The Limits of Corporate Law in Promoting Good Corporate Governance December 2004 Michael d. Klausner Stanford law School Stanford law School John M. olin Program in law and Economics Working Paper No 300 o This paper can be downloaded without charge from the ocial Science Research Network Electronic Paper Collection http://ssrn.com/abstract=637021
The Limits of Corporate Law in Promoting Good Corporate Governance December 2004 Michael D. Klausner Stanford Law School Stanford Law School John M. Olin Program in Law and Economics Working Paper No. 300 This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=637021
The limits of Corporate Law in Promoting Good Corporate Governance Michael Klausner Nancy and Charles munger Professor of Business and Professor of law Stanford Law School Discussions of corporate governance reform often combine prescriptions for legal reform with prescriptions for better governance practices. Both sets of prescriptions--for better law and for better practices-typically focus on the board of directors, and particularly outside or"independent"directors. The assumption is that the law can affect the governance behavior of the board by establishing roles for outside directors and by motivating independent directors to do a good job. The extent to which law can promote good governance in the boardroom, however, is quite limited. To a large extent, good corporate governance must come from other sources of motivation, especially to the extent that a source of good governance is the independent director. This comment will briefly outline the limits of corporate law in promoting good corporate governance and in doing so help clarify the gap that must be filled by nonlegal influences, including the sort of norms that Martin Lipton and Jay Lorsch emphasize A. Traditional Corporate Law Traditionally, there have been three sets of legal rules designed to induce directors to govern in the interest of shareholders. First, there are fiduciary duties and procedural rules that provide lawyers with incentives to bring suits to enforce those duties. Second, there are shareholder voting rules, which allow shareholders to replace directors whom they view as having failed to act in their interests. Third, there are disclosure rules that require management to disseminate information regarding a companys finances and operations. One might also add as a fourth set of rules those rules governing hostile acquisitions, which allow shareholders to separate themselves from inadequate management by selling all their shares to an acquiror. These bodies of law, however, impose a fairly minimal inducement to directors, particularly to independent directors, to govern well. They can be severe in cases of self-dealing by corrupt management, but they are actually weak-and necessarily sowhen it comes to promoting affirmatively good governance practices in the boardroom In contrast to many other areas of activity, the fiduciary duties applicable to outside directors do not, as a practical matter, pose a realistic threat of out-of-pocket liability unless a director has engaged in theft or blatant self-dealing. In other areas, one can expect to pay damages if one fails to meet a certain standard of competence and care Negligence standards apply, for example, to doctors, automobile drivers, engineers and others. Although these people have other motivations to do a good job, the threat of liability, at least for some, provides an additional motivation. Notwithstanding reports
The Limits of Corporate Law in Promoting Good Corporate Governance Michael Klausner Nancy and Charles Munger Professor of Business and Professor of Law Stanford Law School Discussions of corporate governance reform often combine prescriptions for legal reform with prescriptions for better governance practices. Both sets of prescriptions—for better law and for better practices —typically focus on the board of directors, and particularly outside or “independent” directors. The assumption is that the law can affect the governance behavior of the board by establishing roles for outside directors and by motivating independent directors to do a good job. The extent to which law can promote good governance in the boardroom, however, is quite limited. To a large extent, good corporate governance must come from other sources of motivation, especially to the extent that a source of good governance is the independent director. This comment will briefly outline the limits of corporate law in promoting good corporate governance and in doing so help clarify the gap that must be filled by nonlegal influences, including the sort of norms that Martin Lipton and Jay Lorsch emphasize. A. Traditional Corporate Law Traditionally, there have been three sets of legal rules designed to induce directors to govern in the interest of shareholders. First, there are fiduciary duties and procedural rules that provide lawyers with incentives to bring suits to enforce those duties. Second, there are shareholder voting rules, which allow shareholders to replace directors whom they view as having failed to act in their interests. Third, there are disclosure rules that require management to disseminate information regarding a company’s finances and operations. One might also add as a fourth set of rules those rules governing hostile acquisitions, which allow shareholders to separate themselves