CHAPTER TWO

Fiduciary Duties for Conventional Corporations

ENFORCING SHAREHOLDER PRIMACY

Chapter 1 discussed the context in which the modern business corporation operates. This chapter focuses on one critical aspect of the modern conventional corporation: shareholder primacy. It begins with a discussion of some basic corporate law rules, establishing that corporations are a representative system, where shareholders elect directors who manage the corporation. It then discusses, in detail, the historical tug and pull between shareholder primacy and governance oriented toward the interests of all stakeholders. It then shows that, for now, shareholder primacy has emerged as the dominant model in the United States. The chapter then discusses how stakeholders fare in this model, including a specific discussion of how shareholder primacy impacts creditors and preferred shareholders. This latter discussion includes an illustration of the economic irrationality that shareholder primacy can create.

Basic Rules of Corporate Governance

As detailed in chapter 1, the corporation is the final link in the chain that takes financial capital from savers and channels it to productive uses in the economy. In this role, the corporation evolved to perform two essential functions in the modern economy. First, it allowed business to raise the large amounts of capital that are critical to building the large enterprises necessary to create an industrial society. Second, it provided a vehicle for individuals—and the institutions that represent their collective interests—to invest in multiple businesses in order to diversify their investments and maintain liquidity. This chapter discusses the relationship between these two functions. That is, how does corporate law ensure that businesses that possess the financial capital contributed by savers use that capital in a manner that furthers the interests of the business, but also protects the interests of the savers in accumulating and transferring wealth?

The answer lies in the legal concepts that have come to define the relationship between company, management, and shareholders. These include a variety of corporate governance rights that shareholders possess. Among these are the right to elect the directors who manage the business of a corporation, the right to remove directors under certain circumstances, and the right to approve changes to corporate constitutional documents, as well as mergers, assets sales, and dissolutions. Shareholders also have rights to inspect the corporate books.¹

These governance rights are part of what is essentially a representative system, however. That is, while these mechanisms give shareholders the ultimate control over the corporation, they do not involve shareholders in the day-today, or even long-term, management of the corporate enterprise. That remains in the hands of the board of directors and the officers and employees of the corporation. This rule is established in Section 141 of the Delaware General Corporation Law, the statute that governs most publicly traded corporations in the United States: “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors.”²

Section 141 articulates a bedrock corporate law principle that directors manage the corporation.³ This management function is regulated by duties that require directors to manage the corporation’s assets carefully and loyally.⁴ First, the duty of care requires the directors of a corporation to act deliberately, and on an informed basis.⁵ Second, the duty of loyalty requires directors to focus on the best interests of the corporation and its shareholders, rather than on their own interests.⁶ The duty of loyalty includes a requirement to act in good faith.⁷ A shareholder may challenge a director’s loyalty by alleging that the director had a conflict of interest or was influenced by someone who did.⁸ The principles underlying these duties are critical to understanding the problems created by conventional corporation law, and the solution that benefit corporation law offers. This chapter describes the relevant law for conventional corporations, including some areas of dispute that are particularly relevant when considering benefit corporations.

For Whom Is the Corporation Managed?

The preceding (very) simplified portrait of corporate governance represents a fairly basic construct: shareholders provide equity capital to corporations, and retain loose governance rights, but are handing over the management of the enterprise to others—directors and managers. These directors and managers are thus acting on behalf of the shareholders. In so doing, they are expected to hew to the conduct prescribed by the duties of care and loyalty—they must take adequate care, and must also not use the assets for their own selfish interests.

But once the assets are invested in a business enterprise, a host of other stakeholders quickly become relevant. In addition to its shareholders, a corporation has workers, customers, and neighbors. These are just some of the more obvious stakeholders. The operations of a corporation may create wealth and opportunity that benefits individuals around the globe, and future generations as well. By the same token, it may create risks to the global community by using a supply chain with human rights abuses, or create risks to future generations by wasting scarce resources or emitting environmentally harmful substances.

