Theory of Law and Corporate
Governance
Thomas C. Heller
Stanford Law School
December 2001
1
Levels of Discussion
1. Legal Traditions and Corporate Governance
2. The Wave of Corporate Governance Reform: Roles,
Causes and Effects
3. The Rule of Law and Economic Growth
2
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 Records
6. Current instabilities in political economies have resulted in
widespread concerns with corporate governance, but less
focus on complementary institutional reform
3
Competing accounts of causation in corporate
governace
A. Law  Corporate Governance  Financial
MarketsEconomic Growth
B. Political Economy  Effectiveness of Policy 
1. Law
2. Corporate Governance
3. Financial Concentration Growth?
4
Ecology 2
Insider Corporate
Governance
Ecology 1
Outsider Corporate
Governance
Legal 1
Political 1
Economic 1
Entry/Exit/Change 1
Locus of Policy 1
Compensation/Duty 1
Finance 1
Industrial Organization 1
Legal 2
Political 2
Economic 2
Entry/Exit/Change 2
Locus of Policy 2
Compensation/Duty 2
Finance 2
Industrial Organization 2
Political Economy
Economic Growth
Legal Causation
Political Economic Causation
5
Outline 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
6
Outline 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
7
Corporate 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
8
I.
Theory of Law and Corporate Governance:
Standard 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
9
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)
10
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 general
B. 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
11
III. 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.
12
IV. Political Economy as the Effective Cause of Law
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
13
V.
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/Classifications
1. 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
14
V.
Law as Cause (continues)
C. Formalism
1.
2.
3.
4.
Latin America as no compliance, leading edge, archaeology
Effective federalism and functional fragmentation (China)
Private strategies as counter-strategy
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 enforcement
a. certainty and the US civil jury (punitive damages)
b. German active judging
c. French restrictive interpretive formalism is selective
15
V.
Law as Cause (continues)
D. Civil Law (what do we denote by Civil law?)
1. elements
a. genetics (family)
b. legal theory
c. canons of authority
d. institutions (courts, procedures)
e. substantive rules and practices
f. domain (e.g. administrative law)
2. Core of civil law in legal science, genetics, authority—none of
which are concerned with corporate governance
a. 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
16
V.
Law as Cause (continues)
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 law
a. 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
17
V.
Law as Cause (continues)
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 administration
1) French distrust of judiciary and legal science ideal of
certainty
2) Continental criminal procedure reflects extension of
administrative state
3) 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
18
V.
Law as Cause (continues)
4. European modernity (see below) built of:
a. administered social solidarity
b. pervasive administration (forms of rule)
c. establishment delegation
5. Spread through colonial administration (civil and common law
metropoles)
6. Developmentalisnm and installed bases
7. Economic law as a dependent variable
19
VI.
Corporate Governance as Cause
A. Selectivity
1. Portfolio of mechanisms for governance
a. Inside political
b. Legal
c. external politics/regulation
d. economic
e. sociological/cultural
20
VI.
Corporate Governance as Cause (continues)
2. Fitness of non-economic remedies to problems of external
market (public shareholder) protection
a. agency problem of manager control
b. agency problem of blockholder (control shareholder)
control
c. Problems of corporate performance (free cash, below
potential, industry underperformance, bankruptcy, theft,
scandal)
d. effectiveness
1) Unfit by costs or institutional capacity (theft or error?;
bankruptcy or free cash?)
2) Unfit by limited transactions
3) Fit for one goal at cost to another (blockholding
controls managers at price of its possible abuse)
21
VI.
Corporate Governance as Cause (continues)
3. Unselected in LLSV
a. Board performance, composition, standards, committees
b. Legal remedies and procedures (ROL index inadequate)
c. Entry/exit/change regulation
d. Co-determination, works council, labor political power
(especially Germany, Holland and Scandanavia)
e. All economic controls
f. Focus only on equity (shares) with debt and bail outs
22
VI.
