is likely to be only a small part of the statute as a whole. Nevertheless, these are the provisions that comprise the legal core of corporate law that is shared by every jurisdiction. In this Chapter, we briefly explore the contracting efficiencies (some familiar and some not) that accompany these five features of the corporate form, and that, we believe, have helped to propel the worldwide diffusion of the corporate form. Like corporate law itself, however, our principal focus in this book is not on establishing the corporate form per se, but rather on a second, equally important function of corporate law: that is, constraining value-reducing forms of opportunism among the constituencies of the corporate enterprise. In particular, we address three principal conflicts within the corporation: those between managers and shareholders, those among shareholders, and those between shareholders and the corporation’s other constituencies, including creditors and employees. All three of these generic conflicts give rise to problems that are usefully characterized as what economists call ‘agency problems.’ Consequently, Chapter 2 examines these three agency problems, both in general and as they arise in the corporate context, and surveys the range of legal strategies that can be employed to deal with those problems. The reader might object that these agency conflicts—which, in our view, occupy most of corporate law—are not uniquely ‘corporate.’ After all, any form of jointly-owned enterprise must expect conflicts among its owners, managers, and third-party contractors. We agree; insofar as the corporation is only one of several legal forms for the jointly-owned firm, it faces the same generic agency problems that confront all jointly-owned firms. Nevertheless, the characteristics of this particular form matter a great deal, since it is the form that is chosen by most large-scale enterprises—and, as a practical matter, the only form that widely held firms can choose in many jurisdictions.3 Moreover, the unique 2 See Henry Hansmann and Reinier Kraakman, The Essential Role of Organizational Law, 110 Yale Law Journal 387 (2000). 3 Only the corporate form is available in many jurisdictions to the extent that large-scale enterprises are forced to look to the public equity markets for financing. Some jurisdictions permit the equity of non-corporate entities to trade in the public markets as well: for example, in the U.S., the equity securities of so-called ‘master’ limited partnerships and limited liability companies may be registered for public trading. Kraakman / The Anatomy of Corporate Law Final Proof 25.2.2004 8:38am page 2 2 Introduction
Kraakman/The Anatony of Corporate Law Final Proof 25.2.2004 8: 38am page 3 What is Corporate Law? features of this form determine the contours of its agency problems. To take an obvious example, the fact that shareholders enjoy limited liability-while, say, general partners in a partnership do not-has traditionally made creditor pro tection far more salient in corporate law than it is in partnership law. Similarl the fact that corporate investors may trade their shares is the foundation of the anonymous trading stock market-an institution that has encouraged the separation of ownership from control, and so has sharpened the management shareholder agency problem In this book, we explore the role of corporate law in minimizing agency thus, making the corporate form practical the most mportant categories of corporate actions and decisions. More particularly, Chapters 3-8 address, respectively, six categories of transactions and decisions that involve the corporation, its owners, its ers,and the other parties with whom it deals. Most of these categories of firm activity are, again, generic rather than uniquely corporate. For example, Chapter 3 addresses the govern- ance mechanisms that operate over the firms ordinary business decisions, while Chapter 4 turns to the checks that operate on the corporation s transactions with creditors. As before, however, if similar agency problems arise in similar contexts in part on the unique legal features that characterize the corporate fom 3 across all forms of jointly-owned enterprise, the response of corporate law turns Taken together, the latter six chapters of our book cover nearly all of the important problems in corporate law-apart, that is, from the fundamental project of establishing the corporate form itself. In each Chapter, we desc how the basic agency problems of the corporate form manifest themselves in the given category of corporate activity, and then explore the range of alternative legal responses that are available. We illustrate these alternative approaches with examples from the corporate law of various prominent jurisdictions. We explore the patterns of homogeneity and the patterns of heterogeneity that appear. Where there are significant differences across jurisdictions, we seek to address both the sources and the consequences of those differences. Our examples are drawn principally form a handful of major representative jurisdictions, including France, Germany, Japan, the U.S., and the UK, though we also make reference to the law of other jurisdictions to make special points In emphasizing a strongly functional approach to the issues of comparative law, this book differs from some of the more traditional comparative law scholarship, both in the field of corporate law and elsewhere. 4 We join an emerging tendency in comparative law scholarship by seeking to give a highly integrated view of the role and structure of corporate law that provides a clear framework within which to organize an understanding of individual systems, both alone and in comparison with each other. Moreover, while comparative 4 Compare, e. g, Arthur R. Pinto and Gustavo Visentini (eds ) GOVERNANCE IN PUBLICLY HELD CORPORATIONS A COMPARATI s Other examples of this trend include Dennis C Mueller and urtoglu, Country Leg Environments and Corporate Investment Performance, I GERMAN REVIEW187(2000);
