Saturday, March 6, 2021

Shareholders, Stakeholders, and Nine West

Judge Rakoff’s decision in In re Nine West LBO Securities Litigation, 2020 WL 7090277 (S.D.N.Y. Dec. 4, 2020) is all the rage these days.  The short version is that Nine West was taken private in a leveraged buyout by Sycamore; as part of the deal, allegedly the Sycamore buyers caused the company to sell the profitable subsidiaries to its own affiliates for less than they were worth, and the whole thing ended in Nine West’s bankruptcy.  In the wake of all of this, the debtholders (many of whom held debt that predated the sale), via the litigation trustee, sued Nine West’s former directors – the ones who had approved the sale – for violating their fiduciary duties by negotiating a deal that would result in the company’s bankruptcy.  Last year, Judge Rakoff refused to dismiss the claims, in a decision that spawned a thousand law firm updates about directors’ duties when selling the company.

But what I find interesting is how little anyone – including Judge Rakoff – seems to have interrogated the legal question of to whom the directors’ fiduciary duties were owed.

The classic Delaware formulation is that directors owe a duty to advance the best interests of the “corporation and its stockholders.” Firefighters’ Pension Sys. Of Kansas City v. Presidio, 2021 WL 298141 (Del. Ch. Jan. 29, 2021).  Drill down a little further, and you discover that “the corporation” is equated with stockholders.  See, e.g., North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) (“When a solvent corporation is navigating in the zone of insolvency…directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.”); Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173  (Del. 1986) (“A board may have regard for various constituencies in discharging its responsibilities, provided there are rationally related benefits accruing to the stockholders. However, such concern for non-stockholder interests is inappropriate when an auction among active bidders is in progress, and the object no longer is to protect or maintain the corporate enterprise but to sell it to the highest bidder.”).  Under these precedents, the directors’ duties are to maximize stockholder wealth.  Full stop.

Normally, it would be a proposition too obvious to articulate that of course if directors are to maximize shareholder wealth, a subsidiary obligation is to try to avoid bankruptcy.  But that’s because normally, bankruptcy harms the stockholders – they’re the ones left with worthless stock.  But, pace Revlon and Gheewalla, you’d think that if the stockholders themselves eagerly – nay, joyfully – court bankruptcy, because they’re being bought out at $15 per share and they don’t really care what happens after that, the directors have satisfied their duties and nothing more needs be said.  The whole point of Revlon, after all, is that there is such a thing as a endgame transaction, after which shareholders exit the company and fiduciary duties cease.

But even in Delaware, where the law is probably clearest, I’m not sure that’s accurate.  When a corporation is insolvent, the creditors have standing on behalf of the company to sue directors for breach of fidicuary duty. See Gheewalla, 930 A.2d at 101.  And what precisely are the duties of the directors in this scenario?  Per VC Laster, they are the same duties that directors always have, namely, “the fiduciary duties that directors owe to the corporation to maximize its value for the benefit of all residual claimants.” Quadrant Structured Products Co., Ltd. v. Vertin, 102 A.3d 155 (Del. Ch. 2014).  If directors’ duties, generally, are to benefit residual claimants, that presumably means they have a duty to avoid bankruptcy in the first place even if shareholders would prefer it.  But all that just highlights the difficulty with pinning fiduciary duties to residual claimants – all claimants are residual claimants, depending on the firm’s moment in its life cycle.

That’s Delaware.

But Nine West was not incorporated in Delaware; it was incorporated in Pennsylvania.  And, among other things, Pennsylvania has a constituency statute, which states that in discharging their duties to “the corporation,” Pennsylvania directors may (but are not obligated) to consider the effects of an action on all corporate constituencies. See 15 Pa. Cons. Stat. § 1715.  Meaning that whatever else directors’ duties are, they do not include a duty to maximize value to stockholders, whether in a sale scenario or at any other time.  Which is why Nine West’s litigation trustee argued that Pennsylvania law does not require maximizing value to “short-term” shareholders (although that still leaves maddeningly vague what to do when even the interests of long-term shareholders conflict with those of creditors), and the director-defendants argued that no duty to creditors would attach until the actual point of insolvency (never mind that they themselves had allegedly occasioned the insolvency).

Which is how matters stood when the case came before Judge Rakoff.

Rakoff chose not to engage in any of this.  Instead, he simply declared that the directors’ duties were to the company, but quite explicitly treated the company as having different constituencies, namely, stockholders and creditors.  For example, the director defendants tried to argue that any claims against them were res judicata because when the buyout was first proposed, stockholders brought a derivative claim on the company’s behalf arguing that the deal undersold the company, and that claim was settled. Rakoff rejected the argument in part because the stockholder plaintiffs – though they had acted on the company’s behalf – had not adequately represented the interests of creditors, who were now represented on the company’s behalf by the bankruptcy litigation trustee

Having thus recognized that “company” interests may be represented either by stockholders or by creditors – but that these two groups are distinct and often at odds – Rakoff went on to conclude that the Nine West directors had neglected their duties to the company by failing to investigate the effects of the deal on the company, and, in particular, failing to investigate the possibility that the transactions would harm the company by leaving it insolvent.  He further held that the Nine West directors had aided and abetted the fiduciary breaches of the Sycamore directors – who took over after the merger – by assisting them with their plan to sell off the profitable assets, which would bankrupt the company.

