Archives For fiduciary duties

It appears that White House’s zeal for progressive-era legal theory has … progressed (or regressed?) further. Late last week President Obama signed an Executive Order that nominally claims to direct executive agencies (and “strongly encourages” independent agencies) to adopt “pro-competitive” policies. It’s called Steps to Increase Competition and Better Inform Consumers and Workers to Support Continued Growth of the American Economy, and was produced alongside an issue brief from the Council of Economic Advisors titled Benefits of Competition and Indicators of Market Power.

TL;DR version: the Order and its brief do not appear so much aimed at protecting consumers or competition, as they are at providing justification for favored regulatory adventures.

In truth, it’s not exactly clear what problem the President is trying to solve. And there is language in both the Order and the brief that could be interpreted in a positive light, and, likewise, language that could be more of a shot across the bow of “unruly” corporate citizens who have not gotten in line with the President’s agenda. Most of the Order and the corresponding CEA brief read as a rote recital of basic antitrust principles: price fixing bad, collusion bad, competition good. That said, there were two items in the Order that particularly stood out.

The (Maybe) Good

Section 2 of the Order states that

Executive departments … with authorities that could be used to enhance competition (agencies) shall … use those authorities to promote competition, arm consumers and workers with the information they need to make informed choices, and eliminate regulations that restrict competition without corresponding benefits to the American public. (emphasis added)

Obviously this is music to the ears of anyone who has thought that agencies should be required to do a basic economic analysis before undertaking brave voyages of regulatory adventure. And this is what the Supreme Court was getting at in Michigan v. EPA when it examined the meaning of the phrase “appropriate” in connection with environmental regulations:

One would not say that it is even rational, never mind “appropriate,” to impose billions of dollars in economic costs in return for a few dollars in health or environmental benefits.

Thus, if this Order follows the direction of Michigan v. EPA, and it becomes the standard for agencies to conduct cost-benefit analyses before issuing regulation (and to review old regulations through such an analysis), then wonderful! Moreover, this mandate to agencies to reduce regulations that restrict competition could lead to an unexpected reformation of a variety of regulations – even outside of the agencies themselves. For instance, the FTC is laudable in its ongoing efforts both to correct anticompetitive state licensing laws as well as to resist state-protected incumbents, such as taxi-cab companies.

Still, I have trouble believing that the President — and this goes for any president, really, regardless of party — would truly intend for agencies under his control to actually cede regulatory ground when a little thing like economic reality points in a different direction than official policy. After all, there was ample information available that the Title II requirements on broadband providers would be both costly and result in reduced capital expenditures, and the White House nonetheless encouraged the FCC to go ahead with reclassification.

And this isn’t the first time that the President has directed agencies to perform retrospective review of regulation (see the Identifying and Reducing Regulatory Burdens Order of 2012). To date, however, there appears to be little evidence that the burdens of the regulatory state have lessened. Last year set a record for the page count of the Federal Register (80k+ pages), and the data suggest that the cost of the regulatory state is only increasing. Thus, despite the pleasant noises the Order makes with regard to imposing economic discipline on agencies – and despite the good example Canada has set for us in this regard – I am not optimistic of the actual result.

And the (maybe) good builds an important bridge to the (probably) bad of the Order. It is well and good to direct agencies to engage in economic calculation when they write and administer regulations, but such calculation must be in earnest, and must be directed by the learning that was hard earned over the course of the development of antitrust jurisprudence in the US. As Geoffrey Manne and Josh Wright have noted:

Without a serious methodological commitment to economic science, the incorporation of economics into antitrust is merely a façade, allowing regulators and judges to select whichever economic model fits their earlier beliefs or policy preferences rather than the model that best fits the real‐world data. Still, economic theory remains essential to antitrust law. Economic analysis constrains and harnesses antitrust law so that it protects consumers rather than competitors.

Unfortunately, the brief does not indicate that it is interested in more than a façade of economic rigor. For instance, it relies on the outmoded 50 firm revenue concentration numbers gathered by the Census Bureau to support the proposition that the industries themselves are highly concentrated and, therefore, are anticompetitive. But, it’s been fairly well understood since the 1970s that concentration says nothing directly about monopoly power and its exercise. In fact, concentration can often be seen as an indicator of superior efficiency that results in better outcomes for consumers (depending on the industry).

The (Probably) Bad

Apart from general concerns (such as having a host of federal agencies with no antitrust expertise now engaging in competition turf wars) there is one specific area that could have a dramatically bad result for long term policy, and that moreover reflects either ignorance or willful blindness of antitrust jurisprudence. Specifically, the Order directs agencies to

identify specific actions that they can take in their areas of responsibility to build upon efforts to detect abuses such as price fixing, anticompetitive behavior in labor and other input markets, exclusionary conduct, and blocking access to critical resources that are needed for competitive entry. (emphasis added).

It then goes on to say that

agencies shall submit … an initial list of … any specific practices, such as blocking access to critical resources, that potentially restrict meaningful consumer or worker choice or unduly stifle new market entrants (emphasis added)

The generally uncontroversial language regarding price fixing and exclusionary conduct are bromides – after all, as the Order notes, we already have the FTC and DOJ very actively policing this sort of conduct. What’s novel here, however, is that the highlighted language above seems to amount to a mandate to executive agencies (and a strong suggestion to independent agencies) that they begin to seek out “essential facilities” within their regulated industries.

