Traditionally, there is an underlying assumption that in UK corporate law, shareholders own the company that they have invested in. The theory that the company should be operated to maximise shareholder interests is a key doctrine in “modern capitalism”1 and is evidenced in both the running of corporations and in legislation. Shareholders delegate authority to a board of directors to manage the company’s business and matters and trust that they will do so in their interest. This theory of Shareholder Primacy, hereafter called “SP”, has been criticised in favour of alternative stakeholder theories. An economic view of the “nexus of contracts”, also known as Contractarian, theory, balances the interests of all stakeholders, and “does not give primacy to any single group”2, when the concept is “taken in isolation”3. This essay argues that the Contractarian theory does not misconstrue the theory or practice of corporate governance; SP has its flaws, and elements of the Contractarian theory would be a welcome reform in defining and governing the company, if it had not been used by legal theorists to substantiate SP.
It is commonly held that shareholders are the owners of the company. Haldane, the Chief Economist at the Bank of England is a firm proponent that shareholders have primacy as they “claim (its) profits” and “exercise control rights”4 over the Board. SP theorises that directors should prioritise the interests of shareholders over other stakeholders so as to maximise returns on their investments through “allocative, productive, and dynamic efficiency”5. However SP has been criticised for its short-termist approach, agency problem, and its focus on only one group of stakeholders.
Firstly, as shareholders maintain a detached rentier6 role from the company itself, they are mainly interested in the dividends that they receive from their investments in the form of “quarterly earnings or short-term portfolio returns”7. This “short-term fixation”8 neglects Corporate Social Responsibility, hereafter called CSR, and the value of the corporation, in pursuit of profit in unsustainable ways. Essentially, a trait of human nature was one of the causes for the Financial Crisis of 2008. “Greed(iness)”9 trumped any long-term goals of the corporation. The crisis transpired due to stakeholders “increasing … stock price” and engaging in high-risk speculation10 without concern for the long-term wellbeing of the company. While “investor confidence” plummeted, the added pressure from shareholders for profits inevitably led to “the worst financial crisis”11 since the Great Depression.
Secondly, SP has created the Agency Dilemma, which stems from the Agency Theory. Shareholders “delegate… decision making authority” to directors to achieve their corporate interests. However, this creates a problem when the principal and the agent in such an agency relationship do not have “align(ed)” goals. The prominent economist, Adam Smith, acknowledged that realistically, one would not supervise someone else’s money in the “same anxious vigilance”12 that they would their own. Behavioural factors such as “negligence”, “profusion”13, irrational behaviour and selflessness can influence directors to act against the shareholder. As shareholders cannot monitor the behaviour of directors14, there is a possibility that the directors do not report back on the “value of … firm assets and investment opportunities”15, which leads to information asymmetry. The conflict of interests can create agency costs. When shareholder draw up inaccurate contracts due to misinformation, a director can exploit this by “imposing opportunity costs such as shirking”16 of responsibilities, leading to erroneous share price17.
Finally, SP does not acknowledge the contributions of all stakeholders involved, and fails to recognise the route towards “long term value maximization”18 for both input and output19. One must consider how the interests of all stakeholders can be aligned20 to have a prospering business. Although proponents of SP argue that only shareholders bear residual risk, which explains their need to exercise more control, they are not the only stakeholders to do so. As employee and creditor livelihoods are at stake, it will be these groups of stakeholder to feel the long-standing effect both personally and financially in case of liquidation. On the other hand, shareholders can “hedge their risks”21 by spreading their investment amongst companies. They can liquidate their shares to retrieve all of their investment, with the possibility of profit.
The concept of SP has firmly entrenched itself in legislation, and it has done so under the “guise”22 of Enlightened Shareholder Value, hereafter called “ESV”, in s172 of the Companies Act 2006 and the UK Corporate Governance Code 2016.
