Maybe my May talk to the Delaware bar ought to be about why the business judgment rule is not a standard of review. This seemingly perennial problem came up yet again in Vice Chancellor Laster's decision in Reis v. Hazellt Strip Castng Corp. It is an interesting case. Edward McNally explains that:
When a reverse stock split eliminates minority stockholders, they are entitled to be paid the "fair value" of their stock. This decision explains what that means. In particular, it does not mean they get the same value as if their stock were subject to an appraisal. While the valuation process is very similar, it is affected by the standard of review involved, particularly if the squeeze out was done unfairly and the intrinsic fairness standard applies.
The opinion is also an excellent review of the overall Delaware law on the standard of review for any transaction.
Well, no. It is the opinion's description of standards of review that draws my ire. Laster opines that:
Delaware has three tiers of review for evaluating director decision-making: the business judgment rule, enhanced scrutiny, and entire fairness. The business judgment rule is the default standard of review. It presumes that “in making a business decision the directors 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.” Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). “[W]here the business judgment [rule] presumptions are applicable, the board’s decision will be upheld unless it cannot be attributed to any rational purpose.” In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 74 (Del. 2006) (internal quotation marks omitted).
I'm not at all sure Delaware law limits itself to three standards of review. But that's a question for another day. I am confident, however, that the business judgment rule--properly understood--is not a standard of review. It is an abstention doctrine. See my article The Business Judgment Rule as Abstention Doctrine, in which I explain that:
Only the latter, however, makes conceptual or theoretical sense.
The business judgment rule is an inevitable corollary of the director primacy model’s explanation for the separation of ownership and control. To review as briefly as possible, for the benefit of those who came in late, my director primacy theory argues that, due to the limits on cognitive competence implied by bounded rationality, and the uncertainty and complexity inherent in long-term business relationships, incomplete contracts are inevitable, which in turn leaves greater room for opportunistic behavior, and thus inexorably leads to the need for coordination. According to the Coasean theory of the firm, firms arise when it is possible to reduce transactions costs by delegating to a central agency the power to direct how the various inputs will be utilized by the firm; in effect, allowing the central agency to constantly and, more important, unilaterally rewrite certain terms of the contract between the firm and its various constituents. Centralized decision making thus emerges as the defining characteristic of the Coasean firm. The board of directors and its subordinate top management team serve as the central decision-making agency for corporations.
Contrary to what some have argued, this separation of ownership and control is a highly efficient solution to the decision-making problems faced by large corporations. Recall that authority-based decision-making structures arise where team members have different interests and amounts of information. Because collective decision making is impracticable in such settings, authority-based structures are characterized by the existence of a central agency to which all relevant information is transmitted and which is empowered to make decisions binding on the whole. The modern public corporation is a classic example of an authority-based decision-making structure. Neither shareholders nor any other constituency have the information or the incentives necessary to make sound decisions on either operational or policy questions. Overcoming the collective action problems that prevent meaningful shareholder involvement would be difficult and costly. Rather, shareholders will prefer to irrevocably delegate decision-making authority to some smaller group. Separating ownership and control by vesting decision-making authority in a centralized entity distinct from the shareholders is what makes the large public corporation feasible.
To be sure, this separation results in agency costs. A narrow focus on agency costs, however, can lead one astray. Corporate managers operate within a pervasive web of accountability mechanisms that substitute for monitoring by residual claimants. Important constraints are provided by a variety of market forces. The capital and product markets, the internal and external employment markets, and the market for corporate control all constrain shirking by firm agents. In addition, the legal system has evolved various adaptive responses to the ineffectiveness of shareholder monitoring, establishing alternative accountability structures to punish and deter wrongdoing by firm agents, such as the board of directors.
An even more important consideration, however, is that agency costs are the inevitable consequence of vesting discretion in someone other than the residual claimant. We could substantially reduce, if not eliminate, agency costs by eliminating discretion; that we do not do so suggests that discretion has substantial virtues. A complete theory of the firm thus requires one to balance the virtues of discretion against the need to require that discretion be used responsibly. Neither discretion nor accountability can be ignored, because both promote values essential to the survival of business organizations. Unfortunately, they are ultimately antithetical: one cannot have more of one without also having less of the other. As Kenneth Arrow has observed, the power to hold to account is ultimately the power to decide. The board thus cannot be made more accountable without shifting some of its decision-making authority to shareholders or judges. To be clear, this is not an argument for unfettered board authority. In some cases, accountability concerns become so pronounced as to trump the general need for deference to the board’s authority. Establishing the proper mix of deference and accountability thus emerges as the central problem in applying the business judgment rule to particular situations.
Given the significant virtues of discretion, however, one must not lightly interfere with management or the board’s decision-making authority in the name of accountability. Preservation of managerial discretion should always be the null hypothesis. The separation of ownership and control mandated by U.S. corporate law has precisely that effect. Likewise, the business judgment rule exists because judicial review threatens the board’s authority.
In a passage from Van Gorkom that has received less attention than it deserves, the Delaware supreme court struck out a position that is entirely consistent with the foregoing analysis:
Under Delaware law, the business judgment rule is the offspring of the fundamental principle, codified in [DGCL] § 141(a), 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 null hypothesis is deference to the board’s authority as the corporation’s central and final decision maker.
