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Revisiting the Bainbridge Hypothetical : Corporate Purpose in Australia

At the heart of the Bainbridge Hypothetical is a simple question - by what standard should company directors make their decisions?

Devised by Stephen Bainbridge, a law professor from UCLA*,  his thought experiment asks what the ends of corporate governance should be.    This post revisits the question from the perspective of an Australian director (changes to the original are in bold and are mine):

Acme's Limited board of directors is considering closing an obsolete plant. The board is advised that closing the plant will cost many long-time workers their job and be devastating for the local community. On the other hand, the board's advisors confirm that closing the existing plant will benefit Acme's shareholders through a planned share buy back, new employees hired to work at a more modern plant to which the work previously performed at the old plant will be transferred, and the local communities around the modern plant. 

 Assume that:

  • Acme Limited is an Australian Public Company
  • The long- time workers are research scientists from leading universities;
  • obsolete means sustainably profitable but less profitable than the new plant; and
  • the latter groups cannot gain except at the former groups' expense.

 By what standard should the board make the decision in Australia. 

For the past months I've been figuring out how to get to an answer.  How could an either/or be so tough?

In response to his original hypothetical, the Professor says:

Shareholder wealth maximization provides a clear answer -- close the plant.

And, from what I can gather from recent comments from the Chief Justice of the Delaware Supreme Court, there's little doubt the Professor is right - in Delaware.

But, corporations being creatures of statute, what passes for the ends of governance in one place may be beside the point in another.  Put simply, corporations aren't corporations and their purpose reflect the varieties of the world's legislatures.

In Australia, we have an entity statute which makes the shareholder versus stakeholder debate, implicit in the Professor's answer,  a false dilemma.   Again, in his hometown, and in response to the original hypothetical,  his either/or framing is unquestioned by me.   But, where I practice law, there's a third choice and it's mandatory.

Entity statutes impose duties on company directors to exercise their powers and discharge their duties in the interests of the corporation.  As one eminent Australian lawyer explained, under the Australian Corporations Act this duty refers to the interests of the corporation:

 “as a distinct legal and commercial entity, not the interests of shareholders, and conforms to the basic tenet that the duties of directors under these provisions are owed to corporation”

My question is therefore not whether the directors should or can advantage one group over another.  The issue I'm struggling with is whether it's in the interest of Acme Limited, as a distinct legal and commercial entity, to be more profitable?

But surely that's a "duh" question.   

If monkeys could vote for bananas or the welfare of the plant it's self evident what they'll vote for. 

Perhaps in Delaware, where the Chief Justice recently described corporate governance as little more than the advantage to the stronger - "power is purpose" in their system of corporate governance.  In a jurisdiction with an entity statute, it not as obvious as the answer to this riddle - if an 800 pound gorilla wants more bananas what do you do?

Not, that I think my answer matters that much. 

Absent the rigor of academic method or proving my worthiness by first running the hypothetical across the dusty ruler of agency theory and every other theory that has set sail to an armada of doctorates, luck would have better odds than my answer, when it comes to changing anyone's mind.  That's not a criticism.  We can all share the scholar's spirit.  But what elevates advocacy to good knowledge is precisely the rigor and the absence of bias, real or perceived.

For a practically minded sole practitioner, I suspect my best chance lies in more modest ambitions and an appeal to reason.  With that in mind, and with thanks to the Professor for devising the original, I thought I'd share my plans and outline my argument for getting to an answer:  

