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.
Yesterday, attorneys for the shareholders of News Corporation announced an agreement in principle to settle derivative claims filed in various U.S. jurisdictions, including Delaware, against officers and directors of the corporation for $139 million (minus attorney fees, TBD). The payment will be made to the corporation from the various D&O insurance policies. The Memorandum of Understanding is here. The amended complaint is here. The parties agreed to file a stipulation with the Delaware Chancery Court within 14 days for approval. Kevin La Croix's expert commentary on the D & O issues is here.
So, what were the claims? The claims fall roughly into two big groups, both under the Duty of Loyalty: (1) the conflicted $615 million acquisition by News Corp. of an entity owned by (controlling shareholder, CEO and Chair) Rupert Murdoch's daughter; and (2) lack of oversight related to the illegal surveillance scandal involving News Corp.'s 100% owned subsidiary, News of the World. Sprinkled around these claims are accusations of Murdoch using the corporation as a vehicle for supporting his political agenda. The overarching thesis of the complaint is that the board allowed Murdoch to use News Corp. for his own personal purposes: family and political.
Historically, conflict-of-interest claims have teeth; oversight (Caremark) claims do not: waste claims don't even have a mouth. Something here had a lot of teeth given that the parties agreed to go to mediation prior to a ruling on a motion to dismiss and given the $139 million figure. For those of us waiting to see a winning Caremark claim, failure to oversee an ongoing pattern of illegal news-gathering activity that was well-known internally might be it. But, we may never know if the settlement is all about the acquisition or a little bit of both. Perhaps the oral argument for the motion to dismiss last year held some clues that the court thought the oversight claim was not going to be dimissed, at least.
The remedy section of the MOU has not only the monetary award but also positive remedial changes, such as more compliance, a compliance officer, an independent Chairman of the Board, and new definitions of "independent" for board members, etc., that might match up to oversight if the money merely lines up with the acquisition. And, interestingly, a new "Political Activity Policy":
Stay tuned to see if this is a throw-away provision (like most remedial changes in derivative settlements, or something to see.
2. The Company has or will implement a policy requiring annual public disclosure to its shareholders of political conributions made directly by the Company to state or local candidates, political party committees, political committees (e.g., PACs) or other political organizations exempt from federal income taxes under Section 527 of the IRC; payments to any other entity that is earmarked to be used for independent expenditures for a candidate or political party; or to a ballot measure committee. . . .
3. The Company will notify the Board (for its information and not approval) on an annual basis of payments in excess of $25,000 (including special assessments) that are not deductible under Chapter 162(e) of the IRC . . . and are. . .made to any US-based trade association, Section 501(c)(4) organization, or Section 501(c)(3) organization that coordinates directly with the Company in drafting proposed legislation or grassroots lobbying activities. . . .
One of my colleagues said that my latest article (written with one of my excellent students, Jordan Lee) sounds like an R-rated movie. The title is Discretion, and 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.
I wrote an article about a decade ago called "The Critical Resource Theory of Fiduciary Duty" that still gets downloaded and cited a fair amount, at least for a fiduciary duty article. It is about the structure of fiduciary relationships, and I wanted to do a follow on article about how courts know when someone has breached a fiduciary duty. I actually had a fairly long draft of an article that was just horrible, and I never published it, but I kept thinking about and teaching about this problem. Earlier this year, I had a brainstorm about the subject, and the result is this new article.
By the way, interest in fiduciary law seems to have exploded in the past decade. Some of that interest stems from Tamar Frankel's book and the accompanying conference at Boston University. Some of the interest stems from the fact that fiduciary law is interesting in many countries outside the United States, where much of the best writing on this subject is found (see Paul Miller, for example). I look forward to a new surge in interest this summer, as Andrew Gold and Paul Miller have organized an excellent conference on The Philosophical Foundations of Fiduciary Law, to be held in Chicago. I am writing a paper entitled "True Loyalty" for that conference and very much looking forward to reading the other contributions.
