The Law and Finance account of the ubiquity of controlling shareholders in developing markets is based on conditions in the capital market: poor shareholder protection law prevents controlling shareholders from parting with control out of fear of exploitation by a new controlling shareholder who acquires a controlling position in the market. This explanation, however, does not address why we observe any minority shareholders in such markets, or why controlling shareholders in developing markets are most often family-based. This paper looks at the impact of bad law on shareholder distribution in a very different way. Developing countries typically provide not only poor minority protection, but poor commercial law generally. Specifically, the paper considers the impact on the distribution of shareholders of conditions in the product market, where the driving legal influence is the quality of commercial law that supports the corporation's actual business activities, and where the presence of a controlling family shareholder may help support reputation-based trading in a bad commercial law environment.

Keywords: controlling shareholders, family ownership, developing countries

JEL Classifications: G30, K22, L14, L22, O10

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=957895

We address one of the cardinal puzzles of European corporate law: the lack of derivate shareholder suits. In the vast majority of European jurisdictions, shareholders can bring a derivative action (for damages) against the management for breach of fiduciary duty. In spite of corporate fraud by managers there are no such lawsuits. We explain this apparent paradox on the basis of percentage limits which are extremely wide-spread in Europe and typically require shareholders to hold a minimum amount of 5% to 10% in order to bring an action against the management. Since small shareholders are not entitled to sue, there is an incentive for managers to collude with large shareholders. We show that, with the current percentage limits, managers will misappropriate corporate assets and split the proceeds with large shareholders. Contrary to current and past approaches to agency theory, we find that, in this equilibrium, (1) large shareholders do not monitor the management, (2) small shareholders do not free ride and (3) the residual ownership is not held by the shareholders on the whole but by the managers and the large shareholders. This interpretation of the current situation is consistent with empirical studies that find a more concentrated shareholder structure in Europe than in the United States. With lower percentage limits, the results are as predicted by past approaches to agency theory. It reflects the situation of a jurisdiction that has lowered the percentage limits beyond a certain threshold.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=933105

University of Chicago Press, 2008

This book explores the relationship between legal systems and economic development by examining, through a methodology we call the institutional autopsy, a series of high profile corporate governance crises around the world over the past six years. We begin by exposing hidden assumptions in the prevailing view on the relationship between law and markets, and provide a new analytical framework for understanding this question. Our framework moves away from the canonical distinction between common law and civil law regimes. It emphasizes the constant, iterative, rolling relationship between law and markets, and suggests that how a given country's legal system rolls with economic changes depends significantly on its organization rather than its formal characteristics or legal origin. We find that legal systems around the world differ significantly along two crucial organizational dimensions: their degree of centralization of the lawmaking and enforcement processes, and the primary function law serves in support of market activity, ranging from protective functions to coordinative functions.

We use this analytical framework to understand why countries as diverse as the United States, Germany, Japan, Korea, China, and Russia have all experienced corporate crises in recent years, and to analyze the different institutional responses to these crises. These case studies provide insights into the diversity of legal systems and institutional arrangements that support capitalist activity over time and across a range of societies. They also suggest that systemic legal change is rarely achieved by changes in formal law alone, but is the result of changes in the composition and identity of core constituencies within a given system who use (or avoid) law to advance their position in the market. Among other things, our study suggests the need for new thinking about how and why legal systems change, the limits of convergence even in a world where national laws increasingly look alike, and a new emphasis on the demand for law in the process of legal adaptation and change.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=987291

