The Peoples corporate law: unsafe at any speed

by Jeffrey MacIntosh

This commentary was first published in the Financial Post on June 10, 2008.

Ford Motor Co. was founded in 1903 on an investment of $100,000. By 1916, the company was making $60 million a year in profits. A funny thing happened on the way to the bank, however. In an ostensible attack of socialist contrition, Henry Ford publicly announced that the company had made "too much money". Of the $60 million in profits, only $1.2 million would be paid out as dividends. The rest would go to new investment in plant and equipment -- and to finance a lowering of the price of the company's automobiles, so that the benefits of the industrial system could be spread as widely as possible, as Henry put it. Shareholders sued, seeking additional payment of dividends.

As is so often the case, the real story is found not in the text, but in the subtext. Henry knew perfectly well that the plaintiffs - the Dodge brothers -- intended to use their cash dividends to start a competing automobile company (and eventually did). His tale of philanthropic zeal was pure gimcrackery. But in the end good old Leninist cadre Henry was hoist on his own petard. Had he simply stated that it was in the best interests of the shareholders to pay a small dividend and reinvest the balance, his decision would have been legally irreproachable. But the court, taking his story at face value, ordered the payment of an additional $20 million in dividends, stating "a corporation is organized and carried on primarily for the benefit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors is to be exercised in the choice of means to attain that end and does not extend to a change in the end itself?"

The Ford case expresses a principle that has long been a cornerstone of American and Commonwealth corporate law - that the "fiduciary" duty of directors lies in maximizing shareholder wealth. The rights of other claimants, such as bondholders, trade creditors, employees, landlords, and the like, are purely contractual. If these contracts are breached, the corporation must pay damages. End of story.

The recent holding of the Quebec Court of Appeal in the much--publicized case involving BCE is at odds with this principle. Debenture holders complained that a takeover bid, involving the superposition of a large whack of new debt (and debt guarantees) - was prejudicial to the value of their claims. Rejecting the scrupulously reasoned trial judgment in favour of BCE, the court found sympathy with their plea, stating that it was incumbent upon the directors to determine if the takeover bid - effected via a mechanism known as an "arrangement" (essentially just a statutory mechanism for the completion of a fundamental corporate transaction with court approval) - was fair to the creditors. Because the directors had made no attempt to determine if shareholder gains could be secured without prejudicing the value of the debt, judicial approval for the arrangement was withheld.

The Court of Appeal's decision rests on shaky jurisprudential grounds. In particular, the court misunderstands (and thus misapplies) prior "arrangement" jurisprudence involving reorganizations of companies tottering on the brink of insolvency. These arrangements specifically contemplated an alteration of the rights of creditors. The BCE plan does nothing of the sort. It is a combined takeover bid/going private transaction involving a solvent company, in which the creditors' legal rights are in no way adversely affected. These cases have no application.

Then there is the takeover jurisprudence, largely ignored by the Court of Appeal. Up until now the courts have never asked directors to consider the welfare of constituencies other than shareholders in evaluating a takeover bid. In a case that aptly summarizes the law in Canada, the Ontario Court of Appeal has stated that "the obligation of directors when there is a bid for change in control [is] an obligation to seek the best value reasonably available to shareholders in the circumstances" (and contrary to some recent press reports, a more recent holding involving Sunrise Senior Living REIT expressly reaffirms this principle). The board scrupulously followed this mandate. In addition, the procedures adopted by the board to structure and oversee the auction process were impeccable and in strict accordance with extant jurisprudence.

Whether a takeover bid is consummated in the usual fashion or as an arrangement must surely be irrelevant when it comes to defining the content of directors' duties. As a matter of policy and common sense, it would be silly if directors' duties varied depending on the form of the transaction. This was apparently the view of Corporations Canada (the federal agency that administers the federal corporate law), which expressly indicated that it saw no reason to intervene.

The Court of Appeal, however, had another arrow in its quiver - a Supreme Court of Canada (SCC) decision in a case called Peoples Department Stores v. Wise. In Peoples, the court stated that: "Insofar as the statutory fiduciary duty [of directors] is concerned, it is clear that the phrase the "best interests of the corporation" should be read not simply as the "best interests of the shareholders"."

The Peoples decision is plagued with a myriad of problems. Notable among them is that the court's holding concerning the duty of directors improperly derives the law from two lower court decisions - one in B. C., the other in Ontario. The pertinent part of the B. C. decision is what we lawyers call an "obiter dictum" - not an essential part of the court's decision, and therefore not binding as judicial precedent. Oddly enough, the Ontario case cited by the SCC nowhere suggests that director's duties on a takeover bid (or otherwise) are owed to anyone but shareholders. Perhaps more troubling, the SCC ignored other Canadian and Commonwealth jurisprudence asserting shareholder primacy -- most notably three prior decisions of the SCC itself. The SCC's decision in Peoples is thus arguably "per incuriam"; that is, inconsistent with the principle of precedent that is the foundation of our legal system.

But the Quebec Court of Appeal overlooked another important aspect of the holding in Peoples. On the issue of directors' duties, the SCC accepted the lower court's finding that the defendant Wise brothers had not acted in bad faith. They could not, therefore, have breached their fiduciary duties to the corporation. Because that entirely disposed of the legal issue in question, the rest of the SCC's discussion of directors' fiduciary duties (and the overlapping statutory "oppression remedy") is therefore obiter dictum - that is, lacking precedential value. For this reason, it is not binding on the Court of Appeal--or any other court.

