evolution of corporate law & finance business associations section 7c evolution: forces shaping...

Evolution ofCorporate Law & Finance

Business Associations Section 7c

Evolution: Forces shaping modern corporate law

Prof. Amitai [email protected]

College of LawUniversity of Illinois

Copyright © Amitai Aviram. All Rights ReservedS12D

EvolutionOverview of Section 7c

1. Regulatory competition Race to the bottom? Race to the top? Competition with federal law

2. The business cycle3. Political economy of the primacy debate4. Legal origins5. The future of business entities

Copyright © Amitai Aviram. All Rights Reserved

Regulatory competitionCompetition & the market

In a market, competition forces firms to offer better terms to customers

Example I go to the Meijer to buy milk. I did not comparison shop and

have no idea what a “good” price would be. Nonetheless, I am likely to benefit from a competitive price

Meijer faces competition (e.g., Wal-Mart, IGA) I.e., shoppers don’t lose much by turning to competing firms

A sufficient number of other shoppers do comparison shop, and they would shift to a rival if prices were not competitive


Regulatory competitionCompetition & the market for law

Law was traditionally seen as offering no competition State can use violence to enforce its laws State has monopoly over law in its jurisdiction

But some activities can move between jurisdictions E.g., use a Delaware or an Illinois corporation; have my

manufacturing activities in US or in China; keep my money in UK or in France

Laws governing such activities may be subject to the same constraining forces that face firms in a competitive market


Regulatory competitionHow much competition?

The extent & impact of regulatory competition depends on the same forces as in other markets How easy is it to shift the activity to another jurisdiction

People have preferences as to where they live; likely won’t leave Illinois just because I find another state’s criminal laws a bit better

Likewise, some assets are tied to a specific location (e.g., distribution facilities, proximity to complementary services)

But money is easy to move around & constitutional doctrines restrict a state’s ability to thwart regulation by another state

Who are the “comparison shoppers” & how attentive are they to the details of the law? Most people have little knowledge of details of the local law But for big transactions one can hire professionals (lawyers,

accountants, investment bankers) who pay attention to the law


Regulatory competitionCompeting over corporate law

Therefore, competition over corporate law is stronger than most areas of law Involves money, which is easy to transport Dormant commerce clause prevents states from forcing

businesses to use their corporate law Big financial stakes, so stakeholders can hire professionals

to figure out where to incorporate


Regulatory competitionWho is competing? Traditional view

State vs. state The narrative: states want franchise fees from corporations, so they

adjust their laws to attract incorporations But how do states adjust the laws?

“Race to the bottom”: Since directors & officers, rather than SHs, decide where to incorporate, states compete by preferring efficiency to accountability (“pro-management”)

“Rate to the top”: SHs don’t decide where to incorporate, but they decide which company to invest in. If they didn’t like a given state’s laws, they would look to invest in other companies that incorporate in a state with better laws Thus, directors & officers would choose a state that prefer accountability to

efficiency (“pro-SH”), in order to entice SHs to invest in their corporation So, to appeal to directors & officers, states need to be “pro-SH”


Regulatory competitionProblem with the traditional view

Not much is going on in state v. state competition NJ was the dominant player until it voluntarily bowed out

when Woodrow Wilson was its governor (1913) Since then, Delaware dominated

Where’s the competition? Response 1: Only small states can credibly compete

Why don’t we see vigorous competition from Wyoming, Vermont, Montana, Rhode Island?

Response 2: Competition is vigorous, but Del. keeps winning Staying on top under vigorous competition for 100 years? Why doesn’t a plausible #2 emerging? If Del. always wins & #2 gets nothing, why bother competing?


Regulatory competitionProblem with the traditional view

So what’s going on? Perhaps there’s room for just one national standard, and as

long as any state offers this, it has the entire market No incentive for other states to compete unless incumbent bows out

What maintains the standard? Perhaps nothing – as long as the law allows current transactions to

go through, business world converges on a single corporate law Perhaps some level of concern to efficiency vs. accountability – if

Delaware gets it really wrong, it might create room for a rival This is a weakened version of the “race to” theories

Perhaps process & not substance – efficient, knowledgeable courts


Regulatory competitionAn alternative view

Federal v. state The narrative: Del. competes against the Fed. government,

which uses securities laws to regulate same issues But what kind of competition is that?

