Investors frequently wonder how BoDs get away with some things. How do they approve crappy M&A deals? Grant excessive exec comp? Enact entrenching bylaws? Why can’t or don’t we sue directors over what seems like slam-dunk cases of waste, sloth, or stupidity?

The very short answer is, stupidity is not illegal. Sure, shareholders can sue directors, since in the US anyone can sue anyone else for just about anything. But, almost all of the time we won’t win. So, a longer, more formal answer is, a legal principle called the business judgement rule (BJR) protects directors from liability in most situations.

What follows is an explanation for portfolio managers, free of legal citations and jargon. Veteran activist investors and attorneys among us know this, or should know this, already. Please consult your own counsel for a more detailed explanation, and of course for advice about how the BJR applies to a specific case.

The idea of the BJR

Judges don’t have the time or expertise to get involved in running companies. They avoid mediating disputes in which an honest businessperson generated losses instead of profits. The BJR entails defining an “honest businessperson” in a sort-of legally rigorous manner.

As with most corp gov law, the BJR developed largely in Delaware. All other states basically copy its law.

In Delaware, the BJR derives from case law. Nothing in the state corporation code (DGCL) mentions it. Hundreds of cases defined and refined the BJR in the past century. Among the numerous scholarly articles, law firm memos, and other treatises, we found one that explains the BJR in an even remotely accessible way.

Like much of Delaware corp gov, the BJR generally favors companies. Importantly, it “presumes” that the company acted responsibly in the disputed decision, even if the outcome cost investors dearly. Thus, investors have the burden of proof to show that directors and executives are liable for damages.

The structure of the BJR

It imposes two (or three) duties: care, loyalty, and maybe good faith. If you can show that the BoD breached any one of these, then you can argue to a judge that the BoD bears responsibility for whatever loss or problem resulted - from a crappy M&A deal, excessive exec comp, or entrenching bylaw.

1. ❖Duty of care refers to following a proper process. If directors consider appropriate facts in an orderly manner, then they exercise care.
   

2. ❖Duty of loyalty refers to independence. Directors that make the decision can’t have an interest in the outcome.
   

3. ❖Duty of good faith rather refers to deciding honestly and reasonably. It’s a little vague. Even an independent BoD that follows a strict process can waste company money for dishonorable reasons. This duty gives a judge a way, rarely used, to impose liability for horribly bad outcomes.
   

Delaware not only presumes that BoDs exercise care and loyalty. They also have low standards for what constitutes care and loyalty. A BoD can follow an overly-simple or deficient process, as long as they can show that one exists. As long as directors have no direct financial connection to the decision, they are considered independent, even if they have civic, social, or other relationships with the parties or to the outcome.

Two exceptions

One pertains to complete, total, absolute, gross incompetence. A decision to build a plant on the Moon. Paying the CEO every last cent in the corporate treasury. A one-share threshold to trigger a poison pill. Things like that. One observer calls this “galactic stupidity”. These happen rarely.

The other pertains to insider deals, which happen more often. Through a series of cases since the mid-1980s, Delaware escalated CEO-led buyouts and similar deals full of potential conflicts beyond the presumption of the BJR. In these instances, the “entire fairness” doctrine applies, with two components:

1. ❖fair process: all bidders have the same information and opportunity
   

2. ❖fair price: the price paid for the deal is objectively fair to investors.
   

Also, in these cases, the burden of proof shifts to the defendant (the company, really) to show that the deal was “fair”.

So, that’s why shareholders don’t sue companies for bad outcomes. With some good reason, but following principles that heavily favor companies, Delaware makes it really, really difficult to win.