Chief Justice Myron Steele of the Delaware Supreme Court was the keynote speaker at The Directorship Forum on Tuesday, November 17, 2009 in New York City. This is a transcript of his remarks: “Emerging Trends in Director and Officer Fiduciary Duty Litigation.”
If I could title this speech as I wished, I think I would title it: “Comprehensively Changing the Framework for Developing and Testing Principles of Corporate Governance in a Crisis-Driven, Politically Charged Atmosphere.”
Admittedly, it’s a mouthful. But it does set the backdrop for the potential change in litigation trends in this country. I think the impact of the hopefully resolving financial crisis on corporate governance is substantial. My first concern is a backdrop to this, which I will explain. Then I’ll talk about how we have been developing corporate governance in Delaware, and then I’ll tell you what I think the future holds, understanding, of course, [that] although the word “we” may slip in from time to time, I speak only for myself, not for my colleagues on the Delaware Supreme Court, in the Court of Chancery, on the Superior Court, or for that matter, the Justice of the Peace Courts in Delaware. I may be the only person in Delaware that has this view.
But I think we would make a serious mistake if we didn’t focus as we reshape corporate governance on the global competition for capital goods and services. It’s becoming apparent that it’s no longer necessary for international entrepreneurs to come to the United States for capital. There’s competition for capital, there’s competition for ideas, there’s competition in labor costs, which we simply cannot meet.
If we’re going to compete nationally and internationally, we have to focus on what some people have characterized as patient capital. We have to develop a framework in which investors can invest for the long term, and allow capital to produce what is typically American – innovative products that impact productivity, generate new ideas, and make our goods marketable across the world. Ultimately, this great engine that is the corporation is designed to enhance wealth for those who invest in it.
We should be careful when we reshape the framework of internal governance in a corporation, and not take our eye off the larger ball.
In today’s red-hot politicizing of corporate governance principles, we would do well, I think, to thoughtfully approach changes in those principles, changes that affect the relationship between the directors’ exercise of their authority, and their accountability for the way in which they exercise that authority.
In Delaware’s chartered corporations, the law empowers the directors to manage the corporation. But there are limits, and those limits are well described. They are described in two ways: first, by our enabling statute, for all its flexibility, it nevertheless creates a logical framework for making directors accountable for their actions. Some of the limits are shareholders’ concurrent power to amend bylaws, shareholders’ required votes to approve certain transactions, shareholders’ power to elect directors, and more importantly, to proscribe the process for electing directors, and effective August 1 in Delaware with a new proxy access law, proxy access with the right to propose a short slate.
I’ll get to that point in more detail later, but it bears emphasis to suggest that 14a-8 still blocks the now liberal proxy access that’s available under the Delaware law. HealthSouth is the first Delaware corporation, to my knowledge, to adopt a proxy access bylaw consistent with our August 1 statute. It goes nowhere unless the SEC allows proxy access.
I would say, to SEC Chairman [Mary] Schapiro and her colleagues, “Chairman Schapiro, tear down that wall.”
Give us the opportunity at the state level to shape proxy access as it suits each individual corporation and its investors. Don’t mandate proxy access in a way that may work for some but not for others. Our flexible enabling statute and our case law now gives a framework for corporations to shape their own form of proxy access. Let us experiment. Let us see how it works. Every corporation will not necessarily adopt the same bylaw. But our statutes liberally allow full reimbursement, if the corporation so chooses. There is no limitation on a holding period, and there’s no requirement of a certain percentage of shares. Each corporation can draft what suits it and its investors best.
This flexible enabling statute, along with developments on a case-by-case basis in Delaware law through common-law principles, primarily through fiduciary duty and the applications of the fiduciary duties of loyalty, with its subsets of candor, good faith, and due care are the hallmark of the way in which to shape corporate governance principles.
The common law shapes the law incrementally, case by case, based on precise, factual situations as those facts are found by one of our sitting Chancellors, in a court without jury finding fact, and in a court that must produce a written opinion that justifies the facts that the judge finds, the principles of law that the judge believes applies, and an analysis of how those principles have been applied to those facts. It’s reviewable at only one level, and that’s the Delaware Supreme Court, and it’s rarely reviewed because of the quality of work that’s done–not because it’s not actually appealable, but because few parties who have litigated in our Court of Chancery ultimately appeal.
We have proposed bills in Congress that are variously styled. They’re all hyperbolic. A bill of rights for shareholders–what American is opposed to a bill of rights? A shareholder empowerment bill–who can be opposed to power to the people? Common law methodology for shaping corporate governance has an advantage over regulations or statutory mandates. The advantage is, you can look at the real world situation as the dispute developed. You can see the shareholders’ pleaded complaint about the manner in which the directors acted or failed to act. You can apply the principles of fiduciary duty of loyalty and care to those facts, and develop the law in a way that gives a sense of predictability, consistency, and clarity.
