Prof. Bainbridge on Hess: Critics Still Not There Yet

Prof. Steve Bainbridge replied to my post about shareholders paying bonuses to director nominees elected in contested elections, highlighted by the pending proxy battle at Hess.  Steve clarifies his objection to Elliott Associates, the activist shareholder hedge fund, promising to pay its director nominees bonuses if Hess’s stock price outperforms a group of industry peers over the next 3 years:

When I described these transactions as involving a conflict of interest, what I had in mind was the general conflict of interest ban contained in Restatement (Second) of Agency sec 388:  “Unless otherwise agreed, an agent who makes a profit in connection with transactions conducted by him on behalf of the principal is under a duty to give such profit to the principal.”  Surely the hedge fund payments here qualify as, for example, the sort of gratuties picked up by comment b to sec 388:

“An agent can properly retain gratuities received on account of the principal’s business if, because of custom or otherwise, an agreement to this effect is found. Except in such a case, the receipt and retention of a gratuity by an agent from a party with interests adverse to those of the principal is evidence that the agent is committing a breach of duty to the principal by not acting in his interests.  Illustration 4.   A, the purchasing agent for the P railroad, purchases honestly and for a fair price fifty trucks from T, who is going out of business. In gratitude for A’s favorable action and without ulterior motive or agreement, T makes A a gift of a car. A holds the automobile as a constructive trustee for P, although A is not otherwise liable to P.”

How is the hedge fund’s gratitude for good service by the Hess director any different than T gift to A?  To be sure, directors are not agent of the corporation, but “The relationship between a corporation and its directors is similar to that of agency, and directors possess the same rights and are subject to the same duties as other agents.” . . . Thus, I believe, even if the hedge fund nominee/tippees are scrupulously honest in not sharing confidential information with the funds, put the interests of all shareholders ahead of those of just the hedge funds, and so on, there would still be a serious conflict of interest here.

I can offer 4 replies to Steve’s fine legal points, which I’ll first summarize and then elaborate:

1.  While Steve acknowledges that agency law doesn’t apply, he stresses similarities between agency and corporate law when justifying reference to the American Law Institute’s Restatement (Second) of Agency, but then omits the differences that warrant treating directors differently than agents.

2. Even accepting arguendo Steve’s proposal to rely on the Restatement (Second) of Agency,  he chose to present Illustration 4 as governing the Elliott-Hess arrangement, but the next one, Illustration 5 (excerpted below), is more on point and comes out the other way because the agent and principal are free to agree otherwise.

3.  Even if agency law applied, the Restatement (Second) of Agency, initially adopted in 1958, was superseded in 2006 by the Restatement (Third) of Agency, whose provisions support the Elliott-Hess arrangements.

4.  But agency law doesn’t apply.  The ALI’s applicable standard from corporate law is stated in its Principles of Corporate Governance, expressly referenced in the Restatement (Third) of Agency.  This standard puts the burden on those challenging such arrangements to prove defects such as unfairness or secretiveness, which opponents have not done. 

To elaborate on each these 4 points:

1. As Steve notes, directors are not agents and the law of agency does not apply to them. True, as Steve stresses, a set of similar fiduciary duties applies.  But they do not apply in exactly the same way as duties between, say a sports agent and her athlete client or a real estate agent and her developer client.

Reasons include that a corporate director acts for a corporation whose  decision-making apparatus are intricate, involving a combination of board and shareholder voting with different rules concerning quorums, required vote and other matters. These differences are so profound that the American Law Institute, producer of the Restatement (Second) of Agency, doesn’t treat directors there but in its separate treatise, Principles of Corporate Governance.

2.  But before returning to look at the Principles of Corporate Governance as stating the applicable law, assume that Steve is right to reference agency law, and the Restatement (Second) in particular.  The provision Steve quotes (above) emphasizes the possibility of contrary agreement, based on custom or otherwise.   The next illustration captures that scenario, where the principal observes agent behavior and silently assents to it:

Illustration 5. A, the purchasing agent of a large restaurant, receives gifts of packages of food for his private consumption from persons desiring to sell food to the restaurant. The owner, P, witnesses several of these transactions and says nothing. A’s conduct is not a breach of duty to P, and P has no interest in the gifts.

Unlike Illustration 4, which Steve cites, Illustration 5 is more akin to the Elliott-Hess situation.  There, shareholders are informed of the proposal; if Hess shareholders vote for Elliott’s nominees, they agree to it (they reach an “agreement to the contrary”).   Indeed, shareholders voting for director nominees who are promised payments do more than P in this illustration: P simply “witnesses . . . and says nothing” while shareholders vote affirmatively for the slate, pay package and all.

3.  In any event, moreover, the Restatement (Second) of Agency, which the ALI initially adopted in 1958, has been superseded by the Restatement (Third) of Agency, adopted in 2006.  Today’s statement of this branch of the law of agency says:

§ 8.02 Material Benefit Arising Out Of Position.  An agent has a duty not to acquire a material benefit from a third party in connection with transactions conducted or other actions taken on behalf of the principal or otherwise through the agent’s use of the agent’s position.

