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A Comment on Leo Strine's Article on "Board Practices in the Digital Era": Time to Revisit Outsourcing the Board with a Note on the Ever Expanding Caremark Doctrine

Former Delaware Supreme Court Justice Leo Strone recently posted a co-authored article, Board Practices in the Digital Era: Maximizing the Benefit-to-Cost Ratio of Information Technology, which argues that:

Information technology can improve the quality of the deliberative processes of corporate boards of directors. Yet, if used imprudently, these technologies can reduce the integrity of corporate decisionmaking and increase business, legal, and reputational risk.

Regrettably, rather than evolving to keep pace with technological developments, corporate governance practices often involve an admixture of obsolete past approaches and ad hoc new ones, a combination that underutilizes the benefits of technology and increases its potential risks. In this article, we look in particular at two types of board-level practices that should evolve to take into account technological developments:

i) board information policies involving (a) the transmission to and use of information by the board of directors and (b) the documentation of action taken by the board and board committees; and

ii) board meeting practices in the wake of the COVID-19 pandemic and the ubiquitous use of web conferencing platforms to conduct director meetings remotely, rather than in person.

These topics are related, because virtual meetings put pressure on board information policies. Virtual meetings require directors and managers to be self-disciplined so that the efficiency advantages that come with virtual meetings are not undermined by inattention, unproductive online interaction, and insufficient in-person time for the board and key managers to meet and develop the chemistry and expectations for information flow vital to successful governance.

This article is not theoretical, but practical. After situating board practice in its historical context, we make recommendations about affirmative steps — “do’s” — that companies could take to improve their board information policies, positive steps that imply actions to avoid — “don’ts”— which we set forth in correlative footnotes. From there, we recommend “do’s” and “don’ts” for board organizational, calendaring, and meeting practices, an understudied area. We then explain how our recommendations facilitate informed, efficient, and credibly-documented decisionmaking.

First, Strine seems untroubled by the prospect that an emphasis on board information flows and meeting procedures is likely to result in directors having greater exposure to Caremark liability. He appears to believe that board failures with respect to overseeing technology and using technology could result in Caremark liability and that that could be a good thing. (See pp. 7-8.)

I have never shared the enthusiasm for Caremark one sees in some circles. To the contrary, I believe Caremark was a mistake from the outset. I also believe the steady expansion of Caremark liability in recent years has been an appalling error. See my article, Don’t Compound the Caremark Mistake by Extending it to ESG Oversight, which is forthcoming in the Business Lawyer, which argues that:

Since the foundational decision in In re Caremark Intern. Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), Delaware corporate law has required boards of directors to establish reasonable legal compliance programs. Although Caremark has been applied almost exclusively with respect to law and accounting compliance, the original Caremark decision contemplated applying the oversight duty to the corporation’s “business performance.” Accordingly, there is no doctrinal reason that Caremark claims should not lie in cases in which the corporation suffered losses, not due to a failure to comply with applicable laws, but rather due to lax risk management.

The question thus arises as to whether Caremark should be extended to board failures to exercise oversight with respect to environmental, social, and governance (ESG) factors. Obviously, where existing legislation or regulations impose compliance obligations in ESG-related areas, such as human resources, the environment, or worker safety, Caremark already applies. As such, boards must “ensure that compliance and monitoring systems are in place” to oversee corporate compliance with those laws.

Many ESG issues are not yet the subject to legal requirements, however. The question addressed in this Article is whether the board’s Caremark obligations should be extended to encompass oversight of corporate performance with such issues. In other words, should the board face potential liability not just for failing to ensure that the company has adequate reporting and monitoring systems in place to insure compliance with ESG-related legal requirements, but also to monitor ESG risks in areas where corporate compliance would be voluntary or aspirational.

Let us turn, however, to the main issue that jumped out at me when I read Strine's article; namely, the ever increasing demands for board expertise.Strine repeatedly calls for boards to have more expertise regarding information technology:

• He posits that Caremark liability arose in cases in which companies "failed to set up structures that ensured adequate time for board members with relevant industry expertise to focus regularly with key company officers on the companies' most important industry-specific issues."
• He thinks companies "need to update board committee structures to prioritize the most important issues at the forefront of board time and to make sure that diverse business risk, EESG, and legal issues are addressed with adequate expertise ...."

