davis - judicial review of fiduciary decision making

Citation: 80 Nw. U. L. Rev. 1 1985-1986

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Copyright 1986 by Northwestern University, School of Law Printed in U.S.A.Northwestern University Law Review Vol. 80, No. I

NORTHWESTERN UNIVERSITYLAW REVIEW

VOLUME 80 MARCH 1985 NUMBER 1

JUDICIAL REVIEW OF FIDUCIARYDECISIONMAKING - SOMETHEORETICAL PERSPECTIVES

Kenneth B. Davis, Jr. *

I. INTRODUCTION

The fiduciary concept is a critical building block for our laws oftrusts, agency, and business organizations. It is the principal devicethose bodies of law employ to restrict the otherwise unfettered powers ofpersons who are entrusted with control over the assets and affairs ofothers. Necessarily, the personal interests of the controlling party, thefiduciary, and the person whose affairs and assets are subject to control,the principal,1 will from time to time diverge. Through the fiduciary de-vice, the law seeks to create a system of compensation and deterrence toprotect the principal's interests against exploitation which results fromthat divergence.

Not surprisingly, much has been written over the years about thesubstantive content of the fiduciary doctrine. Any casebook or treatiseon the subject of trusts, agency, partnership, or corporations invariablyincludes a lengthy treatment of the components of the fiduciary's duty ofloyalty and her2 related obligations. The courts repeatedly have beencalled upon to apply these concepts, generating opinions describing thefiduciary's burden in lofty terms such as "undivided and unselfish loy-alty,"3 "utmost good faith,"'4 and "the highest standards of honor and

* Associate Professor of Law, University of Wisconsin Law School. The author wishes to thank

his colleagues, Peter Carstensen and Bill Whitford, for their valuable comments on earlier drafts ofthis Article.

I The term "principal" is used throughout this analysis as a generic term for the person onwhose behalf the fiduciary acts. Thus, the term embraces the beneficiary in a trust relationship, theprincipal in a common law agency relationship, and the corporation and its shareholders in a corpo-rate relationship.

2 In the interests of clarity and convenience, the fiduciary will be referred to as "she" through-

out this Article and the principal as "he."3 Guth v. Loft, Inc., 23 Del. Ch. 255, 270, 5 A.2d 503, 510 (Sup. Ct. 1939).

HeinOnline -- 80 Nw. U. L. Rev. 1 1985-1986

NORTHWESTERN UNIVERSITY LAW REVIEW

honesty."' 5 More recently, commentators have sought to explore and de-velop the underlying theory of what the fiduciary doctrine entails and therole it plays. 6

At the same time, the economics literature has been studying theimplications of the divergence of interests between fiduciary and princi-pal. Based on the implicit premise that the application of conventionallegal rules is insufficient to make the fiduciary act in the best interests ofher principal, this literature examines how other, extralegal institutionsserve either to align the interests of fiduciary and principal or to compen-sate for the expected costs of nonalignment. 7

From this body of work, it was but a short step to the developmentof a legal literature-principally in the area of corporate law-suggestingthat the law's traditional recognition and enforcement of formal fiduciaryobligations was short-sighted, and that contract and market mechanismsare available to protect the underlying interests of the shareholders moreefficiently.8 This has, in turn, recently spawned legal research challeng-ing the validity of the implied-contract metaphor to characterize the rela-tionship between corporate managers and shareholders and the adequacyof market processes to control abuses of managerial discretion. 9

This Article advocates a middle ground. While the law and eco-

4 Id. at 271, 5 A.2d at 510.5 Grossberg v. Haffenberg, 367 Ill. 284, 287, 11 N.E.2d 359, 360 (1937). Other well-known and

often-cited judicial expressions of this strict view of fiduciary obligation are Pepper v. Litton, 308U.S. 295, 306-07, 310-11 (1939); Meinhard v. Salmon, 249 N.Y. 458, 463-64, 164 N.E. 545, 546(1928); Wendt v. Fischer, 243 N.Y. 439, 443-44, 154 N.E. 303, 304 (1926); Kavanaugh v. Kava-naugh Knitting Co., 226 N.Y. 185, 192-94, 123 N.E. 148, 151 (1919). The Meinhard and Wendtopinions contain the characteristic prose of Judge Cardozo.

6 See Anderson, Conflicts ofInterest: Efficiency, Fairness and Corporate Structure, 25 UCLA L.REV. 738 (1978); Frankel, Fiduciary Law, 71 CALIF. L. REv. 795 (1983); Jacobson, The Private Useof Public Authority: Sovereignty and Associations in the Common Law, 29 BUFFALO L. REv. 599,615-64 (1980); Sealy, Some Principles of Fiduciary Obligation, 1963 CAMBRIDGE L.J. 119; Sealy,Fiduciary Relationships, 1962 CAMBRIDGE L.J. 69; Shepard, Towards a Unifled Concept of FiduciaryRelationships, 97 LAW Q. REV. 51 (1981); Weinrib, The Fiduciary Obligation, 25 U. TORONTO L.J. 1(1975).

7 See generally Barnea, Haugen & Senbet, Market Imperfections, Agency Problems, and CapitalStructure: A Review, 10 FIN. MGMT. 7 (1981); Fama, Agency Problems and the Theory of the Firm,88 J. POL. ECON. 288 (1980); Fama & Jensen, Separation of Ownership and Control, 26 J. L. &ECON. 301 (1983); Fama & Jensen, Agency Problems and Residual Claims, 26 J. L. & ECON. 327(1983); Jensen & Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and OwnershipStructure, 3 J. FIN. ECON. 305 (1976); Pratt & Zeckhauser, Principals and Agents: An Overview, inPRINCIPALS AND AGENTS: THE STRUCTURE OF BUSINESS 1 (J. Pratt & R. Zeckhauser eds. 1985).

8 This is most visible in the work of Judge Easterbrook and Professor Fischel. See, eg., Easter-brook & Fischel, Corporate Control Transactions, 91 YALE L.J. 698, 711-14 (1982) (portfolio diversi-fication as best antidote for unequal allocation of gains created by corporate control transactions);Fischel, The Corporate Governance Movement, 35 VAND. L. REv. 1259, 1287-90 (1982) (existence ofmarket discipline eliminates any need for increased liability of managers). See also Winter, StateLaw, Shareholder Protection, and the Theory of the Corporation, 6 J. LEGAL STUD. 251, 254-58(1977) (capital markets as limitation on management's ability to choose self-serving law).

9 See, eg., Brudney, Corporate Governance, Agency Costs, and the Rhetoric of Contract, 85


Fiduciary Decisionmaking

nomics scholarship in the corporate area seems often to rest on heroicassumptions about the quality of market processes, the literature con-demning it comparably relies-although here the reliance is far less ex-plicit-upon the ability of the legal system to resolve fiduciary problems"correctly" and at low cost. The fundamental premise of this Article, incontrast, is that the theoretical existence and content of a fiduciary dutycannot be separated from the practical fact of its enforcement. To saythat a fiduciary must act with the utmost good faith and loyalty to theinterests of her principal is one thing; to test whether conduct in the realworld conforms to that ideal is quite another. Thus, any system designedto protect the interests of the fiduciary at the hands of the principal-whether it entails formal legal regulation by the courts and legislature orprivate ordering through contract and the market-has imperfections.This Article therefore seeks to explain the rules governing judicial reviewof fiduciary decisionmaking as a pragmatic accommodation of the com-parative imperfections of legal regulation on the one hand and privateordering on the other.'0

As a backdrop for examining the contribution made by judicial en-forcement of the fiduciary standard, section II of the Article examinespossible private arrangements and incentives between fiduciary and prin-cipal designed to deal with the problems created by the divergence oftheir interests.1 In the process, some of the legal and economic scholar-ship relating to such private arrangements and incentives is reviewed andapplied. 12 Section III briefly examines how legal intervention may fur-ther that private ordering process. 13 Section IV then seeks to developsome basic theoretical tools to evaluate the operation of legal rules gov-erning fiduciary relationships. 14 These tools are applied to the areas ofagency and trust in section V,15 and to corporate law in section VI.16

The latter two sections undertake to reconcile the deferential approachcourts normally take to fiduciary decisionmaking in the corporate areawith the generally strict and vigorous approach taken by the courts in theagency and trust areas. Finally, the concluding subsections of section VIreview some current developments in corporate law and attempt to show

COLUM. L. REv. 1403 (1985); Clark, Agency Costs Versus Fiduciary Duties, in J. Pratt & R.Zeckhauser, supra note 7, at 55.

10 I am indebted to the work of my colleague, Neil Komesar, for so clearly illustrating how legal

rules can be viewed as reflecting an inevitable choice among alternative institutional decisionmakers,each with its own defects. See generally Komesar, Taking Institutions Seriously: Introduction to aStrategy for Constitutional Adjudication, 51 U. CHI. L. REv. 366 (1984); Komesar, In Search of aGeneral Approach to Legal Analysis: A Comparative Institutional Alternative, 79 MIcH. L. REv. 1350(1981). The influence of his work appears throughout this Article.

11 See infra notes 18-71 and accompanying text.12 See id.13 See infra notes 72-76 and accompanying text.14 See infra notes 77-116 and accompanying text.15 See infra notes 117-38 and accompanying text.16 See infra notes 139-348 and accompanying text.

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that the judicial deference shown to managers in some settings is notnecessarily the product of the courts' naive ignorance of the risks of op-portunistic decisionmaking, as suggested by some commentators, butmay instead stem from the courts' implicit recognition of how ill-equipped they are to determine, with accuracy and at low cost, whetherparticular conduct conforms to the fiduciary ideal. 17

II. LIFE IN A WORLD WITHOUT THE FIDUCIARY STANDARD

4. The Core Problem: Nonalignment of Interests and the ResultingIncentives for Opportunistic Behavior

The source of the fiduciary problem is the joinder of the fiduciary'sdiscretionary control over some nontrivial portion of the principal's as-sets and affairs with the unavoidable fact that the interests of the princi-pal and the fiduciary are not perfectly aligned. The ways in which thefiduciary may abuse that discretion to further her own interests at theexpense of the principal's are many and diverse. Most blatantly, the fidu-ciary may cheat the principal, either by appropriating his assets or byself-dealing on terms unfair to him. Further, to the extent that the fiduci-ary's costs of doing business are borne by the principal, as is the case withcorporate managers, the fiduciary may set excessive compensation orfringe benefits or provide perquisites beyond the minimum necessary toconduct the principal's business in the most efficient manner.18

More subtle mechanisms for self-enrichment are available as well.The fiduciary's interest in protecting her employment may lead her toturn down opportunities that would further the principal's objectives butwould also jeopardize the fiduciary's own tenure. 19 Or the fiduciary mayseek to expand her sphere of influence and the basis for her compensationby initiating or acquiring new business opportunities not strictly consis-tent with maximizing the principal's welfare. 20 Finally, there is the fidu-

17 Readers generally familiar with the financial economics literature-particularly that pertain-ing to agency costs and portfolio theory-may wish to skip section II. Much of that section isbackground and the cross-references contained in the subsequent sections should enable the readerto hark back to that section, if necessary, for any points essential to the later analysis.

18 See Jensen & Meckling, supra note 7, at 312-13 (describing an owner-manager's incentive totake a greater level of nonpecuniary benefits from the firm after selling a portion of the equity tooutsiders).

19 See, eg., Easterbrook & Fischel, The Proper Role of a Target's Management in Responding toa Tender Offer, 94 HARV. L. REv. 1161, 1175, 1198 (1981) (rejecting beneficial takeovers); Gilson, AStructural Approach to Corporations: The Case Against Defensive Tactics in Tender Offers, 33 STAN.L. REV. 819, 824-31 (1981) (defending against takeovers); Klein, The Modern Business Organization:Bargaining Under Constraints, 91 YALE L.J. 1521, 1556 (1982) (adopting overly conservative strate-gies); Comment, The Conflict Between Managers and Shareholders in Diversifying Acquisitions: APortfolio Theory Approach, 88 YALE L.J. 1238, 1243 (1979) (excessive diversification).

20 See, e.g., Brudney, Dividends, Discretion, and Disclosure, 66 VA. L. REv. 85, 95-97 (1980)(managerial preferences for reinvestment over distribution of earnings as a concomitant of its prefer-ence for growth in sales and size over growth in earnings); Vagts, Challenges to Executive Compen-



ciary's ever-present incentive to "shirk"-that is, to divert attention fromproductive activities that benefit the principal to activities that offer moreleisure or personal gratification to the fiduciary.21 The fiduciary's capac-ity and incentive to engage in these various forms of conduct that providevalue to herself at the expense of her principal is described in this Articleby the term "opportunism." Opportunism reflects the fiduciary's depar-ture from the pattern of conduct she would engage in were she alone tobear the full costs and enjoy the full benefits of her actions. 22

Fiduciaries and principals theoretically have several methods ofdealing with the problem of opportunism. This section will review brieflythese methods, and some of the legal and economic scholarship discuss-ing them, as a backdrop to considering how judicial enforcement of thefiduciary standard contributes to controlling the fiduciary's propensityfor opportunism. Because this section focuses exclusively on the opera-tion of market incentives and privately negotiated arrangements to solvethe problem of nonalignment of interests, it will be assumed that formallegal regulation of the fiduciary's propensity for opportunistic behaviordoes not exist.23

B. Monitoring, Bonding, and the Opportunityfor Ex Ante Compensation

Even in a world where recourse to the courts through the fiduciarymechanism is unavailable, prospective principals who find it otherwisedesirable to entrust their affairs to another are unlikely simply to sit backand suffer the full adverse consequences of opportunism. To protectthemselves, they will undertake "monitoring" activities designed to re-duce the risk of abuse. 24 Such activities might include requiring the fidu-ciary to give detailed accounts of her performance, hiring outsiders toaudit the fiduciary, or imposing direct restraints on the fiduciary's discre-tion. Monitoring is, of course, costly. The principal, however, has theeconomic incentive to engage in monitoring so long as the marginal costof each additional monitoring step is less than the incremental reduction

sation: For the Markets or the Courts?, 8 J. CORP. L. 231, 235 (1983) (corporate management mayprefer growth and earnings retention while investors may prefer current profitability and dividends);Comment, supra note 19, at 1241-44 (acquisition for purposes of diversification).

21 See, eg., Alchian & Demsetz, Production, Information Costs, and Economic Organization, 62AM. ECON. REv. 777, 780-81 (1972); Anderson, supra note 6, at 758 n.59.

22 Cf 0. WILLIAMSON, MARKETS AND HIERARCHIES: ANALYSIS & ANTITRUST IMPLICATIONS

26-28 (1975) (using the term in a broader context). Muris, Opportunistic Behavior and the Law ofContracts, 65 MINN. L. REV. 521 (1981).

23 The assumptions in this section go only to the nonexistence of fiduciary obligations that aredefined and imposed as a matter of law and are capable of judicial enforcement. Recourse to thecourts is not altogether ignored in this section: any ad hoc agreements made between fiduciary andprincipal are assumed to be enforceable in accordance with their terms.

24 See Alchian & Demsetz, supra note 21, at 780, 781-83; Jensen & Meckling, supra note 7, at308, 323-24.

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it produces in the principal's expected welfare loss due to the fiduciary'sopportunistic behavior. Given the demand for monitoring activities, wemight expect a market for professional monitors to emerge, with theirfees reflecting (at least in the rarefied air of theory) their relative successin reducing opportunism losses.25

Two phenomena undercut the attractiveness of monitoring as acomplete solution to the problem of nonalignment of fiduciary and prin-cipal interests. The first is the very nature of the fiduciary relationshipitself. This relationship is valuable to the principal because it permitshim to free himself of certain activities by delegating them to another. Iflooking over the fiduciary's shoulder is essential to prevent opportunism,this benefit is negated. In addition, many fiduciary activities involve spe-cialized expertise and discretion. To be effective, the monitor would haveto possess comparable expertise, and the costs of the monitoring wouldincrease accordingly. Furthermore, the presence of discretion makes itdifficult for any monitor to determine with certainty whether a given de-cision was tainted by opportunism.26 The second drawback to effectivemonitoring is that because the true principal often may be a relativelysmall-stakes participant in a larger organization supervised by the fiduci-ary, such as a corporate shareholder, the individual gains to the principalfrom effective monitoring are slim in relation to their cost. While itmight be possible for such a principal to pool resources with others simi-larly situated in order to undertake joint monitoring for the commongood, transactions costs and "free-rider" problems will probably causethe resulting level of such joint activity to be less than optimal.27

Thus, the principal can seldom eliminate the entire risk of opportu-nism by any cost-justified level of monitoring. Some residual risk willalways be present, and, assuming the principal appreciates the risk, hemay respond to it in one of two ways. If the risk is too great, he willsimply walk away and forgo the benefits of a fiduciary relationship. Hewill employ an alternative over which he has more control, such as en-trusting his property to a close family member or managing it himself.Alternatively, he may go ahead with the relationship but demand an exante "rebate" from the fiduciary to reflect the amount of the expectedloss. Paying the fiduciary a reduced fee would be an example of such a

25 See Fama, supra note 7, at 293-94 (discussing the market for outside directors as monitors);Watts & Zimmerman, Agency Problems, Auditing, and the Theory of the Firm: Some Evidence, 26 J.L. & ECON. 613 (1983) (discussing the development of the independent auditing profession as aresponse to the demand for monitoring).

26 Ideas similar to those expressed in the foregoing five sentences of the text are contained inAnderson, supra note 6, at 744-45, 747, 758-59; Frankel, supra note 6, at 809-10, 813; Klein, supranote 19, at 1545, 1557; Weinrib, supra note 6, at 4.

27 See M. OLSON, THE LOGIC OF COLLECTIVE ACTION 55-56 (1971); Anderson, supra note 6, at

778-80; Klein, supra note 19, at 1544-45; Levmore, Monitors and Freeriders in Commercial andCorporate Settings, 92 YALE L.J. 49 (1982).



rebate.28

Critical to any such ex ante adjustment process is the principal'sability to predict the fiduciary's behavior. The principal's ability will de-pend upon the information he has concerning the fiduciary's past per-formance. Availability of such "experience-rating" information will be afunction of the ease with which descriptions of past performance can becaptured or quantified in simple summaries, as well as the transactionscosts of obtaining this information from former users.29 For example,the past performance of an investment manager can be more easily dis-tilled and communicated-by comparing the year-to-year fluctuation ofthe portfolios he or she manages to some broad-based market average-than that of the resident manager of an apartment building.30 In thisevaluation process, persons who are in the business of using fiduciaryservices on an ongoing basis ("professional principals," so to speak) willhave a comparative advantage over persons who are not. These profes-sional principals have more to gain from an investment in informationgathering and processing because of their continuing dependence on thefiduciary and, it is likely, their larger amounts at stake. Moreover, wherepast performance data cannot be easily distilled or quantified, but insteadare soft and impressionistic, the costs of information exchange will typi-cally be lower where the participants are professionals linked togetherthrough trade associations, frequent dealings, and a common orientationand language. 31

Even where high-quality past performance data are available, how-ever, there is no assurance that the fiduciary's future conduct will mirrorthe past. With respect to the more mundane forms of opportunism, suchas shirking or the consumption of excessive perquisites, it is likely thatthe fiduciary's performance will not change abruptly. But an unblem-ished prior record can never provide a complete guarantee that the fidu-ciary will pass up the chance to make one big score at the principal'sexpense if such an opportunity presents itself in the future. Thus, the exante adjustment process, even where the principal is well informed,rarely will extract a proper measure of compensation for the more gran-diose forms of opportunism. 32

28 See Jensen & Meckling, supra note 7 (developing a series of formal models premised on the

theory that investors will reduce the amount they are willing to pay for debt or equity interests in thefirm by an estimate of the costs of opportunism).

29 See 0. WILLIAMSON, supra note 22, at 15-16.

30 The usefulness of any such summary will necessarily depend on the extent to which it reflects

the "pure" performance of the fiduciary rather than environmental factors over which she has nocontrol, such as the performance of the economy in general.

31 See 0. WILLIAMSON, supra note 22, at 36 (discussing Leff, Injury, Ignorance and Spite-TheDynamics of Coercive Collection, 80 YALE L.J. 1, 26-33 (1970)).

32 Cf Cox, Compensation, Deterrence, and the Market as Boundaries for Derivative Suit Proce-

dures, 52 GEO. WASH. L. REV. 745, 753-55 (1984) (market for corporate control inferior to deriva-tive suit in deterring one-shot breach of fiduciary duty); Easterbrook & Fischel, supra note 8, at 701

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Of course, even in the absence of judicial intervention, many fiducia-ries will not take advantage of the full range of opportunistic activitiesopen to them. But so long as complete information on performance isnot readily available to prospective principals, the honest and diligentfiduciary will suffer some of the same ex ante adjustment as her less wor-thy cohorts. In essence, she is forced to underwrite a portion of the lat-ters' opportunism. To the prospective principal, all cats may look grayin the dark. The "good" fiduciary, therefore, should take steps to com-municate and warrant her fidelity to prospective principals. Reputationis of special significance to the would-be fiduciary. 33 Professionalizingthe fiduciary's occupation, engaging in self-regulation, and even invitinggovernmental regulation are among the strategies available to instill pub-lic confidence in the absence of standardized criteria for evaluating thefiduciary's performance. 3a In addition, the fiduciary may undertake"bonding" activities-self-imposed restrictions on her ability to engagein opportunism. 35 Because of the coordination and free-rider problemsassociated with restricting the risk of opportunism through principal-ini-tiated monitoring activities,36 fiduciary-initiated bonding may provide amore cost-efficient method of restriction, and thereby reduce the amountof the ex ante adjustment to the fiduciary's compensation. 37

We see a variety of examples of such bonding in the real world.Business lending relationships routinely deal with the borrower's oppor-tunities to favor itself at the expense of its creditors by imposing contrac-tual restrictions on the borrower's ability to do such things as incuradditional debt or take assets out of the business. 38 The early practice ofinvestment bankers serving on the boards of directors of the companieswhose securities they underwrote as a method of instilling public confi-dence provides a good example of market-initiated bonding.39 Contem-porary examples of bonding in the case of conflicts between corporatemanagement and shareholders are less prevalent but do exist. They in-

(various market mechanisms may be inadequate to deal with one-time defalcations); see also infranote 47 and accompanying text.

33 See Frankel, supra note 6, at 835-36 (discussing the commercial fiduciary's incentive to createreputation). Cf Darby & Karni, Free Competition and the Optimal Amount of Fraud, 16 J. L. &EcON. 67, 82 (1973) (incentive to build reputation as a form of capital investment by sellers ofinfrequently purchased experience or credence goods). For a provocative attempt to measure thevalue of reputation in the case of general partners in oil and gas limited partnerships, see Wolfson,Empirical Evidence of Incentive Problems and Their Mitigation in Oil and Gas Tax Shelter Programs,in J. Pratt & R. Zeckhauser, supra note 7, at 101, 112-16.

34 See, eg., Pratt & Zeckhauser, supra note 7, at 29 (creation of self-policing associations andlicensing requirements).

35 Jensen & Meckling, supra note 7, at 325-26.36 See supra text accompanying note 27.37 See Jensen & Meckling, supra note 7, at 326, 338-39.38 See Smith & Warner, On Financial Contracting: An Analysis of Bond Covenants, 7 J. FIN.

ECON. 117 (1979).39 See V. CAROSSO, INVESTMENT BANKING IN AMERICA 32-33 (1970).



elude the voluntary increase in the proportion of independent, nonman-agement directors on boards, the creation of audit, compensation, andnominating committees staffed by such outsiders,40 and the amendmentof articles of incorporation to require management to submit to in-dependent evaluation any takeover bid in excess of the current marketprice of the corporation's stock.41

C. The Operation of the Ex Ante Adjustment Process-An Evaluation

The foregoing concepts lead to some important observations aboutthe real-world operation of the ex ante adjustment process. Because theavailability and quality of this process will determine in large part thestrictness with which the law must deal with the fiduciary, these observa-tions are an important bridge to the latter sections of this Article.

In their influential paper, Professors Michael C. Jensen and WilliamH. Meckling developed a series of formal models demonstrating how,under certain assumptions, the fiduciary will bear the full costs of moni-toring and bonding, as well as the estimated residual risk of opportu-nism. 42 The core assumptions that underlie this conclusion provide agood analytical structure for our evaluation of the ex ante adjustmentprocess.

At first glance, the conclusions of the Jensen-Meckling model con-cerning the allocation of costs may seem to reflect a completely unrealis-tic appraisal of the prospective principal's ability to assess and quantifythe risks of opportunism and the effects of various kinds of monitoringand bonding upon these risks. The point is not, however, that the princi-pal must be able accurately to predict the precise quantum of opportu-nism risk in any given situation, but that, on average, his predictions beright. More specifically, the model requires, first, that the predictions be"rational" in the sense that deviations from the estimate tend to canceleach other out over time, and, second, that these deviations be "in-dependent" across the universe of alternative fiduciary opportunitiesavailable to the principal. In other words, the fact that fiduciary X en-gaged in more opportunistic behavior than had been estimated for the

40 See, eg., A.B.A. Sec. Corp., Banking & Bus. Law, Corporate Director's Guidebook, 33 Bus.LAW 1591, 1619-20, 1625-27 (1978) [hereinafter cited as A.B.A. Corporate Director's Guidebook];Statement of the Business Roundtable, The Role and Composition of the Board of Directors of theLarge Publicly Owned Corporation, 33 Bus. LAw 2083, 2107-11 (1978); Williamson, Corporate Gov-ernance, 93 YALE L.J. 1197, 1219-20 (1984).

41 Consider, for example, the proposal adopted by the shareholders of Superior Oil Co. in May,1983. The adopted proposal created an independent committee to consider any takeover offer for45% or more of the company's shares, to determine whether the offer was fair, and, if so, to recom-mend acceptance of the offer to the full board. N.Y. Times, May 25, 1983, at Dl, col. 5. However,since the proposal was sponsored by a dissident shareholder and opposed by management, it is morean example of principal-initiated monitoring than of fiduciary-initiated bonding. For background onthe controversy, see Family Feud at Superior Oil, N.Y. Times, Apr. 30, 1983, at L29, col. 2.

42 Jensen & Meckling, supra note 7.

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period t has no bearing on how fiduciary Y behaved in that period; thebehavior of each is independent of the other. This latter requirement as-sures that, notwithstanding the inherent uncertainty, the principal may,through diversification, enjoy a close correspondence between his ex anteestimate and the actual outcome.43 The subsections that follow will ex-amine each of these assumptions in detail.

1. Rationality.-The requirement of rationality in the Jensen-Meckling model supposes that principals will not systematically overesti-mate or underestimate the cost and residual opportunism risk associatedwith any combination of monitoring and bonding activities. Two factors,however, erode the principal's ability to make consistent, rational esti-mates of the true risk of opportunism, particularly as the form of oppor-tunism in question becomes more idiosyncratic and speculative: theprincipal's "bounded rationality" and the ability of the fiduciary to ma-nipulate the mix of bonding activities in his favor.

Economists have employed the term "bounded rationality" to em-brace the limits of classical economic models that are tied to the exist-ence of a rational decisionmaker who is seen as setting out to maximizehis or her welfare in the face of an uncertain future. In the words ofHerbert A. Simon, author of the term, it refers to the fact that "[t]hecapacity of the human mind for formulating and solving complexproblems is very small compared with the size of the problems whosesolution is required for objectively rational behavior in the real world-or even for a reasonable approximation to such objective rationality." 44

This principle not only suggests that there are limits to the operation ofthe ex ante adjustment process in general, but also leads to a recognitionthat ex ante adjustment is likely to work better for some kinds of fiduci-ary relationships and for some kinds of opportunism than for others. Wehave already seen some aspects of this.45 In general, the principal's abil-ity to anticipate opportunism will be shaped largely by his access to andability to digest information about the performance of the particular fidu-ciary, or at least of those in comparable undertakings. Where the subjectmatter of the fiduciary relationship is not a standardized kind of transac-tion or where experience-rating information on the fiduciary's past per-formance is not available, the principal will be left to speculation and

43 Jensen and Meckling note that the effect of this uncertainty upon their model is minimal:For simplicity we ignore any element of uncertainty introduced by the lack of perfect knowl-edge of the owner-manager's response function. Such uncertainty will not affect the final solu-tion if the equity market is large as long as the estimates are rational (i.e., unbiased) and theerrors are independent across firms. The latter condition assures that this risk is diversifiableand therefore equilibrium prices will equal the expected values.

Id. at 318.44 H. SIMON, MODELS OF MAN 198 (1957); see also 0. WILLIAMSON, supra note 22, at 65-67

(applying bounded rationality to the problems of drafting contingent contracts); Simon, RationalDecision Making in Business Organizations, 69 AM. ECON. REv. 493 (1979).

45 See supra text accompanying notes 29-32.



intuition. Even where past information is available, it is unlikely to fore-cast the risk of a one-shot fleecing. 46

While it is impossible to say on an a priori basis whether the princi-pal's bounded rationality will be more likely to lead to systematic under-estimation or overestimation of the prospects of opportunism, it seemsplausible to predict that the principal's naivet6 more often than not willlead him to seek inadequate compensation for the true risk.47 Even if thissurmise is wrong and the principal's naivet6 leads to excessive cautionand overestimation of the risk, the implications may be no more attrac-tive. The fiduciary, who typically will be in a better position to evaluatethe true risk, is unlikely to be willing to pay the price for the principal'sunfounded cynicism.

Further, to the extent that some biased estimation routinely exists, itis in the fiduciary's interest to exploit it. This is most apparent in thecase of bonding activities. The fiduciary may gain at the expense of herprincipal by systematically employing those bonding activities that re-strict her opportunistic behavior less than the principal perceives. Forexample, the investment advisor may find it more beneficial and less bur-densome to convert his wardrobe from loud sport coats to pin-stripe suitsin order to garner the faith of his clients than to promise them that hewill spend every Saturday taking an advanced course in portfolio theory.A more familiar example of this phenomenon is the use of "decoy duck"corporate directors48 with impressive credentials but little actual involve-ment in the business. Of course, this point is not entirely one-sided. Theprincipal may be more aware of the implications of various forms ofbonding than the fiduciary. For example, the large organization hiring anew employee fresh from professional school may be able to extract ex-tensive bonding commitments in return, the true effects of which he orshe will come to appreciate only over time.

To summarize, the principal's bounded rationality and the fiduci-ary's capacity to manipulate the mix of bonding activities to her favoraffect the principal's ability to make consistent, rational estimates of thetrue risk. The propensity of these two factors for causing systematic un-derestimations of the risk will depend upon the relative sophistication

46 See supra note 32 and accompanying text.

47 There is reason to believe that people tend to underestimate the probability and conse-quences of events that are difficult to imagine or beyond the realm of normal experience, includ-ing failure of complex systems; they also tend to have illusions of control, with resulting overlyoptimistic estimates of outcomes that are a matter of chance or luck.

Brudney, Equal Treatment of Shareholders in Corporate Distributions and Reorganizations, 71 CA-LIF. L. REV. 1072, 1088 n.39 (1983) (citing authorities from various disciplines); see also Carney,Fundamental Corporate Changes, Minority Shareholders and Business Purposes, 1980 Am. B.FOUND. RESEARCH J. 69, 117-18 n.190.

48 The term is taken from Bishop, Sitting Ducks and Decoy Ducks: New Trends in Indemnifica-tion of Corporate Directors and Officers, 77 YALE L.J. 1078, 1092 (1968). See also Douglas, DirectorsWho Do Not Direct, 47 HARV. L. REV. 1305, 1317-19 (1934).

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and experience of the principal vis-a-vis the fiduciary and the extent towhich available data about the fiduciary's past performance shed lightupon her tendency to indulge in the particular form of opportunistic be-havior at issue.

2. Independence, Risk Aversion, and Diversification.-The secondrequirement of the Jensen-Meckling model-that the probability ofdeviation from the principal's ex ante estimate be independent acrossavailable opportunities-is more elusive than the requirement of rational-ity and raises the issue of risk diversification. Because the concepts ofrisk aversion and diversification permeate the analysis that follows, anelaboration on the basic theory is necessary. 49

Suppose a person is presented with the choice between two invest-ments. Investment A is guaranteed to be worth $10,000 at the end of twoyears; Investment B presents a 50% chance of being worth $5,000 and a50% chance of being worth $15,000. Even though the average or ex-pected value of Investment B at the end of the period is equivalent to thatof Investment A (i.e., $10,000), contemporary economic and finance the-ory holds that most investors will not be indifferent between the two al-ternatives. They will prefer Investment A because it permits them toorganize their affairs with the assurance that exactly $10,000 will beavailable to them at the end of the period. This preference is referred toas "risk aversion." Thus, if risk-averse investors are willing to pay, say,$8,000 for Investment A (and thereby earn a risk-free 25% return overthe two-year period), they may only be willing to pay $7,500 (and earnan expected 33% return) for Investment B. The extra 8% return onInvestment B represents a risk premium to compensate investors for theinherent uncertainty. 50 The greater the variation in the possible out-comes of the investment, the riskier it is, and the higher the expected riskpremium. Thus, a third alternative that poses a 50% chance of beingworth $0 and a 50% chance of being worth $20,000 at the end of theperiod will be worth even less, say $7,000, to risk-averse investors.

Modern portfolio theory teaches, however, that it is possible to elim-

49 For more detailed discussions of these concepts see V. BRUDNEY & M. CHIRELSTEIN, CASESAND MATERIALS ON CORPORATE FINANCE 59-70, 1143-55 (2d ed. 1979); W. KLEIN, BUSINESSORGANIZATION AND FINANCE 145-55 (1980); Modigliani & Pogue, An Introduction to Risk andReturn: Concepts and Evidence, FIN. ANAL. J., Mar.-Apr. 1974, at 68, May-June 1974, at 69.

50 Another way of looking at the investor's aversion to risk is to consider how much of a guaran-teed amount, payable at the end of the two-year period, he or she would be willing to take in ex-change for the risky combination presented by Investment B. As noted in the text, that investmenthas an end-of-period expected value of $10,000. But our risk-averse investor would presumably bewilling to exchange Investment B for a guaranteed return on his or her $7,500 of anything in excessof 25%, that is, for a guaranteed payment of anything in excess of $9,375. Although this certainamount is less than the expected value of Investment B at the end of the period, it provides theinvestor with the same 25% risk-free return on his or her investment that he or she would obtainwith Investment A. The $9,375 amount is therefore referred to as the certainty equivalent of therisky opportunity represented by the 50% probability of receiving $5,000 and the 50% probability ofreceiving $15,000.



inate some risk through diversification. Suppose that instead of investingexclusively in Investment B, a risk-averse investor has the opportunity todivide his or her funds equally among ten investments (Investments B'through B lO), each presenting the same possible outcomes and probabili-ties. Thus, each of the ten alternatives provides the investor a 50%probability of receiving $500 and a 50% probability of $1,500.51 Theexpected end-of-period value of the ten-investment portfolio is still$10,000. But, to the extent the outcome under each of Investments B'through B 0 is independent of each of the others, the investor's overallrisk is reduced considerably from what it would be if the investor concen-trated his or her holdings on any one of the alternatives alone. Our in-vestor will receive the low-end amount of $5,000 only if each of the tenalternatives is worth $500 at the end of the period, and the chance of this,assuming the outcome of each is independent of the others, is 1 in1,024.52 The probability that the total end-of-period value will be be-tween $9,000 and $11,000 is 65.6%.53 Through diversification, then, theinvestor has attained much of the certainty presented by Investment A.Because the expected return of Investment B is significantly higher thanthat of Investment A (33% as opposed to 25%), we would expect inves-tors to shift their funds out of Investment A and into diversified portfo-lios consisting of Investments B' through B o. The effect of this will be tobid down the expected return of Investment B, thereby eliminating therisk premium. On a more general level, finance theory holds that ra-tional capital markets will not compensate the investor for risks that canbe eliminated by rational diversification.

In the above example it is critical to the result that the outcomes ofInvestments B' through B' 0 be independent of one another. Frequently,

51 Viewed differently, Investment B is analogous to the investor's fate being determined by a

single flip of a coin, with the right to receive $15,000 if "heads" appears but only $5,000 if "tails"appears. By diversifying his or her holdings among Investments B through B"°, the investor substi-tutes 10 independent coin flips, receiving $1,500 for each "heads" and $500 for each "tails."

52 When an event is done once and the likelihood of a certain outcome is 50%, the likelihood ofthat same outcome occurring every time when the event is done ten times in a row is 50% X 50%X 50% X 50% X 50% X 50% X 50% X 50% X 50% X 50%, which is equal to a probability of.00098. A probability of .098% indicates that ten identical outcomes will occur I in 1,024 times.

