Galactic stupidity and the business judgment rule.

• Author: Rosenberg, David

1. INTRODUCTION II. IS SUBSTANTIVE DUE CARE "FOREIGN" TO THE BUSINESS JUDGMENT RULE? III. THE "REINVIGORATION" OF SUBSTANTIVE DUE CARE IV. SUBSTANTIVE DUE CARE AND THE REASONABLE DIRECTOR V. THE APPLICATION OF SUBSTANTIVE DUE CARE ANALYSIS VI. DISNEY V IGNORED THE SUBSTANTIVE DUE PROCESS ISSUE VII. APPLYING THE "GALACTIC STUPIDITY" STANDARD VIII. CONCLUSION The only real difference I detect in various formulations of the [business judgment] rule involves the question whether if good faith and due care are established, there nevertheless remains room for a judicial judgment concerning the wisdom of the decision. (1)

1. INTRODUCTION

   It is a truth almost universally acknowledged that American courts will not review the substance of the business decisions of corporate directors except under extraordinary circumstances. Embodied in the much-debated (2) "business judgment rule," the deference displayed towards the decisions of corporate directors arises not from a belief that directors are always right, or even always honorable, but from a belief that "investors' wealth would be lower if managers' decisions were routinely subjected to strict judicial review." (3) Corporate directors take the kind of risks that investors want them to take because the directors know that, whatever the outcome, stockholders will not have any legal recourse for losses arising from those actions unless the decision makers violated a duty such as loyalty or good faith. The belief in this general principle of the business judgment rule is so widespread that, despite the recent scandals and negative publicity surrounding the conduct of corporate directors, few participants in the debate are calling for significant changes to the rule's deference to actions taken by corporate decision makers. (4)

   There is plainly broad agreement that shareholders make more money when directors know they can make decisions--especially risky decisions--without the fear that they (5) or the company will be the subject of successful legal actions should those decisions not ultimately benefit the company or the shareholders themselves. This does not mean that the legislative, judicial, legal, financial, academic, and investor communities do not view with disdain directors who make bad decisions, foolish decisions, or excessively risky decisions. It simply means that these communities do not wish to impose legal liability on directors, or the corporations they oversee, for the negative consequences of such decisions. (6) A board of directors that pig-headedly leads a corporation in the wrong direction is worthy of our contempt and deserves to be voted out or abandoned by investors. But our corporate law does not allow the aggrieved to seek legal action against a corporation just because its directors made a bad decision. As such, the business judgment rule does not seem to have a moral or ethical dimension. Rather, it is one of our most utilitarian rules. Wealth is maximized when corporations are run by directors who know that their decisions will be reviewed by investors, by analysts, by stockholders, and by business partners--but not by the courts. (7)

   Practically speaking, the business judgment rule is "simply a policy of judicial non-review." (8) It is--except when it allows review. The problem is, as a noted scholar has put it, "to identify the circumstances in which review is necessary." (9) While many academics and judges repeatedly assert that the business judgment rule does not allow for review of the substance of director decision making, Delaware courts nonetheless display an apparent willingness to do just that when the directors' actions approach the borderline of good faith. (10) Indeed, in eases in which the plaintiffs allege bad faith but the facts do not present evidence of disloyalty or a knowing breach of duty, courts review the substance of the directors' decision in order to determine whether or not the directors have complied with all of their fiduciary obligations and therefore, whether the plaintiffs have successfully rebutted the presumptions of the business judgment rule.

   Although few courts or commentators are willing to use the term, substantive due care analysis is in fact alive in Delaware fiduciary law, and has been for at least two decades. Whether they call it irrationality, inexplicable behavior, egregious decision making, gross abuse of discretion, inadequacy, action that is beyond the realm of human comprehension, sustained inattention, disloyalty, or bad faith, judges and commentators from all sides of the debate must recognize that sometimes courts cannot avoid reviewing the substantive merits of director's actions. Exemplified by the Court of Chancery's 2005 decision in the Disney litigation, Delaware courts express an unwillingness to engage in substantive review, do it anyway, but almost inevitably find in favor of the defendants.

