by Cydney Posner
In an interesting article In the Harvard Business Law Review, Chief Justice Strine of the Delaware Supreme Court makes clear his view that the concept promoted by some academics and other commentators that corporate directors are entitled to take into consideration the interests of constituencies other than shareholders is naïve, tiresome and misguided. What’s more, he suggests, it’s largely ineffective. A more effective approach, he suggests, is through the newest creation of Delaware corporate law, the public benefit corporation. While cynics might wonder whether his advocacy of the benefit corporation model is just a diversionary tactic, Strine argues forcefully that current corporate accountability structures make it difficult for directors to “do the right thing”; by shifting the power balance to create incentives for good corporate citizenship, he contends, the benefit corporation model may just offer a real-world solution.
The position so scorned by Strine has been espoused in a variety of articles and books. For example, Professor Lynn Stout, author of The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public (2012) has written that “boards exist not to protect shareholders per se, but to protect the enterprise-specific investments of all the members of the corporate ‘team,’ including shareholders, managers, rank and file employees, and possibly other groups, such as creditors.” Steven Pearlstein, a Washington Post columnist, has written that, “[i]n the recent history of management ideas, few have had a more profound — or pernicious — effect than the one that says corporations should be run in a manner that ‘maximizes shareholder value.’ Indeed, you could argue that much of what Americans perceive to be wrong with the economy these days — the slow growth and rising inequality; the recurring scandals; the wild swings from boom to bust; the inadequate investment in R&D, worker training and public goods — has its roots in this ideology.” However, “this supposed imperative… has no foundation in history or in law. Nor is there any empirical evidence that it makes the economy or the society better off.” Professor Stout attributes the development of the “shareholder preeminence theory” to the rise of the Chicago school of economists, including statements by economist Milton Friedman, who famously argued that the only “social responsibility of business is to increase its profits.” Subsequently, two other economists published a paper characterizing shareholders as “’principals’ who hired executives and board members as ‘agents.’ In other words, when you are an executive or corporate director, you work for the shareholders. Stout said these legal theories appealed to the media — the idea that shareholders were king simplified the confusing debate over the purpose of a corporation. More powerfully, it helped spawn the rise of executive pay tied to share prices — and thus the huge rise in stock-option pay. As a result, average annual executive pay has quadrupled since the early 1970s.” In the NYT, columnist Joe Nocera argues that, over time, the focus on “shareholder value” has had none-too-pretty results. He considers the pressure to boost short-term earnings – and the executive compensation that depends on them – to be part of the impetus for the financial crisis, as “financial institutions took on far too much risk in search of easy profits that would lead to a higher stock price.” (See my news briefs dated 10/11/11, 7/2/12, 10/5/12, 8/30/13 and 9/7/13.)
According to Strine, the theory that constituencies such as employees and the larger community may be taken into consideration by directors as part of their decision-making process has two bases. The first is that the board has broad discretion to govern, including discretion to consider effects other than maximizing shareholder value. The other basis is that, except in the context of a sale of the company for cash — when Revlon duties apply — there is no legal mandate that elevates shareholder wealth maximization above all other considerations.
But Strine disclaims any attempt to “engage with either of these contestable lines of argument.” Rather, he argues, there is a more compelling reason to disregard them: they don’t work. Why not? Because they do little to change the incentives of directors to take the interests of these other constituencies into consideration. First, he contends that “[i]f, in the important context of a change of control transaction, the only constituency whose best interests must be considered is stockholders, other constituencies’ interests are decidedly not equal, because how these constituencies will be treated by the new owner is a matter of real-world importance.” Second, even assuming that corporate law permitted other constituencies to be considered, then the law has certainly established a puzzling accountability structure: only shareholders have any rights to vote, inspect records or sue. That’s generally also true, he asserts, even in states that have enacted “constituency statutes,” which permit, but do not require, boards to take into account, as part of their decision-making, the best interests of other corporate constituencies. According to Strine, “even if it were the case that corporate directors and managers were well suited to act as the guardians of employees, consumers, the environment, and society generally, the accountability structure within which they operate in the United States is tilted heavily toward one specific constituency: stockholders.”
The power of shareholders under the existing corporate accountability structure is especially compelling, he believes, now that shareholders are largely led by institutions and are no longer “docile and disaggregated.” Even independent directors, he observes, are prone to cave in on matters of principle when institutions or shareholder activists threaten to toss them out of office if they don’t. Example: the swift demise of the staggered board. “In the end,” Strine contends,
“American corporate law makes corporate managers accountable to only one constituency—stockholders—and that accountability has been tightened because of market developments concentrating voting power in institutional investors and information technology innovations easing communication and joint action among stockholders. Most commentators who are uncomfortable with this reality spend more time urging directors to lean harder into these headwinds, or complaining about the weather, than they do proposing real world solutions to give corporate managers more space and greater incentives to actually give due regard to other constituencies and the best interests of society.”
