Shareholder Primacy: The Misconstruction

In a recent article I explain that the assertion of ‘shareholder primacy’ in corporate law is a misconceived extension of the ‘partner primacy’ of partnership law. The joint stock company, the predecessor of the modern corporation, was a partnership of ‘stockholders’ or ‘shareholders’ featuring centralised management by a subset of the partners (the ‘directors’). Because the joint stock company was an unincorporated association of persons, rather than a distinct legal entity, ‘partner (shareholder) primacy’ fittingly described (for present purposes) the nature of the relation. The directors of the partnership undertook, and became bound, to pursue the best interest of the ‘shareholder’ partners.

The general incorporation legislation introduced in England in the nineteenth century both required and enabled joint stock companies to become corporations by registering their constitutional documents with the government. The aim of the incorporation process was to replace the partners as owners or principals of the business with the corporation as the new owner of the business. That involved radical conceptual change. The change of immediate interest was that the legal duty of the directors to act in the best interest of the partners of the joint stock company was transformed into the legal duty to act in the best interest of the corporation. The principal status of the partners was replaced by the principal status of the corporation. ‘Partner primacy’ was replaced by ‘corporation primacy.’

That conceptual transformation was not initially understood by everyone. Some continued to regard the shareholders as the ‘owners’ of the business. That perception likely persisted because the management structure usually remained unchanged in the corporate form. The joint stock company constitutions that were registered gave the new corporate shareholders the same ‘owner’ powers they possessed in their former capacities as partners (powers to elect/remove directors, amend the constitution, dissolve the firm, etc.), fostering the mistaken view that the shareholders remained the ‘real’ owners or principals of the business.

The controversy in the English jurisprudence was not resolved until late in the nineteenth century. In Salomon v A. Salomon & Co. Ltd. [1897] A.C. 22, the court concluded that corporations were legal persons in their own right, and not merely trustees or agents for the shareholders. That was augmented by Percival v Wright [1902] 2 Ch. 421, where the court rejected the submission that the duty of a corporate director was no different than the duty of a director of a joint stock company. The court denied that directors had a status fiduciary duty to corporate shareholders.

It is necessary at this point to observe that the undertaking of a director to pursue the corporation’s best interest has the distinct tied consequence of triggering fiduciary accountability for that director. While conceptually distinct, the two duties (the best interest duty and the fiduciary duty) frequently are wrongly conflated. That has needlessly confused the jurisprudence. My article is concerned with dispelling the confusion over the fiduciary accountability of directors. The analysis informs and directly confronts the claim of shareholder primacy. Working backwards, directors do not have a status fiduciary duty to shareholders because they do not have a duty to act in the best interest of shareholders. That is, there is no shareholder primacy. There is only corporation primacy.

Crossing the ocean, we find that the nineteenth century US jurisprudence on director duty, informed significantly by the English jurisprudence, was similarly unsettled. An early influential judgment was that of Chancellor Kent in Attorney-General v Utica Insurance Company (1817) 2 Johns. Ch. 371, where, unsupported by authority, he asserted a trust relation between directors and shareholders. In contrast, in Smith v Hurd (1847) 53 Mass. 371, Shaw C.J. carefully explained that the duty of directors was to the corporation. Subsequently the cases continued to diverge. Some judges did recognise that there was a fundamental discordance in the jurisprudence, but no cogent resolution was forthcoming. There was, at the same time, an issue over whether the duty of directors included an element of ‘fairness.’ That amplified the confusion. The US jurisprudence remained a puddle of confusion and contradiction throughout nineteenth century. In particular, there was no definitive judicial resolution of the issue of director duty (shareholder primacy), as there had been late in the century in England. As I have observed elsewhere, it was not until the 1930s that an apparent consensus began to emerge in the United States after certain prominent writers (Adolf Berle, Merrick Dodd) simply assumed that the legal position was that directors were accountable directly to shareholders. It thus appears that the shareholder primacy notion ultimately became ascendant in the United States as a result of unsatisfactory research and analysis by both judges and writers.

That kind of analytical failure, it must be added, has not been confined to the corporate context. The law of fiduciary accountability as a whole presently is vulnerable to core laceration as a result of the introduction or play of multiple misinformed departures from conventional principle. The corporate law malformation that is shareholder primacy (director duty) is but one of several fabrications that are attributable to the wide failure to comprehend the substantive implementation of corporate personality, the narrow function of fiduciary regulation (the control of opportunism), and the separate function of best interest regulation.

Consider whether at this point it is realistic to believe that it is possible to correct this striking mistake of principle. Is the rehabilitation of the law inevitable once the misconstruction of shareholder primacy is understood? Appreciate that there are opposed interests. Most shareholders subscribe to the notion of shareholder primacy. So do corporate managers, believing for example that it justifies or excuses their de facto deference to significant active shareholders. And even those few judges with strong corporate law expertise and experience may today hesitate to question what might appear to be embedded US doctrine, especially where, as with many writers, and many lawyers, they have in their past work made intellectual investments in the shareholder primacy notion, and are not inclined to concede their misconceived assumptions. The conceptual terrain, however, may be shifting. The conviction may be dissolving. As that proceeds (if it proceeds), the Americans will have to address directly what consequences attend corporation primacy.

Robert Flannigan is a Professor of Law at the University of Saskatchewan.

Readers may obtain the full article by contacting the author at r.flannigan@usask.ca.