Many people believe that excessive risk taking at large financial firms was an important cause of the financial crisis of 2007–2008 and that preventing another crisis requires improving risk-management systems at such institutions. One way to do this would be to use board oversight liability to hold directors personally liable for failing to properly monitor the risks that their firms are running. The purpose of this Article is to determine what role director oversight liability can efficiently play in improving risk-management practices at large financial firms.
A key contention of this Article is that previous treatments of this problem have largely failed to appreciate what risk managers at large financial firms actually do, and so the Article begins by explaining some of the financial models that risk managers typically use to measure the market risk and credit risk on portfolios of assets. A realistic appreciation of these models shows that the measurements of risk that they yield must necessarily incorporate paradigmatic business judgments, most importantly because these models aim to predict future results on the basis of historical data. In other words, the predictive ability of the models is founded on the business judgment that the future will resemble the past in relevant respects. Risk-management decisions are therefore always business decisions.
Historically, there existed two main fiduciary duties in corporate law, care and loyalty, and only violations of the duty of loyalty were likely to lead to liability. In the 1980s and 1990s, the Delaware Supreme Court breathed life into the duty of care, created a number of intermediate standards of review, elevated the duty of good faith to equal standing with care and loyalty, and announced a unified test for review of breaches of fiduciary duty. The law, which once seemed so straightforward, suddenly became elaborate and complex. In 2006, in the case of Stone v. Ritter, the Delaware Supreme Court rejected the triadic formulation and declared that good faith was a component of the duty of loyalty. In this and other respects, Delaware seems to be returning to a bifurcated understanding of the law of fiduciary duties. I believe that this is a mistake. This area of law is inherently complex and much too important to be oversimplified.
The current academic debate on the issue focuses on whether there should be two duties or three. In this Article, I argue that the question is misleading and irrelevant, but that if it must be asked, the best answer is that there are five duties—one for each paradigm of enforcement. In defending this claim, I explain the true nature of fiduciary duties and provide a robust framework for the discussion, implementation, and development of the law.
Using a dataset of proxy recommendations and voting results for uncontested director elections from 2005 and 2006 at Standard & Poor’s 1500 companies, we examine how advisors make their recommendations. Of the four firms we study—Institutional Shareholder Services (“ISS”), PROXY Governance, Inc. (“PG”), Glass, Lewis & Company (“GL”), and Egan-Jones Proxy (“EJ”)—ISS has the largest market share and is widely regarded as the most influential. We find that the four proxy advisory firms differ substantially from each other in their willingness to issue a withhold recommendation, in the factors that affect their recommendations, and in the relative weight of those factors. Specifically, ISS focuses on governance-related factors, PG on compensation-related factors, GL on audit/disclosure-related factors, and EJ on an eclectic mix of factors. To the extent these differences are understood, institutional investors can subscribe to those advisors whose recommendations best conform to the investors’ assessments of value-maximizing corporate governance. But if these differences are not known, then proxy advisors may lack accountability for—and can pursue their own agenda in making—their voting recommendations, thereby impairing the effectiveness of the shareholder franchise.
Consider the following hypothetical: Two businesses—X, a software company, and Y, a retailer—reach a typical agreement regarding a software license. After extended negotiations, a written, integrated agreement finalizes the deal; it states that X will license software to Y and provide related hosting and technical support services. It does not include, nor did the two parties ever discuss, implementation of the software. Some time after the agreement was made, Y attempts to compel X to implement the software. Y later argues in court that X made fraudulent oral promises that induced Y to sign the written agreement. Y claims that X additionally agreed to provide both a total cost of ownership guarantee, including implementation, and the assistance of its consulting and development personnel to implement the software. Y’s lawyers correctly realize that, in California, the courts have allowed extrinsic evidence of fraudulent promises when those promises are consistent with or independent of the written agreement, notwithstanding the Parol Evidence Rule (“PER”). Thus, while X can present its best argument that the promise to implement the software would directly contradict or vary the terms of the limited licensing contract, the outcome in court is still unpredictable. Unsuspecting X is in danger of being forced to bear a substantial burden for which it never intended to contract.
The fall of 2007 heralded a tumultuous time in the U.S. capital markets. The implosion of the subprime mortgage market disrupted the economy and caused the credit markets to dry up and become increasingly illiquid. Almost overnight, credit became both more expensive and more difficult to obtain as financial institutions became unwilling to extend financing. The credit securitization market was particularly affected, leaving many financial institutions with pending and existing loans that they could only securitize and sell, if at all, at a large loss. Faced with these potentially large losses, financial institutions began to balk at funding preagreed private equity acquisitions. This sudden, unexpected turn of events and the general revaluation and decline in stock prices it wrought led private equity firms to reassess their pending acquisitions—acquisitions which had been agreed to in more stable times. The private equity firms’ reevaluations were often unkind. Throughout the fall and into 2008, private equity firms repeatedly attempted to terminate their contractual obligations to acquire companies.
