Fiduciary duties for activist shareholders.

• Author: Anabtawi, Iman

INTRODUCTION I. FOUNDATIONS OF SHAREHOLDER FIDUCIARY DUTIES A. Corporate Fiduciary Duties B. Fiduciary Duties of Shareholders C. Limits of Shareholder Duties 1. Controlling shareholders 2. Freeze-outs and closely held corporations D. Summation II. THE EVOLVING ROLE OF SHAREHOLDERS IN CORPORATE GOVERNANCE A. The Activist Shareholder 1. The rise of the institutional investor 2. The SEC's 1992 proxy rule amendments 3. The emergence of shareholder advisory services 4. The rise of activist hedge funds 5. Financial innovation 6. Proposed changes in shareholder voting rules B. The Conflicted Shareholder 1. Conflicts arising from activists' transactions with the corporation 2. Conflicts arising from activists' interests in derivatives or securities of other corporations 3. Conflicts arising from activists' investments in other parts of the corporation's capital structure 4. Conflicts arising from activists' short investment horizons III. TOWARD A GENERAL THEORY OF SHAREHOLDER FIDUCIARY DUTIES A. Past and Proposed Responses to Activist Shareholder Overreaching B. Fiduciary Duties as a Response to Shareholder Overreaching 1. Expanding the notion of control 2. Expanding the notion of shareholder conflicts of interest 3. Incorporating traditional loyalty defenses IV. OBJECTIONS A. Increased Litigation B. Chilling Effects C. Majority Voting CONCLUSION INTRODUCTION

In the typical American public corporation, power is dispersed among three key groups: shareholders, the board of directors, and the company's executive officers, including its Chief Executive Officer (CEO). Each group has rights and privileges. Each also has duties and responsibilities.

Contemporary corporate case law and scholarship, however, pay far more attention to corporate officers' and directors' duties than to shareholders'. Officers and directors are understood to owe fiduciary duties that are broad and deep, constraining their every material business decision. (1) Shareholders are thought to have far more limited obligations. In fact, outside the narrow contexts of closely held companies and self-dealing by majority shareholders, many commentators assume shareholders have no duties at all. (2) Minority stockholders in public companies are often viewed as free agents, at liberty to try to influence corporate policy as they see fit--including trying to influence corporate policy in ways that favor their own interests over those of the corporation and other shareholders.

The risk that minority shareholders in public firms might use their power in self-serving ways has understandably attracted little attention for two reasons. First, until recently, minority shareholders have played a largely passive role in public companies. This passivity has been driven by both economic and legal forces. From an economic perspective, the cost of trying to influence corporate policy has typically outweighed the likely impact of such effort on the value of any single shareholder's interest, leaving dispersed shareholders in public companies "rationally apathetic." (3) From a legal perspective, traditional corporate law rules have done little to overcome this hurdle. (4) The result has been that minority shareholders in public firms have been perceived as having far less power to set corporate policy than directors and officers have.

The second reason why the question of minority shareholders' duties has been largely overlooked is that, even when minority shareholders do try to take an active role in public companies, it has been generally believed that their primary goal is to improve the firm's overall economic performance--an interest that is closely aligned with both the interests of the firm and the interests of other shareholders. Shareholder activism, accordingly, has been assumed to be a beneficial influence. (5)

In this Article, we argue that both of the foregoing assumptions are becoming increasingly inaccurate. The economic and legal context in which American public corporations do business is changing swiftly in ways that create a pressing need to reexamine conventional notions of shareholder duties. As a result of recent developments in financial markets, business practices, and corporate law, minority shareholders are finding it economically rational to try to influence corporate decision-making. The long-standing assumption that public company shareholders lack the ability or incentive to engage in activism is no longer accurate. Meanwhile, even as shareholders are becoming more powerful, their interests are becoming more heterogeneous. Increasingly, the economic interests of one shareholder or shareholder group conflict with the economic interests of others. The result is that activist shareholders are using their growing influence not to improve overall firm performance, as has generally been assumed, but to profit at other shareholders' expense.

