Corporate Governance: Values, Ethics and Leadership [1 ed.] 1409405133, 9780754628392

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Corporate Governance

The Library of Corporate Responsibilities

Series Editor: Tom D. Campbell Titles in the Series: Sustainability

Tom Campbell and D avid Mollica C o rp o rate Social R esponsibility

Wesley Cragg, M ark S. Schwartz and D avid Weitzner C o rp o rate E nvironm ental Responsibility

N eil Gunningham C o rp o rate G overnance

Lawrence E. M itchell C o rp o rate Business Responsibility

Justin O ’Brien

Corporate Governance

Edited by

Lawrence E. Mitchell The George Washington University Law School, USA

O Routledge Taylor & Francis Group LONDON AND NEW YORK

First published 2009 by Ashgate Publishing Published 2016 by Routledge 2 Park Square, M ilton Park, Abingdon, Oxon 0 X 1 4 4RN 711 Third Avenue, N ew York, N Y 10017, USA Routledge is an imprint o f the Taylor & Francis Group, an informa business Copyright © Lawrence E. M itchell 2009 . For copyright o f individual articles please refer to the Acknowledgements. All rights reserved. No part o f this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, w ithout perm ission in writing from the publishers. N o tice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. W herever possible, these reprints are made from a copy o f the original printing, but these can themselves be o f very variable quality. W hilst the publisher has made every effort to ensure the quality o f the reprint, some variability may inevitably remain. British L ib ra ry C atalogu ing in Publication D ata

Corporate governance. - (The library o f corporate responsibilities) 1. Corporate governance. 2. Business ethics. I. Series II. Mitchell, Lawrence E. 658.4-dc22 L ib r a ry o f Congress C on trol Num ber: 2009921938

ISBN 9780754628392 (hbk)

Contents A cknowl edgem ents Series Preface Introduction PART I

THE PURPOSE OF THE CORPORATION

1 A. A. Berle Jr (1931), ‘Corporate Powers as Powers in Trust’, Harvard Law Review, 44, pp. 1049-74 2 E. Merrick Dodd Jr (1932), ‘For Whom are Corporate Managers Trustees?’, Harvard Law Review, 45, pp. 1145-63. 3 Henry Hansmann and Reinier Kraakman (2001), ‘The End of History for Corporate Law’, Georgetown Law Journal, 89, pp. 439-68. 4 William T. Allen (1992), ‘Our Schizophrenic Conception of the Business Corporation’, Cardozo Law Review, 14, pp. 261-81. PART II

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3 29 49 79

THE BOARD OF DIRECTORS

5 Melvin Aron Eisenberg (1975), ‘Legal Models of Management Structure in the Modem Corporation: Officers, Directors, and Accountants’, California Law Review, 63, pp. 375^139. 103 6 Margaret M. Blair and Lynn A. Stout (1999), ‘A Team Production Theory of Corporate Law’, Virginia Law Review, 85, pp. 247-328. 169 7 Stephen M. Bainbridge (2003), ‘Director Primacy: The Means and Ends of Corporate Governance’, Northwestern University Law Review, 97, pp. 547-606. 251 PART III SHAREHOLDERS 8 Dalia Tsuk Mitchell (2006), ‘Shareholders as Proxies: The Contours of Shareholder Democracy’, Washington & Lee Law Review, 63, pp. 1503-78. 9 Marcel Kahan and Edward B. Rock (2007), ‘Hedge Funds in Corporate Governance and Corporate Control’, University o f Pennsylvania Law Review, 155, pp. 1021-93. 10 Ronald J. Gilson and Curtis J. Milhaupt (2008), ‘Sovereign Wealth Funds and Corporate Governance: A Minimalist Response to the New Mercantilism’, Stanford Law Review, 60, pp. 1345-69.

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PART IV A LOOK AT THE FUTURE? 11 Cindy A. Schipani and Junhai Liu (2002), ‘Corporate Governance in China: Then and Now’, Columbia Business Law Review, 2002, pp. 1-69.

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Name Index

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Acknowledgements The editor and publishers wish to thank the following for permission to use copyright material. Cardozo Law Review for the essay: William T. Allen (1992), ‘Our Schizophrenic Conception of the Business Corporation’, Cardozo Law Review, 14, pp. 261-81. Columbia Business Law Review for the essay: Cindy A. Schipani and Junhai Liu (2002), ‘Corporate Governance in China: Then and Now’, Columbia Business Law Review, 2002, pp. 1-69. Copyright Clearance Center for the essays: A.A. Berle Jr (1931), ‘Corporate Powers as Powers in Trust’, Harvard Law Review, 44, pp. 1049-74. Copyright © 1931 Harvard Law Review Assocation; E. Merrick Dodd Jr (1932), ‘For Whom are Corporate Managers Trustees?’, Harvard Law Review, 45, pp. 1145-63. Copyright © 1932 Harvard Law Review Assocation; Margaret M. Blair and Lynn A. Stout (1999), ‘A Team Production Theory of Corporate Law’, Virginia Law Review, 85, pp. 247-328. Copyright © 1999 Virginia Law Review; Ronald J. Gilson and Curtis J. Milhaupt (2008), ‘Sovereign Wealth Funds and Corporate Governance: A Minimalist Response to the New Mercantilism’, Stanford Law Review, 60, pp. 1345-69. Copyright © 2008 Stanford Law Review. Melvin Aron Eisenberg (1975), ‘Legal Models of Management Structure in the Modem Corporation: Officers, Directors, and Accountants’, California Law Review, 63, pp. 375^139. Copyright © 1975 Melvin Aron Eisenberg. Georgetown University Law Center for the essay: Henry Hansmann and Reinier Kraakman (2001), ‘The End of History for Corporate Law’, Georgetown Law Journal, 89, pp. 439-68. Northwestern University Law Review for the essay: Stephen M. Bainbridge (2003), ‘Director Primacy: The Means and Ends of Corporate Governance’, Northwestern University Law Review, 97, pp. 547-606. University of Pennsylvannia Law Review for the essay: Marcel Kahan and Edward B. Rock (2007), ‘Hedge Funds in Corporate Governance and Corporate Control’, University o f Pennsylvania Law Review, 155, pp. 1021-93. Washington & Lee Law Review for the essay: Dalia Tsuk Mitchell (2006), ‘Shareholders as Proxies: The Contours of Shareholder Democracy’, Washington & Lee Law Review, 63, pp. 1503-78. Copyright © 2006 Dalia Tsuk Mitchell. Every effort has been made to trace all the copyright holders, but if any have been inadvertently overlooked, the publishers will be pleased to make the necessary arrangement at the first opportunity.

Series Preface The conduct and governance of corporations raise a host of economic, political and social issues of central importance to human wellbeing in the 21st century. The economic capacity and consequent power of corporations make them institutions with the potential for enormous benefit and grievous harm. It is, therefore, crucial to identify the various advantages and disadvantages of the corporate form and how it is utilised, and to work out how to maximise the economic gains while minimising the social and environmental losses deriving from corporate activities. This requires an appreciation of how the corporation contributes to prosperity and human wellbeing, and what risks it poses to the natural and social environments in which it operates. Since the benefits of corporations are dependent on the exercise of corporate freedoms, and countering the potential harms sometimes requires restrictions on those freedoms, there are structural tensions in developing ethical and legal norms for corporate governance. Moreover, corporate freedoms work well for enhancing prosperity only within an appropriate competitive setting which is itself dependent on mutual trust and a regulatory framework, particularly if it is considered a benefit to achieve an equitable distribution of that prosperity. It is, therefore, a complex matter to gain an overall picture of the corporate rights and responsibilities that are appropriate within a good society, both domestic and global. This series of five volumes on corporate responsibilities gathers together crucially important essays on different dimensions of corporate responsibility. The essays are selected and introduced by internationally recognised specialists in the field. Each volume provides a different perspective and concentrates on distinctive issues. Corporate Business Responsibility (Vol I), edited by Justin O’Brien, Research Professor of Law and Corporate Governance at Queensland University of Technology, focuses on the responsibility of the corporation to enhance and sustain share value within the norms of fair competition. Business responsibility constitutes the distinctive core duty of the corporation as the creature of its investors to maximise its profitability in the interests of its legal ‘owners’ to whom managers and boards are ultimately accountable. This core business duty operates within a wider context of legal and social norms that are directly integral to the conduct of business in a competitive market system which aims at the economic success not only of particular businesses but of business in general. Corporate Environmental Responsibility, (Vol. II), edited by Neil Gunningham Professor of Environmental Law at The Australian National University, centres on the responsibility of corporations towards the natural environment, taking into account the economic, social and intrinsic reasons for preserving and enhancing the natural environment. It deals with the ethical basis for requiring corporate management to factor-in environmental considerations to their economic decision-making, including and going beyond the purely business case for environmental risk management. Essays dealing with ‘smart’ regulation and internal management policies to protect the environment both nationally and internationally are included.

Corporate Governance

Corporate Social Responsibility (Vol. Ill), edited by Wesley Cragg, Professor of Business Ethics, Schulich School of Business at York University, Mark Schwartz, Professor of Business Ethics, Faculty of Professional and Liberal Studies, York University, and David Weitzner, Professor of Strategy and Ethics, Schulich School of Business, York University, examines the emergence of the concept of corporate social responsibility and the use and uses that have been made of the language of corporate responsibility to explore the business/society relationship, or what might be described as the role of the modem corporation in contemporary society. Central to this volume is the challenge of identifying and balancing a corporation’s financial and non financial obligations to a wide range of stakeholders including shareholders but also employees, consumers, suppliers and communities affected by its operations. Issues discussed include the ethical bases for these social responsibilities, their practical application, their on­ going implications for business management and the efficacy of voluntary self-regulation. Corporate Governance (Vol. IV), edited by Lawrence Mitchell, Theodore Rinehart Professor of Business Law, The George Washington University, Washington DC, deals with corporate governance from the point of view of managing and being accountable for the full range of corporate responsibilities. It explores different visions of the corporation in terms of ownership and as a social entity. The structure of the corporation, its legal bases and economic functions are examined. Particular attention is given to the role of the Board of Directors and shareholders in holding management accountable and taking responsibility for corporate conduct. Sustainability (Vol. V), edited by Tom Campbell, Professorial Fellow in the Centre for Applied Philosophy and Public Ethics (CAPPE) at Charles Sturt University, and David Mollica of The Australian National University, focuses on the concept of sustainability and its relevance to the articulation, development and enforcement of corporate responsibilities. Essays are included which trace the origins and multiple meanings of ‘sustainability’ within a range of disciplines, including ecology, economics and politics, and the ways in which they reflect shifts in value priorities, corporate policies, compliance mechanisms, and issues of global and domestic social justice. Consideration is given to the benefits and drawbacks of utilising the concept of Sustainability in theorising and presenting the legal and ethical responsibilities of the modem corporation. Together these five volumes provide a wide-ranging picture of contemporary thinking on corporate responsibilities, taking in debates about their proper content and the legitimate and effectual means of their enforcement. TOM CAMPBELL Series Editor Professorial Fellow, The Centre fo r Applied Philosophy and Public Ethics (CAPPE), Charles Sturt University, Canberra

Introduction Fifty years ago, a volume like this would have seemed peculiar, for the study of corporate governance as an academic discipline is not really that old (Mitchell, forthcoming). Although corporations themselves have been around for centuries, and industrialization began over 200 years ago, the processes by which corporations were governed in the modem sense received little attention. The nature of the corporation first became a major subject of debate on the European continent in the nineteenth century, and had migrated to England and then the United States by the first two decades of the twentieth century (Harris, 2006, pp. 1475-77). Also important were questions about the specific powers of the corporation, the relationship between shareholders and creditors, the powers of the board and the obligations of directors toward shareholders. But none of these is corporate governance in the modem sense. It has only been with the advent of widespread public stockholding in the United States and England - which itself was a rather late development1- that the manner in which corporations were run became an important concern to lawyers.2 In continental Europe and Japan, a scholarly focus on corporate governance developed as globalization challenged existing models of corporate governance among countries and, broadly, between systems.3 It was only with these developments that the study of corporate law moved from an exclusive focus on the details of corporate relationships to a broader and more overarching concern with the way in which the various parts fit into a coherent (or perhaps incoherent) whole. In one respect, the origins of the discipline may be traced back to Adolf Berle’s and Gardiner Means’ 1932 classic, The Modern Corporation and Private Property. This book is generally accepted as popularizing the reality that control had separated from ownership in the American corporation and calling for ways to restrain the otherwise unrestrained power that was the result. But even the observations of Berle and Means didn’t create the modem study of corporate governance, for their focus was more on restraining corporate power than on the way in which the corporation was operated for its own sake. The famous Berle-Dodd debate that followed was far more about the ends corporations were to pursue than how they were run (Tsuk Mitchell, 2003, 2005). The study of corporate governance remained dormant. Indeed there was little, if any, exploration even of the role of the board itself, if there was nonetheless a degree of practical consensus among businessmen. In the United States, it was only with the work of Melvin Eisenberg, in a series of essays that culminated in his 1976 book, The Structure o f the Corporation: A Legal Analysis, that corporate governance developed into its own field of 1 While public shareholding o f industrial companies in the United States began at the very end o f the nineteenth century, it w asn’t until the 1960s that significant numbers o f Americans owned stock. W idespread public shareholding in England came even later. See Cheffins (2003, pp. 7-12). 2 Businessmen, as well as management experts, sociologists and economists, were more interested in the issue somewhat earlier, but the literature even there is scarce. 3 See Jacoby (2000, pp. 5-7), comparing models o f corporate governance between the United States, Japan and Western Europe.

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study.4 Issues of the proper composition of the board of directors, the role of the board, whom it was to serve and how, and the appropriate extent of shareholder participation rapidly became the centrepiece of corporate law study. The explosion of interest in comparative corporate governance that accompanied rapidly increasing sums of transnational capital investment in the 1980s and 1990s led corporate governance to develop as a major scholarly enterprise. As a result, a volume like this does not seem strange nowadays, but rather ordinary. The organization of this Introduction follows the structure the book, covering the major topics in the modem corporate governance debate: the purpose of the corporation, the role of the board, and the place of shareholders.51 conclude with a look at the developing corporate law of the People’s Republic of China as both a contrast and an interesting study in itself. The Purpose of the Corporation

In order even to be able to ask appropriate questions about corporate governance, one must begin with the question of what it is that is to be governed, and why. The question of corporate purpose is at the heart of any understanding of the issues raised in the corporate governance dialogue, and this is why it is the focus of Part I. Corporate purpose was one of the earliest matters of concern and, interestingly, has renewed itself in a healthy and vigorous debate that has gone on for the past 20 years. Nineteenth-century corporate law contemplated the corporation as a community of interests among shareholders, creditors, employees and directors, or as an artificial entity created by the state.6 Thus we see strict laws governing legal capital for the benefit of creditors, the relatively late universalization of limited liability, and long-lingering double liability (and sometimes unlimited liability) for the shareholders of banks, laws holding shareholders liable for the unpaid wages of workers, and strict limitations on the powers of directors in order to protect shareholders’ investments. Eventually, external business policy regulation, like anti-monopoly laws, and straightforward consumer protection legislation such as the Pure Food and Drug Law of 19067 and the Securities Act of 1933 in the United States8 brought consumers into the focus of concern as well. 4 While the importance o f Eisenberg’s book is undoubted, there were significant economic, social and political circumstances in the United States at the time that helped to catalyse scholarly and public concern with corporate governance. Corporate scandals and the rise the o f corporate social responsibility m ovem ent led to corporate governance reforms that sought to balance political and social responsibility w ith the primacy o f shareholder value. See Gordon (2007); and Kenneth B. Davis Jr, (2008, p. 387, n. 26), explaining that Eisenberg was not alone in advancing ideas o f corporate governance and monitoring. 5 I regret that space precludes me from discussing yet another important organ o f corporate governance, at least in the United States. This is the judicial system which, among other things, fills in when a board o f directors or a body o f shareholders is thought to be compromised in their decision­ making processes. 6 Later in that century, theories o f the corporation as a contractual entity developed, followed, even later, by ideas about the corporation as a natural entity. For the best explanation o f these theories and how they developed see Horwitz (1992, ch. 3). 7 US Statutes at Large (59th Congress, Session I, Chp. 3915, pp. 768-72). 8 Act o f 27 M ay 1933, Pub. L. No. 73-22, 49 Stat. 74 (codified as amended at 15 USC §§ 77a-77z-

3).

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The increasingly widely held nature of corporate securities in the United States called this understanding of the corporation as a community of interests into question, initially as a practical matter and eventually as a legal matter. In 1904 Thorstein Veblen observed the growing prevalence of financial manipulation through the stock market as coming to dominate industrial production, but his voice went largely unheeded. Instead, the market pressures to which newly public corporations were subjected led their boards, substantially dominated by bankers, to attempt to satisfy the interests of stockholders and creditors equally. This often overburdened early public corporations but, as corporate managers gained power and banker control dissipated, stockholders became the principal subject of managerial concern and their profit the goal of management’s endeavours. This focus on the stockholders was more or less established by the time of the famous 1919 Michigan Supreme Court case of Dodge v. Ford.9 Faced with Henry Ford’s claims of diminished dividend payments in order to decrease automobile prices and benefit the consumer, the court explicitly noted that corporations were to be run for the benefit of their shareholders and the corporation itself. While the latter phrase left some ambiguity, the former more or less acknowledged what had de facto become the goal of corporate law: to serve shareholder interests.10 The most famous early engagement with the issue is that of Columbia University law professor, Adolf Berle, and Harvard law professor, E. Merrick Dodd, and Part I opens with two essays from their debate. Berle’s essay (Chapter 1) is a brilliantly constructed doctrinal examination of a variety of corporate law rules governing the behaviour of directors. His somewhat conflicted normative view, more completely expressed in The Modern Corporation and Private Property (1932), was that such a posture was necessary in order to restrain corporate power for the benefit of the community. Dodd (Chapter 2) responds by looking to the court of public opinion as well as of business practice. In line with the kinds of argument that had led to US civil service reform during the last quarter of the nineteenth century, Dodd articulates a deeply felt noblesse oblige that requires capital and its custodians, the corporate directors, to acknowledge the responsibility that accompanies their power and to be mindful of the interests of the broader community from which their power arises. Not shareholders alone, but the broader society, then, could be seen to be the legitimate concern of corporate directors. Berle’s role in the debate is often misunderstood. Contemporary advocates of what is now known as shareholder primacy claim him as an intellectual progenitor. A better reading of Berle, together with his Modern Corporation and Private Property (into which this essay was incorporated), suggests that his desire to tie the board’s interests to the shareholders was for the purpose of providing an effective means of controlling board discretion and therefore corporate power.11 Nonetheless, Berle proclaimed Dodd the winner in 1954, although Dodd demurred. If Dodd was indeed victorious, it was a victory that would not last. Its transience is reflected in the third selection for Part I, Henry Hansmann’s and Reinier Kraakman’s ‘The End of History for Corporate Law’ (Chapter 3), which claims the undisputed 9 Dodge v. Ford M otor Co., 204 Mich. 459, 508-509, 170 NW 668 (1919). 10 While the case is typically taken for the proposition in the text, it is often forgotten that the context was an attempt by Henry Ford to freeze out two minority shareholders, which undoubtedly drove the C ourt’s decision in the matter. 11 This reading is presented and elaborated in Tsuk M itchell (2005).

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victory of shareholder primacy. Hansmann and Kraakman assert that, through the process of market competition, the shareholder-centred model has proven itself to be superior in virtually every respect and is therefore destined to become the model that dominates the world. It may well be that Hansmann and Kraakman wrote too soon, before the American corporate scandals of 2002 that revealed the extent to which the shareholder-primacy model - what they refer to as the ‘standard model’ - has resulted in short-term managerial behaviour designed to increase shareholder stock prices at the cost of the real economy. I suspect that they would answer that there is nothing inevitable about this short-termism in the model of shareholder primacy, and as a matter of logic they’d almost certainly be right, but I would suggest that the economic incentives of shareholders, as well as their behavioural defects (by which I mean economically irrational behaviour), strongly tends, if it does not inevitably lead, to managerial short-term behaviour.12 Part I concludes with an essay by the justifiably famous Delaware Chancellor, William Allen, who sat on America’s most important business court from 1985 to 1997.13In an oft-cited 1992 lecture, ‘Our Schizophrenic Conception of the Business Corporation’ (Chapter 4), Allen identifies the central perennial question in corporate law as ‘What is the corporation?’, which carries within it the implicit question: ‘Whom is the corporation to serve?’ Allen describes the way in which two different visions of the corporation - what he refers to as the property conception and the social entity conception - coexisted more or less easily throughout most of American corporate history by means of the mediating device of the long-term/short-term distinction. In other words, the property conception, with its emphasis on the shareholder, could be reconciled with the vision that corporations had broader social responsibilities by acknowledging that short-term costs incurred to engage in socially beneficial activity would benefit the corporation, and thus the shareholders, in the long run. This modus vivendi was destroyed, Allen writes, during the 1980s ‘takeover decade’ in which the two models no longer could coexist. Shareholders who could realize immediate short-term maximization of their share prices could hardly be said to have deep concerns about the long-term welfare of a corporation of which they would no longer be a part. In its famous 1989 decision in Paramount v. Time,u Allen (who wrote the lower court opinion),15 notes that the Delaware Supreme Court affirmed the social entity concept when it held that a corporate board could prevent the shareholders from maximizing short-term value for the long-term welfare of the corporation. At the same time, Allen predicted that this victory would not stand. The increasing globalization of the economy and the rise of institutional shareholders created, he believed, 12 I use the term ‘shareholder prim acy’ here, as it is commonly used and as they appear to use it, as a term that encompasses both the corporate purpose o f shareholder wealth maximization and the role o f the board as subordinate to shareholder desires. In Chapter 7 o f this volume Steve Bainbridge quite persuasively identifies these two meanings o f shareholder primacy and demonstrates the lack o f necessary connection between the two. 13 See Cole (2002, n. 223). The Chancery Court is subordinate to the Delaware Supreme Court, but hears far more cases. Taken together, the two courts constitute the most important judicial institution in A merican corporate law. 14 Paramount Communications, Inc. v. Time Inc., 571 A.2d 1140 (Del. 1989). 15 Paramount Communications, Inc. v. Time, Inc., Del. Ch., C AN o. 10670, 1989 WL 79880, Allen, C. (14 July 1989), a f f ’d, D el.Supr, 571 A.2d 1140 (1989).

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an almost irresistible force for the property conception. Yet, despite the certitude with which Hansmann and Kraakman pronounced the end of history only nine years later, Bill Allen was more nuanced. After all, corporate law is only a reflection of the society in which it exists, and society is always in flux. There would never be a final answer to the question 4What is the corporation?’ because ‘in defining what we suppose a public corporation to be, we implicitly express our view of the nature and purpose of our social life. Since we do disagree on that, our law of corporate entities is bound itself to be contentious and controversial’ (p. 99). And so it is, and so it remains. The Board of Directors

Having explored the fundamental question of corporate purpose, we turn to look at what is arguably the most powerful actor within the corporate structure, the board of directors. I begin the discussion of Part II with an historical review drawn from my own essay, not included in this volume, ‘The Trouble with Boards’ (forthcoming). History shows us that judges, legal scholars and even management scholars had virtually no interest in the role and function of the board of directors until the late 1960s. This rather large gap is understandable in light of the larger scope of the history of the modem corporation; the nineteenth century was a time of control through restrictive charters and detailed statutes dealing with corporate and board powers in the context of a population of overwhelmingly closely held corporations.16 The transformation of industrial concerns from public to private took place at the tail-end of the nineteenth century and the early years of the twentieth, coinciding with a dominating interest in restraining corporate size and power through anti-monopoly laws and regulating destabilizing speculation in the markets for corporate securities.17 By the time these issues had been thoroughly vetted, the United States, by at least the late 1920s, had entered into a phase of what is known as ‘managerialism’, in which, for a variety of reasons, management came to dominate the composition of boards and the limited time and expectations of non­ management directors led them to remain passive. This state of affairs was challenged in the early 1970s as a combination of business, financial, political and social turmoil largely focused on corporate behaviour, with corporate boards at its centre (Gordon, 2007, pp. 1514-20). Of the various reform measures suggested, the one that emerged as successful was the recasting of the board as a ‘monitoring’ board composed substantially of directors independent of management. This monitoring board, most thoroughly and articulately expressed by Mel Eisenberg (see also Davis, 2008, n. 26; 16 Exceptions were some railroads and banks, the shares o f which were publicly traded. 17 European nations, with a somewhat longer history o f industrialization, were less bothered than the Americans with restraint o f trade and, rather than obsess about monopoly, were content to permit industrial cartelization in a manner that eliminated some o f the strong incentives that American concerns had to issue public stock. Some European nations were concerned about speculation, as demonstrated by an 1896 German law that attempted to regulate the practice. The law was a failure and soon repealed. See Jacoby (2000, pp. 11-12), who states that American regulation up to 1950 pushed companies towards unrelated diversification, while Germany and Japan continued to discourage mergers in favour o f cartels, See also Roe (1993, pp. 1936-37), who argues that stock ownership in large German and Japanese firms has traditionally been m uch more concentrated in large blocks controlled by big banks and institutional shareholders. See generally M itchell (2007a).

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Skeel, 2004, pp. 1519-20), was given the principal task of choosing, overseeing, and, when necessary, firing the corporation’s CEO, as well as overseeing the general integrity of the operation and fulfilling its statutory role of making certain significant decisions (Gordon, 2007). This monitoring board was a far cry from the ‘managing board’ of earlier days. Its success was due to a variety of factors but, most important among them, was that it was the least intrusive reform model on the table at the time. Various business groups and their lawyers saw, in the monitoring model, a way of insulating directors from liability by providing them with minimal legal responsibilities and few opportunities to exercise them. Thus the monitoring model became more of a liability shield than a meaningful corporate governance device, although it has started to demonstrate significant possibilities in the wake of the corporate scandals at the turn of the twenty-first century. It has also had one further effect. The dominance on the board of independent directors with little knowledge of the corporation has limited what they are practically capable of doing in terms of the corporation’s success. The simplest metric, if perhaps a deeply incomplete and flawed one, is the corporation’s stock price. It thus is no surprise to see that, with the rise of the independent monitoring board, a broad corporate obsession with share prices and their short­ term maximization has become a dominant trope in corporate governance and, quite naturally, has been taken up by the shareholders as well (Mitchell, forthcoming, 2002; Gordon, 2007; Coffee, 2002, pp. 1413-14). As I noted, Mel Eisenberg’s 1976 book, The Structure o f the Corporation - which in turn was based on a series of essays Eisenberg had been writing since 1969 - was one of the most significant works in the creation of the modem study of corporate governance.18 The essay selected for this volume, ‘Legal Models of Management Structure in the Modem Corporation: Officers, Directors, and Accountants’ (Chapter 5), directly addresses the role of the board in corporate governance. Eisenberg starts with the common observation that the legal and practical roles of the board in the 1970s diverged considerably. The law, at least at the time, demanded that the ‘business and affairs of a corporation shall be managed by a board of directors’ (p. 103). It was obvious that boards did not and, for a variety of reasons including limited time, limited information, and structural biases inherent in board selection and composition and the directors’ resulting loyalties, could not actually manage corporations. A number of reforms had been suggested, all of which sought to make the practice of board management conform to the legal dictates. Among these proposals were calls for professional directors (outside directors whose principal occupation was director), full-time directors (corporate employees whose sole responsibility was directing) and boards with their own full and independent staffs. Eisenberg explains why each of these was impossible, impractical or undesirable. He then turns to review the kinds of function a board could, at least in theory, perform. For a variety of reasons, he dismisses those of ‘providing advice and counsel to the office of the chief executive; authorizing major corporate actions [and] providing a modality through which persons other than executives can be formally represented in corporate decisionmaking’

18 Eisenberg’s practical contribution was to serve as the Reporter for Parts I—III o f the highly influential American Law Institute’s Principles o f Corporate Governance, developed throughout the 1980s and completed and adopted in 1994.

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(p. 119). The sole function that remained, ‘selecting and dismissing the members of the chief executive’s office and monitoring that office’s performance’ (p. 119) is, in Eisenberg’s view, ‘of critical importance to the corporation and uniquely suited for performance by the board’ (p. 124). It was this monitoring role that was the highest and best use of the board as an institution. The monitoring board was rapidly accepted not only by organizations such as the American Law Institute and the powerful American Bar Association’s Committee on Corporate Law, but also by courts, especially by those of Delaware. The timing was propitious. The takeover decade of the 1980s was about to begin, and the monitoring board provided a perfect model to oversee corporate decisions during that era. Given the logical (though not necessary) connection between monitoring and independence, the new model allowed the courts to stress the sanitizing effect of an independent monitoring board on takeover decisions that harboured intrinsic conflicts of interests, as well as other conflict decisions. The monitoring board stuck, and it is the model that not only dominates practice, but also serves as the starting-point for discussions of board reform. While the monitoring board may dominate, the search for a more effective board model continues, especially in the post-Enron era in which the sufficiency of the monitoring model for corporate protection has been cast into doubt. In the early and mid-1990s, concerned especially with the social responsibility of corporations and bolstered by the 1980s passage of stakeholder statutes in a number of states, Lynn Dallas and I published essays proffering as potential models the idea of the board as an institution that balanced the interests of a variety of corporate constituents (Dallas, 1996; Mitchell, 1992). Building on these ideas, and, in contrast to Dallas and me, working from an economic perspective, Margaret Blair and Lynn Stout published ‘A Team Production Theory of Corporate Law’ in 1999 (see Chapter 6), proffering the idea of the board as a ‘mediating hierarchy’ (p. 172), a theory that enjoyed some currency in the early twenty-first century and continues to be debated (see, for example, Millon, 2002; Strine, 2002). Blair and Stout challenge the prevailing corporate governance model - the principalagent model - which treats the primary purpose of the corporation as being to maximize shareholder profit and the principal impediment to this goal the existence of agency problems which arise when managers pursue self-interest at the expense of the shareholders. Their alternative, the team production model, arises from an economic literature that identifies this as the appropriate solution when team members make firm-specific investments and when the organization’s output - in this case, profit - is ‘nonseparable’, creating ‘serious problems ... in determining how any economic surpluses generated by team production - any “rents” - should be divided’ (p. 171). Their argument is that, given the virtual impossibility of contracting with the various suppliers of corporate inputs, the team production model in which the board decides on the allocation of output among various input suppliers working through the processes of corporate governance may represent the best achievable solution to the various problems corporate governance scholars have tried to solve. They base this new model of governance on the conclusion - which should surprise nobody even slightly familiar with corporate history or careful readers of corporate cases - that ‘corporate assets belong not to shareholders but to the corporation itself (pp. 172-73, emphasis in original). Control over the use of those assets and the allocation of their production, as well as the resolution of disputes among team members,

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is to be accomplished ‘by an internal hierarchy’, at the top of which sits the board of directors with ‘virtually absolute’ authority (p. 173). Blair and Stout attempt to address the issue of shareholder-centrism while resolving corporate governance problems with a board absolutely empowered to do so. However, Steven Bainbridge develops a governance model centring on an authoritative board whose mandate remains within narrower parameters. In his fascinating and insightful essay, ‘Director Primacy: The Means and Ends of Corporate Governance’ (Chapter 7), Bainbridge begins with the dominance in corporate governance discourse of the debate over the ends corporate law is to serve and how those ends are to be achieved. Starting with Berle and Dodd, but focusing more on the development of the nexus of contracts model of the firm that arose in the 1970s, he canvasses a variety of theories and concludes that all of them - from the most fundamental neoclassical approaches to the broader stakeholder approaches - derive their ideas of corporate governance from the answer to the question of the interests the corporation is designed to serve. In other words, Bainbridge argues that scholars locate corporate power in corporate ends. Thus, if the corporation is to maximize shareholder wealth, governance theories place ultimate power in the shareholders (Easterbrook and Fischel, 1989, p. 1436; Fama and Jensen, 1983). If stakeholder interests are the concern, those theories locate power in a board which is empowered to balance the interests of the various corporate groups.19 Bainbridge disentangles the question of corporate ends from the means of achieving them, arguing that no necessary logical relationship exists between who runs the corporation and why it is run. As to the former, he locates the centre of corporate governance in the board of directors, developing what he calls a theory of director primacy that corrects for the undue emphasis in shareholder and stakeholder theories on directorial accountability and, instead, balances board accountability with board authority. For it is only with an autocratic board sitting at the top of the corporate hierarchy - Bainbridge idealizes its members as ‘Platonic guardianfs]’ (p. 255) - that the corporation can efficiently achieve whatever ends are set for it or which it sets for itself. For a variety of reasons, Bainbridge chooses the shareholder value-maximization norm as the most workable, efficient and appropriate end of corporate governance but, as he notes, the correlation of director authority with shareholder wealth maximization is not a necessary one. Bainbridge’s work is probably the strongest and, to my mind, the most convincing argument for emphasizing board power as the mechanism of corporate governance, at least from the perspective of maximizing shareholder value (Mitchell, 1992, 2007b). Shareholders

While it is often said that shareholders ‘own’ the corporation, this concept is contested. Some argue that shareholders indeed own the corporation and that their rights exhibit many, if not most, of the traditional indicia of ownership. This notion logically carries with it the related idea that, as owners, shareholders have substantial control rights. While a fairly recent explosion in shareholder activism, both by institutional shareholders and by the relatively 19 See Blair and Lynn Stout (Chapter 6, this volume), who state that the board’s ‘job is to balance team m em bers’ competing interests in a fashion that keeps everyone happy enough that the productive coalition stays together’ (p. 203); also Dallas (2003); Dallas (1996); and M itchell (1992).

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new phenomenon of activist hedge funds (Bratton, 2006; Kahan and Rock, Chapter 9, this volume),20 has demonstrated that shareholders can in fact act like owners, the reality of most corporation law statutes is that they give shareholders very little power, virtually no power to initiate action and only limited power to veto decisions by the board. In the United States the principal device used by shareholders to assert their power, the shareholder proposal rule 14a-8, promulgated by the SEC under the Securities Exchange Act of 1934,21 has waxed and waned as political winds have blown. It may be that we are currently witnessing an expansion, as the Securities and Exchange Commission recently required that shareholder proposals demanding that corporations provide its workers with universal health coverage be included in the proxy materials at such companies as General Motors, Boeing, United Technologies and Wendy’s, thereby expanding the rule’s exception for proposals that relate to the ordinary course of business (Pear, 2008). The SEC has also, over the last decade, considerably relaxed its rules that restricted communications among shareholders - thereby allowing coordination among significant, but not controlling, stockholders - and has permitted the use of electronic proxy voting, which substantially diminishes the cost of mounting a proxy fight and thereby potentially gives a great deal of power to smaller shareholders.22 A different view of the shareholder’s place in corporate governance originates with the contractarian view of the corporation growing out of the application of neoclassical economic principles to the analysis of the theory of the firm.23The understanding of shareholders deriving from this model denies that shareholders are owners of the corporation in any meaningful sense. Rather, they are seen as one class of capital supplier, whose rights are restricted to the receipt of the corporation’s residual wealth. This right leads to certain special shareholder rights observed in corporate law - in particular, shareholder voting rights (Gordon, 2007) and fiduciary rights (Easterbrook and Fischel, (1989). While there are many variations on contractarian theory (see Klausner, 1995, pp. 768-69), directors are considered ‘agents’ of the shareholders. In contrast to the legal conception of agents, in which the principal (in this case, the shareholders) have the power to direct the behaviour of their agents, the contractarian theory uses the term more or less metaphorically in the sense that the ‘agency’ of directors is limited to the purpose of maximizing shareholder profit. Beyond this, shareholders are no more ‘owners’ of the corporation than any other supplier of inputs. The obvious importance of the distinction is to deny that shareholders have meaningful participatory rights in corporate governance. Rather, the limited special rights they do have are designed to ensure that the directors fulfil their obligation to maximize profits.

20 Private equity funds present yet a different type o f investor that can act like an owner, but unlike traditional institutions (such as mutual funds and pension funds), private equity firms typically purchase all, or substantially all, o f a corporation’s stock, which gives them the greatest incentive among all types o f investor to act like owners. See Cheffins and Arm our (2007) 21 17 CFR §240.14a-8 (2007). 22 17 CFR §240.14a-2; 17 CFR §240.14a-17. The deregulation o f restrictions on shareholder behaviour has been accompanied by, and indeed encouraged by, scholarly calls for increased shareholder participation. See Bebchuk (2005), who has been met with equally strong opposition. 23 The contractarian argument is explained in some detail in several o f the essays selected for this volume. See especially Bainbridge (Chapter 7). For the most thorough statement and analysis o f this theory see Easterbrook and Fischel (1991).

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In ‘Shareholders as Proxies: The Contours of Shareholder Democracy’ (Chapter 8), Dalia Tsuk Mitchell presents a deep historical analysis of shareholder activism and the shareholder’s place in corporate governance. Tracing the issues from the beginning of the twentieth century, with the rise of the modem public corporation in the United States, Tsuk Mitchell creates a theoretical construct that shows the uneasy and, in her view, ultimately failed, efforts to achieve shareholder democracy by identifying two visions of shareholders - one as true participants in the corporation and the other as mere investors. She identifies three major periods in the shareholder democracy movement through which the modem place of the shareholder evolved. The first, running from the turn of the twentieth century until the 1920s, was a period during which intellectual and public concern with the corporation was less a matter of shareholder participation for its own sake than with the meteoric increase in the power of public corporations as they grew to become, along with the federal government, the major power in society. While some concern with the interests of individual investors was expressed, the central issue was controlling monopolies, and attempts to mandate public corporate disclosure were designed to aid the federal government in this effort.24 As the 1920s witnessed dramatic growth in individual shareholding, the separation of ownership and control observed by Thorstein Veblen (1904) became a major concern (Holdemess, Kroszner and Sheehan, 1999). Two issues presented themselves. The first was the power of controlling shareholders or shareholder groups to oppress minority shareholders, and the second was the political and economic power wielded by the large public corporation and how to restrain it. Ultimately, the issues were linked, as reformers such as Adolf Berle saw the resolution of the former in the creation of minority shareholder committees - groups to assert the limited powers shareholders did have to protect minority interests - and the latter by linking directors’ interests to shareholder control by the imposition of strong fiduciary duties. The Great Crash of 1929 presented new problems or, rather, old problems that had attained a new urgency with the crisis. These were the issues of fraud and manipulation that had characterized both the issuance of securities and their trading in the market for decades. The newly significant individual investor gave political impetus to the problem, resolved by the passage of the New Deal securities acts, which focused not on corporations per se, but rather on their marketing and trading. The resulting laws emphasized disclosure, but, this time, disclosure was more in the nature of consumer protection laws designed to keep investors fully informed of the material facts relating to the securities they were buying and the corporations that issued them. The central idea of shareholder groups as corporate participants faded as the individual investor became the new focus. The group was not entirely gone, nor was the concept of shareholder as participant. Indeed, shareholder advocates like SEC Chairman William O. Douglas supported Berle’s ideas, and the SEC adopted its shareholder proposal rule 14a-8 in the early 1940s, to help implement the idea of shareholder democracy. But this conception of shareholder democracy rapidly departed from the group concept. As Tsuk Mitchell sees things, the struggle between political

24 While I take no issue with Tsuk M itchell’s discussion o f the centrality o f anti-trust, I have argued elsewhere that it was precisely during this period that the individual investor became a significant factor in the market. See M itchell (2007a).

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democracy and European totalitarianism led American public policy in matters economic, as well as political, to stress the centrality of the individual and her rights, and this individualism underlay the expanding movement towards shareholder democracy. Perhaps most important, it was this democracy that was seen as the legitimating factor behind the modem corporation - an entity that was controlled by people other than the owners. Nonetheless, and recognizing the efficiency and importance of the centrally managed corporation, the new shareholder democracy rules gave limited scope for shareholder initiative. Individualism had become a central American precept again, as even the battle for minority rights shifted from groups to individuals. The environment was ripe for a return to classical economic thought in the form of neoclassical economics. The focus on the individual brought a renewed focus on markets. The new analysis emphasized the efficiency of relatively unrestrained managerial freedom, even as it claimed the shareholder’s ability to self-protect through diversification and the right to sell her shares. With the market for corporate control as the ultimate monitor, the need for shareholder participation disappeared, at least as a matter of theory and policy, and the participating shareholder lapsed back into the contemporary state of the investor shareholder. Innovations in finance and changes in investment style have significant implications for the practical power of shareholders and, with it, lobbying and other efforts to increase the legal recognition of shareholders as a constituent component of corporate governance. In the 1990s institutional investors, whose holdings of all American corporate equities had risen to almost a majority by 1992, seemed, to many, to hold out hope for the kind of shareholder oversight that many observers thought necessary to restrain managerial misbehaviour and ensure attention to shareholder value.25 While institutions filed shareholder proposals under rule 14a-8 and even engaged in negotiations with management, their actual effects on corporate governance are indeterminate.26 One of the most interesting developments with respect to shareholder activism in recent years has been the rise of the activist hedge fund, a phenomenon explored by Marcel Kahan and Ed Rock in their 2007 essay, ‘Hedge Funds in Corporate Governance and Corporate Control’ (Chapter 9). While hedge funds have been operating since the 1950s, by 2006 there 25 For examples o f the literature see Black (1992); Gilson and Kraakman (1991); Rock (1991). For an argument that increased institutional investor activism had the potential to increase pressure for deleterious short-term corporate management, see M itchell (1992). 26 In Chapter 9 Kahan and Rock observe that the principal tool o f institutional investors since the mid-1990s has been negotiation, with shareholder proposals as a last resort (p. 410). A t the same time, institutional activists have won some significant political victories, including the House o f Representatives’ passage in 2007 o f a law authorizing ‘say on pay ’ proposals, giving shareholders at least precatory input into issues o f management compensation (HR 1257, Shareholder Vote on Executive Compensation Act, 20 April 20 200) and an increasing number o f corporations adopting majority voting provisions for directors as a result o f institutional pressure (Amendment to Section 141(b) and 216 o f the Delaware General Corporate Law). (The default rule for electing directors in the United States is typically a plurality o f the votes cast.) One last phenomenon evidencing increased institutional activism, or at least coordination among their votes, is the rise o f proxy advisory services, such as Institutional Shareholder Services, among others. These services help mutual funds fulfil their statutory voting obligations by advising them on voting with respect to directors and shareholder proposals. As Anabtawi and Stout (2008) have pointed out, the result is significant coordination o f institutional voting, since proxy advisors presumably give the same voting advice to all o f their clients.

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were estimated to be in the region of 8000 hedge funds managing more than $1 trillion in assets. Although only approximately 5 per cent of these assets are devoted to activist investing (pp. 414,430), Kahan and Rock observe that the very substantial potential for greater activism that exists simply by virtue of the magnitude of hedge fund assets makes the phenomenon deserving of very careful attention. Their approach to studying the phenomenon is particularly interesting. Rather than attempt to study hedge fund activism in isolation, they compare it to the other notable arena of shareholder activism, institutional activism (by which they principally mean mutual fund and pension fund activism), for the purpose of determining whether hedge fund activism is really different in kind from that of other institutions. They conclude that it is different, in ways that suggest that hedge fund activism may hold out greater hope for meaningful shareholder monitoring, resulting in increased shareholder value. It is not the case, as they are careful to note, that hedge funds typically are activist. Rather, it is the case that ‘hedge funds - to the virtual exclusion of traditional institutional investors - dominate certain modes of shareholder activism’ (p. 414). Among these are the very aggressive manner (backed by significant stock positions) in which hedge funds engage in corporate governance debates, their efforts to block or encourage (or, indeed, force) corporate acquisitions and their own acquisition activities. These types of behaviours stand in significant contrast to the traditional institutional activism of introducing shareholder proposals and negotiating with management. There are a number of possible explanations for these differences in behaviour, including disparate regulatory regimes, the different structures of the investment vehicles, political restrictions (particularly in the case of public pension funds which are among the most active of the institutions), the financial incentives of fund managers and the kinds of conflicts of interest faced especially by bank-sponsored funds which make aggressive activism rather a poor sales strategy for the sponsor’s underwriting, investment banking and other advisory services. They also observe that the diversification strategies of traditional institutions (in contrast with the more concentrated holdings of activist hedge funds) may well explain a rational relative passivity among the former. While Kahan and Rock are cautiously optimistic about activist hedge funds’ potential for diminishing agency costs and enhancing shareholder value, they do note aspects of what they refer to as the ‘dark side’ of hedge fund activism. In particular, their investment interests sometimes conflict with those of other shareholders - conflicts which become especially obvious when funds invest for the sake of influencing a transaction in which they hold positions in both corporations, hedging away their economic interest in one for the sake of achieving substantial gains through the other. Kahan and Rock conclude that the various disadvantages of hedge fund activism appear at this point to be sufficiently outweighed by their potential benefits as to discourage regulatory intervention. The one serious risk of hedge fund activism that Kahan and Rock identify is one that I have been at pains to emphasize both in this Introduction and in my own scholarship, namely the risk that they might exacerbate managerial short-termism in a manner damaging to the long­ term health of their portfolio companies. This takes them through a discussion of whether short-termism is in fact a problem and the extent to which activist hedge funds are responsible for causing or exacerbating it. But here, again, they argue that regulation would be premature; the evidence of a problem is not sufficient, and they articulate a faith in market self-correction over regulation, even if the problem is a real one.

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While still a relatively small influence on corporate governance, activist hedge funds have risen to some public prominence. But there remains yet another potentially more powerful, and possible highly disruptive, shareholding force that has recently attracted public interest. These are the sovereign wealth funds. Sovereign wealth funds are government-owned or directed investment funds that acquire a variety of financial assets. While they have been in existence for decades they have, as Ron Gilson and Curtis Milhaupt point out in ‘Sovereign Wealth Funds and Corporate Governance: A Minimalist Response to the New Mercantilism’ (Chapter 10), begun to attract a great deal of attention for two reasons: the dramatic growth in their size and their increasing shift to corporate equities as their primary investment vehicle.27 Although the acquisition of controlling interests by sovereign wealth funds is regulated by some nations, including the United States, acquisition of large, potentially influential, but non-controlling interests is not. Gilson and Milhaupt describe the particular tensions that have grown because sovereign wealth funds are frequently at the intersection of conflict between what they describe as ‘two very different conceptions of the role of government in a capitalist economy - “state capitalism as opposed to market capitalism’” (p. 464), the former most prominently represented by the People’s Republic of China and the latter by the United States. One of the principal tensions that arises, in their view, is over what they call the ‘new mercantilism’ where ‘the country is the unit whose value is to be maximized’ (p. 464), leaving a far greater role for government coordination of investment (with a consequent risk to the economic sovereignty, or at least the well-being, of the nation whose assets comprise the sovereign wealth fund portfolio), in contrast to the market-driven ideology that delegitimizes significant government involvement in market capitalist economies.28 Gilson and Milhaupt recognize the legitimate concerns of nations whose corporate assets find their ways into the portfolios of sovereign wealth funds, especially when those assets are significant, but non-controlling, blocks of corporate stock. They acknowledge legitimate national security concerns, while fearing, at the same time, that regulatory calls by Western nations could inhibit the manner in which sovereign wealth funds recycle ‘trade surpluses through the capital market’ (p. 469). The economic benefits are clear, and indeed they point out that the long-term nature of equity investments and the need for healthy national economies to preserve value significantly limit any incentive a sovereign wealth fund might have to cause mischief. The public perception of the problem arises, they suggest, from the opacity of some of the largest sovereign wealth funds, leaving the potential for sovereign wealth funds to engage in ‘market abuses’ (p. 478). But this cannot be the real problem, they write, because ‘all shareholdings are nontransparent’in the absence of specific disclosure laws (p. 479). The real problem is that sovereign wealth funds might have ‘strategic motives’ different from the pure investment motives of shareholders that renders opacity non-problematic (p. 480), and they offer technology transfer as an example.

27 Importantly, the growth in size is due to imbalances o f trade surplus caused by currency disparities. In particular, the dollar has been suffering in recent years, leading to a dramatic increase in C hina’s dollar reserves because o f the direction o f American trading. 28 Interestingly, what the new mercantilists appear to be doing is no different than what an institutional portfolio manager does, with the nation taking the place o f the portfolio. Incentives, then, might look somewhat like activist hedge fund incentives where interests conflict with other groups o f investors.

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Their solution is simple. If strategic investments are the problem, strategic investments should be controlled. The problem is that, even with disclosure, a complete explanation by a sovereign wealth fund of its motives is unlikely to occur or, if it does, be credible. The appropriate response must therefore come from within the corporate governance machinery of portfolio companies rather than from the investors. So the answer is to deprive sovereign wealth funds of voting rights in shares of the companies in which they invest. Gilson and Milhaupt recognize that this solution might diminish the value of the shares and thus discourage beneficial sovereign wealth fund investment, so they substitute the idea of suspending voting rights for complete elimination, with the rights to be restored when the fund sells its shares ‘to a non-govemmentally affiliated third party’ (p. 482). This solution is not, they admit, perfect. For one thing, it is underinclusive. Sovereign wealth funds can influence portfolio corporations in ways other than voting, and a sovereign wealth fund is not the only means by which a government can influence the behaviour of a foreign corporation. After describing these other methods, Gilson and Milhaupt explain both the formal and informal mechanisms that should restrain strategic corporate behaviour in favour of a sovereign wealth fund or nation, and where the limitations of their proposal are unavoidable. Finally, they address its overinclusiveness, in that vote suspension would affect American state pension funds resulting from foreign reciprocation by imposing the same vote suspension requirements on them. For the same reasons as they argue in favour of vote suspension for sovereign wealth funds, Gilson and Milhaupt believe that reciprocation would not deter state pension fund investments. They do note, however, that it would prevent the kind of beneficial activism in which such funds are engaged, which benefits all shareholders and, consequently, would be a loss for all shareholders, although they optimistically suspect the cost would be small. A Look at the Future?

