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Why do We Trust Directors?

Julian Velasco poses the titular question in a post that asks:

My concern is that courts are too ready to apply the business judgment rule rather than the entire fairness test or some intermediate standard of review (and that intermediate standards of review eventually are watered down to the point where they do little more than the business judgment rule).  There are many conflicts of interests that courts simply will not recognize as affecting director independence.  Among the most important are those that stem from so-called “structural bias”. ...

Refusing to recognize entire categories of conflicts and sticking with the deference of the business judgment rule implies a great deal of trust in directors.  Whence this trust?

On the one hand, it’s a fair question. On the other hand, it’s also the wrong question. The right question would be: Why should we trust judges?

The power to review is the power to decide. Someone must have the final word. As Justice Robert Jackson once observed of the Supreme Court: “We are not final because we are infallible, but we are infallible because we are final.” The question thus is one of comparative merits. As between two possible sets of fallible decisionmakers - boards and judges - which should have the final say?

Regular readers will not be surprised to know that I think it ought to be the board in most cases. To be sure, there are situations in which accountability concerns are so pressing that we ought to allow judges to intervene. In general, however, it is well to be skeptical of judicial review of board decisions. Corporate directors operate within a pervasive web of accountability mechanisms, including competition in a number of markets. Granted, only the most naïve would assume that these markets perfectly constrain director decision making, but it would be equally naïve to ignore the lack of comparable market constraints on judicial decision making. Market forces work an imperfect Darwinian selection on corporate decision makers, but no such forces constrain erring judges.  As such, rational shareholders will prefer the risk of director error to that of judicial error.

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. To the contrary, given the potential for self-dealing in an organization characterized by a separation of ownership and control, the risk of legal liability may be a necessary deterrent against such misconduct.

I take it, however, that Velasco is not concerned with cases in which the entire board is directly interested in the transaction but rather with the more interesting case in which a minority of the board has an interest in the challenged transaction and a majority is at least nominally disinterested. This is signalled, among other things, by Velasco’s reference to 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 corproate law if we let it out of the bag.

Courts thus police conflicted interest transactions by asking, at least initially, whether the majority of the board appears to be capable of making an informed and independent decision despite the risk of actual or structural bias. If so, the arguments above for letting the board have the final word prevail. 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.