Metaloyalty

Can someone be said to have a duty of loyalty if they can modify the scope and content of their duty?

Here’s an interesting puzzle. Fiduciaries owe a duty of loyalty (to the principal, the trust beneficiaries, the corporation and its shareholders, etc.). But what loyalty looks like depends on specific legal facts. For example: the relevant jurisdiction. Loyalty is not the same in New York, Las Vegas, or London. Or: the type of business organization. Loyalty is not the same for trustees, corporate directors, or managers of an LLC.

Which raises the following question: If the fiduciary has the power to alter those legal facts and does so in a way that weakens or dilutes the kind of loyalty she owes, is she being disloyal?

It is an interesting problem with many ramifications. I call it metaloyalty, because it is loyalty about (the scope and strength of) loyalty. Perhaps one day I will finish the paper I’ve been trying to write on this topic.

Meanwhile, the Delaware Court of Chancery—perhaps the world’s busiest court on questions of fiduciary loyalty—has weighed once again on this topic.

In Peña v. MacArthur Grp. [Westlaw], a minority shareholder complains that the board and the controlling shareholders executed a merger of the corporation into a shell LLC in order to eliminate their fiduciary duties and give themselves legal immunity for past and future wrongdoing. In Delaware, LLCs, unlike corporations, can eliminate fiduciary duties. The Mac LLC Agreement does precisely that.

Fiduciary Duty Waiver. The [LLC Agreement] eliminates fiduciary duties implied by applicable law that certain Covered Persons (which includes the Board of Managers, the Partnership Representative, and officers of [Mac LLC]), [Mac LLC], and the Members, may owe to each other or to any other person that is a party to or otherwise bound by the [LLC Agreement]. The [LLC Agreement] also provides that to extent not prohibited by law, no Covered Person will be liable, for damages or otherwise, to [Mac LLC] or to any Member for any loss that arises out of any act performed or omitted to be performed by it, him or her, in its, his or her capacity as a Covered Person; and [Mac LLC] will indemnify and hold harmless Covered Persons against certain legal actions brought against him or her on account of service provided to [Mac LLC].

As a consequence of the merger, Peña, formerly a minority shareholder of MacArthur Group, Inc., now finds himself in the position of member of an LLC without the protection of fiduciary duties. Does the merger raise fiduciary issues? It is a metaloyalty question.

Vice Chancellor Zurn said that yes, MacArthur’s conversion into an LLC does raise a potential metaloyalty problem. But to understand why the decision is particularly interesting, we need to take a step back and revisit one of Chancery’s most controversial decisions of the last few years: Palkon v. Maffei [Westlaw].

In Maffei, the metaloyalty claim was about TripAdvisor’s re-incorporation to Nevada. Plaintiff argued that the transaction conferred “a non-ratable benefit” on the directors and the controlling shareholder who approved it, because under Nevada law, corporate fiduciary duties are weaker. Vice Chancellor Laster ruled that the plaintiff’s theory was potentially valid and denied the defendants’ motion to dismiss:

As depicted, the [reincorporation] constitutes a self-interested transaction effectuated by a stockholder controller. The reduction in the unaffiliated stockholders’ litigation rights inures to the benefit of the stockholder controller and the directors. That means the [reincorporation] confers a non-ratable benefit on the stockholder controller and the directors, triggering entire fairness. There are no protective devices that could lower the standard of review. Entire fairness governs…

The floor for substantive fairness is whether stockholders receive at least the substantial equivalent in value of what they had before. Before the [reincorporation], the stockholders held shares carrying the bundle of rights afforded by Delaware law, including a set of litigation rights. After the [reincorporation], the stockholders owned shares carrying a different bundle of rights afforded by Nevada law, including a lesser set of litigation rights. That makes it reasonably conceivable that the stockholders do not possess at least the substantial equivalent of what they possessed before, supporting an inference that the [reincorporation] was not substantively fair.

Beneath the technical question (which hinges on the applicable standard of review, which in turn depends on whether the transaction gives an asymmetrical material benefit to the controlling shareholder), the case raised big politico-economic questions. Market players wondered: Is Chancery saying that companies can’t get out of Delaware without paying damages to minority shareholders?

