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Corporate Governance Q&A at the Lowell Milken Institute’s Mini-Conference on Corporate Governance, Tax Law and Nonprofit Law

The Lowell Milken Institute for Business Law and Policy at the UCLA School of Law today celebrated ten years of training the next generation of leaders in business law with a mini-conference for alumni, practitioners, business executives and students. I was honored to be asked to serve on a panel with Kimberly Simpson, Chief Operating Officer and General Counsel, National Association of Corporate Directors, in which we were asked and answered a bunch of questions about corporate governance. In a series of posts below, I revise and extend my remarks:

What are major issues/challenges boards are facing in the next year or two?

What do we mean by the term “corporate governance”?

Do you think corporate culture has any role to play in effective governance?

What is the relationship between defining the corporation’s purpose and establishing principles of corporate governance?

Do you still support outsourcing the board?

How can lawyers get on boards of directors?

How should we respond to crises in corporate governance?

Caremark and the Board's Duty of Oversight

What do each of you see as the major challenges facing boards beyond the economy?

Corporate Governance Panel Question: What are major issues/challenges boards are facing in the next year or two?

Question

What are major issues/challenges boards are facing in the next year or two? They seem to be facing numerous difficult issues including:

• Political issues, e.g. Disney and Florida; crisis in the Middle East
• Marketing issues, e.g. Budweiser marketing campaign involving a transgender influencer
• More “mundane” issues: AI, cybersecurity, lots of questions about the future of regulatory regimes, role of institutional investors on corporate boards.

Answer

1. Cybersecurity. As the frequency and complexity of cyber threats continues to grow, boards are coming under increasing pressure from regulators and litigation (such as Caremark claims) to ensure cybersecurity. Accordingly, board members need to make safeguarding their organization's digital assets and customer data a top priority. This entails consistently assessing and enhancing cybersecurity strategies, allocating resources to establish resilient systems, providing comprehensive training for employees, and ensuring adherence to data protection regulations.
2. Risk management: Cybersecurity is a sufficiently important risk to deserve its own category. But the general problem of risk management remains an important part of what boards must do. Board-level systems designed to monitor and oversee mission-critical functions play a crucial role in showcasing the board's fulfillment of its Caremark duties. This was evident last year when the Delaware Court of Chancery allowed a Caremark duty-of-oversight claim to advance against Boeing Company directors. The court's decision was based on allegations of insufficient board involvement in safety matters and the absence of a dedicated committee with direct oversight responsibilities. Nevertheless, it's worth noting that two subsequent cases, Hamrock and SolarWinds, have underscored the necessity of establishing bad faith rather than merely proving gross negligence for a Caremark claim to succeed.
3. Shareholder activism. The ongoing fluctuations in equity values, characterized by both volatility and a general decline, have brought vulnerabilities to the forefront for many companies while also opening up opportunities for activist investors. This trend is expected to continue into the coming year. What particularly piques my interest is the potential impact of the recent SEC rule mandating the use of universal proxy cards in director election proxy battles. This innovation is poised to streamline the proxy contest process, reducing the costs and efforts associated with activists nominating and seeking proxies for board member elections. Consequently, this change may shift the focus in proxy battles towards assessing the track records and skill sets of individual directors, as opposed to evaluating the overall performance of the company or board as a whole. With the introduction of universal proxy cards, shareholders will gain the ability to selectively choose individual directors from both the company's and the activist's competing slates.
4. Political risks. Boards need to pay attention both to how the corporation engages with politics and how politics affects the corporation. As to the former, activists are paying attention to issues like corporate political spending. As for the latter, the runup to the 2024 presidential election will require boards to assess possible changes in the presidency, Congress, and the membership of the SEC.

Corporate Governance Panel Question: What do we mean by the term “corporate governance”?

Question

Some commentators suggest that the modern iteration of corporate governance in the United States began in the 1970s.[1] So, in 2023, what do we mean by the term “corporate governance”?

Does it just mean the set of legal rules and norms addressing the conduct of directors and officers of a corporation? Does it necessarily include mechanisms of regulatory oversight such as those applied to public companies and certain industries such as banking and certain functions such as privacy? Does it necessarily include criminal laws? Is it more than that?

And, if it is more than just the legal rules and norms addressing the conduct of directors and officers of a corporation, how should we make regulators more effective at enforcing corporate governance norms? Are there other regulatory agencies, federal or state, that should have a direct role in corporate governance?

What about member organizations like the NACD? What should its role be in developing norms for directors? Are organizations like the NACD potentially more effective because they explain the role of the board in terms that non-lawyers can understand?

