Faculty of law blogs / UNIVERSITY OF OXFORD

Corporations Are Not Firms


Jesús Alfaro Águila-Real


Time to read

8 Minutes

Deconstructing Bainbridge

Corporations and firms are not the same in any technical use of the terms. Corporations are separate patrimonies whose ultimate owners are the members of the corporation. A legal fiction owns this separate patrimony: a legal person. Private corporations are established through contracts (usually company contracts) or through an individual decision (as in the case of a foundation). Therefore, Corporate Law belongs to Property Law and to Contract Law. 

A firm is a combination of production factors (capital, land and labour) to produce goods and services to be exchanged in the market. The firm is not a legal concept. It is an economic one. Legally, firms are an agglomeration of contracts, since the relationships established among all the production factors’ owners are voluntary.

Still, confusion between corporations and firms abound (see, recently, Belinfanti/Stout – reviewed here; Bower/Paine – reviewed here; John Kay in this article; Colin Mayer in his book ‘Firm Commitment’, which I reviewed here and here; and ‘The Modern Corporation Statement on Company Law’, which I reviewed here) but Bainbridge’s is paradigmatic.

Bainbridge famously holds that American corporate law is based on the ‘directors’ primacy’ over shareholders: those who control the corporation are not the shareholders, but the directors. And, in his view, this is a fortunate feature of American law. He derives this primacy from the principle enshrined in United States corporate law, according to which the management of corporate affairs is entrusted to directors who run the corporate firm exerting broad discretionary powers and without being bound by shareholders’ instructions. Traces of this conception can also be found in the regulation of the German Aktiengesellschaft.

Bainbridge’s thesis can only be supported by mixing up corporations and firms. It is clear that directors are appointed by the shareholders to run the business. And it is evident that directors, acting in the name and on behalf of the corporation, enter into contracts with all other stakeholders of the firm (labour contracts with the workers; purchasing contracts with the suppliers; sale contracts with customers; loans with banks or bondholders…). It is also obvious that directors – unlike partners in a simple organization like a partnership – must enjoy broad autonomy in the performance of their duties (because the shareholders are many, they are inexperienced and suffer from high coordination costs). And, in this sense, a rule that entrusts directors with broad and discretionary management powers is efficient.

But directors are neither parties to the corporate contract, nor co-owners of the assets assembled as the ‘property of the corporation.’ Therefore, they cannot be considered owners. And, since the corporation is only a legal fiction, and property without owners is a non sequitur, shareholders are the only ones that can be put in that position. If we understand ‘owner’ as the residual holder of the returns produced by the corporation’s separate patrimony, we must conclude that shareholders are to be considered the indirect co-owners of the separate patrimony through their position as members of the corporation.

Let’s see how Bainbridge mixes up corporations and firms. After recognizing that shareholders are ‘residual owners’, he denies that they can be considered the ‘owners’ of the corporation. Let’s replace ‘corporation’ with ‘firm’ in the following paragraphs to highlight the confusion between the two (text in brackets is mine):

‘In order for shareholders to own the corporation firm, the corporation firm would have to be a thing capable of being owned. It is not. The corporation firm is just a(n) legal (economic) fiction, albeit a highly useful one, for the nexus of explicit and implicit contracts between a wide array of stakeholders, of whom shareholders are but one among many. Employees provide labor. Creditors provide debt capital. Shareholders initially provide equity capital and subsequently bear the risk of losses and monitor the performance of management. Management monitors the performance of employees and coordinates the activities of all the firm’s inputs. The corporation firm is a(n) legal (economic) fiction representing the complex set of contractual relationships between these inputs.

Because shareholders are simply one of the many stakeholders bound together by this web of voluntary agreements, ownership is not a meaningful concept in contractarian theory (of the firm, not of the corporation). Someone owns each input (in the firm, not in the corporation), but no one owns the totality (of the firm, not of the corporation). Instead, the corporation firm is an aggregation of people bound together by a complex web of contractual relationships. The validity of this insight becomes apparent when one recognizes that buying a few shares of IBM stock does not entitle me to trespass on IBM’s property—I do not own the land or even have any ownership-like right to enter.’

Note how Bainbridge uses the term ‘corporations’ to refer to ‘firms’. As implied by the wording itself, you can build an economic/contractual understanding of firms. But if corporations are contracts, it is weird to speak of a ‘contractual theory of a contract.’ For the avoidance of doubt, and as explained below, relationships between directors and shareholders inside the corporate contract are voluntary and, therefore, also of a contractual nature.

Bainbridge does not correctly understand what a corporation is. The reason for that is, partly, that American scholarship never developed a theory of legal personality, which was imported very late in the 20th century (albeit Hansmann has properly understood the value of this original Civil Law institution). When economists built the theory of the firm, many economic-minded lawyers transferred its findings to the analysis of corporate law, a very damaging and unnecessary ‘cultural appropriation’.

