Other people's money

Stanford Law Review

Volumn 60, Issue 5, 2008, Pages 1309-1343

  Baird, Douglas G ^a   Henderson, M Todd ^a  

^a UNIVERSITY OF CHICAGO LAW SCHOOL   (United States)

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EID: 45149123133     PISSN: 00389765     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (154)

1. Gwendolyn Bounds, The Perils of Being First, WALL ST. J., Mar. 19, 2007, at R1.
2. See Koehler v. Black River Falls Iron Co., 67 U.S. (2 Black) 715, 720-21 (1862) ("[Directors] hold a place of trust, and by accepting the trust are obliged to execute it with fidelity, not for their own benefit, but for the common benefit of the stockholders of the corporation.").
3. See N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) ("It is well established that the directors owe their fiduciary obligations to the corporation and its shareholders.").
4. ADAM SMITH, THE WEALTH OF NATIONS 700 (Edwin Cannan ed., Modern Library 1937) (1776). We are not the first to borrow this from Smith. It was the title of a series of essays by Louis Brandeis published in 1914.
5. See LOUIS D. BRANDEIS, OTHER PEOPLE'S MONEY AND HOW BANKERS USE IT (1914) (criticizing bankers who sat on boards and controlled firms to do the bidding of the bank, despite the fact that the bankers were investing other people's money). It is also the title of a 2004 screed against investment bankers and President George W. Bush by a former managing director of Goldman Sachs.
6. See NOMI PRINS, OTHER PEOPLE'S MONEY: THE CORPORATE MUGGING OF AMERICA (2004). Other People's Money was also the title of a 1991 film by Norman Jewison starring Danny DeVito and Gregory Peck (based on a play by Jerry Sterne). OTHER PEOPLE'S MONEY (Warner Bros. Pictures 1991). OPM was the name of a corporation whose owners possessed a more acute awareness of acronyms and irony than its customers. It perpetrated one of the major frauds of the 1980s.
7. SMITH, supra note 4, at 700.
8. The obvious analogy, and one we make below, is to the law of trusts. See infra notes 85-87 and accompanying text.
9. See FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 91 (1991). Easterbrook and Fischel link the fiduciary obligations of the directors to the residual claimants, not to equity holders per se. As we explore below, this is not quite right either.
10. So-called "contract" creditors, or ones who voluntarily enter into loan, bond or other debt agreements with the firm usually set out many obligations in the investment contract. Involuntary creditors, such as tort victims, do not, of course, enjoy such protections.
11. EASTERBROOK & FISCHEL, supra note 7, at 91.
12. We are, of course, not the first to point out that shareholders are not always or the only residual claimants and that larger constituencies need to be taken into account. Blair and Stout, among others, have done the important work here. See, e.g., Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 VA. L. REV. 247, 276-87, 314 n.178 (1999);
13. see also Einer Elhauge, Sacrificing Corporate Profits in the Public Interest, 80 N.Y.U. L. REV. 733 (2005) (arguing for management discretion regarding corporate philanthropy in part because of multiple claimants);
14. Lynn A. Stout, Bad and Not-So-Bad Arguments for Shareholder Primacy, 75 S. CAL. L. REV. 1189, 1192-95 (2002) (discussing why shareholders cannot be sole residual claimants).
15. In this Article, we focus narrowly on investors, not on the many others (from workers to surrounding communities) whom the corporation affects. Our focus here - on the way that thinking of fiduciary duties running to, or only to, shareholders is an almost-right but pernicious idea - stands apart from whether the law should oblige the board to take other, non-financial stakeholders into account. The corporate social responsibility debate is about taking power away from investors and giving it to stakeholders, whereas our project is about identifying exactly who the investors are and how to make sense of the relationships among them.
16. Consider two simple examples. A stockholder (who is in a long position) can buy a put option to create a floor for any losses and sell a call that would create a ceiling on any gains. Debtholders can buy call options or get conversion rights that give them the potential to capture upside beyond the plain terms of their debt contract. There are an infinite number of permutations that allow both equityholders and debtholders to create such synthetic positions. This process has been going on for a long time. See Merton H. Miller, Financial Innovation: The Last Twenty Years and the Next, 21 J. FIN. & QUANTITATIVE ANALYSIS 459, 460-63 (1986).
17. For a discussion in the context of tax law, see Alvin C. Warren, Jr., Commentary, Financial Contract Innovation and Income Tax Policy, 107 HARV. L. REV. 460, 461 (1993) ("Continuous disaggregation, recombination, and risk reallocation have produced a changing array of new financial contracts that pose a serious challenge for the income tax.").
18. See Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. PA. L. REV. 1209 (2006).
19. With credit derivatives, debt, which was once held in large blocks and subject to large, heavily negotiated, and covenant-laden contracts, is now sold off into tiny slices to thousands of investors and is subject to many fewer contractual protections. In other words, it looks much more like equity. Equity, which is increasingly finding its way into large private equity funds, takes on some debt-like characteristics, since it is not tradable (at least for many years) and is often held in large blocks and in convertible forms. We could go on and on, and in fact, one of us does in other work. See M. Todd Henderson, Monitoring in a Financially Sophisticated World (2008) (working paper, on file with author). For now it is sufficient to state that the lines are increasingly blurry.
