The Chronicles of a Capitalist Lawyer

Just when we are still absorbing the decision of President Susilo Bambang Yudhoyono to create an anti-pornography task force, Cass Sunstein, the head of the United States Office of Information and Regulatory Affairs and former professor at the University of Chicago Law School, is reporting his success in fostering a more efficient regulatory environment in the United States, at least from the perspective of government agencies. This news just made my day.

No words can perfectly express my deep envy of the above news. For a lawyer who pursues the art of law and economics, having an Indonesian governmental task force whose main purposes are to evaluate the costs and benefits of all existing regulations and to provide recommendations — or even having power to revise or cancel regulations that are not justified — might be a faraway dream. Yet, the dream is still there and we have many good reasons to pursue it.

Too often we see Indonesian regulations that are not justified, not only based on the costs but also their basic reasoning. What is the purpose of having regulations? Regulations exist to maximize the welfare of the society (which include maintaining order and promoting justice).

The fact that regulations are applicable to and will affect the lives of many people means that no regulations should be promulgated unless we clearly understand the intended and unintended consequences of such regulations to society.

In an age where people demand more accountability from the government with respect to the use of their tax money, doing a cost and benefit analysis prior to issuing a regulation and evaluating the issued regulations periodically should be the norm that must be satisfied at all times. It is a continuous process because no law will ever be perfect for all times and places. Yet, I find that many people cannot understand (or maybe refuse to understand) this very simple principle.

If the president really loves to create task forces, this is the ultimate task force that he should make in the first place. The rest can be disbanded immediately simply because we don’t see any justification for their existence other than for wasting our money.

What would be the task and scope of authority for this task force? The task is simply to evaluate all existing regulations in Indonesia, assessing the costs and benefits of having those regulations, especially the actual benefits and costs of enforcement. The task force should also be authorized to revise any regulations issued by governmental agencies, making it a super body standing at the top of the hierarchy of governmental agencies, ensuring that all policies of the government will be synchronized.

For laws issued by the legislature, the task force should only have the power to make recommendations. After all, the legislative body represents the basic idea of our democracy. While I support an efficient and effective government, it does not mean that I support tyranny. Thus, the authority to change regulations should stay within the scope of governmental agencies.

I don’t think that the task force should be granted the power to issue regulations by itself. That part should still be the main job of various governmental agencies and departments, assuming that they have a comparative advantage in starting the process.

By focusing on evaluating and revising the regulations, we can save the costs from doing a redundant job. In short, one body to make the regulations, another to evaluate the regulations. In addition, we cannot expect the drafters of regulations to review their own products. Hence, naturally, the authorities must be separated.

What ideas should be promoted by the task force in evaluating regulations? First, flexibility within the rules. We should always favor flexible rules except in special circumstances. The fact that the world can change drastically in a short time means that there should be less room for rigidity in the law. More freedom should be given to society while the government ensures stability via security maintenance and institutional support.

Second, efficiency. The regulations should aim at maximizing benefits while reducing the costs. This means less administrative procedures from the government side. Don’t make things more difficult when you can make them easier. It’s as simple as that.

It also means that government should only regulate important things when the costs of enforcement are justified. As an example, government should not waste its time to regulate and enforce the laws on private conduct that might be better enforced by family members such as in the case of pornography. Instead, it should focus enforcement on reducing crimes that are disastrous to the society, such as corruption and money laundering. We have limited resources, so please focus only on the pressing matters.

I guess most of the people know about the latest fatwa issued by one of the National Ulema Council (MUI) members, Mr. Cholil Ridwan, stating that viewing the concert of Lady Gaga is prohibited under Islamic law. In this post, I will not discuss the validity of his opinion under Islamic law principles, rather, I want to discuss a more pressing matter, and that is the market for ridiculous ideas. The distribution speed of such fatwa is ridiculously high as everyone want to give their comments, either agreeing with the content, or just for the purpose of mocking the fatwa.

