ProfessorBainbridge.com

DExit is a trickle not a flood and is unlikely to become a cascade

A cascade effect (a.k.a. domino effect or snowball effect) occurs when a change triggers a chain of events in which one state of the world rapidly transforms into a new state. 

Many commentators on the DExit phenomenon appear to assume that we are on the verge of a cascade event in which huge numbers of Delaware corporations decide to change their state of incorporation to some other state.

As I explain in my article, DExit Drivers: Is Delaware's Dominance Threatened?, the number of firms that have moved from Delaware is tiny. It barely amounts to a trickle. As I also explain therein, for most firms, Delaware remains the preferred choice. The only plausible exception is the small number of publicly traded firms having a controlling shareholder, who have faced a greater risk of liability as a result of recent Delware court decisions (discussed in my A Course Correction for Controlling Shareholder Transactions). Assuming SB 21 passes the Delaware legislature, those decisions will be overturned and the incentive driving DExit will be significantly reduced.

But let's assume I'm wrong. Would DExit become a cascade?

This brings us to my friend and UCLAW colleague Andrew Verstein's new article, The Corporate Census. This is a really important new article in which Andrew presents:

... the first database of all entity formations in the United States, going back to the founding. All previous studies were based on tiny subsets of corporations, such as only large public corporations. Looking at the broader sample destabilizes core empirical assumptions in the field. For example, while Delaware is commonly thought to be the leader for incorporations, its law is not even in the top five.

Of particular import for present purposes is Andrew's finding that, although "Delaware is thought to have taken New Jersey's leading role in the early 20th century, New Jersey actually continues to beat Delaware until the late 1980s." Contrary to conventional wisdom there was no cascade in which massive numbers of corporations decamped from New Jersey to Delaware. 

To my mind, Andrew's findings suggest that there will not be a domino effect. If DExit becomes a real phenomenon rather than clickbait, it will still take decades for Delaware to be overtaken. 

This doesn't mean SB 21 is unnecessary. To the contrary, as I discuss in Course Correction, Delaware common law has gone seriously awry in this area. Both as a matter of doctrinal consistency and sound policy, the law needed to be changed. It does, however, suggest that Delaware can take its time and do it right. 

In any case, go read Andrew's article. 

Should we hold corporations liable or the officers and directors who run them? Specifically, social media companies?

A journalist recently posed the following question to me:

I'm looking at the U.K. Government's recent moves to add an amendment to its forthcoming Online Safety law, to create criminal sanctions for the executives of social media companies that are in breach of the law.

On the one hand, this suggests social media companies will work harder to comply with the British regulator that is enforcing the new guidelines, and this seems necessary given that so many of these firms have failed to prevent harm on their networks and have hitherto seen regulatory fines as a cost of doing business. On the other hand, this sort of move would also seem to do more to pierce the corporate veil, which could undermine efforts by corporations to mitigate risk for directors and employees.

The question of individual versus institutional liability is a very interesting one.

There is an argument for imposing civil liability on corporations and other institutions (i.e., legal persons) where their agents commit torts or breach contracts. A major function of civil liability, after all, is compensation of victims of malfeasance and misfeasance. The legal person will often have far deeper pockets than any of the natural persons amongst its stakeholders. Having one defendant rather than many, moreover, reduces tertiary costs for both parties and society.

Having said that, however, I'm not completely convinced. In the first place, most major corporate misconduct implicates senior corporate officials, such that a regime of personal--rather than corporate--liability would provide them with incentives to cause the corporate entity to insure against the risk of such losses, which satisfies the goal of compensation.

More important, however, the role of compensation as a justification for corporate liability is more complicated than one might think. In an important article, Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 U. Ill. L. Rev. 691, Jennifer Arlen and William Carney tackled this question with regard to corporate liability for securities frauds committed by agents of the firm. As they demonstrate, when a corporation pays a large fine the resulting balance sheet effect is to reduce assets on the left side. On the right hand side, liabilities remain constant. To offset the decline in net assets, accordingly, shareholder equity must fall. As a result, the effect of civil monetary liability is to replace "one group of innocent victims with another: those who were shareholders when the fraud was revealed. Moreover, enterprise liability does not even effect a one-to-one transfer between innocent victims: a large percentage of the plaintiffs' recovery goes to their lawyers. Finally, enterprise liability may injure innocent people in addition to shareholders. For example, employees are injured if enterprise liability sends a firm into bankruptcy or causes it to lay off employees." Id. at 719.

The case for corporate criminal liability is even weaker. The principal functions of criminal liability are retribution and deterrence.

A corporation is not a moral actor. Edward, First Baron Thurlow, put it best: "Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and nobody to be kicked?" The corporation is simply a nexus of contracts between factors of production. As such, there is no moral basis for applying retributive justice to a corporation - there is nothing there to be punished.

So who do we punish when we force the corporation to pay fines? Since the payment comes out of the corporation's treasury, it reduces the value of the residual claim on the corporation's assets and earnings. In other words, the shareholders pay. Not the directors and officers who actually committed the alleged wrongdoing. Retributive justice is legitimate only where the actor to be punished has committed acts to which moral blameworthiness can be assigned. Even if you assume the corporation is still benefiting from alleged wrongdoing, the shareholders are mere holders in due course. It is therefore difficult to see a moral basis punishing them. They have done nothing for which they are blameworthy.

As always in corporate accountability, both efficiency and morality require that punishment be directed solely at those who actually commit wrongdoing. In this context, it would be the directors, officers, or controlling shareholders who actually committed the wrong. 

My conclusion in this regard was influenced in part by the Arlen and Carney paper, which argues for imposing liability on the corporation's agents: “we find that there is little reason to believe that enterprise liability is the superior rule from the standpoint of deterrence, and there are many reasons to suspect the contrary. The deterrent effect of the available monetary sanctions under agent liability probably exceeds the deterrent effect of enterprise liability because a civil judgment against an agent hurts his reputation more than does a sanction imposed by the firm in private. Moreover, the threat that sanctions will be imposed appears to be greater under agent liability. Agent liability places the responsibility of sanctioning wrongful agents with the victims, who have no reason not to proceed against them and have every reason to proceed. Enterprise liability, by contrast, places the responsibility of proceeding against the wrongful agents with the firm, and thus with the very agents (and their close associates) most likely to have committed fraud. Moreover, agent liability in effect enlists insurance companies as corporate monitors and disciplinarians, thereby eliminating the agency costs associated with firm managers monitoring and disciplining each other. Furthermore, the judgment proof problem under agent liability can be completely eliminated if, in addition to civil liability, the government imposes sufficient nonmonetary criminal penalties on agents, such as imprisonment.”

Holding individual corporate actors is not inconsistent with limited liability. As I explained in my book, Limited Liability: A Legal and Economic Analysis (Edward Elgar Publishing 2016), coauthored with M. Todd Henderson (Chicago Law), the purpose of limited liability is to encourage investment by shareholders. As the residual claimants on corporate assets and earnings, shareholders do not get a return on their investment until all other claims on the corporation have been satisfied. Because risk and return are positively correlated, shareholders prefer that the corporation take on risky, high return projects so that something will be left over after all other claimants have been paid. By insulating shareholders from the downside risk of firm investments, limited liability thus incentivizes shareholders to use their voting control of the corporation to elect directors who will opt for business activities consistent with the risk preferences of shareholders rather than those of the more risk averse fixed claimants.

Officers and directors are in a different position. To be sure, there may be arguments for limiting their liability exposure to shareholders through doctrines such as the business judgment rule, but those arguments do not apply to civil or criminal liability.

Recommended Reading: Paul Mahoney, The Economics of Securities Regulation: A Survey

An important and very well done review of the literature:

This paper reviews the academic literature that analyzes securities regulation from an economic perspective. It begins by describing the institutional foundations of securities law in the U.S. and distinguishing securities regulation from the private law of contracts, property, and fraud. Section 2 discusses the theoretical literature on mandatory versus voluntary disclosure in securities markets, focusing on information asymmetry and agency problems as justifications for mandatory disclosure. Section 3 surveys empirical work on the efficacy of actual mandatory disclosure rules. The remaining sections describe particular aspects of the U.S. regulatory system, including the regulation of public offerings, publicly-traded companies, trading markets, securities fraud, insider trading, market manipulation, and mutual funds and other collective investment vehicles, and surveys important theoretical and empirical work on each. The paper is intended to offer both institutional background and a summary of key research findings that may provide useful starting points for future research.

