Good Monitoring, Bad Monitoring

The following post comes to us from Yaniv Grinstein of the Department of Finance at Cornell University and Stefano Rossi of the Department of Finance at the Imperial College Business School. This post is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In our paper, Good Monitoring, Bad Monitoring, which was recently made publicly available on SSSRN, we estimate the value of monitoring in publicly traded corporations by exploiting as a “natural experiment,” an unexpected and controversial decision of the Delaware Supreme Court that significantly tightened scrutiny over board decisions in Delaware-incorporated firms in 1985. We analyze the impact of the decision on stock returns using matching and differences-in-differences techniques. We find that, compared with appropriately matched non-Delaware firms, Delaware-incorporated firms in high-growth industries lost, while firms in low-growth industries gained significantly around the announcement of the decision.

These results are robust, and are further corroborated by an out-of-sample test. A later regulatory reform to the Delaware Code that essentially reversed the effects of the Supreme Court decision had opposite results: firms in high-growth industries gained and firms in low-growth industries lost significantly. We interpret these results as implying that “one-size-fits-all” models represent inadequate solutions to the corporate governance problem.

Our results can also help shed light on the economic role of courts and regulation. A large literature in law and economics has pointed out that judge-made law can on average improve the efficiency of Common Law over time, even if individual judicial decisions sometime stem from judicial objectives other than maximizing efficiency. In some cases, though, the idiosyncratic judicial overruling of certain legal precedents can make the legal system steer away from the efficient path (Gennaioli and Shleifer (2007)). In these circumstances, regulation may be needed to step in and restore stability in the legal system.

The Smith v. Van Gorkom Supreme Court decision and the following Section 102(b)7 regulation provide an illustration of these and related issues. In Smith v. Van Gorkom, the Supreme Court overruled the prevalent legal interpretation of the business judgment rule by imposing personal liability on directors. While this decision was beneficial for firms in low growth industries, this decision had several adverse effects, most notably the stifling of growth in industries with high growth opportunities. More important, though, while the decision was on a specific takeover case, it generated substantial uncertainty as to the exact content of the changing Delaware Supreme Court’s view of the business judgment rule, with the potential to have a long-lasting negative effect on the economy. Against this backdrop of legal uncertainty, the Delaware legislature stepped in with Section 102(b)7 to undo much of the effects of Smith v. Van Gorkom.

In sum, our results are also consistent with the view that regulation remedies the failure of courts to solve contract and tort disputes cheaply, predictably, and impartially (Shleifer (2010)). In addition, our results show that, by doing so, regulation may also generate significant costs as some firms are set to lose when the same regulation is applied to a large and heterogeneous set of firms. The welfare implications of these issues are an exciting topic for future research.

The full paper is available for download here.

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