Law, economics, and beyond: a case for retheorizing the business corporation.

• Author: Vasudev, P.M.

This essay presents a critical analysis of the economic theory of corporations and its idioms, such as "nexus of contracts", "agency costs", and "shareholder value". It calls for the development of a richer and more inclusive theory of business corporations that draws on the experience of the last three decades and better addresses the needs of the post-Enron, post-MG world.

The author identifies the following shortcomings of the economic theory of corporations. First, the contractarian interpretation overlooks the role of law and public policy in corporations. Second, using share prices as the yardstick of corporate performance and encouraging practices such as the buyback of shares have serious implications for the competitiveness and sustainability of corporations. Third, there is inadequate attention to the characteristic and normative distinctions between debt and equity. And fourth, hostile takeovers are treated as virtually the only solution to entrenched managements. The problem of managerial power must be reviewed in the light of evidence regarding managerial power and the efficacy of boards. Equally, there is a case for developing a more deliberated, fair, and equitable policy on executive pay.

A travers une analyse critique de la theorie economique des entreprises et de ses idiomes, cet essai appelle au developpement d'une theorie plus riche et plus inclusive qui profite de l'experience des trois dernieres decennies et qui repond mieux aux besoins d'un monde post-Enron et post-MG.

L'auteur identifie plusieurs defauts de la theorie economique des entreprises. Premierement, l'interpretation contractualiste neglige le role du droit et de la politique publique dans les entreprises. Deuxiemement, l'utilisation du prix des actions comme mesure de performance des entreprises ainsi que les pratiques telles que le rachat d'actions ont des consequences importantes pour la competitivite et la viabilite des entreprises. Troisiemement, il n'y a pas assez d'attention accordee aux distinctions caracteristiques et normatives entre la dette et les actions ainsi que l'encouragement indirect de la dette. Quatriemement, le fait de traiter l'achat hostile comme etant essentiellement la seule solution a la question de l'enchassement des cadres est problematique. Le probleme du pouvoir des gestionnaires doit etre revu a la lumiere des faits sur le pouvoir des gestionnaires et sur l'efficacite des conseils. De plus, les politiques de remuneration des cadres doivent etre mieux reflechies, plus justes et plus equitables.

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Introduction I. Economic Theory of Corporations: An Outline II. Economic Theory: Its Milieu. A. Managerial Power and Its Implications B. Shareholder Reward and Stagnant Share Prices C. Rise of the Anti-regulation Sentiment and the Law and Economics Movement 1. The Anti-regulation Sentiment 2. The Law and Economics Movement III. Economic Theory: A Critical Analysis A. The Corporation as a Nexus of Contracts 1. Reporting by Corporations 2 Audit 3. Corporate Law and Creditor Protection 4. Recent Experience: Smith v. Van Gorkom and SOX B. Shareholder Reward and Short-termism C. Corporate Finance: The Blurring of Boundaries between Debt and Equity D. Corporate Control." Constitution and Change 1. Directors' Elections and Takeovers 2. Corporate Shares: Stock Options and Poison Pills E. Managerial Power, Executive Compensation, and Stock Options 1. Managerial Power and the Monitoring Board 2. Executive Compensation and Stock Options Conclusion: A Case for a New Theory of Corporations It is embarrassing to admit that, after several hundred years, social scientists have not yet developed a thorough understanding of the advantages and disadvantages of publicly held profit seeking corporations versus other forms of organizations such as cooperatives, nonprofit corporations, universities, proprietorships, joint ventures and mutuals.

~ Michael C. Jensen and William H. Meckling (1)

Introduction

Economic theory of business corporations has been influential in recent decades. Its terminology, including "nexus of contracts", "agency costs", and "shareholder value", has enriched the understanding of contemporary corporations and their governance. Michael C. Jensen and William H. Meckling's article, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure', (2) and Frank H. Easterbrook and Daniel R. Fischel's article, "The Corporate Contract", (3) present classical expositions on economic theory. These works have played an important role in shaping corporate governance. (4)

This essay provides a critical analysis of the economic theory of corporations and proposes the development of a richer and more inclusive theory of business corporations. It reviews the experience of the last three decades and calls for the development of a more expansive theory that can better address the needs of the post-Enron, post-AIG world. The new theory must incorporate the lessons drawn from an economic perspective and pay attention to other significant issues, with the goal of promoting a more responsible governance of public corporations.

