1 Theory of Law and Corporate Governance Thomas C. Heller Stanford Law School December 2001

1

Theory of Law and Corporate Theory of Law and Corporate GovernanceGovernance

Thomas C. HellerStanford Law SchoolDecember 2001

2

Levels of DiscussionLevels of Discussion

1. Legal Traditions and Corporate Governance2. The Wave of Corporate Governance Reform: Roles, Causes and Effects3. The Rule of Law and Economic Growth

3

Main Points Main Points

1. Law and legal traditions are not exogenous to governance

2. Law is an element of a wider ecology of Political Economy

3. Exit (competition), not voice (politics), dominates effective corporate governance

4. State Centered and Market Centered Political Economies differ in both the domain and mechanisms of policy

5. State Centered Systems Have Varying Growth Records6. Current instabilities in political economies have resulted

in widespread concerns with corporate governance, but less focus on complementary institutional reform

4

Competing accounts of causation in corporate Competing accounts of causation in corporate governace governace

A. Law Corporate Governance Financial MarketsEconomic Growth

B. Political Economy Effectiveness of Policy 1. Law2. Corporate Governance3. Financial Concentration Growth?

5

EcologyEcology 11

Outsider CorporateOutsider CorporateGovernanceGovernance

Legal 1

Political 1

Economic 1

Entry/Exit/Change 1

Ecology 2

Insider CorporateGovernance

Legal 2

Political 2

Economic 2

Entry/Exit/Change 2

Locus of Policy 1

Compensation/Duty 1

Finance 1

Industrial Organization 1

Locus of Policy 2

Compensation/Duty 2

Finance 2

Industrial Organization 2

Political Economy

Economic Growth

Legal CausationPolitical Economic Causation

6

Outline of Argument IOutline of Argument I

A. The Rule of Law, including corporate governance, stands in a complex relation to economic development

B. The civil or common law tradition of a nation does not determine its potential for better corporate governance

C. The diverse portfolio of corporate governance mechanisms have varying fit with different problems of firm performance

D. Significant changes in US corporate governance have been driven importantly by reforms in capital markets and finance

7

Outline of Argument IIOutline of Argument II

E. Alternative patterns of corporate governance track national patterns of of state or market centered political economy

F. State centered political economies vary in the way in which they organize common features including policy monitoring, financial repression, and policy compensation

G. Different state centered political economies have produced a wide range of economic growth, but are experiencing reform pressures reflecting financial, technological, legal and economic factors

H. Corporate governance reform in many systems may often be problematic due to a lack of complementary legal reforms

8

Corporate Governance and the Rule of LawCorporate Governance and the Rule of Law

A. There are multiple levels of the Rule of Law in relation to economic growth

B. All modern political economies require laws that encourage complex contracts (Weber) and credible commitment (North) to protect investment returns

C. Modern economies vary in their organization of competition and regulation legal institutions (state centered and market centered economies) that create and correct markets

D. More recent hypotheses of corporate governance and intellectual property specify in greater detail a theory of property rights and its connections to economic growth

9

I. Theory of Law and Corporate Governance: I. Theory of Law and Corporate Governance: Standard ArgumentStandard Argument

A. There are agency problems between external (public) investors and corporate insiders (managers, controlling shareholders)

B. Law can, in theory, solve the agency problems and allow the development of external capital markets

C. Broad external capital markets are a key to economic growth

D. Common law better protects external investors and solve the agency problems than does Civil law (substantive rules and judicial activism)

E. Adherence to legal traditions is exogenous to the corporate governance issue

10

II. My Critique in Questions II. My Critique in Questions

A. What is the role of legal traditions as causes of the profile of a country’s portfolio of corporate governance instruments? (LAW)

B. Which instruments within the corporate governance portfolio matter in solving the agency problems? (SELECTIVITY)

C. Are broad external (public) capital markets (so far) adequate explanations of when countries will sustain economic growth? (ECOLOGY)

11

II. Questions (continued)II. Questions (continued)1. Common law superiority is attributed to a tradition of activist

judges alienated from the state (as opposed to Civil Law tradiitons that demand passive and literalist judges)

2. If civil law is literal/passive, why not contract (including the importation of other states’ laws by contract) to needed protection?A. Is there weak enforcement in generalB. If weak, why would property rights (CG) reform or regulatory complements be more effective?C. Selective passivity needed, but how explained by law alone?