Mahoney, Paul G., The Economics of Securities Regulation: A Survey (August 24, 2021). Foundations and Trends in Finance, forthcoming, Virginia Law and Economics Research Paper No. 2021-14, Available at SSRN: https://ssrn.com/abstract=3910557

A corporation is not a person in any ontological or metaphysical sense; nor is it a thing capable of being owned. It is a nexus of contracts.

Robert T Miller: 

This short piece responds to an article by Professor McLeod and argues that, even under strong natural law assumptions about the natural rights of human beings to form associations, there is no reason to think that corporations, churches or other associations of individuals are real persons in any ontological or metaphysical sense. Anything we want to say about the rights and obligations of associations under the natural law is fully explainable in terms of the rights and obligations of the individual human beings who compose such associations.

Miller, Robert T., Corporations, Persons and the Natural Law: A Response to Professor McLeod (November 23, 2021). Anchoring Truths (November 23, 2021), Available at SSRN: https://ssrn.com/abstract=3971735 or http://dx.doi.org/10.2139/ssrn.3971735

William Bratton Revisits Team Production but I Remain Wholly Unpersuaded

Bratton, William Wilson, Team Production Revisited (September 29, 2021). U of Penn, Inst for Law & Econ Research Paper No. 21-27, University of Miami Legal Studies Research Paper No. 3935788, Vanderbilt Law Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3935788

This Article reconsiders Margaret Blair and Lynn Stout’s team production model of corporate law, offering a favorable evaluation. The model explains both the legal corporate entity and corporate governance institutions in microeconomic terms as the means to the end of encouraging investment, situating corporations within markets and subject to market constraints but simultaneously insisting that productive success requires that corporations remain independent of markets. The model also integrates the inherited framework of corporate law into an economically derived model of production, constructing a microeconomic description of large enterprises firmly rooted in corporate doctrine but neither focused on nor limited by a description of principal-agent relationships among shareholders and managers. This Article shows that the model retains descriptive robustness, despite the substantial accretion of shareholder power during the two decades since its appearance. The Article also shows that the model taught three groundbreaking lessons to corporate legal theory. First, nothing binds microeconomic analysis together with a theory of the firm rooted in shareholder primacy. Second, microeconomics, with its emphases on efficiency and maximization, can be deployed in the service of an allocatively sensitive description of corporate governance, providing a more capacious methodological tent than anyone in corporate law understood prior to Blair and Stout’s intervention. Third, it is not only possible but arguably necessary to take corporate law seriously when articulating a microeconomic theory of corporate production. To the extent an economic model’s description of the appropriate legal framework differs materially from the inherited legal framework, there is a possible, even a probable, infirmity in the model.

I remain unpersuaded. I have never bought team production as either a descriptive or normative model of corporate governance. To the contrary, I think my director primacy model is superior both descriptively and normatively.

What follows is excerpted from my article Director primacy: The means and ends of corporate governance. 97 Northwestern University Law Review, 547-606 (2003). One of these days I'll get around to updating it for subsequent developments.

Blair and Stout contend that corporate law treats directors not as hierarchs charged with serving shareholder interests, but as referees—mediating hierarchs, to use their term—charged with serving the interests of the legal entity known as the corporation.[1]

The Firm as Team

Team production is an important and highly useful concept in neoinstitutional economics. Blair and Stout stretch the team production model to encompass the entire firm. Doing so is unconventional. In my view, stretching team production that far also detracts from the model’s utility.

Production teams are defined conventionally as “a collection of individuals who are interdependent in their tasks, who share responsibility for outcomes, [and] who see themselves and who are seen by others as an intact social entity embedded in one or more larger social systems ....”[2] This definition contemplates that production teams are embedded within a larger entity. As one commentator defines them, teams are “intact social systems that perform one or more tasks within an organizational context.”[3]

Building on the work of Rajan and Zingales, Blair and Stout define team production by reference to firm specific investments.[4] Hence, for example, they describe the firm “as a ‘nexus of firm-specific investments.’” In fact, however, firm specific investments are not the defining characteristic of team production. Instead, the common feature of team production is task nonseparability.

Oliver Williamson identifies two forms production teams take: primitive and relational. In both, team members perform nonseparable tasks. The two forms are distinguished by the degree of firm specific human capital possessed by such members. In primitive teams, workers have little such capital; in relational teams, they have substantial amounts. Because both primitive and relational team production requires task nonseparability, it is that characteristic that defines team production.

Most public corporations have both relational and primitive teams embedded throughout their organizational hierarchy. Self-directed work teams, for example, have become a common feature of manufacturing shop floors and even some service workplaces. Even the board of directors can be regarded as a relational team. Hence, the modern public corporation arguably is better described as a hierarchy of teams rather than one of autonomous individuals. To call the entire firm a team, however, is neither accurate nor helpful.

As among shop floor workers organized into a self-directed work team, for example, team production is an appropriate model precisely because their collective output is not task separable. In a large firm, however, the vast majority of tasks performed by the firm’s various constituencies are task separable. The contribution of employees of one division versus those of a second division can be separated. The contributions of employees and creditors can be separated. The contributions of supervisory employees can be separated from those of shop floor employees. And so on. Accordingly, the concept of team production is simply inapt with respect to the large public corporations with which Blair and Stout are concerned. [5]

The Domain of the Mediating Hierarchy

John Coates argues that Blair and Stout’s mediating hierarch model fares poorly whenever there is a dominant shareholder. If so, the model’s utility is vitiated with respect to close corporations, wholly-owned subsidiaries, and publicly held corporations with a controlling shareholder. In addition, Coates argues, Blair and Stout’s model also fares poorly whenever any corporate constituent dominates the firm. Many of publicly held corporations lacking a controlling shareholder are dominated one of the constituents among which the board supposedly mediates—namely, top management. Although the precise figures disputed, a substantial minority of publicly held corporations have boards in which insiders comprise a majority of the members. Even where a majority of the board is nominally independent, the board may be captured by insiders.

I more skeptical than Coates of board capture theories, having argued elsewhere that independent board members have substantial incentives to buck management. On balance, however, Coates makes a persuasive case that the mediating hierarch model has a relatively small domain. In contrast, the domain of director primacy, which merely requires the absence of a controlling shareholder, seems considerably larger.

The Foundational Hypothetical

Blair and Stout develop the mediating hierarchy model by telling the story of a start-up venture in which a number of individuals come together to undertake a team production project. The participating constituents know that incorporation, especially the selection of independent board members, will reduce their control over the firm and, consequently, expose their interests to shirking or self-dealing by other participants. They go forward, Blair and Stout suggest, because the participants know the board of directors will function as a mediating hierarch resolving horizontal disputes among team members about the allocation of the return on their production.

On its face, Blair and Stout’s scenario is not about established public corporations. Instead, their scenario seems heavily influenced by the high-tech start-ups of the late 1990s. Yet, even in that setting, the model seems inapt. In the typical pattern, the entrepreneurial founders hire the first factors of production.[6] If the firm subsequently goes public,[7] the founding entrepreneurs commonly are replaced by a more or less independent board.[8] The board thus displaces the original promoters as the central party with whom all other corporate constituencies contract. It is due to my empirical impression that this is the typical pattern that director primacy assumes the board of directors—whether comprised of the founding entrepreneurs or subsequently appointed outsiders—hires factors of production, not the other way around.[9]

Lest the foregoing seem like an argument for shareholder primacy, I think it is instructive to note the corporation—unlike partnerships, for example—did not evolve from enterprises in which the owners of the residual claim managed the business. Instead, as a legal construct, the modern corporation evolved out of such antecedent forms as municipal and ecclesiastical corporations.[10] The board of directors as an institution thus pre-dates the rise of shareholder capitalism.[11] When the earliest industrial corporations began, moreover, they typically were large enterprises requiring centralized management. Hence, separation of ownership and control was not a late development but rather a key institutional characteristic of the corporate form from its inception.[12] At the risk of descending into chicken-and-egg pedantry, the historical record thus suggests that director primacy emerged long before shareholder primacy. Directors have always hired factors of production, not vice-versa.

The Board’s Role

In Blair and Stout’s model, directors are hired by all constituencies and charged with balancing the competing interests of all team members “in a fashion that keeps everyone happy enough that the productive coalitions stays together.” In other words, the principal function of the mediating board is resolving disputes among other corporate constituents. This account of the board’s role differs significantly from the standard account.

