As the personification of the corporate entity faded as a concern, the stage was set for legal academics to think about the corporation in functional rather than abstract terms. Adolf Berle and Gardiner Means’ The Modern Corporation and Private Property, originally published in 1932, provided an ideal platform for the shift in emphasis, at least in the United States. The authors analyzed the results of a ‘corporate revolution’ that had occurred in the US between 1880 and 1930. During this period, in many key industries small closely-held firms managed by their founders gave way to big publicly traded companies characterised by managerial hierarchies. In these ‘quasi-public corporations’ widely dispersed shareholders, each lacking a sufficient financial incentive to intervene directly, left it to professionally trained executives to deal with matters of importance. The result, according to a phrase Berle and Means made famous, was a ‘separation of ownership and control’. An inference that many American corporate law scholars drew from Berle and Means’ separation of ownership and control thesis was that something was seriously amiss in publicly quoted corporations. More precisely, the ‘managerialist’ pattern Berle and Means had described implied that those in charge of America’s larger business enterprises were not sufficiently accountable to shareholders. As a Harvard economist said in 1959, ‘almost everyone now agrees that in the large corporation, the owner is, in general a passive recipient; that typically control is in the hands of management; and that management normally selects its own replacements’. The inference many drew was that managers of large corporations were ‘irresponsible oligarchs’. Academics who were concerned about the uneven balance of power between managers and shareholders advocated various types of reform. These included fostering more participation by investors in corporate affairs (activating ‘shareholder democracy’), strengthening the fiduciary duties top executives owed to their companies and advocating strict monitoring of management by ‘outside’ directors lacking any compromising link with management. Still, while corporate law academics frequently invoked the separation of ownership and control thesis to advocate stronger shareholder protection, this was not the only type of reform that could be advocated on the basis of The Modern Corporation and Private Property. Instead, Berle and Means’ ‘analysis was a gun on a rotating platform that could be pointed in more than one direction’. Most notably, The Modern Corporation and Private Property posed, if indirectly, the question: should the legal system make those managing corporations accountable to society as a whole? The effect was to cast doubt on the received wisdom under US law, which was that the objective of corporations is to generate profits for their stockholders (‘shareholder primacy’). Berle and Means themselves stressed that power was increasingly being concentrated in the hands of large companies. This in turn implied that the corporation needed to be understood as a social and political institution, not merely an economic entity. Various US academics, taking their cue from The Modern Corporation and Private Property, cited the growing power of corporations to advocate changing the law to address concerns about corporate social responsibility. Berle and Means’ separation of ownership and control thesis became ‘the master problem for research’ in corporate law during the decades following the publication of The Modern Corporation and Private Property. As Berle himself observed in 1962, his work with Means had achieved the status of ‘folklore’ within the legal academy. Henry Manne put the point even more strongly, saying in 1987 that ‘no field of American law has ever been so totally dominated by one work as the corporation law area by the Berle and Means classic’. Despite the influence which Berle and Means’ work had, the inferences drawn from it were subjected to increasingly critical scrutiny as the 20th century drew to a close. A pivotal step in this process was the emergence of the economically-oriented ‘contractarian’ model of the corporation. Prior to the 1970s, economists treated the business enterprise, typically referred to as a firm, as a ‘black box’ that simply operated so as to maximise profits. The situation then changed. Economists began to concern themselves with how the conflicting objectives of individual participants associated with firms might be aligned so as to yield the hypothesised focus on profit maximisation. The prevailing view became that market exchanges did not end at a firm’s front door. Instead, the internal organisation of business enterprises was the result of voluntary transactions dictated by market forces. At the same time, market dynamics defined the relationship between a firm and its suppliers, customers, creditors and so on. The firm, in short, was a ‘nexus of contracts’. A pivotal aspect of the nexus of contracts model was ‘agency cost’ theory. Again, the Berle-Means analysis of the widely held company implied that shareholders potentially might be subjected to the untrammeled whims of powerful executives. Agency cost theory provided an analytical framework for examining this divergence of interest. The starting point with the theory was that, whenever one individual (‘the principal’) depends upon another (‘the agent’), from an economic perspective an agency relationship arises. Since agents do not receive all of the returns from the profit enhancing activities they engage in on behalf of their principals, they will always be tempted to put their own interests first. When agents in fact do so, the result is ‘agency costs’. In a corporation with widely dispersed share ownership the shareholders, as principals, depend on management, as agents, to operate the business profitably. Self-serving or reckless managerial conduct therefore creates agency costs for investors. While agency cost theory characterised in a systematic way the sort of incentive problems which Berle and Means had identified, it did more than this. It implied as well that executives in widely held public companies were not as unaccountable as the separation of ownership and control thesis suggested. This is because agency cost theory offered an intellectually elegant account of various market-oriented limitations on the exercise of managerial discretion. One such constraint is the labour market for executives (senior managers want to run companies well to impress potential alternative employers). Another is the market for a company’s products or services (dishonest or incompetent executives will lose their jobs if a decline in market share is sufficiently precipitous to cause the company to fail). Also significant is the capital market (companies which want to raise money receive less advantageous terms if there is evidence of mismanagement). The market for corporate control constitutes an additional constraint on managerial misconduct since bidders, intent on generating profits by installing new executives, can make offers to buy the outstanding equity of poorly run companies. In addition to providing a platform for re-evaluating the position of management, the nexus of contracts model opened the way for a reconceptualisation of the shareholder’s status within the corporation. As exemplified by the phrase ‘separation of ownership and control’, shareholders have often been characterised as the ‘owners’ of a company. Contractarian analysis dispenses with this ‘tenacious notion’ and instead treats those who own equity as ‘residual claimants’. From a contractual perspective, shareholders are defined in this way because they are the ultimate beneficiaries of whatever success a company enjoys, in the sense that the return on their investment is based on what is left over after other claims the company is obliged to meet have been satisfied. Hence, while others who are part of a corporate nexus of contracts will contract to receive fixed cash sums (e.g. creditors and employees), the return a company’s equity yields is variable in nature and is a function of the net cash flow the business generates over time. If shareholders in a company merely constitute one constituency that is part of a nexus of contracts, one could infer that the ‘shareholder primacy’ principle that has influenced US corporate law is misguided. ‘Contractarians’, however, did not embrace such logic and instead sought to justify the pre-eminent position of shareholders. They defended shareholder primacy on the grounds that equity investors, as residual claimants, have strong incentives to encourage maximum corporate achievement in a manner that benefits their fixed claim counterparts. Advocates of the nexus of contracts model also cited the respective bargaining positions of shareholders and non-shareholder constituencies to make their case. The point made was that creditors, employees and customers can feasibly bargain for protection whereas shareholders cannot because of the open-ended nature of an investment in corporate equity. The nexus of contracts model proved to be highly influential, at least in the American context. In fact, ‘(l)aw and economics … swept the academic corporate law area like prairie fire’, so that by early 1990s ‘the dominance of the nexus of contracts model in the legal academy’ was becoming widely recognised. By the end of the decade matters had progressed to the point where the proposition ‘(t)hat a firm (such as a corporation) can be thought of as a “nexus of contracts” … ha(d) become something of a cliché in the university’. Matters ultimately reached the point where some in the US believed that ‘(e)very book and journal article in the corporate law field had to take an economics of law perspective if they were to succeed in the marketplace of ideas’. Cheffins
Posted on: Fri, 28 Nov 2014 01:22:44 +0000
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