Thanks for joining this episode of the No. 86 lecture series, where we discuss basic principles and applications of Corporate Law along with landmark cases. Today’s episode features M. Todd Henderson, who is the Michael J. Marks Professor of Law at the University of Chicago Law School. Professor Henderson’s research interests include corporations, securities regulation, and law and economics. As always, the Federalist Society takes no position on particular legal or public policy issues; all expressions of opinion are those of the speaker. Professor Henderson, in other episodes we talked about the characteristics of corporations and how they operate. But why do they exist? Do we need them? Do they help to make society better? Should they? What's the purpose of the corporation? This has been a debate that has been live for decades and really starts from the position where corporations were doing governmental functions like infrastructure projects or banking, things that were government or government adjacent, real clear social functions that serve the public interest. Over time, the role of corporations dramatically expanded. You didn't need to get the legislature's permission. You could just freely incorporate and do whatever you want. There was a time when the scope of a corporation's activities was limited by its state granted charter, and courts would enforce this through something called the ultra vires doctrine, ultra vires meaning beyond the life. And so the idea was a company is created for a specific purpose like building a bridge, and then if it wanted to do something else that would be beyond its life, ultra vires and lawsuits could enforce that limitation. Over time, in the mid 20th century, especially after World War II, this changed fundamentally, and we had companies that were pursuing a whole range of different activities, and the idea of shareholder wealth maximization took hold. Famously in a 1970s piece in the New York Times magazine, Milton Friedman declared that the idea that corporations would pursue social goals was antithetical to the American spirit, that social goals are permitted... are pursued through government. If we want to create a public good, if we want to clean the environment, if we want to feed the poor or the hungry, we can do that through charitable organizations. We can do that by paying taxes to the government and the government will produce those public goods. And Friedman's idea was businesses should focus on what they're good at, which is making money. Corporate managers trained in business schools, that's their expertise and they should make money from that. The more money they make can then be used by individuals who make money through the corporate forum to fund charities of their choice or it could be used through taxes paid, corporate taxes paid to the government, which could produce public good. So in the Friedman idea, everyone is made better off if companies stick to selling widgets, iPhones, pork bellies, whatever it is, make as much money as possible, employ as many people as possible, and then let the fruits of the tree be used to pursue social goals either through charity or through government. Then in the 1980s, some socially conscious investors, and the first ones were churches, didn't like the fact that companies that they had invested in, they'd invested their church endowments in companies that were engaging in arguably sinful activities, gambling, or other kinds of things that the churches didn't want to be associated with, so the idea of socially responsible investing is we don't want to be shareholders in a corporation that engages in particular activities. During the Vietnam war, shareholders objected to being shareholders of companies that produced cluster bombs or Napalm. The Friedman response is "Well, sell your shares. If you don't want to be a shareholder of Honeywell and Honeywell makes fragmentation bombs or Napalm, sell your shares and be a shareholder of some other corporation,." Certain shareholders brought suits against those companies claiming that they were violating duties to shareholders by engaging in these activities, and those largely didn't go anywhere under the business judgment rule. Socially responsible investing becomes a bigger and bigger thing over time, and today it represents a sizable portion of the money that is invested in equities stocks in the United States. The idea has grown exponentially from "We're a church, and we don't want to be involved in owning a gambling business" to shareholders pressuring companies to be more socially responsible generally. What is the ESG movement and how does it relate to the things you are talking about? There's an unfortunate acronym called ESG, which stands for environment, social, and governance, and companies are now ranked by various shareholder interest groups according to how well they perform on these metrics, how well are they in treating the environment in a good way, being socially responsible in various ways, supporting various causes, their hiring practices, how they interface with consumers, and then governance is a big part. How well governed is the company? I said unfortunate because it's not so clear what these three things have to do with each other or clear how they net out in a particular case. A company might make a decision that's really good for the environment, closing a factory in a particular location, that's