Corporate Governance as Cause (continues)
B. Economic growth in the US
1. US sequence
a. bank limitations, external markets, professional managers
b. product market competitiveness (antitrust)
c. Delaware (decentralized federalism) and judicial
governance
d. NYSE rules precede securities acts of 33 and 34 (see Roe
585 on Berle-Means)
e. Depression and war with alternative governance
f. Post-war rent sharing system
g. 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?
23
VII. Political Economy and the Firm as Locus of Policy
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 effective
2. 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 governance
d. Financial repression and control
e. labor as stakeholder in stabilized (closed) markets
f. oligopolistic competition (dual markets, industry
associations)
24
VII. Political Economy and the Firm as Locus of Policy
(continues)
f. Low judicial capacity relative to administrative
domain/capacity
g. often restricted product market competition
h. 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 packages
l. firm/bureau/party tendency to rent seeking strategies,
imbalance in duty/compensation packages, variation in
state centered systems along these dimensions
1. Once state is rent creating, rational controllers pursue
rent seeking strategies and corporate governance shifts
2. Issue is less private exploitation of minority
shareholders than public exploitation through rent seeking
25
VII. Political Economy and the Firm as Locus of Policy
(continues)
2. Market centered pattern
a. single valued firm objective (nexus of contracts)
b. anti-bank, financial diversification
c. public investor corporate governance
d. labor as open market; local/firm unionization; low
transfers
e. structural, decentralized monitoring competition policy
f. product market competition
g. high judicial domain with facilitated litigation
h. industry specific subsidy (procurement)
i. business school shareholder value socialization
j. Low centralized judicial domain
k. Externalized (from firm) and low policy domain
26
VII. Political Economy and the Firm as Locus of Policy
(continues)
D. Baselines for explanation
1. Always a balance of voice and exit
2. 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
27
VII. Political Economy and the Firm as Locus of Policy
(continues)
E. Roe distinguished
1. I, like Roe, use political economy as a major cause of
corporate governance and growth
2. I see social democracy as a variant of state centered system,
rather than an explanation in itself
3. 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)
28
VIII. Variation in state centered systems
A.
B.
C.
D.
E.
F.
State-interest group relationship
Balance between interests
Organization within interests
Policies selected
Monitoring strategies/capacities
Duty/compensation
1. Balance
2. Techniques or instruments
29
VIII. Variations in State Centered Systems (continues)
A. Variation by economic development (compensation/duty
package)
1.
2.
3.
4.
5.
6.
Traditional authoritarian or empire (non-developmental)
Colonial empire (ex-colonial creolization)
Mercantilism
Socialism
Export enclave developmental
Asian developmental state (Japan)
30
VIII. Variations in State Centered Systems (continues)
7. European modernity sequence
a. Installed base (state/establishment as residual
organization)
b. Romantic nationalism (Savigny)
c. Developmental state (state led late industrialization)
d. Welfare state
e. Contested liberal counter-thrust
1) France (see Duguit)
2) Zollverein and Prussia, Bavaria legal conflict in code
formation
3) Pre-WWI liberal/imperial dualism
f. authoritarian/totalitarian state
g. post-war countercurrents
1) Rechtstaat
2) European Union 1992 agenda
31
VIII. Variations in State Centered Systems (continues)
8. European modernity pattern
a. administered social solidarity
1) Asian direct ethnicity
2) Double differentiation (post-Romantic)
3) Consider example of German demography
a) German diaspora vs. refugees, guestworkers (nonimmigration)
b) Internal administrative controls on residence
c) Minimal number and character of immigrants for
social security
d) Non-ethnics and loss of solidarity with feedback to
welfare state reform
b. pervasive administration and national (genetic) forms of
rule
c. establishment and delegation
32
VIII. Variations in State Centered Systems (continues)
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. Japan
a. regulatory cartels, convoys and cartels for social risk, Calder
compensation, firm based labor and lifetime employment, main
bank system
4. Malaysia
a. export enclaves, local ethnic rents from monopoly firms
5. India
a. license raj, high level courts/PIL, family dominated non-state
firms, state monopolies, development banks
b. South Indian imported law in IT sector
33
VIII. Variations in State Centered Systems (continues)
C. Variation over time
1.
