Corporate Law, Social Norms and Belief

Corporate Law, Social Norms and Belief

Systems

Abstract

Introduction

Corporate law serves both to facilitate and to regulate the conduct of the corporate

enterprise. Insofar as corporate law is regulatory, it provides incentives and disincentives

to the major actors in the corporate enterprise -- directors, officers, and significant

shareholders -- through the threat of liability. In significant part, however, these actors

are motivated not by the desire to avoid liability, but by the prospect of financial gain, on

the one hand, and by social norms, on the other. Much work has been done on the way in

which these actors are motivated on the threat of liability and the prospect of financial

gain, but relatively little work has been done on the operation of social norms.

The neglect of the operation of social norms in the field of corporate law parallels

the neglect of the operation of social norms in the law generally.1 In recent years, a small

but important group of scholars has begun to remedy this neglect.2 However, relatively

little work has been done on the interrelation of law and social norms in specific fields of

law. Instead, most of this work has either concerned the operation of social norms in a

general way, using random illustrations from various fields to illustrate the general points,

or has concerned occupational communities whose members choose to be governed by

their own social norms rather than law in their dealings with each other.3 Furthermore,

much of this work has concerned only those social norms that impose obligations, and

little of the work has concerned the role of belief-systems in the origin and acceptance of

social norms.

In this Article, I examine the interrelation of social norms and law in a given field

of law -- corporations. The purpose of this examination is to illuminate both corporation

law specifically, and the interrelation of social norms and law generally, by studying

ways in which that interrelation operates in a specific field. I will focus on three kinds of

social norms, which I call descriptive norms, conventions, and obligational norms. In the

course of this Article, I will show that even social norms that do not impose obligations

play important roles in the law, and that belief-systems that result from information and

reasoned persuasion play a fundamental role in the origin and adoption of social norms.

The organization of this Article is as follows: I begin by describing and defining

the kinds of social norms that are relevant to law (Part I). I then consider, in a

preliminary way, the effects and origins of social norms (Part II). Finally, I examine the

role of social norms in three central areas of corporate law: fiduciary duties, corporate

governance, and takeovers (Part III). In the course of that examination, I apply and

elaborate the analysis in Parts I and II concerning the kinds, origins, and effects of social

norms, and consider some of the kinds of interrelations between social norms and law.

I. Descriptions and Definitions

An analysis of the operation of social norms in the law presents severe problems of

terminology. To begin with, as a matter of ordinary language the term norm encompasses

both rules and regularities. Because rules and regularities are very different kinds of

phenomena, a single canonical definition of the term norm is not within reach.

Furthermore, rules and regularities each include various types of norms, and the typology

that is employed in a given inquiry will depend in part on the purpose of the inquiry. I

therefore begin by describing and defining the major types of norms that are salient to

law. These descriptions and definitions, in turn, will set the stage for an inquiry into the

manner in which different types of norms operate in areas that are within the scope of

law.

A. Social Norms, Legal Rules, and Organizational Rules

To begin with, I use the term social norm to mean all rules and regularities

concerning human conduct other than legal rules and organizational rules. By legal rules,

I mean the principles and rules of a legal system. By organizational rules, I mean formal

rules adopted by private organizations. Such rules often have the effect of legal rules,

because they are directly or indirectly backed by legal sanctions.4 Even organizational

rules that are not backed by legal sanctions are often backed by formal sanctions, because

many private organizations have monopoly power over important parts of the lives of

persons who are members or want to become members. Consider, for example, the rules

of professional- and amateur-sport organizations, HMOs, and the Boy Scouts and Girl

Scouts.

I exclude legal rules from the definition of social norm that I use in this Article

because the purpose of this Article is to investigate the effect of nonlegal rules and

regularities. I exclude organizational rules because such rules tend to operate in a much

different way than other nonlegal norms; in fact, they tend to operate in many ways like

legal rules. Of course, organizational rules can be and often are considered to be social

norms. For that matter, legal rules can be and often are considered to be social norms. I

exclude those categories from the definition of social norm that I use in this Article not

because doing so is required as a matter of ordinary language, but for clarity in analysis

and convenience in exposition.

B. Three Categories of Social Norms

Social norms can be divided into three categories according to the degree of selfconsciousness

and obligation that they involve. The first category consists of regularities

in human conduct that neither involve a sense of obligation nor are self-consciously

engaged in. One such type of norm consists of functional responses to the facts of the

natural world, like putting on warm clothes when it’s cold. Another consists of average

patterns in a given social population, like the distribution of wealth. Still another consists

of statistical regularities, like the fact that automobile accidents peak during holidays.

The second category consists of rules and regularities that are self-consciously

adhered to or engaged in, but do not entail a sense of obligation. For example, it is a

practice in some law schools to begin “one-hour” classes on the hour and finish at ten

minutes of, and in others to begin at ten minutes after the hour and finish on the hour.

These practices are self-consciously engaged in, and indeed have the look and feel of

rules, but they do not involve a sense of obligation. A law school would normally not be

criticized for changing from one practice to the other, or to a third practice entirely. A

faculty member could normally depart from the practice -- make an exception to the rule -

- without criticism, as long as he could comfortably fit the schedule of his class into the

schedules of others.

Another norm of this type consists of usages that attach meanings to words,

symbols, or stylized conduct. Here is an example from the Restatement Second of

Contracts.

A contracts to sell B 1,000 feet of San Domingo mahogany. By

usage of dealers in mahogany, known to A and B, good figured mahogany

of a certain density is known as San Domingo mahogany, though it does not

come from San Domingo. Unless otherwise agreed, the usage is part of the

contract.5

A different kind of example is the posture and hand-signal used to hitchhike: As a matter

of usage, standing in a certain posture by the side of a road and holding up your hand in a

certain way means that you want a lift.

The third category consists of social norms that take the form of rules or practices

that actors not only self-consciously adhere to or engage in, but feel obliged in some

sense to adhere to or engage in, although (by hypothesis) the rule or practice is neither a

legal nor an organizational rule. I will call social norms in the first two categories --

norms that, whether or not self-consciously adhered to or engaged in, do not carry a sense

of obligation -- nonobligational norms. I will call social norms in the third category --

norms that do carry a sense of obligation -- obligational norms. An operational test of

whether a social norm is obligational is whether a departure from the norm is likely to

involve either self-criticism or criticism by others.

Moral norms are one extremely important type of obligational norm. However, a

social norm may be obligational without being moral. For example, if it is a practice to

wear formal dress to Metropolitan Opera premieres, then regular Metropolitan Opera

goers will probably believe there is an obligation, although not a moral obligation, to

follow along. Correspondingly, those who attend a premiere in informal dress will be

criticized. Similarly, the social norms concerning what kinds of foods should be eaten

with implements, rather than with one’s hands, are not moral norms, but they are

obligational norms.

II. The Effects and Origins of Social Norms

I turn now to a preliminary consideration of the effects of social norms on human

conduct, and the origins of social norms. The effects of social norms depend on two

basic variables: (1) whether or not the norm is obligational and, (2) if it is obligational,

whether or not it has been internalized by the relevant actor. These issues are discussed

in Sections A (obligational norms) and B (nonobligational norms).

Social norms may originate in a variety of ways. In this Article I will focus on one

way in which social norms originate, which is particularly relevant to corporate law: the

formation of belief-systems based on information, reasoned persuasion, or both.. This

and related issues are discussed in Section C and D.

A. Obligational Norms

Legal rules provide a reason for acting in a certain way. So do obligational norms.

A legal rule may provide a reason for acting in a certain way because the actor has

internalized the moral norm of obedience to law; because the actor either fears legal

sanctions or desires a legal benefit, or because the actor fears nonlegal sanctions, like

reputational sanctions, or desires nonlegal benefits, like reputational gains. Similarly, an

obligational norm may provide a reason for acting in a certain way either because the

actor has internalized the norm or because the actor fears external sanctions that result

from noncompliance with the norm or desires external benefits that can be obtained by

compliance with the norm.

