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A Political Theory of Corporate Crime Legislation
Vikramaditya S. Khanna
April
2003Corporate crime has once again become an important issue on the US legislative agenda. Following the recent economic downturn and the spectacular revelations of corporate wrongdoing, Congress and the various regulatory bodies have begun to tighten the law and enhance honesty and completeness in disclosure. The enactment of the Sarbanes-Oxley Act of 2002 is one example and adds to the already sprawling area of corporate criminal liability. However, the continued and rather explosive growth of corporate crime legislation leaves one with a rather strange puzzle: how can such a state of the world arise? After all, corporations and business interests are considered some of the most powerful and effective lobbyists, if not the most effective and powerful, in the country. Yet, we witness the continued expansion of legislation that criminalizes some of their behavior (one estimate suggests over 300,000 federal regulatory offenses that can be prosecuted criminally). How could this have happened given that business interests should be able to lobby to protect themselves? This paper sets out to answer this puzzle.
An answer is important not only for purposes of understanding the political dynamics of current regulation, but also because it provides insights into the effectiveness of our current approach for regulating corporate wrongdoing. Overall, my analysis suggests that corporate criminal liability – the imposition of criminal sanctions on the corporate entity – serves little deterrent or expressive function above that offered by corporate civil liability. This suggests, on first glance, weak support for the growth of corporate criminal liability. However, this is only on first glance. Indeed, on closer inspection, it appears that corporate criminal liability imposes relatively low costs on corporate interests, may help to avoid legislative and judicial responses that are more harmful to their interests, and may at times help to deflect criminal liability away from managers and executives and on to corporations. These effects may often benefit corporate interests and weakens their opposition to corporate crime legislation. In light of this, the growth of corporate crime legislation becomes more understandable. This not only provides some explanations for the impressive growth of corporate criminal liability, but also leads to some interesting normative conclusions. In particular, it leads to the counter-intuitive result that if one starts with the view that there is under-deterrence of corporate wrongdoing then one would probably prefer to reduce corporate criminal liability and focus more on corporate civil liability and managerial liability.
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Re-examining Legal Transplants: The Director's Fiduciary Duty in Japanese Corporate Law
Hideki Kanda and Curtis J. Milhaupt
March 24, 2003
The transplantation of legal rules from one country to another is commonly observed around the world. Legal transplants can range from the wholesale adoption of entire systems of law to the copying of a single rule. Despite the importance of transplants to legal development around the world, scholarly understanding of this ubiquitous form of legal development is still fairly rudimentary. For example, there is little agreement among scholars on transplant feasibility and the conditions for successful transplants, or even how to define "success." Moreover, there is little analysis of how the success or failure of legal transplants relates to the achievement of larger goals, such as economic development.
Japanese law, particularly the legal rules governing economic organization, is a prime example of the transplant phenomenon, both in its systemic and single-rule variations. Japan imported its original Commercial Code (including legal rules on business corporations) from Germany in 1898 as part of a fundamental reform of its legal system, and made large-scale amendments to the corporate law in the immediate post-war period by importing many specific legal rules from the United States. This article attempts to shed light on the role of legal transplants in corporate law by examining Japan's transplantation of a single corporate rule: the director's duty of loyalty, which was added to the Commercial Code in 1950 as a direct import from the United States. For almost forty years after it was transplanted, however, the duty of loyalty was never separately applied by the Japanese courts, and played little role in Japanese corporate law and governance. It finally began to be used in the late1980s, long after Japan had achieved high economic growth. Using a simple theory of legal transplants, we explain the initial non-use and subsequent use of the duty of loyalty transplant in Japanese corporate law.
Part I of the paper provides a simple analytical framework for determining the success or failure of a legal transplant. Part II takes up the specific case study of the transplantation of the duty of loyalty into Japanese corporate law. It begins with a brief examination of the central role of duty of loyalty doctrine in U.S. corporate law. We then contrast the situation under Japanese corporate law, tracing the duty of loyalty from its transplantation to its eventual application by the Japanese courts. Part III evaluates the transplantation of the duty of loyalty in Japan in light of our theoretical discussion.
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Nonprofit Organizations as Investor Protection: Economic Theory, and Evidence from East Asia
Curtis J. Milhaupt
March 10, 2003
Enforcement problems plague shareholder activism and investor protection in many parts of the world. The importance of solving this problem has led scholars to consider a range of partial alternatives to weak domestic corporate law enforcement regimes, ranging from writing "self enforcing" corporate laws to using cross listings on foreign stock exchanges as a means of bonding firms to higher quality enforcement.
The recent experience of the three largest capitalist market economies of East Asia suggests that there is another partial solution to the problem of weak investor protection and corporate law enforcement, one that has received no theoretical or empirical attention—the nonprofit organization. This partial solution emerges from a puzzle at the center of contemporary East Asian corporate governance. With the possible exception of the government itself, nonprofit organizations (NPOs) have emerged as the most important corporate law enforcement agents in Korea, Japan and Taiwan. In each system, an NPO holding a portfolio of shares is engaged directly in the exercise of shareholders’ rights to combat corporate fraud and mismanagement, and to improve the investor protection climate. In numerous instances, these organizations have won significant court victories or settlements against management. This development is puzzling because the defining characteristic of an NPO is the nondistribution constraint. That is, while nonprofits are not prohibited from making profits, they are prohibited from distributing them to their owners. Why are three organizations operating within the nondistribution constraint—rather than institutional investors or individual shareholders represented by plaintiffs’ attorneys—the principal shareholder activists cum corporate law enforcement agents in this region?
This paper analyzes the role of NPOs in East Asian corporate governance, and applies economic theory on the existence of nonprofits as suppliers of public goods (along with several complementary theories) to explain the rise of NPOs as suppliers of investor protection in the region. The paper also examines the academic and policy implications of the East Asian experience. Academically, the NPO as a corporate law enforcement mechanism is a highly distinctive illustration of functional convergence in corporate governance: several societies have spontaneously generated substitutes for the attorney-oriented incentive mechanisms relied upon in the United States to enhance investor protection. Yet each NPO displays its own unique structure and strategy, differences that can be tied directly to the distinct domestic legal and political structures in which they operate. At the level of law reform, for transition economies the NPO has several advantages as a corporate law enforcement device, particularly in societies reluctant or unable to transplant the U.S. "attorney as bounty hunter" model of law enforcement. First, the nondistribution constraint inherent in the NPO form provides a built-in check on frivolous litigation. Second, shareholder activist NPOs seek to use and improve local law enforcement institutions, while most of the alternatives discussed in the literature involve abandoning weak local enforcement regimes.
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Market Bubbles and Wasteful Avoidance: Tax and Regulatory Constraints on Short Sales
Michael R. Powers, David M. Schizer and Martin Shubik
March 24, 2003
Although short sales make an important contribution to financial markets, this transaction faces legal constraints that do not govern long positions. In evaluating these constraints, other commentators, who are virtually all economists, have not focused rigorously enough on the precise contours of current law. Some short sale constraints are mischaracterized, while others are omitted entirely. Likewise, the existing literature neglects many strategies in which well advised investors circumvent these constraints; this avoidance may reduce the impact of short sale constraints on market prices, but may contribute to social waste in other ways. To fill these gaps in the literature, this paper offers a careful look at current law and draws three conclusions. First, short sales play a valuable role in the financial markets; while there may be plausible reasons to regulate short sales– most notably, concerns about market manipulation and panics – current law is very poorly tailored to these goals. Second, investor self-help can ease some of the harm from this poor tailoring, but at a cost. Third, relatively straightforward reforms can eliminate the need for self-help while accommodating legitimate regulatory goals. In making these points, we focus primarily on a burden that other commentators have neglected: profits from short sales generally are ineligible for the reduced tax rate on long-term capital gains, even if the short sale is in place for more than one year.
