The Failure of Corporate Law Fundamental Flaws and Progressive Possibilities

the failure
of cor p or ate l aw



The Failure
of Corporate Law
fundamental flaws
&
pro g ressive p ossibilities

ken t g reen fie ld

the university of chicago press
chicago & london


kent greenfield
is professor of law at Boston College Law School.
The University of Chicago Press, Chicago 60637
The University of Chicago Press, Ltd., London
© 2006 by The University of Chicago
All rights reserved. Published 2006
Printed in the United States of America
15 14 13 12 11 10 09 08 07 06

1 2 3 4 5

isbn-13: 978-0-226-30693-3 (cloth : alk. paper)
isbn-10: 0-226-30693-3 (cloth : alk. paper)

Library of Congress Cataloging-in-Publication Data
Greenfield, Kent.
The failure of corporate law : fundamental flaws and progressive possibilities /
Kent Greenfield.
p. cm.
Includes bibliographical references and index.
1. Corporation law—United States. 2. Corporate governance—United States.
3. Industrial management—United States. I. Title.
kf1416.g74 2006
346.73'066—dc22
2006018111
The paper used in this
publication meets the minimum requirements
of the American National Standard
for Information Sciences—Permanence
of Paper for Printed Library Materials,
ansi z39.48-1992.


for my parents



contents

Acknowledgments ix
part one
1
2
3

4
5

Fundamental Flaws

7

September 11 and Corporate Law 9
Corporate Law as Public Law 29
Workers, Shareholders, and the Purpose of Corporations 41
Corporations and the Duty to Obey the Law 73
Democracy and the Dominance of Delaware 107

part two
6
7
8
9

Introduction 1

Progressive Possibilities 123

New Principles, New Policies 125
Corporate Governance as a Public Policy Tool 153
Workers and Corporate Fraud 187
Irrationality and the Business Judgment Rule 217
Postscript: Getting Real about New Possibilities 241

Notes 245

Index 277



ack n ow l e d g me n ts

This book is the product of more than a decade of teaching and writing in
the area of corporate law. Throughout this time, I have been a member of
the faculty of the Boston College Law School. I could not have completed
this work without the support and good counsel of my colleagues, many
of whom have dedicated numerous hours assisting me in thinking
through the issues discussed here. I am proud to be associated with such
a fine institution and with such an incredible group of colleagues. I also
want to acknowledge Boston College Law School Dean John Garvey, former Law Dean Aviam Soifer, and former Boston College Academic Vice
President John Neuhauser, all of whom supported my research and writing throughout their tenure in leadership positions at Boston College.
Many of the arguments put forth in the book were first developed and
tested in classrooms at BC Law School. Insofar as my arguments are persuasive, it is because they were tested against the intellect of students who
can be counted among the best, brightest, and most dedicated in the
country. Particular thanks go to my research assistants over the past
several years: Michael Carney, Catalina Girald, Kate Devlin, Amanda
Gordon, John Hong, Scott LaFranchi, Travis Norton, Samuel Price, Jason
Radford, Lauren Schumer, Lawrence Sheh, and Christine Westbrook.
Thanks, also, to my editors at University of Chicago Press, particularly
Alex Schwartz,who quickly recognized that something in this project was
ix