The takeover of AIG was fraught with problems, and has birthed a Takings Clause suit that shouldn't be taken lightly. But once taken over, there was plenty of concern that AIG would be run like a Soviet factory. That concern now appears to have been misplaced, and I'm looking forward to apologies from those convinced we were on the road to insurance serfdom, or, at the very least, the relocation of all of the company's investments to the states of Ohio and Virginia by 2012.
Instead with AIG, what we saw was that the government, like any investor laying down an uncomfortably large bet, looked to maximize its returns and get out quickly. Governments - the largest investors, given pensions plans and the like - almost always do plain old risk-adjusted return maximization almost all the time, and it looks to me like the stake-taking during the financial crisis had been no exception to the rule.
Sure, you can wonder about the auto companies. I wonder about the Chevy Volt. But let's not kid ourselves. The 1% of the time that politics may have affected the way the government ran our bailouts should not obscure the 99% of the time it played it straight down the middle. That doesn't mean we should be psyched about bailouts. But it does introduce a little bit of realism about one of the alleged downsides.
The Delaware Limited Liability Company Act provides:
(b) It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.
Del. Code Ann. tit. 6, §18-1101.
With regard to fiduciary duties, the DLLCA allows for complete waiver. See, e.g., Gerber v. Enter. Prods. Holdings, LLC, 2012 WL 34442, at *13 (Del. Ch. Jan. 6, 2012) ("Alternate entity legislation reflects the Legislature's decision to allow such ventures to be governed without the traditional fiduciary duties, if that is what the ... governing document provides for, and allows conduct that, in a different context, would be sanctioned.").
But what if the participants in an LLC are silent about fiduciary duties? Should the courts impose fiduciary duties, even though the DLLCA does not expressly provide for them?
In 2009 Chief Justice Myron Steele of the Delaware Supreme Court wrote a law review article arguing "that default fiduciary duties violate the strong policy favoring freedom of contract enunciated by Delaware's legislature" and that "the costs of default fiduciary duties outweigh the minimal benefits that they provide." Freedom of Contract and Default Contractual Duties in the Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L.J. 221, 223-224 (2009). This prompted Larry Hamermesh to organize an online symposium on the topic of Default Fiduciary Duties in LLCs and LPs over at the The Institute of Delaware Corporate & Business Law.
In Auriga Capital Corp. v. Gatz Properties, LLC, Chancellor Strine confronts the issue of default fiduciary duties in a manager-managed LLC and reaches a different conclusion than Chief Justice Steele’s. Chancellor Strine's composed a section of the opinion under the heading "Default Fiduciary Duties Do Exist in the LLC Context," analogizing to fiduciary law in the corporate context. The text and history of the DLLCA provide some important clues, but Strine's analysis also depends heavily on the structure of the relationship between an LLC's manager and the LLC's members:
The manager of an LLC –- which is in plain words a limited liability “company” having many of the features of a corporation –- easily fits the definition of a fiduciary. The manager of an LLC has more than an arms-length, contractual relationship with the members of the LLC. Rather, the manager is vested with discretionary power to manage the business of the LLC.
While Professor Ann Conaway objects to Chancellor Strine's opinion on several grounds, I think Chancellor Strine is on solid ground. Professor Conaway purports to identify several "errors" in the opinion, none of which seems like an error to me, though, admittedly, each involves a contestable interpretation of the DLLCA. Facing uncertainty in the governing statute, Chancellor Strine analyzes the structure of the LLC and interprets the statute accordingly. He is taking the approach I advocated in The Critical Resource Theory of Fiduciary Duty:
The theory proposed here is animated by the view that fiduciary relationships form when one party (the "fiduciary") acts on behalf of another party (the "beneficiary") while exercising discretion with respect to a critical resource belonging to the beneficiary. The italicized typeface highlights the three core requirements of a fiduciary relationship. Each requirement plays an important role in distinguishing fiduciary from nonfiduciary relationships. When combined, these requirements show how the duty of loyalty that is the essence of fiduciary duty protects beneficiaries against opportunistic behavior by fiduciaries.
