CHAPTER NINE

Constituency Statutes

A VIABLE ALTERNATIVE FOR STAKEHOLDER GOVERNANCE?

Prior to the advent of benefit corporation legislation across the United States, many legislatures responded to the rise of shareholder primacy by adopting “constituency statutes.” These laws permit a board of directors to consider the interests of non-shareholders (“constituencies”) in making certain decisions.

This chapter examines the content of those statutes, as well as the treatment of the statutes in litigation and in the academic literature. The terms of the statutes should provide a useful contrast to the operative provisions of benefit corporation statutes, and the treatment by courts of constituency statutes may provide guidance as to how courts will interpret benefit corporation laws.

Adoption of Constituency Statutes

States began adopting constituency just over thirty years ago, and thirty-three states have now adopted a constituency statute (although Delaware has not).¹ These statutes have not caused the expected increase in litigation, significantly deterred institutional investment, or affected stock values.² Constituency statutes represent attempts by legislatures to change the common law rule of shareholder primacy. Specifically, a constituency statute permits a board of directors to consider non-shareholder interests when making decisions, rather than focusing solely on the interests of shareholders.³ Through this grant of authority, boards are given significant discretion to consider the interests of stakeholders, regardless of the relation of those interests to stockholder value.⁴

Some jurisdictions also used their constituency statute to explicitly reject enhanced scrutiny in change-in-control transactions. As a historical matter, adoption of constituency statutes was initiated in the 1980s as a tool for directors to use in fighting hostile takeovers.⁵ Many were concerned that the real purpose of constituency provisions was to protect incumbent management rather than stakeholders. This concern was fueled by the fact that the provisions were generally permissive; that is, that there was no requirement to consider the interests of stakeholders.⁶

Each state’s constituency statute permits directors to consider one or more of the following non-stockholder interests:

1. employees, customers, creditors, suppliers, and communities in which the corporation has facilities;

2. national and state economies and other community and societal considerations;

3. the long-term and short-term interests of the corporation and its stockholders;

4. the desirability of remaining independent, and the resources, intent, conduct (past, stated, and potential) of a person seeking to acquire control of the corporation; and

5. the corporation’s officers.⁷

The statutes often are silent as to how a director may weigh these various considerations. Some states, such as Indiana and Pennsylvania, explicitly state that no one interest may prevail in the directors’ considerations.⁸

Operation of Constituency Statutes

CONSTITUENCY STATUTES PERMIT, BUT DO NOT REQUIRE, CONSIDERATION OF STAKEHOLDER INTERESTS

Presently, all jurisdictions with constituency statutes permit, but do not require, directors to consider non-shareholder interests. This is a critical distinction from benefit corporation statutes, which obligate boards to consider the interests of stakeholders in their decisions. Connecticut originally had a mandatory statute, which required director consideration of non-shareholder interests, but the statute was amended in 2010 to make it permissive.⁹

Thus, corporations seeking a governance model that is conducive to social responsibility should recognize that incorporation in a jurisdiction with a constituency statute does not, in fact, create any responsibility or accountability to stakeholders—it only decreases responsibility to shareholders.¹⁰ For example, the Indiana code provides: “A director may, in considering the best interests of a corporation, consider the effects of any action on shareholders, employees, suppliers, and customers of the corporation, and communities in which offices or other facilities of the corporation are located, and any other factors the director considers pertinent” [emphasis added].¹¹

In contrast, when Connecticut first adopted its constituency provision in 1988, it required directors of corporations with registered securities to consider other constituencies in making decisions.¹² As enacted, the statute “impose[d] a strict obligation on directors,” mandating consideration of non-shareholder interests.¹³ In 2010, Connecticut amended its code, making it a permissive grant of authority that allows, but does not require, directors to consider other interests.¹⁴

Idaho has a hybrid form, mandating consideration of shareholder interests while permitting consideration of other constituencies.¹⁵ The Idaho code provides:

In discharging the duties of the position of director of an issuing public corporation, a director, in considering the best interests of the corporation, shall consider the long-term as well as the short-term interests of the corporation and its shareholders, including the possibility that these interests may be best served by the continued independence of the corporation. In addition, a director may consider the interests of Idaho employees, suppliers, customers and communities in discharging his duties [emphases added].¹⁶

The permissive nature of constituency statutes seems counter to the claim that shareholder primacy does not exist in corporate law—one of the arguments made against benefit corporation statutes (as outlined in chapter 4). It is not clear why thirty-three states would have thought it necessary to adopt a law that eliminated shareholder primacy if it did not exist in the first place. Indeed, Chief Justice Strine cites Delaware’s failure to adopt such a provision in his academic work explaining why Delaware must be viewed as a shareholder primacy jurisdiction.¹⁷

More importantly, however, even if constituency statutes only confirmed what the law already was in one or more jurisdictions, that law is completely permissive as to stakeholder interests. The current law under all constituency statutes creates no obligations or accountability with respect to those interests.

