Home > Corporate Governance Theory > A case for Director Primacy: Meand and Ends in Corporate Governance, by Bainbridge. Against shareholder empowerment theories

A case for Director Primacy: Meand and Ends in Corporate Governance, by Bainbridge. Against shareholder empowerment theories

The theory of the firm has been developed so that different models can be classified in a two axe table:

 –         Means axis: managerial models are placed at one side, (firm as a hierarchical organization, where directors are figureheads, and shareholders are out of the picture); at the other side, models where shareholders keep a privileged position, (as owners, or special production factors, to whom directors and managers owe fiduciary duties).

–         Ends axis: in one side models defending shareholder`s wealth as the firm goal, and in the other, those defending stakeholder theories.

 Shareholder primacy models somehow accept shareholders control the means and are the correct beneficiaries of director fiduciary duties. Managerial models differ as to what extent they (must) serve shareholders` interests, or all constituencies`s ones.

But Bainbridge suggests a new model, the director primacy (DP) model, (1). As to the means axis, he states that none side is correct; the board controls the firm`s resources. And this model support fiduciary duties are owed to shareholders. The model is based on the concept of the firm as a nexus of contracts.


1.- The board as a nexus of contracts: the Means axis, or who decides?

In order for a firm to survive, it needs to allocate authority so that adaptive decisions are made, (a hierarchy headed by the Board), and norms to guide decision makers, (shareholder`s wealth maximization rule). This –Bainbridge says- is the case in USA, this constitutes his positive theory of Corporate Governance, and he argues the economic history of the USA owes a lot to this particular feature of its economic structure, (the corollary is evident).

 Let`s describe Bainbridge`s model:

 a)      Contractarian Foundation of DP. Corporate constituents contract with the firm; because of the difficulties in communicating between them, they do so with the nexus, the firm.

b)      Fiat: inside the firm, there is no democracy, nor market decision processes; it`s a bureaucratic hierarchical decision model, a member of the team having the power to rewrite internal contracts. The cost of bargaining within the firm is reduced that way, putting together resources, eliminating opportunism, uncertainty and complexity related costs, -after incomplete contracts, a decision body is needed-. Besides, the firm decides by authority, (not consensus as in many small firms), when information is differently located to team members, and when their interests are different, (K. Arrow).

c)      Locating the nexus: in most legal systems the center is the board, (which delegates or not). Shareholders are not entitled to initiate actions, not to approve them, (except for a limited number). The board is the nexus of contracts itself.

d)      Contrary to Managerial theories, Directors are not seen as managers, they are not some managers dominating all others. Bainbridge argues directors are not generally captured by managers: compensation alignment, oversight duties entitling the use of the business judgement rule, the market threat, are the reasons. Accordingly, they sometimes revolt against incumbent managers, and keep the power to oust them. This is for me, one of the weakest points in his Positive Theory of Corporate Governance, (as he describes his own model).

e)      Shareholder primacy theory lies on the ground that a) shareholders own the firm, or b) the residual claim to assets and earnings. Friedman is an example of the first, as he considers the firm can be owned. But the theory of the firm as a nexus of contracts, defends the residual claim right. The agency theory supports the idea that directors and managers are stewards to shareholders, and monitoring is the main concern. But who monitors those charged with monitoring, (directors)?. Alchian-Demsetz argue residual claimants do, so they are the last monitors in the hierarchical chain. But as ownership and control are separated, Bainbridge says this cannot be the case. Moreover, for that to be, if shareholders were the ultimate controllers, their voting rights should be exclusive and strong. But they are not. They are basically limited to electing directors, by-laws, M&A and dissolution. Apart from that there are limits to shareholder activism: disclosure obligations, insider trading regulations, voting rules, etc. The idea that institutional investors exert this control, is also flawed. All those limits can`t come from a shareholder-centric theory. Director Primacy states the boards` powers are “original and not delegated”. If shareholder primacy had a case, directors would be merely advisors to stockholders, and no solution would had been introduced as to the decision-making process. A complete theory of the firm requires to balance the exercise of fiat or discretion and accountability. The Director Centric model as a normative theory, propose that fiat and accountability cannot been reconciled, thus the limitations to shareholder power and to accountability. We will see later, but the business judgement rule closes the gap.

So, Director Primacy model supports keeping the board`s power of fiat.

2.- The ends axis: the stakeholder models vs. director primacy theory

One of the ends may be shareholder wealth maximization, and DP models are ok with that. Directors pursue (and should pursue) that goal, on behalf of shareholders, who do not control the assets.

