In our forthcoming article, Regulating Ex Post: How Law Can Address the Inevitability of Financial Failure, 92 Texas Law Review (2013), we observe that, unlike many other areas of regulation, financial regulation operates in the context of a complex interdependent system. This, we argue, has implications for financial regulatory policy, especially the choice between ex ante regulation aimed at preventing financial failures and ex post regulation aimed at responding to those failures.

Our article begins by considering the nature of systems and the usefulness of systems analysis as a methodology for studying law. Law-related systems are systems in which the law is an integral element. The financial system can be viewed as a complex network in which financial firms interact directly and indirectly (through markets) against the background of legal rules.

…continue reading: How Law Can Address the Inevitability of Financial Failure

There has been an exponential growth in interest in comparative company law in recent years. For example, in the period from 2002 to 2011, no fewer than ten monographs or edited collections were published exploring this new field of enquiry. The burgeoning literature was mirrored by an increase in University Postgraduate courses or programs in comparative company law and corporate governance. Moreover, the dissolution of trade barriers and mass cross-border capital flows engendered by the forces of competition and globalization have necessitated legal practitioners to be conversant with the company laws of jurisdictions other than their own.

In Mathias Siems and David Cabrelli (eds.), Comparative Company Law: A Case Based Approach, Hart Publishing, 2013 (publisher’s website; introduction on SSRN) we have aimed to fill an important gap in this field. Existing books on comparative company law tend to focus on the institutional structure of the corporation but this approach risks overlooking specific cases and how the issues arising from disputes are resolved in different jurisdictions. For example, topics related to directors’ liability, creditor protection and shareholders’ rights may best be understood by analyzing how selected hypothetical cases would be solved in different countries.

…continue reading: Comparative Company Law: Case Based Approach

The paper, Towards a Legal Theory of Finance, develops the building blocks for a legal theory of finance (LTF). By placing law at the center of the analysis of financial systems LTF sheds light on the construction of financial markets, their interconnectedness and thus vulnerability to crisis, and situates power where law is elastic or suspended in the name of financial stability. LTF has four elements: It holds that modern financial markets are (1) rule-bound systems; (2) essentially hybrid; (3) beset by the law-finance paradox; (4) and in the last instance subject to discretionary rather than rule-bound actions.

…continue reading: Towards a Legal Theory of Finance

Among the most important rights of shareholders is the right to elect and dismiss directors. While the election of directors usually garners a lot of attention among scholars and policymakers, the same cannot be said of the right to dismiss directors, even though it is at least of equal concern. In my paper, Europe’s Ius Commune on Director Revocability, which was recently made available on SSRN, I explore the neglected topic of the latitude of shareholder meetings to remove directors of public companies over time and across several jurisdictions in Europe and the United States. The specific question relates to whether the law mandatorily prescribes that shareholders have the right to remove directors at will, and whether common principles can be distilled at a regional or international level.

…continue reading: Europe’s Ius Commune on Director Revocability

In the paper, Law and Financial Development: What We Are Learning from Time-Series Evidence, which was recently made publicly available on SSRN, my co-authors (Simon Deakin at the University of Cambridge; Viviana Mollica at Queen Mary University of London; and Mathias Siems at the University of East Anglia) and I explore the empirical evidence regarding the legal origins hypothesis. It is widely believed that legal institutions matter for financial development. According to the ‘legal origins’ hypothesis developed by La Porta et al. and their collaborators, legal systems vary considerably in the way they regulate economic activity. A principal cause of this diversity is the role played by the different legal traditions or ‘origins’ of the common and civil law (La Porta et al., 2008). It is argued that countries whose legal systems have a common law origin emphasize freedom of contract and the protection of private property, whereas those with civil law roots favor an activist role for the state. These legal differences seem to have tangible economic effects. Common law systems have been found to have more dispersed share ownership (La Porta et al., 1999), more liquid and extensive capital markets (La Porta et al., 1998), and more highly developed systems of private credit, than civilian ones. In part through the Doing Business reports of the World Bank, these findings have come to influence policy reform in ‘dozens of countries’ over the past decade (La Porta et al., 2008:326). Reforms to corporate and bankruptcy law have seen a strengthening of shareholder and creditor rights, particularly the former.

