Judging Close Corporations in the Age of Statutes, 70 Washington University Law Quarterly 365 (1992)
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TABLE OF CONTENTS

INTRODUCTION .............................................................. 366

I. REVENUE INELASTICITY CONCERNING CLOSE CORPORATION LAW .................. 372
A. Dominance of Domestic Domicile: Expenses Disproportionate to Any Advantages Gained ..... 374
1. Additional Costs of Foreign Incorporation .............................. 374
2. The Limited Advantages of Foreign Incorporation ........................ 375
3. The Relative Insignificance of Close Corporation Revenues .............. 376

II. UNDERMINING THE IMMUTABLE REQUIREMENT THAT OWNERSHIP AND CONTROL BE SEPARATED: JUDICIAL ENFORCEMENT OF SHAREHOLDER CONTROL AGREEMENTS .... 378
A. The Immutable Separation: Herein McQuade v. Stoneham ................... 378
B. Limited Nullification and the Statutory Response: Herein Clark v. Dodge 380
C. Expanded Nullification in Galler and Zion .............................. 383

III. LEGISLATIVE OVERSIGHT OF EQUITABLE REMEDIES FOR OPPRESSION ........... 388

CONCLUSION ................................................................ 395
INTRODUCTION

This Article examines the interaction between courts and legislatures in developing the law that governs close corporations. Much has been written analyzing whether corporate statutes are efficient. Others have examined whether individual areas of corporate common law promote efficiency. I hope to gain a new purchase on these issues by examining the interplay between these two sources of corporate law. A crude goal of this Article is to begin an argument among three of the leading academic judges in the United States, who (listed in alphabetical order) are: the Honorable Frank Easterbrook, Richard Posner, and Ralph Winter.

At this crude level, the idea is fairly straightforward. Judge Posner has suggested that common-law rules will tend to be efficient. While Posner has not directly applied this theory to the common law of corporations, there is nothing in Posner's voluminous writings (that I have been able to find) that would indicate that corporate common law should be an exception to his general rule.

Judges Winter and Easterbrook, on the other hand, have suggested that corporate statutes will tend to announce efficient law. This of course is the "race to the top" thesis--that competition among legislatures for charter revenues will promote laws that maximize the shareholders' value (and hence corporate value, because shareholders hold residual claims on the corporate assets). The "race to the top" theory responded to early theories of Professor William Cary and Justice Brandeis, which suggested that the competition among states engendered a "race to the bottom." A great deal of academic writing has sought to evaluate whether state legislatures are engaged in a race to the top or bottom. Some articles have analyzed the substantive content of particular rules to assess whether statutory rules are consistent with the efficient rules derived from economic theory. Other articles have empirically tested whether businesses that incorporate in Delaware--the undisputed leader of the race -- have higher or lower returns. It is striking that law-and-economics scholars have argued that efficient legal rules can be generated by two powerful theories, yet to date no one has compared the relative efficiency of the two theoretical engines themselves.

This Article begins to provide this comparison. By examining how courts and legislatures react to each other's rules, I hope to gain insights into the efficiency of the law. At a very basic level, the three judges cannot be correct simultaneously if we see courts and legislatures fight with each other. If both the common law and statutory law of corporations are efficient, then we would not expect to observe such institutional tensions. These tensions might take two forms: (1) statutes might be drafted to overrule past judicial decisions and, prospectively, to preempt courts' common-lawmaking power; and (2) court decisions might explicitly or implicitly nullify statutory intent.

The existence of either type of tension is evidence against the proposition that the two efficiency theories are both correct. Indeed, the very existence of a statutory race is itself some evidence that the common law was not getting the job done. If, to use Professor Romano's metaphor, the common-law legal product were being efficiently produced, there would be no need for states to legislate. Moreover, if the common law were being efficiently produced in all jurisdictions--as Posner's theory suggests it is in other substantive areas--there would be nothing for individual states to race over, because there would be no legislative opportunity to become more red than the common law rose. Of course, for Posner's common-law efficiency theory to stand, corporate common-law precedents must also change at an efficient speed. There must be an efficient rate of product innovation. But this is no more (or less) true in the corporate context than in the other areas of common law in which Posner has waived the efficiency banner.

