Optimal Defaults for Corporate Law Evolution

Abstract

I. CHOOSING DEFAULTS IN A DYNAMIC BUSINESS ENVIRONMENT This Article focuses on a question that has, in our view, received inadequate attention in the literature on corporate law theory and policy: What approach should guide courts and legislators when they choose a default arrangement to govern a new issue confronting publicly traded companies?1 This question is important because such companies often live a long life after they go public, and they operate in a dynamic, ever-changing environment. Courts and legislators are therefore often faced with the need to provide default arrangements for contingencies that the corporate charter's original designers failed either to anticipate or to consider thoroughly. In this Article, we provide a theory of optimal corporate-law defaults. We argue that, in choosing default corporate-law arrangements, courts and legislators should follow what we call the reversible defaults approach. We also evaluate, in light of our theory, several important choices that state corporate law has made in the last two decades, endorsing some of these choices and suggesting changes in others. Work on the general considerations that lawmakers should use in designing corporate rules has focused on the criteria for deciding whether a given corporate issue should be governed by a mandatory or by a default rule, that is, on whether companies should be allowed to opt out of the arrangement that the law provides.2 In contrast, relatively little has been written about the general considerations that should determine the choice of detion and analyzes how such default arrangements should be designed. The ever-changing nature of the business environment, combined with the long life that many publicly traded companies have, requires corporate law to provide defaults to govern new circumstances that had received little or no proir attention from the designers of corporate charters. For example, the development of the market for hostile takeovers in the 1970s and the 1980s required public officials to provide default rules to govern the new problems and issues associated with this new business environment. The choice of default arrangements is thus an important question for corporate law policy. Our analysis takes into account an important difference between two types of companies to which a default rule will apply: companies that will go public in the future (future IPOs), after the default's rule adoption, and companies that are already publicly traded at the time the new default is adopted (existing companies).4 As we shall show, this distinction is quite significant for the optimal design of default rules. The potential effect of a new default rule on existing companies is especially important, because existing companies wishing to opt out of new default arrangements face some impediments that will not arise for future IPOs. Whenever a default arrangement that legislators or courts adopt turns out to be inefficient, companies going public subsequent to the default arrangement's adoption will most likely opt out of it. Such opting out of defaults that turn out to be inefficient, however, might not take place in existing companies if opting out would be disfavored by management. When default rules are adopted, they generally affect many companies already in existence. At the time they went public, these companies did not anticipate the developments triggering the adoption of these rules, and they thus did not provide contractual arrangements in their charters to govern these developments. Companies that went public in the 1970s, for example, did not anticipate the mid-1980s invention of the poison pill, the changes in director liability following the Van Gorkom decision, or the ways in which classified boards would interact with poison pills to impede hostile takeovers.5 When these developments emerged in the 1980s and 1990s, courts and legislators had to choose default arrangements, recognizing that these arrangements would affect the large stock of public companies already in existence. …