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A Self-Enforcing Model of Corporate Law
Author(s): Bernard Black and Reinier Kraakman

Source: Harvard Law Review , Jun., 1996, Vol. 109, No. 8 (Jun., 1996), pp. 1911-1982
Published by: The Harvard Law Review Association
Stable URL: https://www.jstor.org/stable/1342080
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A SELF-ENFORCING MODEL OF CORPORATE LAW
Bernard Black
Reinier Kraakman
TABLE OF CONTENTS
PAGE
INTRODUCTION .......... ........................................................ I9I3

I. THE NATIONAL CONTEXTS THAT SHAPE CORPORATE LAW ............... ... I920
A. Corporate Law in Developed Economies . .................. I920
B. The Goals of Corporate Law in Emerging Economies .................. .. I92 I
C. Legal and Market Controls in Emerging Economies . ............. I925
D. Cultural Norms for Manager and Large Shareholder Behavior .... ........ I928
II. A SELF-ENFORCEMENT APPROACH TO CORPORATE LAW . ............. I929
A. The Prohibitive Model ...................... ......................... I930
B. The Self-Enforcing Model ..................... ....................... I932
i. Structural Constraints ............................................. I933
2. Simple, Bright-Line Rules and Strong Remedies ..... ................ I934
C. The Limits to the Self-Enforcement Approach . ................ I937
D. Can Law Function Without Official Enforcement? . .............. I939
III. GOVERNANCE STRUCTURE AND VOTING RULES . . . I943
A. Allocation of Decisionmaking Power ................1................... I943
B. Allocation of Voting Power: One Share, One Vote ..........1............. I945
C. Voting for Directors: Cumulative Voting ............. .. ................. I947
D. Voting Procedures: Universal Ballot ..................... I949
E. Protecting Honesty and Quality in Voting ............ .. ................ I950
IV. STRUCTURAL CONSTRAINTS ON PARTICULAR CORPORATE ACTIONS ......... ... I952
A. Mergers and Other Major Transactions . ................... I953
i. Shareholder Approval ............................................ I953
2. Appraisal Rights ................................................. I956
3. Determining Market Value ........................................ I957
B. Self-Interested Transactions .................... ....................... I958
C. Control Transactions .............................. . i960
D. Issuance and Repurchase of Shares .................1................... i964
i. Share Issuances .................................................. i964
2. Repurchase of Shares ............................................. i966
E. Protecting Creditors and Preferred Shareholders . ............... i967
F. The State as Part-Owner .......................... I970
V. REMEDIES.............................................................. I97I
VI. THE PATH-DEPENDENT EVOLUTION OF DEVELOPED COUNTRY CORPORATE
LAW .... I974
CONCLUSION: SELF-ENFORCING LAW IN EMERGING ECONOMIES . . . . I977
APPENDIX: SURVEY OF COMPANY LAW IN EMERGING MARKETS .................. .... i980
I9II

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I9I2 HARVARD LAW REVIEW [Vol. I09:I9II
A SELF-ENFORCING MODEL OF CORPORATE LAW
Bernard Black
Reinier Kraakman*
In this Article, Professors Black and Kraakman develop a "self-enforcing" approach to

drafting corporate law for emerging capitalist economies, based on a case study: a model
statute that they helped to draft for the Russian Federation, which formed the basis for
the recently adopted Russian law on joint-stock companies. The Article describes the
contextual features of emerging economies - including the prevalence of controlled com-
panies and the weakness of other institutional, market, cultural, and legal constraints -
that make it inappropriate to import company law from developed countries. Professors
Black and Kraakman argue that in emerging economies, the best legal strategy for protect-
ing outside investors in large companies while simultaneously preserving managers' dis-
cretion to invest is a self-enforcing model of corporate law. The self-enforcing model
structures corporate decisionmaking processes to allow large outside shareholders to pro-
tect themselves from insider opportunism with minimal resort to legal authority, including
the courts. Among the model's provisions are a mandatory cumulative voting rule for
election of directors, which ensures that minority blockholders have board representation,
and a rule requiring both shareholder- and board-level approval for self-interested trans-
actions. The Article examines how to induce voluntary compliance with the company
law, as well as the implications of the self-enforcing model for the ongoing debate over the
efficiency of corporate law in developed economies.
* The authors are, respectively, Professor of Law, Columbia Law School, and Professor of
Law, Harvard Law School. This Article builds on an earlier article that developed the concept of
a "self-enforcing" corporate law in the context of Russia, prepared for the World Bank Conference
on Corporate Governance in Eastern Europe and Russia held in December I994, and which was
subsequently published as Bernard Black, Reinier Kraakman & Jonathan Hay, Corporate Law
from Scratch, in 2 CORPORATE GOVERNANCE IN CENTRAL EUROPE AND RUSSIA: INSIDERS AND
THE STATE 245 (Roman Frydman, Cheryl W. Gray & Andrzej Rapaczynski eds., i996). Acknowl-
edgments should go first to Jonathan Hay, our coauthor on the precursor article, and to Anna
Stanislavovna Tarassova, the principal Russian drafter of the Russian company law, the develop-
ment of which provided the genesis and many of the ideas for this Article. Other important
participants in the effort to develop Russian company law include Alexander Abramov, Ian Ayres,
J. Robert Brown, Catherine Dixon, Louis Kaplow, Yevgeni Kulkov, Claudia Morgenstern, Me-
linda Rishkofski, Howard Sherman, Sergei Shishkin, Victoria Pavlovna Volkova, and John Wil-
cox. We thank the participants in the World Bank conference, especially John Coffee, Ronald
Gilson, Bruce Kogut, Mancur Olson, Ibrahim Shihata, and Douglas Webb, for helpful comments
on earlier drafts. We also thank participants in the University of Toronto and Harvard Law
School Law and Economics Workshops, Lucian Bebchuk, Jill Fisch, Jeffrey Gordon, Christine
Jolls, Hideki Kanda, Mark Roe, and especially David Charny for his extensive comments. Fi-
nally, we wish to thank Joseph Blasi, Rolf Skog, Andrei Alexandrovich Volgin, and Daniel Wolfe
for their comments on the draft law on which this article is based. Research support was pro-
vided by the World Bank (for both authors), the Open Society Institute (for Black), and the
Harvard Program for Law and Economics, funded by the John M. Olin Foundation (for
Kraakman).

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I996] A SELF-ENFORCING MODEL OF CORPORATE LAW I9I3
INTRODUCTION
What kind of corporate law should govern publicly owned compa-

nies in emerging markets, including newly privatizing economies?
This important question has no ready answer. Corporate law, we be-
lieve, should have the same principal goal in developed and emerging
economies - succinctly stated, to provide governance rules that maxi-
mize the value of corporate enterprises to investors. However, emerg-
ing economies cannot simply copy the corporate laws of developed
economies. These laws depend upon highly evolved market, legal, and
governmental institutions and cultural norms that often do not exist in
emerging economies.1 Developed country corporate laws also reflect
the idiosyncratic history of their country of origin. They are not neces-
sarily efficient at home, let alone when transplanted to foreign soil.
Moreover, in many emerging markets, corporate law must serve a sec-
ond central goal that is less pressing in mature market economies: fos-
tering public confidence in capitalism and in private ownership of
large business enterprises.
Thus, corporate law must be designed substantially from scratch to
work within the infrastructure available in an emerging market. For-
tunately, this can be politically feasible. Precisely because existing in-
stitutions (to which the law must adapt) are often weak or missing,
one can rethink from first principles what corporate law ought to look
like and what related institutions it ought to rely on and promote.
Beyond producing a new model for emerging markets, the effort to
develop corporate law from scratch can expose weaknesses and idio-
syncracies in the corporate laws of developed countries. The model
can highlight the ways in which these laws did not simply evolve to-
ward efficiency, but instead evolved from historically contingent start-
ing places to ending places shaped by preexisting institutions, by the
inertial power of the status quo, and by the preferences of key partici-
pants in the corporate enterprise. For example, German corporate law
adapted to strong banks and labor unions, while American law
adapted to strong capital markets, weak financial institutions, and
strong corporate managers.
In this Article, we sketch the basic elements of a "self-enforcing"
model of corporate law, designed for an emerging economy. The
model is grounded in a case study: the effort, in which we partici-
pated, to develop a new corporate law for Russia.2 We begin with
1 We use the term "institution" in a broad sense to include private organizational str
such as stock trading systems and securities registrars; public organizational structures such as
securities regulators, courts with experience in commercial matters, an honest police force, and a
reliable mail system; and mixed public-private structures such as self-regulatory organizations, an
accounting profession, and sophisticated financial accounting rules.
2 A modified version of our proposed law was adopted in December I995 as the company
law of the Russian Federation. See Federal Law of the Russian Federation on Joint-Stock Com-

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I9I4 HARVARD LAW REVIEW [Vol. I09:I9II
three central claims. First, effective corporate law is context-specific,

even if the problems it must address are universal. The law that
works for a developed economy, when transplanted to an emerging
economy, will not achieve a sensible balance among company manag-
ers' need for flexibility to meet rapidly changing business conditions,
companies' need for low-transaction-cost access to capital markets,
large investors' need to monitor what managers do with the investors'
money, and small investors' need for protection against self-dealing by
managers and large investors. The defects in the law will increase the
cost of capital and reduce its availability.
In developed countries, corporate law combines with other legal,
market, and cultural constraints on the actions of corporate managers
and controlling shareholders to achieve a sensible balance among these
sometimes competing needs. Corporate law plays a relatively small,
even "trivial" role.3 In emerging economies, these other constraints are
weak or absent, so corporate law is a much more central tool for moti-
vating managers and large shareholders to create social value rather
than simply transfer wealth to themselves from others. The "market"
cannot fill the regulatory gaps that an American-style "enabling" cor-
porate law leaves behind.
Further, corporate law in developed countries evolved in tandem
with supporting legal institutions. For example, the United States re-
lies on expert judges to assess the reasonableness of takeover defenses
and the fairness of transactions in which managers have a conflict of
interest. When necessary, these judges make decisions literally over-
night to ensure that judicial delay does not kill a challenged transac-
tion. A company law that depends on fast and reliable judicial
decisions is simply out of the question in many emerging markets. In
Russia, for example, courts function slowly if at all, some judges are
corrupt, and many are Soviet-era holdovers who neither understand
business nor care to learn. Better judges and courts will emerge only
over several decades, as the old judges die or retire. In the meantime,
Russian corporate law must rely on courts as little as possible.
More generally, every emerging economy has some legal and mar-
ket institutions, some norms of behavior, some distribution of share
ownership, and some financial institutions. Corporate law must reflect
panies, No. 2o8-FZ (1995), published in ROSSIISKAYA GAZETA, Dec. 29, 1995, at i, translation
available in Westlaw, Rusline Database, 1995 WL 798968. An annotated English translation of
the law (by Bernard Black and Anna Tarassova) is available from Professor Black.
3 See Bernard S. Black, Is Corporate Law Trivial?: A Political and Economic Analysis, 84
Nw. U. L. REV. 542 (i990) [hereinafter Black, Is Corporate Law Trivial?]; see also Ronald J.
Gilson, A Structural Approach to Corporations: The Case Against Defensive Tactics in Tender Of-
fers, 33 STAN. L. REV. 8i9, 839-44 (i98i) (describing market mechanisms that complement legal
controls on corporate managers); Mark J. Roe, Some Differences in Corporate Structure in Ger-
many, Japan, and the United States, 102 YALE L.J. 1927, 1932 (I993) [hereinafter Roe, Some
Differences] (same).

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW I9I5
these background facts. For example, if (as in Russia) employees often

own large stakes in their companies, but are vulnerable to having their
votes controlled by corporate managers, company law needs special
rules that safeguard the rights of employee-shareholders. Company
law must also limit the influence of dysfunctional background features,
such as widespread corruption.
Our second central claim is that despite the context-specificity of
effective corporate law, there is a large class of emerging capitalist
economies (including formerly Communist countries) that are suffi-
ciently similar to permit generalization about the type of corporate law
that will be useful for them. Russia is perhaps an extreme case, but it
is hardly alone in having insider-controlled companies, malfunctioning
courts, weak and sometimes corrupt regulators, and poorly developed
capital markets. For example, an acute problem in Russia is protect-
ing minority investors against exploitation by managers or controlling
shareholders. Protection of minority investors has also emerged as a
central political issue in the most successful post-Communist economy,
the Czech Republic,4 and is at the core of recent reforms in Israeli
corporate law.5
Our third claim is that our task is not impossible. Despite weak
markets and institutions, one can design a company law that prevents
a significant fraction of the corporate governance failures that would
otherwise occur. Even developed country corporate governance sys-
tems fail with uncomfortable frequency.6 We can expect still more
failures in emerging markets. Nonetheless, it is possible to design a
law that works tolerably well - that vests substantial decisionmaking
power in large outside shareholders, who have incentives to make
good decisions; that reduces, though it cannot eliminate, fraud and
self-dealing by corporate insiders; that minimizes, though it cannot al-
together avoid, the need for official enforcement through courts; that
gives managers and controlling shareholders incentives to obey the
rules even when they could often get away with ignoring them; that
reinforces desirable cultural attitudes about proper managerial behav-
4 See Vincent Boland & Kevin Done, Prague to Update Market Regulations, FIN. TIME
Oct. 24, I995, at 30.
5 See Uriel Procaccia, Crafting a Corporate Code from Scratch, Public

Law School 12-14 (Oct. i8, 1995) (on file with the Harvard Law School Library).
6 See generally JONATHAN P. CHARKHAM, KEEPING GOOD COMPANY: A STUDY OF CORPO-
RATE GOVERNANCE IN FIVE COUNTRIES (I994) (detailing failures in the United States, Britain,
Germany, Japan, and France); MARK J. ROE, STRONG MANAGERS, WEAK OWNERS: THE POLIT-
ICAL ROOTS OF AMERICAN CORPORATE FINANCE I49-230 (I994) (United States, Japan, Ger-
many); Bernard S. Black & John C. Coffee, Jr., Hail Britannia?: Institutional Investor Behavior
Under Limited Regulation, 92 MICH. L. REV. 1997, 2007-77 (I994) (Britain); Ronald J. Gilson &
Reinier Kraakman, Investment Companies as Guardian Shareholders: The Place of the MSIC in
the Corporate Governance Debate, 45 STAN. L. REV. 985, 992-97 (I993) (Sweden); Ronald J. Gil-
son & Mark J. Roe, Understanding the Japanese Keiretsu: Overlaps Between Corporate Govern-
ance and Industrial Organization, 102 YALE L.J. 87i, 874-82 (1993) (Japan).

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1916 HARVARD LAW REVIEW [Vol. I09:19II
ior; and that still leaves managers with

risks and make quick decisions. Such a law can add far more value
than corporate law adds in developed economies, precisely because
other institutions that could shape corporate behavior are weak in de-
veloping economies.
The central features of our "self-enforcing" model of corporate law
are:
(i) Enforcement, as much as possible, through actions by direct partici-
pants in the corporate enterprise (shareholders, directors, and managers),
rather than indirect participants (judges, regulators, legal and accounting
professionals, and the financial press).
(ii) Greater protection of outside shareholders than is common in devel-
oped economies, to respond to a high incidence of insider-controlled compa-
nies, the weakness of other constraints on self-dealing by managers and
controlling shareholders, and the need to control self-dealing to strengthen
the political credibility of a market economy.
(iii) Reliance on procedural protections - such as transaction approval
by independent directors, independent shareholders, or both - rather than
on flat prohibitions of suspect categories of transactions. The use of proce-
dural devices balances the need for shareholder protection against the need
for business flexibility.
(iv) Whenever possible, use of bright-line rules, rather than standards, to

define proper and improper behavior. Bright-line rules can be understood
by those who must comply with them and have a better chance of being
enforced. Standards, in contrast, require judicial interpretation, which is
often unavailable in emerging markets, and presume a shared cultural un-
derstanding of the regulatory policy that underlies the standards, which
may also be absent.7
(v) Strong legal remedies on paper, to compensate for the low
probability that the sanctions will be applied in fact.
Enforcement takes place primarily through a combination of votin
rules and transactional rights. The central voting elements include:
shareholder approval (including in some cases supermajority approval
or approval by a majority of outside shareholders) for broad classes of
major transactions and self-interested transactions; approval of self-in-
terested transactions by a majority of outside directors; mandatory cu-
mulative voting for directors, which empowers large minority
shareholders to select directors (this power is protected by require-
ments of one common share, one vote; minimum board size; and no
staggering of board terms); and a unitary ballot on which both manag-
ers and large shareholders can nominate directors. The honesty of the
7 We use here the conventional distinction between a precise "rule" (don't drive faster than
55 miles per hour) and a vague "standard" (don't drive faster than appropriate for the road and
weather conditions). See Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42
DUKE L.J. 557 (1992).

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW I9I7
vote is protected through confidential voting and independent vote

tabulation, while the quality of voting decisions is buttressed by
mandatory disclosure rules.
Shareholders also receive transactional rights (put and call options)
triggered by specified corporate actions. These include preemptive
rights when a company issues new shares; appraisal rights for share-
holders who do not approve major transactions; and takeout rights
when a controlling stake in the firm is acquired (that is, minority
shareholder rights to sell their shares to the new controlling
shareholder).
The self-enforcing model seeks to build legal norms that managers
and large shareholders will see as reasonable and comply with volun-
tarily. The need to induce voluntary compliance reinforces our prefer-
ence for procedural rather than substantive protections. For example,
managers may evade a flat ban on self-interested transactions, yet
comply with a procedural requirement for shareholder approval be-
cause they think that they can obtain approval. Once they decide to
obtain shareholder approval, the managers may make the transaction
more favorable to shareholders, to ensure approval and avoid embar-
rassment.8 The model often relies not only on bright-line rules, but
also on relatively simple rules. Managers can't comply with, and
judges can't enforce, rules that they don't understand. Nor will man-
agers respect an unduly complex statute.
The British City Code on Takeovers and Mergers offers a good set
of self-enforcing rules to govern change-of-control transactions, which
we largely adopt.9 We propose a delay period before a change of con-
trol occurs to provide a market check on the fairness of the price (30%
ownership is our proxy for control); a takeout offer requirement, under
which a new controlling shareholder must offer to purchase minority
shares (unless the minority shareholders waive this requirement by
majority vote); and a ban on defensive actions that could frustrate a
takeover bid (unless the actions are approved in advance by the tar-
get's shareholders).10 Shareholders are protected against dilutive share
8 In the economic literature, "self-enforcement" is sometimes given only this narrower me

ing - a contract is said to be self-enforcing if it induces voluntary compliance. See, e.g., Lester
G. Telser, A Theory of Self-Enforcing Agreements, 53 J. BuS. 27, 2 7-28 (i980). Inducing voluntary
compliance is an important element of our approach to company law, but it is only part of what
we mean by a "self-enforcing" law.
9 PANEL ON TAKEOVERS AND MERGERS, THE CITY CODE ON TAKEOVERS AND MERGERS
AND THE RULES GOVERNING SUBSTANTIAL ACQUISITIONS OF SHARES (I993) [hereinafter CITY
CODE ON TAKEOVERS AND MERGERS]. The Panel on Takeovers and Mergers, which administer
the City Code, is a self-regulatory organization, with a chair chosen by the Bank of England and
members representing institutional investors, public companies, and the London Stock Exchange.
Panel rulings can be enforced by a number of sanctions, including delisting from the London
Stock Exchange. See Black & Coffee, supra note 6, at 2027.
10 Cf CITY CODE ON TAKEOVERS AND MERGERS, supra note 9, General Principles 4, 7, I0, at
BI-B2, Rule 9.i, at Fi, Rule 2i, at II3 (stating similar rules).

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i9i8 HARVARD LAW REVIEW [Vol. I09:I9II
issuances through a combination of: preemptive rights; a requirement

that shares be issued only at market value (determined by the board of
directors); shareholder approval for issuances to insiders (under the
self-interested transaction rules); and shareholder approval for large is-
suances (our threshold is 20% of the previously outstanding shares).
These and other features of the self-enforcing approach produce a
company law that is novel in the aggregate, even though many indi-
vidual provisions (such as one share, one vote and cumulative voting)
are familiar in developed markets. To be sure, there are limits to what
a self-enforcing corporate law can accomplish. For example, cumula-
tive voting can strengthen the monitoring power of large outside
shareholders but is of little direct help to shareholders who own five
shares each. Nor are these shareholders likely to exercise appraisal
rights if they oppose a merger. Nevertheless, the self-enforcing model
can partially protect small shareholders. All shareholders benefit if
large outside shareholders can monitor management performance and
control self-dealing. All shareholders also benefit if the law induces
managers to comply voluntarily. Small investors remain vulnerable to
insider self-dealing that includes a hidden payoff to large outside
shareholders. But concealment won't always be possible and, when
possible, won't always be attractive because each participant is there-
after vulnerable to exposure by the others.
A caveat: we call our model "self-enforcing." This phrase is a
shorthand attempt to capture the main lines of our model, including
our effort to minimize reliance on official enforcement. But our model
is not purely self-enforcing, any more than Delaware's "enabling" cor-
porate law is purely enabling, or the "prohibitive" model that charac-
terized American corporate law a century ago was purely prohibitive
in character. We can only reduce, not wholly avoid, the need for offi-
cial enforcement.
We develop the basic elements of a corporate law for emerging
economies as follows. Part I describes the goals of corporate law in an
emerging economy and the elements of national context that affect the
law's shape. Part II outlines the alternative drafting strategies open to
emerging economies and explains why our preferred strategy - a
"structural" or "self-enforcing" corporate law - is likely to be superior
to the available alternatives. Parts m, IV, and V describe the primary
components of a self-enforcing corporate law in the particular context
of Russia. Finally, Part VI considers the lessons that can be drawn
from the self-enforcement approach for the supposed efficiency of cor-
porate law in developed countries.
The Appendix compares selected features of the Russian self-en-
forcing law with the corporate statutes of seventeen relatively ad-
vanced emerging markets. The self-enforcing model contains more
procedural protections and fewer substantive protections than any of

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW 19I9
the other statutes. We do not, however, advocate wholesale change in

existing laws. A company law that is already meeting a particular
country's needs should enjoy deference because its success probably
reflects adaptation to local institutions. The self-enforcing model can
be a base for a new law if the current law is seriously deficient, and a
source of ideas for improving laws that already work tolerably well.
We focus here only on corporate law as conventionally understood:
the law that articulates company structure and regulates relationships
among shareholders and between shareholders and corporate manag-
ers. American corporate law, thus defined, includes state corporation
statutes; the common law of fiduciary duty; the provisions of the se-
curities laws that regulate insider liability, shareholder voting, and
control contests; and stock exchange listing standards that impose gov-
ernance requirements on listed companies.11 By contrast, regulation of
the relationship between workers and companies, such as mandatory
employee representation on the board of directors along the lines of
German codetermination,12 or state support for employee ownership
through tax benefits as in American employee stock ownership plans,
is beyond the scope of this Article.
This Article also focuses on large companies where at least some
shareholders do not work in the business. A well-drafted law, of
course, must also consider the special problems of close corporations.
The procedural protections that are appropriate for a company with
ioooo shareholders would be ludicrous and crippling for a tiny com-
pany with five shareholders who all work in the business.
11 Similarly, British company law, for our purposes, includes statutory company law, the c
mon law of fiduciary duty, the London Stock Exchange's listing standards and guidelines, and the
City Code on Takeovers and Mergers.
12 A brief word on codetermination, for those who think this issue too important to be ex-
cluded from our Article: we are not convinced that mandatory employee participation on boards
of directors is a good idea even in Germany, where it began. Moreover, the effort to transplant
the two-tier board to the Czech Republic has failed. Investors there care only about what they
see as the "real" board - the management board. See John C. Coffee, Jr., Institutional Investors
in Transitional Economies: Lessons from the Czech Experience, in I CORPORATE GOVERNANCE
CENTRAL EUROPE AND RUSSIA: BANKS, FUNDS, AND FOREIGN INVESTORS III, I52-53 (Roman
Frydman, Cheryl W. Gray & Andrzej Rapaczynski eds., i996) [hereinafter Coffee, Czech Institu-
tional Investors]. Russia offers an especially weak case for mandating employee participation in
corporate governance. First, employees in most privatized companies own ample shares to elect
their own directors under our proposal for mandatory cumulative voting. Second, in Russia and
other newly privatized economies, many companies must greatly reduce their work force to re-
main competitive. Current employees will often resist these changes. Third, under Communism,
Russian company unions had symbolic value but no real power. They remain weak and often
corrupt. The Russians with whom we have discussed codetermination find an assumption under-
lying codetermination - that labor unions can aggressively represent the interests of employees
-amusing.

