the human nature of corporate boards - donald c. langevoort

7/21/2019 The Human Nature of Corporate Boards - Donald C. Langevoort

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Georgetown University Law Center

2000 Working Paper Series

in

Business, Economics, and Regulatory Law

Working Paper No. 241402

The Human Nature of Corporate Boards: Law, Norms and the Unintended

Consequences of Independence and Accountability

by

Donald C. Langevoort

This paper can be downloaded without charge from the

Social Science Research Network Electronic Paper Collection at

http://papers.ssrn.com/papers.taf?abstract_id=241402



Preliminary Draft: 9/8/00. All rights reserved. Do not cite or quote without seeking the author's permission.

*Professor of Law, Georgetown University Law Center. This project was supported by the Sloan Foundation--

Georgetown University Law Center Project on Business Institutions. I am very thankful to Margaret Blair, Ed Rock,

Charles Elson and participants at the University of Michigan's Olin Law and Economics seminar for constructive

comments.

1See Bayless Manning, The Business Judgement Rule and the Director’s Duty of Attention: Time for Reality, 39 Bus. Law.

1477 (1984).

2 See MYLES MACE, DIRECTORS: MYTH AND R EALITY (2d ed. 1986); JAY LORSCH & ELIZABETH MCIVE R , PAWNS OR

POTENTATES: THE R EALITY OF AMERICA’S CORPORATE BOARDS (1989).

3 See M ICHAEL USEEM, EXECUTIVE DEFENSE: SHAREHOLDER POWER AND CORPORATE R EORGANIZATION (1993); R OBERT A.G.

MONKS & NELL MINOW, CORPORATE GOVERNANCE (1995); Ira Millstein & Paul McAvoy,The Active Board of Directors and

Performance of Large Publicly Traded Corporations, 98 Colum. L. Rev. 1283 (1998); James Tobin, The Squeeze on Directors:

Inside is Out , 49 Bus. Law. 1707 (1994); Ronald J. Gilson & Reinier Kraakman, Reinventing the Outside Director: An Agenda

for Institutional Investors, 43 Stan. L. Rev. 863 (1991); Robert C. Pozen, Institutional Investors: The Reluctant Activists, Harv.

Bus. Rev., Jan.-Feb. 1994, at 140.

4 See M ELVINA. EISENBERG, THE STRUCTURE OF THE CORPORATION 140-48 (1976); Eugene F. Fama & Michael C. Jensen,

Separation of Ownership and Control , 26 J. L.& Econ. 301 (1983). This idea is now expressly embodied in the American Law

Institute’s Principles of Corporate Governance, section 3.01 (1994).

5 This "shareholder-only" characterization is not inevitable as a matter of law or policy. See Margaret Blair & Lynn

Stout, A Team Production Theory of Corporate Law, 85 Va. L. Rev. 247 (1999); Mitu Gulati et al.,Connected Contracts, 47 UCLA

L. Rev. 887 (2000). My paper takes an agnostic view on whether a broader characterization is the better one, though I

am sympathetic to the effort.

The Human Nature of Corporate Boards: Law, Norms and the Unintended

Consequences of Independence and Accountability

Donald C. Langevoort*

Studies of corporate boards of directors often observe team-like traits. Invitations to the board

are based heavily on matters like compatibility and “fit.” The work of the board prizes consensus, not

conflict.1 Absent some sort of crisis, outside members see their value largely in terms of constructive

advice, giving insiders the benefit of an expert external perspective on the company's uncertain world.2

This sunny image is subject to two interpretations. The dominant view in corporate governance

theory today is that heavy emphasis on teamwork and conflict-avoidance marks a board that has been

captured by its CEO, an illusion of a governing body that acts largely as an elite private club with a rubber

stamp. Much of the work in corporate governance over the last twenty-five years in academic circles and

in the lobbying efforts of shareholder activists has been to extinguish this kind of board. 3 Their goal is to

replace it with the new-style “monitoring” board,

4

where independence, skepticism and a rigorous loyaltyto shareholder interests5 are the dominating norms. By most accounts, this effort has had some noteworthy

successes. In the United States, independent boards have become common for larger corporations – in




6 See Sanjai Bhagat & Bernard Black, The Uncertain Relationship Between Board Composition and Firm Performance, 54 Bus.Law. 921, 921-22 (1999).

7 E.g., Brian Cheffins,Corporate Governance Reform: Britain as an Exporter , in HUME PAPERS ON PUBLIC POLICY: CORPORATE

GOVERNANCE AND THE R EFORM OF COMPANY LAW (2000).

8 For a recent review of the finance literature, see Bhagat & Black, supra. This literature is voluminous, and breaks down

associations between board make-up and a wide variety of performance outcomes, from general profitability and stock

price performance to factors such as bankruptcy, shareholder lawsuits, CEO turnover and the like.

9 Id. at 950.

10 See Jill E. Fisch,Taking Boards Seriously, 19 Cardozo L. Rev. 265 (1997); Laura Lin, The Effectiveness of Outside Directors

as a Corporate Governance Mechanism: Theories and Evidence, 90 Nw. U. L. Rev. 898 (1996).

11 See Catherine M. Daily et al., On the Measurement of Board Composition: Poor Consistency and a Serious Mismatch of Theory

and Operationalization, 30 Dec. Sci. 83 (1999).

12 For a classic lament, see Victor Brudney, The Independent Director – Heavenly City or Potemkin Village?, 95 Harv. L. Rev.

597 (1982).

13 This, of course, might just show the general irrelevance of directors. See Fisch, supra, at 278-79.

fact, a majority of such companies have reduced insider presence to a small fraction6 – and these boards

do seem to be more activist. Many other countries are mimicking this emphasis on director independence

as they seek to make their systems of corporate governance more attractive to investors.7

The trend toward independence, however, has encountered an empirical sticking-point. If

independent boards are so self-evidently desirable, then we should see a fairly clear statistical correlation

between measures of board independence and corporate profitability or stock price performance. But a

growing body of economics research has been unable to find any such connection.8 Indeed, Bhagat and

Black make the case in a recent influential study that if anything, there is evidence “suggesting the opposite

– that firms with supermajority independent boards perform worse than other firms, and that firms with

more inside than independent directors perform about as well as firms with majority – (but not

supermajority-) – independent boards.”9

This is something of an embarrassment to modern dogma, as a number of noted legal scholars have

recently emphasized,10 although it is hardly fatal. Researchers concede that measurement problems plague

empirical work in this area.11 “Independence” is a subjective concept that connotes a willingness to bring

a high degree of rigor and skeptical objectivity to the evaluation of company management and its plans and

proposals. However, these studies have to use rough proxies for independence: the simple absence of a

job with the company, a close family connection or (perhaps) some regular stream of income from thecompany apart from directors’ fees and dividends are all that it take to qualify. Under these restrictive

definitions, many directors who lack any real desire to take their monitoring role seriously – who are on the

board for reasons of status-seeking, sociability or the perquisites that come from board membership – fall

into the “independent” category,12 thereby muddying the data.13 If we could identify truly independent

directors more precisely, maybe we would find the expected correlation.

Perhaps so, but there is another possibility. The other plausible interpretation of board cohesion

is that it rests on a sound intuition: that the most productive boards are ones where insiders and outsiders




14 See Leslie Levy, Reforming Board Reform, Harv. Bus. Rev., Jan.-Feb. 1981, at 166. See also Paul Furstenberg & Burton

Malkiel, Why Corporate Boards Need Independent Directors, 69 Mgt. Rev. 26 (April 1980)(insisting on independence, but

within a setting of collegiality).

15 See Bhagat & Black, supra; Barry Baysinger & Robert E. Hoskisson, The Composition of Board of Directors and Strategic

Control: Effects on Corporate Strategy, 15 Acad. Mgt. Rev. 72 (1990); April Klein, Firm Performance and Board Committee

Structure, 41 J. L. & Econ. 275, 278 (1998)(role of insiders on investment and strategy committees).

16 See also John W. Byrd & Kent A. Hickman, Do Outside Directors Monitor Managers?, 32 J. Fin. Econ. 195 (1992)(finding

the strong presence of outside directors improves the profitability of acquirors in takeover activity, but that much of this

value is lost when there are too many outsiders).

17 Bhagat and Black end their article by posing a set of possible explanations, without exploring them in much depth.

My goal is both to elaborate on some of these possibilities, and add to the list.

18 In using these materials, I recognize that they also offer reasons to doubt the effectiveness of board oversight

generally, by insiders or outsiders. The classic use of such materials as an attack on director independence, at least in

the context of review of shareholder litigation, is James D. Cox & Harvey Munsinger, Bias in the Boardroom: Psychological

Foundations and Legal Implications of Corporate Cohesion, 48 L. & Contemp. Probs. 83 (1985); see also Robert Haft, Business

Decisions by the New Board: Behavioral Science and Corporate Law, 80 Mich. L. Rev. 1 (1981). For a creative use of similar

materials in advocating a new two-tiered approach to board structure, see Lynne Dallas, Proposals for Reform of Corporate

Boards of Directors: The Dual Board and Board Ombudsperson, 54 Wash. & Lee L. Rev. 91 (1997).

19 Notwithstanding the similar terminology, my emphasis on the board as a “team” should not be confused with the

separate vision articulated by Blair and Stout of the board as a mediating mechanism for the broader "team" that make

work cooperatively, not at odds with each other.14 If this is so, the monitoring norm misses something

important. To this end, some scholars, including Bhagat and Black, have suggested that a positive case can

be made for a judicious mix of inside and outside directors as the optimal board structure.15 Some

independence is essential on boards, they agree, but there can be too much of a good thing.16

In light of the contemporary dominance of the monitoring image of the corporate board, however,

any such proposal demands a compelling explanation. How could a mixed board possibly perform better

than a super-independent one, given the agency cost problems that plague corporate governance?17 The

existing contrarian literature offers some answers – for example, the informationally-advantaged insight that

insiders bring to board deliberations. But I don't find this set of explanations convincing enough. My aim

in this paper is to do better, pushing the account for the costs of too much independence and the benefits

of balance further than it has. My primary tool (though not the only one) will be work from the disciplines

of organizational behavior and social cognition.18

Part I deals directly with the composition question. It offers two different ways of thinking about

insiders' place on the board. First, borrowing from literature on directors' reputational capital, I argue that

insider presence on the board may be seen as a way of both (a) countering predictableoutsider biases and

(b) making an implicit representation to the company's middle managers that the motivationally-crucial

"tournament" for promotion and monetary rewards will be maintained and protected. Second, and morecentrally, I contend that too much true independence in the boardroom has unintended consequences: by

reducing the level of trust that comes from closer or less adversarial relationships, it chills communication,

leads to a variety of influence activities by insiders, and produces more complicated (and less useful)

agendas and debates. It interferes with the board as a productive team in all its capacities, including

monitoring.19 I would add one additional wrinkle. Given these social dynamics, it may be that optimally




up the corporation. See note --- supra.

20 See, e.g., Jennifer G. Hill, Deconstructing Sunbeam: Contemporary Issues in Corporate Governance, 67 U. Cinn. L. Rev. 1099(1999).

21 See Melvin A. Eisenberg, Corporate Law and Social Norms, 99 Colum. L. Rev. 1253, 1280-81 (1999); Edward B. Rock &

Michael L. Wachter, Islands of Conscious Power: Norms and the Self-governing Corporation (unpublished

manuscript)(2000)[cite?].

