Corporate Law and The Limits of Private Ordering

James D. Cox is the Brainerd Currie Professor of Law of Duke Law School. The following post is based on an article forthcoming in the Washington University Law Review. This post is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Private Ordering and the Proxy Access Debate by Lucian Bebchuk and Scott Hirst (discussed on the Forum here).

Solomon-like, the Delaware legislature in 2015 split the baby by amending the Delaware General Corporation Law to authorize forum-selection bylaws and to prohibit charter or bylaw provisions that would shift to the plaintiff defense costs incurred in connection with shareholder suits that were not successfully concluded. The legislature acted after the Boilermakers Local 154 Retirement Fund. v. Chevron Corp ATP Tour, Inc. v. Deutscher Tennis Bund, broadly empowered the board vis-à-vis the shareholders through the board’s power to amend the bylaws. Repeatedly the analysis used by each court referenced the contractual relationship the shareholders had through the articles of incorporation and the bylaws with their corporation. The action of the Delaware legislation hardly puts the important question raised by each opinion to bed: are there limits on the board of directors to act through the bylaws to alter the rights shareholders customarily enjoy? Stated differently, can the board of directors’ authority to amend the bylaws extend to changing both the procedural and substantive relationship shareholders have with their corporation. In examining this question, the article, Corporate Law and The Limits of Private Ordering, develops two broad points: the shareholder’s relationship is more than just a contract and, even if the relationship was contractual, bedrock contract law does not support the results reached in Boilermakers and ATP Tour, Inc. In conclusion, the article also uncovers an issued overlooked in the debate over the relative prerogatives of shareholders and the board of directors, namely that bylaws proposed by the board of directors carry a strong presumption of propriety whereas those proposed by shareholders do not.

The seeds for Boilermakers and ATP Tour were sewn three decades ago with the metaphorical pronouncements by many commentators that the corporation is but a “nexus of contracts.” The expression is impactful because it is more than just a metaphor; it has substantive bite. The expression not only sets the course for what should be the content of organization law, i.e., principles should be what the parties would have agreed upon if bargaining were costless, but more significantly provides escape from those principles by allowing the parties to “opt out” of norms that are thereby default rules.

Broadly stated, to the nexus-of-contracts crowd, corporate law as provided by the state is merely facilitative of private bargaining; pursuant to this view, corporate law is not public, but private law. In such a realm, the only issue in doubt is what constitutes consent among the affected parties; after all, it is bargaining that then results in consent that Coase and contract theory so heavily depend upon as the basis for the efficiency that lies at its end. Consent is inextricably linked to another central assumption of such private ordering: the belief that the terms of the resulting contract will be fully priced into the shares. Even here, the champions of the nexus-of-contracts approach salve any unease about there being meaningful consent by their obeisance to the efficient pricing of the “contracts” outcomes being reflected in the price of a firm’s securities.

The author reasons that such pricing seems unlikely for multiple reasons developed more in the article. But the ultimate concern developed in the article is that contractarians misunderstand the nature and objective of fiduciary obligations; hence, they miscomprehend the issues surrounding contracting around, or more likely contracting out of, fiduciary obligations.

Fiduciary law efficiently relieves the parties of the burden of providing specification of duties or verification of performance. In the contract context, parties whose contract is incomplete expect they can fill in any gaps that may arise in the future via self-interested arms-length renegotiation; their conduct in such renegotiation is constrained only by the existing contractual duty of good faith and fair dealing. In contrast, if the relationship is a fiduciary one, the law demands that the fiduciary unilaterally adjust to the new circumstances in an “other-regarding way” consistent with duties of care and loyalty. Herein lies a fundamental distinction between judging the parties’ behavior through the contract lens versus the corporate law lens. Contracts and corporate law are not mirror images, as corporate law’s enshrinement of the inquiry causes the protection to be broader than that in contract law, where the protected expectations are derived from the four corners of the contract. Corporate law places an important governor on the directors, officers, and controlling stockholders to modify the relationship with owners.

