A Brief History of Corporate Governance

In the decade of the eighties we watched the unfolding of the "crisis in corporate governance". Boards were seen as universally ineffectual. Shareholders became militant. Then they became hostile. CEOs became objects of derision. The mechanisms of corporate governance were found to be inadequate to leverage meaningful responsiveness from the board; litigation against the board was seen as the only remedy. In landmark cases (Aronson v. Lewis, Del 1984; Smith v. Van Gorkum, Del 1985; and others), jurisprudential wisdom began to turn the corner on its traditional posture of judicial abstention. The business judgement rule became a significantly more porous defense for boardroom decision making. The legal rendering of "due care" was ratcheted up to "due deliberation" as the behavioral mechanics of director involvement were driven from their historic slumber to a new vigilance criterion. 


      The skirmishes in courtrooms, annual meetings, boardrooms and executive suites twisted the orderly and well defined fiduciary playing field out of a century of stability into a decade of tumultuous and frightening unpredictability. Director and officer liability underwriters panicked when the topography of fiduciary risk eluded capture by quantitative models. D & O liability insurance premiums increased as much as 1000%. Some policies actually featured annual premium amounts equal to the face amount of the coverage. But you still had to qualify for underwriting. 


     Shareholder rights activists like Robert Monks and Nell Minow focused the national spotlight on the structural inadequacies of the American form of governance and a litany of recurrent director and officer performance deficiencies.  Boardroom and corporate governance experts Dr. Jay Lorsch at Harvard Business School, Ira Millstein at Weil, Gotschall & Manges and others described the realities of boardroom functioning and offered points of departure conspicuous for their practicality and ease of implementation. Knights of the courtroom roundtable like Joe Flom and Marty Lipton weighed in with further observations. Dale Hansen with Calpers and  Elizabeth Holtzman with Nypers led institutional shareholders to a new level of awareness of the responsibilities of ownership and their implications for sharpening the mechanisms of accountability in the boardroom. And by the late 80s, the Department of Labor, in the so-called Avon letters, asserted that proxy vote decisions were assets of the fund just as much as capital resources and, accordingly, must be treated with the same care and vigilance as any other asset of the fund.


      A parallel conflagration had burned its way to disaster in the S & L and commercial banking world. Fortunes were lost and careers were ruined. The fiduciary fiefdoms of medieval governance practices were arrested and directors were drowned in their own moats. Bank regulators, emboldened by an outraged public and running scared from their own culpability, brandished a new absolute standard of fiduciary risk. If you were a bank director and the bank failed --- you were personally liable. Regulators transformed the personal liability standard associated with fiduciary risk in a way that eliminated effective board defenses. Hundreds of directors went to the financial guillotine and surrendered the family wealth. The famous were not spared either. Recall that John Connally, a Texas governor and Secretary of the Treasury sacrificed a lifetime of accumulated wealth. He died five years later in financial obscurity. 


      It was in the context of this most alarming melodrama that Corporate America and its allies focused on a revolutionary damage control strategy. They took action to legislate themselves out of personal liability. The state legislatures of Indiana and, of course, Delaware, led the way. By 1989, some three dozen states had passed "director protector" statutes which provided domiciled corporations with the option to amend their charter to include limitation or elimination of personal liability for litigation brought against them under their fiduciary duty of care. Personal liability for defective "business judgement" was once again removed from the playing field.  However, directors and officers remained exposed to liability if found guilty of fraud or self-dealing or otherwise found in violation of their fiduciary duty of loyalty. 


     By the early nineties, directors on many boards had taken hold of the reins, placed their CEOs on waivers or on an accountability tether and pushed and shoved Corporate America through an historic period of restructuring. Leaner and more focused, reengineered and downsized, resurgent earnings and the growth of international markets hoisted the mainsail of equity markets and promised shareholders a half decade in the sun. D & O liability insurance premiums were cheap again. Underwriting guidelines were more informed but relatively congenial. Overwrought spleens could be exorcised by tuning in to the mercurial Ken Starr and Bill Clinton show. Thinking about boards of directors and fiduciary performance was no longer passionate. 


