The Basics

This section of the course will acquaint you with the basics of U.S. corporate law. It will also give you an idea of what boards actually do, and introduce you to a variety of shareholder types and relationships.The basic problemThe basic corporate governance problem is how to control those who have been entrusted with the assets assembled in the corporation: managers and directors.This economic problem is called an “agency problem”: how to ensure that the “agents” (managers/directors) act in furtherance of the “principals’” (shareholders’) interests rather than the agents’ own interest? Not employing agents at all is not a solution because centralized management is essential in large organizations. Instead, the trick is to devise appropriate controls.(NB: the economic terminology of “agent” and “principal” employed in this section is related to, but much broader than, the legal terminology in the law of agency. Legally, directors and managers are agents for the corporation, not for shareholders. From an economic perspective, however, the corporation is a fiction — a convenient way of describing relationships between human beings. In this perspective, directors and managers ultimately work for shareholders and hence are shareholders’ agents in an economic, though not legal, sense.)The basic partial solutionsShareholder voting and fiduciary dutiesU.S. corporate law offers two basic solutions to the corporate agency problem: shareholder voting, and fiduciary duties enforced by shareholder lawsuits.First, shareholders vote on certain important corporate decisions. In particular, shareholders elect, and can remove, directors, who in turn appoint management. This is often referred to as “corporate democracy” but, as we will see shortly, shareholder voting differs considerably from political elections.Second, directors and managers hold their corporate powers as fiduciaries, i.e., for the sole benefit of “the corporation and its shareholders.” As fiduciaries, directors and managers owe a duty of care and a duty of loyalty to “the corporation and its shareholders.” Crucially, U.S. courts liberally grant shareholders standing to enforce these duties in court through derivative suits:  “The derivative action developed in equity to enable shareholders to sue in the corporation's name where those in control of the company refused to assert a claim belonging to it. The nature of the action is two-fold. First, it is the equivalent of a suit by the shareholders to compel the corporation to sue. Second, it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it.”Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984).Other shareholder rightsIn addition to voting rights and standing to sue, shareholders also have the right to access certain corporate information. This is an important ancillary right because both shareholder voting and derivative suits require information to work well. DGCL 220 allows shareholders “to inspect for any proper purpose . . . [t]he corporation’s . . . books and records.” Furthermore, publicly traded corporations must make extensive affirmative disclosures under the securities laws.Finally, shareholders can sell their stock. This is important for individual shareholders’ liquidity, i.e., shareholders’ ability to convert the value of their corporate investment into cash when necessary. However, this so-called Wall Street Walk is useless, at least by itself, as a protection against bad management. If the corporation has bad management, its value to shareholders will be less than it could be, and its stock price will be discounted to reflect this. So a shareholder can sell, but that just locks in the loss from bad management; it does not fix it. (By analogy, an arson victim’s right to sell the land with the burnt ruins hardly compensates the victim for, nor prevents, the arson.) Selling is useful only in as much as it enables a buyer to amass a large enough position from which to challenge the sitting board using the first two tools (voting and suing).Default rules vs. contractual arrangementsImportantly, U.S. corporate law generally sets only default rules. Charter provisions and other contractual or quasi-contractual arrangements can supplement or alter all or most of these rules. Indeed, “contractual” arrangements pervade corporate law, from the definition of shareholder rights and allocation of management power in the corporate charter, to bylaws on voting, to executive compensation contracts. Read: DGCL 102(b)(1), 151(a), 141(a), and 109(b).Variations on the basic problemThe board as a monitorSo far, I have framed the basic problem of corporate governance as how to control managers and the board. An important tool of corporate governance, however, is control of managers by the board. Arguably, the primary role of a board composed mostly of outside members (i.e., non-management) is to select, monitor, and thus control managers. It is now standard or even legally required for public corporations’ boards to consist mostly of independent directors, i.e., directors who do not have other relationships with the corporation, especially not a role in management. That being said, in U.S. corporations, it is still customary for CEOs and other top managers to sit on the board and even to chair it.Some countries go even