Judicial Schizophrenia in Corporate Law: Confusing the Standard of Care With the Business Judgment Rule

• Publication year: 2007

§ 24 Alaska L. Rev. 23. JUDICIAL SCHIZOPHRENIA IN CORPORATE LAW: CONFUSING THE STANDARD OF CARE WITH THE BUSINESS JUDGMENT RULE

Alaska Law Review
Volume 24
Cited: 24 Alaska L. Rev. 23

JUDICIAL SCHIZOPHRENIA IN CORPORATE LAW: CONFUSING THE STANDARD OF CARE WITH THE BUSINESS JUDGMENT RULE

FRED W. TRIEM ^[*]

I. INTRODUCTION: A FIERY BEGINNING

II. A WRONG TURN IN ALASKA'S CORPORATE LAW

A. What is the Business Judgment Rule?

B. Distinguishing the Directors' Standard of Care and the Business Judgment Rule

C. The Standard Matters

D. The Business Judgment Rule is Not Codified

III. ALASKA'S COURTS ARE NOT ALONE IN CONFUSING THE DIRECTORS' STANDARD OF CARE WITH THE BUSINESS JUDGMENT RULE

IV. THE BUSINESS JUDGMENT RULE SHOULD NOT BE CODIFIED

V. CONCLUSION: CORPORATE LAW NEEDS A COURSE CORRECTION

FOOTNOTES

Courts are confusing the Business Judgment Rule with the standard of care that governs the conduct of corporate directors and officers. The Alaska Supreme Court declared in recent dictum that the Business Judgment Rule has been codified in Alaska Statute section 10.06.450(b), the directors' duty-of-care statute. The court deviated from well-established principles of corporate law by confusing the corporate directors' statutory standard of care with the Business Judgment Rule, a widely-applied, but uncodified, common law rule about the standard of directors' liability for their mistakes. The former is an ex-ante measuring stick by which directors' decisions are guided; the latter is a presumption of correctness and a safe harbor that protects business decisions from ex-post review in the courts. This Comment identifies this common error of law, describes the difference between these two concepts, explains why many state and federal courts across the nation are confused, and credits the courts that have already discovered the error. It concludes with some reasons why the Business Judgment Rule should not be codified.

I. INTRODUCTION: A FIERY BEGINNING

The Business Judgment Rule ("BJR") first appeared in Alaska in 1975 after a fire destroyed a small factory in Fairbanks that was owned by Alaska Plastics, Inc. ^[1] The fire caused the end of production at the factory, terminated operation of the enterprise, and triggered the beginning of a lawsuit that brought the arrival of the BJR in Alaska. ^[2] To Alaska Plastics' everlasting woe, its [*pg 24] directors had decided not to obtain any fire insurance on the facility. ^[3] Annoyed by this foolish decision, Patricia Coppock, a minority shareholder, filed a derivative action against the directors in which she complained that the directors had breached their duty of care. ^[4]

In Alaska Plastics, the Supreme Court of Alaska affirmed the trial court's rejection of the dissident shareholder's complaint about lack of fire insurance and other directorial misconduct. ^[5] The supreme court held that the directors' decision not to insure the property was protected by the BJR, and therefore it would not be reviewed by the court. ^[6] This was the first time the Alaska Supreme Court had discussed or applied the BJR. The court's most recent BJR case, Shields v. Cape Fox Corp., ^[7] is substantially more controversial, as it mistakenly asserts that the BJR is codified in Alaska Statute section 10.06.450(b), ^[8] confusing the common law rule with the codified corporate directors' standard of care. ^[9]

This Comment traces the history of the BJR in Alaska. It explains where and how the court has erred in its definition of the rule; it explains the difference between two concepts -- standard of directors' care and standard of directors' liability -- and their separate treatment in the Model Act. ^[10] It also collects examples of the same judicial misunderstanding from the case law of other states. It concludes that the BJR has not been codified in Alaska nor in most other U.S. jurisdictions, although there have been recent suggestions to do so in the Model Act ^[11] and in the American Law Institute's Principles of Corporate Governance. ^[12] Finally, this Comment provides reasons why the BJR should not be codified.

