Why governance replaced directorship and why its lacking

Traditional American law should, and does, recognize that the fundamental task of boards is to exercise judgment in a business context. In fact, this is the overarching concept that permeates any understanding of the role of directors in overseeing corporate affairs. Commonly called the “business judgment rule,” this concept is widely recognized in court decisions and in corporation statutes.

Judgment is the ability to weigh matters prudently. This is a skill, often developed from experience, and not a process.

However, much modern law relating to actions of directors of corporations focuses on process and not judgment. That is, in contrast to the focus on the substance of business judgment is the focus on the process of forming a judgment. This difference, seemingly subtle, isn’t.

The contemporary use of the term “governance” to describe the law relating to directing a corporation’s affairs reflects this shift away from leadership and toward the performance of minute tasks, which easily degenerates into a checklist mentality that swamps the role of judgment. Corporate Governance: Principles And Practices reflects today’s swing toward minutiae.

At the forefront of bad evolution

For banks, this trend has accelerated, due to the current economic environment and the resulting increase in regulatory scrutiny.

Bank examiners have not only increased the frequency of examinations, but have also increased the scope of the examinations to delve deeply into specific loan files and specific director decisions evaluating risks. Examiners have criticized directors for failing to comprehend the details of risk, which has prompted directors to focus on the particulars of loans and document their review to the exclusion of overseeing strategy and directing management.

These regulatory actions are illustrated by the complaint filed by FDIC on Nov. 1, 2010, against the directors of Heritage Community Bank in Glenwood, Ill. (For a www.bankingexchange.com analysis of that filing, click here.) The complaint alleges that the directors violated their duties because the bank’s loans were not properly underwritten. It essentially alleges that the directors are liable for the deficient loan underwriting performed by management and staff. A natural result of such allegations by examiners is that bank directors will become surrogate loan officers with increased focus on compliance with loan-to-value ratios and related policies.

Effross acknowledges this trend, which isn’t brand-new. In Section 1.09, entitled “Beyond Rules: Assimilating and Internalizing Corporate Governance Values,” he notes the warnings by commentators that boards are shifting away from approving strategy and advising management and toward ensuring compliance.

Despite his acknowledgment of the issue, in Corporate Governance: Principles And Practices Effross perpetuates the compliance mentality with a checklist approach to evaluating the actions of directors. In the process, he neglects the exercise of judgment. (Effross is a professor at American University’s Washington College of Law.)

In the introduction to Chapter 2, Effross expressly states that a director’s duty of care is marked not by judgment or a lack thereof, but by adherence to procedure. According to Effross, the law absolves directors of liability for a harmful decision if appropriate procedures are followed, but holds directors liable for a harmful decision if appropriate procedures are not followed.

The neglect of the role of judgment extends to the table of contents—which does not even identify the business judgment rule—and the index—which omits any reference to “business judgment” or even “judgment.” Only under the indexed term “directors” and subheading “personal liability” is there a reference to a discussion of the business judgment rule —a discussion that covers only 2 pages of a book that exceeds 500 pages in length.

Corporate Governance: Principles And Practices identifies the fundamental responsibilities of directors as the duty of care and duty of loyalty. That’s correct but incomplete. For example, the exercise of the duty of care is discussed in the form of a checklist of the procedures by which directors act. It makes directorship mechanistic, reducing it to such factors as the number of meetings a director attends, the number of questions a director asks, and related matters that can be quantified and checked on a list.

Closer look at business judgment rule

In contrast to the checklist approach based on procedural compliance with the duties of care and loyalty, the law has traditionally followed the business judgment rule. It’s a common law doctrine created by judges over centuries of decisions rendered in multiple jurisdictions and involving a wide variety of acts. The rule is not set forth in a statute. Consequently, there is no single accepted formulation of the rule, and different court decisions and commentators focus on different aspects of the rule. However, commonly accepted elements of the rule include:

1. Deference. The rule is a rule of deference by courts to business. Business requires the evaluation of risk and the acceptance of some amount of risk in exchange for some amount of reward. The balance of risk and reward will vary between and among people, with some people accepting more risk for the same reward than other people. A court will not substitute its judgment for the directors’ judgment. Business decisions are not required to be perfect or right.

2. Presumption. In addition to being a rule of deference, the business judgment rule is a presumption that directors acted appropriately. A rule of deference simply allows the directors to prevail in close cases; a presumption has the added benefit of shifting the burden of proof and persuasion to those persons who are attacking the directors’ decisions. In other words, directors enter the courtroom with the understanding that the directors are right until proven wrong.

3. Flexibility. The business judgment rule is a flexible concept that evolves to protect and encourage the exercise of judgment in a business environment. The commentary to the Revised Model Business Corporation Act (adopted in its different versions in most states) expressly states that the business judgment rule is not codified because “it would not be desirable to freeze the concept in a statute.” Since the business environment is constantly changing, the rule itself is constantly adapting.

The focus of governance law is to identify circumstances in which directors lose the benefits of deference by the courts, presumption of correctness, and flexibility in application. The flexibility of the current business judgment rule means that there is no single, correct statement of those circumstances. A common statement is that directors benefit from the rule if the directors  act in good faith, on an informed basis, and in the honest belief that the action is in the corporation’s best interests. An alternative formulation is that directors lose the benefit of the business judgment rule if under the facts and circumstances the directors fail to comply with  the two duties of board members. (For more about the duties of loyalty and care, click here.)

Compensation case illustrates key issue

The controversy regarding executive compensation illustrates the differences between compliance approach described by Corporate Governance: Principles And Practices and the business judgment approach actually used by the courts.

An essential role of directors is oversight of management; and a key part of the oversight is the control of management compensation.

The compliance approach to compensation oversight focuses on various measurable factors. These include such issues as the independence of the directors who make the compensation decisions, with independence measured by compliance with precise rules relating to employment, interlocking directorships, charitable donations, and other situations.

The judgment approach to compensation focuses on the actual work done by the executive within the context of the job.

As Effross acknowledges in Section 6.01(E) relating to compensation, the courts do not second-guess the directors’ judgment except in rare cases of waste or fraud, and the courts have expressly rejected multifactor tests in the context of executive compensation. See Menard, Inc. v. Commissioner, 560 F.3d 620,622-623 (7th Cir. 2009).

Book lacks insight and style

Corporate Governance: Principles And Practices has the feel of, and reads like, a professor’s lecture notes that were transformed into a resource book with better printing and binding.

Hence, if a reader is planning to teach a course regarding the law of directing the affairs of corporations, the book is a start.

However, a reader who is a financial institution director that  seeks a comprehensive guide to the topic must look elsewhere. The fundamental issue in corporate governance is the business judgment rule and the circumstances when it does and does not apply. The book neglects the rule.

Thus, the reader must look turn to another source to understand the judicial deference to business decisions, presumption of correctness, and flexibility in application, and to identify the various and numerous circumstances in which courts will abandon the deference, presumption ,and flexibility to hold directors liable.

If this book review was of interest to you, you may also like to read our recent review of Handbook for Directors of Financial Institutions.

 

 

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