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Governance Failures of the Enron Board and the New Information Order of Sarbanes-Oxley
Jeffrey N. Gordon
March, 2003
(Prepared for the University of Connecticut Law Review
Symposium
Crisis in Confidence: Corporate Governance and Professional Ethics
Post-Enron)
This paper argues that the principal governance failure of the Enron board was to approve a disclosure policy that made the firm
's financial results substantially opaque to public capital markets, despite also approving a compensation strategy that made managerial payoffs highly sensitive to stock price changes and despite its unwillingness to engage in intense monitoring of business results and financial controls. In comparable circumstances of constrained monitoring by public markets, LBO firms and venture capitalists undertake a vigorous monitoring role. Important provisions of the Sarbanes Oxley Act can be seen as correcting for a public board's probable inability to adequately monitor a complex corporate finance strategy, "corrective disclosure." But the Act also seems to contemplate immediate disclosure of material business developments even in circumstances where premature disclosure may well sacrifice shareholder value for very little gain in capital market efficiency. The paper criticizes such "price- perfecting disclosure." A further consequence of the Act's disclosure regime may be to shift governance authority away from management and the board toward shareholders, including in the case of hostile takeovers.Keywords: corporate governance, Enron, Sarbanes-Oxley, takeover
law
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Law, Rules, and Presidential Selection
Samuel Issacharoff
February
, 2003Robert Dahl, in "How Democratic is the American Constitution?" criticizes the
institution of the Electoral College as "morally, politically, and
constitutionally wrong." This Article addresses the third of those claims.
Dahl’s critique, like many directed against the Electoral College, presumes a
constitutional commitment to majoritarianism. This Article examines the rather
commonplace departures from strict majoritarian rule in the Constitution, and
concludes that the distortions from majoritarian preferences created by the
Electoral College are actually much smaller in scope than those created by the
U.S. Senate, the Article V amendment process and, to some extent, the House of
Representatives. Moreover, subsequent constitutional developments—namely the
"Reapportionment Revolution" of Baker v. Carr and later cases—have not enshrined
a constitutional principle of simple majoritarianism that might undermine the
constitutional foundation of the Electoral College. The Article then explores
the controversies surrounding the presidential elections of 1800 and 1876 to
argue that there are nonetheless important constitutional principles at stake in
the operation of the Electoral College, namely in the manner in which Congress
dictates rules for the settlement of disputes arising from presidential
elections. The Article concludes by discussing one aspect of the Electoral
College that could be susceptible to constitutional challenge: the
"winner-take-all" system employed by nearly all states to allocate electoral
votes. This practice, which is not mandated by the Constitution, could be
challenged, not on the grounds that it is inconsistent with majoritarianism, but
rather on the grounds that it gives the majority too much power—an argument that
finds much stronger support in our constitutional jurisprudence.
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What Caused Enron?: A Capsule Social and Economic History of the 1990's
John C. Coffee, Jr.
January 20, 2003
Between January 1997 and June 2002, approximately 10% of all listed companies in the United States announced at least one financial statement restatement. The stock prices of restating companies declined 10% on average on the announcement of these restatements, with restating firms losing over $100 billion in market capitalization over a short three day trading window surrounding these restatements. Such generalized financial irregularity requires a more generic causal explanation than can be found in the facts of Enron, WorldCom or other specific case histories.
Several different explanations are plausible, each focusing on a different actor (but none giving primary attention to the board of directors):
1. The Gatekeeper Story looks to the professional
Areputational intermediaries@ on whom investors rely for verification and certification - - i.e., auditors, analysts, debt rating agencies and attorneys - - and views the surge in financial restatements as the product of both (a) reduced legal exposure for gatekeepers (as the result of legislation and judicial decisions in the 1990's sheltering them from liability) and (b) the increased potential for consulting income or other benefits from their clients (resulting in gatekeeper acquiescence in accounting or financial irregularities). This is essentially the story to which the Sarbanes-Oxley Act responds.2. The Misaligned Incentives Story instead focuses on managers and a dramatic change in executive compensation during the 1990's, as firms shifted from cash to equity-based compensation. Stock options (and legal changes that enabled management to exercise the option and sell the security without any delay) arguably gave management a strong incentive to inflate reported earnings and create short-term price spikes that were unsustainable, but which they alone could exploit. Sarbanes-Oxley does not address this potential cause of irregularities.
3. The Herding Story focuses on the incentives of investment fund managers and argues that they are uniquely focused on their quarterly performance vis-a-viz their rivals. As a result, they have an incentive to
Aride the bubble,@ even when they sense danger, because they fear more the mistake of being prematurely prophetic. Again, Sarbanes-Oxley does not address this cause of bubbles and price spikes.This comment compares and contrasts these explanations, finding them highly complementary
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The Ossification of American Labor Law
Cynthia L. Eslund
December, 2002
In this article, Professor Estlund argues that the ineffectuality of American can labor law and the shrinking scope of collective representation and collective bargaining are partly traceable to the law's "ossification" - to its having been essentially sealed off both from democratic revision and renewal and from local experimentation and innovation to a remarkably complete extent and for a remarkably long time. The elements of this process of ossification are various and familiar; yet, once assembled, they make up an impressive set of barriers to innovation. The basic law has been cut off from revision at the national level by Congress; from "market"-driven competition by employers; from the entrepreneurial energies of individual plaintiffs and the plaintiff's bar, and the creativity they can sometimes coax from the courts; from variation at the state or local level by representative or judicial bodies; from the winds of changing constitutional doctrine; and from emerging transnational legal norms. Finally, the National Labor Relations Board - the designated institutional vehicle for adjusting the labor laws to modern conditions - is increasingly hemmed in by the age of the text and the large body of judicial interpretations that has grown up over the years. While the argument may seem to counsel only pessimism about the prospects for reform, it may also help to identify potential pathways of change that have not been fully appreciated. Indeed, some of those pathways are being paved by the process of ossification itself: By impelling private parties to find their own paths outside of the existing regime, the ossification of labor law may be setting in motion the very forces that may eventually lead toward legal change.
This paper forthcoming through Columbia Law Review
www.columbialawreview.org
Enron's Legislative Aftermath: Some Reflections on the Deterrence Aspects of the Sarbanes-Oxley Act of 2002
Michael A. Perino
October 30, 2002
Since Enron’s implosion, an astounding string of accounting scandals have stunned the securities markets. Global Crossing, WorldCom, Adelphia, and a host of other companies have seen plummeting share prices and SEC and criminal investigations. Congress’ reaction has been equally stunning and surprisingly swift. It passed with near unanimity the Sarbanes-Oxley Act of 2002, and President Bush quickly signed it into law. This paper analyzes the new criminal and civil liability provisions of the Act to evaluate whether the Act is likely to achieve its goal of deterring securities fraud. The article concludes that the new criminal liability provisions actually criminalize very little conduct that was not already criminal under existing statutes and do not substantially increase the likelihood of successful conviction. The enhanced criminal penalties are unlikely to create additional deterrence because the Act’s predominant approach is to increase maximum potential sentences. Under the Federal Sentencing Guidelines, such increases have little impact on expected penalties. On the civil side, the article demonstrates that there was no empirical bais for increasing the statute of limitations for private securities fraud causes of action. Finally, the article concludes that the increase in resources and enforcement authority for the SEC may well provide more substantial deterrence than the more publicized criminal provisions of the Act to the extent that these provisions significantly increase the likelihood that securities fraud is detected.