Finally, the Quebec Court of Appeal's holding that the board of BCE failed to consider the interests of the debenture holders is simply wrong. The board clearly did consider their interests. Having (correctly) determined that the debenture holders' entitlement in the arrangement was limited to protection of their legal rights, they crafted a process that ensured that these rights would be protected. The debenture holders had no reasonable expectation that the board would do anything more.

The Peoples decision rests to no small degree on the fact that the statutory oppression remedy (OR) gives the creditors standing to complain of unfair corporate conduct. There is every indication in the legislative report of the committee that drafted the provision, however, that the committee embraced the shareholder primacy rule as a bedrock principle of corporate law. Allowing creditors (as well as directors and officers) to complain about unfair conduct was almost certainly a product of the fact that the committee envisioned that the OR would be applied mainly, if not exclusively, in cases involving private corporations. Because, in such cases, the roles of shareholder, creditor, director, and officer so frequently overlap, the drafters thought that it would be appropriate to allow a shareholder to complain about conduct that was unfair to her in any of those capacities. Hence the broad standing provision. The committee never envisioned that the courts would employ the OR to subvert the most fundamental aspect of corporate law - that directors shall conduct the affairs of the corporation in the interests of the shareholders. Regrettably, however, the courts have employed the OR is ways that clearly fall outside the boundaries of what was contemplated.

As I argue in a companion piece tomorrow, the shareholder primacy rule is sound not merely as a matter of law, but as a matter of policy. Fixed claimants like creditors are fully capable of protecting their interests via their contracts with the corporation. It is not "unfair", nor a violation of "reasonable expectations", to hold them to their contractual bargain. If they fail to negotiate the appropriate protection, they have no one to blame but themselves.

The BCE case is a perfect illustration. The complainants all hold debentures in Bell Canada, a wholly owned subsidiary of BCE. The trust indentures governing their contractual rights contain specific terms that protect the value of the debentures should Bell be merged or amalgamated with another company. For the most part, they do not restrict the ability of Bell to add further debt. Nor do they contain what has become known as a "poison put" - a contractual feature that makes the debt due and payable on a change in control. The debenture holders might easily have bargained for these rights, but did not. It is virtually certain that the price that they paid for their debentures reflected the absence of those protections. The takeover bid in no way compromises the rights that the debenture holders did bargain for. Judicial action that cedes the debenture holders' rights that they could have negotiated and paid for -- but did not -- provides them with an unwarranted and unearned windfall gain.

More generally, providing a judicial right to re--open a sealed contract merely because one has suffered an economic loss threatens the sanctity (indeed, the very purpose) of contract. Losses are more than merely a commonplace in business - they are a necessary and indispensable component of risk--taking. No one who enters into any commercial relationship can for a moment entertain the quixotic notion that loss - without skullduggery or illegitimate advantage--taking -- is impossible. If one can willy--nilly sue upon a loss, no contract is safe from an after--the--fact judicial re--allocation of risk. When sophisticated commercial parties have either explicitly (by express contractual term) or implicitly (by failing to protect themselves against a known risk using a familiar contractual technology), no court should intervene.

Let us have no illusions about the identity of the plaintiffs in the case. They are not the stereotypical "Aunt Minnie from Oshkosh" (as Harvard law professor Louie Loss used to say), crying out for protection from the rapacious predations of baby--killing capitalists. They are sophisticated institutional investors fully capable of protecting their own interests. Indeed, while there is undoubtedly a "retail" tranche of BCE debt, it is these very same institutional investors who negotiated and priced the BCE debentures. That they should now be crying "foul" when BCE stands fully prepared to honour the contractual commitments that they negotiated does them little credit (pun intended).

It is possible that in hearing the BCE appeal, the SCC will reverse the damage of its prior ruling in Peoples and reaffirm the centrality of shareholder primacy in corporate law. We can only hope that the judges will not fall prey to the seductive but pathological argument that every loss deserves a remedy. While Dr. Seuss's Lorax may have exceeded the bounds of decency, in the BCE case his maxim is apt: "business is business and business must grow, regardless of crummies in tummies you know..."

If the court demurs, however, only a legislative solution will suffice. In particular, according creditors - or other fixed claimants - standing to complain about oppression is a non--starter. A simple amendment is all that is needed to address the problem. The consequences of a failure to act cannot be overstated. If Canadian firms are exposed to strike suits not only at the instance of creditors, but every other class of fixed claimant, the cost of capital will surely rise. Moreover, the deliberations of Canadian boards of directors will become a nightmare. It is a tall enough challenge to maximize the wealth of a single constituency. If directors must continually engage in an extended, and necessarily indeterminate political debate about which of a myriad of interests trump which others, the board will cease to be an effective institution of corporate governance. Trial judge Joel Silcoff nailed it on the head when he ruled that to allow the debenture holders to judicially bootstrap their contractual rights would "set a dangerous precedent and could result in uncertainty and instability in the equity and debt markets for years to come." It is only to be hoped that the SCC will be as wise.

This article is the first in a two-part series. Read Part II, "Engine of Wealth".