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 M. Todd Henderson, who is the Michael J. Marks Professor of Law at the University of Chicago Law School. Professor Henderson’s research interests include corporations, securities regulation, and law and economics. As always, the Federalist Society takes no position on particular legal or public policy issues; all expressions of opinion are those of the speaker. Professor Henderson, in other episodes, we talked about what a corporation is and what it does. In this episode, I want to talk about how corporations are run - what is the basic structure? Who is in charge of making decisions? So how's a corporation set up in terms of how it's managed? I'll use Delaware as an example. In Delaware, section 141 of the Delaware Corporate Code says, "Corporations are managed under the direction of the board of directors." A board of directors is a group of persons, more than three, no other real limitations in Delaware that are responsible for managing the affairs of the company. They're the ones who make the decisions. All of the liability for doing things wrong falls on the directors. If the shareholders have a plausible claim that they've been harmed by actions taken by the operation, they sue the directors and the directors are the ones who can be personally liable to the shareholders for things that they do that are illegal. So in the model of agency, shareholders are the principles and they hire a board of directors as their agents. Shareholders turnover money to the company to do things. Hopefully turn that into more money. And they say to the board of directors, "You group of 6, 9, 11," whatever it is, "you're responsible for deciding how to spend our money. What kind of projects are you going to do? What kind of rules are you going to put in place to make sure that our money is well spent?" Now boards of directors don't stop there and they don't actually end up running the business. For lots of interesting historical reasons boards are not managers. They don't specialize in a particular activity. Usually they're people who run other companies. They might be important citizens in a jurisdiction. They might be politicians. They might be successful investors. It's a diverse group of people for whom being a board member is a part-time job. There's probably four board meetings a year plus some other special meetings. They'll show up for those things. They see the big picture, but they're not involved in the day to day management. For that job, the board of directors then hires another group of people which are called managers. The managers are what you've probably heard of people with acronyms like CEO, chief executive officer, the COO, the chief operating officer, the CFO, the chief financial officer. And we could go on all day with acronyms of corporate managers. But by and large, at the typical corporation, there's one person, the CEO, who is responsible for managing the day to day activities of the corporation. That CEO, he or she reports to the board of directors and the board of directors' primary job is to hire the right CEO, monitor that CEO's performance and fire the CEO, when they're doing a bad job. This is the prime directive rule number one for the board is your job is to pick the CEO. Make sure he or she's doing a good job. If they're not doing a job kick them out, bring in a new CEO. So in this model, we've got a principle, which is the shareholders, the board of directors, which is a group of part-timers, a group of six or nine or more people. And their prime job is to pick the CEO who's going to run the day to day activities. We don't trust the CEO to decide all matters and the board has a role beyond just hiring and firing the CEO, but it's really for extraordinary transactions where the board is heavily involved. So the board will do things like set the overall strategy for the business, ensure that the business is reporting to financial markets, the accurate financial condition of the company, that the auditors are doing a good job explaining the financial conditions, but there will be a set of extraordinary transactions where the board will be involved. Typically this involves something called mergers or acquisitions, where the company it's going to combine with another company, a merger. It's going to sell itself to another company, or it's going to engage in a very large acquisition of another company. In those activities, the board will play a special role in part because we don't trust the CEO to make that decision by himself or herself. The CEO as the subagent of the shareholders might take actions that serve their interest and not the interests of the shareholders, because it's a really, really important monumental decision. A decision that might look a little bit more like an investment decision than a business decision. The board plays a role and the board role will not be only to monitor the CEO while he or she is doing that job, also formulating their view about whether or not the transaction is a good transaction. And then crucially making a recommendation to shareholders say, it's a merger, shareholders get to vote on that transaction because it's so extraordinary. Shareholders don't play a role in the day to day decisions of companies. If you own five shares of Apple, you don't get to have a say in the design of the Apple iPhone 14. That's something that you have delegated to the board and the board has delegated to Tim Cook and the other managers of the Apple Corporation. They get to make