Introduction
This
paper is intended to investigate to whom the Corporate Fiduciary Duties should
be owed? Is it the shareholders or the company as a whole? The Fiduciary Duties
of these corporate officers are arising from the contracts they have concluded
with the principals. As to the “incomplete-contracting” theory, these contracts
can never be drafted in a way that no contingency is left out due to high
transaction costs. Therefore, the discretion is left to the corporate officers
to do what would be in the best interest of their principals in given
circumstances that fall outside the boundaries of their contract. The exercise
of this discretion, however, is subject to the “ex-post” review by their
principals and the courts in later stages. The courts in these cases seek to
assess whether the agents have acted in accordance with their fiduciary duties
owed to “the principal” in the said contingency. What is in the best interest
of the principal in the case of corporate officers doing their job in these
contingencies leads to another debate about the identity of their principals.
This question arises especially when the corporate officers have second thoughts
about whose interests should be prioritized - shareholders or the company when
what is in the best interest of one of them does not necessarily give the same
effect on the other. The number of these cases is considerably high and
requires an effective solution once for all.
The
cases coming down to the courts therefore may be scrutinized from a different
perspective as to whose interests should have been taken into consideration
primarily by the acting corporate officers. In many jurisdictions, court
practices more or less accept these fiduciary relationships mainly owed
vis-à-vis the common shareholders, rather than bondholders, stakeholders,
preferred shareholders, or the company as a separate legal personality.[1]
Some jurisdictions, on the other hand, have failed to make any distinction
between the shareholders and the company as another entity. For example,
according to Article 49.3 of the Civil Code of the Republic of Azerbaijan,
“a
person acting on behalf of the legal entity, including any person represented
in management bodies of the legal entity (the supervisory board (board of
directors), executive body) of a legal entity, shall, when executing his duties
for the benefit of the legal entity he represents, be obliged to act
faithfully, in a professional manner and logically, be loyal to interests of the
legal entity and all of its participants, consider the interests of
the legal entity over his own interests, and be careful, and also fair and
impartial in the course of decision-making.”[2]
This
article is known to be describing the fiduciary duties of the governing bodies
of the legal entities, however, the legislators do not differentiate the entity
from its participants by generalizing them as “interests of the legal entity and all of its participants”.
As we will further elaborate below, the interests of these two do not
always overlap and this Article of the Civil Code creates uncertainty both for
those who have discretionary powers to make decisions on the company’s behalf
and for courts in scrutinizing whether or not fiduciaries have acted with the
boundaries of their fiduciary duties.
In
examining this question and trying to find a sound answer to the problem, this
paper has also been inspired by two relatively recent cases, namely Vald
Nielsen Holding A/S v. Baldorino [2019] and Sharp v Blank [2019]. In
the former, the Court held that directors do not owe fiduciary duties to
shareholders by virtue of their office of a directorship except where there is
a ‘special relationship’ – which this was not.[3]
And in Sharp v Blank [2019], the shareholders of Lloyds launched a claim
that the directors of Lloyds had overvalued HBOS (being taken over), which had
resulted in their shareholdings being disproportionately diluted and reduced in
value. The Court rejected the claim that the defendants had breached their duty
when recommending the offer.[4]
These two cases again brought this issue back to the light. Here, it
seems like the courts have favored fiduciary duties running vis-à-vis the
companies as a whole unless specific circumstances are present. However, both
court judgments and prior case law lack any justification behind their
decisions. As a result, it is not clear what is the rationale for courts
reaching those specific decisions - whether a more just/balanced or
economically efficient approach has been employed. Therefore, this paper will address which rule would potentially maximize economic efficiency in society from the Law & Economics perspective.
Assumption
I.
In
order to simplify things, this paper will start with a very simplified version of
today’s corporate world and try to find out the answer to our question under
this scenario. In our simplified version of the corporate world, the company
has two investors one being the shareholder and other one - the bondholder.