One year later, the Delaware Supreme Court reversed. In Maffei v. Palkon [Westlaw], the main argument of the court was that the alleged wrongdoing that TripAdvisor’s controlling shareholder was planning to commit was merely speculative. Sure, maybe Nevada law is friendlier to controlling shareholders—neither the Court of Chancery nor the Supreme Court got to the merits of this question—but to go to trial plaintiff must allege a concrete, actual risk not a hypothetical one:

We hold that the absence of any allegations that any particular litigation claims will be impaired or that any particular transaction will be consummated post-conversion, weighs heavily against finding that the alleged reduction in liability exposure under Nevada's corporate law regime is material.

To the cynical analyst, the Delaware Supreme Court had found a reasonably-sounding way out of a big political problem. Ruling that reincorporating from Delaware to Nevada is potentially disloyal is not exactly good interstate etiquette. The opinion explicitly recognizes this as obiter dictum:

[A]lthough comity concerns are not an independent ground for reversal in this case, our holding furthers the goals of comity by our declining to engage in a cost-benefit analysis of the Delaware and Nevada corporate governance regimes. “The United States is a federal republic that depends on comity among the states for the peaceful and efficient conduct ... of private commerce.” States have taken different approaches on matters such as the scope of director and officer exculpation, standards of review, and the scope of stockholder inspection rights. And litigation rights, as the Vice Chancellor recognized, are only one stick in the corporate governance bundle.

But once stripped of this layer of deflationary rhetoric, the grounds for reversal remain very narrow. The court did not reject the idea that metaloyalty in reincorporations is a thing, let alone that metaloyalty in general is a thing. And how could it?

If there is good reason to give fiduciaries a duty to do X, how could we justify giving them also a power to alter that duty so that they unilaterally obtain permission to do X? Isn’t the first-order duty empty from the very beginning if it comes together with a power to eliminate it?

This is the subject of a longer paper—which will have to engage with Hart, Raz, Chang and other philosophers who have thought about rules of change and normative powers—not of this post. This is post is a reminder that despite what some distracted readers may have thought when the Delaware Supreme Court’s decision in Maffei came out, metaloyalty is a thing in Delaware.

This is precisely Zurn’s reading of Maffei. From Peña v. MacArthur Grp.:

I read Maffei’s guidance on materiality to encompass temporality, maturity, and scope, like the precedent it relies on. It teaches that a waiver that is both retroactive and prospective, enacted in the shadow of actual litigation, and waives the duty of loyalty to the point of excusing intentional misconduct would be material. A waiver that is prospective, enacted on a clear day, and leaves the duty of loyalty undisturbed would not be material. There is much room in between. The Delaware Supreme Court found the Maffei reincorporation exculpated liability prospectively, was approved on a clear day, and intruded on the duty of loyalty but not to the point of intentional misconduct, and concluded it was not a material benefit to Tripadvisor’s fiduciaries.

Here, Mac LLC’s fiduciary duty waiver secured for the former MacArthur directors a waiver that is prospective. And Mac LLC’s fiduciary duty waiver eliminates “all future potential liability for all fiduciary duty claims, including claims for breach of the duty of loyalty.”…

Plaintiff pleads particularized facts that give rise to a reasonable inference that at least Sauer, as the Company’s controller, approved the Merger and adopted the fiduciary duty waiver “in contemplation” of ongoing self-dealing. Sauer and Myers caused MacArthur to take out a $14 million face value whole-life life insurance policy for the sole benefit of Sauer’s wife in mid-December of 2022. Defendants approved the Merger on December 14. Sauer and Myers then approved a $250,000 premium payment on December 16, with the expectation that the next premium payment would be due around March of the following year…

Liability for future disloyalty was thus neither “hypothetical” nor “speculative.”¹¹⁶ Plaintiff has pled the fiduciary duty waiver was adopted on a rainy day.

And so, Plaintiff has pled Sauer obtained a prospective, nonspeculative and absolute waiver of the duty of loyalty that relieved him of liability for disloyal behavior he knew he would continue, and indeed had promised to continue. On the spectrum of waivers, I believe this one is material.

And so metaloyalty is alive and well in Delaware, as it should be, but with limits and exceptions (and within political reasonableness).