Business ethics and the theory of the firm

Business ethics and the theory of the firm

Modern theory of the firm, which is central to finance and corporate law.


The modern theory of the firm, which is central to finance and corporate law, views the corporation as a nexus of contracts among the various corporate constituencies.(1) Upon this foundation, finance theory and corporate law postulate shareholder wealth as the objective of the firm. Research in business ethics has largely ignored this nexus of contracts theory of the firm except to reject the financial-legal model as normatively inadequate.(2) Philosophers generally bring philosophical theories of ethics to bear on problems of business, and they regard the contractual theory of the firm primarily as a subject for criticism using the resources of philosophical ethics. In particular, stakeholder theory, which stresses the importance of all groups that affect or are affected by a firm, has been proposed as a more adequate theory of the firm for studying business ethics.(3)

The purpose of this paper is to examine the implications of the contractual or nexus of contracts theory of the firm for business ethics research. This theory is a powerful descriptive tool in financial and legal theory, but its potential as a normative theory for examining the ethical problems of business has not been systematically explored. This paper does not attempt to defend the contractual theory nor to assert its superiority to any alternative, such as a stakeholder approach. However, the contractual theory provides a framework for identifying and analyzing many business ethics problems and for devising solutions to these problems, and this framework is worth developing systematically. An important benefit of business ethics research conducted within such a framework would be a narrowing of the gulf between business ethics and the fields of financial economics and corporate law. Business ethics is widely dismissed as irrelevant by researchers in these fields because of its failure to recognize the existing financial and legal structures of the corporation, which are built largely on a contractual foundation. Hence, a common framework could increase the relevance of business ethics research and create a mutually beneficial dialogue.

The first section of this paper explains the contractual theory of the firm from its origin in the work of Ronald Coase to the articulation of the theory in finance and law. The fundamental problem for corporate governance with the contractual theory is the need to protect the firm-specific assets of all corporate constituencies. Although the contractual theory addresses primarily the interests of shareholders, it also provides many protections for nonshareholder constituencies. These safeguards are described in the second section. The third section offers a framework for the analysis of business ethics problems from the perspective of the contractual theory that classifies problems and lists the remedies that are available within the contractual theory. As a normative theory of the firm, the nexus of contracts view does not disregard nonshareholder constituencies but provides, in fact, a framework for understanding and addressing their distinctive problems. As an example of how this framework can be applied, a few observations are made about the conflict between shareholder and employee interests that arises from corporate downsizing. Because the contractual theory is concerned mainly with the nature of the firm itself and with the groups that comprise it, many business ethics problems that arise from more general economic forces fall outside the scope of the theory and cannot be addressed by the theory’s framework. A brief description of these kinds of problems is offered in the fourth section.


The theory of the firm has a long and tangled history.(4) In economics, neoclassical marginal analysis regards the firm as a profit maximizing unit in order to explain various economic phenomena. For the purposes of such explanation, marginalists see no need to inquire into the internal workings of actual corporations. Beginning in the 1950s, however, the marginalist theory of the firm has been challenged by behavioral and managerial theories, which draw on empirical investigations of corporate decision making.(5) Behavioral theorists find that objectives other than profit are pursued by managers

Traditional law on corporate governance has reinforced economic theories of the firm, despite the appeal to different grounds. The legal conception of the corporation as an artificial body created by the state is predicated on the assumption that the corporate form confers certain social benefits. Thus, the limited liability of shareholders and the unlimited life of corporations are justified for their contribution to social well-being. Although the fiduciary duties of management were based initially on the property rights of shareholders,(6) this argument has been eroded by the separation of ownership and control, with the result that fiduciary duties are now founded primarily on the need to restrain managerial discretion.(7)

The modern theory of the firm as a nexus of contracts originated with Ronald Coase’s seminal insight that firms exist as less costly alternatives to market transactions(8) In a world of zero transaction costs, economic coordination would be achieved entirely by means of contracting among individuals in a free market. Because of the cost of negotiating and enforcing contracts, however, some coordination can be achieved more cheaply through firms, which substitute hierarchical decision making for decisions made through markets. Thus, there are two forms of economic coordination — firms and markets — and the choice between them is determined by transaction costs. Firms incur some costs in coordinating through hierarchies, and they forgo some of the benefits of market coordination

From a Coasean view, the firm is a market writ small in which parties with economic assets contract with the firm to deploy these assets in productive activity. The reason for deploying assets in a firm instead of the market is to realize the benefits of team production through the reduction of transaction costs

In the financial articulation of the contractual theory, shareholders become residual risk bearers

From the fact that shareholders are residual claimants, it does not follow that maximizing shareholder wealth ought to be the objective of the firm. Shareholders are merely one among many constituencies of a firm, and they differ from other constituencies primarily in the nature of the role they serve. The argument for shareholder primacy is usually completed by contending that only residual risk bearers have the appropriate incentives for making discretionary decisions that maximize the creation of wealth by a firm. Because bondholders, employees, and other constituencies with fixed claims tend to favor decisions that secure their claims and no more, some profitable investment opportunities might not be pursued if these stakeholders had control. Managers, too, lack the incentives to pursue all profitable ventures, especially those that would reduce their power or place them at risk. Finance theory holds that wealth maximizing decisions are more likely to be made by residual claimants, because they bear the marginal costs and gain the marginal benefits of all new ventures. In the financial articulation of the firm, the interests of all constituencies are best served by making the shareholders’ interests the objective of the firm and by securing the interests of bondholders, employees, and other stakeholders with fixed claims.

