380. Mark J. Roe, Corporate Law's Limits, 07/2002; subsequently published in Journal of Legal Studies, Vol. XXXI (2), Pt. 1, 2002, 233-271.
Abstract: A strong theory has emerged that the quality of corporate law primarily determines whether securities markets arise, whether ownership separates from control, and whether the modern corporation can prosper. The theory can used convincingly explain why we see weak corporate structures in transition and developing nations, but less convincingly explains why concentrated ownership persists in continental Europe or why it became less important in the United States. Surely, when an economically-weak society lacks regularitya gap that may be manifested by weak or poorly enforced corporate lawthat lack of regularity and that lack of economic strength precludes complex institutions like securities markets and diffusely-owned public firms. But in several nations in the wealthy west legal structures are quite good and, by measurement, shareholders are well protected, but ownership has still not yet separated from control. Something else has impeded separation. We can hypothesize what that something is by examining the calculus of owners and investors when they decide whether to diffuse ownership. Ownership cannot readily separate from control when managerial agency costs are especially high. And missing from current discourse is the basic concept that even American corporate lawusually seen as high quality nowadaysdoes not burrow into the firm to root out those managerial agency costs that arise from mediocre business decisions. Judicial doctrine and legal inquiry attack self-dealing, not bad business judgment. The business judgment rule, under which judges do not second-guess managerial mistake, puts the full panoply of agency costssuch as over-expansion, over-investment, and reluctance to take on profitable but uncomfortable risksbeyond direct legal inquiry. The consequence is that even if corporate law as usually conceived is "perfect," it directly eliminates self-dealing, not managerial mistake. But managers can lose for shareholders as much, or more, than they can steal from them, and law directly controls only the second cost not the first. If the risk of managerial error varies widely from nation-to-nation, or from firm-to-firm, ownership structure should vary equally widely, even if conventional corporate law tightly protected shareholders everywhere. There is also good reason, and some new data, consistent with this analysis: by measurement several nations have fine enough corporate law; distant stockholders are protected from controlling stockholder and managerial thievery, but uncontrolled agency costs though seem to be especially high in those very nations.