The American Law Institute (ALI) is currently working on a Restatement of the Law of Corporate Governance (“Restatement”). As with all Restatements, the purpose of the proposed Restatement is to clarify “the underlying principles of the common law” that have “become obscured by the ever-growing mass of decisions in the many different jurisdictions, state and federal, within the United States.” As I argued in my paper, Do We Need a Restatement of the Law of Corporate Governance?, corporate law is virtually unique in being dominated by the law of a single jurisdiction; namely, Delaware. Given the prominence of Delaware law in this field, the proposed Restatement is unlikely to be influential.
In my new paper, A Critique of the American Law Institute’s Draft Restatement of the Corporate Objective, I turn to an assessment of a key provision of the proposed Restatement; namely, § 2.01, which purports to restate the objective of the corporation. Section 2.01 differentiates between what the drafters refer to as common law jurisdictions and stakeholder jurisdictions. The latter are those states that have adopted a constituency statute (a.k.a. a non-shareholder constituency statute).
The tentative draft of § 2.01 was approved by the ALI membership at the Institute’s annual meeting. My article is intentionally agnostic on the underlying normative issue of whether corporations should focus exclusively on shareholder interests or should also consider stakeholder interests. Instead, it offers a critique of § 2.01 and offers suggestions so as to clarify important open questions and better align § 2.01 with current law.
The drafters assert that, in common law jurisdictions, the corporate objective is to “enhance the economic value of the corporation, within the boundaries of the law . . . for the benefit of the corporation’s shareholders . . ..” In doing so, corporation is allowed to consider the impact of its actions on various stakeholders, provided doing so redounds to the benefit of shareholders.
In stakeholder jurisdictions, the corporation’s objective is to “enhance the economic value of the corporation, within the boundaries of the law . . . for the benefit of the corporation’s shareholders and/or, to the extent permitted by state law, for the benefit of employees, suppliers, customers, communities, or any other constituencies.”
In both sets of jurisdictions, the drafters assert that the corporation “may devote a reasonable amount of resources to public-welfare, humanitarian, educational, and philanthropic purposes, whether or not doing so enhances the economic value of the corporation.”
In my view, § 2.01 is fundamentally flawed. It makes no sense from a theoretical or practical perspective to speak of the corporate objective. Edward, First Baron Thurlow, reportedly asked: “Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?” To say that a corporation has an objective is thus a form of the reification fallacy. Reification is pervasive because it simplifies discourse, but it is nevertheless error. As Mitu Gulati, Eric Zolt, and William Klein observed: “It may be conceptually useful, for example, to depict corporations as paying taxes, but we delude ourselves and risk error if we do not appreciate that the burden of taxes is borne by individuals.”
Looking at people rather than entities is also more correct from a theoretical perspective. As Jeremy Telman explained, those who take “a contractarian view of the corporation” “avoid reification of the corporation by viewing it as a nexus of contracts.” In other words, contractarians view the corporation as a legal fiction representing a nexus of explicit and implicit contracts. From this perspective, even if an entity can be thought of as having an objective, in the corporate context there simply is no entity that can have an objective.
All of this may seem pedantic and/or scholastic, but it matters. By reifying the corporation, the Principles and the Restatement ignore the basic point that the corporation can only accomplish its objectives by acting through agents. In turn, § 2.01—both the old and new—ignores the basic fact that those agents may have a conflict of interest. It may be the rare case in which managers use that discretion to benefit themselves financially at the expense of shareholders and/or stakeholders, but it seems likely that managers often use their discretion to generate psychic benefits by directing corporate resources to pet charities and other personal preferences. As such, it is inaccurate and unhelpful to frame the question as one of corporate objective rather than one of fiduciary obligation. The principles set forth in § 2.01 thus should be incorporated into the Restatement’s provisions on the fiduciary duties of directors and managers.
Whether § 2.01 remains in place or is incorporated into Chapters 5 and 6 of the Restatement, there are a number of tweaks that the drafters should incorporate to modify and clarify its various provisions. These include: What is the corporate objective? Are tradeoffs allowed? Is opting out allowed? Should § 2.01 mandate obedience to the law? Does § 2.01 embrace Caremark? How does § 2.01 apply in takeovers? What rules govern corporate charitable activities? Why did the drafters ignore the special problems of multinationals?
Clarifying whether opting out is allowed would be especially helpful. Whether corporate law is comprised mainly of mandatory or default rules is a longstanding debate. The law governing corporate purpose is no exception. Some commentators argue that a corporation can opt out of the shareholder value maximization principle in the articles of incorporation. Others contend that the shareholder value maximization principle is a mandatory rule out of which a corporation may not opt.
The Restatement’s blackletter text is silent on this issue. The comments and the illustrations tend to suggest that opting out is allowed. In the Reporters’ Note, however, the drafters opine that § 2.01 ducks the issue on grounds that there is no law to restate. Accordingly, the drafters content themselves with the observation that it is unclear under current law “whether a firm may opt out of shareholder primacy by original charter provision or by charter amendment,” which is true but unhelpful.
The key unanswered question, however, is whether § 2.01’s authorization for the corporation to consider stakeholder interests allows the corporation to make tradeoffs between shareholder and stakeholder interests. In other words, after considering stakeholder interests, could the directors make a decision that enhances the value of the corporation—whatever that means—by transferring wealth from shareholders to stakeholders? Alternatively, could directors make a decision that provides modest benefits to shareholders while providing substantially greater benefits to the stakeholders?
The relevant comment to § 2.01 is somewhat ambiguous:
When decisions involve tradeoffs among stakeholders, the differences between the models become more important and can affect outcome. While under the traditional approach, consideration of nonshareholder interests must be “rationally related” to shareholder benefits, in a “may” or “shall” jurisdiction, consideration of nonshareholder interests sometimes will not only be permissible without regard to shareholder benefit but may be mandatory.
Neither statement is entirely accurate.
It is true that Delaware law—outside Revlon-land—allows a board to consider the interests of “various constituencies in discharging its responsibilities, provided there are rationally related benefits accruing to the stockholders.” Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986). But Delaware law is also clear that directors may make tradeoffs that benefit stakeholders at the expense of shareholders. In In re Trados, Inc. S’holder Litigation, 73 A.3d 17, 40–41 (Del. Ch. 2013), for example, Vice Chancellor Travis Laster held that “the standard of conduct for directors requires that they strive in good faith and on an informed basis to maximize the value of the corporation for the benefit of its residual claimants, the ultimate beneficiaries of the firm’s value, not for the benefit of its contractual claimants.” Trados plausibly can be read as also suggesting that shareholders must be the primary beneficiary of corporate decisions.
Turning to stakeholder jurisdictions, although constituency statutes allow directors to consider interests of non-shareholder constituencies, the statutes do not expressly authorize directors to harm shareholder interests in order to benefit stakeholders. As such, we can understand the constituency statutes as being a narrow rejection of Revlon’s rule that shareholder value is the sole licit metric for director decision making once a sale of control process has begun, which was intended as a tweak rather than a fundamental change in corporate law. Accordingly, the constituency statutes could plausibly be interpreted as preserving a requirement that director actions taken after considering stakeholder interests must still be rationally related to shareholder interests. As Jonathan Macey explained, the statutes “are mere tie-breakers, allowing managers to take the interests of non-shareholder constituencies into account when doing so does not harm shareholders in any demonstrable way.”
The drafters should clarify and confirm that in both common law and stakeholder jurisdictions that directors may not under any circumstances benefit stakeholders at the expense of shareholders. This is demonstrably the law in the former and the most plausible understanding of the constituency statutes.
The complete paper is available for download here.