‘The Center for Law and Economic Studies Columbia University School of Law 435 West 116th Street New York, NY 10027-7201 (212) 854-3739 CHAOS AND EVOLUTION IN LAW AND ECONOMK Mark J. Roe Milton Handler Professor of Law Working Paper # 118 Do not quote or cite without author’s permission.DRAFT/October 25, 1995 32:11 PM Chaos and Evolution in Law and Economics Mark J. Roe” In this essay, I refine the classical evolutionary model from law and economics by modifying it to accommodate three related concepts, one from chaos theory, another of path dependence, and a final one from modern evolutionary theory itself. If I'm successful, we will have a richer understanding of what makes for legal and business institutions ‘The thesis here can be seen as a group of metaphors, beginning with a standard one from law and economics: Economic evolution selects out for extinction very inefficient results, and efficient results tend to survive. This metaphor, however, is by itself not rich enough to explain enough of what we see surviving, nor is it rich enough to explain fully how what survives survived. Within the looseness of acceptable efficiency,} what survives depends not just on efficiency but on the initial, often accidental conditions (chaos theory), depends on the history of what problems had to be solved in the past---problems that may * professor, Columbia Law School. I benefited from discussing path dependence at Columbia during the past few years with Ronald Gilson, Victor Goldberg, and Jeffrey Gordon and from hearing comments on this paper from Jeffrey Gordon, Robert Pollock, and Charles Sabel. The classification of path dependence in the paper's first part grew out of remarks I prepared at Richard Nelson's request for a September 1994 Columbia Law and Economics workshop on path dependence. The Sloan Foundation supported this research. + It's the cost of change---informational, organizational, and political---when the value of change is uncertain, that yields the "give" at the jointschaos and Evolution = be irrelevant today (path dependence), and depends on evolutionary accidents---what might do best today could have been selected out for extinction in the past when a feature, which might survive if competing today, met its evolutionary demise. Although institutions cannot be too inefficient if they have survived, evolution toward efficiency constrains but does not fully determine the institutions we observe. ‘The Classical Evolutionary Paradign The classical evolutionary paradign has a strong grip on law and economics scholarship. what survives is presumptively efficient. If it were inefficient, the practice, the law, the custom would be challenged by its more efficient competitor. The success of the more efficient practice or law allows it to prosper, while its less efficient competitor withers and dies. Entrepreneurs without a clear understanding of what they are doing stumble on an efficient practice. They make money and their firms grow at the expense of firms that failed through bad luck or poor skill to adopt the efficient practice. states compete by producing efficient law. States that fail to provide efficient law get less of the regulated activity. Inefficient rules are challenged, because the challengers find it profitable to do so.” ? several classics of natural selection in economic and organiza- tional evolution are Armen Alchian, Uncertainty, Evolution and Economy Theory, 58 J. Pol. Econ. 211 (1950); Milton Friedman, Essays in Positive Economics 3 (1953); Richard R. Nelson and Sidney Winter, An Evolutionary ‘Theory of Economic Change (1982); Oliver Williamson, The Economic Institutions of Capitalism (1985). For legal uses Of evolution, see Robert C. Clark, The Interdisciplinary Study of Legal Evolution, 90 Yale L.d. 1238 (1981); B. Donald Elliott, The Evolutionary Tradition in Juris-Chaos and Evolution “3+ Here I shall examine this paradigm of a Darvinian survival of the fittest in law and economics. while I cannot shake myself of ite grip completely, the classical evolution-to-efficiency paradigm fails to explain some important phenomena. If one is allowed only a single explanatory concept for business and legal institutions, evolution-to- efficiency is as good as any and better than most. The classical paradigm works best in explaining the survival of business units in a national economy; it works less well in explaining the survival either of politically, legally determined business institutions or of national systems. I£ we want a finer approximation to explain resultant reality, we must add two or three other paradigms The first comes from the science of chaos. Some phenomena are extremely sensitive to the initial position. small changes in the original position make for very large changes in outcome. Weather patterns are so complex, the example runs, that a butterfly flapping its wings today on one side of the globe could induce a torrential downpour next week on the other side of the globe.? Some bankruptcy and corporate structures fit this paradigm better than they fit a classical natural selection paradigm. 1'11 give a few examples below where several solutions to corporate and bankruptcy problems were efficient, and the prudence, 85 Colum. L. Rev. 38 (1985); George Priest, The Common Law Process and the Selection of Efficient Rules, 6 J. Legal Stud. 65 (1977); Paul Rubin, Why is the Common Law Efficient? 6 J. Legal Stud. 51 (1977). 3 games Gleick, Chaos: Making a New Science @ (1988).Chaoe and Evolution os one that prevailed depended on the original conditions. Moreover, although the surviving practices could be perfectly efficient, if they became satisfactory they did so because they were subjected to further adaptations that decreased their costliness. Furthermore, the resulting structures, even if acceptable, may be imperfect when compared to what could have been had the original conditions differed The second paradigm comes from modern thought on evolution. The observed evolutionary outcome may well be the most efficient of the available competitors. But that does not mean that evolution is an onward and upward process. A competitor survived because it was best suited for yesterday's environment, an environment that was destructive of others with which the survivor had competed. But the destroyed group may be best suited for today's environment. Yet nothing in evolution assures that the destroyed group will reappear.* Modern evolutionary biologists use the metaphor of natural selection leading us to the top of this local hill. To achieve the next, mich higher summit in the chain of hills, however, we would have to go down this hill, and then up the next one. But natural selection, by selecting only upward-bound character- istics, stymies us from going down the hill. We are stuck in a local equilibrium, unaware of the higher summit across the valley. Survival does not imply superiority to untried alternatives 4 Recessive genes and sexual reproduction increase the chance that diverse life forms survive and could flourish later. Law's rough equivalent in preserving diversity is federal competition.Chaos and Evolution es ‘The third paradigm is path dependence. All three paradigms overlap, and it's with the last that I'11 begin to detail this inquiry. Path Dependence Consider the most basic instance of path dependency. We are on a road and wonder why it winds and goes here instead of there, despite that a straight road would be a much easier drive. Today's road depends on what path was taken before. Decades ago, a fur trader cut a path through the woods, and the trader, bent on avoiding a wolves’ den and other dangerous sites, took a winding indirect route. Were the fur trader a better hunter of wolves, the trader might have chosen a straighter path Later travelers dragged wagons along the same winding path the trader chose, deepening the grooves and clearing away some trees on the winding path. Travelers continued to deepen and broaden the road even when the dangerous sites were gone. Industry came and located in the road's bends; housing developments went up that fit the road and industry Local civic promoters widened the path and paved it into a road suitable for today's trucks. It's time to resurface the road. Should today's authorities straighten it out at the same time? They see no reason to raze to the ground the factories and housing developments that arose on the path's bends and may not even bother to consider straightening it out. Today's road, dependent on the path taken by the trader decades ago, is not the one that the authorities would lay down if they were choosing their roadChaos and Evolution “6+ today. But society, having invested in the path itself and in the resources alongside the path, is better off keeping the winding road on its current path than paying to build another. (Occasionally, the path dependent road is so costly that a society ripe it up and builds a new one. More about that below.5) If the road winds too much, new technologies will develop that allow the vehicles on the road to hug the road well without giving up too much speed. If the new technologies are too noisy, sound walls may go up along the road. Drivers may have to be better trained and controlled than if the road were a simple straight one. The result won't be ideal, but the transportation system will adapt. ‘This path dependent history maps, more or less, onto chaos analysis chosen to avoid a den and evolutionary analysis. The fur trader's path of wolves and other danger spots---is the original condition for chaos theory. Evolutionary analysis could see the fur trader as rising to the summit of an adaptation when there were wolves to fear and fur to trade. Once society reached that summit, the next hill---a straight road through the forest that's easy to drive through---can only be reached by going down the evolutionary hill, by going backwards and xe-making the road. ‘The competitor- the winding road survived because it was best suited for yesterday's wolf-infested environment, But the destroyed adaptation---a straight road---would have been best suited for today's ® See infra "Punctuated Equilibrium."Chaos and Evolution “7 environment. We did not have an evolutionary competition between straight and winding roads in today's environment. We are stuck in a local equilibrium. Survival does not imply present-day superiority to untried alternatives. Corporate Structures An illustration can help us see how path dependence, chaos, and punctuated evolution affect institutional structures. Corporate law's academic work has analyzed the relationships among stockholders, senior managers, and board of directors of large public