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1989]II.CONTRACTUAL THEORY OF THE CORPORATIONTHE THEORY OF THE FIRM AND THE NATURE OF THE CORPORATIONIn order to understand the nature of the corporation and to provide thebasis for a survey of the contractual theory of the corporation, it is helpful toexplore several fundamental economic issues. This section examines whyfirms exist, the role of efficient capital markets, the theoretical advantages ofthe corporate firm, the role of shareholders in the corporate firm, and theimportance of controlling agency costs in the publicly traded corporation.A.Transaction Costs and the Emergence of Firm OrganizationThe theory of the firm seeks to explain the choice of methods of coordination among specialized individuals in a market economy. There are two basic methods of economic coordination in a market economy - marketcoordination and firm coordination. Market coordination is the processthrough which the price system embodied in the form of contracts directsproduction decisions. In theory, all possible gains from specialization couldbe realized through market coordination in the absence of transaction costs,which include negotiating, contracting, and enforcing costs. Firmcoordination is the process through which production decisions are directedthrough a "firm" - an economic organization that purchases and organizesresources to produce desired goods and services. In essence, the use of thefirm to coordinate and direct the flow of resources represents a substitution ofhierarchical or bureaucratic decision making in production processes forproduction organized through discrete market contracts. Managementorganizes, coordinates, and monitors the production processes within thefirm. The market still serves to guide the economic decisions of the firm withrespect to what products or services to produce, but the internal decisionprocesses are directed by the managerial organization of the firm.The emergence of firm organization, as well as the particular organizational structure adopted, has been explained as an effort to solve the shirkingmonitoring problem of joint production. Ronald Coase was the first to explain that the emergence of the firm as a method of economic coordinationwas the result of an effort to reduce the transactions costs of market coordination.' 0 In a world with zero transactions costs, there would be no need forthe organization of economic activities in firms because all activities could behandled through spontaneous market transactions. However, once transactions costs are added, the least costly, or most efficient, form of coordinationof certain economic activities may be through the firm. On the other hand, theuse of firm coordination also involves costs - generally through the loss of10. Coase, The Nature of the Firm, 4 Economica 386 (1937).

GEO. MASON U.L. REV.[Vol. I11:4information and control of employees in the hierarchical organizationalstructure. These internal control costs explain why firms will not grow without limit - that is, why the economy is not managed by one huge firm. Ingeneral, a firm will expand to the point where the marginal benefit in the formof reduced transactions costs is just offset by the marginal cost of internal organization. Profit maximizing firms will tend to evolve to the most efficientsize - the size that reflects the optimal mix of market coordination and firmcoordination.The modem theory of the firm entered a new era when Alchian andDemsetz went beyond identifying circumstances that led to firm coordinationand developed a framework for analyzing how the nature of the productionprocess affects the form of organization (e.g., sole proprietorship, partnership, or corporation) and the internal organization of the firm. Alchian andDemsetz addressed the emergence of the firm as a response to the benefits ofteam production."I For some production processes, the least cost method ofproduction requires that individuals work together as a team in order to produce the final product. Whenever a team can produce a product or service at alower cost, firms will exist. The benefits of team production, however, arenot free. The transaction costs associated with team production arise becauseit is often difficult to monitor the marginal productivity of each individualmember of the team and reward him on the basis of his contribution. Ofcourse, the members of the team will realize this, and some will rationallytake advantage of the situation by shirking - exerting less than the normalproductive effort - because they know that their wages will not fully adjustto reflect their decreased effort. So long as the increased productive efficiencyof team production exceeds the shirking costs (which include the costs ofcontrolling shirking), the firm will expand to replace independent productionby individuals.Alchian and Demsetz's seminal article spurred a series of importanttheoretical contributions. Jensen and Meckling used agency theory to explainthe development of alternative capital structures within corporations, whenfinance theory suggests that the capital structure is irrelevant to the total valueof the firm. 2 Williamson explored the problem of shirking as post-contractual opportunism and has identified contractual arrangements designed to11. Alchian & Demsetz, Production, Information Costs, and Economic Organization, 62Am. Econ. Rev. 777 (1972).12. Jensen & Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, andOwnership Structure, 3 J. Fin. Econ. 305 (1976).

