Other people's money.

• Author: Baird, Douglas G.
• Position: Fiduciary duty to shareholders

INTRODUCTION I. FIDUCIARY DUTIES TO SHAREHOLDERS A. Board Discretion B. The Business Judgment Rule II. A DUTY TO MAXIMIZE FIRM VALUE III. A CONTRACTARIAN SOLUTION IV. APPLICATION: DELINKING DISCLOSURE DUTIES A. Disclosure Duties B. Big Boys and Anti-Big Boys CONCLUSION INTRODUCTION

I was in one board meeting, and I said, "I started this [company] to do positive things with the world and do good in the Amazon, not necessarily to get a big payout." ... And one of [the angel investors] looked me in the eye and said, "Well, the problem is, then you went out and took $9 million of other people's money." (1) Legal principles that are almost right are often more mischievous than those that are completely wrong. What is transparently wrong is interpreted narrowly (or ignored altogether) and is likely to be repealed. An almost-right principle invites sloppy thinking, vague generalities, and a general distortion of the otherwise sound ideas that lie close by. An example of an almost-fight principle that has distorted much of the thinking about corporate law in recent decades is the oft-repeated maxim that directors of a corporation owe a fiduciary duty to the shareholders.

This principle (embraced by the Supreme Court in the nineteenth century (2) and as recently as last May by the Delaware Supreme Court (3)) is not on its face silly. A board of directors, as Adam Smith observed long ago, is charged with taking care of other people's money, (4) and it is usual in such cases for the law to impose special and unremitting duties. After all, directors lack the "anxious vigilance" that we use when looking after our own money. (5) Hence, directors should have a general legal duty to care for this money as a reasonable person would care for it if acting on her own account. (6)

The money in question usually is thought to belong to the shareholders. They contribute capital in the first place, they typically elect the board, and their blessing is required for major transactions. They stand to gain a dollar if the directors make the right decision and lose a dollar if they make the wrong one. In short, "the corporate contract makes managers the agents of the equity investors." (7) As the residual claimants, and unlike most creditors, (8) "[t]hey receive few explicit promises. Instead they get the right to vote and the protection of fiduciary principles." (9)

But this is not the whole story. The common stockholder is merely one flavor of investor. (10) Others, such as lenders, bondholders, and preferred stockholders, also stand to gain or lose with right or wrong decisions. (11) Moreover, with the right package of derivatives, a debtholder can enjoy the same cashflow rights as an equityholder and vice versa. (12) Shareholders ordinarily control the board, but any number of devices (from loan covenants to voting trusts) can give this power to other investors, including creditors and preferred stockholders. (13) As financial innovation has accelerated over the past two decades, the terms "shareholder" and "debtholder" or "creditor" have become less meaningful. (14) Identifying only shareholders as investors, as opposed to all providers of capital, is misleading. The problems likely to arise are already evident, (15) and the current surge in financial innovation will likely exacerbate them. (16)

The notion that fiduciary duties are owed to shareholders has not yet generated seriously wrong-headed outcomes. (Among other things, the Delaware chancellors are generally too smart to let this happen.) (17) Nevertheless, the reasoning needed to navigate around the sacred cow that the duty of the directors is owed solely to the shareholders has become increasingly awkward. People who should know better paint themselves into embarrassing comers trying to reaffirm the principle. (18) The problem is not as simple as whether investors have offensive fiduciary duty claims (i.e. whether fiduciary duties oblige directors to take particular actions). Creditors are more typically arguing for the disablement of duties owed shareholders. (19) They have sufficient influence over the directors such that the directors are willing to take actions in the creditors' favor, provided only that fiduciary duties owed shareholders do not constrain them. Directors, who must make difficult decisions and who are often forgotten in these cases, must also have clear rules about how they should act--the cases, even if coming to the right result in most instances, leave this question largely unanswered.

