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 Robert T. Miller, the F. Arnold Daum Chair in Corporate Finance and Law. Professor Miller’s research concerns corporate and securities law, the economic analysis of law, and the philosophy 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. Professor Miller, in this episode I want to talk about corporations themselves. What are they? Why do we need them? How do they operate? Let’s start with the question of how corporations originated. A corporation is a way of organizing human activity that is not possible under the common law. So under the common law, if people wanted to go into business together, they could agree among themselves that they would go into business, that I would contribute this, that you would contribute that, that we would agree to split the profits and losses this way or that, the decisions would be made in one way or another. We could enter into a contract as complicated as we wanted to govern our relationship. And this is called a common law partnership. The thing we could not do, however, under the common law was to affect our relationships with third parties. Unless of course they consented, but in many cases they would not consent. So if we were going to borrow money, our partnership, from a bank, the default rule under the common law is that all the partners would be liable to the bank for the repayment of the money. If our partnership is involved in running a business, and we committed tort against somebody else, our delivery driver runs over a pedestrian or we cause a fire and burn down someone's house, the common law rule was that all the partners are jointly and severally liable for the tort, just like they would be if they were individuals who committed the tort. In a pre-industrial economy where businesses were basically small, where the amount of capital you needed to run a business was relatively small, these rules worked just fine. But then the industrial revolution happens. And the economy begins to change primarily because of changes in technology, both scientific technology, how you work with chemicals and metals and so on, but also in economic technology of how we're going to organize businesses. Things begin to change and we get forms of economic activity, think a railroad that require immense amounts of capital. To run a railroad, you have to buy land or rights of way to lay your tracks over for hundreds and hundreds of miles. And then you have to lay those tracks and then you have to buy locomotives and you have to buy train cars that the locomotives will haul and you have to buy lots and lots of coal. And you have to have hundreds of employees and you need to have all of these employees before your first train runs and you can charge to your first customer for anything. You need an immense amount of capital to get this business off the ground. And then the problem is this, you can't raise that much capital from a small number of wealthy people. They just don't have that much money. Maybe they could fund one railroad, but they can't fund the railroad and the shipping company and other railroad and so on. If you want to raise that much capital, you need to raise capital by raising relatively small amounts of money from a relatively large number of people. And then the problem gets very serious because most people are not willing to invest a small amount of money and end up personally liable for all the harms a railroad can cause. Moreover, once you have a large number of investors investing in the same business, it turns out that most of them are not interested in participating in the day to day management of the business. Now who would sign up to invest a small amount of money in a business in which they have no interest in participating on a day to day basis, but where they can end up personally liable for the gigantic harms a large business could cause? That's not going to happen. So if you were going to be able to fund those types of very large forms of economic activity, heavy industry, railroad, shipping companies, you need a form of legal organization in which large numbers of people can invest in which they do not have to take an active role running the business and in which they will not be personally liable for the harms the business causes. They can lose everything they've invested, but no more. That way of organizing economic activity is called a corporation. In my first question, I referred to corporations as “themselves.” Why do we talk about corporations as though they are people? You'll hear a great deal about the idea of corporate personhood. The idea that the corporation is a person because the law says the corporation is a person. This is very much an illusion. A corporation is a way of organizing the activities of human beings. For the purposes of record keeping, for the purposes of administrative convenience, we treat the corporation as if it were a legal person. And we say the corporation owns certain property. The corporation enters into contracts. The corporation is liable for this or that, but all we're doing is organizing the assets that are there in the world. Some of the property is said to be corporate property because its creditors have a claim on that property first, and the shareholders are entitled to what's left. Other property belongs to the shareholders personally, like the house the shareholder owns and lives in, and that property is owned by the shareholder, not by the corporation and creditors of the corporation have no claim on it at all. Corporate personhood is really only a way of carving up claims on assets. Now, the other thing about the corporation is this. If you have large numbers of people involved in investing together and they're not interested, or able, to supervise