The problem is that a combination of increasing regulatory requirements for board expertise, such as the need for financial expertise on the audit committee that resulted from the Sarbanes-Oxley "reforms" to the audit committee, plus the demands of expertise flowing from the steady expansion of Caremark liability, is already forcing companies to seek directors with increasingly specialized expertise. In turn, the demand for specialized firm-specific expertise bumps up against the requirements forcing companies to have almost all board members to be independent directors. 

The problem, as Todd Henderson and I explained in our book, Outsourcing the Board: How Board Service Providers Can Improve Corporate Governance:

In contrast to insiders, who possess significant firm-specific human capital, independent directors tend to be generalists with little firm-specific knowledge, skills, or expertise. Modern boards thus tend to be “composed of individuals who are not qualified to assess the strategic viability of the corporations they direct.” Unfortunately, the rules mandating director indepen- dence virtually ensure that this problem will remain insoluble, because they effectively “rule out just about anybody who has firsthand knowledge of the company and its industry.”...

A board composed principally of generalists will typically lack the sort of specialized skills and expertise many board tasks require.

We also pointed out that the increasing desire on the part of boards to embrace stakeholder theory (a trend I deplore, but that's a story for another day) compounds the needs for board-level expertise:

For the traditional board to manage these stakeholder interests, it will have to have a board member with labor or environmental expertise. Some boards may have these people, but perhaps not. Since the range of potential stakeholders is large, it is unlikely that a firm will have a board member that can claim expertise or networks in all the areas in which a firm may want to deploy the board. After all, boards already need a range of expertise in areas like accounting, finance, strategy, the particular industry, compensation, and a host of other topics.

Strine proposes bringing an insider onto the board:

We also think that the case could be made for adding another member of management to the board; although that individual would not be an independent director, the added expertise and experience would benefit the board as a whole.

But as Henderson and I explained:

Even if there is an expert on labor or environmental issues on the board, there is a potential weakness in relying on an individual board member to be solely responsible for managing this process. Although boards routinely dele- gate authority to committees or subgroups of the board, there is additional risk from having a single individual board member be the only person on the board with the information, expertise, and authority to handle the management of an important stakeholder relationship.

There is, however, a solution. It is a solution that would reduce the risk of Caremark liability and bring a huge increase in expertise to the board. It is what Henderson and I proposed in out book Outsourcing the Board: How Board Service Providers Can Improve Corporate Governance. We asked:

Why does the law require governance to be delivered through individual board members? While tracing the development of boards from quasi-political bodies through the current “monitoring” role, the authors find the reasons for this requirement to be wanting. Instead, they propose that corporations be permitted to hire other business associations – known as “Board Service Providers” or BSPs – to provide governance services. Just as corporations hire law firms, accounting firms, and consulting firms, so too should they be permitted to hire governance firms, a small change that will dramatically increase board accountability and enable governance to be delivered more efficiently.

With regard to the board expertise issue, we pointed out that:

When board members currently need outside expertise, it all too often comes from outsiders hired by or influenced by the CEO, which creates serious conflict-of-interest problems. In the BSP model, by contrast, we assume that the board-service company would have an internal expert staff backing up the individuals who provide the board functions. ... This is a classic example of the choice between “building” (that is, having expertise inside a particular firm) and “buying” (that is, hiring the expertise in the market) that firms face in a host of activities.

As we demonstrate in the book, buying board expertise by outsourcing the board function to a consultant firm is going to be much more efficient.

BSPs are highly adaptable. They are well suited to perform the monitoring function as required by current law and best practices, but they are equally well suited to performing service and managerial functions. Indeed, as we shall see, because BSPs are less subject to time and expertise constraints than individual directors, they are capable of fully carrying out the monitoring function while also simultaneously providing more effective advisory, networking, and managerial services.

So the solution seems to be revisiting the possibilities offered by BSPs.

Tribute for Robert Scott

Another serious problem with the Securities and Environmental Commission climate change disclosure plan

From Bloomberg News:

The proposed language would require companies to disclose to the Securities and Exchange Commission any analyses they use to measure the resilience of their business strategies to climate risks....

Scenario analyses are “dress rehearsals” that companies use to test how potential, hypothetical future scenarios could affect their business.

But the provision would put companies in the position of having to share highly speculative forecasts that may end up being disconnected from reality, according to Cynthia Mabry, a partner at Akin Gump Strauss Hauer & Feld LLP.

“If you had a crystal ball, what would the world look like—how is that helpful to investors?” Mabry asked. “I really struggle with this one. On a Tuesday you could be thinking you see a market opportunity and it’s great, and on Wednesday the war on Ukraine breaks out and you’re not going to do business in Poland.”