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Did The Private Securities Litigation Reform Act Work?
Michael A. Perino
October 2002
In 1995 Congress passed the Private Securities Litigation Reform Act to address abuses in securities fraud class actions. In the wake of Enron, WorldCom, Adelphia, and other high profile securities frauds, critics suggest that the law made it too easy to escape liability for securities fraud and thus created a climate in which frauds are more likely to occur. Others claim that the Act has largely failed because it did little to deter plaintiff’s lawyers from filing non-meritorious cases. This article employs a database of the 1449 class actions filed from 1996 through 2001 to explore whether the Act achieved several of its primary goals—discouraging the filing of non-meritorious suits, reducing litigation risk for high technology issuers, and reducing the "race to the courthouse" whereby class actions were filed soon after significant stock price declines, apparently with very little pre-filing investigation.
The picture that emerges from studying these data is that the PSLRA did not work as intended. This article demonstrates that as many or more class actions are filed after the Act as before. High technology issuers remain at significantly greater risk than issuers in other industries. There is statistically significant evidence, however, that suggests that the Act improved overall case quality at least in the circuit that most strictly interprets one of the Act’s key provisions, a heightened pleading standard. The data in the article also demonstrate that Congress did not achieve its goal of increasing the filing delay in class actions. Actions are filed as quickly now as they were before passage of the Act. Nonetheless, that too may provide indirect evidence that plaintiff’s attorneys are selecting more apparent cases of fraud that require less pre-filing investigation.
http://www.law.columbia.edu/faculty_mperin/perino_publications.htm
Should the Behavior of Top Management Matter?
Vikramaditya S. Khanna
September 2002
Forthcoming, Georgetown Law Journal, Vol. 91, 2003
Recent events, such as the Enron, Worldcom, and Global Crossing debacles, have brought to the forefront the issue of corporate and organizational wrongdoing and the involvement of top management in it. To date, the law’s response to the knowing or reckless involvement of top management in corporate wrongdoing has been primarily two-fold. First, it increases the sanction imposed on top management. Second, it increases the sanction imposed on the corporation (i.e., the shareholders). This paper examines the second response.
The second response can be examined in multiple ways depending on the analytical perspective being utilized. In this paper I consider the question from three perspectives. First, whether our current law can be justified under a deterrence-based approach to corporate criminal liability. This is the bulk of the paper as that has been where much of the literature in the corporate crime area has developed. Second, whether our current law can be justified under an expressive approach to corporate criminal liability. Third, whether our current law might reflect an attempt to place most of the risk of liability on the corporation, which is generally a better risk bearer than top management. My conclusions are that our current law is difficult to justify under any of these approaches and that it is likely imposing costs on society. This suggests that our current law is in need of reform.
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An American Perspective on the New German Anti-takeover Law
Jeffrey N. Gordon
June 2002
Forthcoming, 12 Die Aktiengesellschaft, December 2002
The new German Takeover Act contains antitakeover provisions that reject the "board neutrality/shareholder choice" of the rejected draft of the 13th Directive. These antitakeover provisions may have a particular (albeit temporary) justification as part of negotiating strategy to obtain a Directive with a "level playing field" approach to a wide variety of control barriers in the EU. This is because assent to cross-border mergers and the transnational economic integration associated with such mergers ultimately depends upon the control of economic nationalism. General vulnerability to takeover bids, in which acquirers who engage in value-reducing home country bias would face a control threat, can play a valuable role in controlling economic nationalism.
Nevertheless, the German antitakeover provisions would have much more adverse impact than the US counterparts to which they are frequently compared. First, the favored US defensive measure, the poison pill, is not available under prevailing German principles of preemptive rights and non-discrimination against any shareholder. German firms are likely to substitute irreversible, value-decreasing measures that were replaced in the US by the pill, such as capital structure changes or asset dispositions. Second, the typical US practice of annual shareholder elections of board members combined with heavy institutional investor ownership in large public firms means that managements are highly sensitive to public shareholder interests in considering a takeover bid. By contrast, German supervisory boards turn over much more slowly, and are co-determined. German management feels less legal and cultural pressure to adhere to public shareholder interests. Third, stock option-laden compensation packages make US managers highly receptive to premium bids, especially because a takeover typically triggers the accelerated vesting of such options. German compensation arrangements do not now and, as a matter of culturally constraint, are unlikely to imitate the US version. So if Germany insists too hard on a 13th Directive to its exact taste, it risks sacrificing internal and cross-border mergers that would produce efficiency gains and aid the EU transnational project.
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Reducing the Tax Costs of Indexed Options
David M. Schizer
July 31, 2002
To encourage pay for performance, Congress offers certain tax advantages when stock options are used as compensation. Yet these advantages arguably are not available to so-called "indexed" options, which reward executives for good relative performance (i.e., instead of absolute increases in stock price). The tax costs of indexed options are as ironic as they are unintended. The relevant tax rules are supposed to favor performance-based pay and, if anything, indexed options are more performance-based than conventional options. As a result, these tax rules should be reformed.
While portions of this Article originally appeared in David M. Schizer, Tax Constraints on Indexed Options, 149 U. PA. L. REV.(2001), this Article is substantially different. Most importantly, this Article explains why some practitioners believe indexed options cannot qualify as performance-based pay under Section 162(m), and thus cannot be deducted in excess of $1 million. This Article offers a legal interpretation that allows a deduction, and suggests that the tax authorities are likely to offer a favorable ruling on this issue.
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Understanding Enron: It's About the Gatekeepers, Stupid
John C. Coffee, Jr.
July 30, 2002
Debacles of historic dimensions tend to produce an excess of explanations. So has it been with Enron, as virtually every commentator has a different diagnosis and a different prescription. Yet, in most respects, Enron is a maddeningly idiosyncratic example of pathological corporate governance, which by itself cannot provide evidence of systematic governance failure. Properly understood, however, the Enron debacle furnishes a paradigm of Agatekeeper failure@ - - that is, of why and when reliance may not be justified on Areputational intermediaries,@ such as auditors, securities analysts, attorneys, and other professionals who pledge their reputational capital to vouch for information that investors cannot easily verify. This comment shows that, during the 1990's, the expected liability costs associated with gatekeeper acquiescence in managerial misbehavior went down, while the expected benefits went up - - with the unsurprising result that earnings restatements and earnings management increased. Diagnosing the circumstances under which Agatekeeper failure@ is likely leads in turn to prescriptions focused on re-aligning the incentives of gatekeepers with those of investors.
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Law's Dominion and the Market for Legal Elites in Japan
Curtis J. Milhaupt and Mark D. WestJune 14, 2002
In this Article, we present data on legal elites in Japan - legally trained university graduates poised to pursue successful careers either as fast-track bureaucrats or lawyers handling sophisticated business transactions. The data show a marked shift in employment patterns over the past decade: increasingly, Japan's most elite university graduates are forsaking the bureaucracy for law.
We find that changes in Japan's underlying economic, political, and legal institutions are a primary cause of this shift. We argue that this trend is not a temporary phenomenon, but reflects a more fundamental transfer of authority in Japan from the bureaucracy to the legal system. The evidence sheds new light on two longstanding debates: the impact of law and lawyers on economic success, and the bureaucracy's role in the governance of the Japanese economy.
