By Ben Woessner 

The last few decades have seen significant debate surrounding the generous compensation of the top executives of publicly-held corporations.  While some view the current system of pay as functional and driven by market forces like scarce executive talent,[1] many watch the upward trajectory of an increasingly disproportionate gap between executive pay and the average American’s salary with equally growing dismay.[2]

Some commentators point to the fact that executive compensation packages have increasingly utilized stock-based compensation to account for the trending upward spiral of executive pay, which may pose a threat to a company by potentially misaligning the interests of its directors with those of its shareholders.[3]  For example, while stock-based compensation attempts to award executives based on stock performance, thereby motivating higher returns to shareholders, it can also incentivize hedging transactions that permit directors to shield themselves from stock declines while still benefiting from compensation.[4]

In response to concerns regarding corporate transparency in the wake of the Financial Crisis of 2008, Congress instituted disclosure reforms through the Dodd-Frank Act of 2010, which, among other measures, included provisions for “clawback” recovery of incentive-based pay awarded on the basis of erroneous accounting reports.[5]  The implementation of a provision of the Act requiring a clawback of executive pay based on inaccurate reports regardless of whether the errors are “due to fraud, error, or any other factor” was delayed until recently.[6]

On Wednesday, October 26, the Securities and Exchange Commission (“SEC”) voted 3-2 in favor of a provision of the Dodd-Frank Act requiring publicly held companies to implement clawback policies to recover erroneously awarded incentive-based compensation paid to directors, even where the director had no responsibility over the inaccurate accounting statement.[7]  The new rule will require exchanges to “prohibit the listing of issuers that do not develop and implement policies to recover erroneously awarded incentive-based compensation.”[8]  These policies will be triggered whenever companies are forced to issue financial restatements for later-discovered accounting errors and will apply to compensation awarded up to three years from the policy’s implementation.[9]

The SEC intends the rule to “return erroneously awarded compensation to the issuer and its shareholders.”[10]  In so doing, the Commission hopes to realign the interests of executives and shareholders by increasing corporate accountability regarding the distorted incentives potentially created by stock-related forms of incentive-based compensation.[11]

However, the clawback rule may suffer from overbroad definitions that potentially undercut its goals to align executive and shareholder interest.  The first of these definitions concerns what qualifies as an accounting restatement that would trigger a recovery of incentive-based compensation.  Under the original proposal of the rule, only “Big R” restatements, or those that are “material to previously issued financial statements,” would trigger a clawback.[12]  However, the newly adopted rule also requires recovery of pay after so-called “little r” restatements—those that correct nonmaterial errors that could constitute material errors if left unreported.[13]

While the SEC hopes that including both material and immaterial restatements will incentivize executives to assert more control over accounting, thereby reducing instances of accounting error and allowing shareholders to put greater trust in the financial reporting of a company,[14] the rule contains another expansive definition that potentially undermines this goal.  The rule’s definition of “executive officer” not only includes the President, CFO, and principal accounting officer, but also “any other officer who performs a policymaking function.”[15]  As a result, even individuals who may have no actual control over the company’s compliance with accounting rules, and therefore no practical way to ensure greater accountability, are at risk of a compensation clawback.[16]

Furthermore, the clawback rule includes an expansive definition of what qualifies as incentive-based compensation that is subject to recovery if a company issues a financial restatement, including “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure.”[17]  Therefore, at-risk compensation could include not only bonuses and equity-based compensation, but also nonqualified deferred compensation and long-term incentive compensation, so long as it is granted at least in part on the attainment of a financial reporting measure.[18]

Accordingly, critics of the rule argue that companies are likely to significantly decrease the amount of at-risk incentive compensation offered to executives, who will instead elect for a compensation restructuring to retain executive talent with higher salaries or increased discretionary bonuses unrelated to performance goals.[19]  Such restructuring would tend to go against the very heart of the clawback rule’s purpose—while clawbacks hope to align executive and shareholder interests through increased accountability, a shift away from performance-based compensation altogether may untie executive incentives from stock performance to the shareholder’s detriment.

When the rule goes into effect in about one year, the increasing trend toward shareholder activism may serve to keep potentially detrimental compensation restructuring in check.[20]  In fact, at least one study has shown that clawback policies required by the new rule are popular with shareholders as demonstrated by positive stock returns for companies following the initial 2015 announcement of the newly adopted clawback rule.[21] Nevertheless, in addition to being “burdensome to administer,” the rule may increase the divide between executive and shareholder interests as a result of its sweeping definitions, raising doubts as to whether its proposed benefit will outweigh its costs.[22]

[1] See generally Randall S. Thomas, Explaining the International CEO Pay Gap: Board Capture or Market Driven?, 57 Vand. L. Rev. 1171 (2004).

[2] Josh Bivens & Jori Kandra, Economic Policy Institute, CEO Pay Has Skyrocketed 1,460% Since 1978 (2022),

[3] Luis A. Aguilar, Aligning the Interests of Company Executives and Directors with Shareholders, Harv. L. Sch. F. on Corp. Governance (Feb. 16, 2015),

[4] Id.

[5] Gary Gensler, Statement by Chair Gensler on Final Rules Regarding Clawbacks of Erroneously Awarded Compensation, Harv. L. Sch. F. on Corp. Governance (Oct. 30, 2022),

[6] Id.

[7] Paul Kiernan, Accounting Errors to Cost Executives Their Bonuses Under SEC Rule, Wall St. J. (Oct. 26, 2022),

[8] Sec. & Exch. Comm’n, Listing Standards for Recovery of Erroneously Awarded Compensation 125 (2022),

[9] Id. at 86.

[10] Id. at 80.

[11] Id.

[12] Id. at 28.

[13] Meredith O’Leary et al., What SEC Bonus Clawback Rule Means For Public Cos., Law360 (Nov. 1, 2022, 4:52 PM),

[14] Id.

[15] Id.

[16] O’Leary et al., supra note 13.

[17] Sec. & Exch. Comm’n, supra note 8, at 57.

[18] O’Leary et al., supra note 13.

[19] Kiernan, supra note 7.

[20] Id.

[21] Id.

[22] O’Leary et al., supra note 13.

Friday, March 27th

Worrell Professional Center, Room 1312

CLE Credits:  4.5 Hours General Approved

View the Brochure

Registration is now Closed.
Thank you to all who attended and/or participated.

Directions to the Worrell Professional Center can be found here.

A campus parking map can be found here.

Please direct any questions to Kenny Cushing at [email protected].


The Wake Forest Law Review will host its Spring 2015 symposium, “The Future of Financial Intermediation,” on Friday, March 27th at the Worrell Professional Center at Wake Forest University.  The symposium is co-sponsored by the BB&T Center for the Study of Capitalism.

Just as disintermediation is remaking the way goods and services are sold (think eBay, Craigslist, Airbnb), we seem to be heading toward greater disintermediation in financial markets.

In capital formation, newcomers such as crowdfunding and peer-to-peer lending are obvious examples. In corporate structures, conglomerates and combined firms have increasingly displaced intermediated equity markets. But there are counter-currents:  financial intermediaries (like mutual funds, hedge funds, and sovereign wealth funds) continue to grow and dig in.

This Symposium will explore the future of financial intermediation. What role does (and can) law play in shaping and responding to that future?  What adaptations are appropriate for traditional securities disclosure and oversight regimes?  How do decentralized structures affect rules on internal controls or the laws governing corporate groups? How do these changes affect the long-term versus short-term thinking of investors and managers?


Alan Palmiter Associate Dean of Graduate Programs, Howard L. Oleck Professor of Business Law, Wake Forest University
Andrew Verstein Assistant Professor of Law, Wake Forest University


 8:30 Continental Breakfast
 9:00 Introductory Remarks
 9:10 Peer-to-Peer Disintermediation
Moderator: Andrew Verstein
Michael B. Abramowicz Professor of Law, George Washington University Peer-to-Peer Insurance
Kathryn Judge Associate Professor of Law, Milton Handler Fellow, Columbia University Capital is Fungible: The Diverging Paths of Peer-to-Peer Lending and Kickstarter
 10:00 Short Break
 10:10 Degrees of Intermediation
Moderator: Andrew Verstein
Patricia A. McCoy Liberty Mutual Insurance Professor of Law, Boston College Evaluating Degrees of Disintermediation from a Consumer Protection Point of View
Tom C. W. Lin Associate Professor of Law, Temple University Infinite Financial Intermediation
 11:00 Morning Break (Refreshments Provided)
 11:15 New Directions in Financial Intermediation
Moderator: Alan Palmiter
Onnig H. Dombalagian George Denégre Professor of Law, Tulane University Exchanges, Listless?: The Future of Listing
Dale A. Oesterle J. Gilbert Reese Chair in Contract Law, Ohio State University Investing in the Internet Age: Crowdfunding Has Moved into the Intermediary Market
 12:05 Lunch (click here to see on-campus dining options)
 1:15 Berkshire’s Disintermediation
Introduction: Alan Palmiter
 Lawrence A. Cunningham Henry St. George Tucker III Research Professor of Law
Director, C-LEAF in New York, George Washington University
Berkshire’s Disintermediation
 2:00 Afternoon Break (Refreshments Provided)
 2:15 Disintermediated Corporate Governance
Moderator: Usha Rodrigues – Associate Dean for Falculty Development, M.E. Kilpatrick Chair of Corporate Finance and Securities Law, University of Georgia
Francisco Reyes Villamizar Superintendent of Companies in Colombia Foundations and Evolution of the Colombian Simplified Corporation
Erik P.M. Vermeulen Professor of Business & Financial Law, Tilburg University Corporate Governance in a Networked Age
 3:05 Adjourn


Peer-to-Peer Insurance
Michael Abramowicz

Peer-to-peer lending has begun to make small tentative inroads in the banking industry, but no comparable movement has emerged in the insurance industry. This Article will assess the potential for and obstacles to peer-to-peer insurance. With peer-to-peer insurance, individuals might collectively insurance risks of their acquaintances. A partial version of peer-to-peer insurance would involve individuals underwriting a small percentage of the insurable risk, so that insurance companies could use information about willingness of acquaintances’ to underwrite to improve their own actuarial ratings. A more developed version could allow for full underwriting through social networks, with more distant acquaintances taking on at least some of the function of reinsurers. Underwriters might also serve an adjudicatory function, providing information about whether insureds’ claims are valid. Peer-to-peer insurance is in some sense reminiscent of mutual associations, which were well positioned to take advantage of local information but did not enjoy the economies of scale of larger businesses. Perhaps the most significant obstacles to the emergence of peer-to-peer insurance, as with other forms of disintermediation but perhaps more severely, are regulatory. But cryptocurrencies, which so far have eluded effective regulation, could facilitate the development of peer-to-peer insurance. An offshore insurance company could use cryptocurrencies to sell insurance in the United States or elsewhere without regulatory approval, particularly if local underwriters are effective in limiting fraud. An insurance fund could also serve as a potential application of a self-governing cryptocurrency. Whether or not peer-to-peer insurance can evade regulation, this Article argues for a relaxed regulatory approach to such insurance, particularly in early stages of development, so that information can develop about whether it has advantages in some contexts over more traditional insurance products. Back to Top

Berkshire’s Disintermediation
Lawrence A. Cunningham (based on his book Berkshire Beyond Buffett)

Berkshire Hathaway, a 50-year old company that is now America’s fourth-largest, never uses intermediaries. Despite a market cap exceeding $350 billion, it has never borrowed money; despite being built by scores of acquisitions, it has never hired a business broker. Berkshire’s subsidiaries include several consumer finance companies whose business models dispense with intermediaries; the largest car insurer in the US, which has always sold direct without using intermediaries; and numerous commercial insurance companies, which often likewise skip the broker market. Exploring why Berkshire and its subsidiaries have shunned intermediaries–with answers ranging from thrift to loyalty and paternalism–should shed light on the history and current state of financial intermediation and perhaps on broader questions of business culture, consumer protection, and the role of technology. Back to Top

Exchanges, Listless?: The Future of Listing
Onnig Dombalagian

As the traditional intermediary for secondary market trading in most jurisdictions, securities and derivatives exchanges have historically exercised self-regulatory authority in three interrelated spheres:  regulation of trading practices, regulation of the business conduct of their broker-dealer members, and regulation of listed companies. Within the past decade, competition among demutualized, for-profit exchanges and other trading venues has triggered a series of regulatory reforms that has eroded this self-regulatory authority in the first two spheres. Exchanges, however, have managed to retain their formal authority over admission to listing under both U.S. and EU capital markets legislation, even as such legislation increasingly uses listing as a factor in calibrating the costs and benefits of public company regulation and in assuring the integrity of benchmark derivatives. This contribution will speculate about the future of listing as a commercial intermediary function, in light of developments such as the fall of the credit rating agencies, the rise of FINRA and PCAOB, and the globalization of trading and surveillance. Back to Top

Capital is Fungible: The Diverging Paths of Peer-to-Peer Lending and Kickstarter
Kathryn Judge

The paper explores why the technologies that have so transformed intermediation in other industries (as reflected in the rapid growth of Groupon, Airbnb, and Uber, among others) have not had similar effects on banking and other modes of financial intermediation.  Just a few years ago, peer-to-peer lending appeared positioned to bring similarly radical changes to financial intermediation.  It promised to make credit available to a broader pool of borrowers, to enable retail investors to make unsecured loans, traditionally the exclusive province of banks, and to create a direct relationship between these borrowers and lenders.  It now seems unlikely to fulfill any of these promises.  Peer-to-peer lending platforms increasingly screen eligible borrowers using metrics largely akin to those used by banks and increasingly focus on prime borrowers who get credit elsewhere.  The lender base, while in flux, increasingly consists of sophisticated financial firms who seem likely to cherry pick the best loans, eventually crowding out retail investors.  And, regulatory concerns have resulted in these chains becoming intermediated, with the lending platform now remaining as a node between the suppliers and recipients of the capital.  By exploring the dynamics driving these changes, and the areas where crowdfunding appears to have established a more lasting foothold, this piece sheds new light on how different forms of financial intermediation create value. Back to Top

Infinite Financial Intermediation
Tom Lin

No one is a financial island entire of itself. Intermediation is a fundamental fact of modern finance. Investment banks underwrite stock offerings for companies.  Commercial banks safeguard the savings of workers.  Fund managers invest the pensions of retirees.  Exchanges match orders of buyers and sellers. Brokers facilitate trades of investors.  Credit card companies advance funds to consumers. Collectively, these and other intermediaries form the fabric of modern finance. Yet despite all these existential financial links, entrepreneurs and innovators continue to endeavor towards the possibilities of fundamentally disrupting and disintermediating these financial ties, breaking apart from the financial main, and building new financial islands.

This Article is about those financial links and those disengaging endeavors, the ties that thread the fabric of modern finance and the efforts to tear those threads asunder to create anew, the truths about financial intermediation and the mirages of financial disintermediation.  It presents an examination of the functional evolution of financial intermediation, explains the difficulties of true financial disintermediation by revealing the less obvious links that remain, and highlights potential implications and recommendations arising from such a revelation. Back to Top

Investing in the Internet Age: Crowd Funding has Moved Into the Intermediary Market
Dale Oesterle

As the SEC struggles to amend its rules and procedures to adapt to the Internet Age, Internet investment continues to evolve.  With the Securities and Exchange Commission late on rules for individual, direct investments under the JumpStart Our Business Startups Act of 2012, the Internet is racing forward into the creation of internet investment funds.  AngelList is perhaps the best example.  Small investors use AngelList to form investment syndicates that invest in portfolio companies offering on the Internet.  The practice is yet another example of the need for a complete overhaul of SEC rules on capital offerings in the United States.  The agency needs to put all its offering rules on the table, face the advantages of the internet age, and draft a new system of capital offering regulations. Back to Top

Corporate Governance in a Networked Age
Erik P.M. Vermeulen

Corporate governance research is typically predicated on solving how we design the best way for managers, financial intermediaries, investors and other stakeholders to interact and better yet, do business. Based on this research, policymakers and regulators have introduced agency-based rules and regulations to ensure that self-interested managers will not act in ways that conflict with shareholder value creation. This all sounds great in theory. However, people nowadays are increasingly debating how well corporate governance frameworks truly prevent managerial misbehavior. Speaking from personal experience, when you are on the ground working in a listed company, you immediately recognize that there are other overriding considerations that should take precedence. Indeed, when you conceptualize the relationship between managers and investors as one of hierarchy, you create a short-term mentality that usually leads to stricter control mechanisms on corporate executives, corporate reorganizations, and demands for increased dividends and stock buybacks, making it extremely difficult for companies to recapture the focus on innovation, growth and wealth. It is this disconnect that is slowly but surely causing a shift in corporate governance thinking. This paper covers innovative companies that create wealth and growth and more specifically what we see happening within them. What is it that causes these companies to thrive and stay ahead of their competitors? As we start to think about this “dark matter” in the universe of corporate governance and ask ourselves how to architect and design these type of companies, we come across certain common themes, such as the protection of founder-CEOs, controlling ownership, investor relations that focus on non-financial metrics and a more fruitful interaction between the company’s managers and financial intermediaries. After analyzing the world’s most innovative companies, we come to the conclusion that it is better to view corporate governance as the interface between what a company is today and what it attempts to achieve in the future. Back to Top

By: Kelli A. Alces*


The board of directors has outlived its purpose.  The board is theoretically responsible for directing the management of a corporation, for monitoring its senior officers, and for making significant business decisions.  The typical directors of the largest multinational corporations devote about seventeen hours per month to the governance of the corporation.[1]  So responsibility for the success or failure of the firm lies with a group of professionals, the board of directors, who work part time to monitor the firm’s business, and management, who receive almost all of their information about the firm secondhand.

Certainly the board of directors monitors corporate officers, particularly the CEO, and makes significant business decisions for the firm.  But it is the senior corporate officers who are responsible for the day-to-day operation of the company and who are most involved in its business decisions.  When the board must vote on a particular matter of corporate business, officers and experts selected by the officers brief it on the subject.[2]  Despite being the focus of corporate law’s accountability for corporate decision making, the board of directors relies heavily on the senior corporate officers it is supposed to monitor and lacks the time and expertise to challenge those officers in order to contribute valuable independent business judgment.[3]

There are a number of other groups that exercise oversight over the firm. Creditors, for example, reserve oversight power in their contracts with the firm.  Those contracts often give creditors a veto over some corporate decisions if the company is in a poor financial condition, and creditors often use the declaration of default threat to influence officers’ and directors’ decisions.[4]  Shareholders may exert control over the company through their ability to elect directors and enforce officers’ and directors’ obligations to the firm. Also, shareholder estimation of managerial performance is one component of stock price, which is a significant component of executive compensation.[5]  In firms with unionized labor forces, union representatives are able to influence corporate decision making through their ability to threaten a strike.[6]  Among these corporate monitors, directors are often the ones paying the least attention to the firm on a regular basis, even though they are ultimately responsible for the success of the firm.  The board of directors, as an institution, has failed the modern public corporation with widely dispersed share ownership.[7]

The inability of the board of directors to adequately perform its intended functions exacts serious costs.  A system that relies so heavily on one governance structure is left vulnerable when that structure fails.[8]  Further, placing a strong emphasis on board accountability when boards cannot be meaningfully responsible for corporate decision making leaves those harmed by corporate scandal without recourse.  Money spent on pursuing litigation against corporate directors is wasted, by and large, as directors are shielded from personal liability and yet the law still looks to directors for accountability for corporate decisions.[9]  Our expectations for boards of directors of large public companies far outweigh what such boards can realistically accomplish.[10]

Numerous corporate law scholars have critically examined the structure and functions of the board of directors[11] and have evaluated the relative success of various board compositions.[12]  These commentators have alternatively praised and criticized the board for its ability to monitor management and maximize shareholder wealth.[13]  The academic and business communities have failed to reach a consensus about how exactly the board should fit into the corporate governance structure, what its role and level of influence should be, how it is supposed to work toward the goal of shareholder wealth maximization, and to what extent the board should be responsible for a failure to meet those ends.  Although the members of the corporate law community have reached a variety of conclusions, they all rest on the assumption that a board of directors is both necessary and desirable.

This Article challenges that basic assumption.  It argues that the board of directors in a large public corporation is ineffective to perform the functions assigned to it and should thus be eliminated in favor of a governance system that more accurately reflects corporate decision making.  Corporate officers and the investors and parties in interest that are essential to the firm’s daily operation and capital structure—the real corporate decision makers—should perform the functions assigned to the board, so that the now-vestigial board of directors can completely wither away.

Abolishing a formal board of directors would not spell the end of corporate governance.  In the absence of a board, corporate constituents would be permitted to enforce their rights against the corporation and management directly.  Their contracts with the firm could evolve to fill gaps in corporate decision making.  Because these constituents already exercise significant oversight of the firm, they are well equipped to perform the monitoring and management functions of the board.  Because a post-board firm is so different from what we have had to date, this Article suggests a path that could lead to the gradual elimination of the board governance structure.  This Article is meant to be the first step on a path toward the evolution of the corporate form away from the use of a board of directors and highlights regulations it might be prudent to remove.

Because current legal and regulatory regimes do not appear to permit the wholesale abandonment of the board of directors immediately, this Article also proposes a less radical change to the corporate governance structure—one that would allow it to more accurately reflect corporate decision making within extant legal regimes.  In particular, the Article suggests implementing a board dominated by representatives of the firm’s investors—at least the firm’s creditors and shareholders.  Major bank lenders would be represented on this “investor board,” indenture trustees would represent bondholders, and an equity trustee[14] could represent the shareholders.  Such a board would monitor senior officers directly and also make major corporate business decisions (according to the powers reserved to the board and the investors sitting on it through their respective contracts).  The diversity of the board members’ individual interests assures that they are less likely to settle into too close of a relationship with management, but instead will actively protect their investments, and thereby, best protect the corporation.  The divergence of interests will provide a check on overreaching.

This Article proceeds in three Parts.  Part I explains the conventional justifications given for the current board structure.  It reviews the evolution of the board to its present form and considers the purpose of the modern board of directors.  Modern corporate law favors a board primarily intended to monitor corporate officers.  A board of directors is also expected to perform a more limited management function by advising senior officers about significant corporate decisions.  Part I explains that the current board structure suboptimally allocates authority and oversight in public corporations.

Part II proposes significant changes to the board of directors.  It sketches a post-board firm, suggesting how to monitor corporate managers in different, more direct ways.  Recognizing the hurdles to completely and immediately abolishing the board of directors, Part II suggests how an evolution toward a post-board firm might begin with a board of directors made up of investor representatives.  Such a board would more accurately reflect the balance of power in corporate decision making and would set the stage for an evolution away from the use of a formal board of directors.  A more accurate understanding of corporate decision making will lead to more direct accountability for those responsible for the firm’s financial success.

Part III considers various obstacles to the Article’s proposals.  Corporate and securities laws confine the structure of the board and prevent some kinds of market evolution.  Though several problematic aspects of board governance are the products of market forces, it is the law, not the market, that prevents corporate governance from evolving past its current form and away from the use of a vestigial board of directors.  The market has chosen to render the board of directors weak and relatively meaningless and to empower corporate constituents and officers to dominate corporate decision making.  Part III proposes relaxing or removing laws that prevent the governance structure from expanding upon and formalizing the reality of corporate decision making.

I.  Why a Board of Directors?

Surely, there are reasons, perhaps good ones, for choosing a governance structure in which a board of directors bears primary responsibility for the direction of the management of “[t]he business and affairs of every corporation.”[15]  The fact that the board has evolved to its present form reveals market preferences against a strong board in the extant legal framework.  It is important to understand that evolution before criticizing the board’s diminished role.  Insights from organizational theory also shed light on our current board structure.[16]  This Part will examine each of those observations in order to better understand why the modern corporate board of directors looks and acts as it does.  It will also explain why the current formulation of the board prevents it from effectively performing its assigned tasks.

A.            History and Evolution of Board Structure and Purpose

American corporations have always had boards of directors.[17]  This tradition emerged from English trading companies, which used governing boards to represent business owners in joint stock companies.[18]  The board was to sit at the top of a parliamentary system of corporate governance.[19]  Originally, boards managed the day-to-day business of the firm.[20]  This was because they were made up primarily of controlling shareholders and managers selected by those shareholders.[21]  Particularly in family-run firms, the founders and their closest friends and relatives were the owners and managers of the firm and so constituted the board of directors.

Even into the early 1900s, when corporations were just beginning to grow and move past the realm of family-run local businesses, corporate boards were chosen by dominant majority shareholders and were often composed of firms’ managers.[22]  As corporations grew through the 1970s and shareholding was divided among more widely dispersed shareholders, CEOs, rather than shareholders, began to choose the board members.[23]  Shareholders elect directors, but once an increasing number of firms failed to have a controlling shareholder in place, the CEO was able to run the daily operations of the firm and could handpick nominees to the board.  The result of that change was that the board was effectively inferior to the CEO it was supposed to supervise.  The board’s role “became advisory rather than supervisory.”[24]

That state of affairs persists and continues to shape board composition and effectiveness.  Because shareholders cannot coordinate to exercise control over the firm and its management,[25] the CEO and senior officers have an advantage when it comes to choosing directors.  So chosen, and without intimate knowledge of the firm, the board of directors cannot exert control over the daily business of the firm and cannot easily monitor management.  Directors owe their positions to the officers they are supposed to supervise, and they rely upon those same officers for the information they use in supervising them.[26]  Social pressures also define the relationship between the board and management[27]—“board traditions in the United States make outsiders invited guests, not policy makers.”[28]

Still, there must be some role for the board.  It is, after all, where legal accountability for corporate decision making lies.  The board of directors may not be particularly effective, but it is not yet dismissed as a mere figurehead.  Modern corporate law has settled on a notion of a “monitoring” board.[29]  A monitoring board is composed mostly of independent directors, those not having close personal or financial ties to the firm.[30]  It is supposed to pay attention to management to the extent it can, to discover bad faith or incompetence, and replace officers as necessary.[31]  Board independence is supposed to be optimal for performance of the monitoring function.  An independent board, theoretically, will not have strong ties to individual managers and thus will be comfortable challenging and removing them.[32]  It will force senior officers to defend their choices and will make them notice irregularities or improprieties in management’s conduct of corporate business.[33]  The independent monitoring board has been criticized, however, for being ineffective at performing even the most basic monitoring function.[34]  The next Subparts consider the monitoring and management functions of the modern monitoring board and evaluate the board’s effectiveness in performing those functions.

B.            Monitoring

Directors are supposed to appoint the CEO, perhaps advise the CEO on the selection of other senior officers, and evaluate the work done by the senior management team.[35]  To the extent corporate governance law and practice now favor a monitoring board, the board functions are supposed to be separate from senior management, and the board is supposed to be a largely independent supervisory body.[36]  Rather than holding senior officers directly responsible for corporate well-being, even though officers control the day-to-day business of the company, Delaware law has long placed primary responsibility with directors, providing that directors are responsible for monitoring officers and so are ultimately responsible for whatever corporate decisions the officers make.[37]  The board, then, is conceived of as an independent, relatively distant body charged with overseeing the very highest levels of corporate decision making.

1. Board Independence

In designing a monitoring board for the public corporation, federal and state law as well as public listing exchanges have required that only “independent” board members be allowed to perform certain functions in public companies.[38]  For example, mandatory audit and compensation committees must be made up of independent directors.[39]  Indeed, firms appear to have better and more accurate financial reporting when independent directors with accounting expertise sit on their audit committees.[40]  The majority of board members must be independent.[41]  Independent directors are those having little or no personal or financial relationship with the firm.[42]  The rationale for using independent directors is the expectation that they will not be sympathetic to management, will feel free to challenge managers as necessary, and will remove them without compunction if senior officers are not performing optimally.  For instance, independent directors may not “have a personal financial stake in retaining management.”[43]  If the directors do not have a personal stake in keeping management on board or can keep a certain distance and remove themselves from the company’s business, they will be able to respond dispassionately to problems that arise, prioritizing shareholder wealth maximization.

This definition of “independence” is not clear and guarantees only a certain kind of autonomy from other corporate operations.[44]  Independent directors are neither necessarily socially independent from management nor unsympathetic to the concerns of senior officers.[45]  Professors Gilson and Kraakman note that in trying to find an appropriately independent outside director, shareholders may have succeeded in finding directors who are more independent from shareholders than they are from management.[46]  This is because independent directors are still primarily senior officers of other corporations, making them unlikely to monitor senior officers of the companies on whose boards they serve more than they want to be monitored themselves.[47]

Further, it is difficult, if not impossible, to give independent directors strong incentives to monitor carefully.[48]  Any sort of compensation that tracks corporate or management performance would undermine the very independence required.[49]  If the board is supposed to be a truly independent, distant monitor, then giving directors personal ties to the firm’s finances might make them too much like the managers they are supposed to monitor.  It would truly duplicate the role of officers except that the supervisors, the directors, would only work part-time.  To the extent we rely on reputation to constrain outside directors or to give them incentives to monitor conscientiously, we must remember that those directors are essentially chosen by the CEO.  The directors’ reputations, then, must have more currency with the CEOs that they are supposed to monitor than with the shareholders who passively, and perhaps inattentively, elect them.[50]  Independence for the purpose of monitoring management is, therefore, difficult to achieve.  And even if it were possible, it might not be ideal.

Board members are at a disadvantage when it comes to monitoring officers because they rely on those officers for the information they use to monitor.[51]  If the employee tells her employer why she is doing a great job and gives the employer the information needed to assess the job she is doing, the boss cannot really make an independent judgment about the employee’s performance because all of the information comes from the employee.[52]  This problem with the monitoring structure became manifest during the recent financial crisis.[53]  Independent monitoring boards were not able to discover the serious problems with decisions officers were making and were unable to prevent the collapse of financial firms.[54]  Still, we regulate with an eye toward more independence in board composition,[55] even as it becomes clear that truly independent boards lack the knowledge of the firm that might be necessary to assess managerial performance.

In an article written twenty years ago, Gilson and Kraakman suggest that the market should develop a pool of professional directors to respond to these problems.[56]  They propose that academics and other outside consultants make themselves available to serve on corporate boards and that these “professional directors” devote themselves full time to service on the boards of a handful of companies.[57]  These directors would be beholden only to the shareholders, primarily institutional shareholders, who elect them.[58]  Such a system could create real independence from management in the board and could also result in board members who could invest more time in learning about the companies they supervise.  Unfortunately, the market has not yet evolved toward such a system.  As regulators continue to press for independent, outside directors and those directors are no less likely to be sympathetic to or chosen by management, it is difficult to see how the monitoring board is likely to change.

2. How the Board Monitors

Determining board composition is only one part of designing a board that is able to monitor management.  It is also important to understand how the board is supposed to monitor management and what expectations we have about the board’s monitoring.  We must then try to appreciate how well-suited the board of directors is to performing that level of monitoring.  Understanding the hierarchical, collegial, and probabilistic monitoring described by organizational theory can be useful here.  Hierarchical monitoring contemplates a situation in which the supervisor has the same information as the subordinate actor and can make superior, independent decisions based on more sophisticated knowledge, understanding, or expertise.[59]  This occurs in standard employer/employee relationships and throughout the corporate hierarchy.[60]  Collegial monitoring occurs when the monitor does not “have superior information, or less bias when evaluating the available information.”[61]  In a system of collegial monitoring, managers do not stand as inferiors to their monitors.[62]  Finally, probabilistic monitoring is relatively passive.  Probabilistic monitors respond only when a problem has occurred and try to discern whether the party they are monitoring is responsible for the problem.[63]

The corporate governance monitoring structure is, at various times, hierarchical, collegial, and probabilistic, with directors often acting as more detached, irregular monitors than one would expect given their position at the top of the corporate hierarchy.[64]  For instance, director monitoring is hierarchical when directors decide whether to retain a CEO or which CEO to appoint because they may have sufficient information to make a better decision and obviously lack some of the strong biases the CEO or other senior officers would bring to the decision.  In that situation, the directors’ decision supersedes the preferences of others and their decision is final.[65]  However, directors lack the time and attention hierarchical monitors usually devote to their task.  Directors usually receive their information from officers[66] and so cannot be regular hierarchical monitors because the information the directors have is not as good, let alone superior to, the information officers use to make decisions on a daily basis.  Directors are just not as informed about the day-to-day business of the firm—and they are not expected to be.

Most director monitoring of management is collegial.  That is, directors learn from officers why the officers recommend a particular course of action and officers are not perceived as inferior to directors when the board makes most of its business decisions.[67]  Rather, the officers present an idea to the board and advise directors and then the directors ask questions to determine if they agree with the officers’ judgment.[68]  Directors may consult outside experts (perhaps the same experts officers consulted) to reach as clear an understanding as officers have—not a clearer one.  Directors have to rely heavily on officers for the judgment and information they use in performing their monitoring tasks.  The collegiality between the monitors and the monitored is not metaphorical, but real.  As mentioned above, directors are usually officers of other companies; directors and officers are colleagues and kindred spirits.[69]  Their professional and personal relationships establish a collegial norm for their interaction in governing a corporation.[70]

Directors also engage in some probabilistic monitoring.  Because directors are not always informed about the daily operations of the firm, they cannot know exactly what officers do every day and arguably have little or nothing to do with most decisions officers make.  Directors could not possibly anticipate every problem that may arise and may not know what has caused the difficulties the company faces.  While we expect them to catch big problems and to head off serious financial disasters, directors are not always able to do so.  This occurs, in part, because the board’s oversight responsibility is limited.  The board is only required by law to ensure that reporting mechanisms are in place so that it will hear about serious violations of corporate policy or the law, but the board is not expected to press beyond those systems to discover potential malfeasance.[71]  Also, board members only meet occasionally and are not regularly at the firm observing standard practices.  Because the board only works for the corporation part-time, its members cannot know most of what happens at the highest levels of management.  When a serious problem arises or the company’s value falls precipitously, the board has often been unaware of the potential problem and thus unable to do anything to prevent the crisis.[72]  After the dust has cleared, the board must act as an ex post, probabilistic monitor and must try to determine whether the problem occurred because of the incompetence or dishonesty of the senior officers, or whether it was the result of blameless market- or industry-wide difficulties.

3. How the Board Should Monitor

Given that we expect shareholders to engage in probabilistic monitoring of directors—the best shareholders can do because of collective action problems and their relative lack of information[73]—it seems that the board should be designed to perform closer, more direct monitoring of senior officers.  Collegial monitoring of management by the board is probably the norm.  Both directors and officers are supposed to be working toward the goal of shareholder wealth maximization.  Directors may be somewhat less biased than officers in certain matters, whether because of directors’ “independence” or because they were not part of the decision making up to that point.  Otherwise—because of the problems with board independence mentioned above—board members are no less biased than officers, and so, in the interests of “getting along,” they are most likely to try to reach a consensus with officers over major corporate decisions requiring director approval.[74]

The legislative and regulatory emphasis on board independence might suggest that legislators want directors to engage in hierarchical monitoring.  If the board of directors is supposed to be in charge and the proverbial “buck” is supposed to stop with them, it seems as though corporate governance law favors more hierarchical monitoring of management.  To the extent we ask directors to engage in hierarchical monitoring, we are really asking them to make management decisions because we want them to replace officers’ judgment with their own.  Management is a separate and quite limited role of directors.[75]  Expanding monitoring responsibility and authority too far turns monitoring into an affirmative management obligation.  That is not consistent with the policy choice to limit the board’s management responsibility to a very few significant decisions, and to leave officers with primary responsibility for the day-to-day operation of the firm.  This tension suggests that a board of directors is not actually designed to be an effective hierarchical monitor—and we may not want it to be.

If hierarchical monitoring of senior officers by part-time directors is not possible in most situations, then we must consider collegial and probabilistic monitoring sufficient.  Because shareholders and financial institutions (the latter functioning as both shareholders and creditors) perform probabilistic monitoring of directors[76] and, in some ways, of officers, it seems redundant to have so many layers of “watchers,” unless each additional layer adds something essential.  The board of directors, as currently constituted, is not better suited to hierarchical monitoring than attentive shareholders, creditors, or even labor representatives would be.  As a collegial monitor, the board is not independent enough or knowledgeable enough to exercise distinct decision-making authority in a meaningful way.  The board may be able to challenge the senior officers by asking difficult questions of them about decisions they propose, but it still relies on senior officers for information and guidance about the most efficacious course of action for the corporation.  At best, the board provides a skeptical body to which senior officers must justify their decisions.  This function, while valuable, could just as easily be performed by other parties in interest such as shareholders or creditors.  In fact, in some situations, the senior officers may have to justify decisions to other constituents more often than they have to answer to the board, because those constituents, or their representatives, closely monitor the day-to-day business of the firm in order to protect their contractual rights against it.  As currently constituted, it is hard to see how the board is uniquely qualified to monitor senior officers or corporate business.

C. Management

The board of directors is also supposed to perform a management function.  While not in charge of managing the day-to-day business of the firm, the board is supposed to have the ultimate say on various major corporate issues, such as whether to bring certain lawsuits on the company’s behalf, whether to sell the corporation or to buy another firm, whether to issue dividends to shareholders, and what the corporation’s capital structure should be.[77]  While we have moved more toward a monitoring board over the last forty years or so,[78] the management function of the board cannot be ignored.  The board is expected to make significant management decisions, albeit with the advice of the senior officers and other experts.  Perhaps more importantly, the board performs an advisory function, offering advice and opinions to management about general business concerns.[79]  This advisory function has come to dominate the board’s role when the corporation is healthy.[80]  This Subpart will consider what the board’s management function is, what we may want it to be, and how well suited the current board structure is to making important decisions about the management of the firm.

While most boards of public corporations are now made up of a majority of independent directors, some inside directors sit on all boards.[81]  These inside directors help to set the agenda and help to advise outside board members about the business’s proper course of action.[82]  For many years now, it has been commonplace for the CEO to serve as the chairman of the board of directors.[83]  That means the CEO sets the board’s agenda and calls meetings.[84]  In most instances, inside directors’ work is most important to the board’s management function.[85]  The inside directors know more about the firm’s day-to-day business as well as its relationship with the various parties with whom it contracts.

The board’s very independence may, paradoxically, hinder its ability to make independent business decisions.  As noted above, the board has to rely heavily on inside directors for information and judgment to reach what ends up being a consensus with management.  Professors Gilson and Kraakman point out that outside directors “rarely exercise their judgment today, except during crises, not only because they lack the time and the incentives to do so, but also because board meetings are dominated by a management ethos of forced collegiality and agreement.”[86]  Independent directors are ill equipped to second-guess the decisions of management in a meaningful way.  Not only are they dependent on inside directors for information, but they are kept from “posing hard questions and framing strategic alternatives” which could allow them to “be drawn into real discussions of company policy and might well reject management’s views when warranted” by social and professional norms and personal sympathy with the positions of the company’s officers.[87]

One circumstance stands out as an exception to the general inability of independent directors to exercise meaningful and independent business judgment.[88]  When an acquirer approaches a corporation, the judgment of independent directors becomes vitally important.[89]  Because inside directors have their careers at stake in a potential sale of the company and it is their management of the firm that is being challenged, the “omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders”[90] taints any decisions they may make about the takeover bid, and courts will conduct a review of the decision before affording it the benefits of the business judgment rule.[91]  Outside directors are granted more deference when decisions about mergers are reviewed by courts.[92]  In the takeover context, outside directors play an important role and are expected to make judgments about the future, or demise, of the company mostly independent of insiders.[93]  This is one area where the expertise of a board of directors without close personal or financial ties to the firm may be useful, particularly to the extent that that board may represent the shareholders’ interests in maximizing the value received for their shares.[94]

Because of the heavy reliance on inside directors and other officers to perform the board’s management function outside of the takeover context, a board of directors does not clearly constitute a separate, additional decision-making body.  The board can only do so much, in addition to what senior managers have already done, and it really only serves as a backstop, or a final quality check, before a major decision is finalized.[95]  In order for a board of directors to be worth the time, expense, and effort it represents, it should perform a function that is both valuable and distinct from the work others are already doing.  Some would argue that this special function is the work the board performs by mediating among the various parties that have claims against the corporation’s assets.[96]

If the firm is a nexus of contracts,[97] or a nexus of relationships among people and entities, then managing those relationships is an important responsibility of the board.  The board must balance the requirements of loan covenants against shareholder expectations for profit maximization and dividend payments, all while honoring other contracts into which the firm has entered.  The board must determine how to advance the shareholder interest in profit maximization in the face of relevant laws and regulations that constrain the firm’s business activity and its ability to take investment risks.  A working corporation has a number of moving pieces, and those managing the corporation must take care that those pieces do not collide in a way that will do harm to the firm.

Mediating between corporate constituents requires a solid working knowledge of the rights each party has against the corporation and the corporation’s reciprocal obligations.  The board must understand which parties can enforce which rights in what circumstances and how each set of rights fits—or possibly conflicts—with others.  Because senior officers often negotiate the firm’s contracts on its behalf,[98] they have more intimate knowledge of the deals than the board and may have to explain the interactions of the different relationships to the board.  Again, the board must rely heavily on the senior officers it is supposed to independently monitor in order to do its job.  When the board is asked to make big decisions that involve mediating among various interests, it is simultaneously supposed to be supervising officers’ work in setting up the various contracts in the first place and in making the decisions that have led to the firm’s current position.

Meanwhile, corporate constituents do not sit idly by when significant corporate decisions are at stake.  They work to influence board and officer decision making by threatening to stand on their rights or to use their powers to remove or replace officers or directors.[99]  Institutional creditors are a helpful example.  Major loans from banks include detailed covenants that dictate the firm’s capital requirements and its ability to distribute dividends in certain financial conditions, and that give lenders certain powers over corporate decision making.[100]  If the corporation violates a covenant, the lender may declare a default[101]—a declaration that can have serious consequences.  A default on one loan can, by itself, constitute a default on others[102] and cause a number of obligations to become due and payable immediately, which might lead to the firm’s bankruptcy.  Lenders do not want to declare a default any more than the corporation wants them to, but a creditor can use the threat or at least the right to declare a default as leverage to convince management that it should make certain decisions the creditor would prefer.[103]  A creditor might threaten to declare a default unless a corporate restructuring officer of its choosing is appointed or unless the CEO is replaced with someone the lender trusts and prefers.[104]  At the same time, shareholders can enforce their preferences by electing a new board or selling their shares.[105]  Shareholders might prefer that the board pursue a different course of action or may prefer that the board issue a dividend, while creditors, through the power reserved in their covenants, may be able to block the decisions shareholders would prefer.  The necessary mediation among various corporate constituents can be a significant component of the board’s management of the firm, particularly when considering decisions that may affect the firm’s capitalization or capital structure.[106]

The board’s role in these situations is, ideally, to favor the management decisions that are most likely to maximize profits without violating the law or running afoul of the firm’s contractual obligations.  The business judgment rule protects the board from liability for the manner in which it decides to strike that balance.[107]  The board’s role here might serve an important purpose when, for example, creditors and labor unions are both lobbying for particular positions that might compromise shareholder interests and shareholders are not otherwise adequately represented.  To the extent the board can juggle the claims and interests of various corporate constituents while working toward maximizing the firm’s wealth, it can serve an indispensable function for the corporation.

The board’s management, however, is not the best or the most direct way to perform the mediation function.  Because it must be brought up to speed about the relationships at issue before it can even begin to deliberate,[108] the board is not particularly well-situated to make a final decision and must rely heavily on the judgment of others more involved in the day-to-day business of the firm.  There is no reason to believe that the board’s judgment would be superior under those circumstances.  Further, the board does not directly manage most of the firm’s relationships with and among various constituents on a regular basis.  It only weighs in on particularly significant decisions.

When the firm is doing well, the board’s management role is very limited and it defers much more to the judgment of officers.[109]  In reality, the board’s most useful role may be as a group of experienced, collegial consultants available to advise officers about various business matters.[110]  Board members might provide useful connections to the business community or to particular groups with interests in the corporation or its business.[111]  They might have connections to government regulatory bodies that affect the company’s business.  These functions may be useful, but they do not make up a management role responsible for operating a business.  These advisory, or “relational,” functions could be performed by hired professionals or consultants and need not be contained in the body legally responsible for operating the corporation’s business.[112]  To the extent the firm relies on connections with governmental offices or agencies, there may also be ways to maintain connections by retaining certain people as consultants or counsel to the firm without placing those symbolic ornaments on the firm’s governing body.

