Proceduralism: Delaware’s Legacy

The 1980s were a watershed moment in the history of corporate law. In a series of decisions addressing the board of directors’ duties in friendly mergers and hostile takeovers, the Delaware Supreme Court seemed to depart from its historical deference to directors’ discretion and instead subjected directors’ actions to judicial review. In Smith v. Van Gorkom (1985), the Court held that the highly experienced and long-tenured directors of Trans Union were grossly negligent when they approved a merger agreement, even though the merger provided Trans Union’s shareholders with an almost 50% premium over the market price of the stock. Less than six months later, in Unocal Corp. v. Mesa Petroleum Corp. (1985), the Court held that a target board must demonstrate that a threat to corporate policy existed and that its actions were reasonable given the nature of the threat to justify defensive measures. Shortly thereafter, in Revlon, Inc. v. MacAndrews & Forbes Holdings (1986), the Court declared that a company’s board must strive to ensure that the shareholders receive best price if it decides to allow the sale of the company. In all, the Delaware Supreme Court’s willingness to subject directors’ decisions to review and insist on fair or best price for the shareholders seemed to deviate from Delaware’s historical deference to directors’ business judgment. As Martin Lipton pointedly charged at the time, “Delaware has misled corporate America . . . It lured companies in with a promise that the business judgment rule would govern corporate law. It’s obvious that the state has reneged” (quoted in William Meyers, Showdown in Delaware: The Battle to Shape Takeover Law, Institutional Investor, Feb. 1989, at 75).

Many have since argued that the 1980s marked the end of managerialism (the idea that expert managers could be trusted to lead corporations as they deemed beneficial for all corporate stakeholders) and the birth of shareholder valuism (the notion that corporations should maximize value only to the shareholders) as corporate law’s normative anchor. As Karen Ho writes, the 1980s blitz of hostile takeovers was a means to an end, namely removing the “elite, complacent, and self-serving managerial class” that has presumably “squandered corporate resources extravagantly on themselves or on ill-advised expansions” and “unlocking the value of ‘underperforming’ stock prices” to the benefit of the shareholders (Karen Ho, Liquidated: An Ethnography of Wall Street 130 (2009)).

Using oral histories to explore the 1980s iconic cases, Proceduralism: Delaware’s Legacy demonstrates that the Delaware Supreme Court neither abandoned its deference to the managerial elite nor explicitly endorsed the shareholder wealth maximization norm. Rather, amidst a rapid increase in hostile acquisitions, the Court substituted what I label “proceduralism” for managerialism as a theory legitimizing managerial power. Grounded in the concept of fair dealing, proceduralism is the idea that certain procedures—for example, authorization by disinterested directors or ratification by shareholders—ensure maximization of value, and that corporate law should focus on incentivizing corporate directors to follow these procedures by assuring them that when they so do, their actions will not be subject to judicial review whether or not such actions offered their shareholders a fair price or a price at all. Presumably shareholder-focused, proceduralism justifies deference to the corporate elite not by reference to their knowledge and expertise, but by assuming that they could be trained to follow scripted processes. So long as managers follow such processes, the Delaware courts will not review the substance of their decisions or the fairness of the price they offer their shareholders. Rather than emphasizing directors’ discretion, a la managerialism, proceduralism focuses on internal corporate processes.

The transformation began in Weinberger v. UOP, Inc. (1983). Addressing the elimination of UOP’s minority shareholders through a cash-out merger between UOP and its majority owner, The Signal Companies, Inc., the Delaware Supreme Court held that “when directors of a Delaware corporation are on both sides of a transaction, they are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain” (Weinberger 710). Then, seeking to offer a clear definition of a concept that has been described as “measured by the ‘Chancellor’s foot’” (61 Harv. L. Rev. at 337 (1948)), the Court added that fairness consisted of “two basic aspects: fair dealing and fair price.” Fair dealing “embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained,” while fair price “relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock” (Weinberger, 711).

In the cases that followed Weinberger, fair dealing—seemingly a component of the entire fairness standard of review—quickly substituted for the traditional business judgment rule as the Delaware Supreme Court defined procedures that corporate managers should follow to ensure that their actions would not be subject to ex post review. Take, for one, Smith v. Van Gorkom. When the Delaware Supreme Court held that the highly qualified directors of Trans Union were not sufficiently informed when they approved Trans Union’s absorption into Jay Pritzker’s Marmon Group, and thus breached their duty of care, the Court placed no importance on the directors’ expertise or business judgment. Instead, the Court’s conclusion focused on the procedures the Court expected directors to follow when approving a merger. The Trans Union directors were found liable not because they did not exercise business judgment; they breached their duty of care because they did not follow appropriate procedure—they acted too quickly and did not ask questions before they approved the merger agreement. To use Weinberger’s terminology, the directors’ actions did not constitute fair dealing. Had the Trans Union directors followed appropriate procedure, the Court signaled to the business community, their actions would not have been reviewed.

