Ronald J. Gilson

The Legal Infrastructure of High Technology Industrial Districts: Silicon Valley, Route 128, and Covenants Not to Compete

A locking device for a vehicle having an internal combustion engine and a fuel injection pump is effective to lock an element of the vehicle necessary for its safe operation, such as the steering column, and to render the vehicle inoperative. Means are provided to preclude the possibility that the steering column or other element be locked while the pump is operative.

Globalizing Corporate Governance: Convergence of Form or Function

This paper examines the interplay between selection-driven functional adaptivity on the one hand, and formal institutional persistence or path dependency on the other, that will determine whether such corporate governance convergence as we observe will be formal or functional. Five combinations of formal and functional covergence are considered: 1) purely functional convergence, as with the displacement of inefficient management; 2) the use of formal tools to catalyze the breakdown of formal barriers to functional convergence as with the elimination of tax on the sale of cross holdings; 3) the need for elements of both formal and functional convergence as with the creation of the institutional infrastructure that supports a venture capital market; 4) convergence by contract as with security design or foreign stock exchange listing; and 5) convergence through regulatory competition -- the hybrid of private and public ordering introduced to the European Community by the European Court of Justices recent decision in Centros.

Understanding the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organization

We aim here for a better understanding of the Japanese keiretsu. Our essential claim is that to understand the Japanese system-banks with extensive investment in industry and industry with extensive cross-ownership-we must understand the problems of industrial organization, not just the problems of corporate governance. The Japanese system, we assert, functions not only to harmonize the relationships among the corporation, its shareholders, and its senior managers, but also to facilitate productive efficiency.

Disputing through Agents: Cooperation and Conflict between Lawyers in Litigation

Do lawyers facilitate dispute resolution or do they instead exacerbate conflict and pose a barrier to the efficient resolution of disputes? A distinctive characteristic of our formal mechanisms of conflict resolution is that clients carry on their disputes through lawyers. Yet, at a time when the role of lawyers in dispute resolution has captured not only public but political attention,3 social scientists have remained largely uninterested in

The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights

Equity ownership in the United States no longer reflects the dispersed share ownership of the canonical Berle-Means firm. Instead, we observe the reconcentration of ownership in the hands of institutional investment intermediaries, which gives rise to what we call “the agency costs of agency capitalism.” This ownership change has occurred because of (i) political decisions to privatize the provision of retirement savings and to require funding of such provision and (ii) capital market developments that favor investment intermediaries offering low cost diversified investment vehicles. A new set of agency costs arise because in addition to divergence between the interests of record owners and the firm’s managers, there is divergence between the interests of record owners – the institutional investors – and the beneficial owners of those institutional stakes. The business model of key investment intermediaries like mutual funds, which focus on increasing assets under management through superior relative performance, undermines their incentive and competence to engage in active monitoring of portfolio company performance. Such investors will be “rationally reticent” – willing to respond to governance proposals but not to propose them. We posit that shareholder activists should be seen as playing a specialized capital market role of setting up intervention proposals for resolution by institutional investors. The effect is to potentiate institutional investor voice, to increase the value of the vote, and thereby to reduce the agency costs we have identified. We therefore argue against recent proposed regulatory changes that would undercut shareholder activists’ economic incentives by making it harder to assemble a meaningful toe-hold position in a potential target.

Why Start-Ups?

The prototypical start up involves an employee leaving her job with an idea, and selling a portion of that idea to a venture capitalist. Yet the idea should be worth more to the former employer. In this setting, the former employer can be expected to have better information concerning the employee-entrepreneur and the technology, have opportunities to capture economies of scale and scope not available to a venture capital-backed start-up, and will receive more favorable tax treatment than the start-up should the innovation fail. In connection with an auction of the idea, the former employer should have both a more accurate estimate of its value and receive an element of private value not available to the venture capitalist. In turn, this should give rise to a powerful winners curse: each time a venture capitalist wins the auction, it will have paid more than a party that has better information and receives an element of private value, in contrast to the venture capitalists receipt of only common value. The puzzle, then is why we ever observe start-ups? Our analysis of the former-employers bidding strategy stresses the impact on the employers ongoing research effort of purchasing a share in the employees idea for a price comparable to what a venture capitalist would pay. Where research is a team effort, an employers bidding creates an incentive for employees to establish internal property rights to their research efforts. Such influence activities reduce the future output of the employers R&D efforts. Thus, in setting the internal incentives of its research employees -- in effect, the employers internal bid for the discovery -- an employer must trade off the between the strength of the incentives and the impact on the overall research effort of high individual payoffs to innovation. The employer sets the internal payoff to discovery to equalize the marginal benefit of an additional unit of incentive (a higher bid) and the marginal cost of the resulting decrease in the effectiveness of its research effort. Some employees are therefore allowed to leave, and start-ups are observed.

Controlling Family Shareholders in Developing Countries: Anchoring Relational Exchange

The Law and Finance account of the ubiquity of controlling shareholders in developing markets is based on conditions in the capital market: poor shareholder protection law prevents controlling shareholders from parting with control out of fear of exploitation by a new controlling shareholder who acquires a controlling position in the market. This explanation, however, does not address why we observe any minority shareholders in such markets, or why controlling shareholders in developing markets are most often family-based. This paper looks at the impact of bad law on shareholder distribution in a very different way. Developing countries typically provide not only poor minority protection, but poor commercial law generally. Specifically, the paper considers the impact on the distribution of shareholders of conditions in the product market, where the driving legal influence is the quality of commercial law that supports the corporations actual business activities, and where the presence of a controlling family shareholder may help support reputation-based trading in a bad commercial law environment.

