Corporation As Nexus of Contracts: A Critique

by Soumik Chakraborty

Editor’s Note: The notion of a legally sanctioned corporation remains controversial for several reasons, most of which stem from the granting of corporations both limited liability on the part of its members and the status and rights of a legal person. The nexus of contracts theory is an idea put forth by a number of economists and legal commentators which asserts that corporations are nothing more than a collection of contracts between different parties – primarily shareholders, directors, employees, suppliers, and customers

INTRODUCTION:

In a general sense, a corporation is a business entity that is given many of the same legal rights as an actual person. Corporations may be made up of a single person or a group of people, known as sole corporations or aggregate corporations, respectively.

Corporations exist as virtual or fictitious persons, granting a limited protection to the actual people involved in the business of the corporation. This limitation of liability is one of the many advantages to incorporation, and is a major draw for smaller businesses to incorporate; particularly those involved in highly litigated trade.

A corporation may issue stock, either private or public, or may be classified as a non-stock corporation. If stock is issued, the corporation will usually be governed by its shareholders, either directly or indirectly. The most common model is a board of directors which makes all major decisions for the corporation, in theory serving the best interests of the individual shareholders.

NEXUS OF CONTRACTS THEORY:

The nexus of contracts theory is an idea put forth by a number of economists and legal commentators which asserts that corporations are nothing more than a collection of contracts between different parties – primarily shareholders, directors, employees, suppliers, and customers. Proponents of this theory contend that all disputes about the obligations of a particular corporation should be settled by resort to the methods used to interpret contracts, and that courts should not imply the existence of fiduciary duties on behalf of corporate officers and directors.

Edward, First Baron Thurlow, put it best: “Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and nobody to be kicked?” The corporation is simply a nexus of contracts between factors of production. How do we square the constitutional legal fiction of corporate personhood with that reality?

Although the corporation’s legal personality obviously is a fiction, it is a very useful one. Consider a large forestry company, owning forest land in many states. If the company were required to list all of its owners—i.e., every shareholder—on every deed recorded in every county in which it owned property, and also had to amend those filings every time a shareholder sold stock, there would be an intolerable burden not only on the firm but also on government agencies that deal with the firm. Hence, for example, it is useful for the law to allow the corporation to sue and be sued in its own name and to own and deal in property in its own name.

Likewise, the corporation’s legal personhood is a useful fiction in constitutional law. Government regulation of corporations obviously impacts the people for whose relationships the corporate serves as a nexus. It’s useful to allow the corporation to provide those persons with a single voice when seeking constitutional protections.

Indeed, doing so is not just useful, it is necessary to protect the rights of the parties to those various contracts. As Larry Ribstein explains in Corporate Political Speech, 49 Wash. & Lee L. Rev. 109, because “a corporation is a nexus of contracts, these contract rights should be constitutionally protected to the same extent as other contract rights. Thus, the state must show why intervention in the corporate contract is constitutionally justified given the availability of self-protection through private contracting.” He continues:

The Court must begin to base its decisions on well-developed modern economic theory rather than on unsupported assertions about corporations and the political process. It is particularly important to understand that any regulation of corporate speech or of the electoral process can have far-reaching consequences in terms of both the costs of governing the firm and the deadweight costs of effecting wealth transfers among interest groups. Until the Court understands these consequences, its decisions may be the proverbial bull in the china shop, particularly as pressure builds for more extensive reform of campaign financing and of corporate political activity.

JENSEN AND MECKLING THEORY:

Prof. Jensen has played an important role in the academic discussion of the capital asset pricing model, of stock options policy, and of corporate governance, developing a method of measuring fund manager performance, the so-called Jensen’s alpha.

Jensen’s best-known work is the 1976 paper he co-authored with William H. Meckling, “Theory of the firm: Managerial behaviour, agency costs and ownership structure,” one of the most widely-cited economics papers of the last 30 years. Besides reigniting interest in the theory of the public corporation as an owner-less entity made up of only contractual relationships, a field pioneered by Ronald Coase, the paper laid the foundation for the widespread use of stock options as executive compensation tools.

