One Duty to All: The Fiduciary Duty of Impartiality and Stockholders’ Conflict of Interest
The typical structure of corporations with multiple classes of stock consists of multiple classes of preferred stock and one or more types of common stock. These structures are most commonly used in venture capital-backed companies. Venture capitalists and other ‘outside’ investors receive preferred stock whereas founders and company employees, by and large, hold common stock. The contributions made by the venture capitalists (the preferred stockholders) are not done for free. A venture capitalist will only invest if the deal is logical, which typically means that he will receive an adequate sort of consideration, such as additional voting or economic rights. These additional rights seek to protect the high-risk investment of the preferred stockholders (normally venture capitalists) in start-ups; in its early stages, a start-up success is highly uncertain—it can either become wildly successful or fail entirely.
My forthcoming Article in the Hastings Business Law Journal (Winter 2020) discusses Delaware precedent, primarily In re Trados Shareholder Litigation (Trados) and Fredrick Hsu Living Trust v ODN Holding Corp et al (ODN), pursuant to which a corporate board of directors owe fiduciary duties to holders of corporation’s common stock and not to holders of preferred stock. These cases suggest that enforcement of the preferred additional rights should be carried out in a different manner from enforcement of the common rights. This ‘different treatment’ has the potential not only to diminish the utility of the preferred, but also to disable that productive mode of financing, which would not otherwise be received by alternate sources.
The first major case to suggest this ‘different treatment’ was decided in 2013. That year, the venture capital community was rocked by a decision of the Delaware Chancery Court in Trados. In Trados, the corporation faced financial difficulties when a potential buyer emerged and the board saw to sell the corporation at a deal price almost equal to the preferred liquidation preference. In other words, the preferred stockholders received almost all of their liquidation preference, and the common stockholders received nothing. Before finding that the common stock was actually worth nothing, the court held that when a board of directors considers whether to take corporate action, it should consider solely the interests of its common stockholders as ‘residual claimants’, and the interests of preferred stockholders should be taken into account only to the extent that they do not invoke their special contractual rights and rely on a right shared equally with the common stockholders.
In 2017, the Delaware Chancery Court again ruled in ODN. In ODN, the court refused to dismiss claims against the board of ODN, stating that it breached its fiduciary duties to common stockholders by selling certain corporation business lines and assets to fund a mandatory redemption of preferred stock that had vested after five years. Although the mandatory redemption was a contractual obligation to the preferred stockholders, the court held that such a contractual right is subject to the board’s fiduciary duty; the board has the right/duty to decide whether it is in the best interests of the common stockholders (ie, not the enterprise as a whole) to commit an ‘efficient breach’ of the corporation’s obligation to the preferred stockholders.
Following the court’s holdings in the Trados and ODN, scholars took different views with respect to these decisions. Some praised or otherwise supported the court’s view, whereas others criticized it to a large extent. The current criticism has yet to result in a comprehensive and unified resolution to conflicts of interest among stockholders.
The Article takes a closer look at the legal reasoning and foundations of the court rationale in Trados and ODN and critiques the underlying assumptions of the court in these cases. Specifically, the Article argues that the court failed to make an important distinction among different rights tied to stock ownership and to address the enforcement of the preferred stockholders’ rights at the contractual level. By analyzing the rights tied to stock ownership, laying out the arguments as to the questionable enforcement of the preferred stockholders’ rights on the contractual level, and discussing the implications of the court’s view on agency and transaction costs, and value-maximization issues, the Article argues that the enforcement of preferred stockholders’ rights should be undertaken through the board of directors’ fiduciary duties to all stockholders without prejudice.
The Article further analyzes potential interclass preference conflict between and among different types of preferred and common stockholders, in both privately held and publicly traded corporations. The Article argues that the current approach the Delaware Chancery Court takes lacks a solution with respect to interclass preference conflicts both for privately held and publicly traded corporations.
The Article concludes with a proposed framework for resolving stockholders’ conflicts of interest that were previously discussed. The Article proposes the ‘fiduciary duty of impartiality’ as an analytic framework to resolve conflicts of interest between and among common-preferred stock and interclass preference.
The fiduciary duty of impartiality is the duty to administer the corporation’s affairs in a manner that is impartial with respect to the various beneficiaries (stockholders) of the corporation. It is an extension of the duty of loyalty. The duty of impartiality requires a fiduciary to act in the best interests of the beneficiaries, but recognizes that beneficiaries have competing economic interests and, therefore, it allows a fiduciary to exercise discretion while having a duty to act bona fide in the best interests of the beneficiaries as a whole.
Due to the duty’s recognition that beneficiaries may have competing economic interests, it provides guidelines to the fiduciary that can be applied by her or him in its decision-making process. In sum, the fiduciary duty of impartiality is a balancing test that provides a corporation’s board of directors a flexible tool with which to weigh various, and often conflicting, interests of stockholders to reach a resolution that maximizes the value of the corporation as a whole.
Shachar Nir is a lawyer in the New York office of Kirkland & Ellis LLP.
YOU MAY ALSO BE INTERESTED IN