Introducing the model
The legislator has essentially two toolboxes at its disposal to influence transaction costs in the contractual web of the corporation and guide the firm towards a cost-efficient framework. Cost efficient framework here means a legal framework that lowers transaction costs in the firm’s contractual relations among shareholders (present and future) and between shareholders and the board of directors and/or the executive management. The two toolboxes are the level of regulation intensity chosen in corporate law and the level of default characterizing the rules. Figure 1 illustrates these two aspects (or toolboxes) by movements along the vertical and horizontal axes. By placing regulatory techniques in the model with respect to their level of regulation intensity and the level of default, differences between them are highlighted. In addition, through a transaction cost analysis of the techniques, they can be better understood and compared with each other.
The vertical axis: level of regulation intensity
Several aspects, such as culture and legal tradition, affect how intense and detailed regulation is. Of course, one can question the need of legal rules altogether. In such a case, the legislator either ignores the area, is unaware of it or has concluded that the market will regulate itself, hence, no state interference is necessary. In the latter situation, deregulation, meaning to abolish legal rules, could be an alternative, representing a regulatory technique at the very bottom of the scale of the vertical axis of regulatory intensity. However, in the area of corporate law, some regulation is inevitable (since legal provisions at least must establish the legal personality).Footnote 5 From a legislative perspective, the law must address gaps in explicit contracts (Easterbrook and Fischel 1989, p. 1433). Two legal regulatory techniques to fill in gaps are through rules and standards. We will discuss the transaction cost implications of these two legal techniques.
Crucial assumptions of human beings in transaction cost analysis, as developed by Williamson (1975, 1985), are that people have bounded rationality and opportunistically take advantage of asymmetric information. Bounded rationality and opportunism makes explicit contracts between parties more or less incomplete due to high transaction costs. Contingent claims contracts as envisioned by Arrow and Debreu (1954) that cover all future possible events will be impossible. The pairing of bounded rationality with complexity and uncertainty of the future makes it costly to address contingencies in contracts. In regulation, a distinction can be made between rules and standards. A rule differs from a standard by being specific in the description of what is permitted/prohibited, while a standard is of a more general character with a high degree of vagueness of what is unlawful. As shown by Ehrlich and Posner (1974), a continuum exists between what can be considered rules and standards in terms of specificity and generality. We are inspired by the authors’ approach and see the continuum as a variable for degree of regulation intensity. For example, if the general meeting is regulated by a set of detailed legal rules, this will result in a piece of legislation with high degree of regulatory intensity compared to a legislation that regulate the general meeting in one or a few general standards.
Before explaining our continuum of the degree of regulation intensity as depicted in Fig. 1 in more detail, it is fruitful to note the major difference of specificity of rules and standards in terms of transaction costs implications. A rule saves transaction costs in that it reduces the uncertainty of legal consequences. However, standards cannot be replaced with rules on a one-to-one basis. Several rules are normally needed for each standard that is replaced. Therefore, the reduction of uncertainty eventually is at the expense of the complexity of needing to track many rules. As described by Williamson (1975, 1985), complexities as well as uncertainty increase transaction costs. In other words, there is a trade-off. Another factor to focus on is the high cost of promulgation of rules. This cost is fixed and favors rules for frequent situations as the regulation cost per situation decreases as frequency increases.
The vertical axis of the model in Fig. 1 illustrates the level of regulatory intensity. As will be explained in more detail, there is a non-linear relationship between regulatory intensity and transaction costs. At the bottom, we find regulation that corresponds to a minimum number of legal standards, which only regulate the utterly basic rules for corporations to function as legal persons. On the other end of the scale, at the top, we find a regulation that correspond to a comprehensive and complex set of mostly legal rules and only some standards that are meant to cover as many situations as possible. A preconceived conclusion would be that a complex, all covering, piece of legislation, would be more costly to comply with than a minimalistic regulation. Numerous rules, covering many types of contingencies, indeed make it costly for shareholders, directors and managers to be informed of the legal framework. However, although the complexity affects transaction costs, this preconceived conclusion is only partly true. As can be observed in this section, there are strong arguments for corporate law in the higher portion of the scale. We have identified two main streams of the legal literature about regulation intensity. The first stream is instrumental for explaining transaction cost consequences of movement along the vertical axis, while the second offers a more normative theoretical explanation of why regulation intensity high on the intensity scale is desirable.