from inadequate management by selling all their shares to an acquiror. These bodies of law, however, impose a fairly minimal inducement to directors, particularly to independent directors, to govern well. They can be severe in cases of self-dealing by corrupt management, but they are actually weak—and necessarily so—when it comes to promoting affirmatively good governance practices in the boardroom. In contrast to many other areas of activity, the fiduciary duties applicable to outside directors do not, as a practical matter, pose a realistic threat of out-of-pocket liability unless a director has engaged in theft or blatant self-dealing. In other areas, one can expect to pay damages if one fails to meet a certain standard of competence and care. Negligence standards apply, for example, to doctors, automobile drivers, engineers and others. Although these people have other motivations to do a good job, the threat of liability, at least for some, provides an additional motivation. Notwithstanding reports
in the press about the legal risks directors face, their risk of out-of-pocket damage payments is negligible. In ongoing research with Bernard Black and Brian Cheffins, we have found virtually no case in which an outside director has actually paid money out of his or her own pocket, despite the fact that every year dozens of suits are brought under corporate or securities laws naming them as defendants, and hundreds of suits are filed against their companies. In many cases, suits fail at the outset because the rules governing the pleading of shareholder suits impose a significant bar to plaintiffs regarding what they must credibly allege regarding outside directors' misdeeds. Others are dismissed later under the"business judgment rule, a judicial doctrine under which courts decline to second-guess a boards business decision so long as the decision was informed and so long as there was no conflict of interest involved. Cases that are not dismissed almost al ways settle on terms that have the corporation and the corporation's directorsand officers(D&o) liability insurer make a payment to the shareholders shareholder suits without reaching inside the defendants'own pocke a There is nothing nefarious going on in these settlements. What happens is a logic consequence of the rules governing shareholder suits, a corporation's power to indemnify its directors, D&o insurance, and most importantly, the incentives of all sides to settle We have found that this pattern of de facto immunity to out-of-pocket liability exists not just in the U.S., but also in Australia, Britain, Canada, France, Germany, and Japan-countries that span both common and civil law traditions. We suspect that the pattern is universal. Moreover, looking back at the history of legal rules governing the liability of corporate directors, one finds that when this pattern is disturbed, and outside directors are threatened with liability, either the market or lawmakers step in to reinstate directors'protection Shareholder voting has a similarly weak impact on directors incentives to do a good job. Under the law, shareholders have the power to replace a board of directors, but they virtually never even try to do so outside the context of a hostile acquisition, which I discuss below. The reason for their passivity is the classic collective action problem that shareholders face. A shareholder who mounts such a campaign must pay the cost of doing so up front. The shareholders gain, if it materializes, will take the form of a better managed company and higher share value Unless that shareholder holds a large block of shares, his personal cost-benefit analysis of a campaign to replace the boad will not support mounting the campaign. Moreover, even for a large shareholder, unless a substantial proportion of a company's other shares are also held by one or more block holders, it will be difficult to get the attention of enough other shareholders, let alone See Outside Director Liability, by Bernard s. Black, Brian R. Cheffins, and Michael Klausner, available onlineathttp://ssrn.com/abstract=382422;bErnardBlack,BriancHeffins&MichaelKlausner,"liability Risk for Outside Directors: A Cross-Border Analysis", European Financial Management, vol. 11 (forthcoming2005),availableonlineathttp://ssrn.com/abstract=557070 Bernard Black, Brian Cheffins Michael Klausner, "Liability Risk for Outside Directors: A Cross- Border Analysis", European Financial Management, vol. Il, (forthcoming 2005), available online at tp: //ssrn. com/abstract=557070; Bernard S. Black and Brian R. Cheffins, "Outside Director Liability AcrossCountries",availableonlineathttp://ssrn.com/abstract=438321
