w HARVARD |BUSINESS|SCHOOL 9-806-086 Manci2a/ 2006 Business, Law, and Society: The Systems Approach to Law and Management Firms operate within a larger societal context. Failure to meet society's expectations of appropriate behavior orto treat stakeholders fairly! can jeopardize a firm's ability to compete effectively. Just because something is legal does not mean that a person of integrity has to or should do it. As C, Roland Christensen and, his Harvard Business School business policy pioneers pointed out, the business leaders responsible for formulating the firm's strategy must consider not only afin the im Gin da biitalso what 1hould do? The of this note is to help managers better understand both. Systems Approach to Law and Management Law an busine a System within the broader Society, This system is depicted in Figure A | Michael C Jensen, “Value Masimization, Stakeholder Theory, and the Corporate Objective Function,” Journal of Api Corporate Finance, vl. 42001816 2 Falmund P. Leamed, C. Roland Christensen, Kenaeth R. Andzews, and Wiliam D. Guth Busines Poly: Text ant Cass (Homewood, L: Richard D. Invi, In, 1969, 3-mhe primary pubic polices furthered by busines regulation ae discussed in Constance. Bapey, "Pali Law: The Rules of {he Game." HBS Note No, 804-005 Boston, MA: Harvard Busines Shoo! Publishing, 2005). Profesor Constance E Bag prepare ths note asthe bass for class lscusson Copyright © 206 President and Fellows of Haran Callege. To onder copies or request permission to repretuce materials, al 1.80055 765, wate Harvard Business Schoo Publishing, Boston, MA O21}, of go to up /wnehbypharareda No prt af ts pblton muy Bo reproduced stoned na fetrieval sjstem, used ina spreadsheet or tapered in any fem oF By any means—electonc, mechani, Hoteopying, eacng cr imewisn thou! te pecwtsin of Harvard Bosna Schon: ‘This sooumentisauthorzed fr edvator review use ony by DEVANG DESA\, Aan inte of nrastntie Management nt Jun 2020, Copying or posting is an iningement of omit Pecmisions np nrvtd oo 617 783.7860,506.086 Business, Law, and Society: The Systems Approach to Law and Management Figure A: Systems Approach to Law and Management Entrepreneurial Competti compete Manager Firm Resources Environment Activities in Value Societal Context Public law affects the competitive environment and the resources available to the firm. Given the public law parameters and the firm’s strategic position within the compet resources the legally astute manager can sé 9 varie of legal Yole Yo assis opportunities, 10 develop the fifi value proposition and to select and perform the activities in the value chain. Effect of Law on the Competitive Environment Law affects each of the five forces that determine the attractiveness of an industry: buyer power, supplier power, the competitive threat posed by current rivals, the availability of substitutes, and the ‘This sooumentisauthorzed fr edvator review use ony by DEVANG DESA\, Aan inte of nrastntie Management nt Jun 2020, Copying or posting is an iningement of omit Pecmisions np nrvtd oo 617 783.7860,Business, Law, and Society: The Systems Approach to Law and Management 00-086 threat of new entrants. For exampl ‘enabling firms to obtain higher prices.S Because a structure, “a company, must ask itself, ‘Are there any government actions on the horizon that may influence some elements of the structure of my industry? If so, what does the change do for my relative strategic position, and how can I prepare to deal with it effectively now?”"6 Travelers Insurance andl Citibank dramaticall changed their regulatory environment when, with irms merged! in 2002 to form Citigroup. Regulation may provide unforeseen opportunities for profits by forcing firms to innovate.* 3M claimed that the production process changes necessary to reduce polluting emissions resulted in net savings of $10 million per year.° Proactive strategies for dealing with the interface between a firm's business and the natural environment that went beyond environmental regulatory compliance were associated with improved financial performance. Firms’ ability to reduce pollution became a source of competitive advantage only after viewed the requirements of the Community Reinvestment Act (CRA) as “an ‘opportunity’ to do more than was required and a ‘responsibility’ as a leader of the community” successfully adjusted to a tougher regulatory environment and 4 Michael E. Porter, “How Compatiive Forces Shape Strategy,” in Michael E. Porter, On Competition (Boston, MA: Harvard Business School Press, 1996): 21-22 See G, Richard Shel, Make the Rules or Your Canpetitrs Wil (New York: Crown Busines, 2004), fora discussion of how law affects each