Fresno Lawyer – Randolf Krbechek

Professors Robert Cooter and Bradley J. Freedman analyzed the economic character and legal consequences of the fiduciary relationship.  As discussed below, their strongest point is to explain that not all fiduciary duties are the same – it depends on the nature of the relationship.

As a starting point, they acknowledge that “Legal theorists and practitioners have failed to define precisely when such a relationship exists, exactly what constitutes a violation of this relationship, and the legal consequences generated by such a violation . . . In any of these paradigmatic forms, a beneficiary entrusts a fiduciary with control and management of an asset.  Ideally, for the beneficiary, this relationship would be governed by specific rules that dictate how the fiduciary should manage the asset in the beneficiary’s best interests.”

“Because asset management necessarily involves risk and uncertainty, the specific behavior of the fiduciary cannot be dictated in advance.  Moreover, constant monitoring of the fiduciary’s behavior, which would protect the beneficiary, often is prohibitively costly . . . The fiduciary relationship exposes a beneficiary/principal to two distinct types of wrongdoing: first, the fiduciary may misappropriate the principal’s asset or some of its value (an act of malfeasance); and second, the fiduciary may neglect the asset’s management (an act of nonfeasance).”

Employing a law and economics perspective, Cooter and Freedman pose the question: “How can one party be induced to do what is best for another without specifying exactly what is to be done?”

Cooter and Freedman consider how to deter wrongful conduct by the fiduciary.  As they explain, “Once a consensual relationship in which the principal relinquishes control or management of her asset to the agent is formed, the resulting separation of ownership from control or management creates opportunities for the agent to appropriate the asset or some of its value.”

This leads to the first broadly-stated category of wrongful conduct:  misappropriation, or violation of the duty of loyalty.  “Fiduciary law creates a cluster of presumptive rules of conduct compendiously described as the duty of loyalty . . . Taking advantage of these opportunities whether by theft, diversion, conversion, or trespass would violate the agent’s duty of loyalty.”

“Generally, once a fiduciary is shown to have purchased her own asset on behalf of the principal without its consent, either she is held to be disloyal and allowed no defenses, or she has the burden of proving her loyalty.”

The professors suggest that “If the parties to this agreement possessed perfect information, disloyalty could be controlled or prevented by contract.”

In the real world, that is not correct.  It does not matter how much is written into the contract – if the thief wants to commit larceny, the contract won’t stop him.

Even more, the fiduciary relationship is a “relational contract,” in which obligations morph over time.  Cooter and Freedman correctly state that, “In fiduciary relationships, however, the parties are unable to foresee the conditions under which one act produces better results than another.  Rather, chance events and unanticipated contingencies require continual recalculation to determine which course of action will be the most productive.”

This leads into the second category of wrongful conduct, “negligent mismanagement, [which is] is governed by the duty of care.”

Here lies the strongest points in the article.  Cooter and Freedman state that “Judgment especially is important when decisions involve an element of risk.  The duty of care imposes an obligation on the fiduciary to avoid unnecessary risk.”

“However, different levels of risk are appropriate in different fiduciary relationships.  For example, a trustee often is required to be prudent and conservative in managing an asset, whereas a director of a start-up company may be encouraged to take risks.”

That is a point that is ignored far too frequently.  Different relationships lead to different fiduciary obligations, which cannot be painted all with the same brush.

“The bundle of duties and rights created by fiduciary law must be adjusted continually in response to changing circumstances and fresh litigation . . . Holding trustees to higher standards than directors makes economic sense because the same legal rule that imposes a light burden on a trustee would impose onerous restrictions upon a director.”

Thus, Cooter and Freedman conclude that, “Whenever an optimal contract includes fiduciary duties, the economic character of the fiduciary relationship precludes the specification of exact duties . . . The economic character of the fiduciary relationship embodies a deterrence problem for which the duty of loyalty provides a special remedy . . . [To this end] the duty of loyalty must be understood as the law’s attempt to create an incentive structure in which the fiduciary’s self-interest directs her to act in the best interest of the beneficiary.”

Robert Cooter and Bradley J. Freedman, The Fiduciary Relationship: Its Economic Character and Legal Consequences, in 66 New York University Law Rev. 1045 (1991).

This week we consider another view on the issue of whether some contractual breaches are such that additional remedies should be imposed by the courts, beyond the traditional damages for breach of contract.

In other words, Is some conduct sufficiently wrongful that a court should have the right to impose additional damages to deter such wrongful acts?  The law of fiduciary duties answers “Yes – courts should award additional damages by way of deterrence.”  Does this analysis hold weight in a contractual setting?

Professors Steve Thel and Peter Siegelman state that, in the context of a contractual breach, “Willfulness matters [ ] because it identifies those breaches that should be prevented or deterred – that is, all breaches that could have been avoided at little or no cost to the promisor.”

Now, I agree that wilfulness matters, but I believe that the reason why is tied to the relationship between the parties.  Thel and Siegelman instead posit that “when willfulness [ ] is present, courts rightly award remedies that serve to deprive the promisor of any incentive to breach and to assure the promisee of getting full expectation.”  Thus, they tie “deterrence damages” to the relative ease by which a party could have avoided breach.

