The Chicago School, the Conversion of Judge Posner, and the Delaware Courts (Part 3)

We return to Judge Posner's conversion.  Adhering to Mark Twain's observation in Connecticut Yankee (p. 58), the jurist allowed the facts to modify his views. 

The same ought to be true of Delaware.  What are the facts?  Financial institutions engaged in excessive risk taking, resulting in the current economic carnage.  Financial institutions paid excessive compensation, with formulas often promoting a short term, high risk approach to management.  Boards were largely absent from the process, acting as little or no check on these practices

As we have noted, the lack of board involvement isn't irrational.  Directors have every incentive to do what is in management's best interest.  Given the often lucrative compensation paid to directors, they rationally would like to keep the positions.  They would, therefore, be aware of the types of behavior that can result in removal.  

In that regard, they need not worry about shareholders.  Shareholders have no real authority to remove directors.  Proxy contests almost never occur.  Majority vote provisions leave the board with the discretion to retain the defeated directors.  Indeed, in a study by Riskmetrics, none of the 93 directors in the Russell 3000 who did not receive majority support in 2009 left office because of this shareholder vote.  See Riskmetrics Risk & Governance Blog ("Despite this surge in majority withhold votes, it does not appear that any of the 93 directors have stepped down as a result of investor dissent."). 

The only way directors of public companies can be effectively removed from the board is not to be renominated by the board.  Since the CEO has disproportionate influence on the nominating process (not withstanding SEC efforts to limit this through the use of disclosure, see Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure), directors have every incentive to keep managers happy, not shareholders.  As a likely result, there is less oversight of management than what shareholders would like and less restraint imposed on executive compensation.

Yet despite this obvious dynamic and despite the facts, Delaware has not "modified" its view.  The legislation and decisions coming out of Delaware continue to espouse the pre-crisis philosophy that resolutely favors management.  The current evidence of excess has not changed this view. 

Perhaps the failure to evolve is merely myopic.  Perhaps it is supported by a logic that is not readily apparent.  The solution is likely to be a creeping federalization, with Congress stepping in to rectify what the state will not, perhaps there is an alternative solution. 

In truth, Delaware's best chance of warding off federal intervention and retaining its preeminent position it the corporate governance debate is to concede past mistakes (ala Judge Posner) and accept that the facts of the current financial crisis have shown the need to abandon or modify old approaches.  A somewhat tougher approach to compensation and a somewhat more rigorous approach to board oversight would not significantly change the balance of authority.  Indeed, in many cases, directors would likely welcome the judicial tools necessary to restrain compensation practices.  Yet these modest reforms would remove much of the pressure for reform. 

But they require change and, as the New Yorker article indicates, some have evolved (Judge Posner) while others have not.  Delaware apparently falls into the latter camp.