By focusing on the company, Rakoff obscured the implications of his holding regarding the true parties in interest.  He did not say so explicitly, but the import is that if directors had investigated, and had recognized (correctly) that the deal would leave Nine West bankrupt, but also believed that the price would benefit Nine West’s shareholders, they would still have violated their duties to the company by consciously choosing to leave the company insolvent.

Thus, in this scenario, Rakoff believed the directors’ fiduciary duties prohibited them from elevating shareholders over creditors.  But he didn’t cite any law for this point – not even Pennsylvania’s constituency statute (which by my read gives directors considerable discretion to decide which constituencies to favor).   It’s just what necessarily follows from his reasoning.

Nine West is, then, a real-world example of the “two masters” problem that is frequently used to justify shareholder primacy.   And Judge Rakoff’s opinion rejects shareholder primacy in favor of a stakeholder view of the corporation, with fiduciary duties that follow. 

Here’s my take:  Usually, we can avoid asking whether directors must take Action A or Action B because matters are not obviously a zero-sum game; directors are taking risks, and different constituencies may benefit more or less from those risks.  Yes, shareholders may benefit from risk-taking more than creditors, but it is by no means obvious that the risk won’t pay off for everyone, and exercising business judgment means deciding how to act under conditions of uncertainty.

But the Nine West problem presents things in starker terms: Accepting the allegations as true, it was clear at the outset that the buyout would benefit shareholders at the expense of creditors, because part of the plan was to undersell the profitable Nine West assets to Sycamore affiliates, where they would be out of creditors’ reach.  If that hadn’t been part of the plan, this might simply have been a gamble as to how much debt the company could support; because it was part of the plan, there was an unusually clear choice: cooperate in a scheme to remove assets from creditors’ grasp and pay off the shareholders for their participation, or – don’t.

So the question then becomes, do directors’ duties to shareholders include evading obligations to debtholders?

And I still don’t have a clear answer, but what is true is that on the one hand, directors (at least in Delaware) may not break the law even if it’s intended to benefit shareholders, In re Massey Energy Co., 2011 WL 2176479 (Del. Ch. May 31, 2011) (“Delaware law does not charter law breakers. Delaware law allows corporations to pursue diverse means to make a profit, subject to a critical statutory floor, which is the requirement that Delaware corporations only pursue ‘lawful business’ by ‘lawful acts.’), but on the other hand, in Delaware, directors may efficiently breach a contract if it benefits shareholders, see Frederick Hsu Living Trust v. ODN Holding, 2017 WL 1437308 (Del. Ch. Apr. 14, 2017) (“the fact that a corporation is bound by its valid contractual obligations does not mean that a board does not owe fiduciary duties when considering how to handle those contractual obligations; it rather means that the directors must evaluate the corporation’s alternatives in a world where the contract is binding. Even with an iron-clad contractual obligation, there remains room for fiduciary discretion because of the doctrine of efficient breach. Under that doctrine, a party to a contract may decide that its most advantageous course is to breach and pay damages. Just like any other decision maker, a board of directors may choose to breach if the benefits (broadly conceived) exceed the costs (again broadly conceived).”).

In other words, in a world where statutory law is “law” that the corporation may not break, but contract law is not “law” with a similar prohibition, I … do not know what to do with debt agreements subject to, among other things, bankruptcy’s prohibitions on fraudulent and preferential transfers, etc.

So really, it would be so much easier if bankruptcy law, tort law, and contract law were to solve this problem, and spare corporate law the trouble.

(For more discussion of consequences of shareholder primacy in the bankruptcy context, see Jared A. Ellias & Robert Stark, Bankruptcy Hardball, 108 Cal. L. Rev. 745 (2020)).

Ann Lipton | Permalink


That's a superb discussion of the case, Ann. Many thanks for that. There are a few focal points to the analysis:

1. You ask "to whom the directors' fiduciary duties were owed," and on this point, there are indeed two formulations: "to the corporation" (as in Judge Rakoff's Nine West opinion) or "to the corporation and its shareholders" (as in many Delaware cases). Yet, when we take a close look at Delaware law as a whole, the latter language practically merges with the former: even Delaware adopts a monistic view, where directors' duties run solely to the corporation (outside of "a limited set of circumstances," Paramount v. Time, 571 A.2d 1140, 1150 (Del. 1989), such as Revlon mode). Adding the words "and its shareholders" is meant to serve, at most, as a reminder about the corporation's purpose, but does not modify the recipient of directors' fiduciary duties, which is the corporate entity.

Consider what might be the most important case in Delaware history, Paramount v. Time. There, it was perfectly clear which decision would best serve shareholders' interests: to go with the high-premium transaction, and abandon the course of action that the corporation believed was best for its own future. By definition, fiduciaries are obliged to act in the benefit of their beneficiary, so if the "duties to the corporation and its shareholders" formulation had real weight to it, they would have faced an unresolvable, division-by-zero conflict between two beneficiaries. There was, however, no such dilemma in the first place: the Delaware Supreme Court made clear that "a board of directors [has] the duty to manage the business and affairs of the corporation. This broad mandate includes a conferred authority to set a corporate course of action, including time frame, designed to enhance corporate profitability," id. at 1150 (emphases added).

