Gordon Smith has a thoughtful critique of nexus of contracts theory in a post over at the Conglomerate.
My take on nexus of contracts theory is most concisely summed up in the article from which Gordon quotes, The Board of Directors as Nexus of Contracts. On the one hand, I think Gordon is right to suggest that nexus of contracts theory is of limited utility so long as we focus on the notion that the corporate entity is the nexus of contracts. As I explain, what's more important is the observation that the corporation has a nexus of contracts.
After all, to say that the firm is a nexus is to imply the existence of a core or kernel capable of contracting. But kernels do not contract – people do. In other words, it does us no good to avoid reifying the firm by reifying the nexus at the center of the firm. Hence, we must search for the person or persons who serve as the nexus of the set of contracts making up the firm. Our search will be facilitated if we first identify the central characteristic of “firmishness.”
It is in the process of identifying that central characteristic that I depart most significantly from Gordon's analysis. I simply don't agree that the Alchian and Demsetz model is all that useful.
According to the Coasean theory of the firm, firms arise when it is possible to mitigate these costs by delegating to a team member the power to direct how the various inputs will be utilized by the firm. One team member is empowered to constantly and, more important, unilaterally rewrite certain terms of the contract between the firm and its various constituents. By creating a central decisionmaker – a nexus – with the power of fiat, the firm thus substitutes ex post governance for ex ante contract. Uncertainty and complexity are no longer as problematic, because the central decisionmaker can exercise its power of fiat to mandate a chosen adaptive response to new circumstances. Opportunism is deterred by the prospect of ex post sanctions, obviating the necessity of drafting a complete contract ex ante.
Alchian and Demsetz famously argued that a firm has no power of fiat; instead, an employer’s power to direct its employees does not differ from a consumer’s power to direct his grocer. They may well be right that Ronald Coase erred in treating the firm as a non-market institution in which prices and contracts are of relatively little consequence, but there is no necessary contradiction between a theory of the firm characterized by command-and-control decisionmaking and the contractarian model. The set of contracts making up the firm consists in very large measure of implicit agreements, which by definition are both incomplete and unenforceable. Under conditions of uncertainty and complexity, the firm’s many constituencies cannot execute a complete contract, so that many decisions must be left for later contractual rewrites imposed by fiat. It is precisely the unenforceability of implicit corporate contracts that makes it possible for the central decisionmaker to rewrite them more-or-less freely. The parties to the corporate contract presumably accept this consequence of relying on implicit contracts because the resulting reduction in transaction costs benefits them all. It is thus possible to harmonize the Coasean and contractarian models without having to reject a theory of the firm characterized by fiat.
To be sure, coordination need not imply fiat, as illustrated by the democratic decisionmaking processes of many partnerships and other small firms. In the public corporation, however, fiat is essential. All organizations must have some mechanism for aggregating the preferences of the organization’s constituencies and converting them into collective decisions. Kenneth Arrow identified two basic mechanisms for carrying out this task: “consensus” and “authority.” Consensus is used where each member of the organization has identical information and interests, which results in preferences that are easily aggregated. In contrast, authority-based decisionmaking structures arise where group members have different interests and amounts of information. Because collective decisionmaking is impracticable in such settings, authority-based structures are characterized by the existence of a central agency to which all relevant information is transmitted and which is empowered to make decisions binding on the whole.
The necessity of an actual nexus – a center of power capable of exercising fiat – thus follows in large part from the asymmetries of information and interests among the corporation’s various constituencies. Shareholders care about the value of the residual claim on the corporation. Customers care about the quality and quantity of the goods produced by the corporation. Workers care about salary and conditions of employment. And so on. Under such conditions, efficient decisionmaking demands an authority-based governance structure in which information is channeled to a central decisionmaker empowered to make choices binding on the firm as a whole.
In sum, under conditions of asset specificity, bounded rationality, and opportunism, the ability to adapt becomes the central problem of organization. In large public corporations, adaptation is effected by fiat. Obviously, fiat within firms has limits. Some choices are barred by contract, such as negative pledge covenants in bond indentures. Other choices may be barred by regulation or statute. Still other choices may be unattractive for business reasons, such as those with potentially adverse reputational consequences. Within such bounds, however, adaptation effected through fiat is the distinguishing characteristic of the firm.
Accordingly, the utility of nexus of contracts theory is that it allows us to conceptualize the corporation as a vehicle by which the board of directors hires various factors of production. Hence, the board of directors is not a mere agent of the shareholders, but rather is a sui generis body – a sort of Platonic guardian – serving as the nexus for the various contracts making up the corporation. The board’s powers flow from that set of contracts in its totality and not just from shareholders. My theory of director primacy grows directly out of that insight.
BTW, it appears that the director primacy model is catching on among my fellow academics. Harry Hutchinson recently posted an interesting article to SSRN entitled Director Primacy and Corporate Governance: Shareholder Voting Rights Captured by the Accountability/Authority Paradigm, which extends the model to some useful new areas. And, of course, Wayne Hanewicz did yeoman work in a critical refinement of the model in Director Primacy and Omnicare. Margaret Blair has been quoted as opining that: "We have a director primacy model in this country, not a shareholder primacy model." Director primacy. Catch the wave.