A further concern developed in the article is that “nexus of contracts” perspective is more than a metaphor—it’s a rule of construction; more significantly yet, it is a rule of construction that, within a world of modern enabling corporate statutes, necessarily constrains shareholder rights and protection. In an environment where private ordering prevails, those in control—the board, officers, and controlling stockholders—enjoy an important, and likely unerodible, strategic advantage. First, the informational advantages of those in control permits them not only to time a change to their own advantage, but also to understand better than outside shareholders the full effects of a bylaw change they propose. As a consequence, they can act opportunistically to pursue self-interested ends, the effects of which only they can be fully aware. Second, insiders when acting to amend bylaws do not face the formidable collective action problem that outside shareholders incur in moving a bylaw through the approval process. While both boards and shareholders enjoy the right to amend the bylaws, the board being a cohesive body as a practical matter enjoys lower costs and uncertainty when choosing the bylaw course of action. This is certainly the case when the board acts unilaterally via a bylaw amendment, but also is true when it seeks the approval of the shareholders for the proposed action. Indeed, under corporate law, the board’s costs to act are borne by the corporation, whereas the shareholders’ cost to act, and most importantly to persuade fellow shareholders, is borne by the activist shareholder. Thirdly, the law tilts heavily against shareholders in American public companies having the right to alter the fundamental structure of the corporation; corporate statutes set forth the basic structure of the corporation subject to countervailing provisions in the articles of incorporation. Thus, if altering the default rule, whereby corporate affairs are managed by or under the direction of the board of directors, the preferred structure must appear in the articles of incorporation. In the United States, unlike in other countries, only the board of directors has the power to initiate amendments to the articles of incorporation. This feature of American corporate law not only reduces the shareholders to a reactive role in defining their governance structure, but also necessarily restricts the area that is a proper subject for shareholder action. Consider in this regard CA, Inc. v. AFSCME Employees Pension Plan, 953 A.2d 227 (Del. 2008), holding that the shareholders’ authority to initiate an amendment of the bylaws was limited to matters that are “procedural [or] process-oriented,” [1] so that a bylaw that would encroach upon the managerial authority of the board of directors would be inappropriate. [2] Unquestionably, if shareholders had the authority to initiate an amendment of the articles of incorporation, shareholders would not be limited to process- or procedurally-oriented matters; they could initiate, as the board can initiate, a wide range of substantive alterations to the conduct of the corporation’s affairs. Since shareholders lack authority in the very area that the board enjoys authority, the shareholders’ prerogative to initiate is greatly constrained within a private-ordering environment.

Further evidence of the uneven balance between the prerogatives of the board of directors to act and the shareholders to alter the rules of governance is once again reflected in CA, Inc. Even though the bylaw involved was deemed to be process and procedurally oriented, and thus a proper subject for shareholder action, the court nonetheless held that the proposed bylaw was sufficiently general so that it could require reimbursement in instances that would be inconsistent with the board’s fiduciary obligations. [3] The bylaw proposed in CA, Inc. provided that non-management nominees who are elected to the board should be reimbursed for reasonable expenses incurred in their successful contests for office. The Delaware Supreme Court held that because the bylaw could be invoked by a candidate who sought office solely to advance personal, rather than corporate, interests, the bylaw was invalid. In contrast to CA, Inc., when in Boilermakers challengers to the board-adopted forum-selection bylaw raised multiple examples where the bylaw could be harmful to the corporation, Chancellor Strine summarily dismissed that line of challenge on the ground “it would be imprudent and inappropriate to address these hypotheticals in the absence of a genuine controversy with concrete facts.” [4] We are left, therefore, with the stark conclusion that shareholder- and board-initiated bylaws do not stand on the same footing, so that the efforts of the former are, despite satisfying a generic inquiry with respect to the subject of the bylaw being a proper one, also subject to ex ante scrutiny for their potential inconsistencies with corporate law, whereas the latter bylaws escape such ex ante scrutiny.

A final basis on which to question the contract paradigm in the corporate setting is how contract law and corporate law proceed on very different bases for expected behavior on the part of the parties. The nexus-of-contracts approach meshes poorly with corporate law in light of the very different assumptions that surround contracting parties versus the norm corporate law imposes on managers and dominant stockholders. Under bedrock corporate law, directors and officers are to act selflessly when discharging their corporate duties; in contrast, contracting parties pursue wealth maximization through self-interested, individualistic behavior. Whereas directors owe the corporation and owners a duty of loyalty, contracting parties pursue rugged self-interest, with the only governor being the obligations of good faith and fair dealing within the four corners of their contract. It is not possible to fit the contractual paradigm of individual pursuit of gain with the corporate law, where fiduciary obligations police discretionary behavior by managers and controlling stockholders. Principles and perspectives in the rugged contract setting simply do not survive in the relational setting of corporate law.

But even if a corporation were controlled by contract principles, those principles would not support the results reached in Boilermakers and ATP Tour. The great contracts scholar, Allan Farnsworth, identifies two overarching considerations in determining whether a contract exists: did both parties assent to be bound, and is their agreement definitive? [5] As will be seen, the latter is a prerequisite for the former. The requirement of definiteness is essential, as it goes to the central objective of the contract to protect the expectations of the parties when they exchanged promises in forming the contract. Should there be an alleged breach of performance promised by a party, the courts must “determine … with some precision” the scope of the promised consideration. And, all the greater is the need for specificity when the relief sought for an alleged breach is specific performance. [6] Definiteness has a further role in deciding whether there is a contract. The more terms and conditions the parties have omitted from their agreement, the less likely it is that they in fact intended to enter into an enforceable agreement. Thus, definiteness bears directly on whether there was an intent to contract. Finally, indefiniteness removes the promise from being consideration to support another’s enforceable obligation. That is, a promise that as a practical matter is too indefinite to be enforced cannot be sufficient consideration for a counter-promise. Even in the instance of a requirement contract, the classic form of “incomplete drafting” the law demands that the agreement provide “a reasonably certain basis for giving an appropriate remedy.” [7] For example, price can be omitted when it is to be a “reasonable price at the time of delivery.” [8] Moreover, contract law does not permit the requirement of definiteness, even in the instance of a requirements contract, to be satisfied through the fiat of the well-understood implied covenant of good faith and fair dealing that exists in all contracts.