I find the overall conduct as highly inefficient. Although the article did say that Mr. Ridwan did not represent MUI and that it was only his personal opinion, the title might give a misleading perception to the readers (especially in a world where most people focus only on the headline instead the content of the news), at least evidenced by the multiple comments that I read in my Twitter timeline. And it goes on and on, from saying that such fatwa is a part of fundamentalist thoughts, that the fatwa is being used to blackmail the music promoter, and not to mention people who spend their time explaining to other people that the news is actually misleading. What a waste of time!

Sure, people might say that this is only a single case and the argument of efficiency might not be applicable. But we should also see the facts that this kind of news is only a part of many other stupid news, spreading ridiculous ideas that do not have any social benefit other than to attract readers for the relevant medias. For the media, it is an efficient system. After all, whether the news has a good quality or not is not a problem, the most important thing is that the media can gather as many readers as possible at an instance and engage them in useless debate that will promote the ideas to a new level.

I am a supporter of freedom of speech and I will not say that ridiculous ideas cannot be spread to the general public. But for God's sake, media should act as an effective screening mechanism for useful ideas, somewhat similar to the role of underwriters and investment bankers in capital market. The laws in many countries require these bankers to give their best effort and to satisfy a very high standard of conduct in order to ensure the integrity of the market. We want them to ensure that only the best products that will go to the public or at least that they can give adequate information to the public so that the public can make an informed decision.

The problem with the market of ideas is that it is far more difficult to set the standard for determining a good idea. Different with capital market where we can tag prices to the securities being sold, the value of spreading an idea for a media corporation is not in the idea itself but on how it can attract viewers. And even if the idea is a complete failure and also wasteful, as long as the actual monetary damages to the society is not clear, no one can go to the court and sue the media for spreading such stupid ideas.

I guess this is a good example of market failure where asking for intervention from the government might be more costly than the perceived benefits since I do not want to open any possibilities for the government to censor ideas, even if it is utterly ridiculous. I hope that Indonesian readers would start to treat this kind of news as unimportant and therefore reducing the value of news itself. The more people choose to ignore this kind of news, the more incentives for the media to pick better news to satisfy their readers. That would be an acceptable solution for both parties.

My suggestion for medias, please pick a better source of news, especially when you know that your source is not reliable. Each man is entitled to his own opinion, but it does not mean that each opinion should be treated as important and therefore good for publication. In the short term, doing this kind of thing might be profitable for the media, but I doubt that it will be good for the long term, along with the increase of education level in Indonesia. Smart medias should take this opportunity to establish their own niches as medias that only broadcast high quality materials and attack medias that spread wasteful ideas to attract readers. Who knows, competition might effectively solve this problem sooner that we all expect.

Is burning books an efficient action? It depends. On the one hand, people should be free to do what they want with their own assets, including burning their books. As long as they pay for those books, why should we bother? On the other hand, spreading an idea with a book may be beneficial, so burning them might be costly for society since we’re deprived of the opportunity to receive more knowledge.

But these days, burning books might not be as costly for society anymore. Information can now be transmitted efficiently to a huge audiences that, unless you are the government of China, nothing you do can effectively prevent the spread of the ideas in those books.

With respect to the latest case of book burning, I feel that the action itself was not that significant. Some people wanted to show that they disagreed with certain ideas, bought books they didn’t like and burned them. In a way, such a demonstration is actually good for promoting the books. The burners derived utility from the bonfire, and I assume the costs for buying and burning the books were minuscule for them compared to the benefits they received from burning the books. Life goes on and no one was harmed.

What I am more concerned about is the idea that this action was a symbol of people enforcing the law themselves because the legal authorities did not perform their job properly. In short, the burning was an act of vigilantism. Now that’s a serious matter. Expressing your thoughts publicly is a right guaranteed by the Constitution. Enforcing the law by yourself? Not so fast.

