Academic journal article Journal of Corporation Law

The Contractarian Theory of Corporate Law: A Generation Later

Academic journal article Journal of Corporation Law

The Contractarian Theory of Corporate Law: A Generation Later

Article excerpt

This essay and the symposium to which it is contributed mark the 20th anniversary of the publication of Corporate Law by Robert Clark.1 Clark's book was an important force in bringing economic analysis to bear on issues of corporate law, a process that has transformed corporate law scholarship. At its broadest theoretical level, this transformation reconceived the corporation as a contractual entity and reconceived corporate law as a largely passive adjunct to the contracting process that creates a corporation. Clark, however, had doubts about this contractarian theory of the corporation and corporate law. Using his doubts as a point of departure, I take this opportunity to briefly assess the contractarian theory in light of twenty years of experience and a generation of scholarship. I conclude that while the contractarian theory was a useful starting point for economic analysis of corporate law, more recent research demonstrates that as a description of reality, or a basis for policy prescription, the theory falls short.

Corporate Law was published at a time when, as Clark observed a few years later, the "contractual theory of the firm . . . dominate[d] the thinking of most economists and economically oriented corporate law scholars."2 The core innovation of the theory was to conceptualize the relationship between management and shareholders of a public company as one of contract-a "corporate contract"-in which joint wealth would be maximized as a result of atomistic market-mediated actions.3 The corporate contract consists of the terms of a corporation's charter and the corporate law the firm selects by virtue of incorporating in a particular state. The contractarian theory of the firm also implies a theory of the role of corporate law: corporate law should merely provide a set of default rules that managers may adopt on behalf of their firms, while leaving managers free to customize their companies' charters with legally enforceable rights and obligations. In the contractarian view, states are seen as competing with one another to attract incorporations by providing corporate law that offers value-enhancing default rules. During the period in which Clark was writing his book, Frank Easterbrook and Daniel Fischel published a series of articles that developed and applied this theory. Their work culminated in the other major corporate law book of the time, The Economic Structure of Corporate Law.4

Clark implicitly rejected the contractarian theory with respect to both the contractual nature of the firm and the role of corporate law. His book describes and analyzes corporate law as a regulatory regime. As he explains, the regime responds to problems inherent in three core attributes of the corporation: (a) limited liability, which can be used to shield shareholders from personal liability after they have externalized costs on third parties, particularly tort victims; (b) free transferability of shares, which creates the opportunity for securities fraud; and (c) centralized management, which creates an environment in which agency costs are inevitable.5

Where the law appears to be flawed, Clark proposes regulatory solutions. One of his central themes is that the law governing the duty of loyalty is ill-suited to public corporations, and that the law evolved to this suboptimal point as a result of courts applying a single set of loyalty rules to both public corporations and close corporations.6 Clark argues, for example, that the corporate opportunity rule as it has evolved through court decisions has a degree of permissiveness and open-endedness that is well suited to close corporations, but poorly suited to public corporations, whose managers should instead be subject to a categorical prohibition on taking any business opportunities.7 He argues that states should enact rules that impose such a restriction on managers of public companies.8

Clark expounds on these themes over the course of more than 800 pages, without even a nod toward basic contractarian precepts. …

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