I am very pleased to be editing the new "Fiduciary Law" eJournal on SSRN. You can see a first cut at the papers in the journal here, and you can subscribe to the journal here. Below is a description of the contents of the journal and a list of our amazing Advisory Board!
Description: The Fiduciary Law eJournal includes working and accepted paper abstracts relating to fiduciary law in myriad private and public contexts. Fiduciary principles govern a remarkably broad and diverse set of relationships, offices, and institutions. They govern a wide array of professional relationships, including interactions between lawyers and clients, doctors and patients, and investment advisors and clients. They also underlie basic legal categories of relationship, including agency, trusts, and partnerships. They are the basis on which most private and public offices are held and executed. Not incidentally, they provide the core governance framework for the administration of private and public organizations, from corporations, charities, and hospitals to universities and school boards. Both U.S. political theory and international legal theory also share a rich tradition of employing fiduciary principles to explain and justify the exercise of state authority. Cutting across many varied fields of legal studies, the eJournal is designed to serve a cross-indexing function for legal scholars interested in fiduciary law, with the ultimate objective of stimulating communication and cross-fertilization. The eJournal welcomes a broad range of methodological approaches, including those drawn from economics, history, philosophy, political science, psychology, and sociology.
CHRISTOPHER M. BRUNER
William Donald Bain Family Professor of Corporate Law, Washington and Lee University School of Law
Professor of Commercial and Company Law, University of Luxembourg, European Corporate Governance Institute (ECGI)
Professor of Equity and Trusts, University of Sydney Faculty of Law
EVAN J. CRIDDLE
Professor of Law, William & Mary Law School
Professor of Law, UNSW Australia - Faculty of Law
David F. Cavers Professor of Law, Duke University School of Law
Allen & Overy Professor of Corporate Law, University of Oxford Faculty of Law, European Corporate Governance Institute (ECGI)
Michaels Faculty Research Scholar Professor of Law, Boston University School of Law
ANDREW S. GOLD
Bruce W. Nichols Visiting Professor of Law, Harvard Law School, Professor of Law, DePaul University College of Law
Professor of Law, Attorney at Law (New York), Humboldt University of Berlin - Faculty of Law
ROSEMARY TEELE LANGFORD
Senior Lecturer, Melbourne Law School
PAUL B. MILLER
Associate Professor of Law, McGill University Faculty of Law
Reader in Private Law, King's College London, King's College London – The Dickson Poon School of Law
ROBERT H. SITKOFF
John L. Gray Professor of Law, Harvard Law School
Sir William C. Macdonald Professor of Law, McGill University, Faculty of Law, Paul-André Crépeau Centre for Private and Comparative Law, Professor of Private Law, King's College London - The Dickson Poon School ofLaw
Associate Professor of Law (with tenure), University of Notre Dame
I am very pleased to be writing a paper for this conference:
The McGill University Faculty of Law is pleased to announce the forthcoming conference - Contract, Status, and Fiduciary Law – to be held at McGill on 6-7 November 2015. The conference will feature papers by leading legal theorists exploring philosophical questions concerning relationships between contract law, moral and legal conceptions of status, and fiduciary law. The conference is being convened by Professors Paul B. Miller (McGill University) and Andrew S. Gold (DePaul University / Harvard University). A conference volume edited by Professors Miller and Gold will be published by Oxford University Press in 2016.
A conference schedule, list of presenters, and additional details may be found here.
Last week, the NY Times did a piece on Dan Price, CEO of Gravity Payments, who announced in April that each of his employees should make at least $70,000 a year. You might think that this announcement would make him a very popular figure, but I guess you would be wrong. Polarizing, maybe. Story here. You can read the details, but Price, who was raised in a very religious home, believed very strongly in creating an atmosphere in which employees would not need to worry about basic human needs and therefore be more productive and creative and happy. Where would the new money come from? Well, from his own salary, leveling the pay chart. But not everyone is happy.
Here is probably an incomplete list of the haters: (1) clients who feared their bills would be increased to cover the shortfall; (2) other employers who compete in the labor market; (3) other employers who don't compete for the same labor but who don't want to look bad; (4) Gravity Payments employees who feel that some employees don't deserve $70,000; and (5) Dan's brother and co-founder Lucas Price who feels that as a shareholder, he is being denied a return on his investment. That last number (5) reminds us corporate law geeks a little of Dodge v. Ford. I'm also interested in number (4), having written before on the hatred of so-called "windfalls."
Price v. Price. Here is the complaint. It is brief, and the answer is more brief. The brothers started the company as a 50/50 LLC in 2004. After disagreements, the brothers reorganized as a corporation in 2008, with Daniel having a majority share. This would seem to be a definitive moment for Lucas and possibly his downfall. The complaint does not give any hints as to why Lucas would agree to this, but there must be more to the story -- My brother was trying to grab control of the company, so we reorganized and gave him control to solve the problem? As part of the reorganization, the brothers entered into a Shareholders Agreement, which is not attached. The causes of action are breach of fiduciary duty, not breach of the agreement. The complaint states that Daniel used his majority control to grant himself "excessive compensation and to deprive Lucas of the benefits of ownership in Gravity Payments. Daniel's actions have been burdensome, harsh, and wrongful, and have shown a lack of fair dealing toward Lucas." The complaint does not give examples of the wrongful actions. The complaint was filed shortly after the minimum wage announcement, but had been in the works before. Further litigation may flesh out whether this complaint has a future, but shareholder oppression is a hard case to make out. Most notably, and possibly good news for Lucas, Gravity Payments is a Washington corporation, not a Delaware corporation. Lucas wants, among other things, either dissolution or to be bought out without a minority/marketability discount. Corporations aren't partnerships, Lucas. Dissolution seems a stretch. How does this affect Daniel's minimum wage plan? Well, he wasn't counting on having high litigation expenses when he changed the salary structure.