Professors Thel and Siegelman acknowledge that “contract law generally does not concern itself with the morality of breach in any direct way.  People enter into contracts in hopes that the promises made to them will be kept, and when a promise is broken, the promisee’s injury is typically the same whatever the reason for the breach.  A disappointed promisee ought to be satisfied with full expectation, regardless of what motivated the breach.”

Good point, and an analysis often relied upon by judges.  However, “while contracting parties will agree upon different levels of commitment in different situations, they will almost always agree that some breaches are out of bounds.”

That’s the $64 question.  What kinds of breach fall outside of societal norms?  I think that looking at the conduct inherent in the breach can lead to inconsistent results.  Contract law is, after all, greatly concerned with consistency.  In my view, certain kinds of contractual relationship lead to greater reliance by one of the parties, and therefore the law should impose a higher standard of duty on the breaching party.  This is similar to the concept applied to fiduciaries.

Professors Thel and Siegelman work from a well-known case involving a construction project in which the contractor failed to use the materials specified by the contract.  “Imagine a variant in which the contract calls for Reading pipe, but the builder deliberately substitutes Cohoes, which is cheaper (but just as good), with the intent of keeping the savings.  Should this be treated as a willful breach?  We suggest that it should be.”

Why?  In my view, the reason why is because the property owner placed additional reliance on the contractor and could not defend himself.  According to Thel and Siegelman, ”since the two brands are of identical quality, both builder and owner could be made better off by a breach that substitutes cheaper Cohoes for more-expensive Reading and splits the savings between the two parties . . . That would provide the appropriate party with incentives to look for cheaper materials, and would result in lower contract price.”

Yet, the cost of policing the behavior of the breaching party rises dramatically, and places an undue burden on the property owner.  State Thel and Siegelman, “the problem, of course, is that a builder will have an incentive to substitute not just cheaper but functionally identical materials, but also cheaper inferior ones.”

In a 1906 case, Justice Cardozo wrote that “There is no general license to install whatever, in the builder’s judgment, may be regarded as ‘just as good’.”   Similarly, the court in Groves v. John Wunder Co. explained that “defendant’s breach . . . was wilful.  There was nothing of good faith about it.  Hence, that the decision below handsomely rewards bad faith and deliberate breach of contract is obvious.  That is not allowable.”

Professors Thel and Siegelman conclude that “this is especially true in a construction contract, where such substitute materials are easy to find and substitutions are often difficult to detect.  In the face of this problem, treating the breach as willful and awarding the owner the cost-of-correction measure provides the appropriate incentives for the builder to inform the owner of the opportunity for savings, and to negotiate for consent to deviate from the contract.”

Yet, I think the argument is better cast in terms of the relationship between the parties.  A building owner places substantial reliance on the contractor.  The law should support such reliance, which is the reason why extra-contractual damages should be awarded for wilful breach.

(Steve Thel and Peter Siegelman, Willfulness Versus Expectation: A Promisor-Based Defense of Willful Breach Doctrine, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1517.)

Let’s continue the discussion regarding rules of fault in contract law.  This series is from a law review article written by Professor George M. Cohen, who first notes that:

“The economic justification starts from the same premise as the traditionalist justification – that courts should enforce agreements according to the parties’ mutual intentions.  [Thus,] the strict liability paradigm permeates classical contract law.  Usually, however, the explicit label ‘strict liability’ appears only in connection with the doctrines of performance and breach.”

Prof Cohen is absolutely correct on this count.  Considering the three time frames in a contract – formation, performance, and breach – issues of “fault” really make sense only in connection with performance and breach.

Prof. Cohen continues.  “Under these doctrines, failure in any way to perform a contract breaches the contract, and subjects the breaching party to liability, regardless of fault.  The paradigmatic case is a seller who delivers goods that fail in any respect to conform to the contract.”

“An aggrieved party who can prove breach is entitled to compensation, which contract law generally defines as protecting the expectation interest.  In short, the reason for nonperformance does not matter.”

Yet, in contract law, sometimes it does.  It can depend on the relationship of the parties.  “A traditionalist justification of strict liability must defend the proposition that the parties generally intend that the reason for nonperformance does not matter.  That proposition is, however, contestable, as discussed below.”

Prof. Cohen wants to look to intent, not to the relationship of the parties.  He explains that, “Under both the traditionalist and economic justifications, the argument for strict liability is stronger if mutual intent is easily determined and clearly distinguishable from fault.”

He warns that, “Adopting a fault-based system of contract law in those circumstances would lead to illegitimate social judgments by courts on the traditionalist view, and result in inefficient contracting around or failures to contract on the economic view.”

When, then should fault be considered?  “Determining disputed mutual intent is inherently uncertain.  Mutual intent is an ideal.  Contracting parties attempt to express mutual intent, often in writing, but do so imperfectly.  Contracts are largely a set of private rules, and all rules require interpretation, stories that explain their meaning in a particular situation.”