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I920 HARVARD LAW REVIEW [Vol. I09:I9II
I. THE NATIONAL CONTEXTS THAT SHAPE CORPORATE LAW
Five aspects of national context, in our view, shape and limit cor-
porate law: the goals of corporate law; the sophistication of capital
markets and related institutions; the sophistication and reliability of
legal institutions; the ownership structure of public companies; and the
cultural expectations of participants in the corporate enterprise. In
this Part, we describe how these features interweave to form the con-
text of corporate law in developed economies. We then demonstrate,
using Russia as a case study, how these features differ markedly in
emerging economies - differences in context that require differences
in company law.
A. Corporate Law in Developed Economies
Corporate law, as we define it above, is generally understood to

have a largely economic function in developed economies. This func-
tion might be characterized as maximizing the value of corporate en-
terprises to investors and therefore (on the whole) to society, or as
minimizing the sum of the transaction and agency costs of contracting
through the corporate form.13 From this perspective, corporate law
provides a set of rules (often default rules that can be varied in the
corporate charter) that encourage profit-maximizing business decisions,
provide professional managers with adequate discretion and authority,
and protect shareholders (and to some extent creditors) against oppor-
tunism by managers and other corporate insiders.
But no one imagines that corporate law accomplishes these objec-
tives by itself. Many other control mechanisms also limit departures
from the profit-maximization norm. In the United States, for example,
a competitive product market, a reasonably efficient capital market, an
active market for corporate control, incentive compensation for man-
agers, and at least occasional oversight by large outside shareholders
all exert pressures on corporate managers to enhance firm value. So-
phisticated professional accountants, elaborate financial disclosure, an
active financial press, and strict antifraud provisions assure sharehold-
ers of reliable information about company performance. Sophisticated
courts (such as the Delaware Chancery Court), administrative agencies
(such as the Securities and Exchange Commission), and self-regulatory
13 See, e.g., AMERICAN LAW INST., PRINCIPLES OF CORPORATE GOVERNANCE: ANALYSIS AND
RECOMMENDATIONS ? 2.0i(a) (I994) [hereinafter PRINCIPLES OF CORPORATE GOVERNANCE] (stat-
ing that, subject to certain constraints, "a corporation should have as its objective the conduct of
business activities with a view to enhancing corporate profit and shareholder gain" (citation omit-
ted)). There are important departures from this norm, such as German codetermination or the
antitakeover provisions in some American state corporate laws. But these are seen as just that -
departures from an overall efficiency norm. We do not enter here the debate over whether corpo-
rate law can or should encourage companies to pursue goals other than profit maximization.

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW I92 I
organizations (such as the New York Stock Exchange) keep sharp eyes
out for corporate skullduggery.
These multiple private and legal controls shoulder much of the
burden of protecting investors in public companies, so that the corpo-
rate law itself can tilt far in the direction of providing managerial dis-
cretion and enhancing transactional flexibility. Most American state
corporate statutes (typified by Delaware's) have evolved into "en-
abling" laws, many of whose major provisions are default rules. More-
over, many of the mandatory rules in American corporate codes have
survived because they are either unimportant, avoidable through ad-
vance planning, or match reasonably well what the parties would have
chosen anyway.14 The statutes are accompanied by fiduciary doctrines
that give the courts wide latitude to review opportunistic behavior ex
post, but the courts generally punish only the most egregious instances
of self-dealing or recklessness. All else is left to private institutions
and the market.
B. The Goals of Corporate Law in Emerging Economies
Corporate law in an emerging economy must address a broader set

of goals, and operate within a far less evolved market and legal infra-
structure, than corporate law in a developed economy. The paradoxi-
cal consequence is that the protective function of corporate law
becomes more important precisely when fewer other resources are
available to support that function.
Consider first the goals of corporate law in emerging economies.
The efficiency goal of maximizing the company's value to investors
remains, in our view, the principal function of corporate law. But the
balance between investor protection and the business discretion of cor-
porate managers needed to achieve this goal will be quite different in
emerging than in developed economies.15 In addition, in countries that
are emerging from heavy state control of industry, a second central
objective is the political goal of fostering public confidence in a mar-
ket economy and in private ownership of large enterprises.
The efficiency goal dictates that corporate law provide more inves-
tor protection in emerging than in developed economies, for several
reasons. One is that insiders are likely to exercise voting control over
most public companies. Such controlled ownership structures raise the
obvious concern that the insiders, whether managers or controlling
shareholders, will behave opportunistically toward other shareholders.
14 See Black, Is Corporate Law 7Rivial?, supra note 3, at 55I-62.

15 The corporate laws of emerging economies tend to reflect a different balance between e
abling and restrictive provisions than do the laws of developed economies. The survey of ad-
vanced emerging markets in the Appendix shows that many of these countries have retained (in
varying degrees) more substantive and procedural protections for outside shareholders and credi-
tors than have developed economies such as the United States.

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In Russia, for example, the structure of mass privatization has led to

the great majority of privatized public companies being controlled by
management-led coalitions of managers and workers, which typically
hold 5I-75% of a company's voting shares. Outside shareholders
including banks and investment (voucher) funds - hold on average
I5-20% of the voting shares, while the remaining shares are likely to
be held by individuals, by other companies, and by a state property
fund.'6 This ownership structure presents a clear risk of opportunism
toward outside shareholders.17 Although the particular form of con-
trolled ownership in Russia may be unique,18 experience teaches that
family-controlled companies with minority public participation -the
classic ownership structure in newly industrialized economies -also
require strong minority protections.'9
Outside investors, facing ex ante a high risk of insider opportu-
nism, will insist on a high expected rate of return in the cases when
insiders turn out to behave properly, to compensate for the risk of bad
behavior. In an extreme case like Russia, where the risk of insider
opportunism is especially high (we explore below the multiple reasons
for this), these rational discounts of share prices - to far below the
shares' fair value assuming good behavior - can virtually paralyze
16 See Joseph Blasi & Andrei Shleifer, Corporate Governance in Russia: An Initial L
CORPORATE GOVERNANCE IN CENTRAL EUROPE AND RUSSIA: INSIDERS AND THE STATE, supra
note *, at 78, 79-82 (reporting a survey of 200 privatized Russian companies that shows mean
(median) employee ownership of 65% (6o%)). For background on Russia's privatization scheme,
see ANDERS ASLUND, How RUSSIA BECAME A MARKET ECONOMY 223-7I (I995); MAXIM
BOYCKO, ANDREI SHLEIFER & ROBERT VISHNY, PRIVATIZING RUSSIA 69-I23 (I995); and Maxim
Boycko, Andrei Shleifer & Robert W. Vishny, Voucher Privatization, 35 J. FIN. ECON. 249,
256-65 (I994) [hereinafter Boycko, Shleifer & Vishny, Voucher Privatization].
17 A recent example in which even sophisticated investors were hurt was a large stock issu-
ance (roughly doubling the number of outstanding shares) by the Komineft Oil Company, which
had been among the most popular Russian stocks among foreign investors. The new shares were
sold in early I994, principally to the managers and employees of Komineft, at far below market
value, but the issuance was not publicly announced until six months later. The issuance heavily
diluted the interests of large shareholders who invested in Komineft before the issuance was belat-
edly announced. See Neela Banerjee, Russian Oil Company Tries a Stock Split in the Soviet
Style, WALL ST. J., Feb. I5, I995, at AI4. Efforts by the Russian Securities Commission to have
the issuance cancelled failed: Komineft's management merely apologized to investors and prom-
ised not to make a secret share issuance again. See Julie Tolkacheva, Komineft Agreement Leaves
Investors Cool, MOSCOW TIMES, Oct. 3I, I995, at III.
18 In the Czech Republic, for example, mass privatization led to financial institutions (usually
banks and investment funds) and financial-industrial groups holding controlling stakes in many
large companies. See Coffee, Czech Institutional Investors, supra note I2, at II2-I3.
19 It is well established that, under an American-style enabling statute, controlling sharehold-
ers frequently extract private gains from corporations at the expense of minority shareholders,
despite the market constraints discussed in section I.A. See, e.g., Michael J. Barclay & Clifford G.
Holderness, The Law and Large-Block Rades, 35 J.L. & ECON. 265, 267-78 (I992); Stuart Rosen-
stein & David F. Rush, The Stock Return Performance of Corporations That Are Partially Owned
by Other Corporations, I3 J. FIN. RES. 39 (i990); Roger C. Graham, Jr. & Craig E. Lefanowicz,
The Valuation Effects of Majority Ownership for Parent and Subsidiary Shareholders (Oregon
State Univ. College of Bus. Working Paper, Feb. i996).

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW I923
the equity markets. Honest (nonopportunistic) managers won't offer

shares at what they see as ridiculously low prices. Investors, mean-
while, won't pay more because they don't know which managers will
misbehave. The risk of government misbehavior (such as renational-
ization, currency controls, or confiscatory taxation) further increases
the gap between managers' perception of their firm's value and mar-
ket prices for the firm's shares. Russian companies that have sought
to issue shares have found that investors are willing to pay only a
fraction of the company's true worth.20
In theoretical terms, Russian companies operate in a market with a
severe "lemons" (adverse selection) problem, in which only low-quality
issuers are interested in raising equity capital at current prices. Strong
minority protections respond to this problem by narrowing the range
and reducing the likelihood of insider opportunism. Investors will
then pay more for shares, which will make higher-quality issuers inter-
ested in issuing shares. This will further reduce the ex ante likelihood
of expropriation of investors' funds and further raise stock prices, until
a new equilibrium is reached with higher share prices and a lower cost
of capital.
To be sure, in a world of perfect contracting, without informational
asymmetries, contracting costs, or naive managers or investors, appro-
priate protections for minority shareholders would emerge by contract,
without the need for government fiat. In such an ideal world, marked
by extensive disclosure and populated by savvy investors and issuers,
corporate planners would have incentives to offer optimal investor
protection through their charters.21 Sophisticated market in-
termediaries, such as investment banks, accounting firms, and law
firms, would advise issuers on what disclosures and contractual pro-
tections to offer and would bond the reliability of the issuer's disclo-
sures.22 After shares were issued, the same efficient capital market-
together with the product market and the market for corporate control
- would police company managements. As a consequence, corporate
20 Two examples: first, in the one true Russian public stock offering to date, by t
October candy company in I994, relatively few investors were willing to buy at the offerin
See Janet Guyon, Russian Firms Face Fund-Raising Woes in the Wake of Privatization
sion, WALL ST. J., Apr. I7, I995, at B6A. Second, the Russian natural gas giant, Gazpro
in mid-I995 to sell a roughly io% stake to foreign investors, but withdrew the offer afte
ering that the price investors would pay was far below outside estimates of Gazprom's tru
See Steve Liesman, Limits on Sale Damp Shares of Gazprom, WALL ST. J. EUR., Apr. 3,
I I.
21 See generally Michael Jensen & William Meckling, Theory of the Firm: Manageria
ior, Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305, 3I2-33 (1976) (arguing
entrepreneurs who sell equity bear the anticipated agency costs of equity).
22 For an account of the contribution of such informational intermediaries to the effici
American capital markets, see Ronald J. Gilson & Reinier H. Kraakman, The Mechanis
Market Efficiency, 70 VA. L. REV. 549, 6I3-2I (1984).

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I924 HARVARD LAW REVIEW [Vol. I09:19II
law could be substantially "enabling," even if insiders dominated pub-

lic companies.
This description points to a second, more general reason why effi-
ciency concerns favor a protective corporate law in emerging econo-
mies. The enabling model and its underlying assumptions about
capital markets have both strengths and weaknesses in developed
countries.23 But the assumptions that support the enabling model are
clearly inapposite in emerging economies, where informational asym-
metries are severe, markets are far less efficient, contracting costs are
high because standard practices have not yet developed, enforcement
of contracts is problematic because of weak courts, market partici-
pants are less experienced, reputable intermediaries are unavailable or
prohibitively expensive, and the economy itself is likely to be in flux.
In recently privatized economies such as Russia, the contractarian
base for the enabling model fails for a third reason: the initial struc-
ture of relationships among company participants arose from govern-
ment fiat rather than private contract. The ownership structure and
initial charters of privatized Russian companies were imposed by the
privatization program, and the company's principal bank lenders were
often selected before privatization began. These relationships were not
negotiated by outside investors with an eye to their own self-
protection.
Beyond the efficiency justifications for protective corporate law,
political goals support strong shareholder protection in emerging econ-
omies. Political goals also shape the law of developed economies, but
they are more important in economies where capitalism is less firmly
rooted. Egregious opportunism or corporate scandals may erode the
political legitimacy of private ownership of large firms, as well as sup-
port for the market economy generally.
Even if corporate scandals do not trigger a political maelstrom of
populist reaction, they will damage investor confidence in an environ-
ment where disclosure is minimal and legal remedies are slow and un-
certain. In Russia, for example, a few well-publicized cases of
manager mistreatment of shareholders have seriously impaired the
willingness of investors, especially foreign investors, to buy shares of
23 The most eloquent American proponents of the enabling model are FRANK H. EASTER-
BROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW I-39 (I99I);
and ROBERTA ROMANO, THE GENIUS OF AMERICAN CORPORATE LAW 86-gi (I993). For efforts
to develop the limits of the enabling approach, see Lucian A. Bebchuk, Limiting Contractual
Freedom in Corporate Law: The Desirable Constraints on Charter Amendments, I02 HARV. L.
REV. I820, I835-60 (i989) [hereinafter Bebchuk, Limiting Contractual Freedom]; Melvin A. Ei-
senberg, The Structure of Corporation Law, 89 COLUM. L. REV. I46i, I47I-5I5 (i989); and Jef-
frey N. Gordon, The Mandatory Structure of Corporate Law, 89 COLUM. L. REV. I549, I554-85
(i989) [hereinafter Gordon, Mandatory Structure]. We do not enter here the debate on the proper
limits on the enabling approach in a developed economy.

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Russian firms and surely contributed to the roughly 75 % collapse in

Russian share prices from summer I994 through late I995 .24
Thus, the twin risks of a destructive political reaction to scandal
and of investor overreaction to scandal are important negative exter-
nalities that become more serious as legal rules allow greater insider
discretion. These risks justify stricter controls on abuse-prone activi-
ties than would be appropriate in a developed market - doubly so
because market and cultural controls on abuse of position are rela-
tively weak in emerging economies.
A further political justification for protective corporate law emerges
in mass-privatized economies such as Russia, where the government
has transferred shares to employees or the general public for nominal
consideration. Such a privatization program reflects, in part, a polit-
ical bargain on how to distribute social wealth.25 The recipients of
shares of privatized enterprises expect these shares to have real value.
But in Russia, many citizens have been disappointed by the market
value of their shares and the low dividends they receive. If these re-
cipients also come to believe (often correctly) that insiders are getting
rich at their expense by expropriating the cash flow of privatized com-
panies, the political bargain will be breached. This can - and in
Russia, already has26 - undermined popular support for further
privatization and other reforms needed for a healthy market economy.
C. Legal and Market Controls in Emerging Economies
Even as the economic and political goals of corporate law in

emerging economies favor a strong protective function, limitations on
enforcement resources constrain how this protective function is dis-
charged. Developed economies usually have sophisticated enforcement
institutions that can implement complex, finely nuanced rules. Emerg-
ing economies have less sophisticated enforcement institutions, and
hence need simpler, more easily administrable rules.
24 See Julie Tolkacheva, Secret Takeover Unnerves Investors, Moscow TIMES, Apr. 5, 19
I, 2 (reporting that Primorsk Shipping doubled its outstanding shares and sold the additional
shares for a nominal price to an affiliate controlled by Primorsk's managers, and also that Far
Eastern Shipping plans a similar action); supra note I7 (describing the secret share issuance by
Komineft to insiders); infra note 3I (describing Krasnoyarsk Aluminum's erasure of a 20% share-
holder from its share register).
25 See, e.g., Boycko, Shleifer & Vishny, Voucher Privatization, supra note i6, at 250-53.
26 See, e.g., Can Yeltsin Win Again?, ECONOMIST, Feb. I7, i996, at 43 (describing the Com-
munists' political resurgence in Russia and President Yeltsin's subsequent decision to fire Anatoly
Chubais, the architect of privatization and the last remaining prominent free-market reformer in
the Yeltsin administration); Peter Galuszka & Rose Brady, The Battle for Russia's Wealth: Can
Rich New Capitalists Weather a Popular Backlash, Bus. WK., Apr. i, i996, at 50 (describing
political backlash against the conspicuous wealth of new Russian tycoons).

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I926 HARVARD LAWREVIEW [Vol. IO9:I9II
The most significant enforcement limitation is weak judicial en-

forcement.27 Several weaknesses in a judicial system can hobble the
enforcement of corporate law in emerging markets. First, the substan-
tive legal remedies available to judges may be ill-defined or inade-
quate. A simple but telling example in Russia is the absence of a rule
permitting judges to adjust damages for inflation. Without such an
adjustment, damage awards in a high-inflation environment will com-
pensate for only a negligible fraction of the actual loss when paid
some years later.28 Moreover, judicial procedures may be so cumber-
some, or the court system so overtaxed, that timely judicial action may
be impossible to obtain except in rare cases. Russia, for example, has
no analogue to a preliminary injunction. Further, the judiciary may
lack experience with corporate law cases,29 may be corrupt, or may be
so ill-paid that skilled lawyers will not take judicial jobs.30
If these weaknesses are present in an extreme form, judicial en-
forcement of corporate law will collapse - as it largely has in Russia.
But total breakdown is merely one end of a continuum. Courts may
be able to enforce simple rules and resolve easy cases, at least some of
the time. Just as the criminal law deters as long as the police catch
some criminals, the corporate law can deter misbehavior as long as
some misdeeds are remedied in the courts.31 Enforcement will be eas-
27 Our focus here is on civil enforcement of the rights and duties established by the corpor
law. Criminal enforcement, which can also be relevant in the corporate context in extreme case
suffers from additional limitations, including poorly paid, poorly trained, and sometimes corr
investigators and prosecutors.
-28 An example: one of us is familiar with a contract case to recover 32,ooo rubles brought in
i990, when the ruble-dollar exchange rate was around I:i. The damage award was paid in I995,
by which time 32,000 rubles were worth around $7.
29 A senior member of the Supreme Russian Arbitrage Court (the Russian "arbitrage" courts
exercise jurisdiction over commercial disputes) recently admitted, with unusual candor: "This
share business is too complicated for us. We don't understand it. We have no laws to deal with
it." Elif Kaban, Shares, Guns and Bodyguards in Russia's Courts, Reuters, May I4, I995, avail-
able in LEXIS, News Library, Wires File.
30 For example, the Russian arbitrage courts have experienced little change in personnel
the demise of the Soviet Union. Current judicial salaries are as laughable as other official R
sian salaries. A senior judge today earns around $ioo per month, barely more than a subsist
wage. A competent judge can increase his salary by ten times or more by returning to the
sector as a lawyer - leaving the incompetent and the corrupt to staff the judiciary.
31 For example, Russia's dematerialized system of shareholding, in which the company regis-
ter is the only official record of share ownership, creates a risk that company managers will
simply erase an unwanted shareholder from the shareholder register. The Russian lawyers whom
we asked about this risk expressed confidence that such an effort would fail - the shareholder
could go to court and get her ownership interest restored. An important test of this belief in-
volves Krasnoyarsk Aluminum. In late I994, the managers of this reputedly mafia-controlled firm
canceled the register entry for a foreign investor (also with some unsavory connections) who
claimed to own 20% of the company's shares, and forcibly barred the investor's representatives
from attending a shareholder meeting. See Russian Aluminum: King of the Castle?, ECONOMIST,
Jan. 2I, I995, at 62. The subsequent lawsuit by the shareholder has not yet been resolved.

