Hey guys! In this post, we are going to start answering the question "what is a corporation."
I am a lawyer and have been doing this for more than ten years. I have had the privilege of working with a range of legal structures, and that includes corporations.
In a nutshell, a corporation is a 'legal person' created by the combination of applicable legislation and one or more natural persons' initiative. Incorporation is a powerful legal structure that has both legal and business advantages.
But, you may be wondering what exactly it means for a corporation to be a 'legal person.' I am going to dive into that debate in this post. (Future posts will go over some associated practical questions.)
Last year, when we first got locked down, I was, of course, a bit shocked. As time goes on, I started thinking about how I can give something back to those around me. One idea was to create this blog as a source of credible, reliable information. In particular, I hope this first set of blog posts is helpful for guys (and girls) who are just getting on their entrepreneurship journey.
It's all good, man. Scroll down to find out more.
How Can a Structure be a Legal Person?
Incorporation is a powerful legal structure, and it has both legal and business advantages.
But, as a first-time entrepreneur, it makes sense to have questions. In particular, many guys ask me what it means for a corporation to be a 'legal person.' Today I am going to address that issue from a theoretical perspective.
You are in the right place to understand better the leading theories of how and why modern, common law jurisdictions create a 'legal person.' I am going to dive into the three main theories below, which are:
- Property Aggregation
- Entity Theory
- Nexus of Contracts
Theory 1: Property Aggregation
The first theory we are going to talk about is the corporation as an aggregator of property. On this theory, the corporation is primarily an extension of the shareholders.
According to the aggregation theory, the property and business may be carried on in the corporation's name. But in reality, the property and business belong to the shareholders.
Therefore, the aggregation theory holds that the so-called 'personhood' of the corporation is what is sometimes called a legal fiction. This legal fiction, in turn, does not change the fact that the corporation is just a placeholder for the shareholders.
This theory stresses the close relationship between the shareholders' best interest and the corporation's best interest. As a result, management's duty is to do whatever is in the best interests of shareholders, which is usually defined as maximizing profit.
Theory 2: Entity Theory
The second theory is called the 'entity theory.' On this account, the corporation is a distinct institution, and it is not reducible to its shareholders.
According to the entity theory, many people participate in the corporation. This includes the shareholders and the management and employees, customers, and suppliers. Therefore, it is incorrect to reduce the corporation's identity to just one of these parties.
On this view, the corporation's legal personality is not a pure fiction. Instead, the corporation's legal personality indicates that it has a distinct identity that is separate from any one group. Therefore, the corporation's best interest is not reducible to the best interests of only one group, i.e. the shareholders. In turn, this has the further implication that the duty of directors should not be narrowly defined.
Theory 3: Nexus of Contracts
The final theory we are going to introduce is the 'nexus of contracts' approach. This is also sometimes called the 'bundle of contracts' approach.
According to the nexus of contract theory, a corporation's most salient feature is that it has contractual relationships with numerous other parties. These other parties include the corporation's shareholders, lenders, suppliers, and employees.
For example, shareholders and the corporation have a contract. The shareholders provide the corporation with investment capital. In exchange, the shareholders get benefits such as dividends and voting rights. Another example is the employment contract between the corporation and its employees. Under the employment contract, employees provide labor, and in exchange, the corporation gives them wages.
You can also think of the nexus of contract theory, metaphorically, as a bicylcle wheel. The corporation is the 'hub' at the center of the wheel. And, the corporation's contracts are 'spokes'. The result is a hub-and-spoke network structure with the corporation is at the center. In this way, the corporation plays a coordinating role.
For proponents of the nexus of contract theory, the promise to run the corporation in the interests of the shareholders is no more than a contractual term. (The term is found in the implicit contract between the shareholders and the corporation.) The term is a promise, albeit a legally enforceable promise.
Bonus: Theory 4
The three formulations identified above are the classical theories of the corporation. There is, however, a fourth theory that is percolating in today’s society and merits consideration.
This fourth theory is the ‘stakeholder theory’ of the corporation. I am not going to discuss the stakeholder theory here today. But just wanted to flag it for the time-being. I will return to this topic and the stakeholder theory in later posts.
That is all, Folks
Thanks for reading today’s post. I hope it helped open the question of what exactly is a corporation.
Simply put, we can say that a corporation is a ‘legal person’ that is created by the combination of applicable legislation and the initiative of one or more natural persons. The above reviewed three classical theories, i.e. the corporation as aggregation of property, the corporation as an institution, and the corporation as a bundle of contract. We also previewed the stakeholder theory of the corporation.
But, there is significant debate and disagreement about the true character of the corporate entity that gets created through the above interaction of law and action.