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E EconomicAnalysis of companies and the more complex case of corpo- Corporate Law rate groups. David Gindis1 and Martin Petrin2,3 1Hertfordshire Business School, University of Foundations Hertfordshire, Hatfield, UK 2Faculty of Laws, University College London, Virtually all significant, large-scale business London, UK enterprises around the world are organized as 3Western Law, University of Western Ontario, corporations. Given the existence of alternative London, ON, Canada legal forms business organizers might adopt, the dominance of the corporate form suggests that it offers them some comparative advantages. The Synonyms basic legal characteristics of corporations – legal personality, limited liability, transferable shares, Anatomy of corporate law; Corporate law and delegated management under a board structure, economics; Economic structure of corporate law; and investor ownership (Armour et al. 2017) – Economics of corporate law; Functions of corpo- must be uniquely effective in reducing the costs rate law arising from the organization of productive and commercial activities. One purpose of the economic analysis of cor- Definition porate law is to assess the nature and origins of these relative benefits. Another is to weigh the The economic analysis of corporate law applies costs and benefits of specific existing or proposed the concepts and tools of microeconomics to the corporate law provisions. Still another is to study of the legal rules, regulations, and practices explaintheeconomicforcesshapingtheevolution that govern the formation and operation of busi- of corporate law through time and across geo- ness corporations, most notably as regards to the graphical space. When Henry Manne (1967) rights and duties of directors, officers, share- called for a research program into these questions, holders, and creditors. The literature has focused few tools were available for the task. Since the mostly on publicly-traded corporations, but the early 1970s, advances in the theory of the firm, analytical framework extends to the simpler financial economics, the economics of regulation, cases of close corporations and limited liability and other areas of applied microeconomics have supplied the requisite tools. The view of the firm ©Springer Science+Business Media, LLC, part of Springer Nature 2020 A. Marciano, G. B. Ramello (eds.), Encyclopedia of Law and Economics, https://doi.org/10.1007/978-1-4614-7883-6_767-1 2 Economic Analysis of Corporate Law as a contractual nexus is particularly important for notedbyAdamSmithandmanyotherssince(e.g., the economic analysis of corporate law. FamaandJensen 1983). Thetheoryofthefirmbuildsontheinsightthat Where the owners’ monitoring costs are high firms emerge to economize on transaction costs and the adverse consequences of managerial dis- (Coase 1937). These costs are reduced when the cretion severe, as would be the case if managers complex set of multilateral contracts between were shirking their duties or diverting corporate resource owners that would be required to orga- resources for personal gain, contracts will tend to nize production in markets is replaced by a much include some sort of profit-sharing scheme simpler set of bilateral contracts between each (recently, this has often involved stock-options). resource owner and a common central party or Whilethis reduces the conflict of interest by mak- agent. The central agent is the entrepreneur in a ing managers bear some of the residual risk, sole proprietorship and the owner-manager in agency costs are never quite zero. Some of the the capitalist firm (Alchian and Demsetz 1972). joint output value will necessarily be foregone, at In the case of the corporation, the central agent is the expense of the corporation’s investor-owners, the legal fiction of the separate legal person that who may use their residual control rights to ter- serves as a nexus for a set of contracting relations minate the managers’ contracts. amongindividuals (Jensen and Meckling 1976). Managers can moreover be replaced thanks to An enterprise is only worth pursuing if the the operation of the market for corporate control output value is large enough to cover the costs of (Manne1965).Totheextentthat the market price managing the firm. In any firm involving more of a corporation’s shares reflects managerial effi- than one agent with conflicting interests, manage- ciency, a decline in its price relative to others in ment costs arise from the difficulty of correlating the industry signals managerial efforts and rewards, given that effort is private underperformance, making it an attractive take- information that may be costly to detect. Agents over target for investors who believe they can realizing that their efforts can be reduced without restore efficiency by replacing the incumbent a proportional income loss have an incentive to management team. Whether effected through a shirk and free-ride on others’ efforts. Significant proxy fight, a direct purchase of shares or a management costs also arise from the need to merger, takeovers, and indeed their very threat, elicit specific investments by agents whose com- can be powerful checks on