Hidden Fallacies in the Agency Theory of the Corporation

The agency or ‘nexus of contracts’ model of the firm has been the dominant corporate theory for more than four decades. The classical agency theory of the firm treats the corporation as a fictitious – and purely financial – vehicle, devoid of social connection or responsibilities. The theory also adopts a single-minded focus on one particular agency problem, namely, that which exists between shareholders and managers. 

This paper argues that, by amplifying a single agency problem, specifically managerial opportunism, the agency theory of the firm potentially blinds us to several other important problems associated with corporations, including the economic power of some corporations and harm caused by negative externalities. Also, by treating the corporation as outside society, and by elevating the role of private ordering between firm participants, agency theory discounts the importance of corporate regulation as an accountability mechanism. 

The paper critically explores aspects of the reasoning that underpins the agency theory of the firm. Some of the assumptions associated with agency theory, examined in the paper, include the following:- that agency theory constituted a ‘revolution’ in corporate law; that the corporation can be reduced to a network of private contractual exchanges between natural persons; that these exchanges are necessarily voluntary; that doctrines such as agency and trusts can be deconstructed into mere contracts; that the relationship between shareholders and corporate managers is one of ‘pure agency’; that corporations belong for all purposes in the private, rather than the public, realm; that private ordering is an effective legitimising device; that the role of corporate regulation is restricted to creating malleable default rules; that the market is an effective managerial constraint; and that the agency theory of the firm is necessarily linked to a strong form of shareholder primacy.

 The paper examines these assumptions in the context of contemporary developments in several key corporate governance areas, namely the relationship between managers and investors in start-ups, venture capital and LLCs (which, as discussed in the 2023 Delaware Court of Chancery decision, New Enterprise Associates 14 v Rich, are often viewed as purely a ‘creature of contract’); shareholder activism and ESG; executive compensation; and corporate criminal liability. 

This paper suggests that various assumptions underpinning the agency theory of the firm are now outdated and sit uncomfortably with contemporary ‘on the ground’ corporate law and governance developments. This dissonance between the dominant theory of modern corporate law and the real world suggests that the time may have come to re-evaluate the assumptions that support the use of agency theory as the only comprehensive analytical tool for understanding the corporation and to introduce a broader conception of the public corporation and its relationship with society in the modern world.