A further concern with the view that there is unbridled authority in the corporate setting to engage in private ordering is this ignores the reality that much of corporate law is public norms not private norms. The article identifies a range of areas within corporate statutes that can and should be regarded as anchored in the public arena and beyond private ordering. Importantly, one such area that has substantial public features is that of fiduciary duty law. If corporate law is understood as significantly public law and not private law, the ticklish questions of consent among the parties allegedly involved in the “contracting” process need not be addressed. That is, if corporate law is understood to enjoy substantial public features, then at least our assumptions should change regarding the board of directors’ authority to unilaterally change such public norms. Hence, the question of consent, or power to impose on another a requirement, need only be addressed if a matter is one deemed of solely private contract-like arrangements.

A final area examined the the article is the limits of the agent to define the scope of the agency arrangement. Blasius Industries, Inc. v. Atlas Corp. [9] bears significantly on this inquiry and illustrates the disconnection between the nexus-of-contracts paradigm and the corporation as it is constructed by the state. In concluding in that case that the board needed to establish a “compelling justification” for its action, notwithstanding that the board had established it acted in good faith, Chancellor Allen insightful cast the issue as the power of the agent to define his own authority: Allen reasoned:

A board’s decision to act to prevent the shareholders from creating a majority of new board positions and filling them does not involve the exercise of the corporation’s power over its property, or with respect to its rights or obligations; rather, it involves allocation, between shareholders as a class and the board, of effective power with respect to governance of the corporation. … Action designed principally to interfere with the effectiveness of a vote inevitably involves a conflict between the board and a shareholder majority. Judicial review of such action involves a determination of the legal and equitable obligations of an agent towards his principal. This is not, in my opinion, a question that a court may leave to the agent finally to decide so long as he does so honestly and competently; that is, it may not be left to the agent’s business judgment. [10]

Blasius adheres to the wise advice that agents whose interests may materially diverge from the interests of their principals should not have the power to unilaterally determine or materially vary the rules that govern those divergencies of interests. That is, in the principal-agent realm, the relationship and the methods for selecting and controlling the agent are defined by the principal and not the agent. To this end, and as Blasius illustrates, managerial actions that impact the owners’ ability to pursue the limited powers owners have to discipline managers—sell, suffrage, or sue—are not just of a different order of magnitude; they are within an entirely different sphere of corporate law, that of governance. Because they are not within the board’s managerial sphere, they are to be judged by a very different standard than applies to questions of management’s stewardship of the firm’s business. This conclusion, as well as Blasius’ holding, flow naturally from the fact that corporate statutes—while broadly enabling of the board of directors—nonetheless restrict the board’s powers to matters of the corporation and to the limited areas of the shareholders’ franchise; under today’s statutes the board’s, and hence its appointees’, authority with respect to the firm’s operations is clearly set forth in the command that “all corporate powers shall be exercised by or under the authority of the board of directors of the corporation, and the business and affairs of the corporation shall be managed by or under the direction” of the board of directors.

Thus, the board enjoys a strong and well-justified presumption of propriety with respect to matters within its charge: managing and overseeing the management of the corporation’s affairs. The shareholders’ rights are limited. They can be found in various places in the corporate statute. Statutes contemplate that shareholders can initiate derivative suits. Law recognizes that when one is harmed by another in tort, suit for redress exists. These are rights of the shareholder, and there should be no less than a strong presumption that the board of directors lacks the authority to affect those rights unless expressly authorized by the prevailing corporate statute. Even where so authorized, an informed legislature should ask why it is that the board alone should have the power to act when impacting a right historically enjoyed by the shareholders. Much like a bylaw that classifies the board of directors of a Delaware corporation (which in Delaware requires shareholder approval), minimally public policy should condition the change on shareholder approval.

The full article is available for download here.


[1] Id. at 235.
(go back)

[2] Id. at 235–37.
(go back)

[3] CA, Inc., 953 A.2d at 233–37.
(go back)

[4] Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934, 940 (Del. Ch. 2013).
(go back)

[5] E. Allan Farnsworth, Farnsworth on Contracts § 3.1 (4th ed. 2004).
(go back)

[6] Farnsworth, supra note 64, § 3.1.
(go back)

[7] U.C.C. § 2-204(3) (2002).
(go back)

[8] U.C.C. § 2-305(1) (2002).
(go back)

[9] 564 A.2d 651 (Del. Ch. 1988).
(go back)

[10] Id. at 660.
(go back)

Both comments and trackbacks are currently closed.