really bad for the workers who work at that particular location. So good for the environment, bad for the community that that company finds itself in, in that particular location. So it's not at all clear how these different features net out. There's a whole bunch of companies that are trying to start rankings and indexes for investors, but it's not clear that those are doing very much. There's another kind of concern, and that is that these things are generally only applied to public companies. Public shareholders are demanding these ESG metrics and making investments in public equities according to them, but of course there are plenty of private companies that compete alongside of public companies. And imagine you're a big conglomerate that owns a set of factories that are bad for the environment and you're getting hit on these ESG rankings for that, well, you can just offload those polluting factories into a privately held subsidiary corporation that doesn't have to report those things, or sell it off to people who will keep it private. The net amount of pollution hasn't changed, but the ESG score for that particular company will go up by offloading those assets. So at least from a social standpoint, there seems like there could be a lot of games that are played that don't necessarily result in net benefits for society. There's another problem which is actually more fundamental and goes to the heart of corporate law issues, and that is about agency costs. If you tell a CEO "We're going to evaluate you based on how well you do for shareholders," well, there's a very simple metric. You turn on CNBC or open the Wall Street Journal and look at the stock price, and that is a crystallization of the market's view about your performance. If the stock price is up 10 percent, the market thinks your performance in returning value to shareholders is 10 percent better than it was in the prior period. Now, if you come to a CEO and you say, "We'd like you to do what you can for shareholders and then try to please all these other constituencies, environmental activists, labor activists, governance gadflies, and the like," now the CEO does not have a ready available metric that will police his or her behavior, but a variety of arguments that they can make. "Yes, the stock isn't up quite so much as it should be, but we're doing very well for whales and the workers and all these other constituencies." That muddies the waters, and muddying the waters means increased agency costs for shareholders and the possibility that the managers are pursuing their own selfish interest as opposed to those that the shareholders would want. A very simple example of this phenomenon in a case involves a donation by the CEO of a plumbing supply business to Princeton University. This company gave $1,500 to Princeton and shareholders objected and said, "This money is not being well spent. We the shareholders can donate money to Princeton. There's no need for the corporation to be doing so." And they challenged that donation in court as a violation of the fiduciary duties of the managers of the company. They lost that suit. The court said this was in the business judgment rule, that the possibility of being charitable could inure to the benefit of the company and its shareholders, and permitted this kind of donation. But you can see how this opens up. And if we use ESG to open up the possibilities of acting more like this, how it could run a wedge between what the interest of the shareholders are and the managers. The CEO went to Princeton. She likes to go to the opera, so she donates money of the corporations to Princeton. She donates money to the opera. She's a big environmental activist, so she spends the shareholders' money to reduce the environmental impact of her company beyond that required by law. And she's doing that to please her own interest as opposed to those of the shareholders. So there is the possibility, even though you might have as a first sort of response, that, "Hey, what's wrong with holding companies to be better for the environment or for society?" When it actually comes to it, it opens up some serious problems in corporate law. And the response isn't', "Well, let companies do whatever they want," but instead, the government should pass rules to enforce a social wellbeing, say, environmental behavior, and companies should be responsible for maximizing shareholder value subject to legal can constraints, not the idiosyncratic constraints of the CEO. Is there a market for altruism? Do consumers want corporations to be actively involved in social or political causes? What do shareholders think about corporate activism? The rise of the ESG movement has some serious potential problems by increasing agency costs and decreasing accountability for CEOs, but there's another way to look at it, which might be slightly rosier. Everybody in society wants to help other people, to act altruistically, to do things that make others better off, and if you think about your own life and how you would do that, well, one way you could do it is just help people yourself. Go and buy a sandwich for a homeless person or volunteer to help a troubled kid. But if you want to do that at scale and have a real impact, there are ways of doing that, of cooperating at large scale. You could donate money to a not-for-profit or work for not-for-profit or buy goods from not-for-profit that is committed to doing a