April 13, 2007
The Difference Between Revlon and the Business Judgment Rule
Posted by Gordon Smith

Vice-Chancellor Strine's opinion in In re Netsmart Technologies, Inc. Shareholders Litigation was issued a month ago, and I have been pondering it ever since. This case has a lot of interesting features, and I hope to blog about some others later. For this post, however, I concentrate on Leo's attempt to distinguish the Revlon standard from the business judgment rule:

What is important and different about the Revlon standard is the intensity of judicial review that is applied to the directors' conduct. Unlike the bare rationality standard applicable to garden-variety decisions subject to the business judgment rule, the Revlon standard contemplates a judicial examination of the reasonableness of the board's decision-making process. Although linguistically not obvious, this reasonableness review is more searching than rationality review, and there is less tolerance for slack by the directors. Although the directors have a choice of means, they do not comply with their Revlon duties unless they undertake reasonable steps to get the best deal.

The distinction between rationality review and reasonableness review has been around for awhile. Vice-Chancellor Strine first articulated the difference in In re Toys 'R' Us, Inc. Shareholder Litigation (2005), and he took his cues in that case from Revlon itself and from QVC, both Delaware Supreme Court opinions.

The interesting part of the contrast between rationality and reasonableness is not what it says about the Revlon standard, but what it says about the business judgment rule. Outside of opinions by Vice-Chancellor Strine, it's hard to find Delaware cases that refer to the business judgment rule as a "rationality standard" or "rationality test." There is, of course, the oft-quoted statement from Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del.1971): "A board of directors enjoys a presumption of sound business judgment, and its decisions will not be disturbed if they can be attributed to any rational business purpose." But the reference to rationality in that context is pretty clearly a reference to the substance of the board decision, not the process by which the decision was made. The distinction between substance and process is evident in the Supreme Court's Unitrin opinion:

The effect of a proper invocation of the business judgment rule, as a standard of judicial review, is powerful because it operates deferentially. Unless the procedural presumption of the business judgment rule is rebutted, a "court will not substitute its judgment for that of the board if the [board's] decision can be 'attributed to any rational business purpose.'" (quoting Unocal, which was quoting Sinclair)

In my quick search of the Delaware cases, I found only one instance other than Vice-Chancellor Strine's opinions in which the courts has referred to the rationality of the process. That case was Chancellor Allen's Caremark opinion:

What should be understood, but may not widely be understood by courts or commentators who are not often required to face such questions, is that compliance with a director's duty of care can never appropriately be judicially determined by reference to the content of the board decision that leads to a corporate loss, apart from consideration of the good faith or rationality of the process employed. That is, whether a judge or jury considering the matter after the fact, believes a decision substantively wrong, or degrees of wrong extending through "stupid" to "egregious" or "irrational", provides no ground for director liability, so long as the court determines that the process employed was either rational or employed in a good faith effort to advance corporate interests. To employ a different rule-one that permitted an "objective" evaluation of the decision-would expose directors to substantive second guessing by ill-equipped judges or juries, which would, in the long-run, be injurious to investor interests. Thus, the business judgment rule is process oriented and informed by a deep respect for all good faith board decisions. (emphasis added)

Chancellor Allen's dismissal of substance is only slightly hyperbolic, but the more important point is that even here, the business judgment rule is not a "bare rationality standard," but a standard predicated on the good faith of the board of directors.

I am curious to see whether Vice-Chancellor Strine's characterization of the business judgment rule as a rationality standard catches with the other Delaware judges. As with so many issues relating to the duties of directors, however, the exact formulation of the business judgment rule may not matter much because the important point is the directors are (almost) never liable.

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