20. Modern financial engineering enables investors to parse capital structures - cash-flow rights, voting, and so on - in ways that make any attempt to pigeonhole investments as one type or another nearly meaningless. One prominent example of the confusion created by crude labels is the conduct surrounding the proposed merger of Mylan and King, two pharmaceutical companies. The market believed that this was a bad deal for Mylan (the buyer) but a good one for King (the target). An investor in King wanted the deal to go through, so it engaged in a series of transactions whereby it could in effect buy votes in Mylan, which it would then vote in favor of the deal, without exposing itself to the economic risk of the transaction - what is known as "vote buying." See John Armour & David A. Skeel, Jr., Who Writes the Rules for Hostile Takeovers, and Why? - The Peculiar Divergence of U.S. and U.K. Takeover Regulation, 95 GEO. L.J. 1727, 1750 (2007) (describing vote buying in the Mylan-King deal as "abuse" and doubting the SEC's authority to regulate the practice, absent a new congressional statute).
21. For analysis of the problems that can arise through this fragmentation of ownership interests, see Henry T.C. Hu & Bernard S. Black, Debt, Equity, and Hybrid Decoupling: Governance and Systemic Risk Implications (Univ. of Tex. Law, Law and Econ. Research Paper No. 120, 2008), available at http://ssrn.com/abstract=1084075.
22. See, e.g., Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. CIN. L. REV. 1019 (2007) (describing the new financial products that allow holders of credit to share risk).
23. Many Delaware cases contain dicta suggesting that the interests of "the corporation" can be interpreted to include other stakeholders' interests. See, e.g., Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) (authorizing takeover measures designed to protect unenumerated corporate policies). Legal academics and, more importantly, business people, fall prey to the "shareholders only" mistake with much more frequency.
24. See, e.g., Henry T.C. Hu & Jay Lawrence Westbrook, Abolition of the Corporate Duty to Creditors, 107 COLUM. L. REV. 1321 (2007). Hu and Westbrook argue that directors should owe their duties exclusively to equityholders until the corporation is in bankruptcy. Once having done this, however, they must explain how the directors could ever file a bankruptcy petition (something they think directors should be able to do). They equivocate about how the shareholders might themselves benefit from a bankruptcy petition (something that is rarely true), confess that the problem is hard, and then admit that "[m]uch theoretical and empirical analysis [including many research grants] will be essential in the years ahead." Id. at 1402.
25. There are "offensive" and "defensive" assertions of owed fiduciary duties by both shareholders and creditors. Offensive cases are those in which shareholders or creditors claim that fiduciary duties are owed to them. Shareholders made this claim in Orban v. Field, No. 12820, 1997 Del. Ch. LEXIS 48 (Del. Ch. Apr. 1, 1997), see infra notes 92-99 and accompanying text, and Blackmore Partners v. Link Energy, No. Civ. A 454-N, 2005 WL 2709639 (Del. Ch. Oct. 14, 2005), see infra note 34 and accompanying text. Creditors made similar claims in North American Catholic Education Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). See infra note 82 and accompanying text. Defensive cases are those in which shareholders or creditors claim that fiduciary duties are not owed to the other. An example of a shareholder defensive claim is In re Central Ice Cream Co., 836 F.2d 1068 (7th Cir. 1987). See infra notes 74-77 and accompanying text. Creditors made a defensive claim in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., No. Civ. A. 12150, 1991 WL 277613 (Del. Ch. Dec. 30, 1991). See infra notes 78-84 and accompanying text.
26. In re Central Ice Cream, 836 F.2d 1068; see infra notes 74-77 and accompanying text.
27. For an insightful analysis of the way in which traditional focus upon the agency costs between shareholders and managers falls short, see Robert P. Bartlett, III, Venture Capital, Agency Costs, and the False Dichotomy of the Corporation, 54 UCLA L. REV. 37, 71-74 (2006) (discussing agency conflicts in venture capital contracts among investors as well as between managers and shareholders).
28. See Blair & Stout, supra note 10, at 298-309, 321-22 ("In particular . . . shareholders should be allowed to sue directors only when this serves the interest of the corporation as a whole, rather than serving shareholders' interests at the expense of other stakeholders.").
29. See, e.g., Henry N. Butler & Larry E. Ribstein, Opting Out of Fiduciary Duties: A Response to the Anti-Contractarians, 65 WASH. L. REV. 1, 29-30 (1990) (arguing that fiduciary duties are simply part of the private ordering of control rights). For a discussion of other work that focuses on the idea of maximizing firm value, see infra notes 88-89.
30. One possibility is the incentive-to-do-well argument we float below. See infra notes 102-06 and accompanying text.
31. This is especially true when there is little reason to doubt that the contracts were entered into voluntarily, by parties with knowledge about the terms of the contract and with more or less equal bargaining power.
32. An important distinction here must be made between director conduct that is purely self-serving and conduct that is doing the bidding of those who installed them and that may incidentally benefit the director personally. Imagine two cases: in the first, a director elected by shareholders votes to approve a transaction in which the firm buys a piece of land from him at a significant premium to its market value; in the second, a director appointed pursuant to a contract with a senior creditor, votes to approve a transaction that benefits the creditor (and himself) at the expense of the common shareholders. As we discuss below, it is possible, perhaps even likely, that the second case is a part of the efficient ex ante bargain among investors, and courts should be cautious before disrupting these transactions. The first is obviously a classic self-dealing transaction that any court would disrupt absent ratification by a disinterested board or shareholder vote. Of course, there is a danger that courts will not be able to readily distinguish these two cases (and that the directors in the first case will dress it up to look like the second), but these concerns are overblown. The world we imagine - where there are no fiduciary duties - is one that would still permit courts to police obvious self dealing, while preserving the ability of investors to bargain for efficient control rights. Red flags will be raised not only in cases where directors profit personally in ways that are unique to them, but also in cases in which directors vote in ways that are different from the interests of those who installed them on the board.