Federal government has power to preempt states


Regulatory competitionA nuanced alternative view

Delaware plays “divide & conquer” with federal gov Positions itself to preempt agreement bw/ House & Senate

“Pro-SHs” (accountability at expense of

efficiency)

“Pro-management”

(efficiency at expense of

accountability)House Senate Delaware

A B

House Senate Delaware

A B

House Senate Delaware

A B


Regulatory competition A nuanced alternative view

Delaware acts to address has two interests Avoid preemption

This was explained in the previous slide Maximize incorporations

This is where the “race to” theories still matter – will it maximize incorporations by being “pro-SH”, or “pro-management”?

Previous slide assumed Delaware prefers “pro-management” If it preferred “pro-SH” & House is still to left of Senate, Delaware could

flank House from the left

“Pro-SHs” (accountability at expense of

efficiency)

“Pro-management”

(efficiency at expense of

accountability)House SenateDelaware

AB


1. Regulatory competition2. The business cycle

The business cycle & development of corporate law The bubble law problem Case study: the Sarbanes-Oxley Act Law as a tool to manipulate the public’s risk perceptions

3. Political economy of the primacy debate4. Legal origins5. The future of business entities

Effect of conspicuous law enforcement on behavior of non-perpetrators

How the business cycle affects law Economic effect of the “perp walk”

Conspicuous law enforcement

Individuals’ risk perception

Individuals’ behavior

“Nothing paints a picture as well as people being led away in handcuffs” – Walter Ricciardi, SEC

When Do ProsecutorsEnforce Securities Laws?

Empirical EvidenceCyclical Enforcement: Little during boom, plenty after bust

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

95 96 97 98 99 00 01 02 03 04 05 06

S&P 500 Change, 1yr Lag SEC Enf Actions Change

When Do ProsecutorsEnforce Securities Laws?

Theory

Conspicuous enforcementis greatest when theperception gap (perceivedrisk - actual risk) is greatest

Example

Assume risk of company insiders committing fraud is 0.002% (1:50K) But public misperceives risk to be 1%

AG launches anti-fraud initiative (conspicuous law enforcement) Insiders deterred: 50% reduction in objective

risk, to 0.001% AG “oversells” initiative; Claims 99%

reduction (to perceived risk of 0.01%)

Private benefits to AG: Public observes that actual occurrences are closer to 0.01% than 1%; lends credibility to AG’s claims

Narrowing the perception gap: Over-estimation of fraud reduced from 0.998% to 0.009% ~111 times less misperception

Perceived Risk (%)

Actual Risk (%)

Perception Gap

Before 1 0.002 0.998%After 0.01 0.001 0.009%

Example

Perception gap reduces social welfare: Excessive avoidance of equity investments Excessive self-policing of companies Excessive political pressure to regulate

Narrowing the perception gapincreases social welfare

ExampleEffect on Social Welfare

Bias Arbitrage

Commodity Arbitrage

• Identify gap in price of gold in NY & London

• Take an action that creates private profits while also closing the price gap

Bias Arbitrage

• Identify gap between objective & perceived risk

• Take an action that creates private benefits while also closing the perception gap

Is Cyclical Enforcement a Formof Bias Arbitrage? I.e., does the public over-estimate fraud more

following a bust?

Does the public over-estimate fraud more following a bust?

Cognitive Biases

Does the public over-estimate fraud more following a bust?

Relevant Cognitive BiasesSelf-serving bias

Stock goes up – must be my investment skills Stock goes down – must be fraud

Availability bias Economic hardship removes veil that masks fraud Economic downturn causes hardship to many firms at once

Attribution discounting Fraud rises as a possible cause of downturn Causes people to discount other causes

This could have been the end, but then this paper would be called …

Counter-Cyclical

Enforcement of Corporate

Law

The Dual Message ofConspicuous Law Enforcement

When Jane Doe hears that the SEC is investigating Acme Corp. for fraud, does she think: “The SEC is effective in catching fraud!” (i.e., Ajax Corp.

