On Spec: Corporate Waste and Contract Law
Extravagant corporate expenditures are among salacious details revealed during the economic crisis, from executive compensation, celebratory parties, office renovations and naming sports stadiums. A few courts, even in Delaware, indicate willingness to police extravagance under the hoary corporate law doctrine of waste, and some observers call for reinvigorating that doctrine.
Reinvigoration would be necessary because use of the doctrine of waste to upset corporate transactions is nearly as rare as hen’s teeth. Students of contract law, when beginning to study corporate law, find this rarity strange. They are told corporate law is anchored in fiduciary principles that contrast with contract law’s operating assumption of arms’-length transactions warranting extraordinary judicial deference.
True, standard talk in corporate law jurisprudence concerning both fiduciary duty and waste expresses similar interest in judicial deference, though emphasizing greater willingness to review corporate transactions to evaluate whether officials act in good faith, with due care, and without promoting self-interest over corporate interest. It may be odd, then, that judicial willingness to police corporate transactions under the doctrine of waste is weaker than within traditional law of contracts, such as its doctrine of substantive unconscionability.
Put differently, the issue can be expressed as what kinship exists or should exist between corporate law’s doctrine of waste and contract law, especially substantive unconscionability. The following notes some familiar ways the two show remarkable kinship and the surprising ways they depart from one another. For those looking to corporate law’s doctrine of waste to promote greater corporate accountability, a modest way would simply take more meaningful lessons from the law of contracts.
Corporate law’s doctrine of waste and contract law’s doctrine of substantive unconscionabilty are rarely-invoked tools used sparingly to upset an exchange transaction. Contract law’s sparing use is based on the principle of freedom of contract, along with doubt about judicial competence to evaluate substance of exchanges and deference to individual actors. Corporate law’s sparing use is based on the principle of business judgment, along with like doubt and deference.
Talk in both doctrines overlaps. First, both bodies of law are averse to gifts, although for different reasons. Contract law’s basic principle of consideration marks off as unenforceable promises to make gifts lacking the indicia of bargain seen as central to enforceable exchange transactions; corporate law’s doctrine of waste prohibits gifts of corporate assets when absence of bargain means the corporation received nothing in exchange.
Second, both bodies of law do not insist on any particular or manifest equivalence of the terms of bargain, enforcing and not upsetting transactions so long as the consideration is minimally adequate. In traditional contract law, this is the peppercorn theory of consideration, and works to the extent that even nominal consideration can perform functions required to separate exchanges from gifts. In both contract and corporate law, the issue is whether there is any consideration and, in corporate law, at least some relation between what the corporation transferred and what it received.
Third, both bodies of law investigate adequacy of consideration issue by posing similar questions using similar syntax. In contracts, an exchange or term may be stricken as substantively unconscionable only if no fair minded person would propose it and no rational person would assent to it. In corporations, a transaction may be upset only if the consideration is so inadequate in value that no person of ordinary sound business judgment would deem it worth what the corporation paid.
Despite affinities, numerous differences appear in these contract and corporate law doctrines. Contract law is quintessentially premised on freedom of exchange and assumes party competency and capacity, so that people lacking the latter traits can elect to be excused from contractual obligation. Corporate law is primarily fiduciary law, premised on the idea that officers and directors act on behalf of the corporation and must advance its and shareholder interests, not personal interests. To that extent, one may expect the otherwise roughly equivalent policing doctrines to be more frequently or robustly used in corporate law than in contract law.
But surveys of casebooks and other resources suggest that may not be the case. Indeed, contract law tends to resort to unconscionabilty doctrine only when no other available grounds exist to provide traditional doctrinal excuse, such as lack of capacity or competency, non-disclosure, misrepresentation, breach of warranty, duress, fraud or mistake. In corporate law, a claim of waste is so difficult to sustain that it rarely is possible to prevail unless there is some other grounds for challenging a transaction, such as breach of the duty of care or loyalty or fraud or ultra vires (corporate law’s functional equivalent to lack of capacity or competency, even more rarely used than waste in modern times).
Finally, contract law’s propensity to use substantive unconscionability to police exchanges intensifies according to a fairly coherent logic. First, it is least likely to be used in true arms’-length transactions, even on lopsided terms, like a grubstake contract that pays off 200:1, even by one of uncertain mental capacity, or an emergency loan contract that pays off 80:1, even in a time of war and famine.
Second, it is more likely that a court in equity, at least, would refuse specific performance of a land sale contract with a value ratio of say 40:1, even if not saying it would refuse to award money damages for its breach.
Third, contract law’s policing becomes most likely when a contract is between those in a confidential or fiduciary relationship, such as brother-sister and business manager-client, as when invoking notions of constructive fraud to refuse enforcement of a land sale contract with a value ratio of as little as 15:1. Similarly, it is most likely when a contract is formed at the urging of a trusted relation, such as a an intimate partner, as to exchange a contractual annuity right for a 1/4 of its face value. It is also invoked to refuse enforcement of a prenuptial contract on massively lopsided terms.
So contract law’s logic is to become increasingly skeptical of lopsided exchanges as one moves from arms’-length transactions, to those evaluated in equity, and those involving special relationships of confidence, trust and fiduciaries. It is odd, then, that corporate law, fundamentally a fiduciary body of law founded in equity, remains strongly deferential to lopsided exchanges.
Among the few examples of successful invocation of the doctrine of corporate waste are the award to directors of stock options with an exercise period lasting a decade after they leave office or when a corporation allows an executive to discharge a loan in full by repaying only half of it. At the other end, massive salaries are outside the doctrine, because they so easily meet a longstanding test, stated by the Supreme Court in 1933 (before Erie), denying waste unless there is “no relation” between what the corporation gives and gets. That is a reason why a Delaware company defeated a claim of waste a few years ago even when it paid a newly recruited executive $140 million for a year’s work that was totally unsatisfactory.
So it is exceedingly difficult for shareholders to win claims of corporate waste. Certainly, it is nearly impossible to sustain such claims to challenge mergers or dividend policy. Even as to compensation claims, the context of its likeliest utility, success is rare, when adequate consideration can even be found solely from the possibility that an executive may in the future be available to provide consulting services to the corporation.
Contract law’s policing devices for unconscionable bargains is rarely used too, of course, especially concerning substantive terms of exchange. It is more frequently invoked concerning terms of employee or consumer contracts containing obnoxious clauses concerning matters like arbitration or termination. To that point, one difference between contexts these laws address is the lesser perceived need for judicial superintendence and protection of shareholders of corporations compared to consumers, employees and other vulnerable types signing contracts of adhesion containing dense boilerplate overwhelmingly one-sided.
Yet when a large number of American households have increasingly come to rely upon stock ownership as the primary savings vehicle for retirement, especially through employer defined-contribution plans, the difference between consumers, employees and shareholders diminishes. It may be defensible and desirable for courts, even in Delaware, to sharpen, even if slightly, their oversight of corporate decision making under the doctrine of corporate waste. The basic law of contracts can help.
At least, I think, there may be an article to write investigating the doctrine and its current and potential kinship with contract law and its doctrine of substantive unconscionability. Thanks to my RA, Christa Laser, we are researching this possibility this summer. Thoughts are eagerly welcome on its viability.
Hat Tip: Christa Laser