“There is no such thing to my mind as an innocent stockholder. He may be innocent in fact, but socially he cannot be held innocent. He accepts the benefits of the system. It is his business and his obligation to see that those who represent him carry out a policy which is consistent with public welfare.” — US Supreme Court Justice Louis Brandeis
We seem to have moved very far from Brandeis’ ideal for shareowners, even to the point where directors too, are absolved of all responsibility, as long as they follow a very minimal set of process rules. In an effort to prompt discussion of a poor corporate governance as a critical but largely ignored cause of the financial crisis, Martin B. Robins shifts our focuses to outcomes in his draft Dawn Following Darkness: An Outcome-Oriented Model for Corporate Governance.
After reviewing and largely rejecting several currently proposed reforms, as insufficient by themselves, he suggests that directors at highly interconnected firms that are too big to fail assume a greater amount of direct responsibility for seriously adverse outcomes. Such responsibility would take the form of a reversal of the present burden of proof placed on plaintiffs in actions alleging breach of a directors’ duty of care.
Under his proposal, D&O insurance at such firms, if allowed at all in order to order to reach agreement on reforms, could have a high deductible payable by individual directors. One half the premium would also be paid by the directors and procurement of such insurance would need to be approved in advance by shareowners holding at least 60% of the firm’s voting equity. Directors could escape liability by affirmatively demonstrating they have properly overseen management along the lines of Smith v. Van Gorkom.
Robins writes that he is generally satisfied with current public policies regarding director liability, except where inadequate corporate governance can “impact those outside the corporation,” which seems to me rather broad, since a great many firms externalize costs, but which he restricts to something like what most of us would consider companies that are “too big to fail.” Smith v. Van Gorkom emphasized the need for directors to “inform themselves ‘prior to making a business decision of all material information reasonably available to them.”
However, as Robins points out, to encourage directors to continue to undertake risky but potentially value-maximizing strategies in good faith, the Delaware Legislature promptly enacted title 8, section 102(b)(7) of the Delaware Code to allow corporations to include in their certificates of incorporation language “eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty [other than duty of loyalty or intentional misconduct/bad faith] as a director.” Apparently, more members of the Delaware Legislature are dependent on management than on shareowners, since shareowners would have been unlikely to provide such a total escape from liability.
Robins believes, “the time has come to reconsider this policy of simply absolving directors who properly inform themselves of relevant information of any responsibility for the ultimate use of such information.” Blind deference to the judgment of rating agencies, when you know they have drastically reduced their standards should no longer suffice.
SEC protections are largely built around requirements of disclosure and the prohibition of deceit. Boards are generally fully protected by the business judgment rule, except when their firm is “in play.” Then, they are expected to heighten their focus with respect to potential changes in control. Noting that non-M&A matters like credit underwriting and investment standards can also have great impact, Robins calls for the development of “comparable jurisprudence governing oversight of operational matters.”
Perhaps to build up the value of his own proposed reforms, he appears to attack say on pay and proxy access, which “call upon attenuated logic to believe that shareholders will recognize poor performance by directors early enough to prompt them to exercise authority to cause their removal and timely installation of a new board which will insist upon a reversal of the ill-founded management policies before they do serious damage.” While I would not be so quick to dismiss efforts to align the interests of directors and shareowners, as well as to create mechanisms of accountability, I fully embrace the assertion by Robins that “we need a standard that encourages critical thinking instead of herd behavior.”
We need a legal regimen which forces directors at systemically important firms to familiarize themselves with what management is doing, and ask the tough questions of management before policies are implemented, to see if the downside risk of those policies is understood (or has been considered at all) and to change course when even an originally well conceived strategy is no longer suitable. Ultimately, we need to force directors to consider on an ongo- ing basis whether their firms’ managements should be in their positions at all, in order to screen out dishonest, reckless or incompetent persons.
As mentioned at the beginning of this post, Robins sets out proposed legal changes, at the state level, which include a set of “triggering events” to limit applicability to companies that are too big to fail. He outlines conditions where compliance with Smith v. Van Gorkom would not suffice in any civil action alleging bread of any duty of care, including undismissed criminal and civil proceedings, bankruptcy, large write downs, etc.
I disagree with some of the details of Robins’ arguments and recommendations. Implementation of too big to fail reforms, especially by increasing director liability, seems doomed to failure if we must rely on adoption on a state by state basis. Perhaps I’m a cynic, but I think we have much more of a race to the bottom, rather than a race to the top. Management and self-sustaining boards control the state of incorporation, not shareowners. Robins’ arguments, if not his recommendation, provide additional support for a federal corporation law. Maybe the recent carnage and public desire for change will prompt state courts and legislatures, especially in Delaware, to take a fresh look in attempt to preempt federal action. Both courses should be pursued. Public comments to the Delaware Court of Chancery, Charles M. Elson at the John L. Weinberg Center for Corporate Governance at the University of Delaware and the SEC Chair, and the SEC Investor Advisory Committee might help move such reforms along.
Additionally, while I like the idea of forcing directors to meet a high deductible for D&O insurance in circumstances outlined by Robins, what’s to stop any additional costs from being built into their compensation structure? I also disagree that “failures that arise from faithful management must come from the markets” for all but too big to fail companies. By the time markets recognize board decisions that are stupid, egregious or irrational, shareowner value has generally plunged and correction by markets, involving full blown proxy contests, are very expensive compared to other remedies, such as proxy access.
Robins is too modest in his proposal, many elements of which should be extended well beyond the scope of companies that are too big to fail, especially the ideas of flipping the business judgment rule presumption and requiring affirmative proof of reasonable care, going beyond process, if specified events have occurred. Nevertheless, applicability of these reforms at companies that are too big to fail would represent a good start, with the hope of later expansion. Dawn Following Darkness: An Outcome-Oriented Model for Corporate Governance warrants wide circulation and consideration. I urge readers to include Marty Robins, and his outcome-oriented model, in their discussions around corporate governance reforms that could reduce the likelihood of the next financial crisis.
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