Who owns a corporation? Most economists and legal scholars today seem inclined to answer: Its shareholders do. Contemporary discussions of corporate governance have come to be dominated by the view that public corporations are little more than bundles of assets collectively owned by shareholders (principals) who hire directors and officers (agents) to manage those assets on their behalf. This principal-agent model, in turn, has given rise to two recurring themes in the literature: First, that the central economic problem addressed by corporation law is reducing agency costs by keeping directors and managers faithful to shareholders interests; and second, that the primary goal of the public corporation is-or ought to be-maximizing shareholderswealth. Because corporations are fictional entities that can only act through human agents, problems of agent fealty are frequently encountered by those who study and practice corporate law. Yet the public corporation is hardly unique in its use of agents. Other organizational forms, including partnerships, proprietorships, privately-held corporations, and limited liability companies, also routinely do business through hired managers and employees. Thus, while the principal-agent problem may be important in understanding the business firm, ... question whether it necessarily provides special insight into the theory of the public corporation. In the economic literature, team production problems are said to arise in situations where a productive activity requires the combined investment and coordinated effort of two or more individuals or groups. If the team members investments are firm-specific (that is, difficult to recover once committed to the project), and if output from the enterprise is non- separable (meaning that it is difficult to attribute any particular portion of the joint output to any particular members contribution), serious problems can arise in determining how any economic surpluses generated by team production any rents-should be divided. Ex ante sharing rules invite shirking, while ex post attempts to divvy up rewards create incentives for opportunistic rent-seeking that can erode and even destroy the economic gains that flow from team production. Yet trying to prevent shirking and rent-seeking by defining individual team members duties and rewards through explicit contracts can be impossibly difficult, especially when the team production process is complex, continuous, or uncertain. While team production problems are less well studied than principal- agent problems, we believe the former may represent a more appropriate basis for understanding the unique economic and legal functions served by the public corporation. Our analysis rests on the observation-generally accepted even by corporate scholars who adhere to the principal-agent model-that shareholders are not the only group that may provide specialized inputs into corporate production. Executives, rank-and-file employees, and even creditors or the local community may also make essential contributions and have an interest in an enterprises success. And in circumstances where it is impossible to draft explicit contracts that deter shirking and rent-seeking among these various corporate team members by preallocating rewards and responsibilities, we suggest that the problem may be better left to an institutional substitute for explicit contracts: the law of public corporations. We argue that public corporation law can offer a second-best solution to team production problems because it allows rational individuals who hope to profit from team production to overcome shirking and rent-seeking by opting into an internal governance structure we call the mediating hierarchy. In essence, the mediating hierarchy solution requires team members to give up important rights (including property rights over the teams joint output and over team inputs such as financial capital and firm-specific human capital) to a legal entity created by the act of incorporation. In other words, corporate assets belong not to shareholders but to the corporation itself: Within the corporation, control over those assets is exercised by an internal hierarchy whose job is to coordinate the activities of the team members, allocate the resulting production, and mediate disputes among team members over that allocation. At the peak of this hierarchy sits a board of directors whose authority over the use of corporate assets is virtually absolute and whose independence from individual team members... The team production model of the public corporation both highlights and explains the essential economic function served by that otherwise puzzling institution, the board of directors. The notion that responsibility for governing a publicly held corporation ultimately rests in the hands of its directors is a defining feature of American corporate law; indeed, in a sense, an independent board is what makes a public corporation a public corporation. Yet while the board of directors is central to public corporation law, it raises troubling questions under the principal-agent model. Shareholders rights and powers over directors in publicly held companies are remarkably limited both in theory and in practice, and as a result directors of public firms enjoy an extraordinary degree of discretion to pursue other agendas and to favor other constituencies, especially management,? at shareholders expense. This reality raises a difficult question that has preoccupied corporate scholarship since at least the days of Adolf Berle and Gardiner Means: How can widely dispersed shareholders in public corporations make sure directors use their authority to further shareholders interests? Commentators generally have offered two types of responses to this perceived problem. The first response is that, even though the legal constraints on directors are weak, market constraints product markets, capital markets, the market for corporate control, and so forth-keep directors focused on maximizing profits and share value. The second response has been to criticize director discretion as inefficient, and to attribute the legal rules granting directors so much discretion to a legislative race to the bottom in which states, competing for corporate charters, have given away the store to corporate directors and executives. It should be noted, however, that both of these responses presume that directors should serve shareholders exclusively. Advocates of both views tend to regard changes in the law that weaken shareholders control over directors (for example, anti-takeover legislation or corporate constituency statutes) as bad public policy. Thus both views reflect a shareholder primacy norm that has been prominent in the legal and the economic literature for decades, but has become especially dominant in the last twenty years. The team production model provides an alternative answer to the question of why corporate law grants directors of public corporations so much leeway. In particular, it suggests that the legal requirement that public corporations be managed under the supervision of a board of directors has evolved not to reduce agency costs-indeed, such a requirement may exacerbate them-but to encourage the firm-specific investment essential to certain forms of team production. In other words, boards exist not to protect shareholders per- se, but to protect the enterprise-specific investments of all the members of the corporate team, including shareholders, managers, rank and file employees, and possibly other groups, such as creditors. Because this view challenges the shareholder primacy norm that has come to dominate the theoretical literature, our analysis appears to parallel many of the arguments raised in recent years by the communitarian or progressive school of corporate scholars who believe that corporate law ought to require directors to serve not only the shareholders interests, but also those of employees, consumers, creditors, and other corporate stakeholders. We believe, however, that our mediating hierarchy approach, which views public corporation law as a mechanism for filling in the gaps where team members have found explicit contracting difficult or impossible, is consistent with the nexus of contracts approach to understanding corporate law. Moreover, our approach carries very different policy implications: Where progressives have argued that corporate law ought to be reformed to make directors more accountable to stakeholders, the mediating hierarchy approach suggests that directors should not be under direct control of either shareholders or other stakeholders. Thus we argue that the mediating hierarchy interpretation of corporations is more consistent with the way a corporation actually works than are prominent contractarian interpretations of corporate law that focus on the principal-agent problem. This is because the modem tendency to think of shareholders as corporate owners and directors as their agents glosses over several key legal doc- trines distinguishing public corporations from other business forms that are difficult to reconcile with the principal-agent approach. These fundamental and otherwise puzzling characteristics of public corporation law can be explained as a response to the team production problem. In particular, the mediating hierarchy created when a corporation is formed has the purpose and effect of insulating corporate directors from the direct command and control of any of the groups that comprise the corporate team, including its shareholders. While this legal structure may increase agency costs, it may also provide an efficient (albeit second-best) solution to the contracting problems that arise in team production. Blair,...
Posted on: Fri, 28 Nov 2014 04:34:51 +0000
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