Business Judgment Rule Research Articles

In Praise of Procedure: An Economic and Behavioral Defense of Smith v. Van Gorkom and the Business Judgment Rule

The business judgment rule is one of the most puzzling and widely-criticized doctrines in corporate law. As described in Smith v. Van Gorkom, the rule prohibits courts from second-guessing the wisdom of disinterested corporate directors' substantive decisions. Instead, courts may consider only the quality of the boards' decisionmaking process and particularly whether the board informed itself before taking action. This focus on procedure seems dysfunctional from a rational choice perspective. If directors are rational and self-interested actors, imposing liability on them for following shoddy procedures does not in itself give them incentive to exercise due care. It only gives them incentive to adopt more elaborate, and more expensive, procedures. In this essay I argue that the business judgment rule can be understood if we are willing to modify the homo economicus model of human behavior that underlies rational choice analysis to take account of the reality of socially contingent altruism. Extensive empirical evidence demonstrates that altruistic behavior is both a common and a predictable phenomenon. In particular, numerous studies of behavior in experimental social dilemma games demonstrate that altruism is easily triggered by social context (e.g., subjects' beliefs regarding others' needs, expectations, or behavior). These studies also demonstrate, however, that altruistic behavior tends to diminish as the personal sacrifice involved increases. This last finding suggests that the business judgment rule can be best understood as a mechanism for encouraging director altruism, in the form of a sense of obligation to the firm and its shareholders, by reducing the marginal personal costs associated with altruistic director behavior. In particular, I argue that the rule (1) reduces directors' marginal cost of comprehending what is going on at the firm and what the likely consequences of alternative courses of action might be, and (2) reduces directors' marginal cost of confronting the firm's managers to demand more information or to challenge a management-recommended course of action. The result is that the business judgment rule's procedural focus may provide an elegant, second-best solution to the problem of encouraging director care in situations where courts cannot assess the substantive wisdom of directors' decisions.

Change of Control Board: Federal Preemption of the Law Governing A Target's Directors

This article sets out a proposed federal uniform standard governing the actions by the board of directors of a publicly held corporation that is the target of a change of control transaction. This proposal would apply in each of the following four merger and acquisition transactions: (1) the acquisition of a target in an arm's length negotiated merger or acquisition; (2) the acquisition of a target in a management buyout; (3) the proposed acquisition of a target in a hostile tender offer; and (4) the acquisition by a target's controlling shareholder of the minority interests in such target in a freezeout merger. Under this proposal, an independent and knowledgeable change of control board would be appointed for the target, and this board would have complete authority over the acquisition process. Because of the board's obvious independence, a uniform governance standard, the business judgment rule, would apply in determining if the board acted properly. Thus, this article proposes that federal law preempt state law rules governing the actions of a publicly held target's board in each of these transactions. However, this is only a default rule because a corporation's shareholders could elect not to have the provision apply or could elect to have it apply only in certain circumstances, such as in a hostile tender offer. The adoption of this provision would enhance the competition for corporate governance rules in change of control transactions. This proposal would replace the four separate governance rules generally applicable to a target's directors under Delaware and other state law in arm's length transactions, management buyouts, tender offers, and freezeouts. This article also rejects the four sets of rules proposed for these transactions in the American Law Institute's PRINCIPLES OF CORPORATE GOVERNANCE: ANALYSIS AND RECOMMENDATION. This proposal would also override all state takeover laws, such as control share statutes, business combination statutes and disgorgement statutes, which generally have the purpose or effect of protecting incumbent management. By placing the control of the change of control process in the hands of truly disinterested directors and applying the business judgment rule in all cases in which a change of control board acts, this proposal should cure the problem of unpredictability and vagueness, should result in a substantial decrease in litigation in change of control situations, and should enhance the efficiency of the change of control market.

