Davis - Judicial Review of Fiduciary Decision Making

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Copyright 1986 by Northwestern University, School ofLaw Northwestern University Law Review
Printed in U.S.A. 80, Vol. No. I
NORTHWESTERN UNIVERSITY LAW REVIEW

VOLUME 80
MARCH
1985
NUMBER 1
JUDICIAL REVIEW OF FIDUCIARY DECISIONMAKING - SOME THEORETICAL PERSPECTIVES

Kenneth B. Davis, Jr. *
I.
INTRODUCTION
The fiduciary concept is a critical building block for our laws of trusts, agency, and business organizations. It is the principal device those bodies of law employ to restrict the otherwise unfettered powers of persons who are entrusted with control over the assets and affairs of others. Necessarily, the personal interests of the controlling party, the fiduciary, and the person whose affairs and assets are subject to control, the principal, 1 will from time to time diverge. Through the fiduciary device, the law seeks to create a system of compensation and deterrence to protect the principal's interests against exploitation which results from that divergence. Not surprisingly, much has been written over the years about the substantive content of the fiduciary doctrine. Any casebook or treatise on the subject of trusts, agency, partnership, or corporations invariably includes a lengthy treatment of the components of the fiduciary's duty of loyalty and her 2 related obligations. The courts repeatedly have been called upon to apply these concepts, generating opinions describing the fiduciary's burden in lofty terms such as "undivided and unselfish loyalty," 3 "utmost good faith,"'4 and "the highest standards of honor and
Associate Professor of Law, University of Wisconsin Law School. The author wishes to thank his colleagues, Peter Carstensen and Bill Whitford, for their valuable comments on earlier drafts of this Article. I The term "principal" is used throughout this analysis as a generic term for the person on whose behalf the fiduciary acts. Thus, the term embraces the beneficiary in a trust relationship, the principal in a common law agency relationship, and the corporation and its shareholders in a corporate relationship. 2 In the interests of clarity and convenience, the fiduciary will be referred to as "she" throughout this Article and the principal as "he." 3 Guth v. Loft, Inc., 23 Del. Ch. 255, 270, 5 A.2d 503, 510 (Sup. Ct. 1939).
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HeinOnline -- 80 Nw. U. L. Rev. 1 1985-1986
honesty."' 5 More recently, commentators have sought to explore and develop the underlying theory of what the fiduciary doctrine entails and the 6 role it plays. At the same time, the economics literature has been studying the implications of the divergence of interests between fiduciary and principal. Based on the implicit premise that the application of conventional legal rules is insufficient to make the fiduciary act in the best interests of her principal, this literature examines how other, extralegal institutions serve either to align the interests of fiduciary and principal or to compen7 sate for the expected costs of nonalignment. From this body of work, it was but a short step to the development of a legal literature-principally in the area of corporate law-suggesting that the law's traditional recognition and enforcement of formal fiduciary obligations was short-sighted, and that contract and market mechanisms are available to protect the underlying interests of the shareholders more efficiently. 8 This has, in turn, recently spawned legal research challenging the validity of the implied-contract metaphor to characterize the relationship between corporate managers and shareholders and the adequacy of market processes to control abuses of managerial discretion. 9 This Article advocates a middle ground. While the law and eco4 Id. at 271, 5 A.2d at 510. 5 Grossberg v. Haffenberg, 367 Ill. 284, 287, 11 N.E.2d 359, 360 (1937). Other well-known and often-cited judicial expressions of this strict view of fiduciary obligation are Pepper v. Litton, 308 U.S. 295, 306-07, 310-11 (1939); Meinhard v. Salmon, 249 N.Y. 458, 463-64, 164 N.E. 545, 546 (1928); Wendt v. Fischer, 243 N.Y. 439, 443-44, 154 N.E. 303, 304 (1926); Kavanaugh v. Kavanaugh Knitting Co., 226 N.Y. 185, 192-94, 123 N.E. 148, 151 (1919). The Meinhard and Wendt opinions contain the characteristic prose of Judge Cardozo. 6 See Anderson, Conflicts ofInterest:Efficiency, Fairnessand CorporateStructure, 25 UCLA L. REV. 738 (1978); Frankel, FiduciaryLaw, 71 CALIF. L. REv. 795 (1983); Jacobson, The Private Use of Public Authority: Sovereignty and Associations in the Common Law, 29 BUFFALO L. REv. 599, 615-64 (1980); Sealy, Some Principlesof Fiduciary Obligation, 1963 CAMBRIDGE L.J. 119; Sealy, FiduciaryRelationships, 1962 CAMBRIDGE L.J. 69; Shepard, Towards a Unifled Concept ofFiduciary Relationships,97 LAW Q. REV. 51 (1981); Weinrib, The FiduciaryObligation, 25 U. TORONTO L.J. 1 (1975). 7 See generally Barnea, Haugen & Senbet, Market Imperfections, Agency Problems, and Capital Structure:A Review, 10 FIN. MGMT. 7 (1981); Fama, Agency Problems and the Theory of the Firm, 88 J. POL. ECON. 288 (1980); Fama & Jensen, Separation of Ownership and Control, 26 J. L. & ECON. 301 (1983); Fama & Jensen, Agency Problems and Residual Claims, 26 J. L. & ECON. 327 (1983); Jensen & Meckling, Theory of the Firm: ManagerialBehavior,Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976); Pratt & Zeckhauser, Principalsand Agents: An Overview, in PRINCIPALS AND AGENTS: THE STRUCTURE OF BUSINESS 1 (J. Pratt & R. Zeckhauser eds. 1985). 8 This is most visible in the work of Judge Easterbrook and Professor Fischel. See, eg., Easterbrook & Fischel, CorporateControl Transactions,91 YALE L.J. 698, 711-14 (1982) (portfolio diversification as best antidote for unequal allocation of gains created by corporate control transactions); Fischel, The Corporate GovernanceMovement, 35 VAND. L. REv. 1259, 1287-90 (1982) (existence of market discipline eliminates any need for increased liability of managers). See also Winter, State Law, Shareholder Protection, and the Theory of the Corporation, 6 J. LEGAL STUD. 251, 254-58 (1977) (capital markets as limitation on management's ability to choose self-serving law). 9 See, eg., Brudney, Corporate Governance, Agency Costs, and the Rhetoric of Contract, 85
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nomics scholarship in the corporate area seems often to rest on heroic assumptions about the quality of market processes, the literature condemning it comparably relies-although here the reliance is far less explicit-upon the ability of the legal system to resolve fiduciary problems "correctly" and at low cost. The fundamental premise of this Article, in contrast, is that the theoretical existence and content of a fiduciary duty cannot be separated from the practical fact of its enforcement. To say that a fiduciary must act with the utmost good faith and loyalty to the interests of her principal is one thing; to test whether conduct in the real world conforms to that ideal is quite another. Thus, any system designed to protect the interests of the fiduciary at the hands of the principalwhether it entails formal legal regulation by the courts and legislature or private ordering through contract and the market-has imperfections. This Article therefore seeks to explain the rules governing judicial review of fiduciary decisionmaking as a pragmatic accommodation of the comparative imperfections of legal regulation on the one hand and private ordering on the other.' 0 As a backdrop for examining the contribution made by judicial enforcement of the fiduciary standard, section II of the Article examines possible private arrangements and incentives between fiduciary and principal designed to deal with the problems created by the divergence of their interests. 1 In the process, some of the legal and economic scholarship relating to such private arrangements and incentives is reviewed and applied. 12 Section III briefly examines how legal intervention may further that private ordering process. 13 Section IV then seeks to develop some basic theoretical tools to evaluate the operation of legal rules governing fiduciary relationships. 14 These tools are applied to the areas of 16 agency and trust in section V,15 and to corporate law in section VI. The latter two sections undertake to reconcile the deferential approach courts normally take to fiduciary decisionmaking in the corporate area with the generally strict and vigorous approach taken by the courts in the agency and trust areas. Finally, the concluding subsections of section VI review some current developments in corporate law and attempt to show
COLUM. L. REv. 1403 (1985); Clark, Agency Costs Versus Fiduciary Duties, in J. Pratt & R. Zeckhauser, supra note 7, at 55. 10 I am indebted to the work of my colleague, Neil Komesar, for so clearly illustrating how legal rules can be viewed as reflecting an inevitable choice among alternative institutional decisionmakers, each with its own defects. See generally Komesar, Taking Institutions Seriously: Introduction to a Strategy for ConstitutionalAdjudication, 51 U. CHI. L. REv. 366 (1984); Komesar, In Search of a GeneralApproach to Legal Analysis: A ComparativeInstitutionalAlternative, 79 MIcH. L. REv. 1350 (1981). The influence of his work appears throughout this Article. 11 See infra notes 18-71 and accompanying text. 12 See id. 13 See infra notes 72-76 and accompanying text. 14 See infra notes 77-116 and accompanying text. 15 See infra notes 117-38 and accompanying text. 16 See infra notes 139-348 and accompanying text.
that the judicial deference shown to managers in some settings is not necessarily the product of the courts' naive ignorance of the risks of opportunistic decisionmaking, as suggested by some commentators, but may instead stem from the courts' implicit recognition of how illequipped they are to determine, with accuracy and 17 low cost, whether at particular conduct conforms to the fiduciary ideal. II. 4.
LIFE IN A WORLD WITHOUT THE FIDUCIARY STANDARD
The Core Problem: Nonalignment of Interests and the Resulting Incentives for OpportunisticBehavior
The source of the fiduciary problem is the joinder of the fiduciary's discretionary control over some nontrivial portion of the principal's assets and affairs with the unavoidable fact that the interests of the principal and the fiduciary are not perfectly aligned. The ways in which the fiduciary may abuse that discretion to further her own interests at the expense of the principal's are many and diverse. Most blatantly, the fiduciary may cheat the principal, either by appropriating his assets or by self-dealing on terms unfair to him. Further, to the extent that the fiduciary's costs of doing business are borne by the principal, as is the case with corporate managers, the fiduciary may set excessive compensation or fringe benefits or provide perquisites beyond the minimum necessary to conduct the principal's business in the most efficient manner.18 More subtle mechanisms for self-enrichment are available as well. The fiduciary's interest in protecting her employment may lead her to turn down opportunities that would further the principal's objectives but would also jeopardize the fiduciary's own tenure. 19 Or the fiduciary may seek to expand her sphere of influence and the basis for her compensation by initiating or acquiring new business opportunities not strictly consistent with maximizing the principal's welfare. 20 Finally, there is the fidu17 Readers generally familiar with the financial economics literature-particularly that pertaining to agency costs and portfolio theory-may wish to skip section II. Much of that section is background and the cross-references contained in the subsequent sections should enable the reader to hark back to that section, if necessary, for any points essential to the later analysis. 18 See Jensen & Meckling, supra note 7, at 312-13 (describing an owner-manager's incentive to take a greater level of nonpecuniary benefits from the firm after selling a portion of the equity to outsiders). 19 See, eg., Easterbrook & Fischel, The ProperRole of a Target'sManagement in Responding to a Tender Offer, 94 HARV. L. REv. 1161, 1175, 1198 (1981) (rejecting beneficial takeovers); Gilson, A StructuralApproach to Corporations:The Case Against Defensive Tactics in Tender Offers, 33 STAN. L. REV. 819, 824-31 (1981) (defending against takeovers); Klein, The Modern Business Organization: BargainingUnder Constraints,91 YALE L.J. 1521, 1556 (1982) (adopting overly conservative strategies); Comment, The Conflict Between Managersand Shareholders in Diversifying Acquisitions: A Portfolio Theory Approach, 88 YALE L.J. 1238, 1243 (1979) (excessive diversification). 20 See, e.g., Brudney, Dividends, Discretion, and Disclosure, 66 VA. L. REv. 85, 95-97 (1980) (managerial preferences for reinvestment over distribution of earnings as a concomitant of its preference for growth in sales and size over growth in earnings); Vagts, Challenges to Executive Compen-
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FiduciaryDecisionmaking
ciary's ever-present incentive to "shirk"-that is, to divert attention from productive activities that benefit the principal to activities that offer more leisure or personal gratification to the fiduciary. 2 1 The fiduciary's capacity and incentive to engage in these various forms of conduct that provide value to herself at the expense of her principal is described in this Article by the term "opportunism." Opportunism reflects the fiduciary's departure from the pattern of conduct she would engage in were she alone to 22 bear the full costs and enjoy the full benefits of her actions. Fiduciaries and principals theoretically have several methods of dealing with the problem of opportunism. This section will review briefly these methods, and some of the legal and economic scholarship discussing them, as a backdrop to considering how judicial enforcement of the fiduciary standard contributes to controlling the fiduciary's propensity for opportunism. Because this section focuses exclusively on the operation of market incentives and privately negotiated arrangements to solve the problem of nonalignment of interests, it will be assumed that formal legal regulation of the fiduciary's propensity for opportunistic behavior 23 does not exist. B. Monitoring,Bonding, and the Opportunity for Ex Ante Compensation
Even in a world where recourse to the courts through the fiduciary mechanism is unavailable, prospective principals who find it otherwise desirable to entrust their affairs to another are unlikely simply to sit back and suffer the full adverse consequences of opportunism. To protect themselves, they will undertake "monitoring" activities designed to reduce the risk of abuse. 24 Such activities might include requiring the fiduciary to give detailed accounts of her performance, hiring outsiders to audit the fiduciary, or imposing direct restraints on the fiduciary's discretion. Monitoring is, of course, costly. The principal, however, has the economic incentive to engage in monitoring so long as the marginal cost of each additional monitoring step is less than the incremental reduction
sation: Forthe Markets or the Courts?, 8 J. CORP. L. 231, 235 (1983) (corporate management may prefer growth and earnings retention while investors may prefer current profitability and dividends); Comment, supra note 19, at 1241-44 (acquisition for purposes of diversification). 21 See, eg., Alchian & Demsetz, Production, Information Costs, andEconomic Organization,62 AM. ECON. REv. 777, 780-81 (1972); Anderson, supra note 6, at 758 n.59. 22 Cf 0. WILLIAMSON, MARKETS AND HIERARCHIES: ANALYSIS & ANTITRUST IMPLICATIONS 26-28 (1975) (using the term in a broader context). Muris, OpportunisticBehavior and the Law of Contracts, 65 MINN. L. REV. 521 (1981). 23 The assumptions in this section go only to the nonexistence of fiduciary obligations that are defined and imposed as a matter of law and are capable of judicial enforcement. Recourse to the courts is not altogether ignored in this section: any ad hoc agreements made between fiduciary and principal are assumed to be enforceable in accordance with their terms. 24 See Alchian & Demsetz, supra note 21, at 780, 781-83; Jensen & Meckling, supra note 7, at 308, 323-24.
it produces in the principal's expected welfare loss due to the fiduciary's opportunistic behavior. Given the demand for monitoring activities, we might expect a market for professional monitors to emerge, with their fees reflecting (at least in the rarefied air of theory) their relative success 25 in reducing opportunism losses. Two phenomena undercut the attractiveness of monitoring as a complete solution to the problem of nonalignment of fiduciary and principal interests. The first is the very nature of the fiduciary relationship itself. This relationship is valuable to the principal because it permits him to free himself of certain activities by delegating them to another. If looking over the fiduciary's shoulder is essential to prevent opportunism, this benefit is negated. In addition, many fiduciary activities involve specialized expertise and discretion. To be effective, the monitor would have to possess comparable expertise, and the costs of the monitoring would increase accordingly. Furthermore, the presence of discretion makes it difficult for any monitor to determine with certainty whether a given decision was tainted by opportunism. 26 The second drawback to effective monitoring is that because the true principal often may be a relatively small-stakes participant in a larger organization supervised by the fiduciary, such as a corporate shareholder, the individual gains to the principal from effective monitoring are slim in relation to their cost. While it might be possible for such a principal to pool resources with others similarly situated in order to undertake joint monitoring for the common good, transactions costs and "free-rider" problems will probably cause 27 the resulting level of such joint activity to be less than optimal. Thus, the principal can seldom eliminate the entire risk of opportunism by any cost-justified level of monitoring. Some residual risk will always be present, and, assuming the principal appreciates the risk, he may respond to it in one of two ways. If the risk is too great, he will simply walk away and forgo the benefits of a fiduciary relationship. He will employ an alternative over which he has more control, such as entrusting his property to a close family member or managing it himself. Alternatively, he may go ahead with the relationship but demand an ex ante "rebate" from the fiduciary to reflect the amount of the expected loss. Paying the fiduciary a reduced fee would be an example of such a
25 See Fama, supra note 7, at 293-94 (discussing the market for outside directors as monitors); Watts & Zimmerman, Agency Problems, Auditing, and the Theory of the Firm:Some Evidence, 26 J. L. & ECON. 613 (1983) (discussing the development of the independent auditing profession as a response to the demand for monitoring). 26 Ideas similar to those expressed in the foregoing five sentences of the text are contained in Anderson, supra note 6, at 744-45, 747, 758-59; Frankel, supra note 6, at 809-10, 813; Klein, supra note 19, at 1545, 1557; Weinrib, supra note 6, at 4. 27 See M. OLSON, THE LOGIC OF COLLECTIVE ACTION 55-56 (1971); Anderson, supra note 6, at 778-80; Klein, supra note 19, at 1544-45; Levmore, Monitors and Freeridersin Commercial and CorporateSettings, 92 YALE L.J. 49 (1982).
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rebate.2 8 Critical to any such ex ante adjustment process is the principal's ability to predict the fiduciary's behavior. The principal's ability will depend upon the information he has concerning the fiduciary's past performance. Availability of such "experience-rating" information will be a function of the ease with which descriptions of past performance can be captured or quantified in simple summaries, as well as the transactions costs of obtaining this information from former users. 2 9 For example, the past performance of an investment manager can be more easily distilled and communicated-by comparing the year-to-year fluctuation of the portfolios he or she manages to some broad-based market averagethan that of the resident manager of an apartment building. 30 In this evaluation process, persons who are in the business of using fiduciary services on an ongoing basis ("professional principals," so to speak) will have a comparative advantage over persons who are not. These professional principals have more to gain from an investment in information gathering and processing because of their continuing dependence on the fiduciary and, it is likely, their larger amounts at stake. Moreover, where past performance data cannot be easily distilled or quantified, but instead are soft and impressionistic, the costs of information exchange will typically be lower where the participants are professionals linked together through trade associations, frequent dealings, and a common orientation 31 and language. Even where high-quality past performance data are available, however, there is no assurance that the fiduciary's future conduct will mirror the past. With respect to the more mundane forms of opportunism, such as shirking or the consumption of excessive perquisites, it is likely that the fiduciary's performance will not change abruptly. But an unblemished prior record can never provide a complete guarantee that the fiduciary will pass up the chance to make one big score at the principal's expense if such an opportunity presents itself in the future. Thus, the ex ante adjustment process, even where the principal is well informed, rarely will extract a proper measure of compensation for the more gran32 diose forms of opportunism.
28 See Jensen & Meckling, supra note 7 (developing a series of formal models premised on the theory that investors will reduce the amount they are willing to pay for debt or equity interests in the firm by an estimate of the costs of opportunism).
29 See 0. WILLIAMSON, supra note 22, at 15-16.
30 The usefulness of any such summary will necessarily depend on the extent to which it reflects the "pure" performance of the fiduciary rather than environmental factors over which she has no control, such as the performance of the economy in general. 31 See 0. WILLIAMSON, supra note 22, at 36 (discussing Leff, Injury, Ignorance and Spite-The Dynamics of Coercive Collection, 80 YALE L.J. 1, 26-33 (1970)). 32 Cf Cox, Compensation, Deterrence, and the Market as Boundariesfor Derivative Suit Procedures, 52 GEO. WASH. L. REV. 745, 753-55 (1984) (market for corporate control inferior to derivative suit in deterring one-shot breach of fiduciary duty); Easterbrook & Fischel, supra note 8, at 701
Of course, even in the absence of judicial intervention, many fiduciaries will not take advantage of the full range of opportunistic activities open to them. But so long as complete information on performance is not readily available to prospective principals, the honest and diligent fiduciary will suffer some of the same ex ante adjustment as her less worthy cohorts. In essence, she is forced to underwrite a portion of the latters' opportunism. To the prospective principal, all cats may look gray in the dark. The "good" fiduciary, therefore, should take steps to communicate and warrant her fidelity to prospective principals. Reputation is of special significance to the would-be fiduciary. 33 Professionalizing the fiduciary's occupation, engaging in self-regulation, and even inviting governmental regulation are among the strategies available to instill public confidence in the absence of standardized criteria for evaluating the fiduciary's performance. 3a In addition, the fiduciary may undertake "bonding" activities-self-imposed restrictions on her ability to engage in opportunism. 35 Because of the coordination and free-rider problems associated with restricting the risk of opportunism through principal-initiated monitoring activities, 36 fiduciary-initiated bonding may provide a more cost-efficient method of restriction, and thereby reduce the amount 37 of the ex ante adjustment to the fiduciary's compensation. We see a variety of examples of such bonding in the real world. Business lending relationships routinely deal with the borrower's opportunities to favor itself at the expense of its creditors by imposing contractual restrictions on the borrower's ability to do such things as incur additional debt or take assets out of the business. 38 The early practice of investment bankers serving on the boards of directors of the companies whose securities they underwrote as a method of instilling public confidence provides a good example of market-initiated bonding. 39 Contemporary examples of bonding in the case of conflicts between corporate management and shareholders are less prevalent but do exist. They in(various market mechanisms may be inadequate to deal with one-time defalcations); see also infra note 47 and accompanying text. 33 See Frankel, supranote 6, at 835-36 (discussing the commercial fiduciary's incentive to create reputation). Cf Darby & Karni, Free Competition and the Optimal Amount of Fraud, 16 J. L. & EcON. 67, 82 (1973) (incentive to build reputation as a form of capital investment by sellers of infrequently purchased experience or credence goods). For a provocative attempt to measure the value of reputation in the case of general partners in oil and gas limited partnerships, see Wolfson, EmpiricalEvidence ofIncentive Problems and Their Mitigationin Oil and Gas Tax Shelter Programs, in J. Pratt & R. Zeckhauser, supra note 7, at 101, 112-16. 34 See, eg., Pratt & Zeckhauser, supra note 7, at 29 (creation of self-policing associations and licensing requirements). 35 Jensen & Meckling, supra note 7, at 325-26. 36 See supra text accompanying note 27. 37 See Jensen & Meckling, supra note 7, at 326, 338-39. 38 See Smith & Warner, On FinancialContracting:An Analysis of Bond Covenants, 7 J. FIN. ECON. 117 (1979).
39 See V. CAROSSO, INVESTMENT BANKING IN AMERICA 32-33 (1970).
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elude the voluntary increase in the proportion of independent, nonmanagement directors on boards, the creation of audit, compensation, and nominating committees staffed by such outsiders,40 and the amendment of articles of incorporation to require management to submit to independent evaluation any takeover bid in excess of the current market 41 price of the corporation's stock. C. The Operation of the Ex Ante Adjustment Process-An Evaluation The foregoing concepts lead to some important observations about the real-world operation of the ex ante adjustment process. Because the availability and quality of this process will determine in large part the strictness with which the law must deal with the fiduciary, these observations are an important bridge to the latter sections of this Article. In their influential paper, Professors Michael C. Jensen and William H. Meckling developed a series of formal models demonstrating how, under certain assumptions, the fiduciary will bear the full costs of monitoring and bonding, as well as the estimated residual risk of opportunism. 42 The core assumptions that underlie this conclusion provide a good analytical structure for our evaluation of the ex ante adjustment process. At first glance, the conclusions of the Jensen-Meckling model concerning the allocation of costs may seem to reflect a completely unrealistic appraisal of the prospective principal's ability to assess and quantify the risks of opportunism and the effects of various kinds of monitoring and bonding upon these risks. The point is not, however, that the principal must be able accurately to predict the precise quantum of opportunism risk in any given situation, but that, on average, his predictions be right. More specifically, the model requires, first, that the predictions be "rational" in the sense that deviations from the estimate tend to cancel each other out over time, and, second, that these deviations be "independent" across the universe of alternative fiduciary opportunities available to the principal. In other words, the fact that fiduciary X engaged in more opportunistic behavior than had been estimated for the
40 See, eg., A.B.A. Sec. Corp., Banking & Bus. Law, Corporate Director'sGuidebook, 33 Bus. LAW 1591, 1619-20, 1625-27 (1978) [hereinafter cited as A.B.A. Corporate Director'sGuidebook]; Statement of the Business Roundtable, The Role and Composition of the Board of Directors of the Large Publicly Owned Corporation, 33 Bus. LAw 2083, 2107-11 (1978); Williamson, CorporateGovernance, 93 YALE L.J. 1197, 1219-20 (1984). 41 Consider, for example, the proposal adopted by the shareholders of Superior Oil Co. in May, 1983. The adopted proposal created an independent committee to consider any takeover offer for 45% or more of the company's shares, to determine whether the offer was fair, and, if so, to recommend acceptance of the offer to the full board. N.Y. Times, May 25, 1983, at Dl, col. 5. However, since the proposal was sponsored by a dissident shareholder and opposed by management, it is more an example of principal-initiated monitoring than of fiduciary-initiated bonding. For background on the controversy, see Family Feud at Superior Oil, N.Y. Times, Apr. 30, 1983, at L29, col. 2. 42 Jensen & Meckling, supra note 7.
period t has no bearing on how fiduciary Y behaved in that period; the behavior of each is independent of the other. This latter requirement assures that, notwithstanding the inherent uncertainty, the principal may, through diversification, enjoy a close correspondence between his ex ante estimate and the actual outcome. 43 The subsections that follow will examine each of these assumptions in detail. 1. Rationality.-The requirement of rationality in the JensenMeckling model supposes that principals will not systematically overestimate or underestimate the cost and residual opportunism risk associated with any combination of monitoring and bonding activities. Two factors, however, erode the principal's ability to make consistent, rational estimates of the true risk of opportunism, particularly as the form of opportunism in question becomes more idiosyncratic and speculative: the principal's "bounded rationality" and the ability of the fiduciary to manipulate the mix of bonding activities in his favor. Economists have employed the term "bounded rationality" to embrace the limits of classical economic models that are tied to the existence of a rational decisionmaker who is seen as setting out to maximize his or her welfare in the face of an uncertain future. In the words of Herbert A. Simon, author of the term, it refers to the fact that "[t]he capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required for objectively rational behavior in the real world44 or even for a reasonable approximation to such objective rationality." This principle not only suggests that there are limits to the operation of the ex ante adjustment process in general, but also leads to a recognition that ex ante adjustment is likely to work better for some kinds of fiduciary relationships and for some kinds of opportunism than for others. We have already seen some aspects of this. 45 In general, the principal's ability to anticipate opportunism will be shaped largely by his access to and ability to digest information about the performance of the particular fiduciary, or at least of those in comparable undertakings. Where the subject matter of the fiduciary relationship is not a standardized kind of transaction or where experience-rating information on the fiduciary's past performance is not available, the principal will be left to speculation and
43 Jensen and Meckling note that the effect of this uncertainty upon their model is minimal: For simplicity we ignore any element of uncertainty introduced by the lack of perfect knowledge of the owner-manager's response function. Such uncertainty will not affect the final solution if the equity market is large as long as the estimates are rational (i.e., unbiased) and the errors are independent across firms. The latter condition assures that this risk is diversifiable and therefore equilibrium prices will equal the expected values. Id. at 318. 44 H. SIMON, MODELS OF MAN 198 (1957); see also 0. WILLIAMSON, supra note 22, at 65-67 (applying bounded rationality to the problems of drafting contingent contracts); Simon, Rational Decision Making in Business Organizations,69 AM. ECON. REv. 493 (1979). 45 See supra text accompanying notes 29-32.
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intuition. Even where past information is available, it is unlikely to fore46 cast the risk of a one-shot fleecing. While it is impossible to say on an a priori basis whether the principal's bounded rationality will be more likely to lead to systematic underestimation or overestimation of the prospects of opportunism, it seems plausible to predict that the principal's naivet6 more often than not will lead him to seek inadequate compensation for the true risk.47 Even if this surmise is wrong and the principal's naivet6 leads to excessive caution and overestimation of the risk, the implications may be no more attractive. The fiduciary, who typically will be in a better position to evaluate the true risk, is unlikely to be willing to pay the price for the principal's unfounded cynicism. Further, to the extent that some biased estimation routinely exists, it is in the fiduciary's interest to exploit it. This is most apparent in the case of bonding activities. The fiduciary may gain at the expense of her principal by systematically employing those bonding activities that restrict her opportunistic behavior less than the principal perceives. For example, the investment advisor may find it more beneficial and less burdensome to convert his wardrobe from loud sport coats to pin-stripe suits in order to garner the faith of his clients than to promise them that he will spend every Saturday taking an advanced course in portfolio theory. A more familiar example of this phenomenon is the use of "decoy duck" corporate directors 48 with impressive credentials but little actual involvement in the business. Of course, this point is not entirely one-sided. The principal may be more aware of the implications of various forms of bonding than the fiduciary. For example, the large organization hiring a new employee fresh from professional school may be able to extract extensive bonding commitments in return, the true effects of which he or she will come to appreciate only over time. To summarize, the principal's bounded rationality and the fiduciary's capacity to manipulate the mix of bonding activities to her favor affect the principal's ability to make consistent, rational estimates of the true risk. The propensity of these two factors for causing systematic underestimations of the risk will depend upon the relative sophistication
46 See supra note 32 and accompanying text. 47 There is reason to believe that people tend to underestimate the probability and consequences of events that are difficult to imagine or beyond the realm of normal experience, including failure of complex systems; they also tend to have illusions of control, with resulting overly optimistic estimates of outcomes that are a matter of chance or luck. Brudney, Equal Treatment of Shareholders in CorporateDistributionsand Reorganizations,71 CALIF. L. REV. 1072, 1088 n.39 (1983) (citing authorities from various disciplines); see also Carney, Fundamental Corporate Changes, Minority Shareholders and Business Purposes, 1980 Am. B. FOUND. RESEARCH J. 69, 117-18 n.190. 48 The term is taken from Bishop, Sitting Ducks and Decoy Ducks: New Trends in Indemnification of CorporateDirectorsand Officers, 77 YALE L.J. 1078, 1092 (1968). See also Douglas, Directors Who Do Not Direct, 47 HARV. L. REV. 1305, 1317-19 (1934).
and experience of the principal vis-a-vis the fiduciary and the extent to which available data about the fiduciary's past performance shed light upon her tendency to indulge in the particular form of opportunistic behavior at issue. 2. Independence, Risk Aversion, and Diversification.-The second requirement of the Jensen-Meckling model-that the probability of deviation from the principal's ex ante estimate be independent across available opportunities-is more elusive than the requirement of rationality and raises the issue of risk diversification. Because the concepts of risk aversion and diversification permeate the analysis that follows, an 49 elaboration on the basic theory is necessary. Suppose a person is presented with the choice between two investments. Investment A is guaranteed to be worth $10,000 at the end of two years; Investment B presents a 50% chance of being worth $5,000 and a 50% chance of being worth $15,000. Even though the average or expected value of Investment B at the end of the period is equivalent to that of Investment A (i.e., $10,000), contemporary economic and finance theory holds that most investors will not be indifferent between the two alternatives. They will prefer Investment A because it permits them to organize their affairs with the assurance that exactly $10,000 will be available to them at the end of the period. This preference is referred to as "risk aversion." Thus, if risk-averse investors are willing to pay, say, $8,000 for Investment A (and thereby earn a risk-free 25% return over the two-year period), they may only be willing to pay $7,500 (and earn an expected 33% return) for Investment B. The extra 8% return on Investment B represents a risk premium to compensate investors for the inherent uncertainty. 50 The greater the variation in the possible outcomes of the investment, the riskier it is, and the higher the expected risk premium. Thus, a third alternative that poses a 50% chance of being worth $0 and a 50% chance of being worth $20,000 at the end of the period will be worth even less, say $7,000, to risk-averse investors. Modern portfolio theory teaches, however, that it is possible to elim49 For more detailed discussions of these concepts see V. BRUDNEY & M. CHIRELSTEIN, CASES AND MATERIALS ON CORPORATE FINANCE 59-70, 1143-55 (2d ed. 1979); W. KLEIN, BUSINESS ORGANIZATION AND FINANCE 145-55 (1980); Modigliani & Pogue, An Introduction to Risk and Return: Concepts and Evidence, FIN. ANAL. J., Mar.-Apr. 1974, at 68, May-June 1974, at 69. 50 Another way of looking at the investor's aversion to risk is to consider how much of a guaranteed amount, payable at the end of the two-year period, he or she would be willing to take in exchange for the risky combination presented by Investment B. As noted in the text, that investment has an end-of-period expected value of $10,000. But our risk-averse investor would presumably be willing to exchange Investment B for a guaranteed return on his or her $7,500 of anything in excess of 25%, that is, for a guaranteed payment of anything in excess of $9,375. Although this certain amount is less than the expected value of Investment B at the end of the period, it provides the investor with the same 25% risk-free return on his or her investment that he or she would obtain with Investment A. The $9,375 amount is therefore referred to as the certainty equivalent of the risky opportunity represented by the 50% probability of receiving $5,000 and the 50% probability of receiving $15,000.
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inate some risk through diversification. Suppose that instead of investing exclusively in Investment B, a risk-averse investor has the opportunity to
divide his or her funds equally among ten investments (Investments B'
through B lO), each presenting the same possible outcomes and probabilities. Thus, each of the ten alternatives provides the investor a 50% probability of receiving $500 and a 50% probability of $1,500.51 The expected end-of-period value of the ten-investment portfolio is still $10,000. But, to the extent the outcome under each of Investments B'
through B 0 is independent of each of the others, the investor's overall
risk is reduced considerably from what it would be if the investor concentrated his or her holdings on any one of the alternatives alone. Our in-
vestor will receive the low-end amount of $5,000 only if each of the ten
alternatives is worth $500 at the end of the period, and the chance of this, assuming the outcome of each is independent of the others, is 1 in 1,024.52 The probability that the total end-of-period value will be between $9,000 and $11,000 is 65.6%.53 Through diversification, then, the investor has attained much of the certainty presented by Investment A. Because the expected return of Investment B is significantly higher than that of Investment A (33% as opposed to 25%), we would expect investors to shift their funds out of Investment A and into diversified portfolios consisting of Investments B' through B o. The effect of this will be to bid down the expected return of Investment B, thereby eliminating the risk premium. On a more general level, finance theory holds that rational capital markets will not compensate the investor for risks that can be eliminated by rational diversification. In the above example it is critical to the result that the outcomes of Investments B' through B' 0 be independent of one another. Frequently,
51 Viewed differently, Investment B is analogous to the investor's fate being determined by a single flip of a coin, with the right to receive $15,000 if "heads" appears but only $5,000 if "tails" appears. By diversifying his or her holdings among Investments B through B" , the investor substitutes 10 independent coin flips, receiving $1,500 for each "heads" and $500 for each "tails." 52 When an event is done once and the likelihood of a certain outcome is 50%, the likelihood of that same outcome occurring every time when the event is done ten times in a row is 50% X 50% X 50% X 50% X 50% X 50% X 50% X 50% X 50% X 50%, which is equal to a probability of .00098. A probability of .098% indicates that ten identical outcomes will occur I in 1,024 times. 53 In general, if the probability of a particular outcome in any given trial is p, then the cumulative probability that the outcome will recur exactly k times in n trials is given by the following formula: (n!/kl[n-k]!)p'(1 -p)'-'
See B. LINDGREN & G. MCELRATH, INTRODUCTION TO PROBABILITY AND STATISTIcs 19, 33-34
(3d ed. 1969). Thus, in the hypothetical in the text, p, the probability that any given investment will be worth $1,500 at the end of the period, is 0.5 and n is 10. Under the formula, the probability that exactly 4 of the investments will be worth $1,500 at the end of the period (k =4) with the remaining 6 worth $500-so that the entire portfolio will be worth $9,000-is 0.205. The probability that 5 of the investments will be worth $1,500-so that the portfolio will be worth $10,000--is 0.246, and the probability that 6 of the investments will be worth $1,500-so that the portfolio will be worth $1 1,000--is 0.205. The total of these three probabilities is 0.656. In other words, there is a 65.6% chance that the portfolio will be worth between $9,000 and $11,000.
this will not be the case. The same factors that might cause Investment B 1 to be worth $500 at the end of the period-higher interest rates, excessive inflation, a bad frost, and so forth-might similarly affect Investment B 2 and the others. Thus, financial economists distinguish between systematic risk, that which generally affects all capital assets, and nonsystematic risk, that which is more asset-specific. Nonsystematic risk may be eliminated through diversification, but systematic risk may not. Thus, in a regime of rational and competitive capital markets, risk premiums should exist only to compensate investors for systematic risk. Applying the concept of risk aversion to our discussion of opportunism reinforces the conclusion reached in the preceding subsection that, in real life, the ex ante adjustment process is better suited to deal with the more mundane and ongoing forms of opportunism than the more egregious and episodic ones. Suppose a wealthy widow is choosing between two investment advisors to manage her money--0 (for Opportunism) and F (for Fidelity). She has surveyed the past performance of both and has concluded that for a variety of reasons (which, she suspects, include substantial shirking by 0), funds under F's management have outperformed those under O's by about 0.5% per year on average. Nonetheless, it is more convenient for her to employ 0. Provided that the annual fee she pays 0 is lower than what she would pay F by at least 0.5% of her invested assets, she is fairly compensated, ex ante, for O's inferior performance. She should not be permitted to complain after the arrangement is established that O's shirking has inflicted losses upon her because his performance does not measure up to the standards of F. While the exact level of shirking, and with it the return achieved by 0 on her portfolio, may vary from year to year, there is no reason to believe that it will depart widely from the observed past. The widow's rational estimation of the risk and insistence upon full ex ante compensation works no unjust hardship upon 0 and furthers efficient economic decisionmaking. 0 is forced to evaluate whether the pleasure he derives from the increased shirking is worth the reduction in fees. If a portion of O's consistently inferior performance is attributable not to shirking but, for example, to less astuteness in assessing economic trends, then the reduction in fees is simply part of the competitive weeding-out process of the market. Consider more idiosyncratic forms of opportunism. Suppose that our widow also estimates-ignoring for the moment the clear "bounded rationality" problems that impede any such estimation-that there exists a 1 in 200 chance that 0 will abscond with all her money in any given year.5 4 In theory, she could adjust for this risk as well, on an ex ante basis, by reducing O's fees by another 0.5%. But even assuming that 0
54 As the discussion in the preceding subsection of the text indicated, it is extremely doubtful that our widow will be able to make an evaluation of the risks of a one-shot fleecing on the basis of information specific to 0. Presumably, she would have to make a statistical judgment based on the
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would consent to this reduction, it will not be sufficient to make her indifferent to the existence of the risk, if she is risk averse. The 0.5% percent fee reduction represents the probabilistic equivalent of her assessment of the risk, but, in economic terms, the actual "utility" loss she would suffer by having her entire fortune dissipated will likely be much more than 200 times the annual "utility" gain she receives from the reduced fees. Thus, appropriate compensation would include not just the actuarial equivalent of the risk, but a healthy risk premium on top of it.55 To the extent the widow fails to anticipate this possibility of more blatant opportunism and demand compensation for it, she suffers a loss equivalent to not only the amount of the risk, but the risk premium she would have extracted as well. Conversely, if she does demand compensation, the "honest" investment manager must underwrite not only the residual perceived risk created by his inability to fully bond his honesty, but a risk premium resulting solely from the uncertainty of the situation as well. Finally, as the above discussion of portfolio theory suggests, the widow could reduce the overall riskiness of her position through diversification-for example, she could divide her funds among ten investment managers.5 6 However, this may impose costs of its own. It will no doubt generate increased transactions costs and may destroy any economies of scale created by entrusting all of her business to a single advisor.5 7 Thus, the ex ante adjustment process will tend to work more "painlessly" in the case of idiosyncratic opportunism if diversification is available to prospective principals at a relatively low cost. The risk premium to be borne by the entire class of fiduciaries will be lower and the harm inflicted upon any particular principal by the occasional defalcations that do occur will be dampened. Thus, to link the points made in this and the preceding
incidence of such fleecing within the entire class of fiduciaries to which 0 belongs, assuming such class-wide data could be compiled. 55 See supra text accompanying note 50. 56 A single investment manager represents a 0.5% risk of defalcation and a 99.5% likelihood of nondefalcation. If the investment is divided among ten investment managers, each representing a 99.5% likelihood of nondefalcation, the chance that the widow will lose nothing (the chance that at least one manager will defalcate) is reduced to below 99.5%. At the same time, however, though the risk that the widow will lose something is greater with 10 managers than with only one, the risk that she will lose more than 20% of her portfolio (e., that more than two of the managers would abscond) is only one in 100,000. In comparison, with one manager, the risk that she will lose everything is 50 in 100,000. Thus, as the principal's affairs are parceled out to more and more fiduciaries, the outcomes realized by the principal will come to conform more closely to the ex ante probabilities. Cf. Anderson, supra note 6, at 750-51 (discounting for the possibility of cheating in exchange transactions "is likely to be accurate only over a very large number of transactions"). 57 The existence of economies of scale relevant to the example in the text is reflected by the fact that the fees of many money managers, as a percentage of assets, are scaled down as the size of the portfolio increases. For example, the annual trustee fees of one Madison, Wisconsin bank are 0.6% on the first $200,000; 0.5% on the next $300,000; 0.3% on the next $1 million; and 0.2% on the remainder. United Bank & Trust of Madison, Trust Fee Schedule (Jan. 1981).
subsection with the discussion to come, the legal system's tolerance for episodic opportunistic behavior should be influenced not only by the capacity of prospective principals to anticipate it and extract ex ante compensation, but also by their opportunities for diversification. 3. Competitive Opportunities.-Finally,the Jensen-Meckling model implicitly assumes that alternative investment opportunities are available to the principal. If this is so, we can expect prospective fiduciaries to accept a full ex ante discount in order to meet the competition. But to the extent that the principal does not have such an array of competitive choices, there is no assurance that he can obtain full prospective compen5 sation ex ante. 8 Depending upon the alternatives, he may be forced to choose between either accepting less than full compensation or undertaking the activity himself. 4. A Recapitulation.-To summarize the foregoing subsections, we have seen that the reliability of the ex ante adjustment process as a solution to the problem of fiduciary opportunism is dependent on three factors. The first is the quality of the prospective principal's estimate of the opportunism risk. This will be a function of the principal's experience and sophistication and the availability of information concerning the fiduciary's prior behavior in comparable transactions. Further, it is likely that the principal will be better able to estimate the more routine and common forms of opportunism, such as shirking, than the more blatant and idiosyncratic forms, such as embezzlement. The second factor is the principal's capacity to diversify. Here again, diversification is less important where the form of opportunism is more routine and ongoing in its nature, so that realized behavior will not deviate as widely from the ex ante estimate. The third and final factor is the competitiveness of the market for the fiduciary's services. D. Ex Post Settlements The incentives created by the ex ante adjustment process make it in the fiduciary's self-interest to restrict herself as much as possible while negotiating the arrangement with the principal. After the terms have been set, however, these incentives disappear, and the fiduciary (under our assumed absence of a generalized enforceable fiduciary standard) is free to search for whatever loopholes she can find in the agreed-upon restrictions and to exploit them as she sees fit. Of course, to the extent that the fiduciary's performance over the course of the relationship may be evaluated and added to her cumulative reputation, incentives to abstain from opportunism continue to exist. 59 Again, however, these incen58 Cf. Pratt & Zeckhauser, supra note 7, at 17-18 (who receives benefit from reduction in agency costs depends on relative degree of competition among agents and among principals). 59 Compare Fama, supra note 7 (managerial labor markets achieve a form of ex post settling up for opportunism by revaluing the manager's human capital) with Levmore, supra note 27, at 60-61
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tives are likely to be stronger for more mundane forms of opportunism than for the one-time fleecing. Thus, an astute principal may want more comprehensive protection against this sort of "moral hazard" 60 problem. Possible solutions for the principal include keeping the duration of the arrangement short, retaining the opportunity to review the fiduciary's performance before deciding to renew the arrangement, and reserving the power to terminate the arrangement at will. 61 Alternatively, the principal could negotiate some form of ex post settling up with the fiduciary based on her performance. The problems with periodic review and ex post settling up are similar to those we have repeatedly encountered in connection with monitoring, bonding, and ex ante reputation review. Detailed performance evaluation ideally contemplates that the fiduciary's job description can be decomposed into a series of specific tasks and requirements, an attribute inconsistent with the specialized expertise and discretion characteristic of many fiduciary callings. 62 Thus, holding the fiduciary to a sort of inflexible checklist is not likely to generate the kind of overall performance the principal desires. 63 As a matter of feasibility, therefore, any ex post settling up typically will be based upon a generalized index of the outcome of the fiduciary's performance rather than the content of the performance itself.64 This necessarily introduces problems. First, the settling up will reflect not only the fiduciary's performance, but environmental factors beyond her control as well. Second, ex post settling up, of whatever form, will not eliminate all of the incentives for opportunism unless it shifts to the fiduciary all of the gains or losses she generates. 65 Along with being
(discussing reasons why the labor market may not provide adequate discipline for corporate managers). 60 For general discussions of the moral hazard phenomenon, see 0. WILLIAMSON, supra note 22, at 14-15, 34; Hirschleifer & Riley, The Analytics of Uncertainty& Information-An Expository Survey, 17 J. ECON. LIT. 1375, 1390-91 (1979). 61 See W. KLEIN, supra note 49, at 16-18; Epstein, Agency Costs, Employment Contracts, and Labor Unions, in J.PRAT1 & R. ZECKHAUSER, supra note 7, at 127, 136-41; Frankel, supranote 6, at 812-13. 62 See W. KLEIN, supra note 49, at 6-7; Anderson, supra note 6, at 749-50, 751-52, 757-59; Frankel, supra note 6, at 813-14; cf Alchian & Demsetz, supra note 21, at 786 (profit sharing by team members-rather than central monitoring-more likely where tasks involve discretion and specialization). 63 Cf 0. WILLIAMSON, supra note 22, at 56, 69 (discussing the difference between "consummate cooperation" and "perfunctory cooperation"). 64 For instance, in the investment manager example the client will consider only how his or her portfolio performed, not what research reports the manager read, what alternatives the manager considered, the manager's basis for the investment selections he or she made, the extent to which the manager shopped for the lowest available brokerage commissions, and so forth. 65 The only way to eliminate the risk of opportunism altogether is to assure complete alignment of the interests of fiduciary and principal. If the fiduciary is charged with 10% of the gains and losses, her incentives are different from those where she is charged with 100%; she has less to lose by diverting her time to pursuits more pleasurable than researching investments or by investing in a less
at odds with what the principal probably sought when he entered into the relationship in the first place, this will be unacceptable to the fiduciary if she is risk averse, since her compensation will turn on environmental factors independent of her performance. 66 Finally, the terms of any such less-than-perfect settling up may give rise to new kinds of incentives for opportunism. For example, a requirement that investment managers reimburse their clients ex post for any losses may lead the managers to be more diligent in searching out investments (for which they will presumably charge a higher fee), but also may provoke more conservative strategies than they might engage in if they were investing for themselves. Similarly, the incentive compensation arrangements of corporate managers may lead them to take excessive risks or to favor short-term performance at the expense of long-term returns. 67 In addition, any sort of performance evaluation that has an impact on the fiduciary's welfare provides incentives for the fiduciary to conceal or obscure any negative aspects of her conduct and highlight the positive ones. This possibility adds to the monitoring costs of the principal. 68 E. A Comparative Evaluation of the Ex Ante and Ex Post Processes
Notwithstanding its shortcomings, ex post settling up, where feasible, does enjoy a general comparative advantage over ex ante adjustment because it measures compensation on a situation-specific basis. Of course, where the principal can predict with accuracy the amount of loss from opportunism, it makes no difference whether he is reimbursed ex ante or ex post. As we saw in subsections II.B. and II.C., accurate predictions are more likely where (i) comprehensive past performance data exist to permit experience-rating of the fiduciary; (ii) the principal possesses sufficient sophistication and experience to evaluate this data; and (iii) the kind of opportunism at issue is more mundane and ongoing in its nature, so that the past is a reasonable forecast of the future. Where, on the other hand, the opportunistic activity is more episodic or where reliable data on the fiduciary's past performance are beyond the ken of the principal, the principal is left to conjecture based on whatever information or intuition he happens to have concerning the general incidence of the opportunistic activity in question. It is in this latter class of situations that ex post settling up is most attractive relative to ex ante adjustment. It eliminates the riskiness inherent in ex ante discounting for
attractive stock as a favor to a friend. See Alchian & Demsetz, supra note 21, at 780; Jensen &
Meckling, supra note 7, at 312-13.
66 See W. KLEIN, supra note 49, at 14-16; Shavell, Risk Sharing and Incentives in the Principal
and Agent Relationship, 10 BELL J. ECON. 55 (1979).
67 See generally Anderson, supra note 6, at 784-85; Frankel, supra note 6, at 811-12; Klein, supra note 19, at 1548 n.91, 1558 n. 134; Vagts, supra note 20, at 240-45.
68 See Stone, The Place of EnterpriseLiability in the Control of CorporateConduct, 90 YALE L.J.
1, 24 (1980) (increasing the penalties imposed upon an activity increases the incentives to cover up).
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events which are shrouded in substantial uncertainty 69 and surcharges fiduciaries based upon their actual conduct rather than upon an ex ante forecast of their propensities. But, in those cases where an accurate ex ante evaluation can be made, there are advantages in the ex ante process over the ex post one. First, transactions costs may be lower. As discussed in subsection D., there are problems inherent in working out adequate guidelines to evaluate the fiduciary ex post. An adequately informed ex ante arrangement avoids the need to draft such guidelines because the principal simply buys the level of performance suggested by the fiduciary's past track record. Second, also as mentioned in subsection D., ex post accounting requires that environmental factors be filtered out in evaluating the fiduciary's performance. How much of the loss incurred by the investment manager was attributable to unforeseeable developments in the economy? How much of the loss was attributable to his or her incompetence, bad judgment, or dereliction of duty?70 Because such environmental factors will tend to even out over time, the principal equipped with long-term past performance information may often be better able to forecast and price the fiduciary's "pure" performance ex ante than to distill it from realized outcomes ex post.7 1 This facilitates shifting the risk of environmental factors from fiduciary to principal, which, depending upon the relative risk aversion and diversification potential of each, may or may not be beneficial. We shall return to this notion of the relative advantages of the ex ante and ex post processes from time to time in the analysis that follows. III.
THE ROLE OF LEGAL INTERVENTION
The foregoing discussion permits us to evaluate how the legal system intermeshes with private incentives and protective devices to deal with the nonalignment of interests between principal and fiduciary and the resulting risk of opportunism. First and most fundamentally, the law imposes standardized obligations upon the fiduciary designed to compel her to act in the interests of her principal with a certain level of care and skill and provides the principal a remedy if the fiduciary fails to so act. The remedy serves as a form
69 See supra text accompanying notes 49-50, 54-55.
70 See Scott, CorporationLaw and the American Law Institute CorporateGovernance Project,35
STAN. L. REV. 927, 932, 945-46 (1983) (disussing difficulty of determining duty of care violationsas opposed to duty of loyalty violations---ex post). 71 The statement in the text is somewhat akin to Professor Fama's argument that the wage negotiation process in efficient labor markets operates to impose a form of ex post settling up, with environmental factors being evened out over time. See supra note 59. Cf. Scott, supra note 70, at 946 (market mechanisms are superior to courts and juries in distinguishing between bad decisions and bad luck).
of ex post settling up for departures from the standards. This may seem the kind of contribution whose merit is beyond dispute. Such a conclusion, however, is premature. The implication of the preceding section is that the fiduciary's behavior is not "bad" per se so long as the principal is appropriately compensated for it, either ex ante or ex post. And, while the preceding discussion revealed some of the defects and inefficiencies in both the ex ante and ex post processes, the imposition of standardized 72 legal obligations introduces defects and inefficiencies of its own. Thus, one cannot say a priori whether the imposition of standardized legal obligations upon the fiduciary is, given the alternatives available, a net positive contribution. In fact, what sections V and VI of this Article seek to establish is that current fiduciary regulation represents a hybrid of standardized legal obligations and ex ante compensation in a mix dictated by the relative strengths of each, given the relationship at issue. Before taking up the defects and inefficiencies embodied in a system of standardized fiduciary obligation in section IV, let us consider what, if any, peculiar institutional advantages a regime of standardized obligations, imposed as a matter of law, enjoys over the private ordering process described in section II. These advantages can be grouped into two clusters. The first involves reducing the transaction costs inherent in the private ordering process. The second involves the contribution of standardized legal obligations to the quality of the ex ante adjustment process. Standardized fiduciary obligations can reduce the transaction costs inherent in private ordering. Section II described how the ex ante adjustment process operated to surcharge the honest and diligent fiduciary to the extent that she could not voluntarily divest herself of the capacity for opportunism through bonding or distinguish herself through reputation or otherwise. Further, we saw that where the residual risk of opportunism embodied activities of low probability but considerable potential damage (such as outright embezzlement), the appropriate surcharge would include, absent diversification, a significant risk premium. This would be so unless the principal could be assured of the existence of an adequate ex post settlement process to detect and remedy the activity when it did occur. Yet, the creation of such an expost settlement process is inherenty costly because of the difficulties involved in working out the substantive terms of the restrictions and in putting in place a mechanism for ensuring their enforcement. Furthermore, the restrictions and the enforcement mechanism must be adequately communicated and warranted to prospective principals if they are to have an effect on the ex ante process. The law can supply both the content and the means of
72 These defects and inefficiencies are the risk and cost of error, the resulting uncertainty, and the expense of litigation. See infra text accompanying notes 91-116.
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enforcement through standard rules which prospective principals may learn and rely upon. Accordingly, several recent commentators have viewed fiduciary law as a low transactions cost alternative to ad hoc bargaining between fiduciary and principal, one that ideally adopts terms 73 they would have agreed to had they dickered them out. But the gains available from standardized obligations go beyond avoidance of the costs of requiring parties to come together and work out terms for themselves. Included as well in the notion of transactions costs are the costs associated with the "bounded rationality" of the parties when faced with the complexity and variety of opportunities for divergence of interests between fiduciary and principal. The imposition of legal obligations brings to the parties the collective experience of lawmakers in dealing with diverse forms of opportunism over the years, opportunism that may be beyond the immediate contemplation of the parties. Viewed thus, standardized obligations perform a sort of distributive justice function by endowing less experienced and less well-funded parties with state-of-the-art protection. This does not mean, however, that the obligations imposed upon the fiduciary as a matter of law should remain inviolate. Where the parties possess the capacity to make an informed and explicit modification of the law's standard-form deal to suit their particular needs, they should be permitted to do S0. 7 4 Such a capacity may well exist where the principal consists of a body of security holders participating in a market populated by institutions and other sophisticated investors. Thus, the legal process must be alert to the existence of private bargaining and avoid upsetting the apple cart when an informed modification of the standard set of duties has been agreed to by the parties. 75 This may seem self-evident, but at times it is overlooked by the courts.
73 See, eg., R. POSNER, ECONOMIC ANALYSIS OF LAW 302 (2d ed. 1977); Anderson, supra note 6, at 757-60; Brudney & Clark, A New Look at Corporate Opportunities,94 HARV. L. REv. 997, 999 (1981); Easterbrook & Fischel, supra note 8, at 702-03 (1982). But see Weinrib, supra note 6, at 3: For, however typical the history of the fiduciary obligation's evolution, the substance of the obligation appears to be strikingly unique. Although it functions within the context of planned transactions, its underlying premises are not those of individualistic private ordering. Thus it is present in the relevant relation except in the face of a specific exclusion and, far from embodying a standard which is universally and naturally accepted, it aspires to the pedagogic function of raising the morality of the marketplace by enforcing upon potential profiteers the abnegation of their profits. 74 See Anderson, supra note 6, at 760; Klein, supra note 19, at 1525-26. 75 The well-known corporate law case of Zahn v. Transamerica Corp., 162 F.2d 36 (3d Cir. 1947), provides a straightforward illustration. That case involved the Class A and Class B shares of Axton-Fisher Tobacco Co. (A-F). The Class A shares were convertible into Class B on a share-forshare basis, but upon liquidation were entitled to twice as much per share as the Class B. In addition, the Class A shares were callable at the option of A-F. Transamerica owned virtually all of the Class B and as a result dominated A-F's board of directors. In order to take exclusive advantage of the significant appreciation of A-F's tobacco inventory-a fact unknown to the Class A shareholders -Transamerica caused A-F's board to call the Class A shares at the fixed redemption price and then liquidate the corporation. In a suit by a Class A shareholder, the Third Circuit held that in so doing
The second cluster of advantages attributable to standardized legal obligations is their contribution to the quality of the ex ante adjustment process. Here, the important point is not so much the content of those obligations as the fact that they are standardized. For the ex ante adjustment process to operate effectively in compensating the principal for the prospect of opportunism, the parties must have some appreciation of how much and what kinds of opportunism the particular bonding and monitoring regime they have elected will permit. Where the regime is one of standardized form, data is available from the experiences of countless other relationships operating under a comparable framework. Over the years we have come to develop, for example, a general notion of how much latitude is afforded corporate managers by the "business judgment rule" or how effective outside auditors are in protecting against financial statement misrepresentation. If, by contrast, fiduciary relationships were to be governed by a diverse set of alternative, privately negotiated monitoring and bonding regimes, the results under one regime would not be as 76 readily generalizable to others. Legal rules can contribute to this process in a number of ways. In addition to imposing substantive obligations directly on the fiduciaries themselves, the law can prescribe uniform criteria for the various kinds of monitoring and bonding mechanisms. We saw in subsection IIC. 1. how the savvy fiduciary may subvert the ex ante adjustment process by employing those forms of bonding which restrict her less than the principal perceives. By regulating the content of commonly employed bonding and monitoring devices, the law can seek to conform them to the expecthe A-F board breached its duty to the Class A shareholders to exercise the call provision in a disinterested manner, and that the plaintiff was entitled to damages based upon what he would have received had the Class A been permitted to participate in the liquidation. While the board of directors ordinarily owes a fiduciary duty to all shareholders and cannot favor the majority over the minority, the Third Circuit's decision ignored the contract implicit in the classification of shares. By purchasing Class A shares, the Class A shareholders had bargained away the opportunity to participate as Class A in corporate value over and above the call price. Presumably, in a well-informed securities market, this was reflected ex ante in the price they paid for their stock. But as an additional component of their bargain, the Class A shareholders had the right to avoid the call by opting for Class B status through the conversion privilege. Thus, the true vice of the A-F board's action was to frustrate this part of the bargain by concealing the appreciated value of the tobacco so the Class A could not make an informed decision to convert. Accordingly, the appropriate measure of recovery should have been based not upon what the Class A holders would have received in the liquidation as Class A, but upon what they would have received had they converted to Class B and participated in the liquidation as such. This was ultimately recognized by the district court upon remand, and the Third Circuit concurred. Speed v. Transamerica Corp., 135 F. Supp. 176, 180-86 (D. Del. 1955), modified, 235 F.2d 369, 373-74 (3d Cir. 1956). 76 Compare the following observation by Professor Frankel: [W]ithout regulation the entrustor [i.e., the principal] cannot effectively bargain for protection from the fiduciary's abuse of power. Because the entrustor is generally unable to supervise the fiduciary, he can calculate neither the risk of abuse of power nor the amount of injury he might suffer. When the law regulates the fiduciary, the entrustor can determine the cost of the risk with greater certainty. Frankel, supra note 6, at 834.
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tations of principals. In doing so, the law promotes uniformity and ensures that experience data generated by the monitoring-bonding combination employed in a particular relationship can be generalized to other relationships employing the same combination. This assists the ex ante adjustment process. The imposition of stricter monitoring duties on outside directors and the regulation of independent auditors are examples of this phenomenon. Legal rules also can work to enhance the quality of the ex ante adjustment process by regulating the availability and quality of information regarding the past performance of particular fiduciaries. The disclosure and dissemination components of the federal securities laws, which furnish prospective investors with reliable track record information on a company's management, provide the obvious example. Regulating the availability and quality of such information also contributes to ex post settling up by assuring the accuracy of any performance information upon which the settling up may be based. Thus, for example, corporate managers whose compensation is tied to business profits are restrained from manipulating the books to inflate the apparent success of their efforts. This section of the Article has sought to provide something of a bridge between the discussion of private ordering in section II and the analysis of formal legal regulation of fiduciary decisionmaking in the sections that follow. This section has made the fundamental point that private ordering and legal regulation represent alternative sources of solutions, each with its own defects. Thus, the appropriate framework for analyzing legal rules is to view them as part of a tandem process with the private ordering mechanisms discussed in section II. Put simply, we should expect legal regulation to take on those kinds of judgments and problems where it enjoys a comparative institutional advantage over private ordering and defer the balance to the ex ante and ex post compensation processes and, at the same time, to make whatever contributions it can to improve the quality of those processes. One of the fundamental issues implicit throughout the sections that follow concerns the kinds of judgments and problems that the law has chosen to take on and the kinds that it has chosen to defer to private ordering mechanisms. IV.
THE OPERATION OF THE FIDUCIARY STANDARD
A.
Introduction
What we see as we survey the landscape of fiduciary law is a diverse and often inconsistent variety of legal rules. Where the fiduciary relationship takes the form of a trust or common law agency, the law's response has been rigorous. The fiduciary is held to a strict standard of care and loyalty and is generally prohibited from engaging in any trans-
action in which she has a personal interest. 77 Thus, for example, the trustee is forbidden from selling trust property to himself or herself, notwithstanding the fact that the terms of the transaction may be fair and represent the best deal available. 78 Even where the trustee obtains the beneficiary's consent to the sale, the transaction may be set aside if it is found that the trustee failed to disclose material information. 79 In the case of corporate law, on the other hand, the law's posture slackens considerably. Officers and directors are rarely held liable for negligence or incompetence unaccompanied by self-dealing. 0 As long as the terms are fair, management is generally free to engage in self-dealing.8 1 And while the formal doctrine imposes upon the officer or director the burden of proving "intrinsic fairness," the case law often reveals a less rigorous burden. 82 Indeed, the law has developed several devices that serve to shelter self-dealing from judicial scrutiny for fairness so long as the selfdealing has been approved by the members of the corporation's board of directors who have no personal stake in the transaction.8 3 Further, the formal doctrine itself, under the rubric of the "business judgment rule," protects some fiduciary decisions that have an obvious potential for selfinterested bias, such as management's response to a hostile takeover, and 4 thereby presumes these decisions to be disinterested and sound. Sections V and VI will consider these rules in more detail and seek to explain the apparent inconsistencies. The objective of the present section is to develop the analytical framework and the terminology that will be used in sections V and VI. The central thesis of the discussion that follows is that the differences in the various standards developed by the law to govern fiduciary decisionmaking may be explained in large part by two factors: (i) the relative cost of erroneously upholding opportunistic decisions versus that of setting aside proper ones, and (ii) the comparative ability of fiduciary and principal to deal with the resulting prospect of error through ex ante adjustment, ex post settling up, and diversification. B. The FiduciaryIdeal
An obvious starting point for coming to grips with the process of creating standardized duties to implement the fiduciary ideal is to consider, in terms of formal legal doctrine, what is involved in being a fiduciary. Perhaps the best places to turn for an answer to such a black-letter
77 See infra notes 119-25 and accompanying text. 78 See infra notes 119-20 and accompanying text.
79 80 81 82 83 84
See infra notes 133-38 and accompanying text. See infra notes 192-93 and accompanying text. See infra notes 151-52, 194-202 and accompanying text. See generally infra subsections VI.C.3.-5. See infra notes 214-34 and accompanying text. See infra notes 271-87 and accompanying text.
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question are the Restatements and related materials. The Restatement (Second) of Agency defines agency as a "fiduciary relationship" in which the agent consents to "act on [the principal's] behalf and subject to his control," 85 and describes the agent's fiduciary obligation in terms of a duty "to act solely for the benefit of the principal in all matters connected with his agency."' 86 Similarly, the Restatement (Second) of Trusts defines a trust as a "fiduciary relationship with respect to property, '8 7 with the trustee being under a duty "to administer the trust solely in the interest of the beneficiary." '8 8 A final formulation is supplied by the Model Business CorporationAct, which states that a corporate director shall perform his duties "in good faith" and "in a manner he reasonably believes to be in the best interests of the corporation." 89 Taken literally, each of these verbalizations of the fiduciary's dutyof-loyalty obligation imparts a completely subjective standard, looking solely at the motives and purposes underlying the fiduciary's conduct. The inquiries are whether an agent is acting solely for the benefit of the principal and whether a director reasonably believes he or she is acting in the best interests of the corporation. But there is an inherent "capability problem" 90 in translating the fiduciary ideal into substantive rules. Serious practical difficulties would surround the enforcement of any legal rule that turned upon, and depended upon proof of, what lay within the fiduciary's head. In response, the law has sought to develop objective criteria for enforcement by identifying those instances that present a special risk of bad faith motivation and subjecting them to special scrutiny. For example, the law provides special scrutiny whenever the fiduciary has a personal pecuniary stake in the outcome of the transaction that is potentially at odds with the interests of her principal. In such a case, as we shall see in sections V and VI, the level of scrutiny varies according to the subject matter area of the law into which the transaction falls. C. Type I and Type II Errorand The Tradeoff between Them In view of the fact that translation of the fiduciary ideal into a workable framework of judicial review requires, by its nature, courts and legislatures to speculate about the fiduciary's subjective motivation and decisionmaking process on the basis of her observable conduct, there necessarily will be occasional "mistakes." Some fiduciary decisions that are
85 RESTATEMENT (SECOND) OF AGENCY
1(1) (1957).
86 Id. 387.
87 RESTATEMENT (SECOND) OF TRUSTS 2 (1957).
88 Id. 170 (1).