But “critical resources … needed for competitive entry” could mean nearly anything, depending on how you define competition and relevant markets. And asking non-antitrust agencies to integrate one of the more esoteric (and controversial) parts of antitrust law into their mission is going to be a recipe for disaster.

In fact, this may be one of the reasons why the Supreme Court declined to recognize the essential facilities doctrine as a distinct rule in Trinko, where it instead characterized the exclusionary conduct in Aspen Skiing as ‘at or near the outer boundary’ of Sherman Act § 2 liability.

In short, the essential facilities doctrine is widely criticized, by pretty much everyone. In their respected treatise, Antitrust Law, Herbert Hovenkamp and Philip Areeda have said that “the essential facility doctrine is both harmful and unnecessary and should be abandoned”; Michael Boudin has noted that the doctrine is full of “embarrassing weaknesses”; and Gregory Werden has opined that “Courts should reject the doctrine.” One important reason for the broad criticism is because

At bottom, a plaintiff … is saying that the defendant has a valuable facility that it would be difficult to reproduce … But … the fact that the defendant has a highly valued facility is a reason to reject sharing, not to require it, since forced sharing “may lessen the incentive for the monopolist, the rival, or both to invest in those economically beneficial facilities.” (quoting Trinko)

Further, it’s really hard to say when one business is so critical to a particular market that its own internal functions need to be exposed for competitors’ advantage. For instance, is Big Data – which the CEA brief specifically notes as a potential “critical resource” — an essential facility when one company serves so many consumers that it has effectively developed an entire market that it dominates? ( In case you are wondering, it’s actually not). When exactly does a firm so outcompete its rivals that access to its business infrastructure can be seen by regulators as “essential” to competition? And is this just a set-up for punishing success — which hardly promotes competition, innovation or consumer welfare?

And, let’s be honest here, when the CEA is considering Big Data as an essential facility they are at least partially focused on Google and its various search properties. Google is frequently the target for “essentialist” critics who argue, among other things, that Google’s prioritization of its own properties in its own search results violates antitrust rules. The story goes that Google search is so valuable that when Google publishes its own shopping results ahead of its various competitors, it is engaging in anticompetitive conduct. But this is a terribly myopic view of what the choices are for search services because, as Geoffrey Manne has so ably noted before, “competitors denied access to the top few search results at Google’s site are still able to advertise their existence and attract users through a wide range of other advertising outlets[.]”

Moreover, as more and more users migrate to specialized apps on their mobile devices for a variety of content, Google’s desktop search becomes just one choice among many for finding information. All of this leaves to one side, of course, the fact that for some categories, Google has incredibly stiff competition.

Thus it is that

to the extent that inclusion in Google search results is about “Stiglerian” search-cost reduction for websites (and it can hardly be anything else), the range of alternate facilities for this function is nearly limitless.

The troubling thing here is that, given the breezy analysis of the Order and the CEA brief, I don’t think the White House is really considering the long-term legal and economic implications of its command; the Order appears to be much more about political support for favored agency actions already under way.

Indeed, despite the length of the CEA brief and the variety of antitrust principles recited in the Order itself, an accompanying release points to what is really going on (at least in part). The White House, along with the FCC, seems to think that the embedded streams in a cable or satellite broadcast should be considered a form of essential facility that is an indispensable component of video consumers’ choice (which is laughable given the magnitude of choice in video consumption options that consumers enjoy today).

And, to the extent that courts might apply the (controversial) essential facilities doctrine, an “indispensable requirement … is the unavailability of access to the ‘essential facilities’[.]” This is clearly not the case with much of what the CEA brief points to as examples of ostensibly laudable pro-competitive regulation.

The doctrine wouldn’t apply, for instance, to the FCC’s Open Internet Order since edge providers have access to customers over networks, even where network providers want to zero-rate, employ usage-based billing or otherwise negotiate connection fees and prioritization. And it also doesn’t apply to the set-top box kerfuffle; while third-parties aren’t able to access the video streams that make-up a cable broadcast, the market for consuming those streams is a single part of the entire video ecosystem. What really matters there is access to viewers, and the ability to provide services to consumers and compete for their business.

Yet, according to the White House, “the set-top box is the mascot” for the administration’s competition Order, because, apparently, cable boxes represent “what happens when you don’t have the choice to go elsewhere.” ( “Elsewhere” to the White House, I assume, cannot include Roku, Apple TV, Hulu, Netflix, and a myriad of other video options  that consumers can currently choose among.)

The set-top box is, according to the White House, a prime example of the problem that

[a]cross our economy, too many consumers are dealing with inferior or overpriced products, too many workers aren’t getting the wage increases they deserve, too many entrepreneurs and small businesses are getting squeezed out unfairly by their bigger competitors, and overall we are not seeing the level of innovative growth we would like to see.

This is, of course, nonsense. Consumers enjoy an incredible amount of low-cost, high quality goods (including video options) – far more than at any point in history.  After all:

From cable to Netflix to Roku boxes to Apple TV to Amazon FireStick, we have more ways to find and watch TV than ever — and we can do so in our living rooms, on our phones and tablets, and on seat-back screens at 30,000 feet. Oddly enough, FCC Chairman Tom Wheeler … agrees: “American consumers enjoy unprecedented choice in how they view entertainment, news and sports programming. You can pretty much watch what you want, where you want, when you want.”

Thus, I suspect that the White House has its eye on a broader regulatory agenda.

