If there are two hegemonic ideas in academic corporate over the past half century, they are that corporate governance is defined by the “principal-agent” model and that the corporation is in essence a “nexus of contracts.” These ideas are the intellectual foundation of shareholder primacy that has ruled since the neoliberal turn in the 1980s. They are the product of corporate contractualism, and they have been cited over 12,000 times in the legal academy.
Corporate Contractualism and Jensen & Meckling
The ideas of “principal–agent” model and “agency cost” were introduced in 1976 by economists Michael Jensen and William Meckling in their canonical article, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. The principal–agent model states: (1) shareholders and corporate managers are related in “a pure agency relationship,” and (2) “agency cost” results when the agent manager’s conduct and “decisions which would maximize the welfare of the principal” shareholder diverge. These ideas are not self-theorizing. They needed an intellectual architecture.
Enter “nexus of contracts.” Why are contractarians so preoccupied with the airy idea that the corporation is nothing more than a nexus of contracts? Because nexus of contracts is the antecedent condition of a principal–agent relationship. The basic legal reality of a linear triad of managers ↔ corporation ↔ shareholders in which the corporation is an intermediating entity discredits the economists’ model as pure fiction. An agency-like relationship is plausible only if the corporation is effaced so that there is only a direct bilateral relationship (managers ↔ nexus of contracts ↔ shareholders), if not in a lawyer’s legal fact then in an acceptable academic abstraction.
Schism Between Economic Ideas and Legal Rules
Strangely, in its half-century hegemony, corporate contractualism has been ignored by corporate law. Judicial citations to “agency cost” and “nexus of contracts” are paltry, indicating that these ideas have no operative legal function. As a statement of law, the principal–agent model is indubitably, irredeemably false. This point is neither contested much nor contestable. But is the model true at some abstract level?
The model is not a legitimate “metaphor” which is the way corporate law scholars—wrongly—describe it (and judges too in the rare moments when they are forced to engage with the economic idea). An “as if” metaphor must have a common basis to equate two ideas that are factually distinct but abstractly same: e.g., “I am in the September of my life” is instantly understood even if equating “life” with “September” is literally false because the commonality between them is time. The “agency” metaphor assumes that mutual assent (the “implied contract”) is this commonality in the “as if” analogy. The economists focused on the trivial. Just as water is wet, mutual assent is the basis of all volitional relations in a liberal society. It adds no substantive content to the metaphor. Friends mutually assent to relate—yet it would be strange to define this relationship as principal–agent. The economists ignored the legal fact that control is the essential attribute of a legal agency, and as Berle and Means observed almost a century ago, the corporation works a separation of ownership and control. The economists’ metaphor inverts legal reality. It is unfounded and nonsensical.
The nexus of contracts too is false. The economists’ effacement flies in the face of corporate law and the definition of the corporation, which clearly define the very nature of the corporation as an existence and as a real juridical entity. Nor is the idea a legitimate abstraction because the corporation’s economic value is more than the aggregate of “contracts.” Much of the corporation’s economic production function derives from law-endowed rules: to wit, entityness, personhood, limited liability, fiduciary rules, asset partitioning, and perpetual existence. These law-endowed rules enable the conversion of property into capital, the precondition of a modern equity capital market, and they cannot be explained through a contractual prism. They are a legal–political endowment.
Contractualism’s Analogy and Shareholder Primacy
Contractarianism’s best argument is that the model is an analogical construction, a heuristic: It analogizes the shareholder–manager relationship to principal–agent on the ground that the analogy is analytically useful; specifically, the analogy promotes the right incentives in corporate governance. This argument, however, prompts the obvious question: The right incentive toward what purpose?
Jensen and Meckling had a disclosed agenda. They purported to answer socioeconomic implications of “the definition of the firm, the ‘separation of ownership and control,’ the ‘social responsibility’ of business, the definition of a ‘social objective function’.” To answer these broad economic, business, legal, and societal issues at the fore of professional, academic, and popular thinking in the 1970s (and still today), they applied a two-part syllogism that supported their analogical construction.
