Monday, March 12, 2012

My 100th Article - Understanding the Role of Directors in Public Corporations

After almost 3 years since the inception of this blog, I manage to write my 100th post! Whew, I must say that I am actually amazed that I can finally reach this stage, considering the fact that I am a master of procrastination. I hope that I can continue to write regularly in this blog for many years to come and increase my platforms of writing by publishing books and research papers. Stay tune for those future projects.

For now, I will write about one of the most fundamental issues on corporate law, the fiduciary duties and business judgment rule. After all, writing on law and business issues was actually my primary intention when I first established this blog before I expanded my interest to other fields of law and economics. So, it would be proper if my 100th article deals with such issue. I hope you can enjoy the article and thank you for reading my posts in this blog.

A. Establishing the Duties of Directors

One of the most fundamental issues in the realm of corporate law is how can we define the standard of good business judgment by the management? From such a simple question, various derivative questions can also be asked: when should we deem the directors liable for their business decision? Where can we set a line to separate the good managers from the bad ones? How should we regulate the relationship between shareholders and managers in a corporation? Should we let the market decides how such relationship will work or should the court intervene? If the court should intervene, to what extent?

From economics point of view, corporation can be considered as a business platform where market process (capital, production, and consumption) is integrated through a systematic decision making procedure (what we call as management). From law and economics point of view, corporation is a nexus of contract, i.e. the aggregation of people bound together by a complex web of contractual relationship.

I personally refuse to view corporation as simply an entity whose ownership lies in the shareholders and whose management lies in the board of directors, and therefore, the directors can be considered as the agent of the shareholders and must work for the best interest of the shareholders. Such simplification tends to be problematic in practice.

First of all, what kind of business model is where someone transfers his controlling power to other parties under the guise of ownership versus professional management where he knows that the interest of these so called professionals might not be in alignment with his own interest? Why making such sharp distinction? Second, it should also be noted that there are some instances where the interest of the shareholders will no longer be placed as a priority anymore, such as in bankruptcy cases where creditors will have higher priority than shareholders as the residual claimant.

Instead, I want to view the corporation as a business organization where the parties involved within it should have a good coordination (between the capital owner, the manager, the employees, etc) and should work together in the most efficient way to ensure the maximization of their overall welfare without imposing unnecessary costs to the society. The only way to align all of these interests within the corporation would be to ensure that all party must work for the best interest of the corporation as a whole. From that point we can determine further what would be the proper role of each parties within a corporation, especially the role of shareholders and board of directors.

With respect to the above idea, a specific discussion must be made with the nature of public corporations. As we may be aware, the ownership structure in these public corporations may vary in Indonesia. There are corporations where the ownership structure is pretty much diversified to the extent that it is difficult to find any controlling shareholders, and there are corporations which are being controlled by certain controlling shareholders.

In a perfect world with minimum transaction costs, shareholders and the board of directors can negotiate the terms and conditions for managing the corporation and we can assume that: (i) they will find the best way to balance their authorities and (ii) in case changes must be made, they can quickly adapt to such situation by amending the contract made between them. The problem is, this is almost impossible to happen within a public corporation.

In a public corporation where the numbers of shareholders are huge, it is easy to conclude that they will face collective action problem, preventing them from making an effective negotiation with the directors nor from conducting day to day management of the corporation. As a result of which, the board of directors will ultimately become the controlling party of the public corporation without any internal counterbalancing party. In short, the ownership structure in public corporations create a situation where there is no opposition in the corporation that can ensure a good check and balance mechanism.

The same problem can also occur when controlling shareholders exist within a corporation. Having the majority power to decide what the corporation should do, they can use their power to pursue their own interest at the expense of the corporation and other shareholders. In short, whoever controls the corporation, shareholders or directors, might abuse their power. Thus, a check and balance mechanism would be necessary. For the purpose of this post, I will focus on the directors part.
 
We have these kind of check and balance mechanisms in our government structure (or we think that we have) because we understand that the government consists of people and they are not angels which have no self interest. By simple logic, the same thing should also be applied to corporations which obviously are also managed by a bunch of people. In case shareholders cannot be the counterbalancing party, we need to have other external mechanisms to ensure that the board of directors will have the correct incentives in doing their job.

One of the possible solutions might be to rely on the market. Bad managers will reduce the value of the corporation that they manage and will induce other potential buyers to takeover the corporation and replace the old management. This seems good, but there is no guarantee that it will always work nor will it be be beneficial to the overall stakeholders of the corporation.  Furthermore, in Indonesia, the regulators seem want to limit takeover practices by imposing certain limitations such as the requirement to conduct a mandatory takeover which increases the overall costs of a takeover.

An alternative solution would be having the assistance from the law and the court by filling the gap, creating specific duties that must be performed by directors and that will cause them to be liable either to the corporation or the shareholders (as mandated by the prevailing laws of Indonesia) in case they fail to perform those duties properly. By imposing such liability, we expect the directors will be more careful in performing their work and will always be loyal to the interest of the corporation.