Now we return to relationships and their unfair exploitation.  “As unanticipated situations arise, disputes requiring interpretation inevitably occur.  The objective theory presumes that when one party manifests some intent and then later asserts a different intent, either he negligently or intentionally misled the other party originally, or is acting opportunistically now.”

Here follows a tremendous observation.  “Parties generally resolve these disputes on their own, often driven by reputational concerns.  When these efforts fail, they bring their disputes to court.  In litigated cases, the parties typically contest the requirements of mutual intent . . . But the uncertainty of intent blurs this dichotomy.  When intent is uncertain, fault can help inform intent in a variety of ways.  Most obviously, parties may expressly use fault concepts in their contracts, such as best efforts and good faith clauses, which essentially invite courts to make fault-based judgments in the event of a dispute.”

Prof. Cohen concludes by noting that, “With respect to contract damages, I have previously argued that the choice among different measures of damages (expectation, reliance, and restitution), as well as the limitations on expectation damages, are best understood as doctrines enabling courts to make relative fault assessments.  In fact, damages doctrines are best suited to dividing liability when both parties are at fault.  In light of this crucial role of damages in facilitating relative fault assessments, the resistance of courts to ‘penalty clauses,’ which preclude such assessments, is eminently sensible, despite the continued objection of many economic scholars.”

(George M. Cohen, The Fault that Lies Within Our Contract Law, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1445.)

Let’s continue with the discussion of fault and breach in contract law.  We are starting to see that the law treat different kinds of contracts differently.  Meaning that, with a “relational contract,” being one in which the duties and obligations extend over time, the law imposes higher standards than in a “one-shot” contract.

Professors Oren Bar-Gill and Omri Ben-Shahar comment that “a contractual right entitles a party to the peace of mind that a property right holder enjoys – the right not to be encroached upon.  Deliberate breach is like theft: it undermines this security and diminishes the value of the right.  The problem with the ‘sanctity of contract’ account is that it assumes the conclusion.”

The professors are correct – there are some contracts in which one party establishes sufficient trust in the other side that the law should follow with a higher level of obligation on the breaching party.

Professors Oren Bar-Gill and Omri Ben-Shahar continue.  “To those who regard a contract as a vehicle for promoting the contracting parties’ legitimate commercial interests there remains a puzzle: How is it that willful breach is considered, even by sophisticated parties, to be faulty and wrongful?”

“Why do businessmen reject the notion of efficient breach?  Is there a more subtle reason why a willful breach is perceived to justify supercompensatory damages?”

At this point the discussion takes on a moralistic tone which is lacking in traditional contract theory.  “We argue that willful breach triggers a stronger resentment not because of the harm it causes, but rather because of the harm it reveals.  Willful breach is not any more harmful, nor does it infringe any broader societal interest.  There is no sanctity to contract and no social institution or public good is being violated by willful breach.”

Pause here.  I cannot agree with this premise.  The breach of some kinds of contract causes a societal harm, and there should be additional damages for such wrongful conduct.

Professors Oren Bar-Gill and Omri Ben-Shahar explain that, “Willful breach is a probabilistic indication that the breaching party is the type of transactor who readily chisels and acts in a dishonest way, and has likely exercised such bad faith in other occasions without being sanctioned.”

“An act of willful breach reveals the true nature of the contracting partner: one who would take any opportunity to divert value, if he can get away with it.  This party may act in other self-serving, counterproductive ways that often go undetected and unpunished.  Occasionally, when this party’s opportunistic act is observed and its true nature is revealed, it triggers resentment for what underlies it – for all the other bad things that he likely did, for the choice he made to engage in this pattern of behavior.  That is, when this party is caught in the act of willful breach, he is punished not merely for this act, but for being a nasty type.”

Whatever its attractions, that is not an efficient theory of contracting.  The courts cannot administer justice based on whether a person is a “nasty type.”

Getting back to the discussion.  “Intuitively, this idea tracks a common sentiment experienced by parties who are subject to deliberate breach.  Often, it is not the deprivation resulting from the immediate breach that creates a sense of exploitation for the aggrieved parties, but rather the realization that their partner was not as honest and dependable as they perceived – that he is the type of partner who cares less about their expectations and who would chisel if he can get away with it.”

But a mere moral letdown should not be adequate.  The true disappointment lies in the situational letdown, which is illustrated by the following passage.

“Is this why passengers dislike airlines’ overbooking strategy?  Surely, these passengers do not experience any immediate loss from what is in fact a deliberate booking strategy that leads to occasional nonperformance (indeed, they often line up to receive the offered compensation).  But it is perceived as a symptom of a ruthless strategy of poor service, of skimming off various passenger privileges.  They are angry for what is revealed to be this underlying nonfriendly pattern of treatment.”

Gentlemen, I think you have the right point but the wrong analysis.  The anger and resentment come from misplaced trust.  The passenger was placed in a situation of substantial reliance, and is offended because the airline took advantage of the situation, not because the airline was revealed to be more interested in profits than in its passengers.

(Oren Bar-Gill and Omri Ben-Shahar, An Information Theory of Willful Breach, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1479.)

