Printer Friendly

The tort foundation of duty of care and business judgment.

This Article corrects a misconception in corporation law--the belief that principles of tort law do not apply to the liability scheme of fiduciary duty. A board's duty of care implies exposure to liability, but the business judgment rule precludes it. Tort law finds fault; corporation law excuses it. The conventional wisdom says that the tort analogy fails. This dismissal of tort principles is wrong. Although shareholder derivative suits and ordinary tort cases properly yield systemically antipodal outcomes, they are bound by a common analytical framework. The principles of board liability are rooted in tort doctrines governing duty, customs, and pure economic loss. Properly applied, they produce a duty "to care" (vis-a-vis duty of care), based on good faith undertaking of care, but upon such undertaking no liability for negligently inflicted economic loss--the exact result achieved by the fiduciary duty of care and the business judgment rule. A sound tort analysis not only theorizes the enigmatic relationship between the duty of care and the business judgment rule, but it also explain Delaware's puzzling procedural-substantive divide. Fiduciary duty in corporation law rests on a tort foundation. Lastly, the thesis of this Article has a broader implication. The contractarian view of corporation law seeks to relegate the role of courts to passive custodians of the corporate contractual terms provided by the legislature and the corporation's constituents. However, this view is constrained by a tort framework wherein courts do and should play a robust, albeit reserved, role in regulating important aspects of corporate governance through continued common law process of doctrinal development of the idea of a wrong.


The structure of corporation law is built on two grand rules limiting the liability of participants in the corporate enterprise. The first is the rule of limited liability of shareholders. (1) The second is the rule limiting the liability of directors under the business judgment rule. Jointly these rules promote enterprise by allowing shareholders and directors to take risks without fear of catastrophic personal liability. Without them there would be no corporation as we know it. While the theory of shareholder limited liability is well understood today, (2) we still lack a consensus on the theory of the relationship between the duty of care and the business judgment rule. (3) The academic literature has instead focused on instrumental policy grounds to justify the consensus view that the business judgment rule generally produces correct outcomes. This is a curious state of academic affairs given the importance of the issue. The theoretical deficit has not been for want of scholarship, which has been voluminous. (4)

The duty of care and the business judgment rule are bound together in an enigma. (5) The mystery deepens when the tort analogy is applied. A director's duty of care is frequently analogized to the duty of care in tort law, which is the language of culpability seen in accident law. (6) "Yet, the one thing about the business judgment rule on which everyone agrees is that it insulates directors from liability for negligence." (7) Tort law finds liability; corporation law excuses it. The apparent failure of the tort analogy--the schizophrenic invocation and rejection of negligence--is jarring. Although most people agree that, generally speaking, board liability should be limited, this broad policy is intrinsically unhelpful in conceptualizing the liability boundary. The duty of care and the business judgment rule are not only important to corporation law inter se, but also corporation law influences the laws of other business organizations, (8) including the use of the business judgment rule. (9) Thus, the inquiry here has broad implication in the entire field of business organizations.

This Article provides a theory of the duty of care and the business judgment rule through the prism of tort theory and principles. (10) To be clear, I do not argue that a breach of fiduciary duty is a tort, (11) just the way it is not a breach of contract, notwithstanding the contractarian view of corporate governance. The thesis here is that the liability scheme of corporate boards under the doctrines of fiduciary duty and the business judgment rule can be understood through the analytics of torts. (12) Although corporate law scholars have been wary of inter-doctrinal analysis of corporation law, (13) tort principles are embedded in important doctrines of corporation law. (14) In the arena of board liability for wrongful conduct, an inter-doctrinal analysis is inevitable. (15) When corporation law states that a director should act as an "ordinarily careful and prudent" person (16) and a breach of the duty of care is defined as "gross negligence," (17) it borrows from the lexicon of torts and scholarship should squarely address, and not casually dismiss, this tension.

This Article answers the question: If there was no corporation law of fiduciary duty of care and tort law applied instead, what would the legal framework of a director's duty and standard of liability look like? (18) Few scholars have engaged in this analysis, (19) presumably because most have assumed that the application of tort law to corporate decisions would expand board liability under the general negligence standard to untenable levels. This conventional wisdom is wrong. Tort theory provides not just the lexicon of liability, but the foundational principles of the duty and liability of corporate boards.

Under a correct account of the tort analogy, the duty of care and the business judgment rule are not antipodes of a paradox, but are complementary principles governing duty and its scope. Two principles play key roles. First, an affirmative undertaking to manage the affairs of the corporation (20) not only begets a fiduciary duty of care, but it limits the scope of that duty. Under the tort doctrine of industry customs, the scope of a director's duty of care reflects the implied standard of care that would be adopted by market participants. A tort-based proposition is consistent with the prevailing contractarian theory of corporation law, and it shows that the negligence standard would not apply to the substance of business decisions. Second, theories of pure economic loss provide the foundation principles for the rule that a director's duty of care does not encompass negligently inflicted economic loss. Microeconomic analysis has shown that mistakes in market transactions often result in no social cost, thus justifying a rule of no liability. (21) At a broader political economic level, the precondition of a market economy, one based on profit and risk taking, is uncertainty and imperfect information. This broader analysis has shown that courts refrain from interfering with market outcomes through the rule of no duty. (22) These limitations of duty under tort law explain the principles of the duty of care and the business judgment rule.

