On The Case

If corporations don’t put shareholders first, what happens to business judgment rule?

(Reuters) - Marty Lipton’s inchoate feud with the Council of Institutional Investors may be the juiciest early story to emerge from the Business Roundtable’s announcement this week of a new corporate paradigm. But it’s not the only legal story prompted by the bombshell BRT announcement, in which business leaders pledged to consider the interests of an array of stakeholders – employees, customers, suppliers and community members – in addition to shareholders’ interest in maximizing profits.

Law firms are beginning to contemplate whether corporate boards will continue to be entitled to the deference afforded by the business judgment rule – which broadly shields directors from liability as long as they’re deemed to have acted in the corporation’s interest – if their decisions are prompted by rationales other than maximizing profits. That’s particularly relevant in Delaware, where, as Chief Justice Leo Strine explained in a 2015 paper, The Dangers of Denial, corporate law is resolutely focused on stockholder welfare. Strine (who is due to retire from the Delaware Supreme Court by the end of October), is of the view that Delaware precedent does not provide leeway for judges to sanction board decisions that subordinate shareholder interests.

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If corporate leaders, under the new Business Roundtable principles, elevate concerns about their employees and communities, are their decisions still entitled to deference under the business judgment rule? With some important caveats, Sullivan & Cromwell, Davis Polk & Wardwell and (no surprise) Wachtell Lipton Rosen & Katz predicted in client memos following the Business Roundtable announcement that the rule will continue to shield boards, even if their decisions take into account the interests of stakeholders other than investors. “The (BRT) Statement of Purpose does not change the business judgment rule, which provides directors broad discretion in discharging their duty of care to the corporation and its shareholders,” Davis Polk’s memo said. “So long as … directors are acting in good faith, on a fully informed basis and not grossly negligent, (they) should be protected.”

S&C offered slightly more cautionary advice. If a corporate board makes a fully-informed decision that impacts short-term profitability but can be justified as a long-term benefit to the company - like, for instance, raising employees’ minimum wages - that decision would be protected by the business judgment rule. But it's critical that the board show it is acting in the corporation’s interest, S&C said: “A decision by a board that is not grounded in the best interests of the corporation and its stockholders likely would not be protected by the business judgment rule.”

I figured the best predictor of what Delaware judges will think about the new Business Roundtable statement and the business judgment rule would be a former Delaware judge, so I reached out to Jack Jacobs of Young Conaway Stargatt & Taylor. Jacobs was a vice-chancellor in Delaware Chancery Court from 1985 to 2003 and then a justice on the state Supreme Court until 2014. He told me it’s tough to come up with a one-size-fits-all pronouncement on so-called stakeholder primacy and the business judgment rule.

So, for example, Jacobs said a board that backed a CEO who refused to move operations overseas because he was worried about offending his neighbors couldn’t rely on the business judgment rule. But a board that agreed to raise wages to attract and retain good employees probably could. “The board has to be able to articulate a case that it is allocating resources in a way that serves the company in the long term,” Jacobs said. When boards make decisions that appear to pit shareholder interests against those of other stakeholders, Jacobs said, Delaware courts are going to want directors to explain why those decisions benefit the enterprise.

The question underlying any discussion of the intersection of the business judgment rule and the Business Roundtable’s new principles of stakeholder governance is whether corporate law – and, in particular, Delaware law – requires board members to act to advance shareholder interests. As I mentioned, Chief Justice Strine said unequivocally in that 2015 paper that Delaware law demands shareholder primacy in corporate decision-making.

“Within the limits of their discretion, directors must make stockholder welfare their sole end,” Strine wrote. “Other interests may be taken into consideration only as a means of promoting stockholder welfare.” The soon-to-depart chief justice said Delaware’s Supreme Court first established that principle in 1985’s Revlon v. MacAndrews, when it held that in the context of a merger or acquisition, a board’s directors must act with the sole focus of maximizing the share price. According to Strine, subsequent Delaware rulings, such as then Chancellor William Chandler’s 2010 decision in eBay v. Newmark clarified that shareholder interests must come first even outside of M&A deals.

“It is true that the business judgment rule provides directors with wide discretion, and that it enables directors to justify by reference to long run stockholder interests a number of decisions that may in fact be motivated more by a concern for a charity the CEO cares about, or the community in which the corporate headquarters is located, or once in a while, even the company’s ordinary workers, than long run stockholder wealth,” Strine wrote. “But that does not alter the reality of what the law is….If a fiduciary admits that he is treating an interest other than stockholder wealth as an end in itself, rather than an instrument to stockholder wealth, he is committing a breach of fiduciary duty.”

Wachtell Lipton, however, disputed Strine’s interpretation in a memo issued Thursday – the firm’s third missive this week on the Business Roundtable’s new vision of the corporate mission. Responding to questions about whether stakeholder primacy is contrary to Delaware law, Thursday’s Wachtell memo argued that Revlon’s shareholders-first principle applies only in the narrow circumstances of a corporate takeover. Wachtell pointed instead to the Delaware Supreme Court’s decision in Unocal v. Mesa Petroleum, in which the court said board members can consider the interests of all stakeholders when crafting corporate defenses.

“To be clear, Delaware law does not enshrine a principle of shareholder primacy or preclude a board of directors from considering the interests of other stakeholders,” the new Wachtell memo said. “The fiduciary duty of the board is to promote the value of the corporation. In fulfilling that duty, directors must exercise their business judgment in considering and reconciling the interests of various stakeholders – including shareholders, employees, customers, suppliers, the environment and communities.”

Law firm memos on the business judgment rule and stakeholder governance aren’t going to be the last word in this debate. Just wait until shareholder firms start filing suits claiming that directors shouldn’t be concerned with global climate change or overseas labor laws. The business judgment rule is going to get a whole new workout.