An Examination of the Delaware Public Benefit Corporation Legislation
An Examination of the Delaware Public Benefit Corporation Legislation
The Delaware Public Benefit Corporation is a new legal entity designed for businesses that have strong values or social or environmental missions. Whereas traditional Delaware business corporations place implicit constraints on the purposes of businesses, the Public Benefit Corporation provides greater flexibility and customizability for executives and board members seeking to enshrine their values and mission in the legal structure of their business. This article examines the legislation’s key implications for formation, transition, director and officer duties, stockholder rights of action, and reporting.
On August 1, 2013, a seismic shift took place in the world of corporate governance. With the addition of Subchapter XV of Chapter 1, Title 8 of the Delaware Code, the Delaware legislature added a groundbreaking new section to its General Corporation Law (“DGCL”). This Subchapter allows corporations to elect to be formed as, or convert to, a new business legal entity called a public benefit corporation (“PBC”).1 A PBC is defined by the statute as a for-profit corporation “that is intended to produce public benefits and to operate in a responsible and sustainable manner.”2 Unlike traditional Delaware corporations, in which directors have a duty to focus somewhat narrowly on maximizing stockholder value, Delaware PBCs are freed to focus their decision-making explicitly on creating “shared value.”3 Stockholders of Delaware PBCs are empowered to bring a derivative action to enforce the organization’s stated public benefit purpose,4 which may be, for example, “artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific, or technological” in nature.5 Stockholders of traditional Delaware corporations cannot.6 Delaware PBCs are also required to balance the interests of non-stockholder stakeholders with the pecuniary purposes of the entity,7 whereas the “balance” of interests in a traditional Delaware corporation is already somewhat rigidly predefined: stakeholder interests must generally bow to stockholder interests, though the former may be considered in pursuit of the latter.8
The Fiduciary Duties of Traditional Corporations May Inhibit Directors and Officers Pursuing Publicly Beneficial Activities
For almost a century, Delaware has been the most favored state of incorporation for companies large and small, public and private. It is widely recognized as the world’s incorporation capital. Because investors favor the advantages of Delaware incorporation, Delaware corporations were recently found to trade at a 5% premium over comparable companies incorporated in other jurisdictions.9
The Business Judgment Rule: Broad Protection for Rational Decisions
When reviewing decisions by corporate directors in the day-to-day context, Delaware courts apply the business judgment rule, absent bad faith or self-dealing.10 In essence, the business judgment rule is a rebuttable presumption by courts that, in making business decisions, the directors of a corporation act “on an informed basis, in good faith, and in the honest belief that the action taken [is] in the best interests of the company.”11 This generally provides broad protection for board decision-making outside the context of defensive measures or sale-transaction scenarios.12 If a court, in hindsight, believes a corporate decision to be substantively wrong, “stupid,” or “irrational,” this nonetheless provides no ground for director liability so long as the court determines that the decision-making process was either rational or employed in a good faith effort to advance corporate interests.13 “To employ a different rule — one that permitted an “objective” evaluation of the decision — would expose directors to substantive second guessing by ill-equipped judges or juries, which would, in the long-run, be injurious to investor interests. Thus, the business judgment rule is process-oriented and informed by a deep respect for all good faith board decisions.”14
Stockholder Value Maximization: “Rational” Decision-Making and Nonstockholder Interests
While Delaware courts do not second-guess the substance of director and officer decisions, case analysis of Delaware court decisions illuminates court doctrine that implies that the decision-making process directors and officers implement must seek shareholder value maximization if it is to be considered rational. To do otherwise would be to implement an irrational decision-making process.
In eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1, 33 (Del. Ch. 2010), the Delaware Court of Chancery wrote, “When director decisions are reviewed under the business judgment rule, this Court will not question rational judgments about how promoting nonstockholder interests — be it through making a charitable contribution, paying employees higher salaries and benefits, or more general norms like promoting a particular corporate culture — ultimately promote stockholder value.” (emphasis added) While this holding is frequently cited for the proposition that directors can consider non stockholder interests in their decision-making, the language makes clear that such consideration must be rational; a rational decision is one that is attuned to “ultimately promote stockholder value.” eBay does not provide directors with blanket protection for considering stakeholder interests or promoting non stockholder interests in their own right: to be protected, such consideration or promotion must be rationally related to the promotion of stockholder value.
