Working Paper No. 12-19:
The Contractual Theory of the Corporation

Author(s):

Henry Butler

Date Posted: February 2012

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Abstract:

The modem corporation is one of the most successful inventions in history, as evidenced by its widespread adoption and survival as a primary vehicle of capitalism over the past century. Economists, however, have only recently begun to understand the economic nature of the corporation. In the last fifteen years, the economic theory of the firm has advanced from a struggle with the identification of the economic conditions that lead to the formation of firms to a discourse on sophisticated issues concerning intrafirm relationships. As a consequence of these developments, economists have come to view the firm as a "nexus of contracts" among participants in the organization. When applied to the corporate form of organization, the theory of the firm is often referred to as the contractual theory of the corporation.

This paper offers a summary of the contractual theory of the corporation and considers some of its general implications for corporate law. Section I sets the stage for the discussion by presenting a summary of the traditional legal view of the modem corporation. Section II presents a summary of the theory of the firm as it relates to corporate organization. Section III describes the market and contractual constraints that force managers of large, dispersed-owner corporations to act in their shareholders' best interests. Section IV considers the implications of the contractual theory of the corporation for private ordering of corporate governance issues. Section V offers some concluding comments.