Social Enterprise Laws and Director Primacy’s Demise: Risks to Governance and Growth

Businesses often face criticism for putting profit over people and for sometimes ignoring the needs of various stakeholders, including employees and communities. This reality has led to a variety of efforts, including the corporate social responsibility movement, seeking to encourage more socially conscious business practices. These are worthy goals that have seen only modest success, and there are indications that things are not likely to get better if we stay on the current path.

There are two factors working together that could derail efforts to support large-scale socially responsible business decisions: (1) the emergence of social enterprise-enabling statutes and (2) the demise of the concept of director primacy when courts review business decisions. These developments could have the parallel impacts of limiting business-leader creativity and risk taking. In addition to reducing socially responsible business activities, this could also serve to limit economic growth.

To support socially beneficial business decisions, many state legislatures decided to adopt social-benefit entity statutes, creating the likes of benefit corporations and low-profit limited liability companies (or L3Cs).  The well-intentioned effort seemed, at a minimum, innocuous, and in the best-case scenario seemed to provide a clear path for businesses to seek both profit and social good without limitation. Unfortunately, instead of helping, the emergence of social enterprise-enabling statutes is more likely to be an impediment to increases in socially beneficial decision making. Although it may seem counterintuitive, by creating social benefit entities, legislatures created the appearance that other entities should not, and cannot, seek social benefit, an unintended and unproductive limitation.

To make things worse, as these social benefit entities were emerging, many leading courts, especially those in Delaware, were embracing the idea that shareholder wealth maximization has become a more singular and narrow obligation of for-profit entities than was previously understood.  These courts are increasingly suggesting that other types of entities (such as non-profits, cooperatives, or benefit corporations) are the only proper entity forms for businesses seeking paths beyond pure, and blatant, profit making.  Those paths, they argue, are inappropriate for profit-seeking entities like corporations, partnerships, or LLCs.  Although other state entity laws tend not to be as severe as Delaware’s, the state’s reputation as a leader in entity law, and often a model for other states, means the risk is pervasive.

What it means to “seek profit,” and how to do so, had traditionally been left up to those in charge of the business, and they were given broad latitude in making their decisions. Absent a showing of fraud, illegality, or self-dealing, courts generally abstained from reviewing how a business operates. But there are signs in Delaware and beyond that this is changing into a movement viewing businesses only as profit seekers, and this runs the risk of damaging the ability to maximize business success and creativity.

In parallel with the “business as profit seeker” movement described above, there has been a growing desire to see businesses be more socially responsible and promote public welfare. The corporate social responsibility movement emerged to try to hold businesses accountable and promote a public welfare obligation. In addition, voluntary certification programs now allow businesses to seek external review to demonstrate to consumers their commitment to social responsibility. These private and voluntary actions had value, even if progress was slow.  By limiting these to a specific entity form, though, proponents of these goals (and laws) inadvertently created a potential bar to socially beneficial actions by entities that have not chosen to form (or convert into) a social benefit entity.

The erosion of director primacy and the increasing willingness of courts to intrude on the propriety of business judgments, together with the existence of social benefit entities, will make courts even more likely to question the business purpose of traditional entities. States flocking to pass statutes that provide for social benefit entities have increased the risk that such entities will be problematic foils for traditional entities, even though relatively few entities have adopted the social benefit form. These social benefit entities could potentially lead traditional corporations to eschew socially beneficial behavior for fear that courts will find their decisions were improperly motivated by something other than profit, despite the fact that the decision might have long-term value to both the entity and the community.

The potential harm from social benefit entities and eroding director primacy is not inevitable. Acknowledging these risks is the first step toward avoiding a legally mandated race to the bottom for business leaders.  Before social benefit entities emerged, directors were deemed to be in charge of the company. That should still be the case. Courts should apply the same standard to director decisions regardless of whether or not the decision is clearly profit seeking, because directors are in charge of the company. Before looking behind a decision, plaintiffs must show courts why the directors should be second guessed. The existence of another entity form, social benefit or otherwise, should not change the duties of directors of existing entities. Courts, legislators, and scholars should remain vigilant to ensure that is the case.

This post comes to us from Professor Joshua P. Fershee at West Virginia University’s College of Law. It is based on his recent paper, “The End of Responsible Growth and Governance?: The Risks Posed by Social Enterprise Enabling Statutes and the Demise of Director Primacy,” available here.