acknowledgments

worth pursuing. I much appreciate his support and encouragement
throughout.
A coauthor of mine deserves special mention. John E. Nilsson was a
student at BC when he and I started working together on a project using
Dickens to analyze aspects of corporate law. We eventually published a
piece entitled Gradgrind’s Education: Using Dickens and Aristotle to
Understand (and Replace?) the Business Judgment Rule, 63 Brooklyn L.
Rev. 799 (1997). John’s work was essential to the success of that article. As
chapter 9 in this book was derived in part from that article, it is important
to acknowledge here John’s excellent contributions to our earlier collective work.
Portions of this book spring from articles I published previously.
Chapter 1 is similar to September 11 and the End of History for Corporate
Law, 76 Tulane L. Rev. 1409 (2002). Chapters 2 and 7 are derived in part
from Using Behavioral Economics to Show the Power and Efficiency of
Corporate Law as a Regulatory Tool, 35 U.C. Davis L. Rev. 581 (2002).
Chapter 3 is based on The Place of Workers in Corporate Law, 39 B.C. L.
Rev. 283 (1998). Chapter 4 is based on Ultra Vires Lives! A Stakeholder
Analysis of Corporate Illegality (With Notes on How Corporate Law Could
Reinforce International Law Norms), 87 Va. L. Rev. 1279 (2001). Chapter 5 is
based on Democracy and the Dominance of Delaware in Corporate Law, 67
J.Law & Contemp.Prob. 135 (2004).Chapter 6 derives from New Principles
for Corporate Law, 1 Hastings Corp. L.J. (2005). Chapter 8 is based on The
Unjustified Absence of Federal Fraud Protection in the Labor Market, 107
Yale L.J. 715 (1997). Chapter 9 is derived from Gradgrind’s Education: Using
Dickens and Aristotle to Understand (and Replace?) the Business Judgment
Rule (with John E. Nilsson), 63 Brooklyn L. Rev. 799 (1997). I thank these
journals for their excellent assistance in the editing of the original articles.
Portions of this book have been presented at faculty workshops
at the law schools of Fordham University, Georgetown University,
Georgia State University, Hofstra University, Loyola University (Los

Angeles), Quinnipiac University, Roger Williams University, Seattle
University, University of California at Los Angeles, University of
Connecticut, University of Georgia, University of Limerick, Yeshiva
University (Benjamin N. Cardozo School of Law) and at Brooklyn Law
School. I thank the participants at those workshops for their substantial
contributions. I also have gained much in discussions with other participants in Corporation 2020 (corporation2020.org), a group of scholars,
activists, and business leaders analyzing and redesigning the corporate
form.
x


acknowledgments

Finally, as any author can attest, a book is never the work of one person.
I have benefited immeasurably from a host of friends, colleagues, and
family members on whom I have depended intellectually and emotionally during the development of this project. The book would have been an
impossibility but for them, and I am deeply indebted to them. I especially
want to acknowledge and thank: Jeff Bercuvitz, Victor Brudney, Michael
Cassidy, Linda Caswell, Daniel Coquillette, Lawrence Cunningham,
Nicholas Georgakopoulos, Janet Gilmore, Phyllis Goldfarb, Kirk Greenfield, Liam Greenwell, Don Hesse, Daniel Kanstroom, Robert Katz, Peter
Kostant, Dana McSherry, Lawrence Mitchell, Jane Moscoe, Joseph Singer,
David Souter,Kara Suffredini,Kellye Testy,Greg White,and Adam Winkler.
I dedicate this book to Barbra and Harold Greenfield,my parents.They
gave me the gift of expecting me to think for myself.
The achievements of this book I share with all of these, and with many
still unmentioned. The failures are mine alone.
Melrose, Mass.
November 2005

xi

int ro duc t ion

My son, Liam, and I were playing some time ago in Boston’s Public
Gardens, near the statues of the main characters in the children’s book
Make Way for Ducklings. Liam, who at five was constantly trolling for new
words, turned to me and asked what the word “public” meant. I told him
that if something is “public,” it belongs to everyone.
If I gave a similar answer to the students in my corporate law course, I
would be lying. When used in connection with corporations, the word
“public”means that they are owned by shareholders who buy and sell their
shares in an open market. “Public”corporations are not public in any sense
of having responsibilities to society, or of being owned by the community,
or of being subject to particularly stringent public oversight. In fact, managers of most large,“public” companies are prohibited by law from taking
into account the interests of the public when making decisions, if in so
doing those of the company’s shareholders are harmed.
This was not always the case. For much of the history of the United
States, “public”corporations were deemed to have important civic responsibilities. At the beginning of the twenty-first century, however, “public
corporation” is among the most misleading terms in all of law or business.
In my view, the public should have a much greater say in how corporations are governed. Notwithstanding the terminology, public corporations
are typically seen as private institutions, and the law governing them is
1


introduction

considered a branch of private law (along with contract and property
law), which governs relationships among individuals. But the laws controlling corporations should be much more protective of the public good

