NARRATOR: Thanks for joining this episode of the No. 86 lecture series, where we discuss basic principles and applications of Corporate Law along with landmark cases. Today’s episode features Seth Oranburg, who is an Associate Professor at the University of New Hampshire Franklin Pierce School of Law. Professor Oranburg also co-directs the Program on Business, Organization, and Markets at the Classical Liberal Institute at New York University School of Law. As always, the Federalist Society takes no position on particular legal or public policy issues; all expressions of opinion are those of the speaker. PUBLIUS: In this episode, I want to talk about the role of a corporate board of directors. Can you give us a quick overview of how a corporation is structured? Where does the board of directors fit? Who appoints them? PROFESSOR ORANBURG: The separation of ownership and control is another core idea in corporations and the idea is that shareholders are the owners of a corporation. They own shares or percentages. There's a certain amount of ownership available and if you have five out of a hundred shares, you own 5%, but you don't directly control the corporation. The corporation is set up as a hierarchy where there is some established management who is appointed to control the day-to-day operations, or at least the global operations. Think of a corporation as a hierarchy. At the top of this hierarchy, are the owners, or maybe even outside the hierarchy in a sense are the owners, because the owners have only three rights. They can vote for management. They can sue management for violating certain duties and they can, in some cases, sell their shares and exit the corporation. There are a few additional statutory rights of shareholders. They can make precatory proposals. They can make bylaw amendments, but these are more technical matters that tend not to move the needle very far. The shareholder's primary job is to get a board of directors who is going to run the company and that is the situs. The board of directors is the situs or location of control. It's the control hub. It's the brain, if you will. It's the central unit from which all authority of the corporation comes. And I do say, "Board of directors," not individual directors because they only have power when they are a cohesive board operating at a duly noticed meeting in performance of that particular function. The difference between ownership control is that the owners, the shareholders, have very little rights to control the company. They can put pressure on management. They can say, "Hey, if you don't do what we want, we'll vote for someone else next time," or potentially, "You've done so badly, we're going to sue you for this," right? That puts some pressure. Or they could say, "If you don't change this, I'm going to sell out my shares and that's going to drive the price down and your compensated in stock." Shareholders can influence, but they don't make day-to-day decisions. The board makes the big decisions and the board doesn't even really make these decisions in a large company. They're going to then delegate that authority to management, such as a CEO, chief executive officer, a CFO, chief financial officer. The board will actually appoint these people, will elect them to these offices, and then delegate certain powers to those individuals who will then go and hire other people who will delegate further, et cetera, et cetera. PUBLIUS: Why is it required to separate ownership and control? Are corporations legally required to have a board? PROFESSOR ORANBURG: A corporation has to have a board of directors. In fact, a corporation has to have at least one shareholder, a board of directors, which could be just one director that constitutes the board, and several key officers because some of the officers have to sign for certain functions. You also need a president or CEO, a CFO, or chief financial officer or treasurer, and a secretary. There are certain corporate functions that are required by law. That's to create that hierarchical design that corporations are modeled after where there's a separation of ownership and control. The board of directors ultimately controls the entire corporation. The shareholders have authorized the board to run the corporation. They make almost all the decisions except for ones that are so extraordinary that statute requires shareholder approval. Certain transactions like fundamental mergers or sale of all, or substantially all, assets may require shareholder approval, but basically everything else is decided by the board. Now in practice, that doesn't mean the board is meeting every day to talk about these things. The board's number one function is to make sure that they've got the right executive team. That's the CEO, the chief executive officer, the other executives like VP of finance and chief technology officer. Those are the folks that are making the day-to-day decisions. We might call those ordinary decisions, but the board has to make the extraordinary decisions. Then there is one level above that, sort of, that the company transactions that may require shareholder approval. But, the control of a company is vested in the board. The corporations are run by a board of directors. That's the law. The board of directors, by the way, has to be comprised of human beings, ] which is interesting because corporations themselves are entities, but not human entities. They're not people. While they're made of people, a corporation could have a contract with another corporation, but the board actually has to be run by humans. You couldn't have a corporation constitute another corporation's