Opportunity-cost conflicts in corporate law.

• Author: Cable, Abraham J.B.
• Position: Abstract through I. A Novel Solution to the Problem of Quasi-Residual Claimants, p. 51-77

Abstract

Delaware corporate law has a new brand of loyalty claim: the opportunity-cost conflict. Such a conflict arises when a fiduciary operates under strong incentives to withdraw human and financial capital for redeployment into new investment opportunities. The concept has its roots in venture capital investing, where board members affiliated with venture capital funds may have incentives to shut down viable start-ups in order to focus on more promising companies.

Recognizing this type of conflict has conceptual value--it provides a coherent framework for assessing a fiduciary's incentives, and it may help explain frequently criticized features of corporate fiduciary law. But this article argues that courts should invoke the doctrine sparingly to avoid upsetting the law's current balance between policing managerial abuse and litigation abuse.

Contents Introduction I. A Novel Solution to the Problem of Quasi-Residual Claimants A. Loyalty and Incentive Incompatibility B. Venture Capital as Quasi-Residual Claimants 1. Fixed Claim: Liquidation Preference 2. Quasi-Residual Claim: Conversion Rights 3. Quasi-Residual Claim: Participation Rights C. The Conceptual Problems Posed by Quasi-Residual Claimants D. The Trados Solution: Opportunity-Cost Analysis II. Conceptual Strengths A. Sound Underpinnings B. Normative Implications of Opportunity-Cost Conflicts 1. Why Stop at the Enterprise? 2. The Difference Between VCs and Entrepreneurs III. Operationalizing Opportunity-Cost Conflicts A. Corporate Law's Distinctive Balance 1. The Substantial Cost of Hearing Meritless Litigation 2. The Muted Effects of Dismissing Valid Claims 3. Some Evidence of an Effective System B. Lessons from Entrenchment: The Other-Facts Standard C. What Qualifies as Other Facts? 1. Direct Evidence of Intent Qualifies 2. Industry-Wide Generalizations Do Not 3. Indirect Evidence of Intent Is Difficult to Imagine IV. Potential Objections A. Opportunity-Cost Analysis Was Dicta in Trados B. Why Wasn't Trados Dismissed? C. Contracting or Processing Around Trados D. When Can a Board Pull the Plug? E. Heightened Pleading Standards Haven't Worked F. Plaintiffs Can Plead Anything G. Fix Civil Procedure Instead H. Entrepreneurs Don't Litigate Much Conclusion Introduction

Assume you establish a corporation to operate a restaurant, and you are lucky enough to know Warren Buffet and Bill Gates. (1) Imagine that (a) Buffet and Gates each loan the corporation $500,000 at a reasonable interest rate; (b) Buffet and Gates serve as officers and directors of the corporation; and (c) Buffet and Gates each receive 25.5 percent of the corporation's common stock as compensation for their service and advice. Assume the restaurant operates for five years with moderate success--enough to make the loan payments with only a small amount left over for shareholders. Now suppose you propose a new menu to boost profits, but Gates and Buffet decide their time and money could be put to better use elsewhere. They vote as board members to sell the restaurant for an amount that pays off the loans but leaves only a small amount for shareholders. Assuming Gates and Buffet obtained a good price for the restaurant at that time, have they violated their fiduciary duties to you because they turned their attention to other projects and denied you the chance to unveil your new menu?

The Delaware Chancery Court recently suggested that the answer is yes by recognizing for the first time what this article refers to as an "opportunity-cost conflict." This article argues that this novel fiduciary principle is a double-edged sword: conceptually valuable but difficult to enforce without unsettling the law of corporate fiduciaries.

An opportunity-cost conflict arises when corporate fiduciaries operate under strong incentives to withdraw human and financial capital for redeployment into new investment opportunities. This concept is rooted in the economic principle of opportunity cost--the cost of a course of action is the highest value alternative forsaken. (2) It recognizes that a true understanding of a fiduciary's incentives requires knowing the fiduciary's alternatives to continued dealings with the beneficiary.

Opportunity-cost conflicts are distinct from traditional duty of loyalty claims against corporate fiduciaries. Traditionally, such claims arise in two principal situations: (1) self-dealing between the fiduciary and the corporation to the detriment of the latter (3) and (2) misappropriation by the fiduciary of a corporate opportunity. (4) Unlike traditional self-dealing, a fiduciary with an opportunity-cost conflict does not enter into a transaction with the corporation--the fiduciary simply shuts down the business and withdraws. Unlike a fiduciary who misappropriates a corporate opportunity, a fiduciary with an opportunity-cost conflict does not pursue any business initiative that rightfully belongs to the corporation--the fiduciary simply abandons one corporation in order to focus on a more promising alternative.

Not surprisingly, the concept of opportunity-cost conflicts was born in the context of venture capital investing. Venture capital funds take an unusually active role in the start-ups in which they invest. (5) This hands-on approach requires venture capitalists to allocate their scarce time among portfolio companies. (6) In this setting, continued investment in a moderately promising start-up company may have a high opportunity cost for the venture capitalist because it comes at the expense of spending additional time on more promising companies in the fund's portfolio. (7) Indeed, commentators have long observed that venture capital funds may shut down viable companies in circumstances where company founders might prefer to forge ahead. (8) One can anticipate similar dynamics in any setting where active investors must allocate their efforts among competing projects. (9)

In the recent case of In re Trados Incorporated Shareholder Litigation (10) (Trados), the Delaware Chancery Court expressly invoked this shutdown dynamic while enshrining opportunity-cost conflicts into law. (11) The court held that start-up company board members affiliated with venture capital funds faced a conflict of interest when considering a merger that resulted in a payout to the funds, as preferred shareholders, but no payout to common shareholders. (12) Though an earlier opinion in the Trados litigation (Pretrial Trados) (13) received significant scholarly attention for allowing such a claim to survive a motion to dismiss, (14) only the most recent opinion, which has received less attention from scholars, fully articulates the court's novel reasoning. (15)

Conceptually, Trados deserves credit for giving courts a coherent framework for identifying when a fiduciary's incentives are in fact impaired. Though courts and commentators have long recognized that disparate payouts from a transaction can affect incentives, (16) Trados reminds us that such cash flow rights are only part of the story. In the restaurant example above, Gates and Buffet may not have precisely the same financial incentives as you because only they receive a significant payout from transaction (repayment of their loans). But those payout differentials alone do not really answer the question of whether Gates and Buffet have materially different incentives than you. After all, they are also shareholders who would benefit from a wildly successful new menu, and they continue to receive interest payments on the loans as long as they are outstanding. What really puts you at odds with Buffet and Gates are their lucrative alternatives to your more pedestrian venture.

Another conceptual strength of Trados's new analysis is the light it sheds on contested normative questions regarding fiduciary duties, such as the vexing question of to whom director fiduciary duties should be owed. After deciding that the preferred and common shareholders in Trados had conflicting interests, the court determined that the board owed its fiduciary duty to the common shareholders alone (common maximization). (17) Prominent commentators have instead argued that corporate directors should seek to maximize overall enterprise value (enterprise maximization) rather than common stock value alone, because a rule of enterprise maximization increases...