Rule of law and purpose of the corporation

• Published date: 01 January 2022
• Author: Sanjai Bhagat,Glenn Hubbard
• Date: 01 January 2022
• DOI: http://doi.org/10.1111/corg.12374

SPECIAL ISSUE ARTICLE

Rule of law and purpose of the corporation

Sanjai Bhagat

1

| Glenn Hubbard

2

1

Leeds School of Business, University of

Colorado, Boulder, Colorado, USA

2

Columbia Business School, Columbia

University and the National Bureau of

Economic Research, New York, USA

Correspondence

Sanjai Bhagat, Leeds School of Business,

University of Colorado, Boulder, CO, USA.

Email: sanjai.bhagat@colorado.edu

Abstract

Research Question/Issue: What is the purpose of the modern corporation? How is

the rule of law related to the purpose of the modern corporation?

Research Findings/Insights: We study the role of rule of law in enabling corporations

to enhance economic prosperity and diminish income inequality across the globe.

Theoretical/Academic Implications: First, we provide empirical evidence on the role

of rule of law in enhancing economic prosperity and diminishing income inequality

across the globe. Next, we draw on the law and finance literature and the finance

and growth literature to highlight the role of rule of law in enabling corporations to

be the major driver of a country's economic growth. Specifically, rule of law is neces-

sary for a citizenry's belief in secure private property rights, which gives the citizenry

confidence to invest in physical capital, human capital, and innovation—the three

catalysts of economic growth. Also, the rule of law allows for an effective judiciary

that can enforce legal contracts. Shareholder reliance on limited liability and

debtholder rights originate from the legal contracts among shareholders, debtholders,

and other stakeholders. This highlights the importance of rule of law in enabling

companies to raise equity and debt financing, leading to financial development. Given

this background on the role of the rule of law in the issuance of equity capital to

provide financial resources to corporations, we analyze the current debate among

policymakers, corporate leaders, institutional investors, and social activists on the

purpose of the modern corporation. We conclude that the modern corporation

should maximize long-term shareholder value, while conforming to the law of

the land.

Practitioner/Policy Implications: At the national and international level, policymakers

should focus on improving rule of law—this enhances economic prosperity and

diminishes income inequality. At the individual country level, we suggest steps to

align shareholder wealth maximization with stakeholder interests: first, antitrust

public policies should be vigorously enforced to maintain and enhance competition in

product markets and labor markets. Second, management and board compensation

should be reformed to focus on creating and sustaining long-term shareholder value.

Finally, for many of society's more serious problems, corporations do not represent

the appropriate level of action. Climate change, for example, poses significant

challenges for societies and businesses. But significant changes to combat climate

change require public policy changes in the United States and abroad. Turning more

to corporations because the political process seems broken will not do.

Received: 13 December 2020 Revised: 26 March 2021 Accepted: 29 March 2021

DOI: 10.1111/corg.12374

10 © 2021 John Wiley & Sons Ltd Corp Govern Int Rev. 2022;30:10–26.wileyonlinelibrary.com/journal/corg

KEYWORDS

corporate social responsibility, ESG, income inequality, rule of law, stakeholder value

1|INTRODUCTION

The modern corporation has been an enormously productive societal

and organizational invention. Large corporate organizations have

figured prominently in the economic growth in the industrial world of

the past century. Core ideas of the corporate construct, including

respect for private property and pursuit of profits within the

framework of the rule of law, have lifted billions of individuals from

poverty toward middle-income levels in recent decades in developing

countries.

In this paper, first, we provide empirical evidence on the role of

rule of law in enhancing economic prosperity and diminishing income

inequality across the globe. Next, we draw on the law and finance

literature and the finance and growth literature to highlight the role of

rule of law in enabling corporations to be the major driver of a

country's economic growth. Specifically, rule of law is necessary for a

citizenry's belief in secure private property rights, which gives the

citizenry confidence to invest in physical capital, human capital, and

innovation—the three catalysts of economic growth. Also, and of

equal importance, the rule of law allows for an effective judiciary that

can enforce legal contracts. Shareholder reliance on limited liability

and debtholder rights originate from the legal contracts among

shareholders, debtholders, and other stakeholders. This highlights the

importance of rule of law in enabling companies to raise equity and

debt financing, leading to financial development. Given this back-

ground on the role of the rule of law in the issuance of equity capital

to provide financial resources to corporations, we analyze the current

debate among policymakers, corporate leaders, institutional investors,

and social activists on the purpose of the modern corporation.

We conclude that the modern corporation should maximize

shareholder value, while conforming to the law of the land. To

strengthen the prospects for success of long-term shareholder value

maximization, we suggest steps to align shareholder wealth maximiza-

tion with stakeholder interests: First, antitrust public policies should

be vigorously enforced to maintain and enhance competition in

product markets and labor markets. Second, management and board

compensation should be reformed to focus on creating and sustaining

long-term shareholder value. Third, the Business Roundtable and

other organizations should reconsider their efforts of applying direct

and indirect pressure on corporations to focus on non-shareholder

priorities. Because public corporations are more susceptible to such

pressure, it could be an impetus to companies to go private or not go

public. Recent evidence suggests having fewer public companies leads

to more concentrated product markets, with the increased likelihood

of diminished competition in these product markets. Finally, for many

of society's more serious problems, corporations do not represent the

appropriate level of action. Climate change, for example, poses signifi-

cant challenges for societies and businesses. But significant changes

to combat climate change require public policy changes in the United

States and abroad. Turning more to corporations because the political

process seems broken will not do.

The remainder of the paper is organized as follows. The next

section documents the role of rule of law in enhancing economic pros-

perity and diminishing income inequality across the globe. Also, in this

section, we draw on the law and finance literature, and the finance

and growth literature to highlight the role of rule of law in enabling

corporations to be the major driver of a country's economic growth.

Section 3 discusses conditions under which shareholder wealth maxi-

mization and stakeholder interests lead to identical and different cor-

porate policies. Next, we examine arguments related to managerial

myopia and the need for stakeholder primacy. In Section 5, we discuss

the relation between corporate social responsibility (CSR) and corpo-

rate performance; also, we consider the portfolio performance impli-

cations of socially responsible investing. Section 6 discusses the

impact of the diminishing number of public companies on product

market competition and its relation to the debate on CSR. We high-

light the role of the corporate board in Section 7 and some limits to

value-maximizing corporate actions in Section 8. The final

section includes our conclusions.

2|ECONOMIC INSTITUTIONS,

ECONOMIC GROWTH, AND INCOME

INEQUALITY

2.1 |Determinants of economic growth

Solow (1956) postulated an economy's output growth as a positive

function of physical and human capital growth. Under the twin

assumptions of constant returns to scale and competitive factor mar-

kets, deviations of an economy's actual output growth from the

implied growth would be attributed to changes in technology and

institutional change, such as abrupt changes in law and order (and

property rights) brought about by armed conflict and political

upheavals. Hence, the role of economic institutions in promoting eco-

nomic growth.

1

North (1991) provides a useful definition of economic

institutions: “Institutions are the humanly devised constraints that

structure political, economic and social interaction …Institutions pro-

vide the incentive structure of an economy; as that structure evolves,

it shapes the direction of economic change towards growth, stagna-

tion, or decline.”Economic institutions involve the rule of law and

respect for and enforcement of private property rights.

Where do economic institutions come from? In an insightful review

of their earlier research, Acemoglu et al. (2001) propose a theory of

politicalinstitutions:in brief, individualshave preferences overeconomic

institutions since these institutions play a role in resource allocation. In

BHAGAT AND HUBBARD 11