In cleaning up some old files, I ran across the text of a speech I gave back in 2004 at Syracuse law school on the business judgment rule. The talk was based on my paper, The Business Judgment Rule as Abstention Doctrine, which was published in the Vanderbilt Law Review. The text follows:
The business judgment rule pervades every aspect of state corporate law, from director negligence to self-dealing transactions to dismissal of shareholder litigation and so on. Countless cases invoke the rule and countless scholars have analyzed it. Yet, despite all the attention lavished on it, the business judgment rule remains poorly understood.
Two conceptions of the business judgment rule compete in the case law. The modern trend is to treat the rule as a substantive standard of liability. There is some disagreement, even among its proponents, as to the standard of review applied under this approach. It may be mere subjective good faith, it may be a requirement of rationality, or it may be gross negligence. The key point, however, is that the business judgment rule, so conceived, entails “some objective review of the quality of the [board’s] decision, however limited.”
An older conception, however, treats the business judgment rule as an abstention doctrine. In this conception, the rule establishes a presumption against judicial review of duty of care claims. Under it, provided certain preconditions are satisfied, the court abstains from reviewing the substantive merits of the directors’ conduct.
My project of exploring the rule has both doctrinal and normative components. On the doctrinal front, given the significant liability implications of many director decisions, sorting out the extent to which courts will look at the substantive merits of those decisions obviously is imperative.
On the normative front, it was critical to tackle corporate law’s key doctrine in order to validate the theory of corporate governance I have been developing in recent years.
The model I call director primacy is designed to answer the two basic corporate governance questions: (1) Which constituency’s interests will prevail when the ultimate decisionmaker is presented with a zero sum game? (2) In which organ of the corporation is that ultimate power of decision vested? In the academic literature, the prevailing answers to these questions are provided by the shareholder primacy model. Although its precise dimensions vary from one of its advocates to another, shareholder primacy-based models generally posit that corporate decisionmaking powers must be exercised so as to maximize shareholder wealth and that, despite the separation of ownership and control in public corporations, shareholders wield some form of ultimate decisionmaking power in the firm. In contrast, I claim that shareholder primacy is neither normatively persuasive nor descriptively accurate.
The director primacy model thus stands as an alternative to the prevailing shareholder primacy view. The director primacy model describes the corporation as a vehicle by which the board of directors hires various factors of production. The board of directors is not an agent of the shareholders; rather, the board is the embodiment of the corporate principal, serving as the nexus of the various contracts making up the corporation. Director primacy claims that fiat—centralized decisionmaking—is the essential attribute of efficient corporate governance. In turn, it claims that authority—i.e., the power and right to exercise decisionmaking fiat—is vested neither in the shareholders nor the managers, but in the board of directors. Granted, vesting the power of fiat in the board of directors raises legitimate accountability concerns. Director primacy therefore identifies the tension between authority and accountability as the central problem of corporate law. In turn, I will argue, the business judgment rule is the principal mechanism by which corporate law resolves that tension.
The modern conception of the business judgment rule as a standard of liability is largely the handiwork of Delaware supreme court justices Henry Horsey and Randy Holland. Before they began their work, the business judgment rule generally was seen as a barrier to judicial review of the substantive merits of board decisions. As one old case put it: “the authority of the directors in the conduct of the business of the corporation must be regarded as absolute when they act within the law, and the court is without authority to substitute its judgment for that of the directors.” Or, as another case vividly explained: “The directors’ room rather than the courtroom is the appropriate forum for thrashing out purely business questions which will have an impact of on profits, market prices, competitive situations, or tax advantages.”
In contrast, Horsey and Holland pulled the teeth from the business judgment rule. They described the rule as merely being intended “to preclude a court from imposing itself unreasonably on the business and affairs of a corporation.” Worse yet, they put the cart before the horse by holding that: “To rebut the rule, a shareholder plaintiff assumes the burden of providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty—good faith, loyalty or due care.”
Under their formulation, directors who violate their duty of care do not get the protections of the business judgment rule; indeed, the rule is rebutted by a showing that the directors violated their fiduciary duty of “due care.” This is exactly backwards. The whole point of the business judgment rule is to prevent courts from even asking the question: did the board breach its duty of care?