of Porter's five forces. See also George J. Siedel, Using Law for Competitoe ‘Adoantage (San Francisco, CA: Jossey-Bass, 2002) 5 hichaclE. Porter, Compstitioe Stata Tsu or Analysing Industries and Canetti (Neve Yor: Free Press, 198); se ako Adam Jaffe and Jesh Lerner, Inno and ts Discontents Hae Our Broken Patent System is Ensangering Inaction and Progress and What to Dabo It (Princeton, NJ and Oxford: Princeton University Pres, 200), Porter, Competitive Strategy, 182-184 7 M Lange, Trig Bo the Wal How Sony Wel Fought Hs Way tthe Top ofthe Financial World.and Then Nosy Ls All (Neve York Simon and Schuster, 2003) LJ. Cox, "The Impact of the Citicorp- Travelers Group Merger on Financial Modeenization andthe Repeal of Class-Stepall” Novo Lo Review, vol. 23 (190) 89095, A. E. Wilmarth Jy "The Transformation of the US Financial Services industry, 19752000 Competition, Consolidation, and Tread Risks” Unies fas Lae Rese, vo. 2002 (200) 215-32 8 BME Mitnick, The Polita! Economy of Regulation: Creating, Designing aud Removing Regulatory Forms (New York: Colmbia University Pres, 1980), M. E, Porter and C. van der Linde, “Green and Competitive,” Haraand Business Review, vol 73, n0. 5 (1995) 12034, ° BM. Mitnick) “The Strategic Uses of Regulation —andl Deregulation.” In BM, Mitnick (Ed), Conorate Political Agency: The Construction of Cmmpetition in Public Afars (Newbury Park, CA: Sage Publications, 199}. 10 Wg dye and TJ. Douglas, “Performance Implications ofIncmporating Natural Environmental Issues into the Strat Planning Process: An Empirical Assesment" Academy of Manaement Revie, vol 20 (1988) 1015-1082 RD. Klass ant D.C Wihyfach, "The lnpact of Environmental Technologies on Manufacturing Perormance,” Aademy of Managemen Journal, vl 2 2000) 59-615, 1G. Neh, “Maintainability of Fist Mover Advantages When Environmental Regulations Differ Between Countries,” Academy of Management Revi, vel. 23, no, 1 (1998) 77-87. See also Forest L Reinhardt, “Environmental Product Differentiation: Impliestions for Conporate Stategy,” Calfrnit Management Review, vol. 40 (1098) 4373, and Forest. Reinhardt Doe 10 Earth Applying Business Principe to Encironmental Managenent (Boston, MA: Harvard Basins Schoo Press, 200), ‘This sooumentisauthorzed fr edvator review use ony by DEVANG DESA\, Aan inte of nrastntie Management nt Jun 2020, Copying or posting is an iningement of omit Pecmisions np nrvtd oo 617 783.7860,506.086 Business, Law, and Society: The Systems Approach to Law and Management developed innovative and profitable products to appeal to theretofore underserved lower-income strata.!2 Framing is critical here. The categorization OF an issue as an opportunity or a'threat can affect the decision maker's subsequent cognitions, motivations, level of risk taking, involvement, and commitment.! Effect of Law on Firm Resources Law also affects th ital COREE ENE, hats, the ase if owns and the way the frm is organized." In particular, law affects (1) the allocation of firm resources among stakeholders (for connie by aan power Bete te dcr an Sco i anks and }@) the environment in which resources are converted into products (for example, by imposing strict product liability on each firm in the:chain of distribution); (3) the marshaling of human resources (for example, by permitting employment at-will while requiring the payment of damages for siongfulltermination and banting employment discrimination); (2) the marshaling of financial capital (for example, by offering limited liability to investors, giving entrepreneurs es star under the bankruptcy laws, and prometing transparency in the capital markets under the federal and state securities laws); and (5) the uniqueness of resources (for example, by providing copyright, patent, trade secret, protection and” enforcing certain, oncompete agreements). Failure to implement appropriate legal measures éan prevent firms from fully realizing the benefits of the other resources they control. Robert S. Kaplan and David P. Norton, creators of the Balanced Scorecard strategic management system, point out that “failure to perform adequately on repustory and sail precast sak fe sompany’c ably togperte row and dle etre Yalu fo shareholders”® As result, telincade steeting legal and regulatory a5 well a socal ‘expectations within their discussion of the organizational assets necessary for an effective competitive strategy. ‘Wlegal conduct can pula firm at a competitive disadvantage. Convicted firms earned significantly lower returns on assets than unconvicted firms.'