Movement along the vertical axis and preferred position
In the first stream of literature, the regulatory techniques of rules versus standards are discussed. A rule differs from a standard in being clear-cut in the description of what is permitted/prohibited (Weber 2013). Since the content of a rule is given ex ante, before an act occurs, rules in general generate lower transaction costs for the parties than standards do. The predictability of a rule can have the cost saving effect that parties settle before court (Ehrlich and Posner 1974). Because of the relatively low cost of compliance, it is argued that situations, which are frequent for corporations, should preferably be regulated by rules. In contrast, a standard is more vague in describing what conduct is permissible; instead, the interpretation is made ex post by the adjudicator, e.g., court (Kaplow 1992). This makes the application of a standard more difficult predict; in addition, occasionally, it is necessary to hire expensive legal expertise or to prepare for many different outcomes. Legal uncertainty is always associated with high costs but as the number of precedents accumulates, the content of a standard may become clearer as each precedent supplements the standard with a case-based rule. However, as sometimes argued, specialized court could be better fitted and trusted to handle the discretion of a standard-based legislation (Kaplow 1992, pp. 608–610). The Delaware courts could be seen as an example of this, yet its influential position in American corporate law has lately been questioned (see Goshen and Hannes 2018). On the other hand, it might be argued that specialized courts are also very efficient of dealing with a complex and comprehensive rules-based legislation (see e.g., Parisi and Fon 2009, p. 20). Nevertheless, a legal standard can be more flexible for changes in society and result in an application of the law that is better tailored for the individual parties (Cheffins 1997). This also makes a standard more suitable for regulating non-day-to-day situations (Kaplow 1992).
One of the main disadvantages of using rules is the risk that they do not cover all aspects of the regulated situation, leaving gaps in the legislation, which can be used to circumvent the purpose of the rule. These gaps are overlooked or, for the legislator, unknown scenarios. For example, Ehrlich and Posner (1974) highlights the risk of both under- and over-inclusion of legal rules. In addition, certain areas are overly complex for all aspects to be covered in one clear-cut rule. The alternative, for the legislator, is to elaborate the rule into a set of detailed rules, covering all identified angles of the situation, or to sum all variables in a catch-all standard (Cheffins 1997). For a transaction cost analysis, this means that occasionally an accurate cost comparison must be made between on the one hand a standard and on the other a set of legal rules. Hence, in general, there is not a one-to-one relationship between standards and rules.
The literature on rules and standards, with focus on corporate law, can be summarized in the following manner. In general, compliance with rules adds on less transaction costs for contracting parties then standards. However, a legislative act consisting of only rules and no standards results in a detailed non-perspicuous regulation, putting it on top of the scale of the vertical axis of regulatory intensity. Therefore, maximum regulations with rules that cover all contingencies represent high transaction costs for the firm. Inevitably, certain questions must be regulated by standards. Therefore, corporate law always consists of a mix between rules and standards. On the other end of the vertical scale, a piece of legislation heavily based on standards might be easier to overview, but costlier to comply with. When moving from maximum regulation, replacing rules with standards, transaction costs decreases as it eases the overview of the law (i.e. as the degree of complexity decreases). However, the decrease in transaction costs only continues to a point, where the savings in transaction costs represented by fewer rules are equal to higher transaction costs for compliance and lack of predictability represented by more standards or regulatory gaps (i.e. to the point where the increase of the uncertainty of what to do to avoid legal consequences associated with standards and gaps is equal to the decrease of the degree of complexity of having fewer rules). Beyond that point, the higher transaction costs of standards and legal uncertainty dominates. Hence, there is no linear relationship between regulation intensity and transaction costs. In conclusion, the literature on rules versus standards provides us with a middle course represented by the upper part of the vertical scale in our model as preferred outcomes.
