The Legal Primacy Norm in Corporate Law

The debate over the corporation’s purpose is today a central topic of corporate law scholarship. So far, the discussion has advanced little beyond a two-sided view, considering only the approaches known as shareholder primacy and corporate social responsibility (CSR). In a new article, I offer an innovative way to resolve this fundamental debate about corporate law – a proposal that recognizes the need for the law to take stakeholder interests into account, while at the same time not impairing entities’ and shareholders’ legitimate claims, and operating within the existing structure of corporate law. I argue that corporate law, both descriptively and normatively, follows (and should follow) what I call the legal primacy norm.

Under legal primacy, corporate law permits corporations to eventually pursue profit, or any other purpose (such as those of nonprofit corporations), but that pursuit is mandatorily constrained by a higher-level requirement: that the corporation comply with non-corporate law, such as tort, employment, environmental, or other areas of positive law. We are familiar with the requirement of legal obedience when it arises outside of corporate law; as my article explains, it is time to pay more methodical attention to how corporate law itself operates to maximize the corporation’s legal compliance.

In the article, I argue that this requirement plays a prominent role in every aspect of corporate law. The for-profit corporation’s purpose is not merely the pursuit of profit, but the lawful pursuit of profit. The corporation’s shareholders do not enjoy “primacy” but the opposite: by definition, they rank as the most junior, subordinated claimants on the corporate entity – a fact that matters not only in bankruptcy, but also throughout the corporation’s life as a going concern. Indeed, despite ongoing scholarly criticisms, the residual nature of shareholders’ rights is not an academic construct but an enforceable legal fact. Finally, when they cause (or fail to prevent) the corporation’s non-compliance, directors, officers, and other fiduciaries are exposed to judicial liability – much more substantially so than when they simply make a bad business decision. The business judgment rule does not apply if a fiduciary has been involved in a breach of law, nor do other fiduciary-protective devices, such as Delaware General Corporation Law section 102(b)(7).

My article identifies six different doctrines that form the operative, enforceable aspect of the legal primacy norm. All are well-recognized parts of Delaware law, and most can be found in other U.S. and global jurisdictions as well. These include the fiduciary duty of good faith, which requires directors and officers not to act with the intent of violating the law; the Caremark oversight doctrine, which has recently become a focal point for both litigation and scholarship; the mandatory limits on corporations’ ability to pay dividends to shareholders, or to repurchase their shares; the shift in corporate purpose in situations of insolvency; the seniority of the legal claims held by preferred shareholders and trust shareholders; and the judicial dissolution of law-breaking corporations. So far, corporate law literature has placed these topics in separate silos, but my article demonstrates that they are all facets of corporate law’s structural commitment to rule of law principles and stakeholders’ rights.

Consider, for example, the mandatory limits on dividends and buybacks under Delaware General Corporation Law sections 160 and 170. In many situations, shareholders might welcome a large dividend, or a repurchase of their shares, even if it left the corporation empty-pocketed and unable to meet its obligations to bondholders, employees, tort victims, or other stakeholders. Corporate law prohibits such a move, in a manner which shareholders and directors cannot waive (through the corporation’s charter or otherwise), and while imposing a meaningful sanction against involved fiduciaries and shareholders, possibly up to the full amount of the unlawfully-paid dividend or buyback. As my article argues, this demonstrates not only that legal primacy is a crucial tool for protecting stakeholders, but even more broadly, that conceptions of the corporation as a “nexus of contracts,” or of fiduciary duties and agency costs that run directly between managers and shareholders, are either incorrect or incomplete, and must be revised to capture the full reality of corporate law.

At this stage, some CSR advocates might object to my article’s broad reliance on the concept of positive law, by arguing that non-corporate law is itself imperfect, and provides non-optimal protections to stakeholders, in terms of both its content, its enforcement, and the degree to which it is obeyed. I largely agree: my point is not that non-corporate law, as it currently stands, is optimal and can be left unchanged to cover the full sphere of stakeholder interests. Instead, my argument is that non-corporate law is necessarily better than corporate law at protecting stakeholders. When we choose where to pursue legal reform, the optimal location is non-corporate law. As my article explains, corporate law’s internal legal primacy norm then comes into play, encouraging, deterring, and often penalizing corporate law participants with respect to their legal compliance.

This reliance on non-corporate law is justified for two main reasons. First, it is far from clear that defending stakeholders requires the erosion of effective corporate law protections for entities and shareholders. In other words, there can be profit, as long as it is strictly lawful profit. By definition, shareholders have the most subordinated rights, but that does not equal no rights (or easily manipulable rights). Second, and especially important from the viewpoint of stakeholders, broad statements of social responsibility do not offer concrete, enforceable protections to those who are meant to benefit from them. This is especially true given such doctrines as the business judgment rule, which would effectively foreclose stakeholder attempts to argue, in a corporate law tribunal, that directors and officers should have taken one lawful course of action rather than another. In contrast, the legal primacy norm places unlawful activity outside of the business judgment rule and similar defenses, thus creating a relatively low-information-cost, high-enforceability means to protect and promote stakeholder interests. Clearly, improving the law, especially in times of political dysfunction, is no easy task, but it is easier and more productive than delegating the mission to the diverging views of millions of private and public corporations.

My article offers a new unifying theory for the corporation’s legal relationship with its stakeholders. This theory highlights the way corporate law requires corporations (and, derivatively, their fiduciaries and shareholders) to obey the law—whether civil or criminal, private or public law. When the corporation fails to do so, corporate law imposes an extensive array of sanctions, which transcend fiduciary-protective devices such as the business judgment rule and ensure the residual nature of shareholders’ claims. The legal primacy norm thus offers a nuanced correction to both prevailing approaches in corporate law scholarship – shareholder primacy and corporate social responsibility – one which both strengthens the protections afforded to stakeholders and does not detract from the legitimate rights of entities and shareholders. Despite being a topic of heated debate, corporate law must continue to reside within the boundaries of the rule of law, with its delineated notions of right and duty. My article provides a framework where business, economic, and legal decisions can be reached in a fairer, more conceptually coherent, and more effective manner.

This post comes to us from Asaf Raz, a research fellow at the University of Pennsylvania Carey Law School. It is based on his new article, “The Legal Primacy Norm,” available here.