The data we examine are hard to square with the widespread view of Japan as "Exhibit A" for the proposition that societies encourage economic growth by steering their most talented youth away from "redistributive legal careers." Rather, the data indicate that in Japan (as elsewhere), talented college graduates pursue positions of power, prestige, and profit. While those positions were once located in the elite economic bureaucracy, they are now migrating to the legal system. Contrary to the evidence of stagnation in the economic and policy environments flowing out of Japan in recent years, close examination of the career choices of Japan's most highly regarded youth reveals a society in transition.
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RACING
TOWARDS THE TOP?:
The Impact of Cross-Listings and Stock Market Competition on International Corporate
Governance
May 30, 2002
During the 1990's, the phenomenon of cross-listing by issuers on international exchanges accelerated, with the consequence in the case of some emerging markets that trading followed, draining the original market of its liquidity. Traditionally, cross-listing has been viewed as an attempt to break down market segmentation and reach trapped pools of liquidity in distant markets. The globalization of financial markets, however, renders this explanation increasingly dated. A superior explanation is Abonding:@ issuers migrate to U.S. exchanges in particular because by voluntarily subjecting themselves to the U.S.'s higher disclosure standards and greater threat of enforcement (both by public and private means), they partially compensate for weak protection of minority investors under their own jurisdiction's law and also credibly signal their intention to make fuller disclosure, thereby achieving a higher market valuation and a lower cost of capital.
Still, many issuers who are eligible to cross-list do not do so. Increasing evidence suggests that cross-listing firms are significantly different from firms in the same jurisdiction that do not cross-list, most notably in that the former have higher growth prospects and are willing to sacrifice some of the private benefits of control to obtain equity finance. Conversely, firms that do not cross-list typically have controlling shareholders who have less interest in stock market valuation because they anticipating selling only in a control transaction at a control premium that they will disproportionately capture. As a result, specialized markets seem likely to persist in order to accommodate both firms that wish to offer superior protections to minority investors and those that prefer to cater to controlling shareholders who want to continue to realize the private benefits of control. Path dependency then may persist.
The latest developments in this new form of regulatory competition have been both (i) the creation of new Ahigh disclosure@ exchanges in emerging markets, and (ii) the enactment of reform legislation intended to protect minority shareholders by jurisdictions that have seen their securities markets lose liquidity to international exchanges. Both efforts seek to share control premia with minority shareholders in order to encourage equity investment. However, such efforts appear to be impeded by the continuing willingness of U.S. exchanges to waive governance listing requirements that are mandatory for their domestic firms in the case of foreign firms.
Finding this new form of regulatory competition to be desirable, this article argues that its distinguishing characteristic is that it is Aexit-less@(and thus differs from the Aissuer choice@ model of regulatory competition), and it recommends that the current broad exemption under which U.S. exchanges waive all governance listing requirements for foreign issuers should be reconsidered.
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Incomplete
Law - A Conceptual and Analytical Framework
- And its Application to the Envolution of Financial Market Regulation -
April 2002
This paper develops a conceptual framework for the analysis of legal institutions. It argues that law is inherently incomplete and that the incompleteness of law has a profound impact on the design of lawmaking and law enforcement institutions. When law is incomplete, residual lawmaking powers must be allocated; and enforcement agents have to be vested with law enforcement powers. The optimal allocation of lawmaking and law enforcement powers under incomplete law is analyzed with a focus on the legislature, regulators and courts as possible lawmakers, and courts as well as regulators as possible law enforcers. The timing and process of lawmaking and law enforcement differs across these agents. Legislatures are ex ante, courts are ex post lawmakers, regulators have combine ex ante and ex post lawmaking functions. Courts are reactive law enforcers, while regulators are proactive law enforcers in that – unlike courts - they can initiate enforcement procedures. We argue that the optimal allocation of residual lawmaking and law enforcement powers is determined by the degree and nature of incompleteness of law, the ability to standardize actions that may result in harm, and the magnitude of harm and externalities expected from such actions. Under highly incomplete law, regulators are superior to courts when actions can be standardized and, if allowed to proceed, may create substantial externalities. Otherwise courts are optimal holders of lawmaking and law enforcement powers. We apply this analytical framework to the development of financial market regulation in England since the mid 19th century, with comparative reference to developments in the United States and Germany. The comparative evidence suggests that financial market regulators with both residual lawmaking and proactive law enforcement powers emerged in all three jurisdictions in response to ineffective judicial law enforcement of highly incomplete law.
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What Enron Means for the Management
and Control of the Modern Business Corporation:
Some Initial Reflections
Jeffrey N. Gordon
Forthcoming, University of Chicago Law Review, Summer, 2002
The Enron case challenges some of the core beliefs and practices that have underpinned various positions in the debates about corporate law and governance, including mergers and acquisitions, since the 1980s. In particular, Enron raises at least the following problems for the received model of corporate governance:First, it provides another set of reasons to question the strength of the efficient market hypothesis, here, the company’s dizzyingly high stock price despite transparently irrational reliance on its auditors’ compromised certification.
Second, it undermines faith in the corporate governance mechanism – the monitoring board – that has been offered as a substitute for unfettered shareholder access to the market for corporate control. In particular, the board’s capacity to protect the integrity of financial disclosure has not kept pace with the increasing reliance on stock price performance in measuring and rewarding managerial performance.
Third, it suggests the existence of tradeoffs in the use of stock options in executive compensation because of the potential pathologies of the risk-preferring management team.
Fourth, it shows the poor fit between stock-based employee compensation and employee retirement planning. More generally, it raises questions about the shift in retirement planning towards defined contribution plans, which make employees risk bearers and financial planners, and away from defined benefit plans, which impose some of the risk and fiduciary planning obligations on firms.
Although the disclosure, monitoring and other failures may lead to useful reforms, Enron also reminds us that there is a problem that cannot be solved but can only be contained in the tension between imperfectly fashioned incentives and self-restraint.
Keywords: Enron, corporate governance, efficient market, accountants, directors, stock options, pensions
JEL classifications G14, G34, K22, L14, M52
Download this paper in Acrobat formatForthcoming Columbia Business Law Review, Spring, 2002
In this Essay, Victor Fleischer describes the "gap" between what is taught in law schools and what is needed in corporate transactional practice. The Essay identifies three related reasons why schools have struggled to teach transactions effectively: (1) the lack of a conceptual framework, (2) the lack of qualified teachers, and (3) the lack of quality teaching materials. The Essay then describes how the Deals program at Columbia Law School addresses these problems and provides students with a pedagogically sound and effective introduction to corporate transactional practice
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The Rise and Fall of Article 2
Robert E. Scott
Forthcoming Louisiana Law Review, Vol. 63, 2002
On August 13, 2001 the National Conference of Commissioners on Uniform State Laws voted 89 to 53 to reject the 2001 Amendments to Article 2 of the Uniform Commercial Code that had just been approved in May by the American Law Institute. While negotiations continue, this public split between the two bodies that have together shepherded the UCC project for over fifty years represents the likely end of the fourteen year effort to revise the law of sales as embodied in Article 2.