corporations. with stock ownership scattered for large firms, managers are freer than they otherwise could have been to pursue their own agenda. The history of these relationships illustrates path dependence The U.S. developed corporate structures with strong managers and weak owners (instead of, say, strong owners and weaker managers) partly ue to path dependence. The analogue to the fur trader could be to Andrew Jackson's destruction of the Second Bank of the United states, which (along with the rest of 19th century American financial politics) yielded weak financial institutions that today in the late 20th century would be out of place in the U.S., which is a nation of large businesses and could well absorb large-scale finance. (After the destruction in the 1830's of the Second Bank of the United States, which operated a nationwide network of branches, the U.S. had neither a central bank to mold a truly national financial system nor a model for a national privateChaos and Evolution 5 banking system. In the one hundred and sixty years after its destruction, no American bank has had similar national operations. our many "national" banks have been national only in name; they could branch only locally, and only now, in the 1990's, are they getting authority to operate interstate branches.) © ‘These rules arose because the American public historically abhorred private concentrations of economic power, concentrations that more powerful financial institutions would create, concentrations that a more powerful central government would have made politically palatable, concentrations that if they were first arising today would probably be regulated, not destroyed. Concentrations of private economic power are the wolves that the U.S. feared and built a winding road to avoid. Had the U.S, had a stronger central government back then---were the fur trader a better hunter of wolves---we might have tolerated but regulated the strong financial institutions. As large-scale industry arose at the end of the 19th century, it faced two financing problems that the absence of nationwide financial institutions created: big industry needed to gather lots of capital nationally and certain organizational forms that worked well with strong financial institutions were unavailable. We developed very good substitutes. We developed, for example, high quality securities markets, © For details about the American financial history outlined above and the corporate institutions outlined below, see Mark J. Roe, Strong Managers, Weak Owners: The Political Roote of American Corporate Finance (2994)Chaos and Evolution eos which allowed firms to raise capital in a national market to remedy the absence of a truly national financial institutions---a bank with a nationwide network of branches.7 We developed antitrust rules that Promoted competition and, because competition pushes toward efficiency even firms with substandard internal governance, the costs of internal governance problems were reduced. America's continental-sized economy allowed for enough competition that any corporate governance problems were not too costly. In time, we adopted new institutions, legal and economic, that are not as well-developed in other advanced nations. Corporate boards have well-defined legal duties that partly constrain managers, and we have an active bar that pursues lawsuits, some of which are legitimate and functional. We have developed a professionalism that motivates some managers. We have sought to upgrade the board of directors, to make it a counterweight to managers. We have well-developed incentive compensation for managers and, increasingly, directors. We developed hostile takeovers which constrained managers. Whatever tasks strong financial institutions might have done, other institutions developed to do. Although in this take there is efficiency- driven evolution, to explain what institutions we have, we must resort to examining the original conditions. We did not have an economic battle 7 In many respects securities markets are superior to banks in financing industry; the point is that the American securities markets are even better than they would otherwise have been, or at least bigger, to substitute for the relative weakness of bankschaos and Evolution ae between one form of corporate ownership and another (ownership through decentralized securities markets versus ownership through powerful financial institutions), with one winning and other losing. We barred the second type, allowed only the first type, and the consequential evolution was to make that which was available work satisfactorily.® Below I develop this problem further with two ideas. First, I will ask, what happens when the American system walks out into a globalized economy where different corporate ownership systems prevail? Second, what inefficiencies might there be in the system that prevails, and would domestic competition have been enough to weed out those inefficiencies? ‘The answers may be disturbing. If the foreign systems are as good, but different, we might have to jettison (or modify) classical evolution to efficiency as sufficient to explain what we see. That observation would strengthen the import of the original conditions. And if we needed to see foreign possibilities to believe that, then perhaps there were inefficiencies? built into the American system all along, but something ® Evolution is now often not thought of as a relentless drive toward efficiency, but as adaptation to survive a crisis and then to stay stable. E.g., Stephen J. Gould, Is a New and General Theory of Evolution Emerging?, 6 Paleobiology 119 (1980). And many of biology's great "decisions" did not result from direct contests. Mammals did not beat the dinosaurs in a head-to-head struggle for survival; rather a climactic debacle, probably from the earth's collision with an asteroid, destroyed the big dinosaurs. Mammals, which had been peripheral and small, filled the newly opened biological space ° imefficiencies, that is, compared to what was organizationally possible. Below we reconcile and make everything efficient again, but only by resort to information costs and public choice problems. See infra "Three Analytic Uses---Strong Form Path Dependence."chaos and Evolution a stopped us from eliminating them. Path dependence helps us understand the "something" that precluded us from eliminating them. Let us first though develop a typology of the consequences of path dependence. Our subsequent investigation will be better if we have a typology of what path dependence could in theory do for our understanding of business and legal institutions ‘Three Analytic Uses Path dependence could explain the forms we see. Multiple, equally efficient results might abound and path dependence---a nation's political and culture institutions, or chaotic chance events---could determine which among equally efficient end-results we have. Or path dependence could permit structures that were once satisfactory to become inefficient but not be worth changin the path-determined structures are regretted but left unchanged. Or path dependence could lead to highly inefficient structures that society cannot get rid of. The first two types are common. There's less reason to believe the third is a serious problem (or better put: even if it's a serious problem, it's hard to identify and there's not much we can do about it) Weak-form Path Dependence Path dependence can explain the form of the institution that survives. The U.S. has strong managers and weak financiers, Germany and Japan the opposite. The results are due to path dependence: Way backchaos and Evolution v12- when, the U.S. was populist and comfortable with neither a strong central government nor strong private financial institutions; and way back when, the foreign countries were centralizing and recently feudal, with the populace (to the extent they had a say) comfortable with powerful institutions. Building on that base, American business developed satis- factory substitutes for strong intermediaries---good securities markets for raising capital, independent boards for checking managers, hostile takeovers when things got far out of line; the foreign nations developed satisfactory substitutes for strong boards and good securities markets, i.e., strong financial institutions that could act on managers directly and could provide financing directly without the intermediation of the securities markets.1° For path dependence to be relevant in the first sense, neither institutional result needs to be better than the other; each can be good enough. I they both function equally well (or equally badly), path dependence explains the resulting forms, but saying the results were path dependent says nothing about their relative efficiency. I call this "weak" form path dependence, because the original path does not have to be very strong for it to explain how we got to where we are: a society chose between two institutions and the choice became embedded, but the institution chosen functions as well as the one discarded would have. To 10 r am using corporate history to exemplify the possibility of functional equivalence, not arguing that the two alternative forms are in fact equivalentChaos and Evolution 213+ explain how we got to where we are, we must rely on "weak" path dependence. A road could go equally well along the left bank or the right bank of the river through the forest; even if the choice had no efficiency effect, we might wonder why the road went left instead of right and the original hunter's choice may well be the "weak-form" explanation. ‘Weak" does not always mean unimportant or trivial: Quite a few institutions cannot be well-explained by evolution to efficiency alone and are explicable only when we invoke path dependence. Several satisfactory formats were available, path dependence explains which one we got.2? Semi-strong Form Path Dependence Path dependence of the second type leads to inefficient paths. A decision is made to use this form, instead of that. The road goes in what eventually turns out to be an inefficient direction. Had we known then what we know now, we would not have made that investment. But with capital stock already in place, it's not worth rebuilding our system. We regret the result, but will not pay up to change it. The QWERTY typewriter is claimed to be of this type, which I call "semi-strong" path dependence. (The QWERTY keyboard. named for the placement of letter 21 1 will classify paths as "weak," "semi-strong, and "strong," a typology that comes from capital markets typologies of the efficiency of securities markets. For capital markets, the weak form is the most justifiable and most likely to exist, and strong-form is the least likely to exist. Weak paths are similar to multiple equilibria in economics.chaos and Bvolution ae keys in the keyboard's upper left corner -forces our weaker fingers to type common letters, an advantage in the 19th century when keys jammed easily, but a disadvantage today.