decisions about design features, marketing, where products are produced, who to hire to have various roles. All those decisions are day to day decisions, but if Apple wants to merge with Google, the board of directors plays a very important role in approving that transaction and then recommending that the shareholders approve that transaction as well in a shareholder vote. So managers, the board of directors, and the shareholders all have different roles. Is there one group that “controls” the company? Who controls a corporation? Well, it depends on the thing that's being controlled or what the company's doing. For almost everything a company does, the company is controlled by the CEO. He or she sits at the top of the corporate hierarchy in terms of the day to day activities of the company. So major decisions will be made just with the decision of the chief executive officer. The board of directors has the ultimate authority and control over the CEO and the CEO has to please at least a majority of the board of directors in the decisions that the CEO is making. So the decisions of the CEO will be in the shadow of the approval and control of the board of directors. A CEO has a very close relationship with the typical board. They're frequently sharing information, not just at regularly scheduled board meetings, but in between and depending on what the decision is, it's wise for the CEO to keep his or her board informed and make sure that the board is on board with the direction and decisions that the CEO is making. And then ultimately shareholders have a tremendous amount of control because the shareholders can remove the board of directors. Every year board members are reelected at the shareholders annual meeting. And if the board members are not doing a good job, the shareholders can remove the board members. And of course, if the CEO's not doing a good job, they can be removed by the board. So ultimately shareholders are in charge, but they delegate that authority to the board, which is then in charge. But then they delegate that to the CEO. So there is the paradox that the ultimate control is shareholders, but by and large, everything is managed under the authority of the CEO. There's one other group I should mention and that is creditors. So companies not only raise money from shareholders, they raise them from people who lend money. Those could be banks who give companies loans. It could be bond holders who invest in the company in debt. And those creditors exert an enormous amount of control over the company as well. They don't do it through voting, which is the way that share holders do. Rather they do it through contract. Creditors use something called contractual covenants, which are just terms in debt contracts that give the creditors certain rights. So for instance, the company might raise money through a bond issuance and in that bond indenture, there would be provisions that say things like, "If the company borrows money beyond a certain amount, or if the ratio of the company's income to its assets falls below a certain amount or any other financial metric, that will trigger obligations under the bond indenture. Maybe the bond holders get to redeem the bonds immediately. Maybe they have the right to pick who the new CEO will be. Maybe they'll have the right to put people on the board of directors. They're free to write into their contract for the debt anything that they want to give them certain amounts of control. So shareholders are the ultimate control through the franchise, their ability to vote out the board or control the board in a way to choose who the CEO is and and debt creditors, banks, or bond holders, they exercise control through contractual limitations on the kinds of things the company can do. Is a corporation required to have a board of directors? Have companies always had boards to oversee management? Boards of directors are a common feature of corporations in part because Delaware requires boards for corporations. Also because stock markets, for instance, New York Stock Exchange, it requires that companies have boards of directors in order for them to be listed on the New York Stock Exchange. There are alternatives that you could use if you're a small corporation where it's infeasible for you to have this board structure. So those things are possible. New innovations in business organizations, the limited liability company for instance, allows the LLC to be managed by its members. A member there is just like shareholder, but they call them members. LLCs can be member managed because they don't have the scope of the typical public corporation, which usually involves millions and millions of shareholders. One way to think about the board of directors is it's just resolving a collective action problem. There's a million or 10 million shareholders for Apple Computer. They're spread all over the world. It would be very costly and infeasible for them to meet and vote on particular activities of the corporation, in the same way that we live in a representative democracy, not a direct democracy. We don't have the hypothetical Athenian forum where we would all come together and meet as a polis and make decisions for the democracy. No, no. We elect people that we send to Washington and make decisions on our behalf. We get a say in who they are and we get to vote for who the president is, but by and large, we delegate our authority to make laws that maximize the value of this thing called the United States to our representatives and the same thing is true of