Upstream Liability, Entities as Boards, and the Theory of the Firm

Andrew Verstein is Professor of Law at Wake Forest University School of Law. This post is based on his recent article, forthcoming in The Business Lawyer.

Directors have fiduciary duties, and the most litigated and most demanding of those duties is the duty of loyalty. The key questions for duty of loyalty litigation are director-by-director questions: Did this particular director have a conflict? Is it futile to make a demand on that particular director?

What does it mean to ask director-by-director questions if corporations have just one director, which is itself an entity? Shall we inquire about particular humans in the managing entity or limit our analysis to the entity itself? The question becomes richer and more important if the board-entities opt to bundle services: We know how to evaluate a conflict when a director urges the company to patronize her own accounting or banking firm. How should we evaluate the conflict if a managing entity opts to use its own accounting or banking department? Our conflict analysis is usually of contractual transactions but the essence of the Coasian firm is the absence of a contract to analyze. In a recently published essay, I explore how the duty of loyalty might work when entities manage entities and uncover important lessons about how loyalty works.

The impetus for the article is Outsourcing the Board, a book in which Professors Steve Bainbridge and Todd Henderson advocate that a legal entity (a “board service provider” or BSP) should be permitted to serve as the sole director of a corporate board.

It’s a big proposal that would remake the landscape of corporate law. The boardroom is the theater of corporate drama and the setting for iconic cases. Delaware jurisprudence is forever pivoting on the Archimedean point: “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors.” The directorship is perhaps the most socially important office that could escape a student’s notice until her second year of law school.

Despite the audacity of their proposal, I suggest that the actual uses of the BSP are likely to be far more modest than Bainbridge and Henderson suggest. I argue that deep-seated features of corporate law make it almost inevitable that BSPs will come to reproduce the structures they are meant to supplant. Long after corporate law ceases to require human boards, it will still prefigure them.

My essay investigates fiduciary duties at the BSP. Fiduciary duty law proves fruitful for three reasons. First, it is not extensively addressed in Outsourcing the Board or the preceding article. Second, the fiduciary duty of loyalty is mandatory. Outsourcing the Board is an experiment in dexterous contractarianism, but it must be reconciled with existing, and rigid, duty law.

Third, fiduciary duty law is massively individuated. A single director’s unexcused conflict can subject a transaction to “Delaware’s most onerous standard of review[,] the entire fairness test.” There are director-by-director tests for demand futility, breaches of duty, exculpation, liability, and safe harbors for conflicts. Each of these inquiries is personalized with an “actual director” standard, rather than some impersonal and objective standard. Directors each owe the same non-delegable duties to the company; there is no division of fiduciary labor within the boardroom. Even issues require individualized consideration: Bundling more than one transaction into a single ratification vote will spoil its potential as a safe harbor. Taken as a whole, our duty jurisprudence is inclined toward splitting rather than lumping. It looks for humans in their particularity, rather than as members of a group. There is a tension between the law’s focus on individual directors and transactions, and the aggregating tendencies of the BSP.

The mandatory and individualized character of fiduciary duty law raises questions for a future that elevates entities. When multi-member entities serve as directors, who owes duties to the corporation—the entity, some of its members, or both? If some of its members, who? Similar questions arise for the presence and excusal of conflicts and for the resolution of assertions of demand futility.

I claim that there is a tension between the mandatory individuation of corporate law and the BSP’s radical experiment in combination. Fiduciary duty analysis will ask questions that can be sensibly answered only if corporations operate in rather conventional ways, and so corporations will operate in rather conventional ways. Courts will look inside the entities to spot breaches and conflicts. Entities and their employees will understandably wish to avoid intrusive and challenging lawsuits, and the best ways to do so will be to encrust a familiar dichotomy (director-equivalents and advisor-equivalents) within the managing entity. The BSP proposal will cause a different legal structure to emerge, but not a different organizational structure.

All of this suggests that corporate law is conservative: Change requires more than unbarring the nearest locks. This stands in stark contrast to the view of corporate law as dynamic and experimental. Indeed, putting aside the question of entities-as-boards, isn’t there something quaint about how we analyze fiduciary duties even for orthodox, human boards?

The complete article is available here.

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