What we talk about when we talk about fiduciary duties: the changing role of a legal theory concept in corporate governance studies

ABSTRACT

Corporate law, as a constitutive law in the corporate system, includes the legal theory concept of fiduciary duties. Fiduciary duty law prescribes that a fiduciary should act in the interest of the beneficiary and without self-interest. Fiduciary law, even its proponents admit, is quite complicated to pin down into statutes, and yet it serves many ends in society. In the field of corporate governance, fiduciary law has been challenged by contract law and contractual relations. The proponents of the contractual theory of the firm suggest that contracts more effectively monitor and reduce agency costs, and discipline managers to act in the interest of shareholder, i.e. eo ipso, generate net economic welfare. The article examines how corporate legislation has been reinterpreted overtime, and how legal concepts such as contracts and fiduciary duties have to a varying degree been invoked in the corporate governance literature. In the current regime of shareholder primacy governance, fiduciary is a legal device that can be reintroduced to handle concerns regarding governance issues.

KEYWORDS:

• Fiduciary duties
• legal theory
• the contractual theory of the firm
• incomplete contract theory

Introduction

Within corporate law, a constitutive law in the American legal system, including Delaware law (the most common jurisdiction for incorporation), fiduciary duties are assumed for directors and for the CEO whom the directors recruit and hire. The term fiduciary duty is a subtle and complex legal theory construct that impose quite strict responsibilities on the fiduciary – the actor operating under fiduciary law – to act in the interest of the so-called beneficiary. In contrast, neoclassical economic theory, rooted in rational choice theory, by and large disregards fiduciary duties as an impediment that prohibits the maximization of the efficiency of the corporate system, and suggests that both corporate law and present court ruling grant managers too many opportunities for self-serving and indolent behavior, leading to lower efficiency of the corporate system and, more importantly, the shareholders’ loss. To overcome these legal strictures, economists and legal scholars subscribing to economic theory advocate a contractual theory of the firm, wherein CEOs and directors recognize their role as the shareholders’ agents. ‘The contractual theory of the corporation states that the corporation is a set of contracts among the participants in the business, including shareholders, managers, creditors, employees and others’, Butler and Ribstein (1990, 7) say. Proponents of contract theory claim such contracts substitute and therefore seek to retire fiduciary duties, whereas proponents of fiduciary duties claim that corporate law qua constitutional law include mandatory rules that cannot be bypassed (Eisenberg 1990, 1321). In addition, proponents of fiduciary duties argue that if the question of self-aggrandizing behavior is the contract theorists’ principal concern – albeit commonly operationalized as a matter of ‘efficiency’ and the reduction of ‘agency cost’ – then fiduciary duties as a legal device provides a stricter protection against managerial malfeasance than any contractual relation and contract law do.

The debate between proponent of the legal device of fiduciary duties and proponents of the contract theory of the firm is of relevance for the study of corporate governance in management studies (see e.g. Goranova and Verstegen 2015; Starbuck 2014; Donaldson 2012; Hambrick, Werder, and Zajac, 2008). Today, the bulk of the corporate governance literature emphasizes the dual and contractual relation between shareholders and managers as mandated by agency theory (Daily, Dalton, and Cannella 2003; Starbuck 2014). ‘The overwhelming emphasis in governance research has been on the efficacy of the various mechanisms available to protect shareholders from self-interested whims of executives’, Blair (2003, 371) argue. ‘The extant literature typically viewed governance as a principal-actor problem between shareholders and management’, Hambrick, Werder, and von, Zajac (2008, 3845) add. In this context, it is important to notice that proponents of fiduciary duties do not deny that directors and managers are responsive to shareholder interests, but fiduciary duties vis-à-vis a broader set of stakeholders needs to be recognized in addition to the bilateral relation between directors and managers and shareholder. As for instance Donaldson (2012, 264) remarks, agency theory, stipulating and advocating a principal–agent relation between shareholders and managers, ‘[n]eglects to consider what general obligations, moral or otherwise, principals might have either to their agents or to other groups inside or outside the firm’. Based on this debate, this article has one descriptive purpose and one normative purpose: the descriptive purpose is to demonstrate how corporate law, fiduciary law and contract law has been interpreted overtime, leading to novel corporate governance practices. In making this analysis, the article contributes to the ongoing discussion regarding the role of corporate governance in the contemporary economic system and how accountability can be ensured within the corporate system, an issue debated by legal scholars Adolf A. Berle (1932) and E. Merrick Dodd (1932) in the New Deal era. It should be noted that the literature primarily addresses US corporate law (and more specifically, Delaware corporate law) and an analysis of the differences between various jurisdictions is beyond the scope of the article. This limitation of the study therefore calls for more research on how fiduciary duties are included in national corporate law legislation. By reviewing the literature, including a bulk of texts published in the 1980s and 1990s, a period of extensive debates over the nature of corporate governance, the article addresses how the legal term fiduciary duties have been gradually marginalized in the corporate governance literature.

Second, the normative purpose of the article is to pursue the argument that contract theory, despite its many merits, most recently enshrined by the Nobel Prize in economic sciences in 2016, granted to the incomplete contract theorists Bengt Holmström and Oliver D. Hart (see e.g. Aghion and Holden 2011; Schwartz and Scott 2003; Hart 1988; Grossman and Hart 1986), tend to bypass and marginalize the concept of fiduciary duties, which mandates fiduciary duty of loyalty as a key governance principle. This in turn results in an under-appreciation of legal theory in mainstream corporate governance literature, which potentially translates into governance practices that single-handedly rewards shareholders at the expense of other constituencies, and potentially with a loss in net economic welfare ensuing. Ultimately, the predominance of contract theory in corporate governance literature is a matter of the performativity of economic theory (Mackenzie, Muniesa, and Lucia. 2007). Performativity is an analytical concept that is based on the proposition that ‘[n]o reality exist[s] independently of our conceptualizations’ (Engelen 2008, 111), and that scientific theories, models and statements that purports to describe such realities are not, with Callon’s (2007, 315) phrase, ‘constative’ but ‘performative’. That is, such scientific descriptions ‘actively engaged in the constitution of the reality that they describe’. Pickering (2010, 25) introduces the term performative epistemology to underline how knowledge is ‘part of performance rather than an external controller of it’. Economic theory is founded on a performative epistemology, several commentators remark (Svetlova 2012; Mackenzie 2004). ‘Performativity is the rule and meaning of economic action’, Esposito (2013, 111) argues: ‘Economic operations generate the reality in which they operate and the unpredictability they face as a result’ (Esposito 2013, 112). For instance, MacKenzie and Millo (2003) study of the introduction of the Black-Scholes option pricing model is an exemplary case of how an economic theory serves to shape economic action (and, eo ipso, the economic reality tout court). Originally only poorly predicting option prices, the Black-Scholes option pricing model was adopted and used as a heuristic by traders, thus making market prices converge toward the prices the model predicted. ‘Gradually, “reality” (in this case, empirical prices) was performatively reshaped in conformance with the theory’, MacKenzie and Millo (2003, 127) contend. In addition to economic theory, performativity has been examined as a constitutive feature of the management studies literature (Abrahamson, Berkowitz, and Dumez 2016; Gond et al. 2016; Cabantous and Gond 2011), accounting theory (Revellino and Mouritsen 2015) and legal theory (Faulkner 2012). The performative epistemology of contract theory – and legal theory, to be asserted – serves to explain how mandatory rules in corporate legislation regarding the directors and managers’ fiduciary duties have been marginalized in the era where contract theory has dominated the corporate governance literature. Contract theory is performative in as much as it has constituted a governance regime, wherein fiduciary duties appear to be optional despite its legal basis. A legitimate objection to this view on the performativity of contract theory is that court decisions continue to grant fiduciary law a key role in corporate governance (see e.g. the US Supreme Court and Delaware Chancery Court statements discussed below). It is thus important to notice that only very few governance disputes, in many cases being long-standing controversies following, e.g. critical events such as a merger, a hostile takeover, or some other key decision being made by the board of directors, are subject to court ruling. That is, the term performativity does not denote that the sheer force of certain ideas (including e.g. stipulated benefits of contracting vis-à-vis other legal mechanisms and devices) would displace legal authority and judges interpretation of law as it is written and enforced in the common law system. Instead, the concept of performativity indicates that the scholarly debate on governance and governance practice are shaped and informed by certain ideas, introduced and advocated by scholars with specific interests. The question whether jurisdictions and court ruling are informed by ideas circulating in the wider community is a field of scholarly inquire and debate, and being an empirical question being outside of the scope of this article.