89 MODEL BUSINESS CORP. ACT 8.30(a)(1), (3) (1984). See also RESTATEMENT OF RESTrruTION 190 comment a (1936) ("A person in a fiduciary relation to another is under a duty to act for
the benefit of the other as to matters within the scope of the relation."). 90 This term is taken from R. DANZIG, THE CAPABILITY PROBLEM IN CONTRACT LAW 1-3
(1978).
in fact consistent with a good-faith attempt to act in the best interests of the principal will be prohibited or invalidated, and some that are not will be upheld. The prospect of such legal "mistakes" 91 is, of course, not peculiar to the fiduciary area. In any branch of the law, there is the potential to produce outcomes at odds with the intent of the rules. But the risk is aggravated in the fiduciary area where the operative legal question-"what were the fiduciary's true motives?"-is at least one step removed from the observable legal fact-the decision that the fiduciary made. Thus, the process of asking whether the fiduciary was motivated strictly by a desire to serve her principal is, by its nature, more speculative than asking whether the defendant in a contracts case did in fact promise the plaintiff to do X or whether the defendant in a torts case did in fact strike the plaintiff. The inherent possibility of any set of legal rules to produce such mistakes in evaluating the fiduciary's conduct is depicted in the chart below.
Possible Outcomes of Judicial Review Character of Fiduciary's Decision in Fact
Legal Response Transaction Upheld (Correct Outcome)
#3
Good Faith Decision
Opportunistic Decision
#1
#2
(Type I Error)
#4
Transaction Invalidated (Type II Error) (Correct Outcome)
Boxes #1 and #4 represent, respectively, instances in which the legal system has correctly identified and upheld a decision made by the fiduciary in good faith 92 and correctly identified and set aside an opportunistic decision. 93 An "ideal" legal system would succeed in confining all
91 The use of the term "mistakes" is, admittedly, troublesome. It might strike some readers as overly simplistic to the extent that it suggests there is one and only one set of terms that a prudent, arm's-length decisionmaker would reach, and any departure from these terms is wrong. Obviously, different people have different ideas on what a satisfactory bargain is. This is the root of the problem. In a sense, a court will never be "wrong" because it is virtually inevitable that there would be some independent decisionmaker, somewhere, who would share the court's conclusion as to what the bargain should be. Still, the court's view may nonetheless depart from the consensus that most independent decisionmakers would have reached. The terms "mistake" and "error" are used, therefore, to reinforce the notion that, inherently, there can be no assurance that the court's notion of what should be upheld mirrors the terms the parties would have reached had they been dealing at arm's length. We can never know just what those terms would have been, but we do know there is the inevitable risk that the court will "miss" them, sometimes on the high side and sometimes on the low side. The undeniable existence of this risk is the key to the analysis that follows. 92 A good-faith decision here means one that is consistent with what the fiduciary would have done had she been disinterested. 93 This categorization scheme is more loyal to the law's notion of what being a fiduciary involves than one which is defined in terms of whether the decision was "good" or "bad" or whether it was
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cases of fiduciary decisionmaking to these two boxes, and would do so in a cost-free manner. Since no such ideal system exists, however, there is the inevitable possibility that some opportunistic decisions will be upheld (Box #2) or that some good-faith decisions will be set aside (Box #3). Borrowing the terminology of statistics, these two different kinds of mis94 takes are respectively referred to as "Type I" and "Type II" errors. Seen from this perspective, the fundamental objective of judicial review of fiduciary decisionmaking is to develop those rules and procedures that minimize the risk of error. Whatever rules and procedures are considered, they necessarily are imperfect, and some residual risk of both Type I and Type II error will remain. Further, there is a tradeoff between the two types of error; subjecting fiduciary decisions to more rigorous judicial scrutiny may reduce the risk of Type I error, but it will do so at the expense of enhanced risk of Type II error and vice versa. Thus, at the heart of any evaluation of judicial review of fiduciary decisionmaking must be consideration of not only its reduction of the risk of mistake in general, but also the balance it strikes between residual Type I and Type II risks. The assessment of this balance depends upon the types of costs that each type of error produces. . The "Costs" of Errors
A Type I error may be created in one of two ways. First, the legal system may not be sensitive enough to detect the existence of opportunistic decisionmaking by the fiduciary when a particular decision or pattern of conduct is challenged by the principal. Also, using the concept of Type I error more broadly, the principal-for any number of reasons, such as costs or concern for upsetting an otherwise good relationshipmay not discover or be willing to challenge the opportunistic behavior. Under either source of error, the result is the same. The principal incurs a direct loss of value in the form of suffering a kind of transaction, a set of terms, or a level of costs that he would not have suffered had the
"beneficial" or "detrimental" to the principal's interests. The essence of the obligation is a requirement that the fiduciary act in a disinterested and prudent manner to further her principal's interests. Inevitably, conduct adhering to this requirement will nonetheless produce some bad or detrimental decisions, just as a principal, when making decisions on his own behalf, will select courses of action that turn out to be bad or detrimental. 94 In statistics, the term "Type I error" refers to the possibility of rejecting a true hypothesis; the term "Type II error" refers to the possibility of accepting a false one. See, e.g., R. LARSEN & M.
MARX, AN INTRODUCTION TO MATHEMATICAL STATISTICS AND ITS APPLICATIONS 249-50
(1981). In the format employed in the text, the "hypothesis" to be tested is that the divergence of interest between fiduciary and principal led the fiduciary to act other than in the principal's best interests. Upholding the transactions where this hypothesis is in fact true is analogous to the statistician's Type I error; setting the transaction aside where it is false is analogous to Type II error. Other legal commentators have employed this framework in different areas. See Miller, An Analytical Framework, REGULATION, Jan.-Feb. 1984, at 31, 32; Joskow & Klevorck, A Frameworkfor Analyzing PredatoryPricing, 89 YALE L.J. 213, 223 (1979).
decisionmaker acted in a disinterested manner. This loss to the principal may or may not be offset by an equivalent gain to the fiduciary. 9 5 It is the existence of the possibility of some Type I error that provides the fiduciary her incentive to engage in opportunism; if she were assured of getting caught, she would not chance it. The greater the risk of Type I error, the stronger this incentive. And, in turn, it is the principal's perception of this possibility that creates the incentive to take advantage of the various forms of protection described in section IImonitoring, ex ante adjustment, and ex post settling up. As we saw in that section, this process may cause at least some of the resulting costs of Type I error to be shifted back to the fiduciary. The extent to which this will occur depends upon the principal's capacity either to estimate the risk of opportunism in advance, extract appropriate compensation and diversify against the residual risk, or to determine the existence of opportunism in retrospect and put in place a suitable settling up mechanism. The costs and consequences of Type II error are the mirror image of those for Type I error. Type II error serves in the first instance to shift value from the fiduciary to the principal by permitting the principal to exploit the imperfections of the legal process and recover from the fiduciary even though the fiduciary's decisionmaking was not improperly motivated. Thus, the principal is permitted to shift to the fiduciary a risk that the principal should properly be viewed as having assumed. Alternatively, the principal is permitted to recover profits properly due the fiduciary or to receive the services he bargained for without paying for them. As this formulation makes clear, the expected cost to the fiduciary for Type II error is determined not only by the level of the risk of error but also by the nature of the legal remedies available to the principal. This point will be illustrated in the next subsection. Not surprisingly, the existence of Type II error and the resulting costs to the fiduciary create an incentive for the fiduciary to initiate ex ante or ex post private ordering arrangements of her own in order to pass the cost of error back to the principal. She may, for example, insist upon higher fees to offset the risk of Type II error or to cover the expenses of reducing the risk through bonding-like activities such as third party review of the fairness of the transaction. With respect to either Type I or Type II error, there is the inevitable possibility that private ordering will not suffice to give one or both of the parties adequate protection against the risk of error they perceive. In
95 In cases of self-dealing, there may be a direct one-for-one offset. For example, where the agent buys land from herself on behalf of her principal at an above-market price, the principal's loss is the agent's gain. Suppose, however, the agent incurred costs in concealing her identity as the true seller. Or suppose that the land, in addition to being overpriced, was poorly suited to the principal's needs. In these cases the principal's total loss exceeds the agent's net gain. Further, in cases of shirking, pet projects, or protection of tenure, there is no assurance that the benefits the fiduciary derives will bear any correspondence to the loss the principal incurs.
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that case, their choice will be either to walk away from the relationship or simply to bear the residual risk that ex ante or ex post compensation cannot shift. Whether a party decides to walk away from the relationship will be determined by the residual, noncompensated risk of error he or she perceives and the availability of substitutes. The more attractive the substitute opportunities, the more readily the party will walk away in light of a given level of perceived risk. The Chief Executive Officer of a public corporation has no choice but to sell her services to the corporate principal she controls, even though there is some risk that the resulting price may be attacked as unfair.96 The trustee, on the other hand, faced with the prospect of selling a trust asset that he himself desires to buy, may well be led by the possibility of Type II error inherent in a challenge of a sale to himself to instead sell the trust asset to a third party (or forgo the sale) so long as some roughly comparable asset is available to him from an independent party. The result may be that both the trustee and the beneficiary are worse off as a result of the prospect of Type II error because a mutually advantageous opportunity falls by the wayside. In this sense the cost of error is borne by both parties. In summary, then, the effect of legal intervention through the imposition and enforcement of standardized fiduciary obligations is to shift the focal point of the private ordering process from the principal's attempts to deal with the prospect of unchecked opportunism, as was discussed in section II, to both parties' attempts to deal with the inevitable prospect of error produced by that legal process. This implies that the law's attention in fashioning rules to balance the competing risks of Type I and Type II errors should not be on the direct costs of those errors, but only on those residual costs that cannot be eliminated by the parties through either resort to market substitutes for the conflict-of-interest transaction or implementation of cost-efficient private ordering. For example, proposed rule A may create some risk of both Type I and Type II errors. In contrast, proposed rule B might effect a reduction in the risk of Type I error but at the expense of a radical increase in the risk of Type II error. Nonetheless, if the fiduciary is in a better position to obtain compensation for the risk of Type II error than the principal is in to obtain compensation for the risk of Type I error, rule B might be the "better" rule, despite the greater aggregate amount of error.
96 The Chief Executive Officer is, of course, always free to resign and sell her services to another employer. But because her experience is specific to her present corporation, her services may not have the same value elsewhere. (The general problem of unique benefits available only through selfdealing is discussed in subsection VI.C.5. infra). Further, if the Chief Executive Officer resigns and takes a similar job with another corporation, the same problem remains. In other words, the phenomenon of self-dealing as the only realistic alternative inheres in the inescapable fact that some persons will be in control of the corporate principal that employs them.
E.
Strategic Responses to the Prospect of Error-Some Illustrations
Let us consider the implications of the foregoing discussion from the perspective of the fiduciary's strategic decisionmaking. The previous subsections have made several observations relevant to this process. Because the effect of Type I error is to allow the fiduciary to engage in opportunism and not be penalized, the possibility of Type I error gives the fiduciary an incentive to engage in opportunism. The direct effect of Type II error, on the other hand, is to surcharge the fiduciary with the risk of loss, which she may seek to shift back to the principal either ex ante or ex post. The measure of this risk depends on the nature of the legal remedies available to the principal, because it is created by the principal's ability to exploit the possibility of Type II error and obtain legal relief against the fiduciary even though she has acted in good faith. The fiduciary's ultimate behavior in the face of this risk will depend upon the alternatives available to her. A series of numerical examples will prove useful in illustrating these abstract concepts and will provide raw material for some of the discussion that follows. Suppose that the Chief Executive Officer (C.E.O.) of a publicly-held corporation exercises sufficient control over the board of directors to persuade it to set her salary at any amount she chooses between $300,000 and $500,000. Let us assume that the "correct" level of salary for the C.E.O. is $400,000. 9 7 In a world of certainty, characterized by unanimous agreement among all independent decisionmakers on what the C.E.O.'s salary should be, the C.E.O.'s choice would be clear. She would agree to a salary of $400,000. Given this assumed unanimity of viewpoint, that amount would be upheld if challenged by shareholder litigants and any higher amount would be set aside. Suppose, however, that the C.E.O. appreciates that there is room for considerable difference of opinion on what a fair salary would be. Specifically, she estimates that there is a 25% chance that a judicial decisionmaker would regard $500,000 or more as the fair amount, a 50% chance that it would regard $400,000 as the fair amount, and a 25% chance that it would regard only $300,000 as the fair amount. To tie this into the terminology developed so far, she perceives a 25% chance that a court would uphold an amount higher than the hypothetical arm's97 "Correct" here means the amount that an arm's-length decisionmaker, in good faith, would pay for the given character and quality of the C.E.O.'s services. It is, of course, unrealistic to suggest that there necessarily is one single "correct" amount that every arm's-length decisionmaker would invariably decide upon. See supra note 91. As the next sentence in the text makes clear, there will be differences of opinion and differences in bargaining ability, with the result that we would expect to see a range of possible arm's-length bargains in the real world. The problems with using this range concept as the touchstone for evaluating the fiduciary's decisionmaking will be formally addressed in subsection VI.C.5.. For purposes of the illustrations in this subsection and in order to simplify the analysis, it will be assumed that all arm's-length decisionmakers would agree to the same amount of compensation. This simplification will not affect the substance of the discussion.
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length amount of $400,000 (analogous to Type I error) and a 25% chance that a court would reject that arm's-length amount as unfairly high (analogous to Type II error). How should the C.E.O. strategically respond? 98 If the potential liability she faces is damages measured by the difference between the amount set by the board and what the court regards as the fair amount (in effect, a de novo judicial determination of the fair value), her optimal strategy is to insist upon a salary of $500,000, the maximum amount. It provides her with an expected salary, net of possible liability for damages, of $400,000, the perceived arm's-length
amount. 99 But if she were to settle for that $400,000 amount in the first
instance, her expected salary would drop $25,000 to $375,000.1 As this illustration shows, it behooves the C.E.O. to insist upon a $500,000 salary even though there is only one chance in four that this amount will be upheld. This is necessarily the case where the applicable legal remedy involves a de novo judicial determination of the fair amount. The terms set by the fiduciary work as a "cap" on what she may receive because judicial review of the fiduciary's decision is a oneway process and the court cannot conclude that the fiduciary has treated herselfunfairly and impose liability upon the principal. It is therefore in her interest to select the most attractive terms that she thinks the law might uphold.10 1 In effect, what occurs when the C.E.O. insists upon a $500,000 salary is that her exploitation of the Type I possibility that this amount will be upheld offsets the Type II possibility that the arm'slength amount of $400,000 will be set aside. The opportunity for this exploitation provides the ex ante compensation for the prospect of ad98 The discussion that follows assumes that the fiduciary is risk neutral and that there are no costs associated with litigating the propriety of her conduct. Both these assumptions will then be dropped in the analysis contained in subsection IV.G. 99 The expected salary is determined by "expected value" analysis. "Expected value" refers to the average of the possible outcomes with each outcome weighted by its associated probability. Thus, if the C.E.O. persuades the board to set her salary at $500,000, there is a 25% chance it will be upheld; a 50% chance the court will conclude $400,000 is the fair amount and impose damages of $100,000; and a 25% chance the court will conclude $300,000 is the fair amount and award damages of $200,000. Thus, the C.E.O.'s expected net salary (after litigation) is $400,000 (le., $500,000 X 0.25 + $400,000 X 0.5 + $300,000 X 0.25). 100 By settling for $400,000, the C.E.O. forgoes the $500,000 opportunity, but now there is a 75% chance that the salary will be approved. As a result, her expected net salary drops to $375,000 (ie., $400,000 X 0.75 + $300,000 X 0.25). 101 It should be pointed out that the discussion in the text reflects an important (and controversial) assumption about the response of the courts in applying a fairness test to review fiduciary conduct. This is that the probability that a particular level of compensation will be found to be "fair" is independent of the price initially approved. But it may be the case, for example, that a court would be more willing to accept $400,000 as the fair amount if that is the figure set by the board than it would be to accept $400,000 as the fair amount if the board had chosen $500,000. In other words, having concluded that the $500,000 figure is excessive, the court, now suspicious of the board's independence, may be more willing to impose the lower amount of $300,000. If that is the case, the conclusions reached above will be altered. This point will be developed further in subsection VI.C5.
verse error, so that the net expected amount she receives, ex ante, is the arm's-length amount of $400,000. Next, consider what happens when we expand the available legal remedies to include rescission of the underlying transaction and also create the prospect of alternative, non-self-dealing opportunities. To facilitate these elaborations, let us vary the facts of the hypothetical so that it deals not with the C.E.O.'s salary but with her sale of an invention she developed to the corporation that she controls. For convenience, the dollar amounts and probabilities will be the same as those in the previous example. Unlike the redetermination remedy of damages, where the transaction is upheld, but at a price redetermined by the court, rescission has an "all or nothing" character to it. The price set by the fiduciary is, in effect, an offer to the reviewing court, which the court may either accept (by upholding the transaction) or reject (by setting it aside). The lower the price, the higher the probability that the transaction will be upheld. Thus, under our hypothetical facts, the C.E.O. estimates that there is a 25% chance that a court would uphold a $500,000 price for the invention and a 75% chance that it would uphold a $400,000 price. The C.E.O.'s strategy now will turn on the alternatives available. Suppose that the invention may readily be sold to independent third parties for the arm's-length price of $400,000. In this case, the C.E.O.'s best strategy will be to sell it to the corporation for the high-end price of $500,000. There is one chance in four that the court will uphold it, and if it doesn't, the C.E.O. can always obtain $400,000 from others. In this situation, she has nothing to lose. But suppose, on the other hand, that a sale to the corporation the C.E.O. controls presents a unique opportunity in the sense that the invention in fact has a greater value to the corporation than to third parties. Specifically, while the arm's-length price to the corporation is $400,000, third parties would be willing to pay no more than $300,000. On these assumed facts, it is in the C.E.O.'s interest to exercise some self restraint and accept a $400,000 price from the corporation in order to reduce the risk that the transaction will be set aside and the mutually advantageous opportunity of selling to the corporation foreclosed. 102 The availability of alternatives is important in the damages case as
102 Under the expected value analysis, see supra note 99, if the C.E.O. sells the invention to her corporation at $500,000, there is only a 25% chance that the sale will be upheld. Therefore, there is a 75% chance that the transaction will be rescinded and that the fiduciary will be forced to sell the invention to third parties for $300,000. The expected value to the C.E.O. of a sale at $500,000 then is $350,000 (i.e., $500,000 X 0.25 + $300,000 X 0.75). In contrast, because there is a 75% chance that a sale at $400,000 will be upheld and there is only a 25% chance that the fiduciary will have to sell the invention for $300,000, the expected value of a sale at $400,000 is $375,000 ($400,000 X 0.75 + $300,000 X 0.25). The comparison of the sale at $500,000 and the sale at $400,000 here ignores the possibility that, if the sale at $500,000 is rescinded, the C.E.O. may be able to negotiate a better deal with the corporation at, say, $400,000.
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well but produces a different kind of impact. Under a damages remedy, the existence of alternatives will determine whether or not the C.E.O. elects to sell the invention to the corporation but will not affect her pricing decision once she decides to do so. As computed above,10 3 so long as the fiduciary sets the price to the corporation at $500,000, her net expected proceeds after damages have been assessed will be $400,000. Thus, if she has no alternative buyers at the $400,000 amount, her opti4 mal strategy, assuming she is risk neutral, 10 is to sell to her corporation at the $500,000 price. Of course, if she has alternative buyers willing to pay more than $400,000, she should sell to them. On the other hand, if rescission is the only available remedy, the C.E.O. should sell to the corporation for $500,000 in the first instance, even if she has other buyers willing to pay more than $400,000 (but less than $500,000) in order to take advantage of the one-in-four possibility that the $500,000 price will be upheld. The addition of the rescission remedy introduces further strategic considerations for the fiduciary where the subject of the transaction is a risky opportunity whose future value is uncertain at the time of the transaction. Because the principal may be expected to adopt the transaction if it turns out well but challenge it if it turns out poorly, the fiduciary's exposure to loss through Type II error will be determined by the amount of "downside" risk and will not be mitigated by the potential for "upside" gain, no matter how great. To illustrate this point, suppose that the fiduciary is considering the purchase of two alternative investment opportunities on the principal's behalf. Both cost $100,000 and the fiduciary has a similar conflict of interest (and, therefore, exposure to Type II error) as to each. Alternative #1 poses a 50% chance of being worth $120,000 at the end of one year and a 50% chance of being worth $90,000, for an expected value of $105,000. Alternative #2 poses a 50% chance of being worth $140,000 and a 50% chance of being worth $80,000, for an expected value of $110,000. Assuming the principal is risk neutral, he would favor Alternative #2. But if the prospect of Type II error attached to the two alternatives is the same, the fiduciary will favor Alternative # 1 because her loss exposure there, if the transaction goes sour and is invalidated, is only $10,000 compared with $20,000 for Alternative #2. F. Modes of Judicial Review The law employs three modes of judicial review to enforce the fiduciary ideal. The first is "per se prohibition." A per se prohibition abso103 See supra note 99 and accompanying text. 104 See supra note 98. If the C.E.O. were risk averse, she might prefer a sale to a third party at a price of, say, $390,000 which was immune to modification, over the sale to the corporation for $500,000 which might net her only $300,000 after damages.
lutely prohibits the fiduciary from doing X.10-5 The second mode, "safe harbors," is the opposite of per se prohibition. Once conduct is found to be within the safe harbor, it is immune from further judicial scrutiny. The third mode is "ad hoc review." It is the middle category. In ad hoc review, conduct is examined to determine whether it is "intrinsically fair," "fair and reasonable," or some similar legal formulation, and the inquiry requires that all the facts and circumstances accompanying the 16 0 transaction be taken into account. When the legal system defines standards to govern fiduciary conduct, it is essentially spelling out the boundary between one mode of review and another. The traditional notion of "bright-line" legal rules represents a standard bounded on one side by a per se prohibition and on the other by a safe harbor. Conduct below the standard will be prohibited; conduct exceeding it will be permitted. Alternatively, standards may be employed to designate the boundary between per se prohibitions and ad hoc review or between ad hoc review and a safe harbor. Transactions falling short of the lower standard may be automatically invalidated; those exceeding the lower standard but falling short of the higher standard are subject to fairness review; those exceeding both standards are automatically upheld. A rule adopted by various state Blue Sky law administrators exemplifies all of these possibilities. According to the rule, the annual advisory fees and expenses of a mutual fund may not exceed some predetermined percentage of the fund's net assets. 10 7 Some jurisdictions may apply this rule in the traditional "bright-line" way; that is, any amount of fees and expenses above the standard is prohibited, and
105 Per se prohibitions may be relationship-specific, transaction-specific, or terms-specific. One example of the first type is a rule barring directors from dealing with their corporations. See infra notes 139-40 and accompanying text. An example of the second type is a rule barring directors from borrowing money from their corporations. See, e.g., ALASKA STAT. 10.05.213 (1985); D.C. CODE ANN. 29-304(6) (1981); Miss. CODE ANN. 79-3-89 (1972); NEB. REV. STAT. 21-2045 (1983); N.D. CENT. CODE 10-19-46 (1976) (repealed 1985); OKLA. STAT. tit. 18, 1.175 (1981). An example of the third type is a rule barring directors from borrowing money from their corporations at rates lower than two points above prime. Cf., eg., 12 U.S.C. 375a, 375b (1982); 12 C.F.R. 215 (1985) (restrictions on loans by banks to their officers and directors). 106 Over time, the process of submitting a series of similar transactions to ad hoc review may generate either per se prohibitions or safe harbors. An illustration of this process of generalization is the decision in Singer v. Magnavox Co., 380 A.2d 969 (Del. 1977), that a merger for the sole purpose of freezing out minority shareholders violates the requirement of entire fairness. Id. at 978-80. This aspect of the Singer decision was later overruled by Weinberger v. UOP, Inc., 457 A.2d 701, 715 (Del. 1983) (en banc). Another illustration of the development of per se prohibitions within the ad hoc framework is the position of some courts that directors may not justify usurping a corporate opportunity with the argument that the corporation was financially unable to undertake the opportunity on its own. See, e.g., W.H. Elliott & Sons v. Gotthardt, 305 F.2d 544 (1st Cir. 1962); Irving Trust Co. v. Deutsch, 73 F.2d 121 (2d Cir. 1934), cert. denied, 294 U.S. 708 (1935); Annot., 16 A.L.R.4th 185 (1982); Brudney & Clark, supra note 73, at 1020-22. 107 See, eg., Central Securities Administrators Council, Statement of Policy on Open-End Investment Companies C, I BLUE SKY L. REP. (CCH) 5403 (expenses may not exceed 11 /2% of first $30 million of net assets and 1% of any additional net assets).
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any amount below it is allowed. Other jurisdictions may interpret the rule as designating a boundary between a per se prohibition and ad hoc review; that is, any amount of fees and expenses above the standard are prohibited but amounts below it are reviewed on a case-by-base basis. Still other jurisdictions may interpret the rule as creating a boundary between ad hoc review and a safe harbor; that is, amounts of fees and expenses below the standard are not questioned, but amounts exceeding the standard are reviewed on a case-by-case basis. G. The Tradeoff between Errorand Certainty Resort to standards as an alternative to pure ad hoc review raises the question of increased error. Standards are justified only on the premise that instances of appropriate and inappropriate fiduciary behavior can be neatly sorted out on the basis of earmarks that both transaction planners and after-the-fact adjudicators can identify with ease and certainty. Thus, a per se prohibition reflects a conclusion that the risk of opportunism is all-pervasive across the category of transactions bearing the requisite earmarks. In other words, the costs of any Type II errors that might result from striking down all transactions within the category are more than offset by the gains from completely eliminating the risks of Type I error. Safe harbors reflect just the opposite conclusion. Of course, the universe of possible fiduciary decisions is vast and the underlying facts complex. Furthermore, the instances of proper decisionmaking typically are not so homogeneous that their essence may easily be captured through a single bright-line test. Ad hoc review may therefore be seen as the only viable means of holding both Type I and Type II error to an acceptable level. But minimizing the level of Type I and Type II errors is only one piece of the picture, The unique attribute of bright-line standards is that they permit the parties involved to predict accurately how the courts will respond if the fiduciary's decision is challenged. The ensuing certainty reduces both the risks and the transactions costs associated with litigation. This certainty creates value in and of itself which may serve to offset value lost through increased error. To illustrate, let us return to the example of C.E.O. compensation employed above in subsection E. Recall that the arm's-length value of the C.E.O.'s compensation was $400,000 and the C.E.O. estimated that, under ad hoc review, there was a 25% chance a court would find $500,000 to be the fair amount, a 50% chance for $400,000, and a 25% chance for $300,000. Contrast this with the operation of a bright-line standard. Suppose, for example, a corporate safe harbor law permits any annual compensation for the Chief Executive Officer of a public corporation less than or equal to the sum of $100,000 plus 0.01% of the corporation's annual profit. Similarly, any compensation in excess of that amount is prohibited per se. The certainty aspect of the rule is beyond question; anyone
familiar with it can determine on a moment's reflection exactly how the legal system would respond to a given salary arrangement. But some cases of Type I error will occur as lackluster C.E.O.'s are permitted amounts well in excess of their true worth. And there will be some cases of Type II error as talented C.E.O.'s cannot be paid their true worth. Sooner or later critics will emerge to attack the rule as arbitrary and unfair. They will argue that the rule is a senseless hurdle to unprofitable corporations that need to attract higher quality management in order to turn themselves around; that the rule is a boondoggle for the heads of the corporate giants; and that each C.E.O. should be judged on his or her own merit. Phrased in the vocabulary of this Article, they would say that ad hoc review is preferable to this particular bright-line standard. The argument here is that the performance of individual C.E.O.'s varies too widely to permit the law to create a hard-and-fast standard applicable to all. No such standard-even one which varies with the level of corporate profits--can sufficiently approximate the result of arm's-length bargaining. Thus, the argument concludes, ad hoc review is necessary. But even though resort to the standard-based mode of review may, in any particular case, result in overcompensation due to Type I error or undercompensation due to Type II error, does it follow that the shareholders or the C.E.O. are necessarily better off under ad hoc review? Recall that ad hoc review created the incentive for our C.E.O. to press for the excessive sum of $500,000 in order to assure herself an expected net compensation of $400,000.1081 She might be more than content to receive an assured sum of $400,000. But exposure to the ad hoc review process forecloses her from receiving that assurance and thereby forces her to press for the higher figure. From the shareholders' perspective this creates a strong incentive to challenge the amount of compensation. Assuming the shareholders make the same estimate as the C.E.O. concerning the court's likely response to a $500,000 salary, they stand to gain from a court challenge so long as their legal expenses do not exceed $100,000.109 Even if the C.E.O. correctly anticipates this court challenge, she still will insist on the $500,000 amount so long as the legal costs to her of defending this
108 See supra notes 99-102 and accompanying text. 109 One hundred thousand dollars is the expected recovery from the lawsuit. This amount reflects the fact that there is a 25% probability that a court would uphold the $500,000 figure as fair, so that there would be no recovery; a 50% probability that it would find $400,000 to be the fair amount and award damages of $100,000; and a 25% probability that it would find $300,000 to be the fair amount and award damages of $200,000. Thus, $100,000 is the expected value of the shareholders' recovery (e, $0 0.25 + $100,000 X 0.50 + $200,000 X 0.25). Of course, any recovery from reducing the C.E.O.'s salary will go to the corporation, so the shareholders bringing suit stand to gain only their pro rata share. But, even under real-world derivative suit procedure, there is likely to be some form of litigation cost-benefit calculation along the lines described in the text. Specifically, the plaintiff's counsel's award of attorney's fees will typically be influenced by the amount of the recovery to the corporation.
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figure, over and above the costs of defending a salary of $400,000, do not exceed $25,000.110 Assume that the anticipated expenses of each side in litigating the C.E.O.'s compensation are $10,000. Thus, the net expected value of the C.E.O.'s compensation falls to $390,000 and the net expected gain to the shareholders from challenging it falls to $90,000. In addition, the litigation typically will result in indirect costs to the C.E.O. and to the corporation in the forms of disruption of operations, the discomfort of being subjected to deposition and other discovery, and so forth. Ignoring these latter costs for the sake of simplicity, we can see that there remains a $20,000 range over which both parties would benefit (through the avoidance of litigation) from the substitution of a bright-line standard for the uncertain process of ad hoc review. If the C.E.O. can be assured that her salary will be immune from challenge, she will prefer any amount over $390,000 to the litigation-vulnerable $500,000 figure."' The shareholders should abandon the threat of litigation as long as the C.E.O. consents to accept any amount below $410,000.112 A major problem here is that no vehicle really exists to represent the unified interests of the shareholders. 113 As a result, under ad hoc review there is no way to provide the C.E.O. with effective immunity against challenge and therefore, she may be better off under a bright-line standard because of the avoidance of litigation. In addition to eliminating litigation expenses, a bright-line standard and the certainty it provides reduce the C.E.O.'s exposure to risk. Assuming she is risk-averse with respect to her compensation arrangement (as most people would be regarding their predominant source of income) she will not simply be indifferent between the litigation-risky $500,000 figure and a risk-free amount equal to its net expected value (here $390,000). If the C.E.O. desires to plan her expenditures and lifestyle for
110 This amount represents the difference between the expected value to the C.E.O. of a $500,000 salary (Le., $400,000) and the expected value of a $400,000 salary (Le-, $375,000). See supra notes 99-102 and accompanying text. 111 Recall how the $390,000 figure was determined. Twenty-five percent of the time the court will accept the $500,000 salary; 50% of the time the court will reject that salary and set a new salary of $400,000; and 25% of the time the court will reject the $500,000 salary and set a new salary of $300,000. Furthermore, the litigation expense is $10,000 to the fiduciary. Thus the "expected value" of a $500,000 salary is $390,00 ($500,000 X 0.25 + $400,000 X 0.50 + $300,000 X 0.25 $10,000). 112 The expected salary that the company must pay the C.E.O. after challenge of the $500,000 salary is $400,000. See supra note 111. Thus the company and the shareholders save $100,000 on what they must pay the C.E.O. However, the litigation costs $10,000 so they only reap $90,000 in benefits. Viewed differently, salary plus litigation expenses cost the company a total of $410,000. Thus, if the C.E.O. were willing to reduce her salary to this amount or less in exchange for an assurance that it would not be challenged, the shareholders would benefit. 113 The derivative suit invites conflict between the interests of the plaintiff's counsel and those of the shareholders generally. See, eg., Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541, 548-50 (1949).
the coming year, she may be willing to accept a "certainty equivalent" much lower than the net expected value of the risky arrangement, for example, $350,000.'14 This widens even further the range of potential bargains mutually acceptable to the C.E.O. and the shareholders. The foregoing example illustrates that even though the ad hoe mode of review may better reduce the risk of Type I and Type II errors with respect to a particular class of transactions, the certainty inherent in a bright-line standard provides competing benefits. This is admittedly not a novel observation, but it serves to reinforce the idea that error reduction is not per se good and provides a building block for the analysis that follows. The assumption in the illustration was that the arm's-length value of the C.E.O.'s services was $400,000 per year. Given this, the ad hoe review process in the example may be regarded as quite efficient since it reaches this result 50% of the time. Still, the results of the example demonstrate that a bright-line standard, even one that misses the arm'slength mark by a considerable margin, may represent an improvement from the standpoint of both parties. Specifically, in the above example, any standard that sets the C.E.O.'s compensation between the $350,000 and $410,000 will produce this result. And, it will do so even though it embraces a greater potential for at least some Type I and Type II errors than does ad hoe review. Another implication of the example is that the value of the certainty provided by a bright-line standard varies depending on the characteristics of the party. Two paragraphs above, we speculated that the riskaverse C.E.O. might be willing to accept a $40,000 reduction in net expected salary (from $390,000 to $350,000) in exchange for certainty. For the shareholders, however, certainty has less value, since presumably they are in a position to diversify away the nonsystematic risk inherent in the ad hoc review process by allocating their wealth among many investments.1 15 Thus, they will be willing to concede less in order to tie down the C.E.O.'s salary. On a more general level, this means that the degree to which the uncertain ad hoc review process serves to restrict the fiduciary's conduct depends upon her capacity to diversify away the inherent (but nonsystematic) risk ad hoc review entails. Consider an example. Suppose that a corporate executive, while on vacation, learns of an opportunity remotely related to the business of his employer. Desiring to leave his employment to pursue the opportunity on a full time basis, he consults an attorney who advises him that there is some small risk that a court might find that the opportunity belongs to the corporation. In the case of the individual entrepreneur this is quite threatening, since the result of an adverse determination some years hence would be to deprive him of what, by then, has become his sole
See supra note 50. 115 Recall the discussion of nonsystematic risk and diversification in connection with the widow and investment advisor hypothetical. See supra notes 54-57 and accompanying text.
114
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livelihood. In light of that, he may be led to offer his corporation a considerable participation in the opportunity in order to obtain its consent to his undertaking the opportunity on his own. Suppose, in contrast, that the fiduciary-entrepreneur was a large corporation and the opportunity at issue arguably belonged to a joint venture between it and another corporation. Given the same risk of adverse adjudication as in the case of the individual, the corporation might nonetheless be far more willing to take its chances in defending its exclusive rights to the opportunity, inasmuch as the amount at stake might represent a much smaller percentage of its annual revenues, say, less than 10%. In other words, because the corporate joint venturer is in a much more diversified posture vis-a-vis the opportunity at issue, it is not willing to pay as much to attain certainty. Two final points should be made about the advantages and disadvantages of resorting to bright-line standards in lieu of ad hoc review. First, in addition to the value of certainty per se, any evaluation of bright-line standards must take into account the capacity of the parties to deal with the residual risk of error ex ante or ex post. A safe harbor may create a greater risk of Type I error with respect to a particular kind of transaction than would ad hoc review, but this is not troublesome so long as the principal can identify the risk and obtain compensation. It may in fact be easier for the principal to evaluate and adjust for the costs resulting from the fiduciary's full, unbridled opportunism within the safe harbor than for the principal to evaluate and adjust for those costs that might be left after the application of an uncertain ad hoc review process. In other words, it may be easier in some cases to anticipate the conduct of the fiduciary than that of the courts. We will see examples of this in subsection VI.C. 4. The second point is that in appreciating the disadvantages of brightline standards, one must consider the notions of "neutrality," "bias," and "adverse selection." Suppose, for example, that the applicable standard permits trustees to buy real property from and sell real property to their trusts so long as the price is equal to the property's assessed value for tax purposes. If all the land in the region is systematically overassessed, resort to such a standard is biased in favor of the seller. If it is systematically underassessed, the opposite is true. Suppose, however, that this standard is neutral in the sense that although the market value of the land in the region frequently differs from its assessed value, the amount of overassessed land and the amount of underassessed land are roughly comparable, and the degree of overassessment is roughly comparable to the degree of underassessment. Consider how this kind of neutrality affects the decisions of the trustee. If the trustee was compelled to select land acquisitions for the trust at random, paying the assessed value to itself in those instances where it happened to be the owner of the land selected, resort to this
standard would impose no systematic hardship on either party. The odds that the land would be overassessed are equal to the odds that it would be underassessed. Diversification principles suggest that over a sufficient number of transactions the probability of one party or the other significantly benefitting from the error inherent in the standard is slight. But if the trustee is permitted to buy and sell land as it pleases, the probability that it will benefit from the error is no longer slight. The opportunistic trustee will sell its overassessed land to the trust and sell its underassessed land to independent third parties at market prices. Thus, even though the standard is neutral in the sense that, on average, it reflects the arm's-length price, it is nonetheless subject to exploitation by a fiduciary which has the discretion to choose between dealing with the principal or dealing with third parties. Where such fiduciary discretion is present, therefore, resort to a standard, even though neutral, presents a much greater risk of Type I error than Type 11.116
V. JUDICIAL REVIEW IN THE CASE OF CONCENTRATEDCONSTITUENCY PRINCIPALS: THE LAW OF AGENCY AND TRUSTS
A.
Concentrated-Constituencyand Diffused-Constituency Principals
The balance of the Article will attempt to consider, from the standpoint of the factors discussed in the preceding sections, the rules governing judicial review of fiduciary decisionmaking in a variety of subject areas. While the law has developed separately within the applicable subject areas, the analysis in this and the following section divides the law along functional lines, based on the characteristics of the principal. The argument here is that differences among subject areas can be explained largely by considering the nature of the underlying principal. One body of rules applies where the principal is typically a single person or closely knit group of persons, referred to here as a "concentrated-constituency principal." This is the typical situation addressed by the law of agency and trusts. The other body of rules applies where the principal is, in fact, a group of diverse principals. The shareholders of a public corporation are an example of such a group of principals. These types of principals are referred to as "diffused-constituency principals." The functional significance of this distinction is threefold. First, in the case where the principal is a single person or concentrated group, the
116 The problem is comparable to the "adverse selection" phenomenon discussed by economists where, for example, an insurance company sets premium rates based on the average risk posed by persons within a class, but individual class members are free to decide whether or not to buy the insurance in light of their unique knowledge of how their personal risk compares to the group average. We would expect only the high-risk types to take advantage of the insurance and the low-risk types to pass it up. See Hirschleifer & Riley, supra note 60, at 1389-90; Akerlof, The Market for "Lemons'" Quality Uncertainty and the Market Mechanism, 84 Q.J. ECON.488 (1970).
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transactions costs of reaching ad hoe accommodations with the fiduciary are lower. Thus, legal rules can be shaped with the confidence that the parties may always contract around them to suit their particular 17 needs. Second, the concentrated-constituency principal, almost by definition, exhibits a closer unity of interest between the individual constituents and the principal as a whole. The sole beneficiary of a trust will not challenge a transaction that he believes confers a net benefit on the trust. The small shareholder of a public corporation, on the other hand, will often be motivated by concerns other than the corporation's best interests. Thus, rules applicable to the diffused-constituency principal must be developed with the recognition that the decision to challenge a transaction will be determined more by its litigation value under those rules than its net effect upon the welfare of the principal. This combines with the first attribute to produce the result we observed in the C.E.O. compensation example in subsection IV.G.: under ad hoe review, there is no realistic way for the C.E.O. and the shareholders to bargain for a riskfree amount of compensation.' 18 The third attribute of the distinction is the relative capacity of the parties to diversify. We saw in section II the importance of diversification to the ex ante adjustment process. In section IV, the introduction of a legally enforceable fiduciary standard shifted our attention from the principal's attempts to deal with the risk of opportunism to both parties' attempts to deal with the risk of error and their capacities to diversify with respect to this risk. In the concentrated-constituency principal situation, the fact that the underlying principals are few in number indicates that their individual stakes are sufficiently large that it is economically worthwhile to make them the subject of a separate fiduciary relationship. Large investors might hire an investment manager; small investors rely on mutual funds. And once this separate relationship is created, it will typically be cost-efficient for the principal to entrust all his related business to it. By the same token, since each relationship involves the business of only a few individuals, the fiduciary will likely find it necessary to enter into several similar relationships. Thus, as a very rough generalization, the concentrated-constituency principal will frequently be in a poorer position to diversify than the fiduciary. In the diffused-constituency principal case, on the other hand, where there are numerous principals with small stakes, the principals can more easily diversify. And the combination of their small stakes makes it possible to hire fiduciaries whose entire efforts are devoted to the particular entity in which the principals have invested. Thus, in the diffused-constituency case, the balance
117 See, eg., Brudney & Clark, supra note 73, at 1003-04 (contrasting close corporations and public corporations in terms of feasibility of obtaining consent of all participants to limitations on the fiduciary's involvement). 118 See supra text accompanying notes 111-14.
shifts and the underlying principals will ordinarily be in a better position to diversify against the risk of error. B. The Law's Basic Approach
In the concentrated-constituency principal area, the law's response to the problem of reviewing fiduciary decisionmaking has traditionally been one of per se prohibition. Absent the informed consent of the principal, the fiduciary is strictly foreclosed from engaging in activities if she has a direct interest in conflict with the principal's. Thus, for example, if the trustee sells trust property to herself, the transaction is automatically voidable at the election of the beneficiary. 119 The trustee cannot defend the transaction on the grounds that the terms were fair or that the trust benefitted. 120 Similar rules apply to the common law agent.1 2 1 By adopting a mechanical rule triggered by the existence of objective facts that suggest a motive for biased decisionmaking, this mode of judicial review avoids a detailed inquiry into the quality of the fiduciary's conduct. If those objective facts are present, and if the principal wants out of the deal, the law conclusively presumes that the fiduciary engaged in opportunism. Why has the law prohibited, per se, fiduciary conflict-of-interest transactions in the trust and agency areas rather than subjecting such transactions to ad hoe review or to transaction-specific or terms-specific standards? 122 Any such approach necessarily reflects an emphasis on eliminating the risk of Type I error at the cost of other objectives. In some cases, the adoption of per se prohibitions reflects a conclusion that there is little possibility that a disinterested decisionmaker would have reached the result in question and, therefore, the risk that good faith decisions will be wrongfully invalidated is minimal. An illustration of such a conclusion is the rule of corporate law that a corporation may not indemnify a director for expenses incurred in a derivative suit if the director is - adjudged liable to the corporation. 123 But in the trust and agency areas, the doctrine applies across-the-board, irrespective of the
119 RESTATEMENT (SECOND) OF TRUSTS 170 comment b (1957); G. BOGERT & G. BOGERT, HANDBOOK OF THE LAW OF TRUSTS 95, at 345, 347 (5th ed. 1973); 2 A. SCOTT, THE LAW OF TRUSTS 170.1, 170.2 (3d ed. 1967). 120 RESTATEMENT (SECOND) OF TRUSTS 170 comments b, h (1957); G. BOGERT & G. BoGERT, supra note 119, 95, at 345; 2 A. ScoTT, supra note 119, 170.1, 170.12. 121 Wendt v. Fischer, 243 N.Y. 439, 154 N.E. 303 (1926); RESTATEMENT (SECOND) OF AGENCY 389 comment c (1957); F. MECHEM, OUTLINES OF THE LAW OF AGENCY 501, 504, 507 (4th ed. 1952); W. SEAVEY, HANDBOOK OF THE LAW OF AGENCY 149, at 245 (1964).
122 Per se prohibitions can be relationship-specific, as is the case here where the trustee is completely prohibited from selling the trust property to herself, transaction-specific, or terms-specific. See supra note 105. 123 E.g., MODEL BUSINESS CORP. ACT 8.51(d)(1) (1984); see J. BISHOP, THE LAW OF CORPORATE OFFICERS & DIRECTORS-INDEMNIFICATION & INSURANCE 5.03 [1], at 5-7 (1981). This is a transaction-specific per se prohibition. See supra note 122.
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subject of the transaction. No one can plausibly argue that all transactions between trustee and trust or agent and principal are improper and detrimental to the interests of the trust beneficiary or the principal. Certainly, sometimes fiduciaries will find it desirable to deal with their principals on fair terms. An examination of the rationales tendered by courts and commentators to justify the blanket per se approach reveals two interdependent lines of reasoning. The first displays a prophylactic orientation. Recognizing human frailty and the tendency to favor one's own self interest where permitted, the per se approach acts to prevent fraud by preempting the opportunity to engage in it. It seeks to promote the trustee's good faith by removing temptation. 124 The second focuses on the realities of the litigation process. Where the fiduciary does act to further her own interests at the expense of the principal's, the principal may be unable to get at the underlying facts needed to prove unfairness. The principal's trust and dependence on the fiduciary as a result of the fiduciary relationship is likely to mean that the fiduciary is in a superior position to cover her tracks. Accordingly, and in recognition of the legal system's problems in breaking through to the fraud where it exists, the principal is given the benefit of a conclusive presumption. 125 According to these rationales, because courts are inherently incapable of divining the true motivation of the fiduciary, the only sure cure for fiduciary opportunism is to ban situations that might induce it. Conceding that there nonetheless may be occasions within the sweep of the ban where the fiduciary is in fact acting with good faith means conceding that a certain amount of Type II error is going to occur because of the ban. In other words, opting for an across-the-board per se prohibition permits substantial Type II error in order to foreclose any possibility of Type I error. This raises two questions which will be considered in the balance of this section. First, what does the law's selection of this all-out approach to Type I error in the concentrated-constituency principal cases
124 See Michoud v. Girod, 45 U.S. (4 How.) 503, 555 (1846); Smith v. Pacific Vinegar & Pickle Works, 145 Cal. 352, 365, 78 P. 550, 554 (1904); Thorp v. McCullum, 6 I1. (1 Gilm.) 614, 626-27 (1844); In re Ryan's Will, 291 N.Y. 376, 405-07, 52 N.E.2d 909, 922-23 (1943); Munson v. Syracuse, G. & C. Ry. Co., 103 N.Y. 58, 73-75, 8 N.E. 355, 358-59 (1886); RESTATEMENT (SECOND) OF AGENCY 389 comment c (1957); G. BOGERT & G. BOGERT, supra note 119, 95, at 344, 346; F. MECHEM, supra note 121, 501; 2 A. ScoTr, supra note 119, 170.2, at 1306; Frankel, supra note 6, at 824; Hallgring, The Uniform Trustees'PowersAct and the BasicPrincipleofFiduciaryResponsibility, 41 WASH. L. REv. 801, 803-04, 808-10 (1966). 125 See Thorp v. McCullum, 6 Ill. (1 Gilm.) 614, 626-27 (1844); Stewart v. Lehigh Valley R.R., 38 N.J.L. 505, 522-23 (1875); In re Bond & Mortgage Guaran. Co., 303 N.Y. 423, 431-32, 103 N.E.2d 721, 726 (1952); Munson v. Syracuse, G. & C. Ry. Co., 103 N.Y. 58, 73-75, 8 N.E. 355, 358 (1886); Piatt v. Longworth's Devisees, 27 Ohio St. 159, 195-96 (1875); J. SHEPHERD, THE LAW OF FIDUCIARIES 128-29, 143, 158-59 (1981); Hallgring, supranote 124, at 810-11; Hoover, Basic Principles UnderlyingDuty ofLoyalty, 5 CLEV.-MAR. L. REV. 7, 12-14 (1956) (citing various authorities); Cf, Brudney & Clark, supra note 73, at 1001-02 & n.9 (discussing the difference between the "categorical" and "selective" approaches to corporate opportunities).
say for the efficacy of the private ordering protection available to the principal as discussed in section II? And second, why has the law chosen to weight the balance in these cases so heavily in favor of eliminating Type I error rather than Type II error? C. Private OrderingAlternatives First, let us consider the private ordering alternatives of monitoring and bonding, ex ante compensation, and ex post settling up as discussed in section II. The preemptive nature of the law's response to fiduciary opportunism in the trust and agency areas suggests that the law has little faith in a principal's capacity to fend for himself and little faith in the ability of market forces to check the fiduciary. We can speculate on the reasons for this with the aid of some rough generalizations about the characteristics of the trust and agency landscape at the time the equity courts were beginning to develop the per se approach. 126 In this far less developed commercial world, the cases typically involved individuals on both sides and, at least in the case of agency, one-shot relationships. In such a world, not much could be expected from private monitoring as a regime of protection. The principal's lack of sophistication probably meant that the ways and benefits of monitoring went unappreciated. And, at least in the common law agency context, the episodic nature of the underlying transactions made it cost-inefficient for the principal to put any standardized monitoring scheme in place, even if he anticipated its value. Added to this was the fact that reputation, as a mechanism for penalizing the fiduciary's opportunism ex post, was not significant because the principal was less likely to be a professional and information was not readily exchanged. This same lack of sophistication and unavailability of information undercut the principal's attempts to make valid ex ante estimates of the risk of opportunism. Finally, and this applies with more force in the trust case but extends to the agency case as well, the principal was less likely to be in a diversified position with respect to this risk. Consistent with the above views, we might expect that changes, over time, in the characteristics of trust and agency relationships that might serve to make private ordering a more viable alternative would trigger a reexamination of the strictness of the law's approach. To some extent this has happened. Consider, for example, the emergence of the corporate trustee. Various kinds of transactions that might technically represent self-dealing, such as loans by the trustee to the trust 127 and transfers
126 Scholars trace the doctrine to the eighteenth century, and it appears to have been firmly established by the beginning of the nineteenth. See J. SHEPHERD, supra note 125, at 19; Hallgring, supra note 124, at 807 n.38. 127 See 12 C.F.R. 9.12(0 (1985); UNIFORM TRUSTEES' POWERS ACT 3(c)(18) (1964); 2 A. Scorr, supra note 119, 170.20, at 1364.
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of property between trusts managed by the same trustee,1 28 are now permitted subject to ad hoe review. This trend may be explained in part by the greater availability of performance information concerning the institutional trustee, which facilitates ex ante evaluation, along with the importance of reputation, which serves as an ex post penalty for opportunism. By and large, however, in the concentrated-constituency principal cases, the law has not entrusted much to private ordering. The obstacles to private ordering discussed above lead to the per se approach, which provides the principal with insulation against the more blatant forms of opportunism and requires little investment of time or effort on the principal's part. The principal is assured a remedy simply if he becomes dissatisfied with the results of the fiduciary's decision and can identify the fiduciary's conflict of interest. This makes the fiduciary's good faith irrelevant. As a result, the court does not have to assess the fiduciary's true motivation, an assessment which could lead to Type I error. The fiduciary of course may seek to conceal her interest, for instance, by engaging in the transaction through a straw man. This would increase the principal's monitoring costs. But the principal's absolute right to rescind if he discovers the conflict, 129 coupled with the fact that the fiduciary forfeits her compensation even if the principal is satisfied with the transaction, 130 makes this a costly risk to the fiduciary. Taken together, these remedies go beyond compensating the principal and ex128 See 12 C.F.R. 9.12(d) (1985); UNIFORM TRUSTEES' POWERS ACT 3(c)(4) (1964); RESTATEMENT (SECOND) OF TRUSTS 170 comment r; 2 A. SCOTT, supra note 119, 170.16, at 134950. Examples of other such transactions include the deposit of the trust's funds with the trustee, see UNIFORM TRUSTEES' POWERS ACT 3(c)(6) (1964); RESTATEMENT (SECOND) OF TRUSTS 170 comment m (1975); G. BOGERT & G. BOGERT, supra note 119, 95, at 348; 2 A. ScoTr, supra note 119, 170.18, at 1356-59; but cf. 12 U.S.C. 92a(d) (1982), 12 C.F.R. 9.10(b) (1985) (requiring national banks to set aside marketable securities as collateral for such deposits), and the trust's retention of shares of the trustee, see UNIFORM TRUSTEES' POWERS ACT 3(c)(1) (1964); RESTATEMENT (SECOND) OF TRUSTS 170 comment n (1957); 2 A. ScoTr, supranote 119, 170.15, at 134145; see also 12 C.F.R. 9.12(c) (1985) (permiting national banks to exercise any purchase or conversion rights accompanying such retained shares). But see Hallgring, supra note 124, at 813-16 (criticizing liberalization of the rule). Earlier court decisions had prohibited the corporate trustee from retaining its own shares unless expressly authorized by the terms of the instrument creating the trust. SeeIn re Durston's Will, 297 N.Y. 64,71, 74 N.E.2d 310, 312 (1947); In re Trusteeship of Stone, 138 Ohio St. 293, 303, 34 N.E.2d 755, 760 (1941). A final example is the investment of trust assets in mortgage loans made by the trustee. See G. BOGERT & G. BOGERT, supranote 119, 105, at 383-84; 2 A. SCOTT, supra note 119, 170.14, at 1337; 3 A. SCOTT, supra note 119, 227.9, at 1825-29. 129 This remedy has the effect of shifting the downside risk to the fiduciary while allowing the principal to retain the upside benefits. See supra, final paragraph of section IV.E. 130 Under common law theories of agency, even if the principal retains the fruits of the agent's performance and irrespective of whether the principal was harmed by the conflict of interest, the agent's conflict of interest negates her right to compensation. See Wendt v. Fischer, 243 N.Y. 439, 444, 154 N.E. 303, 305 (1926); Mersky v. Multiple Listing Bureau of Olympia, Inc., 73 Wash. 2d 225, 437 P.2d 897 (1968); Bockemuhl v. Jordan, 270 Wis. 14, 70 N.W.2d 26 (1955); Andrews v. Ramsay & Co., [1903] 1 K.B. 635; RESTATEMENT (SECOND) OF AGENCY 399(k), at 469. Similarly, if a trustee breaches her duty of loyalty, she may, at the court's discretion, be subject to re-
hibit a penal character that serves to assure that the fiduciary stands to lose more than she might gain through her opportunism. They therefore operate as a strong counterweight to the prospect that the fiduciary's conflict of interest may go undetected. D. Dealing with the Prospect of Type II Error What about the substantial risk of Type II error that is inevitably created by any rule that prohibits self-dealing across the board? Applying the general theme of this Article, we would anticipate that the law's willingness to accept such a risk in the interests of eliminating Type I error may be attributed to the fact that Type II error either (i) is for some reason less costly in the case of concentrated-constituency principals or (ii) may be effectively dealt with through private ordering. To evaluate this proposition, let us consider the costs of Type II error and who bears them. Recall that in subsection IV.D. we identified two kinds of costs associated with Type II error. The first is the value transfer from fiduciary to principal that results from the fiduciary's incurring liability for what was in fact a good-faith decision. The second is the opportunity loss to both parties that occurs when the fiduciary is chilled by the prospect of Type II error into forgoing a mutually beneficial transaction. In assessing what kinds of costs will occur in practice, the certainty aspect of the across-the-board, per se approach becomes critical. Whatever the drawbacks of this approach in terms of error, it does have the beauty of predictability:13 1 the fiduciary is assured that if the principal is dissatisfied with the outcome of a prohibited transaction, the transaction will be set aside and, in any event, the fiduciary will forfeit her commission. Given her resulting no-win-high-loss position, the wellcounselled fiduciary will almost certainly conclude that the game is hardly worth the candle. In subsection IV.E., we saw that this decision to forgo transacting with the principal will generally depend upon what alternatives are available to the fiduciary. But the penal dimensions of the per se approach are sufficiently strict and the outcome sufficiently certain that the fiduciary will ordinarily be better off to avoid the transaction and do nothing, even if she has no alternative transaction available. As a result, the costs of the per se approach's propensity for Type II error are for the most part incurred in the form of lost opportunities. This propensity is not troubling as long as the fiduciary and principal can realize the benefits of the opportunity by dealing with other parties. Thus, for example, where a stock broker filled a customer's order from its own inventory instead of buying the shares on the market, and failed
moval and forfeiture of compensation. See G. BOGERT & G. BOGERT, supra note 119, 95, at 350; 2 A. ScoTT, supra note 119, 107, at 842-44; 3 A. Scorr, supra note 119, 243, at 2138-39. 131 This is an example of the general tradeoff between error and certainty discussed in subsection IV.G.
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to disclose that fact to the customer, the common law routinely permitted the customer to set the sale aside even though the price paid was fair at the time. 132 The ready availability of independent market alternatives makes it unnecessary to tolerate even the slight risk of Type I error that might result from permitting the broker to self-deal. The real Type II problem created by the per se approach arises in connection with unique opportunities, mutually advantageous to fiduciary and principal, in which the fiduciary has a conflicting interest. The strict per se disqualification rule denies the principal these opportunities. Such opportunities provide an inherent dilemma from the standpoint of developing efficient standards to govern fiduciary decisionmaking. While these unique opportunities pose the greatest cost to the principal in terms of opportunities lost because of the fiduciary's fear of Type II errors, they also present the greatest risk of Type I error if the fiduciary does try to deal, because no outside market exists to test the fairness of the terms set by the fiduciary. To some extent, the law of trusts, with its emphasis on prudent asset conservation, was willing to write off such lost opportunities. Indeed, concerns for liquidity of the trust estate would favor shying away from such opportunities in favor of those for which there is an active market. Common law agency must, however, be more entrepreneurial in its operation. The solution reached by the law of trusts and agency is to permit the fiduciary to avoid per se scrutiny by, in effect, stepping outside of her fiduciary role. By fully disclosing her interest in the transaction, she becomes free to deal with the principal 133 because the principal's independent judgment is presumably now triggered as a safeguard against the fiduciary's opportunism. Such disclosure does not, however, free the fiduciary to return to the status of a full arm's-length adversary. Two significant limitations on the fiduciary's capacity to deal remain. First, the disclosure to the principal must embrace not only the facts of the fiduciary's conflict, but also any information the fiduciary possesses relative to the wisdom of the deal. 134 Second, the transaction is subject to ad
132 See, ag., Hall v. Paine, 224 Mass. 62, 73-74, 112 N.E. 153, 158-59 (1916); Haines v. Biddle, 325 Pa. 441, 443, 188 A. 843, 845 (1937). Today, the federal securities laws require a broker to disclose whether it is acting as principal for its own account and, if so, the amount of the mark-up or mark-down it is charging. See Securities Exchange Act Rule 10b-10(a)(1),(8), 17 C.F.R. 240.10b10(a)(1), (8) (1985). 133 See G. BOGERT & G. BOGERT, supra note 119, 95, at 350; F. MECHEM, supra note 121, 504, at 348; 3 A. ScoTr, supra note 119, 216, at 1733; W. SEAVEY, supra note 121, 150, at 24647; RESTATEMENT (SECOND) OF AGENCY 390 (1957); RESTATEMENT (SECOND) OF TRUSTS 216
comment b (1957). 134 See G. BOGERT & G. BOGERT, supra note 119, 96, at 352-53; 3 A. SCOTT, supra note 119, 216.3, at 1745; W. SEAVEY, supranote 121, 150, at 246; J. SHEPHERD, supra note 125, at 202-04;
RESTATEMENT (SECOND) OF AGENCY 390, comments a, b (1957); RESTATEMENT (SECOND) OF
TRUSTS 216(2)(b) (1957). The fiduciary's inability to revert to full independent status, and thereby keep her information to herself, can be justified on contractual grounds: the principal, in effect, bought the fiduciary's information-gathering capacity and therefore has a proprietary interest in
hoc review of its objective fairness. If found to be unfair, it will be set aside. 135 In other words, disclosure serves to shift the mode of review from per se prohibition to ad hoc review, but does not safe harbor the decision even though the principal consented to it. It appears, moreover, that the burden of proof remains with the fiduciary. 136 As a result, the fiduciary remains exposed to some risk of Type II error, because if the transaction ultimately turns out unfavorably to the principal, the fiduciary will bear the loss unless she can persuade the court that she gave the principal the best terms available at the time 137 and fully explained the potential risks. 138 The critical feature of the law's response to the concentrated-constituency principal cases is, therefore, the fiduciary's capacity to bargain directly with the principal. This means that lawmakers have considerable flexibility to impose rules that set the initial balance between Type I and Type II errors wherever they please because the parties may contract around it without undue expense. The law opts for per se rules that tolerate a high risk of Type II error in the interests of minimizing Type I error because the principal is probably in an inferior position vis-a-vis the fiduciary both to appreciate the existence and cost of the resulting risk of error and to diversify away the risk. The law's "default option" then is this blanket approach, an approach that is indifferent to the fairness of the particular transaction and made tolerable only by the ready availability of modification. Because of the high certainty of outcome associated
whatever it produces. See Kronman, Mistake, Disclosure,Information, and the Law of Contracts,7 J. LEGAL STUD. 1, 19 n.49 (1978). This rule protects the general right of fiduciaries to sell their services for full value by assuring prospective principals that they will receive the full output of the fiduciary's expertise. 135 See G. BOGERT & G. BOGERT, supra note 119, 96, at 351-52; 3 A. SCOTT, supra note 119, 216.3, at 1747; RESTATEMENT (SECOND) OF AGENCY 390 comment c (1957); RESTATEMENT (SECOND) OF TRUSTS 216(3) (1957). 136 See Goldman v. Kaplan, 170 F.2d 503, 507 (4th Cir. 1948); Succession of Simpson, 311 So. 2d 67, 72 (La. Ct. App. 1975); RESTATEMENT (SECOND) OF AGENCY 390 comment g (1957); G. BOGERT & G. BOGERT, supra note 119, 96, at 352. 137 See Iriart v. Johnson, 75 N.M. 745, 748-49, 411 P.2d 226, 228-29 (1965); L. Loss, FUNDAMENTALS OF SECURITIES REGULATION 964 n.40 (1983). 138 Where elements exist which, in hindsight, cast doubt on the wisdom of the deal, courts often presume that the deal went through because of the fiduciary's undue influence. An example is Judge Cardozo's well-known decision in Globe Woolen Co. v. Utica Gas & Elec. Co., 224 N.Y. 483, 121 N.E. 378 (1918), invalidating a contract that guaranteed the cost of electricity to a woolen mill and made no restrictions on the mill's operations. When the mill altered its operations to engage in more energy-intensive activities, the contract became a severe burden to the power company. Judge Cardozo noted that the fiduciary "takes the risk of an enforced surrender of his bargain if it turns out to be improvident." Id. at 490, 121 N.E. at 380. This statement may be read as permitting postcontract developments to be taken into account in the fairness inquiry. See Note, The FairnessTest of Corporate Contracts with InterestedDirectors, 61 HARV. L. REV. 335, 341 n.45 (1948); see also Rogers v. Hill, 289 U.S. 582, 590-92 (1933) (corporate by-law awarding fixed percentage of corporation's profits to its officers was valid when adopted but due to subsequent increases in profits, payments had become so large that they were subject to review on grounds of waste).
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with these per se rules, the fiduciary can be expected to appreciate that she may deal with the principal only at her peril. The law thus imposes upon the fiduciary the burden of procuring the modification. It then polices the quality of the principal's consent, insisting that the principal be informed fully by the fiduciary. As a last safety net against Type I error, the law also reviews the transaction for objective fairness. This leaves a continued risk of Type II error to the fiduciary, but presumably she is in the better position to adjust for it ex ante in her fees and diversify the resulting risk.
VI. JUDICIAL REVIEW IN THE CASE OF DIFFUSED-CONSTITUENCY
PRINCIPALS: THE LAW OF PUBLICLY HELD

