Redesigning Corporate Law
Design as if nature matters
By Robert Hinkley

  The specific change suggested is simple: add twenty-six words to corporate law and thus create what is called the 'Code for Corporate Citizenship'. Directors and officers would still have a duty to make money for shareholders,

... but not at the expense of the environment, human rights, the public safety, the communities in which the corporation operates or the dignity of its employees.

  AFTER TWENTY-THREE years advising large corporations on securities offerings, mergers and acquisitions, I left my position because I was disturbed by the game. I realized that the many social ills created by corporations stem directly from corporate law. It dawned on me that the law, in its current form, actually inhibits executives and corporations from being socially responsible. So in June 2000 I decided to devote the next phase of my life to making people aware of this problem. My goal is to build consensus to change the law so that it encourages good corporate citizenship rather than inhibiting it.
  The provision in the law I am talking about is the one that says that the purpose of the corporation is simply to make money for shareholders.
  Distilled to its essence, it says that the people who run corporations have a legal duty to shareholders, and that duty is to make money. Failing this duty can leave directors and officers open to being sued by shareholders.
  This explains why corporations find social issues such as human rights irrelevant - because they fall outside the corporation's legal mandate. Secondly, these provisions explain why executives behave differently than they might as individual citizens, because the law says their only obligation in business is to make money.
  This design has the unfortunate side effect of largely eliminating personal responsibility. Directors and officers know that their jobs, salaries, bonuses and stock options depend on delivering profits for shareholders. Companies believe that their duty to the public interest consists in complying with the law. Obeying the law is simply a cost. Since it interferes with making money, it must be minimized - using devices like lobbying, legal hair-splitting and jurisdiction shopping. Directors and officers give little thought to the fact that these activities may damage the public interest.
  Lower-level employees know that their livelihoods depend upon satisfying superiors' demands to make money. They have no incentive to offer ideas that would advance the public interest unless they increase profits. Projects that would serve the public interest - but at a financial cost to the corporation - are considered naive.
  Corporate law thus casts ethical and social concerns as irrelevant, or as stumbling blocks to the corporation's fundamental mandate. That's the effect the law has inside the corporation. Outside the corporation the effect is more devastating. It is the law that leads corporations to actively disregard harm to all interests other than those of shareholders. When toxic chemicals are spilled, forests destroyed, employees left in poverty, or communities devastated through plant shutdowns, corporations view these as unimportant side effects outside their area of concern. But when the company's stock price dips, that's a disaster. The reason is that, in our legal framework, a low stock price leaves a company vulnerable to takeover or means the CEO's job could be at risk.
  In the end, the natural result is that the corporate bottom line goes up, and the state of the public good goes down. This is called privatizing the gain and externalizing the cost.
  This system design helps explain why the war against corporate abuse is being lost, despite decades of effort by thousands of organizations. Until now, tactics used to confront corporations have focussed on where and how much companies should be allowed to damage the public interest, rather than eliminating the reason they do it. When public interest groups protest a new power plant, mercury poisoning, or a new big store, the groups don't examine the corporations' motives. They only seek to limit where damage is created (not in our back yard) and how much damage is created (a little less please).
  But the where-and-how-much approach is reactive, not proactive. Even when corporations are defeated in particular battles, they go on the next day, in other ways and other places, to pursue their own private interests at the expense of the public.
  I believe that the battle against corporate abuse should be conducted in a more holistic way. We must enquire why corporations behave as they do, and look for a way to change these underlying motives. Once we have arrived at a viable systemic solution, we should then dictate the terms of engagement to corporations, not continue letting them dictate terms to us.
  We must remember that corporations were invented to serve humankind. Humankind was not invented to serve corporations.
  Many activists cast the fundamental issue as one of ‘corporate greed', but that's off the mark. Corporations are incapable of a human emotion like greed. They are artificial beings created by law. The real question is why corporations behave as if they are greedy. The answer lies in the design of corporate law.

