How Board Consultants Can Affect Corporate Governance and the Business Judgment Rule

In recent years, boards of directors have confronted a strategic dilemma: whether to appoint specialized directors or engage external consultants to advise them on various aspects of their business. This decision has significant implications for a board’s accountability, the application of the business judgment rule, and the protection of shareholder interests. In a new article, we analyze the increasing use of formal procedures within corporate law and explore the balance between internal expertise and outsourcing functions.

In particular, we analyze the pros and cons of specialized directors and external consultants, considering the legal and economic factors that influence this decision. We argue that the choice is not merely a matter of financial costs andbenefits, but also a reflection of a board’s vision, values, and culture. We also discuss the paradox that cost-saving decisions without consultancy may expose directors to liability, while cost-incurring decisions with consultancy may avoid scrutiny.

A key factor in our analysis is the business judgment rule (BJR), whose application can be complicated as when directors increasingly rely on external specialists to inform their decisions. Directors must exercise due diligence in selecting outside experts, ensuring that they are qualified and independent, and evaluate the advice provided to demonstrate adherence to the BJR. The rule does not automatically protect a board’s choice of an outside expert. Directors must reasonably believe in the expert’s competence and that the expert was selected with reasonable care by or on behalf of the corporation. The BJR’s protection is contingent upon the board’s active participation in the decision-making process, thorough documentation, and regular oversight of the expert’s recommendations.

The BJR may not apply if directors over-rely on outside experts or fail to exercise independent judgment, or if experts have conflicts of interest or provide misleading information. Directors must also ensure that engagements with external experts adhere to ethical standards and legal compliance to maintain the protection of the BJR. In considering the application of he BJR, courts may consider factors such as the board’s reasonable belief in the expert’s competence and the care taken in selecting the expert. Its applicability and the level of protection it affords can vary depending on the board’s oversight, the expert’s independence, the transparency of the selection process, and the outcomes of the decisions based on expert advice.

Aspect of BJR Application to external experts Challenges or limitations
Good faith Directors must select experts in a transparent and unbiased manner, ensuring their qualifications and experience match the company’s needs. Directors may face allegations of bad faith if they choose experts based on personal or financial ties, or if they ignore or manipulate expert advice to suit their own agenda.
Duty of care Directors must exercise prudence in expert selection, due diligence on backgrounds, and analysis of potential conflicts of interest. Directors may be liable for negligence if they fail to verify the expert’s competence, credibility, or independence, or if they delegate too much authority to the expert without adequate oversight.
Duty of loyalty Directors must prioritize the company’s interests and maintain objectivity when collaborating with external experts, avoiding any relationships that could compromise the independence of expert advice. Directors may breach their duty of loyalty if they benefit personally or financially from the expert’s advice, or if they act against the company’s interests based on the expert’s input.
Documentation Directors must document the decision-making process, including expert qualifications, scope of engagement, and specifics of the advice provided, to demonstrate adherence to the BJR. Directors may face scrutiny or litigation if they fail to document the process or the rationale behind their decisions, or if they omit or misrepresent any relevant information from the expert’s advice.
Reasonableness Directors must reasonably believe in the expert’s competence and that the expert was selected with reasonable care. Directors may lose the protection of the BJR if they make decisions that are unreasonable or irrational based on the expert’s advice, or if negative outcomes result from the decision and there are feasible or preferable alternatives.

In our paper, we also consider the transformation of boards into what could be described as “theater boards,” where the directors are reduced to actors on a stage, following a script crafted by external experts. This transformation involves a potential broadening of the role of special committees, suggesting that boards may lose their autonomy and effectiveness by over-relying on outside advisers. These advisers, who might have conflicts of interest or lack a thorough understanding of the corporation’s unique circumstances, risk turning the board’s decision-making process into a carefully choreographed performance, rather than an authentic exercise of governance. We also emphasize the need for transparency, disclosure, and best practices to ensure that the board’s use of external consultants is appropriate and accountable.

The paper provides an analysis of proxy statements from Apple Inc., Amazon.com, Inc., Intel, Johnson & Johnson, JPMorgan Chase & Co., Microsoft Corporation, Visa Inc., Procter & Gamble Company, and Meta, highlighting their approach to board composition and the use of outside consultants. We identify two cross-sector shifts: the influence of diverse stakeholder cohorts and the ascendancy of consultants as board service providers. We envision a strategic evolution of consultants towards becoming board services providers (BSPs) much like Bainbridge’s model. This shift highlights the impact of using outside experts on governance accountability, the application of the business judgment rule, and safeguards against conflicts of interest.

From our research, several nuanced findings emerge. We find, for instance, that the strategic use of external consultants and advisers can significantly benefit corporations by providing specialized knowledge and impartial perspectives on critical matters such as financial strategies, regulatory compliance, and strategic planning. This approach often enhances decision-making processes by offering insights not readily available internally, thereby bolstering risk management frameworks and operational efficiencies.

However, our study also highlights potential challenges associated with this practice. One concern is conflicts of interest, where external consultants may prioritize their own interests or relationships over those of the corporation. This issue underscores the importance of stringent oversight and robust conflict-of-interest policies to safeguard corporate integrity and stakeholder trust.

Moreover, while external experts can bring valuable expertise, their involvement may inadvertently dilute internal ownership and accountability for decisions within the company. This dynamic can lead to reduced organizational learning and the potential for dependence on external guidance rather than nurturing internal capabilities.

From a legal standpoint, the use of external consultants implicates fiduciary duties and the application of the business judgment rule. Courts often scrutinize board decisions involving external advisers to ensure they are made in good faith, with due care, and in the best interests of the corporation and its shareholders. This legal framework underscores the need for boards to exercise prudence in selecting, monitoring, and compensating external consultants, while also ensuring transparency in their roles and responsibilities.

Thus, while leveraging external expertise can provide significant strategic advantages, it requires a delicate balance to mitigate associated risks and uphold corporate governance standards. Future research and policy discussions should continue to explore these dynamics to refine best practices and enhance the effectiveness of corporate decision-making processes in diverse economic landscapes.

Finally, the paper suggests  avenues for additional investigation. These includea broader study on the impact of formal procedures on corporate behavior and decision-making, comparative studies across different jurisdictions to understand the effectiveness of various board composition strategies, qualitative research exploring the decision-making processes behind appointing specialized directors versus engaging external consultants, and investigating the evolving dynamics between diverse stakeholder groups and consultancy firms in shaping corporate governance practices.

Our study suggests that the choice between specialized directors and external consultants is not binary but rather nuanced and context-dependent, requiring careful consideration of the costs and benefits of each option. We recognize the complexities and potential advantages of outsourcing within corporate law, advocating for further examination and discourse on the ideal equilibrium between in-house proficiency and outsourced functions.

This post comes to us from Maria Lucia Passador at Bocconi University – Department of Law. It is based on her recent paper, “Exploring Governance Gambits and Business Judgment in In/Out-Sourcing Tactics,” available here.

Leave a Reply

Your email address will not be published. Required fields are marked *