I used my latest TCS column to explain it:
Last week, the Delaware Supreme Court heard arguments in an appeal by Walt Disney Co. shareholders who unsuccessfully sued Disney's board of directors over the $140+ million severance package Disney paid Michael Ovitz when he stepped down (under pressure) as Disney's President. In reporting on the appeal, the New York Times observed that: "The pivotal legal issue in the appeal is the esoteric 'business judgment rule.'"
As it is usually phrased, the business judgment rule 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. If the Times is right that the rule is understood only by a particular group, that's unfortunate, because the rule deserves to be known to not just business lawyers, but also every corporate director, executive, and shareholder.
The business judgment rule is corporate law's central doctrine. It pervades every aspect of the state law of corporate governance; from negligence by directors, to self-dealing transactions, to termination of shareholder litigation and so on. Of particular relevance, it is the governing standard when shareholders complain that about allegedly excessive executive pay.
Corporate directors are subject to a fiduciary duty of care, which requires them to the sort of care that ordinarily careful and prudent people would use in similar circumstances. Because the corporate duty of care thus resembles the tort law concept of reasonable care, one might assume the duty of care is violated when directors act negligently. Yet, the one thing about the business judgment rule on which everyone agrees is that it insulates directors from liability for negligence.
The rule doesn't completely insulate directors from liability, of
course. As the Delaware Supreme Court explained in an earlier appeal in
the Disney litigation, the rule simply means that:
"...directors' decisions will be respected by courts unless the directors are interested or lack independence relative to the decision, do not act in good faith, act in a manner that cannot be attributed to a rational business purpose or reach their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available.[1]
Yet, even with those qualifications, the rule provides directors with considerably greater protection from liability than most economic actors enjoy.
The business judgment rule's traditional justification is that courts are not business experts.[2] It is probably true that most judges do not have much expertise in business law matters, although that's hardly the case for Delaware's judiciary, which more-or-less specializes in corporation law. Moreover, business law is not the only context in which judges are called upon to review complex issues arising under conditions of uncertainty. Reviewing a board of directors' decision to pay Michael Ovitz $140 million for 14 months work, for example, seems no more technically demanding than reviewing medical or product design decisions. Yet, no "medical judgment" or "design judgment" rule precludes judicial review of malpractice or product liability cases.
Why then do directors of corporations get this special protection?
Justice Jackson famously observed of the U.S. Supreme Court: "We are not final because we are infallible, but we are infallible only because we are final." Neither courts nor boards of directors are infallible, but someone must be final. Otherwise we end up with a never-ending process of appellate review. The question then is a simple one: Who is better suited to be vested with the mantle of infallibility that comes by virtue of being final—directors or judges?
Judges necessarily have less information about the needs of a particular firm than do that firm's directors. A fortiori, judges will make poorer decisions than the firm's board. As one court decision put it:
"[C]ourts recognize that after-the-fact litigation is a most imperfect device to evaluate corporate business decisions. The circumstances surrounding a corporate decision are not easily reconstructed in a courtroom years later, since business imperatives often call for quick decisions, inevitably based on less than perfect information. The entrepreneur's function is to encounter risks and to confront uncertainty, and a reasoned decision at the time made may seem a wild hunch viewed years later against a background of perfect knowledge."[3]
Put another way, judges are no less subject to bounded rationality than any other decision makers. Just as the limits on cognitive competence impede the ability of market actors to write complete contracts, those same limits necessarily impede judicial review. Only with the benefit of hindsight will judges be able to make better decisions than boards, but we have already seen that hindsight review is problematic. While market forces work a sort of Darwinian selection on corporate decision makers, moreover, no such forces constrain erring judges. As such, rational shareholders will prefer the risk of managerial error to that of judicial error.
The posited preference for managerial error, however, only extends to decisions motivated by a desire to maximize shareholder wealth. Given that market forces encourage directors to make such decisions carefully, such a preference makes sense. 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. As Delaware Chief Justice Veasey observes, "investors do not want self-dealing directors or those bent on entrenchment in office. ... Trust of directors is the key because of the self-governing nature of corporate law. Yet the law is strong enough to rein in directors who would flirt with an abuse of that trust."[4] The affirmative case for disregarding honest errors thus simply does not apply to intentional misconduct. To the contrary, given the heightened 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.
The function of the business judgment rule thus is to act as a filter for self-dealing and fraud. As long as the board made an informed decision untainted by conflicts of interest, the court will defer to the board's judgment. Directors are thus allowed to take business risks without fear that an error in judgment or even an act of God might result in liability being imposed on them. Conversely, however, the rule will not allow directors to cheat and self-deal.
Giving Michael Ovitz $140 million to go away after a mere 14 months on the job might not have been the smartest decision a board of directors made, but absent evidence that the board acted from conflicted interests, it is precisely the sort of decision that courts leave to the discretion of directors.
[1] Brehm v. Eisner, 746 A.2d 244 (Del. 2000).
[2] See, e.g., Dodge v. Ford Motor Co., 170 N.W. 668, 684 (Mich. 1919).
[3] Joy v. North, 692 F.2d 880, 886 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983).
[4] E. Norman Veasey, An Economic Rationale for Judicial Decisionmaking in Corporate Law, 53 Bus. Law. 681, 694 (1998).
