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American Bar Association

ABA Section of Business Law

Volume 13, Number 1 - September/October 2003

Nonbinding Opinion
    By Myron T. Steele

  A Delaware justice writes on judging corporate governance

What does Delaware want from corporations in the wake of recent events? Permit a justice of its Supreme Court a few thoughts on the subject.

While there can be no serious quarrel about whether judges simply interpret the law according to legislative will or shape the law through the interaction of substance and procedure, the following comments assume three major premises:

  • That courts approach substantive policy issues retrospectively rather than prospectively.
  • That the dominant source of law is statutory and increasingly regulatory. Necessarily, the courts generally must take responsibility for the substantive results that flow from cases that often present particulars of the case or involve policy issues that the legislature never anticipated.
  • That the parties, through their actions initially and then through discovery, briefing and the presentation of evidence through their counsel, shape the interplay of those substantive facts and policies with procedural devices in ways that materially affect the way judges resolve disputes.
These three premises are not revelations. They do, however, bear consideration when people look to the courts to remedy corporate injustices, whether it be to punish individual corporate wrongdoers, to halt business transactions ranging from the fraudulent to the ill advised, or to reshape the governance relationship between investors and management.

Generally, as is well known, the concept of directors' duty to those whom they serve flows from the law of trusts and recognizes that "by accepting of a trust of this sort, a person is obliged to execute it with fidelity and reasonable diligence." While the typical lawyer may not recognize these words as the lord chancellor's from 1742, it can nevertheless be said that the standard of personal conduct described 260 years ago remains — in Delaware at least — the foundation of a director's duty today.

Exercise care in acting for and on behalf of others. Do so without regard to your own interests and be faithful to those for whom you act. Those bearing these responsibilities must carry out both those fairly self-evident obligations in good faith, recognizing that the Delaware courts examining an individual's conduct will do so in the context of the "Business Judgment Rule." That rule mandates that the actions of disinterested and independent directors — who after reasonable investigation — adopt a course of action that they, in good faith, honestly and reasonably believe will benefit the corporation will not be "second guessed," on the merits of that decision.

The Business Judgment Rule also can shield the deserving director from money damages as well as operate doctrinally to protect or salvage a particular transaction.

Courts in Delaware have long adopted the Business Judgment Rule as the "all things being equal," "default" tool of judicial review of corporate actions.

When complainants launch an attack on directors' decisions or their process for making those decisions, they often strike at the underpinnings of the Business Judgment Rule in an attempt to persuade the court, after initial motion practice, discovery and ultimately trial, that they have alleged and then proved sufficient facts to create doubt that the decision made was, in fact, a "business decision."

A "business decision" is one where a majority of directors acted disinterestedly (that is, had no interests that conflicted with those for whom they acted or the corporation's interest itself), where the directors possessed the information that reasonably prudent people ordinarily would have in the particular business environment or want or need to have, where the directors took the time to review it if it were available, or in the case of a recommendation to shareholders for their action, disclosed all the information to shareholders that the reasonably prudent shareholder would need to review in order to act intelligently on the directors' information.

With that background in mind, how do the Delaware courts reconcile the simplicity of the concept of fiduciary duty with the seemingly tolerant tool of judicial review embodied in the Business Judgment Rule and even then be subject to criticism for inconsistent or unpredictable results? And when those criticisms fairly lie, how can corporate decision makers act with confidence and in anticipation that transactions they believe are in the best interests of the corporation and its shareholders will survive judicial scrutiny?

Even more important, given public perception and awareness of corporate scandal today, widespread stock ownership, increased militancy of institutional investors and legislative limelighting in the wake of Enron, Tyco, TXU and WorldCom, will courts entertain a sea change in approach toward what some believe to be an overly complaisant tool of judicial review?

A recent article from an academic setting in effect demanded to know what Delaware was going to do in light of recent events, legislatively and judicially, to demonstrate our disdain for an arguable tear in the fabric of corporate governance. (Robert B. Thompson and H. Sole, "Securities Fraud and Corporate Governance: Reflections Upon Delaware," 56, Vand. L. Rev. 2003.) The article seemed to suggest that, if Delaware did not react publicly and forcefully, it would lose its pre-eminence in corporate governance.

