CHAPTER SEVEN

Operating Benefit Corporations in the Normal Course

Benefit corporation statutes require directors of corporations to take the interests of a broad range of stakeholders into account, eliminating the concept of shareholder primacy. This chapter discusses how corporations operating in the normal course might operate to pursue this broader purpose, and how the business judgment rule will likely function when applied to this altered value proposition. Standards of review lie at the heart of corporate law. By examining how a court might review a shareholder challenge to an action taken by the board of a benefit corporation and contrasting that process with similar litigation involving a conventional corporation, we can gain insight into why the new statutes are important, and whether they are likely to be effective in changing corporate behavior. Chapter 8 will examine the same type of question for special situations that benefit corporations may encounter.

The Business Judgment Rule

Chapter 3 addressed the standards of review that apply in shareholder lawsuits that challenge decisions made by directors of conventional corporations. One key standard is the business judgment rule, under which courts will not interfere with a disinterested decision made by careful directors, unless the decision is irrational. This procedural litigation rule reflects and implements a critical substantive corporate law rule: business decisions are best made by or under board direction rather than by shareholders or courts. This principle is a critical element in allowing corporations to gather capital from large groups of disaggregated investors and to put that capital to work in a coherent fashion. If business decisions were subject to frequent judicial challenge, few would choose to take on the role of directors, third parties would be hesitant to contract with corporations, and capital formation would be more difficult and expensive.

By engaging in the thought experiment of asking how the business judgment will be applied or changed in litigation challenging decisions by the directors of benefit corporations, we can attain some insight into how decisions should be made by benefit corporations at the board and management level.

The benefit corporation statutes allow for-profit companies to have a purpose of “creating general public benefit”¹ or to “operate in a responsible and sustainable manner.”² In order to function sustainably, benefit corporations are obligated to account for the interests of a broad group of stakeholders rather than narrowly focusing on shareholders.

This accounting for the interests of public beneficiaries alongside the interests of shareholders is explicitly entitled to the protection of the business judgment rule.³ Accordingly, the general operation of the business judgment rule to protect business decisions will remain intact under the public benefit corporation statute. Under the Model Benefit Corporation Legislation, the business judgment rule will apply to fiduciary suits against directors but not to suits against the corporation for failure to meet or pursue its benefit purpose. Under the PCBS, however, any shareholder challenge will be subject to the business judgment rule. For example, a board decision to enter a new line of business will still be protected from judicial second-guessing by the broad parameters of the business judgment rule under the PBCS.⁴

However, in order to come within the ambit of business judgment rule protection, the board process should explicitly address the interests of relevant stakeholders. In order to benefit from this continued protection, directors should make a record of this balancing to establish that they have acted with requisite care.

What does this application of the business judgment rule mean from a substantive perspective? That is, how will it influence the conduct of benefit corporations, and how will it work toward accomplishing the goal of the new laws? First, it is critical to distinguish between the choices made in the MBCL and those made in the PBCS. The drafters of the Delaware model chose to hew more closely to the conventional path. If a decision does not involve a conflict, a sale of the corporation, defensive measures, or the corporate franchise, any challenge from shareholders must overcome the high hurdles of business judgment protection. This means that, in the PBC context, almost all decisions are protected by the business judgment rule. On the other hand, in the case of benefit corporations created under the MBCL, there is room for substantive review of any decision.

ORDINARY DECISIONS AND PUBLIC BENEFIT CORPORATIONS

First consider the Delaware model. The purpose of the PBC, of course, is to create corporations that affirmatively address the needs of all stakeholders. There are two important elements to creating space for this shift to occur. First, the statute must ensure that directors are permitted to incorporate such broad values. Second, in order to be effective, a statute should also require that they do so. With respect to the former, the application of business judgment review on most decisions is clearly an effective tool. As long as directors act independently and rationally, shareholders will not be able to bring legal challenges to the board’s full integration of stakeholder interests into its decision making. For example, directors will be able to make rational decisions that protect the environment and workers, without fearing a lawsuit that they “cared too much” about non-shareholder issues or that those concerns were not “related” to shareholder value.⁵ Although the PBCS requirement of “balancing” does impose a duty to give real weight to the stakeholder concerns, the business judgment rule means that directors have wide latitude in actually prioritizing the various interests for which they are responsible.

