Reinier Kraakman

Stock Pyramids, Cross-Ownership, and the Dual Class Equity: the Creation and Agency Costs of Seperating Control from Cash Flow Rights

This paper examines common arrangements for separating control from cash flow rights: stock pyramids, cross-ownership structures, and dual class equity structures. We describe the ways in which such arrangements enable a controlling shareholder or group to maintain a complete lock on the control of a company while holding less than a majority of the cash flow rights associated with its equity. Next, we analyze the consequences and agency costs of these arrangements. In particular, we show that they have the potential to create very large agency costs -- costs that are an order of magnitude larger than those associated with controlling shareholders who hold a majority of the cash flow rights in their companies. The agency costs of these structures, we suggest, are also likely to exceed the agency costs of attending highly leveraged capital structures. Finally, we put forward an agenda for research concerning structures separating control from cash flow rights.

Toward Unlimited Shareholder Liability for Corporate Torts

Limited liability in tort has been the prevailing rule for corporations in the United States, as elsewhere, for more than a century. This rule is generally acknowledged to create incentives for excessive risk-taking by permitting corporations to avoid the full costs of their activities. Nevertheless, these incentives are conventionally assumed to be the price of securing efficient capital financing for corporations. Although several authors have recently proposed curtailing limited liability for certain classes of tort claims or for certain types of corporations in order to control its worst abuses, even the most

Property, Contract, and Verification: The Numerus Clausus Problem and the Divisibility of Rights

Abstract The law of every jurisdiction defines a set of well‐recognized forms that property rights can take and restricts the creation of property rights that deviate from those forms. We argue that these restrictions serve not to standardize rights as others have argued but rather to aid verification of the ownership of rights offered for conveyance. We explore the feasible verification rules for property rights and illustrate the relationship between those rules and the structure of rights they support in the principal fields of property, including use rights to real and personal property, security interests, legal entities, and intellectual property. We offer a simple calculus for assessing the efficiency of alternative property rights regimes. We define clearly the difference between property rights and contract rights, clarify the connection between property rights and property rules, and illuminate the limits on specific performance as a contract remedy.

Organizational Law as Asset Partitioning

Abstract Organizational law – comprising the bodies of law that govern standard legal entities such as business corporations, partnerships, cooperatives, nonprofit organizations, trusts, limited liability companies, and marriages – serves many functions of an essentially contractual character. These contractual functions – which include most matters involving the allocation of authority and earnings among the participants in the firm – could, however, be performed relatively easily by private contracting even in the absence of organizational law. A far more important function of organizational law, we argue, is its role in partitioning property rights between creditors of a firm and creditors of the firms owners and managers. In particular, organizational law plays a crucial role in permitting the formation of a separate pool of assets that can be pledged to bond the contracts of which the firm is the nexus. While the laws role in partitioning off these bonding assets is seldom remarked, it is far more significant than the better-studied rule of limited liability that characterizes many, but not all, legal entities.

Do the Capital Markets Compel Limited Liability? A Response to Professor Grundfest

We had hoped that our recent article2 exploring a rule of pro rata shareholder liability for corporate torts would spark renewed interest in the limited liability doctrine. Indeed, we concluded that article by inviting limited liability proponents to redress the balance of the argument. We therefore enthusiastically welcome the spirited defense of limited liability offered by Professor Joseph Grundfest in this issue of The Yale Law Journal3 and by his colleague, Professor Janet Cooper Alexander, in a forthcoming article in the Harvard Law Review.4 We predicted in our original article that the strongest arguments supporting limited liability would have little to do with the particular concerns of corporate law or the requirements of the corporate form. Rather, they were likely to rest on a belief that investors would be able to evade a pro rata liability regime, or that the difficulties of extraterritorial enforcement would preclude effective adoption of such a regime in any single jurisdiction. Judging from the arguments of our critics, our prediction was on the mark. For what these critics do not argue is as important to us as what they do. They do not make an affirmative policy case for limited liability, nor do they defend the traditional corporate law view that breaching the limited liability rule might cripple the corporate form or impair the liquidity of the securities market. Instead, they focus on the difficulties of implementing a proportionate liability regime. Professor Grundfest accepts arguendo the policy rationale for proportionate liability but contends that enforcement constraints arising from the dynamism of the capital markets will doom any effort to escape the status quo.

