The Selfish Corporation and its Effect on Ownership and Control

Susan Watson

The corporation is conceived of as a nexus of contracts by many. Some argue that the

shareholders collectively or the board of directors collectively are in a black box at the centre

of the nexus. Others would argue that there is no black box, just a nexus of contracts. Others

view the corporation as hierarchical with authority originating in the shareholders. This paper

draws on and synthesises existing theories of the corporation. It is argued that the

corporation is surrounded by a nexus of contracts but internally it has a centre that is

controlled by the board of directors. The role of the board is to make decisions that are in the

best long term interests of the corporation. The corporation is conceived of as partitioned

from and separate from its shareholders who nevertheless have a special relationship with the

corporation because they hold shares in it. Those shares give the shareholders the right,

through the meeting, to make certain collective “rules of the game” decisions about the

internal rules of the corporation and also to vote in the election of the directors who will sit

on the board. However the shareholders should not “play the game”; it is the board that

makes decisions and those decisions are legitimate to the extent that they sustain and

maximise the corporation in the long term even if those decisions may favour other corporate

contractors such as employees in the short term. It is argued, as a consequence of this

conceptualisation of the corporation, that the role of corporate law is not to solve an agency

problem that shareholders may have brought about by the separation of ownership and

control. Rather it is to enforce the fundamental terms of the explicit and implicit contracts

that exist between those who contract with the corporation and the corporation, and to ensure

that everything possible is done to permit the board of directors to act in the long term

interests of the corporation. This is done by binding directors to the corporation with

fiduciary obligations and by minimising internal and external constraints on board decision

making. In the regulation of corporations it must be recognised that corporations will be self-

maximisers and that it is corporate externalities that should be subject to regulation.

Nevertheless the concession of incorporation by the State permits a standard of good

citizenship from the corporation

I Introduction

As with all milestones, the new millennium was treated as an opportunity to assess and

evaluate where we are now, as well as a chance to predict and recommend where we might

go. In a polarising paper The End of Corporate Law History,1 leading scholars Hansmann

and Kraakman echoed Francis Fukyama’s polemic on the optimal form of Government2 by

suggesting that corporate law had found its ideal in the Anglo-American corporation with

widely dispersed shareholding and with shareholder primacy. They argued that corporate

utopia would arrive when all corporations were widely held and all nations moved their

corporations law to focus on the agency problem brought about by separation of ownership

and control; in any event inevitably corporate ownership would converge on that structure.

A decade and a half after the beginning of the new millennium, major events have led to a re-

evaluation calling into question whether we are in fact converging on an ideal. The first wave

of corporate failures took place shortly after the beginning of the new millennium where

corporations such as Enron and HIH failed spectacularly, with consequences extending

beyond shareholders to employees, other investors and their communities. It is generally

believed that the failure of Enron can primarily be attributed to poor corporate governance

even though, ironically, it was previously touted as a model of good governance. The

second, more widespread, wave of corporate failures led to the global financial crisis of 2008,

which the world economy is still recovering from. There, poor corporate governance is

generally recognised to have been a contributing factor.

Following the two waves of failures, groups of heretics who had suggested that the prevailing

favoured understanding of how we conceive of, operate and legislate corporations may not be

correct, entirely or at all. Competing conceptions of the corporations took on life. Why the

form of these conceptions matter is not of mere intellectual interest- what we believe the

corporation to be will affect how we behave in and around it. It will also affect how

Governments regulate corporations and how boards make decisions.

What is interesting about the competing theories of the corporation is not that there is more

than one; far too little is settled in corporate law for Hansmann and Kraakman’s polarising

assertion to ever have been wholly correct. What is interesting is that the theorists differ so

fundamentally in how they view the corporation. In this paper I argue that the source of the

fundamental differences is the perspective the corporation is viewed from. A hierarchical –

based model, such as shareholder primacy, views the corporation from the inside. A nexus-

of-contracts model views the corporation from the outside. These differing perspectives exist

even though many of the proponents of these theories would argue that a corporation does not

have an inside or correspondingly, an outside. The focus of the paper is an argument that an

acceptance that there is an internal and an external aspect to the corporation and that there are

boundaries between the inside and the outside is key to understanding the corporation and it

is this that distinguishes it from other types of firm. It is argued that the board of directors

acts as a boundary between the internal and external dimensions of the company. It will also

1 Hansmann

2 Fukyama

be argued that in discussing the form of the corporation the temporal aspect is too often

ignored. Key components of the corporation like the board of directors and the general

meeting only exist some of the time. In addition, many individuals may operate in different

capacities in and around the corporation at different times or even at the same time. Also it

will be argued that the same individual can at different times may be internal or external to

the corporation even when acting in the same capacity.

The first section of the paper sets out the prevailing theories of the corporation.

II Theories of the Corporation and flaws with each

Theories of the corporation are manifold, all sharing common elements but differing in

crucial ways. As an illustration, a corporation can be considered either as an artificial person,

(a construct or reification of the people connected with the firm and those who deal with

them), or as a real person (an entity that has an existence like a spiritual being). A

corporation can be viewed as either an atomised aggregate of the individuals who transact in

or around it primarily by means of contract, or as an entity. A corporation can be viewed

owing its existence to a concession or grant by the State and therefore having a public

element, or owing its existence to the economic energy of individuals and therefore not a

suitable subject for regulation because it is private.3

By adopting a broad brush approach to the traditional theories, is possible to group them into

three broad categories all of which have historical origins and all of which have modern

favoured variants. For the purposes of this article, the theories will be labelled (1) legal

fiction theory, which views the corporation as artificial, an entity and public; (2) aggregate

theory, which views the corporation as artificial, aggregate and private; and (3) natural entity

theory, which views the corporation as real, an entity and private.4 Modern variants will be

labelled nexus of contracts theory and shareholder primacy theory.

A: Legal Fiction Theory

This theory posits that the company is a legal fiction and exists because the State or Crown,

either directly, or through an incorporation statute, allows it to exist. Although recognised as

a separate legal entity, the corporation is a shell that exists only in the legal dimension due to

a concession by the State. The theory, which has its origins in Roman law and persisted

through the Middle Ages in Canonist law,5 was set out by the German Savigny in his treatise

3 William W. Bratton, ‘The New Economic Theory of the Firm: Critical Perspectives from History’ 41 Stan. L.

Rev. 1471, 1475 (1988-1989).. 4 M. J. Phillips, ‘Reappraising the Real Entity Theory of the Corporation’ 21 Fla. St. U.L. 1061 (1994) ; R

Harris, ‘The Transplantation of the Legal Discourse on Corporate Personality Theories: From German

Codification to British Political Pluralism and American Big Business’ 63 Wash & Lee L. Rev 1421 (2006). 5 As mentioned above, Pope Innocent IV in 1246 regarded a body corporate as a persona ficta. See A. B.

DuBois, The English Business Company After the Bubble Act 1720-1800 (The Commonwealth Fund, 1938) 1

“… its development influenced by judicial application of Roman-Canonist theories regarding its fictional

nature…”and List and Petiit, n 10, 160.

on Roman law in the mid-Nineteenth Century in work which influenced common law

scholars of the period.6

Corporations did not originate with business corporations in the Sixteenth Century (as

discussed in the real entity section below), but the genesis of the elements that comprise the

modern business corporation was during that period of frenetic activity that preceded the

Bubble Act of 1720. The concept of joint stock as a mode of organising business with freely

transferrable shares had been imported from Europe 150 years earlier.7 Corporate charters

were granted by the Crown or by a special Act of Parliament in England, and were granted by

a special statute (often called a charter) in post-revolutionary America. To obtain a charter,

incorporators usually had to demonstrate that at least ostensibly the corporation would have a

public purpose where a state franchise was required. 8 The Bubble Act of 1720, which limited

the granting of corporate charters, had a chilling effect on incorporation for wider business

purposes. Many corporations were formed to fund infrastructure projects and were granted

charters only for a limited period.9 An analysis of 290 corporations incorporated by charter or

special statute in the UK in the period 1720 to 1844 (when the first general incorporation

statute was passed into law) shows only five were established for manufacturing purposes,

with railways becoming increasingly common in the latter part of the period but with the vast

majority of incorporations being for water, gas, harbours, bridges and canals.10

Interestingly,

in the US, even when the Bubble Act no longer applied, only 335 charters were granted in the

post-colonial period, with a “mere handful” established for manufacturing purposes.11

Adam

Smith’s belief that incorporation should only be for infrastructure projects seemed to be

borne out by the charters granted in both jurisdictions during the period.12

Thus corporate organisations existed and were legitimised by an official grant of authority

from the State or Crown that created them.13

In the influential Case of Sutton’s Hospital in

1613, Lord Coke described a corporation as being “invisible, immortal and rest[ing] only in

intendment and consideration of the law.”14

In the Dartmouth College case in 1819 Chief

Justice Marshall declared that a “corporation is an artificial being, invisible, intangible, and

existing only in contemplation of law.”15

Thus, corporations were regarded as legal fictions.

