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 Sean J. Griffith, who holds the T. J. Maloney Chair in Business Law at Fordham University School of Law. Professor Griffith is also the Director of the Fordham Corporate Law Center. 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 Griffith, in this episode I would like to talk about how corporations work. What are some of the rules that govern them? Who are the primary parties involved and what are their different roles? Well, it helps to think about corporations, maybe in distinction, in counter distinction with partnerships. So what are partnerships? So partnerships are coming together of people to make or do something. But when they come together, everyone owns everything and everyone is liable for everything. So in partnership, we have all the partners being liable for the obligations of the partnership. That's different from the corporate rule of limited liability, where the liabilities of the corporation are the liabilities of the corporation. And the owners of the corporation, the people that come together to form it, their liability is limited to the extent of their investment. They can lose their investment and no more. Another thing that's different between partnership and corporation is that there's no separation of ownership and control. So one of those basic attributes of corporation is not present in the default partnership. In a partnership, we form a partnership. We all get to make decisions, all of us partners get to make decisions about how the business works. And of course, that means a lot of committee time, and that means a lot of committee decision-making, and that can lead to all kinds of problems. But I would say the main way to think about partnership, in distinction from corporations, is the way that the agency problem works. When we were talking about corporations, we're talking about the conflict, that sort of irresolvable conflict between principal and agent or between shareholder and manager, right? The manager is the agent. The shareholders are the owners. What the shareholders want is the agent, the manager, to do exactly what the shareholders want and only what the shareholders want and nothing more, not to serve himself or herself. But we know that no one is completely angel nor completely beast, so we know that sometimes those people will serve their own interests. And so the fundamental corporate law problem is the agency cost problem between shareholders and managers. There is an agency cost problem in partnership too. But that agency cost problem is not between shareholders and managers or owners and managers, it's between all of the owners. Because in a partnership structure, all of the owners are the managers. And so you'll have an agency cost problem with the owners between each other. There'll be conflict amongst themselves about how the business ought to operate. Another way to think about this is, that in partnership, the agency cost problem is horizontal, it's among the owners sitting at the table together. They have conflict. How the business is run, is the product of that conflict or at least is stunted by that conflict. In a corporation, you want to think of it as the owners at the top and the managers at the bottom or vice versa. The conflict is vertical, it's between the owners and the managers, where the owners can't be sure... I want to be sure. I want to design mechanisms to be sure that the manager is doing what the owners want. Let’s talk about the concept of agency. What does that look like in a corporate structure? Well, agency and the restatement of agency is the fiduciary relationship that arises from the manifestation of consent, from a principal to an agent, that the agent will act on the principal's behalf and subject to the principal's control and that the agent's consent to act in that way. But if you take the pieces of that definition apart, what you see is that what agency really is, is about what all business association law is really about, which is about who decides and on what basis. The word, "Control," in that definition is pivotal. You have your own agency relationship, only when the agent acts subject to the principal's control. And that means the principal is who decides, but subject to what constraints are about, what, and that is, that the agent is acting on the principal's behalf. And that brings us back to the question of purpose. Their behalf, subject to what sorts of actions? And then you get these questions about scope. How broad is the agency relationship? How many things is the agent authorized to do in furtherance of the principal's objectives? And how far is too far? You have two basic kinds of problems in the agency law cases. Those problems are contract problems and tort problems. All agency cases really follow a paradigm of an injured third-party, injured either in contract or in tort, trying to hold the principal liable for the acts of some agent. So start out in tort. Take a taxicab operator, so the taxicab operator is driving a cab for a cab company. The c ab company is the principal. The agent is the cab driver. The third party is the person that the cab driver runs over. That tort, the running over of the person, will be the thing that the third party is trying to charge the principal for. This is important to remember and I emphasize this to my students all the time. The person that ran the pedestrian over, the tortfeasor is always liable, right? There's nothing in agency law that changes tort law, it extends tort law, it doesn't limit it. So the fact that the taxicab driver ran over the third party and maybe the taxicab company is also liable, under agency principles, doesn't mean that the taxicab driver is not still liable himself or herself. It's just that that person might be judgment proof and the taxicab company might be a better place to look for satisfaction from the injuries of the third party. So