59.88.197.37 on Thu, 26 Aug 2021 03:35:23 UTC
I996] A SELF-ENFORCING MODEL OF CORPORATE LAW I927
ier if courts can often resolve disputes by applying bright-line rules

rather than broad standards.
In addition to having weak courts, emerging markets are unlikely
to have administrative agencies that can handle issues, such as finan-
cial disclosure, that benefit from detailed rulemaking and administra-
tive enforcement.32 Moreover, these markets lack the nonlegal
enforcement resources found in developed economies, including self-
regulatory institutions (such as the New York and London Stock Ex-
changes and the British Panel on Takeovers and Mergers) and private
firms that protect clients against abuse and reduce informational
asymmetries (such as investment banking, law, and accounting firms).
Accounting rules in emerging economies are likely to be weak or non-
existent and administered by a commensurately undeveloped profes-
sion. Russia, for example, has rudimentary and sometimes bizarre
accounting rules that were developed for state enterprises, and virtu-
ally no accountants with training comparable to that of American cer-
tified public accountants.33
In developed economies, disclosure is an important constraint on
management behavior. Disclosure of management self-dealing can
lead to formal enforcement. Disclosure of self-dealing or business
problems can also lead to market sanctions, such as a drop in stock
price, reduced availability of credit, and difficulty in hiring employees.
Embarrassment from public disclosure also exerts important discipline.
For example, American boards of directors have many times replaced
a poor CEO after - but only after - sharply critical stories appeared
in the business press.
In an emerging market, disclosure, and thus its attendant benefits,
is likely to be diminished or absent. Russia is an extreme case where
market pressures work against good disclosure. A company that dis-
closes its accounts honestly can find itself paying taxes that exceed
ioo% of pretax income.34 Small firms also face a severe risk of mafia
32 For example, the Russian Securities Commission was formally created by presidential
cree only in November I994. The Commission has a tiny budget and an almost nonexistent staf
See, e.g., Steve Liesman, Roiling Stock: Shareholders Meetings in Russia Set Stage for Free-Mar-
ket Fight, WALL ST. J. EUR., Apr. 20, I995, at I [hereinafter Liesman, Roiling Stock]. Its mem-
bers include representatives of the Ministry of Finance and the Central Bank, both of which
opposed the Commission's creation and continue to lobby for limits on its power. See, e.g., id.;
Steve Liesman, Russia's Central Bank Appears to Call for Removal of Top Securities Regulator,
WALL ST. J., Sept. 8, I995, at A6.
33 For an extreme example, the Russian Ministry of Finance, which issues accounting ru
requires companies to account for as profit (and pay taxes on) the excess of the sale price of
shares over the nominal (par) value of the shares.
34 The principal cause of effective tax rates that can exceed ioo% of pretax income is rules
that limit which expenses can be deducted from revenue in computing pretax income. See, e.g.,
George Melloan, Russia Tailspins into a Laffer Curve Crisis, WALL ST. J., Mar. 4, i996, at AI5
(reporting that, in Russia, wages above a specified (low) level are not deductible in computing
pretax income). Developed countries also have rules limiting which expenses are deductible, but
in much less extreme form.

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I928 HARVARD LAW REVIEW [Vol. I09:1911
extortion and know that the local mafia are avid readers of financial
disclosures, the better to judge how much payment to demand. The
supposedly confidential financial statements required by the tax laws,
once given to the government, are often delivered to the mafia by cor-
rupt officials. In this environment, investors do not even want the
companies in which they invest to report profits honestly. The risk
that managers will steal hidden profits is preferable to the certainty
that the government or the mafia will take even more after honest
disclosure.35
D. Cultural Norms for Manager and Large Shareholder Behavior
A further reason why developed countries can make do with weak

formal corporate law rules is that managers and shareholders are em-
bedded in a culture that discourages opportunism. In part, the culture
reflects the underlying legal norms and the penalties for violating
those norms. But cultural attitudes also exist independently of and
reinforce the legal norms, so that formal enforcement is infrequently
needed. Few American corporate managers doubt that they work for
the shareholders, even if they and their shareholders sometimes disa-
gree about what this concept means. More generally, most managers
in developed countries routinely follow laws of all kinds and think of
themselves as law-abiding.
Russia offers a marked contrast. Managers of Russian enterprises
cannot follow the law and stay in business. They must lie about their
income to the tax authorities; bribe the tax inspector, the customs in-
spector, the local police, and many other government officials; pay off
the local mafia; and conduct business despite an intricate and often
senseless web of rules. Not surprisingly, these managers often see cor-
porate law as merely another obstacle, to be overcome in any way
possible. Some managers have declared their corporate charter, or the
stock ownership of top management, to be "commercial secrets." Some
lock unwanted shareholders out of shareholder meetings,36 conduct
shareholder votes by show of hands (dominated by employees), or re-
fuse to transfer shares if they don't approve of the new owner.37 Mis-
35 See id. ("[Elven those companies that are well run and are making a lot of money don't
wish to audit themselves in keeping with international accounting principles because if they do
the government will take what they are making away." (quoting Moscow investment banker Bo-
ris Jordan) (internal quotation marks omitted)).
36 See, e.g., Liesman; Roiling Stock, supra note 32, at 12 (describing a Sovintorg shareholder
meeting at which armed guards enforced management's decision to exclude certain shareholders).
37 An example of Russian attitudes toward legal rules is the reaction of one company to a
privatization decree that required two-thirds of the board of directors to be non-employees. A
company representative reported to an interviewer: "We fired our deputy director, and he was
elected [to the board] as [an] outsider. After some time will pass, we will hire him back." Inter-
view with company manager in St. Petersburg, Russia (Oct. II, 1994) (transcript provided by
Professor Joseph Blasi, Rutgers Univ.).

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW 1929
conduct so basic is rare in developed markets, precisely because it

would be instantly condemned as making hash out of the ground rules
of the corporate form.
To be sure, every country has some cultural ground rules. Russian
managers, for example, often refuse to record a transfer of shares, but
they rarely simply erase an unwanted shareholder from the share reg-
ister. Still, cultural understandings about proper management behav-
ior are likely to constrain managers more weakly in emerging than in
developed markets. The weaker the cultural constraints, the larger the
role that corporate law must play.
The corporate law can respond to judges' and managers' lack of
sophistication about how corporate managers should behave by mak-
ing its requirements more precise. Vague standards will rarely be un-
derstood, and will rarely be followed even when they are understood.
By contrast, explicit instructions are more likely to be followed and
enforced, and over time can help to inculcate a sense of appropriate
behavior in managers. Broad fiduciary standards can have long-term
value in emerging markets because they can foster a managerial cul-
ture of duty to shareholders. In the near-term, however, the enforcea-
ble core of the law must be based on bright-line rules as much as
possible.
II. A SELF-ENFORCEMENT APPROACH TO CORPORATE LAW
Having surveyed the constraints under which corporate law in

emerging markets must operate, we are ready to examine more closely
what form the law should take. Some aspects of corporate law for
emerging markets follow easily from the strong protective function
that the law must discharge and the limited tools available to enforce
it. Given the weakness of market and cultural checks on corporate
insiders and the prevalence of controlled companies, the core rules
should often be mandatory, rather than default provisions changeable
by shareholder vote. Moreover, the law should consist, as much as
possible, of relatively simple rules that can be understood and applied
by corporate participants and judges alike.
When we turn to the task of designing specific rules, two general
approaches are possible. One we term the "prohibitive model": a law
that bars a wide variety of suspect corporate behavior in considerable
detail. The second we term the "self-enforcing model": a law that cre-
ates corporate decisionmaking processes that allow minority sharehold-
ers to protect themselves by their own voting decisions and by
exercising transactional rights.

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I930 HARVARD LAW REVIEW [Vol. 109:1911
A. The Prohibitive Model
The prohibitive model is familiar from nineteenth-century corpora-

tion statutes in the United States and Great Britain and, to some ex-
tent, from European corporate codes and emerging market corporate
codes today.38 A prohibitive code simply bars many kinds of corpo-
rate behavior that are open to abuse, such as self-dealing transactions
and cashout mergers. Such prohibitive statutes were adopted in the
United States and Britain under market conditions that resemble those
of emerging economies today. One plausible approach to corporate
law for emerging economies is to return to this restrictive drafting
strategy from developed countries' pasts. In Russia, for example, the
drafters of the Civil Code provisions that regulate companies con-
sciously borrowed elements of the prohibitive approach from
America's and Russia's pasts.39
That developed economies have evolved away from the prohibitive
model toward an enabling model - far away, in the United States
and Great Britain, less far in Continental Europe - does not mean
that the prohibitive model is inappropriate for emerging markets. Ex-
perience in Great Britain and the United States teaches that an en-
abling law only weakly protects minority investors from controlling
insiders who are determined to exploit them. Both countries have had
their share of scandals and scoundrels - Robert Maxwell in the
United Kingdom and Victor Posner in the United States are prototypi-
cal examples.
If the gross abuse of power by controlling insiders is not common
in either country, this is partly for lack of opportunity (controlled com-
panies are relatively uncommon) but primarily - as we have already
argued - because multiple markets and institutions constrain insider
opportunism. Enabling statutes would fare far worse in emerging
38 The prohibitive model, which imposes substantive regulation, and the self-enforcing mode
which imposes procedural constraints, are ideal types, as is the enabling model that characterize
American and British company law. As indicated in the Appendix, existing emerging mark
statutes generally include a mix of all three forms of regulation. Nevertheless, many of the
statutes have a distinctive prohibitive or self-enforcing orientation. Only one of the 17 surveye
countries (South Africa) has a statute that is primarily enabling in character. Emerging mark
statutes with continental roots tend to be prohibitive, while statutes with British Commonweal
roots are more self-enforcing.
39 A key drafter of the Russian Civil Code, Dean Yevgeni Alexeyevich Sukhanov of the Mo
cow State University Law Faculty, presented to one of us a I994 reprinting by his students o
I9I4 Russian textbook on corporate law. See generally G.F. SHERSHENEVICH, UCHEBNIK
ToRGOVOGO PRAVA [TEXTBOOK ON BUSINESS LAW] (SPARK I994) (I914) (reprinting the te
with an introductory article by Dean Sukhanov). He explained his view that Russia's curren
problems were much like those described in the book, and required a return to the solutio
proposed in this ancient text.

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW 1931
economies, where controlled firms are the norm and nonlegal restraints
on controlling insiders are weak.40
But these considerations suggest only that the prohibitive model
may be a worthy competitor to the enabling model in emerging econo-
mies, not that it dominates other possible approaches. Prohibitive stat-
utes have severe drawbacks even in emerging markets. First, they
often impose major costs on companies by mechanically limiting the
discretion of corporate managers to take legitimate business actions.
By most accounts, the driving force behind the rise of enabling stat-
utes in developed markets was the value of transactional flexibility to
corporate managers, and ultimately to shareholders.41 The inflexibility
of substantive prohibitions can be (and in Continental Europe often is)
reduced by creative judicial interpretation, but this requires creative
and knowledgeable judges, who are likely to be absent in an emerging
market.
Second, we know very little about how effective prohibitive stat-
utes are in thwarting opportunism. Many formal constraints become
ineffective as practitioners discover how to avoid them. The classic
Anglo-American example is the demise of the protective function of
legal capital following the introduction of low-par stock.42 Moreover,
over time, severe substantive prohibitions will tend to be relaxed by
legislators to meet firms' business needs (or the political demands of
corporate managers). Indeed, in Russia, which already had many large
manager-controlled companies, it would have been politically naive to
expect the legislature to prohibit all self-dealing transactions. Yet, if
these prohibitions are absent, the prohibitory model offers nothing to
replace them with.
Third, prohibitive statutes require significant judicial or adminis-
trative involvement. Transaction planners will look for ways to com-
ply with the letter of the statute but not its spirit. These efforts, in
turn, require knowledgeable judges who can resolve the resulting dis-
putes in sensible ways.
40 From this perspective, it is not surprising that European corporate codes have evolved less
far than British and American laws from prohibition to the enabling model. European companie
are more likely to be insider-controlled than British and American companies, and European
countries are less likely to have active public stock markets, which implies weaker market
controls.
41 See, e.g., ROMANO, supra note 23, at 87-89.
42 See ROBERT C. CLARK, CORPORATE LAW ? 14.3, at 6io-i6 (I986). For us, there was per-
verse amusement in watching the Russian Civil Code drafters resolutely relying in I994 on char-
ter capital as a basic form of investor protection, while Russian company managers, having
quickly learned the lessons that American managers learned early in the twentieth century, were
routinely selling stock with a market value many times its par value (aided in this effort by high
inflation). See GRAZHDANSKII KODEKS RF, pt. I, arts. 96-iO2 (I994) [hereinafter GK RF (CIVIL
CODE)], translated in CIVIL CODE OF THE RUSSIAN FEDERATION (William E. Butler trans., Inter-
list Pub. I994).

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B. The Self-Enforcing Model
A central claim of this Article is that, in emerging markets, a self-

enforcing model of corporate law - in which mandatory procedural
and structural rules empower outside directors and large minority
shareholders to protect themselves against opportunism by insiders -
dominates both the prohibitory model and the enabling model. The
self-enforcing model minimizes the need to rely on courts and adminis-
trative agencies for enforcement. Thus, it is robust even when these
resources are weak. And the model combines much, though not all, of
the flexibility of the enabling model with a degree of investor protec-
tion that the enabling model cannot match, and perhaps the prohibi-
tory model cannot match either. We sketch here the main lines of the
self-enforcing model. Details in the Russian context and more exten-
sive justification of particular features of the model are introduced in
Parts IV, V, and VI.43
The self-enforcing model is designed to harness the monitoring
ability of large, albeit still minority, outside shareholders. Collective
action problems preclude effective monitoring by small shareholders.
But large shareholders, in defending their own self-interest, will often
defend the interests of small shareholders as well. Many companies
are likely to have large outside blockholders, in part because sophisti-
cated investors understand all too well the weak position of a small
outside shareholder and thus prefer to hold an influential block of a
company's stock, if they own its shares at all.44
Corporate law and investor preferences interact: the more influence
that the law gives to large outside investors, the more likely investors
are to choose to hold large stakes - and to use the influence that
these stakes provide. In terms of Albert Hirschman's dichotomy be-
tween exit and voice as monitoring mechanisms,45 thin capital markets
eliminate exit as an available option in emerging economies. Investors
therefore look to maximize their voice, and the self-enforcing model
empowers them to do so.
43 The strategy of shifting legal enforcement from courts and regulators to private parties w
are well positioned to thwart misconduct is frequently deployed outside the company law conte
One of us has called this strategy, using examples from tort and criminal law, "gatekeeper
forcement." See Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcem
Strategy, 2 J.L. ECON. & ORG. 53, 73 (i986). The gatekeeper strategy in the tort context involv
imposing legal liability on one private party to create incentives for that party to control
conduct of another. In contrast, the self-enforcing strategy for company law provides out
shareholders, who already have the incentive to control insider opportunism, with the mean
do so.
44 For precisely this reason, investment funds in both Russia and the Czech Republic lobbied
successfully for relaxation of legal restrictions (adapted from the Investment Company Act of
I940, I5 U.S.C. ?? 8oa-i to -64 (I994)) on the percentage stake that a fund could hold in a single
company.
45 See ALBERT 0. HIRSCHMAN, EXIT, VOICE, AND LOYALTY: RESPONSES TO DECLINE IN
FIRMS, ORGANIZATIONS, AND STATES I5-54 (I970).

59.88.197.37 on Thu, 26 Aug 2021 03:35:23 UTC
1996] A SELF-ENFORCING MODEL OF CORPORATE LAW I933
I. Structural Constraints. - The structural constraints that define

the self-enforcing model operate both at the shareholder level and at
the level of the board of directors. At the shareholder level, these con-
straints typically involve shareholder voting requirements or transac-
tional rights (put and call options) triggered by specific corporate
actions.
With regard to voting rules, a self-enforcing statute can require
supermajority shareholder approval for central business decisions such
as mergers, rather than the simple majority approval of the enabling
approach. It can also require shareholder approval for a broader
range of corporate actions than an enabling statute would, such as de-
cisions to issue significant amounts of new equity or to purchase or sell
major assets.46 For self-interested transactions between the company
and its directors, officers, or large shareholders, a self-enforcing statute
replaces the permissiveness of the enabling approach (loosely policed
by courts) and the ban of the prohibitory model with approval by in-
dependent directors, a majority of noninterested shareholders, or both.
The voting decisions of large shareholders, if obtained through fair
voting procedures and with adequate disclosure, are a more fine-
grained way to distinguish between good and bad transactions than
substantive prohibitions could possibly be.
To safeguard the voting mechanism, the self-enforcing statute can
include a one share, one vote rule to prevent insiders from acquiring
voting power disproportionate to their economic interest in the com-
pany, as well as procedures to ensure honest voting, such as use of an
independent registrar to record share transfers, confidential voting,
and independent vote tabulation. Outside shareholders' influence can
be increased through use of a universal ballot that lets them cheaply
place director nominations and other proposals on the voting agenda.
Good voting decisions require good information, but the quality of
shareholders' information can be improved by mandatory disclosure
rules and by cumulative voting, which enhances large blockholders'
access to information about the company.
Voting mechanisms, which by their nature must be exercised collec-
tively, can be supplemented with transactional rights that individual
shareholders can exercise. A self-enforcing law can convey appraisal
rights (put options) to unhappy shareholders for a broader range of
46 To the extent that an enabling statute contains any mandates for shareholder vot
particular types of transactions, it partakes of the self-enforcing approach. The differen
tween the self-enforcing model and an enabling model (with self-enforcement features) are o
degree. The self-enforcing approach contains more and stricter voting mandates because it p
greater weight on the goal of protecting outside investors against insider opportunism and l
weight on maximizing business flexibility.

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1934 HARVARD LAW REVIEW [Vol. IO9:I9II
corporate actions than a typical enabling statute would.47 Exercise of

appraisal rights can be made simpler, and low-ball repurchase offers
chilled, by requiring a company, when it solicits shareholder approval
for an action that will trigger appraisal rights, to publish an offer price
that will be binding on the company if the appraisal rights are exer-
cised. The law can convey mandatory preemptive rights (call options)
to acquire shares in proportion to one's ownership stake, as protection
against underpriced stock issues. It can give shareholders takeout
rights (put options) to sell their shares to a new controlling share-
holder, as protection against transfer of control from known (and pre-
sumably trusted) hands to less trusted ones.
The voting rights and transactional rights approaches can be com-
bined, with voting used to define the extent of the transactional rights.
For example, preemptive rights can be made waivable ex ante by
shareholder vote, and takeout rights can be made waivable by a ma-
jority vote of shareholders other than the new controlling shareholder.
A self-enforcing statute also introduces structural constraints at the
level of the board of directors. For example, it can require that a cer-
tain proportion of a company's board of directors be independent, and
then vest these independent directors with authority over key corpo-
rate decisions - such as approval of self-interested transactions. It
can mandate board structures, such as an audit committee, that am-
plify the power of independent directors but are optional under en-
abling statutes.
A critical feature of the self-enforcing model, linking shareholder
level and board level constraints, is a cumulative voting rule for elec-
tion of directors, buttressed by a mandatory minimum board size and
a ban on staggered terms of office. Cumulative voting allows large
outside shareholders to elect representatives to the board. As long as
outside shareholders hold stakes large enough to elect their own repre-
sentatives, cumulative voting enhances information flow and ensures
that at least some directors will be true shareholder representatives.
An insider majority will still control non-related-party transactions
under this rule, but outside representation makes it harder for insiders
to ignore or deceive minority shareholders. Although other voting
rules, such as class voting, can also ensure minority representation on
the board of directors, a cumulative voting rule is flexible enough to
encompass a wide variety of ownership structures.
2. Simple, Bright-Line Rules and Strong Remedies. - The self-
enforcing model compensates for the weakness of formal enforcement
through a combination of relatively simple, bright-line rules governing
when its structural constraints apply, rules that insiders will often
47 The existence in an enabling law of any mandatory appraisal rights can be seen as reflect-
ing elements of the self-enforcing approach. A pure enabling law would let individual firms grant
or withhold appraisal rights in their charters.

59.88.197.37 on Thu, 26 Aug 2021 03:35:23 UTC
comply with voluntarily, and strong sanctions for violating the rules.
The self-enforcing model might, for example, require a shareholder
vote for a purchase or sale of assets that equals 50% or more of the
book value of the firm's assets. To be sure, book value is an imperfect
measure of a transaction's importance. Moreover, a percentage thresh-
old will be overinclusive in some cases (hindering transactions by re-
quiring a shareholder vote without sufficient reason) and
underinclusive in others (failing to reach transactions that could seri-
ously affect shareholder value). But this rule is far clearer in applica-
tion than the familiar enabling law requirement of shareholder
approval for a sale of "substantially all" assets.48
When a pure bright-line rule is unavailable, the self-enforcing ap-
proach uses more concrete standards than are often found in devel-
oped markets. Compare, for example, the following alternative
instructions to directors who must decide whether to approve a trans-
action between a company and one of its directors:
(i) a self-interested transaction must be either ratified by shareholders or
approved by the noninterested directors acting in the best interests of the
company, or else is subject to "entire fairness" review by the courts;
(ii) a transaction between the company and a director or top manager must
be approved by noninterested directors, who should grant approval only if
the transaction is fair to the company;
(iii) a transaction between the company and a director must be approved by
noninterested directors, who should grant approval only if the company re-
ceives consideration, in exchange for property or services delivered by the
company, that is worth no less than the market value of the property or
services, and the company pays consideration, in exchange for property or
services, that does not exceed the market value of the property or services.
The first approach, with some judicial gloss, is essentially the legal
rule today in the United States and Great Britain.49 In an emerging
economy, it offers meager guidance to directors. The second approach
borrows from current best practice in the United States by vesting the
decision in noninterested directors who are instructed to review the
"fairness" of the transaction. In the United States, this best practice
rests on a cultural understanding that "fairness" turns largely on price,
48 See, e.g., DEL. CODE ANN. tit. 8, ? 27I (I99I).

49 Most contemporary American corporation statutes encourage review of conflict-of-interest
transactions by noninterested directors without specifying what standard of review these director
should employ. See id. ? 144(a)(I) (stating that corporate transactions in which some directors a
interested are not automatically voidable if approved by a majority of noninterested directors
PRINCIPLES OF CORPORATE GOVERNANCE, supra note I3, ? 5.02 reporter's note, at 235-45 (can
vassing state statutes).
50 See, e.g., PRINCIPLES OF CORPORATE GOVERNANCE, supra note I3, ? 5.02(aX2XB) (stating
that disinterested directors may authorize an interested transaction only if they "could reasonably
have concluded that the transaction was fair to the corporation').

59.88.197.37 on Thu, 26 Aug 2021 03:35:23 UTC
relative to market price. But in an emerging economy, directors and

judges may not know what it means for a transaction to be "fair."
We favor the third approach in an emerging economy. Enforce-
ment is still scarcely automatic, but even an unsophisticated judge can
understand that the company's sale of property to a manager, who
promptly resells it for thrice the price that he paid, was not at market
value. A corrupt judge who nonetheless blesses such a transaction ad-
vertises his corruption to all. Sunshine is an imperfect disinfectant,
but an important one nonetheless.
The third approach also tells directors how they ought to behave.
Over time, the norms that a company's transactions with insiders
should be at market prices and should be reviewed by noninterested
directors may become part of corporate culture. The cost of this more
precise approach is that it fails to reach situations where a transaction,
although at a "market" price, is nonetheless unfair to the company-
perhaps because the price was toward the low end of a broad range of
plausible "market" prices.
The prohibitive model also lends itself to bright-line rules, but
transaction planners will exert constant pressure on these rules. Over
time, this pressure will lead to fuzziness at the margin, as judges bend
the substantive rules to allow beneficial transactions to proceed. The
structural rules of the self-enforcing model will experience less pressure
at the margin because they do not flatly bar transactions. Rather, the
self-enforcing model merely imposes procedural hurdles that can usu-
ally be surmounted for beneficial transactions.
The self-enforcing approach further encourages managers to com-
ply with its rules through relatively severe sanctions for noncompli-
ance, which compensate in part for the low probability of enforcement.
For example, the remedy for failure to obtain advance approval of a
self-interested transaction can be automatic forfeit to the company of
the self-interested person's profit from the transaction. This contrasts
with the enabling approach, in which an interested party generally can
defend a transaction on the grounds that it was substantively fair.'
A statute can rely heavily on rules (rather than standards) and still
be so complex that managers and judges can't understand it, and
managers soon give up in disgust and stop trying. Every additional
rule and nuance adds to the law's overall complexity and detracts
from its overall effectiveness. This is a kind of externality - the di-
rect benefits from tailoring the law more closely to fit discrete situa-
tions must be balanced against the indirect costs of complexity.52 To
51 See, e.g., Cinerama, Inc. v. Technicolor, Inc., 663 A.2d I134, 1152-54 (Del. Ch. 1994), ajJd,
663 A.2d II56 (Del. '995).