Delaware Supreme Court dicta in the “intrinsic fairness test” case of Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971) made clear that, when applying the business judgment rule, “the court will not even look at the board’s judgment if there is any possibility that it was actuated by a legitimate business reason. [The Sinclair court’s use of “rational”] clearly does not mean, and cannot legitimately be cited for the proposition, that individual directors must have, and be prepared to put forth, proof of rational reasons for their decisions.”15 Again, while the decision provides directors effectively broad leeway to make decisions actuated by a legitimate business reason, it requires that the decisions be actuated by such a reason. A decision based expressly on promoting nonstockholder interests for their own sake — for the intrinsic value of donating to charity, or paying employees well, or sourcing sustainably — would not be actuated by a legitimate business reason, if it expressly aims to promote non-business impacts regardless of the business’s economic interests, or even to their imminent disadvantage. Such a decision may take on the character of waste.
Public Benefit Activities: “Rational” Decision-Making and Waste of Corporate Assets
In In re Walt Disney Derivative Litigation, 906 A.2d 27, the Delaware Supreme Court considered the doctrine of waste in analyzing exorbitant executive compensation. The court held that a claim of waste will only arise in the “rare, unconscionable case where directors irrationally squander or give away corporate assets.”16 Indeed, “waste” entails any “exchange of corporate assets for consideration so disproportionately small as to lie beyond range at which any reasonable person might be willing to trade.”17 Often, the claim is associated with “a transfer of corporate assets that serves no corporate purpose; or for which no consideration at all is received. Such a transfer is in effect a gift.”18
Though Walt Disney makes clear there is a high bar for committing waste, it also clarifies that Delaware courts construct the default purpose of a business corporation as trade, and treat the notion of a gift as indicative of waste. When a rational relationship between public benefits and corporate economic interests exists, courts will give officers and directors broad leeway to define and pursue innovative, risk-bearing paths to profitability. But the efficacy of that protection hinges on whether directoral decisions “rationally relate” to corporate purposes defined implicitly as the stockholders’ economic interests.
This poses a significant concern for businesses that regard doing good as important for the intrinsic sake of doing good. Whereas the business judgment rule does allow broad protection for directors to pursue decision-making that is rationally related to the company’s financial interests in some direct, immediately conceivable fashion, Delaware corporate law has erected “rationality” and the doctrine of waste as barriers to decisions that may have a more nebulous or uncertain relationship to a company’s financial interests, or for decisions that are simply based on a desire to pursue public benefit for intrinsic reasons. Historically, directors in Delaware corporations have had to craft ways to circumvent those barriers, or abandon public benefit strategies that could cause them to controvert the law’s limitations.
As discussed in the next section, the Delaware PBC legislation assists those directors in two ways: first, by creating a “public benefit-permissive” decision-making legal architecture within which they can pursue dual-purpose outcomes, and second, by creating an entity that is explicitly designed for (and recognizable as) intended to produce dual-purpose outcomes.
The Delaware Benefit Corporation Legislation Both Permits and Requires Benefit Corporation Directors and Officers to Pursue Publicly Beneficial Activities
On August 1, 2013, the Delaware legislature added Subchapter XV of Chapter 1, Title 8 to the Delaware Code, making it the 19th state to adopt benefit corporation legislation. But Delaware’s PBC legislation is distinct from the statutes passed in the other states (and the District of Columbia) in that its statutory regime provides, arguably, the most permissive, flexible, and empowering statute in the country for the achievement of public benefit purposes. We will analyze the key components of the legislation in the following paragraphs.