Islands of Conscious Power: Law, Norms, and the Self-Governing Corporation

This article provides a theory of the relation between legal and non legally enforceable rules and in the corporation, and then uses that theory to analyze a variety of prominent features of corporate law. In the first part, we draw on recent developments in the theory of the firm to identify key problems facing participants in the firm. In developing this approach, we combine the property strand in the theory of the firm with the transaction cost approach. From this perspective, the main issue is solving the related problems of coordinating activities, choosing the firm's assets, and developing appropriate incentives for specific investments. In part II, we argue that the firm so understood will largely be governed through norms, by which we mean non-legally enforceable rules and standards (NLERS). Indeed, the raison d'etre of firms is to replace legal/contractual governance of relations with NLERS. Using this framework, in part III, we analyze the duty of loyalty. In part IV, we analyze the duty of care and the business judgement rule, and a variety of other puzzling features of corporate law. From our perspective, corporate law can be understood as a remarkably sophisticated mechanism for facilitating governance by NLERS. Centralized management is used to determine the assets over which the corporation must have residual rights of control and to develop a governance structure for protecting the match-investments of insiders in these assets. Legal rules provide the default settings through which centralized management operate and prohibit non pro rata distributions (a combination of ex ante rules and the ex post duty of loyalty), which pushes controlling shareholders to maximize the value of the firm. Having established an incentive compatible legal form that facilitates NLERS governance, the law must be careful not to undermine that governance by midstream interference. Here, the duty of care and the business judgment rule are critical. The business judgement rule acts as a jurisdictional rule that facilitates a self governing NLERS relationship by preventing parties from turning to third party adjudicators. As such, it plays a role very similar to the role of the employment at will doctrine in employment law and for the same reasons. This analysis provides an explanation for why the duty of care, despite its appearance, does not function as a negligence rule, and why liability for directorial malpractice is so much less common than liability for other forms of professional malpractice, such as, legal or medical. The principal contexts in which the BJR does not apply are situations in which NLERS governance breaks down, generally because of last period temptations to defect. The difference in the ability of NLERS to govern midstream and end games provides the key to understanding a variety of corporate law puzzles. These puzzles include: the asymmetry between the legal governing purchases and sales of assets; the asymmetry between judicial review over decisions to resist all bids for control (just say no) versus the review of sales of control; and the demand requirement in derivative litigation.

Islands of Conscious Power: Law, Norms and the Self Governing Corporation

This article provides a theory of the relation between legal and non legally enforceable rules and in the corporation, and then uses that theory to analyze a variety of prominent features of corporate law. In the first part, we draw on recent developments in the theory of the firm to identify key problems facing participants in the firm. In developing this approach, we combine the property strand in the theory of the firm with the transaction cost approach. From this perspective, the main issue is solving the related problems of coordinating activities, choosing the firm's assets, and developing appropriate incentives for specific investments. In part II, we argue that the firm so understood will largely be governed through norms, by which we mean non-legally enforceable rules and standards (NLERS). Indeed, the raison d'etre of firms is to replace legal/contractual governance of relations with NLERS. Using this framework, in part III, we analyze the duty of loyalty. In part IV, we analyze the duty of care and the business judgement rule, and a variety of other puzzling features of corporate law. From our perspective, corporate law can be understood as a remarkably sophisticated mechanism for facilitating governance by NLERS. Centralized management is used to determine the assets over which the corporation must have residual rights of control and to develop a governance structure for protecting the match-investments of insiders in these assets. Legal rules provide the default settings through which centralized management operate and prohibit non pro rata distributions (a combination of ex ante rules and the ex post duty of loyalty), which pushes controlling shareholders to maximize the value of the firm. Having established an incentive compatible legal form that facilitates NLERS governance, the law must be careful not to undermine that governance by midstream interference. Here, the duty of care and the business judgment rule are critical. The business judgement rule acts as a jurisdictional rule that facilitates a self governing NLERS relationship by preventing parties from turning to third party adjudicators. As such, it plays a role very similar to the role of the employment at will doctrine in employment law and for the same reasons. This analysis provides an explanation for why the duty of care, despite its appearance, does not function as a negligence rule, and why liability for directorial malpractice is so much less common than liability for other forms of professional malpractice, such as, legal or medical. The principal contexts in which the BJR does not apply are situations in which NLERS governance breaks down, generally because of last period temptations to defect. The difference in the ability of NLERS to govern midstream and end games provides the key to understanding a variety of corporate law puzzles. These puzzles include: the asymmetry between the legal governing purchases and sales of assets; the asymmetry between judicial review over decisions to resist all bids for control (just say no) versus the review of sales of control; and the demand requirement in derivative litigation.