1. Internalized obligational norms. Begin with internalized obligational norms.

The economist Kaushik Basu usefully describes the operation of such norms in his

discussion of what he calls rationality-limiting norms:

A “rationality-limiting norm” means a norm which stops us from

doing certain things or choosing certain options, irrespective of how much

utility that thing or option gives us. Thus most individuals would not

consider picking another person’s wallet in a crowded bus. This they

would do not by speculating about the amount the wallet is likely to

contain, the chances of getting caught, the severity of the law and so on, but

because they consider picking wallets as something that is simply not done.

In traditional economics the ‘feasible set’ of alternatives facing an

individual (from which the person makes his or her choice) is defined in

terms of technological or budgetary feasibility. Thus a consumer’s feasible

set is the collection of all the combinations of goods and services that the

consumer can purchase given his or her income. From the above discussion

it should be evident that a rationality-limiting norm further limits the

feasible set, because now certain alternatives may be infeasible to an

individual not just because they are technologically infeasible “(like

walking on water) or budgetarily infeasible (like buying a Jaguar car) but

because they are ruled out by the person’s norms.”6

Although Basu’s description is apt, his nomenclature might be questioned. Basu

employs the term rationality-limiting norms on the ground that “a person endowed with

norms may forgo options which could have enhanced his utility and thus such a person

would be considered less rational in terms of mainstream economics. Basically, such

norms limit the domain over which the rationality calculus is applied.”7 Here Basu, like

many economists, uses rationality to mean wealth-maximization, and seems to use utility

in the same way. These meanings are unduly restrictive. Rationality is not equivalent to

wealth-maximization, and utility is not equivalent to wealth. It is perfectly rational to

forgo an increase in wealth by adhering to an internalized social norm or, for that matter,

by engaging in conduct that is intellectually, creatively, or socially gratifying.

Furthermore, as Cass Sunstein has pointed out, “[i]ndividual rationality is a function of

social norms. The costs and benefits of action, from the standpoint of individual agents,

include the consequences of acting inconsistently with social norms.”8 Because utility is

not solely a function of wealth, actors often maximize their utility by taking actions that

do not maximize their wealth. So, for example, an actor may maximize his utility by

keeping his promises or telling the truth, even in cases where breaking a promise or lying

would maximize the actor’s wealth.

Basu also doesn’t address just why some things are simply not done. It’s tempting

to answer that question, even insofar as it applies to internalized norms, solely in costbenefit

terms -- specifically, internal costs and benefits. In the case of moral norms, the

internal cost is the pain of guilt -- what Robert Cooter refers to as the “guilt penalty.”9

The internal benefit is the satisfaction an actor obtains from doing the right thing – the

pleasure of rectitude.

However, an analysis in cost-benefit terms, although important, is insufficient.

Moral norms, in particular, may operate by affecting an actor’s moral character, so that

his action follows from sympathy and commitment, to which psychological and external

costs and benefits are not relevant or only marginally relevant. Martha Nussbaum has

captured this point especially well:

[Under a cost-benefit analysis, altruism] tends to be reduced to a type of

egoism, in which people get reputational or psychic goods for themselves.

For some time it has been influentially argued within economics that this

approach is inadequate, even for predictive purposes: we need to recognize

sympathy and commitment as independent sources of motivation. This is

hardly a surprising claim, because it is one that has been argued throughout

the history of Western philosophy -- starting . . . with Aristotle, who argued

that people who die for their friends or family cannot plausibly be said to

do so for satisfaction, because they are risking or forfeiting, in the process,

all prospect of future satisfaction. A theory that focuses on satisfaction will

therefore make bad predictions about what they will do. Recently these

ideas have been receiving striking empirical confirmation: it has been

powerfully argued that economic theories could not have predicted that

anyone would risk life, family, comfort, and reputation to rescue Jews

during the Holocaust. And yet a significant number of people did.10

More generally, as Basu points out, for many or most actors in many or most situations

internalized moral norms operate without a cost-benefit calculation, simply because that

for those actors certain things (like picking pockets) are simply not done, while other

things (like assisting the unsighted across the street) simply are done.

Obligational norms that are not moral norms may also be internalized, and the

effects of such norms may be comparable to those of internalized moral norms. A major

effect of internalized obligational but not moral norms is the way in which they shape an

actor’s social character. For regular Metropolitan Opera goers, not dressing formally for

a premiere might be no more of an option than picking pockets.

This doesn’t mean that cost-benefit analyses don’t figure in the effect of

internalized norms. They often do. In deciding whether to adhere to an internalized

moral norm, an actor may weigh the pain of guilt and the pleasure of rectitude against the

gain from nonadherence. In deciding whether to adhere to an internalized nonmoral

norm, an actor may weigh the pain of shame and the pleasure of conformity against the

gain from nonadherence. Thus, character may explain adherence to internalized norms

by some actors, while the weighing of internal and external costs and benefits may

explain adherence by others. Or, internal and external costs and benefits may figure for

some actors some of the time. Having said that, however, it seems likely that most actors

who have internalized an obligational norm will usually apply the norm naturally, as an

expression of their character, rather than calculatingly, on the basis of a cost-benefit

analysis.

2. Obligational norms that are not internalized. In contrast to internalized

obligational norms, non-internalized obligational norms will be adhered to, if at all, only

for instrumental reasons. Thus the effect of such norms in any given case will depend on

a comparison of the immediate gains from nonadherence, on the one hand, with the longterm

benefits of adherence and costs of nonadherence, on the other. The long-term costs

of nonadherence involve loss of reputation, diminished esteem, public shame (as opposed

to feeling ashamed), and disdain. The long-term benefits of adherence involve enhanced

reputation, increased esteem, public recognition, and social acceptance. As shown by

 adherence and nonadherence to obligational norms have signaling effects.

Adherence to norms signal that one is a cooperator. Non-adherence signal that one isn’t.

An actor who develops a reputation as a cooperator may derive substantial benefits from

the cooperation of others. An actor who develops a reputation as a noncooperator may

not.11

3. Oneness. Often, the effect of obligational norms derives not, or not only, from

an actor’s internalization of a given norm on its own merits, or from the prospects of

external benefits and costs, but from the actor’s internalization of a metanorm that calls

for adherence to the norms of a special group with which he feels at one. For example,

an actor may derive great gratification and self-worth from membership in a special group

that is working toward a shared end, or that shares a special ethos, that the actor believes

to be important. In certain respects, membership in such groups simply sharpens some of

the characteristic incentives to adhere to norms -- in this case, the norms of the special

group. For example, the sanction of disapproval may be especially salient and effective

in such a group. However, there is also a special internal benefit in adhering to the norms

of such a group, just because they are the norms of the group -- the pleasures of

belongingness, of acting in a special and good endeavor, and of surrendering narrow

individuality to a larger cause.

B. Nonobligational Norms

There is a tendency in the legal and economics literature concerning social norms

to focus on obligational norms.12 It’s easy to see why this should be so. In their work on

legal rules, legal and economics scholars characteristically emphasize incentives and

disincentives, and obligational norms, like legal rules, provide incentives and

disincentives. However, obligational norms are not the only kind of social norms that can

affect human conduct. Nonobligational norms can have this effect as well. In a

memorable phrase,  referred to “the normative power of the actual.”13

Jellinek here used “normative” in its obligational sense. What he meant is that

regularities of practice take on a certain oughtness. Partly this phenomenon results from

a respect for tradition. That respect need not be irrational. Traditional practices may be

ways that have worked, that have stood the test of time, even if we are not entirely sure

why any given traditional practice works.14 There are other reasons for this phenomenon.

Many regularities of practice give rise to expectations that they will continue to be

followed. If these expectations seem justified to those who hold them, then a failure to

follow the practice will be treated as a defeat of justified expectations. If a regularity of

practice has been relied upon, then a failure to follow the practice will be treated as a

defeat of justified reliance. Thus is easily becomes ought, and what begins as a practice

may easily end as an obligation.15

Then too, many social norms have both nonobligational and obligational faces.

For example, social scientists may treat the average age at marriage in a given group as a

statistical regularity, while members of the group may feel obliged to marry before

reaching that age. The posture and hand-signal used to hitchhike is a usage, but the usage

may have an obligational effect if would-be hitchhikers find that if they try to hitch rides

in other ways they won’t get rides, either because they are misunderstood or because

drivers don’t want to give rides to unconventional people.