Benefit Corporation Definition
The Delaware legislation defines a PBC as “a for-profit corporation … intended to produce … public benefits and to operate in a responsible and sustainable manner.”19 The definition requires that a benefit corporation “be managed in a manner that balances the stockholders’ pecuniary interests” with the interests of those “materially affected by the corporation’s conduct,”and the public benefit(s) identified in the entity’s certificate of incorporation.20 Public benefit, under the statute, means “a positive effect (or reduction of negative effects) on one or more categories of persons, entities, communities, or interests (other than stockholders…),” including effects of an artistic, charitable, scientific, and other relevant nature.21 In other words, for a Delaware PBC, pursuing the creation of its stated public benefit becomes a legal purpose of the corporation.
Formation and Transition
A Delaware PBC may be formed by filing a compliant certificate of incorporation with the State. The entity must contain in its name the words “public benefit corporation” or the abbreviation “P.B.C.” or the designation “PBC,” and its stock certificates must note conspicuously that the entity is a public benefit corporation. Aside from these fairly simple adjustments, there is no difference in the required legal procedures for forming a new PBC versus those required when forming a new traditional corporation.
Transitioning from an existing business structure, on the other hand, will likely prove slightly more onerous in Delaware. For a transitioning company, the entity must not only amend its certificate of incorporation to include compliant provisions, but also gain the approval of 90% of the outstanding shares of each class of stock. This high bar to transition to the PBC entity is designed to protect shareholders in a traditional corporation from being forced into an entity with a different governance architecture — and therefore different director duties and shareholder rights for enforcement.
Practically, this requirement of 90% shareholder approval will preclude widely held entities from transitioning to the benefit corporation form unless the entity engages in substantial stock buy-backs, complicated financing and buy-out structures, or extensive shareholder advocacy to effectuate the transition. This means that, for entities that plan to adopt the benefit corporation form, the adoption is achieved most easily early on, before stockholders become too numerous and before the capital structure becomes too complex.
Director Duties: Sword and Shield
Unlike traditional Delaware corporations, directors of Delaware PBCs must manage or direct the business and affairs of the PBC in a manner that balances the pecuniary interest of the stockholders with the other interests described above and in Delaware General Corporation Law (“DGCL”) §365. This is the heart of the Delaware PBC entity and perhaps its most substantial difference from a traditional corporation: rather than focusing shareholder value to the exclusion or detriment of non-stockholder interests, Delaware PBCs are required to balance their pecuniary interests with the interests of those materially affected by the corporation’s conduct and with the public benefit purpose of the entity. This balancing element functions as both a sword and a shield.
It functions first as a “shield” for directors to make decisions that might otherwise be precluded by the economic rationality doctrine applied for a traditional Delaware corporation. Whereas the board of a traditional Delaware corporation might be precluded from espousing an express rationale of promoting a nonstockholder interest adverse to stockholder economic interests, or prevented from formulating a strategy that poses certain public benefit outcomes alongside an uncertain prospect for financial returns, such a board would find protection in the Delaware PBC governance structure. The statute is intentionally permissive in this regard: it mandates balancing, but leaves it up to the entity to determine what the precise balance should be and how to achieve it. Within reason, the entity can identify its own materially affected stakeholders, weight them, prioritize them, and structure a decision-making process to serve them as it sees fit. Likewise, the entity is free to identify its own public benefit purpose and how its public benefit purpose relates to its pecuniary interests. Unlike the benefit corporation statutes of most other states, Delaware’s does not mandate a “general public benefit” purpose, and Delaware PBCs are free to determine what role and priority their public benefit purpose will have relative to the other purposes and interests without a statute imposing an external hierarchy.
