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The Theory of the Firm: The Corporation as Sole-Proprietor Surrogate


Charles R.T. O'Kelley


Adolf A. Berle, Jr. Center on Corporations, Law and Society, Seattle University School of Law

June 6, 2011


Abstract:     
What is a corporation? Who owns a corporation? What is the purpose or function of corporation law, particularly fiduciary duty? What is a firm? What does the theory of the firm tell us about the answer to the first three questions? These core questions form the backdrop for the paradigm shift in corporation law scholarship which occurred between 1970 and 1980 and for the current search for a new paradigm. This article reassesses the currently dominant nexus-of-contracts paradigm, and the current controversy over the normative validity of shareholder primacy, and articulate a new vision of the corporation as sole-proprietor surrogate.

For four decades, until the 1970s, the Berle and Means paradigm dominated corporation law scholarship, much as it had dominated the New Deal reform agenda. This paradigm is based on the asserted empirical fact that shareholders, though unquestionably the owners of publicly-traded corporations, do not have effective control over most publicly-traded corporations. Berle and Means also made a normative claim: the primary purpose of corporation law – a regulatory purpose – is to protect shareholders from depredation at the hands of selfish or careless entrenched managers, a risk of harm made possible by separation of ownership and control. Not surprisingly, the dominant research agenda for corporation law scholars during the ascendancy of this paradigm was corporate law reform intended to better regulate the conduct of corporate managers or otherwise protect shareholders’ interests. Equally unremarkably, scholars working out the implications of the dominant paradigm – Progressives – gave little thought to the definition of a corporation, other than to distinguish it from other business forms with different legal attributes, and gave no thought at all to economists’ theorizing about the nature of the firm or the implications for law reform of classical microeconomic theory.

During the 1970s, fueled by the law and economics movement and neo-classical economists’ work on the theory of the firm, a remarkable paradigm shift occurred. By the early 1980s, paying homage to R. H. Coase, but more directly relying on the work of Jensen & Meckling, law and economics scholars had accomplished a corporation law coup d’etat, overwhelming the defenders of the Berle and Means paradigm, and installing a new paradigm – the nexus-of-contracts theory of the corporation, and the corresponding maxim that corporation law could best be understood through economic analysis. Under the nexus-of-contracts paradigm the corporation is depersonalized and described not as an artificial entity created by the state and subject to the state’s paternalistic shareholder-protective regulation, but instead as a nexus of voluntary contractual relationships between and among shareholders, managers, employees, bondholders, suppliers, customers and other corporate constituencies.

However, the now dominant contractarian model has not achieved the near universal acceptance that its predecessor achieved as evidenced by the growing number of scholars who identify as progressives, who reject the “politics” that they associate with new paradigm, and yet find certain aspects of contractarianism irrefutable. I suggest that the current lack of harmony in corporation law scholarship, and the resulting failure to fully integrate legal and economic insights about the firm and the corporation into our study of corporation law, begins with a universal but unrecognized move which all corporation law scholars seem to make – treating the terms “the firm” and “the corporation” as perfect substitutes for each other when referencing a particular incorporated business enterprise. Consider two statements: General Motors is a firm; General Motors is a corporation. As so used, the words “firm” and “corporation” have identical meaning for most economists and legal scholars.

The current dialog is further confused by viewing the firm as having no center. If we depict a sole proprietorship as a circle encompassing its constituents, that firm would have a center, the sole proprietor, who owns the firm’s property, serves as the node for all contracts, and determines and directs the firm’s policies. In contrast, all corporation law scholars apparently view the corporation as a firm with no center, or, as having at its center an artificial and empty contracting node provided by corporation law.

This article demonstrates that the equation of “the firm” and “the corporation” is a fundamental error which masks a principal role of corporation law – providing a substitute or surrogate for the sole proprietor in firms that find it desirable to split ownership among more than one individual – and which encourages the view that corporation law protects, or should protect, the interests of “other constituencies.” I demonstrate that if we conceive of the firm as a circle encompassing its constituents, the corporation should be depicted as a smaller circle within the firm, which smaller circle contains the corporation’s shareholders and directors. With this conceptual shift, corporation law can be described as focusing solely on the relationships between and among shareholders, officers and directors because they are the only constituents of the corporation. Moreover, we can see that the corporation is the smaller circle within the firm which serves as the locus, or contracting node, for the other contractual relationships that make up the firm, just as the sole proprietor is the party to all contracts in the classic firm.

Part I traces the evolution of the nexus-of-contracts paradigm from the work of Frank Knight and R.H. Coase to the present, highlighting the current debate as to whether the Shareholder Primacy norm is a central tenet of, or is inevitably legitimated by, the nexus-of-contracts account of corporation law. Part II introduces the Corporation as Sole-Proprietor Surrogate model and tests its utility in the context of the current debate over the shareholder primacy norm. The article concludes with some tentative observations about the research agenda suggested by the new theory, including its implications for the study of corporate governance and the discussion of corporate social responsibility.

Number of Pages in PDF File: 32

Keywords: Corporate Governance, Coase, Transaction Cost Economics, Nexus of Contracts, Knight, Fama, Jensen, Alchian, Demsetz, Corporate Law, Legal History, Institutional Economics, Theory of the Firm, Adolf Berle, Means, Law and Economics, Intellectual History, Entrepreneur, Microeconomics, Separation of Own

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Date posted: June 8, 2011 ; Last revised: June 13, 2011

Suggested Citation

O'Kelley, Charles R.T., The Theory of the Firm: The Corporation as Sole-Proprietor Surrogate (June 6, 2011). Available at SSRN: http://ssrn.com/abstract=1858936 or http://dx.doi.org/10.2139/ssrn.1858936

Contact Information

Charles R.T. O'Kelley (Contact Author)
Adolf A. Berle, Jr. Center on Corporations, Law and Society, Seattle University School of Law ( email )
901 12th Avenue, Sullivan Hall
P.O. Box 222000
Seattle, WA n/a 98122-1090
United States
206 398 4252 (Phone)
206 398 4077 (Fax)
HOME PAGE: http://www.law.seattleu.edu/x1865.xml

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