CORPORATE LAWS LIMITS benefits, Bcs, corporate law matters quite a bit in equation(1).This is the conventional theory*that we shall next amend We amend by introducing AM, managerial agency costs dissipating shareholder value. If those managerial ag osts are trivial, then the controllers' proceeds from selling into the stock market would be(v-AM)2. Concentration persists if and only if (2)V2+Bc Re-arranging concentration persists if the net benefits of control(Bcs- Ccs) are more than the controllers costs of diffusion(Am/2) (3)Bcs-Ccs>-AM/2 Or, further re-arranging, concentration persists if (4)Bcs+ AM/2> Ccs Quality-of-corporate-law theory predicts diffusion wont occur when Bes>Ccs, with corporate law the means of containing Bcs. But we now can see the limits to the theory: True, without agency costs, AM, the level of private benefits, Bcs, can determine whether ownership diffuses or concentrates. But where AM is high, diffusion wont occur even if Bcs is because AM could take-over and drive the separation decision the controlling shareholder's private benefits, are relatively unimportant if AM is very high. Only when AM>0 do legally malleable private benefits kick in as the critical determinant 13. Some private benefits are matters of taste, preferences for power, family recognition in a family firm, etc. These are not readily containable by law, they might be better analyzed here as part of the costs of control, Ccs, as mitigating the usual costs (lost diversification, liquidity, etc. )They also might vary from firm-to-firm and nation- to-nation. And the capacity to off-load illiquidity and non-diversification might vary milarly. Where risks can be hedged, owners should indulge themselves and keep control more readily than where they cannot
12 CORPORATE LAW’S LIMITS benefits, BCS, corporate law matters quite a bit in equation (1).13 This is the conventional theory14 that we shall next amend. We amend by introducing AM, managerial agency costs from dissipating shareholder value. If those managerial agency costs are nontrivial, then the controllers’ proceeds from selling into the stock market would be (V-AM)/2. Concentration persists if and only if (2) V/2+BCS-CCS>(V-AM)/2. Re-arranging: concentration persists if the net benefits of control (BCSCCS) are more than the controller’s costs of diffusion (AM/2): (3) BCS-CCS>-AM/2. Or, further re-arranging, concentration persists if: (4) BCS+AM/2> CCS. Quality-of-corporate-law theory predicts diffusion won’t occur when BCS>CCS, with corporate law the means of containing BCS. But we now can see the limits to the theory: True, without agency costs, AM, the level of private benefits, BCS, can determine whether ownership diffuses or concentrates. But where AM is high, diffusion won’t occur even if BCS is zero, because AM could take-over and drive the separation decision. BCS, the controlling shareholder’s private benefits, are relatively unimportant if AM is very high. Only when AM®0 do legally malleable private benefits kick in as the critical determinant. 13. Some private benefits are matters of taste, preferences for power, family recognition in a family firm, etc. These are not readily containable by law; they might be better analyzed here as part of the costs of control, CCS, as mitigating the usual costs (lost diversification, liquidity, etc.) They also might vary from firm-to-firm and nationto-nation. And the capacity to off-load illiquidity and non-diversification might vary similarly. Where risks can be hedged, owners should indulge themselves and keep control more readily than where they cannot. 14. See Bebchuk (1999)
CORPORATE LAW'SLIMITS 2. An example. Agency costs as impeding separation can be exemplified. Firm has value V of 150 under concentrated ownership, 100 if it's diffusely owned. Managers will not steal. Law is good enough here But they will be loose with shareholders' investment in the firm. Unlike a controlling shareholder, they will over-expand, react slowly to changing markets, and avoid the tough decisions. Hence Am50. Consider two situations for private benefits to the controlling shareholder: in one it's high, equal to one-third of the firm; in the other Bcs is low, equal to zero Table 1: When agency costs high, private benefits to controlling shareholder irrelevant; concentration persists even if law drives down private benefits of control value areholders owner Private benefits low: Bos=0; Managerial agency costs high: AM=50 Concentrated e ses AM controller sells block for concentration Private benefits high: Bcs1/6 of k Concentrated ownership ership(AM50), sells block for 33 Separation loses shareholders 50 in value. Because that lost value, AM, is high, at 50, shareholders would seek, and pay for(in Ccs, for instance)a structure that would preserve those profits for themselves. If blockholding keeps AM low(which it does as the model defines AM: the 15. Again, this conventional scenario has us assuming that the raider can attack by secretly accumulating the block or without having to pay stockholders the value it standard corporate law story would fade. See supra note 9 or perhaps 150, and the will acquire. If raiders compete, the price will be bid up to 100