53 In general, if the probability of a particular outcome in any given trial is p, then the cumula-tive probability that the outcome will recur exactly k times in n trials is given by the followingformula:

(n!/kl[n-k]!)p'(1 -p)'-'

See B. LINDGREN & G. MCELRATH, INTRODUCTION TO PROBABILITY AND STATISTIcs 19, 33-34

(3d ed. 1969). Thus, in the hypothetical in the text, p, the probability that any given investment willbe worth $1,500 at the end of the period, is 0.5 and n is 10. Under the formula, the probability thatexactly 4 of the investments will be worth $1,500 at the end of the period (k =4) with the remaining6 worth $500-so that the entire portfolio will be worth $9,000-is 0.205. The probability that 5 ofthe investments will be worth $1,500-so that the portfolio will be worth $10,000--is 0.246, and theprobability that 6 of the investments will be worth $1,500-so that the portfolio will be worth$1 1,000--is 0.205. The total of these three probabilities is 0.656. In other words, there is a 65.6%chance that the portfolio will be worth between $9,000 and $11,000.

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this will not be the case. The same factors that might cause InvestmentB 1 to be worth $500 at the end of the period-higher interest rates, ex-cessive inflation, a bad frost, and so forth-might similarly affect Invest-ment B2 and the others. Thus, financial economists distinguish betweensystematic risk, that which generally affects all capital assets, and nonsys-tematic risk, that which is more asset-specific. Nonsystematic risk maybe eliminated through diversification, but systematic risk may not. Thus,in a regime of rational and competitive capital markets, risk premiumsshould exist only to compensate investors for systematic risk.

Applying the concept of risk aversion to our discussion of opportu-nism reinforces the conclusion reached in the preceding subsection that,in real life, the ex ante adjustment process is better suited to deal with themore mundane and ongoing forms of opportunism than the more egre-gious and episodic ones. Suppose a wealthy widow is choosing betweentwo investment advisors to manage her money--0 (for Opportunism)and F (for Fidelity). She has surveyed the past performance of both andhas concluded that for a variety of reasons (which, she suspects, includesubstantial shirking by 0), funds under F's management have out-performed those under O's by about 0.5% per year on average. Nonethe-less, it is more convenient for her to employ 0. Provided that the annualfee she pays 0 is lower than what she would pay F by at least 0.5% of herinvested assets, she is fairly compensated, ex ante, for O's inferior per-formance. She should not be permitted to complain after the arrange-ment is established that O's shirking has inflicted losses upon her becausehis performance does not measure up to the standards of F. While theexact level of shirking, and with it the return achieved by 0 on her port-folio, may vary from year to year, there is no reason to believe that it willdepart widely from the observed past.

The widow's rational estimation of the risk and insistence upon fullex ante compensation works no unjust hardship upon 0 and furthersefficient economic decisionmaking. 0 is forced to evaluate whether thepleasure he derives from the increased shirking is worth the reduction infees. If a portion of O's consistently inferior performance is attributablenot to shirking but, for example, to less astuteness in assessing economictrends, then the reduction in fees is simply part of the competitive weed-ing-out process of the market.

Consider more idiosyncratic forms of opportunism. Suppose thatour widow also estimates-ignoring for the moment the clear "boundedrationality" problems that impede any such estimation-that there existsa 1 in 200 chance that 0 will abscond with all her money in any givenyear.54 In theory, she could adjust for this risk as well, on an ex antebasis, by reducing O's fees by another 0.5%. But even assuming that 0

54 As the discussion in the preceding subsection of the text indicated, it is extremely doubtfulthat our widow will be able to make an evaluation of the risks of a one-shot fleecing on the basis ofinformation specific to 0. Presumably, she would have to make a statistical judgment based on the



would consent to this reduction, it will not be sufficient to make her in-different to the existence of the risk, if she is risk averse. The 0.5% per-cent fee reduction represents the probabilistic equivalent of herassessment of the risk, but, in economic terms, the actual "utility" lossshe would suffer by having her entire fortune dissipated will likely bemuch more than 200 times the annual "utility" gain she receives fromthe reduced fees. Thus, appropriate compensation would include not justthe actuarial equivalent of the risk, but a healthy risk premium on top ofit.55

To the extent the widow fails to anticipate this possibility of moreblatant opportunism and demand compensation for it, she suffers a lossequivalent to not only the amount of the risk, but the risk premium shewould have extracted as well. Conversely, if she does demand compensa-tion, the "honest" investment manager must underwrite not only theresidual perceived risk created by his inability to fully bond his honesty,but a risk premium resulting solely from the uncertainty of the situationas well. Finally, as the above discussion of portfolio theory suggests, thewidow could reduce the overall riskiness of her position through diversi-fication-for example, she could divide her funds among ten investmentmanagers.5 6 However, this may impose costs of its own. It will no doubtgenerate increased transactions costs and may destroy any economies ofscale created by entrusting all of her business to a single advisor.5 7 Thus,the ex ante adjustment process will tend to work more "painlessly" in thecase of idiosyncratic opportunism if diversification is available to pro-spective principals at a relatively low cost. The risk premium to be borneby the entire class of fiduciaries will be lower and the harm inflicted uponany particular principal by the occasional defalcations that do occur willbe dampened. Thus, to link the points made in this and the preceding

incidence of such fleecing within the entire class of fiduciaries to which 0 belongs, assuming suchclass-wide data could be compiled.

55 See supra text accompanying note 50.56 A single investment manager represents a 0.5% risk of defalcation and a 99.5% likelihood of

nondefalcation. If the investment is divided among ten investment managers, each representing a99.5% likelihood of nondefalcation, the chance that the widow will lose nothing (the chance that atleast one manager will defalcate) is reduced to below 99.5%. At the same time, however, though therisk that the widow will lose something is greater with 10 managers than with only one, the risk thatshe will lose more than 20% of her portfolio (e., that more than two of the managers would ab-scond) is only one in 100,000. In comparison, with one manager, the risk that she will lose every-thing is 50 in 100,000. Thus, as the principal's affairs are parceled out to more and more fiduciaries,the outcomes realized by the principal will come to conform more closely to the ex ante probabilities.Cf. Anderson, supra note 6, at 750-51 (discounting for the possibility of cheating in exchange trans-actions "is likely to be accurate only over a very large number of transactions").

57 The existence of economies of scale relevant to the example in the text is reflected by the factthat the fees of many money managers, as a percentage of assets, are scaled down as the size of theportfolio increases. For example, the annual trustee fees of one Madison, Wisconsin bank are 0.6%on the first $200,000; 0.5% on the next $300,000; 0.3% on the next $1 million; and 0.2% on theremainder. United Bank & Trust of Madison, Trust Fee Schedule (Jan. 1981).

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subsection with the discussion to come, the legal system's tolerance forepisodic opportunistic behavior should be influenced not only by the ca-pacity of prospective principals to anticipate it and extract ex ante com-pensation, but also by their opportunities for diversification.

3. Competitive Opportunities.-Finally, the Jensen-Meckling modelimplicitly assumes that alternative investment opportunities are availableto the principal. If this is so, we can expect prospective fiduciaries toaccept a full ex ante discount in order to meet the competition. But tothe extent that the principal does not have such an array of competitivechoices, there is no assurance that he can obtain full prospective compen-sation ex ante.5 8 Depending upon the alternatives, he may be forced tochoose between either accepting less than full compensation or undertak-ing the activity himself.

4. A Recapitulation.-To summarize the foregoing subsections, wehave seen that the reliability of the ex ante adjustment process as a solu-tion to the problem of fiduciary opportunism is dependent on three fac-tors. The first is the quality of the prospective principal's estimate of theopportunism risk. This will be a function of the principal's experienceand sophistication and the availability of information concerning the fi-duciary's prior behavior in comparable transactions. Further, it is likelythat the principal will be better able to estimate the more routine andcommon forms of opportunism, such as shirking, than the more blatantand idiosyncratic forms, such as embezzlement. The second factor is theprincipal's capacity to diversify. Here again, diversification is less impor-tant where the form of opportunism is more routine and ongoing in itsnature, so that realized behavior will not deviate as widely from the exante estimate. The third and final factor is the competitiveness of themarket for the fiduciary's services.

D. Ex Post Settlements

The incentives created by the ex ante adjustment process make it inthe fiduciary's self-interest to restrict herself as much as possible whilenegotiating the arrangement with the principal. After the terms havebeen set, however, these incentives disappear, and the fiduciary (underour assumed absence of a generalized enforceable fiduciary standard) isfree to search for whatever loopholes she can find in the agreed-uponrestrictions and to exploit them as she sees fit. Of course, to the extentthat the fiduciary's performance over the course of the relationship maybe evaluated and added to her cumulative reputation, incentives to ab-stain from opportunism continue to exist. 59 Again, however, these incen-

58 Cf. Pratt & Zeckhauser, supra note 7, at 17-18 (who receives benefit from reduction in agencycosts depends on relative degree of competition among agents and among principals).

59 Compare Fama, supra note 7 (managerial labor markets achieve a form of ex post settling upfor opportunism by revaluing the manager's human capital) with Levmore, supra note 27, at 60-61



tives are likely to be stronger for more mundane forms of opportunismthan for the one-time fleecing. Thus, an astute principal may want morecomprehensive protection against this sort of "moral hazard" 60 problem.Possible solutions for the principal include keeping the duration of thearrangement short, retaining the opportunity to review the fiduciary'sperformance before deciding to renew the arrangement, and reserving thepower to terminate the arrangement at will.61 Alternatively, the princi-pal could negotiate some form of ex post settling up with the fiduciarybased on her performance.

The problems with periodic review and ex post settling up are simi-lar to those we have repeatedly encountered in connection with monitor-ing, bonding, and ex ante reputation review. Detailed performanceevaluation ideally contemplates that the fiduciary's job description can bedecomposed into a series of specific tasks and requirements, an attributeinconsistent with the specialized expertise and discretion characteristic ofmany fiduciary callings.62 Thus, holding the fiduciary to a sort of inflexi-ble checklist is not likely to generate the kind of overall performance theprincipal desires. 63 As a matter of feasibility, therefore, any ex post set-tling up typically will be based upon a generalized index of the outcomeof the fiduciary's performance rather than the content of the performanceitself.64

This necessarily introduces problems. First, the settling up will re-flect not only the fiduciary's performance, but environmental factors be-yond her control as well. Second, ex post settling up, of whatever form,will not eliminate all of the incentives for opportunism unless it shifts tothe fiduciary all of the gains or losses she generates. 65 Along with being

(discussing reasons why the labor market may not provide adequate discipline for corporatemanagers).

60 For general discussions of the moral hazard phenomenon, see 0. WILLIAMSON, supra note 22,at 14-15, 34; Hirschleifer & Riley, The Analytics of Uncertainty & Information-An Expository Sur-vey, 17 J. ECON. LIT. 1375, 1390-91 (1979).

61 See W. KLEIN, supra note 49, at 16-18; Epstein, Agency Costs, Employment Contracts, andLabor Unions, in J. PRAT1 & R. ZECKHAUSER, supra note 7, at 127, 136-41; Frankel, supra note 6,at 812-13.

62 See W. KLEIN, supra note 49, at 6-7; Anderson, supra note 6, at 749-50, 751-52, 757-59;Frankel, supra note 6, at 813-14; cf Alchian & Demsetz, supra note 21, at 786 (profit sharing byteam members-rather than central monitoring-more likely where tasks involve discretion andspecialization).

63 Cf 0. WILLIAMSON, supra note 22, at 56, 69 (discussing the difference between "consummatecooperation" and "perfunctory cooperation").

64 For instance, in the investment manager example the client will consider only how his or herportfolio performed, not what research reports the manager read, what alternatives the managerconsidered, the manager's basis for the investment selections he or she made, the extent to which themanager shopped for the lowest available brokerage commissions, and so forth.

65 The only way to eliminate the risk of opportunism altogether is to assure complete alignmentof the interests of fiduciary and principal. If the fiduciary is charged with 10% of the gains andlosses, her incentives are different from those where she is charged with 100%; she has less to lose bydiverting her time to pursuits more pleasurable than researching investments or by investing in a less

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at odds with what the principal probably sought when he entered into therelationship in the first place, this will be unacceptable to the fiduciary ifshe is risk averse, since her compensation will turn on environmentalfactors independent of her performance. 66 Finally, the terms of any suchless-than-perfect settling up may give rise to new kinds of incentives foropportunism. For example, a requirement that investment managers re-imburse their clients ex post for any losses may lead the managers to bemore diligent in searching out investments (for which they will presuma-bly charge a higher fee), but also may provoke more conservative strate-gies than they might engage in if they were investing for themselves.Similarly, the incentive compensation arrangements of corporate manag-ers may lead them to take excessive risks or to favor short-term perform-ance at the expense of long-term returns.67 In addition, any sort ofperformance evaluation that has an impact on the fiduciary's welfare pro-vides incentives for the fiduciary to conceal or obscure any negative as-pects of her conduct and highlight the positive ones. This possibilityadds to the monitoring costs of the principal. 68

E. A Comparative Evaluation of the Ex Ante and Ex Post Processes

Notwithstanding its shortcomings, ex post settling up, where feasi-ble, does enjoy a general comparative advantage over ex ante adjustmentbecause it measures compensation on a situation-specific basis. Ofcourse, where the principal can predict with accuracy the amount of lossfrom opportunism, it makes no difference whether he is reimbursed exante or ex post. As we saw in subsections II.B. and II.C., accurate pre-dictions are more likely where (i) comprehensive past performance dataexist to permit experience-rating of the fiduciary; (ii) the principal pos-sesses sufficient sophistication and experience to evaluate this data; and(iii) the kind of opportunism at issue is more mundane and ongoing in itsnature, so that the past is a reasonable forecast of the future. Where, onthe other hand, the opportunistic activity is more episodic or where relia-ble data on the fiduciary's past performance are beyond the ken of theprincipal, the principal is left to conjecture based on whatever informa-tion or intuition he happens to have concerning the general incidence ofthe opportunistic activity in question. It is in this latter class of situa-tions that ex post settling up is most attractive relative to ex ante adjust-ment. It eliminates the riskiness inherent in ex ante discounting for

attractive stock as a favor to a friend. See Alchian & Demsetz, supra note 21, at 780; Jensen &Meckling, supra note 7, at 312-13.

66 See W. KLEIN, supra note 49, at 14-16; Shavell, Risk Sharing and Incentives in the Principal

and Agent Relationship, 10 BELL J. ECON. 55 (1979).67 See generally Anderson, supra note 6, at 784-85; Frankel, supra note 6, at 811-12; Klein, supra

note 19, at 1548 n.91, 1558 n. 134; Vagts, supra note 20, at 240-45.68 See Stone, The Place of Enterprise Liability in the Control of Corporate Conduct, 90 YALE L.J.

1, 24 (1980) (increasing the penalties imposed upon an activity increases the incentives to cover up).



events which are shrouded in substantial uncertainty69 and surchargesfiduciaries based upon their actual conduct rather than upon an ex anteforecast of their propensities.

But, in those cases where an accurate ex ante evaluation can bemade, there are advantages in the ex ante process over the ex post one.First, transactions costs may be lower. As discussed in subsection D.,there are problems inherent in working out adequate guidelines to evalu-ate the fiduciary ex post. An adequately informed ex ante arrangementavoids the need to draft such guidelines because the principal simplybuys the level of performance suggested by the fiduciary's past trackrecord.

Second, also as mentioned in subsection D., ex post accounting re-quires that environmental factors be filtered out in evaluating the fiduci-ary's performance. How much of the loss incurred by the investmentmanager was attributable to unforeseeable developments in the economy?How much of the loss was attributable to his or her incompetence, badjudgment, or dereliction of duty?70 Because such environmental factorswill tend to even out over time, the principal equipped with long-termpast performance information may often be better able to forecast andprice the fiduciary's "pure" performance ex ante than to distill it fromrealized outcomes ex post.7 1 This facilitates shifting the risk of environ-mental factors from fiduciary to principal, which, depending upon therelative risk aversion and diversification potential of each, may or maynot be beneficial.

We shall return to this notion of the relative advantages of the exante and ex post processes from time to time in the analysis that follows.

III. THE ROLE OF LEGAL INTERVENTION

The foregoing discussion permits us to evaluate how the legal sys-tem intermeshes with private incentives and protective devices to dealwith the nonalignment of interests between principal and fiduciary andthe resulting risk of opportunism.

First and most fundamentally, the law imposes standardized obliga-tions upon the fiduciary designed to compel her to act in the interests ofher principal with a certain level of care and skill and provides the princi-pal a remedy if the fiduciary fails to so act. The remedy serves as a form

69 See supra text accompanying notes 49-50, 54-55.70 See Scott, Corporation Law and the American Law Institute Corporate Governance Project, 35

STAN. L. REV. 927, 932, 945-46 (1983) (disussing difficulty of determining duty of care violations-as opposed to duty of loyalty violations---ex post).

71 The statement in the text is somewhat akin to Professor Fama's argument that the wagenegotiation process in efficient labor markets operates to impose a form of ex post settling up, withenvironmental factors being evened out over time. See supra note 59. Cf. Scott, supra note 70, at946 (market mechanisms are superior to courts and juries in distinguishing between bad decisionsand bad luck).

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of ex post settling up for departures from the standards. This may seemthe kind of contribution whose merit is beyond dispute. Such a conclu-sion, however, is premature. The implication of the preceding section isthat the fiduciary's behavior is not "bad" per se so long as the principal isappropriately compensated for it, either ex ante or ex post. And, whilethe preceding discussion revealed some of the defects and inefficiencies inboth the ex ante and ex post processes, the imposition of standardizedlegal obligations introduces defects and inefficiencies of its own. 72

Thus, one cannot say a priori whether the imposition of standard-ized legal obligations upon the fiduciary is, given the alternatives avail-able, a net positive contribution. In fact, what sections V and VI of thisArticle seek to establish is that current fiduciary regulation represents ahybrid of standardized legal obligations and ex ante compensation in amix dictated by the relative strengths of each, given the relationship atissue.

Before taking up the defects and inefficiencies embodied in a systemof standardized fiduciary obligation in section IV, let us consider what, ifany, peculiar institutional advantages a regime of standardized obliga-tions, imposed as a matter of law, enjoys over the private ordering pro-cess described in section II. These advantages can be grouped into twoclusters. The first involves reducing the transaction costs inherent in theprivate ordering process. The second involves the contribution of stan-dardized legal obligations to the quality of the ex ante adjustmentprocess.

Standardized fiduciary obligations can reduce the transaction costsinherent in private ordering. Section II described how the ex ante adjust-ment process operated to surcharge the honest and diligent fiduciary tothe extent that she could not voluntarily divest herself of the capacity foropportunism through bonding or distinguish herself through reputationor otherwise. Further, we saw that where the residual risk of opportu-nism embodied activities of low probability but considerable potentialdamage (such as outright embezzlement), the appropriate surchargewould include, absent diversification, a significant risk premium. Thiswould be so unless the principal could be assured of the existence of anadequate ex post settlement process to detect and remedy the activitywhen it did occur. Yet, the creation of such an expost settlement processis inherenty costly because of the difficulties involved in working out thesubstantive terms of the restrictions and in putting in place a mechanismfor ensuring their enforcement. Furthermore, the restrictions and theenforcement mechanism must be adequately communicated and war-ranted to prospective principals if they are to have an effect on the exante process. The law can supply both the content and the means of

72 These defects and inefficiencies are the risk and cost of error, the resulting uncertainty, and

the expense of litigation. See infra text accompanying notes 91-116.



enforcement through standard rules which prospective principals maylearn and rely upon. Accordingly, several recent commentators haveviewed fiduciary law as a low transactions cost alternative to ad hoc bar-gaining between fiduciary and principal, one that ideally adopts termsthey would have agreed to had they dickered them out.73

But the gains available from standardized obligations go beyondavoidance of the costs of requiring parties to come together and work outterms for themselves. Included as well in the notion of transactions costsare the costs associated with the "bounded rationality" of the partieswhen faced with the complexity and variety of opportunities for diver-gence of interests between fiduciary and principal. The imposition oflegal obligations brings to the parties the collective experience oflawmakers in dealing with diverse forms of opportunism over the years,opportunism that may be beyond the immediate contemplation of theparties. Viewed thus, standardized obligations perform a sort of distribu-tive justice function by endowing less experienced and less well-fundedparties with state-of-the-art protection.

This does not mean, however, that the obligations imposed upon thefiduciary as a matter of law should remain inviolate. Where the partiespossess the capacity to make an informed and explicit modification of thelaw's standard-form deal to suit their particular needs, they should bepermitted to do S0. 74 Such a capacity may well exist where the principalconsists of a body of security holders participating in a market populatedby institutions and other sophisticated investors.

Thus, the legal process must be alert to the existence of private bar-gaining and avoid upsetting the apple cart when an informed modifica-tion of the standard set of duties has been agreed to by the parties. Thismay seem self-evident, but at times it is overlooked by the courts. 75

73 See, eg., R. POSNER, ECONOMIC ANALYSIS OF LAW 302 (2d ed. 1977); Anderson, supra note

6, at 757-60; Brudney & Clark, A New Look at Corporate Opportunities, 94 HARV. L. REv. 997, 999(1981); Easterbrook & Fischel, supra note 8, at 702-03 (1982). But see Weinrib, supra note 6, at 3:

For, however typical the history of the fiduciary obligation's evolution, the substance of theobligation appears to be strikingly unique. Although it functions within the context of plannedtransactions, its underlying premises are not those of individualistic private ordering. Thus it ispresent in the relevant relation except in the face of a specific exclusion and, far from embody-ing a standard which is universally and naturally accepted, it aspires to the pedagogic functionof raising the morality of the marketplace by enforcing upon potential profiteers the abnegationof their profits.74 See Anderson, supra note 6, at 760; Klein, supra note 19, at 1525-26.75 The well-known corporate law case of Zahn v. Transamerica Corp., 162 F.2d 36 (3d Cir.

1947), provides a straightforward illustration. That case involved the Class A and Class B shares ofAxton-Fisher Tobacco Co. (A-F). The Class A shares were convertible into Class B on a share-for-share basis, but upon liquidation were entitled to twice as much per share as the Class B. In addi-tion, the Class A shares were callable at the option of A-F. Transamerica owned virtually all of theClass B and as a result dominated A-F's board of directors. In order to take exclusive advantage ofthe significant appreciation of A-F's tobacco inventory-a fact unknown to the Class A shareholders-Transamerica caused A-F's board to call the Class A shares at the fixed redemption price and thenliquidate the corporation. In a suit by a Class A shareholder, the Third Circuit held that in so doing

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The second cluster of advantages attributable to standardized legalobligations is their contribution to the quality of the ex ante adjustmentprocess. Here, the important point is not so much the content of thoseobligations as the fact that they are standardized. For the ex ante adjust-ment process to operate effectively in compensating the principal for theprospect of opportunism, the parties must have some appreciation of howmuch and what kinds of opportunism the particular bonding and moni-toring regime they have elected will permit. Where the regime is one ofstandardized form, data is available from the experiences of countlessother relationships operating under a comparable framework. Over theyears we have come to develop, for example, a general notion of howmuch latitude is afforded corporate managers by the "business judgmentrule" or how effective outside auditors are in protecting against financialstatement misrepresentation. If, by contrast, fiduciary relationships wereto be governed by a diverse set of alternative, privately negotiated moni-toring and bonding regimes, the results under one regime would not be asreadily generalizable to others.76

Legal rules can contribute to this process in a number of ways. Inaddition to imposing substantive obligations directly on the fiduciariesthemselves, the law can prescribe uniform criteria for the various kindsof monitoring and bonding mechanisms. We saw in subsection IIC. 1.how the savvy fiduciary may subvert the ex ante adjustment process byemploying those forms of bonding which restrict her less than the princi-pal perceives. By regulating the content of commonly employed bondingand monitoring devices, the law can seek to conform them to the expec-

the A-F board breached its duty to the Class A shareholders to exercise the call provision in adisinterested manner, and that the plaintiff was entitled to damages based upon what he would havereceived had the Class A been permitted to participate in the liquidation.

While the board of directors ordinarily owes a fiduciary duty to all shareholders and cannotfavor the majority over the minority, the Third Circuit's decision ignored the contract implicit in theclassification of shares. By purchasing Class A shares, the Class A shareholders had bargained awaythe opportunity to participate as Class A in corporate value over and above the call price. Presuma-bly, in a well-informed securities market, this was reflected ex ante in the price they paid for theirstock. But as an additional component of their bargain, the Class A shareholders had the right toavoid the call by opting for Class B status through the conversion privilege. Thus, the true vice ofthe A-F board's action was to frustrate this part of the bargain by concealing the appreciated valueof the tobacco so the Class A could not make an informed decision to convert. Accordingly, theappropriate measure of recovery should have been based not upon what the Class A holders wouldhave received in the liquidation as Class A, but upon what they would have received had theyconverted to Class B and participated in the liquidation as such. This was ultimately recognized bythe district court upon remand, and the Third Circuit concurred. Speed v. Transamerica Corp., 135F. Supp. 176, 180-86 (D. Del. 1955), modified, 235 F.2d 369, 373-74 (3d Cir. 1956).

76 Compare the following observation by Professor Frankel:[W]ithout regulation the entrustor [i.e., the principal] cannot effectively bargain for protectionfrom the fiduciary's abuse of power. Because the entrustor is generally unable to supervise thefiduciary, he can calculate neither the risk of abuse of power nor the amount of injury he mightsuffer. When the law regulates the fiduciary, the entrustor can determine the cost of the riskwith greater certainty.

Frankel, supra note 6, at 834.



tations of principals. In doing so, the law promotes uniformity and en-sures that experience data generated by the monitoring-bondingcombination employed in a particular relationship can be generalized toother relationships employing the same combination. This assists the exante adjustment process. The imposition of stricter monitoring duties onoutside directors and the regulation of independent auditors are exam-ples of this phenomenon.

Legal rules also can work to enhance the quality of the ex ante ad-justment process by regulating the availability and quality of informationregarding the past performance of particular fiduciaries. The disclosureand dissemination components of the federal securities laws, which fur-nish prospective investors with reliable track record information on acompany's management, provide the obvious example. Regulating theavailability and quality of such information also contributes to ex postsettling up by assuring the accuracy of any performance informationupon which the settling up may be based. Thus, for example, corporatemanagers whose compensation is tied to business profits are restrainedfrom manipulating the books to inflate the apparent success of theirefforts.

This section of the Article has sought to provide something of abridge between the discussion of private ordering in section II and theanalysis of formal legal regulation of fiduciary decisionmaking in the sec-tions that follow. This section has made the fundamental point that pri-vate ordering and legal regulation represent alternative sources ofsolutions, each with its own defects. Thus, the appropriate frameworkfor analyzing legal rules is to view them as part of a tandem process withthe private ordering mechanisms discussed in section II. Put simply, weshould expect legal regulation to take on those kinds of judgments andproblems where it enjoys a comparative institutional advantage over pri-vate ordering and defer the balance to the ex ante and ex post compensa-tion processes and, at the same time, to make whatever contributions itcan to improve the quality of those processes. One of the fundamentalissues implicit throughout the sections that follow concerns the kinds ofjudgments and problems that the law has chosen to take on and the kindsthat it has chosen to defer to private ordering mechanisms.

IV. THE OPERATION OF THE FIDUCIARY STANDARD

A. Introduction

What we see as we survey the landscape of fiduciary law is a diverseand often inconsistent variety of legal rules. Where the fiduciary rela-tionship takes the form of a trust or common law agency, the law's re-sponse has been rigorous. The fiduciary is held to a strict standard ofcare and loyalty and is generally prohibited from engaging in any trans-

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action in which she has a personal interest.77 Thus, for example, thetrustee is forbidden from selling trust property to himself or herself,notwithstanding the fact that the terms of the transaction may be fairand represent the best deal available. 78 Even where the trustee obtainsthe beneficiary's consent to the sale, the transaction may be set aside if itis found that the trustee failed to disclose material information. 79 In thecase of corporate law, on the other hand, the law's posture slackens con-siderably. Officers and directors are rarely held liable for negligence orincompetence unaccompanied by self-dealing. 0 As long as the terms arefair, management is generally free to engage in self-dealing.81 And whilethe formal doctrine imposes upon the officer or director the burden ofproving "intrinsic fairness," the case law often reveals a less rigorousburden. 82 Indeed, the law has developed several devices that serve toshelter self-dealing from judicial scrutiny for fairness so long as the self-dealing has been approved by the members of the corporation's board ofdirectors who have no personal stake in the transaction.8 3 Further, theformal doctrine itself, under the rubric of the "business judgment rule,"protects some fiduciary decisions that have an obvious potential for self-interested bias, such as management's response to a hostile takeover, andthereby presumes these decisions to be disinterested and sound. 4

Sections V and VI will consider these rules in more detail and seekto explain the apparent inconsistencies. The objective of the present sec-tion is to develop the analytical framework and the terminology that willbe used in sections V and VI. The central thesis of the discussion thatfollows is that the differences in the various standards developed by thelaw to govern fiduciary decisionmaking may be explained in large part bytwo factors: (i) the relative cost of erroneously upholding opportunisticdecisions versus that of setting aside proper ones, and (ii) the compara-tive ability of fiduciary and principal to deal with the resulting prospectof error through ex ante adjustment, ex post settling up, anddiversification.

B. The Fiduciary Ideal

An obvious starting point for coming to grips with the process ofcreating standardized duties to implement the fiduciary ideal is to con-sider, in terms of formal legal doctrine, what is involved in being a fiduci-ary. Perhaps the best places to turn for an answer to such a black-letter

77 See infra notes 119-25 and accompanying text.78 See infra notes 119-20 and accompanying text.

79 See infra notes 133-38 and accompanying text.80 See infra notes 192-93 and accompanying text.81 See infra notes 151-52, 194-202 and accompanying text.82 See generally infra subsections VI.C.3.-5.83 See infra notes 214-34 and accompanying text.84 See infra notes 271-87 and accompanying text.



question are the Restatements and related materials. The Restatement(Second) of Agency defines agency as a "fiduciary relationship" in whichthe agent consents to "act on [the principal's] behalf and subject to hiscontrol," 85 and describes the agent's fiduciary obligation in terms of aduty "to act solely for the benefit of the principal in all matters connectedwith his agency."' 86 Similarly, the Restatement (Second) of Trusts definesa trust as a "fiduciary relationship with respect to property, '8 7 with thetrustee being under a duty "to administer the trust solely in the interestof the beneficiary." '88 A final formulation is supplied by the Model Busi-ness Corporation Act, which states that a corporate director shall performhis duties "in good faith" and "in a manner he reasonably believes to bein the best interests of the corporation." 89

Taken literally, each of these verbalizations of the fiduciary's duty-of-loyalty obligation imparts a completely subjective standard, lookingsolely at the motives and purposes underlying the fiduciary's conduct.The inquiries are whether an agent is acting solely for the benefit of theprincipal and whether a director reasonably believes he or she is acting inthe best interests of the corporation. But there is an inherent "capabilityproblem" 90 in translating the fiduciary ideal into substantive rules. Seri-ous practical difficulties would surround the enforcement of any legalrule that turned upon, and depended upon proof of, what lay within thefiduciary's head. In response, the law has sought to develop objectivecriteria for enforcement by identifying those instances that present a spe-cial risk of bad faith motivation and subjecting them to special scrutiny.For example, the law provides special scrutiny whenever the fiduciaryhas a personal pecuniary stake in the outcome of the transaction that ispotentially at odds with the interests of her principal. In such a case, aswe shall see in sections V and VI, the level of scrutiny varies according tothe subject matter area of the law into which the transaction falls.

C. Type I and Type II Error and The Tradeoff between Them

In view of the fact that translation of the fiduciary ideal into a work-able framework of judicial review requires, by its nature, courts and legis-latures to speculate about the fiduciary's subjective motivation anddecisionmaking process on the basis of her observable conduct, there nec-essarily will be occasional "mistakes." Some fiduciary decisions that are

85 RESTATEMENT (SECOND) OF AGENCY § 1(1) (1957).86 Id. § 387.87 RESTATEMENT (SECOND) OF TRUSTS § 2 (1957).88 Id. § 170 (1).89 MODEL BUSINESS CORP. ACT § 8.30(a)(1), (3) (1984). See also RESTATEMENT OF RESTrru-

TION § 190 comment a (1936) ("A person in a fiduciary relation to another is under a duty to act forthe benefit of the other as to matters within the scope of the relation.").

90 This term is taken from R. DANZIG, THE CAPABILITY PROBLEM IN CONTRACT LAW 1-3

(1978).

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in fact consistent with a good-faith attempt to act in the best interests ofthe principal will be prohibited or invalidated, and some that are not willbe upheld. The prospect of such legal "mistakes" 91 is, of course, notpeculiar to the fiduciary area. In any branch of the law, there is thepotential to produce outcomes at odds with the intent of the rules. Butthe risk is aggravated in the fiduciary area where the operative legal ques-tion-"what were the fiduciary's true motives?"-is at least one step re-moved from the observable legal fact-the decision that the fiduciarymade. Thus, the process of asking whether the fiduciary was motivatedstrictly by a desire to serve her principal is, by its nature, more specula-tive than asking whether the defendant in a contracts case did in factpromise the plaintiff to do X or whether the defendant in a torts case didin fact strike the plaintiff.

The inherent possibility of any set of legal rules to produce suchmistakes in evaluating the fiduciary's conduct is depicted in the chartbelow.

Possible Outcomes of Judicial Review

Character of Fiduciary's Decision in FactLegal Response

Transaction Upheld

Transaction Invalidated

Boxes #1 and #4 represent, respectively, instances in which thelegal system has correctly identified and upheld a decision made by thefiduciary in good faith92 and correctly identified and set aside an opportu-nistic decision. 93 An "ideal" legal system would succeed in confining all

91 The use of the term "mistakes" is, admittedly, troublesome. It might strike some readers as

overly simplistic to the extent that it suggests there is one and only one set of terms that a prudent,arm's-length decisionmaker would reach, and any departure from these terms is wrong. Obviously,different people have different ideas on what a satisfactory bargain is. This is the root of the prob-lem. In a sense, a court will never be "wrong" because it is virtually inevitable that there would besome independent decisionmaker, somewhere, who would share the court's conclusion as to whatthe bargain should be. Still, the court's view may nonetheless depart from the consensus that mostindependent decisionmakers would have reached. The terms "mistake" and "error" are used, there-fore, to reinforce the notion that, inherently, there can be no assurance that the court's notion ofwhat should be upheld mirrors the terms the parties would have reached had they been dealing atarm's length. We can never know just what those terms would have been, but we do know there isthe inevitable risk that the court will "miss" them, sometimes on the high side and sometimes on thelow side. The undeniable existence of this risk is the key to the analysis that follows.

92 A good-faith decision here means one that is consistent with what the fiduciary would havedone had she been disinterested.

93 This categorization scheme is more loyal to the law's notion of what being a fiduciary involvesthan one which is defined in terms of whether the decision was "good" or "bad" or whether it was

Good Faith Decision Opportunistic Decision#1 #2

(Correct Outcome) (Type I Error)#3 #4

(Type II Error) (Correct Outcome)



cases of fiduciary decisionmaking to these two boxes, and would do so ina cost-free manner. Since no such ideal system exists, however, there isthe inevitable possibility that some opportunistic decisions will be upheld(Box #2) or that some good-faith decisions will be set aside (Box #3).Borrowing the terminology of statistics, these two different kinds of mis-takes are respectively referred to as "Type I" and "Type II" errors.94

Seen from this perspective, the fundamental objective of judicial re-view of fiduciary decisionmaking is to develop those rules and proceduresthat minimize the risk of error. Whatever rules and procedures are con-sidered, they necessarily are imperfect, and some residual risk of bothType I and Type II error will remain. Further, there is a tradeoff be-tween the two types of error; subjecting fiduciary decisions to more rigor-ous judicial scrutiny may reduce the risk of Type I error, but it will do soat the expense of enhanced risk of Type II error and vice versa. Thus, atthe heart of any evaluation of judicial review of fiduciary decisionmakingmust be consideration of not only its reduction of the risk of mistake ingeneral, but also the balance it strikes between residual Type I and TypeII risks. The assessment of this balance depends upon the types of coststhat each type of error produces.

. The "Costs" of Errors

A Type I error may be created in one of two ways. First, the legalsystem may not be sensitive enough to detect the existence of opportunis-tic decisionmaking by the fiduciary when a particular decision or patternof conduct is challenged by the principal. Also, using the concept ofType I error more broadly, the principal-for any number of reasons,such as costs or concern for upsetting an otherwise good relationship-may not discover or be willing to challenge the opportunistic behavior.Under either source of error, the result is the same. The principal incursa direct loss of value in the form of suffering a kind of transaction, a setof terms, or a level of costs that he would not have suffered had the

"beneficial" or "detrimental" to the principal's interests. The essence of the obligation is a require-ment that the fiduciary act in a disinterested and prudent manner to further her principal's interests.Inevitably, conduct adhering to this requirement will nonetheless produce some bad or detrimentaldecisions, just as a principal, when making decisions on his own behalf, will select courses of actionthat turn out to be bad or detrimental.

