Elsevier

Journal of Banking & Finance

Volume 26, Issue 9, September 2002, Pages 1837-1852
Journal of Banking & Finance

Contractors as stakeholders: Reconciling stakeholder theory with the nexus-of-contracts firm

https://doi.org/10.1016/S0378-4266(02)00194-2Get rights and content

Abstract

The contractual or nexus-of-contracts theory serves as a normative foundation for both the stockholder and stakeholder conceptions of the firm. In this theory, each constituency or stakeholder group bargains with the firm over a set of rights that will protect the firm-specific assets that it makes available for production. This paper argues that the main difference between the stockholder and stakeholder conceptions lies in different assumptions about the choice of protections that each constituency would make. The value of this thesis is that it identifies the points at issue between these two conceptions in ways that facilitate a reconciliation.

Introduction

Modern financial economics views the firm as a nexus-of-contracts among its various constituencies. This contractual perspective results from an economic approach that is commonly called the new institutional economics (Williamson, 1975). Until recently, neoclassical economic analysis offered only a rudimentary theory of the firm (Hart, 1989), but in the 1970s, economists, building on the pioneering work of Coase (1937), developed a powerful theory utilizing agency cost and transaction cost economics (Alchian and Demsetz, 1972; Demsetz, 1983; Klein et al., 1978; Fama, 1980; Jensen and Meckling, 1976; Fama and Jensen, 1983; Williamson, 1985).

On the nexus-of-contracts view, each corporate constituency, including employees, customers, suppliers, and investors, provides some asset in return for some gain. Contracts result from bargaining by these constituencies over the terms of their compensation as well as the institutional arrangements that protect this compensation from postcontractual expropriation. The term `contract' is used broadly to include not only explicit and implicit agreements, but also legislative statutes and judicial interpretations (Easterbrook and Fischel, 1991). The firm is the common signatory of these contracts and the entity that connects them to form a nexus (Hansmann, 1996).

This contractual theory is both descriptive and normative. That is, it not only explains why firms are structured as they are but also prescribes how they ought to be structured. As a positive science, financial economics employs the nexus-of-contracts view in its descriptive form. However, the theory has obvious normative implications that have been developed in corporate law, most notably by Easterbrook and Fischel in The Economic Structure of Corporate Law (see also, Klein, 1982; Cheung, 1983; Butler, 1989). Easterbrook and Fischel proclaim that one “openly normative” aim of their book is to “preach to legislatures and judges about what the law ought to be if it is to promote social welfare” (Easterbrook and Fischel, 1991, pp. vii–viii).

The contractual or nexus-of-contracts theory supports a stockholder-centered conception of the corporation in which the duty of managers is to serve the interests of shareholders alone. Business ethicists have generally considered this result – which is often called the “stockholder theory” – to be ethically unacceptable because it unjustifiably neglects the interests of nonshareholder groups. In place of this stockholder-centered conception, some have proposed stakeholder theory. In its normative form, this theory holds that corporations ought to be managed for the benefit of all stakeholder groups, including but not limited to employees, customers, suppliers, and local communities (Donaldson and Preston, 1995; Evan and Freeman, 1993; Freeman, 1984; Freeman and Evan, 1990).

If the consequences of the contractual theory in its normative form are ethically unacceptable, then the theory itself must be normatively flawed in some way. I believe that the contractual theory in its normative form is sound, but this is an ambitious claim that cannot be defended in a short space. I propose instead to offer a framework for reconciling the stockholder and stakeholder conceptions of the firm within the nexus-of-contracts view.

My thesis, in brief, is that both the stockholder and stakeholder conceptions of the firm are compatible with the contractual theory. The argument proceeds, first, by establishing that the nexus-of-contracts view does not neglect any stakeholder group. Rather, in this approach, all stakeholders are regarded as contractors with the firm, with their rights determined through bargaining. The main concern of each group is to protect its firm-specific assets, and for this task, many means are available.