19891CONTRACTUAL THEORY OF THE CORPORATIONprevent opportunism. 3 Cheung explained why productive individuals wouldvoluntarily submit to the managers' commands within a firm. The key pointin understanding this is related to the free rider problem: It is rational for individuals to shirk so long as the other members of the team do not shirk;however, if all of the members of the team shirk, then the wages of all members will decline as each bears a portion of costs of shirking. Faced withthese alternatives, its seems rational for the team members to hire someone tomonitor their behavior in order to enhance the productivity of the team. 4 Themonitor is called the manager, but it is not clear who is working for whomwithin the contractual arrangements. In this perspective, the essence of thefirm is "the nexus of contracts restraining the behavior of contractors."' 5In general, the role of the manager in the theory of the firm is to monitorthe production process, coordinate team production, and discourage shirkingby tying compensation closely to productivity. Of course, this raises thequestion of who is monitoring the monitors? In an important theoreticalcontribution, Klein, Crawford, and Alchian focused on the role of residualclaimants - the contracting parties with the right to the firm's residualincome - and firm-specific investments. 6 They suggested that the"monitoring the monitors" problem is often solved by making the owners ofthe most firm-specific assets the residual claimants. This analysis is mosthelpful in identifying situations where firms will integrate, and perhapswhere firms will have a concentrated ownership structure, but it does notoffer much for the organization of the publicly traded corporation. The"monitoring the monitors" issue underlies much of the corporate governancedebate in the United States and provides a starting point for the analysis ofthe contractual theory of the corporation in Section IV.The theory of the firm helps explain not only why certain activities areorganized through firms rather than markets, but also the particular type offirm organization utilized under different circumstances. In this regard, thetheory of the firm views different types of organizations, including sole13. Williamson, Credible Commitments: Using Hostages to Support Exchange, 73 Am.Econ. Rev. 519 (1983); Williamson, Transaction-Cost Economics: The Governance ofContractual Relations, 22 J. Law & Econ. 233 (1979).14. See Cheung, The Contractual Nature of the Firm, 26 J. Law & Econ. 1 (1983).15. Alchian & Woodward, Reflections on the Theory of the Firm, 143 JITE 110, 111(1987). See Jensen & Meckling, supra note 11, at 311 ("The private corporation or firm issimply one form of legal fiction which serves as a nexus for contracting relationships andwhich is also characterized by existence of divisible residual claims on the assets and cashflows of the organization which can generally be sold without permission of the other contracting individuals.").16. Klein, Crawford & Alchian, Vertical Integration, Appropriable Rents, and theCompetitive Contracting Process, 21 J. Law & Econ. 297 (1978).

GEO. MASON U.L. REV.[Vol.11:4proprietorships, partnerships, and corporations, as contractual responses tothe needs of the firm's participants.B.The Importance of the Efficient CapitalMarkets HypothesisThe development of the theory of the firm, which provides the theoretical basis for the contractual theory of the corporation, would not have beenpossible without the development and empirical verification of the EfficientCapital Markets Hypothesis. 7 The hypothesis states, in most basic terms,that securities prices are efficient in that they accurately reflect all publiclyavailable information about the security. Prices of actively traded securitiesquickly reflect at least all public information about a company.The basic mechanism of market efficiency is that information about afirm continually alters investor expectations about future returns and hencethe prices at which they will sell and buy their securities. 8 This informationreaches investors in a wide variety of ways, including voluntary and mandatory disclosures by firms, stories in the media, reports by securities analysts,and disclosure of insider trades.The efficient markets hypothesis is important because it means that corporate contracts that harm investor interests will be recognized and punishedby price reductions in the market. Incorporation in a state with corporationlaw that facilitates managerial abuse of shareholders, for example, will resultin lower share prices than would be found if the same firm were incorporatedin a state with a different corporation law. 9From a legal perspective, where the concern is often with fairness ratherthan efficiency, the efficient capital markets hypothesis means that securitiesmarkets are fair in the sense that a corporate shareholder gets what he is paying for in both the terms of the contract and the substantive nature of theproduct, including the quality of management. The contractual theory of thecorporation suggests that share prices will not only be fair, but also that corporate managers will have incentives to maximize share value.C.The CorporateFirm:Residual Claimants,Shareholders,andMonitorsExplaining the emergence of the firm does not explain why most of thelargest firms are organized as corporations. The attractiveness of the corporation relative to other forms of business associations is due in large part to the17. For a detailed explanation of the Efficient Capital Markets Hypothesis, see R.Brealey & S. Meyers, Principles of Corporate Finance (3d ed. 1988).18. Gilson & Kraakman, The Mechanisms of Market Efficiency, 70 Va. L. Rev. 549(1984).19. See generally Dodd & Leftwich, The Market for Corporate Charters: "UnhealthyCompetition" versus Federal Regulation, 53 J. Bus. 259 (1980).

