Over at The Defining Tension, Bastiaan F. Assink takes note of an interesting opinion from new Delaware Vice Chancellor Glasscock:
I will let the introductory words written by the new Vice-Chancellor Glasscock in In re The Goldman Sachs Group, Inc. Shareholder Litigation, C.A. No. 5215-VCG (Del. Ch. 2011) of October 12, 2011 (a whopping 68 pages) do the talking. Buckle up!
The Delaware General Corporation Law is, for the most part, enabling in nature. It provides corporate directors and officers with broad discretion to act as they find appropriate in the conduct of corporate affairs. It is therefore left to Delaware case law to set a boundary on that otherwise unconstrained realm of action. The restrictions imposed by Delaware case law set this boundary by requiring corporate officers and directors to act as faithful fiduciaries to the corporation and its stockholders. Should these corporate actors perform in such a way that they are violating their fiduciary obligations—their core duties of care or loyalty—their faithless acts properly become the subject of judicial action in vindication of the rights of the stockholders. Within the boundary of fiduciary duty, however, these corporate actors are free to pursue corporate opportunities in any way that, in the exercise of their business judgment on behalf of the corporation, they see fit. It is this broad freedom to pursue opportunity on behalf of the corporation, in the myriad ways that may be revealed to creative human minds, that has made the corporate structure a supremely effective engine for the production of wealth. Exercising that freedom is precisely what directors and officers are elected by their shareholders to do. So long as such individuals act within the boundaries of their fiduciary duties, judges are illsuited by training (and should be disinclined by temperament) to second guess the business decisions of those chosen by the stockholders to fulfill precisely that function. This case, as in so many corporate matters considered by this Court, involves whether actions taken by certain director defendants fall outside of the fiduciary boundaries existing under Delaware case law—and are therefore subject to judicial oversight—or whether the acts complained of are within those broad boundaries, where a law-trained judge should refrain from acting.
I'm a fan already!
There's much to like in that statement of Delaware law, but the claim that "judges are illsuited by training (and should be disinclined by temperament) to second guess the business decisions of those chosen by the stockholders to fulfill precisely that function" pushes one of my buttons.
I wrote about that argument in my article The Business Judgment Rule as Abstention Doctrine (July 29, 2003), where I explained that:
In Dodge v. Ford Motor Co., the Michigan Supreme Court famously invoked the business judgment rule in refusing to enjoin Henry Ford’s plans to expand production. As justification for its decision, the court modestly observed that: “The judges are not business experts.” Although we shall see that this too is an incomplete explanation for the business judgment rule, at best, it has somewhat more plausibility than it is usually given in the literature.
A modern version of this rationale can be constructed by building on the burgeoning insights for legal analysis of cognitive psychology and behavioral economics. The rational choice model of neoclassical economics assumes not only that individuals act so as to maximize their expected utility, acknowledging no limits on their cognitive power so to do. In contrast, behavioral economics contends that the limitations of human cognition often result in decisions that fail to maximize utility. These limitations are bundled in the concept of “bounded rationality,” which describes the inherent limits on the ability of decision makers to gather and process information. All humans have inherently limited memories, computational skills, and other mental tools, for example.
Under conditions of uncertainty and complexity, boundedly rational decision makers are unable to devise either a fully specified solution to the problem at hand or fully assess the probable outcomes of their action. In effect, cognitive power is a scarce resource, which the inexorable laws of economics tell us decision makers will (to the best of their ability) seek to allocate efficiently. Consistent with that prediction, there is evidence that actors attempt to minimize effort in the face of complexity and ambiguity.
As applied to judicial decision making, the inherent cognitive limitations implied by bounded rationality are reinforced both by the incentive structures familiar from agency cost economics and the well-known institutional constraints on adjudication (such as the necessity in many courts of general jurisdiction to provide speedy trials for criminal defendants). In addition, of course, there is the problem of hindsight bias discussed above. Under such conditions, judges will shirk—i.e., look for ways of deciding cases with minimal effort.
An actor can economize limited cognitive resources in two ways. First, by adopting institutional governance structures designed to promote more efficient decision making. Second, by invoking shortcuts; i.e., heuristic problem-solving decision-making processes. Is the business judgment rule an example of the latter tactic? When one considers the ease with which the Shlensky court disposed of plaintiff’s claims, the idea seems not wholly implausible.
Business decisions are frequently complex and made under conditions of uncertainty. Accordingly, bounded rationality and information asymmetries counsel judicial abstention from reviewing board decisions. Judges likely have less general business expertise than directors. They also have less information about the specifics of the particular firm in question. Consider the Shlensky court’s discussion of possible effects of putting lights in Wrigley Field. The court seems to be acknowledging the limits of its knowledge. Finally, most judges only rarely face business judgment issues. Most judges likely arrive on the bench with little expertise in corporate law and, equally likely, have little incentive to develop substantial institutional expertise in this area after they arrive. Because the legal and business issues are complex, and because judges are as subject as anyone to the cognitive limitations implied by bounded rationality, they have an incentive to duck these cases. In Eric Posner’s useful phrase, they are “radically incompetent”:
[C]ourts have trouble understanding the simplest of business relationships. This is not surprising. Judges must be generalists, but they usually have narrow backgrounds in a particular field of the law. Moreover, they often owe their positions to political connections, not to merit. Their frequent failure to understand transactions is well documented. One survey of cases involving consumer credit, for example, showed that the judges did not even understand the concept of present value. ... Skepticism about the quality of judicial decision making is reflected in many legal doctrines, including the business judgment rule in corporate law, which restrains courts from second-guessing managers and directors....
