Reclaiming Fiduciary Law for the City.

• Author: Schanzenbach, Max

Modem law sets "public" local government law apart from "private" business entities law. Although intuitive, this distinction ignores legal history and, even more troublingly, the contemporary practices of local governments. Due to distressed finances and a political atmosphere favoring privatization, present-day cities routinely engage in sophisticated market transactions typical of private business entities. Current law fails to adequately address this reality. Because cities are deemed public, courts do not analyze their transactions for compliance with the fiduciary duties private law imposes to ensure sound management. Major city transactions thus evade meaningful review.

This Article addresses this worrisome anomaly by demonstrating that the city's supposed public nature need not interfere with the application of fiduciary duties to its market transactions. To the contrary, this Article shows that the fiduciary status of city officials is supported--indeed, necessitated--by U.S. law's history, structure, and normative logic. This Article also devises the appropriate fiduciary duty of care--or sound management--that courts should apply to city officials. It advocates requiring local decisionmakers to abide by certain processes of informed decisionmaking before selling major municipal assets. As primarily a procedural, nonsubstantive test, such a standard would not constrain the political discretion of local officials and could readily be applied by courts.

Table of Contents Introduction I. The Source of City Officials' Fiduciary Duties A. The Public Law Source of All Public Officials' Fiduciary Duties: Recent Works and Their Limits B. The Private Law Source of City Officials' Fiduciary Duties: The City as a Private Law Subject in Nineteenth Century Law 1. The city's origins as a private law subject 2. The city retains a private law status as property owner 3. The city's duties as property owner: the public trust doctrine and fiduciary obligations C. Summary: City Officials as Common Law Fiduciaries II. The Current State of City Officials' Fiduciary Duties A. The City and the Public Trust Doctrine Today B. The City and Modern Corporate Law Doctrines 1. Derivative lawsuits 2. Antitrust C. The City and Fiduciary Duties in Contemporary Law D. Summary: Contemporary Law and the City's Fiduciary Duties III. The Contents of City Officials' Fiduciary Duties A. The Distinct Duties of Care in Trust Law and Corporate Law B. The Reasons for the Distinct Duties of Care in Trust Law and Corporate Law 1. Costs of the duty of care 2. Benefits of the duty of care C. The City and the Trust Law/Corporate Law Divide 1. Costs of a duty of care applied to the city 2. Benefits of a duty of care applied to the city D. The Duty of Care for the City E. Summary: City Officials' Fiduciary Duty of Care Retrieved Conclusion Introduction

For a lump-sum payment of $1,157 billion, an entity's officials decided to transfer, for seventy-five years, all rights to the income derived from one of the entity's major assets. Almost immediately after the contract was signed, facts emerged demonstrating that the entity's conduct in negotiating and approving the deal had been flawed. Although the asset was one of the entity's only marketable properties, the entity's finance committee dedicated only a single meeting to discussing its sale. The meeting was held the day after an offer was announced, and the offer was forwarded to committee members that same morning, with no details to aid in their deliberations. The finance committee heard only one person testify--the entity's chief financial officer--who simply asserted that the offered payment accurately reflected the asset's true value. When asked, he refused to produce figures to substantiate this claim. Nonetheless, the committee approved the deal on the spot. The next day the entity's full decisionmaking body did the same. A "fairness opinion" was issued by an investment bank, but only a summary was provided. Curiously enough, that opinion did not analyze the price the asset could fetch on the open market, the reasonableness of the seventy-five-year term, or the fact that the sale was being conducted during a major liquidity crisis that had temporarily depressed many assets' values. A legal opinion on the deal was also requested from the entity's outside counsel, but it was submitted months after the entity's decisionmakers had already approved the deal. An independent assessment later found that the asset had been undervalued by 46%, or nearly $1 billion.

Imagine that a person holding an interest in the entity objects to the transaction. Will a court be willing to entertain her challenge and review the decision to sell the asset?

