The corporate form has consistently proven to be a superior method of business organization. Great industrial economies have grown and prospered where the corporate legal structure has been prevalent. This organizational form, however, has not existed and served without flaw. The multiple problems arising out of the fundamental agency nature of the corporate relationship have continually hindered its complete economic effectiveness. Where ownership and management are structurally separated, how does one assure effective operational efficiencies? Traditionally, the solution lay in the establishment of a powerful monitoring intermediary the board of directors, whose primary responsibility was management oversight and control for the benefit of the residual equity owners. To assure an effective agency, traditionally, the board was chosen by and comprised generally of the business’s largest shareholders. Substantial shareholdership acted to align board and shareholder interests to create the best incentive for effective oversight.
Additionally, legal fiduciary duties evolved to prevent director self dealing, through the medium of the duty of loyalty, and to discourage lax monitoring, through the duty of care. No direct compensation for board service was permitted. By the early 1930's, however, in the largest public corporations, the board was no longer essentially the dominion of the company’s most substantial shareholders.
The early twentieth century witnessed not only the phenomenal growth of the American economy, but also the growth of those corporate entities whose activities comprised that economy. Corporations were no longer local ventures owned, controlled, and managed by a handful of local entrepreneurs, but instead had become national in size and scope. Concomitant with the rise of the large-scale corporation came the development of the professional management class, whose skills were needed to run such far-flung enterprises. And as the capitalization required to maintain such entities grew, so did the number of individuals required to contribute the funds to create such capital.
Thus, we saw the rise of the large-scale public corporation owned not by a few, but literally thousands and thousands of investors located throughout the nation. And with this growth in the size and ownership levels of the modern corporation, individual shareholdings in these ventures became proportionally smaller and smaller, with no shareholder or shareholding group now owning enough stock to dominate the entity. Consequently, the professional managers moved in to fill this control vacuum. Through control of the proxy process, incumbent management nominated its own candidates for board membership. The board of directors, theoretically composed of the representatives of various shareholding groups, instead was comprised of individuals selected by management. The directors' connection with the enterprise generally resulted from a prior relationship with management, not the stockholding owners, and they often had little or no shareholding stake in the company.
Berle and Means, in their path-breaking book The Modern Corporation and Private Property, described this phenomenon of the domination of the large public corporation by professional management as the separation of ownership and control. The firm's nominal owners, the shareholders, in such companies exercised virtually no control over either day-to-day operations or long-term policy. Instead control was vested in the professional managers who typically owned only a very small portion of the firm's shares. One consequence of this phenomenon identified by Berle and Means was the filling of board seats with individuals selected not from the shareholding ranks, but chosen instead because of some prior relationship with management.
Boards were now comprised either of the managers themselves (the inside directors) or associates of the managers, not otherwise employed by or affiliated with the enterprise (the outside or non-management directors). This new breed of outside director often had little or no shareholding interest in the enterprise and, as such, no longer represented their own personal financial stakes or those of the other shareholders in rendering board service. However, as the shareholders' legal fiduciaries, the outside directors were still expected to expend independent time and effort in their roles, and, consequently, it began to be recognized that they must now be compensated directly for their activities.
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