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Two Models of Corporate Governance

By Michael P. Dooley*

INTRODUCTIONThe American Law Institute's Principles of Corporate Governance: Analysis

and Recommendations (the ALI Governance Project or the ALI Project)' hasgenerated an unprecedented volume of debate that has spilled over from theALI's Annual Meetings to include representatives of the business community,as well as academics and practicing lawyers.2 Many of the participants in thisdebate have been sharply critical of the ALI Governance Project. In fairness, itshould be noted that the Reporters have labored mightily to respond to thecriticism. Since the ALI Governance Project was first authorized in 1979, theReporters have produced what will soon be an even dozen "Tentative Drafts"and who-knows-how-many Reporters' Studies, Council Drafts, Advisory Com-mittee Drafts and plain draft-drafts. Notwithstanding these efforts, there re-mains such a gap between supporters and critics of the ALI Governance Projectthat it can already be counted as one of the most controversial undertakings inthe long, prestigious and generally pacific history of the Institute.

This is not to say that past ALI projects, including Restatements, have notdrawn their fair share of critical fire. In the past, however, criticism has been

*Mr. Dooley, a member of the Illinois, New York and Virginia bars, is the William S. Potter

Professor of Law at the University of Virginia School of Law.An earlier version of this paper was presented at a national institute, The New Dynamics of

Corporate Control V, in New York City on December 6, 1991, sponsored by the Section of BusinessLaw, the Section of Litigation and the Division for Professional Education. The author wishes tothank his colleague, Paul Stephan, for helpful comments on an earlier draft.

1. Unless otherwise indicated, all references to the Governance Project are to American LawInstitute, Principles of Corporate Governance: Analysis and Recommendations (Tentative DraftNo. 11, 1991) [hereinafter T.D. 11].

2. For a small sampling of representative symposia discussions, see, e.g., Symposium, EighthAnnual Baron de Hirsch Meyer Lecture Series: ALl Corporate Governance Project, 37 U. MiamiL. Rev. 169 (1983); Symposium, American Law Institute's Corporate Governance Project, 52 Geo.Wash. L. Rev. 495 (1984); Edited Transcript of Proceedings of the Business Roundtable/EmoryUniversity Law and Economics Center Conference on Remedies Under the ALI Proposals: Law andEconomics, 71 Cornell L. Rev. 357 (1986); Symposium on Corporate Governance, 8 Cardozo L.Rev. 657 (1987); see also National Legal Center for the Public Interest, The American LawInstitute Corporate Governance Project in Mid-Passage: What Will It Mean to You? (1991);Statement of the Business Roundtable on the American Law Institute's Proposed "Principles ofCorporate Governance and Structure: Restatement and Recommendations" (1983).

HeinOnline -- 47 Bus. Law. 461 1991-1992

462 The Business Lawyer; Vol. 47, February 1992

focused on specific provisions dealing with discrete topics. Thus, individualprovisions have been heavily criticized but generally only on one of two grounds:either the principle espoused seemed inconsistent with another, arguably morecentral, principle of the same Restatement or the principle represented a bolddeparture from existing law that portended dramatic, but unforeseeable, conse-quences for a substantial part of the body of law addressed by the Restatement.A familiar example of the first type of controversy is the tension in the FirstRestatement of Contracts resulting from the uneasy marriage of Corbin'ssponsorship of promissory estoppel in section 90 with Williston's enshrinementof the "bargain model" in section 71. 3 Prosser's promotion of strict productsliability in section 402A of the Second Restatement of Torts typifies the secondtype of controversy.

4

Judging from the vigorous criticism it has provoked, one is tempted tocharacterize the derivative suit proposals in Part VII of the current ALTGovernance Project as the lightning rod of the project.5 The ALl GovernanceProject's derivative suit proposals dramatically depart from both existing judi-cial precedent and from the competing proposals put forth by the American BarAssociation's Committee on Corporate Laws in Subchapter D of the RevisedModel Business Corporation Act.6 To focus on the ALl Project's derivative suitproposals, however, is to miss the crucial point: Part VII is perfectly consistentwith the central thrust of the rest of the ALl Governance Project, particularlythe substantive liability provisions in Parts IV and V. Indeed, to substitute thesubstance of existing law or Subchapter D for Part VII would destroy theintellectual integrity of Parts IV and V and render them nearly incoherent.7

3. See Grant Gilmore, The Death of Contract 60-65 (1974).4. See George L. Priest, The Invention of Enterprise Liability: A Critical History of the

Intellectual Foundations of Modern Tort Law, 14 J. Legal Stud. 461, 505-19 (1985) (recounting thehistory of the adoption controversy).

5. See Dennis S. Block et al., The Role of the Business Judgment Rule in Shareholder Litigationat the Turn of the Decade, 45 Bus. Law. 469, 501-09 (1990); Michael P. Dooley & E. NormanVeasey, The Role of the Board in Derivative Litigation: Delaware Law and the Current ALlProposals Compared, 44 Bus. Law. 503, 531-38 (1989) [hereinafter Dooley & Veasey, DerivativeLitigation].

6. See Committee on Corporate Laws, Changes in the Model Business Corporation Act-Amendments Pertaining to Derivative Proceedings, 45 Bus. Law. 1241 (1990) [hereinafter ModelAct Derivative Amendments].

7. This is not to be taken in any way as an endorsement of the current version of Part VII.Indeed, my previously stated position on this matter clearly indicates my belief that any change thatmoves Part VII closer to the Delaware or the Revised Model Business Corporation Act provisions ispreferable. See generally Dooley & Veasey, Derivative Litigation, supra note 5. I believe that sucha change is desirable not only because it would provide a better method for handling shareholdersuits, but because it would limit the potential damages from enforcing Parts IV and V of the ALlProject to the full measure specified in the liability provisions of those parts. I mean to say only thatadoption of Delaware-like derivative suit procedures would render intellectually incoherent PartsIV and V in the same way that I believe Part VI is incoherent, compared with the Project's overallorientation to the Responsibility Model. See infra notes 197-240 and accompanying text.

I should also disclose that I have the privilege of serving as a member of the American BarAssociation Business Law Section's Ad Hoc Committee on ALl Corporate Governance Project


Two Models of Corporate Governance 463

This suggests, then, that critics of the ALI Governance Project have not yetarticulated what it is about the ALI Project that makes them so uneasy. It is thethesis of this Article that the root concern with the current ALI Project is globalin nature. We are disquieted because the Reporters are offering what amountsto a wholly new and untested Model of Corporate Governance.

This Article describes Two Models of Corporate Governance and thendiscusses the principal differences in outcomes that can be expected fromapplying the respective Models to four pivotal areas of corporation law: formu-lation of the business judgment rule, resolution of conflicts of interest, derivativesuits, and the target board's role in unsolicited tender offers.

The first model of corporate governance can be called the "Authority Model."Its substance appears to be the prevailing judicial and statutory precedent. As iscustomary in this area of the law, the terms "prevailing," "weight" and"majority" are all understood to mean "Delaware." It should be noted, how-

ever, that in the two areas in which it overlaps with the ALI Project-namely,conflicts of interest and derivative suits-the ABA's Model Act recently hasbeen amended to include provisions that fit comfortably within the AuthorityModel.8 Such amendments are hereby claimed for and included in the AuthorityModel.

The second model of corporate governance is the "Responsibility Model,"exemplified by the ALI Governance Project. Among other things, the Modelsdiffer in perspective. The focus of the Responsibility Model is on the occasionaland individual irregularity: what set of substantive rules and procedures canbest remedy and deter individual deviations from the commonwealth of thefirm? In contrast, the focus of the Authority Model is on the ordinary operationof the firm on a day-to-day, year-to-year basis: what set of substantive rules andprocedures best supports the most efficient decision-making process for thepublicly held firm?9

It should be readily apparent that neither Model exists in pristine form in thereal world. Standing alone, neither Model could provide a sensible guide to the

governance of firm-organized economic activity because each seeks to achieve adistinct and separate value that is essential to the survival of any firm. Accord-ingly, any feasible governance system must and does contain elements of both

(CORPRO). In such capacity, I have actively participated in CORPRO's negotiations with theReporters on the drafting of the substantive provisions and comments of the ALl Project. Needlessto say, the views expressed herein are entirely personal and do not purport to represent the views ofCORPRO or any of its other members.

8. See Model Act Derivative Amendments, supra note 6; Committee on Corporate Laws,Changes in the Model Business Corporation Act-Amendments Pertaining to Directors' ConflictingInterest Transactions, 44 Bus. Law. 1307 (1989) [hereinafter Model Act Conflicting InterestAmendments].

9. The term "publicly held firm" is meant to describe, and the analysis of both Models isconfined to, economic organizations in which (i) management and residual claimant status (share-holding) are separable and separated functions; (ii) the residual claims (shares) are held by anumber of persons; and (iii) the residual claims are freely transferable and neither entry to nor exitfrom the firm is restricted.



Models, and it is only one's assessment of which value seems to predominate ina given system that justifies categorizing the system as primarily concerned withAuthority or Responsibility.

The question of mix is critical, however, because therein lies the GreatParadox of Corporation Law. Authority and Responsibility are both essentialvalues because each responds to one of the two principal kinds of costs incurredin operating as a firm. Unfortunately, these values are also antithetical, andmore of one means less of the other. To appreciate the consequences of thisparadox, it is first necessary to identify the principal costs associated with firm-organized economic production.

THE COSTS OF THE FIRMIn a free enterprise system, all economic activity is carried on through

individual ownership and voluntary exchange of the various inputs used inproduction. In some cases, the exchange takes the form of bargaining by andamong individual input owners in and across markets, and production isorganized by the price mechanism of the market. 1' In other instances, produc-tion occurs through repetitive exchanges within a coalition of input ownerscalled a "firm." And all firms rely on market exchange for at least some of theirnecessary inputs. What accounts for the fact that both markets and firms existand what determines the choice of one or the other in a given instance?

Since the publication of Ronald Coase's classic article in 1937," it has beengenerally accepted among organizational theorists that the choice betweenmarkets and firms depends on the comparative costs of using each to organizeproduction in a particular case. Collectively, these costs are referred to as"transaction costs." While economic factors may succeed in devising ways toreduce these costs, transaction costs can never be eliminated because they aregenerated by two fundamental facts of human nature. The first of these is"bounded rationality," which refers to the psychoneurological limits of thehuman mind to process information-hence, the limitations on human ability toplan and to solve complex problems. 2 The second is "opportunism," whichrefers to the constant human temptation to pursue self-interest at the expense of

10. For example:

To produce corn, the farmer assembles the necessary factors of production by a series ofdiscrete contracts to purchase, at the prevailing market price, machinery, fertilizer, seed,pesticides and temporary help and sells the harvested corn for whatever it will bring on theopen market. The farmer's production is no less "organized" than [Adam Smith's pin-makerexample], but in the former case the organization is supplied by the price mechanism of moreor less impersonal market exchange.

Michael P. Dooley, Fundamentals of Corporation Law 1-3 (temporary ed. 1991) [hereinafterM. Dooley, Fundamentals].

11. Ronald H. Coase, The Nature of the Firm, 4 Economica, New Series 386-405 (1937),reprinted in Readings in Price Theory 331 (George J. Stigler & Kenneth E. Boulding eds. 1952).

12. The phrase "bounded rationality" is Herbert Simon's, first used in Herbert Simon, Admin-istrative Behavior xxviii-xxxi (3d ed. 1976).



others, even when cooperative behavior would be most beneficial to all con-cerned. 3 Although opportunism is often equated with "cheating," for presentpurposes it will be useful to think of opportunism as embracing all failures to

keep previous commitments, whether such failures result from culpable cheat-ing, negligence, "understandable" oversight, or plain incapacity.

If there were no bounded rationality, including no limitations on humanforesight or the ability to acquire and process information, individuals couldwrite completely specified contingent contracts. Without opportunism, parties

would always perform to the letter of their agreement, and there would be noneed to resort to costly enforcement mechanisms. In such a world of zero-

transaction costs, there would be no firms and no business organization law.In the real world, however, both the making and enforcement of contracts is

costly, and firm-organization may be a less expensive alternative for some kindsof production. There is an almost infinite variety of circumstances that mayaccount for this. For example, if certain tasks regularly recur in a productionprocess, it is obviously more efficient from a management standpoint to hire

more or less permanent employees who could be trained once and then super-vised only episodically, rather than relying on casual labor markets to hire

temporary workers who would require more or less constant training andsupervision. For the same reason, it may be more efficient to integrate, ratherthan contract for, processes that appear functionally related to activities alreadycarried on by the firm. 4 In still other instances, contracting for a criticallyneeded component of production may expose the firm to the hazard of strategic

threats by the input owner that can be avoided if the component is owned by thefirm." Business organization law also may contribute to the comparative cost

advantages of firms. For example, the presumptive assignment to the firm ofexclusive property rights in all of its assets avoids the necessity of writingdetailed and complex contractual protections to secure proprietary information

that may be generated in the conduct of its business.While firm-organized production economizes on some manifestations of the

costs of contracting, it cannot escape them entirely. Accordingly, transaction

costs, unless controlled, will frustrate achievement of the coalition's objectives.Just as bounded rationality precludes the writing of completely specified contin-

gent contracts, the participants in a firm cannot draft a charter specifying howthe plan of business or the relative rights of the various input owners (capital,

13. See Oliver E. Williamson, The Modern Corporation: Origins, Evolution, Attributes, 19 J.Econ. Literature 1537, 1545 (1981).

14. See Ronald H. Coase, The Nature of the Firm: Origin, Meaning, Influence, 4 J.L. Econ. &Organization 3, 38-40 (1988). For the development and application of an interesting transactioncosts model to predict the "make or buy" decision in the context of a shipbuilding business, see ScottE. Masten et al., The Costs of Organization, 7 J.L. Econ. & Organization 1 (1991).

15. This explains why newspapers, for which timely production is critical, own their ownprinting presses, whereas book publishers, which need not meet daily or even monthly deadlines,tend to contract with outside printers. See Benjamin Klein et al., Vertical Integration, AppropriableRents, and the Competitive Contracting Process, 21 J.L. & Econ. 297 (1978).



labor and management) shall be adjusted to adapt to new conditions in anuncertain environment.

Consequently, the participants in a firm must have some governance struc-ture to determine three basic questions. First, what are the general sorts ofadaptive decisions that will need to be made over time? Second, what generalnormative principle guides decision making-that is, for whose benefit aredecisions to be made? And, third, who, within the firm, shall make the adaptivedecisions?

The answer to the second question is the same for all capitalist firms:decisions are to be made to benefit the interests of the residual claimants1 6

because maximizing their wealth necessarily maximizes the wealth of thecoalition. 7 The first and third questions are closely related, but their answersdiffer depending on salient characteristics of the type of firm in question.

In most general partnerships and closely held corporations, there is nofunctional distinction between management and residual claimants because thesame persons perform both functions. Thus, all adaptive decisions, whetherroutine or extraordinary, are made by the residual claimants. In publicly heldcorporations, however, management and residual claimants have sharply differ-entiated functions. This distinction is codified in all corporations statutes byprovisions similar to section 8.01(b) of the Revised Model Business CorporationAct: "All corporate powers shall be exercised by or under the authority of, andthe business and affairs of the corporation managed under the direction of, itsboard of directors, subject to any limitation set forth in the articles of incorpora-tion."

1 8

The different decision-making structures prescribed for partnerships andclosely held corporations, on the one hand, and publicly held corporations, onthe other, result only partially from the number of putative decision makersinvolved in the respective types of firms. The characteristics that primarilydictate the choice of decision-making structure are the similarities in informa-tion and interests of the decision makers. Thus, if all partners actively partici-pate in the management of the business, each partner should have (or, at least,be exposed to) the same facts necessary to make adaptive decisions. And since all

16. Subject, in all cases, to observing the rights of those outside the firm. Thus, the pursuit ofprofit in any form of enterprise is subject to conditions similar to those provided for corporations in§ 2.01(b) of the ALl Governance Project. That section states that the corporation, in the conduct ofits business:

(1) Is obliged, to the same extent as a natural person, to act within the boundaries set by law;(2) May take into account ethical considerations that are reasonably regarded as appropriate to

the responsible conduct of business; and(3) May devote a reasonable amount of resources to public welfare, humanitarian, educational,

and philanthropic purposes.T.D. 11, supra note 1, § 2.01(b). None of these conditions is inconsistent with the normative goal ofmaximizing the wealth of the residual claimants over the long term.

17. This follows from the fact that the legally recognizable claims of all other input owners,including creditors and employees, have priority over the residual claims both with respect toliquidation and distributions from the firm's income stream.

18. Rev. Model Business Corp. Act § 8.01(b).



partners are residual claimants, each has the same interest, namely, increasingthe size of the residual interest. Under these conditions, an elaborate decision-making structure is unnecessary because the partners will tend to reach agree-

ment informally and largely by consensus. Not only is this aspect of partnershipgovernance the one that is most frequently observed, 9 it is also the one predictedby Kenneth Arrow's theories of organizational decision making.2" According toArrow, where an organization's decision makers have identical information andinterests, decisions will be reached by "Consensus" because each participant,

voting in his or her own self-interest, will naturally select the course of actionpreferred by the others. 21

Where information and interests differ, however, it is obviously infeasible to

involve all participants in the decision-making process. Given the normativegoal of increasing the size of the residual interest, it makes sense to conferdecisive authority on the residual claimants in a partnership, but only becausethe partners are also the active managers of the firm. Where the residualclaimants are not expected to run the firm and especially when they are many in

number (thus increasing disparities in information and interests), their functionbecomes specialized to risk-bearing, thereby creating both the opportunity andnecessity for managerial specialists. Again as Arrow predicts, where informa-tion and interests differ, the residuals will no longer either be able or inclined toreach decisions that are in the best interests of their group.22 Instead, it willbecome "cheaper and more efficient to transmit all the pieces of informationonce to a central place" and to have the central place "make the collectivedecision and transmit it rather than retransmit all the information on which the

decision is based."2 3

Arrow calls this latter decisional structure "Authority, "24 and it is obviously

the inspiration for the Authority Model offered herein. The heart of theAuthority Model is the universally recognized requirement for the establish-ment of, and vesting of supreme authority in, the board of directors. Theremainder of the corporate decision-making structure, whether derived from

19. It is significant that the default governance rule for partnerships provides for equalparticipation in management by the partners. See Unif. Partnership Act § 18(e) (1914). Many statecorporations statutes permit close corporation shareholders to adopt a partnership-like governancestructure by dispensing with the board of directors and assuming direct shareholder control of thebusiness. See, e.g., Del. Code Ann. tit. 8, § 351 (1991). The Revised Model Business CorporationAct has recently been amended to provide even greater flexibility by authorizing the use ofunanimous shareholder agreements to tailor the corporation's governance structure to the sharehold-ers' particular needs. See Rev. Model Business Corp. Act § 7.32. This procedure gives closecorporation shareholders the same amount of self-determination regarding governance as is avail-able under the Uniform Partnership Act. See generally Committee on Corporate Laws, Changes inthe Revised Model Business Corporation Act-Amendments Pertaining to Closely Held Corpora-tions, 46 Bus. Law. 297 (1990).

20. See generally Kenneth J. Arrow, The Limits of Organization (1974).21. Id. at 68-70.22. Id. at 70.23. Id. at 68-69.24. See id.



statute or the law of agency, follows logically from this central premise. Thus,although the board, as a practical matter, must delegate operational authority toexecutives, who may also formulate and recommend policies, all executives arehired and fired by the board, and all important policy questions are reserved forits exclusive determination. Similarly, although the shareholders' approval isrequired for certain extraordinary transactions, such as merger, dissolution,charter amendment and sale of all assets, their franchise extends only toratification. All such transactions must first be approved by the board; they maybe neither initiated nor modified by the shareholders. 25

The requirement of shareholder ratification, as well as their rights to electand remove members of the board of directors, may be mistaken as part of thecorporate decision-making process. They are not. Such rights are inconsistentwith the pure Authority Model and must, instead, be seen as governance aspectsdesigned to promote Responsibility. The absolute necessity for some suchrequirements is obvious: if supreme authority is vested in the board, but theboard is not accountable to the shareholders for its exercise, members of theboard and their agents have no incentive to maximize the interests of theshareholders and will be free to indulge other preferences (especially since thereis no requirement that either the board or its agents hold any of the residualclaims). Under those circumstances, the whole point of the coalition will be lostand it will collapse. Indeed, multi-party coalitions that are thereby dependenton Authority for decision making would never be formed without some gover-nance aspects designed to promote Responsibility.

But a governance system that offered only shareholder voting as a shieldagainst management opportunism would be inadequate, given familiar collec-tive action problems that impair fully effective exercise of the shareholders'franchise. Predictably then, the law affords additional protective provisions inthe form of the fiduciary duties of care and loyalty (or, as the latter is describedin the Governance Project, "Fair Dealing"). 6 It is useful to think of fiduciaryduties as judicially implied default terms of the basic agreement betweenshareholders and managers. Strong evidence is required to overcome the appli-cability of these default provisions. While some states have recently authorizedcharter provisions to relax the duty of care, the presumption in favor of somevariant of the duty of loyalty is irrebuttable. 27

25. E.g., Rev. Model Business Corp. Act § 10.03(b) (prior board approval for article amend-ments); id. § 11.03(b) (prior board approval for merger or share exchange); id. § 12.02(b) (prior

board approval for sale of all or substantially all assets); id. § 14.02(b) (prior board approval for

voluntary liquidation).26. See T.D. 11, supra note 1, Part V.27. Since 1986 when Delaware first amended its statute to authorize exculpatory charter

amendments in Del. Code Ann. tit. 8, § 102(b) (1991), some 30 states and the Revised ModelBusiness Corporation Act have followed suit. See James J. Hanks, Jr., Evaluating Recent StateLegislation on Director and Officer Liability Limitation and Indemnification, 43 Bus. Law. 1207,1210-16 (1988); Committee on Corporate Laws, Changes in the Revised Model Business Corpora-tion Act-Amendment Pertaining to Liability of Directors, 45 Bus. Law. 695, 696-98 (1990). Noneof these statutes permits limiting or eliminating liability for loyalty violations, although the precise



It is critical, however, to see the behavior encompassed by the duties of careand loyalty as simply two faces of the general problem of opportunism. Theydiffer principally only in the comparative ease with which one can conclude in agiven case that an agent's behavior was "sufficiently" opportunistic to warrantlegal sanctions. That is, an agent may honestly intend but mistakenly believethat certain ill-advised behavior will advance the principal's interest. Thequestion in that case is not whether the agent's behavior was opportunistic (bydefinition, it was), but rather whether we wish to punish such behavior. Wherethe behavior in question produces a gain for the agent at the expense of theprincipal, however, we have an easier time concluding that the behavior isculpable and deserving of punishment. The important point is that the decisionto punish is analytically distinct from the question of breach and depends uponweighing into the mix other social values that are unrelated to the deterrence ofopportunism.