in the press about the legal risks directors face, their risk of out-of-pocket damage payments is negligible. In ongoing research with Bernard Black and Brian Cheffins, we have found virtually no case in which an outside director has actually paid money out of his or her own pocket, despite the fact that every year dozens of suits are brought under corporate or securities laws naming them as defendants, and hundreds of suits are filed against their companies.1 In many cases, suits fail at the outset because the rules governing the pleading of shareholder suits impose a significant bar to plaintiffs regarding what they must credibly allege regarding outside directors’ misdeeds. Others are dismissed later under the “business judgment rule,” a judicial doctrine under which courts decline to second-guess a board’s business decision so long as the decision was informed and so long as there was no conflict of interest involved. Cases that are not dismissed almost always settle on terms that have the corporation and the corporation’s directors’ and officers’ (D&O) liability insurer make a payment to the shareholders. There is nothing nefarious going on in these settlements. What happens is a logical consequence of the rules governing shareholder suits, a corporation’s power to indemnify its directors, D&O insurance, and most importantly, the incentives of all sides to settle shareholder suits without reaching inside the defendants’ own pockets. We have found that this pattern of de facto immunity to out-of-pocket liability exists not just in the U.S., but also in Australia, Britain, Canada, France, Germany, and Japan—countries that span both common and civil law traditions. We suspect that the pattern is universal. Moreover, looking back at the history of legal rules governing the liability of corporate directors, one finds that when this pattern is disturbed, and outside directors are threatened with liability, either the market or lawmakers step in to reinstate directors’ protection.2 Shareholder voting has a similarly weak impact on directors’ incentives to do a good job. Under the law, shareholders have the power to replace a board of directors, but they virtually never even try to do so outside the context of a hostile acquisition, which I discuss below. The reason for their passivity is the classic collective action problem that shareholders face. A shareholder who mounts such a campaign must pay the cost of doing so up front. The shareholder’s gain, if it materializes, will take the form of a better managed company and higher share value. Unless that shareholder holds a large block of shares, his personal cost-benefit analysis of a campaign to replace the boad will not support mounting the campaign. . Moreover, even for a large shareholder, unless a substantial proportion of a company’s other shares are also held by one or more block holders, it will be difficult to get the attention of enough other shareholders, let alone 1 See “Outside Director Liability,” by Bernard S. Black, Brian R. Cheffins, and Michael Klausner, available online at http://ssrn.com/abstract=382422; Bernard Black, Brian Cheffins & Michael Klausner, "Liability Risk for Outside Directors: A Cross-Border Analysis", European Financial Management, vol. 11, (forthcoming 2005), available online at http://ssrn.com/abstract=557070. 2 See Bernard Black, Brian Cheffins & Michael Klausner, "Liability Risk for Outside Directors: A CrossBorder Analysis", European Financial Management, vol. 11, (forthcoming 2005), available online at http://ssrn.com/abstract=557070; Bernard S. Black and Brian R. Cheffins, "Outside Director Liability Across Countries", available online at http://ssrn.com/abstract=438321
induce them to spend time analyzing whether the insurgent slate of directors will create alue that the incumbents have not The third area of law that may be of some help to shareholders is the securities laws. These laws require a company to disclose, on a periodic basis and prior to issuing ecurities,all material information regarding its finances and operations. These laws work very well in day-to-day settings. Companies regularly disclose material information to the market and market prices generally respond with amazing speed. The disclosure process is managed by company executives. Difficulties occasionally arise however, when a company is having financial or operational trouble, and management cuts corners in its disclosures. It is exceedingly difficult for outside board members to discover that this is going on. As a matter of the law on the books, they are potentially liable for failure to disclose material information, but they are rightfully accorded defenses if they have exercised a reasonable degree of oversight. Consequently, suits brought under the securities laws against outside directors are commonly dismissed Moreover, even for suits that are not dismissed early on, the rules governing indemnification and d&o insurance, and the incentives of all parties to settle render the threat of out-of-pocket liability essentially illusory for an outside director. Thus, once again, the threat of sanction has little direct effect on governance behavior in the boardroom The law of hostile takeovers may be somewhat more helpful, but not by much Theoretically, if management of a company fails to maximize the value of the business someone else will be interested in stepping in to do so. If management is not willing to turn over the reins, a prospective acquiror can instead approach the shareholders directly by making a"tender offer to buy their shares at a premium. Under law developed during the 1980S, however, a board is permitted to obstruct this transaction by adopting a poison pill, a dilutive mechanism that will stop the acquiror in its tracks until the target board of directors removes it. The law governing a target board s decision whether to remove a poison pill and allow a takeover to proceed is oddly schizophrenic. It allows the board to keep the pill in place in the face of a premium bid, if the board believes the bid is for some reason