Archives For conflict of interest

Sokol’s trades

Larry Ribstein —  31 March 2011

Per the WSJ, Buffett associate David Sokol bought shares of a potential Berkshire target, Lubrizol, the day after expressed interest in the company on behalf of Berkshire. He sold those shares a week later, but soon bought more around the time the Lubrizol board met to discuss Berkshire’s interest.  Sokol told Buffett about the deal and the fact that he owned Lubrizol shares a week or so later.  Buffett initially wasn’t keen on the deal, but bit ten days later. Buffett learned the details of Sokol’s purchases only after the Berkshire board offered to buy the company.

Based on these facts, Sokol may have had material information when he bought his second batch of shares: i.e., that he was going to pitch the company to Buffett.  Although he didn’t know whether Buffett would go for it, a company’s just being pitched to Buffett by a trusted insider likely increases its value. [Update:  See Sorkin: “though he had no control over Mr. Buffett’s ultimate decision, he was one of a select few who were in a position to influence such a transaction.”]

But did Sokol breach a duty to Berkshire?  The company policy says employees should ask “themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper—to be read by their spouses, children and friends—with the reporting done by an informed and critical reporter.”

On the other hand, Buffett knew.  On the third hand, did Buffett know the extent of Sokol’s ownership, or the fact that he bought the shares knowing of Berkshire’s possible interest?  On the fourth hand, it seems highly unlikely Sokol thought he was doing anything wrong.

Berkshire might be hurt if Sokol had a conflict of interest in pitching the deal.  But that conflict was disclosed.  It also might be hurt by revelations of a breach of integrity by top executive, though its stock decline on the revelation is probably because of Sokol’s resignation.  

My question:  what 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).

Nevertheless, the WSJ article says SEC is investigating.  Let’s hope nobody at the SEC has stock in Berkshire.

Update:  More on Sokol’s potential insider trading liability from Bainbridge, Bradford, and Davidoff.  I’ll stick to my initial post re materiality.  Bainbridge has a point that Sokol’s disclosure of his conflict may not be exonerating on state law, as I said recently.

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.

Peter Henning discusses “the SEC under fire”, specifically Beckergate, which I’ve already discussed, and Guptagate, which I’ve been mulling since Sorkin’s Dealbook column last Monday. Henning observes that “the questions being asked could undermine the agency’s credibility as an effective regulator of the securities markets.”

As for Beckergate, Henning notes (in addition to the issues discussed in my post earlier today) that ethics approval came 25 minutes after the request from an ethics officer who was supervised by Becker, and “did not consider whether there would be any appearance of impropriety even though work on the matter came within the letter of the conflict of interest rules.” 

Becker was involved in the SEC’s decision whether to clawback money from from a $1.54 million account in which he had an interest.  Does this seem like there might be an appearance of impropriety worth more than 25 minutes deliberation?  

Moreover, even if this is ok with the government, it might not be ok with the DC bar.  Henning points out that Becker’s judgment might well be “adversely affected by the lawyer’s * * * own financial, business, property, or personal interests,” and thus raising a question under DC attorney ethics rules.  

Guptagate is the SEC’s decision on March 1, the eve of its big Rajaratnam case, to file an administrative order against Rajat K. Gupta, former Goldman Sachs and P & G director, for tipping Rajaratnam about nonpublic information at the two companies.  Gupta had responded to a Wells notice only four days earlier, and the SEC made the decision after an unusually short weekend review.

Moreover, the SEC chose this as the first insider trading case (and the first of the 26 Galleon related cases) to be brought under a new Dodd-Frank provision that gives the SEC the benefit of a “home court,” a lower evidentiary standard, and the opportunity to avoid judicial review.  (Betcha didn’t know this was what Dodd-Frank was for).  Yet just a few days later the SEC filed an insider trading case against a lawyer in federal court that involved only $27,400, much less than R supposedly made off Gupta’s information.