94 In statistics, the term "Type I error" refers to the possibility of rejecting a true hypothesis; theterm "Type II error" refers to the possibility of accepting a false one. See, e.g., R. LARSEN & M.MARX, AN INTRODUCTION TO MATHEMATICAL STATISTICS AND ITS APPLICATIONS 249-50(1981). In the format employed in the text, the "hypothesis" to be tested is that the divergence ofinterest between fiduciary and principal led the fiduciary to act other than in the principal's bestinterests. Upholding the transactions where this hypothesis is in fact true is analogous to the statisti-cian's Type I error; setting the transaction aside where it is false is analogous to Type II error. Otherlegal commentators have employed this framework in different areas. See Miller, An AnalyticalFramework, REGULATION, Jan.-Feb. 1984, at 31, 32; Joskow & Klevorck, A Framework for Analyz-ing Predatory Pricing, 89 YALE L.J. 213, 223 (1979).

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decisionmaker acted in a disinterested manner. This loss to the principalmay or may not be offset by an equivalent gain to the fiduciary.95

It is the existence of the possibility of some Type I error that pro-vides the fiduciary her incentive to engage in opportunism; if she wereassured of getting caught, she would not chance it. The greater the riskof Type I error, the stronger this incentive. And, in turn, it is the princi-pal's perception of this possibility that creates the incentive to take ad-vantage of the various forms of protection described in section II-monitoring, ex ante adjustment, and ex post settling up. As we saw inthat section, this process may cause at least some of the resulting costs ofType I error to be shifted back to the fiduciary. The extent to which thiswill occur depends upon the principal's capacity either to estimate therisk of opportunism in advance, extract appropriate compensation anddiversify against the residual risk, or to determine the existence of oppor-tunism in retrospect and put in place a suitable settling up mechanism.

The costs and consequences of Type II error are the mirror image ofthose for Type I error. Type II error serves in the first instance to shiftvalue from the fiduciary to the principal by permitting the principal toexploit the imperfections of the legal process and recover from the fiduci-ary even though the fiduciary's decisionmaking was not improperly moti-vated. Thus, the principal is permitted to shift to the fiduciary a risk thatthe principal should properly be viewed as having assumed. Alterna-tively, the principal is permitted to recover profits properly due the fidu-ciary or to receive the services he bargained for without paying for them.As this formulation makes clear, the expected cost to the fiduciary forType II error is determined not only by the level of the risk of error butalso by the nature of the legal remedies available to the principal. Thispoint will be illustrated in the next subsection.

Not surprisingly, the existence of Type II error and the resultingcosts to the fiduciary create an incentive for the fiduciary to initiate exante or ex post private ordering arrangements of her own in order to passthe cost of error back to the principal. She may, for example, insist uponhigher fees to offset the risk of Type II error or to cover the expenses ofreducing the risk through bonding-like activities such as third party re-view of the fairness of the transaction.

With respect to either Type I or Type II error, there is the inevitablepossibility that private ordering will not suffice to give one or both of theparties adequate protection against the risk of error they perceive. In

95 In cases of self-dealing, there may be a direct one-for-one offset. For example, where the agentbuys land from herself on behalf of her principal at an above-market price, the principal's loss is theagent's gain. Suppose, however, the agent incurred costs in concealing her identity as the true seller.Or suppose that the land, in addition to being overpriced, was poorly suited to the principal's needs.In these cases the principal's total loss exceeds the agent's net gain. Further, in cases of shirking, petprojects, or protection of tenure, there is no assurance that the benefits the fiduciary derives will bearany correspondence to the loss the principal incurs.



that case, their choice will be either to walk away from the relationshipor simply to bear the residual risk that ex ante or ex post compensationcannot shift. Whether a party decides to walk away from the relation-ship will be determined by the residual, noncompensated risk of error heor she perceives and the availability of substitutes. The more attractivethe substitute opportunities, the more readily the party will walk away inlight of a given level of perceived risk. The Chief Executive Officer of apublic corporation has no choice but to sell her services to the corporateprincipal she controls, even though there is some risk that the resultingprice may be attacked as unfair.96 The trustee, on the other hand, facedwith the prospect of selling a trust asset that he himself desires to buy,may well be led by the possibility of Type II error inherent in a challengeof a sale to himself to instead sell the trust asset to a third party (or forgothe sale) so long as some roughly comparable asset is available to himfrom an independent party. The result may be that both the trustee andthe beneficiary are worse off as a result of the prospect of Type II errorbecause a mutually advantageous opportunity falls by the wayside. Inthis sense the cost of error is borne by both parties.

In summary, then, the effect of legal intervention through the impo-sition and enforcement of standardized fiduciary obligations is to shiftthe focal point of the private ordering process from the principal's at-tempts to deal with the prospect of unchecked opportunism, as was dis-cussed in section II, to both parties' attempts to deal with the inevitableprospect of error produced by that legal process. This implies that thelaw's attention in fashioning rules to balance the competing risks of TypeI and Type II errors should not be on the direct costs of those errors, butonly on those residual costs that cannot be eliminated by the partiesthrough either resort to market substitutes for the conflict-of-interesttransaction or implementation of cost-efficient private ordering. For ex-ample, proposed rule A may create some risk of both Type I and Type IIerrors. In contrast, proposed rule B might effect a reduction in the riskof Type I error but at the expense of a radical increase in the risk of TypeII error. Nonetheless, if the fiduciary is in a better position to obtaincompensation for the risk of Type II error than the principal is in toobtain compensation for the risk of Type I error, rule B might be the"better" rule, despite the greater aggregate amount of error.

96 The Chief Executive Officer is, of course, always free to resign and sell her services to another

employer. But because her experience is specific to her present corporation, her services may nothave the same value elsewhere. (The general problem of unique benefits available only through self-dealing is discussed in subsection VI.C.5. infra). Further, if the Chief Executive Officer resigns andtakes a similar job with another corporation, the same problem remains. In other words, the phe-nomenon of self-dealing as the only realistic alternative inheres in the inescapable fact that somepersons will be in control of the corporate principal that employs them.

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E. Strategic Responses to the Prospect of Error-Some Illustrations

Let us consider the implications of the foregoing discussion from theperspective of the fiduciary's strategic decisionmaking. The previoussubsections have made several observations relevant to this process. Be-cause the effect of Type I error is to allow the fiduciary to engage inopportunism and not be penalized, the possibility of Type I error givesthe fiduciary an incentive to engage in opportunism. The direct effect ofType II error, on the other hand, is to surcharge the fiduciary with therisk of loss, which she may seek to shift back to the principal either exante or ex post. The measure of this risk depends on the nature of thelegal remedies available to the principal, because it is created by the prin-cipal's ability to exploit the possibility of Type II error and obtain legalrelief against the fiduciary even though she has acted in good faith. Thefiduciary's ultimate behavior in the face of this risk will depend upon thealternatives available to her.

A series of numerical examples will prove useful in illustrating theseabstract concepts and will provide raw material for some of the discus-sion that follows. Suppose that the Chief Executive Officer (C.E.O.) of apublicly-held corporation exercises sufficient control over the board ofdirectors to persuade it to set her salary at any amount she chooses be-tween $300,000 and $500,000. Let us assume that the "correct" level ofsalary for the C.E.O. is $400,000. 9 7 In a world of certainty, character-ized by unanimous agreement among all independent decisionmakers onwhat the C.E.O.'s salary should be, the C.E.O.'s choice would be clear.She would agree to a salary of $400,000. Given this assumed unanimityof viewpoint, that amount would be upheld if challenged by shareholderlitigants and any higher amount would be set aside.

Suppose, however, that the C.E.O. appreciates that there is room forconsiderable difference of opinion on what a fair salary would be. Specif-ically, she estimates that there is a 25% chance that a judicial deci-sionmaker would regard $500,000 or more as the fair amount, a 50%chance that it would regard $400,000 as the fair amount, and a 25%chance that it would regard only $300,000 as the fair amount. To tie thisinto the terminology developed so far, she perceives a 25% chance that acourt would uphold an amount higher than the hypothetical arm's-

97 "Correct" here means the amount that an arm's-length decisionmaker, in good faith, wouldpay for the given character and quality of the C.E.O.'s services. It is, of course, unrealistic to suggestthat there necessarily is one single "correct" amount that every arm's-length decisionmaker wouldinvariably decide upon. See supra note 91. As the next sentence in the text makes clear, there will bedifferences of opinion and differences in bargaining ability, with the result that we would expect tosee a range of possible arm's-length bargains in the real world. The problems with using this rangeconcept as the touchstone for evaluating the fiduciary's decisionmaking will be formally addressed insubsection VI.C.5.. For purposes of the illustrations in this subsection and in order to simplify theanalysis, it will be assumed that all arm's-length decisionmakers would agree to the same amount ofcompensation. This simplification will not affect the substance of the discussion.



length amount of $400,000 (analogous to Type I error) and a 25%chance that a court would reject that arm's-length amount as unfairlyhigh (analogous to Type II error). How should the C.E.O. strategicallyrespond?98 If the potential liability she faces is damages measured by thedifference between the amount set by the board and what the court re-gards as the fair amount (in effect, a de novo judicial determination of thefair value), her optimal strategy is to insist upon a salary of $500,000, themaximum amount. It provides her with an expected salary, net of possi-ble liability for damages, of $400,000, the perceived arm's-lengthamount.99 But if she were to settle for that $400,000 amount in the firstinstance, her expected salary would drop $25,000 to $375,000.1°°

As this illustration shows, it behooves the C.E.O. to insist upon a$500,000 salary even though there is only one chance in four that thisamount will be upheld. This is necessarily the case where the applicablelegal remedy involves a de novo judicial determination of the fairamount. The terms set by the fiduciary work as a "cap" on what shemay receive because judicial review of the fiduciary's decision is a one-way process and the court cannot conclude that the fiduciary has treatedherself unfairly and impose liability upon the principal. It is therefore inher interest to select the most attractive terms that she thinks the lawmight uphold.101 In effect, what occurs when the C.E.O. insists upon a$500,000 salary is that her exploitation of the Type I possibility that thisamount will be upheld offsets the Type II possibility that the arm's-length amount of $400,000 will be set aside. The opportunity for thisexploitation provides the ex ante compensation for the prospect of ad-

98 The discussion that follows assumes that the fiduciary is risk neutral and that there are nocosts associated with litigating the propriety of her conduct. Both these assumptions will then bedropped in the analysis contained in subsection IV.G.

99 The expected salary is determined by "expected value" analysis. "Expected value" refers tothe average of the possible outcomes with each outcome weighted by its associated probability.Thus, if the C.E.O. persuades the board to set her salary at $500,000, there is a 25% chance it will beupheld; a 50% chance the court will conclude $400,000 is the fair amount and impose damages of$100,000; and a 25% chance the court will conclude $300,000 is the fair amount and award damagesof $200,000. Thus, the C.E.O.'s expected net salary (after litigation) is $400,000 (le., $500,000 X0.25 + $400,000 X 0.5 + $300,000 X 0.25).

100 By settling for $400,000, the C.E.O. forgoes the $500,000 opportunity, but now there is a 75%chance that the salary will be approved. As a result, her expected net salary drops to $375,000 (ie.,$400,000 X 0.75 + $300,000 X 0.25).

101 It should be pointed out that the discussion in the text reflects an important (and controver-

sial) assumption about the response of the courts in applying a fairness test to review fiduciaryconduct. This is that the probability that a particular level of compensation will be found to be"fair" is independent of the price initially approved. But it may be the case, for example, that acourt would be more willing to accept $400,000 as the fair amount if that is the figure set by theboard than it would be to accept $400,000 as the fair amount if the board had chosen $500,000. Inother words, having concluded that the $500,000 figure is excessive, the court, now suspicious of theboard's independence, may be more willing to impose the lower amount of $300,000. If that is thecase, the conclusions reached above will be altered. This point will be developed further in subsec-tion VI.C5.

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verse error, so that the net expected amount she receives, ex ante, is thearm's-length amount of $400,000.

Next, consider what happens when we expand the available legalremedies to include rescission of the underlying transaction and also cre-ate the prospect of alternative, non-self-dealing opportunities. To facili-tate these elaborations, let us vary the facts of the hypothetical so that itdeals not with the C.E.O.'s salary but with her sale of an invention shedeveloped to the corporation that she controls. For convenience, the dol-lar amounts and probabilities will be the same as those in the previousexample.

Unlike the redetermination remedy of damages, where the transac-tion is upheld, but at a price redetermined by the court, rescission has an"all or nothing" character to it. The price set by the fiduciary is, in ef-fect, an offer to the reviewing court, which the court may either accept(by upholding the transaction) or reject (by setting it aside). The lowerthe price, the higher the probability that the transaction will be upheld.Thus, under our hypothetical facts, the C.E.O. estimates that there is a25% chance that a court would uphold a $500,000 price for the inventionand a 75% chance that it would uphold a $400,000 price.

The C.E.O.'s strategy now will turn on the alternatives available.Suppose that the invention may readily be sold to independent third par-ties for the arm's-length price of $400,000. In this case, the C.E.O.'s beststrategy will be to sell it to the corporation for the high-end price of$500,000. There is one chance in four that the court will uphold it, and ifit doesn't, the C.E.O. can always obtain $400,000 from others. In thissituation, she has nothing to lose. But suppose, on the other hand, that asale to the corporation the C.E.O. controls presents a unique opportunityin the sense that the invention in fact has a greater value to the corpora-tion than to third parties. Specifically, while the arm's-length price to thecorporation is $400,000, third parties would be willing to pay no morethan $300,000. On these assumed facts, it is in the C.E.O.'s interest toexercise some self restraint and accept a $400,000 price from the corpora-tion in order to reduce the risk that the transaction will be set aside andthe mutually advantageous opportunity of selling to the corporationforeclosed. 102

The availability of alternatives is important in the damages case as

102 Under the expected value analysis, see supra note 99, if the C.E.O. sells the invention to her

corporation at $500,000, there is only a 25% chance that the sale will be upheld. Therefore, there isa 75% chance that the transaction will be rescinded and that the fiduciary will be forced to sell theinvention to third parties for $300,000. The expected value to the C.E.O. of a sale at $500,000 thenis $350,000 (i.e., $500,000 X 0.25 + $300,000 X 0.75). In contrast, because there is a 75% chancethat a sale at $400,000 will be upheld and there is only a 25% chance that the fiduciary will have tosell the invention for $300,000, the expected value of a sale at $400,000 is $375,000 ($400,000 X 0.75+ $300,000 X 0.25). The comparison of the sale at $500,000 and the sale at $400,000 here ignoresthe possibility that, if the sale at $500,000 is rescinded, the C.E.O. may be able to negotiate a betterdeal with the corporation at, say, $400,000.



well but produces a different kind of impact. Under a damages remedy,the existence of alternatives will determine whether or not the C.E.O.elects to sell the invention to the corporation but will not affect her pric-ing decision once she decides to do so. As computed above,10 3 so long asthe fiduciary sets the price to the corporation at $500,000, her net ex-pected proceeds after damages have been assessed will be $400,000.Thus, if she has no alternative buyers at the $400,000 amount, her opti-mal strategy, assuming she is risk neutral, 104 is to sell to her corporationat the $500,000 price. Of course, if she has alternative buyers willing topay more than $400,000, she should sell to them. On the other hand, ifrescission is the only available remedy, the C.E.O. should sell to the cor-poration for $500,000 in the first instance, even if she has other buyerswilling to pay more than $400,000 (but less than $500,000) in order totake advantage of the one-in-four possibility that the $500,000 price willbe upheld.

The addition of the rescission remedy introduces further strategicconsiderations for the fiduciary where the subject of the transaction is arisky opportunity whose future value is uncertain at the time of the trans-action. Because the principal may be expected to adopt the transaction ifit turns out well but challenge it if it turns out poorly, the fiduciary'sexposure to loss through Type II error will be determined by the amountof "downside" risk and will not be mitigated by the potential for "up-side" gain, no matter how great. To illustrate this point, suppose that thefiduciary is considering the purchase of two alternative investment op-portunities on the principal's behalf. Both cost $100,000 and the fiduci-ary has a similar conflict of interest (and, therefore, exposure to Type IIerror) as to each. Alternative #1 poses a 50% chance of being worth$120,000 at the end of one year and a 50% chance of being worth$90,000, for an expected value of $105,000. Alternative #2 poses a 50%chance of being worth $140,000 and a 50% chance of being worth$80,000, for an expected value of $110,000. Assuming the principal isrisk neutral, he would favor Alternative #2. But if the prospect of TypeII error attached to the two alternatives is the same, the fiduciary willfavor Alternative # 1 because her loss exposure there, if the transactiongoes sour and is invalidated, is only $10,000 compared with $20,000 forAlternative #2.

F. Modes of Judicial Review

The law employs three modes of judicial review to enforce the fidu-ciary ideal. The first is "per se prohibition." A per se prohibition abso-

103 See supra note 99 and accompanying text.104 See supra note 98. If the C.E.O. were risk averse, she might prefer a sale to a third party at a

price of, say, $390,000 which was immune to modification, over the sale to the corporation for$500,000 which might net her only $300,000 after damages.

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lutely prohibits the fiduciary from doing X.10-5 The second mode, "safeharbors," is the opposite of per se prohibition. Once conduct is found tobe within the safe harbor, it is immune from further judicial scrutiny.The third mode is "ad hoc review." It is the middle category. In ad hocreview, conduct is examined to determine whether it is "intrinsicallyfair," "fair and reasonable," or some similar legal formulation, and theinquiry requires that all the facts and circumstances accompanying thetransaction be taken into account. 10 6

When the legal system defines standards to govern fiduciary con-duct, it is essentially spelling out the boundary between one mode of re-view and another. The traditional notion of "bright-line" legal rulesrepresents a standard bounded on one side by a per se prohibition and onthe other by a safe harbor. Conduct below the standard will be prohib-ited; conduct exceeding it will be permitted. Alternatively, standardsmay be employed to designate the boundary between per se prohibitionsand ad hoc review or between ad hoc review and a safe harbor. Transac-tions falling short of the lower standard may be automatically invali-dated; those exceeding the lower standard but falling short of the higherstandard are subject to fairness review; those exceeding both standardsare automatically upheld. A rule adopted by various state Blue Sky lawadministrators exemplifies all of these possibilities. According to the rule,the annual advisory fees and expenses of a mutual fund may not exceedsome predetermined percentage of the fund's net assets. 107 Some juris-dictions may apply this rule in the traditional "bright-line" way; that is,any amount of fees and expenses above the standard is prohibited, and

105 Per se prohibitions may be relationship-specific, transaction-specific, or terms-specific. One

example of the first type is a rule barring directors from dealing with their corporations. See infranotes 139-40 and accompanying text. An example of the second type is a rule barring directors fromborrowing money from their corporations. See, e.g., ALASKA STAT. § 10.05.213 (1985); D.C. CODEANN. § 29-304(6) (1981); Miss. CODE ANN. § 79-3-89 (1972); NEB. REV. STAT. § 21-2045 (1983);N.D. CENT. CODE § 10-19-46 (1976) (repealed 1985); OKLA. STAT. tit. 18, § 1.175 (1981). Anexample of the third type is a rule barring directors from borrowing money from their corporationsat rates lower than two points above prime. Cf., eg., 12 U.S.C. §§ 375a, 375b (1982); 12 C.F.R. 215(1985) (restrictions on loans by banks to their officers and directors).

106 Over time, the process of submitting a series of similar transactions to ad hoc review maygenerate either per se prohibitions or safe harbors. An illustration of this process of generalization isthe decision in Singer v. Magnavox Co., 380 A.2d 969 (Del. 1977), that a merger for the sole purposeof freezing out minority shareholders violates the requirement of entire fairness. Id. at 978-80. Thisaspect of the Singer decision was later overruled by Weinberger v. UOP, Inc., 457 A.2d 701, 715(Del. 1983) (en banc). Another illustration of the development of per se prohibitions within the adhoc framework is the position of some courts that directors may not justify usurping a corporateopportunity with the argument that the corporation was financially unable to undertake the opportu-nity on its own. See, e.g., W.H. Elliott & Sons v. Gotthardt, 305 F.2d 544 (1st Cir. 1962); IrvingTrust Co. v. Deutsch, 73 F.2d 121 (2d Cir. 1934), cert. denied, 294 U.S. 708 (1935); Annot., 16A.L.R.4th 185 (1982); Brudney & Clark, supra note 73, at 1020-22.

107 See, eg., Central Securities Administrators Council, Statement of Policy on Open-End Invest-ment Companies § C, I BLUE SKY L. REP. (CCH) 5403 (expenses may not exceed 11/2% of first$30 million of net assets and 1% of any additional net assets).



any amount below it is allowed. Other jurisdictions may interpret therule as designating a boundary between a per se prohibition and ad hocreview; that is, any amount of fees and expenses above the standard areprohibited but amounts below it are reviewed on a case-by-base basis.Still other jurisdictions may interpret the rule as creating a boundarybetween ad hoc review and a safe harbor; that is, amounts of fees andexpenses below the standard are not questioned, but amounts exceedingthe standard are reviewed on a case-by-case basis.

G. The Tradeoff between Error and Certainty

Resort to standards as an alternative to pure ad hoc review raisesthe question of increased error. Standards are justified only on the prem-ise that instances of appropriate and inappropriate fiduciary behavior canbe neatly sorted out on the basis of earmarks that both transaction plan-ners and after-the-fact adjudicators can identify with ease and certainty.Thus, a per se prohibition reflects a conclusion that the risk of opportu-nism is all-pervasive across the category of transactions bearing the req-uisite earmarks. In other words, the costs of any Type II errors thatmight result from striking down all transactions within the category aremore than offset by the gains from completely eliminating the risks ofType I error. Safe harbors reflect just the opposite conclusion. Ofcourse, the universe of possible fiduciary decisions is vast and the under-lying facts complex. Furthermore, the instances of proper decisionmak-ing typically are not so homogeneous that their essence may easily becaptured through a single bright-line test. Ad hoc review may thereforebe seen as the only viable means of holding both Type I and Type IIerror to an acceptable level.

But minimizing the level of Type I and Type II errors is only onepiece of the picture, The unique attribute of bright-line standards is thatthey permit the parties involved to predict accurately how the courts willrespond if the fiduciary's decision is challenged. The ensuing certaintyreduces both the risks and the transactions costs associated with litiga-tion. This certainty creates value in and of itself which may serve tooffset value lost through increased error. To illustrate, let us return tothe example of C.E.O. compensation employed above in subsection E.Recall that the arm's-length value of the C.E.O.'s compensation was$400,000 and the C.E.O. estimated that, under ad hoc review, there wasa 25% chance a court would find $500,000 to be the fair amount, a 50%chance for $400,000, and a 25% chance for $300,000.

Contrast this with the operation of a bright-line standard. Suppose,for example, a corporate safe harbor law permits any annual compensa-tion for the Chief Executive Officer of a public corporation less than orequal to the sum of $100,000 plus 0.01% of the corporation's annualprofit. Similarly, any compensation in excess of that amount is prohib-ited per se. The certainty aspect of the rule is beyond question; anyone

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familiar with it can determine on a moment's reflection exactly how thelegal system would respond to a given salary arrangement. But somecases of Type I error will occur as lackluster C.E.O.'s are permittedamounts well in excess of their true worth. And there will be some casesof Type II error as talented C.E.O.'s cannot be paid their true worth.

Sooner or later critics will emerge to attack the rule as arbitrary andunfair. They will argue that the rule is a senseless hurdle to unprofitablecorporations that need to attract higher quality management in order toturn themselves around; that the rule is a boondoggle for the heads of thecorporate giants; and that each C.E.O. should be judged on his or herown merit. Phrased in the vocabulary of this Article, they would saythat ad hoc review is preferable to this particular bright-line standard.The argument here is that the performance of individual C.E.O.'s variestoo widely to permit the law to create a hard-and-fast standard applica-ble to all. No such standard-even one which varies with the level ofcorporate profits--can sufficiently approximate the result of arm's-lengthbargaining. Thus, the argument concludes, ad hoc review is necessary.

But even though resort to the standard-based mode of review may,in any particular case, result in overcompensation due to Type I error orundercompensation due to Type II error, does it follow that the share-holders or the C.E.O. are necessarily better off under ad hoc review? Re-call that ad hoc review created the incentive for our C.E.O. to press forthe excessive sum of $500,000 in order to assure herself an expected netcompensation of $400,000.1081 She might be more than content to receivean assured sum of $400,000. But exposure to the ad hoc review processforecloses her from receiving that assurance and thereby forces her topress for the higher figure.

From the shareholders' perspective this creates a strong incentive tochallenge the amount of compensation. Assuming the shareholdersmake the same estimate as the C.E.O. concerning the court's likely re-sponse to a $500,000 salary, they stand to gain from a court challenge solong as their legal expenses do not exceed $100,000.109 Even if theC.E.O. correctly anticipates this court challenge, she still will insist onthe $500,000 amount so long as the legal costs to her of defending this

108 See supra notes 99-102 and accompanying text.109 One hundred thousand dollars is the expected recovery from the lawsuit. This amount reflects

the fact that there is a 25% probability that a court would uphold the $500,000 figure as fair, so thatthere would be no recovery; a 50% probability that it would find $400,000 to be the fair amount andaward damages of $100,000; and a 25% probability that it would find $300,000 to be the fair amountand award damages of $200,000. Thus, $100,000 is the expected value of the shareholders' recovery(e, $0 x 0.25 + $100,000 X 0.50 + $200,000 X 0.25). Of course, any recovery from reducingthe C.E.O.'s salary will go to the corporation, so the shareholders bringing suit stand to gain onlytheir pro rata share. But, even under real-world derivative suit procedure, there is likely to be someform of litigation cost-benefit calculation along the lines described in the text. Specifically, the plain-tiff's counsel's award of attorney's fees will typically be influenced by the amount of the recovery tothe corporation.



figure, over and above the costs of defending a salary of $400,000, do notexceed $25,000.110

Assume that the anticipated expenses of each side in litigating theC.E.O.'s compensation are $10,000. Thus, the net expected value of theC.E.O.'s compensation falls to $390,000 and the net expected gain to theshareholders from challenging it falls to $90,000. In addition, the litiga-tion typically will result in indirect costs to the C.E.O. and to the corpo-ration in the forms of disruption of operations, the discomfort of beingsubjected to deposition and other discovery, and so forth. Ignoring theselatter costs for the sake of simplicity, we can see that there remains a$20,000 range over which both parties would benefit (through the avoid-ance of litigation) from the substitution of a bright-line standard for theuncertain process of ad hoc review. If the C.E.O. can be assured that hersalary will be immune from challenge, she will prefer any amount over$390,000 to the litigation-vulnerable $500,000 figure."' The sharehold-ers should abandon the threat of litigation as long as the C.E.O. consentsto accept any amount below $410,000.112 A major problem here is thatno vehicle really exists to represent the unified interests of the sharehold-ers.113 As a result, under ad hoc review there is no way to provide theC.E.O. with effective immunity against challenge and therefore, she maybe better off under a bright-line standard because of the avoidance oflitigation.

In addition to eliminating litigation expenses, a bright-line standardand the certainty it provides reduce the C.E.O.'s exposure to risk. As-suming she is risk-averse with respect to her compensation arrangement(as most people would be regarding their predominant source of income)she will not simply be indifferent between the litigation-risky $500,000figure and a risk-free amount equal to its net expected value (here$390,000). If the C.E.O. desires to plan her expenditures and lifestyle for

110 This amount represents the difference between the expected value to the C.E.O. of a $500,000

salary (L e., $400,000) and the expected value of a $400,000 salary (Le-, $375,000). See supra notes99-102 and accompanying text.

111 Recall how the $390,000 figure was determined. Twenty-five percent of the time the court

will accept the $500,000 salary; 50% of the time the court will reject that salary and set a new salaryof $400,000; and 25% of the time the court will reject the $500,000 salary and set a new salary of$300,000. Furthermore, the litigation expense is $10,000 to the fiduciary. Thus the "expected value"of a $500,000 salary is $390,00 ($500,000 X 0.25 + $400,000 X 0.50 + $300,000 X 0.25 -$10,000).

112 The expected salary that the company must pay the C.E.O. after challenge of the $500,000salary is $400,000. See supra note 111. Thus the company and the shareholders save $100,000 onwhat they must pay the C.E.O. However, the litigation costs $10,000 so they only reap $90,000 inbenefits. Viewed differently, salary plus litigation expenses cost the company a total of $410,000.Thus, if the C.E.O. were willing to reduce her salary to this amount or less in exchange for anassurance that it would not be challenged, the shareholders would benefit.

113 The derivative suit invites conflict between the interests of the plaintiff's counsel and those ofthe shareholders generally. See, eg., Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541, 548-50(1949).

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the coming year, she may be willing to accept a "certainty equivalent"much lower than the net expected value of the risky arrangement, forexample, $350,000.'14 This widens even further the range of potentialbargains mutually acceptable to the C.E.O. and the shareholders.

The foregoing example illustrates that even though the ad hoe modeof review may better reduce the risk of Type I and Type II errors withrespect to a particular class of transactions, the certainty inherent in abright-line standard provides competing benefits. This is admittedly nota novel observation, but it serves to reinforce the idea that error reduc-tion is not per se good and provides a building block for the analysis thatfollows. The assumption in the illustration was that the arm's-lengthvalue of the C.E.O.'s services was $400,000 per year. Given this, the adhoe review process in the example may be regarded as quite efficient sinceit reaches this result 50% of the time. Still, the results of the exampledemonstrate that a bright-line standard, even one that misses the arm's-length mark by a considerable margin, may represent an improvementfrom the standpoint of both parties. Specifically, in the above example,any standard that sets the C.E.O.'s compensation between the $350,000and $410,000 will produce this result. And, it will do so even though itembraces a greater potential for at least some Type I and Type II errorsthan does ad hoe review.

Another implication of the example is that the value of the certaintyprovided by a bright-line standard varies depending on the characteris-tics of the party. Two paragraphs above, we speculated that the risk-averse C.E.O. might be willing to accept a $40,000 reduction in net ex-pected salary (from $390,000 to $350,000) in exchange for certainty. Forthe shareholders, however, certainty has less value, since presumablythey are in a position to diversify away the nonsystematic risk inherent inthe ad hoc review process by allocating their wealth among many invest-ments.1 15 Thus, they will be willing to concede less in order to tie downthe C.E.O.'s salary. On a more general level, this means that the degreeto which the uncertain ad hoc review process serves to restrict the fiduci-ary's conduct depends upon her capacity to diversify away the inherent(but nonsystematic) risk ad hoc review entails.

Consider an example. Suppose that a corporate executive, while onvacation, learns of an opportunity remotely related to the business of hisemployer. Desiring to leave his employment to pursue the opportunityon a full time basis, he consults an attorney who advises him that there issome small risk that a court might find that the opportunity belongs tothe corporation. In the case of the individual entrepreneur this is quitethreatening, since the result of an adverse determination some yearshence would be to deprive him of what, by then, has become his sole

114 See supra note 50.115 Recall the discussion of nonsystematic risk and diversification in connection with the widow

and investment advisor hypothetical. See supra notes 54-57 and accompanying text.



livelihood. In light of that, he may be led to offer his corporation a con-siderable participation in the opportunity in order to obtain its consent tohis undertaking the opportunity on his own. Suppose, in contrast, thatthe fiduciary-entrepreneur was a large corporation and the opportunityat issue arguably belonged to a joint venture between it and another cor-poration. Given the same risk of adverse adjudication as in the case ofthe individual, the corporation might nonetheless be far more willing totake its chances in defending its exclusive rights to the opportunity, inas-much as the amount at stake might represent a much smaller percentageof its annual revenues, say, less than 10%. In other words, because thecorporate joint venturer is in a much more diversified posture vis-a-visthe opportunity at issue, it is not willing to pay as much to attaincertainty.

Two final points should be made about the advantages and disad-vantages of resorting to bright-line standards in lieu of ad hoc review.First, in addition to the value of certainty per se, any evaluation ofbright-line standards must take into account the capacity of the parties todeal with the residual risk of error ex ante or ex post. A safe harbor maycreate a greater risk of Type I error with respect to a particular kind oftransaction than would ad hoc review, but this is not troublesome so longas the principal can identify the risk and obtain compensation. It may infact be easier for the principal to evaluate and adjust for the costs result-ing from the fiduciary's full, unbridled opportunism within the safe har-bor than for the principal to evaluate and adjust for those costs thatmight be left after the application of an uncertain ad hoc review process.In other words, it may be easier in some cases to anticipate the conductof the fiduciary than that of the courts. We will see examples of this insubsection VI.C. 4.

The second point is that in appreciating the disadvantages of bright-line standards, one must consider the notions of "neutrality," "bias," and"adverse selection." Suppose, for example, that the applicable standardpermits trustees to buy real property from and sell real property to theirtrusts so long as the price is equal to the property's assessed value for taxpurposes. If all the land in the region is systematically overassessed, re-sort to such a standard is biased in favor of the seller. If it is systemati-cally underassessed, the opposite is true. Suppose, however, that thisstandard is neutral in the sense that although the market value of theland in the region frequently differs from its assessed value, the amountof overassessed land and the amount of underassessed land are roughlycomparable, and the degree of overassessment is roughly comparable tothe degree of underassessment.

Consider how this kind of neutrality affects the decisions of thetrustee. If the trustee was compelled to select land acquisitions for thetrust at random, paying the assessed value to itself in those instanceswhere it happened to be the owner of the land selected, resort to this

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standard would impose no systematic hardship on either party. Theodds that the land would be overassessed are equal to the odds that itwould be underassessed. Diversification principles suggest that over asufficient number of transactions the probability of one party or the othersignificantly benefitting from the error inherent in the standard is slight.But if the trustee is permitted to buy and sell land as it pleases, theprobability that it will benefit from the error is no longer slight. Theopportunistic trustee will sell its overassessed land to the trust and sell itsunderassessed land to independent third parties at market prices. Thus,even though the standard is neutral in the sense that, on average, it re-flects the arm's-length price, it is nonetheless subject to exploitation by afiduciary which has the discretion to choose between dealing with theprincipal or dealing with third parties. Where such fiduciary discretionis present, therefore, resort to a standard, even though neutral, presents amuch greater risk of Type I error than Type 11.116

V. JUDICIAL REVIEW IN THE CASE OF CONCENTRATED-

CONSTITUENCY PRINCIPALS: THE LAW OF

AGENCY AND TRUSTS

A. Concentrated-Constituency and Diffused-Constituency Principals

The balance of the Article will attempt to consider, from the stand-point of the factors discussed in the preceding sections, the rules gov-erning judicial review of fiduciary decisionmaking in a variety of subjectareas. While the law has developed separately within the applicable sub-ject areas, the analysis in this and the following section divides the lawalong functional lines, based on the characteristics of the principal. Theargument here is that differences among subject areas can be explainedlargely by considering the nature of the underlying principal. One bodyof rules applies where the principal is typically a single person or closelyknit group of persons, referred to here as a "concentrated-constituencyprincipal." This is the typical situation addressed by the law of agencyand trusts. The other body of rules applies where the principal is, in fact,a group of diverse principals. The shareholders of a public corporationare an example of such a group of principals. These types of principalsare referred to as "diffused-constituency principals."

The functional significance of this distinction is threefold. First, inthe case where the principal is a single person or concentrated group, the

116 The problem is comparable to the "adverse selection" phenomenon discussed by economists

where, for example, an insurance company sets premium rates based on the average risk posed bypersons within a class, but individual class members are free to decide whether or not to buy theinsurance in light of their unique knowledge of how their personal risk compares to the group aver-age. We would expect only the high-risk types to take advantage of the insurance and the low-risktypes to pass it up. See Hirschleifer & Riley, supra note 60, at 1389-90; Akerlof, The Market for"Lemons'" Quality Uncertainty and the Market Mechanism, 84 Q.J. ECON. 488 (1970).



transactions costs of reaching ad hoe accommodations with the fiduciaryare lower. Thus, legal rules can be shaped with the confidence that theparties may always contract around them to suit their particularneeds.

17

Second, the concentrated-constituency principal, almost by defini-tion, exhibits a closer unity of interest between the individual constitu-ents and the principal as a whole. The sole beneficiary of a trust will notchallenge a transaction that he believes confers a net benefit on the trust.The small shareholder of a public corporation, on the other hand, willoften be motivated by concerns other than the corporation's best inter-ests. Thus, rules applicable to the diffused-constituency principal mustbe developed with the recognition that the decision to challenge a trans-action will be determined more by its litigation value under those rulesthan its net effect upon the welfare of the principal. This combines withthe first attribute to produce the result we observed in the C.E.O. com-pensation example in subsection IV.G.: under ad hoe review, there is norealistic way for the C.E.O. and the shareholders to bargain for a risk-free amount of compensation.' 18

The third attribute of the distinction is the relative capacity of theparties to diversify. We saw in section II the importance of diversifica-tion to the ex ante adjustment process. In section IV, the introduction ofa legally enforceable fiduciary standard shifted our attention from theprincipal's attempts to deal with the risk of opportunism to both parties'attempts to deal with the risk of error and their capacities to diversifywith respect to this risk. In the concentrated-constituency principal situ-ation, the fact that the underlying principals are few in number indicatesthat their individual stakes are sufficiently large that it is economicallyworthwhile to make them the subject of a separate fiduciary relationship.Large investors might hire an investment manager; small investors relyon mutual funds. And once this separate relationship is created, it willtypically be cost-efficient for the principal to entrust all his related busi-ness to it. By the same token, since each relationship involves the busi-ness of only a few individuals, the fiduciary will likely find it necessary toenter into several similar relationships. Thus, as a very rough generaliza-tion, the concentrated-constituency principal will frequently be in apoorer position to diversify than the fiduciary. In the diffused-constitu-ency principal case, on the other hand, where there are numerous princi-pals with small stakes, the principals can more easily diversify. And thecombination of their small stakes makes it possible to hire fiduciarieswhose entire efforts are devoted to the particular entity in which the prin-cipals have invested. Thus, in the diffused-constituency case, the balance

117 See, eg., Brudney & Clark, supra note 73, at 1003-04 (contrasting close corporations and

public corporations in terms of feasibility of obtaining consent of all participants to limitations onthe fiduciary's involvement).


