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.