® In addition to the direct costs of sanctions (such as fines and punitive damages) and the legal costs associated with litigation and appeals illegality can divert funds from strategic investments, tarnish a firm's image with customers and other stakeholders, raise capital costs, and reduce sales volume.” 12.) FoxcWolfgramm, K-B.Bosl, and J.G. Hunt, “Organizational Adaptation to Institutional Change: A Comparative Study cof First-Order Change in Prospector and Defender Banks,” Administraioe Science Quarterly, vol. 3, no (1958): 87-126. 13 5, & Thomas, SIM. Clark, and D. A. Gioia, Strategie Sense Making and Organizational Performance: Linkages among, Scanning, Interpretation Action, and Outcomes,” Acton of Managenent Jour ol. 36 (1999): 239-270, 4 Sce Gath Saloner, Andrea Shepherd, and Joel Podolny, Strategie Mangement (New York Jon Wiley and Sons, 200), oe 3 further diseussion ofthe internal context ofthe fim. 8 Robert'§. Kaplan and Davie P. Norton, Strategy Maps: Converting Intangible Assets into Tangible Outcomes (Boston, MA Harvard Business School Pres, 2004) 16. See also Michael C. Jensen, “Value Maximization, Stakeholder Theory, and the Gorporate Objective Function,” ourna of Applet Corporate Finance, vol. 142001: 8, 16 16M. S. Baucus and D. A. Baucus, Academy of Management Journal, vol. 40, no 1 (1957) 129-15 Wi. a ‘This sooumentisauthorzed fr edvator review use ony by DEVANG DESA\, Aan inte of nrastntie Management nt Jun 2020, Copying or posting is an iningement of omit Pecmisions np nrvtd oo 617 783.7860,Business, Law, and Society: The Systems Approach to Law and Management 00-086 At the outer bounds, failure to comply with the law can threaten the very existence and continued viability of a firm. The demise of Drexel Burnham Lambert in the late 1980s as a result of insider trading and other types of securities fraud, of Barings Bank in 1995 in the wake of rogue trading by Nick Leeson, ancl of Enron Corporation in 2002 after massive accounting fraud are but three examples of this phenomenon. On the upside, law can be used to leverage other firm resources ina. variety of ways, Just as management's ability to develop and utilize information technology applications to enhance and support other business functions may be a source of sustained competitive advantage, so might management's ability to use the law effectively to protect, realize, and leverage the value of other firm resources. For example, intellectual property law provides managers with various techniques to realize the value of the knowledge assets that can determine the company's ability to survive, adapt, and compete.” These inclucle copyrighting works, patenting inventions and processes, and protecting proprietary information and tacit knowledge as trade secrets. Trademarks can help preserve the value of brand equity. The ability to license patented inventions offers afiother way to capture the value of innovation. IBM earned $1.5 billion in licensing fees and patent royalties in 2001.2” TBM was not commercializing various types of technology it had developed in the 1970s and 1980s for fear of “cannibalizing IBM existing products, especially the mainframe,or working with other industry suppliers to commercialize new technology.’2! Licensing provided a way to capture the value of the discoveries that IBM did not have the ability to commercialize, It also distributed IBM’s technology more broadly and increased its ability to influence the development of industry standards and protocols.22 Legal Aspects of the Value Chain Like information technology? law affects each activity in the value chain. This is summarized in Figure B, where I have added the words in italics to Michael Porter's framework.™! 18 FJ. Mata, W. L. Fuerst, and J.B. Barney, “Information Technology andl Sustained Competitive Advantage: A Resource Based! Analysis,” MIS Quorterly (December 1995); 487-55, 19D, A. Leonard, Wellorings of Kuoledge: Building and Sustaining the Sources of Imouation (Boston: Harvard Business School Press, 198) 2 Louis V. Gerstner, Je, Who Says Elephants Can’t Dance? (New York: Harper Business, 2002) 2hpid, 149 2a. 2M. E Porter and V. E. Millar, "How Information Gives You Competitive Advantage,” in Michael E, Porter, On Competition (Boston, MA: Harvard Business School Press, 1996) 75-98 24M. E. Porter, Competitive Adetage: Creating ad Sustaining Superior Performance (New York: Free Press, 1985). ‘This sooumentisauthorzed fr edvator review use ony by DEVANG DESA\, Aan inte of nrastntie Management nt Jun 2020, Copying or posting is an iningement of omit Pecmisions np nrvtd oo 617 783.7860,06-086 Business, Law, and Society: The Systems Approach to Law and Management Figure B Law’s Role in the Value Chain Support Firm Tinted Tabi aprate DeTne, ae Basees TT TTS activities infrastructure Haman Bplay Tepe, rong