CORPORATIONS
A.
Background: From Per Se Prohibition to Ad Hoc Review
The initial posture of corporate law in this country was to follow the lead of trust and agency law and categorically prohibit corporate directors from dealing with their corporations. 139 The substance of this early position and the retreat from it over time have been well described elsewhere and need not be repeated here. 140 The important point for present purposes is that the risk of Type II error is significantly greater when this per se prohibition is applied in the diffused-constituency area of the law of publicly held corporations than when it is applied in the concentratedconstituency area of trusts and agency. There are two reasons for this difference. First, the key mechanism for avoiding lost opportunities in the concentrated-constituency principal case is for the fiduciary to disclose the conflict and thereby become free to deal with the principal. This disclosure shifts the level of judicial scrutiny from per se prohibition to ad hoe review. In the case of corporations, one can argue that a similar result should follow so long as there is full disclosure to, and informed consent from, each individual shareholder. But if the shareholders are at all numerous, and thus constitute a diffused-constituency principal, this tactic may not be feasible. Accordingly, by the beginning of the twentieth century, several courts had held that a simple majority of shareholders could ratify a contract between their corporation and a director, and thereby immunize it against per se voidability. 14 1 Nonetheless, this pro139 See, eg., Davis v. Rock Creek L.R. & M. Co., 55 Cal. 359 (1880); Cumberland Coal & Iron Co. v. Parish, 42 Md. 598 (1875); Stewart v. Lehigh Valley R.R., 38 N.J.L. 505 (1875); Munson v. Syracuse G. & C. Ry. Co., 103 N.Y. 58, 8 N.E. 355 (1886). The British courts had adopted the same rule. Aberdeen Ry. Co. v. Blakie Bros., 17 D. (H.L.) 20, 1 Macq. H.L. Cas. 461 (H.L. 1854) (Scot.). 140 See Marsh,Are DirectorsTrustees? Conflict ofInterest and CorporateMorality, 22 Bus. LAW. 35, 36-39 (1966); Note, supra note 138, at 335-36. 141 See San Diego, O.T. & P.B.R.R. v. Pacific Beach Co., 112 Cal. 53, 44 P. 333 (1896); Nye v. Storer, 168 Mass. 53, 46 N.E. 402 (1897); Bjorngaard v. Goodhue County Bank, 49 Minn. 483, 52 N.W. 48 (1892); Hodge v. United States Steel Corp., 64 N.J. Eq. 807, 54 A. 1 (1903); Gamble v.
cedure would be burdensome for routine transactions because it requires formal approval at a shareholders' meeting. The second reason why Type II error may be more likely in diffused-constituency principal cases is that in these cases the decision to challenge a transaction is in the hands of each individual shareholder.142 As a practical matter, that decision will be controlled by the settlement value of the challenge and the attendant opportunity for plaintiff's attorney's fees, rather than an even-handed consideration of whether the transaction, on balance, is in the corporation's interest. In contrast, in concentrated-constituency principal cases, where the principal is, for instance, a beneficiary of a trust, the interests of the principal are the same as the interests of the trust. Thus, the principal's self-interest will normally prevent 3him from challenging transactions that are advantageous 14 to the trust. In the early 1900s, courts began to back off from the strict disqualification doctrine and open the door slightly to interested director contracts. The doctrinal device for doing so was a reexamination of the analogy to the agency and trust rules. The theory was that because the fiduciary could avoid per se prohibition in the agency and trust areas by securing the principal's disinterested consent to the transaction, a comparable result should apply under corporate law. And because the board of directors was statutorily entrusted with management of the corporation, it should be able to render the required disinterested consent. This of course assumed that the interested director did not participate in the board's decision. Moreover, consistent with the agency and trust analogy, the transaction still would be reviewable for fairness.144 The sudden judicial willingness to accept the analogy is particularly curious given that the earlier cases rejected out of hand the argument that strict disqualification should not apply where the interested director's vote did not directly 145 affect the outcome. 146 As Harold Marsh
Queens County Water Co., 123 N.Y. 91, 25 N.E. 201 (1890); North-Western Transp. Co. v. Beatty, 12 App. Cas. 589 (P.C. 1887) (Can.). 142 In some jurisdictions the harshness of the strict disqualification doctrine was tempered by limiting an individual shareholder's right to invoke it. In New York, for example, the Court of Appeals held that the voidability of a contract between the corporation and one of its directors could be raised only by the corporation itself and not by a shareholder in a derivative suit. Burden v. Burden, 159 N.Y. 287, 54 N.E. 17 (1899). 143 Cf. J. SHEPHERD, supra note 125, at 159 (discussing the strict disqualification rule: "By making the transaction voidable instead of void, the courts are, in effect, delegating to the beneficiary the initial determination of whether the fiduciary has abused his powers."). 144 See Marsh, supra note 140, at 39-41; Note, supra note 138, at 336. 145 The interested director might not directly affect the outcome because he or she was only one of many to approve the transaction or because he or she did not participate in deliberations over the transaction and his or her vote was unnecessary for approval. 146 See Stewart v. Lehigh Valley R.R., 38 N.J.L. 505, 523 (1875) (stating that a director should not be allowed to benefit by neglecting his duty to participate in corporate decisionmaking); Munson v. Syracuse, G. & C. Ry. Co., 103 N.Y. 58, 74, 8 N.E. 355, 358 (1886) (stating that the lav cannot
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commented in his widely cited article: "One searches in vain in the de-
cided cases for a reasoned defense of this change in legal philosophy....

