Monthly Archives: March 2009

Making Sense of Cents

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, March 25, 2009
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This post comes from Sanjeev Bhojraj of Cornell University, Paul Hribar of the University of Iowa, Marc Picconi of Indiana University, and John McInnis of the University of Texas at Austin.

In our recently accepted Journal of Finance paper Making Sense of Cents: An Examination of Firms That Marginally Miss or Beat Analyst Forecasts, we provide evidence on the short and long-term price and profitability performance associated with managers undertaking myopic actions to meet short term earnings benchmarks, either through real operating decisions or management of accrual earnings. We also examine whether managers behave in a manner consistent with being aware of the short-term and long-term implications of their myopic choices. Our research design focuses primarily on two particular groups of firms: firms that just beat consensus forecasts (by one cent) but have large income increasing accruals and cuts in discretionary spending, and firms that just miss consensus forecasts (by one cent) but have large income decreasing accruals and increases in discretionary expenditures. We use these two sub-samples to yield the best possible contrasting settings of managerial myopia, where myopic actions are most likely and least likely to have been taken.

Our results show that in horizons of one year or less, firms using accruals or cuts in discretionary expenditures (i.e., low quality earnings) to beat a forecast have stock returns that are equal to or marginally better than firms who miss their forecast but maintain high quality earnings. Moreover, both these groups significantly outperform firms that manage earnings upwards but still miss expectations. This finding suggests a short-term benefit to beating expectations. In the long run, however, we find that firms that beat with low quality earnings under-perform the firms that miss with high quality earnings, which is consistent with the myopic behavior of the managers manifesting in the long-term. In addition, we find that future operating performance improves more for firms that miss with high quality earnings relative to firms that beat with low quality earnings, but this finding is limited to the subset of firms that are profitable. Among profitable firms, return on assets (ROA) increases for missers with high quality earnings relative to beaters with low quality earnings. Similarly, increases in capital expenditures are significantly higher and the market-to-book ratio increases more for firms that miss with high quality earnings. Lastly, we show firms that beat forecasts with low quality earnings are significantly more likely to issue equity in the following year and have significantly greater insider selling. These results hold regardless of whether the firms are compared with those that miss forecasts with high quality earnings or with those that beat forecasts with high quality earnings.

Our results suggest that while managers’ intuition regarding stock price benefits is correct in the short-term, the long-term rationale of this strategy is harmful because the quality of earnings manifests itself in performance over the long-run. We also provide empirical evidence that managers of these firms appear to understand these patterns, as they are significantly more likely to capitalize on the short term price benefits associated with beating the benchmark.

The full paper is available for download here.

Why do countries adopt IFRS?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, March 25, 2009
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This comes to us from Karthik Ramanna of Harvard Business School.

The International Accounting Standards Board (IASB) was established in 2001 to develop International Financial Reporting Standards (IFRS). Since then, nearly 70 countries have mandated IFRS for all listed companies. Further, about 23 countries have either mandated IFRS for some listed companies or allow listed companies to voluntarily adopt IFRS. However, as of 2007, at least 40 countries continued to require domestically developed accounting standards over IFRS, and this list included some large economies like Brazil, Canada, China, Japan, India, and the US. In joint work with Ewa Sletten of MIT, I investigate why some countries adopt IFRS while others do not. Understanding countries’ adoption decisions can provide insights into the benefits and costs of IFRS adoption.

We focus our analysis on a sample of 102 non-EU countries and examine IFRS adoption over the period 2002 through 2007. We exclude the EU member states from our analysis because their decision to adopt IFRS was closely tied to the establishment of the IASB itself.

In our sample of 102 countries, there is evidence that more powerful countries are less likely to adopt IFRS, consistent with more powerful countries being less willing to surrender standard-setting authority to an international body. There is also evidence that the likelihood of IFRS adoption at first increases and then decreases in the quality of countries’ domestic governance institutions, consistent with IFRS being adopted when governments are capable of timely decision making and when the opportunity and switching costs of domestic standards are relatively low. We do not find evidence that levels of and expected changes in foreign trade and investment flows in a country affect its adoption decision: thus, we cannot confirm that IFRS lowers information costs in more globalized economies.

Finally, we find evidence of the likelihood of IFRS adoption for a given country increasing with the number of IFRS adopters in its geographical region (network benefits). This result is significant because it suggests that as the network benefits from IFRS get large, countries may adopt the international standards even if the direct economic benefits from such standards are inferior to those from locally developed standards. The full paper is available for download here.