22 Like most empirical researchers, the law in most states tends not to use that functional test, but instead measures

independence more objectively, by lack of family relationship, pecuniary dependency or self-evident domination by the

CEO. See Aronson v. Lewis, 473 A.2d 805 (Del. 1984); In re Disney Co. Derivative Litig., --- A.2d --- (Del. 2000). This

means that many formally independent directors will not be serious monitors at all, but simply status-seekers or friends

of the CEO. That the law in some conflict of interest settings defers to the judgments of outside directors simply on the

basis of formal independence cannot be justified in terms of actually anticipating good decisions from them. Rather, it

is a desire for predictability and judicial efficiency, coupled with some sense of "just desserts" for the shareholders who

voted them into office. See Norman Veasey, An Economic Rationale for Judicial Decisionmaking in Corporate Law, 53 Bus.

Law. 681 (1998). Put simply, I suspect that judges fear the consequence in terms of both the number and difficulty of

derivative lawsuits when the subjective independence of directors is subject to challenge. On the legal significance of

director independence, the debate over the ALI's Principles of Corporate Governance project was focal. For contrasting

views, see Stephen M. Bainbridge, Independent Directors and the ALI Corporate Governance Project , 61 Geo. Wash. L. Rev.

1064 (1993); James D. Cox, The ALI, Institutionalization and Disclosure: The Quest for the Outside Director's Spine, 61 Geo.

Wash. L. Rev. 1233 (1993); Roberta Karmel,The Independent Corporate Board: A Means to What End?, 52 Geo. Wash. L. Rev.

535 (1984).

functioning boards require not only a mix of insiders and monitors but also some class of board members

who can function effectively as mediators, reducing some of the dysfunctional effects that come from the

inevitable polarization. While there is no obvious test for who these mediators might be, there is a good

possibility that both CEO’s of other companies and so-called “gray” directors – lawyers, investment

bankers, etc. with affiliations to management – might play this role fairly well. If so, we should hesitate

before discouraging such directors from serving. Yet this group is a target in many recent reform proposals.

All of this proceeds from the idea that independence for a director is an attitude of healthy

skepticism vis-à-vis management. Some recent efforts at policy-making have been efforts to encourage

such a state of mind among outside directors by increasing the liability exposure for directors who fall down

on the job and fail to prevent some form of misbehavior by insiders.20 Here again, however, we face the

problem of unintended social and psychological consequences of stepped-up liability that deserve to be

factored into the policy-making calculus. This is the subject of Part II.

Notwithstanding the long-standing legal interest in board independence, I share the sense of many

commentators that the law has played a relatively minor role in the evolution of board structure and

behavior: market and other social forces are far more important.21 Indeed, I suggest leaving the matter of

board independence and accountability largely to these extralegal incentives. But the relationship between

corporate law and corporate norms is complicated. Thus, Part III concludes by posing a set of still openquestions about law and norms in the corporate setting and suggesting a research agenda for further work.

Before beginning, one note of caution. My use of the term "independent" director is exceedingly

subjective – that is, as suggested above, one who actually takes the monitoring task for the benefit of the

shareholders and/or other constituencies seriously.22 This leads to an important caveat. While we can

document empirically the trend toward greater outsider presence on corporate boards, we cannot prove




23 See sources cited in note --- supra.

24 See Jonathan Johnson et al., Boards of Directors: A Review and Research Agenda, 22 J. Mgt. 409 (1996). For an earlier

study using these typologies, see Shaker Zahra & John A. Pearce, Boards of Directors and Corporate Financial Performance:

A Review and Integrative Model , 15 J. Mgt. 291 (1989).

25 On this role, see Patricia Dechow et al., Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject

to Enforcement Actions by the SEC , 13 Contemp. Acct'g Res. 1 (1996).

26 See Rafael LaPorta et al., Legal Determinants of External Finance, 42 J. Fin. 1131 (1997). We need not make any strong

claims that an independent board will do a very good monitoring job – there are ample reasons to doubt that directors

have the time, incentive or information to monitor fully. See James P. Walsh & James K. Seward, On the Efficiency of

Internal and External Corporate Control Mechanisms, 15 Acad. Mgt. Rev. 421 (1990); Jennifer Arlen & William Carney,

Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 U. Ill. L. Rev. 691; Hill, supra. In this sense,

board monitoring is only a piece of the agency cost solution, not sufficient in and of itself. Still, we will assume that some

monitoring is both possible and productive. See Benjamin Hermalin & Michael W. Weisbach, Endogenously Chosen Boards

of Directors and Their Monitoring of the CEO , 88 Am. Econ. Rev. 96 (1998).

by demographic evidence alone that there is in fact greater independence. That can come only from a hard

inside look at the people who make up any given board. There is ample anecdotal and indirect evidence

of a power shift toward greater de facto independence,23 and this paper will assume that there is a positive

aggregate correlation between the observed trend toward more outsiders and a normative inclination on

their part to monitor more aggressively. For any given company, however, outsider domination may simply

create a carefully-calculated illusion of board independence.

I. THEFUNCTIONS AND R OLES OF BOARD MEMBERS

A. The Standard Typology: The Three Well-Recognized Board Functions

The literature on boards of directors identifies three basic functions that boards perform. 24 The

first is the monitoring role, which itself divides into two parts. One is that board members select,

compensate and make implicit or explicit decisions regarding the retention of the chief executive officer and

(occasionally) other members of the senior management team. They also, albeit more infrequently, review

and cleanse conflict of interest transactions between senior managers and the company. The other partinvolves overseeing the process of accounting, financial reporting, auditing and disclosure, the mechanisms

by which investors and other stakeholders are able to make assessments about the performance of the

company and its management.25 These two monitoring functions are the heart of what the agency cost

model of the firm identifies as the central role for the board, necessary in light of managers' temptations

toward shirking or more explicit forms of self-interested behavior. In the absence of an effective monitoring

board, we would expect a diminished willingness of investors to invest in companies under conditions of

widely-dispersed share ownership. This is precisely, according to many comparative corporate law

scholars,26 what we observe in countries without independent boards of directors and the legal apparatus

to assure a reasonably high level of accountability to shareholders. There we find a much higher incidence

of controlling blockholders, whose own monitoring of company managers substitutes for independent boards and legal constraints.




27 See J. PFEFFER & G. SALANCIK , THE EXTERNAL CONTROL OF ORGANIZATIONS (1978). For a legal analysis, see Lynne

Dallas, The Relational Board: Three Theories of Corporate Boards of Directors, 22 J. Corp. L. 1 (1996).

28 See Anup Agrawal & Charles Knoeber, Outside Directors, Politics and Firm Performance (1997).

29 See William Judge & Carl Zeithaml, Institutional and Strategic Choice Perspectives on Board Involvement in the Strategic

Decision Process, 35 Acad. Mgt. J. 766 (1992); Baysinger & Hoskisson, supra.

30 This usurpation, when it occurs, is often driven by law, which may insist on board control over a particular matter.

On the judicial call for independentdirector involvement as a way of reducing the likelihood of judicial second-guessing,

see Weinberger v. UOP Corp., 457 A.2d 701 n. 7 (Del. 1983); Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del.

1985).

31 See M. EISENBERG, supra, at 157-58.

32 My exploration of these kinds of biases is Donald C. Langevoort, Organized Illusions: A Behavioral Theory of Why

Corporations Mislead Stock Market Investors (and Cause Other Social Harms),146 U. Pa. L. Rev. 101 (1997)[hereafter,Organized

Illusions].

33 See William Allen, Independent Directors in MBO Transactions: Are They Fact or Fantasy?, 45 Bus. Law. 2055 (1990).

The second board function, with a long tradition in the sociology of organizational behavior, is to

assist the company in claiming and protecting its shares of external resources.27 Carefully chosen board

members help make the company more legitimate in the eyes of key resource providers such as

governments, customers, labor and so on. Their connections can be of substantial use to the firm.28

The third function, something of a catch-all, is the so-called service role. Boards do help to

formulate corporate strategy, acting as a sounding board for the chief executive and senior management

team29 and providing external input into the strategic process. This role is the one often cited by board

members as their most valuable and satisfying one. On occasion -- as in a significant merger or acquisition

transaction – the board may actually take control of a strategic decision, displacing the management team

as the primary actors in the drama.30

But the service/strategic function is somewhat curious if seen as a completely distinct role from that

of monitoring.31 Why should the provision of advice, perspective and external expertise be a job for the

board? After all, managers who sense the need for these inputs can readily hire consultants, investment

bankers, lawyers and others for exactly the same good outside judgment. Maybe the service function is

better seen as just a different form of monitoring, to compensate for the cognitive biases -- as opposed to

the deliberate self-interest – of the managers and their organizational culture.32 A sizable body of research

in cognitive psychology indicates that, left to their own, managers tend to develop biased construals of thefirm’s strategic position. Moreover, they will be overconfident and heavily invested in those beliefs, and

hence disinclined to seek out information that would suggest that they might be wrong. Only by giving

formal power to a more objective group of outsiders (i.e., making them directors) can the insiders be forced

both to expose their biases and take dissonant viewpoints seriously. The rules encouraging independent

director control over particular decisions may also be a form of support for the monitoring function: those

decisions that require board (and certainly independent director) involvement are ones where management's

self-interest and biases are most clearly at stake.33

The resource-gathering function may or may not be subject to the same recharacterization. To be

sure, management can hire lobbyists, public relations advisers, lawyers and the like to increase the




34 There is a good bit of support from social psychology for the idea that status comparisons exert a great influence on

both cognition and behavior. The consultant who works for the company, no matter how well compensated, is still a

subordinate. Only board membership creates the potential for status equivalency for the kinds of persons who best

perform these functions.

35 See J. LORSCH & E. MCIVER , supra, at 26-30; Dallas, supra, at 104.

36 This reputational hostage notion is a familiar one in evaluating directors vis-à-vis capital providers, though in some

formulations it is based on the special desire for certain individuals to have multiple directorships. See Fama & Jensen,

supra, at 315. Dallas, supra, suggests this mediating function with respect to other stakeholder groups, without using

the hostage metaphor.

37 See Blair & Stout, supra; Gulati et al., supra.

38 Though one interesting (and not well explored issue) is how boards come to conclusions. A "majority rules" regime

would suggest that minority representation has low value. But one in which consensus is prized (see Manning, supra)

gives minority members more bargaining power.

likelihood that key resource providers will look with favor on the firm. Why, then, would it be necessary

for board members to play this role? There are two intuitive answers here. One is that competition for the

best external resource providers is sufficiently intense that they can be attracted to the firm most readily by

conferring status (placing the person at the top of the hierarchy with an elite set of others 34) as well as

compensation.35 Gaining such status triggers a reciprocal sense of responsibility, which may be a useful

motivator by making the person more committed as the company's champion in the hyper-competitive

market for resources and legitimacy. But another explanation is also possible. To the extent that, say,

banking officials are pleased to find a given person on a financial institution's board, it is because they

believe that the person will use her board power and influence in a particular way. In this sense, the

director's reputation is put forward as a form of commitment that the company will be sensitive to the

external interests in question.36 Of course, the commitment may not be sincere, and even if intended

sincerely when the director was elected, there is no guarantee those interests will be respected by the full

board later on. The hostage may be sacrificed. But at least potentially, the director's reputation is on the

line and the director can be expected to work vigorously to protect it.

This can still be seen in monitoring terms – albeit a very different form of monitoring. The well-

connected "hostage" director makes an implicit promise to use her authority to prevent the company from

acting in an overly opportunistic way vis-à-vis the external interest in question. In this sense, she is at leastin part a monitor for that interest. This broader view of monitoring does not fit within the conventional sense

of the board as agents solely for the firm's shareholders. Within that convention, the hostage role must be

seen as a separate and independent (i.e., non-monitoring) function for at least some members of the board

to play. On the other hand, the "monitoring hostage" role fits quite comfortably within broader stakeholder

or team production models of corporate governance.37

In a world heavy with rationality, of course, it is hard to see that constituents would put that much

weight on director's reputations, unless the directors involved made up a sizable fraction of the board. This

seems to be a fairly low-powered form of stakeholder protection.38 Here, we should note the palpable

tension between conventional economics and the other social sciences on the matter of symbolism. In

sociology and psychology, symbols -- as in the choice of a particular set of directors -- have an influence




39 E.g., Andrew Brown, Politics, Symbolic Action and Myth Making in Pursuit of Legitimacy, 15 Org. Stud. 861 (1994); John W.

