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Delaware Legislature Should Revisit 102(b)(7)

Gordon Smith comments on the controversial recent decision in Ryan v. Lyondell:

If you are following the Ryan case, which I blogged about below, you will be interested to read the "Defendants' Memorandum of Law in Support of Their Application for Certification of Interlocutory Appeal and to Stay Proceedings Pending Appeal." (Whew!) The gist of the appeal is that Vice-Chancellor Noble's decision would "eviscerate" section 102(b)(7) because it conflates the duty of care and the duty of good faith. The crux of the argument is that the defendants were "properly motivated, unconflicted and independent directors." As Meatloaf reminded us, two out of three ain't bad.

Vice-Chancellor Noble's opinion acknowledges that the defendants were unconflicted and independent, so he ends up focusing on motivation: "the Board?s failure to engage in a more proactive sale process may constitute a breach of the good faith component of the duty of loyalty as taught in Stone v. Ritter." ...

In the final analysis, however, the defendants have a bigger problem: nothing in Vice-Chancellor Noble's opinion would "eviscerate" 102(b)(7), as claimed by the defendants, because the Lyondell directors can still get the benefit of the exculpation provision if they are found after trial to have breached only their duty of care. The problem with the decision is that they can't get a lawsuit like this dismissed. But I don't see how you can pin that on Vice-Chancellor Noble. He is just taking direction from the Delaware Supreme Court.

I think Gordon's got an excellent point. Ever since the Delaware supreme court held in Emerald Partners v. Berlin, 726 A.2d 1215, 1223-24 (Del. 1999), that a ? 102(b)(7) provision is an affirmative defense, thereby imposing on defendant directors the burden of proving that they are entitled to exculpation under the statute, a ? 102(b)(7) provision rarely entitles directors to a dismissal during the motions stage of the case. The legislative history of section 102(b)(7) is scant and thus does not allow confidence on this issue.

Regardless of whose fault the present state of the law is, however, the present state is most unfortunate. Because 102(b)(7) cannot reliably be invoked to result in a dismissal at the motions stage, plaintiffs will usually get to discovery, which some might call a fishing expedition, and the settlement value of shareholder claims will go up.

The time has come for the Delaware legislature to revisit the issues raised by section 102(b)(7). First, there is the broad issue of freedom of contract. Delaware has been a leader in allowing contractual limitations on fiduciary duty liability in public uncorporations such as LLCs. The legislature needs to start thinking about the extent to which those legal developments should carry over into the corporation law. Section 102(b)(7) would be a great place to start. In my view, it should be permissible for the articles to create a liability limitation provision that would entitle directors to get the case dismissed at the motions stage absent particularized allegations about a very narrow range of misconduct.

Second, although certainty and predictability long have been hallmarks of Delaware law, section 102(b)(7) was a botch job from the outset that has been made worse through judicial interpretation. It now wholly lacks certainy. When revisiting the issue, the Delaware legislature should bear in mind the considerations identified by the comments to the equivalent Model Business Corporation Act provision:

As important as validating the shareholders' right to determine for themselves the extent of the directors' liability is stating the limits of this right in terms promoting a clear understanding of the conduct which is and which is not included in the limitation of liability. Terms such as ?duty of loyalty,? ?good faith,? ?bad faith,? and ?recklessness? seem no more precise than (and therefore as potentially expansive as) ?gross negligence.? All of these formulations are characterizations of conduct rather than definitions of it. Characterizations by nature tend to be more elastic than definitions.

Directors should be afforded reasonable predictability; they are entitled to know whether a contemplated course of action will result in personal liability for money damages. Limits on their exculpation from liability are appropriate but should be expressed in terms that minimize the opportunity for after-the-fact second-guessing.

A coherent liability limitation provision would make clear whether it is intended to come into play pre- or post-trial, and identify with specificity the kinds of director misconduct for which monetary liability may still be recovered.

