Rule of Law, and Purpose of the Corporation

Abstract

Research Question: What is the purpose of the modern corporation? How is the rule of law related to the purpose of the modern corporation?

Research 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 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, 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 won’t do.

Keywords: ESG, CSR, corporate social responsibility, growth, income inequality, rule of law, stakeholder, shareholder value, environment, climate, directors

JEL Classification: [P12, P14, K00, P37, E21, E22, B25, F43