What Independent Directors Should Expect from Inside Directors: Smith v. Van Gorkom as a Guide to Intra-Firm Governance

Abstract

In this article, I appraise the ability of individual directors to motivate those who serve with them on the board to exercise care. I focus on the relationship between independent and inside directors. I discuss horizontal monitoring - the process by which members of a corporate board monitor each other. I suggest that outside directors make clear their expectation that inside directors satisfy care obligations. The goal in this article is to encourage the accountability of inside directors - not to shareholders through derivative litigation - but to independent members of the board through horizontal monitoring. The duty of care, as articulated in Smith v. Van Gorkom and other case law, is a normative guide for internal governance of the corporation. The focus in this article is on the relevance of the duty of care to internal governance processes rather than judicial review of board decisions and processes. The duty of care can provide a way for independent directors to evaluate the inside directors who serve with them. The duty becomes relevant as a way to define the expectations that outsiders should have from inside board members. Once this happens, the duty of care would become an explicit part of what outsiders ask of insiders. Inside directors are likely to fulfill this expectation because of the dynamic of horizontal monitoring that encourages individual board members to perform their duties in a way that will meet the approval of other board members. I also consider the ability of independent directors to monitor and assess the conduct of inside directors when those insiders act as corporate officers. The unitary approach that courts take when reviewing a board's decision-making process ignores the conduct of individual board members who participate in the decision-making process not only as directors but also as officers. The traditional focus on a board's collective decision-making obscures the notion of individual accountability and responsibility. Even if courts should consider board conduct as a collective, this should not obscure the need for clarification of the relationship between inside and outside directors, and the need for independent board members to let inside directors know what is expected of them. The approach to internal governance I advocate in this article requires independent directors to determine when insiders act in their capacity as directors and when they act as officers. I use the term role differentiation to describe the practice of distinguishing among the various roles undertaken by a single individual.