Few major institutions in our society are as misunderstood as the corporation. Artificial legal persons, chartered by governments with special attributes intended to accomplish narrow economic objectives, corporations are one of the most successful legal innovations ever devised.

The distinctive feature of the corporation is lim­ited liability. If the corporate form is respected—that is, if the organization is run by its board of directors rather than its shareholders—then, by law, those shareholders will not be held responsible for the corporation’s debts. That’s the trade-off: the share­holders abstain from managing the business, and in exchange they are insulated from any liability the business incurs.

In addition to staying out of management, share­holders generally lack the right to withdraw the cash or other assets they originally contributed to the corporation in return for their shares. Yes, they can sell their interests to others, but, unless special provisions are made in its charter, the corporation has no obligation to distribute anything—including their own capital contributions—to its shareholders.

Before the advent of the corporate form in the mid-19th century, investors could be charged with the debts of companies, and companies frequently had to liquidate when one or more investors decided to withdraw their capi­tal. With the adoption of state corporate chartering laws, however, corpora­tions could have perpetual existence and were able to establish policies and commit capital independently of their investors.

With this background, what can we say about the glib assertions frequently voiced today that corpo­rations are—or should be—democracies, or that the shareholders are the “owners” of corporations? Both these propositions rest on a weak understanding of corporate law and the elements that have made cor­porations successful as economic actors.

Here's the trade-off: shareholders abstain from managing the business, and in exchange they are insulated from liability.

For example, if shareholders actually took opera­tional control of a corporation—a concept implicit in the idea that shareholders are “owners” of a cor­poration—they would lose their limited liability and would be responsible for the debts of the business. In fact, if operational control is the key indicator of ownership, then, under most corporate laws, the directors are much closer to being the owners of corporations than the shareholders. It’s the directors who have the right and authority by law to direct the affairs of the corpora­tion; they establish the corporation’s major poli­cies and elect and super­vise the managers.

As a formal legal mat­ter, the duty of directors is to act in the best interests of the corporation, not the best interests of the shareholders. The assumption is that if the corporation succeeds, the shareholders will benefit. In legal reality, shareholders are much more like the beneficiaries of a trust than they are like the owners of a piece of property. This is no arbi­trary development. The corporate form developed because, by centralizing authority to use capital in a board of directors, distinct from the shareholders, it promoted the creation of economic value. As Henry Manne has written, “The modern corporation is a market creation, not a political one.”

Yet, there are many who do not understand this basic fact. Take, for example, the following state­ment by Arthur Levitt, former chairman of the Securities and Exchange Commission, in a Wall Street Journal op-ed last fall: “Ever since the recount of 2000, partisans of both parties have paid particular attention to everything from who votes to how they vote and how their preferences are recorded. Counting every vote is not only integral to our political life; it is central to our economic life as well. Shareholder capitalism enables our markets to thrive, our companies to grow and our economy to remain strong. And central to this system is the principle that shareholders can have a voice in the running of the companies that they own, that their votes will count.”

Here is a complete confusion between the idea of voting in a political democracy and voting in a cor­poration, and a complete confusion about the role of shareholders under corporate law. Voting in a polit­ical democracy decides the values of the nation. It is necessary because citizens, unlike sharehold­ers, cannot as easily change countries as they can change investments. What is voting by sharehold­ers supposed to decide—the amount of the dividend, where the next factory will be built, or whether to expand into a new market? The fact that there is something called a “vote” involved here does not suggest that it should have the same meaning in both contexts. Shareholders are not supposed to manage corporations, and if they do they will lose their limited liability. And if they are “owners” they don’t, under corporate law, have any of the powers to control and dispose of the company’s assets that we usually attribute to people called “owners.”

Activists for “corporate democracy,” therefore, should be required to explain what purposes they want corporations to fulfill that they are not already achieving. (Such an explanation was notably absent from the Levitt op-ed.) Since the corporation is an economic rather than a political entity, activists’ interest in electing directors should have some direct connection to the corporation’s role as an economic actor.

In fact, however, those who are in the forefront of asserting what they see as their rights of ownership as shareholders seem to have interests that conflict with the corporation’s role as a creator of economic value for all its shareholders. The pension funds of labor unions, for example, are prominently involved in pressing for corporate democracy. Do they want greater corporate profitability, or is their real inter­est in higher wages and pension benefits? Do they want the corporation to create value or change its position on the minimum wage or on outsourcing to India?

The pension funds of labor unions are prominently involved in pressing for corporate democracy. But do they want greater corporate profitability or greater wages and pension benefits?

To be sure, many of those advocating share­holder democracy have no obvious interests either as investors or employees, so there is a well-founded suspicion that these corporate-democracy activists are really interested either in bringing a business into the political debates of the day on their side or in silencing its voice in opposition to theirs on political questions. This should be no surprise. Hollywood, universities, and even religious institutions are now participants in the cultural and political quarrels that are at the heart of American politics today. Ultimately, once corporations are seen as actors on a larger stage than the creation of economic value, there is no end to the interests that could credibly argue for representation on corporate boards.

The unique contribution of corporations up to now has been their single-minded economic focus. If their boards ultimately take on the look of European corporations, with representation of labor unions, local communities, and spokespersons for various other special interests and causes, their focus on creating economic value will be compromised.

