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