Does a Board of Directors Have a Fiduaciary Duty to Honor Contracts Greater than Its Duty to Its Shareholders

The current financial crisis is likely to produce new law in a number of areas. One of the more interesting in these legal eddies may remake the understanding of fiduciary duty in the United States. That is certainly what might happen if Citigroup Inc. has its way in its battle with Wells Fargo over control of Wachovia Corp. It appears that Citigroup had entered into an understanding with Wachovia, memorialized in an exclusivity agreement. On the strength of that agreement, Citigroup began to supply Wachovia with much needed cash. Now Wells Fargo has come on the scene, offering the shareholders what might be a better deal. Citigroup is set to cry foul and to compel Wachovia to honor the terms of what Citigroup argues in a binding contract.

The arguments for Wells Fargo's bid focus on directors' fiduciary duty to shareholders; Citigroup's arguments focus on an exclusivity agreement between Citi and Wachovia, along with the financial support Citi says it has already provided to Wachovia. . . .

"Citi certainly has a strong argument," said Kip A. Weissman, a partner at Luse Gorman Pomerenk & Schick PC, who has reviewed Citi's agreement in principle with Wachovia. "Wachovia has some explaining to do. According to the terms, they [Wachovia] are clearly in violation" of the agreement.

Since the Wells Fargo offer appears to be a better offer for shareholders, it normally would have been its board's responsibility to present it to shareholders. But the agreement with Citi prevents any such procedure, Weissman said, essentially barring Wachovia from accepting any other offer.

Whether those conditions hold up in court is unclear. But, "It is hard to set aside a signed agreement by two sophisticated parties," despite the issue of Wachovia's fiduciary responsibility, Weissman said. So if the Citi deal goes ahead, Wachovia shareholders might claim compensation, he said.

Aparajita Saha-Bubna and Marshall Eckblad, Wachovia Legal Tangle: Fiduciary Duty v. Exclusivity, CNN Money.com, Oct. 3, 2008. "If the battle over Wachovia "does go to litigation," said James Cox, a securities law professor at Duke University, "which I presume it will, the courts will have to interpret whether the (exclusivity) agreement gets trumped by what's perceived to be the fiduciary duty obligations of the directors of a company in a change-of-control situation."" Id.

Any potential litigation will further test the limits of deal protection measures that companies have been using to attempt to protect their acquisitions from competition from topping bids by competitor suitors. The current standard of deal protection measures date roughly from 1998, when the Delaware corporate code was amended to permit merger agreements to include a term obligating a

The last word on the subject from the Delaware courts broadly suggested that such agreements are unenforceable where they have the effect of restricting the power of the Board of Directors to exercise fully their fiduciary duty obligations. Omnicare, Inc. v. NCS Healthcare, Inc, 818 A.2d 914 (Del. Sup. 2003). The issue of fiduciary duty will take on an interesting twist here.

On the one hand it should be clear that even the most elegantly clever efforts to end run such duty--to bind a board to a particular decision--ought not to be given effect. The courts have spent a century or so privileging such duty. Contract ought not to supersede a well reasoned public policy to broadly privilege the duty of directors to act for shareholders and to treat that duty as dynamic. There should be something to the Onmicar court's suggestion that

It is well established that conflicts of interest arise when a board of directors acts to prevent stockholders from effectively exercising their right to vote contrary to the will of the board. The “omnipresent specter” of such conflict may be present whenever a board adopts defensive devices to protect a merger agreement. The stockholders’ ability to effectively reject a merger agreement is likely to bear an inversely proportionate relationship to the structural and economic devices that the board has approved to protect the transaction. Omnicare, Inc. v. NCS Healthcare, supra, at 36.

Moreover, everyone, including Citi Group and its lawyers are still looking for that holy grail of letter of intent--the one that is invariably deemed to give rise to enforceable rights in contract. It is not clear that the Citi Group Wachovia agreement qualifies for that exalted status.