This suggests, then, that we could quite logically categorize and penalize allfailures, including honest "mistakes," as opportunism in breach of the basiccontractual obligation of management to maximize the shareholders' interests.Other, unrelated social values, however, dictate a different choice, as witnessedby the fact that the duty of care is formulated to make allowances for humanfrailty by encompassing only substandard or negligent behavior. As codified insection 8.30(a) of the Revised Model Business Corporation Act, the duty of carerequires only that:

A director ... discharge his duties as a director, including his duties as amember of a committee:

(1) in good faith;(2) with the care an ordinarily prudent person in a like position would

exercise under similar circumstances; and(3) in a manner he reasonably believes to be in the best interests of the

corporation.28

Concern for human frailty, however, cannot be the whole story, because, bydefinition, fully half of the decisions made by boards of directors in any timeperiod will be below average and thus technically in violation of the duty ofcare. The reason why board decisions are not constantly litigated by sharehold-ers is because shareholder complaints first must clear the hurdle of the businessjudgment rule. This common law invention screens and limits the kinds ofshareholder complaints that courts will entertain.

While explication of the business judgment rule is the topic of the nextsection, 29 consideration of one aspect of the rule will serve to relate it to the

formulation of the loyalty exception varies from statute to statute. Compare Del. Code Ann. tit. 8,§ 102(b) (1991) (specifically excepting "any breach of the director's duty of loyalty") with Rev.Model Business Corp. Act § 2.02(b)(4) (excepting liability for the amount of any financial benefit towhich the director is not entitled and for "intentional harm") and Va. Code Ann. § 13.1-692.1(B)(Michie 1989) (excepting "willful misconduct").

28. Rev. Model Business Corp. Act § 8.30(a).29. See infra notes 34-83 and accompanying text.



present discussion. Generally, the rule precludes judicial review of boarddecisions that are honest and carefully thought out, but just plain wrong fromthe standpoint of advancing the shareholders' interests.30 Courts and commenta-tors have offered a variety of explanations for this, ranging from judicialincompetence to a desire to protect legitimate, entrepreneurial risk-taking. Eachof these explanations is unsatisfactory in its own way,31 and all of them miss thepoint.

To understand the purpose of the business judgment rule it is first necessaryto stop thinking of firm-organized economic production as something uniqueand to see it as it is: another way of dealing with the transaction costs ofexchange but, functionally, no different from contracting. Why, then, do boththe definition of performance and the scope of judicial review of that perfor-mance appear to be so different in the respective legal regimes? After all, we donot seem to worry that a seller who is found to have delivered substandardmaterials will have her entrepreneurial spirit crushed to the point of aban-doning or curtailing future economic activity. In contract law, the question issimply: did the seller deliver "Grade A White Pine Lumber" as promised? Inthe same vein, while it is undoubtedly easier for the trier of fact to determinewhether the lumber delivered was Grade A, or knotty, gnarled Grade C than itis to determine whether a particular risky board decision was "reasonable," wecall on courts to decide whether similarly vague standards such as "good faith"and "best efforts" have been achieved by the parties to relational contracts. 32

The business judgment rule can only be understood as intended to protect theauthority of the board and thus to promote the value of Authority. And now theAuthority/Responsibility Paradox is fully revealed. If the board is never madeaccountable for its decisions, it is liable to exercise its power irresponsibly vis-a-vis the shareholders. On the other hand, the power to hold a party accountableis the power to interfere and, ultimately, the power to decide. Thus, affordingshareholders the right to demand frequent judicial review of board decisions hasthe effect of transferring decision-making authority from the board to theshareholders. As Arrow has observed, "[ilf every decision of A is to be reviewedby B, then all we have really is a shift in the locus of authority from A to B andhence no solution to the original problem." 33

30. See, e.g., In re RJR Nabisco, Inc. Shareholders Litig., [1988-1989 Transfer Binder] Fed.Sec. L. Rep. (CCH) 94,194, at 91,710 n.13 (Del. Ch. Jan. 31, 1989) ("To recognize in courts aresidual power to review the substance of business decisions for 'fairness' or 'reasonableness' or'rationality' where those decisions are made by truly disinterested directors in good faith and withappropriate care is to make courts super-directors."); see also Pollitz v. Wabash R.R. Co., 100 N.E.721, 724 (N.Y. 1912).

31. See Dooley & Veasey, Derivative Litigation, supra note 5, at 521-22.32. See, e.g., Bloor v. Falstaff Brewing Corp., 601 F.2d 609, 613-14 (2d Cir. 1979); Van

Valkenburgh, Nooger & Neville, Inc. v. Hayden Pub. Co., 281 N.E.2d 142, 144-45 (N.Y. 1972).See generally Charles J. Goetz & Robert E. Scott, Principles of Relational Contracts, 67 Va. L.Rev. 1089 (1981).

33. Arrow, supra note 20, at 78.



This suggests a dual function of the business judgment rule. It must not onlyprotect the authority of the board, but, given the necessity of both Authority andResponsibility, it must also attempt to achieve some accommodation between thetwo conflicting values. This further suggests that the precise articulation of therule will have important consequences for corporate governance.

FORMULATION OF THE BUSINESS JUDGMENT RULETHE AUTHORITY MODEL

The Authority Model's version of the business judgment rule is clearlydesigned to preclude judicial review of the vast majority of board decisions,whether routine or extraordinary. As formulated by the Delaware SupremeCourt in Aronson v. Lewis,3 4 the business judgment rule creates:

[A] presumption that in making a business decision the directors of acorporation 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 ...Absent an abuse of discretion, that judgment will be respected by thecourts. The burden is on the party challenging the decision to establishfacts rebutting the presumption.

35

Further, the presumption is overcome only if the plaintiff alleges sufficient factsto create a reasonable doubt that the directors were (1) disinterested andindependent or (2) grossly negligent. 36

The requirement that there be a disinterested majority of the board ofdirectors is simply another way of stating that business judgment protection willnot be afforded any decision in which a majority of the board is personallyinterested. As such, the first requirement represents another manifestation of theAuthority/Responsibility tradeoff, a topic that is further pursued in succeeding

parts of this Article. Because most business decisions (particularly of largercorporations) do not implicate the self-interest of any director, much less amajority of directors, most shareholder complaints will have to clear the secondpart of the Aronson test.

It is clear that the gross negligence inquiry required by the second part of theAronson test will extend only to the process followed by the board in reaching itsdecision.37 The business judgment rule does not permit inquiry into the appro-priateness or reasonableness of the directors' substantive reasons for deciding topursue a particular course of action. 38 In all events, a complaining shareholdercan raise a litigable issue under either prong of Aronson only by pleading

34. 473 A.2d 805 (Del. 1984).35. Id. at 812 (emphasis added) (citations omitted).36. Id. at 812 & n.6, 814.37. See Smith v. Van Gorkom, 488 A.2d 858, 873, 881-84, 893 (Del. 1985); Mitchell v.

Highland-Western Glass, 167 A. 831, 833 (Del. Ch. 1933).38. Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971); Shlensky v. Wrigley, 237

N.E.2d 776, 778-81 (Ill. App. Ct. 1968).



particularized facts, not conclusory allegations.39 Needless to say, discovery isnot available to enable the shareholder-plaintiff to meet this demanding plead-ing requirement.4"

As applied by the courts, the business judgment rule screens shareholdercomplaints even more finely. In the first place, courts simply will not reviewentire categories of business decisions. As Norman Veasey and I have remarkedelsewhere:

It is hard to find reported examples of these "nonreviewable" decisionsprecisely because it is so well understood that they cannot profitably bemade the subject of lawsuits. A dividend may be illegal because it exceedsthe amount permissible under the statute, but we have no concept of a"negligent" dividend policy even though hindsight indicates that a differentallocation between retention and payout of earnings would have beenwiser. Similarly, courts will not entertain shareholder complaints that theboard should have directed management to devote more effort to researchand development or to manufacture this, rather than that, product or thatX would have made a better chief financial officer than Y. 41

This reveals the essence of the Authority Model: the category of nonreviewableboard decisions includes the core of business management. Decisions affectingthe allocation between retention and payout, as well as personnel and productmix are the decisions that will determine the success or failure of the firm overthe long term. Certainly, such decisions are vastly more important to sharehold-ers' welfare than the decision to obtain or forego a fairness opinion from aninvestment banker in a particular transaction. Yet, it is the latter, comparativelytrivial, "process" issue concerning a specific event that is more likely to passthrough the screen of the business judgment rule.42

Even if the shareholder's complaint succeeds in raising a process issueconcerning a specifically identified event that has plausibly caused damage tothe corporation, the degree of scrutiny that the court will apply to the board'sprocesses will vary dramatically depending upon the nature of the event.Bayless Manning has offered an explanation for these different review stan-dards that turns on the distinction between what he calls "enterprise issues" and"ownership claim issues. '43 Manning restricts the latter category to transactionsthat:

[Hit [the shareholder] directly in his role as an "owner," not "owner ofthe corporation" as legal doctrine would have it, but owner of his ownreified piece of property, his share of stock. After centuries of a private-

39. Aronson v. Lewis, 473 A.2d 805, 814-15, 815 n.8 (Del. 1984).40. Levine v. Smith, 591 A.2d 194, 209-10 (Del. 1991).

41. Dooley & Veasey, Derivative Litigation, supra note 5, at 521.42. Compare In re RJR Nabisco, Inc. Shareholders Litig., [1988-1989 Transfer Binder] Fed.

See. L. Rep. (CCH) 94,194, at 91,710 n.13 (Del. Ch. Jan. 31, 1989) with infra notes 45, 50.43. Bayless Manning, Life in the Boardroom After Van Gorkom, 41 Bus. Law. 1, 5 (1985).



property culture, none of us reacts well to receipt of a letter saying, "Thiswill inform you that I have just sold your house. Check is enclosed.""

It is the "check is enclosed" metaphor that best captures the limits of the"ownership claim" issues where the court will be inclined to look closely at theinformational processes of the board. Certainly, it describes precisely the mostnotorious "process" case of our time, Smith v. Van Gorkom.4 5

44. Id. at 5-6.45. 488 A.2d 858 (Del. 1985). The opinion has to be counted as one of the most controversial

corporate law opinions in recent years. Initial reviews ranged from "baffling" (Arthur M. Borden,First Thoughts on Decision of Delaware on Trans Union, N.Y.L.J., Feb. 25, 1985, at 1, 6) to"surely one of the worst decisions in the history of corporate law." Daniel R. Fischel, The Business

judgment Rule and the Trans Union Case, 40 Bus. Law. 1437, 1455 (1985). No more charitable isthe assessment of the majority's opinion by one of the two dissenting judges as a "comedy of errors."

Van Gorkom, 488 A.2d at 894 (McNeilly, J., dissenting).

In Smith v. Van Gorkom, the court found that the directors of Trans Union were "grosslynegligent" in failing to follow certain procedures, including seeking additional opinions concerning

the firm's "intrinsic value," in reaching their decision to sell the corporation at a price thatpreviously had been negotiated between the firm's chief executive and the buyer and presented to the

board. Id. at 874. The negative reaction to the holding cannot be directed at the court's proceduralprescriptions, because those were no greater than any competent lawyer (who had been timely

consulted) would recommend for a similar transaction. Rather, the heart of the criticism is that the

court's insistence on the observance of "normal" procedures was, on the facts of the case, inflexibleand failed to accord sufficient weight to the directors' previous knowledge and expertise as relevant

components of their "business judgment." In other words, the court's critique of the directors'decision-making processes would have been unexceptional if applied to different facts.

Chief among the facts that the critics believe the court accorded insufficient weight was that thesale provided a solution to a business problem with which the board had been concerned for sometime. That problem was finding a way for Trans Union to realize the value of substantial

investment tax credits that the company possessed but could not utilize fully due to insufficientincome. Various other strategies had been pursued to no effect, leaving, as the only remaining

possibility, a "sale" of the credits through a sale of the entire company. Thus, from the board'sperspective, the proposal to sell the company was not a wholly new idea, but merely a new solution

to an old problem. In this respect, the extent of the board's background knowledge seems similar tothat possessed by the General Motor's board in Levine v. Smith, 591 A.2d 194 (Del. 1991)

(discussed infra note 50).The other major criticism is directed to the court's faulting the board for failing to engage in more

formal fact-finding to determine the company's "intrinsic value." First, this is a concept that can be

given content only by a shaman-it is certainly beyond the competence of any lawyer, economist, orinvestment banker. Realistically understood, "intrinsic value" does not refer to a single, calculable

numerical value. Rather, it means only a range of prices that would be paid by a willing buyer who

placed a higher value on the firm than could be realized by its present owners (as here), with the

final sales price determined by negotiation between the parties (again, as here). Second, it isarguable that the board already knew the relevant variables that determine "fair price" or "intrinsicvalue," and that soliciting the opinions of others would not have added greatly to their store of

knowledge or produced a materially different final sales price. This argument depends on giving theboard credit for what appears to be the unusually high degree of experience and sophistication of its

individual members. Giving the board full credit for its collective wisdom, however, yields theconclusion that its members were both aware of the company's current value (available from themarket price published in the daily newspaper) and the value it could command if sold (based upontheir knowledge of the range of premia paid in friendly acquisitions). Under these circumstances,many critics found preposterous the court's insistence that the board engage in a purely formalistic



The metaphor does not serve to describe-indeed, it is at odds with-judicialtreatment of what appears to be a closely related "ownership claim" issue:board action that frustrates a tender offer that the board neither solicited norwanted, but that the shareholders greatly desired. As this Article later discussesin the context of tender offers,46 the Authority Model permits the board to senda letter stating, in effect, "This will inform you that we have decided you cannotsell your house. The check that you anticipated will not be forthcoming." It ishard to distinguish a decision to sell from a decision to prevent selling in termsof the impact that each has on the value of the individual owner's shares. It issimilarly difficult to distinguish the "dilution" that shareholders suffer from anill-advised issuance of shares for overvalued assets (as always, assuming no self-dealing) from the "dilution" sustained from a decline in cash-flows resultingfrom an erroneous decision to alter the firm's product-mix.47

search for the Holy Grail of "intrinsic value," especially when the plaintiff had conceded that theprice received was not unreasonable. See M. Dooley, Fundamentals, supra note 10, at 111-68-73.

46. See infra notes 197-240 and accompanying text.47. This is by way of quibbling with the manner in which Manning develops his otherwise

useful categories: he has fuzzed the line between "enterprise issues" and "ownership claims" byincluding too many things in the latter category. In explaining the distinction between his twocategories, Manning states that directors have little to fear from judicial second-guessing of theirdecision to alter the product-mix of the firm, "even if it soon becomes clear that the decision wasruinously wrong." Manning, supra note 43, at 6. However, Manning goes on to observe:

But when the question before the board involves shares-the personal property of theshareholders-when it concerns, for example, stock issuance, redemption, cashout, reversesplit, merger and the like, the corporate lawyer had better emphasize to his director clients thatthose matters are very close to a nerve, and that the directors would be well advised to be morethan usually alert, deliberative, focused, prepared, counseled, paper-tracked, and generallyprofessional in their behavior.

Id. This is sound advice, but not because these are all "ownership claim" issues. First, theshareholder's tangible property interest extends only to the shares he or she actually owns. Giventhe virtual extinction of preemptive rights, a shareholder has no more tangible property rights inshares the board decides to issue to purchase assets than he does in the board's decision to purchaseor sell assets for cash. While it is true that disputed purchases for shares must be prosecuted in theshareholder's own right, because creditors' rights are not affected by a mere dilution of the residualinterest, whereas purchases or sales for cash must be pursued derivatively, there is no reason to alterthe operation of the business judgment rule because of this procedural distinction. See, e.g.,Robinson v. Pittsburgh Oil Ref. Corp., 126 A.2d 46, 48 (Del. Ch. 1924):

ITihe directors of the defendant [selling] corporation are clothed with that presumption whichthe law accords to them of being actuated in their conduct by a bonafide regard for the interestsof the corporation whose affairs the stockholders have committed to their charge. This being so,the sale in question must be examined with the presumption in its favor that the directors whonegotiated it honestly believed that they were securing terms and conditions which wereexpedient and for the corporation's best interest.

Also, while it is quite true that most of the transactions that Manning cites are "very close to anerve," there are several different relevant nerves here, which will set off alarms in different parts ofthe judicial brain if touched. For example, freezeouts present a particularly high risk of cheating,exacerbated because they occur in a "final period." Indeed, the courts apparently believe thatfreezeouts present such a risk of cheating that they have developed specialized and very elaborate



Perhaps what distinguishes the "check is enclosed" cases such as Van

Gorkom is the finality of the event. Once the board decides to change irrevocablythe nature of the shareholder's claim by selling the company for cash or

securities of another firm, the value of the residual interest in the selling firm isfixed forever. There is no other remedy-not even the option of "turning therascals out" by electing a new board, an option that remains open to thefrustrated tender offeree. The shareholder has no other avenue of appeal, otherthan pursuing appraisal rights, which is more nearly analogous to being given ahearing in small claims court than before a Court of Appeals and which

presents its own formidable procedural obstacles.48

Of course, even in "enterprise issue" cases there is some possibility that a

shareholder can plead facts demonstrating that a board's processes were so

flawed and fell so short of the minimal standards required by the businessjudgment rule that a court will be provoked into granting review. But facts soextreme as to be provocative qualify the case as a "sport." As the next section

argues, "sports" do not count under either the Authority or ResponsibilityModel.49 Otherwise, where the board's decision will not have an immediate,direct and irrevocable effect on the value of the shareholders' personal stakes,the court is unlikely to look closely at the board's processes, even when it

concerns what might otherwise be characterized as an "important" governanceissue.

50

substantive and procedural rules to police such transactions. See Weinberger v. UOP, Inc., 457 A.2d701, 710-14 (Del. 1983); Alpert v. Williams, 473 N.E.2d 19, 26-28 (N.Y. 1984). See generallyM. Dooley, Fundamentals, supra note 10, at IV-51-78. Reverse stock-splits are often incident tofreezeouts or reorganizations that increase management's control, thereby triggering the same sort ofconflicted interest alarms. In other instances, the same transaction may be viewed quite differently,depending on the nature of the firm involved, For example, a decision to repurchase or redeem ashareholder's stock in a publicly held corporation may be motivated by a number of legitimatebusiness reasons, whereas the same transaction in a closely held corporation may raise self-dealingissues, especially if the shares redeemed were owned by a majority shareholder. Compare the ratherrelaxed attitude of the court when presented with a redemption issue in Levine v. Smith, 591 A.2d194 (Del. 1991) (see infra note 50), with the finding of the Massachusetts court in Donahue v. RoddElectrotype Co., 328 N.E.2d 505, 515-20 (1975), that a similar transaction in a close corporationsetting was in violation of fiduciary duties owed by the majority to a minority shareholder. Viewedin this light, many of Manning's examples concern Responsibility issues. Smith v. Van Gorkomseems to stand alone as an example of an "ownership claim" issue that is solely concerned with theboard's authority. The extravagant criticism the opinion has provoked is some evidence of itsuniqueness. See supra note 45.

48. See M. Dooley, Fundamentals, supra note 10, at IV-54-55, IV-77-78 (comparing theeconomics of enforcing appraisal versus other shareholder remedies).

49. See infra notes 59-60 and accompanying text.50. The case that makes this point most forcefully is also the most recent Delaware Supreme

Court decision dealing with the business judgment rule, Levine v. Smith, 591 A.2d 194 (Del. 1991 ).The case involved two consolidated derivative suits, one alleging demand futility and the otherwrongful refusal, complaining of a decision of the General Motors board to repurchase shares andnotes previously issued to Ross Perot and several of his associates. The securities had been issued inconnection with GM's 1984 acquisition of Electronic Data Systems Corporation (EDS), whichPerot had founded and continued to manage as a wholly-owned GM subsidiary. As a result, Perothad become the largest GM shareholder and was also elected a member of its board of directors.



In sum, the Authority Model's formulation of the business judgment rulepreserves Authority by effectively neutralizing, rather than accommodating, theduty of care as applied to most board decisions. "Sports" aside, the formulationpreserves Responsibility only with respect to two types of issues: (1) decisionswhere the board's judgment is tainted with the self-interest of a majority of itsmembers; and (2) gross deviations from reasonable process followed in reachingdecisions concerning "ownership claims," as defined above. Even then, theplaintiff-shareholder faces formidable pleading obstacles.

THE RESPONSIBILITY MODELThe ALI Governance Project's version of the business judgment rule appears

in section 4.01(c):

After numerous disputes with GM management concerning the operation of EDS, Perot becamean increasingly vocal and public critic of GM management and finally demanded to be bought outor allowed to run EDS as he saw fit. The board chose the former option and approved therepurchase of all shares and notes owned by Perot and his associates for approximately $742.8million.

One need not possess either great imagination or an excessively purple vocabulary to see how thisincident could be inflated by the press or an aggressive plaintiff's lawyer into One of the GreatestCorporate Governance Issues of All Times. After all, the board had stifled an important voice ofdissent by what amounts to no more than a bribe - a bribe paid to a favored insider, no less!Moreover, while $742.8 million may not be large in relation to GM's cash flows, it is a figure thatstrikes most of us as large in absolute terms.

The demand-refused case is most relevant to the present discussion. By filing demand, plaintiffLevine effectively conceded the board's independence and disinterestedness, leaving as the onlyavenue of attack the second prong of Aronson. Accordingly, the only issue was "procedural duecare" or whether the board had acted on an informed basis in rejecting the plaintiff's demand.

The plaintiff argued that the board's processes had been flawed in two major respects. First, ithad refused his request to make an oral presentation explaining why suit should be instituted. Thisargument was held legally insufficient. 591 A.2d at 214. The court noted that "there is obviously noprescribed procedure that a board must follow" in considering a shareholder's demand. Id. Further,"a determination of what matters will and will not be considered must necessarily fall within theboard's discretion." Id.

The court's response to the plaintiff's second argument establishes the differences in judicialscrutiny of board processes when the issue does not present an "ownership claim," as in Smith v.Van Gorkom and as narrowly defined in the text. The plaintiff argued that the board "failed toundertake any investigation" and "did nothing" in response to his demand but merely voted to rejectthe demand at its next monthly meeting. Id. at 213. The court held that these allegations weremerely conclusory and "contradicted" by the board's response in rejecting the demand. Id. at 214.The board's response was in the form of a short, simple letter stating that the board had decided notto take any action "following review of the matters set forth in your [demand letter]." Id. Accordingto the court, this document:

[RIeflects on its face the GM Board's consideration of Levine's demand. The only reasonableinference to be drawn from this document is that the GM Directors did act in an informedmanner in addressing Levine's demand. The business judgment rule accords directors thepresumption that they acted on an informed basis.

Id. (citations omitted).



A director or officer who makes a business judgment in good faith fulfillshis duty under this Section if:

(1) he is not interested .. .in the subject of his business judgment;(2) he is informed with respect to the subject of his business judgmentto the extent he reasonably believes to be appropriate under thecircumstances; and

-(3) he rationally believes that his business judgment is in the bestinterests of the corporation.5 t

A casual reading of section 4.01(c) leaves the impression that it differs fromthe Authority Model's formulation only incrementally, although the use of thewords "reasonably" and "rationally" begin to raise questions concerning thedrafters' intent. A closer textual study reveals significant differences betweenthis formulation and the one in the Authority Model.12

The most dramatic contrast to the Authority Model is that the ALl Gover-nance Project's provision is not concerned with the scope of judicial review of aboard's business decisions. Indeed, section 4.01(c) does not focus on the institu-tional role of the board at all. Instead, it is directed to the behavior of individualsoccupying the office of director and seeks only to provide guidance to courts as towhether that individual should be held liable. The necessary, if subtle, implica-tion of this approach is that courts should take jurisdiction of all claims thatplausibly allege harm to the corporation resulting from a business decision. Inother words, section 4.01(c) is concerned with the "punishment" phase of aproceeding that is commenced by, and will proceed inexorably from, the filing ofa derivative complaint that alleges facts sufficient to state a cause of action,without regard to the screening function normally performed by the businessjudgment rule.