Journalist and attorney Lloyd Carter questions whether the benefits of subsidized water outweigh the social costs.  The undisputable fact is that the west side of Fresno County is one of the poorest regions in all of America.  Does current water policy help or does it simply compound the misery?

The Cost for West Side Agriculture

According to Mr. Carter, “The value of Westlands’ federal water subsidy was calculated at $110 million a year in 2002.”

Carter adds, “One little-noticed subsidy is cheap electricity to pump all that water uphill from the Delta to the Westlands.  EWG estimates the electricity subsidy for the CVP is $100 million a year, with Westlands getting $71 million of that annual power subsidy in 2002-an average of $165,000 per farm.”

What’s the bottom line?  According to a 1985 study, “the average subsidy per acre in the Westlands . . . was $217 per acre while the average net revenue per acre was only $290, meaning the most expensive irrigation project in American history was built so growers could make $73 an acre.”

The Reality

All of this money has not brought wealth to the area.  “The Twentieth Congressional District, encompassing Westlands and a portion of the western San Joaquin Valley down through Kings and Kern counties, has the dubious distinction of being the poorest of the 436 congressional districts in America.”

Pause again.  Rep. Jim Costa’s district is the POOREST in all of America.  This district include the Westlands water district.

Adds Mr. Carter, “While Westlands growers contend that cutbacks in water supplies have devastated the western San Joaquin Valley economy, it should be remembered that many West Side communities were desperately poor decades before the current cutbacks in water to Westlands, back in the days when cheap water flowed freely and Westlands got its full (or nearly full) annual allotment.”

Facts

• There is no high school inside the boundaries of the 1,000-square-mile Westlands.

• The Westlands district’s biggest town is Huron.  As of 2007, it’s estimated population of 7,174, which is 98% Hispanic

• Eighty-two percent of the children at Huron’s continuation high school qualified for the free lunch program.  Of these students, none qualified for gifted and talented programs

• A 1979 article cited to the fact that nearly two thirds of the Westlands “farmers” did not live within fifty-miles of their “farms,” although the residency requirement was still in effect.  Among the “family farmers” was Southern Pacific Railroad at 106,000 acres, Standard Oil at 10,474 acres, Boston Ranch (owned by cotton billionaire J.G. Boswell) at 26,485 acres, and Harris Ranch, operator of the world’s largest cattle feedlot, at 18,393 acres.

The Pollution Problem

The cost for West Side agriculture is magnified when you consider the environmental problems triggered by the imported water.

As Mr. Carter notes, the soils in the area “include a host of salts, trace elements like selenium, arsenic and boron, and heavy metals, which created an alkali desert on the West Side over eons.”

To further complicate matters, natural drainage is precluded because “several layers of virtually impermeable, thick subterranean clays run below the topsoil and impede the downward percolation of applied irrigation water.”

Growers had known since before World War II that adequate drainage was needed.  Westlands created the Kesterson reservoir in Merced County to hold the runoff, but the waste water created grave pollution problems and harm to wildlife.

Mr. Carter states that, “An estimated 100,000 acres in the Westlands have already gone out of production in the last few years because they salted up for lack of drainage.”

“This includes land covered by a $140 million 2002 Interior Department settlement of a lawsuit against Reclamation and Westlands filed by nineteen old-guard Westlands families who saw 32,400 acres of their farmland ruined by lack of drainage.  That controversial settlement included $70 million for just four prominent farming families.”

Westlands’ “Solution”

Notes Carter, “Because of the enormous cost of completing a federal drainage canal, Westlands has suggested to the government it would take over resolution of the drainage crisis in exchange for debt forgiveness, a guaranteed water supply, and takeover of some federal project plumbing.”

Westlands is seeking:

• A water-delivery contract in perpetuity

• Transfer from the federal government to Westlands of title to all pumping and diversion facilities along the San Luis Canal, the Mendota Pool, the Pleasant Valley Pumping Plant, and distribution and drainage-collector systems

• Subsidized electricity for any drainage-treatment options requiring electrical power

No Disclosure by Westlands

Westlands acts like a governmental agency, and indeed, has the power of condemnation, which is an essential power reserved to sovereign entities.

But Westlands operates without public disclosure.  As Carter notes, “In 1982, the Reclamation Reform Act was passed, eliminating the residency requirement for farms, [and] increasing the acreage limitation to 960 acres.”

That’s the land ownership limitation established by Congress – only 960 acres per farmer is eligible for subsidized water.

There has never been enforcement of this requirement, nor any disclosure by Westlands.  As Mr. Carter points out, “The actual number of “farms” or “farmers” in Westlands is in much dispute, and Westlands has never provided a publicly available list of all of its “farmers,” “farms,” or “water users”; neither has it confirmed whether the “farmers” are people actually involved in farming or merely have their names listed on land deeds or as part of family trusts.”

It’s shocking that Westlands could suggest that it would acquire large portions of the Central Valley Project for irrigation, yet not make basic disclosures so the public could determine whether it was operating lawfully.

