For whom (and for when) is the firm governed? The effect of changes in corporate fiduciary duties on tax strategies and earnings management

• Published date: 01 November 2021
• Author: Douglas Cumming,Bryce C. Tingle QC,Feng Zhan
• Date: 01 November 2021
• DOI: http://doi.org/10.1111/eufm.12332

Eur Financ Manag. 2021;27:775–813. wileyonlinelibrary.com/journal/eufm © 2021 John Wiley & Sons Ltd.

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DOI: 10.1111/eufm.12332

ORIGINAL ARTICLE

For whom (and for when) is the firm

governed? The effect of changes in corporate

fiduciary duties on tax strategies and

earnings management

Douglas Cumming

1,2

|Bryce C. Tingle QC

3

|Feng Zhan

4

1

College of Business, Florida Atlantic

University, Boca Raton, Florida, USA

2

Birmingham Business School,

University of Birmingham, Birmingham,

United Kingdom

3

Faculty of Law, University of Calgary,

Calgary, Alberta, Canada

4

DAN Department of Management and

Organizational Studies, University of

Western Ontario, London, Ontario,

Canada

Correspondence

Douglas Cumming, College of Business,

Florida Atlantic University, 777 Glades

Rd., Boca Raton, FL 33431, USA.

Email: cummingd@fau.edu

Abstract

The proper object of the fiduciary duties of corporate

directors and officers is frequently described as

the central question in all corporate law. We use the

adoption of constituency statutes, which shift the loci

of corporate managers' duties from shareholders to a

wide range of stakeholders, as a quasi‐natural experi-

ment to determine the actual impact of fiduciary du-

ties. We find that though the adoption of constituency

statutes has no significant effect on measures of earn-

ings management, it has a robust effect on firms' ef-

fective tax rate, which increases in a range between

0.570% and 1.903%. These results are robust in terms of

various measures of the firm's effective tax rate. We

provide explanations for why fiduciary duties appar-

ently do not influence manager behaviours in relation

to shareholders but do affect their behaviours in rela-

tion to the taxing authority. We argue that a change to

fiduciary duties does not appear to alter the motivation

of managers to maximize shareholder welfare

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We owe special thanks to the Editor‐in‐Chief Professor John Doukas and two anonymous reviewers for their very

timely and helpful feedback that substantially improved the paper. Also, we owe thanks to Hong Fan, Sofia Johan, and

the seminar participants at the Academy of Sustainable Finance, Accounting, Accountability & Governance Con-

ference, the Financial Management and Accounting Research Conference, University of Cyprus, and Western

University.

outcomes, but rather it allows them to eschew short‐

term strategies that often impair long‐term outcomes.

KEYWORDS

fiduciary duties, tax aggressiveness

JEL CLASSIFICATION

H26, G34

‘Having chosen a for‐profit corporate form, the Craigslist directors are bound by

the fiduciary duties and standards that accompany that form. Those standards

include acting to promote the value of the corporation for the benefit of its

stockholders. The “Inc”. after the company name has to mean at least that’.

—Delaware Court of Chancery, eBay Domestic Holdings, Inc. vs. Craig Newmark

and James Buckmaster, 16 A3rd 1 (2010)

1|INTRODUCTION

The most important legal duty in corporate law is the fiduciary duty of the directors and officers to

advance the best interests of the corporation. As two legal scholars noted, ‘for nearly two centuries,

a cornerstone of Anglo‐American corporate law has been the fiduciary duty of loyalty, the most

demanding and litigated fiduciary obligation imposed on corporate managers’(Rauterberg &

Talley, 2017). In practice, however, the statutory formulation of this duty fails to provide guidance

to corporate agents as it leaves open the question of whose interests are coterminous with those of

the corporation. The traditional response in the United States has been to privilege the interests of

shareholders above those of other possible constituencies such as the corporation's employees,

creditors, business partners, suppliers, customers, or even the broader society (including govern-

ment). There has been a robust debate between those favouring the shareholder primacy approach

to fiduciary duties and those favouring a broader ‘stakeholder’approach. Three influential judges

specializing in corporate law have referred to this as ‘The Great Debate’(Allen et al., 2002).

