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...Boys CONCLUSION
INTRODUCTION
I was one board meeting, and I said, "I started this [company] to do positive things with the world and do good in the Amazon, not necessarily to get a big payout." ... And one of [the angel investors] looked me in the eye and said, "Well, the problem is, then you went out and took $9 million of other people's money." (1)
Legal principles that are almost right are often more mischievous than those that are completely wrong. What is transparently wrong is interpreted narrowly (or ignored altogether) and is likely to be repealed. An almost-right principle invites sloppy thinking, vague generalities, and a general distortion of the otherwise sound ideas that lie close by. An example of an almost-fight principle that has distorted much of the thinking about corporate law in recent decades is the oft-repeated maxim that directors of a corporation owe a fiduciary duty to the shareholders.
This principle (embraced by the Supreme Court in the nineteenth century (2) and as recently as last May by the Delaware Supreme Court (3)) is not on its face silly. A board of directors, as Adam Smith observed long ago, is charged with taking care of other people's money, (4) and it is usual in such cases for the law to impose special and unremitting duties. After all, directors lack the "anxious vigilance" that we use when looking after our own money. (5) Hence, directors should have a general legal duty to care for this money as a reasonable person would care for it if acting on her own account. (6)
The money in question usually is thought to belong to the shareholders. They contribute capital in the first place, they typically elect the board, and their blessing is required for major transactions. They stand to gain a dollar if the directors make the right decision and lose a dollar if they make the wrong one. In short, "the corporate contract makes managers the agents of the equity investors." (7) As the residual claimants, and unlike most creditors, (8) "[t]hey receive few explicit promises. Instead they get the right to vote and the protection of fiduciary principles." (9)
But this is not the whole story. The common stockholder is merely one flavor of investor. (10) Others, such as lenders, bondholders, and preferred stockholders, also stand to gain or lose with right or wrong decisions. (11) Moreover, with the right package of derivatives, a debtholder can enjoy the same cashflow rights as an equityholder and vice versa. (12) Shareholders ordinarily control the board, but any number of devices (from loan covenants to voting trusts) can give this power to other investors, including creditors and preferred stockholders. (13) As financial innovation has accelerated over the past two decades, the terms "shareholder" and "debtholder" or "creditor" have become less meaningful. (14) Identifying only shareholders as investors, as opposed to all providers of capital, is misleading. The problems likely to arise are already evident, (15) and the current surge in financial innovation will likely exacerbate them. (16)
The notion that fiduciary duties are owed to shareholders has not yet generated seriously wrong-headed outcomes. (Among other things, the Delaware chancellors are generally too smart to let this happen.) (17) Nevertheless, the reasoning needed to navigate around the sacred cow that the duty of the directors is owed solely to the shareholders has become increasingly awkward. People who should know better paint themselves into embarrassing comers trying to reaffirm the principle. (18) The problem is not as simple as whether investors have offensive fiduciary duty claims (i.e. whether fiduciary duties oblige directors to take particular actions). Creditors are more typically arguing for the disablement of duties owed shareholders. (19) They have sufficient influence over the directors such that the directors are willing to take actions in the creditors' favor, provided only that fiduciary duties owed shareholders do not constrain them. Directors, who must make difficult decisions and who are often forgotten in these cases, must also have clear rules about how they should act--the cases, even if coming to the right result in most instances, leave this question largely unanswered.
If we are right that fiduciary duties are becoming more harmful than helpful, the question becomes what principle ought to replace the idea that fiduciary duties are owed shareholders. The most obvious one follows naturally from the idea that ex ante investors presumptively are interested in maximizing the value of the firm. Following the lead of Circuit Judge Easterbrook in In re Central Ice Cream Co., (20) we might instead adopt the following principle: The directors must adopt the course that, in their judgment, maximizes the value of the firm as a whole. This principle of value maximization could also be coupled with a strong business judgment rule. Courts lack information and expertise that would allow them to effectively and efficiently police director decisions and cannot easily determine under any set of facts whether a particular decision was, when made, designed to maximize firm value. Hence, the directors must enjoy a large measure of discretion, and claims by one class of investor against another alleging breach of a fiduciary duty would fail so long as the directors acted reasonably to enhance firm value. (21)
Under this view, there is little we can say about the duties of directors other than that directors should maximize the value of the firm. They rarely, if ever, will be held liable for a decision that, notwithstanding its effect on one type of investor, maximizes firm value (22) (unless their action violates some specific covenant or by-law), and directors invite trouble (but do not necessarily expose themselves to liability) if they make a decision that reduces the value of the corporation. This view follows from the traditional law and economics approach to corporate law. (23)
In this Article, however, we suggest that this approach too may be wanting. Sophisticated investors negotiating for combinations of cash-flow and control rights might well choose models that depart from the simple one that requires directors to always maximize firm value. In some instances the efficient ex ante bargain may include terms that look inefficient ex post. (24) For example, creditors may need to be able to have the ability to engage in self-serving behavior that compromises the value of the business as a whole in order to ensure that the shareholders have the right set of incentives in the previous period. In other words, the real option for one investor to take disproportionate value from the firm under certain circumstances gives other investors and managers incentives to avoid these circumstances. Imposing a value-maximizing duty, even with a strong business judgment rule, may be contrary to what the investors want in their ex ante bargain.
