The tort foundation of duty of care and business judgment.

• Author: Rhee, Robert J.
• Position: Introduction through II. Duty of Care and Affirmative Undertaking, p. 1139-1171

This Article corrects a misconception in corporation law--the belief that principles of tort law do not apply to the liability scheme of fiduciary duty. A board's duty of care implies exposure to liability, but the business judgment rule precludes it. Tort law finds fault; corporation law excuses it. The conventional wisdom says that the tort analogy fails. This dismissal of tort principles is wrong. Although shareholder derivative suits and ordinary tort cases properly yield systemically antipodal outcomes, they are bound by a common analytical framework. The principles of board liability are rooted in tort doctrines governing duty, customs, and pure economic loss. Properly applied, they produce a duty "to care" (vis-a-vis duty of care), based on good faith undertaking of care, but upon such undertaking no liability for negligently inflicted economic loss--the exact result achieved by the fiduciary duty of care and the business judgment rule. A sound tort analysis not only theorizes the enigmatic relationship between the duty of care and the business judgment rule, but it also explain Delaware's puzzling procedural-substantive divide. Fiduciary duty in corporation law rests on a tort foundation. Lastly, the thesis of this Article has a broader implication. The contractarian view of corporation law seeks to relegate the role of courts to passive custodians of the corporate contractual terms provided by the legislature and the corporation's constituents. However, this view is constrained by a tort framework wherein courts do and should play a robust, albeit reserved, role in regulating important aspects of corporate governance through continued common law process of doctrinal development of the idea of a wrong.

INTRODUCTION

The structure of corporation law is built on two grand rules limiting the liability of participants in the corporate enterprise. The first is the rule of limited liability of shareholders. (1) The second is the rule limiting the liability of directors under the business judgment rule. Jointly these rules promote enterprise by allowing shareholders and directors to take risks without fear of catastrophic personal liability. Without them there would be no corporation as we know it. While the theory of shareholder limited liability is well understood today, (2) we still lack a consensus on the theory of the relationship between the duty of care and the business judgment rule. (3) The academic literature has instead focused on instrumental policy grounds to justify the consensus view that the business judgment rule generally produces correct outcomes. This is a curious state of academic affairs given the importance of the issue. The theoretical deficit has not been for want of scholarship, which has been voluminous. (4)

The duty of care and the business judgment rule are bound together in an enigma. (5) The mystery deepens when the tort analogy is applied. A director's duty of care is frequently analogized to the duty of care in tort law, which is the language of culpability seen in accident law. (6) "Yet, the one thing about the business judgment rule on which everyone agrees is that it insulates directors from liability for negligence." (7) Tort law finds liability; corporation law excuses it. The apparent failure of the tort analogy--the schizophrenic invocation and rejection of negligence--is jarring. Although most people agree that, generally speaking, board liability should be limited, this broad policy is intrinsically unhelpful in conceptualizing the liability boundary. The duty of care and the business judgment rule are not only important to corporation law inter se, but also corporation law influences the laws of other business organizations, (8) including the use of the business judgment rule. (9) Thus, the inquiry here has broad implication in the entire field of business organizations.

This Article provides a theory of the duty of care and the business judgment rule through the prism of tort theory and principles. (10) To be clear, I do not argue that a breach of fiduciary duty is a tort, (11) just the way it is not a breach of contract, notwithstanding the contractarian view of corporate governance. The thesis here is that the liability scheme of corporate boards under the doctrines of fiduciary duty and the business judgment rule can be understood through the analytics of torts. (12) Although corporate law scholars have been wary of inter-doctrinal analysis of corporation law, (13) tort principles are embedded in important doctrines of corporation law. (14) In the arena of board liability for wrongful conduct, an inter-doctrinal analysis is inevitable. (15) When corporation law states that a director should act as an "ordinarily careful and prudent" person (16) and a breach of the duty of care is defined as "gross negligence," (17) it borrows from the lexicon of torts and scholarship should squarely address, and not casually dismiss, this tension.

This Article answers the question: If there was no corporation law of fiduciary duty of care and tort law applied instead, what would the legal framework of a director's duty and standard of liability look like? (18) Few scholars have engaged in this analysis, (19) presumably because most have assumed that the application of tort law to corporate decisions would expand board liability under the general negligence standard to untenable levels. This conventional wisdom is wrong. Tort theory provides not just the lexicon of liability, but the foundational principles of the duty and liability of corporate boards.

Under a correct account of the tort analogy, the duty of care and the business judgment rule are not antipodes of a paradox, but are complementary principles governing duty and its scope. Two principles play key roles. First, an affirmative undertaking to manage the affairs of the corporation (20) not only begets a fiduciary duty of care, but it limits the scope of that duty. Under the tort doctrine of industry customs, the scope of a director's duty of care reflects the implied standard of care that would be adopted by market participants. A tort-based proposition is consistent with the prevailing contractarian theory of corporation law, and it shows that the negligence standard would not apply to the substance of business decisions. Second, theories of pure economic loss provide the foundation principles for the rule that a director's duty of care does not encompass negligently inflicted economic loss. Microeconomic analysis has shown that mistakes in market transactions often result in no social cost, thus justifying a rule of no liability. (21) At a broader political economic level, the precondition of a market economy, one based on profit and risk taking, is uncertainty and imperfect information. This broader analysis has shown that courts refrain from interfering with market outcomes through the rule of no duty. (22) These limitations of duty under tort law explain the principles of the duty of care and the business judgment rule.

This Article argues that the board's duty of care is a mischievous misnomer of preposition. This lexicon invokes the general negligence principle requiring an examination of the substance of the action when in fact tort law does not extend the scope of duty and liability that far. Tort theory limits the scope of a board's legal obligation to a duty to care for the corporation, which embodies the duty of good faith intention evinced by effort toward the care and custody of the corporation and the exercise of authority vested in a board whose members affirmatively assume the mantle of directorship. (23) The duty of care imposes an affirmative duty, and the business judgment rule defines the scope of that duty implied in the customary terms of a voluntary undertaking.

This Article theorizes the enigmatic relationship between the duty of care and the business judgment rule. The principles of torts can and do play a robust part in regulating important aspects of the internal affairs of the corporation. In the tort framework, there are several narrow theories under which directors can be held accountable: (1) indifference to caring evinced by a failure to monitor or manage the affairs of the corporation or an abdication of the mantle of responsibility; (24) (2) insufficient effort to care for the corporation evinced by substantial procedural defects in decision-making; (25) and (3) bad faith evinced by a knowing dereliction of duty. (26) These theories of board liability are well recognized, and the common thread is a breach of a director's affirmative duty to undertake care of the corporation. A corrected tort analogy provides theoretical coherence to the liability scheme. It explains corporation law's focus on demonstrable acts of care evincing good faith and benign intentions of a custodian as opposed to an examination of the substantive actions causing economic loss, and Delaware's puzzling substantive-procedural divide wherein duty of care is limited to procedural aspects of decisionmaking.

Lastly, this Article shows that there is a distinct space in corporate law for a tort-based theory of fiduciary duty, the obligation of good faith, and the liability of directors. The contractarian view of corporate law emphasizes the privateness of contracts, and it diminishes the role and power of courts in the realm of corporate governance and board liability. In contrast, the tort framework of fiduciary duty justifies a robust, albeit reserved, role of courts in regulating corporate governance through the common law development of law. When courts refrain from unreasonably interfering in corporate governance, they are expressing an important normative value of the relationship between private decisionmaking and public review.

This Article is written in four parts. Part I frames the issues by summarizing the duty of care and the business judgment rule, and then explaining the apparent failure of...