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E-MailPatrick Corrigan is an Associate Professor of Law at the University of Notre Dame Law School. This post is based on his working paper.
The environmental, social, and governance (ESG) moniker implies a coherence between corporate social responsibility and corporate governance. In a paper recently posted to SSRN, I argue, to the contrary, that governance trade-offs must be made if corporations are going to be able to pursue social benefits other than just profits. The analysis provides a novel diagnosis for why, years after the 2019 Business Roundtable statement on the purpose of the corporation and talk about ESG factors from institutional investors, ESG proponents remain frustrated by the lack of progress on the environmental and social goals of corporations. It also provides two institutional solutions—if pro-social founders and investors are actually willing to pay the requisite costs.
The paper focuses on a basic question of private ordering: in capital markets where investors have heterogenous and sometimes conflicting preferences about social goods, how can founders and investors coordinate joint ownership in a corporation that, ab initio under a public benefit corporation statute, credibly commits to producing both profits and production of a voluntary, costly social good (a “pro-social corporation”)? I define “social good” or “public benefit” capaciously and without judgment to include any religious, environmental, scientific, or other nonfinancial objective. I study the hard case: the social good is “costly” in the sense that producing it directly conflicts with stockholder wealth maximization.
The paper argues that, if the transaction costs of coordinating joint ownership around social goods are sufficiently high, it is impossible to achieve all three of the following corporate governance features simultaneously: liquid share trading of ownership interests; low cost removal of directors by stockholders; and a credible commitment to producing a voluntary, costly corporate social good.
The Corporate Governance Trilemma
The trilemma implies that is not possible to separate corporate governance institutions from corporate externality policies. If founders want to produce a costly corporate public benefit, they have to restrict share transfers or governance rights. If founders want to reap the benefits that arise from making managers accountable to market forces, they’re not going to produce a costly corporate public benefit.
Start with the right side of the triangle: liquid trading of shares and low cost removal of directors by stockholders. This corporate governance institution creates a robust market for corporate ownership interests. By operation of this market, for reasons that are well understood, managers are disciplined and replaced when they leave meaningful profits on the table, including as a result of costly production of social goods (the transaction costs of proxy contests and takeovers are, of course, the limiting factor of this disciplining mechanism). The recent backlash by stockholders of Disney and Budweiser are, arguably, examples of this corrective process. The more general prediction is that managers don’t even attempt to produce meaningful, costly social goods because they understand this disciplining process and wish to avoid it.
An intervention of the paper is to show that market-based corporate governance causes managers to maximize corporate profits in the long run even if the initial owners are pro-social stockholders who prefer production of a social good. In theory, the initial investors could block a change in control to a coalition of profit-motivated stockholders by simply holding their ownership interests indefinitely, but this would frustrate the liquid-trading pillar of the trilemma framework. The initial investors could also block a change in control to profit-motivated investors if they could costlessly trade with other like-minded pro-social stockholders. But this possibility is frustrated by the search costs, verification costs, and costs from incomplete contracting, among other costs, that are prerequisites to selling to other like-minded pro-social stockholders. The rational strategy for each non-pivotal, pro-social stockholder when selling their stock is to economize on transaction costs by selling on-exchange at the highest price available in the market. Accordingly, market-based corporate governance in pro-social corporations leads inexorably to mission drift: profit-motivated outsiders take control of the company and abandon costly production of social goods. This costly coordination theory has explanatory power for, by way of example, the activist campaign by hedge funds following the turnover in Etsy’s stockholder base caused by its initial public offering.
Thus, the transaction costs of joint ownership not only help to explain the ownership structure of the firm, but also realized corporate purpose.
The punch for corporate governance theory and private ordering is that founders need to establish institutional mechanisms— “clubs” in the terminology of externality theory—that protect corporate production of social goods from the start or risk losing the opportunity to produce them at all.
The corporate trilemma framework identifies two institutional solutions for pro-social corporations. First, founders can choose to be closely held by implementing binding restrictions on share transfers—the left side of the corporate governance trilemma framework. The primary tradeoff of this institution is the illiquidity of ownership interests and the lack of access to public capital markets.
Second, founders can restrict transfers of discrete governance rights—the bottom side of the triangle. The bluntest mechanism, and perhaps the most widely used one, involves restricting the transfer of voting rights, as in the case of dual class stock. But more limited restrictions that are more sensitive to managerial agency cost concerns are possible. The primary tradeoff of this institution arises from agency costs—both competency and conflict costs.
Founders should make informed decisions about the relevant tradeoffs. They should pick a pro-social corporate governance design only if they value a corporate social good more than the sum of the foregone profits and the inefficiencies created by institutional design, adjusting for any financial premiums they expect to receive from investors, customers, workers, or other firm patrons who are willing to pay above-market prices as a means of contributing to production of the corporation’s social good.
Case studies and inductive analysis support the theoretical claims. Perhaps the most common structure for pro-social corporations is a closely-held company that is owned by a family or industrial foundation. For example, Patagonia is owned by a not-for-profit foundation and donates 100 percent of its profits to the environment. Chick Fil A is family-owned and it closes on Sundays for religious reasons. Most widely-held companies that are known for producing costly nonfinancial goods—like REI, Warby Parker, and Navy Federal Credit Union—have meaningful restrictions on transfers of governance rights.
The paper’s focus on externality problems departs from ordinary corporate governance analysis. Under the traditional view of corporate governance, the state is the optimal institution to address externality and public goods problems; markets are the optimal institution for corporate governance. True, corporations have “no soul to be damned, and no body to be kicked,” as First Baron Edward Thurlow is said to have remarked. But stockholders are people. They have normative, ethical, religious, and ideological commitments. If the stockholder-owners of a corporation bring pro-social preferences to their investment and governance decisions, then a one-size-fits-all profit-maximization objective artificially truncates the analysis. A richer theory of shareholder primacy ought to study externality problems from an internal point of view.
Many scholars and corporate actors believe that welfare is maximized when externality and public goods problems are addressed through governmental regulation and private charity, not corporate governance. My analysis does not provide any basis for weighing the relative merits of different approaches to addressing externality problems. The modest goal of the paper is to expand the menu of contractual options available to corporate planners by advancing understanding of private-ordering mechanisms that at least some founders and investors claim are important to them, especially in the case where externalities are inextricable with corporate production.
By establishing the path-dependency of corporate purpose on institutional design, the framework shows that the vanguard of costly corporate social responsibility is in startups, not in public companies—precisely the opposite of the conventional wisdom that corporate social responsibility has its greatest hold on publicly traded companies with dispersed stockholders. Unless founders and early investors are willing to forego some financial payoffs through deliberate organizational planning, pro-social corporations are likely to find themselves constrained by the shareholder wealth maximization imperative of market-based corporate governance.
My paper is available here.
