A SELF-ENFORCING MODEL OF CORPORATE LAW 109 Harvard Law Review 1911-1982(1996) This paper can be downloaded without charge from the Social Science Research Network electronic library at http://papers.ssrn.com. tafabstract id=10037 Bernard Black Reinier Kraakman In this Article, Professors Black and Kraakman develop a"self-enforcing"approach to drafting corporate law for emerging capitalist economies, based on a case study. a model statute that they helped to draft for the Russian Federation, which formed the basis for the recently adopted Russian law on joint-stock companies. The article describes the contextual features of emerging economies -- including the prevalence of controlled companies and the weakness ofother institutional, market, cultural, and legal constraints-- that make it inappropriate to import company law from developed countries. Professors Black and Kraakman argue that in emerging economies, the best legal strategy for protecting outside investors in large companies while simultaneously preserving managers'discretion to invest is a self-enforcing model of corporate law The self-enforcing model structures corporate decisionmaking processes to allow large outside shareholders to protect themselves from insider opportunism with minimal resort to legal authority, including the courts. Among the model's provisions are a mandatory cumulative voting rule for election of directors, which ensures that mind blockholders have board representation, and a rule requiring both shareholder- and The authors are, respectively, Professor of Law, Columbia Law School, and Professor of Law, Harvard Law School. This Article builds on an earlier article that developed the concept of a"self-enforcing"corporate law in the context of Russia, prepared for the World Bank Conference on Corporate Governance in Eastern Europe and Russia held in December 1994, and which was subsequently published as Bernard Black, Reinier Kraakma Jonathan Hay, Corporate Law from Scratch, in 2 Corporate Governance in Central Europe and Russia nsiders and the State 245(Roman Frydman, Cheryl W. Gray Andrzej Rapaczynski eds, 1996) Acknowledgments should go first to Jonathan Hay, our coauthor on the precursor article, and to Anna Stanislavovna Tarassova, the principal Russian drafter of the Russian company law, the development of which provided the genesis and many of the ideas for this article. Other important participants in the effort to develop Russian company law include Alexander Abramov, lan Ayres, J. Robert Brown, Catherine Dixon, Louis Kaplow, Yevgeni Kulkov, Claudia Morgenstern, Melinda Rishkofski, Howard Sherman, Sergei Shishkin, Victoria Pavlovna Volkova, and John Wilcox. We thank the participants in the World Bank conference especially John Coffee, Ronald Gilson, Bruce Kogut, Mancur Olson, Ibrahim Shihata, and Douglas Webb, for helpful comments on earlier drafts. We also thank participants in the University of Toronto and Harvard Law School Law and Economics Workshops, Lucian Bebchuk, Jill Fisch, Jeffrey Gordon, Christine Jolls, Hideki Kanda, Mark Roe, and especially David Charny for his extensive comments. Finally, we wish to thank Joseph Blasi, Rolf Skog, Andrei Alexandrovich Volgin, and Daniel Wolfe for their comments on the draft law on which this article is based. Research support was provided by the World Bank(for both authors), the Open Society Institute( for Black), and the Harvard Program for Law and Economics, funded by the John M. Olin Foundation(for Kraakman)
* The authors are, respectively, Professor of Law, Columbia Law School, and Professor of Law, Harvard Law School. This Article builds on an earlier article that developed the concept of a "self-enforcing" corporate law in the context of Russia, prepared for the World Bank Conference on Corporate Governance in Eastern Europe and Russia held in December 1994, and which was subsequently published as Bernard Black, Reinier Kraakman & Jonathan Hay, Corporate Law from Scratch, in 2 Corporate Governance in Central Europe and Russia: Insiders and the State 245 (Roman Frydman, Cheryl W. Gray & Andrzej Rapaczynski eds., 1996). Acknowledgments should go first to Jonathan Hay, our coauthor on the precursor article, and to Anna Stanislavovna Tarassova, the principal Russian drafter of the Russian company law, the development of which provided the genesis and many of the ideas for this Article. Other important participants in the effort to develop Russian company law include Alexander Abramov, Ian Ayres, J. Robert Brown, Catherine Dixon, Louis Kaplow, Yevgeni Kulkov, Claudia Morgenstern, Melinda Rishkofski, Howard Sherman, Sergei Shishkin, Victoria Pavlovna Volkova, and John Wilcox. We thank the participants in the World Bank conference, especially John Coffee, Ronald Gilson, Bruce Kogut, Mancur Olson, Ibrahim Shihata, and Douglas Webb, for helpful comments on earlier drafts. We also thank participants in the University of Toronto and Harvard Law School Law and Economics Workshops, Lucian Bebchuk, Jill Fisch, Jeffrey Gordon, Christine Jolls, Hideki Kanda, Mark Roe, and especially David Charny for his extensive comments. Finally, we wish to thank Joseph Blasi, Rolf Skog, Andrei Alexandrovich Volgin, and Daniel Wolfe for their comments on the draft law on which this article is based. Research support was provided by the World Bank (for both authors), the Open Society Institute (for Black), and the Harvard Program for Law and Economics, funded by the John M. Olin Foundation (for Kraakman). A SELF-ENFORCING MODEL OF CORPORATE LAW 109 Harvard Law Review 1911-1982 (1996) This paper can be downloaded without charge from the Social Science Research Network electronic library at: http://papers.ssrn.com/paper.taf?abstract_id=10037 Bernard Black Reinier Kraakman* In this Article, Professors Black and Kraakman develop a "self-enforcing" approach to drafting corporate law for emerging capitalist economies, based on a case study: a model statute that they helped to draft for the Russian Federation, which formed the basis for the recently adopted Russian law