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Business Law and the Austrian Theory of the Firm

My Missouri colleague, Peter Klein, of Organizations and Markets fame (and, like Larry, a proud non-voter), has been asked to contribute a book chapter on the Austrian theory of the firm and the law. Peter, who has written extensively on the Austrian theory of the firm and maintains an online bibliography on the subject, is an expert on the economics. He asked me to give him some thoughts on the law — i.e., which business law doctrines cohere or conflict with Austrian insights on the nature of the firm.

I’m posting my initial thoughts on the matter in the hope that readers may enlighten us on additional business law doctrines that reflect or reject Austrian thinking. (And, of course, please let me know where I’m off base.) You can either respond to this post or email Peter or me directly.

Before I get into a discussion of specific business law doctrines, let me provide some (extremely cursory!) background on Austrian thought.

Austrian Thought on Economic Planning, the Business Firm, and the Law

A hallmark of Austrian thinking, especially as articulated by F.A. Hayek, is the notion that the information required to allocate productive resources to their highest and best ends, and thereby to maximize wealth, is not readily available to any individual or central authority. Instead, it is widely dispersed among individuals throughout society. Accordingly, attempts to maximize value by allocating productive resources in a centralized fashion — i.e., according to the dictates of central planners — are destined to fail. Those planners lack access to important information (most notably, information about how individual consumers value competing uses of productive resources) and could not effectively process all that information, much of which is conflicting, even if it were accessible.

But, say the Austrians, there’s no need to despair. In a society with well-defined, freely transferable property rights, the impossibility of effective central planning presents little problem. As individuals engage in trades in an attempt to better themselves, prices for productive resources will emerge. Those prices incorporate all available information about the relative value of competing uses of a productive resource (i.e., the person willing to pay the highest price for something will create the most value from it and should possess it if the goal is to maximize wealth). They present that information in a simple, useful form (i.e., one need not worry about calculating the net effect of conflicting bits of information about a resource’s highest and best use; the price mechanism will do so). And they motivate economic actors to take precisely the steps that will maximize total wealth (i.e., relatively high prices for a resource induce producers to make more of it and consumers to substitute away from it; relatively low prices induce less production and more consumption of the resource). Thus, when property rights are well-defined and freely transferable, prices will create a spontaneous order that trumps anything achievable using central planning.

But wait a minute. Isn’t the business firm an instance of central planning?  Within a firm, productive resources are allocated according to the dictates of “central planners” — i.e., managers.  Indeed, Ronald Coase famously observed that the defining hallmark of the firm is “the supersession of the price mechanism.”  Does it even make sense, then, to talk about an Austrian theory of the firm? 

Well, yes, if one understands the business firm as an instance of spontaneous order.  In the so-called “socialist calculation debate,” in which the Austrians contended that economic welfare would be greater in a free economy than in a centrally planned one, the central planners were expected to have state power (legitimate power to coerce using force) and were not expected to face significant competition.  The ”planners” within a firm, by contrast, cannot forcefully coerce their subjects (they must procure consent from resource providers), and they face significant competition from other business firms.  These two considerations constrain planning within a business firm so that it is used only when the benefits it generates — chiefly, a reduction in the costs of using the market (i.e., transaction costs) — exceed the losses it occasions in terms of allocative inefficiency (i.e., mistakes by planners attempting to allocate resources optimally) and agency costs (i.e., losses from planners’ opportunism and neglect).  Thus, in the sort of economic system advocated by the Austrians – one coupling well-defined, enforceable, and transferable property rights with broad freedom to contract — one would expect business firms to emerge spontaneously as entrepreneurs seek to minimize the sum of transaction costs, allocative inefficiencies, and agency costs.  One would also expect the boundaries of the firm to change (spontaneously) as technological and other developments alter the relative costs of bringing functions within the firm rather than procuring them on the market.  Such thinking coheres nicely with the Coasean understanding of the firm.

