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, is there a legal definition of a corporation? What are some of the necessary characteristics for an organization to be a corporation? So there are several key attributes of corporations, personality traits, if you will, of corporations. I should note, however, that in general corporate law is quite permissive. It's what is called enabling law. There are some default rules that the state provides in corporate codes. And by and large, then those are changeable by contract if the shareholders or other stakeholders or the corporation want to adjust them. So, there are some key personality traits, but like with personalities of people, those are not going to describe every kind of variant of corporations. So, what are the key features or personality characteristics of corporations? The first one is a formal creation. You can find your way into a partnership by accident, by just cooperating with another person. You cannot accidentally find yourself involved in a corporation. To create a corporation, you must file specific papers called articles of incorporation with a secretary of the state, of the state in which you are incorporating. Most people incorporate in Delaware. So you file what is like the constitution for the corporation with the secretary of state of Delaware. You pay the nominal filing fee, and you form to create a company. The second characteristic is legal separateness or legal personality. Corporations are separate entities from the people who form them. That separation means that unlike in a partnership where the partners are liable personally and act as the partnership, the partnership is the partners, in a corporation, the corporation is completely separate legal entity. It can be sued in its name, it sues in its name, it has to pay taxes as if it were an individual. The corporation is a separate legal entity from the people that constitute it. A third key characteristic of corporations is limited liability. The liabilities of the corporation are the responsibility of the corporation as a separate entity. In general, subject to some exceptions, the debts of the corporation are the corporation's debts. And people who have claims against the corporation, whether they're tort creditors, or contract creditors, cannot seek to remedy those things by going after the people who are the founders of the corporation, the managers of the corporation, and the employees of the corporation. Those people are protected from any kind of obligation for the liabilities of the corporation. In addition, there's a corollary feature there, which is called affirmative asset partitioning. Affirmative asset partitioning is that the creditors of the individuals who form the corporation cannot go after the assets of the corporation. So if you form a corporation and you put some assets in it, your personal creditors as an individual cannot go after the assets of the corporation. So there's limited liability, which protects you from debts of the corporation as a founder, and there's affirmative asset partitioning, which is your own personal creditors cannot go after assets in the corporation. How is a corporation different from a partnership? Corporations live forever. A partnership ends when one of the partners leaves the partnership. Limited to the lives or whims of the partners. Corporations exist potentially forever. There are some companies in the United States that go back hundreds of years. And that just fits in with this idea that it's a separate legal person from its founders. When companies raise money, they give the people who contribute that money oftentimes something called a share or piece of stock. And that's just a claim on the assets or cash that the company would generate. So take a simple example. I form a corporation. I'm the sole shareholder of the corporation. I give it some capital and I'm going to also use my human capital to have it generate more wealth. As the only shareholder, all the cash that that company generates will come to me. I want to bring in some other people to invest in that corporation. I find nine of my friends. We each take an equal stake. We each own 10% of the company. I have now a claim, a 10% share in that corporation. And for most companies, I can freely sell those shares to somebody else. This is different than a partnership again. In a partnership, your partnership interest is not something that you can sell to someone else. Your partners wouldn't be so keen on you selling your law firm partnership to a stranger. In most corporations, with some exceptions, shares are freely transferable. If I own shares in Exxon Mobil, I am a shareholder, I can buy and sell those shares in a place in a market. We call that place maybe the New York Stock Exchange. And ownership is something that can change hands all the time. And then that fact leads inexorably to the last thing I'll mention, which is a key characteristics of a corporation. And that is the separation of ownership and control. For a typical thing like a partnership that's running a business, the partners are in control. They make all the decisions. And they're the people who are the economic owners of that business entity. In a corporation, it's a little different. Money is collected from people called shareholders. Those