shareholders of big publicly traded companies, where it would be infeasible and inadvisable. The typical shareholder doesn't know anything about running a complicated business. And so that allows a division of labor where shareholders can contribute cash to people who are experts in running businesses and making business decisions and the kind of specialty experience and knowledge that comes with that division of labor. Again, think about the things that the average American knows about budget policy or military policy, or who should be on the Supreme Court. We delegate those to experts in the legislative branch in Congress. And the same thing is true with a separation of ownership and control in corporations. Where do boards come from? It's this ubiquitous feature of corporate law and a central component of the entire structure of state corporate law. But why do we do that? You could imagine an alternative in which there is one person in charge. The President of the United States is in charge of the executive branch. He or she doesn't report to a board of directors which oversees their activities. So where did this idea come from? Well, it's interesting, in America at least, the idea started with Alexander Hamilton. Hamilton was interested in building an industrial park in Passaic, New Jersey. He wanted Congress to do this to increase the industrial capacity of the fledgling United States. I think presciently he saw that power in the world would be derived from economics and the industrial capacity of the country and he wanted to give that a kickstart. Jefferson resisted this. Jefferson and the Republicans in Congress take control in 1800s, early 1800s, and they have a more agrarian vision of the United States, a more limited role for the Federal Government and so they resist Hamilton's entreaties to establish in this industrial park. So Hamilton creates this separate corporation, but he wants it to be under the control of government officials. So he borrowed something that had been used by the Bank of England, another quasi governmental entity. And that was appoint a group of men, they were all men then, who were important, political elected officials who would oversee this new industrial development. And so he borrows this thing from the Bank of England called a board of directors. The board of directors was a political act of installing political figures to oversee something that Hamilton truly wanted to be a governmental activity but just couldn't given the constraints of the public at the time. So various political luminaries take their positions on the board of directors overseeing the society for useful manufacturers and that practice gets copied as the early proto corporations develop. Interestingly, almost all of the first corporations in the United States were about infrastructure projects, banking, big things that the government had historically been in the business of. And so it was natural when going to the state legislature and begging permission in the form of a corporate charter to do an activity that was by and large, something that was in the ambit of the government that they would incorporate this idea of, "Well, it'll be run by a board of directors with these political luminaries and elected officials and that should give you comfort legislature who's going to give us the charter, that this will be managed in a way that's pleasing to you and accountable to these government officials." And then once that is established as the primary mechanism for policing corporate activities, when the entire world of corporations and corporate governance changes from a, you must go to the legislature to get permission to have a corporate charter to build a bridge over a river, and now it's, you can start a company for whatever reason you want. That's the big innovation in New York in 1811 that allows free incorporation without permission from the legislature. The tradition of having a board of directors gets carried over. And so boards today exist in large part because of a historical accident because of how companies started as being basically outsourced government. And yet they've been refined over the years to be a reasonably effective mechanism of corporate governance and control. But I think it would be a mistake to think that it's inevitable or the first best form of corporate governance. We could imagine lots of other ways of structuring companies that may be more of efficient, maybe having one person responsible, maybe having direct democracy would work for some types of corporations. And so we see that innovation, but it largely happens on the margins with LLCs, with very small companies. For large publicly traded companies, the rules of states, the Federal Government and Federal Statutes, the New York Stock Exchange and other stock exchange, which have their own corporate governance rules, they all have accrued on top of each other where they just presume that the board is how it has to be. And that really stifles corporate governance innovation. What happens when there is tension between the board and the shareholders? For instance, can a board stop a shareholder takeover of the company? One of the most important events in a corporation's life is when there is a offer to purchase that corporation. The board of directors, which generally has a passive or quasi passive role in corporate affairs, comes into full sprint when a potential takeover arises. And the corporate governance implications here are pretty profound because shareholders are dependent on