The Prime Directive
Much of the discussion in corporate law centers on executive compensation. While there is a debate over whether the current system is better described as mangers capturing directors so as to pad their pay packet or as the the result of a competitive market, all share the notion the goal of executive compensation is to align the incentives of the managers with the shareholders. Such an alignment may be important, but it is an odd place to start dicussions of corporate governance.
When we think of other organizations, we don't attribute their success to the compensation contracts that are in place. No one attributed the Chicago White Sox winning the World Series to the contracts that employed Ozzie Guillen and the players. When law faculties participate in a dean search, no one asks whether the administration is going to give the new dean a contract that will ensure that she is a faithful agent.
The key task (or as a paper that Douglas Baird and I are working on label it, "The Prime Directive") is to first hire the right person as CEO. After this, the second challenge is to ensure that the CEO is shown the door at the appropriate time. Picking the right leader is no trivial task. Sometimes the promise that the Board saw in the person selected as CEO does not materialize. Othertimes, the challenges that confront the business change. The person who was needed to push through the merger to change the corporate focus may not be well suited to overseeing the integation of the companies.
Leaving the hiring and firing decisions to the board itself may present problems. Human behavior suggests that the Board that reached consensus on the person to lead the company may be too slow in recognizing that a change needs to be made. Moroever, the CEO often can control to some extent the information that the Board receives.
In terms of the hiring decision, law plays at best a modest role. It can remind the directors that they should be looking for a leader who will maximize shareholder value, but it cannot identify which candidate would best accomplish this.
On the firing side, however, law can have a large impact. An underappreciated role of private debt is that it can lead to the dismissal of under-performing managers. Private debt contracts contain numerous covenants. Running afoul of a covenant will trigger a discussion with the lender. While the lender does not necessarily know how to run the business, it needs to have faith in the management team. The CEO who can convince the Board that hired her that things are in fact fine may have more difficulty making the case to the workout group at the bank.
In policing the bank-borrower relationship, law can influence the discussion. Doctrines such as lender liability, equitable subordination, and the tort of deepening insolvency, if pushed too far, can make lenders hestitate, thus prolonging the tenure of managers that need to go.