1. In post No. 4 and post No. 11, I touched upon the tricky nature of ex post judicial review of director conduct in the business judgment realm; tricky due in part to the risks inherent to a psychological phenomenon called the hindsight bias, the tendency for people with knowledge of an outcome to exaggerate the extent to which they believe that outcome could have been predicted. I also stressed the importance of a doctrinal framework that actually provides the court with analytical guidance when reviewing entrepreneurial director conduct - in personal liability proceedings - after the event, which is often the case.
2. The above is nicely illustrated by the Court of Chancery's decision of January 24, 2009 in the case of Citigroup, Inc. Shareholders Derivative Litigation. The case is about a shareholder derivative action brought on behalf of the company, Citigroup, Inc., basically seeking to recover for the company losses arising from exposure to the subprime lending market. The essence of the claim brought against current and former directors and officers of the company was, in the words of Chancellor Chandler, that "the defendants breached their fiduciary duties by failing to properly monitor and manage the risks the Company faced from problems in the subprime lending market and for failing to properly disclose Citigroup's exposure to subprime assets." In essence, what plaintiffs argued - according to the Court, looking through the "lofty allegations of duties of oversight and red flags used to dress up these claims" - was that the defendants should be personally liable for making, or allowing to be made, business decisions that - in hindsight - turned out poorly for the company. The Court of Chancery denied most of the claims - except a corporate waste claim - in a thoroughly motivated, and one could say: pro board, opinion.
3. What I would like to highlight here is that in doing so, Chancellor Chandler went to great lengths to emphasize that Delaware courts primarily deal with these type of claims through the business judgment rule in view of the court's inadequacy, due in part to the hindsight bias, to evaluate in a responsible manner whether the corporate decision makers made a 'right' or a 'wrong' business decision (by evaluating the objective reasonableness of such a decision). The gist of the business judgment rule is, of course:
- that it only allows an objective duty of care analysis as to the preparation of the business decision, the yardstick being gross negligence, or: an irrational - not: unreasonable - decision making process; and
- that it limits substantive review of the business decision to essentially a subjective bad faith analysis;
- provided there is no material conflict of interests;
- with the burden of proof resting on the plaintiff, as the business judgment rule presumes that in making the business decision the directors acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.
4. And this approach makes sense, although one could quibble with some of the elements of the Delaware business judgment rule (see my dissertation Judicial Review of Director Conduct - Under Dutch and Delaware Corporate Law, Deventer: Kluwer 2007, chapters IV and VI-VII). The essence of the business judgment of directors is deciding how their company will evaluate the trade-off between risk and return (risk has been defined as the chance that a return on an investment will be different that expected). The core of corporate business, initiated by entrepreneurial behavior of corporate directors, is making returns by taking on risk. A company that is willing to take on more risk typically has a higher chance of failure, but also on a higher return. The sine qua non of this is that things can turn out greatly but also badly for the company, even if the sitation was not incorrectly evaluated ex ante, and that a bad result does not automatically make the business decision a 'bad' one. This is inherent to risk taking. It is really problematic, if not impossible, for a relative outsider like a reviewing court to determine ex post - and thus in hindsight, with the risk of hindsight bias! - whether the directors of a company properly evaluated risk and thus made the 'right' business decision. In order not to criple bona fide risk-taking by corporate directors, who have to act in real world circumstances, without perfect information/unlimited resources and with a future that is inherently difficult to predict, personal liability for risky business decisions taken in the best interests of the corporation but that turn out badly and result in damage for the company, should not follow easily (not even if, as in this case, the damage is pretty huge). And that is where the business judgment rule comes into play, as this mechanism - when properly applied - provides analytical guidance and prevents improper judicial second guessing. As Chancellor Chandler concluded the opinion:
Citigroup has suffered staggering losses, in part, as a result of the recent problems in the United States economy, particularly those in the subprime mortgage market. It is understandable that investors, and others, want to find someone to hold responsible for these losses, and it is often difficult to distinguish between a desire to blame someone and a desire to force those responsible to account for their wrongdoing. Our law, fortunately, provides guidance for precisely these situations in the form of doctrines governing the duties owed by officers and directors of Delaware corporations. This law has been refined over hundres of years, which no doubt included many crises, and we must not let our desire to blame someone for our losses make us lose sight of the purpose of our law. Ultimately, the discretion granted directors and managers allows them to maximize shareholder value in the long term by taking risks without the debilitating fear that they will be held personally liable if the company experiences losses. This doctrine also means, however, that when the company suffers losses, shareholders may not be able to hold the directors personally liable.
5. In the field of personal liability of directors vis-a-vis their company (just to name one field), Dutch corporate law should move from using vague personal liability standards like 'serious mistake' without any real analytical guidance toward creating a more refined doctrinal framework, to a large extent along the above lines. For a clear proposal, see my dissertation, nr. 42. Talking about 'defining tension'!
HT Francis Pileggi. Also see the observations of the Citigroup and AIG cases by Larry Ribstein.
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