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‘s legal frameworks, and what effect does this have on the ability of firms to innovate? Variations in the broad institutional organization of the German and US political economies result in different processes of contract law modernization in the two countries, with important implications for innovation trajectories. The German institutional infrastructure encourages firms to develop cooperative „diversified quality production“ (DQP) inter-firm strategies. This is promoted through highly regulative contract laws and the existence of strong trade associations that firms engage to create standardized industry frameworks. These contracting arrangements allow the diffusion of standardized governance structures showing firms how to create rules needed to manage complex new forms of organization. While strongly supporting DQP strategies and discouraging opportunistic product market strategies, German patterns of contract law regulation place important constraints against more innovative product market strategies. In the United States legal resources are decentralized across firms, trade associations have few law-making competencies, and courts do not regulate the distribution of risks across firms. Contractual frameworks are developed on a firm-by-firm basis and slowly accommodated within the legal system through the generation of court precedent. This system encourages radical innovation in the law, an important prerequisite for innovative product market strategies more generally. However, the paper shows that a necessary trade-off of legal innovation in the US is that courts cannot implement German-style contract law regulation to constrain opportunism, while the decentralization of legal resource inhibits the creation of standardized contractual frameworks needed for DQP strategies. Through an extensive 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.