is less susceptible to fraud) Need to invest less in addressing risk

Or: “I didn’t realize there’s so much fraud going on!” (i.e.,

Ajax Corp. is more susceptible to fraud that I thought) Need to invest more in addressing risk

Reworking the Example Same assumptions as before, except that enforcement

exacerbates perceived risk by 99% (to 1.99%)

Perceived Risk (%)

Actual Risk (%)

Perception Gap

Before 1 0.002 0.998%After 1.99 0.001 1.989%

Perception gap

increased

Excessive avoidance

Excessive self-policing

Excessive political pressure

A vicious enforcement cycle…Public over-estimates

risk

Incentives for conspicuous law

enforcement

Conspicuous law

enforcement

Excessive avoidance / self-policing /

political pressure

Enforcement increases perception of risk

Solution?

Counter-cyclical enforcement Enforce more when public under-estimates fraud

(boom) to increase risk perception Enforce less when public over-estimates fraud (after

bust) to prevent exacerbating risk perception

But prosecutors’ incentives favor cyclical enforcement… Article suggests mechanisms to modify these incentives


1. Regulatory competition2. The business cycle3. Political economy of the primacy debate

[Omitted]

4. Legal origins5. The future of business entities


1. Regulatory competition2. The business cycle3. Political economy of the primacy debate4. Legal origins

[Omitted]

5. The future of business entities


1. Regulatory competition2. The business cycle3. Political economy of the primacy debate4. Legal origins5. The future of business entities

A brief history of business entities End of the public corporation? End of private equity? Resurgence of large-scale unincorporated business entities?

A brief historyof business entities

A brief history of business entitiesDawn of civilization

Initially, business activity was conducted by the Tribal Firm (and later - the Family Firm). No rights to individuals Enforcement by the

family/tribe, not by a legal system.

A brief history of business entitiesPre-classical era

As civilizations developed legal systems that granted rights and imposed obligations on individuals, two business entities formed:

Sole Proprietorship (General) Partnership

A brief history of business entitiesEarly middle ages

A new entity develops under Byzantine, Jewish & Muslim laws to allow participation in profits without control of the business: the Limited Partnership

One of the original purposes of this entity was to avoid prohibitions on charging interest on loans This entity is not adopted by U.S. law until

the 19th Century

A brief history of business entitiesEarly middle ages

Also at the same time, a specialized form of partnership forms for mining and shipping ventures – the Joint Stock Company. It is a general partnership in which membership is evidenced by the ownership of shares, and those shares can be sold to others. Stora Kopparberg, a Swedish company,

is likely the oldest surviving JSC.It issued stock at least as early as 1288.

A brief history of business entitiesLate middle ages

Two institutions, that will later give birth to the modern corporation, develop:

The guild is a club that receives from the ruler a monopoly on trade in the region, and self-regulates its members.

The ”body corporate” (“corporation”) is a legal fiction, used first for the king and the church, and later for religious and educational entities. Gradually, it was accepted that the king could

create corporations. Later this power was also given to parliament.

At that time, corporations were not used for commercial purposes.

A brief history of business entitiesAge of exploration

Exploration and exploitation of the new world requires a large initial investment.

European powers “privatize” exploration by granting groups of merchants monopoly over trade (and plunder) overseas.

So much capital was needed that many investors had to be tapped, and receive the monopoly together. The chartered corporation, a hybrid of the guild & (old) corporation, begins to be used for semi-commercial purposes.

E.g.: The Hudson Bay Company, The Virginia Company, The Massachusetts Bay Company

A brief history of business entitiesEarly industrial age

Industrialization exploited economies of scale, which required huge investments.

It was expensive to get the king or parliament to charter a corporation, and government liked to intervene in the business of chartered corporations.

To avoid regulation, businesspeople use the Joint Stock Company.

Trade in shares soars.

A brief history of business entitiesThe south sea bubble

In 1711, the South Sea Company was chartered with a monopoly on trade with Spanish South America.

Bad relations between Spain and England made such trade unviable. So, the company decided instead to buy all of England’s national debt in return for shares in the company.

The company was very successful in selling its shares. In a financial frenzy, shares went up from £128 in January 1720, to £890 in June.