2. If active judges, why do they use their discretion to favor outside vs. inside investors?A. judicial opposition to state does not equal opposition to insiders B. insiders must be identified with state whose exploitation they resist by some supplementary political economy propositions

3. But selective passivity and identification of corporate insiders with the state require a richer account of both law and political economy of state-firm relations than is offered and raise issues of legal causation

12

III. Alternative AnswersIII. Alternative Answers

A. Legal traditions: Where the law does not function effectively to foster broad public capital markets and outsider based corporate governance, it is not because its origin is in an exogenously determined civil or common law tradition

B. Effective instruments: Where the law does function effectively to support corporate governance that protects public shareholders and foster broad capital markets, it is because it is one element in a market centered political economy characterized by a mutually reinforcing ecology of institutions that includes wide-ranging, accessible judicial governance, independent regulatory agencies of delimited scope, and competitive capital and product markets.

C. Cause of growth: Both market centered and some state centered political economies-- the latter with more comprehensive policy domains and different patterns of judicial and administrative institutions and corporate governance-- have been associated with sustained economic growth.

13

IV. Political Economy as the Effective Cause of IV. Political Economy as the Effective Cause of Law and Economic GrowthLaw and Economic Growth

A. The concept of legal families is not coherent nor useful in explaining patterns of corporate governance (formality, statutory, complexity of practice)

B. Effective cause in economic law runs from political economy to law

C. Statistical results from selectivity, formality, grouping by legal family, and limits of state centered model

D. Market centered systems, with a characteristic pattern of corporate governance with broad public capital markets, are an exceptional type of political economy in need of specific explanation

E. Varieties of state centered systems, with an alternative pattern of insider dominated corporate governance, constitute the better historical baseline and have variable economic performance

14

V. Law as CauseV. Law as Cause

A. Can we accept the hypothesized connection of Civil Law (substantive rules, procedure, judicial practices) to public markets and growth and the suggestion that legal traditions are exogenous to the structure of corporate governance?

B. Hybrids/Classifications1. Japan and statutory law (Glass-Steagall, labor law,

competition)2. India and colonialism- dual system of courts and

regulation (common law [Benthamite Civil Codes], rule of law, relief in courts, motions practice complex, high courts-low courts)

3. US (civil jury/discovery) vs. UK (Benthamite); federalism 4. Holland (corporatist) vs. France (etatiste)5. Latin American legal systems as layers of traditional,

European civil codes, and United States public and constitutional law

15

V. Law as Cause (continues)V. Law as Cause (continues)

C. Formalism1. Latin America as no compliance, leading edge,

archaeology2. Effective federalism and functional fragmentation

(China)3. Private strategies as counter-strategy4. formality of shareholder suits with up front fees and

lawyer supplies in Japan (vs. contingency in US) or Chinese Board of Directors or one share-one vote (with state control)

5. discovery in civil procedure (decentralized monitoring) in Europe and US, but in Japan in bankruptcy and Korea criminal

6. Rule of Law index as proxy for judicial enforcementa. certainty and the US civil jury (punitive damages)b. German active judgingc. French restrictive interpretive formalism is selective

16


D. Civil Law (what do we denote by Civil law?)1. elements

a. genetics (family)b. legal theoryc. canons of authorityd. institutions (courts, procedures)e. substantive rules and practicesf. domain (e.g. administrative law)

2. Core of civil law in legal science, genetics, authority—none of which are concerned with corporate governancea. what is characterized by corporate governance

literature as civil law is not legal science, but statute and civil procedure that derive later from a resisted state administration

17


3. The legal rules and practices associated with the civil law tradition that characterize its corporate governance are better understood as 19th century attributes caused by state centered political economy (European modernity), are not exogenous to governance, and are more widely spread than civil lawa. thick statutory law (e.g. capital requirements)

1) the code is in its structure an implicit liberal constitution through its (natural) subjective categories

2) interjection of statutory law was resisted as the institutionalization of administrative state power

b. wide administrative domain (forms of rule)1) administrative law as precedential and domain

bounding with high recognized discretion

18


c. stakeholder governance with broad standards (not rules) recognized (corporatism, pillarization, industry associations

d. civil procedure and interpretative formalism (e.g. legal duty or conflicts) as cession to state administration1) French distrust of judiciary and legal science

ideal of certainty2) Continental criminal procedure reflects

extension of administrative state3) selective use of restrictive interpretation 4) Civil procedure with restricted access and

procedure a) Low judicialization consistent with high

administrative domain on in governance b) Channeling by courts to administration

5) central administration of courts

19


4. European modernity (see below) built of:a. administered social solidarityb. pervasive administration (forms of rule)c. establishment delegation