inadequate. ("Grossly inadequate"is the preferred term of targets, their bankers and their lawyers, for whom no bid is ever merely"inadequate. )The law even allows a board to sell the company to a party offering a lower bid--but only if the competing bid would provide target shareholders with stock in the combined company Thankfully, the law does not allow a board to sell the company for cash if a higher bid is available. Once the board decides to sell the company for cash, it must sell to highest bidder Fortunately for shareholders, there is an end- run around a board that uses its legal power to resist an attractive takeover offer. Shareholders can vote out an incumbent board and replace it with a board that will disable the pill and allow the acquisition to proceed. Experience has shown that the immediate prospect of a premium bid is enough to get shareholders to overcome their collective action problem and vote their shares in this context
induce them to spend time analyzing whether the insurgent slate of directors will create value that the incumbents have not. The third area of law that may be of some help to shareholders is the securities laws. These laws require a company to disclose, on a periodic basis and prior to issuing securities, all material information regarding its finances and operations. These laws work very well in day-to-day settings. Companies regularly disclose material information to the market and market prices generally respond with amazing speed. The disclosure process is managed by company executives. Difficulties occasionally arise, however, when a company is having financial or operational trouble, and management cuts corners in its disclosures. It is exceedingly difficult for outside board members to discover that this is going on. As a matter of the law on the books, they are potentially liable for failure to disclose material information, but they are rightfully accorded defenses if they have exercised a reasonable degree of oversight. Consequently, suits brought under the securities laws against outside directors are commonly dismissed. Moreover, even for suits that are not dismissed early on, the rules governing indemnification and D&O insurance, and the incentives of all parties to settle, render the threat of out-of-pocket liability essentially illusory for an outside director. Thus, once again, the threat of sanction has little direct effect on governance behavior in the boardroom. The law of hostile takeovers may be somewhat more helpful, but not by much. Theoretically, if management of a company fails to maximize the value of the business, someone else will be interested in stepping in to do so. If management is not willing to turn over the reins, a prospective acquiror can instead approach the shareholders directly by making a “tender offer” to buy their shares at a premium. Under law developed during the 1980s, however, a board is permitted to obstruct this transaction by adopting a “poison pill,” a dilutive mechanism that will stop the acquiror in its tracks until the target board of directors removes it. The law governing a target board’s decision whether to remove a poison pill and allow a takeover to proceed is oddly schizophrenic. It allows the board to keep the pill in place in the face of a premium bid, if the board believes the bid is for some reason inadequate. (“Grossly inadequate” is the preferred term of targets, their bankers and their lawyers, for whom no bid is ever merely “inadequate.”) The law even allows a board to sell the company to a party offering a lower bid—but only if the competing bid would provide target shareholders with stock in the combined company. Thankfully, the law does not allow a board to sell the company for cash if a higher cash bid is available. Once the board decides to sell the company for cash, it must sell to the highest bidder. Fortunately for shareholders, there is an end-run around a board that uses its legal power to resist an attractive takeover offer. Shareholders can vote out an incumbent board and replace it with a board that will disable the pill and allow the acquisition to proceed. Experience has shown that the immediate prospect of a premium bid is enough to get shareholders to overcome their collective action problem and vote their shares in this context
The threat that an acquiror will appear in the future, and that shareholders will replace their board in order to sell their company, may provide some incentive for a board to govern well. Hostile takeovers, however, typically occur at price premiums of thirty percent or more over market. This suggests that management must be doing a very bad job--running a company at less than 70 percent of potential--for an acquiror to step in and rescue shareholders. So perhaps the threat of a hostile takeover creates an incentive for a board not to govern horribly but it does not create an incentive for the board to overn well In sum, it is difficult to imagine that these sets of legal rules have a significant direct effect on the incentives of a board of directors to govern in an affirmatively effective manner. To the extent boards are attentive and diligent in their oversight of management, it is not(or at least should not be)out of a fear of out-of-pocket liability, or a fear of being voted out of office, or a fear of having their company acquired. Their motivation must lie