In this Essay, I examine the political economy of the Article 2 project from its origins to the present. I begin by analyzing the drafting and enactment process of the original Article 2 and evaluate the success of the new sales law it introduced, a success attributable in no small measure to the replacement of archaic vestiges of property law with efficient contract default rules. I then I consider the effects of the compromises Karl Llewellyn made to secure the enactment of the Code. Of particular significance is how the vague terms that invoke the commercial context (originally intended by Llewellyn as a means of incorporating ex ante default rules) have been used to challenge the objective meaning of disputed contracts. For many commercial contractors, exit may have been a cheaper option than lobbying for clearer and more predictable default rules. But the parties to mass-market sales transactions remain subject to Article 2, and their representatives have sought to influence the revision process. Thus, the focus has shifted from Llewellyn's original goal of prescribing optimal default rules for commercial contracts to the current debate over proscribing freedom of contract in mass-market transactions. The resulting divergence between the interests of producers and those of consumer buyers, computer information licensees and their representatives has produced deadlock.
I conclude that the flaws in the Article 2 project were present from its inception. Given the limits of legal regulation, it is unlikely that any set of "uniform" rules that are promulgated for adoption in every state can both efficiently complete the gaps in commercial contracts as well as optimally police consumer transactions. In sum, the uniform laws process works when there is distributional symmetry (when today's buyer might be tomorrow's seller). On the other hand, the process deadlocks when it seeks to produce uniform rules for transaction-types in which the distributional effects are asymmetric and prices do not adjust efficiently to compensate for the victory of one group in the legislative process.
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Enron's Dirty Little Secret: Waiting for the Other Shoe to Drop
Victor Fleischer
Tax Notes, Vol. 94, No. 8, February 2002
How is it that Enron, allegedly the seventh-largest company in the U.S., didn't pay any income tax for four out of the last five years? In this short commentary piece, I argue that the tax Code got it right and the accountants got it wrong. Using the MIPS transaction (a debt/equity hybrid) and an off-balance sheet partnership as examples, I argue that in Enron's case, the tax Code did a better job of measuring income than the accountants. The reason Enron didn't pay any income tax is because it didn't have any real income. On a more cautionary note, however, the article suggests that the tax bar must move quickly towards effective self-regulation if it wants to avoid the current problems facing the accounting industry.
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Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock
Ronald J. Gilson and David M. Schizer
February 2002
The capital structures of venture capital-backed U.S. companies share a remarkable commonality: overwhelmingly, venture capitalists make their investments through convertible preferred stock. Not surprisingly, a large part of the academic literature on venture capital has sought to explain this peculiar pattern. Financial economists have developed models showing, for example, that convertible securities allocate control depending on the portfolio company's success, operate as a signal to overcome various kinds of information asymmetry, and align the incentives of entrepreneurs and venture capital investors. In this Article we extend this literature by examining the influence of a more mundane factor, tax law, on venture capital structure. A firm that issues convertible preferred stock to venture capitalists is able to offer more favorable tax treatment for incentive compensation paid to the entrepreneur and other portfolio company employees: Instead of being taxed currently at ordinary income rates, the entrepreneur and employees can defer tax until the incentive compensation is sold (or even longer), at which point a preferential tax rate is available.
No tax rule explicitly connects the employee's tax treatment with the issuance of convertible preferred stock to venture capitalists. Rather, this link is part of tax "practice" - the plumbing of tax law, familiar to practitioners but, predictably, opaque to those, including financial economists, outside the day-to-day tax practice. Despite its obscurity, this tax factor is likely to be of first order importance. Intense incentive compensation for portfolio company founders and employees is a fundamental feature of venture capital contracting. Favorable tax treatment for this compensation is a by-product and, we believe, a core purpose of the use of convertible preferred stock.
We also highlight an important but low visibility tax subsidy for the venture capital market, and the early stage, usually high technology, firms that are financed there. Although this subsidy arose inadvertently, it has an interesting structure. Funds are not provided directly to companies selected by the government (a familiar technique outside the United States), or to all companies. Instead, venture capital investors are enlisted as the subsidy's gatekeeper. As a practical matter, only companies that can attract venture capital investment receive this subsidy. Our analysis thus adds a different twist on the familiar debate about providing subsidies through the tax system, instead of through direct expenditures or favorable regulatory treatment.
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Free Riding on Hot Wheels
Victor P. Goldberg
October 2002
Forthcoming, Winter 2002 issue of Antitrust Bulletin
When warehouse clubs started making inroads into its market, Toys R Us responded with a policy designed to limit the clubs’ access to certain toys. The FTC successfully challenged the policy, arguing that TRU had coordinated a horizontal agreement amongst the toy manufacturers to eliminate competition from this new class of competitors.
[1] TRU defended itself, invoking the free-rider rationale. This the Commission rejected as pretext. TRU’s argument was better than the Commission gave it credit for, but it failed to press its best argument. That failure stems in part from the shortcomings of the standard free rider formulation, and in part from the defendant’s need to tailor its arguments to ill-fitting doctrinal constraints. TRU attempted to convince the Commission that its actions were unilateral, within the Colgate exception.[2] Perhaps they were, although the Commission found to the contrary. Regardless, the net result was suppression of an efficiency rationale that emphasized the benefits of cooperation by the toy manufacturers.In this paper, I will argue that TRU emphasized the wrong free rider problem. Properly framed, the behavior of TRU and the toy companies can be seen as consistent with the efficiency goals of antitrust policy. That a plausible efficiency argument can be constructed does not mean that the outcome itself was wrong. My narrow focus here is on showing that the standard formulation led to asking the wrong question.
Part I provides a brief overview of the market and TRU’s behavior. Part II summarizes the defense’s rationale and the Commission’s rejection of it. Part III provides an alternative explanation. Part IV concludes.
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Lipton and Rowe's Apologia for Delaware: A Short Reply
Ronald J. Gilson
December 2001
In Unocal Fifteen Years Later I offered a respectful but negative assessment of the Delaware Supreme Court's post- Unocal efforts to walk a line between managerialists who believe directors should be able to block a hostile takeover, and those who believe the ultimate decision whether to accept a takeover bid belongs to the shareholders. I suggested that Delaware law could be repositioned without requiring the Delaware Supreme Court to confess error by allowing shareholder adopted bylaws that repeal or amend poison pills. Martin Lipton and Paul Rowe responded to my essay by arguing that recent economic challenges to efficient market theory, together with studies showing that the poison pill leads to increased takeover premia, undermines the premise on which a shareholder choice regime is based. In this reply, I correct Lipton and Rowe's misunderstanding of the role of market efficiency (and recent critical studies) in assessing shareholders' role in the governance of takeovers, as well as their assessment of why a poison pill may increase takeover premia.
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The Content of Our Casebooks: Why Do Cases Get Litigated
Samuel Issacharoff
January 2002
Forthcoming in Florida State Law Review, Vol. 29, No. 4This is the 2000 Mason Ladd Lecture delivered at Florida State. It is intended primarily for law students as a guide to the different approaches to the question of why cases actually litigate. The article begins with the premise that in any dispute the only mechanism for reducing the joint welfare of the parties is to engage agents to litigate the distribution of the contested assets. Beginning with that premise, the Article traces the various explanations given for why cases do actually proceed to litigation. The first part of the article is a rendition of the classic account from the economic analysis of law. The second, and longer, part of the Article then turns to various behavioral insights that call into question some of the simpler assumptions of the standard law and economics account of litigation. The paper includes data drawn from posing classic framing questions to the first-year body at FSU to highlight some of the behavioral considerations in litigation.