Accordingly, section 4.01(c) does not create any presumption against judicialreview. The comment to the section explains that the section does not refer to a"presumption" because the word is "imprecise and subject to misinterpreta-tion." 3 Instead, according to the comment, the same effect is achieved byplacing on the plaintiff the burden of proving "a breach of a duty of care,including inapplicability of the provisions as to the fulfillment of duty underSubsection ... (c).""4 Placing the burden on the plaintiff "specifically recognizesthe general propriety of actions by officers and directors.""5 This is sophistry atbest. As any first year law student knows, there are only a few instances inAmerican civil litigation where the plaintiff does not have the burden of

51. T.D. 11, supra note 1, § 4.01(c).52. See supra notes 34-40 and accompanying text for the Authority Model's formulation of the

business judgment rule.53. Id. § 4.01 cmt. g, at 184. The word is, however, not so "imprecise and subject to

misinterpretation" as to preclude the Reporters from using it when it suits their purpose. See, e.g.,id. § 1.06a (providing that a 25% shareholder is "presumed to exercise a controlling influence overthe management or policies of the corporation") (emphasis added).

54. Id. § 4.01 cmt. g, at 184; see id. § 4.01(d).55, Id. § 4.01 cmt. g, at 184.



persuasion. The assignment of such burden in a traffic accident case hardlyqualifies as a "specific recognition" of the "general propriety" of the defendant'sdriving.

The absence of a presumption magnifies the potential mischief of the require-ment in subsection (2) that the defendant be informed to the extent he "reason-ably believes to be appropriate under the circumstances."56 This plainly invitesjudicial scrutiny of all board decisions, without regard to subject matter.Critically, it would not differentiate among "ownership claims," "enterpriseissues" and nonreviewable "core management decisions," as the Authority

Model currently does.The use of the phrase "rationally believes" in subsection (c)(3) signals an

even more consequential deviation from existing law because it calls for anevaluation of the directors' judgment, thereby effectively shredding the businessjudgment rule.5" To the extent that "rational" is to be equated with "reason-able," the trier of fact is invited to second-guess not only the procedural aspectsof the decision, but its substantive soundness as well. In that event, the businessjudgment rule becomes meaningless, and the test for negligent managementbecomes the same as the test for negligent operation of a motor vehicle. TheReporters try to back away from the consequences of their own drafting by acomment:

It is recognized that the word "rational," which is widely used by courts,has a close etymological tie to the word "reasonable" and that, at times, thewords have been used almost interchangeably. But a sharp distinction isbeing drawn between the words here. The phrase "rationally believes" isintended to permit a significantly wider range of discretion than the term"reasonable," and to give a director or officer a safe harbor from liabilityfor business judgments that might arguably fall outside the term "reason-able" but are not so far removed from the realm of reason when made thatliability should be incurred.58

56. Id. § 4.01(c)(2). Section 4.01(c)'s focus on the individual actor's, rather than the board'scollective, "reasonable belief" is quite confusing. Does this suggest that if a particular transaction isauthorized by a ten member board, of which only nine are reasonably informed, the laggard is to beheld liable under 4.01(c)? Or is this focus on the individual actor merely intended as an observationthat the tenth should try harder? See also id. § 5.02 (Transactions with the Corporation) (where asimilar stylistic quirk appears to undermine the entire section). See infra text accompanying notes101-07.

57. T.D. 11, supra note 1, § 4.01(c)(3).58. Id. § 4.01 cmt. d, at 181. The Reporters cite Sinclair Oil Corp. v. Levien, 280 A.2d 717

(Del. Super. Ct. 1971) as authority for their "rationally believes" test, which the Reporters claimadopted a "rational business purpose" test. T.D. 11, supra note 1, § 4.01(c) cmt. f, at 232; id.§ 4.01(c) reporter's note 4, at 241-42. The Reporters' misreading of Sinclair cannot even be calledcreative. The relevant issue in Sinclair was the propriety of a parent corporation's decision to causea majority owned subsidiary to pay out dividends in an amount that the plaintiff, a minorityshareholder in the subsidiary, characterized as excessive. The court, applying the business judgmentrule, held that it would not review Sinclair's dividend policy because:



The Reporters do not provide examples of judgments that might be deemed tofall somewhere between "reasonable" and "irrational," and the English lan-guage is insufficiently rich to allow one to articulate such a distinction. Pendingsome lexical innovation, the antonym of rational is irrational. The Reporterscannot conceivably intend to single out irrational decisions for special attentionbecause the category is an empty set. Firms managed by insane persons do nothave good survival properties and are therefore unlikely to produce manydecisions of any kind. Otherwise, while collective decision-making processesmay not always produce wise decisions, boards composed of ordinary men andwomen will not often reach decisions that other ordinary people find crazy.

What case, then, do the Reporters have in mind? One possibility is that theymean to cover decisions that, even viewed ex ante, seem so degraded fromordinary prudential standards as to seem at least "half-crazy," if not full-blowndemented. Such decisions could correctly be described as aberrant, which isperhaps the word closest to what the Reporters have in mind. By definition,aberrant behavior occurs so infrequently as to qualify as a "sport."

If this is what the Reporters have in mind, two problems remain. First, it isboth unnecessary and silly in drafting a statute (or statute-like document) toprovide specifically (here, exclusively, if the comment is to be taken seriously)for "sports"-behavior that you expect to occur only once in a blue moon.

[A] court will not interfere with the judgment of a board of directors unless there is a showingof gross and palpable overreaching .... A board of directors enjoys a presumption of soundbusiness judgment, and its decisions will not be disturbed if they can be attributed to anyrational business judgment. A court under such circumstances will not substitute its ownnotions of what is or is not sound business judgment.

280 A.2d at 720. In context, then, Sinclair's use of rational is to be equated with conceivable orimaginable and means only that the court will not even look at the board's judgment if there is anypossibility that it was actuated by a legitimate business reason. It clearly does not mean, and cannotlegitimately be cited for the proposition, that individual directors must have, and be prepared to putforth, proof of rational reasons for their decisions. An example of the Sinclair court's line ofreasoning is found in Shlensky v. Wrigley, 237 N.E.2d 776 (I11. App. Ct. 1968), where the courtspeculated about all the legitimate reasons the board of directors of the Chicago Cubs might havehad for deciding not to install lights at Wrigley Field. Id. at 780. As in Sinclair, the board had notoffered any explanation for its conduct. Rather, it had simply argued the business judgment rule insupport of its motion to dismiss for failure to state a claim-the appropriate response to ashareholder complaint concerning board policy where there is no evidence of self-interest. Thecourt's speculations in Wrigley were merely dicta. "Rational business judgment" is part of theholding in Sinclair. As used by the Reporters, however, the phrase is degraded to something lessthan dictum,

Moreover, the comment quoted in the text describes § 4.01(c) as providing "a safe harbor fromliability for business judgments . .. not so far removed from the realm of reason when made thatliability should be incurred." T.D. 11, supra note 1, § 4.01 cmt. d, at 181 (emphasis added). This,coupled with the peculiar focus of the section on the individual director, see supra note 56, confirmsthat the ALl Governance Project's version of the business judgment rule is not intended to provideany screening function. Rather, it assumes that all decisions are reviewable and that the onlyfunction of the rule is to assist judges in determining whether personal liability should be imposed.The absence of a screening function has enormous practical implications for the potential costs ofthe Reporters' derivative suit proposals. See infra text accompanying notes 120-22.



Courts are not so tied to the words of a rule that they cannot recognize and dealwith giddiness when they see it. The rarity of such cases is demonstrated by thefact that most casebooks cite only the same two cases as examples of aberrantboard decisions, one decided in 1940 and the other in 1880."9 On closerexamination, only the 1880 case comes close to qualifying as "not rational."'

59. Litwin v. Allen, 25 N.Y.S.2d 667 (N.Y. Sup. Ct. 1940) and Hun v. Cary, 82 N.Y. 65(1880), are usually cited as the two extant examples of aberrant board decisions.

60. In Hun, the directors of a failing bank, described by the court as "moribund" and "anabortion from the beginning" decided to move the bank from its small leased premises. Accordingly,the directors purchased an "expensive lot" on which they erected an "extravagant building," eventhough the bank was already insolvent. 82 N.Y. at 76-77. According to the court, the directors built"the imposing edifice to inspire confidence, attract attention, and thus draw deposits. It was intendedas a sort of advertisement . I..." ld. at 78. Not surprisingly, the mortgage on the new building wassoon foreclosed, and the bank went into receivership. As the court viewed this venture, it was not "acase of mere error or mistake of judgment on the part of the trustees, but ... a case of improvidence,of reckless, unreasonable extravagance, in which the trustees failed in that measure of reasonableprudence, care and skill which the law requires." Id. at 78-79.

Litwin was a shareholders suit against, inter alia, directors of Guaranty Trust Company of NewYork (Trust Company) and its wholly owned subsidiary (Guaranty Company). The controversyarose when Allegheny Corporation, an important client of Trust Company, needed to raise $10million to meet contractual obligations that would shortly come due. Allegheny could not borrow thefunds because it had already reached a debt ceiling set in its charter. Instead, Allegheny proposed toraise the funds by selling from its portfolio $10.5 million principal amount of 51% Missouri PacificRailroad Convertible Debentures.

Trust Company and Guaranty Company agreed to purchase $3 million of the bonds at par plusaccrued interest, with, however, a catch that became the focus of the litigation. The catch was thatAllegheny insisted, and Trust Company and Guaranty Company agreed, that Allegheny be granteda six month option to repurchase the bonds at the selling price. There was an ostensible businessreason for this covenant (Allegheny's fear of losing control of Missouri Pacific if the debentureswere converted to common stock), but the net effect of the option was that Trust Company andGuaranty Company would bear the entire market risk for six months. There was scant possibilitythat the buyers could realize a capital gain from this transaction since Allegheny would, if it could,exercise the option in the event the debentures had increased in value after six months. Nor couldthe defendants cut their losses before six months in the event of a decline. The debentures wereselling at 1037A when the Executive Committee of Trust Company approved the purchase but haddeclined to 1027A when the Trust Company's full board confirmed the purchase. In less than amonth, when the Guaranty Company's board confirmed its commitment, the debentures haddropped to 98% and were trading between 86 and 81 when the six month option expired. The courtwas nearly as condemnatory of the directors as its predecessor had been in Hun: "I find liability inthis transaction because the transaction was so improvident, so risky, so unusual and unnecessary asto be contrary to fundamental conceptions of prudent banking practice." Litwin, 25 N.Y.S.2d at699.

Viewed through modern eyes, however, the transaction does not appear to be so unusual. Instead,it can be seen as a purchase coupled with the selling of a European call option. In that event, therelevant issue becomes, not the alleged freakishness of the arrangement, but whether TrustCompany and Guaranty Company received adequate consideration (5h% interest on a 37A discount)for granting the call option. One may particularly question the wisdom of the Guaranty Company'sboard in not insisting on renegotiation when the discount had disappeared (and Guaranty Companywas effectively paying a two point premium), but the relevant issue for both boards remains thevalue of the compensation received for the risk assumed, Disputes over value may raise a host ofissues, ranging from inadequate information to corruption (specifically found not to be implicatedhere), but such disputes rarely, if ever, demonstrate that one of the contending parties is irrational.



Second, this is a very dangerous drafting practice. Because legal rules haveconsequences, the words used in formulating the rule are also consequential.Anyone who believes that the plaintiffs' bar will not try to expand the definitionof behavior that is "not quite rational" has not been paying attention. Preciselybecause it is not worthwhile to provide for aberrant behavior, courts will notbelieve that they have been asked to waste their time by searching for theproverbial needle-in-a-haystack. Accordingly, courts will inevitably begin toexpand the otherwise useless definition to fit a "reasonable" (i.e., cost-justifiedin terms of judicial resources already expended) proportion of the cases broughtbefore them. In time, the "close etymological tie" between "rational" and"reasonable" that the Reporters acknowledge will become closer than perhapseven they intended.

CARE AND OVERSIGHTDifferences in the formulation of the duty of care under the Authority and

Responsibility Models need not be compared for one simple reason: it does notmake any difference to the operation of the Authority Model. That is, given thescreening function of the business judgment rule under the Authority Model, itcan hardly matter what standard of care is applied to the few cases that survivescreening. For all the difference in outcomes it would make, the AuthorityModel could accommodate a duty of care formulated to require of directors themost careful consideration and most refined, prudent judgment. Adoption ofsuch a discordant duty of care would have only one observable effect: it wouldundoubtedly increase the perplexity of the drafter who tries to explain therelevance of the duty of care in a statute that is primarily patterned on theAuthority Model and the confusion of those readers who struggle to understandsuch an explanation.6

61. The confusion is plainly evident in the Revised Model Business Corporation Act's treatmentof the duty of care. As previously noted, § 8.30(a) of the Revised Model Business Corporation Actadopts an ordinary care (negligence) standard for directors. See supra text accompanying note 28.Subsection (d) then purports to provide a "safe harbor" for potential liability arising undersubsection (a): "A director is not liable for any action taken as a director, or any failure to take anyaction, if he performed the duties of his office in compliance with this section." Rev. Model BusinessCorp. Act § 8.30(d). The statement is wholly tautological because it says a director isn't liable fornegligence if he wasn't negligent. It is akin to including in the Motor Vehicle Code a statement that"Drivers who exercise all due care shall not be personally liable for automobile accidents." Thecomment to § 8.30(d) struggles to find some reason for its existence:

If compliance with the standard of conduct set forth in former section 35 or section 8.30 isestablished, there is no need to consider the possible application of the business judgment rule.The possible application of the business judgment rule need only be considered if compliancewith the standard of conduct set forth in former section 35 or section 8.30 is not established.

Id. § 8.30 cmt. 4. Procedurally, this statement is exactly backwards: if the business judgment rule isapplicable, the director's conduct will not be reviewed (period), and no standard is relevant. Inadapting the Revised Model Business Corporation Act for the Virginia Stock Corporation Act, thedrafters of the Virginia act avoided the embarrassment of § 8.30 by substituting for the good faithand negligence standards of subsections (a)(l)-(3) the requirement that a director discharge his



Given that the Responsibility Model's version of the business judgment ruleperforms almost no screening function, however, the articulation of the duty ofcare becomes very consequential because it will, in fact, be applied to most cases.This explains the otherwise curious amount of effort devoted in the comment tosection 4.01(a) of the ALl Project to establish the proposition that a majority ofjurisdictions have adopted an objective (ordinary negligence) standard as themeasure of the duty of care.62 A comment to section 4.01(a) states that "nomatter how the facts of given cases may be characterized, in a substantialmajority of the decided cases for over one hundred years courts have articulatedthe culpability standard for duty of care violations in terms of reasonablecare."63 Yet, the Reporters also express agreement with Professor Bishop's well-known observation that "[t]he search for cases in which directors of industrialcorporations have been held liable in derivative suits for negligence uncompli-cated by self-dealing is a search for a very small number of needles in a verylarge haystack." 64 Bishop, himself, engaged in such a search by examining allreported cases involving directors over a twenty-year period. He reported thathe had been able to find just "four specimens," and, after further study,concluded that "none of these cases carries real conviction."65 We would all beastonished to find that a similar twenty-year survey of all reported automobileaccident decisions produced only four cases where one of the parties had beenfound to have driven negligently. We are left with two possible explanations forthe dichotomy between rhetoric and results in director care cases: For over onehundred years American businesses either have been managed with a degree ofcare and skill unknown in any other human endeavor in the history of the worldor American judges have followed an Authority Model and have thereforeintended that their articulation of the duty of care be mostly hortatory.

There is, however, one aspect of directors' duties where articulation of theduty of care makes a difference. That aspect is the duty to oversee the generalconduct of the business. The Reporters are correct in concluding that mostAmerican jurisdictions have "adopted" an ordinary care formulation of the dutyof care.66 As previously argued, and as confirmed by Bishop's findings, this

duties "in accordance with his good faith business judgment of the best interests of the corporation."Va. Code Ann. § 13.1-690.A (Michie 1989) (emphasis added). Virginia also provides a safe harborsimilar to § 8.30(d), but clearly places the burden of proving a violation of the section on theplaintiff. Id. § 13.1-690.C-D. The net effect of these provisions is to state correctly the law: the dutyof care is subject to the business judgment rule.

62. T.D. 11, supra note 1, § 4.01(a) reporter's note 15, at 204.63. Id. § 4.01(a) reporter's note 17, at 206. In the first Tentative Draft, similar statements were

buttressed with an elaborate chart listing all 50 states and demonstrating that a majority had, bystatute or decision, adopted the standard of ordinary care for directors' decisions. American LawInstitute, Principles of Corporate Governance: Analysis and Recommendations (Tentative DraftNo. 1, 1983) § 4.01(a) reporter's note 1, at 166-70 [hereinafter T.D. 11.

64. Joseph W. Bishop, Jr., Sitting Ducks and Decoy Ducks: New Trends in the Indemnification

of Corporate Directors and Officers, 77 Yale L.J. 1078, 1099 (1968), cited with approval in T.D. 11,supra note 1, § 4.01(a) reporter's note 17, at 206.

65. Bishop, supra note 64, at 1099-1100.66. T.D. 11, supra note 1, § 4.01(a) reporter's note 15, at 204.



makes little difference in outcomes concerning specific transactions because most

American jurisdictions apply an Authority Model version of the businessjudgment rule. A gap exists, however, in the protection afforded by the rule. Asformulated, the rule applies only to decisions affecting specific transactions.Accordingly, "the business judgment rule operates only in the context of directoraction. Technically speaking, it has no role where directors have . . . absent aconscious decision, failed to act."67 Again, Bayless Manning has neatly captured

the consequences that would occur if courts were to apply rigorously this"technical" distinction:

[I]n major part the life and activity of the boardroom does not consist oftaking affirmative action on individual matters; it is instead a continuingflow of supervisory process, punctuated only occasionally by a discretetransactional decision. In corporate litigation tomorrow, arising out of the

debris of a company that has failed, the charge that will be leveled at thedirectors is that they were "negligent" in that they passively stood by

without taking affirmative action about this or that. If that is the charge,then by existing definitions the business judgment rule would not beavailable to protect the director. That would mean, astonishingly, that,given the realities of the way boards operate, the business judgment rulewould not operate at all in respect of fully ninety percent of what directors

are actually engaged in. 68

Courts thus far have managed to avoid such absurd results by manipulating

the other elements of negligence to produce outcomes that accord with realisticexpectations of the directors' discharge of their oversight responsibilities. Insome cases, courts achieve reasonable results by finding that the directors had

insufficient notice of some untoward occurrence to be held negligent in failing toact. For example, in Graham v. Allis-Chalmers Manufacturing Co.,69 theDelaware Supreme Court acquitted the defendant directors of negligence fortheir failure to discover and prevent the illegal price-fixing activities of lower-ranking managerial employees. The illegal activities came to light in late 1959,and the plaintiff argued that the entry of antitrust consent decrees against Allis-Chalmers in 1937, when none of the defendants were associated with thecompany, was sufficient to put the defendants "on notice of their duty to ferret

out such activity and to take active steps to insure that it would not berepeated." '70 The court rejected this argument and found that the defendants hadnot violated their duty of care.71 According to the court:

67. Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984); see Rabkin v. Philip A. Hunt Chem.

Corp., 13 Del. J. Corp. L. 1210, 1216-17 (Del. Ch. Dec. 17, 1987) (adopting "ordinary" negligencestandard for oversight issue; "gross" negligence standard applicable only to actual board decisions).

68. Bayless Manning, The Business Judgment Rule and the Director's Duty of Attention: Timefor Reality, 39 Bus. Law. 1477, 1494 (1984).

69. 188 A.2d 125 (Del. 1963).70. Id. at 129.71. Idat 130.



[D]irectors are entitled to rely on the honesty and integrity of theirsubordinates until something occurs to put them on suspicion that some-thing is wrong. If such occurs and goes unheeded, then liability of thedirectors might well follow, but absent cause for suspicion there is no dutyon directors to install and operate a corporate system of espionage to ferretout wrongdoing which they have no reason to suspect exists.7 2

In other instances, courts have excused an admittedly inattentive-thusnegligent-director by insisting upon proof that the director's negligence causedthe calamity complained of. The most famous example of this is Barnes v.Andrews,7 3 where Judge Learned Hand held that there was insufficient proofthat greater diligence on the part of an inattentive director could have avoided abusiness failure attributable to personal hostility and lack of cooperation be-tween the two principal officers of the corporation. 74

But Barnes v. Andrews also suggests the limits of courts' generosity inassessing director negligence in oversight cases. If an inattentive director ischarged, not with failure to remedy pervasive incompetence, but with failure todetect blatant self-dealing with respect to matters already established to bewithin the board's oversight responsibilities, liability will follow.75 In otherwords, the directors' ignorance of wrongdoing will not be excused if and to theextent that the board has an obligation to assure that the firm maintainsadequate internal controls to guard against such wrongdoing. The clearestexample of this is accounting controls, where it has long been recognized thatthe board is obliged to insure the installation of adequate record-keeping andauditing systems.7 6

In keeping with its overall Responsibility thrust, the ALI Governance Projectseeks to establish corporate "legal compliance" systems as an immutable part ofthe directors' oversight responsibilities of the same rank as accounting andauditing systems. The ALI Governance Project seeks, in other words, tooverrule Graham v. Allis-Chalmers Manufacturing Co. and to require theinstallation and operation of "a corporate system of espionage to ferret outwrongdoing which [the directors] have no reason to suspect exists. 7 7 TheReporters were once quite candid about this ambition. Such an obligation wasexplicitly included as part of the definition of the duty of care in section 4.01 ofthe first Tentative Draft. According to 4.01(b) of that draft, "[tihe duty of care. . . encompasses the obligation of a corporate director to be reasonablyconcerned with the existence and effectiveness of monitoring programs, includ-ing law compliance programs." 7s Under section 4.01(c) of that draft, "[tihe duty

72. Id.73. 298 F. 614 (S.D.N.Y. 1924).74. Id. at 616-18.75. See Francis v. United Jersey Bank, 392 A.2d 1233, 1242-43 (N.J. Super. Ct. Law Div.

1978), aff'd, 432 A.2d 814 (N.J. 1981).76. See Atherton v. Anderson, 99 F.2d 883, 888-90 (6th Cir. 1938).77. See supra text accompanying note 72.78. T.D. 1, supra note 63, § 4.01(b).



of care ... encompasses the obligation of a director or officer to make reasonableefforts to cause his corporation to perform its duty under [§ 2.01] to obey thelaw." 79 Although this explicit language was deleted from subsequent versions ofsection 4.01, the requirement survives in subsequent versions-albeit in suchcamouflaged form that it is revealed only by close textual analysis. Thecomment to the current version of section 4.01 indicates that the Reporters seekto achieve the same result by linking section 4.01 with sections 2.01 (TheObjective and Conduct of the Business Corporation) and section 3.02 (Func-tions and Powers of the Board of Directors). Section 2.01 declares that acorporation should conduct its business to enhance corporate profit and share-holder gain, and that "[elven if corporate profit and shareholder gain are notthereby enhanced, the corporation, in the conduct of its business ... [i]s obliged,to the same extent as a natural person, to act within the boundaries set bylaw."80

Section 3.02(a)(2) declares that the directors should "[o]versee the conduct ofthe corporation's business."81 The Reporters seek to complete the loop bystating that "[s]ection 4.01(a)'s statement that a director or officer 'perform hisfunctions in good faith' is intended to indicate that the functions of directors andofficers [under section 3.02], which include the obligation to act consistentlywith § 2.01, must be performed in accordance with the standards of § 4.01"82

Preliminarily, one may wonder whether a simple injunction to perform in"good faith" can bear that much weight. Moreover, the Reporters' interpreta-tion of section 4.01(a) incorporates not only the lawfulness requirement ofsection 2.01 but also its requirement that the business be operated so as toenhance corporate profit and shareholder gain. However laudable all of theseobjectives may be, stuffing them all into a "good faith" requirement brings usback to square one in the task of sensibly delimitating the directors' generaloversight responsibilities.