How are we to decide between these competing conceptions of the business judgment rule? For me, this is where the project got really interesting. I wanted to use the rule – precisely because it is so central to corporate law – as a vehicle for testing out my director primacy model.
Like most economically-minded corporate law academics, I view the corporation not as an entity – a thing capable of being owned – but as a legal fiction representing a complex set of contracts between factors of production. This nexus of contracts model should be revolutionary. If the corporation is not a thing capable of being owned – if the corporation has no owners – then much of the traditional case for shareholder primacy evaporates. Shareholders do not own the corporation; they merely hold a contractual entitlement to the residual claim on corporate assets and profits.
Curiously, however, even the most dedicated contractarians have failed to explore the revolutionary implications of their model. Instead, they have churned out contractarian justifications of the traditional concepts of shareholder primacy. Easterbrook and Fischel’s work on takeovers is probably the best known example of this failure.
In contrast, I wanted to push the edge of the envelope. I started out by asking a very simple question: We call it “the nexus of contracts” model. But contractarians rarely ask: what is the nexus? If you look at the structure of corporate law, the answer is obvious: it is the board of directors.
The chief distinguishing characteristic of the modern public corporation is the separation of ownership and control. Shareholders have essentially no power to initiate corporate action and are entitled to approve or disapprove only a very few board actions. The statutory decisionmaking model thus is one in which the board acts and shareholders, at most, react. (Of course, I recognize the managerialist account of how boards are captured by CEOs and I think I have an answer to that problem, but that’s a task for another day.)
So I started thinking about the corporation as a vehicle by which the board of directors hires various factors of production – including equity capital from shareholders. Once I did so, it became clear that directors are not mere agents of the shareholders. To the contrary, as an old New York case explained, “the directors in the performance of their duty possess [the corporation’s property], and act in every way as if they owned it.” It thus makes no sense to speak of the directors’ powers as being delegated from the shareholders. Instead, as that New York decision also explained, the board’s powers are “original and undelegated.” The directors thus are Platonic guardians of an unique entity in which shareholders are but one of many contracting inputs.
Yet, while directors are vested with wide powers to exercise their discretion by fiat, those powers are limited by their contractual obligations—both explicit and implied in law—to the factors of production with whom they contract. In American business law, one of these implied terms is the directors’ obligation to maximize the wealth of shareholders. A tension between authority and accountability thus arises. On the one hand, the modern public corporation simply could not exist if directors lacked the power of fiat. On the other hand, possession of that power by directors enables them to divert corporate profits from shareholders to themselves. A complete theory of the firm thus requires that the law balance the virtues of discretion against the need to require that discretion be used responsibly.
The difficulty is that authority and accountability are ultimately antithetical: one cannot have more of one without also having less of the other. The power to hold to account is ultimately the power to decide. Consequently, efforts to hold the board accountable necessarily shift some of the board’s decisionmaking authority to shareholders or judges.
Establishing the proper mix of deference and accountability thus emerges as the central problem. Given the significant virtues of discretion, however, one must not lightly interfere with management or the board’s decisionmaking authority in the name of accountability. Preservation of managerial discretion should always be the default. In my view, the business judgment rule follows inexorably from this foundational principle.
My understanding of the rule’s role is consistent with a passage from the Delaware supreme court’s famed Van Gorkom decision that has received less attention than it deserves:
The business judgment rule is the offspring of the fundamental principle … [that] the business and affairs of a Delaware corporation are managed by or under its board of directors. ... The business judgment rule exists to protect and promote the full and free exercise of the managerial power granted to Delaware directors.
In other words, the rule ensures that the default is deference to the board’s authority as the corporation’s central and final decisionmaker.
Critics of the foregoing analysis likely would concede that judicial review shifts some power to decide to judges, but contend that that observation is normatively insufficient. To be sure, they might posit, centralized decisionmaking is an essential feature of the corporation. Judicial review could serve as a redundant control on board decisionmaking, however, without displacing the board as the primary decisionmaker.
An analogy to engineering concepts may be useful. If a mechanical system is likely to fail, and its failure likely to entail high costs, basic engineering theory calls for redundant controls to prevent failure. It would be naive to assume that markets fully constrain director behavior. Why then is judicial review not an appropriate redundant control? If we assume that corporate law is generally efficient, the losses tolerated by judicial abstention must be outweighed by benefits elsewhere in the system. I claim to have identified at least three major benefits.
