CORPORATE LAW'SLIMITS and the developed world. The"OECD and the World Bank agreed [in 1999]to cooperate in the promotion of improved corporate governance on world-wide basis. Both institutions are committed to assisting governments in.. improving the legal, institutional and regulatory framework for corporate govemance in their countries. The move responds to mandates from finance ministers and central bank governors of the G-7 and the oeCd countries These are valuable initiatives. They will contribute to reaching their goals of more stable enterprises and better economic performance. But corporate law, and the reach of government policy-makers through corporate law reform, has limits. Here we demarcate those limits boundaries, beyond which corporate law ceases to be a primary institution. A. Protecting Minority Stockholders The basic law-driven story is straightforward: Imagine a nation whose aw badly protects minority stockholders against a blockholder extracting value from small minority stockholders. A potential buyer fears that the majority stockholder would later shift value to itself, away from the buyer So fearing, the prospective minority stockholder does not pay pro rata stockholder decides not to sell, concentrated ownership persists, and stock markets do not develop Or, approach the problem from the owner's perspective. Posit large private benefits of control. The most obvious that law can affect are benefits that the controller can derive from diverting value from the firm to 7.OECD(1999) 8. OECD(1999a); Witherell (2000). To be clear here, the international authorities have not solely focused on corporate law, but have attended to governance practices as well. E.g, Nestor(2000), WORLD BANK(2000), at 20-24 9. If the public stock-buyers are non-naive, the selling blockholders are have contractual means to stymie raiders. Capped voting, mandatory bids, and poison pills an reduce or end the buying stockholders' fears if the nation enforces contract satisfactorily, even if its corporate law is weak. Moreover, whether the common lawas opposed to other non-law-based institutions-did in fact well protect minority stockholders during the early development of the public firm is open to question. See Roe(2000), at 586n 124& 586-93 and(2001). But here we are making the quality of-corporate-law argument, not yet evaluating it
CORPORATE LAW’S LIMITS 7 and the developed world.7 The “OECD and the World Bank agreed [in 1999] to cooperate in the promotion of improved corporate governance on a world-wide basis. Both institutions are committed to assisting governments in … improving the legal, institutional and regulatory framework for corporate governance in their countries. The move responds to mandates from finance ministers and central bank governors of the G-7 and the OECD countries.”8 These are valuable initiatives. They will contribute to reaching their goals of more stable enterprises and better economic performance. But corporate law, and the reach of government policy-makers through corporate law reform, has limits. Here we demarcate those limits’ boundaries, beyond which corporate law ceases to be a primary institution. A. Protecting Minority Stockholders The basic law-driven story is straightforward: Imagine a nation whose law badly protects minority stockholders against a blockholder extracting value from small minority stockholders. A potential buyer fears that the majority stockholder would later shift value to itself, away from the buyer. So fearing, the prospective minority stockholder does not pay pro rata value for the stock. If the discount is deep enough, the majority stockholder decides not to sell, concentrated ownership persists, and stock markets do not develop.9 Or, approach the problem from the owner’s perspective. Posit large private benefits of control. The most obvious that law can affect are benefits that the controller can derive from diverting value from the firm to 7. OECD (1999); Nestor (2001). 8. OECD (1999a); Witherell (2000). To be clear here, the international authorities have not solely focused on corporate law, but have attended to governance practices as well. E.g., Nestor (2000); WORLD BANK (2000), at 20-24. 9. If the public stock-buyers are non-naive, the selling blockholders are have contractual means to stymie raiders. Capped voting, mandatory bids, and poison pills can reduce or end the buying stockholders’ fears if the nation enforces contract satisfactorily, even if its corporate law is weak. Moreover, whether the common law¾as opposed to other non-law-based institutions¾did in fact well protect minority stockholders during the early development of the public firm is open to question. See Roe (2000), at 586 n.124 & 586-93 and (2001). But here we are making the qualityof-corporate-law argument, not yet evaluating it
