In a well-intentioned op-ed in The Post [“Dialing up the power in people’s phone calls,” op-ed, Feb. 9], Wikipedia founder Jimmy Wales recently extolled his new phone venture, which has pledged to devote a quarter of its profits to “good causes” selected by an independent foundation. Now, I support good causes as much as the next fellow, and I have nothing negative to say about this initiative. I am compelled, however, to note that in delineating the obligations that corporations must meet, Wales made an error at once so common and so fundamental that it screams for correction.
In his discussion of the ways in which increasingly unpopular big businesses defend themselves against their critics, Wales wrote: “They argue, correctly, that the legal requirement of for-profit companies to maximize returns to shareholders limits their behavior.”
I never sought the opportunity to correct Wikipedia’s founder. Nevertheless, facts are facts, and the fact is that there is no legal requirement for for-profit companies to maximize returns to shareholders. When a company is for sale, its directors are required to do all they can to maximize its value. At any other time, corporate law simply dictates that directors are supposed to help the company prosper and do nothing to benefit themselves at the company’s expense. ...
The idea that corporations exist to reward their shareholders arose not in a body of law but from the work of ideologically driven economists. ...
I suppose he could be more wrong, but it is hard to see how.
Corporate law’s classic answer to the question of the proper objective of the directors famously was articulated in Dodge v. Ford Motor Co.[1] Henry Ford embarked on a plan of retaining earnings, lowering prices, improving quality, and expanding production. The plaintiff Dodge brothers contended an improper altruism towards his workers and customers motivated Ford. The court agreed, strongly rebuking Ford:
A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to devote them to other purposes.[2]
Consequently, “it is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others.”[3] Dodge’s theory of shareholder wealth maximization has been widely accepted by courts over an extended period of time. Almost three quarters of a century after Dodge, for example, the Delaware chancery court similarly opined: “It is the obligation for directors to attempt, within the law, to maximize the long-run interests of the corporation’s stockholders.”[4]
To be sure, despite the powerful rhetoric of cases like Dodge, current law allows boards of directors substantial discretion to consider the impact of their decisions on interests other than shareholder wealth maximization. This discretion, however, exists not as the outcome of conscious social policy but rather as an unintended consequence of the business judgment rule.[5] To be sure, some scholars find an inconsistency between the business judgment rule and the shareholder wealth maximization norm. In contrast, I concede that the business judgment rule sometimes has the effect of insulating a board of directors from liability when it puts the interests of nonshareholder constituencies ahead of those of shareholders, but deny that that is the rule’s intent.[6] Instead, as the Delaware supreme court has explained:
Under Delaware law, the business judgment rule is the offspring of the fundamental principle, codified in [Delaware General Corporation Law] § 141(a), 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.[7]
The business judgment rule thus operationalizes the intuition that fiat— i.e., centralization of decision-making authority—is the essential attribute of efficient corporate governance. As Nobel laureate economist Kenneth Arrow explains, however, authority and accountability cannot be reconciled:
[Accountability mechanisms] must be capable of correcting errors but should not be such as to destroy the genuine values of authority. Clearly, a sufficiently strict and continuous organ of [accountability] can easily amount to a denial 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 and hence no solution to the original problem.[8]
The business judgment rule prevents such a shift in the locus of decision-making authority from boards to judges. It does so by establishing a limited system for case-by-case oversight in which judicial review of the substantive merits of those decisions is avoided. The court begins with a presumption against review.[9] It then reviews the facts to determine not the quality of the decision, but rather whether the decision-making process was tainted by self-dealing and the like.[10] The questions asked are objective and straightforward: Did the board commit fraud? Did the board commit an illegal act? Did the board self-deal? Whether or not the board exercised reasonable care is irrelevant, as well it should be.[11] The business judgment rule thus erects a prophylactic barrier by which courts pre-commit to resisting the temptation to review the merits of the board’s decision.
