Behavioral Economics, Federalism, and the Triumph of Stakeholder

Journal of Business Ethics Ó Springer 2011 DOI 10.1007/s10551-011-0822-0

Behavioral Economics, Federalism, Allen Kaufman and the Triumph of Stakeholder Theory Ernie Englander

ABSTRACT. Stakeholder theorists distinguish between As in the Cold War’s conclusion, when the Berlin normative stakeholders, those who gain moral standing by Wall fell, stakeholder theory’s victory over financial making contributions to the firm, and derivative stake- agency theory occurred with a tumultuous event – holders, those who can constrain the corporate association the 2001 stock market crash. Financial agency the- even though they make no contribution. The board of orists were left to concede that financial markets directors has the legal authority to distinguish among were less than perfect (Fama and French, 2004; these stakeholder groups and to distribute rights and Jensen, 2002; Jensen et al., 2004). This was a point obligations among these stakeholder groups. To be sure, this stakeholder formulation appropriately seizes on the painfully reinforced during the recent financial crisis. firm’s voluntary, associative character. Yet, the firm’s Even Michael Jensen, agency theory’s most promi- constituents contribute assets and incur risks to participate nent apostle, proclaimed himself an ‘‘enlightened’’ in market, economic activities. And, as such, the firm’s stakeholder advocate. This qualification permitted ‘‘stakeholders’’ must share an imperfect language to assist Jensen to distinguish himself from those managerial in making two key economic decisions: (1) who are the theorists who had for two decades resisted agency legitimate and who are the derivative stakeholders; and theory’s advance. Yet, his distance seems rather odd, (2) who should sit on the board? Still, stakeholder theo- given the recent widespread acceptance of behav- rists have good reason to be skeptical of neoclassical ioral economics and law. For, when these are economics. Its assumptions that all act opportunistically incorporated into stakeholder theory, the conten- and that all can calculate rationally and fully hardly cor- tious descriptive disagreements find a satisfactory respond to studies on the managerial experience of cor- resolution, leaving discord on that enduring ethical porate coordination. However, advances in behavioral law and economics now provide a cogent economic logic issue – a fair surplus divide. that readily fits into a stakeholder mode. In brief, we In ‘‘The Corporate Objective Revisited,’’ Sun- argue that (1) the firm’s economic purpose designates daram and Inkpen (2004a, b) hearken back to pre- legitimacy to core stakeholders, to those who add value, enlightened agency theory by reciting the well-worn assume unique risk, and can incur harm; (2) the board complaints against stakeholder theory. The authors serves as the principal who coordinates these core stake- summarize these in a series of questions posed to holders to sustain competitive advantage and new wealth stakeholder advocates: (1) ‘‘How should a manager creation; and (3) state incorporation law, Delaware in identify the important stakeholders and on what basis particular, reinforces the board’s function. These, in turn, should other stakeholders be classified as unimpor- supply selection criteria for board membership. We aim tant’’? (2) ‘‘Who should determine the criteria that to synchronize concepts from behavioral law and eco- distinguish important and unimportant stakehold- nomics with stakeholder theory. ers’’? And, (3) ‘‘[w]hose [core] values should be KEY WORDS: behavioral economics, stakeholder the- represented in such management decision making?’’ ory, corporate governance, board of directors, team (Sundaram and Inkpen, 2004a, pp. 352–353). production Answers to these questions, Sundaram and Inkpen insist require a discriminating economic theory. Unfortunately, the stakeholder response, offered by Freeman et al. (2004) conforms to Sundaram and Inkpen’s stereotype. For Freeman et al., dismiss Professor Allen Kaufman died in September 2007. economic theory insisting that it derives from self- Allen Kaufman and Ernie Englander contained academic discursive communities rather 1999; Marens and Wicks, 1999). ‘‘The managerial than from empirical explorations into ‘‘how managers thesis and stakeholder theory’’ section elaborates operate.’’ Once scholars embark on this inquiry, the economic model. Team production and re- Freeman et al., insist, values become the linguistic/ source-based economics furnishes the foundation, behavioral medium by which managers consolidate the first layer (Barney, 1991; Blair and Stout, 1999; corporate associations. And, once placed on this ter- Conner and Prahalad, 1996; Grant, 1996; Kaufman rain, then, stakeholder theory provides the means for and Englander, 2005). The team production model answering Sundaram and Inkpen’s queries: Stake- firmly resides within the behavioral law and eco- holder theorists distinguish between normative stake- nomics literature; resource-based economics be- holders, those who gain moral standing by making longs to the strategic management literature. contributions to the firm and derivative stakeholders, Arguably, resource-based economics extends team those who can constrain the corporate association even production’s constructs into useful managerial tools. though they make no contribution (Mitchell et al., The section begins with behavioral economics’ 1997; Phillips, 2003). The board of directors has the homo socius. The new ‘‘rational actor’’ supplies team legal authority to distinguish among these stakeholder production with the ‘‘raw material’’ for categoriz- groups and to distribute rights and obligations among ing (describing) the firm as a cooperation game, in these stakeholder groups (Phillips et al., 2003). which corporate directors broker (coordinate) the To be sure, this stakeholder formulation appropri- surplus divides (or allocations) that stakeholders ately seizes on the firm’s voluntary, associative char- consider fair (Aoki, 1984). Mutual gain sets the acter. Yet, the firm’s constituents contribute assets and base line ‘‘fairness’’ standard within the market. incur risks to participate in market, economic activities. The divide itself has no objective, impartial stan- And, as such, the firm’s ‘‘stakeholders’’ must share an dard – only the parties’ subjective estimate that imperfect language to assist in making two key eco- cooperation (Pareto and Kaldor/Hicks efficiency) nomic decisions: (1) who are the legitimate and who beats non-cooperation. Thus, mutual gain ‘‘fairness’’ are the derivative stakeholders; and (2) who should sit (economic efficiency) has an intrinsic ethical standard, on the board? Still, stakeholder theorists have good do no harm. However, its assessment depends wholly reason to be skeptical of neo-classical economics. Its on each group’s voluntary agreement to a deal. assumptions that all act opportunistically and that all This formulation integrates ethical (distributive) can calculate rationally and fully hardly correspond to norms and strategic action. Yet, we dissent from the studies on the managerial experience of corporate usual stakeholder rendition that enables boards to coordination. However, advances in behavioral law select among the primary distributive policies of and economics now provide a cogent economic logic mutual gain and impartiality (Donaldson and Dunfee, that readily fits into a stakeholder model (Blair and 1999; Freeman and Evan, 1990; Phillips