Meyer & Brian Rowan, Insitutional Organizations: Formal Structures as Myth and Ceremony, 83 Am. J. Soc. 340 (1977).

40 See Donald McCloskey & Arjo Klamer, One Quarter of GDP is Persuasion, 85 Am. Econ. Rev.

(Papers & Proc.) 191 (1995).

41 See James D. Westphal & Edward J. Zajac, The Symbolic Management of Stockholders: Corporate Governance Reforms and

Shareholder Reactions, 43 Ad. Sci. Q. 127 (1998).

42 Unfortunately (but understandably) the authors do not test whether stock prices declined once it was determined

there would be no implementation. The authors suggest, however, that their data shows a reaction to the symbol of

announcement – with special sensitivity to the rhetoric employed – and not simply a rational prediction that the plans

may or may not be implemented. They point out that there was already substantial evidence of non-implementation from

rational investors could have drawn warning signals.

43 Much work in behavioral finance seeks to identify situations where investors (particularly individual ones trading

in thinner markets) overreact to highly salient but non-particularly informative information – i.e., react to events more

symbolic than real. E.g., Peter Klibanoff et al., Investor Reaction to Salient News in Closed-end Country Funds, 53 J. Fin. 673

(1998)(correlating price movements in closed-end foreign country funds to the column width of news coverage in the

New York Times). See generally HERSH SHEFRIN, BEYOND GREED AND FEAR : U NDERSTANDING BEHAVIORAL FINANCE AND

THE PSYCHOLOGY OF I NVESTING 184-89 (2000).

well beyond the rational message.39 The whole field of public relations (on which commercial and political

actors spend immense sums of money in the real world40) is based on the belief that symbolic actions have

great power to attract support and allegiance, well beyond the informational content of the message. At

this point, we can do little more than suggest that more work needs to be done before deciding one way

or another how the choice of one or two directors might affect the expectations of external constituencies.

But such work surely is warranted, perhaps even as it relates to core stakeholder groups like investors,

where claims of market rationality have long dominated. Along these lines, a study of the announcements

of voluntary performance-based compensation reforms found that upon announcement, stock prices

increased.41 This was especially so when the disclosures were heavily laden with pro-shareholder, agency-

cost rhetoric. What was surprising was not only the effect of the rhetoric, but that this reaction occurred

even though the plans were not yet implemented, and in a large number of cases never were.42 Perhaps

even in the world of investing – and maybe even with respect to things like board independence – symbols

matter more than we think.43

B. The Positive Case for a Balanced Board

If we are searching for a case against board independence, we are now far off course. The

foregoing would simply seem to strengthen the case for independent boards. Independence is essential to

good monitoring, and as we have just seen, the service and resource-oriented functions probably are best

performed by outsiders as well. Yet we seldom observe complete domination by outsiders, and the

empirical work noted at the outset of this article suggests that such clear-cut domination may be costly in

terms of profitability and productivity. The search, then, is for a good set of reasons why.

The most conventional justification for a critical mass of insiders is the idea that insiders bring a

special and detailed knowledge of the company – its history, personnel, prospects and the like that is




44 See sources cited in note --- supra.

45 See R OBERT CLARK , CORPORATE LAW 108-09 (1986).

46 See Sanjai Bhagat et al., Director Ownership, Corporate Performance and Management Turnover , 54 Bus. Law. 885 (1999);

Charles M. Elson, Director Compensation and the Management-Captured Board: The History of a Symptom and a Cure, 50 SMU

L. Rev. 127 (1996).

47 In making this argument, I do not want to ignore the possibi lity that insider presence also operates as something of

a commitment to other constituencies as well. The argument has been made, for example, that creditors value insider

presence on the board as an alignment with their interests as against the very conflicting ones of equity holders

48 Hermalin and Weisbach observe that CEO's will have some say over who is on the board, so that the extent of the

anticipated monitoring will be a function of the CEO's performance-driven bargaining power. See Hermalin & Weisbach,

supra. This concept of bargaining is also part of the account of corporate governance in Gulati et al., supra.

essential to at least the service work of the board.44 But for the same reasons suggested above, this is far

from necessary. One can readily have insider participation in board deliberations, on a regular and invited

basis, without conferring the attendance and voting rights that are the essence of director status. A fully

independent board can make use of whatever inside talent it wants, including inviting full participation in

deliberations, before moving (privately or not) to a vote.

Another claim in the literature carries more weight. Perhaps insiders bring a higher level of

motivation to the task of monitoring and strategic decision-making. They are heavily invested in the

corporation, whereas the typical outsider is not.45 Adding insiders might have a positive influence on the

work habits of the board. While I do not doubt this explanation, it can readily be met with an alternative

remedy that does not involve compromising board independence: creating more high-powered incentives

for outside directors, largely through stock ownership requirements and compensation plans.46

So, the search for a justification for full insider status for a significant portion of the board should

proceed further. Two additional lines of inquiry strike me as promising:

1. The Stakeholder Argument Flipped: Senior and Middle Managers as Key Constituents,

and the Problem of "Outsider Bias"

In the last section, we considered the possibility that a segment of the board might be chosen as

a way of holding those directors' reputations hostage vis-à-vis some constituency besides investors. The

examples used there were labor, community and government-oriented directors. The most obvious

explanation for the value of adding insiders to the board simply extends this logic to the firm's managers as

a constituency. After all, it is the company's management that makes the largest investment of firm-specific

capital, throwing their lot both in terms of reputation and financial well-being to the company as a collective

(or at least the performance of identifiable sub-groups within).47 Naturally enough, they want some

measure not only of influence but control, and the choice of a critical mass of directors whose jobs and

reputations depend on taking due account of managerial interests would be one way of gaining such control.

While this could simply be characterized as a political bargain over control,48 there is probably agood bit more to it. Recall earlier that we said the presence of outsiders is important to counter the myopic

biases of the senior managers. Conversely, we might ask whether the presence of insiders might serve as

a comparable counterweight to predictable outsider biases. Outsiders lack detailed knowledge of the




49 See Michael Weisbach, Outside Directors and CEO Turnover , 20 J. Fin. Econ. 431 (1988). Weisbach hints that outsiders

directors may weight stock price performance heavily in deciding whether to replace the CEO, so that they tend to react

too slowly unless and until there is a stock price shock. Id. at 454-55. On the implications of this point for board

structure, see Bhagat & Black, supra; Hill, supra, at 1108-09. For an interesting study of a corporate failure arguably

attributable to too much outsider influence, see D. Gordon Smith, Corporate Governance and Managerial Incompetence:

Lessons from K-Mart , 74 N.C. L. Rev. 1037 (1996).

50 See MAX BAZERMAN, JUDGMENT IN MANAGERIAL DECISION MAKING 37-39 (3d ed. 1994)

51 See Gulati et al., supra.

52 See Gerard Hertig, Corporate Governance in the United States as Seen from Europe, 1998 Colum. Bus. L. Rev. 27, 41-42

(1998).

53 This produces a number of interesting consequences, not the least of which offers some insight about the moral

character of those who succeed. See R OBERT JACKALL, MORAL MAZES: THE WORLD OF CORPORATE MANAGERS (1988).

Jackall points out that the succession of tournaments in an organization – “probationary crucibles” requiring shifting

loyalties to a series of teams – encourages the development of ethical plasticity (a highly flexible, relativist and self-

protective sense of right and wrong).

firm's inner workings, and are likely to use fairly heuristic forms of though tied to readily observable data

(e.g., stock prices).49 If they are nonetheless overconfident in their inferences about the firm – a common

human tendency, especially among the highly successful50 – they will not draw on insider expertise to the

extent that would be prudent. Give them complete control and these egotistical group biases will be

unchecked. Making them share control with managers, by contrast, forces them to reckon with the more

informed, if sometimes unreflective, insight that management naturally has. The idea of a balanced board

as a symmetrical de-biasing mechanism has not yet been explored in the literature, but deserves

consideration.

If some form of the control-bargain story is plausible, the interesting question becomes how we

define the relevant managerial constituency. The initial temptation is to think in terms of the senior

management team currently in place. They have an immense amount at stake, and – like coaches of

professional sports teams who insist on control over player personnel decisions as well51 – we can readily

understand their desire to insist on a place on the board, not just an expectation that they will be listened

to.

However, my sense is that the key managerial constituency is not only the senior team. After all,

the top managers have strong bargaining power, and can use explicit contracting (especially severance

protection and performance-based compensation) as a trade-off against control. By contrast, as somescholars have begun to see, one of the underestimated elements in the study of corporate governance is the

role of middle management.52 Many managerialist accounts locate the real day-to-day control over the firm

not in its senior management team but more diffusely among the many executives whose line responsibilities

both carry out the often abstract strategy announced at the top and provide the information flow from which

future top-level strategic decisions derive.

These are the line and staff managers, who are almost always hired at-will, and inhabit an intensely

political, hierarchical world of "teams" that support the firm's business activity. Just as important, they –

especially the younger, more mobile ones – compete in a tournament of successive assignments of two or

three year duration,53 after which the successful vis-à-vis their peers move up to the next level and begin




54 The tournament concept is a well-used conceptualization of many elite labor markets. See R OBERT FRANK , THE

WINNER TAKE ALL SOCIETY; Edward P. Lazear & Sherwin Rosen, Rank-Order Tournaments as Optimum Labor Contracts,

89 J. Pol. Econ. 841 (1981). In legal settings, see M ARC GALANTER & THOMAS PALEY, TOURNAMENT OF LAWYERS: THE

TRANSFORMATION OF BIG LAW FIRMS (1991); David Wilkens & Mitu Gulati, Why Are There So Few Black Lawyers in

Corporate Law Firms: An Institutional Analysis , 84 Cal. L. Rev. 496 (1996). Obviously, firms to hire in the external labor

market; indeed inter-firm mobility is a key feature of today's economy. The human relations challenge is incorporating

this phenomenon without damaging internal morale.

55 This particular point has been made in the existing literature as a justification for insider presence on the board. See

Weisbach, supra, at 433-34; Bhagat & Black, supra, at 950.

56 See Byrd & Hickman, supra. They suggest that firms with independent directors are less likely to pursue such

acquisitions -- though the value is lost if there are too many outsiders. See also Bhagat & Black, supra, at 928-29.

57 Conventionally, this bias refers to "empire-building" or other self-serving acts by the company senior managers. On

the bias generally, see Bernard Black, Bidder Overpayment in Takeovers, 41 Stan. L. Rev. 597 (1989). There are many other

explanations, including overoptimism. See Matthew Hayward & Donald Hambrick, Explaining the Premiums Paid for Large

Acquisitions: Evidence of CEO Hubris, 42 Ad. Sci. Q. 103 (1997).

the competition anew.54 Although year-by-year compensation can be based somewhat on team

performance, the most high-powered incentive here is the right to move on toward the place of delayed

but exorbitant pecuniary, power and status rewards, a spot on the senior management team.

