A Legal Theory of Shareholder Primacy

Shareholder primacy is a foundational concept. The principle of profit maximization goes to the most basic question: What is the purpose of the corporation and corporate law? Although normative debate has persisted over many generations of economic history and academic scholarship, we are in a shareholder-centric era as a factual matter. Yet, remarkably, the question of whether shareholder primacy is positive law remains unresolved even today.

Shareholder primacy is universally described in scholarship as a “norm” but seldom as “law.” Viewing the concept of law through the prism of fiduciary duty, managerial authority, and the business judgment rule, opponents reject the idea of law; some diminish shareholder primacy further as an “ideology” or “dogma” or “belief system.” On the other hand, proponents place undue and hackneyed reliance on a single 1919 case fr om Michigan, Dodge v. Ford. Essentially this is wh ere the debate on a positive legal theory stands. It is unsatisfactory. The basic question—“what is the law?”—has not received sufficient empirical or theoretical analyses. In a forthcoming article in the Minnesota Law Review, I advance a positive legal theory. The article answers these basic questions: Is shareholder primacy law? If so, how does it work?

The answers require a systematic empirical review of judicial discussion of shareholder profit maximization. This analysis shows that in the period 1900‒1979, courts were virtually silent on the idea of profit maximization. However, starting in the mid-1980s, judicial discussion of the concept increased sharply.

In light of well-known business, economic, and intellectual histories, the hockey stick pattern of cases with the 1980s as the inflection point should not be surprising. The data is confirming. Shareholder primacy is judge-made law. In the past several decades, courts have recognized shareholder profit maximization at the factual level of business practice (recognition); they have applied the idea in the process of reasoning toward the case holding or issue resolution (application); they have integrated the idea as a rationale for other principles or rules of corporate law (integration); more recently, they have prescribed profit maximization as an unconditioned obligation (dutification). These varying levels of judicial embrace across many jurisdictions and over a long period have legal and jurisprudential significance.

The form of law is important. Shareholder primacy and managerial authority cannot coexist in a rule‒sanction form, i.e., law in Austinian form. Such coupling would be incoherent within the structure of corporate law. The legal mechanism of shareholder primacy must work within these constraints: (1) managerial authority is a rule‒sanction form, and as such it is a first order rule with independent dignity; (2) shareholder primacy is a rule‒no sanction form, and as such it is a second order rule, subordinate to any first order rule in a conflict; (3) the purpose of the first order rule is to serve the second order rule at the level of prescription, and as such the latter must be efficacious in spite of the former. When the problem is framed in this way, we see why, in the absence of an enforceable fiduciary duty, the legal status of shareholder primacy has been opaque and contestable for so long.

The missing idea in a positive legal theory of shareholder primacy is that law can be expressed by the government as an obligation without sanction if the application of such police power would undermine other important rules and a sanction is not needed to achieve efficacy of the law’s prescription.

Law can and often does achieve efficacy through a simple command: do X or else suffer penalty P. Fiduciary duty is in this form of a liability rule. However, Hart famously showed that law need not be exclusively in Austinian form. Scholars in the fields of jurisprudence and social norms have modeled complex ways in which unenforceable law can achieve efficacy. Due to the necessary coupling of a first order and second order rules, the legal mechanism of shareholder primacy is complex and has multiple pathways to efficacy: (1) legal legitimacy, (2) positive and negative incentives, (3) litigation risk, (4) norm.

Corporate law partially achieves the end of shareholder primacy in the transactional context through the rule‒sanction form in two discrete pathways. In realm of corporate finance, when there is an inter-security conflict of interest among capital providers, corporate law mandates that common stock value maximization over the interests of creditors and preferred stockholders. In the realm of takeovers, corporate law imposes the Revlon duty to maximize shareholder wealth in a change of control. However, these rules only go so far, limited to their specific transactional contexts.

As a general rule applicable to the vast realm of day-to-day managerial decisionmaking, shareholder primacy is founded on pervasive judicial acceptance. The form of law is a Hartian obligation: it is recognized and institutionalized by courts; it is an important rule imbued with a seriousness of social pressure; it is said to be foundational to corporate law and governance. This social pressure may be inconsistent at times with the manager’s own value system, but nevertheless she may feel compelled to obey the rule. Reproach directed at one who deviates from the rule would be considered a legitimate social response. And, occasionally we see in cases like Dodge v. Ford the expressive value of such rebuke. Thus, judicial embrace has legitimized shareholder primacy and given it a cloak of legal authority.

The corporate and legal systems advance shareholder primacy through positive and negative incentives. Two major incentive systems are equity-based executive compensation and the market for corporate control. Also, because other rules of corporate law are justified on the rationale of shareholder wealth maximization, the obligation to maximize profit creates legal uncertainty and litigation risk for corporate managers. The incentive, then, is to comply with the obligation as the path of least resistance even though the rule is unenforceable as an independent duty.

Lastly, a legal obligation legitimizes the normative view held by much of the academic, policy, and business communities. It institutionalizes and thus strengthens a social norm, which promotes greater compliance even if there is little risk of a legal sanction for deviations due to the business judgment rule.

In conclusion, the law of shareholder primacy is complex, efficacious, and efficient. The rule is complex because it must harmonize first order and second order rules that is unique to the structure of corporate law while respecting the independent dignity of both rules. It is efficacious because the rule has been internalized by managers even though it is unenforceable. It is efficient because it achieves compliance at minimal cost. Whether the rule is socially efficient, equitable, or ethical—all contestable points—is in the domain of normative theory. However, the normative debate and policy prescription must be informed by a positive legal theory. The cause and effect of shareholder primacy rests on a legal foundation, and not some general notion of collective social belief that perhaps can change with enough suasion or argumentation. Any policy prescription that follows from a normative theory must contend with the law of shareholder primacy.