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Economic Development, Legality, and the Transplant Effect
Daniel Berkowitz, Katharina Pistor & Jean-Francois Richard
September 2001
Forthcoming in European Economic Review
We analyze the determinants of effective legal institutions (legality) using data from forty-nine countries. We show that the way the law was initially transplanted and received is a more important determinant than the supply of law from a particular legal family. Countries that have developed legal orders internally, adapted the transplanted law, and/or had a population that was already familiar with basic principles of the transplanted law have more effective legality than countries that received foreign law without any similar pre-dispositions. The transplanting process has a strong indirect effect on economic development via its impact on legality, while the impact of particular legal families is weaker and not robust to alternative legality measures.
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On the (Fleeting) Existence of the Main Bank System and Other Japanese Economic Institutions
Curtis J. Milhaupt
November 9, 2001
In an accompanying essay to be published in the same journal, Professors Miwa and Ramseyer (M&R) argue that most of the comparative corporate governance academy interested in Japan has been chasing a myth. The myth, which M&R largely attribute to economist Masahiko Aoki’s influential theories tying Japanese production to a system of delegated bank and governmental monitoring, is the existence of the "main bank system" and the related institutions of lifetime employment and keiretsu groups.
In this essay, I critique M&R’s revisionist thesis. After a brief survey of formative events in the creation of the "conventional wisdom" about Japanese corporate governance, I present data and analysis that call into question the significance of the evidence relied upon by M&R to substantiate their claims. Next, I sketch a legal and norm-based analysis of postwar corporate governance that complements Aoki’s economic perspective. I conclude that while M&R provocatively challenge several stylized facts, they do not ultimately cast great doubt on the power of Aoki’s theoretical construct or the (past) existence of Japan’s institutional setting for corporate governance. Interested observers can rest at ease: these economic institutions did exist. Attention can now turn to a more pressing issue: how best to replace them.
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Institutional Change and M & A in Japan: Diversity Through Deals
Curtis J. Milhaupt & Mark D. West
November 5, 2001
This Article offers new perspectives on the market for corporate control, the convergence debate, and Japanese corporate governance. We begin by applying in the corporate governance setting two related insights from other fields: from economics, the theory that there is no universally efficient organizational model; from organizational behavior, evidence that diverse groups outperform homogeneous ones. We then consider the potential for convergence toward a particular governance technology—the market for corporate control—to increase the desirable trait of diversity within economic systems. Takeovers, we argue, are not exclusively a disciplinary device, but also an engine of managerial and legal innovation.
We apply these insights to Japan through a detailed examination of previously unexplored data on Japanese M&A. We first link the historically low level of Japanese M&A activity to a thick institutional environment much more complex than the conventional focus on cross-shareholding suggests. Among the more startling findings is the existence of negative control premiums in Japanese tender offers and the role of legal shareholder protections in dampening the market for corporate control. Next, we show how the dearth of takeovers is inextricably linked to the lack of diversity in Japanese corporate practices. We then explore how recent changes in "institutions for deals" in Japan correlate with increased takeover activity, which in turn is linked to the creation of a broader range of governance practices, managerial innovations, and structural shifts in corporate lawmaking processes. The Article concludes by analyzing the implications of our findings for two academic debates: the role of functional substitutes in comparative corporate governance theory, and the impact of legal investor protections on corporate governance patterns.
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Competition Among Securities Markets: A Path Dependent Perspective
John C. Coffee, Jr.
April 1, 2002
Today, there are an estimated 150 securities exchanges trading stocks around the world. Tomorrow (or at least within the reasonably foreseeable future), this number is likely to shrink radically. The two great forces reshaping the contemporary world - globalization and technology - impact the world of securities markets in a similar and mutually reinforcing fashion:
(1) they force local and regional markets into more direct competition with distant international markets;
(2) they increase overall market capitalization and lower the cost of equity capital, as issuers are enabled to access multiple markets; and
(3) they permit order flow and liquidity to migrate quickly from local markets to international "super-markets," sometimes with adverse consequences for smaller domestic markets.
In overview, these consequences follow because globalization has lowered the barriers to cross-border capital flows, including in particular traditional restrictions on foreign investments in domestic stocks, while technology has made instantaneous information flows feasible, thereby enabling electronic securities markets to link dealers and markets participants around the world in continuous world-wide trading.
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The Acquiescent Gatekeeper:
Reputational Intermediaries, Auditor Independence and the Governance of Accounting
John C. Coffee, Jr.
The role of "gatekeepers" as reputational intermediaries who can be more easily deterred than the principals they serve has been developed in theory, but less often examined in practice. Initially, this article seeks to define the conditions under which gatekeeper liability is likely to work - - and, correspondingly, the conditions under which it is more likely to fail. Then, after reviewing the recent empirical literature on earnings management, it concludes that the independent auditor does not today satisfy the conditions under which gatekeeper liability should produce high law compliance. A variety of explanations - - poor observability, implicit collusion, and high agency costs within the gatekeeper - - provide overlapping explanations for gatekeeper failure. What remedy should work best to minimize such failures? As a more appropriate and supplementary remedy to reliance on class action litigation, this article recommends fundamental reform of the governance of the accounting profession. In particular, it contrasts the structure of self-regulation within the broker-dealer industry with the absence of similar self-discipline in the accounting profession. While such reform may be unlikely, its absence strongly implies that earnings management is likely to remain a pervasive phenomenon. Download this paper in Acrobat formatForthcoming in Pennsylvania Law Review, Vol. 149, Issue No. 6, 2001
This paper analyzes the origins, persistence, and current evolution of a series of non-legal rules (or "norms") that have played an important role in Japanese corporate governance. The four central features of the governance environment examined here include: 1) the main bank system, in which banks voluntarily restructure loans to some distressed borrowers, 2) a social distaste for hostile takeovers, 3) implicit promises of employment stability, and 4) belief systems about the proper role and structure of the board of directors. I show that, despite virtually ubiquitous claims to the contrary, these norms do not enjoy a long history of practice in Japan, but rather emerged only in the immediate postwar period. I hypothesize that they emerged for two reasons: First, they served as a low-cost substitute for a troubled formal institutional environment beset by the "transplant effect" that imperils legal reform in transition economies today. Second, they provided private benefits to the small number of interest groups that emerged intact from World War II. The flow of private benefits to norm adherents explains the persistence of the norms despite clear evidence of their inefficiency over the past decade.
I demonstrate that current models of norm reform, which emphasize the role of exogenous shocks, the workings of norm entrepreneurs, and increased information, explain why the norms of Japanese corporate governance are currently evolving.
Finally, extrapolating from Japan’s experience, I suggest how norm analysis can contribute to the two most pressing questions in comparative corporate governance today: whether law matters to corporate governance, and whether diverse systems of corporate governance are converging toward the Anglo-American model. As to both questions, I suggest that closer attention to norms reveals shortcomings in the existing literature.
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Publication Rules in the Rulemaking Spectrum: Assuring Proper Respect for an Essential Element
Peter L. Strauss
March 7, 2001
The American rulemaking spectrum ranges from one Constitution, through hundreds of congressional statutes, thousands of administrative regulations, and tens of thousands of important guidance documents to innumerable more casual agency documents such as press releases or letters of advice. Our legal system treats constitutions, statutes and regulations, if valid, as binding text, subject only to the requirements that they be authorized by the superior authority and appropriately adopted following designated procedures; if valid, each of them has legislative effect on government and citizen alike, until displaced by another text validly adopted at the same or a higher level. The innumerable casual items at the base of this pyramid, while often in fact influential on private conduct, are denied any formal jural effect. It is at the level of important guidance documents that one finds confusion; confusion whether they are legitimate instruments of agency policy or a ruse to evade the higher procedural obligations associated with adopting regulations; confusion whether an agency may give them any jural effect and, if so, to what degree; and confusion whether and to what extent they must be respected by the courts. Since the frequency with which these documents are prepared suggests their importance, this confusion is regrettable.