The remainder of this article is structured accordingly: The first section introduces the concept of corporate law as being the key legislative piece of the corporate system. The second section reviews the literature on fiduciary duties, both within what legal scholars call fiduciary law and as a component of corporate law. The third section discusses how fiduciary duties have been criticized on basis of a contractual theory of the firm and incomplete contract theory, suggesting that fiduciary duties by and large fails to discipline managers to act in the interests of, e.g. shareholders in the case of the public firm. The fourth section presents legal scholars’ response to and their critique of this model, averting these claims on a variety of grounds. In the final sections of the paper, some theoretical implications and practical consequences are discussed.

The constitution of corporate law and fiduciary duties

Corporate law: the business charters as a vehicle for business ventures

Kaufman (2008, 402) suggests that the ‘corporate organizational form’ is one of the ‘defining innovations of the modern era’. Being based on a specific legal contract, the business charter, between the sovereign state and the business promoter as prescribed by corporate law, the corporation is given rights and responsibilities, and operates under the legal protection of corporate law that enacts the corporation sui juris, as a freestanding legal entity. In addition, a business charter thus includes a combination of duties and benefits, serving to create a ‘legal shield’ protecting, e.g. investors from both insiders’ and outsiders’ appropriation of firm-specific resources (Kaufman 2008, 403).

In hindsight, it is important to recognize that between 1780 and 1810, the majority of private corporations chartered were not business ventures at all, but ‘churches, townships, schools, and voluntary organizations’, all being given specific economic privileges enabling them to amass and protect the capital acquired to finance their activities (Kaufman 2008, 404). The enactment of corporate law as a vehicle for business ventures took off in the nineteenth century in the United States: By the year 1800, ‘only 335 charters had been issued in the United States for business corporations’; by 1890, there were nearly 500,000 incorporated businesses (Blair 2003, 389, footnote 3). Corporate laws were enacted in Massachusetts (1809), New York (1811), Pennsylvania (1836) and Connecticut (1837), and by the end of the 1850s, 15 more states had passed ‘general incorporation statutes’ (Blair 2003, 425–426).

Blair (2003, 389) argues that the success of corporate law and the corporate system is based on at least three solutions to perceived problems facing business promoters: ‘The ability to amass large amount of capital, limited liability, and the centralization of control’. Blair (2003, 390) adds a fourth factor, the incorporators’ ability to not only attract capital, to but also to commit the capital for extended periods of time – for decades or even centuries – to specific team production efforts. Djelic (2013, 596) argues that corporate law established three legal standards: (1) the corporation is treated as a ‘fictional individual’, (2) ownership is defined as the holding of shares and (3) the ownership is accompanied by the principle of limited liability (as listed by Blair 2003). The principle of limited liability is by far the most controversial statute of corporate law. ‘Today’, Djelic (2013, 596) writes, ‘we tend to take for granted both limited liability and its association with the corporate form’. In the nineteenth century, however, policy-makers, legislators and commentators were concerned that the limited liability principle would justify irresponsible and opportunistic behavior, and would thus fail to maximize the net economic welfare in the corporate system and the economy at large. Much of these issues and concerns did not materialize, and the limited liability principle instead actively promoted joint investment in complex economic ventures. As Blair (2003, 397) remarks, the corporate form instituted on basis of corporate law may now, in hindsight, no longer seem so unique or remarkable, and its benefits may even seem trivial as the legal device of the business charter is oftentimes taken for granted. Yet, corporate law played a decisive and central role in turning American and European economies from being agrarian small-scale production economies into modern industrial economies, with manufacturing and infrastructural industries, including transportation, communication, etc., leading the way.

The question of director and manager accountability

In corporate legislation, the sovereign state needs to balance the dangers of ‘laxness and corruption’ on the one hand, and ‘rigidity and excessive regulation’, on the other, Lamoreaux (2009, 18) says – a delicate balancing of liberties and state-centered control in the domain of venturing. That is, the legal construction of the incorporated business did not per se solve all practical governance problems but merely provides a ‘legal script’ for the business venture. This in turn left much questions regarding, e.g. managerial accountability unregulated by law. The debate in the 1930s between Adolf A. Berle, a Columbia Law School professor and one of President Roosevelt’s entrusted advisors in the New Deal program, and the Harvard Law School professor E. Merrick Dodd Jr., regarding the governance question to whom managers are responsible – a debate that would resume in the early 1960s – testify to such lingering concerns. Dodd (1932, 1153) claimed that shareholders are not ‘imbued with a professional spirit of public service’, and therefore they should not be trusted to serve an extended social role beyond their role as investors in public firms. In Dodd’s view, shareholders cannot be assumed maximize net economic welfare simply on basis of their calculated self-interest. Berle (1932) on the other hand, recognized Dodd’s argument but defended private property rights vis-à-vis the unrestricted authority of salaried managers. Consequently, Berle has been consistently associated with a shareholder-friendly position. However, three decades later, well beyond the overbearing risk of competitive capitalism collapsing, Berle and Means (1932) work was criticized by contract theorist Henry Manne (1962), advocating the idea of a ‘market for managerial control’ (Manne 1965, 1967). This time Berle was no longer portrayed as a vigilant defender of shareholder interests. Instead, Manne (1962) regard Berle and Means (1932) work as being part of a corporate system architecture that grant managers excessive privileges and the legal protection to act with discretion and with impunity, by and large at the shareholders expense. In Manne’s (1962) view, an alternative, non-legal model would be to expose managers to market pricing, which would discipline them to act to maximize efficiency.

In the vocabulary used in this article, Berle (1962) advocated a corporate system based on legislation, wherein fiduciary duties are the most effective way to secure and reinforce property rights and to generate economic welfare. In contrast, Manne (1962), one of the first explicit proponent of the many versions of contract theory that would eventually dominate the corporate governance theory and corporate governance system (see also Alchian 1965; Bork and Bowman 1965), flatly rejects such beliefs in jurisprudence over market pricing and governance models derived from economic theory propositions. For Manne (1962, 404), fiduciary duties fail to protect shareholders from managerial self-aggrandizing behavior, and by default invite managers to indulge in ‘[e]xpensive office furnishings, lavish expense accounts, company yachts, time off from day-to-day business concerns, and a variety of other nonpecuniary rewards’. Yet, in his responses to Manne’s allegations – Berle (1962) averts Manne’s criticism point-by-point – Berle (1962, 437) claims that the ‘American industrial system’ as a material fact has done more for more people ‘than any system in recorded history’. Yet, Berle (1962, 437) continues, this system is ‘eons from perfection’. It is in this realm, wherein corporate governance practices’ functional efficiencies and their ability to generate economic and social welfare are assumed, at the same time as its lack of perfection is recognized, that corporate governance scholarship should be located. Hence the importance of fiduciary duties as a legal constructs.

Fiduciary duties: the noncontractual responsibilities of directors and managers

The concept of fiduciary duties

In legal theory, the term fiduciary duty is a key concept that carries very specific connotations and being associated with defined legal intentions and court ruling cases. The term fiduciary derives from Latin fiducia, meaning trust, and the fiduciary – an actor operating under fiduciary law – is ‘expected to act in good faith and honesty for the beneficiary’s interest’ (Lan and Heracleous 2010, 302). Smith (2002, 1407. Emphasis in the original) defines the term: ‘“[F]iduciary duty” connotes an obligation to refrain from self-interested behavior that constitutes a wrong to the beneficiary as a result of the fiduciary exercising discretion with respect to the beneficiary’s critical resources’. Lan and Heracleous (2010, 303) suggest that fiduciary duty law consequently ‘act by shaping and reinforcing social norms of careful and loyal behavior’. DeMott (1988, 880), in turn, argues that the term fiduciary duty should be even more strictly interpreted, being what apply to ‘situations falling short of “trusts”, but in which one person was nonetheless obliged to act like a trustee’. In this stricter sense of the term, the duties of the fiduciary ‘go beyond mere fairness and honesty’. Such duties oblige the fiduciary to ‘act to further the beneficiary’s best interests’ (DeMott 1988, 882). In short, the fiduciary ‘[m]ust avoid acts that put his interests in conflict with the beneficiary’s’, DeMott (1988, 882) summarizes.