shareholders have money and they want to invest in a particular business, but they don't want to run that business. They don't know anything about social media, or raising chinchillas, or drilling for oil in Kazakhstan. All they want is to take money they have and turn it into more money. They hire people called managers, those managers who are first the board of directors, and then the people the board of directors hires, you might have heard of things like the CEO or chief operating officer, the COO. Those people make decisions for the corporation. And so you've got owners who have contributed money, and you've got managers who are in control of the corporation who probably haven't contributed any money. So that separation of ownership and control creates the kind of conflicts that corporate law is really concerned about. One could think of the managers of the corporation as agents of the shareholders. And that gives rise to this possibility that the agents will act in their own self-interest not in the interest of shareholders. And corporate governance is largely about trying to create an environment in which those agents are more likely to act in the interests of shareholders as opposed to their own selfish interests. What is the definition of agency in a corporate context? Tell us more about why it matters for corporate governance. Does it have to be structured according to certain rules? Agency is a legal field that looks at the responsibilities and legal obligations created when agents act on behalf of other people. Almost everything we do requires other people to do things for us. And those people are typically referred to in the law as agents. I ask someone to go around the corner and buy me a sandwich, that person is my agent. I give them some money, I give them expectations, like a pastrami on rye. So they've got cash from me and they've got a responsibility. And if they agree to do that, they're my agent for that particular transaction. Well, all might go well but things might go badly too. The agent might make decisions that don't benefit me but benefit the agent. The agent might misrepresent what their task is. If I give my credit card to the person and say, "Go buy me a pastrami on rye," they might go and buy me other things on the credit card that I'm not interested in. They may make changes to my order. They may see there's a long line at the pastrami counter and they may choose to bring me back a McDonald's hamburger instead. And that's something that's not what I wanted. So what are the rules regarding how agents act on behalf of who their principals are? In general, agents have two obligations. The first one is to be careful, to act as if I would act if I were the person who was doing the particular activity. And the second one is to be loyal. That is to do things that are in my interest and not in someone else's interests. There could be a conflict of interest. Maybe I want to buy my sandwich from a particular store, my agent turns out his cousin owns a deli down the street. And to please his cousin, he goes and buys the sandwich from that deli as opposed to the one that I really like. That's not being loyal to me, that's acting in his interest and not in my interest. So, there's a set of legal rules that try to constrain agents to act in the best interest of their principals. This is important because it establishes the trust necessary to delegate authority. It's after all cooperation that enables us to generate a wealth. It's not surprising that since the founding of the United States around 1800, wealth created in the United States is about 60 times, increase in wealth in just about six or seven generations. And that enormous growth in wealth is largely attributable to corporations and this ability to act and cooperate together. But people won't cooperate. You won't form organizations of massive scale if agents of the corporation can be disloyal to it or act in ways that serve the agents and not the principal's interest. So, if I'm going to turn over my money as a shareholder to a corporation, I'm going to turn it over say to the board of directors, and the board of directors is going to be my agent for allocating and spending that money, making decisions about how to spend that money to get the maximum return. If I can't trust that they'll do a good job, that they'll take care and be thoughtful about that, that they won't act in my interest, then I won't turn over the money, I won't make the investment. Or perhaps I will make the investment, but given the risk of disloyalty that the agent will deviate, I will demand a return on my investment that is significantly higher to compensate me for that risk. And that may sound like a technical point, but it's hugely important because the excess return that I would demand means that there will be a lot of activities the company could engage in that would actually increase wealth, that it won't because they won't satisfy the return necessary to make my shareholders willing to invest. So agency sits at the heart of almost all corporate law issues. Can you tell us more about the primary responsibilities of an agent? Agents have to act in the interest of their principals. These won't always be clear, and so that's why there's a whole body of law called agency. If you look back at the first year curriculum