This Article argues that the board's duty of care is a mischievous misnomer of preposition. This lexicon invokes the general negligence principle requiring an examination of the substance of the action when in fact tort law does not extend the scope of duty and liability that far. Tort theory limits the scope of a board's legal obligation to a duty to care for the corporation, which embodies the duty of good faith intention evinced by effort toward the care and custody of the corporation and the exercise of authority vested in a board whose members affirmatively assume the mantle of directorship. (23) The duty of care imposes an affirmative duty, and the business judgment rule defines the scope of that duty implied in the customary terms of a voluntary undertaking.

This Article theorizes the enigmatic relationship between the duty of care and the business judgment rule. The principles of torts can and do play a robust part in regulating important aspects of the internal affairs of the corporation. In the tort framework, there are several narrow theories under which directors can be held accountable: (1) indifference to caring evinced by a failure to monitor or manage the affairs of the corporation or an abdication of the mantle of responsibility; (24) (2) insufficient effort to care for the corporation evinced by substantial procedural defects in decision-making; (25) and (3) bad faith evinced by a knowing dereliction of duty. (26) These theories of board liability are well recognized, and the common thread is a breach of a director's affirmative duty to undertake care of the corporation. A corrected tort analogy provides theoretical coherence to the liability scheme. It explains corporation law's focus on demonstrable acts of care evincing good faith and benign intentions of a custodian as opposed to an examination of the substantive actions causing economic loss, and Delaware's puzzling substantive-procedural divide wherein duty of care is limited to procedural aspects of decisionmaking.

Lastly, this Article shows that there is a distinct space in corporate law for a tort-based theory of fiduciary duty, the obligation of good faith, and the liability of directors. The contractarian view of corporate law emphasizes the privateness of contracts, and it diminishes the role and power of courts in the realm of corporate governance and board liability. In contrast, the tort framework of fiduciary duty justifies a robust, albeit reserved, role of courts in regulating corporate governance through the common law development of law. When courts refrain from unreasonably interfering in corporate governance, they are expressing an important normative value of the relationship between private decisionmaking and public review.

This Article is written in four parts. Part I frames the issues by summarizing the duty of care and the business judgment rule, and then explaining the apparent failure of the "tort analogy." Part II shows the tort foundation of the duty of care and the business judgment. When principles of duty, industry customs, and pure economic loss are properly applied, a board has a duty of care arising from its affirmative undertaking of managerial power, but the scope of duty is limited by the customary understanding under a contract analysis. Part III develops a broader economic perspective. The doctrine and theory of pure economic loss in tort law explain why a board has no negligence-based duty to prevent a corporation's economic loss. Part IV discusses the larger implications of the tort foundation of duty and business judgment. It argues that courts do and should play a robust and authoritative role, albeit reserved, in regulating important aspects of the internal affairs of the corporation through continued doctrinal development of the idea of a wrong.


A. Fiduciary Duty and Business Judgment

The duty of care has been a feature of organizational law since the precursors of the modern corporation. (27) Analogous to a common obligation under tort law, "directors of a corporation in managing the corporate affairs are bound to use that amount of care which ordinarily careful and prudent men would use in similar circumstances." (28) Failure to conform to this standard implies the real possibility of liability for negligence, though findings of culpability are in fact infrequent (and impositions of personal liability even rarer (29)).

The textbook case on the duty of care is the most famous corporate law case of all: Smith v. Van Gorkom. (30) There, the board of the target company engaged in a flawed process when it approved a merger agreement within a constrained time period without adequate evaluation of the merger consideration, without reading the merger agreement, and without adequate understanding of the negotiation between the chief executive officer and the acquirer that resulted in the proposal for a takeover. (31) The court ruled that the appropriate standard of review was gross negligence. (32) It held that the board's flawed procedure met this standard. This was the first time that the Delaware Supreme Court found a set of facts constituting a breach of the duty of care in connection with the exercise of a business judgment, (33) prompting shocked reactions from the corporate bar and legal scholars. (34)

Several years after Van Gorkom, the Delaware Supreme Court again ruled in favor of liability for a breach of the duty of care in Cede & Co. v. Technicolor, Inc. (35) The facts were similar to those in Van Gorkom: the board was minimally informed; the transaction was driven almost exclusively by Technicolor's CEO; and the board rubberstamped the process. (36) The chancery court, per Chancellor William Allen, expressed "grave doubts" that the board satisfied the Van Gorkom standard. (37) The supreme court deferred to the trial court's finding of "pervasive and persuasive evidence" of a violation of the duty of care, (38) and ruled that in the face of a finding of a breach of duty of care the trial court must apply the entire fairness review to the transaction where the burden is on the defendant to prove fair dealing and fair price. (39) With respect to the business judgment rule, the court opined that the rule "operates to preclude a court from imposing itself unreasonably on the business and affairs of a corporation." (40)

In both Van Gorkom and Cede, the business judgment rule did not protect the board because there was a finding that the board breached its duty of care. The breach of duty arose from substantial procedural defects. In Delaware, the duty of care is limited by a substantive-procedural dichotomy, which was made explicit in Brehm v. Eisner (41):
 As for the plaintiffs' contention that the directors failed to
 exercise "substantive due care," we should note that such a concept
 is foreign to the business judgment rule. Courts do not measure,
 weigh or quantify directors' judgments. We do not even decide if
 they are reasonable in this context. Due care in the decisionmaking
 context is process due care only. (42)