Note the last sentence of the passage from Chancellor Strine's opinion, quoted above (taking some liberty to imply the beneficiary): "the manager is vested with discretionary power to manage the business of the LLC [on behalf of the members]." Fiduciary duties serve a useful function in contexts like these. Participants in a Delaware LLC are permitted to waive the duties, but when they don't, courts should assume they apply ... just as they have done in similar relationships for hundreds of years.
Law schools are under attack. Depending upon the source, between 20-50% of corporate counsel won’t pay for junior associate work at big firms. Practicing lawyers, academics, law students and members of the general public have weighed in publicly and vehemently about the perceived failure of America’s law schools to prepare students for the real world.
Admittedly, before I joined academia a few months ago, I held some of the same views about lack of preparedness. Having worked with law students and new graduates as outside and in house counsel, I was often unimpressed with the level of skills of these well-meaning, very bright new graduates. I didn’t expect them to know the details of every law, but I did want them to know how to research effectively, write clearly, and be able to influence the clients and me. The first two requirements aren’t too much to expect, and schools have greatly improved here. But many young attorneys still leave school without the ability to balance different points of view, articulate a position in plain English, and influence others.
To be fair, unlike MBAs, most law students don’t have a lot of work experience, and generally, very little experience in a legal environment before they graduate. Assuming they know the substantive area of the law, they don’t have any context as to what may be relevant to their clients.
How can law schools help?
First, regardless of the area in which a student believes s/he wants to specialize, schools should require them to take business associations, tax, and a basic finance or accounting course. No lawyer can be effective without understanding business, whether s/he wants to focus on mom and pop clients, estate planning, family law, nonprofit, government or corporate law. More important, students have no idea where they will end up after graduation or ten years later. Trying to learn finance when they already have a job wastes the graduate’s and the employer’s time.
Of course, many law schools already require tax and business organizations courses, but how many of those schools also show students an actual proxy statement or simulate a shareholder’s meeting to provide some real world flavor? Do students really understand what it means to be a fiducuiary?
Second and on a related point, in the core courses, students may not need to draft interrogatories in a basic civil procedure course, but they should at least read a complaint and a motion for summary judgment, and perhaps spend some time making the arguments to their brethren in the classroom on a current case on a docket. No one can learn effectively by simply reading appellate cases. Why not have students redraft contract clauses? When I co-taught professional responsibility this semester, students simulated client conversations, examined do-it-yourself legal service websites for violations of state law, and wrote client letters so that the work came alive.
When possible, schools should also re-evaluate their core requirements to see if they can add more clinicals (which are admittedly expensive) or labs for negotiation, client consultation or transactional drafting (like my employer UMKC offers). I’m not convinced that law school needs to last for three years, but I am convinced that more of the time needs to be spent marrying the doctrinal and theoretical work to practical skills into the current curriculum.
Third, schools can look to their communities. In addition to using adjuncts to bring practical experience to the classroom, schools, the public and private sector should develop partnerships where students can intern more frequently and easily for school credit in the area of their choice, including nonprofit work, local government, criminal law, in house work and of course, firm work of all sizes. Current Department of Labor rules unnecessarily complicate internship processes and those rules should change.
This broader range of opportunities will provide students with practical experience, a more realistic idea of the market, and will also help address access to justice issues affecting underserved communities, for example by allowing supervised students to draft by-laws for a 501(c)(3). I’ll leave the discussion of high student loans, misleading career statistics from law schools and the oversupply of lawyers to others who have spoken on these hot topics issues recently.
Fourth, law schools should integrate the cataclysmic changes that the legal profession is undergoing into as many classes as they can. Law professors actually need to learn this as well. How are we preparing students for the commoditization of legal services through the rise of technology, the calls for de-regulation, outsourcing, and the emerging competition from global firms who can integrate legal and other professional services in ways that the US won’t currently allow?
Finally and most important, what are we teaching students about managing and appreciating risk? While this may not be relevant in every class, it can certainly be part of the discussions in many. Perhaps students will learn more from using a combination of reading law school cases and using the business school case method.