More importantly, the proposal to impose secondary liability on directors forthe illicit acts of others is truly radical, and the case for such a revolutionarychange in existing law is far from being proved. In the first place, the Reporters'proposal goes well beyond the confines of "Corporation Law" to effect sweepingchanges in the whole corpus of American civil and criminal law-at least withrespect to one class of persons. When Congress has chosen to address thequestion of secondary liability in particular statutes, it has done so selectively.Thus, directors are specifically made subject to liability for securities sold bymeans of a registration statement containing false and misleading statements,but they are not, by virtue of their office alone, secondarily liable for saleseffected by some other medium. 83 Surely the question of whether directors

79. Id. § 4.01(c).80. T.D. 11, supra note 1, § 2.01.81. Id. § 3.02(a)(2).82. Id. § 4.01(a) cmt. d, at 191.83. Compare Securities Act of 1933, § 11, 15 U.S.C. § 77k (1988) with Securities Act of 1933,

§ 12(2), 15 U.S.C. § 771(2) (1988).



should be liable for another's violations of the antitrust, labor, civil rights,product safety, environmental or general criminal laws calls for the applicationof no less discriminating judgment.

Secondly, the creation of such a duty to the corporation has the effect ofcreating a cause of action in favor of the corporation that can be prosecuted byone or more of its shareholders, or more realistically, by a lawyer purporting toact on behalf of the shareholders. Thus, putting aside for the moment thequestion of who ultimately benefits from such suits, the shareholders are at leasttheoretically the beneficiaries of any recovery from the directors. There is noapparent justification for this formal wealth transfer (and none is advanced),especially when shareholders have no greater interest in corporate lawfulnessthan any other member of society.

"Law compliance programs" are also likely to present implementation prob-lems that are different in both degree and kind from those associated with otherinternal controls, such as accounting systems. Determining which corporateassets need to be secured is relatively easy, but deciding which laws directorsshould be most concerned about is not.

RESOLUTION OF CONFLICTS OF INTERESTFrom an economic perspective, lapses in diligence are indistinguishable from

lapses in fidelity: both are instances of self-interested behavior that reduce thevalue of the residual interest. Yet, the law has always dealt more strictly withthe unfaithful servant than with the careless one. 4 Judicial invocations of theduty of loyalty are characterized by uncompromising, extravagant rhetoricsuggesting that officers and directors are obliged to observe a standard ofabsolute selflessness in all of their dealings with the corporation.8 5 The results ofthe reported cases suggest, however, that courts are actually concerned with

84. See, e.g., Bayer v. Beran, 49 N.Y.S.2d 2, 5 (N.Y. Sup. Ct. 1944):

The fiduciary has two paramount obligations: responsibility and loyalty.... The responsibility-that is, the care and diligence-required of an agent or fiduciary, is proportioned to theoccasion. It is a concept that has, and necessarily so, a wide penumbra of meaning ....

The concept of loyalty, of constant, unqualified fidelity, has a definite and precise meaning.The fiduciary must subordinate his individual and private interests to his duty ... wheneverthe two conflict.

85. The standard of overstatement was set, as usual, by Judge Cardozo's too-often quoteddeclaration in Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928):

Many forms of conduct permissible in a workaday world for those acting at arm's length areforbidden to those bound by fiduciary ties. A trustee is held to something stricter than themorals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive,is then the standard of behavior. As to this there has developed a tradition that is unbendingand inveterate. Uncompromising rigidity has been the attitude of courts of equity whenpetitioned to undermine the role of undivided loyalty by the "disintegrating erosion" ofparticular exceptions .... Only thus has the level of conduct for fiduciaries been kept at a levelhigher than that trodden by the crowd.

Id. at 546 (citations omitted).



behavior that falls far short of a standard of selflessness. Thus, although therhetoric of loyalty suggests an affirmative duty to behave "fairly" and withsupreme concern for the rights of others in the firm, in application the duty isessentially negative. As tort law's affirmative duty of "care" is transformed inpractice to an injunction against negligently injuring others, so is the duty of"loyalty" applied as a prohibition against "cheating." The term is used here notto describe such generally illicit behavior as fraud or theft, but to refer to the useof one's position in the firm to extract gains at the expense of the residualclaimants or some subset thereof. Accordingly, the law is primarily concernedwith the behavior of those "insiders" with decision-making power-directors,senior executives and controlling shareholders.

The substantive and procedural law applied to loyalty violations differsdramatically from that applied to breaches of care. Once the plaintiff satisfiesthe burden of going forward to raise a credible loyalty violation, the burden ofpersuasion shifts to the defendant-fiduciary to establish the "fairness" of thetransaction in question. 6 The standard of fairness implies a much stricter levelof judicial review than is applied in care cases, and courts will closely examinethe substance of the transaction and the surrounding facts and circumstances toassure that the defendant's behavior and the transaction satisfy the court'snotions of fairness. The same standards apply to board decisions where amajority of the directors were personally interested in the transaction underreview. 87 Where the board cannot claim a majority of disinterested members,Responsibility trumps Authority, and with good reason. If the board's decisionwas clouded with self-interest, there is no reason to assume that its action wasintended to benefit the shareholders. Indeed, the contrary inference seems morelikely, and there is no reason to preserve the authority of the board.

This section focuses' on evaluating which rules should be used to determinewhether an individual director's conflicted interest transaction with the corpora-tion constitutes a loyalty violation when that transaction has been reviewed by amajority of disinterested directors. Specifically, assuming that a disinterestedmajority has determined that the conflicted interest transaction was nonethelessfair to and in the best interests of the corporation, what, if any, level of judicialreview should be applied to the board's decision?

THE AUTHORITY MODELPerhaps because the analogy of express trusts was too firmly in mind, the

early common law regarded an interested director's transaction as presenting apure Responsibility issue. Accordingly, the earliest cases held that any contractor transaction between a director and the corporation was voidable at the option

86. E.g., Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983); Guth v. Loft, 5 A.2d 503,512 (Del. 1939).

87. E.g., Cohen v. Ayers, 596 F.2d 733, 739-40 (7th Cir. 1979); Fliegler v. Lawrence, 361 A.2d218, 221, 224 (Del. 1976).



of the corporation, regardless of fairness.88 By 1910, this rigid rule had givenway to one which held that such contracts or transactions were valid if approvedby a disinterested majority of the board and not unfair or fraudulent to thecorporation.

89

Today, most states deal with the issue by statutory provision. While there aremany local variations, most statutes are similar to section 144(a) of the Dela-ware statute.9" Section 144(a) provides that "no contract or transaction betweenthe corporation and one of its directors or officers shall be void or voidable solelybecause of the conflicted interest" if: (1) the material facts concerning theconflict and the contract or transaction were disclosed or known to the boardand the contract or transaction was approved in good faith by a majority of thedisinterested directors, though less than a quorum; (2) the shareholders ap-proved the contract or transaction after similar disclosure; or (3) the contract ortransaction is "fair as to the corporation as of the time it is authorized, approvedor ratified, by the board of directors, a committee, or the shareholders. "91

All existing statutes provide for some variant of subsections (1) and (2) of theDelaware statute (disclosure to and approval by disinterested directors orshareholders). A number of state statutes, however, simply provide fairness asthe third ground for upholding the contract or transaction,92 whereas subsection(3) of section 144(a) of the Delaware statute clearly contemplates that the boardor shareholders must nonetheless approve or ratify the deal, even if it isotherwise fair.93 This difference in language should not produce differentoutcomes under the two types of statutes. The more elaborate wording ofsubsection (3) of the Delaware statute simply provides a more explicit recogni-tion of, and cleaner way of dealing with, the fact that efforts to set aside aninterested contract or transaction fall into two distinct categories.

The first category, and the one to which subsection (3) is addressed, is wherethe corporation itself, acting through its board of directors, wants to rescind thecontract or transaction. The basis of such an action would be the failure of thedefendant director to disclose his conflicted interest. The intentional failure todisclose is a violation of the duty of candor and thus constitutes a separateviolation of the duty of loyalty,94 notwithstanding the basic "fairness" of thecontract or transaction. Subsection (3) of the Delaware statute merely preservesthe corporation's right of rescission where there has been no disclosure and theboard of directors has determined to penalize the insider's loyalty violation byavoiding the contract or transaction. This same option is available under the"fairness" statutes because virtually all such statutes provide that a contract or

88. Harold Marsh, Jr., Are Directors Trustees?, 22 Bus. Law. 35, 36 (1966).89. Id. at 39-40 (tracing the early common law history).90. Del. Code Ann. tit. 8, § 144(a) (1991).

91. Id.92. See, e.g., Rev. Model Business Corp. Act § 8.31(a)(3), repealed by Rev. Model Business

Corp. Act ch. 8, subch. F.93. See Del. Code Ann. tit. 8, § 144(a)(3) (1991).94. See Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983).



transaction shall not be voidable solely because of the director's interest, and donot purport to eliminate independent grounds, such as a violation of the duty ofcandor, as a basis for avoiding the transaction.9" The important point is thatnothing in either type of statute restrains in any way the corporation's board ofdirectors from exercising its business judgment to discipline loyalty violations byrejecting a contract or transaction in which an officer or director had an

undisclosed financial interest. Delaware section 144(a)(3) is merely an explicitacknowledgment of that principle.

A board's decision to disavow a contract or transaction with an insider onloyalty grounds is, for all practical purposes, nonreviewable. Therefore, it isonly disputes falling under the second category-shareholder derivative actions-that this section addresses. Specifically, this section is concerned only with thesubset of shareholder suits that attempt to reverse a decision by disinteresteddirectors to approve a contract or transaction after full disclosure in accordancewith section 144(a)(1) of the Delaware statute and its analogues. At first blush,subsection (a)(1) of the Delaware statute and its analogues appear to raiseinterpretive questions. For instance, satisfying any one of the grounds wouldappear to make the contract or transaction binding, since they are listeddisjunctively. Moreover, at least under a "fairness" type statute, failure toobtain approval or ratification will not invalidate the transaction so long as theparty seeking to uphold it establishes that it was fair to the corporation at thetime it was made. This suggests, by negative implication, that proper approvalor ratification cuts off a subsequent fairness review by a court. On the otherhand, virtually all statutes provide that the contract or transaction will not bevoidable solely because of conflicted interest if it is approved, ratified, or foundto be fair. The solely hedge might have been intended merely to preserve other,unrelated grounds for avoiding the transaction, such as illegality. Alternatively,and especially in view of the common law background against which thesestatutes were enacted, it might have been intended to preserve the right to obtainde novo judicial review of fairness, even after approval or ratification.9 6

95. It should be noted that § 144(a)(3) of the Delaware statute does not require that the contractor transaction be approved by disinterested directors. The principal implication of this is thatapproval by an interested board suffices to permit the defendant director to defend the contract ortransaction against a shareholder suit by proving that it was "fair," precisely the same defense thatwould be available under those statutes listing unadorned "fairness" as the third ground upon whichrescission of the contract or transaction can be avoided. In effect, approval or ratification by aninterested board under both § 144(a)(3) of the Delaware statute and the "fairness" statutes, or,under the latter type of statutes, the failure of an interested board to take any action, constitutes adecision not to disavow the contract or a transaction that binds the corporation only conditionallyand is subject to rescission in a subsequent shareholder suit if the interested director does not sustainthe burden of proving fairness. See generally 1 R. Franklin Balotti & Jesse A. Finkelstein, TheDelaware Law of Corporations and Business Organizations §§ 4.2, 4.9 (1989).

96. The interpretive problem is made more difficult by the fact that the statutes can be read toappear merely to codify some version of the rather elaborate common law rules that courts hadworked out in an earlier era. As a result, the common law tends to seep back into lacunae left in thestatutes. See Cookies Food Prod. Inc. v. Lakes Warehouse Distrib., Inc., 430 N.W.2d 447, 452(Iowa 1988) (statute based on former Revised Model Business Corporation Act § 8.31 must be



The significance of these questions fades and the appropriate construction ofthese statutes becomes obvious if one views the interested directors statutes asprimarily intended to strike a balance between the conflicting demands ofAuthority and Responsibility. These statutes satisfy the Responsibility criterionby commanding the conflicted director to make full disclosure of his interest andof the material facts concerning the transaction. By definition, full disclosuresatisfies the conflicted director's good faith obligation under the duty of care.Withholding material information is neither good faith nor sufficient to meet thestatutory requirements for director or shareholder approval. Assuming, how-ever, that the interested director discharges his disclosure obligations, he alsothereby discharges his loyalty obligations and the Responsibility criterion issatisfied.97 The only remaining question under the statute is whether thecontract or transaction is "fair" to the corporation. Fairness in this context canonly mean commercial reasonableness.9" Since the Responsibility criterion ismet, the Authority criterion becomes the only relevant value, and Authoritycommands that the question of commercial reasonableness be committed to thedecision maker that decides those questions in all other contexts-the board ofdirectors.

This line of analysis accurately predicts how the substantive rule actually willbe applied. The determination by a disinterested board of the substantivefairness of an interested director contract or transaction is protected by thebusiness judgment rule.99 This rule is codified, in the clearest possible terms, insection 8.61(b) of the Revised Model Business Corporation Act's recentlyadopted Subchapter F, which provides (with respect to a transaction that hasbeen approved by disinterested directors or shareholders):

A director's conflicting interest transaction may not be enjoined, set aside,or give rise to an award of damages or other sanctions, in a proceeding by ashareholder or by or in the right of the corporation, because the director, or

interpreted in conformity with common law, including placement of initial burden on director toestablish "good faith, honesty and fairness," notwithstanding compliance with statutory proce-dures). But see Rev. Model Business Corp. Act ch. 8, subch. F.

97. In this regard, it is well to bear in mind that:

[Ilt is a contingent risk [that] we are dealing with-that an interest conflict is not in itself acrime or a tort or necessarily injurious to others. Contrary to much popular usage, having a"conflict of interest" is not something one is "guilty of"; it is simply a state of affairs. Indeed, inmany situations, the corporation and the shareholders may secure major benefits from atransaction despite the presence of a director's conflicting interest. Further, while the history ofmankind is replete with acts of selfishness, we have all also witnessed countless acts taken bypersons contrary to their personal self interest.

Model Act Conflicting Interest Amendments, supra note 8, at 1309 (introductory comment to Rev.Model Business Corp. Act ch. 8, subch. F).

98. See id. at 1324-25 (official comment on Note on Fair Transactions); see also infra note 110(discussion of the "waste of corporate assets" standard).

99. E.g., Cohen v. Ayers, 596 F.2d 733, 740 (7th Cir. 1979) (construing New York law); Pumav. Marriott, 283 A.2d 693, 695 (Del. Ch. 1971); Marciano v. Nakash, 535 A.2d 400, 405 n.3 (Del.1987) (dictum).



any person with whom or which he has a personal, economic, or otherassociation, has an interest in the transaction .... too

THE RESPONSIBILITY MODELSection 5.02 of the ALl Governance Project is apparently intended as its

version of an interested director statute. Apparently intended is used advisedly.Section 5.02 bears a general architectural resemblance to the interested directorstatutes, and the section's accompanying comment deals extensively with suchstatutes and includes a chart of all state statutory provisions. 1 Both characteri-zation and analysis of section 5.02 are complicated, however, by the fact that thesection, as currently drafted, makes no sense.

The trouble begins with the section's introductory clause, section 5.02(a).Whereas all other interested director statutes directly relate to the validity ofcontracts and transactions in which a director or officer has a conflicting interest,section 5.02 does not. Instead, following the same stylistic quirk noted inconnection with section 4.01(c), 1°2 section 5.02 focuses on whether the conflicteddirector or "senior executive" fulfills his duty of fair dealing under the sec-tion.103 Section 5.02 goes on to provide that the insider fulfills his duty in theusual ways, that is, if the transaction is fair or if the material facts concerningthe conflict and the transaction are disclosed to and approved by, inter alia,disinterested directors."° This suggests that the consequences of failing to fulfilla duty under section 5.02 does not affect the validity of the contract ortransaction but only the liability of the insider for any damages that thecorporation may have sustained as a result of the unfair transaction. Further-more, although none of the published Tentative Drafts reflect this interpreta-tion, the Reporters propose to add a comment confirming that this is, in fact,what they intended in drafting section 5.02.15 If so, section 5.02 will have theeffect of removing much of the sting from, and settlement value of, conflict of

100. Rev. Model Business Corp. Act § 8.61(b).101. T.D. 11, supra note 1, § 5.02 cmt. a, at 274, reporter's note 1, at 304-07.102. See supra note 56.103. T.D. 11, supra note 1, § 5.02(a).104. Id. § 5.02(a)(1) (disclosure), § 5.02(a)(2)(A) (fairness), § 5.02(a)(2)(B) (disinterested

directors), § 5.02(a)(2)(C) (disinterested shareholders).105. See American Law Institute, Principles of Corporate Governance: Analysis & Recommen-

dations 15 (Council Draft No. 17, 1991) [hereinafter Council Draft No. 17]:

Section 5.02 governs only the conduct of the interested director or senior executive, and not theeffectiveness of the corporation's approval of a transaction in terms of its validity as a corporatetransaction, which is governed generally by the business judgment rule as specified in § 4,01.Accordingly, where disinterested directors authorize in advance or ratify a transaction in amanner that meets the requirements of the business judgment rule, relief based on a violation of§ 5.02 should be awarded by way of damages or other remedy against the interested seniorexecutive or director, but the transaction should not be set aside unless the corporation moves todo so.



interest challenges in derivative litigation, and the entire section becomes muchado about-if not quite nothing-nothing very much.

The focus on the conflicted director's discharge of his duty of loyalty causesthe section to become completely unravelled when read against the section'sapproval procedures. Thus, section 5.02(a)(2)(B) states that the duty is dis-charged if, after disclosure, the transaction is approved by disinterested directors"who could reasonably have concluded that the transaction was fair to thecorporation."' 6 Read literally, this suggests that the disinterested directorswould absolve a conflicted director who proposed a transaction that he knew tobe disadvantageous so long as the dimmer-witted disinterested directors thoughtit was fair. Of course, it is possible to save section 5.02 from producing such anonsensical result by invoking the conflicted director's basic obligation of goodfaith or claiming that such an occurrence is precluded by his disclosure obliga-tions. On the other hand, requiring such a doubling-back on the language of thestatute itself or the invocation of extra-statutory concepts seems unusual in aproject that, even if it no longer purports to restate the law, still claims to

analyze in traditional ALl black-letter form the principal common law andstatutory provisions relating to corporate governance. 0 7

To avoid pretermitting discussion, however, assume that the Reporters willsomehow remedy the currently short-circuited wiring of section 5.02 and that itwill eventually emerge as a provision designed to do something. In that event, itis noteworthy that section 5.02 is also designed to diminish the authority of theboard. The prior iteration of section 5.02 called for a judicial determination ofthe fairness of a transaction that had been approved by disinterested directors. 08

While the Reporters have softened this stance somewhat in the current version,the requirement in section 5.02(a)(2)(B) that the disinterested directors "couldreasonably have concluded that the transaction was fair" plainly contemplates

some level of judicial second-guessing of the director's substantive reasons.'0 9

106. T.D. 11, supra note 1, § 5.02(a)(2)(B).107. The official ALl designation of the project was changed from "Restatement and Recom-

mendations" in the first tentative draft to "Analysis and Recommendations" in the second and allsubsequent tentative drafts. According to the foreword to the second tentative draft, "[tlhe changewas made to allay the fears that courts might be misled by the traditional word "Restatement" inthe title to view the entire document as purporting to restate existing law, ignoring the detailedexplanation in the comments of how far that was and how far that was not the case." American LawInstitute, Principles of Corporate Governance: Analysis and Recommendations vii-viii (TentativeDraft No. 2, 1984).

108. American Law Institute, Principles of Corporate Governance: Analysis and Recommenda-tions § 5.02 (Tentative Draft No. 5, 1987).

109. T.D. 11, supra note 1, § 5.02(a)(2)(B). The Reporters claim precedential support for theirproposal by citing a number of cases in which courts have conducted a fairness review. Id. § 5.02reporter's note 1, at 302. The Reporters neglect to point out, however, that virtually all of the citedcases involve closely held corporations in which there were no independent directors and, hence, inwhich the option of independent director approval under the statute was not available. In oneespecially irritating instance of selective citation, the Reporters acknowledge:

The Delaware Supreme Court and Chancery Court have indicated in dictum that approval ofan interested transaction by disinterested directors will be subject to review under the business



There are two principal objections to this approach. First, as previously argued,"fairness" can only mean "commercial reasonableness," and to suppose thatjudges are better evaluators of commercial reasonableness than directors simplyflies in the face of the universally recognized statutory requirement that thedirectors are responsible for managing the company. Second, such a require-ment has the ironic effect of detracting from the Responsibility thrust of all suchstatutes because it diverts attention from what ought to be the principal issue:did the conflicted director fulfill his duty of candor by making full disclosure. Ifdisinterested directors approve a transaction that, viewed in hindsight, seemsfacially unfair to the corporation, there is at least a strong suspicion that theoriginal disclosure was incomplete. In any event, there is every reason to focus

judgment rule. See Marciano v. Nakash, 535 A.2d 400, 405 n.3 (1987); Citron v. E.I. Dupontde Nemours & Company, CCH Fed. Sec. L. Rep. $ 95,420 (Del. Ch. 1990); but see Flieglerv. Lawrence, 361 A.2d 218, 222 (Del. Sup. Ct. 1976).

Id. Fliegler is a case in which the defendant directors both controlled the board and were themajority shareholders, leaving no other avenue under the statute than to prove "fairness." Omittedfrom the Reporters' citations is Puma v. Marriott, 283 A.2d 693 (Del. Ch. 1971), which held thatbusiness judgment, not fairness, is the appropriate standard of review for interested transactions thathave been approved by a majority of disinterested directors. Id. at 695. See supra text accompanyingnote 99. For a critique of the Reporters' citation methods and a considerably more detailed review ofapplicable precedent, see Charles Hansen et al., The Role of Disinterested Directors in "Conflict"Transactions: The ALl Corporate Governance Project and Existing Law, 45 Bus. Law. 2083, 2090-97 (1990).

Puma v. Marriott also apparently escaped the Reporters' attention when they were drafting§ 5.10, concerning transactions between a corporation and a "controlling shareholder." The sectiondoes not provide for disinterested director approval of such a transaction, but only for approval bydisinterested shareholders, subject to a "waste" standard of review. T.D. 11, supra note 1, § 5.10(a).Puma involved a real estate transaction between a corporation and a family group that held 47% ofthe corporation's stock. The court specifically held that the size of the insiders' holdings did notreflect adversely on the reviewing directors' independence. 283 A.2d at 695. For purposes of§ 5.10(a), holding as little as 25% of the outstanding shares is enough to qualify as a controllingshareholder and to disable the board. See T.D. 11, supra note 1, § 1.06a (definition of controllingshareholder).

