By Professor Charles O'Kelley, University of Seattle

For almost forty years, the Nexus-of-Contracts theory of the firm has dominated legal analysis of the modern corporation.  Under this theory, the corporation is merely a nexus for a set of contractual relations between officers, directors, shareholders, employees, consumers, and other constituents involved in the production and consumption activities of a particular “firm.”  In this dominant construct, there is no place for the entrepreneur—the dominant economic actor in the eyes of seminal theorists such as Frank Knight, Joseph Schumpeter and Ronald Coase, and, indeed, there is no place for command and authority. As I have argued elsewhere, this truncated view of the corporation is out of step with the evolving nature of modern firms and fails as a descriptive account of corporation law. Viewing the corporation as a surrogate for the entrepreneur, and, thus, as the owner of the firm, provides a descriptive bridge to the reality of the modern corporation.

Before the nexus-of-contracts theory of the firm, there was the “Berlian corporation.”  First set out in Berle and Means, The Modern Corporation and Private Property (1932), the Berlian corporation featured the separation of ownership and control.  The majority of voting shares were held by tens of thousands of passive, geographically dispersed, rationally apathetic persons.  A small handful of insiders—Princes of Industry—controlled the Berlian corporation.  According to Berle, these Princes of Industry had replaced the entrepreneur and operated the Berlian corporation without reference or concern for the dictates of the market that underlay traditional microeconomic theory. 

In the shadow of the Great Depression, the problem seemed not the displacement of the entrepreneur, but the need to gain social control over the Berlian corporation.  As Franklin Roosevelt famously noted (in a 1932 campaign speech authored by Berle), the second industrial revolution had done its work:

Our industrial plant is built; the problem just now is whether under existing conditions it is not overbuilt. . . . the day of the great promoter or the financial Titan, to whom we granted anything if only he would build, or develop, is over.  Our task now is not discovery or exploitation of natural resources, or necessarily producing more goods.  It is the soberer, less dramatic business of administering resources and plants already in hand, of seeking to reestablish foreign markets for our surplus production, of meeting the problem of under consumption, of adjusting production to consumption, of distributing wealth and products more equitably, of adapting existing economic organizations to the service of the people.  The day of enlightened administration has come.

And, indeed, the day of enlightened administration had come.  From the New Deal until the mid-1970s, Berle’s account played a central role in intellectual and policy discourse concerning the modern corporation.  The great Princes of industry were brought to heel, and not replaced by entrepreneurs, either in theory or practice.  Technocracy reigned, and the corporate CEO played a very constrained, managerial role compared to the Titans of old. 

CEO remuneration reflected this new, lessened role as did the declining fortunes of America’s elite.  In 1928, the top 1% of American earners’ captured 24 percent of national income; by the mid-1970s that share had fallen to 8 percent.  CEO pay similarly declined; by the mid-1970s the average CEO was making 40 times the pay of an average worker.  Not chump change, but modest compared to the heyday of the Berlian corporation.  As John Kenneth Galbraith dryly noted in 1967: 'The great entrepreneur lived out his last days disposing of his wealth or resisting those who sought to have him do so.  The modern executive does not have enough money to so occupy himself.'

On the level of theory, the entrepreneur disappeared from scrutiny.  As Princeton economist William Baumol noted in 1968: 'Obviously, the entrepreneur has been read out of the model.  There is no room for enterprise or initiative...One hears of no clever ruses, ingenious schemes, brilliant innovation, of no charisma or any other stuff of which outstanding entrepreneurship is made; one does not hear of them because there is no way in which they can fit into the model.'

The 1970s witnessed the beginning of the third industrial revolution—the era of cybernetics, computers, bio-engineering and thermonuclear power—and with it the return of the entrepreneur.  Society once again needed the risk-taker and innovator.  And with the advent of this new era, came a new theory of the corporation—the nexus-of-contracts model.   The new construct fit well with the return to individualism: it atomized the firm into ex ante equal contracting parties free to pursue individual self-interest. 

The model “solved” the problem of separation of ownership and control that had undergirded the Berlian account.  In so doing, of course, the new model left no room for government regulation.  It also left no room for the entrepreneur.   As Eugene Fama noted in 1980: '[S]eparation of security ownership and control can be explained as an efficient form of economic organization within the ‘set of contracts’ perspective.  We first set aside the typical presumption that a corporation has owners in any meaningful sense.  The attractive concept of the entrepreneur is also laid to rest, at least for purposes of the large modern corporation.'

Working within the nexus-of-contracts model, scholars have struggled to develop a rhetorical paradigm that provides a descriptive explanation of corporation law.  Shareholder primacy, director primacy, and the board of directors as mediating hierarchy, each staked a claim.  None of these rhetorical theories explain significant features of corporate law.  I suggest that each of these accounts suffers from a fatal flaw—the exclusion of the entrepreneur.  

If, instead, we conceive of the corporation as a small inner circle comprised of the relations between officer, directors and shareholders, and the firm as a larger circle comprised of the relationships between the corporation (acting as entrepreneur/owner) and the employees (and other constituents), then we have the beginning point for a comprehensive theory of the incorporated firm.  The rhetorical device that this model suggests is entrepreneur primacy, the claim that corporation law serves to ensure that corporations are operated entrepreneurially.   Shareholder primacy, director primacy and the board as mediating hierarchy are then properly seen as subordinate rhetorical devices that explain the actions, powers and responsibilities of those whose actions collectively constitute what we call the corporation.

This opinion piece is abridged from Professor O'Kelley's latest research paper, Berle, Knight and the Nexus-of-Contracts Theory of the Firm: A Reflection on Reification, Reality and the Corporation as Entrepreneur Surrogate http://ssrn.com/abstract=2017237