They were treated a separate persons in law from the incorporators or shareholders. The

6 F. C. von Savigny, System Des Heutigen Romischen Rechts, Vol. II (1840).

7 DuBois, n 19.

8 Bratton, n 18, 1484.

9 Bratton, n 18, 1131.

10 These figures are derived from an analysis carried out by the author of information extracted from a

database. Robin Pearson, Mark Freeman and James Taylor) Constructing the Company: Governance and

Procedures in British and Irish Joint-Stock Companies 1720-1844 - (Ms Excess and Access versions, 49, 152

cells of data) deposited with the AHDS, January 2007, plus Summary of variable codes booklet (27 page

introduction to the database). AHDS study no. 5622 at http://www.data-archive.ac.uk/search/searchStart.asp

last visited on 28 March 2014. 11

Lawrence M.Friedman, A History of American Law (3rd

ed, 2005) 130-132 cited in Marks, n 13, 1131. 12

Adam Smith The Wealth of Nations 116-17 (P.F. Collier & Son 1909) (1776). 13

M. H. Hager, ‘Bodies Politic: The Progressive History of Organisational “Real Entity” Theory’ 50 U. Pitt.

L.Rev. 575, .579-580 (1989). 14

Case of Sutton’s Hospital (1613) 77 Eng. Rep. 937, 973. (K.B.) 15

Trustees of Dartmouth College v Woodward 17 U.S. (4 Wheat.) 518, 636.(1819)

attributes of legal personalities such as the ability to own land and perpetual succession were

granted to them by the State.

B: Aggregate Theory

Aggregate theory holds that a corporation is an aggregate of its shareholders and nothing

more. The relationships between corporate participants are primarily contractual. The genesis

of aggregate theory is often primarily attributed to Victor Morawetz’ treatise The Law of

Private Corporations.16

But aggregate theory is much older than Morawetz – and it is

reasonable to assume that Morawetz writing as a young 23 year old solicitor returning from

Europe was influenced by others, even if he did not acknowledge these influences.17

Describing Morawetz’ early struggles to establish himself as a legal practitioner in a history

of the Cravath firm, Swaine says:18

“For the lack of anything else to do he occupied himself in writing a book on the law relating

to corporations, persuading his father to finance him in the year and a half it took him to

complete it. Morawetz’ The Law of Private Corporations, published in 1882 when Morawetz

was but 23 years old was immediately and generally recognised as the first important book in

that field. As the field was new and authorities scarce, he was able to express dogmatically

his own theories on controversial points and he deliberately omitted such authorities as were

against him.” 19

In fact, rather than relying on legal sources, Morawetz and other US corporate treatise authors

of the period such as Charles Fisk Beach and Henry O. Taylor,20

drew on classical economic

notions that conceived of the economy as a system of transactions between individuals.21

These ideas were derived in part from British lawyers of the previous century who asserted

that “only natural persons occupied the legal world and they advanced contractual

conceptions of the firm.”22

Thus, as well as the legal fiction and artificial entity theories,

contractualism was also part of the British contribution to US corporate law.23

16

Victor Morawetz, A Treatise on the Law of Private Corporations ( Boston: Little Brown and Company,

1882) 1-2. 17

In a review of the second edition of Morawetz’ treatise (Victor Morawetz, A Treatise on the Law of Private

Corporations ( Little Brown and Company, Boston, 1886) ) by James. Barr. Ames, the first editor of the

Harvard Law Review. Ames says that Morawetz’ conception of the corporation, different from the commonly

accepted conception, has led him astray occasionally but is speculative rather than of practical importance. That

conception was of course enormously influential at the time and has remained so especially since, as Ames also

acknowledges in the review, Morawetz treatise was regarded as the best work on corporations of its day. The

discussion can be found in Robert T. Swaine, The Cravath Firm and Its Predecessors 1819-1947 (The Law

Book Exchange Ltd) 383. 18

Robert T. Swaine, The Cravath Firm and Its Predecessors 1819-1947 (The Law Book Exchange Ltd) 382-

383. 19

Ibid. 20

Bratton, n 18, 1489. 21

Bratton, n 18, 1484. 22

Bratton, n 18, 1484. See the discussion in A. Jacobson, ‘The Private Use of Public Authority: Sovereignty and

Associations in the Common Law’ Buffalo L Rev 599. (1980) 23

Bratton, n 18, 1484.

The associative concept of the company itself had a lengthy genesis in English law,

descending from the gilds of the Middle Ages. Business units used for craft and trade arose

spontaneously and the advent of joint stock in the sixteenth and seventeenth century did not

diminish their importance.24

Once incorporation by grant became common and the

recognition of the corporation as a separate legal entity widespread, the unincorporated

company might have died away but for the intervention of the Bubble Act in 1720 and the

subsequent stalling of incorporation by charter or special statute.25

Such was the appetite for

the use of the corporate form for trading enterprises that the emerging doctrines of contract

law, agency law and trust law were used by Eighteenth Century lawyers to create a form of

company.26

A deed of settlement was signed by those participating. Because the association

was a partnership at law, this meant that every conveyance would need to be signed by every

member and also that the association would be dissolved on the death of any member.27

To

circumvent these partnership rules that created difficulties for large associations, the

organisation’s real and personal property was placed in a trust. The associations had trustees

and also had a board or committee of management: sometimes but not always these were the

same individuals.28

The intention of the parties to the deeds of settlement was to make

themselves as much like a corporation as was possible through the law of contract.29

Because

of the equitable nature of the ownership structures, unincorporated company law was

developed by the Chancery courts.30

The crucial difference between the companies created by

a deed of settlement and the corporations created by statute was that the former were not

recognised as separate legal persons at law from those who created and owned them.

Unincorporated joint stock companies were unquestionably aggregates of the incorporators.

By the beginning of the Nineteenth Century, there were three forms commonly in use in the

UK; corporations, which were usually involved in infrastructure projects such as canals,

bridges and harbours incorporated by statute or charter; small business partnerships; and large

unincorporated companies created by deeds of settlement. Both the latter forms were

partnerships at common law, although the “shareholders” in unincorporated companies acted

more like shareholders in incorporated corporations. The Chancery Courts recognised the

separation between the shareholder in an incorporated company and the trustee to the extent

of upholding limited liability, but the common law courts continued to treat these entities as

partnerships. 31

In post-revolutionary US, the Bubble Act did not necessitate the use of the unincorporated

form, so incorporation by registration followed seamlessly from incorporation by charter. It is

24

C. A. Cooke Corporation, Trust and Company: An Essay in Legal History (Harvard University Press, 1951)

56; DuBois, n 19, 214; See also Bratton, n18, 1484. 25

Bratton, n 18, 215. 26

Bratton, n 18, 216. 27

Sections 22 and 23 of the Bubble Act 1720 exempted trading partnerships from the Act: Cooke, n 39, 85. 28

DuBois, n 19, 217-219. 29

Cooke, n 39, 86. 30

Cooke, ibid, 85. 31

Cooke, ibid, 95-96. .

almost certainly for that reason that in the US the incorporated form is called a corporation

whereas in the UK it is called a company.32

C: Real entity theory

As discussed above, corporations created by grant (either a charter or a special statute) were

used for business purposes from about the sixteenth century onwards. But these were just one

species of corporations. Other forms, such as municipal and ecclesiastical corporations,

which shared some but not all the characteristics of the early business corporations, preceded

and existed parallel to the nascent business corporations. For example, by the end of the

Thirteenth Century many of the towns that grew up in the Twelfth and Thirteenth Centuries

enjoyed a general corporate organisation of citizenship by franchises conferred by charter.

These towns had many of the characteristics we associate with companies including the right

of perpetual succession, the power to sue and be sued, a common seal and a power of

subordinate legislation.33

Boards or their equivalent pre-dated corporations created by grant:34

These forms of corporations had internal governance mechanisms such as councils and

methods of selecting who would govern the corporation. Some of those characteristics have

morphed and descended into use in the modern company. Because early (business) corporate

law did not focus on the internal governance operation of corporations, many of these rules

relate to that aspect of the company.35

Real entity theory found its way into modern UK and US corporate law in the late Nineteenth

Century at a time when adherents to German “new school” economic ideas were challenging

neoclassical economics.36

The chief proponent of real entity theory was the German academic

Otto von Gierke who, reacting to legal fiction theorists such as Savigny, posited that the real

and social existence of a group makes it a legal person. As such, the corporation was not

created by the law, but was pre-legal or extra-legal.37

Even though the law did not create the

corporation, von Gierke argued that it was bound to recognise its existence.38

The corporation was not regarded as a legal fiction but a real thing in real entity theory; in the

words of Machen a “corporation is an entity – not imaginary or fictitious, but real, not

32

Cooke, ibid, 94 33

Cooke, ibid, 21. 34

F. A. Gevurtz, ‘The Historic and Political Origins of the Corporate Board of Directors’ Hofstra Law Review,

33 (1), 89 (2005). 35

One example might be shareholder voting, which has much in common with the voting systems in municipal

corporations. Some of the early companies’ acts such as the Companies (Clauses Consolidation) Act 1845 drew

heavily in the Municipal Corporations Act 1835. For our purposes here the significance is that some of the other

forms of corporation were arguably not created by the Crown or the State but rather were existing entities given

recognition by the Crown or State.

