Almost 30 years after the American Law Institute published the Principles of Corporate Governance, it has launched an effort covering similar ground, this time promising a Restatement of the Law of Corporate Governance.
The difference between the Principles and the new Restatement, according to the ALI’s director, Professor Richard Revesz, is that the Restatement will be “grounded in the sources of positive law” while the Principles presents “best practices for the affected institutions.” In addition, the Restatement will aim to capture the evolution of corporate law prompted by institutional investors’ increasing share of stock ownership, the rise of activist hedge funds, and the recent emphasis on environmental, social, and governance (ESG) issues. (Tentative Draft No. 1, p. xv.)
Unfortunately, the Restatement has started out with a confusing and flawed description of the corporate objective, which puts the entire project on a shaky foundation.
On May 18, 2022, the ALI membership approved the following § 2.01 as black letter law:
§ 2.01. The Objective of a Corporation
(a) The objective of a corporation is to enhance the economic value of the corporation, within the boundaries of the law;
(1) in common-law jurisdictions: for the benefit of the corporation’s shareholders. In doing so, a corporation may consider:
(a) the interests of the corporation’s employees;
(b) the desirability of fostering the corporation’s business relationships with suppliers, customers, and others;
(c) the impact of the corporation’s operations on the community and the environment; and
(d) ethical considerations related to the responsible conduct of business;
(2) in stakeholder jurisdictions: for the benefit of the corporation’s shareholders and/or, to the extent permitted by state law, for the benefit of employees, suppliers, customers, communities, or any other constituencies.
(b) A corporation, in the conduct of its business, may devote a reasonable amount of resources to public-welfare, humanitarian, educational, and philanthropic purposes, whether or not doing so enhances the economic value of the corporation.
This restatement of the corporate objective does not improve on the simpler, straightforward, and well-known version of § 2.01 in the Principles, and it misinterprets the legal import of corporate constituency statutes in a manner that unduly narrows the discretion of corporate directors and managers.[1] At the same time, it fails even to mention the benefit corporation, an important recent development in the law that relates directly to the corporate objective and is especially relevant to increasing concerns about ESG issues.
It’s helpful to return to some basics. Corporate law in the United States is for the most part enabling, created by frameworks of state statutes, with Delaware playing a leading role. The law empowers private parties to construct business corporations as legal “persons” or “entities.”[2] It sets parameters, and some mandatory rules are included (such as prohibitions against fraud and theft). For the most part, however, corporate law does not itself set or dictate the purposes or objectives of a corporation: It empowers individuals to invent, shape, and use the legal form of the corporation for their own stated business-related ends.
The Restatement reporters seem to miss this bottom-up, enabling feature of corporate law when describing the law as “setting” or “stating” the objective of corporations (Tentative Draft No. 1, § 2.01, cmts. a & j). They go so far as to describe their restatement as an “exhortation” in favor of an exclusionary economic objective, though recognizing that this does not require following the mantra to “maximize shareholder value,” at least not “in the short run” (§ 2.01, cmt. e). However, corporate law gives the founders of a corporation the power to set the original business objective in the charter or certificate of incorporation, which is usually supplemented with bylaws. Within this legal framework, corporate decisionmakers (including the board of directors and authorized managers) may change, define, and shift the corporate objectives or purposes or even the business form within the limits of relevant statutes. (See Principles, § 3.02 & cmt. f.) One limit is that some major changes in business form or objectives may require approval of the shareholders.
In this context, the Restatement reporters might usefully reference the history of the ultra vires doctrine in American corporate law. Initially, many corporations were created with a provision in their charter or certificate of incorporation that specified a particular kind of business, such as building and operating a bridge, a canal, or a railroad. Relatively narrow statements of purpose, however, caused legal problems when corporate decisionmakers wanted to undertake an activity that was outside of the stated corporate objective, such as a railroad company’s entering into “non-railroad” lines of business such as lumber, steel, or finance. Shareholders or third parties often sued to challenge actions as ultra vires or “beyond the power” of the corporation. Corporations learned to overcome this legal impediment by amending their charters to authorize the pursuit of “any business purpose.” This language was soon added as boilerplate to all incorporation documents to avoid ultra vires trouble.
Drawing on this history, an alternative restatement of the corporate objective might be simply: The corporate objective is any business purpose or purposes stated in the charter documents. (See Principles, § 1.05 (defining charter documents)). This would capture the wide discretion afforded those who create and manage corporations for any business reason, without adding the requirement of an economic rationale in every case or decision.
