The limited significance of norms for corporate governance.

• Jurisdiction: United States
• Author: Kahan, Marcel
• Date: 01 June 2001

INTRODUCTION

In organizing a symposium on norms and corporate law, one makes an implicit claim that the concept of norms is significant to our understanding of corporate law and the problems corporate law is meant to address. Unsurprisingly, the main organizers of this Symposium, Professors Rock and Wachter, advance the thesis that firms are largely governed by norms, and not by law.(1)

I am more skeptical about the relevance of norms to corporate law. Partly, my skepticism is related to the very concept of norms as used in the "law and norms" literature. Most contributors to that literature have their own (often itself ambiguous) definition of "norms," and many bemoan the fact that no agreed-upon definition of the term exists.(2) For example, Robert Ellickson, one of the norms pioneers, defines norms as rules that emanate from social forces, distinguishing them from personal ethics (internalized rules), contracts (rules imposed by second-party controllers), rules imposed by organizations, and laws (rules imposed by governments).(3) Eric Posner, in a contribution to an earlier symposium on norms, defines norms as rules that distinguish "desirable and undesirable behavior" and give "a third party the authority to punish a person who engages in the undesirable behavior."(4) Richard McAdams notes that norms refer to "informal social regularities that individuals feel obligated to follow because of an internalized sense of duty, because of a fear of external nonlegal sanctions, or both."(5) For Bob Cooter, by contrast, internalization by a large group of people is a necessary prerequisite for a norm.(6) Richard Posner and Eric Rasmusen regard as norms any social rule "that does not depend on government for either promulgation or enforcement."(7) Striking a similar vein, Ed Rock and Mike Wachter, in their invitation for and contribution to this Symposium, explain that norms mean "nonlegally enforceable rules and standards."(8) For Mel Eisenberg, norms include any behavioral patterns, regardless of whether they entail a sense of obligation and regardless of whether they are self-consciously adhered to.(9)

Since there appears to be no norm for the definition of "norms," the "norms" terminology does not add much conceptual clarity. Possibly, "law and normers" would be better off by jettisoning the term "norm" and instead using a set of different terms.(10) (The persistence of the "norms" terminology despite its conceptual ambiguity, however, suggests that "law and normers" obtain reputational or psychic benefits from participating in a "law and norms" movement.) In this respect, Rock and Wachter deserve applause for using the precise (if inelegant) acronym of NLERS to denote their concept of norms.(11)

My skepticism about the relevance of norms to corporate law, however, extends beyond the conceptual ambiguity of the term. Even well-defined renditions of the norms concept suffer from one of two shortcomings. In their wider definitions, "norms" include phenomena that are so heterogeneous that the term "norms" does not add a useful conceptual tool to their analysis. In particular, many of these wider definitions encompass socially created or enforced incentives as well as market-created structures that have long been analyzed in the traditional economics literature. In the narrower definitions, by contrast, norms tend to be only of limited significance for corporate governance.

Let me qualify my latter argument by stressing that it is context-specific. It is confined to the significance of norms in the "internal affairs" of a public corporation--that is, to the relationship between shareholders and managers--in the present-day United States. "Norms" may well be important in other contexts, such as property disputes in Shasta County,(12) labor relations,(13) safe sex education,(14) or economic transitions,(15) to corporate law in other countries,(16) or even to relations within closely held companies in the United States. But for an understanding of the internal affairs of present-day, U.S. public companies, norms have only a limited significance.

In Part I of this Article, I present a working definition of norms and sketch the role of law in the corporate structure. My definition of norms encompasses rules, other than legal duties, that are regularly followed due to either an external "punitive" sanction administered by a third party or a related internalized sense of obligation. Corporate law regulates the internal affairs of a corporation primarily by establishing a system of powers and only to a lesser extent by creating a system of duties. Necessarily, therefore, nonlegal factors (including, possibly, norms) affect how these powers are exercised.

Part II presents a framework for analyzing the role of norms in corporate governance. The principal structural aim of corporate law is the effective regulation of centralized management. Since centralized management is easily established--by giving a board of directors broad powers to act--the main focus of corporate governance is to establish an incentive structure bearing on corporate managers that assures that managers act in the interest of shareholders. In Part II, I identify six categories of this incentive scheme. The first three categories of incentives--compensation-related, job-preservation-related, and liability-regime-related--derive from the powers and rights established by corporate law. The latter three categories of incentives--future-employment-related, social-status-related, and internalized--are external to corporate law. Norms potentially affect incentives in four of these categories: compensation, job preservation, social status, and internalized incentives.

Part III considers the significance of norms for compensation and job-preservation-related incentives. With respect to executive compensation, I conclude that although its structure is principally driven by economic and regulatory factors, norms may have a limited influence. With respect to director replacement, however, norms play no material role.

Part IV examines the relation between norms and social-status-related and internalized incentives. Although norms may well be significant to social-status-related incentives, these incentives do not have a substantial impact on managerial agency costs. With respect to internalized incentives, I suggest that the key factor is the economic process of managerial selection, which results in the promotion of managers who have internalized beneficial norms, rather than the existence of norms that are specifically managerial.

1. NORMS AND LAW

   1. Norms

      The plethora of definitions of "norms" is troubling in several respects. To begin with, it is obviously difficult to discuss a concept if that concept has no well-defined content. Moreover, the definitions of "norms" exhibit an imperialistic trend, having expanded over time from a relatively narrow set to include virtually everything other than law. Evidencing this expansion, for example, Mel Eisenberg has recently defined social norms to encompass "all rules and regularities concerning human conduct, other than legal rules and organizational rules."(17)

      Perhaps the most problematic aspect of the definitions of "norms," however, is that the wider definitions include under the norms umbrella dissimilar incentive structures, some of which are well-defined and analyzed outside the "law and norms" literature. Under many of these wider definitions, any type of rule ("you shall ..." or "you shall not ...") governing how to conduct oneself, which is regularly followed by at least a relevant subset of actors and which is not a command of law, is a norm. This set, however, includes rules that are followed because they are internalized and rules that are followed because of external (nonlegal) sanctions (with sanctions referring to both a negative sanction--punishment--and a positive one--reward). It includes rules that are enforced by second-party sanctions (that is, sanctions administered by the party who suffers from the rules violation) and rules that are enforced by third-party sanctions (that is, sanctions administered by a person other than the party who suffers from the rules violation). And it includes rules in which enforcement is motivated by self-protection and rules in which enforcement is intended to punish the rule-violator (or reward the rule-abider).

      For example, a small-town grocery store may not sell low-quality produce because the owner takes pride in the quality of the food she sells (internalized rule) or because her customers would buy fewer goods (external sanction). In the latter case, the owner may fear that customers who bought low-quality produce will take their business to another store (second-party enforced) or tell their friends, who will then take their business to another store (third-party enforced). Customers who take their business to a different store may do so because they want to avoid buying low-quality produce in the future (self-protective enforcement) or out of resentment for how their friends were treated when they last bought produce at that store (punitive enforcement).

      I regard these distinctions as important because second-party and third-party self-protective enforcement are primarily economic in character.(18) Such enforcement can be, and long has been, analyzed using traditional economic tools and neither requires nor benefits from being lumped under the heading of "norms."(19)

      For purposes of this Article, I therefore define "norms" to include only rules of conduct, other than legal commands, that are regularly followed and that are sanctioned by punitive third-party enforcement, as well as internalized rules that correspond to such third-party-enforced rules. This definition includes most incentive structures that are not economic or legal in character. And even though it lumps together two distinct enforcement mechanisms, internalized rules and punitive...