Ta, Fa a resource Aliscrimination, eu compensation, Tasr Labor Pctices Act management Technology | Twellecual propery rateion ondisTosreagreminl, asgaens development | srsentions, covenants notte compete, Heensng agreements Procurement | Contacts, Uniform Conimercal Cale, Convention on He Tternaival Sale oF Gacds,bavkrupty ls, securities regulation Tabound —] Operations | Outbound] Marketing] Service logistics logistics | and sales contracts | Workplace | Contracts | Contacts. | strict safety product Antitrust rsirow | tinform Com. | Tali imitson | Enron | met eri Cade cxetsive | mental” | compliance Warranties ‘eating | compliance Convention on contacts the Waivers and Process Intentional | linitaions of Environ | patents Saleof Goods | labity ‘mental’ compliance Consumer | Dectrine of ability Bars on dcop twislending svertsing or sales practices Attra limits oo veri and ark! division, tying, and predatory pricing Import fexport World Trade Organisation Primary Margin Activities ‘Source: Constance E. Bagley, Winning Legally: How to Use the Law to Crete Value, Marshal Resources, and Manage Risk (Boston, (MA! Flrvard Business Sehool Press, 2005) 12 For example, the contract of sale as well as any express or implied warranties made will determine fa firm’s ongoing service obligations. Provisions limiting liability to replacement or repair and disclaiming liability for consequential damages can limit the seller's exposure for property damage in ‘This documents authorized tr educator reveu use only by DEVANG DESAL Adan istue of Ifastusture Management ut Jun 2020. Copying postings an intngerent of copyight. PermisSons @hbspharard.edu or 6177837800,Business, Law, and Society: The Systems Approach to Law and Management 06-086 the event a product proves defective; they will be enforced as long.as they do not allocate tisk in an objectively unreasonable manner. The decision to outsource part of the value chain (such as manufacturing or service) rather than to perform those functions internally rests on the assumption that the other firm will be legally required to perform the outsourced activity at the agreed upon price Law Changes Over Time Law is not static. Public laws will change in response to the firm’s lobbying and other political activities and in response to societal needs and expectations and the desire of office holders to remain in office. Unethical but legal conduct today will often result in far more onerous regulation tomorrow. Passage of the Foreign Corrupt Practices Act in 1978 in the wake of massive bribery of government officials and of the Sarbanes-Oxley Act in 2002 in response to widespread accounting fraud are just two examples of this phenomenon. In the wake of massive fraud at Parmalat and other firms, the European Union toughened its laws against securities fraud, insider trading, and selective disclosure of inside information in 200325 Meeting changing societal expectations is part of every manager's job, The way law is interpreted also changes over time. Even if the wording of a statute or regulation remains the same, juries and judges bring ethical and social considerations to bear when interpreting and applying the law.2* Indeed, failure to consider the ethical aspects of corporate decisions within the broader context of society may itself destroy shareholder value and be a dereliction of duty. Even. economist Michael C. Jensen, a staunch believer in shareholder primacy, acknowledged in a 2001 article the importance of focusing on long-term not short-term shareholder value: “Short-term profit, ‘maximization at the expense of long-term value creation is a sure way to destroy value.” Jensen explained, “In order to maximize value, corporate managers must not only satisfy, but enlist the support of, all corporate stakeholders—customers, employees, managers, suppliers, local communities."*® He cautioned that “we cannot maximize the long-term market value of an organization if we ignore or misteeat any important constituency.” Sometimes, a judge in a common law jurisdiction, such as the United States, Britain, Canada, and Australia, will conclude that changing societal expectations require the recognition of new legal duties. For example, historically, an employer in the United States had no liability for torts, committed by employees driving their own car to or from home and their place of employment. In 1983, the Texas Supreme Court held for the first time that an employer could be held liable for injury to third patties caused by an intoxicated employee ordered home by his supervisor." In imposing a duty to act responsibly to protect third parties from intoxicated employees ordered home, the Texas Supreme Court explained that “changing social conditions lead constantly to the recognition of new duties... [T]he courts will find a duty where, in general, reasonable men would recognize it and 25 otpsider Dealing and Market Manipulation (Market Abuse,” European Parliament and Commission Directive 2008/6/EC 2003 04. (L 96). For the frst time, senior managers in the EU will be required to publicly repor changes in beneficial ‘ownership within ive Business days, Commission Directive 2004/72/EC, 2008 O, (L162). 