Company Law, Lawyers and Innovation Common Law versus Civil Law Francisco Reyes and Erik P.M. Vermeulen Topics in Corporate Law & Economics 2011-3 Electronic copy available at: http://ssrn.com/abstract=1907894 Abstract In this essay we make two major claims. The first is that public legislatures should think seriously about giving maximum effect to the principle of freedom of contract in company law. This would not only give corporate lawyers the tool they need to provide legal services that match the needs of the current global business community, but also encourage legal experimentation. The second claim is that corporate lawyers in common law systems are more open to legal change and innovation than their civil law colleagues. The difference seems to lie in the more experimental nature of common law compared to civil law systems. Keywords: business entities, civil law, common law, company law, corporate lawyer, LLC, legal origin, innovation and entrepreneurship JEL Classifications: K20, K22, L22, L26, L51 © 2011 Lex Research Ltd Electronic copy available at: http://ssrn.com/abstract=1907894 Company Law, Lawyers and Innovation: Common Law versus Civil Law Francisco Reyes1 and Erik P.M. Vermeulen2 I. Introduction Arguably, there is a relationship between company law, lawyers and innovation. The editorial in the Economist of 18 December 1926 clearly describes the relationship: “The economic historian of the future may assign to the nameless inventor of the principle of limited liability, as applied to trading corporations, a place of honour with Watt and Stephenson, and other pioneers of the Industrial Revolution. The genius of these men produced the means by which man's command of natural resources has multiplied many times over; the limited liability company [provided] the means by which huge aggregations of capital required to give effect to their discoveries were collected, organized and efficiently administered.”3 To see this, consider the following principles of the public company form: (1) a corporation is a legal entity that holds the firm’s assets; (2) the limited liability feature allows shareholders, many of whom are wealth-constrained and risk-averse, to diversify their risks and trade their shares publicly; and (3) corporate law creates centralized management, to which shareholders delegate important control rights to a group of specialists. These principles facilitate the separation of residual control from residual risk-bearing - usually referred to as the separation of ownership and control - and, hence, make it possible to publicly raise capital from a large number of equity investors. Undoubtedly, firms’ decisions to embrace the public company and stockmarket listings have accelerated innovation and industry productivity. Provocative work on law, finance and development argued that the protection of investors in corporations that were governed by common law rules and institutions were considerably more effective than the rules originating in their civil law counterparts.4 The difference in investor 1 Francisco Reyes is Director Graduate Program in Corporate Law Universidad Javeriana in Bogota, Colombia. He has been a visiting professor at Louisiana State University, University of Lyon Jean Moulin, Stetson College of Law and University of Fribourg. He is partner and founder of Francisco Reyes & Asociados in Bogota, Colombia. 2 Erik P.M. Vermeulen is Professor of Business Law, Department of Business Law, Tilburg University in the Netherlands, Visiting Professor, Kyushu University in Fukuoka Japan, and Vice-President Corporate Legal Department of Philips International B.V. (Corporate and Financial Law Group) in the Netherlands. The views in this essay are those of the authors and should not be attributed to any organization. We would like to thank Mark Fenwick, Masato Hisatake, Joseph McCahery, Jose Miguel Mendoza, Jun Saito, Karsten Engsig Sorensen, Christoph Van der Elst and Dirk Zetzsche who provided helpful comments and suggestions. We would also like to thank Valentine Snijder for her very helpful research assistance. 3 See also Paul Halpern, Limited and Extended Liability Regimes, in P. Newman (ed.), The New Palgrave Dictionary of Economic and the Law, London, Macmillan Reference LImited, vol. 3, 1998. 4 See La Porta, Lopez-de-Silanes, Shleifer and Vishny, Legal Determinants of external finance, 52 Journal of Finance 1131 (1997); La Porta, Lopez-de-Silanes, Shleifer and Vishny, Law and finance, 106 Journal of Political Economy 1113 (1998); La Porta, Lopez-de-Silanes, Shleifer, Corporate ownership around the world, 54 Journal of Finance 471 (1999); La Porta, Lopez-de-Silanes, Shleifer and Vishny, Agency problems and dividend policies around the world, 158 Journal of Finance 3 (2000). 