Hedge Funds in the Crosshairs

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Tuesday, March 24, 2009
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This comes to us from Barry R. Goldsmith, Daniel H. Ahn, and Brian D. Boone of Gibson, Dunn & Crutcher LLP. The article is reproduced with permission from Alternative Investment Law Report, 2 AIR 347 (Mar. 11, 2009). Copyright 2009 by The Bureau of National Affairs, Inc. (800-372-1033).

By virtually any measure, 2008 was a watershed year on the hedge fund enforcement front. Driven by the turmoil that has reshaped our capital and credit markets, enforcement efforts soared to new heights. Regulators and prosecutors redefined their enforcement priorities, commenced an unprecedented number of investigations and enforcement actions, and, according to a senior SEC insider, reached out to and cooperated with domestic and foreign agencies in a manner that has not been seen in at least 30 years. Explaining the unusually intense scrutiny that regulators placed upon hedge funds in 2008, Bruce Karpati, who coordinates the SEC’s Hedge Fund Working Group out of the New York Regional Office, suggested that, given the economic climate, ”half to two-thirds of hedge funds might go out of business”- and, as the aphorism goes, desperate times may lead hedge funds to take desperate measures. And these measures will continue to draw the SEC’s attention under the Obama administration.

Since 2000, the SEC has reportedly brought 145 actions involving hedge funds; and since 2003, the number of actions involving hedge funds each year has been in the teens or twenties. In 2008, that trend continued with the filing of 22 hedge-fund-related enforcement matters. In addition, the Department of Justice brought five hedge-fund-related criminal actions. While these numbers may seem unexceptional given the unprecedented scrutiny that hedge funds faced, the figures should be considered in light of the fact that 2008 saw: (a) the filing of a significant number of large, complex, or novel cases; (b) the culmination of similarly large, complex, or novel previously filed actions; and (c) the commencement of several broad industry-wide sweep investigations focusing on the activities of hedge funds and other market participants- all of which likely required the deployment of significant regulatory and prosecutorial resources. One need look no further than the highly publicized civil and criminal actions brought against Bernard L. Madoff for allegedly defrauding his advisory clients (hedge funds and others) out of billions of dollars in what might be the largest financial fraud in history. Investor losses from the fraud could reach $50 billion.

The take-away is clear: hedge funds were under extraordinary regulatory scrutiny in 2008 – particularly so once the economic crisis came to dominate the daily news-and that level of scrutiny is expected to continue, if not intensify, in 2009. In our article [link to article] , we review those enforcement priorities that dominated the headlines in 2008 and look to remain at the forefront throughout 2009. Along the way, we also offer advice to hedge funds and their advisers about how to navigate the increasingly hostile regulatory landscape. Much of the information presented is based on our review of cases filed and public sources describing enforcement initiatives and investigations. In addition, we have incorporated salient comments and observations made by senior regulators and prosecutors at a Nov. 24, 2008 Practising Law Institute Conference in New York on Hedge Fund Enforcement and Regulatory Concerns.

The article, which was recently published in the Alternative Investment Law Report, is available here.

The Challenge for Financial Regulation

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Monday, March 23, 2009
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Editor’s Note: This post by Benjamin Heineman is based on an op-ed post by the author appearing in The Washington Post.

Finding a new balance between public regulation and private decision-making is a paramount issue of the time. The crisis in capitalism stems from the systemic failures of business judgment in the financial sector which have caused the credit and solvency crises and led the world to the brink of depression. It is now a commonplace that 30 years of financial deregulation has come to an end.

There is a new consensus on the need for sensible public policy to deal with the causes of private excess and to ensure the safety and soundness of the financial sector going forward — to reconstruct the basic foundation of the world economy by finding a proper new balance between public and private decision-making. Numerous reports have been published both in Europe and the U.S. on regulatory visions of the way forward. This week the Obama administration will unveil its financial re-regulation proposals (as well as new ideas on how to deal with the “effects” of the melt-down — the toxic assets which pollute banks’ balance sheets).

But, lurking behind the consensus, along all points on the political spectrum, is the concern that regulation has problems too. High among those is recognition that decisions in the public sector can often be driven by irrational politics rather than sensible policy — by passions expressing the feelings of the moment, unmoored from sound judgment, which mirror the passions like greed and corruption that have hobbled the private sector.

