In a recent speech at the Netroots Nation, Senator Al Franken tried to frighten the crowd by trotting out the corporate bogeyman that greedily makes decisions without regard to anything other than profit. Franken told them: “it is literally malfeasance for a corporation not to do everything it legally can to maximize its profits.” Individuals across the political spectrum share this common canard. Those on the right, like Milton Friedman, argue that the shareholder-wealth-maximization requirement prohibits firms from acting in ways that benefit, say, local communities or the environment, at the expense of the bottom line. Those on the left, like Franken, argue that the duty to shareholders makes corporations untrustworthy and dangerous. They are both wrong.
While the duty to maximize shareholder value may be a useful shorthand for a corporate manager to think about how to act on a day to day basis, this is not legally required or enforceable. The only constraint on board decision making is a pair of duties – the “duty of care” and the “duty of loyalty.” The duty of care requires boards to be well informed and to make deliberate decisions after careful consideration of the issues. Importantly, board members are entitled to rely on experts and corporate officers for their information, can easily comply with duty of care obligations by spending shareholder money on lawyers and process, and, in any event, are routinely indemnified against damages for any breaches of this duty. The duty of loyalty self evidently requires board members to put the interests of the corporation ahead of their own personal interest.
Under this legal regime, it is not malfeasance for boards or corporate chiefs to make decisions that do not maximize shareholder value. Boards are protected by the so-called “business judgment rule” from claims that their decisions were the wrong ones. The business judgment rule protects corporate decisions unless the plaintiffs can show a breach of one of the two duties. In other words, unless there is a plausible story the board’s decision was woefully uninformed or was tainted by self interest, a shareholder challenge to a corporate decision will fail.
The business judgment rule means that decisions that turn out badly for firms are protected. This encourages risk taking and avoids the hindsight bias of litigation in cases where well-meaning and rational decisions do not maximize shareholder value. It also gives boards wiggle room to take more than just profit into consideration when setting corporate policy. As such, firms can tailor their decisions to the demands of the marketplace. One company might believe that employees, customers, and shareholders (the three big constituencies of any firm) prefer a decision to keep open a more expensive factory in Michigan, while another company might believe these stakeholders prefer a decision to move its manufacturing base to Mexico. Both are lawful.
I agree. Indeed, I've made this point in my own writing on corporate social responsibility. See, e.g., The Bishops and the Corporate Stakeholder Debate. As I explain therein, however, while the business judgment rule has the effect of giving directors latitude to make decisions that deviate from the shareholder wealth maximization norm, that is not the purpose of the rule.
The fact that corporate law does not intend to promote corporate social responsibility, but rather merely allows it to exist behind the shield of the business judgment rule becomes significant in -- and is confirmed by -- cases where the business judgment rule does not apply. See, e.g., Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., a takeover case in which the target's board based some of their decisions out of a concern for the interests of creditors rather than shareholders and got spanked for it:
The original threat posed by Pantry Pride-the break-up of the company-had become a reality which even the directors embraced. Selective dealing to fend off a hostile but determined bidder was no longer a proper objective. Instead, obtaining the highest price for the benefit of the stockholders should have been the central theme guiding director action. Thus, the Revlon board could not make the requisite showing of good faith by preferring the noteholders and ignoring its duty of loyalty to the shareholders. The rights of the former already were fixed by contract. . . . The noteholders required no further protection, and when the Revlon board entered into an auction-ending lock-up agreement with Forstmann on the basis of impermissible considerations at the expense of the shareholders, the directors breached their primary duty of loyalty.
The Revlon board argued that it acted in good faith in protecting the noteholders because Unocal permits consideration of other corporate constituencies. Although such considerations may be permissible, there are fundamental limitations upon that prerogative. 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.
Because the business judgment rule did not apply, the directors "breached their primary duty of loyalty" by failing to obtain "the highest price for the benefit of the stockholders." Corporate social responsibility be damned.
Now let us consider a different case. Imagine a board of directors presented with a pure zero sum decision. Anything they do is going to hurt somebody.The choice is stark: They can do X, which not only increases shareholder wealth, but also increases the total wealth of all internal stakeholders (such as employees and creditors). I make that qualification for reasons that will become apparent in a moment. Unfortunately, X will have a very serious negative impact on society. Or they can do Y, which produces a substantial social benefit, while significantly reducing the value of the enterprise and having a deleterious effect on shareholder wealth. In these days of systemically important firms that are too big to fail, such a hypothetical seems more plausible than one might imagine. The Board chooses option Y.
In In re Walt Disney Co. Deriv. Litig., 906 A.2d at 67 n.111, the Delaware Supreme Court held that:
A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. There may be other examples of bad faith yet to be proven or alleged, but these three are the most salient.
This is significant, of course, because the business judgment rule does not protect a failure to act in good faith.
As I've set up my hypothetical, hasn't the board of directors "intentionally act[ed] with a purpose other than that of advancing the best interests of the corporation"? Notice that good faith/bad faith is premised on failing to act in the best interests of the entity rather than the shareholders. That's why I set up the problem in such a way that the entity was harmed, not just the shareholders. I should note, however, that I find this distinction highly pernicious. The issue ought not to be the interests of the entity; it ought to be the interests of the shareholders. See my article Much Ado about Little? Directors' Fiduciary Duties in the Vicinity of Insolvency.
As far as I know, nobody has addressed the question of whether the emergent doctrine of good faith could be deployed to constrain director discretion to pursue corporate social responsibility. It might be worth doing, however. Speaking as someone who is deeply skeptical of both the corporate social responsibility agenda (see here) AND the doctrine of good faith as it has emerged in Delaware (see here), I'm feeling highly conflicted.
Unfortunately, my research agenda is set for the next couple of years -- I'm up to my neck with book contracts -- so I offer this project up gratis. (Well, not quite. I do expect lots and lots of cites.)
