In recent years, increasing regulatory attention has been devoted to the role of the audit committee. In 1999, the major stock exchanges adopted new listing standards (after being prodded by then-SEC Chairman Arthur Levitt in a classic example of how the SEC uses (arguably, abuses) its “raised eyebrow” power) toughening the rules on audit committees. See generally 64 Fed. Reg. 71, 529 (Dec. 21,1999). Likewise, the SEC adopted new disclosure requirements, most notably requiring an annual Audit Committee Report in the proxy statement. Regulation S-K item 306; Schedule 14-A item 7(d)(3). Sarbanes-Oxley and the accompanying stock exchange listing standard amendments further ratcheted up the burdens on audit committees.
A (relatively) new Delaware chancery court opinion by Vice Chancellor Leo Strine sheds light on the state corporation law fallout from these developments. Guttman v. Huang, 823 A.2d 492 (Del. Ch. 2003). Strine is a very smart fellow, with a strong academic bent, who has written a number of important decisions of late. His opinion in Guttman is the best recent summary of the rules of audit committee liability.
Generally, corporate directors and officers owe their firm and its shareholders three basic fiduciary duties: care, loyalty, and good faith. See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993). Of these, the duty of care is most relevant for present purposes. The duty of care requires corporate directors to exercise “that amount of care which ordinarily careful and prudent men would use in similar circumstances.” Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del.1963). Central to the duty of care is an obligation for directors and officers to avail themselves, “prior to making a business decision, of all material information reasonably available to them.” Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984); see also Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985). Where the directors have so informed themselves, however, judicial review of their decisions and actions is precluded by the duty of care’s chief corollary—the business judgment rule. [NB: In addition to an informed decision, there are a number of other preconditions that must be satisfied in order for the business judgment to insulate a board’s decisions or actions from judicial review. See generally Stephen M. Bainbridge, Corporation Law and Economics 270-83 (2002) (discussing preconditions).]
The business judgment rule, of course, is 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. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). “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.” Joy v. North, 692 F.2d 880, 885 (2d Cir. 1982). See also Kamin v. American Express Co., 383 N.Y.S.2d 807 (Sup.Ct.1976), aff’d, 387 N.Y.S.2d 993 (App. div.1976) (holding that the duty of care “does not mean that a director is chargeable with ordinary negligence for having made an improper decision, or having acted imprudently”); Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944) (stating that “although the concept of ‘responsibility’ is firmly fixed in the law, it is only in a most unusual and extraordinary case that directors are held liable for negligence in the absence of fraud, or improper motive, or personal interest”).
In the leading In re Caremark Int’l case, then-Delaware Chancellor William Allen opined that the directors’ duty of care includes an affirmative obligation to ensure “that appropriate information will come to its attention in a timely manner as a matter of ordinary operations.” In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 970 (Del. Ch. 1996). Yet, it is critical to recognize the distinction drawn by Chancellor Allen between allegations involving lack of oversight by directors and mere inadequate oversight. The business judgment rule is relevant only where directors have actually exercised business judgment; in other words, there rule provides no protection where directors have made no decision at all. See, e.g., Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984) (stating that “the business judgment rule operates only in the context of director action”).
In Caremark, the corporation had no program whatsoever of internal controls to ensure that the corporation complied with key federal statutes governing its operations. When the corporation ran afoul of one of those statutes and was obliged to pay a substantial fine, a derivative suit was brought against the directors. In reviewing the merits of that claim for purposes of evaluating the settlement, Chancellor Allen noted that decisions made deep in the interior of an enterprise by relatively junior employees can have devastating consequences for the firm. Allen also noted two concurrent regulatory trends. On one hand, federal law increasingly uses criminal sanctions to ensure corporate compliance with various regulatory regimes. On the other, the federal criminal sentencing guidelines mitigate sanctions where the corporate defendant had law compliance programs in place. In light of these considerations, Allen rejected the defendants’ argument that “a corporate board has no responsibility to assure that appropriate information and reporting systems are established by management . . . .” Caremark, 698 A.2d at 969-70. Instead, as we have seen, he imposed an affirmative obligation for management and the board to implement systems of internal control. Because the Caremark directors had failed to take any action, the business judgment rule did not insulate them from (potential) liability for this failure. Instead, the duty of care controlled.
Where the board and management have established systems of internal control, however, the business judgment rule becomes the relevant standard of review. [NB: Indeed, it may be plausibly argued that the business judgment rule would insulate directors from liability even if the board considered the issue and then affirmatively decided not to adopt a system of internal controls relevant to the issue at hand. In theory, after all, a decision not to act does not differ from a decision to take action. In Caremark, moreover, Chancellor Allen made clear that directors who act in good faith through proper procedures are not liable even if, in retrospect, they made the wrong decision. Caremark, 698 A.2d at 967-68. The business judgment rule, as typically formulated, would seem to protect directors who rationally adopt either a minimal compliance program or even no program at all after weighing the costs against the benefits. Bainbridge, supra, at 296.