Jensen and Meckling defined an agency relationship as:

” …a contract relationship which one or more persons (the principal) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal.”

Notice that the assumption “utility maximizers” is used instead of “profit maximizers”. This assumption is to highlight the fact that individuals not only try to increase monetary profits (pecuniary activities) but also undertake non-monetary (non- pecuniary) activities that will increase utility (satisfaction), such as taking more coffee breaks during office hours.

Utility can also be increased by simply not undertaking certain activities that require effort, or activities that cause “disutility” like undertaking and managing riskier projects to increase profitability or working harder and smarter to increase efficiency.

To be comfortable on increasing the value, the principal will impose activities that reduce the amount of expropriation that is available to the agent. These activities are known as monitoring activities. Activities like appointing an auditor to check financial accounts, committing managers to pay high dividends (e.g. 50% of profits), and transferring certain powers to the new shareholders, are monitoring activities. Such activities are not free and the company often bears the cost of such activities.

A Brief discussion on the various aspects of the Theory are given below

  • AgencyCosts

Jensen and Meckling (1976) define the agency relationship as a contract under which one party  (the  principal)  engages another  party  (the  agent)  to  perform  some  service  on  their behalf. As part of this,  the  principal  will  delegate  some  decision-making authority to the agent.

These  agency  problems  arise  because  of  the  impossibility  of  perfectly  contracting for every  possible action of an agent whose decisions affect both his own welfare and the welfare  of  the  principal. Arising from this problem is how to induce the agent to act in the best interests of the principal.

Managers  bear  the  entire  cost  of  failing  to  pursue  their  own  goals,  but  capture only a  fraction of the benefits. Jensen and Meckling (1976) argue that this inefficiency is reduced as managerial incentives to take value maximising decisions are increased.

As  with  any  other  costs,  agency  problems  will  be  captured  by  financial  markets and reflected  in a company’s share price.   Agency costs are can be seen as the value loss to  shareholders,  arising  from  divergences  of  interests  between  shareholders  and  corporate managers. Jensen  and  Meckling  (1976)  defined  agency  costs  as  the  sum  of  monitoring costs, bonding costs, and residual loss.

  • (i) Monitoring Costs

Monitoring  costs  are  expenditures  paid  by  the  principal  to  measure,  observe  and  control an agent’s behaviour.  They may include the cost of audits, writing executive compensation contracts and ultimately the cost of firing managers. Initially  these  costs are paid  by  the  principal,  but  Fama  and Jensen  (1983)  argue  that  they  will  ultimately  be borne by an agent as their compensation will be adjusted to cover these costs. Certain aspects of monitoring may also be imposed by legislative practices.

  • (ii) Bonding Costs

Given that agents ultimately bear monitoring costs, they are likely to set up structures that will  see  them  act  in  shareholder’s  best  interests,  or  compensate  them  accordingly  if  they don’t. The  cost  of  establishing  and  adhering  to  these  systems  are  known  as  bonding costs. They are borne by the agent, but are not always financial. They may include the cost of additional information   disclosures to shareholders, but management will obviously have the benefit of preparing these themselves. Agents  will  stop  incurring bonding  costs  when  the  marginal  reduction  in  monitoring  equals  the  marginal  increase  in bonding costs.

  • (iii) Residual Loss

Despite monitoring and bonding, the interest   of managers and shareholders are still unlikely to be fully aligned. Therefore, there are still agency losses arising from conflicts of interest. These are known as residual loss.

They arise because the cost of fully enforcing principal-agent contracts would far outweigh the benefits derived from doing so. Since managerial actions are unobservable ex ante, to fully contract for every state of nature is impractical.      The result of this is an optimal level or residual loss, which may represent a trade-off between overly constraining management and enforcing   contractual mechanisms designed to reduce agency problems.

