The Seattle University Law Review recently published a symposium devoted to a 15 year retrospective on Margaret Blair and Lynn Stout’s article A Team Production Theory of Corporate Law. Deservedly so. It was a provocative article that advanced the ball in many respects. Ultimately, however, I was unpersuaded and explained why in my article Director Primacy: The Means and Ends of Corporate Governance, 97 Nw. U. L. Rev. 547, 592-600 (2003). The following excerpt is taken from my original draft. I offer it up as a rebuttal to the recent symposium. In doing so, however, I am reminded of the lyrics of a Dave Mason song:
...we can't see eye to eye.
There ain't no good guy, there ain't no bad guy,
There's only you and me and we just disagree.
Blair and Stout contend that corporate law treats directors not as hierarchs charged with serving shareholder interests, but as referees—mediating hierarchs, to use their term—charged with serving the interests of the legal entity known as the corporation.[1] In turn, the corporation’s interests are defined as the “joint welfare function” of all constituents who make firm specific investments.[2] Although Blair and Stout tend to downplay the normative implications of their model, they acknowledge that it “resonates” with the views of progressive corporate legal scholarship.[3] They differ from the progressive wing of the corporate law academy mainly on positive grounds. Many progressives believe that corporate directors currently do not take sufficient account of nonshareholder constituency interests and that law reform is necessary.[4] In contrast, Blair and Stout believe that corporate directors do take such interests into account and the current law is adequate in this regard.[5]
A. The Firm as Team
Team production is an important and highly useful concept in neoinstitutional economics. Blair and Stout stretch the team production model to encompass the entire firm.[6] Doing so is unconventional. In my view, stretching team production that far also detracts from the model’s utility.
Production teams are defined conventionally as “a collection of individuals who are interdependent in their tasks, who share responsibility for outcomes, [and] who see themselves and who are seen by others as an intact social entity embedded in one or more larger social systems ....”[7] This definition contemplates that production teams are embedded within a larger entity. As one commentator defines them, teams are “intact social systems that perform one or more tasks within an organizational context.”[8]
Building on the work of Rajan and Zingales, Blair and Stout define team production by reference to firm specific investments.[9] Hence, for example, they describe the firm “as a ‘nexus of firm-specific investments.’”[10] In fact, however, firm specific investments are not the defining characteristic of team production. Instead, the common feature of team production is task nonseparability.
Oliver Williamson identifies two forms production teams take: primitive and relational. In both, team members perform nonseparable tasks. The two forms are distinguished by the degree of firm specific human capital possessed by such members. In primitive teams, workers have little such capital; in relational teams, they have substantial amounts.[11] Because both primitive and relational team production requires task nonseparability, it is that characteristic that defines team production.
Most public corporations have both relational and primitive teams embedded throughout their organizational hierarchy. Self-directed work teams, for example, have become a common feature of manufacturing shop floors and even some service workplaces.[12] Even the board of directors can be regarded as a relational team.[13] Hence, the modern public corporation arguably is better described as a hierarchy of teams rather than one of autonomous individuals. To call the entire firm a team, however, is neither accurate nor helpful.
As among shop floor workers organized into a self-directed work team, for example, team production is an appropriate model precisely because their collective output is not task separable.[14] In a large firm, however, the vast majority of tasks performed by the firm’s various constituencies are task separable. The contribution of employees of one division versus those of a second division can be separated. The contributions of employees and creditors can be separated. The contributions of supervisory employees can be separated from those of shop floor employees. And so on.[15] Accordingly, the concept of team production is simply inapt with respect to the large public corporations with which Blair and Stout are concerned. [16]
B. The Domain of the Mediating Hierarchy
John Coates argues that Blair and Stout’s mediating hierarch model fares poorly whenever there is a dominant shareholder.[17] If so, the model’s utility is vitiated with respect to close corporations, wholly-owned subsidiaries, and publicly held corporations with a controlling shareholder. In addition, Coates argues, Blair and Stout’s model also fares poorly whenever any corporate constituent dominates the firm.[18] Many of publicly held corporations lacking a controlling shareholder are dominated one of the constituents among which the board supposedly mediates—namely, top management. Although the precise figures disputed, a substantial minority of publicly held corporations have boards in which insiders comprise a majority of the members.[19] Even where a majority of the board is nominally independent, the board may be captured by insiders.[20]
I more skeptical than Coates of board capture theories, having argued elsewhere that independent board members have substantial incentives to buck management.[21] On balance, however, Coates makes a persuasive case that the mediating hierarch model has a relatively small domain.[22] In contrast, the domain of director primacy, which merely requires the absence of a controlling shareholder, seems considerably larger.
