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E-MailAndrew F. Tuch is Professor of Law at Washington University School of Law. This post is based on his recent article, published in the Fordham Law Review.
Scholars have long disagreed over which of two fiduciary rules is more effective for controlling self-dealing. Some scholars defend the “strict” no-conflict rule, which categorically bans self-dealing by directors (Marsh, 1966; Brudney, 1985; Criddle, 2017). Others prefer the “flexible” and “pragmatic” fairness rule, which allows self-dealing if it is fair to the corporation and its shareholders (Easterbrook & Fischel, 1991; Langbein, 2005). Proponents of this approach claim that the pragmatic fairness rule better distinguishes between beneficial and harmful self-dealing. The debate has dragged on for decades, beyond corporate law and across the common law world (Kershaw, 2012; Licht, 2019).
In my article Reassessing Self-Dealing: Between No Conflict and Fairness, I challenge a central assumption underlying the debate: that the rules operate differently, to different effect. In practice, the difference between these rules is not as important as scholars believe. Today, this is best seen by comparing the United Kingdom—which continues to employ the traditional no-conflict rule—to the United States (more specifically, Delaware), which adopted the fairness rule.
The key is to understand the structure of the rules and their usual operation. First, these fiduciary rules are similarly structured: they require strict loyalty but provide exceptions or cleansing devices that protect transactions or fiduciaries from liability. Each rule has multiple cleansing devices. Under each rule, harsh remedial consequences follow if none of the cleansing devices operate. Under the U.S. fairness rule, proof of fairness is the signature cleansing device. Under the U.K. no conflict rule, companies may craft their own cleansing devices in their corporate charters, a permissive approach the U.S. rule denies. Comparing the substantive content of each rule, including all their cleansing devices, reveals that neither rule is logically or necessarily stricter, more flexible, or better calibrated to deter harmful self-dealing.
The second step requires us to consider the rules in operation, including the cleansing devices that companies actually adopt and directors actually use. Under the U.K. no-conflict rule, companies commonly crafted a cleansing device requiring directors to get some form of approval from their fellow directors for a self-dealing transaction. A similar cleansing device developed under the U.S. fairness rule. Under both regimes, we would expect rational fiduciaries faced with a strict loyalty rule and multiple cleansing devices to gravitate to the cleansing device they find most attractive, bearing in mind the share of any bargaining surplus that the cleansing device produces and the cost of using the cleansing device. In fact, under both regimes, interested directors do so, routinely using a cleansing device that is remarkably similar: approval by neutral or disinterested directors. I consider a random sample of 100 Delaware-incorporated public companies, finding that almost all adopt—and, to the extent we can tell, follow—internal rules requiring interested directors to seek disinterested director approval for self-dealing. U.K. directors act similarly, seeking neutral director approval for their self-dealing.
To be sure, the U.S. regime does offer a cleansing device (proof of fairness) that the United Kingdom does not. However, I argue that the availability of this cleansing device is unlikely to influence directors’ conduct, even that of opportunistic directors, so strict are its requirements. The availability of the fairness cleansing device occasionally matters; more often it is irrelevant because of its severity. Indeed, some doctrinal differences between the U.S. fairness and U.K. no-conflict rules—in particular, concerning the treatment of controlling shareholders and directors with significant voting power—suggest that the fairness rule operates more strictly than the no-conflict rule.
The article’s analysis undermines claims of American exceptionalism in corporate law (Romano (1993); Lipton (2019)). More specifically, the article exposes the incompleteness of claims about either rule’s superiority on any important dimension. In corporate law, the U.K. no-conflict rule often operates anything but strictly, and the U.S. fairness rule is generally no more effective in distinguishing between beneficiary-benefiting and beneficiary-harming self-dealing. Neither fiduciary rule is obviously friendlier to management or better attends to the needs of commerce. In their operations, the rules closely mirror one another: they enlist neutral directors to patrol self-dealing, a commercially sensitive response. If anything, the U.S. rule is more severe.
Second, the analysis shifts longstanding debate in fiduciary law from the false choice between no-conflict and fairness, showing that policymakers and scholars alike ought to focus instead on cleansing devices—on their substantive content and practical use.
Third, this analysis sheds light on historical narratives in U.S. corporate law, according to which U.S. law weakened as it evolved from a no-conflict rule in the late nineteenth century to a fairness rule (Marsh, 1966). The article suggests that the early U.S. no-conflict rule was never as strict as is often claimed; it included cleansing devices, a “weakness” present from the start. The big change in U.S. law occurred when courts expressly acknowledged that disinterested directors could approve self-dealing. In adopting this cleansing device, U.S. law came more closely to resemble the U.K. law in operation, which had already achieved the same flexibility by enlisting neutral directors to monitor self-dealing. Far from rejecting a stricter U.K. law, as many believe, U.S. law followed the United Kingdom’s lead.
The complete article is available for download here.