36 H. Hovenkamp, Enterprise and American Law 1836-1937 (Cambridge Massachussetts:Harvard University

Press, 1991) 298. 37

O. Gierke, “Political Theories of the Middle Age (Frederic William Maitland trans., 1927) (1990) 611;

Harris, n 19, 1424; M. Petrin, ‘Reconceptualising the Theory of the Firm- From Nature to Function’ Penn State

Law Review 1, 6.(2013). 38

See Phillips, n 19; Harris, n 19, 1421 ; Petrin, , n 52, 6-8.

artificial but natural.”39

Some real entity theorists even considered the corporation to be an

organism.40

Others saw it as a system comprised of human and non-human elements; a

network or a machine.41

The corporation, under “real entity” theory, has its own life in the sense that it has a

sociological or psychological existence.42

The problem that the entity, although “real” could

not act by itself was, in a variant of real entity theory, called “organic theory”, solved by

regarding the entity as having “organs” who in the case of the board and the shareholders

collectively could bind the entity not as agents but as part of the entity itself. Corporations, so

conceived, could incur tortious and criminal liability through these “official” organs.43

Frederic William Maitland introduced von Gierke to the English speaking world; his

description of the “German Fellowship” clearly reveals the origin of Twentieth Century

identification theory (discussed in the section below) in English law:44

”[The company] is no fiction, no symbol, no piece of the State’s machinery, no collective

name for individuals, but a living organism and a real person, with body and members and a

will of its own. Itself can will, itself can act; it wills and acts by the men who are its organs as

a man wills and acts by brain, mouth and hand. It is not a fictitious person; … it is a group-

person, and its will is a group-will.”

D: Theories of the corporation\company incorporated by registration

The three “classical” theories of the corporation were all developed to explain different types

of corporate forms that existed prior to the modern company that is incorporated by

registration. At the risk of being accused of being simplistic, the legal fiction theory

explained joint stock corporations created by charter; the real entity theory explained

corporations that were already in existence such as municipalities that were not created by the

State or Crown; and aggregate theory explained corporations that were created by contract in

the UK in the period after the Bubble Act of 1720. The debate in the late Nineteenth Century

sprang from attempts made by adherents of each theory to explain the new form, the

company incorporated by registration. That debate died away in the Twentieth Century as

interest in legal theory yielded to a focus on company doctrine, but the underlying normative

assumptions about the corporation, based on the pre-existing theories, remain.

39

A..W. Machen, ‘Corporate Personality (pts. 1 and 2)’ 24 Harv. L. Rev. 253 , 262 .M Phillips,’Reappraising

the Real Entity Theory of the Corporation’ 21 Fla. St. U.L. Rev. 1061, 1068 (1994). 40

See Phillips, n 19, fn 49 citing G F Deiser, ‘The Juristic Person (Part 2)’ 57 U. Pa. L. Rev. 300, 310 (1908-

1909); (corporate body is a “composite organism”) and G. Mark ‘The Personification of the Business

Corporation in American Law’ 54 U. Chi. L. Rev. 1441, 1469 (1987) (discussing the organism of, among

others, Gierke and Maitland); Wolff, at 498-501 (discussing several continental thinkers who espoused the

“organism doctrine”) 41

M. Phillips, n 19, 1069-1070. 42

Mark, n 55, 1473; Petrin, n 52, 6. 43

Petrin,, n 52, discussing Gierke and the German theorists 44

O. Gierke, “Political Theories of the Middle Age (Frederic William Maitland trans., 1927) (1990), at xxvi

(translator’s introduction.). Freund’s “The Legal Nature of Corporations” was also influential in the U.S. See

Harris, n19, 1431-1435.

The aggregate view of the company in the UK survived the passing of the acts legitimising

incorporation by registration in the mid-Nineteenth Century. Lord Lindley’s highly

influential treatise on company law started life as an 1863 supplement to his treatise on

partnership law45

and Lord Lindley continued to see company law as a branch of partnership

law subject to its principles.46

Only gradually as the Nineteenth Century progressed were the

most important consequences of incorporation by registration of a company recognised, most

famously in Salomon v Salomon & Sons Ltd in 1897.47

In Salomon the corporation law’

aspect of company law prevailed over its partnership law’ aspect- the company was viewed

as an entity. It is significant that Lord Lindley was a member of the Court of Appeal that was

over turned by the House of Lords. 48

Salomon is primarily remembered as the case that confirmed that a company incorporated by

registration is a separate legal entity from its incorporators. And, as we have seen, it is

separate legal entity that differentiates legal fiction and real entity theory from aggregate

theory. But whilst appearing to lay aggregate theory to rest, Salomon may at the same time

have allowed for an apparent partial acceptance of real entity theory in UK corporate law.

Lord Halsbury refers to the company many times in his speech as “real.” For example,

referring to the judgments in the lower courts, including Lord Lindley’s, Lord Halsbury said:

“My Lords, the truth is that the learned judges have never allowed in their own minds the

proposition that the company has a real existence.”49

Lord Halsbury was also careful to state

that the company is an artificial creation of the State50

but did not limit its existence to a mere

fiction once it is created. “Once a company is legally incorporated it must be treated like any

other independent person with its rights and liabilities appropriate to itself.” The company, as

conceptualised by Lord Halsbury, appears to be artificially created by the legislature (unlike

real entity theory that views the corporation as the creation of its incorporators), but

nevertheless a real thing, not an artificial thing, once conceived.51

Did companies incorporated by registration come to be regarded as more than mere legal

shells given a form of legal life by the State, as legal entity theory would have it, and closer

to real entities? The gradual demise of the ultra vires doctrine suggests that they did. The

ultra vires doctrine was underpinned by an implicit belief that a corporation lacked any

45

N. Lindley, Supplement to a Treatise on the Law of Partnership Including its Application to Joint-Stock and

Other Companies, (5th

ed, London:Sweet & Maxwell, 1863), 205.

46

N. Lindley, A Treatise on the Law of Partnership: Including its Application to Joint-Stock and other

Companies, (5th

ed, London: Sweet & Maxwell, 1860) and Cooke, n 39.

48

Salomon v Salomon & Sons Ltd [1897] AC 22. The House of Lords specifically discussed the judgment of

Lindley LJ, ignoring the other judgments, before it overturned the Court of Appeal. 49

Salomon, ibid, 33-34. Other examples, at 33, include: “My Lords, the learned judges appear to me not My

Lords, the learned judges appear to me not to have been absolutely certain in their own minds whether to treat

the company as a real thing or not. If it was a real thing; if it had a legal existence, and if consequently the law

attributed to it certain rights and liabilities in its constitution as a company, it appears to me to follow as a

consequence that it is impossible to deny the validity of the transactions into which it has entered.” And . “If

there was no fraud and no agency, and if the company was a real one and not a fiction or a myth, every one of

the grounds upon which it is sought to support the judgment is disposed of. “

50

Salomon, ibid, 29 “in truth that artificial creation of the Legislature” at 29; “essential to the artificial creation”

at 30. 51

Cooke, ‘A Real Thing’ in R. Cooke, Turning Points of the Common Law (London, Sweet and Maxwell,

1997).

powers beyond those conferred by the statute. Its decline in both the US and the UK through

the late Nineteenth and early Twentieth Centuries was underpinned by a belief, supported by

both aggregate theory and natural entity theory, that the corporation is primarily a result of

private ordering by individuals rather than a creation of the State.52

Similarly, the rejection of

the old rule prohibiting shareholder ratification or validation of ultra vires actions shows a

conception of the corporation whose powers extend beyond those granted by the legislature.53

Real entity theory gathered traction in the UK in the early years of the Twentieth Century. In

an article reproduced in the Law Quarterly Review in 1911 from a Festschrift for Professor

von Gierke, Frederick Pollock argued not just that the legal fiction theory had been officially

discarded by the English courts, but in fact had never been adopted.54

Others were less convinced. Salmond, writing in 1906 was scathing, talking about German

jurists such as von Gierke, Dernberg and Mestre attempting to establish a new theory that

treats corporate personality as a reality and not a fiction55

being given “sympathetic

exposition, if not express support from Prof. Maitland.”56

Real entity theory posits that the

organisation of human beings is a real person, a living organism “possessed of a real will of

its own, and capable of actions and responsibility for them, just as a man is.”57

Salmond

argues that the will of the company is in fact the wills of a majority of its directors or

shareholders and that when men associate together they do not become one person “any more

than two horses become one animal when they pull the same cart.”58

In the US, the late Nineteenth Century saw the rapid rise of the management corporation.

These were large multi-tiered entities that performed multiple tasks of production and

marketing containing hierarchies of salaried executives.59

Investors no longer involved

themselves in management, leading to the separation of ownership and control later identified

by Berle and Means.60

The management corporation displaced the market economy causing

power to move from individuals involved in bilateral contracting to groups such as investors,

suppliers and consumers.61

These management corporations were capable of monopolistic

control of industries in a manner that had not been foreseen by Adam Smith. By 1890, three-

quarters of the wealth of the United States was controlled by corporations.62

Legal entity

theory died away in this period as incorporation was increasingly not viewed as a privilege

52

See Millon, n 15, 212. See also M. J. Horwitz,‘ Santa Clara Revisited: The Development of Corporate

Theory’ 88 W. Va. L. Rev. 173, 185-186. (1985-86). 53

In the U.S. Lincoln Court Realty Co v Kentucky Title Savings Bank & Trust Company 169 Ky. 840 (1916);

Martin v Niagra Falls Paper Manufacturing Company 122 N.Y. 165 and see Millon, n15, 212.In the 1930s in

the US the doctrine of ultra vires was relatively unimportant. (Horowitz, ibid, 186,) In the U.K. the doctrine

now applies in a limited form to the internal acts of companies. See the discussion in P.L. Davies, Gower and

Davies Principles of Modern Company Law (8th

ed, London: Sweet & Maxwell) 152-155. 54

F. Pollock, ‘Has the Common Law Received the Fiction Theory of Corporations?’[1911] 27 L.Q.R. 219, 235. 55

J.W. Salmond, Jurisprudence: or the Theory of the Law (Steven and Haynes, 1907) 350. 56

Salmond, ibid,, fn 1. 57

Salmond , ibid. 58

Salmond, ibid. 59

Bratton, n 18, 1487. 60

A. Berle and G. Means The Modern Corporation and Private Property (Transaction Publishing:1932). 61

Bratton, n 18, 1488. 62

Horwitz, n 92, 180.

but as a right, and as a normal way of doing business.63

The corporate legal theory debate was

polarised between aggregate theorists on one side and real entity theorists on the other,64

with

the focus shifting to the internal components of the managerial corporation. As Bratton

describes it:65

“The hostile, individualist side advanced a contractual theory of the corporation. This theory

incorporated the classical ideals of a disaggregated producer universe and control through

market pricing. It carried on the individualism of the earlier “legal fiction” and “artificial

entity” conceptions, even as it rejected concession theory, replacing the sovereign with freely

contracting individuals. This theory took an aggregate rather than an entity approach –

separate relationships comprised the corporation’s ontological center rather than the force of

the collective effort.”

