Legal Diversification

Diversification is the best protection investors have from the risks of capital investment. Modern portfolio theory requires that investors diversify their holdings by investing in firms whose financial returns are influenced by different factors. That has traditionally meant investing in firms in different industries. The object is to identify the factors that could cause a firm’s return to vary from what is expected and to invest in firms that differ with regard to those elements of risk. By employing this investment strategy, investors can “diversify away” firm-specific risks.

In my forthcoming Essay, Legal Diversification, I introduce a new dimension along which investors can diversify. “Legal diversification” is an investment strategy whereby investors purchase securities governed by different legal rules in order to diversify away the risk that any one set of legal rules will fail to adequately limit the agency costs of business management. An investor may hold a diversified portfolio of stocks in different kinds of public corporations, but that portfolio would not necessarily be legally diversified. A portfolio would be legally diversified if it contained various kinds of securities issued by privately held limited liability companies, public corporations, emerging growth companies, and various derivatives. By holding a diversified portfolio of investments in firms and securities governed by different legal rules, investors can enjoy some protection from the failures of a particular legal regime while also sampling the benefits more successful regimes offer.

One of the most significant risks investors confront is the risk that those managing firms will make poor decisions or appropriate the firm’s capital to personal use. These agency costs are governed by different legal rules depending on the type of business form the firm adopts or the kind of securities it issues. Investors can use the applicable legal rules to discipline managers, to seek a remedy when their investments are lost, and to obtain information about the firm or its securities to make informed decisions about whether to invest and how much to pay. But if those legal rules are inadequate, investors’ rights in the firm are less valuable. Legal rules influence a firm’s ability to raise capital and the costs of that capital. Because firms’ returns can vary from the expected return differently according to the legal rules they have adopted to minimize agency costs, that is, according to the different risks of loss their particular agency costs present, those legal rules are a useful dimension along which investors can diversify.

Legal rules influence investment returns because agency costs can affect the risk-adjusted return of a particular investment. If managers make poor decisions or misappropriate the firm’s funds, investors are harmed if they have no legal recourse or an insufficient remedy or if the other consequences for the misbehavior are not sufficient to deter it. Managers may be able to systematically exploit a loophole in a particular set of legal rules or a legal rule may have unintended consequences or create perverse incentives. For example, options compensation has been an experiment in aligning managers’ interests with shareholders in order to limit agency costs. Now, many scholars argue that it resulted in inefficient risk-taking by executives to the detriment of our economy. In order to be protected from the risks of each legal rule’s failure to prevent or redress harms resulting from agency costs, but also to take advantage of the benefits of each legal regime, investors should diversify their investments among the various legal rules governing businesses.

The legal diversification I advocate is distinct from the regulatory competition essential to law markets. The goal of legal diversification is not to find the one set of rules that will be best for all firms. Rather, legal diversification relies on the experimentation associated with legal diversity and encourages investors to build portfolios of investments that sample a variety of legal regimes. Firms subject to different legal rules present different kinds and degrees of agency cost even if they are otherwise very similar. Legal diversification demands, for example, not only that we have a number of different LLC statutes, but that we maintain a population of private LLCs next to, and distinct from, a population of public corporations. We should continue to explore better ways of protecting investors from agency costs and investing in the more promising mechanisms of monitoring management. Allowing firms to move between governance forms and securities rules as their circumstances change allows companies and investors alike to find the best ways to strike the right balance of minimizing agency costs and raising capital over time. It is a diversification that leads to better law and investment outcomes not by forcing regulators to compete to discover the optimal business form or governance rules, but by finding yet another way to keep investors and our legal system from putting all of their eggs in one (potentially flawed) basket. To that end, legal diversification complements to a relatively new trend in the literature that argues that the financial markets may be more vulnerable to systemic risk if all financial firms are forced to comply with identical regulations. Diversity is valuable and an important mechanism for protecting investors from the consequences of flawed, or ineffective, legal rules as our legal system adapts to our changing needs.

The full essay is available for download here.