EMPOWERING COURTS IN CORPORATE LAW: Remarks to the Journal of Corporation Law, Spring 2016.

• Author: Velasco, Julian

As you know, I am a corporate law scholar; but I also like to think of myself as a fiduciary law scholar. What is fiduciary law? It is not exactly an area of law in the conventional sense that contracts, torts, and property are. Fiduciary law may better be understood as a set of legal principles that are applied in various substantive areas of law--including, for example, trusts, agency, and corporate law. Each application, or instantiation, is somewhat unique, and so it might be easy to conclude that there is no such thing as fiduciary law. (1) However, there are general principles that are applied in different ways, so the concept of fiduciary law remains meaningful.

What are these principles of fiduciary law? A rough sketch of the contours would be as follows:

A fiduciary relationship is a legally recognized relationship in which one is given power over the interests of another, who thereby becomes vulnerable to abuse. Although such relationships are risky, they can also be very beneficial. In order to encourage and police such relationships, the law imposes a duty on the first party--the fiduciary--to act in the interests of the second party--the beneficiary.... Thus, the raison d'etre of fiduciary duties ... is the protection of the beneficiary from abuse at the hands of the fiduciary. What duty does the law impose on fiduciaries?

At the very least, there is a duty of loyalty. With respect to the fiduciary relationship, a fiduciary may not act counter to the interests of the beneficiary. In fact, fiduciaries must avoid conflicts of interest that might tempt them to act against the interests of the beneficiary.... There are some who argue that the duty of loyalty is the only true fiduciary duty. However, that is a controversial claim. Almost equal in pedigree and stature to the duty of loyalty is the duty of care. A fiduciary must act (i.e., perform the service in question) diligently, exercising an appropriate level of care and skill.... Other duties could be enumerated. In each case, the law protects the beneficiary from abuse at the hands of the fiduciary, in whatever form that abuse might take. (3) These are the core principles of fiduciary law. How are they implemented in corporate law? Corporate law recognizes the twin duties of care and loyalty, (4) but uniquely treats the two very differently. Cases involving the duty of care receive very deferential review under the business judgment rule (5)--if any at all, in light of exculpation provisions in corporate charters (6)--while cases involving the duty of loyalty receive more demanding review under the entire fairness test. (7) The justification for this dichotomy goes as follows. In cases involving only the duty of care, directors can be trusted because their interests are aligned with those of the shareholders: they both want the company to prosper. Thus, exacting judicial review is unnecessary. In cases involving the duty of loyalty, on the other hand, directors cannot be trusted because their interests conflict with those of the shareholders. Thus, judicial review is necessary. (8)

Because of this dichotomy, corporate law scholars seem to believe that the duty of loyalty is policed with great rigor and that the duty of care is relatively unimportant. I do not agree with that assessment. In my last article, published in this Journal, I argued for the continued importance of the duty of care. (9) In a future article, I plan to follow up with an argument that the duty of loyalty is not enforced as rigorously as is generally believed. But this is not the subject of my address tonight.

My view of fiduciary law generally--and corporate law fiduciary duties specifically--is that fiduciary duties are utterly pervasive and can be summarized faithfully only in the broadest terms: "Simply put, a fiduciary has the duty to act in the interests of the beneficiary in all relevant respects." (10) In other words, both care and loyalty, as well as any other fiduciary duties that exist, are all merely aspects of the one overarching fiduciary duty to pursue the interests of the beneficiary.

In an ideal world, we would police fiduciary duties by reading the fiduciary's mind to answer the question: were you acting entirely in the interests of the beneficiary when you made the decision? If the answer is "yes," then fiduciary duties have been satisfied; if the answer is "no"--including "not entirely"--then fiduciary duties may have been breached. Although this test may seem somewhat fanciful, it is fairly orthodox in principle. To quote an article co-authored by Leo Strine, currently the Chief Justice of the Delaware Supreme Court:

[O]ne of the most important Delaware corporate lawyers involved in the last comprehensive revision of the [Delaware General Corporation Law], S. Samuel Arsht, was said to have described the essence of Delaware corporate law as follows: "Directors of Delaware corporations can do anything they want, as long as it is not illegal, and as long as they act in good faith." That statement is only a bit exaggerated. (11) Arsht's point is essentially the same as mine: what matters most to fiduciary law is that the directors actually be acting in the interests of the shareholders. Obviously, mind-reading is not an option, so other enforcement mechanisms must be considered. Thus, we look for proxies for bad faith, like conflicts of interest and negligence. But we should keep the ultimate goal in mind.

We litigate issues of care and loyalty in order to enforce directors' fiduciary duties. However, litigation is imperfect. Let us set aside for a moment the possibility of error. (12) The fact is, litigation is expensive, and therefore demands a cost-benefit analysis. Moreover, courts have come to believe that litigation has been hijacked by us--the lawyers. Entrepreneurial attorneys are essentially acting as businessmen, making investment decisions with their time and taking the risk of profit and loss on cases. (13) They may advance their own interests by maximizing their fees rather than the recovery for the shareholder plaintiffs. The merits of a case need not matter: an entrepreneurial attorney could just as easily pursue a frivolous case for settlement value as settle a meritorious case for higher attorney's fees. Or so it is believed. Is this descriptively accurate? That is a controversial issue. For present purposes, it does not really matter. What matters is that courts and legislators believe it. And they have responded accordingly.

In order to deal with this problem, lawmakers--both courts and legislatures--have imposed significant restrictions on shareholder litigation. I hinted at these in my last article, (14) and will develop them more fully in my next. But look at the challenges facing shareholder-plaintiffs! In order to bring a derivative action, they face the contemporaneous ownership rule (15) and the demand requirement. (16) In order to plead demand futility, they must make particularized allegations without the benefit of discovery. (17) Even if they manage to clear these hurdles, they may face a special litigation committee that gives the directors a second chance to have the case dismissed. (18) On the merits, they face a divergence between the standards of conduct and standards of review--in other words, they need to establish not merely negligence or a conflict of interests, but gross negligence or a conflict that rises to the level of self-dealing. (19) And gross negligence is available only if the corporation has not adopted an exculpation provision, (20) which it probably has.

Each one of these developments may be perfectly reasonable. However, I would like to suggest that they are excessive in the aggregate. They have created a legal landscape in which it is very difficult for a shareholder to prevail except in the most extreme cases of misconduct. The goal may be to prevent entrepreneurial attorneys from bringing non-meritorious...