      And then the season slipped away into the next just the way they always do. It was the juxtaposition of two factors which tipped us off that the season was changing. First, there was the continued drone of the Y2K soothsayers, no longer a rag-tag coterie of wild eyed techies with shrill voices and radical agendas, but now the Y2K chorus was an auspicious collection of hundreds of thousands of programmers and engineers and project managers and human resource managers and attorneys and insurance people and bank regulators and legislators and scientists and senior executives and chairmen of the audit committee and boards of directors. Responsible economists offered recessionary turn-of-the-century forecasts for the entire world. The "usual" recessionary dip occasioned by century mark phenomena would be further spiked by the commercial drag from inhibitory Y2K consequences. However, nothing in these observations moved the tea leaves to report impending doom or catastrophic economic consequences. A blip on the radar screen – significant - but still only a blip. 


      But by the fall of 1998, the second clue of changing seasons emerged. The stability of the Asian economy was seriously questioned amid reports of panic by the Tokyo investor community. Stock markets around the world started to plummet. Brazil and the South American economies were reported wobbling to the Pacific tuning fork. Economic experts around the world called for Alan Greenspan to lower interest rates. Greenspan stalled. The markets continued to flounder. There was “big-time fear talk.” Stockholders lost billions in 10 days. Eventually, Greenspan stepped in and lowered rates one-quarter percent. It was not enough. In mid-October rates were lowered another quarter point and the markets responded. But the genie was out of the bottle again. The season had changed and the respite of anxiety for fiduciaries of Corporate America was ended. 


      Global economic interdependence means that the personal liability of directors and officers of American corporations increases when international markets get tremulous.  The prospect of significant "automatic" hits on revenues and earnings inflicted by world economic conditions are inimical to the interests of all stakeholders of Corporate America, but directors and officers flinch the most. Unsatisfactory commercial outcomes almost always raise the ante for shareholder initiated litigation against the board. When the bulls run in Pamplona each year, sometimes the bystanders get trampled along with the sprinting daredevils. 


      When directors assemble around the conference tables that fall they would remember an earlier time when boardrooms were under siege and shareholder litigation was designed to push the envelop of a moving standard of care. The moving standard of care was intimidating for director defendants because there was no way of knowing in advance of the trial whether or not your discharge of fiduciary duty was sufficient. There was no a priori method of determining if you had deployed enough "care" or reasoned together with enough "due deliberation". 


      With a moving standard there was never a way to know which level of "enough" was enough. But in the fall of 1998, despite their awareness of potential world wide recession and the additive liability of Y2K mediated business interruptions, directors could, nevertheless, muse to themselves, "That was then and this is now. Now we have director protector statutes. Now we have director and officer liability insurance with affordable premiums. Now we are a stronger, more involved board. Now the CEO is neither imperial nor self-absorbed, but committed to the forging of healthy coalitions among the primary stakeholder groups. Now we have abandoned the ‘run and hide’ response to shrill voices in favor of a commitment to engineer consensus into corporate governance policy and practice. Now board service does not carry the threat of financial carnage by way of the personal liability which has historically accompanied fiduciary risk. We will never escape the routine of dealing with disconfirmed expectations and imminent dangers to our commercial viability, but, at least, the family yacht and the polo ponies are not at risk." 


         Irony of Ironies and the Return to Jeopardy


      Since the late eighties, a handful of legal scholars warned that the respite from fear elicited by the director protector statutes could only be temporary. Their line of reasoning was believable. In matters of corporate governance there must always be an accountable party. If accountability to shareholders is blocked in one way, then some alternative way will be discovered to hold boards accountable. Maybe it will be achieved through restructuring the capital markets. Maybe the federal government, through the action of the SEC, will step in, assume control and make new rules. But the wholesale elimination of the accountability feature of corporate governance other than by the mediative impact of acceptable fiduciary performance --- is a concept that ignores the fundamental tenet of the agency relationship. 


