Boards of Directors as Mediating Hierarchs
| Publication year | 2014 |
I. INTRODUCTION
In June of 2014, the board of directors of Demoulas Supermarkets, Inc.-better known as Market Basket, a mid-sized chain of grocery stores in New England-decided to oust the man who had been CEO for the previous six years, Arthur T. Demoulas.(fn1) Most likely, the board of directors did not anticipate what happened next: Thousands of employees, customers, and fans of Market Basket boycotted the stores and staged noisy public protests asking the board to reinstate "Arthur T."(fn2) The reaction by employees and customers made what had been a simmering, nasty, intrafamily feud within the closely held Market Basket chain into national news. In this era of overpaid and aloof CEOs, who expects employees and customers to go to bat for the CEO?
The Demoulas clan feud provides useful context for thinking about the institutional mechanism for resolving disputes at the heart of corpo-rate law: the granting of decisionmaking authority to a board of directors. Most, if not all, long-term relationships do not go smoothly all the time. When people make a decision to live together, work together, own property together, or build something together, they should anticipate that disagreements will arise, sometimes major disagreements. This is as true in a business endeavor as it is in other aspects of life. For this reason, institutional arrangements that are successful at supporting collaborative activities over time are likely to have some sort of dispute resolution mechanism, or decision rule about resolving disputes, imbedded in them. In this Essay, I highlight and explore the dispute resolution function of the corporate law requirement that corporations have boards of directors with "all corporate powers."(fn3)
It is easy to overlook the dispute resolution function of corporate boards. When this institution is working well, most potential disputes do not have to be decided by the board,(fn4) and those disputes that do come up to the board are generally resolved before they become public. Therefore, the role boards play in this regard is mostly invisible. Moreover, the corporate form is used for many other purposes in the twenty-first century, in addition to providing a framework for the self-governance of productive activity.(fn5) Historically, the use of the corporate form for business activity developed first as a mechanism to enable groups of people to combine, invest, and preserve capital to provide a needed product or service to a community-be it churches, colleges, bridges, canals, etc.-and to provide a governance structure for that committed capital. Corporations were also formed to either establish, defend, and control trading routes, or to colonize trading partners.(fn6) In all of these types of activity, some sort of governance mechanism was required. Although research on origins of board governance is thin,(fn7) it seems clear that the earliest corporations almost universally had boards of directors or some similar governing body. Why were boards needed then, and why does the law today require corporations to be governed by boards?(fn8) In recent decades, the dominant answer to that question among legal scholars has been that boards of directors are "agents" of shareholders, whose job is to monitor management for shareholders.
However, team production theory of corporate law, which this symposium explores, argues that boards of directors serve a different function.(fn9) Because boards have "all corporate powers," but do not themselves own the assets being deployed in a corporation, they can serve as a mechanism for resolving potential disputes among the other participants in the corporate enterprise over the strategic direction of the firm, the use of corporate assets, and the allocation of the economic surplus created by the enterprise.(fn10) The assignment of authority by law to the board serves to keep most potential disputes out of the courts, which is where many of them would probably end up if the underlying relationships were purely contractual.(fn11) Moreover, the fact that the board of directors has the final say in internal disputes among corporate participants encourages corporate participants to work out their disagreements among themselves to the extent possible.(fn12) On a day-to-day basis, most corporate participants do not want to have a decision "kicked upstairs." Therefore, it can be argued that the provision that "all corporate powers" are possessed by boards prevents many disputes from arising in the first place.
In Part II, I briefly review the theory of team production in the economic literature, and walk through the argument laid out by Blair and Stout that the institution of boards of directors in corporations fits the description in the economics literature of an important solution to a "team production" problem.(fn13) In Part III, I discuss how the legal structure and duties of boards of directors ensures that most of the potentially highly contentious decisions that must be made in the management and governance of corporations will be resolved internally, without recourse to a court. If they cannot be resolved at a lower level, they will go to the board of directors and be resolved there, which means that a major task of boards is mediation and dispute resolution. Because the law requires that certain decisions must be made by the board, and that most decisions, once made by the board, cannot be challenged in court, board governance helps minimize the number of disputes that might otherwise boil over and require court adjudication. I argue that corporate law has traditionally supported this interpretation of what boards are supposed to be doing better than it supports the idea that boards are supposed to be agents of shareholders. In Part IV, I review new theoretical work on corporate law that explores this idea, and in Part V, I review empirical find-ings on boards of directors that provide support for this interpretation. In Part VI, I review several developments in the Delaware courts that may inhibit the ability of boards to carry out this function. In conclusion, I comment on the effect that these developments may have on how corporate boards carry out their duties.
I. THE TEAM PRODUCTION PROBLEM
Early work by economists on the "theory of the firm" focused on the question of why people organize themselves into firms to carry out production activities.(fn14) Ronald Coase posed this question in 1937 and hypothesized that business people would organize themselves into firms, in which control and decisionmaking is delegated to a managerial hierarchy, when the transactions costs of organizing through markets was higher than the transactions costs associated with production in a firm.(fn15) In his words, in markets, "coordination is the work of the price mechanism," while within firms, coordination is the work of the "entrepre-neur."(fn16) But Coase did not offer any explanation in his article for when or why transactions costs would be higher in the market than they would be within a firm. In 1972, Armen Alchian and Harold Demsetz explored one set of circumstances in which costs would likely be high when transacting in markets but potentially lower when decisionmaking is delegated to an entrepreneur or boss.(fn17) This is the case, they said, in the context of "team production," which they defined as "production in which 1) several types of resources are used . . . 2) the product is not a sum of separable outputs of each cooperating resource. . . . [and] 3) not all resources used in team production belong to one person."(fn18)
In the context of team production, it is extremely difficult to write contracts that simultaneously provide appropriate incentives for team members to cooperate and contribute what they are expected to contribute, and that allocate all of the output in a way that discourages team members from dissipating all of the gains in squabbling over the distribu-tion.(fn19) If the parties attempt to agree up front to a decision rule about allocating the output from a team-such as every member of the team will receive an equal share of the total output-the team members will then have incentives to shirk, since their share of the output is fixed no matter how much they contribute. On the other hand, if they wait until the output has been generated to divide up the surplus created, they will have incentives to squabble over that output, possibly destroying much of the wealth in the process.
The Demoulas family history illustrates the problems that can arise out of team production. George Demoulas and Telemachus Demoulas, sons of the founder of the firm, ran the business together in the 1950s and 1960s,(fn20) and apparently had an implicit agreement that the wealth generated by the firm would be split evenly between George's family and Telemachus's family.(fn21) However, George died at a young age and none of his offspring joined the family business. Telemachus, on the other hand, ran the business and expanded it significantly during the decades after George had died.(fn22) According to court findings in lawsuits between the two branches of the family, Telemachus began siphoning off some of the wealth being generated by the business into related firms that were owned only by the Telemachus branch of the family.(fn23) Arthur T...
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