In “Rethinking the Board’s Duty to Monitor: A Critical Assessment of the Delaware Doctrine,” to be published in 2011 in the Florida State University Law Review (current version available ssrn.com), Prof. Eric Pan of the Cardozo Law School substantially advances the discussion of how corporate governance needs to be improved in order to minimize the macroeconomic impact of poor decision-making at the firm level and the need for costly bailouts. Moving beyond the recent “hot” topics of maximizing director independence, enhancing minority shareholder proxy access and improving the executive compensation process, he focuses on considerations directly impacting the outcome of board deliberations.
This is an essential complement to such topics in that it addresses actual board performance in consideration of issues of business policy – that is, once directors are installed, we need to ensure that they do a good job in addressing company business. Prof. Pan recognizes that the problem of board performance is not solved once we get the “right” people in place.
He correctly observes that to the extent that present Delaware law addresses director performance in its management oversight role at all, it does so by focusing on failure to “monitor” management in order to prevent major legal violations, and almost entirely absolves directors from any responsibility for adverse business outcomes, no matter how disastrous for the single firm or for the economy, so long as appropriate process was utilized. The implications of the Caremark and Citigroup decisions for the former and latter propositions, respectively, are well described. The implications of poor oversight by the Citigroup board for that firm and our economy need no further description. Prof. Pan argues quite persuasively that we need to expand the board’s duty to monitor created in Caremark to encompass management decisions leading to poor business outcomes, even if no laws are violated, irrespective of the process which is utilized.
Rather, boards should be held responsible for business as well as legal outcomes. Courts should shift the burden onto directors to show they made an effort to be informed and to respond to developments leading to such outcomes.
This reviewer has argued in “Dawn Following Darkness: An Outcome-Oriented Model for Corporate Governance,” 48 Duquesne Law Review 33, reviewed on this site in an April 22, 2010 post, that fixing this gap in corporate law with such burden shifting in order to avoid disastrous decisions by our largest firms is a fundamental but overlooked step in the financial reform overhaul currently in process.
Like this reviewer, Prof. Pan argues for a regimen where directors have some – in his view, seemingly undefined – financial responsibility when their firms suffer major losses as a result of management decisions which are not meaningfully challenged by the board, even where there is no legal violation. Presumably, this would apply to situations requiring public bailouts such as the recent financial industry debacles. Prof. Pan would enhance his case by attempting to enumerate specific circumstances, such as a need for governmental assistance, in which such responsibility should attach.
As contemplated in Prof. Pan’s article, the new responsibilities would apply to all firms (or at least to all publicly traded ones). This reviewer strongly disagrees with such breadth.
In that all concerned, including Prof. Pan, agree that such a change would likely reduce business risk-taking, we need to apply it only in cases involving companies of sufficient size and interconnectedness and events of sufficient magnitude, where poor decisions can have significant external effects for the broader economy.
A third concern is that the duty to monitor as advocated in this paper, will usurp the board’s discretion in determining the appropriate degree of monitoring and inhibit risk-taking. We do not want the duty to monitor to prevent corporations from conducting certain activities which may actually be beneficial to the company and its shareholders. In other words, the board may conclude that it is in the best interest of the corporation for it to expose itself to extreme amounts of business risk.
The Citigroup court correctly notes that the present business judgment rule is intended to permit entrepreneurial activity – i.e. risk-taking. While it obviously worked too well for Citigroup, especially today when we face a nascent economic recovery, we should not inhibit risk-taking – and often employment – any more than necessary. There are many large public (and private) companies where the consequences of a poor decision will be limited to that firm and its shareholders without any material ramifications for the economy.
The situation addressed by the Delaware Supreme Court in upholding under the business judgment rule, the actions of Disney’s directors despite their signing off on a wasteful compensation and severance package for a former President illustrate where the current regimen of deference to director business judgment is working effectively. Even though this decision turned out to be a very poor one for Disney, it had no implications elsewhere.
In any event, as Prof. Pan notes in his discussion of how as a result of resistance at the state level, recent innovations in corporate law have largely been under the guise of the federal securities laws, it will be difficult to implement any of the changes he suggests. As such, what is proposed should be as narrow as possible in order to increase the likelihood of its enactment.
Prof. Pan makes a major contribution to the corporate governance discussion by focusing on actual governance issues as opposed to process, compensation and board composition issues, and his ideas should be heeded by those considering changes in this area. However, it is preferable for those ideas to be refined to ensure that they are properly targeted (by firm and event) so as to cause as little disruption to business risk-taking as is possible.
Publisher’s Note: Thanks to guest reviewer Martin B. Robins, an adjunct professor in the Law School of Northwestern University. He is presently, and for the past 10 years has been, the principal of the Law Office of Martin B. Robins where his practice emphasizes acquisitions and financings, technology procurement and licensing, executive employment and business start-ups. The firm represents clients of all sizes, from multinational corporations to medium sized businesses to start-ups and individuals.