My earlier post on the corporate law aspects of the VW diesel engine scandal assumed away the issue of corporate criminality. Prompted by a complaint from my friend and coauthor Bill Klein. however, I'm revisiting the question and this time assuming that what VW did was illegal.
I am still making two of the original simplifying assumptions, however. 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.
Note that we are discussing here solely liability to shareholders for a breach the board's fiduciary duties under corporate law. Criminal and civil liability to the state and/or deceived purchasers is beyond the scope of this discussion.
The initial question is what duty is implicated by corporate criminality. Under current Delaware law, it appears that the relevant law is the duty of good faith (which is technically not a separate duty but rather is subsumed by the duty of loyalty). In Walt Disney Co. Deriv. Litig.,[1] the Delaware supreme court defined good faith as encompassing “all actions required by a true faithfulness and devotion to the interests of the corporation and its shareholders. A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating conscious disregard for his duties.”
In Stone v. Ritter,[2] the court explained that “the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty.” Instead, the obligation to act in good faith is subsumed wholly within the duty of loyalty:
[T]he fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it . . ., “[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.”
I have been highly critical of this line of cases, of course.[3] Assuming Delaware continues with this line of cases, however, intentional board approval of criminality would be bad faith, which automatically results in liability.
Of course, in the usual case, the board is not charged with having intentionally approved criminality but rather with failing to detect criminality by corporate employees. But this would take us off topic and shift us into the Caremark line of cases and its complex body of law. I discuss those cases in The Convergence of Good Faith and Oversight.[4]
I think the automatic liability under the duty of loyalty is bad policy. I also think it’s doctrinally incorrect. Instead, the issue of corporate criminality should be analyzed under the duty of care (and, as a result, the corollary business judgment rule).
In a leading Third Circuit case arising under New York law, for example, the court treated the problem as involving an alleged “a breach of the defendant directors' duty to exercise diligence in handling the affairs of the corporation.”[5] The ALI Principles likewise treat the issue as one involving “a duty of care action.”[6]
The business judgment rule will not insulate from judicial review decisions tainted by fraud or illegality.[7] The key issue in this context is whether the board has a duty to act lawfully. In the oft-cited Miller v. American Telephone & Telegraph Co. decision,[8] the Third Circuit held that directors have such a duty. AT & T failed to collect a debt owed it by the Democratic National Committee for telecommunications services provided during the 1968 Democrat Party’s convention. Several AT & T shareholders brought a derivative suit against AT & T’s directors, alleging that the failure to collect the debt violated both federal telecommunications and campaign finance laws. Ordinarily, a board decision not to collect a debt would be protected by the business judgment rule. Citing a 1909 New York precedent,[9] however, the Third Circuit held that the business judgment rule did not insulate defendant directors from liability for illegal acts “even though committed to benefit the corporation.”[10]
Assuming a duty to act lawfully exists, operationalizing it is a nontrivial task. Should there be a de minimis exception?[11] If a package delivery firm told its drivers to illegally double-park, so as to speed up the delivery process, for example, it is hardly clear that liability should follow. Should the business judgment rule be set aside only where the board ordered violations of criminal statutes or should it also be set aside where the board authorized violation of some civil regulation? The criminal law long has distinguished between crimes that are malum in se and those that are merely malum prohibitum. The latter are acts that are criminal merely because they are prohibited by statute, not because they violate natural law. It is said that “misdemeanors such as jaywalking and running a stoplight are mala prohibita, as are most securities-law violations.”[12] Individuals routinely make cost-benefit analyses before deciding to comply with some malum prohibitum law, such as when deciding to violate the speed limit. Is it self-evident that directors of a corporation should be barred from engaging in similar cost-benefit analyses?[13]
And, yet, still more questions must be answered if a duty to act lawfully is to be imposed. If neither the corporation nor the board was convicted or even indicted, for example, should plaintiff have to make out the elements of the criminal charge?[14] If so, to what extent does the criminal law concept of reasonable doubt come into play? Is a knowing violation of criminal law a per se violation of the duty of care unprotected by the business judgment rule?[15] How are damages to be measured and is causation an issue?[16] And so on.