2.
3.
4.
5.
Pre-modern with no market or penetrated hierarchy
Installed corporatist bases and social stability
Early development coordination (entrepreneurship)
Early modern experimentation (France, Japan)
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
34
VIII Variations in State Centered Systems (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 policy
4. Capital interests organized around penetrated insiders and
nesting
5. Balance and type of duty/compensation?
6. Corruption averse
35
IX. Governance Changes and the Limits of State
Centered Systems
A. Sources of governance reforms
1. state capacity weakened through globalization, regionalization
2. inefficiencies of bureaucratic management of complex systems
3. cost of information (market) falls relative to hierarchy
B. Limits of state centered model
1. political lock-in of optimal public roles
a. fiscal burdens of public support commitments
2. information heavy innovation in short cycle
3. Learning, flexibility and relative advantage in instability
C. Financial liberalization in reform process:
1. Independent reasons in EU, US, East Asian and Basle
2. If financial repression key, relaxation is destabilizing
3. Norm diffusion for economic reorganization in elite bureaucracies
4. New financial agents motivate corporate governance wave
5. Stranded assets and uneven reforms
36
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 disabilities
1. Emphasis on historical trajectories
2. Costs of governance shifts
3. Corporate governance as leading edge of reforms
4. Political dynamics of asymmetric reform
5. Complementary judicial reform is problematic
6. Whatever the motivation for reform– what is the new
landscape?
37
IX. Governance Changes and the Limits of State
Centered Systems (continues)
A. Relative movement toward exit based systems from initial
equilibrium
B. Governance reforms and public law substitutes
1.
2.
3.
4.
independent regulator (plus tiers of self-regulating bodies)
complementary institutions
decentralized monitoring and procedures (judicial capacity)
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 good
3. Assets and ADR listings
4. Reputation monitoring by institutional investors, market
intermediaries, underwriters
38
IX 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
39
Present Governance1
Central Government
Local Government
1. Parties
2. Courts
Traditional
Rule of Law
Constitutes
Individual Actors
(Persons, Firms)
Ad hoc Collaborations
Voluntary Associations
40
Present Governance2
Central Government
Administration
Central Political
Parties
Traditional
Rule of Law
Constitutes
Business
Corporatist
Associations
Social
Establishment
Individual Actors
(Persons, Firms)
41
New Governance
International Regimes
Human Rights
International
Professional
Networks
Central Government
Expanded
Rule of Law
Constitutes
Corporate
NGO’s
Social
Responsibility
Deliberative Democracy
Devolution
Traditional
Rule of Law
Constitutes
Individual Actors
(Persons, Firms)
New Economic
Actors
1. Networks
2. Institutional
investors
Civil
Society
Voluntary Associations
42
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)
43
Law, Economy, Democracy
Weaknesses
Non-Democratic
I.
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 Democracy
I.
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
Decentralized
absence
B.
(Local, Courts)
44
Law, Economy, Democracy
Weaknesses
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 (natural
a. Political
2. Colonial
resources
b. Economic
3. Socialist
5. Corruption
Constitutional Democracy
I.
Rent Driven State Centered
1. Rent creation
6. Privatization
2. Policy Monitoring
7. Import of l aw
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
Decentralized
absence
B.
(Local, Courts)
45
Law, Economy, Democracy
Weaknesses
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
I.
II.
Rent Driven State Centered
Competitive State Centered
1. Family/State Firms
1. Rent creation
6. Privatization
2. Policy Monitoring
7. Import of law
3. Exclusion to Entry
1. Administrative Inclusion
2. Administrative
Domain
3. Oligopoly
4. Bank Finance
5. Shareholder Firms
III.
Market Centered
1. Policy ineffectuality
A.
Independent Regulation
2. Lower domain
2. Shareholder Firms
(Access, Review)
3. Development entrepreneur
3. Judicial Domain
Decentralized
absence
4. External Policy
B.
(Local, Courts)
1. Excessive legal Exposure 1. Public Markets
46