Are the managers of traditional corporations “really” required to maximize profits to shareholders? A review of eBay v. Craiglist et al, in the argument supporting “hybrid” social enterprises.

Over at her blog Razesquire, Karen Raz asked an interesting question summarized as follows: where in the law does it say that traditional corporations must pursue a duty to maximize profits at the expense of social and environmental considerations?

Although proponents of hybrid entities (benefit corporations, social purpose corporations, etc.) will tell you that management for a traditional for-profit corporation is required to simply maximize profits, management’s actual fiduciary duties are more nuanced.  Directors and officers are under a duty to act “in the best interests of the company.”  What is truly in a company’s “best interests” is highly debatable.  It’s easy to second guess a decision made by a director or officer with the benefit of hindsight; a bungled decision always looks worse after it doesn’t pan out than at the time the decision is made.  Because we want our businesses to take risks and innovate, management is protected from Monday morning quarterbacking by what’s known as the “business judgment rule.”  Under the business judgment rule, courts defer to the business judgment of management and will not second guess whether an action is in the “best interests of the company” absent unusual circumstances (like fraud).  An action has to be wholly irrational before a court will hold that the decision was not in the best interests of the company.

So practically speaking—and for actions in the ordinary course of business—the business judgment rule permits corporate managers to consider social and environmental goals at the expense of the bottom line so long as there is a rational argument that the action is in best interests of the company (and might promote long-term company value).  Presently, it’s very good PR to demonstrate corporate social responsibility and citizenship (and devastating PR if you don’t institute measures to better your community). So a company can rationalize spending $100k to facilitate a contaminated park clean-up in its community instead of reinvesting that same $100k in new equipment because the company’s consumers will better respect (and buy from) such a company.

But the business judgment rule is not always the judicial standard for review of management action.

In addition to acting in the best interests of the company, managers are also fiduciaries to the company’s shareholders.  Shareholders are investors; the (presumed) reason why they invest and become a shareholder is to see a return on their investment.  Therefore, to accommodate shareholders rights, when a company is being sold, taken-over, or otherwise in danger of losing its control, management cannot rely on the business judgment rule to shield their decision making.  Instead, a heightened standard of review applies (typically referred to as the “Unocal” or “Revlon” standard after the case law which bears those names).  The intermediate Unocal standard of review puts the burden on the directors to prove that their actions were reasonable—they must: “(1) identify the proper corporate objectives served by their actions; and (2) justify their actions as reasonable in relationship to those objectives.”[1] By applying the Unocal standard to a unique set of facts, the Delaware Chancery Court in eBay v. Craiglist et al, rescinded a decision by the craigslist board of directors (and majority shareholders) to institute a rights plan to dilute the minority shareholder, Ebay.  Why did the craigslist board institute this plan in the first place? Because it wanted to preserve the “company’s culture.”

Craigslist meets most definitions of a “social enterprise.” The company is unabashedly against trying to monetize its website (as the world’s leading classifieds website, btw).  Instead, the company prefers a simple format that is user friendly, permits users to post (mostly) whatever they choose, and is free from adspace or other “clutter” to the user interface.  Craigslist promotes its ideals over profit.  And when the majority stockholders and board members, Craig Newmark and James Buckmaster, felt like eBay was going to take over the company and alter these ideals, they ensured that eBay wouldn’t have a chance. Craig, Jim and eBay are craigslist’s only three shareholders.

Without going into the details, the Delaware Court decided that a for-profit company cannot openly eschew shareholder value to preserve a “company’s culture.” This quote about sums it up:

“The corporate form in which craigslist operates, however, is not an appropriate vehicle for purely philanthropic ends, at least not when there are other stockholders interested in realizing a return on their investment . . . I find, instead, that Jim and Craig acted to punish eBay for competing with craigslist. 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.”[2]

Delaware corporate law is not the law in every jurisdiction, but it is highly persuasive.[3]  It’s unclear where the business judgment rule’s outer boundaries are located, and now eBay v. Craiglist has shed some light on where this might be.  One thing is for certain, there are limits to the business judgment rule and the ability for management to consider social and environmentally friendly policies at the expense of shareholder value in the traditional for-profit corporate structure.

So while “maximizing shareholder wealth” isn’t necessarily the only consideration permitted management of traditional for-profit entities, we know that hybrid corporate structures are necessary for the social entrepreneur who wants to ensure that she has no exposure to liability when she makes a decision that prefers a social goal and eschews profit.

 

The article provided above is for general information purposes only and should not be relied on as specific legal advice. This article does not form an attorney-client relationship. If you have any questions about this article, please feel free to contact Peter J. Smith at peter@apexlg.com



[1] Taken from the craigslist case at page 49: http://www.delawarelitigation.com/uploads/file/int51(1).pdf

[2] At pages 59-61.

[3] For Washington State, see e.g. Sound Infiniti, Inc. v. Snyder, 169 Wn.2d 199, 237 P.3d 241 (2010) (relying on Delaware precedent to resolve the legal standard for a derivative suit).

Share