the board to get the best price possible, and also, the board is potentially conflicted because a attractive takeover offer of the company might result in the board of directors, the CEO, losing their jobs. After all, company A buys company B, company B doesn't need a board of directors, they don't need a CEO. The board of directors of company A that's taking them over will take that responsibility. You don't need two CEOs. So, the decision makers, the people who are responsible for deciding whether to do a transaction in M&A, the people who are going to be making recommendations on whether that's a good transaction, what the price should be, they face some pretty significant conflict of interest problems. Socially, takeovers are one of the most important social technologies that have ever been developed. The agency cost problem is significant and the threat that the company will be taken over and the management ousted is perhaps the best tool we've yet devised to ensure that companies are acting in the interests of their shareholders and in maximizing wealth. If there was no threat of an external takeover, the amount of slack and agency costs at the typical company would be quite large. CEOs would build empires, lavish perks upon themselves, and fiddle while Rome burns and there's not much shareholders could do about it. Yes, they could sell their shares, but that would be cold comfort since their shares are worth a lot less. We rely on activist investors and take over specialists to find undervalued companies, buy them, kick out the management, the lazy self-serving management, replace them with new management, and unlock the hidden value that has been displaced by high agency costs. Those takeover specialists have always been regarded, in almost all circles, as bad people. If you watch any American movie about business, the bad guys are takeover guys. Pretty Woman, the bad guys are Richard Gere who threatening to break up the shipping company, and it's only because he finds a girl who convinces him that he should change his ways that he comes around and says that he's going to build things, not just tear things down. And there's dozens of examples like this in American movies, and it's not just American movies, it's on Capitol hill. There's been legislation after legislation designed to protect corporate managers from takeovers. Not surprising, corporate managers don't like takeovers, it makes them work harder, it's discipline to them, they risk losing their plum positions, and it's a lot easier to go to Capitol hill and plead for special interest legislation to protect themselves than it is to improve things and deliver value for shareholders higher than what they would get from the outside. In light of this, there is a debate in corporate law and a lot of case law on what is the proper role for the board in a takeover. The flip side of the coin for managers is, a takeover could be selfish from the perspective of the company taking over the company. A Company could or a takeover activist could come in, buy the company for less than its value, giving shareholders a bad deal, and then using that company in a way that serves that takeover artist's interests and not the shareholders or society. Moreover, if the board is disabled from resisting a takeover, they may not get the best price. So, you could imagine a company is worth $50, a takeover activist comes in and says, "I'll pay $55," and the board is helpless. It's legally not permitted to say no. The shareholders get $55. If they were able to say no and resist the takeover, they may be able to bargain up the offer to $60, in which case, the shareholders would be better off. So, the ability to say no for the board can be a good thing because it can incentivize negotiation and getting the best possible price for shareholders, it could be a bad thing because it may be designed not to do that, but to protect incumbent managers from the asset moving to its highest valued use. So, if the offer is for $55 for a company worth 50 and the board says no, and the suitor walks away, shareholders are worse off. And the board might couch this in terms of, "We're trying to get the best possible price," but it actually might be just self-serving. And the Delaware cases try to unravel this. How can we strike the right balance between giving boards the power to say no to serve shareholder interests versus making sure that we get sufficient numbers of takeovers so that we're not exacerbating agency costs? In trying to articulate the right posture for boards and governance in a takeover battle, there have been a couple of canonical cases. The first one is Unocal versus Mesa Petroleum. In this case, there was an oil company and a very famous raider with the delightful name T. Boone Pickens. This is straight out of a Hollywood movie. Pickens wanted to buy Unocal and he did so in a very clever way. He offered a two-stage deal. He said, "I'd like to buy 50% plus one of the Unocal shares at a very attractive price. And then once I have control, 50% plus one allows me to control the board of directors, which allows me to control Unocal, I will cash out the rest of the shareholders with a much less attractive deal." Now, you're a shareholder, how are you going to vote in a transaction where Mesa Petroleum says, "I'll buy your shares or I'll buy 50% plus one of the shares at this very attractive deal, and if I could control, I'll buy out the rest for a bad deal"? You're going to vote to sell your shares to Mesa Petroleum, because you want to be in