It thus seems that there are at least two ways to interpret what it means for a director to be both loyal and careful. First, they might view their fiduciary compact as extending solely to shareholders—that is, directors must carefully and loyally manage the corporation in order to provide the best possible return on capital for the shareholders. This manner of operation is known as “shareholder primacy.” In contrast, a director might act carefully and loyally but aim to benefit a broader set of stakeholders, or even all of the corporation’s stakeholders.⁹ The rest of this chapter presents a detailed discussion of this distinction. The argument of the chapter is that traditional corporate law wavers between these two ideas, but has, in the past forty years, moved strongly toward shareholder primacy. Benefit corporation law, the subject of this book, is a tool to move in the other direction and require directors to consider the interests of all stakeholders.

This critical distinction between conventional contemporary corporate governance and benefit corporation governance can be articulated in terms of corporate purpose. Does the corporation exist solely for the benefit of shareholders, or for other stakeholders as well? This question has been the subject of debate for many years; the shareholder primacy and stakeholder models of the firm best encapsulate the competing visions of corporate purpose. Adolph A. Berle and Merrick Dodd were two famous scholars who argued in favor of one or the other model, with Berle arguing for shareholder primacy (sometimes called the “ownership” model of the firm) and Dodd arguing for consideration of other stakeholders (which is sometimes called the “enterprise” model).¹⁰ Under the shareholder primacy model, the shareholders are considered the owners of the corporation and look to the directors to manage their assets solely for their benefit.¹¹ In contrast, the stakeholder model of the firm views the corporation as an institution whose purpose is to serve multiple constituencies.¹² As we discussed in chapter 1, the attributes granted to the corporation by the state—such as the ability to enter into contracts, to limit the liability of investors, and to have unlimited duration—are extremely advantageous to the corporation, which, the stakeholder theory posits, should correspondingly serve the interests of the state.¹³

THE SHAREHOLDER PRIMACY MODEL

The quintessential case cited in support of shareholder primacy is Dodge v. Ford Motor Co., decided by the Michigan Supreme Court in 1919. In Dodge, the corporation stopped paying dividends to shareholders in order to produce less expensive products and to increase employee wages. In determining that the shareholders were entitled to the payment of dividends, the court articulated the basic tenets of shareholder primacy: “A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end, and does not extend to a change in the end itself, to the reduction of profits, or to the nondistribution of profits among stockholders in order to devote them to other purposes.”¹⁴ Thus, the corporation has a single purpose: to maximize value for its shareholders (as “owners”), within the bounds of law.

In addition to ownership, the primacy model has been linked in academic literature to the “nexus of contracts” theory, which views the corporation as a legal fiction that facilitates complex transactions and views directors as agents for shareholders, who are most in need of protection in such a model.¹⁵ Chancellor Allen explains that under this model of the corporation, stakeholders other than shareholders, such as employees or creditors, can enter into contracts with the corporation in return for things like salaries or agreed-upon interest payments.¹⁶

These stakeholders, however, do not bear the same risk as the shareholder, who is not entitled to a fixed return like a salary or an interest payment but rather is only entitled to what, if anything, remains after all of the corporation’s legal commitments are fulfilled.¹⁷ Other stakeholders can also be protected by external laws that regulate the workplace, creditor rights, the environment, and many other areas in which corporate activity affects stakeholders.¹⁸ Thus, the shareholders, as the residual risk bearers, can be understood as having “contracted for a promise to maximize long-run profits of the firm, which in turn maximizes the value of their stock.”¹⁹

Under either the ownership or the contract theory, shareholders are like principals, relying on corporate directors and managers to act as agents on their behalf.²⁰ In the case of the modern corporation, this means that directors and management thus have control over large amounts of the capital that should be managed for the shareholders’ benefit. This control creates a risk that managers will use corporate resources for their own purposes. This risk in turn creates two drains on the shareholders’ capital: any resources actually appropriated by management, and the costs incurred to prevent such appropriation.²¹ Shareholder primacy is sometimes justified as a solution to this “agency problem.”