C. The Foundational Hypothetical
Blair and Stout develop the mediating hierarchy model by telling the story of a start-up venture in which a number of individuals come together to undertake a team production project.[23] The participating constituents know that incorporation, especially the selection of independent board members, will reduce their control over the firm and, consequently, expose their interests to shirking or self-dealing by other participants.[24] They go forward, Blair and Stout suggest, because the participants know the board of directors will function as a mediating hierarch resolving horizontal disputes among team members about the allocation of the return on their production.[25]
On its face, Blair and Stout’s scenario is not about established public corporations. Instead, their scenario seems heavily influenced by the high-tech start-ups of the late 1990s.[26] Yet, even in that setting, the model seems inapt. In the typical pattern, the entrepreneurial founders hire the first factors of production.[27] If the firm subsequently goes public,[28] the founding entrepreneurs commonly are replaced by a more or less independent board.[29] The board thus displaces the original promoters as the central party with whom all other corporate constituencies contract. It is due to my empirical impression that this is the typical pattern that director primacy assumes the board of directors—whether comprised of the founding entrepreneurs or subsequently appointed outsiders—hires factors of production, not the other way around.[30]
Lest the foregoing seem like an argument for shareholder primacy, I think it is instructive to note the corporation—unlike partnerships, for example—did not evolve from enterprises in which the owners of the residual claim managed the business. Instead, as a legal construct, the modern corporation evolved out of such antecedent forms as municipal and ecclesiastical corporations.[31] The board of directors as an institution thus pre-dates the rise of shareholder capitalism.[32] When the earliest industrial corporations began, moreover, they typically were large enterprises requiring centralized management.[33] Hence, separation of ownership and control was not a late development but rather a key institutional characteristic of the corporate form from its inception.[34] At the risk of descending into chicken-and-egg pedantry, the historical record thus suggests that director primacy emerged long before shareholder primacy. Directors have always hired factors of production, not vice-versa.
D. The Board’s Role
In Blair and Stout’s model, directors are hired by all constituencies and charged with balancing the competing interests of all team members “in a fashion that keeps everyone happy enough that the productive coalitions stays together.”[35] In other words, the principal function of the mediating board is resolving disputes among other corporate constituents.[36] This account of the board’s role differs significantly from the standard account.
The literature typically identifies three functions performed by boards of public corporations:[37] First, and foremost, the board monitors and disciplines top management. Second, while boards rarely are involved in day-to-day operational decisionmaking, most boards have at least some managerial functions. Broad policymaking is commonly a board prerogative, for example. Even more commonly, however, individual board members provide advice and guidance to top managers with respect to operational and/or policy decisions. Finally, the board provides access to a network of contacts that may be useful in gathering resources and/or obtaining business. Outside directors affiliated with financial institutions, for example, apparently facilitate the firm’s access to capital.[38] In none of these capacities, however, does the board of directors directly referee between corporate constituencies.
To be sure, institutional economics acknowledges that dispute resolution is an important function of any governance system.[39] Ex post gap-filling and error correction are necessitated by the incomplete contracts inherent in corporate governance. Those functions inevitably entail dispute resolution. As we’ve seen, the firm addresses the problem of incomplete contracting by creating a central decisionmaker authorized to rewrite by fiat the implicit—and, in some cases, even the explicit—contracts of which the corporation is a nexus.