Similarly, when the Delaware Supreme Court in Unocal Corp. v. Mesa Petroleum Corp defined the standard of review applicable to directors’ adoption of anti-takeover defensive measures, the Court emphasized that if a majority of the independent outside directors endorsed the defensive tactic, the board’s action would meet the test’s requirements. The Unocal two-prong test was presumably a test of reasonableness, requiring directors to demonstrate first, that they “had reasonable grounds for believing that a danger to corporate policy and effectiveness existed” and second, that the defensive tactic the board adopted was “reasonable in relation to the threat posed” (Unocal, 955). Yet, as it did in Van Gorkom, the Court assured the business community that if the outside directors properly authorized certain actions, it would not examine their reasonableness. Notably, an authorization by disinterested directors has been the hallmark of fair dealing and is enshrined in Section 144(a)(1) of the Delaware General Corporation Law. Unocal affirmed that a similar procedure would legitimize directors’ reaction to hostile takeovers.

Even in Revlon, Inc. v. MacAndrews & Forbes Holdings, although the Delaware Supreme Court declared that when a “company was for sale,” the duty of the board “changed from the preservation of Revlon as a corporate entity to the maximization of the company’s value at a sale for the stockholders’ benefit” (Revlon, 182), the Court’s analysis did not focus on shareholder wealth maximization, but on the process that the Revlon directors undertook in response to a hostile bid and the concerns that influenced their decisions. When the directors allowed concerns about other constituencies (the noteholders) to cloud their judgment, they failed to meet the fair dealing standard and thus breached their duty of loyalty. Fair dealing was presumed to ensure fair price, but Revlon did not impose a general duty on directors to maximize shareholder wealth. To avoid ex post judicial intervention, directors were only required to follow appropriate (fair) procedure, not to produce fair price.

The impact of the transformation from business judgment to fair dealing was significant. The business judgment presumption was historically justified by reference to directors’ expertise; managerialism, more broadly, was corporate law’s response to social, political, and cultural concerns outside the realm of corporate law. At the turn of the twentieth century, courts empowered corporations and their managers to fight the allure of socialism by protecting the interests of both investors and workers. In the midcentury, courts described corporations as the first line of defense against the threats of totalitarianism and later the Cold War. Corporate executives were deemed heroes and their power justified as necessary for the survival of American democracy. But during the deal decade, as concerns about efficiency and certainty replaced earlier concerns about capitalism and democracy, the Delaware Supreme Court’s gaze turned inward. Fair dealing and fairness, more broadly, were internally focused and as such lacked the legitimating narrative that supported managerial power or the business judgment rule prior to the 1980s. Proceduralism offered an alternative narrative.

Proceduralism was cemented into law in the decade following the hostile takeover boom as the Chancery Court sought to ensure that Delaware corporate law continued to bolster corporate management’s power to run corporations. In cases ranging from the duty to monitor to executive compensation, the Chancery Court focused on offering directors a procedural framework that, if followed, would guarantee their actions the protection of the business judgment rule. In this vein, directors could satisfy their duty to monitor by implementing an information and reporting system, irrespective of the system’s effectiveness (In re Caremark Int’l Inc. Derivative Litig (1996)); and they could fulfill their duty of loyalty by securing the shareholders’ ratification of interested transactions, however self-serving such transactions might be (Lewis v. Vogelstein (1997)). By the turn of the twenty-first century, discussions of directors’ duties and business judgment no longer focused on directors’ discretion or the corporation’s social role but rather on the narrow scripts that the Delaware courts provided directors presumably so they would maximize shareholder value. Proceduralism has replaced managerialism as corporate law’s legitimating theory.

The Delaware courts’ embrace of proceduralism as a substitute for managerialism paralleled what sociologist Mark Mizruchi labeled the “fracturing of the American corporate elite.” According to Mizruchi, the corporate elite that dominated the post-World War II years was a cohesive group that, while not perfect, “helped society flourish, both economically and politically.” Since the 1970s, however, that group was fragmenting and fracturing and while corporations remained powerful, the corporate elite had become too divided and “largely abandoned their concern with issues beyond those of their individual firms,” a neglect that, according to Mizruchi, “is one of the primary causes of the economic, political, and social disarray that American society has experienced in the twenty-first century” (Mark Mizruchi, The Fracturing of the American Corporate Elite, xi-xii, 4-5 (2013)).

The Delaware courts offered a legitimization idea—proceduralism—that supported the corporate elite’s inward turn. The 1980s doctrinal changes brought into boardrooms a new cohort of lawyers whose advice was consistent with post-1980s Delaware law. Focusing corporate directors’ attention narrowly on procedure to the exclusion of all else, the Delaware courts helped deepen the fracturing of the corporate elite. As CEOs of our largest corporations are signaling their interest in moving beyond shareholder wealth maximization and addressing the social and economic concerns of a variety of constituencies, it is perhaps time for the Delaware courts to reexamine their 1980s legacy.

The complete article is available here.