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All organizations must have some mechanism for aggregating the preferences of the organization’s constituencies and converting them into collective decisions. As Kenneth Arrow explained in work that provided the foundation on which the director primacy model was constructed, such mechanisms fall out on a spectrum between “consensus” and “authority.” Consensus-based structures are designed to allow all of a firm’s stakeholders to participate in decision making. Authority-based decision-making structures are characterized by the existence of a central decision maker to whom all firm employees ultimately report and which is empowered to make decisions unilaterally without approval of other firm constituencies. Such structures are best suited for firms whose constituencies face information asymmetries and have differing interests. It is because the corporation demonstrably satisfies those conditions that vesting the power of fiat in a central decision maker—i.e., the board of directors—is the essential characteristic of its governance. Shareholders have widely divergent interests and distinctly different access to information. To be sure, most shareholders invest in a corporation expecting financial gains, but once uncertainty is introduced shareholder opinions on which course will maximize share value are likely to vary widely. In addition, shareholder investment time horizons vary from short-term speculation to long-term buy-and-hold strategies, which in turn is likely to result in disagreements about corporate strategy. Likewise, shareholders in different tax brackets are likely to disagree about such matters as dividend policy, as are shareholders who disagree about the merits of allowing management to invest the firm’s free cash flow in new projects. As to Arrow’s information condition, shareholders lack incentives to gather the information necessary to actively participate in decision making. A rational shareholder will expend the effort necessary to make informed decisions only if the expected benefits outweigh the costs of doing so. Given the length and complexity of corporate disclosure documents, the opportunity cost entailed in making informed decisions is both high and apparent. In contrast, the expected benefits of becoming informed are quite low, as most shareholders’ holdings are too small to have significant effect on the vote’s outcome. Accordingly, corporate shareholders are rationally apathetic. In sum, it would be surprising if the modern public corporation’s governance arrangements attempted to make use of consensus-based decision making anywhere except perhaps within the central decision-making body at the apex of a branching hierarchy. Given the collective action problems inherent with such a large number of potential decision makers, the differing interests of shareholders, and their varying levels of knowledge about the firm, it is “cheaper and more efficient to transmit all the pieces of information to a central place.
Citation preview
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.”
