Corporations today are embedded in a system of shareholder primacy. Nonfinancial concerns—like worker well-being, environmental impact, and community health—are secondary to the imperative to maximize share price. Benefit corporation governance reorients corporations so that they work for the interests of all stakeholders, not just shareholders.
This is the first authoritative guide to this new form of governance. It is an invaluable guide for legal and financial professionals, as well as interested entrepreneurs and investors who want to understand how purposeful corporate governance can be put into practice.
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Corporations and Investors
SETTING THE STAGE
Chapter 1 provides context for the rest of the book. It includes a discussion of just what makes business entities like corporations so important to the global economy. It also explores the special privileges such entities enjoy, and the historical path that led to these privileges. Next is a brief exploration of the system through which savers channel their capital to the productive economy and of how that system interacts with corporations, which are often the final stop for capital flowing through the investment chain. Finally, the chapter raises the question whether the participants in the investment chain should have obligations to safeguard the vital systems they impact, in light of their powerful role in the economy. This question foreshadows the issue raised by benefit corporation law: Should the purpose of corporations encompass obligations to protect the systems that serve all of their stakeholders?
ROLE OF THE CORPORATION
This entire book is dedicated to the study of one form of corporation. The form is relatively new and still rare. As of the date of this publication, there are only five thousand benefit entities out of a total of 8 million business entities in the United States. Why then is the subject worthy of a book? More fundamentally, what is the significance of the distinction between benefit corporations and other entities?
Answering these questions requires an understanding of the importance of business corporations and the role they play in our economy. In particular, it is important to understand the relationship between corporations and shareholders, who own the equity of such entities. These shareholders provide risk capital that drives the world economy. One source estimates that publicly traded equity has a value of $70 trillion, constituting 20 percent of the "value of everything." By way of comparison, the same source estimates $100 trillion in fixed income securities and another $95 trillion in real estate value.
The ability of the corporation to organize capital and apply it to areas of need has long been recognized. A leading treatise from last century described the importance of the modern corporation to industrial society:
Much of the industrial and commercial development of the nineteenth and twentieth centuries has been made possible by the corporate mechanism. By its use investors may combine their capital and participate in the profits of large- or small-scale business enterprises under a centralized management, with a risk limited to the capital contributed and without peril to their other resources and business. The amount of capital needed for modern business could hardly have been assembled and combined in any other way [emphasis added].
The treatise goes on to say that the important elements of the corporate form are the right to hold property and otherwise deal with third parties as a separate person, limited liability for shareholders, continued existence when a shareholder dies or transfers shares, and centralized management and organization.
While this may all seem quite intuitive to a reader who has spent her entire existence in a society where transactions with artificial persons is routine, these corporate characteristics were quite disruptive. Without them, every enterprise that required the equity capital of more than one person would be subject to complex contracting issues, legal uncertainties, and financial risks that would make it extremely difficult to aggregate large amounts of financial capital. One leading English academic has noted the remarkable historical importance of the corporation:
That the corporation can explain the growth of nations around the world and the failure of others to progress is indicative of its macroeconomic significance. That the different nature of the corporation is associated with social benefits and ills and its changes over time with their emergence and eradication suggests that it is to the corporation that we should turn for the source of both our prosperity and our impoverishment.
THE HISTORY OF THE CORPORATION
A very brief history of the corporation will help to explain why the development of the benefit corporation may be the leading edge of a critical turning point in economic history. Initially, when individuals wanted to engage in business enterprises, they could do so as individuals or, perhaps, as partners, but as such, they were subject to liability for everything that the enterprise did, and, whenever a partner left or a new partner was brought in, new contracts had to be established. This system did not work well for encouraging private enterprise that required large amounts of capital, but in the preindustrial age there was limited need for such capital formation.
