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A Systems Approach to Corporate Governance Reform: Why Importing U.S William & Mary Law Review Volume 45 (2003-2004) Issue 3 Institute of Bill of Rights Symposium: Article 7 Property Rights and Economic Development February 2004 A Systems Approach to Corporate Governance Reform: Why Importing U.S. Corporate Law Isn't the Answer Troy A. Paredes Follow this and additional works at: https://scholarship.law.wm.edu/wmlr Part of the Business Organizations Law Commons Repository Citation Troy A. Paredes, A Systems Approach to Corporate Governance Reform: Why Importing U.S. Corporate Law Isn't the Answer, 45 Wm. & Mary L. Rev. 1055 (2004), https://scholarship.law.wm.edu/wmlr/vol45/iss3/7 Copyright c 2004 by the authors. This article is brought to you by the William & Mary Law School Scholarship Repository. https://scholarship.law.wm.edu/wmlr A SYSTEMS APPROACH TO CORPORATE GOVERNANCE REFORM: WHY IMPORTING U.S. CORPORATE LAW ISN'T THE ANSWER TROY A. PAREDES* TABLE OF CONTENTS INTRODUCTION ........................................ 1056 I. THE COMPARATIVE CORPORATE GOVERNANCE DEBATE: DOES LAW MATTER? .......... ... ............. .... 1061 A. Law Matters ................................... 1063 B. TransplantingU.S. Corporate Law ................ 1070 II. THE U.S. CORPORATE GOVERNANCE SYSTEM ........... 1075 A. The Formal Rules of the Game .................... 1077 B. Why Do ShareholdersStill Invest? ................. 1085 C. Overall Coherence and "System Logic".............. 1101 III. IS THE U.S. CORPORATE GOVERNANCE SYSTEM TRANSPLANTABLE? . .. .. .. 1103 A. ComplementaritiesCritique ....................... 1105 B. PrivateOrdering Critique ........................ 1109 C. NonshareholderPrimacy Critique ................. 1116 D. CapitalStructure Critique ....................... 1121 IV. LESSONS FOR DEVELOPING COUNTRIES: A FRAMEWORK FOR CORPORATE GOVERNANCE REFORM ................... 1122 A. When Law Really Matters ........................ 1122 B. "Ground-Level"Benefits of Mandatory CorporateLaw . 1133 C. Some Proposalsto Consider ...................... 1145 CONCLUSION ......................................... 1155 * Associate Professor of Law, Washington University School of Law. Special thanks to Chris Bracey, John Drobak, Frances Foster, John Haley, Bill Jones, Eric Kades, Scott Kieff, Brett McDonnell, Thomas Merrill, Peter Mutharika, Andrzej Rapaczynski, Ted Ruger, and Joel Seligman for helpful comments and discussions in the writing of this Article. Of course, I take responsibility for all remaining mistakes. 1055 1056 WILLIAM AND MARY LAW REVIEW [Vol. 45:1055 INTRODUCTION The task is daunting: Spur economic growth in developing countries. Much attention has focused on bringing economic pros- perity to transitional economies, including Russia and other former Soviet bloc countries, such as Hungary, Poland, and Czechoslovakia. Developing countries in Asia, Latin America, and Africa have also been the subject of reform programs, many of which have been controversial, designed to promote economic growth through privatization, political change, and other means. Today, all eyes are on Iraq and Afghanistan. A recent article in the Wall Street Journal, titled Taking Iraq Private, summed up what many view as central to promoting economic growth in Iraq and elsewhere: Create property rights, the rule of law, and other institutions that will encourage private investment and foster free markets.' While I agree with the article's premise, its title is a misnomer. The goal is less about taking developing countries private than it is about taking them public. One solution for spurring economic growth in the developing world is to promote securities markets. An established body of empirical studies shows, as one might suspect, a link between the development of capital markets and economic growth.2 The basic intuition is straightforward: Robust capital markets allow busi- nesses and entrepreneurs to tap into the financial resources needed to increase output, invest in new technologies, fund research and development, build new factories, hire more workers, and exploit business opportunities domestically and abroad. The question, then, becomes: What policies best promote securities markets as a means of economic prosperity in developing countries? When it comes to promoting equity markets, the question is often rephrased to ask: What accounts for the Anglo-American pat- tern of finance, characterized by dispersed share ownership and the separation of ownership and control in the United States and the United Kingdom, and how can developing countries replicate this 1. Robert McFarlane & Michael Bleyzer, Taking IraqPrivate, WALL ST. J., Mar. 27, 2003, at A10. 2. See infra note 32. 