The material adverse change (“MAC”) clause is a contract provision that periodically dominates the headlines, usually in the wake of a major financial downturn, and the most recent downturn has not been an exception. A MAC clause dispute typically occurs when one side of an agreement no longer wants to complete a merger or acquisition, and often the stakes are high: in the midst of the credit crisis and economic turmoil that began in 2007, MAC disputes erupted in at least thirteen high-profile transactions—the four largest disputes ranging from $1.5 billion to $25.3 billion. As recently as fifteen years ago, the MAC clause was essentially an uncontroversial boilerplate provision, but the clause has since changed dramatically. This Note explores the modern MAC clause in the United States through a comparative analysis with the United Kingdom, which has effectively prohibited a transformation of the traditional MAC clause.
At the heart of the extensive literature on corporate-law federalism is the belief that federalism engenders regulatory competition and federalization eliminates it. Federalism, a mode of governance where states act as providers of corporate law, is said to drive states to compete for charters. By contrast, federalization, which occurs when the federal government promulgates law, preempts state-level competition. Consequently, scholars who believe that regulatory competition promotes the provision of “good” laws have long railed against federal securities statutes like Sarbanes-Oxley that nationalize elements of traditional (state) corporate law. Meanwhile, other scholars have lauded preemptive securities regulation, arguing that federal intervention prevents the dismantling of regulatory standards and a race to the bottom.
In January 2003, the Slammer worm hit the Internet. Five of the Internet’s thirteen root-name servers shut down. Three hundred thousand cable modems in Portugal went offline, all of South Korea’s cell phone and Internet services went down, and Continental Airlines cancelled flights from its Newark hub due to its inability to process tickets. It took only six months after the disclosure of a security flaw for a virus writer to write the 376 byte virus. When it unleashed, it took ten minutes to infect ninety percent of vulnerable systems.
The flaw was a buffer overflow in the Microsoft SQL Server 2000 software. Because the code is embedded in other Microsoft products, not all users were even aware that their systems were running a version of SQL Server. Unfortunately, this was a well-known, preventable security flaw. Moreover, Microsoft had released a patch for the flaw exploited by Slammer six months before the attack. Despite the widespread effects, no flood of lawsuits ensued.
Congress passed the Sherman Act in 1890 to combat the monopolies, trusts, and pooling arrangements that arose as businesses expanded in the wake of the Industrial Revolution. The purpose of the Act was to prohibit the price gouging effects that resulted from the cartel-like behavior of rapidly growing businesses, best represented by the controlling – and later, declared illegal – position of the Standard Oil Company. The nation resented growing corporations that “[s]eemingly at will…could raise prices to consumers, cut the wages of labor, favor some customers over others, and control the supply of basic commodities.” President Cleveland emphasized the need for legislation to protect average consumers stating, “Corporations, which should be the carefully restrained creatures of the law and the servants of the people, are fast becoming the people’s masters.” Legislators hoped that the Sherman Act would be a solution to these ills and that consumers, and later workers, would be protected from the power being amassed by corporations.
These Populist sentiments resonate over a hundred years later as activists, nongovernmental organizations (“NGOs”), and multinational corporations (“MNCs”) seek solutions to similar backlashes against the activities of behemoth companies. President Cleveland’s concerns are discernible as consumers demand greater accountability and protection from major corporations. The demands for reform, however, now come directly from consumers and NGOs, rather than legislators. Moreover, the sought after regulations to limit corporate excesses are being self-imposed in the wake of such pressure. The private sector is developing creative solutions to address the abuses that resulted from the rapid globalization of commerce and production.
Corporate law generally makes voting power proportional to economic ownership. This serves several goals. Economic ownership gives shareholders an incentive to exercise voting power well. The coupling of votes and shares makes possible the market for corporate control. The power of economic owners to elect directors is also a core basis for the legitimacy of managerial authority. Both theory and evidence generally support the importance of linking votes to economic interest. Yet the derivatives revolution and other capital markets developments now allow both outside investors and insiders to readily decouple economic ownership of shares from voting rights. This decoupling, which we call the “new vote buying,” has emerged as a worldwide issue in the past several years. It is largely hidden from public view and mostly untouched by current regulation.