April 11, 2014

Director Primacya.k.a. Board-centric Governance

Stephen Bainbridge

UCLA School of Law

“The theory of our corporation law confers power upon directors as the agents of the shareholders; it does not create Platonic masters.”• Blasius Industries, Inc. v. Atlas Corp.,

564 A.2d 651, 663 (Del. Ch. 1988).

“Allen is one of the most respected jurists on corporate governance. When he writes, lawyers listen.”• James Lyons, Conflicting Interests,

Forbes, Mar. 30, 1992, at 48

Who is in charge?

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Kamin v. American Express (N.Y. Sup. Ct. 1976)Bayer v. Beran (N.Y. Sup. Ct. 1944)

Smith v. Van Gorkom (Del. 1985). Manson v. Curtis (N.Y. 1918).

Marx v. Axers (N.Y. 1996). DGCL § 141(a)

But even Homer nods

“The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors….”

“the business judgment rule is the offspring of the fundamental principle, codified in [Delaware General Corporation Law] § 141(a), that the business and affairs of a Delaware corporation are managed by or under its board of directors. ... The business judgment rule exists to protect and promote the full and free exercise of the managerial power granted to Delaware directors.”

“To encourage freedom of action on the part of directors, or to put it another way, to discourage interference with the exercise of their free and independent judgment, there has grown up what is known as the “business judgment rule.” “

“By their very nature, shareholder derivative actions infringe upon the managerial discretion of corporate boards. . . . Consequently, we have historically been reluctant to permit shareholder derivative suits, noting that the power of courts to direct the management of a corporation’s affairs should be “exercised with restraint”

The board’s powers are “original and undelegated.”

“The directors’ room rather than the courtroom is the appropriate forum for thrashing out purely business questions which will have an impact on profits, market prices, competitive situations, or tax advantages.”

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Working assumption Research question

Delaware law is a “race” to the top• Qualifiers, quibbles

notwithstanding

Why does statute and case law assign so much power to the board of directors rather than shareholders (or managers)?• Setting aside real world Imperial

CEO issue for the nonce

The original motivating question

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Kenneth Arrow

• The Limits of Organization (1974)

Michael Dooley

• Two Models of Corporate Governance, 47 Bus. Law. 461 (1992)

Director primacy

• Authority versus accountability

• The case for authority

Key waypoints

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Consensus Authority

Arrow’s models

Collective decision making• E.g., partnerships

Central decision making body• E.g., public corporation

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“Cheaper and more efficient to transmit all the

pieces of information to a

central place” that makes “the

collective choice and transmit it

rather than retransmit all the

information on which the

decision is based”

Asymmetric information

Divergent interests

Collective action problems

When to opt for authority

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Arrow:

• Accountability mechanisms “must be capable of correcting errors but should not be such as to destroy the genuine values of authority”

• “If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B”

But what about agency costs?

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Endorsed the “board centric” model Why?

Reaffirmed MBCA policy of vesting “the power to direct and oversee the management of the corporation in the board of directors, rather than in the shareholders.”

Board centric model gives shareholders “the regular opportunity to elect the members of the board, but during the directors’ terms, the board has the power, informed by each director’s decisions in the exercise of his or her fiduciary duties, to direct and oversee the pursuit of the board’s vision of what is best for the corporation.”

If the actions of management were the subject of frequent shareholder review:• The ability to rely on

management teams would be diluted

• The time and attention of managers could be diverted from activities designed to pursue sustainable economic benefit for the corporation.

• Particular shareholders may have interests that diverge from those of other shareholders or interests other than sustainable economic benefit.

The ABA Committee on Corporate Laws (2010)

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Individual shareholders lack sufficient stake to justify monitoring• Free-riding issue

Interests of large investors likely to differ from those of shareholders as a whole

Transfer of authority from board to shareholders• Undesirable in itself

– Less efficient decision making– Swapping consensus for authority under conditions favoring the latter

Shareholders do not “own” the corporation

Individual Shareholders Institutional Shareholders

But what about the “ownership” rights of shareholders?

