Corporate culture binds employees together and directs their collective behavior at work. It also has an important impact on the success of organizations. Studying the determinants of corporate culture has been difficult, however, because of its unobservable nature. In a recent working paper, we investigate how the fiduciary duty of loyalty affects corporate culture in the U.S by using quantitative measures that Li et al. (2021) have developed with machine learning techniques. Our paper offers insights into the long-standing agency cost problem and the intra-firm balance between principles and freedom.
A fundamental tenet of corporate law, the fiduciary duty of loyalty, which is required by the corporate opportunity doctrine (“COD”), forces corporate fiduciaries (i.e., directors, officers, and controlling shareholders) to subordinate their own interests to those of the corporation when conflicts of interest arise. It is an important policy lever for addressing any agency problem in firms. In July 2000, Delaware passed the corporate opportunity waiver (“COW”) law, which explicitly allows corporate fiduciaries of companies incorporated there to waive the fiduciary duty of loyalty in taking advantage of a new business opportunity. The waiver allows corporate fiduciaries to explore the opportunity without first presenting it to their employers. Eight more states have adopted the COW law, including Oklahoma, Missouri, Kansas, Texas, Nevada, New Jersey, Maryland, and Washington, thereby freeing thousands of U.S. corporations from the COD.
On one hand, the COW law could improve corporate culture. The duty of loyalty imposed by COD and the litigation risk of COD violation impede corporations’ ability to raise capital, build efficient investor bases, and secure optimal management arrangements. Studies (Bénabou and Tirole 2010; Chu and Zhao 2021) show that the COW law could improve contractual flexibility to expand an investor base and attract more capital. Studies (Rauterberg and Talley 2017; Lin et al. 2021) also suggest that the COW law could benefit firms by improving monitoring and corporate governance. The COW law also enables external directors to join the company’s board and bring prestige, visibility, experience, and commercial contacts.
On the other hand, the COW law and the weakened duty of loyalty could intensify agency conflicts. With the COD requirement waived, corporate fiduciaries will probably be less loyal to their companies and more likely to pursue their own interests. Consequently, the COW law leads to reallocation of new business opportunities between corporate fiduciaries and their company’s ultimate owner, shareholders, which intensifies agency conflict and potentially erodes corporate culture. Also, the COW law encourages directors to serve on multiple boards at the same time, making them busier and rendering them ineffective monitors of corporate management. Wang (2022) finds that shareholders are less likely to vote for directors potentially protected by the COW law. Boyd et al. (2022) document that corporate social responsibility decreases significantly after the passage of the COW law. The evidence in prior studies implies that the COW law exacerbates the classic agency conflict between corporate fiduciaries and shareholders, which potentially damages corporate culture.
Given these competing views, we empirically test which effect dominates across a broad sample of firms. We conduct a difference-in-differences analysis comparing changes in corporate culture between firms incorporated in states that have and have not adopted the COW law. We find that enactment of the COW law leads to a significant decline in corporate culture. The findings confirm that the COW law intensifies agency conflicts and outweighs its possible benefit.
We also investigate how the COW law could damage corporate culture. We show that it encourages directors to serve on multiple boards, leading to more board overlap, intensified agency conflicts, less effective monitoring by directors, and weaker corporate culture. Our paper also conducts heterogeneity analysis and documents that the effect of the COW on a firm’s culture varies, depending on whether firms have directors with legal expertise, poor corporate governance, or attractive business opportunities.
Our study sheds light on decision making by corporate fiduciaries who face valuable opportunities but have a weaker loyalty requirement. That is, we can infer whether relaxing fiduciary duties leads to an optimized corporate outcome or encourages the pursuit of managerial self-interest at the expense of corporate values. Overall, our study contributes to the literature on fiduciary duty and corporate culture by exploiting the staggered adoption of COW law by states as a quasi-natural experiment. We document declining corporate culture in response to the relaxed fiduciary duty after the COW law passage, highlighting the importance of fiduciary loyalty in shaping firms’ corporate culture and solving agency problems. Our study also contributes to the law and finance literature in general on how corporate laws could be used in dealing with conflicts of interest.
Li, K., Mai, F., Shen, R., Yan, X., 2021. Measuring corporate culture using machine learning. The Review of Financial Studies 34(7), 3265-3315.
Bénabou, R., Tirole, J., 2010. Individual and corporate social responsibility. Economica 77(305), 1-19.
Chu, Y., Zhao, Y., 2021. The dark side of shareholder litigation: Evidence from corporate takeovers. Financial Management 50(3), 845-873.
Rauterberg, G., Talley, E., 2017. Contracting out of the fiduciary duty of loyalty: An empirical analysis of corporate opportunity waivers. Columbia. Law Review, 117, 1075.
Lin, C., Liu, S., Manso, G., 2021. Shareholder litigation and corporate innovation. Management Science 67(6), 3346-3367.
Boyd, N., Li, S., Wang, H.H., Wang, X., 2022. Disloyal managers and corporate social responsibility. Working paper.
Wang, X., 2022. Disloyal managers and proxy voting. Finance Research Letters 44, 102636.
This post comes to us from Maggie Hu at The Chinese University of Hong Kong, Cheng Jiang at Temple University, Kose John at New York University, and Ming Ju at Louisiana Tech University. It is based on their recent article, “Fiduciary Duty of Loyalty and Corporate Culture,” available here.