But does this very latitude presage ineffectiveness in the second aspect of stakeholder governance, that is, in requiring stakeholder interests to be considered? To put the question bluntly, is the PBCS just a dressed-up constituency statute, which gives directors the ability to consider all stakeholders when such a path serves management needs but to ignore those stakeholder concerns otherwise? There are several elements to the statutory scheme that should ameliorate this risk.

First, the business judgment rule is only applicable when the board fully informs itself. This means that directors must educate themselves on the material effects their decisions are having on the environment, on the community, and on workers throughout their supply chain. Without applying too much armchair psychology, it is not hard to believe that, by simply requiring these elements to be brought into the boardroom conversation, and by making directors legally responsible for them, the decision-making process is much more likely to give weight to those interests. Moreover, the milieu of a benefit corporation is one where the shareholders have consented to stakeholder values, so that directors will be aware that the shareholders are more likely to tolerate, or even encourage, management decisions that take responsibilities to stakeholders seriously.

Finally, there is the substantive element of the business judgment rule, under which some trade-offs may not be viewed as rational. That concept does not exist in constituency states. Under the PBCS, there will always be an awareness that if a board entirely ignores stakeholder interests, they may be approaching the zone where their conduct will be viewed as irrational for a benefit corporation.⁶ In addition, the benefit reporting requirement creates an obligation to measure, assess, and report on public benefit, and this should also provide some level of accountability. As the aphorism goes, “What gets measured gets managed.”⁷

ORDINARY DECISIONS AND THE MBCL

Turning to the MBCL, the business judgment rule analysis is the same: it provides all the same protections to a director who considers stakeholder interests, and the requirement of being informed, along with the larger benefit corporation milieu, contributes to enforcing some amount of concern for stakeholders. However, in contrast to the PBCS, the MBCL also allows a direct claim against the corporation for failure to pursue or create public benefit, and there is no business judgment rule protection for such a claim, even with respect to ordinary, disinterested business decisions. Thus, such a claim can succeed, even if the board is disinterested, fully informed, and rational. The plaintiffs just need to show that the company is in fact failing to pursue or achieve “a material positive impact on society and the environment.”⁸

This is arguably a stronger regime for regulating corporate conduct than exists in Delaware or any other state adopting the PBCS model.⁹ It presumably allows a plaintiff to take discovery as to all matters relevant to the assessment that the corporation is using, and to challenge whether the corporation has in fact endeavored to create or has created a positive effect. This question will presumably give a court much greater flexibility in litigation and make it easier for a shareholder to win such a case. The only relief available in such a case is injunctive, however, so that the court cannot award any damages. Nevertheless, the risk of lengthy litigation, and the possibility of a highly publicized loss in court, could be powerful inducements for board action that creates public benefit.¹⁰

Thus, with respect to ordinary business decisions, both statutory models give strong protections to directors who account for the interests of stakeholders, and both provide some inducement to do so, although the inducement is arguably stronger in the MBCL.¹¹

A Longer-Term Lens?

Because many constituencies, such as employees and customers, cannot diversify in the way that shareholders can, boards taking their interests into account may need to apply longer-term horizons. One fund manager provided the following example:

Shareholders . . . may be willing to take bigger risks with their capital in the hope of large upside returns, whereas employees may be more risk averse—being unable to take a portfolio approach to employment. This might in a particular case mean that directors [considering stakeholder concerns] decide to eschew a risky transaction involving a lot of debt, such as a new international expansion plan which could result in large gains or insolvency, as the plan may not be in the best interests of all employees.¹²