CORPORATE LAW'S LIMITS himself of herself. The owner might own 51% of the firm's stock, but retain 75% of the firm's value if the owner can over-pay himself or herself in salary, pad the company's payroll with no-show relatives, use the firms funds to pay for private expenses, or divert value by having the 51% controlled firm over-pay for goods and services obtained from a company 100%-owned by the controller. Strong fiduciary duties, strong doctrines attacking unfair interested-party transactions, effective disclosure lav unveil these transactions, and a capable judiciary or other enfore institution can reduce these kinds of private benefits of control.( Private from pride in running and contre olling one s own, or one's familys, enterprise. About this, corporate law has little direct The owner considers whether to sell to diffuse stockholders with no controller to divert value, the stock price could reflect the firms underlying value. But the rational buyers believe, so the theory runs, that the diffuse ownership structure would be unstable, that an outside raider would buy up 51% of the firm and divert value, and that the remaining minority stockholders would be hurt. Hence, they would not pay full pro rata value the owner wishing to sell; and the owner wishing to sell would find that the sales price to be less than the value of the block if retained (or if sold Hence,the block persists. The controller refuses to leave control "up control and reap the private benefits /- control, an outsider could grab abs"because if it dips below 51 See Bebchuk(1999); cf. La Porta et al. series, supra note 2. 11. The literature correctly focuses on corporate laws capacity to contain controlling stockholder thievery. Other features of corporate law--agency theory determining who can represent the corporation, corporate transactional flexibility, limited liability--are down-played. Managerial capacity to mismange the corporation is also down-played, but it is quite relevant. It tends, improperly, to be ignored in the urrent literature. I will seek to introduce it here to modem analysis of the ownership separation decision. The theory has gaps. When the founder is selling out all of his or her stock, the potential stock buyers discount the purchase, the theory runs, because they anticipate raider buying up the stock cheap and then diverting value to itself. But when raiders ompete, the winning raider will bid the stock up to the value of the private benefits of control. Minority buyers would anticipate this competition and pay approximately full pro rata value for the stock when the founder sells. (The theory needs non- ompetitive--or secret--raiders
8 CORPORATE LAW’S LIMITS himself of herself. The owner might own 51% of the firm’s stock, but retain 75% of the firm’s value if the owner can over-pay himself or herself in salary, pad the company’s payroll with no-show relatives, use the firm’s funds to pay for private expenses, or divert value by having the 51%- controlled firm over-pay for goods and services obtained from a company 100%-owned by the controller. Strong fiduciary duties, strong doctrines attacking unfair interested-party transactions, effective disclosure laws that unveil these transactions, and a capable judiciary or other enforcement institution can reduce these kinds of private benefits of control. (Private benefits also arise from pride in running and controlling one’s own, or one’s family’s, enterprise. About this, corporate law has little direct impact.) The owner considers whether to sell to diffuse stockholders. With no controller to divert value, the stock price could reflect the firm’s underlying value. But the rational buyers believe, so the theory runs, that the diffuse ownership structure would be unstable, that an outside raider would buy up 51% of the firm and divert value, and that the remaining minority stockholders would be hurt. Hence, they would not pay full pro rata value to the owner wishing to sell; and the owner wishing to sell would find that the sales price to be less than the value of the block if retained (or if sold intact). Hence, the block persists.10 The controller refuses to leave control “up for grabs” because if it dips below 51% control, an outsider could grab control and reap the private benefits.11 10. See Bebchuk (1999); cf. La Porta et al. series, supra note 2. 11. The literature correctly focuses on corporate law’s capacity to contain controlling stockholder thievery. Other features of corporate law¾agency theory in determining who can represent the corporation, corporate transactional flexibility, limited liability¾are down-played. Managerial capacity to mismange the corporation is also down-played, but it is quite relevant. It tends, improperly, to be ignored in the current literature. I will seek to introduce it here to modern analysis of the ownership separation decision. The theory has gaps. When the founder is selling out all of his or her stock, the potential stock buyers discount the purchase, the theory runs, because they anticipate a raider buying up the stock cheap and then diverting value to itself. But when raiders compete, the winning raider will bid the stock up to the value of the private benefits of control. Minority buyers would anticipate this competition and pay approximately full pro rata value for the stock when the founder sells. (The theory needs noncompetitive—or secret—raiders.)
