2 - Entity Selection, Formation, and Governance

11.1Learning Objectives

Learning Objectives

1. Summarize the fundamental principles which govern international law.

2. Describe different arrangements of international laws which affect international trade and relationships.

3. Illustrate the basic organization of the United Nations and explain the UN’s purpose.

4. Describe the political organization of the European Union.

5. Compare the purposes and organization of the three main world banking institutions.

6. Identify different methods or tools by which international disputes are typically resolved.

7. Describe the regulations imposed by the Foreign Corrupt Practices Act.

8. Compare different standpoints on businesses’ obligation to fulfill social responsibility requirements.

9. Summarize the basic tenets of the foundational ethical philosophies that are commonly applied to business practices.

10. List and describe the five areas which govern the consensus view of good corporate citizenship.

11.2General Principles of International Law

International law describes the set of rules and sanctions which govern the relationships between sovereign states. It is a consent-based system where nation-states bind themselves to international rules to achieve some economic or political goal: trade, technology transfer, peace, and so on. International law is very successful in establishing uniform standards for such things as codifying construction rules for fire prevention, setting standards for weights and measures, and establishing international protocols for airplane safety. In terms of regulating issues of war and peace, and even trade, it is much less so. International law is guided by several principles, including Comity of Nations, Act of State Doctrine, and Sovereign Immunity

Comity of Nations

A fundamental principle of international law is the notion of Comity of Nations. Comity is the doctrine that a sovereign nation’s legal system will adopt or implement the law of another sovereign nation out of deference, mutuality, and respect. For example, in the interpretation of an international contract, a court in Nation A will give deference to that contract’s interpretation under the laws of Nation B, where it was created, as long as the laws of Nation B are consistent with the public policy and law of Nation A. More specifically, a court in Nation A may uphold the ruling of a court in Nation B in a particular case, even if the case may have been decided differently in Nation A. Factors that a court in Nation A would consider in granting comity for a decision in Nation B would be Nation B’s apparent fairness and impartiality of its legal system, jurisdiction over the defendant and subject matter, and the absence or presence of fraud or excess politicization of the legal system.

Act of State Doctrine

Another principle of international law is that each state has the power to regulate its internal affairs unfettered by the legal rulings in another nation. Under the Act of State Doctrine, the United States holds to the principle that every sovereign state must respect the independence of every other sovereign state and that courts in one country may not pass legal judgments upon the acts of national governments done within their borders. For example, suppose the People’s Republic of China outlaws the practice of all religions in the country. Saul, a Jewish U.S. citizen living in California, disagrees with China’s new law. Saul brings a lawsuit against China in a U.S. district court located in the state of California, arguing to the court that China’s law should be illegal. The U.S. district court will apply the Act of State Doctrine and rule that China’s law is an act of that state and that a U.S. court has no authority to hear and decide Saul’s case. The court will dismiss Saul’s lawsuit against China.

Sovereign Immunity

The third fundamental principle of international law is the doctrine of Sovereign Immunity. Sovereign immunity is a long-standing principle of international law and a legal doctrine which holds that a sovereign nation is immune from civil suit or criminal prosecution. It comes from the traditional notion that "a king can do no wrong.” The US recognizes this concept under the Foreign Sovereign Immunities Act (1976). The immunity is not absolute and may be forfeited if a state has waived it or has engaged in a primarily economic activity which has affected the United States. In those cases, a foreign nation may have to defend a lawsuit against it arising in a state or federal court in the United States. An example of sovereign immunity is found in the 2012 North Carolina case Bullard v. Wake County. Dennis and Wendy Bullard sued Wake County for negligent inspection of their new home, which had significant structural defects within only a few months. Their builder went into bankruptcy, so suing the county was the Bullards’ only option. When the case went to the Court of Appeals, the court found that Wake County had not waived its sovereign immunity; thus, the Bullards were unable to recover anything against Wake County.

11.3Sources of International Law

The U.S. businessperson is governed by both domestic and international sources. Trade between a firm in the United States and a foreign business are first and foremost regulated by the United States Constitution by way of both the Treaty Clause and the Foreign Commerce Clause.