11 Lewis & Clark Law Review, 481, 2007

Policy debates about the appropriate risk levels for individual retirement plans and social retirement plans (like social security) often pay insufficient attention to the  inescapable trade-off between “payment risk” (the risk of insufficient funding for anticipated benefits) and “short fall risk” (the risk of insufficient benefits for a satisfactory retirement).   Thus a “prudent retiree rule” would permit a prudent level of  “contingent funding” of retirement payouts.  Contingent funding – basing benefit expectations on funding sources that may not materialize – increases payment risk, yet pension systems without some contingent funding will produce inferior benefits in most states of the world, increasing shortfall risk.  Contingent funding can take different forms: underfunding (in an actuarial sense) of defined benefit promises, which means reliance on the firm’s continued profitability; a tilt toward equity investments in a defined contribution plan, including an appropriate level of employer own stock,  and reliance on pay-as-you-go (PAYGO) funding of social security benefits in which each generation funds its predecessor’s benefits.  The case for the prudent retiree rule is strengthened through a better appreciation of the underlying risks to retirement security:  demographic risk (too many retirees relative to workers); economic risk (insufficient economic growth) and distributional risk (non-effort-based individual economic outcomes).  Policies that address these risks can significantly reduce the risks associated with contingent funding.

JEL:  D30, G23, G28, H55, Ill , J18, J38, K31

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1000231

August 2007
University of Pennsylvania Law Review, Vol. 156, 2008 

Risk-based rules are the tax system's primary response to aggressive tax planning. They usually grant benefits only to those taxpayers who accept risk of changes in market prices (market risk) or business opportunities (business risk). Attempts to circumvent these rules by hedging, contractual safeguards, and diversification are well-understood. The same cannot be said about a very different type of tax planning. Instead of reducing risk directly, some taxpayers change the nature of risk. They enter into informal, legally unenforceable agreements with contractual counterparties that are designed to eliminate market or business risk entirely. The new uncertainty these tax planners inevitably accept, however, is the risk (counterparty risk) that the counterparties will violate the implicit agreements and betray taxpayers' trust. A deliberate substitution of counterparty risk for market or business risk is what this Article calls relational tax planning. The Article offers an economic analysis of different risks and considers two responses to the relational tax planning problem. The analysis suggests that business risk is superior to both market and counterparty risks. Counterparty risk is the most complex of the three. In addition to risk-bearing losses produced by all risks, it reduces transaction costs of future exchanges between relational tax planners, but only if they manage to overcome bargaining obstacles caused by opportunism and asymmetric information. These insights suggest two very different responses. A sweeping reform will allow - and even encourage - taxpayers to engage in relational tax planning, but will also ensure that counterparty risk they incur is sufficiently high. If only incremental improvements are pursued, courts should increase their scrutiny of relational tax planning involving extensive dyadic business relationships and interactions based on social norms.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1008099

August 2007

In the analysis of vertical integration by contract versus ownership one event has dominated the discussion–General Motors’ merger with Fisher Body in 1926. The debates have all been premised on the assumption that the ten-year contract between the parties signed in 1919 was a legally enforceable agreement. However, it was not. Because Fisher’s promise was illusory the contract lacked consideration. This note suggests that GM’s counsel must have known this. It raises a significant question in transactional engineering: what is the function of an agreement that is not legally

August 2007

A casebook favorite for exploring the liquidated damage-penalty clause distinction is Lake River v. Carborundum in which Judge Posner found a minimum quantity clause to be an unenforceable penalty clause.  In this paper I argue that the case was framed improperly.  Had the litigators recognized that the contract afforded one party an option, the result should have been different. The contract was for the provision of a service—setting aside capacity—which was valuable to the buyer and costly to provide for the seller. The primary purpose of the minimum quantity clause was the pricing of that service.  The case raised indirectly a significant damages issue: if there is an anticipatory repudiation of a contract that is take-or-pay or has a stipulated damage clause, should the promisee’s ability to mitigate be taken into account when reckoning damages?

June 8, 2007

Literature suggests two distinct paths to stock market development: an approach based on legal protections for investors, and an approach based on self-regulation of listed companies by stock exchanges. This paper traces China's attempts to pursue both approaches, while focusing on the role of the stock exchanges as regulators. Specifically, the paper examines a fascinating but unstudied aspect of Chinese securities regulation, namely, public criticism of listed companies by the Shanghai and Shenzhen exchanges. Based on both event study methodology and extensive interviews of market actors, we find that the criticisms have significant effects on listed companies and their executives. We evaluate the role of public criticisms in China's evolving scheme of securities regulation, contributing to several strands of research on the role of the media in corporate governance, the use of shaming sanctions in corporate governance, and the importance of informal mechanisms in supporting China's economic growth.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=999698