et al., 2003). Stout, 1999; Jolls et al., 1998; Kaufman and Englander, Product and financial market competition constrain 2005). Once appropriated, stakeholder theory can U.S. boards from deviating far from a Pareto/Kaldor readily offer answers to Sundaram and Inkpen’s ques- Hicks standard. Thus, we concur with economists tions that stay within the queries’ frame. that directors cannot choose between an impartial In brief, we argue that (1) the firm’s economic standard (Rawls’ difference principle, utilitarianism) purpose designates legitimacy to core stakeholders, to and mutual gain (reciprocity/procedural justice) those who add value, assume unique risk, and can (Barry, 1989; Bowles, 2003; Fehr and Gachter, 2000). incur harm; (2) the board serves as the principal who Public policy, instead, becomes the site for remedying coordinates these core stakeholders to sustain com- ‘‘unfair’’ market outcomes. Here, we simply follow petitive advantage and new wealth creation; and (3) the customary distinction between local justice and state incorporation law, Delaware in particular, public policy (global) justice (Child and Marcoux, reinforces the board’s function. These, in turn, 1999; Elster, 1992; Phillips, 1997, 2003; Rawls, 1999; supply selection criteria for board membership. critique of Freeman and Evans, 1990.) We aim to synchronize concepts from behavioral Unregulated markets reproduce bargaining advan- law and economics with stakeholder theory (Freeman, tages. Among them, liquidity confers to money- 1984; Harrison and Freeman, 1999; Jones and Wicks, market-managers’ substantial power. A focal firm Behavioral Economics, Federalism, and the Triumph of Stakeholder Theory corporate control group may fully structure divide/ The managerial thesis and stakeholder allocation rules to benefit the most powerful, e.g., theory shareholders and managers; or the control group may strike deals that distribute benefits to coalesce Managerial theory’s enduring relevance stakeholders into a new wealth-generating team. Moreover, team production generates (descriptive, The theory of the firm (despite the definite article, instrumental) concepts – value creation, unique risk, ‘‘the’’) has been contested among and between neo- and strategic information – that corporate directors classical economists and managerial theorists. Stake- can deploy in constructing an economic strategy and holder theory belongs to the latter, even if it in assembling a board demographically fitted to the has not directly entered formal economic debates. In firm’s core competencies (Kaufman and Englander, the immediate post-WWII years, neo-classical 2005; Prahalad, 1993). These concepts neatly coin- economists spent little time considering the firm. cide with resource-based economics’ powerful con- Instead, they pursued a general equilibrium model tributions to strategic practice (Barney, 1991; Grant, (Arrow and Debreu, 1954). Economists constructed 1996). As conceived by these two theories, the board, this based on homo economicus, who had unlimited rather than senior managers per se, acts as the team trust rational powers (unbounded rationality), full infor- initiator (trustor) (Bhattacharya et al., 1998; Gulati, mation and selfish motivation. These sufficed to 1995; Kaufman and Englander, 2005; Lewicki and demonstrate that perfectly competitive markets Bunker, 1995; McKnight and Cummings, 1998; equilibrated efficiently (Fama, 1970). Whitener et al., 1998). And, because various con- Managerial theorists found the exercise useful but stituents participate in the firm’s surplus value (e.g., raised a simple objection: As an historical fact, firms above spot-market wages) and because new wealth existed and markets churned. The most influential creation occurs over extended capital allocation managerial works came from Carnegie Mellon periods, we use total value maximization as the cor- University (CMU). Unlike their neo-classical coun- porate objective – a maxim on which agency and terparts, the CMU group proceeded from behavioral stakeholder theorists can now concur (Jensen, 2002; assumptions that humans had limited mental abilities Post et al., 2002). (bounded rationality), that they acted from imperfect ‘‘State incorporation acts and directors’ fiduciary information, and that they would engage in coop- duties’’ section considers how corporate law defines erative (other regarding) undertakings (Cyert and the board as coordinator and team fiduciary. Our March, 1963; Simon, 1955, 1959/1976). Firms, argument challenges the widely held academic belief consequently, formed to augment bounded deci- that the state courts actually conceive of shareholders sion-making powers. as the corporate principal and directors as their agent. This formulation, however, lacked sufficient To right this factual error, we review Delaware precision and pushed managerial theorists to con- corporate law. It defines directors the principal and sider alternatives. Initially, transaction cost eco- encumbers them with fiduciary duties to the firm as nomics promised the most. Williamson (1970), a going concern. By defining directors as corporate himself a CMU product, combined the two tradi- trustees, Delaware demands that they behave in tions. He agreed with his CMU mentors that hu- other-regarding ways – that they should be trust- mans had unbounded rationality and imperfect worthy (Bainbridge, 2002a, b; Hardin, 2002; Rock, information. However, he dissented on rationality’s 1997). On this matter, behavioral law and eco- collaborative nature. Accordingly, Williamson pre- nomics has remained silent while stakeholder theory sumed an imperfect, opportunistic homo economicus. has exhibited a bias toward fairness, toward impar- With these assumptions in hand, Williamson set tiality. By including these behavioral law and eco- about to answer systematically, Coase’s (1937) nomic analytics (along with a customary ethical famous question – how do firms improve on market norm) into stakeholder theory, we generate a variant transactions (Englander, 1986; Williamson, 1985). that affords individually corporate boards a cogent Managerial hierarchies appear, Williamson argued, competitive tool and collectively a persuasive when administrative rules are less costly to perform ‘‘technocratic’’ public policy language. than contractual arrangements. Thus, in Williamson’s Allen Kaufman and Ernie Englander rendering, firms are transaction cost minimizing de- cost and resource-based counterpoints, neo-classical vices and managers are sophisticated accountants. economists introduced bounded rationality and imperfect information. These two sufficed to ac- count for the gains that occurred when individuals Resource-based economics entered joint, team production relations (Alchian and Demsetz, 1972; Aoki, 1984). These economists, At first, managerial economists found Williamson’s who chronologically preceded resource-based the- formulation insightful but lamentably not sufficient orists, recognized that firms were able to generate (Ghoshal and Moran, 1996). They agreed that innovations faster than solitary efforts by melding transaction costs rose as firms invested in specialized complementary assets into coordinated action. And, assets. However, the firm’s ability to assemble, so long as firms sustained their joint production coordinate and sustain specialized innovative assets advantages, they earned quasi-rents, which like re- seemed a better account of the firm’s potential source-based theorists, defined the firm’s primary ‘‘economizing’’ advantages