The President of the United States is empowered by Article II, Section 2, Clause 2 of the Constitution, the so-called Treaty Clause, to negotiate agreements between the United States and other countries, subject to a two- thirds approval vote by the Senate. A treaty is an agreement between sovereign states to act in a certain manner, usually on trade matters. Akin to contracts, a treaty is binding on the nations involved and subject to enforcement under the principles of international law. Once approved, the treaty has the full force and effect of law. This means, using a hypothetical situation, that a small wallet manufacturer in Kemmerer, Wyoming, is subject to an international treaty governing the use of snake skin in the manufacture of wallets. Moreover, in an area of law which is the domain of the states, an international treaty could become the law of the land, even if Congress and the President traditionally have little authority over such matters. For example, education law is a domain of the states, but an international treaty which sets standards for the qualifications of elementary school teachers would become the law. This could be true even though Congress and the President traditionally have little authority over education.

A treaty must meet the standards of the U.S. Constitution or it is void, or at least the violating provision is a nullity. Because the treaty becomes U.S. law, Congress retains the power to amend it without reference to the international party with whom the treaty is made. The scope of the authority of the President to unilaterally withdraw from a treaty remains uncertain.

Many treaties are bilateral treaties, which are agreements between two nations. Some trade agreements are between several or more nations, as in the North American Free Trade Agreement (NAFTA), which is between Canada, the United States, and Mexico. Perhaps the most important of any of these multinational agreements is the creation of the United Nations.

Related to the Treaty Clause, which can include many non-business related issues like missile defense, is the Foreign Commerce Clause. Here, the Constitution in Article I, Section 8, Clause 3, gives Congress the power to regulate commerce with foreign nations. This gives Congress the power to regulate international trade. Business must look then at federal trade law to understand which rules apply to a particular international transaction.

In addition to U.S. law governing international trade, business must also comply with what is called customary international law. When a consistent recurring practice develops between nations in the course of their relationship, that practice becomes a binding principle between the nations whether it is accepted into a treaty or not. Most often, customary law is codified into a treaty. An example would be the immunity from criminal prosecution for a visiting Head of State.

11.4The United Nations

It would be impossible to discuss international business without touching on the increasingly important role the United Nations (UN) plays in world affairs. Founded in 1945 as a venue for the resolution of nation-state conflicts leading to war, the UN is comprised of 193 member nations and is headquartered in New York City. It is financed by voluntary contributions from member states, of which the United States is a leading contributor, and its goals now include the maintenance of peace, the fostering of human rights, the promotion of economic development, and the provision of humanitarian aid. The UN is comprised of various subset organizations. The Secretariat is the executive arm of the UN and is comprised of the Secretary General, currently Ban Ki-Moon of South Korea, and staff. The Secretariat provides a forum for member states to discuss and resolve issues, conducts research, and carries out the administrative duties of the UN.

The General Assembly is the main deliberative body of the UN, comprising a representative from each member state. Out of the General Assembly comes the Security Council, which is tasked with keeping international peace. The Security Council is comprised of fifteen member states, five of which are permanent members - The United States, Russia, China, France, and the United Kingdom. Other nations serve in two-year term rotations based upon a regional allocation. The Security Council is a very important body because it can establish international sanction rules and issue binding resolutions to member states. Moreover, the permanent members of the Security Council may veto nominations for Secretary General or member nations serving on the Council itself. Perhaps the most important power the Security Council holds is the ability to authorize and execute military action through UN security forces, called UN peacekeepers. Despite the name, UN peacekeepers are military forces voluntarily provided by member states and have recently totaled a force of 116,837 soldiers.

The matrix of UN operations includes the World Bank Group, which consists of the World Bank and the IMF; the World Health Organization, dedicated to disease prevention and cure, primarily in the developing world; and aid programs such as the World Food Programme, UNESCO, and UNICEF. Finally, the UN sponsors the International Court of Justice to mediate disputes between member nations. It is to this area of international law to which we now turn.

11.5The European Community

Perhaps the largest international agreement between nations is the European Union (EU). With the recent addition of Croatia, the EU is a unification of 28 states creating a political and economic community spanning much of modern-day Western Europe. Following in the footsteps of earlier agreements regarding coal, steel, and atomic energy production after World War II among the nations of Belgium, France, Germany, Italy, Luxembourg, and the Netherlands, the European Union was designed to create a "single market" for trade to compete favorably against America and Asia for commerce.

