The Independent Board as Shield

Abstract

The raison d’etre of independent corporate directors is to constrain the CEO and other top managers. Limitations in the capacity and incentives of such directors, however, mean they are themselves constrained in this job. To date, approaches to this puzzle have taken at face value that the independent board functions as a one-way ratchet empowering shareholders of public companies. Examining the model from a different perspective, however—that of insider-managers, who exercise great influence over directors—reveals a major flaw in the traditional understanding: the independent board works in both directions. It empowers shareholders, and it also empowers managers. A great deal rests on the independent board’s presumed status as a shareholders’ sword rather than a managers’ shield. Consider its interaction with the business judgment rule. By design, the rule insulates workaday decisions such as whether a burger chain should add a breakfast menu. It does not extend beyond that sphere automatically, however; before it can reach the kinds of decisions that require major tradeoffs between the interests of insiders and shareholders—say, the choice of whether to pay a bonus to retain a CEO—the approval of independent directors is required. But if they approve, the rule is triggered and the decision is immunized from shareholder challenge. Reconceptualizing the independent board as a CEO’s shield destabilizes more than just the theoretical and legal vision of the model; it also destabilizes corporate law’s reliance on self-regulation as a substitute for external regulation of the most powerful organizations in the world. To address this in the context of the board, the Article urges that certain sensitive transactions be deemed ineligible for cleansing at the board level and instead be submitted for either shareholder approval or robust judicial review. More broadly, the Article’s analysis suggests that corporate self-regulation may be less efficient than assumed.