Legal Diversification

I’ve just posted my latest paper, Legal Diversification, on SSRN. The paper starts from the premise that investors derive significant protection from the risks of capital investment by diversifying their holdings. By the same token, it seems to me that investors may be able to realize benefits from the broad diversity of corporate and securities laws governing investment opportunities.

The Essay introduces a new dimension of diversification for investors: legal diversification. Legal diversification of investment means building a portfolio of securities that are governed by a variety of legal rules. Legal diversification protects investors from the risk that a particular method of minimizing agency costs will prove ineffective and allows investors to own securities in a variety of firms, with each security governed by the most efficient set of legal rules given the circumstances of the investment. Diversification of investment by legal rules is possible because of the varied menu of legal rules firms can choose from when organizing and raising capital. The most recent addition to the securities laws, the JOBS Act, may compromise the diversity of legal rules that protects investors by pushing even more firms toward organizing as public corporations, thereby threatening to curtail or eliminate the variety that allows effective diversification.

The Essay makes several contributions to the literature. By introducing legal diversification, it reveals a new understanding of how investors, issuers, and society can benefit from maintaining a variety of legal rules to govern investment in businesses. The corporate law scholarship has long advocated preserving a variety of rules under which firms can organize, but it has yet to consider how investors can take advantage of that variety to protect themselves before market competition has revealed the “best” rules. Legal diversification also complements recent literature emphasizing the importance of diversity in financial regulation by highlighting another reason diversity of legal rules is important to healthy capital markets. Legal diversification fills gaps in the literature advocating regulatory diversity by offering an explanation for why that diversity is a valuable protection for investors and an indispensable mechanism for allowing firms to choose the most efficient legal rules to govern their organization and operation.

I’m still working on editing the draft, so would greatly appreciate any thoughts or comments you may have on the project.


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4 Responses

  1. Lawrence Cunningham says:

    Congrats on another pioneering paper and great placement.

    Sounds as if legal diversification is the flip-side, the positive side, of regulatory arbitrage, which got a bad name amid the 2008 financial crisis (and often amid crises that produce “bubble laws” that homogenize rather than maintain diversity).

    It will be interesting to see if investors would really follow this route in practice. They don’t tend to think about the differences you highlight very much and tend to believe that they can be contracted around (that corporate law, securities law, etc are “trivial” to recall an old phrase from a famous paper).

  2. Kelli Alces says:

    Thanks, Larry. I should add the comparison to regulatory arbitrage to the paper. Corporate and securities law may be flexible default rules, but I hope that flexibility is not mistaken for irrelevance. The choices parties make about what terms to use (or default rules to adopt) to govern their relationships still matter very much. I suppose I hope one consequence of the paper will be that investors realize they should pay more attention to the differences between default rules and why it is important to have a diverse menu of defaults to choose among.

  3. Miriam Cherry says:

    Not sure (from practical standpoint) that investors think that much about the legal differences but I look forward to reading the essay…

  4. Kelli says:

    Thanks, Miriam. Investors certainly consider whether a firm is public or private when deciding how to invest and that is a legal difference. Of course, they may not consider differences in business or governance form, but the essay does not argue that they do, rather, that they should. It is a normative, not positive, thesis.