Welcome back to the Conglomerate Junior Scholars Workshop. Today's paper is Trey Drury's What's the Cost of a Free Pass? A Call for the Re-Assessment of Statutes that Allow for the Elimination of Personal Liability of Directors. Trey is a Visiting Assistant Professor at Loyola Law School in New Orleans. Trey was originally scheduled to participate in the first Junior Scholars Workshop two years ago with this paper, but plans were derailed by Hurricane Katrina. We're glad that he's back in NOLA and has resumed his stint at Loyola. Before entering law teaching, Trey practiced for eight years, including a stint in the general counsel's office of Entergy.
Our commentators today are also experts on this topic: Joan Heminway, Lisa Fairfax, Elizabeth Nowicki and former workshop participant Matt Bodie. I will post the comments of these experts below this post throughout the morning. We invite readers to comment on the paper (and the comments) in the comments section of this post. In the interest of running this workshop like a physical world conference, no anonymous commenters, please.
The abstract for the paper is here:
The 1985 Delaware Supreme Court decision in Smith v. Van Gorkom caused considerable unrest among members of corporate boards and their legal advisors. In that case, board members were held personally liable for a breach of their fiduciary duties, even though no conflict of interest existed. Many observers were taken aback by this result, and a public outcry followed. The consequences of this decision, particularly the perceived crisis in securing directors & officers liability insurance, spurred some legislatures into action. By 1986, Delaware had already enacted a statute enabling a corporation to limit or eliminate the personal liability of directors for breaches of their duty of care. Some version of this approach has now been implemented in all fifty states, and virtually all of the nation's largest corporations include these exculpatory provisions in their charters.
This Article argues that the time has come to re-examine these statutes, and that this re-examination points to a need to improve the status quo. Part I of this Article describes the Smith v. Van Gorkom holding, and the subsequent decision in Delaware to allow corporations to remove the prospect of personal liability for directors for duty of care breaches. Part II argues that these exculpatory statutes, in their current form, are doing harm to shareholders and to the orderly function of corporate law. First, this Part demonstrates that the existence and current use of the statute incentivizes board members to engage in sub-optimal behavior. Second, the Part questions the legitimacy of the original stated need for enacting the statute. Third, this Part claims that another area of corporate law, judicial interpretation of the duty of good faith, is being manipulated to circumvent the restrictions placed on courts by corporations that choose to eliminate liability for breaching the duty of care. Part III then introduces the contractarian theory of the firm in support of the current statute, examines the limitations of that theory, and explores the implications of the theory in determining the proper course of action. Finally, Part IV recommends actions available to dissatisfied shareholders, including a specific improvement in the mechanics of the statute – the addition of a requirement that shareholders must reapprove an exculpatory charter provision at least every five years.
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1. Posted by Trey Drury on July 2, 2007 @ 10:19 | Permalink
I would like to thank Christine and everyone at Conglomerate for hosting the Junior Scholars Workshop and for having me as a participant. Receiving this sort of detailed and informed feedback is extremely valuable for those of us just starting out. As Christine noted, I was originally slated to participate in this Workshop two years ago, during what we in New Orleans refer to as the Pre-Katrina days. These last two years have been long and interesting ones, and I regard this belated entry in the JSW as yet another sign that, for me at least, life is returning to some semblance of normalcy.
I'll be back later in the day to discuss the substantive points made by my expert panel of commenters. For now, I just wanted to share my enthusiasm for the JSW and express gratitude to those who have made it possible.
2. Posted by David Friedman on July 2, 2007 @ 13:12 | Permalink
Trey, I very much enjoyed the read.
Marty Lipton and Jay Lorsch (HBS) wrote an article some time ago (early 1990s?) that mused about turning corporate directors into full-time professionals. Their proposal was a bit of a reach, but thought-provoking.
3. Posted by Trey Drury on July 2, 2007 @ 15:52 | Permalink
The commentary posted thus far has been insightful and has focused my attention on a few areas where I can improve the piece between now and its submission. I'd like to thank Professors Heminway, Fairfax, and Bodie (and Nowicki in advance) for their time and attention, and I'd also like to take a brief moment to respond to at least some points raised by their thoughtful critiques.
Response to Heminway:
I have been thinking about her question as to whether a re-occurring shareholder vote will provide benefits adequate to justify its costs. Of course, if shareholders widely use the method to repeal (or later re-insert) these charter provisions, then the value, at least as perceived by these shareholders who are making use of the new mechanism, would seem to far outweigh the relatively low transaction costs. Additionally, I believe the periodic vote will provide adequate value, even if rarely used, for at least two reasons. First, simply knowing that the liability shield can be revoked may impact director behavior, even if shareholders never in fact vote to remove a 102(b)(7) provision from the corporate charter. Second, courts may respond to the fact that shareholders consciously re-affirmed an exculpatory provision and uphold the dismissal of some lawsuits instead of trying to manipulate other law (as exemplified by the duty of good faith in my paper) to find liability.
