Notice & Comment

Essential Businesses and Shareholder Value, by Aneil Kovvali

The COVID-19 crisis vividly demonstrated that Americans rely on certain for-profit corporations to supply the essentials of everyday life. Even in a crisis situation in which the government had assumed an extraordinary role and extraordinary responsibilities, it was deemed necessary for workers handling “essential” tasks to risk infection by continuing their work at private companies. Our society’s capacity to meet basic needs in a crisis thus seems entirely dependent on the capacity of private corporations, which in turn is determined by the decisions of the people with authority at these companies.

At the same time, those people have limited incentives to consider the full implications of their decisions. Under a conventional understanding of corporate law, corporate officers and directors have an obligation to maximize the value of the corporation for the benefit of its shareholders, without considering the interests of other stakeholders like employees or customers. While this legal understanding does give corporate actors practical discretion to consider a broad range of issues as they pursue long term profits, powerful incentives encourage directors and officers to use their discretion to generate quick returns for shareholders. As a result, corporate actors will generally consider issues like employee or customer welfare only to the extent that external factors like legal liability or business dynamics make their welfare relevant to shareholder profits. In addition, corporate actors are normally encouraged to take risks by the business judgment rule, which insulates them from liability for a broad range of decisions taken in good faith. The risk-taking encouraged by the rule normally benefits shareholders, who are generally able to diversify away risks at an individual company by holding a portfolio of stocks.

These principles lead to odd results in a pandemic. External sources of liability like tort lawsuits are unlikely to cause a business to internalize the full costs of its decisions in a pandemic, meaning that a corporation can cause harm without having to pay damages or reduce the corporation’s profits. These harms are amplified at essential businesses, which are likely to keep operating and thus keep causing harm even in the midst of a pandemic. And disruptions to the operations of an essential business are likely to cause downstream impacts on the operations of other businesses – the importance of their goods and services to other businesses and to consumers is part of what makes an essential business essential. As a result, shareholders cannot diversify away the risks that such firms create.

There are some conventional responses to these issues, but they are likely to prove inadequate. First, the government can use emergency powers like those accorded by the Defense Production Act to force essential businesses to carry out necessary tasks. But this power to reshape incentives in the midst of a crisis would do little to improve critical decisions before the crisis and might have undesirable effects. Companies may, for example, anticipate that the government will use its emergency powers to facilitate continued operations during a crisis regardless of safety and thus deem it unnecessary to invest in safety precautions in advance. And if investors expect that emergency powers will be used against critical businesses in a crisis, they may avoid investing in those businesses in the first place.

Second, the government might seek to impose regulations that require businesses to adopt appropriate measures before a crisis. But to be effective, such rules must be set appropriately, corporations must expect that they will be enforced appropriately, and corporations must react appropriately to the regulations that are in place. Political actors with fixed terms, focused on expected costs and benefits, and lacking information uniquely in the hands of corporate leaders are unlikely to adopt appropriately stringent regulations in advance of a crisis. Once a crisis struck, regulators would be understandably reluctant to enforce them against essential businesses, particularly if enforcement might disrupt their operations.

Corporate conduct and incentives can exacerbate these regulatory problems. Corporations are likely to lobby against new regulations that would impose costly burdens. Once a crisis struck, corporate leaders are likely to lobby against enforcement and to threaten noncooperation with other efforts to contain the crisis. Given the power and role of essential businesses, their lobbying efforts are likely to be quite successful. Anticipating this, corporations are unlikely to fully comply with a new regulation before the crisis struck. Corporate officers and directors may also expect to be safely retired or in their next gig by the time of any catastrophe, making them reluctant to take costly precautions that are unlikely to help the company’s stock price.

