Legal Analysis of Agency Theory: An Inquiry into the Nature of Corporation

Purpose – The purpose of this paper is to analyse the Agency Theory in order to understand the true nature of the corporation by determining the respective roles of shareholders and directors/managers within a corporation. Design/methodology/approach – The paper compares the economists’ depiction of the firm with the legal conception of the corporation. It then analyses the legal concept of ownership and proves that the shareholders are the owners of their shares only and not of the corporation which is a separate legal person. The theories of corporation and relevant case law are also analysed. Findings – The analysis reveals that currently there are two distinct models of the corporation. The economists view a firm in terms of a nexus of contracts like a partnership where shareholders are the owners of the firm and the directors/managers are their agents. The law, on the other hand, regards the corporation as a separate legal entity with rights and liabilities of a natural person that is not subject to ownership. This doctrine of legal personality is the grund norm of corporate law from which other principles like limited liability, perpetual succession, transferability of shares and independent board are derived. However, both economic and legal models converge upon the purpose of corporation i.e. maximization of shareholders value. Originality/value – The paper highlights the distinction between economic and legal models of the firm. It points out that from a legal perspective, neither the shareholders are the principals nor the managers are their agents as proposed by the Agency Theory. The economists assume conflict of interests between the shareholders and directors and devise mechanisms to reduce agency costs. Law, on the other hand, determines manifestly the rights and liabilities of each participant in corporate structure. The directors owe their duties to the corporation and manage it without interference from the shareholders. Such arrangement is a product of historical process and qualifies a corporation as a sui generis form of business organization.