To clarify, let us also examine what occurs with transaction costs if we move in the opposite direction from low regulation to high detailed regulation. More regulation is associated with supplementary rules that cover more contingencies. As standards are replaced with more detailed rules, uncertainty is diminished at the expense of more complexity for the individual in the form of more rules to keep track of. As remembered, both uncertainty and complexity lead to higher transaction costs because of the bounded rationality of the human being. Therefore, a tradeoff between complexity and uncertainty is achieved before the maximal regulation point is achieved. This point is likely to be situated at a point where there are more of rules than standards, i.e., above the horizontal line. Above the tradeoff point, transaction costs increase when standards are replaced by rules.
In the second stream of literature involving regulatory techniques, which affect the desired intensity of regulation (preferred position on the vertical axis from a transaction cost perspective), we find the theory of majoritarian defaults. According to this theory, regulation should, in accordance with the hypothetical bargaining model, correspond to what rational parties would have contracted for if they have had perfect information and did not encounter significant transaction costs and could be fully confident that the agreement achieved would be performed as agreed.
When applying the model normatively, with no specific individuals to consider, the model must always include generalization. The legislator must then decide on how detailed the regulation should be referred to as level of idealization (Charny 1991, p. 1821). Should the law correspond to what parties this transaction type would most likely have chosen (considering that parties in general do not regulate issues that are considered non-important or unlikely to occur)? Alternatively, should the law cover all possible scenarios? To lower transaction costs, the law should also cover situations that are rare and difficult to predict and therefore often are omitted or forgotten by actual parties. From the hypothetical bargaining model perspective, the legislator is in a better position than the average parties to formulate contract-covering contingences. The legislator has the advantages of a higher degree of rationality and more information that follows from specialization. People engaged in the lawmaking process have advanced law education and get information and aptitudes from their daily work. These individuals are in a better situation to generate the best rule for a certain transaction type, i.e., a high degree of idealization (Charny 1991). Therefore, the literature supports an all-covering corporate law, which regulate both frequent and rare situations. In conclusion, also the theory on majoritarian defaults supports an inclusive corporate law represented by the upper part of the vertical scale in our model as preferred outcomes.
Horizontal axis: level of default
Let us now consider the horizontal axis to illustrate the level of default in the design of corporate law as a continuum between default and mandatory rules. In this section, we add a transaction cost analysis on default rules and show how these costs affect the level of default. In theory, the parties can derogate from default rules. However, depending on how much effort is needed to replace the legal rule or standard with contract terms, a default rule can be close to the mandatory endpoint because of high transaction costs. It is particularly cumbersome if a corporate law does not follow the hypothetical bargain model. The combination with high transaction costs to derogate from defaults will make most firms choose to stay with potentially suboptimal rules. Before entering into this discussion, let us explore the endpoints of the axis and certain arguments for the need of both mandatory and default corporate regulation.
The left-hand endpoint of the horizontal axis in Fig. 1 corresponds to non-mandatory rules or standards, also referred to as a gap-filling or default regulation (see e.g., Ayres 1993). The right-hand endpoint of the axis corresponds to a mandatory regulation. The parties cannot derogate from mandatory rules or standards, not even by a unanimous decision by the firm’s shareholders. Considering the enabling role of corporate law, providing the parties with a standard contract, the law should correspond to the hypothetical bargaining model. If not, legal rules that do not fit the need of the parties will be costly to comply with. This finding is utterly important if the regulation is mandatory (cf. Bebchuk 1989). In economic theory, given that the legislator cannot foresee all possible circumstances, this argument is used to support a non-mandatory regime. A reason for default regulation is, as mentioned in Sect. 3.3, that no one, including the best lawmaker, will be able to construct a standard contract that suits all firms, e.g., listed versus unlisted firm, family firms versus non-family firms, closed versus open corporations, startups versus older firms, and firms of different sizes. Hence, a standard contract is bound to be a suboptimal for at least certain proportions of the firms in the economy. For example, transferable shares and separation of ownership and control are characteristics of large listed firms, but not of small and medium sized family firms. If the standard contract, provided by corporate law, essentially meet the needs of large firms, it is crucial for the rules to be of default character letting other firms agree on more suitable contract clauses (Hansmann 2006).
