Corporations “101”

[*]

by Jena Martin, Professor
West Virginia University, College of Law
Jena.Martin@mail.wvu.edu
Overview

Understanding corporate law and structure is a fundamental concept for students studying business and human rights. Too often, human rights advocates and business executives clash, not necessarily over ideology, but rather over language. Traditional business and law students steeped in corporate law teachings often find it difficult to relate those concepts to the less familiar tenets of international human rights law. Similarly, students who enter the field of business and human rights as human rights advocates may initially struggle with concepts embedded in business and human rights, such as human rights due diligence and the business case for human rights. This teaching note is an attempt to bridge these gaps – discussing the predominant (and often most problematic) business entity in the United States – corporations – in a way that students in all disciplines can understand and contextualize within the larger business and human rights field.

This note is designed to help teachers provide students with a basic understanding of corporations under U.S. law and discuss how their separate legal personality and purpose relates to corporate human rights impacts. Most of this note addresses corporate law basics – corporate structure, corporate purpose, and regulatory frameworks. (Comparative corporate structures worldwide and their regulation in other national jurisdictions is beyond the scope of this note.) The Teaching Approaches section includes further discussion for instructors who would like to discuss specific examples of corporate structure and how those factors can influence business and human rights issues.

Structure of the Corporation

Corporations come in a wide variety of shapes and sizes, from a small, one person closely held corporation to a large multi-million dollar transnational corporation, however, the unifying feature of all of these structures is that they have a separate legal personality from their owners and investors. To that end, teachers may find it helpful to analogize corporations to structures, providing students with a visual reference of the various stakeholders in a corporation and the role that each plays. It is also important to emphasize that, in a corporation, one person may have multiple roles (or hats) that they take on: knowing which hat that person is wearing when they undertake certain actions could have a significant impact on which legal rule is used to analyze any potential liability under state or federal law

When corporations sell their securities in the open market (a process known alternatively as “going public” or “launching an initial public offering (IPO)”), they are subject to an additional regulatory framework in the United States – federal securities laws (primarily the Securities Act of 1933 and the Securities Exchange Act of 1934). Students should understand that U.S. securities laws regulate corporations primarily by means of disclosure. Specifically, these laws require corporations to report on information which courts have found to be “material” to a reasonable investor.[1]

As reporting companies, publicly traded corporations face additional pressure that often leads them to focus on short term profits and gains rather than long term value for the corporation. Many social issues have arisen when the value horizon of a corporation is shortened in this way.

Structure of a Coproration

  • The Corporation

While the corporate structure is in essence, a legal fiction,[2] corporations have been given certain rights under U.S. law. For instance, a corporation can sue and be sued in its own name (in contrast with a partnership where it would be the individual partners that would be sued). A corporation can also own property, hold accounts in the corporation’s name and generally undertake many of the same actions that a human individual may under the law. One important issue to highlight for students is that although it’s a separate legal entity, the corporation still needs human intermediaries to effectuate its decisions. There are many potential landmines that can arise in those instances. (See Purpose of the Corporation below).

One of the most significant benefits of the corporate structure is that it provides limited liability for its investors. Specifically, investor losses are typically limited to the amount of their initial investment. This is in stark contrast to other organizational structures, such as sole proprietorships or partnerships, in which initial investors are potentially personally liable for all losses arising from the underlying structure. [3]

  • Shareholders

Shareholders are the owners of the corporation. Specifically, they are legal persons (either individuals or, increasingly, other corporate and organizational structures) that invest in the corporation with the expectation of a profit (or a return on their investment (ROI )). A key characteristic of shareholders, particularly shareholders of publicly traded corporations, is the “separation of ownership and control.”[4] One way to illustrate the idea with students is through the use of a basic, colorful comparison between a shareholder of a corporation and an owner of a house:

As the owner of the house, if one wanted to paint the structure pink with purple polka dots, assuming there were no laws (or homeowner association rules) that prohibit it, one could do so. However, if an Apple shareholder made the decision to paint Apple’s headquarters pink with purple polka dots, they would likely be arrested (this is true even if the shareholder only painted the representational value of their interest i.e., if a 10% shareholder only painted 10% of the company).

