The Importance of the Business Judgment Rule

Bernard S. Sharfman is an associate fellow of the R Street Institute and a member of the Journal of Corporation Law’s editorial advisory board. This post is based on Prof. Sharfman’s recent paper, and is part of the Delaware law series; links to other posts in the series are available here.

The business judgment rule (Rule), the most prominent and important standard of judicial review under corporate law, protects a decision of a corporate board of directors (Board) from a fairness review (“entire fairness” under Delaware law) unless a well pleaded complaint provides sufficient evidence that the Board has breached its fiduciary duties or that the decision making process is tainted, such as with a lack of independence or interestedness. [1] Yet, anyone who has had the opportunity to teach corporate law understands how difficult it is to provide a compelling explanation of why the Rule is so important.

To provide a better understanding of the Rule’s importance, my paper, The Importance of the Business Judgment Rule, takes the approach that the Aronson formulation of the Rule [2] is not the proper starting place for its explanation. The Aronson formulation is a common starting point because it includes an aspect of the duty of care, the need for a Board to make a decision “on an informed basis,” that was not found in prior formulations used by the Delaware Supreme Court. Yet, starting with the Aronson formulation is like staring in the middle of a story, with much to be lost in its understanding.

Instead of starting with the Aronson formulation, this Article takes the novel approach of explaining the Rule by starting with a close read of two cases that initiated the application of the Rule under Delaware General Corporation law (DGCL), the Chancery Court and Delaware Supreme Court (Court) opinions in Bodell v. General Gas & Elec. (Bodell I and II). [3] By taking this approach, the following insights into the Rule were discovered that may not have been so readily apparent if the starting point was the Aronson formulation.

First, without the Rule, the raw power of equity, as made clear in Bodell I, could conceivably require all challenged Board decisions to undergo an entire fairness review. In the face of this power, the issue for the courts is to determine how the interests of stockholders are to be balanced against protecting the Board’s statutory authority to run the company without the fear of constantly facing potential liability for honest mistakes of judgment, the first policy driver underlying the Rule. This requires equity to be restrained in order to have balance with Board authority as provided by statutory law. The courts do this by applying the Rule as a tool to determine when a Board decision should stand without further review or when an entire fairness review is required and the full force of equity is to be applied. This is the most important function of the Rule, not the preclusion of duty of care claims.

Second, as a result of equity needing to be restrained, there is no room in the Rule formulation for fairness; fairness and fiduciary duties must be mutually exclusive. An entire fairness review is not allowed unless there is evidence that a fiduciary duty has been breached or taint surrounds the decision making process. If no breach or taint is found, then review is halted and the decision stands, upholding the Board’s statutory authority to manage the corporation. The result is that the Rule serves as a fulcrum balancing the lever upon which the managerial discretion of the Board, as provided by statutory corporate law, and equity, with its focus on fiduciary duties and the potential for an entire fairness standard of review, sit on opposite ends. The Rule and its formulation is the tool that ensures that equity and statutory corporate law co-exist. Removing the Rule as a standard of judicial review (if it were ever to happen) could lead the court to ignore the implications of applying its equitable powers without restraint, potentially allowing the balance to move too far in the direction of equity and resulting in far too many decisions coming under an entire fairness review. In essence, the Rule is a self-imposed constraint on a court’s equitable powers.

Third, the role played by the Rule does not change under DGCL 141(a), [4] the critically important statutory corporate law that provides the Board with authority to manage the corporation (Bodell I and II dealt with Section 4a of the old DGCL, currently DGCL § 152), [5] even though two additional policy drivers are identified that reinforces the use of the Rule versus an automatic entire fairness review. These policy drivers are 1) respect for the private ordering of corporate governance arrangements which almost always grants extensive authority to the Board to make decisions on behalf of the corporation and 2) the recognition by the courts that they are not business experts, making deference to Board authority a necessity.

Fourth, the Rule is an abstention doctrine not just in terms of precluding duty of care claims, as persuasively argued by Stephen Bainbridge, but also in a more fundamental way, by requiring the courts to abstain from an entire fairness review if there is no evidence of a breach in fiduciary duties or taint surrounding a Board decision.

Fifth, stockholder wealth maximization (SWM; an approach to corporate governance that encourages a Board to implement all major decisions with only the economic interests of stockholders in mind) is the legal obligation of the Board and the Rule serves to support that purpose. This is not readily apparent from the Aronson formulation of the Rule. The requirement of SWM enters into corporate law through a Board’s fiduciary duties as applied under the Rule, not statutory law. In essence, SWM is an equitable concept. The implementation of SWM is indirect as all three of the major policy drivers that influence the Rule guide the courts to stay away from a direct focus on SWM unless the Rule has been rebutted.

In sum, the defining moment in the history of the Rule was not the famous case of Smith v Van Gorkom, [6] where the Court made absolutely clear that director liability could result from an uninformed Board decision, but the much older case of Bodell II. [7] This was the case, long before it could be said that the Rule was an abstention doctrine through its preclusion of duty of care claims, where the Rule, by precluding a fairness review of a Board decision unless a fiduciary duty had been breached or some sort of taint had surrounded the decision, was established as an abstention doctrine in the most fundamental way.

The complete paper is available for download here.

Endnotes

1Cede & Co. v. Technicolor, Inc., 634 A. 2d 345, 361 (Del 1993).(go back)

2Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (citations omitted).(go back)

3Bodell v. General Gas & Elec. Corp. (Bodell I), 132 A. 442 (Del. Ch. 1926), aff’d, Bodell v. General Gas & Elec. Corp. (Bodell II) 140 A. 264 (Del. 1927).(go back)

4Del. Code Ann. tit. 8, § 141(a) (2011).(go back)

5Del. Code Ann. tit. 8, § 152.(go back)

6488 A.2d 858.(go back)

7Bodell II, 140 A. 264, 267.(go back)

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