Thus, the scope of the duty of care is limited to the process of decision-making, and not the substantive quality of the business decision. (43)

The duty of care and the business judgment rule are closely related. (44) Like the duty of care, the business judgment rule traces its roots back to the rise of the early corporations. (45) It is a judge-made rule developed through the common law process, (46) and it is based on the judicial recognition of the board's statutory authority to manage a corporation. (47) A modern formulation of the business judgment rule, as articulated in Aronson v. Lewis, (48) provides that the rule "is a presumption that in making a business decision the directors ... 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." (49)

The business judgment rule is applied if these conditions are satisfied: (1) a decision was made upon an informed decision-making process; and (2) it was made in good faith and not tainted by self-interest. (50) The first condition addresses whether the board satisfied the duty of care, and the second condition addresses the duty of loyalty. (51) Unless a plaintiff can show a breach of fiduciary duty, the business judgment rule shields directors from judicial scrutiny of the substantive decision, even if it is patently wrong.

A well-known example of the business judgment rule at work is Kamin v. American Express Co. (52) There, American Express had bought a stake in an investment bank, which subsequently declined in value. The board decided to divest, and it had two choices: sell the stake, or distribute the asset to shareholders through a special in-kind dividend. A sale would have resulted in recognizing a $25 million loss on the income statement, which would have yielded about $8 million of tax savings due to the reduction in taxable income. A distribution of shares would have avoided the loss recognition, but would have forfeited the tax advantage. The choice was between increasing accounting profit at the cost of reducing true economic value, and increasing economic value by recognizing an incurred loss under accounting rules. This is no choice at all. Since firm value is the sum of the present value of the firm's free cash flow, (53) a sale that would have reduced the accounting profit was the correct choice as a matter of finance theory.

The board made the wrong decision and issued the special dividend, though the decision-making process was informed as a matter of procedure. The board considered both options, but believed that a reduction in reported income would lower share price. This explanation is not as irrational as a coin flip, but it has no basis in generally accepted, widely known theory of valuation. Share price is not the same as intrinsic value. (54) Share price boosted by accounting profit alone does not increase the value of the firm, as evinced by the collapse of Enron. With a well-functioning capital market, the decline is the asset value would have already been incorporated into American Express's share price. (55) The board's choice was to take $8 million of cash on the table or nothing at all. Its decision to take nothing was indefensible error. (56) One would be hard pressed to find an economist or a law professor who would defend the decision in Kamin. (57)

In spite of the demonstrably wrong decision, the court properly dismissed the plaintiffs complaint per the application of the business judgment rule. (58) Since the board was reasonably informed and engaged in a proper process, care was given; the board's mistake "presents no basis for the superimposition of judicial judgment, so long as it appears that the directors have been acting in good faith." (59) Once applied, the business judgment rule precludes a substantive review of a board's action, irrespective of the correctness or the intelligence of a decision. The business judgment rule is striking in that not only does it protect risky decisions, but as courts and scholars cheerfully (and correctly) tell us it also protects foolish, awful, and egregious decisions, (60) whereas tort law would never countenance the stupid person defense. (61)

B. Critique of Two Rationales for the Business Judgment Rule

The business judgment rule has been justified on many policy grounds. As I show in Parts II and III, infra, several of these rationales are sound instrumental reasons that justify the rule, and I further show that these reasons are the policy percolations of a theory based on a tort foundation. For completeness of analysis, two frequently cited and widely supported rationales are discussed below. I conclude that these two rationales are problematic on their own terms.

One argument for the business judgment rule is the claim that courts are incompetent to review business decisions. Courts and commentators have suggested that the complexity of business is beyond the intellectual reach of courts. (62) Construed strictly, this argument is at best not a serious thought, and at worst a disingenuous assertion. It elevates the business profession to some rarefied level of incomprehensibility, and as such courts could not presume to venture a review of board decisions. (63) The truth is that many business decisions are subject to rational judicial assessment. One need not be an officer or director to understand that the world is uncertain, profit is not guaranteed, and risks must be taken. Even a child knows the risks of running a lemonade stand. In fact, courts routinely review business decisions under the entire fairness standard upon a plaintiff's rebuttal of the business judgment rule, at which point the court engages in a substantive review of the business decision and must be satisfied of its fairness. (64)

If courts are competent to understand the economics of antitrust, the etiology of diseases, the economic effects of healthcare legislation, or complex business decisionmaking in the context of assigning tort liability, they are capable of understanding and passing judgment on business decisions, complexity notwithstanding. (65) If courts need help, expert witnesses in all aspects of business management are plentiful. All of the epistemological and psychological problems associated with discovering the truth of a past occurrence are no more difficult in corporation law than in other fields of law. Despite frequent assertions, scholars have been rightfully skeptical of the argument that courts lack the technical competence to review business decisions. (66)