Moreover, fiduciary duties apply to a variety of cases and situations, DeMott (1988, 908) argues, and consequently, the term ‘eludes theoretical capture’, i.e. it is a term that cannot easily be formalized into unambiguous written instructions and guidelines. Smith (2002, 1400) interprets this vague formalization of the term more negatively, and argues that ‘fiduciary law is messy’. As a practical legal matter, ‘courts routinely impose fiduciary duties in myriad relationships’, including trustee–beneficiary, employee–employer, director–shareholder, attorney–client and physician–patient. Regardless of this ‘messiness’, DeMott (1988, 908) argues, relationships based on fiduciary duties commonly ‘[i]nclude the fiduciary’s commitment to exercise discretion in a fashion that affects the interests of the beneficiary and the fiduciary’s obligation to exercise that discretion on the beneficiary’s behalf’. Seen in this legal theory view, fiduciary duties are introduced, prescribed, and legally enforced as a relatively strict term that relies on the fiduciary’s willingness to act in accordance with these statutes.

Fiduciary duties and contracts

The differences between fiduciary duties and ‘contract relations’ (Smith 2002, 1403) are clearly specified. Goldberg (1976, 46) defines a contract as, ‘[a] promise or set of promises for the breach of which the law gives a remedy, or the performance of which the law in some way recognizes as a duty’. The fiduciary act in the interest of the beneficiary, i.e. follows the ‘duty of loyalty’ prescribed by fiduciary law, and thus should ‘avoid self-interested behavior that wrongs the beneficiary’ (Smith 2002, 1409). In contrast, contracting parties ‘exercise discretion only with respect to their own performance under the contract’ (Smith 2002, 1403). Expressed differently, the fiduciary must refrain from self-interested behavior that in any way disadvantages the beneficiary, while contracting parties ‘may act in a self-interested manner even where the other party is injured, as long as such actions are reasonably contemplated by the contract’ (Smith 2002, 1410). Frankel (1983, 880) says that in a contractual relation, ‘No party to a contract has a general obligation to take care of the other, and neither has the right to be taken care of’. At the same time, it is important to recognize that fiduciary law, which otherwise stresses the duty of loyalty, still do recognize the interests of the fiduciary in the relation to the beneficiary: ‘[F]iduciary duty should not be equated with a duty of selflessness’, Smith (2002, 1410) says. Regardless of Smith’s (2002, 1410) remark, there is a substantial difference between fiduciary and contractual relations, Frankel (1983, 802) argues: ‘A contract society values freedom and independence highly, but it provides little security for its members’. In contrast, the ‘fiduciary society’, which Frankel (1983, 802) regard as the more differentiated social order, wherein ‘affluence is largely produced by interdependence’, ‘[a]ttempts to maximize both the satisfaction of needs and the protection of freedom’. This valuation of freedom and independence versus security and satisfaction is of great relevance for corporate law and the corporate governance practices the legislation prescribes and enables. Thus the fiduciary relations within corporate law and the corporate system need to be examined in detail.

Fiduciary duties in corporate law

As a matter of being a component of corporate law, what Eisenberg (1989, 1462) refers to as fiduciary rules, ‘govern the duties of managers and controlling shareholders’. More importantly, it is the directors of the firm, to whom the CEO is held accountable, that is bestowed with fiduciary duties to protect the interests of the various contributors that participate in what Blair and Stout (1999) call the team production efforts of the corporation. In this view of the corporation, the corporation’s directors occupy to a ‘trustee-like position’ (DeMott 1988, 880), which means that directors, regardless of their ownership interests, are expected to use their decision-making authority in the best interests of others. That is, DeMott (1988, 880) continues, the directors’ discretionary authority to make decisions and to supervise managers are grounded in fiduciary principles.

Frankel (1983, 806) argues that directors ‘do not fall squarely into the category of either trustee [i.e. fiduciary] or agent’. On the one hand, like a fiduciary is freed from the interference of the beneficiary, corporate directors should be able to manage without the frequent interference of shareholders. This so-called business judgment rule, invoked in court case decisions, is justified on basis of the stipulated efficiency of centralized management, which in turn grants discretion to directors. The directors of the corporation ‘should have freedom to make timely decisions without resorting to shareholder approval’, Frankel (1983, 810) argues. On the other hand, it is the shareholders who elect directors at the annual meeting, just as principals choose their agents, and shareholders therefore can terminate directors’ tenure under ‘appropriate circumstances’ (Frankel 1983, 806). Such tenure could end through consent (i.e. informally), through a takeover (a market mechanism), or in an election process (a so-called proxy fight) (Frankel 1983, 807). Considering these two conditions, directors act as a hybrid construct including fiduciary and agential relations, i.e. operate in a ‘trustees-like position’, in DeMott’s (1988, 880) formulation.

Taken together, the term fiduciary duty prescribes that directors hold a ‘trustee-like position’ that prohibits them from acting on behalf of any of the various contributors to the team production activities (including e.g. the shareholders who supply finance capital to the firm). By implication, a similar role is given to the CEO, the board of director’s agent. The legal strictures of corporate law thus make the directors accountable to a variety of stakeholder, whereof the owners of the firm’s stock are one category of stakeholder among others, yet, in many cases and for qualified reasons, given more attention than other stakeholders. Moreover, fiduciaries (i.e. directors and managers) operate under preventive rules that ‘deter the fiduciary from abusing his power’ (Frankel 1983, 824). Such abuse includes, first of all, self-dealing, which preventive rules prohibit, supervise, and limit. The fiduciary duties of directors and managers, for instance, outlaw inside trade; the situation where individuals who access information that are advantageous to hold when participating in open stock market trading acquire stock on basis of such superior information, as such trade may harm the interests of e.g. shareholders. In contrast, in a contract theory governance model, inside trade is a regulatory issue, handled by the Securities and Exchange Commission in the United States, and the question of inside trade becomes more strictly a legal issue. The duty of loyalty thus prohibits directors and managers from using their position and their access to information to their own benefit as such action may ‘harm the interest of the firm’, their beneficiary.

Furthermore and on a more general level, a corporation’s confidential information (i.e. information that could prompt inside trade if being permitted) is treated as a property to which the corporation has an exclusive right, the US Supreme Court have made clear (e.g. United States v. O’Hagan, cited in Smith 2002, 1446). Also in more controversial cases this rule applies, as in the Massachusetts state court decision that granted a tobacco company the right to refuse to disclose the content of its products (Smith 2002, 1446). Another US Supreme Court case statement expressed this interpretation of corporate law accordingly: ‘In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned trader’s deception of those who entrusted him with access to confidential information’ (US Supreme Court statement, cited in Smith 2002, 1420–1421). Thus the strictness of fiduciary law applies within corporate legislation.

In summary, the historical record demonstrates that corporate law stipulates fiduciary duties of loyalty as a legal device that seeks to strike a balance between the vices of ‘laxness and corruption’ and ‘rigidity and excessive regulation’ (Lamoreaux 2009, 18). Fiduciary duties do not provide directors and managers with any unrestrained privileges to participate in self-serving behavior as their loyalty is with the incorporated business and its stakeholders. Despite the strictness of the corporate legislation, contract theorists have expressed their doubt regarding the ‘efficiency’ of fiduciary law vis-à-vis the market contract governance model. In the following section, this argument will be examined.

Governing the corporation: contracts, fiduciary duties or combinations thereof?