and of the corporation’s stakeholders, such as employees, and the law of
corporations should be evaluated more as a branch of public law, the kind
of law that concerns society more generally, such as constitutional law or
environmental law. Once corporate law is correctly seen as public law, it
will be clear that significant changes should be made.
At first glance, it may be difficult to grasp the importance of corporate
law at all,much less the consequence of a shift from a private conception of
corporate law to a public one. The existing law governing large corporations in the United States is fundamentally flawed, and those flaws cause
wide-ranging and serious harms in the United States and elsewhere. These
harms include not only the corporate scandals that periodically come to
light, but broader harms such as artificially low wages for working people,
environmental degradation, and an even higher risk of terrorist attacks.
They could be avoided, however, since the defects that cause them are neither inherent nor essential in corporations or in corporate law. We could
choose to excise these flaws and still have a vibrant economy that creates
wealth. Indeed, the United States could choose to organize corporations
differently in a number of ways, and—if the right choices were made—
most of us would be better off.
The difficulty is that these flaws, while not inherent in the way we do
business in this country, do indeed lie at a very foundational level and are
often insulated from attack. One example of this kind of defect is shareholder supremacy, the rule that managers of a corporation must pursue
shareholder benefit above all else. This rule goes largely unquestioned in
most texts used in law schools, even though it creates a gladiatorial culture within businesses that makes corporate scandals more likely and
makes it less likely that corporations will take into account the concerns of
other stakeholders (say, those of workers for more stable jobs) or the public interest (say, in safer air travel, healthy food, or clean skies).
Other aspects of corporate law, though terribly flawed, are lauded as
beneficial aspects of corporate governance.An example is the dominance
of the state of Delaware in providing the laws of corporate governance.Six
of every ten of the nation’s largest corporations choose to incorporate in
Delaware. Because of a legal rule called “the internal affairs doctrine,”
Delaware gets to set the rules of corporate governance for those companies, even though most of the companies have little or no connection to

the state other than filing their incorporation papers there. The result is
2


introduction

that a state with less than one-third of 1 percent of the nation’s population
is allowed to govern a majority of the nation’s most powerful businesses.
The mainstream view among contemporary corporate law scholars is
that corporations’ preference for Delaware law shows that Delaware is
offering the best, most efficient law available. If the corporations didn’t
like the law Delaware provided,they would simply incorporate elsewhere.
This creates a “race to the top,” ensuring that states compete to provide
good law, to everyone’s benefit.
The more likely story is that corporations prefer Delaware law not
because it is most efficient but because Delaware offers corporations a
way to bypass democratic pressures and to export the costs of its legal
structure to other states. Delaware’s dominance is hardly a testament to
efficiency. It is rather a product of legal rules that are wrongheaded, inefficient, and undemocratic.
In this book I will catalog these and other core failures of traditional
corporate law, but deconstruction is not the sole goal. In addition, I will
spell out some concrete proposals for changes in the law governing corporations.I will argue that these changes will not only make corporate law
more coherent (certainly a goal for law professors if for few others) but
also more beneficial to society generally. Indeed, I will suggest that corporate governance law should be seen as a regulatory tool, and a powerful
one at that, to address some policy problems that have otherwise been
quite intractable over the years. Concretely, I will argue that improvements in corporate governance would have positive impacts on (at least)
two of the knottiest economic problems of the last 20 years: stagnant
wages for blue-collar workers and stark income inequality. In other
words, corporate law has great promise, if we can harness it as a progressive force.
In making these arguments, I will use concrete examples and evidence

to bolster the persuasiveness of the new ideas set out here. Throughout
this book I not only use theoretical and logical argument but also look at
cases, economic statistics, and behavioral science to build the argument
that the existing framework is fundamentally flawed and that a different
framework holds promise of great improvement. Beyond these, however,
I do not attempt to amass a comprehensive set of empirical data necessary
to convince readers who are unmoved by theory. For some of the arguments made here the empirical research simply has not been done; for
other questions the research is only beginning. In any event, it is not the
purpose of this book to catalog empirical data on corporate governance
regimes. Rather the purpose of this book is to expose the flaws of main3