[*pg 25]

II. A WRONG TURN IN ALASKA'S CORPORATE LAW

Since its first appearance in the Alaska Plastics decision, the Business Judgment Rule has received only occasional mention in subsequent decisions of the supreme court. ^[13] That is, until the court decided Shields v. Cape Fox Corp. ^[14] in 2002. In Shields, the court confused the BJR with the directors' statutory standard of care that is codified in Alaska Statute section10.06.450(b). ^[15] The court erroneously referred to a statutory formulation of the BJR: "The business judgment rule is set out in AS 10.06.450(b). It requires a director to use 'the care . . . that an ordinarily prudent person in a like position would use under similar circumstances.'" ^[16]

For the reasons explained below, ^[17] this dictum is contrary to the great weight of modern corporate law and should be repudiated. However, Alaska is not alone in making this mistake; courts in several other jurisdictions have made the same error. ^[18]

[*pg 26]

A. What is the Business Judgment Rule?

The essence of the BJR is deference to directors' decision-making based on judicial unwillingness to re-examine a business decision and judicial reluctance to discourage directors from risk-taking. ^[19] The BJR is characterized by a number of features. ^[20] First, the BJR applies to business decisions that have been made by corporate directors and officers by supplying a presumption of correctness. ^[21] Second, the BJR requires a judgment or decision. ^[22] [*pg 27] Third, the BJR protects corporate directors and officers from liability for mistakes that were made in business decisions, even when such a decision proves to have been unsound or downright erroneous. ^[23] Finally, the BJR supplies judicial restraint and abstention, for it furnishes a deferential standard of review by which courts will abstain from second guessing the directors' business decisions. ^[24]

The BJR insulates corporate directors from those decisions that are within their authority and are not tainted by fraud or self-dealing. ^[25] The BJR is a venerable common law rule ^[26] that is recognized and applied by courts everywhere to protect directors when they are acting within the scope of their corporate authority:

The rule is simply that the business judgment of the directors will not be challenged or overturned by courts or shareholders, [*pg 28] and the directors will not be held liable for the consequences of their exercise of business judgment -- even for judgments that appear to have been clear mistakes -- unless certain exceptions apply. Put another way, the rule is "a presumption 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 was taken in the best interests of the company. ^[27]

The exceptions referred to by Dean Clark are "managerial fraud and self-dealing." ^[28]

The BJR provides a safe harbor to directors only for decisions in which they have discretion and for which they are permitted to choose between rational business alternatives. The correct expression of the BJR is seen in Alaska Plastics: "Judges are not business experts, a fact which has become expressed in the so-called 'business judgment rule.' The essence of that doctrine is that courts are reluctant to substitute their judgment for that of the board of directors unless the board's decisions are unreasonable." ^[29]

Alaska Plastics provides an excellent example of judicial deference to business decisions. In that case, the shareholder-plaintiff complained that the defendant-directors were negligent in [*pg 29] failing to insure company property -- a plant in Fairbanks -- and that they kept large amounts of cash in non-interest-bearing checking accounts, thus violating the directors' duty of care. ^[30] The court rejected these arguments for the reason expressed in the quoted passage above: ^[31] the directors have discretion about insurance and banking practices, and a court should show deference because "[j]udges are not business experts." ^[32]

B. Distinguishing the Directors' Standard of Care and the Business Judgment Rule

The key difference between the standard of care and the Business Judgment Rule is that the standard of care defines ex ante the conduct to which directors must aspire while the BJR is an ex post standard of review applied by the courts. ^[33] Although some courts fail to distinguish between the standard of care and the BJR, legal scholars have recognized the distinction between these two doctrines. ^[34] The standard of care and the BJR are often confused because "[i]n many or most areas of law, standards of conduct and standards of review are identical." ^[35] But these standards are not identical in the law of corporations:

[*pg 30]

An identity between standards of conduct and standards of review is so common that it is easy to overlook the fact that the two kinds of standards may diverge in any given area -- that is, the standard of conduct that states how an actor should conduct himself may differ from the standard of review by which courts determine whether to impose liability on the basis of the actor's conduct. . . .

The duty of care is a leading example of this divergence. ^[36]

To illustrate, Professor Douglas Branson explains that a director's...