[No. 11] Some Reflections on the Director Liability Threshold 'Serious Mistake'

1. In post No. 7 I made some remarks about secondary director liability under Dutch corporate law and mentioned that, in my opinion, the personal liability threshold 'serious mistake'  - as developed in Supreme Court case law - could use some further development, especially in the section 2:9 DCC setting. In this post, I will elaborate a bit more on my thoughts in this respect.

2. Section 2:9 DCC mandates that every director - both managing and supervisory - of a legal entity must fulfill his tasks vis-a-vis the legal entity in a proper manner. The second sentence of section 2:9 DCC deals with disculpation, but I will not discuss that here. Section 2:9 DCC is not limited to corporations, but also includes for example foundations. Violation of this 'proper management' requirement results in personal liability of the director towards the legal entity. As the Supreme Court has made clear since 1997, personal lability based on section 2:9 DCC requires that the director - in view of all the circumstances of the case at hand - has made a 'serious mistake'. The Supreme Court has never really made clear what the anatomy of such a 'serious mistake' is, as required in the section 2:9 DCC setting; it has made clear:

• that a 'serious mistake' is not the same as intentional misconduct/conscious recklessness;
• that the circumstance that the director has violated a provision in the legal entity's articles of association that aims to protect the legal entity - like the provision mandating supervisory board approval for certain transactions - in principle results in personal liability (i.e., there is an assumption of a 'serious mistake'), although the director does have the possibility to show that on balance that violation does not qualify as a 'serious mistake'; and
• that the circumstances that could play a role in the personal liability analysis include: the nature of the activities undertaken by the legal entity, the risks generally involved with those activities, a division of tasks within the board (if any), guidelines the board has to take into account (if any), information the director had or should have had at the time of the decision or act complained of, and the knowledge and care that can be expected of a director that is up to his task and fulfills this task in a diligent manner.

3. It is quite generally held in legal literature, although not by me, that it is not possible at all to exculpate directors for personal liability based on section 2:9 DCC ex ante. However, there is no case law on point that I know of.

4. In this post, I would like to make four concise remarks about the above (leaving aside the exculpation discussion; that's for another day).