As the principal governance mechanism within the public corporation, the board of directors is that central decisionmaker and, accordingly, bears principal dispute resolution responsibility. Yet, in doing so, the board “is an instrument of the residual claimants.”[40] Hence, if the board considers the interests of nonshareholder constituencies when making decisions, it does so only because shareholder wealth will be maximized in the long-run.[41]
If directors suddenly began behaving as mediating hierarchs, rather than shareholder wealth maximizers, an adaptive response would be called forth.[42] Consistent with the predictions developed above,[43] shareholders would adjust their relationships with the firm, demanding a higher return to compensate them for the increase in risk to the value of their residual claim resulting from director freedom to make trade-offs between shareholder wealth and nonshareholder constituency interests. Ironically, this adaptation would raise the cost of capital and thus injure the interests of all corporate constituents whose claims vary in value with the fortunes of the firm.
E. A Doctrinal Test: The Business Judgment Rule
Because a model’s ability to predict real world outcomes is more important than the extent to which the model’s assumptions accurately depict the real world,[44] the key question is whether the mediating hierarchy model facilitates accurate predictions about the content of the law. To support their claim that the mediating hierarch model explains the substantive content of corporate law as it exists today, Blair and Stout examine a substantial number of doctrinal principles.[45] Out of consideration for the long-suffering reader, because delving deeply may be more instructive than taking a broad overview, and so as to leave something for future articles, I focus here on a single doctrine—the business judgment rule.
The business judgment rule is the separation of ownership and control’s chief common law corollary.[46] It pervades every aspect of the state law of corporate governance, from allegedly negligent decisions by directors, to self-dealing transactions, to board decisions to seek dismissal of shareholder litigation, and so on.[47] Enabling one to make accurate predictions about the business judgment rule’s scope and content thus stands as the basic test for any model.
Blair and Stout correctly assert that the business judgment rule does not reflect a norm of shareholder primacy, but err in suggesting that the business judgment rule does not reflect a norm of shareholder wealth maximization.[48] The case law, properly understood, does not stand for the proposition that directors have discretion to make trade-offs between nonshareholder and shareholder interests.[49] Instead, the cases stand for the proposition that courts will abstain from reviewing the exercise of directorial discretion even when the complainant alleges that directors took nonshareholder interests into account in making their decision.[50]
The question is one of means and ends. In the classic case of Dodge v. Ford Motor Co., the court emphasized that director discretion is the means by which corporations are governed.[51] More recently, the Delaware supreme court 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.[52]
In other words, the rule ensures that the null hypothesis is deference to the board’s authority as the corporation’s central and final decisionmaker.[53] On this Blair and Stout and I agree. We part company, however, when they deny that the end towards which corporations are governed is, as the Dodge court put it, “the profit of the stockholders.”[54]
Put another way, we agree that the business judgment rule exists to preserve director discretion, but disagree as to why that discretion is important. Blair and Stout contend that the business judgment rule insulates the board of directors from “the direct command and control” of shareholders (or other corporate constituents for that matter) so as to prevent the various constituents from opportunistically expropriating rents from the team.[55] In contrast, I contend that the business judgment rule is the doctrinal mechanism by which courts on a case-by-case basis resolve the competing claims of authority and accountability.
As a positive theory of corporate governance, director primacy claims that fiat—centralized decisionmaking—is the essential attribute of efficient corporate governance. As a normative theory of corporate governance, director primacy claims that authority and accountability cannot be reconciled. As Kenneth Arrow observed:
[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.[56]
The business judgment rule prevents such a shift in the locus of decisionmaking 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.[57] It then reviews the facts to determine not the quality of the decision, but rather whether the decisionmaking process was tainted by self-dealing and the like.[58] 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.[59] The business judgment rule thus builds a prophylactic barrier by which courts pre-commit to resisting the temptation to review the merits of the board’s decision. This is precisely the rule for which shareholders would bargain,[60] because they would conclude that the systemic costs of judicial review exceed the benefits of punishing director misfeasance and malfeasance.[61]