Why a Board? Group Decisionmaking in Corporate Governance

The default statutory model of corporate governance contemplates not a single hierarch but rather a multi-member body that acts collegially. Why? This article reviews evidence that group decisionmaking is often preferable to that of individuals, focusing on evidence that groups are particularly likely to be more effective decisionmakers in settings analogous to those in which boards operate. Most of this evidence comes not from neo-classical economics, but from the behavioral sciences. In particular, cognitive psychology has a long-standing tradition of studying individual versus group decisionmaking. This article contends that behavioral research, taken together with various strands of new institutional economics, sheds considerable light on the role of the board of directors. In addition, the analysis has implications for several sub-regimes within corporate law. Are those sub-regimes well-designed to encourage optimal board behavior? Two such sub-regimes are surveyed here: First, the seemingly formalistic rules governing board decisionmaking processes turn out to make considerable sense in light of the experimental data on group decisionmaking. Second, the adverse consequences of judicial review for effective team functioning turns out to be a partial explanation for the business judgment rule.

Corporate Law’s Limits

A strong theory has emerged that the quality of corporate law in protecting distant shareholders primarily determines whether ownership and control separate. The theory helps to convincingly explain why separation is weak in transition and developing nations. But in several rich nations, although legal structures as measured protect shareholders well, separation is shallow. Something else has impeded separation. Separation should be narrow if shareholders face high managerial agency costs if ownership diffused. But most managerial agency costs are not corporate law's focus. Judicial doctrine attacks self‐dealing, not business decisions that hurt stockholders. Indeed, the business judgment rule puts beyond direct legal inquiry most key agency costs—such as overexpansion, overinvestment, and reluctance to take on profitable but uncomfortable risks. Even if a nation's core corporate law is perfect, it directly eliminates self‐dealing, not most managerial mistake or most misalignment with shareholders. If the risk of managerial misalignment varies widely from nation to nation, or from firm to firm, ownership structures should also vary widely, even if conventional corporate law tightly protected shareholders everywhere from insider machinations. I show why this variation in managerial alignment is likely to have been deep.

An Institutional Innovation to Reduce the Agency Costs of Public Corporate Bonds

An Institutional Innovation to Reduce the Agency Costs of Public Corporate Bonds

Corporate Law's Limits

A strong theory has emerged that the quality of corporate law primarily determines whether ownership and control separate, particularly to the extent law stymies controllers' self-dealing transactions that damage minority stockholders. But in several rich nations, shareholders seem satisfactorily protected, but separation is narrow. Something else has impeded separation. Separation should be narrow if shareholders face very high managerial agency costs if ownership diffused. But these agency costs are not corporate law's focus. Judicial doctrine attacks self-dealing, not business decisions that are bad for stockholders. Indeed, the business judgment rule puts beyond direct legal inquiry most key agency costs - such as over-expansion, over-investment, and reluctance to take on profitable but uncomfortable risks. Thus, even if a nation's core corporate law is 'perfect,' it directly eliminates self-dealing, not most managerial mistake or most misalignment with shareholders. If the risk of managerial misalignment varies widely from nation-to-nation, or from firm-to-firm, ownership structure should also vary widely, even if conventional corporate law tightly protected shareholders everywhere from insider machinations. I show why this variation in managerial alignment is likely to have been deep.

Towards a European Modified Business Judgment Rule for Takeover Law

Although mergers and acquisitions activity in Europe has reached unprecedented levels, almost doubling in the past year alone,1 hostile takeovers are still the exception, not the rule, especially in Germany.2 The British telecommunication concern Vodafone's 141 billion Euro takeover bid for its German counterpart, Mannesmann, in December 1999 was the first successful hostile bid for a major German company in postwar history.3 The legal environment for hostile takeovers differs significantly among the Member States of the European Union.4 The most developed regulation is the Code on Take-Overs and Mergers (the City Code), a voluntary agreement concluded by financial institutions in the of London.5 In Germany a

Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law

Conventional legal and economic analysis assumes that opportunistic behavior is discouraged and cooperation encouraged within firms primarily through the use of legal and market incentives. This presumption is embodied in the modern view that the corporation is best described as a nexus of contracts, a collection of explicit and implicit agreements voluntarily negotiated among the selfishly rational parties who join in the corporate enterprise. In this article we take a different approach. We start from the observation that, in many circumstances, legal and market sanctions provide at best imperfect means of regulating behavior within the firm. We consider an alternate hypothesis: that corporate participants often cooperate with each other not because of external constraints, but because of internal ones. In particular, we argue that the behavioral phenomena of internalized trust and trustworthiness play important roles in encouraging cooperation within firms. In support of this claim, we survey the extensive experimental evidence that has been produced over the past four decades on human behavior in This evidence demonstrates that internalized trust is a common phenomenon; that it is at least in part learned rather than innate; and that different individuals vary in their inclinations toward trust. Most important, the experimental evidence indicates that decisions whether or not to trust others are in large part determined by social context rather than external payoffs. By altering social context - subjects' perceptions of others' beliefs, expectations, likely actions, and relationships to themselves - experimenters can reliably produce everything from nearly universal trust, to an almost complete absence of trust, in subjects in social dilemmas. In other words, most people behave as if they have two personalities or preference functions. One is competitive and self-regarding. The other is cooperative and other-regarding. Social framing is key in triggering when the cooperative personality emerges. These behavioral findings carry important implications for corporate law. For example, in this article we demonstrate first that the phenomenon of trust offers insight into the substantive structure of corporate law and particularly the nature and purpose of that elusive legal concept, fiduciary duty. In the process, it adds weight to the claims of anticontractarian corporate scholars who argue against the notion that corporate officers and directors should be free to contract out of their fiduciary duty of loyalty. Second, the experimental evidence on trust sheds light on how corporate law works, by suggesting how judicial opinions in corporate cases direct corporate officers' and directors' behavior not only by altering their external incentives but also by changing their internalized preferences. This possibility helps explain the notoriously puzzling relationship between the duty of care and the business judgment rule. Third, trust highlights the limited power of law by explaining how cooperative patterns of behavior can sometimes develop within firms even when external incentives, such as legal sanctions, are unavailable or ineffective. In the process, it underscores the dangers of the contractarian approach by suggesting how an excessive emphasis on external sanctions - including formal contract and even the rhetoric of contract - may be not only ineffective but counterproductive, serving to undermine trust and trustworthiness within the firm.

European Takeover Law — Towards a European Modified Business Judgment Rule for Takeover Law

Although mergers and acquisitions activity in Europe has reached unprecedented levels, almost doubling in the past year alone, hostile takeovers are still the exception, not the rule, especially in Germany. The British telecommunication concern Vodafone's 141 billion Euro takeover bid for its German counterpart, Mannesmann, in December 1999 was the first successful hostile bid for a major German company in post-war history.

A theory of legal presumptions

This article analyzes how legal presumptions can mediate between costly litigation and ex ante incentives. We augment a moral hazard model with a redistributional litigation game in which a presumption parameterizes how a court 'weighs' evidence offered by the opposing sides. Strong prodefendant presumptions foreclose lawsuits altogether, but also engender shirking. Strong proplaintiff presumptions have the opposite effects. Moderate presumptions give rise to equilibria in which both shirking and suit occur probabilisitically. The socially optimal presumption trades off agency costs against litigation costs, and could be either strong or moderate, depending on the social importance of effort, the costs of filing suit, and the comparative advantage that diligent agents have over their shirking counterparts in mounting a defense. We posit three applications of our model: the litigation rate effects of the 1995 Private Securities Litigation Reform Act, the business judgment rule in corporations law, and fiduciary duties in financially distressed firms.