Why should people be prevented from enforcing the law by themselves? Why can’t we let them to do what the authorities should actually do in the first place? We’ve seen many cases when we feel so helpless with law enforcement in Indonesia that some of us think it’s acceptable for certain criminals to be tried by the masses. It would be more efficient, and it serves them right. Right?

The answer is no. Despite the alluring character of vigilante acts in movies and comics (who doesn’t love superheroes crushing criminals that cannot be touched by the law?), it is not efficient at all if we allow people to assume the role of judge and jury.

First, there are procedural standards that must be satisfied before we can punish someone for conducting criminal activities. Although there are costs associated with such a process, we still need it simply to avoid additional costs that might occur in case we punish the wrong person. The less the chance of being punished, the cheaper the cost of doing crime and the higher the cost to the society.

Second, there should also be a clear standard of violation for enforcing the law. You can’t simply punish an act if you can’t justify the adverse effects to society or certain individuals. Moreover, even when you think you are being harmed by an act, we should also consider whether the benefits of having such an act would still be bigger than its costs. In antimonopoly law, we call this the rule of reason analysis. We determine whether an act should be deemed illegal based on its economic effects to the welfare of the society.

Third, the remedy should also be clear. If we feel that an act adversely affects a person, such a person would be entitled to a remedy. In such a case, we must ensure that the remedy is fair and proportionate to the damages caused by the act. If you can’t justify the damages, there should be no remedy — it’s as simple as that.

This is why in a war of thoughts, it is very tricky to satisfy the three elements above. We can’t accurately judge the correctness of a thought if it stays only as a thought. We can’t assess the damages caused by a thought if it only affects your thoughts. And therefore, we can’t declare a proper remedy for the damages that are non-existent.

There are better ways to fight a thought, and one of them is making a counterargument which I am currently doing through this article. You are free to attack other people’s thoughts, but that war should stay in the realm of words.

Asking law enforcement to join the debate or thinking that you may represent them will only complicate the process. Without clear guidelines, it will become another waste of tax payer money and create unnecessary social unrest.

Fight your war by yourself and fight it decently.

After almost 3 years since the inception of this blog, I manage to write my 100th post! Whew, I must say that I am actually amazed that I can finally reach this stage, considering the fact that I am a master of procrastination. I hope that I can continue to write regularly in this blog for many years to come and increase my platforms of writing by publishing books and research papers. Stay tune for those future projects.

For now, I will write about one of the most fundamental issues on corporate law, the fiduciary duties and business judgment rule. After all, writing on law and business issues was actually my primary intention when I first established this blog before I expanded my interest to other fields of law and economics. So, it would be proper if my 100th article deals with such issue. I hope you can enjoy the article and thank you for reading my posts in this blog.

A. Establishing the Duties of Directors

One of the most fundamental issues in the realm of corporate law is how can we define the standard of good business judgment by the management? From such a simple question, various derivative questions can also be asked: when should we deem the directors liable for their business decision? Where can we set a line to separate the good managers from the bad ones? How should we regulate the relationship between shareholders and managers in a corporation? Should we let the market decides how such relationship will work or should the court intervene? If the court should intervene, to what extent?

From economics point of view, corporation can be considered as a business platform where market process (capital, production, and consumption) is integrated through a systematic decision making procedure (what we call as management). From law and economics point of view, corporation is a nexus of contract, i.e. the aggregation of people bound together by a complex web of contractual relationship.

I personally refuse to view corporation as simply an entity whose ownership lies in the shareholders and whose management lies in the board of directors, and therefore, the directors can be considered as the agent of the shareholders and must work for the best interest of the shareholders. Such simplification tends to be problematic in practice.

First of all, what kind of business model is where someone transfers his controlling power to other parties under the guise of ownership versus professional management where he knows that the interest of these so called professionals might not be in alignment with his own interest? Why making such sharp distinction? Second, it should also be noted that there are some instances where the interest of the shareholders will no longer be placed as a priority anymore, such as in bankruptcy cases where creditors will have higher priority than shareholders as the residual claimant.