A shareholder’s interest in a corporation generally entitles them to: 1) Any dividends that a corporation may allocate; 2) The right to vote on particularly important matters (usually the composition of the board of directors,[5] the decision to merge with another company or whether to change the corporate bylaws or articles of incorporation); and 3) Have an ownership interest in the corporation (i.e., the right to receive the percentage of profits based on their shareholder interest if the company dissolves).

  • Managers

Managers are the personnel responsible for the day-to-day operations of the corporation. They also manage the corporation and its policies. The highest serving managers are also corporate officers. These officers have fiduciary duties rested upon them by the nature of their position. Frequently, individuals who serve as officers of a corporation are also on its board of directors, however, they are not required to be. Under most state law, certain fiduciary duties govern the relationships of officers to corporations and its shareholders. (See The Regulatory Framework). Officers include: the Chief Executive Officer (the CEO); the Chief Financial Officer (the CFO); the Chief Operating Officer (the COO);  the corporation’s General Counsel (the GC); and the Corporate Secretary.

  • The Board of Directors

The board largely functions as a single unit, approving all major decisions of the corporate officers. In addition, the directors serve in a monitoring role, monitoring all of the activities of a corporation for its shareholders. The directors are also bound by specific duties under state law. (See The Regulatory Framework).

  • Other Stakeholders

It is also valuable to share with students other stakeholder groups that can affect the corporation’s structure and its governance framework. Corporate stakeholders may include: employees, suppliers, customers, and the communities where the corporation operates. While none of these stakeholders typically have formal representation within corporate law jurisprudence (i.e., corporate officers and directors are generally not required to put the interests of these stakeholders above the needs of shareholder profitability), these groups can secure influence and leverage with the corporation either through formal contracts (such as collective bargaining agreements for unionized employees) or through softer, reputational influences (such as advocacy campaigns in communities where corporate policies impact social issues, like human rights).

Purpose of the Corporation

The number of corporations in the United States has grown exponentially in the last century. While originally designed as a way of pooling resources (and acting within a very limited corporate charter given by the state), the corporation has now become the primary organizational structure for business enterprises, frequently crossing state and national borders.

The seminal state legal case of Dodge v. Ford[6] forms the basis for the enduring narrative of the purpose of the corporation in the United States. Namely, the corporation is viewed as a vehicle “organized and carried on primarily for the profit of the stockholders.”[7] This driving narrative underlies many of the cases that have been discussed over the years and also forms the basis of many of the key legal principles in corporate jurisprudence.   One of the most important principles that arises from this narrative is the Business Judgment Rule (BJR). The rule “protects directors from personal liability in certain situations”[8] where they are acting on behalf of the corporation.

The “shareholder profit” narrative also results in an inherent tension in the structure and purpose of a corporation. If a corporation can only act through its corporate officers, and the corporate officers are largely shielded from liability for its decisions,[9] there is a danger that corporate officers will make decisions largely for their own self-interest rather than for the best interest of the corporation’s shareholders. To address this concern, state law has created specific fiduciary standards to which corporate officers must adhere in order to receive protection under the law. In short, the Business Judgment Rule and the various fiduciary duties have evolved as a way of addressing the competing tensions between making corporate officers feel comfortable in taking risks that might benefit the corporation while at the same time providing protections for shareholders.[10]

The Regulatory Framework

Corporations are regulated simultaneously under two separate legal frameworks in the United States. First, there is the state law framework that dictates the rules for the organization’s corporate governance structure. Second, there is the federal framework that governs many of the issues relating to the corporation’s sale of securities and, as such, its reporting and representation obligations to the larger investing public. There is some overlap[11] in the two structures but, by and large, these frameworks are complementary in nature.

State Law

State law dictates corporate governance rules (i.e., the internal rules of a corporation). A corporation’s state of incorporation determines which law is applied. If a corporation is incorporated in the state of Delaware, for instance, that is the law that will be applied (particularly for internal corporate governance matters).[12] A majority of publicly traded U.S. corporations, in fact, are incorporated in the state of Delaware, regardless of where the companies are headquartered. (Many commentators argue that Delaware, has a very corporate friendly bench.[13]) Delaware also has a significant amount of corporate law precedent and expertise. As a result, many other jurisdictions rely on Delaware law for certain foundational principles. Law students who are studying corporate law should familiarize themselves with Delaware law on the subject. All of the state law principles discussed below will cite to Delaware case law and statutes.[14]

  • The Business Judgment Rule

Case law in Delaware and other states provides for the Business Judgment Rule (“BJR”). The BJR provides freedom for corporate officers and directors to act on behalf of the corporation and allows them to take risks. Many have argued that the BJR also offers a way for the people who presumably have the greatest level of expertise (namely corporate officers and directors) to make a decision without shareholders and courts second guessing these decisions with the benefit of hindsight.

