Gordon Smith has a very thoughtful post at his Venturpreneur blog on the Disney/Ovitz executive compensation litigation and the emerging duty of good faith in Delaware corporate law. Gordon cogently argues that the duty of good faith presages a revival of the idea that courts will review director conduct to ensure compliance with the so-called duty of substantive due care:
Although the [Delaware Supreme] Court does not like the phrasing, "substantive due care," the idea underlying that notion remains intact. In the future, we are told, litigants and courts should call it "waste" or "bad faith."
To the extent a substantive due care-based standard of review contemplates judicial review of the merits of a board decision, I think that is a very bad idea. Explaining why I think so is a task beyond the scope of any mere blog posting, but if you want 50-odd pages on the subject, check out my article The Business Judgment Rule as Abstention Doctrine, which is forthcoming in the Vanderbilt Law Review. My more modest goal for this post is to suggest that the emerging duty of good faith can be squared with existing law (although I acknowledge the possibility that it might well turn into something entirely new).
As the abstract of my article explains:
Two conceptions of the business judgment rule compete in the case law. One views the business judgment rule as a standard of liability under which courts undertake some objective review of the merits of board decisions. This view is increasingly widely accepted, especially by some members of the Delaware supreme court. The other conception treats the rule not as a standard of review but as a doctrine of abstention, pursuant to which courts simply decline to review board decisions. The distinction between these conceptions matters a great deal. Under the former, for example, it is far more likely that claims against the board of directors will survive through the summary judgment phase of litigation, which at the very least raises the settlement value of shareholder litigation and even can have outcome-determinative effects.
Like many recent corporate law developments, the standard of review conception of the business judgment rule is based on a shareholder primacy-based theory of the corporation. This article extends the author's recent work on a competing theory of the firm, known as director primacy, pursuant to which the board of directors is viewed as the nexus of the set of contracts that makes up the firm. In this model, the defining tension of corporate law is that between authority and accountability. Because one cannot make directors more accountable without infringing on their exercise of authority, courts must be reluctant to review the director decisions absent evidence of the sort of self-dealing that raises very serious accountability concerns. In this article, the author argues that only the abstention version of the business judgment rule properly operationalizes this approach.
How do I square my abstention version of the business judgment rule with the Disney decision about which Gordon writes? I do so by acknowledging that an essential precondition for application of the business judgment rule long has been the absence of irrationality. I phrase the precondition as the absence of irrationality rather than as an affirmative requirement of a rational business decision for reasons made clear in this excerpt from my treatise Corporation Law and Economics (pages 274-75; footnotes shown in brackets):
In Sinclair Oil Corp. v. Levien, the Delaware supreme court held that so long as the board's decision could be attributed to any rational business purpose the business judgment rule precluded the court from substituting its judgment as to the merits of the decision for those of the board. [Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del.1971).] Similarly, in Brehm v. Eisner, the court held that the business judgment rule does not apply when the board has "act[ed] in a manner that cannot be attributed to a rational business purpose." [Brehm v. Eisner, 746 A.2d 244, 264 n.66 (Del.2000).]
The reference to a "rational business purpose," properly understood, does not contemplate substantive review of the decision's merits. As Professor Michael Dooley observes, "Sinclair's use of [the word] rational is to be equated with conceivable or imaginable and means only that the court will not even look at the board's judgment if there is any possibility that it was actuated by a legitimate business reason. It clearly does not mean, and cannot legitimately be cited for the proposition, that individual directors must have, and be prepared to put forth, proof of rational reasons for their decisions." [Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 478-79 n.58 (1992).] Consequently, as Chancellor Allen has stated:
[W]hether a judge or jury considering the matter after the fact, believes a decision substantively wrong, or degrees of wrong extending through "stupid" to "egregious" or "irrational", provides no ground for director liability, so long as the court determines that the process employed was either rational or employed in a good faith effort to advance corporate interests. To employ a different rule--one that permitted an "objective" evaluation of the decision--would expose directors to substantive second guessing by ill equipped judges or juries, which would, in the long run, be injurious to investor interests. [In re Caremark International Inc. Derivative Litig., 698 A.2d 959, 967 (Del.Ch.1996).]
Instead, as Chancellor Allen observed elsewhere, "such limited substantive review as the rule contemplates (i.e., is the judgment under review 'egregious' or 'irrational' or 'so beyond reason,' etc.) really is a way of inferring bad faith." [In re RJR Nabisco, Inc. Shareholders Litig., 1989 WL 7036 at *13 n.13 (Del.Ch.1989).]