The business judgment rule, however, has no application where the board of directors is disabled by conflicted interests.[12] In such cases, concern for director accountability trumps protection of their discretionary authority. In corporate takeovers, for example, a well-known conflict of interest taints target company director decision making. Not surprisingly, therefore, the law denies directors discretion to consider the interests of nonshareholder constituencies in the takeover setting.[13] To be sure, the interests of shareholders and nonshareholder may be consistent in takeover fights, just as they are in many settings. In light of the directors’ conflict of interest, however, we can no longer trust them to make an unbiased assessment of those competing interests. The conflict between management and shareholder interests requires skepticism when management claims to be acting in the stakeholders’ best interests. A board decision to resist a hostile offer may have been motivated by concern for potentially affected nonshareholder constituencies, but it may just as easily have been motivated by the directors’ and managers’ concern for their own positions and perquisites. Selfish decisions thus easily could be justified by an appropriate paper trail of tears over the employees’ fate. Consequently, in the takeover setting, rigorous application of the shareholder wealth maximization norm properly becomes the standard of judicial review.
Shareholder wealth maximization is not only the law, it is also a basic feature of corporate practice. Although some scholars claim that directors do not adhere to the shareholder wealth maximization norm, the weight of the evidence long has been to the contrary. A 1995 National Association of Corporate Directors (NACD) report stated: “The primary objective of the corporation is to conduct business activities with a view to enhancing corporate profit and shareholder gain.”[14] A 1996 NACD report on director professionalism set out the same objective, without any qualifying language on nonshareholder constituencies.[15] A 1999 Conference Board survey found that directors of U.S. corporations generally define their role as running the company for the benefit of its shareholders.[16] The 2000 edition of Korn/Ferry International’s well-known director survey found that when making corporate decisions directors consider shareholder interests most frequently, although it also found that a substantial number of directors feel a responsibility towards stakeholders.[17]
What people do arguably matters more than what they say. Director fidelity to shareholder interests has been enhanced in recent years by the market for corporate control and, some say, activism by institutional investors. Hence, for example, the widespread corporate restructurings of the 1990s are commonly attributed to director concern for shareholder wealth maximization.[18] In addition, changes in director compensation have created additional hostages ensuring director fidelity to shareholder interests.[19] Directors have long given shareholders reputational hostages. If the company fails on their watch, after all, the directors’ reputation and thus their future employability is likely to suffer. In addition, it is becoming common to compensate outside directors in stock rather than cash and to establish minimum stock ownership requirements as a qualification for election.[20] Tying up the proportion of the director’s personal wealth in stock of the corporation creates another hostage, further aligning the director’s interests with those of shareholders.[21]
[1] 170 N.W. 668 (Mich. 1919).
[4] Katz v. Oak Indus., Inc., 508 A.2d 873, 879 (Del. Ch. 1989).
[5] The business judgment rule, of course, pervades every aspect of corporate law, from allegedly negligent decisions by directors, to self-dealing transactions, to board decisions to seek dismissal of shareholder litigation, and so on. See, e.g., Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971) (fiduciary duties of controlling shareholder); Shlensky v. Wrigley, 237 N.E.2d 776 (Ill. App. 1968) (operational decision); Auerbach v. Bennett, 393 N.E.2d 994 (N.Y. 1979) (dismissal of derivative litigation). Two conceptions of the business judgment rule compete in the case law. One treats the rule as having substantive content. In this version, the business judgment rule comes into play only after one has first determined that the directors satisfied some standard of conduct. See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 360 (Del. 1993) (holding that plaintiffs rebut the business judgment rule’s presumption of good faith by “providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty—good faith, loyalty or due care”). Alternatively, the business judgment rule is seen as an abstention doctrine. Under this version, the court will abstain from reviewing the substantive merits of the directors’ conduct unless the plaintiff can rebut the business judgment rule’s presumption of good faith. See, e.g., Shlensky v. Wrigley, 237 N.E.2d 776, 779 (Ill. App. 1968) (holding that: “In a purely business corporation ... the authority of the directors in the conduct of the business of the corporation must be regarded as absolute when they act within the law, and the court is without authority to substitute its judgment for that of the directors.”). For the reasons developed below, I find the abstention version more persuasive. See infra notes Error! Bookmark not defined.-11 and accompanying text.
