Institutional Theory for Corporate Law: An Invitation

Over the past few decades, company law scholarship has largely relied on insights from the nexus-of-contracts theory of the firm, agency-theoretic reasoning in corporate finance, and the economic analysis of law more generally. These insights have led to substantial theoretical and empirical advances and have shaped our current understanding of the connections between company law, securities regulation, accounting and reporting practices, and corporate governance.

At the same time, there is a robust body of critical work that raises important concerns about the foundations and implications of this approach. While we agree that agency theory has its shortcomings, we believe it is important to retain what a straightforward agency perspective can teach us about conflicts of interest among board-level actors. Hence the challenge is to show how agency theory can be integrated into a broader theoretical perspective that can be brought to bear on issues of company law.

In our recent paper, we argue that company law scholars can profitably emulate the stance of the New Private Law literature, which appeals to a broad range of social science ideas and methodologies to rethink the nature of contract, property, or tort (see for example here). We can similarly draw on insights from several traditions of institutional theory found across the social sciences to develop a deeper understanding of the nature and governance of the company.

This broader perspective acknowledges the importance of rules and practices that help align the incentives of board-level actors, but also draws attention to phenomena that the reliance on agency theory leads us to miss. This is especially the case of the business organization that company law is meant to enable and support. Company law scholars rarely consider what anyone below the board level does. Our effort to reverse this tendency draws on and advances recent work on the real entity theory of the company (most notably here).

We build on the work of Oliver Williamson and Elinor Ostrom, who in 2009 shared the Nobel Prize in Economic Sciences for their path-breaking work on economic governance (see here). We follow Williamson’s theoretical pluralism in calling for the integration into company law scholarship of organization theory alongside law and economics (for example here), and rely on Ostrom’s approach to institutional analysis (outlined notably here) to propose a narrative model (or what Ronald Gilson here refers to as an ‘informal analytic narrative’) of the company in terms of nested levels of governance.

Specifically, the Ostromian perspective allows us to propose a visualisation of the company as comprising a set of ‘meta-constitutional’, ‘constitutional’, ‘policy’, and ‘operational’ action situations, where the participants’ positions, powers, and responsibilities are defined by formal and informal rules, shared beliefs, and relevant material conditions.

Action at the meta-constitutional level by one or several entrepreneurs (initial subscribers to the memorandum) and the registrar constitutes the company as a legal actor governed by its articles of association. The legal entity serves as the nexus for contractual relationships with internal and external parties, enabling and supporting an economic organization, whose governance spans the constitutional, policy, and operational levels. These therefore lie within the corporate boundaries. 

At the constitutional level, directors and shareholders adapt the constitutional rules, monitor their implementation, and engage in various strategic deliberations that set the general parameters for lower levels. At the policy level, directors, executives, and managers set targets and issue instructions for the operational level, oversee their implementation, and monitor the results. The larger the organization, the greater the diversity of policy action situations and the greater the spread of operational action situations. At the operational level, employees specialise, combine, and deploy various kinds of tangible and intangible resources to produce goods or services valued by customers in the market.

A surplus is generated when the market value of the output exceeds the costs of producing it. Given that conflicts of interest among claimants to this surplus will inevitably arise, though not necessarily only at the board level, analyses of rules and practices that align the parties’ incentives are without question valuable. But there is more to understanding how organizations, and therefore companies, are run. 

Operational outcomes, such as the production, distribution, and sale of goods or services, create positive and negative changes in the material or social world both inside and outside corporate boundaries. Participants at various levels of governance evaluate these outcomes according to a range of criteria (including efficiency, equity, adaptability, accountability, and conformance to general morality). Conflicts of interest are thus not the only relevant conflicts in the organizational context: conflicts can also arise when people use different criteria to evaluate decisions, procedures, and outcomes. 

To avoid the incidence and potentially detrimental effects of such confrontations concerning valuation and therefore governance, organizations strive to promote a corporate culture, namely a set of overarching norms and shared mental models that provide a sense of community and shared identity. To the extent that they succeed, this set of overarching norms becomes part of the company’s constitutional structure, in the sense that it affects the rules governing the policy and operational levels.

In our paper, we show how this thicker model of the company—though less parsimonious than what Gilson calls ‘single-factor models’, such as agency theory—provides a more realistic picture of how companies are run but also a richer understanding of the law as it stands. This place us in a stronger position to evaluate the likely consequences of certain normative interventions, which we illustrate in matters ranging from executive compensation and reporting to corporate criminal liability. To further showcase the value of our broader institutional perspective, we extend the discussion to ongoing corporate governance debates.

Overall, we believe that it is important to enrich company law scholarship to make it more relevant to the real-world challenges faced by business organizations. We invite our readers to join us in this endeavour.

The authors’ complete article is available here.

David Gindis is an Associate Professor at the School of Law at University of Warwick.

Eva Micheler is a Professor of Law at the LSE Law School at London School of Economics.