The bull phase in the stock market, which began in the early 1980s, continued almost without interruption until mid-2007. Economic theory, with its shareholder-value maxim, drew affirmation from the market and the constant rise in share prices. Recent events such as the scandals at Enron and WorldCom, the latest failures in the financial sector, and the turmoil in the capital markets since 2007, raise questions about the economic model and its theory. These developments present an opportunity for introspection and refinement of the theory of business corporations.

This essay identifies the following shortcomings of the economic theory of business corporations and their governance:

First, the contractarian interpretation is incomplete, as it overlooks the role of law and public policy in corporations. In addition to the fact that corporations are created under statutes, there is the history of regulatory intervention to consider--for example, in the areas of financial reporting and auditing. More recently, the market failures that culminated in the collapse of Enron and WorldCom at the turn of the century led to the enactment of the Sarbanes-Oxley Act of 2002 (SOX). (5)

Second, the economic theory uses share prices as the yardstick of corporate performance and encourages practices such as the buyback of shares. These approaches have significant implications for the competitiveness and sustainability of corporations, as well as for their culture of governance.

Third, economic theory makes no significant distinction between equity and debt, and encourages corporations to borrow. It overlooks the impact that corporate indebtedness has on stability. The perils of leveraging are evident from the ongoing difficulties of auto majors like General Motors, Ford, and Chrysler.

Fourth, economic theory effectively endorses self-perpetuating managements and treats hostile takeovers and leveraged buyouts as the means of changing corporate control. There is a need to develop a more deliberative and nuanced public policy on the issues of entrenched managements and change of corporate control.

Fifth, the problem of managerial power, which economic theory targeted, continues to persist. Indeed, the recent failures in the financial sector suggest that the problem has now taken a different form and is more acute. The two-pronged approach advocated in economic theory-monitoring by the directors and granting stock options to managers to promote a unity of interests with shareholders--needs to be reviewed in light of fresh evidence about managerial power and the efficacy of boards. Equally, there is a case for developing a more nuanced policy on executive pay.

The essay has rive parts. Part I outlines the economic theory of corporations. Part II then explores the milieu in which this theory was developed. This context helps elucidate the relevance and acceptance of economic theory, and aids in assessing the theory's suitability for the present. Part III discusses the shortcomings of economic theory listed above. Finally, the conclusion argues for a richer and more inclusive theory of corporations and lays down a tentative framework for a new theory.

This essay aims to provide a critical analysis of corporate theory in recent decades and to contribute a better understanding of the present. A clear understanding of how we arrived at our current situation is essential to the search for possible options for the future. The brief reconstructive analysis in the conclusion is not intended as a comprehensive theory; rather, it outlines potential elements for a new theory of corporations.

1. Economic Theory of Corporations: An Outline

   Jensen and Meckling trace their work to Ronald Coase, Adam Smith, and Berle and Means. Coase published "The Nature of the Firm" in 1937. (6) According to Coase, firms essentially resulted from cost advantages. In his model, an entrepreneur-coordinator who both owns and manages the enterprise will select the activities that can be handled internally, and those that can be handled externally. Cost will be the consideration in decisionmaking. For instance, a car manufacturer will choose between making batteries internally and buying them from an outside manufacturer, depending on relative cost advantages. All the relationships of the firm, both internal and external, will be governed by contracts negotiated among individuals. For internal relationships, the entrepreneur-coordinator will additionally rely on the employer's authority under the common law governing masters and servants.

   Adam Smith's concern, on the other hand, was focused on the joint stock companies of post-Bubble Act (7) but pre-industrial Britain. For Smith, a major issue was conflict between the shareholders who contrib- the capital of companies, and the directors who controlled it. (8) Smith was...