The AIG bonuses are a microcosm of the problem. The Financial Products Group made terrible mistakes that had enormous, adverse multiplier effects. As financial conditions worsened, any incentive pay should have been carefully tied to positive results. Once those conditions turned into financial disaster and virtual government takeover, AIG and the administration should never have let the bonus money out the door — their justifications of legality and retention were not credible in the narrow case of the senior employees at the Group. Predictably, the actual payments have fanned flames of public outrage.

But the House bill, imposing a 90 percent tax on all 2009 bonuses for all TARP companies receiving government funds of more than $5 billion is nonsensical as a matter of policy (putting aside questions about constitutionality).

Leadership is about defining problems correctly. If they measure real contribution to an enterprise over time — real performance with integrity and sound risk management — phased bonuses are an important incentive, not bad per se. This can be especially important going forward as we seek to repair financial institutions. The blunderbuss House bill has any number of bad impacts: failing to recognize the value of good bonuses; driving people out of financial services; driving companies out of government programs.

Most importantly, the House bill undermines the credibility of public regulation and the importance of sound policy responses to the crisis. It is pitchfork populism — exactly what thoughtful people fear.

I believe deeply that terrible executive compensation systems were the rocket fuel that drove the financial sector to disastrous excess. And the public is rightly outraged about past pay practices and amounts. But finding the right future balance between government regulation of executive pay to ensure safety and soundness and private sector incentives for sensible innovation and wealth creation is one of the hardest problems at the core of the new reregulation consensus. Driving talented, blameless people away from regulated entities cannot be the right result.

President Obama (and the Senate) must reject the House bill and go back to the more thoughtful executive compensation proposals he announced a month ago, which invites a sensible, future dialogue between government regulators and affected corporations. Past failures should be handled and explained sensibly case-by-case for individuals responsible for failure, not mishandled as with AIG Financial Products Group leaders. (And, when passions abate, a Dodd amendment to the stimulus bill that arbitrarily limits bonuses also needs to be modified.)

Nothing less than the credibility of public regulation is at stake, with implications far beyond current anger over executive pay as the watershed re-regulation debate begins in earnest.

Satisficing Contracts

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, March 23, 2009
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This post comes from Patrick Bolton of Columbia Business School.

In my working paper Satisficing Contracts which I recently presented at the Law, Economics and Organizations Workshop here at Harvard Law School, my co-author Antoine Faure-Grimaud and I analyze a contracting model with two agents, each facing thinking costs, in which equilibrium incomplete contracts arise endogenously. The basic situation we model is an investment in a partnership or an ongoing new venture. The contract the agents write specifies in a more or less complete manner what action-plan they agree to undertake initially, and how the proceeds from the venture are to be shared. In any given state of nature both agents face costs in thinking through optimal decisions in that state. Therefore an optimal contract that maximizes gains from trade net of thinking costs is generally incomplete in the sense that it is not based on all the information potentially available to agents in all states of nature. By introducing positive thinking or deliberation costs into an otherwise standard contracting framework, it is thus possible to formulate a theory of endogenously incomplete contracts.

The main results from our analysis are as follows: First, incomplete contracts specifying control rights may emerge in equilibrium (when such contracts are not strictly dominated by a complete contract with the same equilibrium information acquisition). The rationale for control rights in our model—defined as rights to decide between different transactions in contingencies left out of the initial contract—is that the holder of these rights benefits by having the option to defer thinking about future decisions. Second, control rights tend to be allocated to the more cautious party. Indeed, the more cautious party is then more willing to close the deal quickly, even though it has not had the time to think through all contingencies, in the knowledge that thanks to its control rights it can impose its most favored decision in the unexplored contingencies. Third, the sharp distinction between a first contract negotiation phase followed by a phase of execution of the contract usually made in the contract theory literature is no longer justified in our setup. In particular, the contracting agents may choose to begin negotiations by writing a preliminary contract specifying the broad outlines of a deal and committing the agents to the deal. Fourth, when agents’ objectives conflict more, equilibrium contracts are more complete. The main reason is that each agent may be concerned about the detrimental exercise of control by the other agent, so that abuse of power cannot be limited by just allocating control to the agent that is least likely to abuse power. In such situations the exercise of control may have to be circumscribed contractually by writing more complete contracts. Another reason is that when agents have conflicting goals they are less willing to truthfully share their thoughts, so that the net benefit of leaving transactions to be fine-tuned later is reduced.