board. There's been some argument that maybe we should allow that and have sort of professional board corporations that provide a management function, but [00:03:00] under present law, the corporate board not only runs the company, but has to be a group of human beings sitting in chairs around the table or at least nowadays on Zoom. PUBLIUS: What exactly does the board do? What are they responsible for? Who determines their duties? PROFESSOR ORANBURG: The primary duties of directors is the duty of care, the duty of loyalty, and we’ll also say there is a duty of oversight. Although there is a debate about whether the duty of oversight is subsumed by either the duty of care or the duty of loyalty or both. And for nonprofit corporations, there's also something called the duty of obedience to law, that applies to nonprofit corporations. But those duties generally arise from statute. They've been created by statute, which has been interpreted by courts. So I guess it's really a mix of statutory and common law. So we would look at the Delaware General Corporation Law to see what are the fiduciary duties of directors of a corporation that is incorporated in Delaware, for example. Of course, as we know from all areas of law, statutes don't tell the whole story. Statutes are interpreted over time by courts and that sheds light on their actual meaning. So our understanding of fiduciary duties is a function of state law where courts, over time, have interpreted state corporate statutes through judicial decisions in which they've opined on cases where duties were or were not violated. And that's how we understand today, the main fiduciary duties of care and loyalty. Yeah, so care regards decision making. Directors have a duty of loyalty and directors have a duty of care, so what's the difference? A duty of care regards when you make business decisions you have to do them carefully. The duty of care usually comes out in a requirement to attend board meetings, to hire independent analysis before making a financial decision, to get appraisals before purchasing a property or evaluation before acquiring a company, not to waste corporate funds, but to use them for, at least theoretically, profit generating purposes. Effectively, the duty of care says that so long as the directors and officers gave a thoughtful consideration of the facts and took enough time and process, they're going to be protected in their decision by the business judgment rule, sort of like you picked these people to run your company, so don't complain if they're stupid. Just make sure that they're being careful. So long as they're being careful and so long as they are incorporating enough information, you can't really fault them for being wrong in the end, because that's why you hired them. You get the directors that you picked. The business judgment rule really provides a strong defense for directors there. The duty of loyalty is quite different. There's really no virtue in a director who steals from the company, and so the duty of loyalty effectively prohibits any type of usurpation of corporate resources or opportunities, and it's bifurcated in a couple different ways, but we have something called the Corporate Opportunity Doctrine, which is a duty of loyalty concept that says a director cannot take an opportunity in the line of expectancy of a business that he or she manages. That can be defined in a number of different ways, but for example, there's a famous case about the director of a golf course corporation who purchased the parcel of land immediately next to the golf course. Well, golf courses operate on land and the corporation very well might have benefited from purchasing the adjacent land. It's a land owning corporation. Golf courses require a lot of land, so for the director or the manager to receive that information and not to give the corporation a proper opportunity to consider it and reject it might have been a usurpation, and there's no real value to the business for that. This is just an agency problem. This is a problem you have with agents. You put someone in the front of your store, and they're the ones that are going to talk to the customers. What if they're selling their own stuff instead of yours, right? If you put someone in front of the Apple Store and you pay them $15 an hour to sell Apple products, and instead they're saying to the customers that come in, hey, don't buy the MacBook here for $1,000. Come out back to my van and I'll sell you a used one for 500, and they pocket the difference, that's not valuable to the corporation. Loyalty is those type of issues, usurping that corporate sales opportunity, or the conflict of interest transaction doctrine, or the director conflict of interest transaction concept. If a director has any conflict of interest, meaning that they have a personal or really a personal financial, or it could even be stretched to a kinship or maybe even a friendship interest, non-corporate interest in the transaction, and these come up when, for example, a corporation buys land from one of its directors. That director has mixed motives. As the seller of the land, the director wants to get the most value for it, wants to charge the corporation as much as possible, and but for the fiduciary duty, that's what a seller does. Of course the directors are supposed to have the corporation pay as little as possible, try to look out for the corporation by not spending wantonly on resources. If a person is in a conflict position, where they're on both sides of a transaction, this abrogates the business judgment rule, and this person is going to be judged on the basis of acting loyally, which