The Value of Saber-Rattling Proposals to Break the Shield of Business Judgment
POMERANTZ MONITOR | MAY JUNE 2021
A once-in-a-century pandemic is not the only parallel between our current times and the Progressive Era of the late nineteenth and early twentieth centuries, a period of widespread social activism and political reform across the United States. A current progressive issue is shareholder action in response to racial equity and how it impacts shareholder value. Two related stories are now unfolding, as the U.S. Securities and Exchange Commission (“SEC”) blocks Amazon’s effort to stop shareholder votes for racial equity audits, and a Delaware lawsuit says Pinterest’s race and gender bias hurts business. These stories echo the political overtones of the labor disputes of the Progressive Era. In addition, they raise the question: does the business judgment rule survive in today’s political climate that values diversity more than ever?
The mere fact that shareholders are owners does not mean much under Delaware law: the business and affairs of every corporation are managed by or under the direction of the board of directors, not the shareholders. Shareholders have literally no say under state law, except in certain fundamental matters where the General Corporation Law gives them a vote, such as in the election of directors, amendment of charter and bylaws, and certain fundamental transactions. Under black letter law, directors not only can ignore the wishes of the shareholders, but also, they must actually exercise their own business judgment. The shareholders, for their part, can remove directors; but they cannot sue the directors for failing to do their bidding.
On the other hand, federal securities law acts as if shareholders have a right to express their preferences to directors. That is not exactly true under state law, but it is the law that governs shareholder access to the corporate proxy. The concerns investors raise over day-to-day business judgments versus corporate governance is more about federal securities law than it is about state corporate law. But federal securities law generally only allows for precatory shareholder proposals, not mandatory ones.
So much of why the issue of the connection between racial equity and shareholder value is intriguing involves the clash of several different legal principles and policy objectives, which seems to require expanding the narrow and unequivocal duty of care owed by directors.
The Use of Disclosed Interests in Business Judgment
There are at least two different contexts that might expand the narrow and unequivocal meanings of business judgment decisions by a board of directors.
The business judgment rule states that boards are presumed to act in “good faith”—absent evidence to the contrary—regarding the fiduciary duties of loyalty, prudence, and care owed to their shareholders. The general problem with interpreting the business judgment rule in the linguistic context of corporate governance has been well canvassed since the scandals at Enron, Global Crossing, ImClone, Tyco, and WorldCom. That is, the duty of care directed to maximize shareholder value must minimally ensure that the corporation remains a going concern. The cure for this problem is also well known: The board attends to the interest of other stakeholders such as employees, customers, and the economic community writ large.
Unfortunately, although this advice is reasonably sound, it is not very helpful. The advice—exercising judgment as a purposeful guide to careful decision making—is a broad generalization that itself must be decided. A rule for exercising judgment that itself demands judgment calls is not much help. This particular rule tells directors to attend to the “interest,” but the word “interest” is a word like any other word; it too is equivocal. In other words, the technique for exercising purpose appears to be a variant of the first possibility that directors use linguistic context. If this conclusion is correct, then the second possibility collapses into the first except for the distinction that one is expanding the linguistic context beyond the bounds of a single interest. Consequently, unless there is some way to broaden the scope of possible interests, the rule forecloses as many shareholder proposals as it considers. The SEC recently expanded on this point about the evidence that is used to discern business purpose.
Last August, for the first time in thirty years since Chancellor William Allen, of the Delaware Court of Chancery, famously remarked that “a corporation is not a New England town meeting,” the SEC revised the periodic disclosure requirements under Regulation S-K. In many instances, the new regulation replaces the formal prescriptive requirements with flexible guidelines intended to elicit company-specific and industry-wide information deemed material to investors’ understanding of the business purpose behind publicly traded companies. By the same token, the new regulation would appear to give directors new latitude under the purpose-based disclosure requirements to create and provide the information they see as material in this wider context. These broad mandates seem to fit the contours of the current transatlantic movement in unexpected ways. The events of 2020 turned the spotlight on corporate America’s role in creating and perpetuating societal inequities, a development reminiscent of the century-old disputes arising from a formalistic reliance on vested rights of property and freedom of contract by corporations to justify injunctions against labor reform activity and invalidation of labor-protective legislation. During the Progressive Era, Justice Oliver Wendell Holmes led the charge from the Supreme Court bench in dissent from the formalistic view and put enormous pressure on corporations to publicly adopt stakeholder-centric proposals.
The cases Holmes heard submerged a conflict not unlike the present issue between two legally acknowledged “rights”—the right to contract freely that courts recognized, and the right to compete freely that courts suppressed. Because the controversies involved two conflicting categories of “vested” rights, Holmes insisted that deductive reasoning could not neutrally decide the cases. Rather, resolution of the issue required a process of policy balancing. Holmes perhaps put the point best in dissent from the Court in Lochner, where he stated: “General propositions do not decide concrete cases.”
The highly concentrated institutional investiture in today’s stock market, coupled with widespread endorsement from asset managers and comptrollers backing the stakeholder model, may further drive boards to adopt an expanded view of corporate purpose in their decision making.
As Holmes wrote, “if we take the view of our friend the bad man, we shall find that he does not care two straws for the axioms or deductions, but he does want to know what the Massachusetts or English courts are likely to do in fact.” The new SEC disclosures allow shareholders to know in fact under federal securities law what may likewise be more amendable to the needs of modern society, if directors are more open about the non-shareholder value judgments that influenced board decisions, instead of instinctively trying to veil them behind a curtain of syllogistic formal business judgments. Otherwise, companies are likely to face future shareholder actions for their continued failure to disclose such material information.