Ex-Ante Corporate Governance

George S. Geis is Vice Dean and William S. Potter Professor of Law at the University of Virginia School of Law. This post is based on a forthcoming article by Professor Geis. This post is part of the Delaware law series; links to other posts in the series are available here.

Who should make decisions for a corporation? And how should decisions about who makes decisions be made? These fundamental governance questions motivate much of corporate law, as lawmakers seek to strike a sensible balance of power between managers, shareholders, creditors, suppliers, and other players in the corporate system. Historically, much of the governance interplay has been retrospective. Shareholders expelled directors or sued their firms when something went wrong, not in anticipation that something bad might occur. Directors defended against (or, more likely, settled) questionable lawsuits as the cases arose; they did not enact structural incentives to discourage specious filings. Yet this is now changing: corporate governance tactics are increasingly shifting from the ex-post to the ex-ante. My new article, Ex-Ante Corporate Governance, explores this trend and illustrates how both shareholders and directors are turning to strategies that might shape the future balance of power instead of just reacting to historical concerns.

Between managers and shareholders, much of this struggle plays out in three key dimensions: the vote, the lawsuit, and the sale. Shareholders elect directors, who then appoint top managers, and most of the firm’s decision making occurs through this delegated power. But shareholders who are upset with the corporation’s leadership can expel the directors during the next election cycle. Alternatively, shareholders who are concerned with a specific action (or lack of action) can file a lawsuit alleging some harm, such as a breach of fiduciary duty or violation of securities law. And shareholders who do not want to bother with voting or suing might just sell their shares. The common feature of these strategies is that they involve an ex-post response to a perceived slight.

Increasingly, however, shareholders and managers are emphasizing tactics that move from ex-post response to ex-ante planning. Instead of removing individual directors, for example, a shareholder group might try to eliminate staggered boards—such that investors will find it easier to replace the entire board if warranted. Instead of fighting shareholder lawsuits in multiple jurisdictions, a board might adopt a forum selection provision that corrals future litigation into one preferred location. By shaping key aspects of corporate governance, before a specific incident arises, both directors and shareholders aim to establish structural rules that are favorable to their causes.

A primary (but not exclusive) instrument for ex-ante governance is the corporate bylaw. Long neglected, bylaws are gaining new attention as a vehicle for expanding, constraining, or channeling power in the corporate ecosystem. Directors are attracted to bylaws because, unlike charter amendments, they can be adopted without shareholder approval. Activist shareholders are likewise intrigued by bylaws because new rules may be approved over managerial objections. In short, bylaws are the rare unilateral tool in the workshop of corporate governance.

Not surprisingly, these ex-ante governance tactics are raising new legal problems. Judges are increasingly being asked to determine whether a given corporate bylaw is permissible. The current state of play is fluid, but the influential Delaware courts seem to be taking a more permissive attitude, based in part on the parallels between contract law and the corporate relationship. By conceptualizing the corporation as a collection of negotiated agreements between the firm and individual shareholders, proponents of ex-ante governance defend unilateral bylaw initiatives as the permissible product of flexible private ordering. The full implications of shoehorning corporations into contract law are not entirely clear—indeed, it is not altogether obvious who the exact parties are to the “corporate contract”—even though lawmakers have been stating this as a self-evident truth for almost a century. Nevertheless, the loose (though still controversial) embrace of preauthorized one-sided modification in contract law provides some theoretical support for upholding unilateral corporate bylaws.

The problem, however, is that contract law may not be particularly well suited to preside over these types of ex-ante governance disputes. Indeed, invoking contract law to justify unilateral bylaws only implicates a different concern, sometimes described as the “latecomer term” problem. Key parties might be expected to possess proper incentives to mold sensible governance terms at the outset of a venture. But it is much less clear that these incentives will function effectively for downstream modifications by one party only. And if the mechanisms by which bylaw terms are priced into corporate relationships do not work seamlessly for latecomer adjustments, it is worth questioning whether contract theory should really offer much support for this trend.

This article advances two primary claims. First, corporate law should not outsource the resolution of ex-ante governance problems to generalized principles of contract law. Contract law has not done a particularly good job of addressing the latecomer term problem, and the concerns presented are acute in the corporate context. (Moreover, tighter doctrinal coupling of these two legal fields raises a host of unanswered, and seemingly tangential, questions.) Second, if corporate law is to confront this problem directly, then its algorithms for delineating tolerable bylaws will require far greater clarification in the coming years as novel governance strategies proliferate.

The full article is available for download here.

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