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

This Article provides a theory of the relation between legal and nonlegally enforceable rules and standards in the corporation, and then uses that the ory to analyze a variety of prominent features of corporate law. In the fir st Part, we draw on recent developments in the theory of the firm to identi fy key problem facing participants in the firm. In developing this approach , we combine the "property rights" strand in the theory of the firm with th e transaction cost approach. From this perspective, the main issue is solvi ng the related problem of coordinating activities, choosing the firm's asse ts, 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" ("N LERS"). Indeed, the raison d'(e) over cap tre of firms is to replace legal/ contractual governance of relations with NLERS. Using this framework, in Pa il III we analyze the duty of loyalty. In Part Il we analyze the duty of ca re and the business judgment rule, along with a variety of other puzzling f eatures of corporate law. From our perspective, corporate law can be understood as a remarkably sophi sticated mechanism for facilitating governance by NLERS. Centralized manage ment is used to determine the assets over which the corporation must have r esidual rights of control and to develop a governance structure far protect ing the match-investments of insiders in these assets. Legal rules provide the default settings through which centralized management operate and prohi bit non-pro-rata distributions (a combination of ex ante rules and the ex p ost duty of loyalty), which pushes controlling shareholders to maximize the value of the firm. Having established an "incentive compatible" legal form, that facilitates N LERS governance, the law must be careful not to undermine that governance b y 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 partie s from turning to third-party adjudicators. As such, it plays a role very s imilar to the role of the employment-at-will doctrine in employment law, an d for the same reasons. This analysis provides an explanation for why the d uty 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 me dical 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 NLFRS t o 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 bet ween judicial review over decisions to resist all bids for control ("just s ay no") versus the review of sales of control; and the demand requirement i n derivative litigation.