Answer

I like this question a lot. But I will use it as a jumping off point for flagging the importance of non-legal aspects of corporate governance; specifically, best practices. In 1982, Thomas Peters and Robert H. Waterman expanded upon Xerox's practical approach in their influential book, "In Search of Excellence: Lessons from America's Best-Run Companies." Their work brought the concept of best-practices research and implementation into the mainstream of American organizations. The authors conducted a comprehensive study, analyzing sixty-two American companies spanning various industries, and identified eight attributes that they believed epitomized the excellence of America's most innovative entities. With over three million copies sold and a long stint on bestseller lists, Peters and Waterman succeeded in popularizing the adoption of best practices as a strategy for gaining a competitive edge by emulating the most effective strategies of competitors.

As the number of success stories multiplied and the popularity of best practices soared, three primary styles of benchmarking emerged: competitive benchmarking, cooperative benchmarking, and collaborative benchmarking. Competitive benchmarking involves gathering information from competitors to establish a benchmark. This approach entails measuring your functions, processes, activities, products, or services against those of your competitors and continually improving them to attain best-in-class status. Cooperative benchmarking necessitates a company seeking improvement in a particular activity to reach out to a best-in-class firm and request knowledge-sharing with the benchmarking team. Collaborative benchmarking, on the other hand, involves companies coming together to exchange information about an activity with the aim of enhancing their internal processes based on the acquired insights. Ideally, as more companies adopt best practices and engage in cooperative knowledge-sharing, the resulting impact will be widespread, fostering further innovation.

Despite facing its share of critics, the best-practices methodology undeniably remains a common and highly regarded practice among many modern organizations. Most large corporations now engage in at least one form of benchmarking to develop and implement best practices.

The NACD has played an important role in developing and promulgating best practices. The NACD’s Corporate Governance Guidelines, for example, incorporate both legal rules and norms of best practice.

But given the emphasis in your question on the role of regulatory agencies, it would be worth having a discussion of whether the United States should follow the lead of the United Kingdom in having a regulatory body that develops best practice codes.

The UK Corporate Governance Code acknowledges that effective corporate governance cannot be achieved through a one-size-fits-all approach, recognizing that different companies may require different methods. Consequently, it allows for flexibility and permits companies to deviate from the Code, provided they offer a rationale for their non-compliance.

In their annual reports, companies are expected to disclose whether they have: a) fully adhered to all aspects of the Code's Provisions throughout the entire financial year; or b) departed from any of the Code's Provisions (either for the entire financial year or a portion thereof), specifying the Provisions they have not followed and indicating where in the report the explanation can be located.

It's crucial to note that the Code serves as a framework for best practices rather than a strict set of rules. It comprises adaptable requirements. In instances where a company has justified non-compliance with a Provision, it falls upon investors to assess whether the explanation is satisfactory and demonstrates how deviating from the Code benefits the company. In cases where explanations are deemed inadequate, investors are encouraged to engage with the companies and hold directors accountable, with the aim of enhancing governance practices and reporting standards.

 

[1] See e.g., https://www.thecorporategovernanceinstitute.com/insights/lexicon/why-does-corporate-governance-matter-a-look-back-at-history/

Corporate Governance Panel Question: Do you think corporate culture has any role to play in effective governance?

Question

We often speak of a "corporate culture" in the context of corporate governance. What is meant by that? Do you think corporate culture has any role to play in effective governance?

The NACD tries to mold corporate culture through its education programs and Kimberly you have written about that and participated in those programs. What do you think are effective drivers in creating an optimal corporate culture in the boardroom and the C-Suite?

Answer

Corporate cultures are very real. Indeed, I would argue that dysfunctional corporate cultures lie at the root of many corporate business failures and violations of the law.

The interesting issue implied by your question is whether boards of directors have much influence over corporate cultures. Personally, while I agree with those who would argue that “tone from the top” is crucial for creating effective and ethical corporate cultures, I suspect that the “top” for this purpose is the C-suite—especially the CEO—rather than the board of directors. They are the folks the employees of the company will look to for guidance, rather than the board. The board does not interact with most employees even in times of crisis. It is the CEO and the other members of the C-suite who are in the office daily, setting the desired tone.

The board’s role in this regard thus is primarily one of monitoring the CEO and the C-suite to ensure that they are setting the proper tone at the top. The ABA Corporate Director’s Guidebook explains:

The CEO and senior management must take the leadership role to promote integrity, honesty, and ethical conduct throughout the organization. The board's role is to assess the CEO's commitment and efforts in this area, support and encourage appropriate values (including through policies and incentives), and provide oversight of the programs and procedures that management implements to support behaviors and identify issues that may arise (including reporting mechanisms). This board role includes directing the CEO and other members of the senior management team to establish the proper “tone at the top” by setting clear expectations for the corporation's ethical behavior and conduct of its business in compliance with law.[1]

 

[1] The Corporate Laws Committee, ABA Section of Business Law, Corporate Director's Guidebook-Sixth Edition, 66 Bus. Law. 975, 987 (2011).