Why mandatory rules
It must be recognized that not all corporate rules or standards can be defaults. In particular, legal rules that strive to protect a certain interest are argued to be mandatory, to avoid circumvention of the law. This particularly applies to third-party interests. However, it is equally important to recognize that, although certain rules initially may appear as mandatory, they can continue to be legally circumvented. In fact, Romano (1989) argues that mandatory rules are not truly mandatory, since the owners can decide to incorporate in another state, which regulates the question differently. Notwithstanding state competition, rules that are inevitable for the corporation to function as a legal person are truly mandatory, e.g., rules that state that the corporation have legal rights and obligations. No agreement among the shareholders, or with stakeholders, can change this fact.
In corporate law, most mandatory rules have the character of protecting rules. A protecting rule can normally be derogated from by the consent of the protectee. Similarly, as in all private law disputes, the protectee can also choose not to file a lawsuit against the violator of the protecting rule and by doing so impliedly consent to the infringement. Under normal circumstances, this regulatory technique of protecting rules/standards will ensure accurate protection, at least as long as the protectee has reasonable opportunity to exercise his or her right. Given this characteristic of protecting rules, labeling them as mandatory is not always appropriate. In closely held firms, unanimous consent by all shareholders is both feasible and likely to happen. Therefore, shareholders’ protection in these situations is better understood as default rules. In contrast, in corporations with dispersed ownership, unanimous consent might be impossible to achieve and therefore shareholders’ protection rules, although default in theory, are in practice mandatory.
The need of protection in the form of mandatory rules arises when one of the parties is not capable of protecting its own interests, i.e., when transaction costs are excessively high to make contractual solutions between parties possible. This is often referred to as market failure or contracting failure (cf. Klausner 1995, p. 769; Armour et al. 2017a, b, p. 19). We can, as delineated by Cooter and Ulen (2008, pp. 226–231), distinguish three kinds of situations where high transaction costs motivate mandatory regulation. First, there can be external costs in the form of negative spillovers to a third party, i.e., someone not part of contract. Due to contact, contract and/or control costs, this third party cannot influence the contract to internalize the externalities. (For further discussion of this, see Easterbrook and Fischel 1989.) In corporate law, externalities are the typical argument for mandatory protection of creditors and future shareholders. A second reason for mandatory regulation is when parties face unequal bargaining power (Baldwin et al. 2012). The source of such inequality is often asymmetric information, opening the door for opportunistic behavior by one party (see e.g., discussion in Williamson 1985). However, several scholars do not see this as an argument for mandatory regulation. In contract theory, Ayres and Gertner (1999) are using this argument to argue for so-called minoritarian or penalty defaults (later questioned by Posner 2005). In corporate law, Bebchuk and Hamdani (2002) uses a similar argumentation to promote so-called reversible defaults, i.e. whenever lawmakers face a choice between two default arrangements when neither is clearly superior, preference should generally be given to the alternative that is more restrictive of managers (see also Bebchuk 1989, p. 1412). The third reason for mandatory regulation is in situations of monopoly, which also could be seen as another situation with unequal bargaining power. Supplementing Cooter and Ulen’s list, we wish to add a fourth situation; when one party in the contractual relationship in fact constitute a group of individuals, who together only with difficulty can coordinate their decisions to exercise their legal rights (e.g., high coordination costs). This finding occurs where a trade-off has to be made between decision costs and Pareto sanctioned decisions (see Buchanan and Tullock 1962; Charny 1991).
