The Business Judgment Rule amid the Recent Corporate Scandals

Introduction

Sometime in March 2005, when American International Group (AIG) independent directors met to determine the fate of Chairman Maurice R. "Hank" Greenberg, many had an unusual question: Could they bring their own counsel along? Of course, the directors' personal lawyers were not allowed into the meeting—only counsel retained for the group as a whole.¹  But the AIG directors' wish for individual counsel during a critical decision reflects a new level of anxiety over legal liability in corporate boardrooms: an increased sense among directors that they need to worry about their own performance and liabilities.

Although directors theoretically can be held liable for any mistakes made on their watch, there is a high legal standard for proving individual liability. To successfully defend themselves, directors need only show that their decisions were "business judgment" made in good faith and not recklessly.² Nevertheless, many directors have been scrambling to their lawyers for advice since former Enron and WorldCom directors agreed to pay millions to personally settle shareholder suits.³ Such payments are rare because company charters often include provisions that make the corporation responsible for judgments against directors, and directors are further protected by insurance.⁴ Nevertheless, the WorldCom and Enron settlements were a wake-up call in boardrooms across the country that the days of the rubber-stamping, old-boy-network board of directors were gone. Today’s boards are feeling the heat and, unlike in the past, they have begun to respond.⁵ Heads have been rolling: Franklin Raines from Fannie Mae, Carly Fiorina from Hewlett-Packard, Harry Stonecipher from Boeing, Michael Eisner from Disney, Hank Greenberg from AIG, Christopher Milliken from OfficeMax, and Scott Livengood from Krispy Kreme—all cut down by boards that had recently been subjected to a great deal of pressure, in AIG’s case from New York Attorney General Eliot Spitzer and in Disney’s case from institutional shareholders. As the Wall Street Journal put it: "There seems to be a sea change going on here—a kind of maturation of American corporate governance. The king now has a parliament, which in turn answers to powerful constituents."⁶ During the '90s bull market, buoyed by lax "race-to-the-bottom"⁷ case law and statutory amendments after the Van Gorkom decision,⁸ fear was forgotten. But now it’s back. Directors are afraid of losing their money, and in the corporate world that is simply not supposed to happen.⁹

The Business Judgment Rule¹⁰

Historically, the business judgment rule, as interpreted by state and federal courts, presumed that directors of corporations making decisions on behalf of shareholders were correct if they acted (1) in good faith, (2) on an informed basis, (3) in a disinterested manner, (4) with due care, and (5) without discretion or waste.¹¹ If these criteria were met, directors' fiduciary obligations were satisfied. To overcome this presumption, challengers were forced to show that a director had acted in a grossly negligent manner or had had a conflict of interest, but directors could overcome the latter charge by showing that they had informed the board of their interest and that their actions had served the best interests of the shareholders. This unwillingness of courts to intervene and overturn the decisions of private boards of directors can be traced in English common law as far back as 1742.¹²

In the United States, the business judgment rule as a principle of corporate law was first established in 1829 by the Louisiana Supreme Court.¹³ In 1853, the Rhode Island Supreme Court stated the rule succinctly: "We think a board of [d]irectors acting in good faith and with reasonable care and diligence, who nevertheless falls into a mistake, either as to law or fact, [is] not liable for the consequences of such mistake."¹⁴ It appears that the major rationales underscoring the validity of the business judgment rule are (1) that people make mistakes, and that they should be encouraged to assume directorships without fear of failure; (2) that the directors need wide discretion in setting policy and making decisions; (3) that courts should be kept out of boardrooms where they have little expertise; and (4) that all parties concerned should be assured that directors, not shareholders, will set policy and be accountable to all present and future investors.¹⁵

The corporate law doctrine of the business judgment rule is curiously protean in judicial interpretation. During "good" times, courts typically adopt a robust vision of the business judgment rule and pay maximum respect to the principle of board authority. During periods of market decline, however, and with the emergence of highly publicized corporate scandals and their resultant extralegal pressures, judicial review of board decision making increases.¹⁶ However, once the crisis defuses and the pressure recedes, courts return to their position of board deference. In a nutshell: board accountability increases during periods of scandal and crisis and decreases when the crisis blows over.¹⁷