  • Fiduciary Duties

Corporate officers and directors owe two primary fiduciary duties to a corporation (and by extension to its shareholders): the duty of loyalty and the duty of care. If a corporate director is found to have violated either one of these duties then he or she may[15] be personally liable for litigation arising out of the corporate action. Alleged breaches of either duty must be based on the process of how the officers and directors reached a decision (instead of the substance of the decision itself). This requirement prevents shareholders and courts from critiquing a decision with the benefit of hindsight. Students should know that any analysis of a breach of fiduciary duties is intertwined with an analysis of the Business Judgment Rule.

Duty of Care

The duty of care goes hand in hand with the BJR. The duty of care provides that, as long as the corporate officers and directors acted with adequate care in the process of formulating a decision, they will be protected (i.e., will not face personal liability) even if the decision turns out to be a bad one. A duty of care also applies to the board’s procedures in making a decision (not the decision itself).[16] If those procedures are informed, then the Business Judgment Rule applies and there can be no violation of this duty. The court will not examine the merits of the decision. The standard varies from jurisdiction to jurisdiction, but courts typically apply a standard of gross negligence or recklessness to find officers or directors liable for a breach of the duty of care.[17]

Duty of Loyalty

The duty of loyalty provides that the decisions of corpororate directors must be made without self-dealing. Specifically, any transactions made with a board member who also has an interest in the underlying transaction may be subjected to a cause of action for a breach of the duty of loyalty. Other causes of action can arise for a duty of loyalty claim if it is found that the directors acted fraudulently or in bad faith.[18] Defendants can overcome this allegation if they can prove that: (1) the transaction was approved by a majority of disinterested board members; (2) the transaction was ratified by disinterested shareholders of the board’s action or; (3) if the overall transaction was fair.

Shareholder Derivative Suits

State law allows shareholders to enforce fiduciary duties via a “shareholder derivative suit,” which can compel the corporation to sue the firm’s managers for fraud. Derivative lawsuits are the primary method for shareholders to enforce fiduciary duties. Any proceeds from a derivative action go to the corporation.

Federal Securities Law

Publicly traded corporations are subject to an additional regulatory framework – federal securities laws. By and large, these laws do not affect private corporations (although Rule 10b-5 of the Securities Exchange Act is a notable and powerful exception).[19]

The core aim of the U.S. securities law is to require corporations to disclose sufficient information so that investors can make informed choices regarding whether to buy, hold, or sell their investment in the corporation. As a result, any publicly traded corporation must provide periodic public disclosures on a wide range of activities, usually relating financial performance. Certain securities regulations require specific disclosures on non-financial issues, such as reporting on conflict minerals (see Mandatory Human Rights Reporting); and disclosing whether the organization has a code of ethics.[20] In addition, more traditional laws such as the Foreign Corrupt Practices Act[21] (which prohibits payments by corporations to foreign governments) and Rule 10b-5[22] of the Securities Exchange Act of 1934 (providing liability for fraudulent misstatement or omissions by a corporation or its executives) provide additional corporate accountability for the non-financial impacts of corporate activity.

Rule 10b-5 is a powerful weapon used by both the Securities and Exchange Commission and private litigants to establish corporate fraud. A successful action under 10b-5 must prove the following key elements: (1) a misstatement or omission; (2) with scienter (recklessness or knowing intent); (3) that was material; (4) that the plaintiff relied upon; and (5) that caused losses for the plaintiff.[23]

Teaching Approaches

An introduction to corporations provides an opportunity for students to explore and deconstruct the current structure of the corporation and discuss how the corporation’s design (as a separate legal entity with limited personal liability for its investors) and its purpose (primarily as a for profit structure) relates to its corporate responsibilities and human rights impacts. Many business and human rights courses address basic corporate law early on in the syllabus, often in the context of defining “corporate responsibility.”