Both of them have invested in the company in different ways, but both are there
in order to make a profit and recoup their investments. The only thing
differentiating one from the other is the method they have chosen for
themselves to be an investor in the company. Apparently, both of them also hope
that the corporate officials of the companies in which they are investors by
different means will be doing their best to maximize investors’ wealth and
earnings. Each of them is interested in corporate officials prioritizing the
value of their claims against the company rather than the claims altogether or
the value of the company as a whole.
Now
let us assume that when concluding the contract, the transaction costs were so
low that the parties could have listed all the contingencies that may come up
afterward. In this scenario of “complete contracting”, what emergencies would
have been incorporated into the contract by the parties whose main goal is to
increase the value of their claim (equity or debt) against the company in
preference to the total value of the company?
First
and foremost, it is clear that parties would agree on the investments made by
the company which have a positive impact on the market value of the company in
general which leads to an increase in the value of the equities and debts of the
company. On the other hand, the investments whose actual or potential effects
are viewed as detrimental to the company’s total market value and investors’
combined claims would be restricted to the largest extent. Under this
assumption when the transaction costs are significantly low which enables the
parties to eradicate the incomplete-contracting problem, no discretionary power
would be left to the corporate officials to maneuver and there would be no need
for the fiduciary duties to guide their acts. As a result, the said corporate
officials would be constrained to invest only in those projects which at the
very least improve the combined wealth of the company’s shareholders and
bondholders and pursue only this kind of investments. As abovementioned, the
investments maximizing the value of the investors’ claims are more than likely
to also increase the total value of the company as a whole in the meantime.
Nevertheless,
the reality is completely different from the afore-ground scenario. Due to high
transaction costs, the corporate officials are left with discretionary powers
to make decisions on the principal’s behalf and if the corporate officials, who
are responsible for day-to-day business activities of the company, owe the
fiduciary duties exclusively vis-à-vis the shareholders, they will only engage
in the investment opportunities which are wealth-enhancing for the
shareholders, not for the bondholders. They will also avoid any project which
could be increasing the total value of the company as a whole but might be
detrimental to the shareholders. In other words, they will also forego any
investment opportunity that could result in the devaluation of the common
shares. Such a situation has already been experienced by Chancellor Allen who stated
in his infamous “vicinity of insolvency” theory in Credit Lyonnais Bank v.
MGM-Pathe Communications in 1991,[5]
that risky investments pose a greater threat for the bondholders than the
shareholders when made in the “vicinity of the insolvency” given the dispersed
expected outcomes. In those cases, while the successful outcomes would fill the
shareholders’ pockets to a larger degree,[6]
unsuccessful results put bondholders in a more hazardous position since the
shareholders are liable only equivalent to their capital at stake.[7]
Therefore, in those cases, the corporate officials running fiduciary duties
exclusively towards the shareholders will act in their interest and invest in
those risky investments and expose the bondholders to a lot of risks.
Subsequently,
this regime of fiduciary duties urges the bondholders to seek other mechanisms
to protect their interests ex-ante when entering into the contract with the
company. Bondholders will therefore try to find out such tools to prevent the
corporate officials from making investments enhancing the value of the common
shares, and reducing bondholders’ wealth. In fact, such mechanisms are
available and have been widely used by bondholders in the course of their
relationships. However, their existence and wide availability cannot let us
conclude that these rules are efficient as they stand today. The main drawback
for the bondholders is that they cannot negotiate with the corporate officials
to owe the fiduciary duties, not to their shareholders, but to them or to the
company as a whole.[8]
The only means bondholders can employ is to include the protective covenants in
their contracts with the companies to prevent these loyal-to-shareholders
corporate officials from engaging in risky business activities detriment to the
bondholders’ wealth. However, these practices also do involve high transaction
costs. The reason for the incurrence of these costs is the fiduciary duties
owed by the corporate officials to their shareholders. Nevertheless, these
costs could be avoided in the case of corporate officials running these
fiduciary duties exclusively towards the company itself which could result in
more efficiency.