The relevance of the ulta vires history here is that the Restatement reporters treat corporate constituency statutes, which were adopted in response to the hostile takeover wave of the 1980s and Delaware court rulings on directors’ fiduciary duties during takeovers, as having created “stakeholder jurisdictions” that define corporate purpose more broadly than traditional “common-law jurisdictions” such as all-powerful Delaware (Restatement, § 2.01(a)). The better reading is that constituency statutes were meant only to restate the traditional scope of fiduciary duties and the business judgment rule, particularly in corporate control transactions, which in some jurisdictions (especially Delaware) began to impose a stricter “shareholders only” standard in some circumstances (i.e., “sale of control” cases). For this reason, they may be accurately described as “fiduciary duty” rather than “constituency” statutes. As the Restatement reporters recognize, these statutes were designed as a kind of antitakeover statute – and actually, as it turned out, not a very effective one. See, for example, the successful acquisition of Conrail, a Pennsylvania corporation governed by a strong version of the statute, by Norfolk Southern.[3] The moral of the story: Shareholders vote! Even in so-called “stakeholder jurisdictions.”
Unfortunately, the Restatement’s new distinction between “common-law jurisdictions” that represent some version of shareholder primacy and “stakeholder jurisdictions” that allow consideration of broader interests doesn’t correspond with legal reality. To begin with, even the black-letter descriptions of these two supposedly different jurisdictions overlap significantly. So-called common-law jurisdictions allow for the consideration of interests of employees and other stakeholders (§ 2.01(a)(1)). So-called stakeholder jurisdictions honor shareholders and give them at least some degree of primacy (§ 2.01(a)(2)). Only shareholders and not stakeholders vote in all state jurisdictions. The preemptive power of the business judgment rule (Principles, § 4.01 and Restatement, § 4.02) also broadly protects fiduciary decisions made in both types of jurisdictions. In practice, then, the division the reporters draw between “common-law” and “stakeholder” jurisdictions is pretty much a distinction without a difference.
In addition, the approved black letter of § 2.01 contains some significant incongruencies. For example, “the environment” and “ethical considerations” are explicitly included as allowable decision-making factors in common-law jurisdictions but omitted in stakeholder jurisdictions (§ 2.01(a)). Surely corporate decisionmakers in stakeholder jurisdictions may also take account of environmental and ethical considerations even if they are not specified as stakeholder interests.[4]
This creaky construction indicates a more serious problem with the Restatement’s § 2.01. Allowing only an “economic objective” forces out any ethical or environmental consideration that does not technically qualify as a long-term economic rationalization. The Restatement’s § 2.01 departs from the recognition in the Principles that ethical considerations may conflict with the economic objective, and that directors and officers may nevertheless follow their consciences in these situations. (Principles, § 2.01 & cmt. h.) Even Milton Friedman, a famous (or infamous) champion of the economic objective in business corporations, conceded that profit-seeking must “conform[] to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”[5] To employ an updated example, doing the right thing with respect to the climate emergency may require a particular firm (such as a big oil company) to sacrifice some profits even as calculated over the long term.[6] The Restatement’s § 2.01 seems instead to require big oil companies to maximize their long-term profits even it means burning our planet beyond all recognition. It seems also to require a corporation adopting an anti-racist personnel policy to justify it with an economic or “business case” rationale rather than an appeal to an ethics of mutual respect and equal treatment.
In summary, the Restatement’s § 2.01 does not appear to allow for situations in which ethical or environmental considerations may trump the “economic objective” as defined in either common-law or stakeholder jurisdictions.[7] Not only does this position fail to meet the test of common sense, it may also inadvertently open the door to shareholder litigation claiming a failure of directors or officers to justify their decisions sufficiently on economic rather than ethical grounds (though the business judgment rule will likely continue to offer significant protection).
The Restatement’s § 2.01 recapitulates a debate held when the Principles’ § 2.01 was first being formulated more than several decades ago.[8] At first, the Principles reporters expressed the corporate objective as “long term maximization of corporate profit and shareholder gain,” but objections by the ALI’s Council resulted in a softening of language to account for non-economic considerations (including law, ethics, and other values). The final version holds that the corporation “should have as its objective the conduct of business activities with a view to enhancing corporate profits and shareholder gain.” “Enhancing” of course is not “maximizing,” and the Principles’ § 2.01 qualifies its primary objective by allowing deference to the law, ethical considerations, and other values. The Restatement’s new § 2.01 mirrors the language to “enhance the economic value of the corporation,” but refuses to include the ethical and other qualifiers presented clearly in the Principles’ version.
