Advancing a realistic theory for corporate law

By Laura Vialon

Corporate law has been dominated by nexus of contract and agency theory. These theories have proven effective to test corporate law’s efficiency against, but their narrow focus has led to a corporate law estranged from the actual organisation it has to support. For a long time, few have thought about advancing a different, more realistic theory, capturing the complexity of the real-life entity. Recently however, David Gindis and Eva Micheler have – with their latest joint piece published in the Journal of Corporate Law Studies – opened a new debate introducing an institutional theory for corporate law. This blog purports, a more realistic analysis of corporate law’s efficiency is not the only opportunity this offers. Furthermore, a realistic – social sciences, evidence based – theory of the business organisation enables normative advances: When we see what is and how it works, we can actually fix it.

For a long time now, microeconomic theories dominate Anglo-American corporate law and how it is taught in universities: theory of the firm, agency theory, transaction costs with Coase, Jensen & Meckling, Easterbrook & Fischel and others. The firm exists as it reduces transaction costs compared to the market; on the market contracts need to be negotiated on an individual basis, in the firm, a central agent coordinates production and less complex bilateral (implied) contracts reign. Agency theory is about minimising agency costs within the firm which arise through the separation of ownership (shareholders) and control (board of directors). The core of agency theory is that there is always a conflict of interest between these two corporate players and corporate law is the most efficient when it can minimise this conflict the best possible. This elegant model has inspired corporate lawyers to venture into the social sciences, giving them a framework to test corporate law’s efficiency against. Legally this has spurred for example director’s rising pay, independent board structures and hostile takeover legislation (see Johnston or Deakin) and in general (nexus of) contract theory à la Easterbrook & Fischel has led to a more facilitative rather than regulatory corporate law.

Despite law & economics’ success in influencing statute, there has always been critique and empirical testing has now discredited some of its premises. Years of nexus of contract and agency theory from the 1980’s on have not created the efficiency we need today – which would be rather resource efficiency, design intelligence and not profit maximisation from a sustainability perspective – nor have they lead conclusively to ‘greater financial development and firm-level performance’ (Deakin): Apparently axing corporate governance around shareholder value with the aim to reduce managerial agency costs, does not translate into more external finance a firm can attract and thus stimulation of economic growth for all.

Contract and agency theory have drawn the focus on a simplistic conflict of interest between two parties (and only the ones that company law proper recognises): the shareholders and the board of directors. However, this is not the whole story of the corporation. Economics as such is not to blame – it is a broader church than most corporate law scholarship make us believe. At the same time, economics is also not everything and corporate law could make a start to bury the schism between law and the social sciences and follow the ‘new private law’ movement. David Gindis and Eva Micheler recently have made a push into this direction and opened the debate – or in a sense revived it – with an institutional theory for corporate law. The background for this institutional theory is a revival and remodelling of the old real entity theory fromvon Gierke (see Gindis) made fit for today with the advances we have made since in the social sciences. Real entity theory was dominant in the US in the 1920’s when vonGierke was translated into English and it assimilated the corporation with its board of directors (Avi-Yonah; Petrin). Micheler’s new interpretation of real entity theory in her book ‘Company Law – A real entity theory’, puts it like this: The corporation “is a legal entity allowing an organization to act autonomously in law and company law establishes procedures facilitating autonomous organizational decision-making”. The new real entity theory is hence about recognising organisational behaviour – shaped by structure and human agency at the same time (Micheler, p. 24 ff.). Gindis similarly concludes that the firm is a real entity because its consequences are real, it has “existence, identity, unity, and persistence”.

In their joint piece, Gindis and Micheler take their analysis and theory-building further and draw on Oliver Williamson’s call for a law, economics & organisations approach and Elinor Ostrom’s institutional theory with nested levels of governance and action situations. Their assessment: The dominant theories have estranged corporate law from the actual real-life entity. Their approach has two major meta implications: On the one hand, it finally provides the best explanation for how the law deals with an organisation by giving it separate legal personality. In this regard, the theory finally connects to actual doctrine, which cannot be said about contract theory. The law recognises that an organisation is something else than just an individual or a group of individuals. An organisation has a structure, and its actions are more than multiplied individual actions, and this gives the corporation boundaries. On the other hand, it brings everything under the surface of this abstract concept of separate legal personality, the real-life entity, into the light for the law to examine it.

