An old lawyer walks into a boardroom of a public company and explains that a director's duty is to act in the best interest of the corporation - a distinct legal entity that exists independently of its shareholders. The young Chairman says " You may have been to law school, but as a matter of practice we all know that the corporation is nothing more than its shareholders" he continued "Corporations don't have interests. Only our shareholders have interests and it's our duty to act in theirs"". The lawyer, not wanting to contradict the Chair, asks "But what if the shareholder is a corporation. In whose interest will you then act?". "You're a very clever, old man, very clever", said the Chairman. " But it's shareholders all the way down!"
This tale is based on one retold by Stephen Hawking:
”A well-known scientist (some say it was Bertrand Russell) once gave a public lecture on astronomy. He described how the earth orbits around the sun and how the sun, in turn, orbits around the center of a vast collection of stars called our galaxy. At the end of the lecture, a little old lady at the back of the room got up and said: "What you have told us is rubbish. The world is really a flat plate supported on the back of a giant tortoise." The scientist gave a superior smile before replying, "What is the tortoise standing on?" "You're very clever, young man, very clever", said the old lady. "But it's turtles all the way down!”
The young Chair and the old lady are guilty of the same logical fallacy. By proposing a solution that begs exactly the same problem they have fallen into the bottomless pit of infinite regression - where the validity of one proposition depends on the validity of the proposition which follows and/or proceeds it. Leading to a series of never ending cascading turtles and incorporated shareholders. There is no logical end and therefore no shareholder to whom the director owes his duty.
The Chair had succumbed to the incorporated shareholder paradox:
If a shareholder is a corporation, and all corporations are fictions, incorporated shareholders must be fictions too.
If the director is right, and if most shareholders are also corporations, logically both must be mere legal fictions incapable of having their own interests. This leaves the chair and his fellow directors in a bind - if the corporation doesn't really exists, then each incorporated shareholder doesn't exist. In that case, in whose best interest are they supposed to act?
Puzzled, the Chair asks "But surely, the shares are held for the benefit of humans ".
Not according to one survey by Peetz and Murray. Based on their analysis only 3.3% of the shares in the world's very large companies were held by humans. Nearly all the shares were held, through a vast network of interposed entities, by a very small number of corporations. And, it's not necessarily the case these these corporations are acting as trustees on behalf of humans. For the most part, these corporations don't hold shares on trust for individuals. Rather, shares are bought as inputs into their business models to create financial products to be sold to individuals to produce profits to be consumed by other corporations. Just like a steel company buys iron ore, insurance companies buy shares. Even in other insurance companies. According to the Chair's logic, this means the board of one insurance company is under a duty to act in the best interests of their competitor.
Exasperated, the chair says "we'll act for the 3.3% then."
"You misunderstand the problem" responded the old lawyer. "The law does not require that you act for individual or incorporated shareholders. Your responsibility is to the corporation. It may be an artificial legal person, but it's no fiction. It exists." The lawyer continued:
Your duty is to promote the continuing existence of the corporation by acting in its best interests.
That doesn't mean its interests can't intersect or correspond with the the interests of shareholders and others. But, the interests of the corporation must come first".
The chair, interrupted "But why? What about our purpose?".
The lawyer, summoning decades of experience, explained the logical proposition that governs directors duties "without the corporation, there could be no corporate purpose of any kind. What ever the desire of the shareholder, it is contingent upon and subordinate to the survival of the corporation. That's the standard that the law requires."