social good. Another way you can help other people is through the government. Pay taxes and have the government produce public goods to help other people. And then finally, a third way, which is quite similar, actually, is to use a corporation to accomplish those same goals. Consider, for instance, that you wanted to help a poor farmer in Ethiopia. One way that you could help this poor coffee farmer in Ethiopia have a better life is donate to a charity, an international organization that feeds poor farmers, or Doctors Without Borders that helps deliver healthcare to people like that. You could work there, you could give them money, you could buy their products. You could pay taxes to the United States government, which could give foreign aid to Ethiopia in the hopes that it would eventually get into the hands of these poor farmers. That's another of helping that person. But there is a third way. You could buy fair trade coffee. You go to Starbucks and you buy some beans, regular beans from a farmer in a place that isn't impoverished, it cost $10. If you buy fair trade beans, maybe they cost $15. What you've actually bought is a bundle of two goods, regular coffee beans and a five dollar donation to the poor farmer in Ethiopia. That's a direct contribution to that farmer using Starbucks as an intermediary. And one might think that in some instances, corporations with global footprints who engage in purchasing transactions directly with people might have advantages in acting altruistically over the alternatives, the not profit, which you don't know how it's governed. You don't know how they're spending the money. The government and all the problems that are associated with allocating tax monies and where it's directed and will it actually get to the farmers? You might prefer to do that directly through Starbucks. So companies might have comparative advantages in doing good for the world. And if that's the case, we can think of corporations existing in a market for altruism and their competitors are not-for-profits and government. And when we think about doing good in the world, we can do good through these various different avenues. And the important thing, I think, to realize here is we should only want to do good through corporations if they are the best mechanism, if they have a comparative advantage. And in terms of the government, the potential problem is that the government is both a provider of public goods or altruism and a regulator of the other entities in that world. So governments regulate not-for-profits and governments regulate corporations, and when they write those regulations, they may not write them such that there's level playing field among those various providers. So there actually is a pretty compelling argument that in a limited set of circumstances, companies might be the most effective mechanism to allow people to have the impact they want on the world. This would mean, if it's true, we should slightly amend Milton Friedman's statement that corporations exist to maximize shareholder wealth and just say that corporations exist to maximize whatever it is that shareholders want them to maximize. That may be monetary returns. It may be a combination of monetary returns and public goods and social impact, whether it's environment or helping the farmer in Ethiopia, and the corporation is just a mechanism, a social tool to deliver that, and we should allow them to satisfy the demands of their shareholders for whatever they want subject to the concern that by doing this and muddying the waters of what the corporation's purpose is, there is the possibility that we increase agency costs and companies don't do a very good job at anything. “Costs” is usually an economic term. Even if the ESG movement wants to expand corporate purpose beyond profit, corporations can only exist if they operate according to the laws of supply and demand. What about the role of incentives here? Can you first explain what that means, and then apply it to our ESG discussion? Yeah. Okay. A crucial part of understanding corporate law is the role of incentives. People will deliver what they are incentivized to deliver, and there's a good way of thinking about the importance of incentives and the effects that it has. So for most of corporate America's life from the start of the 20th century through the 1980s, CEOs of corporations were paid salaries and some cash bonus based on their performance. They were paid like bureaucrats. What is the effect of paying a CEO a fixed salary? Well, a CEO of a large corporation should make more than a CEO of a small corporation. It just is sensible. If you're running a bigger operation, you have more to worry about. There's more risk and more responsibility. You should be paid more. So if you looked circa 1975 at the pay of the CEOs of America's public corporations, you would have found a pretty tight correlation between size of the company and pay of its executives. What incentives does that create for CEOs? Well, you want to make more money, make your company bigger. No regard to whether it's more profitable for it to be bigger. No regard to whether society is better off if it's bigger. Just make it bigger. And as a consequence, the 1970s was the era of conglomerates pushing together different businesses that really don't have anything to do with each other. They just get smooshed together to make the company bigger. So you saw companies that have