1 protection against expropriation by managers could even explain the divergences in the nature and effectiveness of financial systems, and hence the innovative capacities on a global scale. A widely accepted explanation for this is that common law statutes give the judiciary more latitude to fill gaps in the inherently incomplete statutory company law arrangements that constitute a firm. The argument is that open-ended fiduciary duty concepts in corporate law invite the judiciary to devise efficient remedies, hence providing an abundance of case law to guide the adjudicators in their efforts to resist opportunism within business settings. In this respect, common law statutes are arguably more conducive to economic and social change than comprehensive and largely mandatory civil law codes that discourage the adjudicators’ ability to complement and deviate from statutory law. However, civil law countries have caught up with common law systems during the past decade by implementing a vast array of corporate governance reforms and introducing sophisticated protective measures for passive equity investors. Restoring investors’ confidence in the integrity of capital markets and addressing deficiencies in the relationship between managers and shareholders of listed companies are two important factors motivating the constant drive for corporate governance improvements in the area of listed companies and stock markets in both common and civil law jurisdictions. This is exemplified by the recent global financial crisis, which has yet again spurred legislatures into action to address perceived market failures. It is only to be expected that the recent crisis lead to more mandatory rules and convergence in the corporate governance systems of listed companies around the world.5 This observation leads to an interesting conclusion: the rapid convergence in the legal protection of investors suggests that legal origin (common law or civil law system) is not a major barrier to change and innovation in the area of company law.6 Breaking with the conventional wisdom on the differences between common law and civil law systems, this paper argues that the role of the legal industry - in particular the actions and non- actions of corporate lawyers and other legal practitioners - rather than legislatures and courts, explains the innovative lawmaking approach in common law systems. It is generally acknowledged that corporate law in common law countries tends to be more enabling than in civil law countries.7 This is particularly true for new company law products that, by combining the corporate feature of fully-fledged limited liability with the partnership law principles of flexibility and informality, 5 See, for instance, European Commission, Green paper, The EU corporate governance framework, Brussels, COM(2011), 164. See also Van der Elst and Vermeulen, Europe’s Corporate Governance Green Paper: Do Institutional Investors Matter?, (June 8, 2011). Lex Research Topics in Corporate Law & Economics Working Paper No. 2/2011. Available at SSRN: http://ssrn.com/abstract=1860144. 6 See Armour, Deakin, Sarkar, Siems and Singh, Shareholder Protection and Stock Market Development: An Empirical Test of the Legal Origins Hypothesis, 6 Journal of Empirical Legal Studies 343 (2009). See also Pistor, Keinan, Kleinheisterkamp and West, Innovation in Corporate Law, 31 Journal of Comparative Economics 676 (2003); Lele and Siems, Shareholder Protection: A Leximetric Approach, 7 Journal of Corporate Law Studies 17 (2007). 7 See Ribstein, The Rise of the Unincorporation, Oxford University Press 2010. See als Mendoza, Van der Elst and Vermeulen, Entrepreneurship and Innovation: The Hidden Costs of Corporate Governance in Europe, 7 South Carolina Journal of International Law & Business (2010). 2 completely changed the legal landscape in the United States in the 1990s. The statutes of these “hybrid business forms”, in particular the limited liability company (LLC), were largely a byproduct of practicing corporate lawyers’ drafting and lobbying efforts to better support their clients.8 The proactive attitude of lawyers can be explained by competitive pressures that encouraged them to push for more flexible rules.9 Failing to do so could negatively affect the attractiveness of a jurisdiction’s company laws, which, in turn, could hamper potential long-term fee revenue growth for the corporate lawyers and their firms. Based on our research,10 corporate lawyers in civil law countries are generally inclined to pursue a reactive, non-competitive strategy. Concerned about legal certainty arguments, corporate lawyers and other legal advisors tend to maneuver within the boundaries set by the statutory company law and case law system in a particular jurisdiction. Interestingly