Corporate Governance Panel Question: What is the relationship between defining the corporation’s purpose and establishing principles of corporate governance?

Question

What is the relationship between defining the corporation’s purpose and establishing principles of corporate governance? U.S. society is in the middle of a debate over the proper purpose of the corporation. Do we need to settle that debate in order to decide what is good governance?

On this point, recently the NACD did a survey of which practices directors expect to see more of and less of in the years ahead.  40% of respondents say that in the future it will be less acceptable to focus on shareholders at the expense of other stakeholders. About 62% said that boards will widen their definition of success to include the societal impact of operations.

Answer

There’s a lot going on in this question. It’s really about half a dozen questions rolled into one.

I will start by asking whether the ends of corporate governance can be separated from the means of corporate governance. Put another way, why is board centric governance a feature of shareholder capitalism? Would it also be a feature of stakeholder capitalism? I think (emphasis on the word think) the answer is yes.

But even if a board of directors would exist in corporate system premised on stakeholder capitalism, what would be the role of the board in such a system? At present,  in our system of shareholder capitalism, the board’s role is primarily monitoring. Its service and managerial roles are of minor importance. Would that change in a stakeholder capitalist system? Margaret Blair and Lynn Stout argue the board should function as mediating hierarchs, which would seem to imply an emphasis on managerial decision making.

By the way, as for the NACD survey, it is a fundamental tenet of my book The Profit Motive: Defending Shareholder Value Maximization that what directors and CEOs say is of far less importance than what they do. Most boardroom and C-suite ESG talk is greenwashing.

Corporate Governance Panel Question: Do you still support outsourcing the board?

Question

In 2018, Stephen, with his co-author University of Chicago Law Professor Todd Henderson, published a book entitled Outsourcing the Board: How Board Service Providers Can Improve Corporate Governance. The argument in the book was that after decades of trying, those who advocate for better corporate governance have failed to find ways to implement it as evidenced by corporate scandal after corporate scandal. Professors Bainbridge and Henderson proposed to replace a board of diverse individuals with special service organizations with the subject matter expertise and experience to serve as the board. Are there other changes that could improve corporate governance?

Answer

Short answer: Adopt our proposal. We would not mandate that all boards adopt the board service provider model in which a single outside entity replaces the board, but we think it should be an available option.

Long answer: Read the book.

Corporate Governance Panel Question: How can lawyers get on boards of directors?

Question

Many in our audience are lawyers. Often lawyers want to become members of the board. What does it take for a lawyer to become a member of a board? What are some paths and resources for lawyers interested in becoming a member?

Answer

I wish I knew. As someone for whom the board of directors is his principal academic interest, I’d love to get the experience of actually serving on a board. But nobody’s asked.

Corporate Governance Panel Question: How should we respond to crises in corporate governance?

Question

We get excited about governance whenever there is a crisis. One consequence of that is the public seems to have a poor opinion of corporate officers and directors. For example, there are calls by government officials to hold the officers and directors of Silicon Valley Bank accountable although it is not clear exactly what they did wrong.

Is one of the legitimate goals of corporate governance to bolster (or restore) public confidence in corporations? How should that affect lawyers and policymakers’ work on corporate governance?

Your work has been described as defending the board centric model of corporate governance. If the public has a low opinion of boards and their members, does that affect your model in any way?

Answer

At the risk of seeming unduly flippant, the public also has a very low opinion of the President, Congress, the news media, and so on. But we muddle along with them.

In my book, Corporate Governance after the Financial Crisis, I discuss how the Sarbanes-Oxley Act responded to the crisis caused by the bursting of the tech bubble, the scandals at Enron et al., and how the Dodd-Frank Act responded to the 2007 financial crisis.

In both cases, a powerful interest group coalition centered on activist institutional investors hijacked the legislative process so as to achieve longstanding policy goals essentially unrelated to the causes or consequences of either crisis. Without exception, the Acts’ provisions lacked strong empirical or theoretical justification. To the contrary, there were theoretical and empirical reasons to believe that each would be at best bootless and most would be affirmatively bad public policy. Finally, each eroded the system of competitive federalism that is the unique genius of American corporate law by displacing state regulation with federal law. Unfortunately, this has become a recurring pattern whenever the federal government is moved to action by a new economic crisis.