25 american Bar Association, Model Rules of Profesional Conduet (Chicago TL: American Bar Association, 2002) 7. jensen, "Value Maximization” oid 89 > mie 9 oui Engineering Corp». Clark, 658 5. 24 307 (Tex. 1883). 7 ‘This documents authorized tr educator reveu use only by DEVANG DESAL Adan istue of Ifastusture Management ut Jun 2020. Copying postings an intngerent of copyight. PermisSons @hbspharard.edu or 6177837800,06-086 Business, Law, and Society: The Systems Approach to Law and Management agree that it exists" The Texas court held the employer to this new higher standard even though the law imposed a lesser standard at the time the employer sent the worker home. A dissenting judge argued that in “an attempt to do justice in this one case, the majority has placed an impractical and unreasonable duty upon all employers.”"? He also faulted the majority for eroding “the concept that an individual is responsible for his or her own actions." Although critics lament that such decisions are turning the United States from a “country of pioneers to one of plaintiffs,”** managers ignore such judicial developments at their peril. Prudent managers will refrain from doing anything that foreseeably will result in harm to others and will instruct their subordinates to do the same. They will also procure adequate insurance to protect their companies from suits by not only customers who slip on an icy sidewalk but also trespassers who center the property without permission. ‘Other times a particular constituency may lobby for new rights, as happened when groups representing the disabled lobbied for legislation banning employment discrimination based on disability. Often an industry group will seek new laws to erect barriers to entry, as happened when. the major record labels and other media companies lobbied to add provisions to the Digital Millennium Copyright Act prohibiting firms from selling products that circumvent copy-control technologies designed to prevent illegal copies of music and movies. Sometimes one particular company will lead the charge to enact new rules, as Walt Disney Company did when it persuaded ‘Congress to extend the term for copyrights by 25 years, thereby keeping its rights to the first Mickey Mouse film released in 1928. Law will also evolve to address new technologies, such as the Internet. The Digital Millennium Copyright Act of 1998 provided copyright protection for music, films, software, books, and other creative works transmitted in digital form over the Internet. The Electronic Signatures in Global and National Commerce Act, adopted by Congress in 2000, gave most contracts executed electronically the same legal effect as physical paper contracts with a manual signature. ‘As Debora Spar chronicles in Ruling the Waves there is often a lag between when a new technology is invented and when government begins to regulate it. Often it is the pioneers who staked out claims in the early days who ultimately want enforceable rules to protect what they have gained. This was true of electricity, radio, the telephone, and the telegraph. Thus, there is no such thing’as law with a capital “L.” Laws change—legislatures enact new statutes, the courts make new law, and regulatory agencies adapt new regulations and revoke others Indeed, companies spend millions of dollars on lobbyists and campaign contributors in hopes of influencing the content of legislation and the selection of the people (from the president of the United States on) responsible for administering and enforcing the law.* For example, Citicorp and Travelers, ia ia wid 4 David Moss, When Al Eke Fails: Goverment a Ulinat Risk Monager (Cambridge, MA: Harvard Univesity Press, 2002). 85 Debora L. Spa, Rung the Waves: Cycles of Discovery, Chas, and Welt rom th Compas lth Inert (New York: Harcourt, 200. 