Worse still, this appropriation may come in the form of allocating the financial capital inefficiently, wasting scarce resources that could be used in a more productive fashion. For example, a CEO may expand a corporation by acquiring other companies, in a manner that decreases the shareholder return on equity, due to inefficiencies that come with combining incompatible businesses. The CEO may be tempted to take these actions in order to increase her own salary, because compensation is correlated to business size.²² Shareholder primacy is, in theory, a tool to combat this type of behavior, because it imposes a legal obligation on management to conduct the business in a way that benefits the shareholders, not the managers, which means applying the shareholders’ capital to its most profitable use. Thus, it is argued, shareholder primacy is an efficient tool for allocating capital.

THE STAKEHOLDER MODEL

In contrast, the stakeholder model starts with the idea that the corporation is created by the government and therefore has a social function.²³ Thus, directors should consider not only shareholder returns but also all other constituencies that have a stake in the corporation, such as its employees, its debtholders, the environment, and the community.²⁴ Under this model, it is up to the board of directors to balance these competing interests. Lynn Stout is perhaps the most well-known and articulate contemporary proponent of this model within the legal academic community. In a piece coauthored with Margaret Blair, she described the board’s obligation to the broad community: “Thus, the primary job of the board of directors of a public corporation is not to act as agents who ruthlessly pursue shareholders’ interests at the expense of employees, creditors, or other team members. Rather, the directors are trustees for the corporation itself—mediating hierarchs whose job is to balance team members’ competing interests in a fashion that keeps everyone happy enough that the productive coalition stays together.”²⁵

In the mid-twentieth century, the stakeholder model held sway, at least in popular culture, as this quote from a leading executive of the time demonstrates: “The job of management is to maintain an equitable and working balance among the claims of various directly affected interest groups… stockholders, employees, customers, and the public at large. Business managers are gaining professional status partly because they see in their work the basic responsibility [to the public].”²⁶

Or, as Time magazine put it at the time, business leaders were willing to “judge their actions, not only from the standpoint of profit and loss on the balance sheet, but of profit and loss to the community.”²⁷ This model challenges the basic tenet of shareholder primacy: that a corporation should be managed as if its primary purpose is to maximize profits. Instead, the postwar conception treated the corporation as an institution owned by all of the stakeholders: “In fact, in the first three decades following WW II… the large corporation was in effect “owned” by everyone with a stake in how it performed.”²⁸

Berle himself, often thought of as the quintessential champion of shareholder primacy, seemed to believe that although it was important for shareholders to retain the control of (and the corresponding benefit from) the corporation from managers, such an accomplishment was inevitably a step toward a broader conception of “ownership”: “It is conceivable—indeed it seems almost essential if the corporate system is to survive—that the “control” of the great corporations should develop into a purely neutral technocracy, balancing a variety of claims by various groups in the community and assigning to each a portion of the income stream on the basis of public policy rather than private cupidity.”²⁹

However, the policy significance of the stakeholder model should not be lost in the semantic question of “ownership.” The underlying assumption is that if society is to grant all the privileges of incorporation to business enterprises, then those enterprises, in return, should be managed to create a benefit for society. Accordingly, the rules for managing corporations should be structured to ensure that all of society benefits from those rules, not just shareholders.

One significant criticism of the stakeholder model is that it is simply unworkable. The concern is that there is no good way to balance the profusion of stakeholder interests, so that the model leaves directors with no clear mandate (and thus with ample room to abuse their authority, since there is no good way to measure their fidelity). Economist Michael Jensen describes this objection: “Any organization must have a single-valued objective as a precursor to purposeful or rational behavior…. It is logically impossible to maximize in more than one dimension at the same time. Thus, telling a manager to maximize current profits, market share, future growth profits, and anything else one pleases will leave that manager with no way to make a reasoned decision.”³⁰

Others refute this claim by reference to the multifaceted nature of general decision making.³¹ This dispute—whether enterprises can ever efficiently serve all stakeholders and not just shareholders—illustrates that the proponents of shareholder primacy might accept the premise that corporate law should be fashioned to benefit society as a whole, yet still believe that the way to do that is, in fact, to maximize shareholder value. To a significant degree, that is the argument that has gained the upper hand, as discussed in the next section.