The literature typically identifies three functions performed by boards of public corporations:[13] First, and foremost, the board monitors and disciplines top management. Second, while boards rarely are involved in day-to-day operational decision making, most boards have at least some managerial functions. Broad policymaking is commonly a board prerogative, for example. Even more commonly, however, individual board members provide advice and guidance to top managers with respect to operational and/or policy decisions. Finally, the board provides access to a network of contacts that may be useful in gathering resources and/or obtaining business. Outside directors affiliated with financial institutions, for example, apparently facilitate the firm’s access to capital. In none of these capacities, however, does the board of directors directly referee between corporate constituencies.

To be sure, institutional economics acknowledges that dispute resolution is an important function of any governance system. Ex post gap-filling and error correction are necessitated by the incomplete contracts inherent in corporate governance. Those functions inevitably entail dispute resolution. As we’ve seen, the firm addresses the problem of incomplete contracting by creating a central decisionmaker authorized to rewrite by fiat the implicit—and, in some cases, even the explicit—contracts of which the corporation is a nexus.

As the principal governance mechanism within the public corporation, the board of directors is that central decisionmaker and, accordingly, bears principal dispute resolution responsibility. Yet, in doing so, the board “is an instrument of the residual claimants.” Hence, if the board considers the interests of nonshareholder constituencies when making decisions, it does so only because shareholder wealth will be maximized in the long run.

Blair and Stout posit that the legal mechanisms purporting to ensure director accountability to shareholder interests—such as derivative litigation and voting rights—benefit all corporate constituents. Conceding that shareholder and nonshareholder interests are often congruent, it nevertheless remains the case that some situations present zero-sum games. Further conceding the weakness of those accountability mechanisms, shareholder standing to pursue litigation and/or the exercise of shareholder voting rights nevertheless give shareholders rights that potentially can be used to the disadvantage of other constituencies.

If directors suddenly began behaving as mediating hierarchs, rather than shareholder wealth maximizers, an adaptive response would be called forth.[14] Shareholders would adjust their relationships with the firm, demanding a higher return to compensate them for the increase in risk to the value of their residual claim resulting from director freedom to make trade-offs between shareholder wealth and nonshareholder constituency interests. Ironically, this adaptation would raise the cost of capital and thus injure the interests of all corporate constituents whose claims vary in value with the fortunes of the firm.

Senator Marco Rubio's "Mind Your Own Business Act" would make bad law and is premised on dumb policy grounds

On Thursday, Marco Rubio announced that he had "introduced the Mind Your Own Business Act, which would enable shareholders to hold woke corporations accountable." (HT: Stefan Padfield)

Specifically, the legislation would require corporate directors to prove their “woke” corporate actions were in their shareholders’ best interest in order to avoid liability for breach of fiduciary duty in shareholder litigation over corporate actions relating to certain social policies. It would also incentivize corporate management to stop abusing their positions to advance left-wing social policies by increasing their personal liability to shareholders for breaches of fiduciary duty resulting from those policies.

“Patriotic Americans who love their country and the opportunity it provides should be able to fight back against the growing tyranny of the woke elites running corporate America,” Rubio said.

...

“No more legal tricks that shield these corporate executives from accountability,”Rubio continued. “If they really believe that being woke is good for business, they should have to say so—and prove it—under oath in court.”

[Insert world weary sigh and eyeball here.]

As regular readers know, I am not a fan of woke capitalism--particularly when committed by social justice warrior CEOs. But the Rubio proposal is a lousy response to woke capitalism.

First, it would represent a further step towards the federalization of corporate law. I address the arguments against expanding the federal role in corporate governance in my book, Corporate Governance After the Financial Crisis at 261-70. The supremacy of federal law and the uniform opposition of Congress and the SEC to private ordering eliminates opportunities for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis pointed out many years ago, “It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country.” New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting). So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead may lead to more efficient corporate law rules.

In contrast, the uniformity imposed by federal law precludes experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed—no “laboratory” of federalism. Likewise, the persistent refusal to accommodate private ordering eliminates solutions from emerging from competition in the market. Instead, the federalization of corporate governance has resulted in rules that were wrong from the outset or may quickly become obsolete, but are effectively carved into stone with little prospect for change.

I would also draw the reader's attention to an older article, The Creeping Federalization of Corporate Law, Regulation, Spring 2003, at 26. In it, I explain that:

The corporation is a creature of the state “whose very existence and attributes are a product of state law.” States have an interest in overseeing the firms they create. States also have an interest in protecting the shareholders of their corporations. Finally, as the Court noted in CTS v. Dynamics, a state has a legitimate “interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs.” In other words, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law.

According to the Supreme Court’s CTS decision, the country as a whole benefits from state regulation in this area. As Justice Powell explained, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. . . .

Competitive federalism promotes liberty as well as shareholder wealth. When firms may freely select among multiple competing regulators, oppressive regulation becomes impractical. If one regulator overreaches, firms will exit its jurisdiction and move to one that is more laissez-faire. In contrast, when there is but a single regulator, exit is no longer an option and an essential check on excessive regulation is lost.

Second, we know that much derivative litigation is meritless. Unless the legislation is extremely narrowly focused, changes intended to “increase stockholder plaintiff’s chances of making it pass the pleading stage” will simply increase the settlement value of such suits. Suppose, for example, in the wake of a tragic mass shooting Walmart decides to stop selling firearms. Do we really want some plaintiff lawyer filing suit against Walmart in that instance? Especially since trial lawyer political contributions primarily go to Democrats?

Third, unless the legislation is extremely narrowly drafted, it will likely involve delegating substantial discretion to a Democrat-dominated SEC.

Fourth, it takes a procedural approach to a substantive problem. A derivative suit is a procedural device mainly used to allow shareholders to bring suit against the firm’s directors and officers for breaching a fiduciary duty owed to the corporation. At present, the sort of woke decisions to which I object almost certainly would be insulated from judicial review by the business judgment rule. See my post Can Tim Cook Ignore ROI When Deciding How to Design an iPhone? So the law would have to create an underlying cause of action.  Which would make the intrusion on state corporate law even greater.

Finally, such proposals are just slapping a Band-Aid on a deep systemic problem. I address the underlying problem in my article Corporate Purpose in a Populist Era at pages 568-577. In short,  I think the rise of CEO social justice warriors resulted from a combination of virtue signaling, the business world equivalent of the Linda Greenhouse effect, and the Ivy League/Upper East Side bubble most of them live in. Most large corporation CEOs these days live in families and social circles where social conservatism is regarded as moronic, retrograde, trailer trash, flyover country nonsense. Acting out as SJWs keeps their spouses and kids off their backs, ensures that the NY Times will say nice things about them, gets their pictures on the society pages, and gets them invited to all the best parties. It lets them hobnob with Hollywood elites and hang out with at Clinton Foundation functions. And it differentiates them from the proles in the GOP base. Tinkering with corporate law at the margins is unlikely to do much until the dynamics of the underlying social phenomena change.

At somewhat greater length, I suggest that what we’re seeing is the culmination of what Christopher Lasch called The Revolt of the Elites. In his 1995 classic, Lasch identified an emergent split between what he called the New Elites and the rest of society. The changes Lasch spotted became trends that accelerated in subsequent years. In particular, Lasch explained that “the new elites . . . regard the masses with mingled scorn and apprehension.”  They dismissed the masses’ values as “mindless patriotism, religious fundamentalism, racism, homophobia, and retrograde views of women.”  This tension was perhaps nowhere more pronounced than with respect to religion. When Lasch wrote over two decades ago, he opined that “[a] skeptical, iconoclastic state of mind is one of the distinguishing characteristics of the knowledge classes. . . .  The elites’ attitude to religion ranges from indifference to active hostility.”

If anything, today’s elites have become even more hostile to religious values. As Samuel Gregg observes, the Davos Man’s moral creed is “a mélange of social liberalism, environmentalism, and a new order of a borderless world. . . . [R]eligion is considered the refuge of fanatics and anyone stupid enough to be skeptical of gender ideology and techno-utopianism.”

A quarter-century later, Lasch’s new elites have risen to the top of corporate hierarchies. They brought their values into the C-suite. CEOs increasingly reflect the values of the Blue state coastal bubbles in which they are embedded, especially on environmental and social issues. No Fortune 100 CEOs contributed to Donald Trump’s 2016 presidential campaign, for example, but eleven gave to Hillary Clinton. More generally, “liberal groups accounted for eight of the top ten ideological causes of the ultra-rich, and seven of the ten congressional candidates most dependent on money from such people were Democrats.” Even one of the progressive movement’s favorite whipping boys—David Koch—publicly self-identifies as “a social liberal.”