In contrast to the approach of the House of Lords in Salomon, the US courts, in the 1880s,

treated the corporation as no different to a partnership, lifting the corporate veil relatively

readily, with an Ohio Supreme Court Judge even stating that the idea that a corporation is a

legal entity separate from its shareholders was a mere fiction.66

This disaggregation of the

corporation, which began overtly with Morawetz, continued with others such as Pomeroy

arguing that general incorporation laws meant persons complying with a few formal

requisites could organise themselves into companies that were essentially no different to

partnerships.67

Some opposed to corporate consolidation even argued for a return to

partnership with other aggregate theorists, seeing the increasing shift in power to corporate

management, advocating for a return to shareholder democracy.68

Perhaps these concerns about the loss of the shareholder franchise were well founded. But

aggregate theory, based on classical economics, lost currency after the turn of the century as

the classical model was regarded as not adequately explaining the new managerial, capital

intensive corporations and the oligopolistic economy.69

It was increasingly difficult to view

shareholders as active owners in a form of partnership, as the shareholders moved

increasingly to being passive investors70

with the development of the market for stock, which

really only emerged in the 1890s. Power instead shifted to directors and managers71

although,

interestingly, ultimate power over corporate management had almost always been granted to

63

Horwitz, n 92, 181. 64

Real entity theory was introduced into the U.S. by Ernst Freund in 1884 ( Ernst Freund, The Legal Nature of

Corporations (1884)) 65

Bratton, n 18, 1489. 66

Horwitz, n92, 186. 67

Horwitz, n 92, 204. 68

Horwitz, n 92, 205-206. 69

Bratton, n 18, 1490. 70

Horwitz, n 92, 223. 71

Horwitz, n 92, 183.

elected boards in US incorporation statutes.72

What changed was the recognition and reality

of that authority.73

Manson v Curtis, a decision of the Court of Appeals of New York from 1918, contains an

important and much cited discussion of the role of a board that derives its powers

from a statute:74

“In corporate bodies, the powers of the board of directors are, in a very

important sense, original and undelegated. The stockholders do not confer,

nor can they revoke those powers. They are derivative only in the sense of

being received from the state in the act of incorporation. The directors

convened as a board are the primary possessors of all the powers which the

charter confers, and like private principals they may delegate to agents of

their own appointment the performance of any acts which they themselves

can perform. The recognition of this principle is absolutely necessary in the

affairs of every corporation whose powers are vested in a board of directors.

Hoyt v Thompson’s Executor, 19 N Y 207, 216.”75

The treatment of the board as a body can be seen as having been derived in part from real

entity theory and the conception of the company internally as being comprised of a board that

is the locus of the corporate mind and will. In 1886, the United States Supreme Court held in

Santa Clara Country v Southern Pacific Rail Road,76

without discussion, that a corporation

was a person under the fourteenth amendment and therefore entitled to protection. Horwitz

has convincingly argued that Santa Clara was not an adoption of real entity theory but

instead used an aggregate vision of the corporation to focus on the property rights of

shareholders.77

But nevertheless real entity theorists seized upon Santa Clara as recognition

of the personification of the corporation.

Real entity theory may have burned bright but it did not burn long in the US.78

Like the UK,

by the 1920s discussions of theories of the corporation had yielded to doctrinal discussions of

72

Gevurtz, n 49. 73

The debate mirrored a debate in economics between the neoclassicists and the German School, which

advocated a case based historical approach to economic analysis. For discussion, see H. Hovenkamp, n 51, 298-

305. 74

Manson v Curtis, 223 N.Y. 313,322 (1918). 75

The position remains less straightforward in the United Kingdom. The Companies

Act 2006 (UK) does not confer the powers to supervise the management of the

company on the board of directors. Those incorporating the company must agree

on articles of association to be adopted by the company.9 If articles are not

registered, model articles are imposed on the company.10 The model but

non-mandatory articles for public and private companies provide that: “Subject to the articles, the directors are

responsible for the management of the company’s business, for which purpose they may exercise all the powers

of the company.”Thus it might appear that the source of the powers of boards in the UK companies is the

shareholders through the articles of association. But the difference is more easily explained as a legislative

anomaly initiated in the 1856 and 1862 incorporation statutes caused by the importation of internal

management rules into the nonmandatory Tables in the schedule of the Acts instead of the statue itself rather

than a deep seated difference. S. M. Watson, ‘The Significance of the Source of the Powers of Boards of

Directors in UK Company Law’ (2011) Journal of Business Law, (6), 597. 76

Santa Clara Country v Southern Pacific Rail Road 118 U.S. 394 (1886) 77

M. J. Horwitz,‘ Santa Clara Revisited: The Development of Corporate Theory’ 88 W. Va. L. Rev. 173

(1985-86). 78

M Phillips, n 19, 1068.

corporate law principles.79

Writing in 1951 about the development of the modern company,

Cooke was able to assert that the US moved rapidly toward corporations on one hand and

partnerships on the other.80

What he could not have foreseen was the revival of aggregate

theory, derived originally from the anomaly that was the unincorporated joint stock company

in the Bubble Act period in the UK, and introduced into the US by Morawetz and others, in

the conception of the corporation that sits behind prevailing law-and-economics theories such

as nexus- of- contracts theory,81

and shareholder primacy theory.82

As Millon puts it, “the

private aggregation idea assumed the garb of neoclassical economics under the corporation as

a “nexus-of-contracts” rubric. Advocates of this theory have used the freedom-of-contract

metaphor to support their shareholder primacy, anti-regulatory policy objectives.”83

In the

UK Salomon, with its explicit rejection of the aggregate conception of the company favoured

by a Court of Appeal that included Lord Lindley, could have meant the demise of aggregate

theory in the UK. But the underlying individualistic and contractual conception of enterprise

survived.

The revival of aggregate theory in the US was brought about by the neoclassical economic

movement. Seminal economic tracts like Coase’s The Theory of the Firm ignored legal

literature on the structure of the firm.84

Classical political theory conceived of the firm as a

profit-maximising unit that the “invisible hand” of the market would ensure led to a grand,

profit maximising scheme for the benefit of society. Work by Berle and Means about the

problems for the firm inherent in the separation of ownership and control were ignored.85

Jensen and Meckling, drawing on the theories of agency, finance and property rights, set out

agency theory in their seminal 1976 article.86

In agency theory, shareholders are viewed as

the principal and management are viewed as the agents. The separation of ownership (in

shareholders) and control (in management) means that in effect management is entrusted with

safeguarding the money of shareholders. Because Adam Smith’s aphorism that management

cannot be expected to watch over shareholders’ money “with the same anxious vigilance”87

was accepted, Jensen and Meckling argued that corporate governance mechanisms that

monitor those in control and protect the interests of shareholders as principals needed to be

put in place. Other concerns, sometimes described as agency costs, were the imbalance of

information between management as controllers and the shareholders as owners.88

Discussion

79

Ibid, 1070. See also John Dewey, ‘The Historic Background of Corporate Legal Personality’ 35 Yale L.J. 655

(1926). 80

Cooke, n 39, 94. 81

The nexus-of-contracts theory holds that companies are nothing more than a network of contracts between

different parties – shareholders, directors, employees, suppliers, and customers. 82

Shareholder primacy theory, the prevailing theory in corporate law, holds that management are the agents of

shareholders who as the owners of the company are at the top of hierarchy of the parties that interact with the

corporation. 83

Millon,, n 15, 203. 84

Hovenkamp, n 51, 359. 85

Hovenkamp, n 51, 359. 86

M. C. Jensen and W.H. Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership

Structure’ (1976) Journal of Financial Economics 305. 87

A Smith, A (1838) The Wealth of Nations, Ward Lock London. 88

Agency theory does not differentiate between directors and executive management.

of agency usually centres on shareholders and management. The role of corporate law and

governance is seen to be solving these agency problems.