Perhaps the most obvious conclusion to draw from all this is to note that ideas, models and practices of corporate governance are constantly in flux, as they have been from the beginning of the twentieth century. But this should be no surprise, for during that same period the world has been in flux. So it seems fitting to conclude with a brief look at corporate governance in a nation that is poised to become one of the dominant - if not the dominant - economic powers in the world, the People’s Republic of China. Relentlessly communist from 1949, the capitalist-within-socialist reforms initiated by Deng Xiao Ping in the 1990s have resulted in a virtual Chinese economic explosion. True, most of China’s industrial output is still of a basic manufacturing kind, focused on industrial and commodity-type manufactures, but the rapid industrial and financial growth of the PRC, as well as its own ambitions, suggests that its industrial revolution will be rapid indeed. While Western venture capitalists scour the nation for investment opportunities, the highly active and surprisingly developed Chinese stock market is poised to become, if it hasn’t already, a major factor in global finance. All quite amazing for a country in which significant private ownership was all but prohibited just a few decades ago and in which corporate activity was essentially an organ of state policy. Much has been written on different forms of corporate governance, some of which is discussed in the essays in this volume. But the case of China presents a corporate version of the Galapagos Islands, illustrating, as it does, the evolution from a very basic and somewhat

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dysfunctional system of corporate governance in which corporate governance was virtually inseparable from the government itself to something that might be described as a modem third way between the aggressive market capitalism of most Anglophonic countries29 and the more concentrated and statist Rhenish-Japanese model that characterizes social democracies.30 Thus the final essay in this volume is Cindy A. Schipani’s and Junhai Liu’s comprehensive study, ‘Corporate Governance in China: Then and Now’ (Chapter 11). The essay is detailed and complex, as befits the subject, and space limitations prevent me from describing it expansively, but a few brief points are worth making. Schipani and Liu trace the parallel developments of Chinese economic liberalization and Chinese enterprise law, showing the move from entirely state-owned enterprises that effectively served as organs of government to different types of Chinese-foreign joint ventures to entirely foreign-owned Chinese enterprises, and the distinct and blended laws that govern each. Perhaps most interesting is to see the way in which aspects of older forms of corporate governance tenaciously cling to enterprise management even as new laws are introduced and new forms covered. China’s disparate treatment of closely held and public corporations is sophisticated and modem, eliminating the requirement of a board of directors in the former and permitting voting in terms of proportional financial contribution in contrast to the American system (even in close corporations) of number of shares owned. The close corporation law even has a built-in partnership type of protection by requiring majority (in number of shares) approval for share transfers. While the purpose of the Chinese corporation has rapidly become profit, Chinese corporate law governing state-owned enterprises recognizes eight specific corporate relationships, including those between the corporation and its employees, its creditors, its competitors and its consumers, among others. This is in the service of providing ‘well-defined rights and responsibilities’ (p. 513), part of the goal of which is to separate the conduct of business from the state. Schipani and Liu note difficulties in this process and suggest avenues for reform, but the interesting point to note is the way in which China has used corporate governance law to attempt to effect this separation - this transition from corporation-as-govemment bureaucracy to corporation-as-market-driven private business. Most distinct, perhaps, is the dual board system in Chinese corporations. Although it superficially resembles the German dual board system, it operates rather differently. Unlike the German supervisory board, which oversees the conduct of the board of directors, the Chinese supervisory board and board of directors serve as coordinate branches of corporate governance without hierarchical distinction. Both boards are appointed by the general meeting of shareholders which serves as the original power-conferring body from which corporate power flows (in contrast, for example, to the American system in which the board of directors receives its original authority from the state and the shareholder vote serves only to determine the identities of those who are to serve on the board). 29 But see Dignam and Galanis (2004), who argue that A ustralia’s corporate governance system may have more similarities to the concentrated-ownership systems o f the social democracies than it does to other Anglophonic nations. Canada is also often recognized as having a distinct variation on the Anglophonic system in light o f its historical industrial development characterized by fam ily-owned companies, 30 ‘R henish’ is the term used by M ichel A lbert to characterize the social democratic and Japanese systems o f corporate governance. See Albert (1993).

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One ought not to be surprised that, as Schipani and Liu describe it, the Chinese transition from pure socialism to a more capitalist system, through a maze of new and old laws and an extensive variety of business forms, has not yet resulted in a well-established and smoothly functioning system of corporate governance. At the same time, substantial progress has been made. Even as China has learned from the West as it works its way through monumental transformations, so we, who have well-established corporate governance systems, may learn much as we continue to watch the Chinese experience. References Albert, Michel (1993), Capitalism vs. Capitalism: How America s Obsession with Individual Achievem ent and Short-Term Profit has L ed it to the Brink o f Collapse, New York: Four Walls Eight Windows. Anabtawi, Iman and Stout, Lynn (2008), ‘Fiduciary Duties for Activist Shareholders’, Stanford Law Review , 60, pp. 1255-308. Bebchuk, Lucian Arye (2005), ‘The Case for Increasing Shareholder P ow er’, H arvard Law Review , 118, pp. 833-914. Berle, A dolf A. and Means, Gardiner (1932), The Modern Corporation and Private Property, N ew York: Macmillan. Black, Bernard S. (1992), ‘Agents Watching Agents: The Promise o f Institutional Investor Voice’, UCLA Law Review, 39, pp. 811-93. Bratton, William (2006), ‘Hedge Funds and Governance Targets’, Georgetown Law Journal, 95, pp. 1375-433. Cheffins Brian R. (2003), ‘Law as Bedrock: The Foundations o f an Economy Dominated by Widely Held Public C om panies’, Oxford Journal o f Legal Studies, 23, pp. 1-23. Cheffins Brian R. and Armour, John (2007), ‘The Eclipse o f Private Equity’, ECGI - Law Working Paper No. 082/2007, April. Coffee, Jr, John C. (2002), ‘Understanding Enron: “It’s about the Gatekeepers, Stupid’” , Business Lawyer, 57, pp. 1403-20. Cole, Marcus (2002), “ ‘Delaware is not a State” : Are We Witnessing Jurisdictional Competition in B ankruptcy?’, Vanderbilt Law Review , 55, pp. 1845-1916. Dallas, Lynne L. (1996), ‘The Relational Board: Three Theories o f Corporate Boards o f D irectors’, Journal o f Corporation Law , 22, pp. 1-25. Dallas, Lynne L. (2003), ‘The M ultiple Roles o f Boards o f D irectors’, San Diego Law Review, 40, pp. 781-820. Davis, Jr, Kenneth B. (2008), ‘The Forgotten Derivative Suit’, Vanderbilt Law Review, 61, pp. 3 8 7 452. Dignam, Alan and Galanis, M ichael (2004), ‘Australia Inside-Out: The Corporate Governance System o f the Australian Listed M arket’, Melbourne University Law Review , 28, pp. 623-53. Easterbrook, Frank H. and Fischel, Daniel R. (1989), ‘The Corporate C ontract’, Columbia Law Review, 89, pp. 1416-48. Easterbrook, Frank H. and Fischel, Daniel R. (1991), The Economic Structure o f Corporate Law , Cambridge, MA: Harvard University Press. Eisenberg, M elvin A. (1976), The Structure o f the Corporation: A Legal Analysis, Boston, MA: Little Brown & Co. Eisenberg, M elvin A. (forthcoming), ‘The Trouble with B oards’, in Troy A. Paredes (ed.), The New Corporate Governance , Cambridge; Cambridge University Press. Fama, Eugene F. and Jensen, M ichael C. (1983), ‘Separation o f Ownership and Control’, Journal o f Law and Economics, 26, pp. 301-50.

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Gilson, Ronald J. and Kraakman, Reinier (1991), ‘Reinventing the Outside Director: An Agenda for Institutional Investors’, Stanford Law Review, 43, pp. 863-906. Gordon, Jeffrey N. (2007), ‘The Rise o f Independent Directors in the United States, 1950-2005: O f Shareholder Value and Stock M arket Prices’, Stanford Law Review , 59, pp. 1465-568. Harris, Ron (2006), ‘The Transplantation o f a Legal Discourse: Corporate Personality Theories from German Codification to British Political Pluralism and American Big B usiness’, Washington and Lee Law Review , 63, pp. 1421-78. Holderness, Clifford, Kroszner, Randall and Sheehan, Dennis (1999), ‘Were the Good Old Days That Good? Changes in M anagerial Stock Ownership since the Great D epression’, Journal o f Finance, 54, pp. 435-69. Horwitz, M orton J. (1992), The Transformation o f American Law, 1870-1960: The Crisis o f Legal Orthodoxy, N ew York; Oxford University Press. Jacoby, Sanford M. (2000), ‘Corporate Governance in Comparative Perspective: Prospects for Convergence’, Comparative Labour Law and Policy Journal, 22, pp. 5-32. Klausner, M ichael (1995), ‘Corporations, Corporate Law, and Networks o f Contracts’, Virginia Law Review, 81, pp. 757-852. Millon, David (2002), ‘New Game Plan or Business as Usual? A Critique o f the Team Production Model of Corporate L aw ’, Virginia Law Review, 86, pp. 1001-44. Mitchell, Lawrence E. (1992), ‘A Critical Look at Corporate Governance’, Vanderbilt Law Review , 45, pp. 1263-1301. Mitchell, Lawrence E. (2001), Corporate Irresponsibility: A m erica s N ewest Export, N ew Haven, CT: Yale University Press. Mitchell, Lawrence A. (2007a), The Speculation Economy: How Finance Triumphed over Industry, San Francisco: Berrett-Koehler Publishers. Mitchell, Lawrence E. (2007b), ‘The Board as a Path to Social R esponsibility’, in Doreen McBarnet, Aurora Voiculescu and Tom Campbell (eds), The New Corporate Accountability: Corporate Social Responsibility and the Law, Cambridge: Cambridge University Press. Mitchell, Lawrence E. (forthcoming), ‘The Trouble with B oards’, in Troy Paredes (ed.), The New Corporate Governance, Cambridge: Cambridge University Press. Pear, Robert (2008), ‘S.E.C. Backs Health Care B alloting’, New York Times, 27 May, Section C, p .l. Rock, Edward B. (1991), ‘The Logic and (Uncertain) Significance o f Institutional Investor A ctivism ’, Georgetown Law Journal, 79, pp. 445-506. Roe, Mark J. (1993), ‘Some Differences in Company Structure in Germany, Japan, and the United States’, Yale Law Journal, 102, pp. 1927-48. Skeel, Jr, David A. (2004), ‘Corporate Anatomy Lessons [reviewing The Anatom y o f Corporate L a w ]\ Yale Law Journal, 113, pp. 1519-77. Strine, Jr, Leo E. (2002), ‘The Professorial Bear Hug: The ESB Proposal as a Conscious Effort to M ake the D elaw are Courts C onfront the Basic “Just Say N o” Q uestion’, Stanford Law Review, 55, pp. 863-82. Tsuk Mitchell, Dalia (2003), ‘Corporations w ithout Labor: The Politics o f Progressive Corporate L aw ’, University o f Pennsylvania. Law Review, 151, pp. 1861-912. Tsuk Mitchell, Dalia (2005), ‘From Pluralism to Individualism: Berle and Means and 20th-Century American Legal Thought’, Law and Social Inquiry, 30(1), pp. 179-225. Veblen, Thorstein (1904), The Theory o f Business Enterprise, N ew York: Charles Scribner’s Sons.

Part I The Purpose of the Corporation

[1] C O R P O R A T E PO W E R S AS P O W E R S IN T R U S T * A .A . Berle, Jr.

TT is the thesis of this essay that all powers granted to a corporation or to the management of a corporation, or to any group within the corporation, whether derived from statute or charter or both, are necessarily and at all times exercisable only for the ratable benefit of all the shareholders as their interest appears. That, in consequence, the use of the power is subject to equitable limitation when the power has been exercised to the detriment of such interest, however absolute the grant of power may be in terms, and however correct the technical exercise of it may have been. T hat many of the rules nominally regulating certain specific uses of corporate powers are only outgrowths of this fundamental equitable limitation, and are consequently subject to be modified, discarded, or strengthened, when necessary in order to achieve such benefit and protect such interest; and that entirely new reme­ dies may be worked out in substitution for or supplemental to existing remedies. And that, in every case, corporate action must be twice tested: first, b y the technical rules having to do with the existence and proper exercise of the pow er; second, b y equitable rules somewhat analogous to those which apply in favor of a cestui que trust to the trustee’s exercise of wide powers granted to him in the instrument making him a fiduciary. The question is not academic. Its solution in the sense sug­ gested would give greater flexibility to corporate managements in certain respects. It would permit them, when the action is actually necessary or beneficial, to do things in the doing of which * In preparing this article, the author is indebted for assistance and suggestions to Messrs. Irving H. Dale, David H. Holzman, Wilbur Stammler, William J. Hoff, Hugh R. Dowling, Abraham Marcus, Felix S. Cohen and David Orlikoff, all stu­ dents in the Columbia Law School. The theory herein expressed was suggested by the writer in C a s e s a n d M a t e ­ r i a l s i n t h e L a w o f C o r p o r a t i o n F i n a n c e (19 3 0 ) 62. The need of some syn­ thesis to harmonize the many apparently individual rules in the law of corporations was likewise suggested by the writer in a paper, Organization of the L aw of C orpo­ ration Finance, read before the National Association of American Law Schools in December, 193 0 , and in course of publication in the University of Tennessee Law Review for M ay, 1931.

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they are now unduly hampered by technical rules. But where no showing of benefit can be made, and where one group within the corporation is to be sacrificed for the benefit of another, it would, equally, circumscribe the use of certain apparently absolute powers. In this latter aspect it is noteworthy that for years cor­ porate papers and general corporation laws have multiplied powers and made them increasingly absolute; that charters have to an increasing extent included immunity clauses and waivers of “ rights.” It seems not to have occurred to draftsmen that, through the very nature of the corporate entity, responsibility goes with power. Stated thus broadly, the thesis can be supported only by an examination of the law governing every corporate power. As space does not permit this, five of the principal apparently “ abso­ lute ” corporate powers are here examined. Examination of all other powers would, as far as the writer’s studies have gone, lead to the same result; the five chosen cover a fair cross-section of the field. A . The power to issue stock is at all times subject to the equitable

limitation that such issue must be so accomplished as to pro­ tect the ratable interest of existing and prospective share­ holders. Among the rules developed are: (1) The rule that the incoming shareholder must make a contribution which in good conscience entitles him to participate to the extent al­ lowed by his shares.

The requirement that stock be paid for has two distinct bases in American law. One line of thought required that stock be paid for in order to supply a fund available for the protection of creditors. With this ideology we are not at present concerned. The second line was definitely based on the theory that every shareholder had an interest in the payment made b y every other shareholder upon the issuance of his stock.1 Mathematically 1 The cleanest statement of this rule is found in Luther v. Luther Co., ii2 , 123, 94 N. W. 69, 72 (1903), the court saying: “ For the purposes of the ent case, it is not necessary to consider the unissued stock otherwise than as property, over which the powers of the directors are the same as over any

118 Wis. pres­ mere other

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this is obvious; but it would by no means necessarily follow that the law wpuld adopt the mathematical rule. Statutory provisions requiring payment for stock in cash or property afford no ground for an assumption as to which of the two lines of thought in­ fluenced the legislature. It was left to the courts first to interpret the statutes in this sense, and later to evolve the same result in the absence of statute and even in the face of provisions apparently granting to corporate managements wide latitude as to what and how much consideration should be required to justify the issuing of stock. As long ago as 18 7 6 2 a requirement by statute that all stocks should be subscribed for “ in good faith ” caused an Illinois court to hold that stock issued for a nominal consideration was void; and in this case the thrust of the decision was primarily the protection of other shareholders. Almost at once, however, the question arose in a new form. Statutory provisions generally provided for the issue of stock for “ property received.” “ Property ” is a word so broad as to in­ clude almost every definable fragment of value capable of being transferred. In its wide sense under these provisions stock could be issued for a note of the subscriber (negotiable instruments being certainly personal property), goodwill, contracts for services to be rendered, and a whole range of intangible elements of a similar sort. Commonly these provisions were accompanied by the requirement assets of the corporation, namely, to sell to whom and at such prices as to them shall seem best for the corporation and all its stockholders, in the honest exercise of the discretion and trust vested in them. Even then, however, their duties with reference thereto are fiduciary; they are bound to act uberrim a fides for all stock­ holders. To dispose of or manage property of the corporation to the end and for the purpose of giving to one part of their cestuis que trustent a benefit and ad­ vantage over, or at the expense of, another part, is breach of such duty, especially when the directors themselves belong to the specially benefited class.” This case merely carried forward the line of thought marked out by the Massachusetts court in Hayward v. Leeson, 176 Mass. 310, 57 N. E. 656 (1900), that the fiduciary duty extends to present and prospective shareholders, a doctrine which in turn neces­ sarily follows from the reasoning of the court in Gray v. Portland Bank, 3 Mass. 363 (1807). 2 People v. Sterling Mfg. Co., 82 111. 457 (1876), where the court’s difficulty arose from the fact that the voting rights granted to the common stock were equal to those granted to the preferred, though the former invested only $50,000 and the latter $950,000. Of course, whenever the words “ good faith ” appear, the language in and of itself imports a certain fiduciary quality. In normal business trans­ actions, the state of mind of the opposite party is not a factor; it is enough if there is actual consent without deceit.

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that the par value of stock (prior to 1912 non-par stock was unknown), if not paid in cash, must be paid in by a transfer of “ property.” The courts were at once faced with the problem of determining whether all property could be so received; and if not, of distinguishing between types of property to be accepted and types to be rejected, and giving a reason for the distinction. Greater latitude was introduced at once because, while the meas­ ure of cash is always cash, property must be appraised, and there is great leeway for difference in valuation. The judicial reasoning on both questions is by no means clear in its groundwork; but on both issues the results, particularly in retrospect, are astonishingly plain. Thus, courts declared a note of the subscriber insufficient consideration,3 except when it was adequately secured,4 in which case the security element made the note “ property ” within the terms of the now judicially amended statutes. This was further defined in one case where the security was worthless stock, by throwing out even a secured note of the subscriber. What hap­ pened here was that the courts permitted the corporation to issue stock against one type of risk and declined to permit its issue against other types of risk. The obvious rationale of the decisions is that the former reasonably protected both creditors and stock­ holders; the latter did neither. The question subsequently came up as to patents, obviously property, as remarked by one court, but “ There is no species of property the value of which is more uncertain than letters patent which secure to the patentee the exclusive right to manufacture the patented article. From the nature of the property, 3 Alabama Nat. Bank v. Halsey, 109 Ala. 196, 19 So. 522 (1895); Jones Drug Co. v. Williams, 139 Miss. 170, 103 So. 810 (1925); Southwestern Tank Co. v. Morrow, 115 Okla. 97, 241 Pac. 1097 (1925); Kanaman v. Gahagan, 111 Tex. 170, 230 S. W. 141 (1921); see (1926) 10 M i n n . L. R e v . 536; (1930). 39 Y a l e L. J. 706, 712. But it does not follow that a note so taken is necessarily unenforceable as against the maker, which has given rise to confusion in the result of these cases. See Pacific Trust Co. v. Dorsey, 72 Cal. 55, 12 Pac. 49 (1887); Goodrich v. Reynolds, Wilder & Co., 31 111. 490 (1863); German Mercantile Co. v. Wanner, 25 N. D. 479, 142 N. W . 463 (1913); Schiller Piano Co. v. Hyde, 39 S. D. 74, 162 N. W. 937 (1917). 4 See the discussion in Sohland v. Baker, 15 Del. Ch. 431, 141 Atl. 277 (1927). For a case in which the facts and the statute forced a decision that even a secured note was not property, see Walz v. Oser, 93 N. J. Eq. 280, 116 Atl. 16 (1922).

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the real value of patents can only be determined after the invention is introduced and in use.” 5

Accordingly the quality of the property was referred back to the question of valuation; and in respect to patents this is generally the rule. It will be noticed that this is a less rigid rule, permitting more latitude, and permitting protection of the interests actually involved. A contract for the services of an outsider to help pub­ lish a history has been held not “ property ” within the meaning of these statutes.6 Goodwill — well understood as property in other fields of law, and differing from tangible property only in that it is more difficult to reduce to definite appraisal — has been treated both ways; one case disallowed it com p letely;7 others left the question open for the determination of the possibility of a demonstrable valuation.8 Once in the valuation field, judicial modification of liberty of action becomes even more striking. Both of the principal rules on the subject — the rule that stock may be issued for property at its “ absolute value,” as over and against the rule that stock may be issued for property upon such valuation as reasonable business men would approve under the circum stances9— merely 5 Insurance Press Co. v. Montauk Co., 103 App. Div. 472, 475, 93 N. Y . Supp. 134, 136-37 (i9 °5 )6 Stevens v. Episcopal Church History Co., 140 App. Div. 570, 125 N. Y . Supp. 573 (1910). But see Van Cott v. Van Brunt, 82 N. Y . 535 (1880), where the work done had to be paid for in stock and such stock was issued in good faith. The issue was upheld even though the labor might not be worth the par value of the stock issued. 7 Coleman v. Booth, 268 Mo. 64, 186 S. W . 1021 (1916), a case weakened by the fact that the circumstances raised the issue of probable fraud. 8 This would seem to be the rule in New York. The case of Gamble v. Queens County Water Co., 123 N. Y . 91, 25 N. E. 201 (1890), raised the problem of validity of issue of stock for water mains and connections in adjacent territory. Concededly, the cost of the property was less than the amount of stock issued. Yet its strategic location might very well give it a value to the issuing corporation in excess of cost. The New Y ork Court of Appeals directed a new trial, instructing that this ele­ ment be taken into consideration. The prospective earning power of the develop­ ment — substantially goodwill in the modern understanding of that term — would appear thus to be recognized at least in connection with tangible property. 9 See D o d d , S t o c k W a t e r i n g (1 9 3 0 ) 57 et seq., 7 7 . Dr. Dodd comes to the conclusion that there is no sharp distinction between the rules such as is com­ monly assumed by the bar, the fact being that courts starting from apparently op­ posite premises reach pretty much similar results.

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give the courts the power to correct unconscionable issues of stock, whether they use the value of the consideration or the directors’ morals as the primary test. T he attempt to create a rule that the judgment “ in good faith ” of the board of directors shall be con­ clusive has received only minor support in the ca se s;10 but these holdings necessarily force back even further upon the board of directors the decision as to what constitutes a fair and conscionable consideration for the issue. In determining both the nature of the property for which stock may be issued, and the valuation at which property may be taken to justify the issue of stock, courts have consistently rejected apparently absolute tests set out by statute and carried forward by corporate charters, and have substituted (as they needs must) a test for the conduct of the corporate management. In practi­ cally every case this conduct is couched in terms of “ good faith,” except where the situation has been carried to the point in which apparently the courts thought that no group in “ good faith ” could justify its action. The moment, however, that “ good faith ” is introduced in the picture the fiduciary principle is raised. The phrase implies good faith towards someone, arising out of some previous relation. The argument has never been made that directors “ in good faith ” would believe it desirable for one group of men (not otherwise contributing) to pay one-third the contribution to the corporate capital required from everyone else.11 Nor would such an argu10 Among the cases in this sense are Troup v. Horbach, 53 Neb. 795, 74 N. W. 326 (1898); Holcombe v. Trenton White City Co., 80 N. J. Eq. 122, 82 Atl. 618 (1912); Van Cott v. Van Brunt, 82 N. Y . 535 (1880); American Tube & Iron Co. v. Hays, 165 Pa. 489, 30 Atl. 936 (1895) ; Kelley Bros. v. Fletcher, 94 Tenn. 1, 28 S. W. 1099 (1894). The majority rule requires that a value must be set on the property taken for stock such as would be approved by prudent and sensible business men under the circumstances, exclusive of visionary or speculative hopes. See Detroit-Kentucky Coal Co. v. Bickett Coal & Coke Co., 251 Fed. 542 (C. C. A. 6th, 1910); State Trust Co. v. Turner, 111 Iowa 664, 82 N. W. 1029 (1900) (no statute involved); Ryerson & Son v. Peden, 303 111. 171, 135 N. E. 423 (1922); Jones v. Bowman, 181 K y. 722, 205 S. W. 923 (1918); Van Cleve v. Berkey, 143 Mo. 109, 44 S. W. 743 (1897) (result reached without benefit of statute); Gates, Adm’r v. Tippecanoe Stone Co., 57 Ohio St. 60, 48 N. E. 285 (1897) (without statutory te s t); Cole v. Adams, 92 Tex. 171, 46 S. W. 790 (1898). 11 Conceivably, all of the parties might agree that one set of stockholders should pay less than another, See the discussion in Welton v, Saffery, [1897] A. C.

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ment find much favor in any court. The “ good faith ” phrase is merely a shorthand w ay of saying that the directors must use their power to test the quality and appraise the value of the consideration offered for stock in such a manner that creditors and shareholders will not be hurt. T his is, in rough outline, the result of the cases down to the advent of non-par stock. W ith the appearance of this device legal concern for the protection of the creditors largely passed aw ay.12 There remained the proper protection of the interests of the other shareholders; and this consideration at once became paramount. Commencing with the decision that non-par stock could not be issued for nothing, as a bonus,13 there ensued a de­ cision holding that such stock must be issued at approximately equal prices at the same time to all concerned.14 This decision was subsequently modified by the Circuit Court of Appeals into a rule that where there is an inequality of consideration exacted, reasons must appear justifying the board of directors in making the distinction.15 And the test of justification was whether the amount of consideration required was or was not sufficient to operate as a protection to the remaining shareholders. (2) The rule that after stock has been issued additional stock may be issued only (a) at a price or under circumstances which protect the equities of the existing shareholders or (b) in accordance with a scheme which permits the existing shareholders to protect their equities by subscribing for a ratable amount of the additional stock.

When the stock is without nominal or par value, there is usually direct authority, as clear as can be derived from words, permitting 299 (H. L .), in which both the majority and the dissenters agreed that there was nothing essentially impossible in such an agreement, but differed as to whether the text of the statute involved permitted it. 12 Johnson v. Louisville Trust Co., 293 Fed. 857, 862 (C. C. A. 6th, 1923), the court saying: “ The generally, if not universally, accepted theory of the purpose of such statutes is that they are intended to do away with both the ‘ trust fund ’ and ‘ holding out ’ doctrines.” The court approved Mr. Cook’s remark that the whole theory of stock without par value is to let the buyer beware and let the creditor beware. 13 Stone v. Young, 210 App. Div. 303, 206 N. Y . Supp. 95 (1924), the court saying that the no par stock statute is “ no warrant for the gratuitous distribution.” 14 Hodgman v. Atlantic Refining Co., 300 Fed. 590 (D. Del. 1924). 15 Atlantic Refining Co. v. Hodgman, 13 F.(2d) 781 (C. C. A. 3d, 1926).

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the directors of a corporation to issue stock as they see fit, when they see fit, and for any price they see fit. Prima facie this would appear to be an absolute power. Actually, however, courts have controlled this power almost from the time its implications be­ came apparent. And there is manifestly no difference between the issue of non-par stock and the issue of stock having par value, except that in the latter case statutes and charters prescribe a minimum issue price (the par value) payable in a more or less re­ stricted form (cash, property of approved quality, services actu­ ally rendered). T he situation is approximately the same in both cases, however, barring only this statutory restriction. Even statutory restrictions involving a minimum price upon the issue of par value stock have been swept away by the courts under circumstances in which it appeared that the position of the corporation did not permit the issue of par value stock for its par value,16 but in these cases the courts required that it should be made to appear both that the stockholders had assented or were protected under all the circumstances, and that creditors would not be prejudiced. Faced even with an apparent restriction, the courts evolved an equitable principle to the effect that under the circumstances indicated the restriction could be ignored. E arly in the history of corporation law the equitable principle was developed that prima facie the directors, despite their power to issue stock, must so issue it that the stockholders would be given an opportunity to protect their equities by subscribing to ratable shares of new stock. This rule, evolved in 1807 in Gray v. Port­ land B ank ,17 probably was misunderstood by the bar and by courts generally. An examination of the facts in that case makes it plain that the court did not undertake to lay down a piece of judi­ cial legislation requiring the management to offer stock promiscu­ ously to all shareholders. The court did hold that in that par­ ticular situation the issue of additional shares without permitting a shareholder to subscribe impaired his equity.18 Judge Sewall 16 Handley v. Stutz, 139 U. S. 417 (1891). 17 3 Mass. 363 (1807). 18 It is noticeable that the court was preoccupied with working out a remedy. The preemptive right was arrived at after the court had excluded the possibility of specific relief or of restoration of the stock, and had pointed out that the accu­ mulated dividends were in the hands of third persons, and that the plaintiff had not paid for the stock anyhow. Judge Sewall thereupon came to the conclusion:

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observed that an incorporation for a bank was “ a trust created with certain limitations and authorities, in which the corporation is the trustee for the management of the property, and each stock­ holder a cestui que trust according to his interest and shares,” 19 and he went on to say that the power to the corporation was “ not a power granted to the trustee to create another interest for the benefit of other persons than those concerned in the original trust, or for their benefit in any other proportions than those determined by their subsisting shares.” 20 It followed that the power to in­ crease the number of shares did not “ abolish the security of the members first engaging in it in the beneficial interest and property they might acquire in the institution.” The conclusion was that “ plaintiff’s loss in this case will be compensated by allowing him the market value of the shares he was entitled to at the time when he demanded his certificates, and they were refused to him.” The thrust of the case was that, relying on equitable principles to find the right, the court used equal latitude in evolving a remedy com­ pensating the particular plaintiff. This was the nascence of the so-called preemptive right. It would by no means follow that the preemptive right should attach in every case. But the spirit of the last century sought specific and rigid rules, and built up the doctrine here laid down into a rule that all additional shares, whenever issued and whatever the circumstances, were always subject to a preemptive right. Neces­ sarily the very rigidity of the rule led to equally arbitrary excep­ tions. Some courts declined to attach the preemptive right to previously authorized but unissued stock (obviously fearing that the first subscriber to the share of stock would promptly claim a preemptive right to the entire balance of the issu e ); 21 courts de“ Upon the whole, I am of the opinion that the plaintiff’s loss in this case will be compensated, by allowing him the market value of the shares he was entitled to at the time he demanded his certificates, and they were refused to him ” (3 Mass. at 381), the theory being that at that time the plaintiff could have bought an equiva­ lent number of shares in the open market. 19 3 Mass. at 379. 20 Ibid. 21 Such was the law in New York under the case of Archer v. Hesse, 164 App. Div. 493, 150 N. Y . Supp. 296 (1914), but the doctrine received a rude shock in Dunlay v. Avenue M. Garage Co., 253 N. Y . 274 (1930), holding that authorized but unissued shares could be issued without preemptive right only where it is “ reasonably necessary to raise money to be used in the business of the corporation

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dined to extend the right to treasury stock; 22 and the mistake of a New Jersey vice-chancellor who was pressed for a quick decision over a lunch hour led to the evolution of a third exception — the issue of stock for property.23 None of these exceptions, perhaps, need have been labored as the courts evolving them seemed to think necessary. It would have been simpler to observe that the circumstances in respect to these particular transactions required no preemptive right to protect adequately the interests of the existing shareholders. The case finally came up of an additional issue of preferred stock which could not by any possibility affect either the amount of the equity of existing shareholders or their proportionate voting control; the New Jersey court was forced to say that in such circumstances there was no reason for the rule and it thereupon disappeared.24 Commentators on this situa­ tion, with varying degrees of emphasis but with considerable unanimity, have been forced to two conclusions: first, that the preemptive right, while a rough and ready protection to common shareholders in a corporation having only a simple capital struc­ ture, did not fit many situations where there was a complex capital structure, and frequently was unnecessary even in the simpler cases; second, that the so-called preemptive right was not a right at all, but a remedy — a remedy evolved out of equitable principles — and that unless a situation appeared calling for a remedy and requiring this particular remedy the right should not necessarily be assumed to exist.25 The only conclusion that can be drawn from the tangled history rather than the expansion of such business beyond the original limits.” This is the kind of distinction which satisfies a meticulous jurist and drives a business man to distraction. Must I, says he, determine at my peril whether or not the money I expect to raise by selling stock is for “ the business ” of my corporation or “ the expansion of such business ” ? 22 Borg v. International Silver Co., n F.(2d) 147 (C. C. A. 2d, 1925). 23 Meredith v. New Jersey Zinc & Iron Co., 55 N. J. Eq. 211, 37 Atl. 539 (1897). See the comment in B e r l e , C a s e s a n d M a t e r i a l s i n t h e L a w o r C o r p o ­ r a t i o n F i n a n c e 344. See also Thom v. Baltimore Trust Co., 158 M d. 352, 148 Atl. 234 (1930). 24 General Investment Co. v. Bethlehem Steel Corp., 88 N. J. Eq. 237, 102 Atl. 252 ( 1917). 25 Drinker, P reem ptive Right of Shareholders (1930) 43 H a r v . L. R e v . 586; Dwight, The R ight of Stockholders to N ew Stock (1908) 18 Y a l e L. J. 101; Frey, S h a re h o ld e r P reem ptive R ights (1929) 38 Y a l e L. J. 563; Morawetz, Preem ptive R ights of Shareholders (1928) 42 H a r v . L. R e v . 186.

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of preemptive rights is that the doctrine arose from an attempt to impose an equitable limitation on an apparently absolute power of directors to issue stock; that it should never have hardened into a rigid rule of law, and that it should revert to its original status as a remedy, available in equity and possibly, by transpo­ sition, at law. But it should be considered merely as one of many possible remedies — certainly not an exclusive one and not neces­ sarily the best one. In cases where, b y reason of the exceptions to the preemptive right doctrine, no such right existed, courts have had no diffi­ culty in applying equitable remedies of other sorts and kinds. Thus a Wisconsin court enjoined the issue of shares where the sole motive was to permit the directors to augment a rapidly melt­ ing majority; 28 a federal court insisted that a sale of treasury shares must be made either at public auction or at a price which demonstrably would maintain the equities of the existing share­ holders.27 Non-par stock without a preemptive right was held to be of such nature that the price paid for it must adequately pro­ tect the existing equities.28 A t this point, however, courts ran into a familiar business situation. N ot infrequently it is worth­ while to have a substantial shareholder even though equities are sacrificed to bring him in. Such was the case in Atlantic Refining Co. v. Hodgman,29 and the situation being made plain, the court sanctioned a scheme b y which existing equities of approximately $16 were sacrificed to permit the entrance of the Atlantic R e­ fining Company on payment of $8 a share in view of the added strength which that company lent to the issuing corporation through its connections, its goodwill, and its business tactics. So, a Delaware court sanctioned the issue of non-par stock at $2 5 a share, though its market value was $40 a share, where it ap­ peared that the stock was being offered preemptively to existing shareholders and that the offer of such stock at a low price made 26 Luther v. Luther Co., 118 Wis. 112, 94 N. W. 69 (1903). 27 Borg v. International Silver Co., 2 F.(2d) 910 (S. D. N. Y . 1924). The his­ tory of the handling of the sale of this block of treasury stock is peculiarly inter­ esting as an exercise of the equitable power to protect shareholders in the case of stock freed from the so-called technical rule of preemptive right. 28 Atlantic Refining Co. v. Hodgman, 13 F.(2d) 781 (C. C. A. 3d, 1926); Bodell v. General Gas & Elec. Corp., 15 Del. Ch. 119, 132 Atl. 442 (1926). 29 Supra note 28.

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it possible for the corporation to obtain a higher price for shares issued to outsiders with full knowledge of the facts. The language of the Delaware court in connection with the issue of no par stock is interesting not merely as regards the issue of such stock, but for its bearing on the general thesis of this essay. After pointing out the absolute authority which directors had to issue such stock at any price they deemed fit, the Chancellor said: “ The statute does not impose any restraint upon the apparently un­ bridled power of the directors. Whether equity will, in accordance with the principles which prompt it to restrain an abuse of powers granted in absolute terms, lay its restraining hand upon the directors in case of an abuse of this absolute power, is another question which will be pres­ ently considered and answered in the affirmative. . . . Notwithstanding the absolute character of the language in which the power to the directors is expressed, it cannot be that a court of equity is powerless in proper cases to circumscribe it. The section requires the directors to fix the consideration. It certainly would be out of all reason to say that no court could review their action in fixing it.” 30

And the court went on to point out that directors stood in the situation of fiduciaries; and while not “ trustees in the strict sense of the term, yet for convenience they have been described as such.” The foregoing is by no means a complete resume of the limita­ tions which courts have thrown around the issue of shares de­ spite an apparently absolute power granted to the management. Enough has been said, however, to indicate the completeness with which the apparently absolute power has been circumscribed, and the principal lines of limitation which have been thrown around this power. B. The power to declare or withhold dividends must be so used

as to tend to the benefit not only of the corporation as a whole but also of all of its shareholders to the extent that this is possible. Among the rules worked out are: (1) The rule that dividends must be withheld only for a business reason: private or personal motives may not be indulged. 30 Bodell v. General Gas & Elec. Corp., supra note 28, at 128-29, 132 Atl. at 446.

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The statute and charter alike accord to the directors the power to declare dividends, and impose no limitation on them in so doing or declining so to do except (normally) that dividends may not be declared out of capital or (in most instances) where the capital is impaired. Beyond this their power is at least nominally abso­ lute. Despite this, where dividends were withheld in a family corporation because the father of the fam ily decided that the share­ holders who were other members of the fam ily needed discipline, a court directed the declaration of dividends.31 In another case, where the object of withholding dividends was to depress the price of stock in the market, presumably to enable the management or its friends to buy in such stock at a lower price (a process collo­ quially called “ freezing o u t” ), the court again intervened.32 Where, also, the primary object of the transaction was to accu­ mulate a large surplus ultimately available for objects which M r. Henry Ford believed to be to the general good of the community, an order was made requiring the declaration of dividends; 33 and generally, where dividends are “ unreasonably withheld ” courts have interfered to control the use of the power.34 (2) The rule that dividends may not be withheld so as to benefit one class of stock as against another class, save where there is a business situation requiring such action.

The rule stated in the caption has been the subject of contro­ versy in recent years. Wherever the corporate charter includes in its financial structure non-cumulative stock or its equivalent (participating preferred stocks form such equivalent in a great majority of instances) it is possible, by timing the dividend decla­ rations properly, to withhold earnings and to use these for the purpose of building up surplus which subsequently falls to junior stock. A New Jersey court and two federal courts came to the conclusion that where dividends were earned, they must be either declared or set aside as a dividend credit to the stock which would have been entitled to such dividends had they been declared an31 Channon v. Channon Co., 218 111. App. 397 (1920). 32 Anderson v. Dyer, 94 Minn. 30, 101 N. W . 1061 (1904). 33 Dodge v. Ford Motor Co., 204 Mich. 459, 170 N. W. 668 (1919). 34 See Wilson v. American Ice Co., 206 Fed. 736, 745 (D. N. J. 1913). cases are collected in (1919) 14 C. J. § 1235.

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nually or periodically.35 This doctrine must be regarded as shaken if not completely overset by the recent Supreme Court ruling in Barclay v. Wabash R . R .3e That decision does not go as far as is currently supposed, since the only ratio decidendi is that although non-cumulative divi­ dends, earned but unpaid, have not been paid out to the noncumulative preferred shareholders, dividends may, nevertheless, be paid to the common stock provided the non-cumulative divi­ dend for the year in question has been declared and paid. The facts are worth a glance. The Wabash Railroad had issued noncumulative preferred stock. Over a period of years the unpaid dividends on this stock amounted to some $16,000,000. Y ear by year the railroad had earned sufficient profits to pay these divi­ dends had the directors elected to declare them. The directors did not do so, but converted the earnings into surplus. Finally, having paid the dividends on the non-cumulative stock in one year, they then undertook to inaugurate dividends on the common. A bill for an injunction was brought b y a preferred shareholder; and the Supreme Court reversed a decision of the Circuit Court of Appeals granting the injunction. It is to be noticed, however, that the payment of dividends to the common stock in no way cut into the $16,000,000 accumulated by withholding dividends on the cumulative preferred; the question remains open, therefore, as to the ultimate disposition of the surplus so created. Even assuming that the Wabash case would permit the distribution of this surplus to the common shareholders, as b y a liquidation or in subsequent dividends, the Supreme Court above and the dis­ senting opinion b y Judge Learned Hand below both indicated that where withholding the non-cumulative dividend was unrea­ sonable, a preferred shareholder could bring his suit to compel the declaration of the dividends; and Judge Hand intimated that a design to withhold dividends on the one class of stock so as to benefit the junior stock would in and of itself (and nothing appear­ ing to the contrary) be evidence showing unreasonableness. 35 Basset v. United States Cast Iron Pipe Co., 75 N. J. Eq. 539, 73 Atl. 514 (1909); Collins v. Portland Elec. Power Co., 12 F.(2d) 671 (C. C. A. 9th, 1926); Barclay v. Wabash Ry., 30 F.(2d) 260 (C. C. A. 2d, 1929). 36 280 U. S. 197 (1930), rev’g Barclay v. Wabash Ry., 30 F.(2d) 260 (C. C. A. 2d, 1929).

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It would seem, therefore, that by w ay of dictum at least, even the jurisdictions following the Wabash case have indicated a cer­ tain measure of equitable protection where the declaration of dividends is manipulated primarily with a view toward benefiting one class of stock as against another class, leaving latitude only where a business situation exists in which it may reasonably be said that the withholding of the dividend will ultimately work for the benefit of the corporation as a whole, and that the benefit will be spread with substantial equity over the various classes. (3) The rule that there may be no discrimination between share­ holders of the same class, and no discrimination between any shareholders except as provided in the charter.

This rule, whether worked out in equity or from a “ presumed interpretation ” of simple contract, is fundamental.37 It requires no discussion here save to point out that it forms one of the standard safeguards in equity against the unreasonable manipula­ tion of dividend policy. C. The power to acquire stock in other corporations must be so

used as to tend to the benefit of the corporation as a whole and may not be used to forward the enterprises of the man­ agers as individuals or to subserve special interests within or without the corporation. The rule above stated is probably honored more in breach than in present practice, but there seems to be no reason to doubt its existence as a matter of law. The rule has a history which may be briefly sketched here. Leaving aside special restrictive statutes of which there are many, and assuming a full kit of statutory and charter powers to purchase stock, courts have, nevertheless, limited the use of this power almost from the beginning of cor­ porate history.38 Thus it has been insisted that where one cor37 Cases are collected in (1919) 14 C. J. § 1236. 38 The first line of limitation was that the mere existence of a corporation im­ plied that its powers should be exercised and its capital extended through its own officers and employees and not indirectly through another corporation operated under its control. Anglo-American Land Co. v. Lombard, 132 Fed. 721, 736 (C. C. A. 8th, 1904); see also People v. Chicago Gas Trust Co., 130 111. 268, 22 N. E. 798 (1889); Elkins v. Camden & Atlantic R. R., 36 N. J. Eq. 5 (1882).

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poration purchases stock in another, such purchase must tend to forward the “ p rim ary” purpose of the corporation; as one court said, “ whether the purchase of stock in one corporation by another is ultra vires or not, must depend upon the purpose for which the purchase was made, and whether such purchase was, under all the circumstances, a necessary or reasonable means of carrying out the object for which the corporation was created, or one which under the statute it might accomplish.” 39

This would mean little if the “ object ” of the corporation could be ascertained by merely reading the “ object clauses ” in its charter. It seems plain, however, that in ordinary circumstances the situation is more complicated than that. For instance, although the Prudential Insurance Company certainly had power to purchase stock, where it proposed to buy a majority of the stock of the Fidelity Trust Company which already owned a majority of stock in the Prudential Insurance Company, and the result of the scheme was to create a situation in which the management could maintain itself perpetually in office, the court observed that the purchase was not for the purpose of making an investment (which the insurance company could do) but for the purpose of carrying out a scheme of corporate control of advantage to the management individually.40 Accordingly, the transaction was en­ joined. One may suggest that a so-called investment trust which used its funds for the purchase of shares not primarily for invest­ ment but for the purpose of obtaining control of a corporation to the advantage of the managers of the investment trust, would come under the same condemnation.41 39 Hill v. Nisbet, 100 Ind. 3 4 1 , 349 (1 8 8 4 ) . 40 Robotham v. Prudential Ins. Co., 64 N. J. Eq. 6 73, 53 Atl. 842 (1 9 0 2 ) . 41 This is a problem which should be a matter of general concern. Some bil­ lions of dollars have been acquired by so-called “ investment trusts/’ The theory is that the investment trust managers or officers can supplant the individuals in the management of funds, with advantage to the latter by reason of the peculiar experience and information which the managers have. These rapidly turn up as devices by which the investment trust managers claim actual or partial control of a series of unrelated corporations. Dillon, Read & Co. are said by this means to have obtained representation on the board of the Rock Island Railroad. It was charged that by this means Cyrus Eton sought to control the Youngstown Sheet and Tube Co. These are two of many instances.

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Purchases of stock by one corporation in another commonly fall into two categories. In the one case the purchase does not involve control of the corporation whose stock is being purchased. In this situation normally the only problem is whether the pur­ chase can fairly be treated as an investment by the purchasing corporation. The second category involves situations in which the purchasing corporation acquires control over a second cor­ poration by buying a controlling block of its stock. Here the naked power to purchase is an insufficient justification. Trans­ actions have been steadily enjoined unless*the corporation can justify its purchase on the ground that the controlled corporation may furnish facilities or materials in carrying out its objects, or is engaged in substantially the same enterprise, or that the pur­ chase aids a corporation usefully to the buyer’s business.42 F ail­ ing such justification, the purchase is frequently enjoined. The ground of prohibition is commonly called “ ultra vires.” A t first blush this seems to be a long w ay from equitable limita­ tion. Y e t on closer analysis it develops that the words, “ ultra vires” are here used in a sense quite different from that usually applied to the familiar phrase. The courts do not deny the “ power ” to make the purchase. W hat they say is that by reason of the object, the power is not well exercised. T he only conclusion which can be drawn is that the courts have weighed the power in the light of the circumstances and have in certain cases declined to sanction its use — a position quite different from asserting that the power does not exist. T he criteria adopted in cases where the purchasing corporation is buying control of another, concern management issues in practically every case — a comparison of the 42 Among the many cases may be cited: Edwards v. International Pavement Co., 227 Mass. 206, 116 N. E. 266 (19 17); Femald v. Ridlon Co., 246 Mass. 64, 140 N . E. 421 (1923); Dittman v. Distilling Co. of America, 54 Atl. 570 (N. J. Ch. 1903); State v. Missouri Pac. Ry., 237 Mo. 338, 141 S. W. 643 (1911) ; Ellerman v. Chicago Junction Ry., 49 N. J. Eq. 217, 23 Atl. 287 (1891). On the other hand, see: Sumner v. Marcy, Fed. Cas. No. 13,609 (D. Me. 1847); Pauly v. Coronado Beach Co., 56 Fed. 428 (S. D. Cal. 1893) 5 Savings Bank v. Meriden Agency, 24 Conn. 159 (1855) *> Hunt v. Hauser Malting Co., 90 Minn. 282, 96 N. W. 85 (1903); Bank of Commerce v. Hart, 37 Neb. 197, 55 N. W. 631 (1893); Nebraska Shirt Co. v. Horton, 93 N. W. 225 (Neb. 1903). In these last cases, pur­ chase of stock by a corporation in another corporation was enjoined, the theory being that the object of such purchase did not tend to fulfil or round out the primary objects of the buying corporation.

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purposes of the two corporations, an examination of the relation between them, an assessment of the motive with which the pur­ chase is made. Unless a reasonable connection can be found be­ tween the purposes, and an advantage to the corporation arises from linking the two concerns, and the motive has been to benefit the corporation as a whole, the purchase stands a good chance of being thrown out, although the paper authority is on its face unlimited.43 M anifestly, we are only on the eve of a development of law in this respect. Of recent years aggregations of capital have been collected from the public sale of stock in corporations with paper powers which are broad enough to permit them to rove the world at will. These are nominally supposed to be “ investment ” or "tr a d in g ” corporations. Presently, however, it develops that their funds have been so invested as to give control of one or more enterprises to the bankers managing the so-called invest­ ment or trading companies. In other words, the purpose of the corporation is investment; but the power to purchase stock has been used, not for investment purposes, but to forward the control of the managing group in extraneous fields. The “ investment trust ” has suddenly become a holding and management company. Quaere if this was the “ object ” of the corporation. D . The reserved power of the corporation to amend its charter

must be so exercised that the result will tend to benefit the corporation as a whole, and to distribute equitably the benefit or the sacrifice, as the case may be, between all groups in the corporation as their interests may appear. 43 The question remains open as to whether a corporation may not have as its primary purpose the use of its funds in a fashion analogous to a “ blind pool.” The older corporation statutes do not readily permit a corporation so to state its objects. The modern corporate form does permit precisely this. It would seem that the avowed object of the corporate management, particularly as announced to the public in the publicity surrounding the issue of its stock, might well indicate the “ primary purposes ” sought for in these cases. In any case, a studied trend toward liberality in permitting purchases of stock in other corporations is noticeable. One reason for this seems to be that no field of business is necessarily disconnected from any other field under the prevailing circumstances; it would be a courageous court which would undertake to tell the directors of an enterprise that another area of business necessarily lay outside the scope of reasonable and profitable connection with their enterprise.

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Since the power to amend the charter or by-laws is normally conferred on a majority of shareholders, we are manifestly now dealing with a somewhat different group from that heretofore considered. In principle, however, this would seem to make little difference. A power in the one case exercised by the directors is here exercised by the majority. There is a difference in one respect. The vote of shareholders would at least tend to create a presumption that the action taken benefited all of such share­ holders.44 The presumption is apparently subject to be rebutted either by proof that the majority is a compact group having interests adverse to the corporation as a whole or to the other classes,45 or, possibly, by the mere fact of adverse inter­ ests, though this last is not so clear. Ultim ately courts may take judicial notice of the “ rubber-stamp ” quality of most stock­ holders' votes. In general, however, power granted to a m ajority must be re­ garded as standing on the same footing with power granted to the management. While an individual shareholder normally is not required to exercise his voting rights in a fiduciary capacity,46 nevertheless the power of a majority is subject to certain equitable limitations, which appear to differ under varying states of fact. Thus, a majority composed of scattered shareholders, not actuated by a unifying interest, nevertheless must not so exercise its power 44 See B e r l e , S t u d i e s i n t h e L a w o f C o r p o r a t io n - F i n a n c e (1928) (“ Non­ voting Stock and Bankers’ C o n tro l” ). And the presumption would certainly not exist as regards shares which did not vote. For instance, in the case of a vote of common stockholders reducing capital and thereby reducing the “ cushion” or security behind preferred shares, which did not vote on the reduction. 45 The language of the court in Davis v. Louisville Gas & Elec. Co., 142 Atl. 654 (Del. 1928), would seem to indicate this. The court, after remarking that where a large majority of stockholders have voted for the change there is a presumption of good faith, then examined where stock most hurt by the amendment was held, and pointed out that since the management itself stood to be most prejudiced by the change, the presumption of good faith would be difficult to rebut. But the implication is plain that the presumption is rebuttable. One may feel, however, that the court’s examination of the facts was hardly complete. A public utility holding company (the majority holder in the Davis case) might well have an in­ terest in sacrificing both its own and the minority interests in one company in order thereby to forward the interests of a quite different company. 46 North-West Trans. Co. v. Beatty, [1887] 12 A. C. (P. C.) 589; Camden & Atlantic R. R. v. Elkins, 37 N. J. Eq. 273 (1883) (but quaere whether this case would be decided in the same manner to d ay).

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as to “ confiscate ” the rights of the minority, nor so as to op­ press them unreasonably.47 The mere power concentrated in the hands of, say, a parent corporation, or of the management itself, appears to be tested by rules almost exactly like those applicable to boards of directors. Where the majority power is in fact exercised by or through the management or its control, courts take cognizance of that fact.48 To the principle of equitable control of the power to amend the certificate of incorporation, there seems to be not a single exception in any American jurisdiction. The stringency of the control varies. In substantially all states it is held that no amend­ ment of the certificate of incorporation can interfere with certain specific rights. The principal example of this is the right of a holder of accumulative preferred stock to be protected against any amendment which disturbs accrued unpaid cumulative dividends.49 This is fam iliarly spoken of as a “ vested right,” though the phrase states a conclusion rather than an argument. As a matter of strict English, the right to have unpaid cumulative dividends charged as a preference against the net assets of the corporation seems not different in kind from the right to receive a preference on liquidation up to a stated amount. As such, the former would seem to be as subject to amendment as the latter under a reserved power to alter “ preferences.” Nevertheless, practically every case on the subject prohibits an amendment modifying accrued cumulative dividends, substantially on the theory that to do so is an oppression of the preferred shareholder.