CORPORATE LAW'SLIMITS B. The Attractions of a Technical Corporate Law Theory One sees the appeal of the quality of corporate law argument Technical institutions are to blame, for example, for Russias and the transition nations economic problems. The fixes, if they are technical, are within our grasp. Human beings can control and influence the results rogress is possible if we just can get the technical institutions right. If it turns out that deeper features of society-industrial organization and competition, politics, conditions of social regularity, or norms that support because these institutions are much harder for policy-makers to contro shareholder value-are more fundamental. we would feel ill at-eas (To be clear here, I am not speaking simply of corporate law as just the "law-on-the-books, "but as"law-on-the-books, "including securities law and the quality of regulators and judges, the efficiency, accuracy, and honesty of the regulators and the judiciary, the capacity of the stock exchanges to manage the most egregious diversions, and so on. And as self-contained academic theory, there is little to quarrel with in the quality-of-corporate law argument. It is sparse and appealing. Good corporate law lowers the costs of operating a large firm; it's good for nation to have it. But we need more to understand why ownership doesnt separate from control even where core corporate lnw is good Where managerial agency costs due to potential dissipation are st concentrated ownership persists even if comventional corpo Given the facts that we shall develop in Part lll-there are too many wealthy, high quality corporate law countries without much separation -the quality-of-corporate-law theory needs to be further refined,or replaced. This we do next in Part II 12. The best compendium is in Black(2000)
CORPORATE LAW’S LIMITS 9 B. The Attractions of a Technical Corporate Law Theory One sees the appeal of the quality of corporate law argument. Technical institutions are to blame, for example, for Russia’s and the transition nations economic problems. The fixes, if they are technical, are within our grasp. Human beings can control and influence the results. Progress is possible if we just can get the technical institutions right. If it turns out that deeper features of society¾industrial organization and competition, politics, conditions of social regularity, or norms that support shareholder value¾are more fundamental, we would feel ill at-ease because these institutions are much harder for policy-makers to control. (To be clear here, I am not speaking simply of corporate law as just the “law-on-the-books,” but as “law-on-the-books,” including securities law, and the quality of regulators and judges, the efficiency, accuracy, and honesty of the regulators and the judiciary, the capacity of the stock exchanges to manage the most egregious diversions, and so on.12) * * * And as self-contained academic theory, there is little to quarrel with in the quality-of-corporate law argument. It is sparse and appealing. Good corporate law lowers the costs of operating a large firm; it’s good for a nation to have it. But we need more to understand why ownership doesn’t separate from control even where core corporate law is good enough. Where managerial agency costs due to potential dissipation are substantial, concentrated ownership persists even if conventional corporate law quality is high. Given the facts that we shall develop in Part III¾there are too many wealthy, high quality corporate law countries without much separation ¾the quality-of-corporate-law theory needs to be further refined, or replaced. This we do next in Part II. 12. The best compendium is in Black (2000)
10 CORPORATE LAWS LIMITS A. Where Law Does Not Reach: How Managerial Agency Costs Impede separation Managers would badly run some firms if their firms' ownership cO arated from control. Effective corporate and securities laws constrain trollers'stealing, but do much less to directly induce them to operate their firms well. A related-party transaction can be attacked or prevented where corporate law is good, but an unprofitable transaction law leaves untouched, with managers able to invoke corporate laws business ment rule to ward off direct legal scrutiny Consider a society(or a firm) where managerial agency costs from dissipating shareholder value would be high if theres separation, but low if there's no separation, because a controlling shareholder can contain those costs. When high but containable by concentration, concentrated shareholding ought to persist even if corporate law fully protects minority stockholders from the ravages of dominant stockholders. Blockholders would weight their costs in maintaining control (in lost liquidity, lost diversification, etc. )versus their potential loss in value from managerial agency costs. Control would persist even if corporate law were good This is a basic but important point, and it is needed to explain the data that we look at in the next part ate law without in ng Separatio The arguments in the prior sectionthat variance in managerial agency costs can drive ownership structure even if comventional corporate lany is quite good--can be stated formally in a simple model. High managerial agency costs precludes separation irrespective of the quality la