Running
fiduciary duties towards the company as a whole would eradicate both
opportunistic risky investments made by the corporate officials to the
detriment of the bondholders, but enhance the wealth of the shareholders as
seen above in the “vicinity of insolvency” cases. Furthermore, such a default
rule would also save the investors from the transaction costs of predicting
different possible investment scenarios and negotiating relevant protective
covenants with the companies to deter the corporate officials investing in such
risky projects for the bondholders.
In
comparison to negotiating and contracting the protective covenants for the
bondholders, the redefinition of the default rule of fiduciary duties as
running towards the company as a whole is less costly. In that case,
bondholders are released to find and elaborate on very broad types of
protective covenants to limit the corporate officials’ powers to damage their
investment in the company by seeking purely shareholders’ wealth-enhancing
business opportunities instead of maximizing the total value of the company.
The list of those cases is non-exhaustive and its compilation requires much
more transaction costs than the recognition of the fiduciary duties to be owed
towards the company, instead of the shareholders. In other words, the
bondholders would incur these transaction costs to contract around the
inefficient default rule of fiduciary obligations and create proper incentives
for the corporate officers not to put them at risk by their investments. Thus,
it would be more efficient if the default rule of fiduciary obligations is
defined as running towards the company as a whole only as it was a case when
there were zero transaction costs for the investors (shareholders and
bondholders) concluding the contract. As we discussed above, in the imaginary
world of no transaction costs involved in the conclusion of the contract, the
parties would agree to the investments which are beneficial to both
shareholders and bondholders. Similarly, the redefinition of fiduciary
duties as running exclusively towards the company would bring the results to
this same end. Otherwise, the corporate officials being loyal to the
shareholders expose the bondholders to a lot of risky projects invested by the
company. In order not to let this happen, bondholders are vulnerable to devise
a non-exhaustive number of protective covenants to obstacle those opportunistic
or one-sided investments to be made by the company. Nevertheless, the fiduciary
duties owed exclusively to the company would release the parties from
reflecting and elaborating on this wide range of contractual restrictions and
from incurring very high transaction costs.
Subsequently,
under this simplified assumption, I conclude that the determination of the
fiduciary duties running exclusively towards the company as a whole is a more efficient way than them to be owed merely to the shareholders of the company.
Assumption
II.
Unlike
the simple assumption we analyzed above, today’s corporate world is more
complex. As such, the companies also contain preferred shares or other classes
of shares. Similarly, thanks to the limited liability rule, investors have been
able to diversify their portfolios of assets to a large degree and now they own
completely diversified market portfolios to mitigate their risks of investment.
We concluded under the simple scenario of the corporate world that the
specification of corporate officials’ fiduciary obligations to companies is
more efficient. However, we should now turn to the more complex and up-to-date
assumption to verify the results of the first assumption.
In
case of a more complex capital structure involving different classes of shares
and stocks, the question arises which shareholders’ interests should be
prioritized by the corporate officials who are supposed to maximize the
shareholders’ wealth through their decisions in day-to-day business activities. In
the presence of different ranks of the shares, the clash of the interests of
different classes is almost inevitable.[9]
This is the first cracking line that occurs as a result of this phenomenon of
shareholders-centered fiduciary obligations of corporate officials. Because now
the corporate officials cannot perceive their fiduciary duties as running to
the group of people - shareholders as a whole, but should also pick and choose
between that group whose interests will come first.
Even
if the corporate officials have identified to which group of shareholders these
fiduciary obligations are owed, then the remaining stockholders are now in the
position of the bondholders of our first assumption. This time, the said
shareholders being aware of the fact that they are not protected by fiduciary
duties imposed upon the corporate officials, and they will engage in hard and
long contract drafting with the company when they invest in order to predict
all the future contingencies and limit the opportunistic behaviors of the
corporate officials favoring the other shareholders as much as possible.