Instructors can use Milton Friedman’s classic article[24] to elucidate the tension that is inherent in the structure and design of the corporation. For a more recent counter example, instructors can have students watch Joel Balkan’s documentary, The Corporation.

Law students, many of whom come from a non-business background, often have a particularly hard time discussing the different roles that one person can have in a corporation. Discussing these roles as “hats” that one person can take on and off can been particularly effective in bringing to light the interchangeability of these roles. One exercise that instructors can use: provide law students with a factual scenario of corporate malfeasance and then discuss how standards of liability would change for someone depending on what “hat” within the corporate structure he or she was wearing at the time. Care should be taken to emphasize that a particular actor’s role must be analyzed in determining liability.

The distinction between public and private corporations also provides an opportunity to discuss the federal disclosure framework and discuss what investors typically consider to be material. Specifically, instructors can use Congressional enactment of Sections 1502 and 1504 of the Dodd-Frank Act (relating to Conflict Minerals and Resource Extraction)[25] and the SEC’s tortured path to promulgating rules around these issues[26] to illustrate how non-financial information about a corporation may influence a shareholder’s decision to maintain an ownership interest in that corporation.

Securities Exchange Act Rule 10b-5,[27] which applies to both publicly traded and privately held corporations, allows instructors the opportunity to discuss potential litigation strategies that can be used against a corporation that has been accused of hiding negative human rights impacts from their investors. One possible exercise: a factual scenario in which a corporation had made material misstatements regarding the use of forced labor in its supply chain. Instructors could push students on whether the allegations would be enough to survive a suit under 10b-5.[28]

Business students can discuss in more specific terms the role of corporate managers in influencing corporate structure, as well as discuss the concept of separation of ownership and control for shareholders and the advantages and disadvantages to that model. For instance, an advantage to divesting corporate decision making from the hands of shareholders is more efficient and, potentially, more well-informed decision making. One possible disadvantage arises from the concept of corporate managers “playing with other people’s money.” Business students could also engage in in-depth discussions comparing the corporate structure of closely held corporations and large publicly traded corporations, comparing the impact of those two structures on a corporation’s purpose. For instance, instructors could formulate a case study based on the example of the Body Shop to discuss how the merger of a small privately held corporation (with concentrated control) with a larger publicly traded corporation (with seemingly contradictory values) can affect the direction of a corporation and its owners. (See Teaching Resources)

The corporate design and structure of the corporation also allows instructors to discuss the rise of alternative designs for corporate organizations that combine a focus on profitability with an emphasis on social good. Benefit corporations (and B-Corps) are two examples of these alternative corporate structures.[29]

Policy students need to understand basic corporate law and structure in order to consider how alternative regulatory frameworks can ensure corporate respect for human rights.

Learning objectives for introducing U.S. corporate law basics in business and human rights courses may include:

  • Understanding the purpose of the corporate form, basic corporate structure, and how corporations are regulated in the United States.
  • Identifying the various stakeholders of the corporation.
  • Analyzing how a corporations’ separate legal personality may affect its human rights impacts.
  • Discussing how the concept of limited liability impacts corporate decision-making.
  • Comparing state and federal legal frameworks regulating corporations and their effect on corporate decision-making.
Key Questions

General

  • What is the purpose of a corporation?
  • What are the advantages /disadvantages of the corporate form?
  • Who are the various stakeholders of a corporation? How do their roles impact the corporate structure?
  • What is the significance of the “separation of ownership and control” that is at the heart of corporate structure?
  • What regulatory frameworks govern corporations in the United States?
  • What is the significance of the corporation as a separate legal entity?
  • How has the corporation’s purpose been influenced by the corporation as a for-profit organization?
  • How does corporate law affect or address the corporate responsibility to respect human rights?

For business students

  • What are the responsibilities of corporate managers to address other stakeholders’ concerns?
  • Do corporations have a role beyond generating profits for shareholders? Why or why not?
  • What role can the regulatory framework play addressing the human rights impacts attributed or linked to corporate operations? What role can various corporate stakeholders play?
  • Are there any structures, plans or mechanisms that corporate managers can create within the current for-profit framework to address larger stakeholder issues?