The American Law Institute’s Principles of Corporate Governance justifies the business judgment rule as being necessary to protect “directors and officers from the risks inherent in hindsight reviews of their business decisions” and avoid “the risk of stifling innovation and venturesome business activity.” This claim cannot be a complete explanation of the business judgment rule. Duty of care litigation, after all, probably does far less to stifle innovation and business risk taking than does product liability and securities fraud litigation, but no equivalent of the business judgment rule exists in the latter contexts. Even so, however, encouraging optimal risk-taking is part of the story.
As the firm’s residual claimants, shareholders do not get a return on their investment until all other claims on the corporation have been satisfied. All else equal, shareholders therefore prefer high return projects. Because risk and return are directly proportional, however, implementing that preference necessarily entails choosing risky projects.
Rational shareholders will have a high tolerance for risky corporate projects. First, the basic corporate law principle of limited liability substantially insulates shareholders from the downside risks of corporate activity. Second, shareholders can largely eliminate firm specific risk by holding a diversified portfolio.
In contrast, rational corporate managers—and, to a lesser extent, directors—should be risk averse with respect to such policies. Corporate managers typically have substantial firm specific human capital. Unfortunately for such managers, however, the risks inherent in firm specific capital investments cannot be reduced by diversification; managers obviously cannot diversify their human capital among a number of different firms. As a result, managers will be averse to risks shareholders are perfectly happy to tolerate.
The diversion of interests as between shareholders and managers will be compounded if managers face the risk of legal liability, on top of economic loss, in the event a risky decision turns out badly. Business decisions rarely involve black-and-white issues; instead, they typically involve prudential judgments among a number of plausible alternatives. Given the vagaries of business, moreover, even carefully made choices among such alternatives may turn out badly.
At this point, the well-known hindsight bias comes into play. There is a substantial risk that shareholders and 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. If liability results from bad outcomes, without regard to the ex ante quality of the decision and/or the decisionmaking process, however, managers will be discouraged from taking risks. If it is true that “lack of gumption is the single largest source of agency costs,” as some claim, rational shareholders will disfavor liability rules discouraging risk-taking.
Hence, judges should abstain from reviewing the substantive merits of business decisions. When courts review the objective merits of a board decision, as some variants of the standard of review conception allow, they effectively penalize “the choice of seemingly riskier alternatives.”
Having said all that, however, encouraging risk taking must be deemed an incomplete explanation because it fails to account for many of the rule’s applications. Consider, for example, the business decision made in the famed Shlensky v. Wrigley case, in which the business judgment rule insulated Wrigley from liability to shareholder Shlensky in connection with the former’s famous refusal to install lights at his eponymous baseball field. Was Wrigley an innovator making a venturesome business decision or an eccentric coot who was just behind the times? How can we know when the business judgment rule precluded Shlensky from even getting up to bat? In sum, encouraging risk-taking is part of the story, but only part. Something else is going on as well.
I turn then to a second benefit, which is often derided in the literature. In Dodge v. Ford Motor Co., the Michigan supreme court famously invoked the business judgment rule in refusing to enjoin Henry Ford’s plans to expand production. As justification for its decision, the court modestly observed that: “The judges are not business experts.” One of the contributions of my paper (or so I like to think) is that I have given this claim a fresh interpretation that may rescue it from the rough treatment it has received at the hands of its critics.
Behavioral economics contends that the limitations of human cognition often result in decisions that fail to maximize utility. These limitations are bundled in the concept of “bounded rationality,” which describes the inherent limits on the ability of decisionmakers to gather and process information.
Under conditions of uncertainty and complexity, boundedly rational decisionmakers are unable to devise either a fully specified solution to the problem at hand or fully assess the probable outcomes of their action. In effect, cognitive power is a scarce resource, which the inexorable laws of economics tell us decisionmakers will (to the best of their ability) seek to allocate efficiently. Consistent with that prediction, there is evidence that actors attempt to minimize effort in the face of complexity and ambiguity.
As applied to judicial decisionmaking, the inherent cognitive limitations implied by bounded rationality are reinforced both by the incentive structures familiar from agency cost economics and the well-known institutional constraints on adjudication. Under such conditions, judges will shirk—i.e., look for ways of deciding cases with minimal effort.
