Charter Competition and Corporate Lawbreaking

Sparked by Elon Musk’s widely-publicized grudge against the state of Delaware over his pay package at Tesla, corporate boardrooms and their legal counsel across the United States are actively debating the merits of remaining or leaving Delaware. Across law schools, academics are also starting to rethink conventional wisdom underlying the theoretical building blocks of American corporate law.

While both scholars and practitioners have raised excellent points about this new era of charter competition, the debate is currently underappreciating an important feature of corporate law at stake: the duty prohibiting directors and officers from facilitating or engaging in corporate lawbreaking. In my forthcoming paper, I document jurisdictions undercutting the legal compliance obligations of directors and officers.

Readers of this blog may be familiar with Delaware’s legal compliance jurisprudence. While Delaware is often referred to as a ‘shareholder primacy’ jurisdiction (rightfully so), Delaware historically has not embraced a jurisprudence encouraging ruthless profit maximization in the name of advancing shareholder interests. If canonical cases teach us anything, it is that Delaware corporate law is a version of shareholder primacy that infuses a serious commitment to legal compliance. Thus, for instance, the Delaware Court of Chancery has maintained that directors and officers who steward business corporations ‘may not choose to manage an entity in an illegal fashion, even if the fiduciary believes that the illegal activity will result in profits for the entity’. 

To the contrary, emerging jurisdictions supplying corporate law to American corporations—such as Nevada and the Cayman Islands—have broadly eliminated doctrines that enable shareholder suits against directors and officers who turn a blind eye to corporate lawbreaking. These jurisdictions have also erected a range of procedural barriers that preclude shareholders from holding directors and officers accountable when they actively participate in illicit activities. Perhaps more importantly, the current legal architecture of American corporate law does not prevent a state or a foreign nation from offering a body of law that completely eviscerates legal compliance obligations from modern business corporations.

This insight suggests that charter competition may usher in different versions of shareholder primacy as it relates to profit-maximizing illicit behavior. At the very least, the new era demands a scholarly conversation beyond standard discussions about whether any given jurisdiction’s corporate law can enhance shareholder value.

Importantly, corporate law’s legal compliance obligations play an important role in tackling a well-known problem underlying the modern corporate form. Foundational corporate law doctrines including limited liability encourage socially beneficial entrepreneurial risk-taking by assuring that shareholders do not risk more than their capital investment. Yet, it is widely acknowledged that the structural features of the modern corporate form fuel the excessive risk-taking tendencies of business corporations. Statutory proposals aimed at reforming limited liability, while enjoying luminary status in prestigious law reviews and generating widespread scholarly following, have failed to gain traction in the real world. Legal compliance duties demanded of corporate fiduciaries tame the corporation’s excessive risk-taking tendency not through the gutting of the doctrine of limited liability or through mandating amorphous conceptions of corporate social responsibility. Rather, it does so in part by defining the zone of managerial decisions protected by the business judgment rule to lawful activities. 

The trend of jurisdictions undercutting legal compliance obligations should alarm more than just those who view the role of corporate law as broader than reducing the agency costs between shareholders and managers. While legal compliance obligations embedded in corporate law can reduce agency costs by aligning managerial interest with the long-term value of the firm (after all, lawbreaking can be costly), legal compliance obligations also serve to legitimize corporate law.

Think back to the scandals of epic proportions involving Enron and WorldCom that inspired the Sarbanes-Oxley Act. While well-intentioned, the Act has federalized a significant portion of corporate governance and has been famously critiqued by one leading corporate law scholar as ‘quack’ corporate governance. Viewed from this light, jurisdictions undercutting legal compliance obligations—which can facilitate shocking examples of corporate misbehavior—come at the risk of further federalization of American corporate law.

This is not to claim that corporate lawbreaking can or should be eliminated. The goal is also not to put Delaware corporate law on a pedestal and view any deviation from Delaware as a sign of defect. No centralized decision-making body is equipped to deter all forms of lawbreaking attributable to the corporate entity. And it is not socially optimal to impose severe punishments on directors complicit in corporate lawbreaking. But corporate crimes and misconduct can be deterred, and corporate law is a pillar of legal architecture that can reduce lawbreaking. This is particularly true because corporate law powerfully influences the behavior of corporate managers, who are strategically positioned within the firm to detect and prevent corporate lawbreaking.

Jurisdictions that facilitate corporate lawbreaking have the potential to provide some redeeming social value but come at the cost of encouraging unrestrained risk-taking with potentially catastrophic societal consequences. The proper calibration of the duty for legal compliance remains undertheorized and ought to be a central question with which more scholars and lawyers should tackle head-on in the coming decades. 

William J. Moon is the J.B. and M.K. Pritzker Family Foundation Distinguished Visiting Professor of Law at the Northwestern Pritzker School of Law & Edward M. Robertson Professor of Law at the University of Maryland Carey School of Law.

The author’s complete paper can be found here.