UNIFORM, OPT-IN, AND OPT-OUT CONSTITUENCY PROVISIONS

Constituency statutes are typically uniform in application, reaching all corporations incorporated within a given jurisdiction. However, one state, Pennsylvania, allows a company to opt out of its constituency statute. In addition, a few states have opt-in statutes that permit a corporation to include a constituency provision in its articles of incorporation if it so chooses.¹⁸ For example, Georgia’s constituency statute permits a Georgia corporation to include a provision in its articles of incorporation that allows its board of directors to consider constituencies other than stockholders when making decisions.¹⁹

Reaction to Constituency Statutes

Although thirty-three U.S. jurisdictions adopted the constituency model, the reaction to the concept was not positive among a large segment of the legal community. Delaware, the primary jurisdiction for incorporation in the United States, did not adopt a constituency statute. Nor was such a provision included in the influential Model Business Corporation Act (MBCA). In addition, many commentators questioned the motivation behind the provisions. As we will discuss, benefit corporation law may address the concerns that led to a lack of acceptance of the constituency model.

THE AMERICAN BAR ASSOCIATION AND DELAWARE REJECT CONSTITUENCY PROVISIONS

In 1990, the ABA’s Committee on Corporate Laws considered amending the MBCA to include a constituency provision.²⁰ The committee ultimately rejected such an amendment:

In conclusion, the Committee believes that other constituencies statutes are not an appropriate way to regulate corporate relationships or to respond to unwanted takeovers and that an expansive interpretation of the other constituencies statutes cast in the permissive mode is both unnecessary and unwise. Those statutes that merely empower directors to consider the interests of other constituencies [in the course of managing the corporation in the shareholders’ interests] are best taken as a legislative affirmation of what courts would be expected to hold, in the absence of a statute. Interpreting the statutes to have the same force as the express Indiana provision [which clarified that stakeholder interests could be primary] would accomplish a change in traditional corporate law so radical that it should be undertaken only after there has been extensive and broad-based deliberation on the effects of reshuffling of fundamental relationships among shareholders and other persons who may be affected by the affairs of an incorporated business.²¹

The committee cited with approval Delaware’s case law that allows consideration of other interests when those interests are reasonably related to the long-term interests of shareholders, unless the decision concerns the sale of the company.²² Overall, the committee believed that constituency statutes “may have ramifications that go far beyond a simple enumeration of the other interests directors may recognize in discharging their duties.”²³

Similarly, Delaware did not adopt constituency provisions. Although there is no legislative history explaining the absence of a change, it is likely that the members of the Delaware State Bar Association responsible for drafting changes to the Delaware General Corporation Law had the same concerns as the drafters of the Model Business Corporation Act. Moreover, at the height of the hostile takeover era that engendered constituency statute adoption, the law in Delaware was evolving rapidly, and, in the view of many, was evolving toward a stakeholder model, alleviating any need for a statutory change.²⁴ Equally important, because of the large number of public companies incorporated in Delaware, the effect of a mandatory change in director responsibility would be enormous and sudden. In that environment, it is likely that the Delaware bar felt that changing the statute would do more harm than good.

CRITICISMS OF CONSTITUENCY STATUTES

Early on, constituency statutes were criticized for conflicting with the shareholder primacy norm. As we discussed in chapter 2, the shareholder primacy model views shareholders as the owners of the corporation, which is to be managed solely in their interests.²⁵ Anticonstituency scholars argued that constituency statutes would destroy shareholder value: “Opponents’ greatest fear is that constituency statutes will upset the shareholder primacy norm by changing the fiduciary duties that directors owe to shareholders. Specifically, they fear that constituency statutes allow constituency interests to compete with shareholder interests in corporate decision-making, thereby jeopardizing corporate profitability and shareholder value.”²⁶

The Committee on Corporate Laws based much of its criticism of constituency statutes on their apparent conflict with the shareholder primacy model. The committee found that consideration of non-shareholder interests without relation to shareholder interests “would conflict with the directors’ responsibility to shareholders and could undermine the effectiveness of the system that has made the corporation an efficient device for the creation of jobs and wealth,” and that allowing directors to engage in this balancing of interests would likely yield poorer decisions. The committee emphasized that “courts have consistently avowed the legal primacy of shareholder interests when management and directors make decisions.”²⁷