On the other hand, there are lots of dirty hands in this case. And not all of them belong to Citi Group and its lawyers. Complementing Citi Groups' overreaching is the Wachovia Board's willingness to play. Wachovia was eager for Citi Group money even as the ink dried on their agreement. That ought to count for something. Applying Unitrin's [Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361 (Del. 1995)] standards in the context of measures to protect a merger agreement, the court noted:

It is a recognition that a board of directors needs “latitude in discharging its fiduciary duties to the corporation and its shareholders when defending against perceived threats.” “The concomitant requirement is for judicial restraint.” herefore, if the board of directors’ collective defensive responses are not draconian (preclusive or coercive) and are “within a ‘range of reasonableness,’ a court must not substitute its judgment for the board’s [judgment].” The same ratio decidendi applies to the “range of reasonableness” when courts apply Unocal’s enhanced judicial scrutiny standard to defensive devices intended to protect a merger agreement. . . . Omnicare, Inc. v. NCS Healthcare, supra, at 39-40.

Perhaps the answer lies in a reassessment of the all or nothing approach of the Omnicare rule. And here elementary contract principles migth help. Consider the following: one important reason the Board of directors' fiduciary obligations ought to trump contract is because of the board's principal duty to maximize the value of transactions for the corporation (and or its shareholders). At the same time, contract obligations ought to mean something, as should the transaction costs as a form of downward pressure on value maximization on ultimate shareholder value. It seems to me that in the absence of bad faith, overreaching or other breach of fiduciary duty (loyalty or care principally) a board of director's fiduciary out ought to be mandatory when the value of the alternative is greater than the transaction costs (to the target) of abandoning the deal memorialized in contract. That transaction costs ought to include the costs of any value added to the corporation by the potential purchaser pursuant to its agreement, but not including the costs incurred by the potential (and now rejected) suitor in mounting its bid.

But there is another wrinkle here--the inc reasingly (it seems) presence of the state in the market for acquisitions. It seems that Citi Group might be serving as the "running dog" (though willingly so) of federal regulators who wanted to ,make this deal happen and put govbernment money up for that effort. Ought there to be a different rule of fiduciary duty where the state seeks a particular result? Before October 2008 I might have suggested the idea is ludicrous. After passage of the Emergency Stabilization Act of 2008 I am less sure.

The FDIC is talking out of both sides of its mouth, said Roger Cominsky, partner in law firm Hiscock & Barclay's financial institutions and lending practice. The agency says it stands behind the deal with Citigroup because it hasn't been nixed yet, he said. "But at the same time, they are saying they are reviewing all proposals."

By law, he said the FDIC is required to find the least-costly resolution for taxpayers. The Wells Fargo deal would not rely on any assistance from the government.

The Federal Reserve, which has regulatory oversight of the three big banks, said it hasn't had time to review the proposed sale of Wachovia to Wells Fargo but will work to ensure that all creditors and depositors of Wachovia are protected.

The Fed said regulators will be working with Wachovia and Wells Fargo "to achieve an outcome that protects all Wachovia creditors, including depositors, insured and uninsured, and promotes market stability."

Sara Lepro, Wells Fargo Agrees to Buy Wachovia, Citi Objects, Yahoo News, October 3, 2008. The infusion of state money might make a difference in this case, but it should not. Ont he other hand, the state is also acting in inconsistent capacities here--both as market participant (funding a particular offer) and as market regulator (reviewing both deals). It is not clear what the effect of this conflict of interest might be. On the one hand the government is working against itself, on the other hand, different agencies with different mandates will be vigorously defending their positions--until a higher government force intervenes.

The U.S. Federal Reserve is brokering discussions between Wells Fargo & Co (WFC.N: Quote, Profile, Research) and Citigroup (C.N: Quote, Profile, Research) over which of the banks will buy Wachovia's (WB.N: Quote, Profile, Research) assets, people familiar with the matter said on Sunday.

The Fed is pushing the two banks to compromise by potentially carving up Wachovia between them, the Wall Street Journal reported. Wachovia, the sixth-largest U.S. bank, has been hobbled by the credit crisis but has an attractive branch network.

Mark Felsenthal and Michael Erman, Fed Said Brokering Deal for Wachovia, Reuters UK, October 6, 2008. So much for markets. And the exploration of the rule of Omnicare will have to wait for another deal gone complex.