Columbia law school The center for law and economic studies 435 West 116 St New York. NY 10027-7201 Working Paper No. 186 Updated Corporate laws Limits Prior Title- The Quality of Corporate law A ent and its Limits Mark roe Columbia University School of law January 16. 2002 This paper can be downloaded without charge from the Social Science research Network electronic library at http:/papers.ssrn.com/abstract=260582 An index to the working papers in the Columbia law School working Paper Series is located at http://www.law.columbia.edu/lawec/
Columbia Law School The Center for Law and Economic Studies 435 West 116th St. New York, NY 10027-7201 Working Paper No. 186 Updated Corporate Law’s Limits (Prior Title - The Quality of Corporate Law Argument and its Limits) Mark J. Roe Columbia University School of Law January 16, 2002 This paper can be downloaded without charge from the Social Science Research Network electronic library at: http://papers.ssrn.com/abstract=260582 An index to the working papers in the Columbia Law School Working Paper Series is located at: http://www.law.columbia.edu/lawec/
Corporate Laws Limits Mark j. roe A strong theory has emerged in recent years that the quality of corporate law primari determines whether securities markets arise, whether ownership separates from control, and whether the modern corporation can prosper. The theory has been used convincingly to explain why we se weak corporate structures in transition and developing nations, bur less convincingly to explain why concentrated ownership persists in continental Europe orwhny it became less important in the United States. The theory has its real-world correlates as international agencies focus on corporate overnance for transition and developing economies, while several alreadwwealthyy nations also focus on improving corporate lany. Surely, when an economicallyw-weak sociery lacks regularit-a anifested by weak or poorly enforced corporate lany-thar lack of regularity and that lack of economic strength precludes complex institutions like securities markets and diffitseh- owned public firms. But in several nations in the wealhy west legal structures are quite good and, by measurement, shareholders are well protected, but ownership has still not yet separated from camining the calculus of owners and imestors when they decide whether to difuse ownership. ownership cannot readily separate from control when managerial agency costs are especially high. And missing from curent discourse is the basic concept that even American corporate lant-usuially seen as high quality nowadays-does not burrow into the firm to root out those managerial agency costs that arise from mediocre business decisions. Judicial doctrine and legal inquiry attack self- dealing, not bad business judgment. The business judgment rule, under which judges do not second- guess managerial mistake, puts the fill panoply of agency costs-such as over-expansion, over- inestment, and reluctance to take on profitable but uncomfortable risks-beyond direct legal inquiry.(his limit from the business judgment rule is fect"in corporate lanr: aggressive judicial attack on managerialerrorwotdd replicate the costs of gonernment management of business. omething other than direct legal attack has to control basic managerial agency costs, because judicial action here is far too costy The consequence is that even if corporate law as usually conceied is"perfect, "it eliminates self-dealing, not managerial mistake. But managers can lose for shareholders as mmch, or more, than they can steal from them, and law directy controls only the second cost not the first. If the risk of managerial error naries widely from nmation-io-nation, ar from firm-to-firm, ownership struacture should vary equally widely, even jf coventional corporate lan with this analysis: by measurement several nations hane fine enough corporate lanr, distant stockholders are protected from controlling stockholder and managerial thievery, but uncontrolled agency costs though seem to be especially high in thase very nations
Corporate Law’s Limits Mark J. Roe A strong theory has emerged in recent years that the quality of corporate law primarily determines whether securities markets arise, whether ownership separates from control, and whether the modern corporation can prosper. The theory has been used convincingly to explain why we see weak corporate structures in transition and developing nations, but less convincingly to explain why concentrated ownership persists in continental Europe or why it became less important in the United States. The theory has its real-world correlates as international agencies focus on corporate governance for transition and developing economies, while several already-wealthy nations also focus on improving corporate law. Surely, when an economically-weak society lacks regularity¾a gap that may be manifested by weak or poorly enforced corporate law¾that lack of regularity and that lack of economic strength precludes complex institutions like securities markets and diffuselyowned public firms. But in several nations in the wealthy west legal structures are quite good and, by measurement, shareholders are well protected, but ownership has still not yet separated from control. Something else has impeded separation. We can hypothesize what that something is by examining the calculus of owners and investors when they decide whether to diffuse ownership. Ownership cannot readily separate from control when managerial agency costs are especially high. And missing from current discourse is the basic concept that even American corporate law¾usually seen as high quality nowadays¾does not burrow into the firm to root out those managerial agency costs that arise from mediocre business decisions. Judicial doctrine and legal inquiry attack selfdealing, not bad business judgment. The business judgment rule, under which judges do not secondguess managerial mistake, puts the full panoply of agency costs¾such as over-expansion, overinvestment, and reluctance