CEO Tenure, Performance and Turnover in S&P 500 Companies

The centrality of the CEO is reflected in the empirical literature linking CEO turnover to poor firm performance. However, less is known about the institutional and personal correlates of CEO turnover. In this study, we find two CEO characteristics interact with turnover: tenure and ownership. We interpret our results as indicating that CEOs of S&P 500 firms divide into two groups with different tenure patterns – “owners” (who have large personal shareholdings) and “managers” (who have smaller holdings). The tenure of manager-CEOs (as opposed to owner-CEOs) exhibits a term structure loosely similar to the one produced by the tenure process at academic institutions. Turnover significantly depends on firm performance during a CEO’s first four years on the job. In particular, external turnover by sale of the firm peaks a year 4 during a CEO tenure. By contrast, external turnover peaks at years 5 – 6, and plateaus at relatively high levels until year 9 of tenure. These term effects are strongest for relatively young CEOs. We also find that forced exit, retirement, and deals covary rather than substitute for one another as modes of CEO turnover. However, forced exits and deals both relate to poor performance by the firm on different metrics. Our evidence suggests that most internal turnover, particularly after a CEO’s first five years, is unrelated to firm performance.

Market Efficiency after the Financial Crisis: It's Still a Matter of Information Costs

Compared to the worldwide financial carnage that followed the Subprime Crisis of 2007-2008, it may seem of small consequence that it is also said to have demonstrated the bankruptcy of an academic financial institution: the Efficient Capital Market Hypothesis (“ECMH”). Two things make this encounter between theory and seemingly inconvenient facts of consequence. First, the ECMH had moved beyond academia, fueling decades of a deregulatory agenda. Second, when economic theory moves from academics to policy, it also enters the realm of politics, and is inevitably refashioned to serve the goals of political argument. This happened starkly with the ECMH. It was subject to its own bubble – as a result of politics, it expanded from a narrow but important academic theory about the informational underpinnings of market prices to a broad ideological preference for market outcomes over even measured regulation. In this Article we examine the Subprime Crisis as a vehicle to return the ECMH to its information cost roots that support a more modest but sensible regulatory policy. In particular, we argue that the ECMH addresses informational efficiency, which is a relative, not an absolute measure. This focus on informational efficiency leads to a more focused understanding of what went wrong in 2007-2008. Yet informational efficiency is related to fundamental efficiency – if all information relevant to determining a security’s fundamental value is publicly available and the mechanisms by which that information comes to be reflected in the securities market price operate without friction, fundamental and informational efficiency coincide. But where all value relevant information is not publicly available and/or the mechanisms of market efficiency operate with frictions, the coincidence is an empirical question both as to the information efficiency of prices and their relation to fundamental value. Properly framing market efficiency focuses our attention on the frictions that drive a wedge between relative efficiency and efficiency under perfect market conditions. So framed, relative efficiency is a diagnostic tool that identifies the information costs and structural barriers that reduce price efficiency which, in turn, provides part of a realistic regulatory strategy. While it will not prevent future crises, improving the mechanisms of market efficiency will make prices more efficient, frictions more transparent, and the influence of politics on public agencies more observable, which may allow us to catch the next problem earlier. Recall that on September 8, 2008, the Congressional Budget Office publicly stated its uncertainty about whether there would be a recession and predicted 1.5 percent growth in 2009. Eight days later, Lehman Brothers had failed, and AIG was being nationalized.

Reflections on the End of History for Corporate Law

In this chapter we reflect on our paper ‘The End of History for Corporate Law’ (Hansmann and Kraakman, 2001), originally written for a conference at Columbia University in 1997 on a question that was then just beginning to attract substantial attention: ‘Are corporate governance systems converging?’ There can of course be as many answers to that question as there are interpretations of the question itself. At a macro level, however, it seemed to us that there was an important sense in which the answer to this question was clearly ‘yes.’ In our original paper — with its hyperbolic title and somewhat more modulated text — we sought to expound that view.

Concluding Remarks on Creditor Protection

Summarizing the many thoughtful papers presented at this conference is a difficult task for an outside observer of European law reform. In lieu of bad comments on good papers, I offer instead my own observations on several of the conferences principal themes.

The Link Between the Acquisitions Market and the Market for CEOs

Two empirical literatures tie the displacement of CEOs of widely-held companies to the poor performance of their firms - the turnover and mergers and acquisitions (M&A) literatures. In this paper we demonstrate a strong link between CEO turnover and friendly acquisitions of target firms in the S&P 500 between 1992 and 2004. We find that acquisitions and internal CEO turnover are most likely to occur at the same point in a CEO’s tenure, roughly five years after her initial appointment. We conjecture that deals are potential alternatives to CEO dismissal by the board or imminent CEO retirement. We explore interactions among CEO dismissals, retirements and resignations, and acquisitions on the one hand, and firm performance and CEO tenure on the other. We also investigate more specific hypotheses relating tenure to a CEO’s age, status as an inside or outside appointee, and the level of deal activity in the M&A market. Among our key findings is that the probability of a deal remains constant over the upper half of the age distribution of our sample CEOs, even though their probability of retiring increases sharply. This suggests that - contrary to our conjecture - impending retirement is not among the stronger incentives driving the management of target firms to seek friendly buyers. Finally, this paper contributes on the methodological level by comparing multinomial logistic regression - the traditional methodology of turnover research - to competing risk regression, a methodology adapted from epidemiological and medical research and recently introduced into the empirical finance literature.