Judgment Calls

Recent shareholder suits may be opening cracks in the protection afforded by the business-judgment rule.

The Oracle decision represents a “seismic shift,” says Beth Boland, a partner at the Boston office of law firm Bingham McCutchen LLP. Why? Because it indicates the Delaware court’s willingness “to look beyond quantifiable measures to go into soft issues—business connections, social relationships—in determining independence,” she says. “They have veered away from saying, ‘We’re going to define independence as a bright-line, dollar calculation.’”

Since neither case has come to trial yet, it’s premature to predict any precedent-setting changes to the limits of the business-judgment rule. But one thing is clear, notes Elson: “Board process and independence are going to face a tougher review than they would have a few years ago.”

“Evolving Expectations”

If the courts are indeed more willing to hold boards accountable on matters they previously would have passed over, likely explanations aren’t hard to find. Elson and others point to the recent spate of corporate scandals and the consequent public expectations for higher ethical standards. “The judges are creatures of the society in which they live,” comments Boland. “To believe that the interpretations of legal standards don’t reflect cultural norms is to put one’s head in the sand.”

Others believe that state courts are concerned that the Sarbanes-Oxley Act of 2002 is just the first federal incursion into corporate law, territory usually overseen by the states. State courts, the thinking goes, must be perceived as being tough on corporate misdeeds or risk further incursions. Some observers say these pressures are causing the courts to become increasingly pro-shareholder, pointing to a string of rulings in the Delaware Supreme and Chancery courts in the past year that reversed pro-board lower-court rulings.

Not surprisingly, judges deny they have become any more or less biased toward shareholder interests. E. Norman Veasey, chief justice of the Delaware Supreme Court, argues that the Disney case involved a simple application of existing case law, and that no new precedents were set. The business-judgment rule is “alive and well,” he says. That said, Veasey concedes that board actions are now subject to review based on “evolving expectations.”

“What is evolving is…the attention paid to the process used by directors, and the issue of good faith,” says Veasey. He points out that the concept of good faith has changed dramatically in the past 40 years. “Boards need to know they’re not living in 1963 anymore.”

Today, Veasey adds, judicial expectations of board processes, independence, and good faith could also be judged “against a backdrop of relevant Sarbanes-Oxley [statutes], SEC rules, and SRO [self-regulatory organization] requirements, even though there may be no express right of private action in the federal legislation.” In other words, a given board could be evaluated by a judge based on the expectations set by these new laws and requirements, even though shareholders may not be able to sue companies for breaking those laws and requirements.

Radin of Weil, Gotshal agrees with Veasey’s characterization of the perceived shift. “These judges are applying the same judicial rules regarding the business-judgment rule, but they’re applying these rules in light of today’s norms,” he says. “When you ask, ‘What’s good faith?’ you don’t just look at it in a vacuum.”

Black and Browne

There are signs that shareholders are taking notice that the business-judgment rule is more permeable than before. In December, Cardinal Value Equity Partners, a hedge fund and a major shareholder of Hollinger International, filed a lawsuit accusing the company’s board of lax supervision, lack of due process, and a lack of independence in approving deals and payments requested by former CEO Conrad Black for himself and other company executives.

Black resigned as CEO in November 2003 after an investigation by a special committee of the board turned up more than $300 million in management fees and noncompete payments to him, other companies controlled by him, and other Hollinger executives. About $275 million of the payments had been approved by the board. The investigation was instigated by Christopher Browne, managing director of investment-management firm Tweedy, Browne Co. in New York, which holds 18 percent of Hollinger shares. Tweedy, Browne has not yet filed a lawsuit; however, the Cardinal Value Equity Partners suit relies heavily on information uncovered in the investigation instigated by Browne.

“The Disney case had a direct effect on our decision to actively pursue this case,” says Browne. “The courts are saying [boards] can’t just rubber-stamp things and say, ‘We can do this—we have the protection of the business-judgment rule.’”

Kris Frieswick is a senior writer at CFO.

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