Response to Fairfax:
The connection between 102(b)(7) and 10b-5 first caught my attention when I was preparing a board presentation shortly after the outside directors of Enron and WorldCom used personal funds to settle those shareholder lawsuits. During my research, I was shocked when I read the defendants motions to dismiss. Asserting that the 10b-5 claims must be dismissed for lack of scienter, they read like plaintiff allegations in a duty of care case: meetings were short and not substantive, we relied on management almost completely, no one understood what we were approving. The flaw in the system that I took mental note of at the time was that these directors were pleading duty of care breaches as a 10b-5 defense. The point of that sub-section of my article is that they ought not be allowed to do so, and absent 102(b)(7), they would not be.
Response to Bodie:
Your suggestion of providing context for my proposed solution by discussing the shareholder empowerment literature is a fantastic one. As mentioned in my response to Prof. Heminway, I believe there is value in holding a vote even if those votes rarely succeed, but the power of the argument is much stronger to the extent I can show that these shareholders will not only be given meaningful choices, but will be MAKING meaningful choices.
Thanks again to all. This has been fun, and a valuable learning experience to boot.
4. Posted by Vic on July 2, 2007 @ 16:45 | Permalink
Is there any reason 102(b)(7) has to be all or nothing? Should we consider a system of greater or lesser damage caps, tied to a performance metric of some kind? Asking the shareholders to flip the liability switch on and off is one possible response, but given all of the costs associated with determining shareholder desires, I wonder if a more nuanced set of statutory lawsuit protections might better align incentives.
5. Posted by Joan Heminway on July 2, 2007 @ 17:43 | Permalink
Glad a good conversation has gotten started here. I am responding to Vic's suggestion. I like the thought.
In part of Trey's paper, he does mention the possibility of an "in between" solution, noting that corporations have not really taken advantage of that flexibility in crafting charter provisions under the existing exculpation statutes. Perhaps he can incorporate your idea, Vic, in a more consistent thread throughout the article, including in his shareholder referendum suggestion.
Just a thought . . . .
6. Posted by Joan Heminway on July 2, 2007 @ 18:58 | Permalink
Trey, this is a response to you on your two reasons why a periodic shareholder vote will provide adequate value, even if rarely used. I would like to see you expand on each to convince me (no need to do so here, unless you want to).
As to your first reason, what makes you believe that director behavior may be impacted even if shareholders never in fact vote to remove an exculpation provision from the corporate charter? My experience with boards of directors leads me to think otherwise. Shareholder voting has been a relatively weak determinant of director behavior, yes? But, of course, that's what you're trying to change, isn't it? Greater shareholder control, even if not exercised may have effects. But behavioral biases may offset those effects. In other words, before we can endorse your belief, we must better understand what makes directors behave properly. Give me a bit more to work with here . . . .
As to your second point, I will admit that you may have more faith in courts than I have. I would love to think that they would "respond to the fact that shareholders consciously re-affirmed an exculpatory provision and uphold the dismissal of some lawsuits instead of trying to manipulate other law . . . to find liability." But is there evidence (perhaps from some other area of corporate governance litigation?) that courts are likely to "listen" to shareholders in that way? In many cases (tender offer/takeover litigation being one), it often seems to me that the court believes it knows what's best for shareholders (those poor little lost lambs!) and imposes its will on them.
A thought somewhat related to both points is that you may want to read Amitai Aviram's recent piece "The Placebo Effect of Law: Law's Role in Manipulating Perceptions," 75 Geo. Wash. L. Rev. 54 (2006). Based on my recollection of that article, there may be some arguments in there that help inform your arguments. It's an interesting bit of scholarship, regardless. Also, under the heading "Can Law Function Without Official Enforcement?" in Bernie Black's and Reinier Kraakman's "A Self-Enforcing Model of Corporate Law," 109 Harv. L. Rev. 1911 (1996), you may find some interesting observations relevant to your paper. Of course, you’ll want to address some of Steve Bainbridge’s arguments in his recent article responding to Lucian Bebchuk’s arguments for increased shareholder control over corporate governance: “Response to Increasing Shareholder Power: Director Primacy and Shareholder Disempowerment,” 119 Harv. L. Rev. 1735 (2006). Prior work on shareholder primacy by Bebchuk and by Glommer Gordon Smith and co-commentator Matt Bodie also informs your paper, as you well know. I will let Gordon or Matt pick up that thread, if either is so inclined.
