Volume 2, No. 4 (April, 1992) pp. 62-65
THE ECONOMIC STRUCTURE OF CORPORATE LAW by Frank H. Easterbrook
and Daniel R. Fischel. Cambridge, Mass.: Harvard University
Press, 1991. 370 pp. Cloth $39.95.
Reviewed by Jack Knight, Department of Political Science,
Washington University in St. Louis.
Easterbrook and Fischel's new contribution to our understanding
of corporate law exemplifies some of the best work that the law
and economics movement has produced. In this book, they analyze
the present state of American corporate law in terms of the logic
of wealth-maximization: To what extent can the laws governing
corporate organization and activity be justified and explained by
their effects on the capacity of corporations to maximize their
net wealth?
This book can be recommended on several grounds. It is well
written, comprehensive in scope and intellectually challenging.
The authors present the economic approach to law in a non-
technical, but analytically rigorous way. After presenting the
basic model in the opening chapter, they develop and apply the
model in subsequent chapters in an analysis of several important
issues in the field of corporate law. The range and
sophistication of the arguments are impressive; the authors have
adapted the economic approach to corporate law and have worked
through the logic of the analysis in an exhaustive fashion. In
doing so, they have produced both normative arguments seeking to
justify particular ways that corporate law ought to treat
problems of corporate governance and positive arguments offering
explanations of how such laws have been established. In short,
the book offers a classic statement of the economic analysis of
law approach, thus, providing the reader with an opportunity to
assess both the strengths and weaknesses of the approach.
Let me briefly state the logic of the Easterbrook-Fischel
analysis. Building on the tradition which originated in the early
work of R. H. Coase, corporations are conceived of as a set of
contracts among self-interested economic actors (equity
investors, managers, employees, and creditors.) Taken together
these contracts constitute the "governance structure"
of the corporation. Given the fundamental importance of capital
for the growth and development of corporations, the equity
investors are seen to have the primary effect on the nature and
structure of these contracts. Equity investors prefer to purchase
stock in profitable corporations; so it is the task of the other
actors, primarily the corporate managers, to create governance
structures that will allow the corporation to maximize its net
wealth. Consequently, managers will seek those contracts that
minimize costs (especially agency costs.) If they fail to do so,
investors will take their money elsewhere and through the
dynamics of market competition the less efficient corporations
will die. Over time, only those governance structures that
minimize costs will survive; thus, the competitive pressure of
the market forces economic actors to produce efficient
corporations which will maximize net wealth.
Corporate law enters into the analysis as follows. The law serves
as a framework that enables the actors to enter into wealth-
maximizing contracts. Easterbrook and Fischel state their basic
conclusions early
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in the book: "We treat corporate law as a standard-form
contract, supplying terms most venturers would have chosen but
yielding to explicit terms in all but a few instances. The
normative thesis of the book is that corporate law should contain
the terms people would have negotiated, were the costs of
negotiating at arm's length for every contingency sufficiently
low. The positive thesis is that corporate law almost always
conforms to this model. It is enabling rather than
directive." (p. 15) For the authors, wealth- maximization is
the key; corporate law is both justified and explained by its
capacity to enhance the wealth-maximizing behavior of economic
actors in a competitive market.
The authors apply the logic of the model to an analysis of an
impressive array of corporate issues: limited liability,
fiduciary duty, the business judgment rule, corporate control
transactions, the appraisal remedy, tender offers, close
corporations, insider trading, mandatory disclosure, and damage
laws. These analyses follow a standard format: (1) note an
activity in a corporation that is affected by governance
structure; (2) use the logic of the economic approach to see what
type of governance mechanism would maximize net wealth for the
corporation; (3) in establishing this type as the normatively
desirable law, defend it against arguments that this type of law
either does not maximize wealth or that the argument underlying
it fails to understand the relevant corporate activity; (4) offer
empirical evidence to demonstrate that the normatively desirable
law is or, at least, closely approximates the existing corporate
law; and (5) when reality diverges from the normatively desirable
alternative, criticize the existing law.
A few examples may give more of the flavor of the arguments.
Limited liability for corporate shareholders is explained as an
efficient form of risk-sharing that minimizes monitoring costs.
Fiduciary duty is explained as an efficient alternative to the
more complicated process of promises by managers and monitoring
by investors that would be necessary for investors to protect
their interests in the activities of the corporation. The
business judgment rule in the face of the fiduciary duty of
managers to investors is explained by the fact that investors'
wealth would be lowered if manager's decisions were routinely
subjected to strict review by the courts. Prohibitions against
insider trading may or may not (the authors seem divided on this
one) be an efficient way of guaranteeing that managers will
satisfy their fiduciary duty to investors and maximize the net
wealth of the firm.