I suspect that many inside directors act put their reputations at stake to implicitly vouch for the value

of the tournament to younger generations within the firm. Just as in the other stakeholder contexts, that

does not mean the same thing as guarantee: these inside directors may lose a battle, or sell out their

reputations for some other form of gain. But the presence on the board of a critical mass of persons whose

agenda includes "tournament protection" is meaningful, practically and symbolically, to the mobile segment

of middle and upper-middle managers. Having such a block on the board is likely give voice to a bias for

promoting from within when possible. Moreover, the very presence of multiple “inside” seats gives insiders

a special opportunity to perform visibly for other board members and create social ties that enhance the

possibility of selection as the “CEO in waiting.”55

This implicit directorial role, if powerful enough, has some important consequences. One obvious

one is pressure toward both the growth and autonomy of the company. 56 When their firm is acquired by

another, the acquiror takes over control of the tournament and hence can be expected to bias it in favor

of its own upwardly mobile middle managers. The decline in opportunities for acquiree managers, even

if they do not actually lose their existing jobs, is painful. By contrast, firms that remain independent at leasthave a chance at preserving their tournament, and those that assume the preferred role of acquiror get to

enlarge the size and quality of their own tournament. I have long suspected that a portion what is often

described as an often unprofitable "acquisition bias"57 among American corporations is in fact driven by

senior managers' desire – conscious or not – to benefit the talented subordinate executives in the firm. As

they ascend, these middle managers face the inevitable risk of a slow-down in the pace of their careers as

the pyramid narrows, unless the size of the pyramid increases.

As an aside, I also suspect that directors who see middle and upper middle managers as their key

constituency have a related agenda that conflicts with their shareholder protection role. If the key is

encouraging talented middle managers to keep playing aggressively in the tournament, then it becomes

essential to foster a sense of optimism about the firm's prospects. Organizational optimism promotes trust,




58 See Langevoort, Organized Illusions, supra, at 155-56; see also Lawrence E. Mitchell,Trust and Team Production in Post-

Capitalist Society, 24 J. Corp. L. 869 (1999).

59 See Gerald Salancik & James R. Meindl, Corporate Attributions as Strategic Illusions of Management Control , 29 Ad. Sci.

Q. 238 (1984).

60 See Cox & Munsinger, supra; Dallas, supra, at 105-10.

61 See Daniel P. Forbes & Frances J. Milliken, Cognition and Corporate Governance: Understanding Boards of Directors as

Strategic Decision-making Groups, 24 Acad. Mgt. Rev. 489 (1999).

62 And conversely, close-knit groups are more productive. See Charles Evans & Kenneth Dion, Group Cohesion and

Performance: A Meta-Analysis, 22 Small Group Res. 175 (1991). Group productivity is often also a function of smaller size

(which increases the likelihood of cohesion), thus leading to suggestions that boards of directors should generally be

smaller than many currently are. See Dan Dalton et al., Number of Directors and Financial Performance: A Meta-Analysis, 42

Acad. Mgt. J. 674 (1999).

delayed gratification, and host of other cooperative forms of behavior by middle managers.58 In contrast,

pessimism triggers selfish, last-period behaviors. Directors committed to the efficacy of the tournament can

be expected to adopt a perspective that the firm has better control over its environment than some more

dispassionate observers might consider reasonable.59 While this posture might occasionally be a

manufactured form of corporate "spin," there is strong reason to suspect that those who passionately feel

such optimism may be the most likely winners of their own tournaments and most credibly communicate

it to others once they reach the top. In performing this role, they essentially disqualify themselves from

acting as useful monitors of the candor of corporate disclosures.

By pushing expansion plans and eschewing candor, insiders may impose a cost on firm

performance. But this is nothing new. All that the foregoing goes to show is that insider presence poses

a mix of costs and benefits. Arguably, these might be managed best by having a significant insider presence

on the board that is nonetheless balanced by strong outsider presence.

2. Intra-group Dynamics, and the Role of Trust

a. Diversity versus collegiality

Boards of directors are small groups.60 As such, they are subject to the same social and

psychological influences as small groups generally. To the extent that boards are expected to work at some

task – be it monitoring, resource gathering or service – it is worth considering what impact the structural

balance on the board is likely to have on how well that task will be performed. In other words, we should

relate structure to the efficiency of the board as a work group.

Getting groups to make good decisions is always a challenge. Intuitively, the likelihood of multiple

viewpoints and different sets of information should be a positive factor in the deliberative process, and

sometimes it is. But a variety of forces conspire to blunt the quality of group decisions. The time consuming

and often unpleasant task of coming to consensus is aversive absent high-powered incentives to succeed

– studies show that the more dissension there is in a group, the less committed members become to it.61

Highly "diverse" groups are negatively associated with good performance.62 As one article relating this to

board behavior says, "[W]hen a board's meetings are dominated by prolonged debates between two




63 Forbes & Milliken, supra.

64 See IRVING JANIS, VICTIMS OF GROUPTHINK (1982); Philip Tetlock et al., Assessing Political Group Dynamics: A Test of the

Groupthink Model , 63 J. Pers. & Soc. Psych. 403 (1992).

65 See Cox & Munsinger, supra.

66 See Levy, supra, at 168.

individuals, cognitive conflict may actually inhibit the use of members' knowledge and skills."63 In contrast,

highly collegial groups create a better environment for productive work. Unfortunately, they are subject

to different flaws: most famously, the notion of "groupthink". That phrase, invented by Irving Janis,64 refers

to the tendency of cohesive groups to implicitly (indeed, subconsciously) censor non-preferred points of

view and any information inconsistent with what is preferred. Such implicit censorship is a stress-reducing

mechanism that preserves group solidarity. The key, then, seems to be moderation. The most productive

boards are ones that have enough diversity to encourage the sharing of information and active consideration

of alternatives, but enough collegiality to sustain mutual commitment and make consensus-reaching

practicable within the tight time frames that boards operate.

That is a tricky balance to achieve and maintain. For a variety of reasons, the natural gravitational

pull is away from diversity and toward collegiality. Boards self-select, often with strong input from the chief

executive officer. The natural inclination, as we have seen, is to choose those who will "fit" well with

existing members. The invitation itself creates a strong pressure: the norm of reciprocity, strongly felt in

American culture, inclines people to support those who have favored them in the past. And once one the

board, social ties build so that, as Cox and Munsinger famously demonstrated in their study of board

structural bias,65 those members committed to the group gradually develop a sense of "in-group" bias that

colors how they evaluate claims by others (e.g., derivative lawsuits brought by shareholders) that threatenone or more members of the group. To this one might add another strong tendency: to be overcommitted

to decisions once made, and resist evidence that a mistake has been made. A board that selects or decides

to retain a chief executive officer is likely to see subsequent events in a light most favorable to the CEO,

for otherwise, they bear some of the blame.66 One reason for having a sizable number of independent

directors on the board is to create a critical mass of mutual support for resisting the centripetal pressures

of cognitive conformity. But as we are about to see, too much independence also has some unexpected

costs.

b. Enter the CEO

The dynamics of board behavior become more complicated when we consider the presence of the

company's insiders. Consistent with almost universal practice, assume that the company's chief executive

officer is a member of the board. Assume also that the board has a large number of outsiders. If, for any

of the reasons just discussed, the CEO sees the other board members as weak monitors, then she can

largely turn her attention to other priorities. This does not mean that she will be free to shirk. Other

incentives, such as her compensation package or market forces affecting the firm, might still be strong

constraints. But at least her sense of “in-house” autonomy grows. On the other hand, to the extent that

the CEO expects the outsiders to take their monitoring task seriously, there is a serious dilemma in terms




67 See James D. Westphal & Edward Zajac, Defections from the Inner Circle: Social Exchange, Reciprocity, and the Diffusion

of Board Independence in U.S. Corporations, 42 Ad. Sci. Q. 161 (1997).

68 See Stephen Bainbridge, Participatory Management Within a Theory of the Firm, 21 J. Corp. L. 657, 680-96 (1996);

Langevoort, Organized Illusions, supra, at 119-26.

69 See James D. Westphal, Board Games: How CEO’s Adapt to Increases in Structural Board Independence from Management ,

43 Ad. Sci. Q. 511 (1998). This possibility is raised briefly in Bhagat & Black, supra. The transaction cost economics

literature has long identified the “influence tactics” problem as a severe agency cost problem. See, e.g., Paul Milgrom

& John Roberts, An Economic Approach to Influence Activities in Organizations, 94 Am. J. Soc. S154 (Supp. 1988).

70 See TAN --- supra.

71 Westphal, supra, rightly notes that given the difficulty of board evaluation of CEO performance in light of the noisy

informational environment that exists, CEO influence and ingratiation techniques may well pay off. Westphal, supra,

at 532.

of strategic interaction with the board. Such aggressive monitoring might come from external forces (a

powerful shareholder block), some increase in the directors' own equity holdings, or an attitude shift. On

the latter point, there is an interesting research study that suggests that directors who are CEO's of other

companies become, for psychological reasons, more assertive externally after outside directors at their own

companies seek internally to assert more control over them.67 Such assertiveness can then become

contagious, creating a norm.

There are two kinds of problems that can arise within the boardroom from this. The strategic

dilemma for the CEO comes in terms of communication of information to the board. The senior

management team has a large stock of private information about how the company is being run, the day-to-

day strategic decisions being made, and (especially) likely future performance. This stock of information

is by no means perfect: senior management teams are themselves informationally at the mercy of their

subordinates,68 with strategies for encouraging optimal information flow that will succeed only some of the

time. But it is far superior to what the board has or, given the limits of time, attention and staff, capable of

eliciting on its own.

In the face of serious monitoring, the CEO will be very careful in what she tells the outsiders and

what she doesn't.69 (This is especially so if the CEO anticipates that the outsiders use very heuristic modes

of evaluation – overweighting highly salient numbers and measures70). The goal is to maximize the perceived reputation of the CEO and her team in the context of bargaining over compensation and tenure,

rather than painting an accurate portrait of the firm's prospects. This does not mean deceit, necessarily,

because the outsiders may eventually learn much about the historical performance of the firm via audited

financial reports and other sources of data. If they feel mislead, the CEO's reputation sinks and her job

is in jeopardy. But still, if she senses that full disclosure will have a large enough adverse impact on her

compensation package or prospects for continued employment, there is a strong last-period temptation to

manipulate the information given to the board.71

This incentive to distort information and engage in other influence activities makes the task of

monitoring far more difficult, costly and unpleasant. If the outsiders sense the CEO's temptation and

respond with increased skepticism, the board implicitly subdivides into two separate coalitions, resultingin a growing (perhaps even exaggerated) level of mistrust between the two groups that further chills




72 See Ranjay Gulati & James D. Westphal, Cooperative or Controlling? The Effects of CEO-Board Relations and the Content

of Interlocks on the Formation of Joint Ventures , 44 Ad. Sci. Q. 473 (1999).

73 See James D. Westphal, Collaboration in the Boardroom: Behavioral and Performance Consequences of CEO-Board Social

Ties, 42 Acad. Mgt. J. 7 (1999). In a separate paper, Gulati and Westphal (see note --- supra) show that high measures

of trust based on social ties leads to a greater willingness of CEO’s to pursue joint ventures and strategic alliances with

firms to which there is some interlock connection.

74 Westphal, supra, at 9 (“[I]ndividuals seeking advice from a superior may need to disclose the existence of problems

and to admit their own limitations in solving them – implicitly or explicitly – thus relinquishing power derived from

information asymmetry in the agency relationship.”) For further explorations of this theme, see also Ashford &

Northcraft, Conveying More (or Less) Than We Realize: The Role of Impression Management in Feedback Seeking , 53 Org. Beh.

& Human Dec. Proc. 310 (1992).

75 Westphal, supra, at 20.

effective communication.72 As a consequence, the board becomes less productive as a unit.