to take on profitable but uncomfortable risks¾beyond direct legal inquiry. (This limit from the business judgment rule is not a “defect” in corporate law: aggressive judicial attack on managerial error would replicate the costs of government management of business. Something other than direct legal attack has to control basic managerial agency costs, because judicial action here is far too costly.) The consequence is that even if corporate law as usually conceived is “perfect,” it eliminates self-dealing, not managerial mistake. But managers can lose for shareholders as much, or more, than they can steal from them, and law directly controls only the second cost not the first. If the risk of managerial error varies widely from nation-to-nation, or from firm-to-firm, ownership structure should vary equally widely, even if conventional corporate law tightly protected shareholders everywhere. There is also good reason, and some new data, consistent with this analysis: by measurement several nations have fine enough corporate law; distant stockholders are protected from controlling stockholder and managerial thievery, but uncontrolled agency costs though seem to be especially high in those very nations
TABLE OF CONTENTS Introduction The Argument: Corporate Law as Propelling Diffuse Ownership A. Protecting Minority Stockholders B. The Attractions of a Technical Corporate Law Theory Il. Its limits: Theory… A. Where Law Does not Reach: How Managerial Agency Costs apede Separation B. Improving Corporate Law without Increasing Separation 000 1. The mode 2. An example C. Corporate Law's Limited Capacity to Affect Agency Costs 1. The bu 2. Agency costs: shirking and steal 134467 D. Laws Indirect Effect on Agency Costs F. Precision in Defining Agency Costs and Private Benefits G. Ambiguity in the Legal Theory: Improving it Can Reduce Separatio 9900 1. The offsetting effects. 2. Illustrating the countervailing movement H. The Tight Limits to the Purely Legal Theory IIL. Its Limits: Data A. Measuring Quality 1. Corporate law. what counts 2. Corporate law: the bottom-line B. Data: Nations with Good Corporate Law but Without Separation 1. Market measures of the value of control 2. Dual class common stock 8800037 4. And not-so-rich nations? C. What Beyond Law is Needed for Separation in the Wealthy West 2. Political preconditions D. Data on Explanations Beyond Law Conclusion: The Quality of Corporate Law Argument and its Limits Bibliography
TABLE OF CONTENTS Introduction ................................................................................................................... 1 I. The Argument: Corporate Law as Propelling Diffuse Ownership .......................... 6 A. Protecting Minority Stockholders.................................................................. 7 B. The Attractions of a Technical Corporate Law Theory .................................. 9 II. Its Limits: Theory ................................................................................................ 10 A. Where Law Does not Reach: How Managerial Agency Costs Impede Separation....................................................................................... 10 B. Improving Corporate Law without Increasing Separation............................ 10 1. The model........................................................................................... 11 2. An example ......................................................................................... 13 C. Corporate Law’s Limited Capacity to Affect Agency Costs......................... 14 1. The business judgment rule................................................................ 14 2. Agency costs: shirking and stealing................................................... 16 D. Law’s Indirect Effect on Agency Costs........................................................ 17 E. Even if Law Critically Affects Both ............................................................. 19 F. Precision in Defining Agency Costs and Private Benefits............................ 19 G. Ambiguity in the Legal Theory: Improving it Can Reduce Separation......... 20 1. The offsetting effects........................................................................... 20 2. Illustrating the countervailing movement .......................................... 21 H. The Tight Limits to the Purely Legal Theory............................................... 27 III. Its Limits: Data.................................................................................................... 27 A. Measuring Quality....................................................................................... 28 1. Corporate law: what counts? ............................................................ 28 2. Corporate law: the bottom-line.......................................................... 30 B. Data: Nations with Good Corporate Law but Without Separation............... 30 1. Market measures of the value of control ............................................ 30 2. Dual class common stock ................................................................... 33 3. The control block premium................................................................. 37 4. And not-so-rich nations?.................................................................... 41 5. Enforcing contracts............................................................................ 41 C. What Beyond Law is Needed for Separation in the Wealthy West? ............. 42 1. Economic preconditions..................................................................... 42 2. Political preconditions....................................................................... 43 3. Social preconditions........................................................................... 44 D. Data on Explanations Beyond Law ............................................................. 44 Conclusion: The Quality of Corporate Law Argument and its Limits........................... 47 Bibliography ................................................................................................................ 50