Instead, I want to view the corporation as a business organization where the parties involved within it should have a good coordination (between the capital owner, the manager, the employees, etc) and should work together in the most efficient way to ensure the maximization of their overall welfare without imposing unnecessary costs to the society. The only way to align all of these interests within the corporation would be to ensure that all party must work for the best interest of the corporation as a whole. From that point we can determine further what would be the proper role of each parties within a corporation, especially the role of shareholders and board of directors.

With respect to the above idea, a specific discussion must be made with the nature of public corporations. As we may be aware, the ownership structure in these public corporations may vary in Indonesia. There are corporations where the ownership structure is pretty much diversified to the extent that it is difficult to find any controlling shareholders, and there are corporations which are being controlled by certain controlling shareholders.

In a perfect world with minimum transaction costs, shareholders and the board of directors can negotiate the terms and conditions for managing the corporation and we can assume that: (i) they will find the best way to balance their authorities and (ii) in case changes must be made, they can quickly adapt to such situation by amending the contract made between them. The problem is, this is almost impossible to happen within a public corporation.

In a public corporation where the numbers of shareholders are huge, it is easy to conclude that they will face collective action problem, preventing them from making an effective negotiation with the directors nor from conducting day to day management of the corporation. As a result of which, the board of directors will ultimately become the controlling party of the public corporation without any internal counterbalancing party. In short, the ownership structure in public corporations create a situation where there is no opposition in the corporation that can ensure a good check and balance mechanism.

The same problem can also occur when controlling shareholders exist within a corporation. Having the majority power to decide what the corporation should do, they can use their power to pursue their own interest at the expense of the corporation and other shareholders. In short, whoever controls the corporation, shareholders or directors, might abuse their power. Thus, a check and balance mechanism would be necessary. For the purpose of this post, I will focus on the directors part.

We have these kind of check and balance mechanisms in our government structure (or we think that we have) because we understand that the government consists of people and they are not angels which have no self interest. By simple logic, the same thing should also be applied to corporations which obviously are also managed by a bunch of people. In case shareholders cannot be the counterbalancing party, we need to have other external mechanisms to ensure that the board of directors will have the correct incentives in doing their job.

One of the possible solutions might be to rely on the market. Bad managers will reduce the value of the corporation that they manage and will induce other potential buyers to takeover the corporation and replace the old management. This seems good, but there is no guarantee that it will always work nor will it be be beneficial to the overall stakeholders of the corporation. Furthermore, in Indonesia, the regulators seem want to limit takeover practices by imposing certain limitations such as the requirement to conduct a mandatory takeover which increases the overall costs of a takeover.

An alternative solution would be having the assistance from the law and the court by filling the gap, creating specific duties that must be performed by directors and that will cause them to be liable either to the corporation or the shareholders (as mandated by the prevailing laws of Indonesia) in case they fail to perform those duties properly. By imposing such liability, we expect the directors will be more careful in performing their work and will always be loyal to the interest of the corporation.

It should be noted though that this is but one solution among many solutions to be used in guiding the directors performance. In corporations with small numbers of shareholders, where coordination between managers and shareholders is easy to achieved, limiting liability might be the best way. But for public corporations, that will not work. Imposing liability is necessary as a check and balance mechanism for corporate governance. It is what our law supports and what any rational men will agree anyway.

B. Best Interest and Best Effort

Even though legitimizing the existence of directors duties is not a difficult task, the real challenge is to expand those duties into a standard that would be acceptable to all stakeholders. Two issues that we need to address here: (i) defining the best interest of the corporation, and (ii) defining the standards that the directors must comply in order to satisfy the best interest of the corporation.

1. Defining The Best Interest of Corporation

On the first issue, in line with my view that corporation should be seen as a platform for business organization for various stakeholders, the best interest of the corporation should be translated into maximization of the value of the corporation which will benefit the whole stakeholders of the corporation in general.

