From Corporate Law to Corporate Governance

In the 1960s and 1970s, corporate law and finance scholars recognized that neither discipline was doing a very good job of explaining how corporations were really structured and performed. For legal scholars, Yale Law School professor and then Stanford Law School dean Bayless Manning confessed that corporate law has “nothing left but our great empty corporation statutes—towering skyscrapers of rusted girders, internally welded together and containing nothing but wind.” Michael Jensen and William Meckling made a similar comment with respect to finance. The theory of the firm was an “empty box” or a “black box” that provided no theory about “how the conflicting objectives of the individual participants are brought into equilibrium.” The result of Jensen and Meckling’s seminal reframing of corporate law in agency cost terms, and so into something far broader than disputes over statutory language, was that both Manning’s empty skyscrapers and Jensen and Meckling’s empty box began to be filled. In my essay for the forthcoming Oxford University Press Handbook of Corporate Law and Governance edited by Jeffery Gordon and Georg Ringe, I show through analysis of three admittedly idiosyncratic examples how the progressively more successful effort to complicate corporate law—the move from corporate law to corporate governance—came to fill the empty skyscrapers and boxes.

The first example of complication in moving from law to governance comes from defining governance broadly as the company’s operating system, a braided framework encompassing legal and non-legal elements. A corporation should be defined functionally by reference to the structure that allows the pieces of paper that comprise its formal structure to operate a business and makes it possible for third parties to confidently do business with a legal fiction. Some of these structures are legal rules that, in specified circumstances, allow the corporation to be treated, like Pinocchio, as if a real boy. However, the mass of the corporate structure, both in importance and in bulk, are not legal at all. They are processes of information flow, decision-making, decision-implementation, and decision monitoring: how the corporation (i) obtains the information it uses in making, implementing, and monitoring the results of, its business decisions (including information relevant to regulatory compliance); (ii) re-distributes information from information originators to managers with sufficient expertise and experience to evaluate it; and (iii) makes decisions, communicates decisions to the employees who implement them, and then gathers information about the consequences, for the next round.

It is then obvious that the formal corporate legal skeleton covers only a very small part of how the corporation actually operates to carry out its business and continually adapts to its business environment. The rest and obviously most important part of the governance structure—the dark matter of corporate governance—is the realm of reporting relationships, organizational charts, compensation arrangements, information gathering and internal controls and monitoring, all largely non-legally dictated policies, practices and procedures that do not appear in the corporate statute or the corporation’s charter or bylaws.

The second example adds an additional level of complication by treating corporate governance dynamically: corporate governance becomes a path dependent outcome of the tools available when a national governance system begins taking shape, and the process by which elements are added to the governance system going forward—driven by what Paul Milgrom and John Roberts call “supermodularity.” That characteristic reads importantly on both the difficulty of corporate governance, as opposed to corporate law, reform and the non-intuitive pattern of the results of reform: significant reform leads to things getting worse before they get better, which helps explains why the remarkable series of Japanese corporate law reform has not led to a parallel reform of Japanese corporate governance. An extension of a dynamic account then further complicates corporate governance by expanding it beyond the boundaries of the corporation, treating particular governance regimes as complementary to other social structures—for example, the labor market, the capital market and the political structure—that together define different varieties of capitalism.

The third example then considers commonplace, but I will suggest misguided, efforts to take a different tack from the essay’s treatment of the first two examples: to simplify rather than complicate corporate governance analysis by recourse to now familiar single factor analytic models in academic corporate law and governance: stakeholder theory, team production, director primacy, and shareholder primacy. The essay argues that these reductions are neither models nor particularly helpful; they neither bridge the contextual specificity of most corporate governance analysis nor address the necessary interaction in allocating responsibilities among shareholders, teams and directors. As well, these “models” are static rather than dynamic, a serious failing in an era in which the second derivative of change is positive in many business environments and Schumpeter seems to be getting the better of Burke.

The essay concludes by imagining a discussion across time between Burke and Schumpeter over the importance of a corporate governance system’s capacity to respond to changes in the business environment. In the end, there is a tension that is baked into a capitalist system—governance structures that support commitment to long-term firm specific investment do not fare well in business environments that are changing and can be expected to continue to change rapidly. The essay concludes by posing the question that is largely ignored in today’s short-term/long-term governance debate. The greater the rate of change in the business environment, the more important is a governance system’s capacity to adapt and the less important its ability to support long-term firm specific investment. Do we imagine that the future will be characterized by linear innovation or by an on ongoing increase in the rate of change? If we can answer this question, the governance issues will fall into place with the qualification necessary for any dynamic account: at least for now.

The full paper is available for download here.