Rivista di Diritto SocietarioISSN 1972-9243 / EISSN 2421-7166
G. Giappichelli Editore


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Duty of obedience: the forgotten duty of U.S. Corporate Law (di Alan R. Palmiter)

Articoli Correlati: USA - diritto societario - società


- I. Duty of obedience in the u.s. for-profit corporation - A. Original Duty of Obedience (Corollary to Ultra Vires Doctrine) - B. Abandonment of the Duty of Obedience (Along with Ultra Vires Doctrine) - C. Revival of the Implicit Duty of Obedience (and Ultra Vires Doctrine) - II. Duty of obedience in the U.S. non-profit corporation - A. Scope of Non-Profit Duty of Obedience - B. Survival of Obedience Duty in an Age of Non-Profit Adaptability - III. Revival of explicit duty of obedience in the U.S. for-profit corporation - A. Obedience to Internal Corporate Norms - B. Obedience to Non-Corporate Legal Norms - C. Effect of Disobedience (Fashioning Internal Corporate Remedies) - IV. Conclusion - NOTE

Directors and officers of for-profit corporations in the United States are said to owe two duties to the corporation: care and loyalty. But not so long ago, they also owed the corporation a “duty of obedience”. This third duty, now largely forgotten, compelled corporate fiduciaries to abide by legal norms – both those of the corporation and of external law. In this essay, I assert that U.S. corporate law would do well to revive a “duty of obedience” – and may actually be in the process of doing so. Explicit recognition of such a duty would extend the corporate purpose beyond maximizing shareholder wealth and thus advance the legitimacy of the corporation in society. Moreover, such a duty would recognize that the duties of care and loyalty are incomplete. Corporate actions that violate legal norms, even when those actions are approved by diligent and selfless directors, are inconsistent with fundamental expectations of corporate conduct 1. Recognition and development of an obedience duty would resolve much of the confusion engendered by the “duty of good faith” – a confusion that has engendered much attention 2. Introducing an obedience duty into the corporate fiduciary lexicon would offer a clearer vocabulary for those who counsel corporate fiduciaries about their duties to abide by legal norms. It would provide a principled basis for the judicial review of internal corporate controls and corporate illegality. It would create a framework for more meaningful thinking and implementation of corporate social responsibility. The revival of the duty of obedience is not as big a stretch as might be imagined. In the United States, an obedience duty has a long-standing and continuing history for fiduciaries of non-­profit corporations. Non-profit law imposes clear duties on non-profit trustees to abide by the legal restrictions that apply to their organizations, such as those imposed by the non-profit’s constitutive documents, any donor conditions, and behavior-guiding tax law. In thinking about various fiduciary cases in the for-profit U.S. corporation – many forming the canon of corporate law jurisprudence in the United States – it is clear that judges accept the existence of a duty of corporate actors to abide by legal norms. Thus, the articulated bases and results in a variety of cases hinge not only on directorial care and loyalty, but also on obedience. Were it not [continua ..]

I. Duty of obedience in the u.s. for-profit corporation

A duty of obedience once occupied an established place in the U.S. for-profit corporation. In his magisterial treatise on corporate law, Ballantine declared in 1946 that even before owing duties of care and loyalty to the corporation: “Directors owe a threefold duty to the corporation. First they must be obedient” 11. More recently, looking back at the fundamental aspects of U.S. corporate law, a federal court described the fiduciary duty triumvirate as follows: The duty of obedience requires a director to avoid committing ultra vires acts, i.e., acts beyond the scope of the authority of the corporation as defined by its articles of incorporation or the laws of the state of incorporation .... The duty of loyalty dictates that a director must act in good faith and must not allow his personal interests to prevail over the interests of the corporation .... The duty of due care requires that a director must handle his corporate duties with such care as an ordinarily prudent man would use under similar circumstances 12. The duty of obedience served mostly as a natural corollary to the ultra vires doctrine. Just as the corporation was prevented from acting beyond its powers, corporate actors were obligated not to perpetrate such actions – and could be held liable if they did 13. Although instances of personal liability appear to have been few, the threat was real. Corporations, from the beginning and still today, are to engage only in “lawful business” and thus are not meant to engage in illegality 14. Thus, the original ultra vires doctrine not only set the boundaries of corporate power as established by corporate norms, it also recognized that the corporation is powerless to violate non-corporate norms – that is, external law 15. The obedience duty called on fiduciaries to not permit corporate illegality. But as corporate law (and judicial review of corporate actions) moved from questions of corporate power to those of fiduciary duty, the ultra vires doctrine became largely vestigial – and its appendage, the duty of obedience, quietly wilted away. Speaking as if at a memorial service, one commentator stated: The first of these fiduciary duties, the duty of obedience, is not conceptually interesting and has not generated significant litigation in recent years. It merely requires directors to comply with the pertinent provisions of the articles, bylaws, and state statutory [continua ..]