The Business Judgment Rule: Fiduciary Duties of Corporate Directors

The Business Judgment Rule: Fiduciary Duties of Corporate Directors

A Theory of Legal Presumptions

This article analyzes how legal presumptions can mediate between costly litigation and ex ante incentives. We augment a moral hazard model with a redistributional litigation game in which a presumption parameterizes how a court 'weighs' evidence offered by the opposing sides. Strong prodefendant presumptions foreclose lawsuits altogether, but also engender shirking. Strong proplaintiff presumptions have the opposite effects. Moderate presumptions give rise to equilibria in which both shirking and suit occur probabilisitically. The socially optimal presumption trades off agency costs against litigation costs, and could be either strong or moderate, depending on the social importance of effort, the costs of filing suit, and the comparative advantage that diligent agents have over their shirking counterparts in mounting a defense. We posit three applications of our model: the litigation rate effects of the 1995 Private Securities Litigation Reform Act, the business judgment rule in corporations law, and fiduciary duties in financially distressed firms.

The Statutory Business Judgment Rule: Putting the Wind into Directors’ Sails

Company directors should welcome and embrace the statutory business judgment rule, due to commence on 13 March 2000. It finally provides them with the certainty that they need to take their companies into the next millenium. The Corporate Law Economic Reform Program Bill 1998 was passed by Parliament on 20 October 1999. The position is now clear – the merits of bona fide business judgments made by directors, meeting the four requirements, will not be subject to judicial review. Directors will be taken to have met their duty of care and diligence.

The duty of fair dealing: Board judgment in management led buyouts

This paper investigates board judgment in response to management led buyouts (MLBs). Board response is suggested to be guided by the business judgment rule and its dual duties of care and loyalty. The duty of loyalty is seen to be evolving into a specification of fair dealing. With this trend, the current interpretation of the business judgment rule emphasizes the role of care and relies on the market to insure fairness. Possible failures in the MLB market which limit its effectiveness in assuring fairness are discussed. Recommendations to counteract these failures are suggested.

The Business Judgement Rule vs. the Efficient Market Hypothesis

Contests for corporate control often create a conflict between a legal principle, the business judgment rule (BJR), and an economics principle, the efficient market hypothesis (EMH). The BJR focuses on the process of decision making and requires managers to be guided by their integrity and diligence. The EMH focuses on outcomes and expects decisions to be guided by stock prices. Ideally the principles do not conflict, but when they do, when the market disagrees with managers' decisions, it is important to understand why. This article discusses the principles, why they sometimes conflict, and circumstances when one should outweigh the other.

Defusing the Director Liability Crisis: The Strategic Management of Legal Threats

Boards of directors have been substantially affected by recent changes in their legal environment. The most profound change has been in the area of director liability. New legislation and regulations and a series of court decisions increased the extent to which directors are held accountable for their actions and those of their organizations. These changes resulted in increased liability exposure for directors and a crisis in director liability insurance. Corporations have successfully developed strategies to manage the adverse consequences of these changes in the legal environment. This paper develops an extension of resource dependence theory to enable us to analyze events surrounding the director liability crisis from the perspective of the corporation. It then reviews the legal forces which have affected boards of directors. The concept of director liability is discussed, including the business judgment rule, which has historically protected the decision making discretion of boards. Indemnification and director liability insurance, which provide protection from monetary penalties against directors arising from liability suits, are also described. Recent environmental changes which have affected director protection from liability are then examined. These include legislation specifying certain director responsibilities and granting additional enforcement powers to federal regulatory agencies, court decisions which expanded the personal liability of directors in several important ways, and changes in director liability insurance policies and markets. These developments increased the liability exposure of corporate directors and precipitated the director liability crisis of 1986. Corporations responded to this threat by making changes in board composition, director compensation, and board decision making structures and processes; by developing alternative forms of director liability insurance; and by lobbying for legislation providing greater liability protection for directors. These actions are interpreted within the framework of resource dependence theory. Implications for future research are also discussed.

The Economic Structure of Corporate Law.

The corporate contract limited liability voting the fiduciary principle the business judgment rule, and the derivative suit corporate control transactions the appraisal remedy tender offers the incorporation debate and state antitakeover statutes close corporations trading on inside information mandatory disclosure optimal damages.

Judicial Development of a Business Judgment Rule in Japan

This article examines the application of a business judgment rule in Japan, a civil law jurisdiction with a statutory scheme that is different from that of either the United States of America or Australia. As will be seen, in spite of these differences, a business judgment rule similar to that in the United States of America appears to be developing.