Can Culture Constrain the Economic Model of Corporate Law?

The economic model of corporate law could, with a few simple moves, be seen as potentially having cultural limits. Or, better put, the economic model works well in the United States because not much impedes Coasean-style re-bargaining among the corporate players. Begin with the economic model without limit: Takeovers persisted in the face of anti-takeover law, one can argue, due to executive compensation that paid senior managers to stop strongly opposing takeovers. But executive compensation cannot be varied everywhere as easily as it can be raised in the Untied States. Where it cannot be easily varied, this kind of a Coasean re-bargain is harder than it is here. More generally, culture a) could affect the quality of institutional substitutes, b) could degrade some organizational-types but not others, and c) could reconfigure even a persisting economic model by choosing among equally effective arrangements. Other basic structures of corporate law - indeed, one could imagine even the public firm with diffuse ownership itself - could be subject to the degree to which local norms (and culture) allow parties to vary their deals smoothly. When norms make key variations costly, boundaries to the economic model of a type rarely present in the American corporation appear. I sketch out, with the help of the Symposium's papers, where those boundaries can be glimpsed

The Institutions of Corporate Governance

In this review piece, I outline the institutions of corporate governance decision-making in the large public firm in the wealthy West. By corporate governance, I mean the relationships at the top of the firm - the board of directors, the senior managers, and the stockholders. By institutions I mean those repeated mechanisms that allocate authority among the three and that affect, modulate, and control the decisions made at the top of the firm. Core corporate governance institutions respond to two distinct problems, one of vertical governance (between distant shareholders and managers) and another of horizontal governance (between a close, controlling shareholder and distant shareholders). Some institutions deal well with vertical corporate governance but do less well with horizontal governance. The institutions interact as complements and substitutes, and many can be seen as developing out of a primitive of contract law. In Part I, I sort out the central problems of corporate governance. In Part II, I catalog the basic institutions of corporate governance, from markets to organization to contract. In part III, I consider contract law as corporate law's primitive building-block. In Part IV, I briefly examine issues of corporate legitimacy that affect corporate governance by widening or narrowing the tools available. The interaction between political institutions and corporate governance institutions is an inquiry still in its infancy but promises large returns. In Part V, I re-examine corporate governance in terms of economies of scale, contract, markets, and property rights. Then I summarize and conclude

The Inevitable Instability of American Corporate Governance

American corporate governance faces two core instabilities. The first is the separation of ownership from control - distant and diffuse stockholders own, while concentrated management controls - a separation that creates not only great efficiencies but also big recurring breakdowns. In every decade since World War II, we've faced a fundamental large firm problem. Each emanated from this fundamental instability. We will not stabilize, once-and-for-all, this instability because some form of separation is necessary for large firms, because it provides large efficiencies, and because once we resolve one derivative problem, another will in time arise. The Enron-type scandals are just the latest manifestation of the core fissure in the large American public firm. The second instability arises from our decentralized and porous regulatory system. Decentralization has key advantages - such as flexibility, specialization, and multiple informational channels - but with the advantages come costs in porosity. Our decentralized regulatory system leaves each regulator with weaknesses. Most importantly, they are not fully independent from the regulated. The regulated entities often deter the incompletely independent regulated from acting. The regulated can induce political authorities to deny the regulator enough power to act, they can get Congress to cut the regulator's funding, they can fight the potential regulations in courts and Congress, and they can weaken the quality of the regulation that they face. The Enron-class scandals illustrate this regulatory instability of American corporate governance well. Thus one structural response to the first fissure - separation and managers without immediate bosses - would be to facilitate gatekeeping, via strong boards that check managers, via strong shareholders with the motivation to channel managers toward profitability, via powerfully independent, professionally-driven accountants who verify managers' report card, and so on. Some of these gatekeeping functions arise from contract, best practice, and the natural path of the market. Many are facilitated by regulation, but here the regulated - often managers themselves - can affect the regulatory outcomes, often weakening it. Some regulation that does occur arises when public outrage is sufficiently high that the regulation is more brittle and less supple than would be ideal. Neither of these instabilities can be solved once-and-for-all, so that we can put it behind us. Instead, we resolve the local and immediate problem, move on, and in time face a new problem emanating from one or both of these core instabilities. We muddle through; we don't solve, because we can't