59.88.197.37 on Thu, 26 Aug 2021 03:35:23 UTC
combat this problem, a bias in favor of simplicity must overlay every

discrete decision embedded in a self-enforcing law.
C. The Limits to the Self-Enforcement Approach
The self-enforcing model introduces three types of costs, compared

to the enabling model. First, shareholder votes and transactional rem-
edies add costs and delays. Thus, while these shareholder rights
should be more common under the self-enforcement model than under
the enabling model, deciding how much more common requires bal-
ancing, at the margin, the expected costs and benefits of expanding a
particular protection. The cost-benefit balance, in turn, will depend on
the strength of other institutions that are available in a particular
country to channel the behavior of corporate participants. There are
no clear lines, only informed judgments, about where to strike that
balance in a particular country.
Shareholder-level protections are often more effective, but also
more costly, than board-level protections. But the more effective the
board is in serving shareholders' interests, the fewer the decisions that
should require shareholder action. Thus, one goal of the self-enforcing
model is to create a board that is more responsive to outside share-
holders' interests, which in turn lets the law vest more decisions exclu-
sively in the board.
A second cost of giving a veto over corporate decisions to outside
shareholders or outside directors, or requiring supermajority votes to
approve certain decisions, arises from the usual hazards of departing
from a majority vote rule.53 A large outside shareholder will have
holdup power and may be able to obtain personal benefits by threat-
ening to block a value-increasing transaction. Moreover, the rational
apathy of small shareholders may make it hard for the company to
obtain the votes needed for approval of a value-increasing transaction.
The two concerns interact: the rational apathy of some shareholders
increases the holdup power of other shareholders.
To take a Russian example, suppose that a company's managers
wish to merge with another company - a transaction that will en-
52 In Russia, for example, privatized companies with more than 500 shareholders
required to elect directors using cumulative voting since January I994. See Decree of the Presi-
dent of the Russian Federation No. 2284, ? 9.io (Dec. 24, I994), implementing The State Pro-
gramme of Privatization of State-Owned and Municipal Enterprises in the Russian Federation,
translation available in LEXIS, Intlaw Library, Rflaw File. Many companies haven't complied
with this decree, we understand, because their managers don't understand how cumulative voting
works. This confusion reduces their respect for the law as a whole. In response to this problem,
our proposed Russian law mandated cumulative voting only for companies with iooo or more
shareholders - the companies most likely to have outside blockholders who can make use of
cumulative voting.
53 See RONALD J. GILSON & BERNARD S. BLACK, THE LAW AND FINANCE OF CORPORATE
ACQUISITIONS 64I-52 (2d ed. I995).

59.88.197.f:ffff:ffff:ffff on Thu, 01 Jan 1976 12:34:56 UTC
hance the firm's value for investors but cost jobs today. A high share-
holder approval requirement may let employee-shareholders block this
transaction. Given the majority manager-employee ownership and rel-
atively concentrated outside ownership of most Russian firms, we be-
lieve that approval of key corporate actions such as mergers by two-
thirds of the outstanding shares offers a sensible balance between pro-
viding meaningful shareholder protection and limiting the holdup
power of employees or outsiders. By contrast, a simple majority of
outstanding shares should suffice to approve large share issues, be-
cause preemptive rights also protect shareholders against below-mar-
ket pricing. But a different ownership structure would lead to a
different judgment.
A third cost of self-enforcement protections is a subtle loss of flexi-
bility in designing the business enterprise. The self-enforcement model
controls the structure within which corporate decisions are made. But
a single decisionmaking structure will not fit all companies. To some
extent, the law can allow for this by providing different rules for com-
panies of different sizes and by dictating structure only when there
seems strong need to do so. But we cannot anticipate in advance all
the ways in which companies might want, for good reason, to depart
from the prescribed structure. In theoretical terms, we cannot fully
escape the usual expanded choice argument for an enabling law.
Deciding which procedures are appropriate for which firms, and
how finely to subdivide the universe of firms using an imperfect mea-
sure like number of shareholders, is an exercise in balancing. For Rus-
sia, we would apply the full "large company" procedures, such as
cumulative voting, to firms with iooo or more shareholders. This
choice, however, depends on a background fact: the Russian privatiza-
tion process, in which almost all employees and many individual citi-
zens became shareholders, means that even a relatively small company
can have hundreds of shareholders.
Venture capitalists (active equity investors - domestic or foreign
-who demand influence or even control in exchange for large infu-
sions of capital) are likely to be important sources of equity capital in
emerging economies, where rapidly changing economic circumstances
make almost all companies highly risky. Venture capitalists in devel-
oped economies exploit the enabling model's flexibility to tailor elabo-
rate control arrangements for their own protection. A good measure of
the flexibility costs of the self-enforcing model is how often its
mandatory procedures prevent arrangements that these investors might
otherwise prefer.54
54 For Russia, we considered a "dual" corporate law, with one set of rules for privatized firms
and another, more flexible set of rules for newly created firms, including firms financed by ven-
ture capitalists. We concluded that such a dual law was not feasible, because privatized firms
would be able to use the tools of corporate restructuring (mergers, sales of substantially all assets,

59.88.197.37 on Thu, 26 Aug 2021 03:35:23 UTC
Two features of our proposal may seem especially likely to interfere

with venture capital investments: (i) the takeout offer requirement that
a purchaser of over 30% of a company's common stock offer to buy
all remaining shares; and (ii) the requirement that each company have
a single class of voting common stock. In fact, these provisions are
unlikely to block the control arrangements that venture capitalists
often demand. Suppose, for example, that a venture capitalist wants
to buy a 40% interest in a company directly from the company. Our
control transaction rules permit shareholders to waive their takeout
rights by majority vote. A waiver imposes virtually no added cost on
the company, because the shareholders must vote to authorize a 40%
share issuance in any event. If the venture capitalist wishes to buy a
40% stake from existing shareholders, rather than from the company,
then a waiver vote would entail the extra transaction costs of a share-
holder meeting. In our judgment, these costs are justified by the pro-
tection that the takeout rule accords to minority shareholders.
A more difficult but still soluble problem arises if the venture capi-
talist wishes to make a minority investment while retaining veto rights
over critical transactions. In the enabling model, such a transaction is
often structured by creating a second class of voting stock that gives
the investor both general voting rights and the particular veto rights
that are desired. Under the self-enforcing model, the same control
structure can be created by combining partial ownership of a firm's
common stock with ownership of a class of preferred stock equipped
with the desired veto rights. Virtually the only rights that a venture
capitalist could not demand under our proposed statute are voting
rights for directors disproportionate to the venture capitalist's total eq-
uity investment. And even this restraint can sometimes be finessed
through a voting agreement with other large shareholders.
D. Can Law Function Without Official Enforcement?
The self-enforcement model is designed to minimize reliance on of-

ficial enforcement. But how effective can the law be if judicial en-
forcement is as weak, corruption as widespread, and organized crime
as strong as is currently the case in Russia? Are all efforts to control
private behavior within the corporate form doomed to failure without
some minimum level of enforcement capability?
spin-offs, and the like) to qualify as "new" firms. We did not think a workable line could be
drawn between "genuine" restructurings and "sham" restructurings designed to qualify for the
more liberal corporate law rules. The American tax rules on net operating losses, through which
Congress tried for decades in increasingly complex ways to limit the use of net operating loss
carryforwards to the firm that generated the losses, offer a case study where regulators tried to
draw a similar line and failed. See BORIS I. BITTKER & JAMES S. EUSTICE, FEDERAL INCOME
TAXATION OF CORPORATIONS AND SHAREHOLDERS ? i6.02 (5th ed. I987) (reviewing the history
of the net operating loss rules).

59.88.197.37 on Thu, 26 Aug 2021 03:35:23 UT76 12:34:56 UTC
I 940 HARVARD LAW REVIEW [Vol. I09:I9II
To explore these questions, let us imagine, counterfactually, a

world with no official enforcement - no government organ that can
enforce the official corporate rules. If the self-enforcing approach can
elicit partial compliance in this hypothetical world, then it can only
work better - though still imperfectly - in the more realistic case
where official enforcement is weak but not wholly absent.
The concept of rules without official enforcement is not new. Rob-
ert Ellickson has explored situations in which norms of conduct
emerge without official enforcement, including conflict between whal-
ing vessels in international waters, and situations where official rules
are so out of touch with practical needs that a public consensus devel-
ops around informal norms.55 Here, we consider the potential for rules
to function without official enforcement in the specific context of cor-
porate law. For example, suppose that company directors can ignore
all shareholder voting rules without fear of official intervention. What
recourse is open to a 20% shareholder who loses a board seat because
the company erases him from the shareholder register, refuses to pro-
vide cumulative voting, or conveniently loses his ballot?
One answer is that the question is posed too starkly. Even without
official sanctions, many companies will not resort to such tactics.
Some managers will comply with the written law simply because it is
both written and reasonable; some will comply because their peers do;
others will comply so as not to risk embarrassing news stories. Com-
panies that need capital will comply with the rules to build a reputa-
tion for honest behavior, and companies that plan to enter long-term
contractual relations must safeguard their reputation for honesty and
fair dealing.56
Without official enforcement, the entire corporate law (including its
nominally "mandatory" terms) becomes a set of default rules from
which the participants in the corporate enterprise can depart, jointly
or unilaterally. But, as with any set of default rules, it will be costly
to ignore them or contract around them.
There may also be penalties harsher than loss of reputation for
breaking the rules. A world without official enforcement will surely
develop unofficial enforcement. Suppose, plausibly, that some share-
holders are willing and able to resort to violence if their rights are
violated, and that company directors are not sure which shareholder
55 See ROBERT C. ELLICKSON, ORDER WITHOUT LAW 40-64, i84-206 (i99i).

56 Clear legal rules can enhance reputational sanctions by increasing the visibility of miscon-
duct. Behavior that might otherwise blend into routine, hard-nosed business practice is easier to
identify as illicit against the backdrop of a legal rule that prohibits the behavior. Thus, corporate
law in emerging markets can help to seed the development of the nonlegal controls that are so
critical to the functioning of developed markets. See David Charny, Nonlegal Sanctions in Com-
mercial Relationships, I04 HARV. L. REV. 375, 408-25 (i990) (describing the prerequisites for
reputational enforcement).

59.88.197.37 off:ffff:ffff on Thu, 01 Jan 1976 12:34:56 UTC
i996] A SELF-ENFORCING MODEL OF CORPORATE LAW I94I
may react this way. Fear of these few can cause directors to behave
properly toward all shareholders.57
Few shareholders are likely to shoot a director just for making a
bad business decision. That would be foolish: it is unlikely to en-
courage better decisions in the future and risks retaliation in kind.
But the situation is very different if the directors break a clear rule
conferring voting rights. Now a wrong has been committed, and di-
rectors will face personal liability of a tangible kind if some sharehold-
ers feel they must respond. Thus, few directors will blatantly
disregard the written law. At the very least, they will take seriously a
20% shareholder's demand for board representation by weighing the
personal risks from rejecting the demand against the benefits, much as
if official enforcement of shareholder rights were in prospect. The
more blatantly shareholder rights are violated, the more likely a share-
holder is to take extralegal action, and thus the greater the expected
sanction will be. For example, removing a shareholder from the share
register is more likely to provoke a violent response than refusing to
use the required procedures for approving a self-interested
transaction.58
We do not suggest that unofficial enforcement is anything near
ideal. Some directors will be shot for imagined wrongs or, as at Kras-
noyarsk Aluminum, as part of a quite literal takeover "battle." Share-
holders, too, will be at risk if they complain too loudly when a
company is looted. Large shareholders may succeed in extorting pri-
vate benefits from companies when these can be hidden from other
shareholders. But on the whole, men with guns will often be polite to
each other, especially if, as is common for corporate enterprises, they
expect to meet again. Repeated interaction magnifies both the impor-
tance of reputation and the risk of retaliation for misbehavior. Unoffi-
cial yet still organized enforcement may arise and coalesce around the
written law.59 In sum, a corporate law that defines norms of polite-
57 See Jonathan Hay, Private Enforcement of Law (i996) (unpublished manuscript, on file
with the Harvard Law School Library).
58 From this perspective, the Krasnoyarsk Aluminum case, discussed above in note 3I, wh
a company wiped a 20% shareholder out of its share register, can be seen as the exception, not
the norm. During the year before the company's action, someone had waged an intimidation
campaign against Krasnoyarsk's managers, killing several senior managers and beating up others,
including the CEO. That someone, some informed observers believe (and Krasnoyarsk's manag-
ers surely knew, one way or another), was the 20% shareholder, who already controlled the two
other large aluminum refineries in Russia and wanted control of the third - Krasnoyarsk. If so,
then Krasnoyarsk's managers were responding - extralegally but perhaps appropriately - to an
extralegal effort to take control of their firm.
59 In Russia, organized extralegal enforcement of norms of business conduct already occurs to
some extent. Small businessmen, each "protected" by different mafia gangs, sometimes bring dis-
putes to mafia-run "courts," called "razborkas." (In Russian, razborka is a noun meaning "sorting
out.') Only the very foolish do not comply with a razborka's decision. See Michael Specter,
Survival of the Fittest, N.Y. TIMES, Dec. I7, I995, Magazine, at 66, 69-7I.

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I 942 HARVARD LAW REVIEW [Vol. I0g:IgII
ness in ways that the participants perceive as reasonable can be par-

tially effective even without official enforcement.60
An example: our model law limits the right of insolvent companies
to distribute assets to shareholders or to sell assets for less than
equivalent value. In a developed country, these "fraudulent convey-
ance" rules are enforced by courts and bankruptcy trustees, who chase
and often retrieve improperly transferred assets. In Russia, creditors
cannot rely on this kind of official enforcement. But there is a substi-
tute already in place: creditors often threaten, and not infrequently
shoot, debtors who haven't repaid their debts. The corporate law can
help private actors to distinguish situations when an asset distribution
was proper, even though the business later couldn't pay its debts, from
situations when the asset distribution was improper when made. If
the rules of conduct are clearer, borrowers with good investment op-
portunities will be more willing to risk borrowing money to finance
these investments. The effective cost of capital will decline.
Once we reinstate the possibility of some recourse to courts, even
corrupt courts, the self-enforcing model's effectiveness quickly in-
creases. A corrupt judge can twist a "reasonableness" standard to
reach the decision he was paid to reach, but cannot so easily twist a
requirement that the company provide cumulative voting or appraisal
rights. If the judge finds an exception on some spurious ground, it
will be obvious to all. Yet few corrupt officials want to admit their
corruption in public. Such a judge will also risk personal retaliation,
much as corporate managers do, at the hands of private enforcers.
Moreover, over the longer term, blatant violation of reasonable
norms can create a constituency for enforcement. Shareholders will
bring political pressure to strengthen enforcement capability and will
have obvious abuses to point to. News stories will highlight scandals,
bringing further pressure for enforcement. Test cases, even if they fail
in corrupt or incompetent courts, will form a basis for public opinion
-and repeat players in financial markets may be willing to under-
write the costs of such test cases.
60 Cumulative voting in Russia offers an example of how law can take hold without offic
enforcement. Since December I993, privatized Russian companies with 5oo or more shareholde
have been required to elect directors through cumulative voting. See Decree of the President
the Russian Federation No. 2284, supra note 52, ? 9.I0. In a developed country, one could exp
near universal compliance with such a requirement. In Russia, companies could not be forced
comply with this requirement, and initial compliance was low, partly because managers did
understand how cumulative voting was supposed to work. In a survey of 40 privatized firm
conducted in early I994, only i5% had implemented cumulative voting or even planned to do
within two years. See Blasi & Shleifer, supra note i6, at 83. By late i995, actual compliance h
climbed to i6% of all privatized firms, including 26% of firms with less than majority ownersh
by managers and employees. Compliance with the spirit of cumulative voting was somewha
higher, because some firms that did not formally use cumulative voting had voluntarily ceded o
or more board seats to outside blockholders. The late i995 data is from a survey by Profess
Joseph Blasi of Rutgers University.

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Finally, even if official enforcement is weak today, it may be

stronger tomorrow. The prospect that future enforcement may
threaten their gains will make corporate actors reluctant to presume
nonenforcement, especially if the official sanctions, if imposed, are
likely to be severe. For example, managers may prefer to seek share-
holder approval of a self-interested transaction if they believe that ap-
proval is likely, rather than run even a small risk of facing a future
lawsuit to disgorge profit or have the transaction unwound.
In short, the claim that corporate law can do much to shape pri-
vate behavior even under conditions of weak official enforcement is
not as strange as it may first appear to be. And even law with no
official enforcement is not an oxymoron.
m. GOVERNANCE STRUCTURE AND VOTING RULES
This Part and the next two Parts of this Article describe and jus-
tify in greater detail the elements of the self-enforcing model, with par-
ticular reference to our proposal for Russia. In many cases, there are
no clear lines, only informed judgments, concerning how much share-
holder protection, and what forms of protection, are optimal in the
Russian environment. This Part discusses overall governance struc-
ture; Part IV considers the voting and transactional rights that attach
to particular corporate actions; and Part V discusses remedies.
The self-enforcing approach to corporate law constrains the discre-
tion of managers and majority shareholders by granting voice and
sometimes veto rights over corporate actions to outside directors, non-
controlling shareholders, or both, in the expectation that these actors
can best determine whether proposed corporate actions are value-in-
creasing for the enterprise or merely wealth transfers to insiders. To
avoid manipulation of the board and shareholder voting mechanisms,
governance structure must be simple, and malleable only within nar-
row limits. Some of the enabling model's flexibility with regard to
governance, voting processes, and capital structure is sacrificed to pro-
tect investors while simultaneously preserving flexibility over the range
of substantive actions a company may take.
A. Allocation of Decisionmaking Power
There are two broad strategies available in choosing a review pro-

cess for corporate actions: representative democracy, under which
shareholders elect representatives (a board of directors) to act on the
shareholders' behalf; and direct democracy, under which shareholders
directly approve particular actions. Representative democracy alone is
often unsatisfactory because boards can too easily become lazy or be
captured by management. Thus, the company laws of all developed
countries provide direct shareholder review of selected corporate ac-

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tions such as mergers. On the other hand, direct democracy is far too
slow and costly for most corporate decisionmaking. Moreover, because
small shareholders must act on limited information and face severe
collective action problems, direct democracy can quickly deteriorate
into total manager control in widely-held companies.
We mediate between the weaknesses of each approach with a sim-
ple hierarchical governance structure that allocates managerial power
to a board of directors, subject to shareholder review of particular ac-
tions. The shareholders elect the board of directors; the board chooses
the managers (subject to shareholder review of its choice of top man-
ager); and the board (sometimes a defined subset of the board) ap-
proves particular types of actions, including those that require
shareholder approval. For all other actions, the board decides when
the managers can act unilaterally and when they need board approval.
Governance rules, within the range left open by the law, are speci-
fied in a company charter. To protect minority shareholders against
changes in governance rules, charter amendments require approval by
two-thirds of the outstanding shares, and appraisal rights (discussed in
Part IV) attach if a charter amendment reduces the rights of a class of
outstanding shares.61 To enhance shareholder control of a firm's gov-
ernance rules, charter amendments do not require board approval.
This governance structure has multiple advantages. First, it en-
sures a measure of accountability; shareholders know whom to blame
if things go wrong. Second, it provides the board with reasonable
though not total flexibility. The board decides how best to use its own
limited time, but it must make enough business decisions to avoid de-
scending into ill-informed irrelevancy - a strong risk in the German
two-tier board model, in which the supervisory board meets rarely and
does little more than choose management.62 Third, the structure pro-
vides double review, by both the board and the shareholders, of im-
portant or suspect transactions. Fourth, this structure does not require
more of shareholders than they can deliver. Apart from choosing the
board of directors, shareholders generally review actions that have
been proposed by the board, rather than make decisions unilaterally.
61 The two-thirds-of-outstanding-shares voting requirement for charter amendments, and the

specific vote requirements for other corporate actions discussed below, are minimums. The char-
ter can prescribe a higher but not a lower voting requirement.
62 Our proposed structure has enough flexibility to allow a company largely to replicate the
two-tier management structure if the board so chooses or the charter specifies. The "board of
directors" can hire a "board of managers" and delegate to it day-to-day management responsibil-
ity. The board of managers will then be subject only to whatever oversight the board of directors
chooses to exercise, except when the law or the charter requires approval by the board of direc-
tors. However, the board of directors remains responsible to the shareholders for the conse-
quences of this choice; the board cannot blame a legal structure that limits its power over
management.