In the legal articulation of the contractual theory, the norm of maximizing shareholder wealth is defended on the grounds that having corporate control — or binding the managers who have control to act in one’s interest — is a protection that is of greater value to residual claimants than to other constituencies. Shareholders, therefore, are more willing to pay for the privilege of having their interests be the objective of the firm, whereas bondholders, employees, and other stakeholders rationally prefer different contractual arrangements. The complexity of managerial decision making precludes the possibility of determining in advance the specific decisions that would maximize shareholder wealth. So fiduciary duties are an alternative to explicit contracting that gives management wide latitude in choosing the means for acting in the shareholders’ interests.

The contractual theory of the firm is indifferent between alternative financial and legal structures. Through contracting, any constituency or stakeholder group could become the beneficiary of the firm’s wealth-creating powers or the fiduciary duties of management. Indeed, this is what happens when corporations become employee-owned or customer-owned. Employees have successfully bargained for representation on boards of directors, and bond indentures sometimes give bondholders a right to vote on certain risky ventures. When corporations are in distress, creditors take control from shareholders, and the creditors’ interests become primary until the firm recovers. Finally, so-called other constituency statutes permit directors to take nonshareholder interests into account in responding to takeover bids.(11) Although many structures are possible, some are more efficient than others, and over time more efficient structures tend to predominate through a Darwinian struggle for survival. For this reason, holders of the contractual theory in both finance and corporate law contend that making shareholder wealth the objective of the firm best promotes the welfare of society as a whole. This objective has been tested over time and found to be efficient.


Business ethics problems most commonly involve the treatment of nonshareholder constituencies, which is to say the treatment of employees, customers, suppliers, and other stakeholder groups. The contractual theory of the firm, which assigns a clear role to shareholders, does not neglect nonshareholder interests but treats them differently. The relevant normative question to ask on the contractual theory is whether the treatment of each constituency is ethically justified. This is a complex question that involves at least two separate questions. One is whether the theory allows sufficient opportunity for each constituency to protect or advance its interests in the contracting process. That is, is it possible, given the assumptions of the contractual theory, for each constituency to be treated ethically? The second question is whether each constituency is, in fact, adequately protected or served. And if the answer to the second question is negative, then further questions arise about the best means for improving the condition of any constituency. Does the fault lie with the theory, so that solutions to problems require that we change or abandon the theory itself? Or does the theory permit solutions that have not been fully utilized? In order to answer these questions, it will be useful, first, to examine why safeguards for nonshareholder constituencies are needed. In other words, what do nonshareholders need to be protected against?

The contractual theory assumes that each constituency in a nexus of contracts has firm-specific assets that can be more profitably deployed in team production than in the market. Since firm-specific assets create quasi-rents, which can be appropriated, no constituency will make their firm-specific assets available to a firm without adequate safeguards against post-contractual appropriation. All constituencies, therefore, need protection for the firm-specific assets that participation in a firm exposes to the risk of appropriation. The safeguards for shareholders are the main subject of the financial and legal articulation of the firm. That is, shareholders are protected primarily by making their interests the objective of the firm and the subject of management’s fiduciary duties. If the need for safeguards is to protect firm-specific assets from post-contractual appropriation, then what safeguards are available to nonshareholder constituencies?

The Means for Safeguarding Nonshareholder Constituencies

Nonshareholder constituencies have a number of means available for safeguarding their investment in a firm, many of which are denied to shareholders. Among these are the following.

Explicit Contracts

These include both express and implied contracts and other contract-like agreements that are legally enforceable. Thus, bondholders are protected by bond indentures

Gap-filling Judicial Interpretations

Contracts are unavoidably incomplete, and many disagreements over interpretation are adjudicated by courts, which fill in the gaps between the written words. Courts rely on many factors, including the intentions of the parties in making the contract and the agreements that they would have made had they bargained over the disputed points. Insofar as this judicial gap-filling introduces principles of good faith and fair dealing or considerations of public policy, employees and other constituencies have an additional source of protection. For example, many states have carved out a public policy exception to employment at will that limits the right of employers, even when a dismissal is allowed by an otherwise valid employment contract.(12)