Sorkin notes that despite its extensive phone-tapping, the Gupta calls evidently weren’t recorded.  Also, “you have to imagine that if the evidence was truly overwhelming against him, Mr. Gupta might have sought to become a government witness to save himself.”

So is the SEC in league with Justice to patch a gaping hole in its case against R by tainting a key witness?  If so, it wouldn’t be the first time the government has used its power to threaten and taint potential defense witnesses to smooth its path to victory.  Indeed, as I’ve written, such abuse is a foreseeable result of giving great power to lightly supervised government agents. 

If we’re going to keep passing financial laws that beef up the SEC’s power, we need to watch carefully how that power is exercised.

Update:  Carney reports the SEC was actually at odds with Justice over the Gupta charges and that they were actually a power play by the SEC. So less bad for Justice, but arguably even worse for the SEC.

Doing just about anything in the U.S. today involves seeing a lawyer.  Congress, the states and administrative agencies have passed a vast network of laws spreading over all aspects of life — not just business transactions, but family relationships, personal finance, the workplace, birth and death.  Lawyers are expensive.  Good lawyers are very expensive.  Want to change this?  Go see a lawyer.

Benjamin Barton’s new book, The Lawyer-Judge Bias in the American Legal System, shows how things got this way, and it will open your eyes.

Here’s the basic problem, according to Barton, employing the tools of public choice and “new institutionalism:”

  • Judges interpret and apply the law in our country as well as regulate lawyers. 
  • Judges, in turn, are lawyers, owe their jobs to lawyers, and see the world like lawyers.
  • Legislators could do something about this, but lawyers are a potent interest group, and judges interpret the laws.

Here’s a taste of Barton’s exhaustive description of how lawyers benefit from this system:

  • The first thing a criminal suspect is told when arrested is that he has a right to a lawyer.  But the courts do little to ensure that this lawyer is actually effective.  For misdemeanors, the courts have decided that having a lawyer is more important than having a jury.
  • The courts have gone to great pains to protect lawyers’ image from being tarnished by lawyers who are reduced to soliciting business. No other profession gets the benefit of such anti-competitive rules.
  • In most states all lawyers must belong to the official bar association, which makes lobbying easier for lawyers than for other professions.
  • Bar regulations are enshrined in state law, thereby protecting them from antitrust laws.
  • Lawyers’ independent advice is protected from regulation (Velasquez).  Doctors don’t get similar protection (Rust).
  • Courts have the ultimate power to regulate lawyers, and have protected this power from legislative intrusion by creative interpretation of state constitutions.
  • This regulation goes to great pains to ensure “professionalism” but imposes only minimal standards of conduct.
  • Courts have done little to discipline errant lawyers, leaving this to the bar associations, and thus to the lawyers themselves.
  • Lawyer regulation ensures high entry barriers that raise costs, particularly for lower and middle class consumers, but have little effect on the quality of the service clients get (here’s my paper on this).
  • Law school accreditation standards that are part of these entry barriers prevent the kind of innovation that occurs in the less regulated business school environment.
  • Lawyers get special protection from coverage of federal bill collection laws and state consumer protection laws and are less exposed to malpractice liability than doctors.
  • Strong confidentiality rules give lawyers a competitive edge against all other types of professionals (according to Barton, “if you have a problem that you need to discuss and you want your discussions to remain private in a later legal action, a lawyer is the advisor for you.”)
  • Conflict of interest rules generate more work for lawyers than if everybody didn’t have to have their own lawyer.
  • Enron prosecutors sent executives to jail and put Arthur Andersen out of business.  Guess who got off? 
  • U.S. law is both complex and indeterminate, which increases lawyers’ work and is fun for judges.  Judges and lawyers have a significant impact on legal complexity.

There are, to be sure, significant causation issues — that is, whether the public choice and institutional factors Barton describes, or other causes, account for all of this lawyer favoritism. But Barton has at least raised a prima facie case, in my view, that lawyers didn’t just happen to be the incidental beneficiaries of other forces in society.