managerial discretion. mitment needs to be secured in the face of poten- Bymaximizingthebenefitsofatakeovertoinves- tial expropriation by other agents. tors, the one share-one vote rule further encour- Both underinvestment problems may be miti- ages the selection of efficient management teams gated by incentive-aligning contractual arrange- (Grossman and Hart 1988). ments. These are designed and policed by the entrepreneur in a sole proprietorship and the owner-manager in the capitalist firm. In a corpo- Classic Economics of Corporate Law ration, top management – broadly defined to include directors and officers – acts as if it were The theory of the firm outlined above does not the central agent, designing and policing the con- explain why most large firms are organized as tracts with employees and other parties. But man- corporations. The classic answer is that firms in agers must themselves be incentivized to act on which labor is the primary input are organized as behalf of the corporation’s owners, whose dele- sole proprietorships or partnerships, while firms gated powers they exercise. The agency problem needing to raise substantial amounts of capital associated with the separation of ownership and from large numbers of investors are organized as control, whereby decisions directly impacting the corporations (Posner 1973). To function as an firm’s survival are made by agents who bear little effective capital-raising device, the corporation or no share of the resulting wealth effects, was offers diversified investors a return that does not require personal oversight of the activities of any Economic Analysis of Corporate Law 3 one firm in their portfolios, as well as a low-cost agreed to had they addressed them explicitly. exit option. Share tradeability and the delegation Even for foreseeable contingencies, it may be of the organization of the corporation’s activities cheaper for courts to draft the contractual terms to a board of directors are thus desirable implica- necessary to deal with them, if and when they tions of the separation of ownership and control. arise. This division of labor between contracting Theefficientseparationofmanagerialandrisk- parties, legislatures, and courts maximizes returns bearing functions is also enhanced by limited to investors. investor liability, which distinguishes corpora- Somehaveobjectedthatit is impossible to opt tions from traditional (or general) partnerships, outofprovisionscoveringabroadrangeofissues, in which partners are personally liable for the including director elections, dividend payments, partnership’s debts. This deters risk-averse inves- disclosure requirements, derivative litigation, and tors, as do potentially high exit costs (associated, liquidation, and that mandatory rules exist to pro- for example, with the buyout option) and the tect the parties otherwise severely disadvantaged possibility of the partnership’s dissolution in the by information or power asymmetries (Gordon event of a partner’s death. While contractual pro- 1989). Others have countered that corporate visions may mitigate such risks, the transaction law’s mandatory rules are trivial, in the sense costs of negotiating limitations on liability in that they would have been universally adopted every partnership contract with creditors, sup- by contract had the parties thought about them pliers, and customers will be high. The corporate (Black 1990). In any event, of course, corporate form resolves these problems: its perpetual exis- law rules are to some degree avoidable, given tence removestheneedforcostlynegotiatedsolu- jurisdictional competition and the possibility of tions to the problems of exit and dissolution. regulatory arbitrage. Corporate law serves a transaction cost- Tieboutsortinginthemarketforcorporatelaw, economizing function by supplying a set of off- whereby firms reveal their preference for particu- the-rack terms specifying the rights and duties of lar bundles of corporate law rules and comple- directors, officers, shareholders, and creditors mentary public goods, such as judicial expertise (Easterbrook and Fischel 1991). The fiduciary and a well-developed body of case law (Winter duties of directors, for example, approximate the 1977), is a significant driver of the evolution of bargains that principals and agents would have corporate law. This explains why most US state reached had the bargaining and enforcement corporate law tends to replicate Delaware’s Gen- costs been sufficiently low. Corporate law works eral Corporation Law and may also apply to the like a standard-form contract, in which boiler- convergencedebatebeyondtheUSA(O’Haraand plate, nonnegotiated provisions anticipate the Ribstein 2009). However, there are good reasons parties’ needs (Macey 1993). It further enables to believe that different initial conditions produce business ventures to adapt to diverse and chang- divergent path-dependent trajectories and that ing circumstances by allowing for most default multiple equilibria and persistent divergence are terms to be altered, such that firm-specific gover- possible and likely (von Wangenheim 2018). nance structures may be evolved. That good corporate law approximates hypo- thetical bargains