features of this form determine the contours of its agency problems. To take an obvious example, the fact that shareholders enjoy limited liability—while, say, general partners in a partnership do not—has traditionally made creditor protection far more salient in corporate law than it is in partnership law. Similarly, the fact that corporate investors may trade their shares is the foundation of the anonymous trading stock market—an institution that has encouraged the separation of ownership from control, and so has sharpened the management–- shareholder agency problem. In this book, we explore the role of corporate law in minimizing agency problems—and thus, making the corporate form practicable—in the most important categories of corporate actions and decisions. More particularly, Chapters 3–8 address, respectively, six categories of transactions and decisions that involve the corporation, its owners, its managers, and the other parties with whom it deals. Most of these categories of firm activity are, again, generic, rather than uniquely corporate. For example, Chapter 3 addresses the governance mechanisms that operate over the firm’s ordinary business decisions, while Chapter 4 turns to the checks that operate on the corporation’s transactions with creditors. As before, however, if similar agency problems arise in similar contexts across all forms of jointly-owned enterprise, the response of corporate law turns in part on the unique legal features that characterize the corporate form. Taken together, the latter six chapters of our book cover nearly all of the important problems in corporate law—apart, that is, from the fundamental project of establishing the corporate form itself. In each Chapter, we describe how the basic agency problems of the corporate form manifest themselves in the given category of corporate activity, and then explore the range of alternative legal responses that are available. We illustrate these alternative approaches with examples from the corporate law of various prominent jurisdictions. We explore the patterns of homogeneity and the patterns of heterogeneity that appear. Where there are significant differences across jurisdictions, we seek to address both the sources and the consequences of those differences. Our examples are drawn principally form a handful of major representative jurisdictions, including France, Germany, Japan, the U.S., and the UK, though we also make reference to the law of other jurisdictions to make special points. In emphasizing a strongly functional approach to the issues of comparative law, this book differs from some of the more traditional comparative law scholarship, both in the field of corporate law and elsewhere.4 We join an emerging tendency in comparative law scholarship by seeking to give a highly integrated view of the role and structure of corporate law that provides a clear framework within which to organize an understanding of individual systems, both alone and in comparison with each other.5 Moreover, while comparative 4 Compare, e.g., Arthur R. Pinto and Gustavo Visentini (eds.), The Legal Basis of Corporate Governance in Publicly Held Corporations,AComparative Approach (1998). 5 Other examples of this trend include Dennis C. Mueller and B. Burcin Yurtoglu, Country Legal Environments and Corporate Investment Performance,1German Economic Review 187 (2000); Kraakman / The Anatomy of Corporate Law Final Proof 25.2.2004 8:38am page 3 What is Corporate Law? 3
Kraakman/The Anatony of Corporate Law Final Proof 25.2.2004 8: 38am page 4 Introductio law scholarship often has a tendency to emphasize differences between juris dictions, our approach is to focus on similarities. Doing so, we believe, illumin- ates an underlying commonality of structure that transcends national boundaries It also provides important perspective on the potential basis for the international integration of corporate law that must necessarily take place as economic activity continues to become more global in scope in the decades to come We realize that the term 'functional, which we have used here and in our title means different things to different people, and that some of the uses to which that term has been put in the past--particularly in the field of sociology-have made the term justifiably suspect. It would perhaps be more accurate to call our approach'economic'rather than" functional, though the sometimes tendentious use of economic argumentation in legal literature has also caused many scholars, particularly outside of the United States, to be as wary of economic analysis'as they are of functional analysis. ' For the purposes at hand, however, we need not commit ourselves on fine points of social science methodology. We need simply note that the exigencies of commercial activity and organization present prac- tical problems that have a rough similarity in developed market economies throughout the world, that corporate law everywhere must necessarily address these problems, and that the forces of logic, competition, interest group pressure, imitation, and compatibility tend to lead different jurisdictions to choose oughly similar solutions to these problems That is not to say that our objective here is just to explore the commonality of orporate law across