In a prior post, I argued that the common law of corporations mandates, as the court put it in the seminal Dodge v. Ford Motors Co. case, that "A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end."
Despite the powerful rhetoric of cases like Dodge, of course, current law in fact allows boards of directors substantial discretion to consider the impact of their decisions on interests other than shareholder wealth maximization. This discretion, however, exists not as the outcome of conscious social policy but rather as an unintended consequence of the business judgment rule.[1] To be sure, some scholars find an inconsistency between the business judgment rule and the shareholder wealth maximization norm. I concede that the business judgment rule sometimes has the effect of insulating a board of directors from liability when it puts the interests of nonshareholder constituencies ahead of those of shareholders, but deny that that is the rule’s intent.[2]
Instead, as the Delaware supreme court has explained:
Under Delaware law, the business judgment rule is the offspring of the fundamental principle, codified in [Delaware General Corporation Law] § 141(a), the business and affairs of a Delaware corporation are managed by or under its board of directors.... The business judgment rule exists to protect and promote the full and free exercise of the managerial power granted to Delaware directors.[3]
The business judgment rule thus operationalizes the intuition that fiat— i.e., centralization of decision-making authority—is the essential attribute of efficient corporate governance. As Nobel laureate economist Kenneth Arrow explains, however, authority and accountability cannot be reconciled:
[Accountability mechanisms] must be capable of correcting errors but should not be such as to destroy the genuine values of authority. Clearly, a sufficiently strict and continuous organ of [accountability] can easily amount to a denial of authority. If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem.[4]
The business judgment rule prevents such a shift in the locus of decision-making authority from boards to judges. It does so by establishing a limited system for case-by-case oversight in which judicial review of the substantive merits of those decisions is avoided. The court begins with a presumption against review.[5] It then reviews the facts to determine not the quality of the decision, but rather whether the decision-making process was tainted by self-dealing and the like.[6] The questions asked are objective and straightforward: Did the board commit fraud? Did the board commit an illegal act? Did the board self-deal? Whether or not the board exercised reasonable care is irrelevant, as well it should be.[7] The business judgment rule thus erects a prophylactic barrier by which courts pre-commit to resisting the temptation to review the merits of the board’s decision.
The business judgment rule, however, has no application where the board of directors is disabled by conflicted interests.[8] In such cases, concern for director accountability trumps protection of their discretionary authority. In corporate takeovers, for example, a well-known conflict of interest taints target company director decisionmaking.[9] Not surprisingly, therefore, the law denies directors discretion to consider the interests of nonshareholder constituencies in the takeover setting.[10] To be sure, the interests of shareholders and nonshareholder may be consistent in takeover fights, just as they are in many settings. In light of the directors’ conflict of interest, however, we can no longer trust them to make an unbiased assessment of those competing interests. The conflict between management and shareholder interests requires skepticism when management claims to be acting in the stakeholders’ best interests. A board decision to resist a hostile offer may have been motivated by concern for potentially affected nonshareholder constituencies, but it may just as easily have been motivated by the directors’ and managers’ concern for their own positions and perquisites. Selfish decisions thus easily could be justified by an appropriate paper trail of tears over the employees’ fate. Consequently, in the takeover setting, rigorous application of the shareholder wealth maximization norm properly becomes the standard of judicial review.
[1] The business judgment rule, of course, pervades every aspect of corporate law, from allegedly negligent decisions by directors, to self-dealing transactions, to board decisions to seek dismissal of shareholder litigation, and so on. See, e.g., Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971) (fiduciary duties of controlling shareholder); Shlensky v. Wrigley, 237 N.E.2d 776 (Ill. App. 1968) (operational decision); Auerbach v. Bennett, 393 N.E.2d 994 (N.Y. 1979) (dismissal of derivative litigation). Two conceptions of the business judgment rule compete in the case law. One treats the rule as having substantive content. In this version, the business judgment rule comes into play only after one has first determined that the directors satisfied some standard of conduct. See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 360 (Del. 1993) (holding that plaintiffs rebut the business judgment rule’s presumption of good faith by “providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty—good faith, loyalty or due care”). Alternatively, the business judgment rule is seen as an abstention doctrine. Under this version, the court will abstain from reviewing the substantive merits of the directors’ conduct unless the plaintiff can rebut the business judgment rule’s presumption of good faith. See, e.g., Shlensky v. Wrigley, 237 N.E.2d 776, 779 (Ill. App. 1968) (holding that: “In a purely business corporation ... the authority of the directors in the conduct of the business of the corporation must be regarded as absolute when they act within the law, and the court is without authority to substitute its judgment for that of the directors.”). For the reasons developed below, I find the abstention version more persuasive.