Finally, in contrast to its misplaced emphasis on constituency statutes, the Restatement in its black-letter treatment of the corporate objective omits any mention of benefit corporations, which are expressly intended to expand the ability of incorporators to specify in their charter documents a hybrid social objective rather than a strictly economic one.[9]
As the reporters themselves note, 34 states have provided for benefit corporations, including Delaware. (Restatement, § 2.01, cmt. b & note 8). The main point of these statutes is to eliminate any uncertainty about a hybrid social objective, giving the board the authority to balance “the stockholder’s pecuniary interests, the best interests of those affected by the corporation’s conduct, and the public benefit or public benefits identified in its certificate of incorporation” (quoting the Delaware statute).
The Restatement reporters say they don’t mention the benefit corporation because “it is so new, there is little case law interpreting its [statutes’] provisions and thus it would be premature to restate this form as black letter law.” (Restatement, § 2.01, cmt. b). But corporate law is as much about codes as cases. If anything, the widespread adoption of benefit corporation statutes signals a shift in public sentiment, as expressed through law, toward encouraging greater consideration of environmental and ethical issues in business. The ESG movement, flawed as it may be with respect to measurements and marketing, sends a similar message.[10] Many investors and executives now believe that business corporations should not limit themselves to only an economic objective.
There is plenty of time for the Restatement reporters to correct course, for the project has only just begun. If § 2.01’s treatment of the corporate objective is not significantly revised, however, then this new Restatement will be built on a faulty foundation – and therefore likely to crash.
[1] I cut my academic teeth on constituency statutes when they were first adopted. See Eric W. Orts, “Beyond Shareholders: Interpreting Corporate Constituency Statutes,” 61 George Washington Law Review 14 (1992).
[2] For my take, see Eric W. Orts, Business Persons: A Legal Theory of the Firm 9-51 (rev. ed. 2015).
[3] For an overview, see David N. Hecht, Note, “The Little Train That Couldn’t: Did the Pennsylvania Anti-Takeover Statute Fail to Protect Conrail from a Hostile Suitor?” 66 Fordham Law Review 931 (1997).
[4] There is debate in business ethics about whether the natural environment should be included in a concept of “stakeholders.” For my view that it should not, see Eric W. Orts & Alan Strudler, “The Ethical and Environmental Limits of Stakeholder Theory,” 12 Business Ethics Quarterly 215 (2002). If the Restatement reporters continue to include “stakeholders” in the black letter, then some explanatory references to the literature on “stakeholder theory” are called for in the comments or notes. See, e.g., R. Edward Freeman, et al., Stakeholder Theory: The State of the Art (2010); Thomas Donaldson and Lee E. Preston, “The Stakeholder Theory of the Corporation: Concepts, Evidence, and Implications,” 20 Academy Management Review 65 (1995); Eric W. Orts & Alan Strudler, “Putting a Stake in Stakeholder Theory,” 88 Business Ethics Quarterly 605 (2009).
[5] Milton Friedman, “A Friedman doctrine‐- The Social Responsibility Of Business Is to Increase Its Profits,” N.Y. Times, Sept. 13, 1970, https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-the-social-responsibility-of-business-is-to.html.
[6] Brian Berkey & Eric W. Orts, “The Climate Imperative for Business,” California Management Review (Apr. 2021), https://cmr.berkeley.edu/2021/04/climate-imperative/. See also Einer Elhauge, “Sacrificing Corporate Profits in the Public Interest,” 80 N.Y.U. Law Review 733 (2005).
[7] Like its counterpart in the Principles, § 2.01(b) is aimed primarily to allow for charitable contributions. Here, “environmental” purposes might be usefully added to the Restatement version.
[8] This account is based on correspondence with Joseph Vining, a professor emeritus at the University of Michigan Law School.
[9] See Orts, Business Persons, op. cit., at 206-15 (describing hybrid social enterprises of various types).
[10] Multiple measures and metrics of ESG performance are notoriously conflicting and unverifiable, which has led to allegations that many ESG marketing claims amount to greenwashing, if not outright fraud. This is not to say that ESG values should not be supported and advanced in a more rigorous fashion.
This post comes to us from Eric W. Orts, the Guardsmark Professor of Legal Studies & Business Ethics and professor of management at the Wharton School of the University of Pennsylvania, an elected member of the American Law Institute, and a 1994 JSD graduate of Columbia Law School.