As to the latter issue, Delaware could do worse than tracking MBCA section 2.02(b)(4)'s operative language:

The articles of incorporation may set forth: (2) provisions not inconsistent with law regarding: (4) a provision eliminating or limiting the liability of a director to the corporation or its shareholders for money damages for any action taken, or any failure to take any action, as a director, except liability for (A) the amount of a financial benefit received by a director to which he is not entitled; (B) an intentional infliction of harm on the corporation or the shareholders; (C) a violation of section 8.33; or (D) an intentional violation of criminal law.

The 4 exceptions to the prohibition of money damages here are far more precisely delineated than the vague and repetitive language of 102(b)(7).

The Grasso Lawsuit's Demise: Why Don't Courts Decide Compensation?

Joseph Bachelder offers a detailed and insightful analysis of why Eliot Spitzer's much ballyhooed excess compensation lawsuit against former NYSE CEO Richard Grasso fizzled in the NY courts. One of his theories takes a deeply Legal Realist approach:

One explanation may lie in the March 2008 downfall of Mr. Spitzer, the initiator of the litigation. His aggressive attacks on financial service companies and executives employed by them, for example, destroyed careers and cost some of those companies dearly. Mr. Spitzer?s personal downfall occurred in March 2008, while governor. No doubt, the continuance of this litigation, in a very troubled economic environment for the country, including financial centers like New York, must have seemed an especially undesirable legal intervention at this particular time.

Another is consistent with judicial review of corporate governance generally:

A second reason for the abrupt dispatch of the Spitzer/Grasso litigation certainly must have been the reluctance of courts to be the arbiters of reasonable compensation. ... Courts do not want to be involved in disputes over the size of pay. They will explain at length why they are unable to arbitrate such disputes based on principles such as those imbedded in the business judgment rule or, as in the Grasso case, based on their interpretation of a statute like the N-PCL. But after all the interpretation and elaboration, the real point seems to be that courts do not like deciding whether the size of executive pay in a particular case is reasonable.

The analogy he draws to the Disney litigation is apt.

Judicial reluctance to review executive pay makes perfect sense. 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 na?ve would assume that these markets perfectly constrain director decisionmaking. It would be equally na?ve, 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. Hence, shareholders will want judges to abstain from reviewing board decisions.

Judicial review also threatens to deter boards from engaging in optimal risk taking. In theory, if judicial decisionmaking 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 decisionmaking away from optimal risk-taking.

The Grasso suit died because it never should have been brought in the first place.

Minnesota Supreme Court tackles SLCs

A reader sent along a link to In re UnitedHealth Group Incorporated Shareholder Derivative Litigation, in which the Minnesota Supreme Court answers some certified questions from the US District Court for Minnesota. The court addresses some procedural issues and then notes that Minnesota has a statutory provision governing SLCs:

In Minnesota, a board of directors may create a special litigation committee ?consisting of one or more independent directors or other independent persons to consider legal rights or remedies of the corporation and whether those rights and remedies should be pursued.? Minn. Stat. ? 302A.241, subd. 1. ?Committees other than special litigation committees . . . are subject at all times to the direction and control of the board.? Id. By implication, then, an SLC is not subject to a board?s direction and control.

Accordingly, "a court will defer to the decision of an SLC only if the board properly delegates its authority to act to the [SLC]. Janssen, 662 N.W.2d at 884. In other words, the SLC and its investigation must satisfy the requirements of the business judgment rule."

Interestingly, the court decided to adopt the Auerbach rather than the Zapata approach to judicial review of SLCs, holding that:

The Minnesota business judgment rule requires a reviewing court to defer to a special litigation committee?s decision to settle a shareholder derivative action if the proponent of that decision demonstrates that (1) the members of the committee possessed a disinterested independence and (2) the committee?s investigative procedures and methodologies were adequate, appropriate, and pursued in good faith.

