Opting Out of the Fiduciary Duty of Loyalty: Corporate Opportunity Waivers within Public Companies

Gabriel Rauterberg is Assistant Professor of Law at Michigan Law School, and Eric Talley is Isidor and Seville Sulzbacher Professor of Law at Columbia Law School. This post is based on a recent paper authored by Professor Rauterberg and Professor Talley. This post is part of the Delaware law series; links to other posts in the series are available here.

For nearly two centuries, a cornerstone of Anglo-American corporate law has been the fiduciary duty of loyalty, the most demanding and litigated fiduciary obligation imposed on corporate managers. The duty—which regulates financial conflicts of interest and requires managers to subordinate their own interests to the corporation’s—represents a key policy lever to address the most pernicious of intra-firm agency costs. Practitioners, academics, and jurists alike have characterized loyalty as the most important fiduciary obligation, crediting it with facilitating efficient corporate stewardship and catalyzing investment and entrepreneurship. Indeed, a well-known literature in law and finance has documented the beneficial role that credible conflict-of-interest management plays in promoting company value, vibrant capital markets, and firm longevity. The duty of loyalty has long been characterized as inveterate and unyielding: While much of corporate law consists of “default rules” that parties may freely alter, loyalty is widely perceived as “immutable”—impervious to private efforts to dilute, tailor, or eliminate it.

That perception is false: Beginning in 2000, Delaware dramatically departed from longstanding tradition, amending its statutes to enable corporations to waive a critical component of loyalty—the corporate opportunity doctrine—which forbids corporate fiduciaries from appropriating new business prospects for themselves without first offering them to the company. [1] From that moment forward, Delaware corporations and managers were free to contract out of a significant portion of the duty of loyalty. In the ensuing years, several other states have followed Delaware’s lead, granting their own incorporated entities the statutory authority to execute corporate opportunity waivers (COWs). [2] The Corporate Laws Committee of the ABA has also recently proposed amending the Model Business Corporation Act to permit advance waivers of corporate opportunities. [3]

The reform movement ignited by Delaware represents a significant departure from both long-settled understanding and common law tradition—one that concerns a foundational tenet of company law. It is therefore surprising that no significant study to date has empirically assessed firms’ response to these reforms (save for anecdotal accounts asserting little to no impact). Our newly released study endeavors to fill this void, analyzing empirically how public companies responded to the statutory reforms, and developing conceptual and theoretical account to understand the policy implications of that response. To our knowledge, we are the first to offer either type of assessment.

Based on an extensive data set drawn from U.S. public companies’ filings with the Securities and Exchange Commission, we isolated over 10,000 unique disclosures that were likely to be corporate opportunity waivers. We manually coded a large subset of this group along a variety of dimensions pertaining to the scope, reach, and location of the waivers. In contrast to the conventional wisdom, we estimate that thousands of public corporations have executed waivers, whose terms apply broadly both across both managerial ranks and categorical domains. We thus establish a central empirical fact that is an important baseline for further discussion: Public companies have an enormous appetite for tailoring the duty of loyalty when freed to do so.

Our study also takes on several fundamental questions raised by widespread adoption of waivers of corporate opportunities: Why would a corporation ever choose to restrict the reach of the duty of loyalty? What form will the optimal allocation of corporate opportunities plausibly take in different companies? Under what conditions would such waivers be valuable to shareholders, notwithstanding that such waivers constrain the fiduciary duties owed to shareholders? Delaware’s sixteen-year statutory experiment also provides a unique opportunity to revisit some of the foundational quandaries in corporate law with a fresh perspective. For one, there is a vigorous, decades-old debate that asks whether any of corporate law’s rules should be mandatory, or whether parties should be free to contract out of every governance requirement as they already can from most. That debate concerns whether enlarging the contracting space for fiduciary duties results in greater efficiencies, or instead in unchecked opportunism. There is also a significant set of issues involving whether corporations actually make use of the freedom frequently given them by corporate law to replace default rules, and whether, when they do so, it serves shareholders well.

We argue that there are, in fact, several plausible economic rationales for a corporation to embrace a COW for the sake of shareholder value. Indeed, in the years leading up to Delaware’s initial reform, a growing chorus of critics argued that the exacting requirements of the duty of loyalty had begun to impede corporations’ ability to raise capital, build efficient investor bases, and secure optimal management arrangements. This claim was based in part on the recognition that many then-emerging sources of capital, such as private equity, venture capital, or spin-off transactions may subject their financial sponsors to fiduciary duties in profound conflict with either their larger business plans or with fiduciary obligations they owe to other business entities. [4] Absent the contractual ability to clarify ownership rights regarding new business opportunities, it is difficult to see how such capital structures could stably persist.

