Voting and the Economics of Corporate Self-Dealing: Theory Meets Reality

Abstract

Self-dealing presents a major problem in corporate law. It finds its particular expression in everyday corporate actions and deals between corporations and their controlling parties, subsidiaries, directors, corporate officers, or any other entity in which shareholders may have an interest. Conflict of interests in the context of corporate law may be controlled by a variety of means, ranging from the absolute prohibition of self-dealing to the prohibition of voting with conflicting interests (the majority of the vote), the imposition of fairness duties, and non-interventionary approaches. Based on an economic analysis, the Article presents an innovative and comprehensive theory accounting for the problems inherent in self-dealing (i.e., conflict of interests). The theory enables the author to provide a unique presentation and evaluation of the relative efficiency of the solutions to the conflict of interests problem adopted by different corporate laws.The Article's analysis of the self-dealing problem is based on the novel theory that legal protections can be classified into or not only in the context of individual rights but also in the context of rights. Applying this theory to self-dealing transactions, in which the group is composed of the minority shareholders, the author demonstrates that each of the two most effective solutions to the self-dealing problem can be classified as either a property rule or a liability rule. The requirement of a majority-of-the-minority vote, which prevents any transaction from proceeding without the minority group's consent, can be defined as a property rule. The fairness test, which allows transactions to be imposed on an unwilling minority but ensures that the minority receives adequate compensation in objective market-value terms, can be defined as a liability rule.The choice between the two types of rules is a function of the total transaction costs in a particular legal system. These transaction costs include both the negotiation costs attendant upon a property rule, as well as the adjudication costs associated with a liability rule. The Article further reveals that the sum of transaction costs is influenced by the efficacy of the judicial system and of extra-legal mechanisms, such as the market for corporate control, the capital market, and the type of investors active in the market.An empirical survey and analysis of the regulation of self-dealing in several countries -- Delaware, United Kingdom, Canada, Germany, and Italy -- reveal and confirm the main theoretical claims of this Article. The Article arrives at three principal conclusions. First, corporate laws must incorporate some form of minority protection against self- dealing as a mandatory rule. Second, because of the transaction costs associated with each means of legal protection, there is no single efficient solution suitable for every jurisdiction; any solution chosen to cope with the self-dealing problem must take into account the relevant local conditions. Third, Delaware's rules governing self-dealing, which were believed to be indeterminate and opaque, are shown, for the first time, to be efficient and coherent.