33. See Frank H. Easterbrook & Daniel R. Fischel, Contract and Fiduciary Duty, 36 J.L. & ECON. 425 (1993) (arguing that fiduciary duties are necessary gap filling by courts for incomplete contracts written by shareholders and firms).
34. The principal virtue of using fiduciary duties is contracting efficiency. Inevitable gaps in control right contracts might permit powerful individuals to engage in unanticipated self-serving behavior, thus increasing the firm's cost of capital or, at a minimum, the transaction costs of doing deals as lawyers try to negotiate ever more comprehensive agreements. One solution is to use the duty of good faith and fair dealing as is commonly done with ordinary contracts.
35. There is a robust literature on the so-called "common agency" problem - that is, where multiple principals (investors) are designing an incentive structure for a single agent (managers). See, e.g., B. Douglas Bernheim & Michael D. Whinston, Common Agency, 54 ECONOMETRICA 923 (1986);
36. Joel S. Demski & David Sappington, Optimal Incentive Contracts with Multiple Agents, 33 J. ECON. THEORY 152 (1984);
37. Bengt Holmström & Paul Milgrom, Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design, 7 J.L. ECON. & ORG. 24 (1991). The models in this work are largely unhelpful here, since they deal with coordination issues, private information, and incentive schemes designed in environments that look very little like the ex ante corporate bargain.
38. See, e.g., Fahad Khalil et al., Monitoring a Common Agent: Implications for Financial Contracting, 135 J. ECON. THEORY 35 (2007) (modeling the monitoring incentives of principals in the face of privately informed agents and financial contracts designed in isolation of each other).
39. See Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, 1988 DUKE L.J. 879, 887 ("[F]iduciary obligation sometimes operates precisely in opposition to intention as manifest in express agreements."); see also id. at 923 ("A provision in a trust instrument cannot relieve a trustee of liability for any profit derived from a breach of trust . . . ."). The Uniformed Trust Code limits the ability of the parties to modify fiduciary duties. Section 105(b)(2) and (3) provide that the parties may not waive "the duty of the trustee to act in good faith and in accordance with the purposes of the trust" nor "the requirement that a trust and its terms be for the benefit of the beneficiaries." UNIF. TRUST CODE § 105 (2005).
40. Firms are, with shareholder approval, generally authorized to indemnify directors for some breaches of fiduciary duties. See, e.g., DEL. CODE ANN. tit. 8, § 102(b)(7) (West 2008). Indemnification is limited to cases not involving bad faith and is ineffective at preventing suits designed to extract payment short of the final disposition of the case. Furthermore, the existence of a financial cushion for directors does not necessarily give the right incentives to those directors who want to do what the law requires instead of what won't cost them personally. Indemnification also does not lessen the bite of fiduciary duties in other related areas, like duties to disclose. See infra Part IV.
41. For the importance of maintaining a prohibition on self dealing by insiders and directors, see Larry E. Ribstein, Are Partners Fiduciaries?, 2005 U. ILL. L. REV. 209.
42. As we show, modern securities law and doctrines such as insider trading are premised entirely on state-law fiduciary duties. See, e.g., United States v. O'Hagan, 521 U.S. 642, 662 (1997) (noting that "§ 10(b) liability 'is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a transaction'" (citing Chiarella v. United States, 445 U.S. 222, 230 (1980))).
43. In Odyssey Partners, L.P., v. Fleming Companies, Inc., 735 A.2d 386 (Del. Ch. 1999), a shareholder sued for breach of fiduciary duty on the ground that the firm did not file a Chapter 11 petition, and instead allowed another shareholder, who was the firm's largest creditor, to foreclose on firm assets. The court rejected this claim, noting that the board balanced the effects of various courses of action on shareholders and "creditors and other corporate constituencies" and the decision was to be respected so long as it was not "disloyal to [the firm], taken as a whole." Id. at 420; see also Blackmore Partners, LLP, v. Link Energy, Inc., No. Civ.A. 454-N, 2005 WL 2709639 (Del. Ch. Oct. 14, 2005) (holding that the board could take actions that benefited creditors at the expense of shareholders-that is, getting nothing for shareholders in an asset sale after rejecting a plan that would have returned something to equity holders).
44. See DEL. CODE ANN. tit. 8, § 251(c) (West 2008) (providing that a merger is valid only if approved by a majority of shareholders of both buyer and seller).
45. See id. (providing that a vote must be taken by "each constituent corporation" to the agreement).
46. Various permutations of this basic idea allow selling-firm shareholders to accomplish a similar result.
47. See, e.g., Rauch v. RCA Corp., 861 F.2d 29 (2d Cir. 1988) (rejecting claims that a triangular merger was an improper redemption of stock under Delaware law); Hariton v. ARCO Elecs., Inc., 188 A.2d 123, 125 (Del. 1963) (rejecting business purpose test and de facto merger doctrine).
48. See DEL. CODE ANN. tit. 8, § 262 (West 2008) (giving shareholders who vote no on certain business combination transactions the right to a judicial appraisal process of the value of their shares at the time of the transaction).
49. Barry M. Wertheimer, The Shareholders' Appraisal Remedy and How Courts Determine Fair Value, 47 DUKE L.J. 613, 614-15 (1998) ("The origin of the appraisal remedy typically is tied to the move in corporate law to majority approval of fundamental corporate changes, and away from a requirement of unanimous shareholder consent. When unanimous approval was no longer required, and shareholders effectively lost their individual right to veto corporate changes, the appraisal remedy was provided to them in return.").
