Does the Corporate Structure Make Sense For a Just and Resilient Economy?

Since the 1800s, the corporation with its three-tier structure of shareholders, directors and officers has formed the backbone of American business. The corporate form has the benefit of years of precedential legal decisions to help understand how the corporation should function, but also allows considerable flexibility in its ownership and management structure. Although associated with multinational corporations and profit-driven enterprises, the corporate form can be harnessed to sharing economy goals. This Article looks specifically at the concerns of using the corporate form for a sharing economy enterprise while the following investigates ways to overcome these concerns.

Concern One: Maximizing Shareholder Returns

Ask a business lawyer or an MBA about the purpose of a corporation and you are likely to hear that it is to maximize shareholder return. A corporate board that chooses to consider the needs of stakeholders other than shareholders, according to this view, potentially violates its duties to the shareholders. A board that has the choice between destroying an irreplaceable ecosystem and foregoing the potential for profits MUST chop down that rainforest, so the story goes.

The reality of corporate law is much more complicated, and this section provides a general overview of the shareholder primacy issue.

It’s important to note that corporations are governed by state law, so it is impossible to generalize about the law of corporations—each state has its own statutes and body of case law. Many generalizations that are made about corporations come from Delaware. Delaware is the jurisdiction of choice for big businesses to incorporate in, thanks in part to the large body of published opinions that provides a great deal of guidance to corporate lawyers. More than 50 percent of all publicly traded companies in the United States and 63 percent of the Fortune 500 are incorporated in Delaware. 1

If a business incorporates under a different state’s laws, different rules may apply. The location of the corporation’s headquarters may also affect which laws are applicable. For example, a corporation that is formed under another state’s law but that has significant ties to California is subject to several sections of the California Corporations Code, such as the sections governing election of directors and removal of directors, directors’ standard of care, liability of directors and shareholders, and many more. 2 Given the great variability in state corporate law, it is important for the practitioner to research the laws applicable to a particular client, based on where the client is incorporated and where it is doing business.

Discretion of the corporate board to consider stakeholders other than shareholders

Despite the widespread belief that corporate boards must maximize shareholder returns, the fact is that, in most situations, corporate boards have broad discretion to make decisions based on many factors, including impacts on the community, the environment, and their employees, as well as shareholder return. No state has a statute that requires corporate boards, in all situations, to maximize shareholder return. 3

According to the American Law Institute, “[e]ven if corporate profit and shareholder gain are not thereby enhanced, the corporation, in the conduct of its business: (1) Is obliged, to the same extent as a natural person, to act within the boundaries set by law; (2) May take into account ethical considerations that are reasonably regarded as appropriate to the responsible conduct of business; and (3) May devote a reasonable amount of resources to public welfare, humanitarian, educational, and philanthropic purposes.” 4

The board’s authority to make decisions regarding the management of a corporation is given extreme deference by the courts. This doctrine is known as the business judgment rule. The business judgment rule provides a rebuttable presumption “that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” 5 Even in situations where a board’s decision is certain to lead to reduced shareholder profit, the doctrine has been upheld. 6 This presumption protects against the risk that a court might “impos[e] itself unreasonably on the business and affairs of a corporation.” 7

A plaintiff must produce evidence that rebuts the business judgment presumption; for example, by “showing that the majority of directors who approved the action (1) had a personal interest in the subject matter of the action, (2) were not fully informed in approving the action, or (3) did not act in good faith in approving the action.” 8 Only after the plaintiff successfully rebuts the business judgment presumption will the court then place the burden on the directors to prove that the action was entirely fair. 9

There are two exceptions to this general business judgment rule under Delaware law known as the Unocal and Revlon standards. The Unocal standard is applied when the board of a corporation adopts a measure to try to defend itself from a takeover. Under those circumstances, the burden shifts to the board to prove “(a) reasonable grounds for believing that a danger to corporate policy and effectiveness existed; and (b) that the defensive measure adopted was reasonable in relation to the threat posed. Directors satisfy the first part of the Unocal test by demonstrating good faith and reasonable investigation.” 10

Under the Revlon standard, when a controlling interest in a corporation is being sold, courts grant virtually no discretion to boards—the board is required to maximize the company’s value for the stockholders’ benefit. 11

Whether these doctrines would apply in states other than Delaware is not clear, but many business lawyers assume that they would. Even in Delaware there continues to be some lack of clarity on when this heightened scrutiny would apply. Few corporate boards or their lawyers want to take the chance of a shareholder lawsuit so they err on the side of caution.

