June 09, 2014
The Duty of Care as “Fiduciary Duty”
Posted by Christopher Bruner

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, [1998] 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. 

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June 07, 2014
Empowering Others Through Loyalty
Posted by Gordon Smith

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?

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"Fiduciary Discretion"
Posted by Gordon Smith

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.

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April 02, 2014
Andrew Gold on "Philosophical Foundations of Fiduciary Law"
Posted by Gordon Smith

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! 

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March 08, 2014
Destructive Coordination in Securities Contracts
Posted by Greg Shill

Domino-effect
Image: Flickr

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:

Eurozone Debt Chart 1-1-10 - 7-13-13

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 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:

  1. Validation by third parties: perhaps issuers could use risk-rated contract templates. For example, see credit ratings…but see credit ratings.
  2. 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.
  3. 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.
  4. 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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February 19, 2014
Crowdsourcing Research on Fiduciary Duty
Posted by Gordon Smith

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.

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August 14, 2013
The Duty to Manage Risk
Posted by Christine Hurt

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.

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April 23, 2013
In re News Corp., Duty of Loyalty, D&O Insurance and Political Contributions
Posted by Christine Hurt

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": 

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. . . .

Stay tuned to see if this is a throw-away provision (like most remedial changes in derivative settlements, or something to see.

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March 22, 2013
Discretion
Posted by Gordon Smith

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.

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September 10, 2012
Now That The Government Is Selling Control Of AIG, Did It Mismanage Anything?
Posted by David Zaring

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.

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February 16, 2012
Default Fiduciary Duties in Delaware LLCs
Posted by Gordon Smith

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.

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December 16, 2011
Educating Today’s Law Students to Be Tomorrow’s Counselors and Gatekeepers
Posted by Marcia Narine

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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September 29, 2011
Another Say on Pay Update
Posted by Lisa Fairfax

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.

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May 18, 2011
In Defense of Loyalty
Posted by Gordon Smith

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.

Permalink | Employees| Fiduciary Law | Comments (0) | TrackBack (0) | Bookmark

December 03, 2010
Corporate Law Development of the Year?
Posted by David Zaring

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 keep up with Delaware like my compadres on the blog, but as Gordon has noted, Airgas might be an important case, and, indeed, it has spawned a few opinions.

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?

Permalink | Administrative Law| Delaware| Fiduciary Law| Supreme Court | Comments (0) | TrackBack (0) | Bookmark

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