The basic corporate governance problem is how to control those who have been entrusted with the assets assembled in the corporation: managers and directors.

This economic problem is called an “agency problem”: how to ensure that the “agents” (managers/directors) act in furtherance of the “principals’” (shareholders’) interests rather than the agents’ own interest? If this agency problem cannot be addressed satisfactorily, investors will not be willing to put their money into corporations, and the wealth generating machine matching savers and businesses to finance investment won’t work (see The Really Big Picture above).

(NB: the economic terminology of “agent” and “principal” employed in this section is related to, but much broader than, the legal terminology in the law of agency. Legally, managers are agents for the corporation, not for shareholders, and directors aren’t legal agents for anybody – in particular, they are not subject to shareholder directives. From an economic perspective, however, the corporation is a fiction — a convenient way of describing relationships between human beings. In this perspective, directors and managers ultimately work for shareholders and hence are shareholders’ agents in an economic, though not legal, sense.)

Importantly, it is not a solution to completely forgo the use of agents. In reality, it is essential for large organizations to maintain a centralized management with the flexibility and discretion to guide the course of business as they see fit, especially when responding to novel circumstances or unforeseen challenges. To appreciate this point, consider the alternative: Were shareholders required to approve every single decision made by the organization—whether pursuing a new business venture, or deciding to defend the corporation against a potentially expensive lawsuit—the logistical inefficiency and administrative burden would be simply overwhelming. Obtaining  shareholder approval would consume an inordinate amount of time, leading to delays and potentially missed opportunities. Furthermore, shareholders (especially passive investors without any experience in an industry) may not possess the expertise or experience necessary to make informed decisions on certain complex business matters. This scenario could expose the corporation to unnecessary risk and jeopardize its viability.

Accordingly, the solution to agency problems cannot be to not employ agents at all. Instead, the trick is to devise appropriate controls.

Shareholders’ most visible protection is their right to vote on certain important corporate decisions. In particular, shareholders elect, and can remove, directors, who in turn appoint management (cf. DGCL 211(b), 141(k), 142(b)). Thus, shareholders at least get to choose their “agents.” Shareholders also vote to approve fundamental changes, such as charter amendments (cf. DGCL 242(b)) or mergers (cf. DGCL 252(c)). Other matters may be submitted to a shareholder vote.

Notably, this “shareholder democracy” isn’t truly democratic.

First, the default rule in corporations is one vote per share (“one share one vote”), rather than one vote per shareholder (cf. DGCL 212(a)). Second, the corporate charter can authorize the issue of shares with different voting rights (DGCL 151(a)), which corporations such as Alphabet/Google, Facebook, and other so-called dual-class companies have done: their founders hold high-voting stock, whereas outside investors hold low- or non-voting stock, such that the founders can maintain control even after selling a majority of the equity (measured by cash flow rights) to outside investors.  Finally, incumbents enjoy a large advantage because they control the voting process (dates etc.) and because only they can use corporate funds for their campaign: challengers generally have to pay their own costs.

The corporation must hold at least an annual meeting of stockholders, DGCL 211(b). Under the default rules, only the board can call additional meetings (DGCL 211(a)(1)); shareholders may act instead by written consent (DGCL 228), but even that possibility is usually excluded in the charters of public corporations. Meetings can be in person or online (DGCL 211(a)(1)).

A peculiarity of corporate voting is that voting rights are determined on the “record date,” 10-60 days before the actual vote (DGCL 213). At least in practice, one keeps one’s voting rights even if one sells the shares in between. (Any problem with this?)

By default, there are annual elections for all board seats. Under DGCL 141(d), however, the charter or a qualified bylaw can provide that as few as one third of the seats are contestable each year, i.e., that directors hold staggered terms of up to three years. This so-called “staggered board” probably seems like technical minutiae to you now. But it turns out to be an extremely important provision because it may critically delay anybody’s attempt to take control of the board. An important complementing rule is that unlike annually-elected boards, staggered boards are subject to removal only for cause (DGCL 141(k)(1); cf. DGCL 141(k)(2) for the case of cumulative voting).

Unless otherwise provided in the charter or the statute, a majority of the shares entitled to vote constitutes a quorum (DGCL 216.1), and the requisite majority for a resolution to pass is the affirmative vote of a majority of the shares present (DGCL 216.2). The default for director elections is different (plurality voting, DGCL 216.3), but most large corporations have instituted some form of majority voting rule for director elections in their bylaws or charter. This matters mostly when shareholders express their dissatisfaction through a “withhold campaign” against a particular director. Under the default rule, the director could be elected with a single vote (if running unopposed, as is the norm). A more radical but rare deviation from the default rule is cumulative voting. See DGCL 214 for the technical details. Roughly, cumulative voting ensures proportional representation. Cf. eBay v. Newmark later in the book.

