Intruders in the boardroom: the case of constituency directors.

• Author: Sepe, Simone M.
• Position: II. The Law and Economics of Constituency Directors A. Corporate Fiduciary Law and Its Consequence 2. The Trados Decision through Conclusion, with footnotes, p. 345-378

2. The Trados Decision

   Trados involved an allegation of a breach of fiduciary duty brought by a common shareholder who claimed that the board, dominated by preferred shareholder designees, (148) favored its own interests and the interests of the preferred shareholders at the expense of the common shareholders. (149) Trados Incorporated, the company at issue, was a venture-capital-backed company that faced serious financial difficulties after some years in business. (150) In response, the board hired a new CEO and, at the same time, began to explore a potential sale or merger of the company. (151) In spite of a promising performance improvement, the board approved a merger of the company less than a year after appointing the new management. (152) The preferred shareholders realized almost $ (52) million in liquidation proceeds from the merger. (153) The common shareholders received nothing. (154)

   The court upheld the plaintiffs claim for purposes of denying the directors' motion to dismiss. (155) First, the court reasoned that the interests of the preferred shareholders diverged from the interests of the common shareholders in matters related to the merger. (156) Indeed, the preferred shareholders stood to make millions from the merger while the common shareholders would walk away empty-handed, notwithstanding the legitimate expectation that their participation in Trados could have some future value. (157) Based on this premise, the court framed the central issue in the case as concerning a director's duties when conflicts of interest arise between common and preferred shareholders. Reiterating prior case law about the contractual nature of preferred shareholders' rights, the court acknowledged that "the duty of the board, where discretionary judgment is to be exercised, [is] to prefer the interests of common stock ... to the interests created by the special rights, preferences, etc., of preferred stock, where there is a conflict." (158) In Trados, the preferred shareholders had no specific contractual right to force the merger. (159) Therefore, it was possible that the Trados directors had breached their duty of loyalty to the common shareholders. (160)

   But the court's decisive argument to deny the defendant's motion to dismiss concerned the relationships between the board majority and the preferred shareholders. The court held, in essence, that because the majority of Trados directors "had an ownership or employment relationship with an entity that owned Trados preferred stock," (161) they were to be held interested in the merger and therefore, subject to the strict entire fairness test, rather than the much more flexible business judgment rule. Even more importantly to the purpose of this discussion, the court's dicta indicate a perception that being a board designee of a particular constituency may be sufficient for a director to be incapable of exercising disinterested judgment. (162) Indeed, the court explicitly noted that "a lack of independence can be shown by pleading facts that support a reasonable inference that the director is beholden to a controlling person or 'so under their influence that their discretion would be sterilized.'" (163) In this respect, the fact that the Trados directors had "additional significant relationships to preferred stockholders" only made the court's decision easier, providing further evidence that the directors were interested in the Trados merger. (164)

3. The Residual Control Constraint

   The bottom line that emerges from the Trados decision is that the right to benefit from directors' adaptive decision-making--what the court in Trados dubbed a director's "discretionary judgment" (165)--follows from the special status shareholders enjoy in corporate law and cannot be privately ordered in favor of NCE investors. (166) Such investors can, at best, restrict the extent of the directors' required allegiance to shareholder interests by bargaining for specific control rights. But the residual control directors enjoy once they have honored all the corporation's contractual obligations is not negotiable. It can only be exercised to the benefit of shareholders, (167) regardless of whether a director has been appointed by the shareholders themselves or another corporate constituency.

