Responsible capitalism is all the rage. From the Business Roundtable to Davos, the business elite appears to be embracing a new paradigm in which the purpose of for-profit corporations is to profit but lawfully, ethically, and sustainably and in furtherance of the interests of critical stakeholders other than shareholders. While corporate behemoths the likes of JP Morgan and General Motors rush to rebrand themselves as champions of responsible capitalism, a critical piece of the puzzle has been overlooked: small and medium enterprises (SMEs).
Where the shareholders, managers, and employees are one and the same, responsible capitalism’s tenet of caring for employees’ interests is simply good business.
SMEs are a leading if not dominating presence in the private sector of most economies. Even as state capitalism and private oligopolies become increasingly entrenched, SMEs continue to be the vehicle for entrepreneurship, and an increasingly crucial engine of innovation and sustainable business. SME firms often take legal form as unlisted, closely held business entities (“close corporations”). Close corporations operate very differently from large, listed companies in many ways. Shareholders and C-suite officers of large, listed companies may struggle to understand employee interests and stay divorced from the company’s business “on the ground”. Close corporation shareholders, however, often also wear hats as directors and key employees. Where the shareholders, managers, and employees are one and the same, responsible capitalism’s tenet of caring for employees’ interests is simply good business. Close corporation dynamics are also different. Shareholders have enhanced incentives to focus on the company’s long-term profitability because exit is difficult. Aggrieved shareholders of listed companies can simply do the “Wall Street Walk” and sell their shares on the stock market. Close corporation shareholders rarely have similar options, whether due to share transfer restrictions or the absence of a secondary market for their shares. These “locked in” shareholders thus have good reasons to ensure that the company is managed sustainably for the long term. In Japan’s case, “long term” may well mean centuries.
Doing good and making money may be attractive in theory, but the irreducible tension between profit maximization and non-profit motivations may prove difficult to balance in small business practice.
In short, close corporations are well placed to tick off two boxes on the responsible capitalism checklist: employee interests and long-term profitability. Unfortunately, close corporations have an “Achilles’ heel”: internal conflict between minority and majority shareholders. Such conflicts can arise from interpersonal relationships, majority shareholder opportunism, and other sources. Responsible capitalism-related internal conflict may involve disagreements about the company’s business direction. Doing good and making money may be attractive in theory, but the irreducible tension between profit maximization and non-profit motivations may prove difficult to balance in small business practice.
No legal mechanism, however, has been demonstrably able to solve the problem of corporate participants failing to agree on a corporate purpose in the first place.
Legal efforts have so far focused on enabling companies to signal commitment to socially responsible business models. Business entities specifically designed for social enterprises (e.g. benefit corporations) have proliferated in corporate legislation. It has also been proposed that objects clauses in corporate constitutions can be used by companies to demonstrate their commitment to chosen social purposes. No legal mechanism, however, has been demonstrably able to solve the problem of corporate participants failing to agree on a corporate purpose in the first place.
Capitalists (responsible or otherwise) in classic close corporation settings may avail themselves of exit solutions, if usually only as a last resort. But socially responsible businesses may go beyond just “lock in” of participants like traditional close corporations. Some “lock to” some ambitious pre-defined socially oriented purpose or objects, and some even feature non-distribution constraints that “lock out” exit. If shareholders were barred from recovering any money upon withdrawal or dissolution, even the nuclear options of business divorce or killing the company would hardly work. How then are disagreements over corporate purpose to be resolved?
Rethinking exit and voice in the close corporation for an era of responsible capitalism is critical – and the next frontier in corporate law.
Shareholder voice rights are corporate law’s usual answer to differences of opinion. Majority rule by shareholders governs most close corporation matters and works well enough for good-faith temporary disagreements. Intractable conflict within static shareholder structures without much entry or exit, however, cannot be resolved through voice alone, at least not without disenfranchising a minority permanently. Legal enforcement of objects clauses may bring an emotional rush, but by itself solves nothing while hurting feelings. The limitations of voice-based solutions apply to both profit-driven and purpose-driven enterprise models, but if the ultimate solutions based on exit are also stripped of value via non-distribution constraints, voice alone seems even more feeble. Rethinking exit and voice in the close corporation for an era of responsible capitalism is critical – and the next frontier in corporate law.
Practicing responsible capitalism need not be splashy displays of high principle, whether by listed companies that really own the world or by newfangled social enterprises with ascetism written into their charters. In Japan, for example, classic close corporations are tried and tested forms that can facilitate sustainable businesses that have already lasted centuries. More recently, Singapore introduced the Stewardship Principles for Family Businesses to encourage sustainable growth in family companies. Extending close corporation law protections to employees to employees – by making non-founder or non-family employees also members or shareholders – may be a responsible capitalist solution to wage stagnation in Japan and perhaps elsewhere. However, existing legal mechanisms that work well in for-profit entities have significant limitations in resolving internal disputes over business direction and corporate purpose. Rethinking how exit and voice function in close corporations is crucial if small businesses are to continue thriving in a new era of responsible capitalism.
Dr. Alan K Koh is Assistant Professor at the Division of Business Law, Nanyang Business School, Nanyang Technological University, Singapore.
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