The Watershed Year

The corporate law jurisprudence that emerged in Delaware in the mid-1980s was, like the recent post-Enron decisions, a result of crisis and controversy. With hostile takeover activity exploding, takeover battles were drawing wide public attention. The financiers who engineered the acquisitions were vilified for getting wildly rich while the deals they made resulted in plant closures, asset sales, and layoffs.¹⁸ On one side were the public and corporate managers who were largely opposed to the takeovers; on the other side were the academics and share- holder-rights activists who argued that takeover defenses obstruct the efficient transfer of resources and hinder the ability of shareholders to sell their interests at a premium. In response, the Delaware courts handed down a monumental set of fiduciary-duty decisions by modifying or inventing doctrines which tipped the balance in favor of greater board accountability. In a single year, the Delaware Supreme Court (1) reset the standard of gross negligence in Smith v. Van Gorkom¹⁹ in an unprecedented manner, (2) restricted the ability of an incumbent board of directors to resist an unwanted takeover offer in Unocal Corp v. Mesa Petroleum Co,²⁰ and (3) set limits on when a target board could favor one buyer over another in Revlon Inc v. MacAndrews, Inc & Forbes Holdings, Inc.²¹ Each of these decisions was a reaction by Delaware courts to a climate of controversy and crisis.

The Waters Recede: Resumption of the "Race to the Bottom"

This narrowing of the business-judgment rule doctrine did not last long. The ultimate impact of each of the "watershed decisions" has either been eliminated or substantially reduced: Van Gorkom was reversed by the Delaware Legislature, Unocal was slowly eroded by lax application, and Revlon was expressly narrowed. Once again, the "race to the bottom" continued.²²

Perhaps the most important decision pertaining to the business judgment rule’s expansion and subsequent contraction is Smith v. Van Gorkom.²³ The chancery court imposed individual liability on Trans Union’s directors for gross negligence in approving the acquisition of their company, which board members did after a twenty-minute oral presentation by Jerome Van Gorkom, Trans Union’s CEO. Van Gorkom presented his understanding of the offer, which he had singly negotiated, and after two hours of discussion the board accepted the offer price of $55 per share. The directors were held personally liable for the fair value of Trans Union stock exceeding $55 per share because they were "grossly negligent" in failing to inform themselves of the market value of the stock in a competitive-buyout environment. The court noted that none of the board members was an investment banker or financial analyst, that no valuation report existed, and that it was clear that the directors had merely "rubber stamped" the fair price set by the CEO. The Delaware Supreme Court reviewed the case to determine the fair value of Trans Union shares at the time of the board’s decision and for an amount of damages to the extent that fair value exceeded $55 per share.²⁴ Before the court determination, a settlement was reached for $23.5 million.²⁵

Despite the hue and cry that followed the Van Gorkom decision, Delaware Supreme Court Justice Andrew G. T. Moore, who voted in the majority, stated that the case "[did not] stand for new law. The Court was just applying old law to egregious facts."²⁶ It was apparent that the Delaware Supreme Court’s objection to the board action was because of the board’s failure to follow a process that would have made it informed about significant matters involving the corporation and its shareholders.

Following the Van Gorkom decision, and reacting to a director’s liability insurance crisis,²⁷ the Delaware Legislature enacted a statute that sought to immunize directors from damages for breaches of a duty of care.²⁸ The amended statute permits a corporation to eliminate or limit personal liability of directors and shareholders for money damages for violations of the traditional business judgment rule’s obligation of a duty of care in certain circumstances. However, Section 102(b)(7) does not eliminate or limit the liability of a director for (1) breach of the duty of loyalty, (2) acts or omissions that are not in good faith or that involve intentional misconduct, and (3) any transaction for which the director derived an improper personal benefit.²⁹ Section 102(b)(7) also does not eliminate the duty of care; it merely permits shareholders to limit or eliminate a director’s liability for monetary damages for violations of such a duty, which still may be enforced through equitable remedies like injunctive relief or rescission.³⁰ The liability is limited only when actions are instituted by shareholders or on behalf of the corporation; directors will still be held monetarily liable for a breach of a duty of care in third-party actions. Further, the amendment covers directors only, not officers, and thus director- officers are covered only when they act as directors. Lastly, Section 102(b)(7) does not allow elimination or limitation of liability arising under other state or federal laws such as federal securities laws and the Racketeer Influenced and Corrupt Organizations Act.³¹

Despite the legislative frenzy to limit or eliminate personal liability for a director’s breach of fiduciary duties, there are few cases where directors have personally paid damages for violations of a duty of care.³² Some academics believe that Section 102(b)(7) was a response to a "manufactured" insurance crisis and to Van Gorkom, even though that case was a mainstream decision based on egregious facts resulting in gross negligence.³³ Interestingly, since Van Gorkom, Delaware courts have repeatedly rejected challenges to boards' decisions where a conflict of interest or gross negligence resulting in a violation of the duties of loyalty and good faith have not been shown.³⁴

The "race to the bottom" theorists claim that this race has been exacerbated by Delaware courts' pro-management rulings on the business judgment rule. The amendment of Delaware statutory law to permit Delaware corporations (and those states that have passed similar law) to limit or eliminate the personal liability of directors for money damages for violations of the traditional business judgment rule’s obligation of the duty of care has also contributed to decreased standards.