The firm’s senior officers and managers work with various parties in interest to manage the firm’s relationships with its investors and the outside world.[113]  It is not outside board members, but officers, midlevel managers, and in-house counsel who work most directly with corporate constituents and perform the mediation function.  The board plays only a very limited role in mediating among the corporation’s constituents.  Those constituents take an active role in protecting their own interests and are able to influence management decisions that are important to them.  The day-to-day business of the firm—and so the state of affairs that leads to any decisions the board is asked to make—is largely determined by the interaction of corporate constituents with the firm’s managers.  The board does not perform a meaningfully independent role in the bulk of very important corporate decision-making situations.

Ronald Coase would predict that if we could simply allow corporate constituents to talk with one another when their interests conflict and allow managers to balance the various contracts with the firm between points of conflict, we might reach better outcomes than if we involve a relatively ill-informed third party.[114]  That does not mean transaction costs would be zero, of course, only that a number of transaction costs would be eliminated so direct bargaining could produce better outcomes.  For that reason, it may be appropriate to ask whether the board is in a particularly good position to perform the mediation function: is the board better suited to the task than others, and is a board-centric governance structure justified by the rather insignificant role we see for the board in practice?  The governance structure this Article ultimately proposes contemplates just that kind of communication between the corporation’s parties in interest while allowing the vestigial board to wither away.

II.  Moving Toward the Elimination
of the Board of Directors

Maybe the board structure is not all that many hope it could be, or intend for it to be, but that might not matter if it is still a useful second-best alternative.[115]  The problems with the existing board structure are significant, however, and matter very much to the extent they impede the ability of corporate investors to constrain the agency costs inherent in the corporate form.  The goal of reducing those agency costs has been the preoccupation of corporate law and scholarship for at least the last eighty years.[116]  Corporate monitoring boards are advisory at best and are not designed to bear the weight of responsibility placed on their shoulders by corporate law.  If enough people care about corporate accountability, it should be vitally important to find a way to meaningfully identify and respond to the behavior of the parties actually making decisions for the firm.  By erroneously believing that the board is in that decision-making position, our efforts to improve corporate law and practice are essentially impotent.  The failure of more independent boards to adequately control agency costs is an example of the difficulty the market and reforms have found in trying to fix corporate governance problems by tweaking the monitoring board.[117]  Understanding the reality of corporate decision making and developing a governance structure that openly acknowledges it is essential to providing more efficient, effective corporate management and to ensuring that various forms of effective accountability will be available for investors interested in corporate wealth.

I propose a corporate governance paradigm shift that would result in the eventual elimination of the board of directors.  Because eliminating the board of directors would be a dramatic change in the corporate governance structure—and one that is arguably not possible under extant law[118]—I offer a description of an intermediate step, a so-called “investor board.”  An investor board would be a board of directors made up of representatives of various corporate constituents, including shareholders, creditors, and senior managers.  The makeup of a particular investor board would correspond with the needs and true decision-making structure of each individual company.  Scholars have criticized some corporate governance reforms as requiring a one-size-fits-all board structure despite the fact that different companies have different needs.[119]  The suggestion of an investor board responds to those concerns by providing a blueprint various public corporations can use to design a board of directors that responds to their particular capital structures and the needs of their dominant constituents.  Such a board would accurately reflect the negotiations and relationships the board is expected to mediate.  It would be able to resolve conflicts among corporate constituents directly and knowledgeably.  Most importantly, an investor board moves us further toward an evolution of corporate governance that discards the vestigial monitoring board of directors in favor of a fluid, dynamic governance structure that accurately reflects decision-making power and authority within the modern large public corporation.

Path dependence may have taken us too far down the board of directors road without considering whether the board is necessary and whether the same objectives could be achieved without a board.  As I develop a framework for an investor board in this Part, I will explain at each stage how a component or advantage of the investor board can serve as a valuable step toward the elimination of the board.  I will then explain why progress down this evolutionary path would represent a significant improvement in corporate governance and decision making.

A.            Accurately Reflecting Corporate Decision Making

Part I detailed corporate law’s expectations for the corporate board of directors and explored reasons why those expectations may not be met by the current composition of corporate boards.  The contemporary board does not effectively achieve its stated purposes because it is both too independent to be an effective management body and not independent enough to be an effective monitor.[120]  In coming to terms with the realities of corporate decision making, we may appreciate that certain parties in interest are able to exercise more authority over corporate decision making than others.  Corporate managers, for instance, have much more influence over corporate business than directors can,[121] and creditors may be in a better position to directly influence managers’ choices than shareholders.[122]  By striking or threatening to strike, labor unions may be able to hold up the entire enterprise regardless of what business choices may be best for corporate wealth.  Allowing these parties to interact directly with each other when their interests conflict, and otherwise acknowledging their influence over corporate management in enforcing their contracts with the firm, may lead to a more accurate understanding of corporate decision making and may result in the more effective performance of the tasks currently assigned to the board of directors.  An important first step to eliminating the board is acknowledging that reality and putting those parties in formal monitoring positions with an understanding of their rights and responsibilities that corresponds to their relationships with the firm.

1. The Basic Structure of an Investor Board

An investor board would be made up of representatives of major corporate creditors, a shareholder representative, and, perhaps, labor representatives or others significant to the corporation’s business.[123]  Members of that board would be determined by the significance of their role in the corporation’s life or capital structure.  For example, significant senior creditors and indenture trustees of significant bond issuances would be granted board positions in their loan documents.  The notion of an investor board assumes a shareholder representative like the equity trustee, but, absent a single representative, the company’s largest shareholders could assume positions on the board or get together to select a representative.  A board so composed would be a more effective monitor of senior officers because its members would be less sympathetic to those officers, as well as less socially or professionally entangled with them.  Such a board would also know more about the decisions those officers may make on a daily basis, particularly as those decisions may affect the interests of the various member constituents in the corporation.  Because these parties already serve as effective monitors to a large degree, moving them to the position envisioned for the board could allow the corporation’s governance structure to more accurately reflect the reality of accountability on the ground.  While the investor board would start as a formal replacement for the monitoring board of directors, we may find that in time, the dynamic of the investor board is such that it need only meet to consider certain significant issues.  Over time, we may also find that a governance structure that assigns key constituents different but interlocking and complementary rights no longer resembles a formal board of directors at all.

Without a formal board of directors, the focus of the firm’s decision making would shift to senior officers.  An investor board could capture the important role of senior officers while also balancing their control over decision making against the monitoring powers of significant corporate investors.  For example, senior officers could sit on the investor board and hold voting power for the purpose of reaching important business decisions confronting the firm.  Senior officers make the big decisions about a corporation’s business, and lower-ranking managers make the day-to-day decisions that allow the company to realize the business plan and strategy promulgated by senior officers.  Those business decisions and policies are carried out and prioritized under the influence of the corporate constituents who would exercise oversight on an investor board.  A board composed of senior officers and influential parties in interest may do a better job of reaching management decisions because its members would have more intimate, first-hand knowledge of the corporation’s business than the current monitoring board.

2. Balancing Interests

The key to successfully redesigning the board in this manner is to make sure that the powers of all of the participating parties are equitably and appropriately balanced.  It must be clear what the goal of corporate decision making is supposed to be and how decisions will be reached to that end.  The corporation must also clearly decide what decisions require the input of which parties and who will have what degrees of control in particular situations.  A lot of these issues are already settled in investors’ agreements with the firm.  It will be important that no members of a board composed of corporate constituents are able to exercise more power than they would under their contracts with the firm, and that they will not be able to extract rents from the corporation at the expense of corporate wealth or the protected rights of other constituents.  Senior officers will be responsible for making most business decisions, with the investor board coming together only infrequently to make game-changing decisions such as whether to file bankruptcy or how to respond to a takeover attempt.  For instance, one creditor may already be able to veto a decision to hypothecate more corporate assets or take on additional debt, but its decision to do so may be checked by strong preferences of other, more powerful creditors, or the extent to which the corporation needs the new loan to stay afloat or pursue an important business opportunity.  Shareholders may be able to exert pressure by threatening to avail themselves of their rights to change management personnel or by signaling problems to the capital markets (and so the credit markets) by devaluing the stock through exit.

To some extent, the relevant parties have reached a balance considered optimal because they have negotiated rights and powers with the corporation and each has negotiated knowing the extant and possible rights of others.  Creditors have already reserved the power over the corporation they deem necessary.  They understand how the powers assigned other creditors, shareholders, or significant parties in interest may conflict with theirs or how those other parties may be able to exercise more power in some situations.  Similarly, shareholders understand that they have certain powers over corporate management and have the ability to vote on some corporate decisions, but that they have little control over the activities of officers.  Shareholders also realize that creditors may have more influence over corporate decision making during times of financial distress because those enhanced powers are expressly reserved in loan covenants.[124]

The contracts defining these investors’ rights in and powers over the corporation already fix an important part of the corporate governance structure.  Through the implementation of an investor board, those contracts could evolve to account for their enhanced authority and so eventually fill remaining gaps in corporate decision-making authority.  Eventually, those agreements could so completely define the interaction of particular parties at important moments in the corporation’s operation that a formal board of directors will be unnecessary.  The parties may exercise influence over various decisions, or those with particular concerns can confer as necessary and otherwise monitor management through the enforcement of their agreements with the firm.

3. Adjusting Shareholder Power

Indeed, it is the role and powers of shareholders that would require the biggest change to current corporate governance practice if an investor board were adopted.  Perhaps shareholders’ greatest power over corporate decision making is their ability to elect the members of the board of directors.[125]  If the board becomes a group composed of investor representatives and senior officers, then the shareholder power to elect board members is certainly diminished if not eliminated.  Two important shareholder protections must remain: shareholders must be able to choose an important part of the board and shareholder interests must be specifically represented as effectively as those of other corporate investors.  As to the first point, shareholders should be able to elect the senior officers to the investor board.  As mentioned above, a few senior officers could sit on the board for the purpose of advising and voting on business decisions.  Shareholders could select those officers and perhaps even elect the CEO.  That way, shareholders would maintain some power over corporate personnel.  Upon the elimination of a formal board of directors, shareholders could maintain this authority over the choice of senior corporate managers.  On the second point, particular shareholder representation—to counter creditor representation—would be required.  Some may argue that this shareholder representation is what the board is supposed to do now.  The shareholder representation envisioned by an equity-trustee structure is different because shareholders are not responsible for balancing corporate business concerns or making ultimate business decisions.  The shareholder representation on an investor board would focus on doing the shareholder job as it is assigned to shareholders, not running the corporate business.  The equity trustee can be a zealous advocate for shareholder interests, with a voice that will be appropriately balanced with other interests.  That scheme leads to better and more direct representation of the shareholder interest than the current board provides while still allowing corporate officers to make the business decisions for the firm.

In prior work, I have suggested a way for shareholders to find meaningful, sophisticated representation: an equity committee, made up of the corporation’s largest shareholders, that supervises and works in concert with an equity trustee who is responsible for representing shareholder interests to management.[126]  The equity trustee could sit on the board and represent the shareholder interest in wealth maximization to management and other corporate decision makers.  It could negotiate with other board members on behalf of shareholders and represent the shareholder role in the corporation’s power and capital structure.  Further, the equity trustee could recommend CEO candidates who could then be approved by shareholder vote.  The equity trustee would monitor the CEO with the help of the other board members.  The shareholders’ ability to remove or replace the CEO could have a significant effect on corporate governance.  The shareholders’ power would have to be balanced against the rest of the board’s role in monitoring management.

While significantly different in structure from the current regime, this change in the exercise of shareholder authority would not represent a revolutionary departure from current practices.  The choice of a corporation’s CEO is not free from investor influence now.  Creditors are able to pressure boards to remove and replace CEOs when corporations are in trouble.[127]  The creditors play an active role in monitoring the CEO.[128]  Giving shareholders power over who serves as CEO seems fitting given the power over corporate managers shareholders currently enjoy.  When the corporation is healthy, shareholders are responsible for monitoring the board, and the board is supposed to monitor and hire or replace the CEO with the shareholders’ interests in corporate wealth maximization in mind.[129]  It makes sense, then, to give shareholders more power over who serves as the CEO as a replacement for their power to choose board members if the current board structure is removed or replaced.

One possible way to balance the relevant interests and provide for some stability in management is to allow shareholders to elect the CEO at particular intervals, but to only allow removal of a CEO with a vote by the rest of the board or on account of defined “cause.”  If a CEO is doing a bad job, then the board should agree that his performance is subpar and a vote for removal should be successful.  Removal for specifically defined cause can protect a company from a particularly harmful CEO.  Even if other investors want to remove a CEO and are able to vote to remove or are able to pressure the shareholders to move for a change, the shareholders would choose the replacement—thus the shareholders retain primary control over that part of corporate management.

This exercise of authority replaces the power shareholders now have to elect the board of directors.  In fact, the power they exercise could have a more direct bearing on corporate management and decision making than they now have—shareholders would be able to exercise that power more effectively and directly through a sophisticated, informed representative.  Of course, the parties could reach one of any number of agreements about how to balance the power each constituent can wield over management personnel.  One of this Article’s objectives is to encourage such negotiation so that the constituents of each corporation find the right arrangements for their firm.

While the proposed regime would change some of the process of corporate decision making, the reality of power relationships would remain largely the same.  The CEO is already beholden to various investors and serves at the pleasure of the board, which purports to represent shareholder interests.  With an investor board, the board of directors replicates the monitoring relationships already extant in the modern corporation: creditors monitor through their loan covenants, labor unions enforce their collective bargaining agreements, and both groups have the ability to seek removal of the CEO if their rights are particularly compromised.  Still, a replacement CEO cannot be appointed without the approval of shareholder “representatives”—the modern board.[130]  In the new scheme, the replacement CEO would be chosen by more direct shareholder representatives responsible only for pursuing the interests of shareholder wealth maximization—without the current boards’ sympathy for management and with the advantages of a better understanding of the company.  This understanding would come from the closer monitoring a shareholder representative could provide because an equity trustee would devote more time and resources to representing shareholders in its portfolio of companies.

B.            Why a Post-Board Firm is an Improvement

An advantage of using a collection of active investors at the top of the corporate hierarchy is that it approximates the way corporate decisions are made and so provides a structure for more direct and meaningful accountability for corporate decision making.  Corporate law places such an emphasis on the role of the board of directors, and places so much responsibility and accountability on the board’s shoulders, that it may divert resources from understanding relationships that have more of a bearing on corporate decision making.  Bringing together the most effective board-monitoring parties should decrease the costs of corporate monitoring and decision making and should also highlight the parties responsible for particular decisions so that they can be held accountable for the jobs they are supposed to do.

An investor board would be better at monitoring than the traditional board because investors are not as sympathetic to management and so have the necessary distance from management to monitor more effectively.[131]  An investor board would also better perform the board’s management function because investors who closely monitor the corporation must understand the state of the corporation’s affairs to protect their own interests.  Additionally, investors already form opinions about the major decisions that should be made on the corporation’s behalf.  Of course, these opinions may diverge because of individual interests the board members have that conflict with those of the corporation.  For this reason, an investor board would represent a significant departure from the laws and norms underlying the structure of the modern corporate board and thus would require changes to the legal framework governing corporate management.  Nevertheless, because the recommended structure more accurately approximates actual decision making, it can provide for more predictable, meaningful accountability and do a better job of performing the limited functions of the modern board.

1. Better at Monitoring

An investor board would do a better job of monitoring management than the modern board of directors because the investor representatives would be more socially and, for the most part, professionally independent from management than current board members.  An investor board could, therefore, provide the kind of hierarchical monitoring that second-guesses the subject’s judgment that the board of directors is ideally supposed to provide for the corporation’s management team.  The professionals serving on the investor board would not be officers at other companies.  Rather, they would be responsible for representing the interests of those seeking to protect the expectations of certain investments.  Therefore, they do better professionally if there is more rigorous monitoring of corporate managers, rather than less, because the investors choosing them for their positions will evaluate them based on the job they do protecting those investors.  Most important, unlike current officers or directors,[132] they would not be setting a reciprocal precedent for the monitoring to which they would be subject themselves.

One caveat applies to the claim that investor representatives would be professionally independent from management.  In some instances, the corporation chooses which banks it borrows money from or may hire institutional shareholders to manage firm retirement funds[133] and so, in those circumstances, the corporation would be choosing the investors who would sit on the board.  When parties serving on the investor board depend on the corporation for business, they rely on good relationships with corporate managers.  In those instances, the investors themselves may want to curry favor with management so that they will continue to be selected by the firm.  Such conflicts have proven problematic for auditors in the past—auditors were responsible for independently reviewing corporate financial records, but relied on the managers whose work they were reviewing for business.[134]

Additional protections should be available in a post-board firm to prevent those conflicts from presenting a problem.  For example, the selection of creditors, at least private lenders, should be dominated by the terms of the loan.  Other corporate monitors can ensure that that this takes place and can also provide a check against the conflicted interests of any one investor.  Investor representative sympathies for managers would only be a serious problem if management selected a significant portion of the investors represented on the board.  In those instances, the selection of private lenders could be done with the advice and consent of other board members.  That way, allegiance to management would not be an effective way to maintain the relationship with the firm and the company may proceed on the merits of service offered by the investor or investor representative in question.

These potential conflicts of interest are easier to see and thus easier to guard against than those arising from the empathies plaguing the current board structure.  Investor representatives, by the very nature of their job descriptions (as zealous representatives of reasonably attentive investors[135]), would be less likely to feel sympathetic to management.  Investor representatives already monitor management on their clients’ behalf,[136] by enforcing loan covenants, for example, and do so without problematic allegiance to management.[137]  The dynamics of those relationships between investor representatives and managers should not change by simply elevating the monitoring the representatives do to a more formally recognized place in the corporate governance structure.

Investor representatives would also enjoy an informational advantage over the directors on a modern monitoring board.  Recall that board positions are not full-time jobs.  Most directors have very demanding careers apart from their service on corporate boards.[138]  They simply cannot stay informed about corporate business on a regular basis and must be brought up to speed quickly when it is time to make significant decisions.  Because they are already monitoring the management of relevant companies, investor representatives are paying attention to important information affecting their clients’ investments in a number of firms.  In this way, investor representatives could resemble the professional outside directors suggested by Professors Gilson and Kraakman.[139]  Each new board member would have a portfolio of companies on whose board she sits, and she could devote most of her professional energy to reviewing the information necessary to monitor those companies.

Investor board members would not focus solely on the information necessary to make management decisions or monitor managers.  Most important would be the information the investor must have to enforce its contracts with the corporation.  It is the enforcement of those contracts with the firm that constitutes most of the monitoring of management and most of the new corporate governance structure suggested here.  Monitoring that is driven by individual contracts with the firm can be more predictable for the managers being monitored, making the parameters of their jobs clearer.  The scope of investment contracts and the powers assigned under them also make the powers of monitors over management and the firm more transparent.

This contract-driven scheme resembles governance through “‘Big Boy’ letters” described by Professors Baird and Henderson.[140]  Baird and Henderson suggest that corporate governance by fiduciary duties owed to shareholders is an outdated notion and that sophisticated parties should be able to negotiate ex ante about the responsibilities they want to enforce against the firm’s managers.[141]  They then argue that courts should honor those agreements and that those agreements should in turn shape managers’ duties.[142]  In a corporate governance system dominated by contracts, those with an interest in how the corporation is performing and with interests to protect are paying close attention to corporate management with some, but not too many, means of responding to managerial decision making.  They are able to monitor one another, and each party’s rights, responsibilities, and powers are known to the others.  The enforcement of these contracts yields the most meaningful monitoring in corporate governance.[143]  That is why I propose bringing those relationships to the forefront of corporate governance and why I think that kind of monitoring is superior to the monitoring provided by an independent board of directors.  Bringing the focus more accurately to the parties doing the real governance work should improve our ability to hold the responsible parties accountable for corporate decision making and should make the decision-making structure more transparent and accessible.  It illuminates an important part of the corporate decision-making structure.

2. Better at Management

Because investors are often better informed than members of an independent monitoring board, and because investor representatives already play an important role in corporate decision making, an investor board, or a less formal group of investors, would also do a better job of performing the management function assigned to the board.  Investor representatives often know much more about the day-to-day operation of the business and the state of its capital structure than do monitoring boards, so they are in a better position to make major decisions.[144]  If asked to perform the board’s functions, investors would come into a decision with their own opinions about information acquired from officers as part of the monitoring and enforcement of their contractual relationships, so much of the information on which they would base decisions would not be presented to them immediately before deliberations on a particular question.  Further, the presentation of the information would not necessarily be shaded toward whatever outcome management preferred.[145]

One potential problem with giving investors control over corporate decision making is that they may have interests or other investments that conflict with the “best” course of action for the corporation.  Various investors may have differing risk preferences and may want to influence corporate management to honor their preferences in making business decisions for the company.[146]  A group of creditors could conspire to vote together to exercise control over the company to try to force it to take actions consistent with their creditors’ selfish interests.  This concern arises any time parties with potentially conflicted interests have decision-making authority.  This problem is considered in more detail below.[147]  For now, it is worthwhile to point out that there are several reasons it need not be an intractable problem and that those interested relationships may actually provide important advantages.

The board’s decision-making authority is extremely limited, so to the extent we are finding an alternative way to make those decisions, we are talking about a very limited universe of corporate decision making.  Combine the limits of the board’s decision-making authority with the ability of these investor representatives to influence daily decision making in more direct ways, and it is difficult to see how imputing current board responsibilities to the investor representatives would create a new problem or exacerbate an old one.  To the extent the board’s “independence” and lack of conflicted interest helps it represent shareholders, the shareholders of a company with an investor board would be more effectively and directly represented and have a greater ability to negotiate with the other investors who may compromise their current interests.  Replacing the monitoring board with one that more closely represents the corporate decision-making process serves largely to remove a vestigial middleman of sorts from the appropriate balancing of the financial interests that make up the modern corporation.

3. Contractual Accountability

Transitioning to an investor board would also enhance accountability for corporate decision making.  For instance, enforcement of investment contracts may be a better way to hold managers accountable to investors of all kinds than reliance on fiduciary duties has proved to be.[148]  Baird and Henderson suggest enforcing disclosure requirements against managers through ex ante provisions in investment contracts.[149]  That way, managers are responsible for making sure the corporation abides by disclosure requirements to various parties in interest.  Having received the required disclosures, the investors or corporate constituents in question could protect their other rights against the corporation.[150]  They need managers to make the proper disclosures to enforce their contracts, so it makes sense to hold managers personally responsible for faithfully providing important information about the business.[151]  Further, disclosure is a discreet and specific task that is relatively transparent thus investors will be able to reliably determine whether managers have complied.

Similar terms may be effective beyond disclosure requirements.  To the extent there are specific tasks managers can perform, investors can require them to do so and enforce those requirements contractually.  If managers cause breaches—with a certain predetermined degree of malfeasance—they can be subject to personal penalties or consequences as provided in investor agreements with the firm.  This would allow all corporate constituents to enforce their agreements with the firm and to hold managers personally responsible only for certain, specific obligations.  This prevents uncertainty for managers by delineating their responsibilities and limits the power of individual constituents over the firm and its management in ways other parties in interest can count on.

For instance, shareholders know exactly what power creditors would have over management under particular circumstances and could account for that power in deciding the best course of action.  As suggested above, the power to remove the CEO would belong to an investor board, or to a group of qualified investors, only under certain circumstances.  But if the CEO is removed, all shareholders would have the power to choose a replacement, keeping in mind that their choice should not be completely inimical to the preferences of creditors and other investors.  If shareholders do too much to compromise the interests of other investors, those investors may be unwilling to cooperate when deciding how to avail themselves of their rights against the corporation.

The success of a post-board governance structure relies upon carefully balanced rights and responsibilities among the parties in power, with full disclosure and knowledge of what those rights and powers are and how they may be exercised.  Its strength lies in the ability of the relevant parties to openly discuss what actions they might take to direct the course of the corporation’s business and what decisions each may make when confronted with important choices.  It brings the balancing act that current directors and officers must perform in their heads out into the open and allows for direct bargaining among the parties in interest.

The notion of managerial accountability under an investor board is very different from the traditional norm of relying upon fiduciary duties in corporate governance.  Currently, corporate governance relies heavily upon a fiduciary rhetoric that emphasizes an obligation for directors to run the corporation according to shareholders’ best interests.[152]  The rhetoric is often hollow and rarely leads to serious liability, basically eviscerating any threat of personal liability officers and directors might face.[153]  The choice Delaware courts have made—to not enforce fiduciary duties with personal liability—shows a wariness of using liability as a means to discipline corporate decision makers.[154]  Holding managers accountable through specific contract terms allows more predictable, meaningful liability.  This makes particular sense in the context of an investor board.  There, board members would only be accountable directly to the investors they represent.  Board members want to ensure that managers uphold the bargains the investors have made with the corporation, but only want other investors to be able to exercise clearly-defined powers over management.  In maintaining the proper balance among investors, it is crucial that all board members understand the powers of others as well as when and how those powers may be exercised.  Precise contract terms help to provide that certainty.

4. Leaving Fiduciary Duties Behind

Delaware corporate law relies heavily on fiduciary duties to address agency costs in the large, public corporation.[155]  What is lost in a purely contractual—as opposed to fiduciary—corporate governance regime is the ability to apply more flexible standards and decide ex post what constitutes a breach of the obligation to manage the corporation in the interests of corporate wealth maximization, or, more specifically, to avoid conflicts of interest that compromise a director or officer’s ability to decide what is in the corporation’s best interests.[156]  That loss would not be so great once one considers the fact that the protection afforded by fiduciary duties, outside the social-norm-creating benefits of the rhetoric, is not substantial and the costs associated with misunderstanding the extent of the legal protection provided by fiduciary duties may be significant.[157]  Those norms can arise without the pretense of supposed liability that results in significant wasted time, litigation expense, and legislative angst.  Vague liability rules do not have a place in corporate governance.

One concern about using vague liability rules has been the potential chilling effect of unpredictable personal monetary liability for officers and directors.[158]  We rely on corporate decision makers to exercise business judgment and hope that they will cause the corporation to make investment decisions reflecting a desirable level of risk.[159]  If those decision makers are afraid of being held personally liable for decisions deemed bad in hindsight, then they will likely not take profitable risks.[160]  The business judgment rule protects corporate decision makers from liability for what turn out to be bad business decisions, leaving conflicts of interest as the only reliable basis for personal liability under Delaware corporate law.[161]

That does not mean that corporate investors are powerless in the face of bad decision makers.  Bad decision makers are supposed to be replaced or punished (i.e., paid less than good decision makers).  The current corporate governance model provides officers and directors a great deal of job security.  Directors are generally only removed when they are not reelected in annual elections.[162]  Officers generally have to be removed by directors who tend to be sympathetic to the officers they have chosen because they do not want to admit that they have done a poor job of appointing or monitoring senior managers.[163]  Creditors have enjoyed some success in causing senior officers to be replaced but are only able to do so in the most dire of financial circumstances.[164]  In fact, a great deal of officer turnover occurs when a firm is experiencing severe financial difficulty,[165] but officer positions tend to be secure most of the time and are often otherwise protected by lucrative golden parachutes.[166]

In a post-board firm, officers may enjoy fewer protections and key decision makers may be easier to remove.  For one, investor representatives are directly accountable to those with interests in the firm and those who are actively monitoring their performance.  The officers who make the day-to-day decisions must report regularly to investor representatives in a manner prescribed by the investor contracts with the firm.  The CEO may be removed by the board, but is chosen at regular intervals by shareholder representatives.  This would allow investors to weigh in if they think the CEO is doing a bad job, but leaves the residual claimant the ultimate authority to choose the CEO.  Furthermore, reduced dependence on vague liability rules should mean that investors will remove officers who are performing poorly and officers will, in turn, work to build strong reputations for making profitable, wise decisions for their firms.  The enhanced monitoring provided by the investor board, and the ability investors will have to enforce particular contract terms, will mean that officers’ decisions are more carefully monitored and so can be more accurately evaluated.

Of course, any monitoring and accountability provided should not exceed efficient levels.  Stephen Bainbridge adopts Kenneth Arrow’s view of the relationship between authority and accountability in defending board primacy.[167]  Bainbridge points out that accountability cannot be so great that it overwhelms the authority the board is given to make business decisions for the firm.[168]  Second-guessing every board decision essentially robs the board of its authority and gives it to the parties that can hold the board accountable.[169]  The same concern would arise in a post-board firm to the extent officers may be held accountable for the business decisions they make or other corporate constituents could be held accountable for exceeding the bounds of their authority in making decisions for the firm.  Someone has to have authority to make business decisions and that authority cannot be second-guessed or overturned constantly.  Nothing about a post-board firm’s governance structure, as described here, undermines the business judgment rule or a deference to business decisions made by officers with technical knowledge of the firm’s business.  The accountability this Article encourages focuses on responding to existing violations of governance rules and norms rather than concentrating on defining new ones.  The idea is to hold managers who defraud investors directly accountable, not to limit the activities or discretion of honest managers.

5. Summary

A post-board firm would be run by its managers and representatives of major corporate investors and constituents according to a well-balanced system of contracts.  The investor representatives would fulfill the board’s monitoring role, while the officers would make management decisions subject to the rights and powers of significant parties in interest.  Investors thus empowered would be better at performing both board functions.  They have the independence necessary to be good monitors and the intimate knowledge of the corporation to be capable corporate decision makers.  Problems with conflicts of interest would be different, but not greater than, those faced by current monitoring boards and could be overcome through carefully negotiated and enforced contracts.  Investors would be able to strike a sensible balance of power directly by negotiating various rights and powers with the corporation and enforcing those as necessary, then negotiating with each other when the time comes for concerted decision making.

D.            Problematic Relationships in a Post-Board Firm

The most apparent potential problem with using an investor board as the dominant monitoring and decision-making body for a corporation involves managing the negotiation dynamics of the various parties.  How would various investor representatives interact?  Would they behave strategically to form coalitions to take power from other investors?  Would we allow creditors to exercise too much control over a healthy company?  How do we really moderate shareholder views, particularly as the views of various shareholders may differ?  Might more than one shareholder representative be necessary?  What do we do with divergent views and risk preferences?  Who wins?  What if the “wrong” party wins? We have long counted on the board of directors to mediate these disputes, break these ties, and fill these gaps.

Despite having a board to referee these interactions, these very questions have long plagued corporate governance.  Tomes have been devoted to determining whose interests should drive corporate decision making at different points in the corporation’s life.[170]  How the interests of corporate constituents should be balanced is an important question that dominates the board’s decision making under the current system.[171]  Allowing investors to assume the board’s role would not necessarily end these inquiries about the struggle for corporate control, but there is also little reason to believe that an investor board should make it more difficult to reach satisfactory answers or to find the right balance of power over corporate governance.  In fact, a post-board governance structure would allow each corporation to decide its optimal balance of power according to who its significant investors are and what interests motivate its business decisions.

In thinking about how dominant investors in a post-board firm would interact with each other, it is important to acknowledge that the board has limited power.  The board of directors is only charged with making a few significant decisions for the firm and is mostly concerned with monitoring the CEO and other senior managers.[172]  By shifting those roles to investors, we would simply be acknowledging more directly the monitoring and managing investors already do.  It does not add much to that authority to ask those investors to participate in decisions currently reserved for the board of directors.  Instead of giving the keys to the corporation to investors in a new way, we would be bringing investors’ power over the board’s limited decision-making authority out into the open.  The power investors can exercise over management outside of the board decision-making structure dwarfs the ability of the board to make business decisions for the firm.  Giving the board’s power to investors should not be cause for too much concern.

In the same vein, to the extent we worry that improvident alliances among various corporate constituents, to the exclusion of others, would undermine corporate priorities and the ability to reach decisions that are in the best interest of corporate wealth maximization, we should already be worried about such alliances.  Currently, creditors can form coalitions or coordinate with each other in the enforcement of their covenants.[173]  In fact, that is exactly what the bankruptcy system encourages.  The basic rules and structures of that system often bleed into pre-bankruptcy times of financial distress as creditors work with the debtor firm to arrive at accommodations that will allow the company to stay afloat.[174]  All of that work and negotiation is done to the practical exclusion of shareholders[175] and may or may not involve the concerns of other corporate constituents, depending on how vital those constituents are to the firm’s survival.  It is hard to see why creditors would take such an interest in the management of the firm if the firm is not either financially distressed or at risk of becoming so.  Enhanced powers over management when the firm is healthy are not reserved to creditors in the creditors’ contracts.

One may argue that by including creditors in post-board governance we allow them to cast meaningful votes about corporate decisions even when the firm is healthy.  That is not necessarily true if we define creditors’ roles in similar terms as we do now—that is, empowering them to influence corporate management only when the firm is experiencing financial distress.  To the extent a post-board firm does give creditors some power during times of financial health, creditors’ preferences should not diverge so widely from those of other investors in those instances.  It may be true that creditors disfavor riskier corporate business strategies and that their preferences differ from shareholders’ in that regard.[176]  However, it makes sense to limit creditors’ voting power during times of financial health and enhance it during times of financial distress, just as we currently do with creditor power provided in loan agreements.  Nothing about a post-board governance structure prevents such an accommodation—rather, the proposed structure encourages just that sort of balance.

Furthermore, we must think carefully about the possible effects of inappropriate collusion before we believe it is a significant problem.  Why would a creditor want to take time to run the company in a way the creditor sees fit unless the company is in serious financial trouble?  Using too heavy a hand when it could cause a corporation to be less profitable might cause corporations to disfavor a particular creditor in the future, which, in turn, might cause those creditors to lose business.  Additionally, excessive control by investors that hinders effective or profitable management of the firm may cause a corporation to lose good managers.  Similar problems could arise with shareholders who decide to use whatever authority they have to pursue short-term gain.  No one shareholder has absolute authority over the shareholder position and shareholders still have to assert their will through the decisions of officers and are still checked to some extent by the firm’s contracts with other investors and the power creditors have over corporate governance.  If shareholders push a management agenda that is too risky or that is ineffective, creditors stand ready to assert the considerable authority they would have in times of financial distress.

In a post-board governance regime, it would be easier to see collusive or potentially troublesome activities of corporate investors, bringing their management and monitoring activities into the open.  That would allow the firm to balance its contracts as necessary and would allow constituents with differing interests to check each other.  For now, it is important to set up the necessary safety nets to ensure that no one party has the power to dominate the firm (without buying that kind of control) and that no one investor can usurp corporate authority to the detriment of the firm or other investors.  It will take time to figure out what those agreements and relationships should look like and how they should be structured.

In the meantime, we should do what we can to remove obstacles to what may be a very beneficial and effective evolution of the board of directors.  If we remove legal obstacles that are not essential to useful functioning of the board and put in their place appropriate protective rules that provide more flexibility, then we may realize a deliberate evolution of the corporate governance structure to one that more accurately reflects the realities of corporate decision making.[177]  This strategy should lead to better monitoring and management and also a more effective way to hold those in charge accountable for performing their jobs faithfully and as expected.

The proposal set forth in this Article is intentionally nonspecific.  My intention is not to present a “new board in a box” to which one could add water and have a fully formed new corporate governance system.  I only intend to suggest a path toward what may be natural evolution for corporate governance so that we can see what agreements the relevant parties reach.  I think, in many important ways, the market has already begun work on this by changing the power structure of corporate decision making so as to render the monitoring board very weak.  The next step may be to remove corporate law’s focus on the independent monitoring board so that better governance structures may emerge in its place.  The next Part explains how to begin to do that so that the natural evolution of corporate governance may continue.

III.  Potential Obstacles

Any time someone suggests an innovation in corporate law, the first question posed to challenge the innovation is bound to be, “If it’s such a good idea, why hasn’t it happened already?”  Market forces have been at work on the best way to run a business for hundreds of years and the corporation has grown and changed dramatically in its history.[178]  We have reasons for the corporate governance structures we have chosen, and disturbing those carefully considered choices should be done cautiously and must be justified thoroughly.  If the current board structure is a product of rational market forces and wise choices over the course of generations, then those in favor of changing it drastically may face an uphill battle.

I argue that the changes to the current structure of the board of directors proposed by this Article reflect rather than upend the work market choices have done on corporate governance.  Corporate governance has evolved to the point that corporate constituents and officers exercise more power over the firm than the board, and to the point where the board of directors performs only the most superficial monitoring and is called upon to make few business decisions under the strong influence of the corporation’s officers whom they are charged with monitoring.  The weak position of the board in its very limited role is a product of market evolution, as is the strength of the influence of significant corporate creditors and the influence parties like proxy advisors and some institutional shareholders can have over corporate governance.  The law, not the market, preserves the place of the board of directors in corporate governance.

Market evolution has led us to a corporate governance structure that resembles the investor board suggested here.  To move formally to such a board, several intermediate steps are necessary.  First, legal impediments to the evolution of boards in this direction will have to be removed.  Then, we might find an intermediate step with an advisory board of investor representatives.  That might be a way to gather investor representatives in the same place so they can begin conferring with each other and pooling their monitoring abilities and information.  If they come together to advise and monitor the board, albeit in a nonbinding way, then the relationships may begin to evolve such that the “advisory” board replaces the traditional board of directors.  My goal in this Article is to set the stage for a new (and, I think better) way of constituting a corporate board and to argue that we should clear the way for corporate governance to evolve toward such a change.

Allowing corporate governance to evolve toward an investor board, and, eventually, the elimination of the board of directors, would require removing legal impediments to that evolution.  Rules mandating board independence would have to be relaxed, as would interpretations of prohibited conflicts of interest.  For instance, the investors dominating a post-board governance structure will necessarily be buying and selling the corporation’s securities while they or their representatives have access to material, nonpublic information.  Such conflicts would have to determine the extent to which certain parties could participate in corporate decision making and may result in additional requirements for pre-trading disclosures.

Certain laws relating to corporate governance would have to change to lower the barriers to this kind of evolution.  Lowering those barriers could result in some unintended consequences, and we should be careful not to remove the protections we have against opportunistic or self-interested behavior on the part of officers and directors that could harm the firm.  The emphasis here should be on removing or relaxing regulations that are not actually helpful or that constrain the evolution of corporate governance in unhelpful ways.  From there, any changes to that structure would have to develop slowly and carefully and perhaps reflect the needs of individual firms.  This last Part highlights ways those paths to evolution may be cleared and to suggest possible forms that evolution could take.

A.            Mandatory Board Structure

We might not have yet fully evolved to the governance structure suggested by this Article because state and federal law mandate some aspects of corporate governance.  Right now, the vast majority of corporations cannot dispense with the board of directors entirely because, under Delaware law, the corporation must be operated under the direction and supervision of a board of directors.[179]  Investors and their direct representatives cannot make up a majority of a corporation’s board because public companies must have majority independent boards: a majority of board members cannot have personal or financial ties to the firm.[180]  None of the members of an investor board would satisfy this definition of independence because officers would work for the company and the investor representatives would be working to directly represent the interests of those having financial ties to the corporation.  The Sarbanes-Oxley Act requires the boards of public companies to form audit and compensation committees made up of independent board members.[181]  These statutory and regulatory provisions mandate a corporate governance structure for public companies that an investor board would violate.

The application of common law principles of corporate governance would also have to be adjusted to accommodate the lack of board independence.  For instance, the application of the duty of loyalty to the corporate board would have to be tweaked to accommodate directors representing those with financial interests in the firm and interests that might diverge with those of the corporation.  The investor representatives would have to disclose their trading activities and interests they have that may be adverse to the corporation so that their decision-making authority can be altered accordingly.  Allowing investor board members to continue to trade in the corporation’s securities (trading that defines their board membership in many instances) would also require accommodations in the application of insider trading laws.  This Part addresses these regulatory obstacles and argues that some should be removed while others could be supplemented by special rules regulating the conflicts of interest affecting investor board members.

1. The Board “Requirement”

Delaware corporate law provides that:

The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.  If such a provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors in this chapter shall be exercised or performed to such extent and by such persons as shall be provided in the certificate of incorporation.[182]

The common understanding of this provision is that it requires that each corporation organized under Delaware law have a board of directors.[183]  To the extent the language in section 141(a) allows a firm to provide for a different governance structure, it has generally been interpreted to refer to the power of boards to delegate their authority to committees[184] or officers[185] in certain circumstances.  Nevertheless, section 141(a) is, strictly speaking, a default rule that corporations can contract around in their articles of incorporation.[186]

Thinking of section 141(a) as a default rule might provide an avenue through which corporations could evolve to post-board governance without overturning state incorporation statutes.[187]  Lynn Stout points out that corporations are free to adopt any number of governance structures at the outset, yet public companies have failed to do so.[188]  In fact, public firms and those preparing for IPOs have adopted provisions that strengthen board power vis-á-vis shareholders and hostile bidders.[189]  It is easy to see that the reasons for preferring a strong board of directors have little to do with regard for board decision making and are more likely driven by the fact that the choice is framed as one between giving dispersed, rationally apathetic, and unsophisticated shareholders power over corporate decision making or leaving that power vested in a board.[190]  If that is the choice, indeed board authority is the prudent course of action.  It is not realistic to frame the market choice as one between corporations with boards of directors and those without, because all public corporations have a board of directors.[191]  The infrastructure necessary to allow the elimination of the board in a large, public corporation is not yet in place.

That is why this Article suggests how we could allow the market to slowly move toward a post-board governance structure and does not propose that corporations eliminate boards of directors immediately.  Before the board of directors can be responsibly eliminated, better mechanisms for shareholder representation would have to be in place.  The governance structure of public corporations would have to change slowly.  Perhaps significant investors could begin by forming an advisory committee to more directly communicate with each other while monitoring management and influencing significant corporate decisions.  Then, perhaps that advisory board could take over for the monitoring board of directors.  Finally, the formal board structure could give way to a strong system of investor contracts.  Too abrupt a change would not be beneficial for corporations or investors, so it is inappropriate to take a measure of market preferences in the current regime as a signal of what may happen if market evolution is allowed to take its natural course.  There are still significant obstacles to the evolution away from the board and those legal obstacles must be removed to allow corporations to design the governance structure that best suits their needs.

That freedom is contemplated by state incorporation statutes that provide default terms around which organizing corporations can contract.  Where state law allows freedom to design firm-specific governance structures, the laws governing public companies place far more onerous requirements forcing firms to adopt more uniform governance regimes.  Where state law allows corporations to opt out of a governance structure dominated by a board of directors, federal law seems to prohibit that choice.  That is not to suggest that there is no role for federal regulation of public companies, only that state law has the right idea—adopt default rules that provide certain minimum protections from abuse, and let the parties design the form that works best for their company.

2. Regulations Requiring Independence

The New York Stock Exchange Listed Company Manual requires that listed companies have a board composed of a majority of independent directors.[192]  This would seem to rule out a listed company’s not having a board of directors at all and further defines what the composition of that board should be.  The listing requirements define an independent director as one having a “material relationship” with the listed company.[193]  A comment to the apposite section explains that “material relationship” is to be interpreted broadly and cannot be specifically defined, but would include “commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others.”[194]  This would seem to pose a problem for an investor board as all members would either be managers or investors in the firm.  Creditors would have “commercial” or “banking” relationships with the listed company.

However, the comment clarifies that it means “independence from management,” thus holding a large amount of stock would not necessarily make a board member “not independent.”[195]  That would seem to solve the problem and emphasize that the NYSE intended for boards to exercise their judgment—that as long as the investor did not have ties to managers, it might qualify as “independent.”  The regulation does not say “no material relationship with the listed company’s managers,” however, so it seems that those doing business with the firm or investing with the firm would not be considered independent board members.  A board made up entirely of those investors having “commercial” and “banking” relationships “with the company” and senior managers would not pass the independence requirement.  Because the comment explaining the requirement leaves the door to “independent” board members with financial interests in the firm, and the rule is framed broadly and in a way designed to allow discretion, it may not be difficult to adjust the rule to more clearly allow significant investor representation on the board of directors of a listed company.