Finally, a focus on obligational norms overlooks that nonobligational norms may

have an important effect on conduct by permitting certain behavior. For example, the

norm of racial discrimination in the might be conceived of as either an

obligational norm, to the extent that it obliged even those whites who did not want to

discriminate to do so, or as a nonobligational norm that (among other things) insulated

those who engaged in discrimination from both outside criticism and self-criticism.

Similarly, when smoking is a prevailing practice it will be socially permissible. When

smoking is no longer a prevailing practice it may no longer be socially permissible.

C. Belief-Systems and Social Norms

Most legal and economic accounts of social norms are directed toward the

dynamics that govern the adoption of social norms. Most of the models focus on external

reasons for adhering to social norms, rather than on internal beliefs. Correspondingly,

very little work has been done by legal and economics scholars on why particular social

norms (other than rudimentary norms of cooperation, which are often in actors’ selfinterest)

originate.

A major exception is the work of Robert Cooter, who focuses on three processes

by which social norms are internalized: a Freudian process, in which the repressed

memory of parental sanctions for childhood transgressions becomes transmuted into an

adult superego; a Piagetian process, in which children perfect their ability to internalize

norms as they acquire a capacity for general reasoning; and a Weberian process, in which

actors internalize the norms associated with occupational roles.16 Cooter’s emphasis on

the processes by which norms are internalized is relatively unusual in the legal and

economic literature on norms, and extremely important. However, each of these

processes assumes the prior existence of the norms that are internalized through these

processes, rather than explaining how and why particular social norms originate, or why

adults internalize new social norms other than occupational role norms.

There is no simple, or at least no single, answer to these questions. Undoubtedly,

some social norms, like the prohibitions on murder, theft, and incest, originate because

they are necessary for societies to become viable. Others originate because they prove to

be efficient and are therefore imitated.

Still other social norms originate because actors adopt a new belief-system that

involves new views or new values, on the basis of new information, reasoned persuasion

by other actors, or both. The process by which norms are originated and adopted through

changes in actors’ belief-systems is extremely important generally -- Isaac Berlin is

reported to have said that what philosophers do in the privacy of their studies can change

the course of history.17 More to the point, the effect of belief-systems on social norms is

of special importance in explaining the origin and adoption of many norms that are

18 See text at notes xxx-xxx, infra.

19 An exception, again, is Cooter, whose analysis includes a passage that points out that a smoker

may be persuaded to quit smoking. See Cooter, supra note 2, at xxxx.

20 Thomas C. Schelling, Micromotives and Macrobehavior (1978).

21 Id. at 94 (emphasis in original).

22 Id. at 95.

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significant in corporate law.18 Both for that reason and because this process has been

little studied by scholars who have analyzed the role of social norms in the law, in this

Article I will place heavy emphasis on the role of belief-systems in the origin and

adoption of social norms.19

D. Tipping-Points and Equilibria

The behavior of actors often depends on their expectations of what other actors

will do. In his book Micromotives and Macrobehavior,20 Thomas Schelling gives a

number of examples. A faculty seminar is begun. Whether it will succeed or die depends

on whether the participants expect that enough other participants will continue to come.

Pedestrians gather at a busy intersection, anxious to cross against the light. Whether they

do so depends on whether each believes that enough additional pedestrians will cross so

that a group sufficiently large to stop traffic will be formed. “The generic name for

behaviors like this,” Schelling notes, is “critical mass.”21 He continues, “What all of the

critical mass models involves is some activity that is self-sustaining once the measure of

that activity passes a certain minimum level.”22

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A special case of the critical-mass phenomenon is known as tipping. Tipping

occurs when the success of a social activity depends on the formation of a critical mass,

and enough actors sign on or sign off that the activity succeeds or fails. If enough actors

sign on, the activity is tipped in. If enough actors sign off, the activity is tipped out. A

consequence of the critical-mass and tipping phenomena is that the behavior of a

relatively small number of actors can cause an activity to succeed or fail because the

addition or subtraction of a few actors results in the crossing of a tipping-point.

What is true of social activities in general is often true of social norms in

particular. Social norms may shift when, and because, enough actors change their

behavior that a tipping-point is crossed. And because a relatively small number of

crossover actors may cause a norm to tip in or out, social norms may shift relatively

suddenly. The tipping-point for a social norm may be crossed for various reasons. For

example, it may be crossed because some actors change their belief-systems about the

desirability of adhering to a norm. Or, it may be crossed because actors who adhere to a

norm increase their readiness to sanction actors who don’t, and previously some

nonconforming actors change their behavior to avoid these sanctions.

A phenomenon that resembles tipping-points occurs where a social norm is or can

be radically changed by the defection of a very small number of actors -- perhaps even

one or two. This phenomenon may occur because the norm reflects an equilibrium that

depends on the fear of the consequences of departing from the norm, and a successful

defection allays those fears. Or, it may occur because a successful defection shows that

departure from the norm opens up valuable opportunities. More generally, it is a familiar

phenomenon that actors may be willing to change their course of conduct if, but only if,

others act first. This phenomenon is not limited to shifts in social norms. In the common

law, for example, the first overruling of an undesirable doctrine is often followed by a

wave of additional overrulings.

E. Good and Bad Norms and Belief-Systems

As shown by the norm of racial discrimination in the Jim Crow South, it’s crucial

not to idealize social norms. There is an occasional tendency to view social norms as

good, efficient, or both; in particular, to view social norms as a form of private action that

does a better job of regulating conduct, just because it is private action, than

governmental action. But social norms are not necessarily either good or efficient. They

may be morally bad or at least insulate morally bad conduct from criticism, and they may

promote inefficient behavior or at least insulate inefficient behavior from criticism.23 Bad

or inefficient norms may result from a variety of causes, including self-interest, inertia,

and bad or inefficient belief-systems. Bad or inefficient belief-systems, in turn, may

result from bad information or from persuasion that is founded on false premises or

developed by fallacious or incomplete reasoning.

In short, it is important that social norms not be treated as intrinsically more

desirable than legal regulation in governing conduct. Rather, the issues raised by social

norms, for those interested in the law, are how social norms operate in a field that is

within the scope of law; whether, in any given area, social norms potentially have

advantages over legal rules in regulating conduct; and whether the actual social norms

that prevail in an area are good or bad, efficient or inefficient.24

III. The Role of Social Norms in Corporate Law

I now turn now to the role of social norms in corporate law. I use the term

corporate law here in a broad but standard sense to mean those areas of conduct that are

within the scope of corporate law, and more generally those areas of conduct that are of

ongoing concern to the corporate bar and to students of corporate law, including areas

that are regulated only loosely or not at all by legal rules, such as the structure of the

board and the role of institutional investors in corporate governance.

Often, the operation of social norms is at or near the surface of corporate law. For

example, some corporate-law doctrines explicitly incorporate social norms. Thus the

ALI’s Principles of Corporate Governance provides that a corporation may take into

account ethical considerations that are reasonably regarded as appropriate to the conduct

of business, even if corporate profit and shareholder gain are not thereby enhanced.25 My

focus here, however, is on social norms that are not explicitly incorporated into legal

rules. I consider three central areas of corporate law: fiduciary duties (Section A),

corporate governance (Section B), and takeover bids (Section C).

A. Fiduciary Duties

The major fiduciary duties of corporate actors are the duty of care and the duty of

loyalty. The duty of care concerns the standards that apply to the conduct of corporate

actors who are free of self-interest. My theses concerning the duty of care are as follows:

The level of directorial care is largely driven by social norms, rather than by the threat of

liability or the prospect of gain. Within the last ten years, an inefficient norm that

licensed and insulated a low level of directorial care has been replaced by a more

efficient norm that requires a higher level of care. This norm-shift was in significant part

the result of belief-systems. The change in belief-systems, in turn, was partly induced by

the expressive effect of legal authorities, which clarified and added moral force to the

social norm of care.

The duty of loyalty concerns the standards that apply to the conduct of corporate

actors who are not free of self-interest. My theses concerning the duty of loyalty are as

follows: Adherence to the duty of loyalty is driven by both the threat of liability and

moral norms. The legal rules in this area serve both regulatory and norm-supporting and

-defining functions. Although the regulatory function of these legal rules is important,

the moral norm of loyalty that the legal rules support and define is critical to the efficient

operation of the duty of loyalty.