This, in turn, severely limits the usefulness of the board's strategic advisory function. If the strategic

function were unimportant, this would be little cause for concern. But as we have seen, the strategic

function may be significant, especially as a form of corporate "debiasing." One prominent researcher who

has done work on intra-board relationships, James Westphal, has made the case for a positive correlation

between levels of trust between the CEO and the board and various measures of firm profitability.73 His

hypothesis is that absent relatively strong social ties between the CEO and the board, the CEO will be

reluctant to seek advice freely from board members who are his or her only real peers in terms of status

and experience. Such advice seeking runs the risk that they will be viewed as weak or dependent, and

requires relinquishing the informational advantage that they have vis-à-vis the board.74 On the other hand,

social ties create a more trusting environment in which such fears can better be put aside. Westphal's

empirical study finds – contrary to the conventional view that board friendships are dangerous to

shareholder interests because they compromise board independence – a statistically significant relationship

between measures of social ties and subsequent financial performance. This is especially so if the CEO

has other strong incentives (e.g., from a high-powered performance-based compensation package) to

pursue the shareholders' interests. Indeed, he concludes that "board effectiveness and ultimately, firm

performance, may be enhanced by close, trusting CEO-board relationships combined with moderate tohigh levels of CEO incentive alignment."75

In sum, there are at least three potential costs to worry about once a board is divided between

serious monitors and senior managers. One is decrease in the smooth functioning of the group as a result

of identifying two separate factions with separate roles. As such diversity increases, productivity slows.

The second is a loss of valuable information by the outsiders that would otherwise be provided in a more

trusting environment. Third, there is the increase in the time and attention the CEO devotes to influence

activities instead of more productive tasks. None of this implies that such diversity should necessarily be

abandoned entirely to eliminate these costs: such an abandonment might come at an even higher cost in

terms of lower quality monitoring and excessive cognitive conformity. But we now see why excessive

independence can compromise board effectiveness to some degree. There is a distinct trade-off between




76 Jill Fisch makes this trade-off point clearly, though not in these terms. See Fisch, supra, at 280-81; see also Brudney,

supra, at 632-38.

77 See Westphal, supra, at 10-11.

78 See Brudney, supra; Lin, supra, at 910-12. The SEC has recently become more aggressive in this area. See Role of

Independent Directors of Investment Companies, Sec. Act Rel. 7754, October 14, 1999.

79 For a suggestion that balanced boards are worse than either independent or insider-dominated boards on a variety

of performance measures, see John Wagner III et al., Board Composition and Organizational Performance: To Studies of the

Insider/Outsider Effect , 35 J. Mgt. Stud. 656 (1998).

80 See Mark J. Roe, German Co-Determination and German Securities Markets, 1998 Colum. Bus. L. Rev. 167 (1998).

aggressive monitoring and other tasks that board members perform.76

3. Steps in the Direction of Compromise: The Search for Mediating Directors

One message from all this is that the ideal board structure may be firm-specific, or in some cases,

industry-specific. As Westphal notes, if shareholders can have some confidence in the quality of the senior

management team's incentive compensation packages, or in market constraints imposed by product

competition, high leveraging and the like, there may be a case for diminished independence, especially

where the strategic and resource roles for the board are particularly valuable.77 On the other hand, there

are industries where the case for independence is compelling. The best example here is the mutual fund

industry, where conflicts of interest are commonplace and traditional checks on managerial overreaching

such as vigorous shareholder voting and hostile tender offers do not exist.78 Conversely, the nature of fund

managers' work is such that the strategic dimension of board deliberations, while hardly absent, is far less

pressing.

This insight, however, is not helpful for resolving the dilemma faced by the typical corporation in

finding the most desirable board structure (or those setting regulatory or self-regulatory guidelines for such

a process). If over-independence is not necessarily the wise course, too little independence is even moredangerous. This suggests that we give more careful thought to the virtues of a board of directors that is

made up roughly equally of persons who are either managers themselves or have management's trust and

those who will be diligent monitors.

At first glance, this seems like an unappealing solution.79 There is literature suggesting that parity

is most likely to factionalize, if not paralyze, the board, creating an environment of contentiousness,

frustration and diminished satisfaction with board service. Neither group senses enough control, and too

much time is spent negotiating divergent perspectives rather than working. This is one of the frequent

criticisms of “constituency” boards of directors, such as the German system of co-determination by the so-

called supervisory board.80 According to some scholars, the principal effect has been to diminish the

efficacy and importance of the supervisory board as information flow and real political power moves awayfrom that location toward other more private and cohesive settings.

This danger is apt if we are in fact talking about two distinct factions. But there may be an implicit

form of compromise that probably occurs in many well-functioning boards, whatever the formal

insider/outsider mix. Whenever there are competing interests within a group, there needs to be one or more




81 For an interesting discussion of different personality types among CEO’s, see Michael Macoby, Narcissistic Leaders:

The Incredible Pros, The Inevitable Cons, Harv. Bus. Rev., Jan.-Feb. 2000, at 69.

82 Other CEO's are sometimes questioned as good monitors because they engage in a norm of reciprocity -- treating the

CEO they are supposed to monitor as they would want to be treated.

83 For a discussion of some of the research relating to affiliations short of actual employment relationship with the

company in question, see Lin, supra, at 919-21.

84 On evidence associating committee roles with corporate performance, see Klein, supra.

“mediators” whose main function it is to bridge the chasm between them. This is not necessarily a formally

identified person or persons, but rather those with the skills and desire to be shuttle diplomats and smooth

out the difficult negotiations of reality that arise between the monitors and the managers. To qualify, a

person must have the trust of both sides – formally beholden to neither. Most of the communications that

will occur in this mediation will be private rather than in the formal board meeting itself. If successful, this

should diminish the gamesmanship that the managers might otherwise feel inclined to play, and increase the

confidence of the monitors that their perception of the company is firmly grounded.

Who best plays such a mediating role? One candidate is the CEO of another company, albeit one

who has achieved success by virtue of her consensus-building skills rather than charismatic (often

narcissistic81) vision. Such persons may not, for reasons often emphasized in the literature, be the best

external monitors.82 But they may well make up for this shortcoming as advisers to management and as

emissaries to the true outsiders on the board. The same may be true of the so-called “gray” directors.83

Lawyers and investment bankers may derive, indirectly at least, a higher level of compensation from the

company than other directors – creating a stronger connection to the senior management team than would

be desirable for the perfect monitor. For that reason, they are often criticized as directors. But again,

whatever their limits as monitors, their knowledge of and ties to the senior managers put them in a good

position to earn trust inside. They can then build on this to work with the outsiders to reduce the level of cognitive diversity and allow the board to function more efficiently. If this is an important role for gray

directors, we probably should be less critical.

There is, of course, a risk in seeing the board in terms of three implicit groups. It does seem to

reduce the influence of the true monitors, at least in numbers, thereby threatening whatever confidence

investors might draw from greater numerical superiority. Two responses are possible. First, this three-part

structure could be accomplished while leaving the true monitors with a majority of the board (although this

might diminish the confidence of other constituents, like the middle and upper middle managers). The key

is a critical mass for each of the groups, not necessarily parity. Alternatively, one could have approximate

parity but then give complete control of key committees – most notably the audit committee – to the real

monitors.84 In this light, the recent SEC and self-regulatory organization rule revisions designed to enhance




85 The SEC was instrumental in creating a blue ribbon task force on audit committees. See R EPORT AND

R ECOMMENDATIONS OF THE BLUE R IBBON COMMITTEE ON IMPROVING THE EFFECTIVENESS OF CORPORATE AUDIT

COMMITTEES (1999). The SEC and the various SRO's responded promptly, though it did vary some of the

recommendations. See Audit Committee Disclosure, Exchange Act Rel. No. 42266, Dec. 22, 1999. Though its thrust was

very sensible, one can question whether the still formalistic definition of independence, like that of most all

prevailing rules, falls short of insisting on true monitoring orientation as opposed to simple job-status independence

from the company.

86 See Eisenberg, supra.

87 Especially the institutional segment: pension funds and mutual funds. Moreover, we have the interesting

phenomenon of one category of independent directors – high ranking executives at other firms – showing some

inclination to shift orientation from friend or mediator to skeptical monitor once they have been subjected to similar

behavior on their home boards. See Westphal & Zajac, supra. This by itself pushes the “isomorphic” trend toward

stronger independence in a way that is not easy to reverse.

88 The cautionary note to all this is that trends do tend to take on lives of their own. Once there is a norm-based

consensus in favor of a supermajority of independent directors, it takes courage to break ranks. This is especially so

once such structures become enshrined in codes of best practices and other visible forms of endorsement. Firms

may be reluctant to send a signal that investors might construe as managerial rent-seeking. To the extent that super-

independent boards take on a symbolic role within the investor community beyond their actual capacity to monitor,

the lock-in effect may be that much greater. See TAN --- supra.

the independence of the audit committee,85 as opposed to the full board, make a great deal of sense.

C. Summary

We have now put forward two sets of less conventional reasons why firms with “mixed” boards

may be more productive than super-independent ones. The first is that giving insiders a significant political

presence on the board may help both de-bias the outsiders and bolster the perceived quality and stability

of the internal promotion tournament in which the great bulk of the company’s middle and upper middle

managers compete. The second reason relates is that overloading with board with true monitors may create

too stark a dilemma for the senior managers, forcing them to engage in impression management tactics at

the expense of seeking needed advice and assistance in strategy formulation and resource gathering. The

resulting diminution in collegiality makes the board less efficient as a working group, and less attractive as

a body to which members (especially busy outsiders) develop long-term commitments.

When this is coupled with the more conventional accounts and the empirical data that suggests a

danger to over-independence, we have a clear caution signal. To the extent that legal policy has sought

to prompt increased independence – which in fact it has done only mildly – the message is that structural

matters are probably best left to norms rather than law. Many commentators have concluded that changingnorms have been a more important influence on the structural evolution of board than law anyway. 86 This

is a reflection of the increased power of the investor constituency87 and the vivid financial success of this

investor-oriented model of corporate governance vis-à-vis foreign competitors over the last two decades.

Norms have the virtue of greater flexibility than law. We could expect that as the case for balance becomes

better grounded, the political pressure might ease. The institutional investor community would simply

become more sophisticated at identifying the nuances in board structures that create shareholder value.88




89 It has long been thought that business litigation is a place where the hindsight bias -- the tendency of decisionmakers

to overestimate the forseeability of harm at some point in time once that the are told that the harm actually occurred --

is likely to play a role in generating too much liability. See, e.g., Hal Arkes & Cindy Schipani, Medical Malpractice v. the

Business Judgment Rule: Differences in Hindsight Bias, 73 Ore. L. Rev. 587 (1994).

90 That restraint is buttressed in most states by additional statutory protections authorizing insurance, indemnification,

charter clauses further limiting liability and so forth. See E. Norman Veasey et al., Delaware Supports Directors With a Three-

Legged Stool of Limited Liability, Indemnification and Insurance, 42 Bus. Law. 401 (1987).

91 For two thoughtful studies of liability-deflecting mechanisms in light of the underlying purposes behind corporate

law, introducing a variety of social science materials and perspectives, see Mae Kuykendall, Assessment and Evaluation:

Retheorizing the Evolving Rules of Director Liability, 8 J. L. & Policy 1 (1999); Mae Kuykendall, Symmetry and Dissonance in

Corporate Law: Perfecting the Exoneration of Directors, Corrupting Indemnification and Straining the Framework of Corporate Law,

If all this sounds too harsh an indictment of independence, that is certainly not what I intend. The

growth in board independence has been an important and positive step in contemporary corporate

governance. I am simply suggesting that the extralegal social forces that prompted it be left free to pull

back as well, if that is what seems best for any given firm. Indeed, it strikes me that from a legal

perspective, accepting the multiple functions of the board generally – and the costs as well as the benefits

of independence – may if anything prompt courts to be more skeptical in making judgments about one

context where independence truly counts: controlling conflict of interest situations. Once we see the board

as a complex social unit that implicitly and variably balances monitoring efficacy against other functions, it

is harder to sustain the fiction that formal indicia of independence can be equated with good monitoring

incentives. If that leads to more rigorous judicial scrutiny of independence, thoroughness and

reasonableness in committee-based matters such as setting executive compensation, terminating derivative

suits, erecting takeover defenses and the like, so much the better.

