Margaret M. Blair’s research while affiliated with Vanderbilt University and other places

Corporate governance problems arise because corporations are fictional entities, with a legal status that is separate from any of the individuals involved in them. They are not, themselves, actual persons, yet numerous different groups of individuals --- investors, employees, managers, suppliers, customers --- may have interests at stake in them. Often, they are managed by hired executives. Hence, decision-making authority in corporations is generally separated from personal responsibility and liability. Neither managers (the active decision makers), nor other employees, nor investors (who enjoy the protection of "limited liability") necessarily bear the direct costs of corporate actions. This article, written as the entry on "corporate governance" for the forthcoming International Encyclopedia of Social and Behavioral Sciences, provides a brief discussion of the central governance problems and common mechanisms used to address these problems in the U.S. and in other countries.

In the wake of the financial crisis of 2008-2009, practitioners and theorists in law, finance, and economics are rethinking our theories about how the financial sector influences the real economy. In particular, they are reexamining the linkages among financial innovation, supply of credit and money, monetary policy, bubbles, financial stability, and economic growth. One of the key issues that is being reconsidered is the dynamics of how banks and other financial institutions drive credit creation and credit allocation, and how these factors, in turn affect the performance of the macroeconomy. In this article, I argue that, by providing an alternative to “money” (as traditionally defined), credit acts like money in stimulating the economy. When financial institutions that provide credit to the real economy borrow too much and become over-leveraged, the effect is like an uncontrolled expansion of the money supply, increasing the risk of dangerous asset bubbles and making financial markets unstable. Excessive leverage in the financial sector can set the stage for sudden and catastrophic contractions when multiple financial institutions all try to deleverage quickly and at the same time. This is because when financial institutions collectively withdraw credit from the market, this depresses aggregate economic growth, I further argue that the tendency of financial institutions to use too much leverage will not be self-correcting because leverage has helped to drive up profits and incomes over time in the financial sector. Thus, because of the substantial negative social externalities of excessive leverage, financial market regulations must be deployed to prevent financial institutions from using too much leverage.

In this article I argue that the legal device of creating separate juridical “persons” for certain business activities serves at least four functions that became especially important to business organizers during and after the industrial revolution, and that those functions are still important to most large, publicly-traded corporations. These are: 1) Providing continuity, and a clear line of succession in the holding of property and the carrying out of contracts. 2) Providing an “identifiable persona” to serve as a central actor in carrying out the business activity. Employees and investors in the enterprise, as well as customers of the enterprise, recognize, and perhaps identify with this persona, which serves as the bearer of important intangible assets such as goodwill, reputation and brand. This persona is the counterparty to all contracts that the corporation enters into with its various participants (employees, customers, suppliers, and investors), and can sue and be sued in its own name. 3) Providing a mechanism for separating pools of assets according to which assets are dedicated to the business, and which assets are the personal assets of the human persons who are participating in the business. The ability to partition assets in this way makes it easier to commit specialized assets to an enterprise, and lock those assets in so that they remain committed to the enterprise and can realize their full value (Blair, 2003; Hansmann and Kraakman, 2000). 4) The separateness of the corporate entity, once the corporation is created, requires a legal mechanism for self-governance, at least with respect to the undertakings of the entity. The governance structure prescribed by corporate law since the early 19th century is a managerial hierarchy topped by a board of directors that is distinct from shareholders, managers, and employees, and that has fiduciary duties to the corporation itself as well as to shareholders.These four functions of entity status in corporations, all of which have been associated with the concept of corporate personhood, are important sources of value in organizing business activities that involve a substantial number of people using dedicated assets over long periods of time. All four of these functions have been important since the Industrial Revolution, and continue to be important in business activities today. In large corporations with many shareholders and ongoing business activities, the four functions come as a package and are connected to each other, although the corporate form can be deployed to achieve as few as one of these purposes. These functions would be very difficult, if not impossible, to accomplish using only transactional contracts. Careful analysis of the functions of “personhood,” or “entity status” can shed light on policy questions about what Constitutional rights should be recognized for corporations.

For much of the last three decades, the dominant perspective in corporate law scholarship and policy debates about corporate governance has adopted the view that the sole purpose of the corporation is maximizing share value for corporate shareholders. But the corporate scandals of 2001 and 2002, followed by the disastrous performance of financial markets in 2007-2009, has left many observers uneasy about this prescription. Prominent advocates of shareholder primacy such as Michael Jensen, Jack Welch, and Harvard’s Lucian Bebchuk have backed away from the idea that maximizing share value has the effect of maximizing the total social value of the firm, noting that shareholders may often have incentives to take on too much risk, thereby increasing the value they capture by imposing costs on creditors, employees, taxpayers, and the economy as a whole. In response to the dramatic demonstration of the problems with shareholder primacy, some scholars and practitioners have considered the “team production” framework for understanding the social and economic role of corporations and corporate law (Blair & Stout, 1999) as a viable alternative. Whereas the principal-agent framework provided a strong justification for the focus on share value, the team production framework can be seen as a generalization of the principal-agent problem that is symmetric: all of the participants in a common enterprise have reason to want all of the other participants to cooperate fully. A team production analysis thus starts with a broader assumption that all of the participants hope to benefit from their involvement in the corporate enterprise, and that all have an interest in finding a governance arrangement that is effective at eliciting support and cooperation from all of the participants whose contributions are important to the success of the joint enterprise. Insights from a team production analysis provide a rationale for a number of features of corporate law that are problematic under a principal-agent framework.