The outcome of the debate is important empirically because how the fiduciary duty is

conceived appears to have a profound impact on the real‐world operations of companies. One

of the most obvious features of corporate governance is that the interests of corporate con-

stituencies routinely conflict. For example, a leveraged buy‐out may produce a significant

increase in shareholder value, but it is often followed by cost‐cutting, the termination of

employees, the shuttering or off‐shoring of operations, and a significant increase in the riski-

ness of the corporation's pre‐existing debt.

The outcome of the debate also matters theoretically, because the dominant paradigm

undergirding modern discussions of corporate law is ‘agency theory’as it was formulated in

Jensen and Meckling's (1976) seminal article, Theory of the Firm: Managerial Behavior, Agency

Costs and Ownership Structure. Corporate managers are obviously agents; Jensen and Meckling

assumed their principals were the shareholders. This was almost certainly true when Jensen

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CUMMING ET AL.

and Meckling were writing, and it remains true in Delaware, the most important jurisdiction in

corporate law, but it became less true over time in a majority of U.S. states due to their adoption

of constituency statutes.

Our study tries to contribute to this debate by empirically examining the impact of shifting

from shareholder orientation to stakeholder orientation on the firm's financial reporting, as

well as tax reporting behaviour.

Beginning in the 1980s, various states began introducing legislation that explicitly permitted

(and in some cases, required) directors and officers to consider the interests of corporate

stakeholders as well as that of shareholders (Keay, 2011). For example, the Minnesota statute

provides, ‘A director may, in considering the best interests of the corporation, consider

the interests of the corporation's employees, customers, suppliers, and creditors, the economy

of the state and nation, community and societal considerations’.

1

Another example, Pennsyl-

vania's directors' duty law, specifically requires a board member to consider the interests of

shareholders, employees, customers, creditors, suppliers, and communities which the company

locates. It also requires the board member to consider both the long‐term and short‐term

interests of the corporation (Karpoff & Wittry, 2018). In general, these directors' duty laws

provide legal ground and justifications for corporate decisions that may not serve the best

interests of shareholders.

At the time, these changes were occurring corporate law scholars generally regarded them

as ‘the most significant change in United States corporate law since the New Deal's securities

laws or even the enabling codes of the last [nineteenth] century’(Bainbridge, 1992, p. 973).

These ‘constituency statutes’have been passed in 35 U.S. states, impacting the nature of

corporate fiduciary duties in each of them.

The initial impetus for passing constituency statutes was an attempt by state govern-

ments to protect regional champions from the burgeoning takeover market (Adams &

Matheson, 2000; Hanks, 1991). The idea was that if the directors were freed from the

obligation to maximize shareholder return, they would find it easier to take the necessary

steps to repel hostile suitors. Constituency statutes were often accompanied by a variety of

other antitakeover pieces of legislation (Romano, 1993b). Frequently, the constituency

statutes were adopted after lobbying from a targeted firm (Davids, 1995; Romano, 1993a;

Bebchuk et al., 2021).

Constituency statutes were also adopted in response to a political reaction against a con-

ception of corporate governance in which shareholders were the only stakeholders whose

interests mattered to corporate decisionmakers. This is probably an inadequate way of un-

derstanding corporate decisionmaking in firms incorporated in shareholder‐primacy states

(such as Delaware), but it became increasingly common. The arguments in favour of stake-

holder conceptions of the fiduciary duty were made in popular books (Bakan, 2005; Stout,

2012), in documentaries such as The Corporation and Fishing with Dynamite, and even in

mainstream films such as Other's People Money (McArdle & de Koning, 2020). Other types of

law reform efforts produced ‘benefit corporation’statutes in what is now a majority of U.S.

states, providing an incorporation alternative to the traditional business corporation

(Stecker, 2016). At the heart of these new corporate forms is a revised conception of the

fiduciary duty that closely resembles the stakeholder formulation found in constituency

statutes.

1

MINN. STAT. ANN. §302A.251, subd. 5 (West Supp. 1985).

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