Consider the following three scenarios, each of which involves an activist shareholder seeking to advance its own interests to the exclusion or detriment of other shareholders' interests:

1. A large, publicly held corporation owns and runs a national chain of grocery stores. The chain becomes embroiled in bitter contract negotiations with its employees' union over proposed cuts in employee pay and benefits. The union publicly blames the dispute on the hard-line negotiating stance of the grocery chain's CEO. The employees' union runs a pension fund for its members. The union pension fund portfolio includes significant holdings of common stock in the grocery store chain. Using its status as a shareholder in the company, the pension fund mounts an aggressive proxy campaign to remove the company's CEO.

2. A hedge fund owns a large block of common stock in a troubled biotech company. To raise the stock's share price, the hedge fund urges the biotech company's management to put the company up for sale, but finding a buyer willing to pay a premium for the company's shares proves difficult. Finally, a large health sciences corporation expresses interest in acquiring the biotech firm. Industry analysts voice doubts about the acquisition, believing the price too high. At this point, the hedge fund buys 10% of the common stock of the possible acquirer. The hedge fund keeps formal title to the stock, along with its legal status as a shareholder in the acquirer and the right to vote 10% of the acquirer's common shares. However, the hedge fund enters into a derivatives contract with an investment bank to hedge away its economic interest in the acquiring corporation. If the acquirer's stock price declines, the investment bank, and not the hedge fund, will bear the loss. The hedge fund then approaches the acquirer's board and informs the board that if any of its members oppose buying the biotech company, the hedge fund will use its shareholder status to mount a proxy battle to remove that director from the board.

3. A small environmental services company raises $10 million in new capital from a private investment partnership. In return, the investment partnership gets 45% of the environmental services company's common stock and preferred stock with a $15 million liquidation preference (a right to receive liquidation proceeds that is senior to that of common stockholders). The liquidation preference can be triggered by a sale of all the company's assets approved by a majority of the board and a majority of the common shares. Just a few weeks later, the investment partnership announces it has found a third-party buyer willing to pay $15 million for all the environmental services company's assets. Because the asset sale would trigger the $15 million preferred stock liquidation preference, the company's common stock would become worthless. Thanks to its preferred stock interest, however, the investment partnership would make a quick 50% profit on its initial $10 million investment. The board of directors of the environmental services company, a majority of whom are investors in the investment partnership, quickly approves the asset sale. Because the investment partnership already owns 45% of the company's common shares, the sale will go forward if 5% or more of the firm's other common shares are voted in favor of the deal. The investment partnership approaches several other shareholders of the environmental services company who collectively own 6% of the company's common stock and offers them the opportunity to participate in unrelated business deals on highly favorable terms if they agree to vote their shares in favor of the asset sale. The asset acquisition is approved.

   These scenarios are stylized variations of actual eases reported in judicial opinions or the business press. (6) They illustrate how minority shareholders in public companies can and do use their growing influence to push for corporate actions that serve their personal economic interests. It is unclear whether and to what extent the traditional rules of shareholder fiduciary duty reach such self-serving behavior. This lack of clarity has encouraged activist shareholders, especially hedge funds, to "push the envelope" in employing activist tactics to pressure corporate officers and boards into pursuing business policies that uniquely benefit the activist, while failing to hell--or even harming--the firm and its other shareholders.

   We believe that fiduciary duty doctrine can and should be interpreted in a way that takes into account changes in the corporate landscape and reaches such opportunistic behavior. Indeed, we believe that the law of fiduciary duty is uniquely suited to address the growing problem that opportunistic shareholder activism poses for corporate governance. To this end, we propose concrete recommendations for furthering this doctrinal evolution.

   Our approach has two advantages as a strategy for dealing with self-serving shareholder activists. First, it brings existing fiduciary duty doctrine into line with the changing reality of how...