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shifts and the underlying principals will ordinarily be in a better positionto diversify against the risk of error.

B. The Law's Basic Approach

In the concentrated-constituency principal area, the law's responseto the problem of reviewing fiduciary decisionmaking has traditionallybeen one of per se prohibition. Absent the informed consent of the prin-cipal, the fiduciary is strictly foreclosed from engaging in activities if shehas a direct interest in conflict with the principal's. Thus, for example, ifthe trustee sells trust property to herself, the transaction is automaticallyvoidable at the election of the beneficiary. 119 The trustee cannot defendthe transaction on the grounds that the terms were fair or that the trustbenefitted. 120 Similar rules apply to the common law agent.1 2 1 By adopt-ing a mechanical rule triggered by the existence of objective facts thatsuggest a motive for biased decisionmaking, this mode of judicial reviewavoids a detailed inquiry into the quality of the fiduciary's conduct. Ifthose objective facts are present, and if the principal wants out of thedeal, the law conclusively presumes that the fiduciary engaged inopportunism.

Why has the law prohibited, per se, fiduciary conflict-of-interesttransactions in the trust and agency areas rather than subjecting suchtransactions to ad hoe review or to transaction-specific or terms-specificstandards? 122 Any such approach necessarily reflects an emphasis oneliminating the risk of Type I error at the cost of other objectives. Insome cases, the adoption of per se prohibitions reflects a conclusion thatthere is little possibility that a disinterested decisionmaker would havereached the result in question and, therefore, the risk that good faithdecisions will be wrongfully invalidated is minimal. An illustration ofsuch a conclusion is the rule of corporate law that a corporation may notindemnify a director for expenses incurred in a derivative suit if the di-rector is - adjudged liable to the corporation. 123 But in the trust andagency areas, the doctrine applies across-the-board, irrespective of the

119 RESTATEMENT (SECOND) OF TRUSTS § 170 comment b (1957); G. BOGERT & G. BOGERT,

HANDBOOK OF THE LAW OF TRUSTS § 95, at 345, 347 (5th ed. 1973); 2 A. SCOTT, THE LAW OFTRUSTS §§ 170.1, 170.2 (3d ed. 1967).

120 RESTATEMENT (SECOND) OF TRUSTS § 170 comments b, h (1957); G. BOGERT & G. Bo-GERT, supra note 119, § 95, at 345; 2 A. ScoTT, supra note 119, §§ 170.1, 170.12.

121 Wendt v. Fischer, 243 N.Y. 439, 154 N.E. 303 (1926); RESTATEMENT (SECOND) OF AGENCY§ 389 comment c (1957); F. MECHEM, OUTLINES OF THE LAW OF AGENCY §§ 501, 504, 507 (4thed. 1952); W. SEAVEY, HANDBOOK OF THE LAW OF AGENCY § 149, at 245 (1964).

122 Per se prohibitions can be relationship-specific, as is the case here where the trustee is com-

pletely prohibited from selling the trust property to herself, transaction-specific, or terms-specific.See supra note 105.

123 E.g., MODEL BUSINESS CORP. ACT § 8.51(d)(1) (1984); see J. BISHOP, THE LAW OF CORPO-

RATE OFFICERS & DIRECTORS-INDEMNIFICATION & INSURANCE 5.03 [1], at 5-7 (1981). This isa transaction-specific per se prohibition. See supra note 122.



subject of the transaction. No one can plausibly argue that all transac-tions between trustee and trust or agent and principal are improper anddetrimental to the interests of the trust beneficiary or the principal. Cer-tainly, sometimes fiduciaries will find it desirable to deal with their prin-cipals on fair terms.

An examination of the rationales tendered by courts and commenta-tors to justify the blanket per se approach reveals two interdependentlines of reasoning. The first displays a prophylactic orientation. Recog-nizing human frailty and the tendency to favor one's own self interestwhere permitted, the per se approach acts to prevent fraud by preempt-ing the opportunity to engage in it. It seeks to promote the trustee's goodfaith by removing temptation. 124 The second focuses on the realities ofthe litigation process. Where the fiduciary does act to further her owninterests at the expense of the principal's, the principal may be unable toget at the underlying facts needed to prove unfairness. The principal'strust and dependence on the fiduciary as a result of the fiduciary relation-ship is likely to mean that the fiduciary is in a superior position to coverher tracks. Accordingly, and in recognition of the legal system'sproblems in breaking through to the fraud where it exists, the principal isgiven the benefit of a conclusive presumption. 125

According to these rationales, because courts are inherently incapa-ble of divining the true motivation of the fiduciary, the only sure cure forfiduciary opportunism is to ban situations that might induce it. Conced-ing that there nonetheless may be occasions within the sweep of the banwhere the fiduciary is in fact acting with good faith means conceding thata certain amount of Type II error is going to occur because of the ban.In other words, opting for an across-the-board per se prohibition permitssubstantial Type II error in order to foreclose any possibility of Type Ierror. This raises two questions which will be considered in the balanceof this section. First, what does the law's selection of this all-out ap-proach to Type I error in the concentrated-constituency principal cases

124 See Michoud v. Girod, 45 U.S. (4 How.) 503, 555 (1846); Smith v. Pacific Vinegar & PickleWorks, 145 Cal. 352, 365, 78 P. 550, 554 (1904); Thorp v. McCullum, 6 I1. (1 Gilm.) 614, 626-27(1844); In re Ryan's Will, 291 N.Y. 376, 405-07, 52 N.E.2d 909, 922-23 (1943); Munson v. Syracuse,G. & C. Ry. Co., 103 N.Y. 58, 73-75, 8 N.E. 355, 358-59 (1886); RESTATEMENT (SECOND) OF

AGENCY § 389 comment c (1957); G. BOGERT & G. BOGERT, supra note 119, § 95, at 344, 346; F.MECHEM, supra note 121, § 501; 2 A. ScoTr, supra note 119, § 170.2, at 1306; Frankel, supra note6, at 824; Hallgring, The Uniform Trustees'Powers Act and the Basic Principle of Fiduciary Responsi-bility, 41 WASH. L. REv. 801, 803-04, 808-10 (1966).

125 See Thorp v. McCullum, 6 Ill. (1 Gilm.) 614, 626-27 (1844); Stewart v. Lehigh Valley R.R.,38 N.J.L. 505, 522-23 (1875); In re Bond & Mortgage Guaran. Co., 303 N.Y. 423, 431-32, 103N.E.2d 721, 726 (1952); Munson v. Syracuse, G. & C. Ry. Co., 103 N.Y. 58, 73-75, 8 N.E. 355, 358(1886); Piatt v. Longworth's Devisees, 27 Ohio St. 159, 195-96 (1875); J. SHEPHERD, THE LAW OFFIDUCIARIES 128-29, 143, 158-59 (1981); Hallgring, supra note 124, at 810-11; Hoover, Basic Princi-ples Underlying Duty of Loyalty, 5 CLEV.-MAR. L. REV. 7, 12-14 (1956) (citing various authorities);Cf, Brudney & Clark, supra note 73, at 1001-02 & n.9 (discussing the difference between the "cate-gorical" and "selective" approaches to corporate opportunities).

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say for the efficacy of the private ordering protection available to theprincipal as discussed in section II? And second, why has the law chosento weight the balance in these cases so heavily in favor of eliminatingType I error rather than Type II error?

C. Private Ordering Alternatives

First, let us consider the private ordering alternatives of monitoringand bonding, ex ante compensation, and ex post settling up as discussedin section II. The preemptive nature of the law's response to fiduciaryopportunism in the trust and agency areas suggests that the law has littlefaith in a principal's capacity to fend for himself and little faith in theability of market forces to check the fiduciary. We can speculate on thereasons for this with the aid of some rough generalizations about thecharacteristics of the trust and agency landscape at the time the equitycourts were beginning to develop the per se approach. 126 In this far lessdeveloped commercial world, the cases typically involved individuals onboth sides and, at least in the case of agency, one-shot relationships. Insuch a world, not much could be expected from private monitoring as aregime of protection. The principal's lack of sophistication probablymeant that the ways and benefits of monitoring went unappreciated.And, at least in the common law agency context, the episodic nature ofthe underlying transactions made it cost-inefficient for the principal toput any standardized monitoring scheme in place, even if he anticipatedits value.

Added to this was the fact that reputation, as a mechanism for pe-nalizing the fiduciary's opportunism ex post, was not significant becausethe principal was less likely to be a professional and information was notreadily exchanged. This same lack of sophistication and unavailability ofinformation undercut the principal's attempts to make valid ex ante esti-mates of the risk of opportunism. Finally, and this applies with moreforce in the trust case but extends to the agency case as well, the princi-pal was less likely to be in a diversified position with respect to this risk.

Consistent with the above views, we might expect that changes, overtime, in the characteristics of trust and agency relationships that mightserve to make private ordering a more viable alternative would trigger areexamination of the strictness of the law's approach. To some extentthis has happened. Consider, for example, the emergence of the corpo-rate trustee. Various kinds of transactions that might technically repre-sent self-dealing, such as loans by the trustee to the trust 127 and transfers

126 Scholars trace the doctrine to the eighteenth century, and it appears to have been firmly estab-

lished by the beginning of the nineteenth. See J. SHEPHERD, supra note 125, at 19; Hallgring, supranote 124, at 807 n.38.

127 See 12 C.F.R. § 9.12(0 (1985); UNIFORM TRUSTEES' POWERS ACT § 3(c)(18) (1964); 2 A.Scorr, supra note 119, § 170.20, at 1364.



of property between trusts managed by the same trustee,1 28 are now per-mitted subject to ad hoe review. This trend may be explained in part bythe greater availability of performance information concerning the insti-tutional trustee, which facilitates ex ante evaluation, along with the im-portance of reputation, which serves as an ex post penalty foropportunism. By and large, however, in the concentrated-constituencyprincipal cases, the law has not entrusted much to private ordering.

The obstacles to private ordering discussed above lead to the per seapproach, which provides the principal with insulation against the moreblatant forms of opportunism and requires little investment of time oreffort on the principal's part. The principal is assured a remedy simply ifhe becomes dissatisfied with the results of the fiduciary's decision and canidentify the fiduciary's conflict of interest. This makes the fiduciary'sgood faith irrelevant. As a result, the court does not have to assess thefiduciary's true motivation, an assessment which could lead to Type Ierror. The fiduciary of course may seek to conceal her interest, for in-stance, by engaging in the transaction through a straw man. This wouldincrease the principal's monitoring costs. But the principal's absoluteright to rescind if he discovers the conflict, 129 coupled with the fact thatthe fiduciary forfeits her compensation even if the principal is satisfiedwith the transaction, 130 makes this a costly risk to the fiduciary. Takentogether, these remedies go beyond compensating the principal and ex-

128 See 12 C.F.R. § 9.12(d) (1985); UNIFORM TRUSTEES' POWERS ACT § 3(c)(4) (1964); RE-

STATEMENT (SECOND) OF TRUSTS § 170 comment r; 2 A. SCOTT, supra note 119, § 170.16, at 1349-50.

Examples of other such transactions include the deposit of the trust's funds with the trustee, seeUNIFORM TRUSTEES' POWERS ACT § 3(c)(6) (1964); RESTATEMENT (SECOND) OF TRUSTS § 170comment m (1975); G. BOGERT & G. BOGERT, supra note 119, § 95, at 348; 2 A. ScoTr, supra note119, § 170.18, at 1356-59; but cf. 12 U.S.C. § 92a(d) (1982), 12 C.F.R. § 9.10(b) (1985) (requiringnational banks to set aside marketable securities as collateral for such deposits), and the trust'sretention of shares of the trustee, see UNIFORM TRUSTEES' POWERS ACT § 3(c)(1) (1964); RESTATE-MENT (SECOND) OF TRUSTS § 170 comment n (1957); 2 A. ScoTr, supra note 119, § 170.15, at 1341-45; see also 12 C.F.R. § 9.12(c) (1985) (permiting national banks to exercise any purchase or conver-sion rights accompanying such retained shares). But see Hallgring, supra note 124, at 813-16 (criti-cizing liberalization of the rule). Earlier court decisions had prohibited the corporate trustee fromretaining its own shares unless expressly authorized by the terms of the instrument creating the trust.SeeIn re Durston's Will, 297 N.Y. 64,71, 74 N.E.2d 310, 312 (1947); In re Trusteeship of Stone, 138Ohio St. 293, 303, 34 N.E.2d 755, 760 (1941). A final example is the investment of trust assets inmortgage loans made by the trustee. See G. BOGERT & G. BOGERT, supra note 119, § 105, at 383-84;2 A. SCOTT, supra note 119, § 170.14, at 1337; 3 A. SCOTT, supra note 119, § 227.9, at 1825-29.

129 This remedy has the effect of shifting the downside risk to the fiduciary while allowing theprincipal to retain the upside benefits. See supra, final paragraph of section IV.E.

130 Under common law theories of agency, even if the principal retains the fruits of the agent's

performance and irrespective of whether the principal was harmed by the conflict of interest, theagent's conflict of interest negates her right to compensation. See Wendt v. Fischer, 243 N.Y. 439,444, 154 N.E. 303, 305 (1926); Mersky v. Multiple Listing Bureau of Olympia, Inc., 73 Wash. 2d225, 437 P.2d 897 (1968); Bockemuhl v. Jordan, 270 Wis. 14, 70 N.W.2d 26 (1955); Andrews v.Ramsay & Co., [1903] 1 K.B. 635; RESTATEMENT (SECOND) OF AGENCY §§ 399(k), at 469. Simi-larly, if a trustee breaches her duty of loyalty, she may, at the court's discretion, be subject to re-

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hibit a penal character that serves to assure that the fiduciary stands tolose more than she might gain through her opportunism. They thereforeoperate as a strong counterweight to the prospect that the fiduciary'sconflict of interest may go undetected.

D. Dealing with the Prospect of Type II Error

What about the substantial risk of Type II error that is inevitablycreated by any rule that prohibits self-dealing across the board? Apply-ing the general theme of this Article, we would anticipate that the law'swillingness to accept such a risk in the interests of eliminating Type Ierror may be attributed to the fact that Type II error either (i) is for somereason less costly in the case of concentrated-constituency principals or(ii) may be effectively dealt with through private ordering. To evaluatethis proposition, let us consider the costs of Type II error and who bearsthem. Recall that in subsection IV.D. we identified two kinds of costsassociated with Type II error. The first is the value transfer from fiduci-ary to principal that results from the fiduciary's incurring liability forwhat was in fact a good-faith decision. The second is the opportunity lossto both parties that occurs when the fiduciary is chilled by the prospectof Type II error into forgoing a mutually beneficial transaction.

In assessing what kinds of costs will occur in practice, the certaintyaspect of the across-the-board, per se approach becomes critical.Whatever the drawbacks of this approach in terms of error, it does havethe beauty of predictability:13

1 the fiduciary is assured that if the princi-pal is dissatisfied with the outcome of a prohibited transaction, the trans-action will be set aside and, in any event, the fiduciary will forfeit hercommission. Given her resulting no-win-high-loss position, the well-counselled fiduciary will almost certainly conclude that the game ishardly worth the candle. In subsection IV.E., we saw that this decisionto forgo transacting with the principal will generally depend upon whatalternatives are available to the fiduciary. But the penal dimensions ofthe per se approach are sufficiently strict and the outcome sufficientlycertain that the fiduciary will ordinarily be better off to avoid the transac-tion and do nothing, even if she has no alternative transaction available.

As a result, the costs of the per se approach's propensity for Type IIerror are for the most part incurred in the form of lost opportunities.This propensity is not troubling as long as the fiduciary and principal canrealize the benefits of the opportunity by dealing with other parties.Thus, for example, where a stock broker filled a customer's order fromits own inventory instead of buying the shares on the market, and failed

moval and forfeiture of compensation. See G. BOGERT & G. BOGERT, supra note 119, § 95, at 350; 2A. ScoTT, supra note 119, § 107, at 842-44; 3 A. Scorr, supra note 119, § 243, at 2138-39.

131 This is an example of the general tradeoff between error and certainty discussed in subsection

IV.G.



to disclose that fact to the customer, the common law routinely permit-ted the customer to set the sale aside even though the price paid was fairat the time.132 The ready availability of independent market alternativesmakes it unnecessary to tolerate even the slight risk of Type I error thatmight result from permitting the broker to self-deal.

The real Type II problem created by the per se approach arises inconnection with unique opportunities, mutually advantageous to fiduci-ary and principal, in which the fiduciary has a conflicting interest. Thestrict per se disqualification rule denies the principal these opportunities.Such opportunities provide an inherent dilemma from the standpoint ofdeveloping efficient standards to govern fiduciary decisionmaking. Whilethese unique opportunities pose the greatest cost to the principal in termsof opportunities lost because of the fiduciary's fear of Type II errors, theyalso present the greatest risk of Type I error if the fiduciary does try todeal, because no outside market exists to test the fairness of the terms setby the fiduciary. To some extent, the law of trusts, with its emphasis onprudent asset conservation, was willing to write off such lost opportuni-ties. Indeed, concerns for liquidity of the trust estate would favor shyingaway from such opportunities in favor of those for which there is anactive market. Common law agency must, however, be more en-trepreneurial in its operation.

The solution reached by the law of trusts and agency is to permit thefiduciary to avoid per se scrutiny by, in effect, stepping outside of herfiduciary role. By fully disclosing her interest in the transaction, she be-comes free to deal with the principal 133 because the principal's independ-ent judgment is presumably now triggered as a safeguard against thefiduciary's opportunism. Such disclosure does not, however, free the fi-duciary to return to the status of a full arm's-length adversary. Twosignificant limitations on the fiduciary's capacity to deal remain. First,the disclosure to the principal must embrace not only the facts of thefiduciary's conflict, but also any information the fiduciary possesses rela-tive to the wisdom of the deal. 134 Second, the transaction is subject to ad

132 See, ag., Hall v. Paine, 224 Mass. 62, 73-74, 112 N.E. 153, 158-59 (1916); Haines v. Biddle,

325 Pa. 441, 443, 188 A. 843, 845 (1937). Today, the federal securities laws require a broker todisclose whether it is acting as principal for its own account and, if so, the amount of the mark-up ormark-down it is charging. See Securities Exchange Act Rule 10b-10(a)(1),(8), 17 C.F.R. § 240.10b-10(a)(1), (8) (1985).

133 See G. BOGERT & G. BOGERT, supra note 119, § 95, at 350; F. MECHEM, supra note 121,§ 504, at 348; 3 A. ScoTr, supra note 119, § 216, at 1733; W. SEAVEY, supra note 121, § 150, at 246-47; RESTATEMENT (SECOND) OF AGENCY § 390 (1957); RESTATEMENT (SECOND) OF TRUSTS § 216comment b (1957).

134 See G. BOGERT & G. BOGERT, supra note 119, § 96, at 352-53; 3 A. SCOTT, supra note 119,§ 216.3, at 1745; W. SEAVEY, supra note 121, § 150, at 246; J. SHEPHERD, supra note 125, at 202-04;RESTATEMENT (SECOND) OF AGENCY § 390, comments a, b (1957); RESTATEMENT (SECOND) OF

TRUSTS § 216(2)(b) (1957). The fiduciary's inability to revert to full independent status, and therebykeep her information to herself, can be justified on contractual grounds: the principal, in effect,bought the fiduciary's information-gathering capacity and therefore has a proprietary interest in

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hoc review of its objective fairness. If found to be unfair, it will be setaside. 135 In other words, disclosure serves to shift the mode of reviewfrom per se prohibition to ad hoc review, but does not safe harbor thedecision even though the principal consented to it. It appears, moreover,that the burden of proof remains with the fiduciary.136 As a result, thefiduciary remains exposed to some risk of Type II error, because if thetransaction ultimately turns out unfavorably to the principal, the fiduci-ary will bear the loss unless she can persuade the court that she gave theprincipal the best terms available at the time137 and fully explained thepotential risks. 138

The critical feature of the law's response to the concentrated-constit-uency principal cases is, therefore, the fiduciary's capacity to bargain di-rectly with the principal. This means that lawmakers have considerableflexibility to impose rules that set the initial balance between Type I andType II errors wherever they please because the parties may contractaround it without undue expense. The law opts for per se rules that tol-erate a high risk of Type II error in the interests of minimizing Type Ierror because the principal is probably in an inferior position vis-a-vis thefiduciary both to appreciate the existence and cost of the resulting risk oferror and to diversify away the risk. The law's "default option" then isthis blanket approach, an approach that is indifferent to the fairness ofthe particular transaction and made tolerable only by the ready availabil-ity of modification. Because of the high certainty of outcome associated

whatever it produces. See Kronman, Mistake, Disclosure, Information, and the Law of Contracts, 7J. LEGAL STUD. 1, 19 n.49 (1978). This rule protects the general right of fiduciaries to sell theirservices for full value by assuring prospective principals that they will receive the full output of thefiduciary's expertise.

135 See G. BOGERT & G. BOGERT, supra note 119, § 96, at 351-52; 3 A. SCOTT, supra note 119,§ 216.3, at 1747; RESTATEMENT (SECOND) OF AGENCY § 390 comment c (1957); RESTATEMENT(SECOND) OF TRUSTS § 216(3) (1957).

136 See Goldman v. Kaplan, 170 F.2d 503, 507 (4th Cir. 1948); Succession of Simpson, 311 So. 2d67, 72 (La. Ct. App. 1975); RESTATEMENT (SECOND) OF AGENCY § 390 comment g (1957); G.BOGERT & G. BOGERT, supra note 119, § 96, at 352.

137 See Iriart v. Johnson, 75 N.M. 745, 748-49, 411 P.2d 226, 228-29 (1965); L. Loss, FUNDA-MENTALS OF SECURITIES REGULATION 964 n.40 (1983).

138 Where elements exist which, in hindsight, cast doubt on the wisdom of the deal, courts often

presume that the deal went through because of the fiduciary's undue influence. An example is JudgeCardozo's well-known decision in Globe Woolen Co. v. Utica Gas & Elec. Co., 224 N.Y. 483, 121N.E. 378 (1918), invalidating a contract that guaranteed the cost of electricity to a woolen mill andmade no restrictions on the mill's operations. When the mill altered its operations to engage in moreenergy-intensive activities, the contract became a severe burden to the power company. Judge Car-dozo noted that the fiduciary "takes the risk of an enforced surrender of his bargain if it turns out tobe improvident." Id. at 490, 121 N.E. at 380. This statement may be read as permitting post-contract developments to be taken into account in the fairness inquiry. See Note, The Fairness Testof Corporate Contracts with Interested Directors, 61 HARV. L. REV. 335, 341 n.45 (1948); see alsoRogers v. Hill, 289 U.S. 582, 590-92 (1933) (corporate by-law awarding fixed percentage of corpora-tion's profits to its officers was valid when adopted but due to subsequent increases in profits, pay-ments had become so large that they were subject to review on grounds of waste).



with these per se rules, the fiduciary can be expected to appreciate thatshe may deal with the principal only at her peril. The law thus imposesupon the fiduciary the burden of procuring the modification. It thenpolices the quality of the principal's consent, insisting that the principalbe informed fully by the fiduciary. As a last safety net against Type Ierror, the law also reviews the transaction for objective fairness. Thisleaves a continued risk of Type II error to the fiduciary, but presumablyshe is in the better position to adjust for it ex ante in her fees and diver-sify the resulting risk.

VI. JUDICIAL REVIEW IN THE CASE OF DIFFUSED-CONSTITUENCY

PRINCIPALS: THE LAW OF PUBLICLY HELDCORPORATIONS

A. Background: From Per Se Prohibition to Ad Hoc Review

The initial posture of corporate law in this country was to follow thelead of trust and agency law and categorically prohibit corporate direc-tors from dealing with their corporations. 139 The substance of this earlyposition and the retreat from it over time have been well described else-where and need not be repeated here.140 The important point for presentpurposes is that the risk of Type II error is significantly greater when thisper se prohibition is applied in the diffused-constituency area of the lawof publicly held corporations than when it is applied in the concentrated-constituency area of trusts and agency. There are two reasons for thisdifference. First, the key mechanism for avoiding lost opportunities inthe concentrated-constituency principal case is for the fiduciary to dis-close the conflict and thereby become free to deal with the principal.This disclosure shifts the level of judicial scrutiny from per se prohibitionto ad hoe review. In the case of corporations, one can argue that a simi-lar result should follow so long as there is full disclosure to, and informedconsent from, each individual shareholder. But if the shareholders are atall numerous, and thus constitute a diffused-constituency principal, thistactic may not be feasible. Accordingly, by the beginning of the twenti-eth century, several courts had held that a simple majority of sharehold-ers could ratify a contract between their corporation and a director, andthereby immunize it against per se voidability. 141 Nonetheless, this pro-

139 See, eg., Davis v. Rock Creek L.R. & M. Co., 55 Cal. 359 (1880); Cumberland Coal & Iron

Co. v. Parish, 42 Md. 598 (1875); Stewart v. Lehigh Valley R.R., 38 N.J.L. 505 (1875); Munson v.Syracuse G. & C. Ry. Co., 103 N.Y. 58, 8 N.E. 355 (1886). The British courts had adopted the samerule. Aberdeen Ry. Co. v. Blakie Bros., 17 D. (H.L.) 20, 1 Macq. H.L. Cas. 461 (H.L. 1854) (Scot.).

140 See Marsh, Are Directors Trustees? Conflict of Interest and Corporate Morality, 22 Bus. LAW.

35, 36-39 (1966); Note, supra note 138, at 335-36.141 See San Diego, O.T. & P.B.R.R. v. Pacific Beach Co., 112 Cal. 53, 44 P. 333 (1896); Nye v.

Storer, 168 Mass. 53, 46 N.E. 402 (1897); Bjorngaard v. Goodhue County Bank, 49 Minn. 483, 52N.W. 48 (1892); Hodge v. United States Steel Corp., 64 N.J. Eq. 807, 54 A. 1 (1903); Gamble v.

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cedure would be burdensome for routine transactions because it requiresformal approval at a shareholders' meeting.

The second reason why Type II error may be more likely in dif-fused-constituency principal cases is that in these cases the decision tochallenge a transaction is in the hands of each individual shareholder.142As a practical matter, that decision will be controlled by the settlementvalue of the challenge and the attendant opportunity for plaintiff's attor-ney's fees, rather than an even-handed consideration of whether thetransaction, on balance, is in the corporation's interest. In contrast, inconcentrated-constituency principal cases, where the principal is, for in-stance, a beneficiary of a trust, the interests of the principal are the sameas the interests of the trust. Thus, the principal's self-interest will nor-mally prevent him from challenging transactions that are advantageousto the trust.143

In the early 1900s, courts began to back off from the strict disqualifi-cation doctrine and open the door slightly to interested director con-tracts. The doctrinal device for doing so was a reexamination of theanalogy to the agency and trust rules. The theory was that because thefiduciary could avoid per se prohibition in the agency and trust areas bysecuring the principal's disinterested consent to the transaction, a compa-rable result should apply under corporate law. And because the board ofdirectors was statutorily entrusted with management of the corporation,it should be able to render the required disinterested consent. This ofcourse assumed that the interested director did not participate in theboard's decision. Moreover, consistent with the agency and trust anal-ogy, the transaction still would be reviewable for fairness.144

The sudden judicial willingness to accept the analogy is particularlycurious given that the earlier cases rejected out of hand the argumentthat strict disqualification should not apply where the interested direc-tor's vote did not directly 145 affect the outcome. 146 As Harold Marsh

Queens County Water Co., 123 N.Y. 91, 25 N.E. 201 (1890); North-Western Transp. Co. v. Beatty,12 App. Cas. 589 (P.C. 1887) (Can.).

142 In some jurisdictions the harshness of the strict disqualification doctrine was tempered by

limiting an individual shareholder's right to invoke it. In New York, for example, the Court ofAppeals held that the voidability of a contract between the corporation and one of its directors couldbe raised only by the corporation itself and not by a shareholder in a derivative suit. Burden v.Burden, 159 N.Y. 287, 54 N.E. 17 (1899).

143 Cf. J. SHEPHERD, supra note 125, at 159 (discussing the strict disqualification rule: "By mak-ing the transaction voidable instead of void, the courts are, in effect, delegating to the beneficiary theinitial determination of whether the fiduciary has abused his powers.").

144 See Marsh, supra note 140, at 39-41; Note, supra note 138, at 336.145 The interested director might not directly affect the outcome because he or she was only one

of many to approve the transaction or because he or she did not participate in deliberations over thetransaction and his or her vote was unnecessary for approval.

146 See Stewart v. Lehigh Valley R.R., 38 N.J.L. 505, 523 (1875) (stating that a director shouldnot be allowed to benefit by neglecting his duty to participate in corporate decisionmaking); Munsonv. Syracuse, G. & C. Ry. Co., 103 N.Y. 58, 74, 8 N.E. 355, 358 (1886) (stating that the lav cannot


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commented in his widely cited article: "One searches in vain in the de-cided cases for a reasoned defense of this change in legal philosophy....Did the courts discover in the last quarter of the Nineteenth Century thatgreed was no longer a factor in human conduct?"'147 Some concern musthave remained that the recusal of the interested director might not besufficient to render his or her colleagues disinterested when passing onthe integrity of his or her conduct. 148 Presumably, then, the reason forthis change of judicial heart was a recognition that, as the publicly heldbusiness corporation became a more and more essential mechanism forthe exploitation of large scale entrepreneurial opportunities, this residualrisk of Type I error was more than offset by the cost of the opportunitiesto be lost through Type II error if there was adherence to the strict ap-proach.149 This entrepreneurial concern was aggravated by the fact thatnot only does the prospect of Type II error chill beneficial self-dealingtransactions in general, but the riskier the transaction, the greater thechill. 150

Over time, courts became still more willing to accept interested di-rector contracts. Today, in fact, most jurisdictions permit interested di-rector transactions so long as they are fair, irrespective of whether theyare approved by a quorum of disinterested directors.'15 In some jurisdic-tions, this result has been confirmed by statute.152

accurately measure the influence of the interested director on his associates); Aberdeen Ry. Co. v.Blakie Bros., 17 D. (H.L.) 20, 1 Macq. H.L. Cas. 461, 473 (H.L. 1854) (Scot.) (stating that theinterested director has a duty to give his co-directors the full benefit of his knowledge and skill).

147 Marsh, supra note 140, at 40.148 Judge Cardozo put the point eloquently in the Globe Woolen case some years later:

A dominating influence may be exerted in other ways than by a vote.... A beneficiary, about toplunge into a ruinous course of dealing, may be betrayed by silence as well as by the spokenword .... The members of the committee, hearing the contract for the first time, knew that ithad been framed by the chairman of the meeting. They were assured in his presence that it wasjust and equitable. Faith in his loyalty disarmed suspicion.

Globe Woolen Co. v. Utica Gas & Elec. Co., 224 N.Y. 483, 489-90, 121 N.E. 378, 379-80 (1918).Several contemporary observers continue to share this concern. See infra notes 226-28 and accom-panying text.149 See, eg., Ft. Payne Rolling Mill v. Hill, 174 Mass. 224, 225, 54 N.E. 532, 532 (1899) (Holmes,

C.J.); Robotham v. Prudential Ins. Co. of America, 64 N.J. Eq. 673, 709, 53 A. 842, 856 (Ch. 1903);Genesee & W.V. Ry. v. Retsof Mining Co., 15 Misc. 187, 195, 36 N.Y.S. 896, 901 (Sup. Ct. 1895);H. BALLANTINE, BALLANTINE ON CORPORATIONS § 67, at 171 (rev. ed. 1946); R. STEVENS, HAND-BOOK ON THE LAW OF PRIVATE CORPORATIONS § 143, at 651-53 (2d ed. 1936); Note, supra note138, at 335-36.

150 Recall how the prospect of Type II error creates an incentive for the fiduciary to favor low-

risk projects, as illustrated supra, in the last paragraph of subsection IV.E.151 See AM. LAW INST., PRINCIPLES OF CORPORATE GOVERNANCE: ANALYSIS AND RECOM-

MENDATIONS § 5.08(a)(2)(C) and comments at 123-25, 129 (Tent. Draft No. 3, 1984) [hereinaftercited as ALI CORPORATE GOVERNANCE PRINCIPLES]; 3 W. FLETCHER, CYCLOPEDIA OF THE LAW

OF PRIVATE CORPORATIONS § 931 (rev. vol. 1975); H. HENN & J. ALEXANDER, LAVS OF CORPO-

RATIONS § 238, at 639 (3d ed. 1983); Marsh, supra note 140, at 43-44.152 See, eg., MODEL BUSINESS CORP. ACT § 8.31(a)(3) (1984); CAL. CORP. CODE § 310(a)(3)

(West 1977); DEL. CODE ANN. tit. 8, § 144(a)(3) (1974).



In sum, we see in the way modem corporate law has deviated fromtrust and agency law the critical role played by the concentrated-consti-tutency/diffused-constituency distinction. The underlying concern forType I error that guided courts in the trust and agency context'5 3 shouldbe, if anything, stronger in the case of public corporations, where thefiduciaries are actually in control of the principal. Thus, the distinctionmust result from the other side of the balance: the risk of Type II errorcreated by restricting good faith decisions. As we saw, this concern ismitigated in the trust and agency areas by the fiduciary's ability to obtainthe informed consent of the principal without enormous transactionscosts. This informed consent then operates to waive the per se prohibi-tion. Lacking such an option, the law of public corporations has re-sponded by easing the level of judicial scrutiny to ad hoc fairness review.

There are, nonetheless, discrete instances where per se prohibitionscontinue to be used in the case of diffused-constituency principals. Ex-amples such as loans to directors and indemnification restrictions' 54

probably reflect a conclusion that across-the-board prohibitions createlittle Type II error. Another interesting example is the conflict-of-inter-est provisions of the Investment Company Act.155 These provisions pro-hibit a wide variety of transactions between the investment company andany "affiliated person,"' 156 promoter, or principal underwriter. 5 7 Thepotential restrictiveness of this across-the-board approach is tempered,however, by the SEC's statutory power to exempt particular transac-tions. 158 This exemptive power is the vehicle for avoiding Type II error,as well as affording certainty to the parties. 159 Thus, we see a patternsimilar to the concentrated-constituency principal: a regime deliberatelymade overly restrictive in the interests of catching any possible breach ofduty, with the onus on the fiduciary to bargain its way out. Although theprincipal in this case is diffused-constituency in character, the transac-tions costs of bargaining are low because the power of waiver is delegatedto an administrative agency. 160

153 See supra notes 124-25 and accompanying text.154 See supra notes 105 & 123.155 Investment Company Act of 1940 § 17, 15 U.S.C. § 80a-17 (1982).156 An "affiliated person" is generally an officer, director, 5% or more shareholder, or some other

control person. Id. at § 2(3) (definition of "affiliated person").157 Id. at § 17(a).158 Id. at § 17(b).159 See 2 T. FRANKE, THE REGULATION OF MONEY MANAGERS § 15.1, at 458 (1978) ("It was

clear in 1940 that the sweeping prohibition of section 17(a) could not exist without a grant of exemp-tive powers to the SEC."). In addition, the SEC has created by rule safe harbors within section 17(a)where the risk of opportunism is negligible. See, eg., Investment Company Act rule 17a-7, 17C.F.R. § 270.17a-7 (1985) (purchases and sales of securities between affiliated investment companies,

for cash, at currently quoted market prices).160 Another example of the relationship between the restrictiveness of prohibitions and ease of

bargaining is provided by loan agreements. In general, the covenants in private placement loanagreements tend to be more restrictive than those in trust indentures governing publicly held debt



B. The Case for Ad Hoc Review

Why has contemporary corporate law settled upon the vagaries ofad hoc review as its universal approach to regulating fiduciary decision-making? Why, in the process, has the law failed to develop transaction-specific or terms-specific standards16' to guide corporate management?Subsection IV.G. considered the value inherent in certainty of outcomeand how it traded off against reduction of error. As we have seen, thediffused-constituency nature of public corporations forecloses the fiduci-ary from obtaining the consent of the underlying principals, the primarysource of certainty available to the trustee and common law agent. 162

Under an ad hoc approach, there is no mechanism for assuring the valid-ity of a transaction short of a definitive adjudication that it is fair, and, ashas been discussed, lack of fairness can be raised by any shareholder whothinks the case has good potential for attorney's fees. 163 Yet, certaintyand predictability are, if anything, attributes of special importance to thebusiness and financial planning of public companies. Millions of dollarsmay hang in the balance as the issue of the fairness of a merger takesyears to work its way through the courts. Accordingly, and before exam-ining the content of the ad hoc fairness test in the next subsection, thissubsection will consider the reasons for the law's rigid insistence on an adhoc approach rather than the development of standards.