the business themselves, how could we run a business when there are literally thousands of us with a right to say, "What happens? What do we do? Why we elect a committee, of course, to do it for us. And that committee is called the board of directors. Shareholders have a right to elect the directors. The directors then hire the employees, in particular the officers like the chief executive officer, to actually run the business. This has become known as the separation of ownership, which is in the shareholders, and control, which is in the directors and the officers. It creates a whole host of problems that corporate lawyers seeks to mitigate. But the basic structure is one that's clearly efficient because you're never are going to be able to amass huge amounts of capital to engage in certain forms of economic activity, unless you separate ownership and control. So in the 19th century and earlier if you wanted a corporation, since the corporation involves a change from the rules of the common law, the only way to get that change was to go to the legislature, or in England, the king, and get whoever had the power to make laws, to make a law creating for you a corporation. About 100 years ago or more, that changed and it changed for the better with so-called corporate enabling statutes. Today, if you want to create a corporation, anyone is entitled to do it. You go to the secretary of state, not the secretary of state of the federal government, but the secretary of state of your particular state, say Delaware, where most corporations are based, and you do a filing, which has to conform to certain provisions in Delaware statutory law. You have to state the name of the corporation. You have to state where it's registered office is and a few other simple pieces of information. And you have to pay a very modest filing fee. And then you have a corporation. Delaware corporate law comes with not only the Delaware general corporation law, a statutory body of law that establishes the basic four forms of corporations. You must have a board of directors. The directors must be human beings, not other corporations, for example. And there are a bunch of other mandatory rules establishing the basic form of the corporation. These rules, off the rack rules, of organization of a corporation are designed really for the public corporation. The type of corporations like Exxon Mobil or Google or Facebook or JP Morgan Chase that are publicly traded corporations, where there are huge numbers of shareholders and a board of directors and offices that run the operations. Now this starts to get complicated because when you sell shares to the public, when you become a public corporation, federal law kicks in because you are selling the securities in interstate commerce. And that is governed not by state corporate law, but by federal law, the so-called federal Securities law. That introduces a lot of complications, but let's stay with corporate law for the moment. Let’s talk more about the board of directors. What’s their job? What specific or unique responsibilities do they have in the corporate structure? The major problem in corporate law is that there are certain people, the directors and officers, who have control over the assets, and there are other people, the shareholders, for whose benefit they're supposed to be using that control. Following the economist, we corporate lawyers call that an agency problem. You have one person, the directors and officers, whose job it is to act for the benefit of other people, the shareholders, and the problem is obvious. It could very well be that the directors officers have incentives to benefit themselves at the expense of the shareholders. We deal with that in corporate law by imposing strict duties on directors and officers, and those duties are called fiduciary duties. It's easiest to understand fiduciary duties in contradistinction from the duties you face in the marketplace when you just meet someone and you're doing a business deal with them. In the marketplace, you must be honest. You may not commit fraud. You may not lie to the people you are doing business with. If you lie to them in order to extract value from them, that's what we call fraud. And it's certainly a civil wrong and in many cases, it's a crime. When you enter into a contract with someone to do a business deal, you have to live up to your contract. And if you violate those contractual obligations, you will be liable. But that's all you owe them. Keep your promises and be honest. That's the morality of the marketplace. When you become someone's fiduciary, however you owe them a great deal more, you owe them a duty of unremitting honesty. You are required to act for their benefit, not your own. So for example, in a normal business setting, you may not commit fraud. You may not lie. In a fiduciary setting, the fiduciary when dealing with the person to whom the fiduciary duty runs, the beneficiary, the fiduciary is required not to lie, for sure, but more than that, to tell his beneficiary all the material information that the fiduciary is in possession of. In a very famous case, Justice Cardozo said that a fiduciary, "...must observe a punctilio of an honor, the most sensitive" much more than the morality of the marketplace. Those are the type of duties we impose on directors. They have to in every instance in which they're making a business decision, use their honest judgment to say what's best for the shareholders. And that's what they're required to do in each case. This is called in corporate law, the duty of good faith, but it's much more than good faith in the marketplace. It is a punctilio of honor, the most sensitive. Delaware corporate law recognizes two fiduciary duties. The duty of loyalty and a duty of care. The duty of