Any random search of decisions dealing with interested director transactions will turn up morecases involving closely held corporations than publicly held firms. There are two plausible explana-tions for this. First, given the multiple roles played by participants in closely held firms, transactionsbetween the firm and one of its participating directors, major shareholders, officers, or employees arelikely to occur more frequently than in the large firm setting. For example, shareholders in closelyheld corporations are more likely, for tax or other reasons, to hold title to property used by thecorporation-another frequent source of dispute. The second reason is one already alluded to: giventhe rarity of truly "outside" directors in close corporations, such firms are unlikely to be able tomuster enough disinterested directors or shareholders to use the approval mechanisms of the statuteand must thus fall back on proving fairness. Conversely, even granting the lower incidence of suchtransactions in larger firms, the publicly held corporation is likely to have a majority of memberswho are "disinterested" in all but the most unusual circumstances. Accordingly, it seems likely thatthe few transactions presented to such boards are either rejected or approved under what has been,until the ALl Governance Project, a legal regime that clearly precluded judicial review ofdisinterested directors' determinations of commercial reasonableness. See also Regulation S-K, Item404, 17 C.F.R. § 229.404 (1991) (federal securities disclosure requirements designed to make itunlikely that interested transactions involving publicly held firms will escape notice of shareholders).



the court's attention on that issue. By diverting the court's attention to thecommercial reasonableness of the transaction as viewed by disinterested direc-tors, section 5.02 also diverts attention from what is possibly an even moreserious violation of loyalty on the part of the interested director."1 ' Even if it isrewritten to make sense, section 5.02 will serve only to diminish Authority withno offsetting gains in Responsibility.

The remainder of Part V of the ALI Governance Project consists of unusu-ally detailed provisions specifying how a director or senior executive candischarge his duty of fair dealing with respect to such potentially troublesomeissues as compensation;'1 ' use of corporate property, nonpublic information,or position; 1 2 corporate opportunities;" 3 and competition with the corpora-

l 10. The primacy of disclosure in modern corporate regulation is well illustrated by Weinbergerv. UOP, Inc., 457 A.2d 701 (Del. 1983). In that case, the Delaware Supreme Court devisedelaborate burden-shifting procedures for reviewing freeze-out transactions. If the plaintiff share-

holder meets the burden of going forward to raise a fairness issue, the burden of persuasion shifts tothe defendant majority shareholder to establish the entire fairness of the transaction, unless the

transaction had been approved by a majority of the minority shareholders. Id. at 703. In such a case,

the plaintiff reassumes the burden of persuasion with respect to the fairness issue. Id. Even then, the

burden of showing compliance with the duty of candor remains with the defendant. Id.; see id. at710-11 (discussing the duty of candor).

Two factors may account for the relative inattention to disclosure issues in reported cases dealing

with interested director transactions, First, as discussed above, the vast majority of reported opinionsconcern conflicts in closely held corporations where there are rarely a sufficient number of

disinterested directors or even shareholders to take effective action under the statute and where,

accordingly, disclosure is irrelevant. See supra note 109. Second, as already stated, the early commonlaw continues to exercise some influence in the interpretation of conflicted director statutes. See

supra note 96. The concept of using disclosure as a regulatory device grows out of experiences withfederal securities regulation. Much of the common law relating to interested director statutes wasestablished well before the enactment of the Securities Act of 1933. With disclosure not yet in the

judicial mind, courts naturally sought to evaluate these transactions by the only measure at hand-the substantive "fairness" of the transaction. This is true even of Globe Woolen Co. v. Utica Gas &Elec. Co., 121 N.E. 378 (N.Y. 1918), notwithstanding the impression created by Cardozo's famous

dictum in the case. If the defendant in that case had failed to disclose the material adverse facts that

Cardozo insinuates, but never states, were in his possession, the plaintiff would have had an easy

fraud case. This suggests that Globe Woolen is really not concerned with disclosure in the modern

sense, instead, it should be read as assigning the entire risk of an improvident contract to the

conflicted director.There is yet another example of the tenacity of outmoded common law thinking and its

continuing capacity to direct courts' attention to the wrong issue. The standard usually applied to

challenges to shareholder approval of interested transactions is "waste of corporate assets," and thisstandard is incorporated in §§ 5.02(a)(2)(C) and 5.10(a)(2) of the ALl Governance Project. T.D.11, supra note 1, §§ 5.02(a)(2)(C), 5.10(a)(2). The ALl Governance Project also adopts a fairlystandard definition of "waste" in § 1.34. Id. § 1.34 ("the consideration received is so inadequate invalue that no person of ordinary sound business judgment would deem it worth that which the

corporation has paid"). It is unlikely that such a state of affairs ever occur in a closely heldcorporation with disinterested shareholders, let alone in a publicly held corporation with sophisti-

cated institutional investors, without some grave deficiency in the disclosure made to the sharehold-ers.

111. T.D. 11, supra note 1, § 5.03.

112. Id. § 5.04.

113. Id.§ 5.05.



tion. 1 4 Sections 5.10 through 5.12 create a parallel universe for controllingshareholders (excepting, for obvious reasons, competition), notwithstanding thepaucity of case law detailing the fiduciary duties of shareholders and withoutapparent recognition of shareholder autonomy as an independently importantvalue in corporate law.t1 5

The Reporters apparently believe that section 5.02 (whatever it is) is theheart of Part V of the Governance Project because they propose what isapparently intended as a more relaxed standard of judicial review of boardapproval of matters coming within sections 5.03, 5.05, and 5.06. Again, "appar-ently intended" is the operative phrase because the standard proposed for board

approval is "in a manner that satisfies the standards of the business judgmentrule [§ 4.01(c)]."' 116 As we have seen, however section 4.01(c) places no

limitation on judicial review of decisions, but deals exclusively with the liabilityof individual decision makers. 17 This time, the ALl Governance Project's

drafting difficulties do not arise from crossed wires, as in the case of section 5.02,but from wires that were never connected.

DERIVATIVE SUITSTHE SUPPLY OF DERIVATIVE CLAIMS

A derivative suit involves the assertion of a cause of action on behalf of thecorporation by one of its shareholders. Accordingly, any such suit presents two

analytically distinct questions. First, does the corporation have a valid cause ofaction? Second, does the putative shareholder complainant have standing topursue the cause of action on behalf of the corporation? Under existing law, it isperfectly clear that a decision to pursue, forego, or compromise a corporateclaim against an outsider or a lower-ranking corporate employee is a businessdecision that, like any other business decision, is entirely within the discretion ofthe board of directors.I" As a result, absent extremely unusual facts or evidence

114. Id. § 5.06.115. Id. §§ 5.10-.12; see Ringling Bros-Barnum & Bailey Combined Shows v. Ringling, 53

A.2d 441, 447 (Del. 1947):

Generally speaking, a shareholder may exercise wide liberality of judgment io the matter ofvoting, and it is not objectionable that his motives may be for personal profit, or determined bywhims or caprices, so long as he violates no duty to his fellow shareholders .... The ownershipof stock imposes no legal duty to vote at all.

116. T.D. 11, supra note 1, §§ 5.03(a)(2), 5.05(a)(3)(B), 5.06(a)(2). The standard applicable to§ 5.04 matters is § 5.03(a)(2) if the use "constitutes compensation" or, for all other uses, "thestandards of disclosure and review set forth in § 5.02 as if that section were applicable to the use."Id. § 5.04(a)(2), (a)(4).

117. See supra notes 51-58 and accompanying text.118. E.g., United Copper Sec. Co. v. Amalgamated Copper Co., 244 U.S. 261, 263-64 (1917)

(Brandeis, J.) (affirming dismissal of a shareholder's antitrust suit against a competitor of thecorporation):

Whether or not a corporation shall seek to enforce in the courts a cause of action for damagesis, like other business questions, ordinarily a matter of internal management and is left to the



that the directors are somehow personally interested in the claim, a derivativecomplaint alleging a cause of action against an outsider or lower-rankingemployee will not survive a motion to dismiss. Regardless of whether the motionto dismiss is predicated on the demand requirement or is styled as one for failureto state a claim, it will be directed to the standing issue and not to the basicvalidity of the legal claim asserted. In other words, the corporation may have aperfectly valid claim against an outsider or lower-ranking employee, but it doesnot become a legally cognizable "cause of action" unless and until the board ofdirectors decides to pursue it. The shareholder has no more standing to preemptthe board's authority by asserting such a claim on behalf of the corporation thanhe does to buy or sell other assets for the account of the firm. This proposition isso well established in existing law that virtually the only derivative suitsbrought involve claims against (i) the board itself or (ii) some subset thereof or adominant executive or shareholder, in which it is asserted that the board isdisabled by reason of self-interest in the first case, or by virtue of the dominatinginfluence exercised by the main defendants on the other directors in the secondcase. If these avenues of attack, both of which are addressed to the first prong ofthe Aronson test,119 prove fruitless, it is theoretically possible, but practicallynearly hopeless, for the plaintiff to make a frontal assault on the board'sbusiness judgment in declining to pursue a claim against another director or asenior executive of the firm.

Thus, the supply of claims that can be brought derivatively under existinglaw is constrained by the courts' deference to the institutional role of the board,particularly as that deference is implemented by the screening function of thebusiness judgment rule. As this Article already has asserted, the concept of anindependent board is not given any prominence in the ALI's scheme of things,and its version of the business judgment rule does not limit the kinds of claimsreviewed by the courts-only the liability of individual directors for making thedecision already under review. 120 This means, then, that Parts IV and V of theALI Governance Project have the effect of significantly increasing both theabsolute numbers and the kinds of claims that can be pursued derivatively.

Increasing the supply of derivative claims is, of course, consistent with theResponsibility orientation of the ALI Governance Project. Given that theprobability of detecting opportunistic behavior can never approach unity, thedeterrence of managerial irregularities can be increased only by increasing theseverity of sanctions imposed for those irregularities that are detected or by

discretion of the directors, in the absence of instruction by vote of the shareholders. Courtsinterfere seldom to control such discretion intra vires the corporation, except where the

directors are guilty of misconduct equivalent to a breach of trust, or where they stand in a dualrelation which prevents an unprejudiced exercise of judgment ....

See Dooley & Veasey, Derivative Litigation, supra note 5, at 522-23. See generally Block et al.,supra note 5 (discussing development of business judgment rule's application to the demandrequirement).

119. See supra notes 35-36 and accompanying text.120. See supra notes 51-58 and accompanying text.



devoting more resources to detection and prosecution.1 21 The first choice, whichmight take the form of treble damages or criminal penalties, 122 was not one thatwas made available by the ALl in its charge to the Reporters. The second choicedictates an expansion of the universe of cases that is subject to judicial review forirregularities, and this is what Parts IV and V of the ALI Governance Projecthave done.

If confirming evidence of the ALI Governance Project's intent is needed, itcan be found in the otherwise inexplicable treatment of the effect to be given toboard ratification in matters covered by Part V of the ALI Project. Corporatelawyers are not accustomed to distinguishing between the words "approval" and"ratification," because it is so widely accepted that a board resolution "ratify-ing" some transaction relates back to the time of the original transaction and isas fully effective as though the board had manifested its approval before thetransaction occurred. Indeed, lawyers often speak of board "ratification" ofsome forward-looking action taken by the corporate officers, such as negotiatingthe terms of a merger agreement, even though all parties understand that theofficers' agreement is merely a proposal that will not be binding upon thecorporation unless and until their action is confirmed (or "approved," or"adopted," or "ratified") by the board. Insofar as interested director transac-tions are concerned, many statutes specify "authorized," "approved" or "rati-fied" as alternative expressions of the ways in which disinterested directors canconfirm the transaction and thus bind the corporation, consistent with thebusiness judgment rule. t23 Where the statutory language economically refersonly to "approval," courts have given effect to custom by holding that the termincludes "ratification. ' 124 A manifestation of assent by disinterested directors issufficient to remove the interest cloud from a director's transaction with thecorporation, even when the ratifying action comes after a shareholder hascommenced a derivative action to rescind the transaction.' 25

Given this background, one is taken aback to discover that Part V of the ALlGovernance Project draws a sharp distinction between advance approval andratification. In all previously published versions of section 5.02, includingTentative Draft 11, subsequent ratification by disinterested directors has been

121. See Michael P. Dooley, Enforcement of Insider Trading Restrictions, 66 Va. L. Rev. 1, 25(1980).

122. A prominent example of a high sanction/low probability enforcement strategy is theInsider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA). See M. Dooley,Fundamentals, supra note 10, chapter IV, section C.3c (discussing historical background and effectsof ITSFEA).

123. Thus, the timing of board action is irrelevant under both the original Revised ModelBusiness Corporation Act and its new Subchapter F. See Rev. Model Business Corp. Act§ 8.31(a)(2), repealed by Rev. Model Business Corp. Act ch. 8, subch. F (transaction may be"authorized, approved or ratified" by the board); id. § 8.61(b)(1) ("directors' action respecting thetransaction" may be taken "at any time").

124. Cohen v. Ayers, 596 F.2d 733, 740 (7th Cir. 1979) (interpreting New York law); Blish v.Thompson Automatic Arms Corp., 64 A.2d 581, 604 (Del. 1948). See generally Hansen et al.,

supra note 109, at 2097-98 (discussing cases where courts equate ratification with prior approval).125. Thompson Automatic Arms Corp., 64 A.2d at 604.



given no effect. Instead, the transaction must have been "authorized in advance"by "disinterested directors," or, in the case of a "senior executive" who is not adirector, by a "disinterested superior," to qualify for the somewhat morerelaxed standard of judicial review under section 5.02(a)(2)(B).2 6 The failureto obtain such advance approval, whether by design, inadvertence, or impossi-bility, entitles a complaining shareholder to a full-scale review of the substantive"fairness" of the transaction under section 5.02(b), in which the interesteddirector or executive had the burden of proof.'27

The explanatory comment to section 5.02 admits that the refusal to recognizeratification is not based on "existing statutes or decisions" but on purportedreasons of "principle and policy."' 28 The first policy reason advanced is to"assure" that "a senior executive or director who seeks to bind the corporationby dealing with a person subject to his influence or control demonstrates todisinterested directors or (in case of a non-director senior executive) to adisinterested superior the fairness of his conduct."' 29 This reason, however, isirrelevant because it is unrelated to the timing of review: the interested partycan be required to demonstrate the fairness of his conduct as a condition toratification as well as to approval given in advance.

A second policy reason asserted in the comments is that a board's negotiatingposture will necessarily be weaker when it is asked to ratify conduct that hasalready occurred than when it is asked to approve a proposed course of action. 3

The comment further asserts that when a board is asked to ratify it must eitheraccede completely to the request (perhaps grudgingly) or "expose the interesteddirector or senior executive to a lawsuit."'' This argument is even morefanciful than the first. In the first place, the argument is flatly contradictedelsewhere in the section's comments by a statement that failure to obtainadvance approval entitles the corporation to rescind the transaction. 32 Thepower to rescind is the same as the power to refuse to approve, and independent

directors thus have the same negotiating leverage to modify the terms of thetransaction when asked to ratify as they have when they are asked for advanceapproval. Moreover, since the directors can rescind whenever they learn aboutthe unauthorized transaction, the nondisclosing director or executive bears therisk of all adverse developments, including market changes, that may occurbetween the time the transaction is entered into and the time the board decidesto ratify, modify, or rescind the transaction. Finally, these arguments are not

126. T.D. 11, supra note 1, § 5.02(a)(2)(B) (whether disinterested directors "could reasonablyhave concluded that the transaction was fair").

127. Id. § 5.02(b).128. Id. § 5.02 cmt. a, at 276.129. Id. § 5.02(a)(2)(B) cmt., illus. 7, at 291.130. Id.131. Id.132. Id. § 5.02 cmt. a, at 275 (nondisclosure is grounds for setting aside a transaction "even if it

falls within a range of fairness").



made with respect to shareholder review of a conflict transaction, where negoti-ation is clearly impossible, and yet shareholder ratification is fully effective toinvoke the "waste" standard of review under section 5.02(a)(2)(C)' 33

The Reporters have recently proposed to recognize a limited form of ratifica-tion, subject to strict conditions. The proposal is to add a new subsection (C) tosection 5.02(a)(2) that will give effect to ratification by disinterested directors,provided:

(i) a corporate decisionmaker who was not interested [§ 1.18] in thetransaction acted for the corporation and could have reasonably concludedthe transaction to be fair to the corporation; (ii) the interested director orsenior executive made disclosure to such decisionmaker pursuant to subsec-tion (a)(1) to the extent he then knew of the material facts; (iii) theinterested director or senior executive did not act unreasonably in failing toseek advance authorization of the transaction by disinterested directors or adisinterested superior; and (iv) the failure to obtain advance authorizationof the transaction from disinterested directors or a disinterested superiordid not adversely affect the interests on the corporation in a significantway. 134

Each of these four conditions raises disputable fact issues that need not beresolved when advance approval has been secured. Thus, the Reporters' condi-tional recognition of ratification comes at a sufficiently high cost to guaranteethat advance approval will continue to be the only practical form of disinteresteddirector action in most instances under Part V of the ALI Governance Project.There is an additional price attached to the limited allowance of ratificationunder section 5.02: whereas prior Tentative Drafts had allowed traditionalratification with respect to compensation (section 5.03) and matters otherwisefalling within section 5.04 but intended as compensation, the Reporters proposeto add to the ratification provisions in these sections conditions paralleling thoseproposed for section 5.02.135

The inflation of the "ratification/advance approval" distinction to the statusof a major principle, and the porousness of the arguments advanced in favor ofsuch a proposition, lead one to suspect that the refusal to give full effect toratification is designed to achieve an objective that lies outside the substantiveconcerns of Part V of the ALl Governance Project. One need look no furtherthan the derivative suit proposals in Part VII of the ALl Project. Ratification bydisinterested directors cannot be given effect under Part V because disinteresteddirectors cannot be allowed to control derivative litigation under Part VII. 3 6

133. Id. § 5.02(a)(2)(C).134. Council Draft No. 17, supra note 105, at 3.135. Id. at 53, 58.136. As will be seen in the discussion of the Responsibility Model in this section, see infra notes

165-82 and accompanying text, the central premise of the Reporters' derivative suit proposals is thata disinterested majority of the board of directors should not be able to dismiss derivative litigation



The purpose of this rather lengthy introduction to a comparison of thedifferences in the treatment of derivative suits under the Authority and Respon-sibility Models is to underscore a very basic point: the costs and benefits ofdifferent procedural regimes for derivative suits cannot be compared withoutbearing in mind the effects of the substantive law of the different regimes on thetotal supply of disputes that can be litigated by shareholders.

THE AUTHORITY MODELThe Authority Model's requirements for the commencement of a derivative

suit are derived directly from the Model's business judgment rule. Indeed, thebusiness judgment rule supplies the content of the derivative suit rules to suchan extent that the two are almost indistinguishable, and most of the law ofbusiness judgment has been developed in the derivative suit context.

The only characteristic that serves to distinguish the Authority Model'sderivative suit regime from the Model's business judgment rule is the demandrequirement. Even here, however, the demand requirement and the businessjudgment rule share a common ancestor: the requirement that the business andaffairs of the corporation be managed by the board of directors.

Accordingly, most jurisdictions have adopted a statutory provision or courtrule similar to Federal Rule of Civil Procedure 23.1, which requires that theshareholder's complaint "allege with particularity the efforts, if any, made bythe plaintiff to obtain the action he desires from the directors or comparableauthority and ...the reasons for his failure to obtain the action or for notmaking the effort." '137 The demand requirement recognizes that a legal claim islike any other corporate asset and, under ordinary circumstances, is committedto the exclusive discretion of the board of directors. At the same time, however,rule 23.1 and its analogues recognize that there may be extraordinary circum-stances in which the board is disabled from exercising its usual authority and,accordingly, in which it will become necessary for a surrogate-one or moreshareholders-to act in its stead in pursuing a corporate claim.

These considerations are reflected in the "demand-required/demand-ex-cused" distinction that is the hallmark of Delaware derivative suit law and,until quite recently, was also a universally recognized feature of American

without some level of judicial review of the merits of their decision. This principle is, in fact,bootstrapped from their disallowance of traditional ratification in Part V of the ALl Project:

[Tihe board's rejection of a proposed suit is not easily distinguishable from retrospectivecurative efforts by the board, such as a ratification .... Under Part V, the board's after-the-fact ratification of a self-dealing transaction does not shift the burden away from the fiduciaryto prove its fairness. Consistency dictates that the law treat similar techniques similarly.

American Law Institute, Principles of Corporate Governance: Analysis and Recommendations§ 7.08 cmt. c, at 123 (Tentative Draft No. 8, 1987) (citations omitted) [hereinafter T.D. 8].

137. Fed. R. Civ. P. 23.1.



corporate law. 138 The "demand-required/demand-excused" distinction is de-rived from the state of the board's authority and is applied analogously to theway in which courts apply conflict of interest rules.139 Thus, if the board iscomprised of a majority of disinterested members, it is institutionally capable ofexercising its full authority, and the plaintiff may not commence a derivativeaction without first serving a "demand" or request on the board that it pursuethe cause of action. If the board accedes to the request, it has full control overthe ensuing litigation and the shareholder plaintiff drops out of the picture. Ifthe board declines to sue, it has exercised business judgment, and the plaintiffmay not sue in its stead unless he first establishes that the refusal was"wrongful"-that is, under the circumstances, not entitled to the protection ofthe business judgment rule. 140 In turn, this means that the plaintiff must raise a"reasonable doubt" under the Aronson test, in the face of the limits on pleadingand discovery that frustrate attempts to satisfy that test.141 Indeed, as theDelaware court has recently refined the wrongful refusal requirements, theplaintiff's act in filing a demand amounts to a concession of the board'sdisinterestedness and independence, leaving only the second, "business judg-ment," prong of Aronson to demonstrate that the board's refusal was wrong-ful. 14 2

In contrast, if the plaintiff pleads sufficiently particularized facts to raise areasonable doubt concerning the board's disinterestedness or independence, healso has demonstrated that demand should be "excused" in this case. Theplaintiff, therefore, is free to prosecute the claim on behalf of the corporation. 4 3

As in the case of loyalty issues, Responsibility trumps Authority: a board actingout of self-interest is not promoting the interests of the shareholders and there isno reason to preserve its authority.

Until the development of the Special Litigation Committee (SLC) device, adetermination that demand was excused removed the board from the picture ascompletely as a finding that demand was required removed the shareholder. Ifdemand was excused, the board had no institutional role to play and therepresentative shareholder was free to proceed to win, lose, or compromise thecorporation's case, subject to court approval of any voluntary discontinuance. Inthe late 1970s, however, the idea developed that a board disabled from actingbecause of the interest of a majority of its members could nonetheless delegateits litigation authority to a committee of disinterested directors. The commit-tee of disinterested directors could then exercise the authority of the boardwith respect to derivative litigation. 144 Thus, in Zapata Corp. v. Maldo-

138. See generally Block et al., supra note 5, at 480-82 (discussing jurisdictions following theDelaware Rule). The notable exception is Subchapter D of chapter 7 of the Revised Model

Business Corporation Act. See infra notes 159-64 and accompanying text.139. See supra text accompanying notes 86-87, 99-100.140. See Levine v. Smith, 591 A.2d 194, 212 (Del. 1991).