introduction

stream corporate law theory and to argue the reasonableness of an alternative theory that would likely create outcomes that are more democratic
and more beneficial.
My focus on theory will beg comparison with the leading defense of
the mainstream, law-and-economics view of the corporation, Frank
Easterbrook and Daniel Fischel’s The Economic Structure of Corporate
Law. Published in 1991, Easterbrook and Fischel’s book was the definitive
theoretical account of corporate law from a neoclassical, contractarian
perspective. It has had a huge impact on the scholarship, pedagogy, and
doctrine of corporate law, becoming perhaps the most significant book
in the field since Adolf Berle and Gardiner Means’s 1932 master work
The Modern Corporation and Private Property. In fact, the impact of
Easterbrook and Fischel’s book is such that it has become one of the most
cited books in all of law, in any area of doctrine, in the last 25 years.1
Though countless scholars have used it as both a starting point or target,
there has never been a comprehensive, theoretical response to Easterbrook and Fischel from the stakeholder perspective. This book is intended to fill that gap.
Easterbrook and Fischel’s analysis depends on legal and economic theories, and, in answering them, my style is similar for the most part. But it

would be a mistake to have the debate be only about theory. The arguments
here, and the arguments of the mainstream corporate law theorists, should
be tested.If this book is sufficiently persuasive to bring into doubt the mainstream view so that scholars will test my arguments against those in defense
of the status quo, then this book will have been a success.
This book comes at a moment of significant intellectual ferment among
scholars who study corporations. While the mainstream view of corporations and corporate law continues to hold sway in most court opinions and
at the most prestigious law schools, a growing number of scholars are
contesting some of the basic tenets of the dominant school.Disagreements
go to the heart of the discipline: what corporations are; who owns them;
whether they are public or private institutions; whether managers should
be charged with maximizing profits only or taking care of other social
goals. There is now more disagreement than perhaps in any other area of
law, and the disagreement is at the very core of the discipline.
The question is, of course, so what? Why should anyone care who does
not teach or work in the area? The answer is that corporate law determines the rules governing the organization, purposes, and limitations of
some of the largest and most powerful institutions in the world. The
4


introduction

largest corporations in the world have the economic power of nations. By
establishing the obligations and priorities of companies and their management, corporate law affects everything from employees’ wage rates
(whether in Silicon Valley or Bangladesh), to whether companies will try
to skirt environmental laws, to whether they will tend to look the other
way when doing business with governments that violate human rights.
Corporate law is a big deal. And it is an even bigger deal when one realizes that the United States is actively exporting its corporate governance
norms to the rest of the world by way of the World Trade Organization, the
Organization for Economic Cooperation and Development, and various
trade agreements. If U.S. corporate law is flawed in our own society and

culture, as I believe it is, imagine the difficulties that will arise as this
flawed regime is transplanted elsewhere.
The purpose of this book is to provide grounds to challenge the dominant vision of corporate law in the United States and the other countries
where our corporate law is being adopted. I intend to show how changing
certain foundational assumptions about corporations and the law that
rules them would have meaningful implications for how we think about
corporations and corporate power. I will also propose concrete, achievable adjustments to law and policy that would create real, positive change.
My central claim in this book is that most of us in the United States, as
well as many people throughout the world, would be better off if corporate law were different.We could have better jobs and more money in our
pockets; our rivers and beaches and skies could be cleaner; we could be
safer from crime and terror. Our food could be healthier; the products we
buy could be more reliable.We could trust our employers—and indeed our
employees—more; our communities could be stronger; our politics could
be cleaner. The changes I propose are not panaceas, of course. But the
debate over corporate law is much more important than most people realize, and it should be the concern of more than corporate lawyers and corporate law professors. Indeed, that corporate law matters is this book’s
most audacious claim.

5



part one
fundamental flaws

Much has been written over the past several years about the problems
with corporations and how they are regulated. The corporate scandals of
the first few years of the twenty-first century were serious enough to create widespread concern about the accountability of corporations in the
United States. Time and Newsweek ran cover stories; prosecutors brought
high-profile cases against miscreant executives; art-house cinemas played
documentary films revealing the excess of corporate power.1

These efforts to critique America’s business culture are not new or particularly surprising. This nation has seen a number of periods in which
corporations were the object of popular criticism and distrust, including
the late nineteenth-century populist attacks of William Jennings Bryan
and Theodore Roosevelt, the New Deal of the 1930s, and more recently in
the anti-multinational and pro-environment movements of the 1960s and
1970s.A key difference between these earlier eras of discontent and today
is that the earlier critiques depended on not only political and cultural
attacks but on scholarly condemnation as well. Today a populist critique
of corporate power and globalization is taking hold, but scholars, particularly legal scholars, lag behind. Even though the recent corporate scandals revealed widespread discontent about the power of corporations in
America, most corporate law professors in most American law schools