loyalty includes the duty of good faith, but it also pertains to certain situations where directors have conflicts of interest. Delaware provides corporate law to the nation. Delaware corporate law is a very complicated business. The thing to understand about Delaware corporate law is that there is a clear distinction between the standard of conduct required of directors and the standard of review that courts will use when shareholders challenge director conduct. It's easiest to see this with an example. Directors are required to do what they think is best for the shareholders in every instance. When directors are selling their company, for example, they have to try to get the absolute best deal available for the shareholders that they can get. The highest price for their shares. When shareholders challenge this decision, however, they have to show that the director's conduct did not meet the standard of review. What does that mean? That means that when a court examines what the directors did in selling the company, it does not ask itself whether the directors in fact got the best deal for the shareholders. It asks rather whether the directors used reasonable means to get the best deal reasonably available. So in other words, the court might look at the facts the directors had before them at a certain point in the transactional process and say, "If I were a director, I'd have done something else. My best judgment would've been to do this rather than what the directors did." But as long as the court thinks that what the directors did was reasonable in the circumstances, the directors will prevail in that lawsuit. There is a big disconnect between what directors are required to do under the standard of conduct and how courts review that under the standard of review. Now, why is that? The answer is that if you look at what directors do, it's very different from most other people are doing most of the time. This comes up clearly in the duty of care. If there is a car accident, almost certainly that has happened because somebody was operating their car negligently. If an engineer builds a bridge and that bridge falls down, not in a storm but just falls to out on its own one day, that's almost certainly because the engineer has done something wrong. And so we apply as negligence standard to those cases and we allow the plaintiff to try to show that the person responsible for the accident had behaved unreasonably. Business deals are not like that. Business are very often such that we enter them knowing that there's a gigantic chance of failure. For example, venture capital investing. When venture capital firms invest in startup companies, they know that most of those companies will fail. They don't know which ones, but they know it's very likely that eight or nine out of 10 will fail. The one or two that succeed, they'll make so much money on those they can afford to fail on all the others. So very often with business deals, there's a large chance of failure and a small chance of making a lot of money. In fact, almost all business deals tend to be that way. And for that reason, if we looked at these deals ex post, it could very well look like the directors entered into a deal when it was clear there was a very large chance of failure. And that will look like it was negligent, but it wasn't because that's how business works. So in order to protect directors in those types of situations, there is a difference between what directors are required to do, the standard of conduct, and what the court will ask itself in reviewing those decisions under the standard of review. Tell me more about the duty of care. What are some landmark cases about this issue? One obvious problem in the separation of ownership and control, is that those who have control, the directors and officers, can sometimes find it in their personal interests to do what's not in the interest of the shareholders. This can take the form of just being lax and not working very hard while collecting their salaries or actually of harming the shareholders' interests by promoting their own interests at the expense of the shareholders. Paying themselves lavish salaries, wasting corporate assets on fancy offices or corporate jets, or in the worst instance just looting the corporation. This is known as an agency problem. It's pervasive throughout the law, wherever one person is supposed to act for the benefit of another, the incentives of the agent can diverge from the incentives of the person whose interest he's supposed to be protecting, the principle. And therefore we have to always worry that the agent will act in his own interest and not in the principal's interest. There are many tools for dealing with this. Some of them, probably even most of them, are not legal. They are careful ways of structuring transactions that transactional lawyers create in order to align the incentives of agents with the incentives of their principals. This is why, for example, corporate executives are largely paid with stock and stock options in order to align their incentives with the incentives of shareholders. But there's a legal response to the agency problem too. And the legal response is the law of fiduciary duties. When someone becomes an agent of another, the law imposes on him a fiduciary duty to act for the benefit of the principal. This includes a duty of loyalty, which has to do with conflicts of interest between the agent and the principal, like when the agent deals with the principal directly. And it includes a duty of care, which requires, at least in the corporate context, that the agent exercise a certain level of care in making decisions on behalf of the corporation. So what does that mean in practice? There's a very famous case called Smith vs Van Gorkom which had to