  • Where Agency Conflicts Arise

Agency problems arise from conflicts of interest between two parties to a contract, and as such, are almost limitless in nature. However, both theoretical and empirical research has developed in four key problematic areas – moral hazard, earnings retention, risk aversion, and time-horizon.

  • (i) Moral Hazard Agency Conflicts

Jensen and Meckling(1976) first proposed a moral-hazard explanation of agency conflicts.Assuming  a  situation where a single manager owns the firm, they develop  a model  whereby  his   incentive  to  consume  private  perquisites,   rather  than  investing  in positive  net  present  value (NPV)projects, increases as his ownership stake in thecompany declines.

This   framework   is easily   applied   in companies   where   ownership structure  is diverse   and   the   majority   of   the   company’s   shares   are   not   controlled   by   corporate managers. Moral-hazard problems are likely to be more paramount in larger companies,

Jensen  in 1993 said that while  larger  firms  attract  more  external  monitoring,  increasing  firm  size expands  the  complexity  of  the  firm’s  contracting  nexus  exponentially. This will have the effect of increasing the difficulty of monitoring, and therefore, increase these costs.

Furthermore,  Jensen  (1986)  argues  that  in  larger,  more mature,  companies,  free  cash flow  problems  will  heighten  the  difficulties  created  by  moral  hazard. Where  managers have  such  funds  at  their  disposal,  without  any  strong  requirements  for  investment,  the scope  for  private  perquisite  consumption  is  vastly  increased,  as  it  becomes  more  difficult to monitor how corporate funds are utilised.

Moral-hazard problems are also related to a lack of managerial effort. Asmanagers  own  smaller  equity  stakes  in  their  companies,  their  incentive  to  work  may diminish.

(b)(ii) Earnings Retention Agency conflicts

Brennan  (1995b)  contends  that  moral  hazard  based  theories  over-simplify  the  agency problem  as  one  of  effort  aversion. Grandiose managerial visions and cash distribution to shareholders may be of more concern. Here, the problem of over-investing may be more paramount than that of perquisite consumption and under-investment.

Studies  of  compensation  structure  have  generally  found  that  director  remuneration is  an  increasing  function  of  company  size,   providing  management  with  a  direct  incentive to focus on size  growth, rather than growth in shareholder returns. Jensen furthers this,  arguing  that  managers  prefer  to  retain  earnings,  whereas  shareholders  prefer  higher levels  of  cash  distributions,  especially  where  the  company  has  few  internal  positive  NPV investment opportunities.

Managers  benefit  from  retained  earnings  as  size  growth  grants  a  larger  power base,  greater  prestige,  and  an  ability  to dominate  the board  and award  themselves  higher levels  of  remuneration,  Jensen.  This  reduces  the  amount  of  firm  specific risk   within  the  company,  and  therefore,  strengthens  executive  job  security.   However, finance theory dictates that investors will already hold diversified portfolios. Therefore, further corporate diversification may be incompatible with their interests.

Empirical   evidence   suggests   that   such   a   strategy   is   ultimately   damaging   to shareholder   wealth.             Lang   and   Stulz   (1994)   find   that   returns   to   shareholders   in undiversified firms are greater than for those who had attempted to reduce their exposure to  risk  through  this  diversification. Also,  they  found  that  the  value  of  these  firms  is reduced as they diversified further.

Such  earnings  retentions  reduce  the  need  for  outside  financing  when  managers require funds for investment projects.           However, despite the potential costs of raising new capital,    external markets provide a useful monitoring function in constraining grandiose managerial   investment   policies.

(b) (iii) Time Horizon Agency Conflicts

Conflicts  of  interest  may  also  arise between  shareholders  and  managers  with  respect  to the timing of  cash flows. Shareholders will be concerned with all future cash flows of the company into the indefinite future. However,  management  may  only  be  concerned  with company  cash  flows  for  their  term  of  employment,  leading  to  a  bias  in  favour  of  short- term high accounting returns projects at the expense of long-term positive NPV projects. The   extent   of   this   problem   is   heightened   as   top   executives   approach   their retirement.