Another frequently cited rationale for the business judgment rule is the explanation that the standard of conduct and the standard of review diverge in corporation law. (67) The standard of conduct expressed in the duty of care is an aspirational norm providing boards guidance on how they should manage the corporation, (68) whereas the standard of review expressed in the business judgment rule is the legal rule providing courts the legal standard to assess liability. (69) In other fields of law such as tort law, the standards of conduct and review conflate to a single standard for the purpose of judicial review. (70) In corporation law, the two standards are said to diverge due to the "institutional nature of the corporation." (71) Directors frequently make decisions with incomplete information, and "on the basis of bounded rationality." (72) Merging the standard of conduct with the standard of review, it is said, would impose greater cost. (73) Thus, the explanation of divergent standards answers Robert Clark's question--"Is the duty of care simply gobbledygook, then, or a mere exhortation rather than an enforceable legal duty?" (74)--with a resounding "yes." This idea has been influential and endorsed by prominent scholars and judges. (75) It has been incorporated into the Model Business Corporation Act. (76)

Despite its prominence and the acceptance of the theory by prominent portions of the academic community, the idea of divergent standards is puzzling from the standpoint of explaining the role of courts and the concept of liability for wrongs. (77) No one can deny that the fundamental role of courts is to apply rules of law, determine wrongs, and assign liability. Yet, the theory of divergent standards says that courts are ultimately cheerleaders for the aspiration of "best practices." Given that many academics, think tanks, business roundtables, and pundits contribute to this enterprise, it is unclear what additional value is to be gained from the elocution of courts through essentially advisory opinions. The ultimate source of the expressive value of judicial opinions is derived solely from the power to assess liability (i.e., a consultant in a black robe is still just a consultant). In other fields of law in which disputes are adjudicated with the outcome at stake, courts are special precisely because they can prescribe and enforce laws. This is not to say that, generally speaking, norms are unimportant to corporate governance, (78) and courts may even have a role in opining per dicta and appropriate tangents on the ideals of corporate governance and business management, (79) but the term "fiduciary duty" has special legal meaning, which is a legally binding obligation. The determination of liability for breach of duty is a legal question. (80) The exhortation that directors ought to act reasonably is unhelpful, not because it is wrong, but because it is trite. How else should directors behave? Do they really need judges to remind them that they ought to behave reasonably under the circumstances? If the average motorist of ordinary intelligence, even without the benefit of legal advice, knows that she must act reasonably on the road, one suspects that the average director, typically a highly accomplished and high standing member of our society, would know society's expectation as well. The dichotomy of standards essentially says that a director's "fiduciary duty" is not a legal obligation backed by the force of law. It trivializes the role of courts and laws, and thus attempts to justify academically their excision from decisional matters of corporate governance.

Liability for a wrong should ultimately matter, a point amply demonstrated by the shocked reaction to the finding of liability in Smith v. Van Gorkom. (81) A mountain of papers on aspiration does not hold a candle to a single-page order of judgment. Directors do not need aspirational sermons on the boardroom mount, (82) when we consider that it comes with the price tag of Wall Street investment banks and law firms who must divine what the sermons actually mean, a significant cost attached to every meaningful transaction. Directors are typically highly accomplished, ambitious, sophisticated, and well advised; they know full well that they ought to act reasonably without reminder from the pages of state law reporters as interpreted by expensive legal advisers; they also know that liability, not aspirational norm, ultimately determines the legality of their decision. It is not clear why directors need a special legal framework, requiring expert reading of the tea leaves of Delaware jurisprudence, merely to inform them--in the most convoluted way that corporation law is expressed no less--that in essence they ought to act reasonably under the circumstances. I do not deny that a reminder of their duties in the boardroom may have tangible salutary value, but there is unquestionably a cost-benefit consideration attached to the provision of legal and financial opinions when the preaching of aspirational norms are made to be a necessary transaction cost. (83) If we are left only with an aspirational norm, the whole thing strikes of kabuki theater. This indulgence of judicial ceremony comes at the heavy cost of legal uncertainty and its progeny of derivative suits. (84) And, if the duty of care is simply an aspirational norm, one wonders whether the psychological effect of having a friendly reminder of the aspiration is really worth it, or whether the Sunday boardroom can do without the sermons.

The explanation of divergent standards is a strained and ultimately unconvincing justification for the narrow scope of the duty of care and the excision of courts from the substantive decisionmaking in corporate governance. These ends may well be justified as a matter of policy and theory, and in this respect the explanation of divergent standards serves the limited function of placing descriptive tags for the outcomes that the rules of law correctly achieve in most cases. However, the explanation raises the question without really answering it: Why does the duty of care beget an obligation while the business judgment rule seems to deny it? The answer--exceptionalism of corporate law--is not very satisfying or convincing. The divergence of the standards of conduct and review is not seen in most other areas such as torts, criminal law, environmental law, etc., all of which involve assessing individual decisions of great significance. (85) And, the core disjunction in the concept of board liability persists: the excusal of errors and bad judgments is something we do not see in other areas of law. As theory goes, the explanation creates a convenient illusion of plausibility supporting the consensus intuition that the systematic liability outcomes seen in corporation law are correct.