Employee Envy. According to the article, several employees have left Gravity Payments because they suddenly felt undervalued when junior employees and recent hires received raises, even though they themselves did also. When I wrote The Windfall Myth, I researched the use of the term "windfall" in the NYT and WSJ in a 12-month period. I was astounded at the depth of bitterness people have against other people's "windfalls," even when the windfall does not affect the observer at all. Hundreds or thousands of experiments have tried to capture why subjects will give up money if they believe under that regime others will get more (the Ultimatum Game). Here, GP employees were given raises, but others were given larger ones, and some small raise receivers left for jobs that paid less.
This story is a great case study in how to tackle wealth inequality in the U.S., where a fidelity to pure meritocracy is heavily ingrained. Even when the founder and CEO is willing to reduce the salary disparity at his company, some of his employees were not. Fascinating.
I just posted a new paper on SSRN entitled "The Modern Business Judgment Rule." It's short, so it won't take long to read, especially if you skip the footnotes. My goal is to describe this complex doctrine in simple terms, but the paper is packed with insights that were new to me, even though I have been teaching and writing about this subject for 20 years. Here is the abstract:
For over 150 years, the business judgment rule performed a relatively straightforward task in the corporate governance system of the United States, namely, protecting corporate directors from liability for honest mistakes. Under the traditional version of the business judgment rule, when the board of directors is careful, loyal, and acting in good faith, courts refuse to second-guess the merits of the board’s decisions, even if the corporation or its shareholders are harmed by those decisions.
While modern courts continue to insulate directors from liability for honest mistakes according to this traditional formula, in the 1980s Delaware courts began assigning the business judgment rule a more expansive role. The modern business judgment rule is applied not only in cases without procedural infirmities, but in cases where procedural infirmities at the board level have been mitigated by a special committee, stockholder approval, or partial substantive review by the court. In these new contexts, a court must satisfy itself that a board decision is worthy of respect, not because the decision was substantively correct, but because the effect of the procedural infirmities was sufficiently muted. After the court reaches that point, the business judgment rule “attaches” to protect the substantive merits of the decision from (further) review.
The modern business judgment rule is not a one-size-fits-all doctrine, but rather a movable boundary, marking the shifting line between judicial scrutiny and judicial deference. In describing the transformation of the business judgment rule, this chapter focuses on Delaware judicial opinions, with special attention to cases involving mergers and acquisitions, where the most important changes in the business judgment rule have been forged. The scripting of the business judgment rule’s new role by the Delaware courts is a work in progress, and the current law is inconsistent and confusing. Nevertheless, I trace the development of the modern business judgment rule and attempt to rationalize that development around the simple idea that the rule guides courts through the review of director conduct and marks the point at which judicial evaluation of a decision ends.
I hope you find this paper worthwhile. Comments and insights are most welcome.
Fiduciary law scholars in the U.S. do not pay enough attention to fiduciary law scholars in other countries. Of course, most of us who write in this area are talking about particular cases decided in the U.S. or areas of law with U.S.-specific attributes. But if you want to learn more about fiduciary law generally, it's worth reading the work of the professors teaching in Commonwealth countries. For example, I highlighted the work of Paul Miller in a JOTWELL post last year. Over the next little while, I will highlight some other work that may be interesting to American academics, and this post is about Lionel Smith's (McGill) excellent article on "Deterrence, Prophylaxis and Punishment in Fiduciary Obligations" in the fine Australian journal (edited by Simone Degeling of UNSW) The Journal of Equity, which you can find on Lexis (but not on Westlaw).
The driving motivation for fiduciary law in the Commonwealth is captured in the oft-repeated refrain that fiduciary duties are proscriptive, not prescriptive. Fiduciary law proscribes conflict transactions, without inquiring into harm to the beneficiary or breach of any other legal norms. Stated another way, fiduciary law in the Commonwealth requires the fiduciary to exercise discretion unselfishly. This is in stark contrast to the American model, at least with respect to fiduciaries in business organizations, under which a breach occurs only when a conflict transaction is unfair, that is, only when the fiduciary has exercised discretion with inappropriate selfishness. (I make this point in Fiduciary Discretion, which should have cited Lionel.)
How should we understand this proscriptive regulation?
Many authors contend that fiduciary law has a deterrence function, but Lionel rightly asks, “what is being deterred?” According to Lionel, fiduciary law cannot plausibly be explained as a deterrent because the level of sanction (avoidance or recission of the conflict transaction or disgorgement of any profits) is simply too low to represent a viable deterrent for most fiduciary breaches. Moreover, the fact that “the no-conflict and no-profit rules operate independently of harm or loss to the beneficiary, bad faith of the fiduciary, the breach of other duties, or any consideration at all” means that the law is unjust because it is “willing to inflict sanctions on people who have not engaged in undesirable conduct.”