an oil business go into media and distribution and making consumer goods. All these different businesses, which don't really have any synergies. There's no real management expertise that's the same across them. They are diversified conglomerates. And of course the problem for this is as an investor, I can diversify myself. If there's the risk promoting oil companies and that's offset by owning real estate or land, I as an investor can make these different investments myself. I don't need someone else to do the diversification for me. The only reason for a company to diversify is if there are gains in terms of wealth creation from it being owned by a single entity. But if a CEO is paid by salary and salary is correlated with size, CEOs will justify mergers or acquisitions that create conglomerates that don't actually increase efficiency, but they do make the CEO more money. This dawned on academics in two ways. First, the rise of modern portfolio theory and the idea that investors themselves can diversify as owners. There's no reason for the corporate managers to engage in diversification. This was a product of the early 1980s. There was a very famous Harvard Business Review article written about 1992, which is entitled "It's Not How Much You Pay Your CEO But How You Pay Them That Matters." I'm paraphrasing there. But the idea was that the agency cost problem is endemic. It's driving companies to push together companies that don't really have any gains from being combined, but just to get bigger. And how do you make CEOs more accountable to shareholders? Well, pay them like shareholders. If you a CEOs like shareholders and align the interests of the CEO and the shareholders, then you will get performance for shareholders. And what does paying a CEO like a shareholder mean? It means giving them stock in the company. You want to make the CEO accountable to the owners, make the CEO an owner. And if you make the CEO an owner, the CEO isn't going to get big for the sake of getting big. The CEO is going to try to maximize the value of their ownership, which might mean being small and very profitable. Every shareholder would prefer small and profitable to big and unprofitable because the shareholders don't work there. They don't get any benefits from being part of a large corporation. All they see is the financial returns from that corporation. And lo and behold, once companies started paying CEOs in stock, what we saw was the de-conglomeration of the US economy. Companies started splitting up into smaller but more profitable pieces, more agile pieces, and as a consequence, the stock market soared, making CEOs fabulously wealthy. So what are the harms from adding in additional factors like ESG to a CEO's... what the CEO thinks about on a daily basis? So, first of all, it's going to dramatically complicate decision-making because the CEO now has got to weigh various factors not as they affect the company's bottom line, but how they affect society, people's feelings, people's jobs, the environment. All of these different components add increased complexity to corporate decision-making. How do you trade off a corporate decision that makes the environment slightly worse off, still legal, but makes the environment slightly worse off but leads to a bunch of employment? How should we trade off employment versus the environment? How should we trade off increases in the prices of goods and the potential distributional effects that we'll have within society? All of these kinds of questions are not questions that we normally think of as in the role of the ambit of expertise of CEOs. After all, CEOs are trained in business school and they're not politically accountable. CEOs make decisions that society doesn't like. There's too much environmental protection or not enough environmental protection. They're not accountable to the people. They're only accountable to people who are buying their goods, and the people who are buying their goods may not have very much transparency into the environmental practices. If you fill your car up at Exxon, do you really know about the environmental record of Exxon when you're making that decision? It may be that that's just the gasoline station that's closest by. So these kinds of decisions that CEOs are made, they're not really prepared or trained to make them. They're not accountable to the people, which is ultimately who gets to make these kinds of decisions. They add tremendous complexity to corporate decision-making. They didn't complete that increased complexity is likely to increase the error rate for corporate decisions, which puts pressure on companies. They're going to face litigation as a result of that. The job of the CEO is going to be much, much more difficult. Companies are going to have to pay CEOs more money to offset the increased complexity and risk for those jobs. So you end up with a system that is pushing responsibilities onto corporate officials they're not prepared to make, and there's no evidence at all that they would make decisions that are better than what our elected officials would make. The other problem is that the more you decouple corporate performance from some observable metrics that everybody can agree on, the more slack you give for managers to act, even if they're not acting so selfishly, they may just act with less vigor. They may be lazier. They may slack a little bit more because they know, well, if I really