Aims of the European Union

Officially established by the Treaty of Maastricht on February 7, 1992, the EU has five aims:

1. To strengthen the democratic governing among nations;

2. To improve the efficiency of nations;

3. To establish economic and financial unification;

4. To develop the Community social dimension; and

5. To establish a security policy.

To achieve these goals, the EU has established wide-ranging policies regarding business, education, and social issues. The EU has come under criticism for its unwieldy governing structure, which involves an "institutional triangle" composed of 1) the Council – representing nations; 2) the European Parliament – representing citizens; and 3) the European Commission – responsible for holding up Europe's main interests. The European Council is, essentially, the meeting of the heads of state of member nations. Originally an informal body, it now is officially recognized as an official organ of the EU with authority for directing the EU's general political priorities. It has no power to pass laws. The European Parliament is the primary legislative arm of the EU and its members are directly elected by member nations. The European Commission acts as the executive arm of the EU, and its members - one for each member state - are to look to the interest of Europe as a whole, not just a self-interested member state when making decisions. Because its members are appointed, not elected, and have tax free income, the Commission has come under criticism as an elitist body.

Many of the EU countries have adopted a unified currency known as the Euro. The area in which the Euro is used is known as the Eurozone.

11.6World Financial Institutions

There are three main world banking institutions which deserve the attention of an international business person: the World Bank, the International Monetary Fund, and the Bank for International Settlement.

Established in 1944, primarily under the sponsorship of the United States and the United Kingdom, the World Bank is a financial institution designed to provide loans to developing nations for capital improvements such as roads, dams, and telecommunications facilities, and it loans approximately $25 billion annually. Its Articles state that the purpose of the Bank is “to assist in the reconstruction and development of territories of members by facilitating the investment of capital for productive purposes” and “to promote the long-range balanced growth of international trade and the maintenance of equilibrium in balances of payments by encouraging international investment … thereby assisting in raising the productivity, the standard of living, and conditions of labour in their territories.”

The Bank makes loans at a rate of 0.5 percent above its own operating costs. Loans were originally made only for specific structural improvements, but in 1980 the World Bank began providing loans for the promotion of social reforms.

The World Bank has been criticized as promoting the goals of western nations over those it was ostensibly designed to promote. For example, the United States, a single nation, has one director, while the 47 sub-Saharan African nations who are member nations have only two.

The World Bank also attaches conditions to its loans which give it broad authority to ensure a nation structures its internal economy so as to repay the loan. Every president of the World Bank since its creation has been a U.S. citizen.

Created at the same time as the World Bank is the International Monetary Fund (IMF) International Monetary Fund (IMF). Member countries of the IMF contribute money to a pool through a quota system from which countries with payment imbalances can borrow funds temporarily. The balance of payments includes a country's exports and imports of goods, services, financial capital, and financial transfers. When added together, they must sum to zero, with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit. If a nation has a deficit shortfall, it will have to counterbalance it in some way – such as by funds earned from its foreign investments, by running down central bank reserves, or by receiving loans. This is where the IMF seeks to help.

The Bank for International Settlements (BIS) is the central banker to the world and is located in Basel, Switzerland. It serves member state’s central banks in their pursuit of monetary and financial stability by providing research, promoting cooperation, and acting as a bank for central banks.

11.7International Dispute Resolution

International disputes may be resolved informally between nations through diplomacy and negotiation. However, when that fails, nations may submit complaints to the International Court of Justice (ICJ) in The Hague, Netherlands. The ICJ’s main function is to hear and settle legal disputes among UN member states and to provide advisory opinions—something that we discussed earlier that U.S. courts do not do—on legal questions submitted to it by international agencies and the UN General Assembly. When deciding cases, the ICJ relies for authority upon international conventions, international custom, and the "general principles of law recognized by civilized nations." It may also rely upon "the teachings of the most highly qualified publicists of the various nations" and its previous judicial decisions to help interpret the law. Interestingly, the Court expressly states that it is not bound by the common law principle of precedent or stare decisis. The decisions of the Court are therefore binding only on the parties in a specific dispute.

Another way international disputes are resolved is through the World Trade Organization (WTO). Signed in 1947, the General Agreement on Tariffs and Trade (GATT) is a multilateral agreement regulating trade among 153 countries, and its purpose is to effect the "substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis." Over a series of negotiations lasting years, member nations fine-tuned the agreement and eventually, in 1994, created a permanent institutional structure for regulating the massive trade agreement called the World Trade Organization.