Lionel suggests that rather than playing a deterrent role, fiduciary law serves as prophylactic function. According to Lionel, “[d]eterrence operates by aiming to influence human decision-making; prophylaxis operates by the taking of precautions in an effort to avoid an undesirable outcome.” While some references to the prophylactic function of fiduciary law are simply references to the deterrence function, Lionel suggests a different understanding of prophylaxis, which is intimately connected to the duty of unselfishness. In short, fiduciary law prohibits conflict transactions to reduce the likelihood that the fiduciary will exercise discretion for improper reasons.
This is distinct from deterrence because it is not about changing the fiduciary’s motivation, but rather about implementing a precaution. While this is a rather subtle point, it serves to emphasize the crucial difference between fiduciary law in the U.S. and fiduciary law in the Commonwealth. Fiduciary law in the U.S. cannot plausibly be viewed as a prophylactic under Lionel’s reasoning because courts here do not impose the same sort of blanket proscription on conflict transactions that you see in the Commonwelath. Instead, courts are eager to understand whether the conflict transaction was fair and whether the fiduciary acted in good faith.
My description is an oversimplification of Lionel's argument (it's a blog post, after all) and insufficiently nuanced with regard to Commonwealth and U.S. fiduciary law, both of which are highly variegated, coming from multiple jurisdictions. But I hope that I was able to convey the gist of the argument. If you want to read more, you can find Lionel's paper here.
In a new paper that I am writing this semester, I will argue that the U.S. is uniquely tolerant of conflict transactions, and the lack of any blanket proscription is one evidence of that tolerance. Further, I will argue that this tolerance reflects our general disposition in favor of entrepreneurial action. More on those thesis in posts to come.
It has been a pleasure to guest-blog for the last two weeks here at the Glom. (Previous posts available here: one, two, three, four, five, six, seven, eight, and nine.) This final post will introduce the book that Lynn Stout and I propose writing to give better direction to business people in search of ethical outcomes and to support the teaching of ethics in business schools.
Sometimes bad ethical behavior is simply the result of making obviously poor decisions. Consider the very human case of Jonathan Burrows, the former managing director at Blackrock Assets group. Burrows’s two mansions outside London were worth over $6 million U.S., but he ducked paying a little over $22 U.S. in train fare each way to the City for five years. Perhaps Burrows had calculated that being fined would be less expensive than the inconvenience of complying with the train fare rules. Unluckily, the size of his $67,200 U.S total repayment caught the eye of Britain’s Financial Conduct Authority, which banned Burrows from the country’s financial industry for life. That’s how we know about his story.
But how do small bad ethical choices snowball into large-scale frauds? How do we go from dishonesty about a $22 train ticket to a $22 trillion loss in the financial crisis? We know that, once they cross their thresholds for misconduct, individuals find it easier and easier to justify misconduct that adds up and can become more serious. And we know that there is a problem with the incentive structure within organizations that allows larger crises to happen. How do we reach the next generation of corporate leaders to help them make different decisions?
Business schools still largely fail to teach about ethics and legal duties. In fact, research finds “a negative relationship between the resources schools possess and the presence of a required ethics course.” Moreover, psychological studies demonstrate that the teaching of economics without a strong ethical component contributes to a “culture of greed.” Too often business-school cases, especially about entrepreneurs, venerate the individual who bends or breaks the rules for competitive advantage as long as the profit and loss numbers work out. And we fail to talk enough about the positive aspects of being ethical in the workplace. The situation is so bad that Luigi Zingales of the University of Chicago asks point-blank if business schools incubate criminals.
New business-school accreditation guidelines adopted in April 2013 will put specific pressure on schools to describe how they address business ethics. Because business schools are accredited in staggered five-year cycles, every business school that is a member of the international accreditation agency will have to adopt ethics in its curriculum sometime over the next few years.
We hope that the work outlined in my blogposts, discussed at greater length in my articles, and laid out in our proposed book will be at the forefront of this trend to discuss business ethics and the law. We welcome those reading this blog to be a part of the development of this curriculum for our next generation of business leaders.
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In this post, which follows our earlier discussion of legal strategy, we’ll offer examples of companies situated within each of the five pathways. As Robert and I mentioned in our article, most companies follow the compliance pathway. Such companies insource legal compliance through their in-house legal department, or they may choose to partner with an external compliance verification service. A firm such as ISN, for example, has built a business handling compliance issues for corporations and their subcontractors. According to the Society of Compliance and Corporate Ethics, compliance is a thriving industry due to the increased legal penalties and regulations that companies face in today’s heightened legal environment.
The avoidance pathway is less frequent, given the high stakes and liability attached to this type of strategy. General Motors may have engaged in avoidance if it misled regulators about its faulty ignition switches. Avoidance issues tend to be costly to deal with, given the loss of trust and enhanced penalties that arise from this behavior.
The more interesting and rare pathways involve prevention, value, and transformation. An interesting and controversial prevention legal strategy involves trademark policing, which, in its most egregious form, devolves into the unethical and legally dubious practice of trademark bullying. For example, Chik-fil-A employs an aggressive strategy that targets large and small companies alike and uses the threat of trademark litigation to prevent anyone from encroaching upon its trademarked brands and brand equity. Setting aside the overreaching and legally dubious aspects of this approach, some companies legitimately use a preventive legal strategy that involves cease and desist letters, litigation, and U.S. Patent and Trademark Office administrative oppositions to protect the value of their brands and advertising. The Chik-fil-A case serves as a useful reminder, however, that aggressive legal strategies may push the boundaries of ethical behavior, sound legal argument, and public opinion.