For instance, the Department of Labor recently announced that it would be extending its reach in the financial services industry by changing the standard for when financial advice might give rise to a fiduciary relationship under ERISA. It seems obvious that the SEC or FINRA could have taken up the slack for any financial services regulatory issues – it’s certainly within their respective wheelhouses. But that’s not the direction the administration took, possibly because SEC and FINRA are independent agencies. Thus, the DOL – an agency with substantially less financial and consumer protection experience than either the SEC or FINRA — has expansive new authority.

And that’s where more of the language in the Order comes into focus. It directs agencies to “ensur[e] that consumers and workers have access to the information needed to make informed choices[.]” The text of the DOL rule develops for itself a basis in competition law as well:

The current proposal’s defined boundaries between fiduciary advice, education, and sales activity directed at large plans, may bring greater clarity to the IRA and plan services markets. Innovation in new advice business models, including technology-driven models, may be accelerated, and nudged away from conflicts and toward transparency, thereby promoting healthy competition in the fiduciary advice market.

Thus, it’s hard to see what the White House is doing in the Order, other than laying the groundwork for expansive authority of non-independent executive agencies under the thin guise of promoting competition. Perhaps the President believes that couching this expansion in free market terms ( i.e. that its “pro-competition”) will somehow help the initiatives go through with minimal friction. But there is nothing in the Order or the CEA brief to provide any confidence that competition will, in fact, be promoted. And in the end I have trouble seeing how this sort of regulatory adventurism does not run afoul of separation of powers issues, as well as assorted other legal challenges.

Finally, conjuring up a regulatory version of the essential facilities doctrine as a support for this expansion is simply a terrible idea — one that smacks much more of industrial policy than of sound regulatory reform or consumer protection.

A recently published on-line symposium calls needed attention to Delaware Chief Justice Myron Steele’s remarkable article, Freedom of Contract and Default Contractual Duties in the Delaware Limited Partnerships and Limited Liability Companies, 46 Am. Bus. L.J. 221 (2009) (no free link available).

The Chief Justice makes an argument that is guaranteed to shock traditional business association scholars:  that there should be no default fiduciary duty in Delaware LLCs or limited partnerships.  According to the CJ, this would effectuate “Delaware’s strong policy favoring freedom of contract.”

CJ Steele notes that there are no fiduciary duties currently in the LLC statute, providing no basis for implying duties from the standard form.  This argument is less clear for limited partnerships, which link to the general partnership act’s duty of loyalty in §15-404. The Chief Justice argues that the freedom of contract provision in §17-1101 effectively negates this duty.  Although default duties arguably are preserved by reference in this provision, freedom of contract may trumps a nebulous default.

The ambiguity about default duties calls for application of policy considerations. The Chief Justice relies significantly on my writing, particularly Are Partners Fiduciaries? (for a more recent version of my theory see Fencing Fiduciary Duties).  I argue for narrowly construing default fiduciary duties because of the extra transaction and other costs associated with broad duties. In other articles [see, e.g., Larry E. Ribstein, Fiduciary Duty Contracts in Unincorporated Firms, 54 WASH. & LEE L. REV. 537 (1997) also cited by the Chief Justice] I have argued that the parties ought to be able to narrow default duties by contract.

The Chief Justice builds on these policies to take the extra step of leaving it to the parties to contractually define fiduciary duties from scratch. Here’s his reasoning in a nutshell (46 Am. Bus. L. J. 239-40) (footnotes omitted):

Professor Larry Ribstein has written extensively on the economic costs and benefits of fiduciary duties. Professor Ribstein explains that “the existence of default fiduciary duties depends solely on the structure of the parties’ relationship that is, on the terms of their express or implied contract — and not on any vulnerability arising other than from this structure.” Specifically, for LLCs, Ribstein sets forth three economic rationales to narrowly define fiduciary duties.

First, according to Ribstein, even where fiduciary duties have some benefits, those benefits are outweighed by costs such as “effect on the purported fiduciary’s incentives and the reduction of trust or reciprocity from substituting legal duties for extralegal constraints.” In particular, Ribstein notes, “courts often ignore the costs of fiduciary duties perhaps because these costs matter most in the cases that do not get to court, and therefore seem insignificant compared to the unfairness in the case being litigated.” Second, Ribstein argues that “there are benefits to clearly delineating the situations in which fiduciary duties apply, including minimizing litigation and contracting costs and effecting extralegal conduct norms.” Third, and finally, Ribstein concludes that “a narrow approach to fiduciary duties inheres in the contractual nature of such duties.” Ribstein warns that “[a]pplying fiduciary duties broadly threatens to undermine parties’ contracts by imposing obligations the parties do not want or expect.”

Professor Ribstein’s thoughtful analysis also applies to default fiduciary duties. In particular, the cost of applying any default fiduciary duty is outweighed by its benefit. First, default fiduciary duties add unnecessary costs to contracting. Second, default fiduciary duties also add unexpected litigation costs. Finally, any benefit to default fiduciary duties is limited because the LLC, by its nature, is designed to be a highly customized vehicle, determined primarily by contract. A critic to my cost-benefit analysis will invariably argue: (1) there is no cost to default fiduciary duties because the LLC statute provides that parties may eliminate any default duties and (2) parties benefit from fiduciary duties because they expect them and need not contract for them. However, I will demonstrate why those criticisms are misplaced.

First, default fiduciary duties add unnecessary contracting costs. The nebulous nature of default fiduciary duties makes it difficult for parties to eliminate some, but not all, potential fiduciary duties. * * * If we assume no default fiduciary duties, the parties need only explicitly provide for a self-dealing proscription. The contract is much easier to draft, and the parties have more confidence that they adequately provided for that ban without also introducing other unwanted fiduciary duties.

