In the United States, corporate law, which concerns the relation between a firm’s shareholders and managers, is largely a matter for the states. Firms choose their state of incorporation, a statutory domicile that is independent of physical presence and that can be changed with shareholder approval. The legislative approach is, in the main, enabling. Corporation codes supply standard contract terms for corporate governance. These terms function as default provisions in corporate charters that firms can tailor more precisely to their needs. Firms therefore can particularize their charters under a state code, as well as seek the state whose code best matches their needs so as to minimize their cost of doing business.
Provisions in corporation codes run the gamut from trivial housekeeping to the fundamental fashioning of shareholder-manager relations. They range from specifying that a corporation’s name be placed in its charter to specifying fiduciary duties of managers and voting rights of shareholders, and when they can be waived, and procedures for corporate combinations, including when managers’ as opposed to shareholders’ decisions are controlling. States provide a different set of governance defaults for small, privately held firms, which are called close corporation codes. The variety in corporation codes and in their enabling approach readily accommodates the diversity in organization, capital structure, and lines of business among business firms.
The master problem animating corporation codes is the separation of ownership from control in the modern public corporation. Large firms typically have numerous shareholders with small holdings who cannot actively exercise control over the firm or monitor management. The holdings of managers running such firms are also usually infinitesimal. This creates an agency problem, in which the managers’ operation of a firm may deviate from the shareholders’ wishes to maximize the firm’s value. Managers, for example, may implement a policy that makes their jobs more secure, such as engaging in defensive tactics to thwart a corporate takeover, even though the policy reduces the firm’s value. Or, because the bulk of the managers’ wealth is tied up in the firm in present and future compensation, they may adopt a corporate strategy that reduces firm-specific risk, such as diversifying corporate acquisitions, even though shareholders do not benefit from the policy because they hold diversified stock portfolios that are subject to market, and not firm-specific, risk. A primary function of corporation codes in this regard is to establish corporate governance devices that can mitigate the agency problem by better aligning manager incentives with shareholder interests. The more prominent examples of such devices are (1) shareholder-elected boards of directors who monitor managers, (2) shareholder voting rights for fundamental corporate changes, and (3) fiduciary duties that impose liability on managers and directors who act negligently or with divided loyalty (favoring their own financial interest over that of shareholders).
Corporate law presumes that firms should be managed for shareholders’, and not managers’, interests when those interests conflict. Profit maximization (in a world where cash flows are uncertain, this is equivalent to maximizing equity share prices) is the goal. There are a number of persuasive explanations for this perspective. First, in competitive markets, maximizing share value allocates resources efficiently and thereby maximizes social welfare (Varian, 1992). Second, in competitive markets, it provides managers with a clear-cut decision rule that maximizes the utility of the firm’s owners who may have disparate preferences for current and future consumption, because it enables shareholders to trade against the increased share value to achieve whatever consumption pattern they wish without affecting the firm’s policy (Brealey and Stewart Myers, 1991). In this regard, it also reduces the cost of collective decisions, because shareholders’ interests are more homogeneous than other groups (Hansmann, 1988). Finally, it best matches organizational design with incentives. Because equity investments are residual claims with no fixed income guarantee or maturity date, they are the only investments in the firm that are not periodically renewed: hence, they are more vulnerable than the investments of other stakeholders, such as bondholders and employees, which can be and are protected by express contracting (Williamson, 1984).
A federal system of government produces a number of benefits for its citizens. It protects the individual from the immense power of government, as the states are a counterweight to the national government. It can allocate public goods and services more efficiently, as well as increase individual utility, compared with a centralized government because of its superior ability to match specific government policies with diverse citizen preferences regarding such policies: in a federal system, states and municipalities compete for citizens who choose to reside in the jurisdiction offering their preferred package of public goods and services. Finally, federalism spurs innovation in public policy because of the incremental experimentation afforded by fifty laboratories of states competing for citizens and firms. A policy improvement identified by one state is quickly enacted by other states.
But just as the benefits from federalism are axiomatic in American politics, it is also well recognized that a federal system can impede the administration of government and thereby diminish individual welfare. In particular, if the costs and benefits of a specific public policy do not fall within the boundaries of one jurisdiction, the optimal quantity and quality of public goods and services will not be produced. A state will not want to pay for benefits experienced by nonresidents, for example, and thus will underprovided a public good or service (such as a mosquito-spraying program that will benefit adjoining jurisdictions or highways that are used by interstate travelers). Similarly, states may export the cost of providing goods and services for their residents to nonresidents, for instance, by adopting taxes that are more likely to be paid by out-of-state than in-state individuals or firms—severance taxes in natural resource states, gaming taxes in Nevada, and in Iowa a single-factor corporate taxformula based on sales, which gives advantages to local firms that sell the bulk of their products out of state (Williamson, 1984).