}?) In the abstract one can think of this model: Way back when, the cost of wiping out the wolves equaled the benefit from a straight path Society could have gone either way, but the first trader through the woods was a bad hunter, so we got a winding road with wolves. Today, the cost of straightening the road out is quite high; we regret what we've done. Tt may, however, be inefficient to change, because today's saved transportation costs from a smooth and straight road are not as great as, today's costs of straightening. This is semi-strong path dependence; we regret the result, but it's inefficient to do anything major about it Does corporate history exemplify much semi-strong path dependence? In the U.S., firms developed with weak owners, and this may have had 12 ymether the QWERTY keyboard is really as inefficient as has been claimed, Brian Arthur, Competing Technologies, Increasing Returns, and Lock-In by Historical Events, 99 Economic Journal 116-31 (1989); Brian Arthur, Positive Feedbacks in the Economy, Scientific American, Feb. 1990, at 92-99; Paul A. David, Understanding the Economics of QWERTY: The Necessity of History, in Economic History and the Modern Economist 30-39 (W.N. Parker, ed.), has been disputed. §.J. Liebowitz and Stephen Margolis, The Fable of the Keys, 33 J. Law and Econ. 1-26 (1990). One can think of semi-strong path dependence in terms of economic substitutes. A legal rule that bars oranges will have semi-strong consequences. It will explain why we drink grapefruit juice in the mornings and why my kids eat tangerines instead of oranges. For a few people, the switch to other citrus fruits will be a poor one and they will bear costs.Chaos and Evolution -15- costs in three areas: agency costs, time horizon costs, and industrial organization costs. ‘The first, agency costs, arises from the fact that managers and shareholders have different agendas; managers might not pursue shareholders’ agenda wholeheartedly.3 and corporate academic work in the U.S. has sought to minimize agency costs of managers who did not do their owners’ bidding. One mechanism to reduce agency costs might have been tighter links between financiers and industrial managers ‘The second, time horizon costs, arises from the possibility that distant shareholders excessively rely on short-term performance numbers for firms that cannot credibly communicate soft and proprietary information to the stock market. Although controversial and disputed, influential commentators have urged that the U.S. restructure its financial system to more closely parallel those of its competitors.14 13 whether the shareholders’ interest on average equals the social interest is worth debating, but here to make it simple I'm adopting without question the usual corporate perspective. Whether efficiency should include economizing on all inputs (employee wages, for example) could also be debated, but again to focus us here on one problem only, I'm using terms like efficiency without looking behind their surface meaning. 14 see, e.g., Capital Choices: Changing the Way America Invest in Industry (research report of The Council on Competitiveness, principal author: Michael B. Porter); Michael Porter, Capital Disadvantages America's Failing Investment System, Harv. Bus. Rev., Sept.-Oct. 1992, at 65. American securities markets efficiently process available long-term information; but the stock price of firms that cannot credibly communicate long-term soft or proprietary information will not be boosted xightaway by that soft or proprietary information, inducing, the theory would run, some managers to forego operation decisions that would yield benefits that cannot be quickly reflected in stock price. The significance of such an information gap is itself disputed.chaos and Evolution 216- Financiers inside the boardroom might have avoided these possible costs. ‘he third, industrial organization costs, arises from the possibility that financial institutions can link together related firms, such as suppliers and customers, without forcing them into the stultifying bureaucracy of a vertical organization.15 strong financial intermediaries could have helped build these linkages which, at least in theory, could sometimes be more effective than pure vertical integration. Foreign systems have had stronger financial intermediaries, and although they therefore might not have incurred these costs as severely, they would have faced other costs. The German and Japanese corporate system, for example, has usually been said to involve substantial bank ownership or voting of stock and greater bank presence in corporate policy making. Although the foreign systems would then have not experienced the managerial agency costs, short horizons, and hybrid industrial organization links to the extent that American corporations faced, the foreign systems would have faced other costs, such as financial institution agency costs, over-investment in long-term capital projects, and too many loose supplier-customer linkages that could have 15 see Ronald J. Gilson and Mark J. Roe, Understanding the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organi- zation, 102 Yale L.J. a71 (1993.) 16 To be sure, even this "fact" is now disputed, at least for Germany. See Jeremy Edwards and Klaus Fischer, Banks, Finance and Investment in Germany (1993). In the text I use mainstream "facts", since the goal here is to analyze evolution and path dependence, not resolve corporate analytic disputes; other facts could have done equally well to illustrate path dependenceChaos and Evolution -17- reduced, say, the incidence of entrepreneurial innovation. The point here, if we have a semi-strong path, is that each path dependent ownership system has costs: a system bent on destroying financial power facilitates more managerial agency costs, may encourage industrial short-term investments, and discourages loose supplier- customer linkages. In each case, a bank-centered system encourages the contrary cost. It's not obvious which system's costs are greater. If the costs and benefits over time are in fact equal, we have "weak" path dependence. when the underlying economic imperatives are for, say, liquidating current capital and investing in new technologies, a securities-based system should do better; when the underlying imperatives are for, say, increased investment in know technologies, a bank-centered system would do better. Superiority could thus fluctuate over time; if on average each is equally efficient, we would have weak-form path dependence: the path chosen long ago determined the current results, but there are no efficiency costs over time. Yet it would be serendipitous that if we could measure the net costs and benefits of each system, they would be perfectly equal over time. Tf we lack serendipity, we have semi-strong form path dependence. ach system depends on whether its political past had Andrew Jackson or the feudal manor; absent serendipity, one of these path dependent systems is more costiy than an obvious and extant alternative Again, this does not mean that the less efficient system, even if one could identify which one is less efficient, should change: once aChaos and Evolution ae society has invested in its institutions there is plenty of reason for it not to change them radically, or at all; the costs of change might outweigh any advantages from change. Once the winding road is in place, authorities will not raze the factories and suburban housing developments in the bends of the winding road. We resurface, we do not revolutionize Both systems may persist, and rationally persist. Yet both could have been path determined. And one of them, if we had all the information, is Probably better than the other, unless we are the happy beneficiaries of serendipity.” (And each pure type may be less efficient than a hybrid that used both financing systems.) 1° Semi-strong form path dependence is, I believe (but cannot prove?) , common. The next step, if we were not to attend to the last type of true path dependence, would be to think about what could happen when two different semi-strong path-determined systems emerge from their own histories to compete with one another. We'll think about this after we discuss strong path dependence Strong-Form Path Dependence +7 or, as I speculate below, a very finely-gauged evolution toward efficiency. 18 Were this article more about corporate governance than about evolution, I'd pursue a more complex argument, that both national systems have semi-strong path dependence. My policy bet is that a national economy in which finance-centéred governance competed with managerial- centered governance would be better than one with either alone, because each governance system has special strengths and fits differing kinds of production better than the other does.Chaos and Evolution =19- ‘here's another kind of inefficient path. We've done it, the road is built, and it would be worthwhile to transform the road in terms of Present operational costs. That is, the value of the straight road exceeds the cost of tearing down the buildings we'd have to condemn, added to the cost of a new road. However, we don’t rebuild. Is there a feature inherent in the choosing a path that impedes rebuilding? Episodic mistakes aren't enough: The cost must be created by the path, and although T can think of only two path-created features that systematically impede change, they are big ones: information and public choice. ‘The new road builders are uninfluential in the legislature; the incumbent groups---created because of the path taken---are influential and block change. Or, the information justifying the change, and what the change should be, is hard to assess because we don't know enough about the other path and just thinking about change clashes with our path-induced perception of "normal" mechanisms, so the status quo persists. This third form, which 1'11 call strong-form path dependence, entails costs. (We can reinterpret it as a variant of the second form: Public choice and information are real costs of action. If either blocks reconstruction, either because overcoming the incumbents is costly or because we're not sure what to do, then we might regret how the path turned out, but still not change.19) 39 see Douglass North, Institutions, Institutional Change and Economic Performance 