Two of the major problems that permeate complex modern production and distribution enterprises are coordination and enforcement. While mechanisms of coordination have been studied extensively in management science and organizational economics, issues raised by the second set of problems have been the focus of microeconomic theory, organizational economics, and law, especially property, contract and business entity law (e.g., North, 1990). At least two major mechanisms of enforcement of business and commercial understandings and agreements - legal contracts, and the organization of activities within firms - have been studied at considerable length by scholars in the law and economics tradition (e.g., Coase, 1937; Williamson, 1975). More recently, a third cluster of mechanisms, including norms and reputation, have become an object of study by economists and legal scholars (Richman, 2004; Bernstein, 1996; Bernstein, 1992; Bernstein, 2001; Grief, 1989).

This article opens by identifying two principal reasons for looking into the definition of human capital (HC). Defining HC broadly as the 'skills, knowledge, and capabilities of the workforce', it argues: first, that these are critical inputs to production; and second, that resources expended on increasing them are investments like more conventional investments in resources, facilities, and equipment. While a person's possessing 'skills and knowledge' is an old idea, the article argues that the recent history of HC is its rehabilitation as an additional variable to help explain economic growth not otherwise accounted for by conventional macroeconomic analysis. It reports that despite forty years of objections, HC has become central to macroeconomics, labour economics, growth theory, trade theory, development economics, the economics of education, the theory of the firm, human-resource management, and strategy theory - a very significant impact.

What is a business corporation? What purposes does and should it serve? These questions have been raised repeatedly by legal scholars, practitioners, and policy-makers for at least the past 150 years. Each generation has struggled to find acceptable answers.

To prevent financial markets from imploding again, as they did in the fall of 2008, regulators must find ways to limit the amount of “leverage” financial institutions utilize. Excessive "leverage" means financing with too much debt relative to the amount of equity a firm has. Numerous financial innovations developed in the last few decades have made it easier for firms of all types, but especially financial firms, to finance themselves with debt, or debt-like instruments. Financing with debt is attractive because it can increase the return on equity, so in the years leading up to the financial crisis, firms used unprecedented levels of debt. But excessive leverage swells the financial system as a whole, especially the less regulated parts of the system that have been called a "shadow banking system," increasing risk for the individual firms that use too much debt, and, more importantly, producing systemic instability. Excessive debt exposes the rest of the economy to too much risk by generating asset bubbles, and asset bubbles, in turn, create the illusion that the financial sector is adding substantially more value to the global economy than it really is. The illusion of value creation triggers extraordinary compensation packages that reward the market players whose activities generate the bubble, thus encouraging the use of even more debt. Instead of tackling leverage head on, Dodd-Frank Wall Street Reform and Consumer Protection Act passed in the summer of 2010 leaves all the important details involved in reining in leverage to regulators. Regulators, in turn, take their cues from the work of a previously rather obscure international committee of bank regulators, the so-called Basel Committee. The Basel Committee has approved capital standards for banks that should reduce leverage, but these will not be fully implemented for eight years, and do not apply to non-bank financial institutions. Moreover, it remains up to bank regulators to interpret and implement these standards.

Now that Congress has passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, regulators promulgating the rules under this new bill must tackle a major problem that the reform bill addresses only indirectly. This is the problem of excessive “leverage” – financing with too much debt. Leverage permeates the modern financial system. Leverage makes the system too large, in the sense that large parts of the system operate outside the reach of regulators, and the system has a tendency to create vastly too much money and credit, thereby causing asset bubbles. Asset bubbles create the illusion that the financial sector is adding substantially more value to the global economy than it really is, and expose the rest of the economy to too much risk. Moreover, too much of society’s resources go to compensate the people in the system who are causing this to happen.

This article proposes several simple financial market reforms that can help regulators both identify systemically risky institutions and mitigate the systemic risk associated with derivative trading, especially trading in credit derivatives such as credit default swaps. The Federal Reserve (or other systemic risk regulator) should require that financial institutions publicly disclose detailed information on all credit derivatives in their portfolio - including counterparties and notional value - on a frequent basis. The notional value of credit derivatives provides a gauge of the maximum amount the derivative seller must pay the buyer if the underlying credit instrument defaults. Although the notional value is not a good indicator of a derivative’s market value (it is unlikely that each contract in the portfolio would have to be settled for the full notional amount), the notional value of all credit derivatives in an institution’s portfolio is a powerful indicator of the systemic risk posed by that institution’s investments because it is the maximum amount the institution could owe to (or be owed by) other institutions in an extreme event such as the 2008 credit freeze. The government should use this disclosure to identify which financial institutions are “systemically significant.” Any institution whose credit derivative portfolio has a notional value exceeding a certain threshold for a several days would be regulated for several years as a “Tier 1 Financial Holding Company” per the Administration’s proposal. Exchange-traded derivatives should not count in the notional value threshold for systemic significance, creating an incentive to move OTC contracts to exchanges.