7


fundamental flaws

continue to teach corporate law the way it has been taught for decades,
seldom questioning its fundamental assumptions.
Part 1 highlights several fundamental assumptions that deserve rethinking. These include the corporation’s fixation on profit; the propensity of the firm to cast the costs of its behavior onto others; and the
widespread notion that corporate law is private law, presumptively free of
government regulation. Also critiqued here is the law’s requirement that
the shareholders reign supreme and the workers be seen only as hired
hands. This part also questions the notion implicit in corporate law doctrine that corporations do not have the same obligation to obey the law as
the rest of us. The last chapter in part 1 focuses on the bizarre fact that
Delaware is almost completely dominant in providing the corporate law
of the United States and questions whether such dominance is democratically legitimate.
Of course, this list is not exhaustive of the foundational assumptions
that deserve dismantling. But it is a good start, and changing even these
few would give the nation an excellent shot at taking some of the positive
steps set out in part 2.

8


1
s e p te m b e r 1 1 a n d
cor p or ate l aw

The horrors of September 11, 2001, are still fresh in our hearts and minds,
and not just for those who lost dear ones. The war in Iraq is even fresher.
These are the two biggest news stories of the new millennium so far, and
they are inextricably linked—at least in the sense that the horrors of
September 11 made the Iraq war politically possible. Another of the big
news stories of the last few years was the corporate scandals of 2002.
These scandals brought about the largest bankruptcy in history, a host of
criminal convictions, billions of dollars in shareholder losses, the evaporation of thousands of jobs, and the spoiling of the public’s confidence in
the stock markets and corporate accounting practices. While much has
been written about the connection between the first two events, little has
been said about their connection to the corporate scandals and to corporate law more generally. Unfortunately, there is something to say.
At first glance, it seems obtuse or heartless to talk about corporate law
in connection with the attacks of September 11 and the war in Iraq. It is
indeed obtuse or heartless to say that corporations or corporate law
caused the events of September 11 or brought about the war. It is, however,
correct to say that corporations and corporate law helped create both the
context in which the tragedy of September 11 could occur and the contours of the nation’s response to it. Corporate law made the tragedy of
September 11 more possible, and thus made the war in Iraq more likely
9


fundamental flaws

as well. This connection between corporate law and the attacks of
September 11 is a worthy case study in the flaws of U.S. corporate governance.

september 11 as market failure
Soon after the attacks, many analysts pointed fingers at slipshod airport
security as one of the necessary conditions for the attacks.It may be unfair
to assert that the security personnel working at the airports from which
the hijacked flights departed had failed in their jobs in the strict sense of
the word. The hijackers used pocket knives and box cutters to hijack the
planes, neither of which was prohibited by airline regulations at the time.
Having said that,it does not require a leap of logic to assert that the hijackings could have been prevented by a more attentive security staff (is it not
unusual to have several passengers carrying box cutters on the same
flight?) or security regulations or policies that made safety a higher priority (why did airlines not bar passengers from carrying box cutters?). So
the question arises: why was security so porous that morning?
One possible answer would be that security was flawed that morning
because air travelers did not want or feel they needed anything better.
Airport security on September 11 was largely the responsibility of the airlines and of security firms the airlines hired. Because airline companies
are for-profit corporations operating in a “free market,” traditional economic theory would suggest that the market provided what the consumers desired. If travelers had truly wanted more safety, they would have
demanded it and the airlines, in turn, would have given travelers what
they demanded. The cost of airfares would have necessarily increased to
pay for the additional security. To traditional economists, the fact that
security was not any better on that day means simply that the airlines’customers were not willing to pay what it would cost to have the kind of
screening that would deter the hijackings.
If this economic theory is correct, the correct public policy response to
September 11 would be to trust the market. If people wanted to have better airport security, they would demand it. Air travelers willing to pay
more in exchange for additional safety would provide the economic
incentive for airlines to respond to travelers’ desires, and airlines would
start competing to provide additional safety and security.
It is striking that among all the major investigations and analyses of the

