Academic journal article Northwestern University Law Review

In Praise of Procedure: An Economic and Behavioral Defense of Smith V. Van Gorkom and the Business Judgment Rule

Academic journal article Northwestern University Law Review

In Praise of Procedure: An Economic and Behavioral Defense of Smith V. Van Gorkom and the Business Judgment Rule

Article excerpt

Every year, corporate law professors across the nation present their students with a doctrinal enigma. Case law declares that corporate directors owe their firms a fiduciary duty of care. In other words, directors must manage the firm with the care of the "reasonably prudent person." Yet the same case law holds that directors may not be held liable for negligent decisions. Instead, their conduct is tested under a different and far more lenient standard-the standard of the business judgment rule.1

The business judgment rule is perhaps best summarized as a ban against courts second-guessing the substantive quality of disinterested corporate directors' decisions. In gauging whether or not directors have fulfilled their duty of care in a particular transaction, the rule permits judges to consider only the quality of the board's decision-making procedures.2 Smith v. Van Gorkom3 provides the classic example of this procedural focus. In that case, a minority shareholder of Trans Union claimed that the firm's board of directors had breached its duty of care by approving a merger in which the Trans Union shareholders would receive fifty-five dollars per share (a significant premium over the prevailing market price). To the surprise and dismay of many in the business community, the Delaware Supreme Court agreed-but not because the court believed that the board's decision to sell the company was a bad decision. Rather, the directors of Trans Union were held to have breached their duty of care because they reached their decision too hastily, without the right information, and without asking the right questions.4 The Trans Union directors were found liable not for what they decided but for how they decided it.

This emphasis on process opens the business judgment rule to attack from at least two directions. The first sort of attack emphasizes what the business judgment rule supposedly does not do-discourage director carelessness. According to this view, the business judgment rule needs to be changed because it shields directors who follow the requisite procedures from liability even when they make reckless, foolish, and downright stupid decisions. The second type of attack centers on what the business judgment rule does do-create incentives for directors to adopt elaborate and costly decision-making routines (for example, scheduling longer meetings, keeping detailed formal records of their determinations, and hiring expensive outside consultants). The result, critics charge, is unnecessary delay and expense that ultimately harms the firm and its shareholders.5

Taken together, these two critiques amount to a claim that the business judgment rule imposes substantial costs on firms and shareholders without providing any offsetting benefit. In judging the persuasiveness of this claim, it is important to recognize that the second part of the critique (the charge that the business judgment rule provides no benefit) is essential to the success of the first part (the charge that the business judgment rule imposes costs). After all, one of the first lessons of economics is that some costs are worth incurring.

The notion that the business judgment rule provides no benefits rests, in turn, on an unspoken but essential empirical assumption: that there is no connection between better procedures and better outcomes. This assumption should look dubious to anyone with experience in the business world. Changes in decision-making procedures often produce changes in results.6 The problem, at least from a rational choice theorist's perspective, lies in explaining why. Economic accounts of corporate governance generally begin by assuming that shareholders, officers, and directors are rational actors concerned only with improving their own welfare. From this rational choice perspective, penalizing directors for following poor procedures-but not for reaching poor decisions-seems silly. After all, if directors are rational and self-interested actors, imposing liability on them for failing to jump through the right procedural hoops does not give them incentive to make good decisions. …

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