Assuming Barton’s right, what’s to be done? Barton suggests one fix — non-lawyer judges.  But he doesn’t explain why our lawyer-dominated system would allow this to happen.

But there’s another way.  As Bruce Kobayashi and I have explained in our recently posted Law’s Information Revolution, a new legal information industry is emerging that seems likely to replace or change big chunks of what lawyers now do.  This may significantly alter the political equilibrium Barton describes:

  • It will create new interest groups, including some lawyers, who want to change the existing rules that lock traditional law practice in place.  Legal Zoom and its lawyers are actively litigating against lawyer licensing rules that impede the rise of the legal information industry.
  • The legal information industry will reduce information asymmetry and therefore the need for existing anti-competitive rules that favor traditional lawyers.
  • The potential for lower-cost and higher-value legal information products will motivate consumers and others to lobby against legal barriers to these products.

Barton notes that there was a period in U.S. history — mid-19th century Jacksonian populism — in which the bar’s hegemony was interrupted.  We could be seeing a resurgence of that sort of populism, and therefore maybe a political environment conducive to these changes.

Finally, all of this will have significant effects on law teaching.  I’ll be discussing this on Friday at Iowa’s symposium on the Future of Legal Education, and posting my symposium paper soon after.

PoL invited “Truth on the Market bloggers” to tackle this one.  How could we resist? 

It seems that while the NC bar is apparently unfazed by 40% contingency fees, they’re right on the case when it comes to a law firm offering consumers a discount on services through Groupon.  According to the ABAJ:

[T]he Law Offices of Craig S. Redler & Associates in St. Louis, offered to provide a will and durable power of attorney for $99. Groupon gets paid a percentage of the amount earned by the advertiser, and that’s the issue that will be considered by the North Carolina ethics subcommittee. A proposed opinion written by committee staffers opines that the arrangement amounts to impermissible fee-sharing with a nonlawyer, according to an Oyez column by North Carolina Lawyers Weekly. * * *Redler says the firm lost money when clients got the $99 will and power of attorney. But the ad brought calls from a lot of new clients, most of whom sought additional legal services. From that standpoint, he says, the Groupon worked well.

Law practice commentator Carolyn Elefant, quoted in the ABAJ article, notes:

Though to date, North Carolina is the only disciplinary body that has expressly addressed Groupon, others have ruled on the ethics of other types of discounted services. A number of state disciplinary bodies don’t approve of the practice, finding that discounts may be deceptive (for example, offering a “free” consult when a lawyer never charges for consults anyway), or can give rise to a conflict of interest or constitute a “fee” in exchange for referral if given to a third party, like a realtor, for distribution.

Well, it’s obvious that Groupons or similar devices will divert lawyers from their usual straight and narrow by leading them into all sorts of nefarious practices. After all, what could be more unethical than lawyers reducing prices?

But lawyers better get ready.  Bruce Kobayashi and I discuss even more basic threats to their high-priced business model rumbling down the track.

Packers, LLC?

Larry Ribstein —  1 February 2011

Just in time for the Super Bowl the New Yorker writes about the non-profit Packers — the only NFL team organized in this form.  The argument for the NFL rule barring anymore non-profits is that it takes a lot of money to run an NFL franchise.  But the article says

Green Bay stands as a living, breathing, and, for the owners, frightening example, that pro sports can aid our cities in tough economic times, not drain them of scarce public resources. Fans in San Diego and Minnesota, in particular, where local N.F.L. owners are threatening to uproot the home teams and move them to Los Angeles, might look toward Green Bay and wonder whether they could do a better job than the men in the owner’s box. And if N.F.L. owners go ahead and lock the players out next season, more than a few long suffering fans might look at their long suffering franchises and ask, “Maybe we don’t need owners at all.” It has worked in Green Bay—all the way to the Super Bowl.