Arguably, judicial decisions played, if not an important, then at least a non-trivial role in sowing the seeds of recent corporate scandals. The New York court’s decision in Kamin v. American Express Co,³⁵ which takes an extremely lax approach to interpreting the business judgment rule, is another example of the "race to the bottom" theory.³⁶ In Kamin, the court held that, under the business judgment rule, it was entirely appropriate for the directors of American Express "to cause the company to lose millions of dollars for the sole purpose of improving reported earnings and thereby maintaining the price at which the company’s stock traded."³⁷ With courts giving such carte blanche to directors to engage in transactions lacking real substance and designed simply to improve reported earnings, the recent "cascade of scandals" should not be a surprise.³⁸ Kamin joins other decisions that place beyond challenge nearly any director’s action, no matter how ill-conceived, if it is made without a conflict of interest and if the director thought it was in the corporation’s best interest.³⁹

With the benefit of hindsight, it is eerily interesting to note how the arguments of plaintiffs in Kamin foreshadowed the scandals of 2002. Plaintiffs argued that, coupled with the aggressive accounting approach of American Express, some of the directors had had a conflict of interest in voting for the dividend because these directors were officers and employees of American Express and their compensation depended on the level of reported earnings. Finding no showing that the four insiders had dominated or controlled the sixteen outside directors, the trial court rejected this argument.⁴⁰ In Enron and the other scandals of 2002, the corporations pursued "aggressive accounting" in search of higher reported earnings and higher stock prices which benefited management, much of whose compensation was in the form of stock options.⁴¹ These decisions sent an unfortunate message to future corporate leaders and their attorneys: the doctrine of the business judgment rule would protect management if it pursued more aggressive "earnings management" techniques, even when the actions were designed to pull reported earnings up from low levels without any increase in real earnings.⁴²

Have the Rules Changed?

After the recent spate of corporate scandals, courts have subjected directors' conduct to increased scrutiny. Several recent Delaware decisions call into question the extent of judicial deference to the business judgment of directors. In Brehm v. Eisner, a case involving Disney’s large severance payment to its former president, Michael Ovitz, the Delaware Supreme Court reiterated the traditional formulation of the business judgment rule.⁴³ Later, the Delaware Chancery Court on May 28, 2003, denied a motion to dismiss an amended complaint against Disney directors arising from the same severance payments paid to Ovitz that underlay the Delaware Supreme Court’s broad reading of the business judgment rule in Brehm.⁴⁴ Plaintiffs alleged that the directors did not investigate basic information about the Ovitz contract, including the cost of termination, and allowed Disney’s CEO Michael Eisner to arrange termination payments to his long-time friend Ovitz well beyond what was called for in Ovitz’s employment contract.⁴⁵ Plaintiffs alleged that the Disney directors "failed to exercise any business judgment and failed to make any good faith attempt to fulfill their fiduciary duties to Disney and its stockholders."⁴⁶ They further alleged that the defendant-directors "consciously and intentionally disregarded their responsibilities, adopting a 'we don’t care about the risks' attitude concerning a material corporate decision."⁴⁷ The alleged facts implied that the directors "knew that they were making material decisions without adequate information . . . and they simply did not care if the decisions caused the corporation⁴⁸ and its stockholders to suffer injury or loss."⁴⁹ The chancellor held that the complaint was sufficient to withstand a motion to dismiss: "Where a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director’s actions are either 'not in good faith' or 'involve intentional misconduct,'" and the allegations accordingly supported claims that fell outside the liability waiver provision in Disney’s certificate of incorporation.

