Volume 6, Issue 2 - The Role and Limits of Legal Regulation of Conflicts of Interest (Part II)

Conflicts of interest in corporate law can be addressed by two main alternatives: a requirement of a majority of the minority vote or the imposition of duties of loyalty and fairness. A comparison of Delaware, the UK, Canada, and Israel reveals that while the conflicts of interest problem within publicly-traded corporations receives different treatment in the different jurisdictions — either a fairness rule or a majority of the minority rule — closely-held corporations receive the same treatment of an imposition of duties of loyalty and fairness. This article explains this finding, demonstrating that determining which of these rules is adopted is, in fact, a choice between liability rule protection and property rule protection. This choice depends on the total and relative transaction costs. These costs include both the negotiation costs attendant upon a property rule, as well as the adjudication costs associated with a liability rule. The sum of these costs is influenced by the efficacy of the judicial system and of extralegal mechanisms such as the market for corporate control, the capital market, and the types of investors active in the market. Because the different jurisdictions have different relative costs, due to differences in the economy and the legal systems, publicly-traded corporations are treated differently in each system. However, sometimes conflict of interest situations share the same main characteristics — as with closely-held corporations—leading to the domination of one solution, and thus the same solution is applied for closely-held corporations in the different jurisdictions.

Economists and legal scholars routinely posit an implicit contract between Japanese firms and their principal lender (called their "main bank"). Under this arrangement, the bank implicitly agrees to rescue the firm (through financial and managerial help) when times turn bad. Out of court, it rescues the firm from insolvency. Not only does it save the investments specific to the troubled firm, it lowers the use of costly bankruptcy proceedings and cuts the costs of those bankruptcy procedures firms do occasionally invoke. Given the creditor-shareholder conflicts of interest that arise as firms approach insolvency, such arrangements would seem unstable. Yet according to a long sociological tradition, conflicts of interest matter less in Japan than in the West. According to the emerging economic and legal tradition, Japanese economic actors do face those conflicts, but keep them in check through reputational concerns, close-knit ties, and government supervision. Using two datasets of troubled firms from the 1970s and 1980s, we ask whether Japanese main banks in fact rescue distressed borrowers. We find no evidence that they do: large Japanese firms fail; when large firms approach insolvency, main banks do not increase the share of the firm’s debt they bear; stronger ties between distressed firms and their main bank do not facilitate loans; and troubled firms do not try to preserve their main bank relationship. All told, the claim that Japanese banks ever implicitly agreed to rescue firms is sheer myth. That Japanese banks let troubled firms fail is no recent development; it has been thus for decades. Conflicts of interest do indeed matter in Japan and long have. They matter enough to prevent precisely the incentive-incompatible rescue deals that scholars in the field so routinely posit.

Government can control conflicts of interest in business firms by either issuing obligatory commands to behave in a specified way or by creating incentives to alter private behavior. In order to choose between these two approaches, we also need to know something about the nature of the subject firms and the way that they are likely to respond to particular stimuli. Legislators and legal scholars often rely on intuition to predict the behavior of firms, but this will not suffice for such a complex situation. Fortunately, there is a well-developed body of scholarship that addresses organizational behavior; unfortunately, like many bodies of scholarship, it contains rival and conflicting approaches. This article discusses four of these approaches to organizational behavior: the nexus of contracts theory, an application of rational choice theory to corporations; decision theory; general systems theory and its recent autopoetic variants; and new institutionalism. It then uses each of these approaches to predict the way that firms will respond to obligatory commands and behavior incentives. The specific cases it discusses are the U.S. Sentencing Commission’s Organizational Sentencing Guidelines, the Sarbanes-Oxley Act, and contemporary compliance theory’s idea of reasonable, responsive, or cooperative enforcement.

This paper makes the case for using the independent non-executive directors of a company listed in the United Kingdom exclusively as monitors and regulators of management, particularly as regulators of executive directors’ conflicts of interest, rather than as participants in management who also have a control function. It is suggested that these proposals can be accommodated within current (and anticipated) corporate law in the United Kingdom, that they are practicable, and that they are desirable. The proposals are made against the background of a continued strong emphasis in the United Kingdom on non-executive directors’ dual role both as managers of a company’s business and as monitors of its executive directors. It is suggested that this dual role for non-executive directors tends significantly to undermine the effectiveness of their control function, and that consequently the dual role should be abandoned in favor of the more focused role proposed in the paper. Improving the effectiveness of non-executive directors as regulators of executive directors’ conflicts of interest is vitally important to corporate governance in the United Kingdom: as the paper explains, other legal methods of controlling those conflicts in the United Kingdom suffer from serious deficiencies.

This paper makes the two following claims: 1) The legal dimension of loyalty within organizations goes beyond duties. The governance design aimed at ensuring loyalty may strongly affect standards that characterize each layer of the organization. The interaction between standards of duty and the governance dimension of loyalty should, therefore, be more tailored to specific legal forms and their functional correlation with ownership and financing. 2) There is a greater divergence than has so far been acknowledged between the function of loyalty in vertically integrated firms and in networks of small firms. This difference, created by the relationship between the duty and the governance dimensions, should have repercussions on the definitions of legal standards. In particular, it should reflect the different relationships between hierarchy, monitoring, and loyalty and the choice between prohibitory, authorization-based, and compensatory rules. The analysis concentrates on the key variables that may affect the choice between vertical and horizontal monitoring to ensure compliance with loyal behavior in two polar models: hierarchical firms and networks of small firms. It reveals the importance of considering the governance design when defining duties of loyalty and related standards to evaluate party-related transactions in both cases but, at the same time, the necessity of using different interpretive categories.