put my... If I worked all weekend, I might be able to actually deliver some value for shareholders, but if we don't deliver the value for shareholders, we can sell that based on the fact that we're actually doing good for the environment or workers or for society generally, so I'm not going to put in the extra effort. I've got this wiggle room now that I'm not really being held accountable by any observable metrics like a stock price. The ESG movement has been around for a few years now. Are there noticeable effects in the corporate world? How does a movement like this get evaluated? ESG is having a tremendous impact on corporate America. This didn't start with but really was accelerated by a document that was put out by the Business Round Table and some large investors, Larry Fink at BlackRock was an example, who talked about investment decisions that his fund would be making, that it would only invest in companies that were performing well on ESG, whatever that is. And it's important to understand there is no agreed upon metric for what that is. There is a variety of different indices. They weight different things. There was a recent research paper that came out and said that the ratings are widely variant. They give very different scores to to firms that are doing very similar things and then different indices scored the same firm differently. So there's a lot of uncertainty, and that uncertainty increases agency costs in a way that shareholders, I think, should be skeptical about. But one of the ways to think about what's happening, let's think about it first from the side of the investors and then we'll talk about the company. So from the investor side, there's been a huge change in the American capitalist economy away from people investing in individual companies and towards people investing in broad indices of companies. So instead of owning one company as a shareholder through your 401k, you might own a little slice of every company in the United States. That move towards index investing or passive investing has meant that the ability of investment managers to attract dollars to their funds has been really decreased. It's harder to outperform your rival who is offering you the same package of all the companies in the United States to invest in. So one way that investment funds have tried to differentiate themselves., You should put your money with BlackRock as opposed to Fidelity or TIAA-CREF, is by kind of virtue signaling about how they're focused on ESG. "Put your money with BlackRock. We're going to give you similar returns, but you're going to feel good about it." And that's a way of trying to direct flow so that one way to think about the big ESG push has been basically a public relations stunt run by funds that can't really compete on returns anymore given the rise of passive investing. On the corporate side, this has generated an enormous amount of hand wringing and paperwork on the part of corporations. Companies are increasingly paralyzed by decisions they have to make in the fear that they're going to upset the Twitter mob or the ESG crowd with a particular decision. Again, the people they're going to criticized from might be environmentalists, but the company was trying to maximize the S part or the G part, or maybe it's the other way around. They're maximizing the E part and the S part gets mad at them. So come companies are spending a lot of money in trying to make these decisions, and they're filling out huge documents, these ESG reports. And I've read a lot of these. That's what professors do in their spare time. They're incredibly voluminous. They take a lot of effort to produce them. The companies face liability for any representation they make for shareholders. So the whole production of ESG materials is incredibly expensive and it's important to remember, shareholders are paying for this. This stuff is not produced for free. The impact on corporate decision-making is not for free. The reports that are filed, all of the discussions that are happening at the board level, all that stuff is costing shareholders money. And it's not at all clear what the benefit is. There's a phenomenon called greenwashing, which is companies are still doing the same old stuff. They're just repackaging it and taking activities that get a lot of public attention that make them seem like they're environmental stewards, but they're not really changing their underlying behavior. If we're all susceptible to the marketing that we hear from corporations, what we may end up doing is having shareholders pay a bunch of money to produce a bunch of reports and go through a bunch of kind of show to make it seem like they're actually helping the environment, but really they're not, and all the while increasing agency costs. So the Friedman idea was really have companies stick to doing what they're doing, which is maximize shareholder value subject to the constraints of law and let politicians and elected officials determine what's in the social interest and put those as guardrails around corporate activity. Thank you for listening to this episode of the No. 86 Lecture series on Corporate Law. The spirit of debate of our Founding Fathers animates all of the No. 86 content, encouraging discussion and critical reflection relative to how each subject is widely understood and taught in law schools and among law students. 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