Other Stakeholders

So far, we have been discussing the relationships between boards (managers) and shareholders, and between majority (controlling) shareholders and minority shareholders. We now broaden our horizon and consider other constituencies, such as creditors, workers, and consumers.

The Corporation as a Nexus of Contracts

You might think that non-shareholder constituencies are fundamentally different because they are “outsiders” to the corporation, while shareholders (and boards) are “insiders.” But this is misleading, at least in large publicly held corporations. Most investors in these corporations are “outsiders” no matter how they invest, be it through debt or equity. In fact, from most investors’ and the controller’s (founder’s) point of view, debt and equity are largely interchangeable as investment vehicles, and the choice between them hinges on details of cash flow and control rights, rather than on any notion of inside/outside.

One frequently hears that shareholders are the corporation’s “owners,” while other constituencies are “merely” contracting partners. This may contain some truth for small businesses, but it is clearly not true for large businesses. In the technical legal sense of the term, shareholders only own their shares, not the corporation. In the functional sense, shareholders lack the control rights that one generally associates with ownership. Obviously, individual shareholders cannot deal with corporate property as they please. And at least in Delaware, shareholders cannot even make decisions about corporate property collectively, since business decisions are the prerogative of the board (cf. DGCL 141(a)). As to replacing the board, this is difficult for dispersed shareholders in practice, as we have seen. In fact, shareholders may not even have the legal right to replace the board, or any other meaningful control rights. For example, the dual class share structure in Google and Facebook gives the founders full control of their corporations even though they have sold off most of the equity.

The better, modern view is that the corporation is simply a nexus of contracts (and other obligations). In this view, many different constituents transact with one another through the corporate form. In addition to managers and shareholders, these constituents include creditors, workers, customers, suppliers, and others. Corporate law’s goal is to facilitate their transactions, not to defend ostensible ownership rights. In this view, shareholders are not special — at least in principle.

Shareholder Primacy?

This is not to say that the law should not, or does not, treat shareholders differently for pragmatic reasons. In fact, as you have probably already guessed and we will now confirm, corporate law is almost exclusively concerned with the relationships between shareholders and boards, and between shareholders themselves.

Corporate Law vs. The Laws Governing Corporations

To be sure, for the most part, this is mere nomenclature. Many legal rules govern relationships between corporations and other constituencies. It’s just that we group these rules under different headings: “labor and employment law,” “consumer law,” “antitrust,” “contract law,” etc. In this perspective, corporate law is merely the name we give to those legal rules that specifically deal with “internal governance” — the misleading term (see above) for relationships between shareholders and boards, and between shareholders themselves. By definition then, this “area of law” does not deal with other constituencies. But this is without substantive content.

Fiduciary Duties

The substantive question is the content of corporate fiduciary duties. Corporate directors and officers obviously have to comply with all the laws protecting other constituencies (cf. DGCL 102(b)(7)(ii))). In exercising their remaining discretion, however, can or must they take into account the interests of all affected? Or must they act solely for shareholders’ benefit?

Delaware law: fiduciary duties to whom?

As we have already glimpsed in Revlon and will now see very clearly in Gheewalla and eBay, directors and officers of Delaware corporations owe fiduciary duties only to common stockholders. To be sure, Delaware courts continue to assert that corporate fiduciaries owe their duties “to the corporation and its shareholders.” But when the rubber hits the road, recent Delaware decisions have opted for shareholders. This is often dubbed “shareholder primacy” — the idea that, within the boundaries of contracts and regulations, corporations are to be run for the benefit of shareholders alone.

The competing “stakeholder model” suggests that boards should and do manage corporations for the benefit of all their stakeholders. As a matter of positive law, proponents interpret the words “to the corporation and its shareholders” (emphasis added) as shorthand for their broader view of fiduciary duties. This interpretation sounds sensible, for what else would the words “to the corporation” mean? Then again, the Delaware courts don’t see it that way (see previous paragraph).

In 2013, the Delaware General Assembly dealt a further blow to the stakeholder model by amending the DGCL to add a new “Subchapter XV. Public Benefit Corporations.” The new DGCL 362(a) explicitly provides:

“A ‘public benefit corporation’ is a for-profit corporation organized under and subject to the requirements of this chapter that is intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner. To that end, a public benefit corporation shall be managed in a manner that balances the stockholders' pecuniary interests, the best interests of those materially affected by the corporation's conduct, and the public benefit or public benefits identified in its certificate of incorporation. In the certificate of incorporation, a public benefit corporation shall … [s]tate within its heading that it is a public benefit corporation.”

Thus, corporations organized for a public benefit are clearly distinct from standard Delaware corporations under the DGCL. This strongly suggests that standard Delaware corporations are not to be managed for the public benefit.

Practical relevance?

In normal times, these debates are almost entirely irrelevant from a purely legal point of view. The reason is the lenient standard of review for normal board decisions (i.e., the duty of care). As you already know, the business judgment rule gives boards almost unfettered discretion. Consequently, for a very long time, there was only one reported case where “shareholder primacy” mattered, and of course, everyone cited this one case.

The case is Dodge v. Ford Motor Co. (Mich. 1919). Henry Ford took the stand and argued that the Ford Motor Company did not pay dividends because it needed the money to benefit its workers and customers. In truth, Ford probably just wanted to avoid paying out money to his minority stockholders the Dodge brothers, who had by then become his competitors. In any event, the court held against Ford, on the grounds that “A business corporation is organized and carried on primarily for the profit of the stockholders.” But Ford almost certainly would have won if he had argued that the company needed the cash for future investment or some other business purpose.