47 New Haven & Derby R. R. v. Chapman, 38 Conn. 56 (1871); Perkins v. Coffin, 84 Conn. 275, 79 Atl. 1070 (19 11); Lonsdale Corp. v. International Mer­ cantile Marine Co., 101 N. J. Eq. 554, 139 Atl. 50 (1927); Kent v. Quicksilver Mining Co., 78 N. Y . 159 (1879). 48 Central Trust Co. v. Bridges, 57 Fed. 753 (C. C. A. 6th, 1893); Kavanaugh v. Kavanaugh Knitting Co., 226 N. Y . 185, 123 N. E. 148 (1919). The same rule in a different form appears in Farmers’ Loan & Trust Co. v. New Y ork & Northern Ry., 150 N. Y . 410, 44 N. E. 1043 (1896). See also O'utwater v. Public Serv. Corp. of New Jersey, infra note 56. 49 Yoakum v. Providence Biltmore Hotel Co., 34 F.(2d) 533 (D. R. I. 1929); Morris v. American Pub. Util. Co., 14 Del. Ch. 136, 122 Atl. 696 (1923); Lonsdale v. International Mercantile Marine Co., 101 N. J. Eq. 554, 139 Atl. 50 (1927). But even this right was questioned in Windhurst v. Central Leather Co., 101 N. J. Eq. 543, 138 Atl. 772 (1927), where the corporation was in such bad condition that failure to modify such rights might have been disastrous.

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Certain states, notably New Jersey, enlarge this area of “ vested rights.” 50 A m ajority of jurisdiction^ appear to permit the amendment upon a showing that the business interests of the corporation, including the class of stock whose preferences are affected, require the change. Even Delaware, the loosest of juris­ dictions, suggests, obiter, that if a showing can be made that the majority is acting adversely to the minority, primarily to benefit itself as against the minority, without corresponding compensa­ tion through business strength or otherwise to all concerned, an injunction will issue.51 This process of advantage to one group at the expense of another is usually described under the loose and somewhat misleading term “ fraud but the meaning seems plain. T he m ajority of amendments, even those cutting down specific contract rights such as the right to a fixed dividend, the right to a fixed preference in assets, and the right to a stated participa­ tion, are commonly sustained; but no court seems to have based its decision on the naked power to amend. In every case, the equities have been examined, the business situation considered, and the reasoning upholding the amendment has been grounded on the theory that the amendment was under the peculiar circum­ stances equitable for all concerned. There may be dispute on the facts; there certainly is ground for believing that few dissenting stockholders are in a position to cope with the management (which commonly represents the m ajority) in a battle to determine where the business interests of the group as a whole really lie. But it can not be said that the results lend any color to the proposition that an absolute right to amend the charter has ever been recog­ nized despite the plain power granted b y statute and carried for­ ward b y appropriate provision in the certificate of incorporation. E. The power to transfer the corporate enterprise to another

enterprise by merger, exchange of stock, sale of assets or otherwise, may be exercised only in such a manner that the respective interests of the shareholders of all classes are re­ spectively recognized and substantially protected. Substantially all corporate statutes today grant to corporations created under them the power to unite with other enterprises or 50 Lonsdale v. International Mercantile Marine Co., supra note 49. 51 Davis v. Louisville Gas & Elec. Co., 142 Atl. 654 (Del. Ch. 1928).

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to transfer their activities to other corporations. Various mecha­ nisms are provided to this end. T he old power to merge and consolidate is historic; the power to lease all of the assets fol­ lowed; today, the result is more often obtained by a sale of the assets to the acquiring entity in return for an assumption of all lia­ bilities and for a block of stock, which stock is in turn distributed to the stockholders of the transferring corporation. Another method is the individual transfer by shareholders of their stock in exchange for stock of the acquiring corporation, or in exchange for stock of a holding company, the process becoming complete when a controlling majority of the shares of stock has been so ex­ changed. Financial jargon lumps all these processes, as well as other more recondite methods, under the loose word “ merger.” This power was not inherent in a corporation; historically, it could be exercised only by unanimous consent.52 Under an early decision, the power to sell the assets, for example, did not include the power to take stock of another corporation in compensation and to force this stock down the throats of the old shareholders; but the ground of the decision was lack of power, not misuse of power.53 The modern statute, however, contains such authority, and the modern corporate charter carries forward the authority by inserting an appropriate provision suggesting corporate action by which the authority may be exercised. In its earlier phases, it was thought that the validity of a merger was tested b y power only — a decision flatly contrary to the thesis of this essay. A federal court once remarked that where a sale of assets had taken place and the proceedings con­ formed to the organic law, it did not matter “ that the majority were actuated by dishonorable or even corrupt motives, so long as their acts were legitimate. In equity, as at law, a fraudulent intent is not the subject of judicial cognizance unless accom­ panied by a wrongful act.” 64 Subsequent decisions, however, have obliterated this doctrine. Thus in Windhurst v. Central 52 See B a l l a n t i n e , C o r p o r a t io n s (1928) 594-95. 53 International & Great Northern R. R. v. Bremond, 53 Tex. 96 (1880). 54 Ervin v. Oregon Ry. & Nav. Co., 20 Fed. 577, 580 (C. C. S. D. N. Y . 1884), aff’d, 27 Fed. 625 (C. C. S. D. N. Y . 1886). The quotation belies the actual de­ cision; the court ultimately held the transaction inequitable, and charged the new corporation’s assets with a lien in favor of complainants,

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I 0 yj

Leather Co.,55 the court remarked: “ E very case must to some extent stand on its own facts as they are affected by the principles and doctrines of equity,” a decision which sets out substantially the doctrine of the modern cases. So, where a corporation owned properties leased to a public service corporation,50 the corporate income being the lease rental, and the lessee corporation acquired a majority of the stock of the lessor and then attempted to force a sale of the assets in consideration of preferred stock of the lessee corporation, the transaction was enjoined since in equity the rights of the stockholders of the lessor were being reduced from a first charge on the property of the lessee b y w ay of rental, to a junior charge in the form of preferred dividends. The court made an added point of the fact that the preferred stock was redeemable in three years, so that the transaction amounted to an option b y the lessee corporation to buy out its lessor. In that case, the court did not even require a showing of actual fraud; and, after con­ ceding that the merger agreement was “ in legal form,” remarked, “ The agreement calls for careful judicial scrutiny, and the bur­ den is on the m ajority to show that the consideration is fair and equitable, and judgment, as to fairness, is not to be influenced by the heavy vote of approval, as it otherwise would be if the vote were independent.” 57 T he last remark was, of course, occasioned b y the fact that the majority stock voting in favor of the transac­ tion was owned by the lessee corporation which benefited from it. An earlier case, Jones v. Missouri-Edison Elec. Co.,58 dealt with a merger, likewise carried out in scrupulous accord with the legal requirements, in which the equities of the shareholders of one of the merging corporations were tremendously diluted. Here, the merger was an accomplished fact and the eggs could not be un­ scrambled. T he appellate court remanded the case to the court below with instructions to work out appropriate relief, and pointed out that the directors were in substance trustees for shareholders, that a majority having control was in much the same position, and that a dilution of the equity of the minority was a breach of 55 IOI N. J. Eq. 543, 138 Atl. 772 (1927). 56 Outwater v. Public Serv. Corp.. of New Jersey, 103 N. J. Eq. 461, 143 Atl. 729 (1928). 57 Id. at 464, 143 Atl. at 730. 58 135 Fed. 153 (E. D. Mo. 1905), afi’d, 144 Fed. 765 (C. C. A. 8th, 1906).

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trust. The court took occasion to say: “ The fraud or breach of trust of one who occupies a fiduciary relation while in the exercise of a lawful power is as fatal in equity to the resultant act or con­ tract as the absence of the power.” 59 In a New Y ork case, Colby v. Equitable Trust Co.,80 the court faced a situation in which there was a dilution of the stock in one of the merging corporations. On examination, however, the busi­ ness situation indicated that that corporation had been running a losing race and was facing an uninviting future. The court, taking these facts into consideration, came to the conclusion that the merger was not “ so unfair and unconscionable . . . that a court of equity should interfere and prevent its consummation.” There are many similar cases. Though an equitable limitation was applied in favor of pro rata control when additional stock was issued, the fact that proportionate control is diluted by a process of merger seems not to be persuasive.61 Whether this is because courts today take a more realistic view and recognize pro rata con­ trol as not being worth very much, or because its loss is not a sufficient consideration to over-balance the business interests in­ volved, does not appear; but few students of corporate problems will quarrel with the conclusion. Though by no means complete, the foregoing substantially sum­ marizes the position of courts in regard to the power to consum­ mate a merger. Save in Pennsylvania, where an archaic rule requires that no merger be consummated unless the shareholder is given an option to be paid out in cash,82 the equitable limitation seems undisputed; and even under the Pennsylvania rule it would appear that the courts involved were struggling for an automatic right compensating the shareholder for his loss of position, much as the Massachusetts court in Gray v. Portland Bank struggled for such a right. It is singular that no generalization has been attempted covering equitable control over situations where statute and charter have 59 144 Fed. at 771. 60 124 App. Div. 262, 108 N. Y . Supp. 978 (1908). 61 Mayfield v. Alton R y. Gas & Elec. Co., 198 111. 528, 65 N. E. 100 (1902). 62 Laumann v. Lebanon Valley R. R., 30 Pa. St. 42 (1858); Petry v. Harwood Elec. Co., 280 Pa. 142, 124 Atl. 302 (1924).

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granted apparently clear powers to act. Y e t such a generaliza­ tion is not difficult to find. B y contract shareholders m ay dis­ tribute rights and participations inter sese. T h ey may grant to one of their number a senior preferred position and to another a junior position; they may divide or limit rights in assets, or the immediate participations in earnings as they agree. These are individual agreements among themselves. But where powers are conceded to the management or to any group to act for the corporation as a whole, the obvious, if tacit, assumption is that these powers are intended to be used only on behalf of all. T hey are distinctly not intended to be granted for the purpose of bene­ fiting one set of participants as against another. T o do so would be to violate every intendment of the whole corporate situation. While incidental variations in individual participations, or in class participations may take place as the powers are used, the powers themselves are designed to forward the ends of all, not to forward the ends of some and defeat the ends of others. In this respect, corporation law is substantially at the stage in which equity was when it faced the situation of a trustee who had been granted apparently absolute powers in his deed of trust. So far as the law and the language went, the power was absolute; the trustee could do as he pleased; could perhaps trade with himself irrespective of his adverse interests; could, perhaps, sell the trust assets at an unfairly low price. Y e t to permit untrammeled ex­ ercise of these powers would be to violate the whole underlying concept of the trust institution. It was possible to argue under the old and rigid corporation laws that the statute had carefully laid down the lines of corporate action, and that wherever a power was not to be exercised, the statute had itself declined to grant the ability to act. Modern statutes and charters admit no such in­ terpretation. The statute is in substance a permission to the trustees to claim any powers they choose, within very few limits. This very liberty negatives the assumption that the state through its statute has undertaken to say that all powers, however exer­ cised, must be considered to be properly exercised. Courts, ac­ cordingly, have been substantially forced to the conclusion here expressed: namely, that no power, however absolute in terms, is absolute in fact; that every power is subject to the essential equi­ table limitations.

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In this concept, corporation law becomes in substance a branch of the law of trusts. The rules of application are less rigorous, since the business situation demands greater flexibility than the trust situation. Probably the requirements as to motive and clean-mindedness on the part of the persons exercising the powers are substantially similar. The requirements of exactitude in ap­ portioning or assessing ratable differences must yield to the neces­ sary approximations which business entails. But the fundamental requirements follow similar lines. As a conclusion, it necessarily follows that: First: Whenever a corporate power is exercised, its existence must be ascertained and the technical correctness of its use must be checked; but its use must also be judged in relation to the existing facts with a view toward discovering whether under all the circumstances the result fairly protects the interests of the shareholders. Second: M any of the apparently rigid rules protecting share­ holders, as, for example, the rule creating preemptive rights, are in reality not “ rights ” but equitable remedies, to be used, molded, or discarded as the equities of the case may require. Third: N ew remedies may be worked out and applied by the courts in each case, depending on the circumstances. For ex­ ample, to protect the rights of a non-cumulative preferred stock­ holder whose dividend should be withheld for business purposes but should be retained for him for purposes of equitable treatment, a court might require the declaration of the dividend in stock or scrip. The powers of courts of equity in this regard are as broad as may be necessary to adjust and maintain the relative participa­ tions of the various classes of shareholders. Fourth: No form of words inserted in a corporate charter can deny or defeat this fundamental equitable control. T o do so would be to defeat the very object and nature of the corporation itself.

A. A. Berle, Jr. N ew

Y ork

C it y .

[2] F O R W H OM A R E C O R P O R A T E M A N A G E R S T R U S T E E S ? E. M errick Dodd, Jr.

N individual who carries on business for himself necessarily enters into business relations with a large number of persons who become either his customers or his creditors. Under a legal system based on private ownership and freedom of contract, he has no duty to conduct his business to any extent for the benefit of such persons; he conducts it solely for his own private gain and owes to those with whom he deals only the duty of carrying out such bargains as he may make with them. If the owner employs an agent or agents to assist him in carry­ ing on business, the situation is only slightly changed. The enterprise is still conducted for the sole benefit of the owner; the customers and creditors have contract rights against him and not normally against the agent even when the agent is the person who actually transacts business with them. The agent himself shares in the receipts of the enterprise only to the extent provided b y his agreement. He, however, on his part owes something more than a contract duty toward his principal. He is a fiduciary who must loyally serve his principal’s interests. Substitute several owners for one and the picture is scarcely altered, except that insofar as the owners take part in the conduct of the enterprise, there is a fiduciary relation between owner and owner, as well as between employee and owner. Incorporate the enterprise, making the owners stockholders and some of them or persons selected by them directors, and — if we adopt the widely

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prevalent theory that the corporate entity is a fiction1 — our picture is substantially unchanged. The business is still a private enterprise existing for the profit of its owners, who are now the stockholders. Its customers and creditors have contract rights, nominally against the corporation but in reality against the stock­ holders, whose liability is limited to the assets used in the busi­ ness.2 The directors and other agents are fiduciaries carrying on the business in the sole interest of the stockholders. These latter have indeed lost much of their de jure and, if the enterprise is a large one, perhaps nearly all of their de facto control so that they may appear to be more like cestuis que trust than like part­ ners. Nevertheless they are not strictly cestuis que trust, for it is the association of which they are members and not an individual acting as trustee for them that comes into contract relations with customers and creditors. Stress the theory of the corporate entity and the picture is altered slightly, but more in form than in substance. T h e corpo­ ration as a distinct legal person is now conceived of as carrying on the business and making the contracts, and the directors and other agents are fiduciaries for it. T he sole function of the corpo­ ration is, however, conceived to be the making of profit for its stockholder-members,3 so that they are the ultimate beneficiaries of the business and of the activities of the persons by whom it is carried on. Subject to this, from a practical standpoint, relatively minor controversy as to the emphasis to be placed upon the corporate entity,4 it is undoubtedly the traditional view that a corporation 1 There has been a voluminous amount of legal writing of late years on the cor­ porate personality. Among legal expressions of the view that the corporation is in essence merely an aggregate of its members, see Hohfeld, The Individual L iability of Stockholders and the Conflict of L aw s (1 9 0 9 ) 9 C o l . L . R e v . 492, ( 1 9 1 0 ) 10 id. 283, 5 2 0 ; Radin, The Endless Problem of Corporate Personality ( 1 9 3 2 ) 32 id. 643. Compare also the tendency today to “ disregard the corporate fiction ” in a wide variety of situations. 2 For an analysis of the legal duties of corporations as legal duties of their stock­ holders, see Hohfeld, supra note 1. 3 For a vigorous assertion of this view, see Dodge v. Ford M otor Co., 204 Mich. 459, 170 N. W . 668 (1919). 4 The amount of emphasis which should be given to the corporate entity con­ cept is unimportant for our present purpose if we assume that the sole function of the entity is to make profits for the stockholders. If the latter proposition be dis­ puted, the entity concept may then, as indicated below, become important.

Corporate Governance

FOR W H O M A R E CO R P O R A T E M A N A G E R S T R U S T E E S ?

31 n 47

is an association of stockholders formed for their private gain and to be managed by its board of directors solely with that end in view. Directors and managers of modern large corporations are granted all sorts of novel powers b y present-day corporation statutes and charters, and are free from any substantial super­ vision b y stockholders b y reason of the difficulty which the mod­ ern stockholder has in discovering what is going on and taking effective measures even if he has discovered it. T he fact that managers so empowered not infrequently act as though maximum stockholder profit was not the sole object of managerial activities has led some students of corporate problems, particularly Mr. A. A. Berle, to advocate an increased emphasis on the doctrine that managerial powers are held in trust for stockholders as sole bene­ ficiaries of the corporate enterprise.5 The present writer is thoroughly in sympathy with Mr. Berle’s efforts to establish a legal control which will more effectually pre­ vent corporate managers from diverting profit into their own pockets from those of stockholders, and agrees with many of the specific rules which the latter deduces from his trusteeship prin­ ciple.6 He nevertheless believes that it is undesirable, even with 5 See Berle, Corporate Powers as Powers in Trust (1931) 44 H a r v . L. R e v . 1049. 6 That directors are fiduciaries for their corporations is indisputable. That many of their powers, such as the power of declaring or passing dividends and the power of issuing new stock, may affect the individual interests of the stockholders rather than the corporate enterprise as a whole is obvious and has led to a growing tendency to treat directors as fiduciaries for stockholders as well as for the corporate entity. Thus, a stockholder may under some circumstances compel the declaration of a dividend even though the corporate entity would not be injured by the failure to declare. Dodge v. Ford Motor Co., supra note 3; In re Brantman, 244 Fed. 101 (C. C. A. 2d, 1917). A stockholder may also enjoin the issue of new stock by directors where the purpose of the issue is to change the control of the enterprise, even though the issue may not injure the corporation and even though the stock­ holder may not under the circumstances have any contractual preemptive right to have the stock issued to him. Elliott v. Baker, 194 Mass. 518, 80 N. E. 450 (1907); Luther v. C. J. Luther Co., 118 Wis. 112, 94 N. W. 69 (1903); see Dunlay v. Avenue M. Garage & R. R., 253 N. Y . 274, 279, 170 N. E. 917, 919 (1930). It may be questioned, however, whether some of the problems which Mr. Berle treats as fiduciary problems — e.g., that relating to dividends on non-cumulative preferred stock — are not questions of contract rather than of fiduciary law. Cf. Wabash Ry. v. Barclay, 280 U. S. 197 (1930). A further controversy as to the fiduciary duties of management when management is vested not in directors but in a particular group of stockholders is beyond the scope of the present article. See B e r l e , S t u d i e s i n t h e L a w o f C o r p o r a t io n F i n a n c e (1928) c. 3. But cf. Wood, The Status of M anagement Stockholders (1928) 38 Y a l e L . J. 57,

32

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the laudable purpose of giving stockholders much-needed protec­ tion against self-seeking managers, to give increased emphasis at the present time to the view that business corporations exist for the sole purpose of making profits for their stockholders. He believes that public opinion, which ultimately makes law, has made and is today making substantial strides in the direction of a view of the business corporation as an economic institution which has a social service as well as a profit-making function, that this view has already had some effect upon legal theory, and that it is likely to have a greatly increased effect upon the latter in the near future. Several hundred years ago, when business enterprises were small affairs involving the activities of men rather than the em­ ployment of capital, our law took the position that business 7 is a public profession rather than a purely private matter, and that the business man, far from being free to obtain all the profits which his skill in bargaining might secure for him, owes a legal duty to give adequate service at reasonable rates. Although a growing belief in liberty of contract and in the efficacy of free competition to prevent extortion led to abandonment of this theory for business as a whole, the theory survived as the rule applicable to the carrier and the innkeeper. In recent years we have seen this carrier law expanded to include a variety of busi­ nesses classed as public utilities. Under modern conditions the conduct of such businesses normally involves the use of a sub­ stantial amount of property. This fact, together with the acci­ dental circumstance that a passage from Lord Hale was quoted in one of the briefs in the leading case of Munn v. Illinois ,8 has led to a change in the conventional legal phraseology. Instead of 7 It has been asserted that the medieval like the modern law drew a distinction between those businesses which were public and those which were private. See 1 W y m a n , P u b l ic S e r v ic e C o r po r atio n s (1 9 1 1 ) 5. It is reasonably clear, however, that this view involves reading modern conceptions into the early cases and that what those cases really indicate is that all business publicly carried on was regarded as public in character. See Adler, Business Jurisprudence (19 14 ) 28 H a r v . L . R e v . 135. “ The notion of a distinct category of business ‘ affected with a public inter­ est,’ employing property ‘ devoted to a public use,’ rests upon historical error.” Brandeis, J ., dissenting, in N ew State Ice Co. v. Liebmann, 52 Sup. Ct. 3 7 1, 383 (19 3 2 ). 8 See Hamilton, A ffectation W ith P ublic Interest (1930) 39 Y a l e L . J . 1089,

1095-

Corporate Governance

FOR WHOM ARE CORPORATE MANAGERS TRUSTEES?

33

114 9

talking, as the early judges talked, in terms of the duty of one engaged in business activities toward the public who are his cus­ tomers, it has become the practice since Munn v. Illinois 9 to talk of the public duty of one who has devoted his property to public use, the conception being that property employed in certain kinds of business is devoted to public use while property employed in other kinds of business remains strictly private. This approach to the problem has been justly criticized as at­ tempting to draw an unreasonably clean-cut distinction between businesses which do not differ substantially, and as furnishing no intelligible criterion by which to distinguish those businesses which are private property from those which are property de­ voted to public use .10 The phrase does, however, have the merit of emphasizing the fact that business is permitted and encouraged by the law primarily because it is of service to the community rather than because it is a source of profit to its owners. Accord­ ingly, where it appears that unlimited private profit is incom­ patible with adequate service, the claim of those engaged therein that the business belongs to them in an unqualified sense and can be pursued in such manner as they choose need not be accepted by the legislature. Despite certain recent conservative decisions such as Tyson v. Banton,11 it may well be that the law is approach­ ing a point of view which will regard all business as affected with a public interest. If certain businesses then continue to be al­ lowed unregulated profits, it will be as a matter of legislative policy because the lawmakers regard the competitive conditions under which such businesses are carried on as making regulation of profits unnecessary, and not because the owners of such enter­ prises have any constitutional right to have their property treated as private in the sense in which property held merely for personal use is private. At any rate, there is no doubt that property employed in a business now classed as a public utility is private property only in a qualified sense. Such a utility as an interstate railroad must 9 94 U. S. 1 1 3 ( i 877) • 10 See Hamilton, supra note 8; Brandeis, J., in N ew State Ice Co. v. Liebmann, 52 Sup. Ct. 3 7 1, 383 (19 3 2 ). 11 273 U. S. 418 (19 27) ; cf. N ew State Ice Co. v. Liebmann, 52 Sup. Ct. 3 7 1 (19 3 2 ).

34

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render adequate service, expand its facilities when called upon by public authority, charge only reasonable rates, and treat all cus­ tomers alike even though profitable new business might be secured by making concessions to certain patrons.12 In addition to such regulations of its rates and services, an interstate railroad is powerless to issue new securities even to its existing stockholders without the consent of an administrative board which is charged with the duty of considering primarily the bearing of such se­ curity issue upon the welfare of the traveling or shipping public rather than the desirability of the issue from the standpoint of the stockholders as owners.13 Furthermore, the relations between such a railroad and its employees are no longer solely a matter of private bargaining but have of recent years been regulated, first by the Adamson Act,14 a thinly disguised measure for increas­ ing wages, and more recently by an act creating a labor board with power to determine wages in case of a dispute, although without any weapon save an appeal to public opinion for the en­ forcement of its determinations.15 Whether these labor regula­ tions be regarded as designed to protect the public against pos­ sible interruptions of service due to strikes, or as derived from a partial recognition of the validity of the claims of labor as an integral part of the enterprise to a fair share of the receipts — fairness to be dependent on criteria which, however vague, are not wholly a matter of bargaining strength — it is plain that these regulations, like those previously referred to, involve important limitations on the right of stockholders and managers acting in their interests to treat the enterprise as the private property of the former. The law applicable to interstate railroads has, moreover, re­ cently broken away from the idea that each business enterprise is a wholly distinct entity owing no obligations to aid in the success of the industry as a whole. The Transportation Act of 1920 as construed by the United States Supreme Court in the New Eng­ land Divisions Case 16 treats the railroads of the country as parts 12 See 41 S tat . 474, 483 (19 20 ), 49 U. S. C. §§ 1, 6 (19 2 6 ). 13 See 4 1 S tat . 494 (19 20 ), 49 U. S. C. § 20a (19 2 6 ). 14 39 S t a t . 721 (19 16 ), 45 U. S. C. § 65 (19 2 6 ). Held constitutional in Wilson v. New, 243 U. S. 332 ( 1 9 1 7 ) . 15 41 S tat . 469 (19 20 ), 45 U. S. C. §§ 1 3 1 - 3 4 (19 2 6 ). 16 261 U. S. 184 (19 2 3) C f. Dayton-Goose Creek R y. v. United States, 263

Corporate Governance

35

FOR WHOM ARE CORPORATE M A NA GE RS TRUSTEES?

1151

of a single system to such an extent as to justify the Interstate Commerce Commission in dividing the joint rates charged by con­ necting carriers between those carriers in such a way as to in­ crease the resources of the weaker roads by giving them a dis­ proportionately large share of the total. Although this single system concept has thus far been confined to interstate railroads, the limitations on unqualified pursuit of private profit imposed by the more advanced states on other socalled public utilities such as gas, electric, and telephone com­ panies, are substantially similar to those imposed by federal law upon interstate railroads.17 Outside the public utility field there is in the present state of the law little or no attempt to curtail private property in the interest of the customer, it being generally assumed that competition furnishes him adequate pro­ tection .18 On the other hand, the inequality of bargaining power between employer and employee — an inequality which the re­ cent rise of the large corporation has greatly accentuated — has resulted in a considerable amount of legislation designed to pro­ tect the health and safety, and even to a slight extent the financial rewards, of the employee.19 Recent economic events suggest that the day may not be far distant when public opinion will demand a much greater degree of protection to the worker. There is a widespread and growing feeling that industry owes to its employees not merely the nega­ tive duties of refraining from overworking or injuring them, but the affirmative duty of providing them so far as possible with economic security. Concentration of control of industry in a relatively few hands 20 has encouraged the belief in the practicaU. S. 456 ( 19 2 4 ) ; Fifteen Per Cent Case, 178 I. C. C. 539 ( 1 9 3 1 ) .

(For modification

of the order in that case, see U. S. Daily, Dec. 8, 19 3 1, at 2275.) 17 See, e.g., N . Y . P u b . S e r v . C o m . L a w (19 10 ) c. 480. 18 The United States Supreme Court, as indicated above, takes the position that charges to the consumer can not constitutionally be regulated unless the business is one which in the Court’s opinion may properly be regarded as a public utility. 19 Reasonable health and safety measures such as limitations of hours of service are accepted as proper exercises of the police power. Bunting v. Oregon, 243 U. S. 426 ( 1 9 1 7 ) . Minimum wage laws are deemed invalid. Adkins v. Children’s Hos­ pital, 261 U. S. 525 (19 2 3 ). More limited wage regulations such as those compelling payment in cash have been upheld. Knoxville Iron Co. v. Harbison, 183 U. S. 13 ( 19 0 1). 20 The extent to which control of American industry is thus concentrated has

36

Corporate Governance U 52

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bility of methods of economic planning by which such security can be achieved in much greater degree than at present. This belief is no longer confined to radical opponents of the capitalistic system; it has come to be shared by many conservatives who believe that capitalism is worth saving but that it can not perma­ nently survive under modern conditions unless it treats the eco­ nomic security of the worker as one of its obligations and is intelligently directed so as to attain that object.21 It is true that, as many advocates of industrial planning have pointed out, high wages and economic security for workers tend in the main to increase the profits of stockholders, inasmuch as they tend to increase consumption of the things which business corporations produce.22 It can not, however, be successfully maintained that the sort of industrial planning which may be found desirable to protect the employee is necessarily under all circumstances in line with the interest of the stockholders of each individual corporation. If contemporary discussion of the need for a planned economic order ultimately results in a more stabilized system of production and employment, we may safely predict that this will involve some further modifications of the maximum-profit-for-the-stockholders-of-the-individual-company formula. It may, however, be forcibly urged that all these and other past, present, and possible future limitations on the pursuit of stockholder profit in no way alter the theory that the sole function of directors and other corporate managers is to seek to obtain the maximum amount of profits for the stockholders as owners of the enterprise. Ownership of a modern railroad may today be hedged about with restrictions which make such ownership con­ siderably less absolute than was the ownership of a cotton mill at the time when economic and legal theories of laissez faire were most completely accepted. Ownership in the cotton industry to­ morrow may be even more restricted in some ways than is recently been investigated.

See L a id l e r , C o n c e n t r a t io n

of

C o n tr o l i n A m e r ic a n

I n d u stry (19 3 1). 21 See, e.g., D o n h a m ,

B u s in e s s

A d r ift

(19 3 1)

passim ; T h e

S w o p e P la n

(Frederick editor, i 9 3 i ) ; Address of D aniel W illard , President of Baltim ore & Ohio

R . R . in A m e ric a F a c e s t h e F u t u r e (B e a rd editor, 19 32) 29; B utler, U n e m p l o y ­ m en t, id. at 14 1. 22 E.g., D o n h a m , B u s i n e s s A d r if t 12 9 -3 7 ; T h e S w o p e P l a n 20.

Corporate Governance FOR WHOM AR E CORPORATE M A N A G E RS TR U STEES?

37 1153

ownership in the railroad field today. Regulations imposed in the interest of employees, consumers, or others may increasingly limit the methods which managers of incorporated business enterprises may employ in seeking profits for their stockholders without in any way affecting the proposition that the sole function of such managers is to work for the best interests of the stockholders as their employers or beneficiaries. If, however, as much recent writing suggests, we are under­ going a substantial change in our public opinion with regard to the obligations of business to the community, it is natural to expect that this change of opinion will have some effect upon the attitude of those who manage business. If, therefore, the managers of modern businesses were also its owners, the develop­ ment of a public opinion to the effect that business has responsi­ bilities to its employees and its customers would, quite apart from any legal compulsion, tend to affect the conduct of the better type of business man. The principal object of legal compulsion might then be to keep those who failed to catch the new spirit up to the standards which their more enlightened competitors would desire to adopt voluntarily. Business might then become a profession of public service, not primarily because the law had made it such but because a public opinion shared in by business men themselves had brought about a professional attitude.23 Our present economic system, under which our more important business enterprises are owned by investors who take no part in carrying them on — absentee owners who in many cases have not even seen the property from which they derive their profits — alters the situation materially. That stockholders who have no contact with business other than to derive dividends from it should become imbued with a professional spirit of public service is hardly thinkable. If incorporated business is to become pro­ fessionalized, it is to the managers, not to the owners, that we must look for the accomplishment of this result. If we may believe what some of our business leaders and stu­ dents of business tell us, there is in fact a growing feeling not only that business has responsibilities to the community but that our corporate managers who control business should voluntarily and without waiting for legal compulsion manage it in such a way as 23

Cf.

B r a n d e is , B u s i n e s s — A P r o fe s sio n (1925)*

38

Corporate Governance

1 1 54

HARVARD LAW REVIEW

to fulfill those responsibilities. T h u s, even before the p re sen t d epression h ad set m any business m en th in k in g ab o u t the place of business in society, one of our leading business executives, M r. Owen D . Y oung, h ad expressed him self as follows as to his conception of w h at a business executive’s a ttitu d e should be: “ If there is one thing a lawyer 24 is taught it is knowledge of trustee­ ship and the sacredness of that position. Very soon he saw rising a notion that managers were no longer attorneys for stockholders; they were becoming trustees of an institution. If you will pardon me for being personal, it makes a great difference in my attitude toward my job as an executive officer of the General Electric Company whether I am a trustee of the institution or an a t­ torney for the investor. If I am a trustee, who are the beneficiaries of the trust? To whom do I owe my obligations? My conception of it is this: T hat there are three groups of people who have an interest in that institution. One is the group of fifty-odd thousand people who have put their capital in the company, namely, its stockholders. Another is a group of well toward one hundred thousand people who are putting their labor and their lives into the business of the company. The third group is of customers and the general public. Customers have a right to demand that a concern so large shall not only do its business honestly and properly, but, further, that it shall meet its public obligations and perform its public duties — in a word, vast as it is, that it should be a good citizen. Now, I conceive my trust first to be to see to it that the capital which is put into this concern is safe, honestly and wisely used, and paid a fair rate of return. Otherwise we cannot get capital. The worker will have no tools. Second, that the people who put their labor and lives into this con­ cern get fair wages, continuity of employment, and a recognition of their right to their jobs where they have educated themselves to highly skilled and specialized work. Third, that the customers get a product which is as represented and th at the price is such as is consistent with the obligations to the people who put their capital and labor in. Last, that the public has a concern functioning in the public interest and performing its duties as a great and good citizen should. I think what is right in business is influenced very largely by the 24 tive.

M r. Young practised law for many years before he became a business execu­

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39 1155

growing sense of trusteeship which I have described. One no longer feels the obligation to take from labor for the benefit of capital, nor to take from the public for the benefit of both, but rather to administer wisely and fairly in the interest of all.” 25

More recently Mr. Young’s colleague, President Swope of the General Electric Company, has put forward his plan for the stabilization of industry which is based on the idea that “ or­ ganized industry should take the lead, recognizing its responsi­ bility to its employees, to the public, and to its stockholders — rather than that democratic society should act through its gov­ ernment.’726 That industry as at present organized can take this lead only through the agency of the directors and corporate executives who manage it is obvious and is tacitly assumed by Mr. Swope. As Professor Beard has put it in commenting on the Swope plan, “ Mr. Swope spoke as a man of affairs, as presi­ dent of the General Electric Company. No academic taint con­ demned his utterance in advance; no suspicion of undue enthusi­ asm clouded his product. As priest-kings could lay down the law without question in primitive society, so a captain of industry in the United States could propose a new thing without encoun­ tering the scoffs of the wise or the jeers of the practical.” 27 In his recent study of the situation which confronts American busi­ ness today, Dean Donham of the Harvard Graduate School of Business Administration has stated the problem as follows: “ How can we as business men, within the areas for which we are responsible, best meet the needs of the American people, most nearly approximate supplying their wants, maintain profits, handle problems of unemployment, face the Russian challenge, and at the same time aid Europe and contribute most to or disturb least the cause of international peace? ” 28 Answering this question he says, “ The only way to defend capitalism is through leadership which accepts social responsi­ bility and meets the sound needs of the great majority of our 25 Address of Owen D. Young, January, 1929, quoted in S e a r s, T h e N e w P l a c e (1929) 209. Cf. W o r m s e r, F r a n k e n s t e in , In c o rp o ra te d

o f t h e S to c k h o ld e r

( 1 9 3 1 ) c. 8 . 26 T h e S w o p e P l a n 22. 27 A m e r ic a F a c e s t h e F u t u r e 186. 28 D o n h a m , B u s i n e s s A d r i f t 38.

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people. Such leadership will seek to form constructive plans framed not in the interest of capital or capitalism but in the interest of the American people as a whole. . . . The responsi­ bility of capital for leadership is overwhelming. To a large extent in this industrial civilization of ours the potential leadership of the country is concentrated in industry.” 29 Dean Donham does not explicitly state that leadership of industry is in the hands of those who do not own it but he is too well-informed an observer of modern business not to be thoroughly aware that such is the case. Assumption of social responsibility by industrial leadership necessarily means assumption of such responsibility by corporate managers. The view that those who manage our business corporations should concern themselves with the interests of employees, con­ sumers, and the general public, as well as of the stockholders, is thus advanced today by persons whose position in the business world is such as to give them great power of influencing both business opinion and public opinion generally. Little or no attempt seems to have been made, however, to consider how far such an attitude on the part of corporate managers is compatible with the legal duties which they owe the stockholder-owners as the elected representatives of the latter. No doubt it is to a large extent true that an attempt by business managers to take into consideration the welfare of employees and consumers (and under modern industrial conditions the two classes are largely the same) will in the long run increase the profits of stockholders. As Dean Donham and others have demonstrated, it is the lack of a feeling of security on the part of those who are dependent on employment for their livelihood which is largely responsible for the present under-consumption which has so dis­ astrous an effect upon business profits. If the social responsi­ bility of business means merely a more enlightened view as to the ultimate advantage of the stockholder-owners, then obviously cor­ porate managers may accept such social responsibility without any departure from the traditional view that their function is to seek to obtain the maximum amount of profits for their stockholders. And yet one need not be unduly credulous to feel that there is 29 Id . at 105-06.

Corporate Governance

FOR WHOM ARE CORPORATE MANAGERS TRUSTEES?

41

115 7

more to this talk of social responsibility on the part of corpora­ tion managers than merely a more intelligent appreciation of what tends to the ultimate benefit of their stockholders. Modern largescale industry has given to the managers of our principal corpo­ rations enormous power over the welfare of wage earners and con­ sumers, particularly the former. Power over the lives of others tends to create on the part of those most worthy to exercise it a sense of responsibility. The managers, who along with the sub­ ordinate employees are part of the group which is contributing to the success of the enterprise by day-to-day efforts, may easily come to feel as strong a community of interest with their fellow workers as with a group of investors whose only connection with the enterprise is that they or their predecessors in title invested money in it, perhaps in the rather remote past.30 Moreover, the concept that the managers are merely, in Mr. Young’s phrase, “ attorneys for the investors ” leads to the conclusion that if other classes who are affected by the corporation’s activities need pro­ tection, that protection must be entrusted to other hands than those of the managers. Desire to retain their present powers ac­ cordingly encourages the latter to adopt and disseminate the view that they are guardians of all the interests which the corporation affects and not merely servants of its absentee owners. Any clash between this point of view and the orthodox theory that the managers are elected by stockholder-owners to serve their interests exclusively has thus far been chiefly potential rather than actual. Judicial willingness — which has increased of late — to allow corporate directors a wide range of discretion as to what policies will best promote the interests of the stockholders, to­ gether with managerial disinclination to indulge a sense of social responsibility to a point where it is likely to injure the stock­ holders, has thus far prevented the issue from being frequently raised in clear-cut fashion in litigation.31 30 Some of our most successful industrial corporations have for years obtained all the additional capital which they needed out of surplus profits without any further issue of securities. See, e.g., The General Electric Co., M o o d y ’s M a n u a l o f I n v e s t m e n t s , I n d u s t r i a l S e c u r i t i e s ( 19 3 1) 971, indicating that the only out­ standing bonds of that corporation were issued in 1902 and that no stock has been issued since 1920 except as a stock dividend or split-up. 31 It was raised in the case of Dodge v. Ford Motor Co., supra note 3, in which M r. Fo rd ’s expressions of an intention to share profits with the public through a

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Nevertheless there are indications that even today corporation managers not infrequently use corporate funds in ways which sug­ gest a social responsibility rather than an exclusively profitmaking viewpoint. Take, for example, the matter of gifts by business corporations to local charities. The orthodox legal at­ titude toward such gifts is well stated in the following language of Lord Bowen: “ Charity has no business to sit at boards of directors qua charity. There is, however, a kind of charitable dealing which is for the interest of those who practise it, and to that extent and in that garb (I admit not a very philanthropic garb) charity may sit at the board, but for no other purpose.” 32 Other courts have expressed substantially the same view, which is generally re­ garded as representing the law on the subject.33 There is, how­ ever, another viewpoint which is undoubtedly becoming widely prevalent with laymen if not with lawyers. Most local charities are designed to carry on relief work which, if not thus carried on, might be undertaken as a public enterprise supported by taxareduction in prices were relied upon as justifying a decree compelling the declara­ tion of a dividend out of the large surplus of the company. Neither the language of the opinion nor the relief granted necessarily involves an unqualified acceptance of the maximum-profit-for-stockholders formula. The opinion states that “ a business corporation is organized and carried on primarily for the profit of the stock­ holders ” and that directors cannot lawfully “ conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others.” 204 Mich, at 507, 170 N . W . at 684. Despite testimony of M r. Ford that he planned to expand the enterprise in the interest of consumers rather than of stockholders, the court was careful so to limit its decree as not to interfere seriously with the expansion program. Its avowed reason for so doing was that expansion might be made profitable despite M r. Ford’s expressed indifference to profit. One may suspect that it was also motivated, consciously or unconsciously, by a reluctance to prevent the growth of a socially important enterprise. 32 Hutton v. West Cork R y., 23 Ch. D. 654, 673 (18 8 3 ). “ The law does not say that there are to be no cakes and ale, but there are to be no cakes and ale ex­ cept such as are required for the benefit of the company.” Ib id . 33 The present tendency is to take a liberal view of what gifts may reasonably be thought by the directors to be for the financial benefit of the corporation. Cf. Evans v. Brunner, Mond & Co., 90 L . J . Ch. 294 (19 2 0 ); Armstrong Cork Co. v. H. A. Meldrum Co., 285 Fed. 58 (W . D. N . Y . 19 22). M any of the recent cases on corporate gifts involve the deductibility of the gift from income under the federal income tax act as an “ ordinary and necessary expense incurred in carrying on trade or business.” Here also the modern cases take a liberal view of what may be to the business advantage of the company. Cf. Corning Glass Works v. Lucas, 37 F .(2 d ) 798 (App. D. C. 1929) ; American Rolling M ill Co. v. Commissioner of Int. Rev., 41 F .(2d ) 3 14 (C. C. A. 6th, 19 3 0 ); Forbes Lithograph M fg. Co. v. White, 42 F .(2 d ) 287 (D. Mass. 19 30).

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i l S9

tion. As recent efforts to relieve unemployment indicate, one com­ munity may rely wholly on charitable contributions for what an­ other community may undertake with public funds. Where taxa­ tion is the method used, corporate, like individual wealth, contributes. There is a widespread feeling that it should also contribute where the voluntary method is employed. Lists of contributors to such charitable enterprises as community chests and unemployment relief funds indicate that donations by cor­ porations, even by those whose employees are unlikely to share in any great part in the funds, are becoming frequent.34 Con­ ceivably, a stockholder advantage may result thereby through the creation of good will, but the suggestion that charitable gifts in­ crease the good will of a corporation as a business enterprise as­ sumes that the public no longer whole-heartedly believes in the principle that corporations have no right to be charitable. The view that directors may within limits properly use corporate funds to support charities which are important to the welfare of the community in which the corporation does business probably comes much nearer representing the attitude of public opinion and the present corporate practice than does the traditional language of courts and lawyers. Nor are there wanting signs of the adoption of a more liberal attitude by legislatures35 and judges.36 Such a view is difficult to justify if we insist on thinking of the business corporation as merely an aggregate of stockholders with 34 For example, the N ew Y o rk Telephone Company is said to have spent $2 33 ,000 for charity during the past three years, including $130,000 for unemployment relief. The N ew Y o rk Public Service Commission has recently ruled that such contributions must be charged against surplus and not to operating expenses.

See

(19 3 2 ) 70 N e w R e p u b l ic 219. 35 Cf. Tex. Acts 19 17, c. 15, §§ 1, 3 ; construed in Jam es M cCord Co. v. Citizens’ Hotel Co., 287 S. W . 906 (Tex. Civ. App. 1926) ; N . Y . Law s 19 3 1, Supp. c. 24, § 33-

36 “ Again, we see no reason why if a railroad company desires to foster, en­ courage and contribute to a charitable enterprise, or to one designed for the public weal and welfare, it may not do so. Maitland, in ‘ Collected Essays/ says: ‘ If the law allows men to form permanently organized groups, those groups will be, for common opinion, right-and-duty bearing units; and if the lawgiver will not openly treat them as such he will misrepresent, or, as the French say, he will “ denature ” the facts: in other words, he will make a mess and call it law .’ We see no reason why a railroad corporation may not, to a reasonable extent, donate funds or serv­ ices to aid in good works.” Per Letton, J ., in State ex rel. Sorensen v. Chicago, B. & Q. R . R., 112 Neb. 248, 255-56 , 199 N . W . 534, 537 (19 2 4 ).

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directors and officers chosen by them as their trustees or agents. It is not for a trustee to be public-spirited with his beneficiary’s property. But we are not bound to treat the corporation as a mere aggregate of stockholders. The traditional view of our law is that a corporation is a distinct legal entity. Unfortunately, its entity character has been thought of as something conferred upon it by the state which, by a mysterious rite called incorporation, magically produces “ e pluribus unum.” The present vogue of legal realism breeds dissatisfaction with such legal mysteries and leads to insistence on viewing the corporation as it really is. So viewing it we may, as many do, insist that it is a mere aggregate of stockholders; but there is another way of regarding it which has distinguished adherents. According to this concept any or­ ganized group, particularly if its organization is of a permanent character, is a factual unit, “ a body which from no fiction of law but from the very nature of things differs from the individuals of whom it is constituted.” 37 If the unity of the corporate body is real, then there is reality and not simply legal fiction in the proposition that the managers of the unit are fiduciaries for it and not merely for its individual members, that they are, in Mr. Young’s phrase, trustees for an institution rather than attorneys for the stockholders. As previ­ ously stated, this entity approach will not substantially affect our results if we insist that the sole function for the entity is to seek maximum stockholder profit. But need we so assume? We have seen that the law has already reached the point, par­ ticularly in the public utility field, where it compels business enter­ prises to recognize to some extent the interests of other persons besides their owners. We have seen further that the same trend of public opinion which may in some cases compel such recogni­ tion may in other cases encourage and approve it without com­ pelling it. A sense of social responsibility toward employees, con­ sumers, and the general public may thus come to be regarded as the appropriate attitude to be adopted by those who are engaged in business, with the result that those who own their own busi37 D i c e y , L a w a n d P u b l i c O p in io n i n E n g l a n d (3d ed. 1920) 165.

C f. Laski, See also United Mine Workers v. Coronado Coal Co., 259 U. S. 344 ( 1 9 2 2 ) ; Taff Vale R y . v. Amalgamated Soc. of R y . Serva-nts, [19 0 1] A. C. 426. The Personality o f Associations (19 16 ) 29 H a r v . L . R e v . 404.

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nesses and are free to do what they like may increasingly adopt such an attitude. Business ethics may thus tend to become in some degree those of a profession rather than of a trade. Such a development of business ethics which goes beyond the requirements of law and beyond the dictates of enlightened selfinterest is impossible in these days when most business is incor­ porated unless it can touch incorporated business enterprises as well as those conducted by individual owners. As a practical matter, this can happen only if the managers of such corporations have some degree of legal freedom to act upon such an attitude without waiting for the unanimous consent of the stockholders. That the duty of the managers is to employ the funds of the corporate institution which they manage solely for the purposes of their institution is indisputable. That that purpose, both factually and legally, is maximum stockholder profit has commonly been assumed by lawyers. That such is factually the purpose of the stockholders in creating the association may be granted. Nevertheless, the association, once it becomes a going concern, takes its place in a business world with certain ethical standards which appear to be developing in the direction of increased social responsibility. If we think of it as an institution which differs in the nature of things from the individuals who compose it, we may then readily conceive of it as a person, which, like other persons engaged in business, is affected not only by the laws which regulate business but by the attitude of public and business opinion as to the social obligations of business. If business is tending to be­ come a profession, then a corporate person engaged in business is a professional even though its stockholders, who take no active part in the conduct of the business, may not be. Those through whom it acts may therefore employ its funds in a manner appropri­ ate to a person practising a profession and imbued with a sense of social responsibility without thereby being guilty of a breach of trust. It may well be that any substantial assumption of social respon­ sibility by incorporated business through voluntary action on the part of its managers can not reasonably be expected. Experience may indicate that corporate managers are so closely identified with profit-seeking capital that we must look to other agencies to safe­ guard the other interests involved, or that the competition of the

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socially irresponsible makes it impracticable for the more publicspirited managers to act as they would like to do, or that to expect managers to conduct an institution for the combined benefit of classes whose interests are largely conflicting is to impose upon them an impossible task and to endow them with dangerous powers. The question with which this article is concerned is not whether the voluntary acceptance of social responsibility by cor­ porate managers is workable, but whether experiments in that direction run counter to fundamental principles of the law of business corporations. The view that they do so rests upon two assumptions: that business is private property, and that the directors of an incor­ porated business are fiduciaries (directly if we disregard the cor­ porate fiction, indirectly in any case) for the stockholder-owners. The first assumption is being rapidly undermined, so rapidly that decisions like those in Tyson v. Banton 38 and Adkins v. Children’s H ospital 39 can hardly long survive. Business — which is the economic organization of society — is private property only in a qualified sense, and society may properly demand that it be car­ ried on in such a way as to safeguard the interests of those who deal with it either as employees or consumers even if the pro­ prietary rights of its owners are thereby curtailed. The legal recognition that there are other interests than those of the stockholders to be protected does not, as we have seen, necessarily give corporate managers the right to consider those interests, as it is possible to regard the managers as representatives of the stockholding interest only. Such a view means in practice that there are no human beings who are in a position where they can lawfully accept for incorporated business those social re­ sponsibilities which public opinion is coming to expect, and that these responsibilities must be imposed on corporations by legal compulsion. This makes the situation of incorporated business so anomalous that we are justified in demanding clear proof that it is a correct statement of the legal situation. Clear proof is not forthcoming. Despite many attempts to dis­ solve the corporation into an aggregate of stockholders, our legal tradition is rather in favor of treating it as an institution directed 38 273 XJ. S. 4 18 (19 2 7 ).

39 261 U . S. 525 ( i 9 23 >-

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116 3

by persons who are primarily fiduciaries for the institution rather than for its members. That lawyers have commonly assumed that the managers must conduct the institution with single-minded devotion to stockholder profit is true; but the assumption is based upon a particular view of the nature of the institution which we call a business corporation, which concept is in turn based upon a par­ ticular view of the nature of business as a purely private enter­ prise. If we recognize that the attitude of law and public opinion toward business is changing, we may then properly modify our ideas as to the nature of such a business institution as the corpora­ tion and hence as to the considerations which may properly in­ fluence the conduct of those who direct its activities. E. Merrick Dodd, Jr. H arvard L a w S c h o o l .