If students don’t understand how to recognize, measure, monitor and mitigate risk, how will they advise their clients? If they plan to work in house, as I did, they serve an additional gatekeeper role and increasingly face SEC investigations and jail terms. As more general counsels start hiring people directly from law schools, junior lawyers will face these complexities even earlier in their careers. Even if they counsel external clients, understanding risk appetite is essential in an increasingly complex, litigious and regulated world.
When I teach my course on corporate governance, compliance and social responsibility next spring, my students will look at SEC comment letters, critically scrutinize corporate social responsibility reports, read blogs, draft board minutes, dissect legislation, compare international developments and role play as regulators, legislators, board members, labor organizations, NGOs and executives to understand all perspectives and practice influencing each other. Learning what Sarbanes-Oxley or Dodd-Frank says without understanding what it means in practice is useless.
The good news is that more schools are starting to look at those kinds of issues. The Carnegie Model of legal education “supports courses and curricula that integrate three sets of values or ‘apprenticeships’: knowledge, practice and professionalism.” Educating Tomorrow’s Lawyers is a growing consortium of law schools which recommends “an integrated, three-part curriculum: (1) the teaching of legal doctrine and analysis, which provides the basis for professional growth; (2) introduction to the several facets of practice included under the rubric of lawyering, leading to acting with responsibility for clients; and (3) exploration and assumption of the identity, values and dispositions consonant with the fundamental purposes of the legal profession.” The University of Miami’s innovative LawWithoutWalls program brings students, academics, entrepreneurs and practitioners from around the world together to examine the fundamental shifts in legal practice and education and develop viable solutions.
The problems facing the legal profession are huge, but not insurmountable. The question is whether more law schools and professors are able to leave their comfort zones, law students are able to think more globally and long term, and the popular press and public are willing to credit those who are already moving in the right direction. I’m no expert, but as a former consumer of these legal services, I’m ready to do my part.
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As David notes, one of the fallouts of a negative say on pay vote have been shareholder lawsuits. The lawsuits allege, among other things, that the negative say on pay vote is an indication not only that the board breached its duty of loyalty, but also that the board should not be given the presumption of the business judgment rule for demand futility purposes--and hence that such suits should be allowed to survive a motion to dismiss. This semester I am writing an article on the feasibility of these say on pay lawsuits, and hence I was surprised when earlier last week a U.S. District Court in Ohio allowed shareholders say on pay lawsuit against Cincinnati Bell to survive a motion to dismiss in an order that relied on the negative say on pay vote.
Shareholders brought suit against the directors of Cincinnati Bell after 66% of shareholders voted against the 2010 executive compensation at its May 2011 annual meeting. The order framed the issue in this way, "This civil lawsuit presents the question, among others, whether a shareholder of a public company may sue its directors for breach of the duty of loyalty when the directors grant $4 million dollars in bonuses, on top of $4.5 million dollars in salary and other compensation, to the chief executive officer in the same year the company incurs a $61.3 million dollar decline in net income, a drop in earnings per share from $0.37 to $0.09, a reduction in share price from $3.45 to $2.80, and a negative 18.8% annual shareholder return." To be sure, with such a framing it seemed pretty clear where the court was headed. . .
In its order, the court stated that shareholders' allegations "raise a plausible claim that the multi-million dollar bonuses approved by the directors in a time of the company's declining financial performance violated Cincinnati Bell's pay-for-performance policy and were not in the best interest of Cincinnati Bell's shareholders. In so stating, the court specifically noted shareholders' assertions that the negative say on pay vote provides "direct and probative" evidence that the compensation awards were not in the best interests of the shareholders. This finding is of course precisely what shareholders hoped to achieve with say on pay litigation. Indeed, each of the lawsuits makes a similar claim that the say on pay vote reflects shareholders' independent assessment that the challenged compensation awards were not in their best interests, and as a result, such negative votes should be used to rebut any presumption that directors' action ofapproving executive compensation awards were in the shareholders' best interests. Moreover, the suits often rely on corporate disclosure in their proxy statement and other public documents that expresses a commitment to pay for performance to demonstrate that the challenged award conflicts with the company's own pay policies. The Cincinnati Bell order suggest that relying on corporate disclosure in this way is effective. In that regard, it also may prompt corporations to alter their disclosure to avoid such reliance.
