February 23, 2005
Does Fiduciary Law Matter?
Posted by Gordon Smith

In the late 1990s, four economists -- Rafael La Porta, Florencio Lopez de Silanes, Andrei Shleifer, and Robert W. Vishney (LLSV) -- published a series of studies that together placed on the table the "law matters" hypothesis. The findings at the heart of the law matters hypothesis link legal protections for minority stockholders to strong stock markets and suggest that common law legal systems provide better legal protections for minority stockholders than civil law systems. According to LLSV, one of the critical aspects of common law protection is fiduciary duty: "The vague fiduciary duty principles of the common law are more protective of investors than the bright line rules of the civil law, which can often be circumvented by sufficiently imaginative insiders."

Even those who disagree with LLSV, and there are many, pay homage to the role of fiduciary duty in protecting minority stockholders. The following passage comes from Katharina Pistor, Yoram Keinan, Jan Kleinheisterkamp, and Mark D. West in an article entitled The Evolution of Corporate Law: A Cross-Country Comparison, 23 U. Pa. J. Int'l Econ. L. 791 (2002):

Our argument differs from the one put forward by LLSV. They purport to show that common law jurisdictions have stronger protection of minority shareholder rights than civil law countries. A closer examination of the origins of these protections and the time they were adopted in England, the mother country of the common law, however, has shown that it is hard to make a case that these are in fact genuinely common law type provisions. We have also demonstrated that with regard to legislated controls of shareholder rights on the books, Delaware has indeed followed a race to the bottom as proposed by Cary many years ago. That, however, does not necessarily imply that Delaware law does not protect shareholder rights. In fact, the Delaware example is a glaring example for how misleading assessments of law might be that rely only on a handful of indicators. Effective protection is the result primarily of strong courts that have upheld the principle of fiduciary duty as the threshold for permissible actions by directors. Procedural rules that encourage litigation and the structure of the chancery court have allowed the effective handling of litigations by judges who specialize in corporate law. Delaware courts in combination with a strong securities market regulator have provided the institutional background against which a highly enabling law has given corporations ample room to experiment with the optimal allocation of control rights between shareholders and management. Seen in this light, the problem of civil law countries has been not so much to offer only weak corporate law protection, but to prevent legal innovations by imposing straightjackets of mandatory legal constraints on companies.

But is it true that Delaware offers strong protections for minority stockholders? This is a big question, and I do not purport to provide a complete answer here. My hunch is that common law courts generally do better than civil law courts at filling gaps in the investment relationship through fiduciary law. (And, yes, civil law countries do have fiduciary law, contrary to widely held belief.) Of course, common law courts need to do more if the statutes are enabling as opposed to regulatory.

The more important question, however, is whether common law courts do enough to inspire minority investment. In other words, can we attribute the success of dispersed ownership in the United States to common law courts, notably Delaware? Interestingly, Delaware provides very weak fiduciary protections for minority stockholders in closely held corporations. The law of minority oppression in Delaware is notoriously limited.

But the focus of LLSV is on the connection between minority stockholder protection and stock markets (i.e., not closely held corporations). Perhaps the protection is stronger in that context? While it is true that Delaware offers a robust fiduciary law for situations confronted by public corporations, it would be a stretch to claim that such law is strongly protective of minority interests, at least if you confine yourself to looking at the direct outcomes of cases. Most cases are settled with little or no compensation to stockholders. As for the cases that go to trial, directors win a large percentage.

Nevertheless, one might argue (and I have a lot of sympathy for this argument) that the effect of fiduciary law goes well beyond actual case outcomes. Even if stockholders are not fully compensated for director malfeasance, the threat of director liability might be sufficient to deter misconduct. I hope this is true, and when I am in a good mood, I actually believe it. Though note that it is different from what LLSV have argued, and I wonder why the civil law would be less deterrent.

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