A Property Theory of Corporate Law

In a recent article, I develop a theory of the corporation as a legal entity based upon the foundation of property law, which I call a “property theory of corporate law.” This theory, unlike the contractarian perspective on the corporation, is capable of demarcating the distinctive features of corporate law from other contractual features.

In current legal scholarship, the dominant view of the corporation is contractarian, one that sees the corporation as a nexus of contracts among factors of production. This perspective views employees, creditors, equity investors, and even customers as the various actors who form a set of contracts that collectively make up the corporation. Because the corporation itself is a set of contracts, the law governing the internal affairs of corporations – corporate law – is itself merely a specialized branch of contract law. In other words, the corporation is just contracts.

The contractarian perspective has profoundly influenced scholarly and judicial thinking on the corporation as a legal entity. Whereas corporate law traditionally views the corporate law as governing the internal affairs among shareholder owners and manager fiduciaries, the contractarian theory views these relationships as contracts, much like other contracts the corporation enters into. In this view, the traditional idea of shareholders as owners of the corporation yields to one in which shareholders are contractual counterparties – suppliers of capital and bearers of residual risk. The shareholders are just another contract claimant on the corporation – in the words of Yale Law Professor Jonathan Macey and Delaware Supreme Court Chief Justice Leo Strine, “not so special.”

Yet the contractarian view fails to explain even the most fundamental and important aspects of shareholders’ relationships to the corporation, such as the mandatory rules of corporate law and fiduciary duties. The contractarian stance gives rise to blurry or even non-existent boundaries of the corporation, implying that there is no inside or outside of corporate law.  This lack of inside or outside stands in contrast to standard teaching on corporate law, which defines corporate law by reference to the internal affairs doctrine. As a result, although the nexus of contracts theory provides a useful foundation in the economic theory of the firm, it either contradicts or fails to explain most of the important features of corporate law.

By contrast, the property theory argues that there are legal boundaries of the corporation. The corporation is a nexus of contractual and proprietary interests, and the distinctive aspects of corporate law – fiduciary duty, voting, limited liability, perpetual existence, transferable shares – concern the proprietary portion of the corporation. In the property theory, the relevant residual claimants hold voting rights in the firm protected by default rules and fiduciary duties. Other interests in the firm, those of creditors, employees, suppliers, customers, and the like, are contractual and protected by explicit terms and the duty of good faith.

The property theory of corporate law does not imply that all claims traditionally thought of as corporate law arise from property rather than contract. The property interests in the corporation are the residual governance rights that arise in the common stock directly from the relevant corporation statute, especially (but not uniquely) the plenary and residual voting rights. As a result, the contractual aspects of shareholders’ claims on the corporation are those that go beyond the default rules of the corporation statute. Notably, many preferred stock contracts fall in this category, because by its nature preferred stock contains rights set forth in the charter and not given by default.

My article builds up the property theory of corporate law by applying a Coasian approach to the legal structure of the firm. Whereas Coase asked why transactions are organized for economic purposes in firms (hierarchies) rather than in markets (arm’s length contracting), the article asks why transactions are organized for legal purposes in corporations. Why are there corporations with shares and shareholders, as opposed to direct ownership of business assets with contracts among the owners? The traditional contractarian answer – residual risk-bearing function of corporate shareholders – falls short, as that could be accomplished using other legal structures. The features of the corporation that cannot be replicated by contract law – the in rem-ification of the business of the company – are those that constitute the core of corporate law.

The argument proceeds in a chain of individually modest assertions that together lead to more solid foundations for corporate law. The first assertion is that there are some ownership interests in the corporation. The corporation is not exclusively contractual but instead a mix of contract and property. Indeed, the corporation is better viewed as more than contract (and more than mere property). It is itself an ownership structure, a technology for bundling various property and non-property relationships, stripping them of cumbersome in personam features and packaging them into standardized units of easily divisible and transferable property (shares). This perspective sees the corporation as a technology for converting messy in personam contract rights into tidy in rem property rights.

Second, the strongest ownership interests most plausibly belong to the owners of the residual control rights in the corporation – the voting shares, not necessarily to the holders of the residual economic rights. Central to this argument is that property theory emphasizes the right to exclude as a central (or indeed the defining) feature of property. The voting shareholders, as those who have the ability to elect and remove directors, are the only holders of what my article terms “a non-excludable right to exclude.” This is the interest of shareholders rightly conceived as an ownership interest. The boundaries of ownership are the boundaries of corporate law, meaning that the core of corporate law is better thought of as a subspecies of property law than of contract law.

Third, fiduciary duties formally follow from the ownership interests, not contract interests. The standard rationale for fiduciary duties and voting is that shareholders are the residual economic claimants. The property theory shows that the more important residual in corporate law is the residual of control – voting rights – which is held uniquely by (usually common) shareholders. The shareholders are the residual holders of these proprietary voting claims and are the proper focus of residual claimant analysis for many of the core functions of corporate law, such as fiduciary duties.

Collectively, these assertions establish that there is a line to be drawn between contract and property, ascertained by the underlying theory of property and with a different set of approaches on each side, and that this dividing line identifies the boundaries of distinctively corporate law.  The property theory provides a foundational explanation for many of the features of corporate law that are incongruous within a purely contractarian perspective. It explains why corporate statutes deal almost exclusively with shareholders, why the corporation has so many in rem features, why a single law applies to the internal affairs of the corporation, and why it is sensible to talk about internal affairs at all. In practical terms, the property theory explanation helps to resolve otherwise difficult cases of loyalty in corporations with increasingly complex capital structures, especially preferred stock. Finally, the property theory provides some traction on the question of the social purposes of the corporation.

This post comes to us from Professor Robert Anderson IV at Pepperdine University School of Law. It is based on his recent article, “A Property Theory of Corporate Law,” available here.

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