“Constituency Statutes” designed to protect directors when they take into account non-shareholder constituents

Since the 1980s, in response to a wave of hostile takeovers, about 30 states have adopted “constituency statutes” to protect corporate boards from liability for decisions that fail to maximize shareholder return even in the context of a change in control. 12  The constituency statutes vary a great deal. In Connecticut, for example, directors must consider not only shareholder interests, but “the interests of the corporation’s employees, customers, creditors, and suppliers”; “community and societal considerations”; and other factors. 13 In Arizona, directors must consider both the long-term and short-term interests of the corporation and its shareholders, “including the possibility that these interests may be best served by the continued independence of the corporation.” 14

The merits of constituency statutes have been hotly debated. Some argue that society benefits when directors are allowed (or required in the case of Connecticut) to consider constituencies other than shareholders. Others argue that constituency statutes entrench directors that may be serving nobody’s interests but their own.

Also problematic is the fact that even in states with constituency statutes, there is little guidance for boards on the specific methods or degree to which they can consider other interests besides that of the shareholders. A recent article about benefit corporation statutes noted that “neither the constituency statutes themselves nor state case law address questions such as how directors should decide which parties fall within a protected constituency category, what weight the directors should assign to shareholder and non-shareholder interests and what standards a court should use in reviewing directors’ decisions to consider (or not to consider) non-shareholder interests.” 15 This lack of clear legal authority makes it difficult for directors of social or mission-driven organizations to pursue both profit and a company’s social or environmental mission, because they may not feel that they are legally protected when considering the interests of constituencies other than the shareholders. 16

An example of how all this works is here.

The Take Away

Professor Michal Barzuza reviewed 108 antitakeover decisions in states other than Delaware. Every decision in the states with a strong constituency statute rejected the Revlon doctrine. Every case in a state without a constituency statute followed Revlon. But again, can social enterprises afford the time, energy, and legal fees necessary to find out whether Revlon would apply to them? 17

Given this concern, corporations may not be the best entity for an organization that wants to serve values that may conflict with shareholder profit maximization, certainly absent some of the modifications discussed here.

Concern Two: Lack of True Shareholder Ownership

While corporations are “owned” by their shareholders, this ownership is so diluted and changes so rapidly that it can hardly be considered ownership in the usual sense of the word. Shareholders (except for those few that own very large chunks of stock) have virtually none of the rights typically associated with ownership. They have no control or ability to influence management and they have no right to receive a share of profits. Thus the owners of the corporation have little control, while the board of directors has almost absolute control.

Concern Three: Pressure to Focus on Short Term Interests

Another flaw of large publicly traded corporations is “short-termism”—the pressure on managers to focus narrowly on quarterly profits. As Marjorie Kelly describes it,

The financial meltdown of 2008 was a direct result of the pursuit of immediate profit by investment bankers and mortgage brokers that disregarded the impact of their actions on customers, on the larger economy, and indeed on stockholders and the company itself in the long term. Those that wanted to operate with integrity found it difficult. They were constrained by a corporate design that reinforced the need to ‘make the numbers’ by any means possible. 18

Concern Four: Geographically Dispersed Ownership

One of the most admired qualities of the modern corporate form is the ease with which its ownership can spread to all corners of the earth. However, geographically dispersed ownership is inimical to the sharing economy. Local ownership is essential to the sharing economy because geographic closeness facilitates shared ownership and meaningful accountability. In their seminal report to the Ford Foundation on wealth creation in rural communities, Marjorie Kelly and Shanna Ratner describe the problem as follows:

Absentee ownership is detached from the life of a community and its enterprises. By contrast, shared ownership means that the interests connected to the living fabric of an enterprise—employees, community members, the natural environment—are represented at the table of ownership and governance. 19

An Environmental Protection Agency study found that the average amount of toxins released by absentee-owned facilities or those with out-of-state headquarters is nearly three times more than plants with in-state headquarters, and 15 times more than single location enterprises. 20

Concern Five: Lack of “Siren Protection” to Keep Board Accountable to Original Commitments

Traditional entity structures are quite flexible, which is a double-edged sword. Corporate charters can easily be amended to alter the way that authority and profits are divided. On one hand, the flexibility allows groups, if they so choose, to implement high levels of accountability and creative governance structures. On the other hand, this can allow powerful interests to easily overtake an organization. Corporations, as well as partnerships and limited liability companies [links to these corporate forms] have no built-in “siren protection.”

What is siren protection? In Greek mythology, the Sirens were three women who lured sailors with their beauty and enchanting music to the rocky coast of their island where they would be shipwrecked. To protect themselves, sailors would tie themselves to the mast of their ships when navigating near the Sirens. The basic corporate, partnership and LLC forms do not provide any way to tie oneself to the mast. If a founder that is committed in the beginning to social responsibility and community well-being is lured by the promise of big profits away from this original mission, there is nothing to stop her.