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This process accords with the limited information available to most

shareholders.
Our proposed structure gives broad power to the board of direc-
tors. But this power is constrained, in turn, by granting shareholders
broad power over the board's constituency. Shareholders elect direc-
tors annually through cumulative voting and retain the authority to
remove the board (as a whole) at any time without cause.63 Moreover,
the path toward effective shareholder use of this power is smoothed in
various ways, including restricting companies to a single class of vot-
ing securities (that carry a residual interest in the company's profits)
and facilitating shareholder nomination of director candidates.
B. Allocation of Voting Power: One Share, One Vote
The self-enforcing statute allocates investor voting power in pro-

portion to economic interest by mandating a single class of voting
common stock that has both a residual interest in corporate profits
and one vote per share. This allocation increases the likelihood that
corporate actions will maximize firm value.64 The one share, one vote
principle is widely accepted across jurisdictions. It is the dominant
rule in the United States, Great Britain, and Japan even when it is not
a statutory requirement, and it is mandated by statute in many emerg-
ing market jurisdictions.65 Moreover, non-voting or low-voting stock
has come under strong criticism from large investors in countries like
Germany, where it has been common.
The case for the one share, one vote rule turns primarily on its
ability to match economic incentives with voting power and to pre-
63 For mechanical reasons, a system with cumulative voting must restrict shareholder po
to remove individual directors, but not the entire board. If directors could be removed individu-
ally, a majority shareholder could vote to remove a director elected cumulatively by a minority
shareholder, and thus nullify the effect of cumulative voting. Cf DEL. CODE ANN. tit. 8,
? I4i(kXi) (i99i) (providing that cumulatively elected directors may not be removed individually
if votes against removal would be sufficient to elect them).
64 To avoid evasion of this rule, the law must limit the voting rights of securities (preferred
stock and debt) that are senior to a company's common stock, and limit the company's ability to
issue nonvoting securities, principally options to purchase common stock, that are equivalent or
junior in priority to common stock. In our model, preferred shareholders must approve a charter
amendment that reduces the rights of a class of preferred stock, and the charter can give pre-
ferred shareholders the right to vote (as a class or together with the common stock) on specific
corporate actions such as mergers. But the charter can allow preferred shareholders to vote for
directors only in two limited cases: (i) if preferred dividends are in arrears; or (ii) if the preferred
stock is convertible into common stock. In these cases, preferred stock can be given a number of
votes equal to the number of common shares into which it is convertible.
65 In the United States, a one share, one vote rule is maintained by agreement among th
principal stock exchanges rather than by company law. In Britain, one share, one vote is essen-
tially universal because of strong support from institutional investors, who refuse to buy the
shares of a company with a different rule. See Black & Coffee, supra note 6, at 2024. The one
share, one vote rule is expressly mandated by statute in 9 of the I7 jurisdictions examined in our
survey of company laws in emerging markets. See infra Appendix.

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I 946 HARVARD LAW REVIEW [Vol. I09:191I
serve the market for corporate control as a check on bad management.

By contrast, the case for permitting companies to deviate from a one
share, one vote rule turns on (i) the usual claim that informed parties
will choose optimal arrangements on their own; and (ii) the existence
of a reasonably efficient market, in which the proceeds that company
founders realize when they sell their shares will reflect the voting
rights that those shares carry.66
The arguments against a one share, one vote rule lose much of
their force in emerging markets for several reasons. First, public offer-
ings in those markets are unlikely to be priced with a high degree of
efficiency. Second, in newly privatized economies, including Russia,
there were no true founders who could make an economic decision to
sell control rights together with economic rights. Instead, one faces in
such cases the more troubling prospect of midstream charter changes,
perhaps coerced in various ways by managers who want to cement
their control without paying significant economic value.67 Third, in
emerging markets there is more need for investor protection against
self-dealing by company managers. In Russia, for example, stories
abound about company managers who sell most of the firm's output
to another company but never collect the accounts receivable - pre-
sumably in exchange for payments to these managers' foreign bank
accounts - while not paying the company's rent, taxes, utilities, or
even employees for months or years.68 Voting common shares are no
panacea for this behavior, but they can help, especially when they are
acquired by large outside shareholders.
From a theoretical perspective, control (like other assets) tends to
move to those who value it most. Multiple-class voting structures cre-
ate incentives for control to move from good hands to bad because
those who are willing to abuse control will often value it more than
those who will not. In developed economies, market and cultural con-
straints are often strong enough to keep abuse at manageable levels.
In emerging markets, however, abuse will proliferate. To draw an
analogy to ordinary product markets, when product quality is difficult
for buyers to measure (the "lemons" situation), minimum quality rules
can be welfare-enhancing. The case for minimum quality rules in se-
curities markets is especially strong because of the risk (largely unique
to securities markets) that the quality of what one has bought will be
66 For aspects of the extended American debate over the one share, one vote rule, see Ronald
J. Gilson, Evaluating Dual Class Common Stock: The Relevance of Substitutes, 73 VA. L. REV.
807 (i987); Jeffrey N. Gordon, Ties That Bond: Dual Class Common Stock and the Problem of
Shareholder Choice, 76 CAL. L. REV. i (i988); Louis Lowenstein, Shareholder Voting Rights: A
Response to SEC Rule 19c-4 and to Professor Gilson, 89 COLUM. L. REV. 979 (i989).
67 For discussion of the special problems created by midstream charter changes, see Bebchuk,
Limiting Contractual Freedom, cited above in note 23, at i825-59; and Gordon, Mandatory
Structure, cited above in note 23, at I573-85.
68 See, e.g., Russian Capitalism, ECONOMIST, Oct. 8, I994, at 2I, 23.

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changed after the date of purchase, and the incentive for unscrupulous
insiders to profit by doing precisely that.69
C. Voting for Directors: Cumulative Voting
The one share, one vote rule is conventional in many jurisdictions

and has easily understood virtues. Our approach to voting for direc-
tors, however, relies on a less common solution: mandatory cumulative
voting, together with related requirements for minimum board size
and annual election of directors.70
By giving large minority shareholders a place on the board and a
voice in board actions, cumulative voting addresses several problems
at once. First, a board seat provides access to company information
and gives large shareholders a substitute for the disclosure that is pro-
vided in developed economies in other ways, such as financial disclo-
sure rules, financial press reports, market price signals, and non-public
financial reports to lead banks in Germany and Japan. Second, cumu-
lative voting makes it more likely that a minority of directors is truly
independent of management and - also important though often ne-
glected in the United States - that these directors will owe affirma-
tive loyalty to the shareholders who elect them.71 Director
independence interacts with rules, discussed below, that vest in in-
dependent directors the power both to review transactions in which
managers have a personal financial stake and to choose the company's
auditors and share registrar (who also counts shareholder votes).
Third, cumulative voting reinforces the principle that directors owe
their loyalty to shareholders, not to the company's officers. The pres-
ence of some outside directors who truly represent shareholder inter-
ests can, over time, influence how all directors understand their role in
the corporate enterprise. Thus, cumulative voting is part of a broader
effort in the self-enforcing model to promote behavioral norms that
have served developed countries well.
Because cumulative voting serves these multiple purposes, it is a
central element of a self-enforcing corporate law. We are not so san-
guine as to rely on the board of directors as a whole, or even the
board's nominally independent directors, as the sole protectors of
69 For example, a mandatory one share, one vote rule protects shareholders in compan
initially issue only one class of voting stock, by preventing a subsequent charter amendmen
changes the rule.
70 Under cumulative voting, if a board includes n members elected annually, a shareholder
who holds V, of the votes can elect one director. See CLARK, supra note 42, ? 9.i at 36i-66.
Staggered board terms and small board sizes dilute the effectiveness of cumulative voting because
they reduce the number of directors elected at one time. We would require a firm with iooo
shareholders to have at least seven directors, and a firm with io,ooo shareholders to have at least
nine directors.
71 See Ronald J. Gilson & Reinier Kraakman, Reinventing the Outside Director: An Agenda
for Institutional Investors, 43 STAN. L. REV. 863, 872-76 (i99i).

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I 948 HARVARD LAW REVIEW [Vol. I09:191I
outside shareholder interests; we also contemplate a broad range of

transactions for which shareholders have veto power or other protec-
tions. But cumulative voting can strengthen the boards of many
companies.
Russian data suggest that large outside blockholders both want and
expect to receive board seats. Thus, many investors will make use of
the power to elect their own representatives if it is available.72 More-
over, cumulative voting can have an effect even when management's
slate is the only one proposed. Its availability may determine whom
management puts on its slate, or deter management from actions that
could provoke an outside shareholder to nominate its own slate.
The fact that many companies choose not to adopt cumulative vot-
ing in both developed and advanced emerging economies does not de-
tract from its value as a cornerstone of a self-enforcing law.73 In most
of these countries, market, legal, and cultural forces combine to
achieve the goals that cumulative voting can help to attain. Consider
outside shareholder representation on the board of directors. In the
United States, large outside shareholders can often obtain representa-
tion on the board of directors in rough proportion to their ownership
interest, if they want such representation. Although company manag-
ers might be able to defeat the large shareholder's nominees in an
election contest, the managers will often offer the shareholder a couple
of board seats rather than risk losing the contest, which could mean
losing their jobs. Many companies also offer board representation to
large investors to induce them to invest. Even companies with no
large investors typically appoint a majority of independent directors to
the board, simply because it is customary to do so. These directors
can then perform some of the oversight that would be undertaken by
directors chosen by large shareholders under cumulative voting.74
72 See Blasi & Shleifer, supra note i6, at 8i.

73 Cumulative voting can be adopted by charter provision under the corporate laws of almost
all developed countries and many emerging market jurisdictions. None of the I7 jurisdictions
examined in the Appendix prohibits cumulative voting. Straight voting is the default rule in most
cases, but two jurisdictions (Mexico and Chile) mandate forms of proportional representation akin
to cumulative voting. Note, too, that mandatory cumulative voting was common in the United
States until the I95Os. See Jeffrey N. Gordon, Institutions as Relational Investors: A New Look
at Cumulative Voting, 94 COLUM. L. REv. I24, I42-46 (I994) [hereinafter Gordon, Institutions as
Relational Investors]. Mandatory cumulative voting was subsequently rolled back in the United
States. But Professor Gordon attributes the decline of this system primarily to the political power
of incumbent managers who wanted to make proxy contests more difficult. See id. at I53.
74 Developed countries that do not rely heavily on shareholder-nominated directors have often
developed other oversight mechanisms. For example, institutional shareholders in Great Britain
often lack direct board representation, but British managers know that a modest number of insti-
tutional investors can combine forces to oust the board if the need arises. British institutional
investors are also pressing for boards to include more independent directors, to supplement the
crisis-oriented oversight that they now exercise themselves. See Black & Coffee, supra note 6, at
2037-38. Similarly, in Japan, large shareholders can act through the main bank to force a change

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The principal argument raised against cumulative voting is that a

divided board may be less effective than a board elected on a winner-
take-all basis. But this risk is not likely to be large in practice. Expe-
rience in developed countries suggests that proportional representation
of large shareholders on the board, whether through cumulative voting
or agreement with management, usually works well. Empirical studies
undertaken in developed countries also suggest that shareholders bene-
fit from the availability of cumulative voting.75 Moreover, logic sug-
gests that large shareholders rarely have an interest in interfering with
the smooth functioning of the board. When a large shareholder does
attempt to interfere, it is often a sign of some pathology. Cumulative
voting is an incomplete cure for the pathology, but it is better than the
alternative: a unified board stolidly supporting management as the
company slides toward disaster.76
Our proposed Russian law also requires that large-company boards
contain at least one-third independent directors (defined as directors
who are not, and during the last five years have not been, officers of
the company and who are not related to a company officer). Of
course, many of these directors will be independent only in name. But
even independent directors chosen by management may sometimes
provide a voice against management self-dealing, especially if a truly
independent director or two, perhaps elected through cumulative vot-
ing, can take the lead role in questioning a management proposal.
And the independent-director requirement can reinforce the norm that
the board of directors is in substantial part a watchdog institution,
charged with monitoring management on the shareholders' behalf.
D. Voting Procedures: Universal Ballot
One share, one vote and cumulative voting are only part of the
architecture of a voting system for emerging economies. Ancillary
rules are also needed to govern the form of shareholder proxies (or
ballots), how shareholders can nominate candidates for election to the
board or introduce other proposals for shareholder vote, and how
shareholder votes are counted.
We adopt a "universal ballot" as the framework for nominating
and choosing among directorial candidates, and for introducing and
voting on other proposals. The laws of developed countries typically
require each faction in a proxy contest to distribute its own ballots.
By contrast, the universal ballot lists all candidates on a single consoli-
in management, much as American shareholders might act through an independent board of di-
rectors. See Roe, Some Differences, supra note 3, at I943-46.
75 See Sanjai Bhagat & James A. Brickley, Cumulative Voting: The Value of Minority Shar
holder Voting Rights, 27 J.L. & ECON. 339, 34I-42 (i984).
76 Cf Gordon, Institutions as Relational Investors, supra note 73, at I70-74 (describing the
value of cumulative voting in overcoming the rational apathy of institutional investors).

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dated ballot prepared at company expense and made available to

shareholders well before the shareholder meeting. Under this regime,
the incumbent board, and all shareholder groups exceeding a threshold
size (for Russia, we use a threshold of 2% of the outstanding shares),
may nominate candidates on the company's ballot. Shareholder
groups exceeding this threshold size may also include other proposals
for a shareholder vote (for Russia, we allow a maximum of two pro-
posals), with no restrictions on subject matter.77
Like cumulative voting, these liberal provisions for including share-
holder nominations and proposals on the company's ballot permit rela-
tively small aggregations of shares to participate in shaping the
company's voting agenda. Shareholder groups of a somewhat larger
threshold size should also have the power to convene special share-
holder meetings. For Russia, we use a threshold of io% of the out-
standing shares, which reflects both the expense of holding a
shareholder meeting and the fact that most decisions at such a meeting
(such as a decision to oust the board of directors) would require at
least a majority vote - compared to the IO-I5% necessary to elect a
director under cumulative voting. Majority approval is unlikely unless
a proposal has substantial backing from the outset.
E. Protecting Honesty and Quality in Voting
The best possible voting procedures are useless if they are sub-
verted by coercion, vote buying, or fraud in counting ballots -
chronic dangers in emerging economies. Coercion and vote buying oc-
cur when someone - typically a company insider - induces share-
holders to vote against their investment interests by punishing "wron
votes, rewarding "right" ones, or both. In Russia, coerced voting of
employee shares is a particular danger because management can often
use its workplace authority to control how employees vote.
The first defense against coercion and vote buying is a mandatory
rule of confidential voting. Insiders who cannot monitor shareholder
votes lose the power to manipulate votes through rewards or sanctions.
To protect against fraud and secure confidentiality, we take the func-
tions of collecting, tabulating, and storing shareholder ballots out of
management's hands. The Russian statute vests the tabulation func-
tion in an independent share registrar - a position large companies
are already required to maintain for the separate purpose of reliably
recording share transactions.
These protections won't always work, but they will make cheating
more difficult. It is much harder to police a company's count of its
own ballots than to determine whether the company has an independ-
77 The size threshold is intended to weed out nuisance candidates and proposals. The 2% of
outstanding shares threshold that we suggest for Russia seems large enough to accomplish this
without blocking shareholder proposals or nominations that have a realistic chance of success.

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ent registrar. Relatively few independent registrars are likely to exist

because this business has large economies of scale. These few can be
monitored through licensing requirements, and will have a strong
reputational interest in counting votes honestly.78 Moreover, some
cheating will be so obvious that recourse to the courts or to unofficial
enforcement will be feasible. For example, if a company has seven
directors, a I5% shareholder has the power to elect one director under
cumulative voting. If the shareholder seeks to exercise this power, an
attempt by the company to subvert cumulative voting will be easily
provable.
In many Russian companies, he who votes the employees' shares
controls the company. This fact was not lost on company managers,
who quickly developed ways to control how employee shares are
voted. Confidential voting and independent tabulation help to address
this problem because managers who do not know how an employee
has voted cannot punish her for a vote against management. But
more is needed, lest managers resort to other coercive techniques. For
example, some Russian managers have forced or convinced employees
to transfer their shares to a long-term trust, voted by the managers,
from which shares cannot be withdrawn.79 In developed countries,
there are often statutory time limits (ten years, say) on voting trusts
and similar arrangements that separate the economic interest in stock
from voting power. We considered these limits inadequate for Russia
- both because there is currently no trust law to impose fiduciary
duties on managers who establish employee trusts, and because most
employees cannot make an informed choice about joining a trust.
They are told, and they believe, that they must put their shares into a
trust to be managed on behalf of the "labor collective."
For Russia, we did not propose a ban on employee trusts and simi-
lar devices for pooling employee shares because this would have fore-
closed the possibility of a labor union-controlled trust that might serve
as a counterweight to management. Instead, we proposed several less
extreme rules. First, managers should not be allowed to control any
employee trust. Second, the maximum duration of any such trust
should be short (we proposed two years) in order to give employees
frequent opportunities to opt out of participation. Third, employees
should have the right at any time to sell shares that have been placed
in an employee trust. Finally, company managers should not ask an
employee how she has voted or whether she has sold or plans to sell
78 In Russia, independent share registrars are licensed by the Securities Commission, w

can revoke a registrar's license, thus putting it out of business, if the registrar misbehaves.
79 See Blasi & Shleifer, supra note i6, at ioi.

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her shares, nor retaliate against an employee because of a voting or

sale decision.80
These rules are not easy to enforce, but some managers will honor
them voluntarily if the law labels efforts to control employee votes as
improper. Moreover, once the principle that employees should vote
their own shares is established, the press can expose violations. This
can help even weak labor unions protect their members against overt
retaliation.
The value of shareholder voting as a check on management discre-
tion depends on the shareholders having good information on which to
base their voting decisions. Yet many emerging markets are also char-
acterized by limited financial and other corporate disclosure. We have
only partial answers to the problem of poor disclosure. Requiring
mandatory disclosure to shareholders, including audited financial state-
ments, can help, but only so far. In Russia, many companies will hide
their true accounts from their auditors - and shareholders will not
protest too loudly, because profits hidden from the auditor are also
hidden from the tax collector and the mafia. Cumulative voting also
helps, by improving large outside shareholders' access to information.
If a large outside shareholder can be trusted not to self-deal (in Russia,
this is sometimes the case and sometimes not), then a proposal that
has been approved by the directors) who represent the large outside
shareholder carries a badge of quality, on which smaller shareholders
can rely. And shareholders can always vote against a management
proposal if they distrust the information that management has
provided.
IV. STRUCTURAL CONSTRAINTS ON PARTICULAR CORPORATE

ACTIONS
In any corporate law, the basic governance structure and voting

rules discussed in Part HI are the sole legal backdrop only for routine
business transactions. Very large, suspect, or potentially transforma-
tive transactions are also subject to specialized regulation designed to
protect outside shareholders from correspondingly high risks of abuse.
The self-enforcement approach regulates these transactions through
structural constraints rather than prohibitions. The constraints cover
four categories of transactions: mergers and similar major transactions,
self-interested transactions, control transactions, and issuances and re-
80 These employee protection provisions were dropped from our proposed statute early in the
Russian legislative process. Our best interpretation of the political dynamics is that company
managers opposed the provisions (for obvious reasons), employees were silent (of course), large
investors cared more about other provisions of the law that affected them more directly, and
Communists (who we hoped would support these "pro-worker" provisions) either did not under-
stand why these fairly technical provisions were important or else were more pro-manager than
pro-employee (a not unlikely explanation based on the Communists' votes on other issues).

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purchases of shares. For all categories except control transactions, we

require approval (often by supermajority vote) by both the board and
shareholders. For all categories except self-interested transactions and
share repurchases, we also give transactional rights to shareholders
who do not support the corporate action.
A. Mergers and Other Major Transactions
Mergers, large sales and acquisitions of assets (whether directly or

indirectly through a subsidiary), reorganizations, and liquidations are
essential tools for restructuring companies. However, they can also
radically alter the nature of a shareholder's investment, and they have
historically been a common means by which insiders can loot a com-
pany's assets. To respond to this danger, even enabling laws com-
monly require shareholder approval for selected transformative
actions.81 Enabling statutes also often provide a transactional mecha-
nism for shareholder protection: appraisal rights that let shareholders
demand payment of the fair value of their shares, as determined by a
court, instead of accepting the consequences of a transformative corpo-
rate action.82
The list of transactions that require shareholder approval and ap-
praisal rights in developed countries, and the size of the required
shareholder vote, should form a floor for the corporate law of an
emerging economy. For a self-enforcing statute, the key decisions are:
(i) when to require a higher shareholder vote than majority approval;
(ii) what additional transactions should require shareholder approval;
and (iii) when shareholders should have appraisal rights (and what
kind of rights) if the company completes a transaction that they
oppose.
i. Shareholder Approval. - The appropriate shareholder approval
threshold depends on the ownership structure of public companies.
The typical ownership structure of privatized Russian enterprises (de-
scribed in Part I) leads us to propose approval of major transactions
by two-thirds of the outstanding shares. This threshold is high enough
so that managers and employees cannot routinely complete major
transactions without support from outside shareholders, yet not so
high that companies will often be unable to complete beneficial trans-
actions because the necessary shareholder vote cannot be obtained, nor
81 All of the emerging market jurisdictions in our survey require shareholder approval
mergers, recapitalizations, and dissolutions. See infra Appendix. In most cases, the voting rules
specify supermajority quorum and approval thresholds. These approval requirements, however,
do not usually extend to major sales or purchases of assets.
82 Eleven of the I7 emerging market jurisdictions in our survey provide some form of ap-
praisal rights for shareholders who dissent from mergers. See infra Appendix.

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so high that it gives undue holdup power to outside blockholders (or

to employees).83
Deciding which transactions should require a shareholder vote re-
quires lawmakers to balance flexibility against protection of minority
shareholders. A shareholder vote to approve a transaction is costly in
both time and money - managers must either call a special share-
holder meeting or wait until the next regular meeting to ask for share-
holder approval. This will increase the cost of completing beneficial
transactions and will deter some transactions entirely. Thus, a share-
holder vote should be required only for transactions that transform the
nature of the company or involve a substantial risk of abuse. For
Russia, the transactions that we believed should require a shareholder
vote were:
(i) a merger or other business combination between the company and one
or more other companies;
(ii) a liquidation of the company;
(iii) a transformation of the company into another type of legal entity,

such as a partnership; and
(iv) a sale or purchase of assets, directly or through subsidiaries, for a

price equal to 50% or more of the book value of the company's assets.84
The first three items on this list need little comment. The require-
ment of a shareholder vote for mergers, liquidations, and changes of
legal form is standard in most company laws. Only the fourth require-
ment, dealing with sales and purchases of assets, is stricter than the
corporate laws of developed countries.85 The rationale for requiring
shareholder approval is that self-dealing transactions of this size can
destroy a company's value with the stroke of a pen. Disclosed self-
83 For Russia, we proposed an exception for investment funds, which (i) typically have
number of tiny shareholders, and (ii) lack the substantial employee ownership that charact
privatized firms. The first factor makes a two-thirds vote of outstanding shares harder to
the second makes it less important as a protection against management overreaching. For in
ment funds, we judged that a simple majority of outstanding shares should suffice.
84 There should be a "normal course of business" exception to handle the special case of a
trading company that regularly makes large purchases and sales of goods on a thin equity base.
In addition, the definition of asset "sales" should exclude a pledge of assets to secure a loan. Such
a pledge, followed by intentional default on the loan, can be used as an indirect way to sell assets
without a shareholder vote. But most pledges are likely to be legitimate, and often a default
under one loan agreement will trigger adverse consequences under other loan agreements due to
cross-default provisions. We believe that the flexibility lost by treating a pledge of security for a
loan in the same manner as a sale exceeds the gain in additional protection of shareholders
against sales for less than fair value.
85 For example, American corporate law imposes no restrictions on the purchase of assets and
requires a shareholder vote only for the sale of "substantially all" assets. See, e.g., DEL. CODE
ANN. tit. 8, ? 27I (i99i). A sale of more than 75% of assets, based on balance sheet value,
generally requires a shareholder vote under this provision, while sales of between 26% and 75%
of assets, based on balance sheet value, may trigger a vote. See Leo Herzel, Timothy C. Sherck &
Dale E. Cooling, Sales and Acquisitions of Divisions, 5 CORP. L. REV. 3, 25 (I982).