A brief history of business entitiesThe Bubble Act

Many unchartered JSCs jumped on the bandwagon, promising quick fortunes.

To protect the South Sea Company from rivals (and maybe to protect investors from fraud), Parliament passed the Bubble Act in June 1720, prohibiting JSCs unless they were chartered.

A brief history of business entitiesThe bust of the south sea bubble

Bursting the JSC bubble led to the burst of the South Sea Company bubble. Its shares dropped from £1,000 in August to £150 in September.

Bankrupt investors defaulted on loans, which resulted in a bankruptcy of banks. Inquiries revealed widespread fraud among the company’s directors.

The result was a deep-seated suspicion of corporations. The Bubble Act was not repealed until 1825, and corporate charters were sparsely granted.

A brief history of business entitiesIn the aftermath of the bubble

JSCs now illegal; corporate charters are rarely granted. But investors still needed a business entity that would allow

raising large amounts of money (i.e., that would accommodate many investors).

They modified the common law institution of a trust to form the Business Trust – a creature that was trust in form and corporation in substance. The trustee would manage the trust for the benefit of the

beneficiaries, who could transfer their rights by selling their certificates.

A brief history of business entitiesMoving to the U.S.

In colonial times, states claimed the power to form corporations. An early conflict with England over the purported incorporation by

Massachusetts of Harvard University. Following independence, U.S. courts clarified that the Bubble

Act did not apply, so JSCs were legal. States chartered corporations, but the process was rare and

expensive, and mostly used for public utilities: turnpikes, canals, etc.

As an alternative to chartered corporations, the business trust thrived in Massachusetts, and became known as the “Massachusetts trust”.

A brief history of business entitiesGeneral incorporation statutes

U.S. states had general incorporation statutes to allow churches to incorporate without legislative “permission” Seen as a protection of religious freedom.

A brief history of business entitiesGeneral incorporation statutes

States competed in attracting business by expanding general incorporation statutes to commercial enterprises The first commercial U.S. general incorporation statues was passed by

New York in 1811, boosting industries hurt by the Embargo Act. Early statutes were straightjackets, limited the life of the

corporation (e.g., to 20 years) and the business activities that it can engage in, and did not always limit liability.

A brief history of business entitiesThe dominance of the corporation

The development of railroads and other industries that required raising massive amounts of capital created an increasing demand for corporations.

Over time, general incorporation statues became more flexible, allowed for limited liability and unlimited duration, and applied to all business activities. Corporation dominated the business scene, pushing the

business trust & limited partnership to niches.

A brief history of business entitiesProliferation of corporation types

As corporations became ubiquitous, law begins to distinguish between different types of corporations: Distinction between Close Corporations (which were treated

similar to partnerships) and Public Corporations (around which extensive corporate and securities laws developed).

Distinction in the tax code between C Corporations, which were taxed as separate entities, and S Corporations, which allowed their shareholders to consider the corporation’s gains and losses as their own for tax purposes.

A brief history of business entitiesThe end of corporate dominance?

The dominance of the corporation made public opinion more accepting of the concept of limited liability

Ironically, this acceptance is now leading to a challenge to the corporation’s hegemony


A more flexible business entity In 1977, Wyoming introduced a new business entity: the Limited

Liability Company (LLC). The LLC offered limited liability and allowed the forming

businesspeople to choose either a partnership-like model of member-operation, or a corporation-like model of manager-operation.

It was unclear initially whether this entity could be considered for tax purposes as a partnership.

Tax law ceases to be a barrier 1988: IRS rules that LLCs could qualify for partnership-like tax

treatment. 1997: IRS further liberalizes tax treatment, making it easy for most entities with limited liability and centralized management to be taxed as a partnership, if they wished to do so.

Result: Explosive growth in using LLCs.


As LLCs gained ground, use of other entities declined Hit hardest: entities that did not provide complete limited liability

Other entities change to become more competitive vs. the LLC To compete with the booming popularity of LLCs, older entities

changed to become more attractive: General Partnerships developed the LLP (Limited Liability

Partnership) Limited Partnerships developed the LLLP (Limited Liability

Limited Partnership) The business trust developed into the Statutory Business

Trust

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