Did the courts discover in the last quarter of the Nineteenth Century that greed was no longer a factor in human conduct?"' 14 7 Some concern must have remained that the recusal of the interested director might not be sufficient to render his or her colleagues disinterested when passing on the integrity of his or her conduct. 148 Presumably, then, the reason for this change of judicial heart was a recognition that, as the publicly held business corporation became a more and more essential mechanism for the exploitation of large scale entrepreneurial opportunities, this residual risk of Type I error was more than offset by the cost of the opportunities to be lost through Type II error if there was adherence to the strict approach.14 9 This entrepreneurial concern was aggravated by the fact that
not only does the prospect of Type II error chill beneficial self-dealing
transactions in general, but the riskier the transaction, the greater the chill. 150 Over time, courts became still more willing to accept interested director contracts. Today, in fact, most jurisdictions permit interested director transactions so long as they are fair, irrespective of whether they are approved by a quorum of disinterested directors.'15 In some jurisdic152 tions, this result has been confirmed by statute.
accurately measure the influence of the interested director on his associates); Aberdeen Ry. Co. v. Blakie Bros., 17 D. (H.L.) 20, 1 Macq. H.L. Cas. 461, 473 (H.L. 1854) (Scot.) (stating that the interested director has a duty to give his co-directors the full benefit of his knowledge and skill). 147 Marsh, supra note 140, at 40. 148 Judge Cardozo put the point eloquently in the Globe Woolen case some years later: A dominating influence may be exerted in other ways than by a vote.... A beneficiary, about to plunge into a ruinous course of dealing, may be betrayed by silence as well as by the spoken word....The members of the committee, hearing the contract for the first time, knew that it had been framed by the chairman of the meeting. They were assured in his presence that it was just and equitable. Faith in his loyalty disarmed suspicion. Globe Woolen Co. v. Utica Gas & Elec. Co., 224 N.Y. 483, 489-90, 121 N.E. 378, 379-80 (1918). Several contemporary observers continue to share this concern. See infra notes 226-28 and accompanying text. 149 See, eg., Ft. Payne Rolling Mill v. Hill, 174 Mass. 224, 225, 54 N.E. 532, 532 (1899) (Holmes, C.J.); Robotham v. Prudential Ins. Co. of America, 64 N.J. Eq. 673, 709, 53 A. 842, 856 (Ch. 1903); Genesee & W.V. Ry. v. Retsof Mining Co., 15 Misc. 187, 195, 36 N.Y.S. 896, 901 (Sup. Ct. 1895); H. BALLANTINE, BALLANTINE ON CORPORATIONS 67, at 171 (rev. ed. 1946); R. STEVENS, HANDBOOK ON THE LAW OF PRIVATE CORPORATIONS 143, at 651-53 (2d ed. 1936); Note, supra note 138, at 335-36. 150 Recall how the prospect of Type II error creates an incentive for the fiduciary to favor lowrisk projects, as illustrated supra, in the last paragraph of subsection IV.E. 151 See AM. LAW INST., PRINCIPLES OF CORPORATE GOVERNANCE: ANALYSIS AND RECOMMENDATIONS 5.08(a)(2)(C) and comments at 123-25, 129 (Tent. Draft No. 3, 1984) [hereinafter
cited as ALI CORPORATE GOVERNANCE PRINCIPLES]; 3 W. FLETCHER, CYCLOPEDIA OF THE LAW OF PRIVATE CORPORATIONS 931 (rev. vol. 1975); H. HENN & J. ALEXANDER, LAVS OF CORPO-
RATIONS 238, at 639 (3d ed. 1983); Marsh, supra note 140, at 43-44. 152 See, eg., MODEL BUSINESS CORP. ACT 8.31(a)(3) (1984); CAL. CORP. CODE 310(a)(3) (West 1977); DEL. CODE ANN. tit. 8, 144(a)(3) (1974).
In sum, we see in the way modem corporate law has deviated from trust and agency law the critical role played by the concentrated-constitutency/diffused-constituency distinction. The underlying concern for Type I error that guided courts in the trust and agency context' 5 3 should be, if anything, stronger in the case of public corporations, where the fiduciaries are actually in control of the principal. Thus, the distinction must result from the other side of the balance: the risk of Type II error created by restricting good faith decisions. As we saw, this concern is mitigated in the trust and agency areas by the fiduciary's ability to obtain the informed consent of the principal without enormous transactions costs. This informed consent then operates to waive the per se prohibition. Lacking such an option, the law of public corporations has responded by easing the level of judicial scrutiny to ad hoc fairness review. There are, nonetheless, discrete instances where per se prohibitions continue to be used in the case of diffused-constituency principals. Ex54 amples such as loans to directors and indemnification restrictions' probably reflect a conclusion that across-the-board prohibitions create little Type II error. Another interesting example is the conflict-of-interest provisions of the Investment Company Act.1 55 These provisions prohibit a wide variety of transactions between the investment company and any "affiliated person,"' 156 promoter, or principal underwriter. 5 7 The potential restrictiveness of this across-the-board approach is tempered, however, by the SEC's statutory power to exempt particular transactions. 158 This exemptive power is the vehicle for avoiding Type II error, as well as affording certainty to the parties. 159 Thus, we see a pattern similar to the concentrated-constituency principal: a regime deliberately made overly restrictive in the interests of catching any possible breach of duty, with the onus on the fiduciary to bargain its way out. Although the principal in this case is diffused-constituency in character, the transactions costs of bargaining are low because the power of waiver is delegated 0 16 to an administrative agency.
153 See supra notes 124-25 and accompanying text. 154 See supra notes 105 & 123. 155 Investment Company Act of 1940 17, 15 U.S.C. 80a-17 (1982). 156 An "affiliated person" is generally an officer, director, 5% or more shareholder, or some other control person. Id. at 2(3) (definition of "affiliated person"). 157 Id. at 17(a). 158 Id. at 17(b).
159 See 2 T. FRANKE, THE REGULATION OF MONEY MANAGERS 15.1, at 458 (1978) ("It was clear in 1940 that the sweeping prohibition of section 17(a) could not exist without a grant of exemp-
tive powers to the SEC."). In addition, the SEC has created by rule safe harbors within section 17(a)
where the risk of opportunism is negligible. See, eg., Investment Company Act rule 17a-7, 17 C.F.R. 270.17a-7 (1985) (purchases and sales of securities between affiliated investment companies,
for cash, at currently quoted market prices). 160 Another example of the relationship between the restrictiveness of prohibitions and ease of
bargaining is provided by loan agreements. In general, the covenants in private placement loan agreements tend to be more restrictive than those in trust indentures governing publicly held debt
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B.
The Case for Ad Hoc Review
Why has contemporary corporate law settled upon the vagaries of ad hoc review as its universal approach to regulating fiduciary decisionmaking? Why, in the process, has the law failed to develop transactionspecific or terms-specific standards1 6' to guide corporate management? Subsection IV.G. considered the value inherent in certainty of outcome and how it traded off against reduction of error. As we have seen, the diffused-constituency nature of public corporations forecloses the fiduciary from obtaining the consent of the underlying principals, the primary 162 source of certainty available to the trustee and common law agent. Under an ad hoc approach, there is no mechanism for assuring the validity of a transaction short of a definitive adjudication that it is fair, and, as has been discussed, lack of fairness can be raised by any shareholder who thinks the case has good potential for attorney's fees. 163 Yet, certainty and predictability are, if anything, attributes of special importance to the business and financial planning of public companies. Millions of dollars may hang in the balance as the issue of the fairness of a merger takes years to work its way through the courts. Accordingly, and before examining the content of the ad hoc fairness test in the next subsection, this subsection will consider the reasons for the law's rigid insistence on an ad hoc approach rather than the development of standards. The reasons given for an ad hoc approach fall into two clusters. Both clusters deal with the comparative institutional advantages of courts, the institutions that would apply the ad hoc fairness test, over legislatures, the institutions that would formulate the standards, as the proper reviewers of fiduciary decisionmaking. The first cluster evokes a preference for general principles over specific standards in light of the richness and variety of the factual situations presented by the conduct of corporate managements. It evokes many of the traditional arguments for the common law over a code-based system. Its advocates see the ad hoc approach as the ideal tool to harmonize the potentially conflicting goals of providing management maximum discretion to run the business and of protecting public and minority shareholders from oppression. 164 A more specific code of conduct might decrease the probability of self-dealing, but would at the same time foreclose to the corporation legitimate and valuable opportunities. 165 In addition to this potential for repressing beneficial transactions, a regime of detailed standards creates the risk of a
securities. A likely explanation is the lower transactions costs of negotiating waivers. See Zinbarg, The Private Placement Loan Agreement, FIN. ANALYSTS J., July-Aug. 1975, at 33, 35, 52. 161 See supra note 105 for examples of transaction-specific and terms-specific standards. 162 See supra notes 133-38 and accompanying text. 163 See supra text accompanying notes 118, 142-43. 164 See, eg., Arsht, Reply to Professor Cary, 31 Bus. LAw. 1113, 1113-14 (1976). 165 See Winter, supra note 8, at 258-62 (discussing the tradeoff between eliminating self-dealing and reducing corporate efficiency, which is essentially the Type I/Type II tradeof).
"road map for the unscrupulous," because there will always be a loop166 hole for those intent on evading the policy underlying the code. The ad hoe review process, on the other hand, not only has no loopholes, but also provides a catchall to reach wrongful conduct even if the conduct is in technical compliance with the statutory requirements. Detailed standards cannot do this because no set of legislative pronouncements, no matter how detailed, could be either comprehensive or farsighted enough to properly deal with the full array of schemes and transactions that arise in the business world. Thus, only ad hoc review, its defenders argue, allows the courts flexibility to confront and evaluate these schemes and transactions as they arise. It thus facilitates the development of informed standards over time, and in an experimental and 167 evolutionary manner not available to the legislature. Of course, from the standpoint of predictability as an objective, the diversity-of-the-business-world argument cuts both ways. The fact that any set of prescribed standards might be inadequate in its coverage does not mean that an amorphous standard of fairness provides better guidance. Proponents of clearer standards argue that the uncertainty over how the general standards apply to particular kinds of transactions serves to invite extensive litigation. But, the argument goes, the litigation process is too episodic and fortuitous to assure the development of clear and complete guidelines capable of prescribing future conduct and guid168 ing business planning. Notwithstanding the concerns of the defenders of the ad hoe approach, it would certainly seem plausible that aspects of corporate law in which the need for preditability is strong would be eligible candidates for specific guidelines. Thus, Marvin Chirelstein has argued for more de166 Garrett, The Limited Role of Corporation Statutes, in COMMENTARIES ON CORPORATE STRUCTURE AND GOVERNANCE 95, at 101 (D. Schwartz ed. 1979) [hereinafter cited as CORPORATE GOVERNANCE COMMENTARIES]; Scott, Reports of the Discussion Groups, in id., at 443-44; see Latty, Why Are Business Corporation Laws Largely "Enabling"?, 50 CORNELL L.Q. 599, 614-15 (1965) (discussing the problem of drafting to foreclose evasion). 167 See J.W. HURST, THE LEGITIMACY OF THE BUSINESS CORPORATION IN THE LAW OF THE UNITED STATES 1780-1970, at 128-30 (1970); Arsht, In Staunch Defense of Delaware, in CORPORATE GOVERNANCE COMMENTARIES, supra note 166, at 238, 242-44; Garrett, supra note 166, at 101-02; Jacobsen, Reports of the Discussion Groups, in CORPORATE GOVERNANCE COMMENTARIES, supra note 166, at 420-22; Latty, supra note 166, at 617-18; Scott, supra note 166, at 443. But see Folk, State Statutes: Their Role in PrescribingNorms of Responsible Management Conduct, 31 Bus. LAW. 1031, 1058-59 (1976) (characterizing the arguments that a particular abuse (i) is better left to case-by-case treatment and (ii) cannot be addressed in suitable statutory language as rationalizations frequently employed by corporate law revision committees for justifying their refusal to recommend statutory change). 168 See Chirelstein, Towards a FederalFiduciaryStandardsAct, 30 CLEV. ST. L. REV. 203, 20511, 216-17 (1981); Harris, Reports of the Discussion Groups, in CORPORATE GOVERNANCE COM-
MENTARIES, supra note 166, at 396-98; Kaplan, FairTreatment ofShareholders, in id. at 215, 218; Kaplan, FiduciaryResponsibility in the Management of the Corporation,31 Bus. LAW. 883, 886-88 (1976).
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tailed rules governing what is fair in the context of parent-subsidiary mergers. 169 Most such calls for basic structural change have emerged, however, from the general state-federal controversy, and the proponents of greater federalization have been far more preoccupied with the identity of the lawmaker than the wisdom of increased specificity. Hence, American corporate law generally has been unwilling to recognize that ad hoe fairness review is not the most appropriate solution. There are other important implications of the fact that regulation of fiduciary decisionmaking is essentially left to a litigation-driven ad hoc review process. Because the propriety of a particular transaction cannot be ascertained absent a lawsuit, achieving a high level of compliance with the standard requires plaintiffs willing to make a substantial commitment of resources to detecting possible violations and initiating litigation. This is particularly burdensome since the standard is so heavily fact-oriented and the fiduciary-defendant will be in principal possession of the facts. 170 The social cost of this litigation is, in essence, the price to be paid as the quid pro quo for the standard's flexibility. 17 1 In addition, the litigation process produces standards to guide future conduct only if it is pressed to the point of producing definitive court opinions capable of generalization. But the expense and uncertainty of litigating under a vague and factoriented standard and the desire by some parties to avoid adverse precedents 172 often will lead the parties to settle. In other words, uncertainty might lead to settlement, which in turn contributes to continued uncertainty. A second cluster of justifications for preferring the courts over the legislature is based on the relative independence of each. The argument here is that the basic nature of the state legislative process imparts to it a fundamental bias in favor of management and against shareholder protection. Two reasons may be advanced for this. The first is the familiar "race to the bottom" argument. 17 3 State legislatures, in order to generate revenue from corporate franchise taxes, have a strong incentive to make their corporate laws as attractive as possible to management to induce them to incorporate in their state. Even if the legislators of a particular state were philosophically in favor of toughening up their corporate laws, the effort would be futile in terms of shareholder protection since existing domestic corporations would simply reincorporate in Delaware. Of
169 See Chirelstein, supra note 168. 170 See J.W. HURST, supra note 167, at 100 (discussing the limited utility of shareholders' derivative suits). 171 See Garrett, supra note 166, at 102. 172 Cf Galanter, Why the "Haves" Come Out Ahead: Speculationson the Limits ofLegal Change, 9 LAw & Soc'Y REv. 95, 100-03 (1974) (discussing the litigation strategies of repeat players and the possible precedential value of settlements). 173 Liggett Co. v. Lee, 288 U.S. 517, 562-63 (1933) (Brandeis, J., dissenting); Cary, Federalism and CorporateLaw: Reflections Upon Delaware, 83 YALE L.J. 663, 663-70 (1974); Folk, supra note 167, passim.
course, the particular state would lose franchise revenues if the corporation moved. Thus, California, when it enacted a "tough" corporate law in 1976, felt it necessary to provide that certain key provisions would apply to any corporation with certain California contacts, irrespective of where the corporation happened to be incorporated.1 74 Judges, on the other hand, do not have this fiscal orientation and therefore are more 75 willing to hold management to account. The second factor that may make the judicial process more independent than the legislative one is the typical corporate law drafting process at the state level. Because corporate law tends to be highly complex and specialized, responsibility for developing statutory language is often delegated by the legislature to a corporate law revision committee composed of private lawyers. Membership on the committee tends to come from the large law firms with corporate clients, and this creates the likelihood of a pro-management orientation.176 At the same time, shareholders as a body are not a unified interest group and have no natural spokesman to represent their position. Thus, the legislature may hear only one side and typically lacks the staff expertise to investigate the other. The courts, on the other hand, are at least presented with both sides of the issue; moreover, the increased stature in recent times of the lawyers who specialize in plaintiffs' derivative suits helps to assure that the other side will be well represented. Both these factors, by the way, may provide one reason why the federal securities laws have emerged over the years as the principal source of statutory rigor. The federal government clearly has nothing at stake in the state chartering process and federal standards cannot be evaded by reincorporating elsewhere. In addition, the size and professional nature of the staff in both Congress and the Securities and Exchange Commission precludes the need to rely on private lawyers for expertise. Any complete comparative institutional analysis of why judicially tested fairness has prevailed over legislatively drafted standards must also consider the role of the market. That is, if detailed standards were more efficient in terms of either reducing the amount of Type I and Type II error or in producing certainty gains that offset any resulting increase in error, why, given the efficient nature of securities markets as a whole,
174 CAL. CORP. CODE 2115 (West Supp. 1986); see Halloran & Hammer, Section 2115 of the New CaliforniaGeneral CorporationLaw-The Application of CaliforniaCorporationLaw to Foreign Corporations,23 UCLA L. REV. 1282 (1976). 175 This is clearly true of federal judges and is presumably true for state judges as well. But see Cary, supra note 173, at 690-92 (criticizing the independence of the Delaware state judiciary). 176 See id. at 687; Eisenberg, The Model Business CorporationAct and the Model Business Corporation Act Annotated, 29 Bus. LAW. 1407, 1408-10 (1974); Folk, supra note 167, at 1056-58; Latty, supra note 166, at 615-16 ("You do not find beatniks on corporation law committees."); Comment, Law for Sale: A Study of the Delaware Corporation Law of 1967, 117 U. PA. L. REV. 861, 863-72 (1969).
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haven't market institutions moved to instill them? Judge (then Professor) Winter, in response to a call for detailed federal standards of fiduciary behavior, 177 conceded that such an approach was "infinitely superior to invocations of 'fairness' without decisional criteria," but argued it was more a matter for state law than federal, and added: For one thing, the approach is no answer to the claim that shareholders can't anticipate such events since it provides predictability only after a problem has ripened and been analyzed, and usually only after some courts have addressed it. One may well ask how necessary a solution is at that point since parties are free to adjust their affairs to these court decisions without great costs. Nor is there reason to believe government is of superior competence to private parties in anticipating events affecting their con178 sensual arrangements. Underlying these comments there appears to be a reliance upon the private ordering process described in section II, which in turn suggests the possibility of two market-based solutions to the problem of fiduciary regulation. The first is that prospective shareholders can compensate by paying less or more for a state of the law permitting a given level of management opportunism. This is simply an application of the section II notion of ex ante adjustment and is consistent with the general thesis of Winter's article that the alleged laxity in Delaware corporate law, if it does in fact permit excessive managerial opportunism, will be compensated for by the capital markets, causing Delaware corporations to incur a higher cost of capital. 179 The second market-based solution is that private parties, anticipating the possible arenas for management opportunism, can take steps to protect themselves as easily as the government can. This gets us back into the section II issues of monitoring and bonding, as well as the recognition that fiduciary law functions as an off-therack, low-transactions-cost substitute for the kind of monitoring/bonding regime most parties would desire.' s0 Consistent with this view, the parties should be freely permitted to "fine tune" the standard rules to meet their specific needs. But-the transactions cost issue aside--can we realistically expect such behavior from the parties involved? Let us consider this issue in the context of an example. A kind of transaction presently in vogue is the "leveraged buyout," in which a small group, usually including members of senior management, acquires all of the shares of a public corporation, often through a combination of tender offer and cash-out merger. Much of the cash is obtained by borrowing against the company's assets. Concern has been expressed over 18 1 the potential unfairness of such transactions to minority shareholders.
177 See Chirelstein, supra notes 168-69, and accompanying text. 178 Winter, supra note 8, at 284. 179 See id. at 256-58. 180 See supra note 73 and accompanying text. 181 See, eg., Hill & Williams, Buyout Boom: Leveraged PurchasesofFirms Keep GainingDespite Rising Risks, Wall St. J., Dec. 29, 1983, at 1, col. 6; Longstreth, Fairnessof Management Buyouts
Consider, therefore, the effect of a terms-specific standard that prohibited any insider buyout of the corporation at a price less than 25% above the average market value of the shares for the preceding year. On the one hand, minority shareholders might consider this desirable because it assures them a premium of at least 25% when, under ad hoe fairness review, a lower premium may pass muster. On the other hand, the standard may chill some advantageous buyouts either because the expected gains to the purchasers are below 25% of current value or because the prospect of sharing that much of the gain with the minority erodes the purchaser's incentive to bear the risk and cost inherent in putting together the deal. 182 On balance, are the minority better or worse off under the standard? Any answer would, necessarily, be conjectural; as a result, it becomes tempting to remit resolution of the problem to the mystic efficiency of the market. If such a standard was, in net effect, beneficial to minority shareholders, wouldn't the capital markets respond by valuing the shares of a corporation employing such a standard at a higher amount, thereby reducing its cost of capital? A positive answer would be consistent with Judge Winter's analysis of the capital market's response to Delaware incorporation. And, given that, wouldn't corporate management feel some pressure to adopt such a standard, and thereby bind themselves to pay at least a 25% premium in any buyout? 183 Or wouldn't the underwriters handling the first public offering of a corporation's shares insist upon such a provision? The conclusion might follow, therefore, that the widespread absence of such a standard provides a kind of empirical evidence that submitting any lever14 8 aged buyout to ad hoc fairness review is more efficient. This might be so, but there is a tendency in such arguments to expect too much of the capital markets. We have previously discussed the notion of "bounded rationality" and the limitations upon human actors
Needs Evaluation, Legal Times, Oct. 10, 1983, at 15; Thomas, A Free Ride ForManagement Insiders, N.Y. Times, Jan. 22, 1984, F, at 2, col. 3. But see DeAngelo, DeAngelo & Rice, Going Private: Minority Freezeouts and Stockholder Wealth, 27 J. L. & ECON. 367 (1984) (empirical study provides evidence that minority shareholders benefit from going-private transactions). 182 See Easterbrook & Fischel, supra note 8, at 708-10. 183 See e-g., Fischel, supra note 8, at 1284 (criticizing the concept of mandating independent directors): A far preferable course would be to allow private parties to organize in whatever manner they wish. If the structure advocated by reformers really will increase shareholders' welfare, it will be undertaken voluntarily, just as firms have always voluntarily hired independent accountants to verify representations made to investors. Firms that are organized in a manner that maximizes investors' welfare are at an advantage in attracting capital, and managers of such firms will maximize the value of their own services. (footnote omitted); see also Easterbrook, Manager'sDiscretion andInvestors' Welfare: Theories and Evidence, 9 DEL. J. CORP. L. 540, 543-53 (1984) (discussing market's pressure upon corporation to adopt optimal governance structure). 184 But cf Easterbrook & Fischel, supranote 19, at 1180-81 (arguing that absence of provisions in corporate articles denying management the right to resist takeovers does not reflect implied shareholder agreement).
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in trying to come to grips with complex layers of risk and contingencies.1 85 There is no a priori reason to assume that actors in the capital markets, either alone or collectively, possess the capacity to calculate out the value of such a leveraged buyout standard or to discount for its absence; at best they can offer impressionistic speculations. In addition, corporate promoters, managers, and lawyers-victims of bounded rationality themselves-do not "build from the ground up" every time they put together a business deal. They use traditional forms, not because they are efficient as much as because they are familiar. True, there is innovation, and lawyers and businessmen can strike ad hoc bargains to deal with perceived and tangible risks.186 But they cannot and do not cover everything. And even in the case that is most often pointed to as an example of corporate law by private contract-the covenants, representations, and warranties of loan agrements' 87-- custom tends to rule the day. Lawyers tend to rely on standard collections of boilerplate clauses, which vary little from deal to deal, and plug in the numbers negotiated by the businessmen. The upshot is that it is difficult to draw generalizations from the market's failure to promote the development of bright-line standards to govern fiduciary decisionmaking. The combination of custom, bounded rationality, and risk aversion dampens much of the incentive to innovate when innovation requires tampering with a market-proven product. It may be the case that a corporation's voluntary adoption of our leveragedbuyout standard would receive little warm response from the capital markets. Maybe that says something about its efficiency, but a more likely explanation is that market participants are not quite sure what to make of it. The complete proof will not be in until we can examine the response of the markets to a corporation that rejects such a standard in a world where all other public corporations employ it. C. The Operation of Ad Hoc Review 1. The TraditionalFramework.-We have seen that the movement of corporate law over this century has been to shift from per se prohibitions upon any conflict-of-interest transactions to ad hoc review. Mechanically, the ad hoc review process consists of two alternative formats. If no conflict of interest exists, the decisions of corporate directors will be protected by the "business judgment" rule. The plaintiff's burden under this rule has been defined with varying degrees of severity, but in any event, is heavy. Some courts require proof of "fraud, illegality or
185 See supra note 44 and accompanying text. 186 See Klein, supra note 19, at 1555 n.124. 187 See, eg., id.; Smith & Warner, supra note 38; Cf Gilson, Value Creationby Business Lawyers: Legal Skills and Asset Pricing,94 YALE L.J. 239, 256-94 (1984) (analyzing business acquisition agreements from the standpoint of "transaction costs engineering").
conflict of interest" 188 or of "gross and palpable overreaching."'' 8 9 Others frame the test not so much in terms of misconduct as of the plausibility of the decision, and require a showing that the decision cannot be supported by "any rational business purpose"' 190 or is "so unwise or unreasonable as to fall outside the permissible bounds of the directors' sound discretion." 19 1 Whatever the phrasing, the appropriate judicial inquiry is, in theory, whether the decision at issue is within the universe of possible decisions that a rational board, acting in good faith, might have made; that other possible decisions may have been wiser is irrelevant. In practice, the gist of the rule seems to be that the plaintiff must show that the justification for the transaction is so flimsy, or its terms so unsound, that a strong suspicion arises that the directors were motivated by ulterior purposes or were reckless or irresponsible in their consideration of it.192 Thus, for most intents and purposes, the rule operates to safe harbor disinterested corporate decisionmakers from attacks on the basic wis193 dom of their decisions.
188 Shlensky v. Wrigley, 95 Ill. App. 2d 173, 181, 237 N.E.2d 776, 780 (1968). 189 Getty Oil Co. v. Skelly Oil Co., 267 A.2d 883, 887-88 (Del. 1970); Meyerson v. El Paso Natural Gas Co., 246 A.2d 789, 794 (Del. Ch. 1967). But see Arsht, The Business Judgment Rule Revisited, 8 HoFsTRA L. REV. 93, 102-11 (1979). 190 Panter v. Marshall Field & Co., 486 F. Supp. 1168, 1194 (N.D. Ill. 1980), affid, 646 F.2d 271, 293 (7th Cir.), cert. denied, 454 U.S. 1092 (1981); Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971) The court's opinion in the Sinclaircase used other phrasing as well, including "gross and palpable overreaching," "resulted from improper motives and amounted to waste," and "fraud or gross overreaching." Cf. ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 4.01(a)(3) (Tent. Draft No. 4, 1985) (requiring that director or officer "rationally believes that his business judgment is in the best interests of the corporation"). 191 Cramer v. General Tel. & Elec. Corp., 582 F.2d 259, 275 (3d Cir. 1978), cert. denied, 439 U.S. 1129 (1979). The court's full sentence was: "In addition, where the shareholder contends that the directors' judgment is so unwise or unreasonable as to fall outside the permissible bounds of the directors' sound discretion, a court should, we think, be able to conduct its own analysis of the reasonableness of that business judgment." Id. Some have read this passage as inviting judicial evaluation of the substantive merits of the directors' decision over and beyond whether it is supported by any rational business purpose. Veasey & Manning, Codified Standard--Safe Harboror UnchartedReef?, 35 Bus. LAW. 919, 935-37 (1980). Others have regarded it as little more than a rephrasing of the rational business purpose requirement. ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 4.01(d) comment fat 68 & Reporter's Note 4 at 75 (Tent. Draft No. 4, 1985); Arsht & Hinsey, Codified Standard-SameHarborbut Charted Channel:A Response, 35 Bus. LAW. ix, xxv n.47 (July, 1980). 192 Meyers v. Moody, 693 F.2d 1196, 1209-11 (5th Cir. 1982), cert. denied, 464 U.S. 920 (1983); Gimble v. Signal Cos., 316 A.2d 599, 610-11, 614-15 (Del. Ch.), affdper curiam, 316 A.2d 619 (Del. 1974); Litwin v. Allen, 25 N.Y.S.2d 667, 691-700 (Sup. Ct. 1940); Selheimer v. Manganese Corp. of America, 423 Pa. 563, 573-81, 224 A.2d 634, 642-45 (1966). A recent Delaware decision suggests a much stricter test, however. In Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) (en bane), the court held in a 3-2 decision that the corporation's directors were liable for gross negligence in approving an outside takeover offer recommended by management without first adequately informing themselves concerning the transaction. 193 See, e.g., ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 4.01(a) comment h at 28-29 (Tent. Draft No. 4, 1985) ("Since the turn of the century there have been only thirty or so cases reflected in appellate opinions-almost invariably involving egregious facts-where directors
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Where, however, the transaction involves self-dealing for the possible benefit of the corporation's directors or controlling shareholders, a court will subject it to strict scrutiny. In Delaware, where the case law on this issue is probably the richest, the burden of proof shifts to the
proponents of the transaction, who must demonstrate its "entire fair-
ness." 194 In addition, the Delaware Supreme Court has recently broken down the issue of fairness into two elements: fairness of dealing and fairness of price, 195 a distinction that had also been advanced by various commentators. 19 6 Fairness of dealing involves an inquiry into the justifior officers have been found to have violated duty of care obligations."); Bishop, supra note 48, at 1099-1100: The search for cases in which directors for industrial corporations have been held liable in derivative suits for negligence uncomplicated by self-dealing is a search for a very small number of cases in a very large haystack. My own collection, based on extensive (although not exhaustive) investigation, includes four such specimens .... But to my mind none of these cases carries real conviction. See also Lewin, The Corporate-ReformFuror,N.Y. Times, June 10, 1982, at Dl, col. 3, D6, col. 6 (quoting Stanely A. Kaplan, Chief Reporter for the ALI's Corporate Governance project as saying: "All the A.L.I. draft says is that the director's judgment will be protected as long as it's not ludicrous.... My own view is that we should have said 'Directors are not liable unless they do something goofy,' but you can't use that kind of language in a Restatement."). 194 Sterling v. Mayflower Hotel Corp., 33 Del. Ch. 293, 298, 93 A.2d 107, 110 (Sup. Ct. 1952); see also Sinclair Oil Corp. v. Levien, 280 A.2d 717, 719-20 (Del. 1971) ("intrinsic fairness"). The Supreme Court of the United States has stated the test as "inherent fairness," Pepper v. Litton, 308 U.S. 295, 306 (1939), while the American Law Institute's Principlesof Corporate Governance phrases the requirement simply as "fair to the corporation." ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 5.08(a)(2)(c). By formulating the test of fairness in this manner, recourse is avoided to phrases such as "entire fairness," "inherent fairness," or "intrinsic fairness," which have sometimes been used by the courts in duty of loyalty cases, but which afford insufficient guidance in analyzing particular transactions and suggest an often unattainable degree of precision in analysis. Id. comment at 123. In addition to the case law, numerous jurisdictions have conflict-of-interest statutes that address the fairness requirement. Thus, in California, the self-dealing director has the alternative of proving that the transaction is "just and reasonable" to the corporation. CAL. CORP. CODE 310(a)(3) (West 1977). The analogous provision of the Model Business Corporation Act, section 8.31(a)(3), contains the language "fair to the corporation" and does not specify who has the burden of proof on the issue. It could be argued, therefore, that the burden should fall where it usually does, on the plaintiff. The cases arising under statutes similar to 8.31(a)(3), and its forerunner in the prior version of the Model Act, 41(c), have not, however, read the statutes as altering the mechanics of the pre-statutory fairness test; the burden is still on the proponent. Lewis v. S.L. & E., Inc., 629 F.2d 764, 769-77 (2d Cir. 1980) (construing N.Y. Bus. CORP. LAW 713(a)(3) (McKinney 1963), which was repealed in 1971); Scott v. Multi-Amp Corp., 386 F. Supp. 44, 66-68 (D.N.J. 1974); Fliegler v. Lawrence, 361 A.2d 218, 221-22 (Del. 1976) (by implication); Noe v. Russell, 310 So. 2d 806, 817-19 (La. 1975). 195 Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983) (en bane). See also Alpert v. 28 Williams St. Corp., 63 N.Y.2d 557, 569-72, 473 N.E.2d 19, 26-27, 483 N.Y.S. 2d 667, 674-76 (1984) (to the same effect); Fill Bldgs., Inc. v. Alexander Hamilton Life Ins. Co. of America, 396 Mich. 453, 461, 241 N.W.2d 466, 469 (1976) (director must show not only fair price but also fairness of the bargain to the interests of the corporation). 196 See, eg., L. SOLOMON, R. STEVENSON & D. SCHWARTZ, CORPORATIONS: MATERIALS AND PROBLEMS: LAW AND POLICIES 1019 (1982); Bulbalia & Pinto, Statutory Responses to Interested
cation and purposes of the transaction, its timing, who initiated it, who negotiated it, and who approved it. 197 Fairness of price involves a comparison of the value of what the corporation or its shareholders received with what it or they gave up. 19 8 In theory, these should be independent and conjunctive criteria. One cannot be assured that the principal, if acting independently, would have entered into the transaction simply because the price was fair; he no doubt turns down countless fairly priced opportunities daily. Thus, for example, a transaction undertaken for improper purposes should be set aside, irrespective of whether its terms are fair.199 In addition, the requirement of proper business purpose as an independent prerequisite to validity potentially 2 performs a screening function by allowing the courts to avoid the often indeterminate task of finding fair terms20 1 unless such a task is essential to the corporation's legitimate business needs. Under the present state of the law, however, whether fair dealing and fair price are independent requirements or sim20 2 ply two factors to be weighed collectively is not altogether clear.
Directors' Transactions:A Watering Down of Fiduciary Standards?, 53 NOTRE DAME LAw. 201, 209-10 (1977) (discussing the distinction between procedural and substantive fairness); Moore, The "Interested" Directoror Officer Transaction, 4 DEL. J. CORP. L. 674, 676 (1979) (stating that fair dealing and fair price are the two essential aspects of fairness); Nathan & Shapiro, Legal Standardof Fairnessof Merger Terms Under Delaware Law, 2 DEL. J. CORP. L. 44, 46-48 (1977); Note, supra note 138, at 340. 197 Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983) (en bane).
198 Id.
199 See, eg., Dower v. Mosser Indus., Inc., 648 F.2d 183, 188-89 (3d Cir. 1981) (under Pennsylvania law, merger intended solely to freeze out minority shareholders may be enjoined as breach of fiduciary duty); Alpert v. 28 Williams St. Corp., 63 N.Y. 557, 572-73, 473 N.E.2d 19, 28, 483 N.Y.S.2d 667, 676-77 (1984) (advancement of general corporate interest is necessary in order to justify freeze-out merger); Singer v. Magnavox Co., 380 A.2d 969, 978-80 (Del. 1977) (merger for the sole purpose of freezing out minority shareholders is an abuse of fiduciary duty), overruled by Weinberger v. UOP, Inc., 457 A.2d 701, 715 (Del. 1983) (en banc). The independent business purpose requirement is particularly forceful in the case of close corporations. Where one group of close corporation shareholders is treated differently from another, some courts have required that the unequal treatment be justified by a bona fide business purpose which could not be accomplished by other means. See Wilkes v. Springside Nursing Home, Inc., 370 Mass. 842, 851-52, 353 N.E.2d 657, 663 (1976); Schwartz v. Marien, 37 N.Y.2d 487, 492, 335 N.E.2d 334, 338, 373 N.Y.S.2d 122, 127 (1975). 200 The term "potentially" is used in the text to reflect the fact that, in practice, the defendant may often be able to constrnct with little difficulty a set of justifications sufficient to satisfy the business purpose requirement. Indeed, it was this failure of the requirement to provide meaningful protection that led the court in Weinberger to abandon it. Weinberger, 457 A.2d at 715. 201 See infra notes 204-05 and accompanying text. 202 The Delaware Supreme Court in Weinberger appears to have viewed them as collective factors: "However the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness." Weinberger, 457 A.2d at 711. The American Law Institute's PRINCIPLES OF CORPORATE GOVERNANCE, on the other hand, contain indications that, at least in some cases, the two factors are independent requirements. First, the PRINCIPLES make clear that the interested party's failure to disclose all material facts surrounding the transaction supplies a basis for setting the transaction aside irrespective of its fairness. ALI
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2. "Fairness"Review in Practice.-Describing standard of scruthis tiny is one thing; applying it is another. The basic objective is to determine whether a truly independent board of directors would have produced a comparable transaction. 20 3 But in a significant number of cases it is simply not realistic to ask the courts to predict, in the guise of finding "facts," how a theoretically independent board would have approached a problem or what terms it would have negotiated. 20 4 Passages in several of the opinions reveal the quandary of courts called upon to declare what is fair without the aid of an arm's-length bargained result 20 5 for comparison.
CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 5.08.(a)(1), comment a at 110, comment to 5.08(a)(1) at 116, & Reporter's Note 5 at 133, 138. Second, the comments state that fairness is to be measured "not only by comparison with an arm's-length transaction with an unrelated third party" but also by "whether the transaction affirmatively will be in the corporation's best interest." Id., comment to 5.08(a)(2)(c) at 123-24. In addition, the comments indicate that whether the interested party initiated the transaction or acted for the corporation in setting the terms are factors to be considered in assessing fairness. Id., comment to 5.08(a)(2)(c) at 124-25. 203 Pepper v. Litton, 308 U.S. 295, 306-07 (1939); International Radio Tel. Co. v. Atlantic Communications Co., 290 F. 698, 702 (2d Cir.), cert. denied, 263 U.S. 705 (1923); Weinberger v. UOP, Inc., 457 A.2d 701, 710 n.7 (Del. 1983) (en banc); Johnston v. Greene, 35 Del. Ch. 479, 490, 121 A.2d 919, 925 (Sup. Ct. 1956). 204 Cf. Auerbach v. Bennett, 47 N.Y.2d 619, 630, 393 N.E.2d 994, 1000, 419 N.Y.S.2d 920, 926 (1979): It appears to us that the business judgment doctrine, at least in part, is grounded in the prudent recognition that courts are ill equipped and infrequently called on to evaluate what are and must be essentially business judgments. The authority and responsibilities vested in corporate directors both by statute and decisional law proceed on the assumption that inescapably there can be no available objective standard by which the correctness of every corporate decision may be measured, by the courts or otherwise. 205 Western Pac. R.R. v. Western Pac. R.R., 206 F.2d 495, 499-500 (9th Cir.), cert. denied, 346 U.S. 910 (1953) (allocation of consolidated tax savings between parent and subsidiary); Getty Oil Co. v. Skelly Oil Co., 267 A.2d 883, 886-87 (Del. 1970) (allocation of oil import quotas between parent and subsidiary); Case v. New York Cent. R.R., 19 A.D.2d 383, 390, 243 N.Y.S.2d 620, 627 (1963) (Steuer, J., dissenting), rev'd, 15 N.Y.2d 150, 204 N.E.2d 643, 256 N.Y.S.2d 607 (1965) (allocation of consolidated tax savings between parent and subsidiary); Heller v. Boylan, 29 N.Y.S.2d 653, 679-80 (Sup. Ct.), afl'd mem., 263 A.D. 815, 32 N.Y.S.2d 131 (1941) (amount of executive compensation); see generally Bulbalia & Pinto, supra note 196, at 223-27; Note, supra note 138, at 337-39 (both discussing the difficulties of applying the fairness test). At this point in the discussion, the reader may be inclined to respond that courts are called upon to make tough decisions-including valuations-all the time. For example, in personal injury cases they routinely are called upon to value a lost arm or, for that matter, a lost life. And, closer to home, courts in tax cases must often decide whether an executive compensation arrangement created in an atmosphere of self-dealing is reasonable. See Vagts, supra note 20, at 257-61. What is so special, then, about corporate law? There are several answers to this. First, in areas such as personal injury law, the valuation issue arises only after a determination has been made that the defendant has breached a duty to the plaintiff, and accordingly, there may be a greater judicial willingness to require the defendant to bear the risks of error created by the valuation process. The effect of ad hoe fairness review, on the other hand, is that questions of breach and questions of value are fused. If the value is unreasonable, the fiduciaries have ipso facto breached their duty, are presumed guilty of badfaith motivation, and are liable. This, when coupled with the relative capacities of the fiduciaries to diversify-a topic dealt with infra in subsection VI.C.3.-may lead courts to be more concerned about subjecting corporate fiduciaries to the risk of error on an ongoing basis. Second, special sensi-
In some instances this will not be the case. If the transaction under review represented one of several alternatives, others of which were clearly superior in all material aspects, or if features of the transaction favorable to management or the majority are not supported by a reasonable justification consistent with the legitimate interests of the minority shareholders, the court can comfortably set aside the board's decision as
necessarily stemming from the conflict. 20
6
These kinds of cases reveal
favorable treatment of controlling interests that is not typically consistent with everyday notions of sound business practice. They involve, in essence, giveaways. And while a businessman dealing at arm's length may on occasion find it advantageous to grant special concessions to a particular client or to overlook breaches of contract, the clear risk of Type I error precludes upholding such practices when they are accompanied by self-dealing. Alternatively, if the subject matter of the transaction is fungible or a commodity for which there are market comparables, the court can realis20 7 tically rely on expert testimony to assess the fairness of the terms. The real problem, though, from the standpoint of developing meaningful guidelines to govern decisionmaking by corporate officers and directors is that so many conflict-of-interest scenarios pose opportunities that are unique. 20 8 We saw in section V. that the approach of trust and agency law to such unique opportunities was, upon the principal's intivities in the corporate law area may be created by the nature of the plaintiffs and their readiness to exploit any signs of judicial receptiveness to second-guessing the fiduciaries' conduct. In the tax cases, for example, the plaintiff is the Internal Revenue Service, which presumably exercises some selectivity in deciding which arrangements to challenge. In corporate litigation, by contrast, the plaintiff is any shareholder who chooses to bring a derivative suit. Consider whether the courts would stand as ready to look into whether compensation is reasonable for tax purposes if suit could be brought, discovery initiated, and attorney's fees obtained by any individual taxpayer who has identified a compensation arrangement that he or she believes is worth challenging. 206 See, eg. Sinclair Oil Corp. v. Levien, 280 A.2d 717, 722-23 (Del. 1971) (corporation refused to honor the terms of a purchase contract with its overseas affiliate); Shlensky v. South Parkway Bldg. Corp., 19 Ill. 2d 268, 166 N.E.2d 793 (1960) (a series of special concessions, reduced rents, and rent participation agreements by the corporate landlord to tenants in which its directors had an interest). 207 See, e.g., Lewis v. S.L. & E., Inc., 629 F.2d 764 (2d Cir. 1980) (rental of corporate property at unreasonably low rates). Even in these cases, we can expect considerable room for differences of opinion among the parties' experts. For example, suppose the subject of the self-dealing transaction is a business venture, a not infrequent occurrence. In that case, the valuation will require the experts both to project the business' future cash flows and select an appropriate capitalization rate, to produce a dollar value that attorney Peter Coogan, speaking in a different context, described as "an estimate compounded by a guess." H.R. REP. No. 595, 95th Cong., 1st Sess. 225, reprintedin 1978 U.S. CODE CONG. & AD. NEWS 5963, 6184. 208 See Scott, supra note 70, at 939-40 (most duty of loyalty cases involve goods or services for which no trading market is available); Weiss, Economic Analysis, CorporateLaw, and the ALI Corporate Governance Project, 70 CORNELL L. REv. 1, 19 (1984) ("The transactions that kindle duty of loyalty lawsuits do not involve property or services with readily ascertainable market prices. Thus, courts must formulate hypothetical terms for transactions that unrelated parties dealing at arm's length would have agreed upon.") (footnote omitted); Note, supranote 138, at 337-39 (discussing the frequent absence of comparable market prices and objective standards).
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formed consent to the conflict, to waive the per se prohibitions that otherwise would apply. 20 9 But the direct dealing between principal and fiduciary available in those settings, and necessary to make the waiver realistic, is not typically feasible in the case of a diffused-constituency principal such as the public corporation. Further, the problem is aggravated because often the very reason the conflict-of-interest opportunity is unique is that there is a certain inevitability about the corporation's need to take advantage of it.210 Management compensation and perquisites, parent-subsidiary relationships, responses to takeover bids, and freezeout mergers are all examples of this. Given this unavoidability of the conflict of interest, the costs of the Type II error created by requiring the corporate fiduciaries routinely to submit themselves to an ad hoc fairness review, made speculative by the absence of market standards by which to measure-particularly if they are to shoulder the burden of proof-are substantial. Thus, the existence of these unique-opportunity conflicts of interests places modem American corporate law in an awkward position. Courts have responded to this dilemma by preserving the doctrine that the fiduciary who deals with his or her corporate principal carries the burden of proving the entire fairness of the transaction; in practice, however, courts have accepted much less. For instance, a court may defer to formally independent decisionmakers within the corporation, such as disinterested committees of the board, even though the capacity of such decisionmakers for truly disinterested evaluation of their colleagues is open to considerable doubt;2 11 a court may extend to the corporate fiduciary the benefit of the business judgment rule even though he or she has a substantial conflict of interest; 2 12 or a court may uphold the transaction so long as its terms appear plausible even though arm's-length bargaining 2 13 may well have produced a more beneficial deal for the principal. The common theme in these situations is that the courts are willing to defer to the judgment of an intracorporate decisionmaker, even though there remains reason to doubt that this judgment is capable of producing the same results as would a decision bargained for at arm's length. The balance of this Article discusses several examples of this judicial deference and speculates on the reasons for it in light of the theoretical framework developed thus far. Three possible justifications are tendered: the value of transaction certainty, bargained-for opportunism, and the bilateral-monopoly nature of many conflict-of-interest transactions.
209 See supra notes 133-38 and accompanying text. 210 See Brudney, The Independent Director-Heavenly City or Potemkin Village?, 95 HARV. L. REV. 597, 628-30 & n.83 (1982) (observing that many kinds of self-dealing are unavoidable and therefore cannot be solved by per se prohibitions). 211 See infra notes 226-34 and accompanying text. 212 See infra notes 261-87 and accompanying text. 213 See infra notes 294-304 and accompanying text.
3. Approval by Disinterested Directors,Ratification by Shareholders and the Value of Transaction Certainty.-Courts have been willing to relieve the fiduciary of the burden of proving fairness and to review her self-dealing much less intensely where the transaction has been approved by a formally disinterested decisionmaker within the corporation, such as the disinterested members of the board of directors, an independent board committee, or the shareholders.2 1 4 Do such intracorporate processes provide a realistic surrogate for the rigor of arm's-length bargaining? As a basis for reflecting on this question, consider the situation 2 in Puma v. Marriott, 15 a leading Delaware case on this issue. This case involved a transaction between Marriott Corporation, a publicly-held company, and members of the Marriott family. The Marriotts were the principal owners of six separate corporations (the property companies) that leased real estate to the Marriott Corporation. At the same time, the Marriott family owned 44% of the Marriott Corporation's outstanding shares, and four of the corporation's nine directors were shareholders in the property companies. 2 16 Because the obvious conflict-of-interest problems posed by this arrangement had been jeopardizing the Marriott Corporation's ability to obtain listing on the New York Stock Exchange, the corporation's outside directors proposed that the corporation acquire all of the outstanding shares of the property companies. The Marriott family resisted at first, but ultimately agreed to
214 The precise impact of disinterested approval upon the intensity of judicial review varies from jurisdiction to jurisdiction. Consider, for example, the framework employed by the American Law Institute's PRINCIPLES OF CORPORATE GOVERNANCE, which is illustrative of the positions taken by many courts. If, following disclosure of all material facts concerning the transaction and the nature of the interested director's or executive's conflict, the transaction was authorized by a majority of the disinterested members of the board or by an independent board committee, then the person challenging the transaction has the burden of proving that the directors could not reasonably have believed the transaction to be fair. ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 5.08(a)(2)(A),(b), 5.04. Alternatively, if, following full disclosure, the transaction was authorized or ratified by a majority of the disinterested shareholders, then the challenger must prove that the transaction was a "waste of corporate assets," id. 5.08(a)(2)(B),(b), 5.05, which means that no person of ordinary sound business judgment could conclude that the consideration received by the corporation was a fair exchange for what it gave up. Id. 1.30 (Tent. Draft No. 2, 1984). Finally, if neither disinterested directors nor shareholders approved the transaction, the interested director or executive bears the burden of proving that the transaction was fair to the corporation. Id. 5.08(a)(2)(C),(b) (Tent. Draft No. 3, 1984). 215 283 A.2d 693 (Del. Ch. 1971). 216 Id. at 694. Marriott Corporation's board of directors at the time of the transaction consisted of J. Willard Marriott, chairman and president of the company; Alice S. Marriott, his wife; J.W. Marriott, Jr., his son; Milton A. Barlow, former executive vice-president of the company, who had resigned the year before to found his own real estate development firm; James Martin Johnston, senior partner in the firm that served as the company's investment banker; John Werner Kluge, president of Metromedia, Inc.; Don G. Mitchell, president of General Time Corp.; Louis Watkins Prentiss, a retired Army general and executive vice-president of the American Road Builders Association; and Roger J. Whiteford, senior partner in the law firm that served as the company's general
counsel. MOODY'S INDUSTRIAL MANUAL 182 (June 1965); WHO'S WHO IN AMERICA 114, 1088,
1168, 1353, 1480, 1708, 2288 (1966-67).
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exchange their property company stock for additional shares in Marriott Corporation. Valuation of the stock of the various companies for purposes of setting the terms of the exchange was overseen by the five outside directors of Marriott Corporation. In addition, independent counsel, tax experts, accountants, and appraisers were retained to assist them. The Marriott family accepted the terms of the exchange as set by the independent directors and these terms were approved by the corporation's shareholders. The plaintiff then brought a shareholders' deriviative action attacking the exchange terms and arguing that because the Marriott family stood on both sides of the exchange, it had the burden of proving the transaction's entire fairness. The court disagreed and held that the business judgment rule applied in view of the fact that the valuations were made by a majority of the Marriott Corporation's board of directors, "whose independence is unchallenged," based upon opinions from experts whose qualifications were not questioned.2 17 Giving deference to the business judgment of the directors, the court acknowledged that the expert testimony and legal analysis on the propriety of the valuations were "in hopeless conflict," but held for the defendants because it was "satisfied that in any event the methods of valuation used were not so clearly wrong as to result in an unconscionable advantage secured to the
Marriott Group. "218