Before looking at specific business law doctrines that reflect or reject Austrian thinking, I should note one other Austrian (specifically, Hayekian) distinction, this one between types of legal rules.  Some legal rules are general in their application, are “purpose-independent” (meaning that the law-giver isn’t trying to achieve some specific social outcome but is instead trying to resolve a dispute in accordance with the parties’ settled expectations), and have the effect of setting clear expectations so that parties may confidently predict outcomes in structuring their affairs.  Hayek refers to these sorts of rules as nomos.  Other legal rules are more akin to specific orders from a central authority seeking to achieve some specific purpose.  Such “teleological” rules Hayek refers to as thesis. 

In light of their emphasis on the knowledge problem and the impossibility of effective central planning, the Austrians (most notably Hayek) contended that legitimate law is nomos.  Thesis is something other than genuine law.  The common law, for the most part, is nomos.  Most, but not all, legislation is thesis.  The characterization of any piece of legislation will depend on whether it amounts to specific orders aimed at achieving a set purpose (e.g., the new federal health care law), in which case it is thesis, or is instead simply seeking to codify purpose-independent rules that settle parties’ expectations and allow the to order their affairs in light of the information to which they alone are privy (e.g., the Uniform Commercial Code), in which case it is nomos.   

Below the fold, I discuss some business law doctrines that cohere with Austrian thinking and others that conflict.  Not surprisingly, the doctrines that are most consistent with the Austrian view of the firm are nomos-like; the inconsistent legal doctrines are thesis.

Examples of Doctrines that Cohere

The basic structure of state organization statutes (e.g., state corporation laws, partnership acts, LLC acts).  One aspect of American business law that seems quite consistent with Austrian thought isn’t a specific doctrine; rather, it’s the essential structure of state business organization statutes.  For the most part, those statutes simply posit sets of tailorable default rules that govern relations among the participants in a business organization if those participants do not specify otherwise.  Section 18 of the Uniform Partnership Act (1914), for example, sets the rules that govern how general partners will share profits, losses, and management authority, but expressly makes those rules “subject to any agreement between [the partners].”  By providing default rules on a number matters, the state business organization statutes settle expectations among the parties, permitting them to arrange their affairs with some confidence about outcomes.  By allowing parties to alter those defaults, the statutes enable parties to craft their relationships in light of their private knowledge (including knowledge about parties’ subjective values, etc.), information to which the legislature could never be privy.  The state business organization statutes are thus nomos-like, purpose-independent rules that eschew central planning and facilitate the emergence of spontaneous orders aimed at minimizing the sum of transaction costs, allocative inefficiencies, and agency costs. 

“Tailorable” fiduciary duties.  Fiduciary duties are the law’s primary means of controlling agency costs — the inevitable losses that occur when a rational, self-interested agent purports to act on a principal’s behalf.  The agent, who doesn’t capture all the benefit of his diligent service to the principal, has an incentive to shirk and/or act opportunistically; the principal, knowing her agent’s tendencies, has an incentive to expend resources monitoring the agent.  The combined losses from the agent’s shirking and opportunism and the principal’s monitoring constitute agency costs.  The law has sought to constrain agency costs by saddling agents with fiduciary duties — broad, amorphous obligations whose specific contours are fleshed out ex post (so that they are standards, not rules).  Many of these fiduciary duties are tailorable so that they are, in effect, default contract terms between principal and agent.  For example, a number of the duties preclude the agent from earning any “secret profits” from his agency (i.e., any compensation other than that specifically agreed upon with the principal).  For the most part, though, those duties apply “except as otherwise agreed” (see Restatement (Second) of Agency Sections ….).  Thus, we again see nomos-like rules that facilitate planning but permit parties to tailor relationships in light of their private information.  (Note that the law has deemed some fiduciary duties to be non-waiveable.  Corporate directors, for instance, may not contract out of their duties to shareholders in a way that would permit the directors to engage in insider trading.  Mandatory, “tort-like” fiduciary duties would seem to be inconsistent with Austrian thought.) 

