October 30, 2007
Bainbridge on Trusting Directors
Posted by Julian Velasco

Professor Bainbridge has commented on my earlier post, Why Do We Trust Directors?  He begins by turning the question around ("Why should we trust judges?") and providing what is essentially a defense of the business judgment rule.  I am whole-heartedly in agreement with that doctrine (although not necessarily his defense of it).  He then goes on to get to the real issue, structural bias:

Although most academics focus on structural bias solely in the context of special litigation committees in derivative litigation, it is a much wider problem. If purportedly independent directors are likely to favor their fellow directors when the latter are sued, they are equally likely to do so in any conflict of interest situation. As somebody once said, the structural bias argument thus has no logical terminus. It would swallow up most of corporate law if we let it out of the bag.

I've heard this argument before, but I am entirely unconvinced.  There is a logical terminus: at most, structural bias only covers "any conflict of interest situation"; it does not cover most situations, which do not involve conflicts of interest.  In fact, in my article on structural bias, I note the three main situations in which structural bias is an issue: derivative litigation, hostile takeovers, and executive compensation.  (There is a fourth: proxy contests not involving a hostile takeover.)  This is not a particularly large universe.  Derivative litigation and control contests are relatively rare.  Only executive compensation poses a real problem, because of its ubiquity.

(In my article, I suggest a review for substantive reasonableness which is not quite as deferential as the business judgment rule's rationality standard, but still deferential enough to be decided as a question of law as a threshold matter.  This would not involve too much judicial interference, but would allow courts to reach a case such as Brehm v. Eisner (2000), which the court itself described as "a close case" which "pushes the envelope of judicial respect for the business judgment of directors ....")

The business judment rule counsels that directors, being experts, generally are better at making business decisions than judges.  However, the entire fairness test counsels that conflicted experts are not be better than unconflicted judges.  Bainbridge admits as much:

To be sure, this argument has no traction where a majority of the board is disabled by conflicting interests. The shareholders’ preference for abstention, however, extends only to board decisions motivated by a desire to maximize shareholder wealth. Where the directors’ decision was motivated by considerations other than shareholder wealth, as where the directors engaged in self-dealing or sought to defraud the shareholders, however, the question is no longer one of honest error but of intentional misconduct. Despite the limitations of judicial review, rational shareholders would prefer judicial intervention with respect to board decisions so tainted.  The affirmative case for disregarding honest errors simply does not apply to intentional misconduct.

The problem with Bainbridge's argument is that it assumes that judicial review is limited to cases involving intentional misconduct.  That is simply not true.  The entire fairness test is invoked not by intentional misconduct, but rather by the mere existence of self-dealing (i.e., a situation where the directors stand on both sides of a transaction, or receive something from the company to the exclusion of, and detriment to, the shareholders).  Because of the conflict, we switch the burden of proof: rather than requiring the shareholder plaintiffs to prove misconduct, we require the directors to prove that the transaction was entirely fair.  The protection of the business judgment rule is lost not by intentional misconduct, but by a conflict of interest.

The claim regarding structural bias is that it presents a similar conflict of interest and deserves similar treatment.  Of course, the claim can be rejected -- and it is, by some.  But Bainbridge doesn't seem to be in that camp.  Rather, he seems to suggest that practical considerations outweigh the theoretical ones.  One such consideration has already been discussed above.  Another is as follows:

To be sure, some cases in which the board majority’s decision was swayed by actual or structural bias thus escape judicial review. But so what? Such cases will not escape market review.

Of course, the same could be said of self-dealing.  And my response would be the same: it is not clear that "such cases will not escape market review"; and, even if so, the inefficiency in the market review process allows management to do quite a bit of damage (and/or become quite enriched) before they are replaced.  To me, that is significant enough to merit attention.

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