C. The Flawed Tort Analogy

The relationship between corporation law and tort law has been distant. Commentators have argued that tort law and corporation law are different because the goal of torts is loss spreading, whereas corporation law seeks to incentivize risk taking. (86) The tort system, it is argued, shifts loss from specific victims to a larger pool of risk-bearers through insurance and tort liability. (87) In the corporate setting, such robust liability scheme would concentrate risk by shifting loss from diversified shareholders to directors. These points are well taken, but they are incomplete. It is undercut by the existence of a substantial Directors & Officers insurance market. Furthermore, the argument is based on an incomplete conception of the tort system and it does not present a consensus view of the raison d'etre of the tort system. (88)

Another important aspect of tort law is deterrence, (89) which is the prevailing law and economics perspective. (90) The most prominent example of this thought is the Hand Formula, which conceptualizes negligence as a cost-benefit analysis of accident and precautionary costs for the purpose of achieving optimal deterrence and social cost. (91) If corporation law imposes liability on directors to deter bad business decisions, the laws of torts and corporations should converge. However, prominent corporate law jurists have referenced a director's care to that of a driver or doctor, and have rejected the analogy as "misleading" (92) and "not well-suited to judicial review." (93) The plainest statement of the underlying policy is found in In re Caremark International Inc. Derivative Litigation (94): "It is doubtful that we want business men and women to be encouraged to make decisions as hypothetical" persons of ordinary judgment and prudence might." (95) Scholars have also analogized a director's negligence to common torts, and have dismissed tort law as irrelevant. (96)

At first blush, this consensus view seems right. The duty of care is dressed in the language of torts, (97) and yet directors are not held to a negligence standard for business losses. Courts and scholars correctly argue that directors must not be held liable for negligent, stupid, careless, unlucky, or egregious decisions in spite of any visceral impulse to blame and levy liability for a bad outcome. (98) Of course, such a concept is antithetical to tort law. Since tort law finds liability for negligence and corporation law does not, inter-doctrinal divergence seems correct on the surface. But upon a deeper analysis this argument is flawed.

The tort analogy fails because scholars and jurists have focused on the difference in judicial outcomes, and have wrongly assumed that the application of tort law would require a substantive review of business decisions under the negligence standard. However, the divergence of outcomes is not as meaningful, and the better inquiry focuses on the reasons why outcomes diverge, which is a search for a common analytical framework under which courts formulate duty and its limitation.

We start with the basic observation that the negligent doctor should be liable to his patient, or the negligent driver to the pedestrian, and so forth in the infinite ways negligence can result in liability. However, a cursory review of tort law also shows that liability can be cut off even when there has been a "wrong" or bad conduct in some ordinary, visceral sense. For example, when a railway employee negligently pushed a customer into a train thereby dislodging hidden explosives, he had no duty to a passenger standing in the distance who was injured in the subsequent explosion. (99) When a water company negligently failed to provide sufficient water to a city with which it had a contract to provide water, it had no duty to a city resident whose warehouse burned down due to inadequate water pressure. (100) When an accounting firm negligently certified the solvency of an insolvent client's balance sheet, it had no duty to a creditor who relied on the certification and made a bad loan to the client. (101) When a dry dock negligently damaged the propeller of a ship, thereby preventing the ship from carrying out its charter, it had no duty to the charterer of the ship for lost profit. (102) When a negligent driver caused a traffic delay in the Brooklyn Battery Tunnel, he had not committed a wrong to the investment banker who lost out on a million dollar deal resulting from the delay. (103) In each of these cases, the defendants could be said to have erred in conforming their behavior to some ideal standard, but in each case the court ruled that there was no legal wrong to the one who was injured. The analogy of a director's decision to a doctor's negligence, as frequently asserted in corporate law scholarship, misconceives the analysis. (104) A legal wrong is a flexible concept.

The duty of care in corporation law establishes the basic idea that a director owes a fiduciary duty to the corporation--a fairly uncontroversial point in the abstract. The controversy surrounds defining the scope of that duty and its theoretical justification. "Studies of corporate law have not inquired into the definition of a reasonable director because the prevailing wisdom has been that the law calls for no such inquiry." (105) Corporate law is exceptional, the argument goes, because if it is not, the scope of duty would encompass negligence for making substantive business decisions. This fear is misplaced.


What is the duty of care? What obligation does it impose? What are its limits? These questions can be answered in a theoretically coherent way, consistent with the policy prescriptions that accompany the business judgment rule, through the analytics of tort law.

In tort law, since one's actions can potentially harm many victims, it is said that a person owes a "duty to the world." (106) But strictly speaking, duty is not so expansive. (107) "Negligence, like risk, is thus a term of relation." (108) In most ordinary situations, the imposition of a foreseeable risk to a cognizable interest of another creates a sufficient relational nexus for duty to arise. (109) The requirement of a sufficient connection between actors independent of factual causation in a fortuitous event explains why there is no general duty to act affirmatively on behalf of someone's welfare absent some preexisting relationship or special circumstance. (110) When one undertakes such care (111) or stands in a special relationship, (112) the law imposes a duty of care where there would otherwise have been none.

The modern public corporation is characterized by a separation of ownership and control in the corporation, (113) and this requires a board of directors to assume the mantle of managerial power on behalf of the corporation. (114) This affirmative undertaking and special relationship beget a director's duty of care. One need not belabor the point that directors owe a fiduciary duty of care to the corporation. (115) The primary instrumental function of the duty of care is to say that there is a legal duty as a matter of law, which seems readily apparent but is nevertheless a significant proposition requiring an affirmative statement of law. (116) However, the existence of a duty does not answer the more difficult question of the scope of that duty. Justice Frankfurter's famous statement on fiduciary duty is apropos:
 But to say that a man is a fiduciary only begins the analysis; it
 gives direction to further inquiry. To whom is he a fiduciary? What
 obligations does he owe as fiduciary? In what respect has he failed
 to discharge these obligations? And what are the consequences of
 his deviation from duty? (117)

The existence of a duty invokes the abstraction that a director must act reasonably, but it does not give substance to what "reasonable" means in the context of the voluntary association between the director and the corporation. Tort law teaches us that "[p]roof of negligence in the air, so to speak, will not do," (118) and likewise corporation law must give substance to the meaning of duty, negligence, and wrong. (119)

The nature of a director's undertaking of care invokes two principles of tort law that govern the scope of duty: (1) duty arising from affirmative undertaking; and (2) industry custom as to the standard of care.