[3] The End of History for Corporate Law H en ry Ha n sm an n *

and

R e in ie r K r a a k m a n * *

I n t r o d u c t io n

Much recent scholarship has emphasized institutional differences in corporate governance, capital markets, and law among European, American, and Japanese companies.1 Despite very real differences in the corporate systems, the deeper tendency is toward convergence, as it has been since the nineteenth century. The basic law of corporate governance—indeed, most of corporate law—has achieved a high degree of uniformity across developed market jurisdictions, and continu­ ing convergence toward a single, standard model is likely. The core legal features of the corporate form were already well established in advanced jurisdictions one hundred years ago, at the turn of the twentieth century. Although there remained considerable room for variation in governance prac­ tices and in the fine structure of corporate law throughout the twentieth century, the pressures for further convergence are now rapidly growing. Chief among these pressures is the recent dominance of a shareholder-centered ideology of corporate law among the business, government, and legal elites in key commer­ cial jurisdictions. There is no longer any serious competitor to the view that corporate law should principally strive to increase long-term shareholder value. This emergent consensus has already profoundly affected corporate governance practices throughout the world. It is only a matter of time before its influence is felt in the reform of corporate law as well. I. C o n v e r g e n c e P a s t : T h e R i s e

of the

C o rpo rate F orm

We must begin with the recognition that the law of business corporations had already achieved a remarkable degree of worldwide convergence at the end of the nineteenth century. By that time, large-scale business enterprise in every major commercial jurisdiction had come to be organized in the corporate form, and the core functional features of that form were essentially identical across these jurisdictions. Those features, which continue to characterize the corporate form today, are: ( 1 ) full legal personality, including well-defined authority to * Professor, Yale Law School. ** Professor, Harvard Law School, I. See, e.g., Bernard S. Black & John C. Coffee, Jr., Hail Britannia?: Institutional Investor Behavior Under Limited Regulation, 92 M ich. L. Rev. 1997 (1994); Ronald J. Gilson & Mark J. Roe, Understand­ ing the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organization, 102 Y a le L.J. 871 (1993); Mark J. Roe, Some Differences in Company Structure in Germany, Japan, and the United States, 102 Y a le L.J. 1927 (1993).

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bind the firm to contracts and to bond those contracts with assets that are the property of the firm, as distinct from the firm’s owners;2 (2 ) limited liability for owners and managers; (3) shared ownership by investors of capital; (4) del­ egated management under a board structure; and (5) transferable shares. These core characteristics, both individually and in combination, offer impor­ tant efficiencies in organizing the large firms with multiple owners that have come to dominate developed market economies. We explore those efficiencies in detail elsewhere.3 What is important to note here is that while those character­ istics and their associated efficiencies are now commonly taken for granted, prior to the beginning of the nineteenth century there existed only a handful of specially chartered companies that combined all five of these characteristics. The joint stock company with tradeable shares was not made generally available for business activities in England until 1844, and limited liability was not added to the form until 1855.4 While some American states developed the form for general use a few years earlier, all general business corporation statutes appear to date from well after 1800. By around 1900, however, every major commer­ cial jurisdiction appears to have provided for at least one standard-form legal entity with the five characteristics listed above as the default rules, and this bas remained the case ever since. Thus there was already strong and rapid conver­ gence a century ago regarding the basic elements of the law of business corporations. It is, in general, only in the more detailed structure of corporate law that jurisdictions have varied significantly since then. The five basic characteristics of the corporate form provide, by their nature, for a firm that is strongly responsive to shareholder interests. They do not, however, necessarily dictate how the interests of other participants in the firm—such as employees, creditors, other suppliers, customers, or society at large—will be accommodated. Nor do they dictate the way in which conflicts of interest among shareholders themselves—and particularly between controlling and noncontrolling shareholders—will be resolved. Throughout most of the twentieth century there has been debate over these issues and experimentation with alternative approaches to them. II.

T h e S h a r e h o ld e r -O r ie n te d (o r “ S ta n d a r d ” ) M o d e l

Recent years, however, have brought strong evidence of a growing consensus on these issues among the academic, business, and governmental elites in leading jurisdictions. The principal elements of this emerging consensus are that ultimate control over the corporation should rest with the shareholder class; the

2. See Henry Hansmann & Reinier Kraakman, The Essential Role o f Organizational Law, Y a le L.J. (forthcoming 2000). 3. See H e n ry H an sm an n , T h e O w n ersh ip o f E n te rp ris e (1996); Henry Hansmann & Reinier Kraakman, What Is Corporate Law?, in T h e A n ato m y o f C o rp o ra te Law : A C o m p a ra tiv e a n d F u n c tio n a l A p p ro ach (Reinier Kraakman et al. eds., forthcoming 2001). 4. See P hillip B lumberg , T he L aw of C orporate G roups: S ubstantive L aw 9-20 (1988).

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managers of the corporation should be charged with the obligation to manage the corporation in the interests of its shareholders; other corporate constituen­ cies, such as creditors, employees, suppliers, and customers, should have their interests protected by contractual and regulatory means rather than through participation in corporate governance; noncontrolling shareholders should re­ ceive strong protection from exploitation at the hands of controlling sharehold­ ers; and the market value of the publicly traded corporation’s shares is the principal measure of its shareholders’ interests. For simplicity, we shall refer to the view of the corporation comprised by these elements as the “standard shareholder-oriented model” of the corporate form (or, for brevity, simply “the standard model”). To the extent that corporate law bears on the implementation of this standard model—as to an important degree it does— this consensus on the appropriate conduct of corporate affairs is also a consensus as to the appropriate content of corporate law, and it is likely to have profound effects on the structure of that law. A. IN WHOSE INTEREST?

As we argue in Part IV, there is today a broad normative consensus that shareholders alone are the parties to whom corporate managers should be accountable, resulting from widespread disenchantment with a privileged role for managers, employees, or the state in corporate affairs. This is not to say that there is agreement that corporations should be run in the interests of sharehold­ ers alone—much less that the law should sanction that result. All thoughtful people believe that corporate enterprise should be organized and operated to serve the interests of society as a whole, and that the interests of shareholders deserve no greater weight in this social calculus than do the interests of any other members of society. The point is simply that now, as a consequence of both logic and experience, there is convergence on a consensus that the best means to this end (that is, the pursuit of aggregate social welfare) is to make corporate managers strongly accountable to shareholder interests and, at least in direct terms, only to those interests. It follows that even the extreme proponents of the so-called “concession theory” of the corporation can embrace the primacy of shareholder interests in good conscience .5

5 . In a hoary debate that cuts across jurisdictional boundaries, proponents of the view that corpora­ tions exist by virtue of a state “concession” or privilege have also been associated with the view that corporations ought to be governed in the interests of society— or all corporate constituencies— rather than in the private interest of shareholders alone. See, e.g., E. Merrick Dodd, Jr., For Whom Are Corporate Managers Trustees?, 45 H arv . L. Rev. 1145, 1148-50 ( 1932); P a u l G. M ahoney, C o n t r a c t o r C o n cessio n ? A H is to r ic a l P ersp ectiv e on B usiness C o rp o ra tio n s (University of Virginia School of Law, Working Paper, 1999) (on file with author). Conversely, proponents of the view that the corporation is at bottom a contract among investors have tended to advance the primacy of shareholder interests in corporate governance. In our view the traditional debate between concession and contract theorists is simply confused. On the one hand, corporations— whether “concessions” or contracts— should be regulated when it is in the

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Of course, asserting the primacy of shareholder interests in corporate law does not imply that the interests of corporate stakeholders must or should go unprotected. It merely indicates that the most efficacious legal mechanisms for protecting the interests of nonshareholder constituencies—or at least all constitu­ encies other than creditors—lie outside of corporate law. For workers, this includes the law of lahor contracting, pension law, health and safety law, and antidiscrimination law. For consumers, it includes product safety regulation, warranty law, tort law governing product liability, antitrust law, and mandatory disclosure of product contents and characteristics. For the public at large, it includes environmental law and the law of nuisance and mass torts. Creditors, to he sure, are to some degree an exception. There remains general agreement that corporate law should directly regulate some aspects of the relationship between a business corporation and its creditors. Conspicuous examples include rules governing veil-piercing and limits on the distribution of dividends in the presence of inadequate capital. The reason for these rules, however, is that there are unique problems of creditor contracting that are integral to the corporate form, owing principally to the presence of limited liahility as a structural characteristic of that form. These types of rules, however, are modest in scope. Outside of bankruptcy, they do not involve creditors in corporate governance, but rather are confined to limiting shareholders’ ability to use the characteristics of the corporate form opportunistically to exploit credi­ tors. B. WHICH SHAREHOLDERS?

The shareholder-oriented model does more than assert the primacy of share­ holder interests, however. It asserts the interests of all shareholders, including minority shareholders. More particularly, it is a central tenet in the standard model that minority or noncontrolling shareholders should receive strong protec­ tion from exploitation at the hands of controlling shareholders. In publicly traded firms, this means that all shareholders should be assured an essentially equal claim on corporate earnings and assets. There are two conspicuous reasons for this approach, both of which are rooted in efficiency concerns. One reason is that, absent credible protection for noncontrolling shareholders, business corporations will have difficulty raising capital from the equity markets. The second reason is that the devices by which controlling shareholders divert to themselves a disproportionate share of corpo­ rate benefits commonly involve inefficient investment choices and management policies.

public interest to do so. On the other hand, the standard model is, in effect, an assertion that social welfare is best served by encouraging corporate managers to pursue shareholder interests.

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C. THE IMPORT OF OWNERSHIP STRUCTURE

It is sometimes said that the shareholder-oriented model of corporate law is well suited only to those jurisdictions in which one finds large numbers of firms with widely dispersed share ownership, such as the United States and the United Kingdom. A different model is appropriate, it is said, for those jurisdictions in which ownership is more concentrated, such as the nations of continental Europe. This view, however, is unconvincing. Closely held corporations, like publicly held corporations, operate most efficiently when the law helps assure that managers are primarily responsive to shareholder interests and that controlling shareholders do not opportunistically exploit noncontrolling shareholders. The shareholder primacy model does not logically privilege any particular ownership structure. Indeed, both concentrated and dispersed shareholdings have been celebrated, at different times and by different commentators, for their ability to advance shareholder interests in the face of serious agency problems. Equally important, every jurisdiction includes a range of corporate ownership structures. While both the U.S. and U.K. have many large firms with dispersed ownership, both countries also contain a far larger number of corporations that are closely held. Similarly, every major continental European jurisdiction has at least a handful of firms with dispersed ownership, and the number of such firms is evidently growing. It follows that every jurisdiction must have a system of corporate law that is adequate to handle the full range of ownership structures. Thus, just as there was rapid crystallization of the core features of the corporate form in the late nineteenth century, at the beginning of the twenty-first century we are witnessing rapid convergence on the standard shareholderoriented model as a normative view of corporate structure and governance. We should also expect this normative convergence to produce substantial conver­ gence in the practices of corporate governance and in corporate law. III. F o r c e s

of

Id e o l o g i c a l C

o nvergen ce

There are three principal factors driving consensus on the standard model: the failure of alternative models; the competitive pressures of global commerce; and the shift of interest group influence in favor of an emerging shareholder class. We consider these developments here in sequence. A. THE FAILURE OF ALTERNATIVE MODELS

Debate and experimentation concerning the basic structure of corporate law during the twentieth century centered on the ways in which that law should accommodate the interests of nonshareholder constituencies. In this regard, three principal alternatives to a shareholder-oriented model were the traditional foci of attention. We term these the manager-oriented, labor-oriented, and state-oriented models of corporate law. Although each of these three alternative models has, at various points and in various jurisdictions, achieved some

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success both in practice and in received opinion, all three have ultimately lost much of their normative appeal. 1. The Manager-Oriented Model In the United States, there existed an important strain of normative thought from the 1930s through the 1960s that extolled the virtues of granting substan­ tial discretion to the managers of large business corporations. Merrick Dodd and John Kenneth Galbraith, for example, were conspicuously identified with this position, and Adolph Berle came to it late in life .6 At the core of this view was the belief that professional corporate managers could serve as disinterested technocratic fiduciaries who would guide business corporations to perform in ways that would serve the general public interest. The corporate social responsi­ bility literature of the 1950s can be seen as an embodiment of these views.7 The normative appeal of this view arguably provided part of the rationale for the various legal developments in U.S. law in the 1950s and 1960s that tended to reinforce the discretionary authority of corporate managers, such as the SEC proxy rules and the Williams Act. The collapse of the conglomerate movement in the 1970s and 1980s, however, largely destroyed the normative appeal of the managerialist model. It is now the conventional wisdom that, when managers are given great discretion over corporate investment policies, they tend to serve disproportionately their own interests, however well-intentioned managers may be. While managerial firms may be in some ways more efficiently responsive to nonshareholder interests than are firms that are more dedicated to serving their shareholders, the price paid in inefficiency of operations and excessive invest­ ment in low-value projects is now considered too great. 2. The Labor-Oriented Model Large-scale enterprise clearly presents problems of labor contracting. Simple contracts and the basic doctrines of contract law are inadequate in themselves to govern the long-term relationships between workers and the firms that employ them—relationships that may be afflicted by, among other things, substantial transaction-specific investments and asymmetries of information.

6. D odd and B erle co nducted a classic debate on the subject in the 1930s, in w hich D odd pressed the social responsibility o f co rporate m anagers w hile B erle c ham pioned shareholder interests. See A dolph A. B erle, Corporate Powers as Powers in Trust, 44 H a rv . L. Rev. 1049, 1049 (1931); A dolph A. B erle, For Whom Corporate Managers Are Trustees: A Note, 45 H a rv . L. Rev. 1365, 1367-68 ( 1932); D odd, supra note 5, at 1145. By the 1950s, B erle seem ed to have com e around to Dodd’s celebration o f m anagerial discretion as a p o sitiv e virtue th at perm its m anagers to act in the interests o f society as a w hole. See A d o lp h A. B e r le , J r., P o w e r W ith o u t P ro p e r ty ; A New D evelopm ent in A m erican P o li tic a l E conom y 107-10 (1959) [hereinafter B e r le , P o w e r W ith o u t P ro p e rty !. John Kenneth G albraith takes a sim ilar p o sitio n in The New Industrial State. See J o h n K e n n eth G a lb ra ith , T he New I n d u s tr ia l S ta te ( 1967). 7. See, e.g., B e r le , P o w e r W ith o u t P ro p e rty , supra note 6; G a lb ra ith , supra note 6. For an important collection of essays arguing both sides of the question of managerial responsibility to the broader interests of society, see T h e C o rp o ra tio n in M o d e rn S o c ie ty (Edward Mason ed., 1959).

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Collective bargaining via organized unions has been one approach to those problems—an approach that lies outside corporate law, since it is not dependent on the organizational structure of the firms with which the employees bargain. Another approach, and one that importantly involves corporate law, has been to involve employees directly in corporate governance by, for example, providing for employee representation on the firm’s board of directors. Although serious attention was given to employee participation in corporate governance in Ger­ many as early as the Weimar Republic, unionism was the dominant approach everywhere until the Second World War. Then, after the War, serious experimen­ tation with employee participation in corporate governance began in Europe. The results of this experimentation are most conspicuous in Germany, where, under legislation initially adopted for the coal and steel industries in 1951 and extended by stages to the rest of German industry between 1952 and 1976, employees are entitled to elect half of the members of the (upper-tier) board of directors in all large German firms. This German form of “codetermination” has been the most far-reaching experiment with employee participation. It is not unique, however. A number of other European countries have experimented in more modest ways, typically requiring between one and three labor representa­ tives on the boards of large corporations. Moreover, the Dutch have adopted a wholly unique model for larger domestic companies that combines elements of the manager-, labor-, and state-oriented models. Under the Dutch “structure” regime, supervisory boards are self-appointing, although both labor and share­ holders retain the right to object to the board appointments. In the event of an objection, the commercial court decides. Enthusiasm for employee participation crested in the 1970s with the radical expansion of codetermination in Germany and the drafting of the European Community’s proposed Fifth Directive on Company Law,8 under which Germanstyle codetermination would be extended throughout Europe. Employee partici­ pation also attracted considerable attention in the United States during that period, as adversarial unionism began to lose its appeal as a means of dealing with problems of labor contracting and, in fact, began to disappear from the industrial scene. Since then, worker participation in corporate governance has steadily lost power as a normative ideal. Despite repeated dilution, Europe’s Fifth Directive has never become law, and it now seems highly unlikely that German-style codetermination will ever be adopted elsewhere. The growing view today is that meaningful direct worker voting participation in corporate affairs tends to produce inefficient decisions, paralysis, or weak boards, and that these costs are likely to exceed any potential benefits that worker participation might bring. The problem, at root, seems to be one of governance. While direct employee participation in corporate decisionmaking

8. Amended Proposal for a Fifth Directive Founded on Article 54(3)(G) of the Treaty Concerning the Structure of Public Limited Companies and the Powers and Obligations of their Organs, 1983 O.J. (C 240) 2.

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may mitigate some of the inefficiencies that can beset labor contracting, the workforce in typical firms is too heterogeneous in its interests to form an effective governing body—and the problems are magnified greatly when employ­ ees must share governance with investors, as in codetermined firms. In general, contractual devices, whatever their weaknesses, are (when supplemented by appropriate labor market regulation) evidently superior to voting and other collective choice mechanisms in resolving conflicts of interest among and between a corporation’s investors and employees.9 Today, even inside Germany, few commentators argue for codetermination as a general model for corporate law in other jurisdictions. Rather, codetermination now tends to be defended in Germany as, at most, a workable adaptation to local interests and circumstances or, even more modestly, an experiment that, though of questionable value, would now be politically difficult to undo .10 3. The State-Oriented Model Both before and after the Second World War, there was widespread support for a corporatist system in which the government would play a strong direct role in the affairs of large business firms to provide some assurance that private enterprise would serve the public interest. Technocratic government bureau­ crats, the theory went, would help to avoid the deficiencies of the market through the direct exercise of influence in corporate affairs. This approach was most extensively realized in postwar France and Japan. In the United States, though there was little actual experimentation with this approach outside of the defense industries, the model attracted considerable intellectual attention. Per­ haps the most influential exposition of the state-oriented model in the AngloAmerican world was Andrew Shonfield’s 1968 book, M odem Capitalism, with its admiring description of French and Japanese style “indicative planning .” 11 The strong performance of the Japanese economy, and subsequently of other state-guided Asian economies, lent substantial credibility to this model even through the 1980s. The principal instruments of state control over corporate affairs in corporatist economies generally lie outside of corporate law. They include, for example,

9 . See H an sm an n , supra note 3, at 89- 119; H enry H ansm ann, Probleme von Kollektiventscheidungen und Theorie der Firma—Folgerungen fu r die Arbeitnehmermitbestimmung, in O konom ische A n a ly se d e s U n te rn e h m e n sre c h ts

287-305 (C laus O tt & H ans-B em d S chafer eds., 1993); H enry H ansm ann,

Worker Participation and Corporate Governance, 43 U. T o r o n to L.J. 589, 589-606 (1993). O n the w eaknesses o f G erm an boards, see, fo r exam ple, M ark R oe, German Securities Markets and German Codetermination, 1998 C olum . B us. L. Rev. 167. 10. Some commentators, of course, continue to see codetermination as a core element of a unique Northern European form of corporate governance. See, e.g., M ic h e l A lb e r t, C ap italism vs. C apitalism ( 1993) (asserting generally the superiority of the “ Rhine Model” of capitalism over the “ Anglo-Saxon Model”)- Even Albert concedes, however, the growing ideological power of shareholder-oriented corporate governance. See id. at 169-90. 11. A n d re w S h o n field , M o d e rn C ap italism : T h e C han g in g B a la n c e o f P u b lic a n d P r iv a te P o w er

84-85 (1968).

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substantial discretion in the hands of government bureaucrats over the alloca­ tion of credit, foreign exchange, licenses, and exemptions from anticompetition rules. Nevertheless, corporate law also plays a role by, for example, weakening shareholder control over corporate managers (to reduce pressures on managers that might operate counter to the preferences of the state) and employing state-administered criminal sanctions rather than shareholder-controlled civil lawsuits as the principal sanction for managerial malfeasance (to give the state strong authority over managers that could be exercised at the government’s discretion). The state-oriented model, however, has now also lost most of its attraction. One reason is the move away from state socialism in general as a popular intellectual and political model. Important landmarks on this path include the rise of Thatcherism in England in the 1970s, Mitterand’s abandonment of state ownership in France in the 1980s, and the sudden collapse of communism nearly everywhere in the 1990s. The relatively poor performance of the Japa­ nese corporate sector after 1989, together with the more recent collapse of other Asian economies that were organized on state corporatist lines, has now discred­ ited this model even further. Today, few would assert that giving the state a strong direct hand in corporate affairs has much normative appeal. 4. Stakeholder Models Over the past decade, the literature on corporate governance and corporate law has sometimes advocated “stakeholder” models as a normatively attractive alternative to a strongly shareholder-oriented view of the corporation. The stakeholders involved may be employees, creditors, customers, merchants in a firm’s local community, or even broader interest groups such as beneficiaries of a well-preserved environment. The stakeholders, it is argued, will be subject to opportunistic exploitation by the firm and its shareholders if corporate managers are accountable only to the firm’s shareholders; corporate law must therefore ensure that managers are responsive to stakeholder interests as well. While stakeholder models start with a common problem, they posit two different kinds of solutions. One group of stakeholder models looks to what we term a “fiduciary” model of the corporation, in which the board of directors functions as a neutral coordinator of the contributions and returns of all stakehold­ ers in the firm. Under this model, only investors are given direct representation on the corporate board. Other stakeholders are protected by relaxing the board’s duty or incentive to represent only the interests of shareholders, thus giving the board greater discretion to look after other stakeholders’ interests. The fiduciary model finds its most explicit recognition in U.S. law in the form of constituency statutes that permit boards to consider the interests of constituencies other than shareholders in mounting takeover defenses. Margaret Blair and Lynn Stout, sophisticated American advocates of the fiduciary model, also claim to find support for this normative model in other, broader aspects of

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U.S. corporate law .12 In the U.K., the fiduciary model is a key element in the ongoing debate over the duties of corporate directors.13 The second group of stakeholder models substitutes direct stakeholder repre­ sentatives for fiduciary directors. In this “representative” model of the corpora­ tion, two or more stakeholder constituencies appoint representatives to the board of directors, which then elaborates policies that maximize the joint welfare of all stakeholders, subject to the bargaining leverage that each group brings to the boardroom table. The board functions ideally then as a kind of collective fiduciary, even though its individual members remain partisan repre­ sentatives. The board of directors (or supervisory board) then becomes an unmediated “coalition of stakeholder groups” and functions as “an arena for cooperation with respect to the function of monitoring the management,” as well as an arena for resolving “conflicts with respect to the specific interests of different stakeholder groups .” 14 Neither the fiduciary nor the representative stakeholder models, however, constitute at bottom a new approach to the corporation. Rather, despite the new rhetoric with which the stakeholder models are presented, and the more explicit economic theorizing that sometimes accompanies them, they are at heart just variants on the older manager-oriented and labor-oriented models. Stakeholder models of the fiduciary type are in effect just reformulations of the manageroriented model, and they suffer the same weaknesses. While untethered manag­ ers may better serve the interests of some classes of stakeholders, such as a firm’s existing employees and creditors, the managers’ own interests will often come to have disproportionate prominence in their decisionmaking, with costs to some interest groups—such as shareholders, customers, and potential new employees and creditors—that outweigh any gains to the stakeholders who benefit. Moreover, the courts are evidently incapable of formulating and enforc­ ing fiduciary duties of sufficient refinement to ensure that managers behave more efficiently and fairly. Stakeholder models of the representative type closely resemble yesterday’s labor-oriented model, though generalized to extend to other stakeholders as well, and are again subject to the same weaknesses. The mandatory inclusion of 12. See Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law , 85 Va. L. Rev. 247, 2 8 7 -3 1 9 (1 9 9 9 ). 13. See C om pany L aw R efo rm S te e rin g G roup, M o d e rn C om pany L aw f o r a C om petitive E n v iro n ­ m ent: The S tr a t e g ic F ram e w o rk 39-46 (1999) (setting forth the alternatives o f m aintaining the existing d irectorial duty o f fo llo w in g enlightened shareholder interest o r reform ulating a “p luralist” duty to all m ajo r stakeholders in o rd er to encourage firm -specific investm ent). A fter com m ent and discussion, how ever, the U.K. C o m p an y L aw R eform Steering G roup has chosen to propose the shareholder prim acy norm , in acco rd an ce w ith the em erging consensus o f legal scholars and practitioners every­ w here. See C om pany L aw R eform S te e rin g G roup, M o d e rn Com pany L aw f o r a C om petitive Econom y: D ev elo p in g th e F ram e w o rk 29-31 (2000) (directors m ust act for the benefit o f “m em bers as a w hole,” that is, shareholders). 14. R ein h ard H. Sm ith & G e r a ld S p in d ler, P a th D ependence, C o rp o ra te G o v e rn a n c e a n d C om ple­ m e n ta rity — A C om m ent o n B ebchuk a n d R oe 14, (Johann W olfgang G oethe-U niversitat W orking P ap er Series: Finance and Accounting No. 27, 1999).

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any set of stakeholder representatives on the board is likely to impair corporate decisionmaking processes with costly consequences that outweigh any gains to the groups that obtain representation. Thus, the same forces that have been discrediting the older models are also undermining the stakeholder model as a viable alternative to the shareholder-oriented model. B. COMPETITIVE PRESSURES TOWARD CONVERGENCE

The shareholder-oriented model has emerged as the normative consensus not just because of the failure of the alternatives, but because important economic forces have made the virtues of that model increasingly salient. There are, broadly speaking, three ways in which a model of corporate governance can come to be recognized as superior: by force of logic , by force of example , and by force of competition . The emerging consensus in favor of the standard model has, in recent years, been driven with increasing intensity by each of these forces. We examine them here in turn. 1. The Force of Logic An important source of the success of the standard model is that, in recent years, scholars and other commentators in law, economics, and business have developed persuasive reasons, which we have already explored above, to be­ lieve that this model offers greater efficiencies than the principal alternatives. One of these reasons is that, in most circumstances, the interests of equity investors in the firm—the firm’s residual claimants— cannot adequately be protected by contract. Rather, to protect their interests, they must be given the right to control the firm. A second reason is that, if the control rights granted to the firm’s equity-holders are exclusive and strong, they will have powerful incentives to maximize the value of the firm. A third reason is that the interests of participants in the firm other than shareholders can generally be given substantial protection by contract and regulation, so that maximization of the firm’s value by its shareholders complements the interests of those other participants rather than competing with them. A fourth reason is that, even where contractual and regulatory devices offer only imperfect protection for nonshareholder interests, adapting the firm’s governance structure to make it directly responsible to those interests creates more difficulties than it solves. This reasoning is today reflected in much of the current literature on corpo­ rate finance and the economics of the firm—a literature that is becoming increasingly international. The consequence is to highlight the economic case for the shareholder-oriented model of governance. In addition, the persuasive power of the standard model has been amplified through its acceptance by a worldwide network of corporate intermediaries, including international law firms, the big five accounting firms, and the principal investment banks and consulting firms— a network whose rapidly expanding scale and scope give it exceptional influence in diffusing the standard model of shareholder-centered corporate governance.

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2. The Force of Example The second source of the success of the standard model of corporate gover­ nance is the economic performance of jurisdictions in which it predominates. A simple comparison across countries adhering to different models—at least in very recent years—lends credence to the view that adherence to the standard model promotes better economic outcomes. The developed common-law jurisdic­ tions have performed well in comparison to the principal East Asian and continental European countries, which are less in alignment with the standard model. The main examples include, of course, the strong performance of the American economy in comparison with the weaker economic performance of the German, Japanese, and French economies. One might surely object that the success of the shareholder-oriented model is quite recent and will perhaps prove to be ephemeral, and that the apparent normative consensus based on that success will be ephemeral as well. After all, only fifteen years ago many thought that Japanese and German firms, which were clearly not organized on the shareholder-oriented model, were winning the competition, and that this was because they had adopted a superior form of corporate governance.15 However, this is probably a mistaken interpretation of the nature of the economic competition in recent decades, and it is surely at odds with today’s prevailing opinion. The competition of the 1960s, ’70s, and early ’80s was in fact among Japanese state-oriented corporations, German labor-oriented corporations, and American manager-oriented corporations. It was not until the late 1980s that one could speak of widespread international competition from shareholder-oriented firms. 3. The Force of Competition The increasing internationalization of both product and financial markets has brought individual firms from jurisdictions adhering to different models into direct competition. It is now widely thought that firms organized and operated according to the shareholder-oriented model have bad the upper hand in these more direct encounters as well.16 Such firms can be expected to have important competitive advantages over firms adhering more closely to other models. These advantages include access to equity capital at lower cost (including,

15- To be fair, how ever, A m erican co m m entators tended to praise corporate governance in G erm any and Japan in the nam e o f the sh areh o ld er m odel. T hus, it w as the purported ability o f G erm an banks to m onitor m anagers and co rrectly valu e long-term business projects that caught the eye o f A m erican com m entators after the 1970s, not c o d eterm in atio n or the labor-oriented m odel o f the firm. See, e.g M ic h a e l T. Jac o b s, S h o rt-T e rm A m erica: T h e C auses a n d C u re s o f O u r B usiness M yopia 69-71 (1991). 16. Indirect evidence to this effect comes from international surveys such as a recent poll of top managers conducted by The Financial Times to determine the world’s most respected companies. Four of the top five most respected companies were American and hence operated under the shareholder model (the fifth was DaimlerChrysler, which is “almost” American for these purposes). Similarly, twenty-nine of the top forty firms were either American or British. See Annual Review, World’s Most Respected Companies, Fin. Times (L o n d o n ), Dec. 1 , 1999.

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conspicuously, start-up capital), more aggressive development of new product markets,17 stronger incentives to reorganize along lines that are managerially coherent, and more rapid ahandonment of inefficient investments. These competitive advantages do not always imply that firms governed by the standard model will displace those governed by an alternative model in the course of firm-to-firm competition, for two reasons. First, firms operating under the standard model may be no more efficient than other firms in many respects. For example, state-oriented Japanese and Korean companies have demonstrated great efficiency in the management and expansion of standardized production processes, while German and Dutch firms such as Daimler Benz and Philips (operating under labor- and management-oriented models, respectively) have been widely recognized for engineering prowess and technical innovation. Second, even when firms governed by the standard model are clearly more efficient than their nonstandard competitors, the cost-conscious standard-model firms may be forced to abandon particular markets for precisely that reason. Less efficient firms organized under alternative models may overinvest in capacity or accept abnormally low returns on their investments in general, and thereby come to dominate a product market by underpricing their profitmaximizing competitors. But if the competitive advantages of standard-model firms do not necessarily force the displacement of nonstandard firms in estab­ lished markets, these standard-model firms are likely, for the reasons offered above, to achieve a disproportionate share among start-up firms, in new product markets, and in industries that are in the process of rapid change .18 The ability of standard-model firms to expand rapidly in growth industries is magnified, moreover, by access to institutional investors and the international equity markets, which understandably prefer shareholder-oriented governance and are influential advocates of the standard model. Those equity investors, after all, are exclusively interested in maximizing the financial returns on their investments. Over time, then, the standard model is likely to win the competi­ tive struggle on the margins, confining other governance models to older firms and mature product markets. As the pace of technological change continues to quicken, this competitive advantage should continue to increase. C. THE RISE OF THE SHAREHOLDER CLASS

In tandem with the competitive forces just described, a final source of ideological convergence on the standard model is a fundamental realignment of 17. See, e.g., R om an F ry d m an e t a l., W hy O w nership M a tt e r s ? E n tre p re n e u rsh ip a n d th e R e s tr u c tu r in g o f E n te rp ris e s in C e n t r a l E u ro p e (1998) (asserting that firms privatized to outside owners proved superior to state firms and firms privatized to workers or previous managers in new market development). 18. In this regard it should be noted that small- and medium-sized firms in every jurisdiction are organized under legal regimes consistent with the standard model. Thus, shareholders— and sharehold­ ers alone— select the members of supervisory boards in the vast majority of (smaller) German and Dutch firms. These jurisdictions impose alternative labor- or manager-oriented regimes only on a minority of comparatively large firms.

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interest group structures in developed economies. At the center of this realign­ ment is the emergence of a public shareholder class as a broad and powerful interest group in both corporate and political affairs across jurisdictions. There are two elements to this realignment. The first is the rapid expansion of the ownership of equity securities within broad segments of society, creating a coherent interest group that presents an increasingly strong countervailing force to the organized interests of managers, employees, and the state. The second is the shift in power, within this expanding shareholder class, in favor of the interests of minority and noncontrolling shareholders over those of inside or controlling shareholders. 1. The Diffusion of Equity Ownership Stock ownership is becoming more pervasive everywhere.19 No longer is it confined to a small group of wealthy citizens. In the United States, this diffusion of share ownership has been underway since the beginning of the twentieth century. In recent years, however, it has accelerated substantially. Since the Second World War, an ever-increasing number of American workers have had their savings invested in corporate equities through pension funds. Over the same period, the mutual fund industry has also expanded rapidly, becoming the repository of an ever-increasing share of nonpension savings for the population at large.20 We have begun to see parallel developments in Europe and Japan, and to some extent elsewhere, as markets for equity securities have become more developed.21 The growing wealth of developed societies is a major factor underlying these changes. Even blue-collar workers now often have sufficient personal savings to justify investment in equity securities. No longer do labor and capital constitute clearly distinct interest groups in society. Workers, through share ownership, increasingly share the economic interests of other equity-holders. Indeed, in the United States, union pension funds are today quite active in pressing the view that companies must be managed in the best interests of their shareholders.22

19. Stock market capitalization as a percentage of GDP has risen dramatically in virtually every major jurisdiction over the past 20 years. In most European countries, the increase has been by a factor of three or four. See Schools Brief: Stocks in Trade, T he E conom ist, Nov. 13, 1999, at 85-86. 20. See generally T he G lo b a l C o r p o r a te G o v e rn a n c e R e s e a rc h C e n te r, T he C o n fe re n ce B o a rd , I n s titu tio n a l In v e stm e n t R e p o rt: P a tte r n s o f I n s titu tio n a l In v e stm e n t a n d C o n tr o l in th e U n ite d S ta te s (1997). 21. Latin America offers a telling example. In 1981, Chile became the first country in the region to set up a system of private pension funds. By 1995, Argentina, Colombia, and Peru had done the same. By 1996, a total of $108 billion was under management in Latin American pension funds, which by then had come to play an important role in the development of the local equity markets. In 1997, it was estimated that total assets would grow to $ 200 billion by 2000 and to $600 billion by 2011. See A Private Affair, L a tin Fin., Dec. 1998, at 61; Stephen Fidler, Chile’s Crusader fo r the Cause, Fin. Times (London), Mar. 14, 1997, at 3; Save Amigo Save, T h e E conom ist, Dec. 9, 1995, at 15. 22. See Stewart J. Schwab & Randall S. Thomas, Realigning Corporate Governance: Shareholder Activism by Labor Unions, in Em ployee R e p re s e n ta tio n in th e Em erging W o rk p la c e: A lte r n a tiv e s / Supplem ents t o C o lle c tiv e B a rg a in in g 341 (S. Estreicher ed., 1998).

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2. The Shift in Balance Toward Public Shareholders As the example of the activist union pension funds suggests, diffusion of share ownership is only one aspect of the rise of the shareholder class. Another aspect is the new prominence of substantial institutions that have interests coincident with those of public shareholders and that are prepared to articulate and defend those interests. Institutional investors, such as pension funds and mutual funds—which are particularly prominent in the U.S. and are now rapidly growing elsewhere as well—are the most conspicuous examples of these institu­ tions. Associations of minority investors in European countries provide another example. These institutions not only give effective voice to shareholder inter­ ests, but promote in particular the interests of dispersed public shareholders rather than those of controlling shareholders or corporate insiders. The result is that ownership of equity among the public at large, while broader than ever, is at the same time gaining more effective voice in corporate affairs. Morever, the new activist shareholder-oriented institutions are today acting increasingly on an international scale. As a consequence, their influence now reaches well beyond their home jurisdictions .23 We now have not only a common ideology supporting shareholder-oriented corporate law, but also an organized interest group to press that ideology—an interest group that is broad, diverse, and increasingly international in its membership. In the U.S., the principal effect of the expansion and empowerment of the shareholder class has been to shift interest group power from managers to shareholders. In Europe and Japan, the more important effect has been to shift power away from workers and the state and, increasingly, away from dominant shareholders 24 D. WEAK FORCES FOR CONVERGENCE

We have spoken here of a number of forces pressing toward international convergence on a relatively uniform standard model of corporate law. Those forces include the internal logic of efficiency, competition, interest group pres­ sure, imitation, and the need for compatibility. We have largely ignored two other potential forces that might also press toward convergence: explicit efforts at cross-border harmonization, and competition among jurisdictions for corpo­ rate charters.

23. See, e.g., Greg Steinmetz & Michael R. Sesit, Rising U.S. Investment in European Equities Galvanizes Old World, W a l l St. J., Aug. 4 , 1999, at A l, A8 (describing U.S. investors as sparking important governance changes in large European companies). 24. Of particular interest are signs of change in the cross-ownership networks among major German and Japanese firms. New legislation proposed by the German government would eliminate the heavy (up to fifty percent) capital gains taxes on corporate sales of stock, which is expected to result in widespread dissolution of block holdings. See Haig Simonian, Germany to End Tax on Sale of Cross-Holdings, Fin. Times (L ondon), Dec. 24, 1999, at 1. In Japan, keiretsu structures are beginning to unwind as a result of bank mergers and competitive pressure to seek higher returns on capital. See Paul Abrahams & Gillian Tett, The Circle Is Broken, Fin. Times (L ondon), Nov. 9 , 1999, at 18.

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1. Harmonization The European Union has been the locus of the most intense efforts to date at self-conscious harmonization of corporate law across jurisdictions. That process, however, has proved a relatively weak force for convergence: Where there exists substantial divergence in corporate law across member states, efforts at harmonization have generally borne little fruit. Moreover, harmonization proposals often have been characterized by an effort to impose throughout the E.U. regulatory measures of questionable efficiency, with the result that harmonization sometimes seems more an effort to avoid the standard model than to further it. For these reasons, the other pressures toward convergence described above are likely to be much more important forces for convergence than are explicit efforts at harmonization. At most, we expect that, once the consensus for adoption of the standard model has become sufficiently strong, harmonization may serve as a convenient pretext for overriding the objections of entrenched national interest groups that resist reform of corporate law within individual states. 2. Competition for Charters The American experience of competition among state jurisdictions suggests that cross-border competition for corporate charters can be a powerful force for convergence in corporate law and, in particular, for convergence on an efficient model .25 It seems quite plausible, however, that the choice of law rules neces­ sary for this form of competition will not be adopted in most jurisdictions until substantial convergence has already taken place. We expect that the most important steps toward convergence can and will be taken with relative rapidity before explicit cross-border competition for charters is permitted in most of the world, and that the latter process will ultimately be used, at most, as a means of working out the fine details of convergence and of ongoing minor experimenta­ tion and adjustment thereafter. IV.

C o n v e rg e n c e o f G o v e rn a n c e P r a c tic e s

Thus far we have attempted to explain the sources of ideological convergence on the standard model of corporate governance. Our principal argument is on this normative level; we make the claim that no important competitors to the standard model of corporate governance remain persuasive today. This claim is consistent with significant differences among jurisdictions in corporate practice and law over the short run; ideological convergence does not necessarily mean rapid convergence in practice. There are many potential obstacles to rapid institutional convergence, even when there is general consensus on what consti­ tutes best practice. Nevertheless, we believe that the developing ideological

25. See generally R o b e r ta R om ano, T he G enius o f A m erican C o r p o r a te Law ( 1993).

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consensus on the standard model will have important implications for the convergence of practice and law over the long run. We expect that the reform of corporate governance practices will generally precede the reform of corporate law, for the simple reason that governance practice is largely a matter of private ordering that does not require legislative action. Recent events in most developed jurisdictions— and in many developing ones—bear out this prediction. Under the influence of the ideological and interest group changes discussed above, corporate governance reform has al­ ready become the watchword not only in North America but also in Europe and Japan. Corporate actors are themselves implementing structural changes to bring their firms closer to the standard model. In the U.S., these changes include appointment of larger numbers of independent directors to boards of directors, reduction in overall board size, development of powerful board committees dominated by outsiders (such as audit committees, compensation committees, and nominating committees), closer links between management compensation and the value of the firm’s equity securities, and strong communication between board members and institutional shareholders. In Europe and Japan, many of the same changes are taking place, though with a lag. Examples range from the OECD’s promulgation of new principles of corporate governance, to recent decisions by Japanese companies to reduce board sizes and include nonexecu­ tive directors (following the lead of Sony), to the rapid diffusion of stock option compensation plans for top managers in the U.K. and in the principal commer­ cial jurisdictions of continental Europe. V.

L e g a l C o n ve rg e n ce

Not surprisingly, convergence in the fine structure of corporate law proceeds more slowly than convergence in governance practices. Legal change requires legislative action. Nevertheless, we expect shareholder pressure (and the power of shareholder-oriented ideology) to force gradual legal changes, largely but not entirely in the direction of Anglo-American corporate and securities law. There are already important indications of evolutionary convergence in the realms of board structure, securities regulation, and accounting methodologies, and even in the regulation of takeovers. A. BOARD STRUCTURE

With respect to board structure, convergence has been in the direction of a legal regime that strongly favors a single-tier board that is relatively small and that contains some insiders as well as a majority of outside directors. Mandatory two-tier board structures seem a thing of the past; the weaker and less respon­ sive boards that they promote are justified principally as a complement to worker codetermination and thus share— indeed, constitute one of—the weak­ nesses of the latter institution. The declining fortunes of the two-tier board are reflected in the evolution of the European Union’s Proposed Regulation on the

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Statute for a European Company. When originally drafted in 1970, that Regula­ tion called for a mandatory two-tier board. In 1991, however, the Proposed Regulation was amended to permit member states to prescribe either a two-tier or a single-tier system. Meanwhile, on the practical side, France, which made provision for an optional two-tier board when the concept was more in vogue, has seen few of its corporations adopt the device .26 At the same time, jurisdictions that traditionally favored the opposite extreme of insider-dominated, single-tier boards have come to accept a significant complement of outside directors. In the U.S., the New York Stock Exchange listing rules have long mandated that independent directors serve on the impor­ tant audit committees of listed firms27 and, more recently, state law doctrine has created a strong role for outside directors in approving transactions where interests might be conflicted .28 In Japan, a similar evolution may be foreshad­ owed by the recent movement among Japanese companies, mentioned above, toward smaller boards and independent directors, and by the recent publication of a code of corporate governance principles advocating these reforms by a committee of leading Japanese managers 29 The result is convergence from both ends toward the middle: while two-tier boards themselves seem to be on the way out, countries with single-tier board structures are incorporating, in their regimes, one of the strengths of the typical two-tier board regime, namely the substantial role it gives to independent (outside) directors. B. DISCLOSURE AND CAPITAL MARKET REGULATION

Regulation of routine disclosure to shareholders, intended to aid in policing corporate managers, is also converging conspicuously. Without seeking to examine this complex field in detail here, we note that major jurisdictions outside of the United States are reinforcing their disclosure systems, while the U.S. has been retreating from some of the more inexplicably burdensome of its federal regulations, such as the highly restrictive proxy solicitation rules that until recently crippled communication among American institutional investors. Indeed, the subject matter of mandatory disclosure for public companies is startlingly similar across the major commercial jurisdictions today.30

26. See Lauren J. Aste, Reforming French Corporate Governance: A Return to the Two Tier Board?, 32 G eo. W ash. J. I n t ’l L. & Econ. 1, 45 (1999). 27. See N ew Y o rk S to c k E x ch an g e, N YSE L iste d Com pany M a n u a l § 303.00, available at http://www.nyse.com/listed/listed.html (last visited Nov. 1, 2000). 28. See, e.g., Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983). 29. C o rp o ra te G o v e rn a n c e Comm., C o rp o ra te G o v e rn a n c e Forum o f Japan, C o rp o ra te G o v e r­ n a n c e P rin cip les 48-50 (1998). 30. This can be seen, for example, by comparing the E.U.’s Listing Particulars Directive with the SEC ’s Form S-l for the registration of securities under the 1933 Act. If U.S. disclosure requirements remain more aggressive, one must remember that the E.U. Directives establish minimal requirements that member states can and do supplement. See John C. Coffee, Jr., The Future as History: The Prospects fo r Global Convergence in Corporate Governance and Its Implications, 93 Nw. U. L. Rev. 641, 668-72 ( 1999). See generally Amir N. Licht, International Diversity in Securities Regulation:

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Similarly, uniform accounting standards are rapidly crystallizing out of the babble of national rules and practices into two well-defined sets of international standards: the GAAP accounting rules administered by the Financial Auditing Standards Board in the U.S. and the International Accounting Standards adminis­ tered by the International Accounting Standards Committee in London. While important differences remain between the competing sets of international stan­ dards, these differences are far smaller than the variations among the national accounting methodologies that preceded GAAP and the new International Stan­ dards. The two international standards, moreover, are likely to converge further, if only because of the economic savings that would result from a single set of global accounting standards.31 c.

sh areh o ld er

SUITS

Suits initiated by shareholders against directors and managers are now being accommodated in countries that had previously rendered them ineffective. Germany recently reduced the ownership threshold that qualifies shareholders to demand legal action (to be brought by the supervisory board or special company representative) against managing directors, dropping that threshold from a ten percent equity stake to the lesser of a five percent stake or a one million deutsche Mark stake when there is suspicion of dishonesty or illegality.32 Japan, in turn, has altered its rules on posting a bond to remove disincentives for litigation. At the same time, U.S. law is moving toward the center from the other direction by beginning to rein in the country’s strong incentives for potentially opportunistic litigation. At the federal level, there are recently strengthened pleading requirements upon initiation of shareholder actions, new safe harbors for forward-looking company projections, and recent provision for lead shareholders to take control in class actions. State law rules, meanwhile, are making it easier for a corporation to get a shareholders' suit dismissed. d. takeo vers

Regulation of takeovers also seems headed for convergence. As it is, current differences in takeover regulation are more apparent than real. Hostile takeovers are rare outside the Anglo-American jurisdictions, principally owing to the more concentrated patterns of shareholdings outside those jurisdictions. As sharehold-

Roadblocks on the Way to Convergence, 20 C a rd o z o L. Rev. 227 (1998) (discussing convergence in d isclosure rules, accounting standards, and co rporate g overnance). In addition, a recent survey o f the practices o f E uropean issuers finds th at actual disclosure practices track U.S. an d U.K. disclosure standards even m ore closely than legal d isclo su re requirem ents do. See H o w e ll J a c k s o n & E ric P an , R e g u la to r y C om petition in I n te r n a tio n a l S e c u ritie s M a rk e ts : E vidence fro m E u ro p e in 1999 34-39 (John M. O lin Center fo r Law, Econ. & Bus. W orking Paper, Sept. 18, 2000). 31. See, e.g., Elizabeth MacDonald, U.S. Accounting Board Faults Global Rules, W a l l S t. J., Oct.

18, 1999, at A l. 32. See T h e o d o r B aum s, C o rp o ra te G o v e rn a n c e in G erm any: System a n d C u r r e n t D evelopm ents pt. V m .l (Universitat Osnabruck Working Paper, 1999).

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ing patterns become more homogeneous (as we expect they will), and as corporate culture everywhere becomes more accommodating of takeovers (as it seems destined to), takeovers presumably will become much more common in Europe, Japan, and elsewhere.33 Moreover, where operative legal constraints on takeovers in fact differ, they show signs of convergence. In particular, for several decades the U.S. has been increasing its regulation of takeovers, placing additional constraints both on the ability of acquirers to act opportunistically and on the ability of incumbent managers to entrench themselves or engage in self-dealing. With the widespread diffusion of the “poison pill” defense, and the accompanying limits that courts have placed on the use of that defense, partial hostile tender offers of a coercive character are a thing of the past—a result similar to that which European jurisdictions have accomplished with a “mandatory bid rule,” requiring acquir­ ers of control to purchase all shares in their target companies at a single price. To be sure, jurisdictions diverge in other aspects of takeover law where the points of convergence are still uncertain. For example, American directors enjoy far more latitude to defend against hostile takeovers than do directors in most European jurisdictions. Under current Delaware law, incumbent boards have authority to resist hostile offers, although they remain vulnerable to bids that are tied to proxy fights at shareholder meetings. As the incidence of hostile take­ overs increases in Europe, European jurisdictions may incline toward Delaware by permitting additional defensive tactics. Alternatively, given the dangers of managerial entrenchment, Delaware may move toward European norms by limiting defensive tactics more severely. While we cannot predict where the equilibrium point will lie, it is a reasonable conjecture that the law on both sides of the Atlantic will ultimately converge on a single regime. E. JUDICIAL DISCRETION

There remains one very general aspect of corporate law on which one might feel that convergence will be slow to come: the degree of judicial discretion in ex post resolution of disputes among corporate actors. Such discretion has long been much more conspicuous in the common-law jurisdictions, and particularly in the U.S., than in the civil-law jurisdictions. Even here, though, there is good reason to believe that there will be strong convergence across systems over time. Civil-law jurisdictions, whether in the form of court decisionmaking or

33. Already Europe has seen a remarkable wave of takeovers in 1999, culminating in the largest hostile takeover in bistory: Vodaphone’s acquisition of Mannesmann. In addition, many established jurisdictions are adopting rules to regulate tender offers that bear a family resemblance to the Williams Act or to the rules of the London City Code. See, for example, Brazil’s tender offer regulations, Secs. Comm’n Ruling 69, Sept. 8. 1987, Arts. 1-4 , and Italy’s recently adopted reform of takeover regulation, Legislative Decree 58 of February 24, 1998 (the Financial Markets Act or so-called “Draghi Reform” ),

cited in S tu d io L e g a le A b b atescian n i: A ssociazione P ro fe s s io n a ls di A v v o c ati e D o tto r i C om m ercialisti, The New Italian Law on Takeovers, at http://www.sla.it/takeovers.htm (last visited Nov. 1, 2000),

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arbitration, seem to be moving toward a more discretionary model.34 United States securities law is civilian in spirit and elaborated by detailed rules promulgated by the Securities Exchange Commission (SEC). At the same time, there are signs of growing discomfort with the more extreme forms of unpredict­ able ex post decisionmaking that have sometimes been characteristic of, say, the Delaware courts. Scholars have begun to suspect the open-ended texture of Delware case law ,35 while the American Law Institute has offered a code-like systemization of corporate law in the form of the Corporate Governance Project, which includes even the notoriously vague and open-ended U.S. case law that articulates the fiduciary duties of loyalty and care. VI.