on joint-stock companies. The Article describes the contextual features of emerging economies -- including the prevalence of controlled companies and the weakness of other institutional, market, cultural, and legal constraints -- that make it inappropriate to import company law from developed countries. Professors Black and Kraakman argue that in emerging economies, the best legal strategy for protecting outside investors in large companies while simultaneously preserving managers' discretion to invest is a self-enforcing model of corporate law. The self-enforcing model structures corporate decisionmaking processes to allow large outside shareholders to protect themselves from insider opportunism with minimal resort to legal authority, including the courts. Among the model's provisions are a mandatory cumulative voting rule for election of directors, which ensures that minority blockholders have board representation, and a rule requiring both shareholder- and
board-level approval for self-interested transactions. The Article examines how to induce voluntary compliance with the company law, as well as the implications of the self-enforcing model for the ongoing debate over the efficiency of corporate law in developed economies
board-level approval for self-interested transactions. The Article examines how to induce voluntary compliance with the company law, as well as the implications of the self-enforcing model for the ongoing debate over the efficiency of corporate law in developed economies
Table of contents Introduction . The National Contexts That Shape Corporate Law A. Corporate Law in Developed Economies B. The Goals of Corporate Law in Emerging Economies 778 C. Legal and Market Controls in Emerging Economies 13 D. Cultural Norms for Manager and Large Shareholder Behavior 15 IL. A Self-Enforcement Approach to Corporate Law A. The Prohibitive model B. The Self-Enforcing Model 18 1. Structural Constraints 19 2. Simple, Bright-Line Rules and Strong Remedies C. The limits to the Self-Enforcement Approach D. Can Law Function Without Official Enforcement? Ill. Governance Structure and Voting rules A. Allocation of decisionmaking power B. Allocation of Voting Power: One Share, One Vote C. Voting for Directors: Cumulative voting D. Voting procedures Universal ballot E. Protecting Honesty and Quality in Voting V. Structural Constraints on Particular Corporate Actions A. Mergers and Other major transactions 1. Shareholder Approval 2. Appraisal Rights 3. Determining Market value B. Self-Interested Transactions C. Control Transactions 45 D. Issuance and Repurchase of Shares 1. Share Issuances 2. Repurchase of Shares E. Protecting Creditors and Preferred Shareholders F The state as part-Owner VI. The Path-Dependent Evolution of Developed Country Corporate Law Conclusion: Self-Enforcing Law in Emerging Economies
Table of Contents Introduction ......................................................... . 1 I. The National Contexts That Shape Corporate Law .......................... . 7 A. Corporate Law in Developed Economies ........................... . 7 B. The Goals of Corporate Law in Emerging Economies .................. . 8 C. Legal and Market Controls in Emerging Economies .................. . 13 D. Cultural Norms for Manager and Large Shareholder Behavior .......... . 15 II. A Self-Enforcement Approach to Corporate Law .......................... . 16 A. The Prohibitive Model ........................................ . 17 B. The Self-Enforcing Model ..................................... . 18 1. Structural Constraints .................................... . 19 2. Simple, Bright-Line Rules and Strong Remedies ................ . 21 C. The Limits to the Self-Enforcement Approach ...................... . 23 D. Can Law Function Without Official Enforcement? ................... . 26 III. Governance Structure and Voting Rules ................................ . 29 A. Allocation of Decisionmaking Power ............................. . 29 B. Allocation of Voting Power: One Share, One Vote ................... . 31 C. Voting for Directors: Cumulative Voting .......................... . 33 D. Voting Procedures: Universal Ballot .............................. . 35 E. Protecting Honesty and Quality in Voting .......................... . 36 IV. Structural Constraints on Particular Corporate Actions ..................... . 38 A. Mergers and Other Major Transactions ............................ . 38 1. Shareholder Approval .................................... . 39 2. Appraisal Rights ........................................ . 41 3. Determining Market Value ................................ . 42 B. Self-Interested Transactions .................................... . 43 C. Control Transactions ......................................... . 45 D. Issuance and Repurchase of Shares ............................... . 49 1. Share Issuances. ........................................ . 49 2. Repurchase of Shares .................................... . 51 E. Protecting Creditors and Preferred Shareholders ..................... . 52 F. The State as Part-Owner ....................................... . 55 V. Remedies ........................................................ . 55 VI. The Path-Dependent Evolution of Developed Country Corporate Law ......... . 58 Conclusion: Self-Enforcing Law in Emerging Economies ....................... . 61
APPENDIX: Survey of Company Law in Emerging Markets
APPENDIX: Survey of Company Law in Emerging Markets .................... . 64
ntroduction What kind of corporate law should govern publicly owned companies in emerging markets, including newly privatizing economies? This important question has no ready answer Corporate law, we believe, should have the same principal goal in developed and emerging economies-- succinctly stated, to provide governance rules that maximize the value of corporate enterprises to investors. However, emerging economies cannot simply copy the corporate laws of developed economies. These laws depend upon highlyevolved market, legal, and governmental institutions and cultural norms that often do not exist in emerging economies. Developed country corporate laws also reflect the idiosyncratic history of their country of origin. They are not necessarily efficient at home, let alone when transplanted to foreign soil. Moreover, in many emerging markets, corporate law must serve a second central goal that is less pressing in mature market economies: fostering public confidence in capitalism and in private ownership of large business enterprises Thus, corporate law must be designed substantially from scratch to work within the infrastructure available in an emerging market. Fortunately, this can be politically feasible Precisely because existing institutions( to which the law must adapt )are often weak or missing, one can rethink from first principles what corporate law ought to look like and what related institutions it ought to rely on and promote Beyond producing a new model for emerging markets, the effort to develop corporate law from scratch can expose weaknesses and idiosyncracies in the corporate laws of developed countries. The model can highlight the ways in which these laws did not simply evolve toward efficiency, but instead evolved from historically contingent starting places to ending places shaped by preexisting institutions, by the inertial power of the status quo, and by the preferences of key participants in the corporate enterprise. For example, German corporate law adapted to strong banks and labor unions, while american law adapted to strong capital markets, weak financial institutions, and strong corporate managers In this Article, we sketch the basic elements of a"self-enforcing"model of corporate law, designed for an emerging economy. The model is grounded in a case study: the effort, in which we participated, to develop a new corporate law for Russia. We begin with three We use the term"institution"in a broad sense to include private organizational structures such as stock ading systems and securities registrars; public organizational structures such as securities regulators, courts with experience in commercial matters, an honest police force, and a reliable mail system; and mixed public private structures such as self-regulatory organizations, an accounting profession, and sophisticated financial accounting rules 2 A modified version of our proposed law was adopted in December 1995 as the company law of the Russian Federation. See Federal Law of the Russian Federation on Joint-Stock Companies, No. 208-FZ(1995) published in Rossiiskaya Gazeta, Dec. 29, 1995, at 1, translation available in Westlaw, Rusline Database 1995 WL 798968. An annotated English translation of the law(by Bernard Black and Anna Tarassova) available from Professor black
1 We use the term "institution" in a broad sense to include private organizational structures such as stock trading systems and securities registrars; public organizational structures such as securities regulators, courts with experience in commercial matters, an honest police force, and a reliable mail system; and mixed publicprivate structures such as self-regulatory organizations, an accounting profession, and sophisticated financial accounting rules. 2 A modified version of our proposed law was adopted in December 1995 as the company law of the Russian Federation. See Federal Law of the Russian Federation on Joint-Stock Companies, No. 208-FZ (1995), published in Rossiiskaya Gazeta, Dec. 29, 1995, at 1, translation available in Westlaw, Rusline Database, 1995 WL 798968. An annotated English translation of the law (by Bernard Black and Anna Tarassova) is available from Professor Black. 1 Introduction What kind of corporate law should govern publicly owned companies in emerging markets, including newly privatizing economies? This important question has no ready answer. Corporate law, we believe, should have the same principal goal in developed and emerging economies -- succinctly stated, to provide governance rules that maximize the value of corporate enterprises to investors. However, emerging economies cannot simply copy the corporate laws of developed economies. These laws depend upon highly evolved market, legal, and governmental institutions and cultural norms that often do not exist in emerging economies.1 Developed country corporate laws also reflect the idiosyncratic history of their country of origin. They are not necessarily efficient at home, let alone when transplanted to foreign soil. Moreover, in many emerging markets, corporate law must serve a second central goal that is less pressing in mature market economies: fostering public confidence in capitalism and in private ownership of large business enterprises. Thus, corporate law must be designed substantially from scratch to work within the infrastructure available in an emerging market. Fortunately, this can be politically feasible. Precisely because existing institutions (to which the law must adapt) are often weak or missing, one can rethink from first principles what corporate law ought to look like and what related institutions it ought to rely on and promote. Beyond producing a new model for emerging markets, the effort to develop corporate law from scratch can expose weaknesses and idiosyncracies in the corporate laws of developed countries. The model can highlight the ways in which these laws did not simply evolve toward efficiency, but instead evolved from historically contingent starting places to ending places shaped by preexisting institutions, by the inertial power of the status quo, and by the preferences of key participants in the corporate enterprise. For example, German corporate law adapted to strong banks and labor unions, while American law adapted to strong capital markets, weak financial institutions, and strong corporate managers. In this Article, we sketch the basic elements of a "self-enforcing" model of corporate law, designed for an emerging economy. The model is grounded in a case study: the effort, in which we participated, to develop a new corporate law for Russia.2 We begin with three