do with the sale of a company called Trans Union. The Trans Union board met and decided to sell itself to an entity controlled by Jay Pritzker, a billionaire and famous takeover artist in the 1980s. The shareholders later sued, claiming that the Trans Union directors had not exercised due care in making the decision to sell Trans Union to Pritzker. In this case, the Delaware Supreme Court enunciated the duty of care rules for Delaware, and they're actually quite not what you might think. In Delaware, and in most jurisdictions, the duty of care has nothing whatever to do with the substance of the decision the board makes. It has only to do with the process used in reaching that decision. In particular, the Delaware rule is that in making a business decision, a board of directors must consider all of the material information reasonably available to it before it decides, and what's reasonable and what's material and what's reasonably available are all understood in a gross negligent sense. What that really means is that before making a business decision, if there's some pretty important information that the board could get pretty easily, it better have that information before it and consider it before it decides. But once it decides the substance of its decision, whether the decision was wise and prudent or imprudent and foolish, whether it was smart or dumb or just plain boneheaded, the Delaware courts will not review. In Delaware due care is process care only. Now you might think that for this reason, it's pretty easy to observe the duty of care in Delaware. You'd be wrong. When Smith vs Van Gorkom was decided, the Delaware Supreme Court decided that the directors of Trans Union had not exercised due care before they agreed to sell their company, and as a result, they were personally liable for selling the company too cheaply. They had sold it for $690 million. There was another bid which might have come in at say $750 million. These 11 individuals were going to be personally liable for $60 million. That's a lot of money today, but it was a lot more in 1985 when Smith vs Van Gorkom was decided. After this case was decided, the directors in the offices in the Liability and Insurance Market collapsed. No one wanted to be the director under those circumstances, if they were exposed to that type of liability. Delaware, which provides corporate laws to the nation, responded quickly. It enacted what is now known as section 102(b)(7) of the Delaware General Corporation Law. Section 102(b)(7) provides that a corporation may, it's not required to, but may in its charter include a provision that eliminates the personal liability of directors for certain breaches of their fiduciary duties, including the breach of the duty of care. Nowadays, every public corporation in America has a 102(b)(7) provision in its charter. A lawyer who allowed a company to go public without one would be guilty of malpractice. The market immediately accepted this. Shareholders were happy to approve these provisions. Why? Well, you have to think about how business decisions work. Imagine you're a director. You have before you a business proposition for consideration. Like all business propositions it's risky. It might work out well. It might work out poorly, and it's very hard to say. On balance, you think it's a good idea. You would like to approve it, but then you think. If this works out great, what happens? The company makes a lot of money. I'm only a director. I get the same director's fees, whether the company does great or does poorly. I'm also a shareholder, but I have some tiny, tiny percentage of the shares, much, much less than 1%. My shares will benefit if this proposition works out well, but maybe I'll make a few thousand dollars, maybe a few hundred thousand dollars if I have a lot of shares. But if it works out poorly and the shareholders sue and some judge decides that I didn't exercise due care before deciding on this, why then maybe I'll be liable for a billion dollars. No director in his right mind is going to approve that proposition under those terms. It turns into a Bugs Bunny deal. Heads the shareholders win, tails the director loses. No director would sign up for that type of proposition, and as a result, personal liability for the breaches of the duty of care has been eliminated in Delaware and in every other state. Directors have to exercise due care. If they don't shareholders can sue and ask for the pending transaction to be enjoined, and that sometimes happens. But if the transaction closes, then the duty of care issue largely falls away. You cannot sue a director for a breach of the duty of care if the corporation has a 102(b)(7) provision in its charter, and it always does. Besides fiduciary duties, are there other ways that shareholders hold directors accountable? If there's one story about Delaware corporate law in the last 10 years or so, it's the move away from duty to process. The typical Delaware litigation arises when a company is selling itself. Under those situations, at least if the company is selling itself for cash, the duty of the directors is to get the best price available for the shareholders. In that type of situation, however, the shareholders get a vote. After the board of directors agrees to a deal, they have to hold a shareholder meeting, make full disclosure to the shareholders of all the terms of the transaction, and then the shareholders can vote yes or no on whether or not they want to accept the deal. In a case called Corwin, the Delaware Supreme Court held what we now call the Corwin doctrine, that if there's a merger and if after full disclosure, the shareholders in an uncoerced vote, vote to approve the transaction, then any fiduciary duty claims that shareholders who do not like the deal