P o te n tia l O b s ta c le s t o C o n v e rg e n ce

To be sure, important interests are threatened by movement toward the standard model, and those interests can be expected to serve as a brake on change. We doubt, however, that such interests will be able to stave off for long the reforms called for by the growing ideological consensus focused on the standard model. To take one example, consider the argument, prominently made by Lucian Bebchuk and Mark Roe,36 that the private value extracted by corporate control­ lers (controlling shareholders or powerful managers) will long serve as a barrier to the evolution of efficient ownership structures, governance practices, and corporate law. The essential structure of the Bebchuk and Roe argument is as follows: In jurisdictions lacking strong protection for minority shareholders, controlling shareholders divert to themselves a disproportionate share of corpo­ rate cash flows. The controlling shareholders thus have an incentive to avoid any change in their firm’s ownership or governance, or in the regulation to which their firm is subject, that would force them to share the corporation’s earnings more equitably. Moreover, these corporate insiders have the power in many jurisdictions to prevent such changes. Their position as controlling share­ holders permits them to block changes in the firm’s ownership structure merely by refusing to sell their shares. Their position also permits them to block changes in governance by selecting the firm’s directors. And, in those societies in which—as in most of Europe—closely controlled firms dominate the economy, the wealth and collective political weight of controlling shareholders permits

34. See The Holzjnuller decision of the German Federal Court, BGHZ, Zivilsenat, II ZR 174/80 (1982) (German case law extension of shareholder right to vote to all fundamental corporate transac­ tions). 35. See, e.g., Douglas M. Branson, The Chancellor’s Foot in Delaware: Schnell and Its Progeny, 14 J. C orp. L. 515 (1989); Ehud Kamar, A Regulatory Competition Theory o f Indeterminancy in Corporate Law, 98 C olum . L. Rev. 1908 ( 1998); Jonathan R. Macey & Geoffrey P Miller, Toward an InterestGroup Theory o f Delaware Corporate Law, 65 Tfex. L. Rev. 469 (1987). 36. See Lucian Bebchuk & Mark Roe, A Theory of Path Dependence in Corporate Ownership and Governance, 52 S ta n . L. Rev. 127 ( 1999).

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them to block legal reforms that would compromise their disproportionate private returns. This pessimistic view seems unwarranted, though. If, as the developing consensus view holds, the standard shareholder-oriented governance model maximizes corporate value, controlling shareholders who are motivated chiefly by economic considerations may not wish to retain control of their firms. And, even if nonmonetary considerations lead insiders to retain control, the economic significance of firms dominated by these insiders is likely to diminish over time both in their own jurisdictions and in the world market. A. TRANSACTIONS TO CAPTURE SURPLUS

First, consider the case of controlling shareholders (“controllers”) who wish to maximize their financial returns. Suppose that the prevailing legal regime permits controlling shareholders to extract large private benefits from which public shareholders are excluded. Predictably, these controllers will sell their shares only if they receive a premium price that captures the value of their private benefits, and they will reject any corporate governance reform that reduces the value of those returns. That such controllers will prefer to increase their own returns over increasing returns to the corporation does not imply, however, that they will reject governance institutions or ownership structures that maximize firm value. Bebchuk and Roe are too quick to conclude that controllers cannot themselves profit by facilitating efficient governance. Controllers who extract large private benefits from public companies are likely to indulge in two forms of inefficient management. First, they may select investment projects that maximize their own private returns over returns to the firm. For example, a controller might select a less profitable investment project over a more profitable one precisely because it offers opportunities for lucrative self-dealing. Second, controllers are likely to have a preference for retaining and reinvesting earnings over distributing them, even when it is inefficient to do so. The reason is that formal corporate distributions must be shared with minority shareholders, while earnings reinvested in the firm remain available for subse­ quent conversion into private benefits—for example, through self-dealing trans­ actions. Moreover, a controller’s incentive to engage in both forms of inefficient behavior increases markedly if—as has been common in Europe— she employs devices such as stock pyramids, corporate cross-holdings, and dual-class stock to maintain a lock on voting control while reducing her proportionate equity stake.37 Where law enforcement is effective, however, inefficient behavior itself creates strong financial incentives to pursue more efficient ownership and governance structures. When share prices are sufficiently depressed, anyone—

37. See L u c ia n B eb ch u k e t a l ., S to c k Pyram ids, C ross-O w nership, an d D u a l C la s s E quity : T he C re a tio n a n d A g e n cy C o s ts o f S e p a ra tin g C o n tr o l from C ash F lo w R ig h ts (N B E R W orking Paper No. 6951, 1999).

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including controllers themselves—can generate net gains by introducing more efficient governance structures. It follows that controllers who can capture most or all of the value of these efficiency gains stand to profit privately even more than they profit by extracting non-pro-rata benefits from poorly governed firms. Controllers can capture these efficiency gains, moreover, in at least two ways: ( 1 ) by selling out at a premium price reflecting potential efficiency gains to a buyer or group of buyers that is willing and able to operate under nonexploitative governance rules; or (2 ) by buying up minority shares (at depressed prices) and either managing their firms as sole owners or reselling their entire firms to buyers with efficient ownership structures. For controllers to extract these efficiency gains, however, efficient restructur­ ing must be legally possible: That is, the legal regime must offer means by which restructured firms can commit to good governance practices. This can be done in several ways without threatening the private returns of controllers who have not yet undertaken to restructure. One solution is an optional corporate and securities law regime tbat is more dedicated to protecting minority shareholders than the prevailing regime. For example, firms can be permitted to list their shares on foreign exchanges with more rigorous shareholder-protection rules. Another solution is simply to enforce shareholder-protective provisions that are written into a restructured firm’s articles of incorporation. It follows that even financially self-interested controllers have an incentive to promote the creation of legal regimes in which firms at least have a choice of forming along efficient lines, which, as we have argued, today means along shareholder-oriented lines. Once such an (optional) efficient regime has been established and many of the existing exploitative firms have taken advantage of the regime to profit from an efficient restructuring, there should be a serious reduction in the size of the interest group that wishes even to maintain as an option the old regime’s accommodation of firms that are exploitative toward noncontrolling shareholders. Bebchuk and Roe appear to assume that such developments will not occur because the law will inhibit controlling shareholders from seeking efficient restructuring by forcing them to share any gains from the restructuring equitably with noncontrolling shareholders. It is more plausible, however, to suppose that the law will allow controlling shareholders to claim the gains associated with an efficient restructuring—by means of techniques such as freezeout mergers and coercive tender offers—in jurisdictions where controllers are able to extract large private benefits from ordinary corporate operations. In short, if current controlling shareholders are interested just in maximizing their financial returns, we can expect substantial pressure toward the adoption of efficient law. B. CONTROLLERS WHO WISH TO BUILD EMPIRES

Controlling shareholders do not always, however, wish to maximize their financial returns. Rather—and we suspect this is often true in Europe— they may also seek nonpecuniary returns. For example, a controlling shareholder

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may wish simply to be on top of the largest corporate empire possible, and therefore be prepared to overinvest in building market share by selling at a price too low to maximize returns while reinvesting all available returns in expanded capacity and research and development. Alternatively, a controller may be willing to accept a low financial return in order to indulge a taste for a wide range of other costly practices, from putting incompetent family members in positions of responsibility to preserving quasi-feudal relations with employees and their local communities. Such practices may even be efficient if the controller values his nonpecuniary returns more than he would the monetary returns that are given up. Where the controller shares ownership with noncontrol­ ling shareholders who do not value the nonpecuniary returns, though, there is the risk that the controlling shareholder will exploit the noncontrolling sharehold­ ers by refusing to distribute the firm’s earnings and instead reinvesting those earnings in low-retum projects that are valued principally by the controller.38 Efficiency-enhancing control transactions of the type described in the preced­ ing section may have little to offer controlling shareholders of this type, since the restructuring may require that they give up control of the firm, and hence give up not only the nonpecuniary returns they were purchasing for themselves with the noncontrolling shareholders’ money, but also the nonpecuniary returns they were purchasing with their own share of the firm’s invested capital. Thus, controlling shareholders who value nonpecuniary gains will have less incentive than controllers whose motives are purely financial to favor efficient corporate legal structures. Moreover, inefficient firms with such controllers may survive quite nicely in competitive markets and, in fact, expand, despite their inefficiencies. For ex­ ample, if the controllers place value only on the size of the firm they control, they will continue to reinvest in expansion so long as the return offered simply exceeds zero, with the result that they can and will take market share from competing firms that are managed much more efficiently but must pay their shareholders a market rate of return. Jurisdictions with large numbers of firms dominated by controllers with nonpecuniary motivations will, therefore, feel relatively less pressure than other jurisdictions to adopt standard-model corporate law. Yet even in those jurisdic­ tions—which may include much of Western Europe today—the pressure for moving toward the standard model is likely to grow irresistibly strong in the relatively near future. We briefly explore here several reasons for this.

38. This can, of course, happen only where the controllers somehow have been able to mislead the noncontrolling shareholders. If the latter shareholders purchased their shares knowing that they would not have control, and that the controllers would divert a share of returns to themselves through inefficient investments, then they presumably paid a price for the shares that was discounted to reflect this diversion, leaving the noncontrolling shareholders with a market rate of return on their investment.

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1. The Insiders’ Political Clout Will Be Insufficient to Protect Them To begin with, the low profitability of firms that pursue nonpecuniary returns is likely to select against their owners as controllers of industry. As long as the owners of these firms subsidize low-productivity practices, they become progres­ sively poorer relative to investors in new businesses and owners of established firms who seek either to enhance shareholder value or to sell out to others who will, with the result that economic and political influence will shift to the latter. Furthermore, the success of firms following shareholder-oriented governance practices is likely to undermine political support for alternative models of corporate governance for two reasons. First, as we have suggested above, the rise of a shareholder class with growing wealth creates an interest group to press for reform of corporate governance to encourage value-enhancing practices and restrain controlling shareholders from extracting private benefits. Companies, whether domestic or foreign, that attract public shareholders and pension funds by promising a better bottom line also create natural enthusiasts for law reform and the standard model. The second reason for a decline in the appeal of alternative styles of corporate governance is the broader phenomenon of ideological convergence on the standard model. Where previous ideologies may have celebrated the no­ blesse oblige of quasi-feudal family firms or the industrial prowess of huge conglomerates ruled by insiders, the increasing salience of the standard model makes empire-building and domination suspect, and the extraction of private value at the expense of minority shareholders illegitimate. Costly governance practices therefore become increasingly hard to sustain politically. Viewed through the lens of the new ideology, the old practices are not only inefficient but also unjust, since they deprive ordinary citizens, including pensioners and small investors, of a fair return on their investments. As civil society grows more democratic, the privileged returns of controlling shareholders, leading families, and entrenched managers become increasingly suspect. Indeed, we expect that the social values that make it so prestigious for families to control corporate empires in many countries will change importantly in the years to come. The essentially feudal norms we now see in many patterns of industrial ownership will be displaced by social values that place greater weight on social egalitarianism and individual entrepreneurship, with the result that there will be an ever-dwindling group of firms dominated by controllers who place great weight on the nonpecuniary returns from presiding personally over a corporate fiefdom. 2. The Insiders Who Preserve Their Firms and Legal Protections Will Become Increasingly Irrelevant Finally, even if dominant corporate controllers successfully block reform for some period of time in any given jurisdiction, they are likely to become increasingly irrelevant in the domestic economy, the world economy, or both. At home, as we have already noted, the terms on which public equity capital

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becomes available to finance new firms and new product markets are likely to be dominated by the standard model. Venture capital investments and initial public offerings are unlikely to occur if minority investors are not offered significant protection. This protection can be provided without disturbing the older, established firms by establishing separate standard-model institutions that apply only to new firms. An example of this is the Neuer Markt in the Frankfurt Stock Exchange, which provides the additional protection of enhanced disclo­ sure and GAAP accounting standards for investors in start-up companies in search of equity capital, while leaving the less rigorous older rules in place for already established firms. Moreover, to the extent that domestic law or domestic firms fail to provide adequate protections for public shareholders, other jurisdictions can supply the protection of the standard model. Investment capital can flow to other countries and to foreign firms that do business in the home jurisdiction. Alternatively, domestic companies may be able to reincorporate in foreign jurisdictions or bind themselves to comply with the shareholder protections offered by foreign law by listing on a foreign exchange (as some Israeli firms now do by listing on NASDAQ).39 Through devices such as these that effectively permit new firms to adopt a model that differs from that applicable to old firms, the national law and governance practices that protect controlling insiders in established firms can be maintained without crippling the national economy. The result is to partition off, and grandfather in, the older family-controlled or manager-dominated firms, whose costly governance practices will make them increasingly irrelevant to economic activity even within their local jurisdictions. VII.

E ffic ie n t N o n -C o n v e rg e n c e

Not all divergence among corporate law regimes reflects inefficiency. Effi­ cient divergence can arise either through adaptation to local social structures or through fortuity. Neither logic nor competition is likely to create strong pressure for this form of divergence to disappear. Consequently, it could survive for a considerable period of time. Still, though the rate of change may be slower, there is good reason to believe that even the extent of efficient divergence, like the extent of inefficient divergence, will continue to decrease relatively quickly. A. DIFFERENCES IN INSTITUTIONAL CONTEXT

Sometimes jurisdictions choose alternative forms of corporate law because those alternatives complement other national differences in, for example, forms of shareholdings, means for enforcing the law, or related bodies of law such as bankruptcy. A case in point is the new Russian corporation statute, which 39. See, e.g., C offee, supra note 30, at 674-76 ; E d w a rd R ock, M a n d a to r y D is c lo s u re a s C re d ib le C ommitment: G oing P u b lic, O pting in, O p tin g O u t, a n d G lo b a liz a tio n (U niversity o f P ennsylvania Institute for Law and E conom ics Working Paper, 1998).

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deviates self-consciously from the type of statute that the standard model would call for in more developed economies. To take just one example, the Russian statute imposes cumulative voting on all corporations as a mandatory rule, in strong contrast to the corporate law of most developed countries. The reason for this approach was largely to ensure some degree of shareholder influence and access to information in the context of the peculiar pattern of shareholdings that has become commonplace in Russia as a result of that country’s unique process of mass privatization .40 Nevertheless, the efficient degree of divergence in corporate law appears much smaller than the divergence in the other institutions in which corporate activity is embedded. For example, efficient divergence in creditor protection devices is probably much narrower than observed differences in the sources and structure of corporate credit. Similarly, the efficient array of mechanisms for protecting shareholders from managerial opportunism appears much narrower than the observed variety across jurisdictions in patterns of shareholdings. Moreover, the economic institutions and legal structures in which corporate law must operate are themselves becoming more uniform across jurisdictions. This is conspicuously true, for example, of patterns of shareholdings. All countries are beginning to face, or need to face, the same varied types of shareholders, from controlling blockholders to mutual funds to highly dispersed individual shareholders. Some of this is driven by the converging forces of internal economic development. Thus, privatization of enterprise, increases in personal wealth, and the need for start-up finance (which is aided by a public market that offers an exit for the initial private investors) all promote an increasing incidence of small shareholdings and a consequent need for strong protection for minority shareholders. The globalization of capital markets presses to the same end. Hence Russia, to return to our earlier example, will presumably evolve over time toward the patterns of shareholdings typical of developed economies, and it will ultimately feel the need to conform its shareholder voting rules more closely to the rules found in those economies. B. HARMLESS MUTATIONS

In various cases we anticipate that there will be little or no efficiency difference among multiple alternative corporate law rules. In these cases, the pressures for convergence are lessened, although not entirely eliminated (since we still expect global investors to exert pressure to standardize).41 Accounting

40. Following Russian voucher privatization in 1993, managers and other employees typically held a majority of shares in large companies. Publicly held shares were mostly widely dispersed, but there was often at least one substantial outside shareholder with sufficient holdings to exploit a cumulative voting rule to obtain board representation. See Bernard Black & Reinier Kraakman, A Self-Enforcing Model of Corporate Law , 109 H a rv . L. Rev. 1911, 1922-23 ( 1996). 41. Ronald Gilson refers to processes in which facially different governance structures or legal rules develop to solve the same underlying functional problem as “functional convergence.” R o n a ld J. G ilso n , G lo b a liz in g C o rp o ra te G o v e rn a n ce : C o n v e rg e n c e o f Form o r F u n c tio n (Columbia Law

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standards offer an example. As we noted earlier, there are currently two different accounting methodologies that have achieved prominence among devel­ oped nations: the American GAAP and the European-inspired International Accounting Standards. Because these two sets of standards evolved separately, they differ in many significant details. From the best current evidence, however, neither obviously dominates the other in terms of efficiency. If the economies involved were entirely autarchic, both accounting standards might well survive indefinitely with no sacrifice in efficiency. The increasing globalization of the capital markets, however, imposes strong pressure on all countries not only to adopt one or the other of these regimes but also to select a single common accounting regime. Over time, then, the network efficiencies of a common standard form in global markets are likely to eliminate even this and other forms of fortuitous divergence in corporate law. VIII.

I n e ff ic ie n t C o n v e r g e n c e

Having just recognized that efficiency does not always dictate convergence in corporate law, we must also recognize that the reverse can be true as well: A high degree of convergence need not always reflect efficiency. The most likely sources of such inefficient convergence are flaws in markets or in political institutions that are widely shared by modem economies and that are reinforced rather than mitigated by cross-border competition. A. THIRD-PARTY COSTS: CORPORATE TORTS

Perhaps the most conspicuous example of inefficient convergence is the rule— already universal, with only minor variations from one jurisdiction to the next— that limits shareholder liability for corporate torts. This rule induces inefficient risk-taking and excessive levels of risky activities— inefficiencies that appear to outweigh by far any offsetting benefits, such as reduced costs of litigation or the smoother functioning of the securities markets. As we have argued elsewhere, a general rule of unlimited pro rata shareholder liability for corporate torts appears to offer far greater overall efficiencies.42 Why, then, has there been universal convergence on an inefficient rule? The obvious answer is that neither markets nor politics works well to represent the

School, Center for Law and Economics Working Paper No. 174, 2000). On the assumption that formal law and governance practices are embedded in larger institutional contexts that change only slowly, Gilson conjectures that functional convergence is likely to outpace formal convergence. Such functional convergence, when it occurs, is what we term harmless mutation. In contrast to Gilson, however, we believe that formal law and governance structures are less contextual and more malleable than is often assumed, once the norm of shareholder primacy is accepted. Functional convergence— rather than straightforward imitation— is thus less necessary than Gilson supposes. We also suspect that close substitutes among alternative governance structures and legal rules are less widespread than Gilson implies. 42 . See Henry Hansmann & Reinier Kraakman, Toward Unlimited Shareholder Liability for Corpo­ rate Torts, 100 Y a le L.J. 1879, 1882-83 (1991).

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interests of the persons who bear the direct costs of the rule, namely tort victims. Since, by definition, torts involve injuries to third parties, the parties affected by the rule—corporations and their potential tort victims—cannot contract around the rule to capture and share the gains from its alteration. At the same time, owing to the highly stochastic nature of most corporate torts, tort victims—and particularly the very large class of potential tort victims— do not constitute an easily organized political interest group .43 Moreover, even if a given jurisdiction were to adopt a rule of shareholder liability for corporate torts, difficulties in enforcement would arise from the ease with which sharehold­ ings or incorporation can today be shifted to other jurisdictions that retain the rule of limited liability. B. MANAGERIALISM

A second example of inefficient convergence, arguably, is the considerable freedom enjoyed by managers in almost all jurisdictions to protect their preroga­ tives in cases when they might conflict with those of shareholders, particularly including managers’ ability to defend their positions against hostile takeover attempts. Again, political and market failures seem responsible. Dispersed public shareholders, who are the persons most likely to be disadvantaged by the power of entrenched managers, face potentially serious problems of collective action in making their voice felt. Managers, whose positions make them a powerful and influential interest group everywhere, can use their political influence to keep the costs of collective action high—for example, by making it hard for a hostile acquirer to purchase an effective control block of shares from current shareholders. Corporate law might therefore converge, not precisely to the shareholder-oriented standard model that represents the ideological consen­ sus, but rather to a variant of that model that has a slight managerialist tilt. C. HOW BIG A PROBLEM?

The problem of inefficient convergence in corporate law appears to be a relatively limited one, however. Tort victims aside, the relations among virtually all actors directly affected by the corporation are heavily contractual, which tends to give those actors a common interest in establishing efficient law. Moreover, as our earlier discussion has emphasized, shareholders, managers, workers, and voluntary creditors either have acquired or are acquiring a power­ ful interest in efficient corporate law. Indeed, limited liability in tort arguably should not be considered a rule of corporate law at all, but instead should be viewed as a rule of tort law. And even limited liability in tort may come to be abandoned as large-scale tort damage becomes more common and, conse­ quently, of greater political concern. We already see some movement in this

43. By way of contrast, the largely nonstochastic tort of environmental pollution has made an easier focus for political organizing in the United States and, as noted in the text below, has led to strong legislation that partially pierces the corporate veil for firms that pollute.

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direction in U.S. environmental law, which pushes aside the corporate veil to a startling degree in particular circumstances. C

o n c l u s io n

The triumph of the shareholder-oriented model of the corporation over its principal competitors is now assured, even if it was problematic as recently as twenty-five years ago. Logic alone did not establish the superiority of this standard model or of the prescriptive rules that it implies, which establish a strong corporate management with duties to serve the interests of shareholders alone, as well as strong minority shareholder protections. Rather, the standard model earned its position as the dominant model of the large corporation the hard way, by out-competing during the post-World War II period the three alternative models of corporate governance: the managerialist model, the labororiented model, and the state-oriented model. If the failure of the principal alternatives has established the ideological hegemony of the standard model, though, perhaps this should not come as a complete surprise. The standard model has never been questioned for the vast majority of corporations. It dominates the law and governance of closely held corporations in every jurisdiction. Most German companies do not participate in the codetermination regime, and most Dutch companies are not regulated by the managerialist “structure” regime. Similarly, the standard model of shareholder primacy has always been the dominant legal model in the two jurisdictions where the choice of models might be expected to matter most: the U.S. and the U.K. The choice of models matters in these jurisdictions because large compa­ nies often have highly fragmented ownership structures. In continental Europe, where most large companies are controlled by large shareholders,44 the interests of controlling shareholders traditionally dominate corporate policy no matter what the prevailing ideology of the corporate form. We predict, therefore, that as equity markets evolve in Europe and throughout the developed world, the ideological and competitive attractions of the standard model will become indisputable, even among legal academics. And as the goal of shareholder primacy becomes second nature even to politicians, convergence in most aspects of the law and practice of corporate governance is sure to follow.

44. See Rafael La Porta et al., Corporate Ownership Around the World, 54 J. Fin. 471, 505 (1999) (stating that large firms tend to have controlling shareholders in all but common-law jurisdictions).

[4] OUR SCHIZOPHRENIC CONCEPTION OF THE BUSINESS CORPORATION* William T. Allen** I n t r o d u c t io n

When I was invited to visit with the students and faculty of Car­ dozo School of Law, I hesitated, for I am no scholar. I admire schol­ ars; I respect the effort and the talent that allows them to climb the high hills from which they see further than those of us who, in the struggle with more specific and immediate problems, sometimes are able to make out only the ground beneath our feet. But, while I am no scholar, and do my work not on a hilltop but on the shop floor of the corporation law foundry, amid the bang, gur­ gle and whirl of temporary restraining orders, expedited trials, and all the commotion of a busy trial court, I do still, in my work, search for the general in the particular. This I take to be an impulse that I share with scholars, and is indeed the source of my admiration for their work. This admiration for scholarship in the end overcame my diffi­ dence. I still feel required to put you on notice: I come gladly, but not as Prometheus, who brought the light. I come rather more like a frog that consents to jump onto the biologist’s table.1 * © Chancellor William T. Allen. This Article is based upon a lecture given on April 13, 1992 under the auspices of The Heyman Center on Corporate Governance at Benjamin N. Cardozo School of Law. That lecture was the third, and final, variation of a talk first delivered in 1989 at Lehigh University as the Rocco Tressolini Lecture and later modified as the 1991 Ronald Rutenberg Lecture at the University of Pennsylvania Institute of Law and Economics. I would like to thank each of those institutions for the opportunity to participate in their academic programs. Professors James Cox and Lyman Johnson were kind to share some perceptive comments on an earlier edition of this talk. While such a modest effort as this does not really warrant extensive acknowledgments I should add that I have benefitted from discussions over the years with Professors Ron Gilson, Ed Rock, and Reinier Kraakman, as well as talks with Sam Arsht and Bob Mundheim, all of whom would disagree with some of the points I try here to make. ** William T. Allen is Chancellor of the Delaware Court of Chancery, a non-jury trial court, established in 1792, that in effect is the nation’s only specialized court of corporation law. Chancellor Allen holds a 1969 B.S. degree from New York University, and a 1972 J.D. degree from the University of Texas. He has held the title of Lecturer in Law and Adjunct Professor of Law at the University of Pennsylvania Law School and has been the Herman Phleger Visiting Professor at Stanford Law School. 1 This disclaimer is meant seriously. Judges are rarely scholars. In many instances they have no taste for scholarship. But even for those who have, the nature and demands of their job conspire against the deep and sustained special study that productive scholarship demands. One who reads the H o l m e s - P o l l o c k L e t t e r s (Mark D. Howe ed., 2d ed. 1961), for exam-

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My assignment is to share some of my thoughts about corpora­ tion law—that body of statutes and case precedent that governs the internal organization and functioning of the legal form within which the greatest part of our economic activity takes place. It is in that area that I have had certain experiences that occasioned my invitation. While I want to be true to that specific purpose, I would like as well to use this occasion—and these corporate law materials—to try to make a broader point. That broader point, which will seem trite to scholars, is offered principally to the students. It is this: Corporation law and, indeed, the law generally, is not simply what it may seem at first, a comprehensive system of legal rules. While it is that, it is also a great deal more. People who think of law as a system of legal rules alone fail to understand that law is a social product, inevitably com­ plex, at points inescapably ambiguous, and always dynamic—always becoming something new. Of course, it is essential for the student of corporation law, or of commercial law or constitutional law, to under­ stand the legal rules that at any moment constitute the most elemental part of that body of law. But far more is necessary than that to achieve understanding of our legal order or of any part of it. In order to grasp the dynamic feature of legal rules, it is necessary to see them in their historical and social context. For while, in one sense, legal rules exist “out there,” constituting shared interpretations of our common legal culture, they are, as well, continually re-created within that culture through interpretation. We cannot begin to understand the processes of law,2 unless we try to place law in its rich historical and social context. The evolution of the concept of the corporation can help us see that. But let me not try to state a conclusion now; I pie, would notice that even Justice Holmes was, as the years passed, pulled continually into the specifics o f his important cases, while in contrast Professor Pollock seems to grow in depth of scholarship over the long years o f the correspondence. In most instances, when a judge en­ deavors to speak more generally than he or she does in deciding specific cases, the principal benefit is likely to be modest: exhortation to the profession or the disclosure o f data to the lawyer or social scientist concerning that judge— and by extension other judges— which might help explain judicial action. But not to worry; real scholars have written on my general sub­ ject, if not on the period I am mainly concerned with here. See, e.g., H erber t H o v e n k a m p , E n ter prise a n d A m erican L a w 1836-1937 (1991); Jam es W. H u r st , T he L egitim acy of t h e B usiness C orporation in t h e L a w of t h e U n it e d S t a t e s : 1780-1970 ( 1970); Morton J. Horwitz, Santa Clara Revisited: The Development o f Corporate Theory , 88 W. V a . L. R e v . 173 ( 1985), See also infra note 6. 2 In the jurisprudence o f this country, “the processes of law” means the processes o f adju­ dication, with which we are fascinated. See , e.g. , R o n a l d D w o r k in , T ak ing R ights S eri ­ ously (1977); H .L.A. H a r t , American Jurisprudence through English Eyes: The Nightmare and the Noble Dream , in Essays in Ju r ispr u d en c e a n d P hilosophy 121 ( 1983).

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should first tell the corporation law story that I hope might suggest that conclusion. The 1980s were turbulent years for corporation law. Twenty years earlier it had seemed that every interesting question in corpora­ tion law had been completely answered and that nothing remained to engage the wit and the energy of those with a taste for discovery and construction. The colorful statement of Bayless Manning captured the Zeitgeist: “[Corporation law, as a field of intellectual effort, is dead in the United States,” Dean Manning pronounced. “When American law ceased to take the ‘corporation’ seriously, the entire body of law that had been built upon that intellectual construct slowly perforated and rotted away.” 3 He then added the touch of a talented rhetoritician: “We have nothing left but our great empty corporation statutes—towering skyscrapers of rusted girders, internally welded to­ gether and containing nothing but wind.” 4 I doubt that Dean Manning’s observation was far off the mark in 1962. Modem corporation law statutes were, and still are, “enabling” statutes in the broadest sense of that term. They are almost literally empty, and those few mandatory features that remain—such as the requirement of an annual meeting of shareholders, or a right to in­ spect the company’s books and records for a proper corporate pur­ pose—are themselves under attack from some quarters as paternalistic clogs on efficiency.9 Fifteen years after Dean Manning’s pronouncement, the Ameri­ can Law Institute may have had a similar notion about the fundamen­ tally technical and marginal nature of corporation law when that organization authorized its attempt to restate corporation law. No one realized then that before the project could be completed, the se­ cure ground upon which the accepted suppositions of corporation law had been premised would break apart, and that which had seemed so secure as to be boring would once more become a field over which battles would rage. The dynamic forces in corporation law are easy to identify. The evolution of the junk bond market and takeover entrepreneurs, the growth of institutional investors, and the striking emergence of a global economy came together in the 1980s to force massive change in the private sector of our economy. In that process, tensions and an3 Bayless Manning, The Shareholder’s Appraisal Remedy: An Essay for Frank Coker, 72 Y al e L.J. 223, 245 n.37 (1962). 4 Id. But see H ur st , supra note 1, at 155-58. 5 See, e.g. Fred S. McChesney, Economics, Law, and Science in the Corporate Field: A Critique o f Eisenberg 89 Co l u m . L. R e v . 1530 (1989).

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tinomies in corporation law theory that had been lying beneath the surface for a very long time, were forced out into the open. As a result, during the 1980s corporation law became not boring and mar­ ginal, but important, even fascinating. Articles on corporate theory found their way into leading journals.6 Basic questions excited argu­ ment, and the most basic questions—What is a corporation? What purpose does it serve?—became the stuff of wide discussion and of statutory activity. Everything old became new again. I.

Two

M o d els

I want to discuss this most basic question: What is a corpora­ tion? I suggest that at least over the course of this century there have been, in our public life and in our law, two quite different and incon­ sistent ways to conceptualize the public corporation and legitimate its power. I will call them the property conception and the social entity conception. I want to explain how these inconsistent views managed to co-exist until the tectonic forces of the 1980s takeover movement created a crisis in corporate theory. It forced us to confront the un­ easy, but previously unproblematic, state of conceptual confusion. The question, what is a corporation, has a correlative question: For whose benefit are those in control of a corporation supposed to act? That question was vividly and urgently raised by hostile cash tender offers, especially when, as frequently happened, the vast major­ ity of a target company’s shareholders wanted to accept a tender offer. When, in that setting, directors elected to resist the offer, the question unavoidably arose: Whose interests were they promoting, and whose interests were they supposed to promote? An inquiry into these vital questions exposed the fact that our law and our society had been schizophrenic on the subject of corporation law for a long time. Two inconsistent conceptions have dominated our thinking about corporations since the evolution of the large integrated business corporation in the late nineteenth century. Each conception could claim dominance for a particular period, or among one group or an­ other, but neither has so commanded agreement as to exclude the other from the discourses of law or the thinking of business people. In the first conception, the corporation is seen as the private

,

6 See, e.g. William W. Bratton, Jr., The New Economic Theory o f the Firm: Critical Per­ spectives from History, 41 St a n . L. R e v . 1471 ( 1989); Lyman Johnson, The Delaware Judici­ ary and the Meaning o f Corporate Life and Corporate Law T e x . L. R e v . 865 ( 1990); David Millon, Theories o f the Corporation 1990 D uk e L.J. 201; Symposium, Contractual Freedom in Corporate Law 89 C o l u m . L. R e v . 1395 ( 1989); John C Coates IV, Note, State Takeover Statutes and Corporate Theory: The Revival o f an Old Debate 64 N.Y.U . L. R e v . 806 ( 1989).

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property of its stockholder-owners. The corporation’s purpose is to advance the purposes of these owners (predominantly to increase their wealth), and the function of directors, as agents of the owners, is faithfully to advance the financial interests of the owners. I call this the property conception of the corporation, because it sees the corpo­ ration as the property of its stockholders. This model might almost as easily be called a contract model, because in its most radical form, the corporation tends to disappear, transformed from a substantial insti­ tution into just a relatively stable comer of the market in which au­ tonomous property owners freely contract.7 The second conception sees the corporation not as the private property of stockholders, but as a social institution. According to this view, the corporation is not strictly private; it is tinged with a public purpose. The corporation comes into being and continues as a legal entity only with governmental concurrence. The legal institutions of government grant a corporation its juridical personality, its character­ istic limited liability, and its perpetual life. This conception sees this public facilitation as justified by the state’s interest in promoting the general welfare. Thus, corporate purpose can be seen as including the advancement of the general welfare. The board of directors’ duties extend beyond assuring investors a fair return, to include a duty of loyalty, in some sense, to all those interested in or affected by the corporation. This view could be labeled in a variety of ways: the managerialist conception, the institutionalist conception, or the social entity conception. All would be descriptive, since the corporation is seen as distinct from each of the individuals that happens to fill the social roles that its internal rules and culture define. The corporation itself is, in this view, capable of bearing legal and moral obligations.8 To law and economics scholars, who have been so influential in aca­ demic corporate law, this model is barely coherent and dangerously wrong. These two, apparently inconsistent, conceptions have coexisted in our thinking over the last century. For most of the century the 7 The contract image however does permit others interested in the corporation (e.g., em­ ployees) to be regarded as contracting parties, but it sees the stockholder as the residual risk bearer who in effect is the “ owner” of the firm. The contract metaphor provides the dominant academic paradigm of the corporation at the moment. See R.H. Coase, The Nature o f the Firm , 4 Econom ica 386 ( 1937); Michael C. Jensen & William H. Mecklin, Theory o f the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J, F in . E co n . 305 ( 1976); Oliver Williamson, Corporate Governance, 93 Y ale L.J. 1197 ( 1984); Symposium, Contractual Freedom in Corporate Law supra note 6. 8 See, e.g. , R. Edward Freeman & William M. Evan, Corporate Governance: A Stakeholder Interpretation , 19 J. B eh a v io r a l E co n . 337 ( 1990); Peter A. French, The Corporation as a Moral Person, 16 Am. P hilo . Q. 207, 211-15 ( 1979).

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lack of agreement on the ultimate nature and purpose of the business corporation has not generated intense conflict. A host of macro-eco­ nomic factors—secularly rising prosperity, a lack of global competi­ tion, and the absence of powerful shareholders—probably account for this placid status quo. By the 1980s however, emerging global compe­ tition, capital market innovation, and the growth and evolution of in­ stitutional investors, among other factors, made possible the takeover movement, which glaringly exposed our inconsistent thinking about the nature of the business corporation. Let me dilate upon these different views of the nature of the cor­ poration, and on the masking and unmasking of the conceptual con­ flict that is near the core of corporation law. A.

The Property Conception

At least by the mid-nineteenth century, when the movement to enact general laws of incorporation had become firmly planted,9 the corporation was seen in this country as an artificial creation of the state designed to enable individuals to associate together for state ap­ proved purposes. The emphasis was on the individuals—the share­ holders who had been constituted a corporation. There was a sense, but only a weak sense, of a distinctive, artificial corporate entity.10 The leading corporation law treatise of the mid-nineteenth century regarded corporations as similar to limited partnerships, in that each member exercised some control over the body’s interests through his vote.11 When, for example, the Supreme Court of the United States in 1856 was asked by a shareholder to review the constitutionality of a state tax laid upon his corporation, the Supreme Court did not pause long on the question whether the individual had, in the circum­ stances, any right to assert the claim.12 The Court, unconcerned about the existence of a legal entity, marched very quickly to the merits.13 9 See L a w r en c e M. F r ie d m a n , A H istory of A m erican L a w 188-201 (2d ed. 1985). 10 See Horwitz, supra note 1, at 174; H o v e n k a m p , supra note 1, at 42- 43. 11 Horwitz, supra note 1, at 202. 12 Dodge v. Woolsey, 59 U.S. (18 How.) 331, 341-46 (1856). 13 The Court’s opinion half a century later in a similar case reflects a rather different atti­ tude. In the 1903 case, Corbus v. Alaska Treadwell Gold Mining Co., 187 U.S. 454 ( 1903), the Court dismissed a shareholder’s attack on a state tax brought in the form of a derivative suit to enjoin the corporation from paying the tax. The Court held that it was essential to plead reasons justifying the individual shareholder’s right and need to act. While the differing result does reflect, I suppose, a heightened dignity accorded to the corporate form, more than evolv­ ing concepts of the corporation account for this different result. The Supreme Court was ex­ plicitly concerned with controlling the dockets of federal courts. See Hawes v. Oakland, 104 U.S. 450 ( 1882).

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Consistent with a weak sense of a distinctive entity, corporate shareholders during this period did not enjoy the protection of limited liability to the same degree as they modemly do.14 Some state corpo­ ration statutes, for example, imposed liability on corporate sharehold­ ers in a variety of circumstances, Massachusetts being the famous example.15 Drastic corporate action, such as merger or sale of all as­ sets,16 when authorized, required unanimous shareholder approval. The dominant perception was that the corporation, while an arti­ ficial entity, was essentially the stockholders in a special form. This perception colored the way in which the role and power of the board of directors was seen. When compared to what they would become, corporations in the mid to late nineteenth century appear to have been relatively frail conceptually, with boards of directors limited in power. Directors were seen as agents of stockholders. Thus, if towards the close of the last century one would have asked to whom directors owe a duty of loyalty, a confident answer could have been expected: The corporation is like a limited partner­ ship; its property is equitably the property of the shareholders. The directors are elected by shareholders and it is unquestionably on their behalf that the directors are bound to act. This view, with its genesis in the mid-nineteenth century, was plainly expressed in the law and, I suppose, was the view held beyond the legal community as well. This perspective is perhaps most pointedly captured in the 1919 Michigan Supreme Court case of Dodge v. Ford Motor Co. 17 You may recall the case. The Dodge brothers had sued Ford Motor Company in their capacities as shareholders. They complained that Henry Ford, who controlled the board of directors, was not sufficiently con­ cerned with shareholder welfare. After paying out $1.2 million in div­ idends on $2 million of capital, Henry Ford had decided that Ford Motor Company would suspend further dividend payments indefi­ nitely. The company was retaining $58 million in profits to be used to expand its business and lower the price of its products. Mr. Ford was quoted in the press as saying that the purpose of the corporation was to produce good products cheaply and to provide increasing employ14 I here accept Professor Horwitz’s reading of the common nineteenth century statutory provisions restricting the limited liability rule that was generally otherwise recognized by the early nineteenth century. See Horwitz, supra note 1, at 208-09. This view is a bit different from the interpretation offered by Professor Hovenkamp, see H o v e n k a m p , supra note 1, at 49-55, who sees the exceptions to limited liability as less significant. 15 See E. Merrick Dodd, The Evolution o f Limited Liability in American Industry: Massa­ chusetts, 61 H a r v . L. R e v . 1351, 1361-66 ( 1948). 16 See People v. Ballard, 32 N.E. 54 (N.Y. 1892); Small v. Minneapolis Electro Matrix Co., 47 N.W. 797 (Minn. 1891). See generally Note, 78 U. P a . L. R e v . 881 ( 1930). 170 N.W. 668 (Mich. 1919).

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ment at good wages and only incidentally to make money.18 The Dodge brothers asserted that the shareholders owned the enterprise and that they were entitled to force the directors to pay out some of those accumulated profits. The Michigan Supreme Court agreed: There should be no confusion . . . of the duties which Mr. Ford conceives that he and the stockholders owe to the general public and the duties which in law he and his codirectors owe to pro­ testing, minority stockholders. A business corporation is organ­ ized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to devote them to other purposes.19 The court commanded Ford to pay dividends. Dodge v. Ford Motor Co. reflects as pure an example as exists of the property conception of the corporation. In this conception, the corporation is seen as it is in its nineteenth century roots, as essen­ tially a sort of limited liability partnership. The rights of creditors, employees and others are strictly limited to statutory, contractual, and common law rights. Once the directors have satisfied those legal obligations, they have fully satisfied all claims of these “constituen­ cies.” This property view of the nature of corporations, and of the duties owed by directors, equates the duty of directors with the duty to maximize profits of the firm for the benefit of shareholders.20 This model of the public corporation is highly coherent and of­ fers several alternative arguments to support the legitimacy of corpo­ rate power in our democracy. The first argument in favor of the property concept is political and normative. It is premised on the conclusionary notion that shareholders “own” the corporation, and asserts that to admit the propriety of non-profit maximizing behavior is to approve agents spending other people’s money in pursuit of their own, perhaps eccentric, views of the public good.21 This can be seen 18 2 A l la n N ev in s & F ra nk E. H ill , F o r d : E xpa n sio n a n d C h a l le n g e 1915- 1933, at 99 ( 1957). is 170 N.W. at 684. 20 See, e.g., Frank H. Easterbrook & Daniel R. Fischel, Voting in Corporation Law, 26 J.L. & E con . 395 ( 1983); Michael C. Jensen & Richard S. Ruback, The Market for Corporate Control: The Scientific Evidence, 11 J. F in . E c o n . 5, 29-30 ( 1983), 21 Another form of this argument denies the meaningfulness of the concept of “ public good” at all. In this view since there is no objective referent for the public good one can always disagree whether a particular outcome represents a contribution to the public good. Thus, on this view, the board’s pursuit of the public good can never form a coherent justification for coercive action (such as spending other people’s money).

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as morally wrong without more. On a broader level, proponents of this view assert that it is repugnant to our democratic ideals to have corporate oligarchies determining which of many competing claim­ ants for financial support should be awarded that support. Econo­ mists such as Kenneth Arrow,22 Friedrich Hayek,23 and Milton Friedman24 have asserted this view with conviction. This first argument in favor of a property conception of the cor­ poration is weakest when it asserts that shareholders “own” corporate property and that it is, therefore, normatively wrong to expend their property for the benefit of another without shareholder consent. The premise of “ownership” simply assumes but does not justify an an­ swer. This argument is strongest, however, when it asks whence comes the authority of corporate directors to make decisions on the basis of the public good.25 The second rationale for the property model is that the model, and action consistent with it, maximize wealth creation. This ration­ ale asserts that the purpose of business corporations is the creation of wealth, nothing else. It asserts that business corporations are not formed to assist in self-realization through social interaction; they are not formed to create jobs or to provide tax revenues; they are not formed to endow university departments or to pursue knowledge. All of these other things—job creation, tax payments, research, and social interaction—desirable as they may be, are said to be side effects of the pursuit of profit for the residual owners of the firm. This argument asserts that the creation of more wealth should always be the corporation’s objective, regardless of who benefits. The sovereign’s taxing and regulatory power can then address questions of social costs and re-distribution of wealth. Thus, profit maximizing behavior is seen as affording the best opportunity to satisfy human wants and is the most appropriate aim of corporation law policy.26 22 Kenneth J. Arrow, Social Responsibility and Economic Efficiency , 21 P u b . P olicy 303, 303-07 ( 1973). 23 Friedrich A. Hayek, The Corporation in a Democratic Society: in Whose Interest Ought It and Will It Be Run?, in M a n a g e m e n t a n d C orporations 1985, at 99 (Melvin Anshen & George L. Bach eds., 1960). 24 See, e.g., Milton Friedman, The Social Responsibility O f Business Is to Increase Its Prof­ itsf N .Y. T im es , Sept. 13, 1970, § 6 (Magazine), at 32. But see Joseph W. Singer, The Reliance Interest in Property, 40 St a n . L. R ev. 611 ( 1988) (stating that ownership is a conclusary and analytically unhelpful concept). 25 See Eugene V. Rostow, To Whom and for What Ends Is Corporate Management Respon­ sible?, in T he C orporation in M o d e r n S ociety 46, 67 (Edward S. Mason ed., 1959). 26 See R ic h ar d A. P o sn e r , E conomic A na lysis of L a w § 14.11 (3d ed. 1986). But see Guido Calabresi, The Pointlessness o f Pareto: Carrying Coase Further t 100 Y a le L.J. 1211 ( 1991) (asserting that all allocative questions inevitably implicate distributional questions).

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This second argument for the legitimacy of the corporation as share­ holder property is not premised on the conclusion that shareholders do “own” the corporation in any ultimate sense, only on the premise that it can be better for all of us if we act as if they do. B.

The Entity Conception

The property conception of the corporation was the conception generally held during the nineteenth century and, as Dodge v. Ford Motor Co. reflects, in the early part of this century as well. But, the last quarter of the nineteenth century saw the emergence of social forces that would oppose the conception of business corporations as simply the property of contracting stockholders.27 The scale and scope of modem integrated business enterprise that emerged in the late nineteenth century required distinctive professional management skills and huge capital investments that often necessitated risk sharing through dispersed stock ownership.28 National securities markets emerged and stockholders gradually came to look less like flesh and blood owners and more like investors who could slip in or out of a particular stock almost costlessly.29 These new giant business corpo­ rations came to seem to some people like independent entities, with purposes, duties, and loyalties of their own; purposes that might di­ verge in some respect from shareholder wealth maximization. Henry Ford’s losing position in Dodge v. Ford Motor Co. re27 The evolution o f these large entities and the impact of German philosophy on American scholarship triggered an outburst of scholarly writing on the nature o f the corporation. See, e.g., E rn st F r e u n d , T he L e gal N a t u r e of C orporations ( 1897); John Dewey, The His­ toric Background o f Corporate Legal Personality, 35 Y al e L J . 655 ( 1926); Harold J. Laski, The Personality o f Associations, 29 H a r v . L. R e v . 404 ( 1916); Max Radin, The Endless Prob­ lem o f Corporate Personality, 32 C o l u m . L. R e v . 643 ( 1932); Paul Vinogradoff, Juridical Per­ s o n s 24 C o l u m . L. R e v . 594 ( 1924). 28 See A lfred D. C h a n d l e r , Jr ., T he V isible H a n d : T he M a n a g er ia l R e v o l u ­ t io n in A m erican B u siness ( 1977). Corporation law scholars have recently, and correctly, pointed out that large scale enterprise is not necessarily inconsistent with concentrated owner­ ship o f corporate shares. Pointing to Germany and Japan, where financial intermediaries are said to control or at least constrain industrial companies, they assert that our corporate struc­ ture o f autonomous management is largely the result o f federal statutes limiting the ability of banks to act as owners. See Mark J. Roe, A Political Theory o f American Corporate Finance , 91 C o l u m . L. R e v . 10 (1991); Bernard S. Black, Shareholder Passivity Reexamined, 89 M ich . L. R e v . 520, 551-53 (1990). 29 A s Professor Morton Horwitz tells us: “By the time of the First World War, it was common for legal writers to observe that ‘the m odem stockholder is a negligible factor in the management of a corporation.’ ” Horwitz, supra note 1, at 207 (quoting G e r a l d C, H e n ­ d e r so n , T he P osition of F oreign C orporations in A m erican C o nst itu t io na l L a w 42 ( 1918)). “It cannot be too strongly emphasized,” another wrote, “that stockholders today are primarily investors and not proprietors.” Horwitz, supra note 1, at 207 (quoting J. C ar te r , T he N a t ur e of t h e C orporation as a L egal E n t it y 160 ( 1919)).

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fleeted an idea that was in the air. Others saw these new corporate social actors as different. Owen Young, the President of General Electric, for example, stated in a public address during the 1920s as follows: [M]anagers [are] no longer attorneys for stockholders; they [are] becoming trustees of an institution. If you will pardon me for being personal, it makes a great deal of difference in my attitude toward my job as an executive officer of the General Electric Company whether I am a trustee of the insti­ tution or an attorney for the investor. If I am a trustee, who are the beneficiaries of the trust? To whom do I owe my obligations?30 Mr. Young went on to give his answer: As the chief officer of General Electric, he acknowledged an obligation to stockholders to pay “a fair rate of return”; but he also bore an obligation to labor, to customers, and lastly to the public, to whom he saw a duty to make sure the corporation functioned “in the public interest. . . as a great and good citizen should.” *1 The secure wisdom of the nineteenth century, while convincing to the Michigan Supreme Court, was not strong enough to contain this alternative view of corporations as independent social actors who do not simply owe contract or other legal duties to those affected by its operation, but owe loyalty in some measure to all such persons as well.32 This social entity conception sees the purpose of the corporation as not individual but social.33 Surely contributors of capital (stock­ holders and bondholders) must be assured a rate of return sufficient to induce them to contribute their capital to the enterprise. But the cor­ poration has other purposes of perhaps equal dignity: the satisfaction of consumer wants, the provision of meaningful employment opportu­ nities, and the making of a contribution to the public life of its com­ munities. Resolving the often conflicting claims of these various corporate constituencies calls for judgment, indeed calls for wisdom, by the board of directors of the corporation. But in this view no sin­ gle constituency’s interest may significantly exclude others from fair consideration by the board. This view appears to have been the domi30 E. Merrick Dodd, Jr., For Whom are Corporate Managers Trustees?, 45 H a r v . L. R e v . 1145, 1154 ( 1932).

3»Id. 32 See James M. Gustafson & Elmer W. Johnson, Efficiency, Morality, and Managerial Effectiveness in T he U.S. B usiness Corpo ra tio n : A n I nst it u t io n in T ransitio n 193 (John R. Meyer & James M, Gustafson eds,, 1988) [hereinafter T he U.S. B usiness

,

C orporation ]. 33 Freeman & Evan, supra note 8, at 342- 44, 349-54.

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nant view among business leaders for at least the last fifty years.34 The principal basis for a claim to legitimacy of director power under the entity theory is premised on utility claims.35 According to this view, managerial expertise and discretion is the essential ingredi­ ent for the effective functioning of the large-scale, multi-division busi­ ness corporation. Our need for productive business enterprise commits us to the entity view, it is claimed, because it is corporate management, with its special organizational skills, that knows how to balance the claims made on the corporation in order to make large scale enterprise productive over the long term. For the common good, those managements cannot be hobbled by a short-sighted orien­ tation geared exclusively to stockholders. In claiming that management’s unique expertise enables it to maximize corporate performance, and that its expert judgments about long-term value creation are more dependable than market valuations reflecting investor decisions, this utility basis for the legitimacy of the entity view directly challenges the premise of many economist critics that markets in widely traded securities value future prospects more dependably than does internal management. Thus, not surprisingly, proponents of both conceptions of the corporation base a claim to the validity of their view, in part, on a claim that accepting their perspec­ tive will enhance the economic productivity of corporations. II.

M a s k in g a n d U n m a s k in g t h e C o n f l ic t

One would think that whether the corporation law endorses the property conception or the social entity conception would have im­ portant consequences. Our experience in the 1980s demonstrated that it could. But equally as interesting as that 1980s conflict is the fact that for the fifty years preceding that contentious decade, we did not share agreement on the legal nature of the public business corporation and that failure did not seem especially problematic. The law “papered over” the conflict in our conception of the cor­ poration by invoking a murky distinction between long-term profit maximization and short-term profit maximization. Corporate ex34 See, e.g., The Business Roundtable, Statement, Corporate Governance and American Competitiveness March 1990, 46 Bus. L. 241 ( 1990); Winthrop Knowlton & Ira M. Millstein, Can the Board o f Directors Help the American Corporation Earn the Immortality It Holds so Dear?> in T he U.S. B usiness C orpo ration , supra note 32, at 169. 35 A dolf A. B e rle , J r ., T he 20th C e n tu r y C apitalist R e v o lu t io n 70-115 ( 1954); A lfr ed D. C h a n d l e r , J r ., S cale a n d Scope ; T he D ynam ics of I n d u st r ia l C a pit al ­ ism 594-605 ( 1990); A lfred D. C h a n d l e r , Jr ., St r ateg y a n d St r uc t u r e : C h apters in t h e H istory of t h e I n d u st r ia l E nterprise 314-22 (1962); F rancis X. S ut to n e t a l ., T he A m erican B usiness C r e ed 57-65, 86-87, 155-65 ( 1956).

