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E-MailTamara Belinfanti is a Professor of Law at New York Law School and Lynn A. Stout is The Distinguished Professor of Corporate and Business Law at Cornell Law School. This post is based on their recent article, forthcoming in the University of Pennsylvania Law Review.
Our article addresses the fundamental question: What is a corporation? Some experts say the corporation is a grantee of the state and should serve a public purpose (concession theory). Others describe the corporation as a legal entity that can hold property and enter contracts in its own name (entity theory). Still others argue the corporation is a nexus of privately-negotiated contracts (nexus of contract theory). Or perhaps a corporation is an aggregation of natural persons (aggregate theory) or an aggregation of shareholder property (property theory) or specific assets (team production)?
The apparent conflicts among these contesting visions were highlighted in the recent Supreme Court opinions in Citizens United and Hobby Lobby. Kennedy’s opinion for the majority in Citizens United described corporations as “associations of citizens,” while Steven’s dissent insisted corporations were not associations of people but legal entities with “no consciences, no beliefs, no feelings, no thoughts, no desires.” Stevens also referenced multiple “recognized model[s]” of the corporate entity, including the state grantee, nexus of contracts, and team production models. In Hobby Lobby, Alito repeatedly described a corporation’s shareholders as its “owners,” implying a corporation is its shareholders’ property, while Ginsberg’s dissent maintained corporations were “artificial persons” separate from any individual and further noted that not only shareholders but also workers “sustain [their] operations.” In Citizens United, Steven’s dissent spoke of corporate purpose in terms of “maximiz[ing] shareholder value” and “maximiz[ing] the returns on…shareholders’ investments.” In Hobby Lobby, Alito disagreed, noting that “modern corporation law does not require for-profit companies to maximize profits at the expense of everything else, and many do not do so.”
This judicial discord highlights the clashes perceived to exist among the various “recognized models” of the corporation. Although Anglo-American corporate scholarship has been dominated over much of the past three decades by a “standard” economic account that assumes shareholders own corporations and that corporate managers ought to maximize shareholder value, Citizens United and Hobby Lobby illustrate how this shareholder value consensus seems to be falling apart. Recently it has been subject to escalating criticism, as commentators have pointed out that it ignores corporate legal personhood; does not fit with the very limited control granted shareholders under actual corporate law; does not recognize that stock prices may fail to capture long term value; and leads to social inefficiency when, as may often be the case, contracts are incomplete and regulation is imperfect. Moreover, commentators have associated this view with multiple recent corporate scandals and business failures, including the 2008 financial crisis.
In our article, we shed light on and resolve much of the ongoing debate over the nature and purpose of corporations by suggesting a new and more unifying approach: systems thinking. Systems theory is a design and assessment methodology routinely employed in a variety of fields including computer science, engineering, biology, and environmental science. It can be applied to any process (system) in which multiple elements interact with each other over time to achieve certain purposes or functions. Public companies in particular can be viewed as complex systems in which multiple elements (e.g., financial capital, physical capital, human capital) interact to perform a variety of desirable functions (e.g., providing not only investor returns but also goods and services, employment opportunities, and tax revenues) under uncertain conditions and over time. We show how this approach allows a better understanding of the interaction between the corporate entity and its human actors/agents; recognizes the role of the state without which legal entity status could not be conferred; offers new strategies and methodologies for ensuring managerial accountability; and helps us better understand the relationships among stockholders, directors, creditors, employees, and the corporate person itself.
Part I briefly summarizes competing theories of the corporation, paying particularly close attention to shareholder value theory and its traditional and current justifications. Shareholder value theory initially was justified by the factual claims that shareholders own corporations and are the residual claimants of corporations. Today, these claims increasingly are called into empirical question. Now, shareholder value theory supporters typically argue that corporations ought to maximize shareholder value because only shareholder value offers the single quantifiable metric supposedly needed to hold corporate directors and officers accountable. Yet this new justification also is being challenged, especially on the grounds that when shareholder value is equated to stock price or current accounting profits, it encourages short-sighted business decisions. Thus shareholder value thinking has been associated with excessive risk taking, reduced investment and innovation, and diminished long-term performance.
In light of these new critiques, many contemporary shareholder value supporters now speak of maximizing “long-term value” rather than immediate profit or share price. Yet we show how shifting from defining value in terms of stock price or similar short term metrics, to an amorphous concept like long-term shareholder value, causes the claim that shareholder value theory can hold managers accountable to begin collapsing. Without the fundamental-efficient-markets presumption that today’s stock price perfectly captures intrinsic value, the corporate entity’s perpetual nature raises insoluble barriers to objectively quantifying long-term value. Uncertainty over the future ensures that, once we attach any number other than today’s market price to a company’s shares, the number becomes subject to disagreement and manipulation, undermining the desired goal of accountability. Part I concludes by suggesting there may be a better approach for measuring corporate performance and holding managers accountable: systems thinking.
Part II introduces systems thinking and the idea of a corporation as a system. Systems theory provides an approach to understanding the nature and purpose of corporate entities that is not only consistent with elements of many otherwise-conflicting visions of the firm, but also with important features of real corporate law and practice. It offers proven methods for measuring performance that recognize the possibility of multiple goals and the importance of sustainability. And it cautions that, by ignoring the lessons of systems theory, shareholder value thinking may have encouraged regulatory and policy interventions into corporate governance that are not only ineffective, but destructive.
In particular, while state corporate law has mostly resisted the call to align with shareholder value thinking, the shareholder value approach has stealthily crept into federal law, especially tax code rules tying executive pay to objective metrics and SEC rules empowering short-term investors and defining corporate performance in terms of near-term shareholder returns. Activist investors have used shareholder value rhetoric as a cudgel to browbeat boards into selling assets, repurchasing shares, and cutting payroll and research and development to achieve short term share price increases. Finally, shareholder value theory has been taught as gospel to a generation of policymakers and business leaders. These developments have significantly influenced business behavior over the past quarter-century, especially in public companies. They have been accompanied by declining corporate numbers, decreasing corporate life expectancy, and reduced shareholder returns.
We conclude that systems theory offers an intriguing and arguably superior alternative approach for understanding the nature of corporations, their proper purpose, and the best way to hold their managers accountable. In the process, it integrates and often reconciles the many competing visions of the corporation being debated today.
The complete article is available for download here.