5. Spread through colonial administration (civil and common law metropoles)

6. Developmentalisnm and installed bases7. Economic law as a dependent variable

20

VI. Corporate Governance as CauseVI. Corporate Governance as Cause

A. Selectivity1. Portfolio of mechanisms for governance

a. Inside politicalb. Legalc. external politics/regulationd. economice. sociological/cultural

21

VI. Corporate Governance as Cause VI. Corporate Governance as Cause (continues)(continues)

2. Fitness of non-economic remedies to problems of external market (public shareholder) protectiona. agency problem of manager controlb. agency problem of blockholder (control

shareholder) controlc. Problems of corporate performance (free cash,

below potential, industry underperformance, bankruptcy, theft, scandal)

d. effectiveness1) Unfit by costs or institutional capacity (theft or

error?; bankruptcy or free cash?)2) Unfit by limited transactions3) Fit for one goal at cost to another (blockholding

controls managers at price of its possible abuse)

22

VI. Corporate Governance as Cause VI. Corporate Governance as Cause (continues)(continues)

3. Unselected in LLSVa. Board performance, composition, standards,

committeesb. Legal remedies and procedures (ROL index

inadequate)c. Entry/exit/change regulationd. Co-determination, works council, labor political

power (especially Germany, Holland and Scandanavia)

e. All economic controlsf. Focus only on equity (shares) with debt and bail

outs

23

VI. Corporate Governance as Cause VI. Corporate Governance as Cause (continues) (continues)

B. Economic growth in the US1. US sequence

a. bank limitations, external markets, professional managers

b. product market competitiveness (antitrust)c. Delaware (decentralized federalism) and judicial

governanced. NYSE rules precede securities acts of 33 and 34

(see Roe 585 on Berle-Means)e. Depression and war with alternative governancef. Post-war rent sharing systemg. Crisis without corporate governance controls in law

or politics (GM?)h. Growth of market for corporate control, information

technologies, and specialized financial instruments and institutions (pension funds)

2. US causal direction?

24

VII. Political Economy and the Firm as Locus of VII. Political Economy and the Firm as Locus of PolicyPolicy

A. Ecologies of corporate governance, finance, judiciary are endogenously and simultaneously developed

B. Need for control and capacity grows with domain scope 1. All systems have policy; question is how wide is domain and how made effective2. Modes of rule and regulation

A. Alternative patterns of governance 1. State centered systems

a. the firm as the locus of policy b. Legal concepts: organic, multi-valued theory of

firm)c. Insider (blockholder) corporate governanced. Financial repression and controle. labor as stakeholder in stabilized (closed)

marketsf. oligopolistic competition (dual markets,

industry associations)

25

VII. Political Economy and the Firm as Locus of VII. Political Economy and the Firm as Locus of Policy (continues)Policy (continues)

f. Low judicial capacity relative to administrative domain/capacity

g. often restricted product market competitionh. business socialization to public agency; thin line

between insiders and government officials (ENA)i. organization first boundaries j. social capital intensive organization k. Duty/compensation packagesl. firm/bureau/party tendency to rent seeking strategies,

imbalance in duty/compensation packages, variation in state centered systems along these dimensions1. Once state is rent creating, rational controllers pursue rent seeking strategies and corporate governance shifts2. Issue is less private exploitation of minority shareholders than public exploitation through rent seeking

26


2. Market centered patterna. single valued firm objective (nexus of contracts)b. anti-bank, financial diversificationc. public investor corporate governanced. labor as open market; local/firm unionization; low

transfers e. structural, decentralized monitoring competition

policyf. product market competitiong. high judicial domain with facilitated litigationh. industry specific subsidy (procurement)i. business school shareholder value socializationj. Low centralized judicial domaink. Externalized (from firm) and low policy domain

27


D. Baselines for explanation1. Always a balance of voice and exit2. Predominance of state centered systems over more

market centered equilibrium by installed base in contrast to accident contested and ambiguous compromise in UK, and settler colony revolt

3. Evolution of state centered toward efficiency through competition, but modeling on state centered European modernity

28


E. Roe distinguished1. I, like Roe, use political economy as a major cause of

corporate governance and growth2. I see social democracy as a variant of state centered

system, rather than an explanation in itself3. Roe misses relation between income inequality (Gini)

and concentrated ownership, which typifies South Africa, Brazil and Thailand as much as it does the US)

4. Rightward movement hypothesis is inadequate explanation of shift to market centered model

5. No emphasis on duty-compensation package in state centered model (or its variation)

29

VIII. Variation in state centered systemsVIII. Variation in state centered systems

A. State-interest group relationshipB. Balance between interestsC. Organization within interestsD. Policies selectedE. Monitoring strategies/capacitiesF. Duty/compensation