For law students

  • Is a company a person under the law?
  • Are corporations prohibited from pursuing social objectives?
  • What role do shareholders have in influencing corporate action? How can shareholders use their influence to address the human rights impacts of business?
  • What role do federal securities laws have in bringing about awareness of negative human rights impacts?
  • Are corporate human rights impacts “material” under U.S. securities law?
  • What possible causes of actions can be brought under state law for officers and directors who make decisions that result in adverse human rights impacts?
  • What obstacles does the business judgment rule present to these claims?
  • How would you advise a client who wanted to file suit against a corporation for negative human rights impacts that occurred within the corporation’s operations or business relationships?

For policy students

  • What policy rationales underlie the premise of the corporation as a separate legal entity?
  • What are the consequences of a corporation’s purpose as a for-profit entity on larger societal values?
  • How would you resolve the inherent tension in having corporate officers and directors run an entity on behalf of others (namely shareholders)?
  • What role do fiduciary duties play in resolving that tension?
  • Are there any other concepts of the corporation that could align the for-profit model with social objectives?
  • How can existing regulatory frameworks ensure corporate respect for human rights?
  • How does the concept of limited liability for corporate shareholders affect the decision making of its investors? Its managers?
Teaching Resources
Notes

[*] This Teaching Note may be cited as:

Jena Martin, “Teaching Note: Corporations ‘101’,” in Teaching Business and Human Rights Handbook (Teaching Business and Human Rights Forum, 2017),
https://teachbhr.org/resources/teaching-bhr-handbook/teaching-notes/corporations-101-2/(opens in a new tab).

[1] The United States Supreme Court defined the standard of materiality in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), stating that “an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote [on a proxy solicitation.” This standard has been expanded through securities jurisprudence and regulation so that materiality is discussed as information “to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.” 17 CFR §230.405.

[2] Some scholars, such as Stephen Bainbridge, have devised alternative theories for conceptualizing the corporation. For instance, Bainbridge discusses corporate structure, particularly board of directors, as a nexus of contracts around which costs and transactions are organized. Stephen Bainbridge, The Board of Directors as Nexus of Contracts: A Critique of Gulati, Klein & Zolt’s ‘Connected Contracts’ Model, UCLA, School of Law Research Paper No. 02-05 (January 2002), available at SSRN: https://ssrn.com/abstract=299743.

[3] This is another potential contrast between publicly traded and privately held corporations in that, in rare instances, investors in a closely held corporation can be held personally liable under a theory known as piercing the corporate veil. See David H. Barber, “Piercing the Corporate Veil,”  Williamette Law Review (Vol. 17, 1981), 371.

[4] This concept was originally introduced by Adolf A. Berle’s and Gardiner C. Means in The Modern Corporation and Private Property (1932) cited in Harold Demsetz, “The Structure of Ownership and the Theory of the Firm,” Journal of Law & Economics (Vol. 26, No. 2, 1983).

[5] Even this right has been largely diluted. See Teaching Resources for an example of a shareholder ballot that illustrates the point. [Which resource?]

[6] 170 N.W. 668 (Mich. 1919) (Shareholders sued directors for failing to declare a dividend, alleging breach of their fiduciary duty.)

[7] Id.

[8] Lori McMillan, “The Business Judgment Rule as an Immunity Doctrine,” available at: http://scholarship.law.wm.edu/cgi/viewcontent.cgi?article=1058&context=wmblr. See also Stephen Bainbridge, “The Business Judgment Rule as an Abstention Doctrine,” Vanderbilt Law Review (Vol. 57, 2004), 83.

[9] See The Regulatory Framework, below, for a discussion of the Business Judgment Rule.

[10] There is of course, significant room for discussion regarding whether the law has achieved that end. This would seem to be a good starting point for a discussion on the role of the corporation in society or within a business and human rights framework.

[11] See Stephen Bainbridge, “The Creeping Federalization of Corporate Law,” Regulation, (Vol. 26, No. 1, Spring 2003), 32-39, available at SSRN: https://ssrn.com/abstract=389403 or http://dx.doi.org/10.2139/ssrn.389403.

[12] There are some very limited exceptions which are outside of the scope of this teaching note.