Two recent examples illustrate how employing a legal strategy in the value pathway can generate positive and tangible financial returns. The first instance involves hedge funds investing in a corporate acquisition target and then filing suit in Delaware to challenge the valuation and seek an appraisal from the court. This legal strategy is referred to as appraisal arbitrage. Many of these cases either settle or result in substantially higher prices for the party seeking the appraisal.
Another value strategy that has been in the headlines recently involves tax inversions. Burger King’s recent decision to acquire Canada’s Tim Horton’s will yield business synergies, but it also exploits a legal maneuver allowed under current tax law permitting a company acquiring a foreign entity to reincorporate in the foreign jurisdiction. By reincorporating in Canada, Burger King will effectively lower its tax rate from 35% to 15%.
The last and rarest of legal strategies is transformation. This occurs when the top executives in a corporation integrate law as a core aspect of the firm’s business model to achieve sustainable competitive advantage. Few companies are able to achieve this strategic pathway, and it’s certainly not for everyone. One company that notoriously used law to achieve abnormally large market share and margins in the ticket processing industry was Ticketmaster. The ticket service provider used venue ticket licensing contracts that included several key provisions such as long term renewable exclusivity terms (up to 5 years), and more infamously, fee sharing provisions. Ticketmaster’s business model was, essentially, to take the bad rap for charging exorbitant convenience fees and sharing those fees with the venue, thus contractually locking them into a highly profitable and exclusive business system. It didn’t hurt that Ticketmaster’s pioneering CEO Fred Rosen was a Wall Street attorney turned impresario.
Another company that is showing signs of attempting to pursue a transformative legal strategy is Tesla Motors. Tesla’s recent announcement to offer open licensing terms for its battery and charging station patents illustrates a pioneering mentality that seeks to build a business ecosystem with other auto manufacturers. By doing so, Tesla has made a major legal bet that giving up patent exclusivity rights in the short term will yield long-term competitive advantage by helping to diffuse electric battery and recharging technology. The other legal strategy Tesla has pursued relates to its pioneering distribution model of direct sales to the consumer, bypassing the traditional dealership model established for conventional automobiles. To achieve this direct-to-customer model, Tesla has engaged state regulators to achieve exemptions from state dealership franchise laws. Tesla is clearly strategizing and innovating along many fronts that involve business, technology and law. It remains to be seen, however, whether these legal strategies will offer Tesla a long-term sustainable competitive advantage.
In our next and last post, we’ll discuss our experience teaching the five pathways of legal strategy to business students and how it has been a valuable resource in the classroom.
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Two recent developments in the law and practice of business include: (1) the advent of benefit corporations (and kindred organizational forms) and (2) the application of crowdfunding practices to capital-raising for start-ups. My thesis here is that these two innovations will become disruptive legal technologies. In other words, benefit corporations and capital crowdfunding will change the landscape of business organization substantially.
A disruptive technology is one that changes the foundational context of business. Think of the internet and the rise of Amazon, Google, etc. Or consider the invention of laptops and the rise of Microsoft and the fall of the old IBM. Automobiles displace horses, and telephones make the telegraph obsolete. The Harvard economist Joseph Schumpeter coined a phrase for the phenomenon: “creative destruction.”
Technologies can be further divided into two types: physical technologies (e.g., new scientific inventions or mechanical innovations) and social technologies (such as law and accounting). See Business Persons, p. 1 (citing Richard R. Nelson, Technology, Institutions, and Economic Growth (2005), pp. 153–65, 195–209). The legal innovations of benefit corporations and capital crowdfunding count as major changes in social technologies. (Perhaps the biggest legal technological invention remains the corporation itself.)
1. Benefit corporations began as a nonprofit idea, hatched in my hometown of Philadelphia (actually Berwyn, Pennsylvania, but I’ll claim it as close enough). A nonprofit organization called B Lab began to offer an independent brand to business firms (somewhat confusingly not limited to corporations) that agree to adopt a “social purpose” as well as the usual self-seeking goal of profit-making. In addition, a “Certified B Corporation” must meet a transparency requirement of regular reporting on its “social” as well as financial progress. Other similar efforts include the advent of “low-profit” limited liability companies or L3Cs, which attempt to combine nonprofit/social and profit objectives. In my theory of business, I label these kind of firms “hybrid social enterprises.” Business Persons, pp. 206-15.
A significant change occurred in the last few years with the passage of legislation that gave teeth to the benefit corporation idea. Previously, the nonprofit label for a B Corp required a firm to declare adherence to a corporate constituency statute or to adopt a similar constituency by-law or other governing provision which signaled that a firm’s sense of its business objective extended beyond shareholders or other equity-owners alone. (One of my first academic articles addressed the topic at an earlier stage. See “Beyond Shareholders: Interpreting Corporate Constituency Statutes.” I also gave a recent video interview on the topic here.) Beginning in 2010, a number of U.S. states passed formal statutes authorizing benefit corporations. One recent count finds that twenty-seven states have now passed similar statutes. California has allowed for an option of all corporations to “opt in” to a “flexible purpose corporation” statute which combines features of benefit corporations and constituency statutes. Most notably, Delaware – the center of gravity of U.S. incorporations – adopted a benefit corporation statute in the summer of 2013. According to Alicia Plerhoples, fifty-five corporations opted in to the Delaware benefit corporation form within six months. Better known companies that have chosen to operate as benefit corporations include Method Products in Delaware and Patagonia in California.