the 50% plus one, you don't want to get the raw end on the backside. So, this what's called a two-tier coercive offer designed to get people to sell at a price that may be lower than what they think they're worth, because if they don't offer to sell, they're going to get the second stage, which is even worse. So, the company, they might say, "I think we could get more, but if I don't sell and I vote, no, if 50% plus one of my fellow shareholders vote yes, I'm going to get something that's even worse than what Pickens is offering." In response, Unocal played defense. They adopted various defenses. This is someone there, Unocal thinks it's got a castle, they're the Lord of the manor, here comes the raiders on their horses, and they put up archers, and barrels of flaming oil, and they do all kinds of things to defend to make T. Boone Pickens go away. The Delaware courts looked at the defensive tactics that were used and said, "Well, we're going to let companies play defense but the defense has to be reasonable to the threat that's posed and proportional to the threat that's posed." In other words, you can't threaten to burn down the whole kingdom, because here comes the raiders on a horseback, but you are allowed to play enough defense so that you make it difficult for them so you may be able to negotiate for a higher price. So, the Unocal standard set up this test that said, "Defense is okay, but it's got to be defense that is designed to not make the raiders all die or all go running away, it's just designed to encourage negotiation and a better deal for shareholders." In addition to the Unocal standard, there are Revlon duties. Can you explain what those are? Revlon involved a potential takeover of the cosmetics maker by another raider, a guy named Ron Perelman, and Perelman wanted to buy Revlon and got into a bidding war with other potential buyers, and Revlon to didn't want any of this, they played very aggressive defense. They started negotiating with the other potential bidders and put in place a bunch of defensive tactics. Perelman challenged these because effectively, they turned over Revlon at a lower price than he was willing to offer to a rival bidder that Revlon management preferred. And in Revlon, the Delaware Supreme court said, "You're allowed to play defense," that's Unocal, "but at some point, the company is basically for sale, and once the company is for sale and you're opening your gates to one potential raider, then the job of the board switches from playing defense to being an auctioneer." So, the Revlon duties are, when the sale of the company becomes inevitable, the board has to get the highest price, and it can't say, "Well, we're going to go with a slightly worse price for the company because we like this bidder better. That's not something shareholders are interested in, especially when they're going to be cashed out. If they have to give up all their shares, all that shareholders care about is the price that they get. They don't care about the reputation of one of the buyers, they don't care about the plans of one of the buyers versus the other buyer, all they care about is the money that they're going to get out of it. So, when the sale and the liquidation of the shareholders' interest is inevitable, board members have got to get the highest price. And this all makes good sense. We don't want boards to be able to say no and turn away any potential offer, we don't want them to play defense that is disproportional and not serving shareholder interests, and when the situation gets to the point where all it is on the table is how much money are we going to get for shareholders, then boards have to put their own personal views aside, put defense aside and get the maximum possible amount for shareholders. Apart from takeover issues, can the board make a management decision that the shareholders disagree with? So one of the core principles of a corporate law is something called the business judgment rule. The business judgment rule is a principle that establishes the kind of review that courts will do of corporate actions. Companies make all kinds of decisions. Those decisions may disappoint various stakeholders of the corporation. Shareholders might not like a decision that the board of directors makes, and they may sue in court and say, "The board of directors, they're the people that we have delegated to make decisions on our behalf and running the corporation. They made a bad decision." And they want to bring that action in court. And the business judgment rule says, courts are not going to second guess business decisions, decisions of the board to do a particular thing. Those things will be judged in the market. Those things can be judged by the people who would buy or not buy the products. And if shareholders don't like the decision, they can sell their shares. So, one of the key cases to understand the business judgment role is a case that involves a baseball stadium in my hometown of Chicago called Wrigley Field. And the owner of the Cubs and Wrigley Field resisted pressure to install lights at Wrigley Field. When I was growing up, there were no lights at Wrigley Field, only daytime baseball games. And the Cubs weren't doing very well, and they were losing lots of money. Shareholders sued and said, "This decision not to install lights is not something that maximizes the value of our shares in the Wrigley Corporation." The chair of the Wrigley Corporation defended the decision, not by saying, "I think the long term way to make money for Wrigley shareholders is not to install lights, to build the brand of the Cubs as a day baseball team," but rather said, "Baseball is a daytime sport. I don't want to have night games. I think they're decadent or not the way that the traditional baseball should be played. And also I worry about installing lights in this neighborhood in Chicago, it's going to have a deleterious effect on the neighborhood." And the shareholders are up in arms in this, and they say, "The neighbors aren't shareholders in the Wrigley Corporation, you need to act in our best interests. And your idiosyncratic preferences about day baseball as the way it should be played are irrelevant, make us money." And the court in that case, Shlensky versus Wrigley said, "This claim doesn't even get up to bat," to make a bad joke. You cannot criticize actions by the board of directors, business decisions, whether to install lights or not, unless that decision is tainted by some kind of self-interest. If the board of directors is acting to line its own pockets as opposed to the shareholders, then that could be the basis of a suit. But if you're just alleging they're making a bad business decision, too bad, so sad, you can't win in court. You can win in the investment world by selling your shares or not investing in the first place in this particular corporation, that is not a legal claim. So that Shlensky versus Wrigley is important case, because it describes this judicial abstention known as the business judgment rule. One of the most canonical cases in corporate law involves Henry Ford and two brothers John and Horace Dodge. This case is from the Michigan Supreme Court in 1919. And it involves a dispute about the unbelievable amounts of money that the Ford Motor Company was making at that time and what the company could do with it. The Dodge brothers made all of the chassis for Ford cars at the time. They were shareholders of the Ford Motor Company. And by 1918, the Ford Motor Company was making spectacular profits. It was issuing dividends of millions of dollars a year to the Dodge brothers who were large shareholders, and routinely making special dividends of about $10 million a year in 1918 dollars. So just producing enormous amounts of wealth. Henry Ford decided to stop paying these dividends. And his argument was that he wanted to take that money and instead build an enormous new facility, a fully integrated factory that would bring in raw materials by ship, produce them all there at one location. And that factory was called the River Rouge Factory. The Dodge brothers objected to the Ford Motor Company stop paying dividends. They had their own selfish reasons for that. They wanted the dividends because they were trying to build up their own rival business, which eventually becomes the Dodge Corporation, eventually acquired by Chrysler. And Henry Ford says, "This is a business decision. This is something that is within the ambit of the control of the board of directors." The case goes to trial and Henry Ford desperately didn't want to be viewed as a robber baron. And so at the trial, he testified and said that one of his motivations for reducing dividends of shareholders is he wanted to give more money back to workers. When asked what the role and purpose of the Ford Motor Company was, he said to do as much good as possible for everyone. This didn't sit very well with the court. And the court said that the Ford Motor Company had to continue to pay these dividends, but it refused to enjoin the Ford Motor Company's building of this River Rouge Factory. That was a bridge too far. The court said, "That's a business decision, we're not going to step in there. But you've got to keep paying these dividends." Today, the idea that a court would require a company to pay dividends is no longer good law. What's interesting about the case is some language the court used, which is, the purpose of a corporation is to maximize the wellbeing and returns of shareholders. So, a lot of people hold this up as a kind of canonical principle that corporations exist to make shareholders money. And that's it. I think that's a misreading of the case, but it did establish this as a kind of principle that when boards are thinking about what their job is in terms of running the corporation, they think of it in terms of maximizing the welfare or wellbeing of the entire corporation and of the shareholders. So decisions by the board that aren't necessarily tied to shareholder wealth maximization will not be reviewable in court. Shareholders can't go into court generally and say, "The board could have made another decision, a different decision that would've made us more money," and therefore you need to require them to do that. Courts are not in that business. There will be extreme cases where courts might intervene. But really what I think drove the result in Dodge was Henry Ford's big mouth and his desire to not be seen as a bad guy. If he had just gone into court and said, "Building the River Rouge Factory will in the long run be the thing that makes the Ford Motor Company as valuable as possible," and I think he truly believed that, then he would've won the case and the Dodge brothers wouldn't have gotten anywhere. 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. Subscribe to the No. 86 Lecture series on your favorite podcast platform to have each episode delivered the moment it’s released. You can also go to no86.fedsoc.org for lectures and videos on Federalism, Contracts, Jurisprudence and more. Thanks for listening. See you in class!