Many other Delaware cases take the corporate entity as seriously, including Unocal, Revlon, Credit Lyonnais, Tooley, Gheewalla, Southern Peru, Trados, and all the way to the recent Lacey decision, 2021 Del. Ch. LEXIS 25 (Del. Ch. Feb. 11, 2021). Some of these cases switch mid-text between the two formulations, so we might as well go with the one that better coheres with broader law, fiduciary principles, and the recognition, including by leading economic scholars such as Henry Hansmann, Reinier Kraakman, and Mariana Pargendler, that corporate personality is real and practically important.

Even in Revlon mode, fiduciary duties to the entity do not "cease." It's just that in regard to one specific transaction - changing control over the corporation, which deeply affects the current shareholders, but much less the entity itself - Delaware law says that the obligation runs, ad hoc, to shareholders. From the moment the transaction was completed, and to this day, Ron Perelman (along with the rest of the corporation's fiduciaries) owes duties to Revlon as an entity.

Thus, when Judge Rakoff in Nine West says that the duties were owed "to the company," it's not certain we should try and "pierce the veil," or revert to a sort of aggregate theory of the corporation. Directors' duties are owed neither to shareholders nor to stakeholders, but to the entity, in order to promote its purpose. That purpose can change - between different types of corporations (e.g. for-profit vs. nonprofit), or even temporally, for the same corporation, such as in the vicinity of insolvency (see new article by Amir Licht) - but that is precisely the point of corporate law: lots of dynamic things happen (we're not in ex ante contract land), including the fact that the corporation's shareholders and stakeholders change all the time, in both identity and interests. What does not change is that their counterparty is the corporation itself, and its fiduciaries are obliged to promote its purpose (and, of course, to monitor what the purpose is - especially in the vicinity of insolvency, which they did not do in Nine West).

2. Using the phrase "shareholder primacy" somewhat obscures the fact that the for-profit corporation's purpose is not merely the pursuit of profit, but the lawful pursuit of profit. The two parts are equally important. This is precisely what cases like Massey Energy - and indeed, the very foundational DGCL Section 102(a), stating that a corporation may only engage in "lawful" activities - are about. Relatedly, to fulfill their fiduciary duties, directors must cause the corporation to meet its legal obligations.

You raise the question of whether there is, or should be, a difference between public and private law in terms of the corporation's duty of obedience. Ed Rock touched on this point in his 2013 article (pp. 1965-1966). In my view, it's hard to find any fundamental difference between the two: if a corporation serves as a trustee, for example, and its directors cause it to breach its obligations, there might be a violation of both non-corporate (trust) law and corporate law itself (e.g. Caremark). It's not clear why private - say trust, tort, or property - law should be regarded as more or less significant than public law.

U.S. contract law, for its part, reserves an eminent space for the doctrine of efficient breach. Other jurisdictions place greater emphasis on fulfilling promises, for example by prioritizing specific performance over damages. Yet, this does not mean that contract law, even in the U.S., isn't "law": if you breach a contract, you do have to provide remedy to the other party - it's just that the remedy might be less than what you gained from the breach. The other party has not been left without any legal recourse. Moreover, not every breach of non-corporate law, by the corporation, is also a breach of corporate law, by the corporation's fiduciaries. For the latter to be the case, there must be a corporate-specific doctrine that's been violated, and there are many different such doctrines in the obedience/compliance context: Caremark, the limits on dividends and buybacks under DGCL Sections 170-174, and of course the requirement to switch to more conservative management when the corporation is in, or nearing, insolvency (an obligation enforceable, among other means, by a Gheewalla derivative action).

3. You're spot-on by saying that "it would be so much easier if bankruptcy law, tort law, and contract law were to solve this problem, and spare corporate law the trouble." As I discuss in several articles, these other areas of law don't have things like the business judgment rule, or saying that the corporation can engage in "any lawful act." Instead, they actually provide ex ante information about the corporation's and other people's rights and duties - not perfectly, of course, but working to improve these other areas is so much easier and more beneficial than trying to find solutions in the open-ended, ex post world of corporate law.

As it happens, corporate law already says that pushing a corporation into insolvency is a violation of directors' duties, and Nine West correctly complies with this. If we turn to the contract law example, assuming that lawmakers were to minimize the doctrine of efficient breach, and move to a more substantial remedial regime, there's no reason why it wouldn't be a violation of directors' Caremark duties, for example, to not implement a system of controls over the corporation's contractual compliance.

Posted by: Asaf Raz | Mar 8, 2021 10:30:30 AM

Hi, Asaf. Hah, yes, I knew when I argued that Delaware law requires that directors maximize for shareholders, someone was going to dispute it! And, yeah, that's what makes these problems so vexing, especially since it seems like courts don't want to give a clear answer.

Posted by: Ann Lipton | Mar 8, 2021 10:44:34 AM

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