Implicit Contracts

Implicit contracts consist of claims that firms make to stakeholders that are not easily formulated or are left purposely indefinite. Thus, firms are able to attract employees with assurances of continued employment and good working conditions and to maintain good customer relations with promises of quality and service. Both wages and prices are very sensitive to expectations about the willingness or ability of a firm to honor such implicit contracts. Implicit contracts generally have no legal standing, and so their observance is largely a matter of good faith dealing, although the failure to observe implicit claims often has economic consequences. For example, firms that fail to honor their implicit contracts may lose valued employees or customers.(13)

Government Regulation

Government regulation is an important source of protection for every stakeholder group, and a central aim of regulation is to ensure the equitable treatment of all corporate constituencies. The forms of government regulation and their rationales defy easy generalizations, but, broadly speaking, two approaches to regulation have been taken in the twentieth century, substantive and procedural.(14) The former seeks to impose certain outcomes, whereas the latter seeks to create rules by which outcomes are achieved. The former is often seen as noncontractual or extracontractual in nature and relies on the responsible exercise of managerial discretion, including the observance of certain fiduciary duties. The latter approach, by contrast, attempts to influence outcomes by shaping the conditions under which groups bargain. Although a procedural approach is more in keeping with the contractual theory of the firm, a substantive approach is not incompatible with the contractual theory insofar as our understanding of contracting is expanded to include the competition for favorable regulation.

These four safeguards — explicit contracts, gap-filling judicial interpretations, implicit contracts, and government regulation — are available to shareholder and nonshareholder constituencies alike. The forms that these safeguards take for shareholders, including their claims on management loyalty and the fiduciary duties of management, are different from the forms of protection afforded to bondholders, employees, consumers, and other constituencies. It does not follow from this fact alone, however, that the safeguards for any stakeholder group are better or worse than those of any other. Indeed, the safeguards for nonshareholder constituencies can be very strong inasmuch as they constitute fixed claims, and the residual claims of shareholders are often regarded as weaker substitutes that address the special contracting problems of shareholders.(15)

Fixed and Residual Claims

In order to develop remedies for specific problems of nonshareholder constituencies, we need to be aware of the advantages and disadvantages of fixed and residual claims. Because the residual claims of shareholders make their interests the objective of the firm and the subject of the fiduciary duties of management, it is widely assumed that shareholders are privileged in a way that other constituencies are not. As a result, many critics of corporate governance propose that nonshareholders be made residual claimants like shareholders, which is to say that the objective of the firm and the fiduciary duties of management be expanded to include the interests of other constituencies. However, residual claims may not be the best solution to problems of nonshareholder constituencies, and the attempt to treat nonshareholders like shareholders may draw our attention away from developing effective solutions for the genuine problems that each constituency faces.

If the overriding problem is how to protect the firm-specific assets of each constituency from appropriation, then the solution is to create claims — either fixed or residual — that provide the best protection. To the extent that the fixed claims of other constituencies are weak, the remedy may well be to strengthen these fixed claims rather than to confer residual claims on various stakeholder groups. Residual claims have some undeniable benefits, however, and fixed claims have some corresponding drawbacks, which must be taken into account in the development of solutions for the problems facing nonshareholder constituencies. In particular, residual claims better address two kinds of problems–namely, those that arise from imperfect contracting and the externalization of costs–and some means must be found, therefore, for solving these problems using either fixed or residual claims.

Problems of Imperfect Contracting

Fixed claims have the advantage of certainty. A firm can default on explicit contracts only under conditions of liquidation or bankruptcy, and contract and tort law provide many remedies for the failure to honor other kinds of fixed claims. The certainty of fixed claims provides little protection, and indeed may become a liability, if the terms are not satisfactory because of imperfect contracting. It is well recognized that contracting may not have mutually satisfactory or optimal results because of the problems posed by incomplete knowledge, uncertainty, and bounded rationality. Thus, management and labor unions may negotiate ironclad contracts that one or the other later regrets because of unforeseen developments. In addition, constituencies with only fixed claims may lose control of a relation once a contract is made and have little recourse later. Moreover, all contracts depend to some extent on good faith compliance, so that fixed-claim constituencies may also suffer from post-contractual opportunistic behavior that lacks any legal remedy.

Residual claims solve this problem with respect to shareholders by means of fiduciary duties. Because contracts are always incompletely specified, nonshareholder constituencies run the risk that vagueness, generality, and omission will work to their disadvantage. The fiduciary duties of management, by contrast, do not consist of precisely formulated rules but impose an open-ended obligation to act in the shareholders’ interests. Fiduciary duties are also strongly mandatory and cannot generally be waived, even with shareholder approval. Although the business judgment rule permits management wide discretion in administering the contracts of all constituencies, any benefit to nonshareholders must still be rationally related to shareholder welfare.

Freedom to Externalize Costs

The fiduciary duty to act in the interests of shareholders creates a presumption that firms are free to externalize costs whenever possible and may even have an obligation to do so when shareholders benefit. Thus, takeovers that inflict great losses on bondholders, employees, and communities are justified on the grounds that they maximize the wealth of shareholders. Pollution, consumer injuries, and plant relocation are further externalities that corporations feel free to externalize as a matter of course. Corresponding benefits to nonshareholder constituencies, by contrast, are usually considered to be irregular and in need of special justification. This presumption in favor of externalizing costs generally benefits stakeholder groups with residual claims to the detriment of those with fixed claims.