THE UNITED STATES GENERALLY FOLLOWS SHAREHOLDER PRIMACY

During the twentieth century, economies across the globe moved toward corporate capitalism, as large corporations with disparate shareholders began to control significant amounts of private capital. As we have seen, there has been a lingering question whether this capital is to be managed in the interests of all stakeholders or solely for the benefit of shareholders.

Although some academics would differ, shareholder primacy has essentially won out, particularly in the United States, the United Kingdom, and other jurisdictions that follow the Anglo-American legal tradition.³² Economic theory, along with the liberalization of global capital markets, paved the way for this victory,³³ but it was a series of decisions by the Delaware courts that cemented the place of shareholder primacy.³⁴

The most important of these was the Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. case decided by the Delaware Supreme Court in 1985.³⁵ As mentioned, Delaware is the preeminent corporate jurisdiction in the United States, and the decisions of its supreme court have resonance throughout the United States and beyond. In Revlon, the board of Revlon was faced with an acquisition proposal that appealed to the shareholders but that the board believed would result in a poor outcome for the corporate enterprise, including its bondholders. The board took measures to defeat the takeover bid and was sued for breaching its duty to shareholders. The board defended itself by arguing that the takeover would hurt bondholders.

However, the Delaware Supreme Court invalidated the defensive actions (which involved selling the company to a different bidder), rejecting the idea that the board had the duty, or even the option, to consider the interests of stakeholders other than shareholders in a sale process. The court found that, because the company was being sold, considerations of the interests of such stakeholders could in no way help the shareholders, because for them there was no “long run.” Accordingly, the sole objective for directors had to be immediate wealth maximization for shareholders, even if the high bid might destroy large amounts of bondholder value (or, by extension, worker or community value).³⁶ Other Delaware authority has established that corporations exist primarily to generate shareholder value,³⁷ even though Delaware’s corporate purpose statute broadly states that a corporation may undertake “any lawful business or purpose.”³⁸

eBay Domestic Holdings, Inc. v. Newmark is a more recent example of the Delaware focus on shareholder wealth maximization, even outside the sale context. In eBay, the directors of Craigslist employed defensive measures to prevent or, alternatively, slow eBay’s ability to take control of Craigslist. In defending their actions, the Craigslist board argued that the defensive measures were put in place not for economic reasons but to protect the company’s social values and community-centered culture. The court found that this motivation was inappropriate, and in doing so, clearly embraced shareholder primacy:

The corporate form in which Craigslist operates . . . is not an appropriate vehicle for purely philanthropic ends, at least not when there are other stockholders interested in realizing a return on their investment. [Craigslist’s directors] opted to form Craigslist, Inc. as a for-profit Delaware corporation and voluntarily accepted millions of dollars from eBay as part of a transaction whereby eBay became a stockholder. Having chosen a for-profit corporate form, the Craigslist directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders. The “Inc.” after the company name has to mean at least that. Thus, I cannot accept as valid for the purposes of implementing the Rights Plan a corporate policy that specifically, clearly, and admittedly seeks not to maximize the economic value of a for-profit Delaware corporation for the benefit of its stockholders—no matter whether those stockholders are individuals of modest means or a corporate titan of online commerce…. Directors of a for-profit Delaware corporation cannot deploy a rights plan to defend a business strategy that openly eschews stockholder wealth maximization—at least not consistently with the directors’ fiduciary duty under Delaware law [emphasis added].³⁹

The eBay case underlines the fact that the law requires that corporations operate for the benefit of their shareholders, and, for that reason, directors must perform their duties with the primary focus of increasing shareholder wealth.⁴⁰ Even in light of eBay, some commentators remain unpersuaded.⁴¹ However, even proponents of the stakeholder theory will recognize the difficulty of ignoring the clear language of the case:

The eBay case has the potential for a large impact similar to Dodge v. Ford, especially in the takeover defense arena, even if some academics feel that eBay was wrongly decided or should be limited to minority oppression fact patterns…. The eBay case will likely work itself into corporate lore and could push risk adverse social entrepreneurs, especially those using the Delaware for-profit form, in the direction of shareholder wealth maximization.⁴²

In his academic writings, the chief justice of the Delaware Supreme Court has adopted a reading of the Delaware case law consistent with the shareholder primacy model and has summarized it with the following proposition: “The object of the corporation is to produce profits for the stockholders and… the social beliefs of the manager, no more than their own financial interests, cannot be their end in managing the corporation.”⁴³

As Delaware goes, so goes the nation; as a result of the Revlon decision, many felt that the law of the land was clearly shareholder primacy. In response, thirty-three states adopted specific provisions, called constituency statutes, that gave directors the ability (but generally not the obligation) to consider the interests of other stakeholders. (This will be discussed further in chapter 9.) Delaware, however, did not adopt such a provision.

With Delaware refusing to adopt a constituency statute, and those statutes continuing to permit (if not require) shareholder primacy, the United States remains dominated by shareholder primacy. Moreover, many jurisdictions around the world are heavily influenced by the doctrine, as shown by a series of papers recently drafted by experts in more than thirty countries in response to a 2015 questionnaire prepared by Professor Robert Eccles of the Harvard Business School. The questionnaire was answered for the United States by the American Bar Association’s Task Force on Sustainable Development. That response concluded that: “The United States is a ‘shareholder primacy’ jurisdiction, meaning that the primary focus of corporations is to return profit to shareholders. If stakeholder needs are considered, they are a secondary concern.”⁴⁴

Whether the law in this area creates or reflects societal values is beyond the scope of this work. However, it is important to note the correlation between the two. As mentioned, the postwar attitude in the United States reflected a stakeholder bent: corporations were viewed as having broad purposes. More than a decade before Revlon was decided, however, that consensus had begun to recede. In 1970, Milton Friedman penned an article in the New York Times Magazine with the title “The Social Responsibility of Business Is to Increase Its Profits.”⁴⁵ A deep analysis of the multiple strands of finance, political, and business trends leading to this shift is set out in Pavlos E. Masouros’s Corporate Law and Economic Stagnation.⁴⁶ Contemporary business culture in the early twenty-first century largely accepts this role. In a New York Times article exploring whether ExxonMobil put the interests of shareholders before the global political interests of the United States, a company spokesperson was comfortable explaining, “Absent a law prohibiting something, we evaluate it on a business case basis.”⁴⁷

THE STATUS OF STAKEHOLDERS IN THE CONVENTIONAL CORPORATION

Each of the Ford, Revlon, and eBay cases was unusual, in that there was testimony from management stating that corporate action was taken for the primary benefit of stakeholders. In contrast, directors can usually tie action that benefits stakeholders to a corresponding shareholder value motive. For example, directors may assert that a charitable giving program, while benefiting the recipients of the charities, is ultimately aimed at enhancing the corporation’s reputation in order to improve product sales and employee recruitment and retention. Accordingly, directors retain substantial discretion to consider all stakeholders in determining how to best achieve long-term shareholder wealth maximization under the “business judgment rule,” which we will discuss in detail in chapter 3.⁴⁸ However, the Delaware courts have made it clear that directors may consider other constituencies only if such considerations coincide with the maximization of long-term shareholder value.⁴⁹

Some argue that Delaware case law—specifically, the supreme court’s decision in Unocal v. Mesa Petroleum Co.⁵⁰—has explicitly recognized the legitimacy of directors considering non-shareholder interests as a primary concern when making business decisions. Unocal involved a hostile takeover, that is, a situation where an acquirer was attempting to gain control of the corporation even though the board of directors opposed the transaction. This type of situation often tests the question of what stakeholders a board may consider, because changes in control can result in large premiums being paid to shareholders but, at the same time, may result in corporate restructurings that damage other stakeholders, such as workers and communities.⁵¹ Where the board resists a hostile takeover, it is not uncommon for shareholders to claim that the board is resisting the takeover in order to benefit a constituency other than shareholders. In Unocal, the court recognized this concern but found that a board could consider other stakeholders, as long as that consideration was in service of shareholder value in the long run.

