Ex-ante corporate governance.

AuthorGeis, George S.
  1. INTRODUCTION II. THE RISE OF EX-ANTE GOVERNANCE A. Shareholder Side Governance 1. Proposals and Pressure 2. Shareholder Initiated Bylaws in Delaware a. Background: The "Recursive Loop" b. A Second "Hellerian" Challenge c. Development d. Shareholder Bylaws, Contracts, and Private Ordering B. Director Side Governance 1. Exercising Residual Power 2. Board Initiated Bylaws in Delaware a. Forum Selection b. Litigation Fee Shifting c. Binding Shareholder Arbitration III. CONTRACTUAL FOUNDATIONS OF BYLAW MODIFICATION A. Corporation as Contract B. The Latecomer Term Problem C. Duplicative Review D. Other "Legal Baggage" IV. GOVERNING EX-ANTE CORPORATE GOVERNANCE A. By Statute B. By Judicial Review--Law C. By Judicial Review--Equity V. CONCLUSION I. INTRODUCTION

    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. This tightrope is not easy to walk, however, and no one can design rules that will block faulty managers from abusing control over a firm's activities. (1) Likewise, laws cannot completely prevent a rogue investor from pursuing some actions that yield private spoils but impose greater collective harm on the corporation and other investors. (2) Corporate law can and should try to minimize these frictions, but they must be understood as the inevitable purchase price for other benefits that come with the coordination of economic activity through a firm. (3)

    Between managers and shareholders, much of this struggle plays out in three key dimensions: the vote, the lawsuit, and the sale. (4) 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. (5) 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. (6) Instead of fighting shareholder lawsuits in multiple jurisdictions, a board might adopt a forum selection provision that corrals future litigation into one preferred location. (7) 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. (8) Directors are attracted to bylaws because, unlike charter amendments, (9) they can be adopted without shareholder approval. (10) 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. (11) 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. (12) Nevertheless, the loose (though still controversial) embrace of preauthorized one-sided modification in contract law (13) 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. (14) Indeed, invoking contract law to justify unilateral bylaws only implicates a different concern, sometimes described as the "latecomer term" problem. (15) 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. (16) 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. This Article does not attempt to establish precise standards for evaluating bylaws, but I will offer some thoughts on the topic.

    The discussion is organized as follows. Part II sets the stage by exploring the rise of ax-ante corporate governance strategies--and especially those related to unilateral bylaw initiatives on the shareholder side and the director side of the firm. Part III considers the contractual foundations for this trend, arguing that contract doctrine is not a particularly helpful way to evaluate the proper scope of unilaterally adopted bylaws. This is true for reasons related to regulatory efficiency (i.e., avoiding duplicative legal claims) and for reasons related to contract law's continuing struggle with unilateral modification (i.e., contract law has not really solved the latecomer term problem either). Moreover, contract law brings a host of additional "legal baggage" that seems tangential to the problem at hand. Part IV explores alternative institutions and approaches for adjudicating ex-ante governance problems, as a matter of Delaware corporate law, and posits that both legal and equitable frameworks will require significant growth to manage the task. A brief conclusion summarizes the Article.

  2. THE RISE OF EX-ANTE GOVERNANCE

    The hallmark of corporate governance is delegation. Shareholders may be the residual owners of a company, but they do not collectively vote on every firm decision. Rather, they cede power to a small group of representatives who are entrusted to call most of the shots. By default, only the most extreme decisions require direct investor approval. (17)

    This representative system makes sense, given the widely distributed ownership of many firms and the complexity of corporate activity, but it does present a risk that appointed managers may abuse their discretion. There is no way to solve this agency cost problem, although corporate law does seek to mitigate its effects by giving shareholders some tools to respond when ill deeds do come to light. To date, the primary vehicles for shareholder power are the right to vote, sue, or sell. Equity owners may expel lousy directors during annual elections, launch a lawsuit to punish bad managers, or just sell their shares in disgust and walk away. Like any delegation of power, however, these tools can be corrupted in their own right. Much of corporate law seeks (or should seek) to strike a governance balance that will promote decisions that enhance the overall value of a corporation, while also minimizing the transaction costs (broadly construed) of regulatory compliance.

    Historically, much of the governance interplay between managers and shareholders 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 changing: corporate governance tactics are increasingly shifting from the ex-post to the ex-ante. As this Part will discuss, both shareholders and directors are turning to strategies that might shape the future balance of power instead of just reacting to historical concerns. (18)

    1. Shareholder Side Governance

      1. Proposals and Pressure

        The gateway obstacle for shareholder side governance is coordination. communicating and gathering support for initiatives across a large and diverse body of shareholders is no easy task. Conceivably, an activist shareholder might fund a personal campaign to connect shareholders and lobby for change. But unless that shareholder has a very significant stake in...

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