Intruders in the boardroom: the case of constituency directors.

• Author: Sepe, Simone M.
• Position: Introduction through II. The Law and Economics of Constituency Directors A. Corporate Fiduciary Law and Its Consequence 1. The Undivided Loyalty Principle, p. 309-345

ABSTRACT

Under current fiduciary rules, directors who fail to maintain an undivided loyalty to common shareholders are essentially "intruders," exposed to shareholder retribution and liability for breach of fiduciary duty.

This Article argues that the increasing appointment of "constituency directors" has made the fiduciary principle of undivided loyalty to the common shareholders both outdated and normatively undesirable. A "constituency director" is a director designated to the board by a particular constituency (or "sponsor"). These constituency directors are generally appointed to advocate for investors who are not common shareholders, such as preferred shareholders, creditors, unions, and even the federal government. Contrary to conventional scholarly accounts, these kinds of investors (non-common equity, or "NCE, " investors) cannot always fully protect their interests through contracting alone. Thus, constituency directors are appointed to gain access to the added safeguards that only direct board advocacy can provide. By remedying this condition of "contractual failure," constituency directors make NCE investments worth undertaking where they otherwise might not be.

This analysis suggests that the liability constituency directors face under current fiduciary rules may reduce a corporation's access to important sources of capital. Hence, there is a normative case to be made for turning a director's obligation of undivided loyalty to the common shareholders into a default rule. This reform would allow constituency directors to properly advocate for their sponsors, bridging the gap between corporate practice and corporate law, to the benefit of all involved parties and society as a whole.

TABLE OF CONTENTS INTRODUCTION I. CORPORATE CONTRACTING AND CONSTITUENCY DIRECTORS A. The Canonical View of Corporate Governance 1. Vertical and Horizontal Agency Problems 2. Contractual Incompleteness and Investor Remedies B. The Limits of Corporate Contracting 1. Sensitivity to Management Actions 2. Startups and Declining Corporations 3. Non-Common Equity (NCE) Investors as Quasi Residual Claimants C. The Rise of Constituency Directors 1. Venture Capital Contracts 2. Creditor, Union, and Government Contracts 3. Constituency Directors as Complementary Goods II. THE LAW AND ECONOMICS OF CONSTITUENCY DIRECTORS A. Corporate Fiduciary Law and Its Consequences 1. The Undivided Loyalty Principle 2. The Trados Decision 3. The Residual Control Constraint B. The Economics of Undivided Loyalty 1. A Game Theoretic Illustration 2. Social Welfare Maximization. 3. Coasean Bargaining C. Monitoring and Contract Self-Enforcement III. CORPORATE LAW, PARTY AUTONOMY, AND THE POST-MODERN CORPORATION A. Enhancing Party Autonomy 1. Scope 2. Implementation 3. Feasibility B. Undivided Loyalty as a Default CONCLUSION INTRODUCTION

Just as soon-to-be Americans are required to take an "Oath of Allegiance" to the country that has granted them citizenship, (1) so too are individuals appointed to a corporation's board of directors required to subjugate their partisan interests to those of the corporation's common shareholders. No divided loyalties are permitted in the boardroom, regardless of how (or by whom) a director is designated. (2) Directors who fail to maintain an undivided loyalty to the common shareholders are essentially "intruders," exposed to shareholder retribution and liability for breach of fiduciary duty. (3)

This Article argues that the increasing appointment of "constituency directors" exposes flaws in the current law of fiduciary duty. The requirement that all directors be loyal to none but the common shareholders is no longer practically or normatively justified. This is not to say this rule of fiduciary duty should be discarded. Rather, it should be viewed as the default, around which corporate parties may contract to further all parties' interests.

A constituency director is a director appointed to a board specifically to advance the interest of a certain constituency (the "sponsor" or the "designating investor"). These directors are most commonly appointed to represent investors who are not common shareholders, (4) such as preferred shareholders, creditors, unionized workers, (5) or even the federal government. This Article will refer to such classes of investors as "non-common equity" ("NCE"). NCE investors rely on the wide-ranging control over corporate affairs that only a director can exercise, in situations where contracting alone is inadequate to fully protect their interests. However, under current fiduciary rules, constituency directors who advocate for NCE investors face liability for breaching their obligation to be loyal only to common shareholders. But if NCE investors cannot gain the protections that constituency directors provide, such investors may decline to invest at all, reducing a corporation's access to NCE capital. In tough economic times such as the present, this is especially harmful.