The reasons given for an ad hoc approach fall into two clusters.Both clusters deal with the comparative institutional advantages ofcourts, the institutions that would apply the ad hoc fairness test, overlegislatures, the institutions that would formulate the standards, as theproper reviewers of fiduciary decisionmaking. The first cluster evokes apreference for general principles over specific standards in light of therichness and variety of the factual situations presented by the conduct ofcorporate managements. It evokes many of the traditional arguments forthe common law over a code-based system. Its advocates see the ad hocapproach as the ideal tool to harmonize the potentially conflicting goalsof providing management maximum discretion to run the business and ofprotecting public and minority shareholders from oppression. 164 A morespecific code of conduct might decrease the probability of self-dealing,but would at the same time foreclose to the corporation legitimate andvaluable opportunities. 165 In addition to this potential for repressingbeneficial transactions, a regime of detailed standards creates the risk of a

securities. A likely explanation is the lower transactions costs of negotiating waivers. See Zinbarg,The Private Placement Loan Agreement, FIN. ANALYSTS J., July-Aug. 1975, at 33, 35, 52.

161 See supra note 105 for examples of transaction-specific and terms-specific standards.162 See supra notes 133-38 and accompanying text.163 See supra text accompanying notes 118, 142-43.164 See, eg., Arsht, Reply to Professor Cary, 31 Bus. LAw. 1113, 1113-14 (1976).165 See Winter, supra note 8, at 258-62 (discussing the tradeoff between eliminating self-dealing

and reducing corporate efficiency, which is essentially the Type I/Type II tradeof).

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"road map for the unscrupulous," because there will always be a loop-hole for those intent on evading the policy underlying the code. 166

The ad hoe review process, on the other hand, not only has no loop-holes, but also provides a catchall to reach wrongful conduct even if theconduct is in technical compliance with the statutory requirements. De-tailed standards cannot do this because no set of legislative pronounce-ments, no matter how detailed, could be either comprehensive or far-sighted enough to properly deal with the full array of schemes and trans-actions that arise in the business world. Thus, only ad hoc review, itsdefenders argue, allows the courts flexibility to confront and evaluatethese schemes and transactions as they arise. It thus facilitates the devel-opment of informed standards over time, and in an experimental andevolutionary manner not available to the legislature. 167

Of course, from the standpoint of predictability as an objective, thediversity-of-the-business-world argument cuts both ways. The fact thatany set of prescribed standards might be inadequate in its coverage doesnot mean that an amorphous standard of fairness provides better gui-dance. Proponents of clearer standards argue that the uncertainty overhow the general standards apply to particular kinds of transactionsserves to invite extensive litigation. But, the argument goes, the litigationprocess is too episodic and fortuitous to assure the development of clearand complete guidelines capable of prescribing future conduct and guid-ing business planning. 168

Notwithstanding the concerns of the defenders of the ad hoe ap-proach, it would certainly seem plausible that aspects of corporate law inwhich the need for preditability is strong would be eligible candidates forspecific guidelines. Thus, Marvin Chirelstein has argued for more de-

166 Garrett, The Limited Role of Corporation Statutes, in COMMENTARIES ON CORPORATE

STRUCTURE AND GOVERNANCE 95, at 101 (D. Schwartz ed. 1979) [hereinafter cited as CORPORATEGOVERNANCE COMMENTARIES]; Scott, Reports of the Discussion Groups, in id., at 443-44; see Latty,Why Are Business Corporation Laws Largely "Enabling"?, 50 CORNELL L.Q. 599, 614-15 (1965)(discussing the problem of drafting to foreclose evasion).

167 See J.W. HURST, THE LEGITIMACY OF THE BUSINESS CORPORATION IN THE LAW OF THE

UNITED STATES 1780-1970, at 128-30 (1970); Arsht, In Staunch Defense of Delaware, in CORPO-RATE GOVERNANCE COMMENTARIES, supra note 166, at 238, 242-44; Garrett, supra note 166, at101-02; Jacobsen, Reports of the Discussion Groups, in CORPORATE GOVERNANCE COMMENTARIES,

supra note 166, at 420-22; Latty, supra note 166, at 617-18; Scott, supra note 166, at 443. But seeFolk, State Statutes: Their Role in Prescribing Norms of Responsible Management Conduct, 31 Bus.LAW. 1031, 1058-59 (1976) (characterizing the arguments that a particular abuse (i) is better left tocase-by-case treatment and (ii) cannot be addressed in suitable statutory language as rationalizationsfrequently employed by corporate law revision committees for justifying their refusal to recommendstatutory change).

168 See Chirelstein, Towards a Federal Fiduciary Standards Act, 30 CLEV. ST. L. REV. 203, 205-

11, 216-17 (1981); Harris, Reports of the Discussion Groups, in CORPORATE GOVERNANCE COM-

MENTARIES, supra note 166, at 396-98; Kaplan, Fair Treatment of Shareholders, in id. at 215, 218;Kaplan, Fiduciary Responsibility in the Management of the Corporation, 31 Bus. LAW. 883, 886-88(1976).



tailed rules governing what is fair in the context of parent-subsidiarymergers. 169 Most such calls for basic structural change have emerged,however, from the general state-federal controversy, and the proponentsof greater federalization have been far more preoccupied with the iden-tity of the lawmaker than the wisdom of increased specificity. Hence,American corporate law generally has been unwilling to recognize thatad hoe fairness review is not the most appropriate solution.

There are other important implications of the fact that regulation offiduciary decisionmaking is essentially left to a litigation-driven ad hocreview process. Because the propriety of a particular transaction cannotbe ascertained absent a lawsuit, achieving a high level of compliance withthe standard requires plaintiffs willing to make a substantial commitmentof resources to detecting possible violations and initiating litigation. Thisis particularly burdensome since the standard is so heavily fact-orientedand the fiduciary-defendant will be in principal possession of the facts. 170

The social cost of this litigation is, in essence, the price to be paid as thequid pro quo for the standard's flexibility. 17

1 In addition, the litigationprocess produces standards to guide future conduct only if it is pressed tothe point of producing definitive court opinions capable of generalization.But the expense and uncertainty of litigating under a vague and fact-oriented standard and the desire by some parties to avoid adverse prece-dents172 often will lead the parties to settle. In other words, uncertaintymight lead to settlement, which in turn contributes to continueduncertainty.

A second cluster of justifications for preferring the courts over thelegislature is based on the relative independence of each. The argumenthere is that the basic nature of the state legislative process imparts to it afundamental bias in favor of management and against shareholder pro-tection. Two reasons may be advanced for this. The first is the familiar"race to the bottom" argument. 173 State legislatures, in order to generaterevenue from corporate franchise taxes, have a strong incentive to maketheir corporate laws as attractive as possible to management to inducethem to incorporate in their state. Even if the legislators of a particularstate were philosophically in favor of toughening up their corporate laws,the effort would be futile in terms of shareholder protection since existingdomestic corporations would simply reincorporate in Delaware. Of

169 See Chirelstein, supra note 168.170 See J.W. HURST, supra note 167, at 100 (discussing the limited utility of shareholders' deriva-

tive suits).171 See Garrett, supra note 166, at 102.172 Cf Galanter, Why the "Haves" Come Out Ahead: Speculations on the Limits of Legal Change,

9 LAw & Soc'Y REv. 95, 100-03 (1974) (discussing the litigation strategies of repeat players and thepossible precedential value of settlements).

173 Liggett Co. v. Lee, 288 U.S. 517, 562-63 (1933) (Brandeis, J., dissenting); Cary, Federalismand Corporate Law: Reflections Upon Delaware, 83 YALE L.J. 663, 663-70 (1974); Folk, supra note167, passim.

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course, the particular state would lose franchise revenues if the corpora-tion moved. Thus, California, when it enacted a "tough" corporate lawin 1976, felt it necessary to provide that certain key provisions wouldapply to any corporation with certain California contacts, irrespective ofwhere the corporation happened to be incorporated.1 74 Judges, on theother hand, do not have this fiscal orientation and therefore are morewilling to hold management to account. 75

The second factor that may make the judicial process more in-dependent than the legislative one is the typical corporate law draftingprocess at the state level. Because corporate law tends to be highly com-plex and specialized, responsibility for developing statutory language isoften delegated by the legislature to a corporate law revision committeecomposed of private lawyers. Membership on the committee tends tocome from the large law firms with corporate clients, and this creates thelikelihood of a pro-management orientation.176 At the same time, share-holders as a body are not a unified interest group and have no naturalspokesman to represent their position. Thus, the legislature may hearonly one side and typically lacks the staff expertise to investigate theother. The courts, on the other hand, are at least presented with bothsides of the issue; moreover, the increased stature in recent times of thelawyers who specialize in plaintiffs' derivative suits helps to assure thatthe other side will be well represented.

Both these factors, by the way, may provide one reason why thefederal securities laws have emerged over the years as the principalsource of statutory rigor. The federal government clearly has nothing atstake in the state chartering process and federal standards cannot beevaded by reincorporating elsewhere. In addition, the size and profes-sional nature of the staff in both Congress and the Securities and Ex-change Commission precludes the need to rely on private lawyers forexpertise.

Any complete comparative institutional analysis of why judiciallytested fairness has prevailed over legislatively drafted standards mustalso consider the role of the market. That is, if detailed standards weremore efficient in terms of either reducing the amount of Type I and TypeII error or in producing certainty gains that offset any resulting increasein error, why, given the efficient nature of securities markets as a whole,

174 CAL. CORP. CODE § 2115 (West Supp. 1986); see Halloran & Hammer, Section 2115 of theNew California General Corporation Law-The Application of California Corporation Law to ForeignCorporations, 23 UCLA L. REV. 1282 (1976).

175 This is clearly true of federal judges and is presumably true for state judges as well. But seeCary, supra note 173, at 690-92 (criticizing the independence of the Delaware state judiciary).

176 See id. at 687; Eisenberg, The Model Business Corporation Act and the Model Business Corpo-ration Act Annotated, 29 Bus. LAW. 1407, 1408-10 (1974); Folk, supra note 167, at 1056-58; Latty,supra note 166, at 615-16 ("You do not find beatniks on corporation law committees."); Comment,Law for Sale: A Study of the Delaware Corporation Law of 1967, 117 U. PA. L. REV. 861, 863-72(1969).



haven't market institutions moved to instill them? Judge (then Profes-sor) Winter, in response to a call for detailed federal standards of fiduci-ary behavior, 177 conceded that such an approach was "infinitely superiorto invocations of 'fairness' without decisional criteria," but argued it wasmore a matter for state law than federal, and added:

For one thing, the approach is no answer to the claim that shareholderscan't anticipate such events since it provides predictability only after aproblem has ripened and been analyzed, and usually only after some courtshave addressed it. One may well ask how necessary a solution is at thatpoint since parties are free to adjust their affairs to these court decisionswithout great costs. Nor is there reason to believe government is of supe-rior competence to private parties in anticipating events affecting their con-sensual arrangements. 178

Underlying these comments there appears to be a reliance upon theprivate ordering process described in section II, which in turn suggeststhe possibility of two market-based solutions to the problem of fiduciaryregulation. The first is that prospective shareholders can compensate bypaying less or more for a state of the law permitting a given level ofmanagement opportunism. This is simply an application of the section IInotion of ex ante adjustment and is consistent with the general thesis ofWinter's article that the alleged laxity in Delaware corporate law, if itdoes in fact permit excessive managerial opportunism, will be compen-sated for by the capital markets, causing Delaware corporations to incura higher cost of capital. 179 The second market-based solution is that pri-vate parties, anticipating the possible arenas for management opportu-nism, can take steps to protect themselves as easily as the governmentcan. This gets us back into the section II issues of monitoring and bond-ing, as well as the recognition that fiduciary law functions as an off-the-rack, low-transactions-cost substitute for the kind of monitoring/bond-ing regime most parties would desire.' s0 Consistent with this view, theparties should be freely permitted to "fine tune" the standard rules tomeet their specific needs. But-the transactions cost issue aside--can werealistically expect such behavior from the parties involved?

Let us consider this issue in the context of an example. A kind oftransaction presently in vogue is the "leveraged buyout," in which asmall group, usually including members of senior management, acquiresall of the shares of a public corporation, often through a combination oftender offer and cash-out merger. Much of the cash is obtained by bor-rowing against the company's assets. Concern has been expressed overthe potential unfairness of such transactions to minority shareholders.18 1

177 See Chirelstein, supra notes 168-69, and accompanying text.178 Winter, supra note 8, at 284.179 See id. at 256-58.180 See supra note 73 and accompanying text.181 See, eg., Hill & Williams, Buyout Boom: Leveraged Purchases of Firms Keep Gaining Despite

Rising Risks, Wall St. J., Dec. 29, 1983, at 1, col. 6; Longstreth, Fairness of Management Buyouts

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Consider, therefore, the effect of a terms-specific standard that prohibitedany insider buyout of the corporation at a price less than 25% above theaverage market value of the shares for the preceding year. On the onehand, minority shareholders might consider this desirable because it as-sures them a premium of at least 25% when, under ad hoe fairness re-view, a lower premium may pass muster. On the other hand, thestandard may chill some advantageous buyouts either because the ex-pected gains to the purchasers are below 25% of current value or becausethe prospect of sharing that much of the gain with the minority erodesthe purchaser's incentive to bear the risk and cost inherent in puttingtogether the deal. 182 On balance, are the minority better or worse offunder the standard? Any answer would, necessarily, be conjectural; as aresult, it becomes tempting to remit resolution of the problem to the mys-tic efficiency of the market. If such a standard was, in net effect, benefi-cial to minority shareholders, wouldn't the capital markets respond byvaluing the shares of a corporation employing such a standard at ahigher amount, thereby reducing its cost of capital? A positive answerwould be consistent with Judge Winter's analysis of the capital market'sresponse to Delaware incorporation. And, given that, wouldn't corpo-rate management feel some pressure to adopt such a standard, andthereby bind themselves to pay at least a 25% premium in anybuyout? 183 Or wouldn't the underwriters handling the first public offer-ing of a corporation's shares insist upon such a provision? The conclu-sion might follow, therefore, that the widespread absence of such astandard provides a kind of empirical evidence that submitting any lever-aged buyout to ad hoc fairness review is more efficient. 184

This might be so, but there is a tendency in such arguments to ex-pect too much of the capital markets. We have previously discussed thenotion of "bounded rationality" and the limitations upon human actors

Needs Evaluation, Legal Times, Oct. 10, 1983, at 15; Thomas, A Free Ride For Management Insiders,N.Y. Times, Jan. 22, 1984, § F, at 2, col. 3. But see DeAngelo, DeAngelo & Rice, Going Private:Minority Freezeouts and Stockholder Wealth, 27 J. L. & ECON. 367 (1984) (empirical study providesevidence that minority shareholders benefit from going-private transactions).

182 See Easterbrook & Fischel, supra note 8, at 708-10.183 See e-g., Fischel, supra note 8, at 1284 (criticizing the concept of mandating independent

directors):A far preferable course would be to allow private parties to organize in whatever manner theywish. If the structure advocated by reformers really will increase shareholders' welfare, it willbe undertaken voluntarily, just as firms have always voluntarily hired independent accountantsto verify representations made to investors. Firms that are organized in a manner that maxi-mizes investors' welfare are at an advantage in attracting capital, and managers of such firmswill maximize the value of their own services.

(footnote omitted); see also Easterbrook, Manager's Discretion and Investors' Welfare: Theories andEvidence, 9 DEL. J. CORP. L. 540, 543-53 (1984) (discussing market's pressure upon corporation toadopt optimal governance structure).

184 But cf Easterbrook & Fischel, supra note 19, at 1180-81 (arguing that absence of provisions incorporate articles denying management the right to resist takeovers does not reflect implied share-holder agreement).



in trying to come to grips with complex layers of risk and contingen-cies.1 85 There is no a priori reason to assume that actors in the capitalmarkets, either alone or collectively, possess the capacity to calculate outthe value of such a leveraged buyout standard or to discount for its ab-sence; at best they can offer impressionistic speculations. In addition,corporate promoters, managers, and lawyers-victims of bounded ra-tionality themselves-do not "build from the ground up" every time theyput together a business deal. They use traditional forms, not becausethey are efficient as much as because they are familiar. True, there isinnovation, and lawyers and businessmen can strike ad hoc bargains todeal with perceived and tangible risks.186 But they cannot and do notcover everything. And even in the case that is most often pointed to asan example of corporate law by private contract-the covenants, repre-sentations, and warranties of loan agrements' 87-- custom tends to rulethe day. Lawyers tend to rely on standard collections of boilerplateclauses, which vary little from deal to deal, and plug in the numbersnegotiated by the businessmen.

The upshot is that it is difficult to draw generalizations from themarket's failure to promote the development of bright-line standards togovern fiduciary decisionmaking. The combination of custom, boundedrationality, and risk aversion dampens much of the incentive to innovatewhen innovation requires tampering with a market-proven product. Itmay be the case that a corporation's voluntary adoption of our leveraged-buyout standard would receive little warm response from the capitalmarkets. Maybe that says something about its efficiency, but a morelikely explanation is that market participants are not quite sure what tomake of it. The complete proof will not be in until we can examine theresponse of the markets to a corporation that rejects such a standard in aworld where all other public corporations employ it.

C. The Operation of Ad Hoc Review

1. The Traditional Framework.-We have seen that the movementof corporate law over this century has been to shift from per se prohibi-tions upon any conflict-of-interest transactions to ad hoc review.Mechanically, the ad hoc review process consists of two alternative for-mats. If no conflict of interest exists, the decisions of corporate directorswill be protected by the "business judgment" rule. The plaintiff's burdenunder this rule has been defined with varying degrees of severity, but inany event, is heavy. Some courts require proof of "fraud, illegality or

185 See supra note 44 and accompanying text.186 See Klein, supra note 19, at 1555 n.124.187 See, eg., id.; Smith & Warner, supra note 38; Cf Gilson, Value Creation by Business Lawyers:

Legal Skills and Asset Pricing, 94 YALE L.J. 239, 256-94 (1984) (analyzing business acquisitionagreements from the standpoint of "transaction costs engineering").

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conflict of interest" 188 or of "gross and palpable overreaching."'' 8 9

Others frame the test not so much in terms of misconduct as of the plau-sibility of the decision, and require a showing that the decision cannot besupported by "any rational business purpose"'190 or is "so unwise or un-reasonable as to fall outside the permissible bounds of the directors'sound discretion." 191 Whatever the phrasing, the appropriate judicial in-quiry is, in theory, whether the decision at issue is within the universe ofpossible decisions that a rational board, acting in good faith, might havemade; that other possible decisions may have been wiser is irrelevant. Inpractice, the gist of the rule seems to be that the plaintiff must show thatthe justification for the transaction is so flimsy, or its terms so unsound,that a strong suspicion arises that the directors were motivated by ulte-rior purposes or were reckless or irresponsible in their consideration ofit.192 Thus, for most intents and purposes, the rule operates to safe har-bor disinterested corporate decisionmakers from attacks on the basic wis-dom of their decisions. 193

188 Shlensky v. Wrigley, 95 Ill. App. 2d 173, 181, 237 N.E.2d 776, 780 (1968).189 Getty Oil Co. v. Skelly Oil Co., 267 A.2d 883, 887-88 (Del. 1970); Meyerson v. El Paso

Natural Gas Co., 246 A.2d 789, 794 (Del. Ch. 1967). But see Arsht, The Business Judgment RuleRevisited, 8 HoFsTRA L. REV. 93, 102-11 (1979).

190 Panter v. Marshall Field & Co., 486 F. Supp. 1168, 1194 (N.D. Ill. 1980), affid, 646 F.2d 271,293 (7th Cir.), cert. denied, 454 U.S. 1092 (1981); Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720(Del. 1971) The court's opinion in the Sinclair case used other phrasing as well, including "gross andpalpable overreaching," "resulted from improper motives and amounted to waste," and "fraud orgross overreaching." Cf. ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, § 4.01(a)(3)(Tent. Draft No. 4, 1985) (requiring that director or officer "rationally believes that his businessjudgment is in the best interests of the corporation").

191 Cramer v. General Tel. & Elec. Corp., 582 F.2d 259, 275 (3d Cir. 1978), cert. denied, 439 U.S.1129 (1979). The court's full sentence was: "In addition, where the shareholder contends that thedirectors' judgment is so unwise or unreasonable as to fall outside the permissible bounds of thedirectors' sound discretion, a court should, we think, be able to conduct its own analysis of thereasonableness of that business judgment." Id. Some have read this passage as inviting judicialevaluation of the substantive merits of the directors' decision over and beyond whether it is sup-ported by any rational business purpose. Veasey & Manning, Codified Standard--Safe Harbor orUncharted Reef?, 35 Bus. LAW. 919, 935-37 (1980). Others have regarded it as little more than arephrasing of the rational business purpose requirement. ALI CORPORATE GOVERNANCE PRINCI-PLES, supra note 151, § 4.01(d) comment fat 68 & Reporter's Note 4 at 75 (Tent. Draft No. 4, 1985);Arsht & Hinsey, Codified Standard-Same Harbor but Charted Channel: A Response, 35 Bus. LAW.ix, xxv n.47 (July, 1980).

192 Meyers v. Moody, 693 F.2d 1196, 1209-11 (5th Cir. 1982), cert. denied, 464 U.S. 920 (1983);Gimble v. Signal Cos., 316 A.2d 599, 610-11, 614-15 (Del. Ch.), affdper curiam, 316 A.2d 619 (Del.1974); Litwin v. Allen, 25 N.Y.S.2d 667, 691-700 (Sup. Ct. 1940); Selheimer v. Manganese Corp. ofAmerica, 423 Pa. 563, 573-81, 224 A.2d 634, 642-45 (1966). A recent Delaware decision suggests amuch stricter test, however. In Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) (en bane), thecourt held in a 3-2 decision that the corporation's directors were liable for gross negligence in ap-proving an outside takeover offer recommended by management without first adequately informingthemselves concerning the transaction.

193 See, e.g., ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, § 4.01(a) comment hat 28-29 (Tent. Draft No. 4, 1985) ("Since the turn of the century there have been only thirty or socases reflected in appellate opinions-almost invariably involving egregious facts-where directors



Where, however, the transaction involves self-dealing for the possi-ble benefit of the corporation's directors or controlling shareholders, acourt will subject it to strict scrutiny. In Delaware, where the case lawon this issue is probably the richest, the burden of proof shifts to theproponents of the transaction, who must demonstrate its "entire fair-ness." 194 In addition, the Delaware Supreme Court has recently brokendown the issue of fairness into two elements: fairness of dealing and fair-ness of price,195 a distinction that had also been advanced by variouscommentators. 196 Fairness of dealing involves an inquiry into the justifi-

or officers have been found to have violated duty of care obligations."); Bishop, supra note 48, at1099-1100:

The search for cases in which directors for industrial corporations have been held liable inderivative suits for negligence uncomplicated by self-dealing is a search for a very small numberof cases in a very large haystack. My own collection, based on extensive (although not exhaus-tive) investigation, includes four such specimens .... But to my mind none of these casescarries real conviction.

See also Lewin, The Corporate-Reform Furor, N.Y. Times, June 10, 1982, at Dl, col. 3, D6, col. 6(quoting Stanely A. Kaplan, Chief Reporter for the ALI's Corporate Governance project as saying:"All the A.L.I. draft says is that the director's judgment will be protected as long as it's not ludi-crous.... My own view is that we should have said 'Directors are not liable unless they do some-thing goofy,' but you can't use that kind of language in a Restatement.").

194 Sterling v. Mayflower Hotel Corp., 33 Del. Ch. 293, 298, 93 A.2d 107, 110 (Sup. Ct. 1952); see

also Sinclair Oil Corp. v. Levien, 280 A.2d 717, 719-20 (Del. 1971) ("intrinsic fairness"). TheSupreme Court of the United States has stated the test as "inherent fairness," Pepper v. Litton, 308U.S. 295, 306 (1939), while the American Law Institute's Principles of Corporate Governance phrasesthe requirement simply as "fair to the corporation." ALI CORPORATE GOVERNANCE PRINCIPLES,supra note 151, § 5.08(a)(2)(c).

By formulating the test of fairness in this manner, recourse is avoided to phrases such as"entire fairness," "inherent fairness," or "intrinsic fairness," which have sometimes been usedby the courts in duty of loyalty cases, but which afford insufficient guidance in analyzing partic-ular transactions and suggest an often unattainable degree of precision in analysis.

Id. comment at 123.In addition to the case law, numerous jurisdictions have conflict-of-interest statutes that address

the fairness requirement. Thus, in California, the self-dealing director has the alternative of provingthat the transaction is "just and reasonable" to the corporation. CAL. CORP. CODE § 310(a)(3)(West 1977). The analogous provision of the Model Business Corporation Act, section 8.31(a)(3),contains the language "fair to the corporation" and does not specify who has the burden of proof onthe issue. It could be argued, therefore, that the burden should fall where it usually does, on theplaintiff. The cases arising under statutes similar to § 8.31(a)(3), and its forerunner in the priorversion of the Model Act, § 41(c), have not, however, read the statutes as altering the mechanics ofthe pre-statutory fairness test; the burden is still on the proponent. Lewis v. S.L. & E., Inc., 629 F.2d764, 769-77 (2d Cir. 1980) (construing N.Y. Bus. CORP. LAW § 713(a)(3) (McKinney 1963), whichwas repealed in 1971); Scott v. Multi-Amp Corp., 386 F. Supp. 44, 66-68 (D.N.J. 1974); Fliegler v.Lawrence, 361 A.2d 218, 221-22 (Del. 1976) (by implication); Noe v. Russell, 310 So. 2d 806, 817-19(La. 1975).

195 Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983) (en bane). See also Alpert v. 28Williams St. Corp., 63 N.Y.2d 557, 569-72, 473 N.E.2d 19, 26-27, 483 N.Y.S. 2d 667, 674-76 (1984)(to the same effect); Fill Bldgs., Inc. v. Alexander Hamilton Life Ins. Co. of America, 396 Mich. 453,461, 241 N.W.2d 466, 469 (1976) (director must show not only fair price but also fairness of thebargain to the interests of the corporation).

196 See, eg., L. SOLOMON, R. STEVENSON & D. SCHWARTZ, CORPORATIONS: MATERIALS AND

PROBLEMS: LAW AND POLICIES 1019 (1982); Bulbalia & Pinto, Statutory Responses to Interested



cation and purposes of the transaction, its timing, who initiated it, whonegotiated it, and who approved it. 197 Fairness of price involves a com-parison of the value of what the corporation or its shareholders receivedwith what it or they gave up. 198 In theory, these should be independentand conjunctive criteria. One cannot be assured that the principal, ifacting independently, would have entered into the transaction simply be-cause the price was fair; he no doubt turns down countless fairly pricedopportunities daily. Thus, for example, a transaction undertaken for im-proper purposes should be set aside, irrespective of whether its terms arefair.199 In addition, the requirement of proper business purpose as anindependent prerequisite to validity potentially2°° performs a screeningfunction by allowing the courts to avoid the often indeterminate task offinding fair terms201 unless such a task is essential to the corporation'slegitimate business needs. Under the present state of the law, however,whether fair dealing and fair price are independent requirements or sim-ply two factors to be weighed collectively is not altogether clear.202

Directors' Transactions: A Watering Down of Fiduciary Standards?, 53 NOTRE DAME LAw. 201,209-10 (1977) (discussing the distinction between procedural and substantive fairness); Moore, The"Interested" Director or Officer Transaction, 4 DEL. J. CORP. L. 674, 676 (1979) (stating that fairdealing and fair price are the two essential aspects of fairness); Nathan & Shapiro, Legal Standard ofFairness of Merger Terms Under Delaware Law, 2 DEL. J. CORP. L. 44, 46-48 (1977); Note, supranote 138, at 340.

197 Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983) (en bane).198 Id.

199 See, eg., Dower v. Mosser Indus., Inc., 648 F.2d 183, 188-89 (3d Cir. 1981) (under Penn-sylvania law, merger intended solely to freeze out minority shareholders may be enjoined as breachof fiduciary duty); Alpert v. 28 Williams St. Corp., 63 N.Y. 557, 572-73, 473 N.E.2d 19, 28, 483N.Y.S.2d 667, 676-77 (1984) (advancement of general corporate interest is necessary in order tojustify freeze-out merger); Singer v. Magnavox Co., 380 A.2d 969, 978-80 (Del. 1977) (merger forthe sole purpose of freezing out minority shareholders is an abuse of fiduciary duty), overruled byWeinberger v. UOP, Inc., 457 A.2d 701, 715 (Del. 1983) (en banc). The independent business pur-pose requirement is particularly forceful in the case of close corporations. Where one group of closecorporation shareholders is treated differently from another, some courts have required that theunequal treatment be justified by a bona fide business purpose which could not be accomplished byother means. See Wilkes v. Springside Nursing Home, Inc., 370 Mass. 842, 851-52, 353 N.E.2d 657,663 (1976); Schwartz v. Marien, 37 N.Y.2d 487, 492, 335 N.E.2d 334, 338, 373 N.Y.S.2d 122, 127(1975).

200 The term "potentially" is used in the text to reflect the fact that, in practice, the defendantmay often be able to constrnct with little difficulty a set of justifications sufficient to satisfy thebusiness purpose requirement. Indeed, it was this failure of the requirement to provide meaningfulprotection that led the court in Weinberger to abandon it. Weinberger, 457 A.2d at 715.

201 See infra notes 204-05 and accompanying text.202 The Delaware Supreme Court in Weinberger appears to have viewed them as collective fac-

tors: "However the test for fairness is not a bifurcated one as between fair dealing and price. Allaspects of the issue must be examined as a whole since the question is one of entire fairness." Wein-berger, 457 A.2d at 711.

The American Law Institute's PRINCIPLES OF CORPORATE GOVERNANCE, on the other hand,contain indications that, at least in some cases, the two factors are independent requirements. First,the PRINCIPLES make clear that the interested party's failure to disclose all material facts surround-ing the transaction supplies a basis for setting the transaction aside irrespective of its fairness. ALI



2. "Fairness" Review in Practice.-Describing this standard of scru-tiny is one thing; applying it is another. The basic objective is to deter-mine whether a truly independent board of directors would haveproduced a comparable transaction.20 3 But in a significant number ofcases it is simply not realistic to ask the courts to predict, in the guise offinding "facts," how a theoretically independent board would have ap-proached a problem or what terms it would have negotiated.204 Passagesin several of the opinions reveal the quandary of courts called upon todeclare what is fair without the aid of an arm's-length bargained resultfor comparison.20 5

CORPORATE GOVERNANCE PRINCIPLES, supra note 151, § 5.08.(a)(1), comment a at 110, commentto § 5.08(a)(1) at 116, & Reporter's Note 5 at 133, 138. Second, the comments state that fairness isto be measured "not only by comparison with an arm's-length transaction with an unrelated thirdparty" but also by "whether the transaction affirmatively will be in the corporation's best interest."Id., comment to § 5.08(a)(2)(c) at 123-24. In addition, the comments indicate that whether theinterested party initiated the transaction or acted for the corporation in setting the terms are factorsto be considered in assessing fairness. Id., comment to § 5.08(a)(2)(c) at 124-25.

203 Pepper v. Litton, 308 U.S. 295, 306-07 (1939); International Radio Tel. Co. v. Atlantic Com-munications Co., 290 F. 698, 702 (2d Cir.), cert. denied, 263 U.S. 705 (1923); Weinberger v. UOP,Inc., 457 A.2d 701, 710 n.7 (Del. 1983) (en banc); Johnston v. Greene, 35 Del. Ch. 479, 490, 121A.2d 919, 925 (Sup. Ct. 1956).

204 Cf. Auerbach v. Bennett, 47 N.Y.2d 619, 630, 393 N.E.2d 994, 1000, 419 N.Y.S.2d 920, 926(1979):

It appears to us that the business judgment doctrine, at least in part, is grounded in the prudentrecognition that courts are ill equipped and infrequently called on to evaluate what are andmust be essentially business judgments. The authority and responsibilities vested in corporatedirectors both by statute and decisional law proceed on the assumption that inescapably therecan be no available objective standard by which the correctness of every corporate decision maybe measured, by the courts or otherwise.

205 Western Pac. R.R. v. Western Pac. R.R., 206 F.2d 495, 499-500 (9th Cir.), cert. denied, 346

U.S. 910 (1953) (allocation of consolidated tax savings between parent and subsidiary); Getty Oil Co.v. Skelly Oil Co., 267 A.2d 883, 886-87 (Del. 1970) (allocation of oil import quotas between parentand subsidiary); Case v. New York Cent. R.R., 19 A.D.2d 383, 390, 243 N.Y.S.2d 620, 627 (1963)(Steuer, J., dissenting), rev'd, 15 N.Y.2d 150, 204 N.E.2d 643, 256 N.Y.S.2d 607 (1965) (allocation ofconsolidated tax savings between parent and subsidiary); Heller v. Boylan, 29 N.Y.S.2d 653, 679-80(Sup. Ct.), afl'd mem., 263 A.D. 815, 32 N.Y.S.2d 131 (1941) (amount of executive compensation);see generally Bulbalia & Pinto, supra note 196, at 223-27; Note, supra note 138, at 337-39 (bothdiscussing the difficulties of applying the fairness test).

At this point in the discussion, the reader may be inclined to respond that courts are calledupon to make tough decisions-including valuations-all the time. For example, in personal injurycases they routinely are called upon to value a lost arm or, for that matter, a lost life. And, closer tohome, courts in tax cases must often decide whether an executive compensation arrangement createdin an atmosphere of self-dealing is reasonable. See Vagts, supra note 20, at 257-61. What is sospecial, then, about corporate law? There are several answers to this. First, in areas such as personalinjury law, the valuation issue arises only after a determination has been made that the defendant hasbreached a duty to the plaintiff, and accordingly, there may be a greater judicial willingness torequire the defendant to bear the risks of error created by the valuation process. The effect of ad hoefairness review, on the other hand, is that questions of breach and questions of value are fused. If thevalue is unreasonable, the fiduciaries have ipso facto breached their duty, are presumed guilty of bad-faith motivation, and are liable. This, when coupled with the relative capacities of the fiduciaries todiversify-a topic dealt with infra in subsection VI.C.3.-may lead courts to be more concernedabout subjecting corporate fiduciaries to the risk of error on an ongoing basis. Second, special sensi-



In some instances this will not be the case. If the transaction underreview represented one of several alternatives, others of which wereclearly superior in all material aspects, or if features of the transactionfavorable to management or the majority are not supported by a reason-able justification consistent with the legitimate interests of the minorityshareholders, the court can comfortably set aside the board's decision asnecessarily stemming from the conflict. 20 6 These kinds of cases revealfavorable treatment of controlling interests that is not typically consis-tent with everyday notions of sound business practice. They involve, inessence, giveaways. And while a businessman dealing at arm's lengthmay on occasion find it advantageous to grant special concessions to aparticular client or to overlook breaches of contract, the clear risk ofType I error precludes upholding such practices when they are accompa-nied by self-dealing.

Alternatively, if the subject matter of the transaction is fungible or acommodity for which there are market comparables, the court can realis-tically rely on expert testimony to assess the fairness of the terms.20 7

The real problem, though, from the standpoint of developing mean-ingful guidelines to govern decisionmaking by corporate officers and di-rectors is that so many conflict-of-interest scenarios pose opportunitiesthat are unique.20 8 We saw in section V. that the approach of trust andagency law to such unique opportunities was, upon the principal's in-

tivities in the corporate law area may be created by the nature of the plaintiffs and their readiness toexploit any signs of judicial receptiveness to second-guessing the fiduciaries' conduct. In the taxcases, for example, the plaintiff is the Internal Revenue Service, which presumably exercises someselectivity in deciding which arrangements to challenge. In corporate litigation, by contrast, theplaintiff is any shareholder who chooses to bring a derivative suit. Consider whether the courtswould stand as ready to look into whether compensation is reasonable for tax purposes if suit couldbe brought, discovery initiated, and attorney's fees obtained by any individual taxpayer who hasidentified a compensation arrangement that he or she believes is worth challenging.

206 See, eg. Sinclair Oil Corp. v. Levien, 280 A.2d 717, 722-23 (Del. 1971) (corporation refused tohonor the terms of a purchase contract with its overseas affiliate); Shlensky v. South Parkway Bldg.Corp., 19 Ill. 2d 268, 166 N.E.2d 793 (1960) (a series of special concessions, reduced rents, and rentparticipation agreements by the corporate landlord to tenants in which its directors had an interest).