First, because the corporation is merely a nexus of contracts, the object function of the firm becomes a nullity: If there is no ontological firm to begin with, there can be no object function of the firm. The corporation doesn’t have any “social responsibility” or “social objective function,” and it would be seriously misleading to think otherwise. Second, once a nexus of contracts is substituted for an intermediating entity, one can naturally ask what the consequences of these contractual relations are. Since managers are in pure agency relationship, they have a duty to maximize the welfare of the principal. The second step of the syllogism is easy: Any deviation from this object function constitutes agency cost.
The logic train of Jensen and Meckling’s ideas leads to only one destination—shareholder primacy. Their two-part syllogism explicitly rejects on the one hand the idea of a firm’s object function, but forces on the other hand an agent’s object function of principal wealth maximization. Stripped down to its bare essence, corporate contractualism is not a positive discovery of some higher understanding of economic or legal reality as economists claim. It is a normative political economic project to argue a distinct form of corporate purpose, a point of debate that has waxed and waned for a century.
Contractualism as Ideological Project
Corporate contractualism is an ideology because it is a systematic scheme of ideas that must be adopted and maintained as a whole regardless of countervailing facts or events. In rejecting all notion of corporate social responsibility and ethics, the ideology installs an alternative moral structure of wealth maximization. For example, a fiduciary purchases a jet for personal use or undertakes additional public safety precautions in excess of regulatory minimum. In corporate law’s eyes, the manager violated fiduciary duty in the first act, but not the second act because it was clearly an ethical choice and well within managerial authority and business judgment. In the economists’ eyes, however, both are agency cost because both acts detract from shareholder profit.
Historical evidence indicates that Jensen and Meckling’s paper was born in the intellectual fervor of rising neoliberal ideology of the 1970s. Jensen was influenced by Milton Friedman’s clarion call in his 1970 New York Times op-ed advocating that a corporate manager’s sole duty is “to make as much money as possible” for shareholders. Jensen recollected that several years later he was asked to deliver in a conference a “controversial lecture that is somewhat along the lines of what Milton Friedman’s op-ed in the New York Times magazine was at about the same time the business of business is to make a profit” with the goal “to change the way [European economists], a lot of whom in those days were socialists if not outright communists, thought about economics.”
Influenced by Friedman’s manifesto, Jensen and Meckling’s canonical paper was born out of a fervor of grand political and economic debates on national and geopolitical economic systems. Its ideas supported a reorientation of the American economy toward deindustrialization and financialization, facilitated by leverage and executive pay (ideas that Jensen also advocated). This movement thereby shifted the governance paradigm from stakeholder capitalism and managerialism of the post-war consensus to today’s financial capitalism and shareholderism.
Concluding Thoughts
Why does the academic theory of the firm matter in corporate law and practice? Ideas and ideologies are powerful things. Contractualism has always existed in direct conflict with facts, rules of law, and reality. As abstractions, its ideas are thin. Yet, agency cost and nexus of contracts have been prodigiously cited in legal scholarship. The 12,000 citations evince orthodoxy’s habit of auto-habitual invocation and the legal academy’s purchase of ideology. Ideology, however, doesn’t play much of a role in instrumental law practice. Judges and lawyers are bound by facts, reality, and rules of law, explaining the virtual nonexistence of these concepts in law practice and judicial literature.
Corporate law is a trailing indicator of the political–economic–social moment. It serves a function, and function is a contingent imperative. Policy ideas, however, must be legitimated by an intellectual architecture. Corporate contractualism’s timing was propitious. Today, when the corporation is correctly seen as an institution born from law and public endowment and operating in the milieux of our economy, society, and polity, a consequential idea forms: Per policy imperatives of the moment, the corporation’s object function can accommodate more interests than solely shareholder wealth. Intellectual space opens up to consider the mechanisms and architecture needed to promote the right incentives for advancing “the best interest of the corporation” as an enterprise, legal person, and distinct entity. This thought is consistent with the Business Roundtable’s 2019 statement of corporate purpose. ]
Robert J. Rhee is John H. and Mary Lou Dasburg Professor of Law at the University of Florida Levin College of Law. This post is based on his forthcoming article, “Against Corporate Contractualism: A Reappraisal of Fundamental Neoliberal Ideology of ‘Agency Cost’ and ‘Nexus of Contracts’ in Corporate Law and Economics After Five Decades,” available here.