OBITER - Economic Contractualism: Use with caution

 by Professor Janet Dine - University of Essex.


               The use of economic analysis in the Law Commission’s Consultative document on Director’s Duties[1] is to be welcomed but it should not be forgotten that economic analysis is a tool and not an ideology. Korten[2] has given us a chilling analysis of the consequences of becoming enslaved by market liberalism fuelled by free market liberalism using money as a sole measure of value;

“The freedom of the market is the freedom of money, and when rights are a function of property rather than priesthood, only those with property have rights. Furthermore, by maintaining that the only obligation of the individual is to honour contracts and the property rights of others, the “moral” philosophy of market liberalism effectively releases those who have property from an obligation to those who do not. It ignores the reality that contracts between the weak and powerful are seldom equal and that the institution of the contract, like the institution of property, tends to reinforce and even increase inequality in unequal societies. It legitimises and strengthens systems that institutionalise poverty, even while maintaining that poverty is a consequence of indolence and inherent character defects of the poor.”[3]

The economic analysis starts from the perspective that “the company has traditionally been thought of more as a voluntary association between shareholders than as a creation of the state”[4]. Cheffins argues that “companies legislation has had in and of itself only a modest impact on the bargaining dynamics which account for the

nature and form of business enterprises. Thus, analytically an incorporated company is, like other types of firms, fundamentally, a nexus of contracts”. For the purposes of economic analysis individuals rather than the state are the legitimisation for the operation of the commercial venture. Denial of personality to the group of actors[5] is a necessary foundation for the application of market theories since the underlying assumption is the creation of maximum efficiency by individual market players bargaining with full information[6]. Taking the view that free markets are the most effective wealth creation system[7] neo-classical economists including Coase have analysed companies[8] as a method of reducing the costs of a complex market consisting of a series of bargains among parties.[9] Transaction costs are reduced by the operational design of the company.[10]

The theories rest on notions of rationality, efficiency and information. The economists posit that a person acting rationally will enter into a bargain, which will be to his benefit. In a sale transaction both parties acting rationally will benefit both themselves and therefore society.[11] However, notions of the measurement of efficiency vary. Pareto efficiency requires that someone gains and no one loses. However, the Kaldor-Hicks test accepts as efficient “a policy which results in sufficient benefits for those who gain such that potentially they can compensate fully all the loses and still remain better off”.[12]

The explanation of what is “rational” also varies widely, from simple wealth maximisation to complex motives including altruism leading to the somewhat exasperated criticism that “From the point of view of understanding motivation in terms of rational self interest ... if we expand backward with self-interest as an explanation until it absorbs everything, including altruism, then it signifies nothing- it lacks explanatory specificity or power”.[13]

The third pillar for the economic analysis is information flows. The rational actor is seen as making rational choices with full and perfect information at his command.

Rational actors utilising perfect information will produce maximum allocative efficiency by making choices, which exploit competition in the market. However, allocative efficiency by making choices which exploit competition in the market. However, allocative efficiency will not occur unless all the costs incurred in the transactions are internalised. Thus, if a company pollutes a river, causing damage to other river users but incurring no penalty, the goods produced by that company would be underpriced. That this type of behaviour causes real problems for those whom would impose minimal regulation and rely instead on market behaviour and private law instruments are evident.

Applying market economics to company law involves seeing the company not as a free standing institution but a network of bargains between all involved, all acting rationally with perfect information. The utility of company law is to prevent the high costs of reaching individual bargains with every involved person. Company law thus reduces transaction costs. 

Criticism of economic theories 

The economic contractualist attracts criticism both at the level of the conception of companies and company law and on the basis of the perceived political results of the analysis. The formers are criticisms, which go to the utility and accuracy of the analysis itself. Further problems may arise when the economists view the company [14]in action and designate the interaction between the company and the state (the justifications for regulation) and the relationships between individuals concerned with the working of the corporate constitution. It is at this level that the theory impacts with the designs for regulatory structure.

On the first level we have seen that the conception of rationality is variously perceived and that the further away from pure wealth maximisation as motivation the less valuable it is as an analytical tool. Further, rationality is bound up with the amount of information possessed by the rational factor. Accepting that “perfect information” is a myth, most economists accept the notion of “bounded rationality” or “satisficing”. Bounded rationality accepts that the capacity of individuals to “receive, store and process information is limited”.[15] Satisficing is “searching until the most satisfactory solution is found from among the limited perceived alternatives”.[16] Thus, the “pure” concept of rationality suffers from the twin problems of simplistic motivation and a defect in the theory of perfect information.

At a political level, economic contractualism has the effect of putting the corporation into the sphere of private law, of viewing the legitimisation of the power it wields as coming from the entrepreneurial activities of the members and lessening the state’s justification for regulatory interference.[17] As Korten has shown the results of a wholehearted espousal of this philosophy is a type of corporate colonialism which widens the divide between the very poor and the very rich. “Markets are useful for implementing public priorities but inappropriate for setting them”[18] European Influences.

The implications of the UK’s position in the European Union is not the subject of extensive analysis in the consultation document[19] although one important thrust behind recent European Initiatives is to build a real partnership between capital and labour, and to replace the outdated fiction of the shareholder control with the “community interest” identified by the Davignon group. The report of the group was published in May 1997. The group took as a starting point the importance of the involvement of the workforce in company decision making:

“Globalisation of the economy and the special place of European industry raises fundamental questions regarding the power of social partners within the company. The type of labour needed by European companies – skilled, mobile, committed, responsible and capable of using technical innovations and of identifying with the objective of increasing competitiveness and quality – cannot be expected to obey the employer’s instructions. Workers must be closely and permanently involved in decision making at all levels of the company” (Davignon para19).