Contracts versus fiduciary duties

In law and economics scholarship, a branch within legal theory rooted in economic theory, the legal term fiduciary duty is understood differently than in mainstream legal theory. While legal scholars regard fiduciary duties as absolute and non-negotiable, yet demands recognition of the fiduciary relation’s ‘situation-specificity’ (DeMott 1988, 923), law and economics scholars are concerned about how the corporate system allegedly fails to maximize its efficiency (for a host of studies that advocate the contractual theory of the firm and that shuns fiduciary duties as a legal principle, see Cheung 1983; Baysinger and Butler 1985; Butler and Ribstein 1990; Macey 1991; Hart 1993). For instance, Easterbrook and Fischel (1993, 425), two legal scholars, reject the fiduciary relation of corporate law on basis of the efficiency criterion, and deplore that courts frequently rely on fiduciary duty law in court ruling cases. In Easterbrook and Fischel (1993, 425) view, fiduciary duty as a legal construct is too diverse and broad to be able to effectively handle a variety of ‘agency relations’, including e.g. relations between shareholders and directors and managers. Subscribing to an economic theory view of the firm, Easterbrook and Fischel (1993, 438) suggest that the term fiduciary duties cannot be pinned down as a meaningful definition and thus fails to contribute to the goals that Easterbrook and Fischel (1993, 438) enact, namely efficiency maximization. Consequently, they argue, fiduciary law becomes a de jure and de facto protection of managers that fail to optimize the use of finance capital and otherwise demonstrate indolence or self-serving behavior in their decision-making. In other words, the legal term fiduciary duties does not promote efficiency maximization in the corporate system, and the key stakeholder being disfavored are the owners of the corporation’s stock, allegedly suffering from soaring agency costs (the firm’s investors’ costs to monitor the decision-making quality of managers) and from the managers’ withholding of the so-called residual cash flow that the shareholders have contracted for, according to the contractual theory of the firm. Therefore, in the eyes of proponents of contract theory, fiduciary duties serve as a legal protection against market pricing of the firm’s stock and other issuances (e.g. bonds) that unduly benefits managers. Corporate law, originally designed and enacted as a legal device conducive to increased business venturing and enterprising activities, now, proponents of contract theory argue, de jure and de facto, insulates managers from market-pricing activities. Such legal protection enables managers to invest the cash being generated by the corporation in either projects with low returns in comparison to other investment opportunities that shareholders can take advantage of, or projects that otherwise protects the managers’ own interests.

Easterbrook and Fischel (1993) and other proponents of contract theory suggest that the legal system tolerates managerial malfeasance and self-aggrandizing behavior, and that the lax control of managers lowers the aggregated efficiency and leaves shareholder unprotected against, e.g. self-serving managers. To amend this situation and to bypass mandatory rule of corporate law, contract theorists conceptualize fiduciary duties as a form of contract. As fiduciary duties, by definition, are complicated to represent in one unified and coherent model, contract theorists suggest that the relationship between managers shareholders, defined as the so-called ‘residual risk-bearers’ in the corporate system (See Coffee 1986, 73, note 200), should be understood on basis of the legal term contract. More specifically, such a contract defines shareholders as the firm’s ‘investors’ in the new vocabulary, thus being the principals of the corporation, and with acting managers as the shareholders’ agents (Fama and Jensen 1983). That is, the term contract is introduced as a legal device that operationalizes and formalizes fiduciary duties, and ultimately subsumes fiduciary law under contract law. By simply fiduciary duties as a specific form of contracts, proponents of the contract theory claim to cut the Gordian knot of the alleged sub-optimization of efficiency in the corporate governance function: ‘Contract and fiduciary duty lie on a continuum best understood as using a single, although singularly complex, algorithm’, Easterbrook and Fischel (1993, 446) argue.

Macey (1991), a legal scholar, follows another route than Easterbrook and Fischel (1993) but reaches the same conclusion and prescribes the same remedy, that is, a claim that ‘[c]orporations are merely complex webs of contractual relations’ (Macey 1991: 26). As opposed to Easterbrook and Fischel (1993), Macey (1991) does not reject the legal term fiduciary duties out of hand, but instead argues that shareholders are the residual risk-bearers and the residual claimants exactly because ‘this is the group that faces the most severe set of contracting problems with respect to defining the nature and extent of the obligations owed to them by officers and directors’ (Macey 1991, 25). This implies, Macey (1991, 24) continues, that shareholders are the ‘only group that has any incentive to maximize the value of the firm’. This is a disputable argument beyond the mere substantive argument regarding incentives, precisely because the legal term fiduciary duties is introduced to handle situations where contracts are in fact costly and/or complicated to write and enforce. Furthermore, shareholders cannot both enjoy protection from fiduciary duties and rely on a contract theory that grants them certain ownership rights. These two alternatives are mutually exclusive in legal theory (Coffee 1991, 1281). In addition, it is not only shareholders who operate under the influence of incomplete contracts (in turn derived from the influence of non-parametric risk, i.e. ‘uncertainty’) but basically all stakeholders. For instance, employees and managers who develop firm-specific skills, and who are therefore, in finance theory terms, considerably ‘less diversified’ than the median shareholder are exposed to uncertainty (Coffee 1986, 17). This issue regarding the degree of diversification is a point that contract theorists agree on: Investors are offered a ‘formidable array of investment alternatives’ and are clearly ‘not forced’ to accept any particular investment, Butler and Ribstein (1990, 13) say. Despite this recognition of the supply of investment opportunities, Macey (1991, 26) argues that fiduciary duties should be ‘owed exclusively to shareholders’ on the ground that they are the only residual claimants. This argument is in turn an argument derived from the financial theory proposition that ‘shareholders retain the ultimate authority to control the corporation’, as they are, ex hypothesi, stipulated to have the ‘greatest stake in the outcome of corporate decision-making’. To further support this hybrid version of fiduciary duties and contractual relations, benefitting shareholders, Macey (1991, 26) relies on the oft-repeated contract theory argument that what is good for the shareholders is good for all stakeholders (see e.g. Easterbrook and Fischel,1996, 38) and, by implication, for society at large: ‘[A]ll constituencies will be better off by allocating fiduciary duties within the firm exclusively to shareholders if the latter place the highest value on such duties’.

This alleged benefit of shareholder primacy governance is further substantiated by the theoretical proposition that ‘corporate agents’ (i.e. top managers) are unfit to serve ‘many masters’ – ‘employees, communities, bondholders, customers, suppliers’ – and that such complex instructions in turn create ‘confusion and misunderstanding’ in courts and litigation cases (Macey 1991, 24; ee also Easterbrook and Fischel, 1996, 38; Jensen 2002, 237). Proponents of fiduciary duties would argue that this ability to serve ‘many masters’ is precisely a benefit of ‘centralized management’ as stipulated by corporate law, a distinct managerial competence and skill, trained and acquired through practice.

To further substantiate his argument, Macey (1991) invokes the other key proposition of contract theory, that top managers are underperforming in predictable ways and thus have strong incentives to protect themselves from market pricing and shareholder influence. In the end, for Macey (1991, 26), ‘[I]t seems patently clear’ that the ‘true purpose’ of fiduciary law statutes is to ‘benefit a single nonshareholder constituency’, i.e. top managers in public firms, who regard fiduciary duties as yet another ‘weapon in their arsenal of antitakeover protective devices’. In contrast, to recognize shareholders both as beneficiaries in fiduciary relation and holding contractual rights, per se a curious blend of legal theory traditions, is for Macey (1991) ‘good for all’, and as it provides an ultimate check on alleged managerial malfeasance.

Incomplete contract theory

The literature on incomplete contracts provides a more subtle argument than merely suggesting that fiduciary duties serve as a legal managerial protection device against market evaluations. Instead, when navigating in a world characterized by a shortage of information and costs associated with acquiring information (see e.g. Stiglitz and Weiss 1981; Grossman and Stiglitz 1980; Akerlof 1970), emergence and other conditions that make contracts costly to write, monitor and enforce, i.e. contracting parties ‘cannot anticipate or explicitly describe all future states of the world’ (Christensen, Nikolaev, and Wittenberg-Moerman 2016, 399), contracting parties have to rely on incomplete contracts. In addition, incomplete contract theory was originally developed to examine under what conditions there are integrations within a firm rather than comparable market transactions, i.e. the core objective of incomplete contract theory is not to justify shareholder primacy governance, but to examine under what conditions firms emerge in markets. In Hart’s (123) view, a contract is incomplete when it ‘[c]ontains gaps or missing provisions; that is, the contract will specify some actions the parties must take but not others; it will mention what should happen in some states of the world, but not in others’. In this case, there is a risk of post-contractual opportunism that can be counteracted by the parties’ right to revise the contract. In this process to negotiate the rights and liabilities of contracting parties under the influence of uncertainty, disputes may surface, demanding participation from third parties to resolve them. In Hart’s (1988, 123) view, the incompleteness of contracts implies that there must be ‘[s]ome mechanism by which the gaps are filled in as time passes’, and therefore the incompleteness of contracts ‘[o]pens the door to a theory of ownership’ (Hart 1988, 123). Furthermore, when ownerships become an issue, the concept of governance is implied: ‘[W]hen contracts are incomplete in the sense that they cannot incorporate all future contracting opportunities, governance becomes consequential’, Bengt Holmström suggests (cited in Rock and Wachter 2001, 1631).

