Academic journal article Northwestern University Law Review

Dangerous Liaisons: Corporate Law, Trust Law, and Interdoctrinal Legal Transplants

Academic journal article Northwestern University Law Review

Dangerous Liaisons: Corporate Law, Trust Law, and Interdoctrinal Legal Transplants

Article excerpt

People were shocked by Smith v. Van Gorkom.1 Teeth were gnashed. The Delaware General Corporate Law ("GCL") was amended. The world went on.

But why were people so surprised and so upset? As we all know, corporate law emerged out of the law of trusts and agency. It had long been said that directors, like trustees and agents, have a duty of care. The trustee's duty of care had classically been elaborated in negligence terms, as a duty "to exercise such care and skill as a man of ordinary prudence would exercise in dealing with his own property."2 When trustees act negligently, they are liable for the damages that they cause. Agents, too, are liable for negligence in the performance of their duties.3 And, here, in Smith v. Van Gorkom, we had a case in which, at least in the eyes of the Delaware Supreme Court, directors acted with gross negligence. So liability was imposed. Why such a big deal?

One answer is that it had never happened before. Never before had Delaware directors been held liable for a breach of the duty of care absent a breach of the duty of loyalty, at least outside the context of financial institutions. But, as an explanation, that answer is incomplete. First, it does not explain why it had not happened before. Moreover, it does not explain whether finally having such a case, which brought with it the prospect of additional such cases, was good or bad for shareholders. Finally, it does not explain why this negligence-based fiduciary duty of care was and is a fixture of trust and agency law while it proves so troublesome in corporate law.

So what is going on? How is it that corporate law is drawn to talking about a director's duty of care as "the care that an ordinarily prudent person would exercise under similar circumstances,"4 yet, when courts finally take that talk seriously, the corporate world rebels? Why is corporate law's flirtation with negligence talk such a dangerous liaison? That is the question we address in this Article.

What is required is both an analysis and a diagnosis. We provide both. The duty of care is a "legal transplant": it is a fixture of the classical law of trusts and agency that was transplanted into corporate law along with the duty of loyalty. As is often the case with legal transplants, whether interdoctrinal or cross border, transplants can cause mischief.5 When a legal concept is taken from one context and incorporated into a fundamentally different setting, it may carry with it implications and characteristics that do not serve anyone's interests. The logic of legal concepts has a momentum of its own.

The peculiar problems with corporate law's duty of care derive from the transplanting of a concept from the market context into the firm context. Difficulties arise if one fails to recognize the market-firm boundary as critical. That boundary represents a choice of governance structure, a choice between third-party judicial enforcement of market transactions and nonlegal self-governance within firms.

In moving unselfconsciously across this boundary, the seeds of mischief were sown. It is, indeed, evidence of corporate law's sensitivity to the underlying economic logic of firms that, through the device of the business judgment rule, it was able to keep the mischief at bay for so long. Eventually, however, the logic of legal concepts won out, and the court imposed liability for negligent director conduct.

The story has a happy ending. Shareholders, managers, and the Delaware legislature rode to the rescue, enacted section 102(b)(7), and largely restored the status quo ante. But it is a cautionary tale nonetheless. Transplanting legal concepts, without attention to the underlying context, can cause great mischief.

I. THE MESS

An "ordinary prudence" or "reasonable person" duty of care, if taken seriously, creates an impossible mess for corporate law. To demonstrate this difficulty, this Part will first review the duties of loyalty and care that apply to trustees and agents and will then trace the problems created in the attempts to incorporate these duties into Delaware corporate law and the Model Business Corporation Act. …

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