Under the canonical view of corporate governance, (6) the fiduciary principle of undivided loyalty is justified as the necessary response to the severe contracting difficulties shareholders (7) face in addressing problems of managerial opportunism. (8) Indeed, as residual corporate claimants who bear the risk of failure and receive the marginal rewards of success, shareholders are concerned with all management actions. (9) This makes it unfeasible for them to control a manager's opportunistic behaviors solely through contracting because management of corporate affairs involves continuous decision-making. The right to elect the board of directors and the benefit of fiduciary protection are the mechanisms the law provides to address this condition of "contractual failure." (10) By vesting shareholders with the power to make adaptive (i.e., non-contractually specified) decisions--in the jargon of economists, residual control rights (11)--these mechanisms provide the added safeguards shareholders need to fully protect their corporate interests.

As a corollary, NCE investors are not entitled to these sorts of additional protections. This is because, as fixed corporate claimants, (12) they are concerned with a more limited set of management actions and, therefore, theoretically, in a position to protect their interests by negotiating for specific contractual protections (i.e., specific control rights). (13)

While dominant in both legal doctrine and mainstream academic theories, this view reflects a corporate paradigm that has fallen out of step with the reality of an increasingly large share of U.S. corporations. Under this paradigm, equity is the principal source of capital, (14) company information is generally publicly available, (15) and the bottom-line protection for NCE investments comes from a corporation's net worth (i.e., the margin by which corporate assets exceeds corporate liabilities, (16) in addition to the ability to quickly exit a corporate investment. (17) But these assumptions are no longer generally applicable. In fact, none of these attributes are present in either venture-backed startups or declining corporations--both of which are growing exponentially in importance in the U.S. economy. (18) Instead, such corporations are characterized by significant, company-specific information available only to management, low net worth, and high asset specificity (i.e., limited exit rights). (19) Because under these investment features investors tend to undervalue straight equity claims, NCE capital is often a primary source of funding. (20) Given the attributes that characterize these kinds of corporations, the apparently bright line that separates the contracting positions of shareholders and other capital providers begins to blur. NCE investors become potentially as sensitive to management actions--and, therefore, as exposed to contractual incompleteness issues--as shareholders. As a result, the ability of the contract alone to support NCE investments radically decreases, threatening the viability of such investments.

NCE investors thus appoint designated individuals to the board--constituency directors--to provide added safeguards and adaptive responses that cannot be secured through contract alone. For example, venture capitalists and private equity funds routinely seek representation on, if not control of, the boards of the startups they finance. (21) Creditors do the same, in an attempt to protect their interests in declining corporations. (22) Unions may also demand board representation in exchange for wage or other concessions to financially troubled corporations. (23)

Yet the most innovative use of constituency directors has emerged in connection with the Troubled Asset Relief Program (TARP) that the U.S. Treasury employed to rescue troubled financial institutions during the financial crisis of 2007-2009. (24) In providing preferred stock financing to distressed financial institutions, the Treasury expressly bargained for the right to appoint board members in case of missed repayment deadlines. In implementing this provision, the Treasury has so far elected twenty-six board members to a total of fifteen financial institutions, including financial giant AIG. (25)

The existence of constituency directors, however, becomes problematic when those directors are also expected to abide by the principle of undivided loyalty to shareholders. If a conflict arises between the interests of the sponsor and the shareholders, the law currently requires that the interests of shareholders dominate, unless the sponsor has bargained for a specific course of action in her favor. (26) However, this is antithetical to the task NCE investors appoint constituency directors to perform, which is precisely to gain control over the corporate affairs beyond whatever contractual protections have been negotiated. (27)

These limitations do not simply create legal risks for NCE investors; they interfere with welfare maximization...