The rise of rise of dispersed ownnership: the roles of law and the state in the separation of ownership and control.

• Author: Coffee, John C., Jr.
• Position: Article Abstracts

Deep and liquid securities markets appear to be an exception to a worldwide pattern in which concentrated ownership dominates dispersed ownership. Recent commentary has argued that a dispersed shareholder base is unlikely to develop in civil-law countries and transitional economies for a variety of reasons, including (1) the absence of adequate legal protections for minority shareholders, (2) the inability of dispersed shareholders to hold control when the private benefits of control are high, and (3) the political vulnerability of dispersed shareholder ownership in left-leaning social democracies. Nonetheless, this Article finds that significant movement in the direction of dispersed ownership has occurred and is accelerating across Europe.

What, then, are the legal and political preconditions to the emergence of strong securities markets? Examining the origins of dispersed ownership in both the United States and the United Kingdom during the late nineteenth and early twentieth centuries and contrasting their experiences with the contemporaneous failure of securities markets to develop in Continental Europe, this Article finds little evidence that the existence of strong legal protections for minority shareholders is the explanatory variable that best accounts for the divergent evolution of common-law versus civil-law economies. During this era, particularly in the United States, the private benefits of control were high, controlling shareholders regularly exploited minority shareholders and manipulated markets, and political corruption undercut the effectiveness of those legal remedies that existed. Yet, ownership and control gradually separated in the largest U.S. corporations. The critical factors explaining early market development in the United States appear to have been the private efforts of investment bankers to develop credible bonding mechanisms plus enlightened self-regulation by the New York Stock Exchange. In this light, the decisive difference between the common-law countries, in which securities markets developed, and the civil-law countries, in which they did not, appears to have been less their divergent legal rules than the early emergence of a relatively autonomous and decentralized private sector in the former countries, in which competition could flourish and self-regulation was encouraged. In contrast, market development was impeded in Continental Europe by pervasive state intervention and a view of the securities market as an appendage of the state.

Ultimately, the correlation between strong securities markets and strong legal standards seems real, but the causal sequence may be the reverse of that suggested by recent commentators. Rather than strong legal protections engendering strong markets, securities markets appear to develop first through private initiatives and then create political constituencies that demand stronger legal protections. "Crash then law" is a recurring cycle. Hence, although law contributes to market growth and particularly market stability, it appears more to follow than precede economic development.

Recent scholarship on comparative corporate governance has produced a puzzle. While Berle and Means had assumed that all large public corporations would mature to an end-stage capital structure characterized by the separation of ownership and control, (1) the contemporary empirical evidence is decidedly to the contrary. Instead of convergence toward a single capital structure, the twentieth century saw the polarization of corporate structure between two rival systems of corporate governance:

(1) A Dispersed Ownership System, characterized by strong securities markets, rigorous disclosure standards, and high market transparency, in which the market for corporate control constitutes the ultimate disciplinary mechanism; and

(2) A Concentrated Ownership System, characterized by controlling blockholders, weak securities markets, high private benefits of control, and low disclosure and market transparency standards, with only a modest role played by the market for corporate control, but with a possible substitutionary monitoring role played by large banks. (2)

An initial puzzle is whether such a dichotomy can persist in an increasingly competitive global capital market. Arguably, as markets globalize and corporations having very different governance systems are compelled to compete head to head (in product, labor, and capital markets), a Darwinian struggle becomes likely, out of which, in theory, the most efficient form should emerge dominant. Indeed, some have predicted that such a competition implies an "end to history" for corporate law. (3) A rival and newer position--hereinafter called the "Path Dependency Thesis"-- postulates instead that institutions evolve along path-dependent trajectories, which are heavily shaped by initial starting points and pre-existing conditions. (4) In short, history matters, because it constrains the way in which institutions can change, and efficiency does not necessarily triumph.

These two rival positions do not, however, state the deeper puzzle. That puzzle involves the origins of dispersed ownership. The recent provocative scholarship of La Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLS&V) has not only shown the existence of two fundamentally different systems of corporate governance, but has placed legal variables at center stage in explaining the persistence of these two systems. (5) LLS&V have boldly argued that civil-law legal systems provide inadequate protections to minority shareholders, and hence dispersed ownership can arise only in a common-law legal environment. To support this conclusion, they assembled a worldwide database that shows that the depth and liquidity of equity markets around the world correlate closely with particular families of legal systems, with common-law systems consistently outperforming civil-law systems. (6)

If LLS&V are correct, the implications of their research seem profoundly pessimistic for parts of the world seeking to develop deeper, more liquid securities markets. Absent sweeping legal changes, civil-law countries would seem condemned to concentrated ownership and thin securities markets. Not only might this legal barrier frustrate European efforts to develop a pan-European securities market, but its implications are even more significant and adverse for transitional economies. A growing body of research suggests that an active securities market is an engine for economic growth. (7) Must transitional economies therefore adopt the rules of common-law legal systems (and possibly common-law enforcement techniques) in order to develop their economies? Although a number of transitional countries have in fact begun to adopt U.S. corporate and securities laws, other researchers have warned that attempts to "transplant" law in this fashion have usually failed because the legal rules so adopted are incongruent with local customs and traditions. (8)

Nor are LLS&V alone in predicting the persistence of the current bipolar division of the world into rival systems of dispersed and concentrated ownership. While LLS&V argue that dispersed ownership cannot spread unless fundamental legal reforms protecting minority rights are adopted as a precondition, other recent commentators have advanced entirely independent reasons why dispersed ownership will remain the exception, with concentrated ownership being the rule. Lucian Bebchuk has advanced a "rent-protection" model of share ownership that posits that, when the private benefits of control are high, concentrated ownership will dominate dispersed ownership. (9) The core idea here is that the entrepreneurs taking a firm public will not sell a majority of the firm's voting rights to dispersed shareholders in the public market, because they can obtain a higher price for such a control block from an incoming controlling shareholder or group, who alone can enjoy the private benefits of control. (10) Thus, the control holder will sell only a minority interest or will sell control as a block, but will not break up its control block--and hence concentrated ownership will persist. (11)

Similarly, Mark Roe has offered an entirely independent "political" theory for why strong securities markets are inconsistent with the European political tradition of "social democracy." (12) In his view, social democracies pressure corporate managers to forego opportunities for profit maximization in order to maintain high employment. Under circumstances that would lead firms in other political environments to downsize their operations because of adverse market conditions, firms in social democracies, he argues, are compelled to expend their shareholders' capital in order to subsidize other constituencies. Public firms are relatively more exposed than private firms, he believes, to the higher managerial agency costs that social democracies impose. As a result, concentrated ownership is a defensive reaction to these pressures; through nontransparent accounting, hidden reserves, and direct supervision of management, large blockholders, he claims, can better resist these political pressures to expend the firm's resources on other constituencies.

In overview, a common denominator runs through the theories of LLS&V, Bebchuk, and Roe: Ownership and control cannot easily separate when managerial agency costs are high. Although they disagree about the causes of high agency costs--i.e., weak legal standards versus political pressures that cause firms sometimes to subordinate the interests of shareholders--they implicitly concur that the emergence of deep, liquid markets requires that the agency cost problem first be adequately resolved by state action.

This Article dissents. Although it does not doubt that "law matters," it finds that a transition toward dispersed ownership is already well advanced and seems likely to continue, even in the short-term absence of legal change...