Classical Liberalism and Corporate Law

In a new book chapter I evaluate contemporary corporate law, especially Delaware corporate law, from a classical liberal perspective—i.e., the view of politics and economics that derives from the English and Scottish Enlightenment, underlies the American founding, and has been developed by modern figures such as Hayek, Friedman, von Mises, Stigler, Coase, Buchanan, and Epstein.

Classical liberalism places great value on voluntary human activity, both because it assumes that individuals have a right and a duty to control their own lives (which makes liberty the paramount political value), and because it holds that voluntary cooperation among human beings usually produces better outcomes than coordination secured by coercion (which results in market solutions usually dominating over governmental regulation). From such a perspective, the business firm is thus a critically important institution, for it is one of the most consequential ways of organizing voluntary activity among human beings.

After briefly discussing the economic theory of the firm initiated by Coase, the chapter turns to legal issues concerning the formation and organization of firms. Like the societas of Roman law, the partnership at common law is clearly the result of voluntary agreements among the parties. The corporation, however, like the collegium in Roman law, is different; its formation involves not only the contracting parties but the sovereign, a fact that has given rise to two different views of the corporation.

Under the privilege view, incorporation is a concession from the state benefiting the individuals forming the corporation. Two hundred years ago, when corporate charters could be secured only by a special act of the crown or legislature (and thus, practically speaking, could be obtained only by wealthy and connected individuals) and, moreover, generally came with a right to a monopoly in some market or other, this was a plausible view.

Things changed, however, in the 19th century with the enactment, both in England and the United States, of general corporate enabling statutes, which allowed anyone to form a corporation enjoying no monopoly rights merely by filing appropriate forms and paying a nominal fee. Modern enabling statutes gave rise to the contract view of the corporation, under which the corporate form involves nothing more than could be achieved by appropriate contracts among individuals if transaction costs were low enough. The contract view is clearly correct as regards the internal affairs of the corporation, as is apparent from the operating agreements of limited liability companies, some of which reproduce governance structures substantially identical to those imposed by corporate enabling statutes. The contract view is also clearly correct as regards third parties who deal with the corporation voluntarily, for such parties can be understood as agreeing to contract with the owners of the business (i.e., the shareholders) on a non-recourse basis, the claims of such third parties being limited to a changing set of assets (the corporate assets) in which the owners retain a residual interest. Somewhat analogous provisions exist in certain secured credit facilities.

Such considerations would settle the matter definitively in favor of the contract view of the corporation but for the question of limited shareholder liability with respect to the corporation’s involuntary creditors, such as tort victims. Advocates of the privilege view argue that, even if contractual creditors would agree to make their claims non-recourse, they would do so only in exchange for an appropriate increase in the prices they charge the corporation; for involuntary creditors, there is no analogue. Hence, even if transaction costs were zero, potential involuntary creditors would have no reason to agree to limit the liability of shareholders.

The chapter argues that this argument fails for several reasons and that the contract view is ultimately correct. For one thing, the argument exaggerates the risk that creditors (both voluntary and involuntary) bear, for limits on shareholder liability matter only in the rare case when the corporation is bankrupt. Further, even in bankruptcy, tort victims will benefit from any insurance policies the corporation may have, thus further reducing the risks they face. In practical terms, people probably take a much larger risk of being harmed by uninsured and impecunious drivers than they do of being harmed by insolvent and uninsured corporations. More important, however, is the role of limited shareholder liability in the economy generally. Most large businesses are so capital intensive that they have to raise equity capital from many investors, most of whom would not invest if they had to assume unlimited liability for the debts of the company. Limited liability is thus the price society pays for the benefits that large business enterprises provide.

The question thus becomes whether a rational individual would prefer to enjoy the goods and services available as a customer, the salaries and fringe benefits available as an employee, and the investment opportunities available as a shareholder of large businesses, or else to forgo all those benefits and opportunities in exchange for the assurance that, if he becomes an involuntary creditor of a business firm, the assets of its investors would be available to satisfy his claim. Classical liberals think that rational individuals would choose the former, and so if transaction costs were zero, people would agree to limit the liability of shareholders, thus vindicating the contract view of the corporation. The fact that enabling statutes that produce the same result have for more than a century persisted without challenge in democratic societies confirms this view.

The chapter than moves on to consider what Professor Romano has called the genius of American corporate law: the creation of highly efficient corporate laws resulting from the American system of competitive federalism. The chapter next turns to the preeminence of Delaware and argues that the genius of Delaware corporate law is that it has solved the problem of how to do two seemingly incompatible things: on the one hand, to allow individuals forming business firms the widest possible freedom of contract to arrange their own affairs as they see fit, and, on the other hand, to reduce transaction costs for investors making or considering investments in many different entities by making mandatory certain rules important to such investors, such as strong fiduciary duties for directors and officers. Delaware resolves the paradox by having multiple enabling statutes: the Limited Liability Company Act, which allows the widest possible freedom of contract, and the General Corporation Law, which makes certain protections for investors mandatory.

The chapter then considers how, concurrent with the enactment of enabling statutes by legislatures, courts of equity imposed fiduciary duties on directors, analogizing them to trustees of cestui que trusts. In contemporary form, we thus get the Delaware business judgment rule, with its now explicit distinction between the standard of conduct and the standard of review. The chapter also considers what is perhaps the most significant innovation in corporate law since the enabling statute: the Delaware Supreme Court’s development of a special standard of review applicable to antitakeover devices under Unocal and sales of control under Revlon. In connection with discussing the environmental, social and governance (ESG) movement, the chapter then compares the shareholder model of corporate governance enshrined in Delaware law, which requires directors to manage the corporation for the benefit of the shareholders, and the stakeholder model, which allows directors to direct value to other corporate constituencies even when doing so reduces returns to shareholders in the long run.

The chapter then briefly considers the federal securities laws. It concludes that Delaware corporate law comports well with classical liberal principles, but that the federal securities laws provide some significant points of variance.

This post comes to us from Robert T. Miller, the F. Arnold Daum Chair in Corporate Finance and Law and a professor at the University of Iowa College of Law and a fellow at the Classical Liberal Institute at New York University Law School, where he co-directs the Program on Organizations, Business and Markets. The post is based on his chapter, “Classical Liberalism and Corporate Law,” forthcoming in the Routledge Handbook of Classical Liberalism (Richard A. Epstein, Mario Rizzo and Liya Palagashvili, eds.) and available here.