from law schools, maybe 50 years ago, agency would've been a whole semester class. It's not so much a focus anymore in large part because the idea of agency rules and agency costs arise in other contexts like in the corporate law context. But in general, agents have to serve the interests of their principals. And agency cases involve disputes in which that was in doubt. Maybe the agent is accused of being selfish, maybe the agent is accused of exceeding their authority, maybe the agent is accused of being sloppy. And those generate disputes about whether or not the principal will be liable for the actions of the agent or the agent through their actions is responsible to the principal. I'll give you an example. There was a case from the 1940s called Reading versus Regam. In this case, an officer, I think maybe a sergeant in the British Military, was stationed in Cairo. The military looked in his apartment and foot locker and found thousands and thousands of pounds and was curious where this money came from. Turns out this sergeant in the British Military was using his position in the military, the authority that his uniform brought, to pave the way for smugglers who wanted to move illicit goods in World War II era, Cairo. And the British Military took this money and said, "You got this money using our authority, using your British Military position as the way of earning this money. And the sergeant sued and said, "No, I got this money on my own. I was providing escort services for these smugglers and you have to give it back to me." And the court establishes a pretty strong rule that the sergeant can't keep the money. That the only reason the sergeant was in the position that he was in was because he was an agent of the British crown. Wearing the uniform, he had to do the interest and serve the interests of the British government not his own personal interests. He couldn't use his authority as an agent of the British government to line his own pockets. Now, this seems pretty far removed from a typical corporate law case, but now just imagine you're on the board of directors of a corporation and you're using that position to line your own pockets. You're using your authority as a director of General Electric or Apple Computer to serve your narrow interests and not the interests of the corporation that you're a board member of. Agency and corporate law principles tell us you can't do that. All of your actions as a director of a corporation or officer of a corporation are in the service of shareholders and the corporate entity, they can't be in the service of your own interests. What other types of cases involve questions about agency? The typical agency case that generates liability involves questions of whether or not the principal is bound by the actions of their agents. Usually what happens is the agent will maybe exceed their authority. They'll do something that is not obvious in the interest of the principal, or maybe it even contradicts explicit instructions of the principal. And a third party who relied on that agent will sue the principal claiming I was harmed by your agent, you have to pay me. So think of a canonical case called Watteau versus Fenwick. There was a guy who owned a bar in England. He sold the bar to some silent owners. Nobody really knew this transaction took place. He continued to manage the bar. And the new owners, they're the principals in the transaction. They tell him, "You may not buy anything other than, say, beer for the bar. If you're going to buy anything else, you have to buy it from us or get our explicit permission." Well, the former owner of the bar, who's now the manager of this tavern, disregards these explicit instructions and buys cigars, a kind of meat product called Bovril. I think he spread it on toast. He buys these from a third party and it was several thousand pounds. And this was hundreds of years ago. So that was a lot of money. He doesn't pay. The sellers of the cigars and the Bovril find out about the true owners of this tavern and sue the principal. Their claim is, "Your agent bought these things. They were sold at the tavern you own, that clearly benefited you. Therefore you should have to pay us." The principal said, "Look, you never heard of us. You didn't know we existed. You didn't rely on the fact that we did exist when you were writing this particular contract to sell the cigars and the Bovril. And by golly, we told him he couldn't buy cigars and Bovril. So if anything, he's breached his agency relationship with us. And you didn't know about us, therefore you could only seek recovery from him." The court says the principals are responsible for the actions of their agent. Might strike you as a bit of a strange result. One of the ways to think about this is, there was a mistake that was made. There was transaction that didn't go well. It was an accident, something that caused some social loss. You have a contract that fell apart. They didn't settle on terms like most contracts do. And so this is a contracting accident. And then the question is, well, who's best positioned? Who's the least cost avoider of this mistake and this accident? Who in this triangle, the seller of the cigars and the Bovril, the guy who's managing the tavern, or the principals? Who can best make sure this kind of thing doesn't happen