Wrongful Omissions by Corporate Directors: Stone v. Ritter and Adapting the Process Model of the Delaware Business Judgment Rule

Other Articles WRONGFUL OMISSIONS BY CORPORATE DIRECTORS: STONE V. RITTER AND ADAPTING THE PROCESS MODEL OF THE DELAWARE BUSINESS JUDGMENT RULE Robert T. Miller* When should corporate directors be liable to shareholders for omitting to take a corporate action?1 The question usually arises when subordinate corporate employees have engaged in serious wrongdoing, either looting the corporation or breaking the law and subjecting the corporation to liability, and the directors have not detected and stopped the wrongdoing.' Conceivably, the question could also arise if a shareholder alleged that directors wrongfully failed to have the corporation exploit a particularly lucrative business opportunity. In either case, the shareholder's claim is * Assistant Professor of Law, Villanova University School of Law. I thank Jennifer L. Miller, Colleen Baker, Richard A. Booth, Michael Carroll, Ronald Colombo, Grace H. Consiglio, Jonathan Frappier, John Gotanda, Shannon McKinley, Joan G. Miller, Mark Movsesian, John Murphy, Jennifer O'Hare, Mary Angelita Ruiz, Mark A. Sargent and Elizabeth P. Stedman, as well as the participants at workshops at Hofstra University School of Law, University of Cincinnati School of Law, and Loyola University/Chicago School of Law, for helpful comments and discussion about the ideas presented in this article. 1. See generally, J.F. Rydstrom, Liability of Corporate Directorsfor Negligence in Permitting Mismanagement or Defalcations by Officers or Employees, 25 A.L.R.3d 941 (1969). 2. E.g., Stone v. Ritter, 911 A.2d 362 (Del. 2006) (addressing suit by shareholder seeking to hold directors of bank liable for failure to detect and prevent employees of bank from violating federal Bank Secrecy Act); In re Caremark Int'l Inc. Deriv. Litig., 698 A.2d 959 (Del. 1996) (assessing the claim of a shareholder seeking to hold directors liable for not detecting and stopping employees from entering contracts that violated federal Medicaid laws); ATR-Kim Eng Fin. Corp. v. Araneta, No. 489-N, 2006 Del. Ch. LEXIS 215 (Del. Ch. Dec. 21, 2006) (finding corporate directors liable for failing to detect and prevent controlling shareholder from transferring substantially all corporate assets to members of his own family for no consideration); Francis v. United Jersey Bank, 432 A.2d 814 (N.J. 1981) (holding a director liable for failing to detect and stop officers from converting funds held in trust by corporation). U. PA. JOURNAL OF BUSINESS AND EMPLOYMENT LAW [Vol. 10:4 912 that directors should be liable for their mere omissions-not for considering an action and then deciding not to act, but for failing even to consider acting at all. Perhaps unsurprisingly, plaintiffs have found such cases exceedingly difficult to win. Indeed, in Stone v. Ritter, the Delaware Supreme Court quoted Chancellor Allen as saying that such claims represent "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."3 But if the cases have proved difficult for plaintiffs, they have also proved difficult for courts, for courts have found it very hard to articulate a legal standard to govern such cases. In one sense, the question of when directors should be liable for their mere omissions admits of a deceptively simple answer: wrongful omissions should be treated no worse and no better than wrongful decisions deliberately undertaken. Put another way, the standard for wrongfulness for omissions should be the same as the standard of wrongfulness for deliberate decisions. Such a view seems sensible because there is no obvious reason to treat wrongful omissions more or less harshly than wrongful decisions. Moreover, the essence of the claim is-in some form or other-negligence, 4 and the standard economic analysis of negligence does not distinguish between active and passive conduct. Whether active or passive in a causal sense, a party is negligent in the economic interpretation of negligence if the party could have modified its conduct at a cost less than the expected cost of the accident.' It seems, therefore, that corporate law similarly ought to make no distinction between directors who make a deliberate decision harmful to the corporation and directors who fail to act when they should have in order to prevent harm to the corporation. Asking about the liability of directors to their corporation naturally brings us to the business judgment rule. The business judgment rule, as developed in Delaware, however, makes it impossible to treat wrongful omissions by directors on par with their wrongful decisions. The reason is that, generally speaking, the Delaware rule does not apply a standard to evaluate the substance of decisions by corporate directors; it inquires, rather, into the process of directorial decision-making. As Chancellor 3. Stone, 911 A.2d at 372 (quoting Caremark, 698 A.2d at 967). 4. But see FRANK H. EASTERBROOK & DANIEL FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 93 (1991) (contrasting courts' usual approach in negligence cases with their application of the business judgment rule and stating that in such cases "that there is a specially deferential approach."); id. at 103 (describing duty of care cases under business judgment rule as involving "detect[ing] negligence"). 5. Similarly, when two parties are involved in an accident, what matters from an economic point of view is not which party was active and which passive in a colloquial sense, but which party could modify its conduct at a lower cost-that is, which party was the cheaper cost avoider. E.g., RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 51 (7th ed. 2007). 2008] WRONGFUL OMISSIONS BY CORPORATE DIRECTORS 913 Allen put it in a famous case related to wrongful omissions by directors, the court's review of a board decision under the business judgment rule is not "determined by reference to the content of the board's decision that leads to a corporate loss" but by "the good faith or rationality of the process employed" in making the decision.6 In particular, the court asks whether the directors were fully informed, disinterested and independent; and, if they were, whether at the conclusion of their deliberations they honestly believed that the decision they were making was in the best interest of the corporation, understanding such interest as being the maximization of shareholder value. If fully informed, disinterested and independent directors honestly thought their decision was in the best interests of the company, then the court will limit its substantive review of the challenged decision to the issue of whether the decision can be attributed to any rational business purpose-a standard so easily satisfied in practice that directors are virtually never found to have violated it.7 In short, with this limited exception concerning a rational business purpose, the Delaware business judgment rule is concerned with process only. Hence, in the case of mere omissions-cases where (...truncated)