Structural Corporate Degradation Due to Too-Big-to-Fail Finance

The $6 billion trading loss at JPMorgan Chase — due to the over-sized trading positions taken by the bank’s London trader, colorfully called the London Whale — induced Senate inquiries and hearings earlier this year, embarrassing the bank and its otherwise respected chief, Jamie Dimon. Severe critics saw the bank’s massive loss as showing that banks still do not have their house in order after the 2007–2009 financial crisis, but most viewed the trading debacle as cautionary, not one fundamentally implicating regulatory policy. After all, the losses were only a fraction of JPMorgan’s$20 billion annual earnings. The setback was one for the bank’s shareholders and managers and, hence, one for ordinary corporate governance. Hence, the standard view is that the loss was no major public policy problem, as public funds were never really at risk. This set-up induces us to analyze the corporate governance of the too-big-to-fail American financial firm — analysis that has not yet been systematically done. For industrial conglomerates that have grown too large, internal and external corporate structural pressures arise to re-size the firm. External activists press the firm to restructure to raise its stock market value. Inside the firm, boards and managers see that the too-big firm can be more efficient and more profitable overall if restructured via spinoffs and sales. But for large, too-big-to-fail financial firms (1) if the value captured by being too-big-to-fail lowers the firms’ financing costs enough and (2) if a resized firm after spin-offs and break-ups would lose that funding benefit , then a major constraint on industrial firm over-expansion breaks down for too-big-to-fail finance. I argue in this paper that both propositions (1) and (2) have been true and, consequently, a major retardant to industrial firm over-expansion has been missing in the large financial firm. Debt cost savings — the implicit subsidy — in the too-big-to-fail financial sector have a magnitude amounting to a good fraction of the big firms’ profits. Directors contemplating corporate simplification and spin-offs at a too-big-to-fail financial firm face the problem that the spun-off, smaller firms would lose access to cheaper too-big-to-fail funding. Hence, they will be reluctant to push for break-up, for spin-offs and for slowing down firm expansion. They would get a better managed group of financial firms if their restructuring succeeded, but they would lose the too-big-to-fail subsidy embedded in the lowered funding costs. Subtly and pervasively, the internal corporate counterpressures that resist excessive bulk, size, and growth are absent. This problem of corporate degradation due to too-big-to-fail finance burdens the economy. In addition to the well-known cost of bailouts, too big-to-fail finance induces a hidden but pervasive degradation of financial firm efficiency from the best possible. The analytic here also has policy implications beyond just reducing too-big-to-fail risks. Most post-crisis financial regulation has been command-and-control rules on capital and activities. The corporate governance analytic points us to incentives as unused policy tools. Incentives toward corrective corporate measures degrade, so policymakers could seek to reverse that degradation. By mimicking an effective market with mechanisms offsetting the too-big-to-fail subsidy and, subtly but with long-run staying power, by reproducing the incentives of private parties to make more efficacious market choices,policymakers could harness incentives that too-big-to-fail finance degrades and often destroys in large financial firms. Lastly, the corporate degradation analytic has on-the-ground corporate dealmaking implications: if the command-and-control regulation succeeds, it should lead to sharp corporate restructurings in financial firms. I outline the mechanisms and implications

Legal Origins and Modern Stock Markets

Legal origin - civil vs. common law - is said in much modern economic work to determine the strength of financial markets and the structure of corporate ownership, even in the world's richer nations. The main means are thought to lie in how investor protection and property protection connect to civil and common law legal origin. But, I show here, although stockholder protection, property rights, and their supporting legal institutions are quite important, legal origin is not their foundation. Modern politics is an alternative explanation for divergent ownership structures and the differing depths of securities markets in the world's richer nations. Some legislatures respect property and stock markets, instructing their regulators to promote financial markets; some do not. Brute facts of the twentieth century - the total devastation of many key nations, wrecking many of their prior institutions - predict modern postwar financial markets' strength well and tie closely to postwar divergences in politics and policies in the world's richest nations. Nearly every core civil law nation suffered military invasion and occupation in the twentieth century - the kinds of systemic shocks that destroy even strong institutions - while no core common law nation collapsed under that kind of catastrophe. The interests and ideologies that thereafter dominated in the world's richest nations and those nations' basic economic tasks (such as postwar reconstruction for many) varied over the last half century, and these differences in politics and tasks made one collection of the world's richer nations amenable to stock markets and another indifferent or antagonistic. These political economy ideas are better positioned than legal origin concepts to explain the differing importance of financial markets in the wealthy West