Months before the Disney I decision, the Seventh Circuit in March 2003, applying Illinois law (which closely tracks Delaware law in this area), held that plaintiffs' complaint stated a claim by alleging that the directors of Abbott Laboratories had known of significant problems but decided that no action was required and that the allegations, if proved, showed a "systematic failure of the board to exercise oversight."⁵⁰ The court held that the directors' decision not to act was not made in good faith and that plaintiffs' claims were not precluded by a charter provision under the Illinois law analogous to Delaware’s Section 102(b)(7). The board’s failure to act was not a business decision and, accordingly, was not protected under the business judgment rule.⁵¹

Apparently, it has become harder for defendant-directors to dispose of litigation by preliminary motion without discovery. In the last two years, the Delaware Supreme Court has reversed several chancery court decisions in favor of defendant-directors, thereby heightening its review of director conduct and reflecting a different judicial attitude toward directors' decisions and liability.⁵² Courts, perhaps acutely aware of the corporate scandals and excesses of recent years, are more willing than before to find charter protections against director liability inapplicable because of the exception for actions not in good faith or involving intentional misconduct.⁵³

The "Good Faith" Conundrum

Delaware cases refer to a "triad" of fiduciary duties: duty of care, duty of loyalty, and duty to act in good faith.⁵⁴ The Delaware Supreme Court, by acknowledging in its opinions the duty to act in good faith, and in ranking this side by side with the traditional fiduciary duties of care and loyalty, implies that good faith is to be given a role in any fiduciary duty analysis equal to the other two duties.⁵⁵ However, without a general meaning of its own, good faith is an amorphous principle whose meaning "varies somewhat with the context."⁵⁶ Though it is difficult to give good faith any meaning or substance without restating either the duty of care or the duty of loyalty, an emerging line of cases rejects a vision of good faith as "mere shorthand for the duties of care and loyalty and establishes it, instead, as an independent basis for decision."⁵⁷ These cases suggest that good faith is not merely a new spin on old dicta but a ratio decidendi.⁵⁸ This, in turn, allows courts to review corporate governance decisions outside the confines of care and loyalty.

To gauge the importance of the duty to act in good faith as an independent basis for a court’s decision making, consider a complaint against a board of directors in which the facts do not rise to the occasion of a clear breach of loyalty. In order to overcome the business judgment presumption, plaintiffs
would have to argue a breach of the duty of care, the duty of loyalty, or the duty to act in good faith. Without an argument under the duty of loyalty, the plaintiff would be left with only a duty of care claim. If the defendant corporation has adopted Section 102(b)(7) or a similar provision entitling the board to dismissal of claims arising exclusively under the duty of care, the plaintiff’s case for monetary damages would be doomed—unless the complaint alleges a breach of the duty to act in good faith.⁵⁹ In such a scenario, good faith may prove to be the silver bullet. The plaintiff first would recite facts drawing both the duty of care and the duty of loyalty into question. However, rather than pursuing either of the two traditional fiduciary duties through to its logical conclusion, the plaintiff would alternate between the two and, in so doing, blend the issues raising doubts concerning the good faith of the defendant-directors.⁶⁰

It is no accident that the issue of good faith reemerged during a period of scandal and crisis in American corporate governance. After the likes of Enron, WorldCom, Tyco, etc., the Delaware judiciary faced a heightened threat of federal preemption and responded by modifying or creatively interpreting corporate doctrines.⁶¹ However, judging from the past, this shift toward accountability brought by good-faith interpretations will not be permanent.

The Disney II Decision

Two years after denying summary disposition in favor of the defendant-directors,⁶² the Delaware Chancery Court concluded that defendant-directors did not breach their fiduciary duties or commit waste.⁶³ The court made pertinent rulings regarding the business judgment rule and held that the rule’s protections will not apply if the directors have made an "unintelligent or unadvised judgment."⁶⁴ The court further held that in instances where directors have failed to exercise business judgment, that is, in the event of director inaction, the protections of the business judgment rule do not apply. The court made a distinction between directorial inaction and a director’s conscious decision not to act.⁶⁶ An informed and conscious decision to refrain from acting may be a valid exercise of business judgment and will, accordingly, enjoy the protections of the rule. However, the rule has no role to play where directors have either abdicated their functions or failed to act—clearly, dereliction of duty is not protected. In these circumstances, the appropriate standard for determining liability is widely believed to be "gross negligence."⁶⁷

The Disney II decision also seeks to unravel the mysterious role that good faith plays; however, it does not quite succeed in doing so. To begin with, Delaware decisions are not clear about whether there is a separate fiduciary duty of good faith. Good faith has been said to require an "honesty of purpose" and a genuine care for the fiduciary’s constituents.⁶⁸ Since the law presumes that directors act in good faith when making business judgments, it is probably easier to define bad faith than good faith. Bad faith has been defined as authorizing a transaction for some purpose other than a genuine attempt to advance corporate welfare or when the transaction is known to constitute a violation of applicable positive law.⁶⁹ The Disney II decision states that bad faith also can be a systematic or sustained shirking of duty:

Bad faith can be the result of 'any emotion [that] may cause a director to [intentionally] place his own interests, preferences or appetites before the welfare of the corporation, 'including greed, 'hatred, lust, envy, revenge, . . . shame or pride.' Sloth could certainly be an appropriate addition to that incomplete list if it constitutes a systematic or sustained shirking of duty.⁷⁰

Accordingly, though mere ignorance, in and of itself, probably will not constitute bad faith, a systematic or sustained shirking of duty will. Directorial inaction will not be given the protection of the business judgment rule unless it is a reasoned and conscious decision not to act. However, even though plaintiffs may be able to demonstrate that directorial inaction is a breach of the duty of care and should not be afforded the protection of the business judgment rule, to get monetary damages they will need to get past the protection afforded by Section 102(b)(7). A single and isolated failure to act, though not covered under the business judgment rule, may not be enough to constitute bad faith. As the Disney II decision puts it, only a systematic or sustained shirking of duty will constitute bad faith.

Interestingly, Chancellor Chandler further held:

[T]he concept of intentional dereliction of duty, a conscious disregard for one’s responsibilities, is an appropriate (although not the only) standard for determining whether fiduciaries have acted in good faith. Deliberate indifference and inaction in the face of a duty to act is … conduct that is clearly disloyal to the corporation. It is the epitome of faithless conduct. To act in good faith, a director must act at all times with an honesty of purpose and in the best interest and welfare of the corporation.⁷¹

Here the court does not require systematic or sustained inaction, merely holding that "inaction in the face of a duty to act …. [would be held] disloyal to the corporation."⁷² So, what would constitute bad faith (or not be considered an action in good faith): a systematic or sustained shirking of duty or a few moments of inaction in the face of a duty to act? Would the magnitude or repercussion of that inaction be a deciding factor? How many inactions or failures to act would constitute a systematic or sustained shirking of duty? Apparently, the Delaware Chancery Court leaves many gray areas which invite further litigation.

Disney II leaves us with an impression that to create a definitive and categorical definition of the universe of acts that would constitute bad faith would be difficult if not impossible. The good faith required of a corporate fiduciary includes not simply the duties of care and loyalty but all the actions required by a true, faithful steward of the interests of the corporation and its shareholders. The three most salient examples of bad faith are (1) where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, (2) where the fiduciary acts with the intent to violate applicable positive law, or (3) where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. There may be other examples of bad faith yet to be proved or alleged.

Conclusion

To sum up, the pendulum on the business judgment rule has once again swung toward directors' accountability. Courts are more willing, at least in principle, to find charter protections against director liability inapplicable because of the exception for actions not in good faith or involving intentional misconduct. This emphasizes the need for corporate attorneys to counsel directors on how to demonstrate good faith and informed decision making. The better the process,⁷³ the less likely the courts will be to second-guess director action.

The prescriptions are not new, but they must be taken, recorded, and reflected in making a business decision.⁷⁴ They include the following:

Focusing on and deciding important matters. Courts will defer to directors' business judgment only if the directors have looked at the question and used their business judgment in deciding it. It does not help (see Disney I and Abbott) if directors close their eyes to, rather than trying to wrestle with, a major issue they know about. 

Seeking information. In order to make an informed decision in good faith, the directors should probe to obtain the requisite information and assure themselves that the officers have done their homework to ground their recommendation. The board should actively do this and create a clear evidentiary trail of that effort.

Acting on an informed basis. As the Delaware courts put it, a director must act after considering the material facts that are reasonably available.⁷⁵ Care should be taken so that pertinent reports are disseminated to the board well before a decision is made. It did not help in the Disney case that the compensation committee had not bothered to read the draft employment contract or the termination agreement.

Relying on experts when appropriate. Corporation statutes protect directors who, in discharging their duties, rely in good faith on information presented to the company by a professional about matters the directors reasonably believe are within that person’s professional competence. Directors should have the intricate or technical matters explained to them by a knowledgeable expert, and the minutes or other record should indicate this.

Identifying and minimizing conflicts of interest. The directors should not have material interests that conflict with those of the company. Conflicts must be identified fully and addressed by directors who are fully independent. As the Oracle Corp Derivative Litigation case⁷⁶ makes clear, appearances count.

Acting in the best interest of the corporation. The directors' basic duty is to maximize the shareholders' return and advance the best interests of the corporation. The board must make a real effort to do this and should keep a record of those efforts.

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