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dealing transactions are subject to separate voting rules, described be-

low. But self-dealing transactions won't always be disclosed, and the
incentive for concealment rises with the size and abusiveness of the
transaction. A voting requirement for large asset sales and purchases
provides a back-up constraint on hidden self-dealing transactions.
When so much of a company is at stake, multiple protections are
desirable.
We also propose a shareholder vote on smaller purchases or sales
of assets, involving 25-50% of a company's book value, that are not
unanimously approved by all directors, including outside directors se-
lected through cumulative voting. In effect, we create a hierarchy of
asset sales and purchases, with larger transactions calling for stricter
approval requirements:
(i) purchases and sales of less than 25% of the book value of a com-
pany's assets are governed by a company's usual internal decisionmaking
processes;
(ii) purchases and sales of 25-50% of the book value of a company's

assets require unanimous board approval or, if unanimous board ap-
proval is not achieved, shareholder approval;
(iii) purchases and sales of 50% or more of the book value of a com-
pany's assets require shareholder approval.86
In Russia, book value will understate market value because of in-
flation and managers' incentives to hide profits (and to a lesser extent,
assets) from the tax collector. This understatement makes the 25%
and 50% book value thresholds stricter than they appear to be on the
surface, as well as less accurate measures of transaction importance.
But we still much prefer book value to market value as a measure of
transaction importance.87
86 To enhance enforceability, we use book rather than market values to trigger the share-
holder approval requirements. A market value test is not administrable in a country like Russia,
which has neither an efficient stock market nor reliable professional appraisers. On the adminis-
trative difficulties with a market value threshold for shareholder voting on a sale of assets, even
in a developed economy, see GILSON & BLACK, cited above in note 53, at 653-65.
87 Our proposed 25% and 50% thresholds reflect, albeit crudely, the likely understatement of
asset values due to inflation. An alternate approach would be to use lower thresholds but to
allow the board of directors to adjust book values for inflation. For Russia, we did not propose
this approach - either here or in the other places where we used a book value threshold to
trigger procedural protections - because there is no reliable inflation index and because an infla-
tion adjustment would have made the statute more complex. But we view the question of
whether the law should allow inflation adjustments as a close one. If managers were already
accustomed to using inflation adjustments for other purposes (such as computing income tax or
paying interest on bank loans), then the complexity cost of allowing inflation adjustments for
purposes of the book value thresholds contained in the company law would be smaller and would
be outweighed by the accuracy gains from inflation adjustments. The accuracy gains from an
inflation adjustment would also outweigh complexity cost for a country that was experiencing
hyperinflation - which Russia, in I995, was not.

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2. Appraisal Rights. - Even enabling corporate laws typically give

to shareholders who vote against a major transaction requiring share-
holder approval the right to collect the fair market value of their
shares, as determined by a court. This "appraisal" remedy is far from
perfect. On the one hand, appraisal has been criticized as a possible
drain on a company's liquidity that may deter value-enhancing trans-
actions.88 On the other hand, the appraisal remedy has limited power
as a check on managers' breaches of fiduciary duty, because only large
minority shareholders are likely to incur the legal expense required to
exercise appraisal rights.89
The appraisal remedy will surely work even worse in emerging
markets than it does in developed markets. Yet there is no obvious
alternative. Policing fairness through judicial or regulatory approval
of major transactions is neither practicable nor desirable. Hence, one
can only try to ameliorate the worst problems associated with ap-
praisal rights. For example, in developed economies, a shareholder
must actively oppose a transaction to qualify for appraisal rights. In
an emerging market, this condition weakens an already weak right.
Given poor mail systems, shareholders may not learn of a transaction
in time to vote against it, or may find that their votes did not reach
the company in time or were conveniently lost. Therefore, we propose
that shareholders who do not vote for a major transaction should be
able, promptly after the transaction is completed, to obtain payment of
the fair value of their shares, measured just before the transaction
took place and excluding any effect of the transaction on the value of
the shares.
Typically, too, a shareholder seeking appraisal must go to court (an
expensive process), without knowing in advance what the appraised
value will be. This problem is especially severe in an illiquid market
because published market prices, which provide an effective floor on
the appraisal price in developed economies, are often unavailable or
far below true value. The self-enforcing model responds to these
problems by requiring the company to announce an offer price for
shares in the materials sent to shareholders to solicit approval for the
underlying transaction, and to pay that price promptly on shareholder
demand. The need to announce publicly management's estimate of
the firm's value makes it more likely that the offer price will be plau-
sibly related to true value. And easy access to an (often) reasonable
price opens up the appraisal remedy to small shareholders, for whom
the cost of a formal appraisal proceeding is prohibitive. We address
the separate problem of ill-informed or corrupt judges by giving share-
88 See, e.g., Bayless Manning, The Shareholder's Appraisal Remedy: An Essay for Frank
Coker, 72 YALE L.J. 223, 234-36 (i962).
89 See, e.g., Victor Brudney & Marvin Chirelstein, Fair Shares in Mergers and Take-Ove
HARV. L. REV. 297, 304-07 (I974).

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holders a choice: they can seek appraisal either in court or through

arbitration.90
Company law must also be alert to potential misuse of the ap-
praisal remedy. For example, minority shareholders might sabotage a
beneficial transaction by demanding that the company buy back their
shares at a time when it is strapped for cash. Moreover, shareholders
will be tempted not to vote for a transaction because the right to sell
one's shares back to the company is a valuable put option that can be
exercised if the company's shares decline in value after the transac-
tion, even if the decline is unrelated to the transaction itself. To bal-
ance the need for shareholder protection against the risk of misuse of
the appraisal remedy, we give shareholders only a short period after a
transaction is completed to demand that the company buy back their
shares. For Russia, we proposed thirty days - a period dictated by
the slowness of the mail system.9'
3. Determining Market Value. - A problem that arises with spe-
cial force in emerging markets is how to determine the fair market
value of a company's shares and other property. Determining fair
market value is important not only for appraisal, but also for other
procedural protections discussed below, including those accompanying
share issuances, self-interested transactions, and repurchases by the
company of its own shares.
Even developed countries have trouble defining market value. In
an emerging market, a simple statement that shareholders should be
paid the market value of their shares in an appraisal proceeding, or
that a company should not issue shares for less than market value,
may fail of its intended effect without further definition of this intrin-
sically difficult concept. We adopt the following definition, which is
still vague but better than nothing:
The market value of property shall mean a price at which a seller
who is fully informed about the value of the property and is not obliged
to sell the property would be willing to sell, and at which a buyer who is
90 Because the arbitration proceeding is not based on explicit contract, a mechanism is needed
to identify neutral and reasonably skilled arbitrators. For Russia, we assigned to the Securities
Commission the task of identifying suitable arbitration fora. A shareholder could elect any forum
on the Securities Commission's list or a forum (if any) specified in the company charter.
91 A put option is inherent in any system of appraisal rights. This creates a collective-action
problem - a shareholder who seeks appraisal rights for a merger can, at modest cost, obtain a
significant time window in which to decide whether to pursue the appraisal rights or to abandon
them and receive the merger consideration. A shareholder then has an incentive to oppose a
beneficial transaction, as long as her opposition is unlikely to affect the voting outcome. If mails
and vote-counting procedures are reliable, it is appropriate to limit this free option by requiring
that a shareholder vote against the merger, not simply (as in our proposal) that she fail to vote,
and by imposing tight time limits for exercising the appraisal right (which reduce the option's
value). The option value problem must also inform one's judgment about which corporate ac-
tions should give rise to appraisal rights.

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fully informed about the value of the pro

the property would be willing to buy.
If the property to be valued is a publicly traded security, the person
making the valuation shall consider the market price of the security over
a period of time of at least two weeks prior to the date as of which
market value is measured. If the property to be valued is a company's
own common stock, the "value" of a share shall be understood as a pro
rata claim on the value of the entire company, as presently organized
and managed. In determining this value, the person making the valua-
tion may consider the shareholder capital of the company, the price that
a fully-informed buyer would be willing to pay for all of the company's
common shares, and other factors that he considers important.
This definition can guide those, especially directors, whom the law
charges with determining the market value of shares or deciding
whether a transaction is at market value. Of course, in an illiquid
market, market value is not a single point, but a sometimes wide
range. If the directors act in good faith and reach a reasonable valua-
tion, the self-enforcing model instructs courts not to second-guess that
valuation.
B. Self-Interested Transactions
Transactions by a company that personally benefit directors, man-

agers, or large shareholders (all of whom we call insiders, recognizing
that the description may not be accurate for large shareholders92) are
inherently suspect because the insider has both the incentive and the
ability to cause the company to enter into the transaction on unfair
terms. Yet sometimes these transactions are advantageous to the com-
pany. Outright prohibition, in our judgment, is justified only when
experience discloses both little business justification for a transaction
type and a particularly high risk of abuse.93 We identify two such
92 Our threshold for treating a large shareholder as an insider is ownership of 20% of the
outstanding shares.
93 Prohibition has the apparent virtues of simplicity and clarity. For example, one might pro-
hibit all transactions between public companies and their directors and managers (except
purchases and sales of the company's shares at market value), while employing procedural protec-
tions for self-dealing involving large shareholders (to permit parent-subsidiary and corporate
group structures). For Russia, we rejected this approach for several reasons. One was political:
Russian managers would probably have succeeded in introducing loopholes in the legislative pro-
cess, if not killing the ban entirely. Second, we judged that managers intent on self-dealing are
less likely to evade the law - and more likely to consider shareholder interests - when they can
self-deal legally with shareholder or board authorization. But the most important reason was
efficiency-related. Many managerial conflicts of interest are likely to involve indirect transactions
between the company and other firms with which the company's managers or directors are affili-
ated as shareholders, directors, or managers. A ban on all indirect conflicts would reach struc-
tures that might be efficiency-enhancing (such as interlocking directors), while selective bans on
indirect conflicts would generate severe line-drawing problems and sacrifice the simplicity and
clarity of a general norm.

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cases: loans by the company to insiders,94 and payments (kickbacks)

by another person to an insider in connection with a transaction be-
tween the company and the other person. For other self-interested
transactions, the self-enforcement model relies on a rigorous set of pro-
cedural protections, which apply in addition to any other board or
shareholder approval requirements for particular transactions, such as
mergers.93
The principal procedural protections are (i) approval by noninter-
ested directors (directors who don't have a financial interest in the
transaction); and (ii) for sizeable transactions (our threshold for Russia
was 2% of the book value of the company's assets or 2% of annual
revenues), approval by noninterested shareholders.96 Even noninter-
ested directors will often not act independently. Nevertheless, direc-
tors who are elected by minority shareholders through cumulative
voting are likely to be genuinely independent. Thus, the cumulative
voting rules interact importantly with the rules on self-interested trans-
actions. The size threshold balances the risk that the cost and delay of
a shareholder vote will block good transactions against the need to
block large bad transactions. Noninterested directors can cheaply re-
view all self-interested transactions; only large transactions should re-
quire the costly additional step of shareholder approval.97
The self-enforcement model instructs the noninterested directors to
approve a self-interested transaction only if they conclude that the
company will receive value, in property or services, at least equal to
the market value of the property or services the company gives up.
This required finding informs the directors as to how to exercise their
review power, gives directors who want to reject a transaction a basis
for doing so, and provides a norm around which actual review prac-
tices may gradually coalesce. This standard may also provide a basis
94 Cf CODE DES SOCItTES [COMPANIES LAW] art. io6, translation available in FRENC
ON COMMERCIAL COMPANIES 65 (Commerce Clearing House, Inc. i988) (prohibiting loans or
guarantees provided by a company to its directors or general managers).
95 Only 2 of the I7 jurisdictions in our survey retained some form of outright prohibition on
contracts between the company and its directors or officers. Five statutes required shareholder
approval of some self-dealing transactions, while most of the remaining statutes required approval
by noninterested directors. See infra Appendix.
96 Our self-interested transaction rules are similar to French company law, which (in broad
outline) requires that a self-interested transaction between a company and one or more of its
directors or general managers be approved by the noninterested members of the board of direc-
tors, reviewed by the company's auditors, who prepare a report to the shareholders, and then
approved by the noninterested shareholders. French law does not reach transactions with large
shareholders. See CODE DES SOCItTtS [COMPANIES LAW] arts. IOI-03, translation available in
FRENCH LAW ON COMMERCIAL COMPANIES, supra note 94, at 64; Andre Tunc, A French Lawyer
Looks at American Corporation Law and Securities Regulation, I30 U. PA. L. REv. 757, 766
(I982).
97 For very large companies, it can be feasible to require approval by noninterested ind
dent directors. For Russia, we proposed such a requirement for companies with io,ooo or mor
shareholders.

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i 960 HARVARD LAW REVIEW [Vol. I09:19II
for a court challenge to especially eg

required finding was manifestly not made in good faith.
Sometimes, of course, insiders will hide their interest in a transac-
tion. But in some transactions, the insiders' interests cannot be con-
cealed; in others the insiders will obtain an honest vote to protect the
transaction against later attack in the courts; and managers who think
of themselves as honest will voluntarily follow the rules. When self-
interested transactions are disclosed, shareholders or noninterested di-
rectors can vote down some of the worst transactions, while the "sun-
shine" requirement that transactions be disclosed to shareholders will
deter others.
C. Control Transactions
In a control transaction, a new shareholder or group of sharehold-

ers purchases or aggregates a controlling block of stock in the com-
pany. This acquisition of control can assume a wide variety of forms,
including open market purchases and tender offers, and large share
issues by companies in the course of financings or mergers. Whatever
form it takes, an acquisition of control merits regulation in its own
right - even though many control transactions will also be regulated
by rules governing particular transactional forms, such as reorganiza-
tions, major transactions, or self-interested transactions. Control trans-
actions uniquely implicate both the efficiency goals of corporate law
and its core problems, ranging from minority abuse to management
entrenchment.
The treatment of control transactions varies widely in both devel-
oped countries and emerging market jurisdictions. Friendly transac-
tions are regulated in the most important United States jurisdictions
only if they take the form of a merger or sale of substantially all as-
sets, whereas hostile takeovers are regulated principally with a view
toward discouraging them. Elsewhere, including (as we discuss below)
in Great Britain, both friendly and hostile control transactions are
often regulated regardless of their form.98 Beneath this divergent
treatment lies a familiar policy dilemma. On one hand, control trans-
actions are often engines for efficient restructuring. An investor often
buys a control block because he expects to improve the company's ef-
ficiency in ways that will benefit all shareholders. Moreover, an
outside investor's ability to acquire a controlling block of a company's
stock without the managers' consent is an important constraint on bad
management. Thus, there are powerful efficiency reasons not to over-
regulate control transactions, whether friendly or hostile. On the other
98 Four of the I7 emerging markets in our survey give minority shareholders put rights in the
event of a transfer of control. As this is the basic English rule (described below), it is not surpris-
ing that three of these four jurisdictions are Commonwealth countries (Malaysia, Singapore, and
Nigeria). See infra Appendix.

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW i96i
hand, a new controlling shareholder may loot the company or use con-
trol to manipulate share prices and acquire minority shares at a price
far below their true value.99
The risk of looting is far higher in emerging than in developed
markets. For example, there is little harm or gain to minority share-
holders in the United States, on average, when a control transaction
takes place. Apparently, the efficiency gains from good transactions
roughly balance the losses from self-dealing.100 In contrast, in the
Czech Republic, share prices in many companies collapse after a
change of control, indicating severe harm to outside shareholders.101
Thus, emerging markets require regulation focused on reducing the
risk of looting.
The self-enforcing model protects minority shareholders by giving
them takeout rights after a change of control (we use 30% ownership
as a proxy for control). Under this approach, which we adapt from
the British City Code on Takeovers and Mergers and the proposed
European Community I3th Directive on Company Law,102 a share-
holder who acquires a 30% interest in a company must offer to buy all
remaining shares at the highest price he paid for any of the company's
shares within a specified period of time (we propose six months). This
put option is a powerful deterrent to inefficient control transactions,
for which we are willing to accept the cost of deterring some efficient
control transactions.103
99 For development of these points, see Lucian Bebchuk, Efficient and Inefficient Sales of
Corporate Control, io9 Q.J. ECON. 957, 964-84 (I994), and Marcel Kahan, Sales of Corporate
Control, 9 J.L. ECON. & ORG. 368, 377-78 (I993).
100 See sources cited supra note i9; Robert Comment & Gregg A. Jarrell, Two-Tier and Negoti-
ated Tender Offers: The Imprisonment of the Free-Riding Shareholder, I9 J. FIN. ECON. 283, 300
(i987) (reporting that, in a study of 27 partial tender offers, the price of nonpurchased shares
increased, on average, by 15%).
101 Interview with Dusan Triska, Project Director of the RM-S Securities Exchange of the
Czech Republic, in New York, N.Y. (Nov. i8, 1995).
102 See CITY CODE ON TAKEOVERS AND MERGERS, supra note 9; Commission Proposal f
Thirteenth Directive on Company Law Concerning Takeover and Other General Bids, i990 O.J.
(C 38) 41, 44. An alternative rule for protecting minority investors, first proposed by William
Andrews, would require purchasers of control to offer to purchase shares pro rata from all share-
holders. See William Andrews, The Stockholder's Right to Equal Opportunity in the Sale of
Shares, 78 HARV. L. REV. 505, 5o6 (i965). Unlike the City Code rule, the Andrews rule permits
partial tender offers, which reduce the cost of acquiring control. In our view, this advantage is
more than offset by the costs and likely inequities of channelling control transactions through the
vehicle of a public tender offer in the undeveloped and largely unregulated Russian market. Be-
cause we permit noninterested shareholders to waive their takeout rights by majority vote, they
can vote to authorize friendly partial offers for control, pro rata or otherwise.
103 If a controlling shareholder already extracts large private returns from a company, a more
efficient would-be acquirer may not be able to afford the controller's demand for a premium price
for its shares if the acquirer must pay the same price to minority shareholders. Moreover, in an
underdeveloped capital market, an acquirer may not be able to finance the cost of honoring take-
out rights. Again, these costs can be mitigated (though not eliminated) by our further proposal to
permit minority shareholders to waive the takeout rights requirement by majority vote. For ex-

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i962 HARVARD LAW REVIEW [Vol. I09:I9II
A second danger in control transactions is that disaggregated share-

holders can be induced to sell control too cheaply. For example, an
acquirer may secretly accumulate control through numerous open mar-
ket transactions, when shareholders could have demanded higher
prices if they could have collectively negotiated a control premium,
and other potential acquirers might have offered higher prices as well.
To prevent secret acquisitions of control, we would require sharehold-
ers who acquire I5 % or more of a company's stock to publicly disclose
their identity, shareholdings, and plans to acquire more shares, and
then wait thirty days before buying more shares. This gives the com-
pany's managers time to respond to an impending control transaction
by seeking a higher bidder, proposing an alternate transaction that is
more favorable to the shareholders, or convincing shareholders that
their shares are worth more than the acquirer is offering to pay. A
similar rule would apply to acquisitions of 30% or more of a com-
pany's shares that are approved by the company's managers. These
delay and notice provisions make it more likely that a new controlling
shareholder will have to pay a control premium. The delay period
also provides a market check on the fairness of the premium because a
competing bidder has time to make a higher offer.
These delay provisions, however, exacerbate a third key concern
for control transactions: managers will often try to block changes of
control to preserve their own jobs. Managers typically argue that they
must be able to reject hostile takeover bids to protect the sharehold-
ers' interests. We are skeptical of this argument in developed econo-
mies, and even more skeptical in emerging markets, where managers
are already often heavily entrenched. Thus, we propose, again bor-
rowing from the British City Code, a ban on preclusive defensive tac-
tics such as "poison pills."1'04 Consistent with the overall self-
enforcement approach, the combination of a delay period and a ban
on defensive tactics vests the decision whether to transfer control in
the prospective selling shareholders.105
Some corporate actions both inhibit control transactions and serve
other business goals. For example, cross-ownership of shares among
ample, minority shareholders could waive takeout rights to permit a new investor with manage-
ment skills to pay a control premium to an entrenched blockholder who is willing to sell out, but
only at a price that reflects the value of control to him.
104 See CITY CODE ON TAKEOVERS AND MERGERS, supra note 9, General Principle 7, at B2,
Rule 2i, at I13.
105 United States and European experience teaches that vesting the decision to resist a take-
over in independent directors is insufficient to protect shareholders' interests. Independent direc-
tors too often back the managers' interests in resisting a takeover bid, sometimes at great cost to
shareholders. American directors with the power to do so have often turned down takeover offers
priced at twice the previous market value of their company's shares, on the grounds that share-
holders will do even better if the takeover is defeated. These optimistic predictions do not often
come true. Thus, we believe strongly that shareholders, not managers or directors, should decide
whether a control change occurs by selling or retaining their shares.

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW i963
affiliated companies lets the managers of the affiliated firms entrench

themselves by mutually supportive voting. Yet cross-ownership, in-
cluding the extreme case of subsidiaries holding their parents' stock,
can also arise for good business reasons.106 The self-enforcing model
responds by allowing cross-ownership but limiting cross-voting. Even
in the enabling model, majority-owned subsidiaries cannot vote their
parents' stock.107 In practice, managers of "parent" companies exercise
working control over dependent companies at ownership levels well
below majority ownership. Thus, our model Russian statute would
bar a "dependent" company from voting its stock in a "parent" com-
pany when the parent holds 20% or more of the dependent company's
stock.108
A further risk faced by minority shareholders is loss of liquidity if
a majority shareholder acquirers a high percentage of the outstanding
shares, perhaps through a tender offer. Such an offer can succeed,
even if priced below the market value of the minority shares, because
outside shareholders face a prisoner's dilemma. Even if they would
collectively be better off if they rejected the offer, they individually
cannot risk rejecting an offer that most other shareholders accept, be-
cause the price and liquidity of the remaining minority shares will col-
lapse.109 We respond with an appraisal rights remedy: if a controlling
shareholder's ownership crosses 90%, the company must offer ap-
praisal rights to all remaining minority shareholders. The appraisal
remedy eliminates the prisoner's dilemma: outside shareholders no
longer have an incentive to sell their shares for less than they expect
to receive in an appraisal proceeding.
106 For example, in a reverse triangular merger, a parent company acquires a target by
ing a subsidiary into the target. The consideration for the acquisition is parent stock held by the
subsidiary, which is exchanged for the stock of the target company. This transaction form is
useful because it does not disturb the target's corporate identity or contractual relationships.
107 See, e.g., DEL. CODE ANN. tit. 8, ? i6o(c) (i99i).
108 Such a ban on cross-voting can prevent only egregious entrenchment schemes. It allows
cross-voting at "parent" ownership levels below the 20% threshold, and thus permits groups of
companies to tie up control internally through cross-holdings. For example, the rule would not
bar a Japanese-style keiretsu, in which a dozen companies hold 5% stakes in one another - even
though such a structure precludes a challenge to control of a member company that is not sanc-
tioned by the group. See Gilson & Roe, supra note 6, at 882-go (describing cross-ownership in
keiretsu structures). We permit such structures because they can serve benign as well as defensive
purposes. For example, Gilson and Roe observe that cross-ownership may encourage mutual
monitoring or help to enforce relational contracts in product markets. See id. at 882-94. In
addition, entrenchment is less severe when controlling shares reside in a larger group of compa-
nies, as distinct from a single parent company.
109 For a Russian example of such a tender offer, see Neela Banjerjee, Russian Oil Firm's
Share Swap Draws Fire, WALL ST. J., Mar. 28, i996, at Aio (describing a Russian oil company's
proposal to swap its own shares, with a market value of 630, for shares in its majority-owned
subsidiary that, before the swap was announced, had a market value of around $2).

