Professor Bainbridge...on law, politics, religion, culture & food

Good Faith and Risk Taking

In Business Associations today, I taught Smith v. Van Gorkom (BTW, have you read my “story” article on the case? If not, why not?) One of the issues I always raise when teaching it is the standard governing the extent to which directors must inform themselves. To quote from my Corporation Law and Economics text:

The central issue in Van Gorkom was the board’s failure to make an informed decision. The legal standard that emerges from the decision is straightforward—directors must inform themselves of all material information reasonably available to them. This standard seemingly requires an in-depth study of the problem. The board must be informed of the company’s value to the bidder, the course of the negotiations, the terms of the offer and their fairness, and the like. ...

In contrast, the MBCA and the ALI PRINCIPLES only require directors to be informed to the extent that they reasonably believe to be appropriate under the circumstances. Unlike the Delaware standard, at least as read literally, the ALI standard permits directors to make decisions on less than all reasonable available information, provided they reasonably believe doing so is appropriate given the situation. The time available to make the decision may require that the directors take risks to secure what appears to be a good outcome, which includes the risk that they do not have all of the relevant facts. A decision to accept that risk in order to secure the benefits of a proposed transaction will be appropriate under some circumstances.

Is the Delaware standard in fact substantively different than the ALI/MBCA one? In Brehm v. Eisner, the Delaware supreme court stated that:

Compare the American Law Institute test, which requires that a director must be “informed ... to the extent the director reasonably believes to be appropriate under the circumstances.” Principles of Corporate Governance, supra note 30, at § 4.01(c)(2). Because this test also is based on the objective test of reasonableness, it could be argued that it is essentially synonymous with the Delaware test. But there is room to argue that the Delaware test is stricter. See Roswell Perkins, ALI Corporate Governance Project in Midstream, 41 Bus.Law. 1195, 1210-11 (1986). In the end, the debate may be mostly semantic

So let’s assume that the difference is not just semantic. Let’s further assume that a board conscious decided to make a decision even though the directors knew that there were factors as to which they were uninformed, and which might make the decision look bad in hindsight, but the opportunities available justified taking that risk and going forward on the basis of incomplete information. Under Stone v. Ritter--and, especially, Ryan v. Lyondell--this scenario raises a new and even more troubling question.

In Stone, the Delaware Supreme Court held that: “In Disney, we identified the following examples of conduct that would establish a failure to act in good faith: ... where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.” Would directors who conscious decided to take action even though they knew there were facts they didn’t know therefore have acted in bad faith? It would seem as though they consciously failed to act in the face of their duty to gather all material information reasonably available to them.

One would hope that the doctrine of good faith will not deter risk taking. After all, a key rationale of the business judgment rule is to encourage risk taking. Good faith shouldn’t be allowed to gut that key function.

There are two ways the Delaware courts could get at this problem and I would advocate both. First, Delaware should explicitly adopt the MBCA/ALI standard that requires directors to inform themselves to the extent the directors reasonably believe required under the circumstances. This would allow the directors to take appropriate risks with respect to information. Second, Delaware should make it clear that the conscious disregard prong of good faith relates only to duties involving self-dealing. This would clarify that good faith cannot be used to end run the prohibition on judicial review of substantive due care.