Sarbanes-Oxley[196] requires that public companies have independent audit[197] and compensation committees.[198]  The committees are to be made up of members of the company’s board of directors who are “independent.”[199]  Again, these regulations so strongly assume that public corporations have a board of directors that they practically require that public companies have a board even though state law does not.  Furthermore, independence is not specifically defined, but contemplates members who would not be personally interested in the decisions assigned to the committee[200]—decisions relating to executive compensation and reviewing the work of the firm’s outside auditors.  Many investor representatives would be able to satisfy the independence requirements for the compensation and audit committees even if they would not qualify as independent directors for the purposes of satisfying the listing requirements.  Thus, part of the evolution proposed by this Article could take place under current Sarbanes-Oxley rules, thereby maintaining the protections those federal regulations provide, while the governance structure moves slowly away from the board-centric model.  Then, as firms evolve beyond the use of a board of directors, federal law may have to be tweaked to accommodate the change.

Congress cannot be accused of inventing corporate governance reforms that were out of step with corporate practice at the time they were adopted.  As described above, the market had evolved to favor the use of independent monitoring boards.[201]  The problem is that the regulations requiring the use of increasingly independent monitoring boards of directors artificially stalls that evolution.  The problems with the independent monitoring board have become apparent and each new regulation makes it harder for corporate governance to continue to evolve past the current ineffective board structure.  To the extent regulations force corporate governance to maintain ineffective or meaningless structures, they impose costs and prevent the market from correcting problems it discovers.[202]  Corporate governance has long been considered the province of the states because state law allows firms to adjust their governance structures to suit their particular needs and allows those structures to evolve over time.[203]

B.            Laws Governing Conflicts of Interest

Because directors are supposed to exercise independent judgment about which business decisions are in the best interests of the firm, corporate law focuses on ensuring that they do not place personal interest ahead of firm interest in their work for the corporation.  The fiduciary duty of loyalty prohibits conflicts of interest and self-dealing that compromise the corporation’s wealth.[204]  The federal prohibition of insider trading builds on the fiduciary duty of loyalty imposed by state law.[205]  It prohibits an officer or director’s trading of a corporation’s securities while in possession of material, nonpublic corporate information.[206]  The rationale for the insider trading prohibition is that corporate executives are supposed to use corporate information for the benefit of the firm, not for personal profit.[207]  They breach their duty of loyalty by trading on that information without first disclosing it to the market.[208]

In a post-board firm whose governance is dominated by investor representatives, it will be more difficult to separate investors’ individual interests from the work they do for the firm.  Their individual interests define their role with the firm and place them in their positions of relative power.  In fact, the representation of those individual interests makes investor representatives effective monitors and gives them the incentives to invest in the information necessary to make business judgments for the firm.  Conflicts of interest may pose a different sort of problem in a post-board firm that is regulated by contractual relationships rather than broad fiduciary duties.

The key to overcoming the difficulties associated with moving investors representing individual interests into the firm’s dominant decision-making roles is to understand that a post-board firm contemplates a different governance structure in significant ways.  First, the powers various investors exercise would vary depending on their contracts with the firm.  Different investors would have the power to influence different decisions to varying degrees.  This is in stark contrast to the current board structure that assumes that directors exercise equal authority when making corporate decision as a collective body.  An investment board, and eventually, a post-board governance structure, would make major corporate decisions by consulting the various parties in interest who have the power to influence a particular decision.  Again, that may be drawing on the fact of individual interests that may conflict with the best interests of the firm.  But, with just a few parties in interest at the table, the potentially conflicting interests of each will be more transparent.  Those conflicts can be managed the way director conflicts are now: with disclosure and appropriate modification of the relevant party’s decision-making power.

Regulating insider trading among investors whose trading defines their management authority within the firm and who will have access to substantial, perhaps nonpublic, information about the firm could present challenges.  Insider trading by investors represented in a post-board firm’s governance regime could be addressed in a number of ways.  In regulating insider trading in a post-board firm, we may draw on insights from the regulation of officer and director trading now.  Officers and directors are currently prohibited from trading on material nonpublic information and firms often set certain blackout dates defined by the release of certain corporate information during which officers and directors cannot trade in the corporation’s securities.[209]  In a post-board firm, certain investors may be banned from trading in the corporation’s securities, or derivatives based on the value of the corporation’s securities, while charged with authority to make corporate decisions.  Furthermore, regulations prohibiting investor representatives from sharing certain nonpublic information with their clients may be justified.  To the extent investor rights in a post-board firm mirror the rights influential investors have now, their trading should not present new problems.  If investors have access to more information in a post-board firm, securities law can adapt to address the insider trading risks those investors pose in the same ways it responded to the threat of officer and director trading.


The board of directors has become a vestigial entity that is structurally unable to achieve its intended purposes.  Many reforms have tried to tweak its structure to improve it, but those very reforms have made it even less meaningful and less effective.  Boards are both too independent to be good managers and not independent enough to be good monitors.  In the face of a weak board of directors, other corporate actors have taken a more active role in monitoring management and influencing important business decisions.  A firm’s investors and other influential constituents use their contract rights against the firm to influence management and monitor management more carefully than the board can to protect their interests and investments in the firm.

Because these corporate constituents can do the board’s job more effectively than can the current board, the formal corporate governance structure must evolve to reflect the realities of corporate decision making.  The corporate board of directors should be comprised of investor representatives and, for some purposes, corporate officers so that the parties that do the most to monitor management and decide the course of the corporation’s business can negotiate openly about how to balance and exercise their power over corporate decision making.  Changing the formal structure this way would focus attention and accountability on the actors responsible for corporate decision making.  Transparency that reveals how corporate decisions are really made—and who makes them—should improve that decision making by increasing accountability for those decisions.  We would be able to see who exercises what authority and so would not waste time, money, and energy trying to hold independent board members responsible for decisions they did not know about and could not have controlled.  In time, firms may move away from a formal board structure entirely, allowing the network of investor contracts and the interaction of those parties with management to perform the functions once delegated to the board of directors.

This Article does not offer a detailed description of what post-board firm should look like or what the investors’ contracts should provide.  Rather, it suggests that we allow corporate governance to evolve further down the path it has chosen.  The realities of corporate decision making reflect important choices by knowledgeable market participants.  We should remove obstacles that keep us from formalizing that reality.  A post-board governance structure would reflect a real change in corporate governance and the way we think about and implement management authority over a corporation.  It is impossible to say now exactly how that change should happen or what exactly it should look like because it should be the product of a careful and slow development informed by an appreciation of what structures best serve the needs of companies.  To suppose that the world of corporate investment has changed drastically in the last one hundred years[210] and that the governance structure of the firm has not or should not change at all is nonsensical.  Though we do not yet know what path market actors will choose, evolution away from board governance seems sensible and likely and the path for that evolution should be cleared of legal and regulatory obstacles.

* Loula Fuller and Dan Myers Professor of Law, Florida State University College of Law.  For helpful comments and conversations about this project, I thank Anthony Casey, Larry Cunningham, Jill Fisch, Brian Galle, Andrew Gold, Andrew Hessick, Carissa Hessick, Claire Hill, Zachary Kramer, Dan Markel, Larry Ribstein and participants at workshops at the 2010 Law and Society Association Annual Meeting, the Florida State University College of Law, and the University of Florida Levin College of Law.  I am very grateful to Lauren Vickroy and Sharee Davis for excellent research assistance.

[1]. Korn/Ferry Int’l, 33rd Annual Board of Directors Study 23 (2006).

[2]. See Del. Code Ann. tit. 8, §141(e) (2010).

[3]. Ronald J. Gilson & Reinier Kraakman, Reinventing the Outside Director: An Agenda for Institutional Investors, 43 Stan. L. Rev. 863, 872 (1991).

[4]. Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. Pa. L. Rev. 1209, 1226–28 (2006) [hereinafter Baird & Rasmussen, Private Debt].

[5]. Lucian Ayre Bebchuk, Jesse M. Fried & David I. Walker, Managerial Power and Rent Extraction in the Design of Executive Compensation, 69 U. Chi. L. Rev. 751 (2002).

[6]. Abigail Evans, Cooperation or Co-Optation: When Does a Union Become Employer-Dominated Under Section 8(A)(2) of the National Labor Relations Act?, 100 Colum. L. Rev. 1022, 1048–49 (2000).

[7]. Throughout this Article, when I refer to “public corporations,” I mean public firms with widely dispersed share ownership.  There are many public firms dominated by single shareholders or small groups of shareholders, but this Article’s proposal is aimed at those with widely held ownership.

[8]. Jonathan R. Macey, Corporate Governance: Promises Kept, Promises Broken 56 (2008).

[9]. See Del. Code Ann. tit. 8, § 141(e) (2010); Macey, supra note 8 at 51–52.

[10]. Macey, supra note 8, at 56 (“A crucial, but wholly unexamined, assumption underlying this foundational theory of corporate governance is that boards of directors can reasonably be expected to do what is required of them.  This assumption cannot withstand scrutiny.”).

[11]. See, e.g., Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 Va. L. Rev. 247 (1999); Lisa M. Fairfax, The Uneasy Case for the Inside Director, 96 Iowa L. Rev. 127 (2010); Jill E. Fisch, Taking Boards Seriously, 19 Cardozo L. Rev. 265 (1997) (warning that reforms calling for uniform standards for boards of directors may not improve corporate governance); Gilson & Kraakman, supra note 3; Donald C. Langevoort, The Human Nature of Corporate Boards: Law, Norms, and the Unintended Consequences of Independence and Accountability, 89 Geo. L.J. 797 (2001).

[12]. See, e.g., Sanjai Bhagat & Bernard Black, The Uncertain Relationship Between Board Composition and Firm Performance, 54 Bus. Law. 921 (1999); Victor Brudney, The Independent Director—Heavenly City or Potemkin Village?, 95 Harv. L. Rev. 597, (1982); Laura Lin, The Effectiveness of Outside Directors as a Corporate Governance Mechanism: Theories and Evidence, 90 Nw. U. L. Rev. 898 (1996).

[13]. Compare, for example, the perspective of Professor Stephen Bainbridge with those of his critics.  Bainbridge strongly supports boards, arguing consistently that a board of directors exercising unfettered discretion should serve at the top of the corporate decision-making structure.  See, e.g., Stephen M. Bainbridge, Director Primacy and Shareholder Disempowerment, 119 Harv. L. Rev. 1735 (2006); Stephen M. Bainbridge, Director Primacy: The Means and Ends of Corporate Governance, 97 Nw. U. L. Rev. 547 (2003) [hereinafter Bainbridge, Director Primacy]; Stephen M. Bainbridge, Why A Board? Group Decisionmaking in Corporate Governance, 55 Vand. L. Rev. 1 (2002) [hereinafter Bainbridge, Why a Board?] (explaining why a group, rather than an individual CEO, should dominate the corporate governance structure).  By contrast, other distinguished corporate law scholars challenge these views, emphasizing improvements in shareholder power, among other options.  See, e.g., Macey, supra note 7; Gilson & Kraakman, supra note 3; Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 Harv. L. Rev. 833 (2005).

[14]. An equity trustee is selected by a committee of the corporation’s seven largest shareholders and represents the entire common shareholder class to management in performing the shareholder role in corporate governance.  For further explanation and discussion of the concept of an “equity trustee,” see Kelli A. Alces, The Equity Trustee, 42 Ariz. St. L.J. 717 (2010) [hereinafter Alces, Equity Trustee] (developing in detail the innovation of the equity trustee and explaining what it is, how it could be implemented, and what its role in corporate governance would be); Kelli A. Alces, Debunking the Corporate Fiduciary Myth, 35 J. Corp. L. 239 (2009) [hereinafter Alces, Debunking] (arguing that corporate officers and directors do not truly stand in fiduciary relation to shareholders and the firm, and that equity representation could facilitate meaningful contracting to develop and enforce more effective corporate governance relationships); Kelli A. Alces, Strategic Governance, 50 Ariz. L. Rev. 1053 (2008) [hereinafter Alces, Strategic Governance] (suggesting that an equity trustee could help balance against strong creditor power over corporate management in times of financial distress to provide continuity in equity representation during times of differing financial success).

[15]. Del. Code Ann. tit. 8, § 141(a) (2010).

[16]. See, e.g., Bainbridge, Why a Board?, supra note 13, at 53.

[17]. Franklin A. Gevurtz, The Historical and Political Origins of the Corporate Board of Directors, 33 Hofstra L. Rev. 89, 108 (2004).

[18]. Id. at 110.

[19]. Id.

[20]. Franklin A. Gevurtz, The Function of “Dysfunctional” Boards, 77 U. Cin. L. Rev. 391, 395 (2008).

[21]. See Elizabeth Cosenza, The Holy Grail of Corporate Governance Reform: Independence or Democracy?, 2007 BYU L. Rev. 1, 18 (“Whereas in the 1960s most boards had a majority of in-house, non-independent directors, most boards today have a majority of outside, independent directors.”); Tamar Frankel, Corporate Boards of Directors: Advisors or Supervisors?, 77 U. Cin. L. Rev. 501, 504 (2008).

[22]. Cosenza, supra note 21, at 18 –19.

[23]. Frankel, supra note 21, at 505 (stating that, over time, CEOs began choosing the board members, rather than the board choosing CEOs, and the board’s role became advisory, rather than supervisory).  See also, Jay W. Lorsch & Elizabeth MacIver, Pawns or Potentates: The Reality of America’s Corporate Board 20 (1989) [hereinafter Pawns or Potentates] (explaining that traditionally, nominating and selecting board members was the “exclusive responsibility of the CEO”).

[24]. Frankel, supra note 21, at 505.

[25]. Id. at 504–06.

[26]. Melvin Aron Eisenberg, Corporations and Other Business Organizations 204 (8th ed. 2000); Frankel, supra note 21, at 503–04.

[27]. Frankel, supra note 21, at 508.

[28]. Id. at 507 (quoting Edward S. Herman, The Limits of the Market as a Discipline in Corporate Governance, 9 Del. J. Corp. L. 530, 533 (1984)).

[29]. Fisch, supra note 10, at 269.

[30]. Frankel, supra note 21, at 506–07.  For the SEC’s definition of independent director, see 15 U.S.C. § 80a-2(a)(19) (2006). See also, Developments in the Law—Corporations and Society, 117 Harv. L. Rev. 2181, 2187–94 (2004) (explaining both the NYSE and NASDAQ definitions of independent director).

[31]. Fisch, supra note 11, at 271.

[32]. Id. at 268–72.

[33]. Mark S. Beasley, An Empirical Analysis of the Relation between the Board of Director Composition and Financial Statement Fraud, 71 Acct. Rev. 443, 460 (1996) (finding that firms with larger proportions of outside directors were less likely to commit financial statement fraud).

[34]. Fisch, supra note 11, at 270–71.

[35]. Id.

[36]. Frankel, supra note 21, at 506–07.

[37]. This focus on directors may explain why Congress addressed officer accountability directly in the Sarbanes-Oxley Act of 2002. Pub. L No. 107–204, 116 Stat. 745.  Sarbanes-Oxley (“SOX”) was the congressional response to the corporate scandals of the early 2000s.  A jurisdictional glitch in Delaware law that made it impossible to get personal jurisdiction over corporate officers sitting in other states has been corrected, so we may begin to see more suits against officers for breach of fiduciary duty.  Of course, liability for poor decision making is exceptionally rare for directors, as they receive generous protection from the business judgment rule and Delaware General Corporation Law section 102(b)(7).

[38]. For a general discussion of board independence, see Stephen M. Bainbridge, Corporate Law 80–84 (2d ed. 2009).

[39]. 15 U.S.C. §§ 78j-1, 78j-3 (2010); Fairfax, supra note 11, at 136.

[40]. Lawrence A. Cunningham, Rediscovering Board Expertise: Legal Implications of the Empirical Literature, 77 U. Cin. L. Rev. 465, 478 (2008).

[41]. NASDAQ Rules 5600–5640: Corporate Governance Requirements, available at
=nasdaq-rule_5600&manual=/nasdaq/main/nasdaq-equityrules/ (last visited Sept. 16, 2011) (outlining qualitative rules relating to boards of directors, including audit committees, independent oversight of executive compensation, director nomination, related party transactions, and shareholder voting rights); NYSE Amex PART 8 Corporate Governance Requirements (2010), available at
-acg_8&manual=/AMEX/CompanyGuide/amex-company-guide/ (last visited Sept. 16, 2011) (specifying corporate governance listing requirements).

[42]. Daniele Marchesani, The Concept of Autonomy and the Independent Director of Public Corporations, 2 Berkeley Bus. L.J. 315, 322 (2005) (observing that Delaware corporate law permits transactions where a director has a personal financial interest, so long as a majority of independent directors—those without a personal interest at stake—approve the transaction).

[43]. Gilson & Kraakman, supra note 3, at 873.

[44]. Brudney, supra note 12, at 613 (“No definition of independence yet offered precludes an independent director from being a social friend of, or a member of the same clubs, associations, or charitable efforts as, the persons whose compensation or self-dealing transaction he is asked to assess.”).

[45]. Fairfax, supra note 11, at 146–49; Gilson & Kraakman, supra note 3, at 875 (observing that no definition of independence prohibits outside directors from befriending officers, and outside directors are often the officers of other companies and therefore will not monitor any more vigorously than they believe they themselves should be monitored).  For an in-depth discussion of the social dynamics of corporate boards, see generally Rakesh Khurana & Katharina Pick, The Social Nature of Boards, 70 Brook. L. Rev. 1259 (2005).

[46]. Gilson & Kraakman, supra note 3, at 875 (describing the various institutional, social, and financial mechanisms that draw outside directors towards officers, rather than shareholders).

[47]. Id. (noting that “[sixty-three] percent of outside directors of public companies are chief executive officers of other public companies”); see, e.g., Pawns or Potentates, supra note 23, at 18–19 (discussing the benefits and detriments of board members holding multiple positions as CEO in other public corporations).

[48]. Gilson & Kraakman, supra note 3, at 875 (arguing that “in addition to these dependency, ideological, and social obstacles to monitoring, outside directors typically lack an affirmative incentive to monitor effectively”).

[49]. Id.

[50]. Rachel A. Fink, Social Ties in the Boardroom: Changing the Definition of Director Independence to Eliminate “Rubber-Stamping” Boards, 79 S. Cal. L. Rev. 455, 464 (2006).

[51]. The American Bar Association has made this observation.  Report of the American Bar Association Task Force on Corporate Responsibility, 59 Bus. Law. 145, 158 (2003) (“Outside directors too often have relied almost exclusively upon senior executive officers, and advisers selected by such officers, for information and guidance about corporate affairs.”).

[52]. As Jonathan Macey points out:

[M]anagers have extremely high-powered incentives to present themselves, and their work, to directors in the most favorable light possible.  This, in turn, strongly suggests that the flow of information from management to the board will be biased in ways that put management in the most favorable light possible and undermine the effectiveness of dissident or uncooperative directors.

Macey, supra note 8, at 60.

[53]. See generally Lisa Fairfax, Government Governance and the Need to Reconcile Government Regulation with Board Fiduciary Duties, 95 Minn. L. Rev. 1692 (2011).

[54]. Id.; see also In re Am. Int’l Group, Inc. Consol. Derivative Litig., 965 A.2d 763 (Del. Ch. 2009); In re Citigroup Inc. S’holder Derivative Litig., 964 A.2d 106 (Del. Ch. 2009).

[55]. SOX is a prime example of this.  Pub. L. No. 111–203, § 10C, 124 Stat. 1900, 1900–04 (2002) (codified as amended at 15 U.S.C. § 78j-3 (2010)).  SOX requires board committees that focus on director selection, compensation, and auditing to be composed of independent directors.  Public listing standards promulgated at the same time require public firms to have majority independent boards.  The Dodd-Frank Act also requires some level of independence for various boards of directors.  Pub. L. No. 111–203, § 932(t), 124 Stat. 1872, 1882–83 (2010).  See id. at § 10C (outlining various requirements for the compensation committees for the board of directors of an issuer); see also id. at § 932(t)(2) (requiring one half of a nationally recognized statistical rating organization’s board of directors to be composed of independent members).

[56]. Gilson & Kraakman, supra note 3, at 884–86.

[57]. Id. at 885–86.

[58]. Id. at 885.

[59]. See Mark J. Roe, A Political Theory of American Corporate Finance, 91 Colum. L. Rev. 10, 56 (1991).

[60]. See Bainbridge, Why a Board?, supra note 13, at 7 (explaining that creating a hierarchical monitoring scheme in M-form corporations “addresses the problems of uncertainty, bounded rationality, and shirking faced by monitors . . .”).

[61]. Roe, supra note 59, at 56.

[62]. Id.

[63]. Id.

[64]. Bainbridge, Why a Board?, supra note 13, at 7 (explaining that the board of directors is at the top of the hierarchical organization of the corporation).

[65]. Id. at 4 (describing “authority-based decision making”).

[66]. See id. at 5.

[67]. See id. at 45.

[68]. Id. at 45–47.

[69]. See Gilson & Kraakman, supra note 3, at 875.

[70]. Edward B. Rock & Michael L. Wachter, Symposium: Norms and Corporate Law: Introduction, 149 U. Pa. L. Rev. 1607, 1609 (2001).

[71]. See, e.g., Stone v. Ritter, 911 A.2d 362, 364–65 (Del. 2006) (dismissing shareholders’ complaint because there was no proof that the board knew of the inadequacy of the corporation’s internal controls); In re Caremark Int’l, 698 A.2d 959, 970–72 (Del. Ch. 1996).

[72]. In re Citigroup Inc. S’holder Derivative Litig., 964 A.2d 106, 129–32 (Del. Ch. 2009) (holding that while Citigroup officers and board members may not have adequately understood the riskiness of the investments that constituted a large part of the company’s profit, and caused the company’s eventual collapse, their actions were covered by the business judgment rule).

[73]. Roe, supra note 59, at 14 (stating that scattered shareholders do not intervene in the decision making of management until something dramatic, such as a hostile takeover or leveraged buyout, occurs).

[74]. Macey, supra note 8, at 62 (“Where a CEO makes a proposal to a group of board members, the first board member to raise questions or to disagree with management bears the greatest risk of being branded uncooperative or non-collegial.”).

[75]. But see id. at 54 (stating that the role of directors has recently expanded to include greater participation in management decision making, in addition to its monitoring function).

[76]. Roe, supra note 59 (describing probabilistic monitoring).

[77]. Bainbridge, Why a Board?, supra note 13, at 49–54 (discussing the formal structure of the corporate governance system); Lynn A. Stout, The Shareholder as Ulysses: Some Empirical Evidence on Why Investors in Public Corporations Tolerate Board Governance, 152 U. Pa. L. Rev. 667, 668 (2003) (stating that directors decide “how the firm shall be run, whom it shall hire, . . . in what it shall invest [and] . . . whether corporate earnings will be used to pay dividends—or used instead to build empires, raise salaries, and support charities”).

[78]. See Frankel, supra note 21, at 504–07.

[79]. Donald C. Langevoort, Commentary: Puzzles About Corporate Boards and Board Diversity, 89 N.C. L. Rev. 841, 843 (2011) [hereinafter Langevoort, Commentary].

[80]. Id. (“[S]urvey data indicate that this is the function board members think they are performing most of the time.”) (citing Renee Adams et al., The Role of Boards of Directors in Corporate Governance: A Conceptual Framework & Survey, 48 J. Econ. Lit. 58, 64–66 (2010)).

[81]. Bhagat & Black, supra note 12, at 921.

[82]. Nicholas Johnson, Open Meeting and Closed Minds: Another Road to the Mountaintop, 53 Drake L. Rev. 11, 42 (2004).

[83]. See Robert W. Hamilton, Corporate Governance in America 1950–2000: Major Changes But Uncertain Benefits, 25 J. Corp. L. 349, 351 (2000).

[84]. Johnson, supra note 82.

[85]. Lynne L. Dallas, The Relational Board: Three Theories of Corporate Boards of Directors, 22 J. Corp. L. 1, 5 (1996) (discussing managerial dominance of the board).

[86]. Gilson & Kraakman, supra note 3, at 889.

[87]. Id.

[88]. Delaware courts often defer to the judgment of independent directors when those directors, or a special litigation made up of independent directors, refuse to bring a suit demanded by shareholders or move to have a derivative suit dismissed.  See Cunningham, supra note 40, at 469.

[89]. Cunningham notes the progression of this deference to the judgment of independent directors in the takeover context by tracking the jurisprudence during the takeover boom of the 1980s.

Delaware courts, continuing a pattern dating at least to the bribery scandal litigation, strengthened the appeal of independent directors by increasingly deferring to their decisions.  Using independent directors insulated from judicial review, self-interested transactions, cash-out mergers, adoption of poison pills, resisting hostile takeover threats, and simply “saying no” to them.

Id. at 470.

[90]. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985).

[91]. Id.

[92]. Id. at 955.

[93]. Id.  Even so, boards are allowed wide discretion to block takeover attempts, and corporate law has evolved to allow executives to make hostile takeovers virtually impossible.  Macey, supra note 8, at 123.  Because insiders are so thoroughly protected by antitakeover laws and a judiciary that is traditionally sympathetic to their interests in the takeover context, the threat of a takeover or a merger offer does not threaten their position in the firm as much as it otherwise might.

[94]. Curiously, a board’s decision to choose a course that is designed to enhance long-term shareholder or corporate value over short-term value was upheld in the takeover context.  The Delaware Supreme Court’s decision in Paramount Commc’ns, Inc. v. Time, Inc., 571 A.2d 1140 (Del. 1989), is the oft-cited example of a court allowing the board to make such a judgment over the objection of shareholders who would have preferred to take a higher cash value for their shares in a tender offer.  See also Stout, supra note 77, at 696 (“Change of control transactions consequently provide some of the best illustrations of the remarkable degree of discretion corporate law grants directors to favor nonshareholder interests at the shareholders’ expense.”).

[95]. Langevoort, Commentary, supra note 79, at 847.

[96]. See Blair & Stout, supra note 11, at 280–81; Stout, supra note 77, at 686–88.

[97]. Stephen M. Bainbridge, The Board of Directors as Nexus of Contracts, 88 Iowa L. Rev. 1, 9–10 (2002) (describing the “nexus of contracts” theory as the dominant model of the corporation among legal scholars, and placing its origins in Ronald Coase’s article, The Nature of the Firm, 4 Economica (n.s.) 386 (1937)); Antony Page, Has Corporate Law Failed? Addressing Proposals for Reform, 107 Mich. L. Rev. 979, 984 (2009) (explaining that in the “nexus of contracts” theory, the state supplies a standard contract in the form of default rules, which parties may negotiate to modify).  Note that there is some dispute about this characterization of the firm, with some scholars arguing that the modern corporation is a heavily regulated, formalized structure that lacks the flexibility in form that a “nexus of contracts” would contemplate.  See generally, Larry E. Ribstein, The Rise of the Uncorporation (2010).  Still others argue that the firm cannot really be a “nexus of contracts” because shareholders are unable to actually negotiate contract terms with the firm or its management.  See, e.g., Victor Brudney, Corporate Governance, Agency Costs, and the Rhetoric of Contract, 85 Colum. L. Rev. 1403, 1415–16 (1985) (“[T]o impute to investors knowledge of either the terms of the law when they first enter the ‘contract’ or the changes in the law while stock is held is pure fiction in the case of most individual investors.  In the case of institutional investors or market professionals who advise individuals about investments, it is hardly less.”).  See generally Robert C. Clark, Agency Costs Versus Fiduciary Duties, in Principals and Agents: The Structure of Business 55 (John W. Pratt & Richard Zeckhauser eds., 1985).

[98]. See, e.g., Anne Tucket Nees, Who’s the Boss? Unmasking Oversight Liability Within the Corporate Puzzle, 35 Del. J. Corp. L. 199, 251 (2010).

[99]. While “[s]hareholders nominally have the right to elect directors . . . , the dispersion of shares . . . [makes] the board . . . effectively self-perpetuating.”  Baird & Rasmussen, Private Debt, supra note 4, at 1214; see also Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 Stan. L. Rev. 751, 779 (2002) [hereinafter Baird & Rasmussen, Bankruptcy] (“The board can be replaced by the shareholders.”).  By contrast, creditors influence board and officer decision making in a more substantive way, particularly during times of financial distress.  See Baird & Rasmussen, Private Debt, supra note 4, at 1242–45.  For example, unlike shareholders, creditors—through elaborate loan covenants—have the ability to replace the CEO of the distressed borrower-corporation.  Id. at 1211.  Also, shareholders, because of their wide dispersal, “cannot often galvanize quickly when misfortune strikes.”  Id. at 1242.  Thus, not only do creditors exert more power, they actually provide a more efficient method of oversight.  Id.  Finally, labor unions similarly exert substantial influence over decision making through their stockholdings as pension funds.  See, e.g., Stewart J. Schwab & Randall S. Thomas, Realigning Corporate Governance: Shareholder Activism by Labor Unions, 96 Mich. L. Rev. 1018 (1998).  One way unions have exerted influence is through the heavy use of Rule 14a-8 to place proposals on the company’s ballot.  Id. at 1045.  Such union-sponsored proposals usually “involve standard corporate-governance issues designed to maximize the value of the corporation by improving the efficiency of the market for corporate control and aligning manager incentives with shareholder interests.”  Id.

[100]. For example, Visteon Corporation entered into a loan agreement with five banks following a negotiated bailout with Ford Motor Company.  The agreement contained various affirmative and negative covenants, including granting the bank group priority on after-acquired property and a prohibition on certain debt ratios.  See Visteon Corp., Amended and Restated Five-Year Revolving Loan Credit Agreement (Form 8-K) exhibit 10.4, §§ 7.9(a), 7A.1 (June 30, 2005).  For additional examples, see Delphi Corp., $2,825,000,000 Five-Year Third Amended and Restated Credit Agreement (Form 8-K) (June 15, 2005); Gen. Motors Corp., 364-Day Revolving Credit Agreement (Form 10-Q) (Aug. 7, 2007).

[101]. See Visteon Corp., Amended and Restated Five-Year Revolving Loan Credit Agreement (Form 8-K) exhibit 10.4, § 8, (June 30, 2005).

[102]. Heinrich Harries, Co-Financing Between Public and Private Institutions for Development Financing, 32 Am. U. L. Rev. 111, 117 n.15 (1982) (“A cross-default clause in a loan agreement that a default on any one loan by the borrower entitles the lender(s) to declare the borrower in default of its other loan obligations.”); see also Laura Lin, Shift of Fiduciary Duty Upon Corporate Insolvency: Proper Scope of Director’s Duty to Creditors, 46 Vand. L. Rev. 1485, 1507 (1993).

[103]. One way creditors may have leverage over management is through debt contracts which give the creditors the power to place handpicked persons on the board of directors in times of financial distress.  Baird & Rasmussen, Bankruptcy, supra note 99, at 779.

[104]. Baird & Rasmussen, Private Debt, supra note 4, at 1233.

[105]. Shareholders may also allege a breach of fiduciary duty to the extent the board seems to prefer creditors’ interests or preferred courses of action to their own but are likely to find that the business judgment rule precludes relief.  See Credit Lyonnais Bank Nederland, N.V. v. Pathe Commc’ns Corp., No. 12150, 1991 WL 277613, at *36 n.22 (Del. Ch. 1991).

[106]. Labor unions can be powerful influences on officers and directors and may have interests adverse to those of shareholders and lenders.  The struggle between General Motors and the United Auto Workers for years while GM crept slowly toward insolvency illustrates the point.  See Steven Greenhouse, G.M.’s New Owners, U.S. and Labor, Adjust to Roles, N.Y. Times, June 1, 2009, (discussing the UAW’s use of the threat of a strike to extract concessions from GM management, a move which ultimately contributed heavily to GM’s bankruptcy).

[107]. Credit Lyonnais Bank, 1991 WL 277613, at *36 n.22.

[108]. See Fisch, supra note 11, at 274 (explaining that the board must have detailed knowledge of the corporation prior to making decisions over corporate matters).

[109]. See Benjamin E. Hermalin & Michael S. Weisbach, Endogenously Chosen Boards of Directors and Their Monitoring of the CEO, 88 Am. Econ. Rev. 96 (1998) (putting forth a model that demonstrates that boards become less independent and thus engage in less monitoring of a CEO the longer the CEO has been in office); Langevoort, Commentary, supra note 79, at 846–47.

[110]. Langevoort, supra note 11, at 802–03.

[111]. Lynne Dallas, The Multiple Roles of Corporate Boards of Directors, 40 San Diego L. Rev. 781, 805 (2003); Langevoort, Commentary, supra note 79, at 843.  Professor Dallas explains that the relational role of outside directors allows the corporation to: “(1) coordinate with its external environment, (2) obtain advice and access to information from directors with differing backgrounds, skills, and networks, (3) enhance the support, status, and legitimacy of the corporation in the eyes of relevant audiences, and (4) effectuate monitoring of the strategic direction of the corporation.”  Dallas, supra.

[112]. Langevoort, Commentary, supra note 79, at 843 (noting that the advisory function could be performed by consultants while acknowledging that directors with important political or government connections can be valuable to some firms).

[113]. See Lin, supra note 12, at 914–16 (discussing ways the board of directors’ ability to monitor management is restricted by managements’ control of information and expertise).

[114]. The Coase Theorem, developed by Ronald Coase in his famous article The Problem of Social Cost, 3 J.L. & Econ. 1 (1960), dictates that if transaction costs are zero, then parties will reach an efficient distribution of wealth between them, regardless of their relative bargaining power or strength.

[115]. Benjamin E. Hermalin & Michael S. Weisbach, Boards of Directors as an Endogenously Determined Institution: A Survey of the Economic Literature, Fed. Res. Bank N.Y. Econ. Pol’y Rev., Apr. 2003, at 7, 7.

[116]. Adolf Berle and Gardiner Means are widely credited with describing the separation of ownership from control that defines the modern public corporation in their book The Modern Corporation and Private Property, first published almost eighty years ago.  Adolf A. Berle & Gardiner M. Means, The Modern Corporation & Private Property (Transaction Publishers 2009) (1932).  Since the publication of The Modern Corporation & Private Property, corporate governance law and scholarship has focused primarily on reducing the agency costs Berle and Means illuminated.  In another seminal work, Jensen and Meckling explained how various capital structures could work to constrain agency costs within the firm.  See generally Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305 (1976).

[117]. See Bhagat & Black, supra note 12.

[118]. See Del. Code Ann. tit. 8, § 141(a) (2010) (“The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors . . . .”).

[119]. See Langevoort, supra note 11, at 814 (“[T]he ideal board structure may be firm-specific . . . .”); Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack Corporate Governance, 114 Yale L.J. 1521, 1529 (2005).

[120]. See supra Part I.B.

[121]. See Alces, Debunking, supra note 14, at 249 (explaining that managers will permit their own self interests to direct their business decisions, resulting in greater monitoring of the corporation than any other form of loyalty or fiduciary duty would produce).

[122]. See Alces, Strategic Governance, supra note 14, at 1053–54.

[123]. This investor board structure is similar to corporate governance in other countries.  In Japan, for instance, corporations are owned and dominated by large banks.  German corporations have two boards—one that supervises and one that manages.  The supervisory board is selected by shareholders and labor unions and monitors the management board.  German banks dominate corporate shareholding, as in Japan, and shares in both countries are held in large blocks. Franklin Allen & Mengxin Zhao, The Corporate Governance Model of Japan: Shareholders are Not Rulers, 36 PKU Bus. Rev. 98 (2007), translated in Beijing Bus. Rev. (May 13, 2007) (working paper), available at‑Corporate‑Governance.pdf.  See generally Thomas J. Andre, Jr., Some Reflections on German Corporate Governance: A Glimpse at German Supervisory Boards, 70 Tul. L. Rev. 1819 (1996).  These economies are different from ours, however, and the dominance of banks on both the lending and shareholding side is very different from the American system.  The American system is intentionally diffuse relative to the other systems and no one bank is as able to completely dominate an American corporation.  Roe, supra note 54.  Therefore, the investor board and post-board firm suggested here is very different from the practical realities of foreign systems.

[124]. Alces, Strategic Governance, supra note 14, at 1073–78; Baird & Rasmussen, Private Debt, supra note 4, at 1231–32.

[125]. Julian Velasco, The Fundamental Rights of the Shareholder, 40 U.C. Davis L. Rev. 407, 409 (2006) (arguing that shareholders’ rights to elect directors and to sell their shares are more important than other shareholder rights).

[126]. Alces, Equity Trustee, supra note 14, at 747–50.

[127]. In fact, the power of the lender to appoint new management may be an event of default under a loan covenant or a condition of a loan itself.  See Baird & Rasmussen, Private Debt, supra note 4, at 1233; Frederick Tung, Leverage in the Board Room: The Unsung Influence of Private Lenders in Corporate Governance, 57 UCLA L. Rev. 115, 156–58 (2009).

[128]. Baird & Rasmussen, Private Debt, supra note 4, at 1233; see Tung, supra note 115, at 156–58.

[129]. See Tung, supra note 127, at 119, 133.

[130]. See id. at 118.

[131]. See Fairfax, supra note 11, at 130 (explaining that there is an “overwhelming consensus that boards should be dominated by ‘independent’ directors . . . [because they are] better equipped to monitor the corporation, detect fraud, and protect shareholders’ interests”).

[132]. See Macey, supra note 8, at 54.

[133]. See Jennifer S. Taub, Able But Not Willing: The Failure of Mutual Fund Advisors to Advocate for Shareholders’ Rights, 34 J. Corp. L. 843, 849–51 (2009).

[134]. John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. Rev. 301, 326 (2004).

[135]. The equity committee structure would make shareholders a more attentive group in monitoring the equity trustee than current beneficial owners are in monitoring the institutions managing their investments.  While the structure adds a layer of agents to agents watching agents watching agents, the focus of shareholder power in fewer, more sophisticated hands makes shareholder activity easier to observe and thus more accountable to the larger class of shareholders.  Alces, Equity Trustee, supra note 14, at 748–50.

[136]. See id. at 720.

[137]. Id. at 739.

[138]. Mark J. Loewenstein, The Quiet Transformation of Corporate Law, 57 SMU L. Rev. 353, 376 (2004) (“American corporate governance is wedded to the notion of directors who serve only part time and who have substantial, often overwhelming, responsibilities outside of the corporation(s) on whose board(s) they serve.”).  Twelve of Enron’s fourteen board members were outside directors with other demanding jobs.  The Chairman of the Audit Committee, for example, also worked at Stanford’s School of Business.  See Lisa M. Fairfax, The Sarbanes-Oxley Act as Confirmation of Recent Trends in Director and Officer Fiduciary Obligations, 76 St. John’s L. Rev. 953, 957 n.20 (2002).

[139]. Gilson & Kraakman, supra note 3, at 884–92.

[140]. Douglas G. Baird & M. Todd Henderson, Other People’s Money, 60 Stan. L. Rev. 1309, 1339 (2008).

[141]. Id. at 1315–56.

[142]. Id. at 1342–43.

[143]. See id.

[144]. See Alces, Strategic Governance, supra note 14, at 1098 (“[T]he equity trustee would monitor the corporation and remain informed as to its financial condition and important business decisions and capital structure, ready to spring into action when its agreement with the corporation requires it.”).

[145]. Langevoort, supra note 11, at 813–14.

[146]. Alces, Strategic Governance, supra note 13, at 1061–63.

[147]. See infra Part II.D.

[148]. Baird & Henderson, supra note 140, at 1338–41.

[149]. Id.

[150]. Id.

[151]. Id.

[152]. Lawrence A. Cunningham, Commonalities and Prescriptions in the Vertical Dimension of Global Corporate Governance, 84 Cornell L. Rev. 1133, 1165–66 (1999) (explaining that fiduciary rhetoric performs socializing, educational, and proselytizing functions in corporate governance).

[153]. Alces, Debunking, supra note 14, at 256 (“The current system relies on a clumsy combination of smoke and mirrors to discourage bad behavior through stern threats of possible liability while only punishing truly egregious behavior, often ineffectively and after it is too late.”).

[154]. Id. at 243 (stating that “fiduciary duties are not relied upon to discipline managers, and they are not enforced very often”).  The Delaware Legislature has similarly reflected this desire to punish directors without imposing personal liability.  Del. Code Ann. tit. 8, § 102(b)(7) (2008).  See Alces, Debunking, supra note 14, at 251 (“[T]he Delaware corporation statute allows directors . . . to opt out of personal liability for breaches of the duty of care.  [Therefore,] [o]fficers and directors must be punished for incompetence in other ways.”).

[155]. Baird & Henderson, supra note 140, at 1309–10.

[156]. Some scholars question whether the same duty of loyalty applies to officers as applies to directors.  Lyman P.Q. Johnson & David Millon, Recalling Why Corporate Officers are Fiduciaries, 46 Wm. & Mary L. Rev. 1597, 1600–08 (2005) (arguing that because officers are appointed, rather than elected, officers should be held to stricter fiduciary standards than directors, with agency law serving as the basis for imposing liability).  Still, a contractual system that does not rely on fiduciary duties would mean that officers would not be held to a fiduciary standard.

[157]. Edward B. Rock & Michael L. Wachter, Islands of Conscious Power: Law, Norms, and the Self-Governing Corporation, 149 U. Pa. L. Rev. 1619, 1640–45 (2001).

[158]. Geoffrey P. Miller, A Modest Proposal for Fixing Delaware’s Broken Duty of Care, 2010 Colum. Bus. L. Rev. 319, 332–33 (2010) (“Fear of overwhelming judgments against directors for a good decision gone wrong might deter people from serving on boards, or might discourage them from undertaking risky but desirable ventures if they do serve.”).

[159]. David Rosenberg, Supplying the Adverb: The Future of Corporate Risk-Taking and the Business Judgment Rule, 6 Berkeley Bus. L.J. 216, 221 (2009) (discussing arguments in favor of risk taking and the importance of allowing managers to exercise their business judgment in taking risks).

[160]. Miller, supra note 158.

[161]. Breach of the duty to act in good faith can also lead to liability, but the meaning of that term has been debated.  Most recently, bad faith has been characterized as malicious, willful behavior or behavior that evinces a complete disregard for the director or officer’s duties to the corporation.  See Andrew S. Gold, The New Concept of Loyalty in Corporate Law, 43 U.C. Davis L. Rev. 457, 469 (2009) (describing the Delaware Supreme Court’s decision in Disney V as defining a violation of good faith as acting with “an intent to do harm,” or actions “reflect[ing] a conscious disregard of a director’s duties”).  For unincorporated entities, Gold describes good faith as “contractual gap-fillers: they are a means of filling in implied terms when contracts are silent as to specific contingencies.”  Andrew S. Gold, On the Elimination of Fiduciary Duties: A Theory of Good Faith for Unincorporated Firms, 41 Wake Forest L. Rev. 123, 127 (2006).

[162]. The Delaware Code was amended in 2006 to specifically allow for this type of removal process.  See William K. Sjostrom, Jr. & Young Sang Kim, Majority Voting for the Election of Directors, 40 Conn. L. Rev. 459, 474–75 (2007).

[163]. Macey, supra note 8, at 58–60.

[164]. Baird & Rasmussen, Private Debt, supra note 4, at 1242–45.

[165]. A. Mechele Dickerson, Privatizing Ethics in Corporate Reorganizations, 93 Minn. L. Rev. 875, 915 (2009) (stating that “[e]mpirical studies have found that officers are replaced in roughly half of the firms who are in financial distress”); Tung, supra note 127, at 157 (explaining that the likelihood of CEO turnover is especially related to financial difficulties for firms with private debt).

[166]. David V. Maurer, Golden Parachutes—Executive Compensation or Executive Overreaching?, 9 J. Corp. L. 346, 351–52 (1984); Mary Siegel, Tender Offer Defensive Tactics: A Proposal for Reform, 36 Hastings L.J. 377, 377 n.4 (1985) (explaining that the justification for golden parachutes is that management, knowing it will be financially secure regardless of who is the victor in a takeover battle, will be able to accept or reject the tender offer in an objective fashion); Randall S. Thomas & Harwell Wells, Executive Compensation in the Courts: Board Capture, Optimal Contracting, and Officers’ Fiduciary Duties, 95 Minn. L. Rev. 846, 854 (2011).

[167]. Bainbridge, Shareholder Disempowerment, supra note 13, at 1747.

[168]. Id.

[169]. Id.

[170]. See, e.g., Bainbridge, Director Primacy, supra note 13; Baird & Rasmussen, Private Debt, supra note 4; Bebchuk, supra note 13; Dallas, supra note 82; Einer Elhauge, Sacrificing Corporate Profits in the Public Interest, 80 N.Y.U. L. Rev. 733 (2005); Frederick Tung, The New Death of Contract: Creeping Corporate Fiduciary Duties for Creditors, 57 Emory L.J. 809 (2008).

