June 15, 2001 Will 'Business Judgment' Rule Again in Delaware Courts? By FLOYD NORRIS
Investors, beware. The legal climate for protection of shareholder rights is getting much more chilly.
The cold winds are blowing out of Delaware, the small state where the vast majority of major corporations are incorporated. In an extraordinary paper, two sitting judges who hear corporate suits, joined by a former judge, have challenged a large part of the current merger law as set forth by Delaware Supreme Court decisions.
The paper has received a warm reception from the place where it counts the most. "It is a scholarly paper, and some of the thoughts in it are worthy of consideration," said E. Norman Vesey, Delaware's chief justice, in an interview yesterday, adding that he had told a Delaware Bar Association seminar that the paper could form the basis for an appeals brief in a future case.
There are good - and bad - reasons most companies choose to incorporate in Delaware. The good one is that there is a well-developed body of corporate law administered by the chancery court, a special body run by judges - the chancellor and vice chancellors - who are experts in such law.
The bad reason is that Delaware for a long time had a reputation as a state where corporate managements could be assured of a friendly reception if they were sued by shareholders. The "business judgment rule" reigned supreme, creating a presumption that whatever the board did was acceptable. Absent proof of fraud or gross negligence, it was taken for granted that the directors were acting in the interests of the shareholders, and the courts had no business second-guessing them.
That began to break down in the turmoil of hostile takeovers in the 1980's. In a series of decisions, it became much more risky for directors to seek to keep shareholders from deciding when to sell a company.
The process was not always a pretty one, but it generally served shareholders well, and it clearly made boards nervous about approving sweetheart deals. They knew that the Delaware courts were likely to second-guess any deal that appeared to be unfair in either process or result.
Now this paper, by William T. Allen, a former Delaware chancellor, and Jack B. Jacobs and Leo E. Strine Jr., both vice chancellors, argues that directors need more freedom to act. "We propose that the sounder approach would be for the courts to defer to the business decision reached in good faith by the elected independent directors of the corporation," they wrote.
In an interview, Mr. Allen, now a law professor at New York University, said he was looking for a way to reduce the number of cases in which judges have to decide on the proper price for a company. But he voiced confidence that judges would still block "clear outrages."
In fact, the volume of major Delaware litigation has declined in the last five years. That is not because independent directors are always genuinely independent or because hostile takeover attempts have vanished. It is because the Delaware decisions have led boards to be careful about protecting minority shareholders. They know the fairness of their actions will be evaluated.
Now come two sitting judges with what amounts to an invitation to companies to test the law again, perhaps by pushing through a takeover by an insider when there is a possibility, or even a certainty, that someone else might pay more. At the least, what was settled law in Delaware is now uncertain. Shareholders have reason to worry.