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. Read More