While agency theory permits only the analysis of principal-agent, so binary relationships, Ostrom’s framework permits to look into the real-life entity with all its complexity. It enables analysis within and across different layers and instances of governance, with more actors and more criteria to evaluate actions. Agency theory focuses mainly on two corporate players, the shareholders and the board of directors. However, there are more actors and more than just agent-principal relationships to examine and of interest. The modern capitalist corporation is full of a species which is nowhere to be found in corporate law and no concern for agency theory, but enormously important for the economic performance of the entity: the below board level manager. Equally absent, although the one ‘producing’ the economic output of the entity, is the employee. A quick look into organisation theoretical literature in management scholarship shows that these two are in this field the players for economic performance. These are in included in Gindis & Micheler’s model: Ostrom’s institutional analysis and developmental framework (IAD) permits to investigate action situations which are defined by informal and formal rules, the participants and their interests and cultural background, material and group conditions. These ‘structural variables’ as Ostrom calls them are universal for social settings, with differing values depending on the kind of social setting. The action situations connect across multiple levels of governance. Gindis and Micheler draw a complete map of the corporation with four key nested action situations and layers of governance: meta-constitutional (creation & registration of the corporation), constitutional (shareholder and board of directors deciding on the constitutional rules & their implementation), policy and operational (directors, executives, managers decide on rules/targets, employees taking actions based on these) [Figure 2 in Gindis/Micheler]. Applying Ostrom’s framework to the corporation, two things become clear: Firstly, agency theory by only focusing on the board of directors, assumes that decisions are all taken at board level and fed down without distortion and that is why actors below board level are of no interest. Secondly and consequently, that this is a very simplistic vision of how a corporation works. Who ever played Chinese whispers knows what happens when information is transmitted and this does not even take into account that different people evaluate facts differently, have different values and agendas. Ostrom’s IAD framework captures this and make it come to bear on any decision and information exchange between governance levels. In big corporations there are different departments and many layers of management creating complicated communication channels, making monitoring of compliance with high-level decisions a challenge. Witting also showed that decisions are often not even taken at the top.

While contract and agency theory erase separate legal personality as a core legal feature of the business corporation, degrade it as an “unnecessary fiction”, an institutional theory brings it back to the fore. As Micheler puts it, this feature of corporate law is immensely important as it enables a procedural framework for autonomous organisational action. It is in her view the law’s answer to the institutional reality of the organisation – or firm as the preferred term in economics. Gindis’ and Micheler’s Ostromian model for corporate law decisively makes this clear in their Figure 2: Separate legal personality draws the boundaries of the organisation. Contract and agency theory build a model based on the rational, self-interested actor emphasising human agency disproportionately and limiting the analysis mainly to two participants. In contrast, Ostrom applied to corporate law means the model enables multi-actor, multi-variable and multi-layer of analysis. It transcends a simple view on human agency and furthermore makes it possible to understand and test the interplay between human agency and structure.

In summary, we gain a much more realistic perspective of the corporation and its interactions with Gindis and Micheler’s Ostromian model. The model accepts the fundamentals of corporate law at this point – Gindis and Micheler do not make a statement as to the shareholders vs. stakeholder debate. However, it is possible that there are more lessons to be drawn by dropping agency theory and deploying a realistic lens to look at the organisation that underlies the corporation (my PhD project will investigate in this direction). This does not necessarily need to be via the Ostromian model which Gindis and Micheler apply, but this model is fruitful. For once, seeing how the corporation operates, we can become aware of its hierarchical structure (see discussion Witting). Corporate law does not play an innocent role in this. It does give the corporation one legal organ which decides most matters (except for decisions involving shareholders like appointment or dismissal of directors), represents the whole organisation and is responsible for its success with the board of directors. From a look at Gindis and Micheler’s model, the Companies Law Act 2006 misses important actors on the policy and operational level, they are not visible in the governance of the corporation. Perhaps company law as it stands is simply only interested in the meta-constitutional and constitutional governance levels. Looked at it positively, this leaves freedom for each individual corporate entity to develop and design informal and formal rules when it comes to these neglected levels. Looked at it critically, this freedom however can lead to oppressive work environments (see discussion by Yen/Battilana/Aguirre in George et al.). Company law does indeed enable the corporation to run an autonomous organisation, but it does not provide for procedures that make sure that interactions between all actors are safeguarded or visible or that procedures for conflicts are in place on all levels of governance. A realistic view on the real-life entity reveals a socially structured organisation with real human beings in it who are not one-dimensional but rich in values, interests and needs. This perspective can lead us to think much more about what happens to these real human beings.