3 see Hillman and M. Hit, “Corporate Polis Suategy Formulation: A Model of Approach, Participation, and Strategy Decision” Aatdony of Mansgonent Reno, vol. 24 (1999) 625-42; D. BYolle and'S. Bergeratein, "Creaung Plea! Advantage: The Rive ofthe Corporate Polite Entepreneur,”Calfrns Managenent Revie, ol 28, no. 1 (1985) 124-139; ‘This documents authorized tr educator reveu use only by DEVANG DESAL Adan istue of Ifastusture Management ut Jun 2020. Copying postings an intngerent of copyight. PermisSons @hbspharard.edu or 6177837800,Business, Law, and Society: The Systems Approach to Law and Management 06-086 Insurance predicated their multibillion-dollar merger on the belief that they could persuade Congress to repeal the provisions of the Glass-Stegall Act and the Bank Holding Company Act prohibiting. commercial banks from underwriting securities or insurance.” Paul R. Lawrence and Nitin Nohria faulted General Motors for fighting government regulation of fuel efficiency, emission-control regulations, and auto safety instead “of cooperating with regulators in the drafting of sensible controls that could have served all the auto firms equally by establishing a level playing field for competition while still honoring legitimate public concerns.” They contrast GM's adversarial relations with the government with the cooperative relationship between the Japanese automakers and the Japanese regulators: “[The Japanese auto companies] not only complied with regulations on emissions, safety, and fuel conservation, they helped to write the rules.” ‘As with any managerial action, lobbying (whether through direct contact with lawmakers, the provision of expect testimony and other information, or the payment of campaign contributions) must be conducted with due regard for the letter and spirit of the law, ethical considerations, and the social responsibilty of for-profit firms to al stakeholders, including society at large. Managers should consider both the propriety of the goals to be sought as well as the means employed.” The joint collapse of Enron and Arthur Andersen illustrates the peril of crossing the line. Both companies and many of their peers were major campaign contributors. One of their biggest lobbying successes was derailing efforts by Securities and Exchange Chair Arthur Levitt to end the incestuous relationships between accountants and the firms they audited. These relationships led directly to the Enron/ Anderson debacle and other scandals when accounting firms traded their independence for lucrative consulting work! In the aftermath, many of the transgressors were punished. Unfortunately, their misconduct also burdened law-abiding firms with the costs of complying with the legislation enacted in response—the Sarbanes-Oxley Act. Conclusion This note presented the systems approach to law and management. Public law affects the competitive environment and the resources of the firm. Given the public law parameters and the firm's strategic position within the competitive environment and its resources, the legally astute manager can use a variety of legal tools to assess opportunities, to develop the firm’s value proposition, and to select and perform the activities in the value chain. This is a dynamic model. Law {s not just an external force acting upon managers and their firms. Firms can engage in lobbying and other political activities designed to change the law or the way itis applied over time. In addition, David P. Baron, “Integrated Strategy: Market and Nonmarket Components,” California Management Review, vol 37, 0.2 (1995) 87-65, G: Richard Shell Make the Rules or Your Rivals Wil (New York: Crown Business, 200. 37 monica Langley, Tearing Breaking Down the Wal: How Sandy Well Fought His Way othe Top ofthe Financial Word... and then [Naaly Lest ll (New York, NY: Simon and Schuster, 2003) 38 Paul R. Lawrence and Nitin Noha, Driven How Human Nature Shapes Our Choies (San Francisco, CA: Jossey-Bass, 2002) 223. 2 wie, 238 © Prank Shipper and Marianne M, Jennings, Businss Strategy for the Palitcal Arent (Westport, Conn: Quorum Books, 1984) © arthur Levit, Toke on the Stret (New York: Pantheon Books, 2002) 181-138, 140-143, Former SEC chair Levitt commented that “the Enron/ Andersen audit failure ia perfect example of what Iwas tying lo prevent” by requiring greater auditor independence. bid, 3, e ‘This documents authorized tr educator reveu use only by DEVANG DESAL Adan istue of Ifastusture Management ut Jun 2020. Copying postings an intngerent of copyight. PermisSons @hbspharard.edu or 6177837800,06-086 Business, Law, and Society: The Systems Approach to Law and Management changes in the competitive environment and firm resources, as well as the other activities in the value chain, will affect the societal context and may prompt changes in the public law. 10 ‘This documents authorized tr educator reveu use only by DEVANG DESAL Adan istue of Ifastusture Management ut Jun 2020. Copying postings an intngerent of copyight. PermisSons @hbspharard.edu or 6177837800,