Critics of my approach might concede that judicial review shifts some power to decide to judges but nevertheless contend that that observation is normatively insufficient. To be sure, they might posit, centralized decision making is an essential feature of the corporation. Judicial review could serve as a redundant control on board decision making, however, without displacing the board as the primary decision maker. 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? Just as tort liability for negligence encourages people to be careful, judicial review of board decisions would likewise help reduce the residual loss left by market failures by encouraging directors to be careful. If we further assume that corporate law is generally efficient, the losses tolerated by judicial abstention must be outweighed by benefits elsewhere in the system. The article speculates at length as to the likely source of those benefits. Suffice it here to say that they are substantial.
To be clear, my argument is not for judicial abnegation but only for judicial abstention. The distinction is a significant one. Abstention contemplates judicial reticence, but leaves open the possibility of intervention in appropriate circumstances. Yet again, economist Kenneth Arrow is instructive:
[Accountability mechanisms] must be capable of correcting errors but should not be such as to destroy the genuine values of authority. Clearly, a sufficiently strict and continuous organ of [accountability] can easily amount to a denial of authority. If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem.
To maintain the value of authority, it would appear that [accountability] must be intermittent. This could be periodic; it could take the form of what is termed “management by exception,” in which authority and its decisions are reviewed only when performance is sufficiently degraded from expectations . . . .
The problem then is to identify the circumstances in which intervention is necessary. Put another way, the task is to define the conditions under which accountability concerns ought to trump preservation of the board’s authority.
If the business judgment rule is treated as a substantive standard of review, judicial intervention all too easily could become the norm rather than the exception. How one frames the question matters a lot. In polling, for example, both the order in which questions are asked and the way in which they are phrased can affect the outcome. The same is true of legal standards. This is why Technicolor discussed below is so troubling. Under the decision’s cart before the horse formulation, 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 a substantive standard, trying to measure the “quantity” of negligence is a task best left untried. Courts will find it difficult to resist the temptation to tweak the standard so as to sanction honest decisions that, with the benefit of hindsight, proved unfortunate and/or appear inept. All of the adverse effects of judicial review outlined in the preceding sections are implicated, however, whether or not the board exercised reasonable care. Unfortunately, Technicolor and its ilk threaten to nullify this essential aspect of the business judgment rule.
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. Starting from an abstention perspective, the court will begin with a presumption against review. It will then review the facts to determine not the quality of the decision, but rather whether the decision-making process was tainted by self-dealing and the like. The requisite questions to be asked are 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.
Unfortunately, Delaware law is often unclear as to which version it follows. In the execrable Technicolor decision, the court describing the business judgment rule as being intended “to preclude a court from imposing itself unreasonably on the business and affairs of a corporation.” Compare that formulation to Van Gorkom’s statement that the rule’s purpose is to “protect and promote the full and free exercise of the managerial power granted to Delaware directors.” The striking contrast between these formulations strongly implies that the board’s decision will no longer get much in the way of deference. Instead of preserving the board’s decisionmaking authority, the Technicolor version of the business judgment rule apparently allows courts to second-guess board decisions if it is “reasonable” to do so.
Yet, it gets worse. To be sure, Justice Horsey described the business judgment rule as “a powerful presumption” against judicial interference with board decisionmaking. But he then proceeded to gut the rule:
Thus, a shareholder plaintiff challenging a board decision has the burden at the outset to rebut the rule’s presumption. 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. If a shareholder plaintiff fails to meet this evidentiary burden, the business judgment rule attaches to protect corporate officers and directors and the decisions they make, and our courts will not second-guess these business judgments. If the rule is rebutted, the burden shifts to the defendant directors, the proponents of the challenged transaction, to prove to the trier of fact the “entire fairness” of the transaction to the shareholder plaintiff.
Notice how the justice puts the cart before the horse. 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.” But this is exactly backwards. Under the abstention theory of the business judgment rule, the rule’s core purpose is to prevent precisely what Technicolor requires. The business judgment rule thus precludes courts from asking the question of—let alone deciding—whether the directors violated their duty of care.
OTOH, Delaware courts sometimes do get it right. Former Chief Justice Norman Veasey undestood the BJR perfectly well and got it right.
In Brehm v. Eisner, for example, he failed even to cite Technicolor. More significantly, Chief Justice Veasey’s opinion for the court explicitly rejected, as “foreign to the business judgment rule,” plaintiffs’ argument that the rule could be rebutted by a showing that the directors failed to exercise “substantive due care”:
Courts do not measure, weigh or quantify directors’ judgments. We do not even decide if they are reasonable in this context. Due care in the decisionmaking context is process due care only. . . .
. . . Thus, 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.
None of the predicates to the rule’s application stated by Brehm contemplate substantive review of the merits of the decision. Even the chief justice’s reference to a rational business purpose requires only the possibility that the decision was actuated by a legitimate business reason, not that directors must prove the existence of such a reason. Absent self-dealing or other conflicted interests, or truly egregious process failures, the court will abstain.
If I could get Delaware courts to stick to Brehm, I'd be very happy.