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penditures which at first blush did not seem to be profit maximizing, could be squared with the property conception of the corporation by recognizing that they might redound to the long-term benefit of the corporation and its shareholders.36 Thus, without purporting to abandon the idea that directors ultimately owe loyalty only to stock­ holders and their financial interests, the law was able to approve rea­ sonable corporate expenditures for charitable or social welfare purposes37 or other actions that did not maximize current profit.38 There is a utility in this long-term/short-term device. Though employment of this distinction is subject to obvious manipulation, it can nevertheless resolve the tension between these differing concep­ tions of the corporation in a way that offers the possibility of some judicial protection to shareholders, while affording substantial room to the multi-constituency, social entity conception to operate. With this distinction, judicial review of particular decisions is available under the fiduciary duty standard. But corporate directors are also afforded very considerable latitude to deal with all groups or institu­ tions having an interest in, or who are affected by, the corporation. The long-term/short-term distinction preserves the form of the stock­ holders oriented property theory, while permitting, in fact, a consider­ able degree of behavior consistent with a view that sees public corporations as owing social responsibilities to all affected by their operation. Thus, while early on much ink was spilled on the question to whom should directors be responsible,39 in practice the question of the nature of the corporation seemed essentially unproblematic until the emergence of the cash tender offer of the 1980s. The long-term/ short-term distinction proved a serviceable, if an intellectually prob­ lematic way, for the corporation law to avoid choosing between the alpha of property and the omega of relationships. 36 P r i n c i p l e s o f C o r p o r a t e G o v e r n a n c e : A n a l y s i s a n d R e c o m m e n d a t i o n s § 2.01 (A m erican L. Inst. Proposed Final D raft 1992). T h e final draft o f th e P rinciples o f C orporate G overnance, lik e the cases, equivocates on th e core purpose o f the corporation. In section 2.01(a) it is said to be the “ enhancing corporate profit and shareholder gain” n ot the m axim izing o f such profit or gain, and in subsection (b) it recognizes a pow er to m ake "reason­ able” gifts, n o t expressly lim ited to long-term profit goals. Id. (em phasis added).

37 See, e.g.t A.P. Smith Mfg. Co. v. Barlow, 98 A.2d 581 (N.J.) (charitable contribution cases), appeal dismissed, 346 U.S. 861 (1953). 38 See, e.g.t Shlensky v. Wrigley, 237 N.E.2d 776 (111. App. Ct. 1968). 39 I refer to the still lively and informative Berle-Dodd debate of almost sixty years ago. See A,A. Berle, Jr., Corporate Powers as Powers in Trust, 44 H a r v . L. R e v , 1049 (1931); E. Merrick Dodd, Jr., For Whom are Corporate Managers Trustees?, 45 H a r v . L. R e v . 1145 (1932); A.A. Berle, Jr., For Whom Corporate Managers Are Trustees: A Note, 45 H a r v . L. R e v . 1365 (1932). See also Joseph L. Weiner, The Berle-Dodd Dialogue on the Concept o f the Corporation, 64 C o lu m . L. R e v . 1458 (1964).

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The forces loosened by the takeover movement of the 1980s, however, could not be contained within this verbal formula. Two things made the takeover phenomenon very problematic for the legal theory of the corporation. The first is that the takeover movement put so much at stake. The issue in the takeover cases was not whether a donation of corpo­ rate funds could be made to a museum40 or college;41 it was not whether contributions in lieu of lawful taxes could be paid to local government,42 or any other day to day decision, as in earlier court cases. The issue was frequently whether all of the shareholders would be permitted to sell their shares; whether a change in corporate con­ trol would occur; and often whether a radical restructuring of the en­ terprise would go forward,43 with dramatic effects on creditors, employees, management, suppliers, and communities. As the junk bond market grew in size, larger and larger enterprises were faced with these prospects. The effects of a takeover were seen by those affected as a form of shareholder exploitation of others who had made contributions of var­ ious sorts to the corporation. In the financial setting of the 1980s, dramatically higher stock prices could often be achieved by sharply increasing the debt of the corporation and reducing or eliminating certain operations. But increasing debt substantially made the enter­ prise riskier and thus reduced the value of the corporation’s existing bonds;44 and restricting operations injured workers and management, who were thrown out of work. The bondholders and employees felt that radical corporate changes made in order to increase share value breached implicit understandings that had been the basis of their par­ ticipation in the organization, or so one argument went.43 Thus, the scale of the problems raised by the takeover movement made evasion of the fundamental question of corporate definition difficult. A second difference between the issues of the takeover era and those of the prior sixty years was that the short-term/long-term dis40 See, e.g. , Sullivan v. Hammer, [1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) 95,415 (Del. Ch. Aug. 7, 1990), aff'd sub nonu Kahn v. Sullivan 594 A.2d 48 (Del. 1991). 41 See, e.g., A.P. Smith Mfg., 98 A,2d at 582. « See, e . g Kelly v. Bell, 254 A.2d 62 (Del. Ch. 1969), a ff’d, 266 A.2d 878 (Del. 1970). 43 See, e.g., City Capital Assocs. Ltd. v. Interco Inc., 551 A.2d 787 (Del. Ch.), appeal dismissed, 556 A.2d 1070 (Del. 1988). 44 See, e.g., Kenneth N. Gilpin, Bid for RJR Nabisco Jolts Bonds, N.Y. T im e s, Oct. 21, 1988, at D ll. 45 See, e , g Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504 (S.D.N.Y. 1989); see also Alexander C. Gavis, A Framework for Satisfying Corporate Directors’ Responsi­ bilities Under State Nonshareholder Constituency Statutes: The Use o f Explicit Contracts, 138 U. Pa. L. Rev. 1451 (1990).

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tinction was really of little analytical or rhetorical use in resolving the takeover issues. The most pressing of these issues involved the ques­ tion whether a board of directors could take action that precluded shareholders from accepting a non-coercive, all cash tender offer.46 That question obviously raised the further question: Whose interests is the board of directors suppose to foster or protect when substan­ tially all of the shareholders want to sell control of the corporation?47 The long-term/short-term distinction could not persuasively be used to answer or evade that question when it arose in this context. It is one thing to say that an expenditure of corporate funds that benefits the community—an education grant or the installation of an un­ mandated pollution control device—is really for the long-term finan­ cial benefit of shareholders. Though not compelling, arguments of this type surely are plausible. It is, however, rather a different thing to justify precluding the shareholders from selling their stock at a large immediate profit on the ground that in the long run that will be good for them. While one might of course say that, many people would find it disturbing to put such a result on the basis that directors know what is better for share­ holder then they themselves do. Instead the scope and nature of the issues faced seemed to demand a facing-up to the conceptual ques­ tions: For whom are directors to act? May they act to protect others (and themselves) from claims of shareholder exploitation? Courts were not anxious to grapple with this question. To re­ solve the matter seemed plainly to call for the making of policy in an environment that was warmly contested by powerful interests and in which no widely accepted doctrine offered a clear guide.48 46 See Lucian A. Bebchuk, The Pressure to Tender: An Analysis and a Proposed Remedy, 12 J. C o r p . L. 911 (1987); see also John C. Coffee, Jr., The Uncertain Case for Takeover Reforms: An Essay on Stockholders, Stakeholders and Bust-Ups, 1988 Wis. L. R e v . 435, 439 (“[T]he problem of coercion in takeovers . . . represents the hobgoblin of the law professors.”). 47 See TW Services, Inc. v. SWT Acquisition Corp., [1989 Transfer Binder] Fed. Sec. L, Rep. (CCH) H 94,334 (Del. Ch. Mar. 2, 1989). 48 Perhaps the Delaware cases before Paramount Communications, Inc. v. Time, Inc., [1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) 94,514 (Del Ch. July 14, 1989), a ff ’d, 571 A.2d 1140 (Del. 1990) (“Time-Warner”) can be viewed in that light. TTius, language in Uno­ cal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) apparently endorsing a multi­ constituency view of the corporation was countered with the property vision of Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986) which in turn was moderated in Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334 (Del. 1987). In the Court of Chancery opinions reflecting a strong shareholder-property conception {see, e.g., AC Acquisi­ tions Corp. v. Anderson, Clayton & Co., 519 A.2d 103 (Del. Ch. 1986); Grand Metro. Pub. Ltd. Co. v. Pillsbury Co., 558 A.2d 1049 (Del. Ch. 1988)) were weaved together with cases that evidenced a solicitude for the board’s power to take action to foster “long run” corporate profitability {see, e.g., Shamrock Holdings, Inc. v. Polaroid Corp., 559 A.2d 278 (Del. Ch. 1989); TW Services, Inc. v. SWT Acquisition Corp., [1989 Transfer Binder] Fed. Sec. L. Rep. D e l.

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L e g a l In s t i t u t i o n s A r e F o r c e d t o C h o o s e

Nevertheless, ultimately both our courts and, more importantly, our legislatures have, in effect, endorsed the entity view. In Para­ mount Communications, Inc. v. Time, Inc. (“Time-Warner” ),49 the Delaware Supreme Court seems to have expressed the view that cor­ porate directors, if they act in pursuit of some vision of the corpora­ tion’s long-term welfare, may take action that precludes shareholders from accepting an immediate high-premium offer for their shares. This important case might be interpreted as constituting implicit judi­ cial acknowledgement of the social entity conception, as clearly as Dodge v. Ford Motor Co. reflects the alternative property conception of the corporation. The entity conception was even more clearly endorsed by the law in a remarkable series of legislative acts adopted in some twenty-eight jurisdictions over the course of the last few years of the 1980s.so These so-called constituency statutes differ from each other in a number of particulars but they share the same soul. In one way or another each of them authorizes a board of directors to consider the interest of all corporate “stakeholders” when the board exercises cor­ porate power. These statutes seem plainly to be animated by a social entity conception of the corporation. The statutes of Indiana, Pennsylvania, and Connecticut are par­ ticularly notable. The Indiana statute, as amended in 1989, and the Pennsylvania statute enacted in 1990, explicitly provide that directors are not required to give dominant or controlling effect to any particu­ lar constituency or interest.51 These statutes appear explicitly to de­ couple directors’ duties to the corporation from any distinctive duty to shareholders. Thus, under them, a central notion of corporation law as it has developed over the last 150 years—that the law ought to try to align directors’ action with shareholder interests by imposition of fiduciary duties—is arguably eviscerated.52 Surely, stealing is still (CCH) H94,334; Time-Warner). In these latter cases, at any rate, the Chancery Court offered consistency on the level of technicality, (see, e.g. , TW Services, Inc.) not at the level of a coher­ ent, single animating vision of the corporation. On the possible utility of ambiguity in takeover litigation, see Charles M. Yablon, Poison Pills and Litigation Uncertainty, 1989 D u k e L.J. 54. 49 [1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) U 94,514 (Del. Ch. July 14, 1989), aff% 571 A.2d 1140 (Del. 1989). 50 See Symposium, Corporate Malaise—Stakeholder Statutes: Cause or Cure?, 21 S t e t s o n L. R e v . 1 app. (1991). 51 See, e . g I n d . C o d e A n n . § 23-1-35-1(d), (f) (B u m s 1989); 15 P a . C o n s . S t a t . A n n . §§ 515(a)-(b), 516(a) (P urdon Supp. 1992); C o n n . G e n . S t a t . A n n . § 33-313(e) (West Supp. 1992). See generally James J. Hanks, Jr., Playing with Fire: Nonshareholder Constituency Stat­ utes in the 1990s, 21 S t e t s o n L. R e v . 97 (1991). 52 See Hanks, supra note 51.

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proscribed and self-dealing transactions still have to be justified as fair to the corporation, but what arguably is eradicated is the command— which while equivocal in practice under the prior regime still de­ manded respect—that maximizing the financial interests of sharehold­ ers through lawful means over some time period is the core duty of a corporate director. The real-world effect of rejecting a property conception of the corporation and adopting an entity conception can be dramatic. Under something like the property conception, an active market for corporate control might exist to discipline and remove inefficient cor­ porate management. The recognition of a duty of loyalty that runs only to the stockholders collectively, may severely impede the ability of managers to resist a hostile all cash offer to buy all corporate shares at a high premium.53 On the other hand, if the law accepts an entity conception, this form of market constraint is, for good or ill, effec­ tively removed. The removal of the market constraint has, in effect, been accom­ plished. Economic factors—such as the level of debt on corporate balance sheets, the retreat of the junk bond market, and the business cycle—had a greater role in the disappearance of hostile takeovers at the close of the 1980s than did the de facto acceptance by courts and legislatures of the entity conception of the corporation. But the legal regime remains important, and not only because financial conditions change and those favorable to hostile takeovers will re-emerge at some point in the future. IV.

R e s o l u t i o n o r In t e r r e g n u m ?

The enactment of the stakeholder statutes and the decision in Time-Warner came just at the end of the “deal decade,” and with

those developments the schizophrenia that had long existed in our thinking about corporations was arguably resolved. But was it? In order to hazard a guess about how permanent or how important this resolution is, I want to shift ground and return to the larger subject that I mentioned at the outset: What might this account of conceptual conflict in corporation law teach us about how our legal system func­ tions? Let me raise that question by asking another: When we study law, what is it that we study? For some, when we study law, we study legal rules or, more com­ pletely, we study a system of authoritatively promulgated, compre53 See City Capital Assocs. Ltd. v. Interco Inc., 551 A.2d 787 (Del. Ch.), appeal dismissed, 556 A*2d 1070 (Del. 1988); Grand Metro. Pub. Ltd. Co. v, Pillsbury Co., 558 A.2d 1049 (Del. Ch. 1988); AC Acquisitions Corp. v. Anderson, Clayton & Co., 519 A.2d 103 (Del. Ch. 1986).

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hensive rules and the system (rules) of their administration. As a system of rules, the legal system is astonishingly complex, with an enormous variety of substantive rules regulating our conduct and other rules regulating the legal system itself. When we start out in our study of law, we think that to become a lawyer it is necessary to learn these rules, especially the rules concerning the operation of the legal machinery. We are right to think that, but we would be badly wrong to think that knowledge of legal rules is all that we need to understand the legal world. When we study corporation law we surely must learn the content of the corporation law statutes and the rules announced in court deci­ sions. We must learn the analytical and theoretical tools of a lawyer, so that we can manipulate these rules within the permissible zone of their ambiguity in order to guide and protect clients. But if we were to learn the content of legal rules alone we would achieve only a dry and brittle power that would quickly snap under the dynamic crosspressures of complex and contradictory real life.54 In corporation law, as in every area of law, learning the rules, and the permissible manipulation of the rules, is the crucial beginning. But it is only the beginning. We must discover and understand the principles that stand behind the rules. But even that step is not yet enough. To approach understanding, we must be able to see legal rules and principles as social constructs, affected by their internal logic, but affected even more profoundly by the social world in which they exist. Legal ideas are not static abstractions; the legal process is not simply a deductive exercise, and the evolution of law is not an inevita­ ble working out of anything. In the judicial process the law of each case is constructed from generalities. In explaining that process everything counts. Ideas about efficiency certainly count. But ideol­ ogy also counts. And social forces that judges feel but can only vaguely articulate may be important.55 In this process, the internal 54 T he assum ption that hum ans act rationally suffered an em pirical buffeting by a great deal o f social research in the 1980s, See, e.g., Jon Elster, When Rationality Fails, in T h e L im it s o f R a t i o n a l i t y 19 (K aren Schw eers C ook & M argaret L evi eds., 1990); A m o s Tversky & D aniel K ahnem an, Rational Choice and the Framing o f Decisions, in T h e L im it s o f R a t i o n a l i t y , supra, at 60. T he lo n g run effect on econ om ics, or derivatively on the law and eco n o m ics perspective, o f this research is n o t yet apparent. But see A m it a i E t z i o n i , T h e M o r a l D im en sion *. T o w a r d a N e w E c o n o m ic s (1988).

55 For an outstanding and insightful example of the explanatory power of placing a legal case in an interesting and appropriate large frame, see Jeffrey N. Gordon, Corporations, Mar­ kets, and Courts, 91 C o lu m . L. R e v . 1931 (1991) (employing the ideas of Karl Polanyi to account for the Time- Warner decision).

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logic of the legal system itself will serve as an important constraint, even if it is not determinative in the way our naive selves first thought. The law, like ourselves, is always in flux, always “becoming.” We accept, or invent, or reconstitute structures in the flux because we want order (some of us more than others) and predictability. The concept of the corporation is such a structure. For a long period it seemed settled, although it was not; it seemed known, even boring. The concept of the corporation became problematic only because real world economic forces changed, and those changes exerted pressures that forced legal change.56 But the ever-emergent quality of law sug­ gests that the resolution of the conceptual conflict that was reached in the late 1980s by the endorsement of the entity concept, will not be a final answer to the question, what is a corporation. We cannot of course know the future, but we can see the future stresses that the entity conception of the public corporation will gen­ erate. The entity conception inevitably will give rise to claims of inef­ ficiency and illegitimacy; and those are claims that the blunt instruments of stakeholder statutes can neither answer nor suppress. Each of the two dominant social trends that will exert potentially transformative power on corporate governance in the years immedi­ ately ahead—the evolution of a truly global economy and the continu­ ing growth, and coming dominance, of institutional shareholders—is more consistent with the property conception of the corporation than with the entity conception. As the world becomes a fiercer place for American business, cor­ porate management is forced increasingly to consider financial per­ formance at every stage. Thus, evolving global markets encourage efficiency and value-creating management. These developments tend to push shareholders, as residual risk bearers, back towards the center of thinking about the enterprise. Creating shareholder value, for ex­ ample, is increasingly a financial measure that is used internally in the making of corporate capital budgeting decisions.57 Indeed while the law seems to have ringingly endorsed a managerialist or entity orien­ tation, full-bodied statements of the managerialist philosophy appear now to be rather out of fashion, even among members of senior corpo­ rate management. Today the talk is more likely to be about creating shareholder value than about social responsibility. 56 I do not mean to endorse any sort of crude materialism as an explanation of legal rules. In fact I believe that ideology and culture are important variables in trying to account for social arrangements, including law, existing at any point of time. 57 See, e.g.t A l f r e d R a p p a p o r t , C r e a t i n g S h a r e h o l d e r V a l u e : T h e N e w S t a n ­ d a r d f o r B u s in e s s P e r f o r m a n c e (1986).

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In part, this is in response to the second factor that will generate problems for the entity conception. I refer to the evolution of stock­ holders large enough to overcome the collective action problems faced by dispersed shareholders. As institutional investors grow in impor­ tance, it is thought that the prospect of real stockholder oversight and discipline will also grow.58 This evolutionary factor seems, as well, to privilege the property conception of the corporation. Thus the answer to the question, what is a business corporation, that was given by the constituency statutes and implied by the Time-Warner decision, should itself be seen as provisional, not final. I suppose that there will be no final move in defining the nature or the purpose of the business corporation. It is perhaps asking too much to expect us, as a people—or our law—to have a single view of the purpose of an institution so large, pervasive, and important as our public corporations. These entities are too important to generate that sort of agreement. Within them exists the tension that a dynamic market system creates between the desire to achieve increases in total wealth and the desire to avoid the losses and injuries—the redistribu­ tion—that a dynamic system inevitably engenders. Thus while these entities are surely economic and financial in­ struments, they are, as well, institutions of social and political signifi­ cance. The story of the contending conceptions of the corporation reflects that fact. Indeed, it may not be an exaggeration to imagine that this story resonates with an elemental tension that our society has endured since the days of the industrial revolution. That tension arises from the longing for stability and community in the liberal soci­ ety. Business corporations may strike you as a pale, perhaps even pathetic, source of the meaning and identity people achieve through community membership and interaction. That may be as it is, and it may be as well that any instinct to preserve existing corporate struc­ tures in order to protect meaningful membership in social groups, could be satisfied only at an unacceptable cost to economic efficiency. But putting personal judgments aside, I suggest that anyone trying to understand how our law deals with corporations must have in mind that they are the locus of many conflicting claims, and not all of those claims are wholly economic. Thus I conclude that we have been schizophrenic on the nature of the corporation, but as a society we will probably always be so to some extent. The questions “What is a corporation?” and “For 58 See, e.g., Bernard S. Black, Agents Watching Agents: The Promise o f Institutional Inves­ tor Voice, 39 UCLA L. R e v . 811 (1992). But see Edward B. R ock, The Logic and (Uncertain) Significance o f Institutional Shareholder Activism, 79 G e o . L.J. 445 (1991).

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whose benefit do directors hold power?” are legal questions only in the sense that legal institutions will be required at certain points to formulate or assume answers to them. But they are not simply techni­ cal questions of law capable of resolution through analytical rule ma­ nipulation. Even less are they technical questions of finance or economics. Rather in defining what we suppose a public corporation to be, we implicitly express our view of the nature and purpose of our social life. Since we do disagree on that, our law of corporate entities is bound itself to be contentious and controversial. It will be worked out, not deduced. In this process, efficiency concerns, ideology, and interest group politics will commingle with history (including our semi-autonomous corporation law) to produce an answer that will hold for here and now, only to be tom by some future stress and to be reformulated once more. And so on, and so on, evermore.

Part II The Board of Directors

[5] Legal Models of Management Structure in the Modern Corporation: Officers, Directors, and Accountants’!* Melvin Aron Eisenberg* Contrary to the legal norm, the functions of managing the business of a corporation and making business policy generally vest in the execu­ tives rather than the board . After examining the reasons why this condition prevails, Professor Eisenberg analyzes past proposals for reform, which typically have sought ways to reinvest these functions in the directors. Finding fault with the premise of these proposed re­ forms—that directors can successfully either manage or make busi­ ness policy in modem , complex corporations— he then assesses the remaining functions of the board . His conclusion is that one such function, monitoring the performance of the chief executives office, is both critical to the corporation and uniquely suited to the board . He therefore proposes changes in the law of corporations and corporate accounting to ensure that the board will have adequate independence and sufficient data to perform this monitoring function effectively •

A major function of corporation law is to regulate the maimer in which the corporation is constituted; either directly, by distributing decisionmaking power among the various corporate organs, or in­ directly, by setting the parameters within which the private actors can make such a distribution themselves. At the core of the distributive apparatus of most corporate statutes is a deceptively simple provision: “The business and affairs of a corporation shall be managed by a board of directors.” 1 This provision, in turn, reflects what might be called f Copyright 1975 by Melvin Aron Eisenberg. Th*s is the fourth and last in a series of articles on the allocation of legal powers within the modern corporation. See Eisenberg, The Legal Roles of Shareholder and Management in Modern Corporate De­ cisionmaking, 57 C a l i f . L. R e v . 1 (1969); Eisenberg, Access to the Corporate Proxy Machinery, 83 H a r v . L. R e v . 1489 (1970); Eisenberg, Megasubsidiaries: The Effect of Corporate Structure on Corporate Control, 84 H a r v . L . R e v . 1577 (1971). Most of the research for this article was conducted during a Guggenheim Fellow­ ship. * Professor of Law, University of California, Berkeley. A.B. 1956, Columbia University; LL.B. 1959, Harvard University. 1. II I. S t a t . A n n . ch. 32, § 157.33 (Smith*Hurd Supp. 1974). See also N J. S t a t . A n n . § 14A:6-1 (Supp. 1968); N.Y. Bus. C o r p . L a w § 701 (McKinney Supp. 1974).

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the received legal model of corporate decisionmaking in general, and management structure in particular. According to this model, corpo­ rate operating procedure is pyramidal in form: at the base is the body of shareholders, empowered to elect the board and vote on other major corporate actions; at the next level is the board of directors, whose duties are to select officers, make policy, and generally manage corpo­ rate business; and at the pyramid’s apex is the corps of officers, who “have some discretion but in general are deemed to execute policies formulated by the board.”2 It has become increasingly clear over the years, however, that under what might be called the working model of management structure— that is, the model which embodies actual corporate practice— most of the powers supposedly vested in the board are actually vested in the executives. The purpose of this Article is to explore the skew between these two models of corporate decision­ making, to consider the more prominent alternative models which have been suggested, and to propose a direction for reform.

I L a w a n d P r a c t ic e

A.

The Received Legal Model and the Working Model

Under the received legal model of the corporation, the board selects officers, sets policy, and generally manages the corporation's business. Under the working model, however, the board normally per­ forms none of these functions. To begin with, in practice the board seldom manages the business of a corporation. “Under the system of directorates which has developed in this country among large, listed companies, directors are unable to ‘manage’ corporations in any narrow interpretation of the word. . . . Directors do not and cannot ‘direct’ corporations in the sense of operating them.”3 Instead, in small, closely-held corporations the business is typically managed directly by owner-managers,4 while in large, publicly-held corporations (the principal subject of this Article) the business is typically managed by the top executives. 2 . W . C a r y , C o r p o r a tio n s — C ashs a n d M a t e r i a ls 150 (4th ed. 1 9 6 9 ). See also, e.g., 1 ABA, M o d e l B u s. C o r p . A c t A n n . 7 5 2 , 754 (2 d ed. 1 9 7 1 ); H. B a lla n t i n e , C o r p o r a tio n s 119-20 (rev. ed. 1 9 4 6 ); N . L a t t in , T h e L a w o f C o r p o r a tio n s § 69, at 23 9 (2 d ed. 1 9 7 1 ). 3. J. B a k e r, D i r e c t o r s a n d T h e ir F u n c t io n s — A P r e lim in a r y S t u d y 12 ( 1 9 4 5 ) [h ereinafter cited as B a k e r]. See also R . G o r d o n , B u s in e s s L ea d er sh ip in T h e L a r g e C o r p o r a tio n 7 9-90, 114-15, 128, 134, 143-46 (2 d ed. 1 9 6 1 ) [hereinafter cited as G o r d o n ]; H. M a u r e r , G r e a t E n t e r p r is e — G r o w t h an d B e h a v io r o f t h e B ig C o r p o r a t io n 195 (1 9 5 5 ) ( “ *If outs'd e d i;ectors really try to m an age, there is h ell to pay* ") [hereinafter cited as M a u r e r ]. 4. See, e.g., M . M ace, T h e B o a rd o f D i r e c t o r s in S m a ll C o r p o r a tio n s 87 (1 9 4 8 ).

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Indeed, the proposition that the board usually does not manage the corporation’s business is not directly controverted by any serious student of corporate practice. It is often said, however, that the board does make business policy,5 and it is frequently implied that by making business policy the board fulfills the statutory command.6 In fact, of course, policymaking is not equivalent to management: for example, although civilians may make policy for the Army, they certainly do not manage the Army. But in any event, the typical board no more makes business policy than it manages the business. In the large, publiclyheld corporation, policymaking, like management, is. an executive func­ tion. As early as 1945 the economist Robert Aaron Gordon reported in Business Leadership in the Large Corporation that in both financial and non-financial matters there was little or no indication that the boards of la-ge companies initiated decisions on either specific matters or broad policies. While the board’s approval function was more im­ portant than its initiating activities, Gordon found that “even with re­ spect to approval, many boards in these large companies are almost completely passive,” and that the final approval function was usually exercised by the chief executive in conjunction with either his immedi­ ate subordinates, an executive or finance committee of the board, or a few influential directors acting as his informal advisors.7 Similarly, John C. Baker of the Harvard Business School reported the same year that major policies in production, marketing, finance, and personnel were usually formulated by the executives and not even formally confirmed by the board (although there was often consultation with individual directors), while in such matters as addition of new products, preparation of operating budget, and negotiation of collective bargaining agreements, the board’s role was limited to receipt and con­ sideration of after-the-fact reports.8 More recent studies, particularly that of Professor Myles Mace,9 have confirmed these earlier findings.10 5. See, e.g., J, B aco n , C o r p o r a te D i r e c to r s h ip P r a c t i c e s 93 (Nat’l Indus. Conference Bd. Studies in Business Policy No. 125, 1967) [hereinafter cited as 1967 C o n f e r e n c e B o ard S u rv e y ]; 1 G. H o r n s te i n , C o r p o r a tio n L a w an d P r a c t i c e 526 (1959). 6. See, e.g., 1967 C o n f e r e n c e B o a rd S u rv e y , supra note 5, at 96; B a k e r, supra note 3, at 12, 131-32; H. K o o n tz , T h e B o a rd o f D i r e c t o r s a n d E f f e c t i v e M a n a g e ­ m e n t 33-44, 46-58 (1967) [hereinafter cited as K o o n tz ]. 7. G o rd o n , supra note 3, at 128-29, 131. See also id. at 114. 8. B a k e r, supra note 3, at 131-32. 9. M . M a c e , D i r e c t o r s : M y t h an d R e a l i t y 47-48 and passim (1971) [herein­ after cited as M ace].

10. See, e.g., J. B a co n & J. B ro w n , C o r p o r a t e D ir e c t o r s h i p P r a c ti c e s : R o le , S e l e c t i o n a n d L e g a l S t a t u s o f t h e B o a rd 16-17 (Conference Board R ep. No. 646, 1975) [hereinafter cited as 1975 C o n f e r e n c e B o a rd S u rv e y ;] C. B r o w n & E. S m ith , T h e D i r e c t o r L o o k s a t H is Jo b 24-26 (1957) [hereinafter cited as B ro w n & S m ith ]; M a u r e r , supra note 3, at 200-02. But see P . H o ld e n , L . F is h & H . S m ith , T op

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M odern Board Practice

The drastic skew between the received and working models of management structure is not simply an accident of time or temper. Rather, it is the virtually inevitable result of several critical constraints imposed by modern board practice. 1.

Constraints of time

Some simple statistics: Although a board of directors normally can act only at meetings, a 1967 Conference Board study of 454 manufac­ turing and mining corporations found that the boards of 45 percent of the surveyed corporations met no more than six times a year, and the boards of 96 percent met no more than twelve times a year.11 Virtu­ ally identical findings emerged in a 1970 survey of 474 industrial cor­ porations by the management-consulting firm of Heidrick & Struggles.12 Since board meetings usually last only a few hours,18 the upshot is that M a n a g e m e n t O rganization a n d C o ntro l 17, 2 14 (en larged ed . 1 9 4 8 ) [hereinafter cited as H old e n , F ish & S m it h ]; I nvesto r R e sp o n sib il it y R esearch C e n t e r , I n c ., C hanges in t h e C orporate B oard R o o m : W h a t S ho u ld B e D o n e ? W ho S h o uld D o I t ? 5 -6 ( 1 9 7 4 ) [h ereinafter cited as IR R C ].

The same analysis is generally applicable to nonbusiness corporations.

See H.

W ile n s k y & C. L e b e a u x , I n d u s t r i a l S o c ie ty a n d S o c ia l W e l f a r e 272-73 (1958); Kerr, The School Board as an Agency of Legitimation , S o c io lo g y o f E d u c a tio n , Fall

1964, at 34, 49-55. 11. 1967 C o n f e r e n c e B o a rd S u rv e y , supra note 5, at 127 Table 21. The figures for other types of corporations surveyed were generally comparable, except for the public utilities (of 81 surveyed, 9.9 percent met more than 12 times a year—but none met more than 15 times— and 29.6 percent met six times or fewer) and the banking corporations (of 40 surveyed, 65 percent met 10 to 12 times a year, 30 percent met 13 to 25 times, and only 2.5 percent met fewer than 10 times). Id. A more recent Conference Board survey of a smaller population— 129 industrials— reported that just over 40 percent held 10 or more meetings per year; no breakdown was given for the 60 percent holding fewer than 10 meetings. See Brown, The Board of Directors and Its Work Routine , C o n f. Bd. R e c., March 1972, at 36. 12. H e id r ic k & S tr u g g l e s , P r o f i l e o f t h e B o a rd o f D i r e c t o r s 5 (1971) [hereinafter cited as H e id r ic k & S tr u g g le s ] . The percentages for merchandising, in­ surance, and transportation companies were similar to those for industrials. Among the utilities, 27.8 percent held six or fewer meetings a year, and 11.1 percent held more than 12 meetings a year. Among the banking corporations, 4.4 percent held six or fewer meetings a year, and 26 percent held more than 12 meetings a year. The Heidrick & Struggles survey was conducted by a questionnaire sent to the 1,000 largest industrial companies, 50 largest merchandising companies, 50 largest transporta­ tion firms, 50 largest life-insurance companies, and 50 largest utilities, as ranked by sales volume in Fortune magazine, and 300 largest commercial banks, as ranked by deposits in Polk’s World Bank Directory. Id. at 2. Of the corporations surveyed, 750 provided usable responses, including 474 industrials, 158 banks, 26 transportation companies, 23 merchandisers, 33 insurance companies, and 36 utilities. Letter fiom Heidrick & Strug­ gles to the author, Sept. 30,1972. 13. See K o o n tz , supra note 6, at 158; 'Outside’ Directors Are *In' C h e m ic a l W eek , August 18, 1971, at 57 [hereinafter cited as 4Outside* Directors Are 7/1*1; cf.

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few boards spend more than 36 hours a year in meeting time, and about half spend only 18 hours a year or less.14 Since time spent preparing for meetings is roughly comparable to meeting time,15 it is obvious that by reason of time constraints alone the typical board could not possibly “manage” the business of a large, publicly-held corporation in the normal sense of that term:16 Such businesses are far too complex to be managed by persons who put in the equivalent of five to ten work­ ing days a year. Furthermore, the same imperative precludes the board from making business policy: In a complex organization con­ cerned with complex choices, policy cannot be developed on a parttime basis.17 Nutt, A Study of Mutual Fund Independent Directors, 120 U. P a. L . R e v . 179, 221 (1971); Townsend, Let's Install Public Directors, Bus. & S o c’y R ev., Spring 1972, at 69. 14. Some directors may put m additional time on committee work, but this is nor­ mally relatively limited. For example, although the most common board committee is the executive committee, one-fourth of the 512 manufacturing companies included in a recent Conference Board survey did not have such a committee. J. B aco n , C o r p o r a te D ir e c to r s h ip P r a c t ic e s : M e m b e rsh ip a n d C o m m itte e s o f t h e B o a rd 50, 54 Table 13 (Conference Board Report No. 588, 1973) [hereinafter cited as 1973 C o n f e r e n c e B o a rd S u rv e y ], In those which did, one-fourth of the committees had no outside di­ rectors, and one-fourth had only a minority of outside directors. Id. at 56 Table 15. Almost 10 percent of the executive committees never met. The median number of meet­ ings for those which did meet was seven per year. Id. at 55 Table 14. 15. A study conducted by the Conference Board reported that of 93 responding companies only 19 believed directors spent more time on corporate affairs outside than inside meetings. Of the remaining 74 respondents, 36 believed about as much time was spent outside as inside, and 38 believed less time was spent—usually much less. Brown, supra note 11, at 37; cf. *Outside’ Directors are ‘In,1 supra note 13, at 60. See also Gar­ rett, The SEC Study of Directors? Guidelines, Conf. Bd. Rec., July 1974, at 57, 58. 16. Of course, if the board consists of officer-directors, then the individuals who do manage the corporation’s business are also directors, but they do not manage the busi­ ness by virtue of their directorial capacity. Similarly, large shareholders may utilize the board as a means of exercising control without actually taking a managerial role, see text accompanying notes 75-77 infra, and the board may then play an active role. But in this case too the board’s force derives from nondirectorial capacities. 17. M a c e , supra note 9, at 185; M a u r e r , supra note 3, at 200-01. Even where a part-time board does purport to make policy, the meaningfulness of its decisions may be questionable. “One executive . . . remarked that he did not care who formulated the policy so long as he was left to carry it out, because he knew that by the time the operating organization had modified the so-called major policy decision to meet realities, he would have pretty much his own way.” M . C o p e la n d & A. T o w l, T h e B o a rd o f D i r e c t o r s a n d B u sin e ss M a n a g e m e n t 66 (1947) [hereinafter cited as C o p e la n d & T o w l].

There are, of course, cases where the board does play a meaningful role in making business policy, see M a c e , supra note 9, at 48-52, but in many or most of these cases it will probably be found either that the board is dominated by executives or important shareholders, see note 16 supra, or that the business of the corporation does not involve many operating decisions. C/. SEC, I n s t i t u t i o n a l I n v e s t o r S tu d y R e p o r t , H .R . Doc. No. 64, 92d Cong., 1st Sess. 811-14 (1971) [hereinafter cited as SEC, I n v e s t o r R e p o rt] .

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Constraints of information

Some further statistics: Although an opportunity to consider rele­ vant data is obviously essential to meaningful decisionmaking, of 474 industrials surveyed by Heidrick & Struggles only 17.2 percent sent di­ rectors manufacturing data prior to the meeting, only 21.3 percent sent marketing data, only 5.7 percent sent an agenda, and 11 percent sent no information at all.18 In many corporations* the executives go so far as to wholly deny the board— supposedly entrusted with supreme power over the corporation— access to certain categories of information. One-fifth of the executives questioned on this subject in both the Con­ ference Board and Heidrick & Struggles surveys responded that di­ rectors should not have unrestricted access to company plans and oper­ ating dara.10 Furthermore, the board normally has no staff of its own to evaluate the information it does receive or to gather information directly. In­ stead, the board must rely on the executives to perform those functions, either directly or through the executives’ own staff.20 Getting addi­ tional information is frequently very difficult. In many cases a director does not know what additional information he should request. Even if he does, it is regarded as improper— “just plain bad manners”21— to ask executives challenging questions at board meetings.22 Thus the amount, quality, and structure of the information that reaches the board is almost wholly within the control of the corporation’s executives.23 It need hardly be added that this kind of power over information flow is viitually equivalent to power over decision.24 3.

Constraints of Com position , Selection , and Tenure

While constraints of time and information restrict the board’s abil18. H e id ric k & S t r u g g l e s , supra note 12, at 5. 19. 1967 C o n f e r e n c e B o a rd S u rv e y , supra note 5, at 132; H e id ric k & S t r u g ­ g le s , supra note 12, at 6. See also JECoontz, supra note 6, at 161; Weinberg, A Corpora­ tion Director Looks at His Job, 27 H a rv . B us. R ev. 585, 588-89 (1949). A note accompanying the Heidrick & Stiuggles data states that “[a]mong [those corporations which do not give umestricted access] . . . are organizations involved in government work, since exposure to their data necessitates security clearance,'* but it does not explain how many corporations have this problem or why the diieclors are not cleared. 20. See J . J u r a n & J. L o u d e n , T h e C o r p o r a t e D i r e c t o r 287 (1966) [hereinafter cited as J u r a n & L o u d en ]. 21. M a ce, supra note 9, at 54. 2 2 . See id. at 5 2 -6 1 , 186-88; Nutt, supra note 13, at 2 21 -2 2 . One chief executive told Mace that he liked to have insiders on the board so that he could take advantage of the “commonly observed courtesy” that the president will not be asked embarrassing questions in the presence of h is subordinates. M a c e , supra note 9 , at 124; cf. id. at 54.

23. Cf. C o p e la n d & T ow l* supra note 17, at 169; J u r a n & L o u d en , supra note 20, at 288; M ace, supra note 9, at 30; Zald, The Power and Functions of Boards of Directors: A Theoretical Synthesis, 75 Am. J. Soc. 97, 104 (1969). 24. Cf. Kerr, supra note 10, at 51; Zald, supra note 23, at 104.

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ity to manage the business or make policy, they do not directly subordi­ nate the board to the corporation’s executives. Direct subordination does necessarily follow, however, from a cluster of elements relating to the composition, selection, and tenure of directors. Composition of the board . The most striking of the compositional elements is the degree to which the typical board includes persons who are economically or psychologically dependent upon or tied to the cor­ poration’s executives, particularly its chief executive. Indeed, a sub­ stantial number of seats are held by executives themselves. Employeedirectors held half or more of the board’s seats in 29 percent of the approximately 500 manufacturing corporations included in a 1973 Con­ ference Board survey,25 49.8 percent of the industrials in the Heidrick & Struggles sample,26 and 55.9 percent of the 1970 Fortune 500.2* Dependent on the chief executive for both retention and promotion,28 and on other executives for day-to-day support, the inside director Is highly unlikely to depart at a board meeting from the inside line deter­ mined by management prior to the meeting. As the corporate figures interviewed by Mace reported: The vice president inside-director type is in a precarious position at a board meeting. He just can’t say anything in disagreement with his boss, so what he usually does is sit quietly and wait until he is called upon to speak.29 a.

Insiders don’t ask questions or raise issues at board meetings be­ cause their points of view and contributions have all been expressed at meetings of management prior to the board meeting. All the in­ siders have been through the monthly performance review. Rarely— no, never—does the head of one operating group raise a question at the board meeting concerning the performance of another operating group. He would not do that at a board meeting.30 25. 1973 C o n f e r e n c e B o a rd S u rv e y , supra note 14, at 2, 3. Among approxi­ mately 340 nonmanufacturing corporations only 14 percent had boards with insider ma­ jorities. Id. Financial institut'ons in particular have traditionally had a low proportion of inside directors. Cf. id. at 3 Chart 3. 26. H e id r ic k & S tr u g g l e s , supra note 12, at 4. In the nonindustrial categories, less than 20 percent of the banking, insurance, transportation, and utility corporations, but 65 percent of merchandising corporations, had insider majorities or evenly divided boards. Id. at 4. 27. Smith, Interlocking Directorates Among the *Fortune 500 * A n t i t r u s t L. & E c o n . R ev., Summer 1970, at 47, 49-50. Smith’s data actually covered only 495 of the Fortune 500, since information on five corporations was unavailable. Of tbe 495 cor­ porations, 49.7 percent had a majority of insiders and 6.2 percent were split evenly be­ tween insiders and outsiders. Id. at 50. Of the aggregate seats in the 495 corporat:ons, 57.5 percent were held by insiders and 43.5 percent by outsiders. Id. at 47-48 & Table 1. 28. See note 88 infra. 29. M a ce, supra note 9, at 119-20. 30. Id. at 120.

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. . . We have a sort of rule around here—we’ve even formal­ ized it in a sense. Now, we fight like cats at the management meet­ ings. But if any of our key inside people on the board feels strongly opposed to something the president is asking the board to approve— and again, this doesn’t happen very often—rather than go to the meeting and vote for it contrary to his judgment, he just doesn’t go to that particular board meeting. This is sort of a screwy idea, but tbat’s the way it’s done here.81 Nor is dependence on the corporation’s chief executive confined to inside directors. Recent surveys suggest, for example, that approxi­ mately one-fifth to one-fourth of the outside directors in large American corporations are lawyers or investment bankers.82 Probably most of these are suppliers of services to the? corporations on whose boards they sit, and are therefore highly interested in retaining the good graces of the chief executive, who normally has control over the purchase of such services. The same surveys indicate that approximately 12 to 15 per­ cent of outside directors are commercial bankers, who are also often intent on retaining the corporation’s business.88 Many if not most of the remaining directors are psychologically tied to the chief executive by friendship, former colleagueship, or both.34 Selection and tenure . As a result of current practices on selection and tenure, even those directors who are not bound to incumbent man­ agement by economic or psychological ties are unlikely to be truly inde­ pendent. To begin with, directors are typically selected not by the board, as might be expected, but by the chief executive.33 In making these selections most chief executives will take intb consideration whether the candidate can be counted on not to rock the boat. The retired chairman of a medium-sized company in the mid­ west stated: - “In the companies I know, the outside directors always agree with management. That’s why they are there. I have one b.

id. Smith, supra note 27, at 48-49 & Table 2 (20 percent of 1970 Fortune 500); 1973 C o n f e r e n c e B o a rd S u rv e y , supra note 14, at 29 Table 6 (25 percent of 511 man­ ufacturing companies). The Conference Board data is somewhat ambiguous: Of 2914 outside directors, 359 listed their principal affiliation as “law,” and 299 as “investments.” The Heidrick & Struggles data does not break out figures for the occupation of outside directors. 33. Sm ith, supra note 27, at 48-49 & Table 2 (12 percent); 1973 C o n f e r e n c e B o a rd S u rv e y , supra note 14, at 29 Table 6 (15 percent). 3 4 . See 1973 C o n f e r e n c e B o a r d S u r v e y , supra note 14, at 28 T ab le 4 ; C abot, Management and the Director, C o n f . Bd. R e c., A p ril 1974, at 50. 35. See 1975 C o n f e r e n c e B o a rd S u rv e y , supra note 10, at 6, 10, 12; B r o w n & S m ith , supra note 10, at 109-10; G o rd o n , supra note 3, at 109, 121, 130 & n.24, 131; M a ce, supra note 9, at 94-95; M a u r e r , supra note 3, at 201; Pfeffer, Size and Composi­ tion of Corporate Boards of Director& The Organization and its Environment, 17 Ad. S c l Q., June 1972, at 218, 220. 31.

32.

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friend that’s just the greatest agreer that ever was, and he is on a dozen boards. . . .”38

Beyond the fact that he is usually selected in part because he can be counted on to go along, a new director is likely to be aligned with the chief executive simply by virtue of the fact that he owes the latter his appointment87—an element reinforced by the chief executive’s role in orienting new directors to the board.38 Perhaps even more important than the power of selection, in vest­ ing the chief executive with control over outside directors, is the fact that in life as in law the power to hire implies the power to fire. A director who has been brought on the board by a chief executive— as outside directors typically are—is therefore likely to regard himself as serving at the latter’s sufferance. “Also communicated to, and gen­ erally accepted by, directors was the fact that the president possessed the complete powers of control. Those members of the board who elected to challenge the president’s powers of control were advised, usually outside the board meetings, that such conduct was inappropriate or they were asked to resign.”38 Nor is this power exercised infre­ quently: Almost 37 percent of the industrial respondents in the Heid­ rick & Struggles survey reported that they had fired directors.40 Because it is inherently undesirable for law and practice to be in a state of visible opposition, the drastio skew between the legal and working models of the board would be of serious concern even if no specific dysfunctional consequences could be perceived. In fact, how­ ever, a number of such dysfunctions can be identified. On a relatively 36. M a c e , supra note 9, at 99; cf. M u t u a l F u n d s 285 (R . Mundheim & M. Wer­ ner eds. 1970) (remarks of Allan F . Conwill); University of Pennsylvania Law School Conference on Mutual Funds, 115 U . P a . L . R e v . 663, 739 (1967) (remarks of Abra­ ham L. Pomerantz). As one executive was quoted: “Here in New York it’s a systems club. There is a group of companies . . . where the chief executive of Company A has B and C and D on his board. They are all members of the Brook Club, the Links Club, or the Union League Club. Everybody is washing everybody else’s hands.” M a c e , supra n o te 9, a t 9 9 . 37. Cf. 1975 C o n f e r e n c e B o a rd S u r v e y , supra note 10, at 25; Moscow, The In­ dependent Director, 28 Bus. L a w . 9, 11 (1972); Nutt, supra note 13, at 219. 38. Cf. B r o w n & S m ith , supra note 10, at 88-89; Nutt, supra note 13, at 219. 39. M a c e , supra note 9, at 80. See also id. at 79, 80-81; 1975 C o n f e r e n c e B o a rd S u r v e y , supra note 10, at 10. 40. H e id r ic k & S t r u g g l e s , supra note 12, at 11. Some of these firings may have been attributable to poor performance rather than insubordination. The percentage of other types of companies which had fired directors ranged from 32.3 to 38 percent, except for the utilities, only 11.1 percent of which reported such fir­ ings. Legally, of course, the chief executive does not have power to discharge a director; however, a recalcitrant director can be dropped simply by arranging that he is not re­ nominated when his term expires.

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particularistic level, many legal rules have been shaped on the premise that the board manages the corporation’s business in fact as well as in law. For example, by proceeding from the assumption that officers play a subordinate role to the board, the rules governing the authority of officers frequently embody an unrealisticaUy restrictive view of an officer’s power of position.41 Standards of care, by the same token, often seem to be pitched to the outside director rather than the execu­ tive, as if the former were really running the business.42 In duty-ofloyalty cases the courts have often given disproportionate weight to the fact that outside directors have approved a transaction in which execu­ tives are interested,43 while the legislatures have sometimes gone so far as to provide that approval by outside directors is sufficient to sterilize an otherwise infected transaction.44 In a wider context, the skew be­ tween belief and reality has led to what might be called the quackcure problem—the danger that belief in the validity of the received legal model will forestall meaningful regulation by lulling shareholders, legislators, and the public into the illusion (which often seems deliber­ ately conjured-up45) that a disinterested board is supervising the cor­ poration’s affairs.46 41. See, e.g., Schwartz v. United Merchants & Mfrs., Inc., 72 F.2d 256 (2d Cir. 1934); Phoenix Western Holding Corp. v. Gleeson, 18 Ariz. App. 60, 500 P.2d 320 (1972); Hurley v. Omsteen, 311 Mass. 477, 42 N.E«2d 273 (1942); Douglass v. Pan­ ama, Inc., 504 S.W.2d 776 (Tex. 1974). 42. See, e.g., Graham v. Allis-Chalmers Mfg. Co., 41 Del. Ch. 78, 188 A,2d 125 (Sup. a . 1963); Glassberg v. Boyd, 35 Del. Ch. 293, 116 A.2d 711 (1955). 43. See, e.g., Meiselman v. Eberstadt, 39 Del Ch. 563, 568, 170 A.2d 720, 723 (1961); Beard v. Elster, 39 Del. Ch. 153, 164-65, 160 A.2d 731, 738 (Sup. Ct. 1960). 44. See, e.g., D e l. C o d e A n n . tit. 8, § 144(a)(1) (Michie 1975). 45. Cf.Amex Votes to Reshape its Structure, N.Y. Times, June 8, 1972, at 69, col. 6; Exchange Members Grant the Public a Louder Voice, N.Y. Times, March 2, 1972, at 55, col. 7; Metz, Directors' Role at Exchanges, N.Y. Times, Dec. 26, 1972, at 54, col. 4; Price of Friendship: How Rich Acquaintances o f California Publisher Evidently Lost Bundle, Wall St. J., Aug. 11, 1972, at 1, col. 1; Public Directors Cautious at Big Board, N.Y. Times, May 21, 1973, at 51, col. 5. 46. See M a ce, supra note 9, at 107-08; S. V a n c e , T h e C o r p o r a t e D i r e c t o r — A C r i t i c a l E v a l u a tio n 63-68 (1968) [hereinafter cited as V a n c e ]; Cary & Harris, Standards of Conduct under Common Law, Present Day Statutes and the Model Act, 27 Bus. L aw ., Feb. 1972, at 61, 65-66 (special issue) (remarks of Professor Cary); Heineman, What Does and Doesn't Go On in the Boardroom, F o r t u n e , Feb. 1972, at 157, 159; Zald, supra note 23, at 103; Townsend, Book Review, N.Y. Times, Dec. 12, 1971, § 7 (Book Review), at 3. For example, in the Investment Company Act of 1940 Congress sought to regulate conflicts of interest between investment companies and their investment advisers, which were typically under common control, primarily by directing that no more than 60 per­ cent of an investment company’s board could be affiliated with its investment adviser in specified ways, and that contracts between an investment company and its adviser re­ quired periodic approval by either the shareholders or a majority of the unaffiliated di­ rectors. Investment Company Act of 1940, §§ 2 (a )(3 ), 10(a), 15(a)-(c), 54 Stat. 790, 806, 812-13 (1940). In practice this technique of regulation turned out to be virtually worthless, because the unaffiliated directors of investment companies, like the outside

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n P ro po sa l s f o r R e f o r m o f t h e B o a r d : B r in g in g t h e W o r k in g M o d e l i n t o L i n e w it h t h e R e c e iv e d L e g a l M o d e l

Given the skew between the legal and working models of manage­ ment structure, and the resulting dysfunctions, it is not surprising that proposals for reform of the board have become a permanent part of the American corporate scene. Most of these take the received legal model as a starting point and seek to bring corporate practice into line. From that point on, however, the proposals show wide variation, falling into three broad categories: those calling for professional directors; those calling for full-time directors; and those calling for fully-staffed boards. A.