A question remains: how often will parties want to remove the default fiduciary duties? If, for the most part, parties simply intend to keep the default fiduciary duties, then it would be less costly for parties to contract. However, if we proceed from the baseline of no default fiduciary duty, adding in a wholesale provision adopting Delaware’s fiduciary duty principles could also be easily achieved — without much cost. As I described in the last paragraph, this will benefit the parties who intend to adopt a discrete number of those duties because it will be less costly to contract for those limited duties. Moreover, by adopting an LLC, the parties have consciously chosen to use a highly customizable vehicle–in so choosing, we naturally infer that the parties intend customization.

Second, default fiduciary duties introduce unexpected litigation expenses. Without default fiduciary duties, the parties’ litigation will focus solely on the agreement between them–and not on fiduciary duty principles outside of the contract. * * *

In light of those potential costs, the courts must also weigh them against any benefits to applying default fiduciary duties. Professor Ribstein explains that “[i]n general, this is a matter of articulating standard form terms to minimize contracting costs. It is difficult and expensive for parties to enter into customized contracts covering all of the details of a long-term agency-type relationship.” However, it is important to remember that in the context of an LLC that the parties have specifically chosen to use an LLC agreement, which provides contractual flexibility, and have bargained for the relevant provisions in this agreement. Thus, it does not necessarily follow that default fiduciary duty principles will more accurately reflect the parties’ intent rather than principles of contract interpretation. Instead, because the parties chose a Delaware LLC and because the Delaware judiciary is skilled in resolving difficult issues of contract interpretation, the opposite conclusion is likely true, that is, parties would prefer Delaware courts to determine their rights and duties in accordance with the terms of the contract and not an unbargained-for default fiduciary principle. Moreover, if the parties intended to apply traditional fiduciary duties to their relationship, they could easily add a provision stating precisely that in the agreement.

The Chief Justice has a point.  I grappled with the problem of contracting around default duties in my Uncorporation and Corporate Indeterminacy (at 165, footnotes omitted):

Vice Chancellor Strine’s admonition to lawyers not to address fiduciary duties “coyly” could require such careful and costly drafting that it makes fiduciary duties in effect mandatory. Even a moderate  insistence on careful drafting could put fiduciary duty waivers out of the reach of smaller firms. In other words, by making very skilled drafting the price of avoiding indeterminacy, Delaware’s uncorporate law may be trading lower litigation costs for higher fees to transactional lawyers. This may reserve the benefits of the uncorporate approach only for the largest and most sophisticated uncorporations.

In other words, the current Delaware approach achieves free contracting at significant cost.  Chief Justice Steele’s approach may be the best way to deal with that problem. 

The important question is whether there will be many parties who (1) fail to contract fully regarding fiduciary duties; and (2) expect a certain level of fiduciary duties to apply.  If both apply, then eliminating default fiduciary duties could defeat expectations and increase litigation by frustrated LLC members. The Chief Justice’s response  is that parties to Delaware LLCs know they’re getting a contractual regime and therefore are getting what they expect.  In other words, the market for LLC law offers a potential opportunity to contract not only out of default duties, but also away from the existence of default rules.

The brief articles in the symposium by Ann Conaway, Bill Callison & Allan Vestal, Carter Bishop, Dan Kleinberger, and Louis Hering take both sides of the issue, but do not, in my opinion, fully grapple with CJ Steele’s (and my) policy arguments.  Unfortunately I didn’t have an opportunity to participate in this symposium (not sure why, since after all the Chief Justice does rely on me!) so I haven’t had a chance to insert a full-fledged version of my thinking into the debate. I plan to write at more length on this, but wanted to take this opportunity to opine on the important issues raised by the Chief Justice while the iron was hot.

Alison Frankel gripes about a NJ judge’s ruling throwing out a shareholders’ derivative suit seeking to hold the J & J board accountable for problems concerning the company’s Rispardal drug. Frankel thinks the bad faith standard the court applied is not high enough.

Ted Frank responds that the fact that the company had settled criminal allegations doesn’t mean the board was irresponsible given big companies’ exposure to prosecutorial overreaching (here’s my thoughts on the problems with prosecutors).  He notes that given huge potential penalties and legal costs “even a risk-neutral set of executives would refuse to go to trial on criminal charges that they had a 95% chance of winning.”  As Ted says:

The issue is this: first, any corporate law is going to have to balance false negatives (valid suits against directors being thrown out prematurely) and false positives (invalid suits against directors costing tens of millions of dollars in time and money to resolve). Any opening up of the courtroom doors to challenge directors will reduce false negatives at the expense of more false positives; any increase in the burden to bring suit will reduce false positives at the expense of more false negatives.

Anyway, Ted continues, shareholders of NJ corporations can decide to invest in firms incorporated elsewhere if they think NJ law is too lenient on directors, aptly citing my and O’Hara’s The Law Market.

Of course Frankel might argue that the business judgment rule that the court used to decide the case is ubiquitous, leaving plaintiffs with little choice. Indeed, the only significant dissent is Nevada which is, if anything, even easier on directors than NJ.   Frankel might also argue that this indicates state corporation law is rigged for managers and that we would do better under federal law.  Perhaps what we need is a super Dodd-Frank/SOX on steroids that preempts state law and exposes managers to suits like the one NJ dismissed.