CORPORATE LAW’S LIMITS 13 2. An example. Agency costs as impeding separation can be exemplified. Firm has value V of 150 under concentrated ownership, 100 if it’s diffusely owned. Managers will not steal. Law is good enough here. But they will be loose with shareholders’ investment in the firm. Unlike a controlling shareholder, they will over-expand, react slowly to changing markets, and avoid the tough decisions. Hence AM=50. Consider two situations for private benefits to the controlling shareholder: in one it’s high, equal to one-third of the firm; in the other BCS is low, equal to zero. Table 1: When agency costs high, private benefits to controlling shareholder irrelevant; concentration persists even if law drives down private benefits of control V, firm’s value to shareholders Value to 50% owner Value to minority shareholders Notes Private benefits low: BCS=0; Managerial agency costs high: AM=50 Concentrated ownership 150 75 75 Diffuse ownership (AM=50); controller sells block for 50 100 50 50 Management loses AM; concentration persists Private benefits high: BCS=1/6 of V Concentrated ownership 150 100 50 Diffuse ownership (AM=50); controller sells block for 33 100 33 33 Raider grabs 33 (and perhaps AM) 15; hence, concentration persists Separation loses shareholders 50 in value. Because that lost value, AM, is high, at 50, shareholders would seek, and pay for (in CCS, for instance) a structure that would preserve those profits for themselves. If blockholding keeps AM low (which it does as the model defines AM: the 15. Again, this conventional scenario has us assuming that the raider can attack by secretly accumulating the block or without having to pay stockholders the value it will acquire. If raiders compete, the price will be bid up to 100, or perhaps 150, and the standard corporate law story would fade. See supra note 9
CORPORATE LAW'S LIMITS agency costs that blockholding would avoid), and if the costs of blockholding, Ccs, are low, blockholding will persist irrespective of whether private benefits, Bcs are 50, 25, or zero True, if the costs of blockholding exceed AM, or if the efficiency benefits of diffuse ownership overwhelm AM, then private benefits once- again become relevant. The most plausible scenario under which they become relevant is, again, when AM>0. But when AM, the containable managerial dissipation, is very high, then this managerial agency cost determines whether ownership can separate C. Corporate Laws Limited Capacity to Reduce Agency Cost One might reply that core corporate law when improved reduces the controlling stockholder's private benefits(Bcs, by reducing controller's capacity to siphon off value)and managerial agency costs(AM, by reducing the managers' capacity to siphon off benefits for themselves L. The business judgment rule. This criticism is both right and wrong, but mostly wrong. The reason it's mostly wrong is simple managerial agency costs are the sum of managers' thievery (unjustifiably high salaries, self-dealing transactions, etc )and their mismanagement Economic analyses typically lump these together and call them""agency osts. But agency costs come from stealing and from shirking. It is correct to lump them together in economic analyses as a cost to shareholders, because both costs are visited upon shareholders. But it is incorrect to think that law affects each cost to shareholders equally well The standard that corporate law applies to managerial decisions is, realistically, no liability at all for mistakes, absent fraud or conflict of interest. But this is where the big costs to shareholders of having nanagerial agents lie, exactly where law falls into an abyss of silence Conventional corporate law does little, or nothing, to directly reduce shirking, mistakes, and bad business decisions that squander shareholder 16. Fama(1980)(agency costs come from "shirking, perquisites or 17. Dooley Veasey(1989), at 521 Veasey is now the Delaware Supreme Court chief judge); Bishop(1968), at 1095(managers without a conflict of always win); Rock Wachter(2001), at 1664-68
14 CORPORATE LAW’S LIMITS agency costs that blockholding would avoid), and if the costs of blockholding, CCS, are low, blockholding will persist irrespective of whether private benefits, BCS, are 50, 25, or zero. True, if the costs of blockholding exceed AM, or if the efficiency benefits of diffuse ownership overwhelm AM, then private benefits onceagain become relevant. The most plausible scenario under which they become relevant is, again, when AM®0. But when AM, the containable managerial dissipation, is very high, then this managerial agency cost determines whether ownership can separate. C. Corporate Law’s Limited Capacity to Reduce Agency Costs One might reply that core corporate law when improved reduces both the controlling stockholder’s private benefits (BCS, by reducing the controller’s capacity to siphon off value) and managerial agency costs (AM, by reducing the managers’ capacity to siphon off benefits for themselves). 