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?
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 - but only in Delaware.
My point is that corporations, being creatures of statute, what passes for the ends of governance in one place are entirely out of place in another. Put simply, corporations aren't corporations. Outside of Delaware their nature and 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 the professor's hometown, and in response to the original hypothetical, his either/or framing between stakeholders might be acceptable. But, where I practice law, there's no choice and it's neither of the ones Professor Bainbridge offers.
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 the corporation”
In this sense, the only question posed by my modified hypothetical 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. Theoretically individuals seek utility and firms seek profits. That’s the law or at least the law of economics from which they draw their answer to the Bainbridge Hypothetical. And practically, as the the Chief Justice of the Delaware Supreme Court reminds us - corporate governance is little more than the advantage to the stronger - "power is purpose" in their system of corporate governance. In America, if an 800 pound gorilla wants more bananas, the directors hand over the bananas!
In Australia, the question is far more nuanced and turns on two vital differences,
First, firms (in the form of a corporation) having existence must seek utility. The use value embodied in the different forms of capital required to sustain their very existence. Profits of course have a use value but surprising less than other forms of capital.
Second, might is not right under Australian law. Directors owe their duty to the corporation and not the shareholder or anyone else. In Australia, there is no duty to feed the Gorilla or any other animal in the zoo. In fact, directors who do, may find themselves on the wrong side of the law.
In a country where corporations exist and have their own determinate utility, the decision whether to close the plant requires a very different level of analysis. The idea of exchange value that underpin the American contractarian model is replaced with the Aristotelian idea of use value:
The shareholder versus stakeholder debate is false dilemma. After 100 years of conditioning its hard to do but take this sorry mess of a contest out of your mind. It’s the wrong framing in any jurisdiction with an entity statute.
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.
The entity is both artificial (in that it is a creature of statute) and real (in that it is thermodynamically alive). It must source use value in all its forms from its environment to survive in law.
The purpose of a corporation under an entity statute is to maintain indefinite existence. All other purposes are necessarily contingent upon the survival of the corporation. There is no profit or purpose without existence.
Indefinite corporate existence requires energy in the form of use value. Value is essentially a property of a capital that is transferred to do the work of maintaining and sustaining the existence of the corporation.
To survive the corporation must receive and store more useful value from its business activities than it expends on those activities. Under an entity statute, a corporation has properties analogous to a thermodynamic entity that must convert energy to survive.
Useful value is stored in a variety of capitals (financial, social, intellectual, human etc).
The use value embodied in each form of capital differs in quality/quantity (for reasons that are beyond a brief explanation).
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.
Capitals are both endogenous and exogenous.
To survive the corporation must efficiently* accumulate use value (to sustain existence) by:
converting endogenous capitals into more useful capitals or exchanging endogenous capitals for exogenous capitals with stakeholders;
ensuring that the business model (the process of conversion and exchange) does not consume more capital than created through the actual conversion or exchange .
In so far as stakeholders are concerned , whether one group gains at the former groups expense is no part of consideration. The relative priority of stakeholders to the corporation and each other is determined by the use value of the capital they possess. 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. Something that Adam Smith was big on. It's worth remembering that duty played no part in Adam Smith's political economy.
If the corporation systematically converts low quality capitals into higher quality capitals, the corporation is more likely to maintain its existence and grow. This process is called “capitalisation”.
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 "decapitalisation".
In America, corporate lawyers (and scholars) must think like economists. But in Australia, the lawyer must think more like a physicist - which capitals will yield the greatest value through conversion? The goal of corporate governance is to increase useful energy in its social form - value. Value, and not profit, being the key variable in determining corporate longevity.
More profit is only acceptable if it simultaneously produces more energy in the form of the use value than the endogenous capital exchanged for that profit. For example, if after taking into account the adverse reaction of shareholders, there was still more use value in the human, intellectual, and social capital embodied in the obsolete plant than the use value acquired through closing the plant and buying back use less shares, then logically the interest of the corporation is served by not closing the plant.
In essence, under an entity statute the corporation is devised as a way to convert useful energy more efficiently, than alternative forms or organisation - individuals, partnership and trusts. The more efficient and positive the process of conversion, the more likely the corporation is to achieve the grail of perpetual and indefinite existence. To be clear, more profit does not equal more use value to the corporation.
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.”
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 use value returned on the use value invested (VROI). As a general, and even perhaps novel, proposition the answer to the hypothetical turns out to be 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 value being available to the corporation to sustain its existence - don't close the plant. Put another way if the company has more profit, but that profit can do less work than what was exchanged for the profit, the director’s of ACME Limited have a duty not close the plant.
But of course, none of this analysis applies in Delaware where corporations don't exist and shareholders rule.
* By efficiency I mean the the total return of useful work (value) from a transaction or process. Not to be confused with the consultants modus operandi of simply reducing costs which can decrease overall value.
* Stephen Bainbridge is the William D. Warren Distinguished Professor of Law at UCLA School of Law and has a seriously intimidating intellect. His biography is here and his blog can be found here http://www.professorbainbridge.com/.
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