The answer is probably obvious to any lawyer with the most cursory acquaintance with the law of business associations or trusts. The asset sold did not belong to the officials personally; they held and sold it on behalf of those owning an interest in the entity--the asset's true owners. (1) This separation of control from ownership creates an inherent risk of conflicted or careless decisionmaking: Nonowners--the officials in control of the asset--may not pursue the best deal when selling that asset. (2) They realize little of the gain and bear little of the loss. (3) The law has long acknowledged this "agency problem" and applies a specialized framework to treat it. (4) Specifically, the law subjects nonowner officials to "fiduciary duties" meant to ensure that their decisions are in the best interests of the property's real--or "beneficial"--owners. (5)

These fiduciary duties are commonly divided into two categories: duties of loyalty (6) and duties of care. (7) Under the duty of loyalty, the fiduciary must avoid conflicts of interest when dealing with the beneficiary's assets. (8) Under the duty of care, she must exercise sound management practices. (9) To ensure such sound management, a court will generally assess the quality of the fiduciary's decisionmaking processes in dealing with the beneficiary's assets. (10) In the sale described in the opening paragraph, that process appears hasty, uninformed, and well outside the norms of fiduciary behavior for a transaction of such a magnitude. (11)

Yet when a court passed judgment on this deal, it was not asked, nor did it choose, to engage in such fiduciary analysis. (12) In fact, the court explicitly stated that it would not inquire into the decisionmaking process engendering the deal or into the deal's quality. (13) Instead, the litigants and the court contented themselves solely with arguments over whether the entity had the power to enter a deal to sell the asset. (14) Why? How was an entire body of law--fiduciary law--sidestepped in a case seemingly tailor-made for its application? For just one reason: The entity selling the asset was Chicago, a "public" entity--a city--and not a "private" entity--a corporation or a trust. (15)

This disparate legal treatment of public and private entities is grounded in seemingly important practical distinctions between the entities. Unlike private corporations or trusts, cities are not perceived as the creatures of their members--their residents--set up primarily to efficiently manage those members' property. (16) Rather, the law views cities as creatures of the state set up primarily to tax, regulate, and provide services. (17) Accordingly, modern courts reckon that the only relevant legal question when a city acts is whether the state empowered it to act. (18) The question, prevalent in private law, whether the entity's act lived up to any obligations toward members, is irrelevant. (19)

But the practical distinction between the city and the private entity breaks down in the case described above, in which Chicago sold to an investors' consortium all revenue from its parking meters for seventy-five years. (20) Chicago was not acting as the state's long arm; it was not regulating its residents' activities or providing them with services. It was selling an asset to investors. Chicago was transacting rather than governing (21)

In thus transacting in the market, Chicago was hardly an outlier. The twenty-first century U.S. city turns to the private market in many ways that would have been unimaginable for its twentieth century predecessor. (22) The convergence of the outmigration of key industries, stagnant populations, shrinking federal and state grants, and large pension shortfalls has generated structural upheavals in local finances (23) In response, a wave of outsourcings of services, public-private partnerships, privatizations of city assets, and sophisticated financial dealings is sweeping the nation's cities. (24) Cities are investing in securities and buying revenue-producing venues (25) or offering their waterworks, (26) airports, (27) bridges, (28) and other infrastructure for sale or lease. (29) This wave should only intensify over the next few years, as the Trump Administration has already firmly endorsed such initiatives. (30)

The factual gap between the supposedly public city and the private corporation or trust is thus closing fast. Yet the legal gap between "public" local government law and "private" entities law has steadfastly, and uncritically, persisted. Because the city is "public," its market transactions have avoided the fiduciary scrutiny that private law has developed precisely for such deals, leaving city transactions almost wholly unregulated.

The results have been predictably unfortunate. Like Chicago, many other local governments have been rushing, with little deliberation or expertise, into market deals of highly dubious quality. (31) The judge overseeing Detroit's bankruptcy--the largest municipal bankruptcy in U.S. history (32)--detailed Detroit's transactions with investors and found: "[T]he City lost on [its] swaps bet. Actually, it lost catastrophically on the swaps bet. The bet could cost the City hundreds of millions of dollars." (33)...