Professional Directors

One common type of proposal calls for filling board places with persons who would make a career out of serving as directors in a num­ ber of corporations, and would therefore presumably be more expert in and more attentive to their directorial obligations—so-called profes­ sional directors.47 It is unlikely that private action could be depended upon to effectuate such a reform. Over 88 percent of the corporations in the Heidrick & Struggles survey, including 85 percent of the indus­ trials, reported that they had no interest in using professional direc­ tors.48 Yet it is equally unlikely that such a reform could be effected directors o f oth er corp orations, w ere n o t in co n tro l o f the board, w ere selected and in­ doctrinated b y insiders w h o represented th e in v estm en t adviser, and w ere o ften c lo se ly tied to insiders even th ough n o t tech n ica lly “a ffilia ted .” See SEC, I n v e s t o r R e p o r t , supra n o te 17, at 2 0 7 -1 5 , 3 6 3-64; SEC, R e p o r t o n P u b lic P o l i c y I m p lic a t i o n s o f I n ­ v e s t m e n t C o m p a n y G r o w th , H.R. R ep . N o . 2 3 3 7 , 89th C on g., 2 d Sess. 10-17, 9 4 -1 2 5 , 1 5 0 -5 1 , 162-78 ( 1 9 6 6 ) ; W h a r t o n S c h o o l o f F in a n c e & C o m m e r c e , A S t u d y o f M u ­ t u a l F u n d s , H.R. R ep . N o . 2 2 7 4 , 87th C o n g ., 2d Sess. 2 7 -3 6 , 463*66, 4 7 5 -5 3 9 (1 9 6 2 ) [hereinafter cited as W h a r t o n R e p o r t]; N u tt, supra n ote 13, at 184, 2 1 5 -2 0 . But see University of Pennsylvania Law School Conference on Mutual Funds, supra n ote 36 , a t 7 4 1 , 7 5 5 (rem arks o f Josep h E. W e lc h ).

The Investment Company Act was overhauled in 1970. Among other things, a spe­ cific duty was imposed on investment company directors “to request and evaluate . . . such information as may reasonably be necessary to evaluate the terms*’ of the investment-adviser contract, and a fiduciary duty was explicitly imposed on the adviser with respect to its compensation. 15 U.S.C. §§ 80a-15(c), 35(b) (1970). See Nutt, supra note 13, at 265. 47. See, e.g., W. D o u g la s , D e m o c ra c y a n d F in a n c e 52-55 (1940); H o ld e n , F is h & S m ith , supra note 10, a t 225; J u r a n & L o u d e n , supra note 20, a t 331-33; cf. Bacon, Directors Under Pressure, C o n f . Bd. R e c., F eb. 1972, a t 44, 44-45 (rem ark s o f James E. R o b iso n ). '48. H e id r ic k & S t r u g g l e s , supra note 12, at 10. See also J u r a n & L o u d e n , supra note 20, at 333-35. In addition, 64.5 percent of the surveyed corporations, including 56.7 percent of the industrials, had no interest in using retired executives as directors, and most of the re­

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by law. For one thing, it would be extremely difficult to define the term “professional director” statutorily. For another, it is questionable whether a suitable population of potential appointees presently exists; in a 1973 Conference Board survey of 851 boards, for example, only 75 seats were held by persons who considered themselves to be profes­ sional directors.49 Although the population problem might be miti­ gated by extensive use of retired executives, that solution would simply foster another, equally difficult problem: the creation of a corporate gerontocracy, in conflict with the recent trend toward setting a retire­ ment age for directors as well as executives.60 Even putting aside the difficulties of making such a proposal oper­ ational, the wisdom of putting it into effect seems very doubtful when its implications are considered. Because directorships under present corporate practicc are part-time positions, directorship fees are rela­ tively low: median annual compensation for board service is in the $3400-4800 range.61 To earn a living as a professional director com­ mensurate with the skills required, an individual would therefore need to hold upwards of a dozen directorships.62 Assuming that the number of large publicly held corporations for which such a reform might sensi­ bly be required is approximately 2750,68 that the average number of outside directorships in such corporations is six,64 and that all outside seats would be filled by professional directors, approximately 15,GOO16,000 seats would have to be filled in this manner. If each director were to hold a dozen seats, all of these directorships would be filled by just 1300 individuals. Not only would this generate an enormous and institutionalized conflict-of-interest problem but, what is worse, the maining corporations had no interest unless there was an age restriction. H e id ric k & S m u g g le s , supra note 12, at 10. 49. 1973 C o n f e r e n c e B o a rd S u rv e y , supra note 14, at 29 Table 5, 39 Table 9. See also 1975 C o n f e r e n c e B o a rd S u rv e y , supra note 10, at 40. 50. See 1973 C o n f e r e n c e B o a rd S u rv e y , supra note 14, at 42-47; H e id ric k & S t r u g g l e s , supra note 12, at 10; J u r a n & L o u d e n , supra note 20, at 182-83; c/. B ro w n & S m ith , supra note 10, at 117; Companies Act of 1948, 11 & 12 Geo. 6, c, 38, § 185 (special notice required for resolution appointing a director over the age of 70). 51. J. B a co n , C o r p o r a te D ir e c to r s h ip P r a c t ic e s : C o m p e n s a tio n 3 Chart 3 (Conference Board Rep. No. 596, 1973). This range includes both manufacturing ($4800) and nonmanufacturing ($3400) corporations. 52. Cf. Vanderwicken, Change Invades The Boardroom , F o r t u n e , May 1972, at 156, 282. 53. This figure is based on the number of common stock issues traded on the New York and American Stock Exchanges. Letter from Dorothy Geraghty, Research Associ­ ate, New York Stock Exchange, to the author, Mar. 3, 1975 (1542 issues); Letter from Robert A. Coplin, Vice-President, Information Services Division, American Stock Ex­ change, to the author, Feb. 27, 1975 (1222 issues). 54. The data permits only an estimate on this point, but the figure of six seems fairly reliable, and a range of five to eight would be highly reliable. See 1973 C o n ­ f e r e n c e B o a rd S u rv e y , supra note 14, at 1-2; H e id r ic k & S t r u g g le s , supra note 12, at 4; Smith, supra note 27, at 48.

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professional directors would form an interlocking communication net­ work tying the country’s major corporations together in a wholly unde­ sirable way.55 Finally, one may doubt the accuracy of the premise that profes­ sional directors are more likely than nonprofessionals to be meaning­ fully involved in managing the corporation’s business or making busi­ ness policy: In England, where they have a “profession” known as "company director,” the boardroom life is popularly regarded as a cushy sine­ cure. Said Lord Boothby, a life peer, in a reflective moment: “If you have five directorships it is total heaven, like having a permanent hot bath . . . . No effort of any kind is called for. You go to a meeting once a month in a car supplied by the company, you look grave and sage, on two occasions say ‘I agree,1 say ‘I don't think so' once, and if all goes well you get 500 pounds a year.” 56 B.

Full-Time Directors

A second type of proposal for bringing board practice into line with the received legal model is the restriction of board membership to “full-time directors,” that is, individuals who are in the corporation’s employ on a full-time basis, but differ from executives in that they do not have operating responsibilities.57 Such a model lifts from the board the time constraint that in itself debars most directors from making busi­ ness policy. An official, of Standard Oil of New Jersey, which had such a board for many years,58 put the argument as follows: [I]t’s just inconceivable that a director in a corporation can discharge the [director’s] resppnsibilities . . . unless he does more than attend 55. Cf. Smith, supra note 27; Smith & Desfosses, Interlocking Directorates; A Study o f Influence, Miss. V a l l . J. Bus. & E c o n ., Spring 1972, at 57. See also Clayton Act § 19, 15 U.S.C. § 19 (1970) (u. . . . No person at the same time shall be a director in any two or more corporations, any one of which has capital, surplus, and undivided profits aggregating more than $1,000,000 . . . if such corporations are or shall have been theretofore . . . competitors. . . .” ); Protectoseal Co. v. Barncik, 484 F.2d 585 (7th Cir. 1973); F.X.C. Says 3 Concerns Violate Law on Directors, N.Y. Times, Nov. 25, 1972, at 1, col. 2; Goodyear Chairman Quits Alcoa Board; FTC is Notifiedt Wall S t JM Dec. 1, 1972, at 6, col. 1; Kerr-McGee’s Head Leaves Outside Board, N.Y. Times, July 11, 1974, at 48, col. 1; Legal Actions Prompt Directors to Reassess Their Corporate Roles, Wall St. J., Sept. 17, 1974, at 1, col. 6; Littlefield Quits Board at Chrysler, Re­ mains at GE A fter FTC Move, Wall St. J., March 23, 1973, at 9, col. 1; Second Alcoa Director Cited by FTC Quits a Post, Case Against 3 Firms May Go On, Wall St. J., Dec. 4, 1972, at 7, col. 1; 25 on Boards of Oil Companies Scrutinized in Antitrust Inquiry, N.Y. Times, March 12, 1974, at 1, col. 8. But cf. Towl, Outside Directors Under Attack, H a rv . B us. Rev., Sept,-Oct. 1965, at 135. 56. Chamberlain, Why It's Harder and Harder to Get a Good Board, F o r t u n e , Nov. 1962, at 109. 57. See generally B r o w n & S m ith , supra note 10, at 57-93. 58. See id. at 57; V a n c e , supra note 46, at 190-91.

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a board meeting once a month. Unless he works in between those monthly board meetings very hard, he’d come up with a lot of statis­ tics and have a lot of office traffic, but the real issue is whether a director of a corporation can or cannot discharge his responsibilities adequately . . . if he does not know enough about the functioning of the managers who are implementing board policy, and the results that they obtain, to form of his own knowledge proper opinion about what’s going on. Now that means, as I say, he’s got to be something more than a once-a-month director.69

As with the professional director, however, it is doubtful that the full-time director concept could be implemented by law. The distinc­ tion between operating and nonoperating decisions is not sufficiently clear to be the subject of legislative mandate, and even if it were, most corporations could not easily develop or afford a complete set of full­ time top managers who had no operating responsibilities.00 Finally, even if problems of statutory definition were overcome and the require­ ment restricted to those corporations which could afford it, the wisdom of precluding corporations from combining operating and nonoperating functions in the same individuals is doubtful, since in many businesses the major nonoperating functions (such as measurement of divisional performance, allocation of resources among divisions, determination of corporate-wide business principles, and establishment or acquisition of new businesses) cannot be compartmentalized from operating deci­ sions.61 59. B r o w n & S m ith , supra note 10, at 58. 60. See id. at 62-63; J u r a n & L o u d e n , supra note 20, at 170-71. 61. In 1966 Jersey itself significantly changed its full-time director concept by adding part-time outsiders to its board and transferring the old board’s functions to a reconstituted full-time executive committee* V a n c e , supra note 46, at 191. Perhaps partially in recognition that a board consisting solely of full-time directors is unfeasible in most cases, a variant of the full-time director concept has come into prominence within the last several years. Under this variant, a few (but less than all) of the directors, without taking on management responsibilities, would spend a signifi­ cant portion (but less than all) of their time directly involved with the corporation’s business. See, e.g., Patton, The Working Director—Management's Middleman, C o n f. Bd. R e c., Oct. 1972, at 36. Several major corporations have put such a concept into practice. For example, Westinghouse announced in 1972 that its top executives would retire from their managerial positions at 60, rather than at 65, and would then “be re­ tained as ‘officer-directors,’ reporting to the board on a variety of significant long-range problems. The ‘officer-directors* would spend two-thirds of their time on corporate busi­ ness until the normal retirement age of 65, and would draw two-thirds of their previous salaries Westinghouse to Cut Top Officers' Duties at Age 60 to Facilitate Suecession Process, Wall St. J., July 12, 1972, at 8, col. 2; see 1975 C o n f e r e n c e B o a rd S u rv e y , supra note 10, at 36. See also id, at 37-39; Vanderwicken, supra note 52, at 282, 290. Again, such a practice would be difficult to require in operative statutory terms. Furthermore, such arrangements in themselves seem to hold out little gain over present practice, since such special directors are likely to be super-consultants, dependent

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Fully Staffed Boards

Still a third type of proposal calls for equipping the board with a substantial staff of its own to advise it in reviewing management pro­ posals and thereby allow it to exercise at least a policymaking—if not a managerial—role.82 The best known and most complete proposal of this type was made by Arthur J. Goldberg in 1972 at the time of his resignation from the board of TWA. The Goldberg proposal begins by pointing up the skew between the received and working models of the board, and the inevitability of such a skew under current corporate practice. Since outside directors “cannot acquire more than a smattering of knowledge about any large and far-flung company,” the board “is relegated to an advisory and le­ gitimizing function that is substantially different from the role of policy maker . . . contemplated by the law of corporations.” As a result, “[i]t is difficult, if not impossible . . . for the most dedicated director to have much impact on policy decisions.” Thus the outside director is not fulfilling the policy-making role contemplated by corporate law, leaving him "open to justifiable criticism and legal recriminations.”83 The cure proposed for these ills is the establishment of “a committee of overseers of outside directors” which “would be generally responsion management for their positions, for their support, and for acceptance of any propo­ sals they might make. C f. Patton, supra, at 38. A variant of the variant calls for a special director who would he nominated or approved by some organ independent of the corporation and who would have special re* sponsibilities and special facilities. See Moscow, supra note 37; Townsend, supra note 13. Under Moscow's proposal such a director would be expected to devote at least 12 working days annually to the corporation’s business (in addition to attending board meetings), and would have the purpose of promoting “the long term business success of the corporate enterprise. . . . [and representing] the collective body of future share­ holders. . . Moscow, supra note 37, at 12. This seems like quite a lot to do in 12 days. Townsend’s proposal, which would apply only to corporations with over a billion dollars in assets, calls for the appointment of a full-time “public director” by an ad hoc committee of congressional members. The corporation would give this official an Office on its premises and a million dollars a year with which to pay his own salary and hire staff. He would “receive notice of all meetings conducted throughout the company [which would be] automatically open to attendance by him or one of his staff mem­ bers.** Townsend, supra note 13, at 69 (emphasis in original). He and his staff would have access to all files. He would be required to call two press conferences a year to “report on the company’s progress or lack of progress on issues of interest to the public. It will be argued that he will reveal company secrets. Let us pray he will.** Essentially, this is not an idea for a new kind of director, but for an observer posted at the corpo­ ration by the state. The staff would be the observer’s, not the board’s; the obligations would run to the public, not to the corporation. While the title of “director” might flow from the historical evolution of Townsend’s proposal, it is irrelevant to the proposal’s substance. For the kinds of difficulties such a proposal might involve, see note 106 in­ fra. 62. See, e.g., K o o n tz , supra note 6, at 169-70. 63. Goldberg, Debate on Outside Directors, N.Y. Times, Oct. 29, 1972, § 3, at 1, col. 3. See also N.Y. Times, O ct 19, 1972, at 69, col. 5.

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ble for supervising company operations on a broad scale and make peri­ odic reports to the board.” This committee would be authorized to hire a small staff of experts “who would be responsible only to the board and would be totally independent of management control,” and to en­ gage highly skilled consultants—such as scientific advisors, demo­ graphic experts, consumer advisors, advertising consultants, and finan­ ciers—to provide an independent source of expertise for the board. Together, the staff and consultants “would look into major policy ques­ tions and report to the committee and through them to the board as a whole before decisions are taken on management recommendations.” This assistance “would reassert the position of the board as a focal point for creative policy input for corporate decisions.” 64 The Goldberg proposal carries to its logical conclusion the proposi­ tion that the working model of the board must be brought into line with the received legal model, Given the premise that the board is to man­ age the business of the corporation (or at a minimum make business policy), it follows that unless the board is to consist of full-time corpo­ rate employees, which would be prohibitively costly and possibly ineffi­ cient in most corporations, it must have at its disposal a staff and con­ sultants to scrutinize management’s activities, policies, and proposals preliminary to review and revision by the board. Notwithstanding its logic, however, the Goldberg proposal is both unsound and unworkable. Stripped of its trappings, it would create a shadow staff with an institutionalized obligation to second-guess the management, but with very limited responsibility for results. Assuming that the directors are part-time, in cases where the recommendations of staff and management diverged they would have little choice except to adopt one set of recommendations or the other. Yet absent selfdealing on the part of management, the board’s staff could normally be expected only to decide again—with much more limited facilities and feel for the business, and at the price of additional expense and time—issues which management and the corporate staff have already once decided, if the conclusions of management and staff are the same, nothing will have been gained for this price. If they differ, it is far from clear how the board will choose between them. In short, the proposal would add a further and unnecessary level of decision­ making to corporations which already tend toward overbureaucratization; would add immensely to the difficulties of running the corpo­ ration’s business; and would produce a wholly undesirable diffusion of responsibility as among the executives, the shadow staff, the overseeing committee, and the board itself.65 64. 65.

Goldberg, supra note 63, at 3. C/. Blough, The Outside Director at Work on the Board, 45 N.Y. S ta te BJ .

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in T h e F u n c t io n s o f t h e B o a r d

Given that the Goldberg proposal carries to its logical conclusion the premise that the working model of the board should be brought into line with the received legal model, and given further that the pro­ posal is both unworkable and unsound, its ultimate thrust is to demon­ strate, however inadvertently, the invalidity of the premise from which it proceeds: Since the board cannot be expected either to manage the business or make business policy, the task of reform must lie not in aligning the working model of the board with the received legal model, but in structuring the board to ensure effectuation of any meaningful functions it can perform, and particularly any functions it is uniquely qualified to perform. With management and policymaking beyond the board’s reach, four clusters of functions remain: providing advice and counsel to the office of the chief executive; authorizing major corporate actions; pro­ viding a modality by which persons other than executives can be for­ mally represented in corporate decisionmaking; and selecting and dis­ missing the members of the chief executive’s office and monitoring that office’s performance.68 In considering the bearing of each of these functions on the structure of the board, two related questions must be 467 (1973); Smith, The Goldberg Dilemma: Directorships, Wall St. J., Feb. 7, 1973, at 14, col. 4. Blough points out that while the Goldberg proposal is grounded in signifi­ cant part on protecting the director against liability for failure to obey the statutory mandate that he manage the corporation, it would raise as many legal problems for a safety-first minded outside director as it would settle. If a conflict among staffs arose, some comfort could be taken legally in the board's having considered all viewpoints and its conclusion thus should not ordinarily be questioned by a court under the "business judg­ ment” rule. But the directors would also have to consider . . . the compara­ bility of the quality of the outside staff with the inside group, the possibility that a dissident stockholder would claim that because of a disclosed adverse report the board knew or should have known the investment would turn sour, or that confronted by conflicting views the board did nothing when it should have taken advantage of a golden opportunity. Blough, supra, at 470. For a more sympathetic view of the Goldberg proposal, see Schwartz, A Plan to Save the Board, 28 R e c o rd o f N.Y.C.B.A. 279 (1973). 66. Another function sometimes attributed to the board is handling crisis situa­ tions. See, e.g., M a c e , supra note 9, at 27. On examination, however, this function invariably boils down to selecting a new chief executive when the incumbent dies unex­ pectedly or when the corporation is in deep trouble due to his inadequacy, see id., and is therefore really a special case of the selection-and-dis missal function. The asking of pertinent questions is also sometimes listed as an important board function. See B a k e r, supra note 3, at 19; C o p e la n d & T o w l, supra note 17, at 95114; K o o n tz , supra note 6, at 39-40. In fact boards seldom ask such questions, see text accompanying notes 21-22 supra, but even if they did it would simply be an applica­ tion of the functions described in the tex t

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asked: How important is the function; and to what extent is the board uniquely qualified to perform it? A.

Advice and Counsel

It is commonly stated that a major function of the board is to pro­ vide advice and counsel to the corporation’s chief executive.07 Cer­ tainly a director is in many ways ideally suited to fill such a role. As a member of the corporate institution he has both a reasonable degree of familiarity with its business operations and a special set of loyalties to its welfare. And because he is a formal equal of the chief executive, he may be free to speak Ms mind in a way that is closed to the chief executive’s subordinates, while the chief executive may be able to dis­ cuss with him matters that could not easily be raised with subordi­ nates.08 On the other hand, the advice-and-counsel function is hardly essential to the corporation’s operation. The chief executive could per­ form his own functions with advice only from staff and line. If the chief executive does want outside advice, he can and frequently will obtain it from the corporation’s lawyers, accountants, or bankers, rather than from the board. Indeed, the fact that a given director is a profes­ sional often better accounts for his advice being sought than the fact that he is a director. B.

Authorization of Major Corporate Actions

Many kinds of corporate actions require authorization by the board of directors as a matter of either law or practice. The statutory direc­ tion that the corporation’s business be managed by the board serves to impose a requirement of board authorization for transactions of a cer­ tain quantitative magnitude, regardless of type—a requirement nor­ mally policed by third persons involved in such transactions. The stat­ utes also commonly require board authorization of certain types of transactions regardless of quantitative magnitude—typically dividend declaration, certificate amendment, merger, sale of substantially all as­ sets, and dissolution.09 Furthermore, the internal operating procedures of many corporations require board authorization for capital invest­ ments, acquisitions, long-term commitments, and other defined types 67. See B r o w n & S m ith , supra note 10, at 19 (remarks of unidentified director); G o rd o n , supra note 3, at 135-37; M a c e , supra note 9, at 13-22; Bacon, supra note 47, at 44 (remarks of G ustave L. Levy); Vanderwicken, supra note 52, at 157; Weinberg, A Corporation Director Looks at His Job, H a rv . B us. R ev., Sept. 1949, at 591. 68. See 1975 C o n f e r e n c e B o a rd S u rv e y , supra note 10, at 18; Vanderwicken, supra note 52, at 157-58. 69. See Eisenberg, The Legal Roles of Shareholders and Management in Modern Corporate Decisionmaking, 57 C a lif . L. R ev . 1, 60-68 (1969).

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of transactions involving some designated dollar amount.70 Certainly the authorization function may be a useful one. Even pro forma review is likely to inhibit practices which cannot stand even superficial scrutiny.71 Moreover, the mere expectation that review is required before a plan can become effective probably heightens the ra­ tionality of the decision process by inducing extra care in the prepara­ tion of proposals.72 Finally, providing the chief executive with an organ to which he is accountable, even in form, may dissipate somewhat the strains which accompany ultimate substantive responsibility. A leading executive has remarked that the board “buffers and protects the chief executive and provides him and his subordinate management with a sheltered and supportive environment in which to function.”73 On the other hand, beyond serving as an audience, and a generally agreeable one at that, the board’s reviewing role is usually quite lim­ ited, since its decisions must normally turn on analyses prepared by the very executives who formulate that which is being analyzed. Further­ more, the audience role itself can be played with more effectiveness elsewhere in the corporate structure, and it generally is. Since the modem corporation is highly bureaucratic, most plans must go through several layers of review even in the absence of a requirement of board approval. In all likelihood any one of these reviews has greater poten­ tial for disclosing a proposal’s weaknesses than does review by the board. Indeed, for most or all practical purposes the last real author­ ization level is the office of chief executive.74 Thus, aside from the potential check it provides in conflict-of-interest cases, the board’s au­ thorization function, like its advice-and-counsel function, is of limited importance. C. A Modality for Exercising Influence or Control A third function served by the board is the provision of a modality through which classes of persons other than the corporation’s executives can influence or control corporate action. For example, major share­ holders may want to become meaningfully involved in corporate deci­ sions, yet may not wish to take on an executive position. Exercise of control through formal shareholder channels is likely to be unsatisfac­ tory in such cases because the body of shareholders may not be legally 70. See, e.g., 1967 C o n f e r e n c e B o a rd S u rv e y , supra note 5, at 97; K o o n tz , supra note 6, at 45-53. 71. Nutt, supra note 13, at 223. 72. See K o o n tz , supra note 6, at 24; cf. id, at 23-24; H. W ile n s k y & N. L eb eo u x , I n d u s t r i a l S o c ie ty a n d S o c ia l W e l f a r e 273 (1958). 73. Heineman, supra note 46, at 157. 74. See G o rd o n , supra note 3, at 131-33. •

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permitted to make the relevant decisions,75 and in any event may con­ stitute too clumsy an instrument for this purpose. Exercise of control through informal channels may be undesirable because such a role may subject the shareholder to individual liability,76 and in any event may be unsatisfactory just because of its informality. For sucli shareholders the board provides an ideal modality, since internal corporate processes can be so structured that all transactions of a given class must go through the board or a board committee on which the shareholder sits.77 Major shareholders are not the only persons who want to use the board as a modality for involvement in corporate decisionmaking. Ma­ jor creditors often make similar use of the board for similar reasons,78 and lately much consideration has been given to the desirability of pro­ viding various corporate client groups (for example, employees, suppli­ ers, consumers), and certain disadvantaged social groups (such as •blacks and women) with access to the corporate decisionmaking process through board membership.79 How important is the modality function? For a major shareholder or creditor the mechanism is certainly useful. For the other groups the answer is less clear. Membership in such groups does not guarantee either the financial and business skills or the time required to exert a meaningful say in corporate decisionmaking. In all probability, some client and social groups press for board representation because they fail to realize this and also overvalue the board’s role. But even a group that is aware of the limited utility of board membership might want such representation. While normally the board can, as a practical matter, neither manage the business nor make business policy, it may be able See, e.g., Charlestown Boot & Shoe Co. v. Dunsmore, 60 N.H. 8 5 ( 1 8 8 0 ) . 76. See Kingston Dry Dock Co. v. Lake Champlain Transp. Co., 31 F.2d 265 (2d Cir. 1929) (L. Hand, J.). 7 7 . Seef e.g., O . W illia m s o n , T h e E c o n o m ic s o f D is c r e t io n a r y B e h a v io r : M a n a g e r ia l O b j e c t i v e s in a T h e o r y o f t h e F ir m 105 ( 1 9 6 4 ) ; cf. Great Western United*s Board Reestablishes Executive Committee, Wall St. J., July 31 , 1972, at 1, col. 4 ; Great Western United Faces Proxy Fight as Director Backs Disposal of Some Units, Wall S t J., Aug. 2 3 , 1972, at 6, col. 1. 78. As in the case of a shareholder, direct involvement in corporate decisionmak­ ing by a creditor may result in the imposition of individual liability. Cf. Connor v. Great W. Sav. & Loan Ass’n, 69 Cal, 2d 850, 447 P.2d 609, 73 Cal. Rptr. 369 (1968) (Traynor, C.J.). 7 9 . See Blumberg, Reflections on Proposals for Corporate Reform Through Change in the Composition of the Board of Directors; uSpecial Interest” or “Public” Directors, 53 B.U.L. R ev. 5 4 7 ( 1 9 7 3 ) ; Bunting, Conard, Deutsch, Farrell & Hickman, The Corporate Machinery for Hearing and Heeding New Voices, 27 Bus. L aw . 195, 19 7 -2 0 8 (remarks of Professor Alfred F. Conard), 21 4 -1 8 (remarks of John R. Bunting) (1 9 7 1 ) ; PoKempner, The More Representative Board, C o n f. Bd. Rec., Feb. 1972, at 4 2; Vanderwicken, supra note 5 2, at 28 5 -9 0 ; cf. Firms Find Integration in their Boardrooms is Working Quite Well, Wall St. J., Oct. 5, 1972, at 1, col. 6. 75.

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to impress upon those who do the importance of taking particular kinds of values into account. At a minimum, the allocation of directorships to certain groups may concretely symbolize, to middle and lower man­ agement, top management’s commitment to the values which the group represents.80 On the other hand, there are alternative modalities through which the ends desired by such groups can be achieved. These alternatives can be ranged along a continuum, with informal channels of influence at one extreme and direct government regulation at the other. Be­ tween these poles lie a great variety of formal modalities. For exam­ ple, labor can gain a say in corporate decisionmaking through collective bargaining and the grievance machinery.81 Creditors can exercise con­ trol through restrictive covenants.82 Suppliers and consumers can be organized either through private action, as in the case of American automobile dealers,83 or under legal auspices, as in the case of the con­ sumer councils created by statute in connection with socialized indus­ tries in Great Britain.81 Social groups can gain a say through working relationships developed between the corporation and representative or­ ganizations.85 These modalities may be more effective mechanisms than board membership for the exercise of influence by client and so­ cial groups, since they can be closely tailored to the substantive and procedural needs of each group, while the board’s form is relatively fixed, its jurisdiction necessarily diffuse, and its effective power very limited. Furthermore, board representation by such groups entails costs that may outstrip any potential benefits. For one thing, a director ap­ pointed to represent such a group may face the difficult and at times irreconcilable problems which result from attempting to promote two potentially conflicting objectives: the best interest of the corporation, and the special interests of those whom the director represents.86 Moreover, the special interests of the various groups represented under 80. See Blumberg, supra note 79, at 552; Bunting, et al, supra note 79, at 201 (re­ marks of Prof. Conard), 215-17 (remarks of Mr. Bunting); Vanderwicken, supra note 52, at 290; cf. City to A dd Nurses to Hospital Boards, N.Y. Times, Aug. 2, 1966, at 1, col. 7. 81. See J. K u h n , B a rg a in in g i n G r ie v a n c e S e t t l e m e n t (1961); Feller, A Gen­ eral Theory of the Collective Bargaining Agreement, 61 C a li f . L. R e v . 663 (1973). 82. Cf. A m e ric a n B a r F o u n d a tio n , C o r p o r a t e D e b t F in a n c in g P r o j e c t , C om ­ m e n ta r ie s o n I n d e n t u r e s 312-473 (1971). 83. Cf. S. M a c a u la y , L a w a n d t h e B a la n c e o f P o w e r (1966). 84. See W . R o b so n , N a t io n a l iz e d I n d u s t r y a n d P u b li c O w n e rs h ip 243-77 (1960). 85. Cf. R. W a l t o n & R. M c K e rs ie , A B e h a v io ra l T h e o r y o f L a b o r N e g o tia ­ t i o n s 391-98 (1965). 86. Cf. Vagts, Reforming the “Modern” Corporation: Perspectives From the German, 80 H a r v . L. R e v . 23, 52-53 (1966).

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such a concept are themselves likely to conflict, with consequences that have been pointed up by Professor Vagts: The system [adopted under German law and practice, under which the supervisory board includes labor, banking, supplier, and big-consumer representatives] has . . . special dangers. By bringing the public and the employees into the inner councils of die corporation it tends to screen both the conflicts between the interests involved and their resolution from public view. Thus it causes power to be exer­ cised by a relatively closed group that tends to develop common al­ liances within itself at the expense of those whom it represents.87

In short, while the problem of board representation by client and social groups is a complex one, for present purposes it seems fair to conclude that some benefits derive from such representation; that the benefits probably consist of marginal changes in decisionmaking input, rather than gross changes in decisionmaking output; that most of the benefits can be achieved, perhaps more effectively, through means other than board representation; and that costs as well as benefits re­ sult. On balance, therefore, the importance of the board’s modality function may be considerable as to major shareholders and perhaps creditors, but is questionable as to client and social groups. D.

Selection and Removal of the Chief Executive; the Monitoring Function

A fourth cluster of functions served by the board consists of select­ ing and dismissing the members of the chief executive’s office, and monitoring that office’s performance. Unlike the advice, authorization, and modality functions, the elements of this fourth clustef are both of critical importance to the corporation and uniquely suited for perform­ ance by the board. 1.

Selection

By law and practice the corporation’s chief executive is formally chosen by the board.88 Of course, an outgoing chief executive will 87. Id. at 88. 88. In most cases the board also formally chooses other major officers, and often minor officers as well. Both statutes and practice show considerable variation in this regard. As to the major officers (usually president, vice-presidents, treasurer, and secretary), some statutes provide that these officers shall be chosen by the board. See C a l. C o rp . C o d e § 821 (West 1955); II I. Ann. S t a t . ch. 32, § 157.43 (Smith-Hurd 1963); N.Y. Bus. C o rp . L a w § 715(a) (McKinney 1963); O h io R ev. C ode Ann. § 1701.64(A) (Page Supp. 1973); ABA M o d e l B us. C o rp . A c t § 50 (1969 rev.). Others provide that such officers shall be chosen by the board unless otherwise provided by the bylaws, see N.J. S t a t . A n n . § 14A:6-15(1) (Supp. 1974), or as prescribed by the by­ laws or as the board of directors determines, see D e l . C o d e A n n . tit. 8, § 142(b) (Michie 1975). The statutory variations as to minor officers (assistant secretary, assist-

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have a great deal to say in the selection of his successor.89 Typically a successor will be sought from within the ranks, and in such cases the outgoing chief executive has far better information on candidates than the board.90 Frequently he will have designated a crown prince, either by title (for example, executive vice president), or otherwise; appoint­ ment of anyone else is then rendered difficult by the personal and insti­ tutional expectations such a designation creates.91 And if the chief executive has managed the business well, the board will normally be hesitant to override his judgment as to who can best perpetuate the cor­ poration’s prosperity.92 Nevertheless, despite significant input from the outgoing chief ex­ ecutive, the board’s role in selecting a successor is often considerably more than a formality.93 The elements that prevent the board from making business policy, for example, do not prevent it from taking a meaningful role in selection of a new chief executive. Policymaking for a complex enterprise is a full-time occupation; selecting a chief ex­ ecutive is not. Policymaking requires intimate involvement with the business; selecting a chief executive does not. Policymaking depends on a body of substantive knowledge possessed only by those in the field; in the selection of a chief executive, however, outside directors, who ant treasurer, e tc .) are com parable. S o m e statutes require that th ey b e ch osen b y th e board. See N.Y. B u s. C o r p . L a w § 7 1 5 ( a ) (M c K in n ey 1 9 6 3 ); O h io R e v . C o d e A n n . § 1 7 0 1 .6 4 (A ) (P a g e Supp. 1 9 7 3 ). O thers provide that th ey sh all b e chosen b y the board unless th e bylaw s o th erw ise provide, see N.J. S t a t . A n n . § 1 4 A :6 -1 5 ( 1 ) (S upp. 1 9 7 4 ), o r as prescribed in the bylaw s, see C a l. C o r p . C o d e § 821 (W est 1 9 5 5 ); I I I. A n n . S t a t . ch. 3 2 , § 157.43 (S m ith -H urd 1 9 6 3 ), o r u n less th e b ylaw s o r certificate oth erw ise provide, see Pa. S t a t . A n n . tit. 15, § 1406 (S upp. 1 9 7 4 ), o r as prescribed in the b ylaw s or b y the board, see D e l . C o d e A n n . tit. 8, § 1 4 2 (b ) (M ic h ’e 1 9 7 5 ); A B A M o d e l B u s. C o rp . A c t § 50 (1 9 6 9 r e v .). W hatever th e form , how ever, th e board norm ally just rubberstam ps the c h ie f executive's selectio n s in th e case o f all o ffice r s b e lo w th e c h ie f ex ecu tiv e’s le v e l. See G o r d o n , supra n o te 3, at 107*08; J u r a n & L o u d e n , supra n o te 20, at 8 8, 91-92; M . N e w c o m e r , T h e B ig B u s in e s s E x e c u t iv e 4 0 (1 9 5 5 ) . 89. See 1975 C o n f e r e n c e B o a rd S u r v e y , supra note 10, at 24; G o r d o n , supra note 3, at 129 n.21; M a c e , supra note 9, at 65-68, 70-71; Heineman, supra note 46, at

159; cf. Zald, Who Shall Rule? A Political Analysis of Succession in a Large Welfare Organization, P a c . S o c . R e v ., Spring 1965, at 52. An extreme example is recorded by Juran and Louden: Some [chief executive officersl have resorted to the “sealed letter” method for selecting their successors in an emergency. They have named their succes­ sors and the reasons for their choice but have not announced this. Instead, they have recorded it iu a sealed letter which is not to be opened unless they meet with some sudden emergency. J u r a n & L o u d e n , supra note 20, at 104. 9 0 . See M ace, supra n o te 9, a t 7 0 -7 1 . 91. C/. Zald, supra note 23, at 109. 92. Cf. Zald, supra note 89, at 58-59. 93. See 1975 C o n f e r e n c e B o a rd S u r v e y , supra note 10, at 26; G o r d o n , supra note 3, at 107-08; J u r a n & L o u d e n , supra note 20, at 88, 91-92; M . N e w c o m e r , supra note 88, at 40.

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are themselves often chief executives,94 are likely to be as qualified in evaluating candidates as the outgoing chief executive. Thus the board can be expected to and frequently does play a real, albeit re­ strained role in the selection of a new chief executive. How important is the selection function? It has been argued that in a large, publicly held corporation the chief executive, or even the top executives taken as a group, cannot determine policy, and that instead this power inheres in the technocrats inhabiting the middle cells of the organization chart.95 Although this proposition contains a significant element of truth, it is nevertheless greatly overstated. While it may well be that day-to-day policy can be made only on lower levels, the office of the chief executive (that is, the individual or individuals90 who fill that office together, with associated cabinet and staff) will normally be the locus of final decision on most important policies, and will have an indirect voice in other policies through the selection and domination of the other executives. With its large powers over policy, selection, promotion, and budget, that office can do much to determine the profit­ ability and direction of the enterprise; it is, therefore, generally appro­ priate to give that office credit when the enterprise operates efficiently, and to hold it responsible when the enterprise does not.97 2.

R em oval and Monitoring

The removal power is a concomitant of the selection power. In terms of ongoing corporate activities taken as a whole, the selection power is probably the more important of the two. In terms of the spe­ cial role the board can play, however, the removal power is preemi­ nent—not because removal is so important in itself, but because it sub­ sumes a third, semi-autonomous function: monitoring the results achieved by the chief executive’s office to determine whether the in­ cumbent should remain in place A structure which emphasizes the preeminence of this function may be referred to as a monitoring model. Unlike the received legal model, which, as elaborated, stresses the policymaking function and therefore assumes the board is an integral part of the corporation’s management structure, the premise of a moni­ toring model is that management is a function of the executives, with ultimate responsibility located in the office of the chief executive. 94. See 1973 C o n f e r e n c e B o a rd S u rv e y , supra note 14, at 29 Table 5; M ace, supra note 9, at 87-89. 95.

J. G albraith , T he N e w I ndustrial S ta te 59-71 (2 d ed. 1 9 7 1 ).

96. See Second Thoughts on the 'Office of the President/ B u sin e ss W eek, Oct. 3, 1970, at 42; Vance, Toward a Collegial Office of the President, C a lif . M g m t. R ev,, Fall 1972, at 106; Yunich to Retire at 55 From R . H. Macy, N.Y. Times, Sept. 27, 1972, § 2, at 63, col. 5. 97. Cf, G o rd o n , supra n o te 3, a t 91-97, 106*15.

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Under a monitoring model, therefore, the role of the board is to hold the executives accountable for adequate results (whether financial, so­ cial, or both), while the role of the executives is to determine how to achieve such results.98 Of course, the board cannot perform this func­ tion without regard to policy: Objectives must be set, explicitly or im­ plicitly, against which to measure management’s results, and the selec­ tion of objectives will partly depend on the directors’ broad notions of policy and will interact with the question of what business policies are suitable for the particular firm. Nevertheless, the selection of an objec­ tive is distinguishable not only in theory but pretty largely in practice from the determination of how an objective will be met: It is one thing, for example, to demand a certain return on capital; it is another to de­ cide upon the strategy and tactics which promise to yield that return. The monitoring model, moreover, is not simply mechanistic; moni­ toring must begin with results, but it cannot end there. Apparently satisfactory profits, for example, may have been purchased by skimping on maintenance or research, or may flow from a windfall. Similarly, profits which seem unsatisfactory may be the product of an acceptable risk which did not bear fruit, of heavy start-up costs, or of a natural catastrophe. The concept of monitoring for results thus does not pre­ clude the monitors from going behind the result and either accepting as satisfactory a level of performance which falls short of the applicable objective, or criticizing as unsatisfactory a level of performance which exceeds it. What the concept of monitoring does require is the avail­ ability of sophisticated and independent information-gathering sys­ tems—a matter which will be discussed in Part V—and directors who are equally sophisticated in interpreting both financial and nonfinancial data. The critical importance of monitoring as a board function rests on two elements. First, in the exercise of many of its other functions, in­ cluding even its power of selection, the board must properly pay great deference to the incumbent chief executive. In the exercise of its monitoring function, however, the board must be completely inde­ pendent of the chief executive, since he is the very person whose re­ sults are being monitored. Second, the very premise of the corporate system, in which control of the factors of production and distribution is vested in the hands of privately appointed corporate managers, is that it can be expected to attain a more efficient utilization of economic re­ sources than that achievable under alternative economic constitutions. Given that premise, however, the legal system may and even must in­ sist on some structural assurance that such efficiency will be forthcom98. See IRRC, supra note 10, at 16-19.

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ing, and under appropriate conditions the board’s monitoring function can help provide that assurance. Since those who manage obviously cannot be trusted to assure their own efficiency, the removal of inefficient managers requires some mechanism external to the managers themselves. One such mecha­ nism is the market in which the corporation operates, with its attendant sanction of corporate failure. But this mechanism permits substantial inefficiency, since given the structure of most markets, a firm can usually remain in business for a protracted period of time if it has even the most meager returns.90 A second such mechanism is the takeover bid: If the corporation’s assets are inefficiently utilized, its shares will normally be underpriced, tempting outsiders to acquire control through stock purchases.100 This mechanism, however, also provides excessive leeway for managerial inefficiency, because of the high transaction costs of takeover bids resulting from their inherent mechanics,101 the barriers to success thrown up by the Williams Act,102 and the ability of in­ cumbent executives to oppose such bids through use of the target cor­ poration’s own resources.103 Some further constraint on managerial in­ efficiency is therefore required to assure the most efficient utilization of economic resources. An agency that could monitor the efficiency of the chief executive’s office on a regular basis, and remove the in99. See, e.g., Publicker IndustrieL osses on Operations Irk Critics; Firm Manages by Selling Assets, Wall St. J., April 24, 1972, at 30, col. 1. 100. Cf. D . A u s ti n & J. F ish m a n , C o r p o r a tio n s in C o n f l i c t — T h e T e n d e r O f ­ f e r 43-45 (1970); Fleischsr & Mundheim, Cotporate Acquisition by Tender Offer, 115 U. P a. L. R ev. 317, 324-25 (1967); Hayes & Taussig, Tactics of Cash Takeover Bidst H a rv . B us. R ev., March-April 1967, at 135, 139*40; Manne, Mergers and the Market for Corporate Control^ 73 J. POL. EcoN. 110, 112-13 (1965). 101. Cf. O. W illia m s o n , C o r p o r a t e C o n t r o l a n d B u sin ess B e h a v io r 99-100 (1970). 102. Pub. L. No. 90-439, 82 Stat. 454 (1968), 15 U.S.C. §§ 78m(d), (e), 78n(d> (f) (1970). See Manne, Cash Tender Offers for Shares—A Reply to Chairman Cohen, 1967 D u k e L J. 231. 103. See E . A r a n o w & H . E in h o r n , T e n d e r O f f e r s f o r C o r p o r a t e C o n t r o l 219-74 (1973); Schm ults & Kelly, Cash Take-over Bids—Defense Tactics, 23 B us. L aw . 115 (1967); N ote, Defensive Tactics Employed by Incumbent Managements in Contesting Tender Offers, 21 S ta n . L . R ev. 1104 (1969); cf. A ustin, Tender Offers Revis­ ited: 1968-1972 Comparison with the Past and Future Trends, M e r c e r & A c q u isi­ ti o n s , F all 1973, at 16; H indley, Separation of Ownership and Control in The Modern Corporation, 13 J. L a w & E c o n . 185 (1970); Armada Pauses on Acquisition Trail to Bolster Own Take-Over Defenses, W all St. J., Ju n e 3, 1974, at 17, col. 1; CNA Finan­ cial Corp., Once the A vid Hunter, Now is Worried Prey, W all St. J., July 22, 1974, at 1, col. 6 ; Market Place— Obstacles Cited on Take-Overs, N .Y . T*mes, M ay 28, 1970, a t 52, col. 5; Shelters Impede Takeovers, N .Y . Tim es, M ar. 29, 1970, § 3, a t 1, col, 1. Cf. Del E. Webb Corp. To Seek Bylaw Change on Director Elections, W all St. J., A pril 8, 1975, a t 14, col. 4; Jorgensen Co. Proposes Delaware Rechartering as Take-Over De­ fense, W all St. J., A pril 4, 1975, at 8, col. 5; Instrument Systems Is Asking Its Holders To Make It Even Harder to Oust Directors, W all St. J., F eb. 24, 1975, a t 12, col. 1.

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habitants of that office for inadequate performance, would be ideally suited to aid in the implementation of this critical social function. Such a power might, of course, be vested in some agency othei than the board. But what are the alternatives? The body of share­ holders is too disparate, shifting, and clumsy to conduct the type of in­ quiry involved. Effective replacement would be highly improbable; monitoring in any sense would be all but impossible; and removal situ­ ations would be turned into semi-public semi-trials, involving intoler­ able cost, rigidity, embarrassment, and delay. Assignment of this func­ tion to client groups is precluded not only by administrative considera­ tions, but also by the fact that such groups often have special interests which are inconsistent with the general corporate welfare. A council of corporate executives would not present administrative problems, but vesting the power to remove the chief executive in such an organ would put enormous pressure on the chief executive to select subordinates purely on the basis of their subordination.10* A governmental agency105 would almost surely serve to politicize the selection and re­ moval of corporate executives, in the narrowest sense of that term;100 104. This difficulty might be overcome by also vesting such a council with the power to select and dismiss its own members, but divesting the chief executive of those powers would be both impracticable and unwise. 105. See, e.g., Roth, Supervision of Corporate Management: The "Outside” Di­ rector and the German Experience, 51 N.C.L. R ev. 1369, 1382 (1973); Townsend, supra note 13, at 69-70. 106. The history of General Aniline is instructive. In 1942 the U.S. Government took over General Aniline’s stock as enemy property, and the Secretary of the Treasury. Henry Morgenthau, who was then in charge of alien property, designated a new presi­ dent and board. In 1943 Leo Growley was appo'nted Alien-Propsrty Custodian. He forced out Morgenthau’s president and half of Morgenthau’s board and installed his own designees in their places. In 1947, when Growley’s president retired, his successor came to General Aniline through the chairman of the Democratic National Committee. In 1953, when the Republicans came into office, they reappointed only five of 11 outside directors. Only one of these five was a Democrat. Of the six new outside directors appointed by the Republicans, five were Republicans and the sixth was an independent. In 1955 a friend of Eisenhower was named as General Aniline’s new president. In 1961, when the Democrats regained office, they ousted all the outside directors except the Democrat the Republicans had left in. Of 15 new outside directors, two were em­ ployees of the Justice Department, and the other 13 were either Democrats or inde­ pendent Kennedy supporters, including the principal lawyer for the Kennedy enterprises, prominent Democratic fund raisers, and an old friend of Joseph Kennedy. Over the years, similar shifts were made in the position of counsel. During the Truman administration General Aniline’s general counsel was Steptoe & Johnson, in which Louis A. Johnson, a prominent Democrat and former Secretary of Defense, was a leading partner. During the Eisenhower administration Steptoe & Johnson was re­ placed by Winthrop, Stimson, Putnam & Roberts, a firm with strong Republican connec­ tions. During the Kennedy administration, Winthrop, Stimson was replaced by Manes, Sturim & Laufer, which was chosen by one of Robert Kennedy’s chief assistants who was a longtime friend of one of the film’s senior partners. (The Kennedy administra­ tion also dismissed General Aniline's auditors and advertising agency, retaining in their places firms which had connections to the President or Robert Kennedy.) Ross, Gen­

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in any event it is unlikely that any single agency could effectively screen candidates for executive office in hundreds or thousands of corpora­ tions, let alone effectively monitor the performance of those it had chosen. Optimal performance of the selection, monitoring, and re­ moval function requires an agency, like the board, which is compact and cohesive, relatively free of conflicting interests, and individualized to the corporation, yet capable of being made independent of executive control. E.

Summary

A corporate organ comprised in significant part of nonexecutives can rarely either manage the corporation’s business or make business policy. It can be useful in providing advice and counsel to the chief executive’s office, playing a formal role in the approval of major corpo­ rate projects, and providing a modality for the exercise of influence and control by nonexecutives, but for the most part these functions are either relatively unimportant or can easily be located elsewhere. There is, however, one cluster of critical functions which such an organ eral Aniline Goes Private, F o r t u n e , Sept. 1963, at 127, 128-29, 144. See also Schwartt, Governmentally Appointed Directors in a Private Corporation— The Communications Satellite A ct o f 1962, 79 H a rv . L. R ev. 350, 357-61 (1965) (experience with govern­ ment-appointed directors on the board of Union-Pacific); Nixon Eyes Fitzsimmons for Meany Comsat Seat, Wall St. J., May 19, 1972, at 5, col. 4 (Frank Fitzsimmons to re­ place George Meany as a government-appointed director of Comsat, after Meany quit President Nixon’s Pay Board while Fitzsimmons stayed on as the Board’s only union official). Government-appointed directors may also raise other problems. For example, they may tend to adopt unduly cautious business policies, cf. Ross, supra, at 148, and may be unduly responsive to presidential jawboning, cf. 1948 O f f i c e o f A l ie n P r o p e r t y A n n u a l R e p o r t 34-37, to the needs of American foreign policy, cf. 1943 O f f i c e o f A l i e n P r o p e r t y C u s to d ia n A n n u a l R e p o r t 67-68, and to challenges to corporate practices issued by government agencies, cf. 1944 O f f ic e o f A l ie n P r o p e r t y C u s­ t o d ia n A n n u a l R e p o r t 65-66. These, m turn, are specific instances of a more general problem identified by Professor Vagts: The effect on a firm of having a partially public management may be compared with that of being subject to regulation. In both cases the tendency of management to maximize profits is subject to restraints designed to further other interests. The restraints imposed by public representatives are not, how­ ever, exerted in as plainly visible a fashion and there is less need for the gov­ ernment to take as clear and reasoned a stand. Thus on the one hand there is considerable danger that the government may seek to achieve in the quiet of the conference room what it cannot achieve in the normal administrative process. On the other hand, the asserted tendency of administrative agencies to fall under the influence of the industry they regulate is apt to reveal itself even more with government board members who work together with the regu­ lar management and develop a common set of attitudes and a common esprit de corps. On the whole, one is inclined to believe that a more rational and orderly development of economic law is apt to be achieved by pursuing the American pattern of open regulation rather than the German form of operating through undisclosed negotiations between private and public representatives. Vagts, supra note 86, at 86-87. See also Schwartz, supra, at 363-64.

