In a recent paper, I explore hidden fallacies in one of the most resilient and enduring of modern corporate law paradigms, namely agency theory (aka the “contractual” or “nexus of contracts” model).

My paper contends that the classical agency theory of the firm treats the corporation as a fictitious – and purely financial – vehicle, devoid of social connection or responsibilities. I argue that, by applying a single-minded focus on one particular agency problem, managerial opportunism, the theory creates a form of tunnel vision, potentially blinding us to several different problems. Those problems include the excessive economic power of some corporations and the harm caused by negative externalities, which have become increasingly important. Also, by elevating the role of private ordering between firm participants, agency theory discounts the importance of corporate regulation as an accountability mechanism.

The paper begins by tracking the emergence of agency theory and its ascent to dominance via Jensen and Meckling’s classic 1976 article, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” The agency paradigm resurrected theoretical debate, which had languished for decades, regarding the nature of the corporation. The theory, which represented a “radical rejection” of the earlier managerialist conception of the corporation, flipped the managerialist/anti-managerialist script about the relationship of corporations with society and how corporations should be regulated.

A central aspect of Jensen and Meckling’s agency theory of the firm was that most organizations, including corporations, are “simply legal fictions.” In reaching this conclusion, Jensen and Meckling adopted an aggregate theory of the corporation, deconstructing it into a “nexus of contracting relationships” (a phrase that later morphed into the more familiar term, “nexus of contracts”). Although the reference to legal fictions accorded with the historical notion that the corporation is a legal fiction (or a persona ficta), later interpretations of Jensen and Meckling’s agency paradigm went considerably further, interpreting the corporation as fictitious or non-existent. This later interpretation denigrated the corporation to the status of “a matter of convenience, rather than reality.”

My paper argues that this depiction of the corporation generated various assumptions that became bedrock principles of modern U.S. corporate law. I critically explore a number of these, including the following:

• that agency theory constituted a “revolution” in corporate law;
• that the corporation can be reduced to a network of private contractual exchanges between natural persons;
• that these exchanges are necessarily voluntary;
• that doctrines, such as agency and trusts, can be deconstructed into mere contracts;
• that the relationship between shareholders and corporate managers is one of “pure agency”;
• that corporations belong for all purposes in the private, rather than the public, realm;
• that private ordering is an effective legitimizing device;
• that the role of corporate regulation is restricted to creating malleable default rules;
• that the market is an effective managerial constraint; and
• that the agency theory of the firm is necessarily linked to a strong form of shareholder primacy.

I examine these assumptions in the context of contemporary developments in several key corporate governance areas, such as the relationship between managers and investors in start-ups, venture capital, and LLCs and private ordering; shareholder activism and ESG; executive compensation; and corporate criminal liability. I argue that, in this area, contemporary developments provide an uneasy fit with Jensen and Meckling’s paradigmatic agency relationship, which assumed that corporate managers must comply with shareholders’ wishes. Jensen and Meckling assumed that outside shareholders have only a relatively static, vertical agency relationship with corporate managers. However, as commentators such as Elizabeth Pollman have demonstrated, the governance structure of start-ups is typically at odds with this paradigm. It is dynamic, involving not only vertical tensions between shareholders and managers, but also horizontal conflicts among investors with divergent interests, and is often highly collaborative. Nor is this collaborative aspect restricted to start-ups. As Jill Fisch and Simone Sepe have shown, it is also increasingly evident in modern public companies with many institutional shareholders.

My paper also notes that the widely accepted assumption that private ordering is an efficient corporate-governance tailoring mechanism (and that the market provides incentives for corporations voluntarily to adopt pro-shareholder governance provisions) has been questioned in recent times. Even in the context of alternative entities, such as LLCs, commentators have suggested that private ordering operates not as a device for achieving economic efficiency, but rather as a tool for opportunism. Indeed, although many Delaware cases have in the past viewed LLCs are purely “creatures of contract,” this assumption was definitively rejected by Vice-Chancellor Laster in the recent Delaware Court of Chancery decision, New Enterprise Associates 14 v Rich.

The paper also challenges an assumption, closely related to the power of private ordering, that U.S. corporate law is highly protective of shareholder rights. The paper notes that, in fact, U.S. shareholders possess far fewer corporate governance rights than shareholders in other common law jurisdictions. And, whereas the United States was traditionally viewed as the dominant exporter of corporate law, the rise of powerful, global institutional investors has reversed this trend and rendered the United States a corporate law importer.

In his 1937 article, ”The Nature of the Firm,” Ronald Coase accepted that one of the key questions about economic assumptions is, “[d]o they correspond with the real world?”. My paper suggests that various assumptions underpinning the agency theory of the firm are now outdated and sit uncomfortably with contemporary, on-the-ground corporate law and governance developments. This dissonance between the dominant theory of modern corporate law and the real world suggests that the time may have come to re-evaluate the assumptions that support the use of agency theory as the only comprehensive analytical tool for understanding the corporation and to introduce a broader conception of the public corporation and its relationship with society in the modern world.

This post comes to us from Professor Jennifer G. Hill, director of the Centre for Commercial Law and Regulatory Studies (CLARS) at Monash University Faculty of Law. It is based on her paper, “Hidden Fallacies in the Agency Theory of the Corporation,” published in the book, Hidden Fallacies in Corporate Law and Financial Regulation: Reframing the Mainstream Narratives (Hart Publishing: Saule T. Omarova, Alexandra Andhov, and Claire A. Hill, editors), and available here.