Corporate “Free Exercise” and Fiduciary Duties of Directors

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday March 4, 2014 at 9:15 am
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Editor’s Note: The following post comes to us from Mark A. Underberg, retired partner of Paul, Weiss, Rifkind, Wharton & Garrison LLP, and an Adjunct Professor of Law at Cornell Law School and the Benjamin N. Cardozo School of Law.

This Spring, the Supreme Court will decide whether a for-profit corporation can refuse to provide insurance coverage for birth control and other reproductive health services mandated by the Affordable Healthcare Act (or “Obamacare”) when doing so would conflict with “the corporation’s” religious beliefs. Although the main legal issue in Sibelius v. Hobby Lobby Stores, Inc., et al. and Conestoga Wood Specialties Corp., et al. v. Sibelius concerns the extent to which the guarantee of free exercise of religion under the Constitution and the Religious Freedom Restoration Act may be asserted by for-profit corporations, the Court’s decision may also have important—and unsettling—implications for state corporate laws that define the fiduciary duties of boards of directors.

The plaintiffs in these cases include individual shareholders, but the assertion of “free exercise” rights by the corporate plaintiffs—Hobby Lobby Stores, Inc. and Conestoga Wood Specialties Corp.—is at the center of the debate. In order to assert these rights, each company, presumably by resolution of its board of directors, determined to oppose the Obamacare mandate and to file a lawsuit against the government. It is this corporate decision that raises troubling state law fiduciary duty issues and merits scrutiny.

The companies’ Constitutional arguments are premised on a remarkable (though unremarked upon) notion of state corporate law: that boards of directors may pursue corporate policies based on religious principle with apparent complete disregard of the business interests of the corporation. Such a proposition should startle most corporate lawyers, who regularly and appropriately advise that boards of directors are duty-bound to manage the corporation “with a view to enhancing corporate profit and shareholder gain”. [1]

When making ordinary business decisions, boards are not required to “maximize shareholder value” in the sense of pursuing only those strategies that promise the greatest possible returns. But as the new Chief Justice of Delaware stated in a 2012 law review article, “as a matter of corporate law, the object of the corporation is to produce profits for the stockholders…. the social beliefs of the managers, no more than their own financial interests, cannot be their end in managing the
corporation.” [2]

Of course, courts give boards considerable managerial leeway to determine how that object is best achieved. In the absence of self-interest, so long as a board acts in good faith, with due care, and in a manner it reasonably believes is in the company’s best interests, the business judgment rule will protect most board decisions from judicial second-guessing. (The principal exception to this general rule is the more exacting Revlon doctrine: When the board has decided to sell the company it must maximize short-term shareholder value by seeking the highest price reasonably available and its conduct will be more carefully examined by courts.) At a minimum, then, boards may not pursue corporate policies that are untethered from the corporation’s business interests—revenues, profit, equity value and related matters concerning relationships with customers, suppliers, employees and other stakeholders.

This judicial deference allows boards plenty of latitude to manage companies in accordance with non-profit-maximizing ideological or ethical principles, engage in corporate philanthropy and to implement all manner of “corporate social responsibility” measures. A court will not substitute its views for those of the board “if the latter’s decision can be attributed to any rational business purpose.” [3] As a practical matter, the application of the business judgment rule results in a relatively low fiduciary bar, requiring only a rational relationship between corporate policy and the enhancement of the company’s value over the long-term. But it remains a bar over which boards can occasionally stumble.

Instructive is a 2010 Delaware Chancery Court decision in Ebay Domestic Holdings, Inc. v. Newmark [4], striking down a “poison pill” established by the board and controlling shareholders of a company (Craigslist) to prevent a minority shareholder (EBay) from acquiring future control. In the court’s view, the directors breached their fiduciary duties when they took steps to oppose potential future control by EBay “not because of how it would affect the value of the entity for its stockholders, but rather because of their own personal preferences [regarding the need to preserve Craigslist’s unique corporate culture]…. Having chosen a for-profit corporate form, the Craigslist directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders.”

How would the boards of directors of Hobby Lobby and Conestoga measure up under these fiduciary standards? Not well—at least on the basis of the background provided in the lower courts’ opinions. There’s no indication that the boards of directors of Hobby Lobby, which operates arts and craft stores throughout the U.S. and Conestoga, a manufacturer of wood cabinets, gave any consideration whatsoever to how their companies’ interests would be served by resisting the Obamacare contraceptive and women’s health mandate. For the boards of Hobby Lobby and Conestoga, the sole relevant consideration appears to have been religious principle with no apparent relationship to “a rational business purpose”.

And advancing that religious principle came at a considerable potential cost to the corporation and its stakeholders. According to the companies’ court papers, the boards’ decision not to comply with the mandate exposed their companies to potentially ruinous financial risk—tens of millions of dollars in fines and penalties in the absence of an exemption—and the costs of the lawsuits against the government, which are likely borne in large part by the corporate plaintiffs, could significantly deplete the companies’ financial resources.

The point isn’t that the boards may have gotten the benefit/cost calculation wrong. If the directors’ decision had been grounded on their views regarding the welfare of the corporation, it would have been immune from challenge as a matter of business judgment. [5] Here, the Hobby Lobby and Conestoga boards’ fiduciary duty shortcomings arise not from the directors’ analysis but from their process. Did the boards carefully consider facts reasonably related to the decision to resist the Obamacare mandate in an effort to make a good-faith decision in the best interests of the company? Or did strongly held religious beliefs cause board turn a blind eye to these concerns?

