The current law and economics framework of corporate law rests on four theoretical underpinnings that restrict students’ and regulators’ understanding of the stakes of corporate law. In new research, Mariana Pargendler argues that creating corporate laws that are more attuned to social welfare will require deprogramming its dominant framework.
What does corporate law have to do with corporate power, inequality, and social harm? Generally, business and law schools teach that the answer is nothing. This disregard for how business organizations—some richer and more powerful than many American states—interact with society beyond the provision of goods and services is a remarkable feat. My recent essay, “Deprogramming Corporations,” examines how the law and economics framework narrows corporate law’s subject matter and obscure issues of externalities, inequality, corporate power, and geopolitics. Prevailing forms of thinking in the field (“programming”) narrow the field’s scope in ways that misdescribe real-world developments and foreclose contestation over values and economic and political priorities. Deprogramming surfaces the unasked questions that this law and economics programming hides and, to an extent, produces.
The snap-fit kit
Programming narrows the study of corporate law through four key theoretical moves. The first is what I term the “modular approach” to law and economics. In this view, each area of law contributes to welfare by pursuing a single objective and training lawyers to focus on how the law impacts this one objective. Tort law minimizes the costs of accidents, antitrust promotes consumer welfare, and corporate law protects shareholders by reducing agency costs: the welfare loss when company management prioritizes their interests over those of shareholders. In the case of corporate law, questions of externalities like pollution and distribution fall outside its scope because there is another area of law for that. Environmental concerns are assigned to environmental law, worker protection to labor and employment law, systemic risk to financial regulation, and distribution to the tax-and-transfer system.
This specialization is a historical artifact rather than a natural division of labor. Corporate law itself once performed significant antitrust functions. The reason is that these concerns are not fully separable, or nearly decomposable, to use Herbert Simon’s terminology. Although modularity has limitations across different legal fields, in corporate law the difficulties run deeper. Corporate law is exceptional among legal fields because it structures the exercise of corporate power or, in the language of economics, the residual control rights that inevitably remain after contractual and regulatory obligations have been exhausted. Because transaction costs and bounded rationality prevent both contracts and regulation from anticipating every future contingency, both are necessarily incomplete. Corporate law therefore governs the exercise of power in ways that cannot be easily addressed by other bodies of law.
The second move is conception of the corporation as a contract between shareholders and managers, and the related conception of the corporation as a nexus of contracts. While there is something to this view, it is but a partial picture. Where is the state and the panoply of regulatory and tax obligations? Where are the stakeholders that lack a contractual relationship with the corporation, such as the victims of environmental disasters? They are out of sight and out of mind, relegated to another area of law or another course in the curriculum. As Frank Easterbrook and Daniel Fischel put it, because the choices do not generally impose costs on strangers to the contracts, what is optimal for the firm is optimal for society. Yet the absence of third-party effects is assumed rather than demonstrated, and once assumed it forecloses the question whether corporate law could help address the costs that corporate activity routinely generates.
The third move is the concept of “agency problem” as the sole focus of corporate law. The terms agency problem and agency costs, coined by Michael Jensen and William Meckling in 1976, embed in their own terminology the conclusion that managers are agents of shareholders and that the problem of managerial power is limited to losses suffered by shareholders. The terminology is in fact legally incorrect, since directors are not agents of shareholders, or even of the corporation. Unlike a true agent, the board of directors is not subject to the control of the principals (shareholders) and holds authority in its own right. The label, however, does the work of leaving broader stakeholders out of the picture. To be sure, the problem of corporate managers mismanaging other people’s money—a concern recognized since Adam Smith—is very much real. The trouble is not that agency theory identifies a nonexistent problem, but that it prevents us from seeing other important problems that also deserve attention.
The fourth move is corporate law as a market product. As described by Roberta Romano, state competition is “the genius of American corporate law,” with corporate law best understood as a product that states sell and refine for willing buyers. Tiny states that gain the most from franchise taxes, and that have the fewest stakeholders of their own, hold the advantage in the charter market. The absence of stakeholders in the state is then sold as a virtue, since stakeholder demands, or politics, cannot impinge on shareholders’ interests. To be sure, the choice of the state of incorporation also determines taxation, regulatory obligations, and general jurisdiction—international tax havens selling charters deprive states of funds needed for democratic governance—yet all of this is kept out of the picture.