[13] William Jarblum and Bernard D. Bollinger, Jr., “Incorporation Issues: Why Delaware?” American Bankruptcy Institute Journal (Vol. 18.8, 1999), 6.

[14] Another major statutory source for students interested in corporate law is the Model Business Corporation Act, which has been adopted by many other jurisdictions.

[15] Under Delaware General Corporations Law (§ 102(b)(7)), a corporation may, in its bylaws, waive personal liability for corporate directors even if the directors have violated their fiduciary duties. This provision applies, however, only if the directors acted in good faith in reaching their decision. For a discussion of the duty of care within the context of business and human rights issues see Douglass Cassell, “Outlining the Case for a Common Law Duty of Care of Business to Exercise Human Rights Due Diligence,” Business and Human Rights Journal (Vol. 1:2, July 2016), available at:  http://scholarship.law.nd.edu/cgi/viewcontent.cgi?article=2267&context=law_faculty_scholarship.

[16] Similarly, the decision can be a decision to act or a decision to not act.

[17] Courts have also held that directors who fail to make a decision act without due care. In those cases the Business Judgment Rule would not apply. Francis v. United Jersey Bank, 432 A.2d 814 (N.J. 1981).

[18] Bad faith can arise in two situations: (1) intentional malice (“a subjective desire to do harm”) or (2) an “intentional dereliction of duties” or “conscious disregard for one’s responsibilities.” In re Walt Disney Co. Derivative Litigation, 907 A.2d 693 (Del. 2005). Gross negligence, without more, is not bad faith.

[19] Rule 10b-5 of the Securities Exchange Act of 1934 applies to “any person,” including corporate actors, that violate its provisions. As such, both closely held corporations and publicly traded corporations can be found liable.

[20] U.S. Securities and Exchange Commission, SEC Release No. 33-8177 (2003).

[21] United States Code, 15 U.S.C. §§ 78dd-1, et seq.

[22] Securities Exchange Act of 1934, Employment of manipulative and deceptive devices, 17 CFR 240.10b-5.

[23] Basic Inc. v. Levinson, 485 U.S. 224 (1988). Plaintiffs are also required to show that the above elements were done “in connection with the purchase and sale of a security.” Blue Chips Stamps et. al. v. Manor Drug Stores, 421 U.S. 723 (1975).

[24] Milton Freidman, Social Responsibility of Business, New York Times Magazine (Sep. 13, 1970). Friedman states that the exclusive responsibility of a corporation is to make money for its shareholders. For additional commentary on this perspective and corporate social responsibility see Becker Friedman Institute for Research in Economics: The University of Chicago, “Corporate Social Responsibility: Friedman’s View,” available at: https://bfi.uchicago.edu/news/feature-story/corporate-social-responsibilty-friedmans-view.

[25] The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. Law. 111-203, Sec. 1502 and Sec. 1504 (July 21, 2010).

[26] See Jena Martin, “Hiding in the Light: The Misuse of Disclosure for Business and Human Rights Issues” (forthcoming 2018), available at:  http://ssrn.com/abstract=3028808.

[27] Id.

[28] Instructors should have no shortage of material from which to draw in constructing a fact pattern such as this. See, e.g., See Brett Murphy, “Rigged,” USA Today (June 16, 2017), available at: https://www.usatoday.com/pages/interactives/news/rigged-forced-into-debt-worked-past-exhaustion-left-with-nothing/.

[29] For a discussion of benefit corporations and business and human rights see Joanne Bauer and Elizabeth Umlas, “Making Corporations Responsible: The Parallel Tracks of the B Corp Movement and the Business and Human Rights Movement,” available at: https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2650136. For a discussion on the distinction of benefit corporations and B Corps, see Joshua Fershee and Elaine Wilson, “The March of Benefit Corporation: Next Up, West Virginia (Part I),” available at: http://lawprofessors.typepad.com/nonprofit/2014/08/the-march-of-the-benefit-corporation-next-up-west-virginia-cross-post.html; and Joshua Fershee and Elaine Wilson, “The March of Benefit Corporation: Next Up, West Virginia (Part II),” available at: http://lawprofessors.typepad.com/nonprofit/2014/09/the-march-of-the-benefit-corporation-next-up-west-virginia-part-ii.html.