Prof. Bainbridge on Hess: Critics Still Not There Yet
Prof. Steve Bainbridge replied to my post about shareholders paying bonuses to director nominees elected in contested elections, highlighted by the pending proxy battle at Hess. Steve clarifies his objection to Elliott Associates, the activist shareholder hedge fund, promising to pay its director nominees bonuses if Hess’s stock price outperforms a group of industry peers over the next 3 years:
When I described these transactions as involving a conflict of interest, what I had in mind was the general conflict of interest ban contained in Restatement (Second) of Agency sec 388: “Unless otherwise agreed, an agent who makes a profit in connection with transactions conducted by him on behalf of the principal is under a duty to give such profit to the principal.” Surely the hedge fund payments here qualify as, for example, the sort of gratuties picked up by comment b to sec 388:
“An agent can properly retain gratuities received on account of the principal’s business if, because of custom or otherwise, an agreement to this effect is found. Except in such a case, the receipt and retention of a gratuity by an agent from a party with interests adverse to those of the principal is evidence that the agent is committing a breach of duty to the principal by not acting in his interests. Illustration 4. A, the purchasing agent for the P railroad, purchases honestly and for a fair price fifty trucks from T, who is going out of business. In gratitude for A’s favorable action and without ulterior motive or agreement, T makes A a gift of a car. A holds the automobile as a constructive trustee for P, although A is not otherwise liable to P.”
How is the hedge fund’s gratitude for good service by the Hess director any different than T gift to A? To be sure, directors are not agent of the corporation, but “The relationship between a corporation and its directors is similar to that of agency, and directors possess the same rights and are subject to the same duties as other agents.” . . . Thus, I believe, even if the hedge fund nominee/tippees are scrupulously honest in not sharing confidential information with the funds, put the interests of all shareholders ahead of those of just the hedge funds, and so on, there would still be a serious conflict of interest here.
I can offer 4 replies to Steve’s fine legal points, which I’ll first summarize and then elaborate:
1. While Steve acknowledges that agency law doesn’t apply, he stresses similarities between agency and corporate law when justifying reference to the American Law Institute’s Restatement (Second) of Agency, but then omits the differences that warrant treating directors differently than agents.
2. Even accepting arguendo Steve’s proposal to rely on the Restatement (Second) of Agency, he chose to present Illustration 4 as governing the Elliott-Hess arrangement, but the next one, Illustration 5 (excerpted below), is more on point and comes out the other way because the agent and principal are free to agree otherwise.
3. Even if agency law applied, the Restatement (Second) of Agency, initially adopted in 1958, was superseded in 2006 by the Restatement (Third) of Agency, whose provisions support the Elliott-Hess arrangements.
4. But agency law doesn’t apply. The ALI’s applicable standard from corporate law is stated in its Principles of Corporate Governance, expressly referenced in the Restatement (Third) of Agency. This standard puts the burden on those challenging such arrangements to prove defects such as unfairness or secretiveness, which opponents have not done.
To elaborate on each these 4 points:
1. As Steve notes, directors are not agents and the law of agency does not apply to them. True, as Steve stresses, a set of similar fiduciary duties applies. But they do not apply in exactly the same way as duties between, say a sports agent and her athlete client or a real estate agent and her developer client.
Reasons include that a corporate director acts for a corporation whose decision-making apparatus are intricate, involving a combination of board and shareholder voting with different rules concerning quorums, required vote and other matters. These differences are so profound that the American Law Institute, producer of the Restatement (Second) of Agency, doesn’t treat directors there but in its separate treatise, Principles of Corporate Governance.
2. But before returning to look at the Principles of Corporate Governance as stating the applicable law, assume that Steve is right to reference agency law, and the Restatement (Second) in particular. The provision Steve quotes (above) emphasizes the possibility of contrary agreement, based on custom or otherwise. The next illustration captures that scenario, where the principal observes agent behavior and silently assents to it:
Illustration 5. A, the purchasing agent of a large restaurant, receives gifts of packages of food for his private consumption from persons desiring to sell food to the restaurant. The owner, P, witnesses several of these transactions and says nothing. A’s conduct is not a breach of duty to P, and P has no interest in the gifts.
Unlike Illustration 4, which Steve cites, Illustration 5 is more akin to the Elliott-Hess situation. There, shareholders are informed of the proposal; if Hess shareholders vote for Elliott’s nominees, they agree to it (they reach an “agreement to the contrary”). Indeed, shareholders voting for director nominees who are promised payments do more than P in this illustration: P simply “witnesses . . . and says nothing” while shareholders vote affirmatively for the slate, pay package and all.
3. In any event, moreover, the Restatement (Second) of Agency, which the ALI initially adopted in 1958, has been superseded by the Restatement (Third) of Agency, adopted in 2006. Today’s statement of this branch of the law of agency says:
§ 8.02 Material Benefit Arising Out Of Position. An agent has a duty not to acquire a material benefit from a third party in connection with transactions conducted or other actions taken on behalf of the principal or otherwise through the agent’s use of the agent’s position.
§ 5.04 Use By A Director . . . Of Corporate Property . . . Or Corporate Position. (a) General Rule. A director . . . may not use corporate property . . . or corporate position to secure a pecuniary benefit, unless either: (1) Value is given for the use and the transaction meets the standards of [interested-director transactions, met if fair to the corporation]; (2) The use constitutes compensation and meets the standards [governing executive compensation, again met if fair to the corporation]; . . . (4) The use is . . . authorized in advance . . . by . . . disinterested shareholders . . . and meets [stated] requirements and standards of disclosure and review . . .
(b) Burden of Proof. A party who challenges the conduct of a director . . . under Subsection (a) has the burden of proof, except that if value was given for the benefit, the burden of proving whether the value was fair should be allocated as [in interested-director transactions].