I would respond that the universal acceptance of the business judgment rule represents the market’s rejection of Frankel’s position.  If Frankel wants to complain that the market for corporate law is imperfect,  she would need to persuade me that shareholders are better off in the clutches of Congress.

A recent NY App. Div case, Pappas v. Tzolis, presents a tangled web that illustrates the current state of the LLC contracting architecture in the U.S. I previously discussed the lower court opinion in this case, concluding that ” any appeal of this judgment should be interesting.” (See also Peter Mahler.) I was right about that.

The complaint alleges that Tzolis and plaintiffs formed an LLC (Vrahos) for the sole purpose of entering into a long-term lease.  Tzolis got a sublease on the property in exchange for advancing the LLC’s $1.2 million security deposit and additional payments. Tzolis later took over the lease so he could extinguish the sublease.  The plaintiff members assigned him their interests, receiving a payment that was 20 times what they invested about a year earlier.  Six months thereafter Tzolis assigned the lease to a third party for $17.5 million.  The complaint alleges he was negotiating this sale at the time of buying out the plaintiffs.  Plaintiffs sue on various theories essentially based Tzolis’s breach of fiduciary duty in failing to disclose these negotiations.

At this point the case gets complicated.

To begin with, the LLC operating agreement, in a section titled “Other Activities of Members,” provided that “[a]ny Member may engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC, without obligation of any kind to the LLC or to the other Members.” The title of this section was “other activities.”

Given the title and the reference to “competition with the LLC, this section seems to refer only to dealings outside the LLC rather than a buyout of co-members’ interest without disclosing negotiations to sell the LLC’s only property. The title’s reference to “other activities” clarifies this intent.  Except that the agreement elsewhere says that “headings. . . shall be given no effect in the interpretation of this Agreement.” If the heading has no effect, should the section be limited to outside dealings as it implies, or extended to “investments of any nature whatsoever,” including an “investment” in another member’s interest, as it says?

Confused yet?  Ok, let’s add another layer.  At the time of the assignment the parties signed a handwritten “certificate,” which included the following language:

[E]ach of the undersigned Sellers, in connection with their respective assignments to Steve Tzolis of their membership interests in Vrahos LLC, has performed their own due diligence in connection with such assignments. Each of the undersigned Sellers has engaged its own legal counsel, and is not relying on any representation by Steve Tzolis or any of his agents or representatives, except as set forth in the assignments & other documents delivered to the undersigned Sellers today. Further, each of the undersigned Sellers agrees that Steve Tzolis has no fiduciary duty to the undersigned Sellers in connection with such assignments.

Still not confused?  The LLC was formed in Delaware, which normally means Delaware law applies.  But the operating agreement provided that it was governed by NY law.

How should a court untangle this mess?  Let’s start with what law applies.  As I discussed regarding the lower court opinion in this case, referring to the choice-of-law analysis in The Law Market, incorporating in Delaware indicates the parties’ intent to apply Delaware law notwithstanding a contrary choice of law clause.  This intent is supported by Kobayashi and my paper presenting data indicating that LLCs choose Delaware in order to get the advantages of Delaware’s legal infrastructure.  On the other hand, the parties arguably were focusing on choice of law more in the choice of law clause (NY) than in the state of organization (Delaware).

Both courts in this case concluded that a choice between the two states was unnecessary because both states reached the same result.  The problem is that that same result was different in the two opinions — dismissal of the complaint below, reversed above.

The lower court relied on Delaware’s freedom-of-contract provision, and said that “under New York law, parties are free to contract as they wish, so long as the terms of their contract are neither unlawful, nor in violation of public policy.” But as I noted in my post on the lower court opinion, NY has no equivalent to Delaware’s freedom of contract provision.

If the only relevant contract provision here were the operating agreement, the defendant should lose.  As discussed in my earlier post, even Delaware requires fiduciary opt-outs to be clear, which this was not.  The Appellate Division appropriately cited Kelly v. Blum on that point (which I discussed here).

But does the handwritten certificate have the requisite clarity? There the plaintiffs explicitly disclaimed they were owed any fiduciary duty in connection with the specific transaction at issue.  The lower court didn’t make much of this, saying that the defendant didn’t claim it was a waiver, but that it just evidenced and certified the non-existence of any fiduciary duties defendant might have owed.  This strategy may have been intended to head off the argument that any release of duties in the certificate was invalid because of defendant’s preexisting fiduciary duty.

The Appellate Division didn’t buy this strategy.  Having held that Tzolis owed a duty under the agreement, the court held that the certificate couldn’t override it.

The court relied on Blue Chip Emerald v Allied Partners 299 A.D.2d 278, 750 N.Y.S.2d 291 (1st Dep’t 2002). This is part of a line of cases discussed in Ribstein & Keatinge, §9:5, n.51 involving non-enforcement of seemingly clear fraud waivers. For other cases along the same lines see Kronenberg v. Katz, 872 A.2d 568 (Del. Ch. 2004); Salm v. Feldstein, 20 A.D.3d 469, 799 N.Y.S.2d 104, 106 (2d Dep’t 2005). Also, a non-LLC case, Abry Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006) (criticized here) refused to insulate a seller from liability for intentional misrepresentations despite a clear and comprehensive contract that covered precisely these claims because “the public policy of this State will not permit” a contract that would insulate a seller who deliberately lied or knew that the company had made false representations.