Importantly for purposes of shareholders being able to get their day in court, the order agrees with shareholders' contention that they were excused from making any presuit demand. In the court's view, the fact that directors had approved the compensation award, recommended that shareholders approve the award, and suffered a negative shareholder vote, demonstrated that demand would be futile on such directors. This is interesting. On the one hand, you can imagine directors contending that they only did what federal law now requires them to do. Moreover, Dodd-Frank has a provision specifically stating that the say on pay vote is advisory and should not be construed as overruling directors' decisions, or changing or adding additional fiduciary duties for directors, and many commentators have argued that such a provision indicates that say on pay votes should not be used to somehow alter the law in this area, including the law with respect to demand rules. On the other hand, some commentators have noted that Dodd-Frank does not prevent such votes from being used to support a finding of a fiduciary duty breach. The Cincinnati Bell court cites this latter commentary.
Of course, just because a suit survives a motion to dismiss does not mean that shareholders will win at trial (see e.g., Disney!). Then too, Cincinnati Bell is an Ohio corporation--though the court did cite Delaware law in its demand futility discussion. However, a decision like this certainly prolongs these say on pay lawsuits. Such a decision also suggests that these say on pay votes may impact, and even change, fiduciary duty law regarding compensation.
The American Law Institute is creating a Restatement Third, Employment Law. Chapter 8 of Tentative Draft No. 4, which was discussed today at the Annual Meeting, is entitled "Employee Obligations and Restrictive Covenants." Within that chapter is a section entitled "Employee Duty of Loyalty." This is the core obligation:
Employees owe a duty of loyalty to their employer in matters related to the employment relationship.
This is an uncontroversial (re)statement of the black-letter law, but some members of the ALI challenged the use of the word "loyalty." As noted by several of the ALI bloggers, some members want the ALI to omit references to "loyalty" because it implies that the relationship between employers and employers is reciprocal. These members prefer the term "mandatory obligation," which (to them) connotes that employment is a one-way street.
Although Reporter Samuel Estreicher did not grant the point, he repeatedly invoked the need to "delimit" the concept of loyalty and suggested that the "duty of loyalty" in the ALI's Restatement of the Law Third, Agency was ill-defined. These comments suggest the possibility of some future work to be done rationalizing the duty of loyalty in the two Restatements.
Count me as a fan of the duty of loyalty and as an opponent of attempts to delimit that duty. Such attempts, which surface regularly in the law of business associations, run at cross purposes with the value of the duty as a standard of last resort. Self-interested behavior may be constrained by statute or by contract, but the issue in cases involving the duty of loyalty is whether self-interest was checked in the absence of a specific rule. If courts (or Restatement drafters) are too precise with the boundaries of the duty, they provide bad men with a roadmap for opportunistic behavior. As I have written many times on this blog, ambiguity is our friend in this area.
Is it Dodd-Frank? Probably, on the federal level, but this has been a year of plenty of action. The SEC did its proxy reform concept release. And in enforcement, the post-Galleon spread of wiretaps looks to make next year a big year for prosecutions - so far we just have Don Chu, which threatens uber hedge fund SAC. The enforcement case of the year this year must be the Goldman Sachs ABACUS deal settlement. Here's Adam Levitin on it.
I don't think the US Supreme Court did a lot of corporate law this year, with business patents and PCAOB decisions that could have gone far resolving very little. But the Morrison case, presuming that the securities laws do not apply extraterritorially (and arguably not reversed by a sort of clumsy effort in Dodd-Frank to reverse it), could be pretty big, here's Richard Painter on both issues. And until the honest services statute is revised, Skilling was good news for corporate executives, here's Christine on the case.
On international deals, the killing of BHP's bid for Potash by the Canadian government may a harbinger of protectionism as an M&A defense, so I say it's pretty notable. Here's Steve Davidoff on one aspect of the affair.