At first cut, we should respect the choices investors and directors make, even if they seem to create situations where the board acts in ways that appear to destroy firm value. (25) Corporate finance and corporate governance are not one-size-fits-all, and firm capital structures are heterogeneous, complex, negotiated, and, most importantly, priced by the market. From this perspective, courts should tread lightly, even when faced with self-serving behavior, lest they upset what they do not understand. (26) Our understanding of capital structures is simply too primitive for us to do much more than enforce the contracts that are written as best we can. The default rules we devise--and fiduciary obligations are simply one of these (27)--should be in service of these contracts. (28) Imposing duties on directors that are too rigid or too mechanical may limit the ability of investors to create capital structures that are beyond the ken of those writing the rules. (29)
This is especially true since investors cannot easily opt out of a fiduciary duty once it is put in place. (30) Hence, it may make sense to eliminate the concept of fiduciary duty from corporate law altogether. (31) Rather than any generalized duty to shareholders or to the firm or to sometimes shareholders and sometimes creditors, directors should merely be obliged to honor the terms of the firm's investment contracts, even when they lead to decisions that are not value-maximizing ex post for the investors as a group. Directors would merely have the duty to attend to the affairs of the corporation and act in good faith, a duty owed to investors and strangers alike. In this world, shareholders, like creditors, must protect themselves through their powers under the corporate charter and the by-laws.
This Article proceeds in four parts. Part I shows how the maxim that fiduciary duties are owed to shareholders cannot be reconciled even with current doctrine. Part II goes on to show how the effort to sort out with greater particularity what duties are owed to whom is doomed to fail. Here we use the recent mess in Delaware over fiduciary duties in the "zone of insolvency" as our principal exhibit. This Part goes on to examine the paradigm that sits most comfortably with current thinking about corporate law in the courts and in the academy--the idea of fiduciary duties being owed to the firm as a whole, coupled with a strong business judgment rule. Part III shows how this principle itself may be wanting and sets out an alternative paradigm, one in which no fiduciary duties exist at all, and directors face liability for their decisions (other than for neglect or surreptitious self-dealing) (32) only if they violate a contractual obligation owed to a shareholder, creditor, or other investor.
Part IV briefly shows how separating corporate law from conceptions of duty brings needed clarity to the often-litigated issue of disclosure duties. (33) The problem, we suggest, is largely contractual, and in setting the default rules, the focus should be on the ability of parties to opt out--or opt in.
I. FIDUCIARY DUTIES TO SHAREHOLDERS
Directors routinely make decisions that unambiguously favor creditors and other investors at the expense of the holders of common stock. The most obvious example is the filing of a bankruptcy petition, the immediate effect of which is to destroy the option value of the equity of the business for the benefit of creditors. No one claims that doing this violates directors' duties, and courts generally do not intervene in decisions about whether to file a bankruptcy petition. (34) This is only the most obvious example of what boards can do at the expense of shareholders and to the benefit of other investors. When the examples are tallied together, the conventional account of fiduciary duties being owed to shareholders cannot be reconciled with existing law, even when coupled with an extremely deferential business judgment rule.