‘Asset ownership’ avoids what Aghion and Holden (2011, 184) refer to as ‘underinvestment in productive activities’, which in turn would generate negative consequences for aggregated economic well-being. Christensen, Nikolaev, and Wittenberg-Moerman (2016, 404) explicitly address how incomplete contracts unaccompanied by ownership mechanisms ‘destroy incentives to enter contracts ex ante’, which in the next instant leads to ‘deadweight losses’. In this view, asset ownership is a mechanism that ensure what Christensen, Nikolaev, and Wittenberg-Moerman (2016, 401) refer to as ‘contract efficiency’, defined as ‘the total value, or “joint surplus”, realized by parties entering into a contract’. Asset ownership is functional when one of two contracting parties has stronger incentives to monitor an asset. The contractual right to execute this role through ownership generates economic welfare effects that maximize contract efficiency (Aghion and Holden 2011, 184). For instance, shareholders invest their finance capital in a corporation by acquiring stock, whereas salaried managers, granted the formal and real power to made business-specific decisions, do not serve this role, and therefore shareholders are incentivized to claim the right to make the managers their agents (Aghion and Holden 2011, 185). That is, the shareholders’ ownership of the stock justify their role as the managers’ principals, agency theorists suggest, as this relation is stipulated to maximize the efficiency of the corporate system. However, as Hart (1988) remarks, just because incomplete contracts are written, it does not follow that a specific actor can legitimately make ownership claims, but such processes falls outside of the incomplete contract theory per se.

Schwartz and Scott (2003, 544) follow Christensen, Nikolaev, and Wittenberg-Moerman (2016, 401) claim that contract efficiency is the sole purpose of contract law, i.e. it should ‘[f]acilitate the efforts of contracting parties to maximize the joint gains (the “contractual surplus”) from transactions’. This general proposition, that contract law should maximize efficiency and ‘restrict itself to the pursuit of efficiency alone’ (Schwartz and Scott 2003, 545), rest on the proposition that economic well-being is synonymous with contract efficiency maximization: ‘[E]fficiency is the only institutionally feasible and normatively attractive goal for a contract law that regulates deals between firms’, Schwartz and Scott (2003, 546) write. Furthermore, Schwartz and Scott (2003, 551) make the assumption that firms ‘rationally pursue the objective of maximizing profits’, which in turn provide managers with incentives to choose contracts and contracting strategies that will maximize the surplus. In comparison to courts and ‘statutory drafters’ (Schwartz and Scott 2003, 549), firms, i.e. manager, are in a better position to maximize the economic welfare generated on basis of contracts. However, as Christensen, Nikolaev, and Wittenberg-Moerman (2016, 398) admit, ‘[t]he notion of contracting costs is very general’, and Schmitz (2001, 2–3) suggests that ‘[t]here is no clear definition of what really constitutes an incomplete contract’, which consequently makes it ‘difficult to judge whether a given contract is incomplete or not’.

Similar to agency theory’s foundational concept of agency costs, which managers are assumed out of hand to aggregate to a considerable level, the concept of contracting costs, an important input variable in the optimization of contract efficiency, and more generally the concept of incomplete contract are analytical devices that serves a role in a theoretical pursuit, yet remain complicated to materialize in robust accounting data. Still, in the end, incomplete contract theorists argue, including both economists and legal scholars, incomplete contracts as a legal and operative device generate net economic welfare in excess to the corporate legislation model relying on fiduciary duties. In this view, the extant corporate legislation is inflexible and do not recognize the efficiency criterion of incomplete contract theory, nor does it recognize the externalities generated by the managerial discretion that incomplete contract theorists anticipate. As opposed to traditional contract theory, incomplete contract theory does not downplay the role of governance, nor grant the market the role as an arbiter of efficiency, nor assume that managers are of necessity and always underperforming in predictable ways. The core argument is instead that the freedom to contract maximizes the efficiency of the corporate system and that fiduciary duty law is an inadequate legal device when monitoring the use of economic resources in a world characterized by uncertainty.

Despite the more elaborate incomplete contract theory model, legal scholars reject the contract theory view of fiduciary duties as a contractual relation device, suggesting that it represents a deviation from corporate law as it is written and enforced, in turn being a substantive attempt to handle legal and economic issues that arise within the corporate system. Despite the discrediting of the idea that relations between, e.g. managers and shareholders could be understood in contractual terms on basis of the efficiency criterion in contract law (Schwartz and Scott 2003), and that shareholders should be bestowed with certain privileges as underlying economic theory assumes either (1) market-pricing efficiency as in contract theory (further refined under the label agency theory) or (2) efficiency-gains derived from asset ownership monitoring rights (Aghion and Holden 2011), the contractual theory governance model triumphed in the 1980s and 1990s. By the early 1990s, ‘a consensus has emerged that state fiduciary incorporation charters should be understood in contractual terms’, Kaufman and Zacharias (1992, 559) argue. One key scholarly concern is therefore how corporate legislation and legal theory and scholarship could be bypassed by contract theorists despite the fierce critique of their stated governance model. Elzinga (1977, 1210) proposes that ‘bold statements always have appeal, even when they are incorrect’. In addition to insights regarding the all-too-human preference for new inspiring ideas and venturesome thinking, there is a need for a scholarship that examines how the fiduciary duties of corporate law were systematically discredited from the 1990s and onward.

The legal theory response to contract theory-based governance

Brudney (1997) rejects a ‘legal realism’ position, assuming that there are ‘natural rights’ that are embedded in human reason or in the laws of nature. Instead, Brudney (1997, 596) says, ‘Neither “contract” nor “fiduciary” exists in nature’; such legal constructs are developed within legal discourses to serve normative ends (i.e. practical use) as well as ‘analytic functions’, i.e. to animate debates about the functioning of e.g. the corporate system. Still, as a legal matter, corporate law prescribes a variety of legal devices, and the usefulness of the two terms and their complementarity is a matter of both logical consistency (‘laws in books’) and the practical consequences of their applications (‘laws in practice’; Halliday and Carruthers 2007, 1142). What Gordon (1989) calls ‘normative contractarianism’, it is assumed that (1) parties have the right to engage in free contracting and (2) contracting has bargaining costs and contract monitoring costs (i.e. the cost to ensure that the contracting parties fulfill what the contract prescribes) that are lower than the cost derived from the efficiency loss in extant governance model based on fiduciary duty. The former assumption is rejected by legal scholars on the basis of mandatory rules in corporate law, and the second assumption is treated as being unsubstantiated by empirical evidence, nor being intuitively correct or justifiable (see e.g. Goldberg 1976; Riles 2011). For instance, ‘Under these contracts that provide perfect incentives, the fiduciary relationship is replaced by market exchange. Generally, however, this substitution is unfeasible or too costly’, Cooter and Freedman (1991, 1067) argue.