Each managerial decision to be made by the directors must consider carefully whether there is a perceived benefit for the corporation if such decision is taken. Whether the benefits are for short term or long term should not be a major problem, the more important thing is that the directors when being asked by the stakeholders of the corporation can provide sufficient justification that they have done their best effort to ensure that their decision is made only and only for the benefit of the corporation as a whole.

2. Defining The Best Effort Standard

The next step is to define the term “best effort”. A good standard would not sacrifice the flexibility that the directors have in managing the corporation. Putting too high standard will burden the corporation as it will increase the costs of decision making by the directors. While putting too low standard will defeat the purpose of finding the correct incentives for directors as they can cover their liability even when they are reckless by ordinary standard.

A major issue related to defining the best effort standard is the fact that the court is not a business expert. Creating an ambiguous standard would eventually burden the court since when there is no certainty, we can expect that more cases will come to the court and there is no guarantee that the court can provide the best result. On the other hand, if the court creates a rigid business management standard, what would be the justification to provide such standard? The court could end up damaging the welfare of the society for making standards outside their own expertise.

In order to determine whether the directors have conducted their best effort, I would suggest that the court should not try to create an ambitious standard that will be problematic for future cases. I would instead urge the judges to think as if they are ordinary people who trust their money to certain trustees and expect that they will cooperate with them for their best interest and that they will work with the money as if the trustees own the money themselves. In such position, I will naturally focus on the decision making procedures that have been taken by the trustees before I move on to the end result of their decision.

Can they show that they have enough time to discuss the proposed action? Can they show that a proper study has been conducted by the board of directors, at least internally, that the action is beneficial to the corporation? Can they show that they have considered the risks that might occur, the probabilities of the risks occurrence, and how the corporation will mitigate such risks? I believe that all of these questions reflect the common sense standard in doing a business.

In case of doubt, all of these actions should be judged in accordance with the standard usually used by similar industries or type of business and the court can obviously rely on expert witnesses concerning such matter. If it can be proved that the directors did not meet those standards, they should be deemed violating the best effort standard, and it will open the door of liabilities.

Another solution would be to induce the directors to use the service of independent third party professionals in rendering their decision, such as lawyers, financial advisers, and appraisers. The use of these professionals has already been required by certain capital market regulations and might indicate the good faith of the directors to ensure that they don't make significant mistake in doing their job. Of course, the court can always review the independency of the professional parties to ensure that there is no conflict of interests which may taint the business decision.

C. Conclusion

Although our law has stated that directors have fiduciary duties to satisfy the best interest of the corporation, further elaboration is needed to ensure that all corporation stakeholders can have the right incentives in doing so. There are many ways to ensure that directors stay true to their duties, either bia the market or the law. If we want to use legal mechanism, the role of the court should be expanded as the guardian of the last resort in the business world. Of course, to achieve such state, the quality of the judges must also be improved.

Today is a sad day indeed for Indonesia as one of its greatest economists, Prof. Widjojo Nitisatro, passed away this morning. What a great loss! Although I have never met him in person, I know him through his splendid articles and books about him, especially the Kesan dan Pesan Sahabat-Sahabat Widjojo Nitisastro. Two of my favorite articles of him deal with the economic analysis for national development and the economic analysis of Article 33 of the 1945 Constitution (which discuss the correct economic structure for Indonesia). I consider those articles as the classical example of economic analysis of law in Indonesia and they have significant impact on inducing me to pursue the art of Law and Economics.

While I have been writing about law and economics for many times in my blog, I have never formally written about an introductory article on economic analysis of law itself. I guess this is the right time to do so as a tribute to the late Prof. Widjojo Nitisastro. You will surely be missed and may you rest in peace. God bless you.

Economic analysis of law or law and economics is a school of thought primarily developed in the United States that uses the powerful tool of economics to analyze various legal issues. It discusses three primary questions: (i) What is law? (ii) Why law exists in the society and can have binding power? (iii) What can be considered as a good law? Two prominent scholars can be considered as the early developers of law and economics, Gary Becker, a prominent economist who won Nobel prize in 1992, and Richard Posner, a prolific legal academician who is also considered as one of the best judges in the United States. Both teach at the University of Chicago and contribute significantly to the development of law and economics.