In Unocal, the court acknowledged the “basic principle that corporate directors have a fiduciary duty to act in the best interests of the corporation’s stockholders,” but the court also legitimized the consideration of other concerns when facing a hostile takeover, including “the impact on ‘constituencies’ other than shareholders (i.e., creditors, customers, employees, and perhaps even the community generally).”⁵² Some have claimed that Unocal demonstrates that the board may consider “the corporation,” separate and apart from shareholders, implying that all stakeholders have equal dignity: “The court opined that the corporate board had a ‘fundamental duty and obligation to protect the corporate enterprise, which includes stockholders,’ a formulation that clearly implies the two are not identical.”⁵³ However, others persuasively argue that the decisions in Revlon and eBay explicitly reject any such interpretation.⁵⁴ The chief justice of the Delaware Supreme Court lends credence to the latter interpretation through an anecdote from the Revlon oral arguments: “The Revlon directors argued that it was proper for them to consider the interests of [other constituencies] under the Supreme Court’s recent ruling in Unocal…. The lawyer who argued for the directors, A. Gilchrist Sparks III, indicated that this argument was quickly dispensed with by the Justices at oral argument, when Justice Moore said in words or substance that Unocal did not mean that.”⁵⁵ Instead, the Delaware Supreme Court has held that the rights of other constituencies such as creditors, employees, and the community, are limited to the protections offered by statutory, contractual, and common law rights.⁵⁶

This view, that stakeholder interests are a valid board consideration when related to shareholder value, is consistent with the court’s interpretation of the express statutory power that corporations have to make corporate donations for “charitable, scientific, or educational purposes.”⁵⁷ The courts have limited this power with the principle that such gifts must benefit the shareholders in the long run. According to Theodora Holding Corp. v. Henderson:

It is accordingly obvious, in my opinion, that the relatively small loss of immediate income otherwise payable to plaintiff and the corporate defendant’s other stockholders, had it not been for the gift in question, is far outweighed by the overall benefits flowing from the placing of such gift in channels where it serves to benefit those in need of philanthropic or educational support, thus providing justification for large private holdings, thereby benefiting [stockholders] in the long run.⁵⁸

Thus, the Delaware courts have made it clear that other constituencies may be considered, but only when their interests align with the long-term wealth maximization of the corporation’s shareholders. As Theodora makes clear, however, the tie to shareholder value may be quite tenuous.

MULTIPLE INVESTOR CONSTITUENCIES

In addition to common shareholders, preferred shareholders and creditors may have direct investments in a corporation. These constituencies often have interests that conflict with those of the common shareholders, because they may receive different rewards from the corporation’s success and may suffer different levels of loss in the case of poor performance. For groups other than common shareholders, the protections offered by Delaware law are limited when a corporation remains solvent. In some respects, the limited obligations of directors toward the holders of preferred stock and debt are analogous to the limited director obligations to stakeholders under traditional corporate law. This analogy may serve to highlight the weakness of a governance model that insists on favoring one constituency over all others.

As the Revlon case established, directors do not generally have fiduciary duties to consider the interests of creditors. Traditionally, creditors are “afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights,”⁵⁹ and the general rule is that directors do not owe creditors duties beyond the relevant contractual terms and commercial law, such as fraudulent transfer statutes.⁶⁰ However, creditors have tried to claim that, as a corporation approaches insolvency, the creditors should take the place of shareholders in the fiduciary scheme, because at that point it is creditors who bear the “residual risk,” as described in the contract theory, discussed earlier.