2. Crowdfunding firms. Crowdfunding along the lines of Kickstarter and Indiegogo campaigns for the creation of new products have become commonplace. And the amounts of capital raised have sometimes been eye-popping. An article in Forbes relates the recent case of a robotics company raising $1.4 million in three weeks for a new project. Nonprofit funding for the microfinance of small business ventures in developing countries seems also to be successful. Kiva is probably the best known example. (Disclosure: my family has been an investor in various Kiva projects, and I’ve been surprised and encouraged by the fact that no loans have so far defaulted!)
However, a truly disruptive change in the capital funding of enterprises – perhaps including hybrid social enterprises – may be signaled by the Jumpstart Our Business Start-ups (JOBS) Act passed in 2012. Although it is limited at the moment in terms of the range of investors that may be tapped for crowdfunding (including a $1 million capital limit and sophisticated/wealthy investors requirement), a successful initial run may result in amendments that may begin to change the face of capital fundraising for firms. Judging from some recent books at least, crowdfunding for new ventures seems to have arrived. See Kevin Lawton and Dan Marom’s The Crowdfunding Revolution (2012) and Gary Spirer’s Crowdfunding: The Next Big Thing (2013).
What if easier capital crowdfunding combined with benefit corporation structures? Is it possible to imagine the construction of new securities markets that would raise capital for benefit corporations -- outside of traditional Wall Street markets where the norm of “shareholder value maximization” rules? There are some reasons for doubt: securities regulations change slowly (with the financial status quo more than willing to lobby against disruptive changes) and hopes for “do-good” business models may run into trouble if consumer markets don’t support them strongly. But it’s at least possible to imagine a different world of business emerging with the energy and commitment of a generation of entrepreneurs who might care about more in their lives than making themselves rich. Benefit corporations fueled by capital crowdfunding might lead a revolution: or, less provocatively, may at least challenge traditional business models that for too long have assumed a narrow economic model of profit-maximizing self-interest. James Surowiecki, in his recent column in The New Yorker, captures a more modest possibility: “The rise of B corps is a reminder that the idea that corporations should be only lean, mean, profit-maximizing machines isn’t dictated by the inherent nature of capitalism, let alone by human nature. As individuals, we try to make our work not just profitable but also meaningful. It may be time for more companies to do the same.”
So a combination of hybrid social enterprises and capital crowdfunding doesn’t need to displace all of the traditional modes of doing business to change the world. If a significant number of entrepreneurs, employees, investors, and customers lock-in to these new social technologies, then they will indeed become “disruptive.”
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While my writing on comparative corporate governance has focused principally on the core issues of power and purpose – that is, the division of governance authority between boards and shareholders, and the aims toward which board decision-making ought to be oriented – this work brought another striking divergence to my attention. While in the US we refer to “fiduciary duties” (plural) to describe directors’ duties of loyalty and care, other common-law jurisdictions generally conceptualize only the duty of loyalty as “fiduciary” in nature. That a well-functioning corporate legal system needn’t describe the duty of care as a fiduciary duty led me to ask, in a recent essay, whether there might be some practical utility in drawing such a clear distinction between loyalty and care concepts – and what costs might attend not doing so.
The rationale for applying the “fiduciary” label solely to the duty of loyalty is two-fold. First, the duty of loyalty is unique to fiduciary status, whereas the duty of care isn’t. Second, breaches of these respective duties involve differing consequences that ought to be distinguished analytically. Millett L.J. summarized this position – in a manner consistent with approaches taken in Australia and Canada as well – in the UK Court of Appeal’s 1996 decision in Bristol and West Building Society v. Mothew,  Ch. 1 (Eng.):
The expression “fiduciary duty” is properly confined to those duties which are peculiar to fiduciaries and the breach of which attracts legal consequences differing from those consequent upon the breach of other duties. Unless the expression is so limited it is lacking in practical utility. . . .
It is . . . inappropriate to apply the expression to the obligation of a trustee or other fiduciary to use proper skill and care in the discharge of his duties.
The issue of which duties ought to be described as “fiduciary” in nature has received some attention over recent years among US legal academics, and articulate advocates have urged narrower and broader frameworks, respectively. Compare, for example, the approaches of William Gregory (endorsing the Mothew approach and arguing that equating duties of loyalty and care amounts to “bad law and worse semantics”) and Julian Velasco (arguing that there are five fiduciary duties – care, loyalty, objectivity, good faith, and rationality – corresponding with distinct standards of review). In my essay I approach the issue somewhat obliquely, crediting the Mothew framework as a rational and comprehensible alternative and then asking what costs might have attended the differing US framework. I conclude that describing both loyalty and care as fiduciary in nature has led judges – notably in Delaware – to conflate distinct analytical approaches to evaluation of board conduct, with consequences for the development of US corporate law that are not entirely positive.