Our analysis thus provides new foundations for incomplete contracts and the role of control rights. In particular, our framework allows for contractual innovation by the contracting agents independently of any changes in legal enforcement. In addition, changes in legal enforcement may have no effect on equilibrium contracts if enforcement constraints were not binding in the first place. The full paper is available for download here.

SEC Proposes to Eliminate Broker Votes

Posted by George R. Bason, Jr., Davis Polk & Wardwell LLP, on
Sunday, March 22, 2009
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This post from George R. Bason, Jr. is by his colleagues Phillip R. Mills and Justine Lee.

The SEC recently published for public comment the NYSE’s proposal to eliminate broker discretionary voting in uncontested director elections, signaling that the Commission’s new leadership is prepared to move forward on an issue that has been on hold at the SEC since it was originally proposed in 2006. The rule change—which would not become effective until 2010 at the earliest—could make it more difficult for companies that have adopted a majority voting standard to elect management’s slate of nominees, as discussed below.

The NYSE has long classified uncontested director elections under Rule 452 as a “routine matter,” giving brokers the discretion to vote shares held in investors’ accounts when they do not receive voting instructions from the beneficial owner within ten days of a company’s meeting. Such uninstructed votes can make up a meaningful percent of the vote and have routinely been cast with management in the past. Several close elections have attracted scrutiny in recent years as activists contended that the outcomes would have been different if broker discretionary votes were excluded. In the absence of SEC action on this issue, a number of brokers have recently moved to voluntary policies of proportional voting, under which they vote uninstructed shares in proportion to how their voting clients cast their ballots. While the proportional voting policy was likely chosen over abstention (which would be closer to the NYSE proposal) in order to address quorum and other concerns, it can also skew voting results by disproportionately magnifying the vote of those retail investors that provide instructions to their brokers—a particular concern in the current climate for embattled companies that may have a dissatisfied retail shareholder base. It can also make outcomes less predictable since, unlike instructed shares, which are cast ten days prior to the meeting, shares voted proportionally are not cast until 72 hours before the meeting.

The NYSE proposal would re-classify director elections as a non-routine matter on which NYSE member organizations are not permitted to vote—regardless of which exchange the company is listed on—without instructions from the beneficial owner. If the SEC adopts the NYSE proposal, brokers would no longer be able to vote uninstructed shares, effectively reducing the number of votes in favor of board-nominated directors. This could make it difficult for directors to attain the requisite majority vote at companies with majority vote standards, particularly if there is a large retail investor base or if directors are facing a “withhold vote” campaign.

The proposed amendment is available here.

A Lobbying Approach to SOX

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Saturday, March 21, 2009
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This post comes from Yael V. Hochberg, Paola Sapienza and Annette Vissing-Jørgensen of Northwestern University.

In our forthcoming Journal of Accounting Research paper entitled A Lobbying Approach to Evaluating the Sarbanes-Oxley Act of 2002, we evaluate the impact of the Sarbanes-Oxley Act (SOX) on shareholders by studying the lobbying behavior of investors and corporate insiders in order to affect the final implemented rules under the Act.

Following the passage of SOX in 2002, Congress delegated the drafting and implementation of the principles outlined by SOX to the Securities and Exchange Commission (SEC). The various sections of SOX were divided into separate rules by the SEC, which then solicited public comments regarding the proposed rules, prior to adopting the final releases. Letters to the SEC commenting on the proposed rules were publicly available on the SEC website or through its public reference office. Following the main compliance-related titles of SOX, we classify the rules on which the SEC solicited comments into groups. We focus on three major sets of rules: provisions related to enhanced financial disclosure (including the much-discussed Section 404 assessment of internal controls), provisions related to corporate responsibility, and provisions related to auditor independence.

Our review of these comment letters revealed that Investors lobbied overwhelmingly in favor of strict implementation of SOX, while corporate insiders and business groups lobbied against strict implementation. In addition, we find that the firms most likely to lobby were firms in mature industries, with relatively low forecasted earnings growth, high profitability and poor governance. These are precisely the types of firms that Jensen’s [1986] theory of free cash flow would predict are likely to provide more opportunities to management for expropriation, perquisite consumption or mismanagement of firm resources. In contrast, our analysis of audit fees indicates that lobbying firms are unlikely to be those that expect a large relative increase in compliance costs. Rather, lobbyers on average had lower audit fees relative to initial market value pre-SOX, and their audit fees relative to size increased by less, post-SOX, than those of non-lobbying firms.

