Rethinking Corporate Law and Economics in a Theory of Private Benefits of Control

Abstract

The standard approach to the legal foundations of corporate governance is based on the 'law matters' thesis, according to which corporate law promotes separation of ownership and control by protecting minority shareholders from expropriation. This paper takes a broader perspective on the economic and legal determinants of corporate governance. It shows that protection and exchange of corporate control is at least as important as investor protection, and so are the legal institutions that support them. This result is derived by defining a third category of 'idiosyncratic' private benefits of control, which supplements the more traditional specifications as inefficient consumption of control perquisites ('distortionary' private benefits) or outright expropriation of shareholder value ('diversionary' private benefits).The proposed framework departs from the standard principal-agent models in that it assumes that private benefits of control also account for a further value to be appropriated as reward to entrepreneurship in the corporate structure. The quasi-rent nature of this value makes appropriation by corporate controllers a necessary condition for efficiency ex ante, which implies that residual control rights be allocated separately from ownership. Under a number of reasonable assumptions, a constrained-efficient outcome is derived ex post as Coasian bargain between the incumbent and the insurgent over the value of corporate control.This result has a number of implications for corporate law. When legal institutions effectively constrain expropriation of non-controlling shareholders, they may still distort separation of ownership and control by making ownership structures either more concentrated or more dispersed than it would be efficient. This happens when corporate law fails to provide those who run the company with entitlements to uncontested control independently of how much ownership they retain. Likewise, regulation may undermine the takeover process when it restricts side payments that ultimately support efficient bargaining upon the value of corporate control.