  WE CAN CHANGE that design. We can make corporations more responsible to the public good by amending the law that says the pursuit of profit takes precedence over the public interest. I believe this can best be achieved by changing corporate law to make directors personally responsible for harms done.
  Let me give you a sense of how director responsibility works in the current system. Under federal securities laws, directors are held personally liable for false and misleading statements made in prospectuses used to sell securities. If a corporate prospectus contains a material falsehood and investors suffer damage as a result, investors can sue each director personally to recover the damage. Believe me, this provision grabs the attention of company directors. They spend hours reviewing drafts of a prospectus to ensure it complies with the law. Similarly, everyone who works on the prospectus knows that directors' personal wealth is at stake, so they too take great care with accuracy.
  That's an example of how corporate behaviour changes when directors are held personally responsible. Everyone in the corporation improves their game to meet the challenge. Since the potential penalties are so severe, directors err on the side of caution. While this has not eliminated securities fraud, it has over the years reduced it to an infinitesimal percentage of the total capital raised.
  I propose that corporate law be changed in a similar manner - to make individuals responsible for seeing that the pursuit of profit does not damage the public interest.
  To pave the way for such a change, we must challenge the myth that making profits and protecting the public interest are mutually exclusive goals. The same was once said about profits and product quality, before Japanese manufacturers taught us otherwise. If we force companies to respect the public interest while they make money, business people will figure out how to do both.
  The specific change I suggest is simple: add twenty-six words to corporate law and thus create what I call the 'Code for Corporate Citizenship'. Directors and officers would still have a duty to make money for shareholders,

... but not at the expense of the environment, human rights, the public safety, the communities in which the corporation operates or the dignity of its employees.

  This simple amendment would make individuals responsible for the damage companies cause to the public interest, and would be enforced in much the same way as securities laws are now. Negligent failure to abide by the code would result in the corporation, its directors and its officers being liable for the full amount of the damage they cause. In addition to civil liability, the Attorney General would have the right to criminally prosecute intentional acts. Injunctive relief - which stops specific behaviours while the legal process proceeds - would also be available.
  Compliance would be in the self-interest of both individuals and the company. No one wants to see personal assets subject to a lawsuit. Such a prospect would surely temper corporate managers' willingness to make money at the expense of the public interest. Similarly, investors tend to shy away from companies with contingent liabilities, so companies that severely or repeatedly violate the Code for Corporate Citizenship might see their stock price fall or their access to capital dry up.

MANY WOULD SAY such a code could never be enacted. But they're mistaken. I take heart from a 2000 Business Week/Harris poll that asked Americans which of the following two propositions they support more strongly:

*  "Corporations should have only one purpose - to make the most profit for their shareholders - and pursuit of that goal will be best for America in the long run."
*  "Corporations should have more than one purpose. They also owe something to their workers and the communities in which they operate, and they should sometimes sacrifice some profit for the sake of making things better for their workers and communities.''

  An overwhelming 95 percent of Americans chose the second proposition. Clearly, this finding tells us that our fate is not sealed. When 95 percent of the public supports a proposition, enacting that proposition into law should not be impossible.
  If business people resist the notion of legal change, we can remind them that corporations exist only because laws allow them to exist. Without these laws, owners would be fully responsible for debts incurred and damages caused by their businesses. Because the public creates the law, corporations owe their existence as much to the public as they do to shareholders. They should have obligations to both. It simply makes no sense that society's most powerful citizens have no concern for the public good.
  It also makes no sense to chase endlessly after individual instances of corporate wrongdoing, when that wrongdoing is a natural result of the system design. Corporations abuse the public interest because the law tells them that their only legal duty is to maximize profits for shareholders. Until we change the law of corporate governance, the problem of corporate abuse can never fully be solved.

First published in Business Ethics, January/February 2002.

Robert Hinkley, previously a corporate securities attorney, lives in Brooklin, Maine, USA. rchinkley,