The higher risk-adjusted value to shareholders of taking the risk in this situation reflects the fact that the limited liability nature of the corporation—a state-granted privilege—allows shareholders to internalize the upside of a risky transaction in their capacity as residual risk bearers, while externalizing much of the downside risk onto others, including the employees, creditors, and communities that would be damaged by an insolvency. This differing risk calculus recalls the divergence of interest between common shareholders and preferred shareholders, discussed in the “Multiple Investor Constituencies” section of chapter 2. In any event, taking such risks may result in immediate share price increases in the public markets as the market recognizes the value of the increased risk.¹³

On the other hand, there are long-term uses of capital that may risk the capital without imposing significant insolvency risk or other costs on stakeholders, such as investing free cash flow into employee training. The benefit of such a plan, both to employees and to shareholders, is long term and subject to execution risk as well as the economic uncertainty that comes with any long-range business plan.¹⁴ Short-term-minded shareholders might favor a return of capital as a less risky choice for themselves. This can create pressure on public companies to increase returns of capital at the expense of long-term growth. Indeed, in a January 2017 letter to the CEOs of leading companies, the chairman of the world’s largest asset manager cautioned against this pressure:

Companies have begun to devote greater attention to these issues of long-term sustainability, but despite increased rhetorical commitment, they have continued to engage in buybacks at a furious pace. In fact, for the 12 months ending in the third quarter of 2016, the value of dividends and buybacks by S&P 500 companies exceeded those companies’ operating profit. While we certainly support returning excess capital to shareholders, we believe companies must balance those practices with investment in future growth. Companies should engage in buybacks only when they are confident that the return on those buybacks will ultimately exceed the cost of capital and the long-term returns of investing in future growth.¹⁵

Benefit corporation directors exercising their business judgment are likely to be more able to use a longer-term lens when making ordinary business decisions. This may, in turn, help to combat a short-term bias created by the intermediaries between the real economy and the ultimate beneficial owners of shares, which bias benefits the middle of the investment chain but not the top or bottom.¹⁶ That being said, it is too simple to say that long-term values are equivalent to stakeholder interests and that short-term values favor shareholder interests. After all, some important decisions may improve the lives of stakeholders in the short run and also create long-term value for shareholders. For example, fair treatment of employees in a corporation’s global supply chain will immediately improve the lives of those workers and may preserve the corporation’s reputation, adding shareholder value over the long term.

Practical Implications for Ordinary Business Decisions

STARTING WITH TRANSPARENCY

The best starting point for directors considering broadened benefit corporation obligations may be the statutory transparency requirements. Both the MBCL and the PBCS impose sustainability reporting requirements.¹⁷ Benefit corporations must distribute periodic reports. Under the PBCS, the report must include goals, objectives, standards, and an assessment and must be produced at least once every two years if the corporation has not adopted a provision requiring a more frequent report.¹⁸ Under the MBCL, there is an annual requirement for a report made against a third-party standard. The MBCL also requires annual certification that the corporation is meeting its public benefit obligations.

In order to comply with these obligations, the board of a PBC must determine who is materially affected by the corporation’s business, develop and maintain criteria for balancing the interests of those so affected and any specific benefit identified in the corporation’s charter, and measure progress against those criteria. A PBC board may adopt one or more third-party standards to monitor its actions and progress.¹⁹ For benefit corporations governed by the MBCL, the board will be required to choose and report under a third-party standard. A third-party standard is, of course, an excellent tool for a board to use to understand its stakeholders and their concerns.

Under either regime, the exercise of maintaining a credible reporting function will require the board and management to address important stakeholder issues (whether identified through a third-party standard or otherwise) and maintain a record of that work. The following are additional recommendations of procedures a benefit corporation board may adopt to ensure it is properly addressing stakeholder concerns (see appendix F for a rubric setting forth these procedures).