The Puma case illustrates the willingness of the courts, at least in cases where the conflict of interest seems unavoidable by its nature, 219 to content themselves with the assumption that disinterested persons within the corporation have the wherewithal to neutralize the effect of the conflict. In addition to limiting the scope of review of the merits as in 2 Puma, 2 0 this judicial deference also operates at the procedural level to limit the plaintiff's right to challenge the transaction in the first place. In derivative suits, courts have held that so long as a majority of the corporation's directors had no personal interest in the self-dealing transaction-even though they had participated in approving the transaction
217 Puma, 283 A.2d at 695. 218 Id. at 696. 219 See supra text accompanying note 210. 220 See also Cohen v. Ayers, 596 F.2d 733, 739-40 (7th Cir. 1979) (approval by disinterested members of the board following full disclosure reinstates business judgment rule); Beard v. Elster, 39 Del. Ch. 153, 164-65, 160 A.2d 731, 738 (Sup. Ct. 1960) (board of directors' business judgment in approving stock option plan entitled to utmost consideration despite fact that two members of the board received options under the plan); ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 5.09(a)(2)(A) (applying business judgment rule to decisions by disinterested directors regarding compensation of fellow directors and other senior executives); cf.id. 5.08(a)(2)(A) (upholding self-dealing transactions generally, when authorized by disinterested directors following full disclosure, unless the directors "could not reasonably have believed the transaction to be fair to the corporation"). The comments accompanying 5.08(a)(2)(A) indicate that this standard is intended to embrace judicial scrutiny that is more intense than the business judgment rule, but less rigorous than the fairness test; the standard seeks to establish a "range of reasonableness" test. Id. comment to
5.08(a)(2)(A), at 119.
NORTHWESTERN UNIVERSITY LAW REVIEW and are named as defendants-the plaintiff is required to make a demand upon the board prior to commencing suit.221 Thus, these decisions would have required that Puma first refer the matter to the very outside directors whose valuations he was challenging. And if, following that demand, those directors conclude that the suit is unwarranted-a not unlikely possibility given that they have already expressed their approval of the transaction at issue-many courts hold that their decision not to bring suit is protected by the business judgment rule. 222 Finally, even where a majority of the board has a personal interest in the transaction being challenged, so that the requirement of pre-suit demand is excused, the board still has the opportunity to assemble a committee of independent directors whose decision to terminate the suit will be reviewed by the court. The amount of2 deference granted by the court varies from juris23
diction to jurisdiction.
Are these disinterested directors truly capable of making a fresh and unbiased evaluation? To be sure, the plaintiff is always free to call the court's attention to facts suggesting the directors' lack of indepen221 Lewis v. Graves, 701 F.2d 245, 248-49 (2d Cir. 1983); In re Kauffman Mut. Fund Actions, 479 F.2d 257, 265-67 (1st Cir.), cert. denied, 414 U.S. 857 (1973); Aronson v. Lewis, 473 A.2d 805, 817-18 (Del. 1984). But see Barr v. Wackman, 36 N.Y.2d 371, 379-81, 329 N.E.2d 180, 186-88, 368 N.Y.S.2d 497, 505-08 (1975) (allegation that unaffiliated directors allowed affiliated diretors to engage in pattern of self-dealing suffices to excuse demand); Buxbaum, Conflict-of-Interests Statutes and the Need for a Demand on Directors in Derivative Actions, 68 CALIF. L. REV. 1122, 1129-30 (1980) (arguing that demand should be excused). 222 Abramowitz v. Posner, 672 F.2d 1025, 1030, 1032-34 (2d Cir. 1982); Stein v. Bailey, 531 F. Supp. 684, 693 (S.D.N.Y. 1982); Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984); Zapata Corp. v. Maldonado, 430 A.2d 779, 784 & n.10 (Del. 1981). But see In re Continental Ill. Sec. Litig., 572 F. Supp. 928 (N.D. Ill. 1983); ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 7.08 comment a, at 98 (Discussion Draft No. 1, 1985) (rejecting the demand required/demand excused distinction). 223 Compare Auerbach v. Bennett, 47 N.Y.2d 619, 393 N.E.2d 994, 419 N.Y.S.2d 920 (1979) (independent board committee's decision is protected by the business judgment rule) with Joy v. North, 692 F.2d 880, 887-93 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983), and Zapata Corp. v. Maldonado, 430 A.2d 779, 789 (Del. 1981) (court may apply its own business judgment in evaluating committee's decision). But see AM. LAW. INST., PRINCIPLES OF CORPORATE GOVERNANCE AND STRUCTURE: RESTATEMENT AND RECOMMENDATIONS 7.03(c)(iii) (Tent. Draft No. 1, 1982) [hereinafter cited as AM. LAW INST.] (denying the committee power to seek dismissal of derivative suits challenging transactions between corporations and their controlling persons); cf.ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 7.08(e) (Discussion Draft No. 1, 1985) (dismissal of derivative suit against controlling persons prohibited if they are permitted to retain improper benefits). Some courts have held, however, that directors who are parties to the derivative suit may not create a special litigation committee empowered to bind the corporation. Miller v. Register & Tribune Syndicate, Inc., 336 N.W.2d 709, 718 (Iowa 1983); Alford v. Shaw, 72 N.C. App. 537, 324 S.E.2d 878, 886-87 (1985). The most recent draft of the American Law Institute's PRINCIPLES OF CORPORATE GOVERNANCE purports to take a "position intermediate between Zapata, on the one hand, and Miller and Alford, on the other." ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 7.08 comment a, at 98 (Discussion Draft No. 1, 1985).
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dence. 224 If a lack of independence is established, the business judgment
rule deference will no longer be allowed. 22 5 Commentators have argued, however, that this view is overly narrow and ignores the inherent "structural bias" 226 that exists whenever the independent directors are called upon to pass judgment on their insider colleagues, 227 and that as a result, judicial deference is, on the whole, inappropriate.2 28 To examine the potential for such structural bias, let us consider the Puma case again. First, of the five outside directors, at least two of
224 For example, the court's willingness to defer to the valuations set by the independent directors in Puma v. Marriott was premised on its observation that Except to point out that the Marriott Group owned some 46% of the Marriott stock plaintiff here has utterly failed to make any showing of domination of the outside directors. No attempt was made to impugn the integrity or good faith of these directors, all of whom were men of experience in the business and financial world. There is no testimony which even tends to show that the terms of the transaction were dictated by the Marriott Group or any member thereof. 283 A.2d at 695. 225 Some courts have imposed a fairly strenuous burden on the plaintiff in this regard and required allegations of specific facts demonstrating that, through personal or other relationships, the directors are subject to the domination and control of the interested parties. See, eg., Kaster v. Modification Sys., Inc., 731 F.2d 1014, 1018-20 (2d Cir. 1984) (facts that defendant owned 71% of corporation's voting stock and nominated all but one director do not by themselves excuse demand); Aronson v. Lewis, 473 A.2d 805, 815-17 (Del. 1984) (allegations that defendant owned 47% of corporation's stock and personally selected each director do not excuse demand). Other courts have been willing to assume domination more readily. See, eg., Clark v. Lomas & Nettleton Fin. Corp., 625 F.2d 49, 52-54 (5th Cir. 1980), cert. denied, 450 U.S. 1029 (1981) (court set aside settlement of derivative action approved by nonparty directors on the grounds that defendants in action owned, collectively, a majority of the corporation's stock and that a majority of the directors were insiders and therefore stood to lose their jobs as well as their directorships). See generally AM. LAW INST., supra note 223, 1.15 & comment (criteria for determining whether officers and directors are "interested"). 226 Note, The BusinessJudgment Rule in DerivativeSuits Against Directors, 65 CORNELL L. REV. 600, 601 (1980). The term has begun to gain acceptance in the case law. See, e.g., Clark v. Lomas & Nettleton Fin. Corp., 625 F.2d 49, 53 (5th Cir. 1980), cert. denied, 450 U.S. 1029 (1981); Aronson v. Lewis, 473 A.2d 805, 815 n.8 (Del. 1984); Miller v. Register & Tribune Syndicate, Inc., 336 N.W.2d 709, 716 (Iowa 1983). 227 For general discussions of the factors that inhibit the outside directors' capacity to carry on
forceful oversight, see E. HERMAN, CORPORATE CONTROL, CORPORATE POWER 30-48 (1981);
Brudney, supra note 210, at 607-31; Cox & Munsinger, Bias in the Boardroom: PsychologicalFoundations and Legal Implicationsof CorporateCohesion, LAW & CONTEMP. PROBS., Summer 1985, at 83, 85-108; Solomon, Restructuringthe Corporate Board of Directors: Fond Hope-FaintPromise?, 76 MIcH L. REV. 581, 583-86 (1978). 228 See, eg., Brudney, supra note 210, at 622-31; Coffee & Schwartz, The Survival of the Derivative Suit: An Evaluation and a Proposalfor Legislative Reform, 81 COLUM. L.REv. 261, 283-84 & nn.124-26 (1981); Cox & Munsinger, supra note 227, at 131-34; Dent, The Power of Directors to Terminate ShareholderLitigation:The Death of the Derivative Suit?, 75 Nw. U.L. REv. 96, 111-17 (1980); Scott, supra note 70, at 944-45; Weiss, supra note 208, at 20-21; Note, The Propriety of JudicialDeference to CorporateBoards ofDirectors,96 HARV. L.REv. 1893 (1983) [hereinafter cited as Note, JudicialDeference]; Note, supra note 226. See also Lasker v. Burks, 567 F.2d 1208, 1212 (2d Cir. 1978), rev'd, 441 U.S. 471 (1979) ("It is asking too much of human nature to expect that the disinterested directors will view with the necessary objectivity the actions of their colleagues in a situation where an adverse decision would be likely to result in considerable expense and liability for the individuals concerned.") (footnote omitted).
them-lawyer Whiteford and investment banker Johnston-were suppliers of services to the corporation, 2 29 and thus potentially dependent on the favor of its management as a source of business. 23 0 Moreover, we are told by the court that all of the outside directors "were prominent in legal, financial or business affairs in and about the City of Washington, D.C. [Marriott Corporation's headquarters], ' 23 1 a fact suggesting a network of professional and social relationships among board members not likely to foster independence. 232 More fundamentally, we can expect that none of the five would have been selected to the board in the first place had they not met with the Marriott family's approval and that the continuation of that approval was critical to their tenure. 23 3 All of this is not to imply that the outside directors exercised other than the best of faith in approving the valuations; it is simply to recognize the existence of factors that would likely lead the reasonable person to favor pleasing the Marriotts over displeasing them. Add to this the nature of what the outsiders were called upon to do. They were not, after all, negotiating with the Marriotts after having shopped around for the best deal; rather, their task was to arrive at the "fair" price for a transaction that was predestined. Thus deprived of the opportunity for the strategy and gamesmanship that is characteristic of arm's-length dealing, their work cannot be a realistic substitute for arm's-length dealing, no matter how 2 34 independent they happen to be. If the existence of structural bias calls into question the propriety of judicial deference to judgments of outside directors, the case for relying
229 See supra note 216. 230 For recognitions of the threats to independence when outside directors have significant business dealings with the corporation, see M. EISENBERG, THE STRUCTURE OF THE CORPORATION 146 (1976); Leech & Mundheim, The Outside Directorof the Publicly Held Corporation, 31 Bus. LAW. 1799, 1830-31 (1976); A.B.A. Corporate Director'sGuidebook, supra note 40, at 1620. 231 Puma v. Marriott, 283 A.2d 693, 694 (Del. Ch. 1971). 232 Commentators have discussed how the existence of such relationships contributes to similarity in outlook, a general posture of friendliness among board members, and group cohesiveness, all of which may undercut the rigor of intragroup evaluation. See E. HERMAN, supra note 227, at 41, 4344; M. MACE, DIRECTORS: MYTH AND REALITY 97-100, 108, 195-96 (1971); Brudney, supra note 210, at 612-13; Cox & Munsinger, supranote 227, at 105-07; Dent, supra note 228, at 112; Solomon, supra note 227, at 584-85; Note, supra note 228, at 1899-1901. 233 For analogous discussions of the C.E.O.'s control over the selection and retention of board members and the resulting disincentives to independence, see M. EISENBERG, supranote 230, at 14647, 176-77; E. HERMAN, supra note 227, at 31, 33-34; M. MACE, supra note 232, at 94-95; Brudney, supra note 210, at 610 n.39; Cox & Munsinger, supra note 227, at 97-98. But see Haft, Business Decisions by the New Board: BehavioralScience and CorporationLaw, 80 MICH. L. REV. 1, 21-22 (1981) (unrealistic that outside directors will be beholden to C.E.O. for their nomination). 234 See Remarks by S.E.C. Commissioner Stephen J. Friedman, "How Much Can We Expect from Independent Directors?," delivered to ALI-ABA Conf. on Investment Co. Regulation, at 4-5 (Dec. 12, 1980) (discussing requirement that independent directors approve mutual fund advisory fees and noting that the practical inability of these directors to terminate the arrangement necessarily affects the bargaining positions of both sides, so that it is unrealistic to think that the independence of the directors will produce the same result as an arm's-length negotiation).
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upon shareholder approval as a meaningful litmus test of substantive