[171]. See Bainbridge, Director Primacy, supra note 13 (arguing that balancing the various interests of corporate constituents is a matter that should be left to the discretion of the board of directors); Blair & Stout, supra note 11 (explaining the mediating function of a board of directors).

[172]. Bainbridge, Why a Board?, supra note 13, at 9; James P. Holdcroft, Jr. & Jonathan R. Macey, Flexibility in Determining the Role of the Board of Directors in the Age of Information, 19 Cardozo L. Rev. 291, 291–92 (1997).

[173]. Tung, supra note 127, at 125.

[174]. Baird & Rasmussen, Bankruptcy, supra note 99.

[175]. Tung, supra note 127, at 178–80 (discussing the impact that lenders can independently have on the governance of corporations).

[176]. Id. at 178.

[177]. This is exactly what state regulation of corporate governance is designed to allow.  State corporate law is made up of enabling statutes with many default provisions designed to let incorporating parties design the best governance regime for their business.  Romano, supra note 119.

[178]. See, e.g., Harwell Wells, The Birth of Corporate Governance, 33 Seattle U. L. Rev. 1247 (2010) (discussing the changes, over time, of the corporation, and corporate governance’s reaction to those changes).

[179]. Del. Code Ann. tit. 8, § 141(a) (2010).

[180]. NYSE Amex Section § 802, Corporate Governance Requirements (2010), available at

[181]. 15 U.S.C. § 78j-1 (2006).

[182]. Del. Code Ann. tit. 8, § 141(a) (2010) (emphasis added).

[183]. If one were to use an online service to establish a corporation in Delaware, one would find a notation requiring that a board of directors be formed.  See, e.g., Incorporating 101, Harv. Bus. Servs., Inc., (last visited Sept. 16, 2011) (stating that, as a formality, the formation of a board of directors is required to establish a corporation in Delaware).

[184]. Del. Code Ann. tit. 8, § 141(c)(2) (2010) (allowing the board to designate a committee and stating that such committees “shall have and may exercise all the powers and authority of the board of directors in the management of the business and affairs of the corporation”); see also Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) (considering the business judgment of the corporation’s directors as delegated to a special litigation committee).

[185]. Grimes v. Donald, 673 A.2d 1207 (Del. 1996) (holding, in part, that a board of directors is permitted to delegate its decision-making authority to the firm’s CEO provided it has the power to do so).

[186]. Stout, supra note 77, at 669.

[187]. Id. at 698.

[188]. Id. at 669.

[189]. Id.

[190]. Id. at 698–701 (arguing that a mediating board should be favored as opposed to an independent monitoring one but preferring board decision making to shareholder authority); Bainbridge, Director Primacy, supra note 12 (maintaining that boards should be able to exercise discretion over corporate business without regard to preferred shareholder means because shareholders lack knowledge of corporate affairs and the necessary sophistication to make profit-maximizing business decisions).

[191]. Stout, supra note 77, at 669.

[192]. NYSE Listed Company Manual § 303A.01, available at (last visited Sept. 16, 2011).

[193]. Id. § 303A.02(a).

[194]. Id.

[195]. Id.

[196]. Pub. L. No. 107-204, 116 Stat. 745 (2002) (codified in scattered sections of 15 and 18 U.S.C.).

[197]. 15 U.S.C. § 78j-1(i) (2010).

[198]. Id. § 78j-3.

[199]. Id. § 78j-1(m)(3); id. § 78j-3(a).

[200]. Id. § 78j-1(m)(3).

[201]. See supra Part I.A; see also Langevoort, supra note 10, at 800; Romano, supra note 108, at 1526.

[202]. See Romano, supra note 108, at 1523.

[203]. Id. at 1529.

[204]. R. Franklin Balotti & Jesse A. Finkelstein, Delaware Law of Corporation and Business Organization § 4.16 (2008); see also Anadarko Petroleum Corp. v. Panhandle E. Corp., 545 A.2d 1171, 1174 (Del. 1988) (“It is a basic principle of Delaware General Corporation Law that directors are subject to the fundamental fiduciary duties of loyalty and disinterestedness.  Specifically, directors cannot stand on both sides of the transaction nor derive any personal benefit through self-dealing.”).

[205]. Stephen M. Bainbridge, Corporation Law and Economics 519 (2002).

[206]. Id.

[207]. Id. at 520.

[208]. Id. at 531–37.

[209]. See generally M. Todd Henderson, Insider Trading and CEO Pay, 64 Vand. L. Rev. 505 (2011).

[210]. Jill E. Fisch, Securities Intermediaries and the Separation of Ownership from Control, 33 Seattle U. L. Rev. 877, 877–88 (2010); Tamar Frankel, The New Financial Assets: Separating Ownership from Control, 33 Seattle U. L. Rev. 931, 933 (2010) (“[D]uring the past thirty years, fundamental financial concepts and designs have been warped or eliminated.”).

Article in PDF Form

By: Mira Ganor*


Studies of management’s disregard of the will of the shareholders have focused on combinations of entrenchment mechanisms and special governance structures.  However, management’s power to issue stock—a fundamental element of the ability of management to control the corporation regardless of the will of the shareholders—has received scarce attention.  This Article highlights the significance of the power to issue stock: when managers choose to ignore the will of the majority of the shareholders or when managers choose to circumvent the veto power of the minority shareholders, they often take advantage of their power to issue stock.  A top-up option, for example, which is studied in this Article, is contingent upon the managers’ ability to issue shares and dilute the voting power of the dissenting minority shareholders.  The poison pill is also contingent upon the managers’ ability to dilute a hostile bidder by issuing shares to the shareholders.  The ability of managers to use new stock issuances as a shareholder-circumventing mechanism is particularly important.  It plays a key role in the management’s arsenal and provides an incentive for managers to reserve this unique power and refrain from diminishing it by, for example, replacing equity-based compensation and equity financing with less efficient choices.  This Article explores the key power of managers to issue stock as well as the current and potential limitations on this power.  One such limitation is the size of the authorized capital of the corporation, which provides a ceiling for the total number of shares that can be issued.  The ratio of authorized non-outstanding shares to the issued and outstanding shares—what I shall call the “excess ratio”—is an indicator of the magnitude of the managers’ power to issue stock.  A study of the excess ratio reveals that corporations go public with a high excess ratio—the number of unissued authorized shares is more than three times the number of issued shares.  Further results of the study of the excess ratio are analyzed in this Article.


A company’s board of directors is entrusted with the power to issue stock.  Shareholder approval is usually not required for this basic managerial prerogative.[1]  Conventional issuances of stock by the board of directors generally serve valid business goals, such as financing the firm’s operations and motivating employees.  Raising funds for the company’s operations can be done through equity financing in which the investor gives the company money in exchange for an equity stake in the company.  Aligning the interests of recipients of the issued stock, such as employees and service providers, with the interests of the company is another business-driven motivation to issue stock.

A direct outcome of any issuance of shares is the dilution of existing shareholders.  Voting dilution occurs when the existing shareholder owns a lower percentage of the company than she had before the new issue of stock, and thus her voting rights represent a lower percentage of the total shareholder votes.  Voting dilution can occur even if the value of the shares of the existing shareholder remains the same and is undiluted by the issuance of new shares.  If the new shareholder purchases her shares for a fair consideration, it does not affect the value of the existing shareholders.  The voting rights of the existing shareholder, however, will be diluted if she does not participate in the new issuance pro-rata to her percentage holding prior to the issuance.  After the issuance of new shares, the old shareholder possesses a smaller percentage of the company, yet the company is worth more.[2]  If the consideration received for the new shares is lower than the intrinsic fair value of these shares, then the economic value of the old shareholders is diluted and their stake in the company is worth less after the issuance of the new shares.

This byproduct of issuing new shares, diluting the existing shareholders, can become the intended outcome of the managers.  They can use their power to issue shares to dilute the voting rights of the shareholders or to dilute the economic value of shares.  The managers can take advantage of this power to dilute shareholders to advance inefficient self-promoting goals.  Using the power to issue shares to circumvent the voting power of the shareholders can take several forms.

Perhaps the most common and renowned use of the power to issue shares is the poison pill.  Poison pills refer to shareholder-rights plans that enable managers to thwart a hostile takeover.[3]  These rights plans allow the existing shareholders, but not the raider, to acquire a substantial amount of new shares at an exceptionally low cost.[4]  The expected result of the poison pill, the dilution of the economic value of the raider, serves as a deterrent to a hostile raider.  The managers’ ability to dilute the hostile bidder prevents the takeover and entrenches the managers despite the support of the shareholders who may favor the hostile takeover.

The combination of several entrenchment mechanisms, and in particular the existence of a staggered board along with a poison pill, is especially effective in preventing a hostile takeover, even if the shareholders favor the acquisition.[5]  Yet, even a poison pill by itself can stop hostile takeovers.  For example, a poison pill helped Yahoo’s management in the famous failed attempt by Microsoft to complete a hostile takeover of Yahoo.[6]  Yahoo’s poison pill enabled its managers to dilute a hostile bidder by issuing cheap shares to the existing shareholders only.[7]  This poison pill rendered the takeover economically prohibitive ex ante.

The poison pill, along with a few other entrenchment mechanisms, has been at the center of the conventional focus of research on managers’ efforts to entrench themselves.[8]  The power to issue stock, a fundamental component of the poison pill, was not put at the center of the debate.  It is the power to issue stock, however, that enables the managers to entrench themselves using anti-takeover mechanisms such as the poison pill and the white squire[9] when shareholders are in favor of a sale.  The power to issue stock also helps managers sell the company when they are personally interested in the sale despite significant shareholder opposition.[10]

Top-up options, for example, which are studied in this Article, are powerful tools that have increasingly been used to dilute the voting power of opposing shareholders in takeovers supported by the board of directors.[11]  The grant of a top-up option as part of a takeover may allow for the consummation of a quick short-form merger without a shareholder meeting and despite the opposition of a significant number of the shareholders in excess of the statutory ceiling of ten percent of the shares.[12]  The effect of a top-up option is that a management-friendly bidder faces only a truncated supply curve at the tender offer.  This is because a top-up option lowers the percentage of shares needed to be tendered in order to have a successful outcome.  In addition, the speed of the takeover process makes it harder for a competing bidder to launch an opposing bid.  Like the poison pill, top-up options are contingent upon the managers’ ability to issue a nontrivial number of shares and thus dilute the voting power of the dissenting minority shareholders.

Therefore, through new share issuances the managers have the ability to disregard the will of the shareholders and diminish the shareholder voting power.  Managers can abuse this power for personal gain when they want to entrench themselves and prevent an efficient takeover of the company.  This is the general criticism of mechanisms like poison pills and white squires[13] that can be used by self-interested managers to prevent a hostile takeover.  Similarly, managers may want to push forward an acquisition despite significant shareholder opposition because the managers may stand to benefit from the transaction personally, either because they are related to the acquirer or because they expect to receive personal benefits from the sale, such as retention bonuses or perpetual thrones.[14]

To be sure, not all usages of the power to issue shares are inefficient and undesirable.[15]  In addition to equity financing and equity compensation, even indirect business usages aimed at influencing the outcome of the shareholder vote, such as a poison pill or a top-up option, can be desirable given certain scenarios.[16]  Yet, although there may be some cases in which managers’ use of their power to issue stock in order to dictate the shareholder vote is efficient, the existence of this power to issue stock and its limits[17] are likely to influence managerial decisions in inefficient ways that are in part discussed in this Article.[18]

In particular, in an effort to maintain their power to issue stock, managers have an incentive to refrain from using stock for other business needs.  This is because the managers’ power to issue stock is limited and is mainly capped by the authorized capitalization set in the certificate of incorporation of the company.[19]  As a result, managers have an incentive not to deplete the reserve of issuable shares, which may lead to excessive debt financing and overuse of monetary compensation.

This raises the question of whether or not the managers should have a restricted power to issue stock that would only allow them to issue stock for ordinary, nonorganic uses such as raising funds and aligning interests.  The managers could be completely barred from issuing stock unilaterally, without the approval of the shareholders.[20]  Conversely, should the managers be allowed to use the power to issue shares to influence the shareholders’ vote without any limitation?  In Maryland, for example, managers may be allowed to issue an unlimited number of shares for any purpose.[21]

In between these two extreme possible governance systems, there can be a policy that allows the managers to issue stock subject to certain limitations.  For example, the current Delaware regime restricts the managers’ power to issue stock and requires a cap on the total number of shares that can be issued without shareholder approval.[22]  This cap has to be included as part of the company’s certificate of incorporation.[23]  A nuance of this regime links the maximum number of shares that can be issued without shareholder approval to the number of shares that are already issued by setting the maximum as a percentage of the number of issued shares.[24]

Preemptive rights represent another possible restriction on the power to issue stock.  Preemptive rights allow the shareholders to participate in any issuance of shares pro rata to their percentage holding and thus can prevent dilution of the existing shareholders.[25]

The remainder of the Article proceeds as follows: Part I describes the shareholder power to issue shares, including the phenomenon of granting top-up options, and presents examples of such grants that illustrate the self-interest that has motivated these grants.  Current limitations on the issuance of stock are described in this Part.  Part I also examines the costs and benefits of the power while discussing possible incentive effects.  Finally, the results of an empirical study of the excess ratio are presented in Part II, and the final Part concludes.

I.  Issuance of Shares

Stockholders’ ownership of the corporation manifests itself in shares that give the stockholders various powers.  Most notably, the shares are assigned the right to vote on certain resolutions and the right to transfer and sell the shares.  Voting and selling shares are the conventional tools that stockholders have to control the managers and the corporation.[26]

The desirability and extent of the power of the shareholders to control the company through shareholder votes and sales of their stock has been vastly debated.  Most notably, Lucian Bebchuk in his salient work on corporate governance calls for an increase in the shareholder power and a decrease in managerial control.[27]  Other commentators have critiqued Bebchuk’s view, raising doubts regarding the desirability of shareholder primacy.[28]  In their renowned work, Henry Hu and Bernie Black exposed a major weakness of shareholder voting by demonstrating that share ownership and voting rights can easily be decoupled.[29]

Yet both the possibility of managers abusing their position as agents of the shareholders and the limits to the existing power of the shareholders to monitor the managers effectively are central to the quest of improving corporate governance, regardless of the answer to the question of the optimal level of shareholder control of the company.  As this Article will show, the power to issue stock in its current format enables managers to circumvent the will of the shareholders and promote the managers’ own self-interest at the shareholders’ expense.  To be sure, even opponents of the view that calls for enhanced shareholder power will support lowering agency costs and restricting self-enhancing and self-promoting managerial behavior that comes at the expense of the shareholders.

This Article focuses on strategic issuances of new shares in order to control the shareholder vote.  This is an abuse of managers’ power that creates agency costs by using the shareholder vote, the tool that is supposed to help shareholders monitor managers.  Issuance of shares can help entrench the managers when the shareholders would rather sell the company.[30]  When it serves the self-interest of the managers, issuances of shares can also help sell the company despite significant opposition of shareholders who are not interested in selling.[31]  As we shall see, the new shares may help the managers circumvent the will of the shareholders and promote the managers’ own interests.

Issuance of new shares has a powerful effect on existing shareholders, as it dilutes their holdings.  A shareholder’s voting rights are diluted by the issuance of new shares unless she participates in the new issuance at least pro rata to her old percentage holding in the company and thus maintains at least the same percentage of the company as she did prior to the new issuance of shares.  Issuance of shares can also result in an economic dilution of the existing shareholders.  Economic dilution occurs when the value of the shareholder’s stake in the company declines because of the newly-issued shares.[32]  The value of the existing shares will decline when the consideration received for the new shares is lower than their true value.[33]

The following example illustrates the dilution effect.  Suppose the value of a company is $100 and the shareholders of the company have a total of 100 shares.  A new shareholder pays the company $50 in exchange for 100 newly-issued shares, a price of $0.50 per share.  The new value of the company following the share issuance transaction is the sum of the old value of the company (i.e., $100) and the consideration the company received from the new shareholder (i.e., $50), equaling a total of $150.

The newly-issued shares give the new shareholder the rights to half of the company.  The old shareholders now own only half of the company because the other half belongs to the new shareholder (who owns 100 shares out of a total of 200 shares).  Thus, the voting rights of the old shareholders are diluted from 100% of the rights to vote to only 50% of the voting rights of the company.  In addition, the value of the shares owned by the old shareholders decreases to half of the new value of the company and is now worth only $75 (half of $150).  However, if the new shareholder pays fair value for the newly-issued shares ($100 for half of the company or $1 per share) then, following this fair transaction, the old shareholders’ stake in the company remains $100 (or half of $200) which is the new value of the company after receipt of $100 as consideration for the new shares.  The old shareholder now owns only half of the company, but half of a company that is worth twice as much as it was before the stock issuance transaction.

The value of the shares of the old shareholders remains the same, undiluted by the issuance of new shares if the new shares are issued for their intrinsic fair market value.  Yet the voting rights of the old shareholders are diluted even if the consideration the company receives for the new shares is fair, as long as the old shareholders do not participate in the new issue pro rata to their percentage holding prior to the issuance.

An examination of the contours of the managerial power to issue stock aids in understanding the agency cost related to this power.  Subpart A describes the rules governing the right to issue shares.  Subpart B and Subpart C describe usages of new stock issuances.  Subpart D reviews noncontroversial usages of stock issuances, and the latter Subparts discuss usages of the power to issue stock that can be questionable and that affect the control of the corporation.

A.            Rules Governing the Issuance of Stock

Generally, the board can issue stock without shareholder approval.[34]  This power, however, relies on the availability of sufficiently authorized but unissued shares.[35]  A company cannot issue more shares than the number of authorized shares of its capital that are not already issued.  Thus, the authorized capital sets the upper limit.

The size of the authorized capital, however, is not controlled by the managers alone.  The certificate of incorporation includes the amount of authorized shares of the company.[36]  Consequently, the shareholders must approve any changes in the number of authorized shares because the shareholders’ approval is needed in order to change the charter of the company.[37]

The number of authorized shares set out in the certificate of incorporation of the company is a statutory upper limit to the total number of shares the managers can issue.[38]  Managers can continue to issue shares as long as the total number of issued shares is smaller than the number of authorized shares.[39]  The number of shares that the managers can issue without receiving the shareholders’ approval equals the difference between the number of authorized shares and the number of shares already issued.[40]  Keeping everything else constant, the higher the number of authorized shares, the higher the number of shares that the mangers can issue.  Similarly, everything else equal, the lower the number of existing issued shares, the higher the number of shares that the managers can issue.

However, while the managers cannot unilaterally control the number of authorized shares, they have discretion about whether to issue new shares.[41]  Thus, in order to evaluate whether the number of authorized shares effectively restricts managers’ power to issue shares, we need to look also at managers’ ability to influence the number of already issued and outstanding shares.

Managers can refrain from issuing new shares to keep the number of shares that they can issue high in order to be able to issue more shares in the future.  For example, the managers may choose to finance the firm’s activities with debt rather than equity.[42]  Similarly, managers can opt to pay cash rather than to grant equity-based compensation to employees in order to keep the unissued share reserve intact.[43]

Another way for managers to affect the number of shares they can issue is through share repurchase.  In addition to new shares that are not yet issued, managers can use shares that had been issued but were bought back by the company, and thus are no longer outstanding, to sell shares without running afoul of the upper limit set by the authorized capital.  When the company repurchases shares, it increases the number of issued-but-not-outstanding shares, which are commonly referred to as treasury shares.[44]

When a company repurchases shares, however, it needs to pay for these shares.[45]  Paying for these shares can come at the expense of alternative uses for the company’s funds.  Conversely, managers who wish to conduct share repurchases may engage in excessive cash retention in anticipation of an opportunity for the share repurchase.[46]  If, however, the company independently plans to make a distribution to the shareholders, the managers may choose to do so by conducting a share repurchase rather than by distributing dividends.  By choosing share repurchases, the managers increase the number of shares that may be issued without shareholder approval.  There is evidence that suggests that managers opt for share repurchases instead of using dividend distributions.[47]

Indeed, the increase in the pool of shares available for employee stock option grants is one of a few advantages attributed to share repurchases over dividends.[48]  The repurchased shares can be used to compensate the employees.  Yet doubt has been cast on the need for share repurchases to conduct employee stock option grants that enhance shareholder value.[49]  Arguably, the shareholders would approve the requested increase of the number of authorized shares in order to allow such option grants.[50]

However, when the number of unissued authorized shares of the company is just enough for the option grants, the managers may be reluctant to use the surplus of authorized-but-unissued shares for the option grants.  Such grants may not leave a sufficient number of authorized-but-unissued shares that may be needed for other purposes that enhance the personal interests of the managers, such as entrenchment.  Unlike shareholder-serving employee option grants, certain manager-serving transactions are unlikely to receive the support of the shareholders and may not obtain the shareholder approval needed to increase the number of authorized shares.  Similarly, where the number of unissued authorized shares is just enough for the option grants, the shareholders may not agree to increase the authorized capital at the time of the option grants, knowing that it is not needed for the option grant but that the increase will allow the managers to issue shares in the future for different purposes without going back to the shareholders for approval.

Thus, the limit on the amount of shares that managers can issue without the approval of the shareholders influences the managers’ choice between share repurchase and dividends and adds an additional motivation in favor of share repurchases.  Yet, in spite of certain benefits attributed to share repurchases, there is evidence that suggests dividends are, at least in some cases, significantly more efficient than share repurchases and involve lower transaction costs.[51]

In addition to the quantitative limitation on the managerial power to issue stock, issuances of stock are subject to consideration requirements.  The Delaware requirements, however, are very lenient and allow for the issuance of shares in exchange for any benefit to the corporation.[52]  Moreover, the Delaware statute gives full deference to the directors’ judgment regarding the value of the consideration absent actual fraud.[53]

Another important mechanism that can reduce the number of shares that are issued and outstanding is a reverse stock split.  In a reverse stock split the company replaces the outstanding shares of all the shareholders with a lower number of new shares.  For example, in a reverse stock split, with a ratio of 1:10, every ten shares are replaced with only one new share.  Since a reverse stock split decreases the number of outstanding shares, it can increase the number of authorized but not outstanding shares of the company.  However, as with the case of changing the number of authorized shares, in Delaware a reverse stock split requires shareholder approval.[54]  Thus, the managers cannot unilaterally use a reverse stock split to increase their power to issue stock.

B.            Conventional Business-Operation-Related Reasons to Issue Shares

When the company needs funds for its operations it can generally consider financing either through equity or through debt.[55]  Limited access to equity or debt can dictate the capital structure of the corporation and thus leave no alternative for the managers but to elect the only available option.  For example, in the early stages of the corporation, high-tech startups usually do not have any tangible assets that can serve as collateral for a loan.[56]  Consequently, the ability of a startup founder to raise money for her risky enterprise through debt is practically nonexistent.[57]  In such corporations, financing is limited to equity financing and issuances of stock are crucial for the corporation’s continued operations.

To the extent that both equity and debt financing are available to the corporation, the management chooses the level of each of the financing sources and sets the capital structure of the corporation.  The managerial choice between these two sources of financing and its effect on the corporation have been studied by finance scholars.[58]  These studies show that the value of the corporation is sensitive to changes in the capital structure of the corporation, given real world assumptions of taxes, transaction costs, and inefficient markets.[59]  Thus, even when debt financing is available, it may be more efficient for the corporation to use equity to raise capital for its operations.  For example, debt may be available only if the corporation undertakes to agree to certain restrictive covenants that are designed to protect the lenders.[60]  Since the lenders do not share in the upside of the corporation, these covenants may be overly restrictive.[61]  Thus, the corporation’s ability to issue stock can be central for operations because the stock issuance enables the corporation to receive needed funds.

Grants of shares are also commonly used in another ordinary business-enhancing practice aimed at creating a common interest between the recipients of the new shares and the company.[62]  Equity-based compensation is the main example for this use of shares.[63]  When an employee receives equity in the company, she receives an incentive to increase the value of the company.[64]  Issuing shares is useful when the company is interested in motivating a person to increase the value of the company’s shares.  If the person participates in the upside of the company and is negatively affected when the company is doing poorly, it increases her interest in the success of the company.  To be sure, equity-based compensation can be vulnerable to managerial manipulation that weakens the incentive effect of the equity.[65]  However, commentators have shown that properly designed limitations, such as vesting schemes, unwinding limitations, and hedging restrictions, can ensure a closer connection between the equity compensation and long-term performance.[66]

However, neither raising money nor compensating employees has to be equity based.  Instead, the company can often use debt financing to support its operations and use cash to pay its employees.  Furthermore, when the company has liquidity constraints, the managers do not have to use equity even when they have no alternative to equity financing.  Rather, they can choose to scale down the business.  Reluctant to issue a considerable amount of new equity, the managers can revert to downsizing the operations of the company while forgoing growth opportunities and profitable projects.[67]  Similarly, paying cash to compensate employees through salaries and monetary bonuses and reducing the workforce are alternatives to the use of employee equity compensation.

C.            Control Related Uses of the Power to Issue Shares

The previous Subpart showed that managers can use the power to issue stock for basic business operations of the company.  This Subpart looks at more special uses of the power to issue stock that do not involve the daily operations of the company but rather relate to the ability of the mangers to control fundamental changes to the corporation.

1. The Poison Pill

The poison pill, a shareholders’ rights plan, is an effective antitakeover mechanism that enables the managers to block and deter hostile takeovers.[68]  The poison pill dilutes both the value of the raider’s shares and the voting power of the shares.[69]  The poison pill creates a credible threat to distribute new shares to all the shareholders except to the raider for a radically low price.[70]  The target managers’ ability to credibly threaten the issuance of a large number of significantly undervalued stocks makes a hostile takeover economically prohibitive.

A simple example may illustrate the mechanics of the poison pill.  Suppose the company has 100 million shares issued and outstanding.  The shares are publicly traded at $10 per share.  Suppose further that the management has put in place a poison pill that is triggered when a hostile acquirer accumulates 10% of the equity of the company.  Assuming that under the terms of the poison pill, once it is triggered, all the shareholders except for the hostile acquirer obtain the right to purchase one share for each share they own for half the price—then they will pay only $5 per share.

A hostile acquirer buys 10% of the shares of the company, 10 million shares, for $10 per share, for a total investment of $100 million.  This acquisition triggers the poison pill and the management distributes to all the shareholders, except for the hostile acquirer, new shares at a rate of one new share for each existing share.  The company distributes a total of 90 million new shares.  After the distribution, the company has 190 million shares issued and outstanding, of which the hostile acquirer owns 10 million shares.

In this example, the hostile acquirer’s stake decreased from 10% of the company to only 5.26% of the company.[71]  In addition, after the distribution of the new shares following the triggering of the poison pill, the company’s total value is $1450 million, the sum of the original $1 billion plus the consideration received for the new shares of $5 per each of the 90 million new shares or a total of $450 million.  As a result, the value of the hostile acquirer’s investment is now worth only $76.3 million,[72] almost a quarter less than the original investment.

The above example demonstrates that triggering a poison pill is very expensive to a hostile bidder.  The example also demonstrates that the mechanism of the poison pill relies on the managers’ ability to issue shares upon the triggering event.  In fact, in order to have a strong dilutive effect on the hostile bidder, the management needs to issue a very significant number of shares relative to the already issued shares.  In the above example, the company only issued one share for every share already issued, or a 1:1 ratio.  In a seminal study of poison pills, Guhan Subramanian reports that in the sample of large publicly traded software companies the average poison pill provided for thirteen shares of the target for each existing share, or a ratio of 13:1.[73]  These considerably larger ratios require a nontrivial, large number of authorized-but-unissued shares to enable the exercise of the rights under the poison pill.[74]

The desirability of the poison pill has been extensively debated.[75]  Supporters of the poison pill approve of the managers’ ability to prevent, or at least delay, a hostile acquisition of the corporation, arguing that a managerial veto may help enhance shareholder welfare.[76]  Holders of the opposite view, however, voice strong concerns about the significant agency costs that a poison pill creates.[77]  Managers may use a poison pill to block an efficient acquisition in order to entrench themselves.[78]  The managers may also use the poison pill to negotiate for personal benefits from the acquirer.[79]  A body of empirical studies supports the opponents of the poison pill and shows that the poison pill results in a significant negative effect on shareholder wealth.[80]

2. The Top-Up Option

Another nontrivial use of the managers’ power to issue stock, the top-up option, also arises in the context of a change in control following an acquisition of the company.  Like the poison pill, a top-up option is granted to ensure the outcome the managers want to promote, regardless of the shareholders’ vote.[81]  Unlike a poison pill, a top-up option is used when the management prefers the acquisition;[82] the top-up option is designed to force through an acquisition and a subsequent shareholder freeze-out despite the opposition from a large block of the minority shareholders.[83]  Like the poison pill, as demonstrated in this Part, the top-up option is likely to involve agency costs and diminish shareholder wealth.[84]

A top-up option is a choice that the board of a company gives to a bidder who wants to acquire the company.[85]  After receipt of the option, the bidder conducts a tender offer.[86]  If the tender offer is successful and the bidder acquires at least a majority of the shares,[87] then the top-up option allows the bidder to proceed with the takeover of the company and buy directly from the company newly-issued shares that, together with the shares tendered in the tender offer, will represent 90% of the issued and outstanding shares of the company.  Owning 90% of the capital of the company allows the bidder to buy out the nontendering shareholders using a freeze-out short-form merger.[88]  A short-form merger does not require a meeting or a vote of the shareholders and leaves the shareholders with only appraisal rights as their sole recourse.[89]  In Delaware, a short-form merger only requires owning 90% of each class of shares of the company.[90]

a.  Mechanism

The following example illustrates the mechanics of the top-up option and the resulting implications to the company’s capitalization.  Suppose there are 100 shares issued and outstanding before the tender offer.  Assume the bidder received 50 shares in the tender offer, which also represent 50% of the total issued and outstanding shares of the company.  Following the exercise of a top-up option the company will issue new shares to the bidder, who will own 90% of the number of all outstanding shares at that time.  How many shares should the company issue to the bidder?  In this example the company has to issue 400 new shares to the bidder, increasing the total number of issued and outstanding shares from 100 to 500 shares.  After the exercise of the option the bidder will own 450 shares, comprised of 50 shares that she purchased in the tender offer from the shareholders and another 400 shares that the company issued directly to the bidder following the exercise of the top-up option.  The 450 shares held by the bidder after the exercise of the top-up option make up 90% of the new total number of shares, which includes 500 shares.  The following table summarizes the capitalization of the company.


Table 1: Company Capitalization


Bidder’s Shares

Non-tendering Shareholders

Total Number of Shares

Bidder’s Percentage

Tender Offer 50 50 100 50%
Top-Up Option 400 0 400 100%
Total 450 50 500 90%


More generally, to reach 90% of the shares, the company needs to issue the bidder ten times the difference between the percentage she has acquired and the desired 90%.  In the previous example, the difference was 40%—the bidder acquired 50% in the tender offer and thus was 40% short of 90%.  Ten times the difference of 40% is 400%.  The formula that can be used to derive the number of shares that the company needs to issue if a top-up option is exercised can thus be illustrated algebraically as:

X  =  (90% – Y) × 10

X represents how many shares the company shall issue to the bidder in exchange for the exercise of the top-up option as a percentage of the outstanding shares immediately before the exercise of the option, or 400% in our example.  Y represents the percentage of outstanding stock the bidder owns following the tender offer, or 50% in our example.[91]  Thus, as the formula demonstrates, a large number of shares is needed to use a top-up option.

Once the bidder exercises the top-up option, she needs to buy the new shares from the company and pay the same price for these shares that she paid in the tender offer.  A lower price will not represent a fair market price and may be easily challenged since the tender offer price establishes a fair market price for the shares.  As the example above illustrates, a large number of shares is issued when the top-up option is exercised; hence, the consideration that the bidder should pay the company for these shares is substantial.  However, the consideration for the shares can be, and often is, paid with an unsecured note except for a small part, which represents the par value of the shares.[92]  Following the short-form merger, the unsecured note issued in exchange for the shares is nullified because after this merger the holder of the note is combined with the issuer of the note and they become one.[93]

Therefore, the top-up option, like the poison pill, requires a significant number of authorized-but-unissued shares to allow for the management to issue shares as part of this scheme.

b.  Agency Costs

The power to issue stock to grant a top-up option to a potential bidder can be abused by self-interested managers and hurt the shareholders’ wealth.  The performance of a short-form merger after the tender offer not only allows for a speedy merger because there is no need for a shareholder meeting, a proxy statement, or a shareholder vote, but it also restricts the remedies available to the dissenting shareholders.[94]  Statutorily, the short-form merger is restricted to a situation in which the acquirer owns more than a simple majority of the shares.  In Delaware, the requirement is at least 90% of the company’s issued shares.[95]  The short-form merger protects against holdups by a very small number of shareholders who together own up to 10% of the company’s stock.  The top-up option artificially transforms the acquirer into a holder of 90% of the shares, while the dissenting shareholders constituted more than the maximum statutory threshold of 10% before the exercise of the option.[96]

A dissenting shareholder’s only remedy in a short-form merger is appraisal and not entire fairness.[97]  Thus, the use of the top-up option also protects the board that serves after the tender—the board does not need to perform a statutory long-form merger, which could have subjected the directors to a fairness review.[98]  In this manner the bidder can go ahead with the acquisition even in the face of sizable shareholder opposition.

To be sure, in exchange for the grant of the top-up option the managers may have succeeded in negotiating better terms for the selling shareholders—a higher purchase price.  However, the managers’ interest in the acquisition may be influenced by personal interests.  The managers may be connected to the acquirer through a business association or other relationship with the acquirer.  The acquirer herself may have been a member of the board, and as a result, the acquirer and other managers may have developed close ties because they served together on the board for a long time as colleagues.

The managers may also stand to gain from the acquisition directly.  For example, a promise from the acquirer to grant the target’s directors perpetual thrones (i.e., nominations to the board of directors of the acquirer, may personally incentivize the managers to favor the acquisition).[99]  The managers may have used their negotiation powers to extract benefits for themselves, which may include lucrative retention plans and retention bonuses as well as perpetual thrones.  In exchange for arrangements that benefit the managers, however, the shareholders may well have been deprived of the ability to extract a higher price from the acquirer.

The party interested in acquiring the company and freezing out all of the shareholders has a choice.  For one, the acquirer can ask the managers for a top-up option and reward them for their support.  Under this option, it is sufficient for the acquirer to receive only 50% of the shares in the tender offer and use the top-up option to own 90% of the shares.  Alternatively, the acquirer can conduct a tender offer without the support of the managers and without a top-up option, with the intent of receiving 90% of the shares immediately in the tender offer itself.

Convincing 50% of the shareholders to sell is not the same as convincing 90% of the shareholders.  A bidder must offer all the shareholders the same price per share.[100]  Since the acquirer faces diverse shareholders, rather than only one seller, she likely faces an upward-sloping supply curve,[101] meaning that more shareholders are willing to sell their shares at a higher price than for a lower price.  The higher the offer price used in the tender offer, the higher the number of shareholders willing to tender their shares at the tender offer.  The result is that if the bidder needs to receive more shares in the tender offer, she also has to increase the price offered.

The top-up option, however, essentially truncates the supply curve that the bidder in the tender offer faces and allows her to offer a lower price—the price that will clear only 50% of the shares rather than the higher 90%.  The remaining shareholders who did not want to sell for the low tender offer price will receive the same price paid in the tender offer in the freeze out short-form merger that will follow the exercise of the top-up option.[102]  Thus, it seems that the receipt of the top-up option allows the acquirer to buy the company for a lower price, which hurts the wealth of the shareholders.

The following example illustrates the effect of the top-up option on the price of the tender offer.  Suppose the company has four shareholders each owning 25% of the equity of the company.  Shareholder A values the company’s shares at $10 per share; shareholder B thinks the shares are worth $11; shareholder C assumes that the right price is $12; and shareholder D, being very optimistic about the future of the company, estimates the price of the share at $13.  The table below lists the values that each of the four shareholders assign to the company’s shares.  The holders of 50% of the shares will agree to sell the company for a price of $11 per share; however, the holders of 90% of the shares will not agree to sell the company for $11 per share.  If the holders of 90% of the shares must consent to the sale, the shareholders should be offered at least $13 per share.

Table 2: Shareholders’ Value of Company’s Shares



Price per Share

Accumulated Percentage

A $10 25%
B $11 50%
C $12 75%
D $13 100%


On occasion, the holder of the median share may agree to sell for a fair price; however, many times shareholders waiting for an opportunity to dump their shares form the bottom of the supply curve.  They will sell even at a lower price than the shares are worth, since they cannot do so in the open market because their sale of the shares would cause the price to drastically go down, causing them further loss.  A sale of a significant stake may negatively affect the market price.  The identity of the seller may also negatively affect the price where, for example, the seller is a sophisticated investor or is in a business relationship with the company and the market is likely to view such a sale as a negative sign.[103]  Thus, the price the holder of the median share is willing to accept may not represent a fair price.

It may be efficient to let the deal through at a lower price so that the shareholders waiting to liquidate their holdings may do so even at the expense of the other shareholders who would like to receive a more equitable value for their shares.  However, it may also be the case that it is not just a zero-sum game in which the acquirer wins because she pays less in a transfer of wealth from the shareholders to the bidder.  It may well be that the transaction is inefficient because the acquirer is going to run the operations of the company less efficiently than the company was run as a standalone operation before the acquisition.  In this case, the acquirer truly values the company less than the nontendering shareholders.

The appraisal rights of the dissenting shareholders are designed to ensure that these shareholders receive a fair value for their shares.[104]  Nevertheless, it is well known that the judicial appraisal remedy offers but a weak defense.[105]  Calculating the fair value of a share is not an easy task.  It is based on several assumptions that are hard to predict, such as the appropriate future interest rates and future exchange rates, and it involves forecasting methodologies that are far from being an accurate science.  Efficient markets help reveal the fair market value of shares.[106]  Yet, markets are rarely perfectly efficient, and indeed, acquirers do not pay the shareholders the price at which the shares are traded in the markets.  This affects the predictability of the outcome of the appraisal process and thus increases the risk of a small individual shareholder.

Furthermore, the appraisal litigation procedure involves strict requirements of notification deadlines and a short period for filing.[107]  On the other hand, the appraisal procedure itself may take years, is expensive, complex, and involves the risk of the acquirer becoming insolvent by the time of the resolution of the litigation.[108]  Thus, given the complexity and costs associated with the appraisal procedure, shareholders who oppose the short-form merger may be better off accepting the offered consideration and may choose not to use their right to a judicial appraisal even where they believe they are not fairly compensated for their shares.

The case of Gholl v. eMachines is an example of a successful appraisal action that included a top-up option.[109]  eMachines, a seller of personal computers and Internet services, went public in March 2000 at a price of $9 per share.[110]  By the end of 2000, eMachines was doing poorly and its stock was trading at only $0.5 per share.[111]  In 2001, in an effort to reform the business, the company hired a new management team, replacing its top ranking officials (both its CEO and COO) who introduced a new business plan.[112]

By mid-2001 the company’s business had completely turned around, despite the market perception to the contrary.[113]  The board considered its alternatives, including selling the company, and for that purpose started a bidding process.[114]  However, the only potential acquirer who offered to buy the company offered to pay less for it than the value of the company’s cash; thus, the company rejected the offer and ended the bidding process in mid-September.[115]

In October, one of the founders of the company, and a member of its board, submitted a low offer to purchase the company for less than the last offer made by the outside bidder less than three months before.[116]  The board contacted the outside bidder, and a bidding war ensued between the director and the outside bidder in mid-November.[117]  On November 16, the board announced that all final bids should be submitted within two days.[118]  The director won the bid, offering $4.2 million less than the company’s cash value and ignoring the value of the company’s operations.[119]  The price was set at $1.06 per share.[120]  Nonetheless, the company received a fairness opinion from a financial advisor that indicated the director’s offer was fair, based on valuation studies the advisor conducted.[121]

The board approved the merger, granted the bidding director a top-up option, and recommended the deal to the shareholders.[122]  The bidding director conducted a successful tender offer that did, however, leave him short of the 90% of the shares needed for a short-form merger.[123]  He then exercised his top-up option, acquired the shares he needed to reach 90% of the equity of the company, and performed a short-form merger—freezing out the minority nontendering shareholders by the end of the year.[124]

In the appraisal case brought by nontendering shareholders, the court did not rely on the auction price because it doubted the fairness of the auction and the effectiveness of the manner in which the auction was conducted.[125]  The court assumed that while “as a co-founder, insider, and director, [the bidding director] had access to internal projections and other inside information . . . it is unclear how the information regarding eMachines’ improving fortunes that was made available to [the outside bidders] compares to that available to [the inside director].”[126]  The court also noted that “[t]he quick termination of the bidding may have kept the price down and reduced the chances of another bidder entering the auction.”[127]  Thus, considering all factors available to it, the court came up with its own valuation of the company, a fair value of $1.64 per share.[128]

The difference between the tender-offer price of $1.06 and the price the court awarded, $1.64, an increase of about 55%, helps illustrate the potentially substantial agency costs that may be involved in a top-up option.  However, even though the bidding director lost the appraisal case and was ordered to pay 55% more than the offer price, he was forced to pay the higher price only to the former shareholders who exercised their appraisal right.[129]  Since only a small number of shareholders had exercised their appraisal rights, a mere 1,344,600 shares in total,[130] the bidding director had to pay less than $0.8 million extra,[131] which pales in comparison to his gain from the acquisition even when one only takes into account the company’s cash.[132]

In this case, the manager likely had inside information about the promising prospects of the company and thus may have benefited from the use of a top-up option that expedited the procedure, which was finalized before news about the positive change in the company’s forecast became public knowledge.  Not surprisingly, the other managers of the company supported their colleague, recommended the deal to the shareholders, and also granted a top-up option that facilitated the speedy completion of the acquisition.[133]

The appraisal route is the only remedy available to the dissenting shareholders after the short-form merger.[134]  It is possible, however, to try to challenge the actual grant of the top-up option by the board upon the announcement of the tri-step merger, which starts with the tender offer, proceeds with the exercise of the top-up option, and concludes with the short-form merger.  The grant of the top-up option is announced together with the imminent tender offer as part of one agreement between the bidder and the company.[135]  Challenging this agreement is not easy, and the main and clear beneficiary of such challenges seems to be the plaintiffs’ bar.  The following cases provide two examples of class actions that questioned the grant of a top-up option as part of a request for injunctive relief to prevent a tender offer from proceeding.  These proceedings help illustrate both the difficulty of challenging the grant of a top-up option under the current system and the potential agency costs associated with the top-up option.

In the case of the sale of ZymoGenetics, Inc. to Bristol-Myers Squibb Company, the plaintiffs asked the court for injunctive relief to stop the sale of ZymoGenetics.[136]  ZymoGenetics, a growing pharmaceutical company, was developing a few drugs that had a substantial market and a significant potential for success.[137]  The plaintiffs alleged that the directors of ZymoGenetics breached their fiduciary duties to the company’s shareholders by supporting the sale of the company for an allegedly unfair and low price in a process that included “unreasonable” devices.[138]  The complaint listed the top-up option as one of these devices and argued that its intent was to “circumvent the requirement of a shareholder vote.”[139]  The plaintiffs further alleged that the directors only agreed to the sale in order to further their own personal benefit.[140]  The complaint asserted that a few of the company’s directors had traded the interests of the shareholders for “hundreds of thousands of dollars in personal benefits.”[141]

Shortly after the filing of the complaint, the parties reached a settlement agreement.  The company and its directors continued to deny the plaintiffs’ claims; however, as part of the settlement the company agreed to provide the public shareholders additional information concerning the acquisition, including disclosing information of the transaction bonus that the CEO, who also served as a director, would receive upon the closing of the sale.[142]  The plaintiffs, on the other hand, continued to believe in the merit of their claims, yet plaintiffs’ counsel acknowledged the cost of continuing with the class action through trial and appeal, and the length of such proceedings, and determined that the settlement was in the best interests of the plaintiffs.[143]  As part of the settlement agreement the company also agreed to pay plaintiffs’ counsel $625,000 for attorneys’ fees and expenses incurred in association with the prosecution.[144]  Thus, the ZymoGenetics case shows that challenging the directors’ decision to grant a top-up option as part of a tender offer is not an easy task, but one that can be expensive for the company.