But there are cases upholding fraud waivers.  See DIRECTV Group, Inc. v. Darlene Investments, LLC, 2006 WL 2773024 (S.D. N.Y. 2006), applying Delaware law, and two recent NY Court of Appeals cases: Centro Empresarial Cempresa S.A. v. America Movil and Arfa v. Zamir. Centro emphasized that the release was broad, the fiduciary relationship was “no longer one of unquestioning trust,” and the plaintiff understood that the fiduciary was acting in its own interest. Arfa relied on the facts that plaintiffs were sophisticated and there was distrust between the parties. In these circumstances the courts held that plaintiff could not simply rely on defendant, but had a duty to investigate further. See Peter Mahler’s excellent discussion of these NY cases.

A vigorous dissent in Pappas by Justice Freedman, joined by Justice Friedman, relied on Centros.  The dissent acknowledged that while the operating agreement did not eliminate Tzolis’s fiduciary duties, the certificate notified plaintiffs that they shouldn’t place “unquestioning trust” in Tzolis, and therefore “was tantamount to a release” of fiduciary duty claims.  Moreover,

Tzolis’s substantial offer to plaintiffs should have alerted them to the fact that some deal was in the offing. Pappas and Ifantapoulos did not ask Tzolis why he was offering them 20 times more than what they had invested in Vrahos one year earlier; their lack of due diligence is unreasonable as a matter of law and fatal to plaintiffs’ claim.

Obviously this tangled mess in a substantial deal where the parties clearly could afford sophisticated advice suggests that something is amiss somewhere in the system.

Does the problem lie in the statute?  The parties easily could have taken advantage of Delaware’s broad freedom of contract provision and entered into a clear fiduciary opt-out, which would seem appropriate in the sort of limited joint venture involved in this case.  Instead they deliberately complicated their choice of law to use NY law which lacks such a provision.

But Abry indicates that Delaware law is no panacea.  Is NY clearer, given Centros?  The problem is that it is one thing to say that the parties’ relationship has broken down into clear distrust, as in Centros, and another to derive that distrust from the certificate alone, which is itself subject to the incomplete waiver of fiduciary duties in the initial agreements.

Abry suggests that once the parties agree to fiduciary duties because they failed to opt out, these duties may preclude them from ever opting out.  At that point the best they can hope for is a judicial determination that the fiduciary duty did not result in liability for particular conduct.  That could be based on actual distrust (Centros) or other circumstantial evidence (the high buyout price in a rapidly rising market).

Which raises a final question:  was there even a breach of fiduciary duty in this case?  What difference should it make whether defendant had an offer in hand?  The plaintiffs had reason to know the lease value was rising rapidly.

The basic problem is that this case has been decided on a motion to dismiss, and therefore on the complaint’s allegations.  Issues about what plaintiffs knew, when did they know it, and what did defendant have to tell them are for trial.

The answer here is to let the parties, via a clear agreement, opt out of liability for intentional nondisclosures.  A clear opt out should prevent the need for a trial.  Why can’t at least sophisticated parties agree to fend for themselves in determining what price they should get for their property? Under such a rule it would be up to the lawyers to help the parties clarify their intentions, as the lawyers arguably did here.  But given the incomplete statutory protection in NY and the unclear cases in both NY and Delaware there was an inadequate legal framework for such an agreement.

Update: Read Peter Mahler’s through analysis of the case.

Yaniv Grinstein and and Stefano Rossi have an interesting paper, Good Monitoring, Bad Monitoring, on the effect of corporate law, and specifically of the famous Delaware case Smith v. Van Gorkom and the Delaware legislature’s subsequent “fix” of that result.  Here’s the abstract:

We estimate the value of monitoring in publicly traded corporations by exploiting a natural experiment. A Delaware Supreme Court decision unexpectedly held directors liable for monetary damages for breach of fiduciary duties. The ruling signaled a sharp and exogenous increase in Delaware Courts’ scrutiny over board decisions. We analyze the impact of the ruling on stock returns using matching and differences-in-differences techniques. We find that, compared with appropriately matched non-Delaware firms, Delaware-incorporated firms in high-growth industries lost (CARs of -2.10%) and firms in low-growth industries gained (CARs of 1.40%) in the [0,10] window around the announcement of the Supreme Court decision. A later regulatory reform to the Delaware Code that reversed the effects of the Supreme Court decision had opposite results: firms in high-growth industries gained and firms in low-growth industries lost significantly. Our results shed light on the complex interplay of courts and regulation and on its implications for shareholder value.

In the conclusion the authors state:  “We interpret these results as implying that “one-size-fits-all” models represent inadequate solutions to the corporate governance problem.” In other words, a strict duty of care is good for some companies but not others.

This suggests that firms should be allowed to contract to tailor regulation to their needs. But the Delaware code revision did just that — allow firms to contract.  Yet returns for low-growth firms dropped, despite the fact that the statute allowed these firms to remain subject to the strict care standard.

Does this suggest that corporate contracting is flawed?  Or what?

The WSJ comments on a dumb proposal by the Employee Benefits Security Administration to broaden the definition of “fiduciary” to cover brokerage services with respect to retirement accounts.

As the WSJ notes,

For decades the finance industry has provided investors roughly two kinds of services: the “advisory” model, in which an investment professional makes trading decisions, provides specialized advice and charges savers an annual fee; and the “brokerage” model, in which the saver makes the decisions and pays a fee for each trade and occasional advice. The latter model can be cheaper because the broker is often compensated by the company whose products he’s offering.* * *

The rule would have huge consequences for the retirement savings industry. Brokers would have to weigh the cost of higher regulatory compliance against staying in the business. Investors would pay more for trades and advice and have fewer investment choices. Investment educational seminars would likely halt in many cases, lest organizers think they’ll be held liable as a fiduciary for giving general investment advice.