2. IS SUBSTANTIVE DUE CARE "FOREIGN" TO THE BUSINESS JUDGMENT RULE?

   Courts have a relatively easy time reviewing allegations of disloyalty or self-dealing by corporate directors. Virtually every formulation of the business judgment rule precludes protection of directors who do not act in the best interests of the company but rather for their own benefit. (11) Rebutting the presumption of director loyalty is a fairly straightforward matter for the plaintiff. He must simply show that the director herself benefited from the decision, and that the decision was not fair. (12) The rule therefore allows aggrieved shareholders to recover when a director made a decision that was tainted by self-interest and that was not a good deal for the company. To allow a court to review a disloyal decision and even to impose liability on a company for a disloyal and unfair decision does not threaten the freedom of directors to act with discretion because, in such a situation, one might say that the director did not exercise discretion at all. Rather, the director acted in direct contradiction to her obligation to make decisions on behalf of the well-being of the corporation and its shareholders.

   The appropriateness of judicial review becomes trickier, however, when the plaintiff alleges not that the director breached his duty of loyalty, but rather that the director breached some other duty (we will attempt to define it) that did not apparently involve self-interest. A director breaches no duty simply by making a decision that does not turn out to benefit the corporation, even if it was obvious to most observers at the time that it was a bad decision. It is well settled that the business judgment rule will not allow review of director decisions that, in retrospect, are "pretty dumb," (13) "substantively wrong, or degrees of wrong extending through 'stupid' to 'egregious' or 'irrational,'" (14) as long as the process used was rational or the decision made in good faith. Delaware courts will not, as Chancellor Chandler wrote in Disney IV, "hold fiduciaries liable for a failure to comply with the aspirational ideal of best practices." (15) That is to say, Delaware courts will not review the substantive wisdom of decisions made by corporate directors; put another way, courts will not engage in substantive due care analysis.

   Although the phrase "substantive due care" had been used in various jurisdictions over the years, it became code for that-which-is-not-reviewable in the wake of the Delaware Supreme Court's 2000 decision in Brehm v. Eisner, (16) the first pivotal decision in the Disney litigation. In that decision, the court reviewed a lower court ruling dismissing a shareholder derivative suit against the Walt Disney Company for approving an extremely generous employment contract for executive Michael Ovitz. (17) The deal allowed Ovitz to leave the company fourteen months after his hire with a severance package worth $140 million. (18)

   That Disney's shareholders wanted a court to review the directors' conduct in approving such a payout is not surprising. Nor is it surprising that the Delaware Supreme Court failed to embrace that prospect with much enthusiasm. (19) The court took particular pains to address the plaintiffs' allegation that the directors failed to exercise "substantive due care." In a now much-quoted passage, (20) the court attempted to dispose of the idea of substantive due care review in Delaware law:

   As for the plaintiffs' contention that the directors failed to exercise "substantive due care," we should note that such a concept is foreign to the business judgment rule. 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 decision making context is process due care only. Irrationality is the outer limit of the business judgment rule. Irrationality may be the functional equivalent of the waste test or it may tend to show that the decision is not made in good faith, which is a key ingredient of the business judgment rule. (21) Nonetheless, the court allowed the plaintiffs to amend their complaint so that it would allege more specific facts that might present doubt that the decision of the directors to approve Ovitz's employment package was protected by the business judgment rule. (22)

   The language quoted above ought to have put to rest the idea that courts might be willing to review director decisions based on the substantive wisdom of the decision itself. Indeed, the author of the opinion, former Chief Justice Veasey has taken to quoting its language as an unambiguous affirmation of a rule that requires little interpretation. (23) Far from it. In fact, that ruling led the Court of Chancery to reassert the possibility of reviewing director decisions on the substantive merits by simply calling it by another name. (24)

3. THE "REINVIGORATION" (25) OF SUBSTANTIVE DUE CARE

   In 2003, the Court of Chancery finally got a chance to hear the plaintiffs' amended complaint in the Disney litigation. (26) In refusing...