A more adverse consequence of federalism is the potential for interjurisdictional competition that is not even zero-sum but a negative-sum game. Many commentators have characterized state economic development policies as such a game, in which competing states offer subsidies to firms that exceed the revenue from the local jobs they create. 14. Finally, by tolerating overlapping jurisdictional authority or requiring intergovernmental coordination, federalism raises the cost of implementing public policy, even when there is consensus on the policy objective.
The corporate law literature is a microcosm of this tension in the policy debate over federalism because an important theme in the literature focuses on the effect of competition among the states for tax revenues generated by corporate charters. Corporation codes can be viewed as products, whose producers are states and whose consumers are corporations. A key question is whether there is any reason to suppose that the code provisions produced by state competition benefit investors. The concern arises because one state within the federal structure, Delaware, which is a small state by any measure—population, geography, industrial or agricultural production—has dominated all the rest.
With each day, more and more people are challenging the institutions that exert control over our lives. Among ordinary citizens, skepticism and even hostility to the status quo are on the rise. People are questioning the legitimacy of the money values that guide modern society. They worry that unaccountable powers are out of control. And they are taking action to combat a system that is undermining the life values they hold dear.
Unlike most people’s movements of the late 20th century, this budding revolt is not primarily targeted at governments. Instead, the new rebels have set their sights on that force which during the last generation has nearly supplanted the nation-state as the possessor of true power: the transnational corporation. An insurrection against corporate rule is underway (Varian, 1992).
In the last decade a broad-based citizens’ movement has challenged the post-Cold War ascendancy of corporate power and the “free market” ideology that has been used to justify the corporate takeover of governance. With a passion that has taken much of the establishment by surprise, this nascent social movement is defying the prevailing trend of deregulation, privatization, and laissez-faire economics. Environmental activists, human rights groups, trade unionists, and countless other citizens of conscience are demanding that corporations be held accountable to the public. Disparate forces have united to make the claim that corporations should serve the needs of the public rather than the public serving the needs of corporations.
During the last 15 years, a consensus of the comfortable has arisen which tells the public that we are at the end of history as far as corporations are concerned. Journalists, academics, and politicians have told us that the ascent of corporate power and the diminishment of government are inevitable, that resistance is futile. But a great many people are resisting those all-too-neat assurances.
The rising tide of anti-corporate discontent can be witnessed in the myriad citizens’ campaigns targeting big business abuses. Environmentalists have struggled to stop companies from profiting off the destruction of old-growth forests. Human rights groups have sought to sever corporate links with abusive regimes. Public health advocates have made tobacco companies pay for misleading the public about the effects of their products. And local community groups have fought the efforts of so-called “big box” retailers such as Wal-Mart to locate in their areas. By demanding reforms in corporate behavior, citizens are asserting that corporations owe responsibilities to society.
The movement for corporate accountability is stimulating crucial debates about the role of big business in a democracy. It is declaring that corporations, as institutions that exert enormous influence over society, must be under the control of the public. In raising these issues, the corporate accountability movement is asking some of the most important questions of the new century: Who is writing the rules of the global economy? How are the rules being written? And in whose interests? (Brealey & Myers, 1991)
Such questions pose a clear challenge to the belief that corporations are benign forces, creators of bounty. Citizen activists are saying that, to the contrary, the transnational, limited liability corporation does more harm than good. That point of view overturns conventional definitions of progress. The corporate accountability movement is asking: What is the price of prosperity? By doing so, activists are defying the notion that leaving big business to do whatever it pleases will promote the public good.
In challenging big business behavior, the corporate accountability movement is forcing people to ask whether corporations’ power has eclipsed the sovereignty of the citizens. Every attempt to rein in corporate behavior contains the question: Who is in charge, private interests or the public? Protests against corporate abuses prompt doubts about whether corporate power has rendered democracy meaningless.
For anti-corporate partisans, those initial doubts have already been answered: Corporations rule. Corporations’ campaign cash elects our politicians. Their lobbyists write our laws. Their lures of private privilege corrupt our public servants. Their monopoly on the means of communication allows them to dominate public debate. In such an atmosphere, the people’s voices are ignored, their decisions made void. The reach and power of unaccountable corporations pose a clear and present danger to the health of democracy (Hansmann, 1988).
The anti-corporate insurrection is driven by a desire to limit or revoke the powers of the modern corporation. It is a revolt against corporate rule. It is a rebellion that seeks to reclaim democracy. And it is a movement that hopes to re-establish the principle that sovereignty-ultimate political authority-rests with we, the people, not with corporations.