I then develop a framework in which the rival stockholder and stakeholder conceptions are depicted as different choices among the various means for protecting each constituency's firm-specific assets. Although these two choices are incompatible with each other, they are both consistent with the contractual theory, which provides a common ground. The value of this framework is that it identifies the points at issue between the stockholder and stakeholder theories in ways that facilitate a productive debate between their respective adherents.

Section snippets

Stockholders vs. stakeholders: The points at issue

As the play on words suggests, stakeholder theory has been developed in opposition to the prevailing system of corporate governance, in which shareholders or stockholders are thought to occupy a privileged position. This system may be characterized in three related normative propositions: (1) that shareholders ought to have control, (2) that managers have a fiduciary duty to serve shareholder interests alone, and (3) that the objective of the firm ought to be the maximization of shareholder

Developing a normative contractual theory

In broad outlines, the contractual theory holds that a firm is a nexus of real contracts, which are negotiated with each constituency, and hypothetical contracts, which are created by law in an attempt to duplicate the contracts that the participants would have negotiated had they been able to do so. The resulting system of rights and obligations is justified if it represents agreements among all the parties in a process of fair bargaining and does not unjustly harm those who are not a party to

The argument for the shareholders' role

In the standard argument, shareholders offer capital in return for a claim on the residual returns. Any corporate constituency that provides an asset to the firm in return for a claim on residual revenues assumes a large portion of the risk of the enterprise and thus becomes a residual risk bearer. Consequently, the shareholders contribute to a productive enterprise by providing capital and assuming residual risk. It is this latter role that distinguishes shareholders from other capital

The basis for each constituency's rights

In the normative contractual theory, every constituency or stakeholder group is recognized as a contractor with the firm. Through bargaining with the firm, each constituency has the opportunity to secure a set of rights and other safeguards that best serves its interests, consistent with the consent of the other parties to the nexus of contracts.

From a contractual theory perspective, the rights that are claimed for stakeholders are not ends in themselves – which ought to be recognized in any

Comparing the two theories

The stockholder and stakeholder conceptions posit a particular set of rights for each corporate constituency that may be justified by different normative theories. The contractual theory provides a justification for the main claims of stakeholder theory by contending that the rights in question result from bargaining among all stakeholder groups. The contractual theory argument for a stockholder-centered corporation does not hold that this form of corporate governance is the only one that is

Bargaining over each constituency's rights

Although the means for protecting each corporate constituency are varied, the choices that are reflected in the stockholder and stakeholder views can be represented in a framework that identifies critical differences between the two positions. Once this framework is developed, we will be able to explore the reasons for the different choices that each stakeholder group would make in a nexus-of-contracts firm.

Developing a framework

The available means for protecting each constituency's interests fall into two broad categories, which may be labeled contract and trust approaches (Isaacs, 1929; Berle and Means, 1968). A contract approach relies on precise rules and market mechanisms to direct managerial behavior in the desired directions, whereas a trust approach attempts to direct managers by legal and moral norms, such as fiduciary duties. A contract approach seeks to channel self-interest in socially beneficial ways,

The choice of protections

The main thesis can now be expressed in terms of these two figures. It is that the stockholder and stakeholder conceptions of the modern corporation constitute different choices about the means for protecting each constituency's interests that fall into different areas of the diagram.

The stockholder theory holds that the protections that would be chosen by each constituency generally fall into the area of a contract approach on the system level, with a reliance on market mechanisms. Only in

Normative preferences

The contractual theory involves a search for the most efficient forms of economic organization and assumes that each constituency will seek protections that provide it with the optimal return. The only preferences involved are those that typically guide market decisions, which are broadly utilitarian in character. In short, each constituency is assumed to be maximizing its own utility or welfare. However, stakeholder theorists might hold that welfare embraces more than the utilitarian values

Factual assumptions

Choosing the most effective means for protecting the interests of each constituency or stakeholder group requires accurate economic analysis, and there may be reasonable disagreement about the efficacy of any given means. The efficacy of means may also vary from one context to another. Whether participatory management is generally an effective safeguard, for example, is a subject of dispute, but it may also be more effective in one context than another.