Despite the many strengths of the book, questions that have been
raised about the law and economics approach in general apply as
well to this treatment of corporate law. To highlight them, I
will focus briefly on Easterbrook and Fischel's treatment of
tender offers. Tender offers are "bids for the outstanding
stock of a firm. ... a way of gathering up the equity interests
to make some fundamental change in the firm that the existing
managers oppose; it is an appeal over managers' heads to the
equity investors." (p. 26) The economic analysis of law
approach to tender offers would be to refrain from regulating
them. Let the existing investors, the tendering investors, other
potential bidders, and the managers of the firm sort out the
various costs and benefits and contract for whatever changes in
corporate control that will increase the net wealth
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of the firm. Given the logic of market competition and free
contracting which underlies the economic approach, the
normatively desirable type of corporate law governing tender
offers and corporate control issues would be the one that enables
the relevant actors to do whatever they want. Only those
efficient mechanisms that maximize net wealth would survive in
the long run.
But, as Easterbrook and Fischel note, these are not the types of
rules that have often emerged in the corporate law area. States
have enacted various statutes that regulate and restrict the
types of tender offers and corporate takeovers which can be
attempted. The authors go to great lengths to try to either
reconcile or distinguish these laws with the logic of the
economic analysis. Their efforts highlight three issues which
raise challenges to the arguments presented in the book.
First, there is the question of the importance of distributional
issues for economic analyses of law. Since the actors in the
model are self-interested, we would expect distributional
questions among the various actors to be at the forefront of
issues of corporate governance. But Easterbrook and Fischel
dismiss the importance of such questions and focus on the
interests of equity investors and on aggregate wealth
maximization for the market as a whole. They justify this focus
in two ways. The first relates to the internal dynamics of a
single firm: Since all of the other actors in the corporation
must rely ultimately on investors for their own well-being and
since the market gives investors other opportunities if the
actors in a particular firm seek contracts contrary to the
interests of the investors, all of the actors in the firm will
align their interests with those of the investors. Thus, the
divergence of interests within the firm is offset by the
competitive pressures of the market. The second justification of
aggregate wealth maximization relates to the nature of equity
investors: Although we might anticipate distributional conflict
among equity investors, the importance of this conflict is offset
by the fact that equity investors diversify their purchases
across the corporations in the market. This diversification
causes investors to be concerned about the average net wealth of
the market and not on the profitability of any particular firm.
It should be obvious that the plausibility of the authors' focus
on aggregate wealth depends crucially on the smooth working of
the market. Unless the market is working in the analytically
precise way that it does in the theoretical model, the
opportunities for distributional conflict will be much greater
than one would sense from the authors' emphasis on
wealth-maximization. As the authors demonstrate in the case of
tender offers, this will then have significant implications for
their positive arguments that seek to explain the emergence of
corporate law.
Second, this introduces the related question of how well the
market actually works in these cases. The law and economics
approach has often been questioned on exactly how law comes to be
efficient. Is it the goal of the actors involved in the
transactions or is it the product of some selection mechanism
like a competitive market? Easterbrook and Fischel should be
commended for their clear emphasis on the central importance of
the market as a selection mechanism. Without the constraining
pressure of the market, the actors will pursue their own
distributional interests and eschew aggregate wealth-maximization
unless it
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coincides with their own private interests. So it is incumbent on
the authors to justify the assumption of the competitive market
that underlies their analysis. The explanatory implications have
already been explained. The normative implications are equally
straightforward: If the market does not function in a competitive
manner, then the justification of an enabling corporate law in
terms of the socially beneficial consequences of private market
behavior is undermined. The problems with the market might very
well explain, as the authors admit, why the state has stepped in
and established laws which constrain takeover activities.
Although Easterbrook and Fischel are more attentive to this issue
than are many of their law and economic colleagues, greater
attention to the conditions for market competition would enhance
the analysis.
Finally, I will briefly mention one additional issue which
challenges the book's main normative thesis: why the normative
priority for wealth-maximization? The need to justify this
criterion has been raised against the law and economics approach
since its inception. The debates have been lengthy. Easterbrook
and Fischel give scant attention to this issue, relying mainly on
a few arguments about the fundamental importance of aggregate
wealth-maximization for the welfare of all of the actors in the
society. This is a version of the standard trickle-down theory.
Perhaps it is just as well that they do not spend much of their
time on a question that has defied easy resolution. Their talents
clearly lie in their considerable abilities to explicate the
logic of the economic approach for the complexities of modern
corporate law. Whether you agree with the wealth-maximization
criterion as a normative goal of social policy or not, this book
is worth your time. If you maintain some healthy skepticism about
the strength of some of the central assumptions of the economic
approach, there is much to be learned from this challenging
thesis.
Copyright 1992