In large corporations, few shareholders attend shareholder meetings in person, be it physically or online. Most vote by “proxy”: a power of attorney to vote a shareholder’s shares (cf. DGCL 212(b)). The proxy is usually given on a standard form—the “proxy card”—furnished by those who solicit proxies, nowadays mostly electronically. For most meetings, the only soliciting party is the board, acting for (and with all expenses paid for by) the corporation. The board solicits proxies to ensure a quorum, to prevent a “coup” by a minority stockholder, and because the stock-exchange rules require it (see, e.g., NYSE Listed Company Manual 402.04). The board decides which proposals and nominees to include on the corporation’s proxy card,

except as mandated by the federal proxy rules covered below. Rarely, “dissidents” solicit their own proxies in opposition to the incumbent board, usually in order to elect their own candidates to the board. This is called a proxy fight or proxy contest. The challenger generally bares their own cost, which largely explains why proxy fights are rare.

Proxy solicitations are heavily regulated by the SEC’s proxy rules (Regulation 14A promulgated under section 14 of the Securities Exchange Act).

For a first course on corporations, you only need to know the following:

1. Before any proxy solicitation commences, a proxy statement must be filed with the SEC (rule 14a-6(b)). In contested matters, a preliminary proxy statement must be filed 10 days before any solicitation commences (rule 14a-6(a)).
2. The content and form of the proxy materials are heavily regulated (rules 14a‑3, 14a–4, and 14a–5, and Schedule 14A). Virtually everything you see in an actual proxy statement is prescribed by the rules.
3. “Proxy” and “solicitation” are defined extremely broadly (rule 14a-1(f) and (l)(1)). Accordingly, the sweep of the proxy rules is very wide. In fact, in the past, the proxy rules impeded even conversations among shareholders about their votes. Certain exceptions to the definitions (particularly rule 14a-1(l)(2)(iv)) or requirements (particularly rules 14a-2(a)(6) and 14a-2(b)(1)-(3)) are therefore extremely important — you should read them.
4. Rule 14a-8 requires corporations to include certain shareholder proposals in the corporation’s proxy materials. Under the rule, corporations must include in their proxy certain precatory resolutions and bylaw amendments sponsored by shareholders. By contrast, the rule does not cover director nominations or anything else that would affect “the upcoming election of directors” (see rule 14a-8(i)(8)).You should read the rule — unlike the rest of the proxy rules, it’s written in plain English.
5. In 2021, the SEC adopted the so-called universal proxy rule 14a-19. It provides that in proxy fights, every proxy card must list and allow voting for each individual candidate, no matter who nominated the candidate or who solicits the proxy. Prior to 2021, people would solicit proxies using proxy cards that only allowed voting for the soliciting party’s candidates, and did not permit pick-and-choose among all candidates. Note that a challenger still needs to file a proxy statement, solicit proxies, and bear the associated costs to force the corporation to put the challenger’s candidates onto the corporation’s (universal) proxy. Please read this rule, too.
6. There is a special anti-fraud provision (rule 14a-9).

• The second set of protections that shareholders have are fiduciary duties.

 Directors and managers hold their corporate powers as fiduciaries, i.e., for the sole benefit of “the corporation and its shareholders.” As fiduciaries, directors and managers owe a duty of care and a duty of loyalty to “the corporation and its shareholders.”

Fiduciary duties are creations of equity in the technical sense of having been developed in courts of equity rather than courts of law. While courts of law and equity were merged into courts of general jurisdiction almost everywhere in the 19^th century, this was not the case in Delaware. The Delaware Chancery Court technically remains a court of equity. Delaware judges like to emphasize this fact and the critical role of equity in constraining legal powers, which are not to be used for “inequitable purposes.” In the memorable words of the Delaware Supreme Court:

[I]nequitable action does not become permissible simply because it is legally possible.

—Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437, 439 (Del. 1971).

In fact, as you will see, corporate law, or at least the Delaware variety, imposes so few legal limits—in the technical sense, excluding equity—that fiduciary duties are the only true limit on what is possible. In almost all the cases you will read, corporate fiduciaries do something that is legal under the statute, but the question is whether it complies with the fiduciaries’ fiduciary duties.

Crucially, U.S. courts liberally grant shareholders standing to enforce these duties in court, including through derivative suits:

The derivative action developed in equity to enable shareholders to sue in the corporation’s name where those in control of the company refused to assert a claim belonging to it. The nature of the action is two-fold. First, it is the equivalent of a suit by the shareholders to compel the corporation to sue. Second, it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it.

—Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984).

In addition to voting rights and standing to sue, shareholders also have the right to access certain corporate information. This is an important ancillary right because both shareholder voting and derivative suits require information to work well. DGCL 220 allows shareholders “to inspect for any proper purpose … [t]he corporation’s … books and records,” and Delaware courts have interpreted this very broadly, even including internal emails in some circumstances. Furthermore, publicly traded corporations must make extensive affirmative disclosures under the securities laws.

Finally, shareholders can sell their stock. This is important for individual shareholders’ liquidity, i.e., shareholders’ ability to convert the value of their corporate investment into cash when necessary. However, this so-called Wall Street Walk is useless, at least by itself, as a protection against bad management. If the corporation has bad management, its value to shareholders will be less than it could be, and its stock price will be discounted to reflect this. So a shareholder can sell, but that just locks in the loss from bad management; it does not fix it. (By analogy, an arson victim’s right to sell the land with the burnt ruins hardly compensates the victim for, nor prevents, the arson.) Selling is useful only in as much as it enables a buyer to amass a large enough position from which to challenge the sitting board using the first two tools (voting and suing).

Let us work through a few hypotheticals to illustrate how basic corporate statutory rules operate. These scenarios will highlight the grotesque outcomes that these rules alone would countenance and thus demonstrate the importance of fiduciary duties.

HLS Inc. has a single class of stock and three shareholders owning one third each: John M., John G., and Kristen S. Each shareholder is also a member of the current board. John M. currently serves as CEO. HLS Inc. generates about $10 million in annual profits; it has traditionally paid out all profits to the three shareholders every year.

Consider the following questions – what is the answer under the Delaware statute, not considering fiduciary duties (which will [fortunately] change many of the answers)?

1. Imagine that HLS Inc. is only subject to Delaware default rules, i.e., it does not have divergent charter provisions. Can John G. and Kristen S. do any or all of the following, in their capacity as shareholders and/or board members:

• Remove John M. from his position as CEO and his directorship, and instead elect their friend Jeannie S.—who does not own any stock in HLS Inc.—as a director and CEO.
• Issue new stock only to themselves and/or Jeannie S. at a low price.
• Cancel John M.’s stock.
• Pay dividends only to themselves (and Jeannie S. if she has become a shareholder).
• Stop paying dividends and instead pay out the profits as remuneration for “director services” and/or “CEO services” to themselves and/or Jeannie S., as applicable.
  2. Now imagine that HLS has a staggered/classified board such that only one of the three directors is up for reelection each year (DGCL 141(d)). Does this possibly change any of your answers to Question 1?
  3. Now imagine that HLS Inc. does not have a staggered board but dual class stock: John M. owns 50 shares of class A stock that has 10 votes per share, and John G. and Kristen S. each own 50 shares of class B stock that has 1 vote per share. Does this possibly change any of your answers to Question 1?

So far, we have framed the basic problem of corporate governance as how to control managers and the board. An important tool of corporate governance, however, is control of managers by the board. Arguably, the primary role of a board composed mostly of outside members (i.e., non-management) is to select, monitor, and thus control managers. It is now standard or even legally required for public corporations’ boards to consist mostly of independent directors, i.e., directors who do not have other relationships with the corporation, especially not a role in management. That being said, in U.S. corporations, it is still customary for CEOs and other top managers to sit on the board and even to chair it.

Some countries go even further and fully separate outside directors and management. Under the so-called two-tier system, a “supervisory board” composed exclusively of outside directors is superimposed on the “management board” composed of top managers. Shareholders elect the supervisory board, which in turn appoints and monitors the management board. (In some jurisdictions the supervisory board is self-nominating or partially elected by the corporation’s employees.)

But while directors may indeed monitor management, this only shifts the basic problem one level up: how can we control those who have been entrusted with this monitoring role? Quis custodiet ipsos custodes? (Who monitors the monitors?)

Monitoring the monitor is a particularly acute problem with respect to large, dominant shareholders. Most public corporations around the world have a dominant shareholder. In the U.S. and in the U.K., dispersed ownership is the norm but far from universal. On the positive side, dominant shareholders help overcome shareholders’ collective action problem in monitoring managers and the board. On the flip side, however, dominant shareholders may attempt to extract a disproportionate share for themselves. Delaware limits such minority abuse by imposing fiduciary duties on “controlling shareholders.” Other jurisdictions impose super-majority requirements, or outright prohibit certain transactions, etc.

