Principal Costs: A New Theory for Corporate Law and Governance

The dominant paradigm in corporate law is agency-cost theory, which asserts that the law’s proper role is to reduce managerial agency costs by forcing firms to allocate more control to shareholders. That theory cannot explain why shareholders voluntarily invest in firms that circumscribe their powers to hold managers accountable. This Article introduces principal-cost theory, which states that each firm’s optimal governance structure minimizes the sum of principal costs, produced when investors exercise control, and agent costs, produced when managers exercise control. Because the optimal division of control is firm-specific, firms rationally select from a range of governance structures that empower shareholders to varying degrees. Principal-cost theory generates more accurate empirical predictions than agency-cost theory. It also suggests different policy prescriptions: rather than banning some governance features and mandating others, lawmakers should permit each firm to tailor its structure based on its firm-specific substitution rate between principal costs and agent costs.