Behavioral analysis can inform many aspects of corporate law. In this section, we touch upon a few. As noted in Chapter 2, the principal concern of corporate law is solving the agency problem so that officers and directors will operate the corporation in the best interests of the shareholders.
Corporate law helps by imposing fiduciary obligations on the managers of the corporation and punishing them for breach. Presumably this would be unnecessary if the shareholders and promoters could simply bargain to an optimally efficient result, but this is unrealistic for logistical reasons in public corporations and unrealistic for behavioral reasons in smaller corporations.
Consider the investor who is asked to invest in a neighbor’s small but growing corporation. The neighbor is a promoter and CEO. For reasons of bounded rationality and rational ignorance, the investor’s investigation of the company’s condition will likely not be optimal. Judge Posner has explained why information costs render ignorance rational:
Contracts are costly to make and . . . costs may well exceed the benefits . . . when the contingencies that would be regulated by contract—death or personal injury from using a product—are extremely remote. [When a consumer purchases an expensive item like a car] the greatest [contracting] cost [is] not the direct cost of drafting; it [is] the cost of information. The inclusion of . . . a clause [specifying rights and duties in the event of a remote contingency such as death or personal injury] would not serve its intended purpose unless the consumer knew some- thing about the costs of alternative safety measures that the producer might take and about the safety of competing products and brands. But the cost of gener- ating that information, and particularly the cost to the consumer of absorbing it, may well be disproportionate to the benefit of a negotiated (as distinct from imposed-by-law) level of safety.65
If fraud seems a remote contingency to the investor, then the cost of an optimal investigation of the investment will seem disproportionate to the perceived benefit. And if the investor likes the CEO he will probably, for reasons of the false consensus effect, trust him too much. The investor is
unlikely to detect if he is being lied to, and to be overconfident in his con- clusion that the promoter has been truthful. Once he has decided to trust the promoter, he is unlikely to discount sufficiently representations made if any evidence appears as to the untrustworthiness of the CEO. Cognitive dissonance and belief persistence will impede his processing of information that undermines his initial conclusion that the promoter is honest and that the company is a promising one. Overconfidence and undue optimism will bolster this conclusion. All these factors put together paint a picture of a vulnerable investor whose fate is uncomfortably in the hands of another. A legal regime that imposes duties of loyalty upon the CEO and other man- agers and punishes violations provides protection for the investor that would otherwise be lacking. In so doing, it encourages investment.
Professors Blair and Stout have pointed out that just as shareholders cannot be omnipresent to monitor the stewardship of their investment, neither can the law be everywhere (nor can it be perfectly enforced).66 Therefore, trust remains an important factor in the corporate governance calculation. As those commentators note, however, trust derives largely from social norms. The law dramatically impacts those norms. Professors Donaldson and Dunfee point out that “[o]utside sources may influence the development of norms. Law, particularly when it is perceived as legitimate by members of a community, may have a major impact on what is consid- ered to be correct behavior.”67Thus, when the Civil Rights Act of 1964 out- lawed racial discrimination, people’s views of the acceptability of such discrimination was significantly altered. Because of the conformity bias, what is considered correct behavior exerts a major influence upon how people act.
For present purposes, corporate law establishes that managers and direc- tors are to act in the best interests not of themselves, but of shareholders.
In so doing, the law not only gives them external incentives in the form of liability rules to act in this way, it also changes their internal preferences by helping to establish trustworthy actions as the societal norm. Thousands of cooperation games administered by psychologists over the years establish that people are more willing to cooperate (irrationally, according to eco- nomic incentives) if they are instructed to do so, and/or if they believe that others will cooperate (the conformity bias). The law instructs managers to act in a fiduciary capacity and thereby increases the odds that they will do so. This message is repeatedly sent to managers by judges who often describe the manager’s fiduciary duty in the strongest terms. The law also helps to establish the social norm, reinforcing the likelihood that managers will choose to act as fiduciaries.