[6] To be sure, a few cases can be read to suggest that directors need not treat shareholder wealth maximization as their sole normative objective. Upon close examination, however, most of these cases in fact are not inconsistent with the shareholder wealth maximization norm. In Shlensky v. Wrigley, 237 N.E.2d 776 (Ill. App. 1968), for example, a minority shareholder in the Chicago Cubs sued Wrigley, the team’s majority shareholder, over the latter’s famous refusal to install lights at Wrigley Field. Shlensky claimed the decision against lights was motivated by Wrigley’s beliefs that baseball was a day-time sport and that night baseball might have a deteriorating effect on the neighborhood surrounding Wrigley Field. Id. at 778. Despite Shlensky’s apparently uncontested evidence that Wrigley was more concerned with nonshareholder than with shareholder interests, the Illinois Appellate Court dismissed for failure to state a claim upon which relief could be granted. Id. at 778-80. Although this result on superficial examination may appear to devalue shareholder wealth maximization, on close examination the case involves nothing more than a wholly unproblematic application of the business judgment rule.
[7] Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985). Cf. Marx v. Akers, 666 N.E.2d 1034, (N.Y. 1996) (noting that “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.’”); see also Pogostin v. Rice, 480 A.2d 619, 624 (noting that “the derivative action impinges on the managerial freedom of directors”).
[8] Kenneth J. Arrow, The Limits of Organization 78 (1974).
[9] See, e.g., Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (explaining that the rule creates a presumption that the directors or officers 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).
[10] See, e.g., Kamin v. American Express Co., 383 N.Y.S.2d 807, 811 (N.Y. Sup. 1976) (stating that absent “fraud, dishonesty, or nonfeasance,” the court would not substitute its judgment for that of the directors).
[11] See, e.g., Joy v. North, 692 F.2d 880, 885 (2d Cir. 1982) (stating: “While it is often stated that corporate directors and officers will be liable for negligence in carrying out their corporate duties, all seem agreed that such a statement is misleading.... Whatever the terminology, the fact is that liability is rarely imposed upon corporate directors or officers simply for bad judgment and this reluctance to impose liability for unsuccessful business decisions has been doctrinally labeled the business judgment rule.”); Brehm v. Eisner, 746 A.2d 244, 262-64 (Del. 2000) (rejecting plaintiff’s contention that the business judgment rule includes an element of “substantive due care” and holding that the business judgment rule requires only “process due care”).
[12] See Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944) (explaining: “The ‘business judgment rule’ . . . yields to the rule of undivided loyalty. This great rule of law is designed ‘to avoid the possibility of fraud and to avoid the temptation of self-interest.’”).
[13] Under the Delaware supreme court’s decision in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), a target’s board of directors may not protect stakeholder interests at the expense of shareholder interests. Id. at 182. Rather, any management action benefiting stakeholders must produce ancillary shareholder benefits. Id. In addition, once an auction of corporate control begins, stakeholders become entirely irrelevant. In such an auction, shareholder wealth maximization is the board’s only appropriate concern. Id. Indeed, in this context, considering any factors other than shareholder wealth violates the board’s fiduciary duties. Id. at 185.
[14] National Association of Corporate Directors, Report of the NACD Blue Ribbon Commission on Director Compensation: Purposes, Principles, and Best Practices 1 (1995) (noting, however, that “long-term shareholder gain” requires “fair treatment” of nonshareholder constituents).
[15] See National Association of Corporate Directors, Report of the NACD Blue Ribbon Commission on Director Professionalism 1 (1996).
[16] The Conference Board, Determining Board Effectiveness: A Handbook for Directors and Officers 7 (1999).
[17] Korn/ Ferry International, 27th Annual Board of Directors Study 33-34 (2000).
[18] See, e.g., Michael Useem, Investor Capitalism: How Money Managers Are Changing the Face of Corporate America 137-67 (1996) (discussing corporate restructurings as a consequence of investor pressure).
[19] Hostages—reciprocal transaction-specific investments—are a central concept in institutional economics. Giving and taking hostages is a mechanism for making credible commitments. I’ll pay the ransom, because I know that you will kill the hostage if I do not. See Williamson, supra note Error! Bookmark not defined., at 75-78 and 124-29 (discussing the hostage model of contracting).
[20] See generally Charles M. Elson, The Duty of Care, Compensation, and Stock Ownership, 63 U. Cin. L. Rev. 649 (1995) (discussing stock-based director compensation and incentives created thereby).
[21] See Outside Directors: The Fading Appeal of the Boardroom, The Economist, Feb. 20, 2001, at 67, 69 (relating an anecdote in which one outside director who owned $500,000 worth of corporate stock stated: “If this company faces a challenge, I lose sleep at night”).