again? And so agency law is really about trying to allocate control and responsibility in the hopes that by putting it at one point in this triangle that these kinds of errors and mistakes won't happen a lot, because they're socially wasteful. We had to spend society's resources to go into court and fight about this. It'd be way better if we didn't have to do those things. For some types of contracts, the person who's selling the cigars and the Bovril will be best positioned to avoid that mistake. Somebody comes to you who runs a tavern and says, "I'd like to buy 10 Mercedes Benzes." The person who's the seller says to themselves, "Wow. Why is a tavern owner coming to buy 10 Mercedes on behalf of the tavern? That seems a little bit unusual. Maybe I should try to find out why they're doing that. Maybe contact the owners and say, 'This person you sent from your tavern to buy 10 Mercedes, did they really have authority to do that?'" They are best position to avoid that particular loss. Other times it will be the principals, the people who own the tavern. And you'd say, well, what could they do more than what they did, which was tell this guy he wasn't allowed to buy the cigars and Bovril or anything else from third parties? Well, there's lots of things principals can do. First of all, they can hire good people. They have incentives ex ante to make sure that the agents that they hire are competent, that they're not people who are going to steal. You might not trust that you could do that perfectly as a principal, so you might do something called monitoring. You check in to see how your agents are performing. Back then, that might be doing random site visits. Now I have a friend who owns a bunch of restaurants. He gets all the information about servers and bartenders and the activities of the restaurant that he owns on his phone instantaneously. He's able to monitor what's happening at his businesses to see if anything is out of the ordinary. So principals, if they're going to be responsible, like the court in Watteau versus Fenwick said they are, they'll engage in practices, picking good people, writing good contracts, monitoring those people, to make sure that their agents are faithful. Now, interestingly, what this effect has on agents is agents are going to want to signal to people that they're going to be careful and loyal people. And they might do this by engaging in activities that economists call bonding. They might do things that don't actually serve the principal's interest or the corporation's interest, but make it appear that it is. They may take actions that are not justified on the basis of efficiency but are intended merely to signal that they're faithful agents. So let me give an example that's a little bit abstract. If you think about a case in which there's a potential corporate company acquiring another company, the agents of the corporation who's doing the acquisition, they might be sure that the target company that they're going to be buying is a good deal. But the shareholders might not think that the board is doing a careful job. So the board might hire consultants. They might have people in the organization do a lot of paperwork, do a lot of studies, write a lot of reports, do a bunch of detailed financial models, not because it's necessary to them to decide whether it's a good idea to buy this company, but merely as box checking to show the world that they were serious and thoughtful about this. Those are dead weight costs. They shouldn't really be doing it, but they're bonding themselves with their principal by saying, "Look, we're taking all these actions, you can trust us." The economists will describe the sum of all of these different parts of agency as agency costs. That is, the sums of monitoring by principals, bonding by agents, and the inevitable gap that might arise between what the principal wants and what the agent delivers. And by and large, corporate law is about trying to minimize agency costs because agency costs are wasteful from a social perspective, they are costs that we can avoid or hopefully can avoid because they take away from what would otherwise be productive activities. You mentioned financial decisions in several of these examples. What specific fiduciary duties do agents have? The fiduciary duties of corporations can be broken down into two separate types. The first one is called the duty of care, and it's pretty simple. In exercising your role as a board member, you're an agent of the shareholders. You have to act in their interests, and that means being careful, being thoughtful. How would a prudent person spending their own money, make a particular decision? That's the standard for board members. After some court cases, specifically a case called Smith versus Van Gorkom, board members faced personal liability for making decisions that did not satisfy what the court viewed as its standard for being careful enough. And the facts of that case were pretty remarkable. The board was making decision that was pretty obviously in the interest of shareholders. Shareholders overwhelmingly ratified the decision the board had made. And yet the court still found the directors personally liable for not being careful enough. This was earthquake in corporate America. And in response, the Delaware legislature passed a statute, Section 