Why economics can be a useful tool in analyzing the law? The primary notion used in this school of thought is that men act rationally. Not in the sense that they can always make perfect calculation at all times but in the sense that they respond to incentives and pay attention to the costs and benefits of their actions, even when they are subject to various limitations in doing so. This is the basis of positive law and economics which deals with descriptive analysis on the law and how it will affect human behavior.

The second notion in law and economics is the pursuit of efficiency and welfare maximization of society. This is used by normative law and economics which believes that law should be designed to maximize the welfare of the society, whereas to reach that goal, law must be designed as efficient as possible. The more efficient the better, since it means that we can save costs while produce the biggest benefits to the society.

Interestingly, despite the fact that law and economics has reached a very strong position in the United States, dominating the legal thought there, it is relatively unknown in Indonesia which sadly, still focuses its law teaching with classical legal thought. I guess this should be changed if we really want to improve our Indonesian legal system.

Why law and economics is helpful for developing our legal system? I have three main reasons. First, by paying attention to how the law can shape the incentives of the people, we can shape our law to effectively affect the behavior of the people. As an example, I once argued on limiting the use of prison as a sanction for corruptors and instead using the sanction of assets confiscation. Assets and money are the bloodline of corruptors, the ones that significantly induce them to do the crime in the first place. If we only send them to prison but fail to secure the assets back, that will allow the criminal defendant to use the money to buy his way through the legal system (remember the case of luxury prison).

Second, by paying attention to the notion of efficiency, we will also pay attention to the costs and benefits of having regulation. Only regulate if the costs of doing so are lower than the benefits. Do not try to regulate everything because we cannot have an effective regulation without effective enforcement. And enforcement can be costly, the bigger the scope of the enforcement, the bigger the costs. Classical legal thoughts believe that law should be obeyed because it is promulgated by the relevant authorities. This is completely wrong. It is obeyed either because we find a mechanism to enforce it or the general society believe unanimously that such law is useful. Hence, the need of enforcement.

One good example of this would be laws that deal primarily with regulating private behaviors that do not produce clear harms such as how to dress publicly. On the one hand, regulating those kind of things will be costly, imagine the price for enforcement and the potential social unrest that it will create since it will give legitimation to people to violate other people on the basis of dress. On the other hand, there is no clear benefit of regulating such behavior in the first place other than to serve the idea of several people about morality. We've seen a lot of these absurd laws, such as laws that try to regulate how to name your child. I wonder how these laws could even exist if not only for the purpose of political maneuver.

Finally, by putting the goal that laws should always aim to maximize the welfare of the society, we will have a good guide in developing laws that will be useful for the society. And there are a lot of things that we can discuss here. Some good examples that I have once discussed: how to efficiently regulate liability of people in tort cases (such as whether we need to establish good samaritan liability), whether we should maintain death penalty (do the benefits justify the costs?), how to prevent rape crimes effectively, the extent to which we can limit foreign investment in Indonesia, how to share the legal risks of infrastructure development in order to induce more investors to come to Indonesia, how to reduce courts burden by cutting unnecessary costs for judging petty crimes (the latest Supreme Court regulation is a nice example of this), and many more.

I believe that it is important for law makers and legal enforcers to always strive for welfare maximization in rendering and interpreting the law. You do not enforce the law for the sake of the law itself. Law is not holy, it is not untouchable, it is not derived from the sky, rather it is made to serve men and should be made in view of men needs. Prof. Widjojo Nitisastro has started the idea of using economic analysis in shaping our national development and making sound economic policy long time ago. It was a great contribution, something that we, youngsters, must also strive to achieve. The least thing that I could do is to introduce law and economics to Indonesia and contribute in offering good public policy for our nation.