These benefits of residual claims–and the corresponding deficiencies of fixed claims–are significant inasmuch as they lie at the heart of many business ethics problems. Fixed and residual claims are divisible, however, which is to say that the same claims can be accorded to two or more groups–employees can join shareholders as residual claimants, for example–and the same group can have claims of both kinds. So the safeguards for each constituency are potentially a mix of both kinds of claims–and, indeed, they generally do consist of such a mix. Thus, shareholders have some fixed claims in the form of shareholder rights


As a framework for identifying and analyzing many common business ethics problems, the contractual theory focuses our attention on the need to provide adequate safeguards for each constituency’s interests. Corporate governance is concerned primarily with protecting shareholder interests, in part because the special contracting problems of shareholders are best met by the residual claims that the law of corporate governance creates. The comparative neglect of other constituencies in corporate law is not a matter of concern as long as their interests are adequately protected in some way. How the interests of each constituency are protected–whether by means of corporate governance structures or other means–is a matter of what works best in practice. Before we can devise means for protecting the interests of each constituency, however, we need some understanding of the particular vulnerabilities of nonshareholder constituencies. How specifically can employees, customers, and other constituencies be wronged such that a remedy ought to be devised? In other words, what are the main ethical problems in business?

A Three-fold Classification

A partial answer to this question is provided by the kinds of wrongs that arise in contractual relations. If the corporation is a nexus of contracts, then the kinds of ethical problems that arise in contracting–that is, the kind of vulnerabilities that afflict people whose relations are defined primarily by contracts–should occur in the relations of the corporation with its major constituencies. The following three-fold classification, which is derived from the literature on the ethical problems of contracting, does not encompass every business ethics problem, and, indeed, the next section lists many kinds of problems that are not related to contractual relations. The classification provides a useful perspective, however, on a great many problems of business, and by viewing them within the context of the contractual theory, appropriate remedies can also be identified.

Wrongful Harms

All constituencies, including shareholders, are vulnerable to loss of one kind or another from the activities of a firm. Many of these losses take the form of negative externalities, such as occupational hazards, consumer injury, discrimination, wrongful discharge, pollution, and plant closings. Shareholders, too, can be harmed by fraud, financial manipulation, and mismanagement that reduces the value of a company’s stock. Whether a harm is “wrongful” depends, of course, on some standards for the harms that constituencies ought to be protected against, and although developing such standards is difficult, we have many examples in tort law and government regulation. For example, developing a standard for workplace safety consists of deciding which possible harms are “wrongful” such that workers ought to be protected against them.


Imperfect contracting results mainly in allocational problems in which one stakeholder group benefits (rightly or not) at the expense of another. Whether employees or shareholders bear the cost of declining business, for example


Some of the most egregious corporate wrongs involve sudden upheavals in which one constituency enriches itself in violation of settled agreements. Takeovers in which shareholder gains come at great expense to other constituencies constitute a prime example


Given this classification of business ethics problems, the task of safeguarding nonshareholder constituencies now becomes a question of the most appropriate and effective remedies for each of these three kinds of threats, as well as a question of the extent to which these remedies can be accommodated within the contractual theory of the firm. Although many remedies are available, they fall into three broad categories.

Tort Remedies

The usual remedy for recovery from wrongful harms is tort law. Many of the examples given above are tortious negative externalities which can be remedied through the courts.

Management Responsibility

Corporate law, including the law on fiduciary duties, defines the legal responsibility of management, especially in the exercise of managerial discretion. However, management responsibility extends beyond what is legally required and is shaped by many factors, including social pressure, accepted business practice, and managers’ own preferences. For example, the corporate social responsibility movement attempts to address business ethics problems largely by influencing managers’ conception of their own responsibility.

Political Action

The political process provides a means for protecting each corporate constituency. Obvious examples include worker protection legislation, consumer legislation, antidiscrimination law, securities law, and, indeed, virtually the whole of business law. The political process also enables constituencies to protect their interests by pressure that does not result in specific legislation. For example, public concern about downsizing with the threat of legislation may have had some influence on corporate decision making. Ultimately, the systems of tort and corporate law are the province of the political process, and all economic decision making still takes place within a politically created framework. Many allocative decisions are also left to the political process, and the dividing line between the economic and the political–between management responsibility and the responsibility of government–is itself a matter of public choice.