usually means they have to abdicate from the decision making process, fully disclose their interests, and allow the rest of the board to make the decisions, which also could involve potentially even setting up a special committee of outside experts to provide a recommendation. But these type of transactions are automatically suspect, so the duty of care is going to be a very, very limited doctrine, where we're rarely going to see breaches, because we actually presume that directors are acting carefully and exercising business judgment whenever they render a business decision. However, if they have a conflict of interest or if they have taken for themselves a corporate opportunity, we take away that presumption and we actually reverse it, and we presume that they are acting in their own self interests, not in the corporate interest, and we judge them differently, and so most of the claims that you're going to see in corporate law are at least fundamentally based on some breach of the duty of loyalty, because again, otherwise directors'/ decisions are business decisions and we appointed them to make business decisions, so in general they get a lot of deference when they do. PUBLIUS: You referred to a third possible duty - the duty of oversight. What is that and why is there a debate about whether it’s subsumed under one of the other duties? PROFESSOR ORANBURG: Last, and maybe least is this concept of the duty of oversight and this has come up more recently, especially as we have all these legal reporting requirements. Corporations are not permitted to violate law and directors are obligated to set up compliance programs to ensure that law isn't violated. For example, the Foreign Corrupt Practices Act prohibits bribing foreign officials. Bribery is common in certain countries like China and Brazil, and what have you, and it's how business is done, but our Congress decided that's not how we, Americans, do business in the world and it's illegal and it can have liabilities here in America. Organizations have some obligation to create controls, to create oversight, to create whistleblower programs. And if a company fails to create an FCPA compliance program, [00:54:00] the directors could be liable under this breach of duty of oversight. Now, the duty of oversight again is not really an independent duty and it has alternatively been framed as a breach of the duty of care, meaning they just didn't have a meeting and think about it, or people have tried to shoehorn it into a duty of loyalty claim. It's harder to see the fit with oversight and loyalty because the directors are getting nothing personal. The only colorable argument is that they were off on their yachts [00:54:30] doing something personally enjoyable or running some other business when they should have been here setting up an oversight program. And therefore, it was disloyal because they engaged in self-interest as opposed to keep the company safe from legal liability. But in general, the main duties that we talk about in corporate law are the duty of care, which is protected by the business judgment rule, and which can also be further protected by exculpation, indemnification and insurance. It's not really easy to make a breach of duty of care claim because the business judgment rule, as well as various decisions to exculpate, indemnify, or insure make those claims very hard to pursue. A lot of the action in corporate law is around the duty of loyalty, where you can prove that a director had a personal interest and a transaction. Those benefits, those protections fall away, making it much easier for you to sue that agent. PUBLIUS: The flipside of responsibility is liability. Do directors have legal protection for themselves if shareholders decide that they violated a duty? PROFESSOR ORANBURG: Right. Directors can be protected in three main ways under law. And again, all of director liability comes from statute and their ability to be protected from these liabilities must also come from statute. So there are three ways that directors can be protected from liability, which is exculpation, indemnification, and insurance. And again, all are authorized by the Delaware general corporate law for Delaware corporations and see your favorite state law for its provisions. Many are based on the Model Business Corporations Act, which also provides for some level of protection for directors. But for simplicity’s sake, just thinking about public corporations and Delaware, it used to be thought that directors effectively could do no wrong, could not really violate their fiduciary duty of care if they were engaged in making business decisions and had no personal conflict. That changed after a case called Smith v. Van Gorkom, effectively held that directors could be liable for deciding to sell the company for potentially too cheap, when they didn't spend enough time analyzing the transaction. There are no allegations that any of the directors were personally interested, so there's no loyalty issue, but rather the claim was they were not careful enough potentially to merit protection under what's called the Business Judgment Rule. This alarmed a large number of directors and it seemed to discourage risk taking behavior. So some shareholders actually fought against this ruling and there was some movement in the Delaware legislature to correct for what might have been an over extension of liability onto directors from the courts. And so Delaware enacted section 102(b)(7), which allows corporations to amend their certificate of incorporation and to provide for exculpation for directors. And exculpation effectively strengthens the business judgment