Does Irrationality = Bad Faith?

Bastiaan F. Assink at The Defining Tension blog offers a very interesting discussion of the possible relationship between waste, irrationality, and bad faith. It's a long and detailed post, which you should read in full, but here's the conclusion:

 

1. Waste is doctrinally one of the situations covered by the general business judgment rule element 'lack of any rational business purpose'.
2. This - quite extreme - objective component may be best understood as a requirement that objective indicators be used, as a matter of evidence, to assess the director's subjective state of mind (the same may apply to the "utter failure" language used by the Delaware Supreme Court in Caremark and Revlon situations).
3. Thus, this type of irrationality - or: egregiousness - is indicative of bad faith, and therefore of disloyalty - as opposed to lack of due care - as framed under the Delaware Supreme Court's opinion in Stone v. Ritter and its progeny.

This is in line with what I concluded in post No. 24, discussing the Delaware Supreme Court's opinion in Lyondell Chemical Company v. Ryan:

1. Violation of the good faith component of the duty of loyalty, to be derived from the circumstances of the case at hand, requires facts that are - from a culpability perspective - clearly more egregious than facts that justify a finding of a duty of care breach. This confirms that the 'lack of good faith' concept is to be applied quite narrowly, at least in the director liability setting.
2. If there is no conflict of interests, and the company's charter has an exculpatory clause (the standard situation), it is terribly difficult for a plaintiff to succeed in a director liability proceeding on bad faith grounds in the absence of any clear direct evidence like memo's or e-mails; not just under the business judgment rule and in Caremark claims (duty of oversight), but also in a Revlon scenario.

I'm inclined to agree. This line of reasoning is largely consistent with the analysis I offered in Corporation Law and Economics of the requirement under the business jusgment rule that a decision be "rational":

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.  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.”

 

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.”  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.

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.”

 

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.’”  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.

 

If that's right, however, why are the Delaware courts insisting that there can be bad faith disloyalty without self-dealing?