And in international regulation, Basel III's continuing development gets my nod. The Basel Committee just met, plans to promulgate the text of Basel III by the end of the year, and has concluded, as US regulators like Sheila Bair have been urging, that systemically significant "banks should have loss-absorbing capacity beyond the Basel III standards ... work on this topic continues in the Committee and the Financial Stability Board (FSB)."
What have we missed?
Boston University is sponsoring a fiduciary law conference on October 29, 2010 in honor of Tamar Frankel. Great lineup. The papers will be published in the Boston University Law Review.
If you are interested, note the following: "All are welcome to attend. There is no registration fee, but if you plan to attend, please RSVP to Andrea Larsen, firstname.lastname@example.org. If you have academic questions about the program, please contact Professor Kenneth W. Simons, email@example.com."
Jack Coffee, Larry Ribstein, and J.W. Verret testified before the Senate Judiciary Subcommittee on Crime and Drugs today in a hearing titled "Wall Street Fraud and Fiduciary Duties: Can Jail Time Serve as an Adequate Deterrent for Willful Violations?" Start watching here at about 59:00.
Jack makes the case for fiduciary duties for broker-dealers and warns against "Chicken Littles" who might scream that the imposition of fiduciary duties in this context would cause the sky to fall. Right on cue, J.W. follows with an argument that the hindsight bias inherent in fiduciary duty litigation would bring securities markets to a standstill. Larry bats cleanup with an indictment of fiduciary duty in the criminal context (pun intended) on the ground that fiduciary standards are too "amorphous," and he scored a point here by citing the Supreme Court's recent decision in Jones v. Harris as an example of the difficulty of defining fiduciary obligation.
The exchange between Jack and Larry on the vagueness point after the prepared statements is the best part of the hearing. (Start at about 1:26.) In the end, I am inclined to side with Larry on this one, especially when the issue turns to criminal penalties for breach of fiduciary duty. Fiduciary duty is the wrong tool to deal with the problems in securities markets.
Now that I’ve taught my last class for the semester, I thought I’d jot a few posts with reflections on teaching from the semester before I turn attention to grading and then writing.
Watching the SEC’s Goldman suit, the Senate hearings, and the financial reform legislation unfold has left me convinced that we business association teachers should consider teaching agency and partnership in the basic course (if we don’t already do so). Why? It is not just that many actual business entities are the “uncorporations” that Larry Ribstein writes about and not the “inc.s” in many law school class rooms. Consider the following two problems identified in the Goldman hearings or with respect to the financial crisis:
• Conflicts of interest (by Wall Street firms, rating agencies, mortgage brokers, mortgage originators etc.); and
• Lack of disclosure (to mortgage borrowers, investors in asset-backed securities etc.).
Of course there are lots of other potential areas of concern – like financial institution “safety and soundness,” but the two problems above are essentially about agency costs. As are two of the proposed remedies being discussed:
• Greater disclosure.
We can have a discussion about whether these are the most important problems and the most pressing reforms in the wake of the crisis, but they are front–and-center in the current debate. To frame the basic tradeoffs involved, there are two analytical approaches and two approaches to teaching students. The first is to start deep in the weeds of specialized areas of securities and financial regulation. The second is to start with basic building blocks.
The place to go for those building blocks is agency and partnership law. It is funny how much of the public debate on the Goldman suit resembles debates in those chestnut fiduciary duty cases from a Business Associations case book. Could “sophisticated investors” protect themselves against conflicts of interest with greater diligence or harder negotiations on price? Or do they need (or would it be more efficient to give them) the protection afforded by fiduciary duties? And when we talk about fiduciary duties, even the basic Business Associations course should help students see that those duties could vary quite a bit from one context or form of business entity or state to another.
Perhaps it is just my own learning style, but if I had to take a Business Association class again, I’d prefer to start learning the basic concepts that Corporations borrows from Agency and Partnership rather than being parachuted into the world of staggered boards and poison pills. Don’t kids learn basketball by practicing lay-ups before moving to dunks?
We’ll see how I feel in the fall when I teach my first purely Corporations class.
You may remember this story from last spring….