       And then the plaintiff’s bar weighed in. The lawyers who had earned their stripes from previous D & O litigation had long ago stumbled over the fungibility of the “care” and “loyalty” concepts. For example, is chronic failure to attend board meetings a care or a loyalty issue? What about failure to pay attention in board meetings? What about the duty to object? Despite some case law which solidifies the requirement that directors object to any proceeding or proposition with which they are manifestly uncomfortable, there is clear conceptual ground to treat such indiscretion as either a loyalty or a care violation. Think about it this way. All care issues can be thought of in loyalty terms. It’s a corollary to the idea that amount of effort is a function of degree of motivation. In other words, care is loyalty. Dramatic failure in care is necessarily a failure in loyalty. And the ultimate display of loyalty is the demonstration of great care. There is no alternative conceptualization unless one posits random behavior as a fiduciary strategy. We can understand that loyalty is about purpose and care is about the quality of execution. The notion of “loyalty” is inherent in the notion of “quality of execution.” Likewise, “loyalty” independent of actions which instantiate “care” is without meaning and nonsensical.   The clear conceptual connection comes from the realization that seriously degraded execution calls into question one’s purpose. This conceptual “crossover” from care to loyalty may be vulnerable to specific legal defenses in some jurisdictions depending on the development of relevant case law, but in most jurisdictions characterized by sparse precedent --- the “crossover” turf will be congenial to the effort/motivation::care/loyalty analogy. 


      Yet, surely splitting hairs over “Is it care or is it loyalty?" is of little consequence. Not so. the consequences are huge. Remember that D & O liability insurance does not apply to loyalty violations. Corporate indemnification of directors and officers does not apply to loyalty issues. Director protector statutes do not apply. And the traditional defense of boards in duty of care litigation --- invocation of the business judgement rule --- is not available for the loyalty regime issues. If you put all of these considerations together and look at the board's vulnerability to litigation, you cannot escape the conclusion that directors and officers are considerably worse off in terms of personal liability than ever before in the history of American corporate governance (except for bank and S & L directors in the eighties). Indeed, the logic of the bank regulators in the eighties can be adapted by the plaintiff's bar suing directors today, viz., "material damage to shareholders cannot happen unless somebody goes to sleep at the helm. 'Asleep at the helm' necessarily means that the loyalties are invested somewhere else." This is a paraphrase of the logic used by bank regulators a decade ago. 


      So we see a pretzel-shaped playing field in which the cultural allies of the board have metaphorically shot the directorate in the foot. State legislatures which passed the director protector statutes, despite their sober intent to tilt the legal playing field to the board's advantage, have inadvertently stripped directors of all their most significant defenses. The maneuver which seemed like a blanket attenuation of fiduciary liability in Corporate America becomes interpretable, instead, as an instrument of monumental disadvantage. Plaintiff's counsel might as well abandon strategies for litigation under care --- since this is the legal theatre with monolithic and redundant defenses. Instead, cast all complaints in terms of loyalty violations. None of the traditional protections can be invoked in the directors' defense. This tactic may encourage a high rate of out-of-court settlements with plaintiffs - since "naked" directors will be highly risk-averse. 


The Persistent Problem of Fiduciary Performance and Director Liability


       The question that must be raised after coursing through this most curious two decades of corporate governance turmoil: why is there this chronic problem of directors being sued by shareholders for allegedly failing to do their jobs?  This is a recurrent phenomenon that we see year in and year out through good times and bad. Is there some perverse quality resident in many directors which impels them to perform in a borderline fashion? Are shareholders mean-spirited, pugilistic jerks --- insensitive to the cyclical swings of business and too quick on the trigger when faced with disconfirmed expectations?


       The enumerated rhetorical questions are not helpful to an understanding of the persistence of the agency problem. That is not to say that each constituency does not have an agenda. Nor is it to suggest that there are no dum-dums loose on the fields of corporate governance. There are both … agendas and dum-dums. 


      In the following pages we offer a different conceptualization of the "fundamental problem" which underlies corporate governance and is responsible for the elicitation of the never-ending shareholder/board skirmishes and litigation. By our rendering, this "fundamental problem" decomposes into three distinct issues which must be addressed separately. First, the purpose of the structural mechanisms of corporate governance is to create an agency relationship between the owners and the overseers that provides accountability to the shareholders and flexibility in the exercise of  business judgement  to the board. The board must be accountable to and protective of the interests of shareholders without being submissive to their opinions or intimidated by the bravado with which they express those opinions. Directors and officers should not have to fret about sacrificing their personal estates in a court of law if they are responsibly discharging their fiduciary duties. As well, it is imperative that shareholders have access to some means of extracting the measure of accountability due them by virtue of their role as capitalization agents. 


