Reconsidering the Evolutionary Erosion Account of Corporate Fiduciary Law

My paper, Reconsidering the Evolutionary Erosion Account of Corporate Fiduciary Law, takes a new look at what has been the dominant account of corporate law’s duty of loyalty, an account that originated with Professor Harold Marsh, Jr.’s foundational paper, Are Directors Trustees? Conflicts of Interest and Corporate Morality, published in 1966. Marsh asserted that twentieth century courts steadily relaxed standards of fiduciary scrutiny applied to self-dealing by corporate managers. The law had degenerated in stages from a late nineteenth century rule of categorical prohibition to a regime of fairness review, much to the detriment of the shareholder interest. Marsh’s showing of historical lassitude complemented the then-prevailing account of a corporate governance system impaired by separated ownership and control and a legal system enervated by charter competition.

Marsh’s presentation of the late nineteenth and early twentieth century cases has been forcefully challenged in a recent book by David Kershaw, The Foundations of Anglo-American Corporate Fiduciary Law (Cambridge 2018). Building on previous work and making comparative reference to the law of the United Kingdom, Kershaw shows that, even as relaxation did indeed occur, Marsh much overstates its salience. Kershaw rejects the notion of an inappropriate accommodation of an unaccountable management class, instead explaining the relaxation as sensible adjustment in the ordinary course of the caselaw’s evolution—the result of judicial modification of principles from trust and agency law in their reapplication to corporate fact patterns. Kershaw does not erase erosion from corporate fiduciary law’s historical outline. But his account does negate the notion that categorical prohibition of self-dealing is the law’s natural base point.

My paper takes the occasion of Kershaw’s critique to put the evolutionary erosion account to further questioning, asking whether it continues to exert normative power in today’s corporate governance context. Subsequent commentators took Marsh’s historical story as a platform on which to conduct critical inspection of present practice. They described corporate boardrooms as inappropriate venues for decision-making respecting self-dealing transactions and diagnosed a problem of structural bias in favor of insider interests. Meanwhile, dispersed shareholders could not self-protect, because the shareholder ratification process provided an intrinsically ineffective backstop due to informational constraints and collective action barriers. Even judicial fairness review came up short, for it could never substitute for arm’s length bargaining in a transaction involving noncommodified goods or services. Two points followed. First, the best legal approach to self-dealing transactions is outright prohibition, which just happened to be the erosion account’s lost historical starting point. Second, absent outright prohibition, substantive or procedural barriers to judicial review of transactional fairness were a bad thing. Both points resonated deeply in the context of the corporate governance system that prevailed when Marsh published and for many years thereafter.

The paper contends that this analysis has lost relevance as a policy proposition. This result obtains even though erosion of the standards that courts apply to management self-dealing has continued unabated since Marsh published in 1966. Quite apart from the diffusion of opt outs, today’s plaintiffs face higher hurdles, and not just those from civil procedure, because today judicial fairness scrutiny can be averted by a correct boardroom process. The paper’s discussion of these developments looks closely at developments in Delaware law, in particular judicial readings of section 144 of Delaware’s corporate code.

The paper does not contend that management self-dealing now somehow benefits the shareholder interest. In fact, the contention is to the contrary—officer and director self-dealing transactions make no more cost-benefit sense from the shareholder point of view today than they did when Marsh wrote decades ago. The contention instead is that the corporate governance system has assimilated and redeployed this cost-benefit logic. Today, the system itself discourages self-dealing transactions, and the judiciary no longer stands at the defensive front line. The system no longer holds out sufficient slack to allow management to increase its returns systematically by entering into self-dealing transactions with the firm, at least where ownership and control are separated. The normative implications of evolutionary erosion change accordingly.

To make the case for these propositions, the paper takes a new look at the role played by management self-dealing transactions in public corporations, contending that a norm against classic self-dealing transactions has taken hold in the boardroom. Systemic requirements assure that the norm is enforced. Officers, held to a lockstep salary system in Marsh’s day, now get their returns upfront in the form of liberal equity compensation. Whether or not that compensation is excessive, it is universally seen to be generous, leaving managers no elbow room to make a real-world case for supplemental returns through side deals. Mandatory disclosure reduces the space for backroom coverups. Mandates and norms imposing majority and super-majority independent boards create an additional and potent stick—any outside director who procures an extra dollop of corporate gravy on the side loses his or her independence with a concomitant loss of governance utility. Finally, systemic improvements now render boardroom structural bias less of a problem.

These observations are backed up by reference to two hand-collected data sets. The first takes the 31 companies in the Dow Jones average and adds 31 companies from the S&P midcap 400 and 31 companies from the S&P smallcap 600 and reviews the policies and transactions reported in recent proxy statements. Although plenty of self-dealing transactions are reported—the searching nature of the disclosure rules assures that result—almost none figure materially in the context of the corporations’ financial reports. A small number of big-ticket transactions shows up at controlled companies, but there are business-based explanations even with those. A line is drawn nonetheless: controlled companies are excluded from the paper’s suggestion that the governance system now effectively checks self-dealing transactions.

The second dataset reviews every duty of loyalty case in Westlaw’s Delaware Chancery Court database since 1985 to test the salience of litigation concerning self-dealing transactions. Only a handful of reported cases focused solely on self-dealing transactions in publicly traded companies appear in the database. Today’s public company fiduciary litigation is mostly about mergers and acquisitions, a subject matter as to which Marsh’s sought-for regime of prohibition makes no sense whatsoever.

The paper closes by reconsidering the meaning of evolutionary erosion in light of recent developments in Delaware fiduciary law. Erosion turns out to have a flip side. There are areas in which the envelope of fiduciary scrutiny has expanded and the Delaware courts, even they have opened a door to boardroom validation of self-dealing contracts, have not dredged a safe harbor. Their scrutiny of the process of validation gets stricter all the time.

The paper concludes that the classic self-dealing transaction, though still a focal point of academic discourse on corporate fiduciary law, does not matter all that much in real world companies with dispersed shareholders. It is no longer an unsolved problem stemming from separated ownership and control.

The complete paper is available for download here.