The difference between reasonableness and rationality in corporate law

Bastiaan Assink highlights an interesting passage from VC Leo Strine's recent opinion in In re Dollar Thrifty Shareholder Litigation, C.A. No. 5458-VCS (Del. Ch. 2010), in which Strine discusses the difference between rationality and reasonableness review in corporate law:

The employment of a reasonableness standard to distinguish the type of heightened judicial review required under Unocal and Revlon from the bare rationality review characteristic of the business judgment rule is a move in some ways analogous to a distinction made in political philosophy. In our law, the business judgment rule insulates the ordinary business decisions of non-conflicted directors so long as those decisions are rational. E.g., Sinclair Oil Corp., 280 A.2d at 721. That is, once the determination has been made that the directors have the proper motivation (i.e., to act in the best interests of the corporation and its stockholders), the court will defer to their decisions so long as those decisions are the product of rational thinking. Id.; Citron v. Fairchild Camera and Instrument Corp., 569 A.2d 53, 64 (Del. 1989). In philosophy, despite the definitional similarity between the words reasonable and rational, an analogous separation exists. In the works of John Rawls, rationality refers simply to the ability of a person to use “the powers of judgment and deliberation in seeking ends and interests peculiarly [her] own.” JOHN RAWLS, POLITICAL LIBERALISM 50 (Columbia Univ. Press 1993). By contrast, reasonableness has a less selfish connotation, and requires a person to propose and honor fair terms of dealing (or in Rawls’s terms, cooperation) with others in society, and to be bound by those terms once assured that others will likewise do so. Id. at 49, 51, 54. In other words, to be reasonable, a person’s conduct must be fair-minded in reference to its effect on others, whereas, to be rational, conduct simply has to reflect a logical approach to advancing one’s own narrow, self-interest. JOHN RAWLS, LECTURES ON THE HISTORY OF POLITICAL PHILOSOPHY 54 (Samuel Freeman ed., Harvard Univ. Press 2008) (2007) (“We tend to use ‘reasonable’ to mean being fair-minded, judicious and able to see other points of view, and so forth; while ‘rational’ has more the sense of being logical, or acting for one’s own good, or one’s interests. In my own work . . . the reasonable involves fair terms of cooperation; while the rational involves furthering the good or advantage of oneself, or of each person cooperating.”).

In our corporate law, a reasonableness standard is used when there is a basis for concern that directors without a pure self-dealing motive might be influenced by considerations other than the best interests of the corporation and other stockholders. QVC, 637 A.2d at 45. By tightening the standard from rationality to reasonableness, this concern is taken into account, by requiring that the directors demonstrate that their decision was well-motivated and was a reasonable way to advance the proper interests they must serve, which are the best interests of the corporation and the stockholders. In this sense, therefore, the Unocal/Revlon standards place upon the directors the affirmative burden to show that their decisions were fair-minded in the sense of being a good faith (loyal) and rational (careful and logical) way of advancing the proper contextual objective. This use of a rationality/reasonableness distinction is thus in the same, if more profane, tradition as Rawls. See RAWLS, POLITICAL LIBERALISM at 48 n.1 (tracing the
distinction between rationality and reasonableness back to Kant); RAWLS, LECTURES ON THE HISTORY OF POLITICAL PHILOSOPHY at 54-62 (discussing the distinction between these concepts by reference to the work of Hobbes, who attempted to show why it was rational to follow the (reasonable) Laws of Nature he set forth, assuming others were willing to do so). In this very different context of political philosophy, Amartya Sen has said, obviously without any intention of doing so, something that quickly gives a good sense of the distinction between ordinary business judgment rule review and heightened Unocal/Revlon scrutiny:

Rationality is in fact a rather permissive discipline, which demands the test of reasoning, but allows reasoned self-scrutiny to take quite different forms, without necessarily imposing any great uniformity of criteria. If rationality were a church, it would be a rather broad church. Indeed, the demands of reasonableness, as characterized by Rawls, tend to be more exacting than the requirements of mere rationality. The demands of scrutiny would have to be sharpened and tightened when we move from the idea of rationality to that of reasonableness . . . .

AMARTYA SEN, THE IDEA OF JUSTICE 195 (Harvard Univ. Press 2009) (internal footnotes omitted).

Strine must be gunning for an academic job. As I've often noted, one of the key attributes of the aspiring law professor these days seems to be the ability to tell us what Rawls would think about any legal problem. (Of course, being able to demonstrate what Rawls would think by running regressions would be even better.)

On a more serious note, I disagree with Strine's treatment of the issue. He claims that "once the determination has been made that the directors have the proper motivation (i.e., to act in the best interests of the corporation and its stockholders), the court will defer to their decisions so long as those decisions are the product of rational thinking." He also claims that rationality review contemplates a judicial assessment of whether the board's decision was a "logical approach to advancing the corporation’s objectives."

I think Strine's distinction between motive and rationality review is both inconsistent with precedent and, to the extent that it suggests that there is some independent content to rationality review, bad policy. In particular, I would firmly reject any suggestion that the business judgment rule allows a judge to assess the substantive merits of the board's thinking processes. Rationality review is solely about process.

I've written about this issue in my book Corporation Law:

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.[1] 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."[2]

The reference to a "rational business purpose," properly understood, does not contemplate substantive review of the decision's merits. "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."[3]

           [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.[4]

Instead, "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."[5]

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.' "[6] 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 is often cited as an exception to the foregoing proposition.[7] 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?"[8]

 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.[9] 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.

---

[1]Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del.1971).

2]Brehm v. Eisner, 746 A.2d 244, 264 n.66 (Del.2000).

[3]Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 478n79 n.58 (1992).

[4]In re Caremark International Inc. Derivative Litig., 698 A.2d 959, 967 (Del.Ch.1996) (emphasis in original).

[5]In re RJR Nabisco, Inc. Shareholders Litig., 1989 WL 7036 at *13 n.13 (Del.Ch.1989).

[6]722 A.2d 1243, 1246 (Del.1999) (quoting In re J.P. Stevens & Co., Inc., 542 A.2d 770, 780n81 (Del.Ch.1988)).

[7]Litwin v. Allen, 25 N.Y.S.2d 667 (Sup.Ct.1940).

[8]Michael P. Dooley, Fundamentals of Corporation Law 263 (1995).

[9]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).