For decades, economists have offered competing theories of the firm. Such theories begin by answering one straightforward question: Why do firms exist? After all, everything that a firm does could also be done "by the market," through a contract of purchase and sale. (1) A lawyer can employ a secretary to type her briefs, or she can pay a typing service to do so. Why do individuals organize firms instead of conducting their activities through market contracting? Any answer to this question begs a related one, namely, once a firm is formed, what leads it to perform some activities internally, while relying on "the market" to complete others? (2) (A law firm can pay its employees to make 100 copies of a brief; it can also pay the copy service across the street to do so.) These questions have occupied the attention of many eminent economists, with seemingly fruitful results. (3)
A complete theory of the rim can do more than explain why individuals create rims and what those rims do; it can also help explain what type of firms people create. After all, individuals do not merely form rims: they create partnerships, sole proprietorships, and corporations, just to name a few. (Everything that a partnership does could also be clone by a corporation, and vice versa.) While a robust theory of the firm should explain why two lawyers might choose to form a firm, and why that firm might choose to make its own copies instead of relying upon independent contractors, it can also explain why the lawyers might choose to organize as a partnership instead of as a sole proprietorship or a corporation.
Economists and legal scholars have spent significant effort attempting to explain why individuals might choose one form of business organization over another. (4) In so doing, they have paid particular attention to the economics of the publicly held corporation. Thus, economists and legal scholars have sought economic explanations for various features of the public corporation that distinguish it from other forms of business organization. Why do the purported "owners" of public corporations delegate control over "their" property to managers who may have little or no financial stake in the enterprise? Why are courts so deferential to business decisions made by directors and managers of publicly held corporations who are (apparently) unaccountable as a practical matter to anyone? These and other questions have occupied scholars for some time now.
In the past two decades, a consensus of sorts has emerged about the economic function of the public corporation and the state laws that enable its formation. According to this dominant account, enterprises choose the corporate form over other types of business organization to realize the gains produced by the separation of ownership from control. (5) This separation enables a specialization of function: Shareholders supply capital and bear the risk that comes with their claim to the firm's residual product, and managers act as shareholders' agents, using their expertise to deploy the principals' capital in various ventures.
While the separation of ownership from control and the specialization it reflects can produce enormous benefits, it also comes with a potential cost. By placing their capital under the control of specialists, shareholders subject themselves to a unique risk of opportunism. Without any financial stake in the enterprise, managers and the directors who supervise them may shirk their duty to manage the corporation in the shareholders' interest. Thus, it is said, corporate law and the market mechanisms that support it have evolved to facilitate and preserve the specialization of function while at the same time reducing the "agency costs" that would otherwise accompany the separation of ownership from control. (6) This "principal-agent" account of the public corporation, in turn, implies a "shareholder primacy norm," i.e., a recognition that directors and managers do and should run the corporation so as to maximize the wealth of a single owner, namely, shareholders. (7) Because they hold an exclusive property right in the firm's residual, it is said, shareholders will internalize the costs and benefits of the firm's actions, operating, as they do, in a setting of relatively low transaction costs. (8)
Margaret Blair and Lynn Stout have offered a competing hypothesis about the nature and purposes of the public corporation. (9) As they see things, public corporations do not "belong" to shareholders in any meaningful sense, and directors are not properly viewed as shareholder agents. Instead, directors of public corporations are best regarded as "mediating hierarchs," who are accountable to no particular constituency of the firm. (10) According to Blair and Stout, the public corporation is best viewed as a team of shareholders, creditors, workers, managers, and communities. (11) Shareholders are not the only group that make investments that are specific to this "team": creditors, workers, managers, and communities also make investments that are most productive when employed in connection with the corporate enterprise. (12) Like shareholders, who face the risk of opportunism by managers, these other constituencies run the risk of exploitation by shareholders. As a result, it is said, these groups may be reluctant to place their human and financial capital under the control of managers and directors obligated under the shareholder primacy norm "ruthlessly [to] pursue shareholders' interests." (13) Thus, instead of overseeing managers with a view toward maximizing the wealth of shareholders, they say, directors do and should view themselves as "mediating hierarchs" who resolve competing claims to the collective residual produced by the firm's activities. (14)
By depriving shareholders of an exclusive property right in the team's residual, it is said, a mediating hierarch model of governance can empower firms to make credible commitments to refrain from opportunistic behavior directed at members of the team, thus lowering the cost of obtaining team-specific investment from shareholders, creditors, employees, and communities. (15) According to Blair and Stout, then, this mediating hierarch model of corporate governance can reduce the transaction costs associated with obtaining relationship-specific investments and is thus economically superior to the principal-agent model. (16) This analysis is confirmed, they say, by an examination of Delaware corporate law. More precisely, Blair and Stout assert that their mediating hierarch model provides a plausible account of numerous features of Delaware law that the principal-agent model purportedly cannot explain. (17) As a result, they conclude, the mediating hierarch model should replace the principal-agent model as the paradigm scholars employ to examine and evaluate public corporation law. (18)
Blair and Stout are not the only scholars who have argued that directors of public corporations do and should "mediate" between competing claims of a firm's stakeholders. In recent years, several critics of the principal-agent model have reached similar conclusions and concomitantly called for rejection of the shareholder primacy norm. (19) Unlike most of these scholars, however, Blair and Stout have relied solely and explicitly on the dictates of economic efficiency, eschewing noneconomic considerations such as "fairness," "social justice," and "communitarianism." (20) By refusing to invoke such amorphous concepts, the application of which necessarily varies from context to context, Blair and Stout have constructed a rigorous, internally coherent model with potentially universal application to any number of corporate law problems. (21) Indeed, as noted earlier, Blair and Stout believe that this paradigm provides a complete account of the rationale for public corporations and thus the rules of corporate law that enable their formation and regulate their activities. (22) Several scholars apparently agree, and Blair and Stout's thesis has already spawned a number of articles that employ the mediating hierarch model to examine a variety of corporate law problems. (23) It would therefore appear that Blair and Stout have mounted a credible challenge to the principal-agent model and with it the shareholder primacy norm.
This Essay offers a critique of Blair and Stout's "team production theory of corporate law" and a corresponding defense of the principal-agent model. As an initial matter, it should be noted that Blair and Stout's hypothesis is not the only "team production theory of corporate law." The principal-agent account itself depends upon the team production theory, resting, as it does, on an assumption that the corporation is a "nexus of contracts" among various factors of production. At any rate, Blair and Stout's modified version of the team production theory suffers from several conceptual weaknesses, shortcomings that undermine their assertion that a mediating hierarch model of corporate governance will produce significantly lower transaction costs than the single-owner approach and associated shareholder primacy norm.
Blair and Stout concede that states have not adopted a mediating hierarch approach where private firms like partnerships and closely held corporations are concerned. (24) At the same time, these authors have offered no evidence or argument that participants in publicly held enterprises are particularly vulnerable to opportunism. Relationship-specific investments and the concomitant potential for opportunism are endemic to economic life and are not confined to enterprises organized as public corporations. Indeed, certain attributes of public corporations afford participants in such ventures protections that render them less susceptible to some forms of opportunism than participants in private ventures, while at the same time leaving shareholders more vulnerable to such conduct. Thus, the transaction costs of...