A. Board Discretion
A board of directors can combine two businesses in a manner that denies shareholders of one the ability to vote on the transaction. (35) For example, in Delaware, shareholders of both the "buyer" and "seller" are entitled to vote on all statutory mergers. (36) The board of a buyer, however, can take the vote away from its own shareholders by structuring the merger as a triangular merger: the board creates a subsidiary firm of the buyer, of which the buyer firm is the only shareholder, and then executes a merger between the seller firm and the subsidiary. (37) The subsidiary holds a vote on the merger, and the buyer firm votes its one share in the subsidiary (as per a majority vote of the buyer's board) in favor of the merger. There is no judicial check, say through a "business purpose" test, on the rationale for structuring a merger in the form of a triangle, nor any need to show that the structure maximizes firm value. (38)
The board may do the same thing with shareholders' appraisal rights. (39) The right to receive a judicial appraisal of shares in a merger, like the right to vote, is enshrined in state corporate law statutes. The origin of the appraisal remedy can be traced back to the change in the voting rule for certain fundamental transactions from unanimity to majority rule--the appraisal right was the quid for the quo of allowing transactions to proceed against the will of certain shareholders. (40) It was viewed as an essential stick in a shareholder's bundle of rights. And yet, boards can take it away, and can do so for no reason at all. Boards may structure transactions for the sole purpose of limiting the ability of shareholders to perfect appraisal rights. (41)
The board may also decide, on its own or at the behest of a majority shareholder, to buy out the shares of the minority shareholders even if this is not in the best interests of minority shareholders. (42) It may do so even without stating a business purpose and without any consideration as to the impact on minority shareholders. As the Delaware Supreme Court has held on many occasions, "[i]t is ... settled under Delaware law that minority stock interests may be eliminated by merger." (43) It also may do so without sharing the control premium: controlling shareholders, who also owe fiduciary duties to minority shareholders, may sell their control shares without sharing the control premium with the minority. (44)
In day-to-day activities, long-term project choices, and fundamental transactions, boards may prefer long-term shareholders over short-term shareholders or vice versa. There is no ready check on this ability to choose which type of shareholder to prefer. In addition, the board or a director may even engage in self-dealing transactions, subject only to the requirement that the transaction be fair to the corporation as an entity. (45)
Shareholders may also waive their rights to the duties they are owed, something that sits uncomfortably with the notion of a fiduciary. The ability to waive is seen neither in the law of trusts nor in any other area where fiduciary duties have bite. (46) Indeed, several of corporate law's most famous cases are about explicit or implicit waivers of duties owed by directors or majority shareholders. For example, in Ingle v. Glamore Motor Sales, Inc., Ingle was hired to run the firm and was appointed a director. (47) As part of his employment contract, Ingle agreed to sell back his shares to the firm if he left for any reason. (48) When Ingle was forced out many years later in a corner-office coup, he challenged his termination on the ground that he was, as a minority shareholder, owed a fiduciary duty by the firm and was protected against opportunistic conduct by them. (49) The court rejected his plea, holding in effect that whatever fiduciary duties Ingle was owed as a minority shareholder were waived through his employment contract. (50)
Similarly, in Gallagher v. Lambert, an employee of a closely held firm entered into an employment agreement and a buy-sell agreement, which provided that for the first three years of his employment his shares would have to be sold back at book value. (51) When the firm fired him just three weeks before the buyback period ended (taking about $3 million in potential profits from him), the employee-shareholder sued, claiming a breach of fiduciary duty. (52) The court rejected the claim. The shareholder had effectively waived his fiduciary duties by entering into the shareholder agreement--in other words, the parties' contract "define[d] the scope of the relevant fiduciary duty." (53)
Boards can engage in a variety of maneuverings with the corporate form that allow them to change the rights of shareholders in ways that may not be in the shareholders' financial interest. (54) For example, in a recapitalization, the board can, by creating a shell corporation with a new financial structure and then merging the old firm into the shell, eliminate a particular class of stock. (55) Firms may also reincorporate to a more management friendly state like Delaware, even if this is not in the interests of a particular class of shareholders.
Boards can also act in ways that are overtly beneficial to creditors, who in the traditional account are owed no extra-contractual duties and whose contract fights would seem to be trumped by any shareholder fiduciary fights. For one, creditors can bargain for voting trusts and thereby gain control of the board. (56) The whole point of such devices is to put in place directors who will not do what the shareholders want. A bankruptcy filing, which directors make and which destroys all shareholder value for the benefit of creditors, is just the culmination of creditor-preferring behavior. (57) This ability to control the shutdown decision sits uncomfortably with the claim that creditor-appointed directors cannot act in ways beneficial to those who put them on the board.
Existing law then leaves us in a peculiar place. As a general matter, shareholders lose when they complain about decisions of directors that are wealth-maximizing for the corporation as a whole, but contrary to the interests of the common shareholders. At the same time, however, courts continue to give lip-service to the idea that directors act for the benefit of the shareholders. Just last May, for example, the Delaware Supreme Court noted, "[t]he directors of Delaware corporations have the legal responsibility to manage the business of a corporation for the benefit of its shareholders owners. Accordingly, fiduciary duties are imposed upon the directors to regulate their conduct...
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