Reactions? Lest I sound like a grumpy old woman, I should note that both of your ideas have promise. I just want to see you better develop them.
7. Posted by Trey Drury on July 2, 2007 @ 21:14 | Permalink
Your observation concerning the uniformity of 102(b)(7) charter provisions is a revealing one. There is nothing in the statute itself that provides corporations with such a stark, binary choice - either eliminate all liability or do nothing. The statutory language allows corporations to either limit or eliminate personal liability in any manner that they see fit within certain limits.
I discuss in my article a recent study by Michael Klaussner, where he notes this discrepancy and posits that learning externalities are preventing corporations and their shareholders from experimenting and narrowly tailoring these exculpatory provisions to fit their specific situations. His solution in that piece is for state corporation statutes to provide menus of alternatives for corporastions to choose from when first incorporating such a provision into their charters.
I view my proposed solutions as consistent with Klaussner's approach. My focus is less on determining exactly what the charter provisions should say, and more on getting corporations to consider whether it is in the interests of shareholders to adopt more limited provisions, or do away with them altogether. Ideally, under my approach, if shareholders demonstrate that they care about these exculpatory provisions and are reluctant to allow maximum relief to directors, the corporations themselves will develop the damage caps and performance metrics that you reference. There is ample evidence to suggest that limits and conditions developed by a corporation to fit its individual situation will often be superior to an off-the-rack provision that a legislature would devise.
Thanks for raising such an interesting point.
8. Posted by Bill Sjostrom on July 2, 2007 @ 21:54 | Permalink
I'm not convinced on your 10b-5 point. I agree that a shirking director may have a better argument for negating scienter than a diligent director. However, the shirker would be much more exposed than the diligent director to federal securities laws claims that don't require scienter such as '33 Act Sections 11 and 17(a) and '34 Act Section 18(a) as well as state law claims of bad faith. IMHO, this potential liability for shirking more than counteracts any "incentive" to shirk re: 10b-5.
9. Posted by Trey Drury on July 2, 2007 @ 21:57 | Permalink
Thanks for the comments and the cites.
I do think there's one element of our discussion where I have a good chance of persuading you, and that is on the potential impact on director behavior by shareholder actions short of actually repealing any exculpatory charter provisions.
First, I concede that if my proposal magically appeared in the DGCL and was roundly ignored by everyone, director behavior wouldn't change. However, a different course is more likely. First, some sort of positive momentum would actually precede amending the DGCL to incorporate my suggestion. In that context, if a major shareholder expressed concern about the scope of a corporation's exculpatory provision during the year that its renewal were on the ballot, I believe those shareholders would have significant negotiating leverage to demand revisions, and boards would be incentivized to listen attentively.
There are several real-world analogies to this situation. Boards faced with a poison pill shareholder proposal often negotiate with the shareholder in order to get it removed. Many corporations have recently adopted majority voting provisions when faced with shareholder support for the idea. Even Disney, in many ways a poster child for board intransigence in the face of shareholder protest, adopted a lead director after a campaign to withhold votes from directors garnered a substantial minority vote, even though the withhold campaign would not have technically accomplished anything had a majority voted to withhold.
I believe shareholders would be well-situated to accomplish similar results if my proposal were incorporated into the DGCL and other state statutes.
10. Posted by Matt Bodie on July 2, 2007 @ 22:28 | Permalink
Your last comment is something that I think should be in the paper. Given your substantial real world experience, you shouldn't shy away from using that in developing your policy proposals. There's a tension in your paper between (a) liability waivers are bad and (b) shareholders should be able to create such waivers (as long as they periodically reapprove them). I think there is a middle ground there, but you kind of have to thread the needle to get there. Discussions about how the proposal might play out in real life would help the reader see that the waivers may have problems but that we should still allow shareholders to adopt them.
Also, just to pick up on what Joan mentioned, you should consider how shareholder primacy fits in to your argument. On the one hand, you could say it plays a minor role, since what you're concerned about is a straightforward agency costs problem. But I'm thinking primarily about the "ends" of shareholder primacy, as Stephen Bainbridge describes them. (Both shareholder primacists and stakeholder theorists would agree that directors should manage the company competently.) Your policy proposal, on the other hand, is all about the "means" of shareholder primacy. I agree that the debate between Bebchuk and Bainbridge over the role of shareholders within the corporation should play a central part in your paper.
Glad to see the discussion moving forward -- and I hope this all helps with the paper.