If there’s anything business needs in this interesting time, it is a sense of predictability, consistency, and clarity in the law.
The question in Delaware’s legal system has always been: How can we shape the law to get the correct balance between directory authority and director accountability to the investor? That balance, we continue to explore on the case-by-case, fact-intensive basis.
And we understand that this incremental way of shaping the law has a goal in mind beyond the resolution of an individual case. It is to properly rein in, as well as punish, malfeasance or misfeasance, or breach of fiduciary duty. But it’s also required to be shaped in a way that encourages the best possible people to serve as directors–a legal framework that encourages good people to serve as directors, thoughtful people, people who want to be informed of all the material facts before they cast an objective vote, people who are focused on the trust that’s been placed in them to act for others, and to enhance the corporate interest they serve.
The answer to most of our problems, if not all of them today, is to enhance the quality of directors, and focus them on their attention to their fiduciary duties.
As an aside, I commend to you an article that appeared in the last Business Lawyer, August 2009. It’s an article written by Lyman Johnson and Dennis Garvis. And it’s the kind of article that I enjoy, because it’s based on empirical evidence. It’s not a subjective judgment about where the law ought to go or why it should go there.
They did a survey of both outside counsel and in-house counsel to determine the extent to which counsel was advising both directors and officers of their fiduciary duties. And the results were somewhat startling to them, and to me.
They found, first, that not-for-profits, as opposed to for-profit corporations, were, on the whole, receiving advice about fiduciary duty more often and more thoroughly than for-profit companies. That was a surprising result to me.
More importantly, they found that while more directors were getting fiduciary duty assistance, instruction, [and] education, officers were not. In our Gantler v. Stephens case, we made clear last year what we’ve generally assumed in our law, and that is that fiduciary duties that apply to directors also apply to the officers of a Delaware corporation.
And there’s one huge caveat to note in that respect. For breach of duty of care in most chartered corporations, there is an exculpatory provision: 102(b)(7), we call it. Other states that have copied it call it something else in their code, obviously.
But basically, it says, in order to encourage directors to take a reasonable risk, that they would not be liable for a breach of the duty of care. They’re only liable for breaches–personally liable for breaches of the duties of loyalty, or a failure to carry out the duties of loyalty and care in good faith.
There is no such exculpation for officers who breach their duty of care. That’s why the instruction on fiduciary duty finding that Johnson and Garvis made–that fewer officers were receiving the advice than directors–is, to my mind, counterintuitive. It’s an obligation of directors, I think, to see to it that the full range of fiduciary duty, instruction, and assistance be made available to officers as well as directors, and it’s even more important that that happen sooner rather than later.
The other thing that we are concerned about in Delaware, and should be, is that our law is not applied in such a way that it chills responsible risk taking – that risk taking has been the engine that’s driven the corporation. It’s been the source of wealth enhancement for American corporations for almost 200 years.
We in Delaware have always soundly rejected the counterintuitive position that in order to achieve that proper balance or optimal balance between authority and accountability for directors, every business sector and every listed corporation must have the same internal governance structure.
Now, the politicizing. I tried to look up whether politicization was a word or not, but then I decided, since I can’t pronounce it, it really doesn’t matter whether it’s a word. But the politicizing of corporate governance today is remarkable.
We have bills in Congress that are variously styled. They’re all hyperbolic. A bill of rights for shareholders– what American is opposed to a bill of rights? A shareholder empowerment bill– who can be opposed to power to the people? And then finally, last week, tailed onto a 1,136-page bill designed to revamp the financial system, is a section called Strengthening Corporation Governance. Who in the room is opposed to strengthening corporate governance, empowering shareholders, or voting for a bill of rights?
No one, until you look at what actually might happen. These corporate governance principles, whether you agree with them individually or not, counterintuitively could not be better for everyone under every circumstance. Yet, all are mandated under each piece of this legislation. And the SEC empowered to bar listing your company on a national exchange if you do not comply with each of those corporate governance changes.
Now, I use the word change. I do not use the word reform. Until I personally see empirical data that supports in a particular business sector, or for a particular corporation, that separating the chairman and CEO, majority voting, elimination of staggered boards, proxy access with limits, holding periods, and percentage of shares–until something demonstrates that one or more of those will effectively alter the quality of corporate governance in a given situation, then it’s difficult to say, that all, much less each, of these proposed changes are truly reform. Reform implies to me, something better than you have now. Prove it, establish it, and then it may well be accepted by all of us.
But when you think about it, it’s ironic that these measures are styled “shareholder democracy”, because each of them actually limits what shareholders can choose.
