Opting Only In: Waiver of Liability in Practice (Part 6)

We are discussing a paper recently posted on SSRN titled Opting Only In: Contractarians, Waiver of Liability, and the Race to the Bottom and examining the development and use of waiver of liability provisions.

So what is the bottom line? Does "private ordering" result in the most efficient arrangements, as the contractarians would predict? Not in connection with waiver of liability provisions. The adoption process contains no element of bargaining or private ordering. Instead, it is a management dominated process.

We have chosen as the initial universe for examination the Fortune 100 in the United States (we have plans to expand the list to the Fortune 500). Of that group, ninety-nine are incorporated under state law, with Freddie Mac, a federally incorporated entity, the only exception. Of the remainder, sixty- five are incorporated in Delaware and the rest in a smattering of states.

Among the non-federally incorporated, non-mutual companies, only one did not have some form of waiver of liability, Pepsi Co. The bylaws do provide for indemnification rights “to the full extent permitted by law." Pepsi was incorporated in Delaware in 1919 and reincorporated in North Carolina in 1986. Not only are these provisions ubiquitous, but our study of the articles of these companies shows that all of them waive liability to the maximum extent permitted by law. They do so in a variety of ways. Several companies have a barebones version of the clause containing the following language:

• “A director of the Corporation shall have no personal liability to the Corporation or its stockholders for monetary damages for breach of his fiduciary duty as a director to the full extent permitted by the Delaware General Corporation Law as it may be amended from time to time.”

The others generally repeat the language in the statute, providing that directors shall not be liable for monetary damage then list the exceptions. Some specifically reference recklessness while others prohibit repeal.

The data, therefore, shows that one categorical rule has been replaced with another. While the categorical rule originally allowed for damages in the case of a breach of the duty of care, the adoption of an “opt in” approach to monetary damages simply resulted in everyone opting in. In other words, the results show none of the diversity that private ordering predicted. 

Why does private ordering not take place?  Mostly because of the difficulties imposed on shareholders who might want to engage in some type of negotiations.  Realities on the ground make change difficult despite the presence of activist shareholders.  Many of these difficulties are systemic.  First, only management has the authority to propose an amendment to the articles of incorporation. Directors can pick the most propitious time to propose a matter to shareholders.

The authority goes much further, however, than the power to propose. To the extent management perceives any prospect of losing a vote, it has a variety of tactics that it can deploy to affect the outcome. One example is Mercier v. Inter-Tel (Del.), Inc ., where a special committee of the board sought approval of a merger. When, shortly before the meeting, it became clear the proposal would fail, the committee authorized an adjournment. This occurred despite overwhelming opposition from shareholders for adjournment of the meeting.

Second, waiver of liability provisions can be implemented without the benefit of a direct shareholder vote. The waiver may be in the articles when the company goes public.  In other cases, they may be inserted into the articles when the company reincorporates, with shareholders stuck with approving the entire transaction, not each individual provision in the articles. A waiver of liability provision may also be approved in companies with controlling shareholders, making the opinions of the minority shareholders irrelevant.

Third, even when submitted for approval, shareholders confront the usual bevy of collective action problems.  They lack information, often a consequence of rational apathy.  To oppose management, they would need to lobby other shareholders, made expensive and difficult by the proxy rules.

Fourth, a number of reasons make it less likely that shareholders will oppose a waiver of liability provision. One is the NIMBY phenomenon.  Another is path dependence.  Yet another is the me-too phenomenon. When one board has a waiver of liability provision to fall back on, every other board clamors for the same. With the provisions universally in place, shareholders would have to accept the consequences of denying the waiver to their management while all other large companies, including competitors, have the waiver in place.

Fifth, shareholders also typically want to maintain positive relations with management, preferring to vote with their feet when dissatisfied. Thus, they will not oppose management on every proposal, even if they have reservations. In other words, opposition comes with costs attached. Given the insignificance of the duty of care under Delaware law, these costs likely outweigh the benefits that could result from opposition. 

Directors might be nervous by a provision that departs from what other companies have. In such cases, our evidence might help to explain the persistence of “suboptimal uniformity.”  The suboptimal rule waiving liability to the fullest extent allowed by the law has become uniform because learning or network externalities are significant, especially because of the systemic problem that the waiver of liability provisions are drafted and proposed at the instance of management. Given the agency cost, lawyers on the payroll of the management are unlikely to draft provisions that are against the interests of the management even if such provisions are in the interests of shareholders.