Evidence of judicial and/or legislative nullification, however, cannot--without more--tell who is wrong. Courts and legislatures might disagree for three possible reasons:
(1) The common law is inefficient (i.e., Posner is wrong; Winter and Easterbrook are right). Under this scenario, a "race to the top" would drive legislators to overturn inefficient rules; or
(2) Statutory law is inefficient (i.e., Posner is right; Winter and Easterbrook are wrong). Under this scenario, a "race to the bottom" would drive legislators to overturn efficient common-law rules; or
(3) Both sources of law are inefficient (i.e., all three judges are wrong). Under this scenario, both judge-made and legislature-made law deviate from efficiency, but deviate in different ways--leading legislators to insist (via legislative supremacy) on their brand of inefficiency.

This analysis of "nullification" provides only a single-tailed test of the hypothesis that both the common and statutory law are efficient. Thus, even if courts and legislators never disagreed, it would not prove that both sources of law were efficient. Such evidence could be equally consistent, for example, with the hypothesis that judges join the legislators in racing to the bottom.

This indeed was Professor Cary's original analysis of Delaware (in which he stressed the close identity of interest between judges and members of the Delaware legislature).

While both efficiency theories have provided (and continue to provide) an illuminating benchmark, many scholars believe that the tendency toward efficiency is not strong enough for either to provide a very powerful tool for predicting the contours of any individual legal rule. For these scholars at least, it comes as no surprise that courts and legislatures sometimes disagree. Yet I would argue that an analysis of the judicial and legislative interactions can do more than simply disprove the straw-person theory that both judicial and statutory corporate rules are at all times efficient.

The larger goals of this Article are two-fold. First, I hope to provide a more subtle theory about the situations in which each institution is likely to take the leading role in shaping a particular area of corporate law. Second, I hope to show that the forces that lead to judicial or legislative dominance can also inform our judgement about whether this particular piece of corporate law enhances social welfare. The most important framing force that determines the lawmaking roles of courts and legislatures is the principle of legislative supremacy: when the institutions disagree, the legislature wins.

Yet the ability and desire of legislators to constrain common-law courts--either ex ante or ex post--will often depend on other structural and contextual features that limit the legislators' efficacy in monitoring their judicial agent. Courts also appreciate these structural limitations and are likely to follow their common-law instincts when there is less effective legislative supervision.

My specific thesis is that states competing for corporate charters do not focus on the laws governing close corporations. Because states' revenues are not particularly sensitive to the rules governing close corporations, state competition for close corporation charters will not be nearly as intense as for publicly held corporations. In passing the "modern" corporation statutes in the early years of this century, state legislatures did not have the needs of close corporations in mind. Courts, for example, were the first to see how the immutable statutory rules--especially those regarding shareholder control agreements--were poorly tailored to fit the governance of the close corporations.

As a result, judges have exerted a much greater influence on the law governing close corporations and, at times, have even shown a willingness to openly nullify inefficient corporate statutes. The nullification of certain Procrustean, immutable provisions by a few individual state courts not only initiated a dialogue with the legislatures of those states, but also conveyed information that motivated action by other state legislatures.

Legislatures reacted to these judicial innovations primarily by codifying the common- law rules. However, even absent competition for charter revenues, legislatures may be motivated to act on behalf of well-organized private groups, and at times close corporation statutes constrain common-law trends to reflect these private interests. In sum, legislative neglect of close corporations encouraged courts to alter rules that were Pareto inefficient.

The individual legislatures--not competing for the close corporations' charters--have not been averse to adopting Pareto superior rules, but in certain instances also have been willing to sacrifice general social welfare for local private interests.

As the title suggests, this Article also can be viewed as an application of the insights that my temporary dean, Guido Calabresi, originally formulated in his seminal work A Common Law for the Age of Statutes.

Calabresi argued that common-law courts should at times invalidate obsolete statutes that no longer served their initial function. My thesis that state legislatures do not actively compete for close corporation charters suggests that there would be greater legislative inertia to correct flawed close corporation rules and that judges may legitimately scrutinize these statutes more closely. The close corporation context also suggests that the Calabresian method not only may describe judicial behavior regarding desuetude, but also may comprehend aspects of statutory overbreadth when courts have a structural confidence that certain applications were unintended.

Outside of Delaware's Chancery Court, there are no special state courts for corporate issues, much less for close corporation litigation. This Article argues, however, that judges deciding close corporation issues act differently. Judges who normally would respect the strictures of legislative supremacy have been willing to flout constitutional legislation openly by nullifying successive generations of corporate statutes.

The Article is divided into three sections. The first Section details the structural reasons states are not likely to compete for close corporation charters. The remaining sections consider the role of courts and legislatures in shaping two changing areas in the law of close corporations. Section II analyzes the crucial role of courts in changing the immutable requirement that ownership and control be separated. In Section III, I discuss a variety of legislative responses to innovative judicial remedies for deadlock and oppression.


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