50. See, e.g., Hariton, 188 A.2d at 125 (blessing merger and rejecting business purpose test and de facto merger doctrine). The Delaware Supreme Court blessed a transaction structured as an asset sale (where selling firm shareholders get no appraisal rights) instead of a merger (where they do). This particular ability to act in a way that is contrary to shareholder interests has not been accepted in all jurisdictions, even those with similar statutes, precisely because the act of disenfranchisement or disabling of important rights is viewed as antithetical to the fiduciary-based directorial mission. See CAL. CORP. CODE §§ 181, 1200, 1201, 1300 (West 2008) (creating voting and appraisal rights parity among different business combination transactions to discourage transaction design intended to limit statutory and common law rights of shareholders).
51. To cite just a few of the innumerable examples, a buyout may have severe tax consequences for minority shareholders or may deprive minority shareholders of potential appreciation in the firm's shares.
52. Rothschild Int'l Corp. v. Liggett Group Inc., 474 A.2d 133, 136 (Del. 1984).
53. See, e.g., Zetlin v. Hanson Holdings, Inc., 397 N.E.2d 387 (N.Y. 1979). While inconsistent with traditional notions of fiduciary duty, these decisions likely vindicate the investor's ex ante bargain. See EASTERBROOK & FISCHEL, supra note 7, at 119 ("If control transactions produce gains, and if the gains depend on unequal allocation, then the expected wealth . . . maximized by a rule allowing unequal allocation. All share prices ex ante will be highest when the probability of a value-increasing transaction in the future is the greatest.").
54. See, e.g., Guttman v. Huang, 823 A.2d 492, 502 (Del. Ch. 2003) ("In a typical derivative suit involving a transaction between a director and her corporation, that director is interested because she is on the other side of the transaction from the corporation and faces liability if the entire fairness standard applies, regardless of her subjective good faith, so long as she cannot prove that the transaction was fair to the corporation." (emphasis added)).
55. See DeMott, supra note 30.
56. 535 N.E.2d 1311, 1312 (N.Y. 1989) ("[The parties] entered into a written shareholders' agreement which provided that.. . Glamore would nominate and vote Ingle as a director . . . of the corporation.").
57. See id. at 1312 ("The agreement gave Glamore the right to repurchase all of Ingle's stock if 'Ingle shall cease to be an employee of the Corporation for any reason' (emphasis added).").
58. Id. at 1312-13.
59. See id. at 1313 ("A minority shareholder in a close corporation, by that status alone, who contractually agrees to the repurchase of his shares upon termination of his employment for any reason, acquires no right from the corporation or majority shareholders against at-will discharge.").
60. 549 N.E.2d 136, 136 (N.Y. 1989).
61. Id. at 137.
62. Id.
63. The ability of the board to engage in single-firm reorganizations or recapitalizations varies by state.
64. See, e.g., Fed. United Corp. v. Havender, 11 A.2d 331 (Del. 1940) (permitting firm to eliminate preferred stock, and its dividend arrearages, through recapitalization).
65. This most commonly occurs in firms in financial distress, but nothing prevents this from being used in healthy or near-healthy firms. See Baird & Rasmussen, supra note 13, at 1215-17 (describing the control creditors exercise in financially distressed firms); see also M. Todd Henderson, Paying CEOs in Bankruptcy: Executive Compensation When Agency Costs Are Low, 101 NW. U. L. REV. 1543, 1596 (2007) (same).
66. There are a few rare Chapter 11 cases in which shareholders do enjoy some recovery, but this remote possibility does not mean that the directors are somehow acting on the shareholders' behalf. In any event, in a perfectly standard prepackaged bankruptcy in which equity is wiped out, the directors approve a course of conduct that cannot possibly be in the shareholders' interests, yet no one suggests approving the filing of such a bankruptcy petition constitutes a violation of their fiduciary duties.
67. N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007) (internal citation omitted). For an argument that the confusion generated by applying fiduciary duties to creditors justifies an elimination of all derivative rights of shareholders, see Ann E. Conway, Trenwalla: A Call for Rationalizing Fiduciary Duties to Creditors in Delaware (Widener Law Sch. Legal Studies Research Paper No. 08-09, 2007), available at http://ssrn.com/abstract=991224.
68. Another basis for the shareholder-only nature of fiduciary duties is that shareholder contracts, insofar as they exist, are more open ended and ambiguous than creditor contracts, and fiduciary duties are merely judicial gap fillers of contracts that would be too costly to write in detail. See EASTERBROOK & FISCHEL, supra note 7, at 90-93. Judges are thus delegated the job of writing ex post contracts because writing them ex ante would be impossible or too expensive. This rationale, insofar as it obtains for shareholders, is becoming less unique to shareholders as credit derivatives and other financial innovations blur the lines between debt and equity. In other words, holders of debt are increasingly dispersed and disinterested in the way shareholders are, and credit contracts are containing fewer and fewer contractual restrictions and specifications. See Henderson, supra note 14.
69. 237 N.E.2d 776, 778 (Ill. App. Ct. 1968) ("[Compared to the Chicago White Sox, t]he weekend attendance figures for the two teams was [sic] similar; however, the White Sox week-night games drew many more patrons than did the Cubs' weekday games.").
70. See id. at 778 ("Wrigley . . . refused to install lights, not because of interest in the welfare of the corporation but because of his personal opinions 'that baseball is a "daytime sport" and that the installation of lights and night baseball games will have a deteriorating effect upon the surrounding neighborhood.'").
71. See id. ("It is alleged that he has admitted that he is not interested in whether the Cubs would benefit financially from such action . . . .").