Firstly, ESV was incorporated with the objective of “long term value maximization”23 and it achieves this through directors “promot(ing) the success of the (whole) company”24 and taking into consideration interests of other stakeholders, such as employees, suppliers, customers, the community, the environment, and creditors25 when “driv(ing) the organization towards its objectives”26. Ideally, this provision encourages good corporate governance as it asserts that every stakeholder “merits consideration for (their) own sake”27; they are not at the “expense”28 of shareholders and can be treated on an “equal footing” as all stakeholders. On the surface, this is seemingly a shift towards a more stakeholder-oriented approach. However, the wording of “have regard to”29 in s172 implies a “wide discretion(ary)”30 subjective test as it allows directors to go against stakeholder interest in favour of shareholder interests or other considerations, as long as it appears that the director has done so “in good faith”31 – the wording of which is also difficult to define. This vagueness in wording leads to difficulty in enforcing a breach of directors’ duties. It is doubtful that a stakeholder would bring a claim against a director, as the threshold is quite low. The courts would have difficulty in deciding such a case32, providing that a director truly believed that they had acted “in good faith”33, even if it was an “unreasonable”34 decision that affected stakeholder interests.
Though there is a legal obligation to give weight to other stakeholders, in reality, s172 continues to enshrine SP.
Secondly, SP can be traced in the Code in the Preface, Section A, B, C, D, and E35, where standards of “good …behaviour”36, in relation to board leadership37, “effectiveness”38, “remuneration’39, “accountability”40 and “relation with shareholders”41 are set.
The Code states that the “main focus” is the company’s “accountab(ility) to its shareholders”42. Shareholders also have the right to “challenge companies’ explanations”43, they hear reports which are prepared for them by directors. These provisions continue to promote SP, whilst merely being aware of stakeholder interests. Therefore, because of its shortcomings, SP in practice and theory misconstrues what corporate governance is about; the Contractarian theory would better encapsulate good governance.
A new economic theory of the firm, which was based on neoclassical economics, was developed. Contractarians opine that company value is linked to the “relationships between a company and its stakeholders”44, unlike SP, which prioritises shareholder ownership of the company. In this theory, the concept of ownership it not an issue, as the corporation is not something that can be owned at all. Coase explained that it was not something that could be owned but a “implicit and explicit”45 “nexus of contracts” among “individual economic actors”46. Jensen and Meckling described the firm as a “legal fiction which serves as a nexus for contracting relationships”47, which are “intersecti(ng) (and) voluntary”48. The objective of contractarianism is to “maximise the residual wealth of a firm’s shareholders”49, not to put shareholders on a pedestal, but rather because it is laid out in the contract and resourceful50. This causes them to be more incentivized to want high dividends, even though they are not the owners, unlike in SP. Every actor is equal to each other and has a contractual relationship with the company. Shareholders would even be able to sell off “assets and cash flows” without other stakeholders’ notice. Since all stakeholder rights are contracted, this has led to the development of the communitarian view, where not one group of stakeholders is prioritised above the other. As these are private contracts, contractarianism does not allow for state intervention51, much like in contract law in a free market. Even though this theory at its core illustrates that it could move the company in a more stakeholder-oriented direction as it balances the interests of all contracting parties, instead, it has been used to further SP. However, because the question of ownership is not raised, this is a better interpretation of what corporate governance seeks to achieve, as all parties are placed at equal importance. The lack of ownership is also aligned with the doctrine of separate legal entity52.
Due to the reality of the corporation, the Contractarian theory has not made the mark that it should have had theoretically. There was potential for “contractual innovation and customisation reflected in a diversity of incorporation choices”53. In reality, there lacks diversity in contracts for this to be feasible.
In conclusion, although theories of corporate governance have been debated back and forth by both economic and legal theorists, it is a commonly held view that Shareholder Primacy is the accepted system in governing a corporation. Although this contends the spirit of what corporate governance should be, and that it so encompass the company as a whole, and not isolate a higher group of stakeholders to claim ownership of a company. Due to its shortcomings such as priortising shareholders, its prospect of a short-termist view which is not sustainable and ethical, and also the potential for information asymmetry, corporate governance should aim in a direction where it can develop with more stakeholder-friendly theories in mind. Alternative theories such as the nexus of contracts theory can show differentiation from the firmly rooted SP in the ideology of what Corporate Governance should be in the UK. Though recent theorists have different views on Contractarian theory, it is still a “further application” of previous “aggregate approach(es) to corporate theory”.
Although the same conclusion with different justifications, features of Contractarianism take into account equality over a hierarchy and the abolishment of ownership of a corporation in lieu with the separation of ownership and control. Contractarian theory thus seeks to achieve a more diverse discourse in hopefully achieving reform in the future.