Under the state systems – at least, under ours – all of these listed principles of corporate governance can be adopted by a Delaware chartered corporation –, but they’re not mandated. Why? Because we truly believe in a shareholder democracy. We believe there should be a buffet table of entrées from which you can choose what you prefer, and what principles you believe thoughtfully work in your corporation.
By mandating a set of new corporate governance principles that everyone must swallow, as if it were a pill for a disease you do not have, it seems to me, does not enhance majority voting in a shareholder democracy. The falsely described mandate limits shareholder choice.
Now, I recognize that in the wider world of things, Delaware’s role is small. Wags have said, Delaware is the mouse that roared. Well, to some extent, I don’t suggest to you that my ideas about corporate governance are better than anyone else’s. I’m perfectly convinced in my own mind that common sense tells me that many of these corporate governance principles may well help individual corporations. But common sense also tells me to mandate all of these principles for every corporation on a condition of being listed in our markets is counterproductive at best and foolish, at worst.
We will continue in Delaware to try to shape corporate governance on a case-by- case basis, and address, and look for and find hopefully that proper balance between director authority and director accountability. Where are we going with that? What are we seeing in litigation trends?
I think you can already detect, from what I’ve said in the last few minutes, I perceive as soon as plaintiffs’ lawyers focus on the fact that there’s no exculpation clause for directors, and focus on the fact that as of two years ago, you can get service of process over officers in Delaware corporations but who are not residents of Delaware, that we will see an emphasis in complaints of breach of fiduciary duty focused on officer action or inaction, as well as director action or inaction.
And why not? There’s no exculpation clause. There’s a more likely possibility, one might argue, for finding liability on the part of an officer for a breach of the duty of care, than a dismissal of a complaint that pleads nothing but a breach of duty of care, which can never result in damages, when it’s limited to directors who can rely on 102(b)7. So I would focus my attention, if I were in the boardroom today, on making sure that my officers understood that point, that my in-house counsel was giving them instruction on their fiduciary duties, and make sure that they were, as we used to say in the Army, trained up on the issues.
Corporate governance, and the development of corporate governance through our case law, is not a flavor-of-the-month process. We don’t react to what’s popular in the airwaves today. We are around for a long time. As judges in Delaware, some people may well say, too long. Somebody in the room whispered that, I’m sure. But we focus on these changes over time.
The very same case I mentioned, Gantler v. Stephens that focused on officer fiduciary duty, responsibility, and potential liability, also made another important point that cleared up Delaware law, which had been a bit murky over the years. And it’s important for future litigation. That’s the concept of shareholder ratification.
For many years, it was assumed that once there was a shareholder vote on an acquisition, that any breach of fiduciary duty that occurred before and related to that transaction was, by the shareholder vote on the merger itself, ratified. Therefore, any complaint of breach of fiduciary duty was subject to dismissal.
What this case clarified that, a shareholder vote that is obligated under the law, such as approval of an acquisition or a transaction from either end, will not absolve directors of earlier breaches of fiduciary duty, unless in the vote itself, the facts that would support an alleged breach of fiduciary duty are articulated separately for the shareholders. So the shareholders have a knowledgeable vote, not just on price, but focused also on any potential flaw in the process for achieving that price that could be alleged down the road. That “knowleagable vote” will result in ratification, and a dismissal of any suit for breach of fiduciary duty. It’s an important development in the law on which directors should focus.
As we continue to address issues of corporate governance, and recognize that we can’t separate ourselves from what’s going on in the world outside, I suggest to you that you will see continued development of the concept of good faith. There are two cases I’ll point out to you that I think will illustrate this in the Delaware case-by-case factual context.
Those two cases haven’t come to a conclusion, so nothing I say about them suggests to you, I hope, that I think they were decided correctly or incorrectly. But they do juxtapose exactly what’s going on in the risk-assessment world in Delaware.
The first is AIG, a case decided by one of our most brilliant Vice Chancellors [Leo Strine], who concluded, when the focus was on a motion to dismiss for failure to state the claim, that the facts as pleaded in that complaint, if ultimately proved, would establish that the conflicted board, which lacked independence, acted in such a way that was consistent with them being, and I quote, “a criminal organization,” close quote.
The focus of that case was on whether the plaintiff had adequately pleaded that the directors were not independent. They acted in their own interest, and not in the interest of the corporation itself, and diverted corporate assets to their own profit, rather than enhancing the wealth of the investors.
That case has survived a motion to dismiss. No one at this point knows whether the facts alleged will actually be proved or not. But that is scrutiny of director decision making, with language that in my 39 years of practice, I had never seen before. And it is that very same Vice Chancellor who will be making the ultimate findings of fact when that case goes to trial.