The corporation in most law-and-economics writing is a black box represented by a

production function.89

The role of the directors elected by the shareholders is considered to be

to mitigate the agency problem by taking care of the interests of the shareholders or, in

depersonalised law and economics parlance, as a monitor for equity investors. Many law- and

-economics scholars consider the corporation to be nothing more than a nexus of contracts, an

application of aggregate theory with economic analysis and vocabulary novel, but the

underlying foundation in aggregate theory.90

These scholars take an atomistic approach to the

internal components of the corporation. For example, Oliver Williamson, the Nobel Prize

winning economist, argues in an article on boards of directors that the relation between each

constituency and the firm should be evaluated in contractual terms and that corporate

governance structures such as boards arise as a response to “the needs of an exchange relation

for contractual integrity.”91

The influential book The Anatomy of Corporate Law contains the most fully developed

discussion of aggregate theory as applied to modern corporate law. Its authors assert that if

the rules of corporate law did not exist, the relationships they establish could be created using

contracting.92

Corporate law, they argue, is organized to reduce agency problems brought

about by: conflicts between managers and shareholders, conflicts between shareholders, and

conflicts between shareholders and the company’s other constituencies. The authors argue

that the relationships between participants in a corporation are contractual questioning why

we need corporate law and concluding that default corporate law provisions perform a “gap

filling” function brought about by incomplete contracting for long term relationships. Despite

the focus on contracting, interestingly the authors observe that of the five defining

characteristics of the corporation, separate legal entity clearly requires special rules of law,93

conceding that the characteristics of separate legal entity could not be achieved by

contracting between the business’s owners, suppliers and customers.94

89

Romano, Foundations, 1. 90

Millon,, n 15, 229. 91

O. Williamson, ‘Boards of Directors’ 93 Yale Law Journal 1197 (1984). 92

R. Kraakman,, J. Armour,, P. Davies, L. Enriques, H. Hamsmann, G. Hertig, K. Hopt, H. Kanda, E. Rock The

Anatomy of Corporate Law: A Comparative and Functional Approach (2nd

ed, Oxford University Press, 2nd

ed,

2009) 20. The authors argue that corporation law has a gap filling function because of the incomplete

contracting between corporate participants brought about by the long term relationships between the

participants, at 23,. The authors also assert that unincorporated companies created by deeds of settlement before

incorporation by registration became freely available obtained their legal personality from partnership law and

created the rest of their corporate structure- including limited liability- using contracting. 93

Ibid, 6-9; and 37-38. 94

The authors identify three characteristics; entity shielding, (which involves, first, a priority rule shared with

partnerships that gives secured creditors a claim on the assets of the firm ahead of the claims of personal

creditors of the “owners” and, secondly, liquidation protection, which protects the assets of the firm from its

“owners” and their creditors); authority, which the authors categorise as delegated management with the board

of directors given power to bind the company so that parties dealing with the company know who has authority

to transfer its assets, and, thirdly, procedures for law suits, which need to be specified by the State.( It could be

said therefore that the authors contradict their own argument by acknowledging that most important

characteristic of corporations, separate legal entity, cannot be created by contracting. )

The authors argue that limited liability of shareholders is possible without a special rule of law. It would be

possible for a corporation to contract for limited liability for its shareholders with each of its creditors just as,

conversely, many creditors of limited liability companies insist on guarantees from creditors. Involuntary

Despite this conceded flaw in the idea that companies are no more than a network of

contracts, variants of aggregate theory currently dominate corporate law. Although the

modern neoclassical version originated in the US, its conception of management as agents of

shareholders resonates with many corporate law scholars outside the US. Notwithstanding

the apparently clear rejection of aggregate theory in Salomon, contractualist conceptions of

the company, which developed untrammelled by charters or legitimising statutes in the

Bubble Act period between 1720 and 1825, never died away in the UK. This resonance may

be because both contractualism and the modern neoclassical theories of the firm share

common origins in the classical economic tradition: Jensen and Meckling’s

acknowledgement of Adam Smith is overt.95

Both theories are based on contractual

relationships and both regard directors as agents of shareholders. The agency

conceptualisation of directors is strengthened in the UK by the source of the powers of the

board being shareholders through the constitution of the company rather than the

incorporation statute.

Other modern theories are descended from real entity theory and are influenced by the

managerialist variant’s focus on the role of the board of directors. Stakeholder theorists

regard the consideration of wider interests than shareholders and the profit maximisation

imperative to be legitimate. Blair and Stout conceive of the board as a mediating hierarchy

charged with balancing and considering the interests of competing stakeholders.96

A variant

of real entity theory (although its proponent denies it) is director primacy theory. It does not

address the nature of the corporation but is useful in its discussion of the reality of the control

mechanism in the corporation. Professor Bainbridge shares with aggregate theory proponents

a belief that a company is a nexus of contracts but there the commonality ends because

Bainbridge argues that the board of directors sits as a unit at the centre of the nexus.97

Unlike

most aggregate theorists who favour shareholder primacy, and see separation of ownership

creditors such as tort victims are unable to do this meaning; the authors also argue elsewhere that the case for

unlimited liability for corporate torts is weak.(Nassmann kraakmann unlimitedl iability)

Some evidence exists that shareholders of unincorporated deed of settlement companies had a form of limited

liability, either contracted for or because of the difficulties of enforceability for creditors. There is also some

evidence that, in the rare instances where corporations have had unlimited liability, it has made no difference to

their share price (although in all cases the non-effect can be explained for other reasons.) (See the discussion in

R Romano, Foundations of Corporate Law (Foundation Press, 2010) 107 -113) With respect, that is weak

support for an argument that limited liability is possible without a statutory sanction. The form of limited

liability provided for companies before the Limited Liability Act 1855 (UK) was weak; it is for that reason that

owners of businesses fought hard for statutory limited liability; if contracting had been enough, they would not

have bothered. The State-sanctioned right of shareholders as investors to externalize risk should carry with it a

concomitant obligation on the company, through its board as the body empowered to control the company, to

consider the interests of creditors, especially when a company approaches insolvency. If directors are only

agents of shareholders, the incentive exists for them to trade when insolvent using in effect creditors funds. It is

for that reason that insolvent trading provisions exist in most jurisdictions.

95

This is even though Adam Smith did not foresee the rise of the modern managerialist corporation and indeed

considered that incorporation should be restricted to infrastructure projects.The introduction to Jensen and

Meckling’s 1976 article contains a quote from The Wealth of Nations. 96

M. Blair and L. Stout, ‘ A Team Production Theory of Corporate Law’ 85 Virginia Law Review 247 (1999). 97

S. Bainbridge, Corporate Governance After the Financial Crisis (Oxford University Press, 2012)

and control as an agency problem, Bainbridge argues that it is desirable that power and

control rest as it does with the board. Thus at least in terms of an understanding of the

internal structure of a company, director primacy is closer to real entity theory than aggregate

theory. Although law-and- economics scholar Bainbridge eschews the metaphysics of organic

theory, he clearly views the board normatively and ideally as the locus of control in the

company, and as a body.98

Thus in the unresolved battle of the theories underpinning modern corporate law doctrine, the

notion of the corporation as private gradually but completely triumphed over the notion of the

corporation as public. Legal entity theory lost out in that respect. The powers of the board

being viewed as original and undelegated was the contribution of real entity theory but,

although the source of those powers was statutory (as legal entity theory would hold), the

private law conception of the company won out with the powers being regarded as ultimately

derived from the shareholders. Nevertheless shareholders as natural persons were

downgraded in importance to being regarded as investors and the company as contractual and

as an aggregation of capital rather than individuals.

III Gaps in Existing Theories

A company is a separate entity in law from its shareholders and its directors. Salomon99

established this principle. It is a fundamental principle of corporate law. Aggregate theory,

with its reliance on contracting, does not take sufficient account of the fact that a company

can only be an entity separate in law from its shareholders through the process of

incorporation. Despite the fact that aggregate theory helps us to understand that the

relationships around a company are contractual (essentially a nexus of contracts), its failure in

its purest form to recognise the implications of the fact that the corporation itself is an entity

separate from its shareholders with an internal dimension means that the theory can, in that

fundamental respect, be seen to be flawed or incomplete. Aggregate theory fails to identify or

recognise that the black box that is the company has an internal component and that not all

relationships in the company, for example the relationships between directors on the board,

are contractual.

Real entity theory recognises the internal dimension of the corporation but by analogising the

corporation with a real person unduly anthropomorphises the corporation. As we have seen, a

corporation does not have a mind and subsequently a conscience that in any way resembles

the mind or conscience of a human being. If a corporate person had a fully-fledged mind in

the way that a human being has a mind, you would expect that mind to be the locus of a

conscience and for the corporation to behave like any other person. But no individual, and no

individual conscience, is located solely within an organisation and human beings behave

differently within organisations than they do outside them.100

98

S. Bainbridge, The New Corporate Governance in Theory and Practice (Oxford University Press, 2008) 99

Salomon cite 100

Corporate conscience paper

Legal entity theory identifies that a corporation is a legal fiction and recognises that it is

separate at law from those who own and control it. But it conceives of the company as an

empty shell, again not recognising that a company has an internal as well as an external

dimension and that individuals move and act within and externally to the company.

All theories, which were originally developed to explain earlier forms of the corporation, are

therefore incomplete. Modern models can also be critiqued. Hierarchical perspectives of the

corporation such as shareholder primacy\agency theory models show authority descending

from the shareholders with management the agents of shareholders. Proponents view the

corporation from an internal perspective with management only being accountable to the

shareholders and with separation of ownership and control being seen as the primary problem

of corporate law (the agency problem). Shareholder primacy theories do not take sufficient

account of the fact that a consequence of the “concession” of incorporation by registration

with separate legal entity and limited liability is that corporations have other constituencies.

