Comparative Corporate Governance
5.2 The agency approach
The US corporate governance is based on the conventional agency rela- tionship, which relies on the separation of ownership and control. The underlying idea is that the board shares mutual interest with shareholders in protecting the corporation.
In theory, the board acts as the agent of the shareholders (‘the princi- pal’). Thus, the board must comply with all rights and duties under the principal-agent relationship.
The board of directors owes fiduciary duties to the shareholders: duty of care, duty of loyalty, duty of candor. Breaches of these duties can result from shareholders’ specific suits and damages stemming from the actions of the board.
5.2.1 The board fiduciary duties
Courts in the US, and particularly the Delaware Chancery and Supreme Courts, have developed specific standards to ascertain the board actions.
The directors of Delaware corporations have a triad of primary fiduciary duties: (i) due care, (ii) loyalty, and (iii) good faith. However, the Delaware courts adhere to the view that management owes fiduciary duty of care and loyalty to the corporation and its stakeholders simultaneously. 2 Such an approach has been characterized by Professor Christopher Bruner as a
‘decided reluctance to focus solely on the shareholders, to the exclusion of the other constituencies contributing to the corporate enterprise’. 3 5.2.1.1 Duty of care
Directors must discharge their duty in good faith, with such a degree of diligence, care and skill than an ordinary prudent person would exer- cise under similar circumstances. Directors would be held responsible for either non-feasance or misfeasance, any time their inaction or action causes harm to the corporation.
The duty of care requires directors to take certain responsibilities or actions. In Francis v. New Jersey Bank , 4 the New Jersey Supreme Court held that:
Directors should have some understanding of the business, keep informed on activities, perform general monitoring including attend- ance at meetings, and have some familiarity with the financial status of the business as reflected on the financial statements.
However, the company certificate of incorporation may shield the direc- tors from the liability pursuant to their duty of care if the breach and the harm suffered by the corporation did not occur in bad faith or with an intentional misconduct of disregard.
To establish that a director has failed to act in good faith, a shareholder must show whether that the director’s conduct was motivated by an actual intent to do harm, or that the director acted with a conscientious disregard as to his (her) fiduciary duties.
In In Re Walt Disney Co. Derivative Litigation , the Delaware Court has held: ‘Fiduciary action taken solely by reason of gross negligence and without any malevolent intent does not constitute bad faith.’ 5
5.2.1.2 Duty of loyalty
Directors should perform their duty with loyalty. That is, directors must act (i) in good faith, (ii) with the conscientiousness, fairness, morality and honesty that the law requires of fiduciaries. The duty of loyalty prevents them for engaging in self-dealing, usurping the corporation opportunity, or making secret profits to the detriment of the corporation.
The duty of loyalty is often breached when directors engage in self- interested transactions. Such transactions are suspicious and set aside unless the directors establish that the transactions were fair and reason- able at the time they were entered into; or have disclosed the material facts and won the approval of the board.
Likewise, directors should not usurp the corporation’s business oppor- tunity. This refers to any business or transaction in which the corporation has a tangible interest or expectancy, or logically related to the corpora- tion core and auxiliary businesses.
5.2.1.3 Good faith conduct
The Delaware courts are still struggling to provide clear opinions con- cerning Delaware directors’ duty to act in good faith. The duty to act in good faith has been described simultaneously as a third component of the triad of primary fiduciary duties or, confusingly, as an aspect of the duty of care or the duty of loyalty.
In the Walt Disney cases, 6 the duty to act in good faith was described as independent from the two other duties (care and loyalty).
The Delaware Supreme Court has stated that bad faith conduct may be found where a director ‘intentionally acts with a purpose other than
that of advancing the best interests of the corporation, ... acts with the intent to violate applicable positive law, or ... intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties’.
However, in subsequent cases, the Delaware court held that directors would be liable in bad faith if the facts establish an intentional dereliction of duty, a conscious disregard as to their responsibilities. 7
5.2.2 The safeguards: the business judgment rules
The business judgment rule (BJR) principle can be traced back in the US to the Harvard College and Massachusetts General Hospital v. Francis Amory case in 1830, where Judge Samuel Putnam asserted: ‘trustee cannot be held accountable for bad outcomes except for gross neglect and willful mis- management’. In the same vein, the Supreme court of Michigan went on to add in Dodge v. Ford in 1919, that the best judgment rule must include long-term consideration.
The business judgment rule protects the board of directors against suits that derive from a violation of the duty of care, or malfeasance. It protects directors who are not negligent while making decisions for the corpora- tion. As a general rule, courts will not second guess the board decision even when it is damaging to the business. The rule introduces a rebuttable pre- sumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company. The directors must show that they had reasonable grounds for believing that a danger to cor- porate policy and effectiveness existed. Further, they must show that the defensive mechanism was ‘ reasonable in relation to the threat posed’.
Moreover, that proof is materially enhanced, as in Unocal , 8 where a majority of the board favoring the proposal consisted of outside independ- ent directors who acted in accordance with the foregoing standards. The safeguard of the BJR shields directors even if ‘hindsight later reveals other choices that arguably were better or wiser’. The shareholders can overcome the presumption by establishing malfeasance or breach of duty of care.
When the directors were grossly negligent as in the Van Gorkom case, 9 the Chancery Court has no difficulty finding a breach of duty of care.