Unfortunately, the SEC has failed to understand the stakes here, and, even with a Republican majority, has allowed the groundwork to be laid for European-style “stake­holders” and special inter­ests to gain access to corporate boards.

In September, the Sec­ond Circuit federal court of appeals ruled that a large insurer, AIG, could not rely on an SEC policy that required contested elections of directors to be held under the SEC’s proxy rules. These rules required that challengers to a company’s slate of directors had to file their own proxy statements and could not, without the company’s consent, put their nominees on the company’s own proxy solicitation. The suit was brought by the pension plan of the American Federation of State, County and Munici­pal Employees (AFSCME), and it asked the court to decide whether a bylaw amendment, requiring that the company accept opposition nominees, must be accepted by AIG. The SEC was not a party to the suit but submitted a memorandum explaining its longstanding position that issues relating to the election of directors had to be resolved under the commission’s proxy rules.

The court did not strike down the SEC’s regulation but said that the commission had been inconsistent in implementing its policy in the past and had to explain its position before the court would uphold it in support of AIG’s argument. At this point, the SEC fell into a state of catatonia and could not seem to get together a coherent statement of its policy. A meeting in October was put off until December, and then canceled entirely. Meanwhile, two other companies were threatened with lawsuits if they did not agree to similar plans, and both—without the SEC’s support—gave way. It is likely that before the next proxy season so many such surrenders will have occurred that the AFSCME plan will become a fait accompli at many companies.

Is this something we should really worry about? How likely is it that our corporations will become embroiled in political issues? Unfortunately, very likely. Let’s assume, for example, that a group of shareholders nominates to the board of BigOil Co. a climatologist who favors immediate action on global warming—reversing the corporation’s position that human activity is not yet proven as the primary cause of climate change. Does anyone believe that this nomination would be contested solely within the sedate confines of the BigOil annual meeting? Of course not. There would be editorials in The New York Times and other media calling for support of this nominee and insisting that mutual funds, pen­sion funds, foundations, and other institutional investors do their duty to bring BigOil’s board and management to heel.

Organizations purporting to represent or empower institutional investors would also add their voices in support of the nominee. Institutional investors, which hold about half of all shares of public companies and have little desire to incur public disfavor, will probably end up voting as this public pressure dictates. The likelihood is that the candidate will be elected, and will soon be publish­ing op-ed pieces about how difficult it is to get the “facts” accepted in BigOil board meetings.

Once corporations are seen as actors on a larger stage than the creation of economic value, there is no end to the interests that could credibly argue for representation on corporate boards.

Unfortunately, scenarios like this can be spun out indefinitely—board nominees opposed to the build­ing of various weapons systems or to manufacturing in China or India, in favor of importing pharma­ceuticals from Canada or making smaller cars. The list goes on—all issues that will be taken up by the media and converted from the dry matters of board nominations to the hot topic of where powerful cor­porations stand on the pressing issues of the day.

There is an irony, of course, when some institu­tional investors seek to assert their rights as owners of corporations. If boards of directors and corporate managers are described by the shareholder activ­ists as mere agents of shareholder “owners,” aren’t the managers of labor unions, pension funds, and educational institutions mere agents of their own members, beneficiaries, and other stakeholders? Yet while this set of owners, under the activists’ own theories, have at least the same claim to control as corporate shareholders, they never appear to be consulted when the managers of, say, union pen­sion funds purport to cast votes on their behalf in corporate elections. It doesn’t make sense, if rep­resentation is the standard, to treat pension fund executives as principals merely because they are self-perpetuating, but corporate directors as agents because they are elected.

All of this suggests that we are badly in need of a theory for properly describing the relationship between the members and beneficiaries of institu­tions on the one hand, and the managers who run them on the other. Let me offer such a theory:

First, institutions established for a limited pur­pose should stay that way. Corporations are meant to create economic value and should not be con­verted into vehicles for representing stakeholders. If there are to be contested elections for corporate directorships, the contest should have something to do with the corporation’s economic role, not with political issues that are tangential to that purpose. It is necessary to recall that shareholders who are dis­pleased with how corporations are functioning can easily vote with their feet by selling their shares.

Second, it is important to recognize that many of the institutions that are calling today for more shareholder democracy are among the most undem­ocratic in our society. Unlike corporations, they do not provide their members with a practical means of exit if they are dissatisfied with the management. Many of these institutions are shareholders because they are supposed to be making investments for their beneficiaries or other stakeholders; to the extent that they use their votes in a corporate election, it should be to improve corporate performance. Any other purpose—unless approved by the mem­bers—should be seen as a violation of the fidu­ciary obligations of their managements, for which pension fund members and other stakeholders should have some legal recourse. Some consideration should be given to requiring not only disclosure of votes on shareholder issues and election of directors, but also approval by members of specific votes where boards of these institutions are not already elected.

Finally, the SEC should reassert its policy that all contests for the election of corporate directors should be held under the proxy rules. Only through this competition will the real agenda of a group car­rying on an electoral challenge become clear. If that agenda is to improve corporate performance, the proxy statement should have to explain how; if the improvement of corporate performance is not the objective, then other shareholders who have fidu­ciary obligations should be bound to vote against the challengers.

Peter Wallison, a senior fellow at the American Enterprise Institute, was general counsel to the Treasury Department, counsel to President Reagan, and a law partner at Gibson, Dunn & Crutcher.