August 11, 2005
Risk-taking & Fiduciary Duty
Posted by Gordon Smith

One important justification for judicial deference towards directors relates to the desire to promote risk-taking. I am interested in exploring a simple question: would imposing liability on Disney's directors dampen the enthusiasm of other directors for risk?

Corporate lawyers are fond of distinguishing between the substance of a decision and the process by which a decision is made. In the Disney case, for example, the plaintiffs challenged both the substance of the board's decisions to hire and fire Michael Ovitz under the terms of his employment agreement (arguing that he was paid too much for his services) and the process by which those decisions were made (arguing that the directors did not adequately consider their decisions). The substantive claims fall under the heading of "waste" and the procedural claims fall under the headings of "due care" and "good faith" (and, with respect to Ovitz, "loyalty").

The risk-taking rationale for the business judgment rule appears to focus on the substance of board decisions. Courts refrain from second-guessing board decisions, even when they turn out badly, because courts want to encourage directors to consider risky strategies without worrying about personal liability if the strategies fail. At the same time, courts do not want to encourage sloppy procedures! As a result, application of the business judgment rule is premised on fulfilling minimum procedural requirments. Consider Chancellor Allen's canonical description of the risk-taking rationale for the business judgment rule, which Chancellor Chandler quoted in fn 407 of the Disney opinion:

Corporate directors of public companies typically have a very small proportionate ownership interest in their corporations and little or no incentive compensation. Thus, they enjoy (as residual owners) only a very small proportion of any “upside” gains earned by the corporation on risky investment projects. If, however, corporate directors were to be found liable for a corporate loss from a risky project on the ground that the investment was too risky (foolishly risky! stupidly risky! egregiously risky!—you supply the adverb), their liability would be joint and several for the whole loss (with I suppose a right of contribution). Given the scale of operation of modern public corporations, this stupefying disjunction between risk and reward for corporate directors threatens undesirable effects. Given this disjunction, only a very small probability of director liability based on “negligence”, “inattention”, “waste”, etc. could induce a board to avoid authorizing risky investment projects to any extent! Obviously, it is in the shareholders’ economic interest to offer sufficient protection to directors from liability for negligence, etc., to allow directors to conclude that, as a practical matter, there is no risk that, if they act in good faith and meet minimalist proceduralist standards of attention, they can face liability as a result of a business loss.

Gagliardi v. TriFoods Int’l Inc., 683 A.2d 1049, 1052 (Del. Ch. 1996).

Notice that Chancellor Allen presumes that the directors "act in good faith and meet minimalist proceduralist standards of attention." In other words, if the process is adequate, the court will not second-guess the substance. Of course, the main point of the Disney case was to determine whether the process used by Disney's directors was adequate to justify the protections of the business judgment rule. Now we are getting to the crux of the matter: does the desire not to second-guess substance require judicial restraint in second-guessing process?

In a word, yes.

Remember that courts are asked to review a board's decision-making process only when a decision has turned out badly. Under such circumstances, plaintiffs inevitably find procedural infirmities, and the temptation to engage in hindsight reasoning is enormous. Surely the directors should have anticipated the events that ultimately led to this disaster!

If courts are serious about encouraging risk taking by directors, such reasoning must be confined to a limited range of cases, and Delaware has done just that. After Smith v. Van Gorkom, the Delaware legislature essentially took the duty of care off the table, and the Disney decision limits the duty of good faith to an exceedingly small set of cases. Generally speaking, therefore, the Delaware courts will intervene with board decisions only when directors are subject to a conflict of interest. This was the point recently made by Larry Ribstein. If the Delaware courts attempted to be more aggressive, Chancellor Chandler warned of dire consequences: "The entire advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation would cease to exist, with disastrous results for shareholders and society alike."

This brings us back to the question that started this post: would imposing liability on Disney's directors dampen the enthusiasm of other directors for risk? In my view, this would happen only if the actions of Disney's directors were viewed as falling within the range of ordinary director behavior. If the Disney directors were portrayed as having abdicated their directorial responsibilities -- and the facts on this are quite close -- then imposing liability would not have the ripple effects described by Chancellor Chandler.

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