207 See, e.g., Lewis v. S.L. & E., Inc., 629 F.2d 764 (2d Cir. 1980) (rental of corporate property atunreasonably low rates). Even in these cases, we can expect considerable room for differences ofopinion among the parties' experts. For example, suppose the subject of the self-dealing transactionis a business venture, a not infrequent occurrence. In that case, the valuation will require the expertsboth to project the business' future cash flows and select an appropriate capitalization rate, to pro-duce a dollar value that attorney Peter Coogan, speaking in a different context, described as "anestimate compounded by a guess." H.R. REP. No. 595, 95th Cong., 1st Sess. 225, reprinted in 1978U.S. CODE CONG. & AD. NEWS 5963, 6184.

208 See Scott, supra note 70, at 939-40 (most duty of loyalty cases involve goods or services forwhich no trading market is available); Weiss, Economic Analysis, Corporate Law, and the ALI Corpo-rate Governance Project, 70 CORNELL L. REv. 1, 19 (1984) ("The transactions that kindle duty ofloyalty lawsuits do not involve property or services with readily ascertainable market prices. Thus,courts must formulate hypothetical terms for transactions that unrelated parties dealing at arm'slength would have agreed upon.") (footnote omitted); Note, supra note 138, at 337-39 (discussing thefrequent absence of comparable market prices and objective standards).



formed consent to the conflict, to waive the per se prohibitions thatotherwise would apply.20 9 But the direct dealing between principal andfiduciary available in those settings, and necessary to make the waiverrealistic, is not typically feasible in the case of a diffused-constituencyprincipal such as the public corporation. Further, the problem is aggra-vated because often the very reason the conflict-of-interest opportunity isunique is that there is a certain inevitability about the corporation's needto take advantage of it.210 Management compensation and perquisites,parent-subsidiary relationships, responses to takeover bids, and freezeoutmergers are all examples of this. Given this unavoidability of the conflictof interest, the costs of the Type II error created by requiring the corpo-rate fiduciaries routinely to submit themselves to an ad hoc fairness re-view, made speculative by the absence of market standards by which tomeasure-particularly if they are to shoulder the burden of proof-aresubstantial.

Thus, the existence of these unique-opportunity conflicts of interestsplaces modem American corporate law in an awkward position. Courtshave responded to this dilemma by preserving the doctrine that the fidu-ciary who deals with his or her corporate principal carries the burden ofproving the entire fairness of the transaction; in practice, however, courtshave accepted much less. For instance, a court may defer to formallyindependent decisionmakers within the corporation, such as disinterestedcommittees of the board, even though the capacity of such deci-sionmakers for truly disinterested evaluation of their colleagues is opento considerable doubt;211 a court may extend to the corporate fiduciarythe benefit of the business judgment rule even though he or she has asubstantial conflict of interest;212 or a court may uphold the transactionso long as its terms appear plausible even though arm's-length bargainingmay well have produced a more beneficial deal for the principal. 213

The common theme in these situations is that the courts are willingto defer to the judgment of an intracorporate decisionmaker, even thoughthere remains reason to doubt that this judgment is capable of producingthe same results as would a decision bargained for at arm's length. Thebalance of this Article discusses several examples of this judicial defer-ence and speculates on the reasons for it in light of the theoretical frame-work developed thus far. Three possible justifications are tendered: thevalue of transaction certainty, bargained-for opportunism, and the bilat-eral-monopoly nature of many conflict-of-interest transactions.

209 See supra notes 133-38 and accompanying text.210 See Brudney, The Independent Director-Heavenly City or Potemkin Village?, 95 HARV. L.

REV. 597, 628-30 & n.83 (1982) (observing that many kinds of self-dealing are unavoidable andtherefore cannot be solved by per se prohibitions).

211 See infra notes 226-34 and accompanying text.212 See infra notes 261-87 and accompanying text.213 See infra notes 294-304 and accompanying text.

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3. Approval by Disinterested Directors, Ratification by Shareholdersand the Value of Transaction Certainty.-Courts have been willing torelieve the fiduciary of the burden of proving fairness and to review herself-dealing much less intensely where the transaction has been approvedby a formally disinterested decisionmaker within the corporation, such asthe disinterested members of the board of directors, an independentboard committee, or the shareholders.2 1 4 Do such intracorporateprocesses provide a realistic surrogate for the rigor of arm's-length bar-gaining? As a basis for reflecting on this question, consider the situationin Puma v. Marriott,2 15 a leading Delaware case on this issue.

This case involved a transaction between Marriott Corporation, apublicly-held company, and members of the Marriott family. The Marri-otts were the principal owners of six separate corporations (the propertycompanies) that leased real estate to the Marriott Corporation. At thesame time, the Marriott family owned 44% of the Marriott Corpora-tion's outstanding shares, and four of the corporation's nine directorswere shareholders in the property companies. 216 Because the obviousconflict-of-interest problems posed by this arrangement had been jeop-ardizing the Marriott Corporation's ability to obtain listing on the NewYork Stock Exchange, the corporation's outside directors proposed thatthe corporation acquire all of the outstanding shares of the propertycompanies. The Marriott family resisted at first, but ultimately agreed to

214 The precise impact of disinterested approval upon the intensity of judicial review varies fromjurisdiction to jurisdiction. Consider, for example, the framework employed by the American LawInstitute's PRINCIPLES OF CORPORATE GOVERNANCE, which is illustrative of the positions taken bymany courts. If, following disclosure of all material facts concerning the transaction and the natureof the interested director's or executive's conflict, the transaction was authorized by a majority of thedisinterested members of the board or by an independent board committee, then the person challeng-ing the transaction has the burden of proving that the directors could not reasonably have believedthe transaction to be fair. ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151,§§ 5.08(a)(2)(A),(b), 5.04. Alternatively, if, following full disclosure, the transaction was authorizedor ratified by a majority of the disinterested shareholders, then the challenger must prove that thetransaction was a "waste of corporate assets," id. §§ 5.08(a)(2)(B),(b), 5.05, which means that noperson of ordinary sound business judgment could conclude that the consideration received by thecorporation was a fair exchange for what it gave up. Id. § 1.30 (Tent. Draft No. 2, 1984). Finally, ifneither disinterested directors nor shareholders approved the transaction, the interested director orexecutive bears the burden of proving that the transaction was fair to the corporation. Id.§ 5.08(a)(2)(C),(b) (Tent. Draft No. 3, 1984).

215 283 A.2d 693 (Del. Ch. 1971).216 Id. at 694. Marriott Corporation's board of directors at the time of the transaction consisted

of J. Willard Marriott, chairman and president of the company; Alice S. Marriott, his wife; J.W.Marriott, Jr., his son; Milton A. Barlow, former executive vice-president of the company, who hadresigned the year before to found his own real estate development firm; James Martin Johnston,senior partner in the firm that served as the company's investment banker; John Werner Kluge,president of Metromedia, Inc.; Don G. Mitchell, president of General Time Corp.; Louis WatkinsPrentiss, a retired Army general and executive vice-president of the American Road Builders Associ-ation; and Roger J. Whiteford, senior partner in the law firm that served as the company's generalcounsel. MOODY'S INDUSTRIAL MANUAL 182 (June 1965); WHO'S WHO IN AMERICA 114, 1088,1168, 1353, 1480, 1708, 2288 (1966-67).



exchange their property company stock for additional shares in MarriottCorporation. Valuation of the stock of the various companies for pur-poses of setting the terms of the exchange was overseen by the fiveoutside directors of Marriott Corporation. In addition, independentcounsel, tax experts, accountants, and appraisers were retained to assistthem. The Marriott family accepted the terms of the exchange as set bythe independent directors and these terms were approved by the corpora-tion's shareholders. The plaintiff then brought a shareholders' deriviativeaction attacking the exchange terms and arguing that because the Marri-ott family stood on both sides of the exchange, it had the burden of prov-ing the transaction's entire fairness. The court disagreed and held thatthe business judgment rule applied in view of the fact that the valuationswere made by a majority of the Marriott Corporation's board of direc-tors, "whose independence is unchallenged," based upon opinions fromexperts whose qualifications were not questioned.2 17 Giving deference tothe business judgment of the directors, the court acknowledged that theexpert testimony and legal analysis on the propriety of the valuationswere "in hopeless conflict," but held for the defendants because it was"satisfied that in any event the methods of valuation used were not soclearly wrong as to result in an unconscionable advantage secured to theMarriott Group. "218

The Puma case illustrates the willingness of the courts, at least incases where the conflict of interest seems unavoidable by its nature,219 tocontent themselves with the assumption that disinterested persons withinthe corporation have the wherewithal to neutralize the effect of the con-flict. In addition to limiting the scope of review of the merits as inPuma,2 2 0 this judicial deference also operates at the procedural level tolimit the plaintiff's right to challenge the transaction in the first place. Inderivative suits, courts have held that so long as a majority of the corpo-ration's directors had no personal interest in the self-dealing transac-tion-even though they had participated in approving the transaction

217 Puma, 283 A.2d at 695.218 Id. at 696.219 See supra text accompanying note 210.220 See also Cohen v. Ayers, 596 F.2d 733, 739-40 (7th Cir. 1979) (approval by disinterested

members of the board following full disclosure reinstates business judgment rule); Beard v. Elster, 39Del. Ch. 153, 164-65, 160 A.2d 731, 738 (Sup. Ct. 1960) (board of directors' business judgment inapproving stock option plan entitled to utmost consideration despite fact that two members of theboard received options under the plan); ALI CORPORATE GOVERNANCE PRINCIPLES, supra note151, § 5.09(a)(2)(A) (applying business judgment rule to decisions by disinterested directors regard-ing compensation of fellow directors and other senior executives); cf. id. § 5.08(a)(2)(A) (upholdingself-dealing transactions generally, when authorized by disinterested directors following full disclo-sure, unless the directors "could not reasonably have believed the transaction to be fair to the corpo-ration"). The comments accompanying § 5.08(a)(2)(A) indicate that this standard is intended toembrace judicial scrutiny that is more intense than the business judgment rule, but less rigorous thanthe fairness test; the standard seeks to establish a "range of reasonableness" test. Id. comment to§ 5.08(a)(2)(A), at 119.

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and are named as defendants-the plaintiff is required to make a demandupon the board prior to commencing suit.221 Thus, these decisionswould have required that Puma first refer the matter to the very outsidedirectors whose valuations he was challenging. And if, following thatdemand, those directors conclude that the suit is unwarranted-a notunlikely possibility given that they have already expressed their approvalof the transaction at issue-many courts hold that their decision not tobring suit is protected by the business judgment rule.222 Finally, evenwhere a majority of the board has a personal interest in the transactionbeing challenged, so that the requirement of pre-suit demand is excused,the board still has the opportunity to assemble a committee of independ-ent directors whose decision to terminate the suit will be reviewed by thecourt. The amount of deference granted by the court varies from juris-diction to jurisdiction.2 23

Are these disinterested directors truly capable of making a fresh andunbiased evaluation? To be sure, the plaintiff is always free to call thecourt's attention to facts suggesting the directors' lack of indepen-

221 Lewis v. Graves, 701 F.2d 245, 248-49 (2d Cir. 1983); In re Kauffman Mut. Fund Actions,

479 F.2d 257, 265-67 (1st Cir.), cert. denied, 414 U.S. 857 (1973); Aronson v. Lewis, 473 A.2d 805,817-18 (Del. 1984). But see Barr v. Wackman, 36 N.Y.2d 371, 379-81, 329 N.E.2d 180, 186-88, 368N.Y.S.2d 497, 505-08 (1975) (allegation that unaffiliated directors allowed affiliated diretors to en-gage in pattern of self-dealing suffices to excuse demand); Buxbaum, Conflict-of-Interests Statutesand the Need for a Demand on Directors in Derivative Actions, 68 CALIF. L. REV. 1122, 1129-30(1980) (arguing that demand should be excused).

222 Abramowitz v. Posner, 672 F.2d 1025, 1030, 1032-34 (2d Cir. 1982); Stein v. Bailey, 531 F.Supp. 684, 693 (S.D.N.Y. 1982); Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984); Zapata Corp. v.Maldonado, 430 A.2d 779, 784 & n.10 (Del. 1981). But see In re Continental Ill. Sec. Litig., 572 F.Supp. 928 (N.D. Ill. 1983); ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, §7.08comment a, at 98 (Discussion Draft No. 1, 1985) (rejecting the demand required/demand excuseddistinction).

223 Compare Auerbach v. Bennett, 47 N.Y.2d 619, 393 N.E.2d 994, 419 N.Y.S.2d 920 (1979)(independent board committee's decision is protected by the business judgment rule) with Joy v.North, 692 F.2d 880, 887-93 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983), and Zapata Corp. v.Maldonado, 430 A.2d 779, 789 (Del. 1981) (court may apply its own business judgment in evaluat-ing committee's decision). But see AM. LAW. INST., PRINCIPLES OF CORPORATE GOVERNANCE

AND STRUCTURE: RESTATEMENT AND RECOMMENDATIONS § 7.03(c)(iii) (Tent. Draft No. 1,1982) [hereinafter cited as AM. LAW INST.] (denying the committee power to seek dismissal ofderivative suits challenging transactions between corporations and their controlling persons); cf. ALICORPORATE GOVERNANCE PRINCIPLES, supra note 151, § 7.08(e) (Discussion Draft No. 1, 1985)(dismissal of derivative suit against controlling persons prohibited if they are permitted to retainimproper benefits). Some courts have held, however, that directors who are parties to the derivativesuit may not create a special litigation committee empowered to bind the corporation. Miller v.Register & Tribune Syndicate, Inc., 336 N.W.2d 709, 718 (Iowa 1983); Alford v. Shaw, 72 N.C.App. 537, 324 S.E.2d 878, 886-87 (1985). The most recent draft of the American Law Institute'sPRINCIPLES OF CORPORATE GOVERNANCE purports to take a "position intermediate betweenZapata, on the one hand, and Miller and Alford, on the other." ALI CORPORATE GOVERNANCE

PRINCIPLES, supra note 151, § 7.08 comment a, at 98 (Discussion Draft No. 1, 1985).



dence.224 If a lack of independence is established, the business judgmentrule deference will no longer be allowed.225 Commentators have argued,however, that this view is overly narrow and ignores the inherent "struc-tural bias" 226 that exists whenever the independent directors are calledupon to pass judgment on their insider colleagues,227 and that as a result,judicial deference is, on the whole, inappropriate.228

To examine the potential for such structural bias, let us consider thePuma case again. First, of the five outside directors, at least two of

224 For example, the court's willingness to defer to the valuations set by the independent directors

in Puma v. Marriott was premised on its observation thatExcept to point out that the Marriott Group owned some 46% of the Marriott stock plaintiffhere has utterly failed to make any showing of domination of the outside directors. No attemptwas made to impugn the integrity or good faith of these directors, all of whom were men ofexperience in the business and financial world. There is no testimony which even tends to showthat the terms of the transaction were dictated by the Marriott Group or any member thereof.

283 A.2d at 695.225 Some courts have imposed a fairly strenuous burden on the plaintiff in this regard and re-

quired allegations of specific facts demonstrating that, through personal or other relationships, thedirectors are subject to the domination and control of the interested parties. See, eg., Kaster v.Modification Sys., Inc., 731 F.2d 1014, 1018-20 (2d Cir. 1984) (facts that defendant owned 71% ofcorporation's voting stock and nominated all but one director do not by themselves excuse demand);Aronson v. Lewis, 473 A.2d 805, 815-17 (Del. 1984) (allegations that defendant owned 47% ofcorporation's stock and personally selected each director do not excuse demand). Other courts havebeen willing to assume domination more readily. See, eg., Clark v. Lomas & Nettleton Fin. Corp.,625 F.2d 49, 52-54 (5th Cir. 1980), cert. denied, 450 U.S. 1029 (1981) (court set aside settlement ofderivative action approved by nonparty directors on the grounds that defendants in action owned,collectively, a majority of the corporation's stock and that a majority of the directors were insidersand therefore stood to lose their jobs as well as their directorships). See generally AM. LAW INST.,supra note 223, § 1.15 & comment (criteria for determining whether officers and directors are"interested").

226 Note, The Business Judgment Rule in Derivative Suits Against Directors, 65 CORNELL L. REV.600, 601 (1980). The term has begun to gain acceptance in the case law. See, e.g., Clark v. Lomas &Nettleton Fin. Corp., 625 F.2d 49, 53 (5th Cir. 1980), cert. denied, 450 U.S. 1029 (1981); Aronson v.Lewis, 473 A.2d 805, 815 n.8 (Del. 1984); Miller v. Register & Tribune Syndicate, Inc., 336 N.W.2d709, 716 (Iowa 1983).

227 For general discussions of the factors that inhibit the outside directors' capacity to carry onforceful oversight, see E. HERMAN, CORPORATE CONTROL, CORPORATE POWER 30-48 (1981);

Brudney, supra note 210, at 607-31; Cox & Munsinger, Bias in the Boardroom: Psychological Foun-dations and Legal Implications of Corporate Cohesion, LAW & CONTEMP. PROBS., Summer 1985, at83, 85-108; Solomon, Restructuring the Corporate Board of Directors: Fond Hope-Faint Promise?,76 MIcH L. REV. 581, 583-86 (1978).

228 See, eg., Brudney, supra note 210, at 622-31; Coffee & Schwartz, The Survival of the Deriva-tive Suit: An Evaluation and a Proposal for Legislative Reform, 81 COLUM. L.REv. 261, 283-84 &nn.124-26 (1981); Cox & Munsinger, supra note 227, at 131-34; Dent, The Power of Directors toTerminate Shareholder Litigation: The Death of the Derivative Suit?, 75 Nw. U.L. REv. 96, 111-17(1980); Scott, supra note 70, at 944-45; Weiss, supra note 208, at 20-21; Note, The Propriety ofJudicial Deference to Corporate Boards of Directors, 96 HARV. L.REv. 1893 (1983) [hereinafter citedas Note, Judicial Deference]; Note, supra note 226. See also Lasker v. Burks, 567 F.2d 1208, 1212(2d Cir. 1978), rev'd, 441 U.S. 471 (1979) ("It is asking too much of human nature to expect that thedisinterested directors will view with the necessary objectivity the actions of their colleagues in asituation where an adverse decision would be likely to result in considerable expense and liability forthe individuals concerned.") (footnote omitted).



them-lawyer Whiteford and investment banker Johnston-were suppli-ers of services to the corporation,229 and thus potentially dependent onthe favor of its management as a source of business. 23 0 Moreover, we aretold by the court that all of the outside directors "were prominent inlegal, financial or business affairs in and about the City of Washington,D.C. [Marriott Corporation's headquarters], ' 23

1 a fact suggesting a net-work of professional and social relationships among board members notlikely to foster independence. 232 More fundamentally, we can expectthat none of the five would have been selected to the board in the firstplace had they not met with the Marriott family's approval and that thecontinuation of that approval was critical to their tenure.23 3 All of this isnot to imply that the outside directors exercised other than the best offaith in approving the valuations; it is simply to recognize the existence offactors that would likely lead the reasonable person to favor pleasing theMarriotts over displeasing them. Add to this the nature of what the out-siders were called upon to do. They were not, after all, negotiating withthe Marriotts after having shopped around for the best deal; rather, theirtask was to arrive at the "fair" price for a transaction that waspredestined. Thus deprived of the opportunity for the strategy andgamesmanship that is characteristic of arm's-length dealing, their workcannot be a realistic substitute for arm's-length dealing, no matter howindependent they happen to be.234

If the existence of structural bias calls into question the propriety ofjudicial deference to judgments of outside directors, the case for relying

229 See supra note 216.230 For recognitions of the threats to independence when outside directors have significant busi-

ness dealings with the corporation, see M. EISENBERG, THE STRUCTURE OF THE CORPORATION 146(1976); Leech & Mundheim, The Outside Director of the Publicly Held Corporation, 31 Bus. LAW.1799, 1830-31 (1976); A.B.A. Corporate Director's Guidebook, supra note 40, at 1620.

231 Puma v. Marriott, 283 A.2d 693, 694 (Del. Ch. 1971).232 Commentators have discussed how the existence of such relationships contributes to similarity

in outlook, a general posture of friendliness among board members, and group cohesiveness, all ofwhich may undercut the rigor of intragroup evaluation. See E. HERMAN, supra note 227, at 41, 43-44; M. MACE, DIRECTORS: MYTH AND REALITY 97-100, 108, 195-96 (1971); Brudney, supra note210, at 612-13; Cox & Munsinger, supra note 227, at 105-07; Dent, supra note 228, at 112; Solomon,supra note 227, at 584-85; Note, supra note 228, at 1899-1901.

233 For analogous discussions of the C.E.O.'s control over the selection and retention of board

members and the resulting disincentives to independence, see M. EISENBERG, supra note 230, at 146-47, 176-77; E. HERMAN, supra note 227, at 31, 33-34; M. MACE, supra note 232, at 94-95; Brudney,supra note 210, at 610 n.39; Cox & Munsinger, supra note 227, at 97-98. But see Haft, BusinessDecisions by the New Board: Behavioral Science and Corporation Law, 80 MICH. L. REV. 1, 21-22(1981) (unrealistic that outside directors will be beholden to C.E.O. for their nomination).

234 See Remarks by S.E.C. Commissioner Stephen J. Friedman, "How Much Can We Expect

from Independent Directors?," delivered to ALI-ABA Conf. on Investment Co. Regulation, at 4-5(Dec. 12, 1980) (discussing requirement that independent directors approve mutual fund advisoryfees and noting that the practical inability of these directors to terminate the arrangement necessarilyaffects the bargaining positions of both sides, so that it is unrealistic to think that the independenceof the directors will produce the same result as an arm's-length negotiation).



upon shareholder approval as a meaningful litmus test of substantivefairness seems, if anything, weaker. The combination of management'scontrol over the proxy solicitation process and the disinclination of thesmall-stakes shareholder to spend much time reflecting on how to votehas given rise to a situation whereby shareholders appear to approve al-most anything that management presents to them.2 35 Nonetheless, thecourts adhere to the belief that "the entire atmosphere is freshened...where formal approval has been given by a majority of independent, fullyinformed stockholders. 23 6 Thus, courts hold that shareholder ratifica-tion shifts the burden of proof to the person attacking the transaction todemonstrate that its terms represent waste, 237 a rule that, like deferenceto disinterested directors, has drawn criticism from commentators.238

In light of these criticisms, why have the courts continued to deferto intracorporate decisionmaking processes invoked by the self-interestedcontrolling parties? The weakness in much of the structural bias com-

235 For discussions of the absence of meaningful shareholder participation through proxy voting,

see Easterbrook & Fischel, Voting in Corporate Law, 26 J. L. & ECON. 395, 396, 402-03, 418, 419-20(1983); Hetherington, Fact and Legal Theory: Shareholders, Managers, and Corporate Social Re-sponsibility, 21 STAN. L. REV. 248, 250-55 (1969); Manning, Book Review, 67 YALE L.J. 1477,1483-88 (1958); see also SEC Div. CORP. FIN., STAFF REPORT ON CORPORATE ACCOUNTABILrrY66 (Comm. Print 1980) ("The majority of commentators expressed the view that shareholders havelittle interest in participating in corporate governance-they are interested primarily in the economicperformance of their corporation.") (footnote omitted). The shareholder response to shark repellentmeasures proposed by management provides some evidence of the disinclination of individual share-holders (as opposed to institutional investors) to vote contrary to management even when it is intheir economic interests to do so. See 17 SEC. REG. & L. REP. (BNA) 1960 (Nov. 8, 1985) (study byInvestor Responsibility Research Center finding that of 450 antitakeover amendments submitted toshareholders in first nine months of 1985, only 19 were defeated); id. at 1829 (Oct. 18, 1985) (studyby SEC's Office of the Chief Economist finding that adoption of antitakeover provisions--other than"fair price" amendments-depressed stock prices by average of 3%, and that most harmful provi-sions were adopted by corporations with low institutional holdings); Williams, Investors Vote on Bidsto Fight Hostile Suitors, Wall St. J., Mar. 28, 1985, at 33, col. 3 (of 372 antitakeover resolutionsproposed by management in 1984, only 17 were rejected).

236 Gottlieb v. Heyden Chem. Corp., 33 Del. Ch. 177, 180, 91 A.2d 57, 59 (Sup. Ct. 1952).237 Michelson v. Duncan, 407 A.2d 211, 224-25 (Del. 1979); Gottlieb v. Heyden Chemical Corp.,

33 Del. Ch. 177, 179-80, 91 A.2d 57, 58-59 (Sup. Ct. 1952); Aronoff v. Albanese, 85 A.D.2d 3, 446N.Y.S.2d 368 (1982); ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, § 5.08(a)(2)(B).

238 See, eg., Chasen, Fairness From a Financial Point of View in Acquisitions of Public Companies:Is "Third-Party Sale Value" the Appropriate Standard?, 36 Bus. LAW. 1439, 1474-76 (1981) (ap-proval by public shareholders of acquisition by controlling party); Scott, supra note 70, at 945;Weiss, The Law of Takeout Mergers: A Historial Perspective, 56 N.Y.U. L. REV. 624,676-77 (1981);Weiss, supra note 208, at 21. The experience with mutual fund advisory fees is relevant here. Inresponse to state court decisions holding that the more-or-less perfunctory periodic ratification of thefee arrangement by fund shareholders meant that fundholders challenging the arrangement mustprove waste, see, eg., Saxe v. Brady, 40 Del. Ch. 474, 184 A.2d 602 (Ch. 1962), Congress, at thebehest of the SEC, amended the Investment Company Act in 1970 to include an express federalremedy for contesting the fee. By the terms of that remedy, the court is to give the fact of share-holder approval "such consideration ... as is deemed appropriate under all the circumstances." 15U.S.C. § 80a-35(b)(2) (1982). See Rogers & Benedict, Money Market Fund Mangement Fees: HowMuch Is Too Much?, 57 N.Y.U. L. REV. 1059, 1086-89 (1982).



mentary is the absence of an "as compared to what?" inquiry. Disinter-ested directors or shareholders might not be a true substitute for arm's-length bargaining, but the fact of the matter is that no substitute is avail-able. The only readily apparent alternative to the criticized deference isfull-blown adjudication of substantive fairness, and we have seen that thisposes problems of its own. Thus, perhaps the core reason underlying thewillingness of courts to defer is not so much a misguided faith in thedecisionmaking facilities of disinterested directors or shareholders, but ahealthy respect for the courts' own limitations. 239

Let us consider this in light of the analysis developed in section IV.Subjecting the transaction to an ad hoc fairness review in the absence ofan established market necessarily creates the risk of some Type I andType II errors. Where the conflict of interest is by its nature inevitable-and most of the deference cases involve these kinds of conflicts-theType II error will end up being borne by the fiduciary.240 The fiduciarycan seek ex ante compensation for this error, but, as a full-time corporateexecutive with little opportunity to diversify regarding the subject matterof the transaction, he or she will demand a risk premium as well. Thiswas illustrated in the C.E.O. compensation hypothetical, 241 where wesaw that the certainty attained by substituting a bright-line standard forad hoc fairness review created value in and of itself, because of both theprincipal's risk aversion and the avoidance of litigation costs.

In effect, the creation of this certainty expanded the total pie avail-able to the principal and the fiduciary. Obtaining advance clearance for

239 Cf. Vagts, supra note 20, at 268-69:

Since judging the reasonableness of executive compensation is too imponderable or specializedfor them to handle, the courts tend to defer to established corporate mechanisms. Throughthese mechanisms, the courts hope to purify the process without involving themselves in thedecisions.

W When the board of directors consists of outside members, the courts feel that they canrely upon the disinterested business judgment of that body in remuneration matters. Indeed,they breathe an almost audible sigh of relief when turning the question over to the board.

See also Remarks by SEC Commissioner Stephen J. Friedman, supra note 234:[I]f there are indeed limitations to what we, can expect from the negotiations because of theinability of the board to take the ultimate step and seek a new adviser [see supra note 234], thenthe fact that the shareholders can sue both the directors and the adviser for breach of fiduciaryduty is not much comfort. There is no reason to think that a court, or a jury, will arrive at a feethat is fair under the circumstances.

Id. at 5.240 The fiduciary bears this error because, given the inevitability of the conflict of interest, she is

not free to walk away. See supra text accompanying note 96 & notes 208-10. Where the conflict ofinterest is not inevitable, however, the fiduciary may always avoid the costs of Type II error bydealing with third parties instead of her principal. In view of this possibility, the costs of holding thefiduciary to a strict standard are not nearly as substantial as they are where the conflict is unavoida-ble, and the case for judicial deference to intracorporate decisionmakers is therefore much weaker.Cf. Brudney, supra note 210, at 626-29 (advocating per se prohibitions but recognizing that manyself-dealing transactions are unavoidable and therefore cannot be solved by a categorical rule); supra,text accompanying note 132 (appropriateness of per se prohibitions where market alternatives exist).




the transaction from disinterested directors or shareholders, provided thecourt honors it, is simply an alternative means to deliver this certainty.242

In theory, therefore, this procedure should lead the C.E.O. to settle for alower expected salary, since he or she is immune from the riskiness ofchallenge. 243 The problem, of course, is that once the immunity fromchallenge is granted, the C.E.O.'s opportunism may lead him or her toexploit whatever structural bias exists and press for much more. As aresult, even though the total pie is larger, the shareholders get stuck witha smaller piece. But so long as the shareholders-who are in the idealposition to diversify against error-foresee this increased risk of Type Ierror, they can adjust ex ante by reducing what they pay for their shares.Given the bounded rationality problem, 244 however, calculating theamount of this adjustment will be difficult if the C.E.O. is now truly freeto do as he or she pleases.

This suggests that the contribution that may realistically be ex-pected from the combination of disinterested intracorporate decision-making and judicial review is not eliminating the risk of opportunismaltogether, but simply holding it within tolerable bounds, so that it maybe adequately estimated ex ante. The structural bias problems associatedwith independent directors may assure some regular risk of Type I error,but the interest of those directors in preserving their professional reputa-tions and their personal self-esteem should suffice to keep them from giv-ing away the store. A similar holding-within-tolerable-bounds role maybe played in the case of shareholder approval by the requirement that the

242 The discussion in the text suggests that judicial deference is not as critical where the directors

or shareholders are evaluating the fiduciary's conduct after the fact, as in the decision whether todismiss a pending derivative suit, as opposed to authorizing the conduct before the fact, as in thePuma case. In the case of after-the-fact review, there is no certainty at the time of the transaction inany event. Assuming the intracorporate decisionmaker is truly independent, its reaction to thetransaction will be unknown at that time. Thus, the marginal contribution to be made to overallcertainty by judicial deference to its ultimate decision is not as great. But this is only a question ofdegree. To the extent that the corporate fiduciary has a clearer idea of what will pass muster withthe board or the shareholders than of what will be upheld by the courts, certainty is increased (and,correspondingly, risk is reduced) by judicial deference to the decision of the directors or the share-holders even when their review comes after the fact. On the other side of the balance, though, therisk of structural bias may be greater with after-the-fact review than with before-the-fact authoriza-tion, because the intracorporate decisionmaker is presented with a fait accompli. See Buxbaum,supra note 221, at 1125, 1127-28; ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151,comment to § 5.08(a)(2)(A) at 120-22. The track record of special litigation committees in exculpat-ing corporate management in derivative suits, see, eg., id. § 7.08 Reporter's Note 3, at 123-24 (Dis-cussion Draft No. 1, 1985); Cox & Munsinger, supra note 227, at 85, 103 n.97, suggests thatmanagement is reasonably astute at conforming its conduct to the norms that ultimately are appliedby the committee's members, or that structural bias problems flaw the committee's decisionmakingprocess, or some combination of the two.

243 For example, we saw that for the C.E.O. in the illustration in subsection IV.G., a salary of

$350,000, if protected from challenge, might be as attractive as a nominal salary of $500,000 if thathigher figure is subject to ad hoc fairness review. See supra text accompanying note 114.


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details of the transaction be put on public display in the proxy statement.Consistent with this view, courts need not abdicate altogether. But theirfocus should be on the quality of the intracorporate decisionmaking pro-cess, not its output. So long as the process meets the pre-established min-imum necessary for due consideration-in terms of truly disinteresteddirectors, adequate deliberation, plausible justifications for the decision,full disclosure to shareholders, and so forth-safe-harboring is appropri-ate. Were the courts to go further and substitute their own judgmentconcerning the wisdom and propriety of the result, the corporation'spower to confer valuable certainty would be eroded, and the size of thetotal pie available to both shareholders and management diminished.

In evaluating the capacity of the ex ante adjustment process to dealwith the risk of Type I error that results from this deference, it is impor-tant to recognize that challenges to self-dealing involving individual fidu-ciaries within the corporation (as opposed to self-dealing involving largerentities, as in the case of parent-subsidiary mergers) do not typically in-volve much money in relation to the corporation's resources on thewhole.245 Consider, for example, the controversy at the heart of theZapata Corporation litigation, which to date has produced eleven re-ported decisions in its various trips through the federal and Delawarecourts.246 The cases involve the decision by Zapata's board of directorsto accelerate the exercise date of stock options granted to Flynn(Zapata's C.E.O.) and other senior executives, four of whom were alsodirectors. 247 The arrangement was approved at a meeting attended onlyby Flynn and Zapata's four nonmanagement directors, with Flynn ab-staining from the vote. The objective was to permit the options to beexercised before the announcement of a Zapata tender offer that was ex-

245 See Coffee & Schwartz, supra note 228, at 304-05. The first tentative draft of the American

Law Institute's PRINCIPLES OF CORPORATE GOVERNANCE, in stating the case for a monitoringmodel of the board of directors, had observed: "Market mechanisms, even if they were fully effectivein holding corporate management accountable for efficiency, are unlikely to be effective in regulatingsuch matters as managerial conflicts of interest, since many self-interested transactions are not suffi-ciently material in dollar terms to have significant impact on share prices." AM. LAW INST., supranote 223, § 3.02 comment c, at 62. This prompted Professor Fischel to respond: "This statement isnonsensical. If the only situation in which market mechanisms do not hold managers fully 'account-able' is the situation in which no significant impact on share prices occurs, why worry?" Fischel,supra note 8, at 1288 n.103.

246 Maldonado v. Flynn, 448 F. Supp. 1032 (S.D.N.Y. 1978), aJf'd in part, rev'd in part, 597 F.2d789 (2d Cir. 1979), on remand, 477 F. Supp. 1007 (S.D.N.Y. 1979), petition for mandamus deniedsub nom. In re Maldonado, No. 79-3072 (2d Cir. Oct. 12, 1979); Maldanado v. Flynn, 485 F. Supp.274 (S.D.N.Y. 1980) (corporation's motion for summary judgment granted), rev'd in part, 671 F.2d729 (2d Cir. 1982), on remand, 573 F. Supp. 684 (S.D.N.Y. 1983) (action dismissed); Maher v.Zapata Corp., 490 F. Supp. 348 (S.D. Tex. 1980); 714 F.2d 436 (5th Cir. 1983) (approval of settl-ment affirmed); Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch. 1980), rev'd sub nom. Zapata Corp. v.Maldonado, 430 A.2d 779 (Del. 1981); 417 A.2d 378 (Del. Ch. 1980); action dismissed, (Del. Ch.Civil Action No. 4800, order filed Dec. 14, 1983).

247 The facts in the text are taken from Maher v. Zapata Corp., 714 F.2d 436 (5th Cir. 1983),which contains the most detailed statement of the facts of any of the opinions.



pected to produce a substantial increase in the market price of Zapata'sstock. Allowing the executives to exercise the options at the lower, pre-tender offer price reduced the "bargain spread" that would be taxable, asordinary income, to them upon exercise, and deductible by the corpora-tion. It was this approximately $115,000 reduction in the corporation'sdeduction, which amounted to a little more than one cent per share,2 48

together with the board's grant of interest-free loans to the executives tofacilitate the exercise of the options, that caused the litigation.

Thus, given the relatively small amounts typically at issue in thesecases, the demands upon the ex ante adjustment process are not greatand the compensation necessary to correct for the risks of Type I errorwill often be trivial. 249

In addition to illustrating the trivial amount at stake in many casesof this sort, the Zapata cases show the difficulty inherent in a court de-ciding whether the arrangement is fair. Clearly, accelerating the optionsconferred a benefit upon the executives at the expense of the corporation,but how is the court to determine whether an independent, arm's-lengthdecisionmaker would have acted comparably?

4. Bargained-for Opportunism.-As we have seen,250 the businessjudgment rule represents the courts' willingness to defer in wholesalefashion to management's discretion on questions of business policy, and,as such, the rule has been widely applauded.251 Courts and commenta-tors see the rule as recognizing the courts' limitations in decidingwhether a particular business decision was "right" 252 and as promotingmanagerial creativity and risk-taking by removing the risk of liability fordecisions that turn out poorly.253 Further, and consistent with the analy-

248 Id. at 441. The $115,000 reduction amounted to little more than one cent per share because

Zapata had 10.6 million shares outstanding. Id. at 438.249 It is important, however, to distinguish between what might be thought of as the direct and

the indirect costs of Type I error in matters such as senior executive compensation and perquisites.The direct costs-as measured by the difference between the amount of such compensation upheldby a committee of independent directors or the shareholders and the arm's-length value of the execu-tive's services-may typically be trivial in relation to the value of the firm, but may also give rise toindirect costs that are not. For example, the desire to assure the continued existence of this above-market benefit may contribute to the executive's propensity to manage the firm in an overly con-servative manner or to resist a beneficial takeover, all at a tangible loss to shareholders. The opera-tion of the ex ante adjustment process as it relates to management's protection of its job tenure isdiscussed infra at notes 271-87 and accompanying text.