The long term interests of the corporation as a whole may diverge from the interests of the

holders of shares at any time. Boards frequently and always have made decisions that favour

other constituents such as employees with such decisions being rationalised by shareholder

primacy proponents by the fig leaf that those decisions are in the long term interests of

shareholders. Directors who make such decisions are protected by the business judgment rule

or its equivalent in most jurisdictions.101

But such decisions may not be in the long term

interests of the current shareholders; with algorythmic trading shareholders may only hold

shares for split seconds and the concept of an amorphous group of future shareholders who

may hold the shares of the company at some undetermined future time is imprecise. Current

shareholders, future shareholders and the corporation itself are not the same.

Shareholder primacy proponents like Lucian Bebchuk analogise the corporation with a

democracy with shareholders as electors and favour increasing the powers of shareholders.

The analogy of the corporation with a form of democracy is a comparison which has been

made since the inception of the modern company.102

The Joint Stock Companies Act, passed

in 1856 in the UK, was probably the first modern companies act permitting incorporation by

registration. Its chief architect vice-president of the Board of Trade Robert Lowe was

described recently as the “father of modern company law.”103

Lowe envisaged companies

incorporated by registration operating as “little republics” and this is reflected in the form of

the early legislation. The non-mandatory rules governing the internal operation of the

company, which still exist in a similar form in the Companies Act 2006 (UK), were set out in

a schedule accompanying the legislation (Table B, in later Acts Table A). The internal rules

drew heavily on the Companies (Clauses Consolidation) Act 1845 which in turn drew heavily

in the Municipal Corporations Act 1835, the Act governing UK municipalities. Comparing

101

Blair and Stout 102

Robert Lowe, the architect of the first modern UK companies act that permitted incorporation by registration described companies as “little republics.” I have argued elsewhere that Lowe and other may have insufficiently recognised the difference between limited liability companies created by registration and earlier deed of settlement companies, created by contract. 103

6 J. Micklewait and A. Woolridge, The Company: A Short History of a Revolutionary Idea (New York: Modern Library, 2003), p.51.

shareholders to electors in a municipality does therefore have some historical justification.

Certainly boards do act like Governments in many ways. The source of the powers of boards

in most jurisdictions is not through the electors but instead through statutory provisions.104

Shareholders do elect boards but the crucial difference between shareholders and voters in a

municipality is that these rights to vote are attached to the shares rather than the shareholders.

Some shareholders may acquire a block of shares, which gives them the right to exercise

many votes. Attempts to empower shareholders using the democracy analogy may be

misplaced. In democracies it has always been accepted that decisions are made by the

Government not the people and many scholars argue that management empowerment works

best in companies also.105

Philosopher Edmund Burke's in his Speech to the Electors at

Bristol at the Conclusion of the Poll in the Eighteenth Century distinguished representative

government from the idea that elected officials should merely be delegates:106

“... it ought to be the happiness and glory of a representative to live in the strictest union, the

closest correspondence, and the most unreserved communication with his constituents. Their

wishes ought to have great weight with him; their opinion, high respect; their business,

unremitted attention. It is his duty to sacrifice his repose, his pleasures, his satisfactions, to

theirs; and above all, ever, and in all cases, to prefer their interest to his own. But his

unbiased opinion, his mature judgment, his enlightened conscience, he ought not to sacrifice

to you, to any man, or to any set of men living. These he does not derive from your pleasure;

no, nor from the law and the constitution. They are a trust from Providence, for the abuse of

which he is deeply answerable. Your representative owes you, not his industry only, but his

judgment; and he betrays, instead of serving you, if he sacrifices it to your opinion.”

Nexus of contract models look at the company from an external perspective. They therefore

take account of the fact that many different constituents contract around a company. But

many forms of nexus of contract theory do not allow for the internal dimension of the

corporation.107

Some nexus of contracts models put shareholders at the centre but this ignores

the fact that it is not the shareholders who deal with other corporate constituents for the

company. Other models put the board at the centre of the nexus. Team production theory

characterises the board as a mediating hierarchy between all of the corporate constituencies.

But team production theorists may not sufficiently acknowledge the extent to which the

taxonomy of the corporation compels boards to consider the interests of shareholders,

perhaps, it is suggested, not because shareholders “own” the corporation but because

shareholders vote to decide who will be directors and because shareholders set the internal

rules of the company, a point discussed in more detail below. Stephen Bainbridge is critical

of team production theory arguing that it risks making the board accountable to no one

constituency. Bainbridge argues that the means of corporate governance is through the board

104

S Watson, “The Significance of the Source of the Power of Boards in UK Company Law” 105

For example Bainbridge, W.W. Bratton and M. L. Wachter, “The case Against Shareholder Empowerment,” 158 U. Pa. L.Rev. 653. (2010) 106

The Works of the Right Honourable Edmund Burke. Volume I (London: Henry G. Bohn, 1854), pp.

446–8. (Burke) 107

Eisenberg

but the end is to maximise shareholder value. But once board-centric governance is accepted

as a means of corporate governance it does not necessarily follow that maximising

shareholder value at least in the short term has to be the end. Director primacy theory may not

sufficiently take account of the extent to which boards do in fact legitimately take into

account the interests of other corporate constituencies in the long term interests of the

corporation , as discussed above.

Agency theory, where it is said that the primary concern of corporate law is to reduce the

agency problem inherent in the separation of ownership (in shareholders) from control (in

management.), currently dominates corporate law. The identification of the agency problem

is attributed to Jensen and Meckling, although the identification of the difficulties inherent in

owners not running their own businesses was first set out by Adam Smith in The Wealth of

Nations, a fact overtly acknowledged by Jensen and Meckling in the introduction to their

seminal paper. 108

The Smith quotation used by Jensen and Meckling says:

The directors of such [joint-stock] companies, however, being the

managers rather of other people’s money than of their own, it cannot well

be expected, that they should watch over it with the same anxious vigilance

with which the partners in a private copartnery frequently watch over their

own. Like the stewards of a rich man, they are apt to consider attention to

small matters as not for their master’s honour, and very easily give

themselves a dispensation from having it. Negligence and profusion,

therefore, must always prevail, more or less, in the management of the

affairs of such a company.

The quote seems to demonstrate a sort of prescience by Adam Smith, where he identified the

problems inherent in the separation of ownership and control that characterises the modern

widely held corporation. In the chapter which the quotation is taken from, Smith argued that

without an “exclusive privilege”, essentially a monopoly, joint stock companies had

invariably failed, discussing chartered corporations such as the Royal Africa Company and

the East India Company. Smith concluded that the only trades suitable for joint stock

companies to carry on successfully without an exclusive privilege were ones where

operations could be reduced to a uniformity of method.109

He identified these as banking,

insurance, canals and supply of water.

Certainly Smith was prescient to a certain extent. An analysis of empirical data collected

about companies formed between 1720 and 1820110

shows that almost all corporations

created by charter fell into one of the four categories outlined by Smith. But Smith was not

prescient about the limitations of the joint stock company; he did not predict that it would

become the dominant form of organisation. In his own time Smith did not predict the rise of

the unincorporated corporations created by deeds of settlement and governed by contract and 108

M.Jensen and Meckling 109

Smith, 447. 110

Pearson

trust law. And Smith did not (and could not have) predicted the enactment of legislation

permitting incorporation by registration and the extent to which modern companies created

by registration are a hybrid form derived in part from the unincorporated corporation. In

short, the joint stock companies created by charters that Smith was writing about were

fundamentally different to modern corporations created by registration.

One key difference is the absence of limited liability for stockholders. Once limited liability

existed, shareholders could become rationally apathetic knowing that their risk was confined

to money invested in the corporation. Also, once those who contract with the company

could not recover in full from shareholders, the characterisation of directors as agents of

shareholders who can only act on their behalf becomes less defensible. The law developed

fiduciary obligations of loyalty and care that bound directors to the corporation, even though

the radical way in which this moved the obligations of directors from being owed to current

shareholders as agents, to the corporation as a separate legal entity was hidden in terminology

that described these obligations as being owed to the shareholders as a whole in the long

term. Nevertheless, binding directors to the corporation and mandating loyalty to the

company protected current shareholders as well as other corporate contractors. It could even

be said that the development of fiduciary obligations, drawn from the equitable law of trusts,

solved the agency problem and that solution led to the success of the corporation as a form to

an extent Smith did not predict.

The significance of the limitations of Smith’s analysis for our purposes is that Jensen and

Meckling in turn paid insufficient attention to the primary role of the board of a corporation

in weighing up competing considerations when making decisions about the long term

interests of the corporation. In fact Jensen and Meckling barely discuss the board at all in

their article,111

instead conflating managers and directors. It is an accurate description of

corporations that existed before limited liability and incorporation by registration, where

there was no divergence of interests between shareholders and the company, but not of the

modern corporation.