As a result, as a Slate essay observed, “Fortune 500 companies today are socially liberal, especially on areas surrounding diversity, gay rights, and immigration; they are unabashedly in favor of free trade and globalization, express concern about climate change, and embrace renewable energy.” In doing so, they are simply reflecting the changing values of their CEOs.

Tinkering with corporate law at the margins is unlikely to do much until the dynamics of the underlying social phenomena change.

Major Delaware Corporate Law Development: Delaware Supreme Court "Revises" Aronson Standard for Demand Futility

United Food and Commercial Workers Union v. Zuckerberg, et al., No. 2018-0671-JTL, 2021 WL _______ (Sep. 23, 2021)

Background

Shareholder litigation comes in two possible forms. Direct” shareholder suits arise out of causes of action belonging to the shareholders in their individual capacity. It is typically premised on an injury directly affecting the shareholders and must be brought by the shareholders in their own name. In contrast, a “derivative” suit is one brought by the shareholder on behalf of the corporation. The cause of action belongs to the corporation as an entity and arises out of an injury done to the corporation as an entity. The shareholder is merely acting as the firm’s representative. Our focus here is on derivative litigation.

The law governing derivative litigation has many complexities, most of which result from the collision of two basic principles. On the one hand, the derivative cause of action belongs to the corporation. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions.

Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit.

Accordingly, both Delaware Rule of Civil Procedure 23.1 and the essentially identical Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.[1] The requisite demand can take any form, although most jurisdictions require that it be in writing. The demand need not be in the form of a pleading nor a detailed as a complaint, but rather simply must request that the board bring suit on the alleged cause of action.

Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation.[2] The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement. More precisely, it depends on whether demand is required or excused as futile.

Delaware requires demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware Supreme Court set forth the following test for demand futility:

[T]he Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.[3]

The Court’s use of a reasonable doubt standard has been the subject of much criticism:  

The reference to “reasonable doubt” summons up the standard applied in criminal law. It is a demanding standard, meaning at least a 90% likelihood that the defendant is guilty. If “reasonable doubt” in the Aronson formula means the same thing as “reasonable doubt” in criminal law, then demand is excused whenever there is a 10% chance that the original transaction is not protected by the business judgment rule. Why should demand be excused on such a slight showing? Surely not because courts want shareholders to file suit whenever there is an 11% likelihood that the business judgment rule will not protect a transaction. Aronson did not say, and later cases have not supplied the deficit. If “reasonable doubt” in corporate law means something different from “reasonable doubt” in criminal law, however, what is the difference?, and why use the same term for two different things?[4]

In defense of the reasonable doubt standard, the Delaware Supreme Court rather weakly argued that “the term is apt and achieves the proper balance.”[5] Somewhat more helpfully, the court rephrased the test by reversing it: “the concept of reasonable doubt is akin to the concept that the stockholder has a ‘reasonable belief’ that the board lacks independence or that the transaction was not protected by the business judgment rule.”

The Aronson standard proved awkward in some cases, such as when there had been a turnover in board composition, where the complaint alleged inaction rather than action, and so on. In Rales v. Blasband, Plaintiff brought a double derivative suit on behalf of a parent corporation with respect to the sale of subordinated debentures by its wholly owned subsidiary. Because the derivative suit did not challenge a decision by the parent corporation’s board, the court held that the Aronson standard did not apply:

Instead, it is appropriate in these situations to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. If the derivative plaintiff satisfies this burden, then demand will be excused as futile.[6]

The court noted three scenarios in which this test is to be used in lieu of the Aronson standard: (1) where a majority of the board that made the challenged transaction has been replaced by disinterested and independent members; (2) where the litigation arises out of some transaction or event not involving a business decision by the board; and (3) where the challenged decision was made by the board of a different corporation.

As former Delaware Chief Justice Leo Strine explained in an opinion written earlier in his career during his stint as a Vice Chancellor:

At first blush, the Rales test looks somewhat different from Aronson . . .. [The Rales] inquiry makes germane all of the concerns relevant to both the first and second prongs of Aronson. For example, in a situation when a breach of fiduciary duty suit targets acts of self-dealing committed, for example, by the two key managers of a company who are also on a nine-member board, and the other seven board members are not alleged to have directly participated or even approved the wrongdoing (i.e., it was not a board decision), the Rales inquiry will concentrate on whether five of the remaining board members can act independently of the two interested manager-directors. This looks like a first prong Aronsoninquiry.

When, however, there are allegations that a majority of the board that must consider a demand acted wrongfully, the Rales test sensibly addresses concerns similar to the second prong of Aronson. To wit, if the directors face a “substantial likelihood” of personal liability, their ability to consider a demand impartially is compromised under Rales, excusing demand.[7]

In United Food and Com. Workers Union v. Zuckerberg,[8] the Delaware Chancery Court (per Vice Chancellor J. Travis Laster), took note of the criticism that Aronson has been subject to over the years and proposals that the courts should abandon Aronson and adopt Rales as the general standard. In UFCWU, VC Laster proposed just such a move:

Both [the Aronson and Rales] tests remain authoritative, but the Aronson test has proved to be comparatively narrow and inflexible in its application, and its formulation has not fared well in the face of subsequent judicial developments. The Rales test, by contrast, has proved to be broad and flexible, and it encompasses the Aronson test as a special case.[9]

VC Laster went on to explain that:

In using the standard of review for the challenged transaction as a proxy for the risk of director liability and hence the test for demand futility, Aronson was a creature of its time. Subsequent jurisprudential developments severed the linkage between these concepts. Under current law, the application of a standard of review that is more onerous than the business judgment rule does not render demand futile. Similarly, the availability of exculpation means that a standard of review that is more onerous than the business judgment rule may not result in a substantial likelihood of liability.[10]

Laster reviewed these changes in detail, explaining how they had called into question the continuing utility of Aronson.

In addition to its declining doctrinal relevance, the Aronson test has always been an awkward way of getting at the core problem in the derivative suit context. Recall that we are dealing here not with a lawsuit brought to redress an injury done to the shareholder but rather one done to the corporate entity. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions. Consequently, the law governing derivative litigation must balance the competing policies of deference to the board’s decision-making authority and the need to hold erring directors accountable.

The core question thus is: Do we trust the board of directors to make a good faith decision about the merits of the lawsuit in question. If so, the board should be allowed to control the case. If not, the shareholder should be allowed to go forward.

Aronson gets at that question only indirectly. In contrast, as Laster explained, Rales does so directly:

The significant advance made by Rales was to refocus the inquiry on the decision regarding the litigation demand, rather than the decision being challenged. . . . The Rales decision thus asked directly “whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations.”

Under Rales, a director is disqualified from exercising judgment regarding a litigation demand if the director was interested in the alleged wrongdoing, such as when the director received a personal benefit from the wrongdoing that was not equally shared from the stockholders. A director also is disqualified from exercising judgment regarding a litigation demand if another person was interested in the alleged wrongdoing, and the director lacks independence from that person. Although these aspects of the Rales inquiry look to the relationship between the alleged wrongdoing and the directors considering the litigation demand, they do so for purposes of analyzing the directors’ ability to evaluate the litigation demand, not to determine the standard of review that would apply to the alleged wrongdoing.[11]

On appeal, the Delaware Supreme Court (per Justice Montgomery-Reeves) affirmed.[12]

Facts

In 2016, Facebook proposed a stock reclassification that would allow founder and controlling shareholder Mark Zuckerberg to dispose a substantial amount of his shares while still retaining voting control of the company. Numerous shareholder suits were challenging the proposal, which were consolidated into a single class action. Shortly before the trial was scheduled to begin, Facebook withdrew the proposal and settled the case. Facebook spent almost $22 million defending the class action, including over $17 million on attorneys’ fees. The settlement included payments to the plaintiffs’ lawyers of over $68 million.

A Facebook shareholder, the United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund (UFCWU), filed a derivative suit claiming that Facebooks’ board of directors “breached their fiduciary duties of care and loyalty by improperly negotiating and approving” the reclassification. The new suit was brought derivatively on behalf of the corporation to recover the money Facebook had spent defending and settling the original class action.

The plaintiff did not make demand before filing the derivative suit. When the defendants moved to dismiss the suit for failure to do so, plaintiff claimed that demand should be excused as futile. VC Laster granted the motion. Plaintiff appealed.

Held

Affirmed.