May 30, 2007

The rise of the network as a form of economic organization renders problematic our standard understanding of how capitalism is governed. As the governance of production shifts from vertical integration to horizontal contract, a puzzle arises: how do contracts, presumed to be susceptible to hold-up problems due to incompleteness, control production arrangements that by their nature invite opportunism?  Relying on publicly-available contracts taken from a number of industries, I argue that firms govern their collaborations through a number of new contract mechanisms, the summation of which is a novel governance system.  Because traditional theories of contractual control struggle to fully explain this new behavior, I re-conceptualize contracting as an effort, inter alia, to establish a pragmatic learning process between collaborators.  Such a learning process must be formally instituted among parties because of the unique, endogenous, and pervasive uncertainty that characterizes bilateral experimentation.  Thus, to standard accounts of incomplete contracting, this article provides an alternative (but complementary) explanation of how contract governs inter-firm networks, not by downplaying the importance of hold-ups or by inflating the role of relational norms but by explicating a new positive theory of contract design.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1014420

January 2008

In the United States, few failing businesses invoke the Bankruptcy Code to reorganize or liquidate. Most use non-bankruptcy procedures to accomplish the same purposes. These procedures include voluntary agreements between the debtor and its creditors (workouts) and formal devices such as friendly foreclosures, bulk sales, and assignments for the benefit of creditors. This paper documents the importance of non-bankruptcy procedures using firm-level data from Cook County, Illinois. I find that these procedures are used by eighty percent of distressed small businesses. The paper also identifies the conditions under which a business chooses federal bankruptcy law over non-bankruptcy procedures. I model this choice - theoretically and empirically - as the outcome of a bargaining game between the debtor's owner and its senior lenders. The parties are more likely to consent to non-bankruptcy procedures when bargaining costs are low and when the debtor has maintained a close relationship with senior lenders, who trust the information provided by the owner. When the number of senior lenders is relatively large (raising bargaining costs) or when the debtor has defaulted on senior debt (thereby harming its relationship with lenders), senior lenders are more likely to push for a federal bankruptcy filing. Owners may also prefer a federal filing when in-bankruptcy rules give greater priority to particular creditors whom the owner would like to favor. These findings suggest that federal bankruptcy reforms, such as the Bankruptcy Abuse and Protection Act of 2005, will have two effects on distressed small businesses: They will impact outcomes in federal courts (intensive margin) as well as the debtor's choice between bankruptcy and non-bankruptcy procedures (extensive margin). Variation along the extensive margin can neutralize reforms in federal law, as when a reform designed to protect unsecured creditors raises the cost of federal law and induces businesses to use cheaper non-bankruptcy procedures instead.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1065543

The current debate over shareholder access to the issuer’s proxy for the purpose of making director nomination is both overstated in its importance and misses the serious issue in question.  The Securities Exchange Commission’s new e-proxy rules, which permit reliance on proxy materials posted on a website, should substantially reduce the production and distribution cost differences between a meaningful contest waged via issuer proxy access and a freestanding proxy solicitation. The serious question relates to the appropriate disclosure required of a shareholder nominator no matter which avenue is used.  Institutional investors and other shareholder activists should focus their energies on working through the mechanics of waging short-slate proxy contests using e-proxy solicitations.  Activist institutions need to prepare the disclosure package required under the existing proxy rules.   Such disclosure may be tested (and refined) through litigation, but a standardized package should emerge relatively quickly that the institution could use in proxy contests without a control motive.   Institutional investors need to become facile with the e-proxy model (including coordinating a practice for opting-in to web-access) and should appreciate the extent to which proxy advisory services will do much of the actual solicitation work.  If institutions are unwilling to make the relatively modest investment to master the mechanics of e-proxy contest, both in their initiation as well as voting in support of them, then their role in corporate governance will necessarily be limited.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1085356