94-95 (1990); Brian W. Arthur, Self-ReinforcingChaos and Evolution =20- Information and public choice blocks could induce strong form path dependence. When going down this path instead of that one, a society develops a tacit information set, thereby creating an information asymmetry with the society it would have become had it taken the unchosen path. If a society can't think effectively about the alternative path because it lacks the vocabulary, concepts, or even belief that the other path could exist, then that society can't consciously choose either to return to the branch point for the path taken (and then go down the other path) or to jump to the other path.20 When a society chooses one economic path over another it also creates a political dynamic by making economic incumbents, some of whom will more powerfully influence political institutions (due to the interests’ concentration or their fit with existing political institu- tions) than other incumbents would have been able to. Incumbents’ Mechanisms in Economics, in Philip W. Anderson, Kenneth J. Arrow, and David Pines eds., The Economy as an Evolving Complex System 10 (1988) Arthur discusses how adoption of technologies induces lock-in; North applies the concept to institutions. Here we see that public choice and information paths can cause institutional lock-in. 20 See Michael Polanyi, Personal Knowledge (1958); cf. John C. Harsanyi, Games with Incomplete Information Played by "Bayesian" Players, 14 Management Science 159 (1967) (information asymmetries are critical to game theorists who model outcomes when one side in a game has information the other lacks). Strong-form path dependence can break-down. Change once blocked by politics or disbelief could come about when new coali- tions form or when information spreads through a society so that change is welcomed. If we were to classify further, we'd imagine "Super-Strong Path Dependence": an inefficient path along which consciousness of change cannot arise or along which the public choice blocks are so severe that the change cannot occur within the prevailing political system.chaos and Evolution -21- usually wield their influence to maintain themselves and to stifle upstarts. Dead-locked decison-making on how---and whether---to fairly compensate incumbents also stymies change. Recent economic analyses doubt whether economically important (i.e., strong-form) path dependence can exist, but I believe this is partly because path dependence theorists have neither fully integrated path- created information costs into their theories nor integrated public choice theories at al1.?1 when information and political choice are ignored in path dependence stories, it's plausible to claim that strong- form path dependence doesn't exist. But when information debilities stymie thinking about the alternative paths, we won't even be aware that these debilities are blocking evolution, and thus path dependence advocates will be unable to "show" that we have information-based strong- form path dependence .?? 21 See S.3. Liebowitz and Stephen Margolis, Path Dependence, Lock- In, and History, 11 J-L. Econ. & Org. 205, 217-22 (1995). To be fair, the authors (who classify economic paths not too differently than I do) analyzed whether standards and first-mover advantages could lead to suboptimal economic lock-in of firms and technologies; they did not offer a general theory of path dependence and legal systems, and hence they should not be blamed for omitting public choice. 22 qo be sure, overcoming public choice roadblocks is costly, as is developing new information, s0 one could define away the concept of strong-form path dependence and make the world completely efficient again. Also, to the extent its information theory and public choice theory that make paths strong-form dependent, one might argue that correct analytic road is to ignore path dependence and go right to public choice or information theory, although recognizing them as path dependent costs might affect research agendas, inducing us to look at path-created information deficits and dynamic public choice effects. The path dependence story starts to resemble Mancur Olson's in The Decline of Nations (198_)Chaos and Evolution -22- "False" path dependence could be confused with these three "true" types. Today, we're upset that we have a winding path, because a straight road would be so much better. We regret that we didn't build the straight road way back when; and we feel trapped with the winding, inefficient road. We think we are the victims of path dependence, but we are mistaken, because this time we would have been poorer had we invested early on in the straight path. ‘The cost of hunting down those wolves was higher than the value of having the straight road today.23 Net of costs and benefits, we are better off having the winding xoad (and having avoided the heavy burden of wolf-hunting). The suspicion that a1 path dependent stories are "false" makes some wary of path dependence.24 1 call this type, where the costs right from the beginning and when added up always favored the path taken, "False Path Dependence," which should be distinguished from the Weak, Semi-Strong, and Strong varieties. Two Applications Corporate Governance 23 the hunting costs have to be adjusted for time, i.e., society gained by investing elsewhere the resources saved by not spending on wolf hunting. 24 and with information costs and public choice costs we can make all path dependent stories of this type. Weak paths are not "false" ones: a false path is one not taken but, although (falsely) believed to have been better than that taken, would have been more costly; a weak path is as good economically as the one not taken.Chaos and Evolution -23- I have described America's corporate governance as arising from politically-induced weak intermediaries, which led to strong managers, superb securities markets, and professionalized directors. Although perhaps sometimes seen as the only efficient path imaginable, the American results should be seen as adaptations to the American environment that disallowed strong financial intermediaries. When international competition hit business consciousness in the 1980s, U.S. firms for the first time had to compete against firms with different ownership structures. Germany and Japan had stronger financial intermediaries that owned and controlled big blocks of stock in their largest industrial companies. The U.S. system was not the inevitable end of corporate evolution, but one of at least two possible resulte, each reasonably satisfactory.?5 There were thus at least two models for corporate governance in economically advanced economies. while the American system invested authority disproportionately in the CEO (subject to check by occasional director activism and by takeovers), the German and Japanese structures were more bank-centered, with their CEO's lacking the central authority that the American CEO's had. American CEOs were confined by hostile 5 to be sure, serious academic research on how governance systems function was nearly nonexistent in the 1980s and is spotty even today. Rather, the intellectual challenge came from the brute observation that with all those Japanese cars on American roads, Japanese car-makers---the biggest governed firms there as well as here---and their banks could not be so bad.Chaos and Evolution oa takeovers; German and Japanese CEO's were confined, it was said, by their banks. Neither the American nor the foreign systems were perfect, each had lapses and limitations, but what is important is that both have been seen as different Could both be equally efficient?26 Or, to pose the question first in a way that is easier to answer, could either be highly inefficient? ‘The answer has to be no. Neither could be highly inefficient. one, the economies, which we have assumed to be advanced, could not have had a governance system that shackled their largest firms from operating satis- factorily. (If evolution had led to highly inefficient corporate governance, the economy of that nation would not have been advanced. For @ nation to have a high standard of living from producing a modern economy's goods and services in large corporate structures, a nation's corporate governance had to have been satisfactory.27) 26 "corporate governance devices that have survived in many firms for extended periods are particularly unlikely candidates for challenge as mistakes. We have emphasized that the durability of a practice both enables people to gauge its effects and allows competition among firms to weed out the practices that do not assist investors. There is no similar Process of weeding out among academic ideas or regulations. Quite the contrary, mandatory terms prescribed by law halt the process of natural selection and evaluation." Frank H. Easterbrook and Daniel R. Fischel, ‘The Economic Structure of Corporate Law 31 (1991). 27 gue, a global player may have a high standard of living and a defective corporate governance system, if its wealth comes from an advantage outside its corporate system. Saudi Arabia, for example, has a high standard of living but probably a weak corporate goverance system because it has had no need to develop one, since its wealth thus far has been based more on resource exploitation than the transformation of goods and services that require large-scale corporate organizations. The same distinction doesn't apply to Burope, Japan and the U.S., since all threechaos and Evolution -25- two, global product competition should reduce or eliminate the most inefficient features of a governance system. Firms that have weak governance systems would, in the long-run, decline. (An inferior national system could be stable, but at the price of lower living standards. Transportation, tariff and other barriers could prevent head- to-head international competition. ven without these barriers, the inferior system could persist, if the value of local inputs---dedicated capital and immobile labor---went down. only if the superior organiza- tional form could then be imported, either by foreign fixms moving across borders or by domestic imitators, would the evolution-to-efficiency paradigm play out. If the costs to change exceed the price capital owners and labor pay for stability, then that stability is rational.) ‘Three, cheap telecommunications and frequent international corporate governance conferences mean few secrets are left. Nations and businesses can consciously copy one another's better features, can understand that domestic varieties previously thought to be impossible survive abroad, and can find ways to fix their systems! worst features.2% compete mainly by making and selling modern manufactured goods and When Europe and Japan lagged the U.S. economically, it was plausible to believe that their corporate governance systems were highly defective; now that they compete roughly equally in arenas where governance is relevant, their governance systems cannot be highly deficient. Defects must be small, and it's unclear which governance system has more defects. 