What does it mean to say that corporations rule? How is it that today in the United States of America giant corporations are the most powerful political force in the country? And what does this mean for democracy?
Corporations are able to rule because of their immense power, and their power comes, in turn, from their incredible size. The 1980s and 1990s saw a wave of corporate mergers that dramatically increased the size of the corporations. Between 1998 and 2000 alone, the U.S. economy witnessed $4 trillion in mergers-more than in the preceding 30 years combined. This merger mania cemented the concentration of economic power in the hands of a relatively small number of businesses. The Fortune 500, for example, control one-quarter off all the assets of the 3.8 million corporations in the United States. The largest 1,000 companies oversee about 70 percent of the entire American economy (Williamson, 1984).
The focus on corporate behavior has contemporary precedents. In the late 1980s, Americans seeking to help end the apartheid system in South Africa took their struggle directly to the corporations who were profiting from the racist system. Activists had first appealed to the U.S. government to break from the whites-only regime. But when those efforts resulted in only cosmetic policy changes, antiapartheid groups set their sites on the companies who were doing business in South Africa and-through a combination of shareholder actions and selective purchasing ordinances-forced hundreds of companies to halt or reduce their involvement in South Africa, helping to bring down the regime.
A decade earlier, groups such as INFACT organized a worldwide boycott of Nestlé products after it was revealed that the company was using unscrupulous practices to market its infant formula in developing countries. Nestlé salespeople in poor countries dressed as nurses and gave out free formula samples that lasted just long enough for women’s breast milk to dry up. Many poor women diluted the formula with water to “stretch” the amount of formula, leading to millions of infant deaths due to malnutrition. After years of exposés, protests, and other shaming tactics, activists eventually forced Nestlé and other infant formula makers to sign a code of conduct establishing acceptable business practices (Williamson, 1984).
It was not until the 1990s, however, that the number of corporate campaigns mushroomed into what could be called a movement. As economic globalization redrew the balance of power between governments and corporations, social activists concentrated their energies directly on the corporations instead of appealing for government action. Grassroots groups channeled the popular discontent with corporate behavior into campaigns against specific abuses, and the widespread concern about corporate power made itself felt via the many struggles for corporate accountability.
This political backlash took many different forms. Environmentalists compelled some of the country’s largest food companies to sell dolphin-safe tuna, and shamed major retailers from offering products made with old-growth wood. Public health advocates and state officials revealed the depth of the tobacco industry’s decades-long deception and forced cigarette makers to pay massive fines. In a reprise of the anti-apartheid struggle, campus-based human rights activists demanded that corporations cease doing business with the repressive regime in Burma. Labor unions and human rights groups called on clothing retailers to take responsibility for the people making their clothes. And all of these disparate forces united to challenge corporations’ domination of international trade and finance agreements-the rule-making process of the new global economy.
The corporate accountability movement is strikingly diverse. Many different kinds of people, with a broad range of concerns, are battling corporate rule. Author Naomi Klein says the corporate accountability forces represent a “movement of movements.” Indeed, a close look at the sweep of corporate campaigns reveals a kind of bouquet: The whole is greater than the sum of its parts. The movement’s diversity is the best proof of its strength and the popular resonance of its claims.
Yet no matter what the specific grievance-environmental destruction, worker abuse, or human rights violations-corporate accountability campaigners make a uniform demand: Corporations must be answerable to more than their shareholders. Each corporate accountability struggle represents a challenge to the notion that companies are merely private enterprises instead of public actors that owe obligations to society at large. Every effort against corporate rule is a blow against impunity and a call for a truly democratic society (Varian, 1992).
19th century “race-to-the-bottom” occurred during which states competed to attract businesses by lowering their demands on corporations. Companies played states off one another by asking for ever looser restrictions. In the midst of a “bidding war” between New Jersey and New York, the New Jersey legislature passed an incorporation law that permitted unlimited corporate size and market share, legalized new kinds of mergers and acquisitions, reduced shareholder power in favor of company directors, and removed all time limits on the lifespan of corporate charters. Not to be outdone, Delaware * passed the most permissive incorporation law yet. Delaware’s new law said business owners “may also contain [in the charter] any provision which the incorporators may choose to insert.” Whereas the early charter systems had reserved for the state all powers not explicitly given to the corporation, Delaware’s new process allowed corporations to define their own powers. No one but the companies themselves could set the rules for corporate behavior. The legal framework supporting the idea that corporations should be subordinate to the will of the people was being dismantled.
