By Christopher M. Bruner, Associate Professor, Washington and Lee University School of Law
The financial crisis has prompted a searching reappraisal of the "social contract" between corporations and society, as well as how the risks and rewards of corporate activity are distributed among us. Unfortunately, our principal corporate governance reforms in the wake of the crisis have aimed to strengthen shareholders — a thoroughly misguided response, as the history of U.S. corporate law amply demonstrates. That we have responded to a crisis thought to have resulted from excessive risk-taking by strengthening the corporate constituency that most prefers risk suggests, if anything, that we have effectively lost the creative capacity to align the corporate structure with our larger social goals. Avoiding further crises will require regaining this critical capacity.
Twisting the Corporate Form
Treatises and casebooks on U.S. corporate law typically offer the same concise description of the corporation's core attributes: legal personality, limited liability for shareholders, freely transferable shares, and centralized management through a board of directors owing a duty of loyalty to the corporation and the shareholders. Shortly thereafter, one learns that directors owe a duty of care as well, but that its force is substantially diminished by the business judgment rule — a presumption that directors take informed decisions in good faith pursuit of the company's best interests, which can be overcome only by showing gross negligence.
Really, however, we ought to acknowledge that there is nothing cosmically inevitable about all this — because in certain contexts, we have made substantial deviations from this structure to align the corporation with larger social and political imperatives. Hostile takeover defenses, for example, have carved back quite substantially at the free transferability of shares, allowing target boards to impede unwelcome tender offers through poison pills and the like.
Another context where we have deviated from what are now regarded as core attributes of the corporation is less well known, but every bit as vivid, and it involves a type of firm that has loomed particularly large in the public consciousness following the crisis — financial firms. Fiduciary duties have long applied differently in banks. Numerous courts over the last century have stated that bank directors should show regard not only for the corporation and the shareholders, but also for depositors and even the general public. Likewise, courts and legislatures have at times insisted on a higher standard of care in banks; rather than merely requiring that directors not be grossly negligent, courts have often held directors to the more demanding reasonable prudence standard in the banking context, refusing to give the degree of liability protection taken for granted elsewhere.
Similarly, the shareholders' limited liability protection was, for a long time, reduced in banks. Bank shareholders long faced so-called "double liability" — if the bank failed, shareholders not only lost the money invested, but could actually be assessed for that amount to create a fund for the benefit of the bank's creditors. If I bought bank stock for $100, I could be forced to pay in another $100 if the bank failed. This was the rule for national banks in the United States from the 1860s until the 1930s, by which time it was the rule for most state banks as well.
A Populist Movement
So it seems that the corporation's core attributes are less than fixed and absolute — corporate directors are substantially empowered to impede hostile takeovers, notwithstanding the free transferability of shares, and bank directors and shareholders alike long faced greater personal liability exposure than their counterparts in other contexts, notwithstanding limited liability and the business judgment rule.
The interesting question is why we saw fit to carve back at these corporate attributes in such ways. While the regulation of takeovers and the liability exposure of bank directors and shareholders would appear to have little to do with one another, there is a common thread — for lack of a better word, "populism." In using this word I refer not to the early-twentieth century political party, but more broadly to social and political appeals to the interests of average people. In takeovers this is eminently clear — takeovers were viewed as threatening a "social contract" (if not a literal one), and we carved back at the free transferability of shares to align the corporation with social needs.
Liability and Risk
Increased liability exposure for bank directors and shareholders, on the other hand, has more directly reflected concerns about corporate risk-taking, and how business risks and rewards are distributed among various corporate stakeholders. Limited liability for shareholders arose in the nineteenth century to facilitate industrialization. No one could finance undertakings like the railroads alone. This required amassing small contributions from vast numbers of people, but of course no one would invest in such a massive and risky undertaking if it meant unlimited personal liability for the corporation's debts. Limited liability facilitated small investments in big industrial companies by making shareholders comfortable with big risks — and we gave this protection because it was considered good public policy to do so. Clearly it meant externalizing some risks onto society at large, because those harmed by industrial activity could look only to corporate assets for recovery, but we decided that the social costs of entrepreneurial risk-taking were exceeded by the benefits — useful goods and services, jobs, and investment opportunities. The aim of limited liability, quite simply, was to make shareholders prefer risk, and the business judgment rule went hand-in-hand with limited liability by making directors comfortable undertaking the entrepreneurial risks that shareholders with limited liability prefer.
In banks, on the other hand, we historically reduced such protections, for both the shareholders and the board, and we did this for a straightforward reason — we had far less confidence that risk-taking in banks would be socially beneficial. Double liability rules for shareholders and the heightened standard of care for directors were both intended to reduce risk-taking. The social stakes of bank governance and the costs of their failure being what they are, we were not comfortable fostering the sort of risk-taking that we sought to encourage in other types of companies. So we increased shareholders' and directors' personal liability exposure to decrease risk-taking — and this was expressly done out of regard for bank depositors, typically average working people, and more generally for the benefit of society at large.
The Shareholder Today
This history, though unfamiliar to many, has direct bearing upon challenges we face today. Assessing the current landscape before this historical backdrop, it would seem that our sense of the possible in corporate law has narrowed and ossified because of our sense of the purpose of the corporation has narrowed and ossified. Over recent decades we have increasingly focused on generating returns for shareholders — measured primarily by current stock price — and this has diminished our creative capacity to respond to social problems through corporate law. Given our historical skepticism regarding the social benefits of risk-taking in financial firms — and our historical strategy of reducing risk-taking in these firms by forcing shareholders to bear some of the consequences — it ought to give us pause that the principal corporate governance reform strategy in the wake of the crisis has been to strengthen shareholders. Evidently the belief is that stronger shareholders will endeavor to constrain risk-taking, but we should expect exactly the opposite — stronger shareholders will lead to more risk-taking, not less. This prediction is supported both by the history described above, as well as by a growing empirical literature suggesting that excessive risk-taking to boost financial firm stock prices must figure centrally in any coherent explanation of the crisis.
If we are truly committed to preventing further crises, then we must regain the creative capacity to critique and calibrate the corporate structure itself. The history of corporate law demonstrates that there are multiple levers we can pull within the corporate structure to align business with social goals. Questions that we should be asking ourselves include: What degree of limited liability will most redound to the public good? Likewise, what standards of board conduct will most redound to the public good? In neither domain are the core attributes of the corporation so fixed and absolute as the treatises would have us believe.
Based on remarks prepared for "Rethinking Shareholder Value and the Purpose(s) of the Firm III," sponsored by the Aspen Institute Business & Society Program and the Wharton School, University of Pennsylvania. November 1, 2012. [Note: for additional background, see Christopher M. Bruner, Conceptions of Corporate Purpose in Post-Crisis Financial Firms, Seattle University Law Review, vol. 36 (forthcoming 2013)]
Christopher Bruner is an Associate Professor of Law at Washington and Lee University. His teaching and scholarship focus on corporate law and securities regulation, including international and comparative dimensions of these subjects. His book, titled "Corporate Governance in the Common-Law World: The Political Foundations of Shareholder Power" (Cambridge University Press, forthcoming 2013), presents a comparative theory of corporate governance in common-law countries.