28 Human consciousness makes metaphoric comparisons with natural selection inapt, or at least only partial, because although natural selection operates without consciousness changing genetic structures, human consciousness can change underlying structures. See infra "Two Risks in Thinking Too Much About Path Dependence."Chaos and Evolution -26- Global competition challenged national corporate governance systems in two dimensions, one intellectual and one real. In the intellectual @imension, efficiency explanations for the forms of American ownership and corporate power had to seem weaker. Other systems were possible and not grossly inferior. The possibility that the American path to the corporate present was heavily influenced by American politics seemed plausible when other systems worked differently. Yet for each system to survive, it could not be grossly inefficient. At a minimum, its inefficiencies had to be counterbalanced by efficiencies elsewhere in the system. True, it is possible that ineffi- cient institutions could become embedded in a society, and that society's economy might not prosper. To extend the path dependent metaphor: the winding road is highly inefficient compared to what-could-have-been, but the costs of reconstruction are so high (or the public choice problems so intractable) that it's worth living with the winding road's inefficiencies. A society is stuck. But with the European, American and Japanese economies roughly equally successful, each national corporate governance system could not have been grossly debilitating For example, consider a critical corporate governance decision: firing the CRO. CEO's leave their jobs in all three nations at roughly the same rate after a precipitous decline in stock price or profits.Chaos and Evolution -27- This data suggests rough equivalence in basic governance tasks, 79 although more confirming studies are needed and there are unanswered questions.3° How would one fit rough equivalence in basic tasks into the path dependent paradigm? In stark form, I believe that although America started with comparatively weak financial intermediaries, it eventually developed comparatively strong boards. And while Germany and Japan started with relatively strong intermediaries they developed compara- tively weak boards. ‘The American case can be well-documented. For decades a key task of corporate reform has been to upgrade our boards of directors, to profes- sionalize them, to make them (and senior managers) own stock or receive other incentive compensation, to make directors independent of managers, to set up monitoring committees of outsiders.?+ True, directors have 29 Steven N. Kaplan and Bernadette Alcamo Minton, Appointments of Outsiders to Japanese Boards: Its Determinants and Implications for Managers, 36 Journal of Financial Economics 225 (1994); Steven N. Kaplan, ‘Top Executives, Turnover and Firm Performance in Germany, 10 J.L. Econ. & Org. 142 (1994). Ronald Gilson has used Kaplan's (and Kaplan's co- author's) data to make the textual point in the seminar I referred to in footnote *. See also his Corporate Governance and Economic Efficiency: When Do Institutions Matter?, __ Wash. U.L. Rev. __ (forthcoming) . 3° Do the CO's leave at equal rates after modest firm declines? Is one system better at avoiding the decline, or in dampening its severity, allowing CEO's to survive because the declines are not as frequent or severe? And is it the governance system that induces them to leave, or do the CEO's leave because they disdain the pain of failure? Is one system better than the other at picking a replacement for the fallen CEO? 31 g.g., American Law Institute, Principles of Corporate Governance: Analysis and Recommendations (1994); Smith v. Van Gorkom, 488 A.2d 858 (bel. 1985) (directors liable for failure to scrutinize merger offer favored by company CEO) .Chaos and Evolution -28- often been tools of the CHO, and for years the independence of directors was a formality: they depended on the CEO for information and they were loyal to the CEO, who had hired them. They were well-qualified people who could give good advice. Yet, it may have made a difference by the late 1980's that good, formally independent people were in place, because, if the anecdotes are right, the directors started then to become more active. They do not take the CEO's word for granted, and sometimes they actually fire the CEO. Although one can criticize many boards for waiting too long, for not checking sooner, and so on, the anecdotal facts are that boards acting up in ways that they didn't only ten years ago. And the formal structures are changing as well. Independent committees---an artifact once perhaps of extensive derivative litigation---are taking over substantive business decisions. During crises, independent directors are getting their own legal counsel. The notion of separating the CEO's position from chairman of the board or installing a "lead" independent director has become popular to discuss and occasionally to implement 22 ‘The bottom line is that the American structure was in place to upgrade the board and, while critics could point out gross deficiencies 3? James A. Brickley et al., Corporate Leadership Structure: On the Separation of the Positions of CEO and Chairman of the Board (July 25, 1995) (unpublished manuscript) (University of Rochester School of Business); Dennis C. Carey, Reinventing the committee structure, Corporate Board, Jan. 1992, at 6.Chace and Evolution 229" that remain, the board seems to have been upgraded. Moreover, managers are confined by other economic institutions. They must compete in product and capital markets; they are socialized to do their jobs Properly. They face lawsuits for some derelictions. In the 1960s, and somewhat still today, they faced hostile takeovers. The point here is that when one technique of control---say, financial institution monitoring---is absent, one would predict that other control techniques would strengthen if and when weak corporate governance is seen by the corporate players to be important. In the U.S. it was takeovers in the 19808 and activist boards in the 19908. or, if other institutions of control are strong---say, product market competition in the U.S the incentives to develop strong financial institution monitoring become weak. The history of American ancillary institutions- strong competitive markets, weak institutional monitering- is consistent. ‘The German and Japanese facts exhibit a similar but converse history vis-a-vis the board. That is, with financial institutional influence relatively greater, boards there became relatively even weaker than the old U.S, boards and certainly weaker than the current U.S. boards. The Vapanese board is made up of insiders, with outsiders entering primarily during crisis. The Japanese presidents! council (in which the presidents of affiliated companies meet informally once a month) has pale, board- Like functions. But the council is big, and due to its size and to the time constraints on the presidents, it cannot operate as a goodChaos and Evolution eg substitute for a good board of directors meeting once a month to discuss one company. It is, at most, a "soft" board, German supervisory boards do not meet as often as American boards do and their meetings have been merely formal.?3 Codetermination--- employees have half the board seats in large German firms- may weaken the board as a supervisory mechanism, because managers and bankers may prefer not to make the supervisory board strong, which would give employees more authority than a managerial-banker alliance would want. ‘Thus, although the direct financial presence in the supervisory board is stronger than that found in the large American firm, the board is less powerful than the American board. So, to overly abstract the situation we are describing, Anerica developed weak intermediaries but eventually compensated with strong boards; Germany and Japan developed strong intermediaries but have not yet developed strong boards. Its plausible to believe that the net governance result is that each performs about as well (or as badly) as the other, because from the smattering of evidence now available, each fires senior managers at about the same rate after gross failure. Even if each national business system produces roughly equivalent governance results, this does not mean that they converged to have identical institutions. Rather, each system solved basic problems by modifying its own path dependent institutions, the U.S. with weak inter- 33 see Edwards and Fischer, supra note 16.Chaos and Evolution <31- mediaries, the foreign systems with strong intermediaries. 