This called to mind Usha Rodrigues’s recent Entity and Identity, which discusses non-profits’ benefits of creating (per the abstract) “a special ‘warm-glow’ identity that cannot be replicated by the for-profit form.” Usha discusses, among other examples, the Packers and the Cubs.

The Cubs were the subject of Shlenksy v. Wrigley, 95 Ill. App. 2d 173, 237 N.E.2d 776 (1968), in which an owner challenged the majority shareholder’s refusal to put lights in Wrigley field.  As Usha says (footnotes omitted):

The case illustrates the power of the business judgment rule: directors’ actions cannot be questioned absent fraud, illegality, or conflict of interest. For our purposes, what is interesting is that it appears that Wrigley, who owned 80% of the firm’s shares, may have been interested in running the corporation in a way that “protect[ed] values such as tradition and concern for neighbors, even at the expense of short term profit.” While the business judgment rule provides a shield, nevertheless majority owners in a for-profit organization such goals and motives are vulnerable to attack by minority shareholders. In contrast, the nonprofit structure of the Packers ensures that a Shlenksy-style suit could never even be brought against the management.

George Will has written (in Pursuit of Happiness and Other Sobering Thoughts 311 (1978)) that when, back in the pre-Tribune days, he sought to buy stock in the Cubs a substantial Cub shareholder told him to ignore “price-earnings ratios, return on capital, and a bunch of other hogwash which has no place in a transaction between two true sportsmen.”  Usha is suggesting that it that’s so, the team should make it official and use the non-profit form.

But do you really need a non-profit corporation to ensure the preservations of lofty ideas?  In my Accountability and Responsibility in Corporate Governance I stress the capaciousness of the business judgment rule in accommodating this objective.  After all, Wrigley’s emphasis on traditionalism and no lights helped build a powerful franchise and cement Chicagoans to the team despite the use of the for-profit form.

Usha may have a point that the non-profit form does it better by better signaling the firm’s objectives.  But, as with everything, there are tradeoffs.  Agency costs might be higher in non-profits, which have no owners in the sense of residual claimants to discipline managers. 

It might be better to have a hybrid form, which locks “warm glow” into the for-profit form.  You might do that in a conventional for-profit corporation, and Wrigley did succeed in fighting off the challenge in Shlensky.  But you never know when the rigid precepts of the corporation, including fiduciary duties, will rear up in court and defeat the parties’ idiosyncratic objectives.

That’s where LLCs come in.  As I argue at length in my Rise of the Uncorporation, the flexibility of the LLC form allows the owners to tailor it to their needs without worrying they will be bit by centuries of corporate law.  Even here, uncertainty may arise when the for-profit nature of the firm clashes with “warm glow” objectives.  For example, unless the LLC operating agreement locks the issue down tight, and unless the firm is organized under the clear pro-contract principles of Delaware law, the managers of a “Packers, LLC” turn down a very lucrative bid to leave Green Bay?

A variation on the LLC, the “low profit LLC,” or “L3C,” addresses this problem by providing for a firm that has owners but that commits not to make profits a significant objective of the firm.  I’m skeptical, however, that these firms solve more problems than they create.  See the above book at p. 161 and an earlier blog post.

The bottom line is a “warm glow” is one of the many things that uncorporations do better than corporations. Even so, I’m not suggesting that we need to tinker with the Packers.

[NOTE: I was drafting this post when Henry Manne posted his open letter to Fama and French. I’m hesitant to post over Henry’s important letter, particularly since TOTM was down yesterday and lots of folks may not have seen the letter. I’m doing so only because this post is a good follow-up to Henry’s points about trading and market efficiency. If you haven’t read Henry’s letter, please do so forthwith!]

