“As in all publicly traded companies, TimkenSteel’s board and top executives have a fiduciary duty to shareholders to maximize both profits and investor returns.”
That’s Nelson Schwartz in The New York Times, bemoaning the legal forces that pushed Timken to break itself up in response to pressure from activist investors out to make a buck. Only, as Francine McKenna pointed out here, that fiduciary duty to maximize profits does not exist.
Whether it should exist is a separate question, which I’ll take up later. First I want to emphasize why it doesn’t exist, at least in practice.
It doesn’t exist because corporate boards don’t have a fiduciary duty to do anything in particular. In general, a fiduciary duty is a duty to protect someone else’s interests. The classic case of a fiduciary is the trustee of a trust whose beneficiaries are small children. In managing the assets of that trust, you are required to protect the interests of the beneficiaries, so you can’t, for example, charge the trust excessive fees for your management services.
The specific fiduciary duties of corporate directors, like much of the law, are not written down in any statute (what ordinary people call a “law”). Instead, they are part of what we law professors call the common law: legal principles that have been established by courts in the process of adjudicating cases over the years. As it turns out, in Delaware, which is the state that matters—not only because most large corporations are incorporated there, but because courts in other states tend to look to Delaware law when dealing with new issues of corporate law—there are exactly two fiduciary duties: the duty of loyalty and the duty of care.
They duty of care is basically the duty to pay attention to your job: in essence, to make decisions on the basis of reasonably adequate information. There is an academic controversy—fueled by careless uses of language by the courts—about whether the standard of conduct is negligence or gross negligence. But the point here is that the duty of care isn’t a duty to do any particular thing, such as maximize profits.
The duty of loyalty is marginally more complicated. This duty (like the duty of care) existed in agency law—the law governing the relationship between agents, such as employees, and principals, such as companies—before corporations became widespread in the nineteenth century. There, the duty of loyalty essentially meant that you couldn’t use your position as an agent to make a personal profit—by stealing directly from the principal, via a transaction with the principal, or, in the famous case of Reading v. Regem, by using your British Army uniform to help smugglers during your off hours.
Historically, the duty of loyalty for corporate directors has been defined the same way. Directors are forbidden from making money at the corporation’s expense (e.g., paying themselves outlandish compensation, selling it property at an inflated price); appropriating to themselves business opportunities that belong to the corporation; or using their position as directors to make profits from third parties. Again, there’s no specific duty to do anything—only to refrain from taking personal advantage of your office.
Now, court opinions are slippery things, and you can find language that says that the duty of loyalty has a substantive component. Here, for example:
the duty of loyalty therefore mandates that directors maximize the value of the corporation over the long-term [sic] for the benefit of the providers of equity capital, as warranted for an entity with perpetual life in which the residual claimants have locked in their investment.
I‘m not sure this is true, but let’s take it as given for now. The key thing is understanding what this actually means for a real-world board of directors. The same court continues by emphasizing that the board does not have to cater to the wishes of a subset of the shareholders, or even a majority of the shareholders. Instead, directors are supposed to use their own independent judgment to determine what is best for the corporation.
Now, in any interesting context, what is best for the corporation is not obvious, and reasonable minds may differ. Let’s say that the board decides to do X, and a majority of the shareholders think the board should have done Y. What can they do? They can theoretically vote in a new board, but in any case that’s a pure exercise of shareholder democracy that has nothing to do with fiduciary duties. If they want to claim a breach of fiduciary duty, they have to bring a lawsuit against the board.
Here we come to the business judgment rule, the confusingly phrased non-rule that has launched a thousand law review articles. In practice, the business judgment rule says that when shareholders claim a fiduciary breach, they lose—unless they can show one of a short list of things. That list includes fraud, illegality, and waste (something so irrational that no reasonable person could have thought it was a good idea), which are rare. It also includes conflict of interest and (gross?) negligence, which in practice means a failure of the board to inform itself adequately.
The idea behind the business judgment rule is that business is complicated and directors make difficult decisions all the time, many of which turn out badly. If we hold them liable for well-intentioned, well-informed decisions that lead to bad outcomes, then either no one will sit on a board or board members will avoid risks at all costs. The practical effect of the “rule” is that as long as directors (a) do not have personal conflicts of interest and (b) create a paper trail—preferably stamped by supposedly reputable law firms, investment banks, and accounting firms—showing that they considered their options adequately, they are pretty much immune from shareholder lawsuits.
The bottom line is that even if you think that corporate boards have a duty to maximize stock prices, they can still choose any course of action that is plausibly related to that goal over any time period they choose. Henry Ford lost Dodge v. Ford — in which he was forced to pay dividends to shareholders — not because the court thought he chose the wrong way to maximize profits, but because he went out of his way to insist that he was more interested in the greater good than in the Ford Motor Corporation and its shareholders. That’s why there is no effective duty of a board to maximize profits.
Is this a good thing? I’m actually not so sure. Most people making this point think of shareholders as money-grubbing fund managers who are willing to wreck well-functioning companies (and American manufacturing) in pursuit of short-term stock price gains. To them, corporate directors are (potentially, at least) noble defenders of other stakeholders such as employees or local communities.
But when have you seen a corporate board really stick up for the little guy? By contrast, I tend to think of corporate directors as cronies chosen by the CEO to maximize his already excessive compensation package; to overlook questionable and illegal practices that lead to, say, a global financial crisis; and, increasingly, to acquiesce in his contributions of the corporation’s money to pet charities and political causes. (Here’s a paper I wrote on the last topic.) I worry that the high degree of protection that the business judgment rule gives to directors and officers—combined with the practical difficulties of voting out an existing board—makes possible all sorts of corporate malfeasance.
There are several reasons why a board, like Timken’s, might accede to pressure from investors. One is that they might ultimately decide that the investors are right. Another is that they might fear being voted out of office by the shareholders. A third is that they might not want to fight a PR battle against activist investors who have a good case. But they are never legally forced to, unless they literally cannot think of another course of action that might plausibly lead to a better outcome for the company.