1£ they had failed miserably, their nations would not have become global economic players with a high standard of living. The solutions are not usually beautiful and often are imperfect. Biological evolution is similarly imperfect, based on preexisting structures that adapt to survive, not to be perfect 34 So does it matter? Yes. In three ways. First, we sometimes want to understand why we have the institutions we have, and efficiency alone cannot explain them all. Second, satisfactory resolution does not mean optimal resolution Some systems would do better by having more organizational techniques available: firms with different organizational forms would compete for consumers’ allegiance. Third, in analyzing legal business institutions, @ path dependence search can affect our presumptions: If an institution, legal rule, or dominant practice arose to resolve a problem that is irrelevant today, then it should get no presumption of continuing utility *4 see Stephen Jay Gould, The Panda's Thumb: More Reflections in Natural History 19-30 (1960) (the panda's "thumb", which is not a partic- ularly good one, is not a thunb at all, but a bony outgrowth adapted to hold bamboo satisfactorily although not as well as can primates with "real" thumbs) ; Stephen Jay Gould and Richard C. Lewontin, The Spandrels of San Marco and Panglossian Paradigm: A Critique of the Adaptationist Programme, 205 Proc. Royal Society $61 (1979).Chaos and Evolution -32- When systems emerge to compete with one another, what happens? Would competition lead competitors not only to build on their strengths but also to adopt both constraints on managers, to incompletely converge? I see evidence that this is happening. In the U.S., institutional inter- mediaries are strengthening. True, they neither hold many big blocks of stock in the biggest companies nor sit in the boardrooms of the biggest fixms. But in recent years institutions have pressed the boards of poorly performing companies to act up, and they have been pressing the boards of all companies to strengthen themselves. The U.S. system is adopting some of the foreign techniques of financial institutional strength (not too many and not too strongly, to be sure) but mediated through America's path dependent strength, i.e., a system with the potential to develop a good boara.35 Although I know of no confirming Japanese anecdotes yet, the predic- tions for Germany also fit an adaptive model. That is, as German firms face competition and experience failure, they should seek to strengthen 35 although American financiers began in the last decade to experiment with new relationships, the evidence of functionality is slight. One study, commissioned by a public pension fund, found large gains from activism. Stephen L. Nesbitt, Long-Term Rewards From Corporate Governance, ___J.App. Corp. Fin. __ (199_) (study of stock price changes of companies targeted by CalPERS for corporate governance activism). Two recent academic studies found, however, that firms targeted for institutional activism have only low or no stock price gains afterward. Sunil Wahal, Pension Fund Activism and Firm Performance (University of North Carolina Working Paper) (March 1995); Stuart Gillan and Laura Starks, Relationship Investing and Shareholder Activism By Institutional Investors: The Wealth Effects of Corporate Governance Related Proposals (University of Texas at Austin Working Paper) (1994)Chaos and Evolution =33- their weak governance link, the boardroom. And in the past year or two, there's been increased attention on the potential of the supervisory board, with the board meeting in many firms moving from a mere formality to something closer to a real monitoring board.36 Why, one might ask, didn't domestic competition induce American fixms to adopt alternative governance mechaniems? Why didn't some American firms develop strong intermediaries with boardroom presence? After all, competition was domestic before it was global, and one must explain why domestic competition didn't produce the full range of corporate governance options. Was there something preventing change? one explanation is imagination, of which we never have enough. We often lack the imagination to try nonexistent alternatives if the current system works more or less allright. This is not, net, a bad result: If we were always experimenting with basic institutions---most of which work satisfactorily and many of which work ideally. progress would slow. ‘This roadblock to change is an information cost, and we Americans might have been especially susceptible to it for business institutions, 36 Comments of Ernst-Moritz Lipp, Senior General Manager, Corporate and International Division, Dresdner Bank, at OECD conference on The Influence of Corporate Governance and Financing Structures on Economic Performance, February 24, 1995. After several spectacular failures by the banks to monitor well, political proposals arose to limit the number of supervisory boards on which a single person can serve, a limit that would make it harder for a director to be spread too thinly. andrew Fisher, Bonn May Curb German Banks, Financial Times, Nov. 23, 1994, at 2; Germany's (Economics Minister] Rexrodt Wants Stronger Supervisory Boards, Reuters European Busines Report, Nov. 22, 1994,Chaos and Evolution “34- because we tended to think of our governance system as optimal.?7 only when faced in the 1980's with alternative and roughly equally successful European and Japanese systems did we realize that our system was not unique in ite success.2¢ ‘This aspect is important for understanding legal and institutional evolution. If the climate of opinion about a system does not admit the possibility of radical alternatives, even small-scale evolution and change might not emerge: when the players believe big change is possible, there will be many mutations, most of which will fail; but a few of which will succeed, survive and prosper Another explanation is that corporate governance is not the key indicator of national economic success or even an individual firm's economic success. So firms adapted elsewhere. Internal competition among middle managers may have yielded whatever superior governance at the top might have yielded. Similarly, a competitive product market in the U.S. yielded good economic performance, on top of which better corporate governance might have done little for the national economy. 37 c&. Basterbrook and Fischel, supra note 26, at 31 (arguing that long-lived corporate governance devises are "particularly unlikely" to be mistakes); Carl Becker, The Heavenly City of the Bighteenth-Century Philosophers 1-2 & passim (1932) (differing unarticulated assumptions hinder discourse) 38 porter's prescription, see supra note 14, at 65, which grew out of an American Council on Competitiveness inquiry, and which grew into a government study of possible congressional action, Report of the Capital Allocation Subcouncil to the Competitiveness Policy Council, Lifting All Boats: Increasing the Payoff from Private Investment in the US Economy, at i, 1 (Sept. 1995), was explicitly influenced by perceptions of German and Japanese corporate governanceChaos and Evolution =35- Governance just was not important enough (and, relatively speaking, may still not be) . Another explanation is organizational costs. american politics barred some corporate forms, and no single fizm could change these rules. When American fixms' principal competitors were other American firms, all were playing by the same organizational rules. Law did not allow for some types of gross innovation even if a firm and ite financiers wanted to use the alternative. And keep in mind that the American system did adapt, it just did not adopt every control mechanism imaginable: For example, the hostile takeover and charged-up boards could be seen as America's lowest cost innovations to cure severe governance failures. Bankruptcy To illustrate "true" path dependence of legal and institutional change with one example is unsatisfactory. So I will try a second one ‘The United States has a deep and vibrant corporate bond market Regulation bars bondholder votes to approve certain types of recapitalizations of the bonds, those that would extend the maturity date or change the principal amount. The rule seems to be an anomaly: Few bars of this type persist in similar corporate matters; parallel institu- tions use, indeed require, votes of this kind (such as for other types of bond indenture changes, bankruptcy renegotiations, or changes in stock terms).Chaos and Evolution ie The rule persisted without consequence for decades, because there were few bondholder renegotiations. The 1980's’ explosive use of junk bonds changed that, and many bond failures led both to renegotiations to change the terms of bond issues and to academic analysis of the efficiency of bond market renegotiations, their fairness, and the impact on them of the securities laws.39 These renegotiations could not use a simple vote to change the core agreement between the company and its bondholders: Why did this bar develop and stay in place? ‘The original condition has little to do with bond market efficiency, bond market fairness, or the securities laws. The original condition was @ 1928 New York appellate division doctrinal decision that bonds subject to a vote affecting the core terms would not be negotiable under New York's Negotiable Instruments Law, which required that to be negotiable a bond had to represent a sum certain, due on a date certain.#? A bond issue that allowed a vote to change the maturity date or the sum due at 39 to sample the literature, see David T. Brown et al., The Information Content of Distressed Restructuring Involving Public and Private Debt Claims, 33 J. Fin. Econ. 93 (1993); Victor Brudney, Corporate Bondholders and Debtor Opportunism: In Bad Times and Good, 105 Harv. L. Rev. 1821 (1992); John C. Coffee, Jr. & William A. Klein, Bondholder Coercion: The Problem of Constrained Choice in Debt Tender Offers and Recapitalizations, 58 U. Chi. L. Rev. 1207 (1991). 40 Enoch v. Brandon, 249 N.Y. 263 (1928). ‘The possibility of a vote that could change the principal amount or the due date meant that the sum and the due date were no longer certain. Negotiability would not today depend on the existence of a vote.Chaos and Evolution <37- that date would, if binding on non-assenters, destroy negotiability.4? Negotiability was valuable for all bonds, failed or not, as they could change hands more easily if negotiable. But recapitalization ease is an issue only for failed bond issues, so corporations and their bankers simply reacted by deleting the offensive recapitalization-by-vote clauses, to make the bonds assuredly negotiable During the Depression, Congress and the SEC decided to regulate bond indentures, and they barred bonds that permitted recapitalization-by- vote. The public authorities wanted the nationwide ban on binding votes outside of bankruptcy (which paralleled New York's ban on votes on the core terms of a bond) and inside bankruptcy as well; although bankers familiar with bond recapitalizations thought the ban a bad idea, stuck as they were with the courts’ negotiability decisions, they did not fight either ban hard. ‘The negotiability rules changed during the next decades, allowing negotiability of the previously offensive bonds, and the parallel bans on voting inside bankruptcy were repealed. Yet the explosive use of junk bonds meant many work-outs failed because of the ban on bond recapitalizations by vote outside of bankruptcy. 4? 41 the details of the intertwined history of the negotiability problem and the 1939 ban on voting clauses, although not the semi-strong path dependent story, can be found in Mark J. Roe, The Voting Prohibition in Bond Work-outs, 97 Yale L.g. 232 (1987). 