Let’s get one thing straight: At the end of the day, our recent financial woes were primarily caused by the mispricing of assets. A housing bubble (or, more accurately, a number of local housing bubbles) emerged as home prices grew much faster than home values. People were buying homes that they knew were on the pricey side because they figured they could always sell them to a “greater fool” who’d pay even more. Lenders financed these transactions because they knew they could sell their mortgages to federally-backed greater fools, Fannie Mae and Freddie Mac. Eventually, though, it became apparent that prices were out of line with values, the stream of greater fools dried up, and lots of folks found themselves in the unfortunate position of owing more on their homes than the homes are worth. Homeowners began defaulting on their mortgages, many of which had been sold off and packaged into securities that were purchased by financial institutions. Those defaults caused the mortgage-backed securities to fall in value, reducing the capital of the financial institutions that held them and causing insurers of those securities (e.g., sellers of credit default swaps) to have to pay large claims. It’s a somewhat complicated story, but at the end of the day there’s a clear culprit: real estate (and real estate-related) bubbles.

To prevent future economic harm from similar bubbles, both the House and Senate financial reform bills would create a systemic risk regulator whose responsibility would be to identify system-wide financial risk and limit the activities of systemically important financial firms. The most basic charge of the systemic risk regulator would be to spot incipient bubbles, for, as Clifford Asness has explained, “It is precisely the danger of bubbles and their popping that historically has caused ‘systemic risk’ to be unveiled.” Absent widespread mispricing (overvaluation) of an asset or asset class, systemwide financial risk seems fairly unlikely. Thus, the number one task of the systemic risk regulator will be to ferret out bubbles.

How exactly this Oracle will do its job is a bit fuzzy. It will face at least three major difficulties. Continue Reading…

Looking for something to blame for the Greek debt crisis, some observers are pointing their fingers at credit derivatives. An article in yesterday’s New York Times makes the case that credit default swaps (CDS), and specifically their sale by Goldman Sachs, are somewhat to blame in part for Greece’s problems.

As I explain in this paper, credit derivatives are merely a financial tool that can be used by those exposed to credit risk, say a default by the Greek government or General Electric, to share that risk with others. This lowers the costs of borrowing and helps spread risk. In addition, third parties with no exposure to the particular credit risk can bet on whether the Greeks will default. These secondary-market transactions are the same as an individual buying stock in General Electric betting it will rise. Importantly, these bets provide a liquid market for credit risk, which lowers the cost of hedging for those with primary exposure, and provides the market with better information about whether Greece or General Electric is a good credit risk. Those who might lend to the country or company, those conducting other business with it, and those who might face the risk of default in other ways, can use this information to better plan their activities. For instance, those disbelieving a country or company’s claim of financial soundness, say because of funny accounting (think: Enron or, dare I say, America) can use credit derivatives to short debt, something that was impossible before credit derivatives were invented. This makes debt prices more accurate and holds borrowers, be they sovereigns or corporations, better to account.

Of course, there is the possibility for abuse. Another New York Times article from a few weeks ago highlights the possibility for abuse in this market. (Note the parallel between the conflict of interest across departments at Goldman Sachs and those in the investment analyst scandals from a few years ago.) But abuse is possible in all markets, and everyone should be in favor of vigorous enforcement against those who try to manipulate markets or trade on undisclosed conflicts of interest. The existence of the potential for abuse, however, is no more an indictment of credit derivatives generally than it is of the stock market or any other useful tool of society than can sometimes be abused.

It is the ultimate irony that politicians are blaming their problems on a tool that helps reveal their tricks and mistakes. This is akin to a burglar blaming an alarm system for being caught. Sure, the burglar might have been better off without it, but the homeowner and everyone else is glad it was installed.

In November of 2006, the Delaware Supreme Court issued an opinion in Stone v. Ritter dealing with a director’s fiduciary duties in cases where the complaining plaintiff-shareholder is maintaing that her directors did not sufficiently monitor their corporate charge. (I refer to these “oversight” cases loosely as “asleep at the wheel” cases.) There has been some excellent blogging on the topic by Eric Chiappinelli, Gordon Smith, and  Steve Bainbridge.  Though I was in the middle of moving such that I could not blog in the middle of that wonderful Ritter blog-fest, I am now ready to stake my blogging ground on Ritter.

