Adapting to the new shareholder-centric reality.

• Author: Rock, Edward B.
• Position: Introduction through IV. Grappling with Residual Shareholder-Creditor Agency Costs A. A Failed LBO 1. The Bankruptcy Approach: Fraudulent Conveyance, p. 1907-1947

After more than eighty years of sustained attention, the master problem of US. corporate law--the separation of ownership and control--has mostly been brought under control. This resolution has occurred more through changes in market and corporate practices than through changes in the law. This Article explores how corporate law and practice are adapting to the new shareholder-centric reality that has emerged.

Because solving the shareholder-manager agency cost problem aggravates shareholder-creditor agency costs, I focus on implications for creditors. After considering how debt contracts, compensation arrangements, and governance structures can work together to limit shareholder-creditor agency costs, I turn to available legal doctrines that can respond to opportunistic behavior that slips through the cracks: fraudulent conveyance law, restrictions on distributions to shareholders, and fiduciary duties. To sharpen the analysis, I analyze two controversies that pit shareholders against creditors: a hypothetical failed LBO, and the attempts by shareholders of Dynegy Inc. to divert value from creditors through the manipulation of a complex group structure. I then consider some legal implications of a shareholder-centric system, including the importance of comparative corporate law, the challenges to the development of fiduciary duties posed by the awkward divided architecture of US. corporate law, the challenges for Delaware in adjudicating shareholder-creditor disputes, and the potential value of reinvigorating the traditional "entity" conception of the corporation in orienting managers and directors.

INTRODUCTION I. THE TRANSFORMATION OF THE U.S. CORPORATE LAW SYSTEM: THE WANING OF THE "SHAREHOLDER-MANAGER AGENCY COST PROBLEM" A. A Brief Historical Background B. The Classic Agency Cost Analysis 1. The Core Incentive Story 2. The "Free Cash Flow Problem" 3. Managerial Empire-Building 4. Dispersed Ownership, Passive Shareholders, and Captured Directors 5. Managerial Entrenchment and the Resistance to Hostile Tender Offers 6. Evidence on the Magnitude of Agency Costs C. Subsequent Developments: 1980 to the Present 1. The Core Incentive Story 2. The "Free Cash Flow Problem" 3. The Decline of Managerial Empire-Building 4. Dispersed Ownership, Passive Shareholders, and Captured Directors 5. Managerial Entrenchment and the Undermining of Hostile Tender Offers 6. Evidence on the Magnitude of Agency Costs 7. What Remains of the Classic Shareholder-Manager Agency Cost Problem? II. SHAREHOLDER-CREDITOR AGENCY COSTS III. ADAPTIVE STRATEGIES FOR CONTROLLING SHAREHOLDER-CREDITOR AGENCY COSTS A. The Contracting Strategy B. The Compensation Strategy C. The Governance Strategy IV. GRAPPLING WITH RESIDUAL SHAREHOLDER-CREDITOR AGENCY COSTS A. A Failed LBO 1. The Bankruptcy Approach: Fraudulent Conveyance a. The Basic Theory b. Is the Current Framework Sufficient? Some Doubts About Exclusive Reliance on Fraudulent Transfer Law 2. Delaware Corporate Law Doctrines a. Theory I: The Delaware Limitations on Share Repurchases b. Theory II: Dividends and Reductions-in-Capital i. The Analysis Under DGCL Section 174 ii. The Relevance of the Doctrine of Independent Legal Significance c. Theory III: Would Approving the LBO Breach the Directors' Duty of Loyalty? i. Was the Board's Decision in the Best Interest of the Corporation? ii. Would the Directors' Breach of Fiduciary Duty Be Exculpated? iii. The Fit with the Delaware "Zone of Insolvency" Cases d. Theory IV: Directors' Duty to Obey the Law? B. Shareholder Opportunism in Complex Corporate Structures: the Dynegy Battle V. IMPLICATIONS AND CHALLENGES: IS THE CURRENT FRAMEWORK ADEQUATE? A. The Importance of Comparative Corporate Law: The United Kingdom B. The Divided Architecture of US. Corporate Law and the Specification of Directors' Fiduciary Duties C. Delaware's Role as Impartial Umpire D. Our "Model" of the Corporation CONCLUSION INTRODUCTION

Suppose that the central problem of U.S. corporate law for the last eighty years--the separation of ownership and control--has largely been solved. Suppose further that the solution came mostly through changes in market and corporate practices rather than through changes in the law. What should corporate law and practice focus on now? This Article opens a discussion about how corporate law should adapt to the new shareholder-centric reality that has emerged over the last thirty years by focusing on the implications for creditors.