The duty of loyalty has historically been enforced more aggressively, an approach aiming principally to reduce conflicts of interest that scrupulous directors could realistically detect ahead of time, and thus avoid – associating a correlative moral stigma with breach. The duty of care, on the other hand, generally has gone unenforced in order to promote entrepreneurial risk-taking – reflecting an assumption that even scrupulous directors could not manage their own liability exposure so straightforwardly, and accordingly diminishing the moral stigma associated with breach. (I say that it has “generally” gone unenforced because this has not historically been the case in banking, where skepticism regarding the social benefits of risk-taking resulted in more robust enforcement of the duty of care – a dynamic that I explore here.) As I describe in some depth, however, Delaware’s tendency to conflate the two duties as reflections of a singular fiduciary concept embodied by the business judgment rule (BJR) has tended to blur this core distinction – rendering Delaware’s analytical framework for the evaluation of board conduct considerably less coherent.
The confusion latent in Aronson, 473 A.2d 805 (Del. 1984) – which described the BJR as a presumption of both informed and disinterested director decision-making (in contrast with an earlier formulation suggesting that only disloyalty could give rise to monetary liability) – fully manifested itself in the Cede litigation, 634 A.2d 345 (Del. 1993), where the Delaware Supreme Court depicted the BJR as the primary embodiment of the demands of “fiduciary” status, accordingly describing the duties of loyalty and care alike as mere elements of, and means of overcoming, the BJR. In turn the court reached the remarkable conclusion that a care breach – with no showing of resulting injury – rebuts the BJR and “requires the directors to prove that the transaction was entirely fair,” the standard typically applied in the loyalty context, rendering rescissory damages available. As Steve Bainbridge has observed, rescissory damages in a duty of care case could “have the effect of ordering the defendant directors to return a benefit that they never received,” and “threaten to be so astronomical as to substantially chill the decisionmaking process.”
It is critical to recognize that each step in the development of this muddled analytical framework rests upon the conflation of loyalty and care as twin reflections of a singular fiduciary concept (via the BJR). In this light, I believe that corporate law would have benefited from a clearer conceptual distinction between loyalty and care duties, fostering a clearer analytical distinction between the desirable enforcement regimes in these differing contexts.
So, do I favor pursuing such clarity through a formal re-styling of the duty of care in non-fiduciary terms? No. While I might have favored such an approach if we were writing on a clean slate, we’re most assuredly not writing on a clean slate – and I think it quite reasonable to fear that abruptly re-styling care as non-fiduciary might be misinterpreted as some sort of demotion, potentially undercutting whatever degree of compliance might arise from motivations other than fear of damages. A better approach, in my view, would be a statutory damages rule permitting imposition of monetary damages for loyalty breaches, but not for care breaches (along the lines that I initially proposed here). Such an approach would permit the duty of care to retain whatever fiduciary oomph it currently possesses in the marketplace, while foreclosing the sort of analytical confusion described above and simplifying Delaware’s complex and convoluted framework for evaluating disinterested board conduct.
I just started reading Eric Felton's Loyalty: The Vexing Virtue, and I found this idea in Chapter 1:
Loyalty is about being reliable. Sometimes that helps a group effort, but it can also empower individuals. Sure, we can do more when working together. But I can also accomplish more all by myself if I know I've got someone watching my back.
We usually think of the value of an agency relationship -- with the concomitant duty of loyalty on the agent -- as extending the reach of the principal. In other words, the value of the relationship is to be found in the work done by the agent.
Felton's idea suggests the possibility that the agency relationship also makes the principal more effective. Not just because the agent does things that the principal would otherwise being doing, but because the principal is emboldened in her own work by the support of a loyal agent.
Does that resonate with any of you folks who do fiduciary law?
The final version of my latest article -- D. Gordon Smith & Jordan C. Lee, Fiduciary Discretion, 75 Ohio St. L. J. 609 (2014) -- has been posted on SSRN. Here is the abstract:
Discretion is an important feature of all contractual relationships. In this Article, we rely on incomplete contract theory to motivate our study of discretion, with particular attention to fiduciary relationships. We make two contributions to the substantial literature on fiduciary law. First, we describe the role of fiduciary law as “boundary enforcement,” and we urge courts to honor the appropriate exercise of discretion by fiduciaries, even when the beneficiary or the judge might perceive a preferable action after the fact. Second, we answer the question, how should a court define the boundaries of fiduciary discretion? We observe that courts often define these boundaries by reference to industry customs and social norms. We also defend this as the most sensible and coherent approach to boundary enforcement.
It's easy to read and even easier to cite.
The following comes to us from Andrew Gold of DePaul University College of Law:
First, Paul Miller and I want to thank Gordon for the opportunity to post on Conglomerate! We are editors of a new collection of essays, Philosophical Foundations of Fiduciary Law, that will be published later this year by Oxford University Press – and we are very grateful for the chance to share some details about the volume. The book has an outstanding group of contributors, and the chapters span a wide variety of fiduciary topics and methodologies.
Fiduciary law is still an underdeveloped field in private law theory. Yet fiduciary law is very important to a wide variety of subjects, from corporate law, to lawyer-client and doctor-patient relationships, to parent-child relationships, to political theory. This new volume should fill a major gap in the literature. We thought it might be helpful to provide some links to the drafts now available on ssrn.
