LEGAL & GOVERNANCE INSTITUTIONS

Richard Swedberg (2003) wrote that an economic sociology of law – “a sociological analysis of law’s role in economic life” – doesn’t yet exist.

• What should be the main task of an economic sociology of law – to show how society shapes legal institutions & their influence on the economy?

• Why isn’t the law and economics perspective – which uses the neoclassical rational actor model – sufficient for understanding these relationships?

• What historical shifts in legal theories of the firm have altered conceptions of corporate governance and shareholder control?

• How might corporate governance structures and practices be changed to foster greater stakeholder accountability and corporate social responsibility?

Weber on the LawWeber defined law as “externally guaranteed by the probability that physical or psychological coercion will be applied by a staff of people in order to bring about compliance or average violation.”

Weber linked three authority types to distinct legal systems:

Traditional authority: rule through customary laws

Charismatic authority: laws established through inspiration

Legal authority: rational law (legislative & administrative)

Medieval merchant courts held at fairs and markets adjudicated disputes. Lex mercatoria laid the foundations for modern capitalism’s many legal institutions, including international contracting & arbitration at the heart of globalized economy since the 1960s.

Legal Institutions of the Economy

A key task for economic sociology is to explain the emergence of legal institutions crucial to efficient functioning of capitalism.

• Private property rights – what is alienable?

• Inheritance of property across family generations

• Contracts – about property & employment rights

• Corporation as legal personality – limited liability

“If [corporate] directors are to become in effect trustees, in whose interests should they act? One answer is that they should become trustees for the interests of society as a whole.”

James Coleman (1990:578)

Law and Economics

• Positive L&E uses economic-efficiency analysis to predict the effects of alternative legal rules. For example, an L&E analysis of tort laws would contrast cost-benefit outcomes from applying a strict-liability rule vs. a negligence rule.• Normative L&E seeks to make policy recommendations based on the economic consequences of public policies.

Judge Richard Posner argued that a just decision should rearrange social conditions to maximize the social wealth of affected parties.

Pareto efficiency - a stringent legal exchange rule where one party can be made better-off, only if no other party is made worse-off

Kaldor-Hicks efficiency - a less-strict rule allowing exchanges that increase net social wealth, perhaps by making a side payment to any injured party

What recent legal decisions exemplify efficiency principles? Why did Posner abandon his mediation of the 1999 Microsoft antitrust suit?

Law and economics, at U of Chicago, uses neoclassical economics to analyze legal problems, including regulation and corporate governance.

Coase’s Theorem

Coase’s example: If two radio stations initially interfere by broadcasting in the same frequency band, in absence of TC, that station able to profit most has an incentive to pay the other station not to interfere. But, because transaction costs can’t be neglected, governmental decisions on initially allocating property rights matter a great deal.

Ronald Coase (1960) analyzed the economic efficiency solution for allocating property rights in externality disputes, such as air pollution.

An externality occurs whenever a decision creates costs (or benefits) to stakeholders other than the decision-maker. In absence of transaction costs, all governmental allocations of property are equally efficient, because interested parties will bargain privately to correct any externalities. But, a corollary implies that, in the presence of transaction costs, a government could minimize inefficiency by allocating the property initially to the party assigning it the highest utility.

Why is Coase’s Theorem unable to explain disputes about stray cattle damaging neighboring property in Shasta County (Ellickson 1991)?

Legal Theories of the FirmIn the 19th century, U.S. statutory and case law assigned legal private property rights to a business’ owners - its proprietors, partners, or a corporation’s shareholders (stock owners)

Natural entity theory of corporate governance treats firm as a “corporate personality” originating in the contractual relations between private individuals

Purchasing corporation’s equity (stock, shares) entitles a risk-taking shareholder to:

• dividends paid from any future company profits

• capital gains by re-selling shares in stock market

• “residual assets” if firm dissolves, after debtors paid

Why were legal theory & courts so slow to develop alternative theories about employee rights and consumer protection?