A. Duty from Undertaking

Since the fiduciary duty of care arises out of a voluntary principal-agent relationship between the corporation and the director, (120) the scope of that duty is defined by the nature of affirmative undertaking. This view is consistent with the contractarian perspective that corporation law provides implied contractual terms of the relationship among factors of production. (121) Insofar as fiduciary duty is concerned, the contractarian analysis ultimately serves the tort function of defining the boundary of liability. The contract analogy is a convenient metaphor expressing the simple fact that, in an era in which involuntary servitude has long been eradicated, business enterprise is conducted through voluntary relationships among economic actors seeking gain. Moving forward from this obvious starting point, the tort analogy provides the legal framework defining the liability scheme. With that said, there is no clear analytic division between contract and tort analyses. Many tort problems of assigning liability can be analyzed through a contract prism. (122)

The principal term in the contract between the corporation and its directors is an undertaking of care. The duty to care is not met merely by a demonstration of scienter alone. A good-hearted director of empty deeds is not privileged in the eyes of the law. The duty to care requires affirmative acts of care. In concrete terms, this means that directors must act in good faith toward exercising corporate powers in furtherance of the corporate interest. If so, we expect to see judicial rulings that, notwithstanding the business judgment rule, a breach of the duty of care may result from dereliction of duty, failure to exercise responsibility, and lack of good faith effort toward the care of the corporation. (123) Such a line of cases has long existed.

In Briggs v. Spaulding, (124) a bank went insolvent as a result of misconduct of its officers and employees, and the plaintiffs sued the directors on the theory that they failed to adequately supervise and monitor the bank. (125) The court held:
 They are entitled under the law to commit the banking business, as
 defined, to their duly-authorized officers, but this does not
 absolve them from the duty of reasonable supervision, nor ought
 they to be permitted to be shielded from liability because of want
 of knowledge of wrong-doing, if that ignorance is the result of
 gross inattention.... (126)

Thus the duty "includes something more than officiating as figureheads." (127)

In Barnes v. Andrews, (128) a bankruptcy receiver sued a director for the failure of a corporation, arguing on the theory that the director was guilty of neglect, omission, and inadequate oversight. (129) Interestingly, the cause of action was brought under tort law on the theory of omission when there is a duty to act. (130) The trial judge, Learned Hand, found that the defendant failed to keep informed and was a "figurehead," and liability could be imposed for a failure of duty. (131) However, the court ruled that the receiver failed to show causation between the director's negligence and the corporation's financial injury. (132)

In Francis v. United Jersey Bank, (133) a director failed to monitor the company, abdicated all responsibility for oversight, including a failure to attend board meetings, and was unqualified to perform the tasks of a director because she did not understand the business at a basic level. Reasoning that "all directors are responsible for managing the business and affairs of the corporation," the court imposed liability against the neglectful director, and made clear that the key sin was her failure to undertake affirmative care of the corporation. (134)

In Graham v. Allis-Chalmers Manufacturing Co., the plaintiff argued that the directors failed to take action designed to uncover and prevent violations of federal antitrust laws. (135) The Delaware Supreme Court stated that "absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists." (136) However, the court made clear that if a director "has refused or neglected cavalierly to perform his duty as a director, or has ignored either willfully or through inattention obvious danger signs of employee wrongdoing, the law will cast the burden of liability upon him." (137)

In In re Caremark International Inc. Derivative Litigation, Chancellor William Allen ruled that liability for failure to monitor occurs only upon "a sustained or systematic failure of the board to exercise oversight--such as an utter failure to attempt to assure a reasonable information and reporting system [exists]...." (138) This standard is consistent with the idea that a director must affirmatively care for the corporation, but there is no obligation to provide some objective, negligence-based level of care. Findings of liability are rare because an uncaring director is functionally the equivalent of a director who has abdicated her duty to undertake care within the social and institutional setting of a bard and fellow peers. This explains why a failure of the duty to monitor is "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment." (139)

In the Disney litigation, the Delaware Chancery Court defined bad faith as the intentional dereliction of duty: "Deliberate indifference and inaction in the face of a duty to act is, in my mind, conduct that is clearly disloyal to the corporation. It is the epitome of faithless conduct." (140) A failure of good faith may be shown "where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties." (141) On appeal, the Delaware Supreme Court endorsed these standards. (142)

In Stone v. Ritter, the Delaware Supreme Court endorsed the Caremark standard of "sustained or systematic failure" of oversight, but categorized this type of failure as a duty of loyalty violation. (143) Echoing the language in its Disney opinion, the court reiterated: "Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith." (144) Thus, duty is framed as a conscious disregard of one's affirmative responsibilities. (145)