Reasoning

The Supreme Court emphasized the centrality of a demand requirement with teeth as a gateway to derivative litigation:

[T]he demand requirement is not excused lightly because derivative litigation upsets the balance of power that the DGCL establishes between a corporation’s directors and its stockholders. Thus, the demand-futility analysis provides an important doctrinal check that ensures the board is not improperly deprived of its decision-making authority, while at the same time leaving a path for stockholders to file a derivative action where there is reason to doubt that the board could bring its impartial business judgment to bear on a litigation demand.[13]

(This is, by the way, a point I made at some length in my book Corporation Law and Economics at 399-404, in which I discussed the application of my director primacy theory to derivative litigation.)

In operationalizing that policy, the Court noted that there had been an important doctrinal shift since Aronsonwas decided; namely, the adoption of FGCL § 102(b)(7), which allows corporations to adopt provisions in their articles of incorporation exculpating monetary liability for duty of care claims against directors. Almost all public Delaware corporations have adopted such provisions.

Accordingly, this Court affirms the Court of Chancery’s holding that exculpated care claims do not satisfy Aronson’s second prong. This Court’s decisions construing Aronson have consistently focused on whether the demand board has a connection to the challenged transaction that would render it incapable of impartially considering a litigation demand. When Aronson was decided, raising a reasonable doubt that directors breached their duty of care exposed them to a substantial likelihood of liability and protracted litigation, raising doubt as to their ability to impartially consider demand. The ground has since shifted, and exculpated breach of care claims no longer pose a threat that neutralizes director discretion.[14]

After disposing of plaintiff’s various objections to that conclusion, the Court turned to the question “whether the three-part test for demand futility the Court of Chancery applied below is consistent with Aronson, Rales, and their progeny.”[15] VC Laster’s version of the Rales test stated:

(i) whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;

(ii) whether the director would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand; and

(iii) whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that is the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.[16]

Oddly, although the test is phrased in the conjunctive (“and”), it seems clear that the court intends it to be applied in the disjunctive: “If the answer to any of the questions is ‘yes’ for at least half of the members of the demand board, then demand is excused as futile.”[17]

The Supreme Court adopted “the Court of Chancery’s three-part test as the universal test for assessing whether demand should be excused as futile,”[18] explaining:

The purpose of the demand- futility analysis is to assess whether the board should be deprived of its decision-making authority because there is reason to doubt that the directors would be able to bring their impartial business judgment to bear on a litigation demand. That is a different consideration than whether the derivative claim is strong or weak because the challenged transaction is likely to pass or fail the applicable standard of review. It is helpful to keep those inquiries separate.[19]

The court concluded by denying that this amounted to a dramatic change in the law, arguing that “because the three-part test is consistent with and enhances Aronson, Rales, and their progeny, the Court need not overrule Aronson to adopt this refined test, and cases properly construing Aronson, Rales, and their progeny remain good law.”[20]

Is the corporation a "real entity"?

I'm reading an essay by a friend about whether the corporation is a "real entity." It calls to mind my favorite of my own little essays on the topic: "Is the corporation an entity? With application to the SCOTUS" https://t.co/Mqi3wtAN5B

— Steve Bainbridge (@PrawfBainbridge) August 29, 2021

2/ “Corporations have neither bodies to be punished, nor souls to be condemned, they therefore do as they like,” which is usually misquoted as “Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?,” which is better.

— Steve Bainbridge (@PrawfBainbridge) August 29, 2021

A New Paper by Yours Truly: Don’t Compound the Caremark Mistake by Extending it to ESG Oversight

Posted to SSRN: Don’t Compound the Caremark Mistake by Extending it to ESG Oversight.

Abstract: Since the foundational decision in In re Caremark Intern. Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), Delaware corporate law has required boards of directors to establish reasonable legal compliance programs. Although Caremark has been applied almost exclusively with respect to law and accounting compliance, the original Caremark decision contemplated applying the oversight duty to the corporation’s “business performance.” Accordingly, there is no doctrinal reason that Caremark claims should not lie in cases in which the corporation suffered losses, not due to a failure to comply with applicable laws, but rather due to lax risk management.

The question thus arises as to whether Caremark should be extended to board failures to exercise oversight with respect to environmental, social, and governance (ESG) factors. Obviously, where existing legislation or regulations impose compliance obligations in ESG-related areas, such as human resources, the environment, or worker safety, Caremark already applies. As such, boards must “ensure that compliance and monitoring systems are in place” to oversee corporate compliance with those laws.

Many ESG issues are not yet the subject to legal requirements, however. The question addressed in this Article is whether the board’s Caremark obligations should be extended to encompass oversight of corporate performance with such issues. In other words, should the board face potential liability not just for failing to ensure that the company has adequate reporting and monitoring systems in place to insure compliance with ESG-related legal requirements, but also to monitor ESG risks in areas where corporate compliance would be voluntary or aspirational. 

Revisiting the Contractarian Theory of the Firm

Three British scholars recently tackled the nexus of contracts a.k.a. contractarian theory of the corporation. I'm using it as a excuse to revisit some of my own work on contractarianism.

Gibbs, David and Gindis, David and Whayman, Derek, Not by Contract Alone: The Contractarian Theory of the Corporation and the Paradox of Implied Terms (January 22, 2021). European Business Organization Law Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3771451 or http://dx.doi.org/10.2139/ssrn.3771451

Specifically, we show that this role does not sit comfortably with the ‘strong form contractarian’ position, which demands a literal interpretation of the claim that the corporation is a nexus of contracts.

In contrast, I have argued that:

In a more important sense, ... the corporation has a nexus. After all, to say that the firm is a nexus is to imply the existence of a core or kernel capable of contracting. But kernels do not contract--people do. In other words, it does us no good to avoid reifying the firm by reifying the nexus at the center of the firm.

Stephen M. Bainbridge, The Board of Directors As Nexus of Contracts, 88 Iowa L. Rev. 1, 17 (2002). As I argue therein, "If the corporation has a nexus, however, where is it located? The Delaware code, like the corporate law of every other state, gives us a clear answer: the corporation's 'business and affairs . . . shall be managed by or under the direction of a board of directors.' Put simply, the board is the nexus." Id. at 25.

In any case, back to Gibbs et al.:

Strong-form contractarians (to whom we shall refer to simply as ‘contractarians’ in what follows) reject the suggestion that their use of the term ‘contract’ is too loose to correspond to the legal understanding of an actual, legally enforceable reciprocal promise or agreement, and claim that the contracts involved in corporate ventures are ‘real contracts’6 consisting of express or implied terms struck by real parties. When courts are called upon to imply missing contractual terms, contractarians argue, they do so with a wealth-maximization objective in mind. We show that a considerable extension of standard contract doctrine is necessary for this account to work and contend that courts will refuse to extend it as contractarians require, with the consequence that many gaps either cannot be filled or can only be filled by non-contractual doctrines.

Gibbs et al. thus assert that contractarians claim "that features of ‘corporateness’ have been, and therefore can be, ‘created by contract, supplemented perhaps by other common law devices such as trusts or agency.’" 

In contrast, I have staked out what I suppose might be called a weak nexus of contracts theory:

Many commentators have criticized the contractarian model on the ground, inter alia, that it is an incomplete theory of how people relate to one another within a firm.  If contractarianism claimed to be a valid description of economic reality, this argument might have some traction. In my view, however, contractarianism claims only to offer a richer metaphor than do traditional entity-based theories and, therefore, a more useful heuristic for understanding corporations. Put another way, I tell my classes that the nexus of contracts model is properly viewed as a metaphor rather than as a positive account of economic reality. I analogize contractarianism to Newtonian physics, which no longer credibly claims to be true, but still provides a simple model that adequately explains a large and important set of physical phenomena.

Contractarianism in the Business Associations Classroom: Kovacik v. Reed and the Allocation of Capital Losses in Service Partnerships, 34 Ga. L. Rev. 631, 644 (2000). As a result, I am dubious of strong claims that you could create a corporation purely by contract. To the contrary, I agree with Vice Chancellor Travis Laster, who observed that "that notwithstanding scholarly approaches such as the widely embraced view of the corporation as a nexus of contracts ..., the DGCL rests on a concept of the corporation that is grounded in a sovereign exercise of state authority: the chartering of a 'body corporate' that comes into existence on the date on which a certificate of incorporation becomes effective." Juul Labs, Inc. v. Grove, 238 A.3d 904, 914 n.7 (Del. Ch. 2020). Strikingly, however, VC Laster observes that he that he nevertheless regards the nexus of contracts model "as a helpful metaphor." Id. As, of course, do I.