This suggests a role for corporate governance. Bad corporate decisions about pandemic preparation create problems for shareholders and for a broader range of social stakeholders. Diversified shareholders will experience many of these losses indirectly, both as human beings living in an ailing society and as investors in other companies. Indeed, they will be unable to diversify away the risks associated with such losses, because those risks will strike all areas of the economy. But the losses will not be fully reflected in any individual company’s stock price. As a result, individual corporations running essential businesses are likely to underinvest in protective measures and to seek to eke out additional profits, even at the expense of redundancy or resilience.

To address these problems, modifications to corporate doctrine may be in order. In the wake of a financial contagion a decade ago, professors John Armour and Jeffrey N. Gordon suggested modifying fiduciary duties and the business judgment rule at systemically important financial institutions.[1] The analysis above would support a similar set of modifications at firms that are important to society’s capacity to weather a true contagion. The paradigm case would be firms whose operations are essential in a crisis but also have potentially devastating effects. A real case could also be made for firms whose operations are simply essential in a crisis. In either case, corporate actors must be given incentives to make appropriate preparations for a crisis if economic and social harm is to be avoided.

One way to provide incentives would be to impose liability upon directors and officers at corporations running large, essential businesses whose unapproved or inadequate action or inaction prior to a crisis renders the essential business unable to operate safely at appropriate levels during a qualifying crisis. If each of these predicates were satisfied, the directors and officers would be liable up to an amount not to exceed a set number of years of compensation prior to the crisis. While it is possible to imagine other plausible enforcers, shareholders would be particularly effective plaintiffs.

Each element would require explanation and justification. First, directors and officers have responsibility for monitoring and running the corporation and are a natural target for the reform. Second, the motivating problems described here are at their worst at large essential businesses like major food processors, which have the greatest ability to cause disruptions to the overall system. Third, focusing on decisions prior to a crisis would avoid interfering with government efforts to keep operations going during a crisis. Fourth, making failure to maintain safe operation during a crisis the trigger for liability maintains an appropriate focus on what society needs from essential businesses and the people who lead them. Fifth, limiting liability to a set number of years of compensation would avoid excessively chilling valuable behavior by corporate actors. The important goals of fostering safety and resilience must be balanced against the goal of pursuing efficiency, and the liability regime should not push corporate actors too far in one direction. Finally, shareholders would be effective plaintiffs. Public regulators could have an incentive to ignore some violations, and other stakeholders like workers would be better protected by other areas of law.

If properly calibrated, the regime would improve the incentives of corporate leaders and facilitate more effective regulation. For example, the system would focus on unapproved conduct. If a regulator specifically considered the risk of a crisis and adopted a regulation setting out adequate precautions, the regulation would serve as a safe harbor. Unless the corporation had been aware that the regulation was inadequate because of information not available to the regulator, compliance with the regulatory standard would defeat liability. This aspect of the scheme would encourage corporations to affirmatively encourage regulators to address these risks, and to share relevant information.

There is room for reasonable disagreement about particular implementation choices. But regardless of the details, it is necessary to rethink the relationship between business and government. In the wake of COVID-19, we are (or at least ought to be) entering a period of robust government action in which the state assumes greater responsibility for ensuring the safe and resilient production and delivery of goods and services to its citizens. If corporations are set up to work with the social consensus, they can generate enormous value for their shareholders and stakeholders, justifying the trust placed in them by society. If they are set up to fight and undermine the social consensus, they will reduce the effectiveness of government regulation and damage their own standing. A liability scheme could be one useful step toward properly orienting corporations.

Aneil Kovvali is a Harry A. Bigelow Teaching Fellow and Lecturer in Law at the University of Chicago Law School. This post is based on his recent article, “Essential Businesses and Shareholder Value,” available here.

[1] John Armour & Jeffrey N. Gordon, Systemic Harms and Shareholder Value, 6 J. Legal Analysis 35 (2014). For related proposals focused on financial institutions, see David Min, Federalizing Bank Governance, 51 Loy. U. Chi. L.J. 833 (2020) and Steven L. Schwarcz, Misalignment: Corporate Risk-Taking and Public Duty, 92 Notre Dame L. Rev. 1 (2016).