jurisdictions. Of equal importance, we wish to offer common language and a general analytic framework with which to understand the that can potentially be served by by corporate law. and with which to compare and evaluate the efficacy of different legal regimes in serving those purposes.6 Indeed, it is our hope that the analysis offered in this book will be of use not only to students of comparative law, but that it will be equally valuable afael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert W. vishny, Law and finance, 106 JOURNAL OF POLITICAL ECONOMY 1113(1998); Henry Hansmann and Ugo Mattei, The Func ons of Truest Law: A Comparative Legal and Economic Analysis, 73 NEW YORK UNIVERSITY LAT EVIEW 434(1998); Konrad Zweigert and Hein Kotz, INTRODUCTION TO CoMPARATIVE LAW (3rded translated from the German by Tony Weir, 1998); Ugo Mattei, CoMPARATIVE LAW AND ECONOMICS 6 In very general terms, our approach echoes that taken by Dean Robert Clark in his importan treatise, CoRPORATE LAW(1986), and Frank Easterbrook and Daniel Fischel, in their more recent discussion of U.S. law, THE ECONOMIC STRUCTURE OF CORPORATE LAW(1991). However, ou nalysis differs from-and goes beyond-that offered by these and other commentators in several key respects. First, and most obviously, we present a comparative analysis that addresses the corporat law of multiple jurisdictions. Second, we provide an integrated functional overview tha agency problems at the core of corporate law, rather than focusing on more particular legal insti- more expansive an do other commentators of the anctions of central features of the corporate form such as limited liability and the governance tructure of the corporate board. Our analysis, moreover, is informed not only by a comparative perspective across jurisdictions, but also by a comparative perspective across legal forms for business
law scholarship often has a tendency to emphasize differences between jurisdictions, our approach is to focus on similarities. Doing so, we believe, illuminates an underlying commonality of structure that transcends national boundaries. It also provides important perspective on the potential basis for the international integration of corporate law that must necessarily take place as economic activity continues to become more global in scope in the decades to come. We realize that the term ‘functional,’ which we have used here and in our title, means different things to different people, and that some of the uses to which that term has been put in the past—particularly in the field of sociology—have made the term justifiably suspect. It would perhaps be more accurate to call our approach ‘economic’ rather than ‘functional,’ though the sometimes tendentious use of economic argumentation in legal literature has also caused many scholars, particularly outside of the United States, to be as wary of ‘economic analysis’ as they are of ‘functional analysis.’ For the purposes at hand, however, we need not commit ourselves on fine points of social science methodology. We need simply note that the exigencies of commercial activity and organization present practical problems that have a rough similarity in developed market economies throughout the world, that corporate law everywhere must necessarily address these problems, and that the forces of logic, competition, interest group pressure, imitation, and compatibility tend to lead different jurisdictions to choose roughly similar solutions to these problems. That is not to say that our objective here is just to explore the commonality of corporate law across jurisdictions. Of equal importance, we wish to offer a common language and a general analytic framework with which to understand the purposes that can potentially be served by corporate law, and with which to compare and evaluate the efficacy of different legal regimes in serving those purposes.6 Indeed, it is our hope that the analysis offered in this book will be of use not only to students of comparative law, but that it will be equally valuable Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert W. Vishny, Law and Finance, 106 Journal of Political Economy 1113 (1998); Henry Hansmann and Ugo Mattei, The Functions of Trust Law: A Comparative Legal and Economic Analysis, 73 New York University Law Review 434 (1998); Konrad Zweigert and Hein Ko¨tz, Introduction to Comparative Law (3rd ed. translated from the German by Tony Weir, 1998); Ugo Mattei, Comparative Law and Economics (1997). 6 In very general terms, our approach echoes that taken by Dean Robert Clark in his important treatise, Corporate Law (1986), and Frank Easterbrook and Daniel Fischel, in their more recent discussion of U.S. law, The Economic Structure of Corporate Law (1991). However, our analysis differs from—and goes beyond—that offered by these and other commentators in several key respects. First, and most obviously, we present a comparative analysis that addresses the corporate law of multiple jurisdictions. Second, we provide an integrated functional overview that stresses the agency problems at the core of corporate law, rather than focusing on more particular legal institutions and solutions. Finally, we offer a more expansive account than do other commentators of the functions of central features of the corporate form such as limited liability and the governance structure of the corporate board. Our analysis, moreover, is informed not only by a comparative perspective across jurisdictions, but also by a comparative perspective across legal forms for business enterprise. Kraakman / The Anatomy of Corporate Law Final Proof 25.2.2004 8:38am page 4 4 Introduction