Opportunity-cost conflicts in corporate law.

• Author: Cable, Abraham J.B.
• Position: II. Conceptual Strengths through Conclusion, with footnotes, p. 77-109

2. Conceptual Strengths

   Pretrial Trados received significant attention from legal scholars not only because it affected an economically important method of finance, but also because it implicates key conceptual considerations. The opinion has been a springboard for examining fundamental questions such as who fiduciary duties should protect, (119) the important role that constituency directors play in today's financing market, (120) and the correct "theory" of preferred stock. (121)

   The trial court's opinion is an important elaboration of Pretrial Trados but has received little attention in legal scholarship to date. This Part therefore considers the conceptual strengths of the court's new reasoning. These strengths include: providing a theoretically sound framework for analyzing fiduciary behavior, undermining a prominent alternative to the court's chosen rule of common maximization, and providing at least a plausible rationale for common maximization.

   1. Sound Underpinnings

      The Trados court's portrayal of investor behavior--and the influence of investment alternatives--is well grounded in economic theory. In other words, consideration of opportunity costs may be necessary to the extent courts are committed to analyzing incentive structures of venture capital and other investors.

      In economics, it is axiomatic that individuals make decisions on the basis of opportunity costs. (122) Opportunity costs are distinct from the undesirable consequences of a decision and from the types of expenditures and accruals categorized as costs by accountants. (123) Instead, the opportunity cost of a proposed course of action is the highest value alternative forsaken. (124) The concept takes on vital importance in economics because in a world of scarce resources economic actors cannot pursue every course of action with positive expected value in the sense of producing desirable outcomes or attributes in excess of undesirable outcomes or attributes. Instead, economic actors must make decisions by comparing the value of alternatives. (125) Thus, when one considers whether to build a swimming pool, the costs that drive the decision are not cash outlays for concrete or the pain of digging or supervising the work. Though unpleasant in some sense, these factors are not choice influencing in the absence of a comparator such as buying a new car, spending time with family, or saving for retirement. (126)

      Some observers have nibbled away at the edges of this insight by questioning how effectively people make such comparisons. (127) One entertaining survey suggests that even economists struggle with the concept. (128)

      But in venture capital and similar contexts, where active investors must allocate effort among competing projects, (129) it seems likely that whether a particular course of action is worth it does depend on the investors' alternatives. The same might not be true of all portfolio investors--more passive investors may be able to inexpensively add new securities to a broadly diversified portfolio without foreclosing alternatives. (130) But without adding additional personnel, which may be costly, (131) a venture capital fund only has so much human capital to invest. (132)

      What this means for fiduciary duty analysis is that a court may have difficulty analyzing incentives without expanding the inquiry beyond transaction terms and payouts between the parties. The factors that influence the decision to sell or continue with an investment may be exogenous to the direct business relationship between the fiduciary and the beneficiary. In the Trados example, these exogenous factors at least include the fund's expectations for its other portfolio companies. But even the portfolio may be too narrow a view. For instance, if Fund C in the example above has a relatively weak portfolio, then Company C may be among its better performers. (133) In that case, it is tempting to assume Fund C is motivated to shut down its other companies to focus attention on Company C. But Fund C will want to do so only if continuing with Company C exceeds the opportunity cost of starting a new fund (if Fund C's poor performance hasn't foreclosed that possibility), changing careers, or spending time with family or a new hobby.

      The reference to nonpecuniary uses of time (spending time with family or friends) is worth expanding on because it underscores the limits of opportunity cost analysis. In their purest and most provocative form, opportunity costs are fundamentally subjective and accordingly difficult to observe. Nobel Laureate James M. Buchanan, who devoted an entire book to the concept of opportunity costs, concluded "[c]ost cannot be measured by someone other than the decision-maker because there is no way that subjective experience can be directly observed." (134) Like economists, therefore, courts may never have full visibility regarding a fiduciary's incentives and choices. (135) But courts, like economists, may find suitable enough indicia of opportunity costs and make defensible enough predictions about an economic actor's choices. (136)

      In short, by invoking the shut-down dynamic the court properly identified the type of external considerations that induce economic choice and define a fiduciary's incentives. Precisely how this clever doctrinal solution should be implemented for future cases is the subject of Part III below. For now, it is sufficient to acknowledge that the court sensibly framed the issue at a conceptual level.

