The Legal Basis for Corporate Irresponsibility

Whenever a corporation pursues a path that causes harm to a community, or anguish to some group, or participates in some scheme to avoid paying taxes, or decides to pollute the environment and kill a bunch of people, or commits some other crime against humanity, the explanation that comes back is always the same: "Our responsibility is to maximize the wealth of our shareholders; it would be illegal for us to do otherwise." Not true! Not true at all! So claims Lynn Stout in her new book: The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public. The book cover tells us that Stout is the "Distinguished Professor of Corporate and Business Law, Clarke Business Law Institute, at Cornell Law School. Her work on corporate theory was cited by Supreme Court Justice John Paul Stevens in his dissent in Citizens United." That’s good enough for me!

Let us begin by remembering that corporations have stakeholders, and they have shareholders, a specific type of stakeholder. Corporations exist because states allow them to exist. This is an implied partnership between the corporation and the state in which the corporation receives the legal and physical protection of the state provided it follows the state’s rules. One can argue the state, or the community, or society—however one might wish to phrase it—is a stakeholder in the corporation.

In the beginning a corporation consists of a corporate charter and a board of directors. When employees are added they become stakeholders. When money is borrowed, the holders of the debt become stakeholders also. When funds are collected by selling shares, then the shareholders become stakeholders also. The relationship between the corporation and its various stakeholders might best be described as contractual.

"None of the three sources of state corporate law requires shareholder primacy."

Stout indicates the sources of law or legal interpretation with respect to corporate governance as: the corporation’s charter and by-laws, state codes and statutes, and state case law.

"The overwhelming majority of corporate charters simply state that the corporations purpose is to do anything ‘lawful’."

There is no mandate for shareholder primacy to be found in state statutes.

"To start with the most important example, Delaware’s corporate code does not say anything about corporate purpose other than to reaffirm that corporations ‘can be formed to conduct or promote any lawful business or purposes.’ A majority of the remaining state corporate statutes contain provisions that reject shareholder primacy by providing that directors may serve the interests not only of shareholders but of other constituencies as well, such as employees, customers, creditors, and the local community."

Interestingly, the federal government has little role to play in this area.

"Federal securities laws require public corporations to disclose information to investors, but the feds mostly take a ‘hands-off’ approach to internal corporate governance, leaving the rules to be set by the states; this division of labor has been reinforced by court decisions slapping down Securities Exchange Commission (SEC) rules that interfere too directly with state corporate law."

It is to judicial decisions that one must turn to find what might be used as justification for exalting shareholder wealth. Stout reminds us that judicial opinions include "holdings" that form legal precedent, and "in dicta" comments that express personal opinions, but carry no legal weight. Judges have ruminated over corporate and executive responsibility at length, but have not chosen to deliver any holding that would require the primacy of shareholder wealth.

"....they uniformly refuse to actually impose legal sanctions on directors or executives for failing to pursue one purpose over another. In particular, courts refuse to hold directors of public corporations legally accountable for failing to maximize shareholder wealth."

Courts seem to adhere to what is known as the "business judgment rule."

"....the business judgment rule holds that, so long as a board of directors is not tainted by personal conflicts of interest and makes a reasonable effort to become informed, courts will not second-guess the board’s decisions about what is best for the company—even when those decisions seem to harm shareholder value."

Stout indicates two judicial decisions that are often pointed to as the basis for shareholder primacy. The first is Dodge v. Ford. Henry Ford was the majority stockholder in the Ford Company and the Dodge brothers were minority shareholders. The Dodge brothers wanted to form a rival company. To stop them, Ford cut off their cash flow by eliminating company dividends. Since the Ford Company was not a modern public corporation, the Dodge brothers had a right to sue. They won their case in the Michigan Supreme Court. Associated with the ruling was a nonbinding comment:

"There should be no confusion....a business is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end.’

Stout says that this comment is what lawyers refer to as "mere dicta," a comment that is made in passing and is unrelated to the court’s holding. The insertion of the word "primarily" renders the comment uninterpretable in any event.

The second case often quoted as legal basis is Revlon, Inc. v. MacAndrews & Forbes Holdings. Revlon was a public corporation that was to be sold to a private company and cease to exist as a public entity. The Delaware Supreme Court ruled in this case that Revlon’s directors had the duty to get the best share price for the shareholders. There is no problem with that ruling, but what does it have to do with the activities of corporations that are alive and intend to stay alive?

If there is no legal basis for shareholder supremacy, where did the concept come from? And how did it become fixed in the public consciousness?

Stout tells us that with the emergence of public corporations those who disputed the rules of corporate behavior immediately split into two camps, with one favoring shareholder primacy, while the other suggested responsibility to the broader class of stakeholders. It was the latter camp that won the initial debate. It was in the 1970s when opinions began to shift.

"The process began in the 1970s with the rise of the so-called Chicago School of free market economists. Prominent members of the School began to argue that economic analysis could reveal the proper goal of corporate governance quite clearly, and that goal was to make shareholders as wealthy as possible."

The next step was to mischaracterize the legal relationships between boards of directors, executives and shareholders, and to imbed that mischaracterization in the public consciousness.

"Milton Friedman published in 1970....Friedman argued that because shareholders ‘own’ the corporation, the only ‘social responsibility of business is to increase its profits’."

"Six years later, economist Michael Jenson and business school dean William Meckling published an even more influential paper in which they described shareholders in corporations as ‘principals’ who hire corporate directors and executives to act as the shareholders’ ‘agents’.

Note that these conclusions are inconsistent with corporate charters and with the legally validated principle of the "business judgment rule." They represent what conservative economists believe should be the law of corporate governance.

How did this notion attain supremacy in the public consciousness? Stout said it began with the infection of the legal profession by economists who thought they could inject rigor and physical principles into fuzzy-thinking law schools.

"Thus shareholder value thinking quickly became central to the so-called Law and Economics School of legal jurisprudence, which has been described as ‘the most successful intellectual movement in the law in the past thirty years’."

The popular press picked up the idea because it was simple to understand and it seemed to make sense. Others, including corporate executives, jumped on board because there was profit to be made.

"Lawmakers, consultants, and would-be reformers also were attracted to the gospel of shareholder value, because it allowed them to suggest obvious solutions to just about every business problem imaginable. The prescription for good corporate governance had three simple ingredients: (1) give boards of directors less power, (2) give shareholders more power, and (3) ‘incentivize’ executives and directors by tying their pay to share price."

The movement to tie executive pay to share price has resulted in incentivizing executives to maximize their income by focusing on short term issues that might boost share price—if only temporarily—not what one necessarily would desire.

So what we have is a misconception that has taken hold as gospel. Stout details the harm shareholder primacy can cause. That will perhaps be a topic for another day.

Let us finish with a quote Stout provides from Jack Welch the respected former CEO of GE.

"Welch observed in a Financial Times interview about the 2008 financial crisis that ‘strictly speaking, shareholder value is the dumbest idea in the world’."