LEGAL

1
LEGAL GOVERNANCE INSTITUTIONS
Richard Swedberg (2003) wrote that an economic
sociology of law a sociological analysis of
laws role in economic life doesnt 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 isnt 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?

2
Weber on the Law
Weber 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 capitalisms many
legal institutions, including international
contracting arbitration at the heart of
globalized economy since the 1960s.
3
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 (1990578)
4
Law and Economics
Law and economics, at U of Chicago, uses
neoclassical economics to analyze legal problems,
including regulation and corporate governance.

• Positive LE uses economic-efficiency analysis
  to predict the effects of alternative legal
  rules. For example, an LE analysis of tort laws
  would contrast cost-benefit outcomes from
  applying a strict-liability rule vs. a negligence
  rule.
• Normative LE 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?
5
Coases Theorem
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.
Coases 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 cant be neglected,
governmental decisions on initially allocating
property rights matter a great deal.
Why is Coases Theorem unable to explain disputes
about stray cattle damaging neighboring property
in Shasta County (Ellickson 1991)?
6
Legal Theories of the Firm
In the 19th century, U.S. statutory and case law
assigned legal private property rights to a
business owners - its proprietors, partners, or
a corporations shareholders (stock owners)

• Purchasing corporations 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

Natural entity theory of corporate governance
treats firm as a corporate personality
originating in the contractual relations between
private individuals
Why were legal theory courts so slow to develop
alternative theories about employee rights and
consumer protection?
7
Corporate Governance
Todays 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. 1333
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 451145-1148.
8
Top Executives Take Power
During 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
9
Institutional Investors are Revolting
Recent 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

• 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

Investors had mixed successes in reforming some
badly mismanaged companies GM, USAir, IBM, Time
Warner
10
The Stakeholder Model
Stakeholder theory corporations should be
socially responsible institutions managed in the
public interest. Many organizational
constituencies have interests other than
maximizing firm profits.
Political Groups
Investors
Governments
Suppliers
Customers
FIRM
Trade Associations
Communities
Employees
(SOURCE Donaldson, T. and L.E. Preston. 1995.
The Stakeholder Theory of the Corporation
Concepts, Evidence, and Implications. Academy of
Management Review 2065-91.)
11
Who Holds a Stake?
To identify stakeholders, R. Edward Freeman
applied Immanuel Kants prohibition against
treating persons as means, not as ends.
Property rights are not a license to ignore
Kants 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.)
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?
Which stakeholders are most impacted by the
mills actions? Which stakeholders interests
should have higher priority? How can
stakeholders best participate in making these
decision?
12
Corporate Social Responsibility
CSR 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
Social responsibility obligations and
accountability to society Social responsiveness
proactive to changing social conditions Social
performance achieve successful outcomes and
results

• CSR is often depicted as desirable behavior
  because it satisfies
• Ethical moral obligations Its the right
  thing to do.
• Enlightened self-interest Doing good is good
  for business.

How might the legal system change to promote more
CSR?