1989]CONTRACTUAL THEORY OF THE CORPORATIONeconomic benefits of issuing shares of stock that limit the shareholders liability to the initial investment in the firm. The issuing of stock facilitates theproductive specialization of activities. The publicly traded corporation allowsindividuals with no managerial expertise to participate in corporations asowners by purchasing shares of stock. The corporate form also allows specialization, or centralization, of management functions through the hiring ofprofessional managers. Specifically, the corporation allows individuals withlittle financial capital, but considerable managerial talents, to specialize asprofessional managers of corporations. The talents of such individuals wouldbe much more difficult to tap in the absence of the corporate form of businessassociation based on the separation of ownership and management functions.The theory of the firm also sheds some light on the internal organizationof the corporation, especially the role of managers and residual claimants.Common stockholders are the residual claimants in the publicly traded corporation because, in basic terms, the common shareholders get what is left aftereveryone else has been paid. As a consequence, common stock prices, whichreflect the present discounted value of the residual claim, are extremelysensitive to changes in expectations about the future prospects of thebusiness. Other types of financial instruments, backed by contractual claims,have a more stable rate of return.The residual claimant status of common shareholders means that theyare the primary risk bearers of the corporation. Common shareholders selltheir risk bearing services to the corporation. In fact, it is often suggested inthe economic literature on the theory of the firm that the productive role ofcommon shareholders is that of risk bearers, rather than owners. Limited liability clearly facilitates this specialization by shareholders because it allowsshareholders to be "rationally ignorant" of managerial practices. 0 That is,because their risk is limited to their initial investment, shareholders do notwaste their time trying to monitor managerial behavior.2 Thus, limited lia20. Shareholders are characterized as rationally ignorant because of the large costs associated with staying informed about the corporation's internal affairs and the very small expectedbenefits to the individual shareholder of being informed. After bearing the costs of becominginformed, such shareholders are unlikely to be able to influence the corporation's policies andin any event they must share the benefits of intervention if they are successful. See generallyManne, Some Theoretical Aspects of Share Voting: An Essay in Honor of Adolf A. Berle, 64Colum. L. Rev. 1427, 1440-42 (1964); Fischel, The Corporate Governance Movement, 35Vand. L. Rev. 1259, 1277 (1982).21. Limited liability encourages investment by individuals that have neither the time northe expertise to monitor the management of the business. In order to understand the importanceof this aspect of limited liability, consider the plight of an investor in a large company thatdoes not have limited liability. Because the investor's entire personal fortune is tied to the success or failure of the company (that is, failure of the company allows the company's creditorsto attach the investor's personal assets), the investor will attempt to minimize that great risk

GEO. MASON U.L. REV.[Vol. 11:4bility allows investors to be passive with respect to the internal affairs ofcompanies and to concentrate on the externally observable traits like profitsand rate of return on investment.Another major advantage of the publicly traded, limited-liability corporation is that the investors' ownership interests can be transferred without thepermission of fellow owners and without the expense of locating buyers. Forexample, when a shareholder becomes dissatisfied with the operations orprofitability of a corporation in which he or she owns stock, the shareholdercan sell the shares instead of becoming involved in the corporation's decision-making process. Many shareholders are specialized investors who convey their evaluation of managerial performance by selling or buying shares.The transferring of shares is facilitated by limited liability which allows buyers to purchase shares without incurring more risk than the potential loss ofthe purchase price. Passive investors further benefit from limited liability and"rational ignorance" because they are able to diversify their portfolio byowning interests in several different firms at the same time.The presence of "rationally ignorant" shareholders, however, presentsmanagers of corporations with opportunities to engage in activities that arenot necessarily in the shareholders' best interests. These so-called "agencycosts" are discussed below.D. Agency Theory and the CorporationThe theory of the firm has helped economists and economic orientedlawyers develop a perspective on the corporation which, although recognizing the potential conflict between shareholders and managers, argues thatmost of those conflicts are solved by competitive forces that align managers'interests with shareholders' interests.22 This theoretical approach, which iscalled agency theory or transaction costs economics, provides, the theoreticalbases for the contractual theory of the corporation.In general, agency theory suggests that unity of ownership and controlis not a necessary condition of efficient performance of a firm. This perspective stresses the voluntary, contractual nature of the corporation. A first stepby carefully monitoring the management of the firm. Obviously, the typical risk-averse investor would not be able to invest in more than one or two companies if faced with unlimitedliability. For a thorough discussion of this and other reasons for limited liability, seeWoodward, The Economics of Limited Liability, J. Institutional & Theoretical Econ. 141(1985). The benefits associated with limited liability are not free, however. Meiners, Mofsky &Tollison, Piercing the Veil of Limited Liability, 4 Del. J. Corp. L. 351 (1979).22. Another set of conflicts that must be resolved in the firm is the relationship betweenbondholders and shareholders. For identification of these conflicts and an analysis ofcontractual solutions, see Smith & Warner, On Financial Contracting: An Analysis of BondCovenants, 7 J. Fin. Econ. 117 (1979).

19891CONTRACTUAL THEORY OF THE CORPORATIONin understanding this market-oriented approach is to recognize that it is basedin part on the assumption that the shareholders' primary interest is i

as academic interest. For example, the influential American Law Institute's Corporate Governance Project is based, at least in part, on a conflicting view of the nature of the corporation.4 The long delay in adopting the ALI re-porters' recommendations is evidence of the growing influence of the con-tractual theory.