If this absurd requirement stays in the rules, one important question will be whether the safe harbor in the 1995 PSLRA cover these scenario analyses.

Prayer to Our Lady of Vladimir, Patroness of Russia, for peace in the Russo-Ukrainian war.

The War in the Ukraine Reveals Two Basic Flaws in ESG Investing

Flaw #1: Prior to the 2022 Russian invasion of Ukraine, ESG indices typically excluded defense contractors. Companies that sell ratings of corporate ESG performance likewise downgraded defense companies. In the wake of outbreak of war, however, many rating firms, ESG funds, and index suppliers are reconsidering the exclusion of defense companies. The Russo-Ukrainian war also raised questions about whether fighting climate change was more socially responsible than dealing with inflation and the impact of energy prices on the poor. James Mackintosh, Do Good Investing is Under Pressure, Wall St. J., Mar, 28, 2022, at B1. Trying to be socially responsible is exceeding difficult when the definition of what is socially responsible involves clashing goals and rapidly changing perceptions about what is pro-social.

Flaw #2: European corporations with major operations in Russia prior to the outbreak of the Russo-Ukrainian war typically had higher ESG ratings than those who were not operating in Russia. Doing extensive business in an increasingly authoritarian and militaristic apparently had little, if any, impact on the ESG industry’s perceptions of those companies. Perhaps even more instructively, however, is that companies with lower ESG ratings were more likely to divest or suspend any Russian operations than did companies with higher ESG ratings. Id. All of which tends to call into question the merits of the ESG industry’s claims to be socially responsible.

SEC Releases Climate Change Disclosure Proposal: Too Costly, Too Far Outside the SEC's Authority

I have just started reviewing the SEC's climate change proposal, which is over 500 pages, which tells you something right there. 

The WSJ reports:

The Securities and Exchange Commission formally offered a 534-page proposal Monday that would force publicly traded companies to report greenhouse-gas emissions from their own operations as well as from the energy they consume, and to obtain independent certification of their estimates.

In some cases, companies also would be required to report greenhouse-gas output of both their supply chains and consumers, known as Scope 3 emissions. An SEC official said most companies in the S&P 500 would likely have to report Scope 3 emissions. Companies would have to include the information in SEC filings such as annual reports.

Some thoughts. (1) This is yet another example of the increasing use of regulatory end-runs by Presidents of both parties. With Congress deadlocked and unable to move on addressing climate change, Biden is using executive orders and regulatory actions to effect change without Congressional action. In doing so, however, he perverts the Constitutional scheme of checks and balances. 

(2) Retail investors are already overwhelmed by mandated disclosure. In an era of 100-page proxy statements and annual reports, owning just 20 stocks subjects one to thousands of page of disclosure--vetted if not written by lawyers. The proposal thus represents another shift in the SEC away from its historic mission of protecting retail investors. Instead, as the Journal opined:

SEC Chairman Gary Gensler is redefining materiality as whatever BlackRock and progressive investors want to know.

(3) The requirement that companies disclose Scope 3 emissions will make the rule even more costly and burdensome than the absurd combat mineral disclosures companies have been struggling with for the last decade:

For example, Exxon Mobil would have to report its direct emissions as well as any from fossil fuels burned to generate the electricity it uses. It may have to quantify emissions from the combustion of its products, the tankers that deliver them, and the manufacturing of its rigs and plastic products when they degrade.

Scope 3 emissions have no clear definition. The agency says it has “not proposed a bright-line quantitative threshold for the materiality determination” for Scope 3 emissions because this “would depend on the particular facts and circumstances, making it difficult to establish a ‘one size fits all’ standard.”

Yet the overall rule would impose a one-size-fits-all regulation on thousands of public companies.

There is a significant risk of double counting Scope 3 emissions. An upstream issuer discloses emissions by its customers, while a downstream issuer reports the same emissions (as well as those its supplier).

In other words, we're going to make you companies undertake a hugely burdensome process with no guidance as to whether you're doing it right. But if we decide you did it wrong, we sue you. Heads, the SEC wins; tails, the company loses.

And, speaking of the analogous disclosure regime on conflict minerals, is there any evidence that that regime has educed the use of conflict minerals or made anybody's life better? Or helped investors make more money? I am not aware of any.

(4) As SEC Commissioner Hester Peirce explained in opposing the regulations, the proposals are way outside the SEC's wheelhouse and probably exceed the SEC's authority. (You really need to go read her statement, which is a brilliant dissection of the proposal.)