Another, related concern about constituency statutes was the lack of accountability and the potential for director abuse at the expense of shareholders.²⁸ Because the statutes are generally permissive, directors have complete discretion as to whether to use the expanded considerations in making decisions. Directors can easily justify any decision, depending on how they weigh the considerations, thus harming a plaintiff’s ability to meaningfully challenge board action. One law professor posed the following hypothetical:

What if management simply uses the constituency provision to negotiate a better deal for itself without regard to the constituency at issue. For example, if a rust belt company is approached with an offer to go private at $21, it could well respond, “I’m sorry, but at $21, this deal is not good for our employees, the local community or the environment.” Imagine the surprise of constituencies when, at $25, the board changes its mind, and takes the offer. In the end, the only constituency with standing is the shareholder community. Consequently, one shouldn’t be surprised if/when directors use these statutes as little more than bargaining levers at the expense of the communities they were meant to protect.²⁹

Commentators were concerned that, because the courts will largely defer to the directors’ determination whether to consider permitted constituency interests, there would be little accountability. Others have echoed concerns that these statutes serve to protect directors at the expense of shareholders and other constituencies.³⁰

In addition, and perhaps most importantly, there is the retrospective criticism that constituency statutes simply are ineffective with respect to their primary purpose of countering shareholder primacy:

Constituency statutes, however, do not seem to have been very effective in combating the shareholder wealth maximization norm. Perhaps this lack of effectiveness stems from the fact that the typical constituency statute is permissive and does not give non-shareholder stakeholders standing to sue. While constituency statutes undoubtedly provide some protections for directors seeking to further the social or environmental mission of the corporation, the constituency statutes do not seem to motivate the average director to move beyond the shareholder wealth maximization norm.³¹

BENEFIT CORPORATION LAWS ARE A BETTER ANSWER TO STOCKHOLDER PRIMACY THAN CONSTITUENCY STATUTES

Those states that have adopted uniform constituency provisions have made a public policy decision to reject the shareholder primacy model for all corporations. In light of the modern view that corporate statutes should be “enabling” rather than prescriptive, this may be viewed as an unusual choice. However, the choice may be consistent with the policy considerations that drive the stakeholder model discussed in chapter 2. In this view, the privileges of corporate personality, perpetual existence, and limited liability should not be granted to an entity that will only act selfishly for the benefit of its shareholders and ignore its effect on other stakeholders. However, if this is in fact the justification for the uniform application of many constituency provisions, it seems inconsistent with the permissive nature of the provisions, since the statutes do not create any obligation or accountability for broad stakeholder interests. Public policy making truly guided by the stakeholder model should create corporate governance rules that include accountability for stakeholder interests, like Connecticut’s original constituency statute, or like benefit corporation provisions.

The benefit corporation governance model addresses the concern that constituency statutes lack accountability; under the benefit corporation model, directors must balance the interests of all stakeholders and must be transparent about such balancing. However, even if a provision is mandatory, there may be significant policy objections were its operation uniform, because a uniform statute would mandate a change from shareholder primacy to the benefit corporation model for all corporations.

A mandatory provision, in contrast to an enabling provision, may simply be too much, too quickly, for the markets, particularly in a jurisdiction such as Delaware, where thousands of publicly traded companies are incorporated. Given the competition for corporate charters among states, such a mandatory change in the U.S. corporate system seems like an unlikely first step toward stakeholder governance.³² It should be noted that this circumstance differs from the usual idea that states are “too friendly” to management in an effort to attract charters. In this case, the initial objections would come from shareholders as well as management, because they might perceive the change as taking away their supremacy. The move from shareholder primacy to stakeholder governance is likely to succeed broadly only with considerable investor support, and a broad imposition of change is unlikely to engender such support. An enabling provision, like Georgia’s constituency provision or Delaware’s benefit corporation statute, allows companies to test the stakeholder model waters without mandating wholesale change in the public equity markets.