1. Balance2. Techniques or instruments

30

VIII. Variations in State Centered Systems VIII. Variations in State Centered Systems (continues)(continues)

A. Variation by economic development (compensation/duty package)1. Traditional authoritarian or empire (non-

developmental)2. Colonial empire (ex-colonial creolization)3. Mercantilism4. Socialism5. Export enclave developmental6. Asian developmental state (Japan)

31


7. European modernity sequencea. Installed base (state/establishment as residual

organization)b. Romantic nationalism (Savigny)c. Developmental state (state led late

industrialization)d. Welfare statee. Contested liberal counter-thrust

1) France (see Duguit)2) Zollverein and Prussia, Bavaria legal conflict in

code formation3) Pre-WWI liberal/imperial dualism

f. authoritarian/totalitarian stateg. post-war countercurrents

1) Rechtstaat2) European Union 1992 agenda

32


8. European modernity patterna. administered social solidarity

1) Asian direct ethnicity2) Double differentiation (post-Romantic)3) Consider example of German demography

a) German diaspora vs. refugees, guestworkers (non-immigration)

b) Internal administrative controls on residencec) Minimal number and character of immigrants

for social securityd) Non-ethnics and loss of solidarity with

feedback to welfare state reformb. pervasive administration and national (genetic)

forms of rulec. establishment and delegation

33


B. Variation by national type (duty/compensation balance and type varies)1. France (etatisme)

a. public firms, noyau dur, ENA, regulatory exceptionalism, public banks, pyramids

2. Germany (corporatism)a. industrial associations, house banks, empowered labor,

corporatist welfare, cartels and pre-War history to BKA, stakeholder governance to 1880s

3. Japana. regulatory cartels, convoys and cartels for social risk,

Calder compensation, firm based labor and lifetime employment, main bank system

4. Malaysiaa. export enclaves, local ethnic rents from monopoly firms

5. Indiaa. license raj, high level courts/PIL, family dominated non-

state firms, state monopolies, development banksb. South Indian imported law in IT sector

34


C. Variation over time1. Pre-modern with no market or penetrated hierarchy2. Installed corporatist bases and social stability3. Early development coordination (entrepreneurship)4. Early modern experimentation (France, Japan)5. Craft, tacit knowledge and process in production (DQP

or flexible production)6. public goods and social norm creation (social capital)7. Network costs: rent shifts through bureaucratic

rigidity (Aoki)8. rapprochement and retreat

35

VIII Variations in State Centered Systems VIII Variations in State Centered Systems (continues)(continues)

A. Are there patterns dividing successful and retarded growth in state centerd systems?1. State led (elite bureaucracies)2. Interest balance (inclusive labor)3. Export led policy4. Capital interests organized around penetrated insiders and nesting5. Balance and type of duty/compensation?6. Corruption averse

36

IX. Governance Changes and the Limits of IX. Governance Changes and the Limits of State Centered SystemsState Centered Systems

A. Sources of governance reforms1. state capacity weakened through globalization, regionalization2. inefficiencies of bureaucratic management of complex systems3. cost of information (market) falls relative to hierarchy

B. Limits of state centered model1. political lock-in of optimal public roles

a. fiscal burdens of public support commitments2. information heavy innovation in short cycle3. Learning, flexibility and relative advantage in instability

C. Financial liberalization in reform process:1. Independent reasons in EU, US, East Asian and Basle2. If financial repression key, relaxation is destabilizing3. Norm diffusion for economic reorganization in elite bureaucracies4. New financial agents motivate corporate governance wave5. Stranded assets and uneven reforms

37

IX. Governance changes (continues)IX. Governance changes (continues)

Question is not whether your corporate governance or your judiciary or your administrative law works, but whether your system of governance has particular benefits or disabilities1. Emphasis on historical trajectories2. Costs of governance shifts3. Corporate governance as leading edge of reforms4. Political dynamics of asymmetric reform5. Complementary judicial reform is problematic6. Whatever the motivation for reform– what is the new landscape?