A. Original Duty of Obedience (Corollary to Ultra Vires Doctrine)

Corporate law in the United States began as the regulation of corporate powers. Most early corporate law cases turned on whether the corporation was exercising its powers according to the governing statute and its corporate charter. Most early corporate law treatises devote themselves extensively to questions of ultra vires. In its heyday at the turn of the last century, the ultra vires doctrine provided umbrage for shareholders who sought protection from management excess – whether for acts beyond the power given to the corporation, acts that were illegal, or acts that exceeded the authority conferred by shareholders 21. For example, corporate waste – corporate expenditures lacking business justification – was treated as exceeded power, not failed duty 22. Importantly, the ultra vires doctrine supplied a tool for ensuring corporate compliance with non-corporate norms. Arguing for the revival of the ultra vires doctrine, Professor Greenfield has pointed out: During the height of the ultra vires doctrine, a corporation’s illegal activities were considered a subset of the larger category of ultra vires activities. In no sense were corporations considered as having the authority to perform illegal activities, even when performed to advance the interest of the firm 23. A commonly cited example of the application of the ultra vires doctrine – and its corollary duty to obey non-corporate norms – is the 1909 case of Roth v. Robertson 24. There a New York court held directors of an amusement park (Coney Island) personally liable for “hush money” paid by the corporation to avoid prosecution for violating “blue laws” that forbade business on Sunday. The court made clear that the payments were illegal, “bad in morals,” and ultra vires 25. The penalty in Roth v. Robertson, as well as other earlier cases in which directors permitted the corporation to exceed its powers, was personal liability, not merely an injunction against the corporate overreaching. As a 1901 treatise made clear: “All of the authorities agree that if the directors … do or suffer to be done acts which are beyond their powers ... they may be compelled to make good on the loss” 26.

B. Abandonment of the Duty of Obedience (Along with Ultra Vires Doctrine)

But then a subtle shift began in corporate law. Instead of talking about directors being personally liable for their unauthorized actions, treatise authors began to talk about the liability of directors for failures to act responsibly – a switch from power to duty. For example, a turn-of-the-century treatise declared that if directors “attempt to act beyond their powers, they may be liable to the corporation for mismanagement” 27. Another leading treatise marked the evolution away from power, observing in 1894, “no one can state with confidence what the law on the subject of the ultra vires doctrine is at the present time, still less predict what it will be in the near future” 28. In 1927, the same treatise would conclude that the liability of directors for ultra vires acts is grounded on “violation of authority, or neglect of duty” 29. In 1946, Ballantine concluded that the duty of obedience was losing its force, explaining that, although directors and officers were liable for exceeding charter limitations on their authority, “the better view” is that they are not liable for damages if their excess was “in good faith, without negligence on their part, or if they acted with the consent of the shareholders” 30. The language of power had been supplanted by that of duty 31. Knepper’s treatise of 1974, while continuing to echo the existence of a triumvirate of corporate fiduciary duties, doubted that directors could be personally liable for failing to ensure corporate compliance with legal norms 32. Instead, the duty of obedience had become simply a command – enforceable only by injunction to observe internal corporate norms: While directors have been absolved from liability for permitting their corporation to engage in ultra vires acts, the general rule is that the duty of “obedience” contemplates that ultra vires corporate activities are to be avoided. Directors are supposed to contain their activities within the powers conferred upon the corporation by its charter and within the authority conferred upon them by the articles of incorporation and code of regulations 33. Today corporate law treatises no longer mention the duty of obedience 34. The ALI Principles of Corporate Governance, which in the 1980s sought to summarize and guide U.S. corporate law, identified only the obligation of the corporation to “act [continua ..]

