Business Associations, Doctrinal Issues In

Shareholder Primacy, Stakeholder Theory, and the Theory of the Firm

The primary controversy in U.S. corporate law is whether it should reflect shareholder primacy or stakeholder theory. Traditionally, corporate law has been shareholder centered. This doctrine, reflected in the recommendation of the American Law Institute (ALI) Principles of Corporate Governance, states that “a corporation should have as its objective the conduct of business activities with a view to enhancing corporate profit and shareholder gain” (section 2.01). This focus supports the legal rights of shareholders to elect directors to corporate boards of directors, vote on fundamental changes in the corporation, and bring derivative actions on behalf of the corporation against its directors and officers for breaches of fiduciary duties. Shareholder primacy is also evident in cases that state that officers and directors owe fiduciary duties to the corporation and its shareholders.

Stakeholder theory is evident in constituency statutes that exist in over one-half of the American states. These statutes provide that directors may (or must) take into account in their decision making the interests of stakeholders, including shareholders, employees, customers, creditors, and the community. Stakeholder theory is also reflected in cases that provide that directors and officers do not breach their fiduciary duties when they make decisions that primarily serve the interests of nonshareholder stakeholders, as long as these decisions have a mere rational relation to a shareholder interest. The laws of some foreign nations, such as Germany, support some of this. Germany has a system of employee codetermination whereby employees elect directors to supervisory boards and works councils.

The shareholder primacy or stakeholder debate often relates to the theory of the firm. The most popular theory is the nexus-of-contract theory, which views the firm as a nexus of contracting relations. Supporters vehemently defend this view because it conceives of the firm as private, founded on choice, with autonomy and Pareto-optimal efficiency.

According to this analysis, contracts make the parties better off (or they would not enter into them). Consequently, changing the terms of contracts that parties have agreed to is Pareto inefficient because at least one person is worse off from the change. Supporters often use these arguments to justify status quo corporate governance rules.

However, is the firm a product of contracts? Scholars do not use actual contracts agreed to by real parties to support this theory. Instead, they postulate hypothetical bargains among corporate stakeholders. They reach conclusions about the terms of these bargains based on intuitions concerning what the parties would agree to if they were to negotiate. They often cite existing corporate governance rules as support for these intuitions. However, corporate governance rules vary, and, not surprisingly, scholars have different intuitions about what the hypothetical bargains would provide.

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