Many firms would raise minimum investment amounts to cover their higher costs, cutting off access to lower-income savers. Consultancy Oliver Wyman surveyed about 40% of the investment retirement account market and estimated the proposed rule could “eliminate access to meaningful investment services for over seven million IRAs.” Investors could see “direct costs” rise between 75% and 195%. * * *

Moreover, the SEC is still studying the broker-dealer fiduciary issue pursuant to Dodd-Frank.  Despite its failings, the SEC is the more appropriate agency to consider this sort of move.

The big problem here is that the proposal seeks to apply a fiduciary duty to a relationship that is simply not fiduciary, resulting in massive confusion.  As I said in my recently published Fencing Fiduciary Duties concerning moves to make brokers fiduciaries:

Customers generally do not delegate fiduciary-type open-ended power that would justify fiduciary-type selflessness consistent with this article’s analysis.  Brokers, dealers, and advisers usually lack authority to commit the customer’s property without further instructions.  Nor should customers expect unselfish conduct from people who are selling securities for a commission or profit.  Thus, application of fiduciary duties to brokers, dealers, and advisers would not be consistent with customers’ expectations and would create a potential for confusion.

The Supreme Court’s recent Jones v. Harris provides a good example of the “potential for confusion” in the context of fiduciary duties for mutual fund advisors under Section 36(b) of the Investment Company Act of 1940.  I recently discussed this case and the misbegotten history of this regulation.

Another day, another industry targeted for crippling regulation — in this case smothering investor choice with a wet fiduciary blanket.  The haphazard expansion of fiduciary duties is a senseless move by a regulator that seems to have no idea what it’s doing.

My article, Fencing Fiduciary Duties, has just appeared in a B.U. Law Review symposium.  Here’s the abstract:

This comment on the work of Professor Tamar Frankel builds on her encyclopedic discussion of the various types of duties that have been classified as “fiduciary.” I argue for a more precise definition and more limited application of fiduciary duties which recognizes that their usefulness depends on their being limited and separated from other duties that apply in other settings. The fiduciary duty is appropriately construed as one of unselfishness, as distinguished from lesser duties of care, good faith and fair dealing, and to refrain from misappropriation. The fiduciary duty of unselfishness is appropriate only for a limited class of agency relationships in which the principal delegates open-ended power to the agent, and not for those who may exercise lesser power over the property of others, including co-investors, advisors, professionals, and those in confidential relationships. More broadly applying fiduciary duties could unnecessarily constrain parties from self-protection in contractual relationships, impose excessive litigation costs, provide an unsuitable basis for contracting, and impede developing fiduciary norms of behavior. This analysis of fiduciary duties helps address current issues, including those regarding the duties of brokers, dealers, and investment and mutual fund advisors. In short, fencing fiduciary duties protects both fiduciary and non-fiduciary relationships and enables parties to contract for the precise level of protection that is appropriate to the services they are purchasing. 

The paper develops, updates and applies ideas from my earlier paper, Are Partners Fiduciaries?  Email me if you’d like a free offprint.

Steve Bainbridge discusses a Delaware chancery suit by a Berkshire-Hathaway shareholder against former B-H executive David Sokol for profits he earned by buying Lubrizol stock ahead of his former employer. Steve analyzes state law, concluding

I am unaware of any Delaware precedent holding that a state law cause of action for breach of fiduciary duty lies when the facts fit within the misappropriation framework. It would not be surprising if such a cause of action existed, however. In effect, when an executive misappropriates information and uses it to make a profit by trading in the stock of a potential takeover target the executive has usurped a corporate opportunity. 

Steve explains why this could be true even if Buffett knew about the trades because Sokol should have gotten board approval.

I basically agree with Steve’s analysis.  But this raises another question, as I noted when Sokol’s trades were disclosed:

[W]hat should federal law have to do with all this?  The “hook” for federal securities liability is the trading in Lubrizol — but the breach of duty that triggers liability has to do with the details of Sokol’s dealings with Buffett and Berkshire.  This, as I’ve said before, is appropriately a matter of state law.  See my article, Federalism and Insider Trading, 6 Supreme Court Economic Review, 123 (1998).

Francis Pileggi brings news of an interesting Posner opinion in CDX Liquidating Trust v. Venrock Associates, (7th Cir. March 29, 2011), a case decided under Delaware law.  As Mr. Pileggi notes, the case held, among other things, that disclosure of a conflict of a director’s interest may “insulate the agreement from attack, but does not, per se, protect the director from a claim for breach of fiduciary duty.”  This is an established principle, but benefits from Judge Posner’s clear articulation.  The case also raises some interesting procedural issues.

The case involved a VC’s (Venrock) bridge loan which provided for a substantial payment to the lender in the event of liquidation that would leave nothing left for the shareholders. As Posner says, “[t]he disinterested directors of Cadant [the borrower] * * * who voted for the loan were engineers without financial acumen, and because they didn’t think to retain their own financial advisor they were at the mercy of the financial advice they received from Copeland [who was a director both of the VC and the borrower] and the other conflicted directors.”