Constituency Statute Litigation

A study by Christopher Geczy and colleagues identified forty-seven relevant cases in the thirty-year period from 1983 through 2013.³³ Examination of that case law should provide guidance for corporations opting into benefit corporation status because, although the statutory schemes have differences, they both reject the doctrine of stockholder primacy. The case law addresses constituency statutes from thirteen jurisdictions, and most cases occurred during the last fifteen years. The study categorized cases into one of five categories (Positive, Neutral/Positive, Neutral, Neutral/Negative, Negative) based on the court’s treatment of the constituency statute. Forty of the cases involved claims for breach of fiduciary duty.³⁴

Enforcement was positive overall: twenty-nine of forty-seven cases fell into the Positive and Neutral/Positive categories. Seventeen of these cases recognized expanded director discretion, and twelve recognized that there was no enforceable right for non-stockholders.³⁵ In Positive cases, the statute was a determining factor in the decision and the court recognized the legitimacy of stakeholder consideration, or declined to create enforcement rights in stakeholder constituents. In Neutral/Positive cases, there was a substantive discussion that recognized the expanded scope of director decision making or the limits on stakeholder rights, but such factors were not essential to the holding. In Neutral cases, the court cited or referenced constituency statutes but did not include substantive discussions. Only four out of the forty-seven cases were coded Neutral/Negative and no cases fell under the Negative category. In Neutral/Negative cases, the court addressed constituency statutes but did not recognize expanded director authority or decline to apply Revlon, or declined to permit expanded discretion in situations affecting franchise rights. Negative cases (of which there were none) would have declined to apply expanded director authority where the reasoning would have been a factor in the holding.³⁶ These results suggest that benefit corporation statutes will be enforced, and will provide directors with additional discretion, without creating rights in non-shareholders.

EXPANDED INTERESTS FOR DIRECTORS TO CONSIDER

Much of the case law recognized the expanded interests that directors could consider under constituency statutes. Frequently, constituency statutes were successfully invoked by directors seeking to uphold their decisions. Courts rarely found that directors went too far in considering other constituencies, only finding an abuse of discretion when a decision conflicted with voting rights. Constituency provisions have not been successfully used offensively by plaintiffs claiming that directors failed to consider non-stockholder constituents. However, the constituency statutes have not prevented shareholders from bringing claims that directors either completely ignored shareholders’ interests or acted in a manner that would not advance the interests of any stakeholders. These cases should provide guidance in litigation involving benefit corporations, and three of them are discussed briefly here.

Kloha v. Duda is an example of directors successfully using a constituency statute to uphold a decision.³⁷ In Kloha, the plaintiff alleged that the defendant directors breached their fiduciary duties by, among other things, considering family employment concerns in their decision making. The court determined that the board could consider the impact of its decisions on employees, including family members.³⁸

Similarly, in Safety-Kleen Corp. v. Laidlaw Envtl. Servs. Inc., the court declined to grant a preliminary injunction, finding that the Safety-Kleen board did not breach its fiduciary duties in recommending one proposal to stockholders and keeping defensive measures in place, where the directors’ decision involved the consideration of non-shareholder interests that the Wisconsin statute expressly endorsed. However, the Safety-Kleen court also suggested some limits on director discretion in considering other constituencies, noting that the board might be prevented from ignoring a clearly superior proposal solely due to the interests of other constituencies.³⁹

Moreover, plaintiffs may still allege breaches of duty that do not involve questions of allocating value among different stakeholders and simply reflect breaches to the combined class of constituencies. In Shepard v. Humke, the court found the plaintiff’s fiduciary duty claim sufficient to survive the defendants’ motion to dismiss. The court explained that allegations of involving misrepresentations and a breakup fee could involve a claim that the directors failed to act in the best interests of all of the corporation’s constituencies.⁴⁰

APPLICATION TO VOTING RIGHTS

Although courts have acknowledged the expanded discretion afforded to directors by constituency statutes, that discretion is not without limits, particularly where voting rights are concerned. Those cases may provide important guidance for benefit corporations, because it is likely that the same concern for the corporate franchise will be applicable.

In Warehime v. Warehime, the defendant directors cited the Pennsylvania constituency statute, justifying their actions based on permissive consideration of constituents other than stakeholders. While the court acknowledged the broad discretion granted by the business judgment rule, and the ability of directors to consider non-stockholder constituencies, it concluded that those provisions could not validate actions intended to interfere with voting rights.⁴¹ However, in one case, a Georgia court refused to apply the Blasius test because a constituency statute was in effect.⁴²

IMPACT ON ENHANCED SCRUTINY

The Barzuza study examined the question of whether other constituency statutes affect the judicial standard of review. In some states, the constituency statute explicitly rejects the enhanced scrutiny standards of Revlon and Unocal, and the cases follow the legislative mandate. In other jurisdictions, however, the statute does not explicitly address the standard of review. In some of those states, courts have nevertheless interpreted constituency statutes to mandate business judgment rule treatment of cases that might otherwise be subject to enhanced scrutiny. In other states, the courts continued to apply enhanced scrutiny.⁴³ These cases raise issues that will also be raised when benefit corporations are in situations that involve enhanced scrutiny for traditional corporations.