In sum, the federal role in corporate governance appears to be a case of what Robert Higgs identified as the ratchet effect.^[1] Higgs demonstrated that wars and other major crises typically trigger a dramatic growth in the size of government, accompanied by higher taxes, greater regulation, and loss of civil liberties. Once the crisis ends, government may shrink somewhat in size and power, but rarely back to pre-crisis levels. Just as a ratchet wrench works only in one direction, the size and scope of government tends to move in only one direction—upwards—because the interest groups that favored the changes now have an incentive to preserve the new status quo, as do the bureaucrats who gained new powers and prestige. Hence, each crisis has the effect of ratcheting up the long-term size and scope of government.

We now observe the same pattern in corporate governance. As we have seen, the federal government rarely intrudes in this sphere except when there is a crisis. At that point, policy entrepreneurs favoring federalization of corporate governance spring into action, hijacking the legislative response to the crisis to advance their agenda. Although there may be some subsequent retreat, such as Dodd-Frank’s § 404 relief for small issuers, the trend is towards ever more federal regulation.

[1] See Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government 150-56 (1987) (describing the “ratchet effect” by which Congress increases not only the scale but also the scope of the federal government on a permanent basis).

Corporate Governance Panel Question: Caremark and the Board's Duty of Oversight

Question

Over the past few years, the Delaware Courts have been wrestling with the duty of oversight as first set forth in the Caremark case. The exact parameters of that duty, when it is triggered, and what it entails remains somewhat uncertain.

Putting aside Delaware law for a moment, Do you think that good corporate governance requires a board to have a duty of oversight that is part of the duty of loyalty or duty of care?  (If not, why not.)

Stephen, I know that you have been critical of Caremark and the Caremark line of cases. Do you think the duty of care or the duty of loyalty includes within it a duty of oversight at all or do you think it is unnecessary for effective governance.

Answer

First, Caremark was wrong from the outset. Caremark’s unique procedural posture, which precluded any appeal, gave Chancellor Allen an opportunity to write “an opinion filled almost entirely with dicta” that “drastically expanded directors’ oversight liability.” In doing so, Allen misinterpreted binding Delaware Supreme Court precedent and ignored the important policy justifications underlying that precedent.

Second, Caremark was further mangled by subsequent decisions. The underlying fiduciary duty was changed from care to loyalty, with multiple adverse effects. In recent years, moreover, there has been a steady expansion of Caremark liability. Even though the risk of actual liability probably remains low, there is substantial risk that changing perceptions of that risk induces directors to take excessive precautions.

I think we ought to revive Graham v. Allis-Chalmers Manufacturing Co., 188 A.2d 125, 130 (Del. 1963). Consider the old saying: “every dog gets one bite.” This saying was based on the common law principle that a dog’s master was only liable for bites if the master knew or had reason to know the dog had a propensity to bite. Such knowledge could be based either on the breed’s inherently violent propensities or a prior bite. The economic rationale for such a rule is simple—monitoring costs. Keeping an eye on your dog requires costly precautions, such as leashes, fences, and the like. Why require such expenditures if Fido is as gentle as a lamb?

The analogy to Graham should be self-evident, but let’s beat the dead horse anyway. Just as a dog owner does not have liability unless the owner knows the dog has a propensity to bite, directors are liable only if they are on notice that their employees have a propensity for crime. Just as a dog owner is put on such notice by a prior bite, prior criminal violations can put directors on notice. Just as owners have an affirmative duty to control dogs of an inherently vicious breed, directors may not recklessly fail to monitor an obviously untrustworthy employee.

As with the dog bite rule, Graham implicitly rests on a cost-benefit analysis. Law compliance programs are not free. At the very least, a law compliance program requires preparation of a company manual telling employees not to fix prices. It probably also requires training of employees. Beyond that, the firm probably should send lawyers out to do compliance audits from time to time. Programs with real teeth require substantial high-level commitment and review, frequent and meaningful communication to employees, serious monitoring and auditing, and appropriate discipline where violations are discovered. By analogy to the dog bite cases, one reasonably would expect a firm to go through all this only when on notice of a past violation.

Interestingly, the Model Business Corporation Act’s director liability provisions codify a standard closer to Graham than Caremark. Under MBCA § 8.31(a)(2)(iv), a director may be held liable for sustained inattention but only when “particular facts and circumstances materialize that” would put “a reasonably attentive director” on notice of the need for further inquiry. Under this provision, it would seem, proactive vigilance is not required.