Gibbs et al. further argue that:

The problem can be roughly stated as follows. Given that contracts are incomplete, whenever courts adjudicate contractual disputes, they attempt to fill the gaps using the doctrine of implied terms in order to enforce mutually agreed obligations. But giving effect to obligations by implication comes with the risk that the implied term may not have been truly consented to. This undermines the very basis of contractual liability, namely consent, and conflicts with the courts’ practical imperatives to maintain legal certainty and deter excessive litigation. Courts, as a result, will more often than not refrain from implying terms, even when this runs the risk of not holding parties to their bargains. While the imperative to hold parties to their bargains is rooted in consent, so is the imperative to refuse to imply terms. We call this antinomy the ‘paradox of implied terms’.

As the number of parties increases, the effects of this paradox multiply, inherently limiting contract law’s reach beyond two parties. This constraint limits the courts’ ability to build a nexus by implying third-party obligations by inferring, for example, a contract between its existing members and a putative new member. It follows that the vehicle of contract cannot create the complex set of multi-party obligations which constitute the corporate form. Conversely, in a true corporation, parties can be added to (or removed from) the nexus without the express or implied consent of all other parties in the nexus, and without affecting their liabilities. This is only possible because non-contractual doctrines, that is, doctrines that are not rooted in consent, are involved. This poses a significant challenge to contractarianism.

First, I don't find the issue of consent all that troubling, as explained in my Georgia article:

In the nexus of contracts model, partnership statutes and decisions can be thought of as a standard form contract voluntarily adopted—perhaps with modifications—by the partners. The point of a standard form contract, of course, is to reduce bargaining costs. Parties for whom the default rules are a good fit can take the default rules off the rack, without having to bargain over them. Parties for whom the default rules are inappropriate, in contrast, are free to bargain out of the default rules. I illustrate this point by telling my class the following parable: A while back I flew into LAX and schlepped out to a car rental lot. There was a huge line growing at least as fast as it was being served, so there were many impatient travelers behind me by the time I got to the front. The agent handed me a long and detailed standard form agreement. Did I bargain over the agreement’s terms? No, of course not. Did I even read the agreement? No, of course not. In this context, relying on a standard form contract significantly reduced the transaction costs that would have been associated with bargaining. 34 Geo. L. Rev. at 646.

And, as I have observed elsewhere:

Is a standard form contract any less of a contract just because it is offered on a take-it-or-leave-it basis, however? If the market is competitive, a party making a take-it-or-leave-it offer will set price and other terms that will lead to sales despite the absence of particularized negotiations.

Stephen M. Bainbridge, Director Primacy: The Means and Ends of Corporate Governance, 97 Nw. U.L. Rev. 547, 589 (2003).

Second, I take issue with Gibbs et al.'s explication of hypothetical bargaining and gap filling. I don't think courts use the hypothetical bargain to supply party-specific rules to fill a specific gap in a specific corporation. Instead, I think they use it to come up with default rules applicable to all corporations. See, e.g., id. at 577 (arguing that "a shareholder wealth maximization norm [would] emerge from the bargain as the majoritarian default?").

Third, I note that in the US (by which, of course, I mean in Delaware) courts at least claim they're engaged in facilitating private ordering:

• "The DGCL is intentionally designed to provide directors and stockholders with flexible authority, permitting great discretion for private ordering and adaptation." Hollinger Intern., Inc. v. Black, 844 A.2d 1022, 1078 (Del. Ch. 2004), judgment entered, (Del. Ch. 2004), and aff'd, 872 A.2d 559 (Del. 2005).
• The DGCL is “an enabling statute that provides great flexibility for creating the capital structure of a Delaware corporation.” Shintom Co. v. Audiovox Corp., 888 A.2d 225, 227 (Del.2005)
• The DGCL is “a broadly enabling statute." In re Topps Co. S'holders Litig., 924 A.2d 951, 958 (Del. Ch.2007)
• The DGCL is “is widely regarded as the most flexible in the nation because it leaves the parties to the corporate contract (managers and stockholders) with great leeway to structure their relations, subject to relatively loose statutory constraints.” Jones Apparel Gp., Inc. v. Maxwell Shoe Co., 883 A.2d 837, 845 (Del.Ch.2004)
• “Unlike the corporation law of the nineteenth century, modern corporation law contains few mandatory terms; it is largely enabling in character.” Matter of Appraisal of Ford Hldgs., Inc. Preferred Stock, 698 A.2d 973, 976 (Del. Ch.1997).

Finally, I note with interest that the earliest reference to "nexus of contracts" I could find in Westlaw's law review database was Ronald J. Gilson, A Structural Approach to Corporations: The Case Against Defensive Tactics in Tender Offers, 33 Stan. L. Rev. 819 (1981). It says something about the merits of contractarian theory that we're still arguing about it 40 years later.

The corporation is not a real entity and to argue to the contrary is "transcendental nonsense"

I've been reading the introduction to a new book that claims that the corporation is best understood as a "real entity." 

This book advances an entity theory of company law. It builds on the insight that organizations or firms are autonomous actors in their own right. They are more than the sum of the contributions of their participants. They also act independently of the views and interests of their participants. This occurs because human beings change their behavior when they act as members of a group or an organization. In a group we tend to develop and conform to a shared standard. When we act in organizations routines and procedures form and a culture emerges. These over time take on a life of their own affecting the behavior of the participants. Participants can themselves affect organizational behavior and modify routines, procedures and culture but this takes time and effort.

Organizations are a social phenomenon outside of company law. Company law finds this phenomenon and provides it with a legal structure. It makes available legal personality and a procedural framework facilitating corporate decision making and corporate acting. Company law evolves with a view to supporting autonomous action through organizations.

It will be shown in this book that a framework that conceives companies as vehicles for autonomous organizational entities that are characterized by their routines, procedures and culture explains the law as it stands at a positive level. The framework also helps to formulate normative recommendations guiding law reform and judicial decision making.

An entity approach is sometimes associated with a normative argument advocating for more influence for stakeholders such as employees. This book does not take a position on the normative question whether stakeholders should have more influence than they currently have. The thesis of this book holds irrespective of how the law fine-tunes the influence over corporate decision making.

Micheler, Eva, Company Law - A Real Entity Theory (February 11, 2021). Available at SSRN: https://ssrn.com/abstract=3783696 or http://dx.doi.org/10.2139/ssrn.3783696

So I'm going to revisit a discussion from 2012:

My clearest statement of my own views on the nature of the corporation appeared in The Board of Directors as Nexus of Contracts. (You'll want to download it, but that can wait until we're done here.)

In it, I wrote that:

In one sense, the corporation is a nexus.  To be sure, the traditional insistence that the firm is a real entity tends towards mindless formalism.  Yet, perhaps some deference should be shown the corporation’s status as a legal person. Corporate constituents contract not with each other, but with the corporation. A bond indenture thus is a contract between the corporation and its creditors, an employment agreement is a contract between the corporation and its workers, and a collective bargaining agreement is a contract between the corporation and the union representing its workers.  If the contract is breached on the corporate side, it will be the entity that is sued in most cases, rather than the individuals who decided not to perform. If the entity loses, damages typically will be paid out of its assets and earnings rather than out of those individuals’ pockets. To dismiss all of this as mere reification ignores the axiom that ideas have consequences.

If the connected contracts model is correct, and there is no nexus, employment contracts would cascade—looking rather like a standard hierarchical organization chart—with each employee contracting with his or her superior.  (Debt contracts would be even more complex.) Such a cascade would be costly to assemble, if not impossible.  Most corporate constituents lack any mechanism for communicating with other constituencies of the firm—let alone contracting with one another. Instead, each constituency contracts with a central nexus. Accordingly, constituencies must be (and are) linked to the nexus and not each other. 

Although I perhaps could have been clearer (I am reminded of a quip attributed to Ronald Dworkin: "Once again, my critics have deliberately misunderstood me," but that seems inapt to the present discussion), this passage should not be understood as embracing either the real or artificial entity theory of the corporation.

The passage must be put in context. I am responding here to connected contracts model advanced by my friends Mitu Gulati, Bill Klein, and Eric Zolt:

Gulati, Klein, and Zolt contend that the firm is usefully understood as a set of connected contracts.  Their model departs from contractarian orthodoxy, however, by denying the existence (and even the relevance) of the nexus concept. [Hence,] the firm described by Gulati, Klein, and Zolt neither is nor has a nexus. ...