Our portfolio analysis of returns reveals that during the period leading up to passage of SOX (February to July of 2002), cumulative returns were approximately 7 percentage points higher for corporations whose insiders lobbied against one or more of the SOX ‘Enhanced Disclosure’ provisions than for non-lobbying firms of similar size, book-to-market and industry characteristics. In contrast, we find no significant evidence of higher cumulative returns for those corporations whose insiders lobbied against one or more of the SOX ‘Corporate Responsibility’ provisions or for those corporations whose insiders lobbied against one or more of the SOX ‘Auditor Independence’ provisions than for comparable non-lobbying firms. Our analysis of returns in the post-passage implementation period suggests that investors’ positive expectations with regards to the effects of the ‘Enhanced Disclosure’ provisions were warranted.

The full paper is available for download here.

Is AIG Too Big to Fail?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, March 20, 2009
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Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published in today’s Wall Street Journal.

The AIG bailout—at $170 billion and rising—may end up as the costliest rescue of a single firm in history. There is much debate about bonuses paid to AIG’s executives. But there is far too little debate on the government’s willingness to back all of AIG’s obligations.

The company claims any failure by the government to do so would have catastrophic consequences. This claim is exaggerated. Serious consideration should be given to forcing AIG’s partners in derivative transactions—which are mainly buyers of credit default swaps from the company—to take a substantial haircut.

AIG is a holding company, conducting most of its business through insurance subsidiaries organized as separate legal entities. The financial products subsidiary, which has produced the huge losses from derivative transactions that brought AIG down, is also a separate legal entity—but AIG has guaranteed the subsidiary’s obligations.

While AIG has thus far been able to cover derivative losses using government funds, the possibility of large additional losses must be recognized. AIG recently stated that it still has about $1.6 trillion in “notional derivatives exposure.” Suppose, for example, that AIG ends up with losses equal to, say, 20% of this exposure—that is, $320 billion. Suppose also that the value of AIG’s current assets, including the shares in its insurance subsidiaries, is $160 billion. In this scenario, the government’s fully backing AIG’s obligations would produce an additional loss of $160 billion for taxpayers. Should the government be prepared to do so?

The alternative would be to put AIG into Chapter 11. In this case, AIG’s creditors, including its derivative counterparties, would obtain the company’s assets. They would end up with a 50% recovery on their claims, bearing those $160 billion of losses themselves.

AIG recently stated that failure to meet all of the company’s obligations could lead to a “run on the bank” by customers seeking to surrender insurance policies and “would have sweeping impacts across the economy.” But insurance policy holders wouldn’t be at risk if AIG failed to meet its obligations. The insurance subsidiaries are not responsible for the debts of their parent AIG, and insurance policy claims are backed both by the subsidiaries’ required reserves and state insurance funds.

Still, what about the concern that losses to derivative counterparties—which are now known to include major U.S. and foreign banks—would substantially deplete the capital of some of them? That concern would be best addressed by the U.S. government (or foreign governments in the case of their banks) infusing capital directly—in return for shares—into the banks that need it. There is no reason to back AIG’s obligations as an instrument for infusing capital (with taxpayers getting nothing in return) into, say, Goldman Sachs or Spain’s Banco Santander.

It is true that the collapse of Lehman Brothers last September led to a crisis of confidence among depositors in banks and money market funds, which had a dramatic effect on markets. Letting AIG’s derivative counterparties take a significant haircut, however, should not lead to such a crisis. AIG’s obligations are to derivative counterparties, not to depositors. Moreover, governments world-wide are now committed to backing fully the claims of depositors in financial institutions.

It is important to understand that the government can also employ intermediate approaches between fully backing AIG’s derivative obligations and no backing. For example, the government could place AIG in Chapter 11, but commit to provide supplemental coverage that would make up any difference between the value that creditors would get from AIG’S reorganization and, say, an 80% recovery. Such an approach could allow setting different haircuts for different classes of creditors. The government, for example, might elect not to provide such supplemental coverage to executives owed money by AIG.

At a minimum, the government should conduct “stress tests,” estimating potential losses in alternative scenarios, and formulate a policy on the magnitude and fraction of derivative losses it would be willing to cover. A policy that doesn’t fully back AIG’s obligations should be seriously considered.

