It is well understood that organizational law plays an important role in establishing terms of a (metaphorical) contract between stakeholders in the corporation. In particular, it supplies terms that govern significant elements of the relationships between directors, officers, creditors and shareholders. But the precise function of law in facilitating contracting is not uncontroversial. There are a variety of different theories as to the contribution that organizational law, as distinct from contract law, makes to the corporate contract. For example, Hansmann and Kraakman (2000) conclude that the essential role of organizational law is to partition corporate assets from personal assets. They conclude that some contractual terms that establish asset partitioning, particularly those that shield corporate assets from shareholders' personal creditors, would simply be unavailable in the absence of organizational law because of transaction costs.
In this article we focus on the role of organizational law, and corporate law in particular, in providing specific governance terms in the corporate contract. Easterbrook and Fischel (1991) (and others) suggest that corporate law is valuable in reducing transaction costs for the relevant contracting parties. This argument is not that organizational law is essential to the adoption of certain contractual terms, but rather that corporate law saves transaction costs by allowing adoption of corporate law default terms simply by incorporation. Incorporation alone generates a reasonably complete set of contractual terms. On this theory, the role of corporate law is to provide default rules that most parties would adopt and thus limit transaction costs.
State-provided corporate law may also be a valuable alternative to strict reliance on contract law in that it may facilitate realization of valuable network economies (Klausner 1995; Kahan and Klausner 1997). There are positive network externalities from the adoption of a particular contractual term by a corporation. For example, the more entities that adopt the term, the greater the certainty over time of the term's meaning because of the higher probability of litigation that clarifies its legal significance. This in turn reduces costs from uncertainty. State-provided corporate law facilitates standardization and coordination of contractual choices. Under this theory, private contracting alone would lead to insufficient standardization.
Another theory of how corporate law creates gains unachievable under contract law alone is that it imposes some mandatory terms that cannot be subject to renegotiation. Contract law is generally permissive of renegotiation, which leads to concern that on occasion one party may be in a position opportunistically to insist on renegotiation (Aivazian, Penny and Trebilcock, 1984). Sailors, for example, may demand extra pay when out at sea and the captain has little choice. Courts struggle with reconciling expansive freedom to recontract with concerns about opportunism. Corporate law can avoid these problems in some instances by creating mandatory terms.
Directors' duties, for example, cannot be opportunistically set aside by directors who manipulate votes in their favour, perhaps by strategically bundling propositions to shareholders (Gordon, 1989). Conversely, shareholders cannot opportunistically impose more stringent standards on directors and officers to take advantage of firm-specific investments of human capital by the directors or officers in the corporation. The mandatory nature of some rules may therefore be welcome from a contractual perspective.
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An Empirical Examination of the Governance Choices of Income Trusts