In reply to which, I posed the question of whether "a model lacking the concept of a nexus [can] make useful predictions about the legal rules governing such firms?"

My answer to that question, obviously, is "no." In elaborating on that answer, I was trying to make the point that somewhere within the corporation there must be a nexus of contracts between factors of production. As I explained in the article:

In a more important sense, however, the corporation has a nexus. After all, to say that the firm is a nexus is to imply the existence of a core or kernel capable of contracting. But kernels do not contract—people do. In other words, it does us no good to avoid reifying the firm by reifying the nexus at the center of the firm. Hence, we must search for the person or persons who serve as the nexus of the set of contracts making up the firm….

If the corporation has a nexus, however, where is it located? The Delaware code, like the corporate law of every other state, gives us a clear answer: the corporation’s “business and affairs . . . shall be managed by or under the direction of the board of directors.”  Put simply, the board is the nexus.

Accordingly, as I explained in the introduction to that article:

The director primacy model proposed herein is grounded in the prevailing law and economics conception of the firm; namely, the so-called nexus of contracts model. 

Of course, I don't have a copyright on director primacy. Prof Padfield is free to reinterpret it as he sees fit. But I do want to take issue with his claim that:

Because director primacy theory at the very least has a lot in common with some versions of real entity theory, it seems better to locate it there than ignore it.  For example, real entity theory has been described by Reuven Avi-Yonah as the theory which “represents the most congenial view to corporate management, because it shields management from undue interference from both shareholders and the state” (quote from here). That seems quite consistent with director primacy.  

Just because two roads end up in the same place, doesn't mean that they are one and the same.

I argued in The Board of Directors as Nexus of Contracts (don't forget to download it) that the power of fiat within the corporation is an off-the-rack term of the standard form contract provided by corporate law:

... there is no necessary contradiction between a theory of the corporation characterized by command-and-control decision making and the contractarian model. The set of contracts making up the corporation consists in very large measure of implicit agreements, which by definition are both incomplete and unenforceable. Under conditions of uncertainty and complexity, the parties cannot execute a complete contract, so that many decisions must be left for later contractual rewrites imposed by fiat. It is precisely the nonenforceability of implicit corporate contracts that makes it possible for the central decisionmaker to rewrite them more or less freely. The parties to the corporate contract presumably accept this consequence of relying on implicit contracts because the resulting reduction in transaction costs benefits them all. It is thus possible to harmonize the Coasean and contractarian models without having to reject a theory of the firm in which the board of directors has the power to, say, direct the firm’s workers. Instead, the firm’s constituents voluntarily enter into a relationship in which they accept the board’s power of fiat, while reserving the right to disassociate from the firm.

Likewise, I argued that the business judgment rule--which shields most exercises of that power from judicial review--is another off-the-rack term of the corporate standard form contract.

To the extent that director primacy implies legal rules that shield "management from undue interference from both shareholders and the state," it therefore does so because those rules are majoritarian defaults provided by the law to facilitate private ordering. Not because the corporation is an entity.

Finally, I want to close by disclosing a personal foible. I have a very practical mind. Most abstract reasoning strikes me as metaphysical mumbo jumbo. When I look at the corporation, I thus find myself agreeing with Edward, First Baron Thurlow, who put it best: "Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?"

Apropos of which, in working on this post, I came across a truly wonderful old article: Felix S. Cohen, Transcendental Nonsense and the Functional Approach, 35 Colum. L. Rev. 809 (1935). As John Hasnas summarized the key part of the article (19 J.L. & Pol'y 55):

Felix Cohen began Transcendental Nonsense and the Functional Approach, perhaps the most entertaining law review article ever written, by describing a heaven of legal concepts in which could be found “all the logical instruments needed to manipulate and transform . . . legal concepts and thus to create and to solve the most beautiful of legal problems.” This heaven, which contained

a dialectic-hydraulic-interpretation press, which could press an indefinite number of meanings out of any text or statute, an apparatus for constructing fictions, and a hair-splitting machine that could divide a single hair into 999,999 equal parts and, when operated by the most expert jurists, could split each of these parts again into 999,999 equal parts . . . [was] open to all properly qualified jurists, provided only they drank the Lethean draught which induced forgetfulness of terrestrial human affairs.

This was the realm of transcendental nonsense in which legal questions were resolved by examining the relationships among abstract concepts divorced from any consideration of the practical consequences or ethical quality of the decision.

As his first illustration of transcendental nonsense, Cohen selected the law's treatment of corporations. He pointed out that in deciding whether a corporation incorporated in one state could be sued in the courts of another, one might expect courts to make “some factual inquiry into the practice of modern corporations in choosing their sovereigns and into the actual significance of the relationship between a corporation and the state of its incorporation,” to consider “the difficulties that injured plaintiffs may encounter if they have to bring suit against corporate defendants in the state of incorporation . . . [and] the possible hardship to corporations of having to defend actions in many states, considering the legal facilities available to corporate defendants,” and to decide the case “[o]n the basis of facts revealed by such an inquiry, and on the basis of certain political or ethical value judgments as to the propriety of putting financial burdens upon corporations . . . .” Yet, when the New York Court of Appeals was called upon to rule on this matter, “[i]nstead of addressing itself to such economic, sociological, political, or ethical questions . . ., the court addressed itself to the question, ‘Where is a corporation?’ Was this corporation really in Pennsylvania or in New York, or could it be in two places at once?”

But how is such a question to be answered? As Cohen pointed out,

Clearly the question of where a corporation is, when it incorporates in one state and has agents transacting corporate business in another state, is not a question that can be answered by empirical observation. Nor is it a question that demands for its solution any analysis of political considerations or social ideals. It is, in fact, a question identical in metaphysical status with the question which scholastic theologians are supposed to have argued at great length, “How many angels can stand on the point of a needle?”

Nevertheless, the court ruled that the corporation could be sued in New York because by maintaining an office there, the corporation had come into the state. The problem with this ruling is that

[n]obody has ever seen a corporation. What right have we to believe in corporations if we don't believe in angels? To be sure, some of us have seen corporate funds, corporate transactions, etc. . . . But this does not give us the right to hypostatize, to “thingify,” the corporation, and to assume that it travels about from State to State as mortal men travel. Surely we are qualifying as inmates of . . . [the] heaven of legal concepts when we approach a legal problem in these essentially supernatural terms.

Deciding cases by reifying the abstract concept of the corporation is a classic example of transcendental nonsense.

Put simply, I just can't wrap my head around the metaphysical abstractions required to think of the corporation as an entity--real or otherwise--rather than as an aggregate. Being unable to perform the mental gymnastics necessary to "thingify" the corporation, I am happy to find such a distinguished precedent for dismissing the effort so blithely. After all, as James Boyle wrote (62 U. Colo. L. Rev. 489):

The realist attack was particularly effective in corporation law, where the “constructed” nature of the subject was more apparent. In Transcendental Nonsense and the Functionalist Approach, Felix Cohen suggests that the question “where is a corporation” is the kind of nonsense you can expect from scholastics drunk on their own wordy theories. In fact, talking about whether the corporation is “in the jurisdiction”--or even exists at all--is simply a way of expressing our conclusions about the “policy question” of whether we wish to hold the corporation liable, or grant its directors immunity from suit, or whatever. In other words, to talk of the legal subject is merely to restate a conclusion reached on other grounds. Legal subjects pop in and out of being as a (mysteriously arrived at) set of policy conclusions changes and shifts.

Speaking as a "Reagan realist," i.e., someone who "recognizes the contingent nature of law but insists that such contingency is limited by moral, political, and cultural values that are essentially conservative" (47 Hous. L. Rev. 297), that strikes me as basically right.

New Video on the Parable of the Talents

Ownership Piercing by Lécia Vicente: Recommended Reading

I am reading a very interesting paper by Lécia Vicente, which argues that:

In this article, I develop the concept of "ownership piercing." I use the expression to suggest that courts engage in a process of evaluative reasoning to clarify who owns property rights and controls the limited liability company. I show under what circumstances courts should do that. Ownership piercing entails investigating the reality of the company's governance and tracing the real ownership profile of the company. It means defining who materially controls the company (i.e., managers or members?) and how "tamed" or, in other words, restricted the members' property rights are considering the consensual agreements the members and other stakeholders entered into. The idea that there may be situations in which courts should ownership pierce rests on the substance over form principle, which maintains that the economic substance of transactions rather than their legal form be disclosed.