Indemnification of Director-representatives by PE Firms

Posted by Charles M. Nathan, Latham & Watkins LLP, on
Thursday, March 19, 2009
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This post is by Charles Nathan’s partners Laurie B. Smilan and Howard A. Sobel.

With the increase in private securities, derivative and bankruptcy-related litigation against portfolio companies, private equity firms need to maximize the protections for the private equity firm, the funds they organize and the individuals who agree to serve as their representatives on portfolio company boards. Ironically, however, a private equity firm’s effort to provide “more” protection to its director-representatives may be far more expensive than the firm expects or intends.

Typically, private equity firms and the funds they organize grant their representatives serving on portfolio company boards broad indemnification rights—“to the fullest extent permitted by law.” Typically, too, private equity firms and their funds require that their portfolio companies provide “fullest extent of the law” protections to these same directors. Each of the firm, the fund and the portfolio company likely will have separate insurance policies to satisfy their respective indemnification obligations. Optimally, the firm and the fund will be entitled to indemnification rights from the portfolio company pursuant to the terms of a management services agreement.

Absent thoughtful drafting, however, the broader the indemnification rights provided by the private equity firm or its fund to the individual director, the more likely it is that the firm or its fund will be liable for a disproportionate share of defense and settlement costs incurred by the director in litigation involving the portfolio company and the less likely that such costs can be fully recovered from the portfolio company or its insurer. Moreover, the broader the terms of the insurance provided by the private equity firm, the greater the chances that the portfolio company’s insurers will resist paying out the full proceeds of the portfolio company’s policy before other sources of insurance are tapped.

Often times, the allocation of responsibility for indemnification and advancement obligations as between the portfolio company and the private equity firm and the fund that holds the investment in the portfolio company are not considered until after litigation has been filed. The same holds true with respect to the terms and amount of available insurance, especially at the portfolio company level.

As the foregoing suggests, there are a number of issues that every private equity firm that designates directors on its portfolio companies’ boards must consider to maximize protection against liability to plaintiff shareholders (or trustees in bankruptcy) and minimize the risk of paying the cost of defending against such claims.

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The Defining Role of Good Faith

Posted by Andrew Tuch, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, March 18, 2009
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The Harvard Program on Corporate Governance has issued a new discussion paper entitled “Loyalty’s Core Demand: The Defining Role of Good Faith in Corporation Law.” Co-authored by Leo E. Strine, Jr., who is Vice Chancellor of the Delaware Court of Chancery and Senior Fellow of the Program of Corporate Governance, and by Lawrence A. Hamermesh, R. Franklin Balotti and Jeffrey M. Gorris, the paper examines the role of good faith in corporate law, and its use as the key element in defining the state of mind that must motivate a loyal fiduciary. Employing an historical, etymological, and policy-oriented analysis, the authors address the particular question of whether the obligation of directors to act in good faith is a separate, free-standing fiduciary duty, or a core aspect of the duty of loyalty.

In the paper, the authors outline their views as follows:

We conclude, consistent with the Delaware Supreme Court’s recent decision in Stone v. Ritter, that in the American corporate law tradition, the basic definition of the duty of loyalty is the obligation to act in good faith to advance the best interests of the corporation. What this article also shows is that the duty of loyalty has traditionally been conceived of as being much broader than the duty to avoid acting for personal financial advantage. The duty of loyalty also precludes acting for unlawful purposes, and affirmatively requires directors to make a good faith effort to monitor the corporation’s affairs and compliance with law.

The authors analyze arguments in favor of a free-standing duty of good faith separate from the duty of loyalty. While conceding the importance and enduring relevance of the duty of good faith, the authors see no basis to conclude that the traditional place of good faith — as the definition of a loyal state of mind — should be altered. Doing so to make room for such a separate duty would add confusion not clarity, the authors argue. In so stating, the authors acknowledge and discuss circumstances when the duty of loyalty remains most difficult to apply.

The paper also emphasizes a critical policy implication resulting from Stone v. Ritter – “that an independent director who is accused of having failed in her monitoring duties may only be held liable if a court finds that she breached her duty of loyalty by consciously failing to make a good faith effort to comply with her duty of care.” The authors explain that “by requiring a finding of bad faith before imposing liability on an independent director, the corporate law, as explicated by Stone, protects the policy interests underlying the business judgment role from erosion.”

The paper is available here.

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