Directors cannot (Ford was so told by the Courts when sued by the Dodge brothers) decide to lower profits or dedicate them to a different purpose than giving a reasonable dividend. The long-run interest of the shareholder is still supported by US courts. As for facts, the market for corporate control, compensation best practices and the action of activists, do the job.

But, does it hold in the contractarian model, where there are some other stakeholders? Does shareholder maximization also emerge?

The idea followed by Bainbridge is explained below:

–         firms have law as a default rule; and bylaws as an option after bargaining to form a company.

–         who are those in the bargain? Shareholders versus the others; shareholders and the nexus; in DP it`s directors and shareholders, the last wanting the profit maximization (PM), the former accepting it because it reduces the cost of capital.

–         But once this is done why do directors comply with PM? Bainbridge argues that if directors divert from PM, they increase risk and equity return will rise, and also firm failure. Why should they care? Well, they do, Bainbridge says, because they care about their reputation and their specific capital, because the stock compensation, and pride and self-esteem.

–         Separation from PM engenders some effects: fist, uncertainty about results, and a lack of a decision-making criteria; second, directors could pursue their self-interest.; moreover, the “business judgement rule” would not protect under stakeholder theories, as PM is not the rule any more. The cost of capital would necessarily go up because of that, and equity procurement would be more difficult.


Quasi-rents and fiduciary duties. Bainbridge further support the PM case. He brings forward the idea that default rules shouldn`t allow for private ordering or contrary agreement, in the case of market failures, and mainly in the case of negative externalities. In their presence law should be mandatory, but not always, so he says.

Let`s think of misconduct as an externality, and let`s see Bainbridge`s aregument. Where a transaction specific asset is used so that it generates some quasi-rents, (excess return to the necessary paycheck needed to hire the asset), directors could eventually appropriate these rents, given the reality of incomplete contracts. And contrary to any other stakeholder, a shareholder investment in the firm is a transaction specific asset, as it is at risk and in the hands of a third-party. They are vulnerable to the kind of externality produced by director misconduct. Other stakeholders would find contractual protections enough, but shareholders need to rely on fiduciary duties including the shareholder wealth maximization principle. What`s more, shareholders don`t usually team up to strongly negotiate as some other constituents do, (employees), so the are the weakest and the ones needing more protection for their interests.


The Means axis; are directors mediating hierarchs or shareholder wealth maximization?


Bainbridge makes a difference between his model and Lynn and Stout`s Team Production model, (3) (we referred to it here, https://joaquinbarquero.wordpress.com/2014/02/08/the-team-production-theory-of-corporate-law/).


In L&S`s model, directors are mediator hierarchs, in the sense that they in fact take all stakeholdes` interests into account, while making them all work as a team to favor the corporation`s best interests, receiving what they deserve for their specific assets as provided to the corporation. Bainbridge accepts to describe big public corporations as a hierarchy of production teams. Nevertheless, following Coates, (2), he restricts the mediation concept to firms not controlled by a dominant shareholder or by one of the “team” members, such as management. His own model would only fail in the presence of a controlling shareholder, Bainbridge states. He doesn`t even accept that start-ups, (the kind of firm L&M`s model is based on, according to Bainbridge), when substituting its board at the occasion of an IPO do it on a team production basis, but really pursuing a more director centric firm; from then on, the board hires factors of production, and not vice versa. As for the particular role of the board, Bainbridge refers to monitoring, strategic guidance and resources and contacts procurement, and in none of these he accepts referee behavior to have a role. A board solve disputes using his power to rewrite contracts within the firm, and always as a tool on behalf of residual claimants.


As for the prediction capacity of both models, Bainbridge uses the Business Judgement rule as a test, (the best test for every model, as it constitutes a corollary for the fact that ownership is separated from control). Both L&L and Bainbridge accept the rule refers to the board as the one that decides, (means). But they don`t coincide in the ends axis, as the latter argues the rule preserves director authority from judges`s review only when directors are able to demonstrate they pursued profit maximization, (without fraud, self dealing and the like).


(1) Bainbridge, Stephen M., Director Primacy: The Means and Ends of Corporate Governance (February 2002). UCLA, School of Law Research Paper No. 02-06. Available at SSRN: http://ssrn.com/abstract=300860 or http://dx.doi.org/10.2139/ssrn.300860


(2) http://heinonline.org/HOL/LandingPage?handle=hein.journals/jcorl24&div=40&id=&page=


(3) Blair, Margaret M. and Stout, Lynn A., A Team Production Theory of Corporate Law. Virginia Law Review, Vol. 85, No. 2, pp. 248-328, March 1999. Available at SSRN: http://ssrn.com/abstract=425500 or http://dx.doi.org/10.2139/ssrn.425500

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