Historically and comparatively, corporate law seeks to control three sorts of agency costs: those between managers and dispersed shareholders, between controlling and noncontrolling shareholders, and between shareholders and creditors. (1) Because the magnitude of these agency costs is interrelated, changes in the severity of one sort of agency cost will affect the severities of the others. (2) In shareholder-centric corporate law systems like the United Kingdom, creditor protection is a prominent feature. (3) By contrast, in manager-centric corporate law systems, as in the United States over much of the last eighty years, corporate law's creditor-protection features seem to atrophy. What happens when a system shifts from being manager-centric to shareholder-centric? How can it adapt to the new reality and respond to the increased need for creditor protection?

In this Article, I argue that, since the early 1980s, the U.S. system has shifted from a manager-centric system to a shareholder-centric system. This shift has occurred primarily through changes in managerial compensation, shareholder concentration and activism, and board composition, outlook, and ideology, rather than directly through legal change. (4) With respect to the most important decisions--such as changes in control--there is substantial reason to believe that managers and directors today largely "think like shareholders."

If this is right--if we have evolved into a shareholder-centric system--then the shareholder-creditor agency cost problem should return as a central concern of corporate law. Further, to the extent that we have evolved into a shareholder-centric system through changes in practice rather than law, the law is unlikely to have kept pace. This Article analyzes how the U.S. corporate law system has adapted to, and can continue to adapt to, this new shareholder-centric reality and the shareholder-creditor agency costs that accompany it. I do not argue for changes in the law per se, but I do want to pose the question whether existing law is adequate to respond to the different kinds of problems that emerge. As I describe below, we have a variety of tools for responding to these changes: contracts, compensation, governance arrangements, and legal doctrines (including fraudulent conveyance law, restrictions on distributions, and fiduciary duties). (5)

Do we have all the tools we need? Do we need to develop new tools? Do we need to use existing tools in new ways? Reasonable minds can differ on these important details, but what is clear, I think, is that we need to be alive to the characteristic forms of shareholder--creditor opportunism so that we can respond appropriately. In Part IV, after considering how contracts, compensation, and governance arrangements can and do respond to these challenges, I examine two controversies illustrating the kinds of behavior that can slip through the basic web of protections and pose challenges: a doomed leveraged buyout (LBO), and shareholder manipulation of complicated corporate subsidiary structures to divert value from creditors.

In a world in which managers' high-powered equity incentives make them think and act like shareholders, it is important to remind managers and directors that the goal of the exercise is to create valuable firms, not to maximize shareholder value as an end in itself. Focusing on creditors as a group, despite the conflicts that exist among them, can be a useful proxy for the wider social impact of maximizing shareholder value at the expense of firm value.

1. THE TRANSFORMATION OF THE U.S. CORPORATE LAW SYSTEM: THE WANING OF THE "SHAREHOLDER-MANAGER AGENCY COST PROBLEM"

   The separation of ownership and control has been the master problem of U.S. corporate law since the days of Berle and Means, if not before. (6) Beginning in the 1970s, scholars began to describe this in terms of "shareholder-manager agency costs." In this Part, after a brief historical overview, I review the classic agency cost analysis and then consider the extent to which things have changed. (7)

   1. A Brief Historical Background

      Between the Civil War and World War I, the United States followed a model of "financial capitalism" in which the large, capital-intensive businesses (railroads, oil, steel, communications, electricity, etc.) were financed and monitored by a concentrated group of banks led by the Morgan bank. (8) The capital needs of large enterprises required the development of equity and debt markets and became the foundation of the U.S. capital markets. Because of these companies' ongoing capital needs, their bankers exercised a great deal of influence, often placing directors on the boards, replacing underperforming managers when necessary, and keeping managers focused on profitably developing their companies. (9) During this period, the agency costs of management in public corporations were relatively low, constrained by the monitoring by financial intermediaries.

      After World War I and through the 1920s, this model broke down for a variety of economic reasons (e.g., growth of individual stock ownership) and political factors (e.g., progressive critiques and congressional investigations). (10) By the time of the enactment of the Glass-Steagall Act in 1933, the United States had shifted toward "managerial capitalism." (11) Freed from the banks by new regulations enforcing a separation of finance and commerce, no one substituted for J.P. Morgan and the other large, well-placed investors...