Nevertheless, certain business enterprises did require significant financial capital. For example, trading companies required large amounts of risk capital to finance expensive operations abroad. Early English corporations were formed by royal act, creating charters for particular corporations to trade, such as the East India Company. In Anglo-American history, these were followed by legislatively created charters that enabled corporations to collect sufficient capital to fuel the investments that brought about the industrial revolution. Essentially, legislatures were choosing enterprises that they believed needed capital to deliver needed improvements — canals, bridges, railways, banks, and utilities. The enterprises were granted the advantages that came with incorporation. In exchange for these privileges, shareholders committed capital to enterprises that created social good.
Eventually, legislatures came to see the power of corporations to steer capital to productive use as an important public good, without regard to any particular industry. As a result, general incorporation laws were created, allowing any business to be structured as a corporation, without obtaining a charter from the legislature. This also had the salutary effect of depoliticizing incorporation, as access to the legislature was not a prerequisite to forming a corporation.
In 1811, New York became the first state in the United States to establish a general corporation law, but even that statute limited its use to corporations that manufactured textiles, glass, metals, or paint. Not until 1837 did a state adopt a general incorporation statute that could be used for any "lawful, specified purposes." Within these statutes, states initially imposed limits on corporate power, requiring strict statements of purpose, and limiting the right to own other corporations, but eventually these restrictions were lifted, due in part to competition among the states for charters. As corporations grew in size and strength, they became the dominant players in the economy, and incorporation had fully shifted from a privilege to a right. At the same time, the corporation shifted from being a public institution to a private one. As a result, incorporation ceased to be viewed as a "concession" from the state.
Corporations thus evolved as an institution created by government in order to benefit the societies they governed. They allowed investors to aggregate resources into an artificial person, without fear of personal liability. This, in turn, allowed for massive, efficient investment vehicles that create the goods and services that benefit society. As the economy became more complex, there were more instances in which these vehicles were advantageous. The end point of this evolution was general incorporation laws, which allowed any business to use the corporate form, without regard to social benefit.
The Investment Chain
THE STRUCTURE OF THE INVESTMENT CHAIN
The previous section discussed the history of the corporate form and touched on the rationale for granting it special rights. Corporate forms now dominate global business, with $70 trillion in equity capital invested in public companies, and more in private entities with corporate characteristics. This section examines the context in which that equity is purchased and managed.
The history of the equity investor parallels the history of the corporation itself in many ways. As the economy grew beyond one based on land and agriculture, individuals who accumulated wealth needed ways to invest that wealth in new businesses beyond land ownership — first trade, then industry, and eventually all forms of business activity. Corporate shares provided a method to do this. Investors were able to save, but also to access their wealth by selling their shares. Moreover, they could invest in many different enterprises, without having to take on any of the burdens of managing the enterprises. Shares in corporations provided limited liability, liquidity, and diversification. Investors could fund an enterprise without concern that they could lose more than they invested. Shares of stock in business became a way to save, accumulate, and transfer wealth.
But although savings through stock ownership originated as direct ownership by individuals, the global capital system has become a vast and complex network. For example, in the United States, the value of publicly traded stocks in early 2017 was more than $25.6 trillion, much of which is held by "institutional owners." These institutions include banks, mutual funds, pension funds, sovereign wealth funds, insurance companies, endowments, and foundations. All of these institutions are holding that money on behalf of beneficiaries — insureds, pension beneficiaries, citizens, students, and others. Anne Tucker has pointed out that citizens' participation in the stock market through this system is not voluntary; in the United States, in particular, workers saving for retirement are forced to become "citizen shareholders." Those institutions employ asset managers, who in turn employ consultants and additional managers.
In this system, the directors and officers of corporations are essentially the last line of fiduciaries in a long chain. For example, an individual may buy a mutual fund in a 401(k) plan. That fund may employ asset managers, who in turn rely on outside consultants. Those consultants may recommend the purchase of shares in particular corporations, whose directors and officers finally deploy the assets that underlie the individual's retirement savings into the real economy. As table 1 (on page 14) shows, assets may go through every link in the chain, or skip one or more links, as when a human being invests directly in a public corporation, skipping the layers of asset owners and managers. In contrast, a human being's capital may flow through multiple links, encountering advisers at each level, and perhaps flowing through multiple layers of subadvisers.