Ian Maitland (1994) has argued that

Background conditions

The means that each constituency would choose to protect its interests depend heavily on the background conditions that prevail. Most notable among these conditions are the efficiency of markets, the level of competitiveness, the openness and responsiveness of the legal and political systems, and the distribution of wealth and power in society.

Markets themselves are a form of protection. Thus, employees with ample job opportunities, customers with plenty of competing sellers, and constituencies

Theoretical conditions

The justification of the nexus of contracts that constitutes a firm requires that two conditions be met: (1) that the nexus results from fair bargaining among all the parties, and (2) that no harm be inflicted unjustly on third parties.

The fair bargaining condition raises several difficulties. One is the existence of different interpretations of the concept. The contractual theory is relatively undeveloped as a normative theory in that it makes few assumptions about the precontract state or

Conclusion

To conclude, the contractual or nexus-of-contracts theory provides a powerful normative account of the modern corporation, especially in its relation with shareholders. The theory is normatively adequate, however, only if it offers a justified account of a firm's relations with all of its constituencies or stakeholder groups. Stakeholder theorists object primarily to the stockholder-centered conception of the corporation that is supported by the contractual theory. However, the theory itself

References (36)

  • M.C. Jensen et al.

    Theory of the firm: Managerial behavior, agency costs, and ownership structure

    Journal of Financial Economics

    (1976)
  • A.A. Alchian et al.

    Production, information costs, and economic organization

    American Economic Review

    (1972)
  • A.H. Barkey

    The financial articulation of a fiduciary duty to bondholders with fiduciary duties to stockholders of the corporation

    Creighton Law Review

    (1986)
  • A.A. Berle et al.

    The Modern Corporation and Private Property

    (1968)
  • M.M. Blair

    Rethinking Corporate Governance for the Twenty-First Century

    (1995)
  • W.W. Bratton

    Confronting the ethical case against the ethical case for constituency rights

    Washington and Lee Law Review

    (1993)
  • H.N. Butler

    The contractual theory of the firm

    George Mason Law Review

    (1989)
  • S.N.S. Cheung

    The contractual theory of the firm

    Journal of Law and Economics

    (1983)
  • R.H. Coase

    The nature of the firm

    Economica N.S.

    (1937)
  • R.H. Coase

    The problem of social cost

    Journal of Law and Economics

    (1960)
  • J.G. Dees

    Principals, agents, and ethics

  • H. Demsetz

    The structure of ownership and the theory of the firm

    Journal of Law and Economics

    (1983)
  • T. Donaldson et al.

    The stakeholder theory of the corporation: Concepts, evidence, and implications

    Academy of Management Review

    (1995)
  • F.H. Easterbrook et al.

    The Economic Structure of Corporate Law

    (1991)
  • W.M. Evan et al.

    A stakeholder theory of the modern corporation

  • E.F. Fama

    Agency problems and the theory of the firm

    Journal of Political Economy

    (1980)
  • E.F. Fama et al.

    Agency problems and residual claims

    Journal of Law and Economics

    (1983)
  • R.E. Freeman

    Strategic Management: A Stakeholder Approach

    (1984)
  • Cited by (80)

    • Corporate social responsibility and inside debt: The long game

      2021, International Review of Financial Analysis
    • Power in tourism stakeholder collaborations: Power types and power holders

      2017, Journal of Hospitality and Tourism Management
      Citation Excerpt :

      Yet the success of stakeholder collaborations is largely dependent on coordinating the voice of stakeholders and to do so it is necessary to understand their salience in a collaborative process (Kennedy & Augustyn, 2014; Sheehan & Ritchie, 2005). Identifying stakeholder salience helps effective stakeholder coordination, inclusion or exclusion of stakeholders in cooperative actions, and categorisation of their roles in certain projects (Boatright, 2002; Jamal & Getz, 2000; Medeiros de Araujo & Bramwell, 1999). Mitchell et al. (1997) developed a stakeholder salience model.

    • A Rawlsian Rule for Corporate Governance

      2024, Journal of Business Ethics
    View all citing articles on Scopus
    View full text