The wealthy classes-business owners, judges, corporate lawyers-sought to justify the changes in the law with theories of “laissez-faire” and “Social Darwinism.” The idea of laissez-faire stipulated that the general good would be best served when government refrained from “interfering” with business. Seeking legitimacy in the Jeffersonian idea that “the government is best which governs least, ” proponents of laissez-faire economics argued that the state and federal government should not “meddle” in the affairs of business. If government would stay out of the way, corporations’ actions would benefit society at large. The laissez-faire mentality meshed with corporate owners’ belief that their endeavors were private efforts, not public acts, and that no one had the right to tell them how to run their businesses (Varian, 1992).
Modern Corporation Codes tend to be enabling rather than mandatory statutes: they are standard form contracts specifying the rights and obligations of managers and shareholders, which can often be altered by private agreement to suit the circumstances of particular firms. The enabling approach is a function of the contractual nature of the corporation. Participation in a firm is voluntary; common stock is one of a vast array of available investment vehicles. Although an enabling regime permits shareholders and management to tailor most corporate contract terms to fit their particular needs, the appropriate scope of the regime—whether certain corporate code provisions should be mandatory rather than optional—is a perennial debate among students and practitioners of corporate law. State securities regulation, conversely, is mandatory when it applies. Its jurisdiction is based on the site of the securities transaction (that is, the state of residence of the citizen-purchaser) and not the issuer’s domicile (Brealey & Myers, 1991).
The mandatory-enabling debate can be recast to fit the theme of this monograph: does state competition produce too few mandatory corporate laws? Because of the ease of reincorporation, a provision in one state’s code will not be truly mandatory unless it is included in all other state codes. This leads proponents of mandatory rules to advocate exclusive national corporate laws, which firms could circumvent only by resorting to costly substitutes such as adopting an unincorporated form of business or incorporating in a foreign country.
The case for a national corporation law to ensure mandatory compliance parallels the case for the federal securities laws, from which corporations cannot opt out. An implicit assumption in the comparison is that the federal securities laws work well and ought to be emulated. When analyzed carefully, however, the rationales for the federal securities laws are quite weak, having little to do with shareholder protection, and the empirical evidence of their efficacy is, at best, inconclusive. There is no compelling reason for mandating federal laws governing the content and timing of disclosure of financial and other information, the conduct of tender offers, and trading on inside information. Yet if the strictures of the federal securities laws were enabling rather than mandatory, then the justification for having a national as opposed to state regime is removed. Hence, far from providing ammunition to opponents of state corporate chartering, an examination of the performance of the federal securities laws makes the case for a national corporation code even more problematic. Similarly, the experience with mandatory state securities laws does not support altering the enabling approach of state corporation codes. Despite the negative conclusions concerning the efficacy of the federal government’s involvement in securities regulation, there has been a troubling expansion in recent years of its jurisdiction in the federal criminalization of fiduciary duties under the mail and wire fraud statutes.
A more important question in the mandatory-enabling debate is whether the concept of mandatory corporate law is meaningful in the first place. As noted, corporation codes are highly adaptive and functional. Rules that commentators identify as mandatory provisions have little in common with the ordinary understanding of that term, as they either can be legally side-stepped or pose a nonbinding constraint, because there is no desire by investors to deviate from them. They are laws without bite. Consider just two examples of ostensible mandatory rules that are readily avoided. One, a majority of shares must approve a merger. Management’s ability to choose a transaction’s form makes this rule optional. A deal can be restructured as an asset or stock acquisition and avoid a shareholder vote (Hansmann, 1988). Two, directors must be elected by shareholders annually or through a classified board structure, which is viewed as a prohibition of self‐ perpetuating boards. There is, however, no term limit on individual directors or a mandate that shareholders control the nomination process. Nor are nonvoting or low-voting shares prohibited. Practically speaking, then, the board is self-perpetuating, as management determines its membership.
Many mandatory provisions of corporation codes are, in fact, nonbinding constraints. In several instances, the ostensible mandatory provision, such as management’s duty of loyalty, would be voluntarily adopted by firms if it was not required. 6. In such situations, when there is an overwhelming consensus for the desirability of a particular rule, the claim that the provision is mandatory is not particularly meaningful. In other instances, a mandatory provision may be a housekeeping rule, with no substantive content except to impose technical clarity, such as the rule that a firm must compile the list of shareholders entitled to vote at a shareholder’s meeting at least ten days before the meeting. While this particular rule will have bite in a contested election (for example, management cannot limit a challenger’s access to the list by compiling it only five days before a meeting), it is difficult to divine any deep significance for corporate law from such a provision (that is, there is no significance from the use of the number ten rather than any other) or to identify a strong reason for firms to desire a number other than ten. Furthermore, such housekeeping provisions are not of principal interest to commentators concerned over the mandatory-enabling mix of corporation codes; the other form of nonbinding constraints, such as fiduciary duties, is.
