A Short Primer on the Heated Debate Over Corporate Governance
In the relatively staid world of corporate law, a sharp debate has broken out over the societal role of traditional business corporations and the legal duties of directors. At times, this debate has generated more heat than light. Our “Frequently Asked Questions” below are designed to provide real-world legal guidance to directors and their advisors regarding this debate.
1. What is being debated?
Corporate governance experts are debating whether traditional business corporations should be governed by one of the following two models:
The long-standing “shareholder primacy” model, which for roughly 50 years has held that corporations should focus on maximizing profits for their shareholders
An emerging “stakeholder governance” model, which calls for each corporation to focus on a broader array of its “stakeholders,” including, in addition to its shareholders, its employees, customers, suppliers, and local communities (which are typically referred to as “other stakeholders” or “other constituencies”)
2. What gave rise to the shareholder primacy model?
Many commentators trace the shareholder primacy model to The New York Times’ publication in 1970 of Milton Friedman’s essay “The Social Responsibility of Business Is to Increase Its Profits.” Citing his 1962 book, Friedman concluded his seminal article by stating that:
“there is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game . . .”
Many commentators view this article as the doctrinal foundation for the ensuing era of aggressive capitalism that dominated much of the corporate landscape at least through the 2008 financial crisis.
3. What has given rise to the emerging stakeholder governance model?
Although various commentators have proposed an expanded societal role for corporations for years, critiques of the shareholder primacy model began to crystallize after the recession of 2007–2009. Since then, critiques of corporations’ focus on short-term profits have grown substantially. But arguably the most powerful accelerant of this critique was the Business Roundtable’s August 2019 updated statement on the purpose of corporations. In this statement, which was signed by the CEOs of 181 major companies, the Business Roundtable endorsed a commitment to operate for the benefit of all stakeholders, including customers, employees, suppliers, local communities, and shareholders. The Business Roundtable’s updated statement superseded its prior commitment to the shareholder primacy model, which it had annually endorsed for the preceding 21 years. Since the Business Roundtable’s 2019 announcement, various institutional investors, law firms, academics, international organizations, and advocacy groups have partially or fully endorsed the stakeholder governance model, including its emphasis on long-term sustainable growth.
4. Has the debate changed the laws governing my duties as a director?
No. Notwithstanding statements to the contrary by some of Wall Street’s most prominent corporate attorneys, the laws governing your duties as a director have not changed as a result of this debate.
In the United States, the duties of directors are defined by state corporate laws (particularly those of Delaware) and by courts interpreting those laws. For decades, the statutes and case law prevailing in major commercial states have held that directors of solvent corporations owe their duties to the corporation they serve and its shareholders. To our knowledge, no legislative or judicial bodies of any major commercial states have changed their corporate laws in response to the Business Roundtable’s August 2019 statement. Therefore, each director of a solvent corporation continues to owe his or her duties to the corporation and its shareholders.
5. Does the prevailing legal standard mean that directors can consider only the interests of shareholders?
No. For decades, subject to certain limited exceptions, courts have acknowledged that unconflicted and well-informed independent directors can consider the interests of other stakeholders, as long as they have a good faith belief that doing so maximizes the value of the enterprise. Anything that maximizes the value of a solvent enterprise ultimately benefits its owners, which explains why the interests of a solvent corporation and its shareholders are viewed by Delaware courts as inseparable. Former Delaware Supreme Court Chief Justice Leo E. Strine, Jr., summarized Delaware corporate law as follows:
“[A] clear-eyed look at the law of corporations in Delaware reveals that, within the limits of their discretion, directors must make stockholder welfare their sole end, and that other interests may be taken into consideration only as a means of promoting stockholder welfare.” (Emphasis added.)
6. In practice, how can directors consider the interests of other stakeholders without violating their fiduciary duties?
As long as unconflicted, well-informed directors have a rational good faith belief that they are acting to maximize the value of their enterprise for the benefit of its shareholders, there are countless ways they can consider the interests of other stakeholders without violating their fiduciary duties. Here are a few examples:
The board of a food company can insist on increasing spending on quality control, even if that hurts profit margins, if it concludes this reduces reputational and legal risk and is in the best interests of the enterprise over the long term.
Directors can opt to pay above-market wages to employees if they believe this will enhance the enterprise’s ability to attract and retain more skilled employees.
Directors can choose to transact with a well-established higher-priced vendor of mission-critical supplies over a lower-priced startup if they believe this will benefit the enterprise by reducing operational risk.
Boards can agree to donate company funds to local communities if they believe that the donation will, among other things, generate goodwill that could lead to (i) higher sales, (ii) improved employee recruitment and retention, and (iii) better relations with the company’s regulators and local communities.