1. As I have explained elsewhere, it is my impression that in the eyes of the Supreme Court, the 'serious mistake' requirement is not limited solely to the degree of culpability that is required for personal liability, as is typically stated in legal literature (and, sometimes, in case law). A 'serious mistake' implies, in view of all the circumstances at hand, (i) a violation of an applicable standard of conduct by the director (ii) for which the director can be blamed (or, broader: that is attributable to the director), that is sufficiently serious to justify personal liability. In other words and in short, the 'serious mistake' standard has two basic components: (i) a violation of a standard of conduct (ii) that is attributable - leaving aside the vague over-all requirement of 'sufficient seriousness'; if one includes this, there are three components. As the Supreme Court seems to interpret a 'serious mistake' as always requiring, on balance, more than 'normal'/'basic' - or: qualified - careless behavior (after all: a neutral, non-qualified mistake apparently doesn't suffice), a 'serious mistake' will typically also involve a more than 'normal'/'basic' - or: qualified - degree of culpability. The latter more or less follows from the former. See my remarks in my dissertation, nr. 42a.-b. (Judicial Review of Director Conduct - Under Dutch and Delaware Corporate Law, Deventer: Kluwer 2007) and JOR 2008/89. It would be a good thing if the Supreme Court could be a bit more clear about this mechanism in future cases.
2. As the Supreme Court has made clear in its decision of June 20, 2008, s. 5.3, director liability based on section 2:9 DCC requires that the director has made a 'serious mistake' and that the 'serious mistake' standard must be seen as a high threshold for personal liability. This implies two things: (i) the personal liability standard is by definition 'serious mistake' and (ii) the resulting liability threshold is by definition high. In my opinion, this approach needs nuancing. In some circumstances it makes sense to apply a high personal liability threshold, especially when the subject of debate is whether the director conduct complained of involved business judgment type of questions. Then there is, for example, the real risk that the court's ex post analysis is tainted by the hindsight bias and results in wisdom after the event, which could deter bona fide directors from risk taking in fear of personal liability when risky entrepreneurial decisions turn out badly for the corporation (and some of them by definition do). In those scenario's, assuming (i) the director appears prima facie to have acted in subjective good faith (meaning he/she believed he/she did the right thing, in view of the corporation's best interests) and (ii) there is no debilitating conflict of interests (or, if so, there is a neutral decisionmaker - like the general meeting of shareholders - who approved the director conduct in an informed and bona fide manner), it makes sense to apply a director friendly 'objective care' test, or: standard of review. As I have argued in my dissertation, 42a.-b., I believe it makes sense to limit - not: eliminate - objective judicial review (to which I limit myself here) of the preparation and the substance of the business judgment to an irrationality review, not also covering the reasonableness of the director conduct complained of: the requirement of reasonable care under the circumstances is the applicable standard of conduct here, but not also the applicable standard of review. This also eliminates any real possibility of so-called 'Monday morning quarterbacking'. If the director - in view of the circumstances of the case at hand - clearly acted irrationally (i.e., bizarrely, in a totally inexplicable manner), which would require really exceptional circumstances that are often, but not invariably, indicative of bad faith (i.e., disloyalty) and which normally would also suggest the director can be blamed for this standard of conduct violation (irrational behavior implies unreasonable behavior), this would generally qualify as the 'serious mistake' currently required for section 2:9 DCC director liability. But if there is a material conflict of interests, the director standard of conduct and the judicial standard of review would (i) not diverge and (ii) be stricter for the conflicted director, both in order to protect the corporation against unfair self-dealing and the like (this is the policy rationale). In that scenario, where both the standard of conduct and the corresponding standard of review - treat the corporation objectively fairly! (not the same as acting in subjective good faith, i.e., loyally) - are way less director friendly, a director could more easily be said to have violated the standard of conduct (fairness), through the corresponding standard of review (fairness). In view of this, it makes less sense to me to automatically qualify such mistakes - that in my opinion, and from a policy rationale perspective, could very well result in personal liability - as 'serious mistakes' in the sense of qualified/grossly careless behavior (let alone to rigorously require a 'serious mistake' for personal liability). The reason being that in this setting, mistakes that suffice to accept that the applicable standard was violated clearly need not be as egregious as is required under irrationality review, and that could rightfully be qualified as 'serious mistakes' - from a standard violation point of view - due to the divergence of standard of conduct and standard of review. I see no clear policy objection against treating materially conflicted directors differently from non-conflicted directors, in the sense that the former may very well run significantly higher risks of personal liability vis-a-vis the corporation than the latter, as long as this consequence is clear; this is the basic difference between on the one hand self-dealing acts, when the care requirement intensifies and - correspondingly - the personal liability threshold may be 'normal' mistakes, versus on the other hand purely entrepreneurial acts, when the care requirement loosens and the personal liability threshold will normally be a 'serious mistake'. Such a more controlled application of the 'serious mistake' standard - i.e., not the standard, but the standard for certain situations - could be well combined with the introduction of a Dutch version of the business judgment rule, something I believe is seriously lacking in Dutch corporate law. See, e.g., here and - more in detail - my dissertation, chapters VI and VII. Under current law, the 'serious mistake' standard of section 2:9 DCC offers neither directors nor reviewing courts any meaningful analytical guidance.
3. When the director is conflicted and there is no clear approval by a neutral and informed decision maker within the corporation, I believe it makes sense to place the burden of proof on the director, meaning it is up to him/her to show - assuming there is prima facie good faith - that the corporation was all in all treated objectively fairly (with elements of fair dealing and fair price) and hence that there was no 'improper management'. If the director fails to do so, there is 'improper management' and the director is liable for the damage suffered by the corporation as a consequence thereof. I do not believe the same technique should be used as mentioned under the second bullet above, meaning that if the director is materially conflicted, this results in an assumption of a 'serious mistake' and thus of personal liability (see in that direction, as I understand it, L. Timmerman, Ondernemingsrecht 2009-1, p. 11). The reason is that in itself - unlike the violation of a provision in the corporation's articles of association that aims to protect the corporation - a conflict of interest is not something one is guilty of, something that is wrong or something that suggests bad faith. The fact of the matter is that conflict of interests transactions happen a lot and can be, and quite often are, beneficial to the corporation. The key question is how the director dealt with the conflict of interest, in view of the fact that the material conflict of interests does create the risk - not the certainty! - that not the best interests of the corporation, but the best interests of the director prevailed. In other words, and as always: did the director act loyally (i.e., in good faith) and carefully? The fact that the director is conflicted influences the analysis, through the standard of conduct and the corresponding standard of review. See, e.g., here and my dissertation, nr. 38.e. An assumption of wrongdoing (i.e., a culpable violation of a standard of conduct), let alone an assumption of a 'serious mistake' and thus of personal liability (even leaving aside my above observations), simply because of the existence of a conflict of interests and nothing more, is in my opinion not an entirely proper way for a reviewing court to deal with this complicated area of the law. I note that the outcome may not differ that much, but I also note that courts should be careful to assume to many things too easily and that if they do, there at least must have been - some - prove of wrongdoing, as was the case in the Supreme Court's decision of November 29, 2002, the case in which the Supreme Court decided as paraphrased under the second bullet above (see here). The single circumstance that there was a conflict of interests does not justify such an assumption of personal liability, at least not in my book. The key question should be: was there an attributable standard of conduct violation? Depending on the circumstances, the burden of proof can rest on the director. If the corporation has the burden of proof (Dutch law does not know the derivative suit, see here) and is in itself able to show - essentially - the existence of a prima facie attributable standard of conduct violation, it may be possible - also depending on the standard of conduct involved (think of a pretty clear-cut violation of the corporation's articles of association) - for the director to escape personal liability by showing, in short, that in view of all the other circumstances of the case at hand that would not be a just outcome (for example because, after all, the conclusion must be that in view of the facts shown by the director, he could not realistically have acted differently).
4. In my opinion, the threshold of director liability based on section 2:9 DCC is not - or better: should not be - the same as the threshold for director liability based in tort (i.e., on section 6:162 DCC). As I explained in post No. 7, Dutch corporate law generally also uses the 'serious mistake' standard of liability in the tort setting. The rationale is that in those circumstances, the corporation is normally the only party that may be liable. Personal liability of a director in tort therefore requires a higher threshold than the ordinary tort liability threshold. In the section 2:9 DCC setting, the rationale for applying a more director friendly personal liability standard is related to the difficulties inherent to judging director activity in the business judgment realm that is not tainted by a conflict of interests (see above). In my opinion, whereas it makes sense to apply the 'serious mistake' requirement generally in the section 6:162 DCC setting (in view of its rationale) but not generally in the section 2:9 DCC setting (in view of its rationale), director liability in the tort setting should normally - generally speaking - be somewhat less likely than director liability in the section 2:9 DCC setting. Again, those interested in the doctrine of secondary director liability should really read Simone de Valk's wonderful dissertation about liability of managers of legal entities (see here for further information).

I am interested to learn what others think of this, so please feel free to leave comments.