In their paper Jensen and Meckling highlight the separation of ownership from control that is

a characteristic of the modern corporation with dispersed shareholding as a particular

problem because of the difficulties that exist for rationally apathetic shareholders with small

parcels of shares in exercising control over management. The separation could be

recharacterisied as a desirable ownership structure that insulates boards from shareholder

interference and which makes it more probable that the shareholders will act within the terms

of their corporate contract. Recent scholarship, both theoretical and empirical studies, has

identified the particular advantages of an insulated board for the long term success of the

corporation. This scholarship has attracted its trenchant critics, chief among them Lucian

Bebchuk who in a recent paper “The Myth that Insulating Boards Serves Long-Term

Value”112

argues that board insulation produces significant long term costs. In a paper

countering Bebchuk’s paper, Chancellor Strine argues that in an era where there is

111

Ref Ref 112

L.Bebchuk, “The Myth that Insulating Boards Serves Long-Term Value” 113 Columbia Law Review 1637( 2013).

separation of “ownership from ownership” that comes with institutional investment and

hedge funds, strategies to increase stockholder power may not be beneficial to “ordinary

investors.” Chancellor Strine also questions the value of the empirical studies Bebchuk uses

to support his arguments :“I must admit to having a healthy sketicism whenever the “law

AMPERSAND” movement cranks up its machinery and tries to prove empirically a

contestable proposition about a complicated question involving the governance of a human

community of any kind.” 113

It could certainly be argued that initiatives such as Say on Pay and others increasing

shareholder empowerment are tinkering with a system that has worked well before agency

theory encouraged policy makers to believe that aligning the interests of executive directors

with current shareholders through short term incentives would benefit the company.

In summary, therefore, none of the existing theories appear to provide a complete explanation

of the corporation.

IV Are We Asking the Wrong Question?

The legal philosopher HLA Hart said that to ask what is a corporation (or a State, or a right or

law) is to ask the wrong question. Words such as corporation, right or duty “do not have the

straightforward connexion with counterparts in the world of fact which most ordinary words

have and to which we appeal in our definition of ordinary words.”114

Hart considered that the

meaning of such words is contextual and that we should instead ask questions such as “

Under what types of conditions does the law ascribe liabilities to corporations,”115

arguing

that “this is likely to clarify the actual working of a legal system and bring out the precise

issues at stake when judges, who are supposed not to legislate, make some new extension to

corporate bodies of rules worked out for individuals.” 116

As well as being contextual, the answer will also depend on time and perspective. The

composition of the components of a corporation are not frozen; bodies such as the board of

directors and the general meeting are key components of the corporation but individuals who

are shareholders, directors and employees change all of the time with many individuals

having different roles at different times. Also even though the two key components of the

board and the general meeting must operate at certain times for key decisions to be made and

are the only mechanism by which those decisions can be made, they do not operate all of the

time. So part of the answer to any question about the nature of a corporation must depend on

the composition of the corporation at the time the question is asked.

Perspectives also differ. An employee will view the corporation she works for in a different

way to the person who holds shares in the corporation. Individuals will even view the

corporation differently when they perform the different parts of their role. For example, a

CEO taking part in board meetings will look at the corporation from a different perspective

113

Strine, “Can We do Better .. p 16. 114

Hart, 5. 115

Hart, 24. 116

Ibid.

than when he is involved in the day-to-day operations of the company. An employee who

also holds shares will have two different perspectives of the corporation and will behave

differently in the different roles.

In “The Conception that the Corporation is a Nexus of Contracts and the Dual Nature of the

Firm”117

, Mel Eisenberg analyses the internal and external perspectives of the corporation

and discusses H L A Hart’s distinction between external and internal points of view of legal

rules arguing that the nexus-of-contracts conception only “ captures the external view of rules

and directions, not the internal view. It fails to capture the way in which rules and directions

function in the lives of those who are members of hierarchical organizations, such as

corporations.”118

Hart uses the analogy of traffic lights to compare the differences between

the internal and external perspectives.119

“His view will be like the view of one who, having observed the working of a

traffic signal in a busy street for some time, limits himself to saying that when the

light turns red there is a high probability that the traffic will stop. He treats the

light merely as a natural sign that people will behave in certain ways, as clouds

are a sign that rain will come. In so doing he will miss out a whole dimension

of the social life of those whom he is watching, since for them the red light is not

merely a sign that others will stop: they look upon it as a signal for them to stop,

and so a reason for stopping in conformity to rules which make stopping

when the light is red a standard of behaviour and an obligation.

So part of the answer to questions about the nature of a corporation must depend on the

perspective from which the question is being asked. The perspective of an individual can

relate to their position in the company or their relationship to the company. Perspective also

temporal as the position in or relationship to the company of individual will change at

different times. The company itself will also change at different times depending, for

example, on who exactly the individuals are in the various roles at that particular time, what

part of their role they are performing and whether key components like a shareholders’

meeting is being held at that time.

The next section of this paper sketches out a synthesised model of the corporation that may

take account of the objections to the models described above. The final section briefly

outlines some of the implications of the synthesised model.

V Synthesised Theory of the Corporation

In one dimension (viewed externally) a corporation can be viewed as a series of concentric

circles that sit on top of each other over a centre. That centre has been described as a “fund”

117

Eisenberg, 118

Eisenberg, 829. 119

H.L.A. HART, THE CONCEPT OF LAW 89 (2d ed. 1994). 90 in Eisenberg 828-829.

by Hansmann and Kraakman.120

But the concept of an internal component in a corporation is

much richer than a quantifiable sum of money extending to assets owned by the company and

also intangibles such as intellectual property, goodwill, corporate culture and reputation.

That centre is controlled by a body called the board of directors. Directors at the times when

they act as part of the board (usually at board meetings) occupy that “inner circle” that

controls the centre. Externally the company is a nexus of contracts (in the sense of a nexus of

reciprocal arrangements).121

Outside the inner circle are individuals who have contractual

relationships with the company. This includes creditors and, crucially, shareholders in the

part of their role where they are investors.

Individual shareholders as holders of shares are not internal to the company. Shares are

contractually based and are issued with certain rights attached. These rights usually (but need

not) include a right to a share in the residual claim, a right to a share of dividends, and the

right to vote on certain decisions including the appointment of directors to the board and the

internal rules of the company. These are obligations that the company owes to whoever the

holder of the shares at any time might be rather than directly to the shareholders as

individuals. Many of these rights are, in a substantive sense, similar to rights that other

contractors have. For example, shareholders are residual claimants who share proportionately

in the liquidated assets of a company when it is wound up. But if a company is insolvent

when it is wound up, creditors share proportionately in the residual assets. The rights that set

shareholders apart from other groups of “stakeholders” that contract with the company is not

that they are residual claimants to the assets of the company or that they have the right to a

share in any dividend declared by the board from the profits of the corporation. What is

special about shares and therefore shareholders is that shares usually carry with them the right

to receive notice of, attend and vote at shareholder meetings. When shareholders exercise

these rights collectively they can make decisions about some of the internal rules of the

company (its constitution, bylaws or equivalent) and also, collectively, make decisions about

the individuals who will occupy the positions as directors. What sets shareholders apart from

other corporate contractors is these rights. When shareholders exercise these collective rights

they could be viewed occupying a circle that surrounds the board.

In another dimension (viewed internally) the corporation is a hierarchy. The CEO sits at the

top of the internal hierarchy. When the board meets it sits behind the CEO in the hierarchy

since it is the board that appoints the CEO. The board as a component (even if it is not

meeting) acts as a barrier between the shareholders (either as a component acting collectively

or as individual external contractors) and between other external contractors and those

internal to the company, (the CEO, managers and employees of the company.) Individuals

who are employees of the company can only be viewed as internal to the company and it is

their behaviour that forms part of the corporate culture and ethos of the company that is part

of its centre.

120

The partitioned nature of the fund was recognized and discussed by H. Hansmann and R. Kraakman in ‘The

Essential Role of Corporate Law’ The Yale Law Journal, Vol. 110, No. 3 (.2000), pp. 387-440 but without

perhaps consequently recognizing that the shares were separate from the holders of the shares; the shareholders. 121

Eisenberg 823.

Contractors may have more than one component to their roles in or around the company at

different times. Employees are internal to the company. But employees can also on occasions

act on behalf of the company in its dealings with external contractors such as consumers; at

those times employees are corporate agents.

Directors, at the times when they act collectively as part of the board are acting as the

company. Executive directors are also senior managers within the company and therefore part

of the corporate hierarchy and employees of the company. Executive directors who deal with

external contractors such as creditors are agents of the company at those times.

Nonexecutive directors and independent directors are unlikely to have a relationship with the

company beyond acting collectively and internally as the company as part of the board.

VI Consequences of a Synthesised Theory of the Corporation

How does this conception of the corporation help in an understanding of the corporation.

There are a number of consequences. First the primary objective of the board and of the

individual directors when they occupy their positions as directors on the board is to preserve,

sustain and maximise the corporation in the long term. The maxim that the primary obligation

of directors is to ensure the long term interests of the shareholders as a whole is damaging

because the use of the term “shareholders” implies that directors have an obligation to

shareholders either current or future, either individually or as a group. They do not. They

have an obligation to ensure the long term interests of the corporation, which is a separate

entity from the shareholders. The holders of shares in the corporation at any time will

ultimately benefit or be harmed by any decisions made by the board. But that is a

consequence of the fact that those shareholders hold those shares. Other corporate contractors

such as employees or creditors will also be affected by the decision making of the board.

What sets shareholders apart is not that they will receive a portion of any dividend declared

by the board or that they can sell their shares in the company or that they will be residual

claimants if the corporation is eventually wound up in a solvent state. What sets shareholders

apart is that they have the right to determine the composition of the board. The significance

of the shareholder right to vote on appointments is that directors will consider themselves

accountable to the interests of shareholders in the sense that shareholders can also remove

directors from office by means of using the votes attached to their shares.

Chancellor Strine says:122

“[I]n the American corporate law system, there is no reason to

expect that the interests of the stockholders and top managers will not predominate over those

of labor and the community. After all, in the intra-corporate republic, only capital has the

right to vote!” What the statement really means is not so much that the interests of

shareholders will prevail but rather that boards may do what they think the current

shareholders want, especially those who hold large blocks of shares.