C. Revival of the Implicit Duty of Obedience (and Ultra Vires Doctrine)

The privatization of the corporation failed. The corporate law command that corporate actors must ensure corporate compliance with internal and external legal norms is again well-established 45. Not only have courts returned to the ultra vires doctrine to invalidate management power grabs – such as dead-hand poison pills and backdated options – they have made that clear corporate actors are bound to ensure compliance with non-corporate legal norms. Corporate statutes also make clear that corporate illegality finds no comfort under corporate law. For example, exculpation provisions in Delaware corporations cannot absolve directors from personal liability for “a knowing violation of law” 46. A revival of the ultra vires doctrine – and implicitly the duty of obedience – has come as corporate actors have tested the outer limits of managerial power. Recent cases limiting the power of the board to disenfranchise shareholders have used the language of management power, as well as that of fiduciary duty 47. Likewise, courts looking at backdated options have chastised directors for both breaching their duties of loyalty and disregarding stated plan limits 48. Implicit in both lines of cases is the notion that corporate actors are bound to follow internal corporate norms. Respect for internal corporate norms also undergirds the “reasonable expectations” doctrine in the close corporation 49. The doctrine, by enforcing non-formalized agreements of majority and minority investors, emanates from the duty of obedience. Party expectations, akin to charter-like limitations placed on the controlling investor at the behest of the minority investor, raise questions not of care or loyalty but instead of obedience. The majority is bound to the parties’ expectations not because the majority is inattentive or uninformed, or because it is necessarily acting selfishly toward the corporation, but because it has violated agreed-upon internal norms. As Professor Atkinson has noted, “the more fundamental duty of obedience is clearly in play here. Once the minority has the majority’s commitment to a particular kind of corporate activity, that commitment must be obeyed. Conversely, departures from the specified corporate activities violate the duty of obedience” 50. The revival of a duty of obedience (though not labeled as such) has also arisen in cases that call on [continua ..]

II. Duty of obedience in the U.S. non-profit corporation

The duty of obedience has a clearer and more-established pedigree in the U.S. non-­profit corporation. It is regularly mentioned as a fundamental aspect of non-profit trusteeship, along with the duties of care and loyalty. The legal non-profit literature devotes a good deal of attention to its contours and its place in non-profit law 57. Court cases apply the obedience duty to require non-profit actors ensure compliance with the non-profit’s mission, donative restrictions and tax requirements 58. This is not surprising. The U.S. non-profit corporation exists to serve social purposes, as embodied in both internal and external norms 59. Compliance with these norms is not only central to the legitimacy of the non-profit corporation, but frames the duties imposed on its actors. The non-profit vocabulary of “mission” and “trusteeship” suggests the degree of obedience that non-profit fiduciaries owe to the organization and the space it occupies 60.

A. Scope of Non-Profit Duty of Obedience

The leading textbook on non-profit law explains that non-profit trustees have a duty “to carry out the purposes of the organization as expressed in the articles or certificate of incorporation” 61. The duty has been summarized as mandating that the board refrain from transactions and activities that are ultra vires, that is, beyond the corporation’s powers and purposes as expressed in its certificate of incorporation …. Thus, the director must follow the purposes and powers expressed in the governing legal documents 62. The obedience duty therefore tracks and reinforces the non-profit’s mission – “to act with fidelity, within the bounds of the law generally, to the organization’s ‘mission” 63. Commentators have also pointed out that, beyond complying with internal norms, non-profit fiduciaries also must ensure the non-profit complies with external legal regimes “ranging from federal and state tax laws, civil rights statutes, and antitrust laws which affect all organizations” 64. The consequences of non-compliance by non-profit directors may be even more onerous than for their for-profit brethren: A non-profit fiduciary can be held responsible if an organization violates the law. For example, a director or officer is liable for a corporation’s failure to pay taxes if she meets the Internal Revenue Code’s definition of “responsible person” and the failure to pay has been “willful.” Directors involved in day-to-day administration of the organization in matters related to taxes and financial records are “responsible persons” 65. Some commentators looking at non-profit corporate fiduciary law even argue that the duty of obedience “is more basic, constituting the foundation on which the duties of care and loyalty ultimately rest” 66. Courts echo the view, pointing out that non-profit directors must be “principally concerned about the effective performance of the non-profit’s mission” 67. Besides garnering attention from commentators, the duty of obedience has been a mainstay of non-profit case law, both as a stand-alone duty and as a subset of the duty of loyalty. A leading non-profit case turned on whether a proposed transaction approved by the non-profit’s board furthered the “purposes of the corporation” 68. In describing the duty of non-profit [continua ..]