The transaction cost perspective on default rules
Regarding a transaction cost perspective on default rules, our argument is that such costs affect the level of default. A traditional default regulation uses the opt-out technique. Parties to a contract can derogate from an opt-out rule by including another rule in their agreement. From a corporate law perspective, this contract could either be the articles of association,Footnote 6 or a (unanimous) formal or informal agreement by the shareholders. In certain cases, the contract could be a formal decision made by the board of directors. For parties who want to use the flexibility of the law and adjust their contract accordingly, the regulatory technique of opt-out will lead to (at least) the following costs: The parties must be familiar with the law and the fact that the rules are defaults. Occasionally, this need necessitates obtaining counseling from a legal advisor. The parties then need to investigate alternative solutions to the regulated situation, negotiate and agree on the solution they believe fit their relationship best. The decision can be followed by formal requirements such as majority vote requirements, documentation and registration. Finally, there are costs associated with controlling and enforcing agreements.
As an example, suppose the law states free transferability of share as the default rule. Parties to a closely held business seeks advice from a legal consultant on whether a right of first refusal, a post-sale purchase right or a ban of transfers is recommended in their situation, given the ownership structure and family situation of the owners. The parties agree on a combined solution, which is included partly in the articles of associations, partly in a shareholders` agreement. However, future contingencies can complicate the contractual situation. If 2 years later, one of the owners enters into marriage, it provides the shareholders reason to reevaluate and maybe rewrite certain parts of the agreement. Alternatively, when an owner passes away, the remaining owners will enforce the transfer restriction chosen in the contract.
Irrespective of how natural the measures used in this example appears for any entrepreneur or consultant, one must observe the costs of including contingencies in a contract. High transaction costs carry a risk that rational parties will choose to not consider contingencies and will be stuck with suboptimal regulation instead of contracting for a tailored solution. One reason for such a rational inactivity can be that the parties believe that a situation is unlikely to occur and therefore not worth negotiating around (Eisenberg 1989; Korobkin 1997). In the rare event that a contractual regulation turns out to be needed, the decision of non-activity can be very costly. In conclusion, due to high transaction costs, opt-out as a regulatory technique must generally be placed away from the left-hand endpoint of the horizontal axis of our model and closer to the center of the scale.
There is also a status quo effect to consider in the explanation why parties stick with default rules although it does not appear optimal (Korobkin 1997, 1998). This kind of effect has been found in experimental tests of the Coase theorem. It has been found that “people sometimes demand much more to give up something that they have than they would be willing to acquire it” (Cooter and Ulen 2008, p. 91). This behavior is called the endowment effect. The status quo effect is very similar. This effect also must be considered when placing the opt-out technique along the horizontal axis.
Acknowledging altering rules
There are more transaction costs to be considered when discussing the opt-out regulatory technique, which leads us to what Ayres (2006, 2012) refers to as altering rules. Altering rules are understood as legal conditions for displacing a default rule or standard. One example of such condition found in corporate law concerns the amendment of the articles of association. Such an amendment required several actions. A decision must be made by the general meeting of shareholders, postulating numerous formal requirements to be fulfilled, including documentation and registration of the decision. If the parties fail to fulfill these requirements, the derogation from the default rule will not be legally binding. Scholars has specifically paid attention to the requirement in some American state corporate acts, stating that charter amendments must be precede by a proposal put forward by the board of directors (see e.g., Bebchuk and Hamdani 2002; Hannes 2004; McDonnel 2007), essentially giving management veto power over all charter amendments. We should also consider the costs of different majority requirements. As argued by McDonnel (2007), default rules are more or less “sticky” depending on who is assigned authority to take the decision to deviate from the default rule, and how this decision must be taken. Defaults rules that are the least cost demanding are referred to as Teflon-defaults, e.g., deviation does not compel a charter amendment and the decision can be taken by a simple majority vote by the board of directors. By adding on requirements, default rules becomes more and more sticky, e.g., supermajority vote by the board, majority vote by the general meeting, supermajority vote of the outstanding shares, approvals by supermajority vote of two sequel annual meetings, approvals by both the board of directors and the general meeting, up to the point of requiring unanimity of both.