Put another way, inquiry into the rationality of a decision is a proxy for an inquiry into whether the decision was tainted by self interest. In Parnes v. Bally Entertainment Corp., for example, the Delaware supreme court stated that: "The presumptive validity of a business judgment is rebutted in those rare cases where the decision under attack is 'so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.' " [722 A.2d 1243, 1246 (Del.1999) (quoting In re J.P. Stevens & Co., Inc., 542 A.2d 770, 780n81 (Del.Ch.1988)).] In that case, Bally's CEO allegedly demanded bribes from prospective takeover bidders and, moreover, allegedly received such a bribe from the successful bidder. In holding that the plaintiff shareholder had stated a cause of action, the court observed that "it is inexplicable that independent directors, acting in good faith, could approve the deal" when it was so tainted.
Litwin v. Allen[, 25 N.Y.S.2d 667 (Sup.Ct.1940),] is often cited as an exception to the foregoing proposition. Put another way, Litwin supposedly creates an "incredible stupidity" exception to the business judgment rule. Under this reading of the opinion, it stands as an example of a board decision so irrational as to not deserve the protection of the business judgment rule. One problem with this analysis is that Litwin involved the directors of a bank, who are typically held to a higher standard of accountability than directors of other corporations. Another is that Litwin is a sport -- a case that falls well outside the norm. It is cited so often, because it stands alone as plausible precedential support for the irrationality exception to the business judgment rule. Finally, consistent with our hypothesis that courts use rationality as a code word for self dealing, the Litwin court found the transaction in question to be "so improvident, so risky, so unusual, and unnecessary as to be contrary to fundamental conceptions of prudent banking practice." Although the court expressly declined to find a violation of the duty of loyalty, it seems fair to ask whether "we have reason to disbelieve the protestations of good faith by directors who reach 'irrational' conclusions?" [Michael P. Dooley, Fundamentals of Corporation Law 263 (1995).]
In sum, it may be that there are some board decisions that are so dumb that the business judgment rule will not insulate them from judicial review. [See Gagliardi v. TriFoods Int'l, Inc., 683 A.2d 1049, 1051n52 (Del.Ch.1996) ("There is a theoretical exception ... that holds that some decisions may be so 'egregious' that liability for losses they cause may follow even in the absence of proof of conflict of interest or improper motivation. The exception, however, has resulted in no awards of money judgments...."; emphasis supplied).] Even if the set of such decisions is not an empty one, however, the tail ought not wag the dog. Because a prerequisite of rationality easily can erode into a prerequisite of reasonableness, courts must tread warily here. If they want to persist in requiring that there be a rational business purpose, at least they can ensure that that requirement lacks teeth.
I think Disney fits into the class of cases I'm discussing here. Chancellor Chandler explained in Disney that:
[A]ll of the alleged facts, if true, imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss. Viewed in this light, plaintiffs' new complaint sufficiently alleges a breach of the directors' obligation to act honestly and in good faith in the corporation's best interests for a Court to conclude, if the facts are true, that the defendant directors' conduct fell outside the protection of the business judgment rule.
There are two ways of interpreting this key passage, both of which can be squared with existing doctrine. First, we could be dealing with a case of egregiously flawed process due care. In this interpretation, Chandler is not concerned with the merits of the Disney board's decision, but rather is finding that the procedures by which the decision was made were so fundamentally flawed as to deny the board the protections of the business judgment rule. This requirement of process due care is a well-established principle of Delaware law, as explained at pages 276-83 of my treatise Corporation Law and Economics. This interpretation is what I think is going on in Disney.
Second, however, one could also interpret this passage as emphasizing a requirement of good faith. In this interpretation, the Disney board's decision was so egregiously unsound on the merits as to shock the court's conscience and, therefore, fall outside the protections of the business judgment rule. I gather this is how Gordon interprets it and it is a very plausible reading. Yet, even if this interpretation is correct, Disney still could be squared with existing law by fitting it into the absence of irrationality line of cases discussed herein.
The Disney board made a decision that, on its face, is almost impossible to defend. As the Delaware Suprme Court put it in Brehm v. Eisner, “the sheer size of the payout to Ovitz, as alleged, pushes the envelope of judicial respect for the business judgment of directors in making compensation decisions.” The board gave Ovitz cash payments of $39 million and stock options worth over $101 million for just 14 months work. The facts suggest that Eisner hired his buddy Ovitz, fell out with Ovitz and wanted him gone, cut very lucrative deals for his friend Ovitz both on the way in and on the way out, all the while railroading the deals past a complacent and compliant board. The story that emerges is one of cronyism and backroom deals in which preservation of face was put ahead of the corporation's best interests. As such, the case does not necessarily presage the emergence of what Allen called "'"objective' evaluation of the decision" made by a board. Instead, this looks like another case in which "we have reason to disbelieve the protestations of good faith by directors who reach 'irrational' conclusions?" Michael P. Dooley, Fundamentals of Corporation Law 263 (1995). Once again, a seeming inquiry into the rationality of the decision arguably masks an underlying search for conflicted interests and self-dealing.