Tables and Graphs Table 1: When agency costs high, private benefits to controller irrelevant Table 2: Indeterminate effect of better corporate law in rich nation Table 3: Voting premium and ownership separation Table 4: Control premium and ownership separation Table 5: Correlation matrix Table 6: F-test: Law politics Graph 1: Block premium vs ownership dispersion Graph 2: Block premium vs, ownership dispersion( without Italy and Austria)
Tables and Graphs Table 1: When agency costs high, private benefits to controller irrelevant................. ................................13 Table 2: Indeterminate effect of better corporate law in rich nation........................... ................................26 Table 3: Voting premium and ownership separation.................................................. ................................34 Table 4: Control premium and ownership separation................................................ ................................38 Table 5: Correlation matrix ....................................................................................... ................................46 Table 6: F-test: Law & politics.................................................................................. ................................47 Graph 1: Block premium vs. ownership dispersion .................................................... ................................39 Graph 2: Block premium vs. ownership dispersion (without Italy and Austria) ......... ................................40
Corporate Laws limits Mark j. roe Introduction The critical precondition to developing modern securities markets, and the economic and technological benefits that go with good stock marke most recent analyses posit, is a foundation of solid corporate and securities laws that protect stockholders from the rampages of the dominant majority stockholders or controlling managers. Without such corporate law protections securities markets, it is said, will not arise. And if corporate law is good enough in technologically advanced nations, ownership will infuse away from concentrated ownership into dispersed stock markets This perspective contributes to understanding the fragility of capital markets in transition and third-world economies. But there is too much that is critical to separation that corporate law does not reach in the worlds richest, most advanced nations. And if those conditions-which depend on institutions other than corporate law-aren't met, ownership will not diffuse. And in nations that do not meet those conditions, public policy makers would have little reason to invest much in developing good corporate law institutions, because they just would not be used The conceptual problem is basic: Current academic thinking lumps together costly opportunism due to a controller's self-dealing and costly managerial decision-making that inflicts losses on the owners. The first, self-dealing, corporate law seeks to control directly; the second, bad decision-making that damages shareholders, it does not Other institutions must control the latter and their strength varies from nation-to-nation. Owners tend to stay as blockholders if they expect managerial agency costs would be very high after full separation Corporate law does not even try to directly control the costs of 率 Berg Professor of L Law School. Thanks for comments go to Lucian Bebchuk, Victor Brune oates, Einer Elhauge, Howell Jackson, Ehud Kamar, Reinier Kraakman, Mi and participants in workshops at Harvard Business school. the national f Economic research. the italian Securities Commission(CONSOB), the Sorbonne, and the Columbia, Harvard, Stanford University of Southern California and Vanderbilt Law Schools
Corporate Law’s Limits Mark J. Roe* Introduction The critical precondition to developing modern securities markets, and the economic and technological benefits that go with good stock markets, most recent analyses posit, is a foundation of solid corporate and securities laws that protect stockholders from the rampages of the dominant majority stockholders or controlling managers. Without such corporate law protections securities markets, it is said, will not arise. And if corporate law is good enough in technologically advanced nations, ownership will diffuse away from concentrated ownership into dispersed stock markets. This perspective contributes to understanding the fragility of capital markets in transition and third-world economies. But there is too much that is critical to separation that corporate law does not reach in the world’s richest, most advanced nations. And if those conditions—which depend on institutions other than corporate law—aren’t met, ownership will not diffuse. And in nations that do not meet those conditions, public policy makers would have little reason to invest much in developing good corporate law institutions, because they just would not be used. The conceptual problem is basic: Current academic thinking lumps together costly opportunism due to a controller’s self-dealing and costly managerial decision-making that inflicts losses on the owners. The first, self-dealing, corporate law seeks to control directly; the second, bad decision-making that damages shareholders, it does not. Other institutions must control the latter and their strength varies from nation-to-nation. Owners tend to stay as blockholders if they expect managerial agency costs would be very high after full separation. Corporate law does not even try to directly control the costs of * Berg Professor of Law, Harvard Law School. Thanks for comments go to Lucian Bebchuk, Victor Brudney, John Coates, Einer Elhauge, Howell Jackson, Ehud Kamar, Reinier Kraakman, Mitch Polinsky, and participants in workshops at Harvard Business School, the National Bureau of Economic Research, the Italian Securities Commission (CONSOB), the Sorbonne, and the Columbia, Harvard, Stanford, University of Southern California and Vanderbilt Law Schools