141. See supra text accompanying notes 39-40.142. Levine, 591 A.2d at 212; Spiegel v. Buntrock, 571 A.2d 767, 777 (Del. 1990).

143. Zapata Corp. v. Maldonado, 430 A.2d 779, 784 (Del. 1981).144. See Dooley & Veasey, Derivative Litigation, supra note 5, at 511-12.



nado,'45 the Delaware Supreme Court had to confront for the first time thequestions of whether the authority originally denied to a board of directors in ademand-excused case could be reclaimed by an SLC comprised entirely ofindependent directors and what, if any, degree of deference should be given tothe SLC's recommendation to dismiss the litigation as not in the best interests ofthe corporation.' 46 The court's resolution of these issues demonstrates theparallels between demand-excused and other self-interest cases and, indeed, thesimilarities among all basic corporate governance issues when viewed in termsof the Authority/Responsibility tradeoff. Zapata affords limited recognition tothe authority of the SLC in the sense that it recognizes that the SLC is a properrepresentative of the corporation in the same way that an interested board maylegitimately assert that a conflicted interest transaction is nonetheless in the bestinterests of the corporation. 47 But the fact that the board was originallydisqualified by self-interest, coupled with the fact that the SLC members wereappointed by directors disabled from acting on the matter at issue, raises aResponsibility issue of such magnitude that an independent judicial determina-tion of the corporation's best interests is warranted. 4 Accordingly, in much thesame way that a court will review a conflicted interest transaction for fairnesswhere the board is disqualified, Zapata calls for independent judicial review ofboth the merits of the derivative claim and the SLC's assertion that continuedlitigation of the claim is not in the corporation's best interests. 49

The demand regime is such an integral and elegantly logical part of the basicgovernance system that it is hard to understand how it could produce confusionor a desire to tinker with it. It has, however, produced both. Misunderstandingof the demand requirement led the usually highly perceptive Judge Easterbrookinto reversible error in Kamen v. Kemper Financial Services, Inc. 5 ° In thatcase, arising under the Investment Company Act of 1940, Judge Easterbrookrefused to apply the applicable state law requirement that the plaintiff establishdemand "futility" (i.e., demand-excused), and held that federal courts were freeto fashion their own demand requirements for cases arising under federallaw.' ' The court thereupon adopted a "universal demand requirement," pat-terned after the similar proposal made in the ALI Governance Project.'52

According to Judge Easterbrook, the demand futility exception has produced"gobs of litigation" on an issue that is collateral to the merits of the suit.'53 Heagreed with the ALl Project's Reporters' recommendation that the demandissue should be severed from the question of judicial review of the board'sdetermination not to sue. According to Judge Easterbrook, "[i]f the firm

145. 430 A.2d 779 (Del. 1981).146. Id. at 781.147. Id. at 785.148. See id. at 786-89.149. Id.150. 908 F.2d 1338 (7th Cir. 1990), rev'd, 111 S. Ct. 1711 (1991).151. Id. at 1342-44.152. Id. at 1344.153. Id.



declines to sue, the court can decide whether the board's decision is entitled torespect under state corporate law, which applies in light of the holding inBurks."' s4 The Supreme Court unanimously reversed, holding that the Burkspresumption of state-law incorporation includes the demand requirement.1 55

According to the Court:

Because the contours of the demand requirement-when it is required, andwhen excused-determine who has the power to control corporate litiga-tion, we have little trouble concluding that this aspect of state law relates tothe allocation of governing powers within the corporation. The purpose ofrequiring a precomplaint demand is to protect the directors' prerogative totake over the litigation or to oppose it.156

The Court also noted its doubts about the supposed contributions of a universaldemand requirement to judicial economy.' 57 Such a requirement merely shiftsthe threshold inquiry "to the question [of] whether the directors' decision toterminate the suit is entitled to deference."' 58

The Court's last observation raises some question concerning the allegedeconomizing virtues of the recently promulgated Subchapter D of chapter 7 ofthe Revised Model Business Corporation Act (Subchapter D) in adopting auniversal demand requirement." 9 On the other hand, such a requirement doesat least allow even an interested board to see the error of its ways and to act tocorrect some wrong forcefully brought to its attention by the filing of ashareholder's demand. In contrast to Judge Easterbrook, the drafters of Sub-chapter D have recognized that abolition of the demand-required/demand-excused distinction removes the criteria for judicial review. The drafters, there-fore, have supplied a review system that corresponds to the usual standardsunder the Authority Model, even with a universal demand requirement.

Subchapter D preserves the right of the corporation to dismiss a derivativeproceeding in a way that preserves the authority of disinterested directors.Under the provisions of Subchapter D, a derivative proceeding is commencedninety days after the shareholder has filed a demand unless he has been notifiedearlier that the corporation has rejected the demand. 60 Thereafter, the deriva-tive proceeding:

[Sihall be dismissed by the court on motion by the corporation if one of thegroups specified in subsections (b) or (f) has determined in good faith after

154. Id. at 1347. The referenced case is Burks v. Lasker, 441 U.S. 471 (1979). In Burks, theSupreme Court held that in derivative suits founded on federal claims, federal courts must applystate law to determine the power of the board of directors to dismiss the suit, unless application ofthe state rule would frustrate some overriding federal policy. Id. at 486.

155. Kamen, 111 S. Ct. at 1719.156. Id.157. Id. at 1721.158. Id.159. Rev. Model Business Corp. Act ch. 7, subch. D.160. Id. § 7.42.



conducting a reasonable inquiry upon which its conclusions are based thatthe maintenance of the derivative proceeding is not in the best interests ofthe corporation.

161

The reference to subsection (f) is to a panel of "one or more independentpersons" appointed by the court and need not concern this discussion. 162 Therelevant reference is to subsection (b), which lists the following as groupsentitled to make the "good faith" determination of section 7.44(a):

(1) a majority vote of independent directors present at a meeting of theboard of directors if the independent directors constitute a quorum; or

(2) a majority vote of a committee consisting of two or more independentdirectors appointed by majority vote of independent directors present at ameeting of the board of directors, whether or not such independent direc-tors constituted a quorum. 163

The different standards of review contemplated by Aronson, for demand-required cases, and Zapata, for demand-excused cases, are replicated in Sub-

chapter D by assigning the burden of proof according to whether a majority ofthe board was, or was not, disinterested at the time the board determined to seekdismissal of the suit.

164

THE RESPONSIBILITY MODELThe Governance Project also seeks to establish a universal demand require-

ment, but not for the reasons of judicial economy that motivated the drafters ofSubchapter D. Instead, the Reporter's reasons strike at the heart of the existingAuthority Model. Although recognizing that courts currently adopt "a muchmore deferential standard of review when demand is required," the Reportersassert that "this linkage is an unfortunate one because the two issues-the needfor demand and the standard of judicial review-are logically very distinct, anddifferent criteria should govern. ' 165 In view of the obvious link between the

161. Id. § 7.44(a).162. Id. § 7.44(f).163. Id. § 7.44(b)(1)-(2).164. Id. § 7.44(e). This subsection provides:

If a majority of the board of directors does not consist of independent directors at the time thedetermination is made, the corporation shall have the burden of proving that the requirementsof subsection (a) have been met. If a majority of the board of directors consists of independentdirectors at the time the determination is made, the plaintiff shall have the burden of provingthat the requirements of subsection (a) have not been met.

165. T.D. 8, supra note 136, at 65. Part VII of the ALl Governance Project, "Remedies," is amoving target, and the current version must be pieced together from T.D. 8, T.D. 11 and CouncilDraft No. 17. See supra notes 136, 1, 105. The current published version of the substantiveproposals is in T.D. 11. Unless otherwise noted, all references to specific sections are to that draft.T.D. 11 consists solely of black-letter text, with no comments or reporter's notes. The most recentversion of comments and notes is in T.D. 8, although Council Draft No. 17 contains new andrevised comments and notes. Furthermore, additional revisions are apparently planned for Tentative



demand requirement and the board's authority, why do the Reporters see theissues as "logically distinct" and implicating "different criteria?" In my opinionit is because the Reporters seek to establish a wholly new governance system:

[Tihe demand rule can have a negative impact if it broadly precludesjudicial review in cases where Parts IV and V would find that a breach ofduty had occurred. Thus, even if the board should have the power todismiss some class of cases summarily, it does not follow that the criteriafor defining this class of cases should be co-extensive with the criteria fordetermining when demand would not be useful. It is therefore logicallyconsistent to give the board the benefit of the doubt at the demand stage...but also to subject the board's rejection of demand to greater judicialoversight.166

Under the ALI Governance Project's scheme, demand, while a conditionprecedent to commencing the action, serves merely to put the board on notice ofthe nature of the plaintiff's claim. 67 The board can elect to take over thelitigation, but, assuming the complaint satisfies the proposed, new pleadingrequirements described below, 169 the board can terminate by filing a motion todismiss and convincing the court that continuing the action is "contrary to thebest interest of the corporation."'

69

The level of justification required to dismiss the derivative action varies withthe identity of the defendants and the nature of the underlying conduct of whichthe plaintiff complains. Section 7.07 specifies different procedures to terminatesuits against directors, senior executives, and controlling persons and theirassociates, on the one hand, and all other parties, on the other.170 With respectto the latter group, which would include outsiders and lower-ranking corporatepersonnel, section 7.07(a) directs the court to dismiss the suit if the corporationhas determined that the suit is not in its best interests and "the determinationsand conclusions of the board or committee underlying the motion satisfy therequirements of the business judgment rule as specified in § 4.01 ."171

In contrast, a complaint against a director, officer, or other insider wouldtrigger a Zapata-like review in all instances, even where all or a majority of themembers of the board were disinterested. Thus, section 7.09 requires that theboard or a committee of at least two directors, each of whom must be disinter-ested and, as a group, "capable of objective judgment," must first conduct(assisted by independent counsel) a "review and evaluation that the court finds

Draft No. 12 to be presented to the 1992 ALl Annual Meeting. While there are drafting differencesin the black-letter presentations in tentative drafts 8 and 11, the basic thrust of the proposals has notbeen changed, and T.D. 8, therefore, will be relied on as an authoritative source of explanatorycomment throughout the rest of this section.

166. T.D. 8, supra note 136, § 7.03 reporter's note 2, at 77 (emphasis added).167. T.D. 11, supra note 1, § 7.03(a).168. See infra text accompanying note 182.169. T.D. 11, supra note 1, § 7.08(a).170. Id. § 7.07(a)(1)-(2).171. Id. § 7.07(a)(1).



were adequately informed" of the facts alleged in the complaint. 72 The boardor the committee should then file with the court a written report of its findingsand recommendations.

1 73

In evaluating the findings of the board or committee and assessing thereasonableness of its recommendations, section 7.10(a)(3) provides that thecourt "may substantively review and determine any issue of law."' 1 4 Section7.10 also prescribes different review procedures depending on the nature of theunderlying conduct. Where the conduct of the defendant is alleged to haveviolated Part IV of the ALI Project, other than a "knowing and culpableviolation of law," or a claimed violation of a provision of Part V of the ALIProject that could be reviewed under the business judgment rule (e.g., compen-sation), the court should dismiss the derivative action "unless it finds that theboard's or committee's determinations and conclusions are so clearly unreason-able as to fall outside the bounds of the discretion of the board or committee."'7 5

For all other claims under Part V of the ALI Project and those alleging "aknowing and culpable violation of law," section 7.10 requires a full review onthe merits. 176 Specifically, the section authorizes dismissal of the derivativeaction only if the court finds "in light of the applicable standards under PartsIV or V, that the board or committee reasonably concluded that dismissal is inthe best interests of the corporation, on the basis of adequately supporteddeterminations and conclusions that the court deems to warrant reliance."' 177

As in the case of at least some provisions of Part V of the ALI Project, theReporters prescribe more rigorous standards of judicial review when the under-lying conduct raises a loyalty issue than when due care is at stake. The reasonthe Reporters initially advanced for this disparate treatment is that "litigationremedies are more essential to the effective enforcement of the duty of loyaltythan the duty of care, partly because in the latter case market and other forcesplay a larger role."' 78 This is perfectly plausible as applied to the individualwho is accused of the loyalty violation: no agent has positive incentives to makemistakes, but the unfaithful agent can profit from undetected cheating. That isnot, however, the principal point of dispute. The question is not whether theunfaithful agent should be punished for cheating, but, rather, who should decidewhether the conduct in question constitutes cheating and what should be doneabout it. Unless one assumes that cheating is a communicable disease againstwhich only judges have been inoculated, the nature of the individual actor'sconduct is not a sufficient reason to change tribunals and transfer the traditionalauthority of independent directors to the courts. Although the Reporters do notspecifically address this issue, they have advanced another argument in both

172. Id. § 7.09(a)(1)-(3).173. Id. § 7.09(a)(4).174. Id. § 7.1O(a)(3).175. Id. § 7.10(a)(1).176. Id. § 7.1O(a)(2).

177. Id.178. T.D. 8, supra note 136, § 7.08 cmt. c, at 120.



Parts V and VII of the ALI Project that serves as a complete response:independent directors cannot be trusted to deal with wayward colleagues in anhonorable way.'

79

This response is deeply disturbing in several respects. First, it denigrates thecontributions of outside directors to corporate governance. Given that theirprincipal experience lies outside the firm, outside directors are better able toevaluate the ethical propriety of a proposed course of action than its technicalmerits as a business proposition. Indeed, if the appointment of outside directorshad to be justified solely on the value of their expected contributions to businessefficiency, there would be a real question whether such appointments were cost-justified.'8 0 Second, viewed from a more traditional perspective, the argument isdisturbing because it suggests that directors hold a perversely ordered hierarchyof values in which corruption is preferred to carelessness. The argumentappears to imply that directors, in contrast to most people, are more likely to betolerant of corruption than they are of simple negligence. Assuming that thisimplication was not intended by the Reporters, their argument seems betterdirected to abolition of any vestige of the business judgment rule for careviolations. If directors are prone to be too forgiving of managerial irregularitiesand assuming that their personal values are not perverse, they are certainlymore likely to tolerate good faith lapses in judgment than they are to forgivemorally culpable cheating. Although the Reporters do not address this issueeither, it is implicitly answered by understanding the full implications of theirResponsibility Model. Preserving the authority of the board is not an importantvalue and must always yield to the principal goal of increasing the occasions for

179. With regard to § 5.02, the Reporters observe: "the presence of close relationships amongcolleagues on the board or in management, particularly in smaller corporations, may sometimesinterfere with the ability of directors or superiors to deal with a colleague with the degree ofwariness that is employed in arm's length transactions." T.D. 11, supra note 1, § 5.02(a)(2)(B)cmt., at 286-87. The same argument reappears in Part VII, albeit in the guise of "structural bias,"in justification for the proposal to require greater judicial oversight of derivative suits:

[In cases in which demand is required, the possibility must be recognized that the board in atleast some instances may be subject to a bias or conflict of interest that would not be overtlydiscernible to the court, but which would make the justifications advanced for dismissal appearimplausible to the court (if substantive review of the reasons were permissible).

T.D. 8, supra note 136, § 7.03 cmt. a, at 65-66. Later, the Reporters declare their own neutralitywith respect to "structural bias," while proclaiming the need to appease those who are of a moresuspicious mind-set:

The position taken [regarding judicial review] does not depend on the view one takes on theissue of "structural bias." Rather, given the possible perception that board members may beconsciously or unconsciously partial to the interests of colleagues who are defendants, somejudicial oversight of this process is important in order to maintain public and investorconfidence in the integrity of our system of corporate governance.

Id. § 7.08 cmt. c, at 124. One suspects that the Reporters do protest their open-mindedness toomuch.

180. See Dooley & Veasey, Derivative Litigation, supra note 5, at 535-36 (discussing costs ofincluding outside directors on board).



judicial review of managerial irregularities. Since irregularities of the loyaltyvariety are more "important" (i.e., more responsive to legal, than market,incentives), it is therefore more important to enhance the role of the courts at theexpense of the board's authority with respect to loyalty claims.

The final point of comparison between the two Model's derivative suitregimes concerns the administrability of the respective mechanisms to selectclaims that will be subject to more intensive review. Under both models, themechanism must screen at the pleading stage. Under the Authority Model, theselector is the independence of a majority of the board of directors. This isrelatively easy to determine in the most meritorious cases, i.e., those in whichthe complaint succeeds in raising a reasonable doubt about the independence ofthe directors because of self-interest. Plaintiffs will have a more difficult timeraising a doubt about independence on grounds of dominating influence, but aless rigorous standard would encourage the inclusion in complaints of ill-founded conclusory allegations of bias as a matter of routine. Similarly, aplaintiff will have a hard time raising doubts about the board's businessjudgment, but there is no other practical way to preserve the business judgmentrule given that substantive law standards and derivative suit procedures areinextricably tied together. Once the selector mechanism screens out a complainton business judgment grounds, the case is to all intents and purposes over; theplaintiff can try to overcome the business judgment presumption but would not

put the defendant to much more trouble, given the unavailability of discoveryand the absence of any need for the defendant or the board to justify theirconduct once the shield of business judgment has been raised.

Under the ALI Governance Project's proposals, however, all complaintsstating a plausible claim for relief will necessitate some affirmative corporateresponse by way of justification and some level of judicial review. The selectormechanism for determining the level of justification and the degree of judicialreview turns on allegations made in the complaint regarding the identity of thedefendant and the nature of the underlying claim. There is no reason to beoptimistic that a selector mechanism that depends on such subjective "facts" willprove to be very discriminating in practice:

There is virtually no complaint that cannot, as a matter of pleading, be laidat the doorstep of someone in the corporate hierarchy. Nor is the problemsolved by the Reporters' spurious distinction between "care" and "loyalty"cases. There are very few examples of "pure" care cases, and the speciesmay approach extinction as more statutes limit the permissible grounds forrecovering damages from directors to more aggravated forms of misconduct.The clever pleader, skirting rule 11, may be able to find some colorableclaim of self-interest to justify what is otherwise a nonrecoverable claim ofmistaken judgment. 181

181. Id. at 540.



The Reporters have recently proposed to tighten the pleading requirementsfor derivative complaints. They propose to require in section 7 .04(a) that thecomplaint "plead with particularity facts that, if true, raise a significant pros-pect that the conduct or transaction complained of did not meet the applicablerequirements" of Parts IV, V and VI of the ALT Project. 182 This requirementshould screen out some suits that would have been maintainable under priorversions of Part VII of the ALI Project, but its ultimate effect on the supply ofderivative claims cannot be predicted because both the selector mechanism ofPart VII and the underlying substantive standards of Parts IV and V differ sosignificantly from existing law. More importantly, the proposed amendment tosection 7.04 does not affect the key governance change that Part VII seeks toaccomplish: the authority to initiate corporate claims will be taken away fromthe board of directors and given to the lawyer representing any shareholder whois willing to lend his or her name to the suit.

PROJECTING COSTS AND BENEFITSThe ALI Governance Project's proposals diminish the authority of the board

of directors to control corporate litigation in two major respects. First, theboard's decision to terminate a lawsuit will be subject to, and thus constrainedby, more intense judicial review. Second, the board's control over litigationexpenses is reduced because of the greater formalities imposed on it to terminatelitigation. As a practical matter, the latter aspect is more significant. The moretime and expense required to terminate a derivative suit against the plaintiff'swill, the greater the settlement value of the suit and the greater the incentive tocommence such actions.

Because the cause of action belongs to the corporation, any amounts recoveredin damages or by way of settlement must be paid over to the corporation.Accordingly, individual shareholders have little direct economic incentive tobring such suits, and none would be brought but for the allowance of fees to theattorney who represents the shareholder complainant. Typically, payment ismade by the corporation, either directly or by way of indemnification orpreviously purchased insurance coverage, rather than by the individual defen-dants.'83

While the allowance of attorney's fees equitably spreads the costs of enforce-ment among the presumptive beneficiaries, the shareholders, it also has theeffect of making plaintiffis counsel the real party in interest. Moreover, unlikeclass actions in which fees are payable only from the money damages orsettlement payments actually collected for the class, fees in derivative actions arepayable if the litigation results in a recovery or is deemed by the court to confera non-monetary "substantial benefit" to the class. 184

182. Council Draft No. 17, supra note 105, at 77.183. See generally M. Dooley, Fundamentals, supra note 10, at III-110-113.184. See Alyeska Pipeline Serv. Co. v. Wilderness Soc'y, 421 U.S. 240, 269-71 (1975) (fees in

class action payable only from fund recovered for class); In re General Tire & Rubber Co. Sec.



Given this and the substantive changes in law proposed in Parts IV and V ofthe ALI Governance Project, it is clear that the ALI Project's proposalssignificantly increase the potential payoffs to attorneys from bringing derivativesuits and would thus result in a proportionally significant increase in thenumber of such suits that are filed. One cannot be very confident aboutpredicting whether such a change in the regime would result in net socialbenefits or losses because the two critical components of such a calculation areunobservable. The wide-scale adoption of a Responsibility Model should in-crease the marginal deterrence of managerial irregularities, and this would be a

benefit, albeit one of uncertain magnitude because irregularities that do notoccur also cannot be directly observed. But an increase in the frequency ofpenalties imposed on managers and directors will also generate costs, some ofwhich will deter legitimate risk taking. Risk-averse managers and directors canlower their profiles as litigation targets by engaging in less risky businessactivities. Particularly because no legal system can ever be completely accuratein sorting lawful from unlawful behavior, the chief cost to be anticipated fromincreasing the marginal deterrence of misbehavior is the marginal deterrence oflegitimate risk taking. This is a cost not only to managers and shareholders, butto employees, consumers, creditors and others who would have shared in thebenefits from the foregone entrepreneurial activity. Once again, however, it isvirtually impossible to observe legitimate risky investments that are not under-taken because of liability concerns.

Although it is impossible to predict the magnitude of the most important costsand benefits likely to be associated with a change to a Responsibility Model, onecan be somewhat more confident about making projections based on the bestavailable proxy we have for such costs and benefits, namely, the wealth effectsof the current system. In assessing this projection, it is important to bear in mindthat it is not easy to bring a derivative action under current law.185 Accordingly,

Litig., 726 F.2d 1075, 1085-86 (6th Cir. 1984) (approving derivative settlement agreeing topayment of $500,000 in attorneys' fees, although no corporate recovery). See generally John C.Coffee, Jr., The Unfaithful Champion: The Plaintiff as Monitor in Shareholder Litigation, 48 Law& Contemp. Probs., Summer 1985, at 5.

185. Estimates of the frequency of shareholder suits involving publicly held corporations rangefrom once every 18 years for a sample drawn in the 1970s to once every 48 years for a sample drawnfrom the late 19 60s through 1987. Thomas M. Jones, An Empirical Examination of the Resolutionof Shareholder Derivative and Class Action Lawsuits, 60 B.U. L. Rev. 542 (1980); Roberta Romano,The Shareholder Suit: Litigation Without Foundation?, 7 J.L. Econ. & Org. 55 (1991).