A series of chapters focus on fiduciary relationships and the core duties associated with those relationships. For example, Paul Miller provides a new account of fiduciary relationships and their nature. From a Kantian perspective, Irit Samet considers whether fiduciary loyalty is a virtue. She suggests that it can be. Lionel Smith considers whether there is a fiduciary duty of loyalty; he concludes that there is not. In my own chapter, I inquire into the core minimum content of fiduciary loyalty. In addition to these topics, the book will also include new work on the duty of candor.
Several authors assess fiduciary law from an economic perspective. Examples include Robert Sitkoff’s chapter, which provides an economic theory of fiduciary law in general. Among other things, Sitkoff explains how fiduciary law’s mandatory terms can be squared with efficiency values. In addition, Henry Smith offers a functional account of the link between fiduciary law and equity. Further chapters on the significance of economic analysis will be included in the volume.
Other contributions discuss particular types of fiduciary relationship. For example, Deborah DeMott offers a new account of the interpretation of instructions in agency law. Hanoch Dagan and Sharon Hannes assess financial fiduciaries as a distinctive private law institution. Avihay Dorfman provides an innovative theory of the trust relationship, trust law fiduciary duties, and their connection to ownership. And Martin Gelter and Genevieve Helleringer offer a distinctive account of constituency directors’ fiduciary duties in corporate law.
On the public law side, Evan Fox-Decent provides a new account of fiduciary authority, drawing on the work of Joseph Raz and others on the authority of the state. Ethan Leib, David Ponet, and Michael Serota consider how public fiduciaries should be defined, and, relatedly, which parties should properly be understood as their beneficiaries. Finally, Evan Criddle considers the relation between fiduciary principles and international law, focusing on the relevance of fiduciary principles to state sovereignty and international institutions.
Additional contributions have been authored by Richard Brooks, Justice James Edelman, Tamar Frankel, Joshua Getzler, Michele Graziadei, Daniel Markovits, and James Penner. Each offers insightful new theoretical perspectives on fiduciary law.
Paul and I hope that this volume – and other recent work in the field – will encourage more scholarship on fiduciary law topics. Together with Gordon, and with Evan Criddle, we have also put together some panels on fiduciary law at the upcoming Law & Society conference. We are very excited about this new volume, and we look forward to future discussion!
In my last post—also a shameless plug for my recent article, “Boilerplate Shock”—I argued that boilerplate terms governing securities could serve as a trigger that transforms an isolated credit event into the risk of a broader systemic failure. I’ll now briefly explain why I see this danger—which I call “boilerplate shock”—as a general problem in securities regulation, not just some quirky feature of Eurozone sovereign debt (the focus of the paper and post). Any market where securities are governed by uniform boilerplate terms is vulnerable to boilerplate shock.
The nature of this phenomenon—systemic risk—is of course familiar, but its source in contract language is a little unintuitive. How could private contracts unravel an entire securities market or the world economy?
Coordination around uniform standards.
In the back of our mind most of us probably still conceive of contracting as an activity that occurs among two, or perhaps a few, individuals or firms. But when standard terms are used by virtually all actors within a given market, it’s worth considering the collective impact of those terms as a distinct phenomenon.
Coordination’s benefits are well known. Consider uniform traffic signals. But coordination can also compound the effects of bad individual decisions.
As Charles Whitehead has argued, widespread “destructive coordination” among banks during the precrisis days helped generate systemic risks. When the credit markets froze, for example, firms using the same risk management formulas reacted in the same way at the same time. This helped transform isolated events into systemic ones—e.g., Lehman, the canonical example of a failure that triggered a de facto coordinated panic.
A similar risk, I argue, is present where participants in a securities market rely on the same standardized contract terms. Whether they were intended to or not, these terms will often control what happens in the event of certain legal emergencies, like a country departing the euro or Lehman declaring bankruptcy.
For example, if an effort by Greece to pay its bonds in “new drachmas” is rejected because of Boilerplate Contract Terms A and B, the market will surely be concerned that Terms A and B also govern the bonds of similarly situated borrowers, like Spain, Italy, etc. You’ll see that the borrowing premium the “peripheral” euro countries (the uppermost five lines: Ireland, Italy, Greece (biggest spike), Portugal, Spain) paid versus richer euro countries (Germany, France, the Netherlands, the three lowest lines) zoomed higher as worry over a Greece exit gripped markets in late 2011/early 2012, and again (to a lesser extent) because of Cyprus exit talk in early 2013:
Bloomberg. Click to enlarge.
Moreover, this panic occurred against a backdrop of unduly rosy assumptions (namely, that a departing euro country could convert its bonds into a new currency and thereby avoid default, a likely contagion trigger). I argue that the uniformity of boilerplate across these bonds would intensify these problems significantly since it’s likely to result in a declaration of default.
To my mind, this demonstrates that boilerplate securities contracts, in the aggregate, can be systemically significant. “Boilerplate Shock” introduces this concept and offers a modest proposal to mitigate its dangers in the Eurozone.
Beyond the euro, what about the risks of boilerplate shock in general?
Boilerplate shock is probably an inherent and permanent risk in any securities market.
Securities contracts are quintessential candidates for boilerplate. They are used by sophisticated parties for repeat or similar transactions and are drafted quickly—sometimes in three and a half minutes. The (correct) assumption is that they are more efficient for the parties that use them.
I’d like to begin thinking about how contracts can be drafted with a view to systemic risk mitigation, or at least to avoid exacerbating existing risks. But I think this is a hard problem that lacks an off-the-shelf solution:
- The nature of the risk is that it is a byproduct, not the result of intentional choices about risk allocation. This is the reason for the information-forcing default rule I propose in the Eurozone.
