In Defense of Delaware’s Business Judgment Rule
In a recent Dealbook post, Steven M. Davidoff complains that Delaware’s business judgment rule is too lenient. Davidoff contends that “[a] Delaware court is not going to find [directors] liable no matter how stupid their decisions are. Instead, a Delaware court will find them liable only if they intentionally acted wrongfully or were so oblivious that it was essentially the same thing.” He then asserts that a commonly heard justification for this lenient approach — that it is required in order to induce qualified individuals to serve as directors — is “laughable.”
Prof. Davidoff’s pithy summary of the Delaware business judgment rule seems accurate, and I share his skepticism toward the argument that the rule is justified as a means of inducing highly qualified directors to serve. I disagree, though, with his insinuation that the Delaware approach is unjustified. The rule makes a great deal of sense as a means of aligning the incentives of directors (and officers) with those of shareholders.
Under Delaware’s business judgment rule, courts will abstain from second-guessing the merits of a business decision — even one that appears, in retrospect, to have been substantively unreasonable — as long as the directors acted honestly, in good faith, without any conflict of interest, and on a reasonably informed basis (i.e., they weren’t “grossly negligent” in informing themselves prior to making the decision at issue). Courts treat the rule as quasi-jurisdictional, insisting that they simply will not hear complaints about the substantive reasonableness of a decision as long as the prerequisites to BJR protection are satisfied.
One frequently hears two justifications for this deferential approach. First, courts sometimes seek to justify it on grounds that they are not business experts. Second, as Prof. Davidoff observes, directors and officers often defend it on grounds that it’s needed to prevent qualified directors from being scared off by the prospect of huge liability for good faith business decisions that turn out poorly.
Neither justification works very well. Courts routinely second-guess the substance of decisions in areas where they lack expertise and might, by imposing liability, dissuade qualified individuals from offering their services. Consider, for example, medical malpractice. Courts aren’t medical experts, yet they routinely second-guess the substance of good faith, reasonably informed treatment decisions. And they do this with full knowledge that malpractice judgments dissuade qualified doctors from providing their services. (Remember President Bush’s concern that malpractice verdicts were dissuading gynecologists from “practic[ing] their love with women all across this country”?) There must be something more to the story.
Indeed, there is. By insulating directors from liability for good faith, informed business decisions that turn out poorly, the business judgment rule encourages directors to take greater business risks. This is a good thing, because directors and officers tend to be more risk averse than their principals, the shareholders. I previously explained that point in criticizing Mark Cuban’s claim that shareholders and CEOs “have completely different agendas: Most chief executives want to hit a ‘home run’ — taking big risks for potentially big payoffs — while most mom-and-pop shareholders simply hope not to ‘strike out’ and lose their nest egg.” I wrote:
… Stockholders would normally prefer corporate managers to take more, not less, business risk.
When it comes to managerial decision-making, rational stockholders prefer greater risk-taking (which is associated with higher potential rewards) for a number of reasons. First, stockholders have limited liability, which means that if a business venture totally tanks and creates liabilities in excess of the corporation’s assets, the stockholders are off the hook for the excess. Since stockholders are able to externalize some of the downside of business risks, they’ll tend to be risk-preferring. Moreover, stockholders are the “residual claimants” of a corporation — they don’t get paid until obligations to all other corporate constituents (creditors, employees, preferred stockholders, etc.) have been satisfied. In other words, they get nothing if the corporation breaks even, and they therefore would prefer that managers pursue business ventures likely to do more than break even. Finally, stockholders are able to eliminate firm-specific, “unsystematic” risk from their investment portfolios by owning a diversified collection of stocks. They therefore do not care about such risk (although they do demand compensation for bearing non-diversifiable, “systematic” risk). …
Compared to equity investors, corporate managers (including CEOs) tend to be relatively risk-averse. Unlike shareholders, they get paid even if the corporation breaks even, so high-risk/high-reward ventures are less attractive to them. In addition, they cannot diversify their labor “investment” so as to eliminate firm-specific risk (one can generally work only one job, after all). Managers therefore tend to prefer “safer” business ventures.
The need to reconcile risk preferences among corporate managers (directors and officers) and their principals (the shareholders) provides a compelling justification for Delaware’s business judgment rule. Chancellor Allen clearly articulated this point in footnote 18 of the 1996 Caremark opinion:
Where review of board functioning is involved, courts leave behind as a relevant point of reference the decisions of the hypothetical “reasonable person”, who typically supplies the test for negligence liability. It is doubtful that we want business men and women to be encouraged to make decisions as hypothetical persons of ordinary judgment and prudence might. The corporate form gets its utility in large part from its ability to allow diversified investors to accept greater investment risk. If those in charge of the corporation are to be adjudged personally liable for losses on the basis of a substantive judgment based upon what persons of ordinary or average judgment and average risk assessment talent regard as “prudent” “sensible” or even “rational”, such persons will have a strong incentive at the margin to authorize less risky investment projects.
As Geoff has often reminded us, the optimal level of business risk is not zero.