102(b)(7) of the Delaware corporate law, which allows companies to self-insure for violations of the duty of care. What does that mean? That means that companies are permitted to put in their corporate charter a provision that says, if the directors violate the duty of care, that the company will effectively indemnify them for any of the breaches. So this means shareholders would never really have an incentive to sue for duty of care violations, because if they won, the company would be paying the shareholders. And of course the shareholders would get money that was proportional to their share ownership. And that's exactly the same proportion that would be how much they'd be paying. So the shareholders would be effectively paying themselves. So, as a consequence of Section 102(b)(7), in general, duty of care suits are going to be extremely rare. This means that the duty of care now is more a standard of conduct. You might think, boy, after companies indemnify themselves and put in their corporate charter, as every corporation has done after the passage of this statute, what incentive is there for directors to be careful? Well, after Delaware passes the statute, plaintiffs bring suits under a different theory, which is, this decision was so sloppy, so not careful that it must be the directors were disloyal, that they couldn't have been acting in the best interest of shareholders and been this sloppy. And that's by or taking advantage of this second core fiduciary principle, which is the duty of loyalty. The duty of loyalty says, agents have to serve the interests of their principals, the board members have to serve the interests of the corporation or shareholders and not their own personal interests. And importantly, Section 102(b)(7) in Delaware says, you cannot self indemnifies a corporation for breaches of the duty of loyalty. It makes sense. No rational person would authorize an agent to act on their behalf, and say to that agent, "Oh, it's fine. You can be disloyal." That's a contract that would never really happen. And if we saw that happen, we might be suspicious that it wasn't the result of actual bargaining. So the duty of loyalty is something that is the basically teeth of corporate governance. It's what is really the way that courts oversee how corporations engage in various activities. And the suits today that would have historically been brought under the duty of care now are characterized as duty of loyalty suits. So, the complaint will allege these directors were disloyal, they weren't serving the interests of the principals, be it the shareholders of the corporation, and our evidence for that is they made a super duper sloppy decision. They were reckless in how they made this very important decision. And that must mean that in their hearts they were disloyal. There must have been some other thing that was motivating them. A good example of this is a case called Disney. The Disney shareholder litigation involved extremely large, some would say outlandish pay package for Disney's CEO, a guy named Michael Ovitz. Ovitz had been a prominent talent agent. He was induced to leave that role and joined Disney by Disney's then CEO, Michael Eisner. Ovitz came on board, and to attract him, Disney had to pay him a very large amount. The deal didn't go very well. Ovitz wasn't so great at running Disney, as he had been as a talent agent. And after about a year, Disney decided to kick him to the side of the road. To do so, they had to pay him about a hundred million dollars for one year of pretty bad work. And this didn't rub shareholders well, they challenged this transaction as being a violation of the board of directors fiduciary duties to maximize the welfare of the corporation and the shareholders. This suit generated a kind of idea that there might be a third fiduciary duty called the duty of good faith, that not only do board members have to be careful and act loyally, they have to take their particular activities or do their work in good faith. As it turned out, the Delaware courts said that Mr Ovitz's pay package was fine and the board of directors didn't violate its fiduciary duties in entering into that package or terminating Mr. Ovitz and paying him this outrageous amount. Despite the fact that, as the court said, the board's process was not so tidy. But not so tidy was not enough to potentially raise problems of care or good faith or loyalty. Later, courts in Delaware, specifically a case called Stone versus Ritter, says there is no such thing as the duty of good faith. There's just two. There's a duty of care and the duty of loyalty. But importantly, it noted that the duty of loyalty claims can include allegations like the one that was made in Disney. That is that the board was so sloppy that it raises questions about whether the board was actually loyal to the shareholders of the corporation. And I think what's going on, which explains this complicated history, is the decision in Smith versus Van Gorkom to hold directors liable for being a little bit sloppy in consideration of a merger, created a backlash in the legislature that probably overreached allowing companies to contractually opt out of the duty of care. And that raises a real problem. Oh, now board members really don't have any obligation to be careful unless they're being disloyal. That