This article is adapted from Corporate Law and the Theory of the Firm: Reconstructing Corporations, Shareholders, Directors, Owners, and Investors, part of the Routledge series on The Economics of Legal Relationships, ISBN 9780367895532.
For decades, even centuries, whether in law, accounting, or economics, we have been led to believe that shareowners own corporations, that shareowners are beneficial owners of the corporation, that shareowners are residual claimants, that directors are the agents of shareowners, and that directors are trustees of shareowners. But where is the evidence or legal argument that supports those beliefs? There is none. The evidence and legal arguments in fact prove the opposite. Shareowners do not own corporations. Shareowners are not beneficial owners. Shareowners are not residual claimants. Directors are not agents of shareowners. And directors are not trustees of shareowners.
Shareowners are considered owners of the corporation. But the most important aspects of private property are the rights of exclusion and exclusive use. Thus, if I own land, or an automobile, and you enter upon the land that I own without my permission, or drive away in my automobile, you can be arrested for trespass or theft and fined or imprisoned. Absent an agreement to the contrary, a partner can enter onto the land owned by the partnership without permission because partners are joint tenants and may use partnership property for partnership business.
A deed is evidence that someone owns land. A title to an automobile is evidence that someone owns the automobile. But a share of stock is not evidence that someone owns the corporation. If a shareowner of a corporation enters onto the land owned by the corporation without the corporation’s permission or attempts to use the property owned by the corporation, she can be arrested because she does not own the corporation and has no right of exclusion or exclusive use of the corporation or its property. A shareowner merely owns (x/n) percent of the shares outstanding, not (x/n) percent of the corporation. To hold otherwise is a violation of property law. There is no legal argument that can be made that shareowners own corporations that does not violate property law.
Shareowners are considered to be residual claimants, that is, claimants after claims of creditors. A corporation’s balance sheet shows that assets equals liabilities plus equity, or that assets minus liabilities equals equity. Thus, equity is simply the net assets. Equity is what remains after the claims of creditors are satisfied.
It is indisputable that the corporation owns all of its assets. It is also indisputable that the corporation owes the liabilities and is alone responsible for paying the liabilities. Therefore, it is indisputable that the corporation owns the net assets just as it owns the total assets. But net assets are simply the equity.
In law, economics, and particularly accounting, equity is referred to as shareholders’ equity. But how is it possible for the net assets owned by the corporation to be transformed into equity owned by the shareowners? Even Voldemort could not accomplish such a transformation. The correct accounting equation is assets equals liabilities plus corporate equity, not shareowners’ equity. It is the corporation that owns the equity, not the shareowners. Shareowners have no residual claim against the equity, that is, the net assets, of the corporation.
The purchase of stock from the corporation in an initial public offering (IPO) is a contract, just as the purchase of a bond from the corporation is a contract. Purchasers of bonds (and other creditors) have claims against the corporation for interest and principal, enforceable in a court of law. If the corporation does not pay the interest or principal, creditors can sue and obtain a judgment against the corporation.
Unlike purchasers of bonds (or other creditors), purchasers of stock have no claims against the corporation. Not since Dodge v. Ford can shareowners assert a claim against the corporation, and that was an anomaly. Shareowners are not claimants, residual or otherwise, against the corporation because they have no claim against the corporation, its total assets, its net assets, or its income. To hold otherwise is a violation of contract law. There is no legal argument that can be made that shareowners are claimants, residual or otherwise.
Directors are considered agents of shareowners. But in order for directors to be agents, there must be a principal–agent relationship, which means there must be principals. If there is a principal–agent relationship between shareowners and directors, and directors are the agents, then shareowners necessarily are the principals.
Several legal obstacles prevent directors from being agents. First, principals appoint or hire agents; agents do not appoint principals. When a corporation is formed, directors are either named in the articles of incorporation or elected by the incorporators prior to shares being issued and prior to there being shareowners. Thus, directors exist prior to shareowners existing. Directors issue shares, which would mean directors as agents appoint shareowners as principals. That is not permitted under agency law.
Second, fundamental agency law requires that principals be liable for the acts of their agents, whether in tort or contract. If directors are agents of shareowners, then shareowners as principals are liable for the acts of the directors. However, it is fundamental corporate law that shareowners are not liable for the acts of directors, according to what is mistakenly called the “limited liability” of shareowners. (Shareowners do not have limited liability. They have no liability. The most they can lose is the market value of their shares, none of which is used to pay corporate liabilities.) If shareowners are not liable for the acts of the directors, then shareowners are not principals. Therefore, directors are not agents. Furthermore, since directors are not agents of shareowners, directors cannot owe a fiduciary duty to shareowners. To hold that directors are agents of shareowners is a violation of agency law. There is no legal argument that can be made that directors are agents of shareowners.
Directors are considered trustees of shareowners, and shareowners are the beneficial owners. But fundamental trust law prohibits this. In order for directors to be trustees, a trust must be created. In order to create a trust, the trustor must transfer property to the trustee, who then takes legal title to the property and administers the property for the benefit of the beneficiary who is the beneficial owner. But that is not what occurs between shareowners, corporations, and directors.
Shareowners transfer property (cash) to the corporation in an IPO. It is the corporation, not the directors, that takes legal title to the property. There is no trust relationship between directors and shareowners because directors do not, and cannot, take legal title to the property. Therefore, directors cannot be trustees of shareowners. If there is no trust or trust relationship between shareowners and directors, shareowners cannot be beneficiaries and therefore cannot be beneficial owners. Furthermore, since directors are not trustees of shareowners, directors cannot owe a fiduciary duty to shareowners. To hold that directors are trustees and shareowners are beneficial owners is a violation of trust law. There is no legal argument that can be made that directors are trustees of shareowners or that shareowners are beneficial owners.
It’s the end of corporate law as we know it, and I feel fine.
*With apologies to R.E.M.