59 Stanford Law Review 1465 (2007),

Between 1950 and 2005, the composition of large public company boards dramatically shifted towards independent directors, from approximately 20% independents to 75% independents.  The standards for independence also became increasingly rigorous over the period.  The available empirical provides no convincing explanation for this change.  This Article explains the trend in terms of two interrelated developments in U.S. political economy:  first, the shift to shareholder value as the primary corporate objective; second, the greater informativeness of stock market prices.  The overriding effect is to commit the firm to a shareholder wealth maximizing strategy as best measured by stock price performance.  In this environment, independent directors are more valuable than insiders.  They are less committed to management and its vision.  Instead, they look to outside performance signals and are less captured by the internal perspective, which, as stock prices become more informative, becomes less valuable.  More controversially, independent directors may supply a useful friction in the operation of control markets.  Independent directors can also be more readily mobilized by legal standards to help provide the public goods of more accurate disclosure (which improves stock price informativeness) and better compliance with law.  In the United States, independent directors have become a complementary institution to an economy of firms directed to maximize shareholder value.  Thus, the rise of independent directors and the associated corporate governance paradigm should be evaluated in terms of this overall conception of how to maximize social welfare.

60 Univ. Cincinnati L. Rev. 347 (1991)

By longstanding practice, shareholders of large public corporations have delegated almost all decision rights over business matters to the board of directors.  Given current calls for “shareholder empowerment,” it is worth revisiting the basis for the existing practice, as reflected in this 1991 paper.   Among other things, we see that this “absolute delegation rule” minimizes potential pathologies in shareholder voting, including possibilities for opportunistic side-dealings and destructive voting cycles.  These risks must be addressed  lest shareholder empowerment merely replace one set of problems with another. 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1086453  

Amerian Bankruptcy Law Journal, Vol. 79, p. 951, 2005

Recent scholarship emphasizes the increasing rarity of trials (adversary proceedings) in bankruptcy cases. We assess the importance of this pattern using data from the Northern District of Illinois. Adversaries are indeed rare - they are absent from the vast majority of bankruptcy cases - but their rarity tells us little that is meaningful about the bankruptcy process. They tend to be clustered in a tiny number of cases (one percent of bankruptcy cases account for over fifty percent of adversaries). They also focus on a narrow range of issues (objections to discharge in consumer cases; recovery of preferential transfers in business cases). Little has changed since the early 1990s. Although we see a decline in the rate with which adversaries are filed (from six percent of bankruptcy cases in 1993 to about three percent in the late 1990s), the baseline rate was already very low. The decline only tells us that a rare event has become rarer. One temporal change, however, is noteworthy: the average duration of adversaries fell from ten months to 7.5 between 1993 and 2002. This is consistent with recent evidence on the speediness of today's Chapter 11 process. These patterns tell us two things about the bankruptcy process. First, in consumer cases, the persistent rarity of adversaries, even when consumer filings surged during the late 1990s, casts doubt on claims that bankruptcy abuse was prevalent during the late 1990s and early 2000s. If abuse were becoming more prevalent, we should have seen more frequent use of adversaries to contest a debtor's discharge. Second, in corporate cases, adversary proceedings generally address issues, such as preferential transfers, that are orthogonal to the primary concern of Chapter 11 - rehabilitation of the debtor's business. Moreover, when adversaries are brought to attack preferential transfers, the proceedings are often commenced after the court has confirmed a plan of reorganization.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1065501

Bankruptcy Law Stories, Robert K. Rasmussen, ed., Foundation Press, Forthcoming

The Supreme Court's decision in Timbers of Inwood Forest occupies an unhappy position in bankruptcy case law. It is often remembered as a troubled interpretation of the Code, denying undersecured creditors compensation for an important source of depreciation - depreciation in the real value of a creditor's claim during a lengthy reorganization process. But Timbers was not a simple case in which a bank was denied adequate protection for lost investment opportunities. It was instead a case in which the bank tried to opt out of the bankruptcy process itself. The debtor was an apartment complex. After it entered bankruptcy, it assigned the apartment rents to the bank. These rents, economic theory tells us, closely approximated compensation for physical depreciation as well as lost investment opportunities. Yet the bank wanted more: it requested a second helping of compensation for lost investment opportunities, citing the Code's provision for adequate protection. Surprisingly, the bankruptcy court agreed; so did the Court of Appeals. But by the time the case reached the Supreme Court, it had morphed into something altogether different. Instead of an illustration of bank over-reaching, the case had become a vehicle for testing an abstract question - whether the phrase adequate protection encompasses compensation for lost investment opportunities. The Court may have decided that question incorrectly, but the end result - preventing bank over-reaching - was probably the right one. Indeed, Timbers' long-run impact may not go far beyond the parties to the case itself. The past fifteen years have seen legislative reforms, speedier cases, relatively low interest rates, and creditor control over the bankruptcy process, all of which have effectively neutralized Timbers' impact on most secured creditors.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1065041