Congress gave us an important mission—protecting investors, facilitating capital formation, and fostering fair, orderly, and efficient markets—and granted us sufficient regulatory authority to achieve that mission.  Effective execution of that mission forms the basis for healthy capital markets and, in turn, a healthy economy.  Congress, however, did not give us plenary authority over the economy and did not authorize us to adopt rules that are not consistent with applicable constitutional limitations.  This proposal steps outside our statutory limits by using the disclosure framework to achieve objectives that are not ours to pursue and by pursuing those objectives by means of disclosure mandates that may not comport with First Amendment limitations on compelled speech.

All the disclosure mandates we adopt under authority granted to us by Congress are at bottom compelled speech, and this one in particular prescribes specific content for the speech that it mandates. ...

Large asset managers—who are paid to invest other people’s money—some institutional investors, and some retail investors have been vocal proponents of climate change disclosures.  But why are they asking?  If they are asking for information to help them assess the financial value of companies in which they are considering investing, this information may be material and is likely covered by existing disclosure rules.  But many calls for enhanced climate disclosure are motivated not by an interest in financial returns from an investment in a particular company, but by deep concerns about the climate or, sometimes, superficial concerns expressed to garner goodwill.

I will have more to say about the proposal as it goes forward. But for right now, it's shaping up to be a disaster,

Recommended reading: Roy Shapira, Max Oversight Duties: How Boeing Signifies a Shift in Corporate Law

Regular readers know that the direction of Delaware's Caremark litigation worries me. See my blog post on the disastrous Boeing decision and my forthcoming article on how the Caremark mistake might evolve into imposing duties on directors who fail to conduct ESG oversight to the satisfaction of a Delaware jurist. 

So I noted with great interest Roy Shapira's new article on Caremark:

In September 2021, the Boeing 737 Max debacle turned into an important moment in corporate law. A Delaware court allowed a derivative lawsuit brought by Boeing shareholders to proceed, based on the theory that Boeing’s directors breached their oversight duties by not doing enough to monitor, prevent, and react to fatal airplane safety issues. This Essay explains what the Boeing decision means for director oversight duties going forward, and uses it as a springboard to discuss broader trends in corporate law. Specifically, the Essay makes the following five contributions.

First, the Essay delineates the contours of a new era of heightened oversight duties. Corporate law courts are increasingly willing to designate certain compliance risks as “mission critical,” thereby activating an enhanced scrutiny mode. Boeing suggests that practically all directors of manufacturing companies are operating in or around the mission critical zone these days, and illustrates just how enhanced the scrutiny is once in this zone. Second, the Essay fleshes out a shift in focus: from scrutinizing compliance with regulations meant to protect investors (such as financial reporting), to scrutinizing compliance with regulations meant to protect broader societal interests (such as product safety). Boeing, for example, faults directors for focusing on restoring corporate profitability and image instead of putting consumer safety front and center. Third, the Essay uses Boeing to show how corporate law guides behavior not just directly, through legal sanctions, but also (and indeed more so) indirectly, through shaping norms and reputations in the business community. Boeing did not end in a verdict in favor of the plaintiffs: it was instead settled quickly after the motion to dismiss. Still, the case created significant changes in the advice that lawyers give their director clients, and in the volume and tone of media coverage, which in turn created reputational fallouts. Fourth, the Essay evaluates the desirability of the Boeing development. On one hand, the development holds the promise of mitigating incentives to remain ignorant, and improving accountability. On the other hand, Boeing may have gone too far in removing corporate law’s guards against hindsight bias. Finally, the Essay spotlights two big questions that Boeing left unanswered: officer oversight liability, and director liability for oversight of nonlegal requirements.

I lean so much to the "other hand" position, that I disagree with some of his "one hand" analysis, but I nevertheless think it is a very important article that deserves wide attention.

Recommended Reading: Paul Mahoney, The Economics of Securities Regulation: A Survey

An important and very well done review of the literature:

This paper reviews the academic literature that analyzes securities regulation from an economic perspective. It begins by describing the institutional foundations of securities law in the U.S. and distinguishing securities regulation from the private law of contracts, property, and fraud. Section 2 discusses the theoretical literature on mandatory versus voluntary disclosure in securities markets, focusing on information asymmetry and agency problems as justifications for mandatory disclosure. Section 3 surveys empirical work on the efficacy of actual mandatory disclosure rules. The remaining sections describe particular aspects of the U.S. regulatory system, including the regulation of public offerings, publicly-traded companies, trading markets, securities fraud, insider trading, market manipulation, and mutual funds and other collective investment vehicles, and surveys important theoretical and empirical work on each. The paper is intended to offer both institutional background and a summary of key research findings that may provide useful starting points for future research.