Again, this obviously wise statement of agency law is readily and sensibly applicable to agents but is ill-suited to corporate directors.  For example, the idea and existence of a third party is easier to see in agency relationships compared to the corporate director setting.   After all, it is far from obvious to classify as a “third party” a shareholder proponent in a hostile proxy contest for director elections with the endorsement of the requisite majority of shares eligible to vote.
4. The complexities highlighted in points 2 and 3 help to explain why the law of agency does not apply to corporate directors but that the separate body of corporate law does.  As the current Restatement (Third) of Agency expressly states, the comparable rules for corporate directors appear in the ALI’s Principles of Corporate Governance: Analysis and Recommendations § 5.04.  Those rules are vastly different and reflect the particular features and needs of the corporate setting.  Relevant portions read  as follows:

§ 5.04 Use By A Director . . . Of Corporate Property . . .  Or Corporate Position.  (a) General Rule. A director . . . may not use corporate property . . . or corporate position to secure a pecuniary benefit, unless either:  (1) Value is given for the use and the transaction meets the standards of [interested-director transactions, met if fair to the corporation]; (2) The use constitutes compensation and meets the standards [governing executive compensation, again met if fair to the corporation]; . . .  (4) The use is . . . authorized in advance . . . by . . . disinterested shareholders . . . and meets [stated] requirements and standards of disclosure and review . . .

(b) Burden of Proof. A party who challenges the conduct of a director . . . under Subsection (a) has the burden of proof, except that if value was given for the benefit, the burden of proving whether the value was fair should be allocated as [in interested-director transactions].

Under this formulation, those challenging the Elliott-Hess arrangements have the burden of proving the use of corporate property or position to secure a pecuniary benefit to a director that is either unfair 0r not authorized in advance by disinterested fully-informed shareholders.  It remains far from clear to me that opponents have demonstrated a probability of succeeding in doing so.

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4 Responses

  1. 1. You say that “Illustration 5 is more akin to the Elliott-Hess situation.” I disagree. Electing directors is NOT an adequate ratification of this conflict of interest transaction. You would need specific approval by the holders of a majority of the disinterested shares of the specific gratuity for the reasons set forth in my first post.

    2. I don’t think the Restatement (Third) changes the law on gratuities.

    3. Hess is a Delaware corporation. The ALI Principles thus are not relevant. Delaware law is. As you know, there is no Delaware case on point. Otherwise, we would not be having this discussion.

    4. Delaware law is clear that “Classic examples of director self-interest in a business transaction involve either a director appearing on both sides of a transaction or a director receiving a personal benefit from a transaction not received by the shareholders generally.” Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993). And, under Delaware law, “Under the duty of loyalty, the burden of proof lies initially with the interested party to demonstrate the entire fairness of the transaction.” MacLane Gas Co. Ltd., Partnership v. Enserch Corp., 1992 WL 368614 at *7 (Del.Ch.,1992). Ergo, all “those challenging the Elliott-Hess arrangements” have to do is show that the directors are getting a gratuity not shared with the shareholders and the burden of proof is on the directors to show that what they did was fair (or properly ratified by the holders of a majority of the disinterested shares).

  2. Lawrence Cunningham says:


    Your point 1. is part of the reason why the Restatement of Agency doesn’t work (whether Second or Third). Illus. 5 lets agents keep gratutities merely by principals witnessing the taking and not saying anything. That doesn’t seem like the right approach for directors. Any kind of shareholder vote is certainly much more than merely witnessing something and staying silent.

    And suppose you are right that any shareholder vote should be up or down on the specific payment rather than merely the election of directors known to be given such a promise. If so, that just proves the point that the law of agency is the wrong place to be looking.

    But while I’m sure that agency law is the wrong place to look, I’m not sure Delaware corporate law requires anything more to validate the contracts than the coming proxy vote in the contested election. Every shareholder is fully informed and, so long as a majority of disinterested shares vote for this slate, they are implicitly approving the package.

    Yet nor is it obvious that this arrangement constitutes the kind of interested director transaction supposed. This is not a director on both sides of a transaction with the corporation and any benefit that might be received is a form of compensation tied to gains shareholders receive (i.e., a stock price performance that exceeds a group of peers over three years).

    Finally, another curiosity not yet mentioned is that the people in question are not currently directors of Hess and have no other relationship to it. They have no duties to Hess or its shareholders whatsoever at the time that these arrangements are made. Reminds me a bit of Michael Ovitz in Disney.

  3. Nicholas Georgakopoulos says:

    The wrinkle here is that Elliott is not merely giving the director a gift but is providing the director an incentive to better promote the interests of the shareholders. Essentially, although I agree with Steve that illustration 4 would apply to a simple gift, the incentive effects make it entirely novel, distinguishable, and favor upholding it. Why? Because shareholders would have approved ahead of time. Compare to the board adopting a poison pill with no shareholder vote. A sharper conflict exists, since the directors may use the pill for entrenchment, not even tacit shareholder approval exists, and DE law requires that the pill ONLY be used for entrenchment to invalidate it. As the BJR is interpreted to validate the pill, a fortiori it should validate the incentive scheme on which shareholders have indirectly voted by electing the director with the Elliott incentive. Again by analogy to the treatment of the pill by the courts, if the director makes a decision contrary to the shareholder interests because of the incentive (hard to imagine), then the courts can come upon the challenge of the decision and invalidate it the way that the courts invalidate the inappropriate use of the pill.

  4. Lawrence Cunningham says:


    Excellent contribution, especially on the analogy to the poison pill.