The WTO’s goals include creating a trade system free of discrimination, barriers, uncertainty, and anti-competitive practices. Under WTO rules, all agreements on reducing tariffs and barriers to trade must be passed by all 150 members, on the theory that if all can agree on a rule it must be a fundamentally fair precept. Most nations of the world, at least those of any consequence, have signed on to the GATT and are members of WTO. Of course, as we saw earlier, international law and agreements are consent-based, and nations often ignore WTO rulings if national interest prevents following the rulings. For example, the U.S. has been called out, but continues to ignore, WTO rules in the so-called “Irish music” case. The U.S. allows restaurants and store owners to play Irish music without compensating the owners of the material, a violation of WTO rules. The WTO has in place a dispute resolution mechanism where nation states may bring complaints. When a member nation enacts a policy or takes action which another state considers as breach of the WTO agreed rules, it may seek resolution through the Dispute Settlement Body. The WTO procedures are perhaps the most active international dispute resolution mechanisms in the world.

11.9Social Responsibility of Business

The foregoing discussion about the Foreign Corrupt Practices Act (FCPA), leads us to a general discussion of what constitutes the general ethical obligations of business. With respect to appropriate business behavior—exercising our duty to act as morals and customs demand—the law sets only a minimum standard. Conduct in the business world is measured for its morality, or its ethics; indeed, both for its adherence to social constructs of right and wrong and for its social responsibility to the citizens in the countries in which it operates. Virtually all agree that an action may be legally permissible while being unethical. An example is a marketing tactic employed by a credit card company to sell certain products to people who aren’t eligible for any of the product benefits. While this marketing tactic may not qualify as deceptive advertising under the law, it is unethical because it takes advantage of an unsophisticated consumer.

Beyond a duty to obey the law and act morally, does a business owe a greater duty to society? Some, like economist Milton Friedman, maintain that business has only one responsibility and that is to maximize profits for shareholders. He said: “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” Friedman also stated: “So that the record of history is absolutely crystal clear. That there is no alternative way, so far discovered, of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system.” A case example of maximizing profits occurred in the 1919 Dodge v. Ford Motor Company, in which founder Henry Ford sought to reduce prices on his cars which would increase vehicle production and allow more people to buy cars. The Dodge brothers, two shareholders, sued Ford and claimed that his plan would not increase shareholder dividends. The court sided with the shareholders, saying that Ford’s plan benefitted the public more than the shareholders.

Others vigorously disagree with Friedman and argue that business, by having the privilege of being organized under law, bears a social responsibility to the citizens of the country in which it operates. Moreover, they argue that corporate citizenship requires a firm to actively do good in the communities in which it operates and that the bottom line includes profits, plus a social responsibility factor. This is especially the case for so-called “green” environmental policies. For example, a manufacturing plant that dumps its hazardous waste into a nearby lake is negatively affecting the community and not being socially responsible.

Yet others argue that a firm is ethical if it meets the moral minimum of behavior. That is to say that the ethical duty a business owes to a community and other businesess is to “do no harm.” For example, an oil company that pollutes a body of water and then compensates those whom the pollution has negatively impacted has met its moral minimum of social responsibility.

Finally, stakeholder theory argues that in the calculation of ethical business behavior, a firm is unethical if it does not consider the parties impacted by its decisions. For example, a corporation that viewed its employees simply as means of expanding shareholder wealth would be in violation of the stakeholder theory. As the theory goes, persons or entities who have taken no risk in developing the business, but who may suffer some negative consequence of the firm behavior, should have a say in business decisions or should have their views considered. The definition of who is actually a stakeholder and how broad the stakeholder definition should be applied has not yet been fully agreed upon. Certainly under the theory, employees, customers, suppliers, financiers, communities, governmental bodies, political groups, trade associations, and trade unions and others are considered stakeholders.

11.10Foundational Ethical Philosophies Guiding Business

Business ethics is informed by different ethical philosophies such as utilitarianism, Kantianism, social justice theory, and virtue ethics.

Utilitarianism

Under the ethical theory of Utilitarianism, an action is ethical if it maximizes the greatest happiness for society. For example, if a citywide poll is taken that 85 percent of its population would be happier with a new central park, the park should be built. This theory holds to the notion that results govern what is ethical and society would be best served by the legislature considering which proposed law would benefit the most in society. A few of this theory’s weaknesses are the difficulty of measurement, the lack of sufficient information to make choices, and the very notion of what is beneficial. The principles of utilitarianism may be seen in administrative actions, cost-benefit analyses, and the balancing provisions we discussed in environmental impact statements.

