The United States is going through a moment of extreme political strife and uncertainty. Delaware’s corporate law ecosystem is going through its own moment of strife and uncertainty, albeit with less stratospheric—but still high—stakes. Significant connections exist between the conflict occurring within these two systems, including but not limited to the techno-king himself, Elon Musk.
Ann Lipton explores some of those connections in The Legitimation of Shareholder Primacy. Lipton argues that the central corporate law norm of shareholder primacy was intended to shield Delaware law from political debate, but internal tensions within the concept combined with the political polarization of our times have battered that shield. The development of that argument features Lipton’s deep knowledge of corporate law and governance, which is tied here to an interesting political story.
Lipton ties shareholder primacy to Delaware’s role as the leading choice of state of incorporation for large public corporations. One of our smallest states crafting the law that governs our most powerful non-state economic actors raises hackles. Delaware needs to legitimate itself and its corporate law. It must tell a convincing story as to how its corporate law helps improve our world. Lipton argues that shareholder primacy plays a big part in that story.
At first glance that seems odd. Shareholder primacy imposes on corporate directors and officers the sole goal of making decisions that increase the wealth generated for shareholders. Why will an exclusive focus on shareholders satisfy those citizens who own few or no shares? Lipton sees a two-step argument. First, shareholder primacy constrains corporate managers more meaningfully than any other plausible legal rule. Second, profit-maximizing will largely be in the best interests of society generally so long as they function within mostly well-functioning markets constrained by regulations that limit externalities (shades of Milton Friedman). Delaware accomplishes the first step (constraining managers); the federal government should do the second. Recent controversies surrounding Delaware courts have called both parts of this argument into question.
Two lines of cases raise doubt as to whether Delaware case law’s protections really help shareholders. The first line concerns the procedural protections the courts have put in place for transactions involving controlling shareholders with a conflicting interest. Kahn v. M & F Worldwide Corp., required minority shareholder buyouts to be conditioned from the start of their negotiation on both approval by independent directors bargaining effectively and by a majority of the non-interested shareholders. In re Match Group, Inc. Deriv. Litig., extended those requirements to all transactions with interested controlling shareholders. Both powerful shareholders and much of the corporate bar have pushed back hard.
Perhaps the most dramatic and political important of these controlling shareholder cases was Tornetta v. Musk, concerning the approval of a truly mind-blowing level of compensation for Musk at Tesla, but conditioned on achieving perhaps even more mind-blowing increases in the stock price. Which he achieved. But the process of approving the shares was suspect in many ways, and so the Chancery Court struck down Musk’s pay package. Shareholders then approved it again. That second approval rather calls into question whether shareholders much care about Delaware’s formalistic protections. Lipton argues that the courts have nonetheless stuck to their guns in part because the procedures demonstrate constraints on management to citizens other than shareholders, serving to help legitimate Delaware’s corporate law, not to mention the power large corporations are allowed to wield.
Lipton tells a similar story for West Palm Beach Firefighters’ Pension Fund v. Moelis, where the Chancery Court struck down a type of shareholder agreement that was rather clearly invalid under Delaware law, but which had grown quite common in Silicon Valley startups. A ruckus ensued, and the Delaware legislature amended the law granting carte blanche to shareholder agreements.
In both cases the court followed formalistic rules designed to protect shareholders, but powerful shareholders and the corporate bar objected. In both cases the Delaware legislature amended the corporate law statute in response to those objections. Why, Lipton asks, are powerful managers and their lawyer lackeys willing to explode rules that serve an important legitimating function not just for Delaware but also for them? She speculates that because of the stalemate in politics at the federal level, rich and powerful shareholders feel emboldened to do as they please without fearing a withdrawal of their social license to operate. And so Delaware must fall in line, or risk a “Dexit” as companies leave for other states willing to be more pliable.
The second part of the argument, that markets and regulations will cause profit-maximizing corporations to act in the public interest, has also come under fire. This argument has always had a pretty obvious weak spot as a means to legitimate Delaware’s corporate law: It relies on regulation elsewhere to constrain corporations where market prices don’t reflect true social costs and benefits. If one thinks markets usually work well so regulation need not be terribly extensive, as Friedman believed, that’s not such a problem. But if markets are less effective than that so external regulation needs to be quite heavy, Delaware becomes very dependent on the federal government functioning effectively. Which is not a very comfortable position to be in. Much of Leo Strine’s writing in recent years struggles with this dilemma.
What’s a little state with a big corporate clientele to do? One tack, as Lipton explores, is to hope that markets can be made to function better. And the growth of ESG investing and activism has created potential hope on that front. If investors, employees, and customers all want to be associated with companies that behave in a socially responsible way, then concern for a good reputation will give corporations a strong economic incentive to behave well. For a while, it looked like that might work pretty well. But in the last few years, ESG has become a highly politicized battlefield, and many institutional investors and operating companies are becoming gun shy. Shareholder primacy was supposed to be non-political, and the business case for social responsibility was meant to maintain that neutrality. But in our current political climate, social responsibility is highly contested. The political maelstrom cannot be so easily avoided.
Another tack is to give weak external regulation a boost through encouraging corporations to put much more attention on ensuring they follow the law. Hence the Caremark duty for boards to monitor corporate compliance. This was initially an extremely weak duty, in the sense that the chances of being held liable for a violation of it were slim. But a blatantly weak duty may undermine the legitimacy of the law. And so recently courts have given Caremark somewhat more bite. But, Lipton argues, this then risks running into the fact that often breaking weakly-enforced laws is actually a profit-maximizing move. Shareholders may well not want their companies to put such a stress on corporate compliance. Doctrinally, this shows up in courts not counting potential profits from lawbreaking when considering harms to shareholders. Practically, Caremark has become a way of doing some of the work of external regulators. But that puts Delaware courts squarely in politicized decision making, which the shareholder primacy turn was supposed to avoid.
Lipton ends with a few questions about where Delaware and its corporations will head next. If Delaware relents on the prosocial directions of Tornetta and Caremark, or if it doesn’t and corporations Dexit to more friendly states, will the pitchforks of angry populists reveal themselves, as Lipton puts it? Or will Musk and company have rationally calculated that they no longer need a legitimating story of restraint on their power to cover their ambitions?
It’s not a conclusive ending. Nor necessarily a happy one. But it’s a story well told.