The point is not that corporations should be allowed to break the law. They should not. If a corporation breaks the law, criminal sanctions should follow for the entity and/or the responsible individuals. The point is only that fiduciary obligation and the duty to act lawfully make a bad fit. If the question is one of reconciling authority and accountability, it is not self-evident that corporate law should hold directors accountable simply for deciding that the corporation’s interests are served by violating a particular statute. After all, “[a] business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end.”[17]
Put another way, the point of the business judgment rule is that shareholders should not be allowed to recover monetary damages simply because the directors made the wrong decision. Allowing shareholders to sue over a decision made with the intent of maximizing corporate profits is nothing less than double dipping, even if the decision proves misguided. This claim is further supported by the realities of shareholder litigation. Shareholder lawsuits alleging that directors violated the purported duty to act lawfully will be brought as derivative actions. The real party in interest in derivative litigation is the plaintiff’s attorney, not the nominal shareholder-plaintiff. In most cases, the bulk of any monetary benefits go to the plaintiffs’ lawyers rather than the corporation or its shareholders. In practice, such litigation is more likely to be a mere wealth transfer from corporations and their managers to the plaintiff bar than a significant deterrent to corporate criminality. Accordingly, the illegality of a board decision—standing alone—should not result in automatic director liability. Indeed, one could make the case that illegality should not constitute a basis—again, standing alone—for rebutting the business judgment rule. At the very least, however, courts should carefully consider whether the decision to cause an illegal act was in fact so grossly negligent as to violate the director’s duty of care.
Update: Stefan Padfield suggested a solution via email:
Couldn't you argue the bouncing ball should work as follows?
1. VW SHs allege damages resulting from breach of duty in connection with emissions scandal.
2. Board claims protection of BJR.
3. Plaintiffs overcome presumption of "in good faith" etc. by pointing to illegality of conduct.
4. Board loses ability to dismiss on basis of 102(b)(7) due to bad faith = loyalty violation
5. However, board retains ability to prove "entire fairness" of conduct.
I think this might allow you to get some of the things you're arguing for under the current doctrine, especially if one could argue that "fair" in this context means the expected value calculation at the time of the decision equated to a gain for shareholders (expected gain > (cost of detection x probability of detection)). Of course, I doubt this would ever win the day for policy reasons, but it could at least force discussion/clarification of some of the issues you raise -- especially when one focuses on the fact that we are not talking about the board "getting away with it," but rather whether a successful derivative claim is appropriate on top of everything else.
It's certainly true that "Under Delaware law, when a plaintiff demonstrates the directors made a challenged decision in bad faith, the plaintiff rebuts the business judgment rule presumption, and the burden shifts to the directors to prove that the decision was entirely fair to the corporation and its stockholders." eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1, 40 (Del. Ch. 2010).
I'm not sure that entire fairness does the necessary work, however. Is entire fairness satisfied by evidence that the board made a decision on the basis of a reasonable cost benefit analysis? So it may not work as a doctrinal matter, even before you get into the policy issues Prof. Padfield correctly suggests would probably scare off the Delaware courts.
[2] 911 A.2d 362 (Del.2006).
[3] The Convergence of Good Faith and Oversight, available at SSRN: http://ssrn.com/abstract=1006097.
[4] Available at SSRN: http://ssrn.com/abstract=1006097
[5] Miller v. Am. Tel. & Tel. Co., 507 F.2d 759, 761 (3d Cir. 1974).
[6] ALI, Principles of Corp. Governance § 4.01 (1994).
[8] 507 F.2d 759, 762 (3d Cir.1974) (diversity case arising under New York corporation law).
[10] Miller v. AT & T Co., 507 F.2d 759, 762 (3d Cir.1974). See also Abrams v. Allen, 74 N.E.2d 305 (N.Y.1947) (directors can be sued where they used corporate property to commit “an unlawful or immoral act”); Di Tomasso v. Loverro, 12 N.E.2d 570 (N.Y.App.1937) (directors liable for entering into a contract that was an illegal restraint of trade).
[11] Cf. ALI Principles § 2.01 cmt. g (acknowledging that the “de minimis principle” applies to corporate law compliance “as elsewhere in the law”).
[12] Black’s Law Dictionary 401 (pocket ed. 1996) (emphasis supplied).
[13] But cf. ALI Principles § 2.01 cmt. g (“With few exceptions, dollar liability is not a ‘price’ that can properly be paid for the privilege of engaging in legally wrongful conduct.”).
[14] Miller answered that question in the affirmative. Miller v. American Telephone & Telegraph Co., 507 F.2d 759, 763–64 (3d Cir.1974). Accord ALI Principles § 4.01(a) cmt. d.
[15] That question is answered in the negative by ALI Principles § 4.01(a) cmt. d.
[16] Under the so-called net loss rule, directors cannot be held monetarily liable if the overall gains to the corporation from the violation exceed the losses directly attributable thereto, such as fines or legal expenses. See James D. Cox, Compensation, Deterrence, and the Market as Boundaries for Derivative Suit Procedures, 52 Geo. Wash. L. Rev. 745, 765 (1984).