II. THEU NINTENDEDCONSEQUENCES OF I NCREASED LEGAL THREATS

To some courts and regulators, there is a more potent way of inducing better monitoring bydirectors than trying to influence the formal structure of the board. That is by "tweaking" the liability regime,

threatening some heavier sanction when the directors’ monitoring conduct falls short of the imagined ideal.

The logic here is quite straightforward: a director, who for reasons of agreeability or laziness might be

inclined to be less than a diligent monitor should shift to a more diligent posture or get off the board if the

likelihood of detection and expected liability consequences are high enough.

The issue of directors’ liability for carelessness has long been one of the central issues in corporate

law, and it would be foolish to try to replay the entirety of the debate here. Though the principle of

prudence sounds unobjectionable, it is hard to apply fairly in hindsight89 – hence, the near universal

adoption of the business judgment rule, barring liability for unfortunate business decisions except when there

is some element of disloyalty, illegality, fraud, gross procedural negligence or abject waste.90

Notwithstanding these protective mechanisms, there remain pockets of opportunity for increasing

the negligence-based liability of directors, tempting the policy-maker. My aim here is not to explore the

cost-benefit trade-offs on directors' liability comprehensively. Most of the costs of subjecting directors to

increased liability risk are well-recognized: overprecaution, refusals of good people to serve, demands for

increased insurance, indemnification rights and compensation for the residual risk.91 As in the previous




1998 Colum. Bus. L. Rev. 443 (1998).

92 See Veasey, supra; Veasey et al., supra.

93 Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).

94 Cede & Co. v. Technicolor Inc., 634 A.2d 345 (Del. 1993).

95 See Rock & Wachter, supra.

96 For some recent surveys, see Mark J. Lowenstein, The Corporate Director's Duty of Oversight , 27 U. Colo. L. Rev. 33 (1998);

Melvin A. Eisenberg, The Board of Directors and Internal Control , 19 Cardozo L. Rev. 237 (1997).

97 188 A.2d 125 (Del. 1963).

section, I simply want to look for a richer set of unintended consequences that we might want to add to the

cost-benefit mix, particularly any connections between the threat of liability and the internal workings of the

board.

The consequences that are likely to follow depend, of course, on the severity of the threat. Thus,

our inquiry begins by looking at the current state of the law to see how severe the threat is as a baseline

matter, before turning to some additional proposals for stepped-up liability. After that, we can try to think

through how board members might react to whatever level of fear is engendered.

A. How Much Legal Exposure Do Directors Really Have?

1. State Law: The Delaware Experience

Evaluating state law is complicated, of course, by the many different states’ approaches to this

subject. To simplify, we shall concentrate on Delaware, which is by far the most important state for

publicly-traded corporations and the one whose law on the subject is most well-developed. Like all other

states, Delaware courts strongly implement the business judgment rule, and the legislature has adopted a

series of further protections – the so-called "three legged stool" of charter protection, insurance andindemnification rights.92 Based on the case law, the risk of significant out-of-pocket damage liability for

an affirmative business decision made in good faith is extremely low. To be sure, theVan Gorkom93 and

Cede & Co.94 cases show that some risk of liability exists if the processes of board decision-making

are grossly inadequate. But this threat is manageable via competent legal and investment advice

(though there will always be fear of an odd “hindsight bias” decision that may induce some

sleeplessness in transaction of extraordinary magnitude) and has essentially been limited to the rare

situation where the board is selling control of the company.95

Putting aside duty of loyalty cases, one place in Delaware law where the business judgment

rule loses some of its protective power is under the so-called duty to monitor.96 As initially expressed

in Graham v. Allis-Chalmers,97 this doctrine imposes a duty to take affirmative steps to prevent harm tothe corporation as a result of managerial illegality once the board is on notice that something is amiss.

Graham was long read as very conservative on what constitutes notice: absent new warnings, the court

suggested, the directors had the right to assume that prior illegality had ceased and employees were acting

honorably. Although technically the business judgment rule did not apply because no affirmative business




98 In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).

99 See Basic Inc. v. Levinson, 485 U.S. 224 n. 17 (1988).

100 See J AMES D. C OX ET AL., S ECURITIES R EGULATION : C ASES AND M ATERIALS 693-96 (2d ed. 1987).

101 See, e.g., SEC v. Infinity Group, --- F.3d --- (3d Cir. 2000); Milich, Securities Fraud Under Section 10(b) and Rule 10b-5:

Scienter, Recklessness and the Good Faith Defense, 11 J. Corp. L. 179 (1986).

decision was involved, the court was explicitly anxious to avoid a rule that left directors vulnerable to

second-guessing.

Under Graham, the threat of liability is slim. It was raised, arguably, in the wake of the Chancery

Court decision in In re Caremark International Inc. Derivative Litigation,98 a clear-cut example of

judicial revisionism to prompt more assertive board behavior. Chancellor Allen reinterpreted Graham to

require some affirmative monitoring by boards to assure compliance with law even in the absence of

specific warning signs, especially in settings where the temptations toward illegal behavior are strong.

Whether Caremark will survive as good law is unclear; even if it does, it is doubtful that it imposes a

significant liability threat so long as the board follows some well-known “best practices” in implementing

a compliance program. In fact, while articulating its arguably aggressive legal standard, the court concluded

in its fact-finding that it was highly unlikely that the Caremark board had violated any duty. Moreover, the

charter protection option, if in place, eliminates this kind of liability. In sum, while the risk of liability may

have risen marginally, it remains small.

2. The Federal Securities Laws

More promising for turning up the heat on outside directors to turn them into better monitors arethe securities laws. Because they simply impose obligations of candor in those situations where the

company speaks – whether voluntarily, or in responding to some disclosure mandate – the business

judgment rule is considered irrelevant.99 Yet this creates some awkwardness because there are very few

examples of careless or wrongful behavior about which the full truth is told. As a result, creative

shareholders’ lawyers can often plead what would fail as a state law duty of care suit in terms of some kind

of lie: shareholders were not fully advised in the company’s disclosures of the full extent of the underlying

misconduct. While courts have occasionally struggled to weed out de facto mismanagement suits from the

ambit of the securities laws, this has generally not been successful. 100 When there has been some sort of

concealed wrongdoing touching on the purchase or sale of a security or shareholders’ voting rights, the case

has a good chance of succeeding. The question becomes who to blame.Suppose we have an instance of an issuer misrepresenting some information, thereby violating Rule

10b-5. Any officer or director who is knowingly and actively involved in the misconduct plainly risks

liability. The problem in extending this to expand outside directors’ duties is two-fold. First, it is far less

likely that the outside directors had actual knowledge of the fraud. Their knowledge is often more fuzzy

and ambiguous, if they have any awareness at all. This is not entirely fatal: Rule 10b-5 can be violated by

reckless as well as knowing complicity.101 But recklessness is still a very high standard, presumably

requiring something akin to deliberate indifference to a set of facts highly indicative of wrongdoing by




102 On the other hand, monitoring failure may be enough in a case alleging proxy fraud under Rule 14a-9, for there a number of courts

have found negligence to be the appropriate standard for liability. See Shidler v. All American Life & Fin. Corp., 775 F.2d 917, 927

(8th Cir. 1985); Herskowitz v. NutriSystem Inc., 857 F.2d 179 (3d Cir. 1988), cert. denied, 489 U.S. 1054 (1989). Thus, when shareholder voting is at issue, the risk of liability goes up. Because this typically occurs in a merger or acquisition setting – a control

transaction – this step-up mirrors the comparable increase in these situations found under state law.

103 Central Bank of Denver v. First Interstate Bank Corp., 511 U.S. 164 (1994). See generally Jill E. Fisch, The Scope of Private

Securities Litigation: In Search of Liability Standards for Secondary Defendants, 99 Colum. L. Rev. 1293 (1999).

104 E.g., In re Software Toolworks Inc. Sec. Litig., 38 F.3d 1078, 1090 (9th Cir. 1994). Where the director has signed a report (e.g,

a Form 10-K), there is room to allege primary liability. See TAN --- infra. At the pleading stage, some courts allow a presumption

of responsibility for company insiders once there is a proper allegation of scienter at the corporate level. See Wool v. Tandem

Computers Inc., 818 F.2d 1433, 1440 (9th Cir. 1987). However, outside directors are rarely placed in this group. See In re Glenfed

Inc., 60 F.3d 591, 593 (9th Cir. 1995); In re Imperial Credit Industries Inc. Sec. Litig., [2000] Fed. Sec. L. Rep. (CCH) par. 90,965

(C.D. Cal. 2000). Outside directors on the audit committee might face a different risk exposure, however. See note --- infra.

105 See Wright v. Ernst & Young, 152 F.3d 169 (2d Cir. 1998)(apparently requiring some sort of visible identification with the

disclosure).

106 E.g., Tischler v. Baltimore Bancorp., 801 F. Supp. 1493 (D. Md. 1992). See Lewis D. Lowenfels & Alan R. Bromberg,

Controlling Person Liability Under Section 20(a) of the Securities Exchange Act and Section 15 of the Securities Act , 53 Bus. Law.

1 (1997).

107 See Donahoe v. Consolidated Operating & Production Corp., 30 F.3d 907 (7 th Cir. 1994).

company insiders. Simple failure to monitor is not enough. 102

The second difficulty is assigning responsibility to a director even when the requisite state of mind

is present. The Supreme Court has effectively limited Rule 10b-5 liability in private suits so that only

“primary” violators have direct responsibility.103 What constitutes primary liability is now being debated

in the lower courts, with no clear consensus emerging. But even the most liberal courts in allowing suits to

go forward want something akin to active (if perhaps behind the scenes) involvement in the actual

production of the false or misleading statements. That would not easily capture the director who simply

failed to monitor, not having been involved in preparing, editing or signing the report.104 And many courts

are more restrictive than this in defining primary liability.105

In a private right of action, there are only a few routes to try to get around this. One possible

strategy is to invoke Section 20(a) of the Securities Exchange Act, which imposes joint and several liability

on “controlling persons” who cannot show that they acted in good faith in a way that did not directly or

indirectly cause the violation. This potentially reaches the outside director who can be characterized as part

of the control group of the corporation. And one can argue that enough of a monitoring failure operates

either as lack of good faith or as some indirect cause of the wrongdoing. But by and large, plaintiffs have

been disappointed by this route. Courts typically say that outside directors are presumptively not

controlling persons – it takes more than the standard director’s role to be part of the inner circle of controllers.106 In addition, a most courts have construed the good faith/no inducement defense to impose

some kind of culpable participation in the wrongdoing, at least at the level of recklessness. Except for a

handful of cases involving brokerage firms, a “duty to supervise” argument has made no headway under

Section 20(a).107

Thus, so far as liability in a private class action under Rule 10b-5 goes, outside directors who are

not actual participants in the wrongdoing once more have relatively little to fear on the merits. And so far




108 See, e.g., J. C OX ET AL., supra, at 723-28; 971-75; In re Silicon Graphics Sec. Litig., 183 F.3d 970 (9th Cir. 1999).

109 Aaron v. SEC, 446 U.S. 680 (1979). On the breadth of Section 17(a), see United States v. Naftalin, 441 U.S. 768 (1979)(includes

offers and sales beyond the public offering context).

110 Section 21C of the Securities Exchange Act of 1934.

111 See Arlen & Carney, supra.

112 See John Olsen, How To Make Audit Committees More Effective, 54 Bus. Law. 1097, 1104 (1999).

we have not even considered a host of other obstacles that courts and Congress have put in place to reduce

the incidence of fraud-on-the-market suits that can work to the benefit of director-defendants: heightened

pleading standards that potentially weed out cases where plaintiffs have no come up with enough smoking

gun type evidence of intentional misconduct, safe harbors for forward looking information, and the like.108

The SEC has more room to proceed against outside directors in its public enforcement actions.