By acknowledging altering rules, another type of transaction costs is identified, which affect the level of default in corporate design. To lower contracting costs, attention must also be paid to how altering rules can be eased or abolished. In conclusion, for our model on corporate law design, a regulatory technique with high costs of using the altering rules must be placed further to the right-hand endpoint on the horizontal axis than the exact same technique with less cost intense altering rules. This conclusion applies regardless if the technique is based on rules or standards or if it corresponds to the hypothetical bargaining model or not.
Alternative default regulatory techniques
As shown above, the opt-out regulatory technique carries higher or lower transaction costs and these costs effect the level of defaults. Alternative regulatory techniques can be considered to find an appropriate level of stickiness. In this section we enlighten opt-ins, menus and Future Oriented Defaults to lower transaction costs and sunset provisions in order to make the defaults rules more sticky.
If a legislator truly strives for a default character of the corporate legislation, it must consider other regulatory techniques than opt-out. One alternative is to use opt-in regulation as it adds on less transaction costs for the parties then opt-out. By opt-ins, we understand legal rules or standards that are not automatically applicable to the contract but are dependent on an active choice by the parties. A distinction should to be made between opt-in rules that the firm is free to adopt and the case when the opt-ins represent the only deviations permitted from the main principle. In the latter situation, the opt-in is better understood as a part of a mandatory regime than a non-compulsory alternative.
The cost lowering effect of an opt-in technique is, first that it clearly indicates that the legal question is within a non-mandatory field of the law. Second, it directly states an alternative to the default rule, which helps the parties in their search for suitable alternatives. However, opt-in rules do not only save costs for the firm by supplying ready-made alternative contracts, there is also a network effect to consider (cf. Klausner 1995). The fact that the legislator has approved the formulation of an alternative contract clause is likely to consequently have that the clause will be frequently used and thus be subject to benefits of standardization. As the telephone becomes more attractive and valuable, the more telephones exist; a contract clause also becomes more attractive the more frequently it is used. Among other things, the interpretation, information, price, and accessibility to legal services are facilitated by the benefits of network externalities. This lowers the cost of contracting and enforcement.
Opt-ins can also be combined into sets of rules, often referred to as menus (Ayres 2006). The advantage of such a regulatory system is that the opt-in solutions can be tailored for different groups of firms, e.g., corporations with sole ownership, family firms, closely held businesses and listed corporations with dispersed ownership. This regulatory strategy helps the law to function as a standard contract corresponding to the hypothetical bargaining model for not just one main type of corporate businesses, but several. However, simplification is desired in menus to facilitate the choice of best rules. An excessive number of choices will affect the legislation in regulation intensity, putting it on the cost intense higher end of the vertical axis in our model. A menu of a limited number of opt-in rules that fit two or more types of corporations in the economy can substantially lower transaction costs. For this to be feasible, the menus do not have to cover full charters that regulate all aspects of corporate law (which often seems to be the presumption in the literature). Instead, we argue that opt-ins in the form of menus can preferable be used to determine a selected section of the legislation, such as the transferability of share or the decision-taking organs in the firm. If the legislator succeeds in this endeavor, the regulatory technique of menus can be placed far to the left on the horizontal axis of our model in Fig. 1.
In literature, we also find a specific discussion on enabling default arrangements in the regulation of takeovers. Two articles dealing with this issue are Bebchuk and Hamdani (2002) and Hannes (2004). Bebchuk and Hamdani consider the case where, without an initiative from the boards of directors, shareholders are unable to change the corporate charter in order to opt-out of the default antitakeover devices. Since the default rules are favorable to the management, it is unlikely that it will suggest such an amendment. Hence, although default in theory, due to high transaction costs these rules have become close to mandatory. While Bebchuk and Hamdani suggest a reversible default referring to the material content of the default rule (giving preference to the solution that is more restrictive of managers), Hannes stresses that this will not help midstream corporations that already have clauses in their charters allowing antitakeover devices. Instead, he suggest an alternative regulatory technique, called Future Oriented Defaults, that eliminate current charter provision and at the same time set a new default standard. The corporations are free to change their charter to opt out of the standard, including readopt their old management friendly charter provisions, but it necessitates an approval of the general meeting. The underlining purpose of the Future Oriented Defaults is to increase the level of default of specific rules or standards by penetrating a status-quo situation due to immutable transaction costs. The Future Oriented Defaults should therefore always be placed to the left of the rule it is suppose to revert on the horizontal axis of our model in Fig. 1. However, how far to the left depends on how well it represents a majoritarian default, the costs of altering rules and other transactions costs of contracting.
