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.
- 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:
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. 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 nether 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 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. And practically, 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 difference:
- First, firms (in the form of a corporation) having existence must seek utility. The use value embodied in multitudes 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 a country where corporations exist and have their own utilty, the decision whether to close the plant requires a very different level of analysis:
- The shareholder versus stakeholder debate is irrelevant.
- 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 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.
- 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 a capital differs in magnitude/quality (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. I call this process a state of "capitalism" because the net energy outcome is positive.
- 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 value outcome is negative.
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 the buyback of, then logically the interest of the corporation is served by no closing the plant.
In essence, 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. 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 ("VronVi"). 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.
But of course, none of this analysis applies in Delaware where corporations don't exist but shareholders do.
* By efficiency I mean the value return (less risk) divided by the value invested (plus transaction cost). Not to be confused with the consultants modus operandi of simply reducing costs.