Such   a   problem   may   also   lead   to   management   using   subjective   accounting practices  to  manipulate  earnings  prior  to  leaving  their  office  in  an  attempt  to  maximise performance-based   bonuses,   Healy   (1985). Weisbach  (1988) finds   that   accounting earnings  tend  to  be  significantly  higher  in  the  year  prior  to  a  Chief  Executive  Officer (CEO)   leaving   their  position,  and  attributes  such  findings  to  the  problem  of  earnings manipulations.

(b)  (iv)  Managerial Risk Aversion Agency Conflicts

Conflicts  relating  to  managerial  risk  aversion  arise  because  of  portfolio  diversification constraints  with  respect  to  managerial  income. Should  private  investors  wish  to  diversify their  holdings they  can do so at little  cost  with. However company managers are more akin  to  individuals  holdings  a  single,  or  very  small  number  of  stocks.

The  majority of  a  company  director’s  human  capital  is  tied  to  the  firm  they work for,  and  therefore,  their  income  is  largely  dependent  upon  the  performance  of  their company.  As  such,  they   may  seek  to  minimise  the  risk  of  their  company’s  stock. Therefore,  they  may  seek  to  avoid  investment  decisions  which  increase  the  risk  of  their company, and pursue diversifying investments which will reduce risk.

This   problem   may   be   heightened   when   executive   compensation   is   composed largely  of  a  fixed  salary,  or  where  their  specific  skills  are  difficult  to  transfer  from  one company  to  another. In  addition,  risk  increasing  investment  decisions  may  also  increase the  likelihood  of  bankruptcy. Such a corporate event will severely damage a manager’s reputation, making it difficult to find alternative employment.

  • Control on Agency Problems

Despite  the  existence  of  the  problems  discussed  above,  the  modern  corporation,  with  the diffused  share  ownership  which  leads  to  such  conflicts,  has  continued  to  popular  amongst both  corporate  managers  and  outside  investors  alike. This could be attributed  largely  to the  evolution  of  internal  and  external  monitoring  devices  which  are  aimed  at  controlling such  problems. These devices broadly are

(c)  (i)  The Managerial Labour Market

Fama  (1980)  argues  that  corporate  managers  will  be compensated  in accordance  with  the market’s   estimation  of  how  well  they  are  aligned  to  shareholder’s  interests,  based  on prior performance with other companies.

Three  conditions  are  given  for  the  managerial  labour  market  to  operate  efficiently  in setting   executive  compensation. Firstly,  the  manager’s  talents  and  tastes  for  private consumption  on  the  job  aren’t  known  with  certainty,  are  likely  to  change  through  time and  can  be determined  by  the  managerial  labour  market  from  information  on  past  and present performance.

The  second  condition  is  that  the  managerial  labour  market  can  efficiently  process information  into  its  valuation  of  management. However,  information  gathering  costs  will likely   result  in  an  equilibrium  level  in  markets,  where  different  parties  hold  different amounts of information.

Finally,   argues  that  the  weight  of  the  wage  revision  process  must  be sufficient to  resolve  any problems  with managerial  incentives.

It may be argued that due to the imperfect condition of the labour market there are several limitations of the above theory. Despite  its  limitations,  the  market  for  managerial  labor  can be an important factor in reducing  the agency costs of the separation of share ownership and decision control in corporate  forms.           Where  it  is  efficient  in  disciplining  managers  for  decisions  not  in  the best  interests  of  company   shareholders,   it  provides   a  useful  incentive  in  encouraging management to take decisions in the shareholder’s best interests.

(c)  (ii) Corporate Boards

In  theory,  the  board  of  directors  is  directly  elected  by  shareholders  at  the  company’s annual general  meeting  (AGM). If these directors wish to stay in their jobs they should take decisions which maximise the wealth of their shareholders.