one kind of problem that you have are tort problems and all those tort problems are resolved on the basis of the level of control that the principal has over the agent's conduct. Do they have the ability to control the way in which the conduct is performed, as opposed to just delegating a general thing that they want the person to do? For example, if I'm putting a deck on my house, I might hire an agent to build the deck. I'm not telling the agent where to put every nail. I'm not in charge of every aspect of the construction of the deck or where they get the wood or what employees they hire, or so on, to help build the deck. I just want a deck. Versus, if you're in a business and you're telling the person you have the ability to control all aspects of the business, that would be the type of a relationship that might lead to liability in tort, for the principal. In contract, the situation is different. In contract, again, it's going to be a injured third party, this time, by breach of contract, wanting to sue the principal for the acts of the agent. In the contract cases, the question is authority. What was the level of authority that the principal delegated to the agent in making contracts for it? All of the agency questions they'll come down to an agent acting on behalf of the principal and subject to the principal's control. In a contract setting, the principal may not have delegated total authority to the agent to enter into all sorts of contracts, but have limited the agent's authority to certain contracts. And as long as the third party knows that, or has reason to know that, the principal won't be chargeable for contracts of the agent that go beyond that delegation of authority. Are there strict rules about what authority an agent does or does not have in a corporation? An agent will have the authority that's delegated to the agent by the principal. Now, a lot of the time, there's the cost of incompleteness, so that delegation will be incomplete. And very often what courts will do will imply the delegation of authority that would be ordinary under the circumstances. And then, that kind of general rule of implying the level of delegation that's ordinary under the circumstances will have an incentive effect of placing the principal that wants a lesser delegation or a different delegation to make that transparently clear to the agent or to the third party. When you go through the agency cases and contract, it's normal to allocate the type of agency that's under question into a series of categories. Is it express authority? Is it implied authority? Is it apparent authority or is it inherent authority? What's important to remember about these different categories of authority is that it doesn't change the outcome, whether there is authority or not. The question is just, what are we looking for to prove the presence of authority? When there's express authority, the principal says to the agent, "I give you authority to do X," and the agent does X. When there's implied authority, the principal says to the agent, "I give you the authority to do X. But within the big circle that is X, there's a little circle that is Y." And so that level of authority to do Y is implied in the delegation to do X. When there is apparent authority, the principal finds some way to communicate, not to the agent, but to the third party. And to the third party suggesting that the agent actually has the authority to do X. When in fact, the principal and the agent both know that the agent does not possess that authority. But the third party reasonably believes that the agent does possess that authority, based upon communications between the principal and the third party and that would be a situation for a parent authority. But the last one, the fourth one, is the one that makes the least sense, which is inherent authority, which is just a level of authority that inheres in certain types of businesses, regardless of what the parties say to each other. The famous case of Watteau versus Fenwick is an old English case from, I don't know, the 1700s or 1800s. It's about a pub, And in the pub, what happens is, it used to be owned by a guy named Humble, but he sells it, I think, to a brewery. And then he just runs the pub for them. In his relationship with the brewery, Humble is made to promise that the only authority that he has to act in contract is to buy a certain small number of things, on account of the pub. So those things, I think, included mineral water and bottled ale. So he wasn't allowed to buy other sorts of things that you might want to buy for a pub. Well, what Humble does is disregard those instructions and buys other stuff. He buys cigars and Bovril. Bovril is a drink made out of meat. So what happens is the pub owner, Humble, buys Bovril and cigars and charges them back to the principal. The principal says, "I'm not paying for that. I told you that, that was not in the delegation of authority." And then there's no one to pay the third party's bill. The third party sues. They sue the principal, because obviously, Humble himself is judgment proof. And the court makes the principal, the brewery, pay. And so, how could that be? How could that be, when the owner, the brewery, said to Humble, "You can't buy the Bovril and the cigars." And the answer is, that it would be normal for a pub keeper, under the circumstances, to buy Bovril and cigars, and therefore it was normal for the seller of the Bovril and the cigars to go ahead and sell them under those circumstances. It was the ordinary course of business. Now, students read that case and they say, "Wait a minute, that makes no sense at all. Because the principal said to the agent, 'You don't have the authority to do X. And the agent did X and the principal still had to pay for X.' How does that make sense?" And we go back to the principle of incentives and information. When the principal said to the agent, "You don't have the