250 See supra notes 188-93 and accompanying text.251 See, eg., Gilson, supra note 19, at 823 ("The courts' abdication of regulatory authority

through the business judgment rule may well be the most significant common law contribution tocorporate governance.").

252 See, eg., Auerbach v. Bennett, 47 N.Y.2d 619, 630, 393 N.E.2d 994, 1000, 419 N.Y.S.2d 920,926 (1979) (quoted supra note 204); STATEMENT OF THE BUSINESS ROUNDTABLE ON THE AMERI-CAN LAW INSTITUTE'S PROPOSED "PRINCIPLES OF CORPORATE GOVERNANCE AND STRUCTURE:RESTATEMENT AND RECOMMENDATIONS" 50 & n.156 (Feb. 1983) (citing various authori-

ties)[hereinafter cited as BUSINESS ROUNDTABLE STATEMENT).253 See, eg., Joy v. North, 692 F.2d 880, 886 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983);

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sis in the preceding subsection, shareholders are in the better position todiversify against the risks of such adversity.254 Finally, in terms of mana-gerial incentives, the need for legal intervention is displaced by the exist-ence of a variety of market mechanisms, such as the managerial labormarket, the market for corporate control, and incentive-based compensa-tion, that work to align management's self-interest with that of the share-holders. 255 The clear exception to this general alignment is wheremanagement has a direct personal stake in the transaction at issue, inwhich case the protection of the business judgment rule is denied.2 56

The foregoing explanation of the rule seems, at present, almost uni-versally accepted and not at all controversial. But added to it must beour recognition that business operating decisions necessarily invoke ques-tions of opportunism even where management has no direct financialstake in the transaction. These are the milder forms of opportunism suchas shirking, job tenure, and sphere-of-influence, referred to in sectionII.A..257 Necessarily, when the business judgment rule is extended acrossthe board to managerial decisionmaking, it protects from review not onlybona fide disputes over optimal business policy but also management'sfreedom to engage in these mild forms of opportunistic behavior.258 As aresult, shareholders are left to obtain appropriate compensation for thisopportunism ex ante. Assuming management's proclivities for theseforms of conduct do not change over time, this is not a troublesome task,since these proclivities will be reflected in the financial information re-garding management's past performance. In the case of public corpora-tions, this information is readily available and will be the basis for mostinvestment decisionmaking in any event. Thus, the results of manage-ment's business policy and tastes for mild opportunism blend together,and the securities markets work to price them as a unitary package.

We see a comparable phenomenon in the close corporation. The ma-jority shareholders elect directors who, in the exercise of their independ-ent business judgment, invariably hire representatives of the majority torun the corporation, and the law shows no concern.259 As a result, mi-

ALI CORPORATE GOVERNANCE PRINCIPLES, supra note 151, introductory note, at 2; BUSINESSROUNDTABLE STATEMENT, supra note 252, at 34; Demsetz, The Monitoring of Management, in id.,at B-1 to B-2.

254 See, e.g., Scott, supra note 70, at 936.255 See, e.g., Anderson, supra note 6, at 784-87; Fischel, supra note 8, at 1288; Gilson, supra note

19, at 837-39; Hetherington, supra note 235, at 266-72; Werner, Management, Stock Market andCorporate Reform: Berle and Means Reconsidered, 77 COLUM. L. REV. 388 (1977); Bennett, MoreManagers Find Salary, Bonus Are Tied Directly to Performance, Wall St. J., Feb. 28, 1986, at 27, col.5.

256 See supra text accompanying note 194; ALI CORPORATE GOVERNANCE PRINCIPLES, supranote 151, § 4.01(d)(2).

257 See supra notes 19-21 and accompanying text.258 See Anderson, supra note 6, at 783; Brudney, supra note 210, at 629 n.83.259 See, e.g., McQuade v. Stoneham, 263 N.Y. 323, 336, 189 N.E. 234, 239 (1934) (Lehman, J.,

dissenting) ("The theory that directors exercise in all matters an independent judgment in practice



nority interests command a lower price per share than controlling inter-ests. We might refer to this as a "control premium" but it amounts tobargained-for opportunism. The reason for tolerating bargained-for op-portunism in these situations is, no doubt, that it is easier to compensatefor these milder and ongoing forms of opportunism ex ante than to filterthem out from good-faith decisions of business policy ex post.260

From this perspective, let us examine situations in which the risk ofopportunism is more blatant, but the courts have nonetheless applied thebusiness judgment rule to safe harbor the transaction at issue. Consider,for example, the parent-subsidiary cases. In Getty Oil Co. v. Skelly OilCo.,261 the Delaware Supreme Court held that the parent's decision notto share any of its oil import quota with its 71%-owned subsidiary,which had lost its own quota when acquired by the parent, was protectedby the business judgment rule. The same protection was extended to theparent's decision in Sinclar Oil Corp. v. Levien 262 to cause its 97%-ownedVenezuelan subsidiary (Sinven) to pay dividends well in excess of itsearnings during a seven-year period in which the parent was in need ofcash, thereby foreclosing Sinven from expanding. In both cases, thecourt of chancery had held that the parent's clear domination of the sub-sidiary required that it carry the burden of proving the dealings werefair.263

To the extent that the Delaware Supreme Court's decisions rest onthe assumption-contrary to the view held by the chancery court-thatthe officers and directors of the subsidiaries were acting solely in the sub-sidiaries' interests, notwithstanding their being under the parents' con-trol, its approach seems misguided. 264 But an alternative explanation forthe difference in the two courts' decisions is a disagreement over the com-parative merit of ex ante adjustment versus ex post judicial review in lightof the inherent indeterminacy of the issues the courts were being calledupon to decide: How would Getty and Skelly have allocated the quotahad they been bargaining at arm's length? How much of a dividendwould Sinven have paid had it been independent? Lacking the resources

often yields to the fact that the choice of directors lies with the majority stockholders and thus givesthe stockholders a very effective control of the action by the board of directors.").

260 This is an application of our earlier examination of the comparative advantages of ex ante

adjustment over ex post settling up where the following conditions are satisfied: reliable past per-formance data on the fiduciary's conduct are available; the principal has the sophistication to evalu-ate the data; the principal is in a better position than the fiduciary to diversify against the risk oferror; and the form of opportunism at issue is mundane and ongoing. See supra subsection IY.E.

261 267 A.2d 883, 886-87 (Del. 1970).262 280 A.2d 717 (Del. 1971).263 Levien v. Sinclar Oil Corp., 261 A.2d 911 (Del. Ch. 1969), rev'd, 280 A.2d 717 (Del. 1971);

Getty Oil Co. v. Skelly Oil Co., 255 A.2d 717 (Del. Ch. 1969), rev'd, 267 A.2d 883 (Del. 1970).264 Professor Cary criticized the two Delaware Supreme Court decisions as a part of his general

attack on Delaware's failure to protect shareholder rights. Cary, supra note 173, at 679-83. See alsoE. FOLK, THE DELAWARE GENERAL CORPORATON LAW 77-81 (1972).

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to answer these questions with any measure of precision, the supremecourt's approach was to decline the invitation and leave the parties tofend for themselves ex ante. Thus, prospective Sinven shareholdersshould view what they are buying not as an interest in an independent oilcompany, but rather, as an interest in one part of the overall Sinclairnetwork, and they should price the shares accordingly. 265

Throughout the earlier sections of this Article, we have seen, how-ever, that leaving the principal to cope ex ante with the risk of the fiduci-ary's unmitigated opportunism poses various problems. Let us considertwo of them here: bounded rationality2 66 and the fact that fiduciarieswho desire not to take full advantage of this freedom to be opportunisticmust incur the expense of bonding or pay an ex ante discount plus a riskpremium.267 Necessarily, significant bounded rationality problems arecreated by requiring the subsidiary's minority shareholders to predict thefull range of the parent's opportunistic conduct. But where the issues aresuch that the outcome of any judicial fairness inquiry is inherently specu-lative, as in the Sinclair and Getty cases, these problems will exist in anyevent. It may be easier, when all is said and done, for the minority share-holders to predict the costs of the parent's unbridled opportunism withinthe business judgment rule safe harbor than to predict those costs as re-duced ex post by the possible application of an indeterminate fairnessstandard. In other words, the addition of an ad hoe fairness reviewwould, under the circumstances, only make the minority shareholders'position riskier. On the other hand, on issues where there would bewidespread consensus on how a hypothetical independent subsidiarywould act-that is, where the risk of error is slight-a court may be morewilling to intervene, because its outcome is more predictable ex ante.Thus, in the Sinclair case, the Delaware Supreme Court held thatSinven's willingness to tolerate repeated breaches of contract in its deal-ings with another Sinclair-controlled subsidiary should be tested by thefairness standard rather than the business judgment rule, and as thustested, it was found not permissible.268

The other problem created by safe-harbored opportunism-the re-sulting need for more scrupulous fiduciaries to incur the expense of bond-ing themselves-is troublesome only if a significant number of fiduciarieswould prefer not to take full advantage of the safe harbor. But perhapsthe very factors that make the outcome of judicial review indetermi-

265 See Weiss, supra note 208, at 26 ("If investors in a controlled subsidiary are on notice that the

parent's transactions with the subsidiary will not be reviewed under the proposed duty of loyaltyrules, they can protect themselves by discounting the price they will pay for the subsidiary's stock.");Note, Corporate Fiduciary Doctrine in the Context of Parent-Subsidiary Relations, 74 YALE L.J. 338,349-53 (1964) (advocating a test based on the reasonable expectations of persons in the position ofthe minority shareholder).

266 See supra text accompanying notes 44-45.267 See supra subsection II.B.268 Sinclair, 280 A.2d at 723.



nate-such as the discretionary nature of the activity and the nonavaila-bility of market substitutes-suggest that the flexibility to act freelywithin the safe harbor is something most fiduciaries would find valuable.For example, to Sinclair, the right to operate its various worldwide sub-sidiaries as part of an integrated network, free from judicial oversight,may be worth far more than the increased price it might receive for thesubsidiaries' shares if it could somehow assure investors that each subsid-iary would be managed independently. In these circumstances, thecourt's use of the business judgment rule to delineate a permissible zoneof opportunism may be seen as an attempt to rewrite the standard-formfiduciary contract 269 in situations where the fiduciary would likely find itworthwhile (absent problems of transactions costs) to bargain with theprincipal for a carved-out right to be opportunistic. 270

269 See supra text accompanying note 73.

270 The discussion in the text assumes that the shareholder enters the relationship on notice of the

special risk of opportunism, as would be the case where an investor buys Sinven stock with theknowledge of Sinclair's 97% ownership. The problem posed by the parent-subsidiary cases is how todeal with investors who bought their shares before the control relationship was created. One re-sponse is to say that these investors assumed the risk of the subsequent control relationship and theresulting increased risk of opportunism when they invested. This would theoretically result in theshares of all corporations being discounted ex ante to reflect the risk that they might become con-trolled subsidiaries down the road, an alternative that is not particularly attractive given thebounded rationality problems involved in assessing this risk and the risk aversion of some investorswho may not be in a position to diversify their holdings. See Levmore, supra note 27, at 78 n.153;Weiss, supra note 208, at 26 n.114. Nonetheless, it is one possibility. A number of other possiblesolutions represent efforts to compensate the minority shareholder at the time the control position iscreated. One approach is that recently adopted by Pennsylvania, based on the British City Code onTake-Overs and Mergers, which requires that the parent offer to buy out all minority interests, at astatutorily defined price, once it acquires 30% of the corporation's voting shares. PA. STAT. ANN.tit. 15, § 1910 (Purdon Supp. 1985); see Newlin & Gilmer, The Pennsylvania Shareholder ProtectionAct, 40 Bus. LAv. 111, 115-16 (1984); see also Weiss, supra rote 208, at 26 (suggesting givingminority appraisal rights). The other possible approach is to permit the minority shareholders toparticipate in any premium paid for the controlling interest to the extent any portion of this pre-mium can be fairly seen as representing payment for an increased risk of opportunism. This is inessence the approach of the leading case of Perlman v. Feldmann, 219 F.2d 173 (2d Cir.), cert.denied, 349 U.S. 952 (1955). Unfortunately, this solution reinstates the need for judicial resolutionof by-and-large indeterminate issues, as the court must value the likely effect of the opportunisticconduct. But at least it is a one-time inquiry as opposed to the ongoing inquiry that results fromholding all dealings between parent and subsidiary to a fairness standard.

Judge Easterbrook and Professor Fischel would presumably respond that the better rule is todeny the minority any portion of the premium. See Easterbrook & Fischel, supra note 8, at 715-19.They justify this position by focusing on the minority shareholder's position ex ante, but their argu-ment is narrower than the assumption-of-risk concept set forth above. Specifically, their analysisviews a control premium as representing newly created gain made possible by the control transac-tion, in which case-unlike the view set forth above-the control transaction leaves the minorityshareholders no worse off, even if they are denied the right to pariticpate in the premium. Indeed,they specifically endorse the proposition that no shareholder should incur a loss in the market valueof his or her holdings as a result of the transaction. Id. at 714-15. Thus, they are not arguing thatminority shareholders should go uncompensated for increases in the risk of opportunism caused bythe control transaction, but instead that the existence of those risks is overstated. Id. at 717-19.



A substantive area that is interesting to explore from this standpointis the freedom of a target company's management to resist a hostile take-over offer. Most of the court decisions to date have protected the discre-tion of the target's board of directors to oppose the offer by applying thebusiness judgment rule and placing the burden on the plaintiff to provethat the directors' sole or primary motive was to retain their control. 271

Given the clear potential for error that would result from the court'sattempting to decide in retrospect which takeovers should have been ac-cepted and which rejected, this deference is understandable. But the re-sponse of numerous commentators, 272 as well as legislators, 273 the WhiteHouse,274 and members and staff of the Securities and Exchange Com-mission,275 who cite the underlying conflict of interest of the target'smanagement in retaining their jobs and of the target's outside directors inretaining their prestigious appointments, is to condemn this approach

271 See, e.g., Treco, Inc. v. Land of Lincoln Say. & Loan, 749 F.2d 374, 376-79 (7th Cir. 1984);

Buffalo Forge Co. v. Ogden Corp., 717 F.2d 757, 759 (2d Cir.), cert denied, 464 U.S. 1018 (1983);Panter v. Marshall Field & Co., 646 F.2d 271, 293-95 (7th Cir.), cert. denied, 454 U.S. 1092 (1981);Treadway Cos. v. Care Corp., 638 F.2d 357, 381-84 (2d Cir. 1980); Crouse-Hinds Co. v. Internorth,Inc., 634 F.2d 690, 701-04 (2d Cir. 1980); Johnson v. Trueblood, 629 F.2d 287, 292-93 (3d Cir.1980), cert. denied, 450 U.S. 999 (1981); Moran v. Household Int'l, Inc., 500 A.2d 1346, 1350 (Del.1985) (upholding "poison pill" plan); Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del.1985) (upholding discriminatory self-tender); Pogostin v. Rice, 480 A.2d 619, 626-27 (Del. 1984)(re-quiring demand on directors). But see Hanson Trust PLC v. ML SCM Acquisition, Inc., 781 F.2d264, 274-77 (2d Cir. 1986) (because directors failed to exercise reasonable diligence, burden shiftedto them to justify fairness of lock-up option); Norlin Corp. v. Rooney, Pace, Inc., 744 F.2d 255, 264-67 (2d Cir. 1984)(management had burden to prove that its attempt to tie up voting control ofcorporation's stock was fair and reasonable); Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.,18 SEC. REG. & L. REP. (BNA) 423, 427-29 (Del. Mar. 13, 1986) (since active competitive biddingfor the target had begun, board's grant of lock-up option was not protected by the business judgmentrule, where one of primary reasons for the option was to obtain concessions for noteholders andthereby reduce directors' potential liability).

272 See, e.g., Easterbrook & Fischel, supra note 19, Gelfond & Sebastian, Reevaluating the Duties

of Target Management in a Hostile Tender Offer, 60 B.U.L. REV. 403 (1980); Gilson, supra note 19;Lynch & Steinberg, The Legitimacy of Defensive Tactics in Tender Offers, 64 CORNELL L. REV. 901(1979); Comment, The Misapplication of the Business Judgment Rule in Contests for Corporate Con-trol, 76 Nw. U.L. REv. 980 (1982).

273 See H.R. 5695, 98th Cong., 2d Sess. (1984), reprinted in Takeover Tactics & Public Policy:

Hearings on H.R. 2371 et. al Before the Subcomm. on Telecommunications, Consumer Protection, &Finance of the House Comm. on Energy & Commerce, 98th Cong., 2d Sess. 227-28 (1984)[hereinaftercited as Takeover Hearings] (proposed legislation placing burden on issuer to prove that any transac-tion affecting or defending against change in control is both prudent for the issuer and fair to theissuer's shareholders); Impact of Corporate Takeovers: Hearings Before the Subcomm. on Securitiesof the Senate Comm. on Banking, Housing & Urban Affairs, 99th Cong., 1st Sess. 127 (1985) (state-ment of subcommittee chairman D'Amato that legislation directed to deal with imbalance in theapplication of the business judgment rule is "long overdue").

274 See 1985 COUNCIL ECON. ADv. ANN. REP. 214-15 (suggesting that "natural evolution of the

case law" will lead courts to apply stricter standards to management's defensive tactics).275 See Takeover Hearings, supra note 273, at 22-23 (statement of SEC Chairman Shad); id. at

352-56 (proposal by former Commissioner Longstreth); 16 SEC. REG. & L. REP. (BNA) 639-40(Apr. 13, 1984) (remarks by Director of SEC's Division of Corporate Finance).



and advocate either restricting the board's discretion or easing the plain-tiff's burden of proof. Those who call for restrictions on discretion are inessence arguing that the risk of error is, on balance, better dealt with by aset of per se prohibitions than by ad hoe review. As seen by Judge Eas-terbrook and Professor Fischel,276 these prohibitions should require tar-get management to remain entirely passive in the face of an outsidetakeover offer; as seen by Professor Gilson 277 and by Lucian Bebchuk,2 78

they should permit management to seek competing offers but forbid anyother form of defensive activity. Others argue, however, that the impor-tance of protecting the board's ability to fight off offers which it finds tobe contrary to the best interests of the corporation and its shareholdersdemands the continued application of the business judgment rule.2 79

They are saying, in other words, that the risks of Type I error created bydeferring to managerial discretion are outweighed by the risks of Type IIerror that would be created by increased judicial intervention or limita-tions on managerial discretion.

Comments by Professors Klein280 and Williamson28 suggest, how-ever, than an important dimension of management's discretion has beenoverlooked in this debate-the existence of an element of bargained-foropportunism. By its reliance on fiduciary ideology, corporate law doc-trine is required to treat management as simply the hired hand of theshareholders; management's sole mission is to act selflessly and single-mindedly to further the interests of shareholders. In reality, of course,

276 Easterbrook & Fischel, supra note 19, at 1201-04.277 Gilson, supra note 19, at 865-81.278 Bebehuk, The Case for Facilitating Competing Tender Offers, 95 HARV. L. REV. 1028, 1050-

56 (1982).279 See, e.g., Herzel, Schmidt & Davis, Why Corporate Directors Have a Right to Resist Tender

Offers, 3 CORP. L. REv. 107 (1980); Lipton, Takeover Bids in the Target's Boardroom, 35 Bus. LAW.101 (1979); Steinbrink, Management's Response to the Takeover Attempt, 28 CASE W. RES. L. REV.

882 (1978); cf. Lowenstein, Pruning Deadwood in Hostile Takeovers: A Proposal for Legislation, 83COLUM. L. REV. 249, 313-34 (1983) (advocating continued application of the business judgment rulebut requiring shareholder approval for certain defensive tactics).

280 See Klein, supra note 19, at 1542-44. Under Professor Klein's view, control over businessdecisionmaking is one of several elements that are subject to negotiation in structuring any businessorganization. The law's traditional model of the business organization is inadequate in the sense thatit treats control as being in the hands of an owner-principal who employs an agent as a hired hand.This ignores the agent's legitimate interest in control, because how that control is exercised willaffect the agent's incentive-based compensation along with the future value of his services. In addi-tion, it ignores the inability of atomized equity holders to exercise control and the ever-present op-portunity to modify control by contract.

281 See Williamson, supra note 40, at 1215-18. Under Professor Williamson's view, the firm iscomprised of various constituencies, including management, labor, shareholders, and customers.Unlike many of these other constituencies, however, management is required to make a firm-specificinvestment of its human capital. As a result, its only means of reaping the full value of this capital isto sell it to the firm. Because management stands to forfeit some of this value if discharged from thefirm, it will contract with the firm for compensation for this risk, in the form of higher salary, orprotection against this risk, through the creation of a specialized "governance structure." One suchgovernance structure is "golden parachute" severance benefits upon departure following a takeover.

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management has an understandable self-interest in what happens to thefirm. Due to its firm-specific experience and expertise, along with thefact that its present position is inevitably due in some way to the luck ofthe draw, management may not be able to readily replace its current sta-tus and compensation if forced to seek other employment.282 Protectionagainst termination is therefore an important element in the implied con-tract between management and shareholders.283 Applying the businessjudgment rule to protect management's power to oppose hostile take-overs thus provides the means to extend to management something of thejob tenure that other professionals have come to expect.

We would expect the parties to adjust ex ante for the existence ofthis job protection and the bargained-for opportunism it represents:management would accept less compensation in return for the reducedrisk284 and the shareholders would pay less for their shares to reflect thereduced opportunity of auctioning the firm to the highest bidder.285 Ofcourse, as thus constructed, this implicit bargain will be suboptimal if thevalue to management of job security is less than the loss the shareholdersincur by being denied the right to auction off the firm. If so, we wouldanticipate that shareholders, if feasible, would willingly pay managementto forgo their tenure rights. It is interesting, therefore, that the devicethat to date seems closest to such an arrangement, "golden parachute"severance benefits,286 has invoked such widespread opposition. 287

282 In addition, as discussed supra note 249, senior management may be receiving excessive com-pensation and perquisites as a result of the Type I error created by judicial deference to the decisionsof board committees and shareholders, which it would no longer receive if forced to sell its servicesat arm's length.

283 The benefits created by enhanced protection from takeovers are not limited to senior manage-ment. Recent anecdotal evidence of the kinds of morale problems associated with outside takeoverssuggests that these benefits are distributed across the entire spectrum of the corporation's managerialpersonnel. See D. COMMONS, TENDER OFFER 114, 128-30, 138 (1985) (describing employee traumaand morale problems in takeover of Natomas Co.); Coffee, Regulating the Market for CorporateControl." A Critical Assessment of the Tender Offer's Role in Corporate Governance, 84 COLUM. L.REV. 1145, 1238-43 (1984); Hymowitz & Shellhardt, Merged Firms Often Fire Workers the EasyWay-Not the Best Way, Wall St. J., Feb. 24, 1986, at 35, col. 4; Reibstein, After a Takeover: MoreManagers Run, or Are Pushed, out the Door, Wall St. J., Nov. 15, 1985, at 29, col. 4; Wells &Hymowitz, Gulf's Managers Find Merger Into Chevron Forces Many Changes, Wall St. J., Dec. 5,1984, at 1, col. 6; Levin, Fearing Takeover of Gulf Oil, Employees Are Showing Myriad Symptons ofStress, Wall St. J., Feb. 28, 1984, at 32, col. 4; Tomasson, The Trauma in a Takeover, N.Y. Times,Jan. 9, 1982, at 11, col. 3.

284 See Klein, supra note 19, at 1542 n.69 ("Easterbrook and Fischel [in the article referencedsupra note 19] fail to examine the possibility that barriers to takeovers provide management with aform of employment security they accept in lieu of higher salaries and other benefits; shareholderwealth might therefore be diminished by removing those barriers.").

285 See, e.g., Blumstein, Buying vw% Exploring for Oil, N.Y. Times, Mar. 19, 1984, at Dl, col. 4(comparing the value of the oil and gas reserves of major oil companies with the much lower marketvalue of their outstanding shares).

286 Cf Williamson, supra note 40, at 1217-18. (analyzing the role of golden parachutearrangements).

287 See, eg., I.R.C. §§ 280G, 4999 (West Supp. 1985) (provisions, enacted as part of the Deficit



5. Bilateral Monopoly.-Throughout the analysis thus far, we haveassumed that there was a hypothetical single set of terms that an in-dependent decisionmaker would have reached and that any departuresfrom it were necessarily either Type I or Type II error. For transactionsinvolving nonfungibles, this assumption, of course, is unrealistic, thoughsufficient for illustration. In the real world, however, different independ-ent decisionmakers will have different points of view, so that we are likelyto end up with a "contract range" 288 of terms, all consistent with arm's-length bargaining. Moreover, self-dealing transactions pose an interest-ing extension of this range concept. We have seen that one of the vexingaspects of self-dealing is that it is often unavoidable28 9 because the fiduci-ary and the principal have a unique contribution to make to one another.This uniqueness need not have existed at the time the relationship wascreated, but may nonetheless develop over the course of the relationshipas firm-specific commitments are created. For example, when the C.E.O.was first hired by the corporation, there may have been nothing thatmade this particular employer uniquely attractive to him, and by thesame token, the corporation may have seen him as roughly comparableto several alternative managerial trainee candidates. But over the yearsof working for, and then running, the company, he develops esotericknowledge and experience that cannot be found elsewhere and that hecannot sell to competing employers for the same value as they hold forhis present corporation.290

What results, therefore, is a bargaining range bounded on the lowend by what the C.E.O. could receive for his skills from alternative em-ployers (for example, $300,000), for whom much of his specialized exper-tise has no value, and on the high end by what it would cost thecorporation to hire an outsider and train him or her to the point wherehis or her skills matched those of the current C.E.O. (for example,$500,000). Given the resulting $200,000 range of mutual benefit, it isclearly in each party's interest to deal with the other, and in this sense,the relationship-while close to fungible at the outset-has ripened intoa unique opportunity for both sides. Economists apply the term "bilat-

Reduction Act of 1984, denying deduction for, and imposing an excise tax on, excess golden para-chute payments); SEC ADVISORY COMM. ON TENDER OFFERS, REPORT OF RECOMMENDATIONS39-41 (July 8, 1983) (recommending prohibition on adoption of golden parachutes once tender offerhas commenced and otherwise subjecting them to advisory shareholder votes); Scotese, Fold upThose Golden Parachutes, HARV. Bus. REV., Mar.-Apr. 1985, at 168; Prokesch, Too Much Gold inthe Parachute?, N.Y. Times, Jan. 26, 1986, § 3, at 1, col. 2 (quoting several critics). But see D.COMMONS, supra note 283, at 112-13; Karney, Pols Poking Holes in Golden Parachutes, Wall St. J.,Apr. 16, 1984, at 32, col. 3.

288 See Scott, supra note 70, at 939-40.289 See supra note 208 and accompanying text.290 See generally Williamson, Transaction-Cost Economics: The Governance of Contractual Rela-

tions, 22 J. L. & ECON. 233, 239-42, 257 (1979).

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eral monopoly" 291 to this situation in recognition of the fact that thenonavailability of market substitutes across the full $200,000 bargainingrange compels the parties to contract with each other.

Were the C.E.O. and the corporation to negotiate at arm's length,we could not predict a priori the salary figure they would ultimatelyagree upon; all that we could say is that it would fall somewhere withinthe $300,000 to $500,000 range. We might expect that they would eachengage in strategic tactics (such as bluffing, overstating the attractivenessof their market alternatives, and threatening to walk away) in order tocommand as much of the range as possible. This necessarily creates aquandary for a legal system entrusted with reviewing the fairness of thetransaction when the C.E.O. controls the corporation, so that the bar-gaining is not at arm's length. The notion of the court finding as fact asingle set of terms that independent bargainers would have reached is apretentious one, because given the bilateral-monopoly nature of the prob-lem, the solution is inherently indeterminate. We can with confidencesay (i) that upholding as fair a result above $500,000 represents Type Ierror and (ii) that setting aside as unfair a result in the $300,000-$500,000 range and imposing in its place a result below $300,000 repre-sents Type II error. But that is about all we can say because so long asthe corporation pays the C.E.O. one dollar less than the $500,000 ceiling,both are benefitted by the arrangement. 292 This means that the courts,deprived of all ability to rely upon the pretense of a unitary set of market-dictated fair terms, must fashion and apply abstract principles of fairplay to determine where along the bargaining range the deal, as a matterof law, is to be struck.

In order to investigate the problems associated with developing suchfair-play principles, let us consider the debate over an area of corporatelaw that presents, at its heart, an application of this sort of bilateral-monopoly problem: cash-out or other mergers between a corporationand its controlled affiliate. The parent, through its ownership of theaffiliate's shares and control over its board, has the power to dictate tothe affiliate's minority shareholders whatever terms it chooses. To theminority, these shares represent simply one among many alternative pas-sive investment opportunities, and the parent's control forecloses anyprospect of selling the affiliate, as a firm, to competing bidders. To theparent, however, the minority shares present the unique opportunity to

291 See W. VICKERY, MICROSTATICS 115-16 (1964); 0. WILLIAMSON, supra note 22, at 28;Levmore, supra note 27, at 77 n.145.

292 Of course, added to this must be the recognition that in most cases where the problem arises,the endpoints of the range will not be capable of specification with the precision assumed in theforegoing illustration. That is to say, there will typically be considerable room for difference ofopinion as to what, for example, the C.E.O.'s value to outside employers might be. But at leastreference to the market is still theoretically available to measure this value. The bilateral monopolydimension introduces the complication that, as between those market-derived endpoints, reference tosome external single-point notion of "fair market value" is no longer possible, even in theory.



obtain plenary control over the affiliate's business and its cash flow, andwith it to eliminate a variety of costly burdens, including duplicated stafffunctions, separate securities law reporting obligations for the affiliate,fiduciary problems with intercompany dealings, and minority share-holder relations concerns generally. The resulting difference between thevalue of this opportunity to the parent and the pure investment value ofthe shares to the minority creates the bargaining range over which mi-nority and parent present each other with a unique opportunity to createmutual benefit not otherwise available in the marketplace. 293

As a basis for exploring this issue, let us consider the law of Dela-ware and begin with the case that established the Delaware "entire fair-ness" test, Sterling v. Mayflower Hotel Corp. 294 It involved a challenge tothe stock-for-stock merger of Mayflower Hotel Corporation into HiltonHotels Corporation, which had acquired a majority stake in Mayflowersix years before and at the time of the merger owned five-sixths of itsshares. Mayflower's sole business was the ownership and operation ofthe Mayflower Hotel in Washington, D.C.; Hilton owned and operated anational hotel chain. To determine the merger terms, Hilton had hiredan independent consultant who recommended the exchange of one shareof Hilton, then trading at $14.75 per share, for each share of Mayflower.The consultant's study observed that the financial record of Hilton hadbeen substantially superior to that of Mayflower, and that upon that basisit could be argued that Hilton should not offer better than three-fourthsof a share; it concluded, however, that because of the problems incidentto Hilton's control of Mayflower and the advantages of complete owner-ship, a share-for-share exchange was fair and reasonable to allconcerned. 295

The plaintiffs, minority shareholders of Mayflower, challenged thisexchange ratio as unfair. They submitted evidence appraising theMayflower Hotel at $10.5 million, the equivalent of $27 per share, andargued that because Hilton was in substance buying the hotel, this shouldbe the appropriate measure of what they were due.296 This argumentreveals the essential bilateral-monopoly nature of the situation. At thelow end of the bargaining range is the value of Mayflower shares as apure investment security, based solely on their dividends and earnings; atthe high end, the value to Hilton of outright ownership of the MayflowerHotel. The court sided with Hilton, reasoning that, inasmuch as Hilton's

293 See Chasen, supra note 238, at 1471. Of course, the minority might be able to sell to third

parties, such as investors in the marketplace, and receive something above the pure investment valueof their shares. But this premium would simply represent the purchaser's expectation of ultimatelyreceiving some portion of the bargaining range by dealing with the parent. Thus, the third-partytransaction is merely the substitution of a new minority shareholder for the present one.

294 33 Del. Ch. 293, 93 A.2d 107 (Sup. Ct. 1952).295 Id. at 298-99, 93 A.2d at 110.296 Id. at 300, 93 A.2d at 111-12.

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objective was to continue Mayflower as a going concern, liquidationvalue was an inappropriate measure of what the plaintiffs were entitled toin the merger. In the process, the court stated that "the stockholder ofthe merged corporation is entitled to receive directly securities substan-tially equal in value to those he held before the merger" 297-a formula-tion that has been referred to as the "give-get" test.298

Is this give-get test consistent with the court's earlier statement thatbecause the Hilton directors stood on both sides of the transaction "theybear the burden of establishing its entire fairness, and it must pass thetest of careful scrutiny by the courts"?299 Let us consider this in light ofthe analytical framework developed by Judge Learned Hand in Ewen v.Peoria & Eastern Railway Co.,3°° where the court was called upon toreview a series of arrangements between a railroad and its majority-owned subsidiary, which dominated it pursuant to a joint "OperatingAgreement." Consistent with our bilateral-monopoly analysis, JudgeHand recognized that even though it was "wholly impossible even ap-proximately" to set the terms that the two railroads would have agreedto at arm's length, it might be possible to specify the outside limits withinwhich the parties would be willing to deal. 30 1 The outcome would thenturn on who bears the burden of proof. If it were the subsidiary, thesubsidiary must prove that the terms dictated by the parent were beyondthe minimum it would have accepted if independent-in other words,that the terms were outside the bargaining range and therefore no risk ofType II error would be created by setting them aside. Conversely, if theburden were on the parent, the parent must prove that it would haverefused to deal on terms any more favorable to the subsidiary-in otherwords, that the terms are at the very top of the range, so that no risk ofType I error would result from upholding them.302

Under Judge Hand's approach, the Sterling court's statement plac-ing the burden on Hilton to prove entire fairness would require it to giveup the entire bargaining range to Mayflower, for there can otherwise beno absolute assurance that Hilton did not use its dominance to imposeterms on Mayflower that would not have prevailed at arm's length. Interms of result, however, the Sterling court accepted much less.30 3 Once

297 Id. at 303, 93 A.2d at 112.298 See Brudney & Chirelstein, Fair Shares in Corporate Mergers and Takeovers, 88 HARV. L.

REV. 297, 310 n.35, 315 (1974); Lorne, A Reappraisal of Fair Shares in Controlled Mergers, 126 U.PA. L. REv. 955, 958 (1978).

299 Sterling, 33 Del. Ch. at 298, 93 A.2d at 110.300 78 F. Supp. 312, 315-17 (S.D.N.Y. 1948), cert. denied, 336 U.S. 919 (1949).301 Id. at 317.302 Id.303 See, e.g., Vorenberg, Exclusiveness of the Dissenting Stockholder's Appraisal Remedy, 77

HARV. L. REV. 1189, 1214 (1964) (suggesting that Sterling requires less than that called for by theHand formulation and may be read merely as imposing on those seeking to sustain the transactionthe task of introducing more persuasive evidence that the terms were fair than the plaintiff in-



Hilton demonstrated that the exchange terms represented an honest ef-fort to give Mayflower shareholders value equivalent to their premergerholdings, the court was willing to accept them. In effect, the court de-ferred to Hilton in the face of a clear risk of Type I error.304

In response, various commentators have criticized the give-get testand argued that fairness dictates that the minority be permitted to sharein any merger-created gain. For example, Professors Brudney andChirelstein have advocated that the minority shareholders of the subsidi-ary and the shareholders of the parent be viewed as participants in acommon enterprise, with the fiduciary obligations of parent managementrunning equally to both groups.30 5 Analogizing this situation to an in-vestment advisor called upon to allocate a cost savings among the variousaccounts under his management, Brudney and Chirelstein conclude thatthe merger-created gain should be shared by the two groups of share-holders in proportion to their premerger holdings.30 6 An alternative pro-

troduces that they were not); cf. Brudney & Chirelstein, supra note 298, at 315-17 (suggesting thatarm's-length bargaining would call for sharing of expected merger gains on some basis).

304 See also David J. Greene & Co. v. Schenley Indus., Inc., 281 A.2d 30, 32-35 (Del. Ch. 1971)

(acknowledging the existence of self-dealing, but refusing to enjoin merger when value of securitiesoffered for subsidiary's stock closely approximated its market price); cf Brudney & Chirelstein,supra note 298, at 318 n.49 (observing that results of cases suggest that the difference between thebusiness judgment rule and the intrinsic fairness standard is not significant).

