Fact and fiction in corporate law and governance.

• Author: Klausner, Michael
• Position: Seventh Annual Conference on Empirical Legal Studies: The Empirical Revolution in Law

INTRODUCTION I. CONTRACTING AT THE IPO STAGE A. IPO Charters and Takeover Defenses B. Innovation, Diversity, and the "Plain Vanilla" Charter II. STATE COMPETITION TO PROVIDE CORPORATE LAW III. GOVERNANCE ADJUSTMENTS ONCE A COMPANY GOES PUBLIC: THE "MIDSTREAM" STAGE A. Corporate Governance from the Mid-1980s to the Mid-2000s 1. Takeover defenses a. Poison pills b. Staggered (or "classified") boards c. Other takeover defenses 2. Board independence B. Corporate Governance Since the Mid-2000s IV. A BRIEF DETOUR: ONGOING MISUNDERSTANDINGS REGARDING TAKEOVER DEFENSES AND GOVERNANCE INDICES A. Elements with No Impact on Management Entrenchment B. Elements with No Impact on Firms with an Effective Staggered Board C. Elements with an Impact Only Under Limited Circumstances D. Elements That Are Unrelated to Entrenchment and Affirmatively Good for Corporate Governance E. Use of Governance Indices in Other Research INTERPRETATION, IMPLICATIONS, AND CONCLUSION INTRODUCTION

This issue of the Stanford Law Review, marking the Seventh Annual Conference on Empirical Legal Studies (CELS), provides each of its six authors an opportunity to address the impact of empirical work on important questions in our respective fields. In corporate law and governance, the impact of empirical work has been pervasive, as reflected by the fact that over one quarter of the papers submitted to CELS related to these topics. Beginning in the 1970s, theorists in economics and law laid the foundations of the field. With respect to key questions, however, theory could not provide an answer. For example, are staggered boards value enhancing? Are independent directors? Is separating the positions of CEO and board chair? For each of these questions, there is theoretical support on both sides. Empirical analysis is therefore necessary to answer them.

The same is true of the most fundamental question regarding corporate law--whether market forces promote optimal corporate governance arrangements, independent of law--a theoretical proposition that has framed the study of corporate law since the 1980s. There has been no systematic analysis of where this proposition stands in light of empirical evidence. In this Essay, I provide such an analysis. I conclude that, for the most part, the evidence is not supportive.

The theoretical framework within which we understand corporate law and corporate governance dates back to the finance literature of the late 1970s and the legal literature of the 1980s. In 1984, Roberta Romano commented that "[u]ntil recently, corporate law has been an uninspiring field for research." (1) She quoted Bayless Manning's famous statement in 1962 that "[c]orporation law, as a field of intellectual effort, is dead in the United States.... We have nothing left but our great empty corporation statutes--towering skyscrapers of rusted girders, internally welded together and containing nothing but wind." (2) From both an intellectual perspective and a legal perspective, a "revolution in corporate law" (3) began in 1976 with the publication of Theory of the Firm." Managerial Behavior, Agency Costs and Ownership Structure, by Michael Jensen and William Meckling. (4) That article developed a theory of agency costs in the public corporation, which remains the dominant framework of analysis for corporate law and corporate governance today. A year later, Ralph Winter published State Law, Shareholder Protection, and the Theory of the Corporation, an article that implicitly applied the Jensen and Meckling agency cost model to analyze the question of whether state competition to attract incorporations was a race to the bottom or a race to the top. (5) Then, in a series of articles published in the 1980s that culminated in a highly influential book, Frank Easterbrook and Daniel Fischel extended the Jensen and Meckling framework to develop what they called a positive and normative theory of corporate law. (6) Before long, this work and other legal scholarship grounded in economic theory began to influence the courts and the SEC. (7)

The view of the corporation that emerged over this period through the work of Jensen and Meckling, Winter, Easterbrook and Fischel, and others was a contractarian one. (8) The corporation was viewed as a "nexus of contracts" among "constituents," including managers, shareholders, creditors, employees, and others. Corporate law and governance focus primarily on the agency relationship between managers and shareholders. As in other market settings, the implication of conceptualizing the shareholder-manager relationship as contractual was that--in the absence of transaction costs--market forces could be trusted to maximize joint gains. In the corporate setting, this meant that market forces would lead the parties to create governance arrangements and adopt legal rules that would minimize agency costs and thereby maximize firm value.