1. The business judgment rule. This criticism is both right and wrong, but mostly wrong. The reason it’s mostly wrong is simple. Managerial agency costs are the sum of managers’ thievery (unjustifiably high salaries, self-dealing transactions, etc.) and their mismanagement. Economic analyses typically lump these together and call them “agency costs.” But agency costs come from stealing and from shirking. It is correct to lump them together in economic analyses as a cost to shareholders, because both costs are visited upon shareholders.16 But it is incorrect to think that law affects each cost to shareholders equally well. The standard that corporate law applies to managerial decisions is, realistically, no liability at all for mistakes, absent fraud or conflict of interest.17 But this is where the big costs to shareholders of having managerial agents lie, exactly where law falls into an abyss of silence. Conventional corporate law does little, or nothing, to directly reduce shirking, mistakes, and bad business decisions that squander shareholder 16. Fama (1980) (agency costs come from “shirking, perquisites or incompetence”). 17. Dooley & Veasey (1989), at 521 (Veasey is now the Delaware Supreme Court chief judge); Bishop (1968), at 1095 (managers without a conflict of interest always win); Rock & Wachter (2001), at 1664-68
CORPORATE LAW'SLIMITS value. Elaborate doctrines shield directors and managers from legal action. e business judgment rule is, absent fraud or conflict of interest, nearly insurmountable in America, insulating directors and managers from the udge, and not subjecting them to scrutiny Consider this statement from a well-respected Delaware chancellor theoretical exception to the business judgment rule, protecting directors and managers from liability] that holds that some decisions may be so‘ egregious” that liability… may follow even in the absence of proof of conflict of interest or improper motivation. The exception, however, has resulted in no nards of money judgments against corporate officers or directors in /Delaware/...Thus, to allege that a corporation has suffered a loss . does not state a claim for relief against that fiduciary no matter how foolish the investment One does not exaggerate much by saying that American corporate law has produced only one major instance in which non-conflicted managers overturned by the state leyature no were held liable to pay for their mismanagement: Smith v Van Gorkom, 9 a decision excoriated by manager nd their lawyers, and promptly Nor should we think, "Oh, this is just a gap in American law, one that ould be filled if other legal institutions didn't sufficiently control these managerial agency costs. If the other institutions failed, corporate law would, and could, jump in. One wouldn't want the judge in there regularly second-guessing managers anymore than one would want the commissar or the bureaucrats in there directing the managers. Most American analysts would assume that it would be costly for judges to regularly second-guess managers'non-conflicted business decisions 18. Gagliardi v. Trifoods Int'l, Inc, 683 A 2d 1049, 1052 (Del. Ch. 19 (Allen, J)(emphasis supplied ) 19. 488 A2d 858 (Del. Sup. Ct. 1985). And not just Delaware and not just recently: "[t is only in a most unusual and extraordinary case that directors are held liable for negligence in the absence of fraud, or improper motive, or personal interest. Bayer v Beran, 49NYS2d 2, 6(NY Sup. Ct. 1944) Corp. Code$ 102(bX7). And thirty-eight legislatures at the ossibility of directorial liability if their courts followed Delaware in Gorkom, passed similar exemptive legislation. See Smith(1998),at Corporate casebooks have to go back quite far to find other judicial attacks on managerial error, much less find managerial judicial defeats. Shlensky v. Wrigley, 237 N E 2d 776(Ill. App. 1968); Dodge v. Ford Motor Co. 170 N. W. 668 (Mich. 1919) 21. See Joy v North, 692 F2d 880(1982)(Winter, J
CORPORATE LAW’S LIMITS 15 value. Elaborate doctrines shield directors and managers from legal action. The business judgment rule is, absent fraud or conflict of interest, nearly insurmountable in America, insulating directors and managers from the judge, and not subjecting them to scrutiny. Consider this statement from a well-respected Delaware chancellor: There is a theoretical exception to [the business judgment rule, protecting directors and managers from liability] that holds that some decisions may be so “egregious” that liability ¼ may follow even in the absence of proof of conflict of interest or improper motivation. The exception, however, has resulted in no awards of money judgments against corporate officers or directors in [Delaware]. ¼ Thus, to allege that a corporation has suffered a loss ¼ does not state a claim for relief against that fiduciary no matter how foolish the investment…. 