Further, the group accepted that a concerted approach to work organisation within the company “will improve industrial relations, increase worker participation in decisions and is likely to lead to an improvement in product quality” (para 20). The One successful initiative has been the directive establishing European Works Councils[20]. Once established a European Works Council is “to be informed and consulted ... on the progress of the business ... and its prospects ... in particular  ... the structure, economic and financial situation, the probable development of the business and of production and sales, the situation and probable trend of employment, investments, and substantial changes concerning organisation, introduction of new working methods or production processes, transfers of production, mergers, cut-backs or closures of undertakings, establishments or important parts thereof, and collective redundancies.”[21] The “definitions” provide that “consultation” means the exchange of views and the establishment of dialogue between employees’ representatives and central management or any more appropriate level of management”[22]. This is a minimum requirement. Thus, the requirements go someway to meet the call for “a framework of labour law which circumscribes and limits management’s control of the enterprise”[23]. Thus, despite the provision which asserts in relation to ad hoc meetings where exceptional circumstances ‘affecting the employees’ interests to a considerable extent’ that this information or consultation meeting “shall not affect the prerogatives of the central management”[24] it seems clear that these prerogatives no longer extend to the ability to take unilateral action in the absence of consultation with an EWOC.[25]

What tools have we at our disposal in order to ensure the comfortable implementation of such a restraint on managerial power?

This author has argued elsewhere[26] that the development of fiduciary duties can be a central plank in meeting these challenges, moving the law away from its contractual emphasis in this regard and putting employees in a central corporate governance position. It is to be hoped that the final report of the Law Commission makes no recommendations, which prejudice taking on board these wider concerns.


[1] Company Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties Law Commission Consultation Paper No 153.


[2]When Corporations Rule the World, Berrett-Koehler 1995.


[3]Korten op cit, p.83.


[4]Company Law: Theory, Structure and Operation. P.41. Gower disagrees: “ is clear that without the legislative intervention, limited liability could never have been achieved in a satisfactory and clear-cut fashion, and that it was this intervention which finally established companies as the major instrument in economic development. Of this the immediate and startling increase in promotions is sufficient proof” Gower, 6th ed. Paul Davies, Sweet and Maxwell 1997.  


[5]S.J. Stoljar Groups and Entities: An Enquiry into Corporate Theory, ANU Press, Canberra 1973, p.40 and G. Teubner “Enterprise Corporatism: New Industrial Policy and the “Essence of the Legal Person” (1988) 36 American Jnl of Comparative Law 130.  


[6]Cheffins op cit p.6.


[7]After A. Smith The Wealth of Nations, Everyman, London.


[8]And firms, which are not, always companies.


[9]Alice Belcher The Boundaries of the Firm: the theories of Coase, Knight and Weitzman Legal Studies (1997) Legal Studies Vol. 17 No. 1, p.22.


[10]O E Williamson Contract analysis: “The Transaction cost approach“ in P. Burrows and C G Velanovski (Eds.) The Economic Approach to Law, Butterworths, London 1981, Williamson, Transaction-Cost Economics: The Governance of Contractual Relations 21 Journal of Law and Society 168.  


[11]Ogus gives the following example;

“Bill agrees to sell a car to Ben for 5,000 pounds. In normal circumstances it is appropriate to infer that Bill values the car at less than 5,000 pounds (say 4,500) and Ben values it at more given than 5,000 (say 5,500). If the contract is performed, both parties will gain 500 pounds and therefore there is a gain to society- the car has moved to a more valuable use in the hands of Ben ... this is said to be an allocatively “efficient” consequence.  


[12]Explanation given by Ogus, op cit, 24, who immediately points out that there is no requirement for the gainers to compensate the losers, see below in criticism section.


[13]Ayres and Braithwaite Responsive Regulation OUP 1992, 23.


[15]Ogus, op cit, p.41.




[17]Ibid, p.209.


[18]Korten op cit, p.98.


[19]See paras 1.55 and 11.27-11.28 (regarding s.309 CA 1985).


[20]Directive 94/45/EC of 22nd September 1994. And see Wheeler (1997) Journal of Law and Society 44.


[21]Directive, Annex para 2.


[22]Article 2(1)(f).


[23]Bercussion in Workers, Corporate Enterprise and the Law in R. Lewis (Ed) “Labour Law in Britain” OUP 1986. Can Company law be integrated into labour law so that employees become a central concern of the law governing the enterprise? Could the functioning of enterprises become dependent on compliance with standards and procedures laid down by the labour law? So long as the two spheres of company and labour law are kept distinct, “one is necessarily led” in the words of an eminent French labour lawyer (Lyon-Caen 1983) “to the conclusion that non-compliance with a labour law obligation [will] not affect the validity of a transaction in commercial law.”     


[24]Annex para 3 subparas 3 &4.


[25]Bercusson op cit p.299-300.


[26]Implementation of European Initiatives in the UK: The Role of Fiduciary Duties, Company, Insolvency and Financial Services Law Review, forthcoming 1999.