On a crisp Saturday morning in the spring of 2009, a somber group of citizens from the Connecticut towns of Bridgeport and Hartford boarded a tour bus. The tour route did not pass through the lovely Hollywood Hills homes of Oscar-winning actors perched high above the sprawling city of Los Angeles, nor did the tour route pass through Manhattan’s historic and affluent upper east side to visit the brownstone where Carrie Bradshaw lived or the cupcake shop that she visited in a popular television series titled “Sex in the City.” Upon having loaded its passengers, the bus, flanked by national and international media – more journalists in fact than tour participants – took the road to Fairfield County, Connecticut to tour the homes of executives who work for the American International Group, Inc., a mammoth international insurance company with significant financial services operations in more than 130 countries. The bus tour group, organized by Connecticut Working Families, a coalition of community organizations, labor unions and neighborhood activists that lobby to impact issues important to working and middle class families, considered themselves emissaries of a nation frustrated by an economic crisis. As anticipation of a confrontation between the tour participants and the executives and their families grew, AIG executives like David Poling, recipient of a $6.4 million award, began renouncing their bonuses and enhancing their home security devices.
Sharpen your pitch forks and light the torches. Bonus distributions to executives at bailed-out firms made Americans mad. Moreover, the discovery of the role of credit defaults swaps in the crisis has fueled the rage. Justifiable national frustration suggests that federal rules may soon override state court precedent and legislation that protect directors from liability or at least big bonuses will be more closely watched and possibly denied by the exec comp czar. Possibly. Mark Roe has persuasively argued that the real competition in corporate law is not among the states but between the federal government and Delaware. An interpretation of fiduciary duty that excuses corporate management’s failed efforts to oversee enterprise risk management may offer further evidence to support Roe’s theory.
We have seen a flurry of activity to introduce federal oversight of executive compensation packages for companies that are recipients of the federal dole. (See David Zarig's post here.) In her November 1st blog on Jones v. Harris (here), Michelle Harner offered interesting insight into the issues of interestedness and independence in the context of fee structures. I see an easy application of these arguments in the context of executive compensation and parallels in arguments about effective enterprise risk management.
The consequences of a systemically significant institution’s failure to execute risk management policies with care reverberate through many constituencies. Ever increasing numbers of Americans own a broader array of stocks, even if only through mutual funds or retirement funds. In the absence of action on the part of the Delaware legislature or courts, the federal government might easily commandeer the regulatory stage.Federal preemption in the area of executive compensation may pave the road for preemption in other areas of governance, such as risk management. The poster child for this proposition: AIG. My prediction that we may see federal intervention into corporate governance on risk management is based on the brewing national debate on independence and interestedness.
The audit committee and independence standards and other corporate governance reforms adopted as part of SOX offer examples of ghosts from Christmases past. But additional intervention is appearing on the horizons. Congressional proposals for corporate-last-wills-in-testament, a requirements that companies explain in advance their policy for dealing with potential insolvency, present another example of the Feds pending foray into the corporate governance sphere. This funeral legislation, as it has been described, requires firms to state how they would unwind their businesses and gives the Treasury authority over initiating the unwinding of certain systemically significant institutions. Even lower federal courts seem to “want in” on the movement for a broader interpretation of directors’ fiduciary duties, as illustrated by Judge Rakoff’s rejection of the SEC v. Bank of America/ Merrill Lynch settlement negotiation. With all of the frustration we are left to wonder about future interpretations of directors fiduciary duties.
With all the investors in distress news in today's Times, I'm just glad that we're somewhat close to Thanksgiving. This Madoff motion by the investors who think their losses ought to include some of the scheme's paper profits is pretty cheeky, and completely antithetical to the way the trustee has been doing things. It could also, it seems to me, put the SIPC - the securities industry FDIC - on the hook for the whole fictional $50 billion originally thrown around with regard to the affair, it seems to me. For that reason alone, it seems like a stretch, but one increasingly thinks knowledge of bankruptcy and its cognates would be of real assistance these days. Also in distress - Raj Rajaratnam's defense, ably analyzed by Peter Henning here.