Fitting Economic Concepts into Corporate Law
By Jonny Hardman, 20 April 2021
Dr Jonny Hardman is Lecturer in International Commercial Law at the University of Edinburgh.
Economic analysis is everywhere in corporate law. It almost always produces a shareholder-friendly perspective on any issue. Economic arguments can, though, produce different perspectives. In my paper presented at the Daughters of Themis Corporate Purpose Conference on 16 April, I argue that a different perspective can be reached if we explore the differences between the economic concept of the ‘firm’ and the legal concept of the ‘company’. In this blog post I challenge – using economic arguments – the apparently economic perspective that corporate law should be focused on pleasing shareholders only.
The Firm & the Company
The firm is an economic concept. It refers to the coordination amongst various factors of production (the team), with some members having authority to coordinate the team. Coase argued that it was cheaper to bring activity inside the firm. A common example is that of General Motors (GM) and Fisher Body (FB). FB was the only supplier of certain car body parts to GM under a long term contract. If GM had a rush of demand, they needed to ask FB for additional parts. As GM could not get anyone else to make them, FB could hike the price. GM eventually bought FB – GM brought FB’s operations inside GM’s firm. Where once GM and FB were two separate firms, now they were one. To economists, the boundaries of the firm are set jointly, by agreement between all factors of production, they arise from factual circumstances and are identified objectively. This is very different from the legal concept of the company.
States incorporate companies, based on applications normally signed by directors and shareholders. These constituencies therefore often pick ‘friendly’ jurisdictions – creating a ‘market for incorporations’ as jurisdictions push to attract these constituencies. Shareholders and directors take major decisions on behalf of the company, and shareholders often receive anything left over if the company gets wound up. A company must be incorporated before it does anything. It is established by only certain factors of production, who can use multiple companies in a project if they want. It is easy to see how the company will not always map exactly on to the firm.
For example, there could be several companies within a firm. Law provides the framework of partnership law which could align the two. However, partnership law does not automatically step in to do this. Similarly, there could be multiple firms within a company. Law has tools (like transfer pricing and restrictions on dividends) that could ensure separation of the two firms. Once more, these tools are not deployed. It therefore seems deliberate that the firm and the company do not exactly correspond.
The Nexus of Contracts
This lack of correspondence is significant because some corporate law arguments are based on the economics of the firm. A major corporate law research theme, especially in the Anglo-American world, was and remains the separation between share ownership and managerial control. In this discussion, the boundaries of the firm and the company are treated as identical: it presumes that a single firm maps perfectly to a single company. This analysis morphed into the analytical tool of the ‘nexus of contracts’. It is unclear whether this nexus should apply to the firm or the company. Of course, it does not matter where the two overlap completely. However, this concept is frequently applied to all companies – even where there are several companies within a firm or several firms within a company. This approach by Easterbrook & Fischel in the 1980s spawned the contractarian school, which holds that corporate law should use default rules and generally facilitate shareholder aims. This school is not universally accepted.
For our purposes, neither the company nor the firm perfectly fits the nexus of contracts. For decision making purposes, many legal systems only consider shareholders and directors to be internal to the company (so, for example, neither employees nor suppliers are). Economists consider only consider factors to be internal to the firm if the price mechanism is replaced by control and coordination (so the employee is internal but the supplier is not). The nexus considers all stakeholders to be internal (both employees and suppliers are). But the firm is a better fit. The firm includes more participants and is objectively identifiable – features you’d expect from a nexus of contracts.
The firm being the nexus of contracts undoes the normative weight of contractarianism in corporate law. It means we need to consider the company as only a party to the nexus of contracts, rather than the nexus itself. We can call the rest of the nexus the ‘business’.
Regulating the Business
The company being only one party to the nexus of contracts gives rise to three immediate issues. First, corporate law collectivises the power of certain participants in the nexus (directors and shareholders) and not others. In other words, corporate law adjusts the bargaining power that otherwise would exist within the firm. We can remedy this by providing the ability to centralise the other factors of production and other stakeholders. Centralised fora for those who interact with the company will help promote the exchange of knowledge about interacting with the company, and provide the correct venue for disclosure.
Second, different stakeholders are closer to different concepts. As directors and shareholders have interposed the company between them and the business, they are conceptually further from the business than other stakeholders. Other stakeholders sit further from the company. Proximity dictates who is best to make decisions in respect of the relevant concept. Ultimately, viewing the company as one party to the nexus of contracts, rather than the full nexus, means there should be limitations on the company’s control over the firm.
Third, we can explain why the company holds the legal title to the firm’s assets, and why those stakeholders who have long-term relationships with the firm have to contract with the company – the company does so on behalf of the firm. This justifies limitations on what the company can do with firm property (in the same way that trustees are limited), and also why those who are interested in the firm contract with the company.
Undoing the conflation between the company and the firm makes this possible. When we start pulling at the loose thread within this economic analysis, it starts to unravel. Economic tools have traditionally been used to justify existing power structures in corporate law. In this post I’ve argued that certain existing economic argument structures do not inevitably and automatically flow from their ostensible economic origins. If we challenge such structures more broadly, we can use economic analysis of corporate law to achieve other ends than it’s traditionally deployed for.