   This constraint affects both the monitoring and enforcement functions of constituency directors. Any right claimed by NCE investors through the actions of their board designees needs to be grounded on explicit contractual provisions, unless this right "is not to a preference as against the common stock but rather a right shared equally with the common [shareholders]." (168) Thus, constituency directors will be prevented from disclosing information to their sponsors where a conflict of interest arises with the shareholders, unless the sponsors have bargained for a confidentiality agreement that includes a specific right to a differing course of action. (169) Likewise, constituency directors will be allowed to take actions contrary to the interests of the shareholders only so long as they are contractually entitled to do so. (170)

   Under this approach, Delaware courts have foreclosed the possibility of allowing for additional (i.e., non-contractually specified) protective mechanisms for NCE investors. Building on its prior decision in Trados, the Delaware Chancery Court made this point clear in its 2010 decision in LC Capital Master Fund. (171) Faced again with a conflict of interest between common and preferred shareholders in matters relating to a merger, the court held that bestowing more on the preferred shareholders than they were contractually entitled to would "give them leverage that they did not fairly extract in the contractual bargain, a hold-up value of some kind that acts as a judicially imposed substitute for contractual protections that they could have, but did not obtain...." (172)

   This approach, however, misses two important points. First, there might be corporate situations (such as startups and declining corporations) where NCE investors are exposed to virtually the same contracting problems that common shareholders face, and for which the shareholder franchise and fiduciary protection provide a solution. Second, anticipating that bargaining for specific control rights is insufficient to protect their interests in these situations, NCE investors appoint constituency directors precisely to benefit from discretionary powers that extend beyond whatever contractual protections they have bargained for.

   It is thus unsurprising that Trados and its progeny have attracted a tremendous amount of commentary, especially from concerned private equity lawyers. (173) This great deal of attention reflects the difficulties that NCE investors may bear under the Delaware courts' strict adherence to the undivided loyalty principle. (174)

   But the limitations arising for NCE investors under current fiduciary rules do not just raise distributive concerns. Instead, as the next Part will show, they also raise allocative concerns because they may deter NCE investors who would otherwise invest in a project.

   2. The Economics of Undivided Loyalty

   The limitations imposed by the principle of undivided loyalty on the use of constituency directors, both as a monitoring and as an enforcement device, have social welfare implications, which are best illustrated by a game theoretic hypothetical.

1. A Game Theoretic Illustration

   Consider Del. Corp. Inc., a commercial company incorporated in Delaware. Del. Corp. Inc. started its business with a total asset value of $100, equally funded by the issuance of common shares and debt. However, after two years in business ("period one"), the company's financial prospects have become dire. During the initial period, Del. Corp. Inc. has been unable to generate positive cash flows and, as a result, its asset value has fallen to $55. The company's creditors, concerned with the negative outlook, have threatened to accelerate the repayment of debt. In response to these hurdles, Del. Corp. Inc.'s board has engaged in a search for financing and strategic options, identifying two possibilities. The first is to liquidate the company for $55. This option would allow the company to repay the outstanding debt in full but would leave the common shareholders with only $5. Alternatively, Del. Corp. Inc. could issue $100 in preferred stock--carrying a fixed dividend of $20--to a private equity fund that specializes in distressed investments. (175) This alternative option would allow the company to refinance its outstanding debt while also providing enough funds to enable it to continue operations for some additional time ("period two"). For simplicity, assume that if the board opts for the refinancing strategy, the business will be terminated at the end of period two, with the preferred shareholders having the right to receive their liquidation preferences (i.e., capital plus dividends) in a lump sum and the shareholders being entitled to the residual. (176)

   Assume now that in period two, there can be two equiprobable states of the world (i.e., future scenarios), State 1 and State 2. The realization of these states of the world depends on exogenous market conditions--what game theorists call "a move from nature" (or the "Nature Player"). (177) Moreover, which state of the world materializes is private information of the board. This means that the preferred shareholders are either unable to observe which state of the world will materialize in period two or verify the realized state of the world to a third party (e.g., the court). Hence, the parties cannot write a state-contingent contractual agreement. Further assume that under each state of the world, the board can either choose a conservative strategy or an expansive strategy. The former promises a given payoff with certainty, such as the sale of the company. The latter, instead, involves a riskier course of action, such as...