42 there are side issues of minor relevance here: The renegotia- tions might have been stymied due to other reasons as well as the voting ban. See Alan Schwartz, Bankruptcy Workouts and Debt Contracts, 36 J. & Econ. 595 (1993). The issuers might have banned renegotiations by contract even if the law allowed them to go either way. (I doubt thischaos and Evolution -38- Evolution toward efficiency seems applicable. Bond institutions adapted. First, the law yielded a bit: After 1978, the bankruptcy law allowed binding votes outside of bankruptcy, but only if the parties invoked a formal bankruptcy during which the recapitalization would be confirmed. This feature, known in the trade as a "pre-packaged bankruptcy," wasn't ideal for all parties, but was satisfactory for some. Second, transactional techniques developed to make previously stymied recapitalizations go forward anyway. Many of these transactions had coercive overtones, overtones that elsewhere lead to legal prohibition, but the authorities, explicitly noting that the emergency "necessity" of a nonbankruptcy recapitalization, did not bar the alternative transac- tions.43 ‘Thus even if the substitutes were perfect, we still have "weak-form” path dependence: The original 1928 condition of nonnegotiability facili- tated a ban. ven when the supporting structures changed, the ban on voting persisted. The underlying rule did not change, but jerry-rigged adaptations allowed it to survive But the adaptations were not, I believe, optimal. The voting ban still stymies some renegotiations and allows some to go forward "improperly" (i.e., coercively) or at higher than necessary transactions would be the result, since analogous financial instruments seem always to have a vote.) 43 Katz v. Oak Industries, Inc., 508 A.2d 873 (Del. Ch. 1986).Chaos and Evolution re costs. Thus I suspect that a fine measurement, if possible, would support that at least semi-strong and probably strong-form path dependence is here: The rule would not be adopted today (I believe). It imposes costs (compared with what we would do today if building the road for bondholder renegotiations de novo) But a full-scale reconstruction does not proceed because of organi- zational costs. While financiers and firms would be better off if they could choose between vote bans and recapitalization by vote, and there are no affected third parties, for most firms the value of a vote is small and discounted by ite future incidence. (That is, if the freedom to have a vote is valuable, voting clauses would appear if allowed. But they would only be used for a recapitalization, say, ten years from now and then only occasionally, when one out of fifty issues in 1995 became defective and needed recapitalization. All bonds would be made a little more valuable today by the discounted, 1/50th, benefit of having another recapitalization technique available if needed.) Since the current regulatory structure embeds the voting ban into the contract, and we resist reading terms out of existing contracts, lifting the ban would not (under ordinary regulatory change) affect any outstanding bond issue So with the adaptive mechanisms coercive debt tenders and bankruptcy---satisfactory although not optimal, and with the costs of organizing to change the law and then the practice positive, a system that is less than optimal (but satisfactory) persists. This is strong- form path dependence.Chaos and Evolution -40- Punctuated Equilibrium Classical evolution and path dependence are accretive, slow, and continuous. They look at change through time, with classical evolution being used to posit a drift toward efficiency, and with path dependence supposing that today's structures need not be ideal, because they must be based on past structures. Chaos theory sees original conditions as deeply affecting us later, even when those underlying original conditions have long since gone. Modern evolutionary theory forces us to think of another metaphor for change, one that both partially fits with and is partially inconsistent with classical evolution, path dependence, and the original conditions of chaos theory. In recent evolutionary theory, biological evolution is not seen as proceeding incrementally.*# A species congeals rapidly and its genetic character is stable until a crisis afflicts it. Then either it dies or a minority of the species quickly mutates and adapts. After the crisis is 44 see Gould, supra note 8, at 119; Stephen Jay Gould, Wonderful Life: The Burgess Shale and the Nature of History (1989); Niles Eldredge, Time Frames: The Rethinking of Darwinian Evolution and The ‘Theory of Punctuated Equilibria 15 (1985) ("[Olnce a species evolves, it will usually not undergo great change . . . ."); Niles Eldredge and Stephen Jay Gould, Punctuated Equilibria: An Alternative to Phyletic Gradualism, in Models in Paleobiology 82 (T.J. Schopf ed. 1972) Punctuated equilibrium is controversial among evolutionary theorists. Compare Niles Eldredge, Reinventing Darwin: The Great Debate at the High Table of Evolutionary Theory 103 (1995) with Richard Dawkins, River Out of Eden: A Darwinian View of Life 11, 83 (1995) and Daniel C. Dennett, Darwin's Dangerous Idea: Evolution and the Meanings of Life 63, 238-51, 257-59, 262-312 (1995)Chaos and Evolution are resolved by adaptation or extinction, there is little incremental change ‘There's genetic drift and minor change, but usually there's neither creativity nor adaptation. What could this alert us to about legal. change? Nothing important might happen, except in crisis.*S Institutions and rules would be comparatively rigid until a shock hits the system: an economic depression or political crisis for us, an asteroid smashing into the earth for the biologists. what survives is what is best adapted to Persist during the crisis; once the survivors survive the crisis and the maladapted become extinct, nothing much important happens until the next crisis. The survivors are filled with efficiencies and inefficiencies; all that evolutionary theory would tell us is that, net, the species was good enough to survive, but any one of its features may be maladapted. Let me reinterpret American corporate finance in these terms. In the 1930s, the Depression put many financial structures into upheaval What was best suited to survive the Depression was a relatively fragmented financial system of federally-guaranteed commercial banks with local branching systems, disconnected from investment banks. For fifty 45 Note the similarity to Thomas Kuhn's scientific paradigm shifts. ‘Thomas S. Kuhn, The Structure of Scientific Revolutions 77 (2d ed. 1970) ("[clrises are a necessary precondition for the emergence of novel theories."). (Chaos theory could, if modified, have been the starting metaphor for this section. A system may reverberate in a pattern; an element of the system may change and, although it often changes in just this same way, this time the rest of the system's components are configured so that the tiny change induces the entire system to "leap" to into another pattern.)Chaos and Evolution -42- years, this system broke down along the edges, but did not until recently begin to "evolve" into a new system.*® To see this another way, what if for most of the time legal institu tions did not evolve in any important way? Things stayed the same, minor changes occurred below the surface of the big structures: Marginal corporate tax rates went up a little or down a little, the fragmentation of financial institutions might lessen or heighten, case law and SEC regulation made securities fraud a little easier or a little harder to show. But the big stuff---a corporate tax of between 30% and 50%, American-style securities markets instead of foreign-style big financial institutions, and middle-of-the road securities fraud rules---remained constant until an upheaval profoundly changed the rules by instituting a corporate tax, by fragmenting the financial institutions that moved capital from savers to corporations, or by establishing a federal cause of action for securities fraud. And after that profound change, not much might happen, until the next upheaval Moreover, imagine that some of these changes are linked as part of a general upheaval: The best thinking in the U.S. at one time was that finance should be fragmented, that there ought to a cause of action for securities fraud, and that there ought to be a substantial corporate 46 donald Langevoort, Statutory Obsolescence and the Judicial Process: The Revisionist Role of the Court in Federal Banking Regulation, 85 Mich. L. Rev. 672 (1987).Chaos and Evolution -43- tax.47 Changes cccur, but the big ones occur only during an upheaval and thereafter the institutions created remain constant. Or take a bigger picture: On an overall basis the American system has been remarkably efficient in that liberal capitalism has thus far beaten all alternatives. But the efficiency of any single embedded institution within liberal capitalism is not proven by eurvival and resort to the evolutionary metaphors, because it is the overall system. not its parts---that was selected for success. Evolutionary biologiets analogously dispute the extent to which the gene, the individual, or the species is the unit of natural selection.*® Liberal capitaliem is a blend of economics (private property and competitive markets) and politics (some quantum of social programs). Private property and compet- itive markets provide wealth; social programs provide political stability. From a punctuated equilibrium perspective, analyzing the efficiency of any single subset of economic institutions is misleading, because it's the overall blended structure that provides stability and wealth. American corporate finance had to adapt to the rules best fit for a Depression economy, and it did. It did not need to adapt any further.49 47 I picked corporate institutions put into place during the New Deal and challenged (in part) recently. 48 see Marc Ereshefsky, ed., The Units of Evolution---Easays on the Nature of Species (1992); Elisabeth Vrba, What Is Species Selection? 