The relative infrequency of shareholder suits involving publicly held corporations should becompared with other findings confirming conventional wisdom that publicly held firms are far morelikely to be the targets of such suits than closely held firms. See Dooley & Veasey, DerivativeLitigation, supra note 5, at 541 (reporting a study of 154 reported derivative suits from 1976 to1986, which broke down to 121 cases involving publicly held firms, 24 close corporation cases andnine unclassified). Given that smaller firms rarely have a majority of independent directors, itshould be relatively easier to commence and maintain a derivative suit involving such firms. The lowincidence of derivative actions in closely held firms can be explained by the preference of minorityshareholders for other types of remedies, including involuntary dissolution, designed to provide thema means of exiting what has become an intolerably unpleasant relationship with the majority. See



given plaintiff attorneys' self-interest and comparative advantage in assessingthe value of potential claims, it is reasonable to assume that the universe ofderivative suits under the existing regime is biased toward the stronger or moremeritorious claims. An increase in the number of such suits as contemplated bythe ALI Governance Project will necessarily increase the number of weaker orless meritorious claims that are filed. Accordingly, we should expect that the

average value of shareholders' recoveries from such suits will decline, even iftotal recoveries from judgments or settlements increase under the new regime.

A recent empirical study by Roberta Romano suggests that there is no reasonto expect the ALI Governance Project's proposals to confer net social benefits.Professor Romano found that from the late 1960s through 1987, 139 share-holder suits, both class and derivative, were filed involving ninety-nine (nineteenpercent) of a randomly selected sample of 535 publicly traded corporations. 186

Of 128 resolved suits, eighty-three were settled.'87 Otherwise, shareholder-plaintiffs fared poorly in court; no plaintiff won a judgment actually awardingdamages or equitable relief, and in only two cases did plaintiffs win even ajudgment upholding some of their claims. 188

Shareholders as a group did not do much better in negotiated settlements.Only half of the settlements (forty-six of eighty-three) involved any monetaryrecovery.189 Although recoveries were modest in both types of suits, derivativesettlements were approximately half of those paid in class actions and averaged$0.18 per share ($0.15 after attorneys' fees). 9' Only eleven derivative suitsettlements resulted in any monetary recovery. 9' Professor Romano also foundtwenty-five settlements predicated on structural changes, including four wherethere was also a monetary component. 9 ' Given that the "substantial benefitrule" applies to derivative, but not class, actions, it seems likely that all of thepurely structural change settlements were derivative. The structural changesinvolved amendments to the firm's bylaws, minor changes in executive compen-sation plans and the like. 193 Romano characterizes these changes as "cosmetic,"involving only "inconsequential" gains for shareholders and most likely adoptedin response to "the need to paper a record to justify an award of attorneys' feesto the court."' 94 Tests designed to investigate the possibility that derivative suits

J.AC. Hetherington & Michael P. Dooley, Illiquidity and Exploitation: A Proposed StatutorySolution to the Remaining Close Corporation Problem, 63 Va. L. Rev. 1 (1977).

186. Romano, supra note 185, at 59.187. Id. at 60.188. Id.189. Id. at 61.

190. Id. at 61-62.191. Id. at 62.192. Id. at 63.193. Id. at 63-64.194. ld. at 63.



have positive, but indirect, effects on firm governance similarly produced noevidence that such suits increase shareholder welfare. 95

Romano's study confirmed the popular conception that derivative suits arewealth-enhancing for lawyers. Attorneys' fees were awarded in ninety percentof the settled cases and constituted the sole relief afforded in seven instances. 96

If the current derivative suit regime imposes too few costs on managers anddirectors, providing for direct transfer payments from businesses to the barwould accomplish as much as Part VII of the ALI Governance Project, whilewasting fewer private and public resources.

TARGET BOARD'S ROLE IN UNSOLICITED TENDEROFFERS

It will not be possible to do a detailed, point-by-point comparison of Dela-ware law and the ALI Governance Project's proposals with regard to this finaltopic, because Part VI of the ALI Project (the Role of Directors and Sharehold-ers in Transactions in Control and Tender Offers) has, for all practicalpurposes, ceased to exist. The Reporters' original proposals had already sus-tained considerable erosion-from eighteen sections and 348 pages to twosections and fifty-three pages (with commentary in both instances)-by the time

195. Id. at 65-66. Romano first investigated the returns to shares of firms that became thesubject of lawsuits. She found no significant change in share return on the dates the derivative suitwas filed or first publicly announced. Id. at 66-67. Returns were slightly positive upon theannouncement of a suit's dismissal and slightly negative upon announcement of settlement, but notstatistically significant in either case. Id. at 67-68. Event studies of the wealth effects of litigationmust be interpreted with some caution. The typical derivative suit is filed in response to the publicannouncement of some negative event affecting the firm. Accordingly, it is possible that the market'sinitial reaction to the underlying event anticipated that the event would provoke a derivative action.If so, an estimate of the wealth effects of such litigation, whether positive or negative, would havealready been impounded in share price, and the subsequent filing or announcement of such suitwould have no effect.

Romano also investigated the possibility that derivative suits stimulate and facilitate internalgovernance mechanisms by comparing firms that had been sued (lawsuit firms) against a sample ofsimilar firms in the same industry that had not experienced such suits during the same period. Shefound no significant differences with respect to executive compensation. Id. at 71. The turnover rateof top management was higher for lawsuit firms than for their matches, both before and after thefiling of the lawsuit. Id. at 71-76. The higher turnover rate before litigation suggests that theunderlying problem was the cause of dismissal, and this also muddles any conclusions that might bedrawn from the finding of higher dismissal rates after the lawsuit.

Romano found that director turnover was significantly higher in lawsuit firms than in theirmatches. Id. at 71. Moreover, among lawsuit firms, turnover rates were higher for firms that settledlawsuits than for those that succeeded in having the complaint dismissed. Id. at 72-75. Thesefindings, especially the latter one, suggest that a shareholder's suit stimulates the replacement ofdirectors who proved to be poor monitors by permitting the occurrence of the event that is the subjectof the complaint. Id. at 78. Romano offers another explanation--equally plausible, yet verydistressing: "It could also indicate that more able monitors are leaving for better opportunitiesbecause they dislike being sued." Id. at 78. As some confirming evidence for the latter explanation,Romano did not find any significant decline in other board memberships for directors who departedas compared with those who remained on the boards of lawsuit firms. Id. at 79.

196. Id. at 61.



Part VI was first presented to the ALI membership at the May, 1990 meet-ing.197 Nevertheless, the Responsibility Model was firmly ensconced in the firstsentence of the one substantive of the two surviving provisions. Section 6.02provided that "the board of directors may take an action that has the foreseeableeffect of blocking an unsolicited tender offer [§ 1.32a], unless the action wouldmaterially disfavor the long-term interests of the shareholders."' 98 This sectionwas altered by a floor amendment approved by the membership that effectivelyneutered it and reduced Part VI to intellectual incoherence when comparedwith Parts IV, V and VII. The amendment was very simple; it added the words"corporation and its" before "shareholders" in section 6.02(a). The currentversion of section 6.02 has been redrafted to a more elaborate form, but itcontinues to recognize the right of the board to "take into account all factorsrelevant to the best interests of the corporation and shareholders."' 199

To understand the revolution wrought by the inclusion of this seeminglyinnocuous phrase, it is first necessary to understand that there is a substantialbody of academic opinion overwhelmingly in favor of the proposition thatunsolicited tender offers present the purest form of Responsibility issue.200 Inturn, this literature is informed by an overwhelming body of economic evidenceconcerning the wealth effects of tender offers. While tender offers remain

politically controversial, there is little controversy concerning their economiceffects on shareholders. Accordingly, to appreciate fully the difficulty of thegovernance issues presented by board resistance to an unsolicited offer, it will bemost helpful to accept the following as established propositions:

1. Tender offers are value-increasing transactions, and target companyshareholders capture the largest portion of the gains.20

1

2. Target board resistance to a tender offer enhances shareholder gain onlyto the extent that such resistance attracts other, higher bidders or otherwise

197. Compare American Law Institute, Principles of Corporate Governance: Analysis &Recommendations (Advisory Group Draft No. 7, 1986) with American Law Institute, Principles ofCorporate Governance: Analysis & Recommendations (Tentative Draft No. 10, 1990) [hereinafterT.D. 101.

198. T.D. 10, supra note 197, § 6.02(a).199. T.D. 11, supra note 1, § 6.02(b)(1). As another indication of the damage inflicted by the

1990 amendment to the section's original intent, § 6.02 is now more favorable to the board'sconsideration of non-shareholder interests than is Delaware. Under § 6.02(b)(2), the board maytake non-shareholder interests into account "if to do so would not significantly disfavor the longterm interests of the shareholders." Id. § 6.02(b)(2). The Delaware rule provides that the boardmay predicate a decision based upon such concerns only if "there are rationally related benefitsaccruing to the stockholders." Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173,182 (Del. 1986).

200. See infra note 204.

201. See Michael C. Jensen & Richard S. Ruback, The Market for Corporate Control: TheScientific Evidence, 11 J. Fin. Econ. 5 (1983); Michael Bradley et al., Synergistic Gains fromCorporate Acquisitions and Their Division Between the Stockholders of Target and AcquiringFirms, 21 J. Fin. Econ. 3 (1988).



produces a better offer; resistance that does not produce a subsequent,better offer is value-decreasing.

20 2

3. Claims that shareholders' gains represent mere wealth transfers fromother input owners for whom the board might have a legitimate concernhave been either disproved (in the case of bondholders) or not proved (inthe case of employees).

20 3

With this background, it is easy to see why virtually all the legal academicliterature urges the adoption of one of two rules regarding the target board'srole in unsolicited tender offers. Either the board and management shouldremain entirely passive and let the offer run its course or the board's role shouldbe limited to negotiating with the bidder on behalf of the shareholders. 214 Thereare structural, doctrinal and procedural considerations that support the viewthat the board should have no, or, at most, a carefully circumscribed, role inunsolicited tender offers. Structurally, the tender offer is made by the bidderdirectly to the individual shareholders of the firm. An individual shareholder'sdecision to sell his shares does not seem to concern any institutional responsibil-ity or prerogative of the board; indeed, the offer is intended to bypass the board.In view of the acknowledged disciplinary function of the tender offer and itsthreat to the tenure of incumbent managers and board members, 205 target board

202. See Michael Bradley et al., The Rationale Behind Interfirm Tender Offers: Information orSynergy?, 11 J. Fin. Econ. 183, 193-94 (1983).

203. See Paul Asquith & Thierry A. Wizman, Event risk, covenants, and bondholder returns inleveraged buyouts, 27 J. Fin. Econ. 195 (1990) (bondholders' losses cannot account for more than asmall proportion of shareholders' gains); Debra K. Dennis & John J. McConnell, CorporateMergers and Security Returns, 16 J. Fin. Econ. 143 (1986) (same); Roberta Romano, A Guide toTakeovers: Theory, Evidence and Regulation, at 17-23 (summarizing studies showing that share-holders' gains do not result from labor expropriation) (Working Paper, 1991). Professor Romano'spaper succinctly summarizes the relevant economic evidence.

204. See Frank H. Easterbrook & Daniel R. Fischel, The Proper Role of a Target's Manage-ment in Responding to a Tender Offer, 94 Harv. L. Rev. 1161, 1164-1204 (1981) (advocating a ruleof complete passivity); Ronald J. Gilson, A Structural Approach to Corporations: The Case AgainstDefensive Tactics in Tender Offers, 33 Stan. L. Rev. 819, 865-91 (1981) (advocating a limited,negotiating role for the incumbents). Virtually all of the enormous outpouring of law review articleswritten subsequent to these two articles come down on one side or the other of this debate, althoughrecently the arguments have centered around the desirability of "auctions." Compare AlanSchwartz, Search Theory and the Tender Offer Auction, 2 J.L. Econ. & Org. 229 (1986) withLucian A. Bebchuk, The Case for Facilitating Competing Tender Offers: A Last(?) Reply, 2 J.L.Econ. & Org. 253 (1986). The argument for an auction as a means of promoting shareholderwealth is self-evident. The argument against an auction is based on the deleterious effects ofauctions on the incentive to seek out targets and the resulting likely decrease in the number of tenderoffers, and can be traced back to Easterbrook & Fischel, supra. The literature is summarized in M.Dooley, Fundamentals, supra note 10, at 111-342-347.

205. The idea of the tender offer as a source of gains from replacing inefficient managersoriginated in Henry G. Manne, Mergers and the Market for Corporate Control, 73 J. Pol. Econ.110 (1965). There is convincing evidence supporting Manne's theory. See Randall Morck et al.,Characteristics of Targets of Hostile and Friendly Takeovers, in Corporate Takeovers: Causes andConsequences 101 (Alan J. Auerbach ed., 1988) (hostile targets whose managers are replaced arepoor performers, as measured by low Tobin's q ratios, compared to targets of friendly acquisitions);Kenneth J. Martin & John J. McConnell, Corporate Performance, Corporate Takeovers, and



resistance raises an inevitable conflict of interest. Doctrinally, this conflict ofinterest appears to be of even greater magnitude than those that have beenjudged sufficient to disable the board from exercising its authority in othercontexts. Finally, because board resistance can prevent the occurrence of anoffer, it threatens irreparable injury to shareholders' interests. As a proceduralmatter then, a court will have to review the propriety of board resistance in thecontext of a request for a preliminary injunction. Thus, the court must make

what is, for all practical purposes, a definitive judgment on the propriety of theboard's resistance at a time when its ultimate effect on shareholder welfarecannot be known: will resistance produce a higher price for shareholders andtherefore prove to be value-increasing or will it deter this and future bids andthereby prove to be value-decreasing?

At best, then, target board resistance represents a substantial risk for share-

holders. At worst, it can be disastrous to their economic well-being. Given theseunappetizing choices and the courts' normal sensitivity to conflicts of interest,many have been perplexed and some dismayed by the courts' refusal to ban or atleast severely limit target board resistance. Instead, the Delaware Supreme

Court has developed a specialized system for reviewing challenges to boardresistance that is unique in both its procedural and substantive aspects. Proce-durally, the challenge takes the form of a request for a preliminary injunction.The plaintiff is usually the bidder in the tender offer who is, by that time,invariably also a shareholder of the corporation. Any other shareholder of thecorporation presumably also has standing to seek an injunction. In either event,it is not clear whether the plaintiff is suing in his own right or derivatively.Aside from attorneys' fees, nothing turns on the distinction because the tradi-tional demand requirements are not applied to these proceedings.

The new regime was first articulated in Unocal Corp. v. Mesa Petroleum

Co.106 As an initial proposition, Unocal assigns the burden of proof to the boardto show that their resistance was (1) founded on reasonable grounds forbelieving that the offer represented a threat to "corporate policy and effective-ness" and (2) was reasonable in relation to the threat posed (i.e., "propor-tional").2 °7 Although this is designated as an "initial burden" and variously

described as an "intermediate" test, "enhanced business judgment review" or"conditional business judgment," the Unocal test is, in fact, dispositive. Given

that the most recent litigation concerns the legitimacy of a show-stopping

Managerial Turnover, 46 J. Fin. 671 (1991) (targets of managers who are replaced earned negativeabnormal returns compared with their industry before the takeover, while targets whose managerswere retained earned positive returns). The validity of the disciplinary theory of takeovers does notdepend on proving that all unsolicited bids are so motivated, nor does it depend on the accuracy ofthe perceptions of all hostile bidders. There is, however, evidence that the takeover market is to someextent self-correcting in the sense that managers of firms that make losing acquisitions are,themselves, more likely to be replaced by a subsequent hostile offer than managers who do not. SeeMark L. Mitchell & Kenneth Lehn, Do Bad Bidders Become Good Targets?, 98 J. Pol. Econ. 372(1990).

206. 493 A.2d 946 (Del. 1985).207. Id. at 955-56.



"poison pill" adopted by the board, there is nothing left to decide after theinitial Unocal questions have been answered. If the board sustains its burden, itsdecision to leave the pill in place is business judgment, and the offer will beabandoned. If the board does not meet its burden, the court will order the pillwithdrawn, and the offer will proceed-most likely successfully.

Unocal does not establish any special pleading requirements for the plaintiff.An allegation that the offer is being blocked by the board's defensive tactics isenough to put the board to its proof of compliance with both parts of the test.Placing this initial burden of justification on the board is truly extraordinaryand demonstrates clear recognition that the board's resistance may have beenselfishly motivated.2"' Having gone that far, it is fair to wonder why theDelaware Supreme Court did not take one of the next apparently logical stepsfavored by academics and either prohibit all defensive actions or retain jurisdic-tion of the case to ensure that the board acted only as an honest auctioneer forthe shareholders.

The court's rejection of a "passivity rule" is easily explained. The currentmembers of the board will continue in office and continue to be legallyresponsible for the conduct of the business unless and until the offer succeedsand they are removed by, or resign at the request of, the new owner. Completepassivity is inconsistent with the directors' legal obligations to the corporationand its shareholders. 20 9 Explaining why the court also refused to limit theboard's role to negotiating with the bidder is more complicated, but it yieldsimportant insights concerning the status of the incumbent management teamwhen challenged by an unsolicited bidder, the importance courts attach to theauthority of the board, and, ultimately, the consequences of the AuthorityModel itself.

With regard to the first issue, the Delaware courts have not only recognized

the reality of a "market for corporate control," but, contrary to most academics,have seen no compelling reason to exclude the incumbent management teamfrom the competition. While proxy contests and tender offers are quite dissimi-lar in most respects,210 the two are alike in their competitive aspects. No onewould expect an incumbent management team to vacate their offices at the firsthint of an election challenge. Certainly, no one would endorse a rule thatrequired "complete passivity" on the part of officeholders whose incumbencywas challenged in an election. In this basic respect, the unsolicited tender offer isnot very different from the proxy contest.

It is quite clear that the incumbent management team can make the corpora-tion less vulnerable to takeover by, for example, increasing the dividend paid to

208. Id. at 954 ("Because of the omnipresent specter that a board may be acting primarily in its

own interests, rather than those of the corporation and its shareholders, there is an enhanced dutywhich calls for judicial examination at the threshold before the protections of the business judgment

rule may be conferred.").209. See id. ("When a board addresses a pending takeover bid it has an obligation to determine

whether the offer is in the best interests of the corporation and its shareholders.").210. See M. Dooley, Fundamentals, supra note 10, at 111-292-295.



shareholders, thereby sending a signal to the market enhancing the value of theshares. Indeed, most recent corporate restructurings in which boards have spunoff or liquidated marginal operations, increased dividend payouts and increasedvariance by taking on additional debt, can be seen as preemptive responses tothe threat of takeovers.21' It is hard to imagine a principled objection to boardaction that secures the incumbency of the current management team by increas-ing benefits to shareholders, at least where the action is taken without referenceto any pending bid. Even when such action is taken in response to a specific bid,it can be seen as a form of healthy fair competition.

It may be objected that the foregoing analysis does not make sufficientallowance for the fact that unsolicited tender offers present the board with aninescapable conflict of interest and, hence, the very real possibility that theboard will mask its selfish motivations by pretending that it intends only tocompete with the outsider to maximize the interests of the shareholders. Thisobjection points to two principal conclusions. First, tender offers present aunique conflict of interest that can be avoided only by stripping the board of allor most of its traditional authority. Second, an unsolicited tender offer presents aquestion that only shareholders can decide; the board has no legitimate institu-tional role and, hence, no right to decide. The second conclusion is only partiallya product of the first. It is related in the sense that it implies that the boardcannot be trusted to decide a matter where its own interests are so clearly atstake. The second conclusion, however, carries with it a much broader, andmore important, governance implication. It asserts that tender offers are sounique that the board's decisive authority should be transferred to the share-holders. As in the case of choosing among candidates for the board in a contestedelection, individual shareholders should ultimately have the exclusive right todecide whether the offer shall be accepted.

The conflicted interest objection may be conceded without also conceding thenecessity of instituting a wholly new governance system for tender offers.Tender offers present a risk of conflicted interests that differs only in degree,and not kind, from the risk that is inevitable in conferring so much authority inone group---the board-to act on behalf of another-the shareholders. It is theAuthority/Responsibility Paradox writ large, but no differently. As in otherpotential conflicts, we would expect the courts to develop standards againstwhich the board's behavior can be measured to detect self-interest. The greaterthe risk, the stricter the policing mechanisms required, but adaptability is thecomparative advantage of the common law, as the Delaware court demonstratedby devising specialized policing rules for another high risk-of-cheating transac-tion, the cashout merger.212 The necessity of fashioning some trade-off betweenthe conflicting values of Authority and Responsibility cannot be avoided. It isnoteworthy that the Reporters defended their original, ill-fated version of

211. See Michael C. Jensen, Agency Costs of Free Cash Flow; Corporate Finance, and Take-overs, 76 Am. Econ. Rev. (Papers & Proceedings) 323 (1986); John C. Coffee, Jr., ShareholdersVersus Managers: The Strain in the Corporate Web, 85 Mich. L. Rev. 1, 40-60 (1986).

212. See Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983).



section 6.02 by arguing that their exclusive criterion of shareholder welfareavoided the necessity of examining the directors' motives for opposing an offer:

Section 6.02 reflects the view that judicial review of directors' blockingactions against unsolicited tender offers should not be based on a duty ofloyalty analysis of the directors' motives for their actions. Such a reviewcannot effectively distinguish between cases in which directors favored

themselves and cases in which directors properly looked to the interest ofthe shareholders.

213

To be sure, judicial inquiry into motive is always messy and not alwayssuccessful. But it is precisely the question of motive that determines the extent ofthe board's authority in all other contexts. The only alternative is to strip theboard of its authority whenever the possibility of conflicted interest seems to bepresent (which is what Parts IV, V and VII of the ALI Governance Projectcome perilously close to doing).

In any event, it is clear that the question of motive is the predominantinfluence that has shaped the Delaware approach to board resistance. It drivesboth the initial assignment of justification to directors and the substantivestandards of the Unocal rule. A more subtle but highly significant aspect ofDelaware's oversight of tender offer defenses is the paramount importance thecourts assign to the role of nonmanagement directors in deciding whether andhow to resist an unsolicited offer. This development contrasts sharply with thecourts' assumption of board independence and insistence on well-pleaded factsto even raise the issue of non-independence in other contexts. 214 It also stands insharp relief against the tendency of most commentators and even some courts toassume that the board is mere window dressing for management and that even"outside directors" are in thrall to senior managers and will ignore the interestsof shareholders to preserve their patrons' jobs. 15 Time and again, however,courts applying Unocal have inquired closely into the role actually played by theoutside directors, the extent to which they were supplied with all relevantinformation, the degree of their reliance upon independent advisors and, mostimportantly, the extent to which the outsiders were insulated from managementinfluence and given decisive authority.216 Indeed, it is not too much to say that

213. T.D. 10, supra note 197, § 6.02 cmt. a, at 125.214. See supra text accompanying notes 39-40.215. See Dynamics Corp. of Am. v. CTS Corp., 794 F.2d 250, 256 (7th Cir. 1986) (Posner, J.),

rev'd, 481 U.S. 69 (1987); Panter v. Marshall Field & Co., 646 F.2d 271, 300-01 (7th Cir. 1981)(Cudahy, J., dissenting). The legal literature invariably speaks of "management resistance" and"management defensive tactics" and rarely recognizes any separate institutional role for the board.See supra note 204.

216. E.g., Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261, 1280 (Del. 1989); In reRJR Nabisco Shareholders Litig., [1988-1989 Transfer Binder] Fed. Sec. L. Rep. (CCH)

94,194, at 91,710-15 (Del. Ch. 1989).



the court's assessment of the outside directors' role is outcome-determinativeunder Unocal.217 As Chancellor Allen has observed:

The factor that distinguishes those circumstances in which the decision of acommittee of outside directors has been accorded respect and those in whichits decision has not, is not mysterious. The court's own implicit evaluationof the integrity of the special committee's process marks that process asdeserving respect or condemns it to be ignored. When a special committee'sprocess is perceived as reflecting a good faith, informed attempt to approxi-mate aggressive, arm's-length bargaining, it will be accorded substantialimportance by the court. When, on the other hand, it appears as artifice,ruse or charade, or when the board unduly limits the committee or whenthe committee fails to correctly perceive its mission-then one can expectthat its decision will be accorded no respect. 21

1

If nothing else, the Delaware courts' handling of the tender offer "crisis" of the1980s has underscored the importance of the board as a separate institution thatshould be independent from, and superior to, management.