authority to do X," those were limiting instructions. But those limiting instructions were kept secret. They were secret only between the principal and the agent. The third party had no knowledge of those limiting instructions. They had no knowledge of the existence of the principal at all. What the court is trying to do is protect the third party from information that the other side possesses, that it doesn't possess. And so what the Watteau versus Fenwick rule really does is allocate the costs of that information, right, onto the parties that possess it. And if you want to have limiting instructions that would potentially harm a third party, the burden of making those instructions public is on the principal and the agent. So if the principal and the agent share the fact that there are these limiting instructions, then the third party won't rely upon that information anymore. The third party won't rely upon the principal to pay the bill, will demand that the agent be able to pay or show the ability to pay before they transact. And so it's an information forcing rule. The rule in Watteau vs Fenwick causes the parties not to transact between each other in private, in secret, but rather it gets the parties to communicate out in the open, so that third parties won't be left exposed by secret limiting instructions. Agency is just one of the ways in which people go into business to do the things that they want to do. When you and I start our brewery business, we're going to need people to supply us. We're going to need contracts with those people across markets. And we might need people to be there and work in the business when we're not available. And so that's what agency is for, for hiring those people, for delegating their ability to transact with our suppliers and explain how much authority they have and how much authority that they don't have. Those are all agency law principles. That's why it's normal to teach agency along with corporations, because it's really different views of the same problem. Again, that same problem throughout the entire course being, who's in charge, subject to what constraints. Are there any other notable cases that you teach that involve the tension between principals and agents? One way of thinking about the shareholder stakeholder debate is thinking about what's the purpose of the corporation. Now, in fact, the purpose of the corporation is decided upon by the managers of the corporation so that ultimately the stakeholder question is on whose behalf should the managers make their choice. There's a famous case about this company in New Jersey called the AP Smith manufacturing corporation. Basically it involves a company that wants to give a donation to Princeton University. So the corporation, it's a corporation that makes valves and other kinds hardware. And what it decides to do is give some donation to Princeton. Now, Princeton supplies a lot of liberal arts graduates, but not a lot of valve makers. So it's hard to understand what the immediate benefit of the donation was. And so one of the shareholders sued and said, "Look, this is just a waste of money. Giving the corporations money to Princeton University is basically giving money away that's mine. You might as well just return it to me as an investor. You've gone beyond what the purpose of the corporation ought to be." And in defending this lawsuit, the board of directors have a very vague response to why they think the donation was appropriate. They claim that AP Smith gets better employees by giving donations to universities. But it's not clear that Princeton ever supplied a single employee to the AP Smith manufacturing company. That kind of evidence, that quality of evidence was not taken in the case. Likewise, the defendants claim that no, actually the donations, private donations to private universities ensures the preservation of American Liberty and American democracy. And that may or may not be true, but that's not the kind of explanation that implies a high degree of judicial scrutiny. Basically the judges allowed the board of directors to give the donation without a whole lot of intense scrutiny of the donation itself. What we learned from the AP Smith manufacturing company is that judges aren't going to look very hard at claims that the corporation is not serving the investors purpose. There are other ways that investors can deal with that problem, like voting on a new board of directors to do what they want. Judges aren't going to get involved in that kind of case. And a lot of corporate law is like that, the level of scrutiny that judges apply to the plaintiff's claim. The level of scrutiny that's applied to claims about purpose are very little, in fact, it's the business judgment rule and the business judgment rule is a standard of discretion, discretion to the managers, as long as they are not acting in their own self-interest in the donation. So if, for example, in the AP Smith case, the donation was actually motivated by the desire to get the CEO's child into Princeton, that would be the kind of donation that the court might not have allowed. But a general donation, even though it's the taking away of shareholder wealth and the placing of that shareholder wealth into other hands at management's discretion, is not the kind of thing that the court will get involved in. So there is a very loose standard of scrutiny around most purpose claims during the life of the corporation. And that's something that's important to keep in mind. All of these cases really are about who decides and on what basis. Ultimately, when we say shareholder wealth maximization, most of the time, that's a very loose or fuzzy constraint. In fact, during the midlife of the corporation, the dominant principle of judicial intervention is the business judgment rule. We will leave managers alone, as long as they are not acting out of self-interest, to make whatever decisions they see fit