To Whom are Directors’ Duties Really Owed?

In the paper, Lift not the Painted Veil! To Whom are Directors’ Duties Really Owed?, which we recently posted on SSRN, we identify a fundamental contradiction in the law of fiduciary duty of corporate directors across jurisdictions, namely the tension between the uniformity of directors’ duties and the heterogeneity of directors themselves. The traditional characterization of the board as a homogeneous, often largely self-perpetuating body is far from universally true internationally, and it tends to be increasingly less true even in the United States. Directors are often formally or informally selected by specific shareholders (such as a venture capitalist or an important shareholder) or other stakeholders of the corporation (such as creditors or employees), or they are elected to represent specific types of shareholders (e.g. minority investors). The law thus sometimes facilitates the nomination of what has been called “constituency” directors, or even requires their appointment (e.g. employee directors in some European systems). However, even in systems that require the appointment of such directors, legal rules tend nevertheless to treat directors as a homogeneous group that is expected to pursue a uniform goal. We explore this tension and ask why a director representing a specific shareholder cannot advance this shareholder’s interests on the board?

Looking at heterogeneity on the board is timely and an issue of high practical significance given current developments in corporate case law. One the one hand, the Delaware courts have remained faithful to the traditional approach with respect to directors’ decisions: In the 2009 case of In re Trados Shareholder Litigation, the Court of Chancery refused to grant the benefits of the business judgment rule to the decisions of directors affiliated to a venture capitalist whose interests were at stake in a decision of the board. On the other hand, in the 2013 case of Kalisman v. Friedman, Vice Chancellor Travis Laster stated that “[w]hen a director serves as the designee of a stockholder on the board, and when it is understood that the director acts as the stockholder’s representative, then the stockholder is generally entitled to the same information as the director.”

In terms of their representative role, we can find so-called “independent” directors on one end of the spectrum: they are by definition expected to shield themselves from all types of partisan influence. On the opposite end, some directors are appointed by shareholders or stakeholders who have a specific interest in the manner the company is operated. Venture capitalists will often negotiate the right to appoint a director. Lenders or employees may be represented on the board. Directors appointed to represent the interest of a designated stakeholder are sometimes called “constituency” directors. Constituency directors may be expected to support their appointer or nominator while they discharge their duties. How may a director representing the interest of employees not have reservations as to pure profit-maximization objectives when tackling corporate policy matters? How may a director nominated by a venture capitalist not pay specific attention to the protection of her patron’s investment in the company, or not frame issues with the idea that an exit strategy for the venture capitalist needs to remain available? More specifically, a practical implication may be found in the important question of how constituency directors deal with their sponsors with respect to information. One of the major issues discussed in the recent US literature is whether directors representing venture capitalists should be permitted to share sensitive information with them.

The objective of this article is to explore this tension between the proclaimed uniformity of duties and the inevitable heterogeneity of the individuals on the board. Looking at the law of the US as well as several key European jurisdictions, we advance two larger claims. First, we suggest that the disjunction between the appointment of directors and fiduciary duties is only sustainable because the purported objective of fiduciary duty—however formulated in theory—is not clearly defined at all. Across jurisdictions, the fiduciary duties of directors are delineated primarily negatively; in other words, they almost exclusively say what directors must “not do” and this in quite broad terms. Second, we argue that the increasing heterogeneity on the board can be seen as the consequence of a larger trend. Traditionally, US corporate governance has been dominated by managerial capitalism, where a faceless mass of small investors was juxtaposed to a powerful board of directors. In recent years, a more heterogeneous shareholder structure has begun to develop; consequently, there is an increasing population of larger shareholders who want their voices to be heard more explicitly in the boardroom.

In our article, we attempt to provide a comprehensive analysis of the issue. We provide a taxonomy of directors representing specific interests, looking at the US, the UK, France, and Germany, suggesting that this phenomenon reflects the general structure of a given financial and corporate governance system. We then turn to fiduciary duty and survey the debates about the “general objective” directors are expected to pursue, and how it relates to heterogeneity on the board. Subsequently we muster insights from the social sciences, in particular economics and psychology, on the issue, also taking into account the limited empirical evidence. Economic theory would seem to suggest that governance rights may be the best way of dealing with the necessary incompleteness of both legislation and contracts intended to protect investors and other constituencies of the corporation. While permissiveness in terms of how directors are allowed to interpret them may in fact be efficient, behavioral theory and the limited empirical evidence suggest that it may be inevitable for directors to represent particular interests. At the end of the paper, we return to legal doctrine and look at the arguments in favor and against uniform directors’ duties across jurisdictions.

The full paper is available for download here.