Standards of care and loyalty potentially apply to all major types of corporate

actors, although often in somewhat different ways. I will focus on the application of the

duty of care to directors and the application of the duty of loyalty to directors and

officers.

I. The duty of care. Most observers of the corporate scene believe that the level of

directorial care has risen significantly in the last ten years or so: that directors today are

more attentive to their responsibilities, more ready to displace inefficient CEOs, more

concerned about corporate structure, more active in setting agendas and determining

corporate strategy, and so forth.

What has caused this shift to a greater level of care? Pretty clearly, it’s not an

increased threat of liability. It’s true that during this period the meaning of the duty of

care was greatly clarified and elaborated. Smith v. Van Gorkom26 made clear that

reasonable inquiry by a director was a condition to the invocation of the business

judgment rule. The ALI’s Principles of Corporate Governance formulated the first clear

statement of the business judgment rule, as a special standard of review – that is, a

rationality standard – and the conditions that had to be satisfied, including reasonable

inquiry, before the special business judgment standard of review was applied.27 Cede v.

Technicolor28 made clear that if the conditions to invoking the business judgment

standard of review were not satisfied, the standard of review is reasonability or some

equivalent. The monitoring duty of the board was made explicit and strongly supported,

first in Francis v. United Jersey Bank29 and later and more comprehensively in the

Caremark case.

From a liability perspective, however, the developments during this period were

overshadowed, if not overwhelmed, by the adoption of director-shield statutes that permit

a corporation’s certificate of incorporation to eliminate the liability of directors for

violation of the duty of care. Delaware Section 102(b)(7) is typical. This section

provides that the certificate of incorporation may include:

A provision eliminating or limiting the personal liability of a director to the

corporation or its stockholders for monetary damages for breach of

fiduciary duty as a director, provided that such provision shall not eliminate

or limit the liability of a director (i) for any breach of the director’s duty of

loyalty to the corporation or its stockholders, (ii) for acts or omissions not

in good faith which involve intentional misconduct or a knowing violation

of law, (iii) [for improper distributions], or (iv) for any transaction from

which the director derived an improper personal benefit.

It’s true that the shield statutes have important exceptions. For example, the

statutes typically don’t apply to officers acting in that capacity. This exception, however,

doesn’t affect directors. In addition, the statutes generally concern only liability, not the

validity of directorial action. There are many important validity contexts in which

liability may not be at issue, but the standard of care will be; among the most important

are the validity of decisions by disinterested directors to approve interested-director

transactions or to take defensive actions against a takeover bid. The validity exception,

however, doesn’t reduce the statutes’ protection against liability.

The statutes also typically have exceptions, like those in Delaware § 102(b)(7), for

acts or omissions not “in good faith,” or which involve “intentional misconduct,” or the

like. The meaning of these terms in this context will have to be developed by judicial

interpretation, but a lot can be packed into the concept of good faith. In In re RJR

Nabisco,31 Chancellor Allen stated that an action by a director is not in good faith if it is

based on “any human emotion [that] may cause a director to place his own interests,

preferences or appetites before the welfare of the corporation” including “hatred, lust,

envy, revenge, . . . shame or pride.” In Gagliardi v. Trifoods International Inc.,32

Chancellor Allen stated: “I include within the category of improper motivation those

cases in which particularised claims of director entrenchment are made or in which,

relatedly, transfers of corporate control by the board . . . are involved.” In Caremark,

Chancellor Allen stated that “a sustained or systematic failure of the board to exercise

oversight – such as an utter failure to attempt to assure a reasonable information and

reporting system exists – will establish the lack of good faith that is a necessary condition

to liability.”33 The meaning of “intentional misconduct” is also unclear. For example, a

complete failure to act might be construed as “intentional misconduct” within the

meaning of the statutes. The not-in-good-faith and intentional misconduct exceptions

therefore somewhat diminish the protection the shield statutes afford against directorial

liability for breach of the duty of care. Even when these exceptions are taken into

account, however, the result of the shield statutes is to drastically reduce the threat of

such liability. Accordingly, if directorial care was based solely on the threat of liability

we would expect the level of care to have gone drastically down in the last ten years,

rather than significantly up.

A possible incentive for care, even when there is no significant threat of liability,

is the prospect of individual gain. However, directors’ fees are normally unrelated to

performance. Such fees are invariably uniform for all directors on a given board (subject,

sometimes, to extra compensation for committee service), and indeed are relatively

uniform among all corporations of given kinds. Extra care by a particular director is

therefore unlikely to lead to increased compensation. In theory, extra care might lead to a

greater number of directorships, but there is little or no data to suggest that most directors

want to or do hold a number of directorships, or that there is a market for directors in

which directorial care is appraised.

Since the increased level of directorial care in recent years cannot be accounted for

either by an increase in the threat of liability or by the prospect of gain, and since, indeed,

the threat of liability has been substantially reduced if not virtually eliminated, it’s

difficult to avoid the conclusion that the level of directorial care is determined in

significant part not by the threat of liability or the prospect of gain, but by social norms

concerning the directorial role, and that the increased level of care is due to a shift in

social norms concerning the directorial role.

What has led to this shift?

One factor may be the role of the media. The business press, like the general

press, has become increasingly willing, and indeed eager, to report on the shortcomings

of directors and officers. A juicy story about feckless directors on page one of the Wall

Street Journal is the equivalent of a picture of  on the cover of Vanity Fair. The

increased likelihood of such stories, with their consequence of shaming and the loss of

esteem, may have been one factor in making directors more attentive.

Another factor is that directorial performance has come under closer scrutiny from

institutional investors, who may either put direct pressure on directors or present another

possible source of bad publicity.

But something else seems to be operating; that is, a change in the belief-system of

the business community concerning the obligations associated with the directorial role.

The issue then is what elements may have led to this change in the belief-system. One

possible element was new information. Some of this information was provided by the

rise of the takeover-bid institution. The enormous discrepancy between takeover-bid

prices and market prices conveyed the information that there was a lot of managerial

inefficiency, and that something in addition to takeover bids needed to be done about it.

The decline of such corporate giants as GM and Sears conveyed the same information.

The law may also have contributed to the change in directors’ belief-systems.

Recall that at the same time the shield statutes virtually eliminated liability for the

director’s breach of the duty of care, the courts were greatly clarifying the meaning of

that duty. To understand the impact of this clarification, a distinction must be drawn

between standards of conduct and standards of review. A standard of conduct states how

an actor should conduct a given activity or play a given role. A standard of review is the

test a court applies when it reviews an actor’s conduct to determine whether to impose

liability or grant injunctive relief.

Typically, the elements of a standard of conduct and a correlative standard of

review are the same. For example, the standard of conduct for an actor in driving a car is

to drive carefully, and the correlative standard of review to determine whether liability

should be imposed is whether the actor has driven carefully. In corporation law,

however, the standards of conduct and review pervasively diverge. For example, in the

area of duty of care the standard of conduct is “act reasonably,” but the standard of

review is often the much looser business judgment standard of rationality. Similarly, the

elimination of liability under the shield statutes did not affect the director’s standard of

conduct, but only the liability for failure to adhere to that standard.

Although legal standards of conduct are characteristically accompanied by liability

rules or other enforcement regimes, even a legal standard of conduct that is

unaccompanied by such a regime may be effective because of its impact on social norms.

While social norms differ from legal rules, there is often a symbiotic relationship between

law and norms. On the one hand, legal rules are often based on social norms. On the

other hand, many legal norms have an expressive effect -- that is, in addition to their

regulatory effects, legal norms send messages of various kinds.34 Adoption of a legal rule

that is based on a social norm sends a message that the community regards the norm as

especially important. Furthermore, legal rules add, to the force of a specific obligational

norm, the force of the general norm of obedience to law, which is one of the most

powerful social norms of our society.