 

  1. State of Delaware, Div. of Corps., http://www.corp.delaware.gov/aboutagency
    .shtml.
  2. Cal. Corp. Code § 2115.
  3. Einer Elhauge, Sacrificing Corporate Profits in the Public Interest, N.Y.U. L. Rev. 733, 763 (June 2005).
  4. Einer Elhauge, Sacrificing Corporate Profits in the Public Interest, N.Y.U. L. Rev. 733, 763 (June 2005). (quoting 1 Am. Law Inst., Principles of Corporate Governance: Analysis and Recommendations § 2.01(b)(2)–(3) & cmt. d (1994)).
  5. In re Troll Commc’ns, 385 B.R. 110, 118 (Bankr. D. Del. 2008).
  6. Einer Elhauge, Sacrificing Corporate Profits in the Public Interest, N.Y.U. L. Rev. 733, 842–43 (June 2005). There are limits on the degree to which a board can sacrifice shareholder profits for the purpose of benefiting some other stakeholder. For example, if the board decided to give away half of its assets to charity, the shareholders could have a claim against the board for violation of the duty of care. See Mem’l Hosp. Ass’n v. Pac. Grape Prods., 290 P.2d 481 (Cal. 1955) (holding that there is “reasonable” limit to corporate manager’s power to donate that depends on particular facts of each case).
  7. eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1, 36–37 (Del. Ch. 2010) (internal citations omitted).
  8. eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1, 36–37 (Del. Ch. 2010) (internal citations omitted).
  9. eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1, 36–37 (Del. Ch. 2010) (internal citations omitted).
  10. Paramount Commc’ns, Inc. v. Time Inc., 571 A.2d 1140, 1152 (1989).
  11. “The duty of the board had thus changed from the preservation of Revlon as a corporate entity to the maximization of the company’s value at a sale for the stockholders’ benefit. This significantly altered the board’s responsibilities under the Unocal standards. It no longer faced threats to corporate policy and effectiveness, or to the stockholders’ interests, from a grossly inadequate bid. The whole question of defensive measures became moot. The directors’ role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company. . . . A board may have regard for various constituencies in discharging its responsibilities, provided there are rationally related benefits accruing to the stockholders. However, such concern for non-stockholder interests is inappropriate when an auction among active bidders is in progress, and the object no longer is to protect or maintain the corporate enterprise but to sell it to the highest bidder.” Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1985).
  12. When the California legislature voted to adopt a constituency statue, Governor Arnold Schwarzenegger vetoed the bill. The California Bar was firmly opposed to the bill, arguing that the bill would reduce director accountability by giving directors so much discretion that it would provide a means for directors to escape accountability by invoking one of the numerous interests listed in the bill and make it easier for them to escape liability for failure to meet fiduciary duties to shareholders. According to the California State Bar, “Institutional Shareholder Services, Inc., an influential proxy and corporate governance advisory firm, counts incorporation in a state with non-shareholder constituency provisions like those contained in the Bill as a negative factor when calculating its Corporate Governance Quotient, a well-known standard for measuring the quality of corporate governance.” Corporations Committee, State Bar of California Business Law Section, Statement of Position on AB 2944, June 3, 2008.
  13. Conn. Gen. Stat. § 33-756(d).
  14. Ariz. Gen. Corp. Law § 10-2702.
  15. William H. Clark, Jr. & Larry Vranka, The Need and Rationale for the Benefit Corporation: Why It Is the Legal Form That Best Addresses the Needs of Social Entrepreneurs, Investors, and, Ultimately, The Public (Oct. 31, 2011), at 10, http://benefitcorp.net/for-attorneys/benefit-corp-white-paper.
  16. William H. Clark, Jr. & Larry Vranka, The Need and Rationale for the Benefit Corporation: Why It Is the Legal Form That Best Addresses the Needs of Social Entrepreneurs, Investors, and, Ultimately, The Public (Oct. 31, 2011), at 10, http://benefitcorp.net/for-attorneys/benefit-corp-white-paper.
  17. Michal Barzuza, The State of State Antitakeover Law, 95(8) Va. L. Rev. 1973–2052 (2010).
  18. Marjorie Kelly, Not Just for Profit, Strategy+Bus. (Spring 2009).
  19. Marjorie Kelly & Shanna Ratner, Keeping Wealth Local: Shared Ownership and Wealth Control for Rural Communities (Tellus Inst. & Yellow Wood Assocs. 2009), http://www.yellowwood.org/Keeping%20Wealth%20Local.pdf.
  20. Don Grant, EPA/NSP R828826, Organizational Structures, Citizen Participation, and Corporate Environmental Performance (2001), available at http://www.epa.gov.