The reason that the board will do what they consider current shareholders want is because the

members of the board seek to retain their positions on the board not because, in a normative

122

L.E Strine, “The Social Responsibility of Boards and Directors and Stockholders in Charge of Control Transactions: Is There Any “There” There?” 75 S. Cal. L.Rev. 1169, 1187 (2002)

sense, the interests of shareholders should prevail. In other words, a consequence of the fact

that corporations almost always issue shares to stockholders with voting rights attached is

boards taking into account what current shareholders want. Shareholders with large blocks of

shares or activist shareholders may attempt to influence the board, successfully or

unsuccessfully, to consider their interests ahead of the long term interests of the corporation.

These wishes are likely to be perceived by the board to be the profitability and therefore

dividend yield from the corporation and also the perceived value of the shares. But these

concerns are consequences of the fact that the directors on the board will be aware that the

shareholders could remove them from office.

The board is charged with making decisions that will enhance the long term interests of the

corporation. Often those decisions may favour one corporate constituency, for example,

employees, over another, like, for example, the current shareholders. The decision can be

defended if the board can show that the primary motivation behind the decision was

preserving, sustaining or growing the corporation. The development of the Business

Judgment rule in most jurisdictions is implicit, if not explicit, acknowledgment by the courts

of this point.123

Secondly, boundaries are important. The idea that the relationships between the corporation

and those who interact in and around it at different times is based on contract, in the sense of

reciprocal agreements, has important consequences beyond understanding the nature of a

corporation. Reciprocal agreements carry with them agreed obligations and also limit the

scope of the relationship. For example, a shareholder agrees to hold a share in a company.

That share has certain rights attached to it. Some of these rights are passive rights in that the

shareholder needs to do nothing to exercise these rights. Other rights are active rights in that

they permit the holder of the share to act, usually by exercising a vote at a meeting of the

company. These will involve decisions such as the approval of the internal rules of the

company or the appointment of the individuals who will comprise the board. In theory at least

these active rights are exercised by shareholders acting as part of the shareholders

collectively as part of the meeting. When exercising those rights the shareholders are acting

collectively and have a special relationship with the company.

In terms of the reciprocal agreement (contact) relating to the holding of the shares,

shareholders are entitled to exercise those votes in any manner they think fit. But the contract

extends only that far. Shareholders who use the fact that they hold a large or controlling block

of shares to control or influence decision making by the board may risk acting beyond the

terms of the reciprocal agreement that exists because they hold shares in the corporation.

Shareholders should not step inside the inner circle that is the place of the directors when they

act as part of the board.

It could equally be argued that senior executives who are also directors risk stepping over the

internal boundary that separates the board from the internal dimension of the company. This

may be evidenced by decisions by boards that unduly favour senior executives such as

123

Blair and Stout

excessive remuneration. Corporate law focusses less on conflicts of interest that are caused

by competing roles in or around the corporation, especially when there is not a clear conflict

of financial interests. Independent directors who are independent of influences in their

decision making from within or outside the corporation, as well as financially independent

may provide a solution.

VII Summary

If existing theories of the corporation capture the corporation at a certain time and from a

certain perspective, it can be argued that they are all correct and that they are all wrong. HLA

Hart argues that the answer to the question about what a corporation is, is contextual.

Eisenberg argued that the answer will depend on perspective and I have argued that the

answer will also have a temporal aspect.

Stephan Bainbridge separates corporate governance into means and ends. If the means of

corporate governance is the board of directors, a consequence of accepting the central role of

the board of directors in the corporation is recognising that what matters in corporate

governance is how a board makes decisions. This will be determined by internal matters such

as the composition of the board (for example: the balance of independent and executive

directors), and how the members of the board interact with each other (board dynamics). But

it will also be determined by external factors that influence the board or its members.

Emerging evidence shows that insulated boards that are protected from excessive external

influences such as pressure from shareholders to focus on short term profitability may operate

most effectively in the long term interests of the corporation. In making decisions, instead of

focussing how boards might or should consider different stakeholders, the focus could be on

how different groups (“contractors”) influence board decision makers and board decision

making. Boards will have as a primary focus the interests of shareholders but this is not

because shareholders are residual claimants or because management are the agents of

shareholders, it is because shareholders can remove directors from office. It is for that reason

that shareholders have a unique relationship with the company. If the corporation is listed the

board will be influenced by share price but again this will be a consequence of an awareness

that a low share price may lead to shareholder dissatisfaction or a hostile takeover with the

removal from office of the incumbent directors. The influence of other stakeholders

(contractors) will vary for each corporation. In terms of regulation, as well as the board of

directors being bound to the company by obligations of loyalty and care, directors are

protected when acting as the company by the business judgment rule or its equivalent in most

jurisdictions. It could also be argued that corporate law acts to prevent “contractors” acting

beyond the terms of their explicit or implicit contracts with the company. Veil lifting and

shadow director provisions are examples.

Stephen Bainbridge argues that the end of corporate governance is maximising shareholder

value. It has been argued in this paper that what sets shareholders apart from other corporate

constituencies is their ability to appoint directors to the board and to determine the internal

rules of the company. The right to dividends and the rights as residual claimants are in

essence no more special than the rights of other “contractors” such as creditors. But if the

ends of corporate governance are not maximising shareholder value, what is it? Bainbridge,

and Blair and Stout have convincingly shown why the board of directors is perfectly

positioned to act as the central decision maker in the corporation. Traditionally it was charged

with the vague objective to act in the long term interests of the corporation. What those long

term interests might be- and how competing objectives and imperatives are balanced off

against each other- might be a matter best left to the board.

If it is accepted that decision making is best left to boards and that the rights of shareholders

to remove directors and alter internal rules provides an appropriate structural balance, how

should we legislation treat corporations? In almost all jurisdictions boards are empowered by

statutory provisions The fiduciary obligations of loyalty and care bind directors to the

corporation and the business judgment rule protects directors against action from current

shareholders for decisions that might appear to favour other contractors so long as those

decisions are in the best interests of the company in the long term. If the synthesised model

set out in this paper is correct, the concern of corporate law becomes one of looking at what

influences decision making by boards. The first question will always be if the decision

making is complies with corporate law. For example, have directors a conflict of interest that

means that they have acted in breach of their obligation of loyalty to the corporation?

The second concern might be whether contractors comply with their contractual obligations.

For example, although shareholders may attempt to influence board decision making by

making their views apparent, shareholders have no right to take part in the decision making of

the board. Outside the board room, influence can move on a spectrum from persuasion to

coercion. A shareholder may influence board decision making without stepping over the

boundary that separates the board room from shareholders. If a shareholder holds a large

block of shares, directors will be conscious of the wishes of that shareholder since the

shareholder may remove them from office or if the corporation is listed, sell their shares

reducing value of shares and making company vulnerable to takeover and removal of

incumbent management.

It is not necessary to resile from an acceptance that the primary purpose of a corporation is to

maximise value in the long term and at the same time accept that a corporation can be a good

citizen. Much of law and economics makes a virtue of selfishness; the aphorisms that in

markets players are self- maximisers expolated from an explanation of behaviour in a

particular context to a self-fulfilling prophecy in other contexts. It is a form of corporate

social Darwinism. We all know people who behave selfishly and some of them rationalize

this behaviour by arguing that if everybody behaves selfishly this will somehow result in a

balanced and fair outcome for all. It is the basis of the efficient market hypothesis. We also

know people who behave altruistically. Scientists who study evolution explain such

behaviour as leading to a better outcome for the group in the long term and sometimes also

for the individual. When trouble strikes a selfish individual the group may treat him or her

differently to the unselfish individual; what goes around, comes around. In a similar way

even if they comply with the rule of law, some companies behave better than others.

Although it is dangerous to analogise legal persons with living persons, legal persons are

comprised of living persons. The "organ" closest to a human mind in the corporation is the

board; the board is comprised of individuals with their own values and the board and the

people on it are influenced by internal and external consistencies. The board as a form of

conscience in the corporation is also influenced by what its members believe the overriding

imperative of the company to be. If in fact members of boards regard their roles to be

representative rather than as delegates of current shareholders or of a particular shareholder,

or they are able to separate their roles as directors from their roles of senior executives, or if

they are truly independent directors, this will affect the way in which they approach making

decisions.

In conclusion, and as pointed out by Roberta Romano several decades ago,124

the normative

conception we have of the corporation really does matter. A recent article in the New Yorker

magazine about narcissism included discussion of a book by philosopher Simon Blackburn

where he railed against the increasing disparity in income between America’s richest, and the

rest. Blackburn compared how the American Roundtable viewed the ends of the corporation

in 1981 and 1997. In 1997, predictably, the principal objective of a business enterprise was

said to be to generate economic returns to its owners. Clearly a shareholder primacy

conception with shareholder viewed as owners and management as their agents sat behind

that imperative. Blackburn continues: “In 1981 the American Business Roundtable could

still claim that ‘corporations have a responsibility, first of all, to make available to the public

quality goods and services at fair prices… The long-term viability of a corporation depends

upon its responsibility to the society of which it is a part.’”125

Blackburn acerbically describes

such a notion as quaint. But such a corporate imperative requires only that the boards and

employees who comprise the interior of the corporation believe it to be so.

124

Romano 125

New Yorker