In applying the best judgment rule, the Delaware courts have elabo- rated specific requirements that the boards must meet. These require- ments or standards are often referred to as either the ‘Revlon’ standard, 10 the ‘Unocal’ standard, 11 or the ‘Paramount’ standard. 12 The board must demonstrate that: (i) it had reasonable grounds for believing that a dan- ger to corporate policy and effectiveness existed, 13 and (ii) its defensive actions were reasonable in relation to the threat posed. 14
The Revlon court summarized both steps in the review as follows: (i) when a board implements anti-takeover measures there arises a rebuttable presumption that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders; (ii) the directors must analyze the nature of the takeover and its effect on the corporation in order to ensure balance.
The court also held that when the sale of the target becomes inevita- ble, the board must then be working on getting the maximum price of the company for the benefit of the shareholders. Applying this prin- ciple to the facts, the court come to find that the board entered into an auction-ending lock-up agreement with Fortsman on the basis of impermissible considerations at the expense of the shareholders.
In both Revlon and Paramount , the court held that lock-up clauses are invalid when it favored a bidder, but did allow termination fees. Defendants in the Paramount case contended that they were precluded from negotiat- ing with QVC or seeking an alternative. After considering the merit of the facts, the court held:
Such provision, whether or not they are presumptively valid in the abstract, may not validly define or limit the directors’ fiduciary duties under Delaware law or prevent the Paramount directors from carrying out their fiduciary duties under the Delaware law.
In the Unocal case, the Delaware Supreme Court set forth a list of ele- ments or factors to consider in assessing the existence of the threat to the target corporation. These factors include, inter alia: the inadequacy of the offered price, the nature and timing of the offer, the impact on constituencies other than shareholders, the risk of non-consumption, the quality of securities being offered in the exchange process. However, none of these factors alone should be, per se, considered controlling in the examination process.
In Phelps Dodge Corp , 15 the court held that a merger agreement that has a ‘no talk provision’ is per se invalid. Phelps Dodge challenged the Cyprus Amax merger agreement with Asarco, Inc., which included a ‘no talk’
provision. After examining the merits of the case, the Delaware Chancery Court found that Cyprus Amax and Asarco should not have completely foreclosed the opportunity to negotiate, and that their eager blindness constituted a breach of a board’s duty of care.
In IXC Communications , the court held that directors need flexibility to negotiate a lock-up deal. The Chancery Court was called to rule over the
validity of a ‘no talk’ provision that prevented the parties from entertain- ing other potential deals.
The Court rejected the plaintiffs claim that the board ‘eagerly blinded’
itself by approving the ‘no talk’ provision. The Chancery Court did so because to the challenge ‘no talk’ provision emerged later in the proc- ess, and that the parties had retracted the provision, permitting the board to hear any proposals it saw fit.
In Mills v. MacMillan , 16 the court invalidated a lock-up clause when it found the auction to be unfair.
In Omnicare v. NCS , 17 the court found the lock-up provisions to be pre- clusive and coercive. The lock-up by Genesis took the form of (i) voting agreement with majority shareholders, (ii) no-shop clause, (iii) termina- tion fee of US$6 million, (iv) shareholder approval of the agreement. The court found that Omnicare enhanced its bid to shareholders only when it discovered that a competitor was buying NCS. More importantly, the court found that the voting agreement and the vote requirement used as lock-up were preclusive and coercive.
While one can follow through the development of the aforementioned cases, the shield of the BJR, except in a few cases, immunized sufficiently the board, and to a certain extent the corporate officers from ‘strict’ per- sonal liability that proceeded from their actions. 18
Some have argued that directors and officers of publicly traded corpora- tions should be held personally liable for their failure to live up to their fiduciary duties.
5.2.3 Limited shareholders’ rights
In contrast to the UK, Canada, Japan, and even China, US shareholders have a limited role in the governance of their companies. They do not have the right to amend the corporate charter, they do not have a final say on the event of their corporation wind up. As Professor Lorsch admitted:
US shareholders participate in governance as they always have: by fol- lowing the Wall Street rule. They sell stock when they are unhappy with the company’s performance and prospects, and they buy when a company’s future seems promising. 19
However, Lorsch goes on to explain the US shareholders’ limited participa- tion in corporate governance as follows: ‘The reason is simple: over 60% of US shareholders are institutions (hedge, mutual, and pension funds).’ 20
An examination of the shareholding among developed countries such as the UK or Canada just contradict the facts; Indeed, in both Canada and the UK, institutional shareholders hold more than 60 percent, still other shareholders enjoy substantial corporate governance rights. 21
The reason seems to lie in the role institutional shareholders play in the US. Contrary to the UK or Canada where institutional shareholders have positively contributed to the enhancement of corporate governance rules, US institutional investors have refrained from playing such a role because of both lack of resource and lack of expertise.
5.2.4 Reforming the BJR
The BJR as developed by the Delaware courts has become, in many respects, obsolete or at least irrelevant. The Delaware courts have to evolve towards an enhanced standard of direction with special skills, expertise or knowledge as under the federal tort laws. At some point, the Delaware courts seemed to take such a direction. In In Re Emerging Communications Shareholders Litigation , 22 the court subjected the director with special expertise to an enhanced standard of the fiduciary duties (duty of care). Several applications by the Delaware courts of the duty of care are inconsistent or at least show that corporate judges need to enhance their own skills while deciding some difficult cases. In 2005, for instance, the Delaware Chancery Court stated in a shareholder law- suit filed against the Walt Disney board ( In Re Walt Disney Co. Derivative
Stock Markets
Security Analysts
Federal and State Courts
Institutional Investors’
Organizations Auditors
Law Firms
SEC
Board
Management Shareholders