To the extent that there is primary liability for fraud in the offer or sale of a security, it has the ability under

Section 17(a) of the Securities Act to go forward upon a showing of negligence rather than scienter.109 It

can also take action against those who willfully aid and abet some securities misconduct – though here,

again, there is a high state of mind standard often not easily applied to lax outside directors. An even more

direct route the Commission can take is under its cease and desist authority, which it reads to permit an

enforcement action against any person who negligently “caused” a securities violation. 110 That could be

applied to an outside director who fell asleep at the watch, assuming enough causal nexus between the

supervisory failure and the harm in question. But this kind of action, while broad, is not particularly potent:

the first violations, at least, can only be addressed by an order to desist, not any actual penalty.

So, once again we see what in the aggregate is a fairly low liability risk for outside directors who

are not culpably involved in securities fraud. And while the SEC is not (or at least should not be) hampered by many of the procedural and pleading impediments applicable in private lawsuits, it has its own budgetary

and resource constraints that allow it to bring only a small fraction of the suits it would like. Further, it

settles most of those, on terms often very favorable to peripheral defendants.

3. Perception versus Reality, and the Lawyer’s Bias

The baseline for our analysis, then, is low-level risk that should thus not affect boardroom behavior

to any great extent, putting aside the context of the extraordinary corporate transaction. Perhaps, then, we

have nothing much to be concerned with in this section of the paper and should move on. But I suspect

that this misses two important qualifications. The first is that what drives director responsiveness to legalinterventions is not so much the threat of an adverse judgment (cases with any merit are often settled,

leaving open room for indemnification, insurance and payments from the corporate treasury to take away

the sting111) as the threat of being subjected to prolonged litigation. 112 Even where the outside director is

highly confident that she will not be held liable, once a case moves beyond the preliminary motion stage she

is subject to very time consuming and threatening discovery requests and compelled deposition testimony.

This by itself can produce a high level of fear. A prominent and busy director – say, a CEO of another

company – has to be concerned about the length of time she might have to spend preparing for and being




113 The threat of liability as the prime motivator for board activity is emphasized in John Eichenhauser & David Shields, Corporate Director Liability and Monitoring Preferences, 4 J. Acct'g & Pub. Pol. 13 (1985). On the communal reaction, see Marilyn

Kaplan & J. Richard Harrison, Defusing the Liability Crisis: The Strategic Management of Legal Threats, 4 Org. Sci. 412 (1993).

114 Much work in sociology traces the "diffusion" of information -- or misinformation -- among groups of persons. For an interesting

study on the "total quality management" fad, see Mark Zbaraki, The Rhetoric and Reality of Total Quality Management , 43 Ad. Sci.

Q. 602 (1998).

115 I do not mean to suggest that this is a form of bad faith. Rather, human nature is such that lawyers will simply internalize the

bias under the guise of professional responsibility. The profession, moreover, facilitates this. Law journals and continuing

education programs highlight new events that might signal increased riskiness for clients (and implicitly, business opportunities

for lawyers); they tend not to dwell on the absence or diminution of risk. A good example of all this is the aftermath of the

Caremark case in Delaware. Whatever the significance of that decision in terms of future liability exposure, the bar

rallied around it as ample reason to develop new (and expensive) compliance products for clients and to claim the

need for more careful, intense (and expensive) counseling in the boardroom. On the role of professional biases, see

Donald C. Langevoort & Robert Rasumssen, Skewing the Results: The Role of Lawyers in Transmitting Legal Rules , 5 So.

Cal. Interdisc. L.J. 375 (1997); Marcel Kahan & Michael Klausner, Path Dependence in Corporate Contracting: Increasing

Returns, Herd Behavior and Cognitive Biases, 74 Wash. U.L.Q. 347 (1996).

116 See Lauren B. Edelman et al., Professional Construction of Law: The Inflated Threat of Wrongful Discharge, 26 Law & Soc'y

Rev. 47 (1992); Langevoort & Rasmussen, supra at 428-29, 435-36.

in deposition (and responding to other discovery requests) and the potential exposure of facts in the course

of the deposition that would be embarrassing or costly to the individual involved.

The other qualifier goes to perception. Most directors are not lawyers, and have little or no first-

hand knowledge of legal rules. They do not read statutes or cases, or even long summaries of them.

Rather, they rely on the company’s or their own lawyers to advise them about their liability exposure. A

sadly under-explored subject in business law research is whether officers and directors of publicly-traded

corporations have an accurate perception of the risk of liability or not (and if not, in what direction the bias

points).113

My hypothesis is that under certain predictable circumstances, executives will overestimate the risk

of liability. There are a number of possible reasons. One is that newspapers and business periodicals

highlight dramatic instances of such suits, and hence the threat of liability. Increased perception of threat

may also be a product of the intense political organizing that management-oriented groups have done to

seek support for curbs on liability at both the state and federal level. That lobbying effort benefits from a

perception of a liability crisis. These are all high salient, and easily overweighted.114

Lawyers could counteract this, however, in presenting more objective legal analysis to the board,

thereby restoring the board's sense of relative autonomy. But I suspect that they often do not, instead

reinforcing an overly dramatic view of legal risk. The reasons why are complex. The main one is thatlawyers face an asymmetric reputational dilemma if their advice is wrong. 115 If the advice is

overprecautionary, so that all that the client loses are largely in the form of foregone opportunities, there

is little likelihood of sanction. But if the advice is more aggressive, so that the client is sued and faces

liability, the reputational impact can be severe – even if there was a rational calculated risk. This leads to

a natural bias toward overstatement of risks to clients. In addition, there is often both a pecuniary and a

status-based reason to be dramatic: the more perceptible the legal risk, the more the lawyer’s services are

needed and the more important role she will play in the events.116




117 See Melvin A. Eisenberg, The Divergence of Standards of Conduct and Standards of Review in Corporate Law, 62 Fordham L.

Rev. 437 (1993). Cf. Meir Dan-Cohen, Decision Rules and Conduct Rules: On Acoustic Separation in Criminal Law, 97 Harv. L.

Rev. 625 (1984)(invoking the acoustic separation metaphor, albeit on the assumption that the separation is between what

lawyers hear about law and what other actors hear -- not what actors hear from lawyers).

118 Exchange Act Rel. 34-39157, 1997 WL 597984 (Sept. 30, 1997). For an earlier event with similar message, see Stirling Homex

Inc., [1975-76 Tr. Binder] Fed. Sec. L. Rep. (CCH) par. 80,219 (SEC 1975).

119 See Chip Heath & Forest Jourden, Illusions, Disillusions and the Buffering Effects of Groups, 69 Org. Behav. & Hum. Decision

Processes 103 (1997).

120 See Langevoort & Rasmussen, supra, at 415-16. I should add here the possibility that clients sense lawyers’ tendency to overstate

risk and discount the advice accordingly.

This suggests the possibility that the bar may habitually amplify what may be muted and ambiguous

signals from courts, legislatures and administrative agencies. As in the children’s game of telephone, the

message delivered by lawyers to officers and directors may not be quite the same as the one sent out by

the lawmakers. And if this tendency is predictable, it can be used to effect a kind of “acoustic separation”

in the transmission of law.117 A lawmaker can make some kind of pronouncement that contains a few

aggressive bits of dicta, but all carefully qualified to leave ample room for retrenchment and political cover.

In fact, it may not signal any determinate shift in the law. But the legal profession may well sharpen the

message, muting the qualifiers, and cause an overreaction among clients.

This can be illustrated by reference to a recent “message case” on director liability that has

occurred recently at the federal level, an administrative proceeding brought against two directors of W.R.

Grace & Co., who allegedly knew of undisclosed compensatory payments to the company’s chief

executive officer.118 In their defense, they claimed that all the information they knew was also in the

possession of the company’s lawyers, who did not insist on disclosure. Putting aside this reliance on

counsel defense, all the Commission did was issue a report claiming – without extended legal analysis – that

the directors violated their responsibilities under the securities laws. No penalty was imposed. For a

variety of reasons, both the medium and the message were far from frightening. Yet I suspect that what

lawyers did with W.R. Grace in subsequent interactions with clients may have been somewhat more scary.If so, does that necessarily mean that the officers and directors actually became more afraid?

Perhaps so, but we should be cautious. The lawyer’s advice is not the last step in the cognitive process:

the client’s processing of that information is. And here we have a countervailing effect. Successful people

tend to overestimate their ability to control their environment and avoid harm. They tend to significantly

underestimate the likelihood of their own negligence, for that tends to threaten their sense of identity. We

might predict that boards, collectively, might even have a stronger egocentric bias in this direction.119 This

bias might neutralize the lawyers’: in fact, I suspect that when lawyers overstate legal risk with some degree

of deliberation, it is often in what they see as a good faith effort to penetrate the client’s egotistic resistance

to legal threats.120

In sum, we cannot know for sure how directors perceive the risk of liability, or how sensitive theymight be to tweaks in the liability regime. It may be more fear than is objectively justified, though not

necessarily. This is an area where academic analysis could profit from deeper empirical research. But this

ambiguity is not fatal to our inquiry, for all we need do at this point is assume some non-trivial, lawyer-

induced fear of liability for monitoring failure and see what adverse consequences it might produce.




121 See Philip Tetlock et al., Social and Cognitive Strategies for Coping With Accountability: Conformity, Complexity and Bolstering ,

57 J. Pers. & Soc. Psych. 632 (1989).

122 E.g., Barry Staw, The Escalation of Commitment to a Course of Action, 6 Acad. Mgt. Rev. 577 (1981); Langevoort,Organized

Illusions, supra, at 142-43.

B. The Secondary Effects of Liability Exposure

1. The Feedback Effect: Reorienting the Board

The easiest effect to predict assumes that the liability signal works, and a large number of directors

shift as a result to a more diligent monitoring posture. In that event, what might have been a balanced board

– mixing insiders, monitors and mediators – could lose its balance and become a true monitoring board.

If so, we would simply have a replay of the perverse effects reviewed in Section I. We would expect the

level of trust between insiders and the monitors to diminish, resulting is less candid disclosure and reduced

advice-seeking. Managerial influence activities would increase. In turn, the service function of the board

would diminish in quality, as might middle-level managers' confidence that their interests in the promotion

tournament will be protected. And board service generally would become less appealing. To be sure, the

increase in monitoring quality would produce benefits. But there could easily be a loss in value for

companies where agency cost concerns relating to insider opportunism were controlled reasonably well

by other mechanisms (e.g., compensation arrangements). The net of costs and benefits would be hard to

predict, and would vary from firm to firm.

2. Accountability

A more subtle but potentially pernicious secondary effect also proceeds from the assumption that

the board fears greater liability. As a result, the board sees itself as more accountable to some external

authority, here the judicial system. There is a good bit of work in cognitive psychology on accountability

as an influence on judgment and decision-making.121 For the most part, intuitively enough, it is encouraging:

the more accountable a decision-maker feels, the more care he puts into the decision and the less likely he

is to let heuristic modes of thinking lead to a poor choice. So far, so good.

But there is one downside, and I suspect that it has great relevance in the boardroom. When

people make choices than are in some sense path-dependent – that is, their choices are constrained by previous decisions – then accountability leads to an interesting and oft-observed bias: the tendency to spend

undue time and attention justifying previous decisions that now might seem questionable. This is an internal

process, subconscious for individuals and probably implicit (and very strong) in groups, that leads people

to bolster the reasonableness of previous choices in anticipation of some forthcoming external review. The

pernicious effect comes when the person or group makes subsequent decisions – or more likely, fails to

act – that are driven by the need to make the previous actions look respectable. Illustrations of this are

famous ones. Companies remain over-committed to chosen course of action such as a new product or the

acquisition of another firm, throwing good money after bad.122 Many boards retain CEO's longer than they

should largely because it so painful to acknowledge their own error in choosing him.