20041 A SYSTEMS APPROACH 1057 achievement? Suggesting the difficulties of achieving broad and deep stock markets in which shareholders are willing to hold minority stakes in companies, concentrated ownership structures are more typical around the globe.3 The "law matters" thesis claims that the law has a central role to play in the development of equity markets. In short, the law is essential to securing the property rights of shareholders. Strong legal protections shield shareholders, especially minority share- holders, from having their investments expropriated by insiders, including directors, officers, entrepreneurs, and controlling share- holders. Unless shareholders are protected from agency problems, such as excessive executive compensation, insider trading, self- dealing transactions, and shirking, they will be discouraged from investing. Those who do invest will pay a discount for shares in order to compensate them for the risk of opportunism they are otherwise forced to shoulder. By protecting shareholders from insider abuses, the law can instill in shareholders the confidence needed to invest, thereby leading to thicker and more highly valued equity markets. The "law matters" thesis is supported by an extensive body of empirical studies, led by the work of La Porta, Lopez-de-Silanes, Shleifer, and Vishny.4 Moving beyond whether law matters in concept, the practical question becomes: "What law?" Because the United States by all accounts has the world's thickest equity markets, with over 7500 issues trading on the New York Stock Exchange and NASDAQ alone,5 attention often turns to the United States when policy- makers and others spearheading reform fashion corporate gover- nance agendas for developing countries. Indeed, the "law matters" thesis holds out the possibility that if developing economies craft a corporate law regime like that of the United States, they can 3. See John C. Coffee, Jr., The Futureas History: The Prospects for Global Convergence in Corporate Governance and Its Implications, 93 Nw. U. L. REV. 641, 642 n.2 (1999) (collecting citations to empirical literature). 4. See infra Part I.A. 5. See JOHN C. COFFEE, JR. & JOEL SELIGMAN, SECURITIES REGULATION 24-25 (9th ed. 2003) (citing MARSHALL E. BLUME, THE STRUCTURE OF THE U.S. EQUITY MARKETS (The Wharton School, Univ. of Pa., Working Paper No. 02-16,2002), available at http://fic.wharton. upenn.edu/fic/papers/02/0216.pdf. 1058 WILLIAM AND MARY LAW REVIEW [Vol. 45:1055 achieve developed securities markets. But is the U.S. approach to corporate governance right for developing countries? One danger of transplanting U.S. corporate law to developing economies is that it might not fit with the "importing" country's economic structure, political system, social order, or cultural values. To be sure, the resulting "transplant effects" of any such misfit are important. My focus, however, is the other side of the transplant coin-namely, whether a market-based system of corporate governance, like that found in the United States, ade- quately protects shareholders in developing countries so as to promote equity markets there. Posed differently, to what extent should the government displace private ordering with more substantive regulation of corporate governance in developing countries? U.S. corporate law, and Delaware corporate law in particular, reflect an enabling approach to corporate law made up largely of default rules that parties can opt out of to privately order their governance affairs. The law on the books is supplemented by the judge-made law of fiduciary duties, designed to ensure that directors and officers, who are charged with managing the corporation's business and affairs, exercise their authority over the business with due care, in good faith, and in the best interests of the corporation and its shareholders. While far from trivial, Delaware corporate law provides shareholders relatively few protections from insider abuses.6 Indeed, Delaware corporate law affords directors and officers a great deal of discretion in managing the business free from the interference of shareholders and judges. The gaps in the law are filled by a host of other formal and informal mechanisms that hold management accountable. The market for corporate control and incentive-based compensation, such as stock options, are frequently cited as examples of the nonlaw components that contribute to the U.S. corporate governance system. At bottom, instead of depending primarily on substantive corporate law to protect shareholders, the market-based approach of U.S. corporate governance relies on markets, contracts, and norms, supported by a host of other institutions, to discipline directors and officers. 6. See infra note 60. 20041 A SYSTEMS APPROACH 1059 Not every country has the institutional makeup that allows it to eschew a more heavy-handed corporate law regime and still develop thick equity
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