The contractarian logic is clearest at the point of a company's initial public offering (IPO). Pre-IPO managers and investors design the firm's governance structure. The market sets the price of the company's shares--a price that is expected to reflect the effectiveness of the firm's governance structure in reducing agency costs--and investors buy those shares in the market. The pre-IPO shareholders are expected to reap the benefit of a good governance structure and the cost of a bad one. They are therefore expected to design optimal governance mechanisms that suit each firm's circumstances and to provide for those mechanisms in the firm's charter--the "corporate contract." (9) As a normative matter, contractual governance is seen as superior to legally imposed governance arrangements because firms are different along numerous dimensions and market forces create incentives to customize and to innovate. If the contractarian theory is valid, we would expect to find that companies going public include in their charters customized and innovative governance arrangements.

Once shares of a company are dispersed among public shareholders, there remains a question whether management can take advantage of its control to loosen the governance reins and promote its own interests. (10) Here too, contractarian theorists argued that market forces would induce management to adopt optimal governance arrangements. (11) Empirical support for this element of the theory would take the form of public company management initiating value-enhancing charter amendments or otherwise adopting governance improvements to minimize agency costs.

The contractarian view of the corporation casts corporate law in a supporting role. Corporate law provides "off-the-rack" default rules that save the parties the cost of customizing the terms of their entire relationship. (12) Where management can improve on those default rules, it will opt out of them and draft alternatives into the company's charter, either at the IPO stage or later. In addition, in the United States, the applicable default rules are themselves a matter of contract. When a firm goes public, it selects a state in which to incorporate, and in so doing, it opts into that state's body of corporate law. Once public, the firm can reincorporate with the approval of the firm's board and its shareholders. The contractarian understanding is that a firm will incorporate in a state whose corporate law best reduces its agency costs. Moreover, following Winter, contractarians expected states to be eager to collect the franchise fees that come with incorporation and therefore to compete with each other to provide corporate law that meets this demand--to "race to the top." (13)

The contractarian theory brought economics into the analysis of corporate governance and corporate law, and in doing so it provided a fresh start based on simple assumptions and straightforward economic logic. In the absence of transaction costs, economic theory implies that managers will customize the terms of their relationship with shareholders to maximize firm value. (14) This was the core implication of the contractarian theory, and the one that provided the contractarians with a powerful normative claim--that there was essentially no need for legal intervention because whatever is needed would be accomplished by contract. There remained a question, however, whether the terms of actual corporate contracts are what the contractarians expect, or whether market imperfections impede the establishment of optimal governance arrangements. This is an empirical question, on which the positive and normative contractarian position hinged, and the question on which I focus in this Essay.

On the whole, the empirical literature over the past three decades has provided little support for the contractarian theory. (15) Key pillars of the theory do not match the empirical facts. First, contractarian theory implies that the charters of companies going public will be a locus of vibrant value-maximizing innovation and customization. Empirical evidence, however, shows that essentially no innovation or customization occurs in IPO charters and that these charters are virtually empty from a governance perspective. At the IPO stage, firms adopt the default rules or statutory options of the state in which they are incorporated. (16) The only significant governance provisions that appear in IPO charters are staggered boards, which studies have shown to be value reducing. (17) Second, empirical studies have shown that state competition in the provision of corporate law does not exist. (18) There is no race to the top or to the bottom. Delaware is the only state in the race, and it dominates the market.

Once companies go public, the data on midstream adjustments to the corporate contract is mixed. The empirical evidence does not support the proposition that the invisible hand quickly dispenses with inefficient governance mechanisms, or that it induces management to propose innovative or customized charter amendments for...