Another example of a futile attempt to receive injunctive relief in an acquisition involving a top-up option is the case of Cogent Inc., a developer of automated fingerprint identification systems, which was acquired by the conglomerate 3M Company.[145]  Here, too, the plaintiffs challenged the grant of the top-up option by the board not as part of appraisal proceedings prompted by the short-form merger, but rather beforehand as part of an attempt to stop the tender offer.[146]  The plaintiffs argued that the planned sale of the company was tainted because key employees, including the CEO who was one of its founders and served as president and chairman of the board, were personally interested in the merger, which promised them retention agreements.[147]

There was, however, another potential acquirer of the company who had offered more for the company.  The other potential acquirer was a competitor of Cogent.[148]  Yet, the court agreed with Cogent’s board that the deal with the competitor, which would require regulatory approval, involved a certain level of risk that justified preferring the deal with 3M despite the lower price.[149]  The court also considered the fact that Cogent’s chairman of the board had an exceptionally high equity interest in the company.[150]  This high equity interest in the company, the court reasoned, made it unlikely for the manager to favor a lower priced deal just because the bidder promises him a relatively insignificant retention bonus.[151]  Indeed, from a purely economic perspective, the increase in the purchase price would have more than covered the offered bonus in this case.

However, the likelihood that a manager would remain in charge of the operations of a company following a merger with a competitor seems less probable than the likelihood that his services would be needed if the company merged into an acquirer whose operations do not compete with the target.  The difference in the expertise of the employees of the acquirer, 3M, and the target, Cogent, two companies that were not competitors and did not operate in the same market, made retention of the target’s employees more likely.

Many founders value retention and remaining in control of the company not merely because of the continued pecuniary benefits they receive from the company, but also because controlling the company has an additional reputational and psychological value associated with the status of managing the company.  This added value of continuing to manage the company is not easily quantifiable.  For example, it was recently reported that Mark Zuckerberg, the founder and CEO of Facebook Inc., had declined an acquisition offer made by Microsoft, not because the offered price was too low, but merely because Mr. Zuckerberg was reluctant to relinquish control of Facebook.[152]  Thus, in spite of the large equity interest that the manager of Cogent had in the sale of the company, he may well have had an additional interest in the identity of the acquirer and his possible future relationship with the company that may have also influenced his decision to support the sale to 3M.[153]

In refusing to grant a preliminary injunction, the court in Cogent explained that this remedy is issued only when the plaintiff can clearly show an “imminent irreparable harm.”[154]  The court was not convinced that this was a case of irreparable harm, relying in part on the availability of the appraisal remedy: “Fully informed stockholders may voluntarily choose not to tender their shares and instead seek appraisal under DGCL § 262.”[155]

Following the Delaware Chancery Court’s denial of the request for a preliminary injunction in the Cogent case, the impression among practitioners has been that “the use of top-up options is likely to present little litigation risk.”[156]  To be sure, this result is reassuring to both boards of targets who wish to support the friendly bidder and the bidder herself.[157]

In the absence of a top-up option, a bidder who wishes to acquire the entire target company and freeze out all of the shareholders, but has not succeeded in owning at least 90% of the shares following the tender offer, can still proceed with her acquisition plan.  After acquiring the majority of the shares in the tender offer, the bidder can buy out the minority shareholders who did not wish to participate in the tender offer in a subsequent merger.  Owning less than 90% of the shares, however, forces the acquirer to conduct a statutory long form merger rather than a short-form merger.  Owning the majority of the shares allows the acquirer to approve a merger.[158]  Yet, owning the majority of the shares also transforms the acquirer into a controlling shareholder of the target, and thus subjects the subsequent merger to the enhanced and stringent fiduciary duty of entire fairness.[159]

A top-up option, on the other hand, converts the acquirer to a 90% shareholder and thus permits the use of a short-form merger.  This transformation is critical, since it subjects the freeze-out merger only to the lax requirement[160] of a possible appraisal procedure.  Thus, the top-up option allows the bidder to avoid entire-fairness review while freezing out the opposing shareholders, even without gaining the support of the holders of 90% of the target’s shares.

Adding a top-up option enables the holder of the majority of the shares to avoid fairness review in a freeze out of the minority even without reaching the threshold of 90% of the company’s equity.  Ignoring the will of nontendering shareholders who together own only a trivial number of shares may, at times, be efficient and serve the interests of all the shareholders, including the nontendering ones.  For example, it may be that a collective action problem is responsible for a few of the nontendered shares: some retail investors who did not tender may have done so only because they had not received the tender request or understood that they were asked to respond to the request.  However, while this may explain the behavior of a few shareholders, the closer we get to 50% nontendered shares the less likely it is that we face a collective action problem, but rather a different problem.  Forcing the holders of more than 10% of the equity of the target out with only the lenient appraisal protection may not serve the collective good.  In fact, as shown before, it may allow the bidder to pay the shareholders a lower price.[161]

Acquirers often prefer to use a tender offer followed by a short-form merger rather than a regular long-form merger.  One of the main reasons why acquirers prefer the two-step acquisition of a tender offer and a subsequent short-form merger is that it takes less time to complete.[162]  However, this expeditiousness may hurt the target’s shareholders, who are left with less time to consider the transaction.  Of even more concern is the fact that less time is left for competitors to enter the scene and compete with the bidder for the target.[163]

Not surprisingly, the use of a top-up option in tender offer acquisitions has dramatically increased since the middle of the last decade.[164]  The ubiquity of the top-up option highlights the importance of the power to issue stock and also helps camouflage managerial attempts to abuse the power to issue stock through the grant of the option because it has become the custom.

3. The White Squire

Similar to the poison pill and the top-up option, a white squire is a technique that uses stock issuances to make sure the managers’ wishes prevail despite shareholder opposition.[165]  Managers use a white squire to prevent a hostile bid the shareholders may favor.  Wishing to maintain their position with the corporation, the managers sell a block of shares to a friendly investor who subsequently opposes the hostile takeover and allows the managers to keep their jobs.[166]  Managers’ entrenchment motives explain the use of a white squire in the shadow of a hostile takeover where blocking the change of control does not seem to coincide with the best interests of the shareholders.[167]

For example, the management of Walt Disney Productions used its power to issue stock, which enabled it to recruit a white squire as part of its resistance techniques aimed at fending off a hostile bidder.[168]  In 1984, Disney faced the threat of a hostile bid for the company orchestrated by the corporate raider Saul Steinberg.  Steinberg initiated the proposed takeover by acquiring a large toehold—an equity stake in Disney.[169]  The management of Disney enlisted a friendly acquirer who purchased about 10% of Disney’s shares in exchange for a land development firm that Disney bought.[170]  The new block of shares issued to the friendly white squire diluted the hostile bidder and helped block the bidder’s attempt to take over Disney.[171]

It should be noted that straight vote buying, that is, managers’ use of the company’s resources to control the outcome of a shareholder vote, is specifically limited.  Shareholder voting agreements are generally permitted.[172]  However, in order to protect the shareholders from fraudulent behavior by management, the transfer of stock voting rights to management is prohibited if “the object or purpose is to defraud or in some way disenfranchise the other stockholders.”[173]  Such a transfer of voting rights is “a voidable transaction subject to a test for intrinsic fairness.”[174]  Instead of directly buying the vote, the managers create additional votes through their power to issue stock and distribute those newly created votes, along with the new shares, selectively.  Thus, vote-buying effectively can take a less direct form, such as the use of a white squire or a top-up option, which is much more difficult to challenge.

D.            Restrictions on the Power to Issue Shares

The previous Subpart showed that the power to issue stock can be exploited to the detriment of the shareholders.  The power to issue stock serves as a significant building block for power tools in the managers’ arsenal that can be used to circumvent the will of the shareholders.  Understanding the contours of the power to issue stock can be crucial in assessing the effectiveness of the firm’s corporate governance.  Thus, this Subpart examines the restrictions on the managerial power to issue stock.

1. Quantitative Restrictions

As seen above, in Delaware the difference between the size of the authorized capital—predetermined in the company’s certificate of incorporation—and the number of already issued shares, serves as an upper limit on how many shares management can issue without the shareholders’ approval.  In order to raise this ceiling, the certificate of incorporation of the company has to be amended to incorporate the increased number of authorized shares.  Such amendment can only be done with shareholder approval.  Provided there is a sufficient amount of authorized-and-unissued shares, however, Delaware corporate law does not restrict management’s ability to issue shares.

There is no limit in Delaware on the size of the authorized capital that may be set in the certificate of incorporation.[175]  A large capital may increase the fees that a corporation has to pay the Delaware Secretary of State because the fees are calculated based on the value of the corporation’s capital.[176]  The annual franchise tax, however, is capped and the maximum amount a Delaware corporation may be required to pay is $180,000 per year, a relatively insignificant expense for large public corporations.[177]

Other systems impose different quantitative restrictions on the power to issue stock without shareholder approval.  For example, under the German Stock Corporation Act the total amount of authorized shares may be increased by the shareholders to allow management to issue new shares.[178]  However, the total amount of authorized-but-unissued shares is limited to a maximum amount that should not exceed half the amount of the issued shares at the time of authorization by the shareholders.[179]

The listing requirements of stock exchanges provide another example of linking the higher limit of the amount of shares management can issue without asking for a new shareholder approval to the amount of issued shares.  Both the New York Stock Exchange and NASDAQ listing rules cap the maximum number of shares that the managers can issue without going to the shareholders at 20% of the number of issued shares.[180]  The experience with the listing rules’ restrictions on the power to issue stock indicates that they may have a real effect on the corporate governance of companies.

For example, NASDAQ reported attempts by managers to coerce a favorable shareholder vote on issuances of shares through entering into agreements that provide that the company is penalized and the bidder rewarded if shareholders deny approval of additional issuances.[181]  Such coercive transactions can stipulate a different price per share depending on the outcome of the shareholder vote: If the shareholders do not approve the transaction, then the investor will buy shares only up to the 20% cap in accordance with the listing rules, but will pay a much lower price per share than the price the investor would pay if the shareholders approve the issuance of more than 20% of the issued shares.  NASDAQ has recognized such behavior as coercive and strictly enforces the 20% cap rule, rejecting any attempts to influence the shareholder vote and circumvent the 20% cap rule.[182]

On the other hand, it may seem that the restrictions imposed by the listing rules fall short of the desired outcome in situations where the potential penalty for violating these restrictions, the delisting of the company, no longer poses a real threat to the company.  For example, where management considers issuing a top-up option to a bidder that will result in the issuance of more than 20% of the company’s shares without shareholder approval, it does not need to consider the outcome of delisting the company.  Following the exercise of the top-up option and the subsequent short-form merger with the bidder, the company will no longer exist as a separate legal entity; thus, the threat of delisting becomes irrelevant.  Not surprisingly, then, a top-up option agreement commonly states that lack of compliance with the stock exchange listing requirements does not release the company from its obligation to issue shares pursuant to the top-up option.[183]

2. Class Vote Restriction

A dual-class capital structure can be used in an attempt to circumvent the quantitative restrictions on the power to issue stock.  Section 151(e) of the Delaware Code allows for the issuance of convertible shares.[184]  A convertible share may be converted into a share of another class.  For example, a convertible preferred share can be converted into a common share.  Furthermore, the Delaware law permits the board of directors to set an exchange rate greater than one.[185]  For example, one convertible preferred share can be converted into ten common shares.  There is no statutory limit to the size of the conversion rate used for determining into how many common shares one convertible preferred share can be converted.  Issuing preferred shares convertible into common stock at more than a 1:1 ratio can partially circumvent the limitation on the amount of shares that can be issued, which the maximum number of authorized shares of the company imposes.

A sufficient amount of authorized-but-unissued common stock, however, is required for the conversion of the preferred stock into common stock.  Indeed, it is common for venture capital funds, which invest through convertible preferred stock, to require that the company undertake to reserve common stock for the future conversion of the preferred stock into common stock and to keep a sufficient amount of unissued common stock for the conversion.[186]  Yet, until the actual conversion takes place, the preferred stockholder can have the right to vote along with the common stockholders on an as converted basis, as if the preferred shares were converted into common shares, assigning more voting rights per one single preferred share than per one common share.

The Design Within Reach, Inc. example exemplifies the use of convertible preferred shares due to lack of authorized but unissued common stock.[187]  In this case there were not enough authorized shares of common stock that could have been issued to Glenhill in exchange for its investment of $15 million in the company.[188]  Instead, the company issued preferred shares convertible into common stock so that the investor owned about 91% of the company in a combination of common stock and convertible preferred stock, without a shareholder vote approving the stock issuance or any other part of the transaction.[189]

The ability of the augmented voting rights of the preferred shares to circumvent the quantitative restrictions on the power to issue stock is, however, also limited.  If a class vote is required, a favorable vote by a majority of each class of shares separately is needed, and thus issuing preferred stock is not a good substitute for common stock.  Approval of a short-form merger under Delaware law requires a class vote.[190]  Under Delaware law a short-form merger requires owning at least 90% of each class of the voting shares and not just 90% of the aggregated rights to vote as one group.[191]  As discussed above, short-form merger is the ultimate step in the top-up option scheme.[192]  Thus, a top-up option requires the issuance of a substantial number of common shares and cannot rely on a dual-class capital structure.[193]

Unlike the top-up option, the poison pill can, in theory, rely on the issuance of only blank-check preferred stock[194] if the certificate authorized the managers to issue such class of preferred stock that is assigned higher voting rights and distribution rights than the common stock.  It is, however, common practice to have a poison pill that uses preferred stock convertible into common stock and thus still requires a large amount of common shares for the conversion.  In addition, poison pills often include a provision that explicitly allows the company to distribute cash, assets, and other securities instead of common stock, if the company does not have sufficient common stock when the poison pill is triggered.[195]  The poison pill is intended to deter a hostile takeover by credibly threatening the dilution of the value of the hostile bidder and not merely its voting rights.  Thus, the technique of replacing share distribution with asset distribution, in this case, can effectively circumvent a limit requirement on the number of shares management can issue without going back to the shareholders.  Yet, this technique will not suffice where the desired stock distribution is mainly aimed at increasing the voting rights of the intended recipients of the shares, as in the case of a top-up option where the bidder still needs to own 90% of each class of shares to be able to perform a short-form merger.

3. Qualitative Restriction

The previous Subpart illustrated the deficiencies of challenging management’s use of the power to issue stock in court.  It is very difficult to prove that the purpose of a specific stock issuance lacks good faith and breaches the fiduciary duties of the managers.  In addition, the previous Subpart discussed the shortcomings of the remedy of appraisal, which may be the only available remedy following the issuance of the shares.[196]

Attempts to limit managers’ general ability to issue stock only to ordinary, nonorganic purposes, such as financing ordinary business operations of the company, have failed.  In Moran v. Household International, the Delaware Supreme Court[197] rejected an interpretation of the Delaware statute that limits managers’ power to issue securities only for corporate finance related purposes.[198]  The court has explicitly allowed managers to use their power for nonfinance related purposes such as corporate control related issuances.[199]  In a recent case, following the Delaware Supreme Court in Moran, the Delaware Chancery Court upheld a record long use of a poison pill[200] that prevented a hostile takeover.[201]

4. Preemptive Rights Restriction

Preemption rights allow the shareholders to participate pro rata in any distribution of shares by the company.[202]  The following example illustrates how preemptive rights work.  A company has issued 100 shares and plans to issue another 10 new shares.  Assuming a shareholder has preemptive rights and currently holds 10% of the company, she is entitled to purchase one newly issued share, which represents 10% of the total amount of new shares being issued by the company.  Should the shareholder choose to exercise her preemptive right and purchase the new share, she will then own a total of 11 shares out of the 110 shares of the company, maintaining her 10% holding in the company.

If the shareholders exercise their preemptive rights, they will maintain their percentage holding in the company and prevent dilution by the issuance of new shares.  To the extent that the shareholders have preemptive rights and exercise these rights fully each time the company issues new shares, management’s ability to issue shares cannot circumvent the shareholders’ will, rendering corporate mechanisms such as a poison pill and a top-up option futile.

Preemptive rights are no longer mandatory in the United States.[203]  Other jurisdictions, on the other hand, still treat preemptive rights as a basic mandatory right of the shareholders and enforce stringent restrictions on the ability to waive these rights.  For example, under the German Stock Corporation Act preemptive rights are mandatory and can be waived only if the company issues no more than 10% of the issued capital and provided that at least 75% of the shareholders’ votes approve the waiver.[204]

However, preemptive rights give only the right to participate in future issuances of shares, but the shareholders’ ability to participate in the issuance of shares may in itself be limited.  Participation in a distribution of shares requires paying for the newly issued shares.  Liquidity constraints, as well as collective action problems, can prevent shareholders from exercising preemptive rights.  A shareholder may not want or be able to invest more in the company and may prefer, for example, to diversify her investment and use any available funds to pursue a different business opportunity.  This weakness of preemptive rights may explain why venture capital investors, who customarily require preemptive rights as a condition for their investment in private firms, also negotiate for the right to acquire more shares in new issuances if other existing shareholders fail to exercise their preemptive rights and purchase their entire pro rata share.[205]

II.  The Excess Ratio

After reviewing the key aspects of management’s power to issue stock and analyzing possible implications of this power, I now turn to study the magnitude of the managers’ power to issue stock empirically.  As seen above, one of the major limitations on this power is the size of the authorized capital of the corporation, which provides a ceiling for the total number of shares that can be issued without shareholder approval.[206]  The relative size of the number of authorized shares versus the number of shares already issued determines the extent of management’s power to issue shares.  Thus, the ratio of the authorized shares not outstanding to the already-issued-and-outstanding shares, what I shall call the “excess ratio,” is an indicator of the magnitude of the managers’ power to issue stock.

For example, an excess ratio of one signifies that there are enough authorized-but-not-outstanding shares to double the number of shares already issued and outstanding.  The stock exchanges’ requirement of shareholder approval for an increase of more than 20% of the issued share is equivalent to a 0.2 excess ratio,[207] and the German limit of 50% can be expressed as a 0.5 excess ratio.[208]

A study of initial public offerings of nonfinancial companies[209] incorporated in Delaware reveals that companies choose to go public with a significantly high excess ratio.  I use the data in prospectuses of nonfinancial Delaware companies, which were filed with the Securities and Exchange Commission, to calculate the excess ratios of the companies at the time of the initial public offering.  In 2009, the average excess ratio of the companies in my sample was 5.79 and the median ratio was 3.75.  This high excess ratio allows the management of the firms to more than quadruple the number of issued shares without asking the shareholders for their approval to issue more stock.[210]  Similar results were obtained when the excess ratio was measured for companies that went public in 2008.  The excess ratio, at the time of the initial public offering, of companies that went public in 2003 was also checked since the use of the top-up option, which requires a high excess ratio, has increased since 2004.[211]  The average ratio of firms that went public in 2003 was also significantly high and only slightly lower than in more recent years.  The study found a substantial deviation in the excess ratio: some companies choose to go public with an exceptionally high ratio and the highest ratio in the sample was 25.  Other companies choose to have a relatively low ratio—the lowest in the sample was 0.34.  The following table summarizes these findings.


Table 3: Excess Ratios



Mean Excess Ratio

Median Excess Ratio

Standard Deviation

Sample Size

2009 5.79 3.75 5.13 28
2008 4.74 3.17 5.87 16
2003 4.55 3.26 3.08 37


The study also looked at venture-backed firms separately.  On the one hand, venture capitalists customarily restrict the managers’ ability to issue shares at the private stage of the company.[212]  This indicates that these sophisticated investors are aware of the importance of the managers’ power to issue stock.  On the other hand, venture capitalists may be inclined to enable management to issue a top-up option because of the typical, relatively short-run focus of these investors.[213]  The excess ratio of the venture-backed firms was slightly higher than that of nonventure-backed firms that went public in the same year.  However, the study did not find a statistically significant difference between the excess ratio of the two sets of firms, suggesting that the use of a high excess ratio is not unique to venture-backed firms.

The study found that the use of a high ratio at the time of an initial public offering is prevalent, yet there was no statistical indication that the size of the firm is related to the size of the ratio.[214]  In the years following the public offering, the excess ratio of the firms declined if management issued additional shares.  However, the average excess ratio of venture backed firms that went public in 2004 was notably high 5 years following the public offering, and was on average 3.15.  This finding may suggest that the high ratio is not used for regular stock issuances, either because they are not required or because managers are cautious about weakening their power to dilute the shareholders in the future by issuing in the present.

In addition, the study checked for a relation between the size of the excess ratio at the time of the initial public offering and the likelihood of a future acquisition.  The study looked at the 83 venture-backed companies that went public in 2004.  Out of these companies, 29 were acquired by the end of 2010.  A check for a relation between the excess ratio and the likelihood of future acquisitions did not find a statistically significant correlation between the two.  It should be noted, however, that even though a high excess ratio may have an influence on whether the company is acquired or stays independent, a high excess ratio helps management in both opposing directions.  On the one hand, a high ratio may help management sell the company through the use of a top-up option, and on the other hand, the high ratio may help management prevent a sale through the use of a poison pill or a white squire.

The following table summarizes the mean and median excess ratio of 264 venture-backed Delaware firms that went public in the years 2004–2009.


Table 4: Averages of Mean and Median Excess Ratios


Excess Ratio


























This Article studied the important managerial power to issue stock and shows that shareholders are vulnerable to managers exploiting this power to promote their own self-interest.  On the one hand, the power to issue stock can be used to create entrenchment mechanisms that prevent a sale of the company, and on the other hand, it can help form mechanisms that promote the sale of the company despite significant shareholder opposition.

Even though there are limitations on the managers’ power to issue stock, this Article shows that most of these limitations do not effectively restrict this power and that managers can still take advantage of it to advance their own interests.  Furthermore, the only restriction that can effectively prevent the managers from issuing substantial amounts of shares without receiving the shareholders’ approval—the ceiling set by the number of authorized shares—can distort managerial behavior.  This limit on the power to issue stock may influence the managers to refrain from issuing stock for ordinary business purposes, such as equity financing and performance based compensation, in order to retain their power.

A study of a proxy for the magnitude of the power to issue stock, as is measured by the excess ratio, revealed that companies tend to go public with a significantly high ratio that allows management to more than quadruple the amount of issued shares without shareholder approval.  This incidence of a high ratio, which indicates a significant power in managers’ hands, can be desirable to the extent that it allows the managers to issue stock without worrying about diminishing their power.  On the other hand, mechanisms such as a top-up option require the issuance of such a substantial amount of new shares that managers may nonetheless remain cautious about share issuances despite a high excess ratio.

Further study of the excess ratio may enhance our understanding of corporate governance and of managerial decision-making processes.  Such a study may look at a possible relation between personal characteristics of management and the size of the ratio.  In addition, a study of a possible correlation between the size of the excess ratio and the existence of entrenchment mechanisms may expose interesting patterns, since the excess ratio can serve as an alternative or as a complementary tool.  Similarly, a study of the correlation between the excess ratio and the existence of tools aimed at monitoring management, such as independent directors, can increase our understanding of corporate governance.


* Assistant Professor, University of Texas School of Law.  I am indebted to Jesse Fried for invaluable discussions and comments.  I am grateful for the help, insight, support, and encouragement of Willy Forbath.  I would also like to thank Hans Baade, Brian Broughman, Jens Dammann, Ron Fink, George Geis, Sarah Lawsky, Dick Markovits, Karl Okamoto, Gordon Smith, Matt Spitzer, Deborah Weiss, Sean Williams, and participants in the Law & Entrepreneurship Conference at LSA for very helpful discussions, comments, and suggestions.  Jennifer Georg, Shane Johnson, Kris Teng, and the editors of the Wake Forest Law Review provided valuable editorial assistance.

Comments are welcome and can be sent to me at [email protected].

[1]. Del. Code Ann. tit. 8, § 161 (2010).  For limitations of this right, see infra Part I.D.  In addition, specific contractual requirements may also require a shareholder approval on specific share issuances.

[2]. This is because the total value of the company increases by the value of the added consideration that the company receives for the newly issued shares.

[3]. Poison Pill, Fin. Times Lexicon,
-pill (last visited Sept. 15, 2011).

[4]. See, e.g., Lucian Arye Bebchuk et al., The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence and Policy, 54 Stan. L. Rev. 887, 904–05 (2002) (describing the poison pill).  See id. at 905 n.59 for a discussion of the flip-in pill, which is the more common and potent version of the pill and infra Part I.B, discussing this version of the poison pill.

[5]. Bebchuk et al., supra note 4, at 903–04.

[6]. See, e.g., John Letzing, Yahoo Vulnerable if Microsoft Goes ‘Hostile, MarketWatch (Feb. 11, 2008, 6:34 PM),
/story/print?guid=CB075A77-BD12-417C-B880-9063B4E0DEC4 (quoting Shirley Westcott of Proxy Governance) (“Yahoo has a ‘poison pill,’ and that pretty much blocks the consummation of any kind of tender offer.”).

[7]. Id.

[8]. See, e.g., Andrei Shleifer & Robert W. Vishny, Management Entrenchment: The Case of Manager-Specific Investments, 25 J. Fin. Econ. 123, 137 (1989).

[9]. For a description and examples of the use of a white squire, see infra Part I.C.3.

[10]. See generally, e.g., Mira Ganor, Why Do Managers Dismantle Staggered Boards?, 33 Del. J. Corp. L. 149 (2008) [hereinafter Ganor, Why Do Managers Dismantle Staggered Boards?]; Mira Ganor, Salvaged Directors or Perpetual Thrones?, 5 Va. L. & Bus. Rev. 267 (2010) [hereinafter Ganor, Salvaged Directors or Perpetual Thrones?] (suggesting managers at times prefer to sell the company to advance their own interests).

[11]. See Jim Mallea, M&A Year End Review, FactSet Mergers (Jan. 23, 2009),
=/pub/rs_20090122.html&rnd=101994 (“In 2004, 35% of agreed tender offers included a top-up option. . . . In 2008, the inclusion of a top-up option had become standard as 100% of all agreed tender offers included one.”).

[12]. Del. Code Ann. tit. 8, § 253 (2010).

[13]. For a description of the antitakeover mechanism known as a white squire as well as for an example of the use of a white squire to thwart a hostile takeover, see infra Part I.C.3.

[14]. See generally Ganor, Why Do Managers Dismantle Staggered Boards?, supra note 10; Ganor, Salvaged Directors or Perpetual Thrones?, supra note 10.

[15]. Several commentators support the use of a poison pill by arguing that the pill may help directors negotiate and reach a better outcome for the shareholders.  See generally, e.g., Stephen Bainbridge, Director Primacy and Shareholder Disempowerment, 119 Harv. L. Rev. 1735 (2006); Martin Lipton & William Savitt, The Many Myths of Lucian Bebchuk, 93 Va. L. Rev. 733 (2007); see also Ganor, Salvaged Directors or Perpetual Thrones?, supra note 10 (acknowledging that under certain circumstances, granting perpetual thrones can be efficient).

[16]. For example, a poison pill can be efficient where managers have nonpublic information that the company’s prospects are much better than the market thinks and disclosing this information prematurely will hurt the company.  Without this information being publicly available, a hostile bidder is likely to convince the shareholders to sell the company at a fraction of its true value.

[17]. See infra Part II.D (describing the limitations of the power to issue stock).

[18]. See Richard S. Markovits, Monopoly and the Allocative Inefficiency of First-Best-Allocatively-Efficient Tort Law in Our Worse-Than-Second-Best World: The Whys and Some Therefores, 46 Case W. Res. L. Rev. 313, 329–30 (1996) (discussing the general theory of Second Best, the deficiency of an isolated allocative-efficiency analysis without a study of the aggregate effects, and the applications of this theory to the law).

[19]. Del. Code Ann. tit. 8, § 102 (2010).

[20]. Id.

[21]. For an example of a Maryland corporation that went public with a charter provision that allows its board of directors to issue an unlimited number of shares without shareholder approval, see Under Armour, Inc., Prospectus 85 (Nov. 17, 2005), available at
/494263049x0x60177/D03013EC‑AECD‑4604‑8E42‑C19ABD3F9CF2/S‑111.17.05.pdf (“[Our charter] permits our board to amend the charter without stockholder approval to increase or decrease the aggregate number of shares of stock or the number of shares of stock of any class or series that we have authority to issue and to classify or reclassify unissued shares of stock.”).

[22]. Del. Code Ann. tit. 8, § 161 (2010).

[23]. Id. § 102(a)(4).

[24]. Cf. NYSE, Listed Company Manual § 312.03(c) (2002),; NASDAQ, Corporate Governance Requirements, (stating that NASDAQ Rule 5635 requires shareholder approval for issuance of common stock equal to or greater than twenty percent of preissued shares subject to certain exceptions, such as a public offering).

[25]. See infra Part I.D.4 (discussing preemptive rights).

[26]. There is evidence that managers can also be influenced by tools less conventional than regular voting on shareholder resolutions, such as vote-withholding techniques and voting on nonbinding, precatory resolutions.  These tools also use the voting power assigned to the shares to pressure the managers to conform to the will of the shareholders.  See generally Ganor, Why do Managers Dismantle Staggered Boards?, supra note 10.

[27]. See generally Lucian Arye Bebchuk, The Case for Increasing Shareholder Power, 118 Harv. L. Rev. 833 (2005).

[28]. See, e.g., Bainbridge, supra note 15; Lipton & Savitt, supra note 15.

[29]. See generally Henry T.C. Hu & Bernard Black, The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, 79 S. Cal. L. Rev. 811 (2006).

[30]. See, e.g., Andrew J. Opiola, Should Shares Issued Directly From a Corporation Constitute a Control Share Acquisition?, 1 J. Bus. & Tech. L. 207, 226 (2006).

[31]. See id.

[32]. See id.

[33]. See id.

[34]. Del. Code Ann. tit. 8, § 161 (2010).

[35]. Id.

[36]. See id. § 102(a)(4).

[37]. See id. (requiring certificates of incorporation to include the number of authorized shares); id. § 242(b)(2) (requiring the approval of the affected class of shareholders for any amendment that changes the number of authorized shares of the class).  Maryland is an exception to this rule, for it does not require a shareholder vote to increase the number of authorized shares.  See supra note 21 and accompanying text.

[38]. Del. Code Ann. tit. 8, § 161 (2010).

[39]. See id.

[40]. See Matteo Arena & Stephen P. Ferris, When Managers Bypass Shareholder Approval of Board Appointments, 13 J. Corp. Fin. 4, § 3.1 (2007).

[41]. Del. Code Ann. tit. 8, § 161 (2010).

[42]. Absent transaction costs, taxes, and inefficient markets, the choice between debt and equity should not affect the value of the firm.  See generally Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, 48 Am. Econ. Rev. 261 (1958).  However, since companies operate in inefficient markets with transaction costs and taxes, the capital structure of the firm factors into the value of the firm.

[43]. Cash and equity compensation are not equivalent even when they have equal values.  The grant of cash rather than equity has different effects on the company and on the recipient.  For one, equity-based compensation is generally believed to align the interests of the employees with those of the company.  See infra note 64 and accompanying text.

[44]. It should be noted that quorum and majority requirements are calculated based on the number of outstanding shares and that the company is not allowed to vote or use treasury shares to satisfy the quorum requirement.  See Del. Code Ann. tit. 8, § 160(c) (2010).

[45]. See id. § 160(a).

[46]. For an analysis of potential costs and benefits of share repurchases on managerial cash-hoarding practice, see Jesse M. Fried, Informed Trading and False Signaling with Open Market Repurchases, 93 Cal. L. Rev. 1323, 1371 (2005) (“To the extent that the prospect of future bargain repurchase opportunities lead [sic] to cash hoarding, managers’ ability to engage in such repurchases does not mitigate the problem of free cash retention.”).

[47]. See, e.g., id. at 1326 (“[T]he use of share repurchases to distribute cash has since grown substantially in the United States, increasing from $6.6 billion in 1980 to almost $200 billion in 2000.”); Douglas J. Skinner, The Evolving Relation Between Earnings, Dividends, and Stock Repurchases, 87 J. Fin. Econ. 582, 585 (2008) (stating that newer firms with no history of paying dividends (like Cisco and Dell) tend to rely exclusively on stock repurchases and are unlikely to initiate dividends, helping to explain the declining propensity to pay dividends; since 1980, these firms display an increasing tendency to use repurchases rather than dividends; repurchases now represent about half of total payouts).

[48]. See Fried, supra note 46, at 1327–28.

[49]. Id.

[50]. Id.

[51]. Id. at 1327–29.

[52]. Del. Code Ann. tit. 8, § 152 (2010) (“The board of directors may authorize capital stock to be issued for consideration consisting of cash, any tangible or intangible property or any benefit to the corporation, or any combination thereof.”).

[53]. Id. (“In the absence of actual fraud in the transaction, the judgment of the directors as to the value of such consideration shall be conclusive.”).  Similar rules govern the issuance of options to purchase shares.  Id. § 157; see also Zupnick v. Goizueta, 698 A.2d 384, 387 (Del. Ch. 1997) (“[S]o long as there is any consideration for the issuance of shares or options, the sufficiency of the consideration fixed by the directors cannot be challenged in the absence of actual fraud.  Only where it is claimed that the issuance of shares or options was entirely without consideration will § 157 not operate as ‘a legal barrier to any claim for relief as to an illegal gift or waste of corporate assets in the issuance of stock options.’” (quoting Michelson v. Duncan, 407 A.2d 211, 224 (Del. 1979))).

[54]. Blades v. Wisehart, No. 5317-VCS, 2010 Del. Ch. LEXIS 227, at *28–29 (Del Ch. Nov. 17, 2010) (“[I]n order to effect a forward or reverse stock split, the corporation must follow the prescribed corporate formalities to amend its certificate of incorporation in such a manner that ‘splits’ the outstanding shares in accordance with the corporation’s intentions.”).  Cf. Jesse M. Fried, Firms Gone Dark, 76 U. Chi. L. Rev. 135, 142 (2009) (“Some state corporate laws may permit a reverse stock split without shareholder approval in certain circumstances.”); Minn. Stat. Ann. § 302A.137(a) (West 2010).

[55]. See Definitions, US Legal,
-financing (last visited Sept. 15, 2011).

[56]. See Massimo G. Colombo & Luca Grilli, Funding Gaps? Access to Bank Loans By High-Tech Start-Ups, 29 Small Bus. Econ. 25, 28 (2006).

[57]. To be sure, there may be exceptions to this limitation on raising debt.  For example, a very reputable entrepreneur who founds a new startup after prior proven success may not face much difficulty raising any type of financing for the new start-up, including debt.  Financial institutions may choose to assume the risk and waive the collateral requirement, but they are likely to ask for individual guaranties in most situations.

[58]. See supra note 42 and accompanying text.

[59]. The Modigliani-Miller theorem shows that the method of finance chosen does not affect the value of the firm as long as the markets are efficient and there are no transaction costs and no taxes.  However, once taxes, transaction costs, and inefficient markets are introduced, the capital structure of the corporation can have a notable effect on the value of the firm.  See Modigliani & Miller, supra note 42.

[60]. See, e.g., Brian Cheffins & John Armour, The Eclipse of Private Equity, 33 Del. J. Corp. L. 1, 13 (2008) (“Debt covenants typically . . . oblig[e] executives to operate the company within tight budgetary and operational constraints.”).

[61]. See Alon Chaver & Jesse M. Fried, Managers’ Fiduciary Duty Upon the Firm’s Insolvency: Accounting for Performance Creditors, 55 Vand. L. Rev. 1813, 1823 (2002) (“[M]anagers required to maximize creditor value when the firm is insolvent might forgo risky opportunities that increase total value because they make creditors worse off.  This problem, of course, is the inevitable result of an approach that seeks to maximize creditor value without regard to the effect on shareholder value. . . . The intuition behind this . . . is that creditors bear most of the downside if the firm does poorly but do not enjoy much of the upside if the firm does very well.”).

[62]. See Jesse M. Fried & Mira Ganor, Agency Costs of Venture Capitalist Control in Startups, 81 N.Y.U. L. Rev. 967, 976 (2006).

[63]. See id. at 1010.

[64]. See, e.g., id. (“[E]quity compensation aligns the interests of employees with those of shareholders.”).  Equity compensation can also be used as a substitute for cash compensation when the company cannot compete for talent on the basis of salaries, as is frequently the case with startups.  See id. (“Equity compensation allows liquidity-constrained firms, which are unable to pay competitive salaries and cash bonuses, to compete in the labor market for talented employees.”); see also Ganor, Why Do Managers Dismantle Staggered Boards?, supra note 10, at 162 (studying the connection between CEO equity holdings and the decision to de-stagger the board, based on the hypothesis that “[t]he CEO’s equity holdings help to create an interest in the increase of the company’s value, or at least in the stock price (the perceived market value of the company)”).

[65]. See, e.g., Lucian Arye Bebchuk et al., Managerial Power and Rent Extraction in the Design of Executive Compensation, 69 U. Chi. L. Rev. 751, 763, 783–86 (2002) (criticizing prevailing equity compensation practices for providing suboptimal incentives); Hu & Black, supra note 29, at 831–32 (analyzing managers’ custom of hedging their personal exposure by purchasing financial instruments such as zero-cost collar); Eli Ofek & David Yermack, Taking Stock: Equity-Based Compensation and the Evolution of Managerial Ownership, 55 J. Fin. 1367, 1367–68 (2000) (reporting that managers can hedge the risk of equity-based compensation, yet companies justify the use of equity incentive compensation by arguing that it helps reduce agency problems).

[66]. See, e.g., Lucian A. Bebchuk & Jesse M. Fried, Paying for Long-Term Performance, 158 U. Pa. L. Rev. 1915, 1919–20 (2010) (suggesting limitations on equity-based compensation that will optimally tie managerial pay to long-term performance).

[67]. To be sure, while scaling down the core operations of the company, managers may prefer to use scarce resources on empire building which includes sizable acquisitions of other businesses for the purpose of increasing the managers’ power and increasing the size of the company.  This makes it more difficult to take over the company and helps to entrench the managers.

[68]. Guhan Subramanian, Bargaining in the Shadow of PeopleSoft’s (Defective) Poison Pill, 12 Harv. Negot. L. Rev. 41, 42–43 (2007) (“It is widely believed that a poison pill, even a plain vanilla pill, is a ‘show-stopper’ against a hostile bidder because it severely dilutes an acquirer’s stake if triggered.”); see also Jonathan R. Macey, The Legality and Utility of the Shareholder Rights Bylaw, 26 Hofstra L. Rev. 835, 837 (1998) (“Target firms can now keep their poison pills in place and ‘just say no’ to would-be acquirers, regardless of the market premiums these acquirers are willing to pay to shareholders.”).

[69]. See Macey, supra note 68, at 839.

[70]. See id.

[71]. 10 million ÷ 190 million = 5.26%

[72]. 5.26% × $1,450 million = $76.3 million

[73]. See Subramanian, supra note 68, at 44 (studying the poison pills of “U.S. publicly-traded software companies with market capitalization of at least $1 billion”).

[74]. PeopleSoft, for example, could not have exercised the rights under its poison pill unless it used a cashless exercise because the company did not have a sufficient number of shares of authorized common stock, even though PeopleSoft had almost twice as many authorized shares as issued shares.  See Subramanian, supra note 68, at 49 n.11.

[75]. For a review of the debate about the efficacy of the poison pill, see generally Lucian Arye Bebchuk, The Case Against Board Veto in Corporate Takeovers, 69 U. Chi. L. Rev. 973 (2002).

[76]. See id. at 988–90.

[77]. See id. at 991–94.

[78]. Id. at 991 (“[M]anagers might elect to block a beneficial acquisition in order to retain their independence.”).

[79]. Id. (“[M]anagers might use their power to extract not a higher premium for their shareholders but rather personal benefits for themselves.”).

[80]. For a review of the empirical studies, see id. at 992–93.

[81]. See Aaron Dixon, Delaware Chancery Court Provides Guidance for Terms of Top-Up Options (Mar. 7, 2011),

[82]. Davis Polk & Wardwell LLP, Top-Up Options – Looking Better and Better (Oct. 8, 2010),

[83]. See Dixon, supra note 81.

[84]. See supra note 82 and accompanying text.

[85]. See id.

[86]. See Dixon, supra note 81.

[87]. The minimum percentage of shares needed to be acquired at the tender offer to allow for the subsequent exercise of the top-up option is usually set at 50%.  See supra note 82 and accompanying text.

[88]. Del. Code Ann. tit. 8, § 253(a) (2010).

[89]. See Glassman v. Unocal Exploration Corp., 777 A.2d 242, 248 (Del. 2001) (“[A]ppraisal is the exclusive remedy available to a minority stockholder who objects to a short-form merger.”).

[90]. Del. Code Ann. tit. 8, § 253(a) (2010).

[91]. (Y+X) × (shares outstanding) / (100%+X) × (shares outstanding) = 90%

[92]. Del. Code Ann. tit. 8, § 153(a) (2010) (“[S]hares of stock with par value may be issued for . . . not less than the par value.”).

[93]. See, e.g., In re Appraisal of Metromedia Int’l Grp., Inc., 971 A.2d 893, 898–99 (Del. Ch. 2009) (“As part of the Top-Up Option, MergerSub paid MIG $2 million in cash and issued an unsecured promissory note to MIG in the amount of $358 million in exchange for the additional 200 million common shares. . . . MergerSub merged into MIG, with MIG as the surviving entity. . . . The promissory note given by MergerSub was cancelled because the obligor (MergerSub) and the obligee (MIG) on the promissory note became the same entity, making the note a nullity.”).

[94]. In Glassman v. Unocal Exploration Corp., the court held that a minority stockholder’s only recourse in challenging a short-form merger under 8 Del. Code § 253 was appraisal, stating that “we have held that claims for unfair dealing cannot be litigated in an appraisal. . . . stockholders may not receive recissionary relief in an appraisal.”  777 A.2d 242, 248 (Del. 2001) (reaffirming the interpretation of the appraisal statute’s scope set forth in Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983)).

[95]. Del. Code Ann. tit. 8, § 267 (2010).

[96]. If the acquirer was able to receive at least 90% of the shares in the tender offer on her own, then there would have been no need for her to receive a top-up option.

[97]. Glassman, 777 A.2d at 248.

[98]. See, e.g., Bomarko, Inc. v. Int’l Telecharge, Inc., 794 A.2d 1161, 1177 (Del. Ch. 1999) (explaining that in addition to the appraisal remedy, other forms of equitable relief are available if the court finds that a long-form merger was not entirely fair).

[99]. See generally Ganor, Salvaged Directors or Perpetual Thrones?, supra note 10.

[100]. See 17 C.F.R. § 240.14d-10(a)(2) (2011) (“The consideration paid to any security holder for securities tendered in the tender offer is the highest consideration paid to any other security holder for securities tendered in the tender offer.”).

[101]. Cf. Mira Ganor, Manipulative Behavior in Auction IPOs, 6 DePaul Bus. & Com. L.J. 1 (2007) (demonstrating a strategic use of the downward sloping of the demand for shares).

[102]. In a typical top-up option agreement, the bidder undertakes to pay at the back-end squeeze-out the same price that he pays at the tender offer.  See, e.g., Olson v. ev3, Inc., No. 5583-VCL, 2011 Del. Ch. LEXIS 34, at *2 (Del. Ch. Feb. 21, 2011).  Without this undertaking the tender offer may be perceived as structurally coercive and could face judicial scrutiny.  Cf. In re Pure Res., Inc. S’holders Litig., 808 A.2d 421, 445 (Del. Ch. 2002).  The nontendering shareholders who oppose the subsequent short-form merger can, of course, use their appraisal right and receive the court-assigned fair market price of the shares.  The tendering shareholders will not have their price adjusted even if the tender price is lower.

[103]. See, e.g., Gholl v. eMachines, Inc., No. 19444-NC, 2004 Del. Ch. LEXIS 171, at *64–65 (Del. Ch. Nov. 24, 2004) (“Both TriGem and AOL . . . were past strategic partners of eMachines.  TriGem was being pressured by its biggest customer, and eMachines competitor, Hewlett Packard to distance itself from eMachines.  AOL had been a partner of eMachines under its old Internet-revenue business model, but was by late 2001, not a part of eMachines’ future plans.  These facts suggest that these stockholders may well have had a number of reasons for approving the Merger and thereby creating a liquidity event for themselves, other than a careful and reliable valuation analysis.”).