305 Brudney & Chirelstein, supra note 298, at 317-19. The authors were careful to limit thischaracterization to the case in which the parent-subsidiary relationship was longstanding. Where,by contrast, the merger follows closely on the heels of the parent's initial acquisition of control, theyargued that the merger should be treated simply as the second step of an integrated plan of acquisi-tion, with the merged-out shareholders therefore entitled to receive the same price per share as theparent had earlier paid for control. Id. at 330-40; Brudney & Chirelstein, A Restatement of Corpo-rate Freezeouts, 87 YALE L.J. 1354, 1359-65 (1978).

306 Brudney & Chirelstein, supra note 298, at 319-22. An interesting aspect of the Brudney and

Chirelstein proposal for our purposes is that it represents the sort of bright-line standard we consid-ered in subsections IV.F and G. above. We saw there that the disadvantages of such standards weretheir greater prospensity (relative to ad hoc review) for error, see supra first four paragraphs ofsubsection IV.G., and the "adverse selection" problem created by the fiduciary's ability to deal withthe principal when the standard worked in her favor and to deal on the market when it did not, seesupra text preceding note 116. The Brudney and Chirelstein proposal illustrates that these problemsare alleviated when the relationship between fiduciary and principal represents a bilateral monopoly.First, so long as the terms dictated by the standard are somewhere within the bargaining range, thenotion of error is, as we have seen, academic, inasmuch as there exist no market alternatives tomeasure against. Second, because at every point within that range the terms available are by defini-tion more attractive to the parent than are market substitutes, the incentives creating the adverseselection problem are eliminated.

On the other hand, one may argue that the parent still possesses some power to manipulate themerger terms, even under the standard, through its control over the timing of the merger. SeeBrudney, supra note 47, at 1099, 1131-32; Brudney & Chirelstein, supra note 298, at 305-06; Brud-ney & Chirelstein, supra note 305, at 1373 n.35; Greene, Corporate Freeze-out Mergers: A ProposedAnalysis, 28 STAN. L. REv. 487, 493 (1976); additional authorities cited infra note 321. The parent'sability to defer the merger when it believes, given its access to inside information about the prospectsof both companies, that the parent's shares are undervalued in relation to the subsidiary's and com-pel the merger when the opposite is true may be viewed as a species of adverse selection.



posal comes from Professor Weiss, who argues that the minority shouldreceive their pro rata share of the firm's "third party sale value," that is,the price that could be obtained in a sale of the firm, as a whole, to anoutsider.

30 7

On the other hand, the work of Judge Easterbrook and ProfessorFischel and of Professor Williamson offers possible justifications for theSterling court's posture of deference. Easterbrook and Fischel support arule allowing the parent to retain all merger-created gains, provided theminority shareholders are left no worse off as a result of the transac-tion. 30 8 This is simply one application of their general argument that arule of full-gain retention serves to maximize a corporation's incentivesto incur the cost and risk necessary to search out and put together benefi-cial control transactions, and that under such a rule, shareholders as awhole are better off.30 9 Their objective is in effect to minimize the con-trol person's exposure to Type II error in the interest of inducing efficientcontrol transactions, subject to the constraint of assuring that the minor-ity shareholders' treatment is still within the bargaining range (albeit atthe very bottom) so that the existence of unequivocal Type I error isavoided.

At a more general level, we can view the problem as an applicationof Professor Williamson's theories of transactions costs contracting. Asnoted earlier,310 Professor Williamson has described how a buyer-sellerrelationship, though created in a competitive market setting where bothparties were free to choose among numerous alternatives, may nonethe-less be transformed over its life into a species of bilateral monopoly if theparties are required to make transaction-specific (idiosyncratic) commit-ments to the relationship. 311 Thereafter, as issues arise over gaps in thecontract, or changes in business conditions dictate the need for modifica-tions, each party becomes particularly vulnerable to the other's opportu-nistic conduct inasmuch as abandoning the relationship and turning tomarket substitutes would require a forfeit of those transaction-specificinvestments. As a consequence, the parties (having foreseen this risk)

307 Weiss, supra note 238, at 678-80; see also Chasen, Friedman & Feuerstein, Premiums and

Liquidation Values: Their Effect on the Fairness of an Acquisition, in ELEVENTH ANNUAL INSTI-TUTE ON SECURxTIEs REGULATION 163 (A. Fleischer, M. Lipton & R. Stevenson eds.) (statementby Martin Lipton that most courts would now consider third-party sale value as a major factor indetermining fairness to minority); cf. Chasen, supra note 238, at 1445, 1477 (simulation of arm's-length negotiation requires premium over pre-acquisition value, but does not require third party salevalue); N.Y. Bus. CORP. LAW § 623(h)(4) (McKinney Supp. 1986) (enacted 1982) (dissenting share-holder entitled to fair value determined in light of various factors, including nature of transactionand the valuation techniques customarily applied to comparable transactions in the relevant securi-ties and financial markets).

308 Easterbrook & Fischel, supra note 8, at 723-31.309 Id. at 703-15.

310 See supra text accompanying note 290.311 Williamson, supra note 290, at 239-42.



will insist upon some sort of protective device-what Williamson refersto as a "governance structure" 312-to regulate their contractual relationsin lieu of the market, before agreeing to make any idiosyncratic invest-ment in the relationship. And-because both parties stand to benefitfrom this investment-the creation of such a specialized governancestructure should prove mutually acceptable.

The common thrust of these two approaches is that in the case ofbilateral-monopoly relationships we must focus on the fiduciary's incen-tives not only as of the time of the self-dealing transaction (Step #2), butalso as of the time when the relationship was first being contemplated(Step # 1). Once having taken Step # 1, the fiduciary is forced to look tothe court for the permissible allocation of Step #2 benefits, and has noreal opportunity to walk away. Assuming we deem the combination ofthe two steps to be, on the whole, desirable, we must recognize that theincentive to take Step # 1 may well require some advance assurance thatthe court will not demand the lion's share of the bargaining range as theprice for Step #2. Given this perspective, perhaps the Sterling court'sposition represents more than the simple willingness to tolerate a greaterrisk of Type I error than the Hand formulation would allow, and reflectsan underlying belief that arm's-length bargaining is not the appropriatereferent for reviewing the propriety of the merger's terms. In otherwords, even though the bilateral-monopoly dimension of the relationshipmight permit the minority shareholders-if able to negotiate indepen-dently with the parent-to hold out for a portion of the merger-createdbenefit, they should have no substantive entitlement to it.313 Thus, thecompulsory aspect of the statutory merger, conditioned upon majorityapproval by the affected shareholders-when coupled with the judicialdeference embodied in the give-get test-may be seen as a form of spe-

312 Id. at 234-35.313 This point is illustrated by the Sterling court's response to Hilton's offer to buy any and all of

the Mayflower minority's holdings at $19.10 per share, a significant premium over its market value,which might be viewed as compensation for their strategic position. The Sterling plaintiffs had de-clined the offer, and had pointed to that offer along with the $16.25 market price of Mayflower'sshares-in comparison to the $14.75 per share market price of the Hilton stock they were to receivein exchange-as evidence of the unfairness of the merger terms. The court, however, thought thismarket price comparison must be disregarded, in that the Mayflower price was "fictitious, that is,higher than would be justified in a free and normal market uninfluenced by Hilton's desire to acquireit and its policy of continued buying." Sterling v. Mayflower Hotel Corp., 33 Del. Ch. 293, 300, 93A.2d 107, 111 (Sup. Ct. 1952). It concluded that Hilton's offer of $19.10 per share was "under thecircumstances, no evidence of true market value," id. at 308, 93 A.2d at 115, and that "it is enoughto say, as the Chancellor said, that the minority stockholders of Mayflower suffer no harm from theoffer and have no ground of complaint," id. at 310, 93 A.2d at 116-17.

This position is also consistent with the traditional stance of appraisal statutes, which value thedissenters' shares as of the time immediately prior to the merger and exclude any element of gaincreated by the transaction. See, eg., CAL. CORP. CODE § 1300(a) (West Supp. 1986); DEL. CODEANN. tit. 8, § 262(h) (1983); MODEL BUSINESS CORP. AcT § 13.01(3) (1984). But cf. N.Y. Bus.CORP. LAW § 623(h)(4) (McKinney Supp. 1986) (value as of day prior to shareholder authorizationdate, but no reference to exclusion of merger-created gain).

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cialized governance structure that assures a prospective acquirer protec-tion in advance against opportunistic conduct by minority shareholderswho otherwise would be free to hold out for a substantial share of thebilateral-monopoly bargaining range once the acquirer makes its thresh-old investment 314

Further, even when the fiduciary has taken Step # 1 and therebyentered into the bilateral monopoly relationship, the judicial review pro-cess has continuing incentive implications for the fiduciary's willingnessto follow up with Step #2. By taking Step #2, the fiduciary in effectelects to be bound by whatever price the court ultimately determines tobe fair. In theory, the fiduciary will still be better off for having takenStep #2 as long as that resulting price lies anywhere within the bargain-ing range. But, in reality, courts face the same risk of error in seeking todelineate the outer limits of the bargaining range as they do in seeking topredict how arm's-length decisionmakers would have bargained. In thecase of parent-subsidiary mergers, the endpoints of the range will turn onquestions of valuation-what savings may be expected, how shared costsshould theoretically be allocated, what substitutes are available, and soforth-which of course are matters of judgment and speculation. Thus,in close cases, the parent may conclude that the prospect of Step #2benefits is outweighed by the expense of putting the transaction togetherand the risk that judicial redetermination of the price will leave it worseoff.315 Thus, judicial deference as manifested in the Sterling case or theapplication of an unequivocal standard, such as the Brudney and Chirel-stein sharing proposal, 31 6 has the advantage of contributing to overall

314 This squares with the history of the reduction of the shareholder approval requirement from

unanimity, to two-thirds, to a bare majority, in part to diffuse the hold-out advantages of minorityshareholders. For a description of this history, see generally Carney, supra note 47, at 77-97; Weiss,supra note 238, at 626-31.

315 See Carney, Shareholder Coordination Costs, Shark Repellents, and Takeout Mergers: TheCase Against Fiduciary Duties, 1983 AM. B. FOUND. RESEARCH J. 341, 363-66 (uncertainty anddelay created by fairness test may discourage takeovers). One might argue that so long as theparent's shareholders hold diversified portfolios, the riskiness inherent in judicial review of themerger price should not be a factor in the decision to merge. One response to this is that while theparent shareholders are diversified against the risk, parent management is not. To the extent that acourt's ultimate determination of what is a fair price has an impact upon management-in terms ofamounts of bonuses or other compensation, reputation within the firm, opportunities for advance-ment and so forth-they will be risk averse. Thus, the shareholders themselves may be risk-neutral,but the managers entrusted with making the merger decision are less likely to be. In addition, uncer-tainty will contribute to higher litigation costs.

316 See supra notes 305-06 and accompanying text. The discussion in the text suggests that themost important feature of a standard as a solution to the bilateral monopoly problem is not itssubstantive content-so long as it meets the core requirement of assuring an outcome somewherewithin the bargaining range-but the fact that it is a standard, and therefore has the potential qualityof bright-line certainty. From this perspective, in evaluating the Brudney and Chirelstein sharingproposal, Simon Lorne's exposition of the practical difficulties in applying the proposal to non-stockmergers, Lorne, supra note 298, at 983-87, is considerably more damning to the proposal's utilitythan is his criticism of its singular view of what fair sharing entails, id. at 970-77.



certainty, which as we have seen 317 creates value in and of itself.What are the implications of this approach when we shift our con-

cerns from enhancing the parent's incentives to protecting the interests ofthe subsidiary's minority shareholders? At first blush, this latter concernwould seem best remitted to the ex ante adjustment process. Just as it ismeaningless to speak of a unique "fairness point" within the bargainingrange,318 so too is there little to suggest that any particular rule for allo-cating that range is better than its alternatives in terms of facilitating theex ante estimates of the parent's and subsidiary's shareholders. Thus,considerations of minority protection need not interfere with the law'sfreedom to set the rule at whatever point-so long as it lies somewhere inthe range-that other policy considerations dictate is soundest. JudgeEasterbrook and Professor Fischel in effect press this line of reasoning toits extreme by arguing, as we have seen,319 that efficiency objectives dic-tate that the minority should be entitled only to the market value of itspremerger holdings.320

This position seems plausible in theory. But when we move fromtheory to reality, we must recognize that the inherent risk of Type I errorin the valuation process virtually assures that any rule requiring the par-ent to show merely that the merger leaves minority shareholders noworse off will result in upholding some mergers that in fact do not. In-deed, a concern for the various possible sources of this Type I error un-derlies the work of several commentators and serves to explain theirpositions. Professor Brudney has written frequently that the parent'sability to manipulate the subsidiary's market value through such meansas control over dividend policy and the selection of accountingprinciplies, coupled with its plenary access to inside information, placesit in the position to initiate merger only when it is confident that thestandard of value to be applied by the courts is out of line with the sub-

317 See supra text accompanying notes 108-15 and notes 240-41.318 See supra text accompanying notes 291-92.319 See supra notes 308-09 and accompanying text.320 Easterbrook & Fischel, supra note 8, at 714-15. Easterbrook and Fischel rely upon the share-

holders' position, ex ante, as the solution to problems of adequate protection of their interests, buttheir argument is narrower than the one put forth in the text supra at note 318. They assert thatinvestors as a class will prefer the rule that maximizes their position ex ante. Under their proposi-tion, shareholders of parents gain more and shareholders of subsidiaries gain less than under a ruleof equal sharing. But, they contend, because the total number of gain-producing transactions isincreased, investors as a class benefit. And any individual investor may balance out the risks of beingon the losing and gaining ends, respectively, by holding a diversified portfolio. Id. at 703-04, 711-14.Thus, in their view, the ex ante compensation for the risk of being denied the gain in some transac-tions is the prospect of receiving all of it in others. As a result, their argument is vulnerable to thecriticism that to the extent the investment opportunities in subsidiaries outnumber those in parents,investors will be undercompensated. See, e.g., Brudney, supra note 47, at 1100. But this concern isoverdrawn. So long as the price of subsidiary shares properly reflects the prospect that they will notshare in any gain created through merger with the parent, the holder of these shares receives a "fair"return whether or not he also holds shares of parents.

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sidiary's true worth.32 1 An important theme in Professor Carney's writ-ings is that because individual shareholders value their stockdifferently-that there is, in effect, an upward-sloping supply curve forthe shares-cashing out all minority shareholders at a uniform price,even if it represents a premium over the market-clearing price, will likelyleave some undercompensated.3 22 And attorney Bate Toms has writtenthat the differing tax consequences and reinvestment costs from share-holder to shareholder may result in the merger's making some of themworse off.

32 3

While minority shareholders may compensate ex ante for the com-bined risk of these sources of Type I error, the common theme in thesecommentaries is that the risk is a systematic one. Thus, parent corpora-tions can routinely exploit it to force through mergers that may well beinefficient in the sense that the value the parent stands to gain is actuallyless than the value-if computed in an error-free manner-the minoritystands to lose.324 As a result, unless we deny these sources of Type Ierror, the Easterbrook and Fischel proposal becomes vulnerable to attackby the very efficiency goals that it seeks to promote. And the true advan-tage of a gain-sharing requirement as proposed by Brudney and Chirel-stein may be that, even allowing for the prospect of Type I error in itsapplication, the minority should still emerge from the merger with atleast as much as it had before.

In summary, then, the foregoing suggests why the task of judicialreview in the bilateral-monopoly area is a difficult one even though thecourt has the entire bargaining range within which to work.325 Thecourts must provide rigorous protection against the risk that systematicType I error will allow the fiduciary to undermine efficiency by imposingresults outside the bargaining range, but at the same time provide suffi-cient advance guarantee against the possibility of Type II error to inducethe fiduciary to take both Step # 1 and Step #2 where the transactionwould be mutually beneficial to fiduciary and principal. Measuredagainst these criteria, the Sterling approach may be justified as a rough-

321 See Brudney, supra note 47, at 1099; Brudney, Efficient Markets and Fair Values in Parent-Subsidiary Mergers, 4 J. CORP. L. 63, 69-74 (1978); Brudney & Chirelstein, supra note 298, at 305-06; see also Roland Int'l Corp. v. Najjar, 407 A.2d 1032, 1037 (Del. 1979) (majority shareholdermay time short-form merger to favor itself, based upon status of market and elements of appraisal);Weiss, supra note 238, at 654.

322 See Carney, supra note 315, at 354-57, 385-86; Carney, supra note 47, at 110-18. ProfessorLevmore has also discussed the implications of this phenomenon. See Kanada & Levmore, TheAppraisalRemedy and the Goals of Corporate Law, 32 UCLA L. REV. 429,437-41 (1985); Levmore,Self-Assessed Valuation Systems for Tort and Other Law, 68 VA. L. REv. 771, 850-52 (1982).

323 See Toms, Compensating Shareholders Frozen Out in Two-Step Mergers, 78 COLUM. L. REV.548, 569-70 & n.72 (1978).

324 See Carney, supra note 315, at 352, 367-68, 375; Hoffman, The Efficiency and Equity of Corpo-rate Sharing Rules, 7 CORP. L. REV. 99, 107-09 (1984).

325 The court has this range to "work within" in the sense that so long as its outcome is anywherewithin the range, both parties still benefit from the transaction.



and-ready attempt to provide the incentive guarantees through a generalposture of deference while employing the "entire fairness" and "carefulscrutiny" rhetoric to assure that the outcomes are truly within the bar-gaining range.

Limited judicial deference of this variety is necessarily a two-waystreet. If confident that the fiduciary's decisionmaking process has attrib-utes (such as independent third-party participation) to assure its capacityto produce a result somewhere within the bargaining range, the court candefer to it and thereby avoid having to make the inherently indeterminatecalculation of what terms are fair. The prospect of this deference thenprovides the incentive for the fiduciary to employ a decisionmaking pro-cess of demonstrable quality and independence, for it realizes that if de-fects in the process are patent, the court may redetermine de novo whatis fair, and impose those terms upon the fiduciary with the accompanyingrisk of Type II error. By the same token, unless there is some prospectthat the court will defer to the fiduciary's internal decisionmaking, then,as we saw in subsection IV.E. ,326 the fiduciary's incentives are to forgo allself-restraint and select the most self-serving terms that a court mightultimately allow, with the result that the judicial task of redeterminationbecomes inevitable. Ironically, therefore, the court's increased willing-ness to intervene, by dictating what terms are fair, may operate to induceeven more opportunistic conduct by the fiduciary.

Against this backgroundlet-us considertwo-important implicationsof the Delaware Supreme Court's most recent merger landmark, Wein-berger v. UOP, Inc. 32 7 The first is the court's decomposition of the entirefairness concept into separate elements of fair price and fair dealing.328

This represents an explicit recognition that a principal focus of judicialreview should be the quality of the parent's decisionmaking process, andthe analysis of these fair dealing issues comprises a major part of theWeinberger opinion. 329 The court's detailed examination of how the

326 See supra notes 97-104 and accompanying text.327 457 A. 2d 701 (Del. 1983) (en banc).328 Id. at 711. See supra notes 195-202 and accompanying text.329 The case involved the cash-out merger of UOP, Inc. into its parent, The Signal Companies,

Inc., which had acquired 50.5% of UOP's stock by tender offer three years before. The merger pricewas $21 per share; prior to the announcement of the merger UOP stock had been trading for $14.50per share. The court pointed to several factors in support of its finding that the merger was not theproduct of fair dealing. Probably the most important of these was the fact that a report prepared bytwo Signal officers who were also directors of UOP, which used UOP information and concludedthat acquisition of the remaining UOP shares at any price up to $24 would be a good investment forSignal, was not shared with the outside directors of UOP, 457 A.2d at 705, 708-09, 711. Otherfactors the court cited included (i) the serious time constraints imposed by Signal, which resulted inthe transaction's being presented to and approved by UOP's board within four business days, id. at711; (ii) the fact that UOP's chief executive officer never bargained over price except within the $20-$21 per share range that Signal proposed, id. at 705-06, 711; (iii) the hurried and cursory manner inwhich UOP's investment banker prepared its fairness opinion, id. at 706-07, 712; and (iv) the failureto disclose to UOP's minority shareholders the rushed nature of the fairness opinion and the fact

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merger terms were reached-particularly when read in light of its state-ment that "the result here could have been entirely different if UOP hadappointed an independent committee of its outside directors to deal withSignal at arm's length" 330 -sugests that, consistent with our analysis inthe preceding paragraph, the court was trying to encourage the develop-ment of reliable intracorporate bargaining mechanisms as a substitute forde novo fairness determinations by the court.331 At the same time, itreveals that while the court may be reluctant to second-guess the out-come of the corporation's internal decisionmaking process, it is morecomfortable reviewing the quality of the process itself. The court's recentdecision in Rosenblatt v. Getty Oil Co. 332 confirms, however, that once itis convinced that the intracorporate process truly bears the earmarks ofarm's-length bargaining, the court will defer.333 Some commentatorsread Weinberger, however, as setting too high a price for this deferenceand contemplating disclosures and procedures that may in practice re-quire that the subsidiary's shareholders receive the lion's share of thebargaining range if the deal is to go through.334 If true, these concerns

that Signal had considered any price up to $24 per share to be a good investment, id. at 712. Inaddition to these fair dealing issues, the supreme court also reversed the chancellor's findings on theissue of fairness of price. It concluded that the plaintiff should be entitled to prove value by anyconventional financial techique, including discounted cash flow, and not be restricted to the tradi-tional Delaware appraisal framework. Id. at 712-14.

330 Id. at 709 n.7. The court's footnote continues:Since fairness in this context can be equated to conduct by a theoretical, wholly independent,board of directors acting upon the matter before them, it is unfortunate that this course wasneither considered nor pursued. . . . Particularly in a parent-subsidiary context, a showing thatthe action taken was as though each of the contending parties had in fact exerted its bargainingpower against the other at arm's length is strong evidence that the transaction meets the test offairness.

Id. at 710 n.7.331 This reading of the case is shared with Burgman & Cox, Reappraising the Role of the Share-

holder in the Modern Public Corporation: Weinberger's Procedural Approach to Fairness inFreezeouts, 1984 Wis. L. REv. 593, 656-58. In addition, the authors see the court's revision of theappraisal valuation process as an attempt to endow the minority with a bigger bargaining chip to usein inducing the parent to establish independent bargaining. Id. at 658-62. For other discussions ofthe incentives created by Weinberger to establish an independent negotiating process, see Herzel &Coiling, Establishing Procedural Fairness in Squeeze-Out Mergers After Weinberger v. UOP, 39 Bus.LAW. 1525, 1532-39 (1984); Payson & Inskip, Weinberger v. UOP, Inc.: Its Practical Significance inthe Planning and Defense of Cash-Out Mergers, 8 DEL. J. CORP. L. 83, 86-88, 90 (1983).

332 493 A.2d 929 (Del. 1985). Justice Moore, author of Weinberger, was also the author ofRosenblatt.

333 The court noted that the exercise of independent bargaining power was "of considerable im-portance when addressing ultimate questions of fairness, since it may give rise to the proposition thatthe directors' actions are more appropriately measured by business judgment standards." 493 A.2dat 937-38. The court's decision did not turn exclusively on the existence of independent bargaining,however. It also noted that because the merger had received the informed vote of the majority of theminority shareholders, the burden of proof was shifted to the plaintiffs, id. at 937, and that theparties computed the merger price by using methods conforming to established Delaware legal prin-ciples, id. at 939-42.

334 See Fischel, The Appraisal Remedy in Corporate Law, 1983 AM. B. FOUND. RESEARCH J. 875,886-89; Herzel & Colling, supra note 331, at 1533-37. But Professor Weiss, on the other hand,



would necessarily erode the parent's incentives to put in place a reason-able bargaining process, not to mention its incentives even to undertakeeither the Step # 2 merger or the Step # 1 acquisition in the first place.But the Rosenblatt opinion suggests that at least some of these concernswere misplaced.335

This focus on the parent's incentives to create a realistic intracorpo-rate bargaining process leads to the second important aspect of the Wein-berger opinion for our purposes: the court's announcement thatappraisal would thereafter be the shareholder's exclusive monetary rem-edy.336 Because appraisal is by its nature a remedy of pure redetermina-tion, the parent's optimal strategic response to it would be, as we havediscussed, to adopt the most self-serving terms plausible. Making the ap-praisal remedy truly exclusive would therefore serve completely to neu-tralize any incentives for the parent to exercise procedural fair play insetting the merger terms, notwithstanding Weinberger's extensive discus-sion of the fair dealing requirement. 337 For this reason, the Weinbergercourt's qualification that appraisal "may not be adequate in certain cases,particularly where fraud, misrepresentation, self-dealing, deliberate waste

worried that in the wake of Weinberger courts would defer to negotiating processes that are nothingmore than a "charade." Weiss, The Law of Take Out Mergers: Weinberger v. UOP, Inc. Ushers inPhase Six, 4 CARDoZO L. REv. 245, 254-56 (1983); see also Lowenstein, Management Buyouts, 85COLUM. L. REV. 730, 774-76 (1985). Thus, different commentators at once found excessive Type Irisks and excessive Type II risks in the same procedure.335 The court explained that Weinberger's concern over the failure to disclose the Signal report

detailing the highest price it was willing to pay for the UOP shares, see supra note 329, stemmedfrom the fact that the report was prepared by Signal officers who were also UOP directors andtherefore violated their fiduciary duty to UOP by withholding the information. The court impliedthat Signal had no independent duty, simply because it was a majority shareholder, to disclose thisinformation to the other shareholders of UOP. Rosenblatt, 493 A.2d at 939.

On the other hand, the court in Rosenblatt pointed out that the independence of the subsidiary'snegotiators, which it generally applauded, in the case before it had nearly caused the collapse of thenegotiations on at least two occasions. Id. at 938. The prospect of this level of adversariness led thecourt, in a subsequent decision, to note, after referring to the advantages under the Weinbergerapproach of an independent negotiating committee:

However, we recognize that there can be serious practical problems in the use of such acommittee as even Rosenblatt demonstrated. . . Thus, we do not announce any rule, even inthe context of a motion to dismiss, that the absence of such a bargaining structure will precludedismissal in cases bottomed on claims of unfair dealing.

Rabkin v. Philip Hunt Chem. Corp., 498 A.2d 1099, 1106 n.7 (Del. 1985).336 Weinberger, 457 A.2d at 714-15.337 This is illustrated by Berger & Allingham, A New Light on Cash-Out Mergers: Weinberger

Eclipses Singer, 39 Bus. LAW. 1 (1983). The authors were two Delaware practitioners, one of whomwas to become a vice chancellor. They advised that after Weinberger, measures designed to mirrorindependent bargaining "may not be worth the time and risk." The authors concluded that, so longas the parent disclosed the absence of those safeguards, there was little risk that it would have todefend the entire fairness of the merger other than in an appraisal proceeding. Id. at 24. See alsoWeiss, supra note 334, at 257-60 (making appraisal truly exclusive would negate Weinberger's discus-sion of fair dealing; expanding shareholder's standing to bring class actions would give parent incen-tive to engage in fair dealing to protect merger from challenge).



of corporate assets, or gross and palpable overreaching are involved" 338

takes on important significance. It preserves some potential for the classaction as a sanction for the failure to make a good-faith effort at settingfair terms. 339 While the inclusion of "self-dealing" in this list may meanthat alternatives to appraisal will be available in most parent-subsidiarymergers,340 commentators have suggested strategic considerations thatmay dissuade a plaintiff from relying on their availability. 341

In any event, the Delaware Supreme Court's most recent mergerdecision, Rabkin v. Philip A. Hunt Chemical Corp.,342 indicates that al-ternatives to appraisal still enjoy considerable vitality. The plaintiffs inthat case challenged the cash-out merger of Hunt into its parent, OlinCorporation, at a price of $20 per share. Olin had initially acquired63.4% of Hunt's stock in March, 1983 for $25 per share. As part of thepurchase agreement, Olin promised the seller that if it were to acquirethe remaining Hunt shares within one year thereafter, it would pay allshareholders an equivalent ($25) price. While there was evidence to sug-gest that Olin had intended to acquire the balance of the Hunt sharesfrom the outset, it waited until July, 1984 to effect the merger, at the $20per share price. The plaintiffs argued that his price was grossly inade-quate because Olin unfairly manipulated the timing of the merger toavoid the one-year commitment.343 The chancery court dismissed theaction on the ground that, absent allegations of misrepresentation or

338 Weinberger, 457 A.2d at 714. The court's language parallels the express exceptions containedin many state statutes, which provide that appraisal is otherwise exclusive. See, eg., N.Y. Bus.CORP. LAW § 623(k) (McKinney Supp. 1986) (appraisal not exclusive if "corporate action will be oris unlawful or fraudulent" as to the shareholder); MODEL BUSINEss CORP. AcT § 13.02(b) (1984)(appraisal exclusive "unless the action is unlawful or fraudulent with respect to the shareholder orthe corporation"); cf. CAL. CORP. CODE § 1312(b) (appraisal not exclusive if corporation is con-trolled by another party to the reorganization). Courts have tended to read these exceptions broadly.See, eg., Mullen v. Academy Life Ins. Co., 705 F.2d 971, 973-75 (8th Cir.) (applying New Jerseylaw; extending statutory exceptions to appraisal to merger of life insurance companies to whichexceptions did not apply), cert. denied, 464 U.S. 827 (1983); Alpert v. 28 Williams St. Corp., 63N.Y.2d 565, 567-68, 473 N.E.2d 19, 24-25, 483 N.Y.S.2d 667, 673 (1984) (suit to set aside freeze-outmerger is within exception).

339 Even though the parent is still faced with the prospect of wholesale redetermination in anappraisal, the existence of the class action still provides fair-dealing incentives for two reasons. First,since invariably only a few shareholders will take advantage of appraisal, the magnitude of the rede-termination risk is greater in the class action. Thus, the parent has some incentive to deal fairly inorder to reduce this risk, no matter what may happen in appraisal. Second, the existence of the classaction opens the door to injunctive relief, which we saw in subsection IV.E, see supra note 102 andaccompanying text, creates self-restraint incentives of its own.

340 Berger & Allingham, supra note 337, at 20-21; Payson & Inskip, supra note 331, at 95.341 See Berger & Allingham, supra note 337, at 21-22; Herzel & Coiling, supra note 331, at 1528

& n.13. But see Prickett & Hanrahan, Weinberger v. UOP: Delaware's Effort to Preserve a LevelPlaying Field for Cash-Out Mergers, 8 DEL. J. CORP. L. 59, 77-79, 81-82 (1983) (discussing theprospects of converting appraisal proceeding to class action and of bringing simultaneous class ac-tion and appraisal proceeding).

342 498 A.2d 1099 (Del. 1985). The author of the opinion was, again, Justice Moore.343 Id. at 1103. The plaintiffs also alleged that language contained in the Schedule 13D that Olin



nondisclosure, appraisal was the plaintiff's exclusive remedy.344 Revers-ing, the supreme court observed that the chancery court's narrow inter-pretation of Weinberger "would render meaningless our extensivediscussion of fair dealing found in that opinion, ' 345 and that while theabsence of fraud or deception was one component of procedural fairness,there were also broader concerns, such as the manipulative conduct al-leged by the plaintiffs here.346 Time will only tell, therefore, what effect,if any, the Weinberger language on the exclusiveness of appraisal willhave upon cases involving well-pleaded claims of unfair dealing.347

In summary, Weinberger and its progeny preserve the essential bar-gain implicit in Sterling that judicial deference may serve as the quid proquo for a reasonable intracorporate effort to set fair merger terms,although these decisions have no doubt toughened the procedural mini-mums necessary for the intracorporate process to qualify.

VII. CONCLUSION

The principal thesis of this Article has been that the rules governingfiduciary conduct may best be understood as a compromise between thetwo imperfect institutions available to protect the interests of the princi-pal-judicial review of the fiduciary's decisionmaking and private order-ing by the principal or fiduciary.

Central to this view is the recognition that demanding that the judi-cial process determine such elusive and subjective issues as whether thefiduciary acted in good faith and out of consummate loyalty to the inter-ests of the principal necessarily entails cost and the prospect of error.The existence of these costs and errors has two important implications.

had filed under the Securities Exchange Act of 1934 at the time of the initial purchase constituted aprice commitment, which it failed to honor. Id. at 1101, 1103.344 Rabkin, 480 A.2d 655 (Del. Ch. 1984), rev'd, 498 A.2d 1099 (Del. 1985). Interestingly, the

author of the chancery court opinion was Vice Chancellor Berger, the co-author of the article dis-cussed supra note 337.

345 498 A.2d at 1104.346 Id. at 1104-05. The court added that "[w]hile a plaintiff's mere allegation of 'unfair dealing,'

without more, cannot survive a motion to dismiss, averments containing 'specific acts of fraud, mis-representation, or other items of misconduct' must be carefully examined in accord with our viewsexpressed both here and in Weinberger." Id. at 1105.

Given the posture of the case, the court did not reach the merits other than to conclude that thecomplaint was sufficient to survive a motion to dismiss. If the ultimate result of the case, however, isto hold that Olin had a fiduciary obligation to accomplish the merger within the one-year period andmeet the $25 price commitment, its likely effect, quite understandably, will be to rekindle the kindsof concerns discussed supra at text accompanying note 334. The supreme court's discussion of theplaintiffs' allegations was, however, broader than this one issue and considered--consistent withWeinberger and Rosenblatt-the quality of the bargaining process between Hunt and Olin. Id. at1105-07. Thus, its denial of the motion to dismiss stands on broader grounds.

347 See, eg., Joseph v. Shell Oil Co., 498 A.2d 1117, 1121-22 (Del. Ch. 1985) (decided prior tosupreme court decision in Rabkin; denying motion to dismiss upon concluding that reasonable doubtexisted that appraisal would be adequate to address alleged unfair dealing).

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First, a single rule will have a differing effect on conduct from fiduciaryto fiduciary and from principal to principal, based upon the relative ca-pacity of each to bear these costs and errors. Recall in this regard thediscussion of the effects of the corporate opportunity doctrine in subsec-tion IV.G..348 Second, the search for optimal legal rules should take intoaccount the ever-present availability of private ordering as an alternativewith potentially lower costs and risks of error. More specifically, the"best" rule is not the one that produces the lowest cost and error per sebut the one that produces the lowest residual cost and error after privateordering alternatives have been applied. Thus, given the unavoidable in-determinacy of the underlying legal issues, the desirable course may be totolerate the routine existence of error of one type or another, based uponthe relative capacities of the principal and fiduciary to bear it.

We applied this theoretical framework to explain the differing atti-tudes of agency and trust law, on the one hand, and corporate law, on theother. Section V demonstrated that the per se prohibitions of agency andtrust law reflected the concentrated-constituency nature of the principal.The result is a system of rules that seeks to reduce all risk that opportu-nistic conduct by the fiduciary will be upheld (Type I error) at the ex-pense of an enhanced risk that good faith conduct will be adjudged illegal(Type II error). The harm caused by this increased potential for Type IIerror is tempered by the fiduciary's capacity to bargain directly with theprincipal for his informed consent to the transaction and the fiduciary'stypically superior capacity to estimate and diversify against the residualrisk.

In section VI, we saw that corporate law had come, over time, toapply a less restrictive regime of rules to the fiduciary because the dif-fused-constituency nature of the publicly held corporation, coupled withthe incentives implicit in the shareholders' derivative suit, precluded di-rect dealing to obtain the consent of the underlying principals. And theunavoidable nature of many kinds of self-dealing relationships made anysystem of rules that produced a substantial risk of Type II error unac-ceptable. The adoption of bright-line standards provides one possible so-lution to this problem, but subsection VI.B. examined a number ofreasons, including some institutional characteristics of the legal process,why the law has instead employed a system of ad hoc fairness review.And while the rhetoric of this review process is that the fiduciary shouldcarry the burden of proof-in other words, that the priority is to elimi-nate Type I error-subsection VI.C. sought to show that in practice, thecourts accepted much less by deferring to intracorporate decisionmakingprocesses, notwithstanding their vulnerability to opportunism. That sub-section also considered several reasons for this posture of deference, in-cluding the superior capacity of shareholders to diversify against the risk

348 See supra text following note 115.



of error and the creation of incentives for the fiduciary to enter into mu-tually beneficial bilateral-monopoly relationships. Finally, that subsec-tion concluded that recent decisions, particularly in the area of parent-subsidiary mergers, suggest that courts are becoming more willing to ex-ert control over the quality of the intracorporate process as the price fortheir deference. This process-oriented control may emerge as the courts'principal check against Type I error.

The objective of this Article has not been to take normative standson the various issues now being hotly debated, particularly in the corpo-rate law area, on the proper regulation of fiduciary conduct. Rather, ithas been to try to provide a general framework within which to considerthose issues. The principal implication of this framework for the partici-pants in those normative debates is that a focus that implicitly views full-blown adjudication as a cost- and error-free alternative to a flawed intra-corporate evaluation process is by its nature one-sided. Admittedly, thisconsideration does not negate the value of attempts to prescribe furtherprocedural safeguards to improve the quality of those intracorporateprocesses. But proponents of these prescriptions must ask themselveswhether the benefits from the improvements in reducing the residual riskof Type I error-given the existing opportunities to handle that riskthrough private ordering-are worth the costs.

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davis - judicial review of fiduciary decision making

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