- The risk is also an externality: it is severe because of its collective impact. The parties do not bear the primary risk that uniform contracts will result in a meltdown, and in the unlikely event a crash happens (1) no individual party will be to blame and (2) at least one party to the initial transaction (the initial purchaser of a bond, for example) will probably no longer hold the asset, because most systemically significant securities are actively traded on the secondary market.
But banning or discouraging boilerplate is not the answer:
- The risk that a bunch of assets governed by the same terms will plummet in value is not only an externality. Risk allocation among parties might improve if scrutiny of existing securities boilerplate improves. The terms can evolve.
- A requirement to craft unique, artisanal terms—disclosures, subordination provisions ("flip clauses"), choice of governing law—for each individual securities transaction would be criminally inefficient.
- A requirement to craft unique contract terms might even be unjustified on risk-management terms alone, because it would increase drafting errors.
It's tricky to mitigate the risks of securities boilerplate.
Some options for places to start:
- Validation by third parties: perhaps issuers could use risk-rated contract templates. For example, see credit ratings…but see credit ratings.
- Culture: inculcate systemic risk mitigation as a professional norm among private sector lawyers? In principle, this could work. The number of lawyers who draft these contracts is pretty small. In practice, one could envision many complications.
- Insurance: encourage the development of derivatives to account for the possibility of boilerplate shock? Like some of the other solutions, this one presumes some agreement on what terms create the risk of boilerplate shock. It could also encourage new forms of moral hazard.
- Mandatory regulation: some public entity could be tasked with the mission of proactively identifying and combating the risk of boilerplate shock in contract practices. Arguably a natural choice given that the risk is an externality. Nevertheless, I’m a little skeptical. First of all, who would do it? A domestic regulator, like the SEC or CFTC, that might be dodged on jurisdictional grounds? An international institution, which is arguably more subject to capture? More generally, regulation seems like a heavy-handed first choice.
In sum, when standardized and aggregated, choices that determine legal risks—e.g., contract terms designating governing law, payment priority—can create the same hazards as choices about business risks. This suggests that contract terms should be taken seriously as possible sources of systemic risk alongside more familiar sources, like leverage and credit quality.
Securities contracts as a source of systemic risk—what do you think?
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In Fiduciary Discretion (with Jordan Lee), we argue, among other things, that courts often define the boundaries of fiduciary duty by reference to industry customs and social norms. In our next article, Loyalty Across Time, we claim that, although common law courts strive to conform to the doctrine of stare decisis, their reliance on customs and norms as guides to appropriate fiduciary behavior ensures that the meaning of “loyalty” changes over time. Thus, the requirements imposed by the duty of loyalty vary not only from one relationship context to the next, as many scholars have recognized, but also across time in similar relationships.
We are looking for examples in various areas of law relating to these propositions. We have been concentrating on employment law and corporate law, but the application of fiduciary principles covers a vast territory, and we would be interested in examples from other areas of law. Of course, if you disagree that the meaning of “loyalty” changes over time, we would be interested to know that, too.
July was a writing month for me, and I am happy to say that SSRN has been enriched/increased/saddled with one more article. The title is "The Duty to Manage Risk," and it analyzes every route that shareholders have used to hold managers of financial firms liable for losses their firms suffered because of exposure to subprime risk: securities fraud, duty of care, waste and duty of loyalty. Here is the abstract:
Shareholders, consumers, homeowners, borrowers, employees and other citizens were harmed, in some cases substantially, by the business practices of individuals at various financial firms leading up to the 2008 financial crisis. Unlike after other crises in the financial markets, such as the 2001 accounting fraud scandals, the public was not treated to the catharsis of criminal prosecutions or even large civil judgments and settlements. Instead, financial firms that incurred large losses on behalf of its shareholders repeatedly withstood attempts at legal redress in the courts by those shareholders. Shareholders were turned away from the courthouse door in cases involving federal securities law claims and claims of breaches of state law fiduciary duties. Scholars and commentators have focused on one area of fiduciary duty that seemed to fit: a claim that the board of directors of a firm failed to exercise its oversight duty to monitor firm-wide financial risk. However, this claim was also unsuccessful in the courts as judges viewed the duty to monitor risk as repackaging of the duty of care, which is significantly shielded from judicial review. Therefore, shareholders were left without a cause of action for admittedly “boneheaded” decisions of managers in light of changing economic circumstances.
This Article argues that the failure of the short life of the duty to monitor risk is not a bad development, but a logical and reasoned one. To say that shareholders, and by extension, courts, should not second-guess business decisions of boards of directors that are the result of a rational process, but to say that shareholders can second-guess the supervision of boards of those same decisions is inconsistent with decades of corporate governance jurisprudence. To make room for this duty within the duty of oversight or to create a separate duty to monitor financial risk would have the consequence of opening a side door to the questioning of all kinds of legal business decisions that have within them an element of business risk, political risk, currency risk, environmental risk, and legal risk. Though the oversight duty had before been cabined to holding directors responsible for the crimes and wrongful acts they should have known were being perpetuated by firm employees, the duty to monitor risk would subject legal but risky actions to judicial scrutiny. This eventuality would in effect reduce the business judgment rule to a nullity.