Carter’s Conclusion

“Most Westlands growers live far from the bleak and industrialized farmlands of the district; many reside in an exclusive enclave of mansions in north Fresno, in the zip code 93711, which receives more federal farm subsidy money than any other zip code in America.”

“The subsidized factory farm economy, it seems, doesn’t have much of a trickle down effect for the families and communities of workers who bring in the harvest.  In fact, it appears as though this system has helped to foster a culture of unsustainable farming practices, caused large scale environmental degradation, and has created a massive socioeconomic rift between land owners and their primarily Latino workforce.

“Indeed, one cannot help but see two different agricultural worlds among the Eastern and Western flanks of the San Joaquin Valley.  The East Side, where the original irrigation colonies began 130 years ago, is full of orchards and vineyards and farmhouses every quarter of a mile and small towns every few miles.”

“In the Westlands, with a single giant farm sometimes reaching tens of thousands of acres, one can drive for many miles down Interstate 5 through cotton and row-crop fields without ever seeing a farmhouse or the all-but-invisible farm-worker communities. It is a stark contrast indeed.”

Lloyd G. Carter, Reaping Riches in a Wretched Region: Subsidized Industrial Farming and its Link to Perpetual Poverty, in 3 Golden Gate U. Envtl. L.J. (2009) page 5.

Water supplies for West Side agriculture have been major news items in the past few years.  Many residents, including this writer, are proud of our agricultural heritage and bounty, and have questioned decisions that threaten water supplies for agriculture.

Journalist and attorney Lloyd Carter has penned a provocative article that probes the financial integrity of Westside agriculture.

Mr. Carter’s thesis is that, “While Westlands . . . has produced an undisputable bounty of cotton and field crops over the decades in western Fresno and Kings counties, irrigation of this mineral-laden desert has also created huge environmental problems, and the wealth generated has not trickled down to farmworkers or the surrounding poverty-stricken communities.”

Early West Side Farming

Mr. Carter admirably recites the history of West Side farming.  “In 1900, the West Side of the Valley remained an inhospitable desert with no surface water and only intermittent flow from small seasonal creeks . . . The first wells in western Fresno County were sunk a few years after the start of the twentieth century by a few hardy pioneers.  Deep wells were drilled during World War I by large landholders in order to plant cotton, a salt-tolerant crop in demand by the military.”

Take a look at this remarkable photograph, which shows researcher Dr. Joseph F. Poland standing at the location of maximum land subsidence identified in the Central Valley.  The signs on the pole show the approximate altitude of the surface of the land  in 1925, 1955, and 1977.  The site is in the San Joaquin Valley southwest of Mendota, California.

The level of the earth subsided by more than 28 feet at this location near benchmark S661 southwest of Mendota, due to the pumping of groundwater.

More information can be obtained from the U.S. Geological Survey.

And from this article:
“Land Subsidence in the United States,” by  Devin Galloway, David R. Jones, and S.E. Ingebritsen

In 1942, West Side growers, who were running out of groundwater, formed the Westside Landowners Association to gain support for federal assistance in delivering Northern California river water to their region.

In 1952, pursuant to the California Water Code, the growers formed the Westlands Water District, which would grow to become the nation’s largest federal irrigation district, with over 600,000 acres.

Bernie Sisk’s False Promises

Carter continues.  ”In 1959, Representative Bernard F. Sisk (D-Fresno), who represented the Westlands area, pushed for congressional approval of a U.S. Bureau of Reclamation project to deliver Northern California water to Westlands.”

In 1960, Congress approved the San Luis Unit.  Water deliveries to Westlands began in 1968.

Now, if you live in Fresno County, you will be astonished that Rep. Sisk made the following representations to secure Congressional approval for the water project.  Here’s what he promised:

• “If San Luis is built, according to careful studies, the present population of the area will almost quadruple.  There will be 27,000 farm residents, 30,700 rural nonfarm residents, and 29,800 city dwellers; in all, 87,500 people sharing the productivity and the bounty of fertile lands blossoming with an ample supply of San Luis water.”

• “Recent surveys show that the land proposed to be irrigated is now in 1,050 ownerships. These studies show that with San Luis built, there will be 6,100 farms, nearly a sixfold increase.  And in the breaking up of farms to family-size units, anti-speculation and other provisions of the reclamation laws will assure fair prices.”

We can all pause here.  Westlands was built on a false premise.  Nothing close to this has occurred in the past half century.

Where Are We?

“This Article shows how a long American tradition of helping small farmers has, in the past few decades, morphed into a massive government aid program for large industrialized agribusiness operations-a program that not only drives small farmers off the land but also perpetuates rural poverty because agribusiness requires huge numbers of low-paid, seasonal harvest workers”

Part 2 – Continued next week.

Lloyd G. Carter, Reaping Riches in a Wretched Region: Subsidized Industrial Farming and its Link to Perpetual Poverty, in 3 Golden Gate U. Envtl. L.J. (2009) page 5.

The issue this week concerns the appropriate remedy when controlling shareholder(s) breach the fiduciary duties they owe to the other shareholders.  An article by attorney William S. Monnin-Browder discusses whether courts should apply a minority interest discount in a forced sale.