than transaction cost aim. reduction. Team production addresses this issue by intro- Resource-based managerial theorists have con- ducing ‘‘other-regarding’’ behavior such as bounded tributed the most in developing an alternative. These self-interest. The concept comes from behavioral scholars, following the lead of Penrose (1959/1995), economics, which like managerial theory, has deep and Nelson and Winter (1982), argued that the firm connections to the CMU managerial school (Bow- could improve on the market by combining com- les, 2004). Nevertheless, behavioral economics has plementary assets into unique competitive know– not been adequately integrated into stakeholder how relationships (Barney, 1991, 2001; Grant, 1996; theory. Kay, 1997; Wernerfelt, 1984, 1995). So long as Although cooperation brings gains, neo-classical managers could preserve this know–how within the economists have had great difficulty in explain- firm’s singular social relationships, then, the firm’s ing why individuals would cooperate. Economists members would enjoy above average returns, both encounter two hindrances. First, because the firm on capital and labor. Thus, rather than conceiving can temporarily escape the market’s price-setting the firm as a transaction cost minimizing organiza- mechanism, the team has no way of disaggregating tion, resource-based theorists depicted the firm as a marginal contributions (the non-separability prob- rent-seeking collaborative project and managers as lem). Hence, the team must devise a method for coordinators (Amit and Schoemaker, 1993). allocating the surplus that exceeds marginal returns. Moreover, resource-based economics contested Second, individuals of the homo economicus variety Williamson’s opportunism premise. Conner and find it difficult to agree on division and work rules or Prahalad (1996) develop the latter argument explic- effort – the free-rider problem (Alchian and Dem- itly. They reason that cognitive limitations, even setz, 1972; Hart, 1990; Holmstrom, 1982). As ra- when all act non-opportunistically, establish suffi- tional economic agents, each seeks to maximize cient motivation for individuals to collaborate in utility, and each is indifferent to the other. Thus, hierarchical arrangements. These command systems each wishes to gain as much as possible while allow knowledgeable managers to direct uninformed expending as little as possible. This ‘‘preference’’ and inexperienced workers, thereby economizing order can easily turn cooperative behavior into a on learning costs and augmenting innovation prisoner’s dilemma (PD), where all recognize opportunities. cooperation to be the best choice but defection the rational (default) choice (Hardin, 1982). One solution would have the individuals dis- Homo socius and team production tribute control rights to a member who would act as coordinator and set surplus division and work Most neo-classical economists remained outside rules (Alchian and Demsetz, 1972, 1973). How- these debates, pursuing instead a theory based on ever, the solution comes with inherent problems: joint or team production. Like their transaction How would the individuals select the ‘‘owner’’ Behavioral Economics, Federalism, and the Triumph of Stakeholder Theory endowed with control and residual rights (Gross- Unfortunately, the experiments do not follow the man and Hart, 1986)? Even if the team members predicted pattern. Instead, they demonstrate that could resolve this issue, they would encounter individuals act with regard to others. Individuals another: The owner has the right to sell off the have bounded self-interest as well as bounded team’s assets, discouraging team members from rationality. Thus, ultimatum game deals get struck making firm specific human capital investments within a well-defined range. It functions as a con- (Rajan and Zingales, 1998). Finally, how would the vention, a rule of thumb. It appears as a 50/50 split, ‘‘owner’’ set division and work rules, ex ante or ex adjusted for bargaining power. Common parlance post?Ifex ante, then, members have incentives to would label such a deal fair. This rule of thumb has shirk: if ex post, then each fights for the largest real clout. The responder’s willingness to impose share, stalling or even preventing a final division harm on both of the players illustrates fairness’ and repeated play. power. That each plays by a rule of thumb conforms neatly to cognitive psychologists’ objections to homo The behavioral foundation for team (joint) production economicus. They have long doubted the economist’s construct of a rational actor who calculates alterna- Recent advances in behavioral economics has pro- tive options with exacting scientific accuracy. In- vided an economic agent who does not have the deed, experimental research has demonstrated that same maximizing, non-other-regarding attributes. individuals calculate probabilities by using rule of Neo-homo economicus’ ‘‘other-regarding’’ behavior thumb (heuristic) devices (Simon, 1955, 1959/1976; easily accommodates cooperation. Those engaged in Tversky and Kahneman, 1974). this research enterprise have identified numerous The ultimatum game provides another lesson: behavioral and cognitive characteristics – e.g., Human behavior is malleable. When experimenters aversion to loss, over-optimism, self-serving bias, slightly alter the game’s circumstances, alternative other-regarding preferences, and spite – that are not behavioral patterns arise. Still, they do not conform found in neo-classical economics’ rational actor to rationality’s predictions. Ultimate game outcomes model. We consider those – bounded self-interest also vary when rules or processes are changed. Even (fairness, spite, and endowment) and bounded a change in the game’s name, substituting ‘‘ex- rationality (rule of thumb) – that rewrite homo eco- change’’ for ‘‘ultimate,’’ has a significant effect. In nomicus into a cooperative species (Jolls et al., 1998; the exchange game (played exactly as the ultimatum Sen, 2002; Thaler, 2000; Bowles, 2004). game), the proposers typically offered less and The concept of bounded self-interest comes pri- responders usually accepted. A simple name change marily from empirical studies. Behavioral psycholo- permits previously unacceptable behavior. This is an gists have used an experiment, the ultimatum game, important point to remember when we review to assess whether actual (rather than theoretically fiduciary duty later in our article (Hoffman et al., constructed) individuals behave acquisitively (self- 1994). interestedly) or with regard to others (fairly) (Fehr In all, the ultimatum game provides two gener- and Gachter, 2000). Like the PD, the ultimate game alizations about human nature. First, human behav- is deceptively simple. The game has two players. ior varies (Bowles, 2004). The empirical experi- One acts as the proposer, the other as the responder. ments uncovered distinctive response patterns Each can receive a sum of money if they strike a – selfishness, mutualism, spite, and altruism. Of deal. The proposer sets the divide and offers it to the these, other-regarding behavior dominates. How- responder. If she rejects the offer, then, neither gets ever, it typically does not arise from altruism. To the the proposed payoff. If she accepts then they each contrary, the ultimatum game suggests that the get the sum allocated by the proposer. Neither proposer acts fairly because, on average, it outper- knows the other’s identity. And, they play the game forms rational maximization. Thus, the ultimatum only once. This eliminates reputation effects, retali- game reveals reciprocal rather than altruistic other- ation, and learning from the game (Kahneman et al., regarding behavior (Greenfield and Kostant, 2003). 