The legal framework for corporate governance: explaining the development of contract law in Germany and the United States

How are new forms of industrial organization accommodated into a country'slegal frameworks, and what effect does this have on the ability of firms toinnovate. Variations in the broad institutional organization of the German andUS political economies result in different processes of contract lawmodernization in the two countries, with important implications for innovation trajectories. The German institutional infrastructure encourages firms todevelop cooperative "diversified quality production" (DQP) inter-firm strategies.This is promoted through highly regulative contract laws and the existence ofstrong trade associations that firms engage to create standardized industryframeworks. These contracting arrangements allow the diffusion ofstandardized governance structures showing firms how to create rules neededto manage complex new forms of organization. While strongly supporting DQPstrategies and discouraging opportunistic product market strategies, Germanpatterns of contract law regulation place important constraints against moreinnovative product market strategies. In the United States legal resources aredecentralized across firms, trade associations have few law-makingcompetencies, and courts do not regulate the distribution of risks across firms.Contractual frameworks are developed on a firm-by-firm basis and slowlyaccommodated within the legal system through the generation of courtprecedent. This system encourages radical innovation in the law, an importantprerequisite for innovative product market strategies more generally. However,the paper shows that a necessary trade-off of legal innovation in the US is thatcourts cannot implement German-style contract law regulation to constrainopportunism, while the decentralization of legal resource inhibits the creation ofstandardized contractual frameworks needed for DQP strategies. Through anextensive game theory analysis of bargaining between courts and large firms,the paper explains why these equilibria are maintained, despite strong incentives in the German case for some large firms to deviate.