This line of cases shows that the duty of care is not meaningless verbiage, which is not to say that liability is or should be commonplace. When the scope of duty is viewed as a duty of affirmative undertaking, there is the real possibility of liability. (146) Liability is predicated on a failure to undertake the care of the corporation, and this is consistent with the rule that the business judgment rule protects directors only when they have taken action by exercising judgment. (147) Liability is few and infrequent not because most boards always make correct substantive decisions, but because we do not expect to see a breach of the fundamental obligation agreed upon between a corporation and a board through systematic failure of the cohort of directors forming an institution that is legally obligated to care for the corporation, though sometimes this happens or is adjudged to have occurred. (148)

B. Custom as the Scope of Duty

In defining the scope of duty, courts have distinguished between a failure to undertake affirmative care and a failure to undertake sufficient care. The question is" Why isn't sufficient care a fundamental obligation of the duty of care between the corporation and the board? The tort principle of customs in establishing the standard of care informs the answer.

The tort doctrine of customs provides the concrete analytical framework of the rules of law governing duty and liability. When parties are constituents of a market, many tort problems of allocating losses can be analyzed as a contract problem concerting industry customs and standards. Samuel Arsht has hinted a connection between industry customs under tort law and a director's scope of duty under corporate law: "[T]he primary function of the business judgment rule may be simply to accord to directors the same necessary protection that professionals enjoy under Anglo-American tort law if sued for malpractice." (149) This insight requires further development.

With respect to customs of an industry or profession, courts determine the scope of one's duty under the principle set forth in Learned Hand's opinion in The T.J. Hooper. (150) There, Hand famously advanced this proposition: "Courts must in the end say what is required; there are precautions so imperative that even their universal disregard will not excuse their omission." (151) However, the principle in T.J. Hooper is modified somewhat when contractual constituents are seen as fixing the standard of care with respect to market transactions amongst themselves. For example, in the realm of professional malpractice the implied and express terms of the industry standard of care is often dispositive. (152)

Judge Richard Posner's opinion in Rodi Yachts, Inc. v. National Marine, Inc. (153) illustrates a contractarian analysis of customary industry standards in accident law. There, a barge owned by A cast adrift when it slipped its moorings at a dock operated by B, and collided with another dock and two boats, causing damages to P. (154) The defendants A and B conceded that at least one of them was liable to P. (155) The issue concerned the allocation of liability between A and B. Posner begins the analysis with this emphasis: "Although in form a tort case, in economic reality this is a contract case." (156) The principle set forth in The T.J. Hooper "is obviously sound when one is speaking of the duty of care to persons with whom the industry whose customary standard of care is at issue has no actual or potential contractual relation." (157) Only through tort liability can the costs of injury be made a cost to industry, thus deterring socially undesirable activities. (158) But when the parties are bound together in a market relationship, "the market itself fixes a standard of care that reflects the preferences of potential victims as well as of potential injurers and then the principal function of tort law, it could be argued, is to protect customers' reasonable expectations that the firms with which they deal are complying with the standard of care customary in the industry, that is, the standard fixed by the market." (159) While courts ultimately set the standard of care, they should defer to the implied expectations of market participants in determining the loss allocation amongst them, i.e., the scope of liability. (160)

The doctrine and principle of industry customs provide essential insights into corporation law's liability scheme. Since the basis of a director's duty of care is the assent of the agent to serve, the scope of a director's duty of care should be based on an implied contract analysis. (161) The implied contractual terms on the scope of duty are fairly clear, and are seen in the many policy justifications for the business judgment rule. One such policy reason is that rational directors would surely not assume the risk of liability for mistakes, whether determined to be negligent or not. (162) Directors are not compensated to assume enormous risk; they are not an insurer of the corporation's economic value. They would be poor substitutes for more efficient means to insure against the exposure to any given stock. Shareholders can mitigate exposure to the risk of any given stock through hedging or diversification. Since an investment in the market cannot be guaranteed, which is to say that equity investments are never risk-free, directors would not agree to provide downside protection to the corporation or shareholders. Any attempt to impose that term of agency would result in no undertaking at all. As Judge Ralph Winter has explained, "the business judgment rule merely recognizes a certain voluntariness in undertaking the risk of bad business decisions." (163) This understanding is a basic condition of a director's service. (164) The corporation and shareholders must assume the risk of economic loss, lest directors will not assume the obligation of care.

The implied understanding does not go so far as producing a liability-free scope of duty because the bargaining for terms is not one-sided. Aside from the irrationality of the oxymoron, any attempt by directors to seek a "no liability" term in hypothetical bargaining would result in a rejection of the undertaking by the corporation. (165) Directors must bond their agreement to serve with some enforceable obligation.

The nature of a director's obligation is obfuscated by a mischievous misnomer of preposition. The duty of care is descriptively better stated as a duty to care. (166) The ordinary use of "duty of care" as a term of legal art is shorthand for the duty to comply with some substantive level of prescriptive care, independent of good faith scienter, and attempt to comply with the prescription. This concept is seen in tort law's rejection of the stupid person defense. (167) The term is routinely used without much thought to its semantic construction because in most tort cases it conveys the right idea of focusing on the quality of care. But it does mischief when its shorthand definition clouds the nature of the obligation. The prepositional correction "duty to care" is more than a superficial semantic change. It emphasizes intent invoking a quality of good faith undertaking. This distinction goes to the heart of Delaware's substantive-procedural dichotomy. In an arms-length bargaining with the corporation for the terms of service, rational directors would agree that their obligation is fundamentally custodial in nature. The directors have taken an affirmative obligation to take custody of the corporation, which is the core of the separation of ownership and control, and consistent with this obligation they have undertaken the duty to care for the corporation.