Regarding the first, ‘free to contract’ argument, a business charter is a license granted by the sovereign state serving as a vehicle for business venturing, including a package of defined rights and obligations, subsidies and exemptions. The incorporation of a business is thus constitutionally a relation between the business promoter and the sovereign state (say, the state of Delaware), including considerable fiduciary duties. This key relation undermines the ‘free to contract’ argument as the business charter already prescribes various mandatory rules that prevents free contracting. At the same time, within the business charter, designed to promote enterprising activities, firms are in fact endowed with considerable freedom to contract, e.g. when hiring employees and negotiating their economic compensation, or with subcontractors or clients. Corporate law renders the legal device of the contract a central role in the business venture, but mandates that fiduciary duties cannot be sidelined or bypassed under any contractual relation. Brudney (1997, 598) proposes that the assumption that incorporated businesses are free to contract as they (i.e. the directors) wish to is mistaken. Instead, Brudney (1997, 598) continues, the fiduciaries’ ability to contract is restricted by their ‘state-imposed obligations’ to their beneficiaries. That is, business promoters who incorporate a business cannot eat the cake and have it to. As being a finance capital-raising venture, the new corporation enjoys certain rights and obligations, but such rights and obligations cannot be cherry-picked or simply ignored as it suits the interests of either team production participants, legal scholars say. That is, mandatory rules enact the directors as a ‘unique form’ of fiduciaries who are held accountable vis-à-vis the corporation as an autonomous legal body (Blair and Stout 1999, 291). As stated by e.g. Delaware Chancery Court in one of its court ruling statements, ‘[The Board] had an obligation to the community of interests that sustained the corporation, to exercise judgment in an informed, good faith effort to maximize the corporation’s long-term wealth creating capacity’ (Delaware Chancery Court, Court statement, cited in Blair and Stout 1999, 296). Contract theorists and incomplete contracts theorists in particular, would in turn argue that the corporate legislation as it is written and enforced is too inflexible, and that it serves, unintendedly or not, to protect directors and managers from being held accountable for their decisions. In the next instance, this legislation generates net economic welfare below that of a contract theory governance model. The issue at hand is therefore to provide evidence that the contractual theory of the firm is conducive to surplus economic welfare as stipulated by the theory.

Regarding the second argument listed by Gordon (1989), that contracting is more conducive to the efficient use of firm-specific resources than a comparable governance system based on fiduciary duties, demands an elaborate argument, including an account of several details of extant corporate law. It is here again important to repeat that proponents of fiduciary duties do not in any way deny that shareholder interests are a key concern for corporate directors and managers. What is disputed is that a contract theory-based governance model is more beneficial for shareholders. First of all, Clark (1989) rejects the idea that the downplaying of fiduciary duties would be beneficial for shareholders, and points at court ruling cases to substantiate this claim: ‘Practically minded judges and legislators’ are not accepting the contract theory efficiency argument out of hand, but believe that the ‘net effect’ of retiring fiduciary duties as a mandatory rule would be ‘clearly bad for investors’ (Clark 1989, 1706–1707). However, this is precisely what contract theorists dispute on both theoretical and substantial grounds. Still, legal theorists argue that the campaign to retire fiduciary duties and to introduce contracts as a primary legal device in the governance of the corporate system is unable to finally resolve defined agency problems: ‘[T]raditional fiduciary loyalty strictures more rigorously protect common stockholders against opportunistic behavior by managers and controllers than does classic contract doctrine’, Brudney (1997, 622–635) claims. ‘In the world of contract’, Frankel (1983, 830) adds, ‘self-interest is the norm, and restraint must be imposed by others’. In contrast, ‘the altruistic posture of fiduciary law’ requires that once an individual agrees to act as a fiduciary on behalf of a beneficiary, the fiduciary ‘should act to further the interests of another in preference to his own’ (Frankel 1983, 830). Therefore, courts generally have little to say about contract relations, while they intervene in the fiduciary relation and require the fiduciary ‘to act with loyalty and skill’, and ‘in the beneficiary’s best interests’ (Frankel 1983, 823).

Proponents of fiduciary law also points at some misconceptions in the contract theory framework. Several legal scholars strongly emphasize that shareholders de facto and de jure do not have the legal right to bring managers and directors to the court if they are dissatisfied with their performance, unless other stakeholder interests are harmed. ‘Corporate law only permits shareholders to bring successful derivative claims against directors in circumstances where bringing such claims benefits not only shareholders, but other stakeholders as well’, Blair and Stout (1999, 298. Original emphasis omitted) remark. ‘Much of business law acts to limit shareholder involvement in corporate governance’, Bainbridge (2006, 1735) adds. De jure and de facto, directors and their manager are granted the right to make a series of decisions regardless of dissatisfied shareholders’ grievances. In Stout’s (2012, 44) account, executives and directors own a fiduciary duty of loyalty to the corporation and therefore they cannot ‘enrich themselves’ at the firm’s expense. Yet they are legally free to pursue ‘almost any other goal’, including a variety of decisions that contract theorists and agency theorists certainly would have regard as an attempt to withhold residual cash flow from shareholders, such as donating corporate funds to charity, rejecting ‘potentially profitable business strategies that might harm the community’, actively counteract hostile takeover bids to protect the interests of e.g. employee or the community, etc. That is, Stout (2012, 44) repeats, as long as directors do not violate their fiduciary duties, shareholders cannot successfully sue directors within the present corporate legislation.

Furthermore, proponents of contract theory have time and again repeated that ‘independent directors’ – preferably an investor with substantial financial stakes in the corporation – is the most efficient mechanism to reduce managerial opportunism and for monitoring managerial decision-making, but empirical data betrays this proposition, instead suggesting that firms with a higher presence of independent directors on the board perform worse than firms with lower presence, i.e. they generate less value in terms of higher stock evaluations and dividends (Bhagat and Black 2002, 263; Macey 2008, 15). Interestingly, this tendency is further pronounced with independent directors recruited from the finance industry (Ellul 2015, 289) – an industry that otherwise is preoccupied with financial efficiency maximization, at least in a short- to medium-term perspective. Ultimately, proponents of fiduciary law argue, the image of the shareholder in contract theory as an autonomous investor, vigorously monitoring incumbent managers to maximize the efficiency of the corporate system, allegedly being only modestly efficient in maximizing efficiency unless being checked by investors, is ‘illusory’ (Stout 2012, 44).

The political view of the firm

Howard (1991, 5) commends contract theorists for formulating a ‘seductive argument’ that is both simple and elegant, but this eloquence is accomplished on basis of the elimination of the difficult issues that legislators and courts have to deal with, ultimately making contract theory an inadequate basis for legal reforms. For legal scholars, the rejection of fiduciary duties on basis of the claim that fiduciary duty is an empty term and that there is ‘nothing special to find’ about it (as stated by Easterbrook and Fischel 1993, 438), is mistaken. DeMott (1988, 891) emphasizes that the term fiduciary duty is a technical legal term, comparable to e.g. ‘contract’, ‘agency’, or ‘fraudulent’, which cannot be used ‘metaphorically’ as it suits the spokesperson. For DeMott (1988), the claim made by contract theorists, that fiduciary duties should be simply understood as a specific form of contract under determinate conditions, is a logically inconsistent and unconvincing argument. In the end, therefore, the core question for legal scholars is that the incorporated business should be understood as a legal device within a politico-economic and financial system that, inter alia, enacts corporate legislation and economic policy. Bratton (1989, 432) argues that contract theorists have misstated ‘the political issues underlying corporate law’. Eisenberg (1990, 1331) in turn suggests that the institution of the publicly held corporation, being ‘essentially noncontractual in nature’, cannot be monitored on basis of contract theory. Finally, Howard (1991) rejects that key proposition of contract theory, that the ‘public business corporation’ is little more than a commodity to be traded on the finance market, and instead envisions the corporation as ‘a living, complicated, dynamic social and economic institution’. If the latter view is taken – as Bratton (1989), Eisenberg (1990), and Howard (1991) do – then the contract theory argument is merely ‘a convoluted, oblique attack on political decision-making in the name of “efficiency”’, Howard (1991, 13) summarizes.