Although some jurisdictions have interpreted constituency statutes as eliminating enhanced scrutiny in defensive and sale situations, even where the statues did not expressly do so, it seems unlikely that the benefit corporation statutes would be interpreted in that fashion. Although there is a key similarity between benefit corporation legislation and constituency statutes (i.e., the rejection of shareholder primacy), the statutes are largely driven by different motivations. In many cases, constituency statutes were a response to the courts’ use of the Revlon and Unocal standards to limit board discretion, which raised a concern that the important policies behind the business judgment rule were being ignored. It is thus understandable that courts would read a rejection of those doctrines into constituency statutes. In contrast, benefit corporation law is not driven by a concern that directors have too little discretion—rather it is driven by the concern that the space in which they are allowed to exercise that discretion is circumscribed incorrectly, from a policy perspective. Accordingly, there is little reason to believe that courts will not continue to apply enhanced scrutiny to benefit corporations in situations involving defensive tactics and company sales, as predicted in chapter 8.

STANDING FOR NON-STOCKHOLDERS

The Geczy study found that none of the constituency statute cases recognized an enforceable right for non-stockholders, with twelve explicitly declining to do so.⁴⁴ Because constituency statutes are permissive in nature, no fiduciary duty runs to non-stockholders.⁴⁵ For example, in Official Comm. of Unsecured Creditors of PHD, Inc. v. Bank One, the court relied on the permissive nature of the constituency statute to deny fiduciary duties to creditors.⁴⁶ Similarly, the court in In re I.E. Liquidation, Inc. dismissed breach of fiduciary duty claims based on the directors’ failure to consider creditors’ interests.⁴⁷ Thus, the courts have consistently interpreted the permissive language of constituency statutes as creating neither an affirmative duty to consider non-stockholders’ interests nor an attendant right of action for failure to do so.

Although benefit corporation legislation, including the Delaware statute, is mandatory, the statutes expressly provide that no right of action is created other than the right of stockholders to bring a derivative suit.⁴⁸ Similarly, the MBCL provides no right of action for non-stockholders.⁴⁹ Thus, benefit corporation legislation provides greater clarity than many constituency statutes, where a lack of enforcement right for third parties is only implied by the permissive nature of the statutes.⁵⁰

CONCLUSIONS

Overall, the Geczy study found that constituency statutes truly expanded the authority of directors, as opposed to simply codifying earlier common law.⁵¹ In some jurisdictions, the language permitting directors to consider other constituencies was found to reinstate the business judgment rule where enhanced scrutiny might otherwise apply.⁵² However, with the exception of one case, no courts found that such language altered the standard of review applicable to decisions affecting the stockholder franchise. The case law also shows constituency statutes did not create a concurrent expansion of non-stockholder constituent rights.⁵³ Each of these outcomes is likely to resonate in the interpretation of benefit corporation statutes.

Economic Impact of Constituency Statutes

A 1993 event study determined that the adoption of constituency statutes did not have a statistically significant impact on stock prices.⁵⁴ Nearly twenty years later, the Geczy study was conducted to determine the impact of constituency statutes on investment by high-fiduciary-duty institutions, defined as pension funds and endowments, which share similar, strict fiduciary duties with respect to investing.⁵⁵ Ultimately, the study found no significant adverse impact on investment by high-fiduciary-duty institutions when corporations in which they are invested become subject to constituency legislation:

The empirical findings show that constituency statutes were not a roadblock to institutional investment with especially high fiduciary duties. We cannot rule out that constituency statutes had some effect on HFDI [high-fiduciary-duty institution] investment, but we can rule out that these investors significantly altered investment behavior after the passage of the statutes, as one might expect if these institutions perceived material conflicts with their fiduciary duties. We consider these findings promising for new legislations such as the benefit corporation laws, insofar as constituency laws expanded management prerogatives to consider nonshareholder interests.⁵⁶

At least two other papers have found that the adoption of constituency statutes is linked to increased innovation.⁵⁷ Although the research is limited, it does suggest that eliminating shareholder primacy did not adversely impact corporations or their stockholders. Stock prices were not affected, and investor fiduciaries did not flee based on a perception that investments in companies without shareholder primacy regimes violated their own fiduciary duties. Although the benefit corporation regime provides greater accountability and transparency than does the constituency statute regime, there is no reason to believe that the results for benefit corporations and their stockholders will be radically different.

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The present chapter shows that, although there are important lessons from the experience of a quarter century of constituency statutes, these statutes are not a good alternative for imposing stakeholder governance principles. Chapter 10 will examine whether conventional corporations can modify their own charters in order to take on stakeholder governance without using benefit corporation provisions.