Parenthetically, the enormous growth of alternative business organizations, especially LLCs, and the raging debate over whether corporate fiduciary duty principles should be applied to at least some unincorporated entities, suggest a retreat from the corporate form and arguably from corporate governance principles.

Some of the issues where attention should be directed include:
  • Relaxation of the demand rule in derivative cases; excusing the requirement that shareholders make demand on the board of directors for action or establishing futility of demand before filing suit. What will be the effect of federal definitions of an independent director on state case law? Do we move to inflexible codification and away from the flexibility of common law?
  • A call for a shift in emphasis in the so-called "gray director" area and for a more liberal view of factual situations that prohibit directors from entanglements that taint their independence. Should there be no shift in emphasis, will the new standard for delineating an independent director be set by federal statute, federal regulatory pronouncement or other rules?
  • Readdress Section 102(b)(7) of the Delaware General Corporation Law that exculpates directors from damages for breach of the fiduciary duty of care — even though shareholders routinely endorse the concept by amendment to corporate charters in order to encourage directors to take "reasonable risks for profit."
We recognize that there will be proposals to amend our corporation code to strengthen our ability to reach corporate officers in litigation. Why? Because few corporations' principal offices are physically located in Delaware and, therefore, their officers cannot be reached for service of process under current law. As the federal government and others press for more "independent" directors on boards, fewer corporate officers, other than perhaps CEOs, will be found among potential director defendants.

All of the above have been suggested despite that (1) none of the current corporate scoundrels prompting early calls for reform involved Delaware corporations; and (2) Enron, an Oregon corporation, operated under the Model Business Corporation Act, and had in place an updated "model" code of ethics for officers and directors.

The Securities and Exchange Commission, using the federal securities law and rules of disclosure, is attempting to chart or at least delineate inflexible definitions and a standard of conduct with penalties for noncompliance. Delaware corporations, despite the guidance of Delaware case law, are not immune from potential transgressions. The correct remedy lies in the availability of prompt definitive litigation in the Delaware courts.

The Delaware courts' traditional approach is to create incentives for good things to happen, not to punish except through public embarrassment and occasional money damages for egregious conduct. That is why the doctrinal flexibility expressed in Delaware case law stresses shareholder action and approval after recommendation from the directors; the importance of full, fair disclosure; an untainted shareholder franchise; independent committee action by disinterested directors; burden shifting and emphasis on entire fairness in certain transactions; and a reasonableness test for defensive actions in compelling circumstances.

The cases emphasizing these responses by the courts to claims of breach of fiduciary duty are, of course, transaction specific and based on facts established by the parties. Only in the narrowest terms do they suggest deviation from the still valid 1742 standard of fidelity and careful attention to detail. Pronouncements from the cases may at times seem overbroad, but they are meant to be aspirational, not dictatorial. Although Delaware judges are constrained to "contextually specific teachings under our common law," one can make the case that the Delaware approach serves to encourage people with integrity and a strong work ethic to continue to serve on boards.

What Delaware judges expect from corporate officers and directors when reviewing their conduct retrospectively is a scrupulous adherence to a process of decision making that reflects fidelity to the institution and investors that they serve. Their conduct must also show a dedication to spending the time necessary to educate themselves about the business and the facts surrounding a decision that will lead the court to have confidence that the ultimate course of action adopted was the product of a rational and careful decision- making process made in good faith.

Despite retrospective court scrutiny of their decisions and decision-making process, directors and officers of Delaware corporations who adhere to the basic, intuitive principles of loyalty and due care and who make a careful factual record supporting their adherence to those duties need not fear personal liability, personal disparagement nor the unraveling of transactions made in the best interest of the institution and investors they serve.

At the same time, the Delaware courts will continue to be open and available to redress corporate wrongs by those who seek to abuse or betray the trust they accept when they accept corporate office. In my opinion, Delaware will and should remain the first state contemplated as the forum for business litigation.

Justice Steele is a member of the Delaware Supreme Court. This article is based on remarks to New York University's Stern Executive Program in November, 2002. His e-mail is msteele@state.de.us.

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