1986). Individuals willingly reduce their immediate gain Allen Kaufman and Ernie Englander when they know others adhere to rules that all deem distribution of rights (entitlements), income and fair (Rabin, 1993). And, both adjust their expecta- wealth (endowments) – affect each party’s bargaining tions according to their bargaining power. Reci- power. These (or, their lack) contribute to each procity reformulates self-interested behavior: party’s willingness to set reserve prices and to inflict Individuals best promote their self-interest when injury when unfair deals provoke outrage, thereby, they recognize that gains occur through cooperation turning the best of intentions into disagreeable and that cooperation bounds self-interest (Bowles, behavior (Luo, 2005; Morrison and Robinson, 2004; Thaler, 2000). 1997). The coordinator must carefully explain the Second, process matters. One can accept an out- bargaining advantages and disadvantages that each come that breaks the norm when the process denies bears, if each is to acknowledge the others actual the proposer free will. And, both can act like rational circumstances. economic actors when the game signals acquisitive Fairness, itself, serves as a rule of thumb that behavior to be the norm. For managerial theorists, minimizes conflict (Rabin, 1993). Fairness functions, this finding is hardly novel. It merely reinforces by setting expectations that allow for long-term well-established literatures about the managerial cooperative relationships in which both parties can function and about setting rules for communication gain (Phillips, 1997). And, deviations from the rule and negotiation (Barnard, 1938; Raiffa, 1982). can provoke ‘‘irrational’’ behavior, refusal to close a Bounded self-interest, loss aversion (endowment/ mutual advantage deal. Yet, fairness, itself, has no entitlement), rule of thumb (fairness) and spite offer readily objective designation. Placed within an eco- the material for a complex utility function, one that nomic vernacular, a deal is either optimal or sub- better explains experimental results than the utility optimal (Hardin, 1995). It either allows for the largest function found in neo-classical economics (Bolton surplus possible under given circumstances or it falls and Ockenfels, 2000; Bowles, 2004; Fehr and short. The optimal outcome, however, has no un- Schmidt, 1999; Rabin, 1993). Together they pro- ique division or surplus allocation rule and requires vide the basis for cooperation and for ‘‘rational’’ that human agency reach an accord (Barry, 1989). resistance. Each may refuse offers that, while giving Consequently, the players may delve deeply into them gains over the non-agreement point, challenge distributive justice and select a rule on which all can their sense of entitlement and fairness. agree, e.g., Rawls’ difference principle (Rawls, 1999). Of course, resistance comes with costs – with Or, they may accept mutual gain as the distributive effort expended, harm imposed, and increased risk norm and proceed formally by adopting a bargaining for disagreement. For an agreement to occur, one scenario. For example, the one with the most to lose party must either concede to the other’s best out- concedes (Nash equilibrium). Or, the players might come or the two must make concessions. To strike a just adopt the simple 50/50 rule, disregarding bar- rational agreement, each must make concessions that gaining differences among them (Barry, 1989). are the other finds fair, i.e., that the other’s bar- To be an effective replacement, the coordinator gaining power (endowment and entitlement) de- develops informational and communication skills to mands. accomplish the following: (1) For assessing each stakeholder’s contributions, risks and bargaining power; (2) for facilitating agreement on the surplus Team production and the coordination function division rule that each finds fair, i.e., one that recog- nizes each party’s bargaining power and entitlements; The coordination function emerges out of efforts to (3) for defining the team’s unique know–how and mitigate costly and contentious bargaining. This planning ways to augment it; (4) for monitoring and analysis relies heavily on Aoki’s Co-Operative Game administratively enforcing division and work rules; Theory of the Firm (1984) (See also Rajan and Zin- and (5) for forecasting future market opportunities gales, 1998). The coordinator stands-in for the price and threats (Phillips, 2003). All this requires special- system that if it were operative, would indifferently ization – individuals schooled in the coordination set terms among all stakeholders, including third functions abstract principles. However, proficiency in parties (Aoki, 1984). Background conditions – the abstract reasoning does not suffice. A coordinator Behavioral Economics, Federalism, and the Triumph of Stakeholder Theory must be able to apply these principles in practice and (Hardin, 2002; Whitener et al., 1998). Coordinators’ to earn a reputation by her brokered deals. self-interest derives from their privileged participa- This description suggests that coordinators have tion in a small, but powerful community. flexibility in selecting between a mutual gain pro- As the teams grow in complexity, the coordina- cedure and an impartial standard (Phillips, 1997). tion function cannot be performed by a single However, markets operate through mutual gain individual. The team’s core competencies coalesce transactions (Barry, 1989, 1995; Gauthier, 1986; and evolve as members invest in team-specific skills Nozick, 1974). And, competition imposes a bar- which impose unique risk on each and collectively gaining power band between capital and labor. render market substitutability baseless (Bainbridge, Hence, coordinators typically must adhere to mutual 2002a; Blair and Stout, 1999). This complexity re- gain’s bargaining logic, though tempered by reci- quires a set of coordinators – in corporate gover- procity (Bowles, 2003; Fehr and Gachter, 2000; nance terms, a board of directors. Their combined Fehr and Schmidt, 1999; Phillips, 2003). Outcomes know–how can apprehend the diverse human capital must reproduce bargaining differences among the components that comprise the firm’s innovative contracting parties. Take disadvantaged labor and powers (Mohrman et al., 1995). advantaged capital. Labor gains bargaining power Value creation, unique risk and strategic infor- from firm specific human capital investments. On mation comprise the basic categories for selecting the other hand, capital’s fungible nature advantages it corporate directors (coordinators) who can repro- over labor. Capital resides in financial portfolios that, duce, in effect, the firm’s core competencies – the with electronic speed, traverse financial instruments firm’s core stakeholders (Kaufman and Englander, to obtain maximum risk adjusted returns. Neverthe- 2005). To illustrate, consider the U.S. corporate less, reciprocity tempers capital. It must acknowledge setting in which control (board) and residual rights labor’s bargaining power (effort and shirking), forcing (shareholder/portfolio investor) are separated. Value deals that beat the theoretic minimum above non- creation refers to those stakeholders who have cooperation. specialized skills to generate the firm’s competi- Because mutual gain (Pareto or