B. Survival of Obedience Duty in an Age of Non-Profit Adaptability

The privatization movement has also seeped into the non-profit corporate world. Just as the for-profit corporation is seen as a private adaptation to the business, financial, and legal landscapes in which it operates, the non-profit corporation has come under pressure to get with the times. Old missions must be updated, dead hands must be buried, and non-profit fiduciaries must focus on the bottom line. As a recent treatise author has explained: To the extent the duty of obedience does not carry with it a duty to assure that the trust is meeting contemporaneous needs, it does not set forth an appropriate standard 71. Thus, the duty of obedience has come under attack for limiting non-profit adaptability. The Revised Model Nonprofit Corporation Act (RMNCA), for example, does not recognize the duty of obedience in the non-profit corporation, apparently to create symmetry with its for-profit cousin 72. But rather than deny the existence of a duty to comply with legal norms – the tack taken by the ALI Principles for for-profit corporations – the RMNCA assumes the duty of obedience is subsumed in the duties of care and loyalty 73. This conflation has both rhetorical and normative significance. By conflating obedience with care and loyalty, non-profit fiduciaries are told that diligence and personal fidelity are all that is expected of them 74. Removing obedience from the named triumvirate makes compliance with internal and external norms easier to avoid – in the name of the non-profit carrying out the goals envisioned by current managers. Responding to the attempt to privatize the non-profit corporation, some commentators have defended the importance of a stand-alone duty of obedience: Instead of being eliminated or collapsed under the umbrella of the duty of care, the duty of obedience should be more clearly delineated as one of the three fiduciary duties to which the not-for-profit corporate board is held, thereby sending an important message to the sector that fidelity to the institutional mission is critical 75. Some have argued that without a duty of obedience non-profit directors have no unique duty substantially different from their for-profit counterparts 76. Not only does this imply application of the business judgment rule to non-profit decisions, but “the charitable corporation and the business corporation begin to look and act like each other, regardless of rhetoric and tax [continua ..]

III. Revival of explicit duty of obedience in the U.S. for-profit corporation

Does a duty of obedience in the U.S. for-profit corporation make sense? At one level, the question is beside the point given that corporate law already recognizes an implicit duty of corporate actors to comply with internal and external legal norms. More relevant are two other questions: first, should corporate law formally recognize such a duty and, second, how should its contours be defined? To begin this inquiry, it is useful to cast the duty of obedience in clearer relief. The following diagram identifies the triumvirate of fiduciary duties and their overlapping coverage, using a handful of canonical U.S. corporate law cases to illustrate their operation.   (IMMAGINE)   Cases involving violations of corporate fiduciary duties: Care only:Smith v. Van Gorkom (Del. 1985) – violation of duty of due care (gross negligence) by directors for failing to become informed about company’s value in a cash-out merger 81. Care/loyalty:Litwin v. Allen (Sup. Ct. N.Y. County 1940) – violation of duty of care (taking on too much risk) by bank directors for approving financial transaction with corporation having conflicting ties to bank’s parent 82. Loyalty only:Globe Woolen Co. v. Utica Gas & Elec. Co. (NY 1918) – violation of duty of loyalty by director who failed to inform fellow directors of risk to the corporation in entering into self-dealing transaction with director 83. Care/obedience:McCall v. Scott (6th Cir. 2001) – violation of duty of care by directors for failing to implement internal controls that would have identified Medicare and Medicaid fraud by company employees 84. Loyalty/obedience:Ryan v. Gifford (Del. Ch. 2007) – violation of “loyal fiduciary” duty arising from directors’ failure to comply with shareholder-approved plan for issuance of executive stock options 85. Obedience only:Roth v. Robertson (Sup. Ct. Erie County 1909) – violation of duty of obedience by board of directors for approving bribes by company to operate an amusement park illegally on Sundays 86; Miller v. AT&T (3d Cir. 1974) – violation of duty of obedience by board of directors for failing to collect loan to political party, in violation of campaign finance laws 87. Care/loyalty/obedience:In Re Enron Corporation Securities, Derivative & ERISA Litigation (S.D. Tex. 2008) – violation of [continua ..]