Vicente, Lécia, Ownership Piercing (February 21, 2021). Available at SSRN: https://ssrn.com/abstract=3790108 or http://dx.doi.org/10.2139/ssrn.3790108.

She explains that:

Ownership piercing is not the same as the company's veil piercing. I define ownership piercing as a process of evaluative reasoning that courts undertake to complement the material participation test. Ownership piercing may also shed light on the level of control and the manager's decision-making role. Ownership piercing may help courts understand if an agent occupies a control or decision-making role despite acting under the control of a principal who has the final decision-making authority. In other words, ownership piercing helps understand who exercises ultimate control in the LLC.

I think she is very much on to something here. In particular, I think her work will do much to inform our analysis of cases like AG Resource Holdings, LLC, et al. v. Terral and Focus Financial Partners v. Holsopple. In both of those cases, the question of status as an owner or employee matter a great deal. Ownership piercing gives us a starting point for parsing them out.

Professor Vicente uses Metro Storage International LLC v. Harron to frame her analysis. (I commend to your attention Francis Pileggi's blog post on the case.) On one level, Harron is a constitutional law/civil procedure case, as the question before the court was whether a Delaware court had personal jurisdiction under 18-109(a) of the Delaware code, which implies consent to jurisdiction on the part of both de jury and de facto managers of an LLC. As Professor Vicente points out, however, deciding those issues required the court to parse out what it means to own and control an LLC.

Those who own are not always in control. Therefore, those who control should be held accountable like the owners would if they were in control. ... I am dealing with situations where standard contractual terms give the managers exclusive decision-making power. The role of an acting manager who had that type of exclusive power was analyzed by the Delaware Chancery Court ("Court") in Metro Storage International LLC v. Harron (“Harron”). In light of the company's contractual framework, members are peculiarly vulnerable since they cannot remove the managers, nor is it easy for them to sell their units. I suggest that, under these circumstances, courts may be less willing to give managers the benefit of the doubt as it is done through the application of the business judgment rule.

The first thing that sprang to mind when I read that was Martin Petrin's work on the responsible corporate officer doctrine, which is an analogy I encourage Prof. Vicente to pursue. 

In any case, she poses the question "What does it mean to participate materially in the management of the company?" In doing so, she does a deep dive into there hybrid property and contractual nature of LLC member's rights.

I was interested by her attempt to use the biological concept of pleiotropy to understand legal rights. It's an ambitious attempt at intellectual arbitrage. I'm not 100% convinced, but I admire her scholarly ambition and the modesty that prompts her to forthrightly acknowledge that "legal pleiotropy needs to be continuously studied, particularly to determine the applicable contractual clauses' scope and depth."

There's a digression into some empirical research she did into the UK equivalent of LLCs, which I'm not sure advances the ball. I would urge her to tie it more throughly into the argument throughout. (Or to dump it.)

At page 27, we come to her detailed exposition of how ownership piercing would solve the problems laid out in the preceding sections. What I would encourage her to develop in this section is a clearer statement of how ownership piercing would work. Set out a practical test that a judge could adopt and apply. In particular, it strikes me that she could adapt the veil piercing standard to say something like:

1. Does this individual have de facto managerial control whether by contract or otherwise?
   1. The laundry list of factors used in veil piercing cases could be adapted to ask whether this LLC has de facto allowed this individual to take over the members' control of the company and effect a separation of ownership and control.
2. Would not treating this individual as a controller lead to inequitable results?

Obviously, I'm shooting from the hip here but I think it would be helpful for her to flesh out what it means when she says "Ownership piercing means that the courts engage in a qualified process of evaluative reasoning." How does the court go about unveiling "the company's real owners, that is, the managers."

In sum, I think Prof. Vicente's article has the potential to make a very substantial contribution to an important area of the law that has not been well served by courts or commentators to date.

 

I also note with amusement that my friend Joshua Fershee will be pleased by Prof. Vicente's admonition that "THE LLC IS NOT A BERLE-MEANS CORPORATION." As Josh has often pointed out, much confusion has resulted from courts' failure to understand that point. 

Prof. Vicente draws three points from that distinction:

1. The LLC consists of autonomous individuals and the individualistic aspects of the LLC "do not favor weaker members." The cases in which courts have validated "predatory competition" within LLCs (with appropriate fiduciary duty waivers) come to mind here.
2. The principal-agent problem takes a different form that is "exacerbated by majority rules, the power of controlling or activist members, and the benefit of hindsight of the knowledgeable manager acting opportunistically."
3. The "common understanding in the literature that in LLCs, members are usually part of the management" is simply not true in manager-managed LLCs, where members "grant the managers autonomy, but in the process, become dependent on them to the point that unclear property rights in the units are not sufficient to overcome self-dealing by the management. Hence, without self-motivated investors minding the company's business, managers' effective constraints are small."

 

Public corporations, the public interest, concession theory, and limited liability

Is a private corporation somehow vested with a public interest? Do the facts that formation of a corporation requires a (purely ministerial) state act, that the state provides a set of off the rack rules for corporate governance in its business corporation law, and that that law provides both affirmative and defensive asset partitioning via the rules on limited liability and private creditor access to firm assets make the corporation somehow uniquely subject to regulation in the public interest?

To be sure, some scholars have argued that incorporation—and, in particular, limited liability—is a privilege granted by society that can be revoked at will.[1] This is the once widely shared “concession theory,” pursuant to which the corporation was regarded as a quasi-state actor exercising powers delegated by the state.[2] But it has been over half-a-century since corporate legal theory, of any political or economic stripe, took the concession theory seriously.^[3] See, e.g., Citizens United v. Fed. Election Commn., 558 U.S. 310, 432 (2010) (Stevens, J., concurring in part) (noting that "many legal scholars have long since rejected the concession theory of the corporation").

I note in passing that concession theory is especially problematic for those of us who accept the contractarian model of the firm, because our preferred understanding of the corporation treats corporate law as nothing more than a set of standard form contract terms provided by the state to facilitate private ordering.

Todd Henderson (Chicago Law) and I tackled concession theory as it relates to limited liability in our book Limited Liability: A Legal and Economic Analysis. In it, we explained that:

The notion that the purported privilege of limited liability amounts to a social subsidy in return for which society may demand certain forms of corporate behavior is also flawed. Limited liability is properly regarded as a subsidy only if it constitutes a wealth transfer from one segment of society to another. As Professor Herbert Hovenkamp concludes, however, “[i]t is hard to make such a showing about limited liability.”^[4] To the contrary, society benefits in a variety of ways from limited liability.[5]

In addition, limited liability could be created by contract, at least among the creditors that bargain with the firm. As applied to these creditors—for example, banks, trade creditors, employees, and government agencies—the concession theory makes little sense. In the absence of a limited liability rule, one could be created by contract for them. Nor does it make much more sense for tort creditors. Although tort creditors cannot literally bargain before they are injured, for the reasons discussed in this section, it is likely that the hypothetical bargain they would strike if they could would be limited liability. Of course, after one is injured in a tort, one strictly prefers shareholder unlimited liability. But this is also true for contract creditors! The relevant time of the hypothetical bargain inquiry is before the tort happens. And, at this time, the question is not whether the firm should pay or not, but rather which party is the most efficient bearer of risk. The firm can provide insurance to the victim for the tort, but the party can buy first-party insurance directly from an insurance company, and the government (through the social safety net) can also provide insurance. Once the tort system is seen merely as a way of providing insurance, then the question becomes which of these can provide the lowest cost insurance with the best incentive effects. When answering this question, one must take into consideration both the relative incentive effects the choice will have on the parties, but also the costs of obtaining a judgment or settlement of the claim, including error costs. So, for instance, if obtaining a judgment in litigation is more expensive and more uncertain than obtaining the same relief from an insurance company, net of fees paid, then the latter may be preferable. This is especially true if under prevailing legal standards companies can avoid paying (that is, being pierced) by doing things (such as dotting the I’s and crossing the T’s) that do not materially reduce the risk of harm to potential tort victims.

My book "Corporation Law and Economics" turned up in the oddest place

Well, maybe not the oddest place. But a friend of mine on Facebook spotted this picture on his timeline and sent it to me. The original poster apparently is a French lawyer. Look carefully at the top book.

The book in question is my Corporations: Law and Economic Analysis (2002). It has a LOT more economic analysis than my Concepts and Insights version, so may be especially useful for academics. Lots of director primacy, of course.