38

IX. Governance Changes and the Limits of IX. Governance Changes and the Limits of State Centered Systems (continues)State Centered Systems (continues)

A. Relative movement toward exit based systems from initial equilibrium

B. Governance reforms and public law substitutes1. independent regulator (plus tiers of self-regulating

bodies)2. complementary institutions 3. decentralized monitoring and procedures (judicial

capacity)4. Less likely in state centered system with rent potential

C. Governance and private/imported law substitutes

1. Flow of Weberian history (from familiars to monopoly public good)

2. Law as a hierarchical and public good3. Assets and ADR listings4. Reputation monitoring by institutional investors, market

intermediaries, underwriters

39

IX New governanceIX New governance

A. Asserted shift from formal rule to informal rule in new middle spaces

B. Voluntarism through informal networks, epistemic communities, and transnational organizations

C. Social investment for a retreating or more decentralized state

D. Legislative failure (social choice and monitoring losses) and the issue of democracy

E. Keys are domain, level of government (exit) and character of review

40

Present Present GovernanceGovernance11

Central Government

Local Government1. Parties2. Courts

Individual Actors(Persons, Firms) Voluntary Associations

Traditional Rule of Law Constitutes

Ad hoc Collaborations

41

Present GovernancePresent Governance22

Central Government

Individual Actors(Persons, Firms)

Business CorporatistAssociations

Social Establishment

AdministrationCentral Political Parties

Traditional Rule of Law Constitutes

42

New GovernanceNew Governance

Central Government

International RegimesHuman Rights

InternationalProfessional

Networks

Civil Society

Deliberative Democracy Devolution

Corporate Social Responsibility

NGO’s New EconomicActors1. Networks2. Institutional investors

ExpandedRule of LawConstitutes

Individual Actors(Persons, Firms) Voluntary AssociationsTraditional

Rule of Law Constitutes

43

Law, Economy, Democracy

Non-Democratic

I. Unstable

II. Stable

A. Traditional

B. Modernizing

1. Mercantile

2. Colonial

3. Socialist

Constitutional Democracy

I. Rent Driven State Centered

II. Competitive State Centered

III. Market Centered

A. Independent Regulation (Access, Review)

B. Decentralized (Local, Courts)

44

Law, Economy, DemocracyWeaknesses

Non-DemocraticI. Unstable 1. Political repression

II. Stable of independent innovation

A. Traditional 2. Expropriation or lack of

B. Modernizing long-term commitment

1. Mercantile 3. Rent creating (natural

2. Colonial resources)

3. Socialist

Constitutional DemocracyI. Rent Driven State Centered 1. Rent creation

II. Competitive State Centered 2. Policy monitoring

3. Exclusion to Entry

III. Market Centered 1. Policy ineffectuality

A. Independent Regulation 2. Lower domain

(Access, Review) 3. Development entrepreneur

B. Decentralized absence

(Local, Courts)

45

Law, Economy, DemocracyWeaknesses Strategic

Responses

Non-Democratic

I. Unstable 1. Political repression 1. Familiars

II. Stable of independent innovation 2. Cycles

A. Traditional 2. Expropriation or lack of 3. Leverage (repeat play)

B. Modernizing long-term commitment 4. Alliances

1. Mercantile 3. Rent creating (naturala. Political

2. Colonial resources b. Economic

3. Socialist 5. Corruption

Constitutional DemocracyI. Rent Driven State Centered 1. Rent creation 6. Privatization

2. Policy Monitoring 7. Import of law

II. Competitive State Centered 3. Exclusion to Entry 1. Administrative Inclusion

III. Market Centered 1. Policy ineffectuality 1. Excessive legal Exposure

A. Independent Regulation 2. Lower domain

(Access, Review) 3. Development entrepreneur

B. Decentralized absence

(Local, Courts)

46

Law, Economy, DemocracyWeaknesses Strategic Responses Elements

Non-Democratic

I. Unstable 1. Political repression 1. Familiars 1. Monopoly

II. Stable of independent innovation 2. Cycles 2. Dualism

A. Traditional 2. Expropriation or lack of 3. Leverage (repeat play) 3. Rule

B. Modernizing long-term commitment 4. Alliances

1. Mercantile 3. Rent creating (natural a. Political

2. Colonial resources b. Economic

3. Socialist 5. Corruption

Constitutional Democracy 1. Family/State Firms

I. Rent Driven State Centered 1. Rent creation 6. Privatization 2. Administrative

2. Policy Monitoring 7. Import of law Domain

II. Competitive State Centered 3. Exclusion to Entry 1. Administrative Inclusion 3. Oligopoly

4. Bank Finance

5. Shareholder Firms

III. Market Centered 1. Policy ineffectuality 1. Excessive legal Exposure 1. Public Markets

A. Independent Regulation 2. Lower domain 2. Shareholder Firms

(Access, Review) 3. Development entrepreneur 3. Judicial Domain

B. Decentralized absence 4. External Policy

(Local, Courts)

Documents

1 Theory of Law and Corporate Governance Thomas C. Heller Stanford Law School December 2001