hijackings, not a single one proposed that we should simply allow the
market to work.Instead,the very first public policy response to the hijack10


september 11 and corporate law

ings was just the opposite. Barely two months after the attacks, Congress
voted to federalize the passenger screening function, taking that portion
of the responsibility for airport security away from the airlines and giving
it to a newly created federal agency.
Of course, anyone who travels knows that the new agency is not without its own problems—going through airport security remains a frustrating, inefficient, and occasionally infuriating task. No one has seriously
suggested, however, that the security function be given back to the
airlines. Few trust the economic theory that much. Even though we know
the government agency has its own serious flaws, it is as if September 11
helped us realize at a fundamental level that we cannot trust airlines to
provide the kind of safety we now know we need.
This is why September 11 is not only a story of how fanatic zealots
committed murder on a grand and horrific scale. It is also a story of market failure, of how the market for air travel failed to provide not only what
we needed but also what we would have wanted had we known how
unsafe we really were. This begs the question, then, of why such a market
failure occurred. Why did the airlines not provide better safety? Or more
fundamentally, why did the free market not provide better safety?
To answer these questions one needs to recall that the airlines contracted out the responsibilities of staffing the security checkpoints to private, for-profit security firms. These firms bid on these contracts on the
basis of cost. It is no surprise, then, that the screening firms paid their
workers little more than minimum wage, which made it difficult to attract
the best people. Turnover among screeners averaged over 125 percent
annually, meaning that on average a new person was hired for every position more than once per year.1 Because of the low pay, many of the screeners had to work at some other job as well, making them exhausted and
unable to concentrate effectively. Many of the contractors did not offer
health insurance or paid sick days. As a result, according to the New York
Times, “many screeners report[ed] to work sick and struggled to remain

alert.”2 The fixation on keeping costs low meant that training of checkpoint screeners often consisted of little more than watching a videotape
and receiving about one hour of on-the-job training. A government
report issued barely 18 months before September 11 warned that the
screeners’low pay, poor training, and high turnover posed real risks to the
safety of air travel.3
Sadly, the risks were largely ignored until it was too late. Only after the
tragedies of September 11 did people finally realize that the fixation on low
costs was a massive error.
11


fundamental flaws

It is worth thinking about why screeners’ wages were so low to begin
with. One thing is clear, at least in hindsight: wages were not low because
travelers were unwilling to pay a few dollars more for airline tickets so that
the security firms could pay for good training and decent wages for
screeners. In this respect, the market failure was in large part an information failure. Most people who traveled simply did not know the risks and
did not know how flawed the screening was. To use myself as an example:
Before September 11, 2001, I did not know that airport security was the
responsibility of the airlines, and I traveled often. I assumed travel was
safe. I assumed that someone—the government, really—made sure that
airport security was tight. I was mistaken, as many were.
One reason why we did not know that air travel was unsafe was that the
airlines themselves did not have the incentive to tell us. Because their
interest was to maximize air travel, no airline had any reason to warn travelers that it was possible for teams of fanatics to use box cutters to hijack
planes, fly them purposefully off course for more than an hour, and propel them like missiles into skyscrapers. Much of the information about
the risks of air travel was in the hands of the airlines, and their desire to
make money meant that there was no way they were going to tell us about
those risks.

Moreover, even if one of the airlines had wanted to distinguish itself as
the “safe” airline, it would likely have failed. The reason is that such marketing would have had little meaning to travelers. Because most travelers
assumed air travel was safe, it would have been difficult to make believable claims about the distinctiveness of one airline over another, at least
without panicking the traveling public. In other words, no one traveling
on September 11 really knew how dangerous it was. Some of the risks were
unknowable, to be sure. But the risks that were known were not known by
the travelers, and the market did not provide an incentive to give travelers
that knowledge.
The market failure was more than an information failure, however.
Even if I had known that screeners were poorly paid and trained and that
security was flawed in other ways, my options would have been extremely limited. I could not have volunteered to pay more for my air
travel in exchange for more security. A travel agent would have chuckled
at such a request. I could not have sought out a safer airline, since all the
airlines (at least in the United States) provided basically the same apparent level of safety. Even if I had known how risky air travel really was, the
market would not have provided me a way to satisfy my desire for a safer
trip.
12