There are, however, two ways in which the debate does matter. First, the legal rule probably matters directly in the sale of the company. This is because in this “end game” situation, conflicts between constituencies become very visible. The board can no longer hide behind “long-term shareholder interest” to justify some action that directly benefits a non-shareholder constituency. Cf. the passage on non-shareholder constituencies in Revlon, and watch out for the kind of very nasty things corporate managers are allowed to do to creditors in MetLife v. RJR Nabisco.

Second, the legal rule may matter inasmuch as it guides the behavior of honest, faithful fiduciaries — to the extent it influences “board room culture,” if you will. A director may genuinely care about whether she is legally bound to benefit only shareholders or stakeholders as a whole. Thus, she may vote differently depending on what her legal advisors tell her about the content of fiduciary duties. That these fiduciary duties are not enforceable in court may be irrelevant.

Normative considerations

The right goal vs. an achievable goal

To the extent that the content of fiduciary duties does matter and works literally as intended, it is clearly bad. By definition, maximizing the interests of one group only (common shareholders) generates less social welfare than maximizing the interests of all groups combined. Ex ante, this harms even the favored group, because it will have to make concessions on other points to obtain the collaboration of the other constituencies. Since the pie is smaller (because the law doesn’t maximize it), there will be less for everyone to share.

For example, taken at face value, In re Trados Inc. Shareholder Litigation (Del. Ch. 2013) would force boards of insolvent corporations to bet the corporation’s last cash at the casino (or embark on some similarly risky, negative net present value project). For without the gamble, common stockholders get nothing. With the gamble, there is a chance that the board will win and shareholders get something. To be sure, the gamble is bad for all stakeholders combined, i.e., once creditors and preferred stockholders are included: on average, casino gamblers lose. But Trados claims that boards should work only for common stockholders. Ex ante, this rule is bad even for the common stockholders: to obtain investments from creditors etc., they will have to make other promises that compensate creditors for their anticipated losses from gambling.

Shareholder primacy advocates do not deny the conceptual validity of the preceding argument. They merely question its practical relevance on two complementary grounds. Firstly, they point out that various legal rules and in particular contracts restrict the ability of boards to favor shareholders at the expense of other constituencies. Secondly, they question if there could be any legal oversight over boards if boards were charged with maximizing the interests of all stakeholders. What are those “interests,” and what actions maximize them? It’s hard enough to figure out, e.g., what action maximizes the share price (under Revlon’s deceptively simple maxim of getting the highest price). Shareholder primacy advocates fear that stakeholder interests are so diffuse that they will always provide a pretext for managers to favor themselves. In this view, being accountable to everyone in theory means being accountable to no one in practice.

Framing corporate law: two perspectives

Importantly, no serious commentator argues that shareholders are the only people who matter in the grand scheme of things, workers etc. be damned. Rather, the disagreement is about the method of getting the best collective outcome. The debate between shareholder primacy and stakeholder models is thus closely related to the framing of the main conflict surrounding corporations. Which is the worse problem: (1) unfaithful managers wasting (mostly) shareholders’ money, or (2) shareholders and their faithful managers exploiting other constituencies?

In favor of shareholder primacy, commentators argue that shareholders have no legal means beyond fiduciary duties to get any of their money back. They have no right to dividends, or to withdraw their principal investment. By contrast, creditors (including, e.g., workers as wage claimants) have contractually specified payment rights, and the corporation must file for bankruptcy if it does not fulfill these obligations. Moreover, many other constituencies can withdraw or withhold their contribution if the corporation does not keep to its bargain: workers can move to a different job, customers can buy from different providers, etc. By contrast, shareholders part with their equity investment up front and do not get it back unless the board in its discretion decides to make a distribution. Importantly, this feature is arguably essential to equity as the most flexible form of financing.

Against this, proponents of the stakeholder model argue that shareholders in fact already have strong protection, namely their right to elect the board. No board would completely disregard shareholder wishes, or else it would be fired. There is, therefore, a tendency for boards to favor shareholders at the expense of everybody else, or so the argument goes, and fiduciary duties should at least not exacerbate this tendency. Moreover, the argument that laws other than corporate law sufficiently protect other constituencies is circular and defective to the extent that corporations in fact shape those other laws through lobbying. (To this latter argument, shareholder primacy proponents reply that this is a much broader problem of deficient rules on political spending and lobbying. You should keep this connection in mind when reading Citizens United later in the course.)

The big (comparative) picture

In this connection, it is worth pointing out that some countries push the stakeholder model considerably further in large corporations. They mandate that workers elect part of the board (so-called co-determination in Germany and many other Northern and Central European countries), or that the board be self-perpetuating (Netherlands). In this comparative perspective, U.S. corporate law heavily leans towards shareholder primacy, both normatively and factually, because only common shareholders elect the board in U.S. corporations.

To be sure, shareholder governance is merely the U.S. default. The charter may give board seats to other constituencies. (For example, preferred stockholders nominated the majority of the board of Trados Inc. in the aforementioned Trados case.) That so few large corporations adopt such alternative arrangements may provide some clues about their desirability. But this is an even deeper question that we must postpone until we have encountered some more concrete scenarios.