September 11, 2006
Drawing Lines Between Authority and Accountability
By Stephen Bainbridge
My thanks to PointOfLaw.com for organizing this debate and to my friend Gordon Smith for getting us off to such a great start. Gordon did an excellent job of laying out the basic divide between us; i.e., we both start with Kenneth Arrow's authority versus consensus model, but diverge in its application to the question of shareholder primacy.
I agree with Gordon's observation that:
"Arrow identified the tension between authority and responsibility, but this is only a starting point, not a conclusion. Acknowledging that tension does not tell us where to draw the lines."
A complete theory of the firm requires one to balance the virtues of discretionary fiat on the part of the board of directors against the need to ensure that the power of fiat is used responsibly. Neither fiat nor accountability can be ignored, because both promote values essential to the survival of business organizations. Unfortunately, however, because the power to hold to account differs only in degree and not in kind from the power to decide, fiat and accountability also are antithetical. As Kenneth Arrow explained:
"[Accountability mechanisms] must be capable of correcting errors but should not be such as to destroy the genuine values of authority. Clearly, a sufficiently strict and continuous organ of [accountability] can easily amount to a denial of authority. If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem."
So, on second thought, perhaps the tension between authority and accountability in fact does tell us something about where to draw the line.
One of the striking things about American corporate law (by which, of course, I mean Delaware corporate law) is the extent to which it consistently draws that line in favor of authority.
Indeed, judicial recognition of the proposition that directors cannot be held accountable without undermining their authority pervades many aspects of corporation law. The business judgment rule, for example, substantially insulates director decisions from being challenged by shareholders in litigation. According to the Delaware Supreme Court, the rule in fact exists precisely to prevent shareholders from holding boards of directors to account:
"... the business judgment rule is the offspring of the fundamental principle, codified in [Delaware General Corporation Law] § 141(a), that the business and affairs of a Delaware corporation are managed by or under its board of directors. ... The business judgment rule exists to protect and promote the full and free exercise of the managerial power granted to Delaware directors." Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985).
The New York Supreme Court likewise opined that:
"To encourage freedom of action on the part of directors, or to put it another way, to discourage interference with the exercise of their free and independent judgment, there has grown up what is known as the 'business judgment rule.'" Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944).
(I advanced this understanding of the business judgment rule in Stephen M. Bainbridge, The Business Judgment Rule as Abstention Doctrine, 57 Vanderbilt L. Rev. 83 (2004). Former Delaware Supreme Court Chief Justice Veasey recently cited that article’s analysis, deeming it to be "approach is consistent with the Delaware doctrine that the rule is a presumption that courts will not interfere with, or secondguess, decision making by directors." E. Norman Veasey & Christine T. di Guglielmo, What Happened in Delaware Corporate Law and Governance From 1992–2004? A Retrospective on Some Key Developments, 153 U. Penn. L. Rev. 1399, 1422 (2005).)
In many cases, of course, the defendants never need invoke the business judgment rule because plaintiff's case founders on the procedural limitations on derivative litigation, which thus further insulate boards of directors from shareholder litigation. Again, however, as the New York Court of Appeals seemingly recognized, these limitations follow precisely because corporate law must strive to balance authority and accountability:
"By their very nature, shareholder derivative actions infringe upon the managerial discretion of corporate boards. . . . Consequently, we have historically been reluctant to permit shareholder derivative suits, noting that the power of courts to direct the management of a corporation’s affairs should be 'exercised with restraint.'" Marx v. Axers, 644 N.Y.S.2d 121, 124 (1996).
See also Pogostin v. Rice, 480 A.2d 619, 624 (noting that "the derivative action impinges on the managerial freedom of directors").
We observe similar restrictions designed to protect the board of director's authority with respect to statutory provisions such as those governing interested director transactions. Similar restrictions also may be observed with respect to management buyouts, which involve a significant conflict of interest and therefore tend to get close judicial scrutiny, but which will receive judicial deference in appropriate cases. Stephen M. Bainbridge, Independent Directors and the ALI Corporate Governance Project, 61 Geo. Wash. L. Rev. 1034, 1075-79 (1993). Likewise, corporation statutes grant the board sweeping authority with respect to negotiated acquisitions, which the business judgment rule then largely insulates from judicial intervention. Stephen M. Bainbridge, Mergers and Acquisitions 162-65 (2003). As a final example, the Delaware courts allow the target’s board of directors a substantial gatekeeping role in unsolicited tender offers, which again is attributable to the courts' recognition of the importance of preserving the board's authority. Id. at 352-53.
Given the pervasiveness in corporate law of rules that (a) strike a balance between authority and accountability and (b) are biased towards deference to the board’s authority rather than accountability, it would be surprising if the rules on shareholder voting rights were any more empowering than they are. Put simply, corporate law is designed from the ground up to make holding directors to account very difficult. Proponents of expanded shareholder power thus need to explain why the voting rules need to be changed to create an exception to this general rule.
Posted at 02:42 PM
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