Kaldor/Hicks tive advantage. Because these core stakeholders efficient) ‘‘naturally’’ belongs to market transactions, (employees, suppliers, and customers) invest in spe- we label it focal-firm or local distributive justice, cialized human capital and capital stock, they incur thereby recognizing that the state may readjust unique risk. Here, we consider the firm as a supply market outcomes based on an impartial (utilitarian or chain member. Hence, customers (e.g., original a Rawlsian minimax) standard (Barry, 1989; Elster, equipment manufacturers) cooperate with suppliers 1992; Rawls, 1999). This logic differs from Phillips, to augment productivity and product functionality 1997, 2003. He claims that market-brokered deals (Kaufman et al., 2000). Team members possess skills are impartially fair. Those who engage in these that do not easily transfer to other firms. The indi- negotiations may employ fairness when procedures vidual’s skill has full value only within the team’s permit full discussion. However, market outcomes social interactions. hardly conform to a fairness standard whether in the Shareholders, too, create value even though they Rawlsian or utilitarian sense. And, we speak of the neither participate in the firm’s core processes nor coordinator as a neutral or technocratic broker assume unique risk. Actually, the category share- (Phillips, 2003). A discussion of this distinction holder has become an anachronism. Today, share- occurs in a later section. holders typically find themselves part of an investor’s diversified portfolios. These investors allocate liquid capital as alternative investments (stocks, bonds, Core competencies and team production commercial loans, real estate, etc.) promise higher yields than current ones. And, money market man- If coordinators are to be successful, they must gain agers (institutional investors) have aggregated each team member’s trust. The team’s constituents investor capital into large funds that can augment consider the coordinator trustworthy when indi- and diminish a firm’s value. Thus, investors, while vidual self-interest encapsulates the team interest they keep financial score, incur diversified risk, Allen Kaufman and Ernie Englander adjusted to their preferences. A corporate board without the law and police powers. Yet, as a (a team coordination committee) requires members historic fact, complex teams that amalgamate pro- who have expert knowledge on the capital markets, duction factors take on a special legal status – the if the team is to compete effectively against other business corporation. Incorporation requires a financial instruments. coordination committee, the board of directors. Boards require strategic information beyond the The directors’ public identity legally emerges from financial markets – for example, on commodity the law from incorporation and regulatory initia- markets and on technological possibilities. Such tives. information is neither readily available nor easily Consider the classical liberal account of the state decipherable. Hence, boards (coordination com- that proceeds from Hobbes’ brutish state of nature mittees) must include outside coordinators with where all would gladly concede to a dictator if that specialized knowledge, i.e., know–how in those would guarantee security (Olson, 2000). The state, domains critical to the firms success. by monopolizing military force, abates civil strife and Finally, the firm’s practices may impose unique patterns cooperative behavior. Yet, even the most risk on non-contractual stakeholders who endure authoritarian state cannot suppress crime nor fully third party harm (negative externalities). The chem- enforce all contractual promises and fiduciary obli- ical industry provides a salient example. Its toxic gations. The state merely reduces the risks of con- substances can degrade a community’s environ- tract and fiduciary breaches. mental well-being. A region dependent upon a Risk reduction provides the central impetus for single employer or industry supplies another exam- state incorporation laws. Within a secure property ple. Should technological improvements or out- rights system, suppliers and customers develop sourcing jobs dislocate workers, then, the community ongoing, mass production relationships. Inter-firm will confront economic hardships above the market supply chain dependencies increase business risk. average. When a cooperative team imposes unique Specialized assets and relational contracts put each risks on third party stakeholders, the board must have firm at risk – the risk to be held-up or to be gouged. directors familiar with this group’s circumstances, if Under these circumstances, the integrated firm the firm is to avoid harm (unethical behavior) – by betters the market in managing the asset and bearing pushing costs onto others. the risk (Williamson, 1985). However, vertical With such a diverse group won’t coordination integration requires large amounts of capital for the committees (boards) simply become an arena for initial purchases and for daily cash flow require- distributive conflicts? Won’t these squabbles merely ments. These large capital sums typically exceed an undo the solution that a neutral technocrat pro- investor’s, a creditor’s, or a group of investor/cred- vided? Or, perhaps, the board will work by com- itors’ risk limitations. Incorporation grants limited promise, ‘‘satisficing’’ each stakeholder group instead liability for an investor class, shareholders (Klein and of maximizing ‘‘surplus value.’’ Behavioral research Coffee, 2004). Reduced financial risk lessens equity has shown that powerful incentives are available for capital’s cost. consolidating groups – even those whose short-term Limited liability forms the usual economic ac- interests may conflict (Bainbridge, 2002a). Individ- count for incorporation. However, team produc- uals bond well when they identify themselves as part tion offers another – a coordination committee. of an ‘‘in-group.’’ In fact, empirical research indi- Incorporation acts establish the corporate board as cates that coordinators develop a social network that coordinator and inscribe the board, corporate promotes trust and open dialog (Westphal, 1999). directors, with fiduciary duties (a duty of care and a duty of loyalty) to the corporation as a going concern (Stout, 2003). Thus, corporate law facil- State incorporation acts and directors’ itates coordination by assuring stakeholders that fiduciary duties the board is trustworthy (Rock and Wachter, 2002). The law imposes on directors a local All of these corporate coordination activities oc- obligation to assure the welfare of all corporate cur, in theory, without government assistance, stakeholders. Behavioral Economics, Federalism, and the Triumph of Stakeholder Theory