make against the directors will effectively be extinguished. In other words, a successful shareholder vote, on the basis of all the reasonably available information, will end any fiduciary duty litigation. This has been tremendously important. What it means is, after a board of directors approves a transaction and their transactional lawyers begin drafting the merger proxy, the document that will be sent to the shareholders to inform them of all the terms of the deal before they vote on the deal, the merger proxy and the information in it have become the key things. The amount of disclosure that is now done is much greater than it was in the past. Things people might have thought were immaterial and didn't need to be disclosed are now disclosed, because if you fail to disclose then perhaps you will not get a Corwin vote, an effective Corwin vote to extinguish fiduciary duty claims, if after the fact a court decides that the material you did not include was material after all. We get a lot more disclosure. In some ways that's good because it gives shareholders more information. And in other ways it's bad, because oftentimes it loads them up with information that really is immaterial. These documents are generally only read by professional investors and their advisors anyway, and they can usually sift through the information well enough. So what do you see here? What you see here is a great theme in Delaware corporate world, generally. Business decisions are very hard. They're risky, and they're made under conditions of great uncertainty, usually in ways that only people with an intimate knowledge of the details and of the markets can really make in any good way. That makes them exceptionally hard for law-trained judges who are hearing about the issue for the first time to have a really good opinion on whether or not the directors have made a good business decision or a bad business decision. Lawyers are not great at business. If they had been, they would've all gone to Wharton and become MBAs and been business people, rather than have gone to law school. But what lawyers like us are good at is process. And the great theme of Delaware law is to use good process as a proxy for good results. In other words, if the process was good, then we will trust the result of that process even if the result turns out badly. Because we know that it's the nature of business decisions that they often turn out badly, even when, in the immortal words of John Wayne, it seemed like a good idea at the time. So the Corwin doctrine is really the culmination of a number of steps in Delaware corporate law over the last 40 or 50 years, to substitute process for review of results. And we've now reached the stage where even if a board of directors has engaged in a horrible process selling its company, if the process is good for the shareholders, the shareholders know all the bad things the directors did, because they've been fully disclosed. And in an uncoerced way, the shareholders still say having seen all these terrible things as the directors did, we still like the price they got for us, and we want to sell out shares at that price. Then they're going to be allowed to do so. And that will be the end of the matter, because Delaware essentially trusts the market. If the shareholders want the deal, they're going to get the deal. And that will end the fiduciary duty claim against the directors. An important thing to realize in this discussion is that the shareholders nowadays, are themselves, very sophisticated financial institutions. 70 to 80% of the shares of a public company nowadays are typically held by large institutional investors. If people like that are voting in favor of a deal, it's probably because it's a very good deal. The number of shares that are held by so-called retail investors, individuals, down to around 20 or 30%, usually, in the market today. So you can count, or at least Delaware's theory is that you can count on the institutional investors to be able to evaluate deals rationally and to take the good ones and to turn down the bad ones. You’ve talked a lot about Delaware. Why do businesses incorporate there? Why does Delaware set the standards for corporate law and practice? Nowadays, there are really two different types of business entities people use in the United States. There are corporations and there are limited liability companies. In both cases, people tend to go to the state of Delaware. Now why is that? Delaware became the leading state for corporation law about 100 years ago. And there are long historical reasons for why that is the case, but the reason that Delaware remains the leading state for corporate law today are really two. One reason is that Delaware has the best statutes. The Delaware General Corporation Law provides off the rack, a system of rules for organizing activity well designed for public companies, and more than half of the public companies in the United States are incorporated in Delaware. The other half are more or less evenly distributed over the other 49 states. Nobody has a significant share of this market, other than Delaware. The Delaware Limited Liability Company Act is one of the most beautiful laws you will ever see. It is designed for business entities that will not be public, and what the Delaware LLC Act says in section after section is the following. It shall be like this, unless the parties agree otherwise in their limited liability company agreement, and pretty much you can agree to virtually anything you want regarding the internal organization of your limited liability company and still have limited liability, vis a vis creditors outside the company. Well advised of people today, if they need the corporate form, because they're going to be a public entity, or because they're