February 22, 2008

The charitable deduction has enjoyed relatively little support in the legal academy.  Many commentators have asked what it adds to the tax system and, as critics have observed, the deduction obviously does not itself collect tax revenue.  Defenders respond that the deduction helps measure income and keeps taxpayers from inefficiently substituting leisure for work, but these points are, of course, contested.  Instead of revisiting debates about what the deduction adds to the tax system, this Article focuses on the broader question of what it adds to the pursuit of public goals. The deduction – and any other government subsidy that matches charitable contributions through the tax system (here called “subsidized charity”) – enlists private individuals to pursue public goals in a somewhat unique manner.  While in other settings the government delegates implementation but still specifies the goal to be pursued, charitable donors are allowed to select the goal as well.  Is it desirable to pursue public goals in this way? 

This Article analyzes three reasons to subsidize charitable contributions, each responding to a different information or incentive problem that is inherent in the pursuit of public goals.  First, the subsidy can counter free-riding by encouraging donors to be more generous. A second objective is to measure and respond to popular preferences about public goals.  Subsidized charity can encourage experimentation and competition and can empower minority perspectives that are underrepresented in the political process.  Yet subsidized charity also disproportionately represents the views of wealthy donors.  The third goal, which is new to the academic literature, is to recruit private donors to monitor the quality of nonprofits, so that the government can piggyback on these quality-control efforts. 

Since there are three competing rationales for the subsidy, its institutional design can vary depending upon which has priority – an insight that is new to the literature.  To encourage generosity, the subsidy should focus on wealthy donors, giving them broad discretion about which causes to support and targeting marginal contributions.  Recruiting these wealthy donors as monitors is largely compatible with this program.  Yet by focusing on wealthy donors, the subsidy may fail to reflect broad popular preferences.  In response, one option is to compensate with other policy instruments, such as government programs, to address the preferences of low-income nondonors.  While I find this approach appealing, others could reasonably want subsidized charity itself to be more representative.  Toward that end, we can go to extra lengths to persuade low income taxpayers to contribute more (e.g., through extra-generous matches) or, for that matter, to induce wealthy donors to contribute less (e.g., through caps on giving) or to support causes that reflect broad popular consensus (e.g., through limits on which causes are subsidized).  Yet the cost of making the subsidy more representative in this way is that it will be less effective at advancing our other goals of encouraging generosity and recruiting monitors.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1097644

February 18, 2008

Sovereign wealth funds (SWFs) have increased dramatically in size as a result of increased commodity prices and the increase in the foreign currency reserves of Asian trading countries. SWF assets now roughly equal those in hedge and private equity funds combined. This growth, and the shift of SWF investment strategy toward equities and increasingly high profile investments like capital infusions into U.S. financial institutions following the subprime mortgage problem, have generated calls for domestic and international regulation. The U.S. and other western economies already regulate the foreign acquisition of control of domestic corporations. However, acquisitions of significant but non-controlling positions are not regulated. The danger is that new regulation will compromise the beneficial recycling of trade surpluses accomplished by SWF investments.