Reading

Bainbridge, Stephen Mark, Don’t Compound the Caremark Mistake by Extending it to ESG Oversight (September 2021). Business Lawyer (September 2021), UCLA School of Law, Law-Econ Research Paper No. 21-10, Available at SSRN: https://ssrn.com/abstract=3899528

Bainbridge, Stephen Mark, Caremark and Enterprise Risk Management (March, 18 2009). UCLA School of Law, Law-Econ Research Paper No. 09-08, Available at SSRN: https://ssrn.com/abstract=1364500 or http://dx.doi.org/10.2139/ssrn.1364500

Bainbridge, Stephen Mark and Lopez, Star and Oklan, Benjamin, The Convergence of Good Faith and Oversight. UCLA School of Law, Law-Econ Research Paper No. 07-09, Available at SSRN: https://ssrn.com/abstract=1006097 or http://dx.doi.org/10.2139/ssrn.1006097

Corporate Governance Panel Question: What do each of you see as the major challenges facing boards beyond the economy?

Question

What do each of you see as the major challenges facing boards beyond the economy? For example: Do you think we will see more pressure from certain state actors on corporate policy a la Florida and Disney? Do you think the large funds (Blackrock, State Street, Vanguard) will continue to pressure companies for certain social change?

Answer

In my book, The Profit Motive: Defending Shareholder Value Maximization, I discuss the question of whether CEOs have become social justice warriors. Some have. Most of the supposedly woke CEOs, however, revert to shareholder primacy when push comes to shove.

As for the big three asset managers—BlackRock, State Street, and Vanguard—all claim to have embraced ESG because they believe that ESG factors are positively correlated with firm performance. But I think it’s mostly greenwashing. Case in point: The coal-fired Hardin Generating Station in Montana had been struggling for years. Late last year, a Nasdaq-listed bitcoin miner called Marathon Digital Holdings Inc. partnered with Hardin’s owner to transform the power plant into a hub for mining bitcoin.

The project is in the process of scaling up, with more than 100 megawatts of power capacity planned. Marathon Digital said that by tapping the Montana coal plant, its break-even costs to produce a bitcoin will fall to $4,600, 38% less than previously.

One of Marathon’s biggest shareholders? BlackRock.

Back in March we learned that Vanguard CEO Tim Buckley was backing his massive fund family away from ESG: “Our research indicates that ESG investing does not have any advantage over broad-based investing,” Mr. Buckley said in a recent interview with the Financial Times. Matching word to deed, his comments came after he had withdrawn his firm from the $59 trillion Net Zero Asset Managers initiative, an organization that is part of the $150 trillion United Nations-affiliated Glasgow Financial Alliance for Net Zero. Both alliances are committed to restricting their investments over time to companies that are compliant with the Paris Agreement’s objective of net-zero greenhouse gas emissions by 2050. Mr. Buckley claims the financial world, swept up in climate-change fervor, can’t make such commitments without reneging on its fiduciary duties.

As Delaware contemplates the Match.com case, the court should acknowledge that not all controlling shareholder transactions should require cleansing.

Bloomberg reports:

Delaware’s top court is weighing a potentially groundbreaking ruling that could streamline corporate dealmaking while scaling back protections for minority investors in many transactions that favor insiders.

A case involving dating site Match.com is giving the leading US forum for M&A disputes a chance to reaffirm or rein in enhanced scrutiny of deals involving a potential conflict of interest between a company and its controlling stockholder. ...

The legal framework getting a hard look from the Delaware’s high court is known as the “MFW” doctrine. Named after the court’s seminal 2014 ruling in Kahn v. M&F Worldwide Corp. , it was developed for “squeeze-out” or “freeze-out” transactions that forcibly cash out investors at a price unilaterally set by a controlling stockholder.

But judges on Delaware’s Chancery Court are now applying the standard to a wider range of deals. 

Bloomberg further explains that:

The legal standard facing an unexpected challenge requires corporate leaders to defend a transaction as “entirely fair” unless the board sets up an independent special committee and seeks “majority of the minority” approval from unaffiliated investors, onerous steps that can derail a deal.

IAC is asking the state high court to reject that “belt and suspenders” approach and instead require only one or the other. 

But IAC didn't go far enough. Independent board committees and votes of the disinterested shareholders are what we call cleansing devices. They supposedly "cleanse" the conflicting shareholders' conflict of interest in transactions with the company.

My own view is that not all controlling shareholder transactions need cleansing. I start with the Delaware Supreme Court's decision in Sinclair Oil. v. Levien, 280 A.2d (Del. 1971). Under Sinclair Oil, as I explain in my book Corporate Law (Concepts and Insights):

The Delaware supreme court identified two standards potentially applicable in such situations: the business judgment rule and the intrinsic fairness rule. Under the business judgment rule, the directors of Sinven get the benefit of a rebuttable presumption of good faith. Under the intrinsic fairness test, the burden of proof is on the directors to show, subject to close scrutiny, that the transactions were objectively fair to Sinven. In this case, as in most, it mattered quite a lot which standard applied. As is often the case, the party bearing the burden of proof on a given dispute lost.

