What Corporate Boards Can Learn from Delaware

Here’s a catch-22: While someone starting a cosmetics company, for example, would prefer to surround themselves with the best and brightest in both industry domain expertise (someone who knows the cosmetics industry) and functional domain expertise (someone who knows direct-to-consumer marketing), they’d probably do exactly the opposite if their company were publicly listed.

In fact, they might go out of their way to stock their board with people who knew very little about the business and had very few ties to the industry. Which is absurd. And which begs the question: Why do boards exist?

The role of the board is to manage and supervise the activities of the corporation for the benefit of the common stockholders. That is, the board is a “steward” of the common stockholder, which means (according to Delaware law) that they are responsible for helping guide and advise the CEO on how best to maximize the value of the company for the benefit of those common stockholders.

It naturally follows then that the people most qualified to serve this purpose would have distinguished themselves in their professional careers by having demonstrated expertise in the areas most relevant to the business for which they’re serving on the board.

Still, power can corrupt. We shouldn’t leave unchecked the power of the board to influence the course of the business, what markets the business should pursue, what acquisitions the business should make, and so on.

That’s where Delaware law correctly protects against such abuses by prescribing two well-known duties a board member owes to stockholders:

– The duty of care. This means that a director must stay informed, pay attention, and exercise reasonable judgment when making decisions on behalf of the corporation. In other words, don’t show up at a board meeting ill-informed about what’s happening in the business or approve various corporate actions that impact the stockholders and assume that you’ve discharged your duties.

– The duty of loyalty. A director must put the interests of the corporation ahead of his or her own pecuniary interests. So, if you own a business that will triple in value once you approve a particular corporate action, don’t expect the law to sanction the lining of your own pockets at the expense of the stockholders.

But therein lies the rub … If a corporation wants informed board members with deep knowledge of the industry and businesses in which they operate, then the best pool from which to pick board members is likely filled with people who are already in the industry. And because they are already in the industry, the likelihood of board members benefiting from a corporate decision in which they participate is inherently higher than if companies selected uninformed, yet “independent” directors.

Here again, though, Delaware law comes to the rescue: The law doesn’t compel corporations to compromise independence for expertise. Rather, it provides a set of actions that boards can undertake when potential conflicts inevitably arise. These include board members disclosing the conflicts and recusing themselves from the particular decision at hand; forming independent committees comprised of disinterested board members; engaging outside experts (e.g., consultants) to validate the benefits of an opportunity; etc.

So why do we find public company boards compromising expertise for sacrosanct “independence”? Because the costs and distractions from activist shareholders — whose sole purpose is to line their own pockets through a legalized form of greenmail — crying foul over theoretical conflicts is simply too great.

While Delaware law clearly protects boards that respect the duties of care and loyalty, the practical reality of taking an activist campaign fight to the courts prevails. It’s simply too expensive, too time-consuming, and too deleterious to a company’s stock price to wage a legal battle. As with many other nuisance-like legal battles, it’s simply cheaper to pay off the activist than to pay the lawyers.

The economically rational response is to hand your lunch money over to the schoolyard bully. An even more rational response is to never even show up at the schoolyard in the first place, just to avoid the risk of provoking the bully. In the end, we get precisely the economic incentives for which we bargained — companies whose boards are comprised of know-nothing independents.

This means the common stockholder, whose interests the board member is supposed to protect, gets the short end of the stick. Not only does this situation make no sense, it flies in the face of well-established corporate law. No one wins — except the activists, who take their money and move on to the next playground.

This story originally appeared in Fortune.