…continue reading: Law and Financial Development

In the paper, System and Evolution in Corporate Governance, which was recently made publicly available on SSRN, my co-author, Fabio Carvalho, and I explore the relevance of systems theory for an understanding of legal evolution, with specific reference to the law and practice of corporate governance. Evolutionary ideas play an important role in the contemporary corporate governance debate, being regularly deployed to support deregulatory initiatives and encourage belief in the likelihood of the global convergence of governance regimes. Close inspection suggests that many of these analyses are based on false analogies, drawn from misunderstandings of natural selection processes in the biological realm. They also suffer from a failure to address the issue of the social ontology of law. The key assumption in most law and economics analyses is that legal rules operate as surrogate prices. Given the importance of this step in law and economics reasoning, it is surprising that so little attention has been given to articulating and defending it. The effect, though, is severely to limit the value of the resulting analyses, by dissolving the distinction between the legal and economic systems.

…continue reading: System and Evolution in Corporate Governance

In our paper, Is the World Flat? Country- and Firm-Level Determinants of Law Compliance, which was recently accepted for publication in The Journal of Law, Economics, and Organization, we revisit the effects of a country’s institutional framework on individual firms’ behavior, in particular focusing on their propensity to comply with legal rules. We focus on the compliance with legal rules, primarily for two reasons. The substantive one has to do with the apparent importance of institutions such as the rule of law and legal enforcement for economic performance. The practical reason is that our data contain proxies for law compliance by thousands of business firms from a wide range of countries that display large institutional variation.

While the data contain information on several aspects of law compliance, such as the scope of corruption, bribery, and the extent of informality—by which we mean the propensity of firms to hide output—the main analysis focuses on the latter. This analysis reveals that many of the available firm-level characteristics are indeed relevant for explaining the variation in informality. For example, firm size matters; smaller firms appear to be hiding a larger share of output, while exporting firms and those with foreign ownership appear to be hiding less. Yet, there is strong evidence that most of the variation is driven by differences across countries in their respective levels of institutional quality, thus rejecting the null hypothesis in favor of what is implied by our theoretical model. In particular, commonly used measures of institutional strength emerge as the most statistically significant variables.

We use the same methodology to explain the variation in other proxies for noncompliance with the rule of law, such as corruption and bribery. Generally, the results are similar to—and often even stronger than—those obtained for informality: while firm characteristics matter, most of the relevant variation is explained by country-wide measures for institutional strength, and less so by firm-specific characteristics.

Our conclusion is that countries still matter in providing institutional infrastructure, which determines to a large extent the context within which firms operate.

The full paper is available for download here.

One of the major findings of the law and finance literature comparing corporate governance across countries is that large-percentage shareholders in public corporations are a response to weak legal protections for investors. Thus, it is reported that common law countries have less concentrated ownership than civil law countries because they afford stronger legal protections for investors. Similarly, it is reported that ownership is less concentrated in countries with strong investor protection laws.

The papers that reach these conclusions analyze country averages of ownership concentration instead of firm-level data. I just released a paper in which I show that this creates omitted-variable and aggregation biases. Aggregation, in particular, eliminates all within-group (country) variation, leading to artificial clustering. Most papers also use small samples of large firms. This makes inferences to country populations problematic because ownership concentration is inversely related to firm size and firm size varies across countries.

I correct for these limitations by analyzing firm-level observations; control for firm-level determinants of ownership concentration, including size; and use a broad sample of firms from 32 countries. When I take these steps there is no support for the widely held theory that large shareholders are a response to weak legal protections for investors. In particular, there is no relation between ownership concentration and whether a firm comes from a common law country. Similarly, there is no systematic relation between ownership concentration and 14 broad indices of investor protection laws. An index is as likely to be positively associated with ownership concentration as it is to be negatively associated with ownership concentration.

Given these findings, I re-examine the theoretical literature that predicts a negative relation between investors’ legal protections and ownership concentration. There are two branches to this literature, and they have diametrically opposed views on the role of large shareholders in public corporations. One branch models external blockholders who monitor management to stop the appropriation of corporate resources. The problem is that around the world blockholders typically are managers. The other branch, in contrast, models internal blockholders who appropriate corporate resources. Although this comports with the reality that most blockholders are insiders, it is inconsistent with evidence showing that in most countries firm value increases with ownership concentration. Both branches of the literature ignore the effects of large shareholders on management decisions. Given how broadly large shareholders can impact management and given that management decisions are not subject to judicial review, even in countries with strong legal systems, there is no reason to expect ownership concentration to vary with investors’ legal protections.