operating in a market where they have outside investors who want the ease of knowing instantly what they're getting, what rules will apply, tend to use the Delaware general corporation law. If you're engaged in a sophisticated business, that is not going to be public, then you tend to create a Delaware limited liability company, and then you hire sophisticated transactional lawyers to write you a limited liability company agreement. That agreement might be 120 pages long, single space, carefully allocating rights and responsibilities among multiple classes of investors and multiple classes of control rights among those investors, how we're going to divvy up the money and how we're going to divvy up the control. Most public companies are incorporated in Delaware. One of the reasons for that is the excellence of the Delaware General Corporation Law, but really the most important reason is the Delaware Court of Chancery. Issues arising under Delaware corporate law are channeled directly into the Delaware Court of Chancery. The Court of Chancery is a court of equity. There are no juries. There is one chancellor and number of vice chancellors and you make your case to the chancellor or the vice chancellor directly on both matters of fact and matter of law. The chancellors and vice chancellors are selected in a non-political process and they are chosen from the Delaware bar for their excellence as corporate lawyers. They are routinely voted the best court system in the United States. The Delaware court of Chancery is routinely regarded as the premier corporate and commercial court in the world. There are not many judges who will throw down with an investment banker from Goldman Sachs on the proper way to value a company, but that absolutely will happen in the Delaware Court of Chancery. Delaware judges are in a class entirely by themselves. Read a Delaware Chancery opinion. The first thing you might notice is it could easily be 200 pages long, and the reason is it will be absolutely exhaustive. Another thing you might see is that it might have 700 footnotes, and the reason for this is that the Delaware chancellors not only know Delaware law, but they tend to be very well read in corporate law scholarship, in financial scholarship, in financial textbooks. They will often have read every important corporate law article on a topic and they will cite many of them in their opinions. There's a level of scholarly achievement on that court that is probably unmatched anywhere. Even the Supreme Court of the United States does not cite academic scholarship the way the Delaware Court of Chancery does. If you are a corporate party and you have a dispute, you want several things. You want your contract enforced in accordance with its terms. That will happen in Delaware. There's a Delaware case that says Delaware prides itself on having efficient commercial laws. Delaware is probably the most contractarian state in the nation. In other words, Delaware believes in freedom of contract. Most especially when the parties are sophisticated, commercial parties. Write something down in a Delaware contract, and by God, the Court of Chancery would force it in accordance with its terms. You know ahead of time what you're going to get. The second thing is that you get judges who have a great deal of knowledge about the market. They can't be bamboozled by experts telling them what's going on in the marketplace because usually they already know. Being very experienced, transactional and business lawyers, they have great sense of market judgment about what parties would reasonably likely to have agreed to and what they would never have done. I'll give you an example. There's a famous Delaware case in which a company had issued preferred stock. The preferred stock is governed by a document called the Certificate of Designation, which sets out the rights and obligations of the preferred shareholders. There was a provision in the Certificate of Designation that provided that the company would not undertake certain actions. The company didn't undertake those actions, but what it did do, is it created a subsidiary and the subsidiary undertook those actions. The preferred shareholders sued, claiming that maybe the preferred stock charter didn't literally say the subs couldn't do what the company itself was prohibited from doing. But surely any reasonable person would understand that if the company was prohibited from doing something, then so too was the subsidiary. If that sounds plausible to you, you don't know much about Delaware law. In Delaware law If you go and look at how preferred stock charters are customarily written, they will always say neither the company nor any of its subsidiaries shall do certain things. The Delaware chancellor deciding this case pointed out that's how the market works. He also pointed to the most famous law review article ever written on preferred stock, published in the California Law Review more than 50 years earlier, which said that prohibitions and preferred stock charters should be very careful to mention not just the company, but its subsidiaries when you impose prohibitions on the company. Knowledge of the market, knowledge of the academic literature and freedom of contract. If you want to prohibit the subsidiaries from doing something too, you need to say so. Why? Because this is the law for the sharks, not the law for widows and orphans. Delaware is not protecting consumers. Its corporate law is not aimed at consumers. It's aimed at the sharks, the public companies, the banks, the hedge funds, the investment funds, people who absolutely should know what's in the market and how to properly draft a corporate agreement. They will get what they signed up for. 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!