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