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i964 HARVARD LAW REVIEW [Vol. IO9:I9II
D. Issuance and Repurchase of Shares
Share issuances and repurchases are a fourth class of transactions

that merit special procedural protections.110 Company sales and repur-
chases of shares have the potential both to shift value from outside
investors to company insiders and to reallocate voting power among
shareholders. But nothing is more critical to a company's survival
and growth than its ability to raise new capital as the need or oppor-
tunity arises, without time-consuming procedural obstacles.
i. Share Issuances. - There is a simple way to protect sharehold-
ers against share issuances at less than fair value: forbid authorized
but unissued shares, thus forcing managers to seek shareholder ap-
proval for each new share issue. We reject this strict rule because it
would either make raising capital too difficult or, paradoxically, come
to mean nothing at all. Managers could not exploit unexpected financ-
ing and investment opportunities if every issuance of new shares re-
quired separate shareholder authorization. Moreover, such an
approval requirement would greatly complicate management incentive
compensation plans. Given these drawbacks, managers would search
for a way around a ban. Most likely they would ask shareholders for
blank-check authorization to issue new shares at every annual meeting.
Yet if this ploy succeeded, the draconian restraint on share issuances
would collapse into an empty formality, leaving shareholders with no
protection at all.
The self-enforcing model provides several alternative mechanisms
for protecting shareholders against share issuances that are priced be-
low fair market value or shift control over a company. Shareholders
may authorize unissued shares, to be issued in the future by decision
of the board of directors, as in the enabling model and many emerging
markets.111 Shareholders who distrust their managers could refuse to
give such authorization, but we expect this to be rare. But sharehold-
ers would enjoy four additional protections against abusive share is-
sues, other than the power to withhold authorization. First, a stock
sale to insiders is a self-interested transaction, subject to the approval
requirements discussed in section JV.B. Second, a sale of shares equal
to 25 % or more of a company's outstanding shares requires approval
by a majority of these shares, excluding shares already held by pur-
chasers of the new shares. Third, issuances for less than market value
110 We address here the protection of shareholders during share repurchases. Section IV.E
addresses protection of creditors during share repurchases, dividends, and other distributions of
corporate assets. We also focus here on the interests of the company's existing shareholders. It is
the job of securities law to protect the interests of the purchasers of shares when shares are sold
to the general public.
111 Only 3 of the I 7 emerging markets in our survey (China, Poland, and Turkey) ban author-
ized but unissued shares. See infra Appendix. In our Russian proposal, an increase in authorized
shares, like other charter amendments, requires approval by two-thirds of the outstanding share

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW i965
(as determined by noninterested directors) are banned outright (though

the malleability of the concept of market value limits the effectiveness
of this ban).112 Finally, shareholders receive the preemptive and par-
ticipation rights detailed below for all issuances above a de minimis
threshold (2% of the previously outstanding shares).113
The de minimis exception aside, for new share issuances, a com-
pany would have to offer to its existing shareholders rights to purchase
newly issued shares in proportion to their prior holdings (preemptive
rights).114 Preemptive rights protect shareholders against underpriced
issues, but are costly for companies with many shareholders and can
delay time-sensitive transactions. Thus, the law must allow for waiv-
ers, including routine waivers approved at annual meetings. This re-
vives the risk that shareholders may be harmed by below-market
share issues. To limit this risk, the self-enforcing model gives to share-
holders who do not vote to waive preemptive rights what we call par-
ticipation rights. These rights entitle the shareholders who hold them
to buy from the company after the offering has been completed as
many shares, at the offering price, as they could have bought had pre-
emptive rights been available.
If the offering price is fair, few shareholders will exercise participa-
tion rights, and an offering will take place much as in countries where
a waiver of preemptive rights binds all shareholders. But if a com-
pany sells shares for substantially below market value, shareholders
will rush to exercise their participation rights and buy bargain-priced
stock. This will let those shareholders recoup most of the dilution
caused by the below-market issuance. It will also embarrass the man-
agers by making the underpricing obvious to all, and will make the
shareholders reluctant to waive preemptive rights in the future.115
112 In developed countries, below-market issuances are used almost exclusively as a form of
incentive compensation for managers. Our ban on below-market issuances has the practical effect
of forcing a company that wants to issue shares to managers to pay them a (disclosed) sum of
money, which they can then use to buy shares at market value. Thus, the ban is basically a rule
of disclosure: the cost of the incentive compensation is made explicit by paying it as salary that is
then invested in shares.
113 We do not treat an insider's exercise of preemptive rights as a self-interested transaction,
even though it is technically a transaction with the company, because preemptive rights are avail-
able to all shareholders on equal terms.
114 Preemptive rights are common in both developed countries (notably Britain and Contin
tal Europe) and emerging markets. They are available in ii of the I7 emerging markets in our
survey. See infra Appendix.
115 Participation rights pose a risk to the viability of preemptive rights waivers. The participa-
tion right is a call option, exercisable for a limited period after the company sells shares, to buy
shares at the same price. Like any option, it has value. Even if all shareholders would benefit if
preemptive rights were waived, individual shareholders are better off if others waive preemptive
rights but they retain the participation option. The value of participation rights must be limited
to make them viable. Limits arise in several ways. First, the time period for exercising participa-
tion rights should be short to reduce the time value of the participation option. Second, commu-
nications technology imposes a lag between the time when participation rights can be exercised

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I 966 HARVARD LAW REVIEW [Vol. I09:19II
2. Repurchase of Shares. - Share repurchases can be as perilous

for shareholders as share issues but are less critical to a firm's growth.
Thus, they are banned by many corporation statutes.116 In our view,
this prohibition goes too far. A pro rata (open on equal terms to all
shareholders) repurchase of shares is basically just a way for the com-
pany to distribute cash to shareholders, and therefore raises only lim-
ited fairness concerns. Pro rata repurchase offers can be a valuable
corporate tool, especially if (as in Russia) they are tax-favored com-
pared to dividends. Our model permits pro rata repurchase offers
without special shareholder approval."7 Nevertheless, even pro rata
offers should be made at market value as determined by the com-
pany's independent directors, unless a different price was agreed upon
when the shares were acquired. Approval by independent directors is
necessary because insiders are usually large shareholders who want the
company to buy shares from others for as low a price as possible,
while outsiders may be willing to sell at a low price because they do
not know the true value of their shares.118
In contrast, a non-pro-rata offer to repurchase shares raises a con-
cern that insider shares will be repurchased at more than fair market
value, or that the company will buy out a troublesome shareholder at
a high price. The self-enforcing model requires that a non-pro-rata
repurchase of shares be made at market value, determined by the in-
dependent directors, and be approved by shareholder vote. A non-
and the time when additional shares are received. This prevents risk-free arbitrage, in wh
shareholder buys shares at one price using participation rights and immediately resells the sha
at a higher price in the market. Third, and most critically, an emerging market is characteriz
by wide bid-asked spreads and often by intervals when one cannot sell one's shares at any
sonable price. These features further reduce the option value of participation rights for a f
valued offering. Our judgment for Russia was that the option value of participation rights wo
be small enough not to be a major obstacle to a waiver of preemptive rights, much as the
option inherent in appraisal rights has not, in practice, been a major obstacle to sharehol
approval of mergers.
116 Twelve of the 17 emerging market jurisdictions in our survey ban repurchases of common
stock. See infra Appendix.
117 We do not treat an insider's sale of stock to the company, pursuant to a pro rata repur-
chase offer, as a self-interested transaction, because the offer was available to all shareholders on
equal terms.
118 If stock markets are well developed, a publicly announced repurchase of shares in the open
market can be treated in the same manner as a pro rata repurchase, because all shareholders have
an equal opportunity to sell their shares at the market price. However, in the illiquid stock mar-
kets that characterize many emerging economies, a repurchase, supposedly made on the open
market at the market price, can be used to repurchase shares from insiders at a favorable price
The insiders will know when the company will be buying shares, and can sell at a high price.
Once the company finishes buying shares, the price will drop again. Thus, we treat open marke
purchases as non-pro-rata. This regulatory treatment should change when a country's stock mar-
ket becomes sufficiently liquid.

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I996] A SELF-ENFORCING MODEL OF CORPORATE LAW i967
pro-rata repurchase of shares from insiders is also regulated like any

other self-interested transaction.l9
Turning from repurchases of stock (voluntary for the selling share-
holder) to redemptions (mandatory for the selling shareholder), a com-
pany should be allowed to redeem preferred shares at its option if its
charter so provides. The principal risk is that the price offered by the
company will be too low. To respond to this risk, we believe that a
company should be able to redeem preferred stock only on a pro rata
basis, or by lot to the extent necessary to avoid redeeming fractional
shares. There is no need to allow non-pro-rata redemption of common
stock, which would permit managers to buy out unwanted sharehold-
ers at a low price. Pro rata redemption of common stock, which is
functionally equivalent to paying a dividend, should be allowed if it
offers more favorable tax treatment than paying a dividend.120
E. Protecting Creditors and Preferred Shareholders
Minority shareholders are not the only corporate investors who are
threatened by the information asymmetries and weak capital markets
that characterize emerging economies. The business failures that
plague these economies put stress on credit relationships and create
incentives for opportunism by shareholders or managers at creditors'
expense.
In developed and emerging economies alike, contract is the princi-
pal instrument of self-protection for creditors and preferred sharehold-
ers. Banks can take security interests in assets; bondholders can
demand covenants that restrict distributions of corporate assets; trade
creditors can provide only short-term credit, thus limiting their losses
in the event of default; and preferred shareholders can insist on the
power to elect some or all of the board of directors if dividends are
missed.
But experience also suggests a role for legal limits on distributions
of assets even in developed economies. In the United States, for exam-
ple, company law bars dividends and stock purchases by an insolvent
company;121 "look-back" provisions of bankruptcy law allow recapture
119 If the shareholders whose shares are to be repurchased are known, they should be ineligible
to vote. If the selling shareholders are not known, as in the case of an open market repurchase,
then all shares can vote. Repurchases of preferred stock should be regulated similarly to repur-
chases of common stock. Non-pro-rata repurchases should require approval by the holders of the
class of preferred stock to be repurchased.
120 We allow reverse stock splits, in which small holdings are cashed out in lieu of issuing
fractional shares. This is a form of mandatory, non-pro-rata repurchase of stock. Thus, it should
require approval by a majority of outstanding shares, the price paid for fractional shares should
be market value (determined by the independent directors), and shareholders whose shares are
cashed out should receive appraisal rights.
121 See, e.g., REVISED MODEL BUSINESS CORP. ACT ? 6.40 (1991).

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I 968 HARVARD LAW REVIEW [Vol. 109:1911
of pre-bankruptcy distributions;122 and fraudulent conveyance law al-

lows reversal of transfers made for unfair consideration by insolvent
companies.123 These substantive limits respond to the powerful incen-
tives for shareholders to extract whatever value they can from a fail-
ing company. Banks and other large creditors can protect themselves
by writing detailed contracts and monitoring a borrower's compliance
with contractual covenants. But experience teaches that statutory lim-
its on distributions are important protections for trade and other small
creditors, for whom the transaction costs of writing or enforcing de-
tailed contracts are prohibitive.
In emerging markets, creditors have even greater need for protec-
tion. They are often less sophisticated than creditors in developed
countries, and key credit market institutions are often absent, such as
financing factors who buy accounts receivable and monitor borrowers
on behalf of small trade creditors, and information services that report
a borrower's payment history or financial strength. Yet the available
legal tools for protecting creditors are also limited. In Russia, bank-
ruptcy law does not function at all, let alone contain sophisticated
look-back provisions. Secured lending is crippled by a Civil Code pro-
vision that gives secured lenders third priority in insolvency proceed-
ings, after personal injury claims and employee claims.124 Even
ordinary contracts are often not readily enforceable.
The simplest ways for a company to distribute assets to sharehold-
ers at the expense of creditors are through dividends (whether of cash,
stock, or other property) and stock repurchases. From a creditor's per-
spective, these are identical transactions and should be regulated in
the same manner. The self-enforcing model permits dividends or re-
purchases only if, after the payment, (i) the company will have net
assets (assets minus liabilities) greater than zero, whether assets and
liabilities are measured at book or at market value; and (ii) the com-
pany reasonably expects to be able to pay its bills as they come due.
The first test is an asset test for the company's solvency; the second
test is a liquidity test for solvency.125 (The requirement that the com-
pany repurchase stock at fair market value also provides some creditor
protection because if the company is close to insolvency, its shares will
122 See II U.S.C. ? 547 (I994).

123 See, e.g., UNIF. FRAUDULENT CONVEYANCE ACT ? 4, 7A U.L.A. 474 (i985).
124 See GK RF (CIVIL CODE), supra note 42, pt. I, art. 64.
125 In the United States, a third solvency test is also used: after the transaction, the company
must not have an unreasonably small amount of capital left with which to conduct its business.
See UNIF. FRAUDULENT TRANSFER ACT ? 4(aX2Xi), 7A U.L.A. 652-53 (i985). But this extremely
vague test is rarely used in practice. In keeping with our preference for defining legal require-
ments clearly, to guide both directors and judges, we do not consider this third standard to b
useful in an emerging market.

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1996] A SELF-ENFORCING MODEL OF CORPORATE LAW i969
have little value. 126) The market value test for asset-based solvency is
familiar from developed countries. We add the book value test be-
cause one cannot rely on courts in emerging markets to apply sensibly
a rule that looks to market value to determine whether a company is
insolvent after paying a dividend.127 We keep the market value test
because book value may be an unrealistic measure of value. In Rus-
sia, for example, many intercompany debts that will never be paid are
listed as assets by the company to whom they are nominally owed.
We also protect creditors and preferred shareholders through dis-
closure - companies must notify creditors of dividends or stock re-
purchases that are large enough to significantly affect the company's
creditworthiness (our threshold is a 25% decrease in the book value of
the company's net assets). This disclosure permits creditors to avail
themselves of contractual rights, and evaluate whether and on what
terms to extend new credit. Large creditors can, of course, insist on
notice of dividends or on dividend restrictions by contract. But trade
creditors may not be able to, or think to do so, and trade creditors in
emerging markets will often lack other sources of information about
changes in a borrower's financial condition.
Although dividends and stock repurchases by a company that is in
or near insolvency are particularly suspect as asset distributions, any
corporate transaction can be a vehicle for extracting assets from the
company, to the detriment of creditors and often shareholders as well.
The challenge is how to block bogus transactions without impeding
ordinary business dealings. Here we can do no better than the vague
standard, familiar from fraudulent conveyance law, that a transaction
is improper if (i) the company does not receive equivalent value, and
(ii) the company fails an asset-based or liquidity-based solvency test
after the transaction. We again use both book and market value tests
for asset solvency.
The standard of equivalent value is fuzzy, but it can at least reach
egregious cases where a company transfers most of its remaining assets
to third parties for nominal consideration to evade its creditors. A typ-
ical Russian situation involves a raw materials company selling its
product at a fraction of market value to another company controlled
by its managers, who then resell the product at the market price. A
126 Similarly, to protect preferred stockholders, the law should allow dividends on or
chases of common stock only if, after the payment, the company's net assets (measured at both
book and market values) exceed the liquidation preference that the preferred stock would enjoy if
the company were to be liquidated immediately. If there is more than one class of preferred
stock, a similar restriction would apply to dividends or repurchases of a junior class of preferred
stock. The dividend or repurchase would be permitted only if, after the dividend or repurchase,
the company's net assets were sufficient to pay the liquidation preference of the more senior
preferred stock.
127 If inflation is high, directors should have the option to adjust historical book values using a
generally accepted inflation index to ensure that the book value test is not too constraining.

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I970 HARVARD LAW REVIEW [Vol. I09:1911
creditor, irate shareholder, or even a judge should be able to spot a

sale at a bargain price followed by prompt resale at a far higher price.
As this example suggests, moreover, many fraudulent conveyance
transactions are also self-interested, which enlists the self-interested
transaction rules in protecting creditors and those shareholders who do
not share in the company's largess.
These creditor-protection rules move, in part, beyond the self-en-
forcing model of procedural protection to substantive prohibition.
Substantive restrictions on dividends, stock repurchases, and non-
arms-length transfers are justified by: the strong incentives of share-
holders and managers to grab what they can from a sinking ship; the
dearth of legitimate reasons for a company near insolvency to pay div-
idends (and the total absence of reasons to enter into transactions
without receiving reasonably equivalent consideration in return); and
the difficulty of attacking this problem in another way because a com-
pany's relationships with creditors are too complex to permit a voting
solution.
In part, however, the appearance of substantive prohibition is de-
ceiving. For example, a company that wants to pay a dividend that
the book value test would otherwise prohibit can first raise new equity
capital to pay off its old creditors, then pay the desired dividend. The
company can then recreate its old capital structure if new lenders can
be found. In effect, the dividend limit requires the company to let
creditors vote with their feet. Such a financial end run around the
dividend restrictions involves substantial transaction costs, but its pos-
sibility softens the harshness of a book value test for solvency in an
environment where book value may be a poor measure of actual
value.
F. The State as Part-Owner
The state is frequently an important equity holder in emerging

economies - especially in the privatizing economies of Central and
Eastern Europe. In Russia, for example (after completion of voucher
privatization, but before the current, slow cash phase of privatization),
regional property funds retain some equity in most privatized compa-
nies and hold stakes of 20% or more in perhaps one-third of all
companies. 128
Several concerns are raised by such large state holdings. One can-
not expect government officials to behave as private shareholders who
bear the economic consequences of company decisions. State officials
may form alliances with managers at the expense of shareholders,
128 These estimates are from a survey of a limited number of regional property funds. See
Katharina Pistor & Joel Turkewitz, Coping with Hydra - State Ownership After Privatization: A
Comparative Study of the Czech Republic, Hungary, and Russia, in 2 CORPORATE GOVERNANCE
IN EASTERN EUROPE AND RUSSIA: INSIDERS AND THE STATE, supra note *, at I92, 206 tbl. 6.5.

59.88.197.37 on Thu, 26 Aug 2021 03:35:23 UTC
competitive markets, or both. They may influence company policies in

inefficient directions to accomplish public ends (such as preserving em-
ployment in a particular region). Or they may trade votes for personal
favors that managers can supply. Because we are skeptical about
whether local officials will behave as responsible shareholders, we
favor neutralizing government shares in the election of boards of direc-
tors: state bodies should neither nominate nor vote for candidates for
the board of directors, although they should retain authority to vote on
potentially company-transforming actions such as mergers and charter
amendments.'29
V. REMEDIES
Substantive rules are only one aspect of a well-designed statute.

Remedies are equally important and in some respects even more com-
plex. In formulating substantive rules for a self-enforcing statute, the
need to economize on enforcement resources leads to a preference for
simple, bright-line rules - though we occasionally use general stan-
dards for pedagogical purposes and to influence norms of behavior
over the long term. For identical reasons, a self-enforcing statute
should often define the remedies for violations of the substantive rules,
rather than leave their development to the courts. Defining remedies
isn't always possible, but some common violations can be anticipated
and their consequences elaborated, rather than left to the uncertain
wisdom of judges.
This stress on clarity and simplicity implies that remedies should
often take the form of rights running to shareholders directly, rather
than rights mediated by the corporation (acting on behalf of all share-
holders) or by regulators. One broad example is the set of transac-
tional rights described in Part IV - appraisal, preemption,
participation, and takeout rights - where the substantive rule also
defines a shareholder-enforced remedy. To take another example,
shareholders can be given direct rights to sue an insider to recover the
insider's profit from a self-interested transaction that did not receive
the requisite shareholder approval. The recovery should go to the
company, but the right to sue can belong to the shareholder. Con-
versely, the cumbersome device of the derivative suit - a suit by the
shareholder in the name of the company, with painstaking judicial
oversight of when the company's board can control the suit - has
little place in an emerging economy. We limit nuisance or strike suits
129 Convincing government authorities to adopt a policy of neutrality may be difficult. The
Russian company law, as adopted, not only failed to neutralize the state's shares, but also gave
the state extra powers in some circumstances, most notably the right to maintain its percentage
ownership during an issuance of additional shares if the state owns more than 25% of a com-
pany's shares. See Federal Law of the Russian Federation on Joint-Stock Companies, supra note
2, art. 28, 1[ 4.

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I972 HARVARD LAW REVIEW [Vol. io9:I9II
not through judicial oversight of derivative suits (as under Delaware

law), but instead by requiring that the suing shareholders own a sig-
nificant stake in the company (for Russia, we required ownership of
i% of the company's common stock).
Consistent with the spirit of a self-enforcing statute, shareholders
can sometimes be left to determine the content of a remedy. For ex-
ample, we penalize a shareholder who improperly crosses the 30%
ownership threshold without honoring takeout rights with loss of vot-
ing rights unless these rights are restored by a majority vote of the
other shareholders. Similarly, the penalty for improper voting proce-
dures is a second vote that lets shareholders decide how to react to the
misfeasance of the managers the first time around.
A second remedies issue is the severity of penalties for violating the
rules. In general, sanctions should be more severe than in developed
economies to compensate for the low probability of detection and en-
forcement.130 Consider, for example, the requirement that self-inter-
ested transactions receive the approval of disinterested shareholders.
We propose that insiders who fail to disclose an interested transaction
must return all profits from the transaction to the company. Contrary
to the majority rule in the United States, we reject ex post shareholder
ratification and proof of substantive fairness to the company as de-
fenses to liability because these defenses would undercut the incentive
to obtain shareholder approval ex ante. Managers would be tempted
to ignore the procedures in advance if the remedy for failing to follow
them were merely a reprise of the required procedure. Ex post share-
holder approval also sacrifices the prophylactic value of ex ante ap-
proval and ex ante disclosure. Not every transaction that would be
approved ex post will be proposed ex ante; and not every transaction
that would be disapproved will be challenged.
Because a self-enforcing corporate law makes heavy use of bright-
line rules, it can carry strong penalties with less risk of chilling legiti-
mate behavior than similar penalties would create under an American-
style law that relies heavily on fuzzy fiduciary duties. For example,
our proposed remedy for crossing the 30% ownership threshold for the
control transaction rules without prior notice, or without offering to
buy all remaining shares, was loss of voting power as to all shares
held by the 30% shareholder, unless other shareholders vote to restore
voting rights or the shareholder acquires at least 90% of the outstand-
ing shares. A severe sanction is appropriate here not only because vio-
lations may be difficult to detect (acquirers may hide ownership by
buying through undisclosed affiliates), but also because a clear rule
means that inadvertent violations should be rare.
130 See, e.g., Gary S. Becker, Crime and Punishment: An Economic Approach, 76 J. POL.
ECON. I69, I83-85 (I968).