Clearinghouse Overconfidence

Regulatory reaction to the 2008-2009 financial crisis focused on complex financial instruments that deepened the crisis. A consensus emerged that these risky financial instruments should move through safe, strong clearinghouses, which would be bulwarks against systemic risk, and that the destructive impact of the failures during the crisis of AIG, Lehman Brothers, and the Reserve Primary Fund could have been softened or eliminated had strong clearing-houses been in place. Via the Dodd-Frank Wall Street Reform Act, Congress instructed regulators to construct clearinghouses through which these risky financial instruments would trade and settle. Clearinghouses could cut financial risk, reduce contagion, and halt a local financial problem before it becomes an economy-wide crisis. But clearinghouses are weaker bulwarks against financial contagion, financial panic, and systemic risk than is commonly thought. They may well be unable to defend the economy against financial stress such as that of the 2008-2009 crisis. Although they are efficient financial platforms in ordinary times, they do little to reduce systemic risk in crisis times. They generally do not reduce the core risk targeted-that the failure of a financial firm will cause other firms to fail-but rather transfer that risk of loss to others. The major reduction in risk among the inside-the-clearinghouse traders is largely achieved by pushing that risk elsewhere, often to a systemically dangerous spot. Financial contagion can thus side-step the clearinghouse fortress and bring down other core financial institutions. Worse, clearinghouses could not have readily handled the major stresses that afflicted the economy in 2008-2009, could well have transmitted and magnified them, and can only weakly affect the type of financial stress that Congress targeted with Dodd-Frank. When we add in the other weaknesses of the new clearinghouses-as too-big-to-fail institutions, as institutions whose members' incentives to contain clearinghouse riskiness are weaker than the public's, and as institutions that will not be easy to regulate-even the direction of clearinghouses' impact on systemic risk is uncertain. The stakes are high in correctly assessing the value of clearing-houses in containing systemic risk. Much like an overconfidence inspired by powerful military fortresses that an invading enemy can side-step, the reigning overconfidence in clearinghouses lulls regulators to be satisfied that they have done much to arrest problems of contagion and systemic risk by building up clearing-houses, when they have not

Dodge v. Ford: What Happened and Why?

Behind Henry Ford’s business decisions that led to the widely taught, famous-in-law-school Dodge v. Ford shareholder primacy decision were three industrial organization structures that put Ford in a difficult business position. First, Ford Motor had a highly profitable monopoly and needed much cash for the just-begun construction of the River Rouge factory, which was said to be the world’s largest when completed. Second, to stymie union organizers and to motivate his new assembly-line workers, Henry Ford raised worker pay greatly; Ford could not maintain his monopoly without sufficient worker buy-in. And, third, if Ford explicitly justified his acts as in pursuit of the monopoly profit in the litigation, the Ford brand would have been damaged with both his workforce and the car buyers. The transactions underlying Dodge v. Ford and resulting in the court order that a very large dividend be paid should be reconceptualized as Ford Motor Company and its auto workers splitting the “monopoly rectangle” that Ford Motor’s assembly line produced, with Ford’s business requiring tremendous cash expenditures to keep and expand that monopoly. Hence, a common interpretation of the litigation setting-—that Ford let slip his charitable purpose when he could have won with a business judgment defense-—should be reconsidered. Ford had a true business purpose to cutting back the dividend—spending on labor and a vertically integrated factory to solidify his monopoly and splitting the monopoly profit with labor-—but he would have jeopardized the strategy’s effectiveness by boldly articulating it. The existing main interpretations of the corporate law decision and its realpolitik remain relevant—-such as Ford seeking to squeeze out the Dodge brothers by cutting the Ford dividend to deny the Dodge brothers cash for their own car company. But those interpretations must take a back seat, as none fully encompasses the industrial setting-—of monopoly, incipient union organizing, and a restless workforce. Without accounting for Ford Motor’s monopoly, the River Rouge construction, and the related labor tensions, we cannot fully understand the Dodge v. Ford controversy. Stakeholder pressure can more readily succeed in a firm having significant economic rents, a setting that seems common today and was true for Ford Motor Company in the 1910s