ESTABLISH A COMMITTEE

A committee may be tasked with responsibility for public benefit issues. Assigning this responsibility to a committee should not be viewed as isolating the benefit purposes. Instead, assigning matters to committees is generally perceived as a recognition of the importance of the delegated matters. For this reason, vital functions, such as compensation and audit, are required to be assigned to committees. Research suggests that firms that adopt effective sustainability programs are more likely to form a separate board committee to address sustainability issues.²⁰ The board can delegate this responsibility to an existing committee, such as audit or governance, or create a new, stand-alone committee. The committee that is responsible for sustainability issues should include in its committee charter oversight of and/or recommendations with respect to third-party standards, if any; internally generated standards; choice of certifying body or bodies, if any; the benefit report; and sustainability objectives, standards, strategies, and policies.

MANAGEMENT ROLE

Although the committee should oversee sustainability issues, management must fully integrate benefit purpose into its function. Notably, management should draft the benefit report and report to the board about progress toward the impact objectives. Additionally, management should make recommendations on the following subjects: third-party standards and internally generated standards; certification issues; and sustainability objectives, standards, strategies, and policies. Many companies already have a sustainability function, such as a chief sustainability officer. In a benefit corporation, this role will be heightened in importance, as sustainability shifts to being a primary purpose of the corporation. As we have discussed, board decisions around benefit issues will be protected by the business judgment rule, but the rule requires that directors are fully informed. Accordingly, management and sustainability officers will have a critical role in providing the board and relevant committees with the information necessary to consider and balance the interests of all relevant stakeholders.

PERIODIC ACTIVITY

Certain activities should be conducted cyclically, in accordance with the timing selected for production of the company’s benefit report. Annually, sustainability objectives should be established and assessed. The committee should meet regularly and report to the board. Periodic reports to the board from the committee will allow the board significant opportunity to address stakeholder interests. Management and the committee should meet for an extended period of time, either annually or biannually, regarding these sustainability objectives. Finally, the board should review the benefit report.

NONPERIODIC ACTIVITY

Management and the committee should have different responsibilities with respect to issues that arise in a nonperiodic fashion. Management can be charged with bringing to the board significant sustainability issues that come up out of cycle and that are not covered by policies, such as the effect of a strategic change or product change on workers or customers, or the environmental impacts of significant building projects, fleet acquisitions, or other matters. Depending on magnitude, the committee should consider sustainability issues implicated by new developments, such as whether to purchase renewable energy or obtain Leadership in Energy and Environmental Design (LEED) certification for new buildings, or the effect of a transaction on workers’ compensation or customers.

Of course, in larger benefit corporations, many individual decisions are made at the management level and are not brought to the directors’ attention. For such delegated decisions, it is important that a corporation have adequate policies in place to guide management decisions that affect stakeholders.

With respect to director-level decisions affecting benefit purposes, the committee could make the decision or defer to the board if the particular inquiry is of great significance.²¹ Regardless, the committee should report any and all decisions to the board. In general, clear policies and record keeping with respect to stakeholder concerns will preserve the protections of the business judgment rule for ordinary decisions.

PROCESS ISSUES

Good corporate governance practices can help the board effectively comply with its stakeholder obligations. Foremost, management’s recommendations to the committee and the committee’s recommendations to the board should be distributed well in advance of committee and board meetings in order to give directors adequate time for review.

Meeting minutes should reflect sustainability issues discussed, resolution of those issues, and any direction given to the committee or management. Additionally, if a third-party standard or internal standard has been adopted, materials and minutes should reflect consideration of how the standard maps to the interests of those affected by the corporation’s conduct. Standard meeting procedure should include reviewing internal checklists to determine whether other sustainability issues should be added, and providing redline copies when materials update other materials.²²

BOARD COMPOSITION

Another method to ensure that a benefit corporation board operates within its public benefit duty is to strategically select the board of directors. Such diversity may provide a structure that naturally addresses multiple objectives within the deliberative process. Thus, one or more directors with expertise in a particular stakeholder issue could be elected in an effort to introduce relevant interests into board discussions and prevent misunderstandings.²³ However, any such expert directors would continue to have the general duties of all directors. The PBCS does not have any requirement for a director with any specific obligations regarding the corporation’s public benefit. In contrast, the MBCL does require, under certain circumstances, that a board include a “benefit director,” with specified duties.²⁴