Friday, January 23, 2004

Prof. Bainbridge has posted the text of a lecture on the business judgment rule that contains an interesting definition of his "director primacy" theory. Now, he's been referring to director primacy throughout the life of his blog, but this is the first time I've seen a full explanation of his conception of the corporate board of directors as "hiring the factors of production", by which he means capital, management, labor and resources. More broadly, he is a proponent of this "director primacy" theory of corporate governance, over the conventional "shareholder primacy" theory, which holds that the corporation is a creature of the capital represented by its existing stock issuance. Bainbridge holds that the shareholder is a hireling of the corporation, in the same sense as employees, managers, contractors, and bondholders are hirelings of the corporation.

Now, I am not a lawyer, thus it follows that I can't be any sort of expert on corporate governance. But, as they say, everyone has [an opinion]... Consider it the blog equivalent of thinking out loud.

I can't help but feel that "director primacy" is structurally arbitrary - why should the directors' relationship with the corporation be privileged over that of the shareholders'? In most cases, the directors did not create the corporation, but are rather, themselves, hirelings of the corporation, delegated limited and indirect decision-making authority.

I strongly suspect that this doctrine of "director primacy" is also historically arbitrary - directors are far more often the creatures or cronies of management or majority/plurality shareholders, than they are independent agents. I'm no expert in the subject, but the instances I can think of where the directors are powerful in their own right, that power is usually an expression of some form of interlocking directorate scheme, where the directors derive their power from a syndicate of shareholders or conspirators in some greater, extra-corporate entity, like a trust. CEOs do not "capture" a board - more often than not, they're the architect of the board. They *create* the board by control over the means of appointment. The independent board of directors seems to be no more common in the wild than, say, a free quark. To insist that independent boards of directors can exist in the wild without artificial means strikes me as rather dubious. Thus, I have to wonder at someone who champions directorial independence, while rejecting the very sort of regulation required to maintain such a creature.

Bainbridge points out the conflicting interests of shareholders and managers. Shareholders are protected from the extremes of risk-derived failure, and thus are rationally inclined towards higher-risk decisions. Managers are more exposed to the fallout of high-risk decision-making, and thus will tend towards a lower-risk decision-path, to avoid such things as liability for corporate actions, or the degradation of their human capital. Bainbridge specifically notes the manager's inability to diversify his "capital" in the same fashion that a rational shareholder does, by spreading investments among different corporations. The board, on the other hand, has no significant financial interest in the corporation, by design. A director can sit on numerous boards, and thus "diversify" his "human capital". A director's reputation is not tied intrinsically with the fate of whatever corporations he or she might serve as a director. The director is essentially disinterested in the economic fate of the corporation, barring any self-dealing allowed by the other creatures of the corporation, the law, or the regulation of the state. I would think that it is this very structural disinterest that drives the inevitable capture of a board by one of the other creatures of the corporation, or by outside forces. Just as nature abhors a vacuum, economics must abhor disinterest. The disinterest of the ideal director is displaced by interests: the cronies of the CEO, the representatives of the shareholders or the unions, the agents of an external agent such as a trust or syndicate.

I like his use of "bounded rationality" to argue that rules like the "business judgment rule" are an example of judges "shirking", or avoiding work through a simple heuristic. That is, a legal rule giving strong protection to boards means that the courts don't have to *deal* with insanely complex business judgments, or have to do the work of the boards in the course of evaluating whether their performance meets a required standard of adherence to the shareholder interest. He further notes that due to Delaware's status as a favored residence for corporations, the judges of that state have a much larger body of experience in corporate law, and thus have a lesser inclination to avoid this sort of "shirking", which would explain why the judges of Delaware have recently begun applying a much less stringent version of the "business judgment rule". That is to say, because they have a greater body of experience, they're more inclined to become activists on the subject.

He goes on to discuss boards as consensus-based teams, with accompanying group dynamics. I have to wonder what the difference is between a "team" and a board of representatives? One usually imagines a team as consisting of independent individuals, whose allegiances extend only within the closed system of the team itself. This is not the case in entities like a corporate board of directors. Individual directors are not, usually, independent, but are rather representative of interests or bodies of interests. The CEO's cronies are in this corner, the shareholder representatives in the other, perhaps a minority shareholder representative, or a union advocate, someone with greater industry interests, even trust or syndicate representatives. The result is not consensus, but negotiation.

I have to think that his emphasis on fraud and self-dealing is less to the point than concern over the director as representative of a greater, aggregate fraud, a syndicate for self-dealing on a grander scale. That is, I'm having trouble getting into his mindset, of imagining the directors as agents in their own right, rather than representative of

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