One author described this as a long chain of delegation in the investment management industry:
At the top of the investment management industry are the individual investors, those who invest in pension funds and mutual funds or invest through bank savings accounts or insurance contracts. Individual investors are delegating most of their investment decisions to these asset owners. Asset owners then delegate asset management to in-house managers or external funds. These asset managers then delegate the decision on how to allocate capital across productive projects to corporate executives. Corporate executives can thus be viewed as the bottom of the investment management industry.
This chain of investment performs many important functions. It allows members of society to protect their savings throughout their own life cycle and to save for housing, for education, and for retirement. It allows society to channel savings into productive investments. Finally, and most importantly for the purposes of this book, this investment channel creates a mechanism whereby asset owners — or their representatives — can oversee and provide stewardship for those assets.
THE ABSENCE OF SOCIETAL RESPONSIBILITIES IN THE INVESTMENT CHAIN
The allocation and use of these assets has tremendous effects on civic life and the environment — the corporate executives at the bottom of the investing chain must make decisions about treatment of workers, supply chains, and carbon emissions. In light of the tremendous amount of capital the financial industry oversees, one might believe that the asset managers along the chain would assume a certain level of societal responsibility. Yet, despite their critical role, these investment professionals often believe that their focus as investment fiduciaries must be on maximizing the return on the companies in the portfolios under their charge, and not on broader societal issues: "The majority of mainstream asset owners hold the view that it is not only appropriate, but required, to focus only on delivering financial returns to clients and beneficiaries."
However, this limited view of investing can be self-defeating for beneficiaries, because the long-term financial cost of the externalities to diversified portfolios may outweigh any benefit gained at particular companies that create those external costs. The chief justice of the Delaware Supreme Court has noted that the voice of the ultimate beneficiaries of institutional funds is not heard in this investing chain: "As a human investor, you turn your capital over every paycheck to funds available among fund families chosen by your employer. Those funds are effectively available to you only when you hit fifty-nine-and-a-half years old. Thus, for decades ... you do not get to pick the shares of stock bought on your behalf or to express any view about how those shares are voted."
The money managers and other intermediaries ignore the larger concerns that should be of most concern to those whom Chief Justice Strine calls "the human investor," and Professor Tucker the "citizen shareholder." Their focus on returns within the portfolios they manage means that they may ignore the effect that the components of those portfolios have on the system as a whole, including the markets themselves and the world in which the beneficiaries live. This leads to actions that can actually create systemic damage. Thamotheram and Ward compare the damage done by investment management that ignores systemic risk to doctor-induced illness:
An iatrogenic illness is an illness caused by medication or a physician. By analogy iatrogenic risk is risk caused by the investment industry itself relating to the real world of the end-beneficiary, a world that investment intermediaries, especially the richest and most senior decision-makers, isolate themselves from. In a nutshell, the financial return from investment of, for example, a pension fund may fail to compensate for the costs imposed by environmental and social degradation owing to said investments.
The evolution of this concern, and its interaction with the forces driving the adoption of benefit corporation legislation, are discussed in later chapters. However, this work is only focused on the changes that benefit corporation law effects with respect to the duties of directors. The foregoing discussion suggests that there should be a similar recalibration with respect to the fiduciary duties of asset managers and owners to the ultimate beneficiaries of the assets under management. As with corporations themselves, investment fiduciaries may face problems of collective action and free riding when making decisions that have direct positive effects on investment returns and less direct, but negative, effects on the systems within which those investments operate. Nevertheless, these investment fiduciaries ultimately control immense wealth that may be the only store of societal resources available to address our most pressing concerns: "Philanthropy is a powerful force for good. But the funds contributed by global philanthropy, even when combined with the development or aid budgets of many national governments (themselves facing budget constraints), add up to mere billions. The cost of solving problems such as water scarcity, climate change, and lack of access to health care, education, and affordable housing runs into the trillions of dollars."
