Document Type

Article

Publication Title

University of Pennsylvania Law Review

Abstract

This Article provides a theory of the relation between legal and nonlegally enforceable rules and standards in the corporation, and then uses that theory to analyze a variety of prominent features of corporate law. In the first Part, we draw on recent developments in the theory of the firm to identify key problems facing participants in the firm. In developing this approach, we combine the "property rights" strand in the theory of the firm with the transaction cost approach. From this perspective, the main issue is solving the related problems of coordinating activities, choosing the firm's assets, 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" ("NLERS"). Indeed, the raison d'etre of firms is to replace legal/contractual governance of relations with NLERS. Using this framework, in Part III we analyze the duty of loyalty. In Part IV, we analyze the duty of care and the business judgment rule, along with a variety of other puzzling features of corporate law. From our perspective, corporate law can be understood as a remarkably sophisticated mechanism for facilitating governance by NLERS. Centralized management is used to determine the assets over which the corporation must have residual rights of control and to develop a governance structure for protecting the match-investments of insiders in these assets. Legal rules provide the default settings through which centralized management operate and prohibit non-pro-rata distributions (a combination of ex ante rules and the ex post duty of loyalty), which pushes controlling shareholders to maximize the value of the firm. Having established an "incentive compatible" legal form that facilitates NLERS governance, the law must be careful not to undermine that governance by 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 parties from turning to third- party adjudicators. As such, it plays a role very similar to the role of the employ- ment-at-will doctrine in employment law, and for the same reasons. This analysis provides an explanation for why the duty 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 medical 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 NLERS to govern mid-stream 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 between judicial review over decisions to resist all bids for control ("just say no") versus the review of sales of control; and the demand requirement in derivative litigation.

First Page

1619

DOI

https://doi.org/10.2307/3312895

Volume

149

Publication Date

2001

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