for shareholder, best interest. That's under a theory of shareholder wealth map maximization. There are other constraints operating on those managers during the midlife of the corporation. Most importantly, market constraints. Capital market constraints, product market constraints, employment, market constraints, but the judicial constraint that operates upon the corporation during that time is very loose. One important thing to see in corporate law though, is that at the end of the corporation's life, when a firm sells itself to another firm and the shareholder's interest in that company changes, we see a transformation from that loose standard of shareholder wealth maximization to a stricter standard of shareholder wealth maximization. So even under the current dominant theory of shareholder wealth maximization managers, in fact have wide discretion to serve all kinds of corporate interests. And in fact, it's in their best interest to keep the corporation running to do so. Managers are not subject to lawsuit from shareholders for failing to serve shareholders best interests during the life of the corporation, as long as the managers don't act in their own self-interest. So even under a shareholder paradigm for how corporations ought to be run there's wide discretion for managers to allocate welfare to other constituencies. Is a corporation required to have a board of directors? Let's talk a little bit about the board of directors. The board of directors are those fiduciaries that manage the corporation on the shareholder's behalf. They're not employees of the corporation. They're fiduciaries of the shareholders like trustees, they're trustees in a trust. Now why do corporations have boards of directors? There are two sorts of answers to that. One is that, it's just sort of natural. The problem is the cost of incompleteness. The solution to the cost of incompleteness is fiduciary duty. Someone has to have those fiduciary duties. Who has those fiduciary duties? Answer, the board of directors. That's one answer to the problem and that sort of shows the spontaneous ordering aspect of it. But another answer to the question is, well, the Delaware, 141-A says, "That corporations organized in Delaware shall be managed by a board of directors." In other words, it takes that principle that may have been organic at the beginning and sort of solidifies it or ossifies it into a body of statutory law. So it is true that corporations, under state law, must have a board of directors. You might ask yourself, "Well, are there other ways that we can imagine fiduciary duties being dispensed of or ways of owing fiduciary duties?" And of course, there are, you can see this in LLC's. LLC's are sort of the halfway partnership, halfway corporation. They're like partnerships in the tax sense. They're like corporations in the limited liability sense. The way in which LLC's are governed is highly contractual. So you can sort of decide as an LLC member, which is an investor in an LLC, how the LLC is going to be run. It can be member managed, like a partnership is managed by all the partners or it can be manager managed. In an LLC, you can imagine having all kinds of different permutations between how you might want the LLC to be managed. Corporations, as older creatures of state law, don't have the same level of contractual variability, but there's no reason to suppose that they couldn't have it. If there were a value to having something other than a board of directors, as the organizational principle, you can imagine that emerging from other sort of business forms and becoming an alternative to the corporation. So a corporate director only exercises authority as a member of the board. It's the board that wields authority, not the individual director. The director wheel's authority as a member of the board. But the board's most important job is to hire the CEO. And the CEO is the person that runs the corporation, on a day-to-day basis. Now for a small business, there's no reason to separate those roles. The board might be one or two people or one person who also serves as the CEO. But in a larger corporation, those things are usually separated and the board will have an identity, separate from the C-suite managers. It's not unusual for the CEO also to have a seat on the board, but that's sort of a separate question. The board's principal job is to hire that CEO. And the CEO's job is to work as an employee of that corporation and to report back to that board on how he or she has done so. So the board of directors controls the corporation, but the shareholders own the corporation. How much authority do the shareholders have? What happens when the board and the shareholders disagree? You can have a situation where shareholders would be on the board and that would be, most often, where you have large shareholders, concentrated shareholders. So imagine two kinds of corporations, private and public. So take our private corporation, that's not publicly traded. It's not unusual for a family to have a business where you might have four people that are the four shareholders of that business, 25% ownership each. Well, those four shareholders might put themselves on the board too. So it's not impossible and it's not unusual in small business for shareholders to also be on the board. It is unusual in publicly traded corporations. It's unusual because it's rare for an individual shareholder to have such a large concentration that they're on the board. That said, the board of directors will also be shareholders. They'll be compensated, very often, with incentive-based compensation that will include shares of the corporation. So in a sense, all corporations have shareholders on the board, but it's not clear that the board thinks of themselves principally as shareholders. They're more likely to think of themselves, principally, as directors who have a shareholding interest. A good way to think about