Modularity, the contract view, agency costs, and corporate law as product form a snap-fit kit, distinct pieces designed to click together into a highly portable account of corporate law that keeps broader social issues firmly off the agenda.
Theories as broader political projects
The law and economics framework of corporate law did not emerge as a purely technocratic initiative to understand the law and its economic effects. Jensen and Meckling’s seminal article, which also introduced the idea of the corporation as a nexus of contracts, was a self-conscious effort to rebut the calls for corporate social responsibility that occurred in the 1960s and 1970s. Jensen’s and Mecklings’ contemporaneous writings reveal a broader warning that emerging regulation threatened the very existence of the business corporation and show how they viewed markets and democracy as incompatible. They unambiguously favored markets.
The account by Henry Manne, a prominent figure in law and economics, of the market for corporate control is another case in point. He is famous for arguing that hostile takeovers provide a market solution to agency costs: poor managerial performance depresses share prices and invites hostile bids, which gives management teams an incentive to perform well. What is less recalled is that his principal objective was actually antimodular by using corporate law to address goals of antitrust. Specifically, he aimed to legitimate mergers between competitors, rescuing them from antitrust suspicion by recasting them as mechanisms of managerial discipline. Manne’s scholarship in itself reveals the antimodular nature of real-world economics. The law and economics movement has seemed to only recognize this when it serves its principle of narrowing regulation.
Blinders that persist despite economic analysis
Not every act of legal programming traces back to law and economics. The legal doctrines of limited liability and corporate separateness—that a corporation is separate from its shareholders, directors, and parent company—persists in strong form despite strong critiques by law and economics scholars. Because shareholders capture the upside of corporate risk-taking but are not responsible for the social harm the firm causes, limited liability arguably makes the corporation an externalizing machine as tort victims and workers bear the costs of the corporation’s failures.
The critique is relatively mainstream. Henry Hansmann and Reiner Kraakman, the same scholars who announced that the shareholder value model represented the “end of history for corporate law,” advocated unlimited shareholder liability for corporate torts. Yet, corporate separateness is taught as though it were hard or impossible to change, and that absolutism is then used as cover against reform. John Ruggie, as the U.N. Special Representative on Business and Human Rights, abandoned early proposals for parent-company liability on the ground that the abandonment of the foundational tenets of modern corporate law was not on the agenda. Nevertheless, those tenets are contested and riddled with exceptions, which are however absent from the dominant accounts. For example, New York has long imposed liability on a company’s ten largest shareholders for unpaid wages. Labor and employment law overcome corporate separateness under far more flexible standards than the demanding veil piercing test. And corporate law itself quietly sets separateness aside when the goal is to protect shareholders rather than to expose them.
Frequently unasked questions
Deprogramming shifts attention back to the overlooked social and political functions of longstanding corporate law mechanisms. Consider related-party transactions. When a controlling shareholder engages in abusive self-dealing, the harm is not limited to minority investors. Such expropriation is usually economically regressive, further concentrates wealth and political power, and may increase systemic risk. And in Tornetta v. Musk, the case that invalidated and then saw reinstated Musk’s compensation package worth tens of billions of dollars in Tesla, the implications for concentrated wealth and power could not be more obvious. To the extent this kind of concentration is socially concerning, and is built through corporate governance, is it really the case that corporate law has no role to play? The programming mantra that corporate law may never help address concerns about stakeholders, corporate power, and inequality is inadequate and must go.
Deprogramming
Deprogramming is hard, and the honest problem is which interventions would actually help, even if none is fully transformative on its own. Corporate law has many functions that produces social spillovers. Its doctrines shape not only intra-firm governance but broader patterns of accountability, distribution, and corporate power. Deprogramming, in this sense, requires not only examining potential institutional transformation but also a fuller reckoning with the social and political consequences of the tools already at hand.
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Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
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