By articulating new corporate purposes and mandates, the benefit corporation tweaks that accountability structure:
“That is what is refreshing about the benefit corporation movement. Rather than ignore the importance of the accountability structure within which corporate managers operate, the benefit corporation movement set out to change it. In the liberal tradition of incremental, achievable reform rather than radical renovation, the benefit corporation is a modest evolution that builds on the American tradition of corporate law. But that evolution is potentially important because, if it gains broader market acceptance, the benefit corporation model puts some actual power behind the idea that corporations should be governed not simply for the best interests of stockholders, but also for the best interests of the corporation’s employees, consumers, and communities, and society generally.“
Although, under the benefit corporation model, directors are still accountable only to shareholders, Strine believes that the Delaware benefit corporation statute shifts the underlying power relations sufficiently to provide “incentives for the creation of objectives and standards that allow … directors to be held accountable for managing the corporation in a sustainable and responsible manner.” What are the attributes of benefit corporations that Strine believes make them effective to achieve their goals? First, he contends, the Delaware statute is mandatory: it requires that the board manage the company in a manner that balances the various constituencies, a duty that is enforceable by shareholders derivatively. In addition, the statute requires that the company’s statement of business purpose include one or more specific public benefits that the company will promote; the company must provide shareholders with a statement of its promotion of this benefit every two years. Moreover, changes in this commitment require approval of 2/3 of the shareholders. Among other things, the statute also makes clear that Revlon duties are not applicable to benefit corporations; rather, the board’s good faith balancing of the interests of all relevant constituencies would be entitled to “business judgment” protection. Other than the benefit of maximizing profit, Investors would be entitled to traditional protections.
While Strine believes that these changes in the power balance “can be meaningful,” he recognizes that the ultimate success of benefit corporations depends on several factors. The first wave of entrepreneurs who adopt the benefit corporation model must match “conduct with verbal commitments.” In addition, there must be sufficient numbers of investors “who not only mouth the belief that corporations should be managed for the best interests of all they materially affect, but in fact act on that belief when real world investing and voting decisions have to be made. These investors also must believe that the returns from such an investment strategy are likely to meet their own financial objectives.” Moreover, benefit corporations must be able to
“generate results for equity investors that inspire confidence that companies doing it the right way will generate long-run returns consistent with prudent portfolio growth. One of the reasons why entrepreneurs of all generations find the benefit corporation model appealing is because of its supposedly better alignment with the time horizons required to make a business most sustainably profitable. Many hard-headed executives find the public markets’ and institutional investor community’s obsessive focus on quarterly earnings and rapid portfolio turnover to be inconsistent with the need for the managers of actual productive enterprises to develop new products and services, bring them to market, and deliver value to consumers that leads them to become committed customers. The benefit corporation model supposedly addresses that concern by providing breathing room to corporate executives from short-term pressures. Not only that, advocates for the benefit corporation argue that doing things the right way is the profitable way in the long run, because regulatory shortcuts, product quality compromises, and the like tend to get discovered and result in corporate failures and underperformance. ”
Further, Strine asks, what will happen to benefit corporations that are acquired? Will the larger acquirer defer to the original goals of the benefit corporation when there is only one shareholder to which the benefit corporation is accountable? Or will the acquired benefit corporation create a springboard for the larger company as a whole to adhere to the benefit corporation’s goals? Finally, will benefit corporations be able to go public or will they suffer a severe price discount if they do? As Strine points out, the prevalence of dual-class capital structures that substantially limit the power of public shareholders has not put a dent in the demand for hot IPOs (but voting power and cash in the pockets of shareholders are not necessarily equivalent as a practical matter).
Even as Strine sees it, the potential success of the benefit corporation model as an alternative corporate structure is premised on overcoming a number of very high hurdles. So far, few public companies have taken the risk of changing to the benefit corporation form, leaving the critics of the shareholder preeminence theory with the same objections and observations of negative societal impact as before. See this post. Based on current data, it seems unlikely that we will see a “wave of entrepreneurs” adopting the benefit corporation model in the near future. Still, one really hot start-up adopting the benefit corporation form may be enough to change that trend. Whether any stellar start-up will be willing to take the benefit corporation plunge remains to be seen.