Among the grounds the court advanced for doing so was the argument that:

... a court applying its ?business judgment? is prone to act on its own biases and predilections. Ironically, then, Zapata simply replaces the danger of bias on the part of the corporate directors and the SLC with the danger of bias on the part of the court. The business judgment rule should eliminate bias to the greatest extent possible, not simply reallocate it from one professional to another. As one commentator has observed, any danger of bias in the SLC process is likely to be corrected by natural market forces. See Stephen M. Bainbridge, The Business Judgment Rule as Abstention Doctrine, 57 Vand. L. Rev. 83, 122 (2004). Competition between firms provides even the most self-interested directors with a strong incentive to make good (i.e., profitable) decisions; directors who prove themselves incapable of making profitable decisions will inevitably be replaced by others who are more capable. Whereas ?[m]arket forces work an imperfect Darwinian selection on corporate decision makers, . . . no such forces constrain erring judges.? Id. As a result of the relative inability of the market to rectify a court?s erroneous business decision, ?rational shareholders will prefer the risk of director error to that of judicial error.? Id.

I'm always pleased to be cited, but my view on the specific issue at bar is that Zapata makes much more sense than Auerbach. In Corporation Law and Economics (at 400-404), I explained that:

The Zapata court correctly identified the basic issue: If the corporation can consistently defeat bona fide derivative actions through procedural devices, much of the derivative suit?s supposed utility in punishing and deterring managerial misconduct will evaporate. On the other hand, the underlying cause of action belongs to the corporation and the corporation should be able to rid itself of nonmeritorious or even harmful litigation. Subsequent decisions have recognized an even more serious concern: ?the derivative action impinges on the managerial freedom of directors.? Due regard therefore must be given ?the fundamental precept that directors manage the business and affairs of corporations.? In other words, shareholder derivative litigation presents the same tension between authority and accountability we have pervasively encountered throughout corporate law. Consequently, the question to be resolved is whether the derivative suit process deserves what the Zapata court referred to as its ?generally recognized effectiveness as an intra-corporate means of policing boards of directors.?

The significance of accountability concerns depends, at least in the first instance, on the nature of the defendant and of the claim. A board decision not to sue a supplier for breach of contract, for example, really is no different from a decision to enter into the contract in the first place. On the other hand, a board decision not to sue a fellow board member who has, for example, usurped a corporate opportunity is qualitatively different.

In supplier-type cases, accountability concerns have little traction. Consequently, it ought to be quite easy for the board to regain control over cases in which the shareholder-plaintiff sues some corporate outsider on a derivative basis. If the shareholder-plaintiff sues the board for breach of the duty of care, it likewise should be easy for the board to regain control over the litigation. If the board decided not to sue the supplier, for example, there probably was a reasonable justification for that decision. Even if there was not, the policies against judicial second-guessing of board conduct underlying the business judgment rule remain compelling. Indeed, in light of those policies, one could plausibly argue that shareholders should have no standing to bring derivative suits based on such claims.

In cases in which a director allegedly violated the duty of loyalty, however, accountability concerns seem more pressing.

? As illustrated by Zapata?s concern that SLC members will have a ?there but for the grace of God go I? empathy for the defendants, concerns about structural bias pervade the law in this area. If structural bias is the main concern, Delaware law seems to get at the problem more directly than, say, does New York. Under Delaware law, demand will be excused where a majority of the board is either interested in the transaction or otherwise failed to validly exercise business judgment. Once demand is excused, Delaware courts take a close look at the merits of allowing the litigation to go forward, while New York courts are barred from doing so.

To be sure, Delaware law in this area could stand a good tweaking. The Aronson/Zapata framework continues to rely unduly on bizarrely worded standards that often fail to grapple with the real issue. The Delaware courts would do well to adopt a simpler standard, which asks whether the board of directors is so clearly disabled by conflicted interests that its judgment cannot be trusted. If so, the shareholder should be allowed to sue. If not, the shareholder should not.

In contrast, check out the Minnesota court's argument that structural bias shouldn't drive the law in this area.