In general, a shareholder needs to own close to 50% of the outstanding stock to control the corporation. (“close to” because some other shareholders tend not to vote, such that the controlling stockholder can command a majority of the stock voted at the meeting even though owning less than a majority of the stock outstanding.) However, if the corporation issues multiple classes of stock with differentiated voting rights (“dual class stock”), a shareholder can control (by owning the high-voting stock) even while owning only a small fraction of the cash flow rights (cf. Google Exercise above, and “Shareholder Democracy” below). This exacerbates the conflict of interest with the other shareholders: the lower the controlling shareholder’s proportional economic stake in the corporation, the higher the controlling shareholder’s gain from diverting value from the corporation into the controlling shareholder’s own pockets (cf. Some (Not So) Fictitious Examples in the Duty of Loyalty section below).

Many non-U.S. jurisdictions prohibit dual class stock, but dominant shareholders employ a pyramid structure to achieve a very similar result. To wit, the dominant shareholder will be the majority shareholder of corporation A, which is in turn the majority shareholder of corporation B, which may be a majority shareholder of corporation C, and so on. In such a structure, the dominant shareholder controls each of the layers even though economically the dominant shareholder only receives much less than 50% of the cash flows from the lower layers. For example, if the dominant shareholder owns 50.01% of the stock of A, which owns 50.01% of B, which owns 50.01% of C, then the dominant shareholder indirectly controls C even though the dominant shareholder will receive only 50.01% × 50.01% × 50.01% = 12.51% of any dividend paid by C and passed through B and A to their respective shareholders. In the U.S., pyramids are tax-disadvantaged because each layer is subject to corporate income tax (such that multiplying layers means multiplying tax), and for this and perhaps other reasons virtually inexistent. (For the avoidance of doubt: U.S. corporations do employ holding structures where the top-level corporation owns several subsidiaries, which may own sub-subsidiaries and so on, but all the subsidiaries are wholly-owned by their respective parent(s), such that control and cash flow rights go hand in hand; the IRS exempts such wholly-owned structures from multiple taxation.)

We defer until the end of the book the question of whether corporate law does or should protect constituencies other than shareholders (often called “stakeholders”), such as creditors, workers, or customers. For the time being, we just note that the question is not whether stakeholders should be protected at all, but whether they should be protected by the tools of corporate law—that is, beyond the level of protection afforded by contract (loan agreements, employment contracts, collective bargaining, etc.), and by other branches of law (employment law, labor law, consumer law, etc.).

Enforcement and its problems are of paramount importance for corporate law. At the extreme, if general law enforcement were too weak, managers could, for example, simply abscond with the corporation’s money. No fiduciary duties, shareholder litigation, or shareholder voting could protect against this. Fortunately, criminal law enforcement in the U.S. is strong enough that outright fraud and theft are not the most pressing concerns and can be mostly ignored in this course.

In the more subtle form of inadministrability, however, enforcement problems are key to understanding the rationale behind much of corporate law — and indeed behind much of law generally. Administrability refers to courts’ ability to administer the laws as written. The problem is that courts often lack the requisite information. For this reason, many superficially appealing rules do not work as intended. For example, it is certainly desirable that managers always do only what is best for shareholders, or at least what they think is best for shareholders, and that they do so flawlessly or at least to the best of their abilities. Formally speaking, that is indeed more or less what fiduciary duties require of managers. That does not mean, however, that it is realistic to think that courts could actually enforce such a standard. Courts may not know what action was best for shareholders, much less what the managers truly thought was best for shareholders. Nor can courts easily know whether managers gave their best efforts or loyalty. Courts will inevitably misjudge many careful, loyal actions as disloyal or careless, and vice versa — even after costly and lengthy litigation.

Faced with such difficulties, it may be best to forego costly judicial review altogether unless a transaction raises a red flag. The reddest of red flags is when the decision would financially benefit the decision-makers or their affiliates more than (other) shareholders. That, in a nutshell, is the approach taken in Delaware and other U.S. states and epitomized by the business judgment rule. We will dive deep into the details later. For now, here is the scoop in the words of the seminal case, Aronson v. Lewis:

The business judgment rule is an acknowledgment of the managerial prerogatives of Delaware directors under Section 141(a). It is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts. …

[However, the rule’s] protections can only be claimed by disinterested directors . … From the standpoint of interest, this means that directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing . … See 8 Del.C. § 144(a)(1).

[Moreover], to invoke the rule’s protection directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them. Having become so informed, they must then act with requisite care in the discharge of their duties. While the Delaware cases use a variety of terms to describe the applicable standard of care, our analysis satisfies us that under the business judgment rule director liability is predicated upon concepts of gross negligence.

— Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (footnotes and internal references omitted).

More generally, many rules of corporate law are decidedly second-best. That is, they are optimal only in recognition of the difficulties of enforcing any alternative rule. Agency problems can be reduced. They can never be eliminated.