   2. Normative Implications of Opportunity-Cost Conflicts

      So far, this article has assumed that the Trados court was correct in selecting a rule of common maximization. In other words, it has assumed that when an affiliate of a preferred holder serves on a board of directors, his or her primary duty is to protect the common shareholders. In fact, this issue is hotly debated. Commentators disagree on whether the beneficiary of corporate fiduciary duties should be common holders, preferred holders, the corporation as an entity, or some combination of those alternatives.

      In particular, an alternative rule of "enterprise maximization" has received significant support in recent scholarship. (137) Under a rule of enterprise maximization, directors would owe fiduciary duties to the corporation, as distinct from any particular group or class of investors. (138) In the Trados fact pattern, a rule of enterprise maximization would mean the board should be trained on the goal of increaseing enterprise value, regardless of how that value was to be distributed among investors, and should sell if the expected value of doing so exceeded the expected value of remaining a standalone entity.

      This Part explores how an opportunity-cost focus implicitly supports the court's rule of common maximization by (1) exposing the rule of enterprise value as too atomistic and (2) suggesting a plausible explanation for why a rule of common maximization is necessary to induce entrepreneurs to enter into venture capital bargains.

      1. Why Stop at the Enterprise?

         At first blush, the rule of enterprise maximization is normatively compelling. Proponents of enterprise maximization envision the rule as a default that the parties could override by specific contractual arrangement. (139) In traditional law-and-economics scholarship, such default corporate law rules are ordinarily conceived as majoritarian or bargain mimicking rules, meaning they are an attempt to approximate what most parties want most of the time. (140) The value in setting such defaults is to reduce transaction costs of the parties entering into a business relationship through a corporate vehicle. (141)

         At the risk of stating the obvious, it is important that a majoritarian default rule in fact approximates what most parties want. In a hypothetical world, featuring a large array of organizational choices, the standard might not be so high. A particular package of default rules would serve a useful purpose as long as some constituency finds it acceptable. Others could simply pick a different entity.

         But in practice, there is a fairly limited range of entities from which entrepreneurs choose. (142) These entities differ across a wide range of variables including management rights, mechanics of equity compensation, and tax treatment. (143) With a small number of entities varying across a wide range of attributes, it seems likely that choosing an entity is largely a matter of tradeoff, and parties are likely to accept a great many suboptimal features of secondary importance as they emphasize a few key features in their decision-making. In many cases, considerations outside of corporate law may drive the decision, (144) and the parties may have limited appetite to fine-tune a large number of corporate governance features. The upshot is that an unpopular corporate default rule can itself become a transaction cost as parties make do with it.

         With that background, is it reasonable to assume that, ex ante, parties to a corporate financing will ordinarily want a rule of enterprise maximization? To understand the case for the rule, start with the assumption that, all other things being equal, the parties to a transaction want to maximize the size of their combined welfare so there is more to divide between them. (145) For the moment, also assume that the parties' combined welfare is measured by firm or enterprise value. (146) Common maximization may not achieve the goal, framed in this way.

         The following payout scenario, which is similar to Hypothetical B but with worse prospects for a turnaround, helps illustrate the concept:

         Hypothetical D: Value-Destroying Turnaround Value Probability Acquisition offer for $30,000,000 Company D Liquidation preference $30,000,000 (investment amount + accrued dividends) Turnaround (if successful) $50,000,000 25% Turnaround (if unsuccessful) $20,000,000 75% Average expected value of $27,500,000 turnaround Looking at these payouts alone, the common holders would hazard...