Similar to the first scenario, there are high transaction costs involved, on the
contrary, as the corporate structure gets more complex, the transaction costs
are getting bigger due to the increased classes of the shareholders. In other
words, while in the first scenario of simple assumption, the high transaction
costs are being incurred by the bondholders, here in the latter scenario, the
massive classes of shareholders are also exposed to such high transaction
costs.
Accordingly,
as we move from the simple scenario of two investors to a more complex capital
structure, it becomes more undisputable that the “maximizing the wealth of the
company” rule is the more efficient and optimal solution given the high transactions
costs incurred by many more classes of shareholders for contracting around
“enhancing the wealth of only a few groups of shareholders” rule.
Moreover,
according to modern portfolio theory, investors are diversifying their
investments in order to mitigate their risks. Instead of buying the same type
of securities, they invest in diverse financial instruments.
Therefore, these fully diversified investors cannot strictly be categorized
into any specific classes. Naturally, such investors are in favor of the
running the fiduciary duties to the company as whole in place of the groups of
the shareholders. The latter rule would again lead them to negotiate the scope
of discretionary powers left to the corporate officials and incur high
transaction costs. Subsequently, fiduciary duties owed to the company itself
have a comparative advantage for the fully diversified investors as well from an
efficiency perspective.
Conclusion
In
summary, we conclude that running fiduciary duties towards the company as a
whole is more efficient for both basically structured small firms (as in the first
scenario), but also for large firms involving more complex capital
structures and broadly diversified investors (as in the second scenario).
As
for the simple, privately-held companies where there are two completely
different groups of investors - shareholders and bondholders, if the
transaction costs were zero, they would agree on the fiduciary duties running
to the company separate from the shareholders. However, because it is not the
case in today’s world, the default rule of enhancing shareholders’ wealth
instead of companies poses a real threat to the bondholders especially by the
risky “vicinity of insolvency” investments made by the companies (as discussed
under the scenario I). Thus, the default rule requiring the corporate officials
to enhance the market value of the company is more efficient for this kind of
small, privately-held companies compared to “enhancing shareholders’ wealth|”
which on the contrary requires the bondholders to negotiate and contract around
this inefficient rule.
This
is also true for the bigger, publicly-held stock exchanged companies whose
investors are fully diversified and capital structure is more complex. As these
investors own the diverse classes of the securities in the company, fiduciary
duties owed to the company separately from any group of shareholders are more
in the interests of these investors and save them high transaction costs of
otherwise negotiating contractual protections.
[1] Thomas A. Smith, The Efficient
Norm for Corporate Law: A Neotraditional Interpretation of Fiduciary Duties, 98
MICH. L. REV. 214, 214 n.3 (1999).
[2] The Civil Code of the Republic
of Azerbaijan, https://www.e-qanun.az/framework/46944
[3] Vald Nielsen Holding A/S v
Baldorino [2019] EWHC 1926.
[4] Sharp & Others v Blank &
Others [2015] EWHC 3220.
[5] Credit Lyonnais Bank Nederland,
N.V. v. Pathe Communications Corp., No. CIV.A.12150, 1991 WL 277613, at.1 (Del.
Ch. Dec. 30, 1991).
[6] Credit Lyonnais Bank Nederland,
N.V. v. Pathe Communications Corp., No. CIV.A.12150, 1991 WL 277613, at. 34,
((Del. Ch. Dec. 30, 1991).
[7] Id.; See also Laura Lin, Shift of Fiduciary Duty Upon Corporate Insolvency: Proper Scope of Directors' Duty to Creditors, 46 VAND. L. Rev. 1485, 1491.
[8] Thomas A. Smith, The Efficient Norm for Corporate Law: A Neotraditional Interpretation of Fiduciary Duty, 98 MICH. L. REV. 251, n.3 (1999).
[9] Thomas A. Smith, The Efficient
Norm for Corporate Law: A Neotraditional Interpretation of Fiduciary Duty, 98
MICH. L. REV. 261-263, n.3 (1999).
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