Contractarianism and its discontents: reflections on unincorporated business organization law reform.

• Author: Callison, J. William

The law is often like a Slinky: there are two opposing poles, there is tension between the poles, and when one pole pushes out too far from the other, there is a tendency for the tension to pull the deviating pole back or to flip the opposite pole to the front. Similarly, United States business organization law, particularly as applied to partnerships and limited liability companies (LLCs), is a terrain of conflict in which different theoretical approaches strive for dominance. Unlike the laws of physics that control a Slinky, however, there is no state of nature that forces us to any given legal theory, but rather we choose which applies at any time and from time to time. (3)

1. THE POLARITY

   Before discussing United States partnership and LLC law reform over the last twenty years, we will use contemporary political theory and United States Supreme Court jurisprudence to illustrate one such polarity in American law. The polarity deals with concepts of liberty, the state, and the individual, and we believe it continues to undergird conversations about the nature of business entities and the role, if any, of government in regulating the economic relationships of persons who act together in a firm.

   The polarity of the state and the individual begins at the broadest levels of contemporary liberal political theories. At one pole, there are the Rawlsians, who embrace John Rawls's "difference principle" in which social and economic inequalities are just only if they benefit the least-advantaged members of society and which leads one toward an activist welfare-based state. (4) At the other pole are the heirs of Robert Nozick, who embrace Nozick's theory that a just distribution of goods results from the voluntary exchanges that transpire in a market society. (5) This Nozickian approach leads one toward a laissez-faire "night watchman" state that is limited to the function of protecting its citizens from violence, theft, and fraud and to the enforcement of contracts. Like a Slinky, the debate between Rawlsians and Nozickians is dynamic, with the two approaches alternatively seeming to trump each other.

   The United States Supreme Court has also grappled with the same polarity. For example, in the 1905 case of Lochner v. New York (6) the Court struck down as unconstitutional a New York law prohibiting the employment of bakery workers for more than ten hours per day or sixty hours per week. (7) The Court held that

   [t]he statute necessarily interferes with the right of contract between the employer and employes [sic] .... The general right to make a contract in relation to his business is part of the liberty of the individual protected by the 14th Amendment of the Federal Constitution.... The right to purchase or to sell labor is part of the liberty protected by this amendment.... (8) In reaching its decision, the Court framed the fundamental tension between the state and the individual:

   In every case that comes before this court, ... the question necessarily arises: Is this a fair, reasonable and appropriate exercise of the police power of the State, or is it an unreasonable, unnecessary and arbitrary interference with the right of the individual to his personal liberty or to enter into those contracts in relation to labor which may seem to him appropriate or necessary ...? (9) The court took the laissez-faire position that maximum-hour laws represented an unconstitutional assault on individual liberty. In other words, people should be given the liberty to contract to work as they see fit.

   This provoked Justice Holmes's famous dissenting retort that "[t]he Fourteenth Amendment does not enact Mr. Herbert Spencer's Social Statics." (10) Holmes was a pragmatist and did not believe that the law should lock into any particular political theory, but should instead retain the ability to slip and slide. (11) To Holmes, the law was indeed a Slinky and the common law was its best expression. (12) In his view, society's fixation on one particular theory leads to such events as the Civil War (in which Holmes fought and was severely wounded). Paraphrasing Lincoln at Gettysburg, Holmes remembered the lessons of that great Civil War.

   The so-called Lochner era lasted over thirty years, during which the Court invalidated numerous laws on due process grounds. (13) With the 1937 "switch in time," however, the opposite pole came to dominate: Lochner-style jurisprudence all but disappeared, and the Court became supportive of regulatory interference in the economy. (14) For example, in West Coast Hotel v. Parrish, (15) the case that began the "switch," the Court considered the legality of a Washington state minimum-wage law for women and minors. (16) In upholding the law--and directly overruling Adkins v. Children's Hospital, (17) which struck down such a law in 1923--the Court stated:

   [T]he violation alleged by those attacking minimum wage regulation for women is deprivation of freedom of contract.... The Constitution does not speak of freedom of contract. It speaks of liberty and prohibits the deprivation of liberty without due process of law.... The community may direct its lawmaking power to correct the abuse which springs from [employers'] selfish disregard of the public interest. (18) In the contest between unrestrained individual contractual freedom and contractual freedom constrained by public interest considerations, public interest carried the day and the United States economy has been highly regulated ever since. (19)

2. THE POLARITY AS EVIDENCED IN BUSINESS-ORGANIZATION LAW

   In 1976, Michael Jensen and William Meckling formulated the conception that the corporation is a "nexus of contracts." (20) Under this view, contractual relationships are the essence of the firm and "most organizations are simply legal fictions which serve as a nexus for a set of contracting relationships among individuals." (21) The firm is an aggregate of various inputs that produce an output of goods or services. Employees provide labor; suppliers provide goods and services; creditors provide debt financing; shareholders provide equity and monitor management's performance; and management serves a coordination role and monitors employees.

   All these inputs are bound together through contractual relationships. When particular parties do not enter specific contracts, the role of business organization law is, first, to recognize that transaction costs prevent all parties providing inputs from actually entering into contracts, and, second, to supply a set of "default" rules. (22) These default rules are conceived of as hypothetical bargaining rules into which rational contracting parties would most likely enter if they were to actually contract and from which parties that actually enter into contracts can deviate. For example, a simple default rule in the partnership context is that partners share equally in partnership profits. (23) This rule is rarely followed in practice, and partners often enter an express or implied agreement to share partnership profits on some other basis.

   In the public-corporation arena, transaction costs are particularly high (e.g., individual shareholders of General Motors cannot each bargain for terms), and legal rules generally substitute for private bargaining. Even in such a context, however, the contractarian believes the rules should represent hypothetical bargains. In close corporations, partnerships, and LLCs, contracting barriers are reduced, and in the contractarian view, the power of private bargaining increases. Thus LLC law in the United States has become the contractarian test case, and one frequently hears that the LLC is a "creature of contract," a contractarian dream entity where any deal can be structured among the parties. (24)

   Throughout the 1980s and 1990s and into the new millennium, the "nexus of contracts" conception has dominated the corporate law-and-economics academic literature, and because law-and-economics has developed a strong position in the United States academic hierarchy, "nexus of contracts" theory has had a strong following in the corporate-law arena. Such academic theories form part of the Zeitgeist that translates into judicial and practical perspectives. For example, in a recent article, the Delaware Supreme Court Chief Justice Myron Steele states that

   a critique of the Delaware courts' disposition of limited partnership and limited liability company governance disputes, through the lens of common law fiduciary duty rather than contractual analysis, will demonstrate that the latter is more efficient, more consistent with the parties' business judgment ... and fulfills any rational view about appropriate public policy. (25) Coming from the Chief Justice of America's leading corporate-law state, this is heady contractarian stuff.

   A critical issue raised by the contractarian view is how to approach rules of business organization law rules--specifically whether, and to what extent, there are mandatory rules or whether everything can be left to the parties' contract. A purely contractarian approach would conclude that everything can be left to contract and that it is only the presence of transaction costs that creates default rules. The contractarian also would argue, from a normative position, that this is how it should be; it is both economically efficient and just that individuals...