[104]. See Fried & Ganor, supra note 62, at 1003.

[105]. See, e.g., id. at 1004–05 (“Unfortunately, the appraisal remedy is an extremely weak constraint . . . [and c]ommentators have long recognized that appraisal is a remedy that few shareholders will seek under any circumstance.”).

[106]. See Peter V. Letsou, The Role of Appraisal in Corporate Law, 39 B.C. L. Rev. 1121, 1145 (1998).

[107]. See id. at 1156–60 (describing and analyzing procedural rules of appraisal remedy); Fried & Ganor, supra note 62, at 1003–05.

[108]. See, e.g., Fried & Ganor, supra note 62, at 1003–05; Richard T. Hossfeld, Short-Form Mergers After Glassman v. Unocal Exploration Corp.: Time to Reform Appraisal, 53 Duke L.J. 1337, 1353 (2004) (noting that shareholders seeking appraisal “must also hold an illiquid claim for almost two years, forgoing investment in other promising opportunities that may arise in the interim”); Alexander Khutorsky, Coming in From the Cold: Reforming Shareholders’ Appraisal Rights in Freeze-Out Transactions, 1997 Colum. Bus. L. Rev. 133, 160 (recommending setting “statutory rate of interest at the ‘borrower’s’ cost of debt” to fairly compensate dissenting shareholders, where “borrower” is majority shareholder); Robert B. Thompson, Exit, Liquidity, and Majority Rule: Appraisal’s Role in Corporate Law, 84 Geo. L.J. 1, 40 (1995) (describing the complicated requirements of appraisal and the unavailability of a class action suit).

[109]. See Gholl v. eMachines, Inc., No. 19444-NC, 2004 Del. Ch. LEXIS 171, at *72 (Del. Ch. Nov. 24, 2004).

[110]. Id. at *4.

[111]. Id. at *5.

[112]. Id.

[113]. Id. at *7.

[114]. Id. at *9.

[115]. Id.

[116]. Id. at *10.

[117]. Id.

[118]. Id. *10–11.

[119]. The bidding director’s offer represented a company value of $161 million, and the company had $165.2 million in cash.  See id. at *11, *69.

[120]. Id. at *11.

[121]. Id.

[122]. Id. at *14.

[123]. Id.

[124]. Id.

[125]. Id. at *60–61.

[126]. Id. at *63.

[127]. Id.

[128]. Id. at *69.

[129]. Id. at *73.

[130]. (339,000 + 1,005,600) = 1,344,600 shares, representing less than one percent of the total of 154,612,560 outstanding shares.  See id. at *2, *69.

[131]. 1,344,600 × $0.58 = $779,868.

[132]. See supra note 119 and accompanying text.

[133]. See eMachines, 2004 Del. Ch. LEXIS 171, at *14.

[134]. See Hossfeld, supra note 108, at 1337.

[135]. See eMachines, 2004 Del. Ch. LEXIS 171, at *14.

[136]. See Amended Class Action Complaint at ¶ 46, Mesa v. ZymoGenetics, Inc., No. 2:10-cv-01486 (W. D. Wash. Sept. 17, 2010), available at

[137]. See id.

[138]. See ZymoGenetics, Inc., Recommendation Statement (Schedule 14D-9), at Item 8 (Sept. 15, 2010), available at
/1129425/000119312510210085/dsc14d9.htm (company’s description of the class actions).

[139]. See Amended Class Action Complaint, supra note 136, at ¶ 44.

[140]. See Recommendation Statement, supra note 138, at 38.

[141]. See Amended Class Action Complaint, supra note 136, at ¶ 37.

[142]. See Notice of Settlement of Class Action at 2, In re ZymoGenetics, Inc. S’holder Litig., No. 10-2-32389-9 (Wash. Super. Dec. 10, 2010), available at

[143]. Id.

[144]. Id.

[145]. In re Cogent, Inc. S’holder Litig., 7 A.3d 487, 492 (Del. Ch. 2010).

[146]. Id.

[147]. Id. at 494 (“3M did make its offer contingent on entering into retention arrangements with key employees”) (internal quotation marks omitted).

[148]. Id. at 495 (noting “Company D’s status as Cogent’s competitor”).

[149]. Id. at 498.

[150]. Id. at 506 n.60.

[151]. Id. at 498.

[152]. See, e.g., Alexia Tsotsis, Microsoft: “Yeah, We Tried to Acquire Facebook.”, TechCrunch (Dec. 9, 2010),
-lanman-microsoft-tried-to-acquire-facebook/ (quoting Mr. Zuckerberg telling Microsoft’s CEO: “I don’t want to sell the company unless I can keep control”).

[153]. Additionally, in this case the manager is a billionaire and thus may have a diminished marginal utility of money.

[154]. In re Cogent, Inc. S’holder Litig., 7 A.3d 487, 513 (Del. Ch. 2010).

[155]. Id.

[156]. See Top-Up Options – Looking Better and Better, supra note 82.

[157]. Other attempts to enjoin a two-step acquisition with a top-up option on the grounds of breach of fiduciary duties, arguing that the top-up options interfere with shareholder voting rights and enable managment to avoid a judicial review of fiduciary duties in favor of mere appraisal procedures, were not viewed favorably by the court.  See, e.g., Olson v. ev3, Inc., No. 5583-VCL, 2011 Del. Ch. LEXIS 34, at *6–8 (Del. Ch. Feb. 21, 2011) (reviewing a couple of earlier cases that either rejected the breach of fiduciary duty argument in the context of a top-up option or “described the plaintiffs’ claims as far from compelling”) (internal quotation marks omitted).

[158]. See Del. Code Ann. tit. 8, § 251(c) (2010) (requiring the approval of the holders of the majority of the shares for a long form merger).

[159]. See, e.g., Guhan Subramanian, Post-Siliconix Freeze-Outs: Theory and Evidence, 36 J. Legal Stud. 1, 3 (2007) (“Freeze-outs are generally subject to entire-fairness review by the Delaware courts, a stringent standard of review because of their self-dealing nature. . . . Even procedural protections such as the use of [a special committee] or [a majority of the minority] condition serve only to shift the burden of proof of entire fairness to the plaintiff.”).

[160]. Cf. id. at 4 (“Taken together, Siliconix and Glassman allow a controlling shareholder to avoid entire-fairness review by executing its freeze-out as a tender offer followed by a short-form merger.”).

[161]. See supra notes 101–05 and accompanying text.

[162]. See, e.g., Mallea, supra note 11 (“Tender offers give acquirers several advantages over traditional one step transactions, particularly the speed at which the transaction can be completed and the option to use a short-form merger once more than 90% of the shares have been tendered in the offer.”).

[163]. For the benefit of having more than one suitor, see, e.g., Karen Gullo & Adam Satariano, Citigroup Accused by Terra Firma of Fraud Over Sale of EMI, Bloomberg, (Dec. 12, 2009),
=newsarchive&sid=aVHdh52RtPOQ&pos=6 (describing the suit brought by Terra Firma Capital Partners Ltd. against Citigroup for allegedly misrepresenting that another bidder was interested in acquiring EMI Group Ltd.).  In its complaint, Terra Firma argued it paid an inflated price for EMI because of Citigroup’s alleged misrepresentation.  Id.

[164]. See, e.g., Mallea, supra note 11.

[165]. See Stephen R. Volk et al., Developments in the Law of Mergers and Acquisitions: Developments in Defense, in 577 Corp. L. & Practice Course Handbook Series 287, 324–25 (1987).

[166]. The white squire should be distinguished from a white knight.  While both the white squire and the white knight support the target’s management and help the management defend against a hostile bidder, the white knight is a friendly acquirer who directly competes with the hostile bidder for the whole target.  See Black’s Law Dictionary 1734 (9th ed. 2009) (“A person or corporation that rescues the target of an unfriendly corporate takeover, esp. by acquiring a controlling interest in the target corporation or by making a competing tender offer.”).  The white squire, on the other hand, buys only a stake in the target but does not offer to buy the whole company.

[167]. Incumbents who want to entrench themselves by issuing new shares will do it selectively and find an investor who is going to serve as a white squire and support them.  The incumbents may not be able to rely on old white squires to continue to support them also in the future as the old investors may support the dissidents.  This is one reason why the managers may want to make sure they can continue and issue new shares also in the future.  To be sure, using a poison pill as an entrenchment mechanism does not bear this problem, since the managers apply their power to issue stock only as a deterrent, without actually issuing any shares or relying on new investors.

[168]. See Robert T. Grieves, B. Russell Leavitt & Adam Zagorin, Greenmailing Mickey Mouse, Time (June 25, 1984),

[169]. See id.

[170]. See id. (“The strategy was to buy up other companies in order to diminish Steinberg’s share of Disney. . . . Steinberg sued to stop the deal, but a U.S. district court in Los Angeles ruled in favor of Disney.”).

[171]. See, e.g., Al Delugach, Walker Says He Was Unaware of Disney Strategy, L.A. Times (July 06, 1989),
/business/fi-4208_1_disney-family (“[Disney] was putting 20% of its stock in the hands of Arvida’s controlling shareholders, the billionaire Bass family of Texas . . . .  [The “supermajority” provision of Disney’s bylaws] stated that a takeover not favored by the board must be approved by holders of 80% of the company’s stock.”).

[172]. Del. Code Ann. tit. 8, § 218 (2010).

[173]. See Schreiber v. Carney, 447 A.2d 17, 25–26 (Del. Ch. 1982).

[174]. Id. at 26; see also Hewlett v. Hewlett-Packard Co., No. 19513-NC, 2002 Del. Ch. LEXIS 44, at *11–12 (Del. Ch. Apr. 8, 2002) (“Management . . . may not use corporate assets to buy votes in a hotly contested proxy contest about an extraordinary transaction that would significantly transform the corporation, unless it can be demonstrated . . . that management’s vote-buying activity does not have a deleterious effect on the corporate franchise.”).

[175]. Del. Code Ann. tit. 8, § 242(a) (2010).

[176]. For the formula used to calculate the Delaware annual franchise tax, see How to Calculate Franchise Taxes, State of Del.,
/frtaxcalc.shtml (last visited Sept. 15, 2011).

[177]. Id.

[178]. See Aktiengesetz [AktG] German Stock Corporation Act, Sept. 6, 1965, BGBl I at § 202(1).

[179]. See id.

[180]. See supra note 24 and accompanying text.

[181]. NASDAQ OMX Group, Inc., Equity Rule 5635, (last visited Sept. 15, 2011).

[182]. Id. (“Nasdaq believes that in such situations the cap is defective because the presence of the alternative outcome has a coercive effect on the shareholder vote, and . . . will not accept a cap that defers the need for shareholder approval in such situations.”).

[183]. See, e.g., Section 1.4(a) of the Agreement and Plan of Merger and Reorganization between Rovi Corporation and Sonic Solutions at 13 (Dec. 22, 2010), available at
/000119312510287804/dex21.htm (“The obligation of the Company to issue and deliver shares pursuant to the Top-Up Option is subject only to the condition that no legal restraint (other than any listing requirement of any securities exchange) that has the effect of preventing the exercise of the Top-Up Option or the issuance and delivery of the Top-Up Option Shares in respect of such exercise shall be in effect.”).

[184]. Del. Code Ann. tit. 8, § 151(e) (2010).

[185]. Id.

[186]. See, e.g., the Model Stock Purchase Agreement of the National Venture Capital Association §2.5,
=article&id=108&Itemid=136 (last visited Sept. 15, 2011) (providing that “[t]he Common Stock issuable upon conversion of the Shares has been duly reserved for issuance.”)

[187]. See Letter from Brian E. Covotta, O’Melveny & Myers LLP, in response to comment letter for Securities and Exchange Commission, available at
.htm (last visited Sept. 15, 2011).

[188]. See id.

[189]. See id. (“Because the Company did not have sufficient authorized shares of common stock, the Investor purchased . . . the Company’s remaining authorized shares . . . and 1,000,000 shares of a new series of Series A Convertible Preferred Stock . . . convertible into a number of shares of the Company’s common stock such that . . . [it] will, in the aggregate, represent 91.33% of the Company’s outstanding common stock.”).

[190]. Del. Code Ann. tit. 8, § 253 (2010).

[191]. Id.

[192]. See supra notes 85–90 and accompanying text.

[193]. It should be noted that unlike Delaware, California, as well as a few other jurisdictions that follow the Model Business Corporation Act, requires a class vote to approve a regular statutory long form merger.  See, e.g., Cal. Corp. Code § 1201(a) (2009).

[194]. If the charter includes a blank check preferred stock provision, the board of directors has full discretion to determine the rights assigned to these shares in accordance with section 102(a)(4) of the Delaware General Corporation Law.  See Del. Code Ann. tit. 8, § 102(a)(4) (2010).

[195]. The customary language in poison pills agreements provides that: “In the event that the Company does not have sufficient Common Shares available for all Rights to be exercised, . . . the Company may instead substitute cash, assets or other securities for the Common Shares for which the Rights would have been exercisable under this provision.”  Corvel Corp. Registration (Form 8-A12G/A) (Nov. 24, 2008),
/000089256908001502/a50604e8va12gza.htm; see also Sun Microsystems Inc. Registration (Form 8-A12G/A) (Sept. 26, 2002),

[196]. As in the case of a short-form merger, see supra note 97 and accompanying text.

[197]. Moran v. Household Int’l, Inc., 500 A.2d 1346, 1351 (Del. 1985) (“Appellants are unable to demonstrate that the legislature, in its adoption of § 157, meant to limit the applicability of § 157 to only the issuance of Rights for the purposes of corporate financing.  Without such affirmative evidence, we decline to impose such a limitation upon the section that the legislature has not.”).

[198]. See id.

[199]. See, e.g., Unocal Corp. v. Mesa Petroleum Co., 492 A.2d 946 (1985).

[200]. See Air Prods. & Chems., Inc. v. Airgas, Inc., Nos. 5249-CC & 5256-CC, 2011 Del. Ch. LEXIS 22, at *12 (Del. Ch. Feb. 15, 2011) (“[The poison pill] has given Airgas more time than any litigated poison pill in Delaware history . . . .”) (emphasis in original).

[201]. See, e.g., Gina Chon, “Poison Pill” Lives as Airgas Wins Case, MarketWatch (Feb. 16, 2011),
?guid=42cccb5a-395a-11e0-a9aa-012128040cf6 (“Minutes after the judge’s ruling, Air Products dropped its effort to buy Airgas.”).

[202]. See Andrew L. Nichols, Shareholder Preemptive Rights, 39 Bos. Bar J. 4, 4 (1995).

[203]. See, e.g., John C. Coffee Jr., The Mandatory/Enabling Balance in Corporate Law: An Essay on The Judicial Role, 89 Colum. L. Rev. 1618, 1641 (1989) (“Preemptive rights . . . [was] a rule that was once mandatory, but evolved into a default rule.”).

[204]. See Aktiengesetz [AktG] German Stock Corporation Act, Sept. 6, 1965, BGBl I at § 202; Dr. Hurbert Besner et al., How to Implement a Standard US Venture Capital Term Sheet in Germany (Jan. 21, 2002),

[205]. See, e.g., the Model Investors’ Rights Agreement of the National Venture Capital Association at 25 n.42,
_content&view=article&id=108&Itemid=136 (last visited Sept. 15, 2011) (explaining that this is “commonly referred to as a[n] . . . ‘over allotment’ . . . provision and allows investors to purchase shares not purchased by other investors entitled to purchase rights”).

[206]. See supra notes 34–40 and accompanying text.

[207]. See supra note 24 and accompanying text.

[208]. See supra notes 178–79 and accompanying text.

[209]. I study only nonfinancial companies because financial companies, including real estate investment trusts (“REITs”), are subject to additional regulatory governance requirements that may have a substantial effect on the choice of the size of the excess ratio.  See, e.g., Lucian Arye Bebchuk & Alma Cohen, The Costs of Entrenched Boards, 78 J. Fin. Econ. 409, 418 (2005) (excluding REITs from the sample because such corporations “have their own special governance structure and entrenching devices”); Robert Daines, Does Delaware Law Improve Firm Value?, 62 J. Fin. Econ. 525, 530 (2001) (omitting financial firms from the tested sample because the special federal regulations may influence the corporate governance of such firms).

[210]. To be sure, this assumes that the managers ignore stock exchange restrictions on issuance of shares without shareholder approval, as they often do where top-up options are granted.  See supra note 183 and accompanying text.

[211]. See supra note 164 and accompanying text.

[212]. See, e.g., D. Gordon Smith, The Exit Structure of Venture Capital, 53 UCLA L. Rev. 315, 319–20 (2005).

[213]. See, e.g., id. at 345 (explaining that “[e]xit is not merely optional for venture capitalists. Most venture capital funds have a fixed life, usually ten years with an option to extend for a period up to three years”).

[214]. The size of the assets of the company may influence the choice of the size of the excess ratio at the public offering, because the size of the company may be connected to the likelihood of a future takeover.  An acquirer needs less financing to purchase a small firm, thus there are more potential acquirers that can acquire small firms, suggesting that smaller firms may have a higher incidence of being acquired.  In addition, a bigger company may be subject to more monitoring at the time of the initial public offering as well as later on.  The heightened scrutiny may limit the ability of management to go public with a high ratio and also limit the use of the power to issue stock in the future, even if there are sufficient authorized but unissued shares.

Article in PDF Form

By: Kent Greenfield*


When pondering the question of the “sustainable corporation,” as we did in this symposium, one of the intractable problems is the nature of the corporation to produce externalities.  By noting this characteristic, I am not making a moral point but an economic one.  The nature of the firm is to create financial wealth by producing goods and services for profit; without regulatory or contractual limits, the firm has every incentive to externalize costs onto those whose interests are not included in the firm’s current financial calculus.  In fact, because of the corporation’s tendency to create benefits for itself by pushing costs onto others, the corporation could aptly be called an “externality machine.”[1]

The obvious kind of externality is the one that happens in the same time frame as the benefits gained.  These current externalities take a number of forms.  A company might refuse to provide health benefits to its employees, leaving Medicare or Medicaid to pick up the tab.[2]  The company might save on production costs by skirting environmental laws, thereby forcing communities, neighbors, or employees to suffer risks of harm that do not need to be accounted for on the company’s financial statements.[3]  Alternatively, the company could sell shoddy products to one-time purchasers, produce goods in sweatshops, or underfund employees’ pension funds.[4]

These kinds of externalities are routine to notice and remark on.  They are also the subject of some push-back from stakeholders and regulators.  Those who bear the cost can assert their interests in various ways.[5]

The more difficult kind of externality to address—especially if our focus is on the sustainability of the corporation—is the future externality.  What I mean here is the kind of cost that a corporation’s management can externalize to the future.  From management’s perspective, the future is a much more attractive place to push off costs.  Stakeholders who must bear such future costs will be less aware of those costs than current costs, and even if they do learn of such future costs, they will be less able to gain the attention of regulators.

The aim of this Essay is to ask about one particular kind of future externality: future costs to shareholders.  I recognize that shareholders are not usually the focus in a discussion of externalities.  In the present, their interests are sufficiently (even if not perfectly) aligned with those of management that we need not concern ourselves with externalities borne by shareholders other than through the usual corporate governance tools.  But in the case of future externalities, the analysis is more complex.  Current shareholders may prioritize present returns over future returns,[6] and current shareholders may not expect to be future shareholders at all.  This means that corporate managers have incentives not only to externalize costs to current and future stakeholders whose interests they can ignore but also to future shareholders as well.  This means that corporations will, by their very natures, be fixated on the short term.

If one is worried about the sustainability of corporations from an environmental, social, or political perspective, the problem of “short-termism” has to be a central worry.  This is because, at least according to many who have thought seriously about the topic,[7] in the long run the interests of corporations conflate with those of society as a whole.  (For the sake of this Essay I will assume this to be the case, though I have stated some disagreement elsewhere.[8])  Short-termism is a problem whether we focus our attention on the sustainability of the corporation or the ethics of its management.[9]

Short-termism is also costly economically, since the economy as a whole benefits when companies have a long-term strategy.  The economy is a summation of the fortunes of the millions of companies and individuals that make it up; if most companies make decisions that prioritize the short-term at the expense of the long-term, we all suffer.[10]  A nation’s wealth grows more over time when companies invest for the future and maintain their viability as a going concern.

The financial crisis of 2008 brought into sharp relief the economic costs of short-term management.  Among the competing theories on the cause of the financial collapse—the over-dependence on derivatives, the overuse of leverage, the culture of greed and entitlement in the finance industry, just to name a few[11]—a focus on the short term is an omnipresent narrative thread.  If managers and financiers had taken a more long-term view of the health of their own companies and the fortunes of their investors, we might not have seen the myriad other problems come to such a head.  The addiction to leverage, derivatives, and greed that caused the market to become a casino would only have been possible in a business culture where short-term gains are prioritized over long-term costs.  What might have been assumed to be costs that would be suffered some time in the distant future are being absorbed now.  John Maynard Keynes was wrong on this point: in the long run, we are not all dead.[12]

So despite some naysayers,[13] the problem of short-termism is very real.  Shareholders hold their stocks, on average, for less than a year, and even less for small companies.[14]  Institutional investors have been said to be particularly bad on this front, acting “more as traders, seeking short-term gain.”[15]  Managers admit that they make decisions that harm the company in the long-term in order to meet short-term earnings expectations.[16]  In 2006, both the Conference Board and the Business Roundtable, two of the nation’s most prominent business organizations, issued reports “decrying the short-term focus of the stock market and its dominance over American business behavior.”[17]  And, let’s remember, that was two years before the collapse.

But there is a puzzle.  In contrast to the others who suffer the costs of future externalities, future shareholders have a way to communicate with present-day managers and shareholders.  They “communicate” with the present by way of the market.  What I mean is that in a well-functioning, efficient market, present-day decisions that exact a future cost will affect present-day stock price.  Current stock price will be affected by future losses because current stock price is a function (in part) of future profitability of the firm.  With that truth in mind, why do managers focus on the short term?  Why would a company benefit from short-term management?  If short-termism is a problem because it falsely inflates the company’s stock price, how does that occur?  That is, why would share prices be inflated rather than depressed for such a company?

I.  The Short-term Puzzle

Consider that any shareholder who sells her stock in order to profit in the short-term is selling to someone else, who by definition believes that the stock is selling for less than it is worth.  Share turnover is not by definition a problem, then, since for every seller there is a buyer.  Moreover, it ought to be irrational for Wall Street analysts to require—and company management to make—decisions that hurt the company in the long run but allow the company to meet short-term earnings projections.  In such situations the share price should fall rather than increase or stay steady.  The reason is that in an efficient market, share price is a reflection of the company’s value.  If decisions are being made to decrease the true value of the firm then the share price should reflect that.[18]

To offer a concrete example, let’s say a company chooses to adjust its accounting treatment in such a way as to accelerate earnings and delay costs for the current quarter.  This will give the appearance of a greater profit in the current period, perhaps allowing the company to report to Wall Street analysts that the company has met its earnings expectations.  But no rational, informed investor would pay a higher price for shares in such a company since the company’s value has not changed in reality.  Rather, since the company is still making the same products or providing the same services, its long-term prospects have not changed for the better and may have changed for the worse if management has been spending its energy on accounting rather than productive pursuits.

Indeed, if the company is in fact being managed for the short-term at the expense of the long-term, the share price should fall dramatically and consistently.  The rational buyer would not be willing to pay any more for each share than the sum of the total dividend payments coming to her in the future on the basis of that share (discounted to present value).[19]  And if shareholders know that the company has made future dividends less likely because of management’s short-term orientation, then the market price of the stock will reflect this even if the short-term earnings are inflated.  Indeed, share price should be expected to fall consistently over the period of such managerial strategy.  Again, to make the point concrete: if managers intentionally manage a company to accelerate all profit and earnings into the next five-year period and then go bankrupt, no informed shareholder should purchase shares of that company at the current price.  The shares will be worthless in five years, and fall dramatically in value between now and then.

In figuring out this puzzle, allow me to make an assumption that will simplify the analysis as we go.  Allow me to assume that there are two kinds of companies: one that manages for the short-term and one for the long-term.  The short-term company seeks to maximize profits and earnings in the near future and disregards the long-term.  If decisions can be made to transfer value from the future into the present day, the management will do so—even if it will decrease the total value of the firm aggregated over time.  (I’ll set aside for the moment why management would do this.)  Long-term-oriented companies will make decisions that seek to maximize the value of the company over time.  If decisions can be made in the short-term that cost the company money but will pay returns in the future, then the company will do so—even if in so doing the company will be unable to recognize profits in the near future.

In a company whose management team is oriented toward the long-term, one would expect to see a greater-than-usual dedication to sustaining the company as a going concern over time; a larger commitment to maintaining the loyalty of those who have made investments in the company, whether by way of capital, infrastructure, or work; a dedication to the development of products or services that will pay off in the future; a diversification of firm endeavors and investments to guard against short-term shocks in the financial or consumer markets; and so on.[20]

On the other hand, a company focusing on the short-term will also have a number of strategies at its disposal.[21]  Here is an illustrative list, which is hardly exhaustive:

Cuts in research and development, in order to use the capital that would be spent for R&D to increase dividends or retained earnings temporarily, at a cost to the long-term health of the company;

Accounting adjustments (either legal or illegal) to accelerate recognition of revenue and delay recognition of expenses, inflating current earnings at the cost of deflating future earnings;

The sale of profitable divisions or subsidiaries for cash, realizing future earnings of the division as a cash payment in the present, usually at a discount;

A greater dependence on debt to finance company expenses and projects, which increases the company’s leverage, inflating returns on equity as long as the company is doing well and the market is trending up, but with increased risk of insolvency if the market goes down;

The use of executive compensation schemes that prioritize the satisfaction of short-term financial goals, incentivizing management to look only a few steps ahead;

Breaches in implicit or explicit contracts and understandings with company stakeholders, which allow the company to seize the value of past investments by such stakeholders without paying them their expected returns (an example of this would be a change in company policy away from a commitment to providing stable employment and instead increasing its use of short-term, low-wage employment);

Cuts in employment generally, since savings in labor costs occur in the short-term and costs to the company arising from a decrease in employee loyalty and specific human capital valuable to the company are incurred in the longer term;

A disregard for latent risks in the company’s products or services, whether such risks be environmental (such as the risk of global warming brought about by the use of sport-utility vehicles), social (the social cost of violent media, for example), or financial (the risk of financial crisis brought about by the overuse of risky financial derivatives);

Stock buybacks, which increase share price in the short term but deplete the company’s capital that could be used for a more productive purpose; and

A focus on share price rather than the corporation’s value as a whole or the value of the corporation to its non-equity shareholders.

Each of these short-term strategies will likely impose long-term costs onto the firm but have short-term benefits to the company, the management, or certain shareholders.  There may be situations in which such long-term costs are worth the short-term gain—for example, when the company needs to satisfy some short-term financial obligation (to pay a legal judgment, say) and can only do so if R&D expenditures are put off.  But by definition most of these strategies will be bad decisions for the firm in the long run.

This is not to say that a company that refuses to engage in such short-term decisions will necessarily succeed.  Managers make mistakes, and some mistakes are quite costly.  Moreover, to the extent that a company’s time horizon is long, it may be more difficult to know whether a long-term strategy pays off more than a short-term strategy.  Also, a long-term strategy is more difficult: not only must a company’s management make decisions that are focused on success five, ten, or twenty years out, it must also make short-term, tactical decisions that work as well.  A part of a company’s long-term strategy must always be to survive in the short term.[22]

So here we get to the nub of the problem: if by definition short-termism is costly to companies in the long run and to the economy as a whole—because the economy is a summation of the well-being of everyone—then why do we see the short-term management tactics described above?

II.  Puzzling Out the Puzzle

One possible answer lies in the nature of management.  To state the obvious, companies are controlled by managers, and some managers intend to be at the company for a long period of time and therefore look toward the long-term.[23]  Other managers want to make their money and get out.  This would explain why some managers would want to manage their companies for the short term.[24]  But it does not explain why the market does not consistently punish such behavior.  If managers make decisions that will hurt the company in the long-term for selfish reasons, why does the share price not fall?

Another answer might be that that some investors, too, focus on the short-term, so that they buy stock of companies so oriented.  But even that does not fully answer the question, since short-term-oriented shareholders should not be able to realize any benefit from owning shares in a short-term-oriented company.  If dividends are inflated in the short-term at the cost of the long-term fortunes of the company, whatever benefit realized from the short-term dividends will be more than set-off by the decline in the stock price brought about by the decline in the real value of the company.

In other words, if a company’s short-term strategy is known to the investing public, then the future drop in the value of the company will be “baked in” to the current price.[25]  No benefit should be gained from such a strategy if indeed it is known to the investing public.  As the costs of the short-term strategy become clearer, the stock price will plummet, and those holding the shares of such a company will find fewer willing buyers.

As for companies with long-term strategies, the future earnings will be reflected in current prices as well, so the stock price will be trading at a fairly high price-to-earnings ratio.  (The value of the future earnings will not be fully captured by the current share price, however, since investors will discount future earnings in relation to the time value of money and will also likely impose a “risk discount” in connection with the probability that the company will not actually realize the benefits of its long-term strategy.)  All in all, in a perfectly informed market, the value of long-term-oriented companies will tend to be recognized as such, and their share values will so reflect.[26]

III.  The Information Fallacy

Of course this argument depends on an unreasonable and simplistic assumption—that the market is perfectly informed.[27]  In fact, investors are not perfectly informed, and it is often costly or impossible to determine whether companies are being managed for the long- or short-term.[28]  That is, it is often costly or impossible to determine whether an increase in quarterly earnings is evidence of a short-term orientation that will be costly to the company in the long-term, or if the increase is due to the realization of returns from a successful long-term strategy.

This fact poses a significant difficulty for public policy.  Profits and earnings for a long-term-oriented company may be indistinguishable from profits and earnings for a short-term-oriented company.  It is easy to show the numbers; it is rather difficult for most investors to determine the reason for such numbers.  In fact, a company that is utilizing some of the short-term managerial strategies listed above may show profits and earnings that are greater than companies with a long-term focus.  And capital markets may not “punish” such short-term management if it is not clear that the inflated earnings are based on strategies that are costly in the long-term.

When a company’s management strategy is not known, or is not widely known, a company that is being managed for the short-term may have a share price that is inflated, only for the price to fall along with earnings when the strategy becomes clear.  Those investors holding the stock at the time of the fall will suffer the financial loss.  A windfall will be gained by those who are holding the stock during the run-up of the stock price and are fortunate enough to sell before the drop.  Also, a windfall will inure to managers who time their departure before the drop.

As for long-term-oriented companies, the depressed short-term earnings brought about by the long-term strategy will not be easy to distinguish from depressed earnings caused by bad management or a short-term strategy that has run its course.  The stock price will also be discounted because it will be unclear to investors what the true strategy really is.  This in turn makes the company ripe for takeovers.

So in a world in which (1) short-term management can result in short-term bumps in profits and earnings and (2) such earnings and profits are indistinguishable (or costly to distinguish) from those coming from long-term-oriented companies, then (3) the market will be slow in punishing short-term-oriented management.  That is, there will be a lag between the implementation of a short-term management strategy and when the chickens come home to roost—it may take some time for the capital market to price the shares correctly.

The other side of the story should be told as well: it will often be difficult and costly to distinguish between a company that is showing a low level of short-term profits and earnings because of the costs of implementing a long-term strategy and a company that is showing a low level of profits and earnings because of poor management or a failure of strategy.  So the share price of the company that is actually being managed for the long-term—but showing no signs of success as of yet—will trade deceivingly low.

The existence and extent of this lag time between the establishment of a long- or short- time horizon and the recognition of the costs or benefits thereof in the stock price will depend on a number of factors.  The most prominent of these will be how obvious the strategy is to investors in the market.  The more obvious the strategy, the more efficient the capital markets will be in “pricing” the securities issued by the company.  If a company that is pursuing a short-term strategy is able to camouflage it as a long-term strategy, the stock price will be falsely inflated until the strategy becomes sufficiently clear to the investing public that they recognize that it is overpriced.  Only then will the share price fall to a level that correctly reflects the company’s value.

Most investors will not invest the time to distinguish between the long-term companies that are not yet making money and the companies that are simply floundering.  Instead, they will look toward companies that are showing profits and earnings.  The problem here is that some of these companies—investors will assume—are realizing the benefits of successful long-term strategies, while others are simply exchanging long-term benefits for short-term profits at the cost of the company’s long-term prospects.

IV.  Sophisticated Investors in an Uninformed Market

Note that nothing I have said so far will be unknown to sophisticated investors.  They know that earnings and profits in the short-term do not necessarily translate into long-term success.  They know that a failure to show short-term earnings does not necessarily mean that the company is destined to fail.  But they also know that it is costly to figure out which is which, and that what counts to them is the value of their portfolio as a whole over time, not the profits from a single investment.

So in maximizing the value of their portfolio, sophisticated investors face a variety of choices.  If such investors have a short-term focus, perhaps because their own time horizons are short because of imminent retirement or the like, then they have no incentive to try to pick the long-term successes and hold for the long-term.  These investors will instead look for companies whose stocks will pay off in the short-term, whether such payoff comes as a result of short-term strategies with long-term consequences or as a result of companies that are realizing the payoffs of long-term strategies.

As for long-term investors—individuals planning for retirement years in the future or investment funds that hold accounts for such people—one might expect that they would tend to “buy and hold” investments in companies that appear to be strong for the long-term, even if short-term earnings are disappointing or foregone.  That is true for some long-term investors, but certainly not all.  Such long-term investors, whether individuals or institutions, face a choice: they can (1) try to identify companies that have successful long-term strategies but whose stock is undervalued at present; or (2) identify companies with high earnings and profits in the short-term.  Some of the latter group will be truly successful companies; some will be companies that are utilizing strategies to emphasize short-term gain at the expense of long-term gain.

Both strategies are in fact followed by long-term investors.  Both have their risks and costs.  Under the first strategy, the risk is that the investments chosen will not in fact pay off, and the major cost is the expense of discovering long-term-oriented, undervalued companies.  The cost of research under the second strategy is much less—an investor need only look at numbers.  The risk of the second strategy is holding too long.  If a stock’s inflated value becomes obvious to the market, the stock price will plummet.  In other words, the key to the second strategy is timing.  Get in, ride the wave, and get out before it crashes; then take your money and find another investment in the short-term market.

It is important to note a key fact about the second strategy: a short-term investment strategy will become even more successful if the investor can control the timing of the investment’s withdrawal to capture as many of the short-term gains as possible before the inevitable downgrade in stock price.

Most investors do not have any way to do that.  They can only try to stay ahead of the curve by trading often and quickly, usually on the slightest sign of downturn in a stock.  This makes the market as a whole more volatile, since small upticks in stock price will attract a host of short-termers looking for a place to put short-term money, and small downturns will cause many short-termers to flee in fear that the small downturn is the beginning of something worse.  But such a strategy is highly risky, and unlikely to maximize gains over time (witness that very few mutual funds outperform index funds over time).[29]

V.  Making a Short-term Strategy Work in an Uninformed Market

What if an investor could time their investments?  The gains from the short-term strategy could be immense.  The long-term value of their portfolios would be the summation of a series of above-market, short-term gains.  And the strategy could be maintained as long as there are enough investment opportunities available so that the money investors pull out of one company can find a place to land elsewhere.  But how could such timing be accomplished?

Let us imagine a situation in which investors—whether individual or institutional—can affect the time horizon of a company, to accelerate earnings and capture as much of the company’s future value as possible in the near term.  Let us also imagine a situation where they could keep that information camouflaged from the market generally.  How would they do that?  The answer is by taking over management of the company or by buying enough stock in a company that the management is forced to listen to you.

Obviously, such a tactic would be available only to investors with significant capital to invest.  But if investors are successful in doing so—buying off management or buying up companies—then the company can be made to do the things that shift future company value to the present.  For example, the company can buy back stock, increasing immediate returns to investors; pay management exorbitant compensation, in effect taking present and future earnings of the company as individual compensation; sell off portions of the company for cash, distributing the cash as a dividend; or leverage the company highly, multiplying the return on equity at the cost of increased risk for the firm in the long-term.

Moreover, while the investors themselves are managing the company in such a way, they need not make the true implications of their decisions clear to the investing public.

One mechanism for taking control of companies in this way is private equity.  In fact, private equity funds are defined by this trait: they take over companies and manage them as private corporations, free from many of the reporting obligations required of public companies.  Also, certain hedge funds have such large amounts of capital to throw around that they may be able to get similar results from management without actually taking over the companies.

And note that many managers may want to maximize short-term earnings at the expense of the long-term.  Managers find it advantageous to use short-term strategies as well.  It is much easier to meet next quarter’s Wall Street earnings expectations, by hook or by crook, than it is to guide a company toward a long-term goal.  And if their compensation consists primarily of stock and stock options, then they have incentives to consider themselves investors rather than managers.  When this is true, they can manipulate the company using the strategies described above to maximize their own short-term gain at the expense of the long-term health of the company, and time their departure before the company falls back to earth.

VI.  What to Expect in a Short-Term Market

So that’s the story of how short-term-oriented investors could collude with, or become, short-term-oriented management to cause businesses to manage for the short-term without being punished by the market in the short term.  Such a strategy will hurt the company in the long term and impose external costs onto company shareholders and stakeholders with long-term interests—as well as society and the economy in general.  But such costs will not be borne in the short term by the investors or managers.  As long as they “get out” in time, they will be able to enjoy above-market returns.  And as long as they can continue to find companies that are susceptible to the same strategy, they can maintain above-market returns for the duration.  But of course such returns are not truly a reflection of anything other than being a winner in a zero-sum game.  The returns are not a reflection of excellent management, or product innovation, or the creation of value.  They are only, in economists’ terminology, the “extraction of rents,” the shifting of financial gain from someone who is losing at least as much.  The fact that those who are losing exist mostly in the future does not make the losses any less real.

There is one last thing to recognize: in a market where companies are being increasingly managed for the short term, the typical “Main Street” investor will not stay in the dark forever.  Investors who do not have the access or capital of the hedge funds and private equity funds will eventually recognize what is happening.  So they, too, will start investing with a view toward the short term, and be extremely sensitive to downticks in stock price that might be signs of a more serious downturn.  This will in turn make the market as a whole more volatile.  And as volatility increases, the entire market will become less secure.  More and more investors will either lose their shirts or simply leave the market and put their money elsewhere.  And eventually, the costs of short-term management will be such that the entire economy will suffer.  The chickens will eventually come home to roost.

Over the last few years, I have noticed some roosting chickens.  You?



* Professor of Law and Law Fund Research Scholar, Boston College Law School.  I would like to thank Alan Palmiter for the invitation to take part in such an interesting symposium.  Brian Quinn and David Wood offered valuable comments on an earlier version of this Essay, and Michael Girma Kebede provided excellent research assistance.  An earlier version of this Essay was published in the conference papers of the Second Summit on The Future of the Corporation, June 2009.

[1]. See Lawrence E. Mitchell, Corporate Irresponsibility: America’s Newest Export 49–65 (2001) (calling the corporation an “externalizing machine”).

[2]. See, e.g., Wal-Mart: The High Cost of Low Price (Brave New Films 2005).

[3]. See Joseph Kahn & Jim Yardley, As China Roars, Pollution Reaches Deadly Extremes, N.Y. Times, Aug. 26, 2007, at A1; Jane Perlez & Raymond Bonner, Below a Mountain of Wealth, a River of Waste, N.Y. Times, Dec. 27, 2005, at A1.

[4]. See Steven Greenhouse & Michael Barbaro, An Ugly Side of Free Trade: Sweatshops in Jordan, N.Y. Times, May 3, 2006, at C1; Roger Lowenstein, The End of Pensions?, N.Y. Times Mag., Oct. 30, 2005, at 56, 62–63; Fact Sheet Making Change at Wal-Mart, United Food and Commercial Workers Int’l Union, (last visited Aug. 23, 2011).  For a related (and more provocative) example, see Kent Greenfield, September 11th and the End of History for Corporate Law, 76 Tul. L. Rev. 1409 (2002).

[5]. See, e.g., David Yermack, Shareholder Voting and Corporate Governance, 2 Ann. Rev. Fin. Econ. 103 (2010) (reviewing empirical research on shareholder voting).

[6]. See, e.g., Alan R. Palmiter & Ahmed E. Taha, Mutual Fund Investors: Divergent Profiles, 2008 Colum. Bus. L. Rev. 934, 994–98 (2008) (discussing propensity of investors to choose a mutual fund based on past performance irrespective of future performance).

[7]. See, e.g., Andrew C. Coors & Wayne Winegarden, Corporate Social Responsibility—Or Good Advertising?, Reg., Spring 2005, at 10, 10 (“A profit-centric firm provides the optimal amount of socially responsible behavior.”); Milton Friedman, The Social Responsibility of Business is to Increase its Profits, N.Y. Times, Sept. 13, 1970 (Magazine) at 32.

[8]. See Kent Greenfield, The Failure of Corporate Law: Fundamental Flaws and Progressive Possibilities 134–42 (2006).

[9]. Kent Greenfield, Corporate Ethics in a Devilish System, 3 J. Bus. & Tech. L. 427 passim (2008).

[10]. See Michael E. Porter, Capital Disadvantage: America’s Failing Capital Investment System, Harv. Bus. Rev., Sept.–Oct. 1992, at 65, 76–77 (arguing investors should take a long-term view).

[11]. See, e.g., Liaquat Ahamed, Lords of Finance: The Bankers Who Broke the World 14 (2009); William D. Cohan, House of Cards: A Tale of Hubris and Wretched Excess on Wall Street 303, 426, 531 (2010).

[12]. John Maynard Keynes, A Tract on Monetary Reform 80 (1924) (“But this long run is a misleading guide to current affairs.  In the long run we are all dead.”).

[13]. See, e.g., George W. Dent, Jr., Stakeholder Governance: A Bad Idea Getting Worse, 58 Case W. Res. L. Rev. 1107, 1109–11 (2008) (denying a problem with short-termism exists).

[14]. Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry 277–78 (2007).

[15]. Robert Kuttner, The Squandering of America: How the Failure of our Politics Undermines our Prosperity 144 (2007).

[16]. Mitchell, supra note 14, at 1.

[17]. Id.; see also Lee Drutman, The Long Term Value Moment, Am. Prospect, July 9, 2007,
_value_moment (cataloging various studies pointing out the pathologies of short-termism as a business strategy).

[18]. Aleta G. Estreicher, Beyond Agency Costs: Managing the Corporation for the Long Term, 45 Rutgers. L. Rev. 513, 534 (arguing that for adherents of Efficient Market Hypothesis, any discussion of short-term versus long-term strategies and interests is misguided because in a perfectly efficient market, common stock prices should reflect the sum of all dividends and all payouts to be expected in the future, discounted to their present value); see also R.A. Brealey, An Introduction to Risk and Return from Common Stocks 67–68 (2d ed. 1983); Victor Brundey & Marvin Chirelstein, Cases and Materials on Corporate Finance 479–82 (2d ed. 1987); Benjamin Graham et al., Security Analysis: Principles and Technique 480–81 (4th ed. 1962).

[19]. See Robert J. Shiller, Market Volatility and Investor Behavior, 80 Amer. Econ. Rev., 58, 58 (1990) (surveying literature confirming that rational investors price stocks as present values of forecasted dividends, and forecasts are based on lagged real dividends).

[20]. See Estreicher, supra note 18, at 550–53 (outlining long-term investment strategies and acknowledging an alarming underinvestment in long-term business strategies).

[21]. See generally John R. Graham, Campbell R. Harvey & Shivaram Rajgopal, The Economic Implications of Corporate Financial Reporting, 40 J. Acct. & Econ. 3 (2005) (identifying various kinds of short-term strategies and analyzing managerial behavior with regard to such short-term pressures).

[22]. See Robert M. Feinberg, In Defense of Corporate Myopia, 16 Managerial & Decision Econ. 205, 209 (1995) (arguing against the effects of imposing so-called “long-term management” through tax, subsidy, or regulatory incentives, which the author claims may lead to unproductive rent-seeking activity and other inefficient behavior unintentionally induced by such incentives); Gregory Jackson & Anastasia Petraki, Understanding Short-termism: The Role of Corporate Governance, Glasshouse F., 48 (2011), (arguing that short-termism may be a rational managerial response to shareholder myopia in the face of high risk or uncertainty).