72. See id. at 780 (stating that absent a showing of fraud, illegality or conflict of interest, a decision properly before the directors was "beyond [the court's] jurisdiction and ability").
73. STEPHEN M. BAINBRIDGE, CORPORATION LAW & ECONOMICS 245 (2002) (arguing that the plaintiffs' inability to surpass a motion to dismiss shows that the business judgment rule is an abstention doctrine - that courts don't even inquire into business decisions that are made in good faith).
74. See, e.g., A.P. Smith Mfg. Co. v. Barlow, 98 A.2d 581 (N.J. 1953) (refusing to review gift to Princeton University by small manufacturing company whose CEO was an alumnus). Of course, charitable contributions and other such actions could be justified on shareholder wealth maximization grounds, such as building brand or employee loyalty, but the law does not require this. For example, Delaware empowers boards to donate to charity without regard to its purpose. See DEL. CODE ANN. tit. 8, § 122(9) (West 2008) ("Every corporation created under this chapter shall have power to: . . . (9) Make donations for the public welfare or for charitable, scientific or educational purposes, and in time of war or other national emergency in aid thereof . . . .").
75. While the demand-requirement process is complicated, the practical essence is that well-advised plaintiffs do not make a demand in a derivative case. Making demand is an admission that demand is required, and the board may refuse demand under the shield of the business judgment rule. So if the plaintiffs make a demand, they lose, even if the lawsuit is fairly clearly in the best interests of shareholders. In almost all cases, therefore, plaintiffs will plead that demand was futile, alleging that the board was interested, tainted by a dominating shareholder or director who has a conflict, or the board is otherwise incapable of making a decision that is in the best interest of the corporation. See, e.g., Grimes v. Donald, 673 A.2d 1207, 1219 (Del. 1996).
76. See BAINBRIDGE, supra note 64, at 414-15 (discussing state stakeholder constituency statutes).
77. See, e.g., Kamin v. Am. Express Co., 383 N.Y.S.2d 807 (N.Y. Sup. Ct. 1976) (holding that director decision to distribute dividend of subsidiary stock was protected by the business judgment rule, despite the fact that the firm retaining the stock and marking it to market would have saved shareholders about $8 million).
78. Auerbach v. Bennett, 393 N.E.2d 994, 1000 (N.Y. 1979).
79. Stephen M. Bainbridge, Much Ado About Little? Directors' Fiduciary Duties in the Vicinity of Insolvency, 1 J. BUS. & TECH. L. 335, 359 (2007).
80. In one of corporate law's most famous cases, the Delaware Supreme Court held directors personally liable for agreeing to sell a struggling firm in a terrible industry at a huge premium for shareholders. See Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985). The lesson for directors from such cases is not to reject similar deals when they come along, but to go through the motions of getting advice from bankers and lawyers, shopping the firm to other buyers, and acting in the ways that the law says they must.
81. For a recent discussion of the issue, see Cory Dean Kandestin, Note, The Duty to Creditors in Near-Insolvent Firms: Eliminating the "Near-Insolvency" Distinction, 60 VAND. L. REV. 1235 (2007).
82. See, e.g., Credit Lyonnais Bank Nederland, N.V. v. Pathe Commc'ns Corp., No. Civ. A. 12150, 1991 WL 277613, at *34 n.55 (Del. Ch. Dec. 30, 1991).
83. In re Central Ice Cream Co., 836 F.2d 1068 (7th Cir. 1987).
84. This hypothetical has been one of the central fixtures of corporate law over the last decade. It is set out in Credit Lyonnais, 1991 WL 277613, at *34 n.55.
85. We are oversimplifying here, of course. We assume that the appeal is an all-or-nothing affair and that there are no costs associated with such an appeal. These do not change the underlying problem.
86. The evidence for this is indirect. The Delaware courts have not cited In re Central Ice Cream, but merely converted its facts into a hypothetical (including numbers that make it extremely unlikely that it was a mere coincidence). For his part, while long a major voice in corporate law, now-Chief Judge Easterbrook has never shown any sign he is even aware of the controversy In re Central Ice Cream has spawned.
87. The court was not writing on an entirely blank slate. Before Credit Lyonnais courts had previously noted that the duty of the directors shifts to creditors when the corporation is insolvent. See, e.g., FDIC v. Sea Pines Co., 692 F.2d 973, 976-77 (4th Cir. 1982); Davis v. Woolf, 147 F.2d 629, 633 (4th Cir. 1945). This doctrine had (and continues to have) little bite in practice both because of the business judgment rule and because it is usually hard to tell whether a firm is in fact insolvent.
88. Credit Lyonnais, 1991 WL 277613, at *34.
89. Id. at *34 n.55.
90. For an analysis of the way Credit Lyonnais redirects the board's focus without actually imposing legal liability, see Jonathan C. Lipson, The Expressive Function of Directors ' Duties to Creditors, 12 STAN. J.L. BUS. & FIN. 224 (2007).
91. See N. Am. Catholic Educ. Programming Found, v. Gheewalla, 930 A.2d 92, 101 (Del. 2007). Of course, only directors who are extremely badly advised can ever be tagged with liability. As long as the directors go through the motions and assert that they assessed the settlement offer in light of the interests of everyone, they will be protected by the business judgment rule.
92. For an argument that contract can serve the same function as proposals to expand fiduciary duties to creditors, see Frederick Tung, The New Death of Contract: Creeping Corporate Fiduciary Duties for Creditors (Emory L. & Econ. Research Paper No. 07-24, 2008), available at http://ssrn.com/ abstract=1031242.