Consider, for example, one of the issuers in our database: Prosper Marketplace, Inc., the first and still one of the largest peer-to-peer lenders. The waiver that Prosper adopted in its charter [5] covered any member of Prosper’s board who was not also an employee. The four outside directors in place at the time of the company’s public filing (and a majority of the board) worked for financial firms—three of them in venture capital—and at that point served as directors for at least fourteen other companies, including another online commercial market. As a risky entrepreneurial start-up, Prosper was an ideal candidate for the venture capital financing model. Yet it is difficult to see how those outside directors could avoid intractable fiduciary conflicts without first securing waivers defining the boundaries of their loyalty obligations across different companies. [6]

That said, simply because there are plausible conditions where COWs could enhance shareholder welfare, it does not mean that the firms actually adopting waivers satisfy those conditions. Our empirical analysis allows us to get some traction on this set of questions as well. We find that COW adopters are, on average, reasonably established firms with moderate-to-high asset values. They typically generate sizeable revenues, and they tend to deliver larger overall market returns to their capital investors by comparison to other public companies. Delaware corporations are over-represented, as are firms in industries where diversified, active investments across multiple portfolio companies are the norm (such as venture capital and oil and gas). As a descriptive matter, then, it does not appear that companies that execute waivers are systematically the unscrupulous bottom feeders of the corporate ecosystem. To the contrary, they appear—by and large—to be healthy, growing, and profitable business organizations.

In addition to these descriptive statistics, we further assess whether the adoption of a waiver tends to add or dilute value on the margin, by analyzing market reactions to issuers’ first public disclosure of a COW. Our event study analysis reveals that market reactions are generally favorable, resulting in an average positive abnormal stock return of between 1.0 and 1.5 percent in the days immediately surrounding the announcement date. This return is particularly pronounced for Delaware corporations, and those with asset values just below $1 billion. The positive market response does not seem sensitive to whether the waiver also covers officers and/or dominant shareholders, nor does it appear to vary depending on whether the COW was adopted in a proposed charter amendment, a board-promulgated resolution, or something else. All told, we view these findings as suggestive that public companies not only have embraced their new-found liberty to tailor the fiduciary duty of loyalty, but that they have done so in ways consistent with shareholder value maximization. Our findings are also pertinent for considering current debates about shareholder activism, the appropriate role of “constituency” directors, and whether the delineation of such roles should be subject to immutable rules or left up to the issuers themselves. [7]

The full paper is available for download here.

Endnotes:

[1] Del. Code Ann. tit. 8, § 122(17).
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[2] K.S.A. 17-6102(17); Md. Code Ann., Corps. & Ass’ns § 2-103(15); Mo. Ann. Stat. § 351.38(16); Nev. Rev. Stat. Ann. § 78.070(8); NJ Stat. Ann. 14A:3-1(q); Okla. Stat. Ann. tit. 18, § 1016(17); Tex. Bus. Orgs. Code Ann. § 2.101(21); Wash. Rev. Code Ann. § 23B.02.020(5)(k). See also infra Subsection I.B.4.
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[3] ABA Corporate Laws Committee, Proposed Amendments (2014), https://apps.americanbar.org/dch/-committee.cfm?com=CL270000; see also Proposed Amendments to Sections 2.02 and 8.70 (and Related Changes to Sections 1.43, 8.31 and 8.60) Permitting Advance Action to Limit or Eliminate Duties Regarding Business Opportunity, 69 Bus. Law. 717 (2014).
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[4] That said, prior to the reform, the Delaware Chancery Court took a particularly dim view of the enforceability of such contractual clarifications. Siegman v. Tri-Star Pictures, Inc., 1989 WL 48746, reprinted in 15 Del. J. Corp. L. 218 (1990).
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[5] That Charter was attached to Prosper’s 2007 S-1 filing (available on the Edgar interface at https://www.sec.gov/Archives/edgar/data/1416265/000110465907078072/0001104659-07-078072.txt)
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[6] For those who followed the well-known litigation in In re Trados Inc., 73 A.3d 17, 40-41 (Del Ch. 2013), Prosper suggests a number of possibly instructive analogies.
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[7] See, e.g., J. Travis Laster and John Mark Zeberkiewicz, The Rights and Duties of Blockholder Directors, 70 Bus. Lawyer 33, 49-50 (2015) (arguing that constituency directors should all be compelled to pursue long-term value for shareholders).
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