Scholars have also argued that sometimes it is appropriate to use regulatory techniques associated with high transaction costs in order to protect parties without using mandatory regulation. One alternative is a so-called sunset provision. According to a sunset default rule, any contractual diversion is only applicable for a given period of time; after that, the opt-out solution must be re-approved or the corporation reverts to the default (see eg., McDonnel 2007, p. 410–413). Again, this regulatory technique can be used to address the problem with pro-management provisions in the charters, when amendments of the charter are dependent on management initiatives. The argument is weaker when the corporate act allows shareholders, individually or representing certain percentage of the outstanding stock, to initiate amendments. In theory the technique could also be used for diversion from minority shareholders protection rules in situations when mandatory legislation cannot be fully motivated. However, it should be noted that periodical review of articles of association is costly. Increasing transaction costs of contracting place this regulatory technique rather far to the right on the horizontal axis of our model in Fig. 1.
Finally, it is to be noted that the ownership structure might matter for the need to protect shareholders. In a recent article by Goshen and Hannes (2018) it is argued that the increased competent institutional ownership of US corporations makes it less necessary to use corporate law to protect shareholder interests against managers. Private ordering solutions are increasingly used to solve conflicts outside the courtroom. However this argument is primarily valid for listed corporation and not for the majority of corporations with less than four owners.
Model summary and normative application
Regulatory techniques have different effects on the transaction costs of complying parties, i.e. between shareholders, directors and executive managers in a corporation. To illustrate the differences between regulatory techniques, we use a model showing the level of regulation intensity and level of default. When the two dimensions, represented by the vertical and the horizontal axes of our model, are combined, it is possible to draw general conclusions on preferable techniques from a transaction cost perspective.
Starting with the vertical axis in Fig. 1, we integrate findings from two streams of literature. Both support a regulatory technique that corresponds to a high level of regulation intensity. First, according to the literature on rules versus standards, clear-cut rules are associated with greater predictability and therefore lower compliance costs. Hence, rules should be used to regulate frequent situations for the firm, while standards, being more flexible for changes in society, should be used mainly to regulate non-day-to-day situations. Second, in accordance with the literature on majoritarian defaults, the theory supports legislation to also cover situations, which are difficult to predict and therefore often are omitted or forgotten by actual parties. Together, these two lines of arguments compose the vital elements for corporate law to function as a standard contract. In conclusion, theory support regulatory techniques are to be placed on the upper end on the vertical axis. However, not on top, as such an all-inclusive piece of legislation would be overly costly to overview and comply with.
For the legislation to fulfill the function as a standard contract, the legislator must consider the heterogenic needs of firms. Hence, the legal framework cannot fit the needs of all corporations; therefore, the rules, as a starting point, should be of default character. Examining the horizontal axis in Fig. 1, a transaction cost analysis favors a level of default to the left of the center of the scale. To achieve this level of default, the legislator cannot only rely on opt-out techniques. High transaction costs often make the parties reluctant to derogate from the legal norms. Instead, the legislator should combine opt-out-regulation with opt-in alternatives, possibly combined in small menus. In the mission of lowering the parties’ transaction costs, the legislator must also acknowledge the cost of applying altering rules and recognize when default rules in reality has become mandatory due to immutable transaction costs.
In sum; the preferred area of regulation in our model, when applied to the regulation of organization and decision-taking organs, is illustrated as the shadowed area in Fig. 2.