Legal rules may also serve to clarify a social norm.35 This has obvious relevance

to the duty of care, because one function of the cases that clarify the meaning of that

duty, especially in a directorial context, is to tell directors how to play their directorial

role. Thus one way of looking at the change in the social norm concerning directorial

care is that directors who once believed, as a result of an earlier prevailing practice, that

they could properly satisfy the demands of the directorial role with minimal care, have

been instructed by the courts -- or perhaps more accurately, by their lawyers -- that this1

view is wrong. Having been so instructed, directors who wanted to perform their role

properly made appropriate adjustments in their conduct -- not necessarily to avoid

liability, but just because they wanted to play their roles properly. Ed Rock, in a notable

article,36 shows how much of the Delaware case law on takeovers, and by extension the

duty of care generally, can be understood as directed in significant part toward instructing

directors on how to play their role in that context, and publicly admonishing those

directors who failed to properly play that role.

Legal rules may also be effective, even without an enforcement strategy, because

they facilitate the effectiveness of informal sanctions by norm-compliers against normviolators.

For example, points out that if smoking in public places like airports

violates a social norm but not a legal norm, some norm-compliers will sanction smokers

with words or looks, but others won’t. If a legal rule is adopted to ban smoking in such

places, many of the norm-compliers who previously had kept silent will now speak out.

This effect may be especially important where a relatively small number of additional

informal norm-enforcers may tip the balance in a way that makes norm violations too

uncomfortable to be worth the trouble. (Correspondingly, the adoption of a legal rule,

even without formal enforcement, can cause actors to correctly believe that there will be

more social enforcement of the norm.37) This aspect of the effect of legal rules on social

norms is particularly salient to the duty of care, because the development of the meaning

of that duty in the case law gave institutional investors, the media, and, for that matter,

fellow directors a better purchase for criticism of laggard directors.

The developments in the area of the duty of care illustrates both that descriptive

norms can have significant consequences and that norms may be inefficient. Whether or

not directors today are exercising maximum diligence, it’s clear that they are exercising

significantly more diligence than they were exercising twenty years ago. The prior social

norm concerning the director’s role was essentially the descriptive norm that directors

don’t do much. The effect of this norm was to permit a low level of directorial diligence

by insulating directors who didn’t do much from both external criticism and selfcriticism.

B. The Duty of Loyalty

The duty of loyalty is a shorthand expression for the duty of fair dealing by, and

the trustworthiness of, directors, officers, and controlling shareholders when they are

financially interested in a matter affecting the corporation. A useful entry point into the

relationship between law and social norms in this area is provided by an important article

by and  This article was triggered by the Supreme

Court’s decision in Basic, Inc. v. Levinson,39 which held that a corporation that denies

that it is in merger negotiations violates Rule 10b-5 if the denial is false and the

information is material.40 Macey and Miller criticize this result. They begin by arguing,

as others have, that from an economic perspective fiduciary principles are simply

contractual devices:

This economic perspective is important because it generates a mechanism

by which courts can decide cases. In particular, when scrutinizing

managerial behavior, courts should treat an allegation of a breach of

fiduciary duty as they would treat any alleged breach of contract. This

analytic method often is described as the “hypothetical bargain” approach.

Under this approach to fiduciary duty, courts would evaluate whether the

managers’ actions were consistent with the terms of a hypothetical fully

specified, contingent contract that informed, value-maximizing investors

would have agreed to ex ante.41

Based on this perspective, Macey and Miller argue that lies by corporate officials

should be exempt from liability if they are made with the good faith intention of

furthering the shareholders’ interests, and do not reduce allocative efficiency in ways that

are not internalized by the corporation and create negative externalities. (An example of

a lie that they say would be impermissible under this rule would be a false statement that

a corporation is involved in merger negotiations, where the purpose of the statement is to

make it seem that the corporation is in play, and thereby increase the likelihood of

takeover bids. Here, potential bidders would waste resources in sifting through false

information disseminated by the corporation.)42 Accordingly,  say, the

issue that arose in Basic should have been resolved by asking whether a rational

shareholder group would endorse a corporation’s strategy of publicly and falsely denying

that it was involved in merger negotiations. Based on this standard, Macey and Miller

conclude, a corporation should be able to falsely deny that it is in merger negotiations,

because nondisclosure facilitates merger negotiations, merger negotiations facilitate

mergers, and mergers increase shareholder wealth.

There are important problems with the  analysis even taken on

its own terms. One of these problem is that if the prevailed, then

whenever a corporation made a statement investors could not know whether, if the

statement was a lie, it was the kind of lie that would be permitted or prohibited under the

 rule. Since the Macey and Miller rule isn’t limited to statements

concerning merger negotiations, investors would have to discount all corporate

statements, because they might be permissible lies. Discounting all corporate statements,

however, would make the market significantly less efficient, if not positively inefficient,

which would be bad for shareholders as a class.

Another, related point is made by Ian Ayres. Assuming that a rule that permitted a

corporation to lie was a default rule, then a corporation could vary the rule by committing

itself to honesty. If a corporation didn’t commit to honesty, the market would simply

assume that any statements the corporation made were dishonest. This in turn would

induce all corporations to commit to honesty, which would bring us back to where we are

now.43

The most fundamental problem with the analysis, however, is

that it ignores the expressive function of law. If the Macey and Miller rule was adopted,

the message that the law would send is that there is nothing wrong with lying; that truthtelling

is valued not for its own sake, but only instrumentally. Such a message would

significantly diminish the force of the social norm of truth-telling. Just as the law can add

to the force of an obligational norm by throwing its support to the norm, so it can reduce

the force of an obligational norm by withdrawing support. Even if the result of

sanctioning lies was good for shareholders in their shareholder capacity, therefore, it

would be bad for society, and shareholders are members of society.

There is also a strictly economic reason why the law should not send such a

message. The corporate system operates most efficiently where corporate actors act

loyally -- that is, deal fairly and in a trustworthy manner -- and are perceived to do so.

One way to achieve loyalty is by legal sanctions. This way is very expensive and

probably has limited effectiveness, taken alone, because of the difficulty of detecting

breaches of the duty of loyalty, and the cost of legal enforcement. A second way to

achieve loyalty is to install intracorporate monitoring and bonding systems. This way is

somewhat more effective than a legal regime alone, but it is also very expensive -- and

the more effective, the more expensive.

In contrast, the operation of the social norm of loyalty is very inexpensive. Of

course, if the loyalty norm is adhered to only because the actor fears reputational

sanctions, the problem of detection remains significant. Drawing on terminology used by

 I will refer to loyalty that is based on an internalized norm --

particularly a norm that shapes character -- as authentic, and to loyalty that is based on

reputational concerns as instrumental. Instrumental loyalty is good, but authentic loyalty

is better. Instrumental loyalty will be forthcoming only when disloyalty is easy to

observe. Authentic loyalty will be forthcoming even when disloyalty is difficulty to

observe.

To put the extreme case, if all corporate actors fully internalized the social norm of

loyalty and gave full effect to that norm, the costs of both legal sanctions and monitoringand-

bonding systems would be unnecessary, and the levels of loyalty would be much

higher than those sanctions and systems can achieve. Accordingly, whatever the law does

do to increase the force of the social norm of loyalty, and further its internalization, will

lead to greater efficiency and will therefore benefit shareholders as a class. Whatever the

law does to diminish the force of the social norm of loyalty, and lessen its internalization,

will have the opposite effect. Therefore, even taking the interests of shareholders as a

class, apart from their interests as members of society, a legal regime that promoted the

view that the social norm of loyalty is only instrumental, and thereby diminished both the

force of the norm and its internalization, would reduce the efficiency of the corporate

system.

What is true of the corporate system in particular is also true of the economic

system in general. As stated by Casson:

Overall economic performance depends on transaction costs, and these

mainly reflect the level of trust in the economy. The level of trust depends

in turn on culture. An effective culture has a strong moral content.