fairness seems, if anything, weaker. The combination of management's control over the proxy solicitation process and the disinclination of the small-stakes shareholder to spend much time reflecting on how to vote has given rise to a situation whereby shareholders appear to approve almost anything that management presents to them.2 35 Nonetheless, the courts adhere to the belief that "the entire atmosphere is freshened... where formal approval has been given by a majority of independent, fully informed stockholders. 2 3 6 Thus, courts hold that shareholder ratification shifts the burden of proof to the person attacking the transaction to demonstrate that its terms represent waste, 237 a rule that, like deference 238 to disinterested directors, has drawn criticism from commentators. In light of these criticisms, why have the courts continued to defer to intracorporate decisionmaking processes invoked by the self-interested controlling parties? The weakness in much of the structural bias com235 For discussions of the absence of meaningful shareholder participation through proxy voting, see Easterbrook & Fischel, Voting in CorporateLaw, 26 J. L. & ECON. 395, 396, 402-03, 418, 419-20 (1983); Hetherington, Fact and Legal Theory: Shareholders, Managers, and Corporate Social Responsibility, 21 STAN. L. REV. 248, 250-55 (1969); Manning, Book Review, 67 YALE L.J. 1477,
1483-88 (1958); see also SEC Div. CORP. FIN., STAFF REPORT ON CORPORATE ACCOUNTABILrrY
66 (Comm. Print 1980) ("The majority of commentators expressed the view that shareholders have little interest in participating in corporate governance-they are interested primarily in the economic performance of their corporation.") (footnote omitted). The shareholder response to shark repellent measures proposed by management provides some evidence of the disinclination of individual shareholders (as opposed to institutional investors) to vote contrary to management even when it is in their economic interests to do so. See 17 SEC. REG. & L. REP. (BNA) 1960 (Nov. 8, 1985) (study by Investor Responsibility Research Center finding that of 450 antitakeover amendments submitted to shareholders in first nine months of 1985, only 19 were defeated); id. at 1829 (Oct. 18, 1985) (study by SEC's Office of the Chief Economist finding that adoption of antitakeover provisions--other than "fair price" amendments-depressed stock prices by average of 3%, and that most harmful provisions were adopted by corporations with low institutional holdings); Williams, Investors Vote on Bids to Fight Hostile Suitors, Wall St. J., Mar. 28, 1985, at 33, col. 3 (of 372 antitakeover resolutions proposed by management in 1984, only 17 were rejected). 236 Gottlieb v. Heyden Chem. Corp., 33 Del. Ch. 177, 180, 91 A.2d 57, 59 (Sup. Ct. 1952). 237 Michelson v. Duncan, 407 A.2d 211, 224-25 (Del. 1979); Gottlieb v. Heyden Chemical Corp., 33 Del. Ch. 177, 179-80, 91 A.2d 57, 58-59 (Sup. Ct. 1952); Aronoff v. Albanese, 85 A.D.2d 3, 446 N.Y.S.2d 368 (1982); ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 5.08(a)(2)(B). 238 See, eg., Chasen, FairnessFrom a FinancialPointof View in AcquisitionsofPublic Companies: Is "Third-Party Sale Value" the Appropriate Standard?, 36 Bus. LAW. 1439, 1474-76 (1981) (approval by public shareholders of acquisition by controlling party); Scott, supra note 70, at 945; Weiss, The Law of Takeout Mergers: A HistorialPerspective,56 N.Y.U. L. REV.624,676-77 (1981); Weiss, supra note 208, at 21. The experience with mutual fund advisory fees is relevant here. In response to state court decisions holding that the more-or-less perfunctory periodic ratification of the fee arrangement by fund shareholders meant that fundholders challenging the arrangement must prove waste, see, eg., Saxe v. Brady, 40 Del. Ch. 474, 184 A.2d 602 (Ch. 1962), Congress, at the behest of the SEC, amended the Investment Company Act in 1970 to include an express federal remedy for contesting the fee. By the terms of that remedy, the court is to give the fact of shareholder approval "such consideration ...as is deemed appropriate under all the circumstances." 15 U.S.C. 80a-35(b)(2) (1982). See Rogers & Benedict, Money Market Fund Mangement Fees: How Much Is Too Much?, 57 N.Y.U. L. REV. 1059, 1086-89 (1982).
mentary is the absence of an "as compared to what?" inquiry. Disinterested directors or shareholders might not be a true substitute for arm'slength bargaining, but the fact of the matter is that no substitute is available. The only readily apparent alternative to the criticized deference is full-blown adjudication of substantive fairness, and we have seen that this poses problems of its own. Thus, perhaps the core reason underlying the willingness of courts to defer is not so much a misguided faith in the decisionmaking facilities of disinterested directors or shareholders, but a 239 healthy respect for the courts' own limitations. Let us consider this in light of the analysis developed in section IV. Subjecting the transaction to an ad hoc fairness review in the absence of an established market necessarily creates the risk of some Type I and Type II errors. Where the conflict of interest is by its nature inevitableand most of the deference cases involve these kinds of conflicts-the Type II error will end up being borne by the fiduciary. 240 The fiduciary can seek ex ante compensation for this error, but, as a full-time corporate executive with little opportunity to diversify regarding the subject matter of the transaction, he or she will demand a risk premium as well. This was illustrated in the C.E.O. compensation hypothetical, 24 1 where we saw that the certainty attained by substituting a bright-line standard for ad hoc fairness review created value in and of itself, because of both the principal's risk aversion and the avoidance of litigation costs. In effect, the creation of this certainty expanded the total pie available to the principal and the fiduciary. Obtaining advance clearance for
239 Cf. Vagts, supra note 20, at 268-69:
Since judging the reasonableness of executive compensation is too imponderable or specialized for them to handle, the courts tend to defer to established corporate mechanisms. Through these mechanisms, the courts hope to purify the process without involving themselves in the decisions. W When the board of directors consists of outside members, the courts feel that they can rely upon the disinterested business judgment of that body in remuneration matters. Indeed, they breathe an almost audible sigh of relief when turning the question over to the board. See also Remarks by SEC Commissioner Stephen J. Friedman, supra note 234: [I]f there are indeed limitations to what we, can expect from the negotiations because of the inability of the board to take the ultimate step and seek a new adviser [see supranote 234], then the fact that the shareholders can sue both the directors and the adviser for breach of fiduciary duty is not much comfort. There is no reason to think that a court, or a jury, will arrive at a fee that is fair under the circumstances. Id. at 5. 240 The fiduciary bears this error because, given the inevitability of the conflict of interest, she is not free to walk away. See supra text accompanying note 96 & notes 208-10. Where the conflict of interest is not inevitable, however, the fiduciary may always avoid the costs of Type II error by dealing with third parties instead of her principal. In view of this possibility, the costs of holding the fiduciary to a strict standard are not nearly as substantial as they are where the conflict is unavoidable, and the case for judicial deference to intracorporate decisionmakers is therefore much weaker. Cf. Brudney, supra note 210, at 626-29 (advocating per se prohibitions but recognizing that many self-dealing transactions are unavoidable and therefore cannot be solved by a categorical rule); supra, text accompanying note 132 (appropriateness of per se prohibitions where market alternatives exist). 241 See supra text accompanying notes 108-15.
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the transaction from disinterested directors or shareholders, provided the 24 2 court honors it, is simply an alternative means to deliver this certainty. In theory, therefore, this procedure should lead the C.E.O. to settle for a lower expected salary, since he or she is immune from the riskiness of challenge. 243 The problem, of course, is that once the immunity from challenge is granted, the C.E.O.'s opportunism may lead him or her to exploit whatever structural bias exists and press for much more. As a result, even though the total pie is larger, the shareholders get stuck with a smaller piece. But so long as the shareholders-who are in the ideal position to diversify against error-foresee this increased risk of Type I error, they can adjust ex ante by reducing what they pay for their shares. Given the bounded rationality problem, 244 however, calculating the amount of this adjustment will be difficult if the C.E.O. is now truly free to do as he or she pleases. This suggests that the contribution that may realistically be expected from the combination of disinterested intracorporate decisionmaking and judicial review is not eliminating the risk of opportunism
altogether, but simply holding it within tolerable bounds, so that it may

