Inefficient Tailoring: The Private Ordering Paradox in Corporate Law

Abstract

The conventional wisdom in corporate law posits that private ordering has an important virtue: it allows firms to efficiently tailor governance terms to their particular needs. This virtue is routinely advanced to justify the largely “enabling” structure of U.S. corporate law, and to oppose “one-size-fits-all” mandatory regulation. This Article argues that private ordering frequently produces inefficient tailoring of corporate governance terms—firms that need governance constraints are precisely the ones that do not volunteer to implement them. In theory, the conventional approach assumes that these firms will implement constraints voluntarily because otherwise they would be disciplined by market forces and IPO pricing. Yet such reliance on market discipline has an inherent paradox: the firms that would benefit most from governance constraints are precisely the ones that are subject to weak market discipline, and this Article argues, to inadequate penalties in IPO pricing. Evidence from myriad studies and contexts suggests that firms’ needs for constraints are often not, or negatively, correlated with having them. For exam- ple, the inclination to cross-list on US exchanges is negatively correlated with controlling shareholders’ private benefits, and with the cross-listing premium; firms that benefitted from independent directors were precisely the ones that did not have them prior to SOX; managers of firms that investors believed would benefit most from proxy access were precisely those who were most likely to contest them; Nevada’s lax fiduciary duties attract firms that are prone to finan- cial reporting failures. The Article concludes with implications for data interpre- tation and corporate law policy.