10 CORPORATE LAW’S LIMITS II. Its Limits: Theory A. Where Law Does Not Reach: How Managerial Agency Costs Impede Separation Managers would badly run some firms if their firms’ ownership separated from control. Effective corporate and securities laws constrain controllers’ stealing, but do much less to directly induce them to operate their firms well. A related-party transaction can be attacked or prevented where corporate law is good, but an unprofitable transaction law leaves untouched, with managers able to invoke corporate law’s business judgment rule to ward off direct legal scrutiny. Consider a society (or a firm) where managerial agency costs from dissipating shareholder value would be high if there’s separation, but low if there’s no separation, because a controlling shareholder can contain those costs. When high but containable by concentration, concentrated shareholding ought to persist even if corporate law fully protects minority stockholders from the ravages of dominant stockholders. Blockholders would weight their costs in maintaining control (in lost liquidity, lost diversification, etc.) versus their potential loss in value from managerial agency costs. Control would persist even if corporate law were good. This is a basic but important point, and it is needed to explain the data that we look at in the next Part. B. Improving Corporate Law without Increasing Separation The arguments in the prior section¾that variance in managerial agency costs can drive ownership structure even if conventional corporate law is quite good¾can be stated formally in a simple model. High managerial agency costs precludes separation irrespective of the quality of conventional corporate law
CORPORATE LAW'SLIMITS AM =The managerial agency costs to shareholders from managers dissipating shareholder value, to the extent avoidable via concentrated Ccs =The costs to the concentrated shareholder in holding a block and monitoring(that is, the costs in lost liquidity, lost diversification, expended energy, and, perhaps, error) When AM is high, ownership will persist in concentrated form whether or not law successfully controls the private benefits that a controlling shareholder can siphon off from the firm alue of the firm when ownership is concentrated benefits of control Consider the firm worth V when ownership is concentrated. Posit first that managerial agency costs are trivial even if the firm is fully public. As such, the private benefits of control, a characteristic legally malleable and parates from control. Consider the controller who owns 50% of the firm's stock. As such he obtains one-half of v, plus his net benefits of control. (In this simple first model, the value of the firm remains or Is retains control when the following inequality is true (1)V/2+Bcs- Ccs>V/2 The left side is the value to the controlling stockholder of the control block: half the firms cash flow plus the private benefits diverted from minority stockholders, minus the costs of maintaining the block (in lost diversification and liquidity ). The right side is the value he obtains from lling the block to the public. Equation(1) states that as long rol(e.g, in value shifted stockholders) exceeds the costs of control, then concentrated ownership persists. Because corporate law can dramatically shrink the private
CORPORATE LAW’S LIMITS 11 1. The model. Let: AM =The managerial agency costs to shareholders from managers’ dissipating shareholder value, to the extent avoidable via concentrated ownership. CCS = The costs to the concentrated shareholder in holding a block and monitoring (that is, the costs in lost liquidity, lost diversification, expended energy, and, perhaps, error). When AM is high, ownership will persist in concentrated form whether or not law successfully controls the private benefits that a controlling shareholder can siphon off from the firm. V = Value of the firm when ownership is concentrated. BCS = The private benefits of control, containable by corporate law. Consider the firm worth V when ownership is concentrated. Posit first that managerial agency costs are trivial even if the firm is fully public. As such, the private benefits of control, a characteristic legally malleable and reducible with protective corporate law, can determine whether ownership separates from control. Consider the controller who owns 50% of the firm’s stock. As such he obtains one-half of V, plus his net benefits of control. (In this simple first model, the value of the firm remains unchanged whether it has a controlling stockholder or is fully public.) He retains control when the following inequality is true: (1) V/2+BCS-CCS>V/2. The left side is the value to the controlling stockholder of the control block: half the firm’s cash flow plus the private benefits diverted from minority stockholders, minus the costs of maintaining the block (in lost diversification and liquidity). The right side is the value he obtains from selling the block to the public. Equation (1) states that as long as the private benefits of control (e.g., in value shifted from minority stockholders) exceeds the costs of control, then concentrated ownership persists. Because corporate law can dramatically shrink the private