Although this line of analysis has some considerable traction, it too cannot be a complete explanation for the business judgment rule. In the first instance, business is not the only context in which judges are called upon to review complex issues arising under conditions of uncertainty. Reviewing Wrigley’s refusal to install lights strikes many as no more onerous than reviewing medical or product design decisions. Yet, no “medical judgment” or “design judgment” rule precludes judicial review of malpractice or product liability cases. Something else must be going on.
In the second instance, Posner overlooks both the pervasive role Delaware plays in business judgment rule jurisprudence and the unique incentive structure in which Delaware courts function. The rationality of Delaware chancellors is bounded—just like that of everyone else. Like all judges, moreover, Delaware chancellors face significant resource constraints, especially with respect to the time available for decision making. In contrast to judges in other states, however, Delaware chancellors frequently have considerable prior corporate experience as practitioners. Once on the bench, there is a substantial pay-off for Delaware chancellors who continue to master corporate law. Delaware chancellors sit at “the center of the corporate law universe.” Unlike other courts, which face corporate cases only episodically, such cases make up a very high percentage of the Delaware chancellors’ docket. The frequency with which they face such cases provides a strong incentive for Delaware’s chancellors master both doctrine and the business environment in which the doctrine works. In particular, there is a strong reputational incentive for doing so. Sitting without juries in a court of equity, Delaware chancellors put their reputation on the line whenever they make a decision. Because so many major corporations are incorporated in Delaware, chancery court cases are often high profile and the court’s decisions therefore are subject to close scrutiny by the media, academics, and practitioners. The reputation of a Delaware chancellor thus depends on his or her ability to decide corporate law disputes quickly and carefully.
For these reasons, the adage that “judges are not business experts” cannot be a complete explanation for the business judgment rule. Yet, many old adages have more than a grain of truth. So too does this one. Justice Jackson famously observed of the Supreme Court: “We are not final because we are infallible, but we are infallible only because we are final.” Neither courts nor boards are infallible, but someone must be final. Otherwise we end up with a never-ending process of appellate review. The question then is simply who is better suited to be vested with the mantle of infallibility that comes by virtue of being final—directors or judges?
Corporate directors operate within a pervasive web of accountability mechanisms. A very important set of constraints is provided by a competition in a number of markets. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by directors and managers. Granted, only the most naïve would assume that these markets perfectly constrain director decision making. It would be equally naïve, however, to ignore the lack of comparable market constraints on judicial decision making. Market forces work an imperfect Darwinian selection on corporate decision makers, but no such forces constrain erring judges. As such, rational shareholders will prefer the risk of director error to that of judicial error. Hence, shareholders will want judges to abstain from reviewing board decisions.
The shareholders’ preference for abstention, however, extends only to board decisions motivated by a desire to maximize shareholder wealth. Where the directors’ decision was motivated by considerations other than shareholder wealth, as where the directors engaged in self-dealing or sought to defraud the shareholders, however, the question is no longer one of honest error but of intentional misconduct. Despite the limitations of judicial review, rational shareholders would prefer judicial intervention with respect to board decisions so tainted. The affirmative case for disregarding honest errors simply does not apply to intentional misconduct. To the contrary, given the potential for self-dealing in an organization characterized by a separation of ownership and control, the risk of legal liability may be a necessary deterrent against such misconduct.
Note the resulting link between this justification of the business judgment rule—i.e., the likelihood of judicial error—and the preceding justification—i.e., encouraging optimal risk taking. In theory, if judicial decision making could flawlessly sort out sound decisions with unfortunate outcomes from poor decisions, and directors were confident that there was no risk of hindsight-based liability, the case for the business judgment rule would be substantially weaker. As long as there is some non-zero probability of erroneous second-guessing by judges, however, the threat of liability will skew director decision making away from optimal risk-taking. That this result will occur even if the risk of judicial error is quite small is suggested by the work of behavioral economists on loss aversion and regret avoidance.
Behavioral economists have demonstrated that people evaluate the utility of a decision by measuring the change effected by the decision relative to a neutral reference point. Changes framed in a way that makes things worse (losses) loom larger in the decision-making process than changes framed as making things better (gains) even if the expected value of the two decisions is the same. Hence, a loss averse person (as are most people) will be more perturbed by the prospect of losing $100 than pleased by that of gaining $100. A bias against risk taking is a natural result of loss aversion, because the decision maker will give the disadvantages of a change greater weight than its potential advantages. Hence, the so-called status quo bias.
Closely related to the loss aversion phenomenon, and a possible explanation for it, is the psychological concept of regret avoidance. Decision makers experience greater regret when undesirable consequences follow from action than from inaction. Hence, decision makers tend towards inertia. Because the effect of these cognitive biases is considerably greater than traditional rational choice theory predicts, even a small risk of liability can be expected to have a large deterrent effect on managers who are already risk averse by virtue of their non-diversifiable investment in firm specific human capital. Accordingly, shareholders will prefer judicial abstention to judicial review.
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