The borrower’s board approved a sale of assets for enough to pay off the creditors and preferred (including the VC) but not the common.  The sale was approved by a simple majority of both common and preferred voting together and the preferred voting separately.  The question is whether the bridge loans were a breach of the VC’s fiduciary duty.  Here’s Posner:

The accusation is that the directors were disloyal. They persuaded the district judge that disclosure of a conflict of interest excuses a breach of fiduciary duty. It does not. It just excuses the conflict. * * *

To have a conflict and to be motivated by it to breach a duty of loyalty are two different things—the first a factor increasing the likelihood of a wrong, the second the wrong itself. Thus a disloyal act is actionable even when a conflict of interest is not—one difference being that the conflict is disclosed, the disloyal act is not. A director may tell his fellow directors that he has a conflict of interest but that he will not allow it to influence his actions as director; he will not tell them he plans to screw them. If having been informed of the conflict the disinterested directors decide to continue to trust and rely on the interested ones, it is because they think that despite the conflict of interest those directors will continue to serve the corporation loyally.

I agree that disclosure of the conflict was not enough to eliminate the breach of fiduciary duty issue.  But should it be enough for liability to show that the disinterested directors relied on the interested one?

Well, the real problem here is that the trial judge dismissed as a matter of law without getting a jury determination of the issues.   Posner has some comments about that which get into nuances of procedure often ignored in teaching (and practicing) corporate law:

We note the questionable wisdom of granting a motion for judgment of law seven weeks into a trial that was about to end because the defendants declared that they were not going to put in a defense case. Reserving decision on the motion might have avoided a great waste of time, money, and judicial resources, as the case must now be retried from the beginning.

And because it will be retried Circuit Rule 36 directs that a new judge be assigned unless the parties stipulate otherwise. Either way the parties and the district court may want to rethink how the case should be submitted to the jury. The original trial was bifurcated along traditional lines, separating liability from damages, and with regard to liability for breach of fiduciary duty the proposed jury instructions required the plaintiff to prove duty, breach, causation, and injury. But the burden-shifting structure of the relevant Delaware law—normally applied by Chancery judges—can be difficult for lay jurors to grasp. Although rebutting the application of the business-judgment rule is similar to proving duty and breach, and proving “entire fairness” is similar to disproving causation and injury, the concepts are not identical. When compensatory damages are sought, proving or disproving that the challenged transaction was made at a “fair price” (evidencing “entire fairness”) might require the same evidence as proving or disproving damages. It may therefore make sense to reconsider on remand whether bifurcating liability and damages is the best approach to take in this case. Bifurcation tailored to the requirements of Delaware law might make the jury’s job easier. One possibility would be for phase one of a bifurcated trial to focus on the plaintiff’s evidence in support of rebutting application of the business-judgment rule and phase two to take up the question of “entire fairness” and, if necessary, damages. But this is a case-management issue, which was not addressed by the parties and is best left to the judgment of the district judge who will retry the case.

More broadly, the incredible uncertainty and complexity inherent inherent in this type of case is an argument for the modern “uncorporate” approach, which favors waiver of all fiduciary duties, including the duty of loyalty, and leaving these issues for custom determination in the agreement.  See my Rise of the Uncorporation, and Uncorporation and Corporate Indeterminacy.

Fencing Fiduciary Duties

Larry Ribstein —  12 January 2011

Several years ago I wrote up my theory of fiduciary duties in an inaptly titled paper, Are Partners Fiduciaries? My basic point was that fiduciary duties are and should be narrowly applied, as befits a strict standard that transcends general norms of commercial behavior. Since then I’ve been trying to get across the notion that, yes, fiduciary duties are what I said:  strict and narrow.

My most recent effort is now on SSRNFencing Fiduciary Duties, which I presented at a conference at Boston University in October, discussed here.  Here’s the abstract:

This comment on the work of Professor Tamar Frankel builds on her encyclopedic discussion of the various types of duties that have been classified as “fiduciary.” I argue for a more precise definition and more limited application of fiduciary duties which recognizes that their usefulness depends on their being limited and separated from other duties that apply in other settings. The fiduciary duty is appropriately construed as one of unselfishness, as distinguished from lesser duties of care, good faith and fair dealing, and to refrain from misappropriation. The fiduciary duty of unselfishness is appropriate only for a limited class of agency relationships in which the principal delegates open-ended power to the agent, and not for those who may exercise lesser power over the property of others, including co-investors, advisors, professionals, and those in confidential relationships. More broadly applying fiduciary duties could unnecessarily constrain parties from self-protection in contractual relationships, impose excessive litigation costs, provide an unsuitable basis for contracting, and impede developing fiduciary norms of behavior. This analysis of fiduciary duties helps address current issues, including those regarding the duties of brokers, dealers, and investment and mutual fund advisors. In short, fencing fiduciary duties protects both fiduciary and non-fiduciary relationships and enables parties to contract for the precise level of protection that is appropriate to the services they are purchasing. 

This work is particularly timely as Congress, the courts and the SEC seem hell-bent on stretching the fiduciary duty out of shape as part of financial reform.  I’ve discussed these issues here several times — e.g., on Goldman.  I’ve recently posted two other papers on misshapen federal fiduciary law — Federal Misgovernance of Mutual Funds, and my Senate testimony on Goldman.

Fencing Fiduciary Duties is my most complete discussion of fiduciary duties since my initial paper and includes applications to recent financial reforms, particularly including broker-dealer fiduciary duties now being considered by the SEC (which I discussed earlier here).  So read it while it’s hot.