U.S. federalism and corporate law This amalgam now divides legal scholars. One group emphasizes contract and the other, trust. In the United States, federalism stands among the most Those who stress corporate law’s contractarian lan- efficacious means for restraining governmental abuse guage belong to the law and economics movement (Hardin, 2003). The states’ rivalries and their common (Cheung, 1983; Coase, 1937; Easterbrook and competition against the federal government lessen the Fischel, 1991; Meckling and Jensen, 1976). It chance for government mischief whether by the states repeatedly speaks of the firm as a spontaneous asso- or the national government. Within these overlapping ciation of individuals choosing to organize them- jurisdictions, incorporation and internal governance selves in order to produce and sell something, but belong to the states and stakeholder regulation belongs having no public responsibilities. In contrast, team to the federal government (Romano, 1993). In prin- production (arising within the constructs of behav- ciple, state governments allow for a geographic plu- ioral law and economics) considers the law to be an ralism that engenders competition for corporate enabling device that binds the firm by encumbering franchise revenues although there is disagreement over directors with fiduciary duties (Bebchuk, 1989; Ei- whether this turns into a ‘‘race to the bottom’’ or a senberg, 1989, 1999). Where law and economics ‘‘race to the top’’ (Bebchuk, 1989;Cary,1974; labels directors as private-sector rational actors, team Romano, 1993; Winter, 1977). There is also a third production portrays directors’ standing ambiguously: account in which interest groups, investment bankers As the firm’s principal and fiduciary, the directors and lawyers benefit from Delaware’s dominance and coalesce private-contracting stakeholders into a lobby to sustain it (Macey and Miller, 1987). publicly traded firm. During the twentieth century, state competition Trust and contract form the conceptual building for business incorporations has turned into an blocks of U.S. corporate law. Contact seems clear anachronism. Delaware has effectively ‘‘won’’ the enough. But why trust? Why has it been an race, at least for large publicly traded firms as nearly enduring tradition within U.S. corporate law? Why half of the firms listed on the New York Stock hasn’t contract law, on which the firm’s activities Exchange and almost 60% of the Fortune 500 firms depend solely, informed state incorporation statutes? are incorporated in Delaware. Data also clearly The answer seems simple enough. Trust law pre- shows that nearly all corporations that leave their dated contract law. And, trust’s properties – en- home state to incorporate in another end up in ablement, elasticity, and flexibility – have sustained Delaware (Bebchuk and Cohen, 2003; Bratton and its prominence in corporate law (Maitland, 1981; McCahery, 2006). Consequently, we follow con- Sitkoff, 2004). vention and use Delaware as our standard for our A trust is a state enforceable bargain which was discussion of state corporate law and regulation. originally established between a donor and a trustee (Langbein, 1995). In the pure donative trust, the law regulates relationships in which a donor (settlor) Contract vs. trust employs another (trustee) who acts on a beneficiary’s behalf. The trustee or fiduciary assumes responsi- An incorporation charter instructs corporate directors bilities to preserve and augment the beneficiary’s to act on behalf of all of the firm’s constituents and property without the donor’s oversight. Even treat each of them equitably. The charter legally ob- though the donor and the trustee enter into a con- liges directors to consider the corporate team’s tractual agreement, the beneficiary’s dependency interests first. This legal restraint on homo economicus (vulnerability) binds the state to ensure the trustee’s (i.e., board members acting in their own self-interest) loyalty (Sitkoff, 2004). In its classical legal formula- does not arise from contract law but rather from trust tion, the fiduciary duty of loyalty forbids the trustee law. Both trust and contract come into play in the to engage in self-interested transactions, even when legal definition of the firm. Yet, they uneasily amal- these can be profitable for the beneficiary. Correc- gamate into the business corporation (Kaufman and tive action requires the trustee to disgorge any profits Zacharias, 1992). (Langbein, 1995). Allen Kaufman and Ernie Englander

Law and economics shareholders are the principals and boards are their agents (Easterbrook and Fischel, 1991). The law and economics movement does not deny This contractual logic does yield substantive in- that, historically, trust first facilitated the business sights. Law and economics scholars, for example, corporation’s formation. Yet, if history granted trust present a better account of the courts’ permissiveness prominence in corporate law, then, trust rested on a with fiduciary duties than trust doctrine. Under contingent privilege. Consequently, law and eco- certain conditions, the courts find director self- nomics scholars have enjoined an abstract logic (like dealing beneficial to the corporation. For example, their classical legal predecessors) to bring corporate the Delaware court permits directors and senior law under contract’s dominion. managers to dispose of corporate assets self-servingly Their deductive argument begins with Frederic as long as the corporation is treated fairly and outside Maitland’s original account of trust’s historic con- or independent directors approve the transaction. tractual basis (Langbein, 1995; Maitland, 1981). (Bainbridge, 2002b). Trusts work like contracts in two essential ways. This contractual logic provides an equally satis- First, trust arrangements involve autonomous indi- fying explanation for the courts’ long refusal to viduals who enter into a voluntary, but legally subordinate the business judgment rule to the duty binding agreement. Donor trusts are, in effect, of care. Until the 1980s, the courts routinely de- contracts for a third party beneficiary (Atiyah, 1995; ferred to the lesser business judgment rule rather Langbein, 1995). Second, the donor and the trustee, than the prudent person rule, unless unusual cir- like the promisor and promisee in contract law, cumstances were proven (such as self-serving deals, typically rely on default rules. fraud, or illegality) (Dent, 1981; Horsey, 1994). In recent years, the courts have distinguished Where the prudent person rule asks the courts to between short-term and long-term contracts, ren- consider whether directors acted reasonably, with dering trust unnecessary to corporate law (Atiyah, the care of a prudent person, the business judgment 1995; MacNeil, 1980). When individuals enter dis- rule simply acquiesces to the firm’s internal hierarchy crete, short-term contracts, contingencies and their as a legitimate arbiter (Bainbridge, 2002b). associated risks rarely matter. In contrast, long-term contracts inevitably encounter contractually unspec- ified events and outcomes. To enter a long-term Behavioral law and economics contract, the parties must trust the other to act in good faith, to suppress opportunist impulses, and Trust law, by demanding that the fiduciary acts in fulfill obligations (MacNeil, 1980). another’s interest, differs substantively from contracts When one party breaches the contract, the in- (Marens and Wicks, 1999). Yet, contracts are the jured party seeks redress from the courts. The courts mediating mechanism that coalesce individuals and willingly order compensation when the plaintiff groups into corporate production teams. Why then demonstrates that the defendant has acted uncon- does corporate law rely on a legal tradition outside scionably or in bad faith. To do this, the courts use contracts? Why trust? Why fiduciary duty? Since the ex ante reasoning. Thus, good faith has taken on a 1960s, differences between trust and contract have fiduciary-like quality. Each must strive, when the narrowed. However, the two have not collapsed unexpected arises, to assure the contract remains into one. mutually beneficial (Langbein, 1995). Delaware illustrates this argument. Corporate case Finally, law and economics advances