In this paper, we situate the controversy over SWF investments in the increasing global trend toward direct governmental involvement in corporate activity, a phenomenon we label the New Merchantilism. We explain why increased transparency of SWF investment portfolios and strategy, the most commonly advanced policy recommendation, does not respond to the chief concern that SWF investments have engendered. We offer a regulatory minimalist response to fears that SWFs will make portfolio investments for strategic rather than economic reasons. Under our proposal, voting rights of SWF equity investments in U.S. corporations would be suspended but reinstated on sale. Thus, SWFs would buy and sell fully voting rights, thereby assuring that the incentives to make non-strategic investments would be unaffected, while the capacity to exercise influence for strategic motives would be constrained. The paper concludes by assessing the extent to which even a regulatory minimalist response remains both over and under inclusive; however, the limited imprecision does not undermine the effectiveness of the response.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1095023

March 27, 2008

The consensus view has long been that the class action plaintiff’s attorney possesses excessive discretion to prefer his own interests over those of the class. Critics have thus favored remedies such as the "lead plaintiff" provision of the Private Securities Litigation Reform Act ("PSLRA"), which in theory give class members a stronger voice. Empirically, however, such "voice-based" reforms appear to have had no more than a modest impact. But an alternative remedy appears to be more promising: "exit-based" reforms that seek to provoke greater competition between class counsel and attorneys soliciting class members to opt out of the class and file individual actions with them in state court. Unnoticed by academics, a major trend towards institutional investors opting out of securities class actions has developed over the past five years. More importantly, these opt outs appear to be recovering per share amounts that are a multiple of the class per share recovery. This development poses a variety of issues that this paper examines: (1) Do the opt outs gains come at the expense of those who remain in the class?; (2) Can defendants feasibly restrict opt outs and how should courts respond to such attempts?; (3) Are institutional investors under a fiduciary or ERISA-based duty to opt out?; and (4) Will greater competition produce greater accountability?

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1113845

March 10, 2008, 109 Colum. L. Rev. (Forthcoming 2009)

This paper explores the appropriate system of civil liability for mandatory securities disclosure violations by established, publicly traded issuers. The U.S. system's design has become outmoded as the underlying mandatory disclosure regime that has moved from an emphasis on disclosure at the time that an issuer makes a public offering, to an emphasis on the issuer's ongoing periodic disclosures. An efficiency analysis shows that, unlike U.S. law today, the relevant actors should have equally great civil liability incentives to comply with the disclosure rules whether or not the issuer is offering securities at the time.

An issuer not making a public offering of securities should have no liability because the compensatory justification is weak. Deterrence will be achieved instead by imposing liability on other actors. An issuer's annual filings should be signed by an external certifier - an investment bank or other well capitalized entity with financial expertise. If the filing contains a material misstatement and the certifier fails to do due diligence, the certifier would face measured liability. Officers and directors would be subject to similar liability. Damages would be payable to the issuer. When an issuer is making a public offering, it would be liable to investors for its disclosure violations as an antidote to what otherwise would be an extra incentive not to comply.

This design would address two major complaints concerning the existing U.S. civil liability system: underwriter Section 11 liability for a lack of due diligence concerning disclosures that in modern offerings underwriters have no realistic ability to police, and litigation-expensive issuer class action fraud-on-market liability. The system suggested here would eliminate both sorts of liability. But unlike elimination reforms proposed by underwriters and issuers, it would retain deterrence by substituting in place of these liabilities more effective and efficient civil liability incentives for disclosure compliance.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1115361

April 13, 2008

This Article examines zero-price regulation, the major distinguishing feature of modern network neutrality proposals compared to traditional regulation of infrastructure industries. A zero-price rule prohibits a broadband Internet access provider from charging a content provider to send information to consumers. The Article differentiates two access provider strategies thought to justify a zero-price rule. Exclusion is anticompetitive behavior that harms a content provider to favor its rival. Extraction is a toll imposed upon content providers to raise revenue. Neither strategy raises policy concerns that justify implementation of a broad zero-price rule. First, there is no economic exclusion argument that justifies the zero-price rule as a general matter, given existing legal protections against exclusion. A stronger but narrow argument for regulation exists where socially produced content--content (such as Wikipedia) produced by collaboration without anticipation of financial reward--competes with ordinary market production. Second, prohibiting direct extraction is undesirable and counterproductive, in part because it induces costly and unregulated indirect extraction. I conclude, therefore, that recent calls for broad-based zero-price regulation are mistaken.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1119982