Hence, when reviewing how the directors have exercised their oversight function through an extant system of internal controls—as opposed to entirely failing even to create such a system—the standard of review becomes one that a plaintiff-shareholder can satisfy only with great difficulty. Plaintiff must show the traditional grounds on which the business judgment rule is set aside: fraud, illegality, or self-dealing.
Vice Chancellor Strine’s decision in Guttman v. Huang seems to blur this important distinction. In that decision, Vice Chancellor Strine opined that:
[T]he Caremark opinion articulates a standard for liability for failures of oversight that requires a showing that the directors breached their duty of loyalty by failing to attend to their duties in good faith. Put otherwise, the decision premises liability on a showing that the directors were conscious of the fact that they were not doing their jobs.
823 A.2d at 506. Guttman thus seems to establish a single standard of liability for cases involving negligent oversight through an extant system of internal controls and for failures to exercise oversight by failing to create such a system. If so, in my view, Guttman blurs a doctrinal distinction I regard as critical to understanding Caremark. (The two standards perhaps can be reconciled by arguing that directors who are “conscious of the fact that they were not doing their jobs” have “abdicated their functions,” which is not protected by the business judgment rule. Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984).)
Fortunately, even if Guttman is correct, the standard remains one which a derivative suit shareholder-plaintiff can satisfy only with great difficulty. Vice Chancellor Strine approvingly quoted a key passage from Chancellor Allen’s Caremark opinion:
Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation ... in my opinion only a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists—will establish the lack of good faith that is a necessary condition to liability. Such a test of liability—lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight—is quite high. But, a demanding test of liability in the oversight context is probably beneficial to stockholders as a class, as it is in the board decision context, since it makes board service by qualified persons more likely, while continuing to act as a stimulus to good faith performance of duty by such directors.
Caremark, 698 A.2d at 971 (emphasis supplied), quoted in Guttman v. Huang, 823 A.2d 492, 506 (Del. Ch. 2003). Hence, the Vice Chancellor indicated that a Caremark claim must plead facts showing that, inter alia, “that the company lacked an audit committee, that the company had an audit committee that met only sporadically and devoted patently inadequate time to its work, or that the audit committee had clear notice of serious accounting irregularities and simply chose to ignore them or, even worse, to encourage their continuation.” Guttman, 823 A.2d at 507.
The bottom line thus seems to be that audit committees still receive substantial protection. Mere negligence still shpu;d not result in liability. Instead, a systemic breakdown in oversight or conscious disregard of clear problems is required. In my view, however, Vice Chancellor Strine would have done better to make clearer that the business judgment rule still applies in full force to an audit committee’s oversight functions. I have written a law review article entitled The Business Judgment Rule as Abstention Doctrine, forthcoming in the Vanderbilt Law Review, in which I explain in detail why courts generally should abstain from reviewing board decisions. In my view, those arguments carry over in full force to review of how an audit committee carries out its functions.
In brief, there is the problem of judging by hindsight. Decisionmakers tend to assign an erroneously high probability of occurrence to a probabilistic event simply because it ended up occurring. Christine Jolls et al., A Behavioral Approach to Law and Economics, 50 Stan. L. Rev. 1471, 1523 (1998). If a jury knows that the plaintiff was injured, the jury will be biased in favor of imposing negligence liability even if, viewed ex ante, there was a very low probability that such an injury would occur and that taking precautions against such an injury was not cost effective. Even where duty of care cases are tried without a jury, as in Delaware, judges who know with the benefit of hindsight that a business decision turned out badly likewise could be biased towards finding a breach of the duty of care. Cf. Chris Guthrie et al., Inside the Judicial Mind, 86 Cornell L. Rev. 777, 799-805 (2001) (discussing empirical evidence that judicial decisionmaking is tainted by the hindsight bias). Hence, there is a substantial risk that judges will be unable to distinguish between competent and negligent management because bad outcomes often will be regarded, ex post, as having been foreseeable and, therefore, preventable ex ante.
Second, 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. To be sure, the old 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 are 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 decisionmaking. It would be equally naïve, however, to ignore the lack of comparable market constraints on judicial decisionmaking. Market forces work an imperfect Darwinian selection on corporate decisionmakers, but no such forces constrain erring judges. As such, rational shareholders will prefer the risk of director error to that of judicial error.
Finally, judicial review could interfere with—or even destroy—the internal team governance structures that regulate board behavior. Research on relational teams –which are what boards and board committees are – shows that they are not only hard to monitor, but that they also are hard to discipline. Stephen M. Bainbridge, Why a Board? Group Decision Making in Corporate Governance, 55 Vand. L. Rev. 1, 49 (2002). Instead of external review, relational teams are best monitored by a combination of mutual motivation, peer pressure, and internal monitoring. As I have explained elsewhere in more detail, however, judicial review might well destroy the interpersonal relationships that foster these forms of internal board governance. Id. at 49-50.
In sum, Guttman is an interesting development, but one the Delaware courts should promptly clarify as incorporating the classic business judgment rule. The justifications for the business judgment rule apply in full force to the present setting.