These categories suggest many remedies for business ethics problems within the framework of the contractual theory of the firm. Expanding managerial responsibility, which is the primary remedy suggested by stakeholder theory and calls for corporate social responsibility, has its merits, but the task of safeguarding employees and consumers from wrongful harm, for example, may be more effectively addressed by traditional tort remedies. Because tort law creates legally enforceable rights, this remedy might also be preferred by employees and other stakeholders, who would be more vulnerable if their protection were made the responsibility of management alone. Similarly, with regard to allocation, some allocative decisions are made by managers and others are left to the political process, but to the extent that the responsibility of management is enlarged to include the interests of nonshareholder constituencies, decisions about allocation that arise from imperfect contracting are shifted from the political to the economic sphere. Whether allocation is best handled by managers–and ought, therefore, to be part of their responsibility–or is better left to the political process is itself a complex question of public policy which cannot be answered here. The important point is that decisions about the means used to protect nonshareholder constituencies determine the division between the two spheres.

Misappropriations pose the greatest challenge to the legitimacy of shareholder primacy, and some of the strongest arguments for a fiduciary duty of management to nonshareholder constituencies are based on the need to prevent them.(16) The ethical criticism of hostile takeovers and corporate downsizing, for example, reflects a concern that shareholders are benefiting disproportionately from actions that increase wealth at the expense of employees and some other groups. The redistribution of wealth that occurs in such events is often thought to violate certain implicit understandings. Misappropriations can be prevented, if not remedied, in many ways, including legislation and gap-filling judicial interpretations. Many state antitakeover laws, for example, operate by setting rules (and permitting corporate defenses) that increase the cost of takeovers to a hostile raider. Another approach, however, is to expand the fiduciary duties of management by so-called other constituency statutes, which permit directors to consider the interests of nonshareholder constituencies in responding to takeover bids. Although other constituency statutes appear to use managerial responsibility as a remedy for a problem, some have argued that they merely increase the independence of management from shareholders and other constituencies alike.(17)

An Example: Shareholders vs. Employees

No single example could illustrate all of the resources of the contractual theory for analyzing business ethics problems, but consider the current concern over downsizing that pits the interests of shareholders against those of employees. That profitable corporations should lay off long-time employees in order to increase shareholder value strikes many as a moral wrong that ought to be corrected in some way. However, calls for corporations to exercise greater social responsibility and even legislative measures are likely to be ineffectual, because the causes lie in a system of corporate governance that gives shareholders control. Insofar as shareholder control is founded on a contractual theory of the firm, any challenge to this doctrine must come from a change in the theory–that is, from a modification in the nexus of contracts view–or by means of the theory itself. Stakeholder theory might be understood as an attempt to offer a rival theory that better protects employees by making their interests an end of the corporation along with those of shareholders, but as a rival theory, it is unlikely to dislodge the contractual view from financial economics and legal theory. From the resources of the contractual theory itself, however, remedies can be found to better protect employee interests.

For example, the argument for shareholder control can be turned on its head to support control rights for nonshareholder groups, especially employees. Margaret M. Blair argues that highly skilled employees who develop valuable firm-specific human capital may, in fact, assume considerable residual risk.(18) Firms with a need for firm-specific human capital that is costly to develop can attract people who have the necessary training (or induce people to undertake the training) only by offering to share the quasi-rents that are created with promises of higher wages. If the total rents and quasi-rents fail to cover the promised wages or leave too little for shareholders, then the investment might be considered a failure by the shareholders–even if the firm is highly profitable as measured by the rents and quasi-rents generated by the firm. In such a situation, the shareholders might prefer to liquidate the firm rather than deliver on the promises of higher wages, and the shareholders could not be held to these promises because of their limited liability. In short, shareholders can close down an otherwise profitable firm that generates great wealth for its employees and society at large merely because the profits are flowing to these other groups instead of the shareholders themselves. Thus, Blair concludes: “[T]he promised higher wages are, in fact, not ‘fixed,’ but contingent on the performance of the firm. Employees therefore are also `residual claimants,’ who share in the business risk associated with the enterprise.”(19) This argument is only one of many that challenge shareholder control using the same premises that are used by the supporters of the doctrine,(20) and by developing such arguments, corporate law could serve as a means for providing better protection for employee interests.

The contractual theory also enables us to resist measures that are impractical without very significant changes in corporate governance and other matters. Corporate governance is a complex web in which individual parts cannot be easily changed in isolation from each other. Thus, to protect employee interests, some have called for U.S. corporations to emulate the job security found in Japan. In the Japanese firm, job security is not a concession to employees but an essential condition for another feature of the Japanese firm, namely participatory decision making.(21) The ability to utilize all of the information that employees possess confers an advantage on firms, but doing so also gives employees greater opportunity to promote their own interests. Therefore, Japanese corporations must provide sufficient incentives for employees to commit themselves to the success of the whole enterprise. Inasmuch as Japanese workers develop more firm-specific skills than their U.S. counterparts, they need more assurances against misappropriation of their contribution to a joint effort. The key to this assurance in the Japanese firm is employment security. This security is made possible by the large stakes of a few investors who cannot easily withdraw, in contrast to the liquidity of U.S. equity markets.(22) Both employees and shareholders are “locked in” by their respective investments, so that managers are forced into the role of neutral referees. The lesson for American firms is that greater job security is feasible if the increased cost is offset by the informational advantage that can be gained from participatory decision making and if steps are taken to reduce the liquidity of stock markets in order to encourage long-term investing. Without these changes in American business practice, however, the prospects for emulating Japanese-style job security are dim.