The second case is Citigroup. Citigroup is subject to a different pleading standard: the directors of Citigroup were sued for breach of fiduciary duty; and to summarize the complaint incompletely, it basically alleged that the directors of Citigroup had breached their fiduciary duty of loyalty and care, because they failed to see the warning signs that were developing on the horizon about derivatives and the subprime market. And by failing to predict in advance, they had made investments that they should otherwise have avoided. And the result of that breach of fiduciary duty, cost the investors in Citigroup millions of dollars.
Contrasted with AIG, the Citigroup complaint did not, because it could not, establish a lack of independence on the part of those directors. The Chancellor, who sat on that particular case, dismissed the complaint for breach of fiduciary duty, (you missed the subprime crisis), on the understanding that in the absence of a conscious disregard for their oversight responsibilities, the complaint had failed to plead a breach of fiduciary duty.
It’s important to focus on two things–the independence of the Citigroup directors, as opposed to the directors in AIG, and the burden on the complainant to establish either lack of independence or a conscious disregard of the fiduciary duty of “loyal oversight”.
Those two cases, I think, show that Delaware looks at each case based on the facts developed in the case, and the principles of corporate governance and director responsibility will flow from those incremental fact situations as they’re built over time.
There are final issues that I think we need to look forward to, ( on which we are yet to have cases, but it’s possible we might). So, one eye on the future is important.
What is the link between short termism and risk-assessment difficulties? There’s a wonderful article by William Bratton of Georgetown Law School and Michael Wachter of Penn Law School, examining that very issue. Would shareholder democracy make a difference in what some people think is a risk-assessment, crisis-driven financial system breakdown?
The conclusion in that article is, it would have made no difference, because it’s the very same shareholder community that has been demanding quick returns, rather than patient capital, that drove the risk assessment issues. It’s an article worth reading, whether you agree with its conclusion or not. Again, it’s an empirical study. It’s not based on subjective judgment about what the law ought to be.
I wonder what the role fiduciary duty will play after proxy access brings us the constituent director. Put aside collegiality in the boardroom, put aside long-term strategizing. Will constituent directors elected on a short slate focus on the fact that their fiduciary duties are owed to the entire corporation? Or will they focus on the best interest of those that elected them? Should they have different fiduciary duties, as a result, than other members of the board?
Right now, the law says no. We’ll see how the law develops.
As an increasing number of institutional investors sit back and don’t make independent decisions about how to vote, and allow themselves to be influenced by proxy advisors, will the law in the future, when 60 percent to 70 percent of shares are owned by institutional investors, and 60 percent or 70 percent of those are passive institutional investors who take their advice from proxy advisors, will the law impose upon proxy advisors a fiduciary duty to be well informed before they advise, and to be loyal to the interest of the corporations in which those they advise are invested?
And finally, the 800-pound gorilla in the room: Will the federal government’s investments in nationally traded corporations result in a large equity stake held by the federal government? Will the federal government relies on provisions in its agreement with, for example, TARP recipients, and place federally nominated directors on the board? What will be the fiduciary duty owed by that director or those directors, and whose law will determine what that fiduciary duty should be?
In the three statutes that are proposed in Congress that I mentioned, several times the term “fiduciary duties” is mentioned. No jurisdiction is indicated [as to] who will enforce them; no comment is even made on how to define them.
We can assume the proposed bills mean common-law fiduciary duties, and state law has always defined them. But what if, as was argued in the case (before U.S. District Court Judge Jed S. Rakoff of the Southern District of New York) with former shareholders of Merrill Lynch suing the board of Merrill Lynch before it was merged into the Bank of America, future plaintiffs argue that “federal common law” decides the relative accountability and authority of directors of two Delaware-chartered corporations?
My view is , that to his credit, Judge Rakoff dismissed that argument, and made it as clear as we ever learned in law school, that there is no such thing as federal common law, and that Delaware state law applied–a correct decision not only on that point, but a correct decision as he interpreted and applied Delaware law.
But when terms like fiduciary duty are tossed into a statute without any thought about what do they mean, who and where will they be interpreted, and how will they affect those of you in the boardroom or those of you advising those in the boardroom? It’s a mystery to me how any porposed bill can be passed responsibly before these potential unintended consequences are explored.
I hope, as I close, that what we will see is a thoughtful, considered, incremental development of the future of principles of corporate governance. There is a publicly traded corporation that says, quote, “Progress is our most important product.”
In Delaware, what progress and the development of principles of corporate governance means is, incremental change within a known factual context over time. It’s deliberate, thoughtful, predictable, consistent, and clear.
That’s the path we will continue to travel, and I can be sure of one thing absolutely. Delaware is too small to fail.