Excerpted from "Benefit Corporation Law and Governance"
Copyright © 2018 Frederick H. Alexander.
Excerpted by permission of Berrett-Koehler Publishers, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
Table of Contents
Foreword by the Honorable Leo E. Strine, Jr. xi
Introduction: A Corporate Lawyer's Journey 1
Part I Shareholder Primacy and Its Discontents 7
Chapter 1 Corporations and Investors: Setting the Stage 9
The Corporation 9
The Investment Chain 12
Chapter 2 Fiduciary Duties for Conventional Corporations: Enforcing Shareholder Primacy 19
Basic Rules of Corporate Governance 19
For Whom Is the Corporation Managed? 21
Chapter 3 Standards of Review: How Judges Decide Whether Directors Are Putting Shareholders First 35
Function of Standards of Review 36
The Business Judgment Rule 36
The Entire Fairness Standard 39
Intermediate Standards of Review: Enhanced Business Judgment Rule 39
Standards of Review for Shareholder Voting 41
Chapter 4 The Responsible Investing Movement 43
Responsible Investors 43
Concessionary Versus Non-Concessionary Responsible Investors 45
Doing Well by Doing Good: No Concession 47
The Paradox of the Value of Commitment: The Concession that Isn't 48
Universal Owners: Making Concessions to Preserve the Commons 51
Shareholder Primacy and Responsible Investing 55
Part II Governing For Stakeholders 61
Chapter 5 The Model Benefit Corporation Legislation 63
Prelude: The Benefit Corporation Movement 64
Provisions of the MBCL 68
Chapter 6 The Delaware Public Benefit Corporation Statute 85
Delaware's Approach to Benefit Corporations 86
Responsible and Sustainable Management: The Balancing Obligation 87
Duties of Directors 92
Supermajority Shareholder Votes 102
Appraisal Rights 105
Corporate Name: Providing Notice to Investors 108
Chapter 7 Operating Benefit Corporations in the Normal Course 109
The Business Judgment Rule 109
A Longer-Term Lens? 113
Practical Implications for Ordinary Business Decisions 115
Chapter 8 Operating Benefit Corporations in Extraordinary Situations 119
Benefit Corporations and Conflict Transactions 120
Change-in-Control and Defensive Situations 122
Proxy Contests and Franchise Rights 130
Decisions Affecting Security Holders of Different Classes Differently 131
Part III Other Paths: Stakeholder Governance By Other Means 133
Chapter 9 Constituency Statutes: A Viable Alternative for Stakeholder Governance? 135
Adoption of Constituency Statutes 135
Operation of Constituency Statutes 136
Reaction to Constituency Statutes 138
Constituency Statute Litigation 142
Economic Impact of Constituency Statutes 147
Chapter 10 Could a Conventional Corporation Adopt Stakeholder Values? 149
The Statutory Framework in Delaware 149
Delaware Law Does Not Authorize Private Ordering of Fiduciary Duties 150
Other Jurisdictions and Practicalities 152
Chapter 11 Limited Liability Companies and Social Purpose Corporations 153
Ordinary Limited Liability Companies 153
Benefit Limited Liability Companies 155
Social Purpose Corporations 155
Appendix A Model Benefit Corporation Legislation (with Explanatory Comments) 163
Appendix B Delaware General Corporation Law Subchapter XV: Public Benefit Corporations 193
Appendix C Quick Guide to Becoming a Delaware PBC 201
Appendix D Delaware PBC Charter Provisions 205
Appendix E Quick Guide to Appraisal for Delaware PBCs 207
Appendix F Rubric for Board Decision Making of a Delaware PBC 211
Appendix G Stakeholder Governance Provisions for a Delaware LLC 217
Further Reading 263
About the Author 279