An actor can economize limited cognitive resources in two ways. First, by adopting institutional governance structures designed to promote more efficient decisionmaking. Second, by invoking decisionmaking shortcuts—heuristics. Is the business judgment rule an example of the latter tactic? When one considers the ease with which the Shlensky court disposed of plaintiff’s claims, the idea seems not wholly implausible.
Most judges only rarely face business judgment issues. Most judges arrive on the bench with little expertise in corporate law and have little incentive to develop substantial institutional expertise in this area after they arrive. Because the legal and business issues are complex, and because judges are as subject as anyone to the cognitive limitations implied by bounded rationality, they have an incentive to duck these cases.
Again, I don’t think this can be taken as a complete explanation for the rule – just as part of the puzzle. In the first instance, business is not the only context in which judges are called upon to review complex issues arising under conditions of uncertainty. Reviewing Wrigley’s refusal to install lights strikes many as no more onerous than reviewing medical or product design decisions. Yet, no “medical judgment” or “design judgment” rule precludes judicial review of malpractice or product liability cases. Something else must be going on.
Perhaps even more importantly, the argument overlooks both the pervasive role Delaware plays in business judgment rule jurisprudence and the unique incentive structure in which Delaware courts function. The rationality of Delaware chancellors is bounded—just like that of everyone else. Like all judges, moreover, Delaware chancellors face significant resource constraints, especially with respect to the time available for decisionmaking. In contrast to judges in other states, however, Delaware chancellors frequently have considerable prior corporate experience as practitioners. Once on the bench, there is a substantial pay-off for Delaware chancellors who continue to master corporate law. Delaware chancellors sit at “the center of the corporate law universe.” Unlike other courts, which face corporate cases only episodically, such cases make up a very high percentage of the Delaware chancellors’ docket. Sitting without juries in a court of equity, moreover, Delaware chancellors put their reputation on the line whenever they make a decision. Because so many major corporations are incorporated in Delaware, chancery court cases are often high profile and the court’s decisions therefore are subject to close scrutiny by the media, academics, and practitioners. The reputation of a Delaware chancellor thus depends on his or her ability to decide corporate law disputes quickly and carefully.
For these reasons, the 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. 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?
Variants of the encouraging risk-taking and judicial expertise rationales for the business judgment rule are well-accepted in the literature. At best, I have just put my own spin on these well-established arguments. It is the third rationale for the rule offered in my paper that I think is unique: I focused on the potential implications of judicial review for the internal governance of boards.
In the corporation’s authority-based governance system, information flows up a branching hierarchy to a central office and binding decisions flow back down. At the apex of that decisionmaking pyramid is not a single hierarch, but a multi-member committee—the board—that usually functions by consensus. Curiously, however, corporate law scholarship rarely treats questions about the board as team production problems.
The board of directors is a good example of what Oliver Williamson refers to as a “relational team.” Members of such a team often develop idiosyncratic working relationships with one another. In fact, one might say that members of a relational team develop not only firm specific human capital but also team specific human capital.
Such teams may well make superior decisions than individuals acting alone. Individuals are subject to the constraints of bounded rationality and the temptations to shirk or self-deal. Group decisionmaking responds to bounded rationality by creating a system for aggregating the inputs of multiple individuals with differing knowledge, interests, and skills.
Although teams can be a highly effective decisionmaking mechanism, they are difficult to monitor. Relational teams arise when the production process results in nonseparable outputs. By definition, therefore, the productivity of individual team members cannot be measured on an output basis. Yet, at the same time, individual productivity also may be quite costly to measure from an input perspective. How does one measure how well a board member cooperates in responding to changed circumstances or emergencies, for example? Because neither input nor output can be measured effectively, judicial review of board decisionmaking cannot be an effective monitoring mechanism.
The key problem for present purposes, and the one that differentiates this line of argument, however, is that judicial review could interfere with—or even destroy—the internal team governance structures that regulate board behavior. Research on relational teams shows that they are not only hard to monitor, but that they also are hard to discipline. As they develop team specific human capital, members of a production team develop idiosyncratic ways of working with one another that generate a form of synergy. Under such circumstances, dismissal becomes a highly undesirable sanction, because no team member can be replaced without disrupting the entire team.