Corporate GovernanceToday’s legal theory treats the corporation as its stock owners’ private property. An elected board of directors supervises firm by setting strategy, appointing & monitoring top execs. Only goal of leaders is to maximize financial returns on shareholder investments.

Corporate executives’ sole responsibility to shareholders is “to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”

Milton Friedman. 1970. “The Social Responsibility of Business Is to Increase Its Profits” New York Times Magazine Sept. 13:33

Stakeholder theory asserts firms also have a social responsibility to serve the interests of nonowners.

“Business is permitted and encouraged by the law because it is of service to the community rather than because it is a source of profits to its owners.”

E. Merrick Dodd. 1932. “For Whom Are Corporate Managers Trustees?” Harvard Law Review 45:1145-1148.

Top Executives Take PowerDuring 20th century, widespread dilution of stock ownership enabled top executives to take de facto control of many large corporations (Berle & Means 1932 The Modern Corporation and Private Property)

Owner-management separation gave control over company assets & operations to executives often more motivated by power, prestige, job security than by shareholders’ short-term profit-maximization goals.

• Recommend a hand-picked candidate slate, no opponents

• Solicit shareholders’ proxy cards authorizing the execs to vote those shares

• SEC rules permit a firm to pay its execs’ election expenses

• Insurgents lack adequate campaign resources to fight & win proxy battles

Management control via board elections

Although shareholders elect directors, the top executives control access to the proxy machinery needed to win seats

Institutional Investors are RevoltingRecent institutional investor revolts have tried to make large corporations more accountable to their shareholders

Campaigns led by giant public pension funds (CalPERS, TIAA-CREF) facing a classic Exit-Voice dilemma: dumping their shares would depress stock prices for their pensioners

They forced some CEO ousters & policy reforms, which boosted company performances and thus raised share prices

Investors had mixed successes in reforming some badly mismanaged companies – GM, USAir, IBM, Time Warner

• Widely publicized “hit lists” of poorly performing firms

• Sponsored shareholder resolutions on annual proxy statements; e.g., required minimum directors’ shareholding

• “Relational investing” – pension fund managers directly cajole & jawbone execs into take different strategic actions

The Stakeholder ModelStakeholder theory: corporations should be socially responsible institutions managed in the public interest. Many organizational constituencies have interests other than maximizing firm profits.

FIRM

Political Groups

InvestorsGovernments

Suppliers Customers

Trade Associations

CommunitiesEmployees

(SOURCE: Donaldson, T. and L.E. Preston. 1995. “The Stakeholder Theory of the Corporation: Concepts, Evidence, and Implications.” Academy of Management Review 20:65-91.)

Who Holds a Stake?To identify stakeholders, R. Edward Freeman applied Immanuel Kant’s prohibition against treating persons as means, not as ends.

Which stakeholders are most impacted by the mill’s actions?Which stakeholders’ interests should have higher priority? How can stakeholders best participate in making these decision?

An Oregon sawmill plans to clearcut old-growth forests to boost shareholder profits. Unemployed loggers and truckers will benefit from new jobs. Towns will gain tax revenues from the new spending. Tourist trade will suffer from destruction of scenic vistas. Indians will lose salmon runs to polluted streams. How can & should stakeholder theory reconcile these conflicting interests?

“Property rights are not a license to ignore Kant’s principle of respect for persons. Hence, corporations and managers are ethically and morally responsible for the effects of their actions on others.”

(Freeman. 1984. Strategic Management: A Stakeholder Approach. Boston: Pitman.)

Corporate Social ResponsibilityCSR covers all the economic, legal, ethical & philanthropic expectations that societies have about business firm actions.

Beyond earning profits and obeying the law, should good corporate citizens make decisions & take actions emphasizing:

CSR is often depicted as desirable behavior because it satisfies

• Ethical & moral obligations – “It’s the right thing to do.”

• Enlightened self-interest – “Doing good is good for business.”

Social responsibility: obligations and accountability to society

Social responsiveness: proactive to changing social conditions

Social performance: achieve successful outcomes and results

How might the legal system change to promote more CSR?