Lyman Johnson is the Robert O. Bentley Professor of Law at Washington & Lee University School of Law.
A few weeks ago Chancellor Leo Strine, in a widely-heralded ruling, held that the business judgment rule standard of review applied to controlling shareholders in a self-dealing transaction if two conditions were met. From the outset, the transaction must be subject to the approval of both (i) an independent special committee complying with its fiduciary duties, and (ii) a majority of the minority shareholders in a fully-informed and non-coerced vote.
I argue that Chancellor Strine should not have used a business judgment rule review standard. Regrettably, he chose that doctrinal standard over the strict entire fairness standard for a very simple reason: he likely believed he had no doctrinal alternative. After all, isn’t the BJR the alternative to entire fairness, assuming that neither the special Unocal or Blasius standards apply? It may seem so, but my article argues that such a view is deeply flawed.
Let me make clear at the outset that I have no problem with Chancellor Strine’s outcome. He drew on his earlier thinking on this issue to sensibly provide an avenue for deal lawyers to structure transactions and for defense lawyers to seek pre-trial dismissal of meritless litigation. I do fault Chancellor Strine, however, for the analytical route he traveled to reach his decision. The business judgment rule has no place in analyzing investor conduct – controlling shareholder or otherwise – and it should not be unleashed in this area via MFW or ensuing decisions. Instead, the court should straightforwardly ask: Has the plaintiff sufficiently pled or proffered facts suggesting that the controlling shareholder breached a fiduciary duty? Delaware’s cumbersome BJR edifice need not be introduced into the analysis because it adds nothing, it was not designed for, and its policy underpinnings are not aimed at, shareholders.
To speak of “business judgment” in the shareholder context is incoherent because such a shareholder makes no “business” judgment on behalf of the corporation in the same way directors do. Sure, in a third party merger, shareholder approval is necessary to effectuate the merger, but shareholders in that setting – controlling or otherwise – owe no fiduciary duties to the corporation and other shareholders. They can and do vote based on whether, to them as investors, the merger is financially beneficial. When minority shareholders similarly are empowered under a majority-of-the minority provision in a controlling shareholder self-dealing merger, they too lack fiduciary duties, can vote based on self-interest, and are not required to advance the company’s best interests or those of any other person. And when the ostensibly controlling shareholder in that setting votes on the merger, it does not “control” the outcome (given the dual approval mechanisms), and it properly and likely votes its own investor interests. The issue of the best interests of the corporation is a matter of concern only for directors. Moreover, there simply is no reason to require a “rational business purpose” in reviewing the conduct of a shareholder who does not act for the company.
But my article goes much farther than arguing that the BJR has no place in fiduciary duty litigation involving shareholders. It argues that the rule, similarly, has no place in litigation involving executive officers – never squarely done by the Supreme Court – and, sit down for this, should not be deployed in reviewing director conduct. Rather, in all corporate fiduciary litigation, the Supreme Court should fundamentally alter the “map” of analysis by showcasing fiduciary duties and demoting the business judgment rule. The policy rationales for the rule are sound but, beyond being irrelevant for shareholders, for directors and officers the rule introduces needless doctrinal and analytical complexity. I advance several reasons as to why the rule unnecessarily complicates corporate fiduciary litigation in an unfortunate way.
First, the business judgment rule, not fiduciary duties, currently enjoys pride of place in Delaware. The business judgment rule is a doctrinal vessel of judicial review into which the fiduciary duties of care and loyalty are fitted and subsumed. As noted by the Delaware Supreme Court, the duty of care is but an “element of the rule.” But fiduciary duties are broader in scope than the reach of the business judgment rule, which applies only if an identifiable business judgment is made. An example is a faulty oversight context where no business decision was exercised. And fiduciary duties apply to directors whether or not their conduct is reviewed later in court. The more narrowly applicable doctrine should not serve as the unifying concept for the broader-reaching duties.
Second, the primacy of the business judgment rule over fiduciary duties in Delaware’s analysis of director performance is an accident of history. The duty of care, being a doctrinal latecomer, was, along with the duty of loyalty, embedded into the pre-existing business judgment rule framework in Cede, in a clumsy effort to harmonize those duties with the rule. But the rule retained analytical preeminence, leading to a diminished emphasis on what is really most critical to corporate governance, both in and out of court: Did directors fulfill or breach either of their fiduciary duties? That issue should be doctrinally highlighted, not obscured.
Third, all of the laudable policy rationales undergirding the rule can be preserved while placing primary emphasis on a director’s fiduciary duties. The plaintiff must establish a breach of fiduciary duty. In the duty of care context, the court still would not weigh in on the substantive soundness of director decisions because care is entirely process-oriented. There is no substance to duty of care review. There is no need to add, via the rule, either Aronson’s “presumption” strand of the rule or the Sinclair/Cede “substantive” strand. It is as an aspect of duty of care review that the true “substantive” function of the business judgment rule can be seen. It cogently houses the sensible policy decision of courts not to second-guess business judgments as part of reviewing fiduciary duty of care claims. Ironically, then, business judgment deference is better understood as an “element” of care, not the reverse.
Fourth, elevating fiduciary duties to be the primary focal point in judicially analyzing director conduct – and officer and shareholder conduct – streamlines that analysis and rationally aligns it with other fiduciary approaches in law, such as those used in agency law. For example, in a 2010 decision involving agency principles, Vice Chancellor Parsons noted how a claim for fiduciary duty wrongdoing requires proof of two elements: “that a fiduciary duty existed” and “that a defendant breached that duty.” That simple framework likewise could be used for directors. Of course, directors owe unremitting duties, so the focus in any particular case is, quite simply, whether they did or did not breach a duty. In the care setting, the plaintiff must bear that burden; while in the classic self-dealing loyalty context, one or more directors will shoulder the burden.
Finally, elevating fiduciary duties in prominence, and reducing a threshold emphasis on the business judgment rule, would facilitate teaching law students and others the rudiments of fiduciary duties. Widespread confusion persists over the rule, and not just in the ranks of the elite corporate bar.
As just one law professor who has grappled with teaching this material to law students for almost thirty years, I can say that presenting students with a coherent and cogent understanding of fiduciary duties is made more difficult by Delaware’s current business judgment rule construct. Students – having studied the concept of legal duty in diverse curricular offerings such as torts, trusts and estates, agency and partnership law, and professional responsibility – understand the importance of legal duties, including the scope of duty and situations of no-duty. The concepts of care and loyalty, in all their manifestations, are relatively easy to grasp, if of somewhat surprising contours.
Analytically and doctrinally, the teaching could stop there – with fiduciary duties and their breach – and students would have a solid and workable understanding. Little but unnecessary complexity in the law and pedagogy is added by then filtering all of the above through the threshold of the business judgment rule construct as a standard of review, particularly with the Cede breach of duty/burden shift feature.
The Supreme Court should not use the BJR in shareholder cases and should deemphasize this prolix doctrinal vestige for directors.
This post is based on a forthcoming article in the Delaware Journal of Corporate Law, available here, titled Unsettledness in Delaware Corporate Law: Business Judgment Rule, Corporate Purpose.