We should be careful here, because much of the sense of accountability that drives suchovercommitment is independent of law. Reputational sanctions suffice to trigger fear. Indeed, there is much




127 See Ann E. Tenbrunsel & David M. Messick, Sanctioning Systems, Decision Frames and Cooperation, 44 Ad. Sci. Q. 684 (1999).

128 Cf. Westphal, supra, claiming that the natural tendency of corporate managers subject to greater external control is to reclaim

their autonomy by rejecting the externally desired result – even if they have no inherent objection to it apart from the compulsion (i.e.,

the psychological notion of reactance).

129 Section 11 of the Securities Act of 1933.

the nature of her role as she understands it, liability for what she regards as good faith activity is

inappropriate. That perception could be intensified by feelings that such demands ask too much of an

outside director with so many other claims on her time, and who must operate within a very noisy and

ambiguous informational environment – one where there are thousands of flags out there that might, on

close inspection, have a tinge of red. And further still, it can lead to conveniently cynical perceptions that

the legal demands are the product of illegitimate forces: judges and SEC bureaucrats who don't understand

the realities of business, and self-serving lawyers who selectively attack well-meaning officers and directors

by filing abusive lawsuits. All of these perceptions would simply blunt the impact of any compliance signal

the law tries to send.

To say that the signal is blunted does not necessarily make it counterproductive. Is it possible,

however, that under conditions of low probability of sanction, a compliance signal may actually produce

less monitoring behavior than no legal threat at all ? Here we can only speculate. But it is at least worth

noting claims in the behavioral literature that activity is most effective (persistent, thorough, etc.) when the

actor senses that it is freely chosen, not the product of external compulsion. To this end, there is some

evidence that framing a decision in terms of a low probability/low sanction threat causes people to think

simply in economic terms, which may readily lead to noncompliance simply because the threat of sanction

is so visibly remote. By contrast, leaving the threat out entirely produces marginally higher compliance because the decision can be framed positively in terms of ethics and internal norms rather than a weak effort

at external compulsion.127 If extralegal norms toward more serious board monitoring are indeed growing,

legalizing the issue might actually detract from them.128

C. Some Applications

Because we have not attempted to catalog all of the costs and benefits associated with directors'

liability for lack of care, the analysis we have done cannot by itself lead to any strong normative conclusion

one way or the other. There may be settings in which the benefits of stepped-up monitoring is worth

whatever set of costs we foresee. But our survey suggests caution before threatening directors withadditional liability exposure, especially when we might expect the legal profession to amplify the threat

beyond its specific doctrinal confines.

To illustrate, consider the most recent initiatives in this direction under the securities laws. The

monitoring issue has been posed repeatedly in connection with calls for director "certification" of various

disclosures by the company. Such certification is a statutory requirement -- with a clear-cut negligence

standard for liability -- when the company is raising capital through a public offering of securities. 129 In

1980, the SEC extended it to on-going corporate disclosures by requiring that a majority of directors sign

the company's 10-K report. More recently, the Commission has proposed extending that signature

requirement to a broader range of company reports, and requiring a statement indicating that those signing




130 See Sec. Act Rel. 33-7606A, Item XI(C)(1), Nov. 13, 1998.

131 See note --- supra.

132 See note --- supra.

133 In its audit committee rules, the Commission did adopt a safe harbor from liability -- but without protection from actual fraud.

Id. On the possibility that appointment to an audit committee increases the likelihood of liability in and of itself, see Reliance Sec. Litig.,

[2000 Tr. Binder] Fed. Sec. L. Rep. (CCH) par. 90,953 (D. Del. 2000); In re Gupta Sec. Litig., [1995 Tr. Binder] Fed. Sec. L. Rep.

(CCH) par. 98,689 (N.D. Cal. 1995); Olsen, supra, at 1104 & n.35.

134 See Olsen, supra.

have read the report and know of no material misstatements or omissions.130 Similarly, the recent audit

committee rule changes demand that the directors on that committee (who must be independent by virtue

of NYSE and NASDAQ rules) report on (1) whether they have discussed the company's financial

statements with the auditors and (2) based on that discussion, whether they "recommend" the public filing

of those statements.131

Construed literally and narrowly, these rules are unobjectionable. If the only question is whether

the director has actual knowledge that the filings are untrue, or acts in deliberate reckless disregard of

whether they are or not, then they are unlikely to have an adverse behavioral impact. But note how each

of them could be read more broadly, to impose liability on a director because the fact-finder thinks that he

did not do quite enough to discover the truth. A signature, after all, does increase the possibility that the

signer will be treated as a "primary" participant in the alleged wrongdoing.13 2 That risk is likely to be

highlighted by any lawyers involved.

Imagine, again, the director who is not entirely comfortable that he fully understands some matter

that is subject to disclosure. The obvious response is that she should ask questions until satisfied with her

knowledge.133 And in the abstract, that seems sensible. But suppose now that each outside director feels

compelled to do the same. The meeting lengthens, becomes more confrontational (the more detailed

questions indicate that the directors are not entirely comfortable with management's presentation or conclusions) and, most importantly, the discussion crowds out other matters on which the directors might

be of help (including both strategic and monitoring issues).

Sometimes, that might be worthwhile anyway. The directors may be exposing a weakness in

management's reporting. But the issue is one of judgment: when to drop some matter even though it is not

fully understood, simply because other agenda items are more worth of the finite time and attention the

board has to give.13 4 The risk of legalizing this is that it introduces a bias that may not be the most

productive one in terms of good outcomes.

We still might be concerned that absent a strong legal requirement, directors will choose to look

the other way. Were directors' liability the only incentive to accurate reporting, this might be a problem.

But of course it isn't. The company and the insiders still face direct liability for the misreporting, andenforcement resources and sanctions can be revised to improve the deterrence calculus if better compliance

is desired. Moreover, if we are right that most of the pressure toward greater monitoring comes from

norms rather than the law, the norm-generated pressure will remain even if law takes a hands-off approach.

Here is the main point about liability that we can draw from our inquiry: if we think that directors have much

to offer strategically and in terms of monitoring within a limited time and attention frame, then we should




135 See Eisenberg, supra.

136 M ARK ROE , S TRONG M ANAGERS , W EAK OWNERS : T HE P OLITICAL ROOTS OF A MERICAN C ORPORATE F INANCE (1994).

137 See Edward Rock, Saints and Sinners: How Does Delaware Corporate Law Work?, 44 UCLA L. Rev. 1009 (1997).

hesitate to force them to shift some of that attention toward some other issue (e.g., reporting accuracy)

unless we are convinced that it is truly a better use of their time. If we are not so convinced, it may be best

to leave directors free to exercise their judgment about how to allocate their time and attention, allowing

them to trade-off concerns about collegiality, trust, and the like. Let them be a productive team.

The psychology materials suggest one other thought as well. To the extent that some change in the

legal environment imposes a duty on directors to shift attention in a particular direction, it becomes

especially important to establish the legitimacy of that demand. Failure to do so, as Tyler suggests, is likely

to render the requirement impotent unless there is a substantial commitment of resources to enforcement.

Insistence on some task that directors honestly believe to be a poor use of their time or an unfair source

of liability exposure is unlikely to succeed. Instead, it will simply generate an aversion to the demand and

a devaluation of the law's legitimacy in this area. Once this occurs, corporate law’s expressive function

erodes.

IV. CONCLUSION: LAW’S I NFLUENCE ONCORPORATE NORMS

We should end this paper by looking more closely at its underlying message: that on questions of

board independence and accountability, the law should play a minimalist role, leaving most of the work of promoting a monitoring mindset to the more flexible but fairly powerful marketplace norms that have

evolved over the past two decades. To be sure, the law should continue to insist, perhaps even more

rigorously than it has, on independent director control over conflict transactions. But those are special

situations, not the day-to-day workings of board oversight. When the law becomes too aggressive, it risks

altering the social dynamic of the board in a way that makes it less effective as a working group. Anything

short of an aggressive step, on the other hand, accomplishes little in terms of direct behavioral impact and

risks undercutting the norms that do operate.

So stated, however, this message suggests a cleaner separation between law and norms than is

realistic.135 In scores of subtle and not-so-subtle ways, the law affects how norms are shaped. As Mark

Roe has shown, the law both allocates power between managers and shareholders and sets many of theconditions under which the institutions of shareholding evolve.136 To the extent that director norms are a

product of political battling between investors and managers, the law has written the underlying rules of the

game. In this regard keep in mind one of the forms of norm diffusion observed in the literature on board

independence: a step-up in independence on one board, for whatever reason (law-influenced or not), may

lead the CEO who suffers to then use his influence on other boards to do the same to the CEO there, and

so on. But institutional effects are only one kind of influence. There are cultural ones as well. Ed Rock

has demonstrated that the law also creates a setting to make visible – and subject to praise or criticism –

salient examples of board behavior.137 These expressive messages are bound to have some influence on




138 This expressive power is substantial only if corporate law carries a high degree of legitimacy in the eyes of the director community.

For concern, see TAN supra.

139 See Johnson et al., supra at 432-33.

140 That is one reason why norm shifts are sudden: private changes in perception are often kept that way, until for some reason or

another a handful of people openly signal the change. Then, all the heretofore hidden common believers surface in support. See

generally T IMUR K URAN , P RIVATET RUTH , P UBLIC L IES : T HE S OCIAL C ONSEQUENCES OF P REFERENCE F ALSIFICATION (1995); Timur

Kuran & Cass Sunstein, Availability Cascades and Risk Regulation, 51 Stan. L. Rev. 687 (1999).

141 Rock & Wachter supra

how the community of directors behaves.138

Yet for all these apparent connections, I suspect that we still understand very little about law’s

influence on corporate norms. One thing that is missing is a deep exploration of the “social construction”

of director beliefs about their law-defined role.139 All norms have their roots in perception – how a group

of persons construes their situation under conditions of high ambiguity will influence their definition of

appropriate ways of dealing with it. Shifts in norms usually come from a shift in perception of either what

is right or what is possible, and then only when that shift becomes publicly visible and legitimate.140 If we

want to understand directors, then, we should start with how they interpret the set of institutional constraints

on their activity, including legal constraints.

Within this effort should be careful attention to differences in how lawyers and directors interpret

corporate law. As we noted earlier, most of what directors know about the law is second- or third-hand.

It comes in filtered form, with much of the filtration provided by the lawyers who advise directors, and

lawyers (individually and as a profession) have many incentives to skew the message. Yet legal academics

tend to ignore this “he said/he heard” problem, concentrating solely on what “the law says” to assess its

likely influence, rather than what people hear. For example, it may well be, as Rock and Wachter argue,141

that corporate law has chosen largely to leave the day-to-day activities of officers and directors to “norms-

only” control, absent conflicts of interest or an extraordinary event like the sale of the company. Butwhether that message has been heard by its audience, or whether instead they believe the law threatens

more than this, is impossible to judge without better data. The cacophony of client alerts in the aftermath

of Van Gorkom, Caremark , W.R. Grace, the audit committee reforms and scores of other recent legal

episodes, together with sensitivity to the highly-publicized incidence of shareholder litigation and celebrated

judicial decisions, may all come together to create a very different impression of the law’s demands – both

in terms of what it says and its underlying legitimacy. So, too, with the low-powered but persistent

regulatory messages that relate to board structure and independence. Until we discover exactly what

directors hear amidst all the noise, we cannot begin to evaluate the wisdom of our bundle of legal and

regulatory strategies touching on questions of board of directors’ responsibilities.

the human nature of corporate boards - donald c. langevoort

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