1Velasco, “Shareholder Ownership and Primacy,” University of Illinois Law Review, (2010): 899.
2 Eisenberg, “The Conception That the Corporation Is a Nexus of Contracts, and the Dual Nature of the Firm”, Berkeley Law Scholarship Repository (1998): 821
5 Mayer, “Corporate Governance, Competition, and Performance”, Journal of Law and Society, Vol. 24, No. 1, Corporate Governance (Mar., 1997): 155
6 Ireland, “Externalisation of the Rentier Shareholder… From a Vice… into a Positive Virtue’ (2001): 154.
7 Dallas, “Short-Termism, the Financial Crisis, and Corporate Governance”, Social Science Research Network Electronic Paper Collection, Research Paper No. 12-078 (February 2012): 267
8 Sjåfjell et al. “Company Law and Sustainability”, Cambridge University Press, (21 May 2015): 35
9 Bair, “Lessons of the Financial Crisis: The Dangers of Short-Termism”, Harvard Law School Forum on Corporate Governance & Financial Regulation, (2011)
10 Dallas, “Short-Termism, the Financial Crisis, and Corporate Governance”, Social Science Research Network Electronic Paper Collection, Research Paper No. 12-078 (February 2012): 267
11 Wolf, “How Barack Obama rescued the US economy”, FT (2017)
12 Smith, “Wealth of Nations”, Wordsworth Editions Ltd (2012)
14 Elbadry et al, “Governance Quality and Information Alignment”, University of Surrey,: 3
17 Ibid,: 8
18 Collison et al., “Shareholder Primacy in UK Corporate Law: An Exploration of the Rationale and Evidence”, ACCA, Research report 125 (2011): 36
19 Marshall et al., “Stakeholders and Directors’Duties: Law, Theory and Evidence” UNSW Law Journal (2012), :294
20 Freeman, Edward. “What is Stakeholder Theory?”. Filmed 1984. YouTube video.
22 Ajibo, “A Critique of Enlightened Shareholder Value: Revisiting the Shareholder Primacy Theory”, Birkbeck Law Review Volume 2(1): 1
23 Collison et al., “Shareholder Primacy in UK Corporate Law: An Exploration of the Rationale and Evidence”, ACCA, Research report 125 (2011): 36
24 Companies Act 2006, s 172.
25 Companies Act 2006, s 172.
26 Davoren, “Three Types of Corporate Governance Mechanisms”, Chron
27 Marshall et al., “Stakeholders and Directors’Duties: Law, Theory and Evidence” UNSW Law Journal (2012), :294
28Marshall et al., “Stakeholders and Directors’Duties: Law, Theory and Evidence” UNSW Law Journal (2012), :292
29 Companies Act 2006, s 172.
30 Marshall et al., “Stakeholders and Directors’Duties: Law, Theory and Evidence” UNSW Law Journal (2012), :296
31 Companies Act 2006, s 172.
32 Ajibo, “A Critique of Enlightened Shareholder Value: Revisiting the Shareholder Primacy Theory”, Birkbeck Law Review Volume 2(1): 11
33 Companies Act 2006, s 172.
34 Ajibo, “A Critique of Enlightened Shareholder Value: Revisiting the Shareholder Primacy Theory”, Birkbeck Law Review Volume 2(1): 12
35 Financial Reporting Council (2014). The UK Corporate Governance Code. London: The Financial Reporting Council Limited.
42 Ibid. :3
43 Ibid. :4
44 Freeman, Edward. “What is Stakeholder Theory?”. Filmed 1984. YouTube video.
45 Macey, “Corporate Governance: Promises Kept, Promises Broken” 22 (2008)
46 Moore et al., “Corporate Governance: Law, Regulation and Theory”, Palgrave Corporate & Financial Law (2017): 30
47 Jensen, and Meckling, “Theory of the firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3, no. 4 (1976): 312.
48 Yosifon, “The Consumer Interest in Corporate Law”, University of California, Davis, Vol. 43:253 : 256
51 Butler, “The Contractual Theory of the Corporation”, George Mason University Law Review, Vol. 11, No. 4, pp. 99-123, (1989): 100
52 Abbasi, “Legal analysis of Agency Theory: an inquiry into the nature of corporation”, International Journal of Law and Management, Vol. 51 Issue: 6, pp.401-420, (2009)