Consider this example. A startup company owns a large plot of land that contains a known finite vein of palladium. The company’s directors are presented with two business plans. Under the first, the company will extract the palladium as fast as possible at the lowest cost feasible, thereby maximizing profits prior to a liquidating distribution of those profits. To save costs, (i) the purity of the end product will be merely minimally satisfactory, (ii) wages will be below‑market, (iii) safety equipment purchased from low-cost vendors will meet applicable regulatory requirements with no room to spare, and (iv) precautions against catastrophic damage to the adjoining communities will be considered but not emphasized. Under the second business plan, a portion of the profits from the mine will be used to search for additional mining opportunities, with the hope that the company could grow over time into a multinational mining company. Under this alternative plan, the company will spend additional sums to (i) enhance its customers’ satisfaction with the end product, (ii) pay above-market wages to attract and retain more skilled managers and employees, (iii) enhance the safety of the mining operations, and (iv) safeguard the adjacent communities.
Delaware’s existing business judgment rule will fully protect directors if they determine, in good faith following well-informed deliberations, that adoption of the second business plan will maximize the value of the enterprise over the long term. If their decision-making were challenged, the directors would be able to justify their actions by asserting that (i) they sought to maximize the value of the enterprise on behalf of its owners and (ii) their consideration of the interests of customers, employees, vendors, and local communities was a means to that end.
7. Do directors have authority to select the time frame over which value maximization will occur?
As a general rule, yes. In Delaware and many other jurisdictions that follow its jurisprudence, there are certain specific exemptions to this general rule, including in connection with authorizing sales of control of a corporation. Otherwise, however, directors have broad authorization under these laws to select the time frame over which to maximize the value of the enterprise, provided they are well-informed and act in good faith, and especially if they are independent.
8. Can directors favor the interests of certain non-shareholder constituencies over the interests of others?
Yes. In developing corporate strategies, directors should strive to understand how the different interests of the corporation’s other constituencies impact the goals of preserving and increasing the value of the enterprise and the shareholders’ ownership interests. In doing so, directors may need to identify and resolve conflicts among the interests of different constituencies. For instance, assume that the founder of a promising software development startup headquartered in the central United States presents the company’s board with two equally profitable business plans. Under the first plan, the company will recruit software engineers from the East and West coasts, while under the second plan the company will recruit them from the local community. Further assume that the board determines in good faith that the second plan will result in good relations with the local community and a more stable employee base, but will produce software with a slightly higher incidence of coding errors, to the detriment of the company’s customers. In this instance, the directors might reasonably conclude that favoring the interests of the local community over the customers’ interests will benefit the company and its shareholders more than placing the interests of the customers over community relations. As long as the best interests of the enterprise and its owners serve as its lodestar, an unconflicted board making good faith rational judgments on these types of competing interests should remain protected by the business judgment rule. The risks of being second-guessed by shareholders or other stakeholders will likely be reduced if boards periodically solicit input from shareholders and other stakeholders to help inform their judgments.
9. If directors already can consider the interests of other constituencies, is a change in corporate governance necessary?
Advocates of the Business Roundtable’s 2019 statement believe so. They cite a series of societal problems, including growing inequality, loss of the public’s faith in large institutions, and corporations’ increased emphasis on short-term profits to the detriment of long-term planning. These groups believe those types of problems cannot be ignored, and frequently warn that far more radical solutions may be proposed if no corrective action is taken.
Advocates of the opposing view believe that long-prevailing formulations of fiduciary duties are elastic enough to permit directors to continue to focus on the interests of customers, employees, suppliers, and communities in connection with managing their enterprises, provided that doing so serves the interest of maximizing the value of the enterprise. These advocates challenge the notion that the interests of other constituencies are equal in importance with the interests of shareholders. In their view, if a board must serve multiple masters, in practice it will effectively serve none.
Entrepreneurs who disfavor the traditional shareholder primacy model can choose to operate as “benefit corporations.” This new type of entity was initially sanctioned by Maryland in 2010 but is now permitted by a majority of U.S. states. While the authorizing legislation of these entities differs from state to state, generally speaking, benefit corporations are formed for the purpose of creating shareholder value and producing a general public benefit. Directors of benefit corporations generally must consider the interests of shareholders and other specified constituencies in connection with managing the corporation’s affairs. Investors’ future perceptions of the merits of benefit corporations could significantly impact the current debate on how traditional business corporations should be managed.
10. Is it possible that both sides could “win” the debate?
Yes. Although many commentators appear to suggest that either the shareholder primacy or stakeholder governance model will emerge victorious, the debate is not that simple. In fact, it is possible that both sides will earn partial victories.
Advocates of the shareholder primacy model may, for instance, succeed in retaining the general rule that directors must act in the interest of their respective corporations and their shareholders. But continued criticism of short-term corporate strategies that raise longer-term risks could convince more boards to place a greater focus on sustainable growth or to weigh the interests of a wider range of constituencies in a greater number of scenarios. If so, advocacy of “red tooth and claw” short-term value maximization strategies — which are frequently favored by many hedge funds and other activist shareholders — could be tempered by greater focus on longer-term value maintenance and creation. This, in fact, seems to be the end result favored by several major asset management firms, including BlackRock and State Street.
If this scenario were to occur, then prevailing law on the duties of directors would remain unchanged, but the manner in which directors approach their decision-making could change. If so, both sides will have begun from different rhetorical starting points but will end up at a place where both can claim a partial victory.