Morality can overcome problems that formal procedures – based on

monitoring compliance with contracts – cannot. A strong culture therefore

reduces transaction costs and enhances performance – the success of an

economy depends on the quality of its culture.45

An analogous objection applies to the conception, adduced by  in

support of their argument, that the duty of loyalty is contractual. One problem with this

conception is that it is factually incorrect. The duty of loyalty is seldom if ever imposed

by a contract. Directors and officers do not agree that they will be bound by a duty of

loyalty. Instead, the duty is imposed by law. As stated in Guth v. Loft, “A public policy,

existing through the years, and derived from a profound knowledge of human

characteristics and motives, has established a rule that demands of a corporate officer or

director, peremptorily and inexorably, the most scrupulous observance of his duty. . . .”46

It’s true that the duty of loyalty, and the corresponding rights it creates, may be

limited in certain respects by agreement. However, that a right or a duty may be limited

by agreement doesn’t make the right or duty contractual. For example, the general duty

to exercise reasonable care can be contracted around, within certain limits,47 but that

doesn’t make the law of negligence contractual. Similarly, the right to a jury trial can be

waived, but that doesn’t make the Sixth Amendment contractual. Nor is a right or a duty

contractual because it is imposed on the basis of what courts or legislators believe the

parties would want to do if they had addressed the issue. Even rules governing

nonconsensual transactions, like the rules of tort law, could be justified on that basis.

Furthermore, if the duty of loyalty was contractual, it would follow that the duty could be

completely waived by agreement. Generally speaking, however, it cannot be.48

A more fundamental problem with the contractual conception of the duty of

loyalty is that the critical role of trust in the success of the corporate system would be

significantly undermined if the law sent a message that the duty of loyalty was merely a

contractual duty, not a duty imposed by law. As  has stated:

Competitive corporate contracting cannot achieve all that this [contract]

view . . . promises unless it is aided by the very value that a contractual

understanding of the fiduciary obligation denies, namely, the duty of loyalty

and trust. Trust plays an essential role in all modern economies, and

without it, or without the coordination that is provided by institutional

loyalty, even efficient wealth-maximizing corporate contracting can make

us all worse off. . . . Nor can the concept of trust be very easily

accommodated into the contractual model of the corporation. Properly

interpreted, the concepts of trust and loyalty present a deep challenge not

only to that contractual model, but also to the very conventions of

instrumental rationality upon which the model is based.49

In short, the duty of loyalty is almost never the result of a real contract, and the

adoption by the legal system of the contractual conception of the duty of loyalty, like the

adoption of an instrumental conception of truth-telling, would disserve efficiency

interests.

Another role of the social norm of loyalty is to up the ante for violating the legal

duty of loyalty even for those corporate actors who have not internalized the duty.

Generally speaking, the legal sanctions for violating legal duty-of-loyalty rules are

inefficiently low. The primary legal sanctions are rescission and restitution. Normally,

however, these sanctions only put the fiduciary back to where he would have been if he

had not violated his duty. Because not all violations will be detected, a fiduciary whose

only objective was to maximize his wealth, and who feared only legal sanctions for

violating the duty of loyalty, would have an incentive to violate the duty -- for example,

by taking a corporate opportunity, or dealing unfairly with the corporation in a selfinterested

transaction. If the violation is undetected, the fiduciary comes out ahead. If it

is detected, the fiduciary is normally no worse off, under the legal sanctions, than he

would have been if he hadn’t violated his duty.

Therefore, if the only reason for not violating the duty of loyalty was the prospect

of a legal sanction, fiduciaries would regularly violate that duty. (Although it’s true that

additional legal sanctions are sometimes granted -- for example, loss of salary or punitive

damages -- these sanctions are atypical, and it’s therefore doubtful that the prospect of

such sanctions, discounted by the likelihood that they will be granted, change the picture

that much.) The social norm of loyalty, however, adds the sanction of loss of reputation

to the legal sanction. Because the legal sanction is set at an inefficiently low level, the

increase in sanctions provided by the social norm is necessary if the total sanctions for

breach of the duty of loyalty are to approximate an efficient level.

In the case of the duty of care, the present posture of the law is essentially to

support the social norm of care with a legal standard of conduct that is unaccompanied by

an enforcement strategy. In the case of the duty of loyalty, the legal rules are

accompanied by an enforcement strategy. Thus the legal rules in this area achieve their

ends partly by regulation and partly by the support they give to social norms. The latter,

expressive function of the legal rules in the loyalty area is analogous to the expressive

function provided by many other legal rules. However, the expressive function of the

legal rules of loyalty has a special cast, because those rules not only support the norm but

make it operational and meaningful through concretization.

In this connection, McAdams draws a useful distinction between general norms,

like “friends should be loyal,” and concrete norms, like the obligations “to listen

attentively to a friend’s troubles, to water her plants when she is away, to drive her home

when she is intoxicated, and so on.”50 “Narrow, concrete norms,” he points out, “often

define the meaning of a specific behavior by defining that behavior as complying with or

violating an internalized abstract norm. Thus, an antilittering norm may work because a

consensus arises that littering violates the internalized norm to be a ‘good neighbor.’”51

An important kind of case to which the distinction between general and concrete

norms is relevant consists of norms about how particular social roles should be played:

One social role many in our society internalize is that of “parent”; many

feel guilt if they believe they fail to be a “good” mother or father. Like

most abstract norms, the vagueness of these obligations makes them easily

internalized but provides little concrete behavioral guidance. Yet concrete .

. . norms give many meanings to this obligation: in some communities, the

consensus dictates that a “good parent” reads to his or her children, teaches

them table manners, takes them to church, and provides them with a “safe

environment.”52

Similarly, a general duty of loyalty is one thing; a web of specific duties that

particularize that general duty is another. Few if any philosophers specialize in

delineating the meaning of loyalty in the corporate context. Rather, it is the courts that

have made the general principle of loyalty fully meaningful by spinning out the principle,

through reasoned elaboration, into specific rules governing such matters as the fairness of

self-interested transactions, disclosure, corporate opportunities, the use of corporate

assets, and so forth. Once these rules have been developed, they serve to support the

social norm of loyalty in a variety of ways -- for example, by giving clarity to the norm,

by providing a focal point around which overlapping norms can cohere, and so forth.

These messages, in turn, are amplified by corporate codes of conduct, in which the

specific rules of loyalty are spelled out, and by stories in the business media that discuss

particular transgressions. Thus in the loyalty area, the specific rules that courts develop

simultaneously regulate the conduct of corporate actors and are transmuted into social

norms concerning the conduct of corporate actors.

The role of the law in developing specific social norms in the loyalty area is

important in itself. It also bears on the role of shareholder suits. For at least fifty years,

shareholder suits have come under criticism based on cost-benefit analyses that purport to

show that the financial benefits of such suits are on average less than their costs.53 Most

or all of these studies are technically flawed,54 but I put that to one side. The most basic

problem with these studies is that in calculating benefits they count only direct financial

benefits. This approach ignores two of the most important benefits of shareholder suits.

The first, and most obvious, is their deterrent effect. The second, and even more

important, benefit is that it is through shareholder suits that the specific legal rules of the

duty of loyalty have been shaped. Those legal rules, in turn, have given specific meaning

not only to the legal duty of loyalty, but to the social norm of loyalty. The social norm,

in turn, provides an extremely effective and low-cost way to achieve loyalty. Thus

shareholder suits, whatever their short-term purpose and result, have the long-term result

of creating an extremely valuable public good. The desirability of such suits cannot be

measured without counting the value of that good.

B. Corporate Governance

I now turn to issues of corporate governance, first at the management level and

then at the ownership level. In each of these areas there has been a relatively sudden shift

in the governing norms: in the former area, from a managing board to a monitoring

board; in the latter, from passivity to activity on the part of institutional shareholders.

Each of these shifts in norms resulted in significant part from a change in the beliefsystems

of the relevant corporate actors, and each illustrates the manner in which norms

can shift relatively suddenly once a tipping-point is reached.

1. The Monitoring Board. Until about twenty years ago, the dominant model of

the board was that the board was responsible for managing the business of the

corporation.55 This model was hopelessly unrealistic, because part-time directors cannot

manage the business of, or even set business policy for, a complex enterprise.56

Today, the managerial model of the board has been supplanted by a monitoring

model. The monitoring model recognizes that the business of a publicly held corporation

is managed by its full-time executives. Under the monitoring model, therefore, the

primary functions of the board of a publicly held corporation are, not to manage the

business of the corporation, but to select, regularly evaluate, fix the compensation of, and,

where appropriate, replace the senior executives, and to monitor the conduct of the

corporation’s business to evaluate whether the business is being properly managed.57

This functional component of the monitoring model is complemented by a

structural component. If the board has the function of monitoring the senior executives, it

must be structured to effectuate that function. Effectuating that function requires that the

board consist of at least a majority of directors who are independent of the senior

executives, and that the board have audit, nominating, and compensation committees

composed exclusively of such independent directors.58 I will refer to boards that have

this structure and perform the monitoring function as monitoring boards.