Background

As explained in many published opinions, “stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another . . . They may not act out of avarice, expediency or self-interest in derogation of their duty of loyalty to the other stockholders and to the corporation.”  Donahue v. Rodd Electrotype Co., 328 N.E.2d 505, 515 (Mass. 1975)

Wrongful Conduct by the Controlling Shareholder

Mr. Monnin-Browder explains that, “There are a number of ways that majority shareholders can usurp the interest of the minority.  For instance, the terms ‘freeze-out’ and ‘squeezeout’ are often used, synonymously, to describe a situation where the majority uses its controlling position to exclude a minority shareholder from participation in the business.”

By the wrongful acts of the majority, “minority shareholders can be prevented from gaining a return if they are fired, which a majority-controlled board can freely do . . . One common form of the squeeze-out occurs when a majority shareholder prevents a minority from receiving a return on her investment, and then attempts to buy the minority’s shares when the value of the stock is compromised . . . The lack of a ready market for shares in a close corporation prevents a minority shareholder from selling shares as a means of escape.”

The Remedy

“Once a court determines that majority shareholders have breached their fiduciary duty, the court is forced to find an appropriate remedy.  Remedies for breach of fiduciary duty are equitable in nature . . . Common remedies for breach of fiduciary duty in a close corporation include dissolution, reversal of an offending decision, or buyout of the minority shareholder’s shares by the corporation.”

However, “the most common remedy employed by courts today [ ] is buyout . . . Courts view buyout as a less harsh remedy than dissolution because it compensates the aggrieved shareholder, while allowing the corporate entity to survive.  It is also often the most practical remedy.  A court order to rehire or return the shares sold, for example, may not be a viable option.”

Marketability Discount

But to do so, the court must establish the value of the victim’s interest in the entity.  “Valuing a share in a close corporation usually begins with an analysis of the value of the corporation as a whole.  To do this, courts often look to three major approaches: market value, net asset value, and earnings value.  These factors are weighed differently, according to the specific factual circumstances.”

Two general forms of discount are commonly applied in valuing interests in a closely-held corporation.  The first is a marketability discount.  As explained, “The marketability discount compensates for the absence of a market for shares of a close corporation.  Investors will pay less for these shares, compared to more liquid shares, because they prefer shares that are easily sold and/or transferred.  Marketability discounts can be substantial, averaging from approximately 35 to 50% of the value of the stock. “

Minority Interest Discount

The second principal discount is the minority interest discount.  “The minority discount compensates for the fact that the shares constitute a minority interest in the corporation that is not controlling, so long as there is no shareholder agreement to the contrary.  Investors prefer stock that has the accompanying voting power to influence the operations of the corporation.  Therefore, investors will pay less for those shares than shares in the majority interest.  Like marketability discounts, minority discounts can have a substantial impact on the value of the shares, reducing the price as much as 33%.”

Thus, the combined discount based on minority interest and lack of marketability can exceed 50% of the value of the stock.  Such discounts are commonly used in the estate planning context.

Should a Court Apply the Discount?

The judicial trend is not to apply the discount in the context of a forced buyout of a minority interest.  “Some courts state that the context and purpose of the legislation suggest that no discount should apply.  In Swope v. Siegel Robert, Inc., for example, the Eighth Circuit Court of Appeals applied Missouri law to reject the application of both a marketability and minority discount.”

In this way, “The typical freeze-out situation arises when a minority shareholder has no other choice but to sell their shares to the majority shareholder at less than their fair value.  From a policy standpoint, it would be illogical to discount the value of the shares because doing so would reward an oppressive majority shareholder and injure the party who is relatively blameless.”

That analysis is sound, because the “buyout does not occur on an open market.  Therefore, courts argue that they should not apply discounts that account for irrelevant market conditions.  As Professor Moll writes, ‘the forced-sale nature of buyout proceeding and the identity of the purchasers involved weigh heavily against the application of discounts.’”

An Extreme Result

One court went the opposite direction.  “Rather than force the oppressor shareholder to purchase the oppressed shareholder’s stock, the trial court chose a different remedy, holding that the oppressed shareholder was entitled to buyout the shares of the oppressor.  The court [then] applied discounts.”  Balsamides v. Protameen Chemicals, Inc., 734 A.2d 721, 734 (N.J. 1999).

We could certainly ask – Isn’t sauce for the goose also sauce for the gander?  The court put a real hurt to the wrongdoer by forcing a sale and also applying  a judicially-created discount.

A Point of Dispute

Mr. Monnin-Browder posits that “a heightened fiduciary duty exists among shareholders of a close corporation,” explaining that, “In the wake of the Massachusetts ruling, courts in many other states adopted the fiduciary duty rationale of Donahue, thereby recognizing heightened fiduciary duties among shareholders in close corporations and creating a common-law cause of action.”

That is not a careful use of terms.  Fiduciary duties are, by definition, “heightened duties,” filling gaps in the relationship between the parties.  It does not make a great deal of sense to speak in terms of a “heightened fiduciary duty.”