Braiding: the Interaction of Formal and Informal Contracting in Theory, Practice, and Doctrine

This article studies the relationship between formal contract enforcement, where performance is encouraged by the prospect of judicial intervention, and informal enforcement, where performance is motivated by the threat of lost reputation and expected future dealings or a taste for reciprocity. The incomplete contracting literature treats the two strategies as separate phenomena. By contrast, a rich experimental literature considers whether the introduction of formal contracting and state enforcement “crowds out” or degrades the operation of informal contracting. Both literatures, however, focus too narrowly on formal contracts as a system of incentives for inducing parties to perform substantive actions, while assuming that the effectiveness of informal enforcement depends on pre-existing levels of trust. As a result, current scholarship misses the relationship between formal and informal contract mechanisms characteristic of contemporary contracting in practice. Parties are responding to rising uncertainty by writing contracts that intertwine formal and informal mechanisms – what we call “braiding” – in a way that allows each to assess the disposition and capacity of the other to respond cooperatively and effectively to unforeseen circumstances. These parties agree on formal contracts for exchanging information about the progress and prospects of their joint activities, and it is this information sharing regime that “braids” the formal and informal elements of the contract and endogenizes trust. We argue that the low-powered enforcement associated with the formal governance structure in these braided contracts complements rather than crowds out the informal mechanisms that rely on increasing levels of trust. We examine the braiding phenomenon in a variety of contexts characterized by rising uncertainty. These range from the uncertainties of technological innovation to commercial ventures and corporate acquisitions where the uncertainty centers on the importance of the search for new partners. In each instance, courts appear to have harnessed the braiding phenomenon by using low-powered sanctions to protect formal contractual “preliminaries” without creating potential liability that will crowd out informal contracting. This technique allows potential collaborators to explore and develop their relations but it does not impose mutually enforceable obligations to pursue a particular project. But despite the wisdom of temperate enforcement of braided contracts, courts that emphasize the contemporary duty to negotiate in good faith are often tempted to expand the legal sanction and thereby unwittingly undermine the very informal arrangements that braided obligations are designed to support. We conclude, therefore, by explaining how courts can best support the braiding strategies that are critical to the success of an integrated regime of formal and informal contracting.

Sales and Elections as Methods for Transferring Corporate Control

Delaware case law has rendered the tender offer obsolete as a method for purchasing a company whose directors oppose the acquisition. A potential acquirer facing target opposition today must run an insurgent director slate, in the expectation that its directors are more likely to sell. The Delaware courts have not justified their preference for elections over markets as the preferred vehicle for implementing changes in control. Informal scholarly analyses ask transaction cost questions, such as whether proxy contests are more costly than takeovers. This article attempts to break new ground by asking whether there are systematic differences in the performance of elections and markets in the corporate context. Recent models of voting processes, we argue, strongly suggest that elections are inferior to markets. Proxy contest elections sometimes can be won by incumbent managements when a transfer of control would be efficient, a conclusion consistent with the sparse data; and the proxy election process aggregates information regarding the sale decision less well than markets do, thereby implying that proxy voters are less well-informed. Theory and data thus suggest, at the least, that the intellectual burden of proof should change: the task now is to justify using elections to transfer control despite their apparent deficiencies. The article briefly considers the policy implications of this change in perspective.

Economically Benevolent Dictators: Lessons for Developing Democracies

The post-war experience of developing countries leads to two depressing conclusions: only a small number of countries have successfully developed; and development theory has not produced development. In this article we examine one critical fact that might provide insights into the development conundrum: Some autocratic regimes have fundamentally transformed their economies, despite serious deficiencies along a range of other dimensions. Our aim is to understand how growth came about in these regimes, and whether emerging democracies might learn something important from these experiences. Our thesis is that in these economically successful countries, the authoritarian regime managed a critical juncture in the country’s development - entry into global commerce by the transition from small-scale, relational exchange, to exchange where performance is supported by government action, whether based on the potential for formal third party enforcement or by the threat of informal government sanctions. Compared to a weak democracy, a growth-favoring dictator may have an advantage in overcoming political economy obstacles to credibly committing that rent seeking will not dissipate private investment. We explore this hypothesis by examining the successful development experiences of three countries in the late twentieth century: Chile under Augusto Pinochet; South Korea under Park Chung-Hee; and China under Deng Xiaoping and his successors. Although the macroeconomic policies and institutional strategies of the three countries differed significantly, each ruler found ways to credibly commit his regime to growth. Decades of law reform activity by the World Bank, IMF, and other international organizations, along with a vast academic literature, assume that an impartial judiciary is the key to the transition from relational to market exchange. Our study reveals that a variety of alternatives are possible. We then consider a now familiar question raised about contemporary China: Does economic development inexorably lead to political liberalization? The conventional wisdom says yes, drawing support from the experience of Chile and South Korea. We show that the conventional wisdom overlooks important features of the Chilean and Korean historical experiences that bear directly on China. The same incentive structures that have propelled Chinese economic growth are likely slow political liberalization.