elsewhere Moreover. if the law were changed to increase the likelihood that outside directors would be penalized more severely for inadequate governance, corporate governance could well suffer. Many people would decline to serve as directors, particularly those with substantial assets or reputations at stake, and others would become excessive defensive in their oversight role. In addition, directors fees would have to increase to compensate for the heightened personal risk borne by those who do serve. Paradoxically, this could have the effect of compromising the independence of directors for whom tees become a meaningful portion of total income. Directors in this position might hesitate to rock the boat, let alone resign, in the face of management decisions that they find troubling B. Sarbanes-Oxley and Subsequent Reform Efforts The Sarbanes-Oxley Act of 2002 and the related changes in New York Stock Exchange and NASDAQ rules, all following in the wake of the Enron and other corporate scandals, imposed a set of structure and process rules on boards. For example, a majority of directors must be"independent, a term the rules define in great detail audit, compensation, and nominating/governance committees must be constituted with all independent directors; and independent directors must meet alone periodically, with one among them identified publicly as the director presiding over those meetings Leaving aside whether these legal rules, on balance, promote good governance more than other structures and procedures that boards might instead adopt on their own, it is reasonable to expect that structure and process, in general, will have an impact on directors'governance behavior, and that many of the recent reforms may have a positive impact on the governance of many companies. The nature of the impact, however, is place directors in settings in which other motivations will ideally take effect and lead them to govern effectively. For example, an independent director, sitting in a compensation committee meeting, will not challenge a management recommendation or commend firing a CEO solely because management is not present at the meeting. Nor
The threat that an acquiror will appear in the future, and that shareholders will replace their board in order to sell their company, may provide some incentive for a board to govern well. Hostile takeovers, however, typically occur at price premiums of thirty percent or more over market. This suggests that management must be doing a very bad job—running a company at less than 70 percent of potential—for an acquiror to step in and rescue shareholders. So perhaps the threat of a hostile takeover creates an incentive for a board not to govern horribly, but it does not create an incentive for the board to govern well. In sum, it is difficult to imagine that these sets of legal rules have a significant direct effect on the incentives of a board of directors to govern in an affirmatively effective manner. To the extent boards are attentive and diligent in their oversight of management, it is not (or at least should not be) out of a fear of out-of-pocket liability, or a fear of being voted out of office, or a fear of having their company acquired. Their motivation must lie elsewhere. Moreover, if the law were changed to increase the likelihood that outside directors would be penalized more severely for inadequate governance, corporate governance could well suffer. Many people would decline to serve as directors, particularly those with substantial assets or reputations at stake, and others would become excessively defensive in their oversight role. In addition, directors’ fees would have to increase to compensate for the heightened personal risk borne by those who do serve. Paradoxically, this could have the effect of compromising the independence of directors for whom fees become a meaningful portion of total income. Directors in this position might hesitate to rock the boat, let alone resign, in the face of management decisions that they find troubling. B. Sarbanes-Oxley and Subsequent Reform Efforts The Sarbanes-Oxley Act of 2002 and the related changes in New York Stock Exchange and NASDAQ rules, all following in the wake of the Enron and other corporate scandals, imposed a set of structure and process rules on boards. For example, a majority of directors must be “independent,” a term the rules define in great detail; audit, compensation, and nominating/governance committees must be constituted with all independent directors; and independent directors must meet alone periodically, with one among them identified publicly as the director presiding over those meetings. Leaving aside whether these legal rules, on balance, promote good governance more than other structures and procedures that boards might instead adopt on their own, it is reasonable to expect that structure and process, in general, will have an impact on directors’ governance behavior, and that many of the recent reforms may have a positive impact on the governance of many companies. The nature of the impact, however, is to place directors in settings in which other motivations will ideally take effect and lead them to govern effectively. For example, an independent director, sitting in a compensation committee meeting, will not challenge a management recommendation or recommend firing a CEO solely because management is not present at the meeting. Nor