Mahoney, Paul G., The Economics of Securities Regulation: A Survey (August 24, 2021). Foundations and Trends in Finance, forthcoming, Virginia Law and Economics Research Paper No. 2021-14, Available at SSRN: https://ssrn.com/abstract=3910557

Lawrence Cunningham Posits that the SEC has Lurched Left "Off the Political Rails"

GW law professor Lawrence Cunningham has a new column out (sadly behind a paywall), in which he criticizes the SEC for designing its recent regulatory proposals so as to facilitate efforts by progressive political activists to influence corporations to achieve social justice and ESG issues that they cannot achieve politically.

Under Chairman Gary Gensler, the SEC is backing the team that views corporations mainly as social institutions, while trying to defeat the team that views corporations as primarily economic ones. ...

Cunningham focuses on the SEC's proposed changes to the rules under Sections 13(d) and 13(g) of the Securities Exchange Act. Those rules basically require investors who own 5% or more of a company's shares to file a disclosure document setting out their holdings, plans, and intentions.

... the SEC would make it easier for political activists to use corporate shareholder voting in campaigns promoting climate control, civil rights and board diversity — policies championed by the environmental, social and governance, or ESG, movement. For instance, the proposal narrows the concept of "group" for this cohort to make it easier for social activists to coordinate campaigns with each other and increase votes for ESG proposals.

... The SEC seeks to handicap traditional economic activists in favor of ESG activists. This runs counter to the SEC's historical mandate to serve the economic interests of Main Street shareholders, not put its weight behind particular political philosophies.

... Starting this year, the SEC has [also] liberalized its approach to the topics shareholders may require companies to put on the corporate ballot. Historically, companies could omit proposals pushing broad social policy unrelated to a company's business.

But now anything having to do with ESG must go on the ballot, with updated guidance noting staff will disregard "the nexus between a policy issue and the company" and instead focus on "the social policy significance of the issue" raised in the proposal. Expect novel proposals spanning from internal civil rights audits to disclosures of every director's sexual preference.

... While most shareholders will vote against such proposals as nonstarters ... the costs the SEC is imposing on shareholders are nontrivial.

In short, Gary Gensler has turned a historically apolitical federal agency into an arm of the progressive wing of the Democratic Party.

"How Would Directors Make Business Decisions Under a Stakeholder Model?": Recommended reading

I really enjoyed Robert Miller's new article, obtaining a number of useful insights to incorporate into the book I'm writing on corporate social responsibility and stakeholder capitalism:

Strong forms of the stakeholder model of corporate governance hold that, in making business decisions, directors should consider the interests of all corporate constituencies (employees, customers, suppliers, shareholders, etc.) in such a way that directors may sometimes decide to transfer value to a non-shareholder constituency even though doing so produces no net benefit for shareholders even in the long-term. This article makes four main points about the stakeholder model. First, although its advocates often speak as if the model placed all corporate constituencies on a par, in fact the model uniquely disadvantages shareholders: since the claims of other constituencies arise in contract or by law, directors have no power to invade these claims for the benefit of shareholders; hence, business decisions made under a stakeholder model will often transfer value from shareholders to other constituencies but never from other constituencies to shareholders. Second, although critics of the stakeholder model have long argued that the model provides no definite standard by which directors may decide what to do in particular cases, this greatly understates the point. In fact, the stakeholder model leaves business decisions radically indeterminate, for it includes no normative criteria by which any business decision could be judged to be any better or any worse than any other. Third, some normative criteria that can be added to the stakeholder model and might seem to solve this problem in fact fail to do so; this includes criteria based on Kaldor-Hicks efficiency, on hypothetical bargains among the corporate constituencies, or even on Delaware doctrines about allocating merger consideration among classes of shareholders. Finally, the article notes a surprising point of agreement between advocates of stakeholderism and its critics, viz., that decisions made under a stakeholder model would be essentially political in nature. That is, they will be based not on rational, normative considerations but on the varying abilities of different constituencies to pressure or lobby the directors—i.e., business decisions become essentially rent-seeking contests.

Miller, Robert T., How Would Directors Make Business Decisions Under a Stakeholder Model? (February 6, 2022). Business Lawyer (2022 Forthcoming), Available at SSRN: https://ssrn.com/abstract=4032539 or http://dx.doi.org/10.2139/ssrn.4032539