Filling the Gaps in the Close Corporation Contract: A Transaction Cost Analysis

This Article develops a more refined transaction-cost based theory which explains: why rational investors in jointly owned, closely held firms initially choose corporate form; why they leave the contractual gaps that they do; and how efficiency-minded judges should respond to postharmony disputes made possible by the form chosen and the gaps left. My theory takes into account not only the possibility that investors should have chosen partnership law, but also the advantages and disadvantages of organizing production as an implicit team, via long-term contracts between separate businesses or as a sole proprietorship. In explicating this theory of form choice, the Article initially assumes that investors are fully rational. Later, I relax that assumption and consider how courts should respond to situations in which rational investors would not have selected corporate form. Central to my theory is an understanding of the dichotomy between opportunism and adaptability. This Article shows that rational individuals choose to operate as a firm in response to a governance problem endemic to team production supported by team-specific investment – the need to maximize individual and collective ability to adapt to changed circumstances, and at the same time, to minimize the ability of team members to obtain more than their fair share of team-specific value through opportunistic use of available adaptive mechanisms. Rational individuals, then, choose a governance structure for their firm that provides the optimal mix of adaptability and protection from opportunism. Individual adaptability is maximized by rules allowing each owner to withdraw her capital at will. Collective adaptability is maximized by a governance structure that determines all adaptations, including the individual's right to withdraw capital, by majority rule. As individual adaptability is enhanced, so is the risk of minority opportunism. Conversely, as majority adaptability is increased, so is the risk of majority opportunism. Drawing on the dichotomy between opportunism and adaptability, the Article explains in detail: (1) when joint ownership is more desirable than a sole proprietorship; (2) why partnership form is optimal for jointly owned, closely held firms where fear of majority opportunism imposes greater ex ante costs than fear of minority opportunism; and (3) why corporate form is optimal when fear of minority opportunism predominates. The Article builds on this theory of rational form selection to explain the gap-filling role of efficiency-minded courts. In so doing, I hope to shed light on the so-called contract analogy and the “would have wanted” gap-filling theory. I argue that an efficiency-minded court's goal should be to assist investors in achieving an optimal ex ante balance between adaptability and opportunism. However, in pursuing this goal, the court must avoid a gap-filling approach that undermines the value-maximizing reasons that prompted shareholders to choose corporate form. Thus, the court must fashion a gap-filling rule that recognizes the relative concern for minority and majority opportunism indicated by both the form chosen and by the team members' investment characteristics.