Under Sinclair Oil, a court will apply the intrinsic fairness standard, as opposed to the business judgment rule, when the parent has received a benefit “to the exclusion and at the expense of the subsidiary.” In other words, the fiduciary obligations owed by a parent corporation are limited to self-dealing. The more exacting intrinsic fairness standard comes into play only when the parent is on both sides of the transaction and, moreover, used its position to extract non-pro rata benefits from a transaction to the minority shareholders’ detriment. (Page 210)

Accordingly, the initial question is whether the controlling shareholder “has received a benefit to the exclusion and at the expense of the subsidiary.” Only if that is the case does thee transaction require cleansing. Controlling shareholder transactions that do not involve such a benefit are reviewed under the business judgment rule without the need for cleansing by an independent board committee of disinterested shareholder vote.   (To be sure, Sinclair Oil involved a parent-subsidiary relationship, but the parent by definition is a controlling shareholder and the principles are the same.)

The fact that the controlling shareholder is a party to the transaction is not enough to trigger ckeansing. The controlling shareholder must have gotten a benefit that is both at the expense of and to the exclusion of the minority shareholders.

This is made clear by the court’s treatment of the minority’s objection to the subsidiary’s dividend policy. Sinven (the subsidiary) had adopted at Sinclair Oil’s behest a policy of paying out the maximum lawful dividend. This benefited Sinclair Oil but did not constitute self-dealing by Sinclair Oil because Sinclair received nothing from Sinven to the exclusion of its minority stockholders.” Id. at 772.

Moreover, the need for cleansing is not triggered even if the controlling shareholder get a benefit or even if that the benefit is not shared. The controlling shareholder must get a benefit not only that excludes the minority but comes at their expense. This is made clear by the court’s treatment of the minority’s complaint that Sinclair Oil had denied Sinven opportunities to develop oil properties outside of Venezuela. “From 1960 to 1966 Sinclair purchased or developed oil fields in Alaska, Canada, Paraguay, and other places around the world. The plaintiff contends that these were all opportunities which could have been taken by Sinven.” Id. But the court rejected that claim: “Sinclair usurped no business opportunity belonging to Sinven. Since Sinclair received nothing from Sinven to the exclusion of and detriment to Sinven's minority stockholders, there was no self-dealing.” Id. Again, you must have both exclusion AND detriment.

I will grant you that some recent Chancery Court cases appear to assume that any “interested” transaction involving a controller is subject to intrinsic fairness analysis (unless cleansed as per below). But that is not the law, at least in Delaware. Under Sinclair Oil, there are two standards of review. If the plaintiff can carry the burden of proof of showing that the controlling shareholder benefited itself at the expense and exclusion of the minority, then entire fairness is the standard. But if the plaintiff cannot, the business judgment rule is the standard of review. The requirement that the controller receive a benefit “to the exclusion and at the expense of the" minority is essential because it ensures that courts will only get involved where there is a real conflict in the sense of a detriment to the minority, not just a benefit to the controller.

The rule thus is not: Controlling shareholder > was controlling shareholder connected to transaction > fairness unless cleansing.

The rule is: Controlling shareholder > did controlling shareholder benefited at the expense of and to the exclusion of minority shareholders > if yes, fairness unless cleansed; if no, business judgment rule.

In other words, If the plaintiff can't carry the burden of proof of showing that the controlling shareholder benefited itself at the expense and exclusion of the minority, then no cleansing--whether ordinary Kahn v. Lynch or MFW--is required.

As been ably said by a court otherwise quite protective of minority shareholder rights, “The majority . . . have certain rights to what has been termed ‘selfish ownership’ in the corporation which should be balanced against the concept of their fiduciary obligation to the minority.” Wilkes v. Springside Nursing Home, Inc., 353 N.E.2d 657, 663 (Mass. 1976). This seems to be the principle animating Sinclair Oil, which allows some controlling shareholder transactions the protection of the business judgment rule even without the sort of cleansing envisioned by either Kahn v. Lynch or MFW.

In Corporate Law (Concepts and Insights) I go on to explain that you can understand many controlling shareholder doctrines through the Sinclair Oil lens. I argue for example, that sale of control cases like Perlman v. Feldmann can be understood as an application of Sinclair Oil:

Perlman does not stand for the proposition that a controlling shareholder must give all other shareholders an equal opportunity to sell their stock on a pro rata basis. Instead, it simply stands for the proposition that a controlling shareholder may not usurp an opportunity that should be available to all shareholders. One could have reached the very same result under a Sinclair Oil-style analysis. The controlling shareholder received a benefit “to the exclusion and at the expense” of the minority. Not only were the minority excluded from the opportunity to sell at a premium, they were left worse off as a result.