Although the contractual theory of the firm provides many means for safeguarding nonshareholder interests, it affords little protection from certain kinds of problems that are regarded as a part of business ethics. The contractual theory is limited, for the most part, to the internal workings of firms and to relations with constituencies. Thus, the theory has little application to ethical problems that arise from competitive markets or the structure of the economy. These kinds of problems would arise under any theory of the firm. Nevertheless, it is important to acknowledge the problems in order to understand the limitations of the contractual theory for business ethics research.

Systemic Economic Changes

Some ethical problems, such as layoffs from restructurings, are caused by fundamental transformations in the economy as U.S. corporations seek to remain competitive in global markets. There is widespread recognition that the traditional contract of American corporations with respect to employees, for example, is unraveling and that the rise of large institutional investors is altering the nature of shareholder-management relations. Problems of this kind are difficult precisely because they upset existing contractual arrangements and lead to a process of renegotiation. Since the causes of these changes lie outside the contractual theory of the firm, they cannot be analyzed as problems of imperfect contracting to be solved by the usual remedies. Still, the main question that systemic economic changes raise is how the inevitable sacrifices will be distributed among the various stakeholder groups, and this itself can be understood within the framework of the contractual theory.

The Institutional Role of the Corporation in Society

The theory of the firm yields no specific prescriptions about the role of the corporation in such matters as addressing social problems or participating in politics. In particular, the theory is neutral with respect to contending views on the distinction between the public and the private, which affect how managers use their discretion in the public policy process.(23) Thus, the institutional role of the corporation in society, which is at the core of disputes over social responsibility, is regarded by the theory of the firm as a matter of choice to be made by corporate managers, shareholders, and the rest of society.

A Neglect of Hidden or Unrepresented Social Costs

Insofar as contracting in a firm aims at safeguarding constituencies from negative externalities and other harms, it will focus on those social costs that are well recognized and have powerful representatives. Thus, the contribution of corporations to long-term environmental dangers and to problems of poverty and racial discord, in which burdens fall heavily on nonconsenting third parties, will not be effectively addressed in the contracting process, and some other means must be found to protect all of those who are affected.

The Reinforcement of Existing Power Relations

Perhaps the most serious shortcoming of the contractual theory is that it takes no account of differences in the relative bargaining power of different constituencies and thereby reinforces existing power relations. Certainly, many of the ethical problems of business arise from the lack of bargaining power. It is unlikely, however, that unbargained safeguards could effectively correct any problems that result from imbalances of power. Expanding the fiduciary duties of management to employees, for example, would prompt employers to recover the costs of these duties in some way, such as reducing wages or the number of workers, and employees could resist these reductions only if they had sufficient power to bargain for the protection of fiduciary duties in the first place. Correcting imbalances of power, therefore, cannot be achieved by changes in the financial or legal structure of the firm unless they are accompanied by social and political changes in the larger society.

The Role of Strategic Preference

Other business ethics problems result from strategic decisions by management that are unrelated to the contractual process. Thus, American employers have opted for adversarial labor relations, in which a largely disempowered workforce is motivated by rewards and punishments and is offered little incentive to invest loyalty in a firm. The results of such adversarial labor relations include high monitoring costs and an inability to utilize employees’ information. Japanese mangers have opted for very different arrangements, which avoid these consequences but at the price of providing benefits that American workers lack, such as job security. It might be argued that these represent optimal strategies under different circumstances, but a more likely explanation is simply the preferences of American and Japanese managers, which are due less to economics than to historical and cultural forces. If so, then perhaps the solution to some ethical problems lies not in changing the stockholder-centered nature of the firm but in changing the strategic preferences of managers in carrying out their role as defined by the contractual theory.

The Legitimation of Certain Interests Over Others

Shareholder primacy under the contractual theory of the firm tends to legitimize all corporate efforts on behalf of one favored constituency, namely shareholders, and to render efforts to benefit other constituencies as irregular and in need of justification. This result gives management a free hand to impose negative externalities and other harms on society, and, indeed, it may even create an obligation on managers to do so at every opportunity. Government regulation, which is a major corrective to negative externalities that involve a social cost, is also recognized as legitimate, but the legitimation provided by shareholder primacy creates a presumption that prevails until it is countered by regulation. However, any theory of the firm will hold that some interests are legitimately superior to others, and the legitimation of the interests of shareholders in the contractual theory is a benefit that is factored into the value of corporate control.