The disgorgement remedy for breach of fiduciary duty.  An aspect of the law on fiduciary duties that strikes me as a particularly Austrian is the remedy for a fiduciary duty breach involving “secret profits.”  That remedy is disgorgement:  the agent must pay the principal the amount of money he earned in secret even if the breach of duty didn’t injure the principal in any way and the principal couldn’t have earned the profits herself.  This is a somewhat curious doctrine, for most breaches of fiduciary duty could alternatively be analyzed as breaches of contract (either express or implied contracts), and a punitive disgorgement remedy would never be allowed if the breach were so analyzed.  (Contract doctrine rejects punitive damages for breach of contract because they deter efficient breaches.)  The disgorgement remedy for breach of fiduciary duty may make sense, though, as an information-forcing “penalty” default.  The idea here is that we want to encourage agents who know of potential side businesses in which they could earn additional profit to disclose those opportunities to their principals, bargain over them, and strike mutually beneficial deals in which the opportunities are exploited and the profits shared in whatever proportion makes most sense, given the information to which only the principals and agents themselves are privy.  If the default rule ”punishes” agents who have private information about potential business opportunities by requiring them to disgorge any profits they earn exploiting such opportunities, it encourages agents to share the information and tailor mutually beneficial arrangements.  Because the disgorgement remedy (1) recognizes and seeks to harness the value of private information and (2) facilitates private ordering, it seems particularly “Austrian.”  (Note: This post explains my basic point here in much greater detail.)    

Contemporary antitrust rules on vertical intrabrand restraints.  Until the mid-1970s, antitrust doctrine was quite hostile to “vertical intrabrand restraints” — i.e., manufacturer/distributor agreements under which the distributors promise not to sell the manufacturers’ goods on certain terms.  Both vertical price restraints (e.g., resale price maintenance agreements under which a retailer may not sell a manufacturer’s product below a certain price) and vertical non-price restraints (e.g., agreements under which a retailer is forbidden to sell a manufacturer’s product outside a specified geographic region) were per se illegal.  Manufacturers were therefore limited in their ability to distribute their products through dealers while simultaneously exercising control over how those dealers distributed their products.  Instead, manufacturers generally confronted a stark “make or buy” decision with respect to product distribution:  They could either ”make” product distribution by distributing their products themselves (i.e., by vertically integrating) or “buy” it by selling through distributors, over whom they could assert little control.  Limiting manufacturers’ freedom to engage in ”partial vertical integration” by outsourcing distribution but then contractually controlling their distributors’ conduct conflicted with the Austrian notion that decisions about distribution arrangements are best left to the “man on the spot,” who should be free to tailor his distributor arrangements in whatever way he believes (based on his private information) will maximize total sales of his product.

In the last few decades, antitrust doctrine has become far less hostile to vertical intrabrand restraints.  All such restraints — both non-price and price — are now judged under a rule of reason that recognizes that contractual arrangements achieving a “partial vertical integration” are generally output-enhancing and should be premitted.  Antitrust thus permits more of the sort of private ordering favored by the Austrians. 

Examples of Doctrines that Conflict

While the aforementioned aspects of business law seem consistent with Austrian insights on the nature of the firm, a number of business law doctrines appear to conflict with Austrian ideas.  Those doctrines, unlike the ones discussed above, tend to be thesis, not nomos. 

Statutes and rules mandating particular firm structures.  In recent years, [Sox requires that audit committee retain direct responsibility for the hiring, firing, and compensation of auditors.  Members of the audit committee must be independent directors.  NYSE and NASDAQ listing standards go even further: a majority of board members must meet independence standards, and all members of the audit, compensation, and newly mandated nominating  committees must be independent.]   

Proxy access rules (including shareholder proposals).  [14a-7: must assist SHs seeking to control via voting; 14a-8: must include certain SH proposals on the ballot; Dodd-Frank provisions on director nominations by SHs, say-on-pay.]

Regulation of compensation at financial institutions.

The insider trading ban.

Statutory impediments to takeovers.  Williams Act. 

Currrent tying doctrine.

Filed under: truth on the market

Full post as published by Truth on the Market on November 07, 2010 (boomark / email).