Fama  and  Jensen  (1983)  argued  that  effective  corporate  boards  would   be  composed largely  of  outside  independent  directors  holding  managerial  positions  in  other  companies. They  argued  that  effective  boards  had  to  separate  the  problems  of  decision  management and decision control. However, if  the CEO was able to dominate the board, separation of these  functions  would  be  more  difficult,  and   shareholders   would  suffer  as  a  result. Outside directors, they contend, are able to separate these  functions and exercise decision control,  since  reputational  concerns,  and  perhaps  any  equity  stakes,  provide  them  with sufficient incentive to do so.

Corporate   boards   should   act   as   monitors   in   disagreements   amongst   internal managers   and   carry   out   tasks   involving   serious   agency   problems,   such   as   setting executive   compensation   and   hiring   and   firing   managers. Effective corporate governance by company  boards  requires  both  good  information   and the will to act on negative information.

Agrawal  and  Knoeber  (1996)  examine  a  range  of  governance  variables  within  a simultaneous  regressions  framework  and  find  that  the  proportion  of  outside  directors  on company  boards  is  the  only  governance  mechanism  which  consistently  affects  corporate value.

(c) (iii) Corporate Financial Policy

The  financial  structure  and  policy  of  companies  may  also  have  strong  implications  for agency  controls.

Jensen  and  Meckling  (1976)  argue  that  the  existence  of  debt  reduces  the  amount  of equity, and  enables higher levels of insider ownership.     Jensen (1986) also argues that the existence of debt in the firm’s capital structure acts as a bonding mechanism for company managers. By issuing debt, rather than paying dividends, managers contractually bind themselves to pay out future cash flows in a way unachievable through dividends.

During the intervening period of development of the Theory in 1976 till date a plethora of literature has been developed why such problems  arise within  the ‘nexus  of contracts’ that Jensen   and   Meckling   describe   as   characterising   the   modern   corporation   and   how managers  and  shareholders  may  act  to  control  these  costs  to  maximise  firm  value and also covers areas  where  manager’s  interests  are  likely  to  diverge  from those of  the  shareholders  who  employ  them  and also means by  which  such  conflicts  can  be  resolved.

Easterbrook   (1984)   argues   that   external   capital   market   monitoring   brought   to companies  by  debt  financing  forces  managers  in  value  maximising  strategies,  rather  than personal utility maximisation.

The   bankruptcy   costs   of   debt   and   the   personal   embarrassment   arising   from bankruptcy  act  as  effective  incentive  mechanisms  in  encouraging  managers  to  be  more efficient.    This   function   is   particularly   important   in   firms   with   low   internal   growth prospects and high free cash flows.

Paying  dividends  also  reduces  the  agency  costs  of  free  cash  flow.     However,  they  don’t carry  the  same  legally  binding  obligation  to  make  payments  as  debt,  making  them  a  less efficient  means  of  forcing  managers  to  pay  out  cash-flows,  Jensen  (1986).

Franks found  that  equity  issues  by  financially  distressed  companies provide  the   most  significant  means  of  disciplining  management

(c)(iv) Block Holders & Institutional Investors

Ordinary  atomistic  shareholders  may  not  have  the  time,  skill,  or  the  interest  to  monitor managerial  activities. Since they own a small portion of the total shares, there may be a free-rider  problem,  whereby  it  is  not  in  their  best  interests  to  monitor  management  while others  will  also  derive  the  benefits  from  this. The  existence  of  large  block  investor(s) may   overcome  this  problem,  as  they  may  have  more  skill,  more  time,  and  a  greater financial incentive to overcome this free-rider problem and closely monitor management.

In   addition,   such   large   shareholders   may   be   able   to   elect   themselves   onto company boards, increasing their ability to monitor management.  CEO’s may also tend to voluntarily   disclose   information to blockholders to reduce monitoring costs.

Denis,  Denis  and  Sarin  (1997)  contend  that  internal  governance  mechanisms  such as  company  boards  may  act  more  efficiently  in  the  presence  of  information  provided  by external  control  markets. The  purchase   of  large  share  stakes  by  outside  investors represents  such  a  control  threat  to  company  management  and  can  provide  pressure  for internal governance systems to operate more efficiently.