William S. Monnin-Browder, Are Discounts Appropriate?: Valuing Shares in Close Corporations for the Purpose of Remedying Breach of Fiduciary Duty under Massachusetts Law, in 40 Suffolk Univ. Law Review, Vol. 3 (2007) page 723.

This posting continues the question of whether fault should be considered in evaluating a claim for breach of contract, specifically, whether the courts should weigh the “fault” of the non-breaching party.

When would such “fault” by the non-breaching party arise?  It would seem that three time frames could be considered:

• Before (i.e., during the formation of contract)
• During performance
• After breach

The bigger question is, Are we better off as a society if we disregard all fault by the non-breaching party when we assess liability for breach of contract?

Here are several hypotheticals from Prof. Porat, and my comments regarding them.

Before performance:

“Ann, a contractor, and Bob, the owner of a certain piece of land, enter a contract for the performance of construction work.  Due to geological difficulties, there is a delay in performance that causes Bob substantial losses.  It becomes evident, however, that Bob knew about these obstacles at an early stage (although not prior to entering into the contract with Ann).  Had he revealed this to Ann in due time, the delay could have been prevented.”

Response:  This is a thorny issue for contract purists, who would insist that Ann had the obligation to review the situation fully before entering into the contract.  Yet, Bob had the power to prevent some of the losses, and, indeed, could probably help reduce the overall cost of performance.  The law should impose a duty on Bob to cooperate and assist in the performance of the contract.

During performance:

“In the course of a construction project, Charles makes demand for an installment payment.  In fact, Charles is not entitled to any payment, because she failed to meet an additional condition stipulated by the contract.  Charles is not aware of this additional condition because of an oversight on her part.  Debbie refuses to pay, stating that he is not obliged to do so under the contract, but Debbie provides no other explanation.  Charles then stops her work, causing loss to Debbie.  Only after a month, during which Debbie stubbornly refuses to meet with Charles, does Debbie explain to Charles why he was not entitled to payment.”

Response:  The law should encourage efficiency.  Debbie should not be rewarded for her failure to act in a commercially reasonable manner, and the damages should be reduced accordingly.

During performance:

“Edward undertakes to construct a building for Fay.  During the last stage of performance, Fay gives Edward’s employees confusing instructions on the construction work required.  In the end, there is a delay in the completion of performance; moreover, some of the construction work is found to be defective.  Had Fay refrained from instructing Edward’s employees, the contract would have been adequately performed.”

Response:  In this hypothetical, the contributing fault of Fay, the non-breaching party, should be considered to reduce liability.  Fay caused part of the harm, and Edward should not bear all of the losses.

Comment:  The hypothetical is not complete, as we need to know the nature of the losses suffered by Fay.

During performance:

“In a home remodeling contract, both George and Harold are aware that there could be delays in completion.  Even though Harold is well aware of this risk, he enters into a contract with a contractor to refurnish the house starting on the day set for delivery.  He also incurs expenses advertising the house for rent.  In the end, George breaches due to late delivery, and Harold suffers losses due to forfeiting the contractor’s deposit and his advertising expenses.  These losses would have been prevented had Harold waited to see whether the contract would be adequately performed.”

Response:  It would seem that Harold assumed the risk of loss.  However, assumption of the risk is not a traditional contract defense.  This is an uncomfortable fit for the law, as Harold caused some of his own losses, yet it appears that George is liable for late delivery.

After breach:

“Ike, a carrier, undertakes to ship a crank shaft from Jane’s mill for repair and to bring it back in one week’s time.  Ike instead brings the shaft back after two weeks, which results in high consequential losses to Jane, who could not find a substitute shaft.  At the time of contracting, the parties were aware of a small risk that a substitute shaft would not be available.  One week later it became clear to Jane, but not to Ike, that this risk had materialized.  Had Jane conveyed this information to Ike on time, Ike would have taken costly precautions to ensure that he would return the shaft on time, thus preventing the breach.”

Response:  Historically, the law has favored common carriers, in the sense that the public does not want to pay exorbitant rates for carriage.  It seems that the carrier could have take precautions to avoid the loss.  However, I want know whether the rate structure reflected the potential loss.

In other words, Did the price for shipping reflect a one-week delivery time?  Ike could have shopped for someone who would have guaranteed delivery.  Further, the additional loss was not due to any acts or omissions on the part of Ike, in that Jane simply could not locate the replacement part in a timely manner.

(Ariel Porat, A Comparative Fault Defense in Contract Law, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1397.)

This week’s posting considers whether culpability should be considered in a claim for breach of contract.  The traditional answer in the U.S. (traditional at least since 1900) is No.

As discussed in a recent symposium, “In terms of the Restatement of Contracts conception, then, contract law is strict liability without a contributory negligence defense . . . The core of contract law as applied in the courts is a no-fault regime.”

“Among the many debates about fault in contract law, one principle remains unchallenged: a promisor is strictly liable for defective performance or nonperformance despite her exercise of due care.”

“Even the most fervent adherents of fault in contract law concede that the law always applies this rule strictly.  Thus, the promisee does not have to prove that the promisor failed to take cost-effective precautions against breach.  Nor, for that matter, can the promisor escape liability by showing that the breach was caused by exogenous factors beyond her control.”