[23]. See Kevin J. Laverty, Economic “Short-Termism”: The Debate, the Unresolved Issues, and the Implications for Management Practice and Research, 21 Acad. Mgmt. Rev. 825, 832 (1996).

[24]. See id.

[25]. See id. at 833–34 (finding that many writers have argued, and many managers believe, that the stock market undervalues investments that will pay off only in the long run).

[26]. See Allan C. Eberhart, William F. Maxwell & Akhtar R. Siddique, An Examination of Long-Term Abnormal Stock Returns and Operating Performance Following R&D Increases, 59 J. Fin. 623, 648 (2004) (finding that investors systematically underreact to R&D investment, an example of a long-term management decision, partly because they are not always fully informed).

[27]. See Jeffrey N. Gordon & Lewis A. Kornhauser, Efficient Markets, Costly Information, and Securities Research, 60 N.Y.U. L. Rev. 761, 764 (1985) (“[T]he legal rush to embrace and apply the efficient market hypothesis has been overly precipitous and occasionally unwise.”).  Scholarship has called into question the Efficient Market Hypothesis’s (“EMH”) empirical and theoretical claims.  See, e.g., Stanford J. Grossman & Joseph E. Stiglitz, On the Impossibility of Fully Informed Markets, 70 Am. Econ. Rev. 393, 405 (1980); Emanuel Sciubba, Asymmetrical Information and Survival in Financial Markets, 25 Econ. Theory 353, 370 (2005); William K.S. Wang, Some Arguments that the Stock Market is Not Efficient, 19 U.C. Davis L. Rev. 341 passim (1986).

[28]. See Ronald J. Gilson & Reinier H. Kraakman, The Mechanics of Market Efficiency, 70 Va. L. Rev. 549, 580 (1984).

[29]. See David McPherson, Index Funds vs. Actively Managed Funds: Which is Better?, ABC News (Oct. 20, 2009),
/PersonalFinance/index-funds-actively-managed-funds-best/story?id=8866429 (citing a Morningstar study that found only thirty-seven percent of actively managed U.S. stock mutual funds beat their respective Morningstar indexes).

Article in PDF Form

By: Dana Brakman Reiser*


Founders of social enterprises believe profits and social good can be produced in tandem and wish to form organizations that will pursue these dual missions.[1]  They will, however, encounter obstacles to articulating and enforcing such dual missions if they adopt either a traditional nonprofit or for-profit form of organization.  Nonprofit forms bar profit distribution[2] and for-profit forms will create practical, if not legal, pressure to favor profit maximization over social good when the two come into conflict.[3]  And these two imperatives will certainly, at times, conflict.  If more profit could always be obtained by pursuing social good, traditional for-profits would produce the optimal level of social goods, charities would be swimming in resources, or both.  Social entrepreneurs believe social good can be produced along with profits and desire hybrid forms of organization to smooth a single enterprise’s path to realizing both goals.[4]

A mounting number of jurisdictions have attempted to meet this demand by enabling new hybrid organizational forms.  These include the low-profit limited liability company (“L3C”) available in nine U.S. states[5] and the community interest company (“CIC”) available in the United Kingdom.[6]  In addition, “B Corp” is a private certification available to U.S. for-profits that demonstrate their commitment to a dual mission of making profits and promoting social good.[7]  Qualifying entities can license the B Corp mark to market themselves to consumers, investors, and others.  This Article examines another recent entrant into the hybrid form category: the benefit corporation.  A handful of states have enacted statutes enabling “benefit corporations” in the past two years, and several more are considering similar legislation.[8]  The benefit corporation form differs from the L3C, CIC, and B Corp in several respects, especially in its use of third-party standard-setting organizations to vet the social good bona fides of potential incorporators.[9]  This Article evaluates whether the innovations in the benefit corporation form can meet the goals social entrepreneurs have for hybrid organizational forms, ultimately concluding it will fall short.

This Article proceeds in two parts.  The first Part explores the new benefit corporation form.  After briefly summarizing the key elements of the L3C, CIC, and B Corp for purposes of comparison, it describes the major components of the benefit corporation form.  The second Part then undertakes an admittedly preliminary assessment of the benefit corporation.  This Part offers four reasons why social entrepreneurs view hybrid organizational forms attractive: articulating and enforcing a dual mission, expanding funding streams, branding their enterprises, and achieving sustainability.  The new benefit corporation form offers potential gains in formally articulating a dual mission, an advantage as compared with traditional nonprofit and for-profit forms.  However, like the other hybrid forms simultaneously under development, the benefit corporation lacks robust mechanisms to enforce dual mission, which will ultimately undermine its ability to expand funding streams and create a strong brand for social enterprise as sustainable organizations.

I.  The Benefit Corporation

Before delving into the details of the new benefit corporation form, it is useful to describe the dynamic scene onto which it enters. When social entrepreneurs’ frustration with traditional nonprofit and for-profit forms became apparent, jurisdictions began to respond with new hybrid forms.  An early mover here was the United Kingdom, which established the CIC in 2004.[10]  The CIC is a company formed for community benefit purposes, which may offer investors limited dividends, but must lock its assets and earnings beyond these limited disbursements into the community benefit stream.[11]

Innovation began stateside with the L3C, first adopted by statute in Vermont in 2008.[12]  Eight other states have since enacted similar legislation.[13]  The L3C is a limited liability company formed to “significantly further the accomplishment of one or more charitable or educational purposes” and for whom neither income production nor property appreciation may be a significant purpose.[14]  An L3C may have investor members who can receive unlimited disbursements during the L3C’s existence or upon dissolution, and if the L3C ceases to pursue its educational and charitable purposes it transforms into an ordinary LLC.[15]

In addition, companies have been able to obtain private certification as a “B Corps” since 2006.[16]  B Corps must provide in their formative documents that fiduciaries must consider the impact of their decisions on various nonshareholder constituencies, including the environment and the local, state, and national economy.[17]  A private nonprofit organization, B Lab, vets aspiring B Corps to confirm that these governance structures have been established and conducts an extensive survey to determine how well an applicant uses “the power of business to solve social and environmental problems.”[18]  Those applicants meeting B Lab’s standards may license the B Corp mark and are subject to audit by B Lab on an ongoing basis.[19]  B Lab, of course, cannot confer a legal form on an organization.  By varying governance structures and conveying information about conforming entities, however, B Corp status appeals to social enterprises in a manner similar to official hybrid forms.

In 2010, Maryland became the first state to establish a “benefit corporation” form of organization, the subject of this Article.[20]  This new form blends both state enabling legislation and a third-party certification system.  Vermont, New Jersey, Virginia, and Hawaii have since followed suit[21] and benefit corporation legislation has also been introduced in numerous other states.[22]  Although Maryland was the first mover here and all enacted and pending statutes share many attributes, future references to the statutes will highlight important points of divergence.

A.            Separate Statute

The benefit corporation concept has thus far been enacted only under special statutory authorization, separate and apart from the adopting jurisdiction’s standard corporate legislation.  States could have, alternatively, inserted provisions to allow the articulation or preference of social goals into their existing corporation laws as an opt-in provision.[23]  Yet, all of the benefit corporation statutes envision a form of organization that is distinct from the standard corporate form.[24]  Perhaps proceeding with a special statute eases legislative adoption, but the special statute approach also ties in with the statutes’ recurring theme of avoiding infiltration of general corporation law by benefit corporation norms.  Yet, this walling-off does not go both ways.  When benefit corporation statutes are silent, for-profit corporate statutory and decisional law will fill the gaps.[25]

Although it exists under a separate statutory framework, “benefit corporation” status is available both to newly forming corporations that may use the form from their inception and to existing for-profit corporations that adopt benefit corporation form by amending their charters.[26]  The statutes use labeling and voting requirements to protect initial and existing shareholders from confusion.  Upon adopting this status, charter documents, and in Maryland the stock certificates, must be clearly labeled or re-labeled to include the term “benefit corporation.”[27]  Those purchasing shares in the benefit corporation and inspecting its documents are thus placed on notice of the special nature of the corporation in question, if not specifically of the limits on what a benefit corporation may or may not do.  Clearer labeling would be provided if the corporation’s name were required to include the “benefit” term, as state law often demands inclusion of a designation of limited liability in other forms.[28]  In May 2011, Maryland added the requirement of a benefit legend into corporate names;[29] it is thus far the only state to have done so.

For an existing business corporation to reinvent itself as a benefit corporation, the statutes demand significant support for the change among shareholders.  Charter amendments require a vote of at least two-thirds of the outstanding shareholders, with the request for a vote providing notice of the change.[30]  In Vermont, the notice of a shareholder meeting at which a change to benefit corporation status will be approved “shall include a statement from the board of directors of the reasons why the board is proposing the amendment and the anticipated effect on the shareholders of becoming a benefit corporation.”[31]  Requiring specific notice and a statement of reasons provides greater information to shareholders whose interest may be transformed by the change to benefit corporation status.  Similar notice and supermajority voting requirements apply if a business corporation merges with a benefit corporation.[32]  Notably, these requirements for opting into benefit corporation status apply to benefit corporations seeking to resume ordinary business corporation status as well.[33]

B.            Public Benefit

The main thrust of benefit corporation statutes is to require these entities to pursue purposes beyond profit-making.  A benefit corporation must be formed for a “general public benefit,” meaning a “material, positive impact on society and the environment.”[34]  Other than in the New Jersey statute, general public benefit is defined by measurement against a “third-party standard,”[35] and all statutes permit incorporators to also pursue more “specific public benefits.”  They include:

Providing [low income or underserved] individuals or communities with beneficial products or services;

Promoting economic opportunity for individuals or communities beyond the creation of jobs in the normal course of business;

Preserving [or improving] the environment;

Improving human health;

Promoting the arts, sciences, or advancement of knowledge;

Increasing the flow of capital to entities with a public benefit purpose; or[and]

The accomplishment of any other particular [identifiable] benefit for society or the environment.[36]

The statutes provide little clarification of the hierarchy of purposes a benefit corporation will serve.  Except in Virginia, the statutes do state that while a benefit corporation may adopt purposes to pursue specific public benefits, these specific public benefits do not limit its obligation to pursue a general public benefit.[37]  However, general and specific public benefits may be articulated in addition to other purposes for which a corporation may be created, and these public benefits may, but need not, limit more traditional business purposes.[38]  Finally, the statutes all declare that the general or specific public benefits that benefit corporations pursue “are in the best interests of the corporation,” seemingly conclusively.[39]  This provision alone might be used to trump potential shareholder claims that directors’ decisions to pursue general or specific public benefits undermine the best interests of the corporation when they interfere with profit maximization or other business goals.  The benefit corporation statutes, however, offer greater detail on how directors ought to make decisions and provide additional liability shields.

C.            Directorial Obligations and Protections

Each statute explains the obligations of benefit corporation directors.  They are required to consider the impact of their decisions on shareholders, employees of the corporation, subsidiaries and suppliers, “customers [to the extent they are] beneficiaries of the general or specific public benefit purposes of the benefit corporation,” the community, society, and the local and global environment.[40]  Some later-enacted statutes clarify that directors need not prioritize any particular person’s or group’s interests in their deliberations.  Unless an individual benefit corporation elects to do so through a statement in its charter, directors may take action based on the effects of their decisions on any one of these groups or interests.[41]

The intent of this language appears to be broadening the range of appropriate considerations in directorial decision making, in order to give directors discretion to make decisions favoring social mission achievement over profit-maximization.  The statutes’ permission for a director to also “consider any other pertinent factors or the interests of any other group that the director determines are appropriate to consider”[42] goes even further down this road.  Moreover, in case this wide range of potential justifications for directorial decisions does not sufficiently comfort benefit corporation directors, the statutes also specifically provide directors of benefit corporations with immunity from liability for performance of their duties within the broad discretion described above[43] and provide that no duty of such a director runs to the corporations’ beneficiaries.[44]

This language is clearly modeled on language from constituency statutes, also known as anti-takeover legislation.  Such statutes permit directors to consider nonshareholder constituencies in weighing takeover offers and other decisions[45] and have been criticized as simply giving directors cover to vote against control-shifting transactions and to take other actions in order to entrench themselves in their positions.[46]  The broad discretion benefit corporation statutes accord to directors can likewise be faulted for giving directors unbridled discretion, with which they might pursue social good or might pursue foolish or self-serving practices.

Provisions in the later-enacted statutes suggest that their drafters may have had specific concerns about protecting benefit directors in the takeover context.  These statutes require directors to consider “the short-term and long-term interests of the benefit corporation, including benefits that may accrue to the benefit corporation from its long-term plans and the possibility that these interests may be best served by the continued independence of the benefit corporation.”[47]  Thus, directors of benefit corporations appear protected from personal liability on claims that they have insufficiently produced public benefits or inadequately pursued profits for shareholders, whether in the context of ordinary business decisions or control transactions.

D.            Third-Party Standard-Setters

The significant divergence between the corporate purposes and directorial obligations in business corporations and benefit corporations makes it vital that shareholders and others can differentiate the two.  The crucible here is the issue of public benefit: only corporations pursuing a general (and perhaps also specific) public benefit can qualify as benefit corporations.[48]  Those that do not pursue a public benefit are excluded from the category.  Rather than entrusting a government agency to make these initial determinations, the benefit corporation statutes delegate this responsibility to third-party standard-setters.  All of the statutes anticipate that such third parties will make available standards “for defining, reporting, and assessing” the social and environmental performance of aspiring benefit corporations.[49]  The statutes decline to provide even minimum content for such standards.  In addition, they do not dictate how the standards should be applied, how often, or by whom.

Instead, the statutes simply mandate that standard-setters be independent and transparent.[50]  Sufficient independence is shown if the standard “is developed by a person [or entity] that is independent of the benefit corporation.”[51]  The Maryland statute offers no further definition of independence, but the later-enacted statutes define independence to exclude those with direct or indirect “material relationships” with the benefit corporation or its subsidiaries, including current or recent employment, familial relationships with executive officers, or direct or indirect ownership or management of five percent or more of the benefit corporation’s equity.[52]  For transparency to be sufficient, each statute requires the certifying party to make publicly available four types of information.[53]  Standard-setters must publicize “the factors considered when measuring the performance of a business, the relative weightings of those factors, and the identity of the persons who developed and control changes to the standard, and the process by which those changes were made.”[54]

B Lab has been deeply committed to and involved with the passage of benefit corporation statutes.[55]  Its survey and audit processes are fully documented online[56] and thus appear to fit the transparency requirements, and B Lab will be independent of any unrelated potential incorporators.[57]  B Lab evaluates potential B corporations using the B Impact Assessment, which looks at issues of corporate accountability, employee policy, products’ benefit to consumers, the company’s relationship with its community, and its impact on the environment.[58]  The assessment contains a total of two-hundred points, and companies must score eighty points to be certified and granted access to the B Corp mark.[59]  B Lab also audits twenty percent of those companies who qualify for B Corp certification every two years.[60]

Although the third-party standard-setter role seems tailor-made for B Lab, numerous existing standard-setters and entity-certification programs would also appear to qualify under the statutes.[61]  Certifiers of fair labor practices consider social and, to some degree, environmental performance in their standards.[62]  They are transparent and would likely be independent in most cases.  Certifiers of high environmental performance, such as those authorized to assess compliance with the ISO 14001 Environmental Management System standard, could likewise qualify as third-party standard-setters with a few changes.[63]  Even corporate governance advisory firms might be adjusted to fit the bill.  As they are already beginning to offer advisory services to institutions and individuals seeking socially responsible investments,[64] retooling to certify benefit corporations could likely be done with ease.

Likewise, current product-focused standard-setters could also enter the market to qualify benefit corporations.  Consider Cradle to Cradle (“C2C”), a certification offered by McDonough Braungart Design Chemistry LLC (“MBDC”).[65]  C2C is a multi-attribute product label that is licensed to those meeting MBDC’s criteria for Material Health, Material Reutilization, Renewable Energy Use, Water Stewardship, and Social Responsibility.[66]  C2C was not designed to vet aspiring benefit corporations.  Rather, C2C is currently offered to products, such as the Method line of soap and cleaning products, rather than to entities.[67]  However, MBDC publicizes its standards for environmental and social performance (required only for the tiers of certification beyond “basic”), and is transparent regarding how the standards are weighted[68] and the identity of those who develop and control changes to the standards.[69]  Thus, it could offer certification to potential benefit corporations.  It is not yet clear whether the benefit corporation certification market will attract rating agencies, governance advisory firms, or existing product or entity certifiers.  In any case, meeting the statutes’ limited transparency and independence requirements will not be a significant barrier.

E.            Enforcement

Whether or not B Lab is joined by other standard-setters, it is not the only body empowered to monitor and enforce the public benefit to which benefit corporations are devoted.  The statutes also impose disclosure obligations upon benefit corporations, requiring them to provide annual benefit reports to their shareholders and to post them on their public websites.[70]  The statutes describe the contents of this report differently.  Again, the Maryland statute is briefer than the later enactments, but all require timely benefit reports including elements of description and assessment.  All benefit corporations must describe how they have pursued their general and specific public benefit purposes and any circumstances that hindered their ability to do so.[71]  Vermont’s statute also demands that benefit corporations give a statement of actions they can take to improve performance in the future.[72]  Vermont, New Jersey, and Hawaii also require the report to disclose the names and addresses of a “benefit director” and optional “benefit officer,” director compensation, a statement by the benefit director, and the names of anyone owning five percent or more of the corporation’s stock.[73]  Assessment requires each benefit corporation to consider and report how well it performed in accordance with its third-party standard as compared with prior performance.[74]

In addition to demanding publication, the New Jersey statute requires the report to be filed with the state Department of the Treasury, on penalty of forfeiture of benefit corporation status.[75]  Vermont’s statute does not require filing, but demands that benefit corporations must submit the annual report for shareholder approval or rejection.[76]  The statute does not explain the consequences if the report is rejected.  Hawaii’s statute disavows any government involvement explicitly, mandating that the report state that “the sustainable business corporation and its activities are subject to the oversight of the board of the sustainable business corporation and are not subject to the direct oversight, regulation, or endorsement of any governmental body.”[77]

The positions of benefit director and benefit officer merit additional explanation.  Vermont, New Jersey, and Hawaii require benefit corporations to name a benefit director and permit them to appoint a benefit officer.[78]  The benefit director must include in the annual report her own statement assessing whether the benefit corporation and its directors have acted in compliance with the benefit purposes of the corporation during the relevant period.[79]  If a benefit director opines that the benefit corporation has failed to meet the requirements of the law, she must describe these failures.[80]  In New Jersey and Vermont, benefit directors are immune from personal liability for their performance of these evaluative tasks, so long as they act in good faith and do not engage in intentional misconduct, knowing violations of law, or self-dealing.[81]  Unlike the benefit director, a benefit officer is optional in every enacting jurisdiction.  If a benefit corporation chooses to select one (who may be the same person as the benefit director), the benefit officer “shall perform the duties in the management of the benefit corporation relating to the purpose of the corporation to create public benefit.”[82]  Identifying at least one and perhaps two roles with clear responsibility for tracking and assessing public benefit provides additional monitoring and enforcement resources over mandated disclosure alone.

In addition, all benefit corporation statutes other than Maryland’s, offer a special right of action often called a “benefit enforcement proceeding” to enforce the special duties of benefit corporation directors and officers and the public benefit purposes of the corporation.[83]  The statutes limit potential plaintiffs in benefit enforcement proceedings to shareholders entitled to bring derivative actions and, in some cases other groups, if specified in a corporation’s charter.[84]  Thus, the additional proceeding does not expand standing to challenge conduct of benefit corporation fiduciaries, but does express support for an expanded range of inquiry in suits by traditional parties.

As yet, there is no case law addressing the obligations of benefit corporation fiduciaries, and the statutes do not speak to how courts should analyze such claims.  One commentator argues that “the core duty of the benefit corporation can be defined as the duty to secure profits for the shareholders while considering the socially beneficial purposes of the corporation.”[85]  This seems a fair statement as far as it goes, but without greater legislative explanation or judicial interpretation, it remains difficult to provide guidance to fiduciaries in situations where profit and social benefit goals conflict.

F.            Conclusion

The benefit corporation is thus significantly different from both traditional nonprofit and for-profit business forms and from other hybrid forms.  By retaining traditional business purposes and adding the requirement of pursuing general public benefit, the benefit corporation allows entities to pursue a dual mission of both profit and social good.  This duality of mission contrasts sharply with traditional nonprofit and for-profit forms, but is consistent with all other hybrid forms.

The benefit corporation, however, also differs in substantial ways from other hybrids currently available.  Unlike the United Kingdom’s CIC, the benefit corporation may offer investors unlimited midstream and residual returns and is subject to no government regulation of its purposes or activities.  These attributes are shared by L3Cs, but the benefit corporation has more rigid governance structures than the almost fully flexible governance by contract in an L3C.  The benefit corporation also requires greater disclosure than the L3C, and the Vermont, New Jersey, and Hawaii enactments require entities to vest particular individuals with responsibility for stewarding and reporting on the organization’s public benefit achievements.  These disclosure and fiduciary authorization mandates also represent a divergence from the B Corp structure, though B Corps and benefit corporations share the fundamental idea of third-party review of public benefit purposes.  This idea of delegating to private parties the responsibility to certify the bona fides of hybrid entities is not found in either the CIC or L3C.

II.  Assessing the Benefit Corporation

The range and diversity of emerging hybrid organizational forms raises the question of which is best.  It is likely impossible to answer this question for all social enterprises in all situations, but this Part will undertake a preliminary assessment of how the benefit corporation serves the needs and goals of these entities and their founders.  Fundamentally, founders and operators of social enterprises unsatisfied with traditional nonprofit or for-profit forms seek a type of organization that will legally establish their sense of a dual profit-making and social mission and enforce it over time.  They would also like a hybrid form to expand the range of funding streams they can effectively access.  Further, they seek to use the hybrid form as part of their effort to brand their social enterprises to enable them to market their products and services to consumers, business partners, and others as special and different from those offered by typical nonprofit charities and for-profit businesses.  Many believe that achieving all or some combination of these three goals is the only way to make their endeavors sustainable.  This Part evaluates whether and to what extent the benefit corporation form will accomplish these various and often overlapping goals.  The exercise here is a limited case study of one form of organization.  But, this effort will begin the important work of theorizing more generally the value hybrid forms offer to social enterprises.

A.            Articulating and Enforcing a Dual Mission

Those forming a social enterprise have both profit or business goals and social goals and many want to pursue them both using the same entity.[86]  A hybrid form is desirable if it will help them to articulate and enforce this dual mission of profit and social good.

1. The Limitations of Traditional Forms

One might think social entrepreneurs could use traditional nonprofit or for-profit forms to house their dual mission enterprises.  After all, nonprofit forms do not bar profit-making.  These forms do, however, dramatically cabin profit distribution under the nondistribution constraint.[87]  This constraint is imposed by state law on all nonprofit forms of organization and will prevent a social enterprise formed as a nonprofit from distributing net profits to those with organizational control, including shareholders, other investors, directors, and officers.[88]  In addition, if formed as a tax-exempt nonprofit, a social enterprise will be prohibited from distributing net profits by the inurement, private benefit, and excess benefit transaction rules under federal tax law.[89]  Therefore, if a social entrepreneur wishes to distribute profits to investors, a nonprofit form is a nonstarter.  Even in the unlikely scenario of a social entrepreneur interested in pursuing profits from his enterprise solely to reinvest them, various anticommerciality restrictions might prove challenging for obtaining tax-exemptions.[90]  Thus, nonprofit form will be suboptimal for many dual mission organizations.

The problems with adopting a traditional for-profit form for social enterprise are more complex and arise from both legal and nonlegal sources.  At inception, it appears permissible to include charitable or social goals as part of a corporation’s purposes.[91]  Yet, anecdotal reports suggest that in some states, inclusion of such goals as a major component of corporate purposes may stall or block acceptance of articles by the secretary of state.  Typically, LLC law will be flexible enough to allow adoption of both profit and social purposes, though partnership statutes requiring a “business purpose” may create barriers to social enterprises in that form.[92]

Still, there are concerns that in a social enterprise formed as a traditional for-profit, fiduciaries will be hemmed in by their responsibilities to pursue profits for owners.[93]  There is considerable debate about the degree to which for-profit fiduciaries may properly pursue other purposes without breaching their duties.[94]  Moreover, with the many obstacles in the path of a successful shareholder suit to challenge fiduciary compliance,[95] lawsuits may not be the most salient risk for fiduciaries in a for-profit social enterprise.  Even those who argue that for-profits possess substantial leeway to pursue social goals seem to be arguing about the edges of for-profit activity, not its core.[96]  Whatever the correct answer is on the state of the law, fiduciaries rightly or wrongly are often wedded to the idea that in a for-profit entity their foremost goal should be maximizing the entity’s value to its owners.[97]

Practical obstacles will also likely confound for-profit fiduciaries who seek to maintain a dual mission, especially if they desire to expand their social enterprises and require capitalization beyond the founders’ own funds.  To scale up a social enterprise, capital can be borrowed or ownership can be expanded, and usually some combination will be needed.  To raise capital by expanding ownership without upsetting the stability of a dual mission, social enterprises will need to attract and retain owners equally committed to that dual mission.  Dual-class stock structures, partnership agreements, shareholder agreements in closely held corporations, and operating agreements in LLCs can all be used to limit owners’ ability to undo a dual mission.  These structures can be implemented in an attempt to match dual mission minded investors with social enterprise investments.[98]  Of course, one cannot be sure that a sufficient pool of investors with preferences aligning to the founders’ will exist.  Indeed, even investors initially committed to the dual mission might change their minds if the entity becomes sufficiently successful, and any of these private arrangements can be changed by the very people who would benefit financially from changing them.

If a for-profit social enterprise wants to draw market-rate investors, its dual mission will be squarely put at risk.  Consensus favoring a dual mission can easily break down and market-rate investors may refuse to invest or quickly or detrimentally sell off their ownership stakes.  Rather than fearing litigation, the founder of a for-profit social enterprise may instead worry about locking in a dual mission legacy,[99] about sufficient access to capital, or both.  Dual mission is not easily embedded in traditional for-profit forms.

Ideally, a hybrid organization would offer a solution to this dual mission dilemma.  To solve it, a hybrid form of organization should provide guidance on which goal, profit maximization or social good production, has priority and in what situations this priority must be given.  This does not necessarily mean that either profit maximization or social good production must be prioritized every time the two come into conflict.  In order to ease the tension inherent in a dual mission organization, some structure is needed for balancing these goals.  This structure must work predictably and relatively transparently, and there must be some method for enforcing it.

2. The Benefit Corporation and Dual Mission Articulation

The benefit corporation statutes not only permit, but require, articulation of an expressly dual mission.  These are corporations formed for profit and to pursue a “general public benefit.”[100]  This express dual mission mandate contrasts starkly with traditional nonprofit forms, which prohibit entities from acting to pursue profits for owners.  It also represents a significant change from for-profit forms in which some pursuit of social good is certainly within legal bounds, but significant sacrificing of profits to further social goals engenders real risks.

When one thinks more deeply about how a dual mission will be articulated in a benefit corporation, however, doubts emerge.  The requirement of general public benefit is vague and undefined.  The determination of whether a particular organization’s goals pursue a general public benefit is left to an unregulated third-party standard-setter.[101]  Moreover, the statutes provide no baseline or guidance for the standards these third parties should use to make this determination; they require only transparency and independence.  If a standard-setter clearly and transparently sets low standards, it may qualify unrelated entities to form as benefit corporations just as would a standard-setter with higher standards, leaving the door open to greenwashing or even fraud.  Perhaps transparency will enable consumers and investors to judge the mix of profit and social good individual benefit corporations serve based on which standard-setter is used.  This, however, would require highly motivated consumers and investors to engage in significant research.[102]  At the moment, benefit corporations require only formal articulation of a dual mission, and oversight over the genuineness of these statements is lacking.

3. The Benefit Corporation and Dual Mission Enforcement

Third-party standard-setters, fiduciaries, and shareholders all play enforcement roles in the benefit corporation.  Except in New Jersey, third-party standard-setters serve as initial gatekeepers; in order to qualify for benefit corporation status, an entity must meet the requirements of an independent third-party standard.[103]  As noted earlier, these standard-setters play this certification role bounded by neither standards nor oversight.  Moreover, the role of the standard-setters themselves in ongoing enforcement is less clear.  All of the statutes envision public benefit assessments in annual benefit reports will be made with reference to the third-party standard.[104]  But, none of the statutes specify whether or how standard-setters should be involved in vetting public-benefit provision after incorporation.  Standard-setters may choose to engage in auditing or other monitoring functions to boost enforcement or they may consider their role complete when initial certification is granted or denied.

Shareholders are also involved at the initial adoption of benefit corporation status and on any exit from that status.  Shareholders must be granted express notice of the change and must vote by a supermajority to approve it.[105]  These provisions may have been drafted to protect unsuspecting investors from being surprised by a benefit corporation’s dual mission orientation.  Yet, the notice and voting requirements apply in both directions.  Thus, they also protect the benefit corporation and enforce its dual mission against termination without a strong consensus among shareholders.

Outside the context of transformation to fully for-profit status, though, the statutes offer little guidance to shareholders or fiduciaries on the thorny issue of how profit and social good should be balanced.  They allow directors to forego profit maximization in favor of social good production or vice versa,[106] but they do not instruct directors on how to exercise this broad discretion.  Directors are not told to err on the side of social good in every decision, to pursue more profit than social good across the enterprise, or the opposite of either instruction.  Rather, directors are merely instructed to consider the impact of every decision on nonshareholder constituencies.[107]  In addition, the statutes provide directors with a broad range of interests that they may act to benefit, and the role of benefit corporation director is constructed to be highly discretionary.[108]  Thus, the statutes impose no clear framework for directorial decision making.  Without one, it is difficult to identify a metric by which shareholders might enforce fiduciaries’ compliance with dual mission.

Shareholders of all benefit corporations retain the informational, voting, and litigation rights of ordinary shareholders. Any of these rights could, theoretically, be used to enforce dual mission.  Benefit corporation shareholders may demand to inspect corporate books and records beyond the benefit report to determine how a particular mission conflict was resolved.  They may vote out directors who fail to sufficiently pursue their favored balance of profits and mission.  They may even sue directors for a failure to meet their special fiduciary obligations under the statute, and the later-enacted statutes also provide for the benefit enforcement proceeding.[109]

Still, shareholders are unlikely to be assiduous and consistent enforcers.  Their ability to obtain damages to redress faulty directorial decisions is significantly limited by ordinary fiduciary liability concepts like the business judgment rule and will be further frustrated by benefit directors’ broad and unguided discretion and immunity.  Moreover, benefit corporation shareholders have an additional reason not to engage in enforcement of dual mission—or at least a serious potential bias toward one-half of it.  If a benefit corporation begins veering away from its dual mission to achieve greater profits, shareholders stand to gain financially from this decision.  Thus, although many routes exist for shareholder enforcement, shareholders are uniquely hamstrung as enforcers in the benefit corporation context.

The statutes uniformly exclude other potential parties from engaging in enforcement through litigation.  Beneficiaries and the public will not have standing to challenge actions by benefit corporation directors.[110]  This position resonates with the traditionally extremely limited standing to challenge actions by nonprofit corporate directors.[111]  This policy is justified as necessary in order to recruit directors, which are most often uncompensated, to serve on nonprofit boards.[112]  However, the nonprofit context provides for government enforcement by state attorneys general and, for exempt nonprofits, the IRS.  There is no regulatory role for any public official in the benefit corporation.[113]

Other hybrid forms of organization take very different stances on enforcement than the benefit corporation.  The United Kingdom adopted public enforcement, launching a specialized CIC regulator in addition to allowing shareholder enforcement of dual mission.[114]  The regulator possesses broad authority to investigate, remove fiduciaries, and even terminate CICs found out of compliance.[115]

L3Cs rely solely on private enforcement, and the contours of this enforcement remain somewhat unclear.  LLC members have internal means to challenge fiduciary actions and legal standing to enforce managers’ fiduciary obligations.[116]  The exact scope of these duties, and the means of their enforcement, is not addressed by the L3C statute and the nature of LLC fiduciary duties is both contested and jurisdictionally diverse.[117]  Moreover, as a species of LLC, an L3C operating agreement may tailor fiduciary duties to a significant degree, generally including reducing those obligations when “not manifestly unreasonable.”[118]  Drawing on the language of the L3C statutes, John Tyler has suggested that the fiduciary duty of L3C managers should be understood to require prioritization of charitable and educational purposes over their profit-making ones.[119]  Further, he has argued that enforcement mechanisms borrowed from for-profit forms should suffice to enforce these obligations.[120]  Whether or not these views of L3C fiduciary obligation and enforcement become widely accepted, the statutes certainly offer no regulatory or other enforcement vehicles.

Like the benefit corporation, the B Corp retains the existing enforcement mechanisms of a for-profit corporation, including shareholder informational and voting rights as well as derivative suits.  This private certification form, however, does not add benefit directors, benefit officers, or benefit enforcement proceedings found in some benefit corporation statutes.  B Corp status also subjects adopters to potential audit by B Lab,[121] which B Lab and other standard-setters may require for benefit corporations, but the statutes do not require by their terms.

4. The Benefit Corporation’s Disclosure Model

The benefit corporation form relies significantly on disclosure, both to amplify dual mission articulation and to lubricate enforcement.  The benefit report[122] gives shareholders and the public an opportunity to view how the entity reacts to situations in which profit and social mission conflict.  Of course, the benefit report need not address these questions specifically.  It must only report on public benefits achieved and circumstances that have hindered public benefit production.[123]  The Vermont, New Jersey, and Hawaii statutes demand that benefit corporations provide somewhat greater information in their benefit reports.  They also compel them to charge a benefit director with a monitoring role, including preparing an opinion of the entity’s public benefit performance.[124]  The New Jersey and Vermont statutes also provide for potentially greater review of the annual report, demanding filing with a government agency and shareholder approval, respectively.[125]  Whether these recipients of disclosure will actively enforce is not yet known.  Empowering individuals required to engage activity in the process of creating and approving disclosures, however, may at least somewhat improve the likelihood that enforcement action will be taken based upon them.

In terms of disclosure, benefit corporations occupy a sort of middle ground between the situations of traditional nonprofit and for-profit entities.  On the one hand, benefit corporations must issue self-styled disclosures about public benefit provision to shareholders and allow for public review, a different kind of transparency than would be required of a nonprofit.  Nonprofits must provide standardized annual reports on their charitable activities to state attorneys general[126] and, if they are tax-exempt, they must submit annual informational tax returns to the IRS and make them public.[127]  The level and contents of required disclosures for benefit corporations should provide greater transparency on how a dual mission is being managed than would be available from a standard for-profit corporation, partnership, or LLC.  Corporations may have annual reporting obligations to shareholders and the secretary of state,[128] and LLCs may be required to report annually to state authorities as well.[129]  For-profits regulated by federal securities law may have additional reporting obligations.[130]  None of these required reports, however, must contain information regarding the social goals and achievements of the disclosing organization.  Benefit corporation disclosures are thus fairly robust and are certainly more closely tailored to address dual mission performance than either nonprofit or for-profit disclosures.

Benefit corporations also require more disclosure on the question of social and profit-making activity than any other hybrid forms currently available in the U.S.[131]  L3C statutes require no disclosures beyond the annual reporting obligations derived from related LLC statutes, which include no requirement of reporting on the entity’s furtherance of charitable and educational purposes.[132]  Investor-members in an L3C could certainly demand such reporting, but it is not statutorily mandated.  The B Corp certification requires B Lab to have access to certified entities for potential audits[133] but does not require any periodic disclosures to it, to investors, or to the public.

5. Conclusion

In sum, the benefit corporation form is effective in allowing social enterprises formally to articulate a dual mission.  It clearly allows shareholders to take profits and requires a statement of purposes for the general public benefit.  This is an improvement over traditional nonprofit and for-profit forms, but does not gain the benefit corporation a comparative advantage over other existing hybrids, which also clearly allow dual mission to be articulated formally.  Indeed, the delegation to third-party standard-setters to vet this public benefit and the lack of a statutory floor for what counts as public benefit make low standards and greenwashing particular concerns for the benefit corporation.

In terms of enforcement, the benefit corporation usefully limits movement in and out of dual mission status by its shareholder vote requirements but gives little guidance on enforcing dual mission outside of the ultimate exit question.  Third-party standard-setters could take a more active role here, but they need not do so under the statutes.  Benefit corporation statutes expressly permit, but do not require, the pursuit of social goals over profit, and bend over backwards to protect fiduciaries from liability for their decisions.  In this context, shareholder enforcement will be challenging and shareholders themselves may become biased toward profit goals or be bought out by others seeking financial over social gains.  Some statutes may generate more robust enforcement by empowering benefit directors and creating specialized benefit enforcement proceedings.  These innovations remain untested, but the benefit corporation’s model of enhanced disclosure will at least provide a mechanism for shareholders and the public to track dual mission.  In relative terms, this low level of enforcement is not damning, however, as other extant hybrid forms also provide limited enforcement regimes.

B.            Expanding Funding Streams

The ability to effectively articulate and enforce a dual mission is the baseline requirement for a hybrid organization.  It is also intimately related to the second reason social entrepreneurs are interested in hybrid forms—expanding their access to a range of funding streams.  Founders or operators of social enterprises can opt to form their entities as traditional nonprofit corporations or as one of various for-profit organizational forms.  Yet, any of these choices will limit the funding streams available to their enterprises.

Due to the nondistribution constraint, equity capital will not be available to social enterprises formed as nonprofits, but they can obtain capital through donations, income earned on investments, or sales of goods and services, and borrowing.  To attract donations, a social enterprise will want to qualify as tax-exempt and eligible to receive tax-deductible contributions.  Preserving this eligibility, though, may significantly curtail a social entrepreneur’s activities.  Tax law imposes limitations on commercial activity, affiliations with other for-profit entities, and even some compensation plans, as well as lobbying and campaign activity.[134]  Earned income is, of course, another source of revenue.  Although some of this income will qualify as tax-exempt,[135] for social enterprises just starting out, investment gains are unlikely to be large and revenue from sales of goods and services may be of a size uncertain even to fund current activities, let alone build capital.  For startup social enterprises, investment gains are also unlikely to be large.

Finally, a social enterprise formed as a nonprofit might look to borrowing as a potential funding source.  Nonprofit corporations may borrow from willing lenders, as could any other legally recognized organization.[136]  Practical obstacles can figure prominently here, however, as banks and other lenders may be less willing to lend to nonprofits[137] or require more onerous terms from them due to an accurate or mistaken impression of the organization’s financial risk or its lack of an equity cushion.  If social enterprise founders or operators view donations, income earned on investments and sales of goods and services (whether subject to full or partial taxation or not), investment income, and borrowing as providing insufficient funding, then hybrid forms permitting equity financing become attractive.

Organizing as a traditional for-profit entity will give social entrepreneurs access to equity and debt, in addition to earned income (though it will be subject to taxation).  A social enterprise organized as a for-profit may sell shares or memberships, privately or publicly, and may seek equity-investing partners or bank or other lenders.  As in any small for-profit, it may be difficult for a social entrepreneur to convince arms-length investors to take equity positions, and it may be hard to obtain loans without offering personal guarantees or collateral.  Using traditional business forms may avoid some concerns among investors or lenders about the incentives of the entity and its leaders to succeed financially and to repay its debts.  Yet, for diligent investors or lenders who closely examine the business plan of a social entrepreneur, the mix of social and profit purposes may raise eyebrows and interest rates.

A social enterprise organized as a for-profit will also have limited access to donated funds.  Adopting a traditional business form bars tax-exemption and eligibility for deductible contributions, despite calls by some for a change in this position.[138]  This is so regardless of whether an entity pursues social purposes or charitable activity.  Of course, forming as a for-profit will not necessarily preclude all socially-motivated sources of revenue.  Cause-related marketing[139] campaigns like the various “pink” product sales for breast cancer awareness[140] and the RED campaign to combat AIDS in Africa[141] have raised millions of dollars through sales by purely for-profit corporations.  If a for-profit social enterprise can convince consumers or investors that it will use some of their dollars for good, they too may be able to attract the funds of those with mixed social and financial motivations.  If hybrid forms can ease access to donations and other socially-motivated funding sources, social entrepreneurs will prefer them to traditional for-profit forms.

The benefit corporation statutes do not speak expressly to the question of financing, but adopters of this form would certainly be ineligible to receive deductible contributions.  Rater, benefit corporations can pursue the funding sources available to traditional for-profits. In this pursuit, the dual mission embedded in the form may or may not prove advantageous.  The benefit corporation form seems likely to draw potential investors and lenders’ attention to the dual mission of the organization.  On the one hand, this may make those motivated purely by profit even more hesitant to invest or lend to a benefit corporation than to a for-profit social enterprise.  On the other hand, it may attract potential investors or lenders who are interested in combining their financial contributions with a purchase of social good.  Socially-motivated investors may be more willing to risk lower financial returns from a firm credibly committed to simultaneously pursuing profit and social good.  While they might distrust the bona fides of a pure for-profit social enterprise, a benefit corporation statutorily committed to pursue public benefit could be more attractive.

In fact, both results might occur.  Then, the question is whether the gain of attracting socially-motivated investors and lenders outweighs the cost of driving off purely-profit-motivated ones.  This empirical question cannot yet be answered.  Even assuming the gains would outweigh the costs, however, the potential gains are premised on the idea that the enforcement of dual mission is credible.  The credibility of this claim comes back to enforcement and, as noted in Part II.A, enforcement in the benefit corporation remains uncertain.

The indeterminate ability of the benefit corporation form to expand funding streams is not unusual in the hybrid space.  None of the other current hybrid forms can offer tax deductions to donors.  The only one that claims the ability to attract tax-benefitted assets is the L3C, which is designed to attract foundation funding through program-related investments (“PRIs”).[142]  PRIs are investments by foundations in taxable entities motivated by the recipient’s charitable program rather than the foundation’s desire to earn income.[143]  Qualifying PRIs avoid penalties on foundations for risky, jeopardizing investments and count toward the roughly five percent of assets foundations must distribute annually.[144]  Foundations may believe a costly private letter ruling process is necessary to assure qualification as a PRI; if the L3C smoothed that path, it would perhaps become a preferred vehicle for foundation funding.[145]  As of yet, the IRS has not offered any assurances that investments in L3Cs qualify as PRIs on the basis of L3C form alone, and it seems unlikely to do so in the near future.[146]  Thus, no current hybrid form promises significant access to true donations, though they all share the benefit corporation’s ability to perhaps attract socially motivated dollars.

Likewise, none of the other hybrids appear much more likely to attract market-rate investors.  CICs offer only capped dividends and lock remaining assets into the community benefit stream; thus, its investments are simply not on par with market-rate products.  In fact, the capped dividend rates were viewed as unattractive enough to investors to necessitate a cap increase in 2010.[147]  The L3C is amenable to tranched investment, which some believe will enable it to draw investors seeking market-rate returns.[148]  As I have written elsewhere, without providing governance or other guarantees to market-rate investors, I am skeptical that they will view L3C investment as a substitute for market-rate products.[149]  Further, if guarantees were made to satisfy market-rate investors that profit motive will control, it would undermine dual mission and the interest of foundations and other socially-motivated investors to contribute their funds.[150]  Thus, to my mind, the L3C, like the CIC, the B Corp, and the benefit corporation, is likely to draw in new investment capital only from the socially-motivated category of investors.  This may be a large market and a significant benefit of hybrid forms, but none so far makes a strong argument for reaching the clearly larger category of market-rate investors.