      The structural mechanisms of corporate governance suffer from a singular defect which has invited almost all of the significant problems of agency which have manifested over the last sixty years. All of the available remedies to shareholders for addressing a performance deficiency of the board are post hoc to the commitment of the perceived wrong.  The principle is: instead of looking for remedies to compensate for the damage incurred because the horse got out of the barn, let's figure out how to prevent the horse from escaping the barn. There are currently no ad hoc control mechanisms in place to monitor and impact fiduciary performance at the locus of the decision making event. It is the point at which directors and officers make the critical decisions where control mechanisms are needed. The mechanisms of accountability may be sharpened if the locus of control is imported from the extant post hoc remedies to real time ad hoc control mechanisms suitable for identifying and changing the offense before it is past the point of remediation. How to achieve this is, of course, another matter. But there can never be a good solution until you accurately identify the nature of the problem. 


      The second aspect of the "fundamental problem" of corporate governance is the lack of a well defined job description for the board. Veteran governance observers and analysts may have a  knee jerk reaction to this assertion as shallow and simple minded. Nevertheless, in every single piece of D & O litigation we examined since 1952, the plaintiffs and defendants entertained a major difference in perception of the board's specific duties. The role of referee fell to the Bench and subsequent rulings were largely a function of the job description preferred or asserted by the Court. This is plausible when we recall that most statutory definitions of fiduciary duty are cryptic and ambiguous. Case law fills in some of the blanks but fails to sufficiently detail a comprehensive job description --- even at the most conceptual level. This precipitous failure is not exclusively attributable to the legislators in each jurisdiction; corporate boards share in the responsibility. Legal advisors have often opined that it is risky to be specific about board duties and also risky to be too specific in the way board meeting minutes are written. We take exception to this posture by reminding that ambiguity is helpful only under conditions when you don't know what you're doing and are having to feel your way or, contrapuntally, you know exactly what you should be doing and you are not doing it for some reason. Ambiguity may be an ally in these two conditions, but we respectfully submit that neither condition should be tolerated by management, the board or the shareholders. "Plausible deniability" may have value for covert political operatives, but the fiduciaries of Corporate America will be better served by traditions which underscore the virtues of clarity, deliberateness and completeness. Ambiguity is the ally of the weak and the infirm and is, itself, a very weak ally.    


     The third component of the "fundamental problem" of corporate governance is closely related to the matter of the poorly defined job description of the board. We know that the domain of the board's job description is a corpus of decision making activities related to the firm's efforts to achieve competitive advantage in the marketplace. And we know that the duties of care and loyalty and the criteria which must be met to allow invocation of the   business judgement rule are about standards of quality which are to be applied to the directors' making of those decisions. But the ambiguity which we found to be characteristic of the board's job description is also a problem with the standard of quality applicable to board decisions. Exactly what is that standard?  Perhaps the clearest articulation of it is found in Smith v. Van Gorkum, 1985. Antecedent to the making of a business decision, directors must inform themselves "of all material information reasonably available to them" and "proceed with a critical eye in assessing [such] information ...." This statement of the standard of quality of decision making performance suggests that the Court is proposing a substantive and reasonably challenging set of criteria.  The Delaware Supreme Court further noted that "due care" must be elevated to the level of "due deliberation". Nevertheless, the failure to reference any operationally defined procedures leaves us, once again, ensconced in ambiguity. As with the matter of the board's job description, if the standard of judgemental performance required is undefined, then all players --- directors, shareholders, managers, attorneys and judges --- pontificate from a theatre of subjectivity according to standards most congenial to their overriding purpose.    


  By way of review, we say that the "fundamental problem" of corporate governance --- which has historically been responsible for eliciting decades of D & O litigation, manifests in three distinct  "correctable deficiencies". It is, primarily, a history of the inability to deal with complex decision making tasks which accrue to boards of directors and corporate officers. This inability to deal with complex decision making issues self-presents in three critical ways: (1) The structural accountability mechanisms of corporate governance are post hoc to the value creation events which those very mechanisms were (theoretically) designed to inspect and control. Those value creation events are primarily boardroom decisions. (2) The corpus of decisions which naturally constitute the "critical decisions" of the firm are never identified by any programmatic effort based on any economic-centric value creation model. It is this domain of "critical decisions" which should define the primary fiduciary duties of the board. The failure to carefully define the job description of the board makes assessment of the health of the agency relationship impossible. And, (3) the critical decisions of the firm are rarely monitored or inspected relative to a pre-determined qualitative standard. It is difficult to assess the propriety of fiduciary performance if no one agrees on the topography of the playing field.  Clearly, there is something about conventional wisdom's way of dealing with boardroom decision making that deserves reexamination.   