(Robert E. Scott, In (Partial) Defense of Strict Liability in Contract, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1381.)

Which means that contract law is applied as a binary system – either you perform the contract or you do not.  If you do not perform (i.e., if you breach), then you are liable for damages.

This system is effectively 180 degrees different from tort liability, in which culpability is always an issue.  Another commentator notes that,

“The main puzzle that emerges from the discussion is why contract law puts the burden on the wrongdoer to show that he was not at fault in order to avoid paying damages, while tort law puts the burden on the victim to show that the wrongdoer was at fault in order to obtain damages.”

(Eric A. Posner, Fault in Contract Law, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1431.)

Thus, one of the issues is whether society is better when contract law is treated as a binary system of liability, without consideration of fault by either party.  A third commentator considers whether the non-breaching party contributed to the loss.  Prof. Ariel Porat proposes that “the comparative fault defense should be available to a breaching party against an aggrieved party when the latter’s fault has contributed to his own losses.”

In this scenario, “the promisee should be considered ‘at fault,’ and should shoulder part of the loss, when he fails to meet a legal burden to reduce his potential losses by cooperating with the promisor or avoiding overreliance.”

Next week’s posting further examines comparative fault as a defense to a breach of contract claim.

(Ariel Porat, A Comparative Fault Defense in Contract Law, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1397.)

Trusts have been employed in the English legal system for hundreds of years.  In 1979, Prof. R.H. Hehnholz reviewed court records to examine the early history of trusts.

Prof. Hehnholz started by noting, “As a means of avoiding feudal incidents and of evading the common law rule prohibiting devises of freehold land, the feoffment to uses, ancestor of the modem trust, enjoyed a popularity at least from the reign of Edward I (1327-1377).”

The question is, How were they enforced?  “Enforcement of the feoffor’s directions, however, long posed a problem.  What of the feoffee who refused to carry out those directions after the feoffor’s death?”

“How can so important and so widespread an institution have existed without legal sanction?  Can its effectiveness really have rested solely on the conscience and good sense of the feoffees prior to the time the Chancellor began to intervene? This seems implausible.”

Jurisdiction over decedent’s estates was, in the early years, an ecclesiastical matter.  “As is well known, the English Church exercised probate jurisdiction throughout the Middle Ages, and even afterwards.  One of the responsibilities attendant upon that jurisdiction, in the eyes of the men who exercised it, was the duty to secure a person’s final wishes.”

“In an age when the grant of land need not have been by deed, and in which the Church courts would enforce the wishes of a dying man with no requirement of a testamentary writing, there was inevitably much room for uncertainty and disagreement.”

Prof. Hehnholz finds that the historical record reflects the long-standing enforcement of the use.  “In fact, good evidence to support the suggestion does exist: the court records from the ecclesiastical courts of the dioceses of Canterbury and Rochester contain many cases involving feoffments to uses.  The records are in manuscript.  They are hard to read, and often difficult to interpret.”

Humorous aside: G.R. Elton has described these early court records as “among the more strikingly repulsive of all the relics of the past.”  G. ELTON, ENGLAND, 1200-1600, at 105 (1969).

Prof. Hehnholz explains that “the records furnish the best test of the actual scope of the Church’s jurisdiction, and although they do not allow for absolutely confident generalization, they tend to prove that some English Church courts regularly enforced feoffments to uses.”

“For example, in a suit brought at Canterbury in 1416, the Act book records that ‘the aforesaid Henry was ordered to restore the three virgates of woodland’ . . . The records unfortunately supply no evidence on what remedies the Church courts offered in more complicated cases, if indeed any was available . . . Nor is there any sign of the recovery of money damages from defaulting feoffees.  So far as the records reveal, an order for specific performance was the sole remedy available.”

Violation of the church order meant that “they were excommunicated.  What action they had to take to have the sentence lifted, and whether or not they took it, unfortunately does not appear in the surviving records.”

However, the evidence is limited.  “The fact that all the evidence comes from the two English dioceses that lay within the county of Kent is undeniably troublesome.  The pre-eminent influence there of the archbishop of Canterbury, not only England’s most powerful churchman but also a powerful secular landlord within the county, suggests at least the possibility of a special place for the Church courts in his diocese.  Not every man would question the rights of an archbishop who happened also to be his lord.”

As time passed, the enforcement of the use/trust shifted to courts administered by the crown (as opposed to courts administered by the church).  “Cases involving feoffnents to uses cease to appear in the court records after the middle third of the fifteenth century.  The last unambiguous example found comes from 1465 . . . By that date, of course, the jurisdiction of Chancery over uses had been established.”

And, of course, there were lobbyists 500 years ago.  “The Statute of Uses (1536), was passed specifically to put an end to these evasions of the common law.  The ability to devise lands was quickly restored, because of pressure from the land-owning classes, in the Statute of Wills (1540).”

R. H. Hehnholz, The Early Enforcement of Uses, in 79 Columbia Law Review 1503 (1979)