while giving effect to express Recent Functional Approaches agreements follows from the conception of the corporation as a set of contracts, which also Theclassicviewisthatcorporatelawspecifiesthe implies that courts should employ the same logic rights and duties of directors, officers, share- if they are to protect principals from their agents. holders, and creditors in order to obviate the Givencontractual incompleteness, in cases of dis- need for costly bargaining between the parties putes arising from unforeseen contingencies, involved. All corporate features could have been courts play a gap-filling role by supplying the achieved by contractual arrangement but only at a wealth-maximizing terms the parties would have greater cost. By contrast, recent research suggests 4 Economic Analysis of Corporate Law that the pattern of creditor rights associated with default terms, many of which may be waivable, the corporate form is rooted in property law and the business creditor priority rule is mandatory cannot be created by private contract alone and essential (Hansmann and Kraakman 2000). (ArmourandWhincop2007).Theessential func- Its purpose is not merely to protect some vulner- tion of corporate law,andorganizationallawmore able parties, but to create the sort of asset generally, is that it partitions assets and liabilities partitioning without which significant firms are in a manner that enables firms to operate. unable to operate. A firm can serve effectively as a nexus for The separation between business and personal contracts with creditors, suppliers, customers, assets is a feature of partnerships law, which pro- and other parties if its central agent has both the vides that in the event of the firm’s insolvency the authority to design and police the contracts in claims of the partners’ personal creditors are sub- question and the ability to bond its contractual ordinated to those of business creditors. Function- and financial commitments (Armour et al. 2017). ally, this makes the partnership a legal entity, even Thecentralagentmusthavecontroloverapoolof in jurisdictions (such as England) where lawyers assets that provides credible security to a fluctuat- point out that partnerships lack legal personality. ing group of creditors, which implies that the firm Partnerships, however,donotenjoytheadditional musthaveanassetpoolwhichisdistinct fromthe benefit of liquidation protection, which prevents personal assets of its managers or owners, against owners of corporations (or limited liability com- whichcreditors may enforce their claims in court. panies) from withdrawing all or part of their The firm, in sum, needs to be a separate legal equity share and stops their personal creditors person or legal entity with a capacity for property, from forcing a payout from the corporate assets contract, and litigation (Gindis 2016). (Hansmann et al. 2006). Akeydimension of the separation of business This stronger form of shielding protects the from personal assets is the extent to which the firm’sgoingconcernvaluebybarringopportunis- former are shielded from the personal creditors tic individual owners from threatening to with- of the firm’s owners. At the very least, this draw some corporate assets in order to extract a requires an arrangement where business creditors higher share of the surplus. In turn, this improves have priority over personal creditors. To achieve the incentives of employees, suppliers, and other this by contract even in the simplest of firms, an parties that are required to make the long-term, entrepreneur would need to secure the consent of firm-specific investments that maximize the joint present and future personal creditors to subordi- surplus value (Blair and Stout 1999). By delegat- nate their claims to those of present and future ing control over the assets used in the specializa- business creditors, who would need to agree to tion process to an independent board of directors limit their claims to some specified subset of the bound by a duty of loyalty and a duty of care, entrepreneur’s assets. Such a complex set of investors in effect help bring about this result agreements would likely never be reached, not while retaining their low-cost exit option. Histor- because of prohibitive transaction costs, but ically, this arrangement has served investors well because neither category of creditor has any rea- (Blair 2003). son to agree to such terms. This inability to separate business from per- sonal assets and liabilities makes it difficult to Specific Issues distinguish legally sole proprietorships from nat- ural persons. It also limits the significance of such While the partitioning of assets and liabilities a firm’s contractual and financial commitments. identified in recent functional approaches is Matters change considerably when an entrepre- undoubtedly important, it is neither entirely com- neur forms and becomes the sole shareholder of plete nor entirely unproblematic. Shareholders, a business corporation or a limited liability com- for example, may still be personally liable toward pany. While both legal entities come with a set of a corporation’s creditors where they themselves
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