Model acts can operate to balance the tension between the centripetal and centrifugal forces inherent in a federal system. Pulling the states together to capture the scale benefits from a single regime drives a familiar effort to harmonize at the federal level. At the same time, we observe the decentralizing logic of responding to local conditions that bears on why a federal rather than a unitary state was chosen in the first place. Model statutes thus work the interstices of a federal system, responding to the gravity of uniformity but easing the repellent of local differences. In my contribution to a symposium on the European Model Company Act (“EMCA”), I address a particular characteristic of company law that complicates the intermediating role of a model act in a federal system. Because complex corporate transactions inevitably are associated with significant uncertainty, transaction designers and legislative drafters tend to frame applicable contractual and legal rules as standards, such as fairness and equal treatment, rather than as rules. In turn, the effectiveness of a standard in the face of complexity and uncertainty depends on the experience and expertise of the reviewing court. The outcome, I argue, is that a model company law court can complement a model company code.
The analysis proceeds as follows. Part I considers alternative approaches to addressing related party transactions between a controlling shareholder and a corporation with minority shareholders. On the one hand, controlling shareholders can play an important governance role. But there is also a dark side to the controlling shareholder force: she may have an incentive to take a disproportionate share of the corporation’s profits, most obviously through related party transactions whose terms favor the controlling shareholder. Thus, the regulatory design problem confronting company law drafters is how to craft a structure that causes the controlling shareholder’s impact on the corporation to be a net positive—meaning the increase in performance from the controlling shareholder’s participation as a monitor or operator should exceed her private benefits of control. The potential for self-dealing may be addressed ex ante by means of structural prohibitions on the characteristics that create or sustain control or through which control is used to extract private benefits. It should come as no surprise that such ex ante regulation is a crude measure. Precisely because drafters cannot predict a company’s future circumstances, rough categorization—no related party transactions, no leveraged control, no controlling shareholder—is about the best that can be done ex ante.
This is where ex post transaction review and courts take center stage. In contrast to ex ante regulation, ex post review of the terms of a particular related transaction by reference to a standard has the obvious advantage of being contextual. A sophisticated court review, unlike the terms of the company act, serves to identify, in effect, whether a particular transaction leaves the minority shareholders net better off because of the controlling shareholder’s participation in monitoring or operating the company. However, once we focus on ex post transaction review, courts, as opposed to substantive law, take center stage. Put simply, the standard cannot be more effective than the courts that enforce it and the underlying procedural rules through which enforcement takes place.
Part II focuses on this typically understated role of courts in crafting the substance of company law. Ex post transaction review by courts comes with characteristic costs. In addition to the associated litigation costs, there is always a risk that the judge will err in applying the standard, whether in its legal interpretation of the standard or in its understanding of the related party transaction’s structure. If parties anticipate that the risk of error is high when deciding how to craft their relationship in the first place, one or both of two bad things can happen. First, controlling shareholder ownership structures may be unintentionally discouraged, at the cost of less effective monitoring or operation. Second, because the likelihood of error will reduce controlling shareholders’ capacity to credibly commit to limiting private benefits of control, a lemons market of sorts can result, with controlling shareholders who will not extract an inefficient level of control unable to distinguish themselves from controlling shareholders who will extract more than the efficient level of private benefits. The result will be to lower the value of minority shares and so increase the cost of capital for companies with a controlling shareholder.
The upshot of this analysis is that the effectiveness of ex post review of related party transactions depends on the quality of the reviewing court. A sophisticated company law court that applies standards, when coupled with timely enforcement, allows controlling shareholders to commit credibly to a level of private benefits that can support an efficient controlling shareholder regime: that is, controlling shareholders and companies with a smaller minority shareholder discount and a lower cost of equity capital. But the promise of controlling shareholders—that they can increase the value of minority shareholders’ investment by more than the private benefits they receive—is a mirage for a corporation that is chartered in a jurisdiction without an effective judicial system. Moreover, despite the freedom offered by Centros and its progeny, there appear to be significant barriers for entrepreneurs in the EU to choosing a jurisdiction in which to incorporate based on the quality of its courts.
To address this circumstance, Part III reprises the argument that harmonization of the quality of judicial enforcement of corporate statutes may be more important than harmonization of the substantive law. In this respect, a model company law court is powerfully complementary to a model company act. The intuition is that an EU-level company law court can take advantage of the scale economies associated with a court’s developing commercial experience and expertise in just the settings where the payoff is likely to be greatest. Such a “model” company law court roughly parallels the intermediate federal logic of the EMCA—it is an alternative, not a requirement, and so occupies much the same space in a federal system. Rather than harmonizing substantive corporate law, an EU company law court would simply stand available for individual corporations to use – through election in their articles of incorporation – for review of related party transactions rather than the courts of the jurisdiction under whose laws the corporation is organized.
However powerful the supporting logic, I recognize that the political economy barriers to creating an EU level commercial court to complement the EMCA may be insurmountable. This reality brings us, full circle, back to the EMCA. In his contribution to this volume, Michael Klausner has suggested a very useful soft law approach that importantly ameliorates the absence of effective courts in some jurisdictions. He proposes a permanent EMCA committee whose task is not just to update the EMCA in response to changing conditions, but to offer advise on how particular issues should be resolved under the EMCA. This clever approach uses soft law to overcome political barriers that do not apply to a private organization, captures some of the scale economies associated with a central body addressing common legal issues, and makes adoption of the EMCA even more attractive to jurisdictions that do not have a rich company law history. Adopting the EMCA with this add on function both provides a statute and a companion device that will speed up the development of local courts.
Ronald J. Gilson is the Stern Professor of Law and Business at Columbia Law School, the Meyers Professor of Law and Business Emeritus at Stanford Law School, and a Fellow at the European Corporate Governance Institute.