In summary, legal scholars reject the claim that the legal system per se, enacted to ensure an efficient use of corporate charters, impose additional costs that cannot be justified. Howard (1991, 5) argues that much contract theory advocacy assumes that ‘statutory corporate governance rules’ prescribe and justify ‘heavy-handed interference in the affairs of the corporation by government administrators, the courts or both’. ‘Nothing could be further from reality’, Howard (1991, 5) pithily retorts (see e.g. Simmons 2015; Romano 1985; on the specific case of Delaware corporate law). In the contract theory view, the firm is little more than a ‘bundle of contracts’ or a ‘nexus of contracts’ (Jensen and Meckling 1976), leaving to the market entirely the right to define the corporation and to determine its performance on basis of the market pricing of the firms stocks and other issuances. This sceptical or even hostile view of the state and its legislative action and law enforcement in contract theory is ultimately rooted in the belief in the market as a supreme information processing and price-setting mechanism, with the state merely interfering into what are portrayed as self-organizing, even ‘naturally occurring’ markets (Harcourt 2011). In a legal theory view, in contrast, things are less rectilinear and neatly separated into self-enclosed and mutually exclusive categories, and consequently many of the hardest questions that the legislators of corporate law deal with, including that of rights, obligations, benefits, and the interests of various stakeholders are excluded from or understated in contract theory. This results in the contract theorists’ rejection of legislative action as an inferior mechanisms to ensure the efficient use of resources. ‘No matter how much quantitative data and other empirical support is advanced to show that a market would be inadequate to achieve a given end, the pure contractarian’s answer is always the same: the existing mandatory rule is worse’, Eisenberg (1990, 1331) summarizes.

Recent views of fiduciary duties

As indicated by Hawley et al. (2014) edited volume Cambridge handbook of institutional investment and fiduciary duty, the concept of fiduciary duty addresses a core issue in the corporate governance literature, especially in the area of institutional investment in the finance industry. The various contributors to the edited volume either advocate the fiduciary duties or the contract theory solutions to perceived governance problems, and many authors emphasize the growing complexity of the finance industry as being a key issue for scholars to address. In addition, Darr (2014) shows that industry representatives are concerned about the long-term sustainability of institutional investment, and therefore affirm the role of fiduciary duties in finance trading. Lydenberg (2014) argues that the rational choice model, underlying contract theory, has been overstated vis-à-vis other mechanisms, including e.g. fiduciary duties, to the point where it no longer served its purpose:

We have reached a point in the financial world where the exclusive focus on rational behavior in finance has been extended beyond the limited of its usefulness. The hyperactive search for yet more self-interested investment has begun to destabilize finance, harm social structures, and neglect much-needed opportunities to build sustainability and durability into our world. The idea of reasonable fiduciaries cannot impartially and objectively use their investments to achieve positive ends leaves their potential to serve their beneficiaries substantially unrealized. (Lydenberg 2014, 298)

Also Molinari (2014, 164) advocates what she refers to as fiduciary obligations as fiduciary law is ‘premised on protecting the interest of vulnerable parties when others make decisions on their behalf’. In contrast, contract law as a general rule ‘assumes that parties to a contract begin on equal footing’ (Molinari 2014, 164), which testifies to the rationalist assumption of contract law. In the domain of institutional investment, today controlling around 75 percent of all publically traded stock in the United States (Gilson and Gordon 2013, 874), fiduciary obligations remains of central importance: ‘Virtually all asset owners have delegated the day-to-day investment decisions to asset managers and strategic planning to investment consultants, and whether these agents are bound by fiduciary obligation is often unclear’, Molinari (2014, 159) argues. At the same time, Molinari (2014, 159) claims that ‘the space for fiduciary obligations’ is shrinking in the institutional investment world in a period of time when beneficiaries ‘may need it the most’. ‘Pension scheme members of the future can expect less a paternalistic type of protection, and will be expected to be self-sufficient in advancing their own interests’, Molinari (2014, 166) writes. In Lydenberg’s (2014) view, there is no trade-off between self-interested rationality and fiduciary duties, rooted in what Lydenberg (2014) calls reason. On the contrary, only the recognition of ‘the outward-looking acknowledgment of one’s duties to others’ (Lydenberg 2014, 298) will ensure the ‘sustainability for future generations’ in institutional investment. Hawley et al. (2014) offer a variety of arguments and views, but ultimately testifies to an ongoing vivid scholarly debate regarding the role of fiduciary duties in the governance of institutional investment.

Also contract theory continues to inspire studies of fiduciary duties and their role in corporate governance. Rauterberg and Talley (2017) argue that public companies now regard fiduciary duties as a legal device subject to contracting, thus making fiduciary duties merely optional: ‘Public companies have an enormous appetite for tailoring the duty of loyalty when freed to do so’ (Rauterberg and Talley 2017, 1078. Original emphasis omitted). It is important to notice that Rauterberg and Talley (2017) distinguish between two component of fiduciary law, duty of care (which can be subject to contracting within various jurisdictions) and duty of loyalty, which is traditionally has been ‘immutable’ (Rauterberg and Talley 2017, 1085). Based on the observations that ‘Delaware and the vast majority of other states allow parties to contract around the duty of care in various respects’ (Rauterberg and Talley 2017, 1084), and that public companies use such liberties when designing their governance model, Rauterberg and Talley (2017) make the claim that also the duty of loyalty should be subject to legal reform. Ivanova (2017, 1084) thus contributes to the critical literature on fiduciary duties, stipulating the shareholders as the ‘ultimate owners’ of public corporations.

Summary: fiduciary duties in the scholarly literature

Prior to the 1970s, fiduciary duties were not an issue subject to systematic scholarly inquiry and ongoing debate. The pro-business campaign of the 1970s, following the decline of the level of profitability in American industry and the bear stock market, fiduciary duties became an issue subject to critique. Law and economics scholars and economists treated fiduciary duties as a legal complication that protected low-performing managers from market evaluations, thus providing only weak incentives for managers to act in concert with shareholder interests. In the 1980s and 1990s, fiduciary duties was targeted by law and economics scholars and economists, and defended by primarily legal scholars. The former group advocated legal reforms to reduce managers and directors’ legal protection against market evaluations, whereas the latter maintained that fiduciary duties are (1) mandated by corporate law as it is written and enforced and (2) regardless of these strictures, beneficial for shareholder interests. By the turn of the millennium, the shareholder primacy governance model was instituted on broad scale (Hansmann and Kraakman 2000), indicating the success of the law and economics scholarship campaign to downplay managers and directors’ responsibilities vis-à-vis a broader set of constituencies. Yet, to this date, scholars continue to publish work that criticizes the role of fiduciary law within corporate legislation (see e.g. Rauterberg and Talley 2017). The 1980–1999 was thus the period wherein fiduciary duties was more actively debated, but arguably attending less scholarly attention when finance industry reforms by the end of the 1990s and financial innovations created new means for controlling corporations on basis of the market-pricing mechanism, paving the way for the current situation. The main arguments are summarized in Table 1.

Table 1. The scholarly literature on fiduciary duties.

	Theoretical focus	Main arguments	Exemplary publications (chronological order)	Exemplary quotes
Supportive of fiduciary duties	Legal theory	1. Corporate law is a constitutional law. Fiduciary law provides mandatory rules. 2. Fiduciary law provides better protection for shareholders than contract law does. 3. The marginalization of fiduciary law is an attempt to (1) separate the legal device of the corporation from the sovereign state and (2) to marginalize the role of the sovereign state as a legitimate market-maker.	Frankel (1983 DeMott (1988) Clark (1989) Eisenberg (1989 Gordon (1989) Cooter and Freedman (1991) Brudney (1997) Smith (2002 Stout (2012)	“To many who have had experience in the corporate world, it seems obvious that if a corporation adopts a charter amendment opting out of the fiduciary duty of loyalty, the net effects will be clearly bad for investors”. (Clark 1989, 1706–1707) “[T]raditional fiduciary loyalty strictures more rigorously protect common stockholders against opportunistic behavior by managers and controllers than does classic contract doctrine”. (Brudney 1997, 622–635)
Critique of fiduciary duties	Law and economics theory Economic Theory	1. Fiduciary duties impose unnecessarily complicated legal strictures on market actors. 2. Fiduciary duties protect low-performing managers from market control And justify low-return investment at the shareholders expense. 3. Contracts stipulate and define responsibilities between business partners.	Legal theory Butler and Ribstein (1990) Macey (1991) Easterbrook and Fischel (1993) Rauterberg and Talley (2017) Economic theory Cheung (1983) Baysinger and Butler (1985) Hart (1993)	“Markets lead managers to adopt the optimal mix of legal and market governance structures for their firms. The optimal mix reflects the preferences of the firm’s residual claimants”. (Baysinger and Butler 1985, 182–183) “[T]here may be substantial scope for loosening at least some of the ossified strictures of the duty of loyalty, permitting corporations greater freedom to tailor their governance arrangements so as to best suit their needs and capabilities”. (Rauterberg and Talley 2017, 1147)

Discussion

‘Most works on corporate governance…focus primarily on internal governance, which relates to the balance of power among shareholders, boards of directors, and managers’, Pargendler (2016, 362) argues. Yet, she (2016, 370) continues, ‘corporate governance is not the sole possible solution to agency problems and agency problems are not the exclusive target of corporate governance’. This singular focus on the relationship between managers, shareholders, and directors at the expense of all other stakeholder relations have been widely recognized as concern among management scholars (Starbuck 2014; Donaldson 2012; Lan and Heracleous 2010; Hambrick, Werder, and von, Zajac 2008; Daily, Dalton, and Cannella 2003). ‘In nearly all modern governance research governance mechanisms are conceptualized as deterrents to managerial self-interest’, Daily, Dalton, and Cannella (2003, 372) say. Consequently, they add (2003, 379), there is a need for ‘alternative theoretical perspectives’ in corporate governance studies. One way to re-articulate corporate governance problems is to return to the original corporate legislation and to emphasize how fiduciary duties and contracts have been portrayed as legal devices conducive to economic welfare.

The contractual theory of the firm proposes the efficiency criterion to justify the retirement of fiduciary duties and to mandate contractual relations within the corporate system. Legal scholars dispute such claims on multiple grounds, as summarized below:

• Legal theory arguments, e.g. corporate law include mandatory rules, and fiduciary duties are a technical, legal term that cannot be compromised. That is, business participants are not free to enter contractual relations that violate the fiduciary duties of the directors and managers.

• Substantial grounds, e.g. even if legal issues could be bypassed or muted (through e.g. legal reform), fiduciary duties still provide a stronger protection against managerial opportunism and substandard decision-making quality than the contract device do.

• On an ideological basis, e.g. the corporation is characterized as a ‘political’ institution, i.e. it is a multidimensional and social entity irreducible to contract relations. In addition, the state does not impose heavy-handed legal and regulatory control that inhibits economic dynamics and efficiency, and the state as legislator and its regulatory agencies actively promote rather than slow down or prevent enterprising on basis of legislative action and law enforcement.

Yet, the contract theory view trumps the multidimensional and politicized view of the corporation in legal theory, presenting a schematic and easy-to-tell image of convoluted and difficult-to-oversee economic conditions that discredit the more accurate but also more complicated image. As Offer and Söderberg (2016, 2) remark, ‘Economics is not easy to master, but easy to believe’. In contrast, the term fiduciary duty, the centerpiece of corporate law, troubled by its own vagueness and reliance on situation-specific information in e.g. court ruling cases, is a more complex analytical and practical device than contract theorists tend to admit. In this view, contract theorists and incomplete contract theorist, despite their concern for the efficiency of the corporate system and its capacity to generate economic welfare, do not yet present a model that justifies legal reform, i.e. the retiring of fiduciary law in corporate governance. In the end, however, legal scholars seem to have lost the debate as contract theorists and incomplete contract theorist make a ‘bold statement’ (Elzinga 1977, 1210) and present a ‘seductive argument’ being both ‘simple and elegant’ (Howard 1991, 5). The contract theory governance model apparently appealed to top managers, now acting in accordance with normative shareholder primacy prescriptions (Rock 2012): ‘The “shareholder value” movement of the past generation has succeeded in turning managers into faithful servants of share price maximization, even when it comes at the expense of other considerations’, Davis (2015, 155) argues. Such claims are substantiated by finance market data: Between 1982 and 1997, Dow Jones Industrial Index ‘increased eight-fold’ while salaries was stagnant. ‘Shareholder value creation indeed’, Blair and Stout (1999, 325) remarks.

In hindsight, a substantial empirical literature suggests that a corporate governance system that downplays or marginalizes fiduciary duties and embraces contracts as the principal legal device for regulating relations between the corporation’s stakeholders did not at all lead to prudence and moderation on part of managerial elites. The present regime of investor capitalism (Conard 1988; Useem 1996) or agency capitalism (Gilson and Gordon 2013) promotes shareholder primacy governance, with other stakeholders losing positions in the competitive game. While some governance scholars are agnostic regarding the medium to long-term consequences of the shareholder primacy governance (e.g. Morrell and Heracleaous 2015), other governance scholars point at substantial consequences and its consequences for competitive capitalism as a dynamic and resilient system (Tomaskovic-Devey, Lin, and Meyers, 2015). The new regime of contract relations coincides with seismic shifts in executive compensation (Suárez 2014; Frydman and Jenter 2010; Bebchuk and Grinstein 2005, 286; Bebchuk and Fried 2004), the eruption of corporate scandals (as in the case of the LIBOR manipulation scandal; see Vaughan and Finch 2017; Ashton and Christophers 2015), slower economic growth (Ivanova 2017; Gordon 2015), increased economic instability (Charles 2016; Calomiris and Haber 2014), increased economic inequality (Kristal and Cohen 2017; Bonica et al. 2013; Kristal 2013), lower investment in production capital, human resources, and R&D and innovation (Lysandrou 2011; Stockhammer 2004), and, overall, a less resilient corporate system (Gordon 2015; Decker et al. 2014). In this view, the legal theory concept of fiduciary duties is still relevant for the governance of the corporate system, and it may be successfully rehabilitated to restore the trust in what has been called the ‘Berle-Means firm’ (Roe 2000, 546) or the ‘Berle-Means Corporation’ (Garvey and Swan 1994, 143), the public corporation being defined as a bundle of legal rights and responsibilities, intended to serve as vehicle for enterprising and business venturing for the benefit of economic welfare. Possibly, given the reported decline in Initial Public Offerings and the growth of private equity firms (Fang, Ivashina, and Lerner 2015; Harris, Jenkinson, and Kaplan 2014; Turco and Zuckerman 2014; Appelbaum and Batt 2012), we may already be witnessing, Davis (2015) suggests, ‘the twilight of Berle-Means corporation’.

Conclusion

This article defined two purposes: The descriptive purpose was to discuss how corporate legislation and the legal devices of fiduciary duties and contracts have evolved overtime and as responses to perceived political, economic, and legal challenges, demanding purposeful action and legislative reform. The normative purpose was to critically discuss how contract theory has actively undermined and rendered fiduciary duties suspicious within the shareholder primacy governance model, being advocated from the early 1960s (with Manne 1962, critique of the work of Berle and Means as an early, notable contribution). The article thus contributes to corporate governance literature by stressing how alternative or complementary legal devices and concepts are invoked in debates regarding the governance of the corporation. Rather than being neutral and disinterested terms, contracts and fiduciary duties are concepts that are invoked within a political and economic context wherein choice alternatives need to be justified by what social actors regard as substantiated theories. That is, as demonstrated in the sections above, contract theorists’ criticism and rejection of fiduciary law within corporate legislation should be understood as a more deep-seated structural shift in corporate legislation and governance, best summarized as the entrenchment of shareholder primacy governance. Expressed differently, legal theories of contracts and fiduciary duties are performative (Callon 2007) inasmuch as they serve to construct the economic conditions and legal frameworks they purport to describe and apprehend, making the question of legal theory constructs not only a matter of epistemological certainty but also an issue of operational flexibility and anticipated substantive economic consequences. As the field of corporate governance studies report many challenges for the future, the historical development of central terms is not only of more marginal interests, but do in fact reveal how the incorporated business was originally enacted by the sovereign state as a vehicle for enterprising and venturing – not a device univocally constructed to enrich finance capital investors. To ignore such historical records is to turn a blind eye to the legal constitution of the corporation. In the end, therefore, further corporate governance research is needed examine the consequences of the enactment of the firm as a bundle of contracts or, alternatively, a device conducive to team production efforts.

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No potential conflict of interest was reported by the author.

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Alexander Styhre

Alexander Styhre, PhD, is Chair of Organization and Management, School of Business, Economics, and Law, University of Gothenburg, Sweden. He has published widely in the field of organization studies. His most recent work includes Corporate Governance, The Firm and Investor Capitalism (Edward Elgar, 2016).