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By contrast, other factors cut against very severe sanctions in many

circumstances. Some of these factors arise from the need to adapt the
Russian statute to the sophistication and sensibilities of Russian man-
agers. One cannot assume that corporate managers will always know
the rules. Thus, it can seem unacceptably harsh to penalize inadver-
tent violators heavily, especially for rules that apply importantly to
small companies. Moreover, the law must be seen to be fair if it is to
induce voluntary obedience and, ideally, the conformity over time of
culture to the new law. To meet this need for perceived fairness, sanc-
tions must fall well short of the deterrent ideal, which sets expected
penalties (actual penalties if caught multiplied by the probability of
detection) equal to the harm caused by misconduct. These considera-
tions explain why, for example, we do not propose double or triple
damages for failure to disclose self-interested transactions - even
though the conventional logic of deterrence might recommend doing
so.
Furthermore, intrinsic enforcement limitations make severe sanc-

tions unworkable under some circumstances. For example, the draft
Russian statute never imposes liability on directors for decisions taken
in good faith and without a conflict of interest. In effect, we close off
the narrow American recklessness/gross negligence exception to the
business judgment rule because we have no confidence that Russian
courts can decide when conduct is sufficiently outrageous to warrant
imposing (often ruinous) personal liability on directors. In this context,
any liability for good faith decisions creates the problem that the busi-
ness judgment rule - which protects directors from liability even for
demonstrably stupid decisions - was designed to solve: the risk of
liability can chill risk-taking in a world where managers often need to
take gambles, sometimes long-shot gambles, on limited information.
Sometimes, too, there are no effective remedies for the violation of
a statutory norm. Suppose that a company fails to use cumulative
voting. One cannot invalidate the actions of the improperly elected
board without imposing an unrealistic burden of investigation on third
parties who deal with the company. The violation is clear enough so
that one can imagine imposing personal liability on board members for
loss to the company from actions approved by an improperly elected
board. Yet the Russian draft stops short of this sanction, partly be-
cause even honest directors may not understand how to implement cu-
mulative voting, and because the directors who would resign to avoid
this liability may be the best available. We are left with the weak
sanction of running a new election - which will at least allow share-
holders to vote again, knowing how their directors have behaved in
the past.

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VI. THE PATH-DEPENDENT EVOLUTION OF DEVELOPED COUNTRY

CORPORATE LAW
Our work has important implications for the ongoing debate about
the efficiency of corporate law in developed countries. In the United
States, the debate is traditionally framed as between race to the bot-
tom proponents - who see American states as competing to adopt lax
corporate laws in order to attract corporate managers, who make the
reincorporation decisions13'- and race to the top proponents - who
believe that (perhaps with an exception for antitakeover rules) states
attract corporations by offering efficient rules.'32 The principal evi-
dence offered by race to the top proponents is a set of empirical stud-
ies showing that reincorporation in Delaware either increases or does
not decrease stock price, and thus is either efficiency-enhancing or at
least efficiency-neutral.133
We believe that the empirical evidence is ambiguous, and that the
evolution in the United States of corporate law for large public compa-
nies is more complex than either camp has acknowledged. We propose
the following alternative, which fits our anecdotal sense of the history
of American corporate law but must remain tentative until we can
complete the historical research needed to confirm it. 134
American corporate law evolution began in the mid-nineteenth cen-
tury from a historically contingent starting point of rigid formal rules,
which reflected public suspicion of corporations, weak market con-
straints that called for strong investor protections, poor communica-
tions that made impractical some of the shareholder approval
procedures embodied in the self-enforcing model, and a misunder-
standing of corporate finance that led to an early obsession with char-
ter capital. Corporate law then evolved from this starting point
toward today's enabling law on a path conditioned by a mix of effi-
ciency considerations, political considerations, and historical con-
straints, but not entirely determined by any of these factors.
An important degree of freedom in the evolution of corporate la
was made possible by the emergence of other institutions that fille
gaps in the early corporate laws. For example, corporate law early on
permitted deviation from the one common share, one vote principle.
But the New York Stock Exchange filled that gap for public compa-
nies in I926. Corporate law permitted such outrages as issuing divi-
dend checks that, when endorsed by the shareholder, gave managers a
131 See, e.g., William L. Cary, Federalism and Corporate Law: Reflections upon Delaware, 83
YALE L.J. 663, 663-86 (I974).
132 See, e.g., ROMANO, supra note 23, at 52-53, I48-5i; Ralph K. Winter, Jr., Stat
Shareholder Protection, and the Theory of the Corporation, 6 J. LEGAL STUD. 25I, 254-5
133 See ROMANO, supra note 23, at I7-i8 & nn.7, 20 tbl. 2-I (reviewing studies).
134 This work is in progress, under the tentative title: Reinier Kraakman & Bernard Blac
Path-Dependent Evolution of American Corporate Law.

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proxy to vote the shares as they pleased. In response, stock exchange

rules and the federal securities laws intervened to provide a better
proxy voting system. Corporate law required little financial disclosure
by companies to shareholders - but again, the federal securities laws
intervened to erect a system of mandatory disclosure. In addition,
common law judges exercised substantial power under fiduciary doc-
trines to fill the gaps left by other bodies of law.
Interstate competition for new incorporations also significantly con-
strained the development of corporate law. The states needed to sat-
isfy two competing constituencies: shareholders, who were interested in
efficiency; and managers, who wanted more discretion. Managers ini-
tiated incorporation decisions, and were thus a critical constituency. A
reincorporation that increased share values but decreased manager au-
tonomy would not interest managers. But managers also had to ap-
pease shareholders. It would be too bold and potentially embarrassing
for managers to propose a reincorporation in another state, or a
change in the law of one's own state, that gave the managers more
discretion but visibly harmed shareholders. The path of least resist-
ance was legal reform that both enhanced (or did not decrease) man-
agers' autonomy and increased (or did not decrease) company value.
As we see it, corporate law meandered down this path of least
or at least low - resistance. Consider, for example, the rules gov-
erning transactions in which directors and managers had a conflict of
interest. The early rigid rules against self-dealing could have been re-
placed by shareholder review, as we propose in the self-enforcing
model. Instead they were primarily replaced by the weak constraint of
board approval. Here is one plausible story for why corporate law
might have evolved in this way, without ever finding the potentially
better approach of shareholder review. Corporate managers were
acutely aware of the problems with the prohibitive model, and pushed
for greater discretion. Over time, courts and legislatures responded.
The managers had no incentive to suggest replacing prohibition with
shareholder review. Legislators were thus never presented with the
self-enforcement option developed here, or anything close to it. It was
left to the courts to modestly counteract legislative permissiveness by
requiring strict review under a fairness standard of self-interested
transactions that are not approved by noninterested directors. In this
story, the enabling model could dominate the prohibitive model as a
means of regulating self-interested transactions (though even that is
debatable'35), and yet be sub-optimal relative to self-regulation by
shareholder approval - an approach that was never considered.
Additional examples of corporate law following a path of low
resistance are easy to find. As Delaware law became more friendly to
135 See, e.g., Harold Marsh, Jr., Are Directors Trustees? Conflict of Interest and Corp
Morality, 22 Bus. LAW. 35, 43-57 (i966).

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mergers, it did not provide effective a

to fill this gap too. Unlimited director
duty of care can cause outside director
that became real after the Delaware Sup
duty of care violation in Smith v. Van
the Delaware legislature to respond. The legislature might have
capped director liability at a multiple of director compensation.137 In-
stead, it gave companies the option, soon taken by most large firms, to
have no director liability at all for duty-of-care violations. When man-
agers' jobs were directly at risk during the takeover wave of the
i980s, they wanted power to resist takeovers strongly enough to sup-
port statutes that shareholders frequently opposed and that risked de-
creasing the value of their own companies' shares. Often, the
managers got what they wanted. And so on.
This model - in which corporate law evolves in a path-dependent
fashion down a route of low resistance - is consistent with both the
realpolitik stressed by race to the bottom supporters (that managers
make reincorporation decisions) and the empirical evidence cited by
race to the top supporters (that reincorporations tend to increase, or at
least not decrease, share values). It is also consistent with recent
scholarship that emphasizes the importance of path dependence and
legal rules in determining the ownership structure of large public com-
panies.138 In effect, we seek to extend the path dependence story be-
yond stock ownership by financial institutions (a story already told) to
the corporate law itself.
The path-dependence argument can be taken further. The evolu-
tion of corporate law is intertwined with the evolution of financial in-
stitutions. If financial institutions are economically and politically
powerful, the evolution of corporate law will reflect their interests as
well as those of company managers. And financial institutions, in
turn, will evolve in ways influenced by the corporate law. For exam-
ple, both Britain and the United States have long had active capital
markets, including active markets for corporate control. In the United
States, financial institutions were weak, in part because political deci-
sions made them So.139 American managers succeeded in obtaining
broad discretion to oppose takeovers - the one clear case of evolution
in American corporate law away from efficiency. In Britain, financial
institutions, especially insurance companies, were strong, and success-
136 488 A.2d 858 (Del. i985).

137 Such a cap was proposed in PRINCIPLES OF CORPORATE GOVERNANCE, supra note I3,
? 7.I9.
138 See, e.g., ROE, supra note 6, at 26-28; Black & Coffee, supra note 6, at 2082-84;
Roe, Chaos and Evolution in Law and Economics, io9 HARV. L. REV. 64I, 643-58 (i9
139 See, e.g., ROE, supra note 6, at 26-28; Bernard S. Black, Shareholder Passivity R
ined, 89 MICH. L. REV. 520, 564-66 (i990).

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fully opposed takeover defenses that would take the change-of-control

decision away from shareholders.
In Germany, unlike Britain and the United States, universal banks
have long been strong. They run mutual funds and investment banks,
and their representatives sit on company boards. Tight restrictions on
conflicts-of-interest and insider trading would have limited the banks'
freedom to profit from their multiple roles. Is it simply an accident
that Germany had little insider-trading regulation until recently, when
European unification and the internationalization of capital markets
created a constituency for stronger rules, or that Germany still allows
conflicts of interest that even the most pro-manager Delaware judges
would find intolerable?
The Russian story also illustrates the importance of politics and
powerful players in determining the structure of corporate law. In
Russia, as elsewhere, corporate managers are influential. Many want a
corporate law that insulates them as much as possible from share-
holder oversight. The corporate law that Russia adopted is largely
based on our self-enforcing model, but contains elements that can only
be understood as pro-manager compromises. For example, our effort
to introduce a British-style system of takeover regulation - with re-
quirements for advance notice of a control transaction, a mandatory
takeout offer for minority shares, and a ban on defensive tactics -
lost the ban on defensive tactics along the way.140
Historical accident matters too. For example, the recently adopted
Russian Civil Code contains some rigid, dysfunctional charter capital
rules.141 From this starting place, we expect, Russian company law
will evolve along its own path of low resistance - with dysfunctional
rules falling by the wayside, with managers adding to the discretion
that the law already gives them, but with other institutions developing
over time to ameliorate the consequences of excessive managerial
discretion.
CONCLUSION: SELF-ENFORCING LAW IN EMERGING ECONOMIES

In this Article, we have argued that the best model for company
law for an emerging economy is neither the enabling model that char-
acterizes developed economies today, nor the prohibitive model that
characterized corporate law a century ago, but instead a "self-enforc-
ing" model. The core of this model is an effort to harness the incen-
140 Also see note 8o above, noting that our proposed protections for employee shareho
were dropped from the Russian company law, as adopted.
141 For example, under articles 99 and ioi of the Russian Civil Code, if losses cause a com-
pany's net assets to be less than its charter capital, the company must reduce its charter capital.
But doing so requires giving each creditor an option to demand immediate repayment of its loan
to the company, which could quickly exhaust the company's liquid assets. See GK RF (CIVIL
CODE), supra note 42, pt. I, arts. 99, ioi.

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tives of participants in the corporate enterprise, especially large

minority shareholders, in order to provide meaningful protection to
minority shareholders despite the absence of the multiple private and
public enforcement resources of developed economies. Minority share-
holders require strong legal protection from insiders in emerging mar-
kets because the market controls that provide such protection in
developed economies are weak. Yet because public enforcement is also
weak, company law in emerging markets cannot simply substitute for-
mal law enforcement for the missing market controls.
To operate effectively in this difficult environment, company law
must be self-enforcing in a double sense. First, it must provide proce-
dural mechanisms to replace the largely absent mechanisms for formal
enforcement, and allow outside shareholders and outside directors to
police the opportunism of managers and controlling shareholders.
These constraints should be primarily procedural (rather than substan-
tive, as in the prohibitive model) to preserve flexibility in corporate
decisionmaking.
Second, because self-enforcement in this first sense is uncertain, the
company law must elicit a substantial measure of voluntary compli-
ance from managers and controlling shareholders. Toward this end,
the statute must articulate bright-line and easily understood rules, pro-
vide terms that corporate actors recognize as appropriate to their busi-
ness circumstances, and strongly sanction departure from these norms
(in the rare cases in which formal sanctions are imposed). Thus, the
model does more than substitute private enforcement for formal judi-
cial enforcement; it also relies on "self' enforcement of a different kind:
the inherent organizing force of clear and legitimate law in an other-
wise chaotic business environment.
The drafting strategy implicit in the self-enforcing model reaches
almost every aspect of company law. At the most basic level, our
model statute structures the company's voting system to increase the
influence of minority blockholders. It mandates a single class of vot-
ing common stock; a one share, one vote rule; and a cumulative voting
rule for the election of directors. In addition, it provides for a univer-
sal ballot, on which large shareholders can nominate board candidates.
The model statute relies on a combination of voting constraints
and transactional rights to regulate especially important or suspect
transactions. Significant self-dealing transactions must be authorized
by majority vote of both noninterested directors and noninterested
shareholders. Mergers, liquidations, and large purchases and sales of
assets require approval by a supermajority of outstanding shares (we
suggest two-thirds as the appropriate threshold in Russia), with ap-
praisal rights for shareholders who do not vote to approve the transac-
tion. In addition, new issues of shares are subject to preemption
rights. These rights can be waived by a shareholder vote, but share-
holders who do not approve the waiver receive ex post participation

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rights, much as shareholders who do not approve a merger receive

appraisal rights. Finally, the acquisition of control stakes carries an
obligation to offer to buy minority shares, and defensive measures that
might prevent shareholders from selling to would-be acquirers are
prohibited.
These and other features of the self-enforcing approach produce a
company law that is novel in the aggregate, even though many of its
individual provisions are familiar. The model flatly prohibits almost
nothing except efforts to opt out of its process requirements. Nonethe-
less, it significantly constrains insiders by allocating to large-block mi-
nority shareholders - those shareholders with sufficient holdings or
support to win board representation under a cumulative voting rule -
considerable power to influence corporate decisionmaking.
If, as we have argued, optimal corporate law depends on institu-
tional context, then a country's corporate law should evolve as its
economy and legal system evolve. As compared with the enabling
model, the self-enforcing model gives greater power to outside inves-
tors, but at the cost of less flexibility in the basic structure of corpo-
rate governance. As market constraints and a sophisticated judiciary
develop to limit opportunism by managers and large shareholders, the
comparative merit of the enabling model will increase. In a decade or
two, mandatory cumulative voting, or a mandatory one share, one
vote rule, may have outlived its usefulness and can be relaxed. Per-
haps, too, as market liquidity increases, institutional shareholders will
choose to make the "exit" alternative to voice more viable by reducing
their percentage stakes in companies.142 If large investors choose exit
over voice, the voice-enhancing benefits of the self-enforcing model
will shrink, while the costs of our voice-promoting rules will remain.
Corporate law then should, and probably will, evolve toward fewer
voice-promoting rules.
But evolution toward the enabling model is not a foregone conclu-
sion. Given the mutual interaction between the law and the evolution
of companies and financial institutions, in which strong protections for
large outside investors encourage them to hold large percentage stakes,
the self-enforcing statute may prove substantially stable. These large
shareholders could also provide the political constituency to preserve
the self-enforcing model against the attacks of managers seeking
greater autonomy. The result would be a new model of mature com-
pany law: one that relies much more on internal decisionmaking
processes and shareholder authorization - and much less on ex post
litigation - than is currently the practice in the United States.
142 For development of the argument that financial institutions will often choose exit over
voice, if both options are available, see John C. Coffee, Jr., Liquidity Versus Control: The Institu-
tional Investor as Corporate Monitor, 9i COLUM. L. REV. I277, I3P8-28 (i99i), and Black &
Coffee, supra note 6, at 2007-77.

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I 980 HARVARD LAW REVIEW [Vol. I09:I9II
APPENDIX
SURVEY OF COMPANY LAW IN EMERGING MARKETS

The table below surveys selected aspects of the company laws of
seventeen emerging market countries (plus the new Russian self-en-
forcing law, for comparison). All but a couple of the countries have
fairly recently adopted or updated their company laws.143 The table
tallies seven possible substantive restrictions and eleven possible proce-
dural rules.
Some substantive restrictions are extremely common. For example,
twelve of the company laws include a general ban (often with limited
exceptions) on company share repurchases.144 Almost as many laws
include limits on a company's power to issue bonds and/or preferred
stock (ten jurisdictions), a ban on ownership of parent company shares
by subsidiaries (ten jurisdictions), and minimum capitalization require-
ments (ten jurisdictions). Only three jurisdictions ban authorized but
unissued shares (though limitations on the amount or period of valid
authorization are more common); and only two ban transactions be-
tween companies and insiders. Finally, no jurisdiction sets the nomi-
nal (or par) value of shares equal to their issue price, as did an early
draft of the Russian Civil Code and a competing company law draft
in Russia.
On the procedural side, the most common restriction on insider dis-
cretion is a shareholder vote on fundamental transactions such as
mergers, liquidations, or recapitalizations. Such approval requirements
exist in all seventeen statutes, although transactional coverage and
quorum and vote thresholds vary greatly. Most jurisdictions also per-
mit shareholders to remove directors between regular board elections
(fifteen jurisdictions), mandate appraisal rights for dissenters in merg-
ers or sales of assets (eleven jurisdictions), require preemptive rights
for new issues of stock (eleven jurisdictions), and mandate a one share,
one vote rule for common stock (nine jurisdictions).
Less common are requirements for shareholder approval of large
share issuances (five jurisdictions, including those that bar authorized
but unissued shares) and self-interested transactions between compa-
nies and their officers or directors (five jurisdictions). Two prominent
features of the Russian draft statute we proposed - proportional
board representation and put rights for minority shareholders in con-
trol transactions - are found in only two and four jurisdictions re-
spectively. Some protections in the draft Russian statute, such as a
secret ballot in corporate elections, are not mandated by any existing
statute.
143 The table is based on the most recent versions available to us.
144 The data in the textual portion of the Appendix exclude the Russian company law.

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i996] A SELF-ENFORCING MODEL OF CORPORATE LAW i98i
These summary checklists of substantive and procedural restric-

tions provide snapshots of the drafting styles and levels of regulation
that characterize the company laws of emerging markets. Only one
comparatively developed jurisdiction - South Africa - has an en-
abling statute, and even this law is more restrictive than the Delaware
statute. Four jurisdictions rely heavily on substantive restrictions (Po-
land, the Czech Republic, Hungary, and Turkey). A group of four
Asian and Latin American statutes are appropriately characterized as
"mixed," with fair numbers of both procedural and substantive restric-
tions. And a group of eight countries (half of which are Common-
wealth jurisdictions) have statutes that offer many procedural
protections for shareholders but impose few substantive restrictions.
These company laws exhibit aspects of the drafting strategy that char-
acterizes the self-enforcing model. No company law in our sample,
however, contains as few substantive prohibitions or as many proce-
dural protections as we recommend.

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I 982 HARVARD LAW RE VIEW [Vol. IO9:19II
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A Self-Enforcing Model of Corporate Law

Author(s): Bernard Black and Reinier Kraakman

Stable URL: https://www.jstor.org/stable/1342080

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INTRODUCTION .......... ........................................................ I9I3

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A SELF-ENFORCING MODEL OF CORPORATE LAW

In this Article, Professors Black and Kraakman develop a "self-enforcing" approach to

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What kind of corporate law should govern publicly owned compa-

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three central claims. First, effective corporate law is context-specific,

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these background facts. For example, if (as in Russia) employees often

5 See Uriel Procaccia, Crafting a Corporate Code from Scratch, Public

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ior; and that still leaves managers with

(iv) Whenever possible, use of bright-line rules, rather than standards, to

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vote is protected through confidential voting and independent vote

8 In the economic literature, "self-enforcement" is sometimes given only this narrower me

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issuances through a combination of: preemptive rights; a requirement

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the other statutes. We do not, however, advocate wholesale change in

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I. THE NATIONAL CONTEXTS THAT SHAPE CORPORATE LAW

A. Corporate Law in Developed Economies

Corporate law, as we define it above, is generally understood to

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B. The Goals of Corporate Law in Emerging Economies

Corporate law in an emerging economy must address a broader set

14 See Black, Is Corporate Law 7Rivial?, supra note 3, at 55I-62.

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In Russia, for example, the structure of mass privatization has led to

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the equity markets. Honest (nonopportunistic) managers won't offer

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law could be substantially "enabling," even if insiders dominated pub-

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Russian firms and surely contributed to the roughly 75 % collapse in

C. Legal and Market Controls in Emerging Economies

Even as the economic and political goals of corporate law in

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The most significant enforcement limitation is weak judicial en-

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ier if courts can often resolve disputes by applying bright-line rules

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D. Cultural Norms for Manager and Large Shareholder Behavior

A further reason why developed countries can make do with weak

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conduct so basic is rare in developed markets, precisely because it

II. A SELF-ENFORCEMENT APPROACH TO CORPORATE LAW

Having surveyed the constraints under which corporate law in

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A. The Prohibitive Model

The prohibitive model is familiar from nineteenth-century corpora-

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B. The Self-Enforcing Model

A central claim of this Article is that, in emerging markets, a self-

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