It should be noted though that this is but one solution among many solutions to be used in guiding the directors performance. In corporations with small numbers of shareholders, where coordination between managers and shareholders is easy to achieved, limiting liability might be the best way. But for public corporations, that will not work. Imposing liability is necessary as a check and balance mechanism for corporate governance. It is what our law supports and what any rational men will agree anyway.

B. Best Interest and Best Effort

Even though legitimizing the existence of directors duties is not a difficult task, the real challenge is to expand those duties into a standard that would be acceptable to all stakeholders. Two issues that we need to address here: (i) defining the best interest of the corporation, and (ii) defining the standards that the directors must comply in order to satisfy the best interest of the corporation.

1. Defining The Best Interest of Corporation

On the first issue, in line with my view that corporation should be seen as a platform for business organization for various stakeholders, the best interest of the corporation should be translated into maximization of the value of the corporation which will benefit the whole stakeholders of the corporation in general.

Each managerial decision to be made by the directors must consider carefully whether there is a perceived benefit for the corporation if such decision is taken. Whether the benefits are for short term or long term should not be a major problem, the more important thing is that the directors when being asked by the stakeholders of the corporation can provide sufficient justification that they have done their best effort to ensure that their decision is made only and only for the benefit of the corporation as a whole.

2. Defining The Best Effort Standard

The next step is to define the term “best effort”. A good standard would not sacrifice the flexibility that the directors have in managing the corporation. Putting too high standard will burden the corporation as it will increase the costs of decision making by the directors. While putting too low standard will defeat the purpose of finding the correct incentives for directors as they can cover their liability even when they are reckless by ordinary standard.

A major issue related to defining the best effort standard is the fact that the court is not a business expert. Creating an ambiguous standard would eventually burden the court since when there is no certainty, we can expect that more cases will come to the court and there is no guarantee that the court can provide the best result. On the other hand, if the court creates a rigid business management standard, what would be the justification to provide such standard? The court could end up damaging the welfare of the society for making standards outside their own expertise.

In order to determine whether the directors have conducted their best effort, I would suggest that the court should not try to create an ambitious standard that will be problematic for future cases. I would instead urge the judges to think as if they are ordinary people who trust their money to certain trustees and expect that they will cooperate with them for their best interest and that they will work with the money as if the trustees own the money themselves. In such position, I will naturally focus on the decision making procedures that have been taken by the trustees before I move on to the end result of their decision.

Can they show that they have enough time to discuss the proposed action? Can they show that a proper study has been conducted by the board of directors, at least internally, that the action is beneficial to the corporation? Can they show that they have considered the risks that might occur, the probabilities of the risks occurrence, and how the corporation will mitigate such risks? I believe that all of these questions reflect the common sense standard in doing a business.

In case of doubt, all of these actions should be judged in accordance with the standard usually used by similar industries or type of business and the court can obviously rely on expert witnesses concerning such matter. If it can be proved that the directors did not meet those standards, they should be deemed violating the best effort standard, and it will open the door of liabilities.

Another solution would be to induce the directors to use the service of independent third party professionals in rendering their decision, such as lawyers, financial advisers, and appraisers. The use of these professionals has already been required by certain capital market regulations and might indicate the good faith of the directors to ensure that they don't make significant mistake in doing their job. Of course, the court can always review the independency of the professional parties to ensure that there is no conflict of interests which may taint the business decision.

C. Conclusion

Although our law has stated that directors have fiduciary duties to satisfy the best interest of the corporation, further elaboration is needed to ensure that all corporation stakeholders can have the right incentives in doing so. There are many ways to ensure that directors stay true to their duties, either bia the market or the law. If we want to use legal mechanism, the role of the court should be expanded as the guardian of the last resort in the business world. Of course, to achieve such state, the quality of the judges must also be improved.

3 comments:

Walesa World of Dream's Monday, March 12, 2012 11:46:00 AM  

WOW, first of all congratulation for your 100 articles, really this is a good achievement.

Pram, I have one question? what if on the public corporation there are an involvement of the government that can create an influence for the company in making their decision? so this situation can make a limitation for either stakeholder or even director.

Is there any regulation or maybe limitation that prevent such a thing occur?

Pramudya A. Oktavinanda Monday, March 12, 2012 11:58:00 AM  

You mean that there are any legal barriers created by the government? Unfortunately, when such thing occur, the acts that can be done by the management are quite limited, i.e. challenging the government regulations or decisions.

For government administrative decisions, we can challenge them through the administrative court (PTUN). For regulations below the level of a Law (undang-undang), we can challenge them via the Supreme court. And for Laws, we can challenge them via the Constitutional Court (MK).

In general, management cannot be blamed for governmental intervention. The best thing that they can do is to challenge the problematic regulations as I said above.

Walesa World of Dream's Monday, March 12, 2012 1:46:00 PM  

yap that's what I mean. thank you for the answer pram. Its very clear now.

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