While contractarians argue that the fiduciary duty is just another in the
“nexus of contracts” that comprise corporate law, Blair and Stout argue
convincingly that it is much more. To allow managers to opt easily out of the fiduciary duty via simple contract would “undermine trust among cor- porate participants by implying that trustworthy behavior is not important, not common, and not expected.”68Fortunately, most corporate law does not allow such contracting out. As Blair and Stout note:
The phenomenon of trust behavior suggests that fiduciary relationships are created by the law in situations in which it is efficient or otherwise desirable to promote other-regarding, trusting and trustworthy behavior. Moreover, the key to a successful fiduciary relationship lies in framing both economic and social conditions so as to encourage the fiduciary to make a psychological commitment to further her beneficiary’s welfare rather than her own. For example, by making directors and officers who violate their duty of loyalty to the firm liable for damages, the law encourages trustworthy behavior in corporate fiduciaries by reducing the expected gains from malfeasance (thus reducing the fiduciary’s cost of behaving trustworthily). At the same time, case law on the duty of loyalty unambiguously signals that the fiduciary relationship is a social situation that calls for other-regarding behavior, to the point where the fiduciary is discouraged from even thinking about her own interest through a prophylactic rule that bans unauthorized personal gains even in circumstances in which the fiduciary could arrange this without harm to her beneficiary. Similarly, the sermonizing tone typically adopted by courts in fiduciary cases reinforces the social message that other-regarding behavior is demanded.69
By setting up a system where shareholders believe they can trust managers given the social norms (formed in part by the law) and the legal liabilities (established by the law), investors do not have to expend substantial time, effort, and money to investigate whether their managers do or do not purport to act in the investors’ best interests, avoiding an “information externality”
created if contracting out of the fiduciary relationship is permitted.70 The agency problem is composed not just of intentional wrongdoing by managers. Behavioral considerations highlight numerous other pitfalls that make corporate law extremely helpful for disciplining managers, com- pensating investors, and encouraging investment. Consider the subject of executive compensation. Because of the self-serving bias and general overconfidence, officers tend to think that they are worth what they are being paid, especially because the high compensation that other officers were receiving indicated through the conformity bias that this was the appropriate standard and because reference-dependent utility made the matter important to the managers. Numerous abuses have ensued, in part because incentive compensation was largely untethered from actual firm performance. Stock option grants tend to be timed to precede favorable firm-specific news announcements, allowing company executives to profit arguably unfairly.71Stock options that were under water because of poor
performance were often repriced. At the highest levels, CEO compensation alone absorbed most corporate profits at some companies that were doing comparatively well.72
Because of the same behavioral considerations, such as the conformity bias and undue optimism affecting the judgments of directors, current cor- porate law rules were insufficient to prevent tremendous abuses. However, in the absence offiduciary duties, the situation would likely have been many times worse. One of the Sarbanes-Oxley Act’s corporate governance provi- sions requires officers and directors of companies that have to restate their earnings (323 public companies in 2003) to forfeit their stock profits and bonuses gained on the basis of the bogus numbers. Before this provision, often companies would announce record profits, the officers would pocket record bonuses, the companies would later restate their financials, but the officers would retain the unearned bonuses. Sarbanes-Oxley’s forfeiture provision changes that situation.
When contemplating why 300 companies a year are restating their financial statements, again consider the possibility that not all are blatant frauds. Because of the behavioral factors noted above, it is possible that the top brass of companies often times really believe (or talk themselves into believing) that their firms are doing well. Professor Langevoort used behav- ioral analysis to suggest that in organizations, optimistic, self-confident,
“can-do” people tend to be promoted and that people prefer to send good news up the corporate ladder over bad news. When biased information is fed to unduly optimistic, overconfident managers who suffer from the illu- sion of control, they often end up misperceiving risks and harboring unre- alistically optimistic views about their company’s status and prospectus.
The self-serving bias also helps these officers to see what they wish to see, especially if they have previously committed to a particular course of action. Sunk cost effects and cognitive dissonance can make it particularly difficult to change course.73
All of these are difficult biases to overcome, but Sarbanes-Oxley’s section 404 provision for internal controls could help. It is a corporate governance provision aimed primarily at improving the odds that full and accurate infor- mation relating to the financial situation of the company will rise to the top of the corporate chain of command. Perfection will never be achieved, but a corporate governance provision such as this, coupled with the fiduciary duties imposed upon officers and directors, should improve the quality of corporate decisionmaking over what would occur in their absence.
The most difficult aspect in all of this is striking the proper balance.
Managers must be constrained and monitored to ensure that they are working in the best interests of shareholders. At the same time, if monitoring is excessive, managers cannot work efficiently. Economists Easterbrook and
Fischel propose an efficiency rationale for the business judgment rule—the courts’ refusal (with rare exception) to second-guess the decisions of a company’s managers unless there exists a conflict of interest.74There is a behavioral reason as well—the hindsight bias. Courts realize that not only are they not business experts, but they should not impose liability upon managers for merely careless decisions based on second-guessing those managers with the benefit of 20–20 hindsight.75