93. See also Simone M. Sepe, Directors' Duty to Creditors and the Debt Contract, 1 J. BUS. & TECH. L. 553, 562 (2007) (arguing for a contract-based view of duties to creditors).
94. See Kelli A. Alces & Larry E. Ribstein, Directors' Duties in Failing Firms, 3 J. BUS. & TECH. L. (forthcoming 2008) (arguing that there are no director fiduciary duties in the zone of insolvency, and that all of the cases supposedly so holding can really be explained by the business judgment rule).
95. Judge Easterbrook, of course, was not expressly setting out this idea as a principle of corporate law. As noted, In re Central Ice Cream is a bankruptcy case. Moreover, as a sitting judge of an inferior federal court, Easterbrook's views on first principles of state corporation law would not be binding in any event. The idea is not also an entirely new one. The U.K. Companies Act of 2006 provides that directors are obligated to "promote the success of the company for the benefit of its members as a whole." Companies Act 2006, c. 46, § 172(1), available at http://www.opsi.gov.uk/acts/acts2006/ukpga_20060046_en_1.
96. See AUSTIN WAKEMAN SCOTT, WILLIAM FRANKLIN FRATCHER & MARK L. ASCHER, SCOTT AND ASCHER ON TRUSTS § 17.15, at 1259, § 20.1, at 1462 (5th ed. 2007). There is a related literature on common agency. See also supra note 29.
97. RESTATEMENT (THIRD) OF TRUSTS § 79(1)(a) (2007). An interesting modern example is the battle for control of Dow Jones, Inc., the publisher of, among other things, the Wall Street Journal. Media mogul Rupert Murdoch made a bid for Dow Jones at $60 per share in cash (it was trading at about $34 before the offer). The complication was that about sixty-four percent of Dow Jones shares were held in various trusts for descendents of the Bancroft family. Some of the family members - the young ones generally - preferred the cash, while other family members - the old ones generally - valued the "journalistic integrity" of the paper, so objected to it falling into the hands of the controversial Mr. Murdoch. See, e.g., Tim Arango, Shaking the Bancroft Family Tree, FORTUNE, May 28, 2007 (describing generational split). In this case, the conflicting issue for the trustee is not different monetary valuations, but money versus idiosyncratic preferences. We cannot imagine the law doing much here, short of holding that trustees, like directors, must show up, work hard, and not line their own pockets.
98. See Thomas A. Smith, The Efficient Norm for Corporate Law: A Neotraditional Interpretation of Fiduciary Duty, 98 MICH. L. REV. 214 (1999). Smith argues that since investors are presumed to hold a market basket of securities, the average investor's portfolio will have the same equity holdings to debt holdings ratio as the average equity to debt ratio in the capital structure of firms. Accordingly, an investor who loses as a shareholder in one firm will make it up as a debt holder in that firm or in the fortunes of another firm. Alon Chaver and Jesse Fried add an important coda to Smith's argument, noting that "performance creditors," that is, those owed contractual performance instead of cash, should be considered in any analysis of fiduciary duties.
99. Alon Chaver & Jesse M. Fried, Managers' Fiduciary Duty upon the Firm's Insolvency: Accounting for Performance Creditors, 55 VAND. L. REV. 1813 (2002).
100. This is just a standard observation about agency costs. Any mechanism put in place to ensure that the value of the firm is at all times optimized comes at some cost. Everyone may be better off ex ante if someone with expertise has discretion even if her incentives distort decisionmaking to some extent. See, e.g., Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976).
101. See Barlett, supra note 21, at 83-90 (discussing the conflict created by down-round financing in venture capital contracts).
102. The other crucial time in a firm's life is its death, and financial distress raises the same issues. Not surprisingly, venture capitalists and entrepreneurs have a firm's death in mind when bargaining for control rights at firm creation.
103. No. 12820, 1997 Del. Ch. LEXIS 48 (Del. Ch. Apr. 1, 1997).
104. Id. at *2-3 ("[Plaintiffs' claim] asserts that the board, which was controlled by holders of preferred stock, exercised corporate power against the common and in favor of the preferred and, thus, breached a duty of loyalty to the common.").
105. See id. at *29.
106. Id.
107. See id. at *26 n.23 ("There is no claim that . . . the merger . . . was not in the best interests of the corporation.").
108. See id. at *22 ("[I]t is clear that negotiations ensued in which Mr. Orban attempted to extract a payment of $4 million from the company in exchange for his agreement to support the merger.").
109. For a general discussion of venture capital structures and exit strategies, see D. Gordon Smith, The Exit Structure of Venture Capital, 53 UCLA L. REV. 315 (2005). More and more firms are seeing radical changes to their financial structure as a result of the surge in private equity investments and going-private transactions. (In terms of the corporate finance issues discussed herein, venture capital and private equity investments are similar.) The problems of senior investors holding tranches of debt and equity, along with board seats, conversion rights, and other contracted-for rights, participating with common shareholders is likely to become much more common in light of these trends.
110. One of these reasons is tax. See Jesse M. Fried & Mira Ganor, Agency Costs of Venture Capitalist Control in Startups, 81 N.Y.U. L. REV. 967, 984-86 (2006) ("[T]he use of preferred stock rather than common stock can reduce the tax cost of equity-based incentive compensation given to founders and other employees of the startup.").
111. See Smith, supra note 98.
112. See Orban, 1997 Del. Ch. LEXIS 48, at *23-24 ("[T]he company extended sufficient consideration to the Series C holders ($3,013,995) to enable them to exercise warrants to permit them, as a group, to hold more than 90% of Office Mart's outstanding common stock.").
