The Independent Board as Shield
59 Pages Posted: 17 Sep 2019 Last revised: 25 Aug 2020
Date Written: February 15, 2020
CEOs and directors are barred by the fiduciary duty of loyalty from managing companies for personal gain. A pair of modern corporate law staples—the independent board and the business judgment rule—nominally reinforces this command. But together, these devices in fact operate to protect those actors. This protective role isn’t surprising for the business judgment rule; it was designed as a shield for CEOs and directors. But given that the independent board supposedly benefits shareholders, it’s more surprising that that device functions as a shield too.
U.S. public companies are overseen by boards composed of independent directors who do not work for the company. Their raison d’être is to represent shareholder interests and constrain the CEO and other managers. The effectiveness of these directors is sharply limited, however, and in some ways the independent board actually empowers CEOs. Nowhere is this perversity more consequential than in transactions that benefit the CEO, which are authorized by independent directors.
The business judgment rule, which insulates board decisions from review, extends the independent board’s role beyond authorization of such transactions to immunization. The rule is commonly justified as giving legal effect to the comparative advantage of businesspeople in their domain—in deciding the price of the company’s products, for example. But independent directors can opt to extend the rule’s protection beyond this narrow category of duty of care cases to acts that squarely implicate the duty of loyalty. The result is a shield for conflicts of interest.
This Article proposes to eliminate the independent board’s paradoxical shield quality by ending business judgment rule protection for claims implicating the duty of loyalty. Judges would apply the familiar entire fairness standard instead. The clearest rationale for this change comes from the logic of the rule itself: comparative advantage. Judges, not businesspeople, are best situated to assess conflicts of interest. More broadly, the Article’s analysis suggests that the pro-shareholder reputation of independence is overstated and may have inadvertently fostered a sense of complacency around board power.
Keywords: board of directors, corporate law, corporate governance, business judgment rule, agency costs, M&A, executive compensation, mutual funds, insider, manager, cleansing, conflict of interest, fiduciary duty, securities regulation, director primacy, shareholder litigation
JEL Classification: K22, K41
Suggested Citation: Suggested Citation