From Duty to Power

Brett McDonnell is the Dorsey & Whitney Chair and Professor of Law University of Minnesota Law School. This post is based on a recent article by Professor McDonnell, forthcoming in the Alabama Law Review. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here) and Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

A growing number of businesses aspire to be social enterprises, adopting a dual mission of generating profits for investors while also pursuing a greater good. Entrepreneurs and investors, especially younger millennials, want to make a decent living but in an organization they think makes the world a better place. New statutes, especially those creating an entity called the benefit corporation, attempt to help social enterprises credibly commit to this dual mission using the governance tools of fiduciary duty and disclosure. There is much doubt, though, whether those tools are strong enough. In a new article I argue that voting power for stakeholders is a stronger tool that more social enterprises should use. In this my argument resembles Senator Elizabeth Warren’s proposed new Accountable Capitalism Act, but with a crucial difference.

Like all businesses, social enterprises face governance challenges, but the dual missions of profit and social good heighten those challenges. They must find ways to systematically balance their sometimes competing goals, and to credibly commit to investors and others that they will not prioritize profits over other goals. In the past decade, states have created a variety of new statutory business association forms that try to address the special challenges of social enterprises. Most important among these is the benefit corporation. Benefit corporations are ordinary corporations in most ways, with three differences. (1) Benefit corporations must have as a purpose pursuing “general public benefit.” (2) Directors and officers have a fiduciary duty to consider the interests not merely of shareholders, but also a variety of other stakeholders, including employees, customers, the community, and the environment. (3) Benefit corporations must regularly report what they have done to pursue this broader set of interests.

Do benefit corporations provide an effective way for corporate founders to commit to pursuing goals beyond making money for shareholders? Many, myself included, doubt it. A common, and correct, refrain in the criticism is that fiduciary duty suits are quite unlikely to succeed, and thus provide only a weak disciplinary device. As for disclosure, there are currently no clear, agree-upon metrics which can force companies to reveal genuinely useful information.

Founders of social enterprises need stronger governance tools to credibly commit to seriously pursuing the interests of stakeholders beyond shareholders. Voting power can put new decisionmakers in place who will have both better information about the needs and desires of stakeholders, and stronger incentives to take those needs and desires into account. There are of course costs as well as benefit to giving voting power to corporate stakeholders. It may lead to conflict between the representatives of groups whose interests sometimes conflict. Also, some stakeholders are quite diffuse groups, so that collective action problems may limit their ability to effectively elect and monitor their representatives.

The tradeoffs between the benefits and costs of stakeholder voting mechanisms will vary across businesses and across different stakeholders. There is no one-size-fits all solution that works best for all companies and stakeholders. Thus, my article does not advocate one simple voting mechanism to impose on all companies, or all those that call themselves social enterprises. Rather, it argues for experimentation across companies, with potential legal reforms to help guide and encourage that experimentation.

The article explores various dimensions of variation in how stakeholders are given voting power in order to catalog some of the options open to social enterprises. Individual companies can and should adopt representational governance mechanisms in ways tailored to their individual needs and circumstances. However, relying on private ordering is not enough. Social enterprises generate externalities that individuals involved in the enterprises may not be adequately incentivized to pursue as far as socially optimal.

In response, the article argues for rewarding social enterprises that adopt powerful-enough mechanisms for incorporating the interests of stakeholders. It briefly considers two ways to do so. The first is reducing corporate tax rates for social enterprises with adequate participation policies. The second would weaken, waive, or allow flexibility in applying some legal rules in companies that adopt adequately vigorous forms of stakeholder representation.

The two central provisions of the Accountable Capitalism Act, recently proposed by Sen. Elizabeth Warren, straddle the line between benefit corporations and more robust stakeholder participation. The Act creates a new federal charter, and requires all corporations with gross receipts greater than $1 billion per year to adopt the charter. That charter has two core provisions relevant to this discussion. The first provision adopts benefit corporation language for corporate purpose and duty. The second provision requires companies to have at least 40% of their directors elected by their employees, a critical form of stakeholder participation that I applaud.

But where I part ways with the Act is in mandating the charter for all corporations above a certain size. For some businesses where employee participation has lower benefits and higher costs, this could cause serious governance problems. And as for the purpose and duty provisions, which are already weak governance mechanisms, they become weaker still if imposed externally as in the Act. Hostile managers will easily be able to comply with the letter but not the spirit of this proposed law. These problems with the Act would be avoided if it were revised to be optional rather than mandatory, but with incentives to adopt the charter such as the tax reduction or regulatory forbearance strategies I discuss.

The complete article is available for download here.

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