will independent directors meeting out of management's presence necessarily put in the hard work needed to understand a difficult issue that they fear the Ceo is minimizing solely because the Ceo is not present at the meeting. a director will not become diligent as a result of structure or process alone. There must be further inducements whether they be carrots or sticks, and the recent reforms do not alter the stick of liability isk, nor do they provide any carrots C. If Not Law what Can Promote Good governance? A full discussion of the extra-legal forces that can motivate good governance in the boardroom lies beyond the scope of this brief essay. One obvious source of extra- legal influence is economic. If board members hold substantial blocks shares throughout their tenure on the board, they would presumably be more attentive in the boardroom. It would be impractical for the law to impose such a requirement, since the number of shares that constitute a block substantial enough to motivate good governance depends on how wealthy a particular board member is. Nonetheless, boards could adopt this policy on their own and disclose the policy, the directors shareholdings, and at least some additional details in their filings with the Securities and Exchange Commission. Shareholder advocates have been pressing for this arrangement for some time Professional norms are another potential force motivating good governance presumably a force that already explains in part why governance fiascos, prominent as they have been, have actually been rare. These norms are fostered by the financial press every time they write a story that exposes bad board behavior, and, on occasion, when they write a story applauding good board behavior. Shareholder suits that shine a light on bad behavior, and that at times generate court decisions, help create and disseminate norms as well--even if they do ultimately settle at no out-of-pocket cost to the directors Codes of best practices written by management and shareholder ations. while often dissemination and director education is certainly worth a try as wel eation an h impact bland in the extreme and resembling lessons one learned in kindergarten, have as well. Lipton and Lorsch's prescription of more deliberate norm cre In conclusion, while the law can deter egregious self-serving behavior, it can only go so far in promoting good governance in the boardroom. The slack must be picked by economic and social forces. Those forces already exist, but perhaps they can be enhanced as Lipton and lorsch suggest Edward Rock, Saints and Sinners: How Does Delaware Corporate Law Work?, 44 U.C. L.A. L. REV. 1009(1997)
will independent directors meeting out of management’s presence necessarily put in the hard work needed to understand a difficult issue that they fear the CEO is minimizing, solely because the CEO is not present at the meeting. A director will not become diligent as a result of structure or process alone. There must be further inducements, whether they be carrots or sticks, and the recent reforms do not alter the stick of liability risk, nor do they provide any carrots. C. If Not Law, What Can Promote Good Governance? A full discussion of the extra-legal forces that can motivate good governance in the boardroom lies beyond the scope of this brief essay. One obvious source of extralegal influence is economic. If board members hold substantial blocks of a company’s shares throughout their tenure on the board, they would presumably be more attentive in the boardroom. It would be impractical for the law to impose such a requirement, since the number of shares that constitute a block substantial enough to motivate good governance depends on how wealthy a particular board member is. Nonetheless, boards could adopt this policy on their own and disclose the policy, the directors’ shareholdings, and at least some additional details in their filings with the Securities and Exchange Commission. Shareholder advocates have been pressing for this arrangement for some time. Professional norms are another potential force motivating good governance, presumably a force that already explains in part why governance fiascos, prominent as they have been, have actually been rare. These norms are fostered by the financial press every time they write a story that exposes bad board behavior, and, on occasion, when they write a story applauding good board behavior. Shareholder suits that shine a light on bad behavior, and that at times generate court decisions, help create and disseminate norms as well—even if they do ultimately settle at no out-of-pocket cost to the directors.3 Codes of best practices written by management and shareholder associations, while often bland in the extreme and resembling lessons one learned in kindergarten, have an impact as well. Lipton and Lorsch’s prescription of more deliberate norm creation and dissemination and director education is certainly worth a try as well. In conclusion, while the law can deter egregious self-serving behavior, it can only go so far in promoting good governance in the boardroom. The slack must be picked up by economic and social forces. Those forces already exist, but perhaps they can be enhanced as Lipton and Lorsch suggest. 3 Edward Rock, Saints and Sinners: How Does Delaware Corporate Law Work?, 44 U.C.L.A. L. REV. 1009 (1997)