Generally ignored provisions of the American Administrative Procedure Act, 5 U.S.C. 552(a)(1,2), appear to recognize that these documents may be treated as if they were precedents (not legislative documents) if they have been appropriately published. Hence, they may be described as "publication rules," to distinguish them from the more formal regulations that are adopted following notice and comment procedures and that enjoy, if valid, legislative effect. The paper builds on these provisions to critique recent judicial decisions and to suggest a general approach to publication rules following the model of precedent.
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Tax Constraints on Indexed Options
David M. Schizer
February, 2001
Indexed stock option grants reward executives for outperforming a benchmark, such as the market as a whole or competitors in the same industry. These options offer superior incentives by diminishing the influence of factors beyond an executive's control, such as general market and industry conditions. Yet indexed options are almost never used. Professor Levmore seeks to explain this puzzle with norms. The main point of this comment on his Article is that tax plays a larger role in this puzzle than Professor Levmore acknowledges, although tax is not a complete explanation. The tax appeal of traditional options is that they offer value that is not really performance-based (i.e., a bet on the market as a whole), but nevertheless is treated as Aperformance based@ under Section 162(m) -- and thus is deductible without limitation. Accounting and Professor Levmore's norms-based account are then briefly considered.
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Frictions as a Constraint on Tax Planning
David M. Schizer
February, 2001
In recent years, the government has enacted a series of narrow tax reforms targeting specific planning strategies. Sometimes these reforms stop the targeted planning, but sometimes they merely prompt a new, more wasteful variation. The difference often lies in so-called frictions, which are constraints on tax planning other than the tax law, such as fees, accounting or regulatory treatment, credit risk, and the like. While frictions are important, reformers often lack key information, and legal academics should help provide it. This Article offers general observations about frictions that deter end runs. Most promising are strong "discontinuous" frictions that impose significant costs when taxpayers depart, even in subtle ways, from the transaction covered by the reform. Costs of relying on frictions are also considered, including information costs and distributional effects. Two case studies also are offered involving tax-motivated use of derivative financial securities. These reforms use essentially the same statutory language, but taxpayers have responded differently – and frictions explain this difference. The first reform, the "constructive sale" rule of Section 1259, targets use of derivatives in effect to sell an appreciated asset without paying tax. The second, the "constructive ownership" rule of Section 1260, targets use of derivatives in effect to invest in a hedge fund (or other pass-through entity) without the usual adverse tax consequences (i.e., less deferral and a higher tax rate). Theoretically, taxpayers can avoid either rule through relatively modest changes in the derivative’s economic return. This strategy is commonly used to avoid Section 1259, a reality that was understood by government and taxpayers alike when the measure was enacted. In contrast, this strategy is not commonly used to avoid Section 1260. The difference, which was not well understood by Section 1260’s drafters, is that securities dealers cannot supply the derivative that theoretically avoids the rule.
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Mark Roe
January 16, 2002
A strong theory has emerged in recent years that the quality of corporate law determines whether securities markets will arise, whether ownership will separate from control, and whether the modern corporation will prosper. The theory has been used convincingly to explain why we see weak corporate structures in transition and developing nations, less convincingly to explain why concentrated ownership persists in continental Europe, and probably incorrectly to explain why ownership separated from control in the United States. Surely, when an economically-weak society lacks regularity?a gap that may be manifested by weak or poorly enforced corporate law?that lack of regularity and that lack of economic strength precludes complex institutions like securities markets and diffusely-owned 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 the decision is being made as to whether to diffuse ownership. Ownership cannot readily separate from control when managerial agency costs are especially high. And missing from current theory, empirical work, and discourse is the basic concept that even American corporate law? usually 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 full panoply of agency costs?such as over-expansion, over-investment, and reluctance to take on profitable but job-threatening risks?beyond any 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 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 protects shareholders. There is also good reason, and data, consistent with this analysis: by measurement several nations have fine enough corporate law; distant stockholders are well-protected from controlling stockholder and managerial thievery, but ownership in those nations still has not separated from control. As it happens, legally uncontrolled agency costs though seem to be especially high in those very nations. Download this paper in Acrobat formatProduct markets are weaker in some nations than they are in others.. Weaker product markets have more monopolies and more monopoly profits, both of which affect politics and corporate governance structures. They affect corporate governance structures directly by increasing managerial agency costs to shareholders, which shareholders then seek to reduce. One would expect corporate governance structures, laws, and practices to differ in nations with monopoly-induced high agency costs from those prevailing in nations with more competition, fewer monopolies, and lower agency costs. The monopoly profits also affect corporate governance structures indirectly by setting up a fertile field for conflict inside the firm as the corporate players—shareholders, managers, and employees—seek to grab those monopoly profits for themselves. And we might speculate that these rents when large enough affect democratic politics and law-making: directly by making monopolists political targets (and political forces); and indirectly as the players inside the firm seek to capture those monopoly profits through political action, with political parties and ideologies (and, in time, laws and standards) that parallel the players’ places inside the firm. Data from the industrial organization, finance economics, and political science literature is consistent.
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Recent empirical work has found that the private benefits of control differ significantly depending upon the underlying legal system in which the firm is incorporated. In particular, common law systems appear to outperform French civil law systems, but are trumped in turn by Scandinavian civil law systems. This evidence could be read to support the "law matters" thesis first advanced by Professors LaPorta, Lopez-de-Silanes, Shleifer and Vishny, which finds that "common law" legal systems incorporate superior legal protections for minority shareholders and therefore have deeper capital markets and more dispersed ownership. But the apparent superiority of Scandinavian legal systems complicates, and possibly subverts, this analysis, both because Scandinavian legal systems are more "like" other civil legal systems than they are "like" common law legal systems and because Scandinavian law does not encourage private enforcement of law through class actions and similar devices. Hence, an alternative hypothesis suggests itself: social norms in Scandinavia may discourage predatory behavior by those in control of the firm. This paper explores the competing merits of these two rival hypothesis - - law versus norms as instruments of social control - - by comparing the private benefits of control in various countries to other benchmarks, such as rates of criminal victimization. Although it finds no universal pattern, some strong congruences are discernible within particular legal systems (i.e., Scandinavian crime rates are very low, as are the private benefits of control that controlling shareholders expropriate from Scandinavian firms). A revised hypothesis is thus suggested: crime rates and the private benefits of control are the lowest in countries having the highest level of social cohesion and the lowest level of recent social and political disruption. This explanation works well for countries with crime and high private benefits of control (e.g., Russia, Mexico, and Brazil), but less well for many common law countries (such as the U.S.) in which the private benefits are low, but crime is high.
One implication of this comparison is that the impact of norms may be greatest when law is the weakest. This possibility may explain best why behavior within Scandinavian firms is different from that in French civil law firms, when both share relatively weak legal rights.
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Deep and liquid securities markets appear to be an exception to a worldwide pattern in which concentrated ownership dominates dispersed ownership. Recent commentary has argued that a dispersed shareholder base is unlikely to develop in civil law countries and transitional economies for a variety of reasons, including (1) the absence of adequate legal protections for minority shareholders, (2) the inability of dispersed shareholders to hold control or pay an equivalent control premium to that which a prospective controlling shareholder will pay, and (3) the political vulnerability of dispersed shareholder ownership in left-leaning "social democracies." Nonetheless, this article finds that significant movement in the direction of dispersed ownership has occurred and is accelerating across Europe.