18 One does not exaggerate much by saying that American corporate law has produced only one major instance in which non-conflicted managers were held liable to pay for their mismanagement: Smith v. Van Gorkom, 19 a decision excoriated by managers and their lawyers, and promptly overturned by the state legislature.20 Nor should we think, “Oh, this is just a gap in American law, one that could be filled if other legal institutions didn’t sufficiently control these managerial agency costs. If the other institutions failed, corporate law would, and could, jump in.” One wouldn’t want the judge in there, regularly second-guessing managers anymore than one would want the commissar or the bureaucrats in there directing the managers. Most American analysts would assume that it would be costly for judges to regularly second-guess managers’ non-conflicted business decisions.21 18. Gagliardi v. Trifoods Int’l, Inc., 683 A.2d 1049, 1052 (Del. Ch. 1996) (Allen, J.) (emphasis supplied). 19. 488 A.2d 858 (Del. Sup. Ct. 1985). And not just Delaware and not just recently: “[I]t is only in a most unusual and extraordinary case that directors are held liable for negligence in the absence of fraud, or improper motive, or personal interest.” Bayer v. Beran, 49 N.Y.S.2d 2, 6 (N.Y. Sup. Ct. 1944). 20. Del. Corp. Code § 102(b)(7). And thirty-eight legislatures, aghast at the possibility of directorial liability if their courts followed Delaware in Smith v. Van Gorkom, passed similar exemptive legislation. See Smith (1998), at 289 n.52. Corporate casebooks have to go back quite far to find other judicial attacks on managerial error, much less find managerial judicial defeats. Shlensky v. Wrigley, 237 N.E.2d 776 (Ill. App. 1968); Dodge v. Ford Motor Co. 170 N.W. 668 (Mich. 1919). 21. See Joy v. North, 692 F.2d 880 (1982) (Winter, J.)
16 CORPORATE LAW'S LIMITS ALD+ AMm), where total managerial agency costs are the sum of\ea h 2. Agency costs: shirking and stealing Stated more formally: A controllable diversions, ALD (stealing), and legally uncontrollable managerial error that dissipates value, AMM(shirking in the economic literature). So substituting into(2)above, we obtain (5)V/2+Bcs-Ccs>(V-ALD-AMM)2 Good basic corporate law reduces Bcs and ALD, a component of agency costs, but it doesn't touch AMA. With perfect corporate law, Bcs=0 and aLd=0, which yields (6) V/2-Ccs>(V-AMM)2 (7) AMN2>CCS When(7)holds, ownership does not separate from control, even if a perfect corporate law reduces the private benefits of control to zero. And orporate law does not directly affect AMM. Good corporate law is insufficient to induce se One might refine this analysis by adding a term to account for controlling shareholder error. One could. but the costs of these errors would be smaller than legally uncontrollable managerial error. True milar legal doctrines(the business judgment rule)shield the controlling shareholder from lawsuits for a non -conflicted mistake. but because the controlling stockholder owns a big block of the company's stock, it internalizes much of the cost of any mistake (unlike the managers) Because the controlling stockholders, in contrast to the managers, bear the costs of their error, they immediately internalize their errors, unlike managers who must be made indirectly to internalize them( via incentive compensation, labor market constraints and the like). Controlling
16 CORPORATE LAW’S LIMITS 2. Agency costs: shirking and stealing. Stated more formally: AM = ALD + AMM), where total managerial agency costs are the sum of legally controllable diversions, ALD (stealing), and legally uncontrollable managerial error that dissipates value, AMM (shirking in the economic literature). So substituting into (2) above, we obtain: (5) V/2+BCS-CCS>(V-ALD-AMM)/2. Good basic corporate law reduces BCS and ALD, a component of agency costs, but it doesn’t touch AMM. With perfect corporate law, BCS=0 and ALD= 0, which yields: (6) V/2-CCS>(V-AMM)/2. Or: (7) AMM/2>CCS . When (7) holds, ownership does not separate from control, even if a perfect corporate law reduces the private benefits of control to zero. And corporate law does not directly affect AMM. Good corporate law is insufficient to induce separation. * * * One might refine this analysis by adding a term to account for controlling shareholder error. One could, but the costs of these errors would be smaller than legally uncontrollable managerial error. True, similar legal doctrines (the business judgment rule) shield the controlling shareholder from lawsuits for a non-conflicted mistake. But because the controlling stockholder owns a big block of the company’s stock, it internalizes much of the cost of any mistake (unlike the managers). Because the controlling stockholders, in contrast to the managers, bear the costs of their error, they immediately internalize their errors, unlike managers who must be made indirectly to internalize them (via incentive compensation, labor market constraints and the like). Controlling