The Elevation of Efficiency Over Other Values

Insofar as a system of contracting is justified for its ability to produce maximally efficient outcomes, efficiency is elevated over other values that ought to be realized by a firm’s activities. A nexus of contracts firm may be efficient, critics admit, but it is morally deficient to the extent that it neglects such basic values as human dignity, fulfilling work, and participation in decision making. The neglect of these values is not due to the theory of the firm, however, since it permits contracting with respect to any values. Ben & Jerry’s, for example, is just as much a nexus of contracts as Exxon, and the ice cream maker has made a good profit by selling implicit claims to its socially concerned employees, suppliers, and customers. Moreover, the adoption of certain values, as well as their rejection, is often a strategic preference that is not determined by the structure of a firm.

Drawing the Boundary Between the Economic and the Political

Finally, the critical issue in corporate governance is not whose interests management ought to serve but where decisions about the distribution of wealth ought to be made. Corporate law in the United States has generally focused management attention on shareholder interests and placed distributional matters in the political sphere, largely in order to avoid the danger of unrestrained managerial power. Thus, efforts to expand the fiduciary duties of management to include other constituencies reflect a movement of responsibility for decisions about distribution from the political sphere to the economic. The boundary between the economic and political–like the distinction between the public and the private–is itself a political decision of the utmost importance. However, the contractual theory is, in principle, neutral with regard to the placement of that boundary. Because contracting focuses on private individual transactions and neglects the public, institutional aspect of firms, a nexus of contracts view will tend, in practice, to expand the economic sphere or the realm of the private. Where the boundary is drawn depends more, however, on decisions made in the political sphere and on decisions by managers themselves to assume greater responsibility for matters of distribution.


Although the contractual theory of the firm has been developed in financial economics and corporate law for purposes of explanation in those fields, it also provides an important framework for research in business ethics, conducted from both a descriptive and a normative perspective. Within this framework, business ethics is concerned mainly with protecting or serving the interests of the various constituencies or stakeholder groups that form the nexus of contract firm. Many means exist for safeguarding the interests of these constituencies aside from explicit contracting. These means include implicit contracts, gap-filling judicial interpretations, and government regulation. In the financial and legal articulation of the firm, shareholders have mainly residual claims, and these are the basis for shareholder primacy. However, other groups are protected largely by fixed claims, which are not necessarily inferior and may even be superior in some respects to the residual claims of shareholders. Whether any given corporate constituency is adequately protected is a complex question that depends not on the features of these two kind of claims in the abstract but on the efficacy of the actual claims of the group in question.

Within a contractual framework, business ethics problems can be identified mainly as wrongful harms, misallocations, and misappropriations. These categories are commonly employed in economics, finance, and corporate law in the analysis of various kinds of problems, which are usually attributed to market failures, imperfect contracting, and other causes. The main solutions to these problems are also well-known in the relevant literatures, namely the adoption of tort remedies, the expansion of management responsibility, and political action, including government regulation. The framework provided by the contractual theory does not address all business ethics problems. However, many of these other kinds of problems arise from larger economic and political forces that would affect any theory of the firm, and so their neglect in the framework developed in this paper is not due specifically to the contractual theory itself.

Should researchers in business ethics adopt the framework provided by the contractual theory of the firm? Certainly, philosophical ethics provides its own perspective and suggests deficiencies in the contractual theory for understanding and addressing business ethics problems. The neglect of the contractual theory of the firm, however, deprives business ethics research of a potentially useful framework that could integrate its results with work in financial economics and corporate law. In addition, the failure of business ethics researchers to work within the contractual theory–or to develop a rival theory with the same intellectual rigor and explanatory power–diminishes the relevance of their work to these other disciplines. Much is to be gained, therefore, by taking seriously the framework provided by the contractual theory, and developing this framework is a necessary first step. (1) A contract approach to the firm is inherent in the classical liberalism represented by Adam Smith’s Wealth of Nations, which describes economic activity as the exchange of property in a market, and the firm as a nexus of contracts is assumed in the controversy over the “personality” of the corporation by those who viewed the corporation as an artificial entity. For an explanation of the artificial entity view see Morton J. Horwitz, “Santa Clara Revisited: The Development of Corporate Theory,” West Virginia Law Review, 88 (1985), 173-224. The contractual theory in its modern form is due to Ronald M. Coase, “The Nature of the Firm,” Economica, N.S., 4 (1937), 386-405

(2) Criticism of the theory of the firm by business ethicists has focused primarily on the rejection of corporate social responsibility by Milton Friedman in Capitalism and Freedom (Chicago: University of Chicago Press, 1963) and in “The Social Responsibility of Business Is to Increase Its Profits,” New York Times Magazine, September 12, 1970, pp. 32-33, 122, 124, 126. Ronald M. Green, “Shareholders as Stakeholders: Changing Metaphors of Corporate Governance,” Washington and Lee Law Review, 50 (1993), 1409-21 contains a more direct attack on the contractual theory, although Friedman’s view is still the point of departure for Green’s discussion. Much of the stakeholder literature contains implicit criticism of the contractual theory. See R. Edward Freeman, Strategic Management: A Stakeholder Approach (Boston: Pitman, 1984)

