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Promoting Innovation: The Law of Publicly Traded Corporations

Fox, Merritt B.

Improving economic welfare requires that society’s scarce savings be allocated among proposed real investment projects in a way that appreciates the prospects of promising new innovations. Corporate and securities law help structure important elements of this process of allocation. This article sketches out an approach based upon a seemingly paradoxical analogy of a market economy’s overall finance process to the way a hierarchical organization gathers and processes relevant bits of information dispersed among many individuals in order to make decisions. It thereby takes advantage of important thinking in communications and organizational theory about how to make organizations sensitive to the potentialities of new information and ideas.

The analysis suggests that established firms should pay out a relatively high portion of their cash flows. There should be a substantial venture capital sector and an active market for IPOs. Primary and secondary market prices should be relatively accurate. Incumbent managers of established firms should be judged in part by the medium term share price performance of their firms and poor performers should be under threat of replacement.

A comparison of four moments in economic history—the United States in the 1970s and 1980s, Japan since 1995, continental Europe since the 1995, and the United States since the 1995—supports these conclusions. The United States since 1995, relative to the other three moments in economic history, has had the least capital deepening and the fastest rate of growth in productivity per hour worked. It has also had, relative to the other three moments, a finance system most closely resembling what is called for here.

Achieving such a system requires rigorous, effectively enforced securities disclosure and anti-fraud laws. Corporate law must leave poorly performing incumbent management vulnerable to removal by hostile tender offer, or shareholder or independent board vote. Share price based compensation must be legally practical. And there must be serious constraints on non-pro-rata distribution among shareholders of the wealth created by the firm.


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Capitalism and Society

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October 14, 2015