Vast corporate growth over more than a century has weakened shareholder voting rights, as highlighted by, among other things, the rise of dual-voting stock IPOs. The extent of that growth, and the lack of people’s power to negotiate with corporations, provide legal justification for the possible application of standard contracts law to corporate law in general, and especially to the laws regulating publicly-trade corporations.
Applying standard contracts law to corporate bylaws was first recognized in Israel in 1997 by the Israeli Supreme Court and applied to cooperative corporations (and in later opinions to other types of corporations). In this “ancient” case, consumer protection doctrines were applied to a cooperative corporation, one of the largest public transportation service providers in Israel, of which the members of the cooperative were also its employees. The application of consumer protection doctrines rested on the “nature of the relations between the cooperative corporation and its members,” which was deemed a supplier-consumer relationship. As a corollary, since the separation between ownership and control is a built-in feature of corporations, especially publicly-traded corporations, the logic of the Israeli court’s opinion can also be applied to the bylaws of public corporations.
Under common law, it is assumed that dispersed shareholders in public corporations are inferior contractual parties with negligible impact on the formulation of corporate bylaws due to inherent problems of coordination, information asymmetry, and rational passivity. In essence, this is true for both retail and in some sense institutional investors as well. It thus seems appropriate to identify a harmonious conception for contractual, consumer, and corporate doctrines. This conception calls for an innovative “consumerist” approach that acknowledges that the application of traditional proprietary and contractual classifications, primarily the notion that a corporation is a “nexus of contracts,” is anachronistic. This integration of doctrines is a natural progression for the age of the “post-contractual” corporation, as deep changes in the power differentials between corporations and the public coincided with decreasing prominence of the will theory in contract law and the principle of freedom of contract.
Viewing certain elements of corporate activity through the lens of consumer protection raises similar issues to those discussed in the iconic symposium volume of Columbia Law Review from 1989 devoted to the question of contractual freedom in corporate law. My two cents on this debate is that, for public corporations, the rationally passive shareholder shares attributes with the typical “consumer,” which contributes to the agency problem between shareholders and their representatives. Typical modern public corporations expose dispersed shareholders’ lack of expertise, information, incentives, bargaining ability, and voting power, especially in corporations with dual-voting structures, where even institutional investors have limited incentives to serve as shareholders’ fiduciaries. This view is consistent, on the one hand, with the practice of diversified shareholders acquiring their shares, including the respective contractual obligations, through an impersonal mechanism such as trading on capital markets. On the other hand, it is also consistent with the philosophy underlying standard contracts law, which is that the party formulating the contract may abuse its power due to the practical inability of the other party to participate in setting the final terms of the contract. The routine interactions between shareholders with the content of “their” corporate bylaws is an obvious area where freedom of contract may be limited in a manner resembling other categories of standard contracts, which are most common in transactions among giant organizations and their other constituencies, such as customers, as well.
Analysis of the implications of the separation between ownership and control, also known as the “agency problem,” has produced a large body of legal and economic literature. This literature has stressed the conflicts that stem from the incentives of controlling shareholders or management (the “agents”) to profit for themselves or pursue self-interested ends at the expense of the passive shareholders, who are effectively excluded from control and, in corporations with dual-share voting structures, prevented from voting. The agency problem is aggravated when accompanied by the passive shareholders’ informative and professional inferiority, rational indifference, and lack of bargaining power. This dynamic justifies legal intervention, such as securities laws, to protect passive shareholders from overly self-interested behavior by their agents. Securities laws are, for all intents and purposes, another type of consumer protection law, in that the law considers investors in public corporations to be inferior contractual parties in need of legal protection. This further supports the application of other consumer protection principles (as reflected in standard contracts law) on corporate bylaws. Given that securities law has much in common with the principles underlying standard contracts law, and is also concerned with inherently contractual transactions, there is no reason to preclude application of general consumer protection and contract law doctrines in such cases when the applicable corporate and securities laws fail to provide satisfactory solutions and remedies.
In other words, securities law includes distinctive consumer-oriented elements, chief among them the replacement of the rule “caveat emptor” with the rule “caveat venditor,” through expanding corporate disclosure obligations, which can be viewed as a clear indication of a “consumerist” philosophy. Mandatory disclosure requirements (the “caveat venditor” approach), combined with the regulatory incentives for the public to pursue securities class-action litigation, another consumerist legal tool, constitute the foundation of the securities laws that apply to the contractual corporate relationships between investors in public corporations and members of the public.
The “consumerist” orientation embodied in standard contracts law is therefore well-suited for application in the realm of public corporate law in which diverse shareholders, who are the company’s owners, are viewed as passive “consumers” of management, who “produce” returns on the owners’ investments. This perception of shareholders, embodied in the agency problem, is one of the main objects of regulation in common law. Obviously, the existence of a direct and specific system of corporate and securities laws does not negate the other laws that also mitigate the agency problem. The issues arising from the separation between ownership and control make allocating inferior voting rights to dispersed shareholders all the more problematic. The bylaws of a public corporation conform with the formal as well as the substantive requirements for the application of standard contracts law, only the “consumer” is replaced by the dispersed shareholder. Like the consumer protected by standard contract law principles, the dispersed shareholder is only “free to contract” in theory, while in reality the choice is “take it or leave it”, regardless of the desirability and suitability of the contract terms. In such circumstances, the application of the “nexus of contracts,” and other doctrines biased towards free market and freedom of contract, fall short. Applying consumerist principles where the freedom to contract exacerbates power differentials, i.e. application to the bylaws of publicly-traded companies, is a logical byproduct of the transition to a “post-contractual” era of corporate law.
In the current corporate climate, therefore, it is a misconception to view the drafting and modification of corporate bylaws, specifically shareholder voting rights provisions, as a fair fight between the dispersed, rationally passive shareholders and the controlling shareholders. Instead, non-controlling shareholders share attributes with consumers who have no influence in the contracts signed with large corporations and are thus protected by standard contracts law. Both dispersed shareholders and consumers might ultimately be harmed by the principle of freedom of contract, due to the power differentials that characterize each set of dynamics – management controlling shareholders versus dispersed shareholders in the context of corporate bylaws, and powerful corporations versus individual consumers regarding transactions for goods or services. Accordingly, insofar as public corporations’ bylaws are considered contracts among the shareholders themselves, as well as between the shareholders and their company, consistency requires that the same rules that apply to standard contracts may be also apply to the bylaws of public corporations, thereby subjecting the latter to a special scrutiny. Interpreting corporate bylaws through the lens of standard contracts law, and subjecting management controlling shareholders to stricter standards of behavior, could effectively supplement minority shareholder protections, thereby coping with the modern-day iteration of the agency problem and the challenges presented by corporate power differentials.
This post comes to us from Professor Eli Bukspan at Radzyner Law School, Reichman University, Israel. It is based on his article, “On The Linkage Between The Fundamental Problem in Corporate Law and Standard Contracts Law,” available here.