The Nexus Paradox: Legal Personality and the Theory of the Firm

Abstract

In the last four decades, one of the fastest-growing fields of research in economics has been the contractual theory of the firm developed in Coase’s (1937) footsteps. Yet despite what otherwise seems to be a genuine success story the question of the nature of the firm remains an empirical and theoretical challenge, painfully illustrated by the lack of consensus regarding the definition and boundaries of the firm. The argument of this thesis is that many thorny questions that plague the literature, including issues related to ownership, boundaries, and intra-firm authority, are due to the fact that contractual theorists of the firm have generally overlooked a key legal feature of the economic system, without which theories of the firm are like Hamlet without the Prince. An elementary institutional fact about firms and markets is that in order to become a fully operational firm in a modern market economy, an entrepreneur or an association of resource owners need to go through a registration or incorporation procedure by which the legal system creates a separate legal person or legal entity in which ownership rights over assets used in production are vested, in whose name contracts are made, and thanks to which the firm has standing in court. With this assignment of legal personality, the legal system creates the efficiency-enhancing nexus for contracts that literally carries the organizational framework of the firm, and secures its continuity by locking-in the founders’ committed capital, thereby allowing them to pledge assets, raise finance and do business in the firm’s own name. Given the basic principle that only legal persons may own property and have the capacity to contract, and the implication that legally enforceable contracts can only exist between legal persons, it is something of a paradox that the notion of legal personality is absent from the prevailing narrative in the contractual theory of the firm. The thesis examines the reasons behind this state of affairs, and identifies alongside the widespread view among economists that firms can be defined with little or no reference to law, particularly statutory law, the lasting influence of Jensen and Meckling’s (1976) ambiguous dismissal of legal personality as a legal fiction that unavoidably leads to misleading reification. In order to disentangle the issues involved, the thesis puts this argument into historical perspective, and suggests that much can be learned from the corporate personality controversy that in the past has addressed the same questions. As the overview of the history of this debate reveals, the category mistakes that Jensen and Meckling presented as inevitable can be easily avoided once the meaning and functions of legal personality are properly understood. The thesis dispels enduring misunderstandings surrounding the notion of personhood, and proposes a legally-grounded view of the nature and boundaries of the firm that recognizes in law’s provision of legal entity status a fundamental institutional support for the firm while fitting the overall Coasean narrative.