Not by Contract Alone: The Contractarian Theory of the Corporation and the Paradox of Implied Terms

The contractarian theory of the corporation holds that a business corporation is a creature of contract and, more specifically, a nexus of incomplete contracts between directors, shareholders, employees, suppliers, customers and other parties (see here). This draws attention to the express or implied consent of all the participants and suggests that the role of corporate law and the courts is to enable and support private ordering: corporate law supplies the transaction-cost reducing standard-form terms the parties would have agreed to had they addressed them explicitly, and courts settle disagreements by filling the contractual gaps using the same hypothetical bargain logic. Much of the existing critique has focused on showing that the contractarian account downplays or ignores the mandatory or public features of corporate law (see here, for example). In our recent paper, we articulate a critique that targets the role contractarians assign to courts.

We show that this role does not sit comfortably with the ‘strong form contractarian’ position (we borrow this expression from here), which demands a literal interpretation of the claim that the corporation is a nexus of contracts. On this view, the contracts involved in corporate ventures are ‘real contracts’ consisting of express or implied terms struck by real parties (see here), and when courts are called upon to imply missing contractual terms, they do so with a wealth-maximization objective in mind. We argue that a considerable extension of standard contract doctrine is necessary for this account to work and contend that courts will refuse to extend it in this manner, with the consequence that many gaps either cannot be filled or can only be filled by non-contractual doctrines.

The problem can be roughly stated as follows. Given that contracts are incomplete, whenever courts adjudicate contractual disputes, they attempt to fill the gaps using the doctrine of implied terms in order to enforce mutually agreed obligations. But giving effect to obligations by implication comes with the risk that the implied term may not have been truly consented to. This undermines the very basis of contractual liability, consent, and conflicts with the courts’ practical imperatives to maintain legal certainty and deter excessive litigation. Courts will thus often refrain from implying terms, even when this runs the risk of not holding parties to their bargains. While the imperative to hold parties to their bargains is rooted in consent, so is the imperative to refuse to imply terms. We call this antinomy the ‘paradox of implied terms’.

As the number of parties increases, the effects of the paradox multiply, inherently limiting contract law’s reach beyond two parties. The courts’ ability to build a contractual nexus by implying third-party obligations, such as a contract between its existing members and a putative new member, is therefore highly limited. It follows that, in practice, the vehicle of contract cannot create the complex set of multi-party obligations which constitute the corporate form. Conversely, in a true corporation, parties can be added to (or removed from) the nexus without the express or implied consent of all other parties in the nexus, and without affecting their liabilities. This is only possible because non-contractual doctrines, which are not rooted in consent, are involved. This poses a significant challenge to contractarianism.

We substantiate this argument by showing that the portrayal of the courts’ gap-filling role relies on an efficiency theory of contract that conflicts with the objective theory of contract employed by English and other common law courts. We then demonstrate how the paradox of implied terms prevents courts from manufacturing counterfactual consent, before studying the limits of the courts’ ability to imply third-party obligations in real-life multi-party contract cases involving few and many parties, which we call ‘micro-’ and ‘macro-nexuses’, respectively. We use recent shipping cases as straightforward illustrations of micro-nexuses and old cases involving the unincorporated joint-stock company, often cited as evidence of the contractual nature of the corporation, as illustrations of macro-nexuses. We also test the claim that the fiduciary duties of directors can be created by consent. Overall, our analysis shows that a fully-functioning body corporate cannot plausibly be created by contract with the support of the courts.

David Gibbs-Kneller is a lecturer in law at the University of East Anglia Law School, UK.

David Gindis is a senior lecturer in economics at Hertfordshire Business School, University of Hertfordshire, UK.

Derek Whayman is a lecturer in law Newcastle University Law School, UK.