A. Obedience to Internal Corporate Norms

As the ultra vires doctrine has been rediscovered, in a more subtle and textured form, so too its implicit duty of obedience. Courts speak about the limits on the power of directors to adopt takeover defenses that undercut shareholder rights – such as dead-hand poison pills and supermajority voting requirements 89. And, hand in hand, directors bear a duty not to adopt such defenses. Likewise, as corporate governance has shifted from conduct-based to disclosure-based regulation, corporate disclosures define new templates of corporate power. Courts again speak about the limits of management power when norms implicit in disclosure documents are violated – such as backdated options and other option grants 90. And directors bear a duty not to permit such power excesses. Although the line between limits imposed by power boundaries and those imposed by fiduciary duties is sometimes blurred, recent cases make clear that the ultra vires doctrine is still alive as an admonition to follow corporate statutes and corporate-specific guidelines 91. And where directors stray from the template for corporate powers, there is reason (and a long tradition) for corporate law to address not only the corporation, but also its actors. Although not yet openly tested, the duty of obedience to comply with internal corporate norms waits in the wings not only to mandate a corporate outcome (through declaratory or injunctive action), but also to impose personal liability on corporate actors who would brazenly overstep corporate norms. That is, backdating options again and again could well cross the line from poor judgment to bad judgment. The directorial duty of obedience in this context, however, need not be entirely a matter of on-off liability. It also serves an aspirational function, particularly in view of the rising phenomenon of majority-approved shareholder resolutions. Although corporate law generally constrains shareholders to phrase their views only as precatory requests, not as mandatory directives, the question of what boards of directors are to do with such requests remains open. Certainly, just as politicians are politically compelled to consider polling data, directors act at their own political peril by disregarding precatory shareholder resolutions. The high incidence of directorial compliance with majority-approved shareholder resolutions suggests that even if there is no legally-enforceable obedience duty to abide by shareholder [continua ..]

B. Obedience to Non-Corporate Legal Norms

Here, the duty of obedience is called on to do yeoman’s work. The ultra vires doctrine and its duty of obedience were primarily seen as means to limit the corporation to those activities envisioned first by the legislature and later by shareholders – an internal function. Although the classic doctrine makes passing references to compliance with non-corporate legal norms, this was not the original function of the duty of obedience. Perhaps, as some have argued, extending the obedience duty to non-corporate legal norms goes too far 93. The duty of obedience perhaps should be understood only to reach compliance with internal corporate norms, such as statutory restrictions or limits in the articles of incorporation. There are many problems with this argument. For one, times have changed. Modern corporate law has moved ineluctably beyond an internal ultra vires doctrine to one that also covers the corporation’s obligation to comply with law – that is, one that addresses corporate externalities. As the ultra vires doctrine has lost its central role in controlling internal conflicts, recognition of the corporation’s moral obligation to comply with law has become firmly established. That is, while the doctrine has lost its preeminence, the obedience duty has grown into a powerful (if unstated) premise of the modern corporation. The obedience duty as fashioned by Delaware courts (and confirmed in Sarbanes-Oxley) reaches well beyond internal corporate norms. As Caremark 94 and Stone 95 teach, corporate actors face a positive mandate to ensure corporate compliance with external law – a duty of obedience. Recent lower court decisions in Delaware highlight the now-unquestioned principle that the for-profit corporation is bound to obey law, and the responsibility for legal compliance rests squarely with the board of directors. For example, the corporation’s failure to produce records of an adequate legal compliance program (such as board oversight of securities filings) is enough for a Caremark claim against directors to proceed96. The failure of a board to respond to shareholder’s demand for internal controls in compliance with the board’s Caremark duties can be the basis for a claim against the directors 97. Moreover, directors whose corporations operate in countries whose “legal strictures … or ethical mores” are in doubt have [continua ..]