Bainbridge also misses the point when he says that IBM shareholders lack the right to use the property of IBM. IBM shareholders are not entitled to use the assets that are part of the separate patrimony which IBM Inc. is, not because they do not own it, but because they are not direct co-owners. IBM’s property is owned by IBM’s shareholders through the legal person which is IBM Corporation, and their rights and duties as indirect co-owners are not determined by the general common law rules about co-ownership but by those about the ‘law of legal persons’ (ie, corporation law, articles of incorporation and bylaws). Since shareholders didn’t pool together their assets to use them in common (as it happens in the exploitation of a common resource), but as a contribution to the firm’s business, they relinquished part of their rights as common legal owners to obtain the advantages of diversification and specialization in their investments. Shareholders choose to be members instead of direct co-owners because they are not interested in using the assets that make up the separate patrimony. They do not want to trespass the corporation’s land. They want dividends.

But no one else in the firm is a member of the corporation. None of the other stakeholders in the firm are members of the corporation or parties to the contract. They are third parties to the corporation and they must enter into a contract with the corporation in order to establish a claim on the corporate assets – the separate patrimony. Therefore, their rights and duties are set by the contracts they enter into with the corporation and by labour law, supply contract law or the law of sales; not by the corporate contract, not by corporate law.

Since the premise (corporation = firm) is false, wrong conclusions abound. This is especially the case in the discussion about corporate social responsibility, the idea of ​‘shareholder value’ as a guide to the behaviour of directors, the relationship between the board of directors and the shareholders, fiduciary duties, and almost any other subject that relates to corporate law. The confusion is so widespread in the United States that it has reached the point where late developments in Delaware Law affirm that directors can modify the corporate contract - the bylaws - but shareholders are not entitled to do so.

I am not implying that it wouldn’t be a good idea to transform the shareholders’ position from members to creditors or to transform business corporations into endowments or foundation-like corporations, but the legislative choice of how to design private organisations must be preceded by a proper understanding of those basic ideas about contracts, collective property and the goals of corporation law. Let’s see how we reached this point. It will be submitted that corporate law is not the appropriate tool to deal with the social, economic and political problems that big firms pose to our societies.

Corporate Law is not about firms. Corporation law is about contracts and property.

The theory of the firm is not a legal doctrine. It’s an economic model formulated by economists such as Coase, Alchian, Demsetz, Hart and Jensen & Meckling, among other luminaries, to explain why markets are not ubiquitous. Law scholars who use the theory of the firm to study corporate law problems are advised to handle it with care. In common law scholarship this is not always the case. Many legal scholars and business economists seem to systematically confuse the firm as defined by economists with the corporation, which is a legal institution as old as the Roman Coliseum, although it has been employed to organize business firms only since the 17th century. The corporation is an institution (a ‘pattern of social behaviour with stereotyped roles’) created by the Law to allow groups of individuals to pursue common goals by owning property. Corporations thus allow these groups to act as a single entity that can be the nexus of all the contracts needed to build a firm.

A corporation is, legally speaking, a contract that sets up an organization and a class of jointly held property.

The corporation is a legal entity, that is, a set of assets/goods, credits and debts, whose boundaries are fixed and detached from other sets of assets, credits and debts (as Hansmann and Kraakman put it: a ‘separate patrimony’). This ‘patrimony’ is owned immediately by a legal fiction and ultimately by the members of the corporation. The shareholders are, then, both parties to the contract that sets up the organization and indirect co-owners of the separate patrimony. As such, the corporation is a form of collective/joint property whose owners are unified through the fiction of a ‘legal person.’

The corporation is not an individual. Corporations are not people.

From a continental law perspective (which should not differ greatly from a Common Law one) , a corporation should be considered a species that belongs to the genre of ‘business entities’, which also includes, as its most basic form, the partnership. While partnerships tend to be simple organizations, corporations are usually more complex ones. As such, corporations have distinctive features when compared with partnerships. One of the most relevant differences comes from the fact that corporations are not natural persons (whereas partnerships are, simply, groups of individuals) and, therefore, cannot sell or buy property or sign contracts (as partners do) by themselves. They need to set up positions – offices – and fill them with individuals (directors) to act in the name of this separate patrimony in order to establish legal relationships between this separate patrimony and third parties (workers, clients, suppliers, etc).

Corporations are the nexus for all the contracts that form a firm.

A firm is an organization of production factors (capital, labor, land, entrepreneurship) directed to the production of goods and services for the market. From a legal point of view, firms are an agglomeration of contracts because the relationships between all those who contribute to the firm’s production (clients, suppliers, workers, lenders, managers...) – the stakeholders – are voluntary, that is, all participants make their contribution to the firm’s production through contracts that define their contribution and the correspondent remuneration. But instead of multiplying the number of contracts among all the stakeholders of the firm, the firm (not the corporation) is organized in such a way that the corporation acts as the ‘nexus’ for all those contracts (see Hansmann’s ‘Firm Ownership and Organizational Form’).

Corporations are contracts concluded among those who contribute the equity capital that will be necessary for the production of the goods and services to be sold at the market. And, again, only the shareholders are parties to the contract that sets up the corporation. Shareholders are, therefore, members of a corporation (indirect co-owners of the separate patrimony formed with the contributions of the shareholders) and parties to the contract that sets up the corporation.  ‘Firm’ is a concept used by neoclassical economists and by institutional economists to explain which combination of production factors is more efficient, but these terms can’t be used interchangeably. Many corporations are not business organizations and many firms are not organized as corporations.

Jesús Alfaro Águila-Real is Profesor Titular of Business Law at the Facultad de Derecho de la Universidad Autónoma de Madrid.


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