Kantian Ethics

Kantian ethics, named after its originator, German philosopher Immanuel Kant, hold that ethical action arises from executing a duty and that duties arise from rational thought. Kantianism holds that any action must be able to be universalized–applied to all persons equally–in order to be ethical. If the action can be consistent–applied in all circumstances, and reversible–returning in kind to the doer without harm, it is ethical. For example, if you rationalize that it is acceptable for you to not fulfill contract terms to your utmost ability, it is acceptable for competitors to do the same. Kant espoused the notion of one categorical imperative–one rule from which all moral action could derive–which is: “Act only according to that maxim by which you can, at the same time, will that it should become a universal law.” It most closely aligns with the “golden rule” which is present in many ethical systems.

Social Justice Theory

Twentieth century thinker John Rawls espoused a social justice theory wherein he argues the greater good compels the loss of some freedom for individuals. In other words, social justice or fairness is the measurement of whether an action is ethical. Rawls' work was founded on the philosophy of John Locke and Jean-Jacques Rousseau who argued under so-called social contract theory that a person’s moral obligations are founded on a social contract with others to live in an ordered society. Rawls wrote that “Each person possesses an inviolability founded on justice that even the welfare of society as a whole cannot override. For this reason, justice denies that the loss of freedom for some is made right by a greater good shared by others." Very simply, he argued that each individual must surrender some rights to a legislative trustee who acts in good faith for the greater good and that the least advantaged in society should be afforded special treatment. Social justice theory has been criticized because fairness and justice are subjective terms which can never be quantified. For example, state seatbelt laws compel people to forgo the choice of wearing a seatbelt, but the laws have an overall good effect on society.

Virtue Ethics

Virtue ethics is a theory developed by the Greek philosopher Aristotle which emphasizes the value of virtuous qualities rather than rules or results. Aristotle argued that the individual should choose personal inward behavior to be ethical rather than relying solely on external law and customs. The idea is that if a person's character is virtuous, his or her choices and actions will be also. For example, regarding lying, a virtuous ethicist will focus less on the lying and more on what telling a lie says about one’s character and moral behavior.

11.11Corporate Governance

Recent corporate misconduct has resulted in a renewed focus by regulators, shareholders, and business thought leaders on the concept of corporate governance. Corporate governance is defined as the systems of control, both external and internal, which monitor the actions of directors and management in an effort to mitigate risk and prevent misdeeds.

External Controls

External controls include law, customs, and reporting requirements. In recent years, corporate reporting requirements have become more onerous for firms as legislatures around the world have sought to protect investors from corporate malfeasance. Additionally, the rules governing disclosure of misconduct by those providing services to a firm, like accountants and lawyers, have become more demanding. As noted earlier, the passage of Sarbanes-Oxley is just such a response.

Internal Controls

Internal controls are measures that regulate a corporation’s actions, auditing, and authorizations and accounting to major creditors. It consists of monitoring of board and management action, auditing internal procedures and finances, reviewing remuneration rubrics, reporting to shareholders, maintaining a balance of power over financial decisions, and authorizations and accounting to major creditors.

Areas of Corporate Citizenship

There are five areas which govern the consensus view of good corporate citizenship.

Disclosure and Transparency

First is the requirement of disclosure and transparency. Organizations must make known the roles and responsibilities of key players in the business and maintain best practices procedures for financial recording and reporting.

Safeguarding the Rights and Interests of Shareholders

Second, a firm must safeguard the rights and interests of shareholders. A modern organization has the duty to inform shareholders of corporate actions, encourage shareholders to exercise their rights and responsibilities, and promote participation of shareholders in the annual meeting.

Strong Board of Directors

Third, a firm must have a strong board of directors. Much of the criticism of recent years about corporations has been the lackadaisical approach of the board of directors to executive manager oversight. Many boards were only too happy to hear the good news of high profits, without delving into the details of how some of those extraordinarily high results were achieved. The modern view is that a board of directors must be skilled, active, and vigilant in protecting the interests of shareholders with oversight.

Considering the Interests of Stakeholders

Fourth, a modern firm must account for the interests of stakeholders. As we saw earlier, it is often difficult to identify who is a stakeholder to which a corporation owes a duty, as many persons wholly unconnected with a company may be impacted by a corporate decision. Nevertheless, with every major action, a firm should take into consideration the interests of employees, customers, local communities, and policymakers, as well as environmental interests. These stakeholders may not have formal legal or contractual rights, but the modern view is that corporate social responsibility compels their inclusion into the decision-making process.

Integrity and Ethical Conduct

Finally, and perhaps most importantly, integrity and ethical behavior must permeate the culture of an organization. The possession of high ethical and moral conduct should be the highest priority in selecting board and executive officers of the firm. Every firm must have a code of ethics that is taught and modeled by senior executives.