Blockholder pressure may also deter management from        non-value adding diversification strategies. Since such investors already hold diversified portfolios, further risk-reductions aren’t of interest to them.

  • The Market for Corporate Control

Takeovers  may  occur  in  relation  to  the  earnings  retention  conflict  between  shareholders and  management. Jensen  (1986)  argues  that  takeovers  occur  in  response  to  breakdowns of  internal  control  systems  in  firms  with  substantial  free  cash  flows  and  organisational policies  which  are  wasting  resources. In short, where management are using resources inefficiently. The  market  for  corporate  control  can therefore  serve  to transfer  control  of the firm’s assets to more efficient managers.

  • Managerial Remuneration

The  structure  of  executive  compensation  contracts  can  have  a  large  influence  in  aligning the  interest  of  shareholders  and  management. Compensation  contracts,  and  their  revision, represent  a  financial  incentive  for  management  to  increase  company  value. Higher levels of  such  incentives  should  ultimately  lead  to  higher  company  performance,  Jensen  and Meckling (1976).

Compensation generally takes four forms: basic salary, accounting-based performance   bonuses,   executive   stock   option   schemes   and   long-term   incentive   plans (LTIP’s).   Baker, Jensen and Murphy (1988) argue that the level of pay determines where managers  work,  but  the  structure  of  the  compensation  contract  determines  how  hard  they work. Effective   compensation   contracts   should   provide   management   with   sufficient incentive to make value maximising decisions at the lowest possible cost to shareholders.

  • Managerial Ownership

The final method of reducing agency conflicts to be discussed in this paper is managerial share ownership. Jensen and Meckling  (1976) argued that as ownership of the company by inside  managers increases, so to does their incentive to invest in positive NPV projects and reduce private perquisite consumption.

CONCLUSION:

The  above discussion  provides  some  insights  into  the  ‘nexus  of  contacts’ which  Jensen  and  Meckling  (1976)  originally  discuss  as  their  basis  for  a  theory  of  the firm.           It  can  be  seen  that  very  few  strong  conclusions  upon  the  importance  of  each conflict, and mechanisms for resolving these, has truly been determined.

The arguments of Kole (1995) and Himmelberg et al (1999) perhaps summarise this research most conclusively.  They argue that such agency conflicts are heterogeneous across different firms in different industries, and most likely different cultures. Himmelberg et al.  refer  to  differing  firms  with  different  contracting  environments,  which refreshes  an  important  point  from  Jensen  and  Meckling’s  (1976)  original  theory,  that  no two firms will have the same ‘nexus of contracts.’

The scope of each type of agency conflict will differ from one firm to another, as will the effectiveness of governance mechanisms in reducing them. As has been proved, and then often questioned again, each type of governance mechanism can be important in reducing the  agency costs of the separation of ownership and control. What is required is a more detailed understanding of what makes these mechanisms important for some firms and ineffective for others.

The notion of a legally sanctioned corporation remains controversial for several reasons, most of which stem from the granting of corporations both limited liability on the part of its members and the status and rights of a legal person. Some opponents to this granting of “personhood” to an organization with no personal liability contend that it creates a legal entity with the extensive financial resources to co-opt public policy and exploit resources and populations without any moral or legal responsibility to encourage restraint.

Edited by Saksham Dwivedi

  1. Company Law, Fifteenth Edition by Avtar Singh
  2. Theory of Firm: Managerial Behaviour, Agency Costs and Ownership Structure by Michael C Jensen and William H Meckling
  3. A Nexus of Contracts Theory of Legal Entities by Kenneth Ayotte and Harry Hansmann
  4. Agency Theory and Corporate Governance: A Review of Literature from UK Perspective by Patrick McColgan
  5. Joint Ventures and Mergers and Acquisitions in India: Legal and Tax Aspects by Seth Dua and Associates.

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