C. Effect of Disobedience (Fashioning Internal Corporate Remedies)

Corporations invariably violate the law. Should corporate actors be personally liable for allowing the corporation to violate internal and external norms? The answer, thus far, has been almost uniformly no. Although judicial rhetoric that directors are obligated to ensure corporate compliance is common, personal liability is the great exception – if not wholly absent. It is a big step from saying that corporate actors are bound to ensure corporate compliance to saying they should face personal liability for failing to remain watchful and rein in corporate illegality. For this reason, perhaps, Delaware has avoided mention of an obedience duty out of a concern of explicitly making corporate actors responsible for compliance with non-corporate norms. After all, it’s a delicate balancing job to ensure the legitimacy of the Delaware corporation, while limiting the responsibility of Delaware corporate actors. A duty of obedience even in the context of non-corporate legal norms, however, need not imply personal liability for organizational illegality. As the Delaware courts have made clear, personal liability can attach only when (even selfless) corporate actors “consciously disregard” their duties, including their duty to monitor corporate illegality 102. This would seem an acceptable compromise. So like the duty of care, the duty of obedience may best be seen as largely aspirational. Just as corporate law calls on directors to be informed and diligent, it rarely finds sufficient fault in specific cases to warrant crushing personal liability. And just as corporate law urges directors to observe (and have the corporation observe) corporate and non-corporate norms, directorial failures to obey have (mostly) not deserved the blunt reproach of full personal liability. Furthermore, internal and external law is convoluted. Any meaningful duty of obedience cannot expect absolute compliance – perfection would become the enemy of the good. Just as the obedience duty in the non-profit corporation may have some room for adaptability, so too its non-profit cousin should give corporate actors a chance to test limits. Nor should every instance of noncompliance with external norms that results in fines or penalties against the corporation lead to personal liability or even a rebuke in a non-damages lawsuit 103. Just as individuals, the elemental moral actors in society, have (or should have) the freedom to make [continua ..]

IV. Conclusion

The duty of obedience, once a recognized element of the for-profit corporate landscape, continues to have aspirational and normative meaning. Whether in cases applying the ultra vires doctrine to board decisions that stray beyond internal corporate norms, statutory mandates of internal controls, or articles that exculpate directors except for knowing violations of law, the duty of corporate actors to ensure legal compliance by the for-profit corporation is imbedded in corporate law. Compliance with internal corporate norms and external legal requirements is central to the legitimacy of the corporation. So why has the duty of obedience, as such, vanished from the corporate lexicon? One explanation is that its original and principal function as a liability corollary to the ultra vires doctrine disappeared with the demise of the full-blown ultra vires doctrine. As the corporation has come to be accepted as an open-ended enterprise and questions of corporate power have been displaced by questions of fiduciary duty, the need for obedience-based liability dissolved. Another explanation for the disappearance of obedience may come from the (temporary) rise of the theory of the corporation as a “private contract” between investors and managers. As such, corporate actors should owe no duties (beyond those specifically imposed upon them by law) to ensure corporate compliance with legal norms. But over the past two decades, a host of criminal sentencing guidelines, statutory requirements, and court-created norms has roundly rejected the theory. Today corporate actors cannot disregard internal norms or external law – except at their personal peril. A final explanation for the disappearance of an obedience duty may be the concern that such a duty would distort, and even displace, the external norms that corporate law would be asked to enforce. For example, as illustrated by Miller v. AT&T, a hard duty of obedience applied to directorial non-compliance with campaign finance laws might well lead corporate law to impose greater personal liability for non-compliance than that envisioned by the campaign finance regime itself 107. All of this suggests that it may be time to recognize (and speak openly about) the animating “ghost” behind such normative regimes as the “reasonable expectations” doctrine, the binding nature of shareholder-approved compensation plans, the organizational Sentencing Guidelines, and [continua ..]