113. Consider the launch of Apollo 12. Lightening struck the rocket carrying the Apollo 12 module shortly after takeoff causing the computers on board to shut down. In such situations, those in control must both look for a solution and decide how long to look before aborting the mission. The abort switch was entrusted to Pete Conrad, the commander of the mission. He did not know how to fix the problem, but he waited long enough for a steely-eyed ground controller to suggest a fix and fellow astronaut, Alan Bean, to implement it. See Apollo 12 Lightning Strike, http://www.aerospaceweb.org/question/spacecraft/ q0140.shtml. Conrad's incentives to abort the mission at the optimal time were not perfect. He was not perfectly informed and did not completely internalize all the interests at stake. We can imagine elaborate, theoretically more perfect alternatives such as a voting mechanism among the astronauts or by mission control executives or engineers, carefully calibrated according to experience, perspective, optimism, dispassion, residual loss bearers, information, and so on. But simple solutions sometimes work best. Putting the abort switch in the hands of the mission commander worked in this instance and may have been the best choice under all the circumstances. In the corporate environment, there also needs to be some mechanism to ensure the shutdown decision is made optimally, and here too simple, imperfect solutions may work best. Although stories could be told about why one decision mechanism or another is preferable, outsiders should be careful about meddling in the choice of experienced professionals and should be very leery about writing rules that inhibit choice. Although the analogy here is imperfect, it shows how decision rules are complex and difficult to unpack from all of the other elements of a successful space (or corporate) endeavor.
114. See Orban, 1997 Del. Ch. LEXIS 48, at *29.
115. See, e.g., Weinberger v. UOP, Inc., 457 A.2d. 701, 710 (Del. 1983) (requiring defendants in entire fairness inquiry to show that the transaction in question was entirely fair to the corporation).
116. See, e.g., George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive Corporate Governance, 83 CAL. L. REV. 1073, 1093 (1995) (arguing that loan covenants "serve as trip wires for the lender's right to . . . enforce or to intervene in the borrower's decisions").
117. This, of course, does not excuse some types of self-dealing on the part of the venture capitalist or any other senior investors. Consider the following scenario: The venture capitalist makes an initial investment in a startup, taking convertible preferred shares and a board seat. The venture capitalist board member dominates the board, reassuring other directors that funding options are abundant, while encouraging profligate spending, and all the while knowing that turning away deals is going to force the firm into desperation, and thereby forcing the firm to agree to additional financing from the venture capital firm on onerous terms. The venture capital firm arranges a bridge loan to the firm, taking nearly free warrants that dilute entirely the value held by common shareholders. If the common shareholders could show that the deals the venture capitalist board member turned away were legitimate, that the board process was insufficient, and that the board was dominated by a director with a conflict of interest, it could overcome Orban, since the transaction in question was not the final deal, but the entirety of the firm's search for financing.
118. Easterbrook and Fischel reach a similar conclusion, albeit for different reasons. See EASTERBROOK & FISCHEL, supra note 7, at 269-70 ("'Fiduciary duties' are a questionable basis on which to distinguish insiders from others. . . . It is not at all clear that the distinction between 'insiders' and 'outsiders' matches the class of trades that would be prohibited by contract . . . .").
119. 186 N.E. 659 (Mass. 1933).
120. Id. at 659 ("They had certain knowledge, material as to the value of the stock, which the plaintiff did not have.").
121. Id. at 660 ("The contention of the plaintiff is that the purchase of his stock in the company by the defendants without disclosing to him as a stockholder their knowledge of the geologist's theory . . . constitute actionable wrong for which he as stockholder can recover.").
122. Id. at 661. The U.S. Supreme Court endorsed the rule that a disclosure obligation may exist in face-to-face transactions in Strong v. Repide, 213 U.S. 419 (1909). The minority rule prevalent in a handful of states is that directors have a duty to disclose all material information to shareholders before trading with them. See, e.g., Oliver v. Oliver, 45 S.E. 232 (Ga. 1903) (holding that a director must always disclose material facts when trading against a shareholder).
123. See SEC v. Tex. Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968).
124. Id. at 852.
125. Instead of relying on the broad grounds on which the government had won below, Easterbrook pressed for a conviction based on Chiarella's misappropriation of inside information. Brief for the United States at 70-71 n.48, Chiarella v. United States, 445 U.S. 222 (1980) (No. 78-1202). Easterbrook's name does not actually appear on the brief, as he left the Solicitor General's office just before it was filed. (The brief was filed in early August 1979 and Easterbrook departed in July of the same year. See Curriculum Vitae of Frank H. Easterbrook, http://www.law.uchicago.edu/faculty/ easterbrook/cv.html.) But Easterbrook's portfolio up until the time he left included all economic matters, and his fingerprints on the brief are manifest to anyone familiar with his work. See, e.g., Frank H. Easterbrook, Insider Trading, Secret Agents, Evidentiary Privileges, and the Production of Information, 1981 SUP. CT. REV. 309, 314-17. While the government did not prevail on Easterbrook's misappropriation theory, the government's brief did direct the Court away from an inappropriately broad view of insider trading. Chiarella, 445 U.S. at 233 ("Formulation of such a broad duty, which departs radically from the established doctrine that duty arises from a specific relationship between two parties . . . should not be undertaken absent some explicit evidence of congressional intent.").
126. 445 U.S. at 233.
127. Id.
128. No one invests in gathering information about securities if they cannot profit from trading on it. See, e.g., HENRY G. MANNE, INSIDER TRADING AND THE STOCK MARKET (1966) (arguing that insider trading laws reduce incentives for investing in information about firm value).