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is optimally suited to perform: selecting, monitoring, and removing the members of the chief executive’s office.107 It therefore follows that the primary objective of the legal rules governing the structure of cor­ porate management should be to ensure effective performance of that cluster of functions—if possible, without precluding the board from playing additional roles if it so chooses. To achieve this objective, these rules must: (1) make the board independent of the executives whose performance is being monitored, and (2) assure adequate and objective information to enable the board to execute its monitoring function. Parts IV and V will explore these requirements in turn. IV T h e L e g a l R u l e s G o v e r n in g t h e C o m p o s it io n a n d S t r u c t u r e o f t h e B o a r d : I n d e p e n d e n c e o f D ir e c t o r s

Although the monitoring role of the board is crucial as a theoreti­ cal matter, the available evidence admittedly suggests that in practice boards do not perform this function well. Most boards will not remove a chief executive for inefficiency unless the corporation has entered the crisis zone, and cases such as Penn Central,108 L-T-V,109 Ampex,110 and Memorex111 indicate that many boards will not act until the crisis has become virtually irredeemable. Indeed, outside directors will often re­ sign rather than attempt to remove an inefficient management.113 One interpretation of this behavior, of course, is that the concept of the monitoring function is an illusion. An alternative interpretation, however, is that effective monitoring has been all but precluded by cur­ rent corporate ideology and practice. The ideological problem is that the board is commonly conceived as an agency whose primary obliga­ tion is not to monitor management, but rather to make policy as an inte107. Cf. Bacon, supra note 47, at 44 (remarks of Gustave L. Levy); PoKempner, supra note 79, at 42 (remarks of John R. Bunting). 108. See J. D a u g h e n & P. B in ze n , T h e W r e c k o f t h e P e n n C e n t r a l (1971); Townsend, B ook Review, N.Y. Times, Dec. 12, 1971, § 6 (B ook Review), at 3. 109. See L T V Recounts Its Many Ills, B u sin e ss W eek , Dec. 19, 1970, at 42. 110. See How Ampex Saturated Recorded Tape Market and Got Soaked Itself, Wall St. J., March 9, 1972, at 1, col. 6; Ampex Corp. Had Loss Totaling $32 Million in Fiscal First Period, Wall St. J., August 23, 1972, at 19, col. 6; Ampex Expects $40 Million Loss For Fiscal 1972, Wall St. J., Jan. 12, 1973, at 4, col. 2. 111. Memorex Concedes I t s in Financial Morass and That Bank of America Has Intervened, Wall St. J., May 16, 1973, at 4, col. 2. 112. “[F]ar more dangerous than the general ineffectiveness of boards in disaster situations . . . is the lack of any mechanism for identifying and eliminating mediocrity of management. . . . [Directors are far more likely to *go along,* or resign, than to demand changes because of mediocre performance.” Heineman, supra note 46, at 157. See also M a c e , supra note 9, at 15, 33-36, 61, 187; Ludlow, The Board of Directors Faces Challenge and Changet C o n f . Bd. R e c., Feb. 1972, at 39, 41 (remarks of Harleston R . Wood),

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gral part of management.113 The problem of corporate practice is that while effective performance of the monitoring function is conditioned on monitors who are (i) independent of those who are monitored, and (ii) capable of obtaining adequate and objective information concern­ ing management, in the case of most boards neither condition is pres­ ently fulfilled. First, state corporation law has done little or nothing to insure board independence, and as a result most directors in most publicly held corporations are closely tied to the chief executive— either economically, through an employment, professional, consulting, or supplier relationship with the corporation,114 or psychologically, through friendship, prior employment, or the fact that they have been selected and indoctrinated by the chief executive and hold their seats at his pleasure.115 Second, most boards have had no independent mechanism for obtaining adequate and objective information. Instead, directors are almost wholly dependent for information either on the very executives whose performance the information is supposed to re­ flect, or on accountants who are themselves dependent on those execu­ tives.118 Although it may be that even independent and fully-informed boards cannot be expected to perform a monitoring function,117 that proposition cannot be established on the basis of the existing record. If the monitoring function is to be effectively performed, then, the first task of the legal rules governing the composition of the board must be to ensure that it is independent of management. The problem is how to achieve that independence consistent with the best effectuation of the monitoring function and, to the extent possible, the board’s re­ maining functions as well. At least three alternative models must be considered: (1) a single-board system in which all directors are re­ quired to be independent of management; (2) a single-board system in which independent directors constitute a clear majority: and (3) a dual-board or two-tier system in which managers and supervisors are members of separate corporate organs. A.

A Single Board Comprised Wholly of Independent Directors

Assuming that the present single-board system is retained, the ad­ vantages of requiring all directors to be independent are obvious. Since the board’s principal function is to monitor management’s per113. Cf. H e id r ic k & S tr u g g le s , supra note 12, at 5. 114. See text accompanying notes 27-33 supra; cf. J uran & L o uden , supra note 20, at 164-70, 203-04; Kilborn, Singer’s High-Key Diversification Hits a Sour Note, N.Y. Times, Oct. 24, 1974, at 61, col. 3. 115. See text accompanying notes 34-40 supra. 116. See text accompanying notes 176-81 infra. 117. Cf. M ace, supra n o te 9, a t 195; R o th , supra note 105, a t 1381-82.

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formance, and since a director who is not independent can scarcely be trusted to perform that function, board membership for such persons seems counterproductive. Nor, in most cases, would exclusion of nonindependent directors hamper the board’s performance of its other functions. To the contrary, permitting the corporation’s executives to sit on the board is inconsistent with the board’s advice-and-counsel function, since the executives are already paid to give advice and coun­ sel in their executive capacity; inconsistent with the authorization func­ tion, since the board is usually called upon to authorize only what the executives themselves have proposed; and inconsistent with the modal­ ity function, since the purpose of that function is to give nonexecutives a voice in corporate decisionmaking.118 Similarly, permitting outside counsel to sit on the board severely compromises his objectivity, since he is then simultaneously attorney and client,119 and permitting the cor­ poration’s investment banker to sit on the board often gives rise to 118. Cf. M a ce, supra note 19, at 119, 126-27. Against this view it has been argued that board membership for executives (i) aids in recruitment; (ii) educates executives in board-level management processes; (iii) enables outside directors to evaluate execu­ tives who may eventually be candidates for chief executive; and (iv) ensures the pres­ ence at board meetings of persons who can answer questions concerning corporate oper­ ations. See M a ce, supra note 9, at 111-19 (quoting corporate executives); cf. 1975 C o n f e r e n c e B o a rd S u rv e y , supra note 10, at 63-65. None of these arguments will withstand analysis. The first and second are essentially circular, for if executives were barred from the board it would be unnecessary to educate them to board-level processes, and directorships would cease to be a part of the recruitment apparatus. Additionally, the second rests on the doubtful premise that there is such a tbing as board-level man­ agement. The premise behind the third is similarly dubious. Where promotion is from within, as it usually is, the recommendation of the outgoing chief executive, rather than the casual evaluations of outside directors, will normally be dispositive. Furthermore, the board-meeting context may provide “an artificial, synthetic exposure” in which to measure ability. Id. at 117. The fourth supports the presence of executives at board meetings, not their membership. It is sometimes said that executives will speak out more freely at board meetings if they are members rather than merely invited guests. See id. at 115 (quoting a cor­ porate executive). But on what subjects will they speak out? Certainly they are not going to criticize each other or the chief executive. “If you watch what happens at board meetings, you will observe that any questions are asked by outside directors and never by insiders. And it’s a little bit like a tennis match—if a questioning outside director is at one end of the board table, and the president is at the other end, the question and response results in all eyes moving in unison to whoever is speaking.” Id. at 119-20 (quoting a corporate executive). 119. See Swain, Impact of Big Business on the Profession: A n Answer to Critics of the Modern Bar, 35 A.B.A.J. 89, 170 (1949); Gartner, A Question for Mr. Casey, Wall St. J., March 3, 1971, at 10, col. 3; SEC Head to be Sued for Role as Director of Small Firm in *68-70, Wall St. J., Jan. 16, 1973, at 1, col. 1; Redcay, Corporate Counsel on H is Client's Board of Directors, March 8, 1973 (unpublished paper, copy on file with the California Law Review); cf. Investment Company Act, 15 U.S.C. §§ 80a 2 (1 9 )(A )(iv), (B )(iv) (1970). For data concerning the extent to wh:ch counsel for publicly held corporations double as directors, see W. H u d s o n , O u ts id e C o u n s e l: In s id e D i r e c t o r (1973).

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severe conflict-of-interest problems,120 and may impair the corpora­ tion’s ability to raise capital on the most advantageous terms, since the investment-banking community frequently views such a membership as a territorial signal.121 B.

A Single Board with a Clear Majority of Independent Directors

Despite the advantages of a rule mandating complete independ­ ence, a rule requiring that only a clear majority of the board be inde­ pendent would probably be preferable, at least today. First, the former rule would in the minds of many persons represent an unacceptably sharp break with tradition in a social sector which puts a premium on stability. The latter rule, on the other hand, is already almost within reach. Partly as a result of a policy adopted in the jnid-1960’s by the New York Stock Exchange,122 all but a dozen or so of the 1400 corpo­ rations listed on that Exchange already have at least one or two outside directors,128 94 percent have at least three,124 and half have at least seven.128 Similarly, nonemployee directors held half or more of the seats in approximately 45 percent of the Fortune 500, 50 percent of the industrials in the Heidrick & Struggles survey, and 70 percent of the 120. See M a c e , supra note 9, at 133-34; Slade v. Shearson, Hammill & Co,, [19731974 Transfer Binder] CCH F ed , S ec. L. R ep. 94,329 (S.D.N.Y.), question certified, [1973-1974 Transfer Binderl CCH F ed . S ec. L. R ep, If 94,439 (S.D.N.Y.), interim appeal denied, CCH F e d . S ec, L, R ep. fl 94,914 (2d Cir, Dec, 16, 1974); Black v. Shearson, Hammill & Co., 266 Cal. App, 2d 362, 72 Cal. Rptr. 157 (1st Dist. 1968). 121. See M a c e , supra note 9, at 132, 144-48; cf. J u r a n & L o u d e n , supra note 20, at 202. But see M a c e , supra note 9, at 148-49; Robertson, The Underwriters Have to Offer Even More , F o r t u n e , Jan. 1973, at 116, 117-18. 122. N e w Y ork S tock E xchange , C om pa ny M anual B-23; N e w Y ork Stock E x­ change , T he C orporate D irector and t h e I nvesting P u blic 7 (1965). Until re­ cently, the Exchange required two outside directors for newly-listed companies, but it now recommends a minimum of three. N e w Y ork S tock E xchange, R ecom m enda ­ t io n s and

Com m ents

on

F inancial R epo rting

to

S hareholders

and

R elated M at -

5-6 (1973). A requirement of two outside directors is statutorily imposed by the new Ontario statute. Ontario Business Corporations Act, ch. 53, § 122(2), [1970] Ont. Rev, Stat. 427-28. The proposed new Canadian Business Corporations law would also require two outside directors for publicly-held corporations. Bill C-29, § 97(2), House of Com­ mons, 1st Sess,, 30th Pari. (Can. 1974). See also Law No, 66-537 of July 24, 1966, on Commercial Companies, Art. 93, [1966] J.O. 6402, [1966] B.L.D. 353 [hereinafter cited as French Commercial Companies Law], translated in CCH, F r e n c h L a w o n C o m m e rc ia l C o m p an ies (1971). 123. See Publicker Industrief Losses on Operations Irks Critics, Wall St, J., April 24, 1972, at 28, col. 1; V a n c e , supra note 46, at 198. 124. N e w Y ork S tock E xchange , R e spo n se to W h it e P aper Q uestio nn aire

te r s

C oncerning “R ec o m m endation s and C o m m e n t s on F inancial R epo rtin g to S hare ­ holders and R elated M atters 1’ 1 (1974) [hereinafter cited as W h it e P aper R espo nse ].

125. Id.

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industrials in the Conference Board survey.126 Another advantage of a clear-majority rule is that it would not in itself exclude any category of persons from board membership, and therefore would moot argu­ ments that certain types of persons are valuable board members despite their lack of independence. Correspondingly, a clear-majority rule would put much less strain on the statutory definition of independence in the case of persons whose independence is debatable, such as com­ mercial bankers and retired executives.127 Finally, permitting a struc­ tural overlap between the managerial group and the reconstituted board would encourage management to continue to take important issues to the board on at least a pro forma basis—a practice which is extremely desirable since it significantly augments the board’s capability for effec­ tive monitoring. But a clear-majorily rule would be effective only if two conditions are met. First, the definition of independence must be rigorous. Spe­ cifically, any person who is an executive of the corporation, or who has a professional relationship or material business dealings with the corpo­ ration, and any close relatives of such persons, must be treated as not independent.188 Second, the independent directors must be inde126. See text accompanying notes 25-27 supra. Of course, many of the directors now classified as “outside” are not really independent. See text accompanying notes 3234 supra. Therefore, some outside seats would have to be shifted to achieve de jure in­ dependence, and other steps would have to be taken to achieve de facto independence. See text accompanying notes 129-30 infra. 127. Compare M a ce, supra note 9, at 123, with id. a t 192 and M oscow , supra note 37, a t 11. 128. It may be that any director proposed by management should also be consid­ ered not independent for these purposes. Cf. W h a r t o n R e p o r t , supra note 46, at 465-

.

66

Two important recent cases, SEC v. Mattel, Inc., CCH Sec. R e g . R e p . 94,807 (D.D.C. 1974), and Springer v. Jones, Civ, No. 74-1455-F (C.D. Cal. Nov. 23, 1974), terminated in settlements involving the restructuring of the board to ensure a clear ma­ jority of independent directors. The Mattel action was based on violations of the SEC’s antifraud and corporate-reporting requirements. A consent decree required Mattel to ap­ point additional unaffiliated directors, who are approved by the SEC and the court, in sufficient number to constitute a majority of the board. Mattel also agreed to main­ tain an executive committee consisting of three or more members, “a majority of whom shall at all times consist of additional directors.” For other provisions of the de­ cree see note 217, infra. See also Mattel Posts 27% Drop in Earnings and Adds- Seven to Its Board, Wall St. J„ Dec. 17,1974, at 6, col. 2. Springer v. Jones was a derivative action against officers of Northrop Corporation based on illegal political contributions, and a class action against Northrop itself based on violations of the proxy rules. The settlement requires a number of important changes in Northrop’s board. First, the size of the board must be increased by the addition of four new directors, who are to be approved by the court as qualified in terms of experi­ ence, independence, integrity, and ability. Second, 60 percent of the board must consist of “Independent Outside Directors,” defined to mean “any person who (i) is not an offi­ cer of the Company; (ii) has not individually received from the Company in any of the preceding four . . . years or is not presently proposed to receive in the next year

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pendent in fact as well as in form, and must have effective power to select and remove the members of the chief executive’s office. These two objectives can be achieved only if the board’s control of the corporate proxy machinery—that is, the power to nominate di­ rectors on the board’s behalf and to spend corporate funds and devote corporate facilities toward the election of such nominees—is vested ex­ clusively in the independent directors as a group.120 £ince control of the proxy machinery carries the de facto power to select and dismiss members of the board, who in turn have the power to select and dis­ miss the executives, whoever has that control has ultimate control over the corporation. At present, the power to select and dismiss directors is typically vested in the chief executive. Since the full board has con­ trol of the proxy machinery, and since the chief executive usually domi­ nates at least a majority of the board, he can effectively remove any single board member who opposes him by wielding his power over the board majority to prevent that director’s renomination. A director who would otherwise oppose the chief executive will therefore normally either remain silent or resign, unless he can somehow himself mobilize a majority cabal, which is rarely possible. As a result, the external sources of the chief executive’s dominance over individual directors, whether economic or psychological, are reinforced by internal political realities, which in turn reinforce his economic and psychological domi* nance. In order to break this circle it is necessary not only to strike at the externals, by ensuring that a majority of the board is not econom­ ically tied to the chief executive, but to recast the internal realities as well. Vesting control of the corporate proxy machinery in the indein excess of $25,000 (other than fees as a director) for services rendered or from the sale of material; and (iii) is not associated with a company or firm which has in any of the four . . . preceding years received or is not presently proposed to receive in the next year in excess of one percentum . . . of its gross sales from transactions with the C o m p a n y T h e four new directors are specifically required to meet this test. In addi­ tion, no lawyer who serves as (or is associated with a law firm serving as) outside coun­ sel to Northrop can be a director. Finally, Northrop must reconstitute its executive committee so that seven of its eight members, including its chairman, are independent outside directors, as defined. For additional provisions of the decree, see notes 130, 217 & 230, infra. As a matter of full disclosure: The plaintiff in Springer v, Jones was represented by the Center for Law in the Public Interest, a public interest law firm in Los Angeles. I served as a consultant to the Center in connection with that action. 129. See Conard, A Behavioral Analysis o f Directors’ Liability for Negligence, 1972 D uke L.J. 895, 917-18; cf. Comment, Duties of the Independent Director in OpenEnd Mutual Funds, 70 M ic h . L. R ev . 696, 724 (1972). Some investment companies have already begun on an informal basis to follow simi­ lar practices in selecting outside directors. See Glazer, A Study of Mutual Fund Com­ plexes , 119 U. P a . L. R ev . 205, 234-35 (1970); Nutt, supra note 13, at 216. However, since the arrangement is voluntary, and the independent directors need only make up 40 percent of such boards, see note 46 supra , the practice stops considerably short of what is necessary to vest control of the board in independent directors.

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pendent directors would facilitate their structural and psychological in­ dependence by locating the source of their appointment and the power of their removal elsewhere than in the chief executive. Only so can the monitoring function be made fully effective.130 C.

The Two-Tier System

A third alternative remains to be considered: the dual-board or two-tier system, in which the functions supposedly performed by the single board under the received legal model are distributed between two corporate organs, one entrusted with management and the other with supervision. Originating in Germany in the second half of the nineteenth century,181 the two-tier system has been spreading through­ out Europe in recent years. The Netherlands has already adopted a variant,182 Belgium and Luxembourg are expected to do so,188 and France has permitted use of the system on an optional basis since 1966.184 In addition, the system is embodied in the present draft of 130. As part of the settlement of Springer v. Jones, see note 128 supra, Northrop Corporation agreed to create a board nominating committee, consisting entirely of inde­ pendent directors, which “shall nominate all candidates for directors on the Board’s be­ half; shall cause the names of those candidates to be listed in the proxy materials of this Corporation prepared in connection with any meeting at which directors are to be elected; shall be empowered to expend corporate funds to support those candidacies, to the extent permitted by law; and shall appoint the persons who shall serve as proxies to vote the proxies solicited by management . . . Civ. No. 74-1455-F (C.D. Cal. Nov. 23, 1974). The technique of treating independent directors as a separate corporate organ for certain purposes also finds precedent in the Investment Company Act, which provides that certain types of matters require approval by a majority of the independent directors, rather than a majority of the board. See 15 U.S.C. § 80a-15(c) (1970) (contracts be­ tween the fund and an investment adviser or principal underwriter); 15 U.S.C. § 80a31(a) (1970) (retention of accountant). Probably the law should also require the chairman Of the board to be an independ­ ent director, since this position provides a potential focal point for leadership of the board, not only because of the title, but also through the power to call, set the agenda for, and chair board meetings. Cf. 1975 C o n f e r e n c e B o a rd S u rv e y , supra note 10, at 25-26. 131. Conard, Company Laws of the European Communities from an American Viewpoint, in T h e H a r m o n is a tio n o f E u ro p e a n C o m p an y L a w 45, 52 (C . Schmitthoff ed. 1973); Vagts, supra note 86, at 50-51. 132. Sanders, The Reform of Dutch Company Law, in T h e H a r m o n is a tio n o f E u ro p e a n C o m p an y L a w 133, 134-35 (C . Schmitthoff ed. 1973); Van De Ven, Corpo­ rate Developments in the Netherlands, 27 Bus. L aw . 873, 875-77 (1972). 133. See E. S te in , H a r m o n is a tio n o f E u ro p e a n C o m p an y L a w s 154 (1971); Conard, Mace, Blough, & Gibson, Functions o f Directors Under the Existing System, 27 Bus. L aw ., Feb. 1972, at 23, 25 (special issue). 134. French Commercial Companies Law, supra note 122, A rts^l 18-50. Of 3443 French corporations organized in 1968 and the first half of 1969, only 42 chose the new two-tier form. Approximately 260 corporations already in existence also adopted the new form. E. S te in , supra note 133, at 124-25. For a discussion of somfc of the differences between the French and German systems, see Will, Recent Modifica­

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the proposed European Stock Corporation Law,185 and is presently re­ flected in the proposed Fifth Directive for the Harmonization of Com­ pany Law of the Member States of the European Economic Commu­ nity.18® While details vary, the German version may be regarded as proto­ typical. Under that version, in virtually all stock corporations and in the larger limited liability companies, direct control of the corporate enterprise is vested in an organ known as the Vorstand, or managing board,137 which is comprised of the corporation’s top executives. The managing board, in turn, is supervised by a second organ known as the Aufsichtsrat, or supervisory board,188 which cannot include any mem­ bers of the managing board.130 The supervisory board can adopt rules requiring its approval for specific types of transactions, but is not otherwise empowered to involve itself in the management of the corporation,140 and exercises only indirect control over the man­ aging board. It appoints the members of the managing board for peri­ ods not exceeding five years and may revoke such appointments for substantial cause, such as gross breach of duty or inability to conduct the corporation’s business properly; it can express disapproval of the tions in the French Law of Commercial Companies, 18 I n t ’L & Com p. L .Q . 980, 98891 (1969). 135. P roposed S tatute f o r the E u ro p ean C om pany, A rts. 62-79, 13 J o u r n a l O f f ic i e l d e s C o m m u n a u tS s E u ro p £ e n n e s , N o . C 124, a t 14-18 (O ct. 10, 1970), translated in B u l l . E u r o p e a n C o m m u n itie s, A ug. 1970, Supp., a t 55-68. See Sanders, Structure and Progress o f the European Company, in T h e H a r m o n is a tio n o f E u ro p e a n C o m p an y L a w 83, 89-96 (C . S chm itthoff ed. 1973); V agts & W elde, The Societas Europaea; A Future Option for U.S. Corporations?, 29 B us. L aw . 823, 825-27 (1974). 136. T h e C om m ission d ra ft w ould have m ade a tw o-tier system m andatory. P ro ­ posal f o r a F ifth D irective o n the S tructure o f the C om pany, 15 J o u r n a l O f f i c i e l d e s C o m m u n a u te s E u ro p e e n n e s , N o . C 131, a t 49 (D ec. 13, 1972), translated in B u l l . E u ro p e a n C o m m u n itie s, Oct. 1972, Supp. H ow ever, a n opinion o f the E conom ic and Social C om m ittee o f th e E uro p ean P arliam ent, rendered a t the request o f the C ouncil, recom m ends th a t it be optional. 17 O f f i c i a l J. E u ro p e a n C o m m u n itie s, N o. C l 09, a t 9, 10-11 (D ec. 21, 1974). See generally F ieker, The EEC Directives on Company Law Harmonisation, in T h e H a r m o n is a tio n o f E u ro p e a n C o m p an y L a w 66 , 80-81 (C . S ch m itthoff ed. 1973). 137. See Law of S e p t 6 , 1965, [1965] BGB1. I 1089, §§ 76-94 [hereinafter cited as Aktiengesetz], translated in CCH, G e r m a n S to c k C o r p o r a t i o n A c t (F. Juenger and

L. Schmidt transl.. 1967). See generally Roth, supra note 105; Schoenbaum & Lieser, Reform of the Structure of the American Corporation: The *'Two-Tierfi Board Model, 62 K y . L.J. 91, at 95-108 (1973); Vagts, supra note 86, at 48-64. The two-tier system is mandatory for virtually any “Aktiengesellschaft" (roughly speaking, a publicly-held corporation), and any “Gesellscbaft mit bescbrankter Haftung” (roughly speaking, a close corporation) with over 500 or more employees. Juenger, In­ troduction to CCH, G e r m a n S to c k C o r p o r a ti o n A c t at 1, 2-4 (1967); Schoenbaum & Lieser, supra, at 98; Vagts, supra note 86, at 32-35. 138. Aitiengesetz §§ 95-116. 139. Id. § 105. 140. Id. § 111(4).

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managing board in its comments to the shareholders on the results of the annual audit; and it can call a special shareholders’ meeting to con­ sider the appointment of special auditors to investigate the managing board’s conduct of the business.141 Within the last few years there has been much discussion whether the two-tier system should be adopted in the United States.142 Cer­ tainly such a system would be preferable to the present working model, but it would probably not be preferable to a requirement that the board have a clear majority of independent directors vested with control of the proxy machinery. To begin with, it must be borne in mind that despite their apparently great dissimilarity, most of the differences between the single-board and two-tier systems tend to be marginal. In fact, many or most large American corporations have already adopted working structures strikingly similar to the two-tier system. 141. Id. §§ 84(1), 84(3), 111(3), 142(1), 171(2). 142. See, e.g., Cary & Harris, supra note 46, at 66 (remarks of Professor Cary); Schoenbaum & Lieser, supra note 137. Although such a system is not required under the lav/s of any state, it might be permissible under some o f the more recent state cor­ porations statutes. For example, the Delaware code provides: The business and affairs of every corporation . . . shall be managed by or under the direction of a board of directors, except as may be otherwise pro­ vided . . . in its certificate of incorporation. If any such provision is made in the certificate . . . the powers and duties conferred o r imposed upon the board of directors by this chapter shall be exercised or performed to such ex­ tent and by such person or persons as shall be provided in the certificate . . . . D e l . C o d e A n n . tit. 8, § 141(a) (Michie Supp. 1974). See also A riz . R ev. S t a t . A n n . §§ 10-122, 10-191 (1956); Wise. S t a t . A n n . § 180.30 (Supp. 1974); ABA M o d e l Bus. C o rp . A c t § 35 (1969 rev.); cf. N.J. S t a t . A n n . §§ 14A:6-1, 14A:2-7 (1969); N. L a t t i n , supra note 2, at 242-43. Professor Ernest Folk, who served as Reporter to the Committee which drafted the 1967 revision of the Delaware statute, has commented that ‘‘the Delaware corporation enjoys the broadest grant of power in the English-speak­ ing world to establish the most appropriate internal organization and structure for the enterprise.” E. F o lk , A m e n d m e n ts t o t h e D e l a w a r e C o r p o r a tio n L a w 5 (Corp. Serv. Co. 1969). Under the more traditional corporate statutes, however, a full-scale two-tier board would probably be impermissible. These statutes typically provide that the board of di­ rectors shall manage the business of the corporation, see text accompanying note 1, su­ pra, and a formalized and permanent delegation of that power to a second corporate or­ gan would in all likelihood be deemed invalid. See Jackson v. Hooper, 76 N J . Eq. 592, 603, 75 A. 568, 573 (Ct. Err. & App. 1910); Long Park, Inc. v. Trenton-New Brunswick Theatres Co., 297 N.Y. 174, 77 N.E.2d 633 (1948); Continental Securities Co. v. Bel­ mont, 206 N.Y. 7, 16, 99 N.E. 138, 141 (1912). The rationale for this view has been stated as follows: “The State, granting to indi­ viduals the privilege of limiting their individual liabilities for business debts by forming themselves into an entity separate and distinct from the persons who own it, demands in turn that the entity take a prescribed form and conduct itself, procedurally, according to fixed rules.” Benintendi v. Kenton Hotel, 294 N.Y. 112, 118, 60 N.E.2d 829, 831 (1945). But see Kessler, The Statutory Requirement of a Board of Directors: A Cor­ porate Anachronism, 27 U . C hi. L . R ev. 696 (1960). The English cases reach a sim'lar result, although it is based on a contractual rather than a statutory theory. See Wedderbum, The Relationship of Management and Shareholders in the English Company, in E v o lu ti o n e t P e r s p e c tiv e s D u D r o i t D e s Soci£r£s X l a L u m i£ re d e s D i f f e r £ n t e s E x p e rie n c e s N a t i o n a l e s 163, 165-69 (1965).

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la one such structure, authority for direction and control of the enterprise is vested in a formally constituted general management com­ mittee consisting of top executives;148 like the German managing board, this committee “determines operating policies and objectives and concentrates upon the broad direction, coordination and control of the business as a whole.”144 It has been said of corporations utilizing such committees that they “have in effect two boards: an inside work­ ing board and an outside board of review.”145 In this type of struc­ ture, however, the “outside” board of review is likely to be dominated by members of the inside working board. A second (and overlapping) type of working structure, in which the board of review is not likely to be dominated by the working man­ agers, is found in the decentralized corporation. In a centralized corpo­ ration the corporate business is departmentalized on the basis of func­ tions, such as production, marketing, and engineering. Since each de­ partment constitutes only a fragment of a business, there are frequently no ready criteria by which to judge a department’s performance—cer­ tainly not profitability. Headquarters in such corporations typically consists of a central office comprised of the president and the chiefs of each functional department; it is therefore responsible both for the coordination of corporate operations and for the determination of over­ all corporate strategy. In contrast, in a decentralized corporation the corporate business is divisionalized on the basis of product or geogra­ phy, and each division includes a substantially complete set of func­ tional departments. The performance of each division (and of its gen­ eral manager) can therefore be measured by profit criteria and, within the constraints of corporate policies and capital funding set by corporate headquarters, the divisional manager can be given substantial auton­ omy, at least if divisional profits and market share meet expectations. Headquarters in such cases typically consists of a general office com­ prised of executives who are relieved of responsibility for operations and functional coordination. Instead, they are charged solely with set­ ting general corporate policy, making strategic corporate decisions, and allocating corporate resources among the operating divisions. The gen­ eral office exerts control not by directing operations, as does the central office in the centralized corporation, but through budgetary and ac143. See G ordon , supra note 3, at 100-03; P. H olden , C. P ederson & G . G er ­ T o p M an ag em ent 71-72 (1968) [hereinafter cited as T op M anagem ent ]; H olden , F ish & S m it h , supra note 10, at 24-26; M aurer , supra note 3, at 201, 207-17. 144. H olden , F ish & S m it h , supra note 10, at 24. Many corporations have adopted a variant o f this concept, in which a formally con­ stituted management council serves principally as a communicative rather than a policy­ making device. See Top M anag em ent , supra note 143, at 72-73; cf. H olden , F ish & S m it h , supra, at 22-24. 145. M aurer , supra note 3, at 201. m ane ,

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counting processes, selection and promotion of personnel, and the es­ tablishment and interpretation of corporation-wide principles.148 In sucli corporations each division manager is a counterpart to the chief executive in the received legal model of the corporation, while the gen­ eral office is a counterpart to the board: The top executive group becomes an “activated board of directors” whether or not they are the legally constituted board. . . . Such an executive group . . . does not “manage” in the usual sense of the word . . . . Instead the role of such a group is more like that of an investment manager with the power to choose the particular users of funds . . . and to judge performance of those whom it authorizes to use the capital.147 146. A m e r ic a n I n s t i t u t e o f M a n a g e m e n t, C o r p o r a t e S t r u c t u r e in t h e B usi­ n e s s E n t e r p r i s e 121-51 (rev. ed. 1961); A .D . C h a n d le r , S t r a t e g y a n d S t r u c t u r e 1015, 43-50, 382-89 (Anchor ed. 1966); O. W illia m s o n , C o r p o r a t e C o n t r o l a n d B usi­ n e s s B e h a v io r 18-19, 46-49, 113-19, 124-27 (1970); Chandler & Redlich, Recent Devel­ opments in American Business Administration and Their Conceptualization, Bus. H is t. R ev., Spring 1961, at 1, 4-20; Heflebower, Observations on Decentralization in Large Enterprises, J. In d . E c o n ., Nov. 1960, at 7. The decentralized corporation has been described as follows: Each division is equipped with a self-contained organization having complete jurisdiction over manufacture, sales, and finance, subject to control from the central authority. The ordinary, everyday questions of policy, embodying even such important matters as production schedules, inventory commitments, design of product, and methods of distribution, are left ordinarily within the consideration and decision of the divisions themselves, under certain general limitations, and in every way the men on the firing line are inspired with a sense of responsibility for results. Brown, Pricing Policy in Relation to Financial Control, 7 M a n . & A d. 195 (1974). 147. Heflebower, supra note 146, at 18. Williamson wrote of the decentralized corporation: The relationship of the headquarters unit to the operating divisions appears to be largely one where operating divisions are free to conduct their affairs without interference as long as they achieve a certain ‘objective’ profit goal. This relationship is thus similar to the one that exists between the stockholders and the firm. There are, however, major differences that should be noted. First, the headquarters unit has access to vastly more information than the stock­ holders and hence is able to make a more exacting appraisal. Second, the ma­ chinery for replacing a division head is considerably simpler than that for re­ placing the company president. In both respects, the division is subject to greater pressure than is the firm. O. W illiam so n , T h e E conom ics o f D iscretionary B ehavior 120 (1964); c/. J. B ow er , M anaging t h e R esource A llocation P rocess 293 (1970). The resemblance between these working structures and a formal two-tier board is often heightened by constituting the members of the general management committee or general office as the board’s executive committee. See B r o w n & S m ith , supra note 10, at 28-30, 94-96; G o rd o n , supra note 3, at 103-04; H o ld e n , F is h & S m ith , supra note 10, at 229; Top M a n a g e m e n t, supra note 143, at 72; Mylander, Management by Execu­ tive Committee, H a r v . B us. R ev., May-June 1955, at 51. Of 508 manufacturing corpo­ rations surveyed by the Conference Board, 377 had executive committees; of these, 24 percent were composed entirely of insiders. See 1973 C o n f e r e n c e B o a rd S u rv e y , su­ pra note 14, at 55-56 Tables 14, 15. Under modern statutes, such a committee can be vested with extensive powers. For example, the Model Act permits such a committee to exercise all the authority of the board except as to certificate and bylaw amendment,

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The major advantage of the two-tier system, therefore, is not that it creates two levels of administration where only one existed before, or that it recognizes management as a separate corporate organ, but that it achieves the separation of those who manage from those who monitor in a particularly sharp manner,148 and therefore results in ex­ treme organizational transparancy.149 Separation and transparancy, however, can both be achieved even without a two-tier system: the former, by requiring a clear independent majority and by vesting con­ trol of the corporate proxy machinery in the outside directors to ensure their structural and psychological independence from the chief execu­ tive; the latter, by making clear that the board can function as a moni­ toring rather than a managing organ160 and by constituting the inde­ pendent directors as a separate corporate organ for certain purposes, such as control over the proxy machinery.161 merger, sale of substantially all assets, and dissolution. ABA M o d e l Bus. C o rp . A c t § 42 (1969 rev.). In such cases, therefore, the general management committee or general office is, like the German managing board, a formally constituted corporate or­ gan vested with both factual and legal power to manage the corporation's business. Cf. L. G o w e r , P r i n c ip le s o f M o d e rn C o m p an y L a w 141 (3d ed. K. Wedderbum, O. Weaver & A. Park 1969). 148. Under German law and practice, this separation is far from complete. Ger­ man law bars members of the managing board from serving on the supervisory board, but does not bar other executives from serving on the supervisory board. Cf. Roth, supra note 105, at 1380. Furthermore, it is common for banks to be represented, some­ times heavily, on the supervisory board, and the managing board may have leverage over those banking members as a result of competition between banks for corporate accounts. See note 153 infra. 149. See Will, supra note 134, at 991; cf. Vagts, The European System, 27 Bus. L aw ., Feb. 1972, at 165, 166 (special issue); Riger, Book Review, 60 G eo . L J. 859 (1972). 150. For example, under the 1974 amendments to the Delaware corporation law, “[t]he business and affairs of every corporation . . . shall be managed by or under the direction of a board of directors.” D e l. C o d e A n n . tit. 8, § 141(a) (Michie Supp. 1974) (emphasis added). Similarly the Ontario statute provides: ‘TOhe board of di­ rectors shall manage or supervise the management of the affairs and business of the corporation.” Ontario Business Corporations Act, ch. 53, § 132(1), [1970] Ont. Rev. Stat 430 (emphasis added); cf. ABA M o d e l B us. C o rp . A c t § 35 (1974 rev.). 151. A corollary advantage of the two-tier system is that the sharp legal allocation of roles in the two-tier system helps assure that substantive rules of corporation law are based on accurate premises as to the roles of executives and directors, but this advantage too is only marginal, since even without this sharp allocation enough is now known about corporate life to enable American legal institutions to mold corporate rules on the basis of corporate reality. For example, the courts could even now readjust concepts of o ff cers' authority to be more reflective of the truths of corporate life. See, e.g., Lee v, Jenkins Bros., 268 F.2d 357, 365-71 (2d Cir.), cert. denied, 361 U.S. 913 (1959); Gronholz v. Saginaw Sav. & Loan Ass’n, 41 Mich. App. 735, 201 N.W.2d 98 (1972); Holman-O.D. Baker Co. v. Pre-Design, Inc., 104 N.H. 116, 179 A.2d 454 (1962); Yucca Mining & Petrol. Co. v. Howard C. Phillips Oil Co., 69 N.M. 281, 365 P.2d 925 (1961). Similarly, courts could adopt separate standards of care for executive and nonexecutive directors. See, e.g., Bates v. Dresser, 251 U.S. 524 (1920); Boulecault v. Oriel Glass Co., 283 Mo. 237, 223 S.W. 423 (1920); Cary & Harris, supra note 46, at 64-65; Folk, Civil Liabilities under the Federal Securities Acts: The BarChris Case, 55 Va. L, Rev,

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On the negative side, we know very little about the effect of the two-tier system as a structural abstraction. The working of the system in Germany, the only country in which it has an established track his­ tory, is integrally related to the German social and economic context. For example, the number of large national commercial banks is rela­ tively small, so that each is very powerful, and because most corporate stock is held in bearer form and deposited with the banks for safekeep­ ing, proxies for a great proportion of the voting stock are in the bankers’ hands.182 Bankers who sit on the supervisory board therefore often carry enormous weight, and their presence helps assure the independ­ ence of many supervisory boards.158 Again, the German two-tier sys­ tem is intimately related to the principle of codetermination, under whicli labor is formally represented at the board level. Adoption of the two-tier system in the very different American economic setting might produce results very different from those hoped for.164 A second problem with the two-tier system as compared to a reconstituted board is that the former would represent a radical break with present institutional practices, while the latter would not. The tradition of the American corporation is that important business decisions come before the board, even if only by way of post hoc review. Reconstituting the single board would be unlikely to im­ pede this practice, particularly if the reconstituted board includes insid­ ers. In contrast, the creation of a wholly new institution in which mana1, 46 (1969); Israels, A New Look at Corporate Directorships, 24 Bus. L aw . 727 (1969); cf. Lanza v. Drexel & Co., 479 F.2d 1277 (2d Cir. 1973); Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 544, 576-78 (E.D.N.Y. 1971); Escott v. BarChris Constr. Corp., 283 F. Supp. 643 (S.D.N.Y. 1968); Bennett v. Propp, 41 Del. Ch. 14, 187 A.2d 405 (Sup. Ct. 1962). 152. See Roth, supra note 105, at 1378-79; Vagts, The European System, 27 Bus. Law., Feb. 1972, at 165, 169 (special issue); Petrodollar Pressure on Big Three German Banks, N.Y. Times, Jan. 24,1975, at 41, col. 1. 153. The extent of the bankers* influence may vary substantially according to the financial strength of the corporation, since the management of a strong corporation v/hich does business with several banks may be able to neutralize them by playing one off against the other, or by threatening to shift the corporation’s business entirely. Cf. Roth, supra note 105, at 108. 154. Putting these questions aside, a reconstituted single board might have several distinct advantages over the specific two-tier system adopted in Germany. For example, under American law managers can normally be discharged from their positions without cause. Under the German two-tier system, however, the members of the managing board cannot be discharged during their term (which may run up to five years) except for “wichtiger Grand”—substantial cause. See Aktiengesetz, supra note 137, § 81; Scho­ enbaum & Lieser, supra note 137, at 95-96. The German system therefore gives man­ agement a security of tenure which tends to defeat one of the very purposes the separa­ tion of managers and monitors should be designed to achieve. Again, under American law the intra-executive structure can be made to vary according to the needs of the indi­ vidual business. Under the German two-tier system, however, a formal collegial struc­ ture is imposed on the top executives whether o r not it is suitable to the needs of the business. See Aktiengesetz, supra note 137, § 77(1).

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gers and monitors did not mix might well result in cutting off the flow of business decisions to the outside board on an ongoing basis, thereby reducing that board’s capacity to gain the feel for the corporate situa­ tion which helps bring the financial data to life. The net result of adopting a two-tier system in this country might therefore actually be a weakening of the crucial monitoring function, as compared with the results achievable through a reconstituted single board. V T h e F l o w o f I n f o r m a t io n to t h e B o a r d a n d th e R ole of th e A cc o u ntan t

To the extent that the autonomy of corporate management ulti­ mately rests on notions of efficiency, and to the extent that the board’s major role is to monitor management, the institutions by which mana­ gerial efficiency is measured—whether by the board or by others— must be a central concern of the corporate system. As a practical mat­ ter, such institutions must have three interrelated characteristics: (1) the indexes they employ must be numerical in nature; (2) the numbers they generate must be comparable with those generated in measuring the efficiency of management in like enterprises; and (3) the methods by which the numbers are generated must be as objective as possible. The primary techniques used today to measure managerial efficiency center on indexes involving corporate profits. Such indexes obviously meet the first qualification: they are nothing if not numerical. It is widely recognized, however, that the profits of a corporate enterprise can never be determined with complete objectivity and comparability, since they are in significant part a function of the choice of accounting principles employed in the preparation of its financial statements.156 In theory, a satisfactory degree of objectivity and comparability is nevertheless achieved through institutional means—the central role given to independent accountants. In practice the theory has not held 155. C risis

in

See A r th u r A ndersen & Co., E stablishing A ccounting P r in c ipl es — A D ec isio n M aking 1-2 (1965) [hereinafter cited as C risis ]; P. G rady, I n ­

ventory o f

G enerally A c c epted A ccounting P r in c ipl es

fo r

B usiness E n terprises

33-34, 373-97 (AICPA Accounting Research Study No. 7, 1965) [hereinafter cited as G rady]; Graham, Some Observations on the Nature of Income, Generally Accepted Accounting Principles, and Financial Reporting, 30 L aw & C o n t e m p . P rob . 652, 669-72 (1965); Even Accountants Find Some Financial Reports of Combines Baffling, Wall St. J., Aug. 5, 1968, at 1, col. 6; Were 'Golden Fleece1 Earnings Per Share $3.14 or $1.99? Well . . . , Wall St. J., Aug. 5, 1968, at 14, col. 3. See generally A. B r il o f f , T h e E ffec tiv e n ess o f A ccounting C o m m u n ic a tio n (1967); A . B r ilo f f , U naccountablb A ccounting (1972). Although this Article will focus on accounting principles, similar observations are applicable to accounting estimates. Cf. Frishkoff, Consistency in Auditing and APB Opinion No. 20, J. A ccountancy , August 1972, at 64.

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up, due to a series of institutional failures. First, responsibility for se­ lecting accounting principles has been placed with management rather than with the accountants; second, management has been given enor­ mous discretion in selecting among competing accounting principles; and finally, the accountants have been dependent upon management for their selection, tenure, and dismissal. If the board is to monitor the efficiency of management in a meaningful way, these failures must be clearly perceived and effectively remedied. A.

The Failure of the Accountants

1 . Responsibility for Selecting Accounting Principles

Since a major purpose of f i n a n c i a l statements is to measure man­ agement’s performance, and since the financial data reported by a corporation depend in significant part on discretionary choices among competing accounting principles, it is reasonable to expect that the prin­ ciples employed in the preparation of a corporation’s financial state­ ments will be selected by the corporation’s outside accountant, and not by its managers.156 The outside accountant, after all, is a professional, skilled in accounting principles and practice, and presumably objective in the exercise of his discretion. In contrast, the manager typically has no advanced training in accounting and is invariably highly self-inter­ ested in selecting those principles that show off his performance in the best possible light.167 Yet the official position of the American Institute of Certified Public Accountants is that “the accounts of a company are primarily the responsibility of management. The [only] responsibility of the auditor is to express his opinion concerning the financial statements and to state clearly such explanations, amplifications, disagreement, or disapproval as he deems appropriate.”168 To put this differently, the accountants’ position is that their role is not to determine which accounting principles most appropriately present the financial results, but only to certify that the principles selected by management are not completely inappropri156. Cf. Letter from E. Feany, J. A ccountancy , A p ril 1967, at 27. 157. Cf. D. L add, C o n te m p o r a r y C o r p o r a t e A c c o u n tin g a n d t h e P u b l ic 164 (1963) [hereinafter cited as L add]; Johnson, Management and Accounting Principles, 30 L a w & C o n te m p . P ro b . 690, 693-98, 702-05 (1965); Miller, Audited Statements—Are They Really Management’s?, J. A c c o u n ta n c y , Oct. 1964, at 43, 45; Sterling, Account­ ing Power, J. A c c o u n ta n c y , Jan. 1973, at 61, 65; Kripke, Book Review, 73 C o lu m . L . R ev. 1681, 1686 (1973). 158. A m er ic a n I nstit u t e o f C e r t ifie d P ub lic A ccountants [hereinafter referred to as A IC P A ], A ccounting R esearch and T erm inology B u ll et in s 10 (final ed. 1961) (emphasis added). See also A IC P A , C o m m it t e e on A uditing P rocedure , S ta t em en t on A uditing Standards § 110.02, at 1-2 (1973) [hereinafter cited as A u ­ diting S tandards] (“Management has the responsibility for adopting sound accounting policies"); G rady, supra note 155, at 12.

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ate. As an academic accountant has stated: “An analogy might be having the baseball batter calling the balls and the strikes.”159 2.

Discretion in Selecting Among Competing Accounting Principles; the Test for Certification

Placing responsibility for selecting accounting principles with man­ agement rather than with the accountants might perhaps be tolerable if management’s discretion in selecting among competing accounting principles were relatively circumscribed. But here too reasonable ex­ pectations have been confounded. Since the accountant’s major control over the financials is his power to withhold or qualify his certification, the test for determining whether a clean certificate will be granted is critical to the integrity of the process. The test the accountants have formulated is whether the financial statements “present fairly the finan­ cial position of [the company] and the results of its operations . . . in conformity with generally accepted accounting principles . . . .”160 As elaborated and applied this test has been fundamentally defective, because an accounting principle may be “generally accepted” without being fair, and because certification has been deemed permissible even though the corporation’s financial statements do not fairly present its financial position and the results of its operations. a. “Generally accepted accounting principles.” It might seem reasonable to expect that the essential standard for certifying the ac­ ceptability of an accounting principle would be that the principle pre­ sents fairly the transactions it describes. The accountants, however, do not so interpret the matter. In their view, a principle can be certi­ fied as “generally accepted” merely on the basis of past use in other financial statements or support in the literature.181 Since accounting principles are selected by management, however, the test of past use need only mean that a few accountants have agreed not to object to a management decision,162 while the test of support in the literature need only mean that a single accountant has published his reasons for not objecting to such a decision. Furthermore, when the significance 159. Horngren, Accounting Principles: Private or Public Sector?, J. A c c o u n ta n c y , May 1972, at 37, 41. See also Johnson, supra note 157, at 698-99. 160. A u d itin g S ta n d a r d s , supra note 158, § 511.04 at 81. The accountants prefer to use the terms “opinion” or “report,” rather than “certifi­ cate,” but the latter is both more meaningful and more prevalent in common usage. 161. See id. §§ 410.03, 410.04 at 71-72; T. F i f l i s & H. K rip k e , A c c o u n tin g f o r B u sin e ss L a w y e rs 86-87 (1971) [hereinafter cited as F i f l i s & K rip k e ]; G ra d y , supra note 155, at 52-53; Miller, supra note 157, at 44. 162. Cf. A u d itin g S ta n d a r d s , supra note 158, § 410.03 at 71 ("an accounting principle may have only limited usage but still have general acceptance”); Armstrong, Some Thoughts on Substantial Authoritative Support, J. A c c o u n ta n c y , April 1969, at 44, 47-48. Armstrong holds that intraoffice memoranda based on discussions inside the firm and with other accountants can constitute “substantial authoritative support” ren­ dering a principle “generally accepted.”

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of past use is combined with the power of management to determine what principles are used—subject only to the test of past use by other managements—it follows that an accountant may certify a statement even though he believes that the principles employed in its preparation do not account for the underlying transactions as fairly as competing principles that management has rejected.168 This in turn provides further support for the principle, and since managers of competing companies are evaluated by comparing the financial results of their corporations with those of their competitors, there is great pressure for inferior principles to spread throughout an industry. The net result is a frequent tendency toward general deterioration of both account­ ing principles and financial statements. As one accountant has put it: “[T]his chain reaction . . . leads to a reverse of keeping up with the Joneses; it is a keeping down with the Joneses. As Leonard Spacek has observed, the tendency noted by Gresham’s Law, that bad money drives out the good, seems to apply to accounting: The bad alternatives drive out the good alternatives.”164 The rule that “general acceptance” can rest on past use or support in the literature, which is the foundation of this tendency in account­ ing, was far from inevitable. Even if individual accountants did not want to render a judgment on the fairness of individual accounting prin­ ciples—notwithstanding the language of their certification—the AICPA’s Accounting Principles Board (APB) was empowered to issue 163, See Briloff, Old Myths and New Realities in Accountancy, 41 A c c o u n tin g Rev, 484, 489 & Table 4 (1966); Hoenemeyer, Compatibility of Auditing and Manage­ ment Services—II. The Viewpoint of a User of Financial Statements, J . A c c o u n ta n c y , Dec. 1967, at 32, 35; Kripke, Conglomerates and the Moment of Truth in Accounting, 44 S t. J o h n ’s L. Rev., Spring 1970, at 791, 794 (special issue); Kripke, Book Review, supra note 157, at 1688; cf. Seidler, Auditors Labor Under Mighty Handicaps, Com. & Fin. Chron., Jan. 13, 1972, at 1, 18. 164. Miller, supra note 157, at 4445. Another accountant has put it more suc­ cinctly: “The development and regulation of accounting theory and practice is basically the result of ad hoc expedients, largely dictated by the very corporations whose affairs are being accounted for.” L add, supra note 157, at 160. “General acceptance . . . tends to mean *anyth:ng goes.’ ” Id. at 163. Consider the following statement by a then-member of the APB: A few weeks ago, I received a telephone call from a practicing certified public accountant who was trying to decide whether he should accept a change in an accounting principle proposed by one of his clients . . . . [who] had just returned from a convention where a competitor had told how he intended to improve earnings merely by adopting the proposed accounting method. The acceptability of the new method was in doubt I asked whether any authoritative support had been found for the proposed principle and he replied, “Well, I looked for an example in Accounting Trends