Because relational teams often become insular, moreover, even external sanctions falling short of dismissal may have ripple effects throughout the team.
Relational teams are best monitored by a combination of mutual motivation, peer pressure, and internal monitoring, rather than external review. Worse yet, external review might well destroy the interpersonal relationships that foster these forms of internal board governance. Again, shareholders will therefore prefer a rule under which judges abstain from reviewing board decisions.
This line of analysis justifies several aspects of the business judgment rule unexplained by alternative theories. Under it, for example, the inapplicability of the business judgment rule to fraud or self-dealing is readily explicable. Duty of care litigation is typically concerned with collective actions by the board of directors as a whole. In taking such actions, we have seen, the board is constrained to exercise reasonable care by a combination of external market forces and internal team governance structures. When an individual director decides to pursue a course of self-dealing, however, he or she usually acts alone and, moreover, betrays his or her fellow directors’ trust. It makes sense for courts to be less concerned with damage to internal team governance when the defendant director’s misconduct has already harmed that governance structure through betrayal. Instead, by providing a set of external sanctions against self-dealing, the law encourages directors to refrain from such betrayals.
Proponents of treating the business judgment rule as a standard of liability rather than as an abstention doctrine might well concede the arguments I’ve been developing. They might argue, however, the benefits attributed to the rule in those sections can be obtained while treating the rule as a standard of liability, so long as the standard is sufficiently lenient. But this is error.
The argument herein has not been one for judicial abnegation of its role, but rather one for judicial abstention. The distinction is a significant one. Abstention contemplates judicial reticence, but leaves open the possibility of intervention in appropriate circumstances. The problem is to identify the circumstances in which intervention is necessary. Put another way, when do accountability concerns trump preservation of the board’s authority?
If the business judgment rule is treated as a standard of liability, rather than an abstention doctrine, judicial intervention readily could become the norm rather than the exception. This is why Justices Horsey’s and Holland’s formulation of the rule is so problematic. Their cart before the horse formulation implies that the business judgment rule does not preclude judicial review of cases in which the board failed to exercise reasonable care. Yet, if the business judgment rule is to have teeth, it is precisely those cases in which it is especially important for courts to abstain. No matter how gingerly courts apply the standard of liability, trying to measure the “quantity” of negligence is a task best left untried. As we have seen, courts will be tempted constantly to apply the standard in ways that sanction honest decisions that, with the benefit of hindsight, proved unfortunate and/or appear inept. All of the adverse effects of judicial review we’ve outlined are thus implicated whether or not the board exercised reasonable care.
If the business judgment rule is framed as an abstention doctrine, however, judicial review is more likely to be the exception rather than the rule. The court begins with a presumption against review. It then reviews the facts to determine not the quality of the decision, but rather whether the decisionmaking process was tainted by self-dealing and the like. The requisite questions to be asked are more objective and straightforward: Did the board commit fraud? Did the board commit an illegal act? Did the board self-deal? Whether or not the board exercised reasonable care is irrelevant, as well it should be. The business judgment rule thus builds a prophylactic barrier by which courts pre-commit to resisting the temptation to review the merits of the board’s decision.
To say that the abstention conception of the business judgment rule is objective, of course, does not mean that it admits of bright-line solutions. To the contrary, once we recognize that reconciling the competing claims of authority and accountability is the central problem for business judgment rule jurisprudence—indeed, for all of corporate governance—the misnomer inherent in the law’s nomenclature becomes apparent. It has become conventional to distinguish between standards and rules. Rules say, “Drive 55 mph,” while standards say, “drive reasonably.” Within that dichotomy, the business judgment rule clearly is misnamed—it is a standard, not a rule. The question is not whether the directors violated some bright-line precept, but whether their conduct satisfied some standard for judicial abstention. The greater flexibility inherent in standards frequently comes into play in business judgment rule jurisprudence, as courts fine tune the doctrine’s application to the facts at bar. Much of that fine tuning can be explained as an unconscious attempt to strike an appropriate balance between authority and accountability under specific factual circumstances. The principal law reform implication of this analysis thus may be that courts ought to be more explicit both about the fact that they are balancing competing concerns and why they believe the balance struck in a particular case is the appropriate one.