Beyond Perlman’s unique facts, where are corporate opportunity issues most likely to arise? Probably in connection with structuring of acquisitions. Suppose Lorraine Looter approaches Susan Stockholder with an offer to buy Stockholder’s control block at a premium. Should there be liability? Not if we adopt the Sinclair Oil analogy. The majority shareholder can do whatever she wants as long as she does not deprive the minority shareholders of something to which they are entitled. On these facts, there is no corporate opportunity to be usurped. (Pages 218-19)

To be sure, the Sinclair Oil approach does not explain the law in freeze-out mergers. As a policy matter, I think that it makes sense to go immediately into an entire fairness review--and thus to require cleansing--in this context. tThe potential conflict of interest is especially pronounced in this context. After all, “a merger in which it is bought out is the most important event that can occur in a small corporation's life, to wit, its death . . ..” SEC v. Geon Industries, Inc., 531 F.2d 39, 47 (1976). In a freeze out merger, the transaction takes on even greater significance than in the ordinary case because the controlling shareholder is buying the company and thus has a strong incentive to minimize the price at the expense of the minority. Freeze out mergers thus have long been the subject of especially close review.

Julian Velasco's "A Catholic Defense of Corporate Law and Practice"

As regular readers know, exploring the implications of Catholic social teaching for corporate law and governance is one of my principals areas of interest. I just read a wonderful contribution to that literature by Notre Dame Law Professor Julian Velsco. Here's the abstract:

In this essay, I provide a defense of corporate law and of pursuing a career therein from the perspective of Catholic teaching. I argue that Catholicism is not incompatible with the pursuit of wealth as such, but rather insists upon the appropriate use of wealth. I also argue that it is appropriate for corporate actors to pursue the interests of shareholders, provided that they do not break the law or otherwise sin in doing so. I also explain why I found transaction practice personally fulfilling.

Velasco, Julian, A Catholic Defense of Corporate Law and Practice (August 25, 2023). 38 Notre Dame J.L. Ethics & Pub. Pol’y ___ (Forthcoming), Available at SSRN: https://ssrn.com/abstract=4552281 

I was very flattered by footnote 114:

As for the actual benefits that flow from the use of the corporate form, I point the reader to the works of Michael Novak and Stephen Bainbridge in particular. See, e.g., MICHAEL NOVAK, TOWARD A THEOLOGY OF THE CORPORATION (AEI Press, rev. ed. 1990); Stephen M. Bainbridge, Community and Statism: A Conservative Contractarian Critique of Progressive Corporate Law Scholarship, 82 CORNELL L. REV. 856, 898-99 (1997); Stephen M. Bainbridge, In Defense of the Shareholder Wealth Maximization Norm: A Reply to Professor Green, 50 WASH. & LEE L. REV. 1423, 1446 (1994) (“That rule [i.e., the shareholder wealth maximization norm] has helped produce an economy that is dominated by public corporations, which in turn has produced the highest standard of living of any society in the history of the world.”). They have argued that the corporate form is not only morally acceptable, but positively beneficial. According to them, it has led to unprecedented levels of prosperity and the alleviation of incredible amounts of suffering. Their arguments, which I find generally persuasive, should help to destigmatize corporations and corporate law.

But I would strongly recommend readuing the paper even if he had left out that part. 

Adapting corporate law for a non-bricks and mortar world

The latest long form Chancery Daily observes: 

We briefly observe that Delaware business entity law has overwhelmingly developed in what might be called the bricks-and-mortar corporate paradigm, where companies had offices and people worked there, doing physical tasks having some form of tangible representation -- if only on paper (or an electronic file simulating paper) -- that evidenced their existence. Today, to a much greater degree than even just a few years ago, business operations are virtual, decentralized, and even ephemeral -- and as TCDrecently noted in its September 27, 2023 edition, we begin to see questions regarding whether entities or individuals actually exist.