At the core of this duty is a director's good faith and honest intention as evinced by affirmative deeds consistent with their heart. In short, directors have a duty to care for the corporation, which manifests in the affirmative engagement of activities consistent with good faith intention to care--a duty to exercise business judgment, to monitor, and generally to assume the mantle of authority and responsibility. (168)

This understanding is consistent with the business judgment rule. This passage nicely summarizes the concept:
 [H]ow does the operation of the ... "business judgment rule" tie in
 with the concept of negligence? There is no conflict between the
 two. When courts say that they will not interfere in matters of
 business judgment, it is presupposed that judgment--reasonable
 diligence--has in fact been exercised. A durector [sic] cannot
 close his eyes to what is going on about him in the conduct of the
 business of the corporation and have it said that he is exercising
 business judgment. Courts have properly decided to give directors a
 wide latitude in the management of the affairs of a corporation
 provided always that judgment, and that means an honest, unbiased
 judgment, is reasonably exercised by them. (169)

In other words, the failure to undertake affirmative, good faith care of the corporation defines the meaning of "negligence" in the context of corporation law. The modern formulation of the business judgment rule incorporates the definition of negligence when it presumes that in making a business decision a director "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." (170) A shareholder must overturn this presumption, which is to say that he must prove a breach of duty, by presenting particular evidence to the contrary on these matters: a business action was taken; the decision was not informed; or it was not in good faith. Thus, the business judgment rule gives substance to the question: What does it mean when we say that a director has been negligent and failed to meet the standard of care?

The critical misunderstanding has been a conflation of an "error" with a "wrong," and the resulting strained efforts to rationalize two conflicting visceral senses: on the one hand the correctness of the case outcomes, and on the other hand the felt need for accountability for mistakes. This tension is also seen in tort law. In torts, negligence is always an error, but an error is not always a civil wrong. The applicable principle was famously set forth by Cardozo in Palsgraf. The scope of duty cannot be discerned by reference to an isolated examination of the quality of the conduct for it "is built upon the shifting meanings of such words as 'wrong' and 'wrongful,' and shares their instability." (171) While a director could be said to have committed a "mistake" or an "error" upon a demonstrably poor decision, (172) the legal concept of duty does not support such a definition. "Negligence in the abstract, apart from things related, is surely not a tort, if indeed it is understandable at all." (173) One of the earliest applications of the business judgment rule, seen in Percy v. Millaudon, recognized this tort-based principle of duty:
 The only correct mode of ascertaining whether there was fault in an
 agent, is by enquiring whether he neglected the exercise of that
 diligence and care, which was necessary to a successful discharge
 of the duty imposed on him. That diligence and care must again
 depend on the nature of the undertaking. There are many things
 which, in their management, require the utmost diligence, and most
 scrupulous attention, and where the agent who undertakes their
 direction, renders himself responsible for the slightest neglect.
 There are others, where the duties imposed are presumed to call for
 nothing more than ordinary care and attention, and where the
 exercise of that degree of care suffices.

 The directors of banks from the nature of their undertaking, fall
 within the class last mentioned, while in the discharge of their
 ordinary duties.... In relation to these officers, the duties of
 directors are those of controul, and the neglect which would render
 them responsible for not exercising that controul properly, must
 depend on circumstances, and in a great measure be tested by the
 facts of the case. If nothing has come to their knowledge, to
 awaken suspicion of the fidelity of the president and cashier,
 ordinary attention to the affairs of the institution is sufficient.
 If they become acquainted with any fact calculated to put prudent
 men on their guard, a degree of care commensurate with the evil to
 be avoided is required, and a want of that care certainly makes
 them responsible. (174)

The point in Percy illustrates Cardozo's concept that wrongs cannot be discerned in the abstract, but that the determination depends on "the nature of the undertaking." (175) Tort law readily provides the core principle that certain conduct, like firing a gun randomly, is wrong in some circumstances (e.g., in a crowded city) and not wrong in other circumstances (e.g., on a deserted island).

In the corporation law context, market participants set the implied terms of care. The failure to conform one's action to a reasonable person has shifting meanings. The inquiry in tort cases focuses on the quality of the particular decision and the outcome as the measure of reasonableness, and thus an error in judgment results in a legal wrong. The inquiry in corporation law focuses on the demonstrable effort and the quality of decisionmaking as the measure of reasonableness, and thus an error in judgment is not a wrong. The answer to the question what would a reasonable director do?--does not lie in a review of the substance of the business decisions, (176) but instead on the substance of good faith and effort made by the custodians toward the care of the corporation.
COPYRIGHT 2013 University of Notre Dame Law School
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2013 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:Introduction through II. Duty of Care and Affirmative Undertaking, p. 1139-1171
Author:Rhee, Robert J.
Publication:Notre Dame Law Review
Date:Feb 1, 2013
Previous Article:Death of paradox: the killer logic beneath the standards of proof.
Next Article:The tort foundation of duty of care and business judgment.

Terms of use | Privacy policy | Copyright © 2019 Farlex, Inc. | Feedback | For webmasters