Put another way, is there what I call the "rational 5 year old" exemption to the business judgment rule? If a rational 5 year old would tell you "that's a really dumb idea" and the board does it anyway, should the board be liable?
My thoughts on that question are prompted by the VW diesel engine scandal, of course. In a lengthy article on the current state of the investigation, the WSJ reports that:
“Our company was dishonest with the EPA, and the California Air Resources Board, and with all of you,” Michael Horn, head of Volkswagen of America, told dealers last month in New York City. “We’ve totally screwed up.”
In using this story as a case study, I am making three simplifying assumptions. First, VW is incorporated in Delaware. Obviously, that's not the case. But I don't know German law on the subject and, candidly, my purpose here is just to use the story as a thought experiment about US law. Second, the VW board knew about and approved the decision to use the emissions testing software. This lets us eliminate the Caremark issues and their complex body of law. Third, there is no element of self-dealing or illegality, which leaves us dealing with the standard duty of care/business judgment rule analysis.
Note that we are discussing here solely liability to shareholders for a breach of the duty of care under corporate law. Criminal and civil liability to the state and/or deceived purchasers is beyond the scope of this discussion.
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. As the late Professor Michael Dooley observed, “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] 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.[4]
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.”[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 theory, 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. But, in practice, the set of such decisions appears to be an empty one to date.[9]
[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, 478-79 n.58 (1992).
[4] In re Caremark Derivative Litig., 698 A.2d 959, 967 (Del. Ch. 1996).
[5] In re RJR Nabisco, Inc. S’holders 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, 780-81 (Del Ch. 1988)).
[7] Litwin v. Allen, 25 N.Y.S.2d 667 (Sup. Ct. 1940). Delaware Justice Henry Horsey, Technicolor’s author, asserts that Litwin articulates a Technicolor-like formulation of the business judgment rule under which, “for the rule of judicial deference to be invoked, directors of a board must be found to have met not only their duty of loyalty but also their duty of care.” Henry Ridgely Horsey, The Duty of Care Component of the Delaware Business Judgment Rule, 19 Del. J. Corp. L. 971, 976 (1994). As described in the text, however, we regard Litwin as being even less defensible than Technicolor.
[8] Michael P. Dooley, Fundamentals of Corporation Law 263 (1995).
[9] See Gagliardi v. Trifoods Int’l, Inc., 683 A.2d 1049, 1051-52 (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).