Moreover, I believe that the courts' concern with motive explains severalother prominent decisions that have been read by others to convey various, andsometimes conflicting, messages. The first is the so-called "duty to auction"established in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.219 Insimplest form, Revlon holds that whenever the directors have committed to sellthe company (whenever its breakup has become inevitable), the target boardmay no longer discriminate among competing bidders, but becomes bound tocease all defensive measures and devote itself to obtaining the "highest price forthe ... stockholders." 22

1 It is possible to view Revlon as dealing with an"ownership claim" and, like Smith v. Van Gorkom, recognizing a special dutyof the board, and corresponding right of the shareholders, to maximize the valueof the shares. 21 For the reasons developed below, I think this is not a correctreading.

The second important case is City Capital Associates Limited Partnership v.Interco Inc.222 Interco involved a proposed restructuring adopted in response toan unsolicited tender offer. The bidder attacked both the restructuring and theInterco board's decision to leave in place a poison pill to defend it. Intercoproposed to sell certain assets, using the proceeds together with borrowings tofund several extraordinary dividends to its shareholders in cash, debentures andpreferred stock. The total value of the dividends was put at $66 per share, and

217. Compare Mills Acquisition Co., 559 A.2d at 1280, with In re RJR Nabisco, [1988-1989Transfer Binder] Fed. Sec. L. Rep. (CCH) 94,194, at 91,710-15.

218. William T. Allen, Independent Directors in MBO Transactions: Are They Fact orFantasy?, 45 Bus. Law. 2055, 2060 (1990).

219. 506 A.2d 173 (Del. 1986).220. Id, at 182.221. See supra notes 45, 47.222. 551 A.2d 787 (Del. Ch. 1988), appeal dismissed, 556 A.2d 1070 (Del. 1988).



the board's investment banker opined that the Interco's equity "stub" (the stockoutstanding after the restructuring) would trade at no less than $10 per share.The latter figure was vigorously disputed by the bidder whose own investmentbanker opined that the stub would trade at no higher than in the range of $4.50to $5.50 per share and estimated the total value of the restructuring plan (whichdepended, in part, on assumed savings from cost reduction) at only $68-$70 pershare.

Although Chancellor Allen observed that the actual value of the restructuringwas "highly debatable," he did not attempt to resolve the valuation dispute. 223

For purposes of the litigation, then, the relevant choice for Interco shareholderswas between retaining an equity interest in Interco and receiving a totalconsideration of $76 per share over the several months it would take to completethe restructuring or selling their shares to the bidder for an immediate paymentof $74 in cash.

Chancellor Allen held that the restructuring plan was a reasonable responseto what the board had in good faith determined was a "threat," that is, theirconclusion that the unsolicited bid was "inadequate." 22' 4 The restructuringtherefore satisfied the Unocal test. The board's decision to protect their planwith a poison pill, however, did not satisfy Unocal, and Chancellor Allenordered the pills withdrawn.2 If the restructuring was reasonable, why wasthe board's effort to protect their decision by leaving the pill in place notreasonable? Chancellor Allen's explanation is ambiguous-and in an important

way:

[R]ecognizing the relative closeness of the values and the impossibility ofknowing what the stub share will trade at, the board, having arranged avalue maximizing restructuring, elected to preclude shareholder choice. Itdid so not to buy time in order to negotiate or arrange possible alternatives,but asserting in effect a right and duty to save shareholders from theconsequences of the choice they might make, if permitted to choose.

Without wishing to cast any shadow upon the subjective motivation ofthe individual defendants ... I conclude that reasonable minds not affectedby an inherent, entrenched interest in the matter, could not reasonablydiffer with respect to the conclusion that the [bidder's] $74 cash offer didnot represent a threat to shareholder interests sufficient in the circum-stances to justify, in effect, foreclosing shareholders from electing to acceptthat offer.

... To acknowledge that directors may employ the recent innovation of"poison pills" to deprive shareholders of the ability effectively to choose to

accept a noncoercive offer, after the board has had a reasonable opportu-nity to explore or create alternatives, or attempt to negotiate on theshareholders' behalf, would, it seems to me, be so inconsistent with widely

223. Id. at 799.224. Id. at 797-98.225. Id. at 798-800.



shared notions of appropriate corporate governance as to threaten todiminish the legitimacy and authority of our corporation law.226

The ambiguity in the preceding quotation reveals the fundamental gover-nance question presented by unsolicited offers: does the right to decide whetherto accept or reject the offer reside with the shareholders or is it, like all otherimportant policy questions, initially a decision for the board to make until itreveals itself to be disabled by self-interest. The first paragraph of ChancellorAllen's opinion appears to embrace the view that the board's role is limited tonegotiation in the case of "structurally noncoercive" offers 227 and that thedirectors must ultimately defer to the shareholders' judgment.

But, if that is the case, what is the point of the reference in the secondparagraph to "reasonable minds not affected by an inherent, entrenched interestin the matter?" If the board has exhausted its negotiating role so that the rightto decide has passed to the shareholders, why should the board's state of mindmatter? That it does seem to matter suggests that the Unocal "reasonableness"test is intended to function as a filter for conflicted interest, rather than as anobjective measure of whether the board's action was reasonably calculated tomaximize shareholder wealth. From this perspective, Revlon and Interco can beseen as cases where the specific action approved by the board strongly suggestsself-interest. Why else would a faithful agent refuse to permit a competingproposal to be put forward if not for fear that his own proposal is, in fact, notcompetitive? And why would the honest auctioneer ever seek other than thehighest bid if not to seek side payments or otherwise indulge personal prefer-ences? Note that in neither case did the court actually find that the board actedout of self-interest. But given Unocal's recognition of the inherently conflictednature of a tender offer defense, a mere inference of self-interest may suffice,

unless it can be negated by the board.In Interco, Chancellor Allen did not have to decide whether the decisive

authority regarding tender offers belonged to shareholders or the board: once hedecided that the board was disqualified from continuing to block the rival offer,

it was only the shareholders who had anything left to decide. Seven monthslater, the key issue was squarely presented to Chancellor Allen in ParamountCommunications, Inc. v. Time, Inc.22 1 Paramount sought a restraining orderagainst a proposed merger of Warner Communications Inc. so that it couldproceed with its own proposed cash tender offer to Time shareholders. The

226. Id. at 799.227. See Ronald J. Gilson & Reinier Kraakman, Delaware's Intermediate Standard for Defen-

sive Tactics: Is There Substance to Proportionality Review?, 44 Bus. Law. 247 (1989). The authorsdraw a distinction between offers that are "structurally coercive," that is, containing offer termsdesigned to induce tenders for fear of being left behind (such as the now mythic "two-tiered front-end loaded" offer), and those that are viewed by the target board to be "substantively coercive," thatis, merely for an "inadequate" price. Id. at 256-65. Chancellor Allen's Interco opinion drawsheavily on the article, which was then in draft form.

228. [1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) 94,514 (Del. Ch. July 14,1989), affd,571 A.2d 1140 (Del. 1990).



proposed merger with Warner was the culmination of a long-term strategic planof Time's board to increase the company's video operations. Time had explor-atory talks with Warner regarding possible joint ventures as early as 1987 andbegan to consider seriously the possibility of a permanent combination withWarner as early as the summer of 1988. On March 3, 1989, the boards of bothcompanies approved a merger agreement. The plan of merger called for Warnerto be merged into a Time subsidiary in exchange for Time common stock.Although Time was not formally a party to the merger and its shareholders'approval was thus not required under Delaware law, New York Stock Ex-change rules required a vote of Time shareholders because of the number ofshares to be issued. A vote was scheduled to be taken on the issuance (and,effect, on the merger) at Time's annual meeting to be held on June 23, 1989.

On June 7, 1989, Paramount announced that it would make a cash tenderoffer for all Time shares at $175 per share, provided that the Time-Warnermerger agreement was terminated. Paramount was not interested in acquiringWarner and believed that the combined companies would simply be too largefor anyone to acquire. Time's board met four times to discuss Paramount's offerbefore rejecting it on June 16. Two principal reasons were given: first, $175was an inadequate price if Time were to be sold, and, second, given the board'sopinion on the long-term prospects of the Time-Warner combination, it was notin the best interests of Time or its shareholders to sell the company at that time.

Time's board was advised by its investment bankers that if the company wereto be sold it would likely command in excess of $250 per share. Time's shareshad traded in a range of 1035/8 to 113Y4 in February and rose to 105-122-y inMarch and April, after the announcement of the Warner merger. The invest-ment bankers further advised that the shares of the combined Time-Warnercould be expected to trade initially around $150 and, based on projected cashflows, would steadily increase over the next three years until trading in therange of $208-402 per share in 1993. As Chancellor Allen drily observed, thelatter was a "range that Texas might feel at home on." 229

Faced with the prospect that its shareholders might now vote to reject themerger in order to accept the Paramount offer, Time's board voted to recast thetransaction to avoid the scheduled vote. Accordingly, instead of issuing shares,the new plan called for Time to acquire Warner shares for cash in a highlyleveraged transaction. One June 22, Paramount increased its bid to $200 pershare. The offer was again rejected, and Paramount, joined by a number ofother Time shareholders, brought suit to enjoin the merger with Warner.

Chancellor Allen first rejected Paramount's argument that the original trans-action put Time in a "Revlon mode," whereby the board became obliged to seek

229. Id. 94,514, at 93,273. It is also a preposterous prediction, given that (i) share price is afunction of return and (ii) the return on any individual security is in part a function of the return onthe market as a whole. Any investment banker who is capable of predicting the return on the marketfour years hence is wasting his time giving advice.



only the highest price.2 30 This conclusion was sufficient to answer what Chan-cellor Allen described as the first of two "overarching questions" presented bythe case: that the board has a duty to maximize current value only when thecompany is in a "Revlon mode." 231 Otherwise, the board of directors may, ingood faith, "follow a course designed to achieve long-term value even at the costof immediate value maximization. '23 The second "overarching question" is:

[W]here legally (an easy question) and equitably (more subtle problem)the locus of decision-making power does or should reside in circumstancesof this kind. The argument of the plaintiffs is that the directors' duty ofloyalty to shareholders requires them at such a time to afford to sharehold-ers the power and opportunity to decide whether the company should nowbe sold.

233

In proceeding to answer that question, Chancellor Allen agreed with plain-tiffs' argument that the recasting of the transaction to avoid a shareholder votewas "reactive" and thus to be judged under the standards of Unocal.234 How-ever, he distinguished prior Delaware decisions ordering the cancellation ofpoison pills and similar measures as all involving circumstances where the only"threat" identified by the board was to shareholders and then only that theywould accept an allegedly "inadequate" price.235 In contrast, the transactionhere had its "origin and central purpose in bonafide strategic business planningand not in questions of corporate control." '236 He also noted that the merger wasnot "the functional equivalent" of the sale proposed by Paramount and ap-peared to be an alternative only because Paramount chose to cast its offer thatway. 237

Chancellor Allen concluded that the recasting of the transaction was areasonable measure to protect a bona fide corporate interest-Time's strategicplan of expanding its interest in video media-and thus satisfied the second legof Unocal.23s The opinion concludes by recognizing the possible risk the holdingposed for Time shareholders:

Reasonable persons can and do disagree as to whether it is the better coursefrom the shareholders' point of view collectively to cash out their stake inthe company now at this (or a higher) premium cash price. However, thereis no persuasive evidence that the board of Time has a corrupt or venalmotivation in electing to continue with its long-term plan even in the face

230. Id. 94,514, at 93,277.231. Id. 94,514, at 93,277-78.232. Id. 94,514, at 93,277.233. Id. 94,514, at 93,278.234. Id. 94,514, at 93,283.235. Id. 94,514, at 93,282-83.236. Id. 94,514, at 93,283.237. Id.238. Id.



of the cost that the course will no doubt entail for the company's sharehold-ers in the short run. In doing so, it is exercising perfectly conventionalpowers to cause the corporation to buy assets for use in its business ...

The value of a shareholder's investment, over time, rises or falls chieflybecause of the skill, judgment and perhaps luck-for it is present in allhuman affairs-of the management and directors of the enterprise. Whenthey exercise sound or brilliant judgment, shareholders are likely to profit;when they fail to do so, share values will likely fail to appreciate. In eitherevent, the financial vitality of the corporation and the value of the com-pany's shares is in the hands of the directors and managers of the firm. Thecorporation law does not operate on the theory that directors, in exercisingtheir powers to manage the firm, are obligated to follow the wishes of amajority of shares. In fact, directors, not shareholders, are charged with theduty to manage the firm.

In the decision they have reached here, the Time board may be proven intime to have been brilliantly prescient or dismayingly wrong. In thisdecision, as in other decisions affecting the financial value of their invest-ment the shareholders will bear the effects for good or ill. That many,presumably most, shareholders would prefer the board to do otherwisethan it has done does not, in the circumstances of a challenge to this type oftransaction, in my opinion, afford a basis to interfere with the effectuationof the board's business judgment.2 39

Alas, there is no happy ending to the Interco and Time stories. The judgmentof the board of directors in Interco proved to be fatal; in the case of Time, it hasthus far proved merely value-decreasing, although increasingly alarmingly so.240

CONCLUSIONAnd now we see the costs associated with the Authority Model of Corporate

Governance. Preservation of the board's authority will necessarily sacrifice some

239. Id. 94,514, at 93,284.240, The Interco reorganization left it with well over $1.65 billion in debt. The company was

unable to sell its non-core subsidiaries for as much as originally anticipated, and the continual drainfrom its debt-servicing obligations eventually consumed more than its once-profitable core opera-tions could generate. On January 25, 1991, Interco filed for chapter 11 reorganization. See MarkPotts, Chapter 11 Protection Is Sought by Interco; St. Louis Conglomerate Also Sues Firm inRestructuring, Wash. Post, Jan. 26, 1991, at CI.

Time's decision to switch from shares to cash left the combined Time-Warner saddled with over$11 billion in debt. In an effort to meet obligations coming due in 1993, Time-Warner, in June,1991, proposed an "innovative" (read "coercive") rights offering plan, in which accepting share-holders would be obligated to purchase new Time-Warner common stock before a final subscriptionprice was established. The price depended on the degree of shareholder interest indicated during therights offering period and would vary between a rate of $105 for each new share and a rate of 16shares at $63 per share. The plan was abandoned in the face of shareholder suits and SEC pressure.A more conventional rights plan succeeded in raising $2.6 billion to be applied to the $3.3 billionmerger debt payment due in 1993. During November, 1991, Time-Warner was selling at $90 pershare, compared with the $200 per share offered by Paramount for Time alone in June, 1989.



degree of Responsibility. Ill-advised, as well as value-enhancing, tender offerdefenses will be permitted. Instances of managerial misbehavior of both thecareless and corrupt variety will go undetected and unpunished. It cannot beotherwise. Chancellor Allen's opinions in Interco and Time and, indeed, thewhole of the Authority Model represent second-best solutions to a complexproblem.

But this need not be taken either as cause for lament or a call for revolution.Virtually all of law is a second-best solution, for reasons well founded in theory

and reality. The theory of the second-best holds that in a complex, interdepen-dent system it is better to tolerate an inefficiency in one part of the system if"fixing" it would create even greater inefficiencies in the system as a whole. Inreality, the existing governance system is driven more by economics than law,and it is the market that supplies the principal deterrent to managerial misbe-havior. Hence, the deficiencies in the existing Authority Model loom large onlywhen the model is viewed in isolation from the real world context in which itoperates.

The law's tradeoff between Authority and Responsibility seems paradoxicalonly because we continue to look for the source of accountability in the wrongplace. To restate the puzzle with which we began: if it is agreed, as a normativeproposition, that the board is primarily responsible for shareholders' welfare,and if it is further agreed, as an empirical proposition, that shareholders are noteffective monitors of the board, does it not follow that the board is notaccountable to shareholders and, hence, irresponsible?

No, it does not follow because one of our major premises is false. Why havewe assumed that it is the shareholders (or their lawyer-agents) and courts whomust act as monitors and disciplinarians of the board and the management teamit selects? The law clearly does not dictate that result. On the contrary, as wehave seen, many prominent features of corporation law seem designed for theexpress purpose of making it difficult for shareholders to hold the board and itsmanagers legally responsible, except in the most provocative circumstances.

The Responsibility criterion is satisfied if conditions exist that reward man-agers for increasing shareholder wealth and impose costs on them for decreasingshareholder wealth. Even without such direct stakes, the reputation and, even-tually, the tenure of the board is determined by the performance of themanagement team it selects.

The necessary conditions for accountability are supplied by competitive forces

in the product market, in the internal and external markets for managers and,ultimately, in the market for corporate control. Without attempting to summa-rize the rich body of economic literature on these subjects, its flavor can beconveyed by asking several simple questions. First, how do managers get ahead,both in rising through a particular firm's hierarchy or in obtaining a betterposition with another firm? The answer is surely not by being associated withfailed projects, sub-par performance and personal venality.

The second question would also shed some light on the allocation of decision-making power between shareholders and the board-both directly and as



supervisors of management. As between shareholders and managers, who standsto lose the most from firm failure? Again, the correct answer is surely not theshareholders. Shareholders can and should hold diversified portfolios so that thefailure of an individual firm will not greatly decrease their total wealth and mayconceivably benefit those shareholders who also have holdings in competitivefirms. Managers, on the other hand, cannot diversify their human capitalamong a number of different firms and thus commit their principal source ofwealth to the fortunes of a single firm. As between shareholders and managers,it is the latter who have the greatest incentives to work for the firm's success andto avoid making "bad" decisions.

And, so, are we to conclude that the market will operate to assure us of thebest of all possible worlds? Obviously not. No market, or any other humaninstitution, works perfectly, and the day of reckoning may come late or never.The bankruptcy of Interco is a "market solution" to a bad decision, but one thatinvolves excessive costs in human and financial resources.

The admission of imperfections in the existing system invites proposals to"fix" it, and this is what the ALI Governance Project proposes to do. It isconceivable that a more Responsibility-oriented governance system would en-hance efficiency, but that happy outcome depends upon a comparison of thepossible benefits of liability-induced incentives with the costs of adjudication,including error costs. Unfortunately, the law, like the market, is imperfect anderror costs loom large when one tries to sort bad business outcomes on the basisof fault. One explanation for the traditional judicial restraint represented by thebusiness judgment rule is that courts intuitively realized that they would have avery difficult time distinguishing between bad decisions and plain bad luck. I amnot suggesting that the market is any better at making this distinction, only thatit need not make it. Since the market measure is performance, chronicallyunlucky managers are likely to be replaced in any event and thus have strongincentives to avoid those mistakes that can be avoided, without regard towhether avoidable mistakes occasion legal penalties.

The ultimate problem with the ALI Governance Project is that it is detachedfrom both the real world and legal tradition. It is "lexo-centric" in that itimplicitly assumes that the law determines, rather than supports, the gover-nance system. 241 It is dangerously optimistic in assuming that the level of

241. Compare Willard Hurst's assessment of the historical relationship between law and

markets:

The private market-sustained patterns of private trading for profit-was primarily theproduct of goals set and means fashioned by industrialists, merchants, bankers, lenders and

borrowers, employers and employees, and ultimate consumers. To these various participants intheir roles as parties to private bargains the prime function of the market, which warranted itan acceptable institution of social control, was to apply certain and specialized criteria ofefficiency in use of scarce economic resources. Relative to the whole play of factors thatproduced the market, the law was marginal. This is not to say that law was unimportant.

Willard J. Hurst, Law and Markets in United States History 9 (1982).



judicial supervision of business can be dramatically increased without unfore-seeable and incalculable consequences for the efficiency with which businesseswill make necessary adaptive decisions.242 It ignores its own legal tradition bysupposing that a century of experience can be easily improved with (quite) afew strokes of the drafters' pen.

Ultimately, then, I expect we will be left with "One Model of CorporateGovernance": the existing one. A few courts will be attracted to the supposedlymore "modern" approach of individual provisions of the Governance Project,and parties litigant can be expected to comb its voluminous and wide-rangingComments for helpful snippets. Thus, we can expect to see the GovernanceProject cited-perhaps assuring that some of its strange language will beincluded in the legal lexicon-in cases where it will not affect the outcome. 243

The ALI Governance Project and the Responsibility Model it espouses swimagainst too strong a tide to ever make a lasting impression on Americancorporation law. In the unlikely event that it ever did appear likely to makesignificant inroads, we can be sure that business management would seek, andmost likely obtain, legislative relief that would restore Authority at greater costto Responsibility than is incurred under the current regime.244

In the final analysis, the ALI Governance Project, like its section 5.02, willprove to have been much ado about nothing very much.

242. Compare with the concern for unforeseeable consequences demonstrated by ChancellorAllen in a passage from his opinion in Interco:

Delaware courts have employed the Unocal precedent cautiously. The promise of that innova-tion is the promise of a more realistic, flexible and, ultimately, more responsible corporationlaw. The danger that it poses is, of course, that courts-in exercising some element ofsubstantive judgment-will too readily seek to assert the primacy of their own view on aquestion upon which reasonable, completely disinterested minds might differ. Thus, inartfullyapplied, the Unocal form of analysis could permit an unraveling of the well-made fabric of thebusiness judgment rule in this important context. Accordingly, whenever, as in this case, thecourt is required to apply the Unocal form of review, it should do so cautiously, with a clearappreciation for the risks and special responsibility this approach entails.

City Captial Assocs. Ltd. Partnership v. Interco, Inc., 551 A.2d 787, 796-97 (Del. Ch. 1988).243. Although several courts have already adopted various versions of the Reporters' derivative

suit proposals, because Part VII of the ALl Governance Project has been redrafted so many times,the specific rules adopted vary from case to case and, now, state to state. See Houle v. Low, 556N.E.2d 51 (Mass. 1990); Alford v. Shaw, 358 S.E.2d 323, 327 (N.C. 1987); Miller v. Register &Tribune Syndicate, Inc., 336 N.W.2d 709, 717-718 (Iowa 1983). It should be noted that each of thethree cases involved a close corporation in which there was no disinterested board and which,accordingly, would have triggered a Zapata review had it been brought in Delaware.

244. The most prominent example is the success that incumbent managers have had in gettingill-advised and inefficient anti-takeover legislation enacted by state legislatures. See Roberta Ro-mano, The Future of Hostile Takeovers: Legislation and Public Opinion, 57 U. Cin. L. Rev. 457(1988); Roberta Romano, The Political Economy of Takeover Statutes, 73 Va. L. Rev. 111 (1987);Committee on Corporate Laws, Other Constituencies Statutes: Potential for Confusion, 45 Bus.Law. 2253 (1990) (explaining decision not to add such a provision to the Revised Model BusinessCorporation Act). For a critical analysis of the various types of legislation now in force, seeRomano, supra note 203.



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(,1 2 1/,1( - University of Virginia School of La · HeinOnline -- 47 Bus. Law. 461 1991-1992. 462 The Business Lawyer; Vol. 47, February 1992 focused on specific provisions dealing