Creditors have tried to use this argument to create fiduciary duties to creditors when a corporation is in the “zone of insolvency,” but the Delaware courts have rejected such arguments.⁶¹ When a corporation is actually insolvent, however, courts have held that its creditors do take the place of the shareholders as the residual beneficiaries of any increase (or decrease) in value of the corporation. Accordingly, the corporation’s insolvency “makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value.”⁶² Due to this shift, the Delaware Supreme Court has recognized a creditor’s ability to bring a derivative claim against a corporation for a breach of fiduciary duty when the corporation is insolvent, but has nevertheless expressly rejected any direct claims against a corporation by individual creditors for breach of fiduciary duty.⁶³

The position of preferred shareholders with respect to director fiduciary duties is less clear. Their rights are generally contractual in nature.⁶⁴ However, the corporation may owe fiduciary duties to preferred shareholders when the right claimed is shared equally with the common shareholders.⁶⁵ (This might involve a claim for breach of the duty of care, for example.) When the interests of the common and preferred shareholders diverge, however, “the directors generally must ‘prefer the interests of common stock—as the good faith judgment of the board sees them to be—to the interests created by the special rights, preferences, etc., of preferred stock.’”⁶⁶ The Delaware courts have also suggested that preferred shareholders may be owed certain fiduciary duties when the preferred shareholders have no contractual protection.⁶⁷

The implication of this requirement of “common shareholder primacy” can be quite stark, and perhaps counterintuitive, because the fact that creditors and preferred shareholders are paid off before common shareholders creates strange incentives if a corporation’s value barely covers the priority due to the preferred shareholders. Indeed, cases such as Trados and LC Masterfund suggest that directors are required to take actions (such as engaging in high-risk transactions) that benefit common shareholders over creditors or shareholders with preferences, even where the actions do not create the most value for the enterprise as a whole. In such situations, if the corporation’s assets would only be enough to pay off the creditors and the preferred stock, the common shares will gain most of the upside if a risky decision creates value, while the downside of such a decision is mostly suffered by those with preferred returns, including creditors and preferred shareholders. This asymmetric risk allocation means a board charged with maximizing common share value may make a bet with a negative risk adjusted return, because the downside risk is borne by security holders to whom no duty is owed, while the security holders to whom a duty is owed receive any upside.

Interestingly, earlier case law suggested that directors should ignore the risk profiles of particular investors when the company was near insolvency, and should take actions that create the most value for the enterprise as a whole, in order to avoid inefficient decisions.⁶⁸ The evolution of the cases toward a single constituency (the common shareholder, as residual risk-bearer) with a single goal (high share value) follows the post-Revlon shift to promote shareholder interests over those of all other stakeholders. From a holistic perspective, each of these narrow focal points can lead to similarly inefficient outcomes.

DIRECTORS CANNOT PROTECT IDIOSYNCRATIC COMMON SHAREHOLDER GOALS

Even common shareholders may have goals other than maximizing share value. For example, a controlling shareholder may have a preference for a transaction that promises liquidity, which could create a conflicting interest.⁶⁹ Nevertheless, courts have noted that a controlling shareholder’s desire for liquidity rarely creates a “disabling conflict of interest” when all shareholders receive the same pro rata consideration in a transaction. In addition to liquidity concerns, a controlling shareholder could favor a transaction for tax or other idiosyncratic reasons.⁷⁰ For example, a director might want to promote the interests of another stakeholder in the corporation, regardless of any connection to shareholder value, or have an interest in preserving the environment or the local community. Supporting such an interest to the detriment of shareholders could be “conscious disregard” for the interests of shareholders and thus constitute “bad faith.”⁷¹ Accordingly, even nonfinancial interests of the common shareholders themselves must be subordinated by directors bound by the shareholder primacy model.

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In this chapter, we have seen how shareholder primacy has come to dominate corporate law. Chapter 3 will explain how courts enforce this rule.