Today, the monitoring model of the board has been almost universally accepted

and adopted in large publicly held corporations. Ultimately, the acceptance and adoption

of the monitoring model of the board rests on its perceived economic advantage in

providing an additional system to monitor the efficiency of management -- in particular,

of the CEO. The monitoring board, taken alone, is an imperfect mechanism to achieve

that end, but because all systems to monitor the efficiency of the management of publicly

held corporations are imperfect, it is important to construct a web of overlapping and

even redundant monitoring systems. The monitoring board is one important part of that

web.

However, the monitoring model would have made as much economic sense twenty

years ago as it does now. The significant question then is not why the monitoring model

has been widely accepted and adopted, but why has it only recently been widely accepted

and adopted -- that is, why a social norm that is efficient now, and would have been

efficient then, wasn’t adopted then? As in the case of the duty of care, the answer in

large part is that there was a shift in the belief-systems of the relevant actors. The

business community, the investment community, the bar, and the bench came to believe

that the monitoring model was important, and acted accordingly.

To begin with, the business community accepted the monitoring model. Thirty

years ago, many prestigious corporations had few or even no independent directors, and

the audit and especially the nominating committee were still in early days. Now, the

situation has completely turned around. The business community’s widespread

acceptance of the model is evidenced not only by actual practice, but by that

community’s statements on best practice. For example, The Business Roundtable, which

consists of the CEOs of 200 American corporations, including most of the largest

corporations, has issued several statements on corporate governance, each of which has

included a strong endorsement of the monitoring model.59 At this point, the monitoring

model is not only endorsed by the business community, but virtually taken for granted.

Similarly, the investment community came to believe in the economic value of

monitoring boards, and began to put pressure on corporations that did not adopt it.

Boards that do not adopt the monitoring model are subjected to severe criticism by

institutional investors, and are publicly derided in forums like Business Week’s annual list

of the twenty-five worst boards, CalPers’s annual list of underperforming companies, and

a list of turkeys issued by the Council of Institutional Investors.

The corporate bar also came to believe in the efficiency of the monitoring board,

and transmitted that belief to the business community, partly through the ALI’s Principles

of Corporate Governance60 and the ABA’s Corporate Director’s Guidebook.61

Finally, decisions of the Delaware courts over the last fifteen or twenty years

provided an incentive for adopting the monitoring model, by making clear that in duty-ofcare,

duty-of-loyalty, and takeover cases very heavy weight would be put on process

considerations, and that the structure of the board, and the way that structure found

expression in the particular case, was a very important process consideration. Indeed,

many of the Delaware cases in the last fifteen or twenty years concerning the duty of

care, the duty of loyalty, and takeover bids can be viewed in significant part as corporategovernance

cases.

It could be argued that this legal stimulus, rather than a change in belief-systems,

caused the change in board norms. Certainly the regulatory aspects of these cases

contributed to the adoption of the new norm, but it is not a full explanation. The criticism

that institutional investors and the media level at corporations that have not adopted the

monitoring model is not based on liability concerns. The promotion of the monitoring

model by the Business Roundtable, the ABA, and the ALI is not based on liability

concerns. Furthermore, an explanation of the new norm based solely on the regulatory

effect of Delaware decisions would fail to explain what led the Delaware courts to reach

these decisions. Judicial decisions don’t drop from clouds. They are, to a significant

extent, the product of the same belief-systems that motivate private actors.

What then caused the shift in belief-systems concerning board function and

structure? One possible reason is simply that the relevant communities were persuaded

by a new idea. Not too long ago, the dominant concept was that the board had the

function of directing the business of the corporation, not of monitoring management. The

new monitoring idea may have been taken up partly because it struck the business

community, the investment community, the bar, and the courts as markedly better than

the old idea.

Another possibility is that the information concerning managerial efficiency that

was transmitted by the spread between takeover-bid prices and market prices affected not

only belief-systems concerning the individual director’s duty of care, but also beliefsystems

concerning the functions and structure of the board.

It might be objected that acceptance of the monitoring model did not result from a

change in belief-systems, but from new efficiency considerations. However, such an

objection would be hard to sustain. One possible story would be that until twenty years

ago all managements were highly efficient, and a monitoring board was therefore

unnecessary. Then, managers became inefficient and monitoring a board became

necessary. This story seems highly unlikely.

Another possible story would be that the institution of takeovers, coupled perhaps

with an upsurge in foreign competition, required corporations to be managed more

efficiently than they had been before. But that wouldn’t be a story showing that the

monitoring board wasn’t needed twenty years ago. Instead, it would be a story that

inefficiencies that were tolerated up to twenty years ago were no longer going to be

tolerated. That story would leave us where we started from: A mechanism that is

efficient now, and would have been equally efficient then, wasn’t adopted then.

An important implication of this history is that it suggests that the governance

structures in place at any given time are not necessarily the most efficient structures.

This suggestion is in line with recent work by Mark Roe,63 Michael Klausner,64 Marcel

Kahan,65 Jody Kraus,66 and others on elements such as path dependence, network

externalities, and the theory of cultural evolution. However, the problem does not reflect

only those elements. Board structure involves a significant conflict of interest, because a

CEO will normally prefer not to be monitored. It took a certain amount of weight on the

other side of the scale to overcome this conflict-of-interest preference. This weight

needed to build up until it reached a tipping point, through the accumulation of changes

in belief-structures and outside pressures that were themselves based on those changes.

Once the tipping point was reached, the result was a relatively sudden widespread

acceptance and adoption of the new norm.

The monitoring-board model is an obligational norm, in that publicly held

corporations that deviate from the model are subject to criticism. It is, however, an

unusual kind of obligational norm. On its face, it seems to apply to institutions, rather

than to individuals. Furthermore, most obligational norms involve interactions between

actors. In contrast, on its face the obligation of the monitoring-board norm seems to

concern only how the corporation should organize itself, rather than how it should

interact with other actors.

Federal Reserve Flow of Funds Accounts as reported by the New York Stock Exchange

in its booklet Shareownership, partly because my major interest here is in historical

changes, and even assuming that there are somewhat more accurate measures than the

Flow of Funds Accounts (which is not at all certain), that data is presumably internally

consistent in its methodology from year to year, so that the rate of change should be

reliable even if the percentages reported for each year are slightly too high or too low.

According to this data, institutions held approximately 50% of all corporate stock

in 1987, around the time when the norm began to shift, and this figure has stayed fairly

constant. But in 1974, almost 25 years earlier, institutions held only 20% less of all

corporate stock -- 41% rather than 50%. And as far back as 1969, institutions held 31%

of corporate stock. Moreover, these figures understate the amount of publicly held stock

held by institutions, because they represent the percentage of all stock so held, not merely

publicly held stock. The New York Stock Exchange estimates that this understatement is

around 10%. Making that adjustment in the data, institutions held around 46% of

publicly held stock as far back as 1974, which corresponds with an estimate made by the

New York Stock Exchange that in that year institutions held 45% of stock listed on that

Exchange.

To fully explain the shift in the norm, therefore, two other factors must be added

to the mix. The first -- once again-- is the rise of the takeover institution. In the face of

tender offers at prices well above the market value of portfolio stocks, institutional

investors who had always sided with management often found themselves opposing

management. Once the passivity norm was breached in this way, it became easier to

breach it in other ways.