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Why a board? What decision-making norm?

Groups better at exercising critical evaluative judgment

Agency cost solution:• Harder for top decision maker

to self-deal or shirk when part of a group.– Mutual monitoring– Peer pressure and social

norms• Board creates status equals

(nominal superiors) vis-à-vis CEO

Shareholder wealth maximization norm• It’s the law• It’s what the parties would

bargain for (hypothetically speaking)

• It’s what executives do.

Subsidiary questions

Vs.

=

Vs.

Vs.

Vs.

OR

Director control

Shareholder wealth maximization

Prioritizes authority

E.g., takeover defenses allowed

E.g., no new shareholder powers

Delaware

Shareholder control

Shareholder wealth maximization

Prioritizes accountability

E.g., takeover defenses disallowed

E.g., constantly growing shareholder powers

Federal

Director versus Shareholder Primacy

=

Vs.

Vs.

Vs.

Vs.

OR

Director decision making priority

Views board as a team

Directors hire factors of production

Shareholder wealth maximization norm

Directors decide

Contractarian

Director decision making priority

Views firm as a team

Factors of production hire directors

Consistent with stakeholder perspective

Directors mediate

Entity?

Director Primacy versus Team Production

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Doesn’t account for takeover law (Bruner)

Doesn’t explain existence of shareholder voting rights (Bruner)

Criticism: Lacks Predictive Power

Unocal at 20: Director Primacy in Corporate Takeovers: Delaware courts struck an appropriate balance between two competing but equally legitimate goals of corporate law: Because the power to review differs only in degree and not in kind from the power to decide, the discretionary authority of the board of directors must be insulated from judicial oversight. Because directors are obligated to maximize shareholder wealth, there must mechanisms to ensure director accountability. Unocal does the job.

The Case for Limited Shareholder Voting Rights: Shareholder voting is properly understood not as an integral aspect of the corporate decision-making structure, but rather as an accountability device of last resort to be used sparingly, at best.

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Each doctrinal problem must be carefully analyzed to determine where to strike the balance between authority and accountability. The necessary analysis typically requires one to go beyond the “Arrowian moment” to consider other policies.

The utility of director primacy is confirmed by its ability to explain the truly striking extent to which the balance between authority and accountability in fact leans towards the former in US corporate law.

“The argument … only tells us that there is a trade-off between authority and accountability, and that both have real value. … None of the major pro-accountability reform proposals currently in play, however, comes even close to eliminating board authority. In the world in which we live today, Arrow's argument is not able to tell us whether reform in favor of somewhat more accountability at the expense of some, but far from a total, loss in authority is a good idea or not.”

The Arrowian Moment (McDonnell)

The Arrowian Moment (McDonnell) It is useful

Criticism: Overstates importance of authority

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In re CNX Gas Corp. S'holders Litig. (Del.Ch.2010)Hollinger Inc. v. Hollinger Intern., Inc. (Del.Ch.2004)

Seth W. Ashby, 2005 U. ILL. L. REV. 521, 533 Kevin L. Turner, 57 ALA. L. REV. 907

Larry Ribstein, 1 BERKELEY BUS. L.J. 183 Jean Jacques du Plessis ( 2011)

Conclusion: To quote Will Sonnett, “no brag, just fact”

“Stephen Bainbridge … provides some exciting new perspectives on corporate governance models by expanding on the ‘director primacy model’ that he developed recently.”

“A new theory of the firm has emerged that appears more complete than its predecessors: Professor Stephen M. Bainbridge’s model of director primacy.”

“It is through this centralized management that stockholder wealth is largely created …. One of the articulate advocates of this view of our law is Stephen Bainbridge.”

“Corporate governance is best characterized as based on ‘director primacy.’”

“Delaware jurisprudence favors director primacy in terms of the definitive decision-making power …”

“[D]irector primacy remains the centerpiece of Delaware law, even when a controlling stockholder is present.”