33 Systematic Zoology 318 (1984) 49 vor proof problems, see below "Two Risks in Thinking Too Much About Chaos, Evolution, and Path Dependency---Imprecision: The Absence Of Refutable Implications." We can recognize embeddedness and the needChaos and Evolution a Two Risks in Thinking Too Much About Chaos, Evolution, and Path Dependency Government Direction What if many economic systems and the institutions they foster exhibit semi-strong and strong form path dependence? Original conditions led our rules to the top of a hill and they could not evolve to get to the next hill. The path has wound around the wolves, but the wolves are gone, and each actor (QWERTY-like) continues to deepen the grooves on a suboptimal path Natural selection works without consciousness. It propels a species to the top of the local evolutionary mountain and there the species will remain stuck absent cataclysmic change or genetic drift, despite that the next much higher and better mountain is attainable if the species could back-track a bit down the current mountain. We human beings are, in contrast, conscious of our business and legal institutions and, if we believe we are stuck in a local equilibrium due to path dependence or original conditions that are now irrelevant, we can change our environment. We can move ourselves from one mountain to another, making the pure analogies to natural selection inapt. If we are mired in strong for political stability without abandoning analyzing law's economic impact: Not all all changes will have political impact, and analysis could always add an implicit assumption that change would not have political ramificationsChaos and Evolution ae path dependence, we can consciously re-engineer our road system either by resurfacing it or by returning to the branch node and going down the other path. Genes are Darwinian, but civilization is Lamarckian.5° our limits in moving and rebuilding are those of consciousness and politic: ‘The original conditions, or the strong-form path, could have led us to be unable to imagine a change or to be unable to make the political jump. When they don't so limit us, change is not limited by paths or evolution. Thinking about path dependence tempts us toward greater government direction. For many law and economics advocates (and I include myself here), it would be most satisfying to believe in evolution-toward- efficiency if we could believe that no important path could be ineffi- cient, a belief that the modern biological analogy does not support. If we could believe what survives is efficient, then we need not consider the possibility that a centralized administrator might get the needed 50 For genetic drift giving the push off a genetic peak, see Gould, supra note 8, at 126 n.*. For a recent analysis of local evolutionary equilibria, see Stuart A. Kauffman, The Origins of Order: Self- Organization and Selection in Evolution 33-120 (1993). The idea originates in Sewall Wright, __ (1936) and Armen Alchin, supra note _, remarkably anticipates the problem for classical economic evolution. Note that social institutions could replicate the detrimental effect of a genotype disappearing that would have become useful later. If we cannot adopt something that is nonexistent, because, say, of limite of human cognition, then an institution's disappearance could knock it off as an evolutionary possibility. Similarly, institutions are embedded in complex networks; once the arrayed network adapts to accommodate an institution of type X during a period of flux, type Y may disappear and not be available later when it would be useful, because the surrounding institutions at the later time accommodate X, not Y. Analgoues to genetic selection could arise in by examining institutional routines--- about which the actors are not fully conscious. These routines could replicate---or not---as do genesChaos and Evolution n46- information fastest and make a correct decision to change the path. A. mistrust of governmental action is more persuasive (and more satisfying in constructing a coherent belief system) if one could convincingly presume the efficiency of every key economic institution we see. Tf we cannot, because too much depended on chaotic original conditions or path dependence, then the verbal space would widen in which to debate government action and directives for change.5? I do not believe that in the U.S., with our pattern of government, we should search widely for path dependent traps. ven if mich of what we see may be path determined, government directives to change would be unwise and, I believe, government should in general loosen constraints of developing business mutations, some of which will work well. But this is @ belief, based on observation of the limits of American government and here it is expressed off-the-cuff; it is neither a belief derived from a sense that evolution inevitably yields the most efficient results nor a conclusion deduced from thinking about path dependence. Indeed, path dependence and local biological equilibria tempt one to greater government direction. ‘There is more. We have at least two units of evolution here: Business units and national units. Competition among business units- 52 this psychological point remains true even if the original condi- tions in the examples in this paper involved government action. If one believed that markets have already efficiently adjusted to original conditions that are deep in our past, then one would think new government directives to be unwiseChaos and Evolution a the type usually subject to evolutionary metaphors---best fits a natural selection paradigm. Competition among national unite might fit a punctuated equilibrium metaphor: we cannot readily know what combination of free-wheeling business unit competition and government direction will best survive the intermittent political crises that affect national units. Imprecision: The Absence of Refutable Implications Path dependence analysis has ancther scar: it yields us, for now, Little direct policy prescription. That helps to explain why path dependence has not yet played a strong role in law and economics scholarship, mich of which is policy-oriented. ‘True, when we identify current structures that were path-determined by forces irrelevant to today's world, we would not accord the current rule or institution any Presumption of utility. But since it is hard to clearly identify strong form path dependence (where the policy potential is strongest), path dependence alone cannot tell us where legal change is warranted. It's even worse. Right now, none of the three additional paradigms---chaos, evolution to the local hilltop, or path dependence. is well enough developed to enable us to make explanatory predictions They do not tell us that if this happens, then that happens. They're not even very good at letting us classify past paths as strong, semi-strong, or weak, because we rarely have the bases to compare what might haveChaos and Evolution naa happened if events in the deep past had taken another turn.5? Conclusion I sought in this essay to refine the evolutionary model from law and economics, first by making it accommodate concepts from chaos theory, path dependence, and punctuated equilibrium theory, and then by applying path dependence analysis to a bankruptcy problem and a corporate structure problem. Path dependence can be seen as either weak, semi-strong, or strong: If weak, it need not have done much work and yet it still can explain why we have one of several efficient possibilities; if semi-strong, we did not do as well as we could have done but the costs of change make further adaptation unwise; if strong, change is recommended but a society is stuck due to lock-in effects arising from public choice or information problems. ‘The evolution-toward-efficiency paradigm has an America-centered origin. We---corporate and business law scholar in general- sought to 52 path dependence and comparative law fit together well, because we now get natural experiments of variant evolutionary paths. This opportunity could disappear in a few decades, if Europe, America, and Japan copy one another's better institutions. Biological evolutionary theory is afflicted with proof weaknesses analogous to those mentioned in the text. CE. Ernst Mayr, One Long Argument ---Charles Darwin and the Genesis of Modern Evolutionary Thought 68 (1991) ("Phenomena that are due to a chain of historical events cannot be ascribed to simple laws and can therefore not be proven in the same way as can phenomena studied in the physical sciences."); Robert Pollack, Signs of Life---The Language and Meanings of DNA 153 (1994)chaos and Evolution Niet explain American business institutions. Many of us have an underlying policy preference for limiting government directives. With the U.S. as the world's leading economy, American business institutions could not be grossly inefficient, and we tended to find efficiency explanations for much of what we saw. As Buropean and Asian economies caught up, we saw them sometimes adopting the sane institutions, either because they were finally becoming efficient or because they were imitating the presumptive leader in efficiency. This trend toward convergence confirmed the evolution-toward-efficiency explanations. But foreign evolution sometimes did not lead to the same institutions we had, institutions that we thought best explicable in the U.S. by efficiency. If they didn't adopt our institutions and if their economies were roughly at the same level as ours, we needed further explanation Although economic institutions cannot be too inefficient if they survived, evolution toward efficiency only constrains within possibly broad parameters; it does not fully determine the institutions we observe. Integrating chaos theory, path dependence, and modern evolu- tionary thinking into the traditional evolutionary paradigm provides a richer understanding of how legal and economic institutions arose and survived. What survives depends not just on efficiency but on the initial, often accidental conditions (chaos theory), depends on the history of what problems had to be solved in the past---problems that may be irrelevant today (path dependence), and depends on evolutionary accidents---what might do best today could have been selected out forChaos and Evolution -50- extinction in the past when a feature, which might survive if competing today, met ite evolutionary demise#104 #105 #106 #107 #108 #109 #110 #111 WORKING PAPER SERIES UPDATE Bernard S. Black, Reinier H. Kraakman, Jonathan Hay, CORPORATE LAW FROM SCRATCH. Forthcoming - Corporate Govemance in Eastern Europe and Russia, Edited by Roman Frydman, Chery! Gray and Andrzej Rapaczynski, World Bank, 1995, John C. Coffee, Jr., COMPETITION VERSUS CONSOLIDATION: THE SIGNIFICANCE OF ORGANIZATIONAL STRUCTURE IN FINANCIAL AND SECURITIES REGULATION. Published - The Business Lawyer, 1995, John C. Coffee, Jr., INSTITUTIONAL INVESTORS IN TRANSITIONAL ECONOMIES: LESSONS FROM THE CZECH EXPERIENCE. Forthcoming - Corporate Governance in Eastern Europe and Russia, Edited by Roman Frydman, Cheryl Gray and Andrzej Rapaczynski, World Bank, 1995, Victor P. Goldberg, THE COASE THEOREM AND SOME PUZZLES ON THE ‘TORT/CONTRACT BOUNDARY, No update. Victor P. Goldberg, THE GOLD RING PROBLEM. No update. William K. Jones, EMINENT DOMAIN AND LAND: A RATIONALE OF THE LAW OF ‘TAKINGS. Forthcoming - Hofstra Law Review, Vol. 24, No. 1, pp. 1-, 1995. ing pp. David W. Lebron, DISCRIMINATION IN THE INTERNATIONAL TRADE: THE MOST- FAVORED-NATION OBLIGATION. No update. David W. Leebron, LYING DOWN WITH PROCRUSTES: AN ANALYSIS OF HARMONIZATION CLAIMS. Forthcoming - Harmonization and Fairness, by J. Bhagwati, R. Hudec, MIT Press, 1996.