Boards-R-Us: reconceptualizing corporate boards.

AuthorBainbridge, Stephen M.
PositionIntroduction through III. Mapping the BSP to the Current Board A. How BSPs Address the Reasons Current Boards Fail 2. Incentives a. Compensation Incentives, p. 1051-1085

Introduction I. The Jobs and Failures of the Current Board of Directors A. What Do Boards Do? B. Boards Fail C. Why Boards Fail 1. Directors are subject to significant time constraints 2. Directors have an inherent information disadvantage 3. Directors are generalists 4. Directors do not have well-designed incentive II. The Basic BSP Model. A. The Basic Idea B. Institutional Choices 1. Appointment and elections 2. Composition and function. 3. Compensation 4. Liability. III. Mapping the BSP to the Current Board. A. How BSPs Address the Reasons Current Boards Fail. 1. Economies of scale and scope. a. Time. b. Information c. Specialization 2. Incentives a. Compensation incentives. b. Liability-based incentives c. Reputational incentives d. Exposure to market forces. e. Measurability. B. Board Functions. 1. Managing the firm. 2. Providing services. 3. Monitoring management. IV. BSPs and the Law. V. Extensions. A. Shareholder Access to the Proxy B. Increasing Managerial Power VI. Objections A. Limited Liability. B. Sticky Equilibria. C. Special Interest Representatives. D. The Value of Personal Leadership. E. Other Objections Conclusion [Alexander] Hamilton would have no trouble recognizing the corporate board of today. The structure and composition of boardrooms have changed surprisingly little in more than 200 years. (1)

INTRODUCTION

Corporate boards of directors are one of the most important institutions in our capitalist system. This is because state law requires boards to mediate the relations between ownership and control of the corporation. (2) Separating capital and management is thought to be a source of efficiency, since those with capital may not be best positioned to manage publicly held firms. (3) But the separation generates the potential for opportunism since managers may be less careful spending other people's money than they would their own. (4) To optimize the tradeoff between management efficiency and opportunism, shareholders elect boards of directors to supervise management of the firm by corporate officers. (5) Although day-to-day decisions are made by managers, directors are obligated to make fundamental decisions, like hiring and firing the managers, setting compensation incentives, raising capital, and entering into mergers and acquisitions. (6) This latter category of decisions routinely involves high stakes and potential conflicts among corporate stakeholders, making the board the place where legal rules about corporate governance have the most relevance.

In recognition of the centrality of the board in corporate governance, judicial control of corporate activities is almost exclusively effected through review of board decisions and refinement of board duties to shareholders. (8) Through their review of board actions in connection with mergers, executive compensation, supervision of firm risk, approval of conflicted transactions, and so on, state courts have created many of the basic rules of corporate governance. (9)

Legislation (from both states and the federal government), as well as private rules from stock exchanges, also focuses on optimizing corporate governance through attempts to perfect the board and optimally define its position in the corporate decisionmaking hierarchy. (10) For instance, in response to numerous corporate scandals during the late 1990s, the Sarbanes-Oxley Act of 2002 required, among other things, that all listed companies have audit committees composed entirely of independent directors. (11) Similarly, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) implemented numerous corporate governance reforms, including new disclosures about consultants working for boards and about compensation of directors, as well as new independence standards for board compensation committees. (12)

Influencing boards is the primary focus of good governance advocates of various kinds, as well. Proxy advisor firms, like Institutional Shareholder Services (ISS) and Glass, Lewis & Co., spend considerable resources trying to improve corporate governance by giving shareholders information about how they should vote in director elections. For instance, ISS sells institutional shareholders recommendations on how to vote for every director of large, publicly traded firms based on firm policies regarding areas ranging from executive compensation to corporate strategy. (13) Although the power of ISS and the other proxy advisor firms is disputed, (14) it is without doubt that their ability to influence corporate behavior is cabined by the current corporate governance structure. Because shareholders have limited ability to directly effect change, much of their power--and thus that of ISS and its ilk--derives from voting on director elections. (15)

The importance of the board of directors is further illustrated by the considerable extent to which academics hoping to improve corporate governance focus on the role and composition of the board. (16) Almost every corporate governance reform proposed over the past several decades has focused on the board of directors. (17) The central academic debate is whether boards have too much control over corporate affairs, too little, or just the right amount. (18) This battle is fought on the grounds of who board members are, whether they are independent, who appoints them, how they are elected, how they are compensated, what the standards for their conduct and liability are, whether there should be more independent directors, what the optimal board size is, and so forth. (19) All of these reforms are an attempt to optimize the monitoring and governance role played by the board. (20)

Despite the long and zealous efforts of corporate law reformers to understand and improve the board of directors, there is a gaping hole in the corporate governance literature. No one has yet questioned a fundamental assumption of the current corporate governance model--that is, only individuals, acting as sole proprietors, should provide professional board services. To be sure, there seem to be legal reasons why this is the case. For example, state law seems to require directors to be natural persons, as do the provisions of federal law pertaining to corporate governance and the listing requirements of stock exchanges. (21) This Article puts these obligations to scrutiny, asking whether this requirement makes sense. To do so, it posits a novel alternative: board services could be provided by other entities, be they partnerships, corporations, limited liability corporations, or any other type of business association. We call these firms "board service providers" (BSPs). To be clear, we do not have in mind individual board members forming professional corporations to get the protection of limited liability, but rather all director services being provided by a single firm. In other words, just as companies outsource their external audit function to an accounting firm rather than multiple individuals, the board of directors function would be outsourced to a professional services company.

To see our idea, imagine a firm, Boards-R-Us, Inc., serving as the board of Acme Co. Instead of Acme shareholders hiring a dozen or so individual sole proprietors to provide board functions, they instead hire one firm--a BSP--to provide those functions, whatever they may be. (22) Boards-R-Us would still act through individual agents, but the responsibility for managing a particular firm, within the meaning of state corporate law, would be that of Boards-R-Us the entity. This means, for instance, that a suit by shareholders for breach of the board's fiduciary duties would be against Boards-R-Us, and not against individuals or groups of individuals.

This Article considers the various details of what this might look like and sets forth the costs and benefits of the BSP approach compared with the current model. To see the basics of the BSP model, it is probably helpful to imagine no other change to governance--that is, holding the current election, function, and liability regimes constant. (23) All of the current rules of federal and state law, as well as stock exchange listing standards, governing the nomination and election of directors would continue to apply. All that would change is that instead of multiple individuals, only a single entity would be selected.

Our proposal is well grounded in state corporate law theory and supported by analogous cases in which firms serve as boards. Corporate law is generally permissive about how companies structure their governance, providing merely a set of default rules that can be altered by contract. (24) Mandatory rules are very rare, and the case for them is weakened when there are significant benefits, as here, that can flow from freedom of choice. In addition, there are many cases in which entities, like our imagined BSPs, are already serving as boards or in board-like capacities. Unincorporated entities, such as partnerships, limited liability companies (LLCs), and the like, are typically permitted to have business associations serve in the management role played by a corporate board of directors for corporate entities. (25) In addition, several federal statutes, including the Investment Company Act of 1940, permit directors to be incorporated entities, and the Supreme Court has construed portions of the securities laws broadly to include corporations acting as directors when the policy justifications for that result are strong. (26)

Our proposal has no ideological or particular substantive corporate governance valence. The use of BSPs would not necessarily result in more shareholder power or more managerial power. What it would do, however, is make either of these options more likely, depending on the other forces at work. If shareholder access to the proxy with the goal of more competition for board seats is desired, our proposal can achieve this more directly, at lower cost, and with less downside than the...

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