More important in the history of corporation codes, when a mandatory rule’s constraint becomes binding such that an increasing number of firms wish to deviate from it, the rule is repealed and revamped toward a less restrictive one. The examples of corporation codes continually progressing over the years along enabling lines are legion. For instance, voting requirements for mergers have been reduced, prohibitions on self-interested transactions have been repealed, preemptive rights and cumulative voting are no longer required, and directors’ liability for breach of the duty of care can be eliminated by shareholder vote (Williamson, 1984).
For a corporate law to be truly mandatory, it must be adopted by all fifty states and the District of Columbia, because firms can change their statutory domicile. The place for exploring mandatory rules in corporate law therefore involves national, not state, regulation. Restrictions or heavy taxes on reincorporation might also do the trick, but such penalties might run afoul of the commerce clause.
Federal rules are indeed mandatory and not enabling. Firms cannot opt out of the federal securities laws regulating insider trading, corporate disclosure, and takeover bids. The rationale for straying from the contractual paradigm, along with its persuasiveness, varies across contexts.
The making of American corporate law is unique among federal political systems: state competition has produced innovative corporation codes that quickly respond to changing market conditions and firm demands. Corporate law commentators have long debated whether this responsiveness is for the better. The best available evidence indicates that, for the most part, the race is for the top and not the bottom in the production of corporation laws. But the direction of corporate law reform is not linear. The adoption of state takeover statutes, which have adverse effects on shareholder wealth, demonstrates that state competition is far from perfect; so may rules facilitating shareholder litigation. Perfection, however, is not the proper yardstick for measuring the legislative output of state competition: the time frame of analysis is more important. In the short run, there will inevitably be deviations from the optimum in a federal system. But in the longer run, competitive pressures are exerted when states make mistakes, as in the example of the vast majority of firms exiting from much of Pennsylvania’s takeover regime. Such self-correcting pressure is absent in a centralized national system. There is no reason to believe that where state laws are inadequate, a national corporation law would be better, and there is, indeed, some reason to believe that it would be worse (Williamson, 1984).
The answer to the question of the efficacy of state competition is therefore between the polar positions of Winter and Cary, albeit far closer to the Winter (that is pro—state competition) than to the Cary (that is, pro—federal regulation) end of the continuum, given the numerous event studies surveyed throughout this monograph. One implication of the analysis is that investors and public policy are best served by detailed examination of the effects of specific statutes on shareholder welfare rather than rhetorical debate over the appropriate sovereign for corporations, for there is no reason to support federal regulation. Another implication is that the default regime for coverage by new code provisions for which there is a discernible conflict of interest between managers and shareholders, such as takeover statutes, should be an opt-in one. That would ensure that coverage would be decided by those who bear the cost of a value-decreasing charter provision, while at least partially neutralizing management’s advantage over challengers in the proxy process by requiring management, and not shareholders, to commence the amendment process. A final implication concerns the mandatory federal laws that regulate securities transactions, at best with inconclusive efficacy; we should open these laws to experimentation by making them optional at the shareholders’ choice. Such a policy is consistent with the wealth‐ increasing, enabling approach of state corporation codes. Finally, the trend to federal criminalization of fiduciary duties should be stopped; apart from the general policy question concerning the appropriateness of criminal sanctions for torts, particularly questionable violations, it undermines the essence of state competition, autonomy of the incorporation state over manager-shareholder relations.
Competition for incorporation revenues makes U.S. states sensitive to investor concerns: such competition is the genius of American corporate law. Lacking complete control over their corporation laws, Canadian provinces apparently have not engaged in charter competition. With no similar financial incentives and legal barriers to reincorporation, European nations have maintained corporation codes that promote mixed objectives. The EC’s harmonization process further sustains the adoption of these codes. This is exemplified by the persistent effort in the EC’s harmonization effort to require employee participation in corporate governance (the proposed fifth directive), an effort to mandate provisions that do not emerge in a competitive corporate law regime, for neither U.S. states nor firms have opted for such governance structures. Concerns over the emergence of a European Delaware are, from the shareholders’ perspective, profoundly misplaced, since state competition for charters in the United States has, on balance, benefited shareholders, while harmonization may have a deleterious effect on their interests. One possible consequence, or possible cause, of the lack of charter competition in Canada and Europe is the more concentrated stock ownership of