The efficient norm for corporate law: a neotraditional interpretation of fiduciary duty.

• Author: Smith, Thomas A.

To economically oriented corporate law professors, distinguishing between directors' fiduciary duty to shareholders and a duty to the corporation(1) itself smacks of reification(2) -- treating the fictional corporate entity as if it were a real thing. Now the orthodox view among corporate law scholars is that the corporate fiduciary duty is a norm that requires firm managers to "maximize sharer older value."(3) Giving the corporation itself any serious role in the analysis of fiduciary duty, the thinking goes, obscures scientific insight with bad legal metaphysics.

Some recent scholarship(4) and legislation, such as constituency statutes,(5) have challenged this "shareholder primacy"(6) view. Contestants on both sides of the debate over corporate fiduciary duty assume, however, that economic analysis inevitably favors shareholder primacy.(7) Critics of shareholder value maximization encourage this assumption by making their case turn, in part, on criticisms of economic methodology itself(8) and on invocations of moral and political values most economists would find controversial at best.(9)

Nevertheless, the economic approach to corporate law does not foreordain the maximization of shareholder value as the primary norm of corporate law. The economic case for shareholder value maximization is, in fact, initially puzzling and ultimately unconvincing. If economic efficiency is the normative guidepost for substantive law, the principal norm of corporate law cannot be the maximization of shareholder value.

It is easy to see why this must be so. The corporate fiduciary duty, according to the leading economic analysis of corporate law, is a principle that fills gaps in the "corporate contract."(10) The "corporate contract" is the metaphorical contract consisting of the sum of the voluntary arrangements among the various parties who contribute resources to the corporate enterprise and have claims against it.(11) Discovering the correct gap-filling principles for the corporate contract involves hypothetical bargain analysis -- asking what contractual terms rational parties would have agreed to had they addressed ex ante the matter that falls into a contractual gap.(12) For corporate contracts, the prevailing view is that this gap-filling principle should be "maximize shareholder value." According to this view, that is the substance of the corporate fiduciary duty.

One can adopt the contractual approach to corporate law and agree that the fiduciary duty is essentially a principle for filling gaps in corporate contracts. Nevertheless, the next step in the argument for the prevailing view, that the substance of this gap-filling principle should be shareholder value maximization, does not follow. Rational corporate investors in a hypothetical bargain setting would not agree to shareholder value maximization as their gap-filling rule. The main point of this Article is to explain why they would not and to explain what they would choose instead.

Rational corporate investors would not choose shareholder wealth maximization as their gap-filling rule because of what investor rationality entails. In economic analysis of corporate law, it is standard to treat shareholders as rational in the sense described in basic finance theory, in particular, the Capital Assets Pricing Model ("CAPM"). Investors who are rational in the CAPM sense would hypothetically agree to a gap-filling principle, but it would not be "maximize shareholder value." Under CAPM, rational investors will diversify among all classes of capital assets, including both corporate stocks and bonds. In fact, they will hold the "market portfolio," that is, a portfolio that is a microcosm of all capital assets, in which each type of capital asset has the same place proportionally in the rational investor's portfolio as it does in the capital market as a whole. Thus it would be irrational for investors to agree to a principle that required the value of their shares to be maximized if it meant reducing the value of their bonds (or of any other nonresiduary class of capital assets they might hold) by more than the increase in the value of their stock. The shareholder value maximization norm allows, and under plausible assumptions even requires, managers to make inefficient decisions which hypothetical rational investors would not permit ex ante. Rational investors would therefore not agree to it.

To what corporate law norm would rational investors hypothetically agree? They would agree to a norm that told managers to maximize the value of the diversified portfolios that CAPM says rational investors would hold. As a gap-filling principle, this would require firm managers to make the choices that would maximize the value of the sum of financial claims against the corporation, because these claims will be held proportionally by rational CAPM investors holding the market portfolio.(13) If a public corporation were financed half by stock and half by bonds, a rational investor holding the market portfolio would have his investment in that corporation divided evenly between its stock and its bonds. He would obviously not agree to a rule that allowed managers to make choices that diminished the value of his bonds by more than they increased the value of his stock. He would insist on a rule that required managers to maximize the value of the sum of the two classes of claims against that corporation. This rule would be the gap filler which rational investors would agree managers should follow if the corporate contract did not provide otherwise. This would be the content of the fiduciary duty rational investors would accept ex ante.

Articulating this duty has interesting consequences. A fiduciary duty running to the corporation itself would be most consistent with the gap-filling rule that emerges from hypothetical bargain analysis. This rule would require corporate managers (absent explicit contractual terms to the contrary) to take whatever actions maximized the value of "the corporation" -- maximized, that is the sum of the value of financial claims against the corporation -- whether doing so primarily benefited shareholders or some other class of corporate claimants. Far from mysteriously reifying the corporation, this approach requires nothing more conceptually murky than addition. This reformulation of the duty is notably inconsistent, however, with treating one class of corporate claimants, such as common shareholders, as the exclusive and direct beneficiaries of the fiduciary duty, as is now standard in economic analysis of corporate law. It is also inconsistent, however, with making all or several classes of claimants against the corporation direct and simultaneous beneficiaries of the fiduciary duty, as seems to be suggested by some advocates of bondholder rights.(14) The "neotraditional" conception of fiduciary duty I propose, a duty running to the corporation itself, would require actions of managers that would sometimes benefit one class of claimants and sometimes another, depending on the circumstances. Once one dispenses with misguided fears of reification, there is nothing particularly troubling about this approach.

There is, however, more than a mere theoretical quibble in the difference between a fiduciary duty owed to the shareholders of public corporations to maximize the value of their shares and a duty owed to the corporation to maximize its value. It is true that managers of a "plain vanilla" public corporation, one with a simple capital structure and little debt, might have incentives to maximize the sum of the value of all financial claims against that corporation. When corporate capital structures get more complicated in certain ways, however, the shareholder value maximization version of fiduciary duty will mislead managers. And there is every reason to expect corporate capital structures will become increasingly complex in just those ways, as Professor Hu, one of the leading prophets of financial complexity, has convincingly argued.(15) For example, the "equity" of firms can be (and is being) sliced up into various derivative securities.(16) Stock can be structured as claims on the profits of certain parts of the issuer's business rather than on the whole business of the corporation.(17) Firms can become highly leveraged(18) and can issue hybrid securities.(19) These innovations strain traditional concepts of fiduciary duty. This problem is not as difficult to resolve, however, as Professor Hu seems to think. The neotraditional conception of fiduciary duty I propose responds, for all its simplicity, remarkably well to these challenges, as I explain below.

This Article begins by describing in Part I the familiar conflict between the interests of shareholders and those of bondholders. I add a new point by stressing, however, that this problem is not limited, as is often supposed, to the "vicinity of insolvency,"(20) to use Chancellor Allen's phrase.(21) It will, under standard and plausible assumptions of modern finance theory, never be efficient for firm managers to "maximize shareholder value," as long as there are fixed claims such as bonds in the firm's capital structure. The "vicinity of insolvency," strictly speaking, is determined only by the riskiness of the investments available to the firm. If financial markets are complete, as modern finance theory usually assumes, available investments will not be limited by their riskiness. The capital market will offer a complete menu, including even extremely risky investments. Some of these risky opportunities will increase the expected value of stock, the residual claims on a firm, but decrease the value of nonresidual claims by even more, thus decreasing the expected value of the sum of financial claims again the firm. Thus the "vicinity of insolvency," as Chancellor Allen has imagined it, cannot be defined, and therefore the moment at which a firm enters it is indeterminate. In a simple world...