The Post-revolutionary Period in Corporate Law: Returning to the Theory of the Firm

Publication year2012
CitationVol. 35 No. 04


The Post-Revolutionary Period in Corporate Law: Returning to the Theory of the Firm

Matthew T. Bodie(fn*)

I. Introduction

Corporate law academia has an established story about the transformation of the field-a revolution, in fact-that took place in the 1970s and 1980s. According to the traditional narrative, what was once a swampy doctrinal backwater became a vibrant hub of intellectual activity through the new methodology of law and economics.(fn1) Economic theory introduced such concepts as agency costs, the market for corporate control, and shareholder primacy-concepts that in turn became the dominant framework for the corporate law and theory of today. Some scholars have characterized this revolution as the "end of history" of corporate law: namely, an international consensus on the corporation's basic structure and principles.(fn2)

The consensus on corporate law theory has narrowed the field's doctrinal and methodological foci. Although the vibrancy of shareholder primacy has at times been called into question as a matter of law,(fn3) both boardrooms and courts have taken the normative call for shareholder wealth maximization increasingly to heart. There is little doubt that the revolution has not only substantially affected legal theory but also legislation,(fn4) court decisions,(fn5) and corporate behavior.(fn6) It achieved a level of success unusual for an academic discipline; it not only transformed the field but also the world.

We now find ourselves in the post-revolutionary period. For some academics, it is time to refine the revolutionary principles and attend to the subsidiary issues that are left to be worked out.(fn7) But for me, it is time to look forward to the next revolution. This Essay argues that corporate law academics should look to the economic literature on the theory of the firm in taking those next steps. The fundamental question about corporate law is not how to manage the relationships between shareholders, directors, and executives; instead, it is why we have created and sustained corporations in the first place. In going back to basic principles, we need to ask ourselves the following question: Why do we have firms, rather than markets? And how do corporations serve our needs for firms? Can the model be improved? Are there other models to consider?

Fortunately, we have a robust existing literature seeking to answer at least some of these questions. The question of firms versus markets was famously posed by Ronald Coase in The Nature of the Firm,(fn8) and the economic literature on the theory of the firm has grown (in fits and starts) over time to flesh out his work. Although the law and economics revolution gave lip service to this literature, in fact, it has largely been marginalized.(fn9) It is time to begin incorporating this body of research more directly into corporate law, and to start a new revolution that reex-amines many of the basic principles of the earlier law and economics upheaval.

Part II of this Essay explores the law and economics revolution and discusses the different levels of attention to the finance and theory of the firm literatures. Part III sets out the basics of the theory of the firm literature. Part IV discusses how several significant strands of corporate law scholarship have already incorporated the theory of the firm literature.

Finally, Part V explores two potential avenues for inquiry and connection moving forward: the role of employees in corporate law, and connections with business and organizational theory academics.

II. The Lopsided Law and Economics Revolution in Corporate Law Scholarship

Sadly, it is unusual for academics to offer stand-alone chronicles of the changes within their field.(fn10) Roberta Romano's After the Revolution in Corporate Law,(fn11) on the other hand, takes up this task with zest and incisiveness. Her article opens: Corporate law is a field that underwent as thorough a revolution in the 1980s as can be imagined, in scholarship and practice, methodology and organization. The term "revolution" is invoked all too often in popular culture, but as this article will suggest, it is entirely apt in this case. The revolution in corporate law has been so thorough and profound that those working in the field today would have considerable difficulty recognizing what it was twenty-five to thirty years ago.(fn12)

Much of Romano's history is familiar rhetorical ground: the "ossified, stagnant" state of corporate law in the 1960s;(fn13) the early work of pioneers such as Henry Manne(fn14) and Ralph Winter;(fn15) and the wave of law and economics scholarship that transformed the field in the 1980s. Rather than a simple string of successive cites, however, her article seeks to single out the specific aspects of the revolution that were critical to its success. She identifies three distinct "strands" to this transformation: modern finance theory, work on the theory of the firm, and the boom in hostile takeovers in the 1980s. The first strand imported concepts such as the efficient capital market and the capital asset pricing model (CAPM) into business law theory and doctrine.(fn16) The second strand introduced transaction cost economics and agency costs theory to corporate law, building on the earlier work of Berle and Means.(fn17) Finally, the relevance of these theories was demonstrated in practice when buyouts and other novel transaction techniques exploded across the business landscape. These three strands-finance, firm, and takeover mania-created the new law and economics approach to corporate law and theory.

Romano goes into significant detail on the role of modern finance theory in shaping the transformation. The portfolio theory of investment decision-making, irrelevance theories of firm capital structure and valuation, and CAPM provided the intellectual architecture for the notion that the corporation represented a somewhat fungible mass of investment signals.(fn18) And those signals were relatively straightforward to study. Romano notes that finance "differs from many other fields of economics because it has a decidedly empirical focus."(fn19) Through event studies, which measured the effect of certain "events" on share prices, scholars could study the efficiency of state governance statutes, federal legislation, and international regulatory regimes.(fn20) Thus, finance brought together a theory having a relatively straightforward normative agenda-namely, the overall maximization of share price-with a methodology for testing results against that agenda.

Romano also cites to the importance of the theory of the firm to the corporate law revolution but spends considerably less of her discussion on it. Romano discusses the advances in the economics of the firm and specifies two lines of research in this regard: transaction cost economics and agency cost theory.(fn21) Citing to Williamson for the former(fn22) and Jensen and Meckling for the latter,(fn23) Romano argues that these two developments had a "lasting impact on the thinking of corporate law academics."(fn24) She acknowledges that agency costs theory stemmed from Berle and Means's work on the separation of ownership and control, but argues that the theory was redeveloped from the corporate finance literature and was later "mathematicized and refined by economists."(fn25)

Although the theory of the firm research is important enough to Romano that she lists it as a coequal strand with finance theory, her program for the future better demonstrates her actual balance on the two subjects.(fn26) She suggests that aspiring corporate law professors would be better served by a background in finance than a background in economics. Graduate economics programs focus more on theory and formal modeling, while finance tends to use empirical tools. These empirical tools, argues Romano, were more likely to "facilitate the sorting out of theories" than would further research based on modeling.(fn27) Noting that empirical work depended on a consensus on the ends of a particular policy or regulatory scheme, she claims that most corporate law scholars agreed that the objective of publicly held corporations was to maximize the overall wealth of shareholders.(fn28) Given these ends, event studies could be employed to determine which policies increased share prices and thereby maximized shareholder wealth.

Finance has indeed become the most important outside discipline in the contemporary study of corporate law. Sophisticated number crunching of stock prices has become a critical-perhaps even the dominant- analytical tool for today's corporate law scholar.(fn29) Academics have employed event studies to address some of the thorniest issues in corporate law theory, such as the efficiency of state corporate law,(fn30) staggered boards,(fn31) federal securities and state derivative suit litigation,(fn32) independent directors,(fn33) and executive compensation.(fn34) Legislation such as the Sarbanes-Oxley Act(fn35) and the Dodd-Frank Act(fn36) has been judged based on its grounding (or lack thereof) in empirical research.(fn37) Even the courts have gotten into the act; the D.C. Circuit has referred to the empirical literature in addressing whether the SEC had demonstrated sufficient support for its independent mutual fund chairpersons and proxy-access rules.(fn38)

This growing use of empirical study of stock prices...

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