rule and puts corporations and management liability back to how it was for the Van Gorkom case was rendered. So effectively, exculpation says that directors are not liable for breaches of the duty of care, but Delaware 102(b)(7) does not permit exculpation for breaches of the duty of loyalty. So basically exculpation is a way to restore the business judgment rule to its more fulsome authority that it enjoyed before the Smith v. Van Gorkom case cast the business judgment rule into some doubt. In addition, Delaware also permits indemnification, which means that if a director is sued, the corporation can elect to, or can in advance, commit to step into the shoes of that director, pay for litigation expenses, reimburse for litigation expenses. There's a variety of different ways that corporations can do this because litigation is obviously expensive and directors may not want to take the job and become directors if they could potentially be sued and have to spend $1 million defending that lawsuit. So corporations can indemnify directors, effectively giving them the corporate treasury as a resource for them to defend against a shareholder suit. Now, this is ironic in the case of a derivative suit, because remember a derivative suit is where the shareholder causes the corporation to sue its directors, because the shareholder is derivatively harmed. For example, by the lowering of stock value, by a director's action and the director won't cause the corporation to sue the director cause people don't sue themselves. So we have this other mechanism where shareholders can cause the corporation to sue the directors derivatively. And then that sort of ironically conflicts with the indemnification provision, because then the corporation pays for the defense of the person it's suing. Pays for the defense of the person its suing. Now, if the lawsuit is successful, the director may have to pay for those costs, and indemnification can be set up in a variety of different ways, and there are some studies done on whether indemnification increases or decreases stock value when these procedures are implemented, but effectively, indemnification is the process by which a corporation stands in the shoes of a director and takes over the costs of its litigation. Finally insurance, your director and officer insurance is what it sounds like. It's insurance against being sued, sort of like having driver's insurance. If you have driver's insurance and you get into an accident, and you hurt someone or someone gets hurt, let's say, there very well might be a lawsuit, some tort lawyer is going to come after you for damages to his client, and an insurance company will pay for your defense in court, and up to a certain amount, it will pay for your settlement or the cost of your verdict. It's the same thing with insurance for directors and officers. It's simply a policy that you take out, and again, the corporation pays for it, and this may be, by the way, directors may insist on this. If you are asked to be the director of a corporation, you may want to ask well, do you have insurance so that if I get sued I don't have to sell my house to pay for my defense? Often these policies are insisted upon by would-be directors, and just like any other form of insurance, if the bad event happens, if the shareholder lawsuit happens, the derivative lawsuit happens, direct lawsuit, class action lawsuit happens against the directors, the insurance company now will pay for the defense. Now this in some ways is better than the corporation paying the defendant where it's also paying as plaintiff. Insurance can be a good result, can be a good product, director and officer insurance can be a good product for corporations to invest in, but it's expensive and these policies can cost millions of dollars. It really depends on how risky shareholder litigation is in that industry. To summarize, there are three ways that directors have protection from liability, exculpation, where effectively lawsuits are going to be dismissed because we're strengthening the business judgment rule, indemnification, where the company is going to provide either some or all of the upfront or reimbursed costs for litigation, especially where successful, and insurance, where a third party is going to pay for the cost of litigation against directors, but you have to pay a premium for those. Those are protections predominantly against the duty of care violations, alleged breaches of the duty of care because many of these policies don't include alleged breaches of the duty of loyalty because corporate directors are encouraged to take risks and sometimes risks go badly, and then there's a claim that it wasn't a good risk but it was careless. But we don't really want directors to be enriching themselves at the corporate expense, so most of these protections for directors don't apply to when the director has a conflict of interest or has taken a corporate opportunity for himself or herself or has otherwise enriched him or herself at the corporate expense. Those instances typically are not going to get the same level of protection because they don't really benefit the corporate franchise in the same way that encouraging smart directors to take calculated risks could result in corporate profit. NARRATOR: Thank you for listening to this episode of the No. 86 Lecture series on Corporate Law. The spirit of debate of our Founding Fathers animates all of the No. 86 content, encouraging discussion and critical reflection relative to how each subject is widely understood and taught in law schools and among law students. 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