The second factor was a change in the demography of institutional investors,

consisting of the dramatic rise in the relative percentage of institutional shareholdings

held by public-pension funds. The passivity norm reflected both the conflicts of interests

of institutional investors and the cultural attitudes of their managers. Although the

public-pension funds are not completely free of conflict-of-interest problems, their

conflicts of interest with managers are much less severe than the conflicts of most other

institutional investors, and their cultural outlooks are not the same as managers of private

entities. As a result, the public-pension funds are able to get out in front on wealthenhancing

issues. Managers of more conflicted institutional investors, who might be

uncomfortable getting out in front, often feel less discomfort in following behind. Thus

the leadership of public-pension funds sparked what Jeff Gordon has aptly called the

latent activism of other institutional investors.73

At the same time, the expressive effect of the DOL’s letters and interpretive

bulletins, even in the absence of a vigorous enforcement apparatus, made the passivity

norm hard to justify. Managers of many institutional investors also became persuaded

that at least some actions at the shareholder level, such as the elimination of poison pills

or the rejection of poorly designed mergers, could add value to portfolios. The combined

weight of liability and economic changes, on the one hand, and changes in beliefstructures

resulting partly from changes in demography, built to a tipping-point that

moved institutional investors relatively quickly from the passivity norm to the activity

norm

VI. Takeover Bids

Until the mid-1970s, hostile takeover bids were not of overarching significance.

After that time, the institution of hostile takeover bids exploded and, in tandem with

increased foreign competition and drastic changes in information technology,

significantly altered the manner in which American businesses were managed. What

caused the change?

Hostile takeovers were far from unknown before the mid-1970s. Indeed, by that

time they were regulated on the federal level by the Williams Act, which had been

adopted in 1968. However, prior to the mid-1970s the social norms of the members of

the business, financial, and legal establishment were strongly opposed to hostile

takeovers. In general, establishment corporations would not make hostile tender offers,

establishment investment bankers would not assist in hostile tender offers, establishment

commercial banks would not finance hostile takeovers, and establishment law firms

would not represent hostile bidders. Accordingly, until the mid-1970s hostile takeovers

were normally engaged in and aided by non-establishment players, such as law firms

consisting of lawyers whom establishment law firms had either cast off or would not hire

because of religious discrimination.

The norms of the establishment were not economically justified. Hostile takeovers

could increase the wealth of shareholders, investment banks, commercial banks, and

lawyers. The threat of hostile takeovers could increase the efficiency of those firms that

were not targets but that were afraid they might be. There was, however, one prominent

group whose wealth or at least whose position would be decreased by hostile takeovers:

corporate managers. Accordingly, it was in the self-interest of corporate managers to

view hostile takeovers as something that was not done, and establishment investment

banks, commercial banks, and law firms adhered to the norm -- partly because they were

concerned with loss of corporate business if they were perceived as norm-violators, and

partly because, as members of the establishment, they internalized the norm.

The equilibrium was changed, and the norm was shifted, by several linked events

in the mid-1970s. In 1973, United Technologies wanted to acquire ESB, a battery

company (formerly known as Electric Storage Battery) whose technologies were

compatible with those of United. ESB turned United away, and United, following the

then-prevailing norm, did not attempt to make a hostile bid. In 1974, however,

International Nickel (Inco) did make a hostile bid for ESB. International Nickel was a

member of the corporate establishment, but not completely -- it was a Canadian

corporation.75 More important, a premier establishment investment bank,

, decided to break ranks and assist Inco’s hostile bid. The story is told by

 in his book, The House of Morgan.

[In the early 1970s, corporate] restructuring was still curbed by Wall Street

etiquette, which frowned on unsolicited takeovers. Afraid of conflicts with

clients,  had a rule against hostile takeovers. In 1970, it

nearly engaged in its first hostile bid when Warner-Lambert decided to take

over part of Eversharp’s shaving business, in that case, the mere threat of a

hostile takeover made the target submit. So Morgan Stanley’s taboobreaking

hostile raid was postponed until 1974, when International Nickel

(Inco) pursued the Philadelphia-based ESB, formerly called Electric

Storage Battery.

. . .[T]he auspices [of the bid] shocked Wall Street, for Inco was a

conservative, blue-chip firm and Morgan Stanley was the official

custodian of the Gentleman Banker’s Code.76

* * *

The nearly forty Morgan Stanley partners . . . debated whether to spurn

Inco or defy a code that had governed the world of high finance for almost

150 years. . . .

. . . The argument of inevitability was probably the decisive one. As

one partner recalls, “The debate was, if we don’t do what our clients want,

somebody else will.” . . . .

 [ chairman] figured out how to twist

the desecration of tradition into seeming veneration: in obliging Inco, the

firm would simply be honoring an old  tradition of serving faithful

clients. But Petito had enough qualms about what they were doing to cast

the upcoming Inco raid as an exception. A compromise was forged: the

bank, in future, would engineer hostile raids only for existing clients and

would fully warn them of unpleasant consequences. This, of course, didn’t

rule out much business. Morgan Stanley’s large clients were just the sort

that would now want to conduct raids, and they would know all about the

unpleasant consequences. The compromise mostly reassured the firm’s

clients that it wouldn’t be coming after them.

The qualifications that Baldwin put on Stanley Morgan’s willingness to assist in

tender offers serve to underline the extent to which Morgan Stanley realized that it was

transgressing the social norm. So does the ensuing situation with Morgan’s traditional

law firm, , as reported in book, The House of Morgan:

At this juncture, Morgan Stanley made another unorthodox decision.

. . . [T]he firm had long relied on the white-glove law firm of Davis, Polk,

and Wardwell, which had looked on takeover work as vulgar and avoided it.

With Morgan Stanley partners terrified of lawsuits onsuing from takeover

work, they now wanted a tough, seasoned specialist. . . . [and hired] the

experienced . . [

had] pioneered in hostile takeovers in the 1950's, when Skadden, Arps was

still a humble, four-man operation. For twenty years, he thrived on the

scraps from law firms that were too haughty or too dignified to conduct

hostile raids. . . .

When  was made a special counsel to Morgan Stanley, there

were stormy scenes with  partners, who were deeply offended

by the decision. Whatever its other consequences, the trend in hostile

takeovers democratized the New York legal world and provided an opening

in Wall Street for Jewish lawyers.77

Stanley flipped, the norm crumbled.78

Once Morgan Stanley sanctioned hostile takeovers, competitors

jumped in. A year later, of First Boston paired up

and to launch a separate M & A operation. In

1974, $100 million was still considered a big deal. By 1978, over eighty

deals exceeded that amount, with a $500- to $600-million range already

commonplace. . . .

Established corporations -- including United Technologies, in 1975 -- launched

hostile takeovers. Similarly, establishment corporations and establishment banks began

financing hostile bidders, and establishment law firms began representing hostile

commercial bidders.

In one important respect, the takeover story is somewhat different than some of the

stories considered up to now. In the cases of directorial care, the structure of the board,

and the role of institutional shareholders, the old, inefficient norm was descriptive, and

gained its power through its licensing or insulating effect. In the takeover case, however,

the old, pre-takeover norm was not merely descriptive, but obligational: making or

assisting in takeovers wasn’t done -- at least, not by those who conceived of themselves

as blue-chip players. In other respects, however, the takeover story resembles those other

cases, by illustrating both the highly significant role of social norms in corporate law, and

the way in which social norms may be bad or inefficient as well as good or efficient.

VII. Conclusion

The role of social norms is pervasive in the law generally, and in corporate law in

particular. In some cases, social norms increase efficiency. This has traditionally been

true in the loyalty area, where the efficiency of social norms in achieving loyalty far

exceeds the efficiency of liability rules or monitoring and bonding systems. Today, at

least, this is also true in the other areas considered in this paper -- care, board structure,

the role of institutional investors, and takeovers. As recently as twenty or thirty years

ago, however, the social norms in those areas promoted inefficiency. Indeed, one

valuable lesson that can be learned from studying the role of social norms in corporate

law is to reinforce the point, made by the recent literature on the corporation from

somewhat different perspectives,79 that notwithstanding modern arguments of social

Darwinianism,80 the structure of corporate institutions at any one time is not necessarily

the most efficient structure.

At least three other important lessons can be learned from studying the role of

social norms in corporate law.

First, it isn’t possible to understand the field of corporate law without

understanding the role of social norms in that field.

Second, to fully evaluate the effect of legal rules and legal institutions in the field

of corporate law, account must be taken of their impact on the formation and effect of

social norms in that area.

Third, the classic distinction between private action and collective action is too

simplistic. Under this distinction, the term collective action is more or less a synonym for

official rules of conduct backed by coercive sanctions. Social norms, however, are also a

form of collective action, which often take the form of private collective rules backed by

coercive sanctions. From this perspective, the operation of social norms in corporate law

may be viewed as a kind of “soft” regulation.

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