To counterbalance this enhanced directoral freedom to pursue publicly beneficial activities, the Delaware PBC statute provides a stockholder “sword” to hold directors accountable to their public benefit purposes. The notion of the stockholder “sword” is addressed in DGCL §367, which expressly provides shareholders owning at least 2% of issued shares the right to bring a traditional derivative action to enforce director duties. Notably, no action can be brought to enforce PBC provisions by anyone other than shareholders who meet the 2% threshold set forth in DGCL §367: no non-stockholders can enforce PBC provisions (this is true of all current benefit corporation statutes). Additionally, the DGCL does not provide stockholders a unique and express right to enforce any PBC statutory provision other than director duties.22
The derivative-enforcement nature of the Delaware PBC “sword” is thoroughly distinct from the accountability mechanisms adopted in each of the other 20+ benefit corporation jurisdictions. Many other benefit corporation jurisdictions follow the benefit corporation model legislation, which wholly precludes any action to enforce or challenge an entity’s activities related to the benefit corporation statute other than through a specialized, statutorily defined “benefit enforcement proceeding.” The benefit enforcement proceeding exculpates directors and officers from any monetary liability for such activities, and precludes enforcement action by any shareholder who owns less than 5% of the issued shares of the corporation.23 In contrast, DGCL §367 does not, as a matter of statutory law, preclude monetary damages for a breach of PBC duties.
One rationale for avoiding the creation of an alternative procedure for bringing a PBC stockholder action is to provide certainty around how the action will be handled by the courts. Because PBC enforcement proceedings are comprised exclusively of derivative suits, Delaware can apply its well-developed body of law regarding procedure and substance for those claims rather than conjuring a whole new body of procedural law to handle them. Although there are some PBC enforcement uncertainties within the derivative action context,24 the standards by which that uncertainty will be addressed are thoroughly established.
Although the PBC’s derivative action provides that an action may be brought for monetary damages related to a failure to pursue the creation of public benefit or otherwise comply with the PBC statute in Delaware, DGCL §365(c) provides that PBCs may significantly mitigate any potential monetary liability arising from a PBC-related breach by including in the certificate of incorporation a provision “that any disinterested failure to satisfy this section shall not… constitute an act or omission not in good faith, or a breach of the duty of loyalty.” This, of course, leaves open the possibility that Delaware PBCs may not be able to exculpate breaches of the PBC’s duty of care.25 But in the traditional conception of public benefit activities, there would be little economic incentive for a stockholder to bring a derivative action for monetary damages; within that conception, a failure to appropriately allocate resources toward public benefit activities is presumed likely to create an economic surplus for the corporation — rather than donating to charity or sacrificing profits to high wages, the corporation retains those earnings as a surplus. Such value-creating (though public benefit-depriving) allocations of resources would not normally be likely to elicit a litigious response from stockholders.26 Thus, actions to enforce duties may be more likely to seek equitable remedies that aim at simply getting directors to properly perform their PBC duties.
Public Benefit Reporting
The final salient attribute of the Delaware PBC legislation is the public benefit-reporting requirement under DGCL §366. Under that section, PBCs are required to issue a biennial statement to stockholders describing the entity’s efforts to promote its stated public benefit. Unlike most other benefit corporation statutes, Delaware PBCs need not publish this report publicly, nor do Delaware PBCs need to, as a matter of law, evaluate their pursuit of creating public benefit according to a third-party standard. While the Delaware statute allows PBCs to use a third-party standard, DGCL §366B simply requires that PBCs state the standards by which the board has decided to evaluate the PBC’s performance with regard to creating its public benefit.
This laissez faire approach to the reporting requirement will likely be viewed favorably by corporate officers and investors, who may prefer to retain discretion over corporate reporting and wish to customize the report according to the desires and interests of the organization rather than the dictates of a third-party standard. Notably, the Delaware PBC statute’s permissive stance on public benefit reporting reaffirms the notion that no PBC legal entity — in Delaware, or elsewhere — needs to attain the “B corporation” certification independently administered by the non-profit organization B Lab, or even use the certified B corporation third-party standard, in order to achieve or maintain its benefit corporation legal status.
Traditional corporations, from a legal perspective, have historically suffered from “profit-purpose redux,” which tends to skew performance measurement and management toward strictly financial indicators. Many competitive strategy theorists have noted that viewing performance through the narrow and superficial lens of profits has shortchanged organizations of the broader view provided by nonfinancial performance indicators. With profit-exclusive legal strictures removed, Delaware PBCs have the ability to re-conceive their competitive strategy to more effectively embody their values, mission, and core beliefs.
Contact the author:
Dirk Sampselle, JD, MBA - B Revolution - firstname.lastname@example.org