The question of virtual firms was one that fascinated my friend and colleague Bill Klein. In his most complete treatment of the issue, Bill and two coauthors wrote:

This Article proposes the metaphor "connected contracts" for understanding collaborative economic activity. Connected contracts refers to the interrelating agreements and relationships among the participants in a business venture. From the perspective offered by this metaphor, there are no firms, no predetermined hierarchies, no organizations with personalities of their own, and no a priori notions of ownership or control; there is no shareholder or managerial primacy and no centralizing "nexus." The view is from the bottom up rather than from the top down. Boundaries and governance are neither central issues, nor do they loom in the background. There are no boundaries and there is nothing to govern. The connected contracts perspective is applied to an important aspect of joint activity?the putative bargain over control. Looking at business activity as bargains among individuals who agree to undertake a specific project leads to the insight that control of the venture is not automatically allocated to equity. The concept of an "owner" has little value. The connected contracts perspective suggests, among other things, that, all else equal, different capital structures can be viewed as representing different bargains over control. Capital structure is not irrelevant, but reflects unique bargains over control in general and future decisions about projects in particular. The inquiry then broadens to encompass more participants and types of contributions and to speculate on how the connected contracts metaphor might affect thinking about a variety of topics in corporate and tax law, including piercing the corporate veil, insider trading, executive compensation, the taxation of corporations, and the differential taxation of debt and equity. Finally, and tentatively, the essay offers a list of criteria that might be used to judge the value of models and metaphors and, by offering the list, suggests that scholars should be more conscious of the risks and rewards of reliance on models and metaphors.

Gulati, Mitu and Klein, William A. and Zolt, Eric M., Connected Contracts. Available at SSRN: https://ssrn.com/abstract=217590 or http://dx.doi.org/10.2139/ssrn.217590

You should also check out:

Klein, William A. and Gulati, Mitu, Economic Organization in the Construction Industry: A Case Study of Collaborative Production Under High Uncertainty (July 16, 2003). Available at SSRN: https://ssrn.com/abstract=428600 or http://dx.doi.org/10.2139/ssrn.428600

 

Gulati, Mitu and Isaac, Thomas M. and Klein, William A., When a Worker's Cooperative Works: The Case of Kerala Dinesh Beedi (April 24, 2002). Available at SSRN: https://ssrn.com/abstract=308759 or http://dx.doi.org/10.2139/ssrn.308759

More on Chancellor McCormick and the future of Caremark: We still need to call a halt to the "'disintegrating erosion' of particular exceptions"

Apropos a preceding post, my friend GWU law professor Lawrence Cunningham sent along the following email, which he has kindly authorized me to post:

I didn't see the Bloomberg report, but just to clarify, Chancellor McCormick did not make a speech yesterday. We were on a Caremark panel together at the Delaware Governance Institute. The remarks she made about reducing concern around Caremark were responses to my opening and closing comments on the panel about directors' concerns on Caremark. She said "don't worry Larry" and explained how the law has not changed since Bill Allen wrote.

I stressed that the string of cases denying motions to dismiss got huge coverage and encouraged the 200 Delaware lawyers/judges present and more listening to put as much emphasis on ProAssurance and Solar Winds. She agrees and it makes me less worried. There were many Delaware judges in the audience, including 4 of 5 Supreme Court justices and several VCs. I think I got the message across.

My conclusion emphasized the intersection of the proposed Noclar rule from the PCAOB and asked the judges to be careful with red flags about legal violations. The real danger today is from Washington not Wilmington.

Several thoughts. First, I would be the first to concede that Gary Gensler's SEC and Congress folk like Elizabeth Warren pose a far greater danger to good corporate governance than the Delaware judiciary.

Second, ProAssurance and Solar Winds were important cases that provide some reassurance about Caremark being constrained. In the former, VC Will stated: "Oversight claims should be reserved for extreme events." As for the latter, the estimable Kevin LaCroix has written that:

A claim alleging a board’s breach of duty of oversight has long been regarded as one of the most difficult for a plaintiff to sustain. But after the Delaware Supreme Court’s 2019 opinion in Marchand v. Barnhill, breach of the duty of oversight claims (or Caremark claims, as they are sometimes called) have in recent years, as Vice Chancellor Sam Glasscock put in in his recent opinion in the SolarWinds case, “bloomed like dandelions after a warm spring rain.” Some commentators questioned whether oversight breach claims were in fact as difficult to sustain as is so often said. However, in his recent opinion, the Vice Chancellor emphasized the oversight breach claims remain “one of the most difficult claims” to sustain and granted the defendants’ motion to dismiss the cybersecurity-related oversight breach claims asserted against the board of Solar Winds.  A copy of Vice Chancellor Glasscock’s September 6, 2022 opinion in the SolarWinds case can be found here.

Again, good news for those of us who have questioned the direction Caremark has taken.

Third, however, on the other side of the scales one can stack up Marchand, Boeing, and McDonald's. Taken together, these cases and their ilk call to mind Judge Cardozo's reference--albeit, of course, in a very diffent context--in Meinhard v. Salmon to the "'disintegrating erosion' of particular exceptions."

I would feel better about the direction of Delaware law if we started seeing some opinions drawing clear redlines beyond which Caremark cannot reach. This far shall it go and no farther.

A new The Profit Motive video