The full paper is available here.

On Wednesday February 27, HLS Professor George Triantis delivered his inaugural lecture “The Future of Transactional Legal Practice” marking his appointment to the Eli Goldston Professorship of Law.

In his lecture, Triantis surveyed the reasons why major U.S. law firms have enjoyed robust growth in their transactional practices over the past several decades, including the fact that they have often provided their clients with substantial business guidance in addition to legal advice. But he warned that many of the services they’ve offered are increasingly provided by others—investment bankers, management consultants, accountants, offshore outsourcing firms, and other business professionals—more cheaply.

Triantis observed that transactional firms grew and rose to prominence by negotiating and drafting three kinds of contracts: “standardized” contracts that are easily adaptable for use by successive clients; “innovative” contracts; and “tailored” contracts uniquely geared to their clients’ particular circumstances. But increasingly, he said, law firms are losing market share to other players in all three categories.

To recapture lost market share and to stem the tide against further erosion, Triantis said, law firms should refocus on innovative contract design that does what other business professionals can’t do as well: anticipate and plan for what happens if and when a deal doesn’t work out—litigation.

“Litigation, in its various forms, is the core competency from which lawyers can derive comparative advantage in designing transactions for their clients,” said Triantis. “Lawyers can help their clients choose the mode of enforcement and mold their legal commitments accordingly, knowing that they will be enforced through or in the shadow of an adversarial judicial process. …The modern law firm is organized around practice groups. Two of these groups—litigation practice and corporate transactions—often fail to mesh at the interface of particular transactions because the firm that litigates a transaction is often not the firm that did the deal in the first instance. … By connecting these two services, rather than treating them as distinct tasks or modules, law firms can recapture some of the lost revenues.”

Click here for a webcast of this event.

We have just posted a paper on SSRN, Opting Only In: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom, challenging one of the core positions of the contractarian approach to corporate law. Contractarians espouse an enabling approach to regulation allowing corporations to opt in or opt out and oppose a mandatory approach based on categorical rules. In their view, an enabling approach allows private ordering and enables owners and managers to derive the most efficient set of provisions, tailored to each company’s specific circumstances. This position has been reflected in attacks on legislations like SOX. Many commentators objected to its provisions because they were categorical and did not allow for private ordering.

Our study seeks to test this theory’s explanatory power in one area of corporate law. We chose a recent example of states replacing a categorical requirement with an enabling provision – waiver of liability provisions – for examination. These provisions allow companies to “opt out” of a rule that imposes liability on directors for breach of the duty of care. They may do so through the mechanism of an amendment to the articles. The amendment process requires the consent of both owners and managers, presenting conditions ripe, at least in theory, for the two groups to “bargain.”

We note first that waiver of liability provisions were authorized not in response to Van Gorkom, as is typically represented, but in response to the D&O insurance crisis occurring in the 1980s. In other words, the provisions were designed to interfere in the market for insurance. No evidence was offered, nor could we find any, indicating that this was a more efficient way of dealing with the economic uncertainties that existed at the time.

Second, we examined the waiver of liability provisions implemented by the Fortune 100 (data that we will eventually expand to the Fortune 500). Our analysis does not offer any evidence of private ordering. With one exception, all non-mutual companies in the Fortune 100 have eliminated liability for breach of the duty of care (in some states, this was done statutorily, with no company “opting out” of the no liability regime). Moreover, none of the waiver provisions reflected bargaining, with the wording of the provisions being remarkably similar. The companies in our sample waived liability to the fullest extent permitted by law.

Our analysis shows that one categorical rule favoring shareholders (liability for the breach of the duty of care) was replaced by another categorical rule favoring management (no liability for breach of the duty of care). While we do not rule out the possibility, we are not persuaded that any significant evidence demonstrating that one was more efficient than the other exists.

Our conclusion is supported by the fact that no actual bargaining occurs. Particularly where provisions are implemented by an amendment to the articles, it is management that drafts the language and only management that can initiate adoption or repeal. In other words, whatever theoretical benefit can result from the contractarian view of private ordering, it can only arise in practice if shareholders have the ability to meaningfully participate in the bargaining process. Our evidence suggests that they do not.