be adequately estimated ex ante. The structural bias problems associated with independent directors may assure some regular risk of Type I error, but the interest of those directors in preserving their professional reputa-
tions and their personal self-esteem should suffice to keep them from giving away the store. A similar holding-within-tolerable-bounds role may be played in the case of shareholder approval by the requirement that the
242 The discussion in the text suggests that judicial deference is not as critical where the directors or shareholders are evaluating the fiduciary's conduct after the fact, as in the decision whether to dismiss a pending derivative suit, as opposed to authorizing the conduct before the fact, as in the Puma case. In the case of after-the-fact review, there is no certainty at the time of the transaction in any event. Assuming the intracorporate decisionmaker is truly independent, its reaction to the transaction will be unknown at that time. Thus, the marginal contribution to be made to overall certainty by judicial deference to its ultimate decision is not as great. But this is only a question of degree. To the extent that the corporate fiduciary has a clearer idea of what will pass muster with the board or the shareholders than of what will be upheld by the courts, certainty is increased (and, correspondingly, risk is reduced) by judicial deference to the decision of the directors or the shareholders even when their review comes after the fact. On the other side of the balance, though, the risk of structural bias may be greater with after-the-fact review than with before-the-fact authorization, because the intracorporate decisionmaker is presented with a fait accompli. See Buxbaum, supra note 221, at 1125, 1127-28; ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, comment to 5.08(a)(2)(A) at 120-22. The track record of special litigation committees in exculpating corporate management in derivative suits, see, eg., id. 7.08 Reporter's Note 3, at 123-24 (Discussion Draft No. 1, 1985); Cox & Munsinger, supra note 227, at 85, 103 n.97, suggests that management is reasonably astute at conforming its conduct to the norms that ultimately are applied by the committee's members, or that structural bias problems flaw the committee's decisionmaking process, or some combination of the two. 243 For example, we saw that for the C.E.O. in the illustration in subsection IV.G., a salary of $350,000, if protected from challenge, might be as attractive as a nominal salary of $500,000 if that higher figure is subject to ad hoc fairness review. See supra text accompanying note 114. 244 See supra text accompanying notes 44-45.
details of the transaction be put on public display in the proxy statement. Consistent with this view, courts need not abdicate altogether. But their focus should be on the quality of the intracorporate decisionmaking process, not its output. So long as the process meets the pre-established minimum necessary for due consideration-in terms of truly disinterested directors, adequate deliberation, plausible justifications for the decision, full disclosure to shareholders, and so forth-safe-harboring is appropriate. Were the courts to go further and substitute their own judgment concerning the wisdom and propriety of the result, the corporation's power to confer valuable certainty would be eroded, and the size of the total pie available to both shareholders and management diminished. In evaluating the capacity of the ex ante adjustment process to deal with the risk of Type I error that results from this deference, it is important to recognize that challenges to self-dealing involving individual fiduciaries within the corporation (as opposed to self-dealing involving larger entities, as in the case of parent-subsidiary mergers) do not typically involve much money in relation to the corporation's resources on the whole. 24 5 Consider, for example, the controversy at the heart of the Zapata Corporation litigation, which to date has produced eleven reported decisions in its various trips through the federal and Delaware courts.246 The cases involve the decision by Zapata's board of directors to accelerate the exercise date of stock options granted to Flynn (Zapata's C.E.O.) and other senior executives, four of whom were also directors. 247 The arrangement was approved at a meeting attended only by Flynn and Zapata's four nonmanagement directors, with Flynn abstaining from the vote. The objective was to permit the options to be exercised before the announcement of a Zapata tender offer that was ex245 See Coffee & Schwartz, supra note 228, at 304-05. The first tentative draft of the American Law Institute's PRINCIPLES OF CORPORATE GOVERNANCE, in stating the case for a monitoring model of the board of directors, had observed: "Market mechanisms, even if they were fully effective in holding corporate management accountable for efficiency, are unlikely to be effective in regulating such matters as managerial conflicts of interest, since many self-interested transactions are not sufficiently material in dollar terms to have significant impact on share prices." AM. LAW INST., supra note 223, 3.02 comment c, at 62. This prompted Professor Fischel to respond: "This statement is nonsensical. If the only situation in which market mechanisms do not hold managers fully 'accountable' is the situation in which no significant impact on share prices occurs, why worry?" Fischel, supra note 8, at 1288 n.103. 246 Maldonado v. Flynn, 448 F. Supp. 1032 (S.D.N.Y. 1978), aJf'd in part,rev'd in part, 597 F.2d 789 (2d Cir. 1979), on remand, 477 F. Supp. 1007 (S.D.N.Y. 1979), petitionfor mandamus denied sub nom. In re Maldonado, No. 79-3072 (2d Cir. Oct. 12, 1979); Maldanado v. Flynn, 485 F. Supp. 274 (S.D.N.Y. 1980) (corporation's motion for summary judgment granted), rev'd in part, 671 F.2d 729 (2d Cir. 1982), on remand, 573 F. Supp. 684 (S.D.N.Y. 1983) (action dismissed); Maher v. Zapata Corp., 490 F. Supp. 348 (S.D. Tex. 1980); 714 F.2d 436 (5th Cir. 1983) (approval of settlment affirmed); Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch. 1980), rev'dsub nom. Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981); 417 A.2d 378 (Del. Ch. 1980); action dismissed, (Del. Ch. Civil Action No. 4800, order filed Dec. 14, 1983). 247 The facts in the text are taken from Maher v. Zapata Corp., 714 F.2d 436 (5th Cir. 1983), which contains the most detailed statement of the facts of any of the opinions.
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pected to produce a substantial increase in the market price of Zapata's stock. Allowing the executives to exercise the options at the lower, pretender offer price reduced the "bargain spread" that would be taxable, as ordinary income, to them upon exercise, and deductible by the corporation. It was this approximately $115,000 reduction in the corporation's 2 48 deduction, which amounted to a little more than one cent per share, together with the board's grant of interest-free loans to the executives to facilitate the exercise of the options, that caused the litigation. Thus, given the relatively small amounts typically at issue in these cases, the demands upon the ex ante adjustment process are not great and the compensation necessary to correct for the risks of Type I error 249 will often be trivial. In addition to illustrating the trivial amount at stake in many cases of this sort, the Zapata cases show the difficulty inherent in a court deciding whether the arrangement is fair. Clearly, accelerating the options conferred a benefit upon the executives at the expense of the corporation, but how is the court to determine whether an independent, arm's-length decisionmaker would have acted comparably? 4. Bargained-for Opportunism.-As we have seen, 250 the business judgment rule represents the courts' willingness to defer in wholesale fashion to management's discretion on questions of business policy, and, as such, the rule has been widely applauded.25 1 Courts and commentators see the rule as recognizing the courts' limitations in deciding whether a particular business decision was "right" 252 and as promoting managerial creativity and risk-taking by removing the risk of liability for decisions that turn out poorly.25 3 Further, and consistent with the analy248 Id. at 441. The $115,000 reduction amounted to little more than one cent per share because Zapata had 10.6 million shares outstanding. Id. at 438. 249 It is important, however, to distinguish between what might be thought of as the direct and the indirect costs of Type I error in matters such as senior executive compensation and perquisites. The direct costs-as measured by the difference between the amount of such compensation upheld by a committee of independent directors or the shareholders and the arm's-length value of the executive's services-may typically be trivial in relation to the value of the firm, but may also give rise to indirect costs that are not. For example, the desire to assure the continued existence of this abovemarket benefit may contribute to the executive's propensity to manage the firm in an overly conservative manner or to resist a beneficial takeover, all at a tangible loss to shareholders. The operation of the ex ante adjustment process as it relates to management's protection of its job tenure is discussed infra at notes 271-87 and accompanying text. 250 See supra notes 188-93 and accompanying text. 251 See, eg., Gilson, supra note 19, at 823 ("The courts' abdication of regulatory authority through the business judgment rule may well be the most significant common law contribution to corporate governance."). 252 See, eg., Auerbach v. Bennett, 47 N.Y.2d 619, 630, 393 N.E.2d 994, 1000, 419 N.Y.S.2d 920, 926 (1979) (quoted supra note 204); STATEMENT OF THE BUSINESS ROUNDTABLE ON THE AMERICAN LAW INSTITUTE'S PROPOSED "PRINCIPLES OF CORPORATE GOVERNANCE AND STRUCTURE: RESTATEMENT AND RECOMMENDATIONS" 50 & n.156 (Feb. 1983) (citing various authori-
ties)[hereinafter cited as BUSINESS ROUNDTABLE STATEMENT). 253 See, eg., Joy v. North, 692 F.2d 880, 886 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983);
sis in the preceding subsection, shareholders are in the better position to diversify against the risks of such adversity. 254 Finally, in terms of managerial incentives, the need for legal intervention is displaced by the existence of a variety of market mechanisms, such as the managerial labor market, the market for corporate control, and incentive-based compensation, that work to align management's self-interest with that of the shareholders. 25 5 The clear exception to this general alignment is where management has a direct personal stake in the transaction at issue, in 2 56 which case the protection of the business judgment rule is denied. The foregoing explanation of the rule seems, at present, almost universally accepted and not at all controversial. But added to it must be our recognition that business operating decisions necessarily invoke questions of opportunism even where management has no direct financial stake in the transaction. These are the milder forms of opportunism such as shirking, job tenure, and sphere-of-influence, referred to in section II.A..257 Necessarily, when the business judgment rule is extended across the board to managerial decisionmaking, it protects from review not only bona fide disputes over optimal business policy but also management's freedom to engage in these mild forms of opportunistic behavior.25 8 As a result, shareholders are left to obtain appropriate compensation for this opportunism ex ante. Assuming management's proclivities for these forms of conduct do not change over time, this is not a troublesome task, since these proclivities will be reflected in the financial information regarding management's past performance. In the case of public corporations, this information is readily available and will be the basis for most investment decisionmaking in any event. Thus, the results of management's business policy and tastes for mild opportunism blend together, and the securities markets work to price them as a unitary package. We see a comparable phenomenon in the close corporation. The majority shareholders elect directors who, in the exercise of their independent business judgment, invariably hire representatives of the majority to run the corporation, and the law shows no concern. 259 As a result, miALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, introductory note, at 2; BUSINESS ROUNDTABLE STATEMENT, supra note 252, at 34; Demsetz, The MonitoringofManagement, in id., at B-1 to B-2. 254 See, e.g., Scott, supra note 70, at 936. 255 See, e.g., Anderson, supra note 6, at 784-87; Fischel, supra note 8, at 1288; Gilson, supra note 19, at 837-39; Hetherington, supra note 235, at 266-72; Werner, Management, Stock Market and Corporate Reform: Berle and Means Reconsidered, 77 COLUM. L. REV. 388 (1977); Bennett, More ManagersFind Salary,Bonus Are Tied Directly to Performance, Wall St. J., Feb. 28, 1986, at 27, col. 5. 256 See supra text accompanying note 194; ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, 4.01(d)(2). 257 See supra notes 19-21 and accompanying text. 258 See Anderson, supra note 6, at 783; Brudney, supra note 210, at 629 n.83. 259 See, e.g., McQuade v. Stoneham, 263 N.Y. 323, 336, 189 N.E. 234, 239 (1934) (Lehman, J., dissenting) ("The theory that directors exercise in all matters an independent judgment in practice
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nority interests command a lower price per share than controlling interests. We might refer to this as a "control premium" but it amounts to bargained-for opportunism. The reason for tolerating bargained-for opportunism in these situations is, no doubt, that it is easier to compensate for these milder and ongoing forms of opportunism ex ante than to filter 260 them out from good-faith decisions of business policy ex post. From this perspective, let us examine situations in which the risk of opportunism is more blatant, but the courts have nonetheless applied the business judgment rule to safe harbor the transaction at issue. Consider, for example, the parent-subsidiary cases. In Getty Oil Co. v. Skelly Oil Co.,261 the Delaware Supreme Court held that the parent's decision not to share any of its oil import quota with its 71%-owned subsidiary, which had lost its own quota when acquired by the parent, was protected by the business judgment rule. The same protection was extended to the parent's decision in Sinclar Oil Corp. v. Levien 262 to cause its 97%-owned Venezuelan subsidiary (Sinven) to pay dividends well in excess of its earnings during a seven-year period in which the parent was in need of cash, thereby foreclosing Sinven from expanding. In both cases, the court of chancery had held that the parent's clear domination of the subsidiary required that it carry the burden of proving the dealings were 263 fair. To the extent that the Delaware Supreme Court's decisions rest on the assumption-contrary to the view held by the chancery court-that the officers and directors of the subsidiaries were acting solely in the subsidiaries' interests, notwithstanding their being under the parents' control, its approach seems misguided. 264 But an alternative explanation for the difference in the two courts' decisions is a disagreement over the comparative merit of ex ante adjustment versus ex post judicial review in light of the inherent indeterminacy of the issues the courts were being called upon to decide: How would Getty and Skelly have allocated the quota had they been bargaining at arm's length? How much of a dividend would Sinven have paid had it been independent? Lacking the resources
often yields to the fact that the choice of directors lies with the majority stockholders and thus gives the stockholders a very effective control of the action by the board of directors."). 260 This is an application of our earlier examination of the comparative advantages of ex ante adjustment over ex post settling up where the following conditions are satisfied: reliable past performance data on the fiduciary's conduct are available; the principal has the sophistication to evaluate the data; the principal is in a better position than the fiduciary to diversify against the risk of error; and the form of opportunism at issue is mundane and ongoing. See supra subsection IY.E. 261 267 A.2d 883, 886-87 (Del. 1970). 262 280 A.2d 717 (Del. 1971). 263 Levien v. Sinclar Oil Corp., 261 A.2d 911 (Del. Ch. 1969), rev'd, 280 A.2d 717 (Del. 1971); Getty Oil Co. v. Skelly Oil Co., 255 A.2d 717 (Del. Ch. 1969), rev'd, 267 A.2d 883 (Del. 1970). 264 Professor Cary criticized the two Delaware Supreme Court decisions as a part of his general attack on Delaware's failure to protect shareholder rights. Cary, supra note 173, at 679-83. See also E. FOLK, THE DELAWARE GENERAL CORPORATON LAW 77-81 (1972).
to answer these questions with any measure of precision, the supreme court's approach was to decline the invitation and leave the parties to fend for themselves ex ante. Thus, prospective Sinven shareholders should view what they are buying not as an interest in an independent oil overall Sinclair company, but rather, as an interest in one part of the265 network, and they should price the shares accordingly. Throughout the earlier sections of this Article, we have seen, however, that leaving the principal to cope ex ante with the risk of the fiduciary's unmitigated opportunism poses various problems. Let us consider 2 two of them here: bounded rationality 6 6 and the fact that fiduciaries who desire not to take full advantage of this freedom to be opportunistic must incur the expense of bonding or pay an ex ante discount plus a risk premium. 2 67 Necessarily, significant bounded rationality problems are created by requiring the subsidiary's minority shareholders to predict the full range of the parent's opportunistic conduct. But where the issues are such that the outcome of any judicial fairness inquiry is inherently speculative, as in the Sinclairand Getty cases, these problems will exist in any event. It may be easier, when all is said and done, for the minority shareholders to predict the costs of the parent's unbridled opportunism within the business judgment rule safe harbor than to predict those costs as reduced ex post by the possible application of an indeterminate fairness standard. In other words, the addition of an ad hoe fairness review would, under the circumstances, only make the minority shareholders' position riskier. On the other hand, on issues where there would be widespread consensus on how a hypothetical independent subsidiary would act-that is, where the risk of error is slight-a court may be more willing to intervene, because its outcome is more predictable ex ante. Thus, in the Sinclair case, the Delaware Supreme Court held that Sinven's willingness to tolerate repeated breaches of contract in its dealings with another Sinclair-controlled subsidiary should be tested by the fairness standard rather than the business judgment rule, and as thus 268 tested, it was found not permissible. The other problem created by safe-harbored opportunism-the resulting need for more scrupulous fiduciaries to incur the expense of bonding themselves-is troublesome only if a significant number of fiduciaries would prefer not to take full advantage of the safe harbor. But perhaps the very factors that make the outcome of judicial review indetermi265 See Weiss, supra note 208, at 26 ("If investors in a controlled subsidiary are on notice that the parent's transactions with the subsidiary will not be reviewed under the proposed duty of loyalty rules, they can protect themselves by discounting the price they will pay for the subsidiary's stock."); Relations, 74 YALE L.J. 338, Note, CorporateFiduciaryDoctrinein the Context of Parent-Subsidiary 349-53 (1964) (advocating a test based on the reasonable expectations of persons in the position of the minority shareholder). 266 See supra text accompanying notes 44-45. 267 See supra subsection II.B. 268 Sinclair, 280 A.2d at 723.
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nate-such as the discretionary nature of the activity and the nonavailability of market substitutes-suggest that the flexibility to act freely within the safe harbor is something most fiduciaries would find valuable.
For example, to Sinclair, the right to operate its various worldwide subsidiaries as part of an integrated network, free from judicial oversight, may be worth far more than the increased price it might receive for the subsidiaries' shares if it could somehow assure investors that each subsidiary would be managed independently. In these circumstances, the court's use of the business judgment rule to delineate a permissible zone of opportunism may be seen as an attempt to rewrite the standard-form fiduciary contract 269 in situations where the fiduciary would likely find it
worthwhile (absent problems of transactions costs) 270 bargain with the to