only a law in Delaware defines the board as the corpora- superficially satisfying answer to the knotty question: tion’s authoritative body or as the corporation’s To whom are directors accountable (Dodd, 1932)? principal (Bainbridge, 2002a, b; Springer, 1999). Law and economics tries to banish ambiguity by Shareholders elect directors, but Delaware instructs engaging modern microeconomic theory, in par- directors that their fiduciary obligation extends both ticular, financial agency theory. The argument pro- to the shareholders and the corporation, itself ceeds by analogy and transports agency law into Johnson and Millon (2005). Delaware’s incorporation corporate law. Financial agency theory declares that charter is unequivocal on the corporate board’s Behavioral Economics, Federalism, and the Triumph of Stakeholder Theory primacy and on its authority to oversee the firm a trustee (fiduciary) a critical resource (whether (Bainbridge, 2002b; Clark, 1985; Rock, 2000). The tangible as land, or intangible as confidential infor- charter plainly states that the corporation shall be mation). This transfer legally binds the fiduciary to under the direction of a board of directors who are use the resource on the beneficiary’s behalf. Unlike a encumbered with fiduciary duties. principal–agent relationship, the beneficiary does not The board assembles a management team or directly control or oversee the trustee. delegates this responsibility to senior executives. The Corporate law does not conform to either the board has the authority to specify administrative agency or donative trust structure. Corporate law work rules, to draw and redraw the firm’s bound- establishes its own variant though it is derived from aries, and to provide incentives for recruiting, donative trust. The corporation forms when indi- retaining, and motivating employees. In all, the viduals or contracting parties commit (by analogy, board animates the firm’s physical assets (capital donate) resources to a joint effort. The corporate stock) by allowing or disallowing human capital team members expect the board to transform their access to these resources (Rajan and Zingales, 1998). critical resources into the firm’s core competencies Once hired, corporate officers conduct business as and to enhance the firm’s competitive capabilities. the directors’ agents. They, not directors, come These trustees, then, act on the corporate team’s under agency law – contrary to financial agency behalf (beneficiaries) and augment their wealth- theory (Johnson and Millon, 2005; Langevoort, generating powers and distribute the benefits among 2003; Marens and Wicks, 1999; Rock, 2000). Still, team members. To enable the board to function as directors remain accountable to shareholders who coordinator, corporate law establishes clear fiduciary are endowed with specific rights: (1) the right to (behavioral) expectations. In imperfect markets, vote on directors, bylaw amendments, mergers, sales corporate donors cannot write complete contracts of corporate assets, and dissolution and (2) the right and instead rely on fiduciary duties as gap fillers to initiate derivative suits. More important, share- (Kaufman, 2002). holders, as institutional investors, hold boards Although elastic, corporate duty of loyalty differs accountable by reallocating funds among financial from good faith and fair dealing in relational con- portfolios, and augmenting the value of some tracting. Relational contracts, even when clearly instruments and diminishing the value of others. tempered by good faith provisions, permit the contracting parties to act self-interestedly, even injuriously to the other, as long the contract coun- Team production and trust tenances the questionable actions (Smith, 2002). When courts are asked to interpret a party’s good The team production model uses these legal facts to faith actions, the weight does not favor either party. counter claims that fiduciary status is a mere default Rather, the courts seek out the mean between the rule and that the duty of care is subordinate to the two (Brudney, 1997). Hence, the distinction be- business judgment rule (Blair and Stout, 1999, 2001). tween corporate fiduciary loyalty and relational The counterpoint begins with corporate law’s specific contracts remains (Smith, 2002). adaptation of trust. How does the fiduciary relation- If the courts permit corporate fiduciary unwind- ship between directors and the corporation differ from ing, then, they lose their role in superintending the donative trust law? From agency law? How has the director trustworthiness (Frankel, 1995; Stout, concept of trust been adapted within corporate law? 2001). Corporate value-adding stakeholders would Each fiduciary relationship involves trustworthi- only have protection under relational contract’s ness and trust; all make demands that exceed spot good faith standard. They would lose the court’s market contract relations; and all rely on the courts interventions to shape director ‘‘other-regarding as background enforcer. Where the principal–agent behavior’’ (Rock, 2000; Rock and Wachter, 2001). relationship covers party to party transactions Fiduciary duty cognitively biases judges (and, con- (including entities), trust and corporate law regulate sequently, directors) to perceive directors as fidu- relationships between the trustee and a beneficiary. ciaries, as those who have a legal obligation to be In a donative trust relationship, the donor transfers to trustworthy. The judges’ cognitive bias encourages Allen Kaufman and Ernie Englander them to survey from the corporate case law best egy differentiates them from neo-classical economics practices and to transmit them in each new ruling (Freeman et al., 2004). To be sure, many economists Veasey, 2001, 2003). The courts’ rulings, which stubbornly enforce the distinction between efficient include moral language, inform directors (as advised and fair. However, economists who belong to the by legal counsel) on their responsibilities and cajole law and economics (Chicago School) movement, them to constrain their rational maximizing persona similarly, find the rigid separation artificial. They (Alexander, 1997; Mitchell, 2001a, b). have waged a protracted intellectual campaign to Corporate law enables the firm. Fiduciary duty’s integrate ethical norms and descriptive paradigms, legal definition and its sanctions for breach enable distributive justice and Pareto efficiency (Yergin and corporate stakeholders to deem directors’ trustwor- Stanislaw, 1998). These libertarians did not have to thy and to transfer resources to their care. Directors go outside economic theory for an entry way into coordinate stakeholder contributions as corporate ethical reason: Contract’s underpinnings – auton- trustees for the corporate constituents’ benefits. Even omy, liberty, secure property rights – provided the though the law encumbers directors with responsi- materials that naturally led to a procedural justice bilities, the law cannot organize a new wealth- standard (Knight, 1947; Nozick, 1974; Posner, 1981; creating association. This occurs spontaneously, von Hayek, 1944, 1960). Still, their reliance on homo contractually, as each seeks to gain from joint pro- economicus distances law and economics from stake- duction. As deals get struck and boards emerge as holder theory. Freeman and Phillips (2002) claim the coordinators, a director community materializes, libertarian terrain among stakeholder theorists. Yet, establishing a socially privileged group whose these two differ from the Chicago School by arguing membership depends on each director’s trustwor- for a complex human psychology and by suggesting thiness (Herman, 1981; Westphal, 1999; Westphal that fairness – of a Rawlsian sort – be incorporated and Zajac, 1995, 1997, 1998). Those who violate into the firm’s contracts (Freeman, 1994). this trust face communal sanctions, e.g., reputation These differing conceptions of human nature loss, public shame, etc. The law codifies this com- returned us to the Carnegie Mellon managerial tra- munity and promulgates evolving behavioral norms. dition. Our retrospective includes a prospectus on Together, the statutory and the self-generative, can behavioral law and economics, which has done invest trustworthiness into a director’s self-identity much to advance the CMU perspective. Behavioral (Cook et al., 2005; Eisenberg, 1999; Hardin, 2002; economists and their legal scholar partners have Mitchell, 2001a). generated a contrary archetype, homo socius, one that Fiduciary duty defines the coordinator’s focal good. we argue ‘‘naturally’’ inhabits to stakeholder theory. The coordinator acts ‘‘selflessly’’ to secure the cor- Our argument devolves into five summary porate team and to distribute neutrally its generated propositions. First, the make-over of homo economicus surpluses. The distributive standard proceeds from into homo socius permits the creation of a parsimo- Pareto to Kaldor/Hicks efficiency and, if necessary, to nious firm. Team production, the behavioral law a utilitarian cost/benefit outcome (Hardin, 2006). and economics’ joint product, proceeds deductively The director-community’s collective function, to to construct the firm and to analyze corporate law’s oversee the corporate sector’s wealth-producing supportive role. Second, team production and stra- capabilities, engages the directorate in debates over a tegic management generate categories – value crea- large social good, a social distributive justice standard. tion, unique risk, and strategic information – for Democracy’s basic values, liberty and equality, identifying the firm’s ‘‘core’’ wealth-producing establish the options. The U.S. federal government stakeholders (Conner and Prahalad, 1996; Grant, provides the stage. 1996). This categorization brings stakeholder theory into the strategic management literature, with its emphasis on core competencies and resource-based Conclusion competitive advantage. These categories do not displace stakeholder theory’s well established ‘‘con- Stakeholder theorists have often claimed that their tingent’’ analytics, e.g., legitimacy, power, urgency, insistence on integrating ethics into corporate strat- and salience (Mitchell et al., 1997). The firm’s Behavioral Economics, Federalism, and the Triumph of Stakeholder Theory dynamic development, its actions among various their control. Now, outsiders, primarily, current and social and political arenas, resists a single managerial retired CEOs, populate this committee. These new schematic. Still, ours provides a means for designating circumstances encourage board members to consider core competency salience by linking stakeholder themselves as corporate sector stewards rather solely as analysis to resource-based economics. And, our cat- the focal firm control group. This reformation rein- egories amplify the other important stakeholder forces the corporate directors’ ability to resist collec- identification method, the normative/derivative tively challenges to managerial – now, collective distinction (Phillips, 1997). Like ours, it uses con- CEO – control, even if this means punishing the few tributions, benefits and harm. However, our proce- who perform inadequately (Englander and Kaufman, dure refines these terms by bringing stakeholder 2004; Kaufman et al., 1995; Khurana, 2002). theory into the strategic management literature. These concluding propositions contain rich re- Three, corporate law has a greater importance in search implications, of a theoretical, empirical and our synthetic paradigm than is normally the case practical sort. We only consider here two, one among stakeholder theorists. True, stakeholder the- empirical, one theoretical. Recent empirical work orists speak of the firm as a bundle of rights and evaluating stakeholder management’s impetus – obligations (Donaldson and Dunfee, 1999), how- whether it proceeds from ethical rules or from stra- ever, our model requires state incorporation charters tegic needs have upheld the latter. This finding has and corporate laws as being essential to the U.S. disturbed some who find it difficult to reconcile firm’s constitution. Incorporation solidifies team stakeholder theory’s ethical instructions – that stake- production by requiring a board of directors whose holders be treated as autonomous moral ends – with members must exhibit other-regarding behavior. In the market’s preponderance to convert all into loss or turn, they set standards for their agents, senior gain (Berman et al., 1999; Harrison and Freeman, managers, demanding them to be trustworthy 1999; Jones and Wicks, 1999). The anomaly vanishes (Whitener et al., 1998). Our detailed account of the if one considers managers constrained by market courts’ assistance in coalescing corporate stakehold- competition and ‘‘coerced’’ into the old-fashion ers brings an extra, empirical benefit: Incorporation, strategic (instrumental) way (Hendry, 2001). Still, the as practiced in Delaware (and in most other states) Kaldor/Hicks standard furnishes a reasonable limit on conceives of the firm as a stakeholder association, market instrumentality. And, procedural processes do rather than as a shareholder maximizing institution, count in establishing a fairness-felt sense. as agency theory normatively instructs. This conclusion, though, does not insinuate that Fourth, team production (behavioral law and managers are unable to act by non-market generated economics) identifies corporate boards as the cor- norms. However, the possibility occurs in the porate coordinator. Typically, stakeholder theorists political sphere where managers may lobby for speak of managers as the corporate coordination/ policies to correct the market’s ‘‘unfair’’ conse- control group. Of course, the separation of residual quences. These correctives may rely on direct and control rights has allowed managers/senior redistribution or they may be regulatory initiatives to executives to dominate the board and the board’s strengthen the least advantaged’s bargaining position. nominating committee. However, even inside direc- Of course, if managers have volition, they may tors are encumbered with fiduciary duties. simply affirm procedural justice, which, in effect, Fifth, and finally, the corporate board fits within corroborates market outcomes. Historically, U.S. an interlocking network, generating a corporate corporate managers have demonstrated a preference directorate – a community that has eluded stake- for each. After WWII, until the 1980s, managers holder theory. The recent reforms (new governance promulgated a technocratic creed in which they guidelines at the New York Stock Exchange and the conceived of the firm as a stakeholder coalition and Sarbanes-Oxley legislation in particular) have chan- public policy as means for correcting bargain ged this interlocking network’s members and their advantages. Since then, managers abandoned their identities. Where insiders once dominated boards, neutrality and rallied to shareholder partisanship and now outsiders do. 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