129. 445 U.S. at 234-35.
130. Id. at 228 (quoting RESTATEMENT (SECOND) OF TORTS § 551(2)(a) (1976)). As the law has later developed, liability can also exist even if the person who trades violates a fiduciary duty he owes to someone other than the person with whom he is trading. See United States v. O'Hagan, 521 U.S. 642, 655 (1997) (applying misappropriation theory). For example, an employee who learns that his company is about to make a tender offer violates 10b-5 if he violates his obligations to his employee and purchases stock of the target. See id. This source of liability is not relevant to our discussion here.
131. Goodwin v. Agassiz, 186 N.E. 659, 661 (Mass. 1933).
132. See Laidlaw v. Organ, 15 U.S. 178 (1817) (holding that contracting party had no duty to disclose material fact - in this case, the end of the War of 1812 - to a stranger on the other end of the bargain).
133. 815 F.2d 429 (7th Cir. 1987).
134. See M. Todd Henderson, Deconstructing Duff and Phelps, 74 U. CHI. L. REV. 1739 (2007).
135. JP Morgan Chase Bank v. Winnick, 350 F. Supp. 2d 393 (S.D.N.Y. 2004).
136. For an account of Global Crossing's rise, see GEORGE GILDER, TELECOSM: HOW INFINITE BANDWIDTH WILL REVOLUTIONIZE OUR WORLD 183-90 (2000).
137. Reinhardt Krause, More Worries Surface About Global Crossing After Canceled Merger, INVESTOR'S BUS. DAILY, Nov. 13, 2001, at A8.
138. Under Rule 10b-5, there is also the additional question of whether the bank loan counts as a "security."
139. See Winnick, 350 F. Supp. 2d at 401.
140. Securities Exchange Act of 1934, 15 U.S.C. § 29(a) (2000).
141. Courts are split on whether these contracts are valid waivers of claims under the securities laws. Compare Harsco Corp. v. Segui, 91 F.3d 337, 341-48 (2d Cir. 1996) (upholding contract and dismissing claim), and Jensen v. Kimble, 1 F.3d 1073, 1074 (10th Cir. 1993) (same), with AES Corp. v. Dow Chemical Co., 325 F.3d 174, 180 (3d Cir. 2003) (refusing to hold as a matter of law that nonreliance provisions are sufficient to immunize any Rule 10b-5 claims).
142. See Daniel M. Sullivan, Comment, Big Boys and Chinese Walls, 75 U. CHI. L. REV. 533 (2008).
143. This idea that the law can play a useful role in providing menus for parties to draw upon was first developed by Robert Rasmussen. See Robert K. Rasmussen, Debtor's Choice: A Menu Approach to Corporate Bankruptcy, 71 TEX. L. REV. 51 (1992).
144. In recent years, others have expanded on this insight. See, e.g., Ian Ayres, Menus Matter, 73 U. CHI. L. REV. 3 (2006);
145. Yair Listokin, What Do Corporate Default Rules and Menus Do? An Empirical Examination (Yale Law Sch. Working Paper No. 335, 2005).
146. As Michael Klausner has pointed out, providing a menu of choices in such circumstances may be a way to mitigate the network externalities problem that exists when each party is forced to craft its own terms. See Michael Klausner, Corporations, Corporate Law, and Networks of Contracts, 81 VA. L. REV. 757, 837-41 (1995).
147. See Bernard Black et al., Outside Director Liability, 58 STAN. L. REV. 1055, 1068-70 (2006) (finding twelve cases of personally liability over the period between 1991 and 2004, all of which were for securities fraud or breaches of fiduciary duty).
148. See DEL. CODE ANN. tit. 8, § 102(b)(7) (West 2008).
149. In general, trusts and fiduciary duties are not capable of modification by exculpatory provisions. See UNIF. TRUST CODE §1008 (2005) ("(a) A term of a trust relieving a trustee of liability for breach of trust is unenforceable to the extent that it: (1) relieves the trustee of liability for breach of trust committed in bad faith or with reckless indifference to the purposes of the trust or the interests of the beneficiaries; or (2) was inserted as the result of an abuse by the trustee of a fiduciary or confidential relationship to the settlor."); see also RESTATEMENT (SECOND) OF TRUSTS § 222(3) (1959) (same).
150. For example, Lucian Bebchuk's academic project is primarily about increasing the power of shareholders vis-à-vis managers. Not only are "shareholders" becoming increasingly hard to define, but Bebchuk, like most others, largely leaves other investors out of the equation. A recent book-length treatment of the issue of shareholder activism is typical in its neglect of creditors. In The Rise of Fiduciary Capitalism, James Hawley and Andrew Williams praise the stakeholder model of corporate governance, noting that "stakeholder claims directly challenge the finance model's assertion that shareholders are the only . . . claimants on the firm's residual profits and those with ultimate control authority."
151. JAMES P. HAWLEY & ANDREW T. WILLIAMS, THE RISE OF FIDUCIARY CAPITALISM 85 (2000). The authors go on to define their claim for stakeholder power: "For example, in its broadest form a stakeholder perspective takes what can be characterized as the 'social debt' of the corporation perspective." Id. The authors are not alone in largely ignoring creditors or "financial debt" and its role in the governance of firms.
152. See, e.g., BRANDEIS, supra note 4, at 36 (describing the "endless chain" of transactions that bankers in control of firms used to benefit themselves).
153. Id. at 135-36.
154. See ADOLPH A. BERLE, JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY (1932).