principal for a carved-out right to be opportunistic.
269 See supra text accompanying note 73. 270 The discussion in the text assumes that the shareholder enters the relationship on notice of the special risk of opportunism, as would be the case where an investor buys Sinven stock with the knowledge of Sinclair's 97% ownership. The problem posed by the parent-subsidiary cases is how to deal with investors who bought their shares before the control relationship was created. One response is to say that these investors assumed the risk of the subsequent control relationship and the resulting increased risk of opportunism when they invested. This would theoretically result in the shares of all corporations being discounted ex ante to reflect the risk that they might become controlled subsidiaries down the road, an alternative that is not particularly attractive given the bounded rationality problems involved in assessing this risk and the risk aversion of some investors who may not be in a position to diversify their holdings. See Levmore, supra note 27, at 78 n.153; Weiss, supra note 208, at 26 n.114. Nonetheless, it is one possibility. A number of other possible solutions represent efforts to compensate the minority shareholder at the time the control position is created. One approach is that recently adopted by Pennsylvania, based on the British City Code on Take-Overs and Mergers, which requires that the parent offer to buy out all minority interests, at a statutorily defined price, once it acquires 30% of the corporation's voting shares. PA. STAT. ANN. tit. 15, 1910 (Purdon Supp. 1985); see Newlin & Gilmer, The PennsylvaniaShareholderProtection Act, 40 Bus. LAv. 111, 115-16 (1984); see also Weiss, supra rote 208, at 26 (suggesting giving minority appraisal rights). The other possible approach is to permit the minority shareholders to participate in any premium paid for the controlling interest to the extent any portion of this premium can be fairly seen as representing payment for an increased risk of opportunism. This is in essence the approach of the leading case of Perlman v. Feldmann, 219 F.2d 173 (2d Cir.), cert. denied, 349 U.S. 952 (1955). Unfortunately, this solution reinstates the need for judicial resolution of by-and-large indeterminate issues, as the court must value the likely effect of the opportunistic conduct. But at least it is a one-time inquiry as opposed to the ongoing inquiry that results from holding all dealings between parent and subsidiary to a fairness standard. Judge Easterbrook and Professor Fischel would presumably respond that the better rule is to deny the minority any portion of the premium. See Easterbrook & Fischel, supra note 8, at 715-19. They justify this position by focusing on the minority shareholder's position ex ante, but their argument is narrower than the assumption-of-risk concept set forth above. Specifically, their analysis views a control premium as representing newly created gain made possible by the control transaction, in which case-unlike the view set forth above-the control transaction leaves the minority shareholders no worse off, even if they are denied the right to pariticpate in the premium. Indeed, they specifically endorse the proposition that no shareholder should incur a loss in the market value of his or her holdings as a result of the transaction. Id. at 714-15. Thus, they are not arguing that minority shareholders should go uncompensated for increases in the risk of opportunism caused by the control transaction, but instead that the existence of those risks is overstated. Id. at 717-19.
A substantive area that is interesting to explore from this standpoint is the freedom of a target company's management to resist a hostile takeover offer. Most of the court decisions to date have protected the discretion of the target's board of directors to oppose the offer by applying the business judgment rule and placing the burden on the plaintiff to prove 271 that the directors' sole or primary motive was to retain their control. Given the clear potential for error that would result from the court's attempting to decide in retrospect which takeovers should have been accepted and which rejected, this deference is understandable. But the response of numerous commentators, 272 as well as legislators, 273 the White House, 274 and members and staff of the Securities and Exchange Commission, 275 who cite the underlying conflict of interest of the target's management in retaining their jobs and of the target's outside directors in retaining their prestigious appointments, is to condemn this approach
271 See, e.g., Treco, Inc. v. Land of Lincoln Say. & Loan, 749 F.2d 374, 376-79 (7th Cir. 1984); Buffalo Forge Co. v. Ogden Corp., 717 F.2d 757, 759 (2d Cir.), cert denied, 464 U.S. 1018 (1983); Panter v. Marshall Field & Co., 646 F.2d 271, 293-95 (7th Cir.), cert. denied, 454 U.S. 1092 (1981); Treadway Cos. v. Care Corp., 638 F.2d 357, 381-84 (2d Cir. 1980); Crouse-Hinds Co. v. Internorth, Inc., 634 F.2d 690, 701-04 (2d Cir. 1980); Johnson v. Trueblood, 629 F.2d 287, 292-93 (3d Cir. 1980), cert. denied, 450 U.S. 999 (1981); Moran v. Household Int'l, Inc., 500 A.2d 1346, 1350 (Del. 1985) (upholding "poison pill" plan); Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985) (upholding discriminatory self-tender); Pogostin v. Rice, 480 A.2d 619, 626-27 (Del. 1984)(requiring demand on directors). But see Hanson Trust PLC v. ML SCM Acquisition, Inc., 781 F.2d 264, 274-77 (2d Cir. 1986) (because directors failed to exercise reasonable diligence, burden shifted to them to justify fairness of lock-up option); Norlin Corp. v. Rooney, Pace, Inc., 744 F.2d 255, 26467 (2d Cir. 1984)(management had burden to prove that its attempt to tie up voting control of corporation's stock was fair and reasonable); Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 18 SEC. REG. & L. REP. (BNA) 423, 427-29 (Del. Mar. 13, 1986) (since active competitive bidding for the target had begun, board's grant of lock-up option was not protected by the business judgment rule, where one of primary reasons for the option was to obtain concessions for noteholders and thereby reduce directors' potential liability). 272 See, e.g., Easterbrook & Fischel, supra note 19, Gelfond & Sebastian, Reevaluating the Duties of Target Management in a Hostile Tender Offer, 60 B.U.L. REV. 403 (1980); Gilson, supra note 19; Lynch & Steinberg, The Legitimacy of Defensive Tactics in Tender Offers, 64 CORNELL L. REV. 901 (1979); Comment, The Misapplicationof the Business Judgment Rule in Contestsfor Corporate Control, 76 Nw. U.L. REv. 980 (1982). 273 See H.R. 5695, 98th Cong., 2d Sess. (1984), reprinted in Takeover Tactics & Public Policy: Hearingson H.R. 2371 et. al Before the Subcomm. on Telecommunications, ConsumerProtection, & Financeof the House Comm. on Energy & Commerce, 98th Cong., 2d Sess. 227-28 (1984)[hereinafter cited as Takeover Hearings] (proposed legislation placing burden on issuer to prove that any transaction affecting or defending against change in control is both prudent for the issuer and fair to the issuer's shareholders); Impact of Corporate Takeovers: HearingsBefore the Subcomm. on Securities of the Senate Comm. on Banking, Housing & Urban Affairs, 99th Cong., 1st Sess. 127 (1985) (statement of subcommittee chairman D'Amato that legislation directed to deal with imbalance in the application of the business judgment rule is "long overdue"). 274 See 1985 COUNCIL ECON. ADv. ANN. REP. 214-15 (suggesting that "natural evolution of the case law" will lead courts to apply stricter standards to management's defensive tactics). 275 See Takeover Hearings,supra note 273, at 22-23 (statement of SEC Chairman Shad); id. at 352-56 (proposal by former Commissioner Longstreth); 16 SEC. REG. & L. REP. (BNA) 639-40 (Apr. 13, 1984) (remarks by Director of SEC's Division of Corporate Finance).
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and advocate either restricting the board's discretion or easing the plaintiff's burden of proof. Those who call for restrictions on discretion are in essence arguing that the risk of error is, on balance, better dealt with by a set of per se prohibitions than by ad hoe review. As seen by Judge Easterbrook and Professor Fischel, 276 these prohibitions should require target management to remain entirely passive in the face of an outside 2 78 takeover offer; as seen by Professor Gilson 277 and by Lucian Bebchuk, they should permit management to seek competing offers but forbid any other form of defensive activity. Others argue, however, that the importance of protecting the board's ability to fight off offers which it finds to be contrary to the best interests of the corporation and its shareholders 2 79 demands the continued application of the business judgment rule. They are saying, in other words, that the risks of Type I error created by deferring to managerial discretion are outweighed by the risks of Type II error that would be created by increased judicial intervention or limitations on managerial discretion. Comments by Professors Klein 28 0 and Williamson2 8 suggest, however, than an important dimension of management's discretion has been overlooked in this debate-the existence of an element of bargained-for opportunism. By its reliance on fiduciary ideology, corporate law doctrine is required to treat management as simply the hired hand of the shareholders; management's sole mission is to act selflessly and singlemindedly to further the interests of shareholders. In reality, of course,
276 Easterbrook & Fischel, supra note 19, at 1201-04. 277 Gilson, supra note 19, at 865-81. 278 Bebehuk, The Casefor FacilitatingCompeting Tender Offers, 95 HARV. L. REV. 1028, 1050-
56 (1982). 279 See, e.g., Herzel, Schmidt & Davis, Why Corporate Directors Have a Right to Resist Tender Offers, 3 CORP. L. REv. 107 (1980); Lipton, Takeover Bids in the Target'sBoardroom,35 Bus. LAW. 101 (1979); Steinbrink, Management's Response to the Takeover Attempt, 28 CASE W. RES. L. REV. 882 (1978); cf. Lowenstein, Pruning Deadwood in Hostile Takeovers: A Proposal Legislation, 83 for COLUM. L. REV. 249, 313-34 (1983) (advocating continued application of the business judgment rule but requiring shareholder approval for certain defensive tactics). 280 See Klein, supra note 19, at 1542-44. Under Professor Klein's view, control over business decisionmaking is one of several elements that are subject to negotiation in structuring any business organization. The law's traditional model of the business organization is inadequate in the sense that it treats control as being in the hands of an owner-principal who employs an agent as a hired hand. This ignores the agent's legitimate interest in control, because how that control is exercised will affect the agent's incentive-based compensation along with the future value of his services. In addition, it ignores the inability of atomized equity holders to exercise control and the ever-present opportunity to modify control by contract. 281 See Williamson, supra note 40, at 1215-18. Under Professor Williamson's view, the firm is comprised of various constituencies, including management, labor, shareholders, and customers. Unlike many of these other constituencies, however, management is required to make a firm-specific investment of its human capital. As a result, its only means of reaping the full value of this capital is to sell it to the firm. Because management stands to forfeit some of this value if discharged from the firm, it will contract with the firm for compensation for this risk, in the form of higher salary, or protection against this risk, through the creation of a specialized "governance structure." One such governance structure is "golden parachute" severance benefits upon departure following a takeover.
management has an understandable self-interest in what happens to the firm. Due to its firm-specific experience and expertise, along with the fact that its present position is inevitably due in some way to the luck of the draw, management may not be able to readily replace its current status and compensation if forced to seek other employment. 282 Protection against termination is therefore an important element in the implied contract between management and shareholders. 2 83 Applying the business judgment rule to protect management's power to oppose hostile takeovers thus provides the means to extend to management something of the job tenure that other professionals have come to expect. We would expect the parties to adjust ex ante for the existence of this job protection and the bargained-for opportunism it represents: management would accept less compensation in return for the reduced risk 284 and the shareholders would pay less for their shares to reflect the reduced opportunity of auctioning the firm to the highest bidder.2 85 Of course, as thus constructed, this implicit bargain will be suboptimal if the value to management of job security is less than the loss the shareholders incur by being denied the right to auction off the firm. If so, we would anticipate that shareholders, if feasible, would willingly pay management to forgo their tenure rights. It is interesting, therefore, that the device that to date seems closest to such an arrangement, "golden parachute" severance benefits, 28 6 has invoked such widespread opposition. 287
282 In addition, as discussed supra note 249, senior management may be receiving excessive compensation and perquisites as a result of the Type I error created by judicial deference to the decisions of board committees and shareholders, which it would no longer receive if forced to sell its services at arm's length. 283 The benefits created by enhanced protection from takeovers are not limited to senior management. Recent anecdotal evidence of the kinds of morale problems associated with outside takeovers suggests that these benefits are distributed across the entire spectrum of the corporation's managerial personnel. See D. COMMONS, TENDER OFFER 114, 128-30, 138 (1985) (describing employee trauma and morale problems in takeover of Natomas Co.); Coffee, Regulating the Market for Corporate Control."A CriticalAssessment of the Tender Offer's Role in Corporate Governance, 84 COLUM. L. REV. 1145, 1238-43 (1984); Hymowitz & Shellhardt, Merged Firms Often Fire Workers the Easy Way-Not the Best Way, Wall St. J., Feb. 24, 1986, at 35, col. 4; Reibstein, After a Takeover: More Managers Run, or Are Pushed, out the Door, Wall St. J., Nov. 15, 1985, at 29, col. 4; Wells & Hymowitz, Gulf's ManagersFind MergerInto Chevron Forces Many Changes, Wall St. J., Dec. 5, 1984, at 1, col. 6; Levin, FearingTakeover of Gulf Oil, Employees Are Showing MyriadSymptons of Stress, Wall St. J., Feb. 28, 1984, at 32, col. 4; Tomasson, The Trauma in a Takeover, N.Y. Times, Jan. 9, 1982, at 11, col. 3. 284 See Klein, supra note 19, at 1542 n.69 ("Easterbrook and Fischel [in the article referenced supra note 19] fail to examine the possibility that barriers to takeovers provide management with a form of employment security they accept in lieu of higher salaries and other benefits; shareholder wealth might therefore be diminished by removing those barriers."). 285 See, e.g., Blumstein, Buying vw%Exploringfor Oil, N.Y. Times, Mar. 19, 1984, at Dl, col. 4 (comparing the value of the oil and gas reserves of major oil companies with the much lower market value of their outstanding shares). 286 Cf Williamson, supra note 40, at 1217-18. (analyzing the role of golden parachute arrangements). 287 See, eg., I.R.C. 280G, 4999 (West Supp. 1985) (provisions, enacted as part of the Deficit
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5. BilateralMonopoly.-Throughout the analysis thus far, we have assumed that there was a hypothetical single set of terms that an independent decisionmaker would have reached and that any departures from it were necessarily either Type I or Type II error. For transactions involving nonfungibles, this assumption, of course, is unrealistic, though sufficient for illustration. In the real world, however, different independent decisionmakers will have different points of view, so that we are likely to end up with a "contract range" 288 of terms, all consistent with arm'slength bargaining. Moreover, self-dealing transactions pose an interesting extension of this range concept. We have seen that one of the vexing aspects of self-dealing is that it is often unavoidable2 8 9 because the fiduciary and the principal have a unique contribution to make to one another. This uniqueness need not have existed at the time the relationship was created, but may nonetheless develop over the course of the relationship as firm-specific commitments are created. For example, when the C.E.O. was first hired by the corporation, there may have been nothing that made this particular employer uniquely attractive to him, and by the same token, the corporation may have seen him as roughly comparable to several alternative managerial trainee candidates. But over the years of working for, and then running, the company, he develops esoteric knowledge and experience that cannot be found elsewhere and that he cannot sell to competing employers for the same value as they hold for 2 90 his present corporation. What results, therefore, is a bargaining range bounded on the low end by what the C.E.O. could receive for his skills from alternative employers (for example, $300,000), for whom much of his specialized expertise has no value, and on the high end by what it would cost the corporation to hire an outsider and train him or her to the point where his or her skills matched those of the current C.E.O. (for example, $500,000). Given the resulting $200,000 range of mutual benefit, it is clearly in each party's interest to deal with the other, and in this sense, the relationship-while close to fungible at the outset-has ripened into a unique opportunity for both sides. Economists apply the term "bilatReduction Act of 1984, denying deduction for, and imposing an excise tax on, excess golden parachute payments); SEC ADVISORY COMM. ON TENDER OFFERS, REPORT OF RECOMMENDATIONS 39-41 (July 8, 1983) (recommending prohibition on adoption of golden parachutes once tender offer has commenced and otherwise subjecting them to advisory shareholder votes); Scotese, Fold up Those Golden Parachutes,HARV. Bus. REV., Mar.-Apr. 1985, at 168; Prokesch, Too Much Gold in the Parachute?,N.Y. Times, Jan. 26, 1986, 3, at 1, col. 2 (quoting several critics). But see D. COMMONS, supra note 283, at 112-13; Karney, Pols Poking Holes in Golden Parachutes,Wall St. J., Apr. 16, 1984, at 32, col. 3. 288 See Scott, supra note 70, at 939-40. 289 See supra note 208 and accompanying text. 290 See generally Williamson, Transaction-CostEconomics: The Governance of ContractualRelations, 22 J. L. & ECON. 233, 239-42, 257 (1979).
eral monopoly" 29 1 to this situation in recognition of the fact that the nonavailability of market substitutes across the full $200,000 bargaining range compels the parties to contract with each other. Were the C.E.O. and the corporation to negotiate at arm's length, we could not predict a priori the salary figure they would ultimately agree upon; all that we could say is that it would fall somewhere within the $300,000 to $500,000 range. We might expect that they would each engage in strategic tactics (such as bluffing, overstating the attractiveness of their market alternatives, and threatening to walk away) in order to command as much of the range as possible. This necessarily creates a quandary for a legal system entrusted with reviewing the fairness of the transaction when the C.E.O. controls the corporation, so that the bargaining is not at arm's length. The notion of the court finding as fact a single set of terms that independent bargainers would have reached is a pretentious one, because given the bilateral-monopoly nature of the problem, the solution is inherently indeterminate. We can with confidence say (i) that upholding as fair a result above $500,000 represents Type I error and (ii) that setting aside as unfair a result in the $300,000$500,000 range and imposing in its place a result below $300,000 represents Type II error. But that is about all we can say because so long as the corporation pays the C.E.O. one dollar less than the $500,000 ceiling, both are benefitted by the arrangement. 292 This means that the courts, deprived of all ability to rely upon the pretense of a unitary set of marketdictated fair terms, must fashion and apply abstract principles of fair play to determine where along the bargaining range the deal, as a matter of law, is to be struck. In order to investigate the problems associated with developing such fair-play principles, let us consider the debate over an area of corporate law that presents, at its heart, an application of this sort of bilateralmonopoly problem: cash-out or other mergers between a corporation and its controlled affiliate. The parent, through its ownership of the affiliate's shares and control over its board, has the power to dictate to the affiliate's minority shareholders whatever terms it chooses. To the minority, these shares represent simply one among many alternative passive investment opportunities, and the parent's control forecloses any prospect of selling the affiliate, as a firm, to competing bidders. To the parent, however, the minority shares present the unique opportunity to
291 See W. VICKERY, MICROSTATICS 115-16 (1964); 0. WILLIAMSON, supra note 22, at 28; Levmore, supra note 27, at 77 n.145. 292 Of course, added to this must be the recognition that in most cases where the problem arises, the endpoints of the range will not be capable of specification with the precision assumed in the foregoing illustration. That is to say, there will typically be considerable room for difference of opinion as to what, for example, the C.E.O.'s value to outside employers might be. But at least reference to the market is still theoretically available to measure this value. The bilateral monopoly dimension introduces the complication that, as between those market-derived endpoints, reference to some external single-point notion of "fair market value" is no longer possible, even in theory.
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obtain plenary control over the affiliate's business and its cash flow, and with it to eliminate a variety of costly burdens, including duplicated staff functions, separate securities law reporting obligations for the affiliate, fiduciary problems with intercompany dealings, and minority shareholder relations concerns generally. The resulting difference between the value of this opportunity to the parent and the pure investment value of the shares to the minority creates the bargaining range over which minority and parent present each other with a unique opportunity to create 293 mutual benefit not otherwise available in the marketplace. As a basis for exploring this issue, let us consider the law of Delaware and begin with the case that established the Delaware "entire fairness" test, Sterling v. Mayflower Hotel Corp.294 It involved a challenge to the stock-for-stock merger of Mayflower Hotel Corporation into Hilton Hotels Corporation, which had acquired a majority stake in Mayflower six years before and at the time of the merger owned five-sixths of its shares. Mayflower's sole business was the ownership and operation of the Mayflower Hotel in Washington, D.C.; Hilton owned and operated a national hotel chain. To determine the merger terms, Hilton had hired an independent consultant who recommended the exchange of one share of Hilton, then trading at $14.75 per share, for each share of Mayflower. The consultant's study observed that the financial record of Hilton had been substantially superior to that of Mayflower, and that upon that basis it could be argued that Hilton should not offer better than three-fourths of a share; it concluded, however, that because of the problems incident to Hilton's control of Mayflower and the advantages of complete ownership, a share-for-share exchange was fair and reasonable to all 295 concerned. The plaintiffs, minority shareholders of Mayflower, challenged this exchange ratio as unfair. They submitted evidence appraising the Mayflower Hotel at $10.5 million, the equivalent of $27 per share, and argued that because Hilton was in substance buying the hotel, this should be the appropriate measure of what they were due. 296 This argument reveals the essential bilateral-monopoly nature of the situation. At the low end of the bargaining range is the value of Mayflower shares as a pure investment security, based solely on their dividends and earnings; at the high end, the value to Hilton of outright ownership of the Mayflower Hotel. The court sided with Hilton, reasoning that, inasmuch as Hilton's
293 See Chasen, supra note 238, at 1471. Of course, the minority might be able to sell to third parties, such as investors in the marketplace, and receive something above the pure investment value of their shares. But this premium would simply represent the purchaser's expectation of ultimately receiving some portion of the bargaining range by dealing with the parent. Thus, the third-party transaction is merely the substitution of a new minority shareholder for the present one. 294 33 Del. Ch. 293, 93 A.2d 107 (Sup. Ct. 1952). 295 Id. at 298-99, 93 A.2d at 110. 296 Id. at 300, 93 A.2d at 111-12.
objective was to continue Mayflower as a going concern, liquidation value was an inappropriate measure of what the plaintiffs were entitled to in the merger. In the process, the court stated that "the stockholder of the merged corporation is entitled to receive directly securities substantially equal in value to those he held before the merger" 297-a formula298 tion that has been referred to as the "give-get" test. Is this give-get test consistent with the court's earlier statement that because the Hilton directors stood on both sides of the transaction "they bear the burden of establishing its entire fairness, and it must pass the test of careful scrutiny by the courts"? 2 99 Let us consider this in light of the analytical framework developed by Judge Learned Hand in Ewen v. Peoria & Eastern Railway Co.,3 where the court was called upon to review a series of arrangements between a railroad and its majorityowned subsidiary, which dominated it pursuant to a joint "Operating Agreement." Consistent with our bilateral-monopoly analysis, Judge Hand recognized that even though it was "wholly impossible even approximately" to set the terms that the two railroads would have agreed to at arm's length, it might be possible to specify the outside limits within which the parties would be willing to deal. 30 1 The outcome would then turn on who bears the burden of proof. If it were the subsidiary, the subsidiary must prove that the terms dictated by the parent were beyond the minimum it would have accepted if independent-in other words, that the terms were outside the bargaining range and therefore no risk of Type II error would be created by setting them aside. Conversely, if the burden were on the parent, the parent must prove that it would have refused to deal on terms any more favorable to the subsidiary-in other words, that the terms are at the very top of the range, so that no risk of 302 Type I error would result from upholding them. Under Judge Hand's approach, the Sterling court's statement placing the burden on Hilton to prove entire fairness would require it to give up the entire bargaining range to Mayflower, for there can otherwise be no absolute assurance that Hilton did not use its dominance to impose terms on Mayflower that would not have prevailed at arm's length. In terms of result, however, the Sterling court accepted much less. 30 3 Once
297 Id. at 303, 93 A.2d at 112. 298 See Brudney & Chirelstein, FairShares in Corporate Mergers and Takeovers, 88 HARV. L. REV. 297, 310 n.35, 315 (1974); Lorne, A ReappraisalofFairShares in ControlledMergers, 126 U. PA. L. REv. 955, 958 (1978). 299 Sterling, 33 Del. Ch. at 298, 93 A.2d at 110.
300 78 F. Supp. 312, 315-17 (S.D.N.Y. 1948), cert. denied, 336 U.S. 919 (1949). 301 Id. at 317. 302 Id. 303 See, e.g., Vorenberg, Exclusiveness of the Dissenting Stockholder's Appraisal Remedy, 77 HARV. L. REV. 1189, 1214 (1964) (suggesting that Sterling requires less than that called for by the Hand formulation and may be read merely as imposing on those seeking to sustain the transaction the task of introducing more persuasive evidence that the terms were fair than the plaintiff in-
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Hilton demonstrated that the exchange terms represented an honest effort to give Mayflower shareholders value equivalent to their premerger holdings, the court was willing to accept them. In effect, the court de34 0 ferred to Hilton in the face of a clear risk of Type I error. In response, various commentators have criticized the give-get test and argued that fairness dictates that the minority be permitted to share in any merger-created gain. For example, Professors Brudney and Chirelstein have advocated that the minority shareholders of the subsidiary and the shareholders of the parent be viewed as participants in a common enterprise, with the fiduciary obligations of parent management running equally to both groups. 30 5 Analogizing this situation to an investment advisor called upon to allocate a cost savings among the various accounts under his management, Brudney and Chirelstein conclude that the merger-created gain should be shared by the two groups of shareholders in proportion to their premerger holdings. 30 6 An alternative protroduces that they were not); cf. Brudney & Chirelstein, supra note 298, at 315-17 (suggesting that arm's-length bargaining would call for sharing of expected merger gains on some basis). 304 See also David J. Greene & Co. v. Schenley Indus., Inc., 281 A.2d 30, 32-35 (Del. Ch. 1971) (acknowledging the existence of self-dealing, but refusing to enjoin merger when value of securities offered for subsidiary's stock closely approximated its market price); cf Brudney & Chirelstein, supra note 298, at 318 n.49 (observing that results of cases suggest that the difference between the business judgment rule and the intrinsic fairness standard is not significant). 305 Brudney & Chirelstein, supra note 298, at 317-19. The authors were careful to limit this characterization to the case in which the parent-subsidiary relationship was longstanding. Where, by contrast, the merger follows closely on the heels of the parent's initial acquisition of control, they argued that the merger should be treated simply as the second step of an integrated plan of acquisition, with the merged-out shareholders therefore entitled to receive the same price per share as the parent had earlier paid for control. Id. at 330-40; Brudney & Chirelstein, A Restatement of Corporate Freezeouts, 87 YALE L.J. 1354, 1359-65 (1978). 306 Brudney & Chirelstein, supra note 298, at 319-22. An interesting aspect of the Brudney and Chirelstein proposal for our purposes is that it represents the sort of bright-line standard we considered in subsections IV.F and G. above. We saw there that the disadvantages of such standards were their greater prospensity (relative to ad hoc review) for error, see supra first four paragraphs of subsection IV.G., and the "adverse selection" problem created by the fiduciary's ability to deal with the principal when the standard worked in her favor and to deal on the market when it did not, see supra text preceding note 116. The Brudney and Chirelstein proposal illustrates that these problems are alleviated when the relationship between fiduciary and principal represents a bilateral monopoly. First, so long as the terms dictated by the standard are somewhere within the bargaining range, the notion of error is, as we have seen, academic, inasmuch as there exist no market alternatives to measure against. Second, because at every point within that range the terms available are by definition more attractive to the parent than are market substitutes, the incentives creating the adverse selection problem are eliminated. On the other hand, one may argue that the parent still possesses some power to manipulate the merger terms, even under the standard, through its control over the timing of the merger. See Brudney, supra note 47, at 1099, 1131-32; Brudney & Chirelstein, supra note 298, at 305-06; Brudney & Chirelstein, supra note 305, at 1373 n.35; Greene, CorporateFreeze-out Mergers: A Proposed Analysis, 28 STAN. L. REv. 487, 493 (1976); additional authorities cited infra note 321. The parent's ability to defer the merger when it believes, given its access to inside information about the prospects of both companies, that the parent's shares are undervalued in relation to the subsidiary's and compel the merger when the opposite is true may be viewed as a species of adverse selection.
posal comes from Professor Weiss, who argues that the minority should receive their pro rata share of the firm's "third party sale value," that is, the price that could be obtained in a sale of the firm, as a whole, to an 7
outsider.
0 3
On the other hand, the work of Judge Easterbrook and Professor Fischel and of Professor Williamson offers possible justifications for the Sterling court's posture of deference. Easterbrook and Fischel support a rule allowing the parent to retain all merger-created gains, provided the minority shareholders are left no worse off as a result of the transaction. 30 8 This is simply one application of their general argument that a rule of full-gain retention serves to maximize a corporation's incentives to incur the cost and risk necessary to search out and put together beneficial control transactions, and that under such a rule, shareholders as a
whole are better off.30 9 Their objective is in effect to minimize the con-
trol person's exposure to Type II error in the interest of inducing efficient control transactions, subject to the constraint of assuring that the minority shareholders' treatment is still within the bargaining range (albeit at the very bottom) so that the existence of unequivocal Type I error is avoided. At a more general level, we can view the problem as an application of Professor Williamson's theories of transactions costs contracting. As 0 noted earlier, 3 1 Professor Williamson has described how a buyer-seller relationship, though created in a competitive market setting where both parties were free to choose among numerous alternatives, may nonetheless be transformed over its life into a species of bilateral monopoly if the parties are required to make transaction-specific (idiosyncratic) commitments to the relationship. 3 11 Thereafter, as issues arise over gaps in the contract, or changes in business conditions dictate the need for modifications, each party becomes particularly vulnerable to the other's opportunistic conduct inasmuch as abandoning the relationship and turning to market substitutes would require a forfeit of those transaction-specific investments. As a consequence, the parties (having foreseen this risk)
307 Weiss, supra note 238, at 678-80; see also Chasen, Friedman & Feuerstein, Premiums and Liquidation Values: Their Effect on the Fairnessof an Acquisition, in ELEVENTH ANNUAL INSTITUTE ON SECURxTIEs REGULATION 163 (A. Fleischer, M. Lipton & R. Stevenson eds.) (statement by Martin Lipton that most courts would now consider third-party sale value as a major factor in determining fairness to minority); cf. Chasen, supra note 238, at 1445, 1477 (simulation of arm'slength negotiation requires premium over pre-acquisition value, but does not require third party sale value); N.Y. Bus. CORP. LAW 623(h)(4) (McKinney Supp. 1986) (enacted 1982) (dissenting shareholder entitled to fair value determined in light of various factors, including nature of transaction and the valuation techniques customarily applied to comparable transactions in the relevant securities and financial markets). 308 Easterbrook & Fischel, supra note 8, at 723-31.
309 Id. at 703-15.
310 See supra text accompanying note 290. 311 Williamson, supra note 290, at 239-42.
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will insist upon some sort of protective device-what Williamson refers 2 to as a "governance structure" 3 1 -to regulate their contractual relations in lieu of the market, before agreeing to make any idiosyncratic investment in the relationship. And-because both parties stand to benefit from this investment-the creation of such a specialized governance structure should prove mutually acceptable. The common thrust of these two approaches is that in the case of bilateral-monopoly relationships we must focus on the fiduciary's incentives not only as of the time of the self-dealing transaction (Step #2), but also as of the time when the relationship was first being contemplated (Step # 1). Once having taken Step # 1, the fiduciary is forced to look to the court for the permissible allocation of Step #2 benefits, and has no real opportunity to walk away. Assuming we deem the combination of the two steps to be, on the whole, desirable, we must recognize that the incentive to take Step # 1 may well require some advance assurance that the court will not demand the lion's share of the bargaining range as the price for Step #2. Given this perspective, perhaps the Sterling court's position represents more than the simple willingness to tolerate a greater risk of Type I error than the Hand formulation would allow, and reflects an underlying belief that arm's-length bargaining is not the appropriate referent for reviewing the propriety of the merger's terms. In other words, even though the bilateral-monopoly dimension of the relationship might permit the minority shareholders-if able to negotiate independently with the parent-to hold out for a portion of the merger-created benefit, they should have no substantive entitlement to it.313 Thus, the compulsory aspect of the statutory merger, conditioned upon majority approval by the affected shareholders-when coupled with the judicial deference embodied in the give-get test-may be seen as a form of spe312 Id. at 234-35.
313 This point is illustrated by the Sterling court's response to Hilton's offer to buy any and all of the Mayflower minority's holdings at $19.10 per share, a significant premium over its market value, which might be viewed as compensation for their strategic position. The Sterling plaintiffs had declined the offer, and had pointed to that offer along with the $16.25 market price of Mayflower's shares-in comparison to the $14.75 per share market price of the Hilton stock they were to receive in exchange-as evidence of the unfairness of the merger terms. The court, however, thought this market price comparison must be disregarded, in that the Mayflower price was "fictitious, that is, higher than would be justified in a free and normal market uninfluenced by Hilton's desire to acquire it and its policy of continued buying." Sterling v. Mayflower Hotel Corp., 33 Del. Ch. 293, 300, 93 A.2d 107, 111 (Sup. Ct. 1952). It concluded that Hilton's offer of $19.10 per share was "under the circumstances, no evidence of true market value," id. at 308, 93 A.2d at 115, and that "it is enough to say, as the Chancellor said, that the minority stockholders of Mayflower suffer no harm from the offer and have no ground of complaint," id. at 310, 93 A.2d at 116-17. This position is also consistent with the traditional stance of appraisal statutes, which value the dissenters' shares as of the time immediately prior to the merger and exclude any element of gain created by the transaction. See, eg., CAL. CORP. CODE 1300(a) (West Supp. 1986); DEL. CODE ANN. tit. 8, 262(h) (1983); MODEL BUSINESS CORP. AcT 13.01(3) (1984). But cf. N.Y. Bus. CORP. LAW 623(h)(4) (McKinney Supp. 1986) (value as of day prior to shareholder authorization date, but no reference to exclusion of merger-created gain).
cialized governance structure that assures a prospective acquirer protection in advance against opportunistic conduct by minority shareholders who otherwise would be free to hold out for a substantial share of the bilateral-monopoly bargaining range once the acquirer makes its thresh314 old investment Further, even when the fiduciary has taken Step # 1 and thereby entered into the bilateral monopoly relationship, the judicial review process has continuing incentive implications for the fiduciary's willingness to follow up with Step #2. By taking Step #2, the fiduciary in effect elects to be bound by whatever price the court ultimately determines to be fair. In theory, the fiduciary will still be better off for having taken Step #2 as long as that resulting price lies anywhere within the bargaining range. But, in reality, courts face the same risk of error in seeking to delineate the outer limits of the bargaining range as they do in seeking to predict how arm's-length decisionmakers would have bargained. In the case of parent-subsidiary mergers, the endpoints of the range will turn on questions of valuation-what savings may be expected, how shared costs should theoretically be allocated, what substitutes are available, and so forth-which of course are matters of judgment and speculation. Thus, in close cases, the parent may conclude that the prospect of Step #2 benefits is outweighed by the expense of putting the transaction together and the risk that judicial redetermination of the price will leave it worse off.3 15 Thus, judicial deference as manifested in the Sterling case or the application of an unequivocal standard, such as the Brudney and Chirelstein sharing proposal, 31 6 has the advantage of contributing to overall
314 This squares with the history of the reduction of the shareholder approval requirement from unanimity, to two-thirds, to a bare majority, in part to diffuse the hold-out advantages of minority shareholders. For a description of this history, see generally Carney, supra note 47, at 77-97; Weiss, supra note 238, at 626-31. 315 See Carney, Shareholder Coordination Costs, Shark Repellents, and Takeout Mergers: The Case Against Fiduciary Duties, 1983 AM. B. FOUND. RESEARCH J. 341, 363-66 (uncertainty and delay created by fairness test may discourage takeovers). One might argue that so long as the parent's shareholders hold diversified portfolios, the riskiness inherent in judicial review of the merger price should not be a factor in the decision to merge. One response to this is that while the parent shareholders are diversified against the risk, parent management is not. To the extent that a court's ultimate determination of what is a fair price has an impact upon management-in terms of amounts of bonuses or other compensation, reputation within the firm, opportunities for advancement and so forth-they will be risk averse. Thus, the shareholders themselves may be risk-neutral, but the managers entrusted with making the merger decision are less likely to be. In addition, uncertainty will contribute to higher litigation costs. 316 See supra notes 305-06 and accompanying text. The discussion in the text suggests that the most important feature of a standard as a solution to the bilateral monopoly problem is not its substantive content-so long as it meets the core requirement of assuring an outcome somewhere within the bargaining range-but the fact that it is a standard, and therefore has the potential quality of bright-line certainty. From this perspective, in evaluating the Brudney and Chirelstein sharing proposal, Simon Lorne's exposition of the practical difficulties in applying the proposal to non-stock mergers, Lorne, supra note 298, at 983-87, is considerably more damning to the proposal's utility than is his criticism of its singular view of what fair sharing entails, id. at 970-77.
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certainty, which as we have seen 317 creates value in and of itself. What are the implications of this approach when we shift our concerns from enhancing the parent's incentives to protecting the interests of the subsidiary's minority shareholders? At first blush, this latter concern would seem best remitted to the ex ante adjustment process. Just as it is meaningless to speak of a unique "fairness point" within the bargaining range,3 18 so too is there little to suggest that any particular rule for allocating that range is better than its alternatives in terms of facilitating the ex ante estimates of the parent's and subsidiary's shareholders. Thus, considerations of minority protection need not interfere with the law's freedom to set the rule at whatever point-so long as it lies somewhere in the range-that other policy considerations dictate is soundest. Judge Easterbrook and Professor Fischel in effect press this line of reasoning to its extreme by arguing, as we have seen, 3 19 that efficiency objectives dictate that the minority should be entitled only to the market value of its 320 premerger holdings. This position seems plausible in theory. But when we move from theory to reality, we must recognize that the inherent risk of Type I error in the valuation process virtually assures that any rule requiring the parent to show merely that the merger leaves minority shareholders no worse off will result in upholding some mergers that in fact do not. Indeed, a concern for the various possible sources of this Type I error underlies the work of several commentators and serves to explain their positions. Professor Brudney has written frequently that the parent's ability to manipulate the subsidiary's market value through such means as control over dividend policy and the selection of accounting principlies, coupled with its plenary access to inside information, places it in the position to initiate merger only when it is confident that the standard of value to be applied by the courts is out of line with the subSee supra text accompanying notes 108-15 and notes 240-41. See supra text accompanying notes 291-92. See supra notes 308-09 and accompanying text. Easterbrook & Fischel, supra note 8, at 714-15. Easterbrook and Fischel rely upon the shareholders' position, ex ante, as the solution to problems of adequate protection of their interests, but their argument is narrower than the one put forth in the text supra at note 318. They assert that investors as a class will prefer the rule that maximizes their position ex ante. Under their proposition, shareholders of parents gain more and shareholders of subsidiaries gain less than under a rule of equal sharing. But, they contend, because the total number of gain-producing transactions is increased, investors as a class benefit. And any individual investor may balance out the risks of being on the losing and gaining ends, respectively, by holding a diversified portfolio. Id. at 703-04, 711-14. Thus, in their view, the ex ante compensation for the risk of being denied the gain in some transactions is the prospect of receiving all of it in others. As a result, their argument is vulnerable to the criticism that to the extent the investment opportunities in subsidiaries outnumber those in parents, investors will be undercompensated. See, e.g., Brudney, supra note 47, at 1100. But this concern is overdrawn. So long as the price of subsidiary shares properly reflects the prospect that they will not share in any gain created through merger with the parent, the holder of these shares receives a "fair" return whether or not he also holds shares of parents. 317 318 319 320
NORTHWESTERN UNIVERSITY LAW REVIEW sidiary's true worth.32 1 An important theme in Professor Carney's writings is that because individual shareholders value their stock differently-that there is, in effect, an upward-sloping supply curve for the shares-cashing out all minority shareholders at a uniform price, even if it represents a premium over the market-clearing price, will likely leave some undercompensated.3 22 And attorney Bate Toms has written that the differing tax consequences and reinvestment costs from shareholder to shareholder may result in the merger's making some of them
worse off.
32 3
While minority shareholders may compensate ex ante for the combined risk of these sources of Type I error, the common theme in these commentaries is that the risk is a systematic one. Thus, parent corporations can routinely exploit it to force through mergers that may well be inefficient in the sense that the value the parent stands to gain is actually less than the value-if computed in an error-free manner-the minority stands to lose. 324 As a result, unless we deny these sources of Type I error, the Easterbrook and Fischel proposal becomes vulnerable to attack by the very efficiency goals that it seeks to promote. And the true advantage of a gain-sharing requirement as proposed by Brudney and Chirelstein may be that, even allowing for the prospect of Type I error in its application, the minority should still emerge from the merger with at least as much as it had before. In summary, then, the foregoing suggests why the task of judicial review in the bilateral-monopoly area is a difficult one even though the court has the entire bargaining range within which to work.325 The courts must provide rigorous protection against the risk that systematic Type I error will allow the fiduciary to undermine efficiency by imposing results outside the bargaining range, but at the same time provide sufficient advance guarantee against the possibility of Type II error to induce the fiduciary to take both Step # 1 and Step #2 where the transaction would be mutually beneficial to fiduciary and principal. Measured against these criteria, the Sterling approach may be justified as a rough321 See Brudney, supra note 47, at 1099; Brudney, Efficient Markets and Fair Values in ParentSubsidiaryMergers, 4 J. CORP. L. 63, 69-74 (1978); Brudney & Chirelstein, supra note 298, at 30506; see also Roland Int'l Corp. v. Najjar, 407 A.2d 1032, 1037 (Del. 1979) (majority shareholder may time short-form merger to favor itself, based upon status of market and elements of appraisal); Weiss, supra note 238, at 654. 322 See Carney, supra note 315, at 354-57, 385-86; Carney, supra note 47, at 110-18. Professor Levmore has also discussed the implications of this phenomenon. See Kanada & Levmore, The AppraisalRemedyand the Goals of CorporateLaw, 32 UCLA L. REV. 429,437-41 (1985); Levmore, Self-Assessed Valuation Systems for Tort and OtherLaw, 68 VA. L. REv. 771, 850-52 (1982). 323 See Toms, CompensatingShareholdersFrozen Out in Two-Step Mergers, 78 COLUM. L. REV. 548, 569-70 & n.72 (1978). 324 See Carney, supra note 315, at 352, 367-68, 375; Hoffman, The Efficiency and Equity of Corporate Sharing Rules, 7 CORP. L. REV. 99, 107-09 (1984). 325 The court has this range to "work within" in the sense that so long as its outcome is anywhere within the range, both parties still benefit from the transaction.
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and-ready attempt to provide the incentive guarantees through a general posture of deference while employing the "entire fairness" and "careful scrutiny" rhetoric to assure that the outcomes are truly within the bargaining range. Limited judicial deference of this variety is necessarily a two-way street. If confident that the fiduciary's decisionmaking process has attributes (such as independent third-party participation) to assure its capacity to produce a result somewhere within the bargaining range, the court can defer to it and thereby avoid having to make the inherently indeterminate calculation of what terms are fair. The prospect of this deference then provides the incentive for the fiduciary to employ a decisionmaking process of demonstrable quality and independence, for it realizes that if defects in the process are patent, the court may redetermine de novo what is fair, and impose those terms upon the fiduciary with the accompanying risk of Type II error. By the same token, unless there is some prospect that the court will defer to the fiduciary's internal decisionmaking, then, as we saw in subsection IV.E.,326 the fiduciary's incentives are to forgo all self-restraint and select the most self-serving terms that a court might ultimately allow, with the result that the judicial task of redetermination becomes inevitable. Ironically, therefore, the court's increased willingness to intervene, by dictating what terms are fair, may operate to induce even more opportunistic conduct by the fiduciary. Against this backgroundlet-us considertwo-important implications of the Delaware Supreme Court's most recent merger landmark, Weinberger v. UOP, Inc. 32 7 The first is the court's decomposition of the entire 328 fairness concept into separate elements of fair price and fair dealing. This represents an explicit recognition that a principal focus of judicial review should be the quality of the parent's decisionmaking process, and the analysis of these fair dealing issues comprises a major part of the Weinberger opinion. 329 The court's detailed examination of how the
See supra notes 97-104 and accompanying text. 457 A. 2d 701 (Del. 1983) (en banc). Id. at 711. See supra notes 195-202 and accompanying text. The case involved the cash-out merger of UOP, Inc. into its parent, The Signal Companies, Inc., which had acquired 50.5% of UOP's stock by tender offer three years before. The merger price was $21 per share; prior to the announcement of the merger UOP stock had been trading for $14.50 per share. The court pointed to several factors in support of its finding that the merger was not the product of fair dealing. Probably the most important of these was the fact that a report prepared by two Signal officers who were also directors of UOP, which used UOP information and concluded that acquisition of the remaining UOP shares at any price up to $24 would be a good investment for Signal, was not shared with the outside directors of UOP, 457 A.2d at 705, 708-09, 711. Other factors the court cited included (i) the serious time constraints imposed by Signal, which resulted in the transaction's being presented to and approved by UOP's board within four business days, id. at 711; (ii) the fact that UOP's chief executive officer never bargained over price except within the $20$21 per share range that Signal proposed, id. at 705-06, 711; (iii) the hurried and cursory manner in which UOP's investment banker prepared its fairness opinion, id. at 706-07, 712; and (iv) the failure to disclose to UOP's minority shareholders the rushed nature of the fairness opinion and the fact 326 327 328 329
merger terms were reached-particularly when read in light of its statement that "the result here could have been entirely different if UOP had appointed an independent committee of its outside directors to deal with Signal at arm's length" 330 -sugests that, consistent with our analysis in the preceding paragraph, the court was trying to encourage the development of reliable intracorporate bargaining mechanisms as a substitute for de novo fairness determinations by the court. 3 31 At the same time, it reveals that while the court may be reluctant to second-guess the outcome of the corporation's internal decisionmaking process, it is more comfortable reviewing the quality of the process itself. The court's recent decision in Rosenblatt v. Getty Oil Co. 332 confirms, however, that once it is convinced that the intracorporate process truly bears the earmarks of arm's-length bargaining, the court will defer. 333 Some commentators read Weinberger, however, as setting too high a price for this deference and contemplating disclosures and procedures that may in practice require that the subsidiary's shareholders receive the lion's share of the bargaining range if the deal is to go through. 334 If true, these concerns
that Signal had considered any price up to $24 per share to be a good investment, id. at 712. In addition to these fair dealing issues, the supreme court also reversed the chancellor's findings on the issue of fairness of price. It concluded that the plaintiff should be entitled to prove value by any conventional financial techique, including discounted cash flow, and not be restricted to the traditional Delaware appraisal framework. Id. at 712-14. 330 Id. at 709 n.7. The court's footnote continues: Since fairness in this context can be equated to conduct by a theoretical, wholly independent, board of directors acting upon the matter before them, it is unfortunate that this course was neither considered nor pursued. . . . Particularly in a parent-subsidiary context, a showing that the action taken was as though each of the contending parties had in fact exerted its bargaining power against the other at arm's length is strong evidence that the transaction meets the test of fairness. Id. at 710 n.7. 331 This reading of the case is shared with Burgman & Cox, Reappraisingthe Role of the Shareholder in the Modern Public Corporation: Weinberger's Procedural Approach to Fairness in Freezeouts, 1984 Wis. L. REv. 593, 656-58. In addition, the authors see the court's revision of the appraisal valuation process as an attempt to endow the minority with a bigger bargaining chip to use in inducing the parent to establish independent bargaining. Id. at 658-62. For other discussions of the incentives created by Weinberger to establish an independent negotiating process, see Herzel & Coiling, EstablishingProcedural Fairnessin Squeeze-Out Mergers After Weinberger v. UOP, 39 Bus. LAW. 1525, 1532-39 (1984); Payson & Inskip, Weinberger v. UOP, Inc.: Its Practical Significance in the Planningand Defense of Cash-Out Mergers, 8 DEL. J. CORP. L. 83, 86-88, 90 (1983). 332 493 A.2d 929 (Del. 1985). Justice Moore, author of Weinberger, was also the author of Rosenblatt. 333 The court noted that the exercise of independent bargaining power was "of considerable importance when addressing ultimate questions of fairness, since it may give rise to the proposition that the directors' actions are more appropriately measured by business judgment standards." 493 A.2d at 937-38. The court's decision did not turn exclusively on the existence of independent bargaining, however. It also noted that because the merger had received the informed vote of the majority of the minority shareholders, the burden of proof was shifted to the plaintiffs, id. at 937, and that the parties computed the merger price by using methods conforming to established Delaware legal principles, id. at 939-42. 334 See Fischel, The Appraisal Remedy in CorporateLaw, 1983 AM. B. FOUND. RESEARCH J. 875, 886-89; Herzel & Colling, supra note 331, at 1533-37. But Professor Weiss, on the other hand,
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would necessarily erode the parent's incentives to put in place a reasonable bargaining process, not to mention its incentives even to undertake either the Step # 2 merger or the Step # 1 acquisition in the first place. But the Rosenblatt opinion suggests that at least some of these concerns
5 33 were misplaced.
This focus on the parent's incentives to create a realistic intracorporate bargaining process leads to the second important aspect of the Weinberger opinion for our purposes: the court's announcement that appraisal would thereafter be the shareholder's exclusive monetary remedy. 336 Because appraisal is by its nature a remedy of pure redetermination, the parent's optimal strategic response to it would be, as we have discussed, to adopt the most self-serving terms plausible. Making the appraisal remedy truly exclusive would therefore serve completely to neutralize any incentives for the parent to exercise procedural fair play in setting the merger terms, notwithstanding Weinberger's extensive discussion of the fair dealing requirement. 337 For this reason, the Weinberger court's qualification that appraisal "may not be adequate in certain cases, particularly where fraud, misrepresentation, self-dealing, deliberate waste
worried that in the wake of Weinberger courts would defer to negotiating processes that are nothing more than a "charade." Weiss, The Law of Take Out Mergers: Weinberger v. UOP, Inc. Ushers in PhaseSix, 4 CARDoZO L. REv. 245, 254-56 (1983); see also Lowenstein, Management Buyouts, 85 COLUM. L. REV.730, 774-76 (1985). Thus, different commentators at once found excessive Type I risks and excessive Type II risks in the same procedure. 335 The court explained that Weinberger's concern over the failure to disclose the Signal report detailing the highest price it was willing to pay for the UOP shares, see supra note 329, stemmed from the fact that the report was prepared by Signal officers who were also UOP directors and therefore violated their fiduciary duty to UOP by withholding the information. The court implied that Signal had no independent duty, simply because it was a majority shareholder, to disclose this information to the other shareholders of UOP. Rosenblatt, 493 A.2d at 939. On the other hand, the court in Rosenblattpointed out that the independence of the subsidiary's negotiators, which it generally applauded, in the case before it had nearly caused the collapse of the negotiations on at least two occasions. Id. at 938. The prospect of this level of adversariness led the court, in a subsequent decision, to note, after referring to the advantages under the Weinberger approach of an independent negotiating committee: However, we recognize that there can be serious practical problems in the use of such a committee as even Rosenblatt demonstrated. . . Thus, we do not announce any rule, even in the context of a motion to dismiss, that the absence of such a bargaining structure will preclude dismissal in cases bottomed on claims of unfair dealing. Rabkin v. Philip Hunt Chem. Corp., 498 A.2d 1099, 1106 n.7 (Del. 1985). 336 Weinberger, 457 A.2d at 714-15. 337 This is illustrated by Berger & Allingham, A New Light on Cash-Out Mergers: Weinberger Eclipses Singer, 39 Bus. LAW. 1 (1983). The authors were two Delaware practitioners, one of whom was to become a vice chancellor. They advised that after Weinberger, measures designed to mirror independent bargaining "may not be worth the time and risk." The authors concluded that, so long as the parent disclosed the absence of those safeguards, there was little risk that it would have to defend the entire fairness of the merger other than in an appraisal proceeding. Id. at 24. See also Weiss, supra note 334, at 257-60 (making appraisal truly exclusive would negate Weinberger's discussion of fair dealing; expanding shareholder's standing to bring class actions would give parent incentive to engage in fair dealing to protect merger from challenge).
of corporate assets, or gross and palpable overreaching are involved" 338 takes on important significance. It preserves some potential for the class action as a sanction for the failure to make a good-faith effort at setting fair terms. 339 While the inclusion of "self-dealing" in this list may mean that alternatives to appraisal will be available in most parent-subsidiary mergers, 340 commentators have suggested strategic considerations that 341 may dissuade a plaintiff from relying on their availability. In any event, the Delaware Supreme Court's most recent merger decision, Rabkin v. Philip A. Hunt Chemical Corp.,342 indicates that alternatives to appraisal still enjoy considerable vitality. The plaintiffs in that case challenged the cash-out merger of Hunt into its parent, Olin Corporation, at a price of $20 per share. Olin had initially acquired 63.4% of Hunt's stock in March, 1983 for $25 per share. As part of the purchase agreement, Olin promised the seller that if it were to acquire the remaining Hunt shares within one year thereafter, it would pay all shareholders an equivalent ($25) price. While there was evidence to suggest that Olin had intended to acquire the balance of the Hunt shares from the outset, it waited until July, 1984 to effect the merger, at the $20 per share price. The plaintiffs argued that his price was grossly inadequate because Olin unfairly manipulated the timing of the merger to avoid the one-year commitment. 343 The chancery court dismissed the action on the ground that, absent allegations of misrepresentation or
338 Weinberger,457 A.2d at 714. The court's language parallels the express exceptions contained in many state statutes, which provide that appraisal is otherwise exclusive. See, eg., N.Y. Bus. CORP. LAW 623(k) (McKinney Supp. 1986) (appraisal not exclusive if "corporate action will be or is unlawful or fraudulent" as to the shareholder); MODEL BUSINEss CORP. AcT 13.02(b) (1984) (appraisal exclusive "unless the action is unlawful or fraudulent with respect to the shareholder or the corporation"); cf. CAL. CORP. CODE 1312(b) (appraisal not exclusive if corporation is controlled by another party to the reorganization). Courts have tended to read these exceptions broadly. See, eg., Mullen v. Academy Life Ins. Co., 705 F.2d 971, 973-75 (8th Cir.) (applying New Jersey law; extending statutory exceptions to appraisal to merger of life insurance companies to which exceptions did not apply), cert. denied, 464 U.S. 827 (1983); Alpert v. 28 Williams St. Corp., 63 N.Y.2d 565, 567-68, 473 N.E.2d 19, 24-25, 483 N.Y.S.2d 667, 673 (1984) (suit to set aside freeze-out merger is within exception). 339 Even though the parent is still faced with the prospect of wholesale redetermination in an appraisal, the existence of the class action still provides fair-dealing incentives for two reasons. First, since invariably only a few shareholders will take advantage of appraisal, the magnitude of the redetermination risk is greater in the class action. Thus, the parent has some incentive to deal fairly in order to reduce this risk, no matter what may happen in appraisal. Second, the existence of the class action opens the door to injunctive relief, which we saw in subsection IV.E, see supra note 102 and accompanying text, creates self-restraint incentives of its own. 340 Berger & Allingham, supra note 337, at 20-21; Payson & Inskip, supra note 331, at 95. 341 See Berger & Allingham, supra note 337, at 21-22; Herzel & Coiling, supra note 331, at 1528 & n.13. But see Prickett & Hanrahan, Weinberger v. UOP: Delaware'sEffort to Preserve a Level Playing Fieldfor Cash-Out Mergers, 8 DEL. J. CORP. L. 59, 77-79, 81-82 (1983) (discussing the prospects of converting appraisal proceeding to class action and of bringing simultaneous class action and appraisal proceeding). 342 498 A.2d 1099 (Del. 1985). The author of the opinion was, again, Justice Moore. 343 Id. at 1103. The plaintiffs also alleged that language contained in the Schedule 13D that Olin
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nondisclosure, appraisal was the plaintiff's exclusive remedy. 344 Reversing, the supreme court observed that the chancery court's narrow interpretation of Weinberger "would render meaningless our extensive discussion of fair dealing found in that opinion, ' 345 and that while the absence of fraud or deception was one component of procedural fairness, there were also broader concerns, such as the manipulative conduct alleged by the plaintiffs here. 346 Time will only tell, therefore, what effect, if any, the Weinberger language on the exclusiveness of appraisal will 347 have upon cases involving well-pleaded claims of unfair dealing. In summary, Weinberger and its progeny preserve the essential bargain implicit in Sterling that judicial deference may serve as the quid pro quo for a reasonable intracorporate effort to set fair merger terms, although these decisions have no doubt toughened the procedural minimums necessary for the intracorporate process to qualify.
VII. CONCLUSION
The principal thesis of this Article has been that the rules governing fiduciary conduct may best be understood as a compromise between the two imperfect institutions available to protect the interests of the principal-judicial review of the fiduciary's decisionmaking and private ordering by the principal or fiduciary. Central to this view is the recognition that demanding that the judicial process determine such elusive and subjective issues as whether the fiduciary acted in good faith and out of consummate loyalty to the interests of the principal necessarily entails cost and the prospect of error. The existence of these costs and errors has two important implications.
had filed under the Securities Exchange Act of 1934 at the time of the initial purchase constituted a price commitment, which it failed to honor. Id. at 1101, 1103. 344 Rabkin, 480 A.2d 655 (Del. Ch. 1984), rev'd, 498 A.2d 1099 (Del. 1985). Interestingly, the author of the chancery court opinion was Vice Chancellor Berger, the co-author of the article discussed supra note 337. 345 498 A.2d at 1104. 346 Id. at 1104-05. The court added that "[w]hile a plaintiff's mere allegation of 'unfair dealing,' without more, cannot survive a motion to dismiss, averments containing 'specific acts of fraud, misrepresentation, or other items of misconduct' must be carefully examined in accord with our views expressed both here and in Weinberger." Id. at 1105. Given the posture of the case, the court did not reach the merits other than to conclude that the complaint was sufficient to survive a motion to dismiss. If the ultimate result of the case, however, is to hold that Olin had a fiduciary obligation to accomplish the merger within the one-year period and meet the $25 price commitment, its likely effect, quite understandably, will be to rekindle the kinds of concerns discussed supra at text accompanying note 334. The supreme court's discussion of the plaintiffs' allegations was, however, broader than this one issue and considered--consistent with Weinberger and Rosenblatt-the quality of the bargaining process between Hunt and Olin. Id. at 1105-07. Thus, its denial of the motion to dismiss stands on broader grounds. 347 See, eg., Joseph v. Shell Oil Co., 498 A.2d 1117, 1121-22 (Del. Ch. 1985) (decided prior to supreme court decision in Rabkin; denying motion to dismiss upon concluding that reasonable doubt existed that appraisal would be adequate to address alleged unfair dealing).
First, a single rule will have a differing effect on conduct from fiduciary to fiduciary and from principal to principal, based upon the relative capacity of each to bear these costs and errors. Recall in this regard the discussion of the effects of the corporate opportunity doctrine in subsection IV.G..348 Second, the search for optimal legal rules should take into account the ever-present availability of private ordering as an alternative with potentially lower costs and risks of error. More specifically, the "best" rule is not the one that produces the lowest cost and error per se but the one that produces the lowest residual cost and error after private ordering alternatives have been applied. Thus, given the unavoidable indeterminacy of the underlying legal issues, the desirable course may be to tolerate the routine existence of error of one type or another, based upon the relative capacities of the principal and fiduciary to bear it. We applied this theoretical framework to explain the differing attitudes of agency and trust law, on the one hand, and corporate law, on the other. Section V demonstrated that the per se prohibitions of agency and trust law reflected the concentrated-constituency nature of the principal. The result is a system of rules that seeks to reduce all risk that opportunistic conduct by the fiduciary will be upheld (Type I error) at the expense of an enhanced risk that good faith conduct will be adjudged illegal (Type II error). The harm caused by this increased potential for Type II error is tempered by the fiduciary's capacity to bargain directly with the principal for his informed consent to the transaction and the fiduciary's typically superior capacity to estimate and diversify against the residual risk. In section VI, we saw that corporate law had come, over time, to apply a less restrictive regime of rules to the fiduciary because the diffused-constituency nature of the publicly held corporation, coupled with the incentives implicit in the shareholders' derivative suit, precluded direct dealing to obtain the consent of the underlying principals. And the unavoidable nature of many kinds of self-dealing relationships made any system of rules that produced a substantial risk of Type II error unacceptable. The adoption of bright-line standards provides one possible solution to this problem, but subsection VI.B. examined a number of reasons, including some institutional characteristics of the legal process, why the law has instead employed a system of ad hoc fairness review. And while the rhetoric of this review process is that the fiduciary should carry the burden of proof-in other words, that the priority is to eliminate Type I error-subsection VI.C. sought to show that in practice, the courts accepted much less by deferring to intracorporate decisionmaking processes, notwithstanding their vulnerability to opportunism. That subsection also considered several reasons for this posture of deference, including the superior capacity of shareholders to diversify against the risk
348 See supra text following note 115.
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of error and the creation of incentives for the fiduciary to enter into mutually beneficial bilateral-monopoly relationships. Finally, that subsection concluded that recent decisions, particularly in the area of parentsubsidiary mergers, suggest that courts are becoming more willing to exert control over the quality of the intracorporate process as the price for their deference. This process-oriented control may emerge as the courts' principal check against Type I error. The objective of this Article has not been to take normative stands on the various issues now being hotly debated, particularly in the corporate law area, on the proper regulation of fiduciary conduct. Rather, it has been to try to provide a general framework within which to consider those issues. The principal implication of this framework for the participants in those normative debates is that a focus that implicitly views fullblown adjudication as a cost- and error-free alternative to a flawed intracorporate evaluation process is by its nature one-sided. Admittedly, this consideration does not negate the value of attempts to prescribe further procedural safeguards to improve the quality of those intracorporate processes. But proponents of these prescriptions must ask themselves whether the benefits from the improvements in reducing the residual risk of Type I error-given the existing opportunities to handle that risk through private ordering-are worth the costs.

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Citation: 80 Nw. U. L. Rev. 1 1985-1986 Content downloaded/printed from HeinOnline (http://heinonline.

Printed in U.S.A. 80, Vol. No. I

NORTHWESTERN UNIVERSITY LAW REVIEW

JUDICIAL REVIEW OF FIDUCIARY DECISIONMAKING - SOME THEORETICAL PERSPECTIVES

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through B 0 is independent of each of the others, the investor's overall

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Good Faith Decision

Transaction Invalidated (Type II Error) (Correct Outcome)

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Strategic Responses to the Prospect of Error-Some Illustrations

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