opens up a huge slack in the agency and really undermines the trust that shareholders might have that board members are doing good work, which is what the shareholders want them to do. So, the Delaware Supreme Court responds to the legislature's overreaching by saying, "Well, maybe there's a good faith obligation that brings back care claims which are now have been excised by corporations charters, which indemnify them. And then eventually the Delaware Supreme Court settles on we're not going to have a third fiduciary duty. There's only two. But things that are really sloppy, more sloppy than Smith versus Van Gorkom can generate disloyalty claims. So now in Delaware, basically every shareholder lawsuit is effectively a loyalty claim. But cases in which the board was really sloppy can satisfy that under certain circumstances. You referred to the landmark case of Smith v. Van Gorkom. Can you give us a quick overview of that? Another canonical case that is essential to understanding corporate law is a case from Delaware in 1985, called Smith versus Van Gorkom. In this case, a company called TransUnion, you may know it now as the company that does a lot of the credit reporting services, but back then they were a failing logistical railroad company. And TransUnion was the object of a potential takeover by a guy named Jay Pritzker. This is the Pritzker family who now has as one of its representative, the governor of the State of Illinois. And Jay Pritzker wanted to buy TransUnion because it would be more valuable in his hands, with him as the owner, than it was with its current ownership. That had to do with some tax rules and some other complicated things. But he was the best owner of those particular assets. TransUnion was trading at about $35 a share and Jay Pritzker offered $55 per share. And if you're a shareholder of TransUnion, this is the greatest day of your life. You own something worth $35 and someone comes along and says, "I'll pay you $55." So shareholders were understandably very excited about this. And the CEO of TransUnion, a guy named Jerome Van Gorkom, he was very excited about this prospect too. Not least of which, because he was looking to retire and this would be a big payday for him as his going away present. Pritzker proposed this transaction to him during the intermission at the Lyric Opera in Chicago. And the two of them scribbled down a preliminary deal on a cocktail napkin while standing in the lobby. Eventually, the deal is presented to the board of directors, who reviews it in a perfunctory manner. They had a 20 minute oral presentation. They looked at some of the terms of the deal and said, "Hey, we're business executives. We've got lots of experience. We know a good deal when we see it. This is a good deal done." They vote to approve it as is required under corporate law in Delaware and every other state. This transaction requires approval of the shareholders. We don't just trust the board to make this kind of decision because after all the shareholders are going to be bought out. The shareholders overwhelmingly approved this transaction. One shareholder, Mr. Smith, does not like this deal and sues, claiming that the board of directors didn't fulfill its obligations to look after the best interest of shareholders. This eventually works its way up to the Delaware Supreme Court and in a three to two decision, which is noteworthy because the Delaware Supreme Court, unlike the US Supreme Court, makes most of its decisions unanimously. In a three to two decision, the Supreme Court of Delaware said that the board of directors did not fulfill its fiduciary obligations to look after the best interest of shareholders. And that's a head scratcher. After all, this was a really great deal. There was some consideration of the matter at the board level and shareholders overwhelmingly approved it. So, what was the Delaware Supreme Court thinking? Well, the Delaware Supreme Court didn't like the fact that the board considered the case or the Delaware Supreme Court did consider the transaction in such a loose goosey fashion. They didn't take it seriously enough. And the Delaware Supreme Court invoked a fiduciary duty principle known as the duty of care. Directors have to be careful when they are deciding what to do with what after all is the shareholders' money. Shareholders invest capital in a corporation, they hire the board of directors effectively to manage that capital, and they have an obligation to do so as one would if you were investing your own money. A kind of how would you handle your own affairs? Would you do it so sloppily? And the Delaware Supreme Court believed that this was too sloppy transaction. They held directors personally liable. I think the damages were on the order of 25 or $30 million effectively. And so, these corporate directors, including a Yale economics professor, were personally liable for their shortcoming in not getting as good a deal as possible from Mr. Van Gorkom that they could have had they negotiated more aggressively or followed these procedures. So Smith versus Van Gorkom stands for the proposition that board members have to be careful and act prudently as if they were investing their own money, even if from an outside perspective it seems like a no brainer. 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!