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Questioning the Theory of Director Primacy

September 13, 2006 6:31 AM

In my introductory post in this debate, I observed that acknowledging the tension between �authority� and �responsibility� does not tell us where to draw the lines in the corporate governance system. Steve initially seemed to agree, but �on second thought,� he suggested that �the tension between authority and accountability in fact does tell us something about where to draw the line.� Reasoning from existing corporate law � which �consistently draws that line in favor of authority� � he concluded with a challenge:

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.

In this post, I will challenge Steve�s challenge. That is, rather than accepting the premises of the challenge, I will offer two responses that undermine those premises.

First, the lesson that Steve draws from Arrow�s analysis of authority and responsibility might be summarized as follows: introducing any (additional) quantum of responsibility via shareholder oversight into the corporate governance system risks obliterating authority. This may be a bit of a caricature, but not much. In his most recent article on this subject, Steve wrote:

Boards of directors are subject to a pervasive network of accountability mechanisms that are more or less independent of shareholder oversight. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by firm agents. [T]hese incentive structures induce directors to behave generally in ways consistent with shareholder wealth maximization.

Stephen M. Bainbridge, Director Primacy and Shareholder Disempowerment, 119 Harv. L. Rev. 1735, 1746-47 (2006).

The problem with reasoning from the status quo, as Steve does in his last post and throughout his work on director primacy, is that the status quo contains two mechanisms of direct shareholder oversight: shareholder litigation and shareholder voting. To sustain his argument in favor of director primacy, Steve must contend that these mechanisms, like the human vermiform appendix, either have no function or have a function that is hidden from our understanding. (Perhaps shareholder litigation and shareholder voting are vestigial organs of an ancient corporate governance system?)

Why should we prefer this account of shareholder litigation and shareholder voting to an alternate account? We might view shareholder litigation and shareholder voting as potentially useful mechanisms that have been crippled by misguided legislatures, agencies, and courts. Or we might view each mechanism as highly specialized and appropriate for use only in extreme circumstances. For example, shareholder litigation may be useful in policing conflict-of-interest transactions, but may be relatively unhelpful in policing negligence, while voting may be important for effecting changes in control, but not for charting new corporate strategies.

My point is simply that shareholder oversight may be valuable, even if it operates only at the margins of the corporate governance system. And if we perceive instances when shareholder oversight improves corporate governance, we should remain open to the possibility of value-enhancing reforms. Despite the phrasing of Steve�s challenge quoted above, the theory of director primacy is more than just a call for rigorous justification of reforms. Steve uses director primacy as a basis for arguing against reform, which leads to my second response to Steve�s challenge: the theory of director primacy does not support the notion that increased shareholder participation in corporate governance is presumptively bad.

In my initial post, I focused on director elections, and Steve�s challenge mentions �voting rules.� But every example of director primacy in his post was drawn from the context of shareholder litigation. Of course, arguments in favor of increased shareholder participation in corporate governance sometimes extend to shareholder litigation � this has been particularly noticeable in connection with the recent Disney litigation in the Delaware courts � but my focus and the recent proposals made by Lucian Bebchuk relate to shareholder voting.

Obviously, Steve recognized this, and I don�t intend to imply that he missed the point. Instead, I think his decision to focus on litigation rules reveals something important about his approach to the corporate governance system. Steve could have approached the issue of shareholder voting directly by pointing to numerous legal rules that limit the efficacy of shareholder voting as a monitoring device and suggesting that such rules bolster his case for director primacy. Instead, he chose to observe that directors are rarely held accountable in shareholder litigation, then to assert, �[g]iven 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� the rules relating to litigation.


Steve wants us to believe that �deference to the board�s authority� is the defining characteristic of corporate law. He perceives such deference in the litigation rules, and suggests that similar deference should be reflected in voting rules. I see two problems with this line of reasoning: (1) the notion of deference is too diffuse to be a useful analytical tool, and (2) one cannot justifiably infer a policy of "deference to authority" merely from the fact of shareholder disablement. I elaborate on each point in turn.

What constitutes �deference�? Delaware courts are quite reluctant to impose personal liability on directors in any circumstance, but they are much more willing to grant injunctive or other equitable relief, especially in cases involving managerial conflicts of interest. Thus, the deference to directors displayed by the Delaware courts varies depending on the remedy sought and the duty that is alleged to have been breached. Are the courts being "deferential" in all of these circumstances? Or are they being intrusive to different degrees?

Another fundamental objection relates to Steve�s attempt to compare �deference� in litigation to �deference� in elections. Limits on shareholder litigation have different origins and rationales from limits on shareholder voting. As a result, assuming one could compare the respective levels of shareholder power in litigation and elections, one might reasonably hold the view that judicial interventions on behalf of shareholder litigants should be less expansive than direct shareholder interventions through elections. (Or vice versa?) The fact � if it is a fact � that shareholders are substantially hindered in both litigation and voting is not necessarily evidence of an overriding policy of �deference to authority� in the corporate governance system.

In this post, I have argued that Steve�s account of the corporate governance system seems unrealistic to the extent that it depends on the existence of elaborate and costly mechanisms of shareholder oversight that have no meaningful function. In addition, I have argued that �deference to authority� is not necessarily the defining characteristic of corporate law, even if we observe that shareholders are relatively impotent to influence most business decisions. Obviously, these are arguments against the theory of director primacy, rather than an affirmative case for shareholder participation. More in that latter vein in another post.




Rafael Mangual
Project Manager,
Legal Policy

Manhattan Institute

Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.