this is that boards of directors act and shareholders react and they don't get to react about everything. So boards of directors get to act. They get to decide what to do. They get to put agenda items forward. If the corporation starts out making bottles, the board of directors can change directions and start making bricks. It's up to the board of directors to do that, not the shareholders. The board of directors conducts the business of the business. The shareholders most important role is to vote for those directors. So if the director is all of a sudden, they're going to change course, it makes bottles, now it's going to make bricks and the shareholders don't like that, they had better vote off those directors. And so there's an opportunity, usually once a year, to do that. The most important thing that shareholders do is react to who the directors are. But then there are a few other situations where shareholders have statutory rights to approve or disapprove of what the board is doing, principally, in situations where there's an amendment to the charter. And a way to think of that is, that the charter or the articles of incorporation are the fundamental contract under which the business operates. Anytime you alter the fundamental contract of anything, there's going to be an opportunity for the negotiating parties to have to approve it. And so if you think about the shareholders as the negotiating party, to the fundamental contract of the charter, if you're going to amend the charter, the shareholders get to say, yes or no. Likewise, if you're going to sell the corporation, in a merger or acquisition transaction, the shareholders get a right to say, yes or no. They don't have the right to initiate the transaction. They don't get to say, "Look, please sell the company to Microsoft or Google." But they get to say, once the board of directors has agreed to that transaction, whether the transaction occurs or not. Do you have any other examples of important cases where the shareholders sue the corporation for not representing their interests? Dodge v. Ford is another very fun purpose case. It's sometimes remembered as the case that announces the principle of shareholder wealth maximization. But it's a strange case to get that principle from. Dodge v. Ford involves Henry Ford and the Dodge brothers, who were initial investors in the Ford Motor Corporation. And the Ford Motor Corporation, well, it did very well in the early days of its history and it paid this massive dividend. What the Dodge brothers wanted to do was take that dividend and start their own car company, which would eventually build the Ram truck. But at that time, they were dependent upon the dividend coming out of the Ford Motor Corporation and Ford slashed his dividend. What he did was reinvest a lot of that money back into the corporation. The Dodge brothers sued, and they said, "Look, you can't do that. This money is for the shareholders. You have to pay it out." What's interesting is that the court ultimately agreed that what Henry Ford was doing wasn't motivated to serve the shareholders best interests. And it's a strange conclusion, because if you look at a couple of the things that were complained about, the couple of the things that he did, that were a big problem in the case, you can easily see how they are wealth maximizing from a shareholder perspective. For example, one of the things that Henry Ford did was pay his workers twice the going wage, twice the wage that was going in the area. And you might ask, "Well, why are you doing that?" The story that gets told in the case is that he's kind of a protosocialist. He's paying the wage because he really wants to improve the benefit of the working man. I'm sure that was true in part. But what Henry Ford was really doing at that time was constructing an assembly line. What he needed was the same worker to be at the same spot all the time, 100% of the time reliable. So how did he assure that that would occur? He paid them more. And so, he got sober, trustworthy, reliable workers on his assembly line. What's the other thing that Henry Ford did? He slashed the price of the car. Slashing the price of the car was characterized in the case as another non shareholder interest, you should be charging as much for the car as you possibly can. But of course, anyone that thinks a little bit about business can see that, well, there are lots of reasons to lower the price of your good, including to capture market share. And so there are plenty of wealth maximizing justifications for what Henry Ford did. If you dig a little bit deeper in the case, there's testimony, you get the testimony of Henry Ford. He's cross-examined by counsel for Dodge and he's asked, "Why is he doing the things that he's doing?" What Henry Ford says in the testimony is, "That he was motivated to help the common man." So there was a disconnect between what Henry Ford's portrayal of himself was and what the business or economic outcomes of the things that Henry Ford ultimately did. At the end of the day, the court believed the testimony and not the underlying economic reality and sided with the Dodge brothers in finding that Henry Ford had not served shareholder wealth maximization, nevermind the fact that he subsequently captured a massive section of the market for the Ford Model T and that he built a massive plant. This was the River Rouge Manufacturing Plant that he was building at the time, which was an industrial marvel to help him capture the market for the automobile. So it's an interesting case because it announces this principle. But it's a strange case to get the principle out of, because in the case itself, Henry Ford is clearly trying to do those things that would serve shareholder wealth. But at the same time, he is found not to have done it. And part of the answer why, is his own testimony on cross- examination. 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!