If we are right that fiduciary duties are becoming more harmful than helpful, the question becomes what principle ought to replace the idea that fiduciary duties are owed shareholders. The most obvious one follows naturally from the idea that ex ante investors presumptively are interested in maximizing the value of the firm. Following the lead of Circuit Judge Easterbrook in In re Central Ice Cream Co., (20) we might instead adopt the following principle: The directors must adopt the course that, in their judgment, maximizes the value of the firm as a whole. This principle of value maximization could also be coupled with a strong business judgment rule. Courts lack information and expertise that would allow them to effectively and efficiently police director decisions and cannot easily determine under any set of facts whether a particular decision was, when made, designed to maximize firm value. Hence, the directors must enjoy a large measure of discretion, and claims by one class of investor against another alleging breach of a fiduciary duty would fail so long as the directors acted reasonably to enhance firm value. (21)

Under this view, there is little we can say about the duties of directors other than that directors should maximize the value of the firm. They rarely, if ever, will be held liable for a decision that, notwithstanding its effect on one type of investor, maximizes firm value (22) (unless their action violates some specific covenant or by-law), and directors invite trouble (but do not necessarily expose themselves to liability) if they make a decision that reduces the value of the corporation. This view follows from the traditional law and economics approach to corporate law. (23)

In this Article, however, we suggest that this approach too may be wanting. Sophisticated investors negotiating for combinations of cash-flow and control rights might well choose models that depart from the simple one that requires directors to always maximize firm value. In some instances the efficient ex ante bargain may include terms that look inefficient ex post. (24) For example, creditors may need to be able to have the ability to engage in self-serving behavior that compromises the value of the business as a whole in order to ensure that the shareholders have the right set of incentives in the previous period. In other words, the real option for one investor to take disproportionate value from the firm under certain circumstances gives other investors and managers incentives to avoid these circumstances. Imposing a value-maximizing duty, even with a strong business judgment rule, may be contrary to what the investors want in their ex ante bargain.

At first cut, we should respect the choices investors and directors make, even if they seem to create situations where the board acts in ways that appear to destroy firm value. (25) Corporate finance and corporate governance are not one-size-fits-all, and firm capital structures are heterogeneous, complex, negotiated, and, most importantly, priced by the market. From this perspective, courts should tread lightly, even when faced with self-serving behavior, lest they upset what they do not understand. (26) Our understanding of capital structures is simply too primitive for us to do much more than enforce the contracts that are written as best we can. The default rules we devise--and fiduciary obligations are simply one of these (27)--should be in service of these contracts. (28) Imposing duties on directors that are too rigid or too mechanical may limit the ability of investors to create capital structures that are beyond the ken of those writing the rules. (29)

This is especially true since investors cannot easily opt out of a fiduciary duty once it is put in place. (30) Hence, it may make sense to eliminate the concept of fiduciary duty from corporate law altogether. (31) Rather than any generalized duty to shareholders or to the firm or to sometimes shareholders and sometimes creditors, directors should merely be obliged to honor the terms of the firm's investment contracts, even when they lead to decisions that are not value-maximizing ex post for the investors as a group. Directors would merely have the duty to attend to the affairs of the corporation and act in good faith, a duty owed to investors and strangers alike. In this world, shareholders, like creditors, must protect themselves through their powers under the corporate charter and the by-laws.

This Article proceeds in four parts. Part I shows how the maxim that fiduciary duties are owed to shareholders cannot be reconciled even with current doctrine. Part II goes on to show how the effort to sort out with greater particularity what duties are owed to whom is doomed to fail. Here we use the recent mess in Delaware over fiduciary duties in the "zone of insolvency" as our principal exhibit. This Part goes on to examine the paradigm that sits most comfortably with current thinking about corporate law in the courts and in the academy--the idea of fiduciary duties being owed to the firm as a whole, coupled with a strong business judgment rule. Part III shows how this principle itself may be wanting and sets out an alternative paradigm, one in which no fiduciary duties exist at all, and directors face liability for their decisions (other than for neglect or surreptitious self-dealing) (32) only if they violate a contractual obligation owed to a shareholder...