C.            Branding

The third reason founders and operators of social enterprises may find a hybrid form attractive is to help them to create a distinctive brand.[151] The American Marketing Association defines a brand as “[a] name, term, design, symbol, or any other feature that identifies one seller’s good or service as distinct from those of other sellers.”[152]  Social entrepreneurs wish to market their enterprises and their products to consumers, partners, and employees as meaningfully different from either traditional nonprofits or for-profits and view a hybrid form as one route to accomplish this goal.[153]

Nonprofits, in essence, sell their halo.  When they offer products to consumers, affiliations to partners, and jobs to employees, they are selling a sense of righteousness or trustworthiness, or both.  For-profits sell efficiency.  They offer products of the highest quality and lowest price, affiliations to draw in revenue, jobs that pay a market wage, and training in efficient business operations.  Social entrepreneurs see themselves as offering something quite different.  The profit motive makes them lean, efficient, innovative.  But, their social mission keeps them virtuous and responsible.  Thus, neither traditional nonprofit nor for-profit forms send the right message.  Yet, it is difficult to convey what a social enterprise has to offer to consumers, partners, and employees quickly and credibly.  Hybrid forms of organization are attractive to social entrepreneurs if they can provide a brand that will distinguish their products and enterprises.

Whether the benefit corporation form can effectively function as such a brand, however, depends on whether it is a credible proxy for truly dual mission entities.  The benefit corporation form will work as a brand only if it conveys relevant information to consumers, partners, and employees, demonstrating the value they will obtain from a relationship with the entity the brand denotes.[154]  These claims of value, and the benefit corporation’s claims of differentiation from typical nonprofit and for-profit entities, also must be reliable.[155]  Consumers, partners, and employees interested in purchasing from, partnering with, or being employed by a dual mission entity will look for or be swayed by brands that demonstrate an entity can be trusted to pursue both profit and social good.  This tracks, of course, back into the problems of dual mission articulation and enforcement addressed above.[156]

The process of building the benefit corporation brand is at too early a stage to evaluate fully, though the uncertainties about enforcement of dual mission within the form create serious obstacles for its success.  Of course, individual benefit corporations can certainly provide greater assurances of their dual mission bona fides, through shareholder agreements or other precommitment devices.  By doing so, these individual benefit corporations may themselves become powerful brands.  However, for the benefit corporation form of organization itself to function as a brand, it must convey this salient information on its own.

Finally, brands are weak unless and until they become familiar to their target audience.[157]  Even if an organizational form could reliably convey commitment and follow-through on dual mission, it can function as a strong brand only when enough entities adopt it and the brand’s meaning becomes known in the marketplace.  Standard-setters clearly have a stake in disseminating information about the benefit corporation brand and encouraging social enterprises to adopt it.  This need to generate adoptions seems, indeed, to explain B Lab’s involvement in pursuing benefit corporation legislation in the various states.  Thus far, there has been some publicity about benefit corporations, but few entities have adopted the form and little is known about how its future adopters will behave.

As is the case with expanding access to capital, other hybrid forms also face challenges similar to those of the benefit corporation in their drive to become effective brands.  First, each form will need to prove an effective proxy for entities with clearly articulated and reliably enforced dual missions, issues addressed above.[158]  Second, each form will need to be adopted widely enough to spread knowledge of the brand to potential customers, partners, and employees.  This job is already underway for each developing hybrid form.  B Lab, of course, has a strong interest in creating awareness of the B Corp form and is actively pursuing this goal.[159]  Americans for Community Development is a “professional organization comprised of the individuals and organizations participating in the movement to create L3Cs,”[160] which has been heavily involved in spreading the word about the L3C to legislatures and the public.[161]  In the United Kingdom, the CIC regulator has taken a role in informing the public about the CIC.[162]  Each of these entities is pursuing a solid brand for its favored form; yet, the growing number and diversity of legal forms for social enterprise may lead to some confusion in the marketplace.

D.            Sustainability

Finally, social entrepreneurs may also see a hybrid form as providing their enterprises with greater sustainability than traditional nonprofit or for-profit forms can offer.[163]  Of course, sustainability can mean many different things.  When thinking about sustainable development, the UN Brundtland commission defined it as “meeting the needs of the present without compromising the ability of future generations to meet their own needs.”[164]  When researching sustainable corporations, one quickly runs across ideas like the triple bottom line (economic, social, and environmental outcomes) or the 3-P model (People, Profit, Planet).[165]  These ideas clearly resonate with the fundamental ideas of a social enterprise, melding pursuit of profits with social good, often including environmental goals.  But, the benefit corporation form is not there yet.  This new hybrid form must allow social enterprises to articulate and enforce dual missions, to obtain greater access to capital, and to brand themselves to consumers and partners as distinct and special entities offering distinct and special products, in order to truly embody the sustainable corporation.


The benefit corporation will not yet achieve all of the goals social enterprises desire from a hybrid form.  Benefit corporation statutes have opened up a place for social enterprises to legally articulate their dual mission, and have guarded the ultimate exit from the hybrid form with significant shareholder voting requirements.  Leaving all content to unregulated standard-setters and providing little guidance or enforcement apparatus for midstream decision making, however, does not do enough to ensure benefit corporations can enforce a dual mission over time.  Thoughtful founders and leaders of social enterprises considering the benefit corporation form will consider whether investors, consumers, partners, and employees will find this balance and brand appealing.  Until a hybrid form is created that clearly and powerfully enforces dual mission, though, I believe access to expanded capital, effective branding, and sustainability will remain elusive.


* Professor of Law, Brooklyn Law School.  I greatly appreciate the support of Brooklyn Law School’s summer research stipend program, the research assistance of Priti Trivedi, and the comments and suggestions of Claire Kelly, Melanie Leslie, Antony Page, and the panelists and participants at the Wake Forest Law School’s Symposium, “The Sustainable Corporation” and the “L3C A to Z” Conference.  Any remaining errors are, of course, my own.

[1]. See Robert Katz & Antony Page, The Role of Social Enterprise, 35 Vt. L. Rev. 59, 86–93 (2010); Thomas Kelley, Law and Choice of Entity on the Social Enterprise Frontier, 84 Tul. L. Rev. 337, 338–342 (2009).

[2]. See Henry B. Hansmann, The Role of Nonprofit Enterprise, 89 Yale L.J. 835, 838 (1980).

[3]. See Einer Elhauge, Sacrificing Corporate Profits in the Public Interest, 80 N.Y.U. L. Rev. 733, 736–38 (2005) (arguing the view that corporate managers must only pursue profit maximization is widely held, though not strongly supported).

[4]. See Kelley, supra note 1, at 339.

[5]. See 2011 R.I. Pub. Laws 67 (authorizing L3Cs in Rhode Island); Elizabeth Schmidt, Vermont’s Social Hybrid Pioneers: Early Observations and Questions to Ponder, 35 Vt. L. Rev. 163, 170 (2010); Carter G. Bishop, Fifty State Series: L3C and B Corporation Legislation Table (Legal Studies Research Paper Series, Research Paper 10-11, May 26, 2011), available at; see also Legislative Watch, Americans for Community Development
/legislativewatch.php (last visited Aug. 28, 2011) (providing updated counts of states adopting and considering L3C legislation).  Bills authorizing the L3C structure have also been introduced in a great many additional states.  See Bishop, supra note 5; Schmidt, supra note 5, at 170; Legislative Watch, supra note 5.

[6]. See Companies (Audit, Investigations and Community Enterprise) Act 2004, c. 27, Part 2, available at

[7]. See B Lab, About Certified B Corps, Certified B Corp., (last visited Aug. 28, 2011).

[8]. See Bishop, supra note 5; B Lab, Benefit Corporation Legislation, Certified B Corp., (last visited Aug. 28, 2011) (providing updated counts of states adopting and considering benefit corporation legislation).

[9]. See, e.g., Md. Code Ann. Corps & Ass’ns § 5-6C-01(e) (LexisNexis 2011) (defining the role of third-party standard-setters); Vt. Stat. Ann. tit. 11A, § 21.03(a)(8) (2011) (similar).

[10]. See Dana Brakman Reiser, Governing and Financing Blended Enterprise, 85 Chi.-Kent L. Rev. 619, 630 & n.74 (2010).  Other examples from abroad also exist, but will not be discussed here.  See, e.g., Matthew F. Doeringer, Note, Fostering Social Enterprise: A Historical and International Analysis, 20 Duke J. Comp. & Int’l L. 291, 308–09 (2010) (describing, inter alia, Belgium’s Société à Finalité Sociale).

[11]. See CIC Regulator, CIC Guidance Chapter 1: Introduction, Office of the Regulator of Community Interest Companies, 12–14, available at‑950‑community-interest-companies-guidance-chapter-1-introduction.pdf.

[12]. See Vt. Stat. Ann. tit. 11, § 3001(27) (2011).

[13]. See Schmidt, supra note 5, at 163, 170; Legislative Watch, supra note 5.  Boosters of an L3C model for the United Kingdom have also proposed adoption of a similar form there, dubbed the social enterprise limited liability partnership (“SELLP”).  See Claudia Cahalane, What Is the Perfect Legal Structure for a Community Interest Company?, The Guardian (Apr. 4, 2011),‑enterprise‑network/2011/apr/04/legal‑structure-community-interest-company; Stephen Lloyd, The Social Enterprise LLP – What Is It; And What Is It For?, The Barrister,‑listing/current‑issue/the‑social‑enterprise-llp-%E2%80%93-what-is-it;-and-what-is-it-for.html (last visited Aug. 28, 2011).

[14]. Vt. Stat. Ann. tit. 11, § 3001(27) (2011).

[15]. See Brakman Reiser, supra note 10, at 650.

[16]. See B Lab, About Certified B Corps, supra note 7; see also David Adelman, Understanding B Corporations, Greenberg & Bass LLP (Aug. 6, 2010), (describing the establishment and history of B Corps).

[17]. See B Lab, Legal Framework, Certified B Corp., (last visited Aug 28, 2011).

[18]. See B Lab, Why B Corps Matter, Certified B Corp., (last visited Aug. 28, 2011).

[19]. See B Lab, Who Certifies? Certified B. Corp., (click on “How do we Certify and Audit companies as B Corporations?” ) (last visited Aug. 28, 2011).

[20]. See Md. Code Ann., Corps. & Ass’ns §§ 5-6C-01 to -08 (LexisNexis 2011); see also John Tozzi, Maryland Passes ‘Benefit Corp.’ Law for Social Entrepreneurs, Bloomberg Bus. Wk. (Apr. 13, 2010),; B Lab, Maryland First State in Union to Pass Benefit Corporation Legislation, CSRWire (Apr. 14, 2010),

[21]. See N.J. Stat. Ann. § 14A:18-1 to -11 (West 2011); Vt. Stat. Ann. tit. 11A, § 21 (2011); Va. Code Ann. § 13.1-782 to -791 (2011); S.B. 298, 2011 Leg. 26th Sess. (Haw. 2011).  The Hawaii legislation dubs its form a “sustainable business corporation,” but it is otherwise aligned with the other benefit corporation enactments.  S.B. 298, 2011 Leg. 26th Sess. § 2 (Haw. 2011).

[22]. See B Lab, Benefit Corporation Legislation, supra note 8; BusinessWire, Gov. Christie Signs Benefit Corporation Legislation (Mar. 7, 2011),‑Christie‑Signs-Benefit-Corporation-Legislation (discussing the passage of New Jersey’s legislation and stating that New York, North Carolina, California, Pennsylvania, Colorado, and Hawaii are introducing and moving similar legislation).

Legislation to permit a different kind of incorporated hybrid, the “flexible purpose corporation,” has been introduced in California.  A flexible purpose corporation would pursue profit and at least one charitable purpose or a purpose to pursue the interests of employees, suppliers, customers, creditors, community, society or the environment.  See S.B. 201, 2011 Gen. Assemb., Reg. Sess. (Cal. 2011) (proposing a change to Cal. Corp. Code § 2302(b)(2) (2011)).  These purposes would be disclosed to the secretary of state, but not vetted by a third party as benefit corporation statutes contemplate.  See id.  See also Jonathan Greenblatt, Business Model Needed to Promote Social Enterprise, S.F. Chron., May 31, 2011,
/30/ED0R1JMHF8.DTL; Keren Raz, What is a Flexible Purpose Corporation? (Sept. 8, 2010),
-purpose-corporation-by-keren-raz/ (describing the flexible purpose corporation and its differences from the benefit corporation).

[23]. See Or. Rev. Stat. § 60.047 (2009) (permitting corporations to include in their articles “a provision authorizing or directing the corporation to conduct the business of the corporation in a manner that is environmentally and socially responsible”); see also Judd F. Sneirson, Green Is Good: Sustainability, Profitability, and a New Paradigm for Corporate Governance, 94 Iowa L. Rev. 987, 1019–20 (2009) (describing the Oregon provision).

[24]. Some of the statutes make this point more vociferously than others.  Compare Md. Code Ann., Corps. & Ass’ns § 5-6C-02(b)–(c) (LexisNexis 2011) (“This subtitle applies only to benefit corporations. . . . The existence of a provision of this subtitle does not of itself create an implication that a contrary or different rule of law is or would be applicable to a corporation that is not a benefit corporation.  This subtitle does not affect a statute or rule of law as it applies to a corporation that is not a benefit corporation.”) and Vt. Stat. Ann. tit. 11A, § 21.02(b) (2011) (similar) with S.B. 2170, 214th Leg., 2nd Ann. Sess. (N.J. 2011) (describing the act as merely supplementing its general corporate law).

[25]. See, e.g., Md. Code Ann., Corps. & Ass’ns § 5-6C-02(a) (LexisNexis 2011); Vt. Stat. Ann. tit. 11A, § 21.02(a), (d) (2011).

[26]. See, e.g., Md. Code Ann., Corps. & Ass’ns § 5-6C-03 (LexisNexis 2011); Va. Code Ann. § 13.1-784 to -785 (2011).

[27]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-05 (LexisNexis 2011); Vt. Stat. Ann. tit. 11A, §§ 21.03(a)(1), 21.04, 21.05 (2011).

[28]. See, e.g., Vt. Stat Ann. tit. 11, § 3005(a) (2011) (requiring limited liability companies to include those words or abbreviations like “LLC” in their names and requiring low-profit limited liability companies to include those words or the abbreviation “L3C”).

[29]. See Md. Code Ann., Corps. & Ass’ns § 1-502(a)(2) (LexisNexis 2011).  This change was approved on May 19, 2011, and was part of legislation enabling benefit limited liability company status, on terms analogous to the benefit corporation statute.

[30]. See Md. Code Ann., Corps. & Ass’ns §§ 5-6C-03, 5-6C-04 (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-3 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.05(2) (2011) (allowing individual corporations to set a voting requirement above the two-thirds floor); Va. Code Ann. § 13.1-785 (2011) (requiring such an amendment be approved by “all shareholders entitled to vote”).

[31]. Vt. Stat. Ann. tit. 11A, § 21.05(1) (2011).  Virginia expressly requires that the amendment follow its typical corporate protocol for article amendments, which requires the board to notify shareholders of the amendment item on the meeting notice and to explain the board’s position on it.  See Va. Code Ann. § 13.1-785 (West 2011).

[32]. See, e.g., N.J. Stat. Ann. §§ 14A:18-3 to 18-4 (West 2011).

[33]. See, e.g., Va. Code Ann. § 13.1-786 (2011).

[34]. S.B. 298, 2011 Leg., 26th Sess. §§ 2, 5 (Haw. 2011); Md. Code Ann., Corps. & Ass’ns §§ 5-6C-01(c), 5-6C-06(A) (LexisNexis 2011); see also N.J. Stat. Ann. § 14A:18-1 (West 2011) (similar); Vt. Stat. Ann. tit. 11A, § 21.03(a)(4) (2011) (using virtually identical language); Va. Code Ann. § 13.1-782 (2011) (similar).

[35]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-01(c) (LexisNexis 2011); Va. Code Ann. § 13.1-782 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.03(a)(4) (West 2011); S.B. 298, 2011 Leg., 26th Sess. § 2 (Haw. 2011).

[36]. Md. Code Ann., Corps. & Ass’ns § 5-6C-01(d) (LexisNexis 2011) (bracketed language included in all but Maryland statute); N.J. Stat. Ann. § 14A:18-1 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.03(a)(6) (2011); Va. Code Ann. § 13.1-782 (West 2011); see also S.B. 298, 2011 Leg., 26th Sess. § 5(b) (Haw. 2011) (providing a similar list and also including using patents for certain purposes).

[37]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-06(b)(2) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-5(b) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.08(b) (2011).

[38]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-06(a)(2) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-5(a)-(b) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.08(a) (2011).

[39]. Md. Code Ann., Corps. & Ass’ns § 5-6C-06(c) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-5(c) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.08(c) (2011); Va. Code Ann. § 13.1-787(B) (2011).

[40]. Md. Code Ann., Corps. & Ass’ns § 5-6C-07(a)(1) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-6(a) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.09(a)(1)(C) (2011) (bracketed text is in Vermont statute); Va. Code Ann. § 13.1-788(A)(1) (2011).

[41]. See N.J. Stat. Ann. § 14A:18-6(b)–(c) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.09(a)(2)–(3) (2011); Va. Code Ann. § 13.1-788(A)(3) (2011).

[42]. Md. Code Ann., Corps. & Ass’ns § 5-6C-07(a) (LexisNexis 2011); see also N.J. Stat. Ann. § 14A:18-6(b)(2) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.09(a)(2) (West 2011); Va. Code Ann. § 13.1-788(A)(2)(b) (West 2011); S.B. 298, 2011 Leg., 26th Sess. § 6(a)(H) (Haw. 2011).

[43]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-07(c) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-6(d) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.09(c)–(d) (2011); Va. Code Ann. § 13.1-788(C) (2011); S.B. 298, 2011 Leg., 26th Sess. § 6(b) (Haw. 2011).

[44]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-07(b) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-10 (West 2011) (clarifying the limited rights to sue); Vt. Stat. Ann. tit. 11A, § 21.09(e) (2011); Va. Code Ann. § 13.1-790 (2011) (similar to New Jersey statute).  Some later-enacted statutes provide similarly broad discretion and immunity from liability for benefit corporation officers.  See N.J. Stat. Ann. § 14A:18-8 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.11 (2011); Va. Code Ann. § 13.1-789 (2011).

[45]. See Martin Lipton & Steven A. Rosenblum, A New System of Corporate Governance: The Quinquennial Election of Directors, 58 U. Chi. L. Rev. 187, 214–15 (1991); Jonathan D. Springer, Corporate Constituency Statutes: Hollow Hopes and False Fears, 1999 Ann. Surv. Am. L. 85, 94–97 (1999).

[46]. See, e.g., Frank H. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law 38 (1991) (“[A] manager told to serve two masters (a little for the equity holders, a little for the community) has been freed of both and is answerable to neither.”); Lucien Arye Bebchuck, Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law, 105 Harv. L. Rev. 1435, 1493 (1992) (stating “the primary effect of these constituency statutes is simply to enhance managers’ discretion in responding to hostile takeover bids”).  See generally Rutherford B. Campbell, Jr., Corporate Fiduciary Principles for the Post-Contractarian Era, 23 Fla. St. U. L. Rev. 561, 621–23 (1996) (making this criticism and noting the literature); Brett H. McDonnell, Corporate Constituency Statutes and Employee Governance, 30 Wm. Mitchell L. Rev. 1227, 1231–36 (2004) (reviewing the literature).

[47]. N.J. Stat. Ann. § 14A:18-6(a)(6) (West 2011); Va. Code Ann. § 13.1-788(A)(1)(f) (2011); S.B. 298, 2011 Leg., 26th Sess. § 6(a)(E) (Haw. 2011); see also Vt. Stat. Ann. tit. 11A, § 21.09(a)(1)(F) (2011) (containing very similar language); Vt. Stat. Ann. tit. 11A, § 21.09(a)(4) (2011) (stating that no “different or higher standard of care” applies in contexts where control is an issue).

[48]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-06 (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-5; Va. Code Ann. § 13.1-787 (2011); Vt. Stat. Ann. tit. 11A, § 21.08 (2011); S.B. 298, 2011 Leg., 26th Sess. § 2 (Haw. 2011).

[49]. See S.B. 298, 2011 Leg., 26th Sess. § 12 (Haw. 2011); Md. Code Ann., Corps. & Ass’ns § 5-6C-01(e) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-1 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.03(8) (2011); Va. Code Ann. § 13.1-782 (2011).

[50]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-01(e) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-1 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.03(a)(8) (2011); Va. Code Ann. § 13.1-782 (2011); S.B. 298, 2011 Leg., 26th Sess. § 12 (Haw. 2011).

[51]. Md. Code Ann., Corps. & Ass’ns § 5-6C-01(e)(1) (LexisNexis 2011) (bracketed language is only in Maryland statute); N.J. Stat. Ann. § 14A:18-1 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.03(a)(8) (2011); Va. Code Ann. § 13.1-782 (2011); S.B. 298, 2011 Leg., 26th Sess. § 12(2) (Haw. 2011).

[52]. See N.J. Stat. Ann. § 14A:18-1 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.03(a)(5) (2011); Va. Code Ann. § 13.1-782 (2011); S.B. 298, 2011 Leg., 26th Sess. § 12 (Haw. 2011).

[53]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-01(e) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-1 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.03(a)(8) (2011); Va. Code Ann. § 13.1-782 (2011); S.B. 298, 2011 Leg., 26th Sess. § 12 (Haw. 2011).

[54]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-01(e)(1)–(2) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-1 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.03(a)(8)(B) (2011); Va. Code Ann. § 13.1-782 (2011). The Hawaii legislation adds “an accounting of the sources of financial support for the organization that developed and controls revisions to the standard, with sufficient detail to disclose any relationships that could reasonably be considered to present a potential conflict of interest.”  S.B. 298, 2011 Leg., 26th Sess. § 12(3)(E) (Haw. 2011).

[55]. See B Lab, 2011 Annual Report: If Not Now, When, The Case for B Corp, Certified B Corp.,

[56]. See Who Certifies?, supra note 19.

[57]. Id.

[58]. See B Lab, B Impact Assessment 2010 Version 2.0,‑B‑Impact‑Assessment%20(1).pdf.  B Lab is currently beta testing an updated impact assessment.  See B Lab, Registration for Public Beta V3.0 Impact Assessment, (last visited Aug. 28, 2011).

[59]. See B Impact Assessment 2010 Version 2.0, supra note 58.

[60]. See B Lab, Become a B Corporation, Certified B Corp., (last visited Aug. 28, 2011).

[61]. Indeed, the B Lab website itself offers a number of suggestions of other possible third-party standard-setters, including “Global Reporting Initiative (“GRI”), GreenSeal, Underwriters Laboratories (“UL”), ISO2600, [and] Green America,” as well as a list of over one hundred raters on a referenced raters list.  See B Lab, Benefit Corporation – Legal FAQs, Certified B Corp.,  But see Doug Morris, Benefit Corporation Laws Hold Social Ventures Accountable, Sustainable Bus. Oregon (Mar. 1, 2011),
/2011/03/benefit-corporation-laws-hold-social.html (“The B corporation standard is not mentioned specifically in the statute[s], but few, if any, other third party standards currently exist. Therefore a benefit corporation may also need to become a certified B corporation.”).

[62]. See The SA8000 Standard, Soc. Accountability Int’l,‑ (last visited July 30, 2011); WRAP 12 Principles, Worldwide Responsible Accredited Production, (last visited Aug. 28, 2011).

[63]. See generally ISO 14001:2004, Abstract, Environmental management systems – Requirements with guidance for use, Int’l Org. for Standardization (2004) (specifying “requirements for an environmental management system to enable an organization to develop and implement a policy and objectives which take into account legal requirements and other requirements to which the organization subscribes, and information about significant environmental aspects”).

[64]. See Services for PRI Signatories, MSCI,
/esg/unpri_signatories/ (last visited July 30, 2011).

[65]. Certification Overview, MBDC Cradle to Cradle,
/detail.aspx?linkid=2&sublink=8 (last visited July 12, 2011).

[66]. Certification Criteria, MBDC Cradle to Cradle,
.aspx?linkid=2&sublink=9 (last visited Aug. 28, 2011).

[67]. Certified Products, MBDC Cradle to Cradle,
/list.php?order=type (last visited July 30, 2011).

[68]. See Cradle to Cradle Certification Program, Version 2.1.1, MBDC Cradle to Cradle (Jan. 2010),

[69]. See FAQ, Who Develops the Cradle to Cradle® Certification Criteria?, MBDC Cradle to Cradle, (last visited Aug. 28, 2011).

[70]. See Md. Code Ann., Corps. & Ass’ns. § 5-6C-08 (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-11 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.14 (2011); Va. Code Ann. § 13.1-791 (2011); S.B. 298, 2011 Leg., 26th Sess. § 11 (Haw. 2011).

[71]. See Md. Code Ann., Corps. & Ass’ns. § 5-6C-08 (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-11 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.14(a) (2011); Va. Code Ann. § 13.1-791 (2011); S.B. 298, 2011 Leg., 26th Sess. § 11(a)(1) (Haw. 2011).

[72]. See Vt. Stat. Ann. tit. 11A, § 21.14(a)(1)(D) (2011).

[73]. N.J. Stat. Ann. § 14A:18-11(a) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.14(a) (2011); S.B. 298, 2011 Leg., 26th Sess. § 11(3)–(6) (Haw. 2011).

[74]. See Md. Code Ann., Corps. & Ass’ns. § 5-6C-08(A)(2) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-11(a)(2) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.14(a)(2) (2011); Va. Code Ann. § 13.1-791(A)(2)(a) (2011); S.B. 298, 2011 Leg., 26th Sess. § 11(a)(2) (Haw. 2011).

[75]. N.J. Stat. Ann. § 14A:18-11(a)(6)(d) (West 2011).

[76]. Vt. Stat. Ann. tit. 11A, § 21.14(c) (2011).

[77]. S.B. 298, 2011 Leg., 26th Sess. § 11(a)(8) (Haw. 2011).

[78]. N.J. Stat. Ann. § 14A:18-7 (West 2011); Vt. Stat. Ann. tit. 11A,§ 21.10 (2011); S.B. 298, 2011 Leg., 26th Sess. § 7(a) (Haw. 2011).

[79]. See N.J. Stat. Ann. § 14A:18-7(c) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.10(c)(3) (2011); S.B. 298, 2011 Leg., 26th Sess. § 7(c) (Haw. 2011).

[80]. See N.J. Stat. Ann. § 14A:18-7(c) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.10(c)(4) (2011).

[81]. See N.J. Stat. Ann. § 14A:18-7(e) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.10(f) (2011).

[82]. N.J. Stat. Ann. § 14A:18-9 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.12 (2011); S.B. 298, 2011 Leg., 26th Sess. § 9 (Haw. 2011).

[83]. See N.J. Stat. Ann. § 14A:18-10 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.13 (2011); Va. Code Ann. § 13.1-790 (2011); S.B. 298, 2011 Leg., 26th Sess. § 10 (Haw. 2011).

[84]. See Vt. Stat. Ann. tit. 11A, § 21.13(b) (2011) (empowering directors, individuals or groups owning ten percent or more of the equity of a parent of the benefit corporation); N.J. Stat. Ann. § 14A:18-10(b) (West 2011) (similar); Va. Code Ann. § 13.1-790(B) (2011) (including no rights for owners of a parent company); S.B. 298, 2011 Leg., 26th Sess. § 10 (Haw. 2011).

[85]. Marc J. Lane, Social Enterprise: Empowering Mission-Driven Entrepreneurs 128 (2011).

[86]. Social entrepreneurs view the lack of a legal form for their enterprises as a significant problem.  See Katz & Page, supra note 1, at 85 (“A recent survey showed that 71% of social entrepreneurs believed that the choice of legal structure was the single greatest challenge for their ventures.”).

[87]. See Hansmann, supra note 2, at 838.

[88]. See id. (“A nonprofit organization is, in essence, an organization that is barred from distributing its net earnings, if any, to individuals who exercise control over it, such as members, officers, directors, or trustees.”).

[89]. See I.R.C. § 501(c)(3) (2010) (permitting exemption only to organizations that take “no part of the net earnings of which inures to the benefit of any private shareholder or individual”); I.R.C. §4958 (2010) (imposing penalty taxes on insiders engaging in “excess benefit transactions” with their exempt organizations); see also Marion R. Fremont-Smith, Governing Nonprofit Organizations: Federal and State Law and Regulation 248–64 (2004) (describing these doctrines in detail).

[90]. See generally Evelyn Brody, Business Activities of Nonprofit Organizations: Legal Boundary Problems, in Nonprofits & Business 83 (Joseph J. Cordes & C. Eugene Steuerle eds., 2009) (reviewing legal constraints placed on nonprofits’ business activities); see also Dana Brakman Reiser, Charity Law’s Essentials, 86 Notre Dame L. Rev. 1, 18–25 (2011) (describing the anticommerciality bias of current tax exemption law).

[91]. See Lynn A. Stout, Why We Should Stop Teaching Dodge v. Ford, 3 Va. L. & Bus. Rev. 163, 169 (2008); see also Principles of Corporate Governance § 2.01 Reporter’s Note 6 (1994) (“[T]here is little doubt that [restrictions on the general profit-making objective] would normally be permissible if agreed to by all the shareholders.  Such an agreement might be embodied in the certificate of incorporation, or not.”).

[92]. Compare Rev. Unif. Ltd. Liab. Act § 104(b) (clarifying that an LLC “may have any lawful purpose, regardless of whether for profit”), with Rev. Unif. Partnership Act § 202(a) (1997) (stating that any “association of two or more persons to carry on as co-owners a business for profit forms a partnership”).  See also Robert R. Keatinge, LLCs and Nonprofit Organizations—For-Profits, Nonprofits, and Hybrids, 42 Suffolk U. L. Rev. 553, 555, 583 (2009).

[93]. See, e.g., Kent Greenfield, The Failure of Corporate Law 41–42 (2006) (describing shareholder primacy as a “foundational principle” that “informs every aspect of corporate and securities law” in a work arguing corporate law should embrace a broader sense of proper corporate purposes); Lane, supra note 85, at 119.  Comments in a recent Delaware Chancery Court case have reinforced these fears.  See eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1, 35 (Del. Ch. 2010) (“Directors of a for-profit Delaware corporation cannot deploy a rights plan to defend a business strategy that openly eschews stockholder wealth maximization—at least not consistently with the directors’ fiduciary duties under Delaware law.”).

[94]. Compare, e.g., Robert Charles Clark, Corporate Law 17–18 (1986) (describing the obligations of corporate fiduciaries “to maximize the value of the company’s shares”), with e.g., Elhauge, supra note 3, at 735–39.

[95]. These include most importantly the demand requirement and business judgment rule protection.  Where these protections are less certain or do not apply, as may be the case in suits alleging oppression by a controlling shareholder in close corporations, litigation may become a more realistic cause for concern.

[96]. See Elhauge, supra note 3, at 735–39, 842–48; Antony Page, Has Corporate Law Failed? Addressing Proposals for Reform, 107 Mich. L. Rev. 979, 987–89 (2009); Sneirson, supra note 24, at 995–1007.

[97]. See, e.g., Mark J. Roe, The Shareholder Wealth Maximization Norm and Industrial Organization, 149 U. Pa. L. Rev. 2063, 2073 (2001) (noting that “[n]orms in American business circles, starting with business school education, emphasize the value, appropriateness, and indeed the justice of maximizing shareholder wealth”).  But see Sneirson, supra note 24, at 1011–12 and sources cited (arguing the claims of shareholder primacy’s hold on businesspersons is overstated); D. Gordon Smith, The Shareholder Primacy Norm, 23 J. Corp. L. 277, 290–91 (1998) (similar). Particularly interesting and subtle arguments on this matter can be found in Jay W. Lorsch with Elizabeth MacIver, Pawns or Potentates 37–55 (1989).  This empirical study found corporate directors’ self-reporting of their obligations often included rhetoric about shareholder primacy, but then explained a more broadly-focused and textured reality.

[98]. See Brakman Reiser, supra note 90, at 45–47 (describing how founders may entrench their dual missions in various for-profit forms of organization).

[99]. Cf. eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1, 32 (Del. Ch. 2010) (controlling shareholders argued they needed to undertake defensive measures to protect their chosen corporate culture after their deaths).

[100]. See Md. Code Ann., Corps & Ass’ns §§ 5-6C-01(c), 5-6C-06(a) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-1 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.03(a)(4) (2011); Va. Code Ann. § 13.1-782 (2011).

[101]. Although the New Jersey statute does not define general public benefit with reference to a third-party standard, it does not offer any other means for determining the bona fides of incorporators’ public-benefit claims.

[102]. Even if this mechanism is workable, it undercuts the ability of benefit corporation status alone to operate as an effective brand, a point to which I will return in Part II.C.

[103]. See Md. Code Ann., Corps. & Ass’ns. § 5-6C-01(c) (LexisNexis 2011); Vt. Stat. Ann. tit. 11A, § 21.03(4) (2011); Va. Code Ann. § 13.1-782 (2011).

[104]. See Md. Code Ann., Corps. & Ass’ns. § 5-6C-08(a)(2) (LexisNexis 2011); N.J. Stat. Ann. §§ 14A:18-11(a)(2) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.14(a)(2) (2011); Va. Code Ann. § 13.1-791(A)(2)(a) (2011); S.B. 298, 2011 Leg., 26th Sess. § 11(a)(2) (Haw. 2011).

[105]. Md. Code Ann., Corps. & Ass’ns. § 5-6C-04(b) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-4(a) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.07(2)(B) (2011); Va. Code Ann. § 13.1-786 (2011); S.B. 298, 2011 Leg., 26th Sess. § 3 (Haw. 2011).

[106]. See Md. Code Ann., Corps. & Ass’ns. § 5-6C-07 (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-6(c) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.09(a)(3) (2011); Va. Code Ann. § 13.1-788(A)(3) (2011).

[107]. See Md. Code Ann., Corps. & Ass’ns. § 5-6C-07 (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-6 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.09 (2011); Va. Code Ann. § 13.1-788(A) (2011).

[108]. See Md. Code Ann., Corps. & Ass’ns. §§ 5-6C-07(a)(1)-(2) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-6(a) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.09(a)(1)-(2) (2011); Va. Code Ann. § 13.1-788(A) (2011).

[109]. See N.J. Stat. Ann. § 14A:18-10 (West 2011); Vt. Stat. Ann. tit. 11A, § 21.13 (2011); Va. Code Ann. § 13.1-790 (2011).

[110]. This is only a default rule and can be changed by individual benefit corporations.  See N.J. Stat. Ann. § 14A:18-10(b)(2)(d) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.13(b)(4) (2011); Va. Code Ann. § 13.1-790(B)(2)(c) (2011).

[111]. See Fremont-Smith, supra note 89, at 324–42.

[112]. See id. at 324–25.  This concern was raised in bar association comments to proposed New York benefit corporation legislation.  See Letter from Committee on Corporation Law to Speaker Silver and Senator Squadron (Feb. 16, 2011) (on file with author) (noting concern regarding “attracting qualified individuals to serve” as benefit corporation directors even with limited standing).

[113]. The Hawaii statute makes this abundantly clear.  S.B. 298, 2011 Leg., 26th Sess. § 11(a)(8) (Haw. 2011).

[114]. See Companies (Audit, Investigations and Community Enterprise) Act 2004, c. 27, Part 2, § 27, available at
/27/section/27; About Us, CIC Regulator,
/about-us (last visited Aug. 28, 2011).

[115]. See Companies (Audit, Investigations and Community Enterprise) Act 2004, c. 27, Part 2, §§ 42–51, available at

[116]. See, e.g., Rev. Unif. Ltd. Liab. Co. Act §§ 901–903 (2006) (providing members with direct rights of action and only members with rights to sue derivatively, after demand or a showing of demand’s futility).

[117]. See Sandra K. Miller, What Fiduciary Duties Should Apply to the LLC Manager After More Than a Decade of Experimentation?, 32 J. Corp. L. 565, 586 (2007).

[118]. See, e.g., Rev. Unif. Ltd. Liab. Co. Act § 110(d) (2006).

[119]. See John Tyler, Negating the Legal Problem of Having “Two Masters”: A Framework for L3C Fiduciary Duties and Accountability, 35 Vt. L. Rev. 117, 141 (2010).

[120]. See id. at 154.

[121]. See B Lab, How Are Companies Certified and Audited as B Corporations?, Certified B Corp.,
?fuseaction=modalContent.content&id=f7224b49-ed7f-4037-894c-31c6e3c32178 (last visited Aug. 28, 2011).

[122]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-08(a) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-11(a) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.14(a) (2011); Va. Code Ann. § 13.1-791(A) (2011).

[123]. See Md. Code Ann., Corps. & Ass’ns § 5-6C-08(a)(1) (LexisNexis 2011); N.J. Stat. Ann. § 14A:18-11(a)(1) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.14(a)(1) (2011); Va. Code Ann. § 13.1-791(A)(1) (2011).

[124]. See N.J. Stat. Ann. §§ 14A:18-11, 14A:18-7(c) (West 2011); Vt. Stat. Ann. tit. 11A, §§ 21.14(a), 21.10(c)(3) (2011).

[125]. See N.J. Stat. Ann. § 14A:18-11(6)(d) (West 2011); Vt. Stat. Ann. tit. 11A, § 21.14(c) (2011).

[126]. See Fremont-Smith, supra note 89, at 315.

[127]. See id. at 409–11.

[128]. See, e.g., Model Bus. Corp. Act §§ 16.20, 16.21 (1984) (requiring corporations to provide shareholders and the secretary of state with annual reports); Del. Code Ann. tit. 8, § 502 (West 2011) (requiring Delaware corporations to file annual reports including very limited information with the secretary of state).

[129]. See, e.g., Rev. Unif. Ltd. Liab. Co. Act § 209 (2006).

[130]. See, e.g., 17 C.F.R. § 240.13a-1 (2011) (requiring companies issuing registered securities to file annual reports with the SEC); § 240.14a-3 (requiring that annual reports accompany proxy solicitations relating to annual meetings).

[131]. The highly regulated CIC does require annual reporting on the achievement of its community benefit, which reports are provided to the Regulator, are made available to the public, and should be provided to shareholders.  See The Guidance: Statutory Obligations, CIC Regulator 2–3 (May 14, 2005), available at

[132]. Illinois, unique among L3C-enacting jurisdictions, has directed that L3C managers are treated as charitable trustees and regulated by the state Attorney General.  See 805 Ill. Comp. Stat. Ann. 180/1-26(d) (2011).  Thus, Illinois L3Cs will have a reporting obligation that covers their public benefit activities.  See 760 Ill. Comp. Stat. Ann. 55/7(a) (2011).

[133]. See B Lab, Become a B Corporation, supra note 60 (requiring no ongoing reporting from “B” licensees, but subjecting them to potential on-site auditing by B Lab).

[134]. See Dana Brakman Reiser, For-Profit Philanthropy, 77 Fordham L. Rev. 2437, 2454–55 (2009) (describing some of these limitations).

[135]. Tax-exempt organizations are exempt from tax on income from sales of goods and services only to the extent it is not deemed unrelated business income, defined as income from a trade or business that is “regularly carried on.”  I.R.C. § 512(a)(1) (2010).  “[T]he conduct of which is not substantially related . . . to the exercise or performance” of exempt functions.”  § 513(a).

[136]. Only quite large and sophisticated nonprofit social enterprises will be able to access private debt markets through qualified tax-favored bond offerings.  These bond offerings are regulated through I.R.C. sections 103, 141–150, and accompanying regulations.  See generally IRS, Tax-Exempt Bonds for 501(c)(3) Charitable Organizations: Compliance Guide (2011), available at

[137]. See Henry Hansmann, The Rationale for Exempting Nonprofit Organizations from Corporate Income, 91 Yale L.J. 54, 72–73 (1981).

[138]. See, e.g., Dan Pallotta, Uncharitable: How Restraints on Nonprofits Undermine Their Potential 35–37 (2008); Anup Malani & Eric A. Posner, The Case for For-Profit Charities, 93 Va. L. Rev. 2017, 2020–21 (2007).

[139]. See Terri Lynn Helge, The Taxation of Cause-Related Marketing, 85 Chi.-Kent L. Rev. 883, 885–86 (2010) (explaining the cause-related marketing concept).

[140]. See, e.g., Save Lids to Save Lives, Yoplait,
/default.aspx (last visited Aug. 28, 2011) (describing the yogurt producer’s cause-related marketing campaign to benefit itself and Susan G. Komen For the Cure).

[141]. See The (RED) Idea, (RED), (last visited Aug. 28, 2011) (explaining the concept of selling products for which companies have promised to donate half of their profits to the Global Fund for HIV/AIDS).

[142]. Frequently Asked Questions, Americans for Community Development, (click on Financing) (last visited Aug. 28, 2011) (“The L3C vehicle is designed to attract PRI investments.”).

[143]. See I.R.C. § 4944(c) (2011).

[144]. See id.; Qualifying Distributions – In General,,,,id=162934,00.html (last visited Aug. 28, 2011).

[145]. See Michael N. Fine & Kerrin B. Slattery, Illinois Recognizes New Business Entity That Mixes For-Profit and Nonprofit Elements, McDermott Will & Emery, Aug. 28, 2009,
/publications.nldetail/object_id/7e32373a-065a-4d91-a8c2-556532d769a9.cfm (“The only way to be certain of PRI treatment, currently, is for a private foundation to seek a private ruling from the IRS.  However, the private letter ruling process consumes both time and money.”).

[146]. See Mark Hrywna, The L3C Status: Groups Explore Structure that Limits Liability for Program-Related Investing, The Non-Profit Times, Sept. 1, 2009,  available at
+explore+structure+that+limits+liability+for.%20.%20.-a0208056187 (reporting comments made by the IRS’ Ron Schultz, who “warned against jumping on the LC3 bandwagon too early because of unresolved tax questions”).

[147]. See Notices under the Companies (Audit, Investigations and Community Enterprise) Act 2004, CIC Regulator,

[148]. See Robert Lang & Elizabeth Carrott Minnigh, The L3C, History, Basic Construct, and Legal Framework, 35 Vt. L. Rev. 15, 17 (2010).

[149]. See Brakman Reiser, supra note 10, at 647–48, 650–51.

[150]. See id. at 650–51.

[151]. Note that the branding issue shares much common ground with that of how social enterprises can appeal to investors, addressed supra Part II.B.

[152]. Dictionary, American Marketing Ass’n,; see also Tim Calkins, The Challenge of Branding, in Kellogg on Branding 1, 8 (2005) (“Brands are sets of associations linked to a name or mark associated with a product or service.”).

[153]. See Kelley, supra note 1, at 361–62; see also David A. Aaker, Building Strong Brands 135 (1996) (explaining how an organization’s brand identity is important for “employees, retailers and others who must buy into [a company’s] goals and values and implement [its] strategies”).

[154]. See C. Whan Park, Deborah J. MacInnis & Joseph Priester, Brand Attachment and a Strategic Broad Exemplar, in Handbook on Brand and Experience Management 3, 3 (Berndt H. Schmidt & David L. Rogers, eds. 2008) (explaining the consensus in the business academic community “that strong brand equity is contingent on a powerful relationship between the customer and the brand”).

[155]. See Alice M. Tybout & Brian Sternthal, Brand Positioning, in Kellogg on Branding 11, 12–13 (2005) (explaining that a brand’s positioning must include “reasons to believe” and arguing these reasons are “more important when the claims are relatively abstract,” like those of a social enterprise will be).

[156]. See supra Part II.A.

[157]. Cf. Aaker, supra note 153, at 307 (explaining that for a consumer brand to be powerful, consumers must be aware of the brand and understand what it represents, and noting such brand knowledge is “not simply built by exposures; rather it is generated by a real customer intimacy with the brand”).

[158]. See id.

[159]. See B Lab,  2011 Annual Report, supra note 55, at 16–17.

[160]. Karen Woods, Welcome to the New Americans for Community Development, Americans for Community Development, (last visited Aug. 28, 2011).

[161]. See Considering Legislation in Your State?, Americans for Community Development,
.php (last visited Aug. 30, 2011); PR of L3Cs, Americans for Community Development,
.php (last visited Aug. 28, 2011).

[162]. See About Us, supra note 114.

[163]. Intriguingly, Hawaii calls its benefit corporation type entity a “sustainable business corporation.”  S.B. 298, 2011 Leg., 26th Sess. § 2 (Haw. 2011).

[164]. United Nations, G.A. Res. 42/187, Report of the World Commission on Environment and Development, available at

[165]. See John Elkington, Cannibals with Forks: The Triple Bottom Line of 21st Century Business 20 (1998); Peter Fisk, People Planet Profit: How to Embrace Sustainability for Innovation and Business Growth 3 (2010).

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