[2] To be sure, a few cases can be read to suggest that directors need not treat shareholder wealth maximization as their sole normative objective. Upon close examination, however, most of these cases in fact are not inconsistent with the shareholder wealth maximization norm.
[3] Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985). Cf. Marx v. Akers, 666 N.E.2d 1034, (N.Y. 1996) (noting that “shareholder derivative actions infringe upon the managerial discretion of corporate boards…. Consequently, we have historically been reluctant to permit shareholder derivative suits, noting that the power of courts to direct the management of a corporation's affairs should be ‘exercised with restraint.’”); see also Pogostin v. Rice, 480 A.2d 619, 624 (noting that “the derivative action impinges on the managerial freedom of directors”).
[4] Kenneth J. Arrow, The Limits of Organization 78 (1974).
[5] See, e.g., Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (explaining that the rule creates a presumption that the directors or officers of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company).
[6] See, e.g., Kamin v. American Express Co., 383 N.Y.S.2d 807, 811 (N.Y. Sup. 1976) (stating that absent “fraud, dishonesty, or nonfeasance,” the court would not substitute its judgment for that of the directors).
[7] See, e.g., Joy v. North, 692 F.2d 880, 885 (2d Cir. 1982) (stating: “While it is often stated that corporate directors and officers will be liable for negligence in carrying out their corporate duties, all seem agreed that such a statement is misleading.... Whatever the terminology, the fact is that liability is rarely imposed upon corporate directors or officers simply for bad judgment and this reluctance to impose liability for unsuccessful business decisions has been doctrinally labeled the business judgment rule.”); Brehm v. Eisner, 746 A.2d 244, 262-64 (Del. 2000) (rejecting plaintiff’s contention that the business judgment rule includes an element of “substantive due care” and holding that the business judgment rule requires only “process due care”).
[8] See Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944) (explaining: “The ‘business judgment rule’ . . . yields to the rule of undivided loyalty. This great rule of law is designed ‘to avoid the possibility of fraud and to avoid the temptation of self-interest.’”).
[9] Shareholders unquestionably benefit from a successful takeover. Successful bids produce positive abnormal returns for targets ranging from 16.9 percent to 34.1 percent, with a weighted average of 29.1 percent. Moreover, target shareholders appear to capture the most of the gains, as abnormal positive returns to bidding firms range from 2.4 percent to 6.7 percent, with a weighted average of 3.8 percent. If a hostile takeover bid fails because of management resistance, the consequences to target company shareholders are thus quite severe. In addition, all shareholders indirectly benefit from takeovers because the disciplining effect of hostile takeovers encourages all corporate managers—not just those fighting off a takeover bid—to maximize shareholder wealth. See Frank A. Easterbrook & Daniel R. Fischel, Takeover Bids, Defensive Tactics, and Shareholders’ Welfare, 36 Bus. Law. 1733 (1981); Frank A. Easterbrook & Gregg A. Jarrell, Do Targets Gain From Defeating Tender Offers?, 59 N.Y.U. L. Rev. 277 (1984); Gregg A. Jarrell et al., The Market for Corporate Control: The Empirical Evidence Since 1980, 2 J. Econ. Persp. 49 (1988); Michael Jensen & Richard S. Ruback, The Market for Corporate Control: The Scientific Evidence, 11 J. Fin. Econ. 5 (1983). In contrast, incumbent target managers are the one group unarguably harmed by hostile takeovers. In today’s hostile takeover environment, target directors and officers know that a successful bidder is likely to fire many of them. Kenneth J. Martin & John J. McConnell, Corporate Performance, Corporate Takeovers, and Management Turnover, 46 J. Fin. 671 (1991).
[10] Under the Delaware supreme court’s decision in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), a target’s board of directors may not protect stakeholder interests at the expense of shareholder interests. Id. at 182. Rather, any management action benefiting stakeholders must produce ancillary shareholder benefits. Id. In addition, once an auction of corporate control begins, stakeholders become entirely irrelevant. In such an auction, shareholder wealth maximization is the board’s only appropriate concern. Id. Indeed, in this context, considering any factors other than shareholder wealth violates the board’s fiduciary duties. Id. at 185.