Stone v. Ritter was an oversight case, in which the complaining shareholders maintained that the directors of AmSouth failed to maintain a sufficient monitoring and reporting program such that red flags (in this case pertaining to banking law violations) could be detected by the board. This, the shareholders maintained, was a violation of the directors’ fiduciary duties. The chancery court dismissed the plaintiff-shareholders’ claims, and the Delaware Supreme Court affirmed, saying “In the absence of red flags, good faith in the context of oversight must be measured by the directors’ actions ‘to assure a reasonable information and reporting system exists’. . . .”

What the court also says about the duty of loyalty, however, is more interesting to me that the good faith references.  The en banc panel says: “[T]he fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it in Guttman, “[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.”

Enter Lyman Johnson and his article “After Enron: Remembering Loyalty Discourse in Corporate Law,” 28 Del. J. Corp. L. 27 (2003). In that article, Professor Johnson takes the position that “loyalty” in the context of a director’s “duty of loyalty” should be interpreted the same way the word is interpreted in daily life. Being loyal, as that term is normally used, covers conduct that we corporate law folk have always tried to finagle under the “duty of care.” We should expect directors to be loyal in the same way we expect others be loyal. That is to say, if I ask my loyal friend, Monica, to vote for me for state senate, I envision that Monica, my loyal friend, would march to the polling place and vote for me. How loyal is my friend if, after work, she decides on the spur of the moment and with no prior plans instead to go to “happy hour” somewhere?  Can I say “Monica is a loyal friend?” She is not a loyal friend, is she? It is not that she is a traitor. Rather, she is just not loyal.  I cannot look at Monica up on her stool at the bar for happy hour, not having voted for me, and say “Now THERE is a loyal friend.  That Monica is loyal.

In his article, Lyman references “Christ’s famous charge to His apostle Peter to ‘take care of my sheep.’” If Peter is the loyal apostle, he will affirmatively care for the flock. If he is loyal. Not if he is “acting in good faith” or “acting with due care.” If he is truly a loyal disciple, he will affirmatively do whatever is needed to “take care of [the] sheep.” That, Lyman Johnson maintains, is what loyalty means.  Loyalty is that broad.  Asking if the actor is loyal subsumes the care and good faith inquiries.

Back to Ritter:  “[T]he fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it in Guttman, “[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.”

With that language, it is almost as though the Delaware Supreme Court taking a position that is totally consistent with Professor Johnson’s very broad position on what “loyalty” in the phrase “duty of loyalty” should mean. To breach the duty of loyalty, the actor does not need a conflict of interest. Simply failing to act in “the good faith belief that her actions are in the corporation’s best interest” is enough. Simply failing to be “loyal,” as that term is used in common parlance, is enough.

I like that.

I recently published an article on section 36(a) of the Investment Company Act of 1940. Section 36(a) provides a federal cause of action for “a breach of fiduciary duty involving personal misconduct in respect of any registered investment company� by an officer, director, investment adviser, or principal underwriter of an investment company, among others. Although the article is dated October 2005, it did not actually come out until two months ago. Hence, I was pleased to discover today that a court has already cited it (S.E.C. v. Treadway, Slip Copy, 2006 WL 1293499, S.D.N.Y.); that is, until, I read this part of the courts opinion:

One commentator has suggested that “involving personal misconduct” should be interpreted to incorporate the substance of the business-judgment rule–an enumerated party under section 36(a) is not liable for what turns out to be a bad business decision as long as the party made the decision “on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” William K. Sjostrom, Jr., Tapping the Resevior: Mutual Fund Litigation Under Section 36(a) of the Investment Company Act of 1940, 54 U. Kan. L.Rev. 251, 302 (2005) (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del.1984)). One court in this district has found that the business judgment rule applies to claims under Section 36(b) of the Investment Company Act, which imposes a fiduciary duty with respect to investment advisers’ compensation, against an investment company’s independent directors. See Reserve Mgmt. Corp. v. Anchor Daily Income Fund, Inc., 459 F.Supp. 597, 611 (S.D.N.Y.1978). Although Sjostrom’s effort to fill the interpretive gap is well-intentioned and well-argued, it fails to account for the fact that the benefit of the business judgment rule is ordinarily extended only to disinterested and independent parties.

