Tuesday, July 18, 2017

Long Live Director Primacy: Social Benefit Entities and the Downfall of Social Responsibility

The more I read about social enterprise entities, the less I like about them.  In 2014, my colleague Elaine Wilson and I wrote March of the Benefit Corporation: So Why Bother? Isn’t the Business Judgment Rule Alive and Well?  We observed:

Regardless of jurisdiction, there may be value in having an entity that plainly states the entity’s benefit purpose, but in most instances, it does not seem necessary (and is perhaps even redundant). Furthermore, the existence of the benefit corporation opens the door to further scrutiny of the decisions of corporate directors who take into account public benefit as part of their business planning, which erodes director primacy, which limits director options, which can, ultimately, harm businesses by stifling innovation and creativity.  In other words, this raises the question: does the existence of the benefit corporation as an alternative entity mean that traditional business corporations will be held to an even stricter, profit-maximization standard?

I am more firmly convinced this is the path we are on.  The emergence of social enterprise enabling statutes and the demise of director primacy threaten to greatly, and gravely, limit the scope of business decisions directors can make for traditional for-profit entities, threatening both social responsibility and economic growth. Recent Delaware cases, as well as other writings from Delaware judges, suggest that shareholder wealth maximization has become a more singular and narrow obligation of for-profit entities, and that other types of entities (such as non profits or benefit corporations) are the only proper entity forms for companies seeking to pursue paths beyond pure, and blatant, profit seeking. Now that many states have alternative social enterprise entity structures, there is an increased risk that traditional entities will be viewed (by both courts and directors) as pure profit vehicles, eliminating directors’ ability to make choices with the public benefit in mind, even where the public benefit is also good for business (at least in the long term). Narrowing directors’ decision making in this way limits the options for innovation, building goodwill, and maintaining an engaged workforce, to the detriment of employees, society, and, yes, shareholders. 

I know there are some who believe that I see the sky falling when it's just a little rain. Perhaps. I would certainly concede that the problems I see can be addressed through law, if necessary.  I am just not a big fan of passing some more laws and regulations, so we can pass more laws to fix the things we added.  My view of entity purpose remains committed to the principle of director primacy.  Directors are obligated to run the entity for the benefit of the shareholders, but, absent fraud, illegality, or self-dealing, the directors decide what actions are for the benefit of shareholders. Period, full stop.  


Corporations, Delaware, Joshua P. Fershee, Legislation, Management, Shareholders, Social Enterprise | Permalink


I agree that there are a number of problems with social enterprises (which makes them fun to write about), but I believe that the shareholder wealth focus in Delaware was well underway before the emergence of social enterprise entities. The emergence of social enterprise entities was to combat the statement you conclude with "directors decide what actions are for the benefit of SHAREHOLDERS" (emphasis added)--- social enterprises want directors to benefit various stakeholders, even when directors think the decision will hurt shareholders in the short and long-term. Finally, most benefit corporation statutes expressly state that they do not change or impact existing traditional corporate law (though whether judges will honor this statement or not is an open question....)

Posted by: Haskell Murray | Jul 18, 2017 5:37:57 AM

Thanks to Professor Murray for suggesting I comment. I would need a book to fully respond.
I will just make one point here, which goes to the need for a form of governance that allows managers to consider the interests of the entire system in which their firms are embedded, rather than viewing the world through narrow company-by-company lenses.
Directors are protected by the business judgment rule in deciding what is in the best interests of shareholders, but that is all they can decide. They cannot decide that the company will factor in the social and environmental cost of carbon, rather than pursuing an unsustainable path if that path maximizes return to that individual company’s shareholders. Investors desperately need a vehicle that provides their portfolio companies with an escape from this prisoner’s dilemma, because upwards of 80% of investment return is based on market performance, not company or portfolio alpha. In other words, the portfolio performance of diversified investors is being put at risk by the “value maximizing” actions of individual companies in their portfolios. (Remember 2008? The risky behavior that brought down the entire market was perfectly rationale from the view of the financial institutions involved.)
In our increasingly interdependent world, investors cannot afford to ignore the effects their investments have on the market. Modern Portfolio Theory is simply wrong in viewing overall systemic and market performance as exogenous to investment activity—if the $80+ trillion invested in public markets, venture capital and private equity is continually put to work grazing the commons, tragedy will inevitably follow. Benefit corporations allows investors and corporations to responsibly manage the systems in which they are embedded.
Forty years ago, this wasn’t a concern, because shareholder primacy didn’t dominate the law and markets. But now it does, and we can’t turn back the clock—conventional corporations are bound by Revlon and eBay, and subject to the short-termism that dominates equity markets. Companies and investors who want to find a better way need a tool to address these developments. Benefit corporations are that tool.

Posted by: Rick Alexander | Jul 18, 2017 1:51:25 PM

Thanks very much for the comment. I don't disagree that Revlon and eBay are problematic, and I don't dispute that social enterprise entities are great vehicles for doing the things you suggest. The problem I have with the evolution of traditional entity doctrine is that is has become so rigid that traditional entities have too little room to promote a varied path to success. I'd like all entities to become social enterprise entities, but I don't see that happening, and I still fear the option. - in or out - portends bad things for society and shareholders. More soon, and I appreciate the dialogue from both of you.

Posted by: Joshua Fershee | Jul 18, 2017 1:55:47 PM

With due respect to Rick and Haskell and you, Josh (since I seemingly disagree with all of you to some extent), I will strike out and say that the more I think about the benefit corporation form, the more I believe that it attempts to oversimplify what should be a naturally complex and useful board process. A firm (whether or not organized as a corporation) that does not produce profit (or at least break even) is not sustainable. Yet, not every decision of a corporation's board should be one that is made only or primarily to advance profit maximization or maximize shareholder wealth. Firms organized as for-profit corporations that exist to serve stakeholders other than shareholders have been around since the corporate form was created.

In the main, two reported court decisions (Dodge and eBay) find for-profit board decision-making processes faulty for over-emphasizing non-shareholder concerns. (Revlon is a takeover case in a specific takeover context, and other cases to which one might site have less compelling shareholder wealth maximization language in them. I do not count them here.) Yet, boards of directors of for-profit corporations are constantly making choices that implicate the concerns of shareholders and other stakeholders. It’s hard work, but in my career, I have seen many boards handle these issues well-with thoughtful deliberation and balancing—and the overall sustainability of the corporation in mind. They have known their work would be subject to potential legal challenge, and they took that work seriously but did not shy away from the task.

The benefit corporation guts the accountability mechanism for boards engaging in these complex decision-making processes. A benefit corporation board is given an easier trade-off between discretion and accountability. As such, the board of a benefit corporation is seemingly incentivized to make decisions to favor stakeholders other than shareholders in situations that may compromise the sustainability of the firm. I fear that some will engage less thoughtfully in the board decision-making process because most benefit corporation statutes promise little detriment to taking that path.

It also seems fair to note that many business promoters and entrepreneurs seem to choose the benefit corporation form more because of its signaling power than its legal basis. Lawyers may be promoting the benefit corporation for its governance attributes, but clients may be selecting it to attempt to signal their social or environmental “goodness.” This troubles me. A firm should be able to signal its contribution to society without resorting to corporate labeling heuristics. (I realize that may be an unduly harsh characterization, but I will toss it out there for further thought and comment . . . .) I fear over-signaling or mis-signaling in this context, to the detriment of investors.

Push back on any or all of this, as warranted.

Posted by: joanheminway | Jul 19, 2017 7:37:07 PM

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