The latter seems far more probable, and therein the problem; it’s hard to imagine that a state court would sanction a decisionmaking process in which the business interests of the corporation aren’t even considered. It’s practically black-letter law that a failure to act in good faith occurs “when a fiduciary intentionally acts with a purpose other than of advancing the best interests of the corporation.” [6] Indeed, it’s easy to imagine a double-barreled shareholder complaint alleging breaches of duties of loyalty and care against the boards of Hobby Lobby and Conestoga; for an experienced shareholder plaintiff’s lawyer, it practically writes itself.

And what of the fact that the boards’ decisions advanced the religious beliefs of shareholders, all of a like-mind with the board? Most obviously, it means that there’s little risk to the Hobby Lobby and Conestoga boards that claims of breach of fiduciary duty are likely to be filed anytime soon, at least so long as all of the shareholders hold identical religious beliefs and no creditors have been harmed. (Under some states’ law, creditors may be able to assert such fiduciary duty claims against directors.)

But beyond this practicality lies important concerns. Whether or not the religious beliefs of shareholders may be “passed through” to the corporation, there’s no dispute that a clear legal distinction exists between personal and corporate decisionmaking. Certainly the board can take into account the personal views of shareholders, but corporate law endows the board of directors with the exclusive right and obligation to make their own independent decisions about what’s in the best long-term interests of the company. That’s what state law says the for-profit corporate form is all about; boards can’t “pass through” their fiduciary obligations to shareholders.

There’s little precedential basis for exempting directors from their duty to consider the best interests of the corporation simply because the directors believe that shareholders don’t want them to do so. In fact, the corporate laws of Oklahoma and Pennsylvania, where Hobby Lobby and Conestoga are incorporated, respectively, suggest otherwise—they do not permit shareholders to waive the duty of loyalty in corporate charters.

Moreover, such an exemption would put boards in the risky business of divining shareholder intent and provide fodder for countless future court cases seeking to determine the extent of shareholder agreement that’s necessary to establish the “corporation’s belief” short of unanimity. In addition, the availability in many states of a corporate entity called a “benefit corporation”, which allows for-profit corporations to specify alternative corporate purposes in their charters, provides an objective way for boards to assess shareholders’ non-financial priorities. But “regular” for-profit corporations like Hobby Lobby and Conestoga and thousands of others are predicated on longstanding fiduciary principles that require boards of directors to consider far more than religious principle—no matter how widely and deeply held among shareholders—when setting corporate policy.

Whether or not the Hobby Lobby and Conestoga boards breached their fiduciary duties under state law in opposing the Obamacare contraception mandate may be of little significance to the Supreme Court’s Constitutional analysis. But it’s important to recognize that an important question of state corporate law is implicated in the Federal “corporate free exercise” debate.

Endnotes:

[1] American Law Institute, Principles Of Corporate Governance: Analysis & Recommendations (1992).
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[2] Leo E. Strine, Jr., Our Continuing Struggle with the Idea that For-Profit Firms Seek Profit, 47 Wake Forest Law Rev. 135 (2012). I recognize that some commentators, particularly in academia, dispute the clarity—and a few, the very existence—of the legal obligation to manage the corporation primarily for the economic benefit of shareholders.
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[3] Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971).
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[4] Ebay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1 (Del. Ch. 2010).
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[5] Though this wouldn’t necessarily have been the case if, for example, the Hobby Lobby board had implemented an anti-takeover measure to prevent non-believers from acquiring shares; in such event, the business judgment standard would likely yield to more exacting judicial scrutiny.
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[6] In re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 67 (Del. 2006).
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  1. I would guess that the lost profits from not operating on Sunday would vastly exceed those of the mandate lawsuits. Are you proposing that a director who follows his shareholders’ wishes and stays closed on Sunday violates his ethical duties?

    Just as relevant: how about Apple? An executive recently said, with apparent sincerity, that the company was engaging in “Green” activities despite their unprofitability. Should he be liable for damages to shareholders? (Note that the damage to profits is clearer than in the Hobby Lobby case.)

    Comment by Eric Rasmusen — March 21, 2014 @ 6:40 pm

  2. I don’t know the specifics of the Hobby Lobby and Conestoga cases, nor the corporations themselves, but it seems to me that, from a corporate law perspective, there is at least one way by which corporate boards could reasonably justify the embracement of religious principles by the corporation. If the corporation has been historically selling itself as, for example, a “Christian” corporation (could be any other religion), or as a corporation run with attention to Christian values, or the board and executives have consistently defended or applied such values when running the corporation, one can argue that this behavior serves to signal a degree of, for example, honesty or decency that positively impacts business, by facilitating business relations, attracting consumers, employees and business partners and so on. This effect could be especially felt if the corporation operates in a predominantly Christian community or in any community in which Christian values are perceived as positive signals of good business behavior. In such scenario, acting against the adopted values could jeopardize the reputation that the corporation built or aimed at building and that yields or is reasonably expected to yield profits.

    Comment by Bianca M. — July 2, 2014 @ 7:42 am

 

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