Islands of conscious power: law, norms, and the self-governing corporation.

AuthorRock, Edward B.
PositionSymposium on Norms and Corporate Law

This Article provides a theory of the relation between legal and nonlegally enforceable rules and standards in the corporation, and then uses that theory to analyze a variety of prominent features of corporate law. In the first Part, we draw on recent developments in the theory of the firm to identify key problems facing participants in the firm. In developing this approach, we combine the "property rights" strand in the theory of the firm with the transaction cost approach. From this perspective, the main issue is solving the related problems of coordinating activities, choosing the firm's assets, and developing appropriate incentives for specific investments. In Part II, we argue that the firm so understood will largely be governed through "norms," by which we mean "nonlegally enforceable rules and standards" ("NLERS"). Indeed, the raison d'etre of firms is to replace legal/contractual governance of relations with NLERS. Using this framework, in Part III we analyze the duty of loyalty. In Part IV, we analyze the duty of care and the business judgment rule, along with a variety of other puzzling features of corporate law.

From our perspective, corporate law can be understood as a remarkably sophisticated mechanism for facilitating governance by NLERS. Centralized management is used to determine the assets over which the corporation must have residual rights of control and to develop a governance structure for protecting the match-investments of insiders in these assets. Legal rules provide the default settings through which centralized management operate and prohibit non-pro-rata distributions (a combination of ex ante rules and the ex post duty of loyalty), which pushes controlling shareholders to maximize the value of the firm.

Having established an "incentive compatible" legal form that facilitates NLERS governance, the law must be careful not to undermine that governance by midstream interference. Here, the duty of care and the business judgment rule are critical. The business judgment rule acts as a jurisdictional rule that facilitates a self-governing NLERS relationship by preventing parties from turning to third-party adjudicators. As such, it plays a role very similar to the role of the employment-at-will doctrine in employment law, and for the same reasons. This analysis provides an explanation for why the duty of care, despite its appearance, does not function as a negligence rule, and why liability for directorial malpractice is so much less common than liability for other forms of professional malpractice, such as legal or medical malpractice.

The principal contexts in which the business judgment rule does not apply are situations in which NLERS governance breaks down, generally because of last period temptations to defect. The difference in the ability of NLERS to govern midstream and endgames provides the key to understanding a variety of corporate law puzzles. These puzzles include: the asymmetry between the legal standards governing purchases and sales of assets; the asymmetry between judicial review over decisions to resist all bids for control ("just say no") versus the review of sales of control; and the demand requirement in derivative litigation.

INTRODUCTION

Economic investigation of the nature of the firm is often traced to Coase's classic 1937 article, The Nature of the Firm.(1) In it, Coase quotes the observation of D.H. Robertson that we find "`islands of conscious power in this ocean of unconscious co-operation [that is, the market] like lumps of butter coagulating in a pail of buttermilk.'"(2) Coase then famously asks, "But in view of the fact that it is usually argued that coordination will be done by the price mechanism, why is such organization necessary? Why are there these `islands of conscious power'?"(3)

Since Coase, economists have provided a great variety of theories that try to answer Coase's question, theories that are called "theories of the firm." A theory of the firm, by describing why we have firms, what goes on inside firms, and what are the boundaries of the firm, helps us identify the key problems that parties to the firm need to solve. A theory of the firm can also help us figure out what problems the parties are able to solve themselves, how they solve them, and the role the law plays in facilitating or interfering with solutions.

In this Article, we draw on recent developments in the theory of the firm and on the "law and norms" literature to explicate the core organizing role of centralized management and the facilitating role played by corporate law.(4) Our central claim is the following: according to an emerging consensus among theorists of the firm, the raison d'etre of firms is to replace legal governance of relations with nonlegally enforceable governance mechanisms (what are sometimes called "norms"). Corporate law, we argue, should be understood as protecting and perfecting this choice. We show that understanding corporate law in this way allows one to explain a variety of features of corporate law that seem quite peculiar from the more traditional agency theory. These features include: the content and scope of the duty of loyalty; the fact that the duty of care, despite appearances, is not a negligence rule; the asymmetries in legal regulation of midstream versus endgame decisions, including "just saying no" and sales of divisions versus sales of companies; and the demand requirement in derivative suits. Our claim is not that agency costs are unimportant; indeed, in certain areas such as the duty of loyalty, agency concerns may be central. Rather, we argue, agency costs are not the only thing that matters in corporate law and, standing alone, are either unable to explain major areas of corporate law jurisprudence or are even misleading.

In this Article, we do not try to show all the implications of the emerging theory of the firm for corporate law. Here, we primarily use it to understand the duty of care, the business judgment rule, and companion doctrines. In later papers we intend to extend our analysis to other areas, such as the standards governing defensive tactics adopted by management to fend off hostile tender offers and the rules governing when shareholder ratification is required.

Theories of the firm teach us that for firms to exist and thrive, they must figure out how to encourage and protect specific investment in tangible and intangible assets. In Part I, we discuss the incompleteness of the "nexus of contracting" theory of the firm and offer a synthesis of the "property rights" and "transaction cost" theories that now represent the most complete explanation for why firms exist, what determines the boundary between firms and markets, and how firms survive in competitive markets.

In Part II, we provide a bridge between the theory of the firm and the "norms" literature by arguing that the firm thus understood is a context in which governance will primarily be through "norms," by which we mean nonlegally enforceable rules and standards ("NLERS").

In Parts III and IV, we turn to corporate law and ask how corporate law helps solve the problems identified by the theories of the firm in Part I and how it facilitates the NLERS governance described in Part II. Using this perspective, we analyze the key features of corporate law including the default settings of the corporate form, the duty of loyalty, the duty of care and the business judgment rule, and the demand requirement in derivative suits. We also address a variety of puzzling asymmetries.

This approach casts a different light on the role and function of corporate law than the traditional agency cost approach. Viewed from this perspective, corporate law emerges as a remarkably sophisticated mechanism for facilitating self-governance by NLERS. Centralized management is used to determine the assets over which the corporation must have residual rights of control and to develop a governance structure for protecting the match-investments of insiders in these assets. Legal rules provide the default settings through which centralized management operate and prohibit non-pro-rata distributions (a combination of ex ante rules and the ex post duty of loyalty), which pushes controlling shareholders to maximize the value of the firm.

Having established an "incentive compatible" legal form within which governance is primarily by NLERS, the law must be careful not to undermine NLERS governance by midstream interference. Here, the duty of care and the business judgment rule are critical. The business judgment rule acts as a jurisdictional rule that facilitates a self governing NLERS relationship by preventing parties from turning to third-party adjudicators. As such, it plays a role very similar to the role of the employment-at-will doctrine in employment law and for the same reasons. The duty of care, despite looking like a typical legally enforceable standard of care, actually is best understood as an NLERS, with the business judgment rule assuring that enforcement is almost entirely nonlegal. This analysis explains why whole categories of cases are not brought (such as duty of care cases in response to disastrous mergers or investments), and why liability for directorial malpractice is so much less common than liability for other forms of professional malpractice, such as legal or medical. The principal situations in which the business judgment rule does not apply are situations in which NLERS governance breaks down, generally because of last period temptations to defect. Finally, it helps explain the very late appearance of the duty of care in Delaware law and the doctrinal tensions that continue to plague it.

In a sense, this Article is as much about what we do not see in corporate law as it is about what we see. That is, we are trying to understand both the cases that are brought and those that are not. This point is vital, as corporate lawyers are not primarily litigators. In many...

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