      By this rendering, we make the observation that the “new frontier” of corporate governance analysis and assessment lies in the theatre of those complex decisions afflicted with risk and uncertainty which necessarily accrue to directors and officers as they attempt to discharge their fiduciary duties to the corporation. To continue the analogy: in this theatre, the drama is partitioned into three acts. First, what are the critical economic value creation decisions of the firm? These must be identified and must become the centerpiece of the board’s job description. Second, control mechanisms upon which we shall rely for evaluating and modifying governance performance must be implemented at the real-time locus of the decision making events. Failure to do so is a refusal to take responsibility for assessing the quality of governance performance. And, third, the control mechanisms to be placed at the locus of critical decision making events must be capable of evaluating the complex decisions at the level of the decision mechanics which behavioral decision scientists routinely treat. In other words, it is an area of technical expertise which requires specialists in the behavioral science of human judgement and complex decision making. 


Welcome to the Decision Age


      All exit ramps off of the information superhighway lead directly into the Decision Age. The reason that we have developed methods and machines to gather, manipulate and store information is to empower ourselves to make better decisions. The only value that information has is its instructive value to direct our action. We immerse ourselves in information so that we can make better decisions about what to do, about what to tell our children to do, about what to tell our employees to do, about what to tell our legislators to do. 


      The Information Age was the child of the Industrial Age because the increasingly competitive marketplace inexorably migrated to more and better information as an additional and, increasingly, more important source for achieving competitive advantage. Years before the proliferation of the internet, data mining and data warehousing practices, business players already had more rarefied information than they could combine and integrate into strategic decisions driving value creation purposes. Advances in information technology have accelerated the pace and magnitude of social, political and economic change. Predicting the future --- never an easy assignment --- has become correspondingly more intractable. The decision environment in which today's business leaders must operate is characterized by ever more imposing doses of complexity, uncertainty and risk. Not to mention the invasive levels of scrutiny from both friendly and hostile quarters. And, of course, there's a Matterhorn of data to examine and integrate and much less tolerance for allocating the time required to do it. Shorter business cycles require faster endorsement or rejection of proposed plans of action. The chameleon face of opportunity appears --- more discernible to some than to others --- and momentarily vanishes. 


      Even though  people often complain about the limitations of their memory, nobody complains about the accuracy of their judgement. Despite this, the fallibility of human judgement is well known and documented in the research literature of experimental psychology. Even in the simpler days of three decades ago, the Nobel Laureate Herbert A. Simon was describing the bounded rationality of human decision makers and calling for the implementation of protocols sensitive to the limits of human rationality. 


       By the late seventies behavioral scientists had established a strong empirical case for the notion that people cope with information overload conditions by developing ad hoc algorithms, or heuristics, to relieve the information processing burden. Heuristic-mediated judgement facilitates task completion which, otherwise, might never occur or, at best, might require inordinate time. The downside to the otherwise adaptive use of judgemental heuristics is the characteristic distortion, or bias, which the various heuristics automatically build into judgemental behavior. Put another way, these intellectual "shortcuts" compromise accuracy by introducing systematic distortions.       


What characterizes the Decision Age as much as any other factor is the realization that now we have the informational and computing resources barely imaginable twenty years ago, but we still are searching for the Holy Grail that can empower us to use it all effectively. We are crushed by the information overload. The substantive knowledge that we collect, analyze and store is seen as a cache of potentially awesome power in the marketplace if it can be liberated from its dormancy by the judgemental algorithms which characterize superior decision making capability.


With this brief history of corporate governance and a quick peek at the decision making fallibility of humans – even the brightest and most capable – now, we can introduce the two worlds – corporate governance and decision making science – and begin to examine the implications.