  1. The shareholder versus stakeholder debate is irrelevant to my answer because Australia has an entity statute.
  2. The law of purpose in Australia requires a company director to unquestionably act in the interests of the corporation as a distinct legal and commercial entity.
  3. The purpose of a corporation under an entity statute is to maintain its indefinite existence.  All other purposes are necessarily contingent upon the survival of the corporation.
  4. To survive the corporation must receive and store more useful energy from its business activities than it expends on those activities.   A corporation is analogous to (if not) a thermodynamic entity that must convert value internally and exchange value externally to survive. 
  5. Useful energy is stored in a variety of capitals (financial, social, intellectual etc).
  6. The quality of energy stored in each capital ranges from low (manufactured capital) to high (social capital). 
  7. Financial capital is generally a low quality capital due to factors that include (a) it exhausted fully by use(b) "loses" useful energy without use ie. inflation; and (c) in the absence of appropriate defenses, excess financial capitals makes the corporation vulnerable ie. activist attack. 
  8. To survive the corporation must efficiently convert low quality/low productive capital into high quality/high productive capital while maintaining requisite financial capital to fund its business model and activities. 
  9. The priority of stakeholders is therefore determined by the quality of capital available to be exchanged with the corporation.   In other words, priority is determined by the self interest of the corporation and its own survival rather than a duty or responsibility to any other person or group.
  10. If the the corporation systematically converts high quality capitals into low quality capitals, the corporations is more likely to end its existence.   I describe this process as a state of "decapitalism" because the net energy outcome is negative. 
  11. If the corporation systematically converts low quality capitals into higher quality capitals, the corporation is more likely to maintain its existence and grow.  I call this process a state of "recapitalism" because the net energy outcome is positive.

In essence, I propose that the corporation under an entity statute is devised as a way to convert useful energy more efficiently, than the alternative.  The more efficient and positive the process of conversion, the more likely the corporation is to achieve the grail of perpetual and indefinite existence.  

An approach with tacit approval from Peter Drucker:

“profit maximization” is the wrong concept, whether it be interpreted to mean short-range or long-range profits or a balance of the two. The relevant question is, “What minimum does the business need?” – not “What maximum can it make?” This “survival minimum” will, incidentally, be found to exceed present maxima in many cases.”

Based on these propositions, I've started to reformulate the question (again) and turned it into a working equation.  In short, when asking whether to close or keep the plant open, the director needs to account and evaluate, in respect of each option,  the value returned on value invested ("VronVi").   As a general, and even perhaps novel, proposition the answer to the hypothetical becomes relatively simple in an entity jurisdiction.  As absurd, naive and unthinkable as it sounds in other parts of the world, if opening a new plant results in more profit to the corporation but less overall useful and productive energy being available to the corporation to sustain its existence - don't close the plant.  

The equation looks something like this:

Mindful of easy criticism, I'm aware of the rough and bold nature of my propositions.  But, they are just first steps.  And there are benefits to working with propositions as opposed to conclusions.  There seems far less competition.  That doesn't mean I won't try to back up the propositions and come up with an answer.  I'll keep working at it and share my advice to the board of Acme Limited in the coming months.  

In the meantime, for those who sailed their professional careers on these turbulent seas in the past decades, I understand that my propositions might not appear on your maps or, if some do, as nothing more than legends and myths.   But long before economists like Friedman and Jensen erased the corporation from the ends of corporate governance, accountants and scholars like Li, Raby and Eells were theorising the corporation into existence and hypothisizing its goals.  For those of us who live under the rule of an entity statute, these academics, like our Southern Cross, point the way.   

And, for those company directors who, like the monkeys would vote for more bananas, you might think twice before relying on a simple profit heuristic to make your decision.  If the profit comes at the cost of higher quality productive capital, and the math shows it, you might wish you voted for the same amount of bananas and a viable plant.

Of course, it's all conjecture and bit of fun - If an 800 pound gorilla wants more bananas it obvious what you do - ask the elephant in the room.  

Seriously, can any one imagine a board resolving to close a sustainable and profitable research division, whose bygone discoveries and inventions underpinned the companies success, to buy back the one thing that the company has virtually an unlimited supply?  

* Stephen Bainbridge is the William D. Warren Distinguished Professor of Law at UCLA School of Law, with a seriously intimidating intellect.  His biography is here and his blog can be found here http://www.professorbainbridge.com/. 


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