As a corporate law professor, I obviously know that the BJR can be rebutted by proving a director has a conflict of interest, etc. I mention this in my article and was not trying to suggest it should be any different in the context of 36(a). So there was no reason for me to “account for the factâ€? because I was not arguing otherwise. Unfortunately, it looks like the court misinterpreted (or perhaps defense counsel purposely misinterpreted) this part of my article. But at least the court said the article was “well-argued.”

This article describes a new Deloitte & Touche/CPM Group survey on business continuity management programs.  The survey finds that “[m]ore than 83 percent of companies have developed business continuity management programs, compared with only 30 percent of companies just six years ago.â€?  Deloitte and CPM attribute the increase to the fact “that executive management remains primarily concerned with regulatory compliance, and with fulfilling fiduciary responsibilities by addressing operational resilience in response to a broad array of disruptive events.â€?Â

I don’t know offhand what regulations require or encourage a company to adopt a business continuity program, but I don’t doubt that there are some.  What I find curious is the reference to “fulfilling fiduciary responsibilitiesâ€? which seems to imply there is a fiduciary duty to adopt such a program.  There is no such specific duty.  A decision on whether a business should put a program in place is just like any other business decision.  Absent a conflict of interest, as long as the decision is made on an informed basis, in good faith and in the honest belief that the decision is in the best interests of the corporation, the board has fulfilled its fiduciary responsibilities regardless if the decision is to adopt or not to adopt a continuity program.  Ultimately, if the board takes up the issue, it should consider the probability and magnitude of various business disruption risks and make a judgment as to whether it believes it is in the best interest of the corporation to put a program in place.Â

Maybe I’m reading too much into the article, but this looks like another example, in addition to the one Gordon Smith points out here, of business people having a more expansive notion of fiduciary duty than is the case under corporate law, which seems to me is not a good thing because it leads to suboptimal risk taking by the board.

Icahn Sued by Hedge Fund

Bill Sjostrom —  3 February 2006

Carl Icahn has been all over the news lately. I’m beginning to think it’s to garner publicty for the launch of a new reality show called something like “The Activist.� I would watch it.

Anyway, today the W$J reports (click here) that Icahn is being sued by a hedge fund in connection with proposed transactions between XO Communications (Icahn is XO’s chairman, owns 8% of its common stock, 90% of its long term debt, and 95% of its preferred stock) and Elk Associates, an entity controlled by Ichan.

According to the article:

The arrangement calls for XO to sell its business and key assets to Elk Associates . . . for $700 million. Most of the proceeds — $556 million — would go to Mr. Icahn to redeem preferred stock and make an early repayment of $392 million in debt XO owes to Mr. Icahn. XO’s minority shareholders would be left with the roughly $300 million XO has in cash and a group of wireless licenses that aren’t generating meaningful revenue, the suit says. XO’s attorney, Bruce Kraus of Willkie Farr & Gallagher, said a board committee went to great lengths to attract other bidders and approached 89 potential buyers.

XO is incorporated in Delaware, so Delaware corporate law controls. The suit looks like a classic duty of loyalty case, but its hard to say without all the facts. I assume the committee referenced above attempted to comply with DGCL section 144(a)(1) (safe harbor for conflict of interest transaction disclosed to board committee and approved in good faith by a majority of disinterested directors on the committee). If so, then the plaintiff may be alleging that there was not adequate disclosure to the committee, the committee was not disinterested, or the committee did not act in good faith. If true, Icahn would then have the burden of proving that the transactions are intrinsically fair to XO.