But can this trend persist in the absence of strong legal protections for minority shareholders and in the presence of high private benefits of control? To understand how dispersed ownership might both arise and persist in the absence of the supposed legal and political preconditions, this article reconsiders the appearance of dispersed ownership in the late 19th and early 20th Centuries in the U.S. and the U.K. and contrasts their experience with those of France and Germany over the same period. During this era, the private benefits of control were high, and minority legal protections in the U.S. were notoriously lacking, as the famous Robber Barons of the age bribed judges and legislators and effectively employed regulatory arbitrage to escape even minimal anti-fraud regulation. Nonetheless, strong self-regulatory institutions (most notably, the New York Stock Exchange) and private bonding mechanisms by which leading underwriters pledged their reputational capital by placing directors on the board of sponsored firms enabled the equity market to expand and dispersed ownership to arise. In contrast, in the U.K., the London Stock Exchange for a variety of path-dependent reasons played a far more passive role and did not become an effective self-regulator until much later in the 20th Century. Yet, dispersed ownership also arose, although at a slower pace. The lesser role for private self-regulation in the U.K. may have been the consequence of its lesser need for self-regulation as a functional substitute for formal law, given both earlier legislation in the U.K. and lesser exposure to judicial corruption and regulatory arbitrage.
In contrast to the New York and London Exchanges, the Paris Bourse over this same period made little, if any, effort to develop a self-regulatory structure or to upgrade listing or disclosure standards. Why not? The answer seems closely associated with the fact that it operated as a state-administered monopoly whose stockbrokers were formally considered civil servants and who were legally denied the ability to trade as principals for their own account. Facing no competition and composed of members having little incentive to promote or enhance its reputational capital, the Paris Bourse did not innovate and fell behind the London Stock Exchange. The intrusive role of state regulation, which discouraged private self-regulatory initiatives, appears to have a factor in its competitive decline. In Germany, the state strongly supported the growth of large private banks but imposed a high stamp tax on securities transactions that quickly chilled the then growing securities market. In addition, because the German central bank offered very liberal rediscounting terms to the principal private banks, German banks were in effect subsidized in their role as providers of capital to German heavy industry, while the securities market was correspondingly denied the ability to extend credit by punitive legislation enacted in 1896. In this respect, concentrated ownership seems less to have evolved naturally than to have been subsidized by the state.
What then are the preconditions for the separation of ownership and control? The U.S. and European experiences in the late 19th Century suggest that the first step is the separation of the market from politics. When, as in late 19th Century France, the government administers the market, the market suffers. Although proponents of the "law matters" hypothesis argue that liquid securities markets cannot develop in the absence of a legal system that protects shareholder rights, the U.S. and U.K. experience are to the contrary and suggest that functional substitutes for close governmental regulation can be developed. This conclusion does not require rejection of the "law matters" hypothesis, because the principal historic advantage that common legal systems gave the embryonic securities markets of the late 19th Century was a decentralized state, in which self-regulation was the norm and close state control the exception. In contrast, in civil law systems of the same era, the state monopolized all law-making initiatives.
The critical achievement of self-regulation in the United States was the development of mechanisms by which control could be held in the public market, rather than simply in the hands of controlling shareholders. During the late 19th Century, this meant protection from predatory raiders who sought to assemble controlling blocks without paying a control premium. In both the U.S. and the U.K., these protections were first developed through private (or semi-private) ordering and then formalized in legislation. For the future, private ordering may similarly be able to close much of the gap between "advanced" Western legal systems and those of transitional economies, even in the absence of desirable reforms in mandatory law. By no means does this article argue that state regulation of securities markets is undesirable or unnecessary. Market manipulations have characterized all unregulated securities markets and have ultimately elicited regulation. Its more modest claims are that (i) intelligent self regulation by securities exchanges and professional associations in transitional economies can close much of the gap between "advanced" Western markets and those of transitional economies, and (ii) the first necessary step towards dispersed ownership is to enable control to be held in the market by legal rules and/or private ordering mechanisms that protect the public shareholder from stealth acquisitions of control.
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Forthcoming in Revue Internationale du Droit d'Auteur, January 2001
A dispute resolution panel of the World Trade Organization in June 2000 held the United States in contravention of its obligation under art. 13 of the TRIPs accord to Aconfine limitations or exceptions to exclusive rights to certain special cases which do not conflict with a normal exploitation of the work and do not unreasonably prejudice the legitimate interests of the right holder.@ In the dispute resolution proceeding, initiated by the European Union at the behest of the Irish performing rights organization, the contested exception, enacted in the 1998 ADigital Millennium Copyright Act,@ exempted a broad range of retail and restaurant establishments from liability for the public performance of musical works by means of communication of radio and television transmissions.
The WTO panel decision marks the first time an international adjudicative body has interpreted either art. 13 of TRIPs, or art. 9.2 of the Berne Convention, the text TRIPs incorporates, and generalizes from the Berne Convention reproduction right to all TRIPs and Berne rights under copyright. Berne art. 9.2/TRIPs art. 13 impose the Athree-step test@ to evaluate the legitimacy of exceptions and limitations on copyright; the panel's decision extensively analyzes each of the steps. As other multilateral instruments, such as the 1996 WIPO Copyright Treaty (art. 10) and WIPO Performers and Phonograms Treaty (art. 16.2), as well as the pending European Union Information Society Directive (art. 5.4), increasingly adopt the Athree-step test,@ the WTO Panel decision may significantly advance the development of a truly supra national law of copyright.
This article will analyze the Panel's interpretation of the test's three steps, and their application to the U.S.-law exemption. The article will also compare the Panel's treatment of the three-step test with the prior analyses proposed by several Berne Convention commentators, in order to reflect on what the Panel's analysis might mean for copyright exceptions more broadly. It is important to recognize, however, that the decision's actual impact on international copyright law will also depend on other considerations that will not be addressed here, including: Member State compliance with Panel decisions; the precedential effect of one Panel decision on later dispute resolution panels; and the willingness of national courts to look to WTO Panel decisions for guidance in evaluating local exceptions.
Download this paper in Acrobat formatSales and Elections as Methods for Transferring Corporate Control
Ronald J. Gilson & Alan Schwartz December, 2000 Under standard accounts of corporate governance, capital markets play a significant role in monitoring management performance and, where appropriate, replacing management whose performance does not measure up. Recent case law in Delaware, however, appears to have altered dramatically the mechanisms through which the market for corporate control must operate. In particular, the interaction of the poison pill and the Delaware Supreme Court's development of the legal standard governing defensive tactics in response to tender offers have resulted in a decided, but as yet unexplained, preference for control changes mediated by means of an election rather than by a market. In this paper, we begin the evaluation of the preference for elections over markets that the Delaware Supreme Court has not yet attempted. We apply to this effort both doctrinal logic and insights derived from an interesting but complex formal literature that has developed to understand how voting structures work in political contests and jury deliberations. Since these contexts differ substantially from transfers of corporate control, our analysis raises a question of fit: are voting models suitable for analyzing the question asked here; In our view, the models do shed some light on the takeover institution, but if this view is ultimately rejected, then we will have eliminated what at least superficially appears to be a useful set of tools.