further and fully separate outside directors and management. Under the so-called two-tier system, a “supervisory board” composed exclusively of outside directors is superimposed on the “management board” composed of top managers. Shareholders elect the supervisory board, which in turn appoints and monitors the management board. (In some jurisdictions the supervisory board is self-nominating or partially elected by the corporation's employees.)But while directors may indeed monitor management, this only shifts the basic problem one level up: how can we control those who have been entrusted with this monitoring role? Quis custodiet ipsos custodes?Dominant shareholdersMonitoring the monitor is a particularly acute problem with respect to large, dominant shareholders. Most public corporations around the world have a dominant shareholder. In the U.S. and in the U.K., dispersed ownership is the norm but far from universal. On the positive side, dominant shareholders help overcome shareholders' collective action problem in monitoring managers and the board. On the flip side, however, dominant shareholders may attempt to extract a disproportionate share for themselves. Delaware limits such minority abuse by imposing fiduciary duties on “controlling shareholders.” Other jurisdictions impose super-majority requirements, or outright prohibit certain transactions, etc.Protecting other constituenciesI defer until the end of the course the question of whether corporate law does or should protect constituencies other than shareholders (often called “stakeholders”), such as creditors, workers, or customers. For the time being, I just note that the question is not whether stakeholders should be protected at all, but whether they should be protected by the tools of corporate law beyond the level of protection afforded by contract (loan agreements, employment contracts, collective bargaining, etc.) and other branches of law (employment law, labor law, consumer law, etc.).EnforcementEnforcement and its problems are of paramount importance for corporate law. At the extreme, if general law enforcement were too weak, managers could, for example, simply abscond with the corporation’s money. No fiduciary duties, shareholder litigation, or shareholder voting could protect against this. Fortunately, criminal law enforcement in the U.S. is strong enough that outright fraud and theft are not the most pressing concerns and can be mostly ignored in this course.In the more subtle form of inadministrability, however, enforcement problems are key to understanding the rationale behind much of corporate law — and indeed behind much of law generally. Administrability refers to courts’ ability to administer the laws as written. The problem is that courts often lack the requisite information. For this reason, many superficially appealing rules do not work as intended. For example, it is certainly desirable that managers always do only what is best for shareholders, or at least what they think is best for shareholders, and that they do so flawlessly or at least to the best of their abilities. Formally speaking, that is indeed more or less what fiduciary duties require of managers. That does not mean, however, that it is realistic to think that courts could actually enforce such a standard. Courts may not know what action was best for shareholders, much less what the managers truly thought was best for shareholders. Nor can courts easily know whether managers gave their best. Courts will inevitably misjudge many careful, loyal actions as disloyal or careless, and vice versa — in spite of costly and lengthy investigations.Faced with such difficulties, it may be best to forego costly judicial review altogether unless a transaction raises a red flag. The reddest of red flags is when the decision would financially benefit the decision-makers or their affiliates more than (other) shareholders. That, in a nutshell, is the approach taken in Delaware and other U.S. states and epitomized by the business judgment rule. We will dive deep into the details later. For now, here is the scoop in the words of the seminal case, Aronson v. Lewis:“The business judgment rule is an acknowledgment of the managerial prerogatives of Delaware directors under Section 141(a). It is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts. . . .[However, the rule’s] protections can only be claimed by disinterested directors . . . .. From the standpoint of interest, this means that directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing . . . .  See 8 Del.C. § 144(a)(1).[Moreover], to invoke the rule's protection directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them. Having become so informed, they must then act with requisite care in the discharge of their duties. While the Delaware cases use a variety of terms to describe the applicable standard of care, our analysis satisfies us that under the business judgment rule director liability is predicated upon concepts of gross negligence."473 A.2d 805, 812 (Del. 1984) (footnotes and internal references omitted).More generally, many rules of corporate law are decidedly second-best. That is, they are optimal only in recognition of the difficulties of enforcing any alternative rule. Agency problems can be reduced. They can never be eliminated.