(3) Some attention has been given by both philosophers and organizational theorists to agency theory, which is integral to the contractual theory of the firm, and attempts have been made to derive some features of a stakeholder approach from an agency model of the firm. See the chapters in Norman E. Bowie and R. Edward Freeman, eds., Ethics and Agency Theory: An Introduction (New York: Oxford University Press, 1992), especially those by J. Gregory Dees, Richard T. DeGeorge, and Barry M. Mitnick. See also Kenneth E. Goodpaster, “Business Ethics and Stakeholder Analysis,” Business Ethics Quarterly, 1 (1991), 53-73

(4) See G. C. Archibald, “Firm, Theory of,” The New Palgrave (London: Macmillan, 1987)

(5) William J. Baumol, Business Behavior, Value, and Growth (New York, Macmillan. 1959)

(6) A. W. Scott, “The Fiduciary Principle,” California Law Review, 37 (1949), 539555

(7) Adolf A. Berle, Jr., “For Whom Corporate Managers Are Trustees: A Note,” Harvard Law Review, 45 (1932), 1365 72. In the famous exchange with Merrick Dodd, Berle agreed that shareholders are no longer the owners of the corporation, but Berle declined to follow Dodd in allowing corporate mangers to serve the interests of other constituencies, arguing instead that these interests would be better served by an unswerving devotion to shareholder wealth. Corporate law has developed, then, largely as a check on management power in order to harness the benefits of private profit for the public good. See E. Merrick Dodd, Jr., “For Whom Are Corporate Managers Trustees?” Harvard Law Review, 45 (1932), 1145-63. Berle later conceded the correctness of Dodd’s view in The 20th Century Capitalist Revolution (New York: Harcourt Brace, 19541, 169.

(8) Coase, “The Nature of the Firm,” note 1.

(9) The work Coase has been extended by Alchian and Demsetz, “Production, Information Costs, and Economic Organization,” note 1, who explored the implications not only for firm size but for organizational structure

(10) On this point see Klein, Crawford, and Alchian, “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,” note 1.

(11) See Eric Orts, “Beyond Shareholders: Interpreting Corporate Constituency Statutes,” Gearge Washington Law Review, 61 (1992), 14-135.

(12) M. J. Levine, “The Erosion of the Employment-at-Will Doctrine: Recent Developments,” Labor Law Journal, 45 (1994), 79-89.

(13) Finance has traditionally considered only the claims of explicit contracts in the valuation of a firm, but several writers have observed that implicit claims can also affect firm valuation. Cornell and Shapiro, for example, develop the concept of net organizational capital to reflect the impact of implicit claims on firm valuation. Bradford Cornell and Alan C. Shapiro, “Corporate Stakeholders and Corporate Finance,” Financial Management, 16 (1987), 5-14.

(14) That this divide runs through American business regulation is a thesis in Allen Kaufman, Lawrence Zacharias, and Marvin Karson, Managers vs. Owners: The Struggle for Corporate Control in American Democracy (New York: Oxford University Press, 1995), although this book identifies the two approaches as trust and contract.

(15) See Jonathan R. Macey, “An Economic Analysis of the Various Rationales for Making Shareholders the Exclusive Beneficiaries of the Corporate Fiduciary Duties,” Stetson Law Review, 21 (1991), 23-44. (16) For discussions of misappropriations involving bondholders, see M. Barkey, “The Financial Articulation of a Fiduciary Duty to Bondholders with Fiduciary Duties to Stockholders of the Corporation,” Creighton Law Review, 20 (1986), 47-74

(17) See Orts, “Beyond Shareholders,” note 11

(18) Margaret M. Blair, Ownership and Control: Rethinking Corporate Governance for the Twenty-first Century (Washington, D.C.: Brookings Institution, 1995).

(19) Blair, Ownership and Control, note 18, 257. Blair advocates governance structures that encourage employee ownership in firms where employees assume residual risk. Steps in this direction have already been taken by many high-tech firms, especially in the computer industry, which compensate their employees in stock. This form of compensation solves the problem of contracting with highly-skilled workers, who otherwise might seek to protect themselves by starting their own companies.

(20) For another example, see O’Connor, “Restructuring the Corporation’s Nexus of Contracts,” note 16.

(21) This analysis of the Japanese firm is derived from Masahiko Aoki, The Cooperative Game Theory of the Firm (London: Oxford University Press, 1984)

(22) For